In PodCasts


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

A Fist Full of Dollars, Fifties & Hundreds Please
July 22, 2020

Municipalities are increasingly unable to meet their obligations and are unwilling to implement austerity. Look, it’s even harder to do those things in an election year because you’re setting a dangerously partisan tone if you are the one with the budgetary knife. So cuts are being made, but they’re just not deep enough. And that’s where I think, by the end of the year, you’re talking about massive interventions bailouts, which is going to be necessary.
– David McAlvany


Kevin: David, I’ve been talking just straight for the last couple of weeks to clients who are wanting to hear more about this cash shortage, this change shortage, and I’ve been thinking about it. There are really two types of people right now. There’s mask and no mask, right? There are also people who trust the Fed. Look at the investment community right now. Trust the Fed. We don’t want cash. We want stocks. We trust the Fed, even if it doesn’t make sense. And then there are the people who say, you know what? We don’t trust anything. We’re holding on to cash. Those are the consumers. And so everybody who really doesn’t trust the Fed wants a fist full of dollars.

David: Yeah, the Federal Reserve, it’s fascinating. They have to provide more and more dollars when there’s not the money that they’ve already printed in circulation. So this scarcity of dollars that’s out there is in part because you have almost the impending storm mentality that’s in the marketplace today were, you know, what I mean by that is, coming into hurricane season, it’s not unusual with a storm coming in to go to the ATM or the bank and get a few extra physical dollars, maybe stop off and grab an extra tank of propane and make sure you get water and provisions and things like that. And you’re just thinking ahead because you know if the lights are out and the electricity’s off, your credit card doesn’t really do you any good.

Kevin: Talk about sort of sad timing, actually, because the actual movie Fistful of Dollars has a great theme song. In fact, you sent it to me, right? I was making breakfast for myself this morning. As I made the eggs, I just played it over and over and over again. Ennio Morricone, he passed away just recently, and he was the Spaghetti Western, the composer who really set the way we hear the West from a European’s point of view.

David: There are hundreds of recordings, not just from the Spaghetti Westerns, but he was an amazingly talented film score composer. And, yeah, I read his obituary in The Economist. And you know, I was listening to my old favorites from “The Good, The Bad and The Ugly” and “A Fistful of Dollars.” And that’s exactly what people want right now, it is at least one fistful of dollars.

Kevin: Okay, It’s not just the cash, it’s not just the disappearance of cash that’s speaking to us right now. The gold/silver ratio was 97 a few weeks ago, it’s 86 today. Silver sometimes really is one of the best reactors to future potential of inflation.

David: Yeah, and we’ve been seeing that in terms of kind of the broadcast from the industrial commodities as well, where you’re seeing copper and nickel and zinc and some significant moves in industrial commodities, which would be complementary to the move in golden and silver, and suggest that there is some concerns about inflation on the horizon. And, you know, so that’s a fascinating story in and of itself. The gold/silver ratio is something that we’ve talked about routinely here. We saw the highs of 125. The all time highs of 125, typically it trades in a range between 100 on the high side, 30 on the low side. Got to 15 once, in-ground ratio is 16 or 17 to 1, but typically if you’re talking about a trading range, you can expect between 30 or 40. So here we are at 86. I’d estimate that 40 level is a place that we can arrive between 2021 and 2022. Maybe we get there a lot faster. But what that implies is a doubling of ounces taking silver that you might own today and moving to gold tomorrow at a more favorable ratio. And that’s the kind of thing that we’ve been doing for clients for 30 or 40 years in terms of maximizing exposure to the metals.

Kevin: Yes, and for the listener who wants to see a little bit more about that, we actually have some good reports on the gold/silver ratio, so attached to this show, you can just go ahead and click on that and you can download the flyer. Dave, can you believe in March we were at 125 ounces of silver to one ounce of gold? Now we’ve moved from 97 to 86. Can you believe it’s only July? Okay, I mean, it’s hard to believe this last four or five months has been, probably, I have to say, one of the most disorienting periods of time in my lifetime.

David: Yeah, I think one of the things just keep in mind with the metals, as with any asset class, is when you start to see frenetic energy, we’ve talked oftentimes about the rate of change, and the faster the pace, the more ground that’s covered in a short period of time, you’re almost begging for some sort of a pause. A correction, if you will. And you know, will that be off of $23 for the price of silver, off of 26 or 28? I don’t know, but I wouldn’t be surprised by a correction off of some level. Again, we’re at 21 today. Maybe it is 21. Maybe it’s 23. Maybe it’s 28. But when the correction comes were still in the context of a bull market, a long-term bull market, and this is not sort of reaching an expiration date. It just means that the gains that we’ve seen off of the March lows today, it’s over 80% off of the March lows for silver. They have to be digested. So it’s really not that extreme of a rate of change if you’re talking about the year-to-date total return, which is now 20 odd percent, I think it’s 24% for silver, 21% for gold or vice versa. And those are not extreme in terms of a rate of change, but just something to keep in mind. You have these major moves. When it corrects, appreciate that it’s not the end of the move. You didn’t make a mistake. It is digestion. It’s like running the 100-yard dash and needing to take a pause before you go into the next heat and take another race or another stab at your best time.

Kevin: It reminds me of the transition periods in the triathlons that you do Dave. You know, you do your swim, you transition, you do your ride, you transition, you do your run. You know one of the things we do real well, Dave, and this is bragging a little bit because I’ve worked with your family’s company for 33 years. We’ve watched this gold/silver ratio for those decades, along with platinum and palladium, and it really works, so definitely give us a call. Another thing, though, Dave, through those decades we were reading a guy named Doug Noland. I would have never thought that Doug would be working here because his expertise, it’s not necessarily gold and silver, but it’s the debt markets, and nobody knows them like him.

David: Yeah, it’s credit. So, I mean, I find it difficult to believe we’re nearing the end of July already, solidly in the second half of 2020 and for anyone who’s interested in the comments and the insights, you can join us this Thursday for our quarterly tactical short conference call. So that will be July the 23rd and again, that’s the quarterly tactical short conference call, Doug Noland and I will cover our views on the markets and dive into positioning for tactical short and non-correlated in the second quarter, and then comment on where we think things are headed towards year-end and the opportunity we see there in terms of a market short as we come into this crazy election season.

Kevin: Okay, so one more time. If a person wants to listen in on the tactical short call, how did they do that?

David: Go to go to our website and you can register. You’ll get a reminder email and the access code for the call. And again, it’s just amazing how fast time is passing. When we started the year, the consensus view was that this would be another great year in the economy.

Kevin: Can you imagine? Remember unemployment? I mean, it was at 50-year lows.

David: Yeah, sitting at multi-decade lows across all age categories. In fact, we had the best numbers, the most improvement seen in almost every ethnic community for decades, for decades. So at end of 2019, the Bureau of Labor Statistics recorded the Asian American community at 2.2% unemployment. Absolutely phenomenal.

Kevin: That’s fully employed if you’ve ever taken economics.

David: Right. The white community was at 3.1. The Hispanic community was 3.9%, the African American community at 6.1%. All incredible. Best numbers in decades, right? So, to date, the economy remains, and this is again sort of where we were just a few months ago. All is well, unemployment is great, the economy is sensational, the stock market is fantastic. And then all of a sudden, we’ve got this economic impact from COVID. And so, yeah, we’re under unbelievable pressure. The employment figures are, in most categories, worse than they were during the global financial crisis. This is just since the beginning of the year. The differences between the last crisis and this one are stark, and yet there are also many similarities as well. You’ve got COVID-19 and the government’s shutdown of the economy in response. That is a unique variable.

Kevin: Let me ask you, though, the debt that it’s taking to continue this thing even running at all, can we sustain these debt levels at all?

David: Well, that’s a variable that is the same if you’re looking back at the 2008-2009 timeframe. The unsustainability of high debt levels without massive market accommodation are the same from then to now. And I think, frankly, the scale may be larger as our debts both in the government and corporate sectors have mushroomed since the global financial crisis, the debt crisis of 2008 and 2009. Nevertheless, we carry on with an acknowledgement of uncertainty and that word continues to be sort of—it was the word that was on my mind as we went from 2019 to 2020—that uncertainty would be the defining factor for 2020. That’s where we started the year as a company. And now, in retrospect, it is seared into the brains of every man, woman, and child globally. And that shift from carefree to uncertainty, that shift is most significant.

Kevin: When I used to go take my son to mountain bike races because he was a very, very serious mountain bike racer, we would always do what they call a pre-ride, okay, and the pre-ride was really just there to build certainty on the trail. You’ll never run a trail or ride a trail the same once you’ve seen it, you’re going to ride it a little bit different. Right now, we don’t know what the trail looks like at all. It’s like riding a race in the unknown and running it or riding it in a way having never seen the trail.

David: Yeah, it’s funny. I’ve gone on many trail runs, and the first time you go on a run and you’ve never been there, it seems to take forever. And actually it does take longer than it will take on subsequent trips out. When we’re uncertain, our behavior shifts. If you know where you’re at and where you’re going, again like when you’re running a trail, you move swift. You move with a surety of foot. If you’re in new territory and the terrain is unfamiliar, you move more slowly and you look for confirmations that you’re on the right path. Are you moving in the right direction? Did you miss the turn off? Are you still headed to the right destination? Everything slows down. There is a layer of caution that is in place, and I think it’s to be expected because of the unfamiliarity, because of a feeling of uncertainty.

Kevin: You know, earlier I mentioned that you’ve got two classes of people: mask or no mask, trust the Fed or don’t trust the Fed, you know, holding cash. We’ve got a divergence right now that is so stark I’ve never seen it like this before. The financial markets, which are the stock and bond markets, and the economy. The divergence is profound.

David: Yeah, and this gets back to this issue of uncertainty. This is where we see the massive divergence between the economy and the financial system. No one has been down this road before. Not exactly. There are analogs, but nothing with the precise elements of what we have today. Look, we’re combining a worldwide health crisis with a breakdown in global cooperation, including many established relationships that we’ve had for decades in Asia, in Europe, in the Middle East, we’ve had a brief, at least up to this point it was brief, collapse in asset prices, including everything from equities to oil and now a level of uncertainty relating to education and schooling. You know, are kids going to go back to school? What are we going to do from a job standpoint?

Kevin: How about the election? We’re three months from an election.

David: I forget to mention that. An incredibly divisive election is just a few months away. No one knows what to expect across those categories. No one can make swift and sure decisions on an unfamiliar path.

Kevin: That’s when people take cash out of the bank. They put it in an envelope. They put it in their mail basket, okay, so that they can get to it if they need to. Uncertainty creates a need for a fistful of dollars like that we were talking about before.

David: And tell me where you keep your fistful of dollars, where is the mail basket exactly?

Kevin: (laughs) Maybe there’s 60 bucks there. Stay out of my house.

David: (laughs) So, in The Economist magazine, there are reports of increasing levels of household savings, and they were highlighting the UK. In the UK, the percentage of income saved versus consumed jumped from 5% in February to 30%. Now this drives a Keynesian nuts because you don’t want money on the sideline, you want it in the economy getting turned over and over again. So that’s a problem, and they’ve got to solve it. Regardless of the country, you’ve got governments who have stepped in to fill the gap, and that gap is, again, you were consuming…. That gap, that 25% difference between 5 and 30, that was consumption. Now that is off the table. Governments are filling the gap, and they’ve taken a significant hit in order to bankroll the unemployed to try to prevent a complete collapse in demand.

Kevin: We’re going to have Richard Duncan on the show here in a couple of weeks, and Richard Duncan says you have to keep growing. The way you keep growing, you borrow. Do we show anyone who has any GDP growth right now worldwide?

David: You know, China, for what their numbers are worth…

Kevin: Oh, China says yeah?

David: …they have multiple sets of books, which I guess is, you know, in some quarters is normal. But the IMF has called for GDP to shrink in the US by 6.6% for 2020. Canada, just to the north of us, because their economy is significantly tied to ours, expected to fall by 8.1%. I think the Chinese are the only ones reporting GDP growth to this point, roughly 3.2%. And maybe that’s not a surprise given an annual run rate of over $4 trillion in credit growth. Let me say that differently. It’s not an annual run rate. That’s what they’ve done in the last 12 months. They’re not on track to do that. They have done that. A tally of the last 12 months gets you to $4 trillion in credit growth in the Chinese market. So maybe it’s not a surprise to see some of that credit sloshing around into the economy and improving things – granted, off a relatively low and stagnant number.

Kevin: Well, if you were looking at Wall Street right now, they don’t want a fistful of dollars. They want a fistful of stocks. They want Tesla. They want Amazon. You know, at this point they don’t want cash. Maybe the consumer does, but they don’t.

David: Yeah, and that’s where we find the financial markets are totally different. It’s as if certainty does exist. The certainty of a central bank support structure, and arguably that does exist. The will to survive, the will to thrive, the will to make things happen does exist with central bankers. That’s the only certainty. Beyond that, financial markets have very little visibility, very little certainty. I mean, you look at a company like IBM, and, you know, they reported again revenues tumbled the most in five years, right? But they lowered expectations – their earnings per share, what they expected – so much that they ended up beating expectations. And, of course, the stock goes higher. Now, how are they doing? From a revenue and sales standpoint, this is an awful environment. Does the market care? No. They beat expectations. Let’s move on. Let’s celebrate that, at least.

Kevin: The market is going long the Fed. Let’s just face it. They’re not going long any of these stocks, they’re going long the Fed, they’re just saying this is going to work.

David: That’s right, so you’ve got stocks moving higher with central bank promises of more money. Your risk-averse indicators, on the other hand, are still suggesting caution is warranted.

Kevin: So a collapse could happen. I mean, we could see what we saw back in March again.

David: That’s possible. And, actually I would not say just possible, but likely. Because typically what you’ll have is a crash on the front end, a recovery or a counter-trend move to the upside, and then the real move lower is a secondary move lower. It’s not the first one, it’s the second one that is the more painful, and it’s also the one that’s more damaging. You saw it in the 1980s in Texas real estate, where again the smartest guys in the room stepped in and bought the dip. It recovered, and then they handed back all of their gains and more. It doesn’t matter the asset class, it could be stocks, it could be real estate. It could be gold…

Kevin: You get your dead cat bounce, and this particular cat happens to be made out of super ball rubber. Let’s just put it that way because of the Fed, but it could still be a dead cat bounce.

David: Well, and again when I talk about the risk averse indicators, what I’m talking about is things like the volatility index, VIX, it is remaining stubbornly high in the mid-twenties, and it’s been as high as the thirties just in recent days. Gold is above $1840. Silver’s well above $20 an ounce. The 10-year treasury, incredibly low. It’s 61 basis points. The German 10-year Bund, it is negative 46 basis points. So in spite of these…call them contrary indicators where you would say somebody doesn’t buy it, that equities are the place to be. Somebody is buying liquid assets and prioritizing liquidity, that’s really the theme there when you’re talking about the 10-year treasury, the German Bund and gold. Somebody’s prioritizing liquidity over what they view to be a speculative boost in gains. But in spite of these indicators, risk is piling on. You’ve got the emerging markets, risk is piling on.

Kevin: Okay, but let’s look at the generations we’re talking about, because when I’ve talked to the older generations who’ve been through some of these things, especially who’ve been investing through ups and downs, they’re concerned. Okay, but you go below the age of maybe 40, and the idea is, where am I going to make the quickest buck? Fundamentals don’t matter. Where am I gonna make the quickest buck? Because this is where it’s happening, man.

David: I had a fascinating conversation over the weekend with a young guy who’s trading Robinhood and, you know, confessions of a Robinhood day trader, he is not day trading. He only does that three days week, and he’s not addicted. He only looks at his account three times a day. But it’s fascinating because, from online blogs, which kind of distill options trades and the next speculative stock to buy, to what he’s bought and sold, there’s this fascinating churn, inexperienced churn that’s happening.

Kevin: And he’s winning right now, like Charlie Sheen, he’s winning.

David: Well, for all the ups and downs, he’s only up about 15%.

Kevin: Oh, okay.

David: And I thought, this a lot of gyrations, a lot of gains and a lot of losses. You know, 100% gain here, 100% loss there, all in small positions…

Kevin: You know, there’s the same people who call it black swan. When they do lose, they go, “Oh, it was a black swan. It could have never been seen.” It’s like, oh no, that’s not true.

David: My comment to him was, the sooner you lose this money, the better. Because then you really start to care. The more you win, the less you understand what’s actually happening, and the more you believe this was about you. And so the idea of his few grand being tuition, absolutely critical. He needs to pay tuition. He needs to take some losses and he needs to analyze the mistakes that were made on the assumptions that went into it, the companies that he should not have bought and why. And you begin to appreciate, with a little bit of pain, you begin to appreciate the value of process and discipline in the art of investing.

Kevin: You know, two weeks ago you talked about, you know, we’re talking about two different types of people now. Two weeks ago, you talked about the hedge fund investors, the guys who invest billions and hopefully have maybe decades of experience. They’re exiting. They’re leaving the management business.

David: Yeah, but the day traders from age 18 to 36 are piling in. So again, we’ve got a positive number on GDP from the Chinese, up 3.2%. So I guess it’s no surprise that we’re seeing some recovery in emerging market currencies, credit default swaps, the prices of those are coming down and the emerging markets. You’ve got junk bonds again, risk is piling on. Risk is piling on in the emerging markets, risk is piling on in the junk bonds. Risk is piling on NASDAQ and the quality of the investor, I mean, we’re talking about depth of pockets and length of time in the business to be able to judge where we’re at and where we’re going. It really is being defined by day traders displacing the hedge fund experts who are exiting the money management business altogether. It’s a fascinating time. You wonder who the bag holder will be.

Kevin: You know, you sent me an article from the Financial Times that talks about this division that we’re talking about between consumers and investors. We talked about how consumers at this point want to hoard cash. They don’t trust what’s going on, the investors themselves, they want to spend the cash, get it into stocks. Big, big difference.

David: Yeah, I read from the Financial Times, “The comfort of cash in a time of coronavirus” was the headline and again…

Kevin: I keep mine with my toilet paper. Let’s just put it that way, okay, since you wanted to know where it is.

David: (laughs) Well, I mean, you were talking about the difference between a consumer who’s finding comfort in cash and the investor who has to be all in, wants to be all in, and there is a contrast there because cash is, as economists would describe it, there is a liquidity preference, a liquidity preference today in the marketplace by many consumers. They’re holding cash, and it is an expression of a psychology also mirrored by things like eating comfort food. It makes you feel better in a period of uncertainty. And Eric Rosengren of the Boston Fed was quoted in this article saying cash is one asset people are pretty confident isn’t going to lose value. I was reading through the article and I’m like, well, that’s easy for a Fed President to say. Cash is something that’s not going to lose value. Right, okay, Rosengren. (laughs) And he went on to say people are deciding they’d much rather hold more of their assets in cash.

Kevin: Do you remember when we actually could see how much cash was in the system? The federal government actually reported M1. I wonder what M1 would be right now if we saw the reporting?

David: Yeah, the currency component of M1, physical cash outside banks, is about $1.6-1.7 trillion. For frame of reference, it’s the largest number ever seen, and you could compare it to roughly 500 billion in the period leading up to Y2K. Obviously, if computers were going to shut down, the electric grid was going to go away, and we were moving back towards something like the Stone Age. Or fast forward to Mad Max Beyond Thunderdome, you needed cash or something to trade with. That was the Y2K mentality. We’re now three times, more than three times, that amount of cash that’s in the system, but not in the banks.

Kevin: Well, and I’m finding myself to do that, too. Okay, I’m paying with credit cards when I can. I am keeping a little bit of cash. Not a lot, but I don’t…I’m hesitant. I’ll open up my wallet and I’ll see three or four twenties. It’s like, you know, I’m going to hold on to those and I’ll pull the credit card out and, you know, they can say contact free payment, but that’s not really what’s going on in my mind. We’ve talked before. There’s probably much larger agendas going on as far as ultimately moving towards a cashless system altogether.

David: But there is a psychology for the consumer, and this is kind of typical behavior for people who are anticipating a hurricane, literally anticipating a hurricane. You hoard bills like you would hoard water or propane for your barbecue if you think the system is not gonna work, if you think that the electricity is going to go out and you can’t pay with a credit card or debit card. So there’s money that’s been taken out of the system so we have a scarcity of coins and bills, with some people saying we’re just not going to take them anymore, anyways.

Kevin: This goes back to Ennio Morricone and A Fistful of Dollars. It’s true. The fistful of dollars is preparation for something that you call uncertainty, like a hurricane.

David: Right, so you use your credit and debit card for as long as you can. That’s what the article is saying, is that everybody now wants a fistful of dollars, so, sad that Ennio Morricone had recently passed, brilliant, I love his music. In an emergency like a hurricane, demand for physical cash increases hundreds of percent. If you go back to Hurricane Maria in Puerto Rico, Hurricane Maria required the Federal Reserve to increase supplies to be shipped to Puerto Rico. They increase their supplies of cash, this is the supply of bills, by 800%, and of course it’s because the electric grid was down, digital payment systems were frozen, and the only thing that you could deal with is on a cash basis.

Kevin: I was talking to a client of ours a couple of days ago, a former Senator, and he went down to the bank in Denver, it could have been Colorado Springs, but it was over on the East Slope, and he requested some cash and he wanted some change. And they told him that the Loomis truck is barely delivering anything right now. And he said, well, what do you do for the businesses that require change, like car washes? And the girl told him. Yeah, we limit it to two rolls of quarters a day, two rolls of quarters a day. So something really strange is going on if the Loomis truck just doesn’t have anything on it.

David: Yeah, well, I mean, there’s a contrast which is significant and goes back to the investors and investors…while a consumer, someone who’s concerned about what’s on the horizon may stuff a few hundreds away or twenties or tens or whatever, investors view cash as a pox on their portfolio performance, and they don’t want it.

Kevin: It could be Tesla.

David: That’s right. Why? You’re giving up potential gains. Consumers prefer the security and comfort that cash provides. At least that’s what we’re seeing reflected in the numbers of M1, the cash component of M1 that’s not in the banking system. Of course, we have huge numbers of bank deposits because a lot of the money that came from the government, as we’ve talked about in previous weeks, is just sitting there as a balance with the banks, anyways.

Kevin: I have a question for you. Okay, if the government mandates economic closure of business, how in the world can they say we’re going to stop sending the free cash, the 600 bucks a week? How can they stop that if they’re mandating these closures, do you see that happening?

David: To some degree, this is like conditioning us for universal basic income because we think of UBI as something that’s kind of preposterous. Like who is going to? They’re going to send me just for breathing $2-3000 a month just for breathing?

Kevin: (laughs) Sounds like a good deal to me.

David: Where does it come from, though, Kevin. Where does it come from?

Kevin: Oh, yeah, that’s right. I hear helicopters (helicopter noise).

David: I mean, universal basic income is just a selective redistribution of wealth, so it has to come from someone, somewhere.

Kevin: It’s Bernanke’s helicopter. I’m telling you, that’s where it comes from.

David: But if the helicopter is dropping something, it has to, by necessity, pick it up from somewhere. So who’s pocket are they picking to create universal basic income? But anyways, if the governments are mandating economic closure, it’s like by necessity they’ll have to continue whether they call it unemployment benefits or UBI or a direct fiscal stimulus, it is the helicopter money Bernanke used to talk about.

Kevin: But what about the states? The states and the cities, they can’t print money, they don’t have a helicopter.

David: Well this is the difference. The other area that’s acutely vulnerable right now are cities and states, and you look at the difference between Trump and Biden today, and again we talked about this last week. This is kind of a bid for the White House. How much money are you willing to spend to buy votes? A trillion here, no, I raise you to two, no I raise you to three, like they want to spend a lot of money. Actually, a lot of that money, at least on the Democratic side, is geared towards municipalities and cities. Not only has COVID crushed tax, and we are talking sales tax income tax, those revenue streams. But it’s taken local services, the businesses, small businesses to the brink. And so, if you extrapolate out from business closures to boarded-up storefronts, you know, where are you getting your real estate tax from? Where is that coming from? You could tie it all to COVID, but on top of that, you’ve had more social unrest than you’ve seen in decades. And that in some instances has literally torched the infrastructure necessary for us to go back to business as usual.

Kevin: Okay, so for the person who is loaning money to cities and states, municipalities, those are called municipal bonds, and you can’t print money to pay off a municipal bond. What do you tell the muni bond owner at this point?

David: I’d say this. You know, when I was working at Morgan Stanley, I had a great connect with the municipal bond desk in San Francisco. And, you know, it’s amazing what a pizza here and there on a Friday afternoon, or 10 fresh baked cookies will do. When a Morgan Stanley client deceases and there’s not enough bonds to put into a larger mutual fund portfolio, a high quality Roseville GO triple-A rated bond.

Kevin: Sort of a guarantee. I mean, this is a guarantee, tax-free guarantee.

David: Exactly. So I mean, I love munis. I spent a lot of time with munis, I built a book of business at Morgan Stanley around municipal bonds. Of course, at the time they were yielding between 6-6.5%, tax free. Can you imagine that? 6.5% tax free. So your taxable equivalent yield was upwards of 8 to 9%.

Kevin: Do you know your dad built a book of munis before you did, back in the early ’70s? That was what he did before he became a gold guy.

David: I know, and we went through the same intellectual transformation, to go, wait a minute, we’ve got some vulnerability here. What if there’s inflation? Don’t you want hedge that with something?

Kevin: You both came to your own conclusions separately, which is interesting. You were raised with that. You went to the munis and the stocks, and then you started coming to that conclusion. It’s a fascinating story. People ought to read your book, the legacy book, seriously.

David: Well, you won’t get the business transformation you’ll get some of the family transformation and you will probably know more dysfunction about our family than you care to know.

Kevin: But it’s really interesting to see the cycle. And this is why when a McAlvany talks about municipal bonds, either father or son, you’d better listen.

David: Well, the municipal bond market was a $20 billion market, going back to, say, like 1945, and it grew to a $360 billion, roughly that, by 1980. And today it’s over a $3.7 trillion market. That’s a lot of cities and a lot of states borrowing a lot of money, and they don’t have a printing press. The first significant difference between the treasury market, the federal treasury market and the municipal bond market is that there is no printing press behind the municipal bond market. And its original design was to finance the local development of infrastructure.

Kevin: Well, and it was a good idea. I mean, if you really look at it, look at the things that we have today because of municipal borrowing, borrowing from the public. It’s a very free market. Wonderful idea if it works.

David: Yeah. I mean, in different iterations throughout the history of the bond market, you had originally some almost private public partnerships where you had municipalities raising money for private rails, and that did not end well. It did build, successfully, build infrastructure that ended up serving, you know, future generations. But the first-in folks, the early speculators got decimated.

Kevin: Yeah, but you love to run in Central Park. Dave, Central Park came from a municipal bond offering.

David: Yeah. I mean, I think if you look at the muni market, it was wild and then ultimately wildly successful in the 19th century. And you’re talking about the Erie Canal, you’re talking about New York Central Park, you’re talking about the Brooklyn Bridge, San Fran’s Golden Gate Bridge, Baltimore’s Gunpowder Water Tunnel, Chicago’s sewer system, the Chesbrough sewers. We had more water and sewer lines in place in places, like St.Louis and Chicago and Buffalo, New York, than London and Berlin did in the late 1800s, let’s say 1890 to 1900. There were more paved roads in Boston than in Berlin. Buffalo and Cleveland had more miles of streetcars than London did. I mean, we were building infrastructure like nobody’s business.

Kevin: And they did it without the backing of the federal government, Dave.

David: I mean, you could argue there was some backing in the sense that you got the subsidy and ultimately you didn’t need the subsidy in the 1800s because there was no income tax. Keep that in mind.

Kevin: Right, they waved it and made it tax free.

David: The income tax did not exist before 1913. There is a curious coincidence that we create the Federal Reserve, someone to manage your money, other than Congress…

Kevin: And someone to take it.

David: …And then we, by necessity in the same timeframe, create an income tax, because up until 1913 an income tax didn’t exist. So, it was only after 1913 that having a tax-free status for municipal bonds actually mattered, because then it provided something of a subsidy to the local investor. And actually, that was one of the transformative things that happened. The municipal bond market went from being this crazy market where foreign investors would pump money in and then take it right back out, so you had lots of hot money flows in and out of the municipal bond market in the 19th century because it wasn’t geared towards a local investor. When you geared it with that tax free status, again post-implementation of the income tax, then it appealed more to a domestic audience, and all of a sudden the radical inflows and outflows began to moderate.

Kevin: Now we have a crisis. The states, the counties, the cities. Those guys are not getting the tax revenue that they need to pay those bonds. Does the federal government now need to step in and do something?

David: You know, I think this is where we begin to see a homogenization of credit, where, if the government is going to nationalize all things, whether it is, you know, high yield bonds, investment grade bonds, treasuries, munis…and keep in mind, municipal debt was never fully backed by the federal government, still isn’t, and so always traded at a higher interest rate, reflecting an increased credit risk. But when the tax-free status was granted to municipal paper, again the federal government, in essence, was subsidizing the paper. That was a transition, and I think we’re looking at a new transition, and that is the homogenization of credit, where you can’t really differentiate between quality because the footprint of the Federal Reserve, for the Treasury, call it government in general, is so much bigger. It’s a much bigger footprint.

I read a fascinating paper by David Schleicher. If you’re interested. It’s 50-60 pages of reading called, “The Trilemma Facing the Federal Government During State and Local Budget Crises.” And he does a good job surveying the history of the muni market, describing different periods where the federal government took a hands-off approach, and that being one side of the equation, to the other extreme, where, you know, President Grant threatened to send troops to Iowa in 1872 to actually force small towns to pay their debts. So hands-off to very hands-on.

Kevin: Strong, strong measures.

David: Yeah, and there was always a sanctity of credit to be maintained. If you look at sort of the history of the muni market, the overriding objective was the delegation of infrastructure development to those locals that knew what they needed to facilitate, what economic expansion needed to occur to improve the production and movement of goods, to create hubs where products could come in and be redistributed, etcetera, etcetera.

Kevin: So enter COVID-19, which is becoming an excuse for an awful lot of agendas to be forwarded. But maybe there’s an excuse for that.

David: Yeah, it’s raised an interesting specter for municipal bonds. Will the government stand back? You know, I mean, already, we’ve seen them get involved a little bit. There’s the short-term financing put in place through a facility, they call it the municipal lending facility. They also did $150 billion in federal funds to match the state funds in Medicaid. This is to help directly with COVID costs. And then you’ve got some minor assistance to schools and transit agencies. There’s an interesting sort of Medicare-Medicaid issue in this COVID mix, because if you look at how hospitals have been reporting COVID cases, your reimbursement for a COVID case is I think either three or four times greater than if it’s a non-COVID case. So they’ve created this economic…

Kevin: An impetus, yeah.

David: …incentive.

Kevin: There was a guy who was killed on a motorcycle, counted as a COVID death.

David: Yeah, he was counted as a COVID death.

Kevin: They finally backed that away, right? I think they had to give the money back.

David: That’s right. But the incentive was because you’ve got federal funds coming in through Medicaid, I think I’m wrong in saying Medicare. But again, they were trying to help with COVID costs. And that’s where federal money is coming in to complement state efforts. A little bit trickled through the schools, a little bit has flowed through the transit agencies…

Kevin: Okay, so let’s look at the steps. What can they do? I mean, whenever you sit down and try to figure something out, you write out a plan and you say okay, these are the steps. These are our options, these are the pros, the cons. What can they do?

David: Will they backstop cities and states even more? is the issue and what would the limits be to that? So as the paper describes it, David does a good job in saying, okay, first of all, you’ve got moral hazard. Then you’ve got the potential, secondly, to take a hard line, not intervene, but understand that there’s a cost or a trade-off to doing that. There’s a trade-off with a moral hazard where you step in and bail everything out. There’s a trade-off to…

Kevin: Letting everybody fail.

David: Yeah, it’s going to make a recession worse. You’re not going to intervene, but you do somehow maintain the sanctity of the municipal bond market. You understand there are winners and losers, and that’s just the way the market goes. Or you can reduce future state and local infrastructure development, if you allow for municipalities to go through Chapter 9 bankruptcy. You end up reducing, this third option is you reduce future state and local infrastructure development because lenders in the future will be less likely to give money to finance a project, knowing that lenders in the past have absolutely been put to the wall. They’ve been fried, and they don’t want to be the creditor at risk.

Kevin: Do we have a historical precedent for default?

David: Absolutely, and you know, 1843, this is before they implemented Chapter 9. And so that’s been a development in the municipal market law that governs these debits and credits. Eight states defaulted in 1843. No intervention came, very hands off approach focused on moral hazard. That was … the ethic of the day was, we’re not gonna bail out the “speculator” that is the creditor or investor in bonds. We’re going to emphasize, double underscore, moral hazard is the issue. No intervention came. There was kind of a murky or a less clear approach. In the 1930s you had an Arkansas debt crisis in the 1930s where the government was sort of on and off again in terms of what it was going to do and how it was going to intervene. They did a little bit. Then they turned it off. Same thing happened with the New York City fiscal crisis of the 1970s. The support came and went.

Kevin: Okay, so the type of client that I have that owns municipal bonds is also the type of client that is very risk-averse. Okay, these are retired people, they don’t like paying taxes. They like having something as close to a sure thing as possible. So I think it’s very important at this point, Dave, to review, what are the options that we’re looking forward to with the muni market, because the cities, states, counties, what have you… they’re in trouble.

David: Well, again we talk about the homogenization of the credit markets and losing the distinctives of variance in price, where, you know, an interest rate tells you what kind of risk you’re taking with the product, and as that homogenization occurs, you can’t really gauge risk. So that muni investor, the first problem is it’ll become more and more of an issue, how do you determine the risk and reward equation when you’re putting money to work in any market, and munis would be a part of that, too. 

But there are three basic options for walking through the scenario that the government has today. You can bail out the bankrupt jurisdiction, and again that potentially creates moral hazard. In an environment that’s already nationalized…take the Chinese landscape. That’s different. That’s different on this point because you’ve got subnational debt, subnational debt being your regions and your smaller cities, smaller cities, still millions and millions of people. But that subnational debt is effectively treated as national debt because it is more or less guaranteed by the People’s Bank of China. We don’t have a nationalized system, so there’s that question out there when you buy a municipal bond today, are you betting on a bailout? Is that what you’re betting? Because you have to assume that with the issues relating to COVID, the lack of revenue coming in for rev bonds and really a lack of certainty at this point that municipalities can even stay put on GOs, general obligation bonds.

Kevin: You may not be betting on a bailout. All you need is President Grant’s threat. You can just force the issue, force the payment.

David: That would be the second thing; the federal government could say, look, you have to make payment that keeps the municipal market healthy. It reduces moral hazard, but it does come at a cost. It requires major budget cuts, you know, which, if you’re talking about at the national level, this is what Cyprus and Greece had to face and which was so unpopular. The Germans were saying, “cut the budget, cut the budget” and the Greeks were like, look, you’re cutting into our flesh. This is austerity, which is painful, stop it. Right? So the outsiders said stay fiscally responsible. Those who were subject to the cuts said, “you’re killing us here. You’re killing us here.” So that’s the issue. You have huge budget cuts and tax increases which are necessary…

Kevin: Do you think they could even pull that off in today’s environment?

David: Tell me how that goes over today. I mean, this is an environment of Black Lives Matter. I mean, try getting this past muni investor lives matter? I mean, is that going to appeal to the populist? I mean, when you’re talking about, really the only people who like municipal bonds are people who have an income and wealth problem, in other words, they’ve got a lot of it, and that tax-free status in terms of municipal income, it’s an advantage to them. No.

Kevin: I see the guillotines. I can see ‘em in the background already.

David: Yeah, you’re never going to get MBLM on the same plane as BLM. Municipal bond lives matter, not gonna happen. The third alternative is encouraged defaults, and this is kind of a new iteration since Chapter 9 was put into effect, restructuring bankruptcy. It completely shifts the cost to creditors.

Kevin: It’s a different type of guillotine, basically cuts those municipal bonds off. Boom.

David: Yeah, you’re separating out the winners and losers a little bit differently. The creditors lose, taxpayers win. The danger here is that creditors may not want to fund future projects. And there’s another danger here. And this is where I think option three, encouraging defaults or Chapter 9, is off the table on a broad scale because there’s this nasty word that starts with a D and it ties to all the credit markets. It’s what we know as derivatives. So if you take a $3.7 trillion market and say, actually there are derivative products attached to it, which means that the implications of a shift in value…

Kevin: You’re talking tens of trillions…

David: I actually don’t know what the precise number is in derivatives relating to it, but you can assume that 3.7, maybe 5 to 10 to 20 trillion in terms of the unintended consequences if you start causing the creditor to carry the cost.

Kevin: Yeah, so what you’re saying, you know, if you start choosing who the winners and the losers are, it’s going to encourage bad behavior amongst the others. Right? When somebody sees the bailout, it’s like, well, I’ll be bailed out too.

David: Yeah, and the bottom line is, on those three points, you either bailout forced payment, which is via austerity, or take a risk of an unquantifiable number of dominoes falling, forcing creditors to just eat losses. Right? So encouraging defaults and restructuring…really, I don’t think that is going to happen. Austerity, not politically popular. Not gonna happen. Look at the political environment we’re in today. So bailout for the bankrupt jurisdiction, that is likely what’s going to happen. And that means going back to a conversation that we had with Russell Napier many years ago. He said, look to Eastern Europe as a model for how we’re going to do economics in the future.

Kevin: I hated that day. I hated that commentary because this was a guy who loved the free markets, he had studied them, and you said, how do we move forward from here? And he said, look at Eastern Europe.

David: Yeah, so one more step towards nationalization. So there is a difficulty here right now, and I think this is where the White House is hung up. Because if you choose states and cities to get money, that’s going to end up being contentious. For instance, I don’t think Trump wants to send money to Illinois, and he doesn’t want to send money to California. He didn’t want to send money to decidedly blue states, right? He’s not going to bail out past problems or anything like that. If one city is irresponsible, one state is irresponsible, fiscally, there’s another issue here, and it’s that if you give them money from the federal government, it ends up encouraging bad behavior amongst other cities and states because they realize, wait a minute, we don’t have to run a tight budget.

Kevin: Moral hazard, that’s what it’s called.

David: That’s right. So the likely solution in a bailout scenario is not that money goes to the few that have the most glaring deficit problems. But to keep things politically equal, the likely solution is more or less equal distribution to all states and municipalities so that the responsible states don’t feel like they are subsidizing the irresponsible ones.

Kevin: You know, a couple of weeks ago we talked about the musical Hamilton, and, you know, just thinking about this, Hamilton was the guy who was sort of bringing up these issues back during that period of revolution and the period of our country’s beginnings. The question was, how much does the Federal Reserve play? What role do they play in this type of thing?

David: And of course, the Federal Reserve was not there for Hamilton. But he was the founder of the first central bank here in the United States, and he modeled it after…

Kevin: He was pro-centralization, more so than the other…

David: He was in love with the Old Lady of Threadneedle Street, he loved the Bank of England and wanted that to be a model here in the United States. He loved the idea of centralized control, and so the notable exception…we talked about the hands-off approach. The notable exception was highlighted in Hamilton. You Go Back to Lin-Manuel Miranda’s play Hamilton, the song, “The Room Where It Happens,” so a deal was brokered between Hamilton and James Madison for the federal government to assume all debts that the states had incurred in the common defense during the Revolutionary War. That was the deal that Lin-Manuel Miranda was talking about in “The Room Where It Happens.” Virginia had already paid out as they went, and so as a part of this deal they were told that they be reimbursed. And of course, there was reasonable concerns amongst the Founding Fathers about a shift of power from the states to the federal government. Right? And again, Hamilton has been characterized by that kind of shift towards greater centralization, federal control. When the Feds assumed the state debt, he said this exactly what was going to happen.

Kevin: Isn’t it amazing that crisis makes people waver on their ideals? Okay, so the ideal was, no way are we going to have federal intervention on this, centralized control. But just like COVID, we’re throwing everything out now. We’re throwing the ideals out because the centralization did happen with Hamilton.

David: Hamilton said it would cement more closely this union of states. And that’s exactly what happened.

Kevin: It did.

David: Yep. And so there was further federal bailouts for municipalities that happened following that. So it kind of set a precedent. You had, following the War of 1812, you had another bail, 1836… Everything shifted following the 1840s. The defaults proliferated, and the government was more involved, right? So it was hands off, now it’s hands on, but with some strings attached. 1841, 1843, 1857, which is a pretty key year because there was a broader market decline in 1857, which is pretty important as well. 1861, 1877, 1894, 1887…there are many more.

Kevin: Well, you’ve brought up Leviathan before. Higgs, who wrote the book Crisis and Leviathan. It’s more and more centralization and more and more growth of that centralized unit.

David: What’s different this time is that we’re talking about a municipal problem, which is not just, I mean, we can pick on the unfunded liabilities of Illinois and Chicago, right? Or, you know, what we saw in Detroit and may see, like a scratching on a record not too many years after the 2008 crisis, all over again in Detroit. But what we’re really talking about is a nationwide problem and a nationwide solution that may be proffered, and a nationwide power grab. It’s the same power shift which I think is about to occur. And that’s what Hamilton was after. There was a shift in power from the states to the federal government in the room where it happened. And it’s because municipalities are increasingly unable to meet their obligations and are unwilling to implement austerity. That is, unwilling to radically cut budgets and increase taxes. Look, it’s even harder to do those things in an election year because you’re setting a dangerously partisan tone if you are the one with the budgetary knife. So cuts are being made, but they’re just not deep enough. And that’s where I think, by the end of the year, you’re talking about massive interventions bailouts, which are going to be necessary.

Kevin: I can even feel it in my own emotions, Dave. I have a certain way I think things should be until I know somebody whose job is threatened. Okay? Like a schoolteacher, a good friend who is a schoolteacher. Are they going to be able to pay the schoolteachers here in Durango? We don’t even know what this looks like. You and I talked about how the world is going to look very different, the way they do business, what have you. But there are a lot of people right now who the stakes are high as to what the answer is. What is it going to be? Door number one, door number two, or door number three on where the state’s get their money?

David: Yeah, and we’ve always had this idea of debt limits, where, you know, either it’s the federal debt ceiling or, you know, actual hard-coded debt limits into state legislation. Then there’s always been sort of a wiggling around those debt limits using revenue bonds or special authorities or special assessment bonds, or using leases or long term contracts to avoid the debt limits. But what we’re really talking about in the bigger picture is a blowing of the mind. Get rid of the concept of debt limits altogether and get used to the fact that you can have as much as you want. Again, the limiting factor has been state legislation in terms of debt limits and what a municipality, either a city municipality or state, can do, but that’s in the process of being undone. If you end up with a federal backstop, if you end up with the equivalent of what the Chinese have, which is nationalization, you see?

Kevin: Yeah, it seems like that forms slavery over time, Dave. As I think of the things we’re talking about, we’re talking about no debt limits, which means spend as much as you want, we’ll make more. And then you also have, let’s go ahead and defund the police. Let’s just get rid of the police. That’s an interesting one to think through. Okay, so as I think through never having to worry about how much debt I have, because it’s always going to be paid for, and as I also think about not having the police around anymore, you have to say, okay, well, what’s the next thought? What’s the consequence of either one of those things?

David: And again, we’re playing with things that ought not be played with or taken lightly. There should be clear-cut debt limits for an authority. We understand that municipalities can’t print their way out of a problem, but if you’re just kind of just going to sweep everything into the Treasury and Federal Reserve universe, where unlimited amounts of credit, which is the new money, can be printed and distributed, backstopping every market, what you’re playing with is an inflationary fire. And that’s, again, I think something that you’re beginning to see. Inflationary concerns. 

If you’re talking about your industrial commodities, they’re sending you a signal. Metal is sending you a signal. The only thing that you could say is counter to sending you a signal is the incredible demand for Treasuries and bonds. Again, but that could be viewed as a risk off as much as it could be a deflationary defense position. But I think you have to look at these limits and say, when you cross a threshold, as you asked the question, what are the consequences? Limits are pushed, defaults and restructuring bailouts more and more…as time goes on, these are the things that become center stage. And then it’s a question of what kind of default, what form of default, what form of restructuring. Are we talking about negative interest rates? Are we talking about inflation as an informal default mechanism? These are all things that come into play. Last week, we discussed Trump’s $1 trillion proposal, the Democrats’ $3 trillion proposal as an auction for the White House, and the big difference between those two proposals are the two plans. One of them has greater scale and scope for municipal bailouts. Right? So there’s, embedded into the next round of bailouts is how well municipalities are going to be taken care of here, or how much squirming there’s gonna be on the part of municipal creditors.

Kevin: So could we call this uncertainty as to how the municipal problem will be handled?

David: Absolutely. But the bet is still consistently, the Fed is going to bail us out. I mean, the consistent thing, whether it’s the credit markets or the equity markets. The bet is consistent here. The Fed will bail us out. Federal Reserve will bail us out. We don’t know the policy choices that cities and states are going to implement in response to COVID. So here we are coming towards the second half of the year, right? And we don’t know as we head towards September, October, November, if re-openings are going to be completely reversed. We’re probably talking about the de facto nationalization of the muni market, right? With bailouts, with backstops, with, again, the federal, directed from the federal level to the states with all the necessary quid pro quos. Who is handing out, who is assigning, who is determining what those quid pro quos are? That is a November deal. You know there will be strings attached. There has always been strings attached according to what happens in the room where it happens.

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