- “Control oil & you control nations. Control food & you control people.” – Kissinger
- Russia & Ukraine generate 10% of all global calories
- Powell raises rates – How much more will he go before reversing again?
Collectivists, Dictators, & Technocrats vs. Personal Liberty
March 22, 2022
“It’s a perfect world of simple inputs, and there’s so much confidence packed into this because there’s powerful means put at the disposal of the central bank community. It’s no longer a question of what might go wrong. Nobody cares. ‘Well, what could go wrong here?’ What a silly question to ask. There are tools for every possible outcome, probably tools for market stability, even the case of nuclear war. At least there’s the posturing and the rhetoric to support that.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany.
Dave, it’s interesting as we go through preparation for war, whatever that looks like, the polarization is really happening. You and I were talking about just the excluded middle where what we’re seeing with comments from our clients, comments from our listeners, just listening to various news sources, there’s very little middle ground that’s being approached at this point. Most people are taking sides, and it’s difficult to find agreement. Are you finding that as you travel?
David: Well, very much so. I think people like certainty when there is more uncertainty, and lean more heavily on definitive statements and strong conclusions. Even though it might not match the reality, it certainly feels better.
Kevin: Something that I’m finding is people are sending me must-see YouTubes so that we can understand what’s going on overseas, understand what’s going on with China, understand what’s going on with Russia and the World Economic Forum. What’s interesting is these must-sees, they don’t necessarily agree with each other. So obviously, these must-sees, there’s got to be something different that I’m not seeing.
David: For about the last 15 years, the Economist has put together a study which is pretty helpful just to see the shifts in numeric terms in what they consider a measure of democracy. The Economist Intelligence Unit publishes their Democracy Index, and it shows the direction of individual countries and particular geographies, an entire continent, if you will, or parts of the world. That came out this week. Not to anyone’s surprise, China and Russia still rank near the bottom. They’re in the authoritarian category. Russia is number 124. China is 148. That’s out of 167 countries on the index. China was once again laid low on its score in the electoral process and pluralism categories and their nearly nonexistent civil liberties. So you’ve got this 85-pager which starts out by saying that the pandemic has accelerated a creeping authoritarianism on a global basis, and you only have 21 countries that remain in the full democracy category. It’s a really fascinating thing.
Kevin: And I’ll bet the US is not on that list.
David: That’s right. It’s in the flawed democracy category, which is a separate category, and so it does not even make the full democracy list. That didn’t prevent the US from holding two summits for democracy at the end of 2021, which according to the report elicited cynicism in many parts of the world. So again, the report goes back over the last 15 years, and at least 108 of these 167 countries have recorded the decline in their index scores through that timeframe, or have just stagnated. This is a trend worth watching. The study describes how the last two years, again, going back to Covid, has impacted the way people experience freedom and the way they engage with government, so the Covid strictures, the shutdowns, the mandates. Now post-Covid, it remains to be seen what citizens will expect and what they’ll acquiesce to.
Kevin: We often talk about governments taking away our freedoms, but honestly, there’s a new form of government. I mean, has technocracy, this rise of technocracy and Twitter and Facebook and YouTube, has that had an impact on freedoms?
David: Yes. It seems a coincidence in the decline in democracy and the rise of technocracy—technocracy being, again, your non-elected elites, those who are PhD certified in some particular skillset, and as experts in their field are willing to bring bureaucratic prowess in ways that no one else could. Yeah, I think there is this correlation between the decline in democracy and the rise in technocrats. Does globalization and the de-globalization process, does de-globalization relate or correlate with this decline in democracy? Perhaps, at least insofar as the unseen hand of the market is being displaced by the seen hand of an expert administrative class. And this administrative class is driven off of idiosyncratic interests and agendas.
Kevin: Free speech has been such an important part of democracy. Our founding fathers, that was one of the main things. We talk about controlling the people, technocracy can control free speech. But you think about some things that are probably more concrete like food and energy, if you can control the debate between people and information, and then you can control food and you can control energy, what else is there? I mean, at that point, you’ve got full control.
David: Yeah. Well, Henry Kissinger once said, “Control oil and you control nations; control food and you control people.” And I think that comment captures both the risks of energy dependency as we saw play out in the 1970s oil embargo, that era, and now as we see it play out in Europe. Most critically, the roots of political and social stability are now in play with food insecurity and higher rates of inflation impacting households around the world. This issue of unfilled bellies in certain geographies becomes a flash point for social instability as we move forward. Inflation, to many of us, is largely an inconvenience. If you look at inflation in the developed world, yes, it’s a source of agitation, but that’s what it is at its worst. Maybe it’s an instigator for political change, but it’s very much a bigger deal elsewhere.
Kevin: Yeah, this brings to mind what you’re talking about, this Democracy Index. I’m not sure exactly how it’s measured, but you and I have talked in the past to Frederic Bastiat’s book, The Law. And one of the things that he talks about are basic God-given rights, the right to life, the right to liberty, the right to private property, to be able to own and not have to have something stolen from you. So, this decline— food is really probably one of the primary needs. Between air, water, and food, if you are seeing a decline in food availability, there’s going to be submission to some sort of system if a person’s to eat.
David: Well, and it’s always important to keep in mind the basis of law, right? I mean, we take these truths to be self-evident. When we start talking about law in the context of the United States, it really is with this idea that rights come from someplace else. They’re not granted to us by government, as in today you have them and tomorrow we can take them away, but they’re implicit to the organizational structure of society. If you start with the basic unit of society, family, and build out of that, states, nations, you can see that there’s this implicit— At least that’s the way it’s written into our constitution, is that it’s implicit, right? It’s not the case everywhere.
We reflect on the Democracy Index and the gradual decline of the index scores through time, and one of these things that is a very powerful variable we should watch here in the next few years is something as basic as food flow. Food flow is a powerful variable to keep in mind. Without food security, you cannot have political stability. With food insecurity comes the opportunity for unscrupulous actors to consolidate power, to leverage circumstances toward social control, and to, in essence, rewrite the laws. It’ll be interesting to compare the 2021 Democracy Index scores, which just came out, with those of 2022. We will be even further past Covid and, in the wake of the Ukraine-Russia crisis, assuming that too has passed— If it is not, the marginal loss of food will have significant geopolitical ramifications. Right now we’re talking about a very short-term issue, if this is a short-term problem. But if it extends very far, it’s a game changer.
Kevin: Well, let’s talk about that short-term problem. I mean, year by year, the crops make a big, big difference. So short term can become a long-term issue. What is the impact on Russia and Ukraine as far as just food security for the world?
David: The US Farm Bureau summarized a number of Russian and Ukrainian inputs which leave you wondering about food security in the coming months. As much as Germany has had to ponder their energy security, you got Russia and Ukraine that are major food producers. On one measure, they’re responsible for generating 10% of all global calories.
David: If you think about that, that’s a big deal. Ukraine exports $27 billion in ag products. Europe takes about 7.6 billion of that. China takes 4.2 billion. India takes 2 billion of Ukrainian imports, Egypt, one and a half billion, Ukraine, one and a half billion as well. And so, this is the basic stuff. This is corn. This is sunflower seeds—oil actually, sunflower oil—wheat, grape seed, again for oil, barley, sunflower meal. How this conflict unfolds in the coming weeks is critical, because nature has its cycles and they can’t really be flexed or changed.
Kevin: In past history, it was known that kings went to war in the springtime, but farming oftentimes was disrupted. So a lot of times war in the past would be organized around, first of all, getting the crops planted and in between harvest, what have you. At this point, if you’ve got Russia and Ukraine fighting, are they actually going to be planting normal crops? I mean, are the farmers actually going out to the fields and doing normal business?
David: Well, you mentioned springtime, this is one of the fascinating things about Ukraine. This morning, we were leaving my in-laws’ ranch in South Texas and big rainstorms came through. We went out the wrong gate. We had to turn around and there was some concern that we weren’t going to make it out of the field because you get off the road and it gets muddy real fast. We had four-wheel drive, it’s a big truck, it’s no big deal, but this is what is being faced right now in Ukraine. Things are softened up. It’s springtime.
You look at those big, long lines of troop carriers and tanks, they can’t get off the roads, otherwise you’re talking about a big muddy mess. A part of their logistical constraints have been being limited to roadways. And so, spring is cropping up in very interesting ways. What happens from April to May is really critical, back to the food issue, April to May, because you have planting. With the exception of wheat and grape seed, which were planted in the fall and are growing now, farmers have to put something in the ground. And as you know, you plant, and then you wait.
And the planting season is this frenetic and focused season, of course, just as the harvest season is just as intense, but it’s a few months later. The question of whether the planting season will receive a focused effort in the context of war is very consequential, right? We can fast forward to the autumn harvest, and it’s just too far away to matter at this point, but the planting season is nearly here, and it becomes material. It becomes material if farmers are fighting and not planting because Ukraine is the seventh largest producer of corn in the world. They’re the eighth largest producer of wheat.
You’ve got these concentrated exports that are going to countries that need that food, can’t produce it on their own, and they’re going to have a hard time finding it elsewhere or paying premiums to get it from someplace else. Think of Egypt, think of Indonesia, think of Turkey, think of Pakistan, think of Morocco. These are some of your big trade partners with Ukraine. And if it doesn’t get planted, it’s not going to get harvested.
And now we’re not talking about food inflation in the spring of 2022, we’re talking about an extended issue throughout the year and into next year. Russia, of course, massively outranks Ukraine in terms of wheat production. They are a 20% producer. Total global wheat production, 20% of it comes from Russia. So it’ll be interesting to see, the more pressure we put on them, how much do they constrain their exports and maintain a focus on feeding Russians first. You combine the two, you combine Russia and Ukraine, and a third of all the world’s wheat comes from these two countries.
Kevin: Wow. Wow.
David: Ukraine is the world’s largest producer of sunflower seeds, 47% of global exports. And you say, “Well, that many people driving around chewing on sunflower seeds.” I do when I go on long-distance road trips, absolutely. No, but this is more of, again, the sunflower seed oil, which ends up being critical for anyone who’s cooking basic food stuff. You’re not talking about microwave dinners in India and most of China and Iraq, you’re talking about cooking the old-fashioned way, on top of your stove, and that’s where a lot of these exports go. India, China, and Iraq are the top three.
Kevin: I think of the conversation we’ve had many times, Dave, about the need for reserves because when one shoe drops, oftentimes another shoe drops and then another shoe drops. And what I’m thinking right now is, we’ve got these supply disruptions that are going on, whether it’s Covid or whether it’s war in Eastern Europe, but you also have at the same time 10 to 12 years of easy monetary policy that built inflation into the mix. You’ve talked oftentimes that inflation is felt first by the poor, and inflation and starvation, unfortunately, oftentimes go together.
David: Yeah. I mean, at the margins of food security are the Ukrainians first of all, because they’re in the middle of the conflict. And then you’ve got China, India, Egypt, and Turkey, the countries that are trading with Ukraine. I leave out Europe, even though they’re the largest trade partner with Ukraine for foodstuffs, only because there’s greater latitude with Europe to source alternatives, and they can pay higher prices. I mean, certainly inflation is a concern for all of these countries, but the threshold of despair, as you described it, Kevin, it’s reached sooner amongst countries with sizeable and fragile social classes, less robust household income. If it’s true that lower classes are more negatively impacted by inflation regardless of the economy, then I think it’s also true that lesser developed countries are more at risk when you have rising food costs or less supply available.
Kevin: And sometimes it can sound cold when you talk, almost like Machiavelli, the writer of The Prince. But Machiavelli was an interesting read, you and I both read it at the same time, talking just about the practicality of the wielding of power and how it can be kept, and how it can be maneuvered. And so, lest anyone think that while we’re talking on this commentary we’re not sensitive to the actual emotion and pressures that’s going on worldwide, we are. We apply that to prayer and thought and all the human things that we can do. But from a Machiavellian point of view, and I think of Henry Kissinger a little bit in that view, when he’s looking at world politics and diplomacy, Kissinger for 60 years has been operable with that kind of mindset. I think he would talk about food security and energy security more like a chess player plays on a chess board, wouldn’t you?
David: Sure. Yeah, absolutely. And he points to that energy security and food security. We already know the dependency on Russian energy, right? Russia is the third largest oil producer in the world, second largest natural gas producer. A lot of those exports obviously Germany is dependent upon. And these exports fund a third of Russian government revenue. So this is a big part of their governmental structure, national income. And thus far, they have not been restricted. So the flows of oil are going out, flows of dollars and euros and everything else are coming back in. Trade surpluses exploded higher the first quarter.
These are actually rich days for the oligarchs. I mean, we can think about how we’re really putting the screws to these guys. Perhaps they can’t spend it all at Harrods or they can’t easily traipse around Paris scurrying from Louis Vuitton to Chanel to Hermes, but the cash flows are robust. The coffers are quickly filling. March is going to likely break all previous records for trade and exports for Russia, having combined the two elements of higher energy prices on the one hand and very robust global demand on the other.
Kevin: Well, and correct me if I’m wrong, but petroleum plays a key role in food production. I was talking to a farmer client of mine and he said, “You wouldn’t believe the cost of fertilizer right now, nitrogen.” So we’ve got this overlap. We talk about food and energy, but sometimes there’s a direct overlap, isn’t there?
David: Oh yeah. The volatility is unreal in that area. I mean, one area of dependency is where the food and fuel come together. Fertilizer, Russia is a significant producer of your three major fertilizers. Those supplies are in question as Russia reviews non-energy exports. So again, maybe they hold back some of their fertilizer exports, maybe they hold back some of their food exports. And that has ripple effects into other countries in terms of their political and social stability.
But if you’re thinking about fertilizer in particular, nitrogen in particular, it’s pressured by rising energy costs. 70 to 90% of the cost of nitrogen comes from natural gas. So Russia, as I mentioned earlier, is number two for natural gas in terms of production, right behind the US. And this is where, 2021 to 2022, our hard asset strategies have benefited, not only from exposure to oil and gas, but also fertilizers. There’s now a huge job for us at hand in terms of risk mitigation because the volatility in all of these sectors is unreal.
Kevin: Well, the volatility and just the cost of keeping up with inflation. Food’s got to be one of the most basic things that we need to watch as far as prices increasing, and a lot of times we look at what’s going on in the United States and we forget the rest of the world. What was it that I read recently? That year on year, food inflation worldwide, it’s over 18%, isn’t it?
David: Yeah. I mean, we like to reference CPI and PPI, consumer price index and producer price index. We know that those are baskets, and each of the components in the basket is given a weighting. And so, you can play with the weightings to adjust what the final number is and some of that gamesmanship— I mean, we’ve had the baskets and the weightings and the way that CPI is calculated from the 1980s has changed just shy 20 times since 1980. I mean, we think, “Oh, well, inflation was X percent in the 1970s and ’80s, and it’s a lot less now.” Well, yeah, we’ve changed how we count it close to 20 times, and it’s gotten smaller and smaller deliberately as we go.
It’s interesting, the UN puts together a couple of different measures for inflation, specifically for food. They’re not trying to strip anything out because, again, what they’re looking at is, again, social stability and some of the things that tie into political regime continuity. The UN Food and Agriculture Organization measures food inflation in a variety of baskets. They’ve got the Food Price Index, the FFPI, suggests that the Russian-Ukrainian crisis is now extending globally, likely to continue this negative influence as it impacts the prices of wheat and corn, sunflower oil. If you look from January to February this year, that index is up 3.9%, just in one month, and the year over year change, February to February, 18.7%.
Kevin: Wow. Wow.
David: The UN, again, this is the Food and Agriculture Organization, they measure cereal prices. Again, this is just back to the basic stuff that goes into what you probably had for breakfast, what I had for breakfast this morning. It’s up 12.9% year over year. Vegetable oil prices up 34.5%, and that vegetable oil covers a lot of things. We talked about sunflower and soy and a whole variety of things go into that mix. Call it 35%. These things begin to add up, and it’s safe to assume that food prices are continuing higher for at least a little while.
Kevin: And so, we’re going to break one direction or another. I mean, we’ve talked before, revolution can break either the way the French Revolution broke or it can break the way the American Revolution broke back a few hundred years ago. With the deterioration of democracy that you were talking about a little bit earlier, when people are hungry, oftentimes they’ll look to a dictator to solve the problem, won’t they?
David: Yeah, the countries that can least afford the increases are going to face the most stress politically. So that represents either protest or a large request for the strong hand of government. And might that suggest that 2022 is the year of the coup? Possibly. We’re already seeing deterioration in the Democracy Index. Would it be a surprise to see autocrats seek greater control even as citizen’s voice greater frustration, and maybe even bring their protests to the street? You’re either going to fight those protests or you’re going to harness the energy that’s on the streets for your own ends. Voices is perhaps the only thing that’s going to keep ’22 from being the year of the coup. And voice, I mean people having the opportunity to express themselves. To the extent that dissent is squashed, I think you’ve got significant issues, really explosive political dynamics where you don’t allow for voice to be recognized.
Kevin: Well, and do you think people really feel that their voice is recognized right now? I mean, we talked about technocracy. I mean, if we say something wrong on this YouTube channel, they can just cut us off. Twitter, the same type of thing. Facebook, the same type of thing. And then, of course, there’s the dictatorial governments like China, they’ll just cut you off if you don’t say something positive about them all the time. But you remember that book by Hirschman that you had recommended that I read called Exit, Voice, and Loyalty? I mean, you can see it in any human endeavor, whether it’s a company or a country, you need to feel like you either have a voice or there has to be loyalty to the company or the country, or people will just find a way of exit, and exit can look like a lot of different types of things. Hirschman’s book was very insightful in a period of time where people need to feel like they have a voice.
David: I think it’s a must read. I think it’s a classic. And if you’re looking at it from the standpoint of family dynamics or office dynamics or country dynamics, it provides a reasonable model for release of social pressure. So voice is dissent, it’s expression of opinion or opposition. And unfortunately, as you suggested, it’s being managed on a tighter and tighter basis, both by government and non-governmental private party interests.
So as censorship increases, what ends up happening is social anger proliferates. Lacking the classic first form of pressure release, all of a sudden it’s bottled-up energy, which again becomes, in my opinion, dangerous. So when we consider the long-term implications of censorship, whether that’s Twitter or Facebook, those come to mind, but the media is more and more a channel of suppression, it’s worth reflecting on the social response to suppression, the unintended consequences of it. You think, “Well, we’re winning the story by controlling the narrative.” Narrative control may have its benefits, but it’s ill advised to reduce free speech and freedom of expression without substituting a new valve for release.
Kevin: Well, how about loyalty? Okay, loyalty. Is that something that a company or a country can lean on when they don’t give voice?
David: It just depends on the environment you’re in because loyalty, certainly if there’s brand loyalty, you can lean on it pretty heavily. But this is where, in a world of bad reviews, you go from having 50 five-star reviews to having 50 two-star reviews, and loyalty all of a sudden changes, maybe not because of your direct experience, but because of your vicarious experience. And that’s just at the level of brands. If you’re talking about politics, loyalty is not a reliable factor to lean on all the time, particularly in a period of contentious or partisan politics. That’s the kind of period where we are now. And as we discussed a few weeks ago with reference to the University of Michigan surveys, faith in institutions is waning. So politicians I don’t think can rely on that rail either.
Kevin: So that brings us to exit. We started with voice, all right, and then we talked about loyalty. But if those two fail, there is an exit. Now the question would be, where is the exit to? I mean, I guess we could look at the extreme right now, the exit of the Ukrainians into Poland. We’ve got friends that are missionaries in Poland and they’re taking in Ukrainian exiles right now. I guess that’s a very, like I said before, concrete form of exit, but exit can take on many forms as well.
David: Well, you’re right. I’ve got friends who are living in Portugal who are taking in a family from Ukraine as well. Exit, of one sort or another, is also limited. Where do you go? You may not have all of your options open. And it’s not just a move away from something. Obviously we can see what that looks like, moving away from a war zone, but it’s also moving towards something. Where are you going? I think voice is still the preferred— If I looked at those three, it’s the easiest to facilitate. And so, it really makes no sense why today we would be limiting it at all. Voice is preferred over both loyalty and exit, and yet voice is being constrained. And I don’t think that’s going to be without consequence. So boiling agitations, ever-polarized perspectives, it’s not working shutting off voice because we don’t live an age where loyalty is that clear, that dedicated, or dear. And exit, there’s not that many options if you think about it.
Kevin: This is where the confusion comes in. I was talking about the must-see videos that are out there right now. People have great points in a lot of different directions. I mean, do I want to see the World Economic Forum get their way? No. Do I see Putin and China as being possibly the way that the World Economic forum doesn’t get their way, which means I should cheer for Putin and China? See? We’ve got a lot of conflicting things going on right now. You’ve got modern-day prophets who are saying this, and you’ve got people who want to rule the world saying that. This is where I think we have to be careful that we don’t exclude the middle. You look at both sides and say, “Well, this can’t be completely black. It cannot be completely white.” Because we can slip very quickly into the hands of a dictator if we think that we’re slipping away from the hands of another.
David: I turned on a podcast the other day, and I started listening to this gentleman. He was raised in the US, educated that the University of Arizona, and did his PhD— I forget where. But spent probably 25 years as a heavy metal rock star in China and today runs this blog here in the US. I’ve never heard anyone more articulate in terms of Chinese politics. I mean, it’s kind of coincidental that he was a heavy metal rock star, PhD in political science, and he just happens to— Again, look, whatever. Almost not worth mentioning.
But I’m listening to him and I’m listening to him interview three or four different academics from East Coast, West Coast schools, and I realize there’s so much more detail as it relates to China and the Chinese political structure that I know nothing about. If we really appreciated how little we know about anything, all of our opinions would be tempered, and all of our temper tantrums would be turned off. We get so heated and so angry about things that we know absolutely nothing about. Nothing. It was a reminder as these guys started getting into the weeds, I mean really into the weeds. It was totally humbling, totally humbling. So—
Kevin: Yeah. Well, look, Dave, look at the last 10 years, I mean, are you the same guy that you were 10 years ago?
David: No, and I —
Kevin: Was he the same guy 10 years before?
Kevin: I mean, I’m embarrassed about things that I thought very strongly about 10 years ago now that I’ve learned more.
David: We actually had a client suggest this the other day, that China and Russia represent the antidote to the globalizers from the World Economic Forum, that they represent some sort of a truer font of freedom in a world driven towards idealisms of all varieties. And I just thought, “That is pure insanity. That is pure insanity.” And maybe this is what is meant by the fog of war. No one really sees clearly in the confusion and chaos of conflict. Do they represent an anti-something compared to the WEF? Sure. But again, I don’t think anyone sees real clearly in the confusion and chaos of conflict.
Kevin: Yeah. But isn’t it funny? We think we do. We think we see clearly at times.
David: Well, we’re grasping to understand reality, and the harder it is to grasp, maybe the harder we try and the more committed we are to our conclusions even if they’re too colored over with emotion. If you go back to the Epic of Gilgamesh, for all time there has been— I mean, we’re talking thousands of years here. A common theme from then to now has been a drive to city build, to unify, to homogenize. So you’ve got the autocratic versions of that city build being expressed by Putin and Xi, and that’s not an antidote to the Klaus Schwab version of city building, city builders.
Kevin: Everybody thinks they’ve got the right answer. Everybody builds their own city to say, “We built this city.” I guess since you brought up rock and roll before, I guess we can’t forget that. But everybody feels like they’re building their own city as the solution. If it’s the World Economic Forum, we’re told, “You will own nothing and be happy.” That’s the city that they want to build.
David: Yeah, but that’s kind of like the Gramscian version. And maybe it’s easier to resent Gramsci. It’s more subtle. There’s some manipulation. There’s undercurrents of control, but it’s less obvious. But if you look at the score again on that Democracy Index, 124 for Russia, 148 for China. That says something. That says something about the lack of political engagement, about the lack of due process, about the lack of freedom of expression, about the lack of general civil liberties. So to resent manipulation and control is one thing. I get it, you may not like the Gramscian version. But to ignore domination and control and treat it as superior alternative, when I heard the client say that, I thought, “That carries with it a tragic forgetfulness, a very dangerous form of 20th century amnesia.”
Kevin: We talked about the duration this incursion can take with Putin being in Ukraine and how long Russia can actually pay its debts. You brought up last week that we had a critical maturity coming. Did Russia step up to the plate? Did they pay their debt when that maturity came?
David: All but two issues. So the majority of last week’s bond obligations were paid by the Russians. Financial Times reported that two were not. And so, now we enter the 30-day grace period. You’ve got sanctions, which are kind of a state’s way of playing the game of chicken. You engage your opponent in a bet. You’re matching willpower and determination, and maybe even matching pain thresholds to see who can tolerate the changes. And some of those changes, some of those sanctions, end up having a boomerang effect, they can come back to you. But the big concern is with $150 billion in private sector obligations that Russian companies have. These are loans and bonds of corporations that are denominated in other currencies.
So when the ruble loses 50% out of its value, because it has to be paid back in the foreign currency, the burden to pay back that debt in foreign currency terms on a 50% devaluation increases by 100%. So the incentive to default increases. And this is a curious case of Western countries actually putting their own financial operators at risk vicariously through the sanctions. Because, see, who owns that $150 billion in debt? A lot of it is US banks, financial asset owners, European banks. And so, when we increase the probability of default, who does it hurt worse? The Russians who no longer can gain access to the credit markets? You look at the history of sovereign defaults, and actually it’s only a few years before you’re allowed to come back. In some instances, there’s no time lag at all before all is forgiven, all is forgotten, and bankers are willing to lend again.
Kevin: Don’t cry for me, Argentina, Argentina, Argentina.
David: That’s right.
David: That’s right.
Kevin: All right.
David: The countries in Central America that tried to honor their obligations were the ones that suffered the most over the longest period of time versus just defaulting and walking away. Maybe it’s a little bit different with corporations, but I doubt it. I doubt it. So again, there is a curious case of financial operators being put at risk, US financial operators and European financial operators and banks being put at risk through these sanctions. So are the sanctions going to have teeth or no teeth? That’s the question. Will the sanctions be effective? Clearly the devaluation, which has already occurred, suggests they are very effective. Although, who’s it impacting the most? It’s highly impactful for all Russians, we know that. With the devaluation, there’s no way of avoiding the cost. Life is, all of a sudden, much more expensive. But as we’ve talked about in terms of food security, there are a growing list of people who are fodder, if you will, in this process. It’s not just the perpetrators of chaos that are caught up in it, but there’s some unintended consequence here too.
Kevin: One of the things that we’ve been able to do is run a world with no interest here this last decade, virtually no interest, artificially low interest on all government debt, even corporate debt. I mean, yeah, junk bonds paying what Treasurys used to pay recently. But with rates increasing, I mean, I think about Russia having to pay back with the devaluation of the ruble, that devaluation is costing them twice as much when they pay back their debts on bonds. But all of us are going to be paying a lot more, including our own government, if rates continue to increase, and they have to. I mean, the Taylor rule, we’ve talked about it, you’ve got to have interest rates at some point that are above the inflation rate or you have a runaway inflation environment. So with rates rising, what is going to be the change as we move forward?
David: Yeah, this is the hope and prayer, this is the hope and prayer of central bankers is that inflation comes back down and they can look at a much more modest number implied by the Taylor rule. Instead of a 9% number, maybe it’s Larry Summers at 5%, maybe it’s James Bullard from the St. Louis Fed at 3%. But rates, probably the most consequential change from last week came from Jerome Powell, who finally took us in a different direction. We’ve been almost three-plus years, 39 months, since an increase in rates, and massive expansion in balance sheet. So you had two people step out last week and make a significant shift. Consequential change came from Jerome Powell and also from Liu He, Vice Premier and Xi Jinping’s top economic advisor. Liu He intervened in last week’s market meltdown.
I mean, we watch the indicators on a daily basis, Kevin, and to see the meltdown occurring in Chinese bonds where just as recently as September, a bond is yielding 6% and now it’s yielding 30%. I mean, we’ve talked about Evergrande, bond yielding 60%, which is pretty darn bad, now yielding greater than 100%. I mean, you’re talking about a complete financial meltdown in the developer bond segment, and it’s growing, right? We started to see technology shares sell off. You had declines of between 30 and 50% in one week. Chinese equities were basically moving towards a nasty, nasty outcome.
And so, you have verbal intervention in the middle of the week, in the middle of the market meltdown. It reverses prices dramatically in Chinese equities, brings the corporate debt markets back from the brink. I mean, they’re still ugly. They’re just not as ugly as they were. So on a relative basis, they’ve improved. On an absolute basis, they still look like the walking dead.
Powell’s impact was less dramatic but it was still truly meaningful as he reversed a three-year course of easy money. Interest rates have been artificially suppressed that entire time. Federal Reserve balance sheet has more than doubled to accomplish that feat, from 4 trillion to just shy of $9 trillion on the balance sheet. Ironically, last week he is talking about ending QE, shrinking the Fed balance sheet, and increasing interest rates, and yet he did add something like $43 billion to the balance sheet last week. So watch what they do, not necessarily what they say. Will they ultimately shrink the balance sheet? I think that’s the plan. At least that’s the job-owning part, the verbal part.
Now, to normalize the balance sheet and the interest rate market will be easy, we’re told, we’re told. And inflation is going to be manageable, and it’s expected to return to low levels quite soon, they say, they say. And the economy is strong and expected to remain strong for some time. That’s the position that they hold. And of course, unemployment is low and may, in fact, go lower. That is what is believed. It’s a perfect world. It’s a perfect world of simple inputs.
There’s so much confidence packed into this because there’s powerful means put at the disposal of the central bank community. It’s no longer a question of what might go wrong. Nobody cares. Kevin, this is what’s remarkable, well, what could go wrong here? What a silly question to ask. What an absolutely ridiculous notion. There are tools for every possible outcome, probably tools for market stability, even the case of nuclear war. At least there’s the posturing and the rhetoric to support that.
Kevin: Dave, you’ve done many dangerous things, but have you ever been with somebody who’s with you who does not understand the danger and everything they’re saying has to do with everything being fine, and no, this is no problem, I’ve done this many times, and you know that you need to get out of the situation because the person is either deluded, insane, or lying? Remember when you brought up the recession, nine out of the last 11 tightening cycles? Who was it that was talking about that?
David: Alan Blinder.
Kevin: Yeah. Yeah. Well, it sounds to me like it doesn’t match what Powell was saying at all.
David: My good friend Jerry Root, who introduced me to Tomas Sedlacek— Actually, if you look at the introduction to Sedlacek’s book, he thanks Jerry for letting him finish the book in his basement there in Chicago. Jerry Root used to say, “There’s two kinds of people in the world. The people who are goofy and know they’re goofy, and the people who are goofy and don’t know it.” It’s that latter category that’s dangerous. And that’s the reality, is self-knowledge is something that’s so important to living life well, but also not damaging other people’s lives as much as we would otherwise. This goes back to the Ancient Greeks. I don’t even know how to pronounce that, I just know how to spell it. G-N-O-T-H-I, gnothi seaton, S-E-A-T-O-N, know thyself, know thyself, know thyself. It’s a theme that gets played out throughout history in tragic ways. That, I think, is one of the things that is missing. There is an assumption about who we are and the way we operate and what we can accomplish, and it lacks a bit of realistic self-knowledge, self-reflection.
Kevin: Well, talk about goofy, remember what Bernanke said right before the global financial crisis?
Kevin: It almost sounds like what Powell’s talking about right now.
David: Exactly. The Federal Reserve is not currently forecasting a recession. There’s January 10th 2008. So you go back to the global financial crisis, we’re on the cusp of one of the worst financial debacles we’ve seen in the US or global financial market history, and the Federal Reserve Chief, Ben Bernanke, says, “The Federal Reserve is not currently forecasting a recession.” And they’re not forecasting a recession today either.
Most of the time you’d be right in not forecasting a recession. But just before a recession occurs, you’d hope that a cadre of 600 PhDs can see something developing. And so we go back to that Blinder comment from last week on the Commentary, nine out of 11 tightening cycles preceded recessions. You start to tighten money and credit, and there is an impact in the financial markets. There’s an impact in the economy. The only two exceptions, ’66 and ’44, were unlike the current circumstance. Today we have higher inflation, which translates, in combination with financial tightening, to a virtual guaranteed recession. And then you have yield curve inversions as further confirmation of recession just around the bend. But nobody in the Federal Reserve’s talking about it. It’s not currently forecast.
Kevin: Yeah. And for the person who’s listening who maybe doesn’t watch yield curves all the time, there’s a simple statement that a short-term interest rate should not be as high as a long-term interest rate. When the short-term interest rates exceed long-term interest rates, that’s almost always a signal of recession.
David: That’s right. So yield curve inversions, you’ve got the three years— This is, again, US Treasurys. The three years are above the 10. The five years are above the 10. The seven years are above the 10. The sevens were actually the first to flip last week in terms of the inversion, which was kind of interesting. The threes are above the fives. So with history showing a clear path towards recession, again coming back to this notion of tightening cycles preceding recessions, and now you’ve got the yield curve providing corresponding data to support that conclusion. All you can conclude is that market apathy is unreal.
Kevin: Market— Oh, are you describing a market where— Okay, let me just put some words in the mouths of maybe some of the listeners right now. It’s like, “Yes, yes, yes, yes, yes. Okay, so you talk about war, you talk about recession, you talk about inflation, you talk about food shortages. You guys are just a bunch of naysayers. I’m staying in the stock market. It’s always paid off. I don’t see at all where you’re going to be right on the market.” Now, obviously I’m overstating this, but we’ve got a lot of people that we talk to who are like, “Yeah, it looks bad from one respect, but I sure like the returns that I’ve had in the stock market the last four or five years.” So what’s your thought on that? Is that apathy, Dave, or are they just being pragmatic?
David: Returns are based on your purchase price. So if you underpay for an asset, you’re going to make money. If you overpay for an asset, you’re going to lose money. There’s no two ways around it. Valuation matters because the trajectory of your personal returns are based on what you paid for the asset. So unless you’re a trader, in and out in two seconds, value matters. How is it that the S&P 500, the Dow are less than 10% from all time highs with war in Europe, with recession in the US around the corner, with a Chinese financial system that requires a do-whatever-it-takes promise from the powers that be? I mean, this is apathy that I don’t know has ever been measured in this scope and scale.
Kevin: Okay. So let’s talk about interest rates because oftentimes interest rates are signaling what people see ahead. I was talking to Morgan, one of the analysts that you have working for McAlvany Wealth Management, Dave, and he said, “Built right into the interest rates is the knowledge that they’re not going to be able to continue to raise rates for long before dropping them back again.” What do you say to that, where we see higher interest rates right now, but with the thought that there’s no way the Federal Reserve’s going to be able to continue and, I guess, man up to the interest rate that we have to have to match inflation?
David: Yeah. So Bullard, that is the head of the St. Louis Fed, suggests that rates should be north of 3% by year end. Larry Summers raises that number to 5%. I mean, indeed, they need to be higher than that to tame the inflation beast. We’ve talked about the Taylor rule and what that implies about interest rates, the Fed funds being upwards of 9% to tame inflation as we know it today.
Last week we go from this range of zero to a quarter of 1%. But again, we’re like locked on the floor, zero to a quarter of 1%, 25 basis points, to a new range of 25 to 50 basis points, a quarter percent to half a percent. That was last week. The question remains if there would be an impact in the financial markets from, let’s just take Bullard’s number, 3%. So if we’re currently at max 50 basis points, adding 250 basis points to get us to three, this gets interesting.
Kevin: What does that cost? Yeah, what does that cost?
David: Jim Grant points out that only 23.7 trillion of our federal debt is held by the public, right? So—
Kevin: Only. Only.
David: Interest rates, instead of the 30, reduce it back to what is owned by the public and what is going to be impacted by an increase in rates. So interest rate increases only really impact that portion. And he says that each percentage point increase boosts the Treasury’s servicing costs by $237 billion. For a sense of scale, total government spending on Veteran benefits and services amounted to 236.3 billion last year. So thanks, Jim.
But you look at Bullard’s goal, and it implies a gradual shift in interest costs, weighing in at, again, two and a half percent from here. That’s almost $600 billion in added annual interest expense. I mean, I like Larry Summers in some respects, but I’m not exactly sure how we raise the fed funds rate to 5% as prescribed. Not sure that even that is enough to tame inflation. But you know what the cost is? I mean, you’re talking about an extra trillion dollars in interest expense to do what he’s talking about.
Kevin: And this is why you have to call this— they are completely caught between a rock and a hard place that they’ve created themselves. Because as you increase interest rates to fight inflation, you’re not going to be able to tax all that from the people. And so, if you can’t tax it from the people, you’re going to have to print it. Well, that creates more inflation, which means you have to raise interest rates more so that you can fight inflation, raise interest rates that you have to pay on that debt. And then you have to print more money, which raises inflation. I could go on and on and on. It’s a repeating feedback loop, Dave, that ends— How does it end? Poorly.
David: Well, it does, because as we mentioned earlier, it really is just taking the oxygen out of the room. And you can’t expect to operate at a more powerful level with less oxygen. As an athlete, it’s something I’m sensitive to. When you start competing at 10,000 feet or you’re climbing a mountain and you’re 14,000 feet, the air is thin, you can’t push it as hard. And yet we want to push the economy as hard as we ever have, right? You just can’t. You can’t. Yes, there’ll be a consequence in asset prices.
And to Morgan’s point, the bond market is far more wise. They have the ability to see the future a little bit more clearly than the equity market. And at this point, the bond market would say, “Yeah, rates will come up before they come down again, because you can’t possibly bear the toll of a half a trillion dollars or a trillion dollars in added interest expense.” That’s a reality that is too much to bear. So the markets can try to ignore a war in Europe. The markets can try to ignore the beginning of a tightening cycle and what that implies in terms of recession. They can ignore overvaluation and a variety of asset classes, but to the degree that they do, the participants in this marketplace are living in fantasy land.
Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany. You can find us at mcalvany.com, M-C-A-L-V-A-N-Y.com. And you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new addition of the McAlvany Weekly Commentary.