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- Iran has been “feeling empowered by its perception of U.S. weakness”…
- Petrodollar system is clearly changing – we now loan ourselves what we borrow
- Did the U.S. strike before Israel? Saving us from full scale war?
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Drone Strikes, The Petrodollar, and “Politics By Other Means”
January 8, 2020
“It’s difficult for an American to conceive of an ounce of gold trading above $2,000, $3,000, $4,000. And yet, where was the yen just a few years ago? Where was the rupee just a few years ago? Gold, in essence, is not going up. It is marking the gradual decline of all paper currencies, moving toward their intrinsic value, which we know to be zero.”
– David McAlvany
Kevin: In 1989 it was interesting, August of 1989, I remember reading in the Wall Street Journal how Saddam Hussein had amassed his Republican Guard – 200,000 men up on the border of Kuwait. It was like, “Wow!” So many people were shocked by that, but actually, being a gold broker in 1989 gave us a little bit of insight ahead of time, Dave, because in February – I can’t remember the months, but three or four times we saw the Saudis buying massive amounts of gold. They would first hit the market, knock it down $20-30…
David: Which was about 10% of the market back then.
Kevin: But then they would come in and buy three to four times the gold. So I remember calling clients and saying, “Hey, maybe they’re preparing for an oil embargo or something that we had seen in the 1970s. Now, looking back, we saw that they were preparing for war. I look at 2018 and 2019, and one of the shocks that people are watching is that central bankers who are trying to manage the perception of the people that everything was fine, were setting records as to how much gold they were buying. Isn’t it interesting? Tensions changing in Iran, we have things coming about in the liquidity markets. I’m wondering if we saw the preparation in 2018 and 2019 for what we are now seeing in 2020?
David: Oftentimes over the last eleven years – we’re entering our 12th year, can you believe it?
David: This dynamic of there being something in the financial markets which has an economic impact, so a financial crisis, becoming an economic crisis, becoming a political crisis, and then ultimately becoming a geopolitical crisis. It’s because there are relations between these different areas and implications. When one thing happens, how do policy-makers respond? And it is not new, although we can think about central bank policy and perhaps the creative uses of central bank tools here in the last few years. But Clausewitz used to say, “War is a continuation of politics by other means.”
Kevin: Okay, for example, we have had guests on our show from STRATFOR and from some of the intelligence services. I remember reading in late December a report about tensions in Iran might meet a head in 2020, and the reason they were going to come to a head was because of the uranium enrichment. And sure enough, it wasn’t but a few days later that we saw tensions come to a head.
David: And certainly we have seen the efforts by central planners to kind of hold the status quo in place, and that is where, again, I think you see creativity applied. The human mind and problem solving applied to maintenance of the status quo, and ultimately, this reality that you can’t hold onto it. There is change, there is cyclicality, and war may very well be a natural next step, whether it is this year or in future years. What we have is central banks that are exhausting what they can do in terms of monetary policy.
Kevin: Controlling the narrative – let’s just call it what it is. It’s controlling the narrative.
David: And I think where we see war as a continuation of politics by other means, perhaps being front and center 2020, is that if it becomes politically unviable for a major helicopter drop. If you have that idea of a massive fiscal spend and some version of modern monetary theory in application, if that becomes nonviable – you just can’t get it passed, you can’t spend the dollars to replace the footprint in the marketplace of the monetary policy, tools that have been so frequently used the last 5, 7, 10 years – then I think war does become that natural next step.
Kevin: Let’s just go back to September. There were two things in September that were really interesting. One is that Iran took out about half of the oil production for Saudi Arabia. That was one thing, but at the same time, we found that we, really, are no longer able as a nation to borrow money. You said a couple of weeks ago the Federal Reserve has been buying, since September, 80% of all of our U.S. treasury debt because we’re not paying enough interest for it, Dave.
David: Yes, I think what you mentioned on the Saudi attack is really interesting because it was brazen. That was September 14, and the Abqaiq oil facility, that impacted Saudi production in a significant way. It impacted global oil supplies to a significant degree. And yet, how did the oil markets respond?
Kevin: Not like the old days.
David: No, exactly. Beyond a two-day micro-reaction, there really was nothing. And then this last week we had the assassination. I guess for those with more sensitive ears it is a “targeted strike” but the assassination of a top Iranian general while he was in Iraqi soil. Arguably, this is an event that, according to General David Petraeus, is more important than the elimination of Baghdadi or Osama bin Laden, either one of them. Again, how did the oil markets respond with there being the likelihood of a continuation or an escalation, if you will, in conflict between the U.S. and Iran?
Kevin: Well, if you look at the Persian Gulf wars – pleural – you could go back and say a lot of that had to do with our dependence on the oil that is coming from the Middle East and the protection of the petro dollar. Granted, there were other issues, but we can go back and look at oil wars. Something seems to have changed at this point. The markets are not being influenced nearly as much by the threat to Middle Eastern oil.
David: Yes, and I think this is really key for anyone wanting to appreciate some of the structure, the structural issues in the backdrop here. Something has shifted in the structure of the oil supplies, and I think there are a few important contextual issues worth keeping in mind. The first thing that comes to mind is Israel. It is possible that U.S. action here in recent days prevented an escalation in the Middle East.
I know that may sound odd on the face of it, because it looks like escalation if you look at the last ten days to two weeks, and in that time horizon there is an obvious tit-for-tat between U.S. forces, the President, and whether you want to categorize them as Iraqi protestors or paramilitary or what have you – the mainstream media has decided to call them mourners – but we have had an escalation, obviously.
But stretch it back six months and the picture is a little different. And it is even more so if you count back, say, five or six years, and you begin to see the U.S. silence in the face of poking and prodding from the Iranian quarters.
Kevin: Yes, that report that we read was from late December, before the strike on the Iranian general. That report said that if it doesn’t come to a head with the United States, it certainly may with Israel. Now think about that. What would that have caused if Israel had done the same thing that we saw last week?
David: So if Israel was close to a targeted strike, which could have caused World War III, then the U.S. pre-empting such a strike may well have prevented a larger scale ideological conflict.
Kevin: Part of this report, as far as the tensions with Iran, actually had to do with uranium enrichment, which is going to be right in the backyard of Israel.
David: Yes, anytime you have an escalation and it involves Israel it’s because there is some sort of existential threat. And the uranium enrichment program at Natanz, those facilities, increased considerably in the 4th quarter of 2019.
Kevin: So they weren’t keeping the agreements, period, even though they said they are now not going to. They weren’t.
David: There were limits, and they were monitored, and then they blew past those limits in the 4th quarter, and then they also began operating centrifuges in Fordow, where Iran was not permitted to process uranium. That also got started up in the 4th quarter. Again, what that started was a timeline to breakout in weapons development as soon as April 2020. So you have the quantities of enriched uranium being produced. They’re on a trajectory that is uncomfortable for Israel, given the timeframe to weaponized viability.
Kevin: You know what surprised me about the news of last week was the reach that Iran has into other countries. I don’t think I really realized until recently just how much Iraq is influenced by what used to be a former enemy. You remember the Iranian/Iraqi war back in the 1980s? When I first started working for your dad back in 1987 those two countries were going at it, and now what we have is Iranian influence, especially in the Shi’a world, into Iraq.
David: We’ve had some sort of conflict with the Iranians going back to 1979. Our state department was far more involved in bringing Khomeini into power and overthrowing the Shah of Iran than many would readily admit to. But the Shah, Reza Pahlavi, was taken out by the U.S. State Department, and we replaced him with someone that we thought would be friendlier to us.
Turns out that we ended up with something of a firebrand, someone who had ideology and a passionate heart for bringing in the caliphate. So from 1979 to the present, we have had sort of proxy fights, and that’s where you see, on a regional basis, Iran shows up and they have different iterations and they have sponsored different conflicts throughout the region.
Kevin: It’s like the Soviets 40 years ago during the Cold War, what you have is Iran who is reaching into other countries like Syria and Lebanon and Iraq.
David: And most recently it has been Iranian extension of power through local militias in the region and then you have, of course, their missile distribution. This also, is, again, sort of tapping the existential nerve for Israel because distribution is into Syria, it’s into Lebanon, it’s into Iraq, and the weapons development timeline in Iran on the nuclear side is critical, both to the Saudis and Israel. So Israel was already in an act of engagement with air strikes in Syria and in Iraq and in Lebanon starting in the summer, so they have been very proactive, you could say. That is being continued at the present time. Iran, in that context, if we go back to June/July of this year and then fast forward to last week, Iran has actually showed an extraordinary amount of restraint in light of the Israeli strikes.
Kevin: Does that have anything to do with their ability to deliver delivery types of weaponry for this upcoming nuclear power?
David: I think there is a bigger reason, there are bigger goals in mind, and sometimes you sacrifice the small things to get the bigger things. And so Israel has been in escalation mode for six months, particularly as you have seen greater accumulations of ballistic missiles built up in Iraq, supplied by Iran. And so what we did, and what Trump did, basically, if you’re going back to sort of the old Persian chess board, he changed the pressure on the board.
Kevin: He also drew a line in the sand, or at least, Pompeo did, because it was expressly communicated to Iran that if Americans died there would be retaliation.
David: Which is funny because the American red lines, if you go back over the last ten years, that’s why I think this is really kind of a significant shift in the foreign policy field, because over the last ten years our red lines have been something of a joke to the global strongman population. It doesn’t matter if you’re in North Korea, or the Middle East, or wherever you are, but Trump is, I think we’re safe in saying, less diplomatic by nature.
Kevin: And actually, less predictable. We’ve talked about this before, but really, it is hard to predict Trump’s next move. And that gives him an advantage in business and politics, and, in this particular case, strategy.
David: And I think it is read as being unhinged and out of control, and he may very well be unhinged and out of control, but there is a strategic advantage to being unpredictable and I think he is going to get some of the benefit of that. STRATFOR has described it this way: Iran has been feeling empowered by its perception of U.S. weakness. And I guess that’s the point. The red line actually stuck this time, an American contractor was killed, and with the assault on the embassy, enough was enough.
So we end up with a targeted strike on Iran’s number two man, and we have a show of strength, we have – and this is, I think, really critical – a psychological recalibration amongst every autocratic regime out there. So if they had any sort of defiant attitude or dangerous agenda vis-à-vis our foreign policy priorities, then, again, this is another recalibration. What was communicated was that the U.S., at least on Trump’s watch, will not tolerate another Benghazi.
Kevin: We’re not just talking about Iran, we’re not talking about Iraq only. We’re talking about terrorist organizations and ties to them – Hezbollah. If you’re Israel, you’re looking north and you’re saying, “Hezbollah hates us, they want to see us eliminated,” and guess who is supplying the supplies?
David: Right. Hezbollah’s Secretary General in a recent speech was discussing the vital role that Soleimani played in every battlefield in the Middle East. He described it as being important to Gaza, to Lebanon, to Syria, to Iraq, to Yemen, to Afghanistan, and of course, Iran. This is a guy whose importance was recognized.
Kevin: Out of their own mouths.
David: Sure. And Israel could have, and I think would have, taken the shot, so to say, but also certainly would have brought the entire Muslim world down on their heads had they done so. So Trump does that instead, and it communicates in a language that is very easy to translate, and it is unencumbered by diplomatic double speak.
Kevin: And what other countries are watching? That is what I’m wondering, too. Is this a message not just to the Middle East?
David: Yes, so you have Iran which can translate the message, you have Korea which can translate the message, China which can translated the message, Russia which can translate – everybody can translate. This is not from the White House, but from the State Department, where they said, “We can confirm in the past several days General Soleimani has been traveling in the Middle East coordinating further imminent large-scale attacks against U.S. diplomats and service members. These threats were highly credible and the intelligence sound.”
I’m not here to make a moral argument for what was done, but I think one of the critical things that I come away with is that there is a change in the structure of the oil market such that something that ten years ago, or certainly 20 years ago, would have taken the price of oil up $30 to $40, to $100 a barrel, barely budged the market. And that’s really where I’m going to focus in on our thoughts today because I think it’s worthy of note that the nature of warfare has not changed, but I think the presentation is getting more direct. So maybe it was more obscure, but today we have no qualms with sort of directly attributing this as a call from the White House.
Kevin: Let’s just look at that, because what I’ve heard from the press is, “How could Trump do something like this? The guy wasn’t even looking.” And if you go back to the Obama administration, drone strikes are not new. In fact, I have a friend of a friend who is a drone pilot, I will tell you, he is very, very sober about his job. There is no flippancy to these types of strikes. There is an awful lot of thought that goes into it. These guys are not just shooting at anything.
David: No, and I think what is here, again, is not a change in the nature of warfare as much as it is, this is overt versus covert action. And generally, Americans are not upset by things that they don’t know about. For instance, Obama ordered 542 drone strikes. And not a one of those was with the approval of Congress. The estimated death toll was just under 3800 people. From those White House directed drone strikes, 324 civilians estimated dead amongst the 3800 people.
My point is not to shift the conversation to domestic politics, but to say that as long as it is covert nobody cares, but if you make it overt now there is a big kerfuffle about what it means, and how we’re changing, and losing our country, and everything else. This was a high-ranking military officer. Yes, it was an assassination, and I think it definitely sets a new tone for statecraft in the 21st century, so I certainly have my concerns. But drone attacks are not new.
Kevin: Last night when we were meeting, Dave, because we have our famous meeting the night before we do the Commentary, we started talking about paradigms and zeitgeist, and how we, ourselves, have to watch and shift as things change. I’m very much a Cold War kid, and you were, too. I remember what the Cold war was, how it shaped the way we thought. Now things have shifted. I think later when I first started at ICA the first 20-25 years, war really was about the petrodollar and supplies of oil from the Middle East. Now, myself, I have to change my paradigm and say, okay, maybe it’s not about the supplies of oil anymore. Maybe it’s about something else.
David: There are two movies that I grew up watching, probably too much. The first movie was The Wizard of Oz, and the reason we watched it so often was because when we got a VHS machine it was the only tape that we had, and so we just watched it over and over and over and over again.
Kevin: Did you know that the original book was written about the gold standard?
David: Absolutely. I didn’t know that at the time.
Kevin: I’m not trying to get you off the subject, I already know what the second movie is.
David: The second was Red Dawn.
Kevin: Right, D-o-n, your dad.
David: That’s right. So I watched that with my kids for the first time this weekend. No coincidence, I wasn’t trying to tie it in, it just happened to be top of mind, or whatever. So we watched it, and they couldn’t really imagine this world, this pre 1989, pre-fall of the Berlin wall where everyone would be concerned with communism. It just seem odd.
Kevin: An existential threat into the United States. That’s what that movie was about.
David: But as you said, there are paradigms that exist, and we operate and live our lives in light of these paradigmatic structures. And so that’s what we’re stuck with. To the degree we can, we need to be engaged with the world that we’re living in, but also sort of separate out the modern zeitgeist and figure out if the dominant thinking of that period is accurate or not. So can you live in the world and yet not be sucked into the mindset of the world? Can you still appraise things on a fairly objective basis? I recognize that there was a world pre-1989 which did not allow me to see anything but an inevitable crisis as it related to the Reds.
Kevin: So let’s look at the world now. The United States can provide most of its energy needs without the Middle East, so we have to think differently.
David: And I’ve read a fair bit in recent days where writers are trying to fit the Iranian event into a particular paradigm – it’s kind of the oil politics frame, where we need control of Iraqi supply. This is why we’re doing what we’re doing. And we don’t want to see Saudi compromised in its regional role, so that’s why we’re doing what we’re doing. And we must maintain open shipping lanes in the Straits of Hormuz, and that’s why we’re doing what we’re doing. So the critical piece here is avoiding the global supply shock and the recessionary depression which could be implicated from that. So to a degree, I think that that thinking reflects the last chapter, and not the current chapter in oil politics.
Kevin: So let’s talk about the shale revolution. How has that changed things?
David: Yes, because supply uncertainties have been a critical motivator for U.S. foreign policy in the past, because again, supply shocks, whether it is for the U.S. market, or anywhere else, they have been, at least for the time being, neutralized. They have been neutralized by the shale revolution and production growth here in the United States in recent years. And I’m not saying that the current chapter permanently insulates us. That’s not the case. But we have solved one-half of the petrodollar issue temporarily.
Kevin: That’s the supply issue.
David: Exactly. And this is by a massive increase in supply for the U.S. So we have reduced the risk of supply shocks which have long been a catalyst, or realistic theoretical catalyst for U.S., or even global, recession, or even worse depression. So there is a key risk variable here economically speaking which has shifted, and it has shifted over the last decade, and with it, the underlying need for a particular type of engagement in the Middle East. So we engage toward a certain end in the past, and I worry that we, today, are not taking our old alliances seriously enough.
Kevin: Well, think about it. If you’re Saudi Arabia and you’re used to the United States being completely dependent on your rulership of OPEC and the supply of oil, and you start, as a nation, the United States, supplying your own oil, what happens to Saudi Arabia? We have seen, in a way, they sort of feel naked and alone. Their reliance toward Israel has increased. In fact, we have even talked about the alliances toward Russia. Things do change. That chess board – like you said, the tension areas in the chess board change.
David: There are two parts to the petrodollar issue. In the old petrodollar paradigm, what we have is the requirement that we secure our supplies. And that was a priority. And it’s not that much of a priority today. But I do think, and this is, again, sort of my concern about not tending to our old alliances seriously enough in the Middle East. In the not too distant future, I think we’re going to have to figure out how to encourage peace in the Middle East, and that may be, again, with a more muscular presence there.
Kevin: Let’s redefine the symbiotic relationship that we have had up to this point because it helps us to understand how the dollar survived off of the gold standard originally. We’ve talked about this before, about the dependence on the Middle East and the monopoly of the dollar being able to buy oil. We protected the Middle East, the Middle East understood that, and so the Middle East at that point said, “Yes, any excess dollars that we have, we’re going to loan back to you.”
So we ran as a deficit government, and we knew that we have people who were going to buy our treasuries because we had the guns and we were going to protect Middle Eastern oil flows. We’ve had this conversation through the last few years, Dave. What happens when we no longer need those supplies? We still need them to loan us money.
David: The classic devaluation scenario was observed in the mid ’60s and the late ’60s by Jacques Rueff, who was advisor to de Gaulle in France. He had seen a massive devaluation in Britain in the last 1920s. He was financial attaché in Britain at the time as a young man. So he is writing about deficits without tears. He is concerned about major deficit spending in the United States, and ultimately devaluation of the dollar. So the French actually did start pulling gold out of the U.S. And they were right. We were in the process of a massive devaluation of the dollar.
As you said, what saved the dollar at the time, and we sort of lived off of the merits of this petrodollar system, was kind of a dog and pony show through the Middle East convincing our oil suppliers to trade and settle trade contracts in U.S. dollar terms. What that did is it put dollars in their pockets. We’re buying oil, they’re stuck with greenbacks, and they have to do something with the greenbacks. They recycled them into U.S. treasuries and we solved two problems in one. We found a captive audience for our treasuries, and ultimately, stability for the dollar. Otherwise, we would have been in a period of sort of terminal decline for the dollar at that point.
Kevin: That system required tension, and one-half of that tension has been not completely eliminated, but reduced by our technological advances, enabling us to get oil shale.
David: Exactly. So we have kind of leapt into a technological benefit which gives us short-term surpluses in oil here in the United States. I say short-term because I don’t think that is long-lived. But that doesn’t mean that we have solved our debt market issue. This is the other side of the equation. This is the other side of the petrodollar equation. Recall that you have the valuable intertwining of U.S./Saudi relations, which tied the flow of the commodity to, ultimately, demand for U.S. debt. And as demand for one product, specifically, Saudi and Middle Eastern oil, has diminished, guess what has also diminished? The demand for the other part, U.S. treasuries.
Kevin: There is a name for that. The name is petrodollar recycling.
David: That’s right. Essentially, that has been grinding to a halt, and it has forced a very different style of international relations. What we have seen in the last few days is, this time I think, a very strong message, an overtly communicated message – international relations through violence. And it is worth considering what the longer-term issues of dollar dethronement might be, because the measures brought by interested parties, whether it is the U.S. government or the military industrial complex, or what have you, to fight against that ultimate dethronement of the dollar, I think will be considerable.
Again, foreign policy may get very unkind for a time, and we may have just seen the first major example of that, where, “Covert? Let’s forget that. What are we going to do? We don’t like you, we snuff you out.” So just as the markets, if you look at the stock market of late, there really hasn’t been much violence. It has been fairly peaceful and calm, and volatility, if you go back to 2017, 2018, 2019, there hasn’t been a lot going on except for the price of everything going up, and that trend may be over. Again, the sort of greater viciousness in pricing, we certainly anticipate that, and so also for foreign affairs. This could become more like a street right and less like a sort of cocktail party with canapés and champagne and passing Hors d’oeuvres and what have you.
Kevin: You had mentioned that Clausewitz had said that war is a continuation of politics by other means, but actually, the last decade or so has seen that central bank policy is a continuation of politics by other means. There has been a smoothing out. It is a different form of warfare. We have used our treasuries and access to SWIFT transfer systems, that type of thing, to keep the violence from occurring, or maybe to smooth things out, but that doesn’t seem to be working quite to the extent that it was this last decade.
David: Just as we saw things changing in the 1960s and a few people perceived the significance of it and started to take action, and it ultimately required Kissinger and his team to pull off some pretty major things, instituting the petrodollar and that recycle program, I think it is very convenient that over the past ten years we have had the global central bank community which has acted in unison. And they have acted in unison monetizing debts. The significance of that has been there is less immediate consequence due to their uniformity of action.
Again, we’re talking about currencies which don’t have any solid anchor, no absolute reference point for value, they all trade on a relative basis. And so the uniformity of central bank action means that there is less relative consequence. So when you are comparing them, you really don’t see the issues. The global economy has rebounded over the last ten years – not on a massive scale, but it has rebounded over the last ten years since the global financial crisis.
And yet, central bank asset buying in that same timeframe has been immense. In fact, if you compare the growth of central bank balance sheets, the total scale of central bank balance sheet growth, a true measure of monetization, in fact, that artificial demand for debt, central bank buying, monetization, that number exceeds the total growth in global GDP over the same timeframe.
So what have we done? We talk about a growing economy when, in fact, we’ve just basically bought it by monetizing debt. It was debt, not actual true growth, and that debt wasn’t bought by a real buyer, it was monetized by central banks. This is extraordinary.
Kevin: It’s like paying for a credit card with a credit card.
David: So you have artificial sourcing of demand. This is, again, sort of the last chapter, the last ten years, and it has proven to be of little consequence. Actually, it is massively consequential. I want to make very clear, it has proven to be of little consequence because there has been no real financial market pain to this point, but it is massively consequential and it, at this point, has yet to yield systemic financial market pain, but I think that is the next chapter.
So the last chapter is, central banks have been able to sort of smooth what we the decay of the petrodollar system by their actions in the marketplace, because the second component of the petrodollar recycling is, who is going to buy our debt? Well, lo and behold, maybe it’s sheer luck in terms of the timeline, central banks were all buying their own debt, and so it didn’t show up that there was a vacuum of interest in the market for U.S. dollar-denominated debt. In fact, we lowered rates in a cycle, in a period of time where ordinarily you would have seen an increase in interest rates.
Kevin: Let me make sure that I am understanding this right, because I think this is important. We’re talking about paradigm shifts and being able to shift our thinking, and I’m having to work at that myself. We went from a gold standard under the Bretton Woods system that started to fall apart in the late 1960s. Jacques Rueff pointed that out, de Gaulle figured it out and also started taking gold out of the United States. We went off the gold standard in 1971 like they thought they thought they would.
But we went to an oil petrodollar standard where we were getting our dollars recycled back. As long as the oil producers would come back and loan us the money back, then we had a symbiotic agreement. Now we have moved to another realm where the last decade central banks have been coming in and instead providing that. Now what is the next step, Dave? Who buys our debt because the central banks – we should have seen it. This last few years – actually I said the last two years were record-breaking for central bank buying of gold, but if you look at the last 12 years since 2008/2009, the central banks have been buying more gold for their reserves than they have been selling.
David: I would just change the sequence of that a little bit to go from the gold standard to the Bretton Woods system, then to the petrodollar standard. And then, really, in the interim we had sort of a trade dollar recycling issue with the Chinese where we’re buying so much Chinese goods, and they’re doing the same thing. They were recycling, buying U.S. treasuries, as well. Well, that has begun to come to an end, too, but in the interim, as the petrodollar system has wound down and the trade recycling system has come to an end, monetization has filled the gap and we have yet to see the consequence of monetization. But everyone is assuming that this is normal.
So what really has maintained order? I guess I’m talking now about political order. In the post World War II world, it has been us. It has been a military force which has no equal. You can go throughout the Cold War, and I guess that was questionable because the arms race with the Russians implied that an equal either existed or was emerging to challenge U.S. hegemony.
Kevin: That was a decision by Rand Corporation as far as making sure the public understood that there was a threat that was equal to our own, so that we could continue the arms race.
David: And this was the point of the conversation over the weekend where I was explaining to the kids that we did something that, from a fiscal standpoint, was objectionable. I remember conversations around the dinner table with my dad, and he was livid that the Reagan administration would double the national debt. And yet, had we not been willing to double the national debt, and basically spend against the Russians, we would not have bankrupted them. We would not have seen the fall of the Berlin wall, and the world could look very different today. And maybe they would have been on a course toward bankruptcy some other way on a slightly different timeframe.
But since the close of the Cold war, there has not been a real threat to U.S. hegemony. Now, I guess you could say in the last 5-10 years you have the meteoric economic rise of the Chinese, but that is a different kind of competition. It relates to the dollar, it relates to U.S. fiscal stability in a way, because again, if you look at 15 of the last 20 years, we had trade dollar recycling which took the pressure off of the U.S. Treasury to find a real buyer for its debt instruments as that petrodollar thematic was diminishing.
And so it is only as the trade dollar recycling system has sort of come to a grinding halt, and we recognize that was a phase in Chinese growth and development which was based on mercantilism, and they are shifting gears completely. So it doesn’t work for them anymore, and it’s not going to work for us. And yet, we have somehow gone gold standard, Bretton Woods, petrodollar, trade recycling, and now we’re stuck with monetization, and everyone is assuming, this is just what works. Look, since 2008, 2009, 2010, why not?
Kevin: There is no one left to loan us money but ourselves. That is the story I told about the big oven. At some point you just burn the house down to supply the big oven to keep the place warm.
David: The trade relationship with the Chinese has allowed us to ignore the diminishing role of the Middle East in financing our deficits. And now you have the overlap of muscular monetary policy throughout this period.
Kevin: QE-1, QE-2, QE-3.
David: Now QE-4, and that has obscured what was once brute facts related to our need of Saudi fiscal support as a true quid pro quo, because we take the oil from them, they take the paper from us, and in turn, to keep the system of regional stability in play, what we did is we guaranteed our assets. We would say, “Look, you’ve got a carrier fleet on call, we’ll put in local bases, we’ll provide direct arms sales.”
Kevin: Well, now it’s just the Fed. The Fed is like a big carrier sitting out in the water just waiting to, what? Sink?
David: This is what is fascinating, because again, bear in mind, the shift from the petrodollar system to a system directly financed by the Fed has shown very little trauma, and it is in large part due to the universal application of monetization by the big central banks. No one looks worse relative to anyone else. That is, unless you are measuring the weakness in euros, in pounds sterling, in yen, in U.S. dollars, against a truly reliable currency – gold.
Kevin: Last year gold hit new highs against most of those currencies – last year, 2019.
David: And so I think that one of the more critical messages to keep in mind as we close out the decades of the 2010s and enter a new decade, in a world of relative peace and calm over the last five years – keep in mind, that has been the context – gold had risen by a minimum of 50%, depending on your reference currency. In U.S. dollar terms, 50%.
Kevin: So that answers the question people have had over the last couple of days. Is this gold move that we are seeing right now just simply geopolitical turmoil? Is it tensions? Is it something that would not have happened had we not had that strike last week in Iraq? That’s the question in people’s minds. I think what you are showing is, this is a large scale systemic change and gold is the barometer of the failure of that last system.
David: Starting early 2019 I wanted to get on radio and television as much as possible and talk about gold, and very little responsiveness. Nobody wanted talk about it, because frankly, nobody wants to talk about things when they should be talked about. They want to talk about them after the fact, and sort of unpack what has happened as opposed to, I think, what is more relevant – what is going to, or likely to, happen. So here we are, early 2020, and again, I’ve had probably eight requests to talk about the move in gold in the last two days because everybody wants to know about gold’s big move vis-à-vis what happened in Iran. And I want to say, “Wait a minute.”
Kevin: “Where were you guys?”
David: “What are you talking about? We had a 5% move in December which predates this. We’re talking about a $50-dollar move in a matter of days, which in percentage terms doesn’t even matter anymore. Right? We had a 5% move in the month of December capping off an 18-20% move for the year, and you think the move in gold…
Kevin: In two days.
David: Is driven by – nobody cares about price, nobody cares about the market, nobody is paying any attention. So here you have the classic barometer of currency stability, that is gold, and the classic barometer of market concern, which has, over the last five years, with 50%, slowly and quietly moved and it has been prompted by central banks, it has been prompted by investor demand, signifying that there are small audiences that want a hedge on the current world system of debt-driven growth.
And these are audiences that think that is prudent. We’re not talking about large audiences, but the gold price action is sending a signal and so far, by and large, the market is tone deaf. It literally takes a missile strike, a drone strike taking out the number two man in Iran, for someone to ask the question, “What’s going on with gold this year?”
Kevin: And you’re talking about Americans. Because if you look here in America, this is so weird, when we’re talking about gold, if you were talking to the Chinese, or India, or Turkey, or Russia, or the central banks, these guys are buying gold with both hands. But you try to sell an American a gold coin right now, they just laugh. “Why would I need gold? I’ve got Apple.”
David: It’s interesting. Gold is a shiny little object, but it’s almost like it’s dulled in the minds of investors, and they can’t see it for what it is. U.S. Mint coin sales for 2019, just measuring that in ounces or tons, is the lowest in 15 years.
Kevin: In a year that gold went up 20%.
David: So the public was in the gold market aggressively buying back in 2011, and mint sales showed that. Mint sales again showed heavy public traffic in 2016, as well, but 2019 was dead, an almost multi-decade low. So curiously, when you look at even returns of mining shares, 30-50% gains in 2019, a good place to have money in 2019, and we did. The primary ETFs, these are GDX, GDXJ, they saw a shrinkage in the number of shares outstanding, and a shrinkage in money under management in 2019, actually, money leaving the space. Think about that. Gold is at 20%. Mining share investors can’t get out of their way to sell stuff and move someplace else. Where are they moving?
Kevin: And why wouldn’t I want Apple, or Micron, Microsoft? Wonderful places to go.
David: And this is, again, whether it is Apple or Microsoft, 70%, 55%, Micron up 80% this last year, and this is as the price action of gold is sending a critical signal. Just let this sink in. The price action of gold is a critical signal in this environment, and it is worth knowing that these are early days for the gold investor as we watch the trifecta of uncertainties play out over the next several years, not months. Over the next several years you have the trifecta of geopolitical uncertainty which is on display. Great, so it’s an influence. It’s not the driving factor. Political uncertainty – you don’t think we have that for 2020? Certainly we have it in 2020 and we will see how chaotic and unhinged it becomes beyond that. And financial market uncertainty, which we think is not far off.
Kevin: So, let’s go back to what the dollar used to be. We talked about Bretton Woods, but Bretton Woods was strong for three reasons. One is, we had gold behind the dollar. Two, we had this oil monopoly already in place. That was pillar number two. The third pillar was reserve currency status. Every bank in the world had to have a certain amount of dollars and they had to support the dollar when it was starting to fail. We’re seeing a migration away from that third tier, as well. We have gotten rid of the gold standard so we don’t have that. The petrodollar we have already addressed. You’ve said we’re phasing out of that. The third pillar – this reserve currency status – Dave, what if the people who don’t like us don’t want to use dollars anymore.
David: We’ve talked about central banks, and it is usually, these days, smaller or mid-tier central banks that have been doing the buying of gold as a replacement for dollar reserves. And so the dollar-based system is being diversified away from by the small and mid-tier central bankers. Investors – what role are they playing? They are merely hedging excessive monetary policies and what are soon to be fiscal policy commitments, and so in Europe you are going to see it – major fiscal spending and probably in Britain, too.
If Boris has a rough ride coming out of the euro, he does have an ace up his sleeve, which is just go spend billions of dollars domestically and gin up the economy using fiscal policy. Might have a consequence for the pound sterling, but again, who cares? If everybody is implementing fiscal policy in a way that could detrimentally impact their currency, but they’re doing it at the same time, what is the relevant impact, because monetary policy – again, the impact has been muted by the universal application of monetary policy by the big central bankers. So you have some political cover, as well, if in fact everyone is implementing the same fiscal policies.
Kevin: When you say fiscal, I just want to account for that. You’re either building a bridge, you’re fixing a road, or, Dave, you’re fighting a war.
David: Or fighting a war. But everyone who is paying attention right now, and I’m going to those investors who have begun to hedge and diversify into gold, everyone that is paying attention can see that we aren’t getting very much bang for the monetary policy buck. So the shift for the next several years will be dramatically toward fiscal spending. Smart money sees that, they know the reflationary consequences which are baked into the cake with fiscal policy spending, and we already have a very tight labor market with rising wages, even if only rising a little bit now – tight labor market, massive fiscal spending – and guess what we have? The smart money was spending a lot of 2019 repositioning. Frankly, our hard asset strategies – they’re in a sweet spot.
Kevin: Yes, but we talked about Americans. We had a question from a listener last week and I still ruminate on it because it is truly in the minds of a lot of people. The interventionist strategies of the central banks, having everybody’s back and any time one of the assets that they don’t want to fail starts to, they just go buy it. How long can that last? And are we really going to continue with some sort of artificial wind in our sails?
David: Back to gold for just a minute, because the masses have not scurried for gold.
Kevin: I think it’s for that reason.
David: Yes, and there is no sort of “the sky is falling” panic at this point. It is the minority that has taken a skeptic’s view on the current interventionist backdrop. Everyone else has great faith in the interventionist backdrop and will welcome with open arms the fiscal policy helicopter drops of 2020. Economic growth? What do we have? In the U.S. it has been anemic. Globally, it has been slowing for several years. China hit a 30-year low in terms of economic growth this last year, and we see them changing reserve requirements to add more money to the banking system to try to expand credit and lending and gin up, again, activity.
Kevin: Isn’t this growth sort of an illusion because corporate growth and corporate earnings are dropping?
David: If you’re talking domestic, yes. For 2019, corporate America, 2019 corporate earnings were in decline, which of course, seemed to drive even more moths to the flames, ironically. Investors didn’t pay attention to deteriorating fundamentals, in fact, the majority of investors are content playing momentum with stocks regardless of the deterioration in corporate fundamentals. We mentioned Micron earlier. Take Micron Technologies as an example. Earnings per share were down 84% year-over-year. Operating earnings were down 86%. They lowered guidance on revenue, lowered guidance on earnings, all for the current quarter.
Kevin: That sounds like a stock you would want to sell.
David: Micron stock – drumroll – was up 70% for 2019.
Kevin: And you said momentum. Momentum investing – we have all known people who come to you and say, “You need to buy this.” And it’s like, “Well, why?”
David: It’s insane.
Kevin: “Because it’s going up.”
David: Deteriorating fundamentals. You can’t get out of the way of Micron’s success except when you look at their inventory levels, when you look at their business, what they are booking, and sales, this is a problem. This is a very big problem. And yet investors would say, “What problem? The Fed’s got our back.” So the fact that gold was up in 2019 was not just convenient or beneficial to the owner of the asset, it was important. It set new all-time highs in a variety of foreign currencies – 5, 6, 7, 10 different currencies – and in U.S. dollar terms it moved up nearly 20%. Remarkable, because in my view it is remarkable how it performed vis-à-vis the stock market. So stocks performed well across the board, and yet gold did, too. December strength was also notable.
Kevin: But let me ask. When you have these gap-up types of moves over the last few days, should it take a breather? Should gold, at some point, recalibrate, and even if it doesn’t change trend, maybe take a breath?
David: Yes, sometime when you see large moves, and certainly on the daily charts, it did gap up twice, and it wouldn’t be a surprise to see it sort of backfill. But I think the bigger issue is that if you’re looking at a chart, its price on a chart has risen to meet the low points put in in 2012. And that represents considerable overhead resistance.
So yes, consolidation should occur after a great 2019, and when that consolidation is over, I think the trifecta of uncertainties will drive gold to levels that fully express global demand, global desire, for security, for sound money, for reliable savings. That is why we launched our Vaulted program not long ago, to be that reliable savings in the context of currency devaluation. You see that currency devaluation happening on a uniform, on a distributed basis, cross-border, basis around the world.
Kevin: How do you measure gold when you have currencies that could go to zero? It’s sort of silly to measure against currency anyway, isn’t it, because they may not even be around?
David: A British paper asked me what my price projections were for gold in 2020. Part of the problem with prices is they are hard to determine when your reference currencies are unhinged. We may live in a period of unhinged politics, but talk about unhinged currency values – think about this. The yen and the Indian rupee – these are great examples where an ounce of gold equals 170,000 currency units. We’re talking about yen. Because one ounce of gold equals 170,000 currency units, yen. We think, “Gold is at $1500. Maybe it will go to $5000.”
You don’t have a clue about what is happening. This is a broad-based currency devaluation on a global scale. The smart money is already seeing what the consequences are of when you run out of ammunition, your central banks can no longer do the heavy lifting, they don’t have any efficacy, and you’re forced to go the fiscal route. Ultimately, something like Modern Monetary Theory – just finance everything.
Where does that leave us, 2020, 2021? If you’re in India you say, “An ounce of gold is worth 112,000 currency units.” That’s rupee – 112,000 currency units. It is difficult for a European to imagine an ounce of gold trading above 3,000, 4,000, 5000 euros. It is difficult for an American to conceive of an ounce of gold trading above $2,000, $3,000, $4000. And yet, where was the yen just a few years ago? Where was the rupee just a few years ago?
Gold, in essence, is not going up. It is marking the gradual decline of all paper currencies moving toward their intrinsic value, which we know to be zero.