Tag Archive | "Barry Eichengreen"

Your Gold in 2012



A Look At This Week’s Show:
-Eleven great years in gold:  slow and steady
-Major supply sources are not keeping up with demand
-The East dominates the West in gold consumption

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December 4, 2012; The Battle for 2012: Constitutional Encroachment


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, Happy New Year! It’s a strange one, though, I have to admit. We were sitting here talking about 2011. But, as we look into 2012, we have people right now actually looking at numbers and saying, “Hey, the recession is over. Was that really a recession? There are people who said it was greater than the Great Depression. Was that really greater than the Great Depression?”

David, I don’t know that we have really felt, yet, the default of the world sovereign system.

David: Kevin, this is what is so fascinating. Coming into the new year, there is, again, sort of a bifurcation, two different views, two very different camps – one that says, “Look, we have record earnings from the S&P.” Of course they are ignoring the fact that the majority of Dow 30 stocks have actually lowered expectations for the fourth quarter, and are looking at an incredibly slower start to 2012.

Kevin: 2011 was a loss year for the S&P, so for people who are thinking that this is a recovery, where was that in the stock market?

David: But there is also, on one hand, the sense of greater nervousness that the policy makers are really up against it. They don’t have many tools to use. The ones that they have tried using have at least kept us above water, but we are not returning to a healthy environment. Unemployment is still high. Those are the defined concerns of one crowd.

The other crowd is on the other side saying, “Hey, if we will just think more positively, we will be above this, and beyond it, in a New York second.”

Kevin: But for those who can print money, like the United States. We have exorbitant privilege, according to Barry Eichengreen, and I agree with that. We don’t necessarily feel the pain, though we can see what is on the news. Let’s face it. We’ve witnessed more social unrest last year than any time since the late 1960s.

David: Kevin, I think this is just an important recollection. Looking at 2011, and thinking about all the things that changed in terms of political power structures, it was a year of almost uninterrupted drama in the news headlines. We began in December of 2010 with the gentleman who immolated himself in Tunisia, set himself on fire, in response to sugar prices being too high.

Kevin: That reminds me of the 1960s. We were seeing those same images at that time.

David: It was in Tunisia that we saw the beginning of the end, if you will, for that regime – Tunisian riots, followed by a new government, then Egyptian rights, and a new government, then Libyan riots, along with western support, and a new government. We have Syrian riots, and the government now hanging by a thread. We had riots last year in cities like London, New York City, Moscow. Actually, throughout countries like China, Chile, Israel, and India – we are talking about mass riots, even on a larger scale, last year, than India normally sees – there are generally 70,000 instances of civil disobedience, not full-blown riots, but protests of one sort or another. In China, last year, it was even greater.

Kevin: Think about Greece and Italy, and the European countries, especially what we call the PIIGS countries – that’s not a very flattering title, but it includes Portugal, Ireland, Italy, Greece, and Spain.

David: Again, Kevin, if you look at 2011 and consider the political power structures that were upset – as you mention, we have Greece, which had a new government put in place in 2011, we have Italy, and a new government put in place in 2011, we have the same thing in Portugal, and we have the same thing in Spain, both with new governments in 2011.

It appears that whatever is in the air, frankly, is not very good for incumbents, or frankly, anyone at the end of a populist whip. It just depends on what issues they are focused on. And frankly, it doesn’t matter what your belief system is. If you are in charge during this period of stress and strain, you will be held responsible, or the finger is going to ultimately be pointed at you.

Kevin: David, there is something that has occurred in the last week that has almost sneaked under the radar. Back in 1913 we had the passage of the Federal Reserve Act, and it was probably the greatest change in U.S. history. It changed our entire monetary system, yet we don’t understand it, still. Many people don’t understand the Federal Reserve.

But what occurred during this particular holiday season, and in 1913 they also sneaked it in during the holidays, is that we have lost our constitutional rights. Congress voted for something, almost across the board, that takes away our constitutional rights. They can jail us right now, any of us, without any constitutional reason.

David: Kevin, just to give a preview, this is the kind of thing that can lead to civil war, and I am saying that in a strange way, because if you look at the causes and the causal chains, if you will, there are many other things, of course, that have to be in the mix. But when you take away the rule of law, and the defense of individual liberties by the rule of law, you have done something that creates an incredible amount of political and social instability and insecurity, and leaves everything on the table that would normally not be on the table in a law-driven society.

What are we talking about? Going back to what we saw in 2011, Kevin, we have seen people, by and large, act with decorum, and the idea here is that we certainly hope that frustration does not smolder into anger, or any greater violence. We have seen things fairly well controlled with Occupy Wall Street. We have seen the riots in London and Moscow, where we are not talking about bloodshed at this point – it was in North Africa, and perhaps in the Mediterranean region where we have seen a lot more violence and indignation.

If there is, in 2012, an escalation, if you will, of greater anger, greater anxiety, and greater violence, that would only serve to justify the entrance of police state tactics – intimidation, counter-violence, things that, frankly, we hope we never see. Particularly dire consequences, are even, as you mention, now in the mix here in the United States after the weekend signing of the National Defense Authorization Act.

Kevin: Which basically says that they can jail anyone, does it not, if they see them as a threat to the country? And they can hold them indefinitely.

David: Kevin, as far as I understand the presidential signing statement, which went along with the signing of the NDAA, he said, “Under my administration, my interpretation will be different, and this is what it will be,” and that essentially comes due at the end of 2012. So, if he is re-elected, I don’t know if the presidential signing statement is in place, or if he has to actually create another one, but the reality is that this is changing the structure of the relationship between the governed and the governing, in a very unhealthy way.

Kevin: And of course, it is in the name of safety, and I have to think back to what Ben Franklin said. “When the governing bodies have decided that safety is more important than liberty, we actually deserve to lose both.” Does that not happen? All these things are passed on best intention, are they not?

David: Certainly, and that is, I think, one of the issues here, that you are really talking about a subnote, wherein American citizens deemed to be a threat by the president, can be indefinitely detained without any due process whatsoever. There is no call to your lawyer, there is no court hearing. You could sit and rot in Gitmo for the next 30 years, and there is absolutely no recourse for you. That, Kevin, is expressly unconstitutional, and as such, my feeling is that every legislator who voted for it should be thrown out of office in any ensuing election.

This is the kind of accountability that needs to be appreciated between the governing and the governed. It is our job as citizens to voice concern. We talked about the book, Exit, Voice, and Loyalty, and it is one of those things where a citizen, or any member of a body, whether that is a company, or what have you, will either, out of a sense of loyalty, stay connected, give a voice, and that is like letting off steam and thus remaining connected to that body, or they will simply exit.

Exit, in terms of a body of business, means that you will no longer do business with a company that you don’t like, or you will leave as an employee because you don’t feel it is a just situation. But that exit, in terms of citizenship – I’m not talking about a mass exodus of people renouncing their citizenship – is protests. That’s why I started by saying, the document that was signed by the Executive Branch, if not addressed by the judiciary, would be the first in the causal chain of things, which five, ten, or fifteen years from now, could lead to civil war here in the United States.

Kevin: When the U.S. citizens lose the defense of the rule of law, they have lost everything that the constitution grants them, and at that point, they are at the whim of whatever leader is in power.

David: Right, because you are essentially having to live in fear of the arbitrary use of power against you. So, if you lose every reason to honor the powers that be, and in turn, fight, because you feel threatened by them, again, looking back to the causal chain of what originally got this going, the destabilizing event, which maybe only finds traction five, ten, or fifteen years later, Kevin, I think this is just it: The National Defense Authorization Act is just such a thing, and you were right to quote Ben Franklin, because we don’t deserve liberty, or safety, if we are willing to so superficially sacrifice liberty for something as surface-oriented as safety.

Kevin: Well now, David, where do go from here? This has been passed by Congress, and it has been signed by the president. When you are talking about exit, voice and loyalty, what do we do? We have to speak up somehow, and the only way, constitutionally, that we are allowed to speak up, at this point, is at the polling place, and with our freedom of speech.

David: I think there are two places to press that. One is that the current mix of Republicans and Democrats will have, with this act, destroyed the social contract with the stroke of a pen. I think, to communicate that back to them, again, just letting them know that they have lost your vote, and that you are pledging monetary support to anyone, anyone, that opposes them in the next election on the basis of this issue.

Kevin: David, that means throwing them all out.

David: I’m okay with that. It was almost a universal consent that we needed the NDAA, even with the baggage that came with it, and this is where legislators need to know that they are crafting laws that are supposed to be consistent with the constitution, and here is something that is so grossly anti-constitutional. Again, I am hurling an insult at both the Republicans and Democrats for being so small-minded in this way.

Kevin: It would be wrong to blame the Obama administration.

David: Absolutely not. This does not rest on his shoulders. He may have signed it into law, but guess how many hundreds of people, from all across this land, who purport to represent you and me, signed it into law first, who wanted it as an ideal?

Kevin, this is why we have three parts in our governmental system. We have found two that are lacking. We hope and pray that the judiciary will see this as unconstitutional and throw it out. If they don’t, then we need to make our voices heard at the polls. So as we come into this next year, Kevin, an election year, it is very important that we focus the attention of the governing on the real interests of the governed, and that is, that we have our constitutional rights respected.

I could care less about the issues raised by Occupy Wall Street, or the Tea Party, as it concerns fiscal issues. Those things will come and go, with long-term business and credit cycles. As much as I care about the solvency of this country and the stability of our dollar, nothing compares in significance to our constitutional rights being sacrificed for something as silly as safety.

Kevin: David, in this particular case, I know you don’t agreed with the ACLU very often, but the ACLU actually agrees with what you are saying right now.

David: They came out with a statement immediately after the signing, and we are talking about within minutes of the presidential signing on the 31st. While we were toasting with champagne and bringing in the New Year, the president was signing something that, as even the ACLU said, “This is an abomination in terms of our civil rights.”

Kevin: David, I’ll tell you something. After going out and talking to the guys at Occupy Wall Street, which we have talked about on this program before, and I wasn’t impressed, but one thing that I have seen about the protests here in America, maybe even in Western Europe, that is different as we look east, is that these people right now are focusing on “capitalism” and they are blaming the financial markets and they are blaming the big bankers. Of course, the big bankers should take some blame. But they seem to be completely leaving out blaming the politicians, and what we saw on December 31st means we should be looking at the politicians, not capitalism.

David: Kevin, that is exactly right. I think what we have allowed politicians to have is a free pass in 2011, at least in the U.K. and in the United States. The emphasis has been much more on the money mandarins, and I think, actually, we will see that change as we move into 2013 and 2014.

Kevin: When I talked to people in Occupy Wall Street, no one cared anything about protesting in Washington. They just wanted to protest in New York, because it must be the guys in the suits.

David: Kevin, I think that is a critical distinction between the global protestors and the emphasis placed on politicians, the pressure for real political change, and the protestors here in the “West” who are putting more of an emphasis on changes in banking, changes in fairness, changes in redistributive policies.

I think that is the real critical difference. The rest of the world seems to be going straight for the political class, and that on a wholesale basis. We would say that social unrest on a worldwide scale, not only was seen in the 2011, but it is going to continue in 2012, because we have newly enfranchised politicians who are being given the impossible task of maintaining stability in a totally destabilized world.

The great de-leveraging, or unwind, of 50-60 years of credit domination in the marketplace is what these politicians are up against, and as the West takes its three steps back, the developing world, the emerging markets, they take their steps back, as well. They take their lumps, as well. And regardless of who is in political power today, the same question is going to be asked by their constituents: “What are you doing for me today?” – even the ones who put them in power, rejecting the old power structures, because they didn’t feel like they were being tended to.

Kevin: David, sometimes we have a myopic mindset. We were just talking about constitutional rights. We have certain things that we value here in the West. As you look east, people don’t value the same types of things. When you have a society that has been ruled by a dictator or a tyrant, and they have been kept in order, be careful what you wish for, because that voting public may not have the kind of values that you would want to have running the country.

David: I think this is the illusion that we have when we think of a “democratically elected government” – that all of a sudden that is going to bring the virtues and full representation of the people. Again, bringing back this idea of the rule of law and how important that is to our democratically elected government in the United States, law is paramount. The constitution is paramount.

If you go back to Czechoslovakia, and Vaclav Havel, after the Velvet Revolution, what was the first thing that he did? He said, “I will not be in office in the next election, and I am setting my limit. I am setting my own term limit to two years. That is the time frame we have to create a constitution, something that will endure through the generations.” And that is, in fact, what gave Czechoslovakia its great success.

Kevin: I remember the patriots, the founding fathers, who did the same thing here in America. George Washington – they were trying to make him King George, and he set his own standard, and said, “No, I’m not going to do that. You don’t want another King, you want transitory power.”

David: And that is the nature of democracy, Kevin. Unfortunately, if you don’t have the substructure of the rule of law, you are really not talking about the greatest number of people who get to vote, you are talking about the loudest voices that get heard, and that is what becomes a representation of the people.

Kevin: So, in the years 2012 to 2103, we may begin to wince. It may really be painful, because what we are seeing is that these new democracies are really just old extremists now regaining power.

David: That is certainly the case, if you are looking at the Middle East, and this is where we see the Muslim Brotherhood in Egypt already asserting its power, and what was viewed as a charitable organization looking for peace and generosity, we find, that they, in fact, are having to reassert power, reassert dominance. All of the riots in Tahrir Square are happening again, already, because people are not having their expectations met. We are already seeing sectarian differences expressed. And while it worked last time – show up in the square, and if you are loud enough, people will respond – now they are being loud and the Muslim Brotherhood is saying, “If you are not quiet, we are going to shoot you.”

This is an issue where, again, Kevin, your comment is appropriate. The new democracies, which the West is so keen on seeing enfranchised, are really just the old extremists that have received the blessing of the West because the process involved “democratic elections.” But their priorities and their intentions were never questioned, and that should have been done at the front end.

Kevin: You know, David, we live in such a complicated time, too. Think of the James Bond movies. That is probably one of the best meters as to who your enemies are. Back in the old days, my son and I were talking about it. He is only 21, so he doesn’t really remember the Cold War, but in a weird way, the Cold War was comfortable, because you just had Russians who were the bad guys, and you just had two sides. But at this point, and we talked about this before, there is a lack of headship and we have old extremists coming into power, old tyrants being either shot or taken out of power. Nobody likes a Mubarak, necessarily, or a Khadafy, or a Saddam Hussein, but let’s face it, from a geopolitical standpoint, things are being destabilized.

David: It was just a simpler world. I’m not saying it was a better world, but it was easier to make judgments and define relationships in that Cold War polarity. There were the good guys and there were the bad guys, and everybody lined up accordingly. You were a friend of the good guys, which made you a good guy, or you were a friend of the bad guys, which made you a bad guy.

Kevin this is the point: Those who are democratically elected – and for us that is a moral victory, as we have seen democracy spread throughout the Middle East – now may, in fact, behold things, or believe in things, that we find very morally objectionable.

Kevin: David, let’s face it. Not everybody has a religious directive for world domination, but there are some of the people who are running some of these countries who believe that they have, because of their god, a reason to take over the world. So, yes, democratically elected, and we are talking about relationships based on trade or security, or what have you, but they may have a motivation that is far beyond what we can imagine.

David: Kevin, I think, as an indication of that, consider the al Qaeda-linked group in Nigeria that, over the weekend, was responsible for several bombings. It’s a militant group whose name translates “western education is sin.” That’s the literal translation.

Kevin: So it’s good to know the language if you want to know what the motive is.

David: And as long as we are talking about multicultural expression and a greater globalized, homogenized world, listen. You want to be homogenized with this? Great! Western education is sin. That would include everything that isn’t directly out of the Koran. Basically, we have excluded, by defining the only source of education as the Koran. That is problematic, I think, for many in the West. That is problematic for many in Europe. That is problematic for the whole world. But we have this flashpoint, Kevin, and I think this is something that we need to remain sensitive to – Iran, of course, with their nuclear rods and their surface-to-air missiles, and their saber-rattling over the Strait of Hormuz.

Kevin: And now, our drone.

David: Yes, of course, they have our drone, which they shot down. Of course, that’s not what happens when you shoot something down. It usually ends up in a thousand pieces.

Kevin: It sure looked like it landed well to me. There is an old saying when you are a pilot, “Any landing where you walk away from the plane is a good landing.” Well, there was nobody to walk away from the plane, but they could have.

David: Humpty-Dumpty – this would have been a magical Humpty-Dumpty story, where you definitely got it put back together again.

We have growing tensions in the Middle East, and I think this is one of the things that we will have to explore in 2012, the irony of destabilization by getting what we wanted. We chose safety, and we ended up with what? We chose democracy, and we ended up with what? There are probably about ten different themes which we can explore this year, Kevin, where we thought we were saying yes to one thing, and we got something else completely different.

That is the same strange irony that we have with the derivatives market. We have someone who is willing to leverage their balance sheet. If you look at the average U.S. financial institution, or global financial institution, and they are willing to leverage their balance sheet 10-to-1, 12-to-1, 17-to-1, 25-to-1 – massive leverage. Of course, massive profits, with very little capital involved. And they are willing to take that risk because they have taken out insurance policies to mitigate some of that risk.

Kevin: Which are called credit default swaps.

David: Credit default swaps is one of the key varietals. And guess what? We discovered in 2011 that credit default swaps aren’t worth the paper they are written on, if you get politicians involved. Why? Because most politicians have a legal background, and if you have a legal background you know that words are subject to interpretation, and we just discovered the reality that the word default is subject to interpretation. A 50% haircut is not a default as long as it is done on a “voluntary” basis. A curious loophole for the whole world of finance, which is leveraged to the gills on the basis of this insurance component that allows them to be “safe.” And again, the things that we asked for are not necessarily what they seem.

Kevin: That’s what I don’t understand, Dave. We have talked over the last couple of years about the danger of all these derivatives sitting out there that could be triggered at any moment if we saw a default. What we have seen instead of “default” – maybe it’s default with a small “d,” not with a capital “D” – these guys have basically said, “Let’s not call it default, let’s call it something else, so that those insurance policies don’t trigger.” These guys still took a 50% haircut, but David, that credit default swap cloud is still out there, and all it would take is the right word being used, and it would still be triggered. Isn’t that the case, or are the CDSs gone?

David: No, the CDSs are not gone. They are still there. There is very little reform that has taken place since 2008. As in our conversation with Rick Buchstaber, this was an amazing discovery from someone who is going before Congress and saying, “We have to change this, we have to regulate the market, we have to have these things traded on an exchange. And if we don’t, you have no idea what you are staring down the barrel of.”

Kevin, this was the question that was asked on Fox News last night, in the interview that I did with them. They asked, “2008, reasonable problems. What do we see in 2012?” And my response was, “2008 was a crisis, but 2012, 2013…”

Kevin: Is maybe the crisis.

David: The crisis.

Kevin: Now that scared the commentator a little bit, David Asman, and he even said that.

David: I think the issue here, Kevin, is that we think that we have gotten past the worst, when, in fact, we have changed nothing. And the things that have changed are actually creating other areas of destabilization, and now we are talking about politics and geopolitics. But as we discussed, negative feedback loops from one of these areas – politics, geopolitics, finance, economics – can end up having a negative influence on all, as they come back around and surprise.

Kevin: Let me ask you a question, David. This is 2012-related, but it is actually bringing it down to a more personal level, because we have been talking about the state of the world. You and I are not going to change the state of the world, but we are talking to people who are saying, “Okay, I have a family, I have a household, I have savings. Are we going to coast through 2012?” Granted, 2011, was pretty turbulent, but, for the most part, we have coasted through an entire year without really feeling the effects of these things. 2012 is different.

Let me ask you. From a personal point of view, for the people who are listening, who say, “Okay, what do I do right now? What should I look at with my finances?” Gold. Let me just take it to the base of the triangle, to start with, David. Gold had a good year, from $1300 to close to $1600 by the end of the year, but it also had fallen from $1900 in the last quarter. What are we looking for on gold at the base of the triangle, and maybe the rest of the triangle? Would you comment?

David: I think that applies specifically to the financial, and we could certainly talk about the social and political, as well, because these are areas, Kevin, where, as we suggested last week, we will see extreme regime change. We are coming into a period in time where, as Franck Biancheri suggested, in the context of crisis, time gets shrunk and compressed, and the amount of things that do change in a very short period of time will shock and amaze you.

2012 and 2013 will see social unrest, and will see political change as a result of that. But certainly, we also focus on the financial element. We sent out a news alert to everyone on our email list on Friday. Gold hit the 65-week moving average. This is a technical range that gold has recovered from every time over the last ten years. If we are still in a bull market, and we have good reason to believe that we are, then, as a buying opportunity, as a place to be reallocating, as a place to look and say, “Okay, well, now that that asset class has been fully compressed, what can we expect?”

Kevin, I think we are actually standing on a loaded spring when we are talking about the precious metals, coming into 2012 and 2013, again, because we have both the political change, and the social unrest, in the background, 2011 being a precursor in that regard. We have had a preview of coming attractions. We have seen it in sort of the fringe world, and coming to a theater near you, is Washington D.C., New York, San Francisco, Seattle, and if we are talking about Moscow, then throw in half a dozen other cities. If we are talking about London, then throw in half a dozen other cities in the U.K.

Kevin, where we are seeing social unrest, we will see social unrest on a more frustrated scale, on a more out-of-control scale, and the response to that, is a much more controlled, and frankly, unfortunately, more violent response. Those are the issues, Kevin, which I think serve now as the structure, the undergirding, for people making a decision like this.

I could choose dollars, and why would I? Because I see the systems, as they are, being called into question. I don’t know who is going to be in power next year. I don’t know, even if we have a free and fair election in 2012, that they will maintain power for six, or twelve, months. Those kinds of questions will emerge in the context of an unstable social environment.

Kevin, remember, the last time we had this much social unrest, and you brought up the 1960s, we have not seen that kind of social unrest in the U.K., or in Moscow, and I don’t think that is a Putin concern today, or a concern for this current administration, nor should it be. Because again, I think people can, and should, act with the requisite decorum, to pursue the rule of law, the application of the rule of law, and the healthy expectation of the governed, stating their opinions to the governing, in a healthy way.

But Kevin, this is the context where investors say, “All bets are off. All bets are off on the dollar. All bets are off on Treasuries. All bets are off on a healthy, functioning stock market. All bets are off in terms of free trade.” We can very easily see this morph into what was also the summer of 1931, where a regional banking crisis in Eastern Europe became a banking crisis in London, became a banking crisis in the U.S., and what was a severe recession became a major depression.

That is the environment, and whether you are looking at the political, whether you are looking at the economic and financial, it is a period of extreme dysfunction and chaos, and in that environment, Kevin, people scramble for control. I look at gold being at the 65-week moving average, and say, “If not now, when?” There is only one instance in the last ten years where this level was breached, Kevin, and it was in the fall of 2008. And by the way, the asset did recover by the end of the year, so in spite of a 30% decline, it did recover to a 5-6% positive return by the end of the year.

Kevin: David, wouldn’t you say, for the person who is saying, “All right, there may be chaos in your life, but my life is just perfect. Don’t worry about it, I think maybe it’s a recovery. You guys are just crying wolf. That’s all you’re doing, just crying wolf.” So let’s just say, we say, “Yeah, okay, that’s it, just crying wolf.”

David: Kevin, that’s the value of the perspective triangle, because it allows you to be right and wrong, regardless of the outcome. If it is a deflationary vortex that we get sucked into, and everything gets sold down to zero, guess what you have a third of your assets in? The one thing that people want the most – cash. Great! You’re a hero! Your cash, in terms of purchasing power just expanded a multiple, and you can buy the world for ten cents on the dollar, making the other two-thirds of the portfolio, which may have been hit hard, inconsequential.

Kevin: But let’s say it’s inflation.

David: In that case, your cash is worth nothing, your equity values succumb to the pressure in the market of an earnings crisis, and guess what? Your insurance policy in the form of physical metals pays off, and it doesn’t matter what happened to your cash, and it doesn’t matter what happened to your equity portfolio. It becomes inconsequential.

And if, on the other hand, the Pollyannas of the world today are saying that yes, we are in recovery, the recession is past, we have a bright future today and tomorrow; if they are right and we are wrong, guess what? You are leveraged on the upside and a third of your portfolio will, probably, over a 5-7 year period, make up for any losses that you have had in the cash position, and in the metals position, in your portfolio.

Kevin: So the answer to the question that I posed a few minutes ago, as to what a person should do with their own finances, still doesn’t change. It is a third in gold, a third on the left side for growth, and a third on the right side for cash, or at least something where you are aware of those percentages.

David: 2012 requires that you take a balanced approach to the markets. There are these different views, as we pointed out when we began the conversation today, Kevin, of extreme concerns and extreme happiness, that, in fact, the worst is behind us. When people have the facts all lined up on both sides, and they happen to be opposing and contradictory, you realize that no one knows what is going to happen next.

Taking a balanced approach, a diversified approach, which we find the perspective triangle to be … yes, I think that is the best way to approach this year – a most conservative one – certainly, in light of the facts as we see them.

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September 21, 2011; The Final Days of the Keynesian Utopia: An Interview with Hunter Lewis


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, as promised, we talked about looking at Keynes again, even though it is an ugly picture. We have as our guest today Hunter Lewis.

David: Kevin, I think the importance is this: We see experiments over, and over, and over again, with bailouts, both here in the U.S., and in Europe, and around the world, and they are predicated on the same things – basically, Keynesian economics. We are now into the third round of bailouts for Greece. The first didn’t work, the second didn’t work, and the third – of course it will work. At least that is the belief, and we do the same thing over and over again, believing, not that the method was wrong, but that we were only wrong by degrees. We should have done more of the same. We didn’t do enough of it. We didn’t spend enough. Billions weren’t enough, we needed hundreds of billions. Hundreds of billions weren’t enough, we needed trillions. Trillions weren’t enough, and this is the same kind of insanity that led to the Havensteinian nightmare, if you will…

Kevin: Back in the early 1920s.

David: Exactly. Dr. Rudolf Havenstein was a very smart man, a national icon in Germany, and he had the full support of the academics of the day, saying, “If things are getting more expensive, just print more money, and that way it will be more affordable,” and everyone loved the idea, and no one questioned some basic assumptions. I think that is what I love about now turning back and saying, “Let’s pause, let’s think about this. We need to reassess the way we view economics.”

This is a dismal science. Nobody particularly likes economics, but listen, your life is being predetermined for you by economic, fiscal, monetary policies, not only here in the United States, but around the world, where there is collaboration, and everyone is agreeing that we should do the same thing. This is the definition of insanity, Kevin, in which you do something, it doesn’t work, and yet you do it again, and again, and again. I want to explore that a little bit with Hunter Lewis today.

Kevin: David, it defies common sense, and that is the thing that Keynes was known for, defying common sense. Last night I was grilling steaks on the grill and we were talking to my son. He doesn’t live here, he is up in college in Boulder, and he said, “Who do you interview tomorrow?” I said, “Hunter Lewis. He wrote the book, Where Keynes Went Wrong.” Then I started to say, “Okay, here is what Keynes believed,” and he cut me off, and he said, “Dad, I know what Keynes believed – spend more.”

David: It is interesting. I think it is becoming more common knowledge that the guy was a bit of a quack. He agreed with Sylvio Gesell’s idea that you print money with an expiration date on it. In other words, you don’t save it. If you own it, you need to get out there and get it moving.

Kevin: Penalized for saving, basically.

David: He loved progressive taxation where you take more from the wealthy and redistribute it to those who have to, or will, spend every bit of it, rather than save and invest. He loved the idea of setting interest rates at zero and keeping them there permanently.

Kevin: How in the world would anybody retire? I don’t understand. If you set interest rates at zero, what is your CD going to do for you?

David: It is the issue of price controls, central planning, government monopolies, the role of the state being bigger and bigger because they are better and better, in his mind, and you do see shades of a world view that puts the state in control of everything. In fact, that was a part of Keynes’s ideals, not just in economics, but in politics. If you go back to Plato’s Republic, you find that Plato really fancied the philosopher king as the person who should be making all the decisions, and you couldn’t trust the hoi polloi, the average voter. “Well, just what do they really know? And really, things should be centralized around one person.”

Ironically, you find this figure, the philosopher king, being at the center of the universe. Keynes was no different. He created a structure of thought which propelled him to the very top. Basically, it should be central planning, and I am your consigliere. I am your advisor. I am the philosopher king from behind the scenes who is dictating, not only political issues, but economic, as well.

Kevin: David, with that in mind, when we have taken economics classes in the past, we have had these ISLM curves, and we have had a lot of different equations. It becomes so amazingly complicated, when in reality, really, all that is being taught is that you need to make sure that you don’t spend more than you make, and you spend productively what you spend. I would just say, when you had us read this book a couple of years ago, Where Keynes Went Wrong, the entire office, and then we discussed it, it was a way of condensing voluminous material on Keynes, and I wouldn’t encourage anybody to just go sit down and read all of Keynes’s material. Not only does it not make sense, but it is unnecessarily complicated so that the person actually is intended not to understand what he is reading. But this book, Where Keynes Went Wrong, is a great summary of Keynes, and why it doesn’t make sense, and then what does make sense, wouldn’t you say?

David: I would, and Kevin, I think this is one of the things that gets to the heart of it for me, and I think for our listeners, too. The fact that Keynes did not take a look ahead, he was not concerned about the future, he did not care about future generations. It was not in his equation at all. Everything was about the present moment, and that is reflected in his own life, it is reflected in his personal decisions, it is reflected in his orientation to an economics which is driven by success today, irrespective of what happens tomorrow.

Kevin: Like the cavaliers. “Eat, drink, and be merry, for tomorrow you may die.”

David: And he justified it by saying, “In the end, we’re all dead.” So by putting that finality out there, he concentrated on the here and now, so much so, Kevin, that he betrayed future generations. I think that is what we have to be cognizant of, as thinkers, as actors, in the marketplace today. We cannot afford to betray future generations as our current body politic has done, and will continue to do, to the degree that it continues to hold Keynesian ideas in its stock of beliefs. And this is why Hunter Lewis is joining us today.

David: Joining us again today is Hunter Lewis, and the discussion is Keynes, his book, Where Keynes Went Wrong. I have gone through the book, yet again, and this is a book that we read in the office, nearly two years ago, and benefited from immensely. It is on the shelves of every person in the office and we had some in-depth discussions, not only about what Keynes said, but just how confusing, at times, it can be, and almost incoherent, except the man was truly brilliant, and that was how he got away with saying what he did. No one really wanted to challenge him.

What Hunter Lewis has done in his book, Where Keynes Went Wrong, is to parse out some of the things said, and what has been misconstrued, what has been put into place as policy, and assumed to be good economic theory. I couldn’t recommend the book more highly. You can either get it in hardback or paperback. Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles and Busts.

Thank you for joining us, Hunter.

Hunter Lewis: It’s a pleasure.

David: In some respects, Keynesian economic theories were simply a justification for his own personal choices and ethical leanings, really, as a rejection of 19th century social conventions or values, what was conventional morality at the time, including things like thrift, savings, maybe even an orientation to the future, the 19th Century certainly had that, predicated on traditional family structures, and again, savings for future investment. He really had a focus on the here and now, maximizing the present, whether it was present pleasure, or present economic stimulus. Maybe you can look at where we are today. We had this conversation, to some degree, two years ago. Has anything changed in the last two years in terms of the government pursuing a more or less Keynesian solution to the current economic malaise?

Hunter: Not only has our government not changed, but every government in the world is continuing to follow the same Keynesian policies, and of course, they haven’t worked, they aren’t working, but we just keep doing more of the same.

David: We find ourselves looking at the classic phrase, “A spoonful of sugar helps the medicine go down. In this case, that simple shot of sugar helps the system feel better, although it doesn’t necessarily bring health. The criticism of Keynes, and this is a self-reflective criticism by practicing Keynesian economists, seems to be that 2008 rolled around, and we gave it a spoonful. Now, we have found that we needed a cupful. Now we need a wheel barrowful. Now we need a dump truck-full. The only criticism seems to be that we didn’t do enough, and there doesn’t seem to be a preceding criticism of, “Does this actually work?” Maybe you can comment on that.

Hunter: First of all, back in 2009 when we were coming out of the crash, in the first interview I had about the book with the BBC, they said, “Are you proposing to take the patient off life support?” And I said, “That’s the wrong way to look at it. It’s not life support, it’s just more alcohol for the alcoholic, or it’s more heroin for the drug addict. Then of course, you need more and more of that to keep an addict from being in withdrawal, but it doesn’t help the problem, it just makes it worse, and that’s essentially what has been going on.

Moreover, the most interesting thing to me is that as time has passed and these solutions have not solved anything, but, in fact, they’ve made it worse. None of the Keynesian economists who were propounding, “Let’s have more stimulus,” are providing any justification for it, on a theoretical basis, or an evidence basis. They just take it for granted. In every article you will read, even the recent one by Robert Shiller, in which he said, “It’s undeniable that we need more stimulus now.” He doesn’t explain why it’s undeniable, because the truth is, there is no logic and there is no evidence for it.

David: One of the things you point out in your book, Hunter, is that that actually was the force of argument that Keynes used, himself. It was stated so emphatically that there really wasn’t evidence that was provided, and he got away with it. In his General Theory, it’s not as if he built a case, he just stated emphatically, “Thus so,” and everyone went along with it. That has been, I think, one of the particularly insightful things about your book is that, really, it is just a statement, there is nothing there that supports it.

Maybe we can look at some of the things that you and I would share in common a criticism of, but maybe the listener doesn’t know just what it is that gets under my skin, and I think perhaps yours, as well. Ideas like the rate of interest, set by the market. We are used to that. We look at the bond market as market practitioners, and see that people judge credit risk, people judge ability to pay. People judge all of these things, and give you, basically, a market grade. How do you fare in the pecking order? A junk bond may be 10-12%, and someone who is considered to be a good credit risk is maybe 2, or 3 or 4%. So there is that grading in the marketplace. As far as Keynes was concerned, the rate of interest, if it is set by the market, is always too high, with the ultimate target being zero. Why would Keynes target a zero interest rate policy – which frankly, sounds very familiar today – why would he target that as a perpetual ideal?

Hunter: This goes absolutely to the heart of what is wrong today. We have a market system which is based on prices and profit, and yet, the government keeps interfering with the price system, and it is the price system that tells everybody in the market what they need to do. So they are really shutting off the flow of information that is essential to prosperity.

When you have high unemployment, that tells you that there is something wrong with the price system, that there are prices that are not in the right relationship to each other, and yet, the government keeps messing up the biggest, most important prices of all, one of which is interest rates. The system really can’t function if the information that the market is providing in the form of the interest rate, is not available.

And of course, it makes no sense at all, as Keynes advocated, to keep driving interest rates down to zero and hold them there. That is essentially giving away money. And of course, we are giving away money, today. The Federal Reserve provides newly printed money to Wall Street, to firms like Goldman-Sachs. They are getting virtually free money, and of course, they make a lot of money with that money, themselves. So then we have this problem of crony capitalism that goes along with it – all these people who are getting rich off these government policies which are not helping the economy as a whole.

David: You raise an interesting point. The market system is dependent on an information feed, and prices tell you what is happening, whether it is healthy or unhealthy, and for governments to step in and play with the price system, via interest rates, is distorting the information feed, and it confuses investors. It also, with a zero interest rate policy, disincentivizes savers. That is also at the heart of Keynes, is it not? That you really don’t want there to be a saving, or using the 19th Century language, a rentier class?

Hunter: That’s right. He basically suggested that the government could print new money. That money would flow into the economy in the form of debt, and that would take the place of savings, but there is just no evidence for that at all, there is no logic behind that. In fact, if you want a good economy, what you need is savings, and you need then to invest those savings, and you need to invest those savings in a wise way.

Of course, Keynes completely ignores the issue of how you are investing. For him, not only is any investment equivalent to any other investment, but spending is equivalent to investment. It just doesn’t make any sense at all. If you want to restore the economy, you have to save, you have to invest, and above all, you must invest wisely.

David: And he went even further to say, whatever means necessary to use up those savings. You bring this out in your book. He argued that natural disasters, earthquakes, even wars, were a way to increase wealth by using up savings. I have to scratch my head on that one – the more you use up savings, even if it is for something like what just happened in Japan – that is productive? That is a move toward an increase of wealth for the Japanese? Help me understand that.

Hunter: It’s a complete logical fallacy, because the idea is that after the disaster, the Japanese have to spend a lot of money, and that will help the economy, but what that ignores is that they then can’t spend the same money on something else which would have been more productive. Obviously, just restoring what they had before is not the best investment they could make. The best investment they could make would be something new and productive. It’s illogical. It’s just a logical mistake on Keynes’ part, and yet, he made lots of logical mistakes.

David: It sounds awfully like the broken window fallacy.

Hunter: It is the broken window fallacy, which Henry Hazlitt wrote about a long time ago, back in the 1950s. Here we have the world’s governments basing their policies on Keynesian economic theory that just makes no sense.

David: We oftentimes discuss, here in the office, Thomas Kuhn’s book, The Structure of Scientific Revolutions, and the idea that there is no real evolution, but there is revolution within a theory of ideas, a theoretical framework. Whether we are talking about a scientific framework, or an economic framework, or even something relating to literary theory or philosophy, there tends to be a textbook community, a group of people who have agreed what is acceptable and true knowledge, and the educational system then perpetuates what is “real” or “true” or “reliable” information. Up until the point where you have problems that cannot be solved by the prevailing paradigm, people just accept it as common knowledge.

It seems we’ve done that with Keynesianism. Keynesianism is economics, largely, and as you said earlier, it is not just the U.S. government, it’s not just the Fed and Treasury, but if you go to any central bank or fiscal or monetary authority around the world, they have the same bias because, largely, they have studied at similar universities, and share that same textbook knowledge.

The point with Kuhn was, really, you get to the point where there are too many problems that can’t be solved by the existing paradigm, and then something replaces it. Do you see that as a possibility? And is the replacement a better one, or a worse one, given what we have in the social milieu today?

Hunter: Yes, there are, in effect, intellectual bubbles, just as there are economic bubbles, and Keynesianism is an intellectual bubble which is underlying the economic bubbles that we have had and that have gotten us into trouble. These things are very hard to change, but they do change, and an idea gets bigger and bigger and bigger, but eventually it does explode, the change comes very rapidly, and then it’s all put behind.

Some people have observed that there is a process in which these ideas change. First of all, an idea is ridiculed: Anti-Keynesianism, in recent decades, has been ridiculed. Then it is ignored – it is getting around, but you don’t want to give it any publicity: The major media today, in general, tries to ignore anti-Keynesian ideas. Then it is fought ferociously. Then, at the end of the process, everybody who fought it says, “Oh, I knew that all along.” That is the typical way that these ideas change. But, eventually, they do change, and they change dramatically. I have no doubt that Keynesianism is on its last legs, but in the meantime, billions of people are suffering as a result.

David: Yes, there is real human suffering, which is far more important than something that is, perhaps, catastrophic to one’s portfolio. Tying in something that you mentioned in your book, negative real rates, this is a chief consideration for everyone, and a consequence of that manipulation of interest rates, keeping them too low, too long.

Negative real rates – there are some practical considerations. You quote Peter Fisher, former Undersecretary of the U.S. Treasury, and New York Federal Reserve Bank. It is not as if officials at the U.S. Treasury or Fed are unaware of these issues, but he says capitalism is premised on the idea that capital is a scarce commodity and we are going to ration it with a price mechanism. When you make short-term funds available essentially free, with negative real rates, and you say rates lower than inflation have happened, for example, between 2001 and 2004, crazy things start to happen.

This is where we are today. We have negative real rates of return. There are different ways of constructing the inflation number – the models in the 1980s, the models in the 1990s, the way we count it today. Today it is less than 3%. If it was counted by the old model in 1990, it would be over 6. If it was counted by the Volker view of inflation, it would be double digit today. We have deeply negative rates, and it forces major misallocation of capital. Maybe you can talk about the consequences of being in a negative real rate environment and the bubbles that are perpetuated. Really, what was set forth in 2008 is the seed of a future problem. Would you agree with that?

Hunter: Yes, absolutely. But first, I want to stress the point you just made, which is that the way the government calculates inflation and unemployment today has changed a lot over time. Some of the biggest changes came during the Clinton administration. If we calculated unemployment the way we did in the 1930s, we would have depression levels showing right now, a lot more than what they are saying, and we would certainly have more inflation showing, as well.

We do have an environment of both inflation and unemployment and that, again, is just the result of these bubbles that have been blown up since the mid 1990s, and they have been blown up, just as you said, by holding interest rates too low, printing way too much money, in an effort to keep interest rates down. A combination of too much money and too low of an interest rate just creates a bubble. Meanwhile, again, the Keynesian economists – and that means most economists – say, “Oh, bubbles are just natural. Bubbles are just part of the market system.” If that is true, why is it we have had nothing but bubbles since the mid 1990s, and we didn’t have bubbles before that for decades? Again, it is just nonsensical to say that these kinds of bubbles are normal, when they are so evidently abnormal, and they are the source of our problems.

David: The business cycle is something that Keynes was not particularly fond of – abolish slumps, and instead, seek to maintain a perpetual quasi-boom, to paraphrase him. There was, in the 19th Century, a period, let’s say between 5 and 10 years, where it was more or less two steps forward, one step back, and a regular, if you want to call it, mini-boom and mini-bust cycle. Nothing deeply catastrophic, but surely painful to those who were on the wrong side of an investment, and those messes got cleaned up pretty quickly, again, in a two steps forward, one step back process. Keynes’s response was, “No – perpetual bliss.” And wasn’t his view really that of a utopian?

Hunter: Absolutely. As in any other utopian thinking, it just doesn’t make sense. It doesn’t recognize reality. The truth is that mild recessions are the price you pay for avoiding deep recession. When you try to eliminate mild recessions, as Alan Greenspan did, and Bernanke did, all you do is create the kinds of problems we have today.

But even in the past, when you had deep recessions, or even depressions, they didn’t last long. The market cured them in fairly short order. The early 1920s depression is a good example of that. The government did nothing and it was over in about 14 months. Contrast that to the Great Depression, or the kind of problems we have had since, where it just goes on, and on, and on, because the medicine the government applies actually just makes the patient worse. It provides temporary relief, but then it doesn’t solve the problem and makes it worse in the long run, or even in the short run.

David: You are talking about Harding, and his response, essentially, to Herbert Hoover. Hoover suggested they pump tons of money into the system in a very Keynesian fashion. Harding said, “Go fly a kite,” and he cut the budget significantly. If I recall, he cut spending almost in half, and we went from a 12% rate of unemployment, to 2%, by 1923 – 2% and change. A very different response, and it was, as you mentioned, a deep recession. It just didn’t last that long, because a different solution was offered by the Harding administration.

Hunter: Right. And there is more recent evidence of that sort, when the East Asian economy got into trouble in the late 1990s, they did not have the resources to apply Keynesian policies, they acted more like Harding and they got over it very quickly. They had a very strong rebound in no time at all, and that is in contrast to the countries that have practiced Keynesian responses, where they don’t get a rebound. They don’t fix the problem, they just make it worse.

David: Is it going to be a surprise to the average man in the street, or woman in the street, who comes to terms with this bankrupt ideology – will it come as a surprise to them just how nonsensical it was to believe in it? And how Ph.D.’s, very, very bright men, have held to these views, which are utterly nonsensical, and very against common sense? I go back to the Redbook article that was from 1934, in which John Maynard Keynes wrote in answer to the question, “Can America spend its way into recovery?” He answered, “Why, obviously, the very behavior that would make a man poor, could make a nation wealthy.” Is it going to pass muster with the voting public that politicians of both stripes, that academics, that Wall Street geniuses, to some degree, rely on Keynes as an intellectual pillar?

Hunter: Keynes was always the smartest kid in the class. He always had his hand up, and he was always telling the teacher, “No, everything you are saying is wrong.” He loved to provide what seemed to be a paradox. If too much debt causes a crash, load on more debt. It’s okay to grow debt faster than income, indefinitely. If debt becomes too burdensome, just cut interest rates. If low interest rates are causing bubbles, just lower them further. He was a specialist in these kinds of paradoxes.

And it is generally thought today that economics shows us that it is an area, it is a discipline, where common sense is actually wrong. But that in itself is wrong. Real economics, which is completely violated by Keynesianism, does reflect common sense. That’s what you need, you need common sense. You cannot violate common sense and expect to do anything for the poverty in the world, or to help the middle class. You have to have common sense policies. And it is just incredible that brilliant people, like Robert Shiller, a Yale professor and greatly respected, just keep clinging to these views, even though there is no logic, and no evidence offered to support them. They are just completely assumed.

David: In recent weeks we have talked about the Fed getting very aggressive in providing liquidity to Europe. It is just within recent days that they have done that, that they are providing ample liquidity through currency swaps and short-term lending via the EC in a coordinated effort with the ECB, the Swiss National Bank, the Japanese. We are re-liquefying the system yet again, and the amazing thing is that the markets love it. The markets absolutely love it. Are the markets really that bright, that they should be saying, “Hey, this is fantastic?” To me, it looks like the smile on the face of the dope addict who just took another hit, and “Boy, isn’t this grand?” Am I seeing this accurately?

Hunter: When we talk about the market, in this case, we are really talking about Wall Street, and Citi and people like that, and as I alluded to earlier, Wall Street has gotten rich off of all these bubbles. Wall Street gets rich off the printing of the money, and keeping interest rates low. They love this kind of thing, and they are only concerned with how much money they make in the next quarter, or the next year, and they are certainly not concerned with the long term. So it is not surprising that the stock market goes up when these fallacious policies are pursued even more intensely.

In terms of Europe, one of the big factors is that the European Central Bank operates under rules in which, if there is any default of the bonds that they hold, they have to sell them immediately, or not count them as capital. So the European Central Bank is faced with technical bankruptcy unless they just completely refinance, if Greece defaults. Just for that reason alone, they are doing everything possible to avoid the default. What a default actually is, is just a recognition that there is way too much debt, it cannot be repaid. That is called reality. That is called common sense. And throwing more money, more money, and more money, after bad, is not common sense.

David: I did a radio interview here in the last day, and the gentleman in Houston said, in a somewhat unrefined manner, “I look at gold as my stupid politician insurance.” I was thinking to myself, “You know, I might have said it differently, but we are really talking about insurance against Keynesian economic policies when we look at a money substitute like gold. Combine negative real rates of return, combine poor policy and the fact that this is really ideologically driven, and there really is a commitment to the ideal. Someone wrote a thesis, they have staked their professional career and reputation on it, there is ego involved, and no one is going to recommend a different course until we have actually gone off the cliff. Is there a reason to assume a different investment thesis at this point, that, really, insurance is unnecessary? Or should we still prioritize insurance in the equation, perhaps not against stupid politicians, but ideas that are bankrupt, themselves?

Hunter: No, I think insurance is even more important. Every day that passes, it just gets more important. There are different scenarios of where we go from here. We could head into a major depression, or deflation, or we could head into a major consumer price inflation, or a combination of the two, but protecting yourself against both is extremely important. In the old days, you could protect yourself against depression by owning bonds, and the longer the bonds, the higher quality, the better, but that doesn’t work right now because the chances of inflation are so great, that could destroy the value of bonds. So the only things you can really rely on now are cash as a deflation hedge, gold as somewhat of a deflation hedge, and gold also is also a great inflation hedge, so gold is really the prime asset. And the irony about gold is that the trouble of holding gold is that you don’t earn any income on it. That would normally make it seem disadvantageous to do so, but because the politicians are holding interest rates so low and refusing any kind of return to the saver, it makes the lack of income return on gold seem not so bad.

David: That is the issue of negative real rates, and going back to Gibson’s paradox and the Summers-Barsky thesis: Low-to-negative rates drive investor interest into something that represents almost a sideline position. “If there is too much risk and no reward, then just count me out until I can look at productive assets with a keener eye to benefit.” Again, we go back to our original point. This is a market system, based on prices and profits, and if profits are taken out of the equation, then people look to opt out, so to some degree, gold is an opt out.

Hunter: I just want to add that Keynesians, of course, say that if you buy gold you are hoarding, if you just keep a savings account, you are hoarding – you are not investing, you are a hurting the economy. But actually, you are helping the economy, because you are keeping capital available for future investment when the opportunity finally arises to make a good, sound investment.

David: It seems, though, if people look at the price of the insurance – you have credit default swaps, for instance, an insurance against default, against a particular underlying asset. Let’s take Greek paper, as an example. It is trading at records of 3 million dollars for every 10 million dollars of underlying paper, or over 3000 basis points, and that is even with the new ECB and U.S. interventions. That insurance seems expensive, and yet, it also seemed expensive at 2000 basis points, it seemed expensive at 1000 basis points, it seemed expensive relative to other types of insurance at 500 basis points. The argument is being laid similarly against gold. It was expensive at $900, it was expensive at $1200, it was expensive at $1500. This insurance continues to get more expensive. At what point does it just not make sense to buy the insurance, because it is just flat too expensive?

Hunter: Again, the Keynesian argument would be that gold is in a bubble, that it is going to burst, and every time gold retreats a bit, you read, “Ah, the gold bubble is bursting.” But I don’t think it is a bubble at all. I think it is still just insurance, and it is still sensible insurance at this price, and that it has potential to go up a lot more because, unfortunately, politicians are not going to change what they are doing anytime soon.

David: With the existing stock of thinkers, we probably won’t see remonetization of gold, but with a different stock of thinkers and policy makers, do you see the potential for a partial remonetization?

Hunter: Yes, I think that there is a great potential. In fact, I am sure that is what will happen, eventually, and it might come sooner than people think, because as the monetary system breaks down, they are going to have to find a new monetary system, on short notice. Monetary systems do tend to break down every 40, 50, 60 years. And when they do, they are doubtless going to bring gold back. The danger is that they will bring gold back in an inadequate way. People talk about the gold standard being a problem in the Depression. Well, we didn’t really have a gold standard then. And you can have a phony gold standard, as we did after World War II. But what you really need is a true gold standard, of the sort that existed before World War I, before the Federal Reserve was created. But it is less likely that they will do that.

David: It seems that it is less likely because it limits government spending, and certainly, the gold exchange standard, as a quasi-gold standard, that you just mentioned, allowed for greater flexibility, so to say, and freed politicians to spend wantonly. You are suggesting bringing it back in part might now be enough, going back to the old gold standard, circa 1860 to 1914, or what the Brits had from 1717 forward, with the exception of wars here and there. What is the political context that would legitimize a full return to the gold standard?

Hunter: I think the present monetary system will collapse, and when it does, they will bring back a so-called gold standard, but it will be something more like Bretton Woods, what we had after World War II. They certainly won’t bring back a full gold standard if they can possibly avoid it. I don’t expect that to happen, but that is what is needed, because that is the only way to really control government, as you said, and prevent more and more of the same Keynesian policies of print money, spend money, borrow, spend, and bailouts. All of that would not be possible under a true gold standard.

David. We had an interesting conversation with Giulio Gallarotti, and his comment was that under a system of universal suffrage, it is very difficult to maintain those disciplines. Politicians are inclined to spend more on their constituency groups than under a gold standard, or what a gold standard would allow for, so perhaps a return to disciplines reflective of the gold standard, but certainly not a return to the full gold standard. And he said the era of post World War II was different. We have moved toward universal suffrage, and politicians won’t allow for it, and frankly, neither would constituency groups, because it would mean less money from the government trough. Would you feel like that is an accurate assessment?

Hunter: No, because the problem is not the universal suffrage, the problem is the special interest groups.

David: Yes.

Hunter: The special interest groups, the big businesses, the unions, the trial lawyers, and so on – they are the people who are active in Washington and Wall Street, who are actually deriving benefits from all these Keynesian policies, and the country as a whole is not, the average voter is not. If the average voter really understood what was going on, they certainly wouldn’t support this kind of thing.

David: That’s a very good distinction.

Hunter: There is nothing about democracy, I think, that leads us to this problem. In fact, we need more participation from the average voter and the average person, not less.

David: You see the present monetary system unwinding. Any thoughts on the euro? Any thoughts on a basket of currencies? Certainly, Keynes was fond of the Bancorp idea. The IMF and the SDR structure is certainly being bandied about a bit. What do you see as the world’s money system 3 or 4 years out? What would you speculate would be our reality?

Hunter: The most likely outcome would be to try to go back to the system that Nixon destroyed – the post World War II system. But certainly, we don’t need Bancorp, we don’t need the SDRs. That is just an international organization printing money, in addition to individual governments printing money, so that just magnifies the problem and makes it even worse. What we need to stop is all the money printing. That certainly doesn’t take us where we need to go.

David: Something very similar to Bretton Woods where currencies relate to a particular sound, or more sound, currency. That was the dollar. Do you think that is the dollar still? Barry Eichengreen would argue, probably not, it will have to be a duopoly, certainly not a dollar monopoly, any longer.

Hunter: Yes, it is quite hard to imagine that the dollar would remain the sole reserve currency under a new system. That certainly is not very likely. In terms of the euro, I was just hearing on the radio yesterday, a distinguished commentator saying, “We have a choice here, either the European governments will intervene and rescue the euro and save the day, by basically bailing out Greece, and other countries, or they will let the euro collapse and that will be a disaster, and that will cost the European government much more money in the long run – six times as much money.”

But that is just all fallacious, because bailing out Greece, or bailing out Portugal, doesn’t solve anything. Again, you have to accept the reality that their debts simply cannot be repaid, you have to accept default, and you have to rebuild from there. The idea that those are the only two choices is just basically ridiculous. And we also have to keep in mind that, actually, if they kicked Greece out of the euro, the euro could appreciate considerably, so there actually is the possibility that if the Germans don’t buckle under, and they kick bad performers out, they could actually make the euro a very attractive currency again, more attractive than the dollar. No one is talking about that possibility.

David: That has been our position, that if you take the barnacles off the underside of the boat, you have much smoother sailing.

Hunter: Right.

David: What you said about the distinguished commentator from Europe giving those two alternatives, I just want to come back to your book, because this is one of the gifts that you have, Hunter, in pointing out the logical inconsistencies. Here is one example of the fallacy of false alternatives. You look at Keynes and you say, “Come on, he is misusing technical language, he shifts definitions, he misuses even common terms, he confuses cause and effect, he creates things that are representative of false determinism. And I think it is a very fair portrayal. You let him speak, and then you add some comment to it, and say, “Guys, come on, wait a minute. Does this make sense to you?” It is not just common sense, but also a keen criticality, a real insightful, logical appraisal of where Keynes went wrong.

I want to encourage listeners, if you don’t feel like you know what is being done to you, not necessarily for you, but to you, under the current administration, the past administrations, and as we have pointed out in this conversation, not just here in the United States, but globally, by the fiscal and monetary authorities, you should know Keynes. You should know him on a first-name basis. You need to get to know him. Make your introduction to him. Get a copy of Hunter’s book. If you have interest beyond that, then certainly, order an original copy of Keynes’s writing, and dig into the primary text, as well, but this is a great introduction.

Hunter, I want to thank you for opening up the conversation and getting people thinking. We don’t know, in the future, what will have turned the tide, but you have offered an opportunity. You have set something out there that I think critical thinkers, people who care about our country and the direction it goes, and frankly, the world, can look at and say, “Wow, I didn’t think about that. I need to reappraise. I need to check my assumptions. As logical as my macro-economics class in college seemed, it appears that the professor, and myself, didn’t reassess our assumptions, and that needs to be done.” Thank you for raising the questions, and presenting that for the average American to take a look at and say, “We need a different set of ideas. Let’s see if we can get that done.”

Hunter: Thank you, it’s been a pleasure.

David: We look forward to our future conversations, and again, you can find Where Keynes Went Wrong at amazon.com, or at any of the media outlets, in either hardback or paperback. We ordered it by the case, and hope you will, too.

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August 24, 2011; David McAlvany in Argentina: Protect Yourself from the Horrible Consequences of Government Mismanagement


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we are joining you today in Argentina. Argentina is a country that has shown the extremes of some of the things that we may be facing today. They have shown the extremes of debt default. They have shown the extremes of inflation. They have shown laissez-faire, and then they have shown full government control. That is one of the reasons you are in Buenos Aires right now, it is not?

David: Well, certainly, I think when you look back at history, there are lots of things to see, similarities, and also differences, and we have plenty of differences, as well, in our own debt structures in the United States, but looking at the loose credit which has preceded crises in the past, it hasn’t really mattered whether it was a full-fledged, developed country or an emerging market. It is fascinating to look back and see what loose credit creates, and the problems that it creates: Banking crises, and currency crises. We can certainly see quite a few similarities between us and them.

Kevin: David, I think it might be wise to bring in historical perspective. If we were to go backward 100 years, or a little over a 100 years ago, Argentina was an economic engine in Latin America. It was the economic engine in Latin America. Then they experienced mismanagement of funds, mismanagement of debt, and mismanagement of currency and politics. You were mentioning something that happened to you last night in the cab, when we were talking before the program. You said it was sort of indicative of the attitude of the people on the street right there in Buenos Aires.

David: Kevin, I guess what you are describing is the underlying discontent with their ability to make ends meet, an underlying desperation. I was coming from the airport and paid my taxi fare, which was roughly $40 in U.S. dollar terms, for a 40-minute taxi ride, and the conversion to pesos. I handed him two bills, and he turned on the light, and said that I had underpaid him, and in fact, it appeared I had. I had given him two tens, instead of two hundreds, but I thought I had given him two hundreds. As it turned out, there was a little bit of a swindle, as I realized that when I got to my room and counted the remaining pesos in my pocket. It had been picked, and I then, more or less on a voluntary basis, just handed him that many more dollars, because I thought I was behind in scheduling the payment.

I guess, when you look back, this is an interesting place. I look outside my window and see a place that, on the one hand, is beautiful, on the other hand, is tragically behind. It has not been maintained. It has echoes of Eastern Europe, in the sense that you can see former greatness. There was something here that was amazing in terms of wealth generation, and in terms of creativity and in terms of real dynamism.

Unfortunately, that was probably prior to World War I, and I guess that is where you see the beauty of the place, and the mystique, the European appeal of the place, all took place prior to 1920. That was really when they peaked, if you will, and they went into a serious decline from 1920 forward. A lot of this goes back to the Argentine Barings crisis.

Kevin: That was back in the 1880s, was it not?

David: Barings was considered the sixth great power, one of the most influential groups of people the world over, more important and influential than most political entities at the time. It is interesting that the Argentine Barings crisis was preceded by a decade of low interest rates throughout the major money centers.

Kevin: Would you say it was artificially low interest rates, like we have experienced over the last decade or so?

David: I would say, yes, in fact, it was artificially low, although higher than the rates that we are used to today. It was just a different interest rate environment at the time. As the Bank of England began to raise rates and tighten their monetary policies, moving them from 4% to 6% in a short period of time, that is when they went into a period of institutional failure. This is one of those things that we can learn, looking throughout South America, Latin America, and the rest of the world, that credit booms often fuel unsustainable growth.

You generally see, during these credit booms, an attraction of foreign capital. Sometimes you could even view that as naïve capital, or naïve money, and that money increases growth rates and becomes sort of a self-reinforcing cycle. A little bit of money comes in and it attracts even more hot money, and all of a sudden you end up with this great growth story, and when the credit environment changes, when the credit boom ends, all that hot money goes away. Investors flee the other direction, and you end up with serious collapse.

Kevin: The definition of hot money is money that is not necessarily going to be loyal to that country for long. We call hot money, in banking systems, money that is chasing the next great high CD rate, if that even exists any more. But the bank, itself, identifies that money as hot money, and they say, “Look, we can’t count on this always renewing, because this could go somewhere else for a fraction of a percent, and that same thing happens to countries. When a country is going through a credit boom, a lot of capital flows into that country, and just as things start going bust, not only does the normal amount of capital that would flow out of that country come out, but much, much more. Is that what you are saying?

David: True, and one of the similarities that we have between Argentina and a number of the BRIC countries, at least Brazil and Russia, is the fact that their economy is dependent on, or the largest component of their GDP, is based in commodity exports. Just as Mexico and Argentina had booming economies prior to 1920, that blessing became a curse as their natural resource exports began to shrink, and then the debts that they had carried – this is very common among booming markets – you generally see an increase in leverage at exactly the wrong time.

With the success comes the opportunity and the willingness for investors to leverage up that success, essentially borrow in the context of growth. Then when the growth goes away, you are left with massive amounts of debt relative to a shrinking economy, and your debt-to-GDP numbers are still upside-down. They cannot be supported by existing revenues, and that is when you end up with some sort of default. That is a pattern that we see and it is something that we anticipate, looking at, at least Brazil and Russia, certainly not China and India, at least in that category, because they are not natural resource or commodity exporters.

Kevin: So, what you are talking about is this borrowing being ramped up – sounds very much like the United States, all the way up to 2007, 2008, with the real estate market. It grew, it was a massive bubble. It is sort of funny to me when I read these articles that say gold is in a bubble, when in reality, gold is going up because currency is going down. It doesn’t have much to do with people taking debt out, like they would with a mortgage, but debt, itself, creates bubbles, doesn’t it? It can be a bubble in real estate, it can be a bubble in tech stocks, but one way or another, when that debt, or the ability to borrow, goes away, that bubble pops.

David: That’s right. I think one of the things that is worth noting, and we have made mention of this before on the program, is that prior to 1914 – which is essentially when the gold standard was abandoned by European countries who were the big, heavy-hitters in the financial markets up to that point – currency crises were far less severe, and that was partly based on what was called the restoration rule, or the resumption rule, which was that if you had to leave the gold standard for any particular reason, there was always the assumption that you would resume or restore that point of stability. So you had confidence, not in man, but in this immutable thing which was almost a self-managing function within the economic or financial picture of the country.

It also happened that recoveries occurred much faster, and this is quite fascinating. In banking crises, prior to 1914, it took two years afterward for there to be a full-fledged recovery. It began to change after 1914, and most radically, it began to change after 1972. In looking at what happened in 1971, the complete suspension of the gold standard, moving into a completely free-floating currency system, now we have, 1914 to the present, and 1972 to the present, where there is this deep connection between banking crises and currency crises, and in the case of a banking crisis, it now takes twice as long to resume the growth cycle after a banking crisis.

Kevin: David, you have brought up in the past that the financial travels to the economic, travels to the political, and then, of course, the geopolitical, or geostrategic. It seems to be a progressive pattern. But do banking crises have to be tied in with a following currency crisis? Before 1914, weren’t they separate events?

David: They were completely separate events, Kevin, and that was the issue. You may have an individual bank balance sheet which may be impaired because of poor lending standards, and if that bank goes under, so that bank goes under, but it was not related to the currency markets at all. That didn’t mean that you didn’t have currency crises. In fact, you did have currency crises, but it was usually related to war, or some sort of military incursion, a one-off event, a huge spike in expenditures that could not be afforded, and so you had a currency crisis in the making, but there really was no connection, at least under the gold standard era, between banking crises and currency crises. Now, on the other hand, you have the money mandarins who will manage the economy, if you will, and try to keep banking crises from becoming systemic. A lot of it has to do with what has changed on bank balance sheets. Bank loans used to always be carried at their current face value, and we have something very different today.

Kevin: David, you have pointed out that when we were on a gold standard, up through 1914, these crises were separate, but when you merge a banking crisis and a currency crisis, aren’t we really just saying that the government is printing money to try to solve the problem?

David: That is correct. The gold standard had prevented central banks from using monetary policy to absorb macro-economic shock. It also prevented them from being the lender of last resort in the banking system. If you asked a central banker how he thought about that, he would say, “Well this is the problem with the gold standard,” and I think our side would be very different, we would say, “No, actually, that is the virtue of the gold standard.”

I think of the climbing that I have done in younger years, most of it at the end of a rope, and occasionally, not on the end of a rope, and I climb very conservatively, if I am not attached to a rope. If I have no safety net, something that is keeping me from my own demise, then I tend to be very, very conservative in the management of each move. And I think bankers, in general, will tend to take fewer risks and we will see less risk in the banking system as a whole, if there is no safety net, if the central bank cannot just print, ad infinitum, in order to solve its own problems. So, I think boldness is in proportion to the protections in place. That is certainly the case when I am climbing. I tend to be much more bold at the end of a rope, and not the kind that is hanging me, the one that is supporting me safely. So, yes, I think we would see a very different change in the banking community if the central bank could not be the lender of last resort to the banking system, as it is today.

Kevin: David, we just recently had a guest who said it very succinctly. He said that the system, as it is designed today, allows the gains that the banks take to be privatized, but the risks that they take to be socialized. I think about being a parent. We were diligent to discipline our children. You are a parent. You are diligent to discipline your children. It doesn’t have to be overdone, but a spanking creates a certain amount of pain, and it can save that child, when they grow up, from a major catastrophe later.

I think about the spankings that banking failures caused back in the 1880s, when we were under the gold standard – 1890s, early 1900s. There were some spankings, there were some financial crises, and I am thinking even of the financial crisis in 1907. But we did not have the kind of worldwide currency crisis tied to it that we are facing today. The person in the street right now is saying, “How in the world do we get out of this? Are we going to default?” In fact, I’m going to raise that question to you, Dave. As Americans, are we looking at a default right now on foreign debt, or is there another way that we are going to solve this problem?

David: Kevin, not only the time spent down here in Argentina, but a lot of the reading that I do on debt restructuring and the structure of U.S. debt, I am more convinced than ever, if you wanted to sum up this whole program, you could do it with this one statement: I am more convinced than ever that the government will default via inflation, not via the outright default that we have seen in past episodes. I look at banking crises for that determination. I look at currency crises for that determination. And I look at the structure of our own debt.

All of our debt in the United States is dollar-denominated, which is a privilege, a privilege which we explored in conversation with Barry Eichengreen, a privilege which no country has ever been afforded in the history of the world outside of Great Britain, and this is the key point: When you look at the serial defaulting countries, including Argentina – five times they have defaulted since 1950 – this is common. Defaulting on foreign debt is very, very common. It is not going to happen in the United States. It is not going to happen in the United States because our debt is not denominated in foreign currencies. I don’t think people realize just how significant that one variable is, in the structure of our debt.

Kevin: So, they are not going to default outright, like we have seen with the talk about Greece, or Spain, or Italy, or some of these other countries that may default, but the default is still insidious. Didn’t John Maynard Keynes talk about a different form of default in the form of inflation? I don’t know if you have that quote or not, but it is something that most people don’t understand. Ultimately, it makes them poor, and they don’t know why.

David: John Maynard Keynes said this: “There is no subtler, no surer, means of overturning the existing basis of society, than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” Specifically, we are talking about inflation.

We really have two issues to address here. One: Why fiscal measures are not sufficient, nor will they be employed. Two: We have the privilege, so why not abuse it? Specifically, of inflating away our debt.

First, on the point of austerity. If you look at the economic policy continuum here in South America, there are the extremes of government intervention on the one hand, and control – that would be Venezuela, Brazil, certainly to a lesser extent Mexico. Then if you move toward the other side of the continuum, speaking past and present tense, Argentina, and then ultimately, the laissez-faire Chile, you see that there is more of a market orientation on the Chilean side, and a more government interventionist and controlling element in places like Venezuela. What you end up with is an emphasis, if you will, on the owners of resources, versus labor, and government tends to cater toward the government interventionist side. The central planners of the world, tend to cater toward labor, whereas the free market-oriented tend to focus their energies and comply with a different constituency group, the owners of the resources.

This is important because when you look at austerity measures, these are fiscal measures which are being employed in certain parts of Europe, it is the debate that we have had in the United States over where we should cut spending, and you end up with a payment crisis. This is the problem with austerity. I think it is something that should be considered, but the problem is that it becomes politically untenable. It represents a payment crisis with organized labor. It represents a payment crisis with government employees. It represents a payment crisis with certain protected industries, and so we have seen instances in the past, even here in Argentina, where they have attempted to rein in their financial problems via fiscal measures and austerity and it has simply failed. It has failed because enough people have voted, either voted at the poles, or voted through political violence, and said, “This will not work for us. Take it out on someone else, but it won’t be on our dime.”

Kevin: David, it makes me think that we should probably talk about the last 50 years, just briefly, in Argentina, because we see this fluctuation between control and release of control, but it seems to get worse and worse. It is a frequency that increases. I am thinking, there is a famous musical that Andrew Lloyd Weber wrote, called, Evita. It is about Eva Peron. It started with her husband, and it ultimately went to military control and then ended in war, so this seems like another reason to maybe talk about Argentina a little bit, because it does give us a model of the pattern of things.

David: Kevin, I think this is where there are some similarities, and also, some critical differences, because what we saw with Argentina, and what is certainly reflected in the United States, as well, is an unwillingness to look at fiscal measures as a part of the solution to any real degree. So we are left with, in the case of the Argentines, default, default, default – banking crisis, and currency crisis, on a repetitive basis. The last 100 years have been rife with it.

I think the key distinction is that they had no other choice, because they had seen a collapse in commodity prices, and because they had to finance themselves on external debt, they had to consider default on that external debt, as a real means of return to normalcy. We are in a different position, although fiscal measures are off the table for us, as well, and we are also financed heavily on external debt, our debt is not denominated in foreign currencies, it is denominated in the currency which we can print an infinite amount of, so the reality is, we can continue to make payments, whereas they could not. They did not have access to a British printing press. They had to print in pesos, and pesos had to ultimately translate into British pounds, which was where they were at a disadvantage. We maintain the extreme advantage of financing ourselves on external debt, but paying it back with domestic dollars. That is an absolute coup, and that is one of the key differences between us and them.

You are suggesting the Peron era, Kevin. He was actually in office as president twice. The second time he came into office was in the 1970s, and he did attempt a redistribution of the countryside wealth, if you will, to the city. It was a real emphasis on moving the resources from the landowners, the wheat farmers, the cattle ranchers, directing those resources to labor, and to city interests. He died in 1974, and his wife took over, which is really funny, because it is almost the same kind of thing that happened with the current president today. Mrs. Kirchner is president, whereas Mr. Kirchner used to be. That same sort of translation happened with the Perons back in the 1970s. I don’t think this could happen – well I guess maybe it could happen in the United States if Hilary is elected, where Mr. is retired, for whatever reason, and Mrs. comes into power.

What happened next was kind of interesting. Things spun out of control, there was 499% wholesale price inflation between 1974 and 1976. That led to a breakdown of society, essentially, and they had urban violence, which was escalating. That caused the military to come in and take over, to bring some sort of control back into the system. Violence was just off the charts by 1976. Why were people rioting? Why were people unhappy? Because they couldn’t feed themselves. We weren’t calling it a democracy movement here. We weren’t calling it the Latin American Spring. This was just flat out inflation-driven, just as it is, frankly, in the Middle East and North Africa today.

Kevin: Sure. It’s the insidious effect of not being able to buy your own rice, or buy your own bread.

David: You bet. But Kevin, they saw a deterioration in per capita GDP, and it did not recover for many, many, many years. External debt during that period of time here in Argentina, talking about 1975 to 1982, went up seven times.

Kevin: Wow.

David: Prior to the military incursion into the Malvinas, there was nationalization of over 71 financial institutions, domestically, to attempt to hold the financial system together.

Kevin: And did it work?

David: No, it didn’t, and I think, frankly, we could learn a thing or two about that. Nationalizing Fannie Mae and Freddie Mac has done us no good. They will lose 9 billion dollars this year. They are bleeding, and the problem is we haven’t fixed anything structurally, within our lending system, within the real estate system in the United States. So, no, nationalization, while it may buy you time, is not a real solution, and as we found was the case in Argentina, they nationalized 71 financial institutions in an attempt to prop up the financial system. That, ultimately, failed as well, and on the verge of collapse, they launched an offensive against the British – the Falkland Islands.

Kevin: I remember that war. That was 1982. I had just graduated the year before. I couldn’t believe a country like Argentina thought that they would be able to come up against the British Empire. It didn’t seem like a fair fight.

David: And they still do not call it the Falklands. They call it the Malvinas Islands, because they still assert their right to the islands. But that incursion jumped that 499% – nearly 500% annual inflation rate – to over 1000%. By 1982, they were in complete collapse. This goes back to fiscal measures and austerity. They came up with what was called the Austral plan. The Austral plan was effective for almost a year-and-a-half. They brought the inflation rate from 1000% a year down to 100% a year, which is still very high, of course, but they were making improvements.

The problem is that those fiscal solutions were politically charged. What I mean by that is that it affected certain groups within society. It affected certain interest groups, and those interest groups raised the angst and ire that they were experiencing, brought that to the political process, and they did away with Austral plan about a year-and-a-half into it. Lo and behold, inflation started clipping back toward 500% pretty quickly. It was 300% within six months’ time, and they saw massive capital flight in the country.

It is interesting, because traveling around a bit, you get the sense that if one has money, it is kept hidden, and it is a really bizarre thing, because this is a beautiful place. As I mentioned earlier, the buildings are fantastic, straight out of Western Europe, in the sense that the architecture is absolutely stunning, but it has that reminiscence of Eastern Europe, in the sense that there has been so much control, there has been so much social betrayal. There is a grayness to it, and a hiddenness. Anyone with money does not keep their money in this country, because they don’t trust the system. The political system has swung back and forth so many times between favoring the owners, the haves, if you will, to favoring the have-nots, that there really is a breakdown in trust, and it means that basic infrastructure has been neglected for a long time. It means that technological innovation has been neglected for a long time. It means that, at this point, even now, their educational system is deteriorating.

What you have is the slow degradation of the social structures of this country. And yes, crime is a huge issue, drugs are a huge issue, disenfranchised youth is a huge issue, and you see this deterioration on the other side of both a banking and monetary crisis. I fear that our banking and monetary crisis will have similar social effect, although the nature and characteristics of that banking and monetary crisis, as mentioned earlier, are very distinct, very unique, and much more inflationary, as opposed to seeing a default, deleveraging, and a deflationary scenario.

Kevin: David, you have been recently talking about something that you feel is looming on the horizon. In the past, we have seen, just to distinguish the risk that we have in today’s society versus the risks that maybe banks had 100 years ago. As a bondholder, when I buy a bond – I’m an individual, I go out and I buy a bond, I know that I am looking at the country that I am buying the bond from, or the company that I am buying the bond from and I say, “What is the likelihood of payback?” If I lose on that bond, if there is a default on that bond, I, as an individual, lose, but I don’t take the whole country with me.

We will have a guest on next week who discusses this danger, but I would like to bring up, and have you discuss this right now, the point that the bond market, itself, is an individual moving market. It displays a transparency when you can see it rise and fall, because people are buying individually. The opposite of that is bank loans, which are not transparent. In the past you have brought up that banks could keep bad loans on their books for long periods of time and it would not necessarily show up because no one really knew that they were a bad loan. There seems to be a merger at this point, where with the big banks, this whole too-big-to-fail thing, is really true. Bank of America, Wachovia – we could go on, and on, and on, but if these banks actually failed, because they hold so much in the way of bond holdings, they could take a country down with them. Would you address the bond market a little bit, the transparency, and something that is casting a larger shadow than even the bond market failing? Talk to me about that a little bit right now.

David: Kevin, I think this is important, because the banking system that we have known in the past is very different than the banking system that we have today. The banking system now, as we suggested earlier, being directly tied to banking crises, and currency crises, being one and the same, inextricably linked – this is an issue in our modern era. If we, in fact, have a banking crisis today, which I would argue we do, and I think we can look at Western Europe and the U.S. over the last few years and say that, clearly, we have had one, then, yes, a currency crisis is looming, not only here, but globally.

Let’s just back up and say, “What is so different about the banking system today, than the banking system in past years?” It is mainly this: A majority of banks’ assets used to be loans. Today, a majority of their assets are securities, and by securities, we are talking primarily about different fixed income instruments, specifically, bonds. This is very different, because bank loans, as you suggested, can be carried on their balance sheet at face value, for the duration, and if they have to renegotiate something with a particular debtor they can do so, and maybe even throw on principle payments at the tail end, extend the terms, renegotiate, etc. But it never affects their solvency, per se, because they can always carry it at face value.

Bonds are very different. Bonds have a signaling function. What I mean by that is that with bonds, you have an asset that trades in the secondary market. It trades publicly, and you can track its current value. This is a complicating factor for anyone who owns corporate bonds, for anyone who owns sovereign paper, and this is why we have such a concentrated emphasis, particularly in Europe right now, with the renegotiation of sovereign paper. The impact to the banking community in Europe is absolutely profound.

Kevin: What you are saying is that what we have is the problem that bank balance sheets are impaired, or even worse, by the write-down of bonds. But we have a market out there that is larger than even the bond market that starts to trigger. It’s the insurance policy on those bonds, or the insurance policy on the possibility of a default, and we call those derivatives. How does the derivative market react when the banks have these defaults right there on their books?

David: This is what is particularly interesting, because when you look at the renegotiation of the old bank loans, those could be done in a way that was fairly isolated. There were no dominoes to fall on the basis of a default affecting a particular bank loan.

Kevin: Lending party to creditor party, but it was an isolated case.

David: Exactly. What you are really talking about is maintaining the integrity of the contract. With a bond, yes, you need to maintain the integrity of the contract, and here is where we have added a new dimension into the bond market, and into the banking system. The debt markets today are dwarfed by their own shadow. What I mean by that is that the shadow within the debt markets is the derivative market, which is, as you have suggested in conversations with me before, like Jupiter outsizing any one of its moons. It pales in comparison. So, you have not only the contracts, which are legally binding contracts in the bond market, where you have a creditor and debtor relationship. Those are not as easy to renegotiate, particularly when you have a contract behind the contract, which means you have to respect the original contract for the CDS, the credit default swap, or derivative contract, to be respected, as well.

Kevin: David, what you are saying is that we may, in fact, have a much larger crisis in the derivatives market than in the bond market. This all leads me to believe that this is completely unsolvable without a worldwide default, or a worldwide hyperinflation. Am I missing something?

David: My concern is the same as yours. I don’t see a way out of an inflationary scenario. I don’t see a way out of U.S. dollar-denominated debt being taken care of via inflation, and it will not help them, if it is a hyper-inflation, or even a super-inflation. But if they can get away with 5-10%, or very surreptitiously, even a 15% inflation rate, lying to the general public about the current state of inflation, the Chinese are dealing now with nearly 15% inflation, but the official rate is stated at 6½%. Our inflation is already double digits, and close to 11%, while we are stating it is at around 3%. This is very common. We need to inflate our way out, and we need to try to maintain a sense of normalcy in the process. The problem is, the general public is taking it on the chin through this inflation, but not only are we taking it on the chin through the inflation, but we have something that has been used by monetary authorities, over, and over, and over again, in past episodes of financial and banking crises.

Kevin: Financial repression means, not only can you not go out and buy enough bread, or pay for the things that you need, but if you do have savings, and you try to put it in some sort of fixed investments, like the retirement community does, they are not going to make the interest that will keep up with the reduction of the buying power of their currency. That is the repression, is it not?

David: That is correct, and this is what is fascinating, because we essentially have the Fed doing the Treasury’s work. We have the Fed acting as tax collector. Financial repression, in other words, keeping interest rates extraordinarily low, is a form of taxation. Essentially, what the Fed has done, is that banks have become instruments of the state, squeezing indirect taxes from citizens, by monopolizing both the savings and payment systems, on top of the currency monopoly that they already have.

The Fed is now more in charge of our financial system, and is closer to being a direct tax scheme, than we have seen in all of U.S. history. This low interest rate which Bernanke has said he will keep in place until 2013, according to academics like Reinhart and Rogoff, is defined historically as financial repression, a tax which monopolizes the savings and payment systems on top of the currency monopoly. That is very important as a concept to wrap your mind around. Taxes have already been increased. You didn’t know it, but the redistribution of income is very similar to the redistribution of wealth, whether it is coming from current income, or income that you should have received, but are not receiving due to the Fed’s actions in the marketplace.

Kevin: The Federal Reserve and the government may be able to hide this inflation, to a degree, and they may be able to keep interest rates artificially low for a period of time. I don’t know how long they can do that, where there is a negative rate of return, but the one tattletale that is out there, and it has always been a tattletale of truth, is the gold price. We have been watching gold hitting new highs, David.

This is my question, and I think I probably know the answer to this, but is the only way a person can hedge themselves from what we have been talking about on this program to own some sort of physical asset – gold, silver, some sort of resource that would be redeemable in more currency down the road?

David: This underscores the point, Kevin, that for the Fed, while they have a monopoly on our currency in the United States, gold represents a problem for that currency monopoly. It represents a problem for any currency monopoly, because it essentially breaks the monopoly. It gives someone the ability to choose a currency outside of the world of fiat currencies. They can choose the currency that is its own anchor, as opposed to the free-floating world of fiats.

Relative to each other you may be doing better today in euros, or better tomorrow in British pounds, or better the next day in U.S. dollars, but we have monetary authorities the world over which are using financial repression, which are, in fact, inflating away their debt problems, that have gone through a 30-40 year credit boom. It is no wonder that we are in the context of a credit bust.

It is no wonder that we are seeing massive changes within Europe and they have to use fiscal measures and austerity measures because they don’t have monetary independence anymore. But in the areas where there is monetary independence and monetary control, they are abusing the inflationary thematic very significantly. Sophisticated investors have seen this coming for a long time, but there are a number of people for whom it is just dawning on them, and maybe they are equally sophisticated, but just have a higher trust in the system, and higher trust in their own government.

What people all around the world have forgotten is that governments consistently and regularly screw their own people. This is just classic historical fact. I don’t care if you are talking about the Greeks, the Romans, the British, the Spanish, the Portuguese, the Argentineans – you can go anywhere in the world, and go back 5,000 years, 2,000 years, 100 years, or yesterday – and find that governments screw their people. This is what we are seeing happen, and this is why I think you are seeing a global move into gold. The monopoly is being broken, and it is the only place that you can go if you don’t want to be subject to the arbitrary diminution of your purchasing power.

Kevin: David, I’m sure it is helpful, traveling the world, especially going to countries where we have seen similar patterns to what we are seeing in the United States right now. I am bringing up Argentina. You happen to be there, observing, on the scene, and talking to the people on the street, as well as reading the histories and the economic analysis. It seems that if people would learn from history, they would see the patterns repeating over and over. You were talking about government abuse of the people. It is a recurrent pattern.

I am looking at a chart from the Reinhart and Rogoff book right now that shows that over 40% of the countries, worldwide, that actually had money, defaulted on their debt in 1830, 1880, 1930s, 1990s. It was over 40% each time. If you could see this chart, it is recurrent, and it looks like a heartbeat. What seems to happen is that you have a default, or you have a high inflation, you have some sort of theft, and that is what it is, from the people, and they don’t forget for a while, because they have lived through it, and then the next generation comes along and gets duped completely, again. The frequency in Argentina is just a little bit more rapid than what I just mentioned, and I am sure you are observing the after-effects.

David: The unfortunate thing is that bad policies hurt good people. I look back at a book that Richard Weaver wrote years ago, Ideas Have Consequences, and the title echoes through to this day. Ideas have consequences, and bad ideas have really bad consequences. We are dealing with that in the banking system. We are dealing with that in the global currency markets. We are seeing that reflected in the positive move in the gold price.

Kevin, we can hope for a better day, with better policy-making, and where policies are supportive of good people, not only here in Argentina, but also in the United States. We have our challenges ahead, probably a few more hurdles to get over, before we are on the other side of this. I think what people the world over will have to come to terms with, is that government has never been benevolent. It doesn’t matter if it is your party in office or not, there comes a point in time when survival is more important to them than you are. So, yes, I think we are in a period of time where the benevolence of government can be utterly discounted, or recognized for what it is – nonexistent – in political history. That means that individuals are going to have to fend for themselves in terms of faring well financially, and hope for a much better day.

In the office we are reading a book right now that we have discussed on our program, The Fourth Turning. I think it is a profound, profound look, at what we have ahead. The book is written by William Strauss and Neil Howe, and it is one that I would encourage all of our listeners to get a copy of and study through.

It is discouraging, on the one hand, that there are difficult times to face. It is very encouraging, on the other, that on the other side of difficult times there are periods of rejuvenation and renewal, that countries find themselves and find their identities again, on the other side of difficult times. That is a must read, and certainly being in Argentina, I recall one of our earlier reads this year, When Money Dies. If you, as a listener, have not gotten a copy of When Money Dies, that is an absolute must-read, to understand the social and cultural dimensions of inflation.

Kevin: David, thanks for joining us from Argentina. It is always better to talk about a place when you’re there rather than talking about it from afar.

Posted in TranscriptsComments Off

May 25, 2011; Debt, Derivatives and Dominoes


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, gold has been going up in dollars for the last few years, but something that a lot of times people do not pay attention to, is what is happening in other currencies.  Right now, isn’t gold very, very reactive to, for instance, the British pound, or the euro?

David: Kevin, characteristic of this particular bull market is gold and silver appreciating in every currency around the world and we have talked about this a number of times, in which we have basically said the inflation that we experience here in the United States is a rather benign thing, whether it is the single digit, which the BLS confesses to, or using their older models, as high as low double-digit, 10.7%, using their 1980 methodology, and it still, relative to our national income, and the average income for the average American, is insignificant.  But what we see, globally, is inflation on steroids.

Kevin: Are we seeing gold reacting to the inflation that other people are feeling overseas right now?

David: That is exactly right.  We see increased physical demand for metals other places in the world.  If you look at the U.S. market, it is still a dominant paper trade, where people will trade contracts, people will trade options, but the physical metals are really not important to most people here in the United States.  Globally, because they are experiencing on-the-street inflation, you are dealing with individual investors who are saying, “I’ve got to do something to protect myself against inflation, and against the demise of my home currency, whether that is the rupee, whether that is the pound sterling, whether that is the euro.

In every currency, globally, gold is moving up, silver has been, too, factor in the correction, and they are both in a strong up-trend.  Today, you have gold higher, at the highest levels they have ever been in euro and British pound terms.  We have just broken out to new highs.  This is similar to the U.S. market.  We are fairly fixated on ourselves here in the U.S. and don’t realize that gold is in a correction here, and it is not in a correction in other parts of the world, namely, the second largest economic block on the planet, and then, Britain, as well, the previous heavyweight in the monetary world.  We are in a raging bull market, across the globe.

Kevin: Dave, you and I were talking just recently about how in the United States, the public here is so numbed right now with QE-II and this talk of possibly a recovery.  It is like morphine that has numbed the body, and we are not matching the tempo of the rest of the world.  The tempo of the rest of the world is to buy gold and hedge against, not future inflation, but actually, hedge against the inflation that they are experiencing right now.

David: It is always a forward-looking project, too.  It is real world in that they are experiencing something of a money panic today, but it is with the outlook not really changing.  When they look at their monetary authorities, they come to the same conclusion we should here in the United States.  It’s the same song, it’s just a different verse.

Kevin: David, today we were talking to Trader Roy before we came into the studio.  This is a man who has been directly involved in the precious metals business as far back as the 1980 bull market.  He put things in perspective.  Back during that 1980 period, gold, you would think, was trading in extremely high volume.  People understood gold quite a bit at that time.  Gold shot up to $850 an ounce.  But about 3½ billion dollars of gold was traded per day.  He put that in perspective.  He said, “If you want to see what is really going on right now, guys, 38 billion dollars worth of gold is trading on a daily basis right now.”  Yet America is asleep.  It is not this hyper-energized understanding of gold like it was in 1980 when it was sky-rocketing.

David: Kevin, that perspective is interesting.  We have basically seen a ten-fold increase, a little bit more, from 3½ to 38 billion in gold traded per day.  Two-thirds of that, consistently, from then until now, was paper, one-third, physical metals.  Then, as now, we were trading about two-thirds of all volume in gold on the paper side, with about one-third being physical metals.  What was 1 to 1.2 billion dollars traded in physical metals in 1980, is now 12 to 14 billion dollars of physical metals traded every day.  That is a big increase, but then, remember this, too.  The world’s monetary aggregates are not up ten-fold, as the trading in gold is up ten-fold.  They are up twelve-fold.  We have far more liquidity in the marketplace today, and I think we will continue to see higher volumes in the metals market traded.  The biggest transition ahead is when we see two-thirds traded in paper, to two-thirds traded in physicals instead.

Kevin: Right now, physical trading is probably about 3-4 times what the entire gold market was, paper and physical, before, on a daily basis.  When he was putting this in perspective, Trader Roy said that it is actually these large hedge funds, and some of these larger institutions that are buying physical, and moving away from margin.  They have been burned with the rule changes at the commodities exchanges.  The strut that we saw in the metals just a few weeks ago was actually precipitated by a man-made event.

David: Kevin, we are going to talk today about debt, derivatives, and dominos.  These three things – debt, derivatives, and dominos – relate very well to the gold market, because as we explore this morning, the growing interest in the physical metals by the commodity trading advisers and the hedge funds, is not on the paper side of the trade.  They have, in the post 2008 world, become suspicious of counter-parties.  They don’t want to borrow money and have to pay back on short notice.  They don’t want to be any part of a rigged game.  They know how well rigged games can be played, and if they are not the ones calling the shots, they are going to be the patsies.  They are going to be the ones taken advantage of.

The reason why people are moving into gold today is on the basis of an insurance policy being necessary in the context of a concerted, global, competitive devaluation in currencies – not just the dollar – but as we have seen even today, with the euro, gold price in euros, and gold price in British pounds.  This is a devaluation globally.  We are seeing that response in the marketplace, but people aren’t playing games any more.  People aren’t wanting there to be any added risk variables in the metals that they hold.

Kevin: When you say people, you are actually talking about sophisticated investors.  The people down on the lower levels of investment right now are being fueled by risk and speculation and shooting for higher returns.  It is the large hedge fund manager right now that is battening down the hatches, is it not?

David: In the late summer of 2008 we had an interesting conversation with Bill King up in Chicago.  He has been in the commodity pits.  He has been trading in the financial markets and has been a guest on our program a number of times, and off-air, he commented that he had paid off his house recently, and had added a few ounces to the gold stash, and the interesting thing was, these guys have good instincts, and we are seeing a growing number of commentators, writers, traders, looking at this period of June to October as absolutely treacherous, where we could see a turn in the stock market.  What is the precipitating event?  We don’t know.  Is it the end of QE-II?

Kevin: Or could it be the European situation – Greece?

David: It could be.  We are going to talk a little bit about the European situation today, because it is really critical.  There are some undercurrents that are worth taking an appraisal of, and that is where we are going to begin talking about debt, derivatives, and dominos.

Kevin: Before we get to that, David, let me ask you a question.  When you were in the Bahamas earlier this year, silver was really perking and starting to show quite a bit of potential, but when asked if you could only own one investment this year, your reply was gold.  Can you explain your reasoning?  There were people who had stocked up on silver and it had paid off, but you still said gold first, without detracting from silver.  Explain.

David: It was interesting, Kevin, several participants were visibly surprised, and they stood up out of their seats and said, “Well, what about silver?”  They wanted to know.  They had already placed their bets and wanted to know immediately.  My response was that while I like and continue to own significant amounts of silver, we are moving into a period of international financial dislocation, similar to 2008, with differences being that the governments who were there to bail out the financial markets don’t have the balance sheets that they had then.

Kevin: They’re out of bullets.

David: Exactly.  To step in and bail out the markets this time around will look quite a bit different.  Silver would be fine, and I think will be fine, eventually, but gold was, and is, and will be, more of a solid choice based on its appeal in the midst of crisis.  Real money moves to that particular metal, gold, when other assets are not providing real returns, and silver tends to follow that trend.  I had no idea silver would run as it did in the first quarter of the year, but I am confident that gold will be the standout for 2011.

Part of this does tie directly into what we are talking about with Europe.  We had Italy, who was put on negative watch.  When a company puts a firm or a country on negative watch, whether it is Standard and Poor’s, or Fitch, they are giving it a one-third probability that over the next two years, that entity will be downgraded, so Italy has been put on negative watch.  Last week we had Greece downgraded three notches.  We covered this in our weekly comments on Friday on the wrap-up.

This is what we think is happening.  Greece has been an issue within Europe, and the fear there is that contagion will spread within the banking community if there is a reduction in the value of the assets held by those banks that are, in fact, Greek paper.

Kevin: There is a musical named Grease, and I keep hearing in the back of my head, “[Greece] is the word, is the word, is the word…” because really, that is all you see right now on television.  It seems to be the focus, not only of the Europeans, but it seems to be the focus here in America.  Those two don’t necessarily seem tied together.  But are they?

David: There are two things going on.  First of all, we have just the nuts and bolts of the way that a bank would buy different sovereign paper.  We had the opportunity to distribute mortgage-backed securities and agency paper for a number of years, and we have investors all over the world look at it and they said, “Okay, wait a minute.  I can buy treasuries that yield “x” percent, or I can buy agency paper, which has the implicit guarantee of the U.S. government, not explicit, like the treasuries, but the implicit guarantee, and I’ll earn an extra 150 basis points, 1 percent, 1½ percent more.”

Kevin: That sounds awfully familiar, David.  Let’s face it.  That has happened here in America a number of times, and it just blew up in 2008.

David: Right.  The same thing was done in the context of the European banking community.  You could buy euro-denominated German paper, or you could buy euro-denominated Spanish paper, or Greek paper, and earn a little bit more.  But one of the things that you were assuming was that Frankfurt had your back, and that the ECB would not allow failure.

Kevin: When you say Frankfurt had your back, you are talking about the European Central Bank?  That is where they are headquartered.

David: Correct.  This is the issue.  You had almost an implicit guarantee with these peripheral countries, where you may have made a little bit extra, and it made sense from a liquidity management standpoint.  For managing your float at the bank, you wanted to maximize the deposits.  So, to get paid a little more for really not taking any more risk, because, after all, the ECB had your back on that, it just made sense.  So you bought Greek paper, you bought Portuguese paper, you bought Spanish paper, you bought Irish paper, and that is what is chock full in these banks.

There are two tiers that we are going to discuss real quick.  One is an obvious exposure that these banks have, and that is, directly to this country-specific, euro-denominated paper.

Kevin: They bought paper that the country may not pay on.  That is considered a default.  That is the obvious risk.

David: Exactly.  When paper is marked down, if those banks have to take a loss on the paper, or it has to be marked to market because it is trading at a lower level than its original face value, it affects that banking institution’s leverage ratios, or “capital adequacy ratios,” as they like to call them.  Capital adequacy ratios are just tier-1 capital, plus tier-2 capital, divided by the risk-weighted assets on their balance sheets.

Kevin: But for the guy who doesn’t understand that equation, let’s face it.  Credit default swaps are here to help us.  We have insurance against these events, so this obvious default risk really shouldn’t be an obvious default risk, because there are credit default swaps.

David: Tier-1 capital, you are supposed to have a 4% cushion on, so if you want to put it in laymen’s terms, rather than CAR, and all the fancy names that go with it, you need to have a cash cushion, and if the bank doesn’t have an adequate cash cushion, they are in trouble.  What is considered an adequate cash cushion for tier-1 capital is 4% cash.

Kevin: That doesn’t sound like much.

David: Not much.  For tier-2 capital, 8%.  So what happens is, if you have a bunch of assets that you own, and they get marked down in value, all of sudden you don’t have as much in terms of your leverage ratios, or capital adequacy ratios.  They change in light of the impairment to the asset.

Kevin: So you have to raise liquidity somehow.

David: You have to raise liquidity, so what ends up happening is that you precipitate either a liquidity crisis, or a solvency crisis.  This is what they are trying to avoid in Europe.  They don’t want to see a replay of 2008 where they see one or the other, a liquidity crisis on the one hand, a solvency crisis on the other.

Kevin: Isn’t that what happened to AIG?

David: That is what happened to AIG, and this is where they are concerned about contagion.  If one institution is impaired, others with similar exposures can see that sort of classic run on the bank, so if the bank doesn’t have adequate liquidity, you could have depositors taking out more money than is actual available liquidity, and that causes a real problem for the bank.

Kevin, what you were alluding to earlier, credit default swaps, or CDSs, this is the second part of the problem.  The first problem is pretty nuts and bolts.

Kevin: It’s just a lack of liquidity.

David: Yes, and if you take a loss on assets, it can impair your management of the remaining assets, and in fact, your liquidity, or even solvency, in a worst case scenario.  Where there is further complexity in this instance, is with derivatives.  Derivatives feature prominently in this equation, as credit default swaps have become more popular over the last ten years, in particular.  They have served multiple purposes.  They have helped off-load risk.  They have helped hedge out certain parts of risk, and they have also allowed for speculators to come in and make what you might call unidirectional bets, where you are hoping that the market is going to work for you or against you.  It is basically a way of shorting a particular asset and profiting when that asset goes down in value.

Kevin: For the guys who are positive on derivatives, a lot of times they are positive on derivatives because it is supposed to bring safety to the market.  That’s why I brought it up earlier.  When these things happen, there should be some sort of insurance against that and that insurance, like any insurance type of product, needs to be spread out over a broad spectrum to reduce the impact in a single area.  We saw that go terribly wrong in 2008.  Are CDS-derivative types of products built into this European paper?

David: That is the issue, Kevin.  AIG covered, or insured, as a counter-party, a number of bets, which they were required to pay on in the event of insolvency or default.  This turned a low probability cash requirement at AIG into a real-time liquidity shock.  The sums were staggering, and the requirement to pay was immediate, which forced the demise of the institution.

This is the issue.  If we see a default, and the ECB is fighting against this, they don’t want to see any form of default restructuring.  They have a whole number of new names that they can call this, but any kind of default at all will trigger a credit default swap payment.  The question is:  Do those counter-parties have adequate liquidity?  Can they make payment on short notice?  Or are they invested such that they cannot actually get to the capital they need to make payment on that insurance policy?

Kevin: This is why they call it a contagion.  It spreads like the bird flu, or something like that.  It doesn’t just affect a single institution, or even a single country, or even a single euro-group like Euroland.  We are talking about a worldwide contagion that could be triggered by a single country going into default.

David: Sure.  What was the lesson learned from 2008 from AIG?  You have to pay attention to your counter-party risk.  Know who is making one-way or unidirectional speculative bets, as well as who is hedged, and with whom.  In other words, who has taken the other side of the bet?  You think the asset class that you are interested in, whether that is a Greek bond, or an ounce of gold, owning those things, to you, as an investor, for one reason or the other, may make sense.  Who is betting against you?  It is interesting to know who is betting against you, because you need to know how deep their pockets are.  They may be able to hold the trade longer than you are, and force you to close out the trade.  They win, you lose, because they had deeper pockets.

Kevin: This takes us back to the gold issue.  Actually, you eliminate counter-party risk when you buy an ounce of gold, because it carries with it, its actual buying power everywhere it goes, and you really don’t have to know who is betting against you.

David: It is no one else’s liability, and I guess that is the point of owning physical, versus paper, gold, in any form or fashion.  That is what I think is happening at the institutional level.  CTAs and hedge funds are realizing that counter-party risk is involved in virtually every asset class they touch, with one exception.

Kevin: And that is gold.

David: You could even look at a treasury bond and assume that there is counter-party risk in the sense that you are counting on the treasury to remain solvent and make payments on that investment.  If they are no longer around, or are impaired, or they restructure, as we are considering with Greece, as we are considering with Spain, Portugal, Italy, Ireland, and a number of other European countries, then your counter-party risk is there, as well.  There really is only one asset, physical metals, that has no counter-party risk.

Kevin: Since gold is not an IOU, and what we are talking about is the default, possibly, of IOUs, you would think that the banks would be out buying gold and trying to hedge themselves, but the banks are loaded, aren’t they, with this IOU counter-party risk?

David: This is what we see throughout Europe, where the retail franchise banks loaded up with this European paper.  It made sense, on the same basis that buying mortgage-backed securities and agency paper made sense, because it paid a little bit more, and the risk didn’t seem to really factor in.  Granted, we may look at that differently today, but throw on the lens of analysis that would have been used 3, 4, or 5 years ago, before sovereign debt crisis was even in the vernacular.

Kevin: We would buy something with the seal of approval of the European Central Bank.  Let’s face it, it was a completely new currency, it was a currency that finally unified the other currencies.  These guys basically gave the thumbs-up that they would be behind it.

David: And the interest rates on those loans were reflective, not of the individual country’s specific credit risks, but rather, of a collective obligation to pay, or a collectively assigned credit rating, an average, if you will, of the good, and the bad, to the benefit of the poorly rated countries.

Kevin: Did these banks add any of these credit default swaps to the list, partially to insure against problems, but then, partially to enhance the return?

David: Let’s say that I have 100 million dollars worth of Greek paper on my balance sheet.  I own the paper, I am getting paid by the Greek government regularly, and that is fine, but I do have some concern, so I decide to hedge that part of my portfolio, not completely, but I hedge a part of it.

Kevin: No different than a wheat farmer, who possibly will hedge his crop just in case something happens.

David: I can buy credit default swap on the Greek paper that I own, and in the case that they do default, I lose on one side of my investment portfolio, gain on the other, and suffer less by having the insurance policy in place.  That is the role that a credit default swap can play when used as a hedging instrument.

Kevin: If that was the only way the credit default swap market worked, it probably would work to a high degree of substance, but in reality, traders come in and start speculating on these credit default swaps, people who aren’t hedging against anything, they are just betting against something.  Don’t you need to know who took the other side of that bet, and how much control they have over the outcome?

David: I think that is where we are beginning to see a very interesting sub-story, if you will, within Europe.  We have the ECB, and they are not wanting to allow for any default, whatsoever.

Kevin: Why?  Let me ask you, because restructuring is something that we have seen many times before.  Why is there such a fear of restructuring this debt?

David: If you look at the Latin American debt restructuring in the 1980s, and the Brady plan that was put in place, it was very common to see debts restructured, and a 40-50% reduction in principle payments.

Kevin: Adding also to the maturities, or the length of time that it pays, right?

David: Sure, you could restructure a number of different ways, whether it was just a simple haircut, or changing the terms of the loan itself.  There are some interesting things happening in Europe.  I think the question remains, “Who has taken the other side of the bet?”  Not as a hedge, but as a speculative bet.

Kevin: Are we about to go cloak and dagger here, a little bit?

David: A little bit, because what we have found with Wall Street, and particularly, the financial gurus of our day – when you meet a child who is both bright and clever, you always keep your eye on him, because he is smart, but he may be too smart for his own good.

Kevin: Are you talking about the golden boy, or maybe the Goldman boy?

David: Or the Goldman boy. (laughter)  Kevin, the reason we bring up this concept of cleverness, is because what we have seen become more and more common in the financial arena is rigged games, where you are not just betting on the future appreciation of a particular asset class, or its decline, but you structure it in such a way that you can’t lose.  We watched a number of shenanigans occur and we mentioned this a few weeks ago on the commentary, back in 2001, with Goldman creating those 13 currency swaps, and covering over just how bad the Greek debt problem was then, as they were coming into the EU.  There has been some obfuscation and some subterfuge already put into the context of Europe, with Goldman being involved.

Kevin: Goldman-Sachs keeps coming up in non-financial press.  Rolling Stone Magazine has had multiple articles on Goldman-Sachs, how not only do they package an investment and sell it to somebody, then they bet against it, because they knew exactly what was going to happen, that it couldn’t possibly pay off.  That is criminal.

David: I guess what we are looking at is a kind of division of interests between the ECB and the euro-banks, on the one hand, worrying about their solvency, worrying about their capital adequacy ratios, and then London and New York, who have taken out bets on the demise of these peripheral European countries.

Kevin: They are betting against it and they are ready to rake in the winnings.

David: Pounding the drum – “Default, default, default, default.”

Kevin: David, let me get this clear.  The European Central Bank really would be the loser if there were defaults at this point.  They don’t want to see defaults.  They would like to see the thing with Greece work out – Spain, Italy, whoever.  But you have Wall Street, and you have London, not the entire market, but the people that we are talking about, would benefit dramatically, if there was a default?

David: I guess the person to ask about who would benefit the most might be Mario Draghi.  Mario is an interesting character.  If you look at his CV, he is eminently qualified to be in the financial spheres within Europe, and he is being considered the likely European Central Bank presidential replacement for Jean-Claude Trichet.  Trichet’s term ends in October of 2011.  So we have an interesting changing of the guard.  Whoever is on the selection committee is hard at work now putting together the short list of candidates to be approved to become the head of the ECB.

Kevin: Help me on this, though, David.  Isn’t Mario Draghi an MIT-educated Ph.D. in economics, brilliant guy?  But he is also Goldman.

David: He has a lot of real-world experience, a lot of academic experience, but some of his real-world experience, the sign of approval, or the seal of approval, if you will, came from his tenure running Goldman-Sachs as a managing director in Europe between 2002 and 2005.

Kevin: This sounds to me like putting the Fox in the hen house.  If the ECB doesn’t want to see default, and Goldman and the guys in London and New York are betting against it, why would you put a Goldman man in the ECB?

David: Right.  And would Goldman take proprietary positions that benefit from the demise or the impairment of a client?  We need to go back and ask John Paulson this.  When he made his cool 3½ billion dollars on a single bet, was it genius, or was it a rigged game?  Again, signs of the times, but Wall Street has become a collection point for the particularly clever, not the particularly trustworthy, and that is an unfortunate state of affairs.  But you find people who are setting up bets that they can’t lose on, and certainly Paulson is one case in point, with Goldman being complicit in that case.  The genius of what these men are doing is that they are structuring them legally.  That is where, if you can skirt the legal issues, although you might consider it criminal, although from the common sense level you would consider it fraudulent, all the I’s are being dotted, and the T’s crossed, to be considered above-board, on a technical basis.

Kevin: This reminds me of the late 1980s, when you had these guys coming in, like Carl Icahn, these hostile take-over guys coming in, tearing apart single companies, large companies, and selling off the assets, and actually, you would think the take-over was to save the company, but in reality, it was just to put money in the pocket of the guy who took it over.  It seems to me like this has been transferred from a company scale to a country scale, or even a continental scale.

David: I guess that is what is in play here.  If you wanted to draw the lines between the interests in Frankfurt, and Frankfurt representing the European Union and the European banks, and those interests being very different than what you would find in New York and London, wherein it doesn’t matter the way the market goes – we don’t live there, it’s not our country, it’s not our currency, it’s not our way of life.  It’s simply this year’s way to make profits, whether that is profiting on the up-side or profiting on the down-side.  It appears that the London interests and the New York interests are deeply opposed to the Frankfurt interests and the ECB.  The ECB is arguing against any sort of default or restructuring.  What is interesting is that they are now calling it, not restructuring, but re-profiling.

Kevin: That’s the latest euphemism, isn’t it?

David: As you said, Kevin, the ECB and the European banking community are the ones that lose in a scenario of default.

Kevin: But for every loser, there is always a winner.

David: You are right, and the winner is clearly not Frankfurt.  It’s not the ECB.  It’s not the German, Italian and French retail banks that hold that sovereign paper on their balance sheets and whose books are currently under pressure.  The winner is the person, or the financial organizations, that have bet against the peripheral countries, making this unidirectional speculative bet on a soft restructure, or as they are now calling it, the re-profiling, or whatever kind of default.  It has to be categorically a default, sufficient to trigger payment, as legally required by the credit default swap contract.

Kevin: In a way, we actually have a war going on right now between Europe, Britain, and America.  It seems to be very similar, but this is just being played out in the financial scheme.

David: Right.  Continental Europe versus everyone else.  And everyone else really doesn’t care about continental Europe, unless you are talking about a currency alternative, in which case Asia certainly cares about the direction of Europe, and on that basis, I think the harder you see the European banks pressed, and the ECB pressed, to bring about a default with the sovereign paper, you may see China just step in and spend 100 billion.  You may see them come in and spend 500 billion.  They certainly have the money to do it.  The Chinese wanting to see the dollar decline over a longer period of time would imply that they don’t want to see the euro crater, and will act as something of a backstop.  They may be the knight on the white horse, stepping in to save continental Europe from a debt or default restructure.

Kevin: What an amazing complexity that has been added to this spectrum.  It really is.  If you go back and study the makings of a World War I, or a World War II, from a military or political standpoint, it is very complicated.  We like to simplify it and say Hitler was a bad guy, and he was, but it was far more complex than that, being played out in the financial markets, and especially the derivatives market, which, when you add it all up, is the greater part of all the money markets out there.  We have talked over a quadrillion, when you count all the money.  We have Asia working in their best interests, possibly.  That would be a surprise if they come in on a white horse.  It certainly would shock the markets.  We have Goldman-Sachs working their way into the very thing that could be their pay-off, which is Mario Draghi.  How do you hedge against these things, David?  I guess it brings us back to gold, right?

David: I think you do want to look at your counter-party risks and realize that every asset class that you own, whether it is a stock portfolio, a currency portfolio, a managed futures portfolio – whatever it is, you’re dealing with institutions, and if you haven’t adequately hedged that institutional risk, or counter-party risk, you don’t know the context that we are in.

Kevin, you are right.  We have Europe fighting New York and London.  Europe is fighting what appears, more and more, to be a rigged game, one in which the Goldman-Sachs boys, along with other global financial speculators, are playing for keeps, again, in an already-rigged game.  They know how bad the numbers are because they came in with these sovereign entities and helped obscure, originally, just how bad it was 3, 4, 5, 6, 7 years ago, so they know exactly what they are betting.  They have put together the portfolios which they can now short, and profit from.

Kevin: And now they are sending their man in, Draghi.

David: This is if – if and when Draghi comes to the helm of the ECB, you will have your default delivered over to London and New York hedge funds.  Goldman will make a killing.  Goldman may play for keeps, and this is what will be interesting.  They stand to benefit in two ways – one, certainly, financially.  If Draghi comes in, as a former Goldman man, you know that the EBC’s hard stance on a default or restructuring goes away, and the logic of default, the logic of restructuring, all of a sudden, becomes a part of the ECB tune.

Kevin: Are they doing this all for profit, David, or is there more?

David: No, because frankly, London and New York benefit more significantly by translating that money and profit into power within the Eurozone.  Certainly, money means something, but it means less when you are making billions a quarter.  Power is the next best thing, frankly, to being God in a kingdom of your own making, and that is what Goldman has a vision of.  And we are not just picking on one firm.  There are other firms involved in this particular game.

Kevin: Sure.  J.P. Morgan, Morgan Stanley.

David: And there are tons of hedge funds that are on board as well.  It is not difficult to see that we have mismanaged our own books here in the United States.

Kevin: Let’s go mismanage the ones in Europe.

David: Right.  What you have is the new form of financial wizardry – setting up a package of securitized products that you can’t lose when you bet against.  That is amazing.  That is absolutely amazing, and something that will ultimately change, as there is a public uproar against it.  This was never meant to be.  If you go back to Greenspan’s speech in the 1990s about how wonderful derivatives were, he envisioned derivatives for the financial market being, as you described, Kevin, a way that someone who brings in corn, or wheat, or soy, is able to hedge their current production and lock in today’s price so that they don’t have to experience the vicissitudes of the market – the ups and downs and volatility of the commodity trading pits.  They were essentially hedging.  That is what derivatives were intended to be.  They have become, truly, financial weapons of mass destruction, and the war that is being waged is continental.

Kevin: David, one of the ways that the average guy can actually measure risk, like the risk of default, is by watching interest rates.  Don’t the credit default swaps, in some way, let us know what the likelihood for these various countries is, for some sort of default or other kind of non-paying event?

David: This is why we are talking today about debt, why we are talking today about dominos, and the falling of one domino leading to the fall of another, why we are talking about derivatives, and derivatives being central to this fall of the dominos within the debt markets in Europe.  It is because we already have credit default swaps, the insurance that you pay against default, at higher rates than we had a year ago, when the ECB was bringing out their 1.1 trillion-dollar or 750 billion-euro bailout.  This was the giant shock and awe – “We are going to change Europe, we are going to backstop every country, there will be no defaults, we are going to implement austerity, and here is all the money the world could ever want to fix the problem,” and yet, 12 months on, the situation is worse, and the probabilities of default, as indicated by credit default swap pricing, is even higher.

Kevin, takes these countries in Europe as the primary example.  In Greece, if you have a million dollars that you want to insure, it is going to cost you 147,000 per year to insure it.  That’s almost 15% to insure something that pays 16.7%.  You are eking out a marginal profit, but you have to insure against default.  It is costing you almost 15% to insure against default.  In Portugal it is better.  It is only $67,000 for every million dollars, or 6.7%.  In Ireland it is 6.6%.  In Spain it is 2.68%.  In Italy it is 1.69%.  So you can see where the concern is most concentrated, Greece, Portugal, then Ireland, ultimately Spain, the real revolution will be over the next few months as we see things materialize, particularly in Spain, and it goes from the bottom of the list to being near the top of the list.

Kevin: Let me ask you about that, because some people that I have read and we have talked about, Greek debt isn’t necessarily the big issue.  Even Portugal debt is not really the big issue.

David: It is because they don’t have that much, to speak of.

Kevin: But Spain is a different issue, isn’t it?

David: Spain and Italy are two borrowing giants.  There are tons of paper, and that is the issue.  Again, on the basis of contagion, it is not that you have to worry about Greek debt default.

Kevin: That wouldn’t take the ECB down, or the Euroland down.

David: It wouldn’t.  It doesn’t destroy the euro project.  Portugal, if you face default or a restructuring in Portuguese paper, again, it doesn’t impair the EU project.

Kevin: But these are the dominos that you are talking about, one domino leading to another.

David: Exactly, and the big one that you can’t recover from, because there is too much debt, is Spain, and then Italy, even more so.  But with Spain, since 2008, you have 17 autonomous regions, like our states, practically, which have doubled their debt, to 160 billion dollars.  You have municipal debt, so the cities within those states, which have debt that is right around 50 billion – 47 or 48 billion – and then central government debt, which in dollar terms, is pushing 700 billion dollars.  This is in addition to about 37 billion dollars worth of debt that hasn’t been factored in because it is being considered as unpaid bills and things of that nature, so they haven’t actually added an extra 37 billion to the negative side of their balance sheet.  Spain is a far bigger problem than Greece, Portugal, and Ireland.  Contagion, spreading to Spain, would be terminal for the EU project, as we know it.

Kevin: David, since we are on the subject of musicals, we talked about Grease, but I think maybe [Greece] isn’t the word.  It’s the rain in Spain, but we just don’t want it to fall, do we?

David: Unless it’s mainly on the plain.

Kevin: That’s right.

David: I think, Kevin, when you look at the debt that is in Europe, this is not a European problem only.  We have that clearly in the United States, too.  Our balance sheet is just as impaired as many of these European countries.  We have what they don’t have, which is an exorbitant privilege, as Barry Eichengreen has described it – that of world reserve currency status.  As that gets chipped away at, we are in the same boats as these folks are, too.  We have the Chinese Central Bank advisor saying just this last week again that he eventually expects to see a default of U.S. paper.  That may be a far-fetched notion for U.S. investors today, and maybe that is something that will only happen on a 5, 10, or 15-year time frame, but when you see a revolution in interest rates, when you see a revolution in the bond market, these things never happen gradually.

Kevin: David, I think probably one of the greatest signs of seeing that our sovereign debt is going to be defaulted on is watching the Goldman guys.  If we knew that Goldman started betting against the dollar ever paying up, we probably should run for the hills, shouldn’t we?

David: We already have the PIMCO guys saying, “We don’t want any part of the U.S. treasury market, which is a first strong indicator that short positions will be building over the next few years.  I think as we look at modern finance as a truly rigged game, this is where the smart money begins to figure out who their counter-parties are, and how they can insure against default, whether it is domestically, whether it is with their own currency, whether it is with a particular financial institution, that is where individuals and institutions and hedge funds, and even central banks, are all turning to gold as that insurance.

 

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April 27, 2011; Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International System. An Interview with Barry Eichengreen


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we have watched gold and silver continue to climb, really, without correction.  We have been getting calls, people saying, “Hey, when do you expect the correction?”  But every once in a while, we do get little corrections, and they are expected events, but they are not necessarily something you would read about in the newspaper.

David: If you look back at the last ten years, and look at a chart of either gold or silver, it looks like there has been uninterrupted growth.  In fact, that is not the case.  We have had two steps forward, one step back, two steps forward, one step back, a steady progression which has taken us to some pretty significant levels.

Kevin: That is a normal bull market, isn’t it?  You go up a little bit, and then, of course, the traders take a profit, or what have you.

David: And usually what precipitates those declines is something in particular.  This is a classic case in point.  The 26th of April is options expiration, so you have many leveraged positions which either have to be closed out, or will be worthless.  They will expire worthless.  A bet that the price of metals would be price X by time X …

Kevin: Either up, or down, you could bet both directions.

David: Exactly.  But getting to options expiration, there is typically volatility when you have this date occur – par for the course, no big deal.  I would relish a correction in both metals.  If we could see a 6%, 7%, 8% correction in gold, a good 15% to 20% correction in silver, these would be healthy corrections.  This is what allows for these markets to be extended over a longer period of time.   That’s sort of micro in the markets.  We have the Dow and the S&P moving higher, with the expectation that quantitative easing will continue.  This is the dope that the market really is enjoying.  And it is interesting, if you take it away, if is not renewed in June, you are likely to see some downside volatility.  On that volatility issue, we have the VIX, which has peaked below 15 earlier in the week.

Kevin: Why don’t you explain that a little bit to the listeners?  What does the VIX actually tell us?

David: The Volatility Index is basically an expectation monitor, if you will.  Are we going to see prices go up, or down?  And the lower that index gets, people are really comfortable, and are assuming that there is no downside.

Kevin: So they are just on cruise control when the VIX is low.

David: Exactly.  You see a spike in the VIX when people are concerned about price volatility, when they are concerned about prices going down, particularly in equities.  So, we have relatively high complacency in the stock market.  Every time in the last year where the VIX has slipped below 15, it has, within a matter of days or weeks, spiked to 25-40, and what that means is that we do have a correction in equities around the corner, if you are using that as a forward indicator.

Kevin: What it reminds me of is a guy who is sort of falling asleep at the wheel.  He gets a little too comfortable, the heat is on in the car, he starts to doze, bumps on the side of the road … (laughter) and it wakes you up.  Whoa, wait a minute, wait a minute.  The VIX is a good indicator that way.

This brings us, then, to the subject of today’s conversation, David, because when we talk about corrections, we are talking about a correction versus a particular currency.  In this case, we are talking about the U.S. dollar.  The dollar has enjoyed, for decades, what our guest today talks about as exorbitant privilege, and that is the reserve currency status.  But over the last week or two, especially, we have started to see things that are chipping away at that reserve currency status or the potential of it.  Even the IMF is now talking about China overtaking the United States at a much more rapid pace than what they had originally said.

David: On the same front, Kevin, the IMF said just two weeks ago the U.S. lacks a credible strategy to stabilize its mounting public debt.  They said it poses a small, but significant risk of a new global economic crisis.  They are looking at the balance sheet, the way our foreign creditors are looking at the balance sheet, scratching their heads, saying, “I don’t know if this is going to end well.” And interestingly, Mr. Eichengreen, in today’s interview, actually picks a date and says, “No, in fact, it might not go well, particularly if you are looking out on the time horizon and 2013 is of any interest to you.

Kevin: Let’s go ahead and put Mr. Eichengreen in perspective for our listeners.  This is a man who writes for Foreign Affairs.  He has written a number of academic books, published by Oxford University Press.  He would fall into the category of a Keynesian economist.  We have talked to Keynesians throughout the years, we have talked to Austrians, we have talked to monetarists.  There are different mindsets.  But, David, we truly are under a Keynesian regime, like it or not, right now.  So we actually have to consult the guys who have those central bankers’ ears.

David: Kevin, one of the most important things we can do on a regular basis is to understand the context that we are in.  So, to look at our political elite and wonder, “Who is the whisperer?  Whose is the informed opinion that they are relying on so heavily?”  That is where a Barry Eichengreen fits into the picture, because he has been professor of politics and economics at UC Berkeley for a good many decades, and he is an established academic.  He is well regarded for many of his books:  Golden Fetters, European Economy since 1945, Global Imbalances and the Lessons of Bretton Woods.

When it comes to monetary history and the interplay between politics and economics, this is a guy who is central, from any administration’s perspective, primarily because, whether it is Republicans or Democrats, guess what they are, primarily, when it comes to their economic views?  They are Keynesians.  So, who could they go to for an opinion?  The “best and the brightest” within that sphere.  And that is the role that he plays.  He is a seer, if you will, within a particular community, and it is vital, not only for our listeners, but our clients, as well, to understand that the decision-makers today have their influences, and if you want to see where we are going, it is an orchestrated – not an accidental – but an orchestrated decline in the dollar.

There are reasons for it.  There are influences behind those opinions, and there are things that are being put in place today which have a strong intellectual basis.  That is the importance of talking to a Barry Eichengreen, and maybe even reaching out and getting the book, Exorbitant Privilege, and seeing it as a script, not necessarily as an analysis.

Kevin: There you go.  Well, David, something that you have encouraged the guys here at the office to do for years.  We read a book a month, but they are not always books written by people that we agree with.  What is interesting is, if you read from all sides, you are going to make a much more objective decision on your investments than having a real strong political view one way or another.  That can really hurt your pocketbook.

David: Kevin, I have to say, this is an author whom I have learned a tremendous amount about, and my appreciation for his work is that, as an academic, he has gone through so many details, that for you and I as non-academics, we would simply be bored out of our minds.  But he has distilled them down, and saved us years, or decades worth of research and work, and put them into a format that we can spend a day, spend a weekend, spend a week going through.

Kevin: A monetary history education.

David: That is exactly right.

Kevin: David, let’s go ahead and talk to the author of Exorbitant Privilege, Barry Eichengreen.

David: 1977 was a very good year for both the United States and Portugal.  For us, we had 80% of international foreign currency reserves denominated in U.S. dollars, and for Portugal, that was one of the best years for port in a hundred years.  Some things have changed since then.  Now we are at only about 60% of foreign currency reserves.  They are still making great port, not quite the 1977 vintage, but we want to take a look at some of the things that are coming into the currency market, specifically, and our current international monetary regime.

The dollar has been the supreme player.  We have existed in a unipolar world for some time, and there are things that have been changing, and may actually be coming to cusp sorts of events, where we could see a more rapid change, even from this point.  This week we have had the U.S. debt put on negative watch by S&P.  Goldman has looked at GDP estimates, and revised them from 3¼ to 2½ and then to 1¾.  Our economy apparently is not growing as fast as they were anticipating it would.

What we see happening internationally is a recognition of balance sheet frailties in the United States.  The BRIC countries are seeking to diversify through settling trade in their own currencies, and they are looking for alternatives.  Do they have alternatives?  Will that include the SDRs suggested by the IMF many decades ago, or will it be new up-and-coming currencies like the euro, the renminbi, or what have you?  Today we have Barry Eichengreen joining us to explore past, present and future, as we try to wrap arms around what is happening in the international monetary regime and what it means for us today.  Thanks for joining us, Professor.

Barry Eichengreen: Good to be here.

David: Let’s start with the most newsworthy and present tense.  The S&P company has looked at U.S. debt and has determined that we are not quite as stable as we were once considered to be.  Maybe you can explore what they are looking at and what this implies.

Barry: Well, it is clear that S&P is worried  that, starting in 2013, the markets will lose patience with the U.S. political class, and all the debt that we are issuing, and that the dollar’s safe haven status could be jeopardized.  So my own view is that the S&P is not the canary in the coal mine.  They are simply telling us what we already knew.  The one thing they did was to put a date on the forecast that everybody is already worried about.  Starting in 2013, the market could grow impatient and fed up with chronic U.S. budget deficits.

David: We have current budget deficits.  We also have the outstanding stock of debt.  Roughly two-thirds of that has to be rolled over in the time period between now and 2013.  Do you think rollover risk factors into the S&P concerns?

Barry: I cannot speak for S&P but I think it should factor into investors’ concerns.  The treasury department is now embarked on a campaign to try to lengthen the maturity structure of the debt to reduce this rollover risk.  I think the very fact that they are engaged in that process is an indication that economists and officials in charge of U.S. economic policy are painfully aware that this risk does exist.

David: We looked this week at the Chinese Central Bank, Governor Zhou Xiaochuan, who is also concerned about, not only dollar holdings, but specifically, Treasuries, and is suggesting that they create new vehicles through which to diversify away from the U.S. dollar.  That certainly has implications for funding of future liabilities.  We need to, at least according to the congressional budget office, finance upwards of a trillion dollars a year, each year, for the next ten years.  If we do not have someone there to support the debt markets, where do you see interest rates going in that environment?  Do we see a 100 basis-point jump, a 200 basis-point jump?  Is this something where we are moving toward not only a dollar crisis, perhaps, but also a debt crisis?

Barry: I can imagine two different scenarios.  In the first one, foreign central banks, including People’s Bank of China, stopped adding to their holdings of U.S. Treasury debt.  The studies that were done of the last decade suggest that interest rates on U.S. Treasury bonds were 50-100 basis points lower than they would have been otherwise because of those foreign central bank purchases.  So, my scenario number one would be one in which interest rates go up by 50-100 basis points.

Scenario number two is darker.  That is one in which foreign central banks grow alarmed about fiscal and financial stability in the U.S. and they not only stop accumulating, but they actively dispose of some, or all, of their holdings, and that would be the dollar crash scenario in which the exchange rate collapses, interest rates shoot up, and so forth.  I am not predicting scenario number two, but I do think it is something to worry about, and that is why there needs to be a sense of urgency around budgetary negotiations.

David: On that point, the budgetary negotiations that are taking place in Washington, what was agreed in order not to shut down the government was roughly 38 billion dollars in cuts.  As a percentage of the deficit, that is only about 2.4% of the problem solved.  How do we make progress on that point?

Barry: I think we need to have a debate, number one, about entitlements.  So, say what you will about Paul Ryan’s plan – I personally am not a fan – but it ought to have put the issue of entitlements reform on the table, whether we are going to cut spending on Medicare and Medicaid, for example.  It is interesting that there seems to be some public support for the Ryan plan, but, at the same time, when you poll Americans, and ask them if they want to see cuts in Medicare, or cuts in entitlements, three quarters of Americans say no.  So we need a debate over that issue.

Finally, I think it is going to be, to put a label on it, impossible to solve this problem through spending cuts alone.  So politicians consider it poison to talk about tax increases, or about allowing the Bush tax cuts to expire, or even about revenue enhancement, but I think we are going to have to get there, and have a discussion about that, if we are ever going to solve the problem.

David: Certainly there is popular concern with recent news of General Electric moving back to a strong state of profitability and in recent years paying hardly anything in taxes.  I think that will be something that is voted for positively in terms of tax reform and an increase in revenues.  Certainly there is openness to that, if nothing else.

We have had problems in Europe.  We explored some of these in a conversation with Otmar Issing many months ago, actually, prior to many of these crisis issues coming to a head, and gleaned some insight.  We have progressed further into the midst of this crisis.  It is a fiscal crisis.  It is not solvable along the same classic monetary lines that you would expect, where you can just print more money if you have fiscal problems, because that, in fact, was an issue of sovereignty given over to the ECB, and these individual countries are no longer in control of their monetary destiny.

What is the way forward?  Is the way forward a greater cooperation at fiscal levels?  A greater connection politically?  Is that even feasible?  We have seen, whether it is Westphalia, or some of the other German states in absolute revulsion to Germany bailing out these other countries.  There are other issues involved, of course, in those elections, but it does not seem that there is popular approval, if you will, for a move toward greater political and fiscal connection.

Barry: Well, I think I would disagree a little bit with your characterization, which, I think, reflects Otmar Issing’s characterization, that Europe’s crisis is a fiscal crisis.  The recent crisis is a fiscal crisis, but elsewhere in Europe, it is basically a banking crisis, so step #1 toward solving it will be to strengthen Europe’s banks, and I think there has been progress there in the last couple of weeks.

Commerce bank, one of the big German banks, has announced it is going to raise more capital.  One of the big Italian banks is following.  One of the German state banks, one of the Landesbanken, has been instructed to raise more capital, and the European banking authority, kind of the EU overseer of the banks, has announced that they will hold the banks to pretty high capital standards in the second stress tests that are coming in a couple of months.  That is good news.  Once the banks are strengthened, it will be possible to restructure the problem debts of countries like Greece and Ireland and Portugal without bringing down the European banking system, without blowing a hole in their balance sheets, and that, I think, will be enough to draw a line under the crisis.

That is the good news.  The bad news is that there is going to have to be cooperation among governments, between countries, about how to do this and how to coordinate the bank recapitalization and the debt restructuring.  There are those revolts in Germany which you described.  There was the election of 19% of the vote earned by the True Finn Party with Sunday’s election in Finland, and they are opposed to financial assistance to the crisis countries, so it is going to be a hard political task to get the cooperation they need.

David: When we look at the U.S., we have seen a change over time.  We once were a creditor nation.  Looking at our own balance sheet and the issues that we have to sort through, if we are going to maintain reserve currency status, or perhaps that is something that is already slipping and cannot be maintained.  We would love your opinion on that.  But has becoming a net debtor put the U.S. in a precarious position, compromising our international influence?

Barry: Well, it certainly doesn’t help.  It creates a pressure point that, in principle, foreign governments can exploit in a dispute with the United States.  So one could imagine a dispute between the U.S. and China over Taiwan in the future, or over a policy toward Iran, and China could use its leverage in the U.S. Treasury market to get the U.S. to compromise.  That is what we, the United States, did to the U.K. in 1956 when they were part of the Suez invasion, and we threatened to sell sterling to get them to withdraw.

I think the situation now is different because the U.S. is big, and the U.S. Treasury market is big, whereas the U.K. sterling market was small 50 years ago.  If China were to sell Treasuries, big-time, in response to a dispute with the U.S., they would essentially be shooting themselves in the foot, as well, because they would be taking big losses.  But I do agree with the premise of your question, that it is not helpful to be in debt to the rest of the world.

David: When we talk about Great Britain and the Suez Canal, you have noted that a nation whose economy does not grow, loses political and strategic power.  In what ways are we witnessing that in the U.S. today?

Barry: I think to be a global power and a global financial and monetary power, in particular, you need three things:  First, you need a big platform.  You need a big and growing economy.  Second, you need liquid financial markets.  Third, you need stability – stability that breeds confidence in your currency, globally.  So the problem you alluded to earlier, that growth forecasts for the U.S. are being revised downward, is a real one, if we balance our budget by cutting spending on infrastructure and education and training for our workers.  It is going to be that much harder to grow the economy.

I think it is inevitable that the other poor economies will continue to catch up with the U.S. over time.  We were 50% of the world economy after World War II.  Now we are closer to 20% or 25%.  That is a natural evolution, but if we underperform in terms of growth, we accentuate that problem, and the migration away from the dollar takes place faster than it needs to.

David: Considering the dollar exchange rate, should further depreciation occur, is there a level at which American standards of living would be significantly impacted, in your view?

Barry: I think that were the dollar to lose its exorbitant privilege as the world’s currency, the currency used not only by central banks for reserves, but in international transactions of all kinds, the dollar would be likely to fall by some 20%, and that would translate over time, I suggest in my book, to about a 3% decline in U.S. living standards.  That is one year’s worth of normal economic growth.  It is not a disaster, but Americans would definitely feel it in the pocketbook.

David: We are not likely to continue consuming and investing a trillion dollars more than we produce each year.  You were talking earlier about exorbitant privilege.  The trade deficit is likely to come in line.  Isn’t the budget deficit of greater concern?  Could you look at those two deficits and say, “No, this is actually the greater concern?”  What is your view?  Which has been the greater advantage to us?  Being able to finance trillions of dollars of debt in the Treasury market, having that liquid financial market and with stability, being able to finance things into the future, or the exorbitant privilege that you speak of in regard to trade?

Barry: I think the budget deficit is, or soon will become, the fundamental problem, and external deficit of the United States, the trade and current account deficit, is the symptom.  So the fact that foreigners have an appetite for dollars means that they lend to us more freely than they would otherwise.  The question is:  What do we do with that funding?  Do we run yet bigger government budget deficits as a result, because we can currently place Treasury debt at low interest rates?  Does that remove some of the urgency that could be attached to the budget discussions?

I think the answer has been yes.  If we take that foreign funding and we invest it recklessly in a real estate bubble, rather than investing it in infrastructure, education, training, and other things that enhance the competitiveness of the U.S. economy, then yes, it becomes part of the problem.  But, fundamentally, in my view, the problem going forward will be the budget deficit, and I still worry that we do not have the kind of frank dialogue around that, and discussion across the aisle in the Congress that we are going to need to solve it.

David: The Obama Administration has estimated that the interest component on the national debt will be rising from just under $200 billion a year, to about $554 billion over the next five years, assuming a gradual increase in interest rates.  You suggested a couple of scenarios where, in fact, we could see interest rates bump up even more than that, perhaps even putting greater pressure on the interest component.  At what level are you concerned about the interest component on our national debt?

Barry: We will be in a situation when interest rates return to normal levels in 2013, or thereabouts, where, if nothing is done, one-quarter to one-fifth of all federal government tax revenues will go to debt service, leaving that much less for other purposes, so I am worried about 2013, like S&P, when the debt-to-national income ratio in the United States will be approaching 100% if nothing is done.  If at that point, interest rates are back up on Treasury debt, or back up at 4% or 5%, I think that is quite an alarming scenario, and the numbers it suggests are larger, in terms of the increasing debt service and burden, than the administration forecasts that you mentioned.

David: How do we keep our foreign creditors from viewing a mild inflation, whether it is 1½ to 2% target, or some other number?  Let’s say it gets ahead of us and it is 3½ or 4%, how do we have them satisfied, owning U.S. dollar-denominated assets, since we really are moving toward a subtle form of default?

Barry: Well, it is going to be hard.  In other words, private foreign investors have already begun to effectively curtail their purchases of U.S. Treasury debt.  It has been mainly the Fed and foreign central banks, almost entirely, who have been buying the new debt issuance, so I do think the scenario that you described is a plausible one.  The Fed is not going to be consciously attempting to inflate away the value of the debt, but it will come under pressure not to raise interest rates as quickly as otherwise, because raising them will make the federal budget situation even more difficult to solve, as we were discussing a moment ago.  That will translate into more inflation if nothing is done about the deficit problem.

You ask, “What can we do about this?”  I think the answer is to put in place a credible medium-term fiscal plan, so even if we cannot eliminate the budget deficit in the short term, indeed, I would argue it would be undesirable to eliminate the budget deficit in the short term because the economy needs that spending support right now, with slow growth and unemployment above 8%, but a plan about exactly what we are going to do starting in 2013 would be what those foreign investors need.

David: You mention, in your book, a meeting between Richard Nixon and the then-head of the Federal Reserve and pressure was certainly brought on the Fed at that time to devalue or goose the system, if you will, a little bit, create a little bit more liquidity, and in essence, create a little bit of inflation.  Help me with my concern about Fed independence.  In these periods of financial stress and strain, how are they able to maintain political independence?

Barry: The basic answer is that they are not able to maintain it, so central banks are embedded in the political system, like it or not.  They have to work as hard as they can.  They have to run as best they can to limit the challenge to their independence, to limit the erosion of their independence.  The Fed has already come under a lot of political pressure because of the unprecedented kinds of interventions in which they would have to engage during the financial crisis, and now the difficulty of backing those out.

But I think what the Fed needs to do to protect itself is to communicate clearly what its priorities and intentions and strategies are.  So I think, actually, it is a good thing that Mr. Bernanke has gone on 60 Minutes and the Fed has decided he should hold press conferences several times a year as a way of communicating what they are doing and why, and as a way of trying to remind the public of their mandate and reassert their independence of the politicians.  That is, effectively, all they can do.

David: This is a question relating somewhat to the Taylor rule.  We have kept a zero interest rate policy for some time.  We experimented with that in 2002-2003, and in your book you argue that perhaps the administration at that time kept rates too low, perhaps by as much as 3 percentage points too low.  Are we in a similar situation today under a different Fed administration, no longer Greenspan, but Bernanke, and does this tie at all into Knut Wicksell’s idea that if you keep interest rates too low, too long, they ultimately will go much, much higher?

Barry: I think there is something to that idea.  It is clear that the appetite for risk is back, and part of that is because of the very low interest rates and very low funding costs that investors who want to take a bet in U.S. stock markets, or Brazilian stock markets currently face.  What I would add to the point, however, is that hindsight is 20/20, that we can look back, I could look back in my book at 2002-2003 and say the Fed overestimated, with benefit of hindsight, the risk to the economy from 9/11.  But we didn’t know that at the time.

I think, in contrast, the risks to the U.S. economy and financial system in late 2008, early 2009, from Lehman Brothers, were very grave, and the Fed was fully justified in terms of lowering interest rates to support the economy and the financial system at that time.  Now we are paying a price for that, several prices for it, one of which is the return of excessive risk-taking.  But this is simply another way of saying that we dug a very deep hole for ourselves by allowing the financial crisis to take place, and, indeed, we are now paying the price of that.

David: As we move toward a conclusion today, in a recent article, you had on April 11th written about a tripolar currency system.  We have had the unipolar, dollar-centric monetary regime since 1944.  It has changed somewhat in the post 1971 era, where we have a free-floating system.  What do you see as the future for a monetary system?  Is it something that we, as Americans, should be concerned about?

Certainly, Great Britain is still a great country, even though they are not the leader that they were, controlling either the world’s land mass that they did, or having the kind of influence in the capital markets that they once had.  What should our concerns be as Americans when we look at the idea of a tripolar currency system?  Is it one of greater stability, or one of downgrade for us?

Barry: I am hopeful that it can be a more stable system than the one we have had for the last 20 years.  One way of understanding the financial crisis which we have been through is that there was an imbalance, or a tension, between what is an increasingly multipolar world, where we are no longer the only big economy.  There is also Euroland and China, among others.  There is a tension between this multipolar world economy and a still dollar-dominated, or dollar-centered monetary and financial system.

The world through which we lived was one in which, when we hang ourselves, we Americans, by engaging in reckless financial excesses, foreigners give us more rope.  They lend to us more freely, because they need our dollars for international transactions.  I think in a world where there are alternatives to the dollar in the global sphere, where there will also be the euro and the Chinese renminbi, the U.S. will feel market discipline more regularly, and earlier, if we show signs of engaging in those financial excesses again.

Ultimately, that will make the world a safer financial place, so I think ten years from now, when there will be three global currencies, we can look forward to greater financial stability.  The problem is that ten years is a long time, and history tells us that we tend to get a financial crisis of one sort or another, not every ten years, but more like every three years.

We go back to those three things that you mentioned, having a platform, a growing economy.  Certainly China has that.  Euroland, in total, does, with certain engines of growth, primarily.  Liquid financial markets.  You certainly see that with the euro more than the renminbi.  I am trying to look at those three things that you said that we need:  Liquid financial markets, stability, and a growing economy, to see which of those apply today, or are likely to apply more so in the future, for China and Euroland.

Barry: Euroland, first they need to work on the growth.  They need to work on the market liquidity, because they don’t yet have an integrated treasury bond market, Euroland-wide, and they need to work on the stability in places like Greece and Ireland and Portugal.  In the case of China, they have had the growth, although there is debate at the moment about whether and when China will slow down.

They need to continue to work on the stability because there are also worries about Chinese financial markets and a housing bubble and so forth.  But most of all, they need to work on the market liquidity.  I think they are serious about that.  They have said by 2020 Shanghai will be a true international financial center, which means, they will have to have liquid markets that are open to the rest of the world.  China is moving in that direction.  They are, in fact, making faster progress than many people appreciate.

Looking at things this way reminds us that the greatest strength the dollar has, in terms of remaining the leading global currency, is that the obvious rivals, the euro and the renminbi, have plenty of problems of their own.

David: So, being the incumbent does have some privileges.

Barry: In normal circumstances.  Think about an incumbent politician.  Normally, incumbency makes it easier to get re-elected, but if there is widespread dissatisfaction about the policies of the government, voters turn around and say, “Throw out the bums.”  My worry is that if there developed widespread dissatisfaction and skepticism about U.S. economic policy in the medium term, there could be, similarly, a flight from the dollar and that would not be a good thing for the U.S.

David: Perhaps this last question is more on the political than the economic side, but as Harold James pointed out in his book, The End of Globalization, there exists potential international conflict in the period ahead, as individual nations prioritize domestic constituency groups over international cooperation.  It is a similar theme that Mr. Kagan picks up in his book, The Return of History and the End of Dreams.

I am interested in what your opinion would be.  What risks do we run today of seeing the world move toward greater insularity, and away from a cooperative relationship?  Would that include the re-emergence of capital controls, as individual countries clamp down on their version of security and stability?  Might the EMU be the reasonable test case to watch and see how this unfolds?

Barry: My view, contrary to Harold’s, is that globalization has come very far and is now very deeply embedded.  I do think there will be strains, and that we will continue to see more use of capital controls by countries that are having trouble managing financial implodes.  There will be trade disputes between the U.S. and China, and difficulties in the Congress in ratifying proposed bilateral trade agreements.  I am pessimistic about the successful conclusion of the Doha round of trade negotiations.

But all that said, I don’t see globalization being rolled back.  I think global supply chains are too fully developed.  I think Chinese foreign investment has gone too far for the Chinese to turn their backs on globalization.  They need our technology and they need foreign energy too desperately to do that.  So, clearly, there will be strains, there always have been, and I think governments have always prioritized the needs of domestic interest groups over international cooperation.

It is only when we have had extraordinary leadership, as I think we did briefly at the beginning of 2009, that leaders have been able to come together around the necessary cooperation.  I don’t know if all this renders me an optimist or a pessimist.  I don’t know how much cooperation we are going to have, but I do think that globalization will survive.

David: If you will allow one more question, the inflation issue is one that is becoming of greater concern as we talk to people all across the country.  There is one thing that I am recalling from a conversation with Giulio Gallarotti, and that is that while the gold standard would never be reintroduced, and gold is no longer a part of our money system, something that has a discipline, should be, or needs to be, introduced into our money system.  What are your thoughts on that?  Should we be concerned about inflation?  And is there something that needs to change with the dollar in the way the Fed handles our currency, to introduce a characteristic, perhaps, of the gold standard without going back to gold, specifically?

Barry: I think the right way to think about this is in terms of the Fed’s mandate.  The Fed has a dual mandate to pursue two objectives:  The first one is price stability – low and stable inflation.  The second one is full employment.  There are people, I am not one of them, but there are people who say this dual mandate is part of the problem – that we should eliminate the second part, which requires the Fed to worry about the pursuit of full employment, and require the Fed to keep its eye on inflation alone.  If you are one of those folks who is worried about the prospect of runaway inflation in the not-too-distant future, I think the right way to respond to those fears, and the right question to inject into the political debate, is whether we should be narrowing the Fed’s mandate or not.

David: That is very helpful, and I appreciate your time today.  We look forward to continuing a conversation into the future.  Thank you for your most recent contribution, Exorbitant Privilege, The Rise and Fall of the Dollar and the Future of the International Monetary System. This is one of many books we could recommend, but certainly one that is approachable, and gets to some very critical issues being discussed to day or need to be discussed today, and our listeners would be that much more informed and able to contribute to a dialogue, having read your book.  So, thank you for joining us.

Barry: Thank you for the kind words.

Kevin: David, Barry Eichengreen has the ears of an awful lot of decision-makers worldwide, so he has to be careful what he says.  But a couple of things that he focused on over and over were this day of reckoning, possibly in the year 2013.  He was careful not to call it a day of reckoning, but if you read between the lines, he is concerned.

David: Kevin, I think for good reason.  If you look at the BRIC countries’ decision to seek diversification through settling trade in their own currencies, if you look at the Goldman downgrade of GDP growth, if you look at U.S. debt being put on negative watch by S&P, what he is addressing in the book is very central to what is happening in today’s news.  Dollar supremacy, what he describes as the unipolar world, moving to a more tripolar world – that is interesting.  And the fact that this is wrapped up in a bow, particularly – greater global stability?

That has my particular interest, that we are seeing a U.S. downgrade as universally beneficial.  That is worth considering – not necessarily from the standpoint of agreement again, but what is happening is a shift in opinion.  We used to view having a strong dollar as the greatest way forward, and certainly a benefit to U.S. citizens.  Now there is a shift in academia.  A shift in academia ultimately leads to a shift in policy.  A shift in policy ultimately leads to a shift in what we experience as citizenry, and what is that?  We should prize a dollar that is worth less over time.  I am not sure how we get there, but we do, in fact, have some things to learn from this book, Kevin.

Kevin: So, what they are telling us is we should prize it, and maybe it would be best for us, even though that is a downgrade in our standard of living.

David: And I think it is worth going through the different points in this book, whether it is development of U.S. financial markets in the 1920s and 1930s.  In 1930s Britain, seeing the support that they gave to the banking system, very much like what we are doing right now.  There are some interesting parallels as you go back to the downgrade that occurred in Europe circa the 1914 to 1950 period, that World War I, World War II, post Bretton Woods era, and what we are seeing happen today.

Kevin: Yes, from a historic standpoint, there are a lot of parallels to what we have seen before, not only in Britain, but with France now, cashing dollars in for gold back in the 1960s.  He talks about that.   We have that same cashing-in occurring with China and Asia right now.  It is not being done over an official table from the U.S. government, but they have been accumulating a lot of resources.  You have, also, the parallels with the Suez Canal that he talked about.  He mentioned that in the interview, how we applied political pressure on Britain just by not supporting the pound.

David: Kevin, I think the strength of the book was smack dab in the middle where he is talking about the development and the history of the EMU and the euro, and there you see a projection forward, what it will take for the EMU to become that much more significant, including British participation in the monetary union.  There are a number of things that remain questions in my mind where I think more explanation, and I think a deeper exploration, is needed, particularly when it comes to the renminbi in China, and whatever headwinds they are facing currently, seeing new numbers that real estate there is actually in free-fall, the bank raising reserve requirements now to north of 20%, and trying to get ahold of inflation, and what are the consequences of that into the marketplace?

I think for the renminbi to take a regional role, or ultimately a global role, as a foreign currency alternative, we are going to have to see some interesting things occur there, and, in coming months, we will have a few experts that I already have in mind, to address those particular issues relating to China and the growth in Asia that we are seeing, and what might impair it.

Kevin: That will be something that we will continue to investigate, as the months go on, with this program.

 

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April 20, 2011; Reserve Currency of the World – But for How Long?


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we have talked so often about the privilege that we have as a reserve currency nation.  The dollar has been the reserve currency at least since Bretton Woods.  But we are seeing news, a lot, even this week, that is making us think, “Are we going to be a reserve currency much longer?”

David: Kevin, I think it is always worth looking at risks and re-analyzing and re-looking at them and re-appraising them as we go on.  There is a lot happening this week that I think is worth looking at, in addition to the stresses and strains in the U.S. market.

Let’s just take that as an example.  Early this week, we had a downgrade by S&P of U.S. debt, put on negative watch, we are triple A status still, but when you get a negative watch, essentially, what that means is that over the next two years you have a one-third chance of downgrade, assuming that nothing deteriorates beyond what they think it is going to.  So they are projecting decline, they are anticipating it.  They are saying, “We do have real issues here.”

What is interesting is that when that occurred, we would have expected a sell-off in the treasury market, and we did not see it.  What we did see was an increase in the dollar and a decline in the euro, because, actually, trumping the news of our instability here, was instability in Europe.

Kevin: That is the thing that we have talked about in the scope of our programs the last few years.  The dollar is a reserve currency.  It is in big trouble.  But actually, where is the competition?  With the euro, they have monetary unification, but they do not have any political unification, so all the southern states can continue to abuse the system, and the northern states can resent them.

David: I think this brings a lot of things back into focus.  For the last 48 hours I have watched CNBC and Bloomberg, and for the first time in a long time, they are giving attention to balance sheet issues here in the United States, and they are asking, “Okay, well, if the S&P company says that there is something wrong with U.S. debt, what is it?”  As if this comes as a surprise to them.  This, to me, shows how far in the sand these ostriches have their heads planted.

This is the issue.  It would appear that this has not been an issue up to this point, and the market should be surprised.

Kevin: It is a little bit like being surprised that Greece is in trouble, or Portugal is in trouble.

David: That is exactly what we had with Schaeuble’s statements also this week.  He said, “Okay, guess what?  We are going to have a debt problem in Greece.”  And then everyone in Europe is all over him, saying, “You shouldn’t be saying this.  This is not true.”  He is just stating the obvious.  S&P is just stating the obvious.  For the first time you have a company acknowledgement that the king has no clothes, in the United States.  Schaeuble, across the pond, is being castigated for just speaking his mind and speaking to the obvious.

Essentially what you have is states, whether it is the United States, or individual states within Europe, who have spent too much money, and they do not have enough income to make payments on the debts that they have.  This is issue number one.  Issue number two is, what is the value of these IOUs that they have issued into the market?

Kevin: What is their ability to pay?

David: And here is the real complicating factor, because the ECB, the European Central Bank, cares about keeping stability in the financial markets, and specifically, in the banking arena.  This is the problem.  You have banks in France, you have banks in Germany, and banks in Italy, that are chock full of debt.  These are IOUs from Ireland, IOUs from Portugal, IOUs from Greece, and if that debt is diminished in its value, now you are talking about solvency issues within individual banks in these countries.

Kevin: David, you have pointed out before, and we are talking about Europe right now, but talking about Greece, we think, “Well, it’s just a basket case.”  But actually, from a debt-to-GDP standpoint, the United States is in worse shape.

David: Right.  We are in no better condition.  What we have is a privilege accorded to us by one thing, and you mentioned it earlier, Kevin.

Kevin: Reserve currency status.

David: We have reserve currency status.  What does it mean to have reserve currency status?  What it means is that transactions that happen on an international basis are settled in dollars.  It means that oil, when it is sold, even if it is between Iran and Italy, or between Nigeria and Great Britain – guess what?  It is not done in euros and it is not done in sterling.  Those transactions are settled in U.S. dollars.

Kevin: And it hasn’t always been that way, David.  Let’s face it.  Just 50 or 60 years ago it was the sterling, it was the British pound.  But let’s take a little bit of a look as to how the dollar has risen.  You have talked about 1977 being a very good year for not only the United States, but another basket case country, Portugal.  1977 was a good year for both countries.

David: It was the peak year for us in the United States, wherein, as a percentage of international reserves, the dollar made up the largest percentage, at that point, 80%, of international currency reserves.

Kevin: Central banks that held reserves, 80% of those reserves, even if they were a country in Europe, were in dollars.

David: In dollars.  1977 was also the best year in a hundred years for port in Portugal.

Kevin: (laughter) Well, now, that’s a different kind of a reserve.

David: It was a very good year.

Kevin: It is a different kind of reserve and I know you try to keep those reserves.  (laughter)  Okay, let’s go ahead and talk about dollar supremacy, because we have had dollar supremacy up to this point, but things are starting to look like we are hearing more about the renminbi, we are hearing more about the euro, a basket of currencies, SDRs.  Where are we on that?

David: I think the idea of being dollar-centric, and having a unipolar world focused on the U.S. dollar, that is what is on the table.  That is what is in question.  But it is not newly on the table, it has been on the table for a long time.  If you look at the obligations that Europe had to the United States following World War II, there was not only a debt of gratitude, but an actual debt, and they were friends and allies of necessity.  We were rebuilding Europe.  There was a tremendous benefit to them, that we had resources and they had none.

Kevin: We not only had resources.  We not only had a dollar that was backed by gold, but we actually had GDP.  We had growth in this country.  This is one more thing that happened this week – Goldman Sachs started at about 3½ percent on their estimates this year for our GDP.  They have downgraded it twice, Dave.  What is it down to now?

David: 3¼ to 2½, and the most recent was 1¾.  When you look at Europe and the history of what has happened in Europe, what happened in World War I and World War II was vitally important to the U.S. dollar becoming what it is, because it wasn’t just that we had great innovative minds in America.  Certainly we did.  And certainly we have seen an improvement in industrial productivity, all through the 1920s, 1930s, 1940s, and 1950s, but what we had was steady growth in the context of Europe taking a major step back and, relatively speaking, we were propelled forward into the number 1 position.  It truly was not simply on the basis of dollar strength, but on the basis of fiscal weakness and monetary weakness elsewhere.  So the sterling took a back seat.  The French franc took a back seat.  Even the German mark took a back seat, to the U.S. dollar.  Why?  Again, replay World War I and World War II and you see how vitally important it was to these countries which were bombed out and had to be rebuilt from nothing, and did not have the resources to do that, that they were forced to borrow.  And what did they borrow in?  They borrowed in dollars.

Kevin: Yes, but David, that was when we were a creditor country.  Now we are a debtor country.

David: And the progression has been more than just us moving from creditor to debtor.  It has also been a shift in these countries being essentially in abject poverty, taking handouts from the United States, and being willing to hock their future, because they had none otherwise, and do it in dollar terms.  And as they have gotten back on their feet, as the engine of growth has been restored within Germany, and within Europe – guess what?  They have had aspirations to go back to what they had.  The French want their franc, the Germans want their deutschmark.  Or, collectively, they wanted and compiled all of their resources together to make the euro.

Kevin: David, it was fascinating, after World War II, just the utter destruction in all the countries that were involved, except for our country, actually.  You have Germany, which, if you have been to Germany, they are still rebuilding after World War II.  There are still cranes up where they are rebuilding these old historic buildings.  Japan – the same thing.  Now, look at the two currencies that became so strong all through the 1970s, 1980s, 1990s, and then ultimately, allowed a merger for the European Union for the German mark, but the German mark and the Japanese yen actually became the bastions of strength as far as currency goes.

David: They were.  And there is an interesting parallel, Kevin, when you look at the Japanese yen and the story that it had through the 1970s and early 1980s.  It is the same story that is being told of China today, of growth.  The engine of growth in Asia – was it China then?  No, it was Japan then, and they were invoicing up to 40% of all of their exports in yen terms.  This is something that the Chinese are beginning to initiate.  They are outpacing our growth here in the United States by three times.

There has been a replacement in Asia.  The yen is impaired, the Japanese economy is impaired.  China, relatively speaking, has much more significant year-on-year growth.  But they have significant things which they still have to put in place if they want to become a regional currency player, or even an international currency player.  They question is, can they do those things?  Will they accomplish them?

Kevin: And you wonder about how much time it is going to take.  In past conversation with Stephen Roach and other experts on China, they talk about time being the difficulty, because there are a lot of things we see with China, but you and your dad, last week, sort of disagreed, I have to admit, about how quickly China is going to take over.

David: And it is a combination of time and favorable circumstances.  If you look at developments of the U.S. financial markets, it was the 1920s when we saw a greater issuance of U.S. denominated debt instruments.  Prior to the 1920s, we had the U.S dollar, and yes, we had seen a radical change in terms of industrial growth, and we were exporting even more by 1916 than Great Britain.  But guess what?  Our currency was a domestic local currency.  It wasn’t until the 1920s, again, sandwiched between World War I and World War II when we didn’t have competition and we were able to begin marketing U.S. debt, when we began to denominate foreign debt, foreign IOUs, in U.S. dollar terms, to a U.S. audience that was investing feverishly.

Kevin: And there are two key operative words, that, actually, we have recommended for portfolios, as well, and one is stability.  You cannot have a reserve currency without stability.  The other, is liquidity – the ability to clear international types of transactions very quickly.  The dollar has offered that, but we are seeing at this point, countries opting not to do that with the dollar – namely, the BRIC countries.  We are talking about Brazil, Russia, India, and China.  They are starting to talk about trading outside of the dollar, amongst themselves, just with their own currencies.

David: Right, so in other words, you are settling transactions, and you do not have to convert to dollars first in order to settle those transactions.  But if it is a transaction that occurs between South Africa and China, it is going to be settled either in the rand or the renminbi.  It is not going to have to go through dollars to be settled, as has been the case for so long.

Kevin, you just hit on a very important point.  Currency stability is a vital part of this reserve currency status and it is one of the things that Great Britain began to lose in the 1930s.  In the 1930s, Britain provided emergency support to the financial and banking system, and it was at the expense of the pound sterling.

Kevin: That’s when they really lost it, isn’t it?

David: It reinforced the trend of marginalization of the sterling.  And the exchange rate slipped relative to the dollar, from 4.86 to 3.25, in about a year, a one-third depreciation in about a year, as the monetary authorities favored the banking system and the financial markets over currency stability.  It was, again, one of those things that added to the hand-off of the baton from the pound sterling to the U.S. dollar, as world reserve currency.

Kevin: That was the 1930s with Britain, but that sounds very familiar right now.  Oh my gosh, I mean, how much has the dollar declined over the last few years?

David: We have had about a one-third decline just in the 2000-2004 period, and we have been flirting with another support level.  If we break 70, I am not sure that we won’t give up another 20% or 30% in short order.  It is reminiscent of what the French did.  It is reminiscent of what countries throughout time do when they have control of their currencies.

This is the great disadvantage of the European countries who have put their stock in the euro.  They don’t control their currency, and when things get out of balance in terms of their debt, in other words, they have too many liabilities and not enough assets or income to pay those liabilities, then they de-value.

The French were serial de-valuers through the 1950s, 1960s, and 1970s.  The British were, likewise, serial de-valuers all through this last century.  We went from almost a 5-to-1 to the dollar, to now about 1.6-to-1 to the dollar, if you are looking at pound sterling.  That has been the legacy over a 100-year period.

We are doing the same thing today, favoring the banking system, favoring the financial system, over our currency, and the one thing that has kept investors coming back to the dollar, year-in, year-out, in spite of us having a poor balance sheet, even 20 or 30 years ago, was that there were no alternatives, and that changed in 1999 with the launch of the euro.

Kevin: David, let’s hit the rewind button just a little bit then.  Let’s go back to the end of World War II, to Bretton-Woods, and how it came about.  There were no other options, as you said, but there was something that the United States promised the rest of the countries, and that was a solid gold standard.

David: It was the assumption that the dollar was a good as gold.  And why was it as good as gold?

Kevin: It was redeemable in gold.

David: So it was gold!  By proxy, the U.S. dollar was gold, because if you wanted gold instead of paper scrip, you could have it.  That has not been the case since 1971.

Kevin: What happened in 1971?  We know Nixon closed the gold window, but talk about what led up to that.

David: We had a whole series of things that happened in Europe, when they began to grow suspicious of our ability to pay.  We were offering to settle these transactions in gold versus paper scrip, and we still presented ourselves as completely together, from a financial standpoint – completely solvent.  And yet, the French were looking at our balance sheet, saying, “Hmm.  We are not sure that what is being presented is the truth.”  In other words, this is not the first time, Kevin, that the government here in the United States has fudged the numbers.

Kevin: We had people who had actually seen it happen to Britain ahead of time.  Jacques Rouffe is a perfect example.  He was advising Charles de Gaulle at the time in the 1960s.

David: Exactly.  We have talked about this before, Kevin.  He was a young man watching the pound sterling being devalued in the 1920s and 1930s, and remembered it, and he knew what to look for.  So there he is in his older years, seeing something similar, something that has a resonance with the past, and saying, “Wow.  I think there is a problem with the dollar.”

Kevin: He was a French attaché for France in England at the time that the sterling was losing that power, and coming off of the gold standard.  He saw the same thing had to happen.  In fact, there was a guy named Triffin, when he saw that the Bretton-Woods agreement was going to create an unlimited amount of dollars, and there was a limited amount of gold in Fort Knox…

David: There was a dilemma!

Kevin: It was called the Triffin dilemma.  I can’t believe it even has a name, because it is so obvious, but the Triffin dilemma is, you can’t print unlimited money, make it redeemable in gold, if you have a limited amount of gold.

David: Right.  I guess the importance here is that we are watching the things which structurally have to take place for there to be a euro which has legs into the future, for there to be a renminbi which has legs into the future, for there to be a dollar which has or has not legs into the future.  These things are swirling all around us, so that in the daily news we hear that there is another meeting in the south of China where five countries get together and determine that they are no longer trading in dollars, they are going to work out a trade relationship where they settle transactions directly.

Kevin: Right.  Well, David, we have seen a deterioration in reserves, and we have talked about the countries in Asia wanting to have other reserves and demanding other types of currencies.  We were 80% in 1977, where are we now?

David: The dollar as a percentage of reserve assets with central banks, those which are reported, has gone from 80% to 66% at the beginning of this decade, now it is between 60% and 61%.  So we are beginning to see a marginal shift.  There was a pretty radical shift from the 1970s, but just in this last decade, a marginal shift away from the dollar and toward other currencies.  We do not have that true alternative to the dollar, we have the possibility of alternatives to the dollar.  That is what we think will be exacerbated by what we see in the news today, this week.

This morning, the central bank governor, Zhou Xiaochuan, said, “We need to be reducing our exposure to the dollar, and we are going to set up vehicles in order to do that.  We are not going to tell you now, we are not going to tell you what we are investing in, but we have determined that we are not at a safe level in terms of our dollar exposure.”  What that implies is that the central bank of China is not happy with what they own, and are not intending to continue to buy treasuries and finance our deficits.

Kevin: Speaking of deficit, this is what Standard and Poor’s was bringing out on Monday, when they talked about downgrading, or at least creating a negative impression on the dollar’s future.  Paying back our deficits is probably the biggest problem the United States has, and there is a concept that you have talked about with inflation that we can actually pay back our deficits by just inflating the dollar.  That does not work when almost all of Americans’ money is in dollars, but when it takes 51% of foreigners’ money to support the dollar, which is what is happening right now, 51% foreign buying of treasuries, isn’t it tempting to start to devalue the dollar in the form of inflation, and would this be why the reserves in these various other countries are starting to be reduced?

David: Kevin, I think that is on the money.  What we have is a subtle form of default, because we have world reserve currency status.  We are not forced to a formal default, but through inflation, we are defaulting on our debt obligations.  What is very different, if you are looking at monetary history, is that, classically, what you have with these devaluations, is a stated devaluation.  They will come out and say, “We have just devalued the currency by 14%.”

Kevin: You said the French did it over and over.

David: Right, so whether it was 5%, or 7%, or 6.9%, or 14%, or 12%, but it was very specific in terms of a stated monetary de-valuation.  We have had de-valuation here, but it has been on a non-stated basis.  I think what is happening is that by understating CPI, by understating the official inflation rate, but running a higher inflation rate, 6-6%, or if you are going back to the old models, as much as 10% inflation here in the United States, we are solving our debt issue on the backs of our foreign creditors.  Tell me if that doesn’t have geopolitical implications.

Kevin, just to reiterate, we have Moody’s, which left Ireland, this last week, on negative watch, and dropped the country’s debt rating two notches, just above junk status.  We have Portugal, stresses and strains there.  We have Greek debt which is now yielding over 20%, which is a harbinger of collapse.  You are there, in terms of “renegotiation,” or default, if you prefer just plain language.

Kevin: That’s like reading a sign that says, “We are just about to default,” instead of running down the street, saying, “Guess what I just got on my Greek bonds!”

David: Renegotiation!  Yeah, language is funny that way, isn’t it?  We have Europe, which has great potential, and major constraints.  We have China, which has great potential, and major constraints.  We have America, which has great potential, and major constraints.  I would love to explore some of these issues.  Every once in a while we dip our toe into an academic question-and-answer.  Barry Eichengreen is a tried and true monetary guru.  He has been at the University of California-Berkeley for decades, and is worth, I think, having a conversation with to entertain some of these issues.

Kevin: I think we probably have to ask the question from someone more from an establishment perspective, because let’s face it, David, the central banks are establishment, and as they move these directions, the question as to whether the dollar stays the reserve currency, whether we move to a tripolar currency – the euro, the renminbi, the dollar, or SDRs – you have to ask the guys who have actually come up with that stuff.  Of course, Barry Eichengreen just wrote a book this year called Exorbitant Privilege, about this very subject.

David: Kevin, if you were following the yellow brick road, and were going to Oz, once you got there, you would want to look behind the screen and ask a few of the guys who were wizards, “What exactly is happening here?  What do you think?  What is your perception of reality?”  Not that it is the reality that we look at and accept, but one that we certainly appreciate from an establishment perspective.  It is helpful to see the direction of the decision-makers the world over.

Kevin: For those who would like to actually hear that conversation and read the book ahead of time, Exorbitant Privilege, we are going to be interviewing Barry Eichengreen next week, discussing this very subject.

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