Waterworld

Have been on the sidelines this week. No positions in anything, anywhere. Exited my positions in Gold (Aug) last week and Gold (Spot) this week with small profits.

I'm trying to make sense of the massive increase in liquidity around the world. This article tells me that, if History is anything to go by, it won't end well for the developed world.

I would like to compare the properties of economic power with that of water. In my school days, I learned of the propensity of water to find its own level. A container of water has 2 compartments with a tap connecting the two at the bottom. The tap is closed. Water is poured into one compartment till it reaches a level near the top (say, level L1). The only way for more water to be held in the container is for the tap connecting the 2 compartments to be opened.

When the tap opens, 2 things happen: the first is that water rushes in to fill the second compartment. In my economic power/water analogy, opening the tap is akin to the concept of globalisation - and economic power started flowing from the container that has water (the 'haves', like the US, UK, etc.) to the compartment that doesn't (the 'have-nots', like India and China).

The second consequence of the tap being opened is that the level of water in the first compartment falls! In my analogy, this means that the 'haves' become worse off - in the real world, this translates into a loss of jobs, technology, etc. To keep the level of water (economic standards) at its previous high (level L1) in the first compartment, the flow of water into it must increase at an equal, or higher, rate as the transfer of water from the first compartment to the second. In the real world this could be taken to translate into credit expansion. However, since the propensity of water is to find its own level, more and more water finds itself into the second compartment. The relative distance between L1 and the level of water in the 2nd compartment keeps on narrowing - in fact all the increase in water in the first compartment goes into filling the second compartment.

In other words, the worldwide expansion in credit is the only way for the West to maintain its standard of living and economic power. At this moment, judging by the way asset prices in the developed world have jumped from their historical rate of growth, I'd say that the addition of water into the first compartment is faster than the transfer of water into the second compartment.

The consequence, in this theory, is that either the credit expansion will slow down in a hurry (or else the first compartment will overflow, and no one likes to clean up a mess), or this increase in credit will increase its speed of transfer to the developing world - or both. In any case, I need to get my act together on investing in developing markets right away.

As money in the developing markets increases, their demand for energy, metals and food will go up exponentially. Hence, my strategy needs to be focussed around these areas.