In What Order will Asset Values Fail in the Next Financial Crisis?
As posted to LesJones.com on September 9, 2009

Reproduced from the article: “Word of the Day: Exter’s Inverted Pyramid of Assets”

John Exter’s inverted pyramid. The idea is that things high on the pyramid are derivatives of asset classes further down the pyramid. From FOFOA.

Note that in FOFOA’s expanded version of Exter’s inverted pyramid there are all sorts of derivatives at the top of the inverse pyramid. Those derivatives were wildly inflated and at one pointed passed the one quadrillion mark, which is greater than the value of all physical, privately-owned assets on Earth.  How is that possible? It’s possible because derivatives and paper markets are often larger than the underlying physical markets.

In a nutshell, the notional value of the paper market can be much larger than the underlying physical assets. Imagine a desert island with one coconut tree that produces one coconut per year.  Now imagine that somehow that one coconut is supporting a hundred firms trading coconut stocks, coconut bonds, coconut futures, and coconut derivatives. All of that activity is resting on an inverted pyramid supported by a single coconut per year. Like gold, the coconut is real. The farther away from the coconut you go in the pyramid the more derived and abstract the value of the asset and also the larger the market, because the paper market is puffed up with hot air and empty promises.

The theory is that when asset values are inflated and risk is perceived as low money moves up the inverted pyramid (away from cash, gold and coconuts).

During a debt deflation (which is a situation on the short-term horizon), a panic, or a perceived high risk environment money moves down the inverted pyramid (towards cash, gold and coconuts, as well as other more fundamental, less-derived assets).

Now . . . review your own financial portfolio in relation to Exter’s Pyramid.  How will you fair during the coming financial crisis, believed to eclipse that of 2008-2009?

 John Exter (September 17, 1910 – February 28, 2006) was an American economist, member of the Board of Governors of the United States Federal Reserve System, and founder of the Central Bank of Sri Lanka. He is also known for creating Exter’s Pyramid.