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About this week’s show:

  • Pattern of gold manipulation becoming obvious
  • Erosion of trust moves to a breaking point
  • Wall Street fines & litigation through the roof

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we almost saw a repeat of April, didn’t we?

David: The CFTC is virtually shut down at present. You are right, they might have looked at the activity on Friday with raised eyebrows, to say the least. It was an interesting sequence, actually almost the exact same sequence we had in April, where the Goldman announcement came, that Friday you saw a real Buffaloing of the price, trying to drive it lower, and hoping for follow-through, a real sense of urgency developing over the weekend, so that it just got blistered on Monday, and that’s what happened. We had, again, Goldman reiterating a sell order this last week.

Kevin: Yes, they told everybody, the public…

David: If you looked at a monthly gold chart you could say, “It looks like heck. Why don’t you sell short until Goldman comes out with a buy order?” Well, then, last Friday, near the open, about 8:42 in New York timeframe, you had 5,000 contracts sold.

Kevin: That is 100 ounces per contract.

David: These are futures contracts. So on a tonnage basis, it’s about 17 tons.

Kevin: Just on the open … now Dave, I will tell you this. It’s interesting. They wait for low volume moments. I had the opportunity back in the 1990s, I’ve mentioned this before, to stand outside those pits and watch these guys, and really, most of the time they’re just taking turns going outside to smoke. There’s not a lot going on in a gold pit very often. There are 120-150 contracts traded, then all of a sudden – whack! 5,000.

David: If you want the best price, then you want there to be a pretty wide audience, and you want to take some time to sell the product that you have in order to get the best price without creating a lower bid structure for yourself. But if you want to start an avalanche and take out all the stop losses that are on the books, again, this happened earlier in the year. You have the sequence, Goldman speaks, wise guys act, and then lemmings run for the cliff.

Kevin: Right.

David: Only on Friday, this was before a government holiday on Monday, and you didn’t see any Monday follow-through.

Kevin: It did not work, it was fun to watch on Sunday night when the Asian markets opened. They were like, “You know, no, we’re not scared. In fact, we’ve seen this before. We’re going to go ahead and buy.”

David: Exactly. Well, Tuesday we watched the second attempt to Buffalo the gold price. This time they started in the overseas market, I think, with hopeful thoughts that it would carry through to New York, and again, we were 20 points lower on the gold price, it was about 3:00 a.m. Yes, we were up (laughter).

Kevin: You may have been up. I got up and checked it at 6:00.

David: Yeah, it turned out to be no big deal by the time normal people were putting creamer in their coffee.

Kevin: A guest that we have often, and I really enjoy him, is Marc Faber. Marc Faber has pointed out that the Federal Reserve is about the largest organization in the world. You have these organizations that are just making distinctions in the markets.

David: Right. He says this: “You consider that the Fed, led by its chairman, is the most powerful organization in the world. Because of printing money, it can finance the government (that’s fiscal deficits and wars), manipulate the cost of money (interest rates), directly intervene in the economy by bailing out failing institutions (banks, or countries, Greece), intervene in the foreign exchange market, and even influence elections. It just makes me think. We return to the simple sequence we suggested six years ago.

Kevin: You’re talking about the financial, leading to the economic, leading to the political, leading to the geopolitical. It really is a sequence, and the Federal Reserve has a lot of control over the first two, at least.

David: What we describe is the natural process of events and reactions within a period of crisis. You have the financial crisis, and really it’s nothing more than a sign or symptom of a deeper-seated illness. You have economic and monetary policies that can create problems in the financial system. Again, that’s where the Fed factors in, they can actually create the bubbles that lead to busts, and real problems in the financial system.

Kevin: Dave, I remember the Volcker years, and it was nothing like what we had right after Volcker. The Greenspan era really became the era where the Fed became, not only the financial markets, but the economy, itself.

David: Yes, and we’ve seen, I think, a growing level of dysfunction between economic policy-makers and the monetary policy-makers, those at the Fed. We end up with the economic crisis. So, financial crisis first, then economic crisis.

Kevin: Second step, yes.

David: And in that context, political problems are exaggerated, political crisis, that can be a crisis of leadership. Or it can be where policies don’t address real structural change, and the blame gets moved further along. That’s really the danger point, life danger point, because that last stage, which can include international, or geopolitical conflict, you’re talking about something that, on the nice side it’s just trade wars, a little nationalism, decline in globalization trends, maybe some capital controls. But if the gloves come off, you have the potential for armed conflict, and this is where we see a lot of crises in history resolved by blaming someone else for your own internal problems, but it’s a scapegoating mechanism and it allows the status quo, to some degree, to be maintained amongst the political elite, as long as they get away with blaming someone else, the neighbor, so to say.

Kevin: If you look at the last 100 years, Dave, we’re going into 2014. That will mark the 100th anniversary of what was to be the war to end all wars, World War I. We actually saw this sequence, the financial move to the economic, the political to the geopolitical. It turned into a horrible war that actually was just continued in World War II. So actually, we really had one war of the century that destroyed the world.

If you look at what China is saying right now, I’d love to cover that today sometime, because China is starting to get angry at our political system, so it’s moving from the political to the geopolitical.

David: Yes, and these subsequent fears of crisis can act as a negative feedback loop into one of the earlier crises to reinforce them. So are we out of the financial sphere? Are we out of the woods, so to say? Or are we, in fact, heading back into them? We could very well see the political chaos in Washington lead us right back into full-fledged financial crisis.

Kevin: I want to address this, Dave, because uncertainty is something that we have factored into the market. That’s part of the reason the market has different pricing each day, if it’s a free market. It’s uncertainty.

David: We often think of that uncertainty narrative on Wall Street, and assume that things can cause uncertainty. That unnerves investors, that causes them to be more cautious, it changes their investing behavior. Maybe this is just me philosophizing, but uncertainty – this is life. This encompasses everything in life. Nothing is guaranteed, neither in life, nor in investing. At best, you can guess from one event to the next what will occur, and you may even have laws which govern those outcomes.

You want certainty, now that’s for sure. We want certainty, we create it in our minds, but certainty and the desire for it, is in my opinion, more of a psychological control mechanism. It helps us cope with all of life’s uncertainties. And in fact, ironically, death is certain, and that’s one which most people try to ignore, so we want certainty, and then when it comes to the only thing in life that is certain, we want to ignore that one piece. But from one day to the next, can you say anything else is certain?

Kevin: All of history, as you just pointed out, is uncertain, but there seems to be something different motivating the markets right now. There seems to be a loss of trust. We talk about the Federal Reserve coming in and manipulating things, Goldman-Sachs coming in and manipulating things. How many times can you get spanked for an unnatural event from somebody who has more money than you, or can create more money, and still have trust in the marketplace?

David: I think you’re right. Just as uncertainty is an insufficient explanation for what drives the markets, and I don’t think Wall Street really wants to deal with the issue of trust, because it raises a whole notion in the back of one’s mind – trust, trustworthy. Is this true? Is it false? Am I being lied to? That’s a dialogue that needs to just stay out of the picture. Certain and uncertain; we are certain, or there’s uncertainty in the market, and we can resolve that uncertainty if. That’s how the news media and marketing commentators deal with that issue.

So, bottom line is, Wall Street is more a study in probabilities. Certainty is pie in the sky. Just as a thought experiment: what if uncertainty was irrelevant, and trust was the lynchpin in the marketplace? You’re talking about confidence, which is based on lots of things. Look at a contract, for instance. A contract relationship, there is a degree of trust implicit. There is also some distrust. If you look at the length of a contract, it’s an indicator of how much trust exists between parties, or doesn’t.

Kevin: Right. Interest rates do the same type of things. Interest rates talk about how much you trust that something will not default.

David: Right, and if there is a high probability that someone is going to default, that’s fine, we just factor it into the price. We invest because we trust that a business is what it represents itself to be, because we trust published numbers are accurate, and audited. We trust management to do their best to deliver on stated objectives. And when they don’t, we expect them to offer reasonable explanations of why they didn’t accomplish their goals. We trust in people, we trust in the integrity and functionality of market mechanisms.

Kevin: Call it the free market, allowing a price to be accurate, and not manipulated.

David: Yes, we trust that when we put money to work in the marketplace, we have a reasonable playing field. And we may be right or wrong on a given investment, but we trust that being wrong is not being taken advantage of, or not being stolen from.

Kevin: It’s like playing a game. You trust that the dice are balanced. If somebody has weighted dice, that’s not a fair game. You are willing to lose the game if you play the game fairly.

David: And it boils down to probabilities. I love playing Backgammon. It’s one of my favorite games. But it’s all probabilities. What are the odds of rolling a 7, a 4, a 3, a 6, a 10, a 12? All of these things factor into the strategy, the risks that you are willing to take or not take, in light of the probability of what you are going to roll, or what your opponent is going to roll.

Kevin: Well, it is similar to capitalism, Dave. With capitalism, that’s what the promise is, to allow for the price that two parties agree on.

David: Right. So long-term capital formation, or frankly, the opposite of that, deformation of capital, I would say you are tying it to trust, and not certainty or uncertainty.

Kevin: I got you.

David: When trust is broken, people want to take their marbles out of the game and go home. And that could be for lots of reasons, questionable conduct, questionable business practices, an unfair playing field, like you mentioned, a mechanism that favors one market participant over another, a rigging of the variables. Those factors cause the normal person to simply pull back, or just get out, pull out of the market altogether.

Kevin: When you get burned, that’s what you do. I’ve been burned before. I usually don’t touch the stove twice.

David: So, if trust is the lynchpin of the marketplace, why is this the topic for discussion? Virtually all of the major banks have come under regulatory scrutiny in recent years for questionable practices, or outright unethical behavior. We have billions in fines that are being paid to make the issues go away quickly. And here is what is unfortunate, how to allow profits to as quickly as possible simply cover over the memories of misdeeds.

Kevin: It’s like there is an ethical blank right now, or a moral blank, Dave. These guys are putting money aside so that they can pay fines so that they can continue to do misdeeds so that they can continue to profit more than they should. It reminds me of a banana republic police department that funds itself. You set aside funds when you go to a banana republic to pay off the cops if you’re caught speeding, or not speeding, just caught.

David: But I think for the average market participant, it’s not a question of forgive and forget. There is that practical side of “We need to get on with our 401(k)s growing back to full health,” but I think, really, there is still that residue of innocence lost and naïveté which is moving to past tense. Because everyone remembers, we have in the back of our minds now, the corporate misdeeds epitomized by WorldCom, Enron, and you have the executives, Bernie Ebbers, Dennis Koslowsky, Jeffrey Skilling.

Kevin: How about Madoff?

David: Well, Madoff, he was the one-time chairman of NASDAQ. I mean, chairman of NASDAQ.

Kevin: Yeah! So he was running the game and he was supposed to be fair.

David: Right. We lost an auditing giant, Arthur Anderson. Their numbers were less certified and more probably certifiable (laughter). So you lose the franchise over a lie. And we watched our rating agencies, here and in Europe, rubber stamp garbage paper as Triple A.

Kevin: They were calling it Triple A, Dave, and it’s the stuff that later failed.

David: Right. For someone who doesn’t appreciate or understand investing and the role that rating agencies play, it’s like the Food and Drug Administration certifying rotten, maggot-infested meat as USDA Prime Plus. The banks were caught red-handed, originating loans to people with no ability to pay them off, only to resell them to investors with the assurance that due diligence was done, that these rating agencies had done their jobs. In fact, they were complicit. We find that for years, if not decades, one of the primary references in the financial market, LIBOR…

Kevin: Explain LIBOR, for the person who doesn’t understand the London markets, the interest rate markets. What is the LIBOR?

David: The London Interbank Lending Rate. This is, essentially, a reference point for bank lenders. What do you tie a loan to? What is a banker going to loan money to you on the basis of? What is the market rate? This is basically a collection, a poll amongst banking professionals, as to what the interbank lending rate should be.

Kevin: And it should be somewhat free market between the banks that are talking this through. They’re coming up with what they think is supposed to be a competitive rate.

David: Right. Now we find that after years or decades, it was rigged by a cobble of Wall Street firms. That has opened the door now for the CFTC to look at investigations of commodities manipulation into precious metals and energy, specifically. This week we have the Justice Department, which is opening a criminal investigation into the manipulation of the 5.3 trillion dollars, the daily volume in the foreign exchange markets. Once the Justice Department has opened that door, the FBI, which has been involved with the LIBOR scandal investigation, is starting its own look into the foreign exchange manipulation.

And we’re not alone. It’s not just us here in the United States with regulators saying, “Hey, a series of misdeeds, etc., we want to know more.” Swiss regulators are hot on the trail of financial parties they believe are potentially implicated in rigging a completely different system, the benchmark for your interest rate swaps. This is the ISDA fix.

Kevin: Now we’re talking about derivatives, now you’re talking hundreds of trillions.

David: A 379 trillion-dollar market, and again, we’re talking about interest rate swaps, and the benchmark for that being manipulated, or rigged, as well. So you’ve got suspicions that are now very high that manipulation has occurred for benchmarks. The oil market, interest rates, derivatives, foreign exchange, and this is likely to be confirmed as Joaquín Almunia, the EU Competition Commissioner, as he looks into this. Listen, we see a series of these misdeeds and this reinforcement of trust really eroding.

Kevin: The thing is, though, Dave, these guys continue to pay their fines, but they don’t seem to be convicted. That’s the thing that’s bothersome to me. It’s like a cost of doing business.

David: Yes, fines have been handed down to most of the big banks, and after rigging and manipulating markets, we’re talking worth hundreds of trillions of dollars, you pay a few billion here, you pay a few billion there, and then it almost seems as if there’s a mea culpa. “I’ll never do that again.” (laughter)

Kevin: Right. “As long as I don’t get caught.”

David: Right. And that seems to be sufficient, just pay the fine and move on. And this should come as no surprise. We’ve come through an era of deregulation. We have set loose the natural tendencies of greed within the human heart, and we’ve empowered them by the best technology money can buy. And regulators have been unable to keep up with the advancement and sophistication of the schemes in play by Wall Street, and sanctioned by Wall Street operators.

Kevin: Also, you figure a lot of these regulators, a lot of these regulation organizations, are manned by people who benefit from Wall Street doing exactly what they’re doing. I hate to say it.

David: I would say the regulators are doing their best to catch up with the misdeeds, and I would applaud them for that. It’s just a question of regulatory arbitrage in a world that has gone global, and a world of international finance which has gone global. You have any of the big banks or financial firms that have a footprint, a shingle hung in 10 or 20 different locations around the world, dealing with 10 or 20 different regulatory bodies and it allows them to bob and weave where they want to, where it’s convenient for them to, “according to the jurisdiction.”

Kevin: David, that brings us back to the Marc Faber comment about the Fed being the largest organization in the world. Well, how can we trust that?

David: Yes. We have encapsulated, really, I think, the heart of the problem. You have sanctioned manipulation, and legal manipulation by the Fed. On the other hand, you have unsanctioned and unethical or illegal activity. The Fed manipulates prices across all asset classes via manipulation of the benchmark rate. And this is what is strange. If you look at how people proceed in their professional careers, most of the Wall Street elites have spent time at the Fed or at Treasury.

So you learn the ropes, then you move to the private sector and work with a major financial institution to apply your knowledge of the trade, and does it surprise us that regulators are struggling to keep up? They’ve already had a sneak peak at what major regulatory or oversight bodies are looking for or looking at. And this is where I think it boils down to one thing. It’s the culture which has an anything-goes attitude. The brightest minds on Wall Street – where to they emerge from? They emerge from our culture. We’ve inculcated this into our youth for decades.

Kevin: Where there’s no cost to doing evil, because maybe there is no evil.

David: Nietzsche said a long time ago that God was dead. He declared that God was dead, and Dostoyevsky finished with the conclusion that if God is dead, then anything is permissible. Maybe we digress, but when you kill God, metaphorically, and subsequently redefine morality, anything becomes acceptable. And our culture of corruption should come as no surprise if you just want to look at how morality is understood and how ethics have lost any real concrete reference point. (laughter) I guess I digress, but only a little bit.

Kevin: Look at J.P. Morgan. J.P. Morgan is setting aside money for legal fees that they know will come up in the future.

David: They’ve already set aside and/or spent 28 billion dollars on regulatory and litigation issues just since 2010, and they’ve only now displaced City Group, who under Sandy Weill’s leadership, set the records. They set the records for both profits, in the banking industry, and regulatory fines and litigations.

Kevin: You get one, you get the other, I guess.

David: But they’re not alone. Bloomberg, this morning, reported that the six biggest U.S. banks, combined, have had more than 103 billion dollars in expenses for settlements, lawyers, litigation, since the financial crisis. I think it’s very interesting, if you compare what they did there, selling their physical commodities business in July. It was December when the Chinese came in and bought the London metals exchange. Maybe you just need to know what your limits are, or who you should not cross. (laughter) I think what comes to mind for me is that the Chinese, perhaps, carry a different weight, and command a different level of respect, so it depends on who you’re going to cheat. You want to be very careful that it doesn’t have real life consequences, as in, not just a fine to pay, but maybe you show up with a horse head in your bed, I don’t know. (laughter)

Kevin: If you look at how much gold and commodities China has been buying, and now, with them buying the London Metals Exchange, that is an interesting sequence, Dave, I hadn’t thought of that. Was it the Chinese buying the metals exchange that caused J.P. Morgan to say, “You know, there are new players in the game, we’re just going to go ahead and move to another field?”

David: Of course, you also have the Federal Energy Regulatory Commission, which reached a settlement with Morgan for 410 million dollars, and that was on manipulation of the energy markets. Manipulation of this, manipulation of that, control, rigging – they have to get past this now pending 11 billion dollar settlement. That’s still hanging over them. This is relating back to the mortgage bond concerns. Time will tell if the number is bigger or smaller.

What is the point I’m trying to make? It took a combination of events to get us to a point where the market is, today, a picture of fraud and deceit, and is it fixed by insiders, for insiders, at the expense of the average investor? I don’t know, but it’s looking and feeling a lot more like a rigged game all the time, and this is particularly in a non Glass-Steagall world. When we deregulated in 1999, we really opened the door for that “anything goes,” “permission granted,” “ask forgiveness not permission” attitude, on Wall Street, and I think we get to see the tip of the iceberg, as investigators in the U.K., Switzerland, Europe, and the U.S. try to catch up with what we talked about earlier, what many have come to know as regulatory arbitrage. You have deregulation on the one hand, you have technological advancement, you have easy money policies, you have the price distortions created by rates being kept artificially low, compliments of the Fed, and that has all contributed to the temptation to game the system.

Kevin: And that brings us back to the point of trust. If the system is gamed, as long as the gamers can continue to run the game the way that everybody benefits, you’re fine. But how can you trust a system that is taking from you and always winning on their side?

David: Right. And I think that is the critical point, simply that trust is a frail thing, and if you break it sufficiently, it can take a generation to rebuild it. I don’t see that uncertainty sets secular trends in motion. Perhaps short-term cyclical moves can be influenced by certainty/uncertainty. I do see that a breakdown in trust is a game-changer. This confidence factor underscores the stability we have enjoyed, here in the U.S, with the U.S. dollar market.

Kevin: Sure, the reserve currency status.

David: Right. This confidence is evidenced by how deep our capital markets are here in the U.S. compared to anywhere else in the world. This trust goes deep. There’s depth, there’s volume. The challenge is that that volume can also go elsewhere and do something else. Individuals the world over need to feel that they can trust in people, and in the integrity and functionality of market mechanisms. We trust that when we put money to work in the marketplace, it is a reasonable playing field, and that although we can be right, we can be wrong, on a given investment, at least we know we’re not being taken advantage of or stolen from. That’s the assumption that we have in this trust factor in the marketplace. There is plenty of foreign and domestic capital that is invested today that is content with the idea that all is well, and all is fair. Trust is bruised and battered, but it’s not yet broken.

Kevin: I think we should probably clarify that we’re not talking about every financial person in the marketplace. Most of the guys who come in, whether it’s Wall Street, or financial planners, or people who are accountants or rating firms, most of these people are trying to do a good job.

David: Right. I think what we are really setting the stage for is a complete and total reworking of the regulatory landscape, and I would grant you that there is probably 80%, maybe 90%, of the people connected to Wall Street that should be left out of this conversation – hard working, intelligent, integrous, workers doing their best to live out their professional lives. The last time this reworking of the regulatory landscape occurred was in 1932. That was an excellent time to be buying equities. It was what preceded 1932 that keeps me concerned, and very cautiously allocated today.

Kevin: That’s the thing, Dave. So often I’m sitting here talking to clients and they are saying, “How do we diversify? What are our options? What are some of the good things to invest in right now?” And it’s just so limited right now, as far as the danger goes.

David: Right. Investment options that make the most sense are extremely limited. What we are witnessing is the markets marching forward with blissful ignorance, again, with that idea that all is well, and all is fair. There have been plenty of warning signs over the last decade that the market is rife with fraud and deceit. There have been multiple opportunities to realign a portfolio, and that realignment bucks the trend in the marketplace. Stocks and bonds have gone higher, and frankly, they’ve gone higher than is justified by economic conditions.

Kevin: It is interesting. I was on the phone with a potential client. It is the daughter of a client who has worked with me for years. She called from her financial planner’s office and she said, “You know, Kevin, he’s wanting me to put 100% of my assets in S&P 500 equities. He’s had a great track record. I really don’t know why I shouldn’t trust him. He showed me something called The Rule of 72, and with me making 10% a year, I’m going to double money every seven years. And he also said that gold was speculative.” I said, “Well, what do you mean by speculative?” She said, “I really don’t know, but it didn’t sound good, it didn’t sound like something that I’d want.” I asked her, “Is he assuming 10% a year just in the stock market?” She said, “Yeah, it seems like he is.”

So, people don’t understand, we have these economic tsunamis, we just had one in 2008, we had one in 2000. 10% a year, guaranteed, which was what hit her. He showed her the Rule of 72, and he showed her that at 10% she was going to double her money every 7 years. It’s a shame, Dave, that doesn’t factor in the change.

David: Right, here is what makes me angry when I hear things like that, because when you look back over the last 100 years, the vast majority of that time, if you were invested in stocks, you had, on average, a 4% rate of return. The only reason that number gets bumped to 7%, in Jeremy Siegel’s book, Stocks for the Long Run, is because he gets to factor in the 1982 to 1999 period.

Kevin: Right, the largest rise in history.

David: Right, and with that factored in, now you have a 7% average return over the last decade. By the way, half of that time you spent earning either negative rates of return, as much as -5% per year, so you aren’t talking about non-volatility. And by the way, 10% per year? Pie – in – the – sky. It happens once in a while, and if it just happens this year, oh wait, 19% year-to-date in the Dow, guess what? Count your lucky stars.

Kevin: That brings us to certainty versus uncertainty. That brings us to trust versus a lack of trust. Now she obviously trusts this man because the man said, “I’ve had a good track record in the past.” Now, he hasn’t had a 10% return like you talked about, but that was a simple way for him to gain her trust. What it doesn’t factor in, Dave, is what these guys call black swan events, and the problem is, there are black swans all over the place, and they happen all the time.

David: When you think about the causes of a tsunami, or major natural disasters, what you are dealing with is tectonic shifts which take place gradually and slowly, and then all at once. And they generally go under-observed until they create a violent change. And you have, in a moment, this unleashing of power which is unimaginable. We witnessed the consequences of that power. The tectonic plates are shifting and they are doing that same thing, rubbing against each other in the world of finance. I would say that the breaking of trust in the marketplace may be attributed to something much smaller than a budget impasse, or potential default on U.S. debt.

Kevin: A trading trigger event, is what you’re saying.

David: It could be anything that unleashes a tremendous amount of power, again, under-appreciated by today’s investor, whether it’s a private investor, an institutional investor, the erosion of trust we have been talking about is in motion. The breaking of trust is merely a timing issue. If you can’t be patient, then you need to join the mass of investors making money today, either willfully, or woefully, ignorant of the risks they’re taking. Unfortunately, Kevin, this group that is either willfully or woefully ignorant is going to be caught in the chaos of our coming economic adjustment.

Kevin: The story I read yesterday about China calling for a New World Order, a new reserve currency, talk about a tectonic shift, our entire lifetimes, Dave, have been managed on a world basis by a reserve currency of the U.S. dollar. The dollars that I have in my pocket are the reserve currency of the world. A tectonic shift. How many times have reserve currencies shifted through the years, if you look at the centuries?

David: You’re talking about the article that was calling for the de-Americanized version of the world. They want the world, essentially, expunged, cleansed, changed, moved away from, we need to move on, move forward. You can’t underestimate the power of tectonic shifts. In the world of money and finance, think about this. In 600 years, the baton of reserve currency status has been passed six times. It’s not a permanent position of power, and by the way, there is a radical consequence once it is lost. Once those changes get rolling, they’re unstoppable.

Kevin: Which brings us back to the sequence that we started with, Dave. For the last six years we’ve told people. “Watch, it’s a sequence from the financial crisis that morphs to the economic, it morphs to the political. If people let it, if it gets out of hand, it’s going to go to a geopolitical crisis.

David: And it doesn’t have to, but that is often where it goes, given human nature and the inability, or unwillingness, for people to accept responsibility for bad decisions. And we’re talking about policy-makers both sides of the aisle. We have China’s comments this week, and they really do strike a nervous chord with us, because how we respond and play our hand is key to outcomes.

The Republicans and Democrats may be bluffing with each other, but the real poker game is a global one, and the pot that is at stake, the pot that is holding things such as reserve currency status, or our ability to fund future deficits at at least a reasonable cost, and the ability to influence foreign policy issues, granted, we sometimes influence foreign policy issues on a unilateral basis, and we can get away with it, with very little consequence. Or, perhaps differently, on a real multilateral basis, transnational organizations. Listen, they want a de-Americanized global power structure.

Kevin: And I can see why. If you think about it, the dollar has lost 95% of its value since we went off of the gold standard. Everybody else has to play the game with that reserve currency. So yes, we have been irresponsible, we’ve been immature.

David: Right. The developed world nations are only too eager to see us be displaced. And it’s a collective displacement. The United States, call it the City on a Shining Hill, yes, they’d like to see us go, or at least, move over and create some space for them. Their own version of leadership, their example of what the 21st century should look like, that is less clear. They just know that the status quo has to change. All we’re doing is drawing attention to a national dysfunction, our political system, the elites that have run it, and frankly, have become disconnected from the common man, and they, of course, claim to represent him, they know that that rhetoric is what is needed in campaigns. The work that is done on the campaign trail, we all know that that is a separate reality from the work of legislating, and this is really the simplistic distinction there of talk versus action, what they say they’re going to do versus what they deliver.

Kevin: And talk about talk versus action, Dave. Last week, the program that we had was to let people know that we do have enough revenue to pay the interest on our debt, so a default should be out of the picture. But even Obama brought up Social Security checks being late, which was, I hate to say it, an outright misrepresentation, because Social Security isn’t even part of that process. It’s a separate organization. So we’re threatening the world with possible default on bonds, which is not necessary. We’re threatening those who are in need of Social Security with taking that away. These guys, like we said last week, Dave, are swinging clubs. The problem is, they’re in a China closet right now, and they may hit something, literally a China closet.

David: I think this is what is compelling, that the national dysfunction, which we have lived with for a long time, is becoming more apparent to more people, and it is particularly critical at this point in history. 10-20 years ago it wouldn’t have mattered, we didn’t have an alternative to the U.S. dollar. In the world monetary system, now we have the euro, and now we have another country that would like to be first, a regional hub, and someday, a global hub for currency trade. That would be the Chinese, as well.

Again, this sort of tripartite participation, the U.S. dollar, the euro, and the yuan, this is what they want. Not that the dollar will go away, but that it just will play a lesser role. And the consequences – what’s the bottom line there for a U.S. person? You lose the world’s reserve currency status and just like every country, the other five that have lost it in the last 600 years, you will see a radical increase in the cost of everything. Your currency, essentially, is depreciated, and the cost of real things. If you lose 50% of your purchasing power, that means the cost of a loaf of bread is up 100%, your Starbucks coffee from $3.50 to $7.00, your gallon of gas from $3.00 to $6.00. Just double your cost structure and realize that your income may not have the same kind of elasticity. It may not grow alongside the doubling of everything in value.

So there’s a real crunch when it comes to the economic side, when it comes to the household financial management side, losing reserve currency status. This is not just a question of let’s be more fair to the rest of the world. I’m all in on fairness, right? But just understand the cost in what you’re asking for when you give up reserve currency status, and that is what the majority of the world would like to see.

Kevin: Even with the reserve currency status still in place, Dave, they’re finding ways around it. Look at what the ECB has done with swap deals with China. They are finding other ways of swapping, through swap lines, around the dollar systems, so it’s developing naturally, if not officially.

David: Probably two years now, and running, we’ve been talking about this re-engineering of the plumbing in the world financial system that allows for invoicing between two currencies, two countries, instead of using the dollar as middle man. That way you were always including this third person. They are eliminating that as an unnecessary encumberment, and so we’ve seen that between Brazil and China, we’ve seen that between Russia and China, we’ve seen that between over a dozen different countries. Just six days ago, Financial Times ran a great piece summarizing the agreement that came together between the European Central Bank and the Chinese, for these same kinds of currency swap arrangements.

Kevin: And they’re not small deals. We’re talking hundreds of billions, in some cases.

David: These are all little pieces in a grand puzzle which remakes the world monetary system. Look at the Chinese today. They’ve got something like 1.2 trillion in treasuries. They actually have more than that in terms of dollar exposure, about 3.5 trillion in dollar-denominated assets, again, more than just the treasuries. When you suggest moving toward a de-Americanized world, that includes the dollar, but with the currency system comes a decrease in transnational organizations, with others playing a larger part. And this is where they’ve demanded that we take a step back in the IMF and the World Bank and the Chinese take a step forward. If they don’t get what they want, they can take their marbles home and just quit playing.

The ramifications for the debt markets here in the United States are catastrophic. The ramifications for the U.S. dollar market are catastrophic. I don’t know who needs whom more at this point, but we are moving toward this situation of mutually assured destruction. We need them to continue buying our treasuries. They still, to some degree, need us to continue to buy their products, but at the same time, they are re-engineering their economy in its entirety to focus less on exports. You can see that in the radical shift higher in their currency over the last couple of years and in the radical shift higher in terms of compensation for the average employee.

This is a big change. The average compensation per year used to be the equivalent of $1200, now it’s closer to $4200. That’s a big jump, if you’re looking at growth rates in income. It speaks to a successful step forward for Chinese rebalancing. Part and parcel to that, and that’s why we covered this in The Fuse Is Lit, the part on China, we have a treasury issue. We have a dollar issue. The fuse is lit. China may have very well lit the match. We have to negotiate this time and this sequence of events very carefully. It’s China’s comments this week that yes, strike a chord with us, and we have to hope that our politicians aren’t just looking at our national dysfunction, but if we lose trust with our international creditors, that may be the final straw in the breaking of trust which destroys the system that we know today.

Kevin: We talked about trust, we talked about uncertainty, Dave, we talked about this issue of the de-Americanizing of the world. But let’s say that you’re someone who is listening who has a pension fund, an IRA, has put a little savings in the bank, maybe a little bit of gold. The question to you is this, Dave. With all of this, with this lack of trust, with the uncertainty that we have, with what’s going on with China, the possibility of the dollar being taking off of reserve currency status, either officially or these around-end routes, what do I do with my assets? What should I do, today, to take advantage of what I just learned?

David: Marc Faber was in an interview with Bloomberg earlier this week, and it’s always interesting to see the commentator’s jaw drop in response to what he has to say. He basically said that there is nowhere you can hide. A collapse is coming, and bank deposits are not safe, treasury bills are not 100% safe, bonds are not safe, stocks are too expensive. You need to diversify between cash, gold, real estate, equities, and hope that they don’t all implode at the same time. That’s the classic characterization of the markets and how bad things are getting from the man who writes the Gloom, Boom, & Doom Report, and yes, there’s a lot of gloom and doom in it.

It does come back to this issue: We’re at a transitional phase, and it’s a transition that you only see in these major market cycles. Trust builds over a 20-30 year period and it takes about half that amount of time to completely destroy the trust which was built in the previous generation. And then it takes another generation to rebuild that trust. We are in the period of trust deteriorating, being broken down. Ultimately, when it’s broken, people clamor for control. They want real assets.

So the two things that I would be most comfortable with, on Marc’s recommendation, would be real estate, not leveraged real estate, but we’re all in, something that you own, dirt that you can work. Gold, I like. And actually, I do still like cash. I like cash even though the Fed is doing their best to devalue the dollar year-in and year-out. It has, as one of our friends likes to call it, optionality. Purchasing price optionality. When things get cheap, you want cash. I prefer to look at my gold as a cash substitute, but there still is a role for those nasty little greenbacks. Maybe the color will change someday, but until then, we just have to deal with them, too.

Kevin: We have been drawing triangles for decades now with clients, where the base of the triangle is gold, the left side is growth assets, that can be equities, bonds, or whatever is appropriate, and then the right side is cash. What amazes me, Dave, is that continues to be, probably, the best answer. In good times, in bad times, in times of trust, in times of lack of trust, you typically cover the bases if you cover those three sides. We don’t mention real estate in the triangle because real estate is something that we don’t count as a liquid asset, but it still makes sense to have maybe some productive land, something you can grow something on. Like you said, something that you can actually own that can’t be re-created.

David: As we wrap up, it’s just this issue of national dysfunction showing itself to be an intolerable point for our international creditors. I don’t know if the end-game in the markets is generated by them, or generated by us. It may be that, domestically, there are enough people who look and say, “The game is rigged, I don’t like the way it’s played. I can see that the equity maket is rigged. I can see that the bond market is rigged. I can see that the derivatives market is rigged. I can see that LIBOR was rigged. I can see that everything under the sun is rigged, and I’m just going to take my marbles and go home.”

Is it the domestic audience that pulls the marbles, or is it an international creditor audience that pulls the marbles and just goes home and doesn’t want to play anymore? That’s the real concern, because with it comes a complete realignment, and that’s where I think you see a change in sentiment, a change in market psychology, and a radical shift in asset prices overnight. That’s not something you can address in real time. If you don’t address it ahead of time, you will be caught up in the chaos and the power of that cataclysm.

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