Lighthouse Investment Management

Lighthouse Investment Management
Special Report
The Bottle is Full
Novem
November 2014
Special Report - November 2014
Page 1

Contents
Summary ....................................................................................................................................................... 3
50 Shades of Debt ......................................................................................................................................... 4
Inflation: Debtor's Best Friend ...................................................................................................................... 6
What Drives GDP Growth?............................................................................................................................ 8
The Bottle Is Full.......................................................................................................................................... 10
Are We There Yet? ...................................................................................................................................... 13
Point of No Return ...................................................................................................................................... 14
Geopolitical Game of Power in Ukraine...................................................................................................... 21
In The Year 2024 ......................................................................................................................................... 28
Page 2

Summary
Few people will challenge the notion the world has accumulated too much debt. Many of us, who are
not burdened by debt, are not aware that every debt has a corresponding asset. Usually a financial
asset. Too much debt unfortunately also means too many financial assets or savings. Your savings. When
the Big Reset comes, it will, without doubt, destroy a large part of savings.
The total amount of debt has a dampening effect on growth, since it needs to be serviced. Debt is
nothing else than pulling future expenditures forward, or borrowing from the future. If growth is rapid
enough, that gamble might pay off. However, economic growth as measured by GDP is driven by
changes in the size of working population and productivity gains. Both have peaked. Lower growth rates
cannot support debt levels as high as in the past, so fiscal austerity is needed to bring budget deficits
under control. This, too, takes away from growth. Finally, inflation seems to be dead, despite the best
efforts of central banks. Debt is a nominal value. Nominal GDP growth consists of real (volume) and
price (inflation) growth. Everything else equal, lower inflation leads to lower nominal growth. While
positive for the debt-free consumer, deflation is lethal for highly indebted entities, and, particularly, the
banking sector (thanks to its razor thin cushion of equity).
Our economic and monetary system is based on growth; without the creation of new debt the system
stalls or even collapses. Dammed to grow, we are touching the limits. Barring a miracle we have reached
the point of no return. The demise of our current monetary system seems inevitable. The question of
"when" is unanswerable. Few assets will survive. Your ETF holdings will, if the stock market is still open,
trade at huge discounts to net asset value, since the assets have been lent out to dubious counterparties. The stocks you thought were safely kept by your bank or broker have been lent out and
rehypothecated many times, completely legally so, since you didn't read the fine print when you opened
your account.
The IMF has made no secret of its plans to replace cash with digital money, and all currencies by one
world currency. There will be no cash to hide under your mattress. Bank insolvencies will be resolved by
converting part or all of your deposits into bank equity (shares). The ECB is now the banking supervisor
for the Euro-zone. The most powerful people in the world will be central bankers and IMF directors, all
non-elected officials. There will be no recourse or protest possible at the voting booth.
After years of having to curb their gold sales for fear of depressing prices, central banks have recently
turned buyers. The repatriation of gold from New York and London is accelerating, as central banks eye
each other as potential enemies. Huge amounts of gold are refined in Switzerland and shipped to China,
leaving Western vaults for good.
Resurrecting a new monetary system will most likely be based on gold. The size of the national gold
stash will determine its monetary base, and therefore the size of its economy and wealth. In this game
of musical chairs, investors should prepare for the moment the music stops.
Page 3

50 Shades of Debt
I love people who look at current US debt-to-GDP level and say "Oh but we have been much higher than
that in the 1940's, and look how nicely it came down afterwards"1:
Okay. For starters, give me a reason why you wouldn't look at the total debt borne by the public and
private sector. In the end, all debt is borne by the private sector. You can temporarily 'park' some debt
at the public sector, but that just means taxpayers will have to come up with that money in the future.
Name a sovereign that exists without the backing of its taxpayers (there is none). Governments are only
creditworthy as long as they have the ability to tax their citizens. You can mess around with the tax rates
in order to move a bit debt from one sector to the other, but that does not change the aggregate
number.
For the US, a good number for all-sector-debt is TCMDO (Total Credit Market Debt Outstanding).
1
Those people usually also claim that war is 'good' for the economy
Page 4

It currently (Q1 2014) stands at $57.5trn, or 359% of GDP:
Now look at what happened when the growth rate of that total debt slowed down (see above chart).
Note that the chart does not show the rate of growth; it is merely the difference in growth rate from its
peak. When the rate of growth slows, bad things happen: a stock market crash (1987) and the worst
recession since 1933 (2009). Note that debt never declined in 1987/88. It was just the rate of growth!
The five quarters from Q1 2009 to Q2 2010 were the only period since WW II where TCMDO actually
declined (by $1trn or 2%). Two percent! And look at the damage that did. Our financial system is so
fragile that it can barely survive a slower growth in debt. We are debt addicts. There must be more debt
in order for the show to continue.
Over the past 60 years, developed nations were able to grow their way out of precarious debt levels. If
you are at 100% (public sector) debt-to-GDP, and your economy grows by (nominal) 5%, your debt-toGDP falls to 50% after 14 years (unless you are running fiscal deficits). As long as GDP grows faster than
your debt, things probably will be fine.
Inflation plays a big role. In nominal terms, inflation boosts your GDP (while debt remains same). Or, in
real terms, inflation reduces the value of debt. Either way you look at it, inflation helps debtors.
Page 5

Inflation: Debtor's Best Friend
Since the inception of the Federal Reserve Bank around 100 years ago we mostly had inflation. Plenty of
inflation. So much inflation that a 96% of debt created in 1913 has since been destroyed in real terms
(see chart below). That is amazing:
That wasn't always the case. We had significant bouts of deflation from 1870 to 1933:
Page 6

Now imagine if inflation disappeared. Suddenly, the debt you incurred 10 years ago is still worth the
same. Doesn't happen? Look at Japan:
Today's price level is still lower than it was in 1998 (blue arrows). That's 16 years of deflation. The debt
you incurred in 1998 has actually grown in real terms.
To add insult to injury, Japan's GDP has been shrinking. It is now lower than 20 years ago:
Page 7

Some people then point to Switzerland, which has been living happily with very low rates of inflation
over the past 20 years. Indeed, but Switzerland has a debt-to-GDP ratio of 25%, while Japan is at over
200%.
There are the 'deficit owls' (like Krugman) who argue that deficits didn't matter and that government
debt does not and will not ever be paid back. So how come Greece just went bankrupt? Oh, because
they couldn't print their own money? So does that mean the US cannot go bankrupt because it could
always 'print' more dollars? Well, technically, yes. But with 6 out of $12 trillion marketable Treasury
securities in foreign hands, how long would foreigners be willing to hold a hot potato? If printing
excessive amounts of money didn't lead to destruction of currency, why wouldn't every country
pursue this easy path to happiness?
What Drives GDP Growth?

Back to Japan. GDP growth can be modeled pretty well by adding productivity growth to employment
growth. Employment can, in the long run, grow only if population grows2. It is not a coincidence the
Japanese economy has started shrinking once its
working age population peaked (see chart).
Working age populations for the big countries of the
Euro-area Germany3, France, Spain and Italy have all
peaked. That alone is a huge burden on GDP growth.
Even the Chinese working population will peak in

2016.
Immigration could fill a gap, but Japan is a pretty xenophobic society, so that is unlikely to happen
Germany was recently able to reverse the trend thanks to immigration: in 2013, 1.2m people moved to Germany, 0.8m moved
away, leaving 0.4m net immigration - the largest since 1993.
3
Page 8

All major developed countries have suffered
a dramatic decline in GDP growth since the
1980s (see chart on left). Of course, nominal
GDP growth was 'helped' by rampant
inflation driven by soaring oil prices.
But even in real terms (chart lower left),
growth rates are declining.
Combine low inflation (or even deflation)
with low real GDP growth and you have a
(debt) problem. Elevated levels of debt are
only sustainable in economies that keep
growing, helped by a certain level of
currency debasement via inflation.
But can we really grow infinitely? Space and
resources on our planet are limited, so the
answer seems to be "no". That means we
cannot rely on growing and inflating our way
out of elevated debt levels. There is a limit.
And that limit is likely to be lower than 20
years ago, since nominal GDP growth is
much lower.
How do you reduce government debt levels?
By running budget surpluses. Going from
deficit to surplus takes away either a lot of
government spending (if that's the one that
is cut) or transfers from the private sector
(via higher taxes). Both decreases GDP
growth. So just when growth is dampened
by demographics, it gets slammed by
austerity measures. A double whammy.
Page 9

The Bottle Is Full
What happens with a system growing in a limited space? We are going to
use a simple example of bacteria growing in a bottle4.
Let's say that these bacteria have all the food they need. In this story, the
only limit to the bacteria's growth are the walls of their bottle. The cells
grow steadily by dividing every minute.
It begins at 11:00 o'clock with one cell.
After one minute, we find two cells in the bottle.
After two minutes, we have four cells.
Three minutes, six cells. And so forth.
At 12:00 the bottle is full.

Question: at which time was the bottle half-full?
Source: www.WorldPopulationBalance.org
Page 10

The bottle was half-full at 11:59. And the bacteria still
felt pretty good. They didn't see the imminent
problem. They felt good all the way from 11:00 to
11:59.
That is the problem with exponential growth.

On a log scale, US GDP and US total debt (see below) look relatively benign. But when you switch to
linear scale (see next page), the exponential nature of debt becomes clear.
Page 11
The scary thing is not only that exponential growth functions will eventually find their limit, but that any
attempt to decelerate ends in a recession or even depression. Dammed if you grow, dammed if you
don't.
Page 12

Are We There Yet?
When will we reach the debt limit? Unfortunately, that question is impossible to answer. Jim Rickards
has, I believe, the best analogy: an avalanche. Looking at a mountain slope the only observation you can
make is that the amount of snow has become unstable, but you cannot forecast which snowflake will
trigger an avalanche. The sound from the snapping of a tree branch could be enough to trigger a
disaster.
It is safe to say that when the current financial system collapses, it will happen pretty quickly, and there
will be little time to run for the hills.
Who was talking about the state of Greek government debt before October 2009? Nobody. Six month
later we were discussing a bail-out.
When US municipalities were running into trouble in late 2008 because of "auction rate securities" it
was the first time I learned such instruments existed.
Today, Deutsche Bank's EUR 52 trillion gross position in derivates, largest of any bank in the world and
20 times the size of Germany's GDP, is mentioned only on certain blogs. Yet they exist, if only in a
footnote on page 189 of the 572 pages strong annual report.
As unsatisfactory as it may be, it is simply impossible to predict the moment of collapse. Global financial
markets today consist of millions, if not billions, of individuals with emotions and unpredictable crowd
behavior. We do not know about critical levels triggering larger events. How many people have to
withdraw money from a bank until it becomes a self-fulfilling bank run? How much decline can a
currency like the Yen suffer before its citizens begin fleeing towards foreign currencies (or gold)?
Page 13

Point of No Return
Is there really no hope? Have we reached the point of no return? Germany is on the road towards a
balanced budget for the first time 1969, US consumers are slowly deleveraging and the global economy
is growing again.
In 2014, Germany will probably show a positive current account balance around 7.5% of GDP. Germany's
record positive trade balance is some other country's negative trade balance. Without this external
'help', Germany would be running a fiscal deficit of 7.5% of GDP (or the private sector would incur less
saving / higher debt).
Is the world really deleveraging? In their recent report5, the International Center for Monetary and
Banking Studies (ICMB) comes to a
different conclusion: "Contrary to widely
held beliefs, the world has not yet begun
to delever and the global debt-to-GDP is
still growing, breaking new highs". See
the accompanying chart on the left.
Some really smart deficit owls came up
with the following: (1) for every debt,
there is an asset, so it is wrong to look at
debt alone. (2) The current ultra-low
interest rates are simply an expression
of strong demand for safe assets.
Governments should respond by running higher deficits and issue more debt in order to satisfy that
demand.
To point number 1: that's true. However, there are two problems: a) valuation of those assets and b)
distribution of those assets (or wealth in general). In the US, the top 1% own roughly 50% of the
country's financial assets, while the bottom 50% own only 0.5% of those investments.
Income inequality is even worse, so the gap in wealth distribution is getting worse, not better. This
leaves a large part of the population with current and future debt, while a tiny part grabs most of the
assets. The average citizen continues to bear more and more debt.
CONCLUSION:
I believe we have surpassed the point of no return. Any attempt to reduce current debt levels would
trigger a recession, probably combined with deflation. Both would make debt-to-GDP ratios worse.
Maybe the discovery of free energy or rapid replacement of all fossil fuels with solar energy could
5
"Deleveraging? What Deleveraging?" - by Vincent Reinhart et al, ICMB, September 2014
Page 14

temporarily help developed nations by improving their trade balances. However, this would, by
definition, bring existential problems for oil-producing countries.
Would a gold standard be the answer? I don't think so. Initially, gold is needed to successfully introduce
a new currency (remember, confidence in the old fiat currency has been completely destroyed by then,
and people will naturally be skeptical). But an inflexible monetary system is not practical. Some
countries will always have trade deficits, and would, at some point, run out of gold to settle trade
deficits.
Maybe a partial gold coverage would work, with each country free to set its own exchange rate towards
gold. Individual devaluations would be necessary in case of trade deficits. However, such a system would
not offer much benefit over a free-floating fiat currency system. On the contrary; countries would try to
avoid devaluations until the pressure has become too strong and it must be accommodated with a large
and painful adjustment.
Maybe we are dammed to suffer from alternating currency systems: 50 years of fiat, 50 years of gold
standard, and so on. No system is perfect, and we will flee into the other system as we get fed up with
one.
Japan is a perfect example
of how "Quantitative
Easing" does nothing for the
real economy (apart from
blowing bubbles in financial
assets). An increase in sales
tax in spring drove the
Japanese economy into
recession - the fourth time
since 2008. A planned
further increase in sales tax
had to be cancelled, a
"significant development"
for Japan's credit rating
according to Fitch Ratings.
So far, financial markets
have been completely
sanguine regarding Japan's
credit risk. Credit default swaps (see above chart) are at benign levels in line with other AA-rated
countries. 10-year Japanese Government bonds (JGB's) yield 0.5%, just a tad more than those of
Switzerland (0.36%). Switzerland has a debt-to-GDP ratio of 36%, Japan 227% (more than 6 times as
high).
Page 15

Why are JGB's not selling off, you might ask. Simple answer: foreigners (almost) do not own any, and the
domestic holders are mostly captive (insurance companies, pension funds, banks and the Bank of
Japan). The BoJ has committed to purchase JPY 6.6 trillion of bonds with under 5 years' maturity each
month - more than the JPY 5.5 trillion issued by the finance ministry. This leaves the exchange rate as
only "outlet" for price adjustments.
Japan is on track to slaughtering savers three-fold:
Wrecking pensions and insurances once as zero-interest rate policy robs them of interest
income
Wrecking them a second time as bonds suffer losses on rising interest rates
Wrecking them a third time as hyperinflation destroys financial assets.
In the end, Fed will have to buy JGB's (and therefore Yen) to prevent the Japanese currency and
economy (and therefore the main US ally in the Pacific) from collapsing.
So the Fed will be forced to buy foreign assets. This will open a new chapter in currency wars, as buying
foreign assets helps lift the foreign currency and depress the domestic one. In a world where everybody
tries to "export" deflation (via lower exchange rate), the central bank with the deepest pockets (the Fed)
wins. Which ultimately means a weaker dollar.
The Swiss National Bank (SNB) has quietly accumulated shares in foreign companies worth CHF 75bn,
while spending only 4bn on domestic stocks.
"In 2013, the SNB increased the share of equities in foreign currency investments
from 12% to 16%. It expanded its equity portfolio to cover equities of small cap
companies6."
This is on top of billions of sovereign bonds from the Euro-zone. The SNB has to invest Euros
accumulated by defending the Euro-Swiss Franc cap of 1.20. According to rumors, SNB buying was one
of the major forces in driving German government bond yields into negative territory all the way to
three years maturity. Negative bond yields may indicate investors' distrust of local banks, hence start
rumors of insolvency. Ultra-low German bond yields also help increase spreads towards other Euro-zone
sovereign bond yields, which in turn can trigger doubt regarding their commitment towards reduction of
fiscal deficits.
The problem: Central banks need to buy something if they want to keep blowing money into the
economy. Central banks increase money in circulation (= a liability for CB) by purchasing assets. Alas,
there is one asset that is free of any unintended consequences: gold. Central banks could drive the gold
price up to the moon, and nobody would complain. After all, central banks already own around 32,000
tonnes of gold, so they would be among the biggest beneficiaries of an increase in the price of gold.
6
SNB: 2013 Annual Report, page 15
Page 16

Central banks used to
be sellers of gold.
Gold does not pay
any interest or
dividends. So in order
to please their
masters
(governments) with
higher profits they
started to switch out
of gold and into
assets with better
return. Their rush to
the exit was so
hurried central banks
needed to curb their
annual sales in so-called "Central Bank Gold Agreements" (CBGA), in which they agreed to not sell more
than a certain
amount of gold
(between 400 and
500 tonnes) per
year. The
agreements each
covered 5 years.
However,
beginning with the
financial crisis of
2008, central bank
gold sales
diminished, and
they turned net
buyers again.
Page 17

The largest seller of gold since 1993
was the Swiss National Bank, selling
1,500 tonnes at rock--bottom prices.
Now the SNB is upset the Swiss people
do not trust
st it anymore to adequately
take care of their gold.
If the upcoming referendum on Swiss
gold (November 30) goes through
(which I don't believe), the SNB would
have to purchase around 1,500 tonnes
of gold, or significantly reduce its
holdings of foreign currencies
cu
(which,
in turn, would probably be the end of
the EUR/CHF cap at 1.20).
So when will central banks start purchasing gold more aggressively? Obviously when the situation of the
monetary system is about to get out of hand. So I was surprised to read the following:
"ECB could buy gold to revive economy"7
Yves Mersch (pictured) mentioned in a speech
at a conference in Frankfurt "the
"
ECB may turn
to buying gold, shares and exchange-traded
exchange
funds in an attempt to boost inflation" in the
Euro-zone.
That would
ould mirror the most extreme form of
QE practiced by the Bank of Japan.
I find this quite surprising. Surely Mr. Mersch
knows about the significance of such a
statement, even if he watered it down by
speaking of a "theoretical" possibility. At least this cconfirms
onfirms the idea exists within the heads of central
bankers. They have, unsuccessfully so far, tried to stoke inflation with measures we wouldn't even have
dreamt of six years ago. In the end, central bankers might have to embrace the "barbaric relic", the
ultimate anti-fiat, the useless non-yielding
yielding metal and might have to push its price into stratospheric
heights. Unless the market preempts them in doing so due to physical shortage.
And why not $50,000 per ounce of gold? After a currency crisis, money normally
mally has lost a lot of value,
so prices have risen substantially. For simplification, a few zeros are usually cut off, so that a loaf of
7
"ECB could buy gold to revive economy", The Telegraph, November 17, 22014
Page 18

bread does not cost $300, but rather 3 "new" dollars (or however it will be called). So if the gold price
went to $50,000 an ounce, it would be back to $500 in terms of the new currency.
Just as I was about to finish this report, a stunning revelation:
"The Dutch Central Bank says it has recently shipped 122.5 tons of gold worth
around 4 billion Euros ($5 billion) from safekeeping in New York back to its
headquarters in Amsterdam."8
That's quite a bit of gold. And a bit of a surprise, since the Bundesbank cited "logistical problems" for
having been unable to repatriate more than five tonnes in 2013. The entire story surrounding German
gold stored in New York stinks. Here is a reminder:
Plan to repatriate 300 tonnes from New York to Frankfurt until 2020
(Bundesbank, 1/16/2013)
Only 5 tonnes transferred in 2013. 300-tonnes-plan reiterated (Bundesbank,
1/20/2014)
New plan: transfer only 150 tonnes, but until 2015 (Handelsblatt, 2/6/2014)
Gold repatriation plan abandoned; German gold to stay in New York (Bloomberg,
6/23/2014)
On the left you see the amount of

gold held by the Federal Reserve Bank
of New York (FRBNY) for the account
of foreign central banks. In 2013, the
amount declined by five tonnes, the
first drop in over five years (probably
those were sent to Germany).
However, in 2014, the withdrawals
accelerated. Over the first nine
months, 77 tonnes were withdrawn.
Was that the Dutch gold? The October
update should show.
If the October update shows a
8
AP, November 21, 2014
Page 19

withdrawal of 122 tonnes or more, then someone else is withdrawing gold from the FRBNY. It is possible
the German repatriation request caused too much of a stir among other central banks. The Germans
might have agreed to pretend to abolish their plan (but quietly, after a brief pause, continue to
repatriate).
In any event, the Dutch move is significant as it is the first non-emerging market central bank to
repatriate gold. In addition, the Dutch did not advertise their move in advance. Now that the news is out
it probably means they are done for now.
Repatriation of gold is a clear sign of mistrust among central banks and speaks volumes. A central bank
could, for example, confiscate foreign gold as retaliation for meddling in exchange rates ("currency
war").
Anyone dismissing the dangers of "Quantitative Easing" (or other euphemisms for printing money)
should answer the following question:
I had a discussion with an economist9, who asked why the ECB was not doing enough to fight off
deflation. I asked if a system, which was too fragile to survive little bouts of deflation, was worth saving.
He replied that democracy was fragile, yet worth saving, and the Euro-zone had stabilized Europe for the
past 60 years. We came to the conclusion that inflation (Weimar Republic) as well as deflation (collapse
of banking system) are both threats to democracy. Systems that create extreme poverty or
concentrated wealth seem to self-destruct. We unfortunately agreed there were no good outcomes;
savings will either be destroyed via accelerating inflation or destroyed via banking collapse following
deflation.
Sebastien Galy, Societe Generale
Page 20

Geopolitical Game of Power in Ukraine
Russia has annexed Crimea and is in the process (directly or indirectly via "rebels") of occupying eastern
parts of mainland Ukraine. Here is what I wrote in my Market Comment "Ukraine: Disaster in the
making" (December 10, 2013):
"Russia tried to prevent Ukraine from signing a treaty of association with the EU
(triggering local unrest). All it needs are staged attacks on the Russian minority
(mainly east of Dnjepr river) in order for Russia to intervene to protect those
minorities. If you provoke the bear, it will attack (see Georgia).
CONCLUSION: This is a disaster waiting to happen. Best case: bailout by the IMF.
Worst case: default and partial occupation by Russia including military force."
Later (Market Comment, March 4, 2014), I described the Russian motivation and strategy behind their
move:
Crimea given to Ukraine in 1954 assuming it would remain in USSR
Strait of Kerch, less than 3 miles wide, controls access to ice-free waters (Black
Sea, Sea of Azov, Mediterranean and Atlantic, Don and Volga)
Crimea houses Russia's Black Sea fleet in Sevastopol
Ukraine harbors and maintains Russia's R-36M2 (ICMB10)
Once "pro-Russian" troops started fighthing the Ukrainian army, the US pressured Europe into agreeing
to sanctions.
Russia had warned it would not take attempts to integrate Ukraine into NATO lightly. Nevertheless,
Hillary Clinton said the following11:
"I enthusiastically welcome the Janury 11 [2008] letter from Ukrainian President
Viktor Yushchenko, Prime Minister Yuliya Tymoshenko, and Verkhovna Rada
Chairman Arsenii Yatsenyuk to NATO Secretary General Jaap de Hoop Scheffer,
which outlines Ukraine's desire for a closer relationship with NATO, including a
Membership Action Plan. I applaud the fact that Ukraine aspires to anchor itself
firmly in the trans-Atlantic community though membership in NATO and look
forward to working with Ukrainians and Ukrainian-Americans to reach that goal."
10
11
ICBM = Inter-Continental Ballistic Missiles

"Statement from Senator Hillary Clinton on Ukrainian Membership in NATO", January 28, 2008
Page 21

The US knew Ukraine was a "hot topic" for Russia. In a cable12 dated February 1st, 2008, US Ambassador
Burns warned everyone with name and rank:
Following a muted first reaction to Ukraine's intent to seek a NATO Membership
Action Plan (MAP) at the Bucharest summit, Foreign Minister Lavrov and other
senior officials have reiterated strong opposition, stressing that Russia would
view further eastward expansion as a potential military threat. NATO
enlargement, particularly to Ukraine, remains "an emotional and neuralgic" issue
for Russia, but strategic policy considerations also underlie strong opposition to
NATO membership for Ukraine and Georgia. In Ukraine, these include fears that
the issue could potentially split the country in two, leading to violence or even,
some claim, civil war, which would force Russia to decide whether to intervene.
Additionally, the GOR and experts continue to claim that Ukrainian NATO
membership would have a major impact on Russia's defense industry, RussianUkrainian family connections, and bilateral relations generally.
So what on earth were US Senators McCain and Murphy doing in Kiev in late 2013, speaking to a crowd
of demonstrators:
"The destiny you seek lies in Europe. People of Ukraine, this is your moment! The
free world is with you, America is with you, I am with you! If you are successful,
the US Senate will stand with you all the way!"
President Yanukovych, under pressure from Moscow, refused to sign a EU Association Agreement (talks
"suspended" on November 21, refusal to sign November 26, 2013). This infuriated demonstrators and
led to his flight from Ukraine (February 21, 2014). Beginning on February 26, "pro-Russian" forces began
to swiftly occupy strategic positions and infrastructure across the Crimean peninsula. On March 16, a
referendum was held to join Russia. The following day, the Crimean Parliament declared independence
from Ukraine and asked to join the Russian Federation.
By now, Putin was on a roll. Supported by high approval ratings at home, he felt emboldened to go for
parts of Eastern Ukraine (important defense and coal industries, mostly Russian-speaking population).
Controlling the shoreline of the Black Sea from Mariupol all the way to Moldova would be a plus.
The Russian's accused the CIA to be actively involved in Ukraine. The US denied. However, confronted
with pictures of the head of the CIA, the US had to admit:
"The White House confirmed Monday that CIA Director John Brennan travelled to
Kiev, Ukraine, in recent days as part of a longer trip to Europe."13
12
"08MOSCOW265_a", Confidential cable from Ambassador William Burns to Joint Chief of Staffs, NATO EU Cooperative,
National Security Council, Secretary of Defense, Secretary of State. Source: WikiLeaks
Page 22

I am not defending Putin's actions in any way. All I am saying is that you have to understand the
motivations behind each player in order to be able to understand the game being played. The US is not a
saint, either. And not very clever at hinding that fact:
"Vice President Biden's son Hunter is joining the board of a gas company [Burisma
Holdings, Ukraine's largest private gas producer] that operates in Ukraine
Ukraine."
."14
Why would you do that? As the president's son, would you like to sit in a country which is at war with
Russia and meddle in a local gas business? Of course not. More likely, this was a "thank you" from
Ukraine to the Biden family. Hunter will get paid handsomely, and maybe join a conference call once a
quarter from a safe distance. Since he is being paid for his "work", it's not corruption.
Of course, the US pretends to be gravely concerned by Russia's moves
moves.. A lot of finger wagging. Some
financial
inancial help for Ukraine (via IMF, but that went straight to Gazprom to pay for gas delivery arreas). And
then you look at a map of the location of US aircraft carriers. The closest one to Ukraine,
Ukraine USS Bush, just
left the Mediterranean via the Strait of Gibraltar (coming from Marseille, France).
Wouldn't the first thing to do include moving some military assets close
closer to the conflict zone (Black
Sea)? This does not make sense. Unless...
13
14
"White House: Brennan was in Kiev this weekend", USA Today, April 14, 2014
"Biden's son joins board of Ukraine gas company", USA Today, May 13, 2014
Page 23

Unless the US is as paranoid about the preservation of its power as Russia. The enormity of the NSA's
spying operations, even on its allies, speaks volumes.
Despite spending more on defense than the next ten countries (China, Russia, UK, Japan, France, Saudi
Arabia, India, Germany, Italy and
Brazil) combined, the US is
somehow worried about its
security.
The US has by far the most
aircraft carriers on earth.
Developing and maintaining
those swimming fortresses is
extremely costly. The US has
budgeted $12-14.5bn for the
replacement of its current
Nimitz-class carriers (not
counting $12bn for
development and research). Hence cost is a barrier to entry, and size of economy (and ability to absorb
those costs) a strategic asset.
The importance of controlling the seas of this earth cannot be overestimated. Here is The Policy Tensor15
on the subject:
"The United States, alone among the major powers, has the tremendous strategic advantage of having two of the
worlds great oceans as moats. The stopping power of water is such that no state in the international arena can
threaten the US homeland. The oceans offer not just protection but also access to world markets. People, ideas, goods,
and technologies are transmitted smoothly and rapidly over sea-lanes protected by US naval primacy.
Sea power is different from land-based military power. Threats by land travel weakly over distances. Although a seaborne invasion of a territory well-defended by a great power is well-nigh impossible, sea power can be easily projected
far from home. Moreover, unlike on land, where a rough balance of forces can persist for long periods of time, the
blue-water security market is a natural monopoly. Jean D. Bloch, the turn of the century Russian railroad baron and
prominent banker who predicted the course of the First World War, argued in 1902 that there was no point in building a
blue-water navy that is not supreme, since a fleet that is not supreme is just a hostage in the hands of the power whose
fleet is supreme."
The US is fine, as long as the dollar remains the world's reserve currency and Japan, it's last major ally in
the Western Pacific, doesn't collapse under its debt. The US has two choices: let Japan collapse under its
debt or help finance the government by purchasing Japanese government bonds. The latter would
probably drag the dollar into the abyss, too. A collapsing Japan would leave large parts of the area to the
Chinese (having just built their first aircraft carrier).
15
"The Third World War", by: The Policy Sensor, May 21, 2013
Page 24

Which brings us to Europe. Two thirds of world currency
reserves are currently in US dollar. A quarter in Euros. 4%
British Pounds, 3% Yen, and 2% all the rest (including Swiss
Francs). So the only currency that would be able to
dethrone the US dollar is the Euro.
Europe and Russia make one huge land mass. Western
Europe gets relatively inexpensive and (until recently)
reliable energy from Russia. Russia builds its foreign
currency reserves and is part of the BRICs trying to break
the dominance of the dollar. The Chinese are working on
making the Yuan convertible and investible, but they lack deep markets to invest in.
Here's my theory: US willingly provoked Russia by enbracing Ukraine, therefore exposing one of Russia's
achilles heel, the narrow Strait of Kerch. Putin had no choice but to act, and he acted swiftly. The US
pressured the EU to enact sanctions. Vice-President Biden admitted16 that "it was America's leadership
and the president of the United States insisting, oft times almost having to embarrass Europe to stand
up and take economic hits to impose costs". The EU grudgingly approved sanctions. However, on the
day the sanctions were announced, Siemens CEO Kaeser met with Putin as well as the head of Gazprom.
By far greater damage, however, was inflicted on Russia by falling oil (and gas) prices. Oil demand and
supply are very price inelastic, meaning that consumers and producers do not quickly change their
quantities based on price changes. You simply don't drive more miles because the oil price declined.
Similarly, it is very costly to shut down an oil well or rig. So you keep it flowing. Oil is toxic and relatively
cheap (it's cheaper than beer, for example). So storage is a problem. Once all available storage is full,
producers need to sell - at
any price. Hence a few
100,000's of barrels a day
in oversupply can really
wreck havoc with the oil
price. Traditionally, the
world's largest producer,
Saudi Arabia, has played
the "valve", reducing
output in times of
oversupply and vice-versa.
But what if the US told
Saudi Arabia to keep it
flowing no matter what?
Hurt Putin where it hurts
16
RT, October 4, 2014
Page 25

most. Oil & gas. Crude oil prices, both North Sea Brent and West Texas Intermediate, are down about
30% since mid-June. Oil and natural gas sales accounted for 68% of Russia's total exports in 2013. The
fiscal break-even price for Russia is around $100/bl (see next page).
Falling oil and gas revenues caused the Russian Ruble to tumble (see chart previous page), losing roughly
a quarter since the middle of the year. Apart from the Ukrainian Hryvnia it is among the worst
performing emerging market currencies. The Russian Central Bank has already spent $70bn intervening
(selling dollars, buying Rubles) in the foreign exchange market. This leads to a contraction in the local
monetary base, adding to the negative effect of rising interest rates.
Over the past three years the Euro has risen from 40:1 to 60:1 to the Ruble, making imports from the
Euro-zone 50% more expensive and hurting Euro-zone exports to Russia. Inflation has risen to 8%.
Russia's population peaked at 148m in the early 1990's (today: 143m). Under the assumption no nuclear
weapons will ever be used, Russia, in the long run, poses no threat to the US. However, Western Europe
combined with cheap Russian energy might be able to mount a challenge.
Page 26
What are the consequences of those geopolitical games? At first sight, lower oil prices might be good for
consumers (less money spent at the pump = more discretionary spending). However, tapped-out
consumers might prefer to pay down debt instead. Oil exploring / producing and service companies, on
the other hand, are quite prominent in the US high yield ("junk") corporate bond market. More
importantly, Russia has been an important export market, especially for German companies. The conflict
in Eastern Ukraine will weigh on Russian-European relations for some time to come, dampening trade.
In the end, the conflict serves as a wake-up call to Western Europe, accelerating the move towards
renewable energy sources and reducing Russia's potential oil & gas revenues.
Page 27

In The Year 2024
Jim Rickards17 recently penned an article "In the Year 2024" (you can google it). He adds it "describes a
fictional dystopia, not a firm forecast or prediction in the usual analytic sense. Instead, it is intended to
provide warning, and encourage readers to be alert to dangerous trends in society, some of which are
already in place."
Below I summarize a few points:
Financial markets have been closed after the Panic of 2018
Money became worthless after too much had been printed in 2017 under QE7 (Quantitative
Easting program number 7)
Between 2018-20 the G20 abolished all currencies except for the Dollar, the Euro and the Ruasia
(a combination of the Russian Ruble, the Japanese Yen and the Chinese Yuan). Fixed exchange
rates have made currency trading redundant.
All gold has been confiscated in 2020, all gold mining nationalized after the gold price soared to
$40,000 per ounce in 2019
The value of all bonds has been wiped out in the hyperinflation of 2019
Governments closed stock and bond markets, nationalized all corporations and declared a
moratorium of all debts.
The elimination of cash meant governments' total control over money. Negative interest rates
were simply deducted from people's bank accounts, without any way to escape those charges.
Any questions or feedback highly welcome.

Alex dot Gloy at LighthouseInvestmentManagement dot com
Disclaimer: It should be self-evident this is for informational and educational purposes only and shall not be
taken as investment advice. Nothing posted here shall constitute a solicitation, recommendation or
endorsement to buy or sell any security or other financial instrument. You shouldn't be surprised that
accounts managed by Lighthouse Investment Management or the author may have financial interests in any
instruments mentioned in these posts. We may buy or sell at any time, might not disclose those actions and
we might not necessarily disclose updated information should we discover a fault with our analysis. The
author has no obligation to update any information posted here. We reserve the right to make investment
17
Author of "Currency Wars" and "The Death of Money"
Page 28

decisions inconsistent with the views expressed here. We can't make any representations or warranties as to
the accuracy, completeness or timeliness of the information posted. All liability for errors, omissions,
misinterpretation or misuse of any information posted is excluded.
+++++++++++++++++++++++++++++++++++++++
All clients have their own individual accounts held at an independent, well-known brokerage company (US)
or bank (Europe). This institution executes trades, sends confirms and statements. Lighthouse Investment
Management does not take custody of any client assets.
Page 29

Lighthouse Investment Management - Special Report - 2014 November - The Bottle Is Full

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Special Report - November 2014