The Next Crisis

From the Financial Times, London:

Forget credit and oil - the next crisis will be over food

By Gillian Tett

Published: February 15 2008 02:00 | Last updated: February 15 2008 02:00

I used to think that the fastest way to become worried about markets was to stare into the bowels of a monoline. No longer. A few days ago, I happened to hear Goldman Sachs discuss the state of the global financial system with European clients.

And what struck me most forcefully from this analysis - aside from the usual, horrific litany of bank woes - was just how much trouble is quietly brewing in corners of the commodities world.

Never mind that oil prices are high; that problem is already well known and reams of ink have been spilt debating that, along with the pressures in metals and mineral spheres.

Instead, what is really catching the attention of Goldman Sachs now is the outlook for agricultural prices. Or as Jeff Currie, head of commodities research at the US bank, says with disarming cheer: "We think we could go into crisis mode in many commodities sectors in the next 12 to 18 months . . . and I would argue that agriculture is key here."

Now, to some readers of the Financial Times, that observation might seem odd. After all, inhabitants of the western world typically spend far more time worrying about the price of petrol for their car, rather than the price of wheat or corn. And when western investors do think about "commodity shock", their reference point typically tends to be the 1970s oil crisis.

However, as Mr Currie observes, this is a dangerously blinkered view. Back in the 1970s, famine touched a much bigger proportion of the world's population than the energy crisis, he says. And even today, rising food prices pack a powerful political punch in the developing (or partly-developed) world, to a degree that is sometimes underappreciated by the pampered west.

Indeed, there is already ample evidence that political tensions are building: the World Food Programme, for example, now thinks a third of the world's population lives in countries with food price controls or export bans.

However, Goldman Sachs thinks this is just part of a much bigger problem of capital and resource misallocation. After all, Mr Currie argues, if the world today was a rational economic place, then regions such as the Gulf which are food-constrained ought to be investing heavily in agriculture. And since the US is the world's biggest agricultural supplier, this implies that the Saudi Arabians, say, should be snapping up farms in Wisconsin - as America secures oil in the most efficient manner by sending teams of Texans to Riyadh.

But in practice numerous investment controls prevent Saudi Arabians from buying Wisconsin farms and Americans owning Saudi oil wells. And these controls are not being dismantled now. On the contrary, mutual mistrust is now rising. Hence the fact that Gulf leaders are currently considering desalinating sea water to plant wheat in the desert - while the US and Europe are trying to turn corn into fuel. Such exercises might make sense in domestic political terms; but they are apt to be fiendishly expensive. Thus the upshot of this misallocation, Mr Currie would argue, is even more inflation - even if the world does experience some form of growth slowdown.

Now, for any investor who is long on commodities right now (and I would guess that club includes Goldman Sachs), such trends might seem to smack of good news. For anybody who is dirt poor in the developing world, however, the picture is disastrous. A WFP official, for example, recently showed me the red plastic cup that was used to dole out daily rations to starving Africans - and then explained, in graphically moving terms, that this vessel is typically now only being filled by two-thirds each day, because food prices are rising faster than the WFP budget.

But leaving aside this very real human tragedy, what should also be crystal clear for investors is that this is not a picture that points to 21st-century capital markets progress; nor is it likely to breed stability in the medium term. Anyone who thinks this decade's problems start and end with credit, in other words, may yet receive a rude shock; sadly, we live in a world where soyabeans may yet pack as painful a punch as subprime.

Wealth, War and Wisdom

Publisher: Wiley, 2008

Wealth, War & Wisdom by Barton Biggs, Conclusion (pp 331-333)
(Annotated commentary by The Anecdotal Economist, with particular emphasis on Mr. Biggs's suggestion regarding acquisition of an easily accessible "safe place" ranch or farm.)

Equity markets are wise. The invesor crowd has great intuitive wisdom. Stock markets, in their long run judgments, are the perfect, dispassionate, separately-but-directly motivated crowd.
(Only for 25-50-75 year time frames, as any less is only “noise.”)

Disregard the ranting and raving of the self-proclaimed elite thinkers and alleged experts on wars, economies, politics, and, above all, the stock market. They are empty suits with vacant heads, and their opinions cluster around the probable. They lack the imagination and the courage to predict the unexpected, the 10 standard deviation events that transform the environment. (An extremely unlikely event, as the universe is not yet old enough for even one 10-sigma event to have occurred, yet we are hearing frequently of 25-sigma events – Subprime).

History doesn’t evolve in a slow and orderly way; often it leaps forward in disorderly, chaotic jumps.

People with wealth should assume that somewhere in the near or far future there will be another time of cholera when the Four Horsemen will ride again and the barbarians unexpectedly will be at their gate. (Sooner, most likely, should a confluence of events spin out of control in a short period of time.)

By definition, the next Black Swan will be some form of a total breakdown of civilized society and the social and financial infrastructure as we know it. (A low-probability, unknown, unforeseen event, unexpected because the event never has occurred before in human history.)

The issue is what form it will take, what costume it will wear? (The essence of a Black Swan event is that it is completely unknown, and, therefore cannot be predicted.)

It is likely to have the general effect of the anarchy of an occupying army in World War II. The trigger event could be a massive terrorist or nuclear attack that disrupts the economy for months and maybe for years. A power failure that lasted not a day but a month would paralyze a modern economy. Or it could be a plague, a massive SARS epidemic, in which hundreds of millions die, or an electronic explosion that cascades into a complete breakdown of the world’s financial accounting systems. Whatever happens, it most likely will be an event that is both unexpected and we will not be prepared for. (These are all “known” unknown events. As above, a Black Swan event cannot be described, as it is an “unknown unknown.”)

The world is very good about locking the barn door after the horses have been stolen.

What can you do? In simplest terms, the conclusions are to diversify your fortune both as to asset class and location, anticipate the anticipation of trouble, and pay attention to the message of the markets. (Valid advice in regard to diversification of assets and location. It’s why many West German companies were eager to set up U.S. locations in the late 1970s-early 1980s at the height of the U.S.-U.S.S.R. cold war.)

Equities are the place to be in the long run because of their proven and virtually unique ability to increase the purchasing power of capital. (So far. A Black Swan event could negate this observation exactly because it renders past performance or observations irrelevant.)

In my considered but not necessarily correct opinion, a family or individual should have 75% of its wealth in equity investments. (Only if the remaining 25%, however diversified, can produce sufficient income to cover all conceivable living expense over long periods of time.)

A century of history validates equities as the principal, but not the only, place to be. (As above, so far. A Black Swan event could negate this observation exactly because it renders past performance or observations irrelevant.)

As David Swenson likes to say, you as an investor in an inflation-prone world want to be an owner – not a lender. (Again, over very long periods of time, and so far. Consideration also must be given to what securities/money would be most liquid in the immediate aftermath of an event – Gold, food, short-term government obligations.)

Most of that commitment should be in publicly traded global equities. Don’t try to time short-term market swings. What you want to capture is that wealth purchasing power compounding from the real return of stock. Tilted, refreshed index funds, or even just plain vanilla index funds, are fine. Don’t fuss with high fee investment alternatives, and in general, don’t get fancy and try to pick the best global managers or hedge funds. Last year’s superstar may be next year’s bum.

(Some Really Good Advice from Mr. Biggs)
Another, much smaller part of your diversification strategy should be to have a farm or ranch somewhere far off the beaten track, but which you can get to reasonably quickly and easily. (The “money shot” and quite possibly the key to survival.)

Think of it as an insurance policy, and for rich people in the developed economies a farm is a fine diversifier and probably an excellent long-term investment. (With considerable tax benefits.)

Perhaps its purchase price should amount to five percent of your net worth. (Assuming one’s net worth is at least $20 million, otherwise expect to pay at least $1 million to acquire, develop, stock and provision a farm or ranch to double as a secured safe-haven, plus another $100,000 or more a year for upkeep.)

The control of food-producing land is a basic instinct of mankind, and landowners seen to find considerable psychic satisfaction just from the knowledge of possession. There are few things as fulfilling as having a drink in the sunset and looking at your fields and cows.

There is no way of knowing how much time we will have to reach our Shangri-La next time. It will not be of much use having a wonderful estate in New Zealand if you can’t get there. (Preferably within an hour’s drive in optimal conditions and a two-day hike otherwise.)

Long-range air travel is likely to be one of the first things to go. On the other hand, you want your sanctuary to be remote enough to be inaccessible to the dispossessed hordes. (Electricity-generating capability with at least a 30-day source of fuel for continuous power and a very good, self-contained security system.)

You should assume the possibility of a breakdown of the civilized infrastructure. Your safe haven must be self-sufficient and capable of growing some kind of food. (Including indoor or underground cultivation.)

It should be well stocked with seed, fertilizer, canned food, wine, medicine, clothes, etc. (Etc., of course, means weapons and ammunition and sufficient training for their use, especially rifles.)

Think Swiss Family Robinson. Even in America and Europe there could be moments of riot and rebellion when law and order temporarily completely breaks down. (We watched live on television, in real time, the breakdown of civilized society in New Orleans in the aftermath of hurricane Katrina, about 48 hours before chaos ruled. In “moments” of riot and rebellion, one should plan on no assistance from any official source, particularly law enforcement.)

A few rounds over the approaching brigands heads would probably be a compelling persuader that there are easier farms to pillage. Brigands tend to be cowards. (On the other hand, a large, motivated group of cowardly brigands, enticed by the possibility of gaining control of a well-provisioned, well-armed safe-haven, may not be deterred by warning shots, and even encouraged. Shots fired should be shots meant to mortally wound and kill, no exceptions, hence the requirement for adequate arms training, and the knowledge that a safe-haven must be adequately manned by competent adults.)

I repeat that history suggests that the rich almost always are too complacent, because they cherish the illusion that when things start to go bad, they will have time to extricate themselves and their wealth. (More likely they are unable, or unwilling, to recognize the scope of the detrimental impact of a Black Swan event as it is occurring, which entails the need to change one’s mindset to survival mode. The possibility, however small, of “losing everything,” when one has much to lose, can cloud the judgment required for safety and survival.)

It never works that way. Events move much faster than anyone expects and the barbarians are on top of you before you can escape. Black Swans by definition have to be unexpected. (Yes, they are “unknown unknowns.”)

The temptation always is to try to salvage wealth, but by the time it is apparent you need to, it is usually too late. It is expensive to move early, but it is far better to be early than to be late. (The essence of this conclusion, but the most difficult concept to grasp. “Things” always can be replaced, health and lives cannot.)

Confucius said: “Study the past if you would divine the future.” (Which is about the most useless scrap of wisdom when dealing with the possibility of a Black Swan event and contradicts everything previously discussed. The past never provides the benefit of experience when confronted with an unknown unknown, and is another reason people are slow to react. As in, there will not be another Hitler/Nazi Germany, as we’ve already seen that horror movie and, in knowing how it ends, will not allow it to happen again. However, there are movies to come, whose ending we do not know. These are the events for which we must remain vigilant, prepared and ready and willing to act, even if only a “drill.” One day it will not.

Chicken Soup for the U.S. Economy

A head cold lasts a week if you treat it, seven days if you don’t. Chicken soup often makes one feel better, as do some medications, but they do nothing to cure an illness caused by a constantly mutating virus. A cold’s symptoms, the sneezing, runny nose and congestion which make one feel miserable, are not caused by the infecting virus, but, in fact, by the defense mechanisms employed by the body to rid itself of the infection.

The U.S. economy has caught cold, and it will last the usual amount of time, about half a year for a mild case. Symptoms only now are beginning to be evident: slowing economic growth, rising unemployment and jobless claims, a weakening dollar and falling asset prices in residential real estate and the stock market. The Federal Reserve is ladling out economic chicken soup as fast as it can in the form of liquidity injections and slashed fed funds target rates, but the economy still is starting to feel lousy.

We view the current recession as that seven-day cold (and it sure seems like we’re in a mild one now, with preliminary 4^th Quarter 2007 GDP falling to +0.6%). Annoying, frustrating and to be ignored only at a greater risk of developing something far worse from a weakened immune system, but not something to be overtreated. But, of all the luck, we’re in the middle of an election year.

And so we are seeing a concerted effort to “treat” the symptoms which have been caused by the economy’s own infection-fighting mechanism designed to wring excesses from the system. The Fed and the U.S. Treasury have run to the Congressional drug store for a strong dose of good-old-fashioned fiscal stimulus, which may mask some of these symptoms but will do nothing to cure the disorder. That the economy must do for itself. Whether it can, or lapses into something worse, is the trillion-dollar question.

The proposed $150 billion or so tax rebate, a moderate “helicopter drop” of money on the U.S. economy, won’t take effect until summer, but unless patients follow the dosage instructions exactly and spend every dime of their rebate checks instead of saving the money or paying down debt, this over-the-counter medication will have little effect. (Alternatively, it could protract the illness since all $150 billion must be borrowed, increasing the budget deficit and adding to $9.2 trillion of national debt. About half will be borrowed from foreigners, and if we buy imported merchandise, including imported oil, there is some debate as to exactly whose economy ultimately is being stimulated.)

As former Fed chief Alan Greenspan observed in unusually understandable English nearly a year ago, economies are cyclical and, all things considered, given the duration of the current U.S. expansion (since early 2002) “we are in the later stages of a cycle.” The “maestro of money” then gave one-in-three odds of a U.S. recession by year-end 2007, which now looks like a winning bet.

On occasion, cures may be worse than the illness, so we must be vigilant for other symptoms of a worsening condition, namely stagflation. Once thought eradicated by central bankers, as no cases have been observed since the mid-1970s, stagflation could make a virulent comeback, if commodity price increases escalate out-of-hand, affecting not only us, but other economies as well.

Some think the Fed should prescribe Dr. Volcker’s patented cold-turkey economic shock therapy, a dire treatment which calls for much higher interest rates and constricted money supply, resulting in an immediate depressionary deflation: crashing asset prices, high unemployment, a stronger dollar, widespread bankruptcies and financial sector failures. It has not been prescribed since 1980.

But as one economist recently observed, “When a man is in the middle of a heart attack, don’t lecture him about his diet. Fix him, get him on his feet again and then try to modify his habits. Mr. Bernanke’s Federal Reserve likely will not reach for Dr. Volcker’s inflation-fighting tonic, believing wholesale asset deflation to be a far more sinister malady than the present ailment.

Let’s wait and see the Fed seems to be saying. Take a tax rebate, two more rate cuts, get plenty of liquidity and call us in October. And don’t forget the trip to Disneyland after you receive your check this summer, the economy is depending upon you.

Coordinated, ongoing efforts by the Federal Reserve, the Treasury, Congress and the Administration to “do something” about the economy may mask emerging recessionary symptoms. If mild and if, in fact, it already has begun, we’ll only know it was a textbook recession officially long after the fact, perhaps closer to election day or after a new president is inaugurated.

If we are at the beginning of something more serious, say an economic heart attack, more potent medicines such as Dr. Volcker’s elixir, despite its foul taste and terrible side effects, may be necessary to shake off a quarter-century of accumulated bad fiscal habits. It would be the unthinkable, and yet could be the first crisis of a new presidency.