Barron's: What's your view of the current macro picture?
Mikhailovich: The U.S. has so far succeeded in going slowly to allow an orderly deleveraging of financial assets. But the policy measures—essentially zero interest rates—are like antibiotics. The effectiveness wears off over time, you need to take more and more to achieve less and less, and eventually they stop working. Our concern is that excessive indebtedness around the world is driving governments to try to perpetuate a protracted deleveraging, because short-term deleveraging is very painful. But there are some natural limitations. Interconnectedness in markets—now higher than it has ever been—has been created by disruptive new technologies, which aren't very well understood.
One technology is securitization, such as CDOs, where high-risk debt is recharacterized into investment-grade securities. The other is over-the-counter credit derivatives, which are basically grossly under-reserved insurance. When you combine the government policies with the level of interconnectedness in markets, it creates a recipe for disaster.
What are the short-term chances that we see a meltdown comparable to 2008?
Chances are high. Although there's faith in the U.S. and its ability to help Europe navigate this situation financially, the U.S. itself has a big pending problem of the debt ceiling, of automatic tax increases, of the presidential election. There's tremendous uncertainty. Many things have to go right in the short term to delay the eventual resolution, if you will. Based on recent precedent, it's clear the politicians have no incentive to act unless they are faced with some sort of existential threat. A compromise will only delay the problem, because it's a problem of excessive indebtedness and you can't solve a balance-sheet problem without solving it, except by delaying it.
So the risks are greater than 2008?
The ability of governments to sustain the unsustainable ultimately rests on their ability to maintain faith in their creditworthiness, and faith is something that takes a long time to crumble. But once it goes, it can go very quickly. Here is the paradox: Governments are borrowing more and more, and the spreads of government securities are getting tighter and tighter. So the creditworthiness is getting worse and the cost of funding is getting better.
How do you explain it?
Very simple. It is faith. It is muscle memory. It's normalcy bias, a psychological phenomenon that prevents people from seeing unconventional threats. People overestimate their previous experience and they underestimate future experience…. But there may come a moment when it doesn't work, and then what's a safe haven? lt is gold. It's silver, diamonds, Rembrandts, Picassos, real estate. It's agricultural land. It's the means of production.
But you have to consider the Philadelphia problem. In the movie Trading Places, the hero is trying to sell his very expensive Swiss watch at a pawn shop in Philadelphia, and he is told that in Philadelphia it's worth 50 bucks. The benefit of land and of paintings and other stores of value is that they are not financial assets and they do preserve value over an extended period. But they are not liquid during times of disruption. You can't get a fair price; they're unique, whereas gold is ubiquitous. It's divisible. It's measurable. It's testable. There is a global market for it. So you will never have the Philadelphia problem. You may not like the price, but it is never going to be a rip-off.
So, gold is going to rise over time.
The price of gold never rises. It is the value of financial assets that declines. Gold is a store of value. Gold is not an investment. However, in the current environment, gold can produce tremendous real returns because it's an asset that doesn't produce any cash flow. Its valuation is driven exclusively by supply and demand. In the 10 years through 2010, a study has shown, 80% of physical demand for gold came from emerging markets and only 20% from the developed world, and half of that was for jewelry. Developed markets that are the repositories of most of global financial wealth have had de minimis demand for physical gold. If this devaluation of financial assets proceeds apace and the moment of clarity comes for many investors in the West who realize they need to diversify into assets that can protect against devaluation, demand for physical gold has the potential to rise dramatically.