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Flight of Icarus

Leveraged 30 times to economic output, the whole financial world resembles an over-geared investment bank...

MANY PEOPLE know the fable of the flight and fall of Icarus in Greek mythology, writes Toby Birch of Birch Assets Limited in Guernsey.

Carried away by the freedom of his wax-bound wings, the feckless youth ignored his father's wisdom – whose message for moderation was twofold:

  • Don't fly too high or the sun will melt the wax;
  • Don't swoop too low or the sea will soak your feathers.

Like the ill-fated Icarus, the global economy has been elevated to levels neither sustainable nor desirable. The high water mark of 2008 should therefore be looked on as a layer of scum left behind after a disastrous flood; one that should induce loathing, not longing.

Yet we continue to label the ascent of the Greenspan era as 'good' and the current times as 'bad'. It is therefore understandable that so few people can comprehend the big picture; that this downturn is a blessing in disguise which can only be appreciated many years hence.

The great sickness of the last century has been the private creation of false money in the form of bank credit. Its initial symptoms of rosy-cheeked prosperity led to ashen-faced penury. Current dogma now demands that growth must resume at any price, no matter how much debt is dumped on future generations – the 'solution' of the G20 meeting in London which will prove to be the tipping point, I believe, toward Depression.

'Legacies not Liabilities' should instead be the mantra. There is a corporate and government imperative to intervene and 'do something', but asset prices should be left to find a floor and establish a new, much lower equilibrium; the sooner the better.

Attempting to stave off the inevitable will worsen the outcome in direct proportion to the time spent in pseudo-stimulation mode. The wholesale dilution of our money will soon become clear when bond yields spike and currencies plummet relative to real assets like gold and commodities. Sadly, Anglo-Saxon governments continue to be advised by apparatchiks of a failed financial system who believe that bailing out banks is pre-requisite for saving the economy. Like quack-doctors of old, financiers have come to believe their own bogus diagnosis that further debt creation is just the tonic. Applying more leeches is not the cure, but the cause of our economic anaemia.

Humans carry a built-in design flaw which extrapolates current trends ad infinitum. So caught up in the consensus, market analysts could not comprehend that corporate earnings were generated from cosmetic credit creation and were a bubble in their own right. The delicious irony was that the very measure of value in the form of a price/earnings ratio was a falsehood. It was not like 1929 or 2000 (where indices obviously overshot earnings) but one where earnings instead pushed up equity prices from below. The denominator became the dark destroyer whose current deflation drags down equities, and will continue to do so for many months to come.

The talk of 'green shoots' is being dished up by the same people who a year ago refuted any suggestion of a recession. Their risk-weighted-probability models couldn't see a crash coming and should not be given credence for calling the bottom. Given that there were 7 bear market rallies in the Great Depression, the recent rally should be used to liquidate rather than accumulate. Because the coup de grâce from derivatives has yet to unfold and the numbers do not lie.

Global GDP of $45 trillion supports roughly $550 trillion of listed credit derivatives and $850 trillion of over-the-counter (OTC) derivatives. This ratio in excess of 30 times means that the world has come to resemble an investment bank.

As with extrapolation, it is also human nature to resuscitate the familiar, even when it has broken beyond repair. The unfamiliar is always fearful, so governments wish to help. The public need assistance, but banks sit in the middle. They cannot lend money because their off-balance sheet liabilities are a monstrous black hole that suck in capital. This is not to say that banks should be eradicated; the majority of bankers are both decent and diligent. But the mentality of the mob blames anyone but themselves, and it has many dangerous precedents in history. So this will truly be a case of swords to ploughshares, as an equity slump enables a natural extinction of share options whose disappearance will purge many conflicts of interest.

Perhaps banks will once more be constrained by the likes of the Gold Standard when our leaders were stewards and not salesmen. Given the sheer volume of credit creation we may well need a Precious Metal Standard combining Gold Bullion, silver and platinum to stand any chance of matching metal with money. But we should never replicate the 'go for growth' approach of the past that took us too close to the sun. It is time to grow up and face the inevitable: the Greatest Depression awaits us and we must close our ears to the siren voices and propagandists who led us down the wrong path in the first place.

One day we will achieve stability in markets and money creation where the recycling of yield from real assets replaces capital growth from esoteric products. The only saving grace is that all great reformations require deformation to start again. Given that the derivatives market equates to some $200,000 per person on the planet, it would not take much to crystallize just such an event. Only when the old era of debt and derivatives becomes despised can a new and better one begin.

Toby Birch is managing director of Birch Assets Limited in Guernsey. Educated at the City University in London and a Fellow of the Securities and Investment Institute, he also holds the Securities Institute Islamic Finance Qualification and is author of The Final Crash: Addictive Debt & the Deformation of the World Economy (Pendula Press), written under the pen-name Hugo Bouleau.

See the full archive of Toby Birch articles.


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