The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“If we are in a world where governments are increasingly choosing the outcome, setting the price, that’s dangerous. It’s not just about these technical economic issues. It actually begins to threaten the whole notion of freedom. You want to have the right balance between these two forces, because if it’s too heavy in either direction you end up with socially bad outcomes.”
– Dr. Pippa Malmgren
Kevin: Our guest today, Dr. Pippa Malmgren, is somebody we have been talking about the last couple of weeks. I love it when somebody who has been on the inside comes out and gives us a warning because they would know.
David: It is also encouraging to know that as a presidential advisor there is more than academics that is coming to the table, so when she was in the Bush administration, she had formerly been chief currency strategist at Banker’s Trust and Deputy Head of Global Strategy at UBS and brings some market savvy to her role on the President’s Working Group for Financial Markets.
Kevin: And she was there during a time that I think I would actually like there to be a Plunge Protection Team, during the September 11th attacks back in 2001. Literally, Wall Street had no power. The power supply was coming from the World Trade Center and they had to find ways of rerouting power. Maybe that’s a good example of when you do want the President’s Working Group to intervene on the market.
David: Certainly, intervention is something that is critical when you think of a doctor’s role in the emergency room, but that kind of medicine is different than natural health and well-being, and so I think that is where there is equal room to look and say, what are the limits of governmental role in the marketplace, and that really is the point of her book, Signals: The Breakdown of the Social Contract and the rise of Geopolitics, looking at the contrast between the state, and the role of the state, and the citizen.
And again, this question of, is the social contrast being compromised? One of the things she references is an Esquire magazine article from 1935 where Ernest Hemingway, of all people, writes, “The first panacea for a mismanaged nation is inflation of the currency. The second is war. Both bring a temporary prosperity. Both bring a permanent ruin.” And I think it is right that in Pippa’s book, she points to the possibility of geopolitical conflict, certainly in terms of our own analysis and structure of a crisis domino effect. Geopolitics is a very interesting and potential area for conflict and problems to emerge.
Kevin: She comes from a rich and diverse background, Dave. Her dad had worked in politics and in economics in Washington, D.C. before she did, and her mom has a literature background. You might find a little bit of a kinship there because her mom went to Oxford University, studied under J.R. Tolkien, actually got to sit and have conversations with C.S. Lewis, so that is a rich background, and it is a book definitely worth reading.
David: I love the style. The style is very approachable. And for the topics, as grave as they may be, as important as they certainly are, it is done in such a way that you read through it from one page to the next, one chapter to the next, really engaged. It is well-written. I remember a novel by Mark Helprin where the main character started his career on Wall Street, ultimately as an economist. He started as a runner, and he got promoted through the years to one of the senior ranking economists of the firm, and he insisted always on traveling the world and making his economic observations as the man that walks the streets, sits at the café watching people, riding in the taxi, gathering information every other way than by the officially distributed statistics. Those he discounted.
That book left its mark on me and perhaps that is why, Pippa, I resonated with your book on signals. The character in this story continued to operate even if official statistics and signs were muted, misleading, if there was radio silence, he was able to still gather information and look past what might have been distortions in the marketplace. And certainly we have some of those distortions today. Today you do have the financial sphere, whether it is in London or New York or anywhere in the world, which seems dependent on official numbers. Does it behoove us to ignore those official numbers more, and focus on what we observe in everyday life?
Pippa: Well, you’re not the first to liken me to a road warrior because that is kind of the work that I do. I run around the world and I am involved in both observing, but also conversations, with people who are running real businesses, the largest pools of capital, the policy-makers all over the world, and it is fascinating what you hear from those conversations that often isn’t reflected in the official data, and so that is an area of great interest for me. I think we are in a very unusual environment. Normally, markets are very good at sending signals. Prices are signals. But in the current environment, with the advent of quantitative easing and all of these efforts by central banks to push the markets in a particular direction, an upward direction, we have a world where, actually, price signals may not tell us much about reality.
It may be more a function of the fact that governments have become the price-makers, which is just a very strange situation, and not what we usually face. So I like looking at reality. The Buddhists say that if there is a cause of suffering it is because you start arguing with reality. So my question is, then, “Okay, then what is reality?” Let’s go look at the grocery store, what is actually happening to prices versus what the official data says, and interestingly, they are increasingly different.
David: You also look at things like art, lyrics, fashion, and creative expressions that speak to underlying realities in a society. These are the things that, to you, represent signals. And it seems that your work as a road warrior is furthered by a general sense of curiosity and an ability to think laterally. These are the tools of the trade, it would appear. How does one approach the world with that mindset? What is the disposition where you are gleaning insights from these very different informational signals?
Pippa: The purpose of writing the book was actually to help people understand that they don’t need to be an economist, they don’t have to have a Ph.D. in mathematics, to understand what is happening in the world economy, that actually, if they just open their eyes and observe what is happening around them, a huge amount of information is available to us, and when I say things like, if you watch the arts and fashion, as an example, think about what we already know about what happens to urban areas. If we think about New York City, as an example, I remember when the meat packing district in New York City was just the worst part of town and nobody was going to go there because you would get mugged. And because it was dangerous and not popular, it was also very cheap. And so artists started to move in to that part of town because they can’t ever afford to live anywhere that is expensive.
And slowly, but surely, if enough artists start to populate an area it gets to be cool, it starts to be hip, it’s like, “Oh, that’s where the action is.” And then, suddenly, the values of the property start to go up, and eventually you end up with today’s situation where the meat packing district is a very cool, über hip part of town that is actually quite expensive. And are the artists still there? No, they move on to some other part of town. So, in a way, if you follow the artists, you can begin to see where urban regeneration and upward price movements are more likely to occur. That is a very different way of thinking about things than a usual property developer, property investor thought process, but it is, I think, equally valid.
David: And so you are looking at these signals as a means of moving toward action. You talk a lot about reading the signals. You also note that the purpose is to inform action. Why do so few people read the signs of the times, and even more than that, why do so few take action?
Pippa: I think we’ve all been brainwashed into thinking that economics is complicated, it’s highly mathematical, so your average person is pretty much frightened off of the subject. They kind of relegate that to someone else. “I don’t do economics. Someone else is doing that for me.” And you kind of hope that there are these smart people in Washington, either in government or somewhere in the central bank, at the Federal Reserve, who are making the right decisions on our behalf, but I had the privilege of being one of those people. When they said “the smart people in the room,” that became me, and I was like, “What? Me? Okay, let’s look at what these people who are on the inside really know and don’t know.” And I concluded that they are not smarter than the rest of us, and in fact, they may even have less information, in many ways, than the general public. So the important thing is to empower a regular person to have confidence in their own perception of reality.
And let’s add to the mix, because the debt burden is so huge, and I argue it can’t be paid off. It’s so big, you could tax Americans, or frankly, any of the industrialized countries’ citizens, 100% of their income and you would still be left with a hole, with a debt problem. So, you can’t just solve it easily by raising taxes somewhere because if we could do it, we would have done that by now. So, if it can’t be paid, that means it has to be defaulted on, and what are the different ways governments can default on their debt? Two important ways that we should remember are, the state defaults on the citizens. It says, “I know I made you all these promises about what I deliver, like pick up the trash twice a week, and you would get a certain level of education, for example, but we’re broke now, so we can’t, and in fact, we’re going to tax you more and pick up the trash less frequently.”
This is a kind of default on the citizen that we call austerity. But another version of it is to pursue inflation. And inflation is a tax on the citizens, it is a default on the promises, and therefore, do you think government has any interest in drawing our attention to the fact that the inflation rate, in real life, might be higher and different than the official inflation rate? No, they have every incentive to say, “There’s absolutely no inflation, so you don’t need to worry your pretty little head about that.” And yet, the only thing anybody ever talks about in most industrialized countries is the rise in cost of living.
David: If debt is an abused option, debt has been the easily abused fiscal option for years, now monetary policy seems to be that escape from beneath the burden. Of course, we have had quantitative easing, we have had a zero interest rate, or near zero interest rate policy, not just here in the United States, but in other countries, too, actually, negative rates in many places at present. Of course, these are extraordinary central bank policies. We wonder, is it possible for monetary policy to lead to military action as creditor countries look at that sort of default and decide to reject soft default?
Pippa: This is the most controversial part of the argument that I make and I am fully expecting to get quite a lot of blowback, but yes, the way China, Russia, and many emerging markets look at this is that they say, “Right, the history of the United States is clear. Whenever there is a massive debt problem, then they default using inflation.” In other words, China, Russia, and other emerging markets have lent the United States money, and that is how we have been able to live beyond our means for a long time. So, they lent us 100 bucks, they think we will pay them back 100 bucks, but what it will buy is less, because the price of things over time will go up. And therefore, that is a form of default.
I had one Chinese official who said to me, “It’s a Goldfinger problem.” I said, “A Goldfinger problem?” He said, “Yes, you know, James Bond. Goldfinger says, ‘Once is happenstance. Twice is coincidence. Three times is enemy action.’ And your history in America is, you paid for the American Revolution with inflation, you paid for the Civil War with inflation, you paid for Vietnam and the Great Society period with inflation, and we know what this looks like now. This is now enemy action.”
And their concern is that if prices start rising, for example, the price of property, then rent goes up. And if rent goes up, in an emerging market, that creates enough pain that you can start to get social protests. If food prices go up, and we are having record high prices for proteins, as an example, right now, in spite of the seeming record low inflation, the fact is we have record high prices for things like beef, lamb, fish. These are core issues for emerging market workers, and they will start to go to the streets when these costs begin rising. So, that’s why the emerging markets see it as not just a default, but almost an act of aggression because their view is the industrialized world is destabilizing the emerging markets for their own interests.
David: I think it was John Connolly who said, “It’s our dollar, and your problem.” And the reality is, in a post Bretton Woods world, we have a dollarized world. Our monetary policy does reach to every stretch of the planet. You mentioned China just a moment ago. We have China soliciting again to be part of the SDR system, the Special Drawing Rights program, coordinated by Christine Lagarde and the folks at the IMF. What we are really talking about is a shifting emphasis in the world monetary system where the dollar has been the default kingpin.
And we have seen the emergence of the euro over the last few years. Of course, there are issues with that today, but the RMB, the renminbi, is likely to play a larger role over the next 2, 5, 10, 20 years, if for no other reason than, on a trade-weighted basis, it is a very significant currency. Is this what we are talking about? We export inflation because we live in a dollarized world, and different people around the world start to say, “This isn’t working for us. We need to change the monetary system as it stands (or maybe it’s a monetary non-system) and make it more fair.”
Pippa: I think that is precisely the argument that underpins some of the things we see today. There has been a lot of news recently about this new institution called the Asian Infrastructure Investment Bank, which is a Chinese institution. They are backing it with 50 billion U.S. dollars, and the idea is to use capital to build infrastructure projects in emerging markets. All that sounds fine, but the issue is, what they are really saying is, “In the past we took all the savings from the Chinese economy, and other emerging market economies, and we put them in the U.S. treasury market and the British gilt market, but we put it into the industrialized world in your debt instruments, and that kept your interest rates down, and it let you spend more than you earned. Well, we’re no longer going to do that, because after all, what is the return? It is practically zero, because you have left interest rates down at zero, and we think you’re going to inflate, so we won’t get the full value of the hundred dollars back. So instead, we’re now longer going to do that, we’re going to put the money directly into infrastructure projects in emerging markets.”
Now, that poses a kind of existential threat to the United States, because it basically means we’re going to be constrained to spend within our means. We won’t have somebody else funding the gap between income and expenditure. And so that means a tightening of the belt in many ways for the industrialized world, for the United States. The other thing is, it’s a real challenge to the whole post war international financial and economic architecture. And yes, you’re right, the emerging markets are saying, “You know, that post war Bretton Woods system was designed to ensure that all of the members had more benefits by being in it than by being out of it.”
And now, because of the debt problem and the decisions being made by the U.S. and its other industrialized country partners, it is no longer serving the interests of the emerging markets as well as we would like. Let’s build our own institutions. So, to be clear, the new AIIB – well, let’s put it this way, China – China has three times the level of reserves of the IMF, so it’s hard to argue that the old institutions are stronger and better when China is in a position to finance new ones that will actually have more capital.
David: At the same time we have the tradable goods sector and dollar recycling, which you described, into the treasury market, allowing us to live beyond our means. We have, at least in the recent past, moved a little bit more toward energy independence. That is less petrodollar recycling into the treasury market, as well. This implies that we really have to tighten our belts and that we’re not going to be able to solve every problem by monetary policy. Actually, we might have to get active at the fiscal level. Is that a political possibility?
Pippa: I think it is a correct analysis, and the question is, will anybody in politics fix the fiscal side? And I think the answer so far is no. And I don’t see any sign of either the Republicans or the Democrats being able to genuinely reduce the spending. Instead, they all talk about how they have reduced the trajectory of future spending. In other words, they continue to spend more in future just by a smaller amount, which is not the same as cutting spending. And so, I don’t see much optimism on that front.
But, having said that, I am incredibly optimistic about the ability of the real economy in the United States, frankly, and Britain as well, and some other industrialized countries, to innovate at the grass roots level and build a better, stronger economy for tomorrow than we have today. But the key question is, will the state seek to tax all those entrepreneurs and initiative-takers so hard that it is not worth it, or will the state become more hospitable to their effort? And I say that knowing full well there is such a huge, raging fire of a debate about inequality.
And I want to be clear, I am not arguing that the current tax system is ideal. My argument is, roughly 60% of all the net new jobs in industrialized economies come from farms that employ less than 50 people, and right now we treat those little companies with exactly the same tax requirements as big companies, except that big companies can hire great lawyers and wiggle out of them, little companies can’t. So, when we say we are going to tax the rich harder, who are we really hitting? If you are hitting the little guys, you are actually producing a counterproductive outcome.
David: I had this conversation with a colleague last night, looking at the difference between small businesses that cannot afford tax attorneys and accountants to lower their marginal tax rates, and major Fortune 500 companies, just as an example, General Electric with close to 1,000 tax accountants, specifically designing their tax structures to bring them to 7% or less. And as a country, we sport a very high corporate tax rate, but the reality is, there is a two-tier system. If you can afford it, you can buy your way down, and if you can’t afford it then you still pay those premiums.
You mention a quote by Admiral Fisher. Churchill seemed to like it. And it was, “Gentleman, now that the money has run out, we must start to think.” My question is, between the socialist idea of spending other people’s money and having an arsenal of printing presses, when will we run out of money, and when will we be forced to think?
Pippa: Yes, this is a very interesting question because everybody says, “Well, this can’t last forever. They can’t just keep printing money. And the Federal Reserve is being very clever in its management, because now Janet Yellen says, “No, we are going to raise interest rates, and so you don’t have to worry that we’ll just keep doing this forever. We are going to reverse. But the way in which she is doing it is so minor, it is so subtle, that she can take credit for raising interest rates, but not actually tighten the conditions at all, and in this way they can achieve what they want, which is a higher inflation rate, and yet be seen to be protecting the interests of the currency. So, they are trying to play it both ways. One of the key questions is, can the Federal Reserve control the amount of inflation that arises from their monetary policy actions?
And Paul Volcker, who I always think of as kind of the Bruce Willis of the world economy, because he’s the guy who saved us from the last inflation we had when he was the head of the Federal Reserve back in the 1980s, his view is, you can’t control it, and you are delusional if you think you can. Janet Yellen’s view is, we can aim at 2%, or even 3%, inflation and then stop it in its tracks and reverse it. We have total control. And I think this is what makes people really nervous because throughout history, central bankers typically don’t have that much control, and so Paul Volcker, I think, is correct on this, and we have a lot of hubris at the moment in the central banking world.
We had so much hubris in the financial markets that the markets got themselves punch drunk and practically drove the economy into the ditch, and the central bankers grabbed the steering wheel away and put us back on the right road. But now that they control the vehicle they are reluctant to give control back to these crazy people in the markets, and so hubris has moved from the markets right into the central banks.
David: It’s kind of a version of Revenge of the Nerds. You come out of the basement, so to say, and now you have rock star status. Who really wants to go back to the unrecognized world? I quote from your book, “Perhaps the most important signal in any economy is the price of money.” Discussion of normalizing interest rates, of course, that is what has been around, but as you mention, very little action has been taken. So, let’s discuss the costs of distorting interest rates.
Pippa: Yes, so just to be clear, if you raise interest rates from the current 0.25% level, it is not really tightening, because you have to get to some kind of a break-even level before you actually have traction, so really, what you are doing is just normalizing. So, in other words, we are in emergency-level liquidity conditions, emergency-level interest rates, when the emergency happened seven years ago, and arguably, the economy is actually doing much better. It is producing jobs, it is producing reasonably good GDP numbers, not great, but not an emergency that requires emergency-level interest rates. So, they would have to raise those interest rates by quite a lot to get back to a level where it actually began to have traction and would slow down investment decisions.
And keep in mind, the normal sequence is when central banks start to raise interest rates, it acts as a confirmation that the growth in the economy is genuine and real and reliable. And so that is why stock markets usually go up when interest rate hiking cycles begin, and a lot of people think, “Oh, the stock market will collapse and the economy will collapse.” If that’s the case, they will have made a terrible mistake raising interest rates even once. So, another outcome is that, actually, this can persist for a very long time, longer than you imagine, because they can get into a rate-hiking cycle and then the markets and property prices and asset values and GDP performance actually all rise because you’re not really tightening the liquidity, you’re confirming the growth, and that’s all you are doing.
David: And so if you keep rates low – there was a very popular, 1860-1890, that time frame, and I don’t think anyone has refuted Knut Wicksell’s ideas that if you keep rates too low for too long, ultimately, rates go considerably higher than you would have wanted them to.
David: Is that one of the implicit costs of distorting interest rates, like holding the ball beneath the level of the water? It won’t stop at the level of the water, what you might describe as equilibrium. It tends to move beyond that.
Pippa: Yes. And that’s a beautiful analogy, that’s exactly right. And to go further, another thing that that economist who nobody remembers today, Knut Wicksell, said was that the interest rate is a kind of justice mechanism. It is designed to balance the interests of the borrowers and the savers. And so when a central bank artificially holds the interest rate down, what they are doing is definitely favoring the interests of the borrowers against the interests of the savers. And that’s why some people would say – I think Stanley Druckenmiller, the very famous hedge fund manager who managed George Soros’ hedge funds for many years, describes the current situation as a transfer of wealth, from the poor to the rich, actually.
It is a transfer of wealth from the savers to the speculators, because the purpose of making interest rates so low is to force you to stop keeping your money in a savings account in the bank, and to compel you to go buy some kind of a risky asset, whether that is something in the stock market, or a property, or even an investment decision in real assets of any kind. And in that sense, it is a tilting of the interests of the members of society against those who are a bit weaker, either have chosen to save, or don’t have anything to fall back on and now face a world with potentially higher prices. Because inflation always hurts the poor the most. The rich can manage inflation, but the poor can’t.
David: So, you suggest that when faced with currency debasement or any kind of effort to make a piece of paper worthless, smart investors, good economic historians, know they need to do several things. First, I quote you: “The principle refuge against the depreciation and debasement of paper money is to be found in hard assets.” That being said, while that may be true, it seems that there still is a deep level of confidence in central bank policy. That is still there. Can you perhaps comment on the cognitive dissonance between faith in the state, the Fed, and what you have described as “qualitative squeezing.”
Pippa: Yes. What I’ve said is, quantitative easing leads to a kind of qualitative squeezing. So, I should talk a little bit about a notion that I think is very interesting called “shrinkflation.” And I’ll give you some examples. It is a kind if precursor to inflation. For example, I live in London so I’m going to use some British examples, but I think everybody knows Philadelphia Cream Cheese, and it used to be that the package was 200 grams; they just reduced it to 180 grams, but the price has gone up. A loaf of bread has gone from 800 grams to 750 grams, but the price stays the same. These are examples of the price actually rising, because you’re getting less for what you’re paying. Each unit, the weight of it – you are getting less for your money. That’s a kind of precursor to an actual price hike.
I think that we are definitely seeing that, but because this doesn’t show in the data very well. We can have confidence in the Fed that actually, I don’t think their numbers are wrong. I’m not saying that the Fed is deliberately mismanaging how they collect inflation data. I’m saying, maybe we should question what is included and what is not included. For example, no central bank in the world includes asset prices in their inflation calculation, so the value of your house can go up, the value of the stock market can go up, but that’s considered irrelevant to the inflation rate. And yet, most people would say, well, if the house price is going up, then the rent will go up, and rent does matter to my life. And in fact, rent is included in the inflation calculation, and sure enough, we’re seeing, even in the United States, inflation numbers are starting to pick up because rents are rising, but you could have seen that coming.
So, I’m just saying there is an interesting debate about the data collection, and within the Fed I write about the discussion about what is the right measure. For many years, the right measure has been core CPI. The central inflation measure has been called CPI. But, there are some in the Fed who said that, really, producer prices, which is a different measure, might be a better, more accurate one. And so, this is an open debate about, are we using the right model?
And let me finish with one last piece of this puzzle because I think it is important. One of the things that has given us low inflation over the last 25 years has been the fall of the Berlin Wall. When billions of workers from the previously communist world suddenly entered the world economy and systematically pushed down wages and prices, because they were willing to work for pretty much nothing, just to be part of that possibility of becoming rich tomorrow. Well, that was a huge, what they call disinflationary force, that drove prices and wages down.
Well, today we have the opposite. Emerging market workers are asking for much higher wages. I think Chinese wages have quintupled in the last three years alone. They are no longer willing to work for nothing. They are no longer convinced that they will definitely be rich before they get old if they work hard enough because the world economy is not delivering on its promises. So, now that wages and prices are rising, I find it very hard to hear central banks argue that it mattered when wages and prices were falling, and emerging markets were pushing them down, but now that they’re pushing them up it’s irrelevant? No, of course it’s relevant. And it means we have a higher inflationary base from which the world economy will operate going forward because there isn’t an endless supply of people who are willing to work for nothing any longer.
David: It is interesting that as we look at demand statistics for gold, for instance, they continue to rise all around the world, but there is really no interest in the investor community in the United States, in part because there is this perception of low to no inflation. And as you mention in the book, there are the issues of shrinkflation and zigzagging of pricing, an increase in the aperture of whether it is toothpaste or shampoo or what have you, these things are precursors to major inflation here, or more significant inflation there, but we already have very significant inflation in other parts of the world, and so demand for that kind of inflation hedge, whether it is in Vietnam, or in Thailand, or in China, or in Japan, is very real. These would be signs, if you will, of consequences, not only of monetary policy, but as you suggest, the change in wage structure.
We know the Cold War is behind us. We mentioned the fall of the Berlin Wall. The Cold War is behind us, but you argue that there may be a new era of commodity conflict, present reality or future reality. Is this a developed and developing world problem, or is there a shadow cast from the Cold War characters into this new conflict?
Pippa: Oh, there is definitely both. And I think this is such an interesting question because we now have a generation of people who are running businesses, running money, who were born since 1980, and that means, by definition, they don’t even have any memory of the Cold War. And frankly, they say these days more than half of the participants in the financial markets are so young that they have no memory of the last interest rate hike in the United States, which was in 2006. So, we have a whole generation of people who are managing businesses and money and assets who really have no experience of either geopolitics or the return of inflation in any way. Part of my book was aimed at explaining the historic context, that we have seen these things before.
The Russian and Chinese perspective – I’ve described a little bit about their concern about what inflation really does, and how politically destabilizing it is. But there is a different angle, and that is, in the post Berlin Wall period communism was on its back, and both China and Russia were forced by circumstances, by being broke, basically, to open up their economies to market forces.
We in the United States and the West think that is a great thing, but there are people in both economies who think that, actually, that was just a moment of weakness and they were forced to adapt, but that really, the correct position is that there should be more than one superpower, and Russia is now very determined to restore its position as a superpower. It is stronger, in their view, than it was at the time of the fall of the Berlin Wall, and so they want to restore that balance of power.
The view in the U.S. is that Russia has a tiny and weak economy and it doesn’t warrant being referred to as a superpower. I think that is one of the reasons the Russians are being pretty quick to bring nuclear weapons back onto the negotiating table and to say, “You know what? We have them, we can deploy them, and don’t treat us as if we are immaterial.”
The Chinese have a slightly different view. Their view is, the world order was always biased in the direction of the United States in recent generations and that doesn’t serve their interests, and they now have the need to reach for assets – food, energy, raw materials – that are required for their population, and if the U.S. really wants to get in a fist fight over that, good luck, because they can hold their own.
And this is one reason we see these really fascinating military incidents where you get these very close near misses between Chinese fighter jets and American spy planes that come within less than 50 feet of each other in the South China Sea, or incidents with the Russians where you get Russian long-range bombers and their fighter jets getting very, very close with NATO fighter jets. So, the risk of an accident is definitely rising.
David: There is this process in place today, and we will come back to the geopolitical in just a minute, where the state is essentially assigning the costs of recovery following the global financial crisis. Who will pay for this? And we are going to see that in an increase in taxes. We already see it in the form of financial repression, the distortion between keeping rates below the rate of inflation and subsidizing, as you mentioned earlier, those who are borrowers at the expense of savers or households. Are there actions that an individual, family, family office, investor should take in light of the state choosing winners and losers?
Pippa: Sure. The first thing is to be aware how aggressive states will become in trying to get their hands on the cash that they need to survive. As one example, on the one hand I’m arguing I think inflation is set to be higher in future years than it has been in the past. Most people think that means, I assume, that interest rates will sell off, and I argue, no, it’s quite the opposite, because the central banks are very determined to prevent that from happening. And they are the biggest buyers of U.S. and British interest rate instruments, and the Europeans, as well. They can actually hold down those rates, which actually means there are no brakes on inflation, because usually when the bond market sells off that’s the brake that slows inflation. So, I’m saying we’re going to get more inflation, and we have no brakes.
In that situation, who gets run over? And I think the answer is, the pensioners. For example, if the Chinese and the Russians and the Indians and emerging markets are not going to be buying treasuries and gilts any more, then they would sell off, or the government would have to buy them up. But there is another way, which is, the government can say to every pension fund, “You know, you should only do safe things with the money you are managing, because after all, you are responsible for Grandma’s retirement, so our definition of safe is only our government’s debt.” And suddenly pension funds are holding a whole lot more government sovereign debt than they would naturally, just because they feel under a regulatory pressure to do so. I call it “regulatory-suasion” or “moral-suasion” you could call it, or you could even call it “immoral-suasion.” It depends how you look at it.
David: There seems to be a real tragic irony. One of the main subjects of your book is the social contract, and this is where each of two parties is assuming that the other party is going to deliver, in good faith, on a set of obligations, and yet, we have just described, for the last several minutes, the difference between the interests of the borrower, and today you are talking about states being some of the largest borrowers. And citizens – the average citizen, pensioner, what have you – it seems that there is the fight for survival. Robert Higgs wrote a book, Crisis and Leviathan, many years ago.
Pippa: Yes. Great book.
David: He described this is basically where the state, in order to survive, is willing to, in essence, eat its own, or do whatever it takes to survive. Is this an inevitability? We had the inflationary periods, the hyperinflationary periods of Hungary and of Germany at the extremes in the last century. Or do you see us experiencing something more like the 1970s, where real returns in investments dropped because you have the CPI, or PPI, or PCE, or whatever measure of inflation is used – people are actually getting squeezed, because the real rate is different than the official rate, and so investors, those who are dependent on pension income, retirement income, don’t have enough? They are running out of money before they run out of month.
Pippa: What nobody said when quantitative easing first began to be part of the discussion and the solution was, “What will be the price? What will be the cost?” The idea was, you took the losses from the financial markets and you moved them onto the government’s balance sheet, and the government, of course, is us. It moved it onto the back of the taxpayers. So taxpayers will be paying, and the form in which they will pay is varied, but part of it is, potentially, we have to retire later than we expected, and potentially, for a lower standard of living than we anticipated, unless we can build something new that generates a whole lot of new wealth before then. And that is possible, and I use the example of the industrial revolution, which occurred in the immediate aftermath of a massive debt problem incurred by many, many wars, many years of wars, as well. It’s not impossible to generate a growth spurt, even out of dire circumstances, but it’s not easy to do it, either.
So, yes, we need to think about, what are the ways in which government will seek to pass on losses to the general public, but without explaining that to them? And inflation is another version of that. So when they say, “Well, we’ve got zero, or maybe half a percent of inflation today, and we’re just trying to push it up to 2,” which is a normal amount, that sounds okay. But the reality is that for a real live person, especially a low-income person or a saver, a pensioner, to go from zero to 2% is a massive change in their lifestyle, in their quality of living. It’s a huge change for a pension fund in their allocation, what kind of assets they are going to buy or not buy. It’s partly because people really don’t understand compounding, and that a small move can result in a big change in the outcome.
So, I don’t think we’re going to end up with a hyperinflation. I think that the combination of poor demographics, meaning aging populations, in conjunction with a massive innovation in technology – these two things will prevent prices from exploding to the upside. But, the effort to create inflation is sufficient that we will get more, so we’re probably going to go from a world of zero or half a percent, to a world that is more like 2-3%. It sounds like nothing. In reality, it’s a huge change, and people should begin to think about how they are going to be affected by that change. How many years does that add to the amount of time you are going to have to work?
The good news is, there are so many new different kinds of work that we can do. It’s no longer a world where you have one job and you have to do that for life, or there reaches a point where you can’t do it anymore and therefore you can’t be employed. Now we live in a world where people can do entrepreneurial things, they can be consultants and advisors. Their skills, potentially, are more valuable. These days people who know how to drill and mine are getting paid more than Harvard Business School graduates. We have shortages of skills, so people will start to learn practical skills. So, I think in the end it will work out, I don’t have a dire view, but I do think the way to manage this is to understand, the losses don’t just disappear. Someone will end up paying them, and could that be me? And what are the ways in which I might be compelled to pay for those losses?
David: Pippa, I have one last question for you, and this relates to your time spent in the oval office. Market intervention seems to occur with greater frequency, in both the equity and bond markets. Of course, we have a Fed, as we described earlier, who has officially taken over the driver’s seat, so to say, controlling prices via the interest rate structure, via QE, etc. They have bought the alphabet soup of structured products, mortgage-backed securities, and of course, treasuries. And overseas we see the Japanese government doing something similar. They are actually buying equities to boost prices. So my question is, what limits are there, or should there be, on the role of the President’s Working Group on Financial Markets, as they coordinate market intervention on occasion?
Pippa: I served on the President’s Working Group on Financial Markets, and I have to tell you, I find it quite funny, this perception that somehow they’re all sitting in there with all these levers, able to control prices in the markets. Mainly, it’s a whole bunch of government bureaucrats who really don’t even understand how markets work. However, having said that, I do think that when cabinet officials play golf with the people running the biggest banks in the world, and over a golf game the government official says, “Well, you know, we wouldn’t want to see the stock market fall,” that gets interpreted by the bankers as, “Oh, they will do what they have to, to support the stock market. Buy stocks.” And then the stock market goes up. In other words, it is more subtle. It’s not like a directed intervention, although we have had directed interventions, don’t get me wrong, I appreciate that governments have definitely been buying specific assets, which naturally pushes up their price. But generally speaking, I don’t think the President’s Working Group is where that game really happens.
Having said all that, I also think that the whole point of the philosophical debate between communism and capitalism, or socialism and capitalism, is at the heart of this matter. The question is, how much of the allocation of assets and wealth in the world economy do you want done by the state, and how much do you think should be done by the market? Now, the view in most of the industrialized world is that it’s really dangerous when a state starts allocating wealth, and when it starts telling the society, “You can earn a lot, but you have to do this kind of job, you have to do this other kind of job.”
When the government is choosing the outcomes, the outcomes are substandard, or suboptimal. Markets are better, and fairer, in general, at distributing the allocation of wealth and resources, and making things more efficient. Now, that’s not to say markets are perfect and there are lots of complaints about how they work, but given a choice between some guy in a wood-paneled room in Washington deciding how much iron ore and how much steel are going to be made and collected versus the markets determining that, I think there is a tendency to think that markets are, generally speaking, better.
Therefore, if we are in a world where governments are increasingly choosing the outcome, setting the price, that’s dangerous, and that gets to Freidrich von Hayek’s notion that it’s not just about these technical economic issues, it actually begins to threaten the whole notion of freedom, and that’s what I think we need to think about. What do we want the state to do? What do we want the balance of power between the state and the market to be?
Or even more precisely, there are two forces at work in the world economy. There is the ability of the individual to generate a profit, and it could be a corporate individual, and there is the ability of the state to tax it. And you want to have the right balance between these two forces, because if it’s too heavy in either direction you end up with socially bad outcomes.
David: The title of your book is Signals: The Breakdown of the Social Contract, and the Rise of Geopolitics. I think it’s a must read. Just to communicate how much I think it’s a must read, it’s our office read for this month.
Pippa: Oh, thank you so much.
David: So, forty books just disappeared off the shelves. I want to end where you begin, which is in a dedication to your father, a father’s experience distilled, and a tone that he set, it sounds like, for your family, which was unique – there is always a difference between the story being reported in the news and what actually happened. He set the stage for you to look beyond the simple observation and derive real meaning and significance from that simple signal. So, I thank you for your contribution, the book, and will look forward to carrying on a future conversation.
Pippa: Excellent. Thank you so much.
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Kevin: Well, Dr. Malmgren certainly does interview the way she writes. I liked the accessibility and the approachability of it. In fact, I thought about this when I was reading the book, if a person doesn’t necessarily want to get into deep economic thought with numbers and graphs and charts, but wants to understand the overall feel of what is going on, I think this is one of the best books on the market, don’t you?
David: I do. And it reminded me, as I mentioned at the beginning of the interview, of Mark Helprin’s book, Memoir from Antproof Case, what sort of set the tone for me, a few years later, running across Jim Roger’s book, The Investment Biker. And of course, knowing the history of John Templeton, who was famous for being able to see things that other people didn’t see, but he wasn’t looking in the same place that all of Wall Street was looking, either.
Kevin: Yes, it’s “get your hands dirty” economics.
David: I think what she emphasizes is the reality that many people, if they trust their intuitions, if they look at what they know and are willing to connect those dots, this is economics, it’s a study of choices – that is economics, the study of choices, whether it is micro or macro. Big picture choices, little picture choices. It’s actually quite easy to understand and quite approachable, and she writes it in such a way. Signals: The Breakdown of the Social Contract and the Rise of Geopolitics – I would highly recommend ordering it. You can get it on Amazon. If you would like to follow up on what Pippa is going to be working on down the line, certainly you can follow the links on our website to her website.
Kevin: And everyone in the office is going to be reading it here, as you said, so you’re ordering 40, just the same way that you’re recommending that our listeners do.