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The BIG Picture

August 19, 2003

Common sense tells us that - because an Economy as a whole is really nothing more nor less than a very large Corporation - the same principles of "Key Performance Indicators" (KPIs) and "Business Drivers" (Drivers) can be applied to it.

KPIs are typically ratios that are used by Financial Managers to assess the ongoing performance of a business under review. Two simple examples of KPIs would be Gross Profit as a Percentage of Revenue, and Revenue per Employee. There are many others.

KPI's are essentially measurements of "output", whilst "inputs" are referred to as Drivers - which are factors that can be managed to influence the financial performance of a business. For example, if a business' Management wishes to increase its profitability, they may attempt sell for a higher price or buy for a lower price in an attempt to increase the Gross Profit percentage, which is the KPI.

It is important to understand the subtle difference between outputs (KPIs) and inputs (Drivers). Sometimes, a KPI will be influenced by manipulating a Driver that does not appear to be directly related.

Each business will have its own set of Drivers - which flow from its unique Business Model.

Clearly, "price level differentials" (year on year price changes) can be used as a KPI (output measurement) for any Economy, and equally clearly, "Inflation" (Money Supply differential) is one Driver which gives rise to this output. But price level differentials - which is an outcome - should not be thought of as a driver.

It is strongly recommended that readers study the 450 year chart of US Prices (1665 - projected 2013) as reflected in the web link below:

What it shows - with crystal clarity - is that whilst generalised rising prices is a phenomenon which has manifested over the centuries, the type of price rises we are experiencing today has only really begun to manifest since the end of WWII. In short, what we are living through today is indeed unique in human history.

What has been "Driving" these price rises?

The answer to this question is not as obvious as it seems, as can be observed from the following Table:

Note: All numbers shown below are in Nominal Dollars, unadjusted for inflation

Sources of information:

Alert readers will note that the above Table does not attempt to measure annual growth rates of the various discrete numbers. Rather, it attempts to isolate "ratios" with the objective of simulating Drivers that one would typically find in a corporate environment.

The Table therefore emphasises ratios of Per Capita Money Supply as a percentage of Per Capita GDP (a proxy for personal income), and Per Capita Debt as a percentage of Per Capita GDP.

The year 1982 was used as a base, because it was in that year that the Reagan Administration took a conscious decision which would lead the USA to morph from the world's largest Creditor Nation, to the World's largest Debtor Nation.

An obvious question that arises is: What is an "Unsustainably high" ratio of debt relative to income? Clearly, the answer to this question is dependent on two parameters:

  • What is the interest rate payable on this debt?
  • What is the repayment term on this debt?

Several Factors are different today from what they were in 1982:

  • Tax rates are probably lower at the margin
  • Interest Rates are lower
  • Repayment Terms are longer

This last item is worthy of further discussion.

The rise in house prices has facilitated TWO discrete consumer activities:

  • Debt as a percentage of income has risen
  • Debt repayment terms have lengthened. For example, if a consumer previously bought a car on a 5 year repayment plan, but now chooses to finance the car with (lower interest) borrowings using his house as security, the "burden" of this debt may actually be LESS onerous.

Analysis and Discussion

The ratio of M3/GDP in 1982 was 75.7%, whilst the ratio in 2002 was 78.7%. This is not a significant difference.

On the other hand, there is a very significant difference in the debt ratios: 36.7% in 1982 vs an estimated 62.3% in 2003.

It seems reasonable to conclude that (surprisingly) "debt levels" have been more of a Driver of price inflation than have M3 levels.

Another significant observation is that - although debt levels have been rising significantly in absolute dollar terms, the 2003 level (as a percentage of income) is actually lower today than at its 1996 peak.

Another Perspective

Quite apart from the above analysis, there are three additional factors in the economic environment which present cause for concern. These are:

  • Price inflation is navigating uncharted waters. In truth, the concern here flows from the unknown, as opposed to a "defensible" justification for worry. As long as incomes rise equally with or faster than prices, standards of living can be maintained or improved regardless of the rate of price escalation. This concern may turn out to be more emotionally than objectively based.
  • With an increase in the level of financial sophistication over the years, has arisen an increased propensity to speculate. The derivatives markets (and equity markets) have assumed dimensions for which they were never originally intended. Originally derivatives were for the purpose of "managing" risk. Nowadays, the derivatives markets are assuming characteristics of gambling casinos. However, it should ALWAYS be borne in mind, that in a gambling casino, the odds favour the house. In this case, the "House" is usually a Bank or a Financial Institution, and so the counterparty most likely to lose in a derivative "bet" is the speculator, as opposed to the Bank or Financial Institution. Again, the objective facts do not necessarily support the view that the entire Financial System is unduly at risk. Most Institutions do in fact attempt to manage their risk exposures.
  • Given that a Price:Earnings ratio actually means "The number of years it will take to get back one's capital if the underlying company continues to generate earnings at the current level" - Price:Earnings ratios on the equities markets are certainly at unjustifiably high levels. Lets look at this a bit more deeply. The return on equities (inverse of Price:Earnings ratio) "should" bear some relationship to the long bond rate - or risk free return. Historically, total returns on equity investment have typically been around three times that of the long bond rate, in order to compensate for the additional risk. With the long bond rate currently at around 5.4%, an implication is that future return on equities "should" be around the 16.2% p.a. level, including both capital gains and dividends. Unfortunately, with saturated markets and currently high P/E ratios, the probabilities of this materialising over the next few years are probably remote.

Putting it all together

There has been a degree of (probably uncalled for) hysteria revolving around absolute levels of money supply and debt but, when looked at in "Driver" terms, the ratios of per capita money supply to income and per capita debt to income are not particularly worrying - given that other things in the economic environment have also changed over the years. The most notable of these changes has been debt repayment terms - which have lengthened, and interest rate levels - which have fallen.

There is some small risk of implosion of the derivatives markets, but the odds seem to be against the speculators making a "killing" at the expense of the Financial System.

As there is no benchmark against which to measure the impact of price inflation since 1945, there are grounds for some concern in this area, but the concern may turn out to be more emotional than objective.

The clear and unambiguous risk revolves around the levels of equity prices relative to underlying earnings.

Against this latter background, we seem to be facing a period of economic stagnation - which is likely to last for at least as long as the authorities continue to emphasise monetary and fiscal management at the expense of "new" industry growth. However, even if the authorities do come to understand the simple, self-evident fact that a person can only wear one shirt at a time - and move to change their management emphasis - it will take some years before the new technological Drivers of the economy reach critical mass.

In previous articles I have argued that the technological Drivers of the future economy will be:

Superconductor electrical cabling (which will reduce the need for energy production - and therefore will reduce greenhouse gas emissions) by up to 33%, because a superconductor has virtually zero energy wastage flowing from the friction (and heat loss) that occurs with copper cabling Fuel Cell driven private transportation - which will also give rise to a further (overall) 20% - 25% reduction in greenhouse gas emissions

Superconductor based magnetically levitated trains for mass transportation

Technologies that are targeted at improving the health/wellbeing of both individuals and the environment.

Education Infrastructure

The Role of Precious Metals


The hard fact is that gold has for many years been behaving more as a commodity than as a currency of last resort. It is highly simplistic to argue that gold will "inevitably" be the ultimate fall back currency because the mechanics of funding transactions between the roughly six billion inhabitants of the planet preclude the physical metal itself from being the preferred medium of exchange. There is simply not enough gold to go around and it is probably safe to say that this will NEVER happen.

What might (and probably eventually will) happen is that some form of fractional reserve system will evolve whereby paper currencies are subjected to the discipline of a formalised relationship with gold. In the event of a financial "accident", the probabilities of the emergence of a fractional reserve system will escalate. Further, as the equities markets are rising in the face of inadequate underlying values, this gives rise an escalating probability of a financial accident. Ultimately, it is for THIS reason, gold should be regarded as an essential insurance policy.

Notwithstanding this escalating risk, to invest more than a "sensible" proportion of one's portfolio in gold is tantamount to planning for failure, and it is not sensible to plan for failure. That is the behaviour of "losers". If one regards gold as an Insurance Policy, then probably a maximum of 10% of one's asset portfolio is at the limit of sensibility.


A key raw material in Fuel Cells is platinum which, I understand, acts as a catalyst to the chemical reaction. However, given that Fuel Cells are probably a decade away from becoming economically relevant, an investment in platinum should be regarded as a long term play.


Superconductors (in which silver is a major component) are probably also 10-15 years away from being economically relevant (to the economy as a whole) and silver's main current application - in photography - is waning. Silver also has an important role to play in the area of micro-organism disinfection, but this is also probably some way into the future. Nevertheless, the current supply/demand relationship of silver is seriously out of balance - even given the current commercial negatives. Further, in the event of an economic accident, silver might also assume some role as a currency reserve, and so it offers the dual benefit of a commodity investment AND a financial insurance policy. These reasons probably make Silver the most sensible investment of the three precious metals under discussion.

Where to invest?

A portfolio made up of the following seems sensible:

  • Gold - 5% - 10%
  • Silver - up to 10%
  • Cash and Short Term Treasuries - 35% - 40%
  • Revenue producing real estate (un-geared) - Up to 35%
  • Other tangible assets - Up to 10%

Regardless of the "seemingly" bullish direction of the Equities markets, the Primary Trend remains down, and the underlying values are not there. Investment in equities under these circumstances will be tantamount to betting against the house.

The rationale for Real Estate is more related to supply/demand factors than anything else. Throughout history, real estate has offered the best security against borrowings, but the current interest rate regime has given rise to a bubble - which logic dictates should deflate. Nevertheless, we are not focussing on "price" so much as "value". Like gold and silver, real estate probably never loses its inherent value and, over time, probably becomes more valuable because it is in finite supply.

Gold weighs 19.3 times as much as an equal volume of water.
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