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About this week’s show:

  • Richard Duncan: The New Depression
  • Michael Pettis: Asia Woes
  • Richard Taylor & Russell Napier

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, as promised, sometimes we need to go back and listen to some of the “best of” shows, and I know you are going to be talking to Richard Duncan over the next couple of weeks. The last time we talked to Richard Duncan a couple of months ago, he was talking about “the New Depression.” He has a book about it, and you are going to continue that commentary in few weeks when you meet him in Denver.

David: What we are doing today is a look back at conversations with Richard Duncan, with Russell Napier, with John Taylor, and with Michael Pettis. I chose these four from last year as some of the guiding lights as we head into 2013 and 2014, defining some of the major themes, both in terms of globalization, the dollar, debt markets, current interest rate trends, and we get some policy insights from John Taylor on that.

That, I think, is going to be very helpful as we try to frame what 2013 and 2014 hold for us, as investors, as individuals. The insights that we gained last year, frankly, need to be reviewed, and then, of course, as you mentioned, we will be having a second conversation with Richard Duncan here in the next couple of weeks, as well as with Michael Pettis in another couple of weeks.

For those of you who didn’t listen to last year’s interview with Richard Duncan and Michael Pettis, this is just to give you an idea of the framework where they are coming from, and some of the ideas that they have been thinking about prior to this year’s exploration and the most recent conversations we will be publishing here in weeks to come.

Kevin: Let’s go to that recording right now. For the sake of the listener, and for the sake of time, we are not going to comment a lot between the clips, so we will be listening to the Richard Duncan clips without interruption until the end.

David: Here are the highlights from Richard Duncan:

David: As he notes in The New Depression, the Breakdown of the Paper Money Economy, there are a number of things that have changed over the last hundred years. We have moved from a gold currency standard to a fiat currency standard. But, more subtly, there has been a shift away from just simply fiat money to a massive expansion of credit instruments, and in fact, he argues in the book that we have moved to a situation that is hyperinflationary, in terms of our credit expansion. The only thing that masks that hyperinflation is one key component – globalization – and a tremendous drop in labor rates.

Richard Duncan: The big change, I think, happened in 1968 when the U.S. changed its laws and no long required the Federal Reserve to back dollars with any gold, whatsoever. At that point, the nature of money changed. Up until then, we had been on a commodity-backed monetary system. In other words, gold backed up our money. Afterward, we moved to a pure fiat monetary system, or pure paper money system.

Afterward, the nature of money changed. Before, if you took a dollar bill to the Treasury Department, at least in theory, they were meant to give you some gold in exchange for that. Now, if you take a dollar bill to the Treasury, they will just give you another dollar bill. So, what is the difference now between a dollar bill and a ten-year Treasury bond? They are essentially both credit instruments. In the past, there was a clear difference between money, which was gold, and credit. Now this difference is blurred, or perhaps there is no longer any difference. Money is credit. So the nature of money changed. That was the beginning of the big change in our economic system.

Nixon, in August of 1971, ended the Bretton Woods system by refusing any longer to allow other countries to exchange their dollars into U.S. gold. Before that, President Johnson, in 1968, had asked Congress to remove the requirement that the Fed maintain its gold backing for dollars. Up until that time the Fed was required to keep 25% gold backing for each dollar. Johnson made a speech to Congress, saying, “We don’t need to keep gold to tell us what our money is worth. We’ve moved beyond that.”

But oh how wrong he was. Once we broke the link between dollars and gold, everything began to change, and the most important thing that changed is that credit absolutely exploded. Debt and credit are really two sides of the same coin. Total debt in the United States, and by that I mean government debt, household sector debt, corporate debt, and financial sector debt – all debt – first went through 1 trillion dollars in 1964. Over the following 43 years, total debt expanded 50 times, to 50 trillion – from 1 trillion to 50 trillion in less than 50 years.

This explosion of debt completely created the world we live in. Our world was made out of that credit. We have all been much more prosperous than we would have been had we remained on a gold standard. This ushered in the age of globalization. It allowed Asia to pursue its very successful strategy of export-led growth and transformed China from a very third-world country into the China we know today.

This explosion of credit completely changed our world, and I would really suggest that it created a different kind of economic system, which I will discuss a little later, I hope. But in 2008 we hit the limit, it seems, for credit to expand any further, at least on the private sector side, because in 2008 the private sector effectively went bankrupt. It couldn’t repay its old debt and was cut off from any additional debt, and it was at that point that the New Depression, as I call it, began.

David: The New Depression. We are approaching that period, or arguably, we are in it today. You are assuming that credit expansion is the hallmark of growth in a credit-dependent economy, and therefore, if credit is contracting, naturally, the economy is getting off the rails. You have just suggested that the private sector credit expansion ended in 2008, but perhaps there is something else that can fill the gap. My one concern would be, and maybe this harkens back to the title of your book, The Corruption of Capitalism. How do you avoid public sector debt expansion, and having that be legitimate in terms of going toward real needs and growth-oriented projects, as opposed to the crony capitalism that we have seen, where perhaps the debt expansion or the credit expansion is just to the “friends” of those in Washington, D.C.

Richard: Yes, well, a very good question. In Chapter 9 of the new book, The New Depression, I describe how our system evolved from laissez faire capitalism into this new system, which I call creditism, for lack of a better word. I think the starting point for everyone in the United States, and what we all really need to understand, is that our economic system hasn’t been capitalism for decades. Laissez-faire capitalism died in World War I, when Europe went off the gold standard and when all the European nations’ governments took over their economies to fight the war, followed by the U.S. jumping in and taking over the U.S. economy to fight World War I.

And then, not that long after, the U.S. government took over complete control of the economy again during World War II, controlling all aspects of production, prices, and distribution to fight the war, and, effectively, the government has been spending between 20-25% of GDP every year since World War II, so we haven’t had capitalism now for going on a century. And that was the starting point. We don’t have capitalism.

To move to something else where we are discussing a better way for the government to spend money, this isn’t abandoning the economic system we have now, this is adapting the economic system that we have now to make it work better. The economic system we have now is creditism. First, let me explain. In capitalism, the growth dynamic was driven by the private sector. Businessmen would invest, and some of them would make a profit. They would save that profit, or, in other words, accumulate capital – hence capitalism – and they would repeat the process. Investment, savings, capital accumulation, investment of savings – that was the growth dynamic. It was very difficult, and it took a lot of hard work.

That is not the way our system has worked now, for decades. The growth dynamic in our economic system has been driven by credit creation and consumption, and more credit creation, and more consumption. And that has worked miracles. That has created very rapid economic growth now for 4-5 decades. The problem is that this new economic system seems to have hit the full extent of its potential to create any more growth, and actually, it quite possibly has collapsed into a very protracted depression, because the private sector can’t bear any more debt. That means only the government sector can bear any more debt, so the real issue is, how is the government going to spend the debt that it is going to accumulate to keep the economy from collapsing into a depression?

These have been very aggressive moves of paper money creation, much more aggressive even than Japan. But as a result of those moves, with paper money creation and buying government bonds, in the case of the Fed, this has driven down interest rates even further.

The reason they have been able to get away with this, and one of the main reasons that this hasn’t already led to very high rates of inflation, is because of globalization. Globalization is putting extreme downward pressure on wages, globally. In fact, this resulted in a 95% drop in the marginal cost of labor. Before, if you wanted to hire an industrial worker to build an automobile, you had to pay someone in Michigan $200 a day. Now, you can pay someone in India $5 a day.

This collapse in wage rates is creating extreme disinflationary or deflationary pressure that has enabled the central banks to get away with massive paper money creation without creating high rates of inflation. They won’t be able to continue doing this forever – running trillion-dollar budget deficits and financing with paper money – but they should be able to do this without too much more difficulty for another five years, perhaps even ten years. The problem is that ten years from the U.S. government is going to be just as bankrupt as Greece, and at that point, then, very, very bad things will begin to happen.

It is crucial to change the way the government spends money between now and then, and actually have the government spend money in a sensible way through investing that restructures the economy and generates new technologies that restructure the U.S. economy, eliminates the global imbalances that have led to this crisis, and actually prevents us from collapsing into a new severe or great depression ten years from now.

Kevin: David, Richard Duncan made the point that the United States is going to be more broke than Greece, or actually, on paper we are right now.

Another guest that we have had that we would love to go back and listen to is a regular guest, Russell Napier.

David: That’s right, Kevin, Russell is on the program with some regularity because he has a lot to say, a lot to offer. Let’s cut right to it. We start with an explanation of what is happening in China, the rebalancing there, and move on to general over-valuation in both the stock and bond markets here in the U.S. This was the early part of last year when prices were actually quite a bit lower than at the end of the year, meaning that over-valuation started at levels that were unhealthy at the beginning of the year, and only got worse as the year progressed.

David: Maybe we could start with China, as perhaps the big thing that is not getting as much attention this year, Europe still in the headlines, but China, you believe, will be even more so as the year goes on?

Russell Napier: Yes, that is correct. The good thing about China is that it is becoming less competitive and that is good for a lot of people working in the U.S. and the United Kingdom in job creation, and it is the rebalancing of global growth which we have always been told has been a good thing, and clearly, that part of it is a very good thing, and I think you can see that is coming to fruition.

But there is a crucial flaw in this rebalancing, which is the surpluses which China has been amassing for many years, are finding a way into the hands of the People’s Bank of China, and may have concentrated virtually all of them in foreign government securities, primarily Treasuries, but other foreign government securities, as well. As we rebalance global growth, the People’s Bank of China simply finds itself accumulating fewer dollars, and therefore has less to invest in these particular security markets.

That rebalancing is good, primarily, for developed-world corporations. A very clear example would be Apple Corporation. Ultimately, Apple Corporation is not going to have the vast bulk of its accumulated cash in the Treasury markets. As we rebound, we see global growth removing the allocation of the surplus savings in the world out of the hands of central bankers, who choose government debt over every other asset.

We are moving it more into private hands like Apple, or other developed-world corporations, or, increasingly, private hands in the form of individual Chinese who are moving their capital out of China, and they simply are not allocating the great, vast majority of it to the Treasury market or the Eurobond market. The burden of funding these developed world governments will increasingly fall upon the people of those countries,

It begs the obvious question: Are there sufficient savings in these countries to fund both the government and the private sector? I question whether there is. I think this private sector deleveraging we have been witnessing for some years now has a considerably further way to go unless somebody else turns up to fund the government.

I think if we want to look to the future, then perhaps the government of Italy is a poster child for what happens when the going gets tough. Italy was cruising along with relatively low financing costs up until the summer of last year, but then very suddenly over the summer that all changed and ten-year bond yields went above 5%, and then suddenly, briefly above 7%.

And Italy was transformed. It lost its democratically elected government. It got a government of technocrats. It began to aggressively try to implement existing taxation laws, and bring in new taxation laws, act on spending, act on pensionage, act on all the things that make Italians different from Germans. It was almost as if, overnight, moving the bond yield from 3% to 7% transformed Italy from a land of Italians to a land of Germans, or a land of aspiring Germans.

The jury is out as to whether than can be achieved or not, but I think for all the rest of us, it gives us some idea of just how far the goalposts have to be moved in a period when the bond yield would go from 2-3% into the 5-6% range.

I think history tells us very clearly that when we get to that stage then the government will be in the business of forcing people to buy government debt. You might say it is impossible, it can’t be done, but it has been done historically.

A classic way this was done in the United States after World War II was through regulation Q where the government mandated the deposit rate. The banks were not allowed to set their own deposit rates. The government did that. When the government constantly mandates a deposit rate well below inflation, it becomes relatively easy for the government to sell T-bills below the rate of inflation, and if we manage a reasonably high level of normal GDP growth, significantly above normal bond yields, then over a prolonged period of time, and I mean decades, the government can grow its way out.

This manipulation of the yield on government debt is the answer for the government, and socially, it is so much more acceptable than the alternatives. Whatever you think of the history of hyperinflation, austerity, default and deflation, they are socially incredibly disruptive, incredibly socially dangerous, and many of those market-driven events have led to warfare or massive domestic social unrest.

I think in the grand scheme of things when the government sits down and decides which avenue to pursue, this avenue of repression, which is a form of theft of savings – there is no better word for it – that form of theft of savings will always be more socially acceptable than the market-driven events of austerity, hyperinflation, deflation, devaluation.

The catalyst is the bond yield. At a certain level of bond yield, as Italy has shown us, these are the things that have to be done by the government, and I think these are the things that will be done by the government.

David: Do you force the model just by continuing the conversation? Let’s say the world’s central bankers continue to repeat over and over again that we have concerns about deflation, and thus, we see more of a trickle of investment dollars flowing into the bond market, willingly participating in a negative real rate of return environment, but feeling like the credit risk is warranted, given a “deflationary environment,” even if that “deflationary environment” is just a figment of the government’s imagination.

I am just wondering how you force the model of negative real rates of return and have people voluntarily take that on. The Summers-Barsky thesis, which Larry Summers wrote many decades ago, implied that the math behind that certainly forces people in the direction of gold. With negative-to-low real rates of return, people simply opt out. Is there a way of keeping people from opting out?

Russell: It’s a great question. I think it strikes at the very core of how a financial repression works. The scale of restrictions you need to implement financial repression to force people into government debt is really huge, and they are not of a scale that this generation of investors has come across before.

One that would rise to the top of the list would be capital controls, exchange controls, restrictions on the free movement of capital. If I am in the business of trying to make my insurance companies or banks fund the government almost regardless of the yield relative to inflation, I may have to stop them doing other things. It is not just a matter of saying “you have to do this,” I may have to try to stop them doing other things.

In the period from 1945 to 1972, obviously, the gold price was pegged, at least in dollar terms it was pegged, so that you couldn’t actually make any money in gold, all your gold payment came at the end. Gold is a much more flexible item now. But if we could concoct a world in the past wherein the gold price wasn’t moving freely, we can concoct a world in the future where the gold market isn’t moving freely.

When I think of financial repression and what it means, for many people it may be rather arcane. For people who don’t have any savings they may say, “Surely this is the best way to do it.” But for me, the problem is the issue of civil liberties and civil rights and freedom in a world where the government needs money. When you begin to get your hands deeper and deeper into the pockets of the people, then I think many, many very serious questions have to be raised.

For those of you who know the history of the hearth tax, which we used to have in the United Kingdom, there was a tax depending on how many hearths you had in which to light a fire. This proved to be not really a tax that could be implemented because it involved going inside a property to assess the level of taxation, and that was deemed to be an infringement on rights. However, it was replaced with a window tax, and as those windows can be counted from the outside, then the taxation system moved forward.

Repression is a very big issue and takes us well beyond just the issue of making life insurance companies buy more government debt, into capital controls and other restrictions. That is the history of it. It comes with a whole bundle of restrictions. It is not just this one targeted item. It is a very different world. It is a world of government control, less markets. But when governments are desperate to be funded, governments will be funded, and I think this is where the rubber meets the ground in terms of what has to change.

Kevin: Well, David, that is the sad fact. Governments don’t produce anything, but they definitely get funded if they need the funding. Any economic student out there knows the name John Taylor. The Taylor rule is something that comes up with a fair and orderly way of adjusting interest rates, if you are a central bank.

David: Interestingly, in the interview with Russell Napier we talked about repression of interest rates below a natural level in order to fund government. As Napier said, government will be funded. So, we go to the Taylor interview with that in mind, knowing that there is a normal rate that rates should be set at, and if it is below that rate, you are not really following the Taylor rule, you are breaking the rules toward some other end.

John is a policy maker, an economist who has served several different presidential administrations, and here is just a brief sampling from our conversation with John this last year:

John Taylor: It is not an exaggeration to say that spending is a major source of the problem now, and I think it is very important to get that spending growth under control. It’s not really even cutting spending, it’s just preventing it from rising so rapidly, which is what is happening now and is projected to rise in the future.

In my view, we should not be raising taxes, or making the economy slow down on the basis of higher tax rates, but what we should be doing is looking for tax reform, making the tax system more efficient to encourage economic growth, and also, at the same time, removing the unnecessary programs that have expanded so rapidly very recently.

David: If you had the ear of the next president, whoever, it may be, as you have had the ear of past presidents, if there was singular bit of advice, what would you start the conversation with?

John: The principles that I outlined in my book would be a preamble, there is no question about it, because it makes so much sense. The policy has been unpredictable, the rule of law has been deviated from. We need to fix those two things. We have to have more emphasis on a market system and incentives, and limiting the role of government. But then the thing is, how do you apply those? Those are abstract, if you like, more academic. They are extraordinarily important, but how do you apply those principles?

I would start with the budget. We have a gigantic budget gap. We have a deficit that is getting larger, and the debt is exploding, so, taking that into account, I have a plan to do that which is not draconian, it’s not austerity, it’s just common sense. As for monetary policy, you mentioned the dual mandate, unwinding the programs that we have currently put in place, getting back to a more normal kind of monetary policy and regulatory policy, the same kind of thing, trying to pull back some of the extra regulations that have been put in place recently.

I think in all these cases, it is pretty straightforward what you need to do. A person has to be committed to it, and has to have people around him, or her, that will do these things. That is what I would urge – the principles, and the people who will deliver on the principles.

David: On occasion, our listeners will listen to a CNBC pundit or an academic mention the Taylor Rule, and, lo and behold, this is your rule. You have devised a way of figuring out where interest rates should be. Maybe you could explain that a little bit, and suggest where interest rates should be. We had Operation Twist under the Kennedy administration in the 1960s, and we have Operation Twist today, which is essentially a manipulation of interest rates, a changing of where the yield curve is, whereas, it should be at a different level. Where should rates be, following the John Taylor Rule?

John: The rule is a guideline for central bankers to use to determine where they should set their interest rate. It is very straightforward. The guide says when inflation picks up then the interest should rise by a certain amount. When the economy goes into a recession the interest rate should fall by a certain amount. The terminology “by a certain amount” is very important because the rule says how much the interest rate should change, and that is why I think it has become interesting, and useful, quite frankly, to many central bankers around the world when they are making their decisions. Monetary policy is a very tough job, and if they have a guideline like this it helps.

With respect to your question about where rates should be now, I think they should be moving into positive territory. The Federal Funds rate is between 0 and 0.25, so effectively, zero. I think it would be wiser if the Fed started to move up toward 1% at this point. That is what the Taylor Rule would suggest. That would allow the money markets to function a little better, and I think it would also get us in a situation back to the kind of normal policy that we have had in the past.

Whether you call it the Taylor Rule or something else, the message of history is clear. When central bankers have been close to this kind of a policy principle, things have worked well. When they have deviated, things have not been so good.

David: The academic discussion today is sort of chained versus unchained CPI and the argument is actually that we are overstating inflation, that it needs to come down a number of basis points. Maybe that is just for the academics to sort out, but I look at the Kennedy administration’s Operation Twist, and in their buying of long-term Treasury bonds and selling of short-term Treasury bills, it is the same thing that we are doing today, and we really don’t have a clear reference point in the interest rate market. What are your thoughts on, is it fair to say, a manipulation of interest rates? We certainly can’t afford more than the 2% that we are paying on the national debt, so there is a clear motive to keep it low.

John: Manipulation is the correct word that has inserted itself into the money market, and almost has replaced the money market with itself. It has pumped in so many reserves and the interest rate is now manipulated simply by deciding how much interest will be paid on bank reserves. It is not a market rate in the sense that supply and demand is determining the rate.

I taught my students for many, many years that Operation Twist in the 1960s didn’t work. That was the conventional wisdom, by the way. That is what most faculty, most professors, who taught the subject, taught their students, that Operation Twist didn’t work. So it’s quite remarkable that we have moved back to Operation Twist. It is like we just ignored all the things that had been done. What that shows to me is that there is this urge to intervene, there is this urge to do something, even if there is experience that says it doesn’t work. We have to get away from that. I read a lot of books about history, and history is so important for understanding these things, so that we won’t make these mistakes again.

Kevin: Again, David, it comes up over and over. Be a student of history. If you don’t understand what has happened before, you are not going to understand what happens again. I know you are going to be talking to Michael Pettis, who is a true economic historian.

David: He has made a life study of market history, of financial history, of financial economics, and, teaching at a university in Bejing, is applying that in real-time, and we will certainly enjoy our conversation with him in a few weeks. But just as a review and a preview, we should look at some of the key themes. If making mistakes can be avoiding by understanding the past, then I think understanding globalization and what went into past periods of globalization will certainly help with that.

David: The whole world has been operating with a debt-driven growth model, where exponential growth has been exceeding the exponential accumulation of debt. Everyone has remained happy as long as that has been case. Now growth is slowing, but the accumulation of debt has not. It is as if the entire globe rises and falls on a sea of easy money. Where are we in the cycle of credit expansion or credit contraction, in your opinion?

Michael: I think of these more broadly as globalization cycles. We have seen, by my count, roughly six of them in the last 200 years, and they all look fairly similar, for some reason. It could be discoveries of gold, it could be changes in the structure of the banking sector. You get this increase in underlying liquidity, and with the increase in liquidity, risk appetites go up, the risk premium goes down. Money goes into lots of different sectors, and it becomes self-reinforcing, because asset prices move up, etc. We have seen this many times before.

One of the consequences is that you get increasingly risky debt structures, and, increasingly, debt is used to finance things that cannot be repaid. If you look at countries like the United States and Spain before the crisis, a lot of the debt was being used to finance consumption. In addition, and this is the problem in China, a lot of the debt is used to finance assets, the value of which isn’t sufficient to pay the debt, ultimately.

The history of globalization makes pretty clear that one of the things that always comes out during these periods of globalization, or whatever the contemporary word for it is, is that it is often proclaimed as being irreversible. It is part of the process that we claim that it is irreversible, and yet in every case, it has not been irreversible. There has been a significant contraction of what had previously been called globalization. So the fact that the World Bank claims that it is irreversible is par for the course. That is part of the process, and it has very little information content, I would argue.

But the way it seems to work, for example, we have been through, in the 1990s and the past decade, a major technological revolution, driven by personal computers and the Internet. But the truth is that neither of these were recent innovations. With the personal computer, the most important steps were pretty much taken in the 1970s, and the Internet, itself, arguably, was invented in the 1960s. It wasn’t really until there was a significant amount of capital available to fund rapid expansion in the Internet infrastructure that we really began to experience the effects of this Internet revolution.

So I would argue that what really drove this stage of the technological revolution was the availability of financing, and if you look at past stages of the industrial revolution, they always seem to coincide with burgeoning stock markets, massive capital flows to risky countries, etc., and I think that is not a coincidence. It is capital that drives all of that. And just as we have periods of rapid credit expansion, those are always followed, when they become excessive, and they usually tend to become excessive, by periods of credit contraction, and it is during those periods when we see a lot of the reversals of the supposedly irreversible process.

And never in history has there been a major globalization contraction, in which the poor countries, the peripheral countries, the developing countries, didn’t suffer disproportionately. There have been periods when it seemed it wasn’t going to happen – for example, in the 1970s. But it always does happen, and the reason I suspect it happens is because developing countries, peripheral countries, are even more sensitive to changes in liquidity than the rich countries are. So, as you get that contraction, the rich countries suffer, and the poor countries suffer more, although it may be a delayed suffering.

I was never particularly impressed with the survivability of the euro. But what we are seeing recently is a very classic change in type of crisis, and there is a lot of name-calling and blame back and forth, whoever’s fault it is. Germany put into place policies that forced up the savings rate in Germany, and there had to be an automatic correspondence somewhere else, and given monetary union, that somewhere else ended up being within Europe. So it automatically forced down the savings rate in countries like Spain.

Now Spain needs to adjust, and what Keynes pointed out is that you can’t have adjustments on one side. You must have adjustments on both sides. While we are forcing up the Spanish savings rate, we must simultaneously force down the German savings rate. In other words, if you want Spain to repay Germany, then Spain must run a current account surplus, and Germany must run a current account deficit. Otherwise, it is impossible for there to be net capital flows in that direction.

So the argument is, and quite a number of people are making this argument – Krugman, Martin Wolf, etc. – that it is meaningless to call for austerity in Spain without calling for a massive reflation in Germany, because if only Spain adjusts – and when I say Spain, I mean all the peripheral countries, but it is the country I was born in so I usually refer to it – then the adjustment must take place through a significant rise in unemployment. And then Spain is faced with a choice. It can intervene in trade and force the unemployment into Germany, or it can not intervene in trade, and keep the unemployment at home, and under those conditions, Spain will probably intervene and leave the euro.

There is really where the problem is. If both Spain and Germany make the right kind of adjustments that cause the German surplus to turn into deficit, and the Spanish deficit to turn into surplus, then it is at least theoretically possible that we can get out of the European crisis without a significant rise in unemployment – theoretically. Practically, it could be quite difficult. But if Germany doesn’t make an equally big adjustment as Spain does, then it is even theoretically impossible for the adjustment to take place without a significant rise in unemployment, and that is like what we are seeing in Spain – unemployment is at 20-something percent – but that had to happen, there was no way around that.

So my view is that since there is very little evidence that Germany, rightly or wrongly, is willing to take the necessary steps to reflate the domestic economy to bring the savings rate down to run into a large enough current account deficit that allows peripheral Europe to survive the crisis, then there are only two other possibilities. One is that Spain accepts very high levels of unemployment for many, many years, but I think in a well functioning democracy that is impossible, and rightly so.

That just leaves the other possibility, and that is that Spain devalues the currency, which means leaving the euro. So, one way or the other, I am convinced the euro breaks, and I am convinced that several countries will have to leave the euro. Just from a purely arithmetic point of view, I really don’t see any way around that, absent a major change in attitudes in Germany. If that happens, we are going to have a year of panic and chaos.

But it might end, for the peripheral countries, much more quickly than that, because once they are able to adjust their domestic currencies, if they don’t completely mismanage the process, we could see fairly decent growth. After all, remember after the Asian crisis, after the Mexican peso crisis in 1994, after the Argentine crisis in 2001, there was a very, very difficult year, but after the adjustments were made, all of those countries grew quite quickly.

So it is not necessarily bad for the peripheral countries to break and leave the euro. In fact, I would argue that the sooner they do it, the better. But the country that will suffer the most, and this is very clear from the historical precedents, is the leading surplus country, which in this case is Germany. If the peripheral countries leave the euro, Germany will be the one that suffers the most, so it is in their interest to do whatever it takes to reflate the domestic economy, but that is just politically a very hard sell, so I don’t expect it to happen. That is a long way of saying, David, that I really don’t think the euro survives, and I have never really believed it would.

Kevin: Well, David, on that happy note, that the euro doesn’t survive, I guess we just have to thank the listener for traveling with us this last year, and listening to, and engaging in, the conversation that carries us around the world. We don’t know the future. They don’t know the future. But we continue to unpack things and dig as deep as we possibly can at the moment that we are in.

David: And as Michael has just suggested, I think it echoes what we said in our first DVD last year, dealing with Europe and European perils, that we are not past the crisis, but we are past the point of imminent demise. We may see a reshuffling of the players in the eurozone.

The members of the European monetary unit may change, and that may be what constitutes a new and reorganized Europe, but there is a political commitment there which is very, very strong, and we will see if the forces of the market and the fiscal integration which needs to take place in order for them to survive, is in fact feasible from a political standpoint.

We have an election coming up in Germany this next year, which will be very telling – how that will look. Will it be a coalition German government? Most likely it will be. How will that be managed into the future? We still are not past the crisis, but just past the point of imminent demise.

Kevin: David, in this last year you analyzed, in detail, the European issue in The Fuse Is Lit, Part I, the DVD. In The Fuse Is Lit, Part II, analyzed Asia and China, in detail. Part III, like we said a couple of weeks ago, is a summary. It puts it all together as a package. Our listeners need to call, if they haven’t called, and get a hard copy of those DVDs.

David: Those are now available. They are back from the printer. Yes, they’ve made it across the ocean, not quite five weeks on the boat (laughter), but they are available. Go to if you want to order it online, or call us at 800-525.9556, and, of course, you can watch it online if you are comfortable with that. Just make sure and send it to as many friends as you can. I think it is very important that people understand the challenges that we face here in the United States over the next several years.

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