In PodCasts


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

The Fed Breaks The Window, Then Offers The Loan To Fix It
October 21, 2020

“This is unbelievable. The fact that they’re talking this way suggests to me that there is an imminent problem. The game is nearly up. Instead of saying, ‘I’m sorry,’ or ‘We did it wrong,’ they’re basically saying, ‘We’ll just need greater regulatory control to make sure it doesn’t actually get out of hand.’ I’d suggest that this is a whole new level of reverse incentives where central banks get to create the mess, then rather than be discredited for their contribution to it, they’re charged with cleaning it up.”

– David McAlvany

Kevin: Well, of course, since we talk about economics, we all have on our bookshelves here at the office, and I even have one at home, Economics In One Lesson. One of the examples right as you start into that book is what they call the broken window fallacy where an economist might say, “Well, gosh, if there’s a broken window, we’re going to see economic expansion because you’ve got the people who make the glass, you’ve got the workers who put the new window in.” But actually, the fallacy of that is there is no real productivity.

And thinking about this, Dave, as we look at what’s going on with the central bankers creating problems and then coming in and saying, “Hey, we can solve your problem.” It reminds me of the broken window fallacy, only one more step. That step is, they break the window, then they provide the resource is to fix the window. Sounds like an abusive relationship to me.

David: Right. “I created the problem, but I can solve the problem for you, as well, for a fee. I oftentimes wonder, how did we get here? And sometimes there are inspiring cases where if you unpack that question, you can see a strategy worthy of emulation, or at a minimum, there is inspiration and gratitude. There are also the cases where maybe it’s more cautionary than rousing, where answering the question, how do we get here, is a reminder of what not to do, and we’re still living in the dreamy side of credit expansion at present. So nobody’s really asking the what not to do aspect of it, because it’s working.

So here’s today’s preview. Somebody is going to add to your Economics 101, not Economics In One Lesson, that’s already been written, but the New Economics 101, or Managerial Finance 101, the nightmarish aspect of the credit markets.

Kevin: How many people when they’re young don’t find the nightmarish aspects of credit markets on their own? When my wife and I got married we had come from middle class families and obviously we had not really wanted for anything. We weren’t rich, but when we got married, we really wanted to continue the pattern, even though I was making, I think, $4.85 an hour and she wasn’t making much more than that. So we had credit cards. I remember when I married my wife she was like, “You don’t have credit cards? And I’m like, “No.” She said, “Oh, well, I have good credit. We want to make sure that we continue to use it.” And we did.

David: Living the dream.

Kevin: We used that credit. Well, it’s a little bit like the nightmarish outcome, because at some point you have to pay that credit off. Unless – unless you’re the government.

David: Well, you know, every 18-year-old who heads off to college will find in that first week on campus that there are credit card companies everywhere and they play into the naiveté of an 18-19 year old. And this is where you start your credit. You have to start young and they’re there to help you.

Kevin: We got married at 20 and getting married is another time … everybody wants to give you a credit card.

David: As in past episodes of asset price appreciation, as long is the scheme is working, we revel in plenty. We love it, we don’t complain, and we take that question of how we got here for granted.

Kevin: It’s because, let’s face it, there’s candy. If you can have a little bit of candy, even if you can’t afford it, we will go ahead and take the candy. So it’s like an incentive.

David: Yes, who cares as long as the trend continues and it seems to be in your favor? So we operate as individuals, as companies, as countries, according to incentives and there is a positive aspect to that, whether it’s a bonus or promotion. But if the incentives are perverse, there can be negative effects, as well, that linger into the future. And these are the questions and thoughts that buzz around our minds as we as we think of our current episode of debt expansion, because debt, in particular, has lingering effects, given, as we’ve often said, that it is really nothing more than pulling tomorrow’s consumption and growth into today.

Kevin: Okay, but let’s go back to this story because, like I said, when my wife and I got married she really did have good credit. We were able to qualify for our first condo. I had been raised that debt is bad. She had been raised that debt is good. Now the question is, bad or good?

David: This is something that young couples have to sort out and have long discussions about. I suggest you have those conversations before you get married. But yes, many of you may think debt is bad. And maybe it’s a grandparent or a parent who preached that getting out of debt was one form of financial freedom. Well, what translates as health and wealth for the individual, as it turns out, is different than it is for a corporation or a municipality, or the nation. In large measure, the elimination of debt has this value for its psychological benefits. It is kind of like getting the monkey off your back. It doesn’t exactly translate to the polity, the municipality, the corporate entity, and everybody that owns a home, I think, can relate to this. You pay the mortgage or you lose the house.

Kevin: The bank owns the house, actually, until that last payment,

David: It’s not yours until the bank is fully paid. But even for the individual, debt is less of a burden when the rate of interest declines. Dickens tells a story in Nicholas Nickleby where one of his characters lives very well, maybe beyond his means, has the fancy clothing, the trappings of wealth. I think he does live well beyond his means. And ultimately he is taken off to debtor’s prison, both he and his wife, when the bill comes due. And it is the equivalent of about 30 years’ worth of earnings. He definitely borrowed from the future.

Kevin: Was it the interest on the debt?

David: The straw that broke the camel’s back was a smallish loan of £75 with an interest rate of 25%. Call it a penalty rate in light of the risk, but he was nearly bankrupt and only his creditors knew that, and they were still willing to extend credit, but at that penalty rate.

Kevin: Yes, but what if he was given incentives beyond just what he got with the debt? What if he was given tax incentives for it? The way our system works, even the mortgage that you brought up, you are encouraged to be in debt because you can take that off your taxes.

David: Yes, and that is an indication of how public policy drives some of the things that happen within our financial system. We want to encourage home ownership so we create a subsidy for that, and that is a tax break on your mortgage interest. Your tax could provide relief from the burden of debt and avoidance of a consequence. We never in our lifetimes have had to consider debtor’s prison. But you have this Dickens character who loses his home, and loses everything in it. Along comes one of his employees who for ages has kind of worked quietly and saved what little she made. She steps in and buys his business as a tailor. A counter-example to having sucked the future into the present and leaving little to nothing for tomorrow is this other character who actually was quite thrifty.

Kevin: Something that really does bug me though, Dave, because we’re talking about getting married and I’m on year 37, but strangely enough, interest rates peaked just about the time that I got married. And so debt, as onerous as it seems to be, the cost of debt has fallen now. You talk about the cycles, how we go through 30 to 35-year cycles of rising interest rates, which we had just finished about 1981, 1982, 1983. That’s when we got married. And then we’ve been falling ever since. None of us, virtually no one listening to this program right now, has experienced what it looks like to have rising interest rates rather than falling interest rates.

David: Alan Shaw and Louise Yamada, both technical analysts for Smith Barney back in the day, had put together some numbers studying US interest rates and how in 200 years, the shortest term either moving up or down was 22 years, and the longest was about 36. So we’ve expanded beyond that 36-year that would have been sort of an artificial cap. Nothing says it can’t go further.

But one of the contributing factors to how we got here, measuring credit excess in nominal terms, $27 trillion for the government, and then throw in corporate and household debt and whatever, is obviously the decline in rates orchestrated by central bankers. And it’s not just here in the United States, all over the world it is the case. So if rates were 25%, like for the character in Nicholas Nickleby, people would be cautious about the debts they assume. Their behavior would be impacted by that. And yet there would still be a few who, even on those onerous terms, would obligate themselves.

And so if the rate is 2.5% instead of 25% you end up with a different behavior. If the rate is 25 basis points, a quarter of 1%, now you begin to see perverse incentives. You think less of the burden of debt because, frankly, it’s a very light burden. It’s quite manageable. From a cash flow standpoint you can take on more and more of it, and it’s just not a problem.

Kevin: Something that’s been a strange anomaly for me, and just a sort of a strange challenge is, I’ve talked to people about their finances through this company for 33 years, and we all agree that debt someday will catch us. But strangely enough, year after year, Dave, I’m asked, “When is that going to happen, because I haven’t really seen the consequences of debt?” Now, looking forward, are these corporations and these governments actually going to see the consequences of debt?

David: I think one of the things we have to bear in mind is that we can look at particular sectors within the credit system and say there’s some that are more constrained than others. And this is one of the reasons why we’ve got the Democrats and Republicans wrangling over support. We mentioned this last week because there are some cities which are in dire need of billions of dollars just to pay back bills.

Kevin: But you mentioned that the Federal Reserve could possibly step in and just go ahead and backstop that, too.

David: That’s right, if the constraints were removed. But the constraints for the federal government don’t exist because they have a printing press. The constraints for the municipalities do exist because they do not have a printing press, and neither do corporate Americans or your average American. If they were found with the printing press, guess what? There’s a high consequence.

Kevin: Do you think they would help me out? What I’m thinking is, since they don’t have constraints federally, but they do have constraints statewide, what about just continuing to remove the constraints until they pay everybody’s debt off, just total debt forgiveness? Let’s go with the question, though. If corporations actually don’t find any consequence to being in debt, why in the world wouldn’t they do that?

David: This is where the math works. They’ve basically made it possible that you can take on more and more debt and the math works. It works for now. We’ve been in a declining trend for some time. What does that ultimately set the stage for? Yes, it does set the stage for credit crisis. Financial Times recently celebrated the contribution of two Nobel Prize winning economists, Franco Modigliani and Merton Miller, and based on work they did 50 years ago, corporations have embarked on a path that would be unthinkable. It’s just not sustainable for an individual. But it’s the way the game is now played in a corporate setting. The conclusion from their research was that it didn’t matter if a company funded itself with debt or with equity. Up to that point, too much debt was considered negative.

Kevin: That’s not what Grandpa teaches you, though. Grandpa is going to teach you that equity is better than debt. But not with a corporation.

David: Introduce the tax deductibility of interest payments, which they have, and corporations can get over the old stigma of debt to grow a business with borrowed money. And so you then get to, as you mentioned, 37 years of watching this, the slide in interest rates, just ride that slide. Nearly four decades of a trend beginning in 1982, and as a company, proportionately grow the liability side of your balance sheet as rates come down and you have resources for easy access to liquidity that you can then use for acquisitions, all kinds of growth. And, of course, it’s financed growth. You’re leveraging your future cash flows from an existing business to sort of amp up present tense growth.

Kevin: My question is, is it sustainable? Is it resilient? Is it something that could actually endure the other side of the interest rate cycle?

David: (laughs) I mention something, because Andrew Smithers, who was a guest on our program years ago, used to also complain about this fact that, and this is sort of a coincidental thing in the context of executive compensation, but as rates have come down you’ve been able to leverage balance sheets, concentrate growth in corporate America, and guess what else has been squeezed?

Kevin: You squeeze out the bonus. You squeeze that bonus right on up.

David: Increase executive compensation as you go. Well, the Financial Times article concedes that this was, and is, an efficient way to manage a business.

Kevin: So what you’re talking about is the debt versus the equity. It’s efficient.

David: Yes, it’s very efficient. But they do say it’s not resilient.

Kevin: It can’t be sustained long term.

David: So even with debt service the cheapest it’s been in, really, living memory, Standard and Poor’s counts 88 corporate defaults in the second quarter of 2020. That’s the largest number of major corporate defaults since the global financial crisis.

And you say, “Well, this is Covid.” Of course, it’s Covid. What it had to do with was an inability to make payments. They were leveraged to the eyeballs and could not then make payments on their debt because something changed and there was an unreliability in terms of sales and revenue.

So for smaller firms, obviously it was more catastrophic. If you had access to the bond market, maybe you kept your doors open. But we’re talking about doors closed forever for tens of thousands of small businesses who can’t go to Goldman Sachs or JP Morgan or Citigroup and say, “Hey, I need to issue another billion dollars’ worth of bonds, $500 million worth of bonds, $2.5 billion worth of bonds.” And for those large corporations, discipline isn’t necessary when you have access to that liquidity.

And frankly, if you look at that in a broader sense, discipline isn’t necessary in a world of free money. You see that show up in credit ratings. The household FICO scores – good credit is above 700. Great credit rings the bell between 800 and 850. Great corporate credit was in the form of a triple-A rating. Four decades ago, before all of this decline in rates started and people had to make very wise decisions about the amount of debt they took on because the price of debt was very high, or the payment on it, interest rates were very high, you had 65 companies that were triple-A, and 679 companies that had an A rating. This was out of 7,000-8,000 companies.

Rates have come down and you think, “Well, that has added to growth.” Yes, but it hasn’t necessarily added to creditworthiness. Rates have come down and so has the creditworthiness of borrowers. So of course, implicitly, there is more risk in the credit markets. But you wouldn’t know that by the pricing of interest rates, by the pricing of that risk. Today, you only have five companies that have a triple-A rating out of 5,000 that remain.

Kevin: Wow. So the old saying, one in 1,000. One in 1,000 right now of the companies that you see have a triple-A credit rating. You know what this reminds me of, Dave? I do look back, and it made all the sense in the world that my wife and I saved that parrot’s life at the pet store and spent $500 to save that poor parrot that I was the only person who it responded to when we when we bought the parrot. So we had to charge it. We went to Burger King, my wife and I.

David: What kind of parrot was it?

Kevin: It was a talking parrot.

David: No, but I mean, you know,  Orange-winged Amazon?

Kevin: It was a green one that actually would have gone well with hollandaise sauce.

David: (laughs)

Kevin: I’m just telling you, I didn’t mean to distract, but this is a true story. My wife and I, we walked in, and the pet shop owner looked at us, and this parents started talking to me. And I thought, this is the coolest thing ever. And the pet shop guy said, “You know, the owner had to leave the country, and you’re the first person in 30 days that has made this parrot perk up.” And so I asked, “How much is the parrot?” He said it was $500. We didn’t have $500. We had just gotten married.

So we went over to Burger King right next door, and we said, “You know, this makes all the sense in the world. This is a good reason to go into debt, and we can, and maybe we should, and maybe we must. And we went home with a parrot. That’s always a mistake, folks. Don’t ever go home with a parrot. They will outlive you. And this one, we had to end up giving it back to the pet store after 30 days. That’s my story, but it has to do with credit. But it was because we could. And then when we sat down, and we realized we were trying to save a life, we should, and then we must. And sure enough…

David: And the credit market degeneration, I think, fits into those three steps – we can, we should, we must. You go from Modigliani and Merton’s ideas, where corporations were granted permission, so we can increase debt, and there is going to be little consequence. And that’s true. We can. Then corporate boards capitulate over the decades to we should. We should increase leverage and gain as much competitive advantage as possible, even if the growth is tenuously constructed, the balance sheet isn’t quite what it once was.

Kevin: You can see the path. You can understand the path. It’s a human nature path.

David: And now we’re in the final stage. We’re in the final phase of central banks sustaining that credit binge with we must. It’s now no longer an option. So to sustain a low-rate environment you have to do what the ECB, the Bank of Japan, the Bank of England, or the Fed are doing or the music stops.

Kevin: Last week, you talked about musical chairs. The music hasn’t stopped up to this point, it’s just gotten louder.

David: Yes, and that’s where the money miracle ends with the realization that as prices rise and fall, and rates, too, rise and fall, and this balance sheet construction was not resilient at all. It was efficient, maybe, for the sake of argument. But in the end, it wasn’t resilient and it wasn’t responsible.

Kevin: So finish this statement. The borrower is the servant to the …

David: … lender.

Kevin: But that’s not what our last 40 years’ experience has been. But what you’re saying is the borrower, ultimately, will be servant to the lender.

David: So who will we hand the keys to on our way out the door? Who ends up with the equity at the end of the cycle? It’s the creditors. This is very personal, I have two friends in the energy patch that have learned this the hard way in the last 30 days. In one case, equity at $25 a share, to now equity at five cents a share, heading into bankruptcy restructuring, and from equity in the other case of $55 a share to 15 cents, also going through a restructuring.

So we reflect on the academic argument that a company funded with debt or equity doesn’t really matter, and we have to pause at some point and, let’s give credit where credit is due. That’s BS. What someone in a particular point in a credit cycle sees as brilliant. So, again, Modigliani – it’s not that they were wrong, but they were only right for a certain part of the credit cycle. Once you get to an advanced stage or the end part of the cycle, what was brilliant earlier on turns out to be balderdash. So at another point in the cycle, it just doesn’t work.

Kevin: So we have these little witty sayings that we hear, maybe Ben Franklin or whoever says it, but they basically tell you that equity is better than debt. Can you think of some of those phrases?

David: Equity is soft, debt is hard. Equity is forgiving, debt insistent. Equity is a pillow, debt is a sword. Modigliani and Mertin forgot a few caveats about cycles. They forgot a few insights about restructuring in the conversation on company funding. And while adding to efficiency, what they constructed was a view that hurts resilience. And this is a reality we’re waking up to, and in part it’s due to Covid-19, but in part this was a trend that extends far beyond that. I mean, again, we go back to the accommodative policies that we’ve had under multiple central bank headships.

Kevin: This is we must. Basically they’re telling us we must because of Covid-19.

David: Yes, but it’s been in the we must stage since we were dealing with the outcomes of the bubble and bust.

Kevin: Right. And then later the global financial crisis.

David: Real estate bubble and bust. And we look at Covid, and it’s a real thing. 1,081,000 cases, 218,000 deaths here in the United States, and the death rate is, on average, sitting at now actually just below 3%. And not to minimize it, that’s a lot of lives, and the percentage is slipping a little bit lower in terms of mortality, and as we’ve talked about in past weeks, disproportionately skewed to a 70-plus age group, and typically, with one or more pre-existing ailments or co-morbidities, they like to call them.

So it’s a reality. It’s one of the things that has taken corporate America by surprise, it’s taken municipalities by surprise, and the income and revenue that they expected to generate they’re not generating. And all of a sudden the debt matters.

Kevin: And you talk about equity versus debt. Going back to your friends in the energy patch. Did they have debt? You talked about how the value of the equity has gone down. That can affect debt because you had talked about equity as a pillow, debt as a sword.

David: Yes, that’s true, not only for the corporations, but for them personally. It was only a few years ago that one of those friends, we’re talking about a 40-year veteran in energy, asked me if $5 million in personal debt compared to $25 million in assets was a reasonable ratio. And my response was that asset values fluctuate, but debt is permanent.

Kevin: Well, it sounds reasonable. You said he had 25 million in equity and 5 million in debt? That sounds reasonable until the equity turns …

David: … into a five cent per share proposition, and then all of a sudden the ratio is out of whack.

Kevin: So do we get used to the new normal? I’m answering my own question, I know that. We’ve talked about this week after week after week. If you’re doing something dangerous – let’s say you’re free-climbing a cliff – if you do it every day for a year, you think, “You know, this is not as dangerous as I thought.”

David: Yes, you just start taking for granted how safe that environment is, while it’s really not. And we forget what normal was as the new replaces the old. The treasury market, for instance, for decades has been the global benchmark for “the risk-free rate.” Yet you look at what is normal today. The U.S. 10-year treasury is at 79 basis points, it’s less than 1%, compared to the French 10- year at negative 33 basis points.

Kevin: That’s amazing.

David: Negative 1/3 of 1%. The German 10-year is negative 61 basis points.

Kevin: Okay, but to keep them there, to keep interest rates low because debt has expanded by the trillion, this goes back to the we can borrow, we should borrow, now we must, because we’re going to have to actually buy our own debt from ourselves.

David: It’s the compulsion to save the system. It’s the we must. If you want to call it the last part of the play, the last part of the credit saga, it includes the realization that the system is broken, in fact is broken because of the Fed’s activism and central bank activism, not in spite of it.

Kevin: Remember, we were talking a few months ago how Europe was buying everything and still not finding enough debt to buy to keep those interest rates low. With all the trillions that our own Treasury is needing to borrow, are there enough people to buy the debt, or do we need the Treasury and the Fed just to buy the debt that the Treasury and the Fed produced in the first place?

David: One of the unintended consequences here is a malformation within the bond market. Randal Quarles, the fed’s Vice Chairman of Supervision, admitted that growth in the Treasury market over the past decade, particularly here in recent years, in his words, has outpaced the ability of the private market infrastructure to support stress of any sort there. He went on to say that the Fed will have to participate for some time supporting the functioning market in treasuries.

Kevin: What you’re talking about, the private market, that’s the whole world other than the Fed. In other words, the whole world is the private market, and it’s not big enough to actually buy the debt that we’re creating.

David: There’s no ability for the normal-functioning market to handle the volumes of paper that are being created by the central bank, and he’s talking specifically about U.S. treasuries. You start thinking about the kind of credit that’s also created in China and Japan and in Europe. This is a global phenomenon.

Kevin: It reminds me of for want of a nail. You know it goes, but really, isn’t it started with a little crisis in a little area like short-term funding? Remember September of 2019 a year ago we were talking about how something really changed in this market. The repo market, all of a sudden, needed liquidity. That’s short-term funding.

David: But it’s not the first time. Typically, when you have a solvency issue, what came before it was a liquidity crisis. So liquidity crisis becomes a solvency crisis when a company that needs short-term funding all of a sudden can’t, and what they assumed in terms of access to liquidity simply goes away. That’s the place that municipalities are at now. That’s what Pelosi is arguing for, to save some of the big blue cities and states, because they have run out of options.

Kevin: And we can, we should.

David: And now we must. So Quarles, again, the Fed’s Vice Chairman of Supervision, also pointed out that this is something we learned in 2019. This is why on our Wealth Management platform we started raising cash in the 4th quarter of 2019 because you had a problem in the repo market.

Kevin: You smelled a rat in the repo markets.

David: And we came very close to losing the financial system. Lo and behold, the 1st quarter of 2020 we’ve got an echo of the instability, which was already sort of endemic within the financial spheres. But he was pointing this out in an interview, again Financial Times. He says. “Several short-term funding markets proved fragile, again, lessons from 2019, and have needed support. Vulnerabilities associated with short-term funding have always been at the heart of financial crises, and central banks’ efforts to promote financial stability.” (laughs) That’s right. That’s how it goes.

And so for those of you who have followed the Commentary for a little while, September 2019, maybe that was a lifetime ago when the world moves in nanoseconds, but the repo markets were falling apart, and they required hundreds of billions in direct support from the Fed each night. And here’s what’s very interesting, if you want to bring this present tense, you’ll be comforted to know that the repo markets, which 13 months ago were frozen in panic, are now the basis of $80 trillion in derivatives. As of this past weekend, the reference rate for $80 trillion in notional value of derivatives has moved from the London Interbank offer rate, LIBOR, to SOFR, the Secured Overnight Financing Rate.

Kevin: So the difference between LIBOR? and So Far…

David: So far, so good. That’s all we can say here midweek is, so far so good. The issues with it­­­­ – I mean, what could go wrong? LIBOR referenced future lending. In other words, it was structured off of a forward-looking view by a number of banks, and that time frame stretched out as far as a year. So, where do we think interest rates are? Where do we think they’re going? How should we set LIBOR? And of course, there was some corruption.

This is one of the reasons why LIBOR was falling apart because we found that, actually, the banks weren’t dealing fairly with the public, go figure, but that they were sort of self-dealing. And so we’ve come up with a better rate, the Secured Overnight Financing Rate. The problem is this is a repo market structure. We are talking about overnight lending. It has yet to be extended out. It doesn’t have that element of longer-term anticipation.

Kevin: When you’re driving, you’re looking down the road, but it’s almost like when you’re looking at the SOFR, so good, let’s call it. S-O-F-R. It’s like driving faster and faster in a thick fog. There’s danger there. You can still do it, but you drive faster and faster and you’re not looking forward anymore.

David: You and I like to mountain bike, your son did that professionally for a while, and you know that there is this element of anticipation, which is very important. So the faster you go, the farther out you want to look, not the closer to the front of your tire. Because the closer you look to the front of your tire, if you are going faster and faster, I promise you, there’s going to be an oopsy-daisy.

Kevin: I was following Chase just about a week ago. He heard me hit a rock that he had missed. And he calls back to me, “Were you looking down?” And I said, “No, I was looking at you.” Of course I was defensive at that point, but it’s exactly what you’re talking about. I didn’t see it because I wasn’t looking down the road. I really was just looking down.

So without getting too complex, you’re talking about $80 trillion in derivatives that’s built up over the last 13 months with this repo bailout. But whenever the government redefines something, or whenever they start measuring in a different way – remember when they got rid of M3 because it was just for our own good? Everybody looked at each other and thought, “Why did they get rid M3?” Now, my question would be, why have they shifted on this measurement of the derivatives from the LIBOR to the SOFR? Does it hide or conceal a problem? That’s my question.

David: I’m not sure that it hides or conceals anything. I think their desire is to improve the structure of the markets.

Kevin: Does it make it more opaque?

David: It makes it more fragile to the degree that the market has just become more complicated. We basically have taken financial market mechanics and moved from pretty complicated to incredibly complex. Again, what’s wrong with that? Now we have something new to think about as we head into another financial crisis, whether that’s two days, two weeks, two months, two years, we have $80 trillion in derivatives, which have as a value reference SOFR, and we don’t know how it behaves. And we do know that overnight lending can get very squirrely as we saw in September of 2019. And what are the implications for derivatives contracts should we see aberrant temporary behavior? And what’s required? What is the we must compulsion that the world central banks have to then step into to backstop the derivatives market? We’re not talking about a few hundred billion here.

Kevin: We’re talking about trillions.

David: We’re actually talking about tens of trillions.

Kevin: You bring up complexity and we’ve talked about this and actually interviewed Richard Bookstaber, who is one of my favorite interviews because his understanding of the dangers of complexity. Complexity can work well for you for a while – and then not. I remember reading Chuck Yeager, the first American who broke the sound barrier back in 1947, I think it was.

Chuck wrote that he was on the Challenger commission when the challenger blew up. He said there are over a million parts on the shuttle. As a test pilot back in the 1940s and 1950s, Chuck knew how to take a plane apart and put it back together again, the entire thing, so he knew what he was getting into whenever he got into a plane. He said the complexity of the way the shuttle works and the modern day aircraft, there is no possible way that you can know everything that can go wrong. Bookstaber talks about that a little bit in the financial markets.

David: Yes, I think Quarles is concerned about short-term funding, and it’s frankly hard to get any shorter term than this SOFR rate. So again, what could go wrong? We know that when the financial markets are under pressure once again that you’re dealing with mechanics, and so this issue of complexity does become a real issue.

Kevin: So does it change what we would normally think of as a safe haven?

David: I’m convinced that the traditional safe havens, things like U.S. treasuries and German bunds are in the process of being redefined as unreliable, unpredictable, and unsafe. And it’s a revolution in thought for your average asset allocator or investor to somehow think that treasuries aren’t ultimately a safe-haven asset. Of course, we’ve mentioned this in the past. If you look at the history of the U.S. bond market, U.S. bonds were once called Certificates of Confiscation, so it’s not as if they have a perfectly pristine past. But for treasuries to become toxic and bunds to be treated like they carry the bubonic plague, something radical has to shift, and I believe it is.

Kevin: So let me ask you about Modern Monetary Theory because we’ve actually been practicing Modern Monetary Theory. Covid was the excuse, but we’ve been practicing it at least since March, where the only solution – this from we can, we should, we must – we’re so far into the must at this point, are we just going to have to print money and continue to do this?

David: Well, it’s almost a new version. Modern monetary theory gives us a whole new lease on life in terms of fiscal policy, and it’s almost like we’re trying to restart this whole cycle again and saying, “Well, we can.” They would say, “No, we’re not desperate anymore because we just figured out that you’re stressing too much about printing money.”

Kevin: People were saying we can before Covid, and then during Covid they said we should.

David: We should. So like Merton and Modigliani, they created the intellectual space for corporations to ultimately destroy their creditworthiness. Now you’ve got the ivory tower, the intelligencia and economists desperate to keep the game going, and they’re suggesting fiscal interventions, which are, when you look at the cooperating nature of mechanics, the creators of modern money, not just theory, but the actual creators of modern money, they’re almost certain to – again, as I say, I believe there’s a radical shift occurring – challenge the status of these safe havens. So if you want to call I Modern Monetary Theory, if you want to call it debt monetization, the moves to directly pay for increased credit growth with the printing presses will in the end be disastrous. And you have Merton and Modigliani, who gave a great grift to corporations and executives – that was grift, not gift – and we have the economic economists of our day engineering another great grift.

Who benefits? Who pays the price? I think that actually is going to be the defining causal factor in the social and political upheaval that lies ahead. When you ultimately unpack how we came to hate each other and fight with each other, the haves/have-nots, those who benefited, those who appeared to be tied into a very corrupt system, I think what you will find is that it actually wasn’t that corrupt. It just happened to be that bad ideas had grave consequences. And this grift, maybe it was accidental. Maybe there were pure incentives to help and to be benevolent. But in the end, it came at a very high cost.

Kevin: Well, you just get trapped in the must. That’s the problem with doing anything wrong in the beginning. You get trapped in the must. I keep going back, Dave, when we’re talking, even when we’re not on the commentary, we go back to Richard Duncan. I know I’ve raised everybody’s blood pressure again – Richard Duncan. But Richard Duncan realizes that we’re in the must, or he believes we’re in the must, to the point where we must do more. But one of the points that I think you have maybe contention with him on is, if he says, “Well, we just need to go out and spend another $10 trillion, but what we need to do is make sure it’s spent wisely. What does that mean? How do you regulate that? Wouldn’t you need regulation? Let’s say that we must come up with another $10 trillion just out of thin air.

David: Ironically, you have the senior officials at the Fed, and this was reported by the Financial Times on the 17th of October, and they’re now calling – this almost laughable – they’re now calling for tougher regulation. This is a quote from one of them, “Tougher regulation to prevent the U.S. central bank’s lower interest rate policies from giving rise to excess risk-taking and asset bubbles in the market.”

Kevin: So we need more regulation to keep the bubble from blowing up.

David: So you have loose monetary policy which causes bubbles and encourages risk-taking. Really? So wait. There’s more to this because not only did we create the problem, going back to your broken window fallacy, somebody’s walking around with stones. We can create the problem, then solve it using other macro-prudential tools.

Eric Rosengren telling the Financial Times, “If you want to follow monetary policy that applies low interest rates for a long time, you want robust financial supervisory authority in order to be able to restrict the amount of excessive risk-taking.” I’m wondering when this is going to get implemented because I haven’t noticed any yet, Kevin, in terms of this restriction on excessive risk-taking. But he says, “You want to be able to restrict the amount of excessive risk taking occurring at the same time. Otherwise, you’re much more likely to get into a situation where interest rates can be low for long, but be counterproductive.”

And I think actually, this is where you’re getting a bit of honesty, a bit of candor, and there’s almost a strain of mea culpa. They understand what is happening. They really don’t know what they can do about it. Lael Brainard, also a Fed governor, said, “Expectations of low interest rates were conducive to increased risk appetite.” No kidding? “Reach for yield behavior?” Oh, wait a minute. You mean if they lower rates, people are going to have to go find rates in higher risk assets? The search for yield is on?

And it goes on. She says, “Incentives for leverage, thereby boosting imbalances in the U. S. Financial system.” This is unbelievable. The fact that they’re talking this way suggests to me that there is an imminent problem. This is time sensitive – imminent problem. The game is nearly up. That’s one way of responding to this. You just say, “Yeah, it is.” And now, instead of saying, “I’m sorry,” or, “We did it wrong,” they’re basically saying, “We’ll just need greater regulatory control to make sure it doesn’t actually get out of hand because it’s not out of hand. By our definitions, it’s not out of hand.”

Kevin: So the system that creates the problem is now going to solve the problem. But it needs regulatory control because people might actually assume that they’re going to come in and solve the problem. It’s not just in the banking system, though. We do this everywhere we go.

David: Imagine the FDA defining the major food groups. We’re kind of used to that. And then incentivizing farmers to produce this stuff and fatten up as many people as you can. Then create a regulatory body to manage obesity and incentivize consumer behavior with sticks, not just carrots. That analogy, that word picture breaks down because you have to eat a lot of carrots to get fat. But they create the problem and then they’re going to solve it, we just need the ability to regulate what you eat. How many calories are you taking in?

I would suggest that this is a whole new level of perverse incentives, where central banks get to create the mess, then rather than be discredited for their contribution to it, they’re charged with cleaning it up, given a new regulatory framework, given more power, authority and oversight. This is astonishing to me.

Kevin: I just continue to go over in my mind and actually I have been sharing it with clients and friends, these four steps that the central banks have created. You talked a few months ago about the zombification of companies. So as things should fail, they don’t, because we can, we should, we must save those companies. And so what happens is we zombify the economy.

The second thing we do is we devalue the currency because we’re printing it. The third thing we do then is we keep interest rates so low that you can’t keep up with the devaluation of the currency. So zombification, devaluation, and then what we have is, of course, repression. That’s what Carmen Reinhart called it. But Carmen Reinhart also told you when you interviewed her that to keep people in the system because of those first three steps, they’re going to have to create a captive audience. Now, we haven’t experienced that fully yet, but you can smell it coming. You can smell it.

David: Oh yeah. She is now Chief Economist at the World Bank. Bright gal. She is no longer at the Harvard Post. I think she appropriately says you first worry about fighting the war, then you figure out how to pay for it. So a change in tune from a decade ago for Carmen was, “Be very, very cautious about stepping over the line.” And between her work and Ken Rogoff’s, that line was sort of the 90% line, debt to GDP, you start to destabilize from that point. So there’s some fiscal discipline which needs to be employed.

Kevin: Yes, the book that they wrote was warning about debt and how debt always defaults if you keep doing it the same way.

David: The current theme is, “Put that on hold, Covid-19, we have to spend, and we’ll worry about how we pay for this later on.”

Kevin: We must.

David: We must. And this was one of the reasons why – go back to February. Go back to March when we originally were talking about Covid and it was just kind of an emergent thing, and we said C-19, maybe for some that’s Covid. For us, it’s convenience because it allows for the justification, it gives cover to the expansion for politicians and policymakers to do what they’ve already been doing, but to now do even more of it, recklessly transferring future energy into the present. That’s the nature of debt.

So now, under the guise of Covid and like knights on a white horse, they’re able to justify and stand in as heroes. And should they do anything different? Listen, I don’t know how this ends except, not well. Could they do anything else? They’ve put themselves in a very awkward position – the must do. This is where there is an urgency. There is huge consequence if they don’t. We must is because they understand how grave the circumstances are. Duncan’s theory of spending $10 trillion is a we must desperation because he understands the implication of doing anything less. It doesn’t make it the right thing to do, but we’ve come down this road, and it is a road towards graver and graver consequences if we ever lose control.

Kevin: So Grandpa was right, ultimately, that debt is worse than equity. It’s good to have equity. It’s good to own what you have.

David: (laughs) He seems like such a fuddy-duddy in the in-between because you’re living the dream, as, long as the bill has not come due, he doesn’t know what he’s talking about.

Kevin: Hey, Grandpa, loan me the money so I can pay my credit card off so that I can be good again. The problem is, until you really pay the price, you don’t really understand. So the long-term implications, what are they?

David: I love this week’s series of Financial Times articles because they’ve announced that austerity is dead.

Kevin: (laughs)

David: Austerity is dead.

Kevin: Discipline. Austerity.

David: Yes. So the long-range implications are the critical piece here. You’ve got monetary policy. It’s matched with fiscal policy and the implications of monetization for the debt markets? We’re talking about interest rates moving outside of the approved tolerances, again, going from being managed to being very unmanageable, and the U. S dollar losing stability, you have to conclude that you hedge accordingly.

2021 is bound to be volatile regardless of who wins the election in November, more so based on the adoption of creative economic theories. As smart as these economic theories seem on a must do basis, they seem that way on the surface, but I think what they predicate is long-term hardship for U.S. asset holders.

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