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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Inflation? Forget About It, “Let’s Just Devalue!”
June 17, 2020

David: We’re talking about the high likelihood of devaluation on the one hand and financial repression on the other. They’re creating the framework that justifies both, right? And what does Grant conclude? Wholeheartedly agree with him: unofficially buy gold.

Kevin: We’ve talked a lot about inflation, Dave, and in the last three decades that I’ve worked here, I’ve watched other countries do something other than inflation, which is called devaluation. And I remember in the ’90s in Mexico, people, it was about the holidays. It was time, Christmas-ish, and I remember the Mexicans just devalued the peso by half. The Russians did that several times as well. So what I’d like to do today is also talk about not just a slow devaluation of a currency or a rapid devaluation with inflation. How about an instant devaluation if the government says so?

David: Yeah. The other day I was chopping up vegetables. Sometimes we cook together as a family, and even the six year old is in on it. He’s had to learn some knife skills early on. And so I’m chopping up some vegetables and he brings over a cleaver, right? And I’m like, that’s a little overkill. But I mean, if you’re thinking about inflation in terms of, you know, what happens, it’s either death by 1,000 cuts, little cuts, over a long period of time, or someone introduces the cleaver and whack, it goes straight through everything…

Kevin: And our country has done this in the past.

David: Lots of countries have. You mentioned Mexico, the British have, the U.S. has. Where it’s an orchestrated evaluation overnight, it’s just decided. Whether it’s trade competitiveness or relieving the burdens of debt, it’s decided. This is what has to be done now.

Kevin: So if this 27-day world’s shortest bear market is actually not gonna play itself out to be the world’s shortest, there’s a possibility that with the expansion of household debt over the last couple of decades, there might be a place to tap, and the way you tap that is to devalue the currency.

David: Yeah, as we suggested last week, I think the odds of the longest economic financial market expansion in U.S. History, which ended in February, that whole period being digested in a matter of 27 days is very remote.

Kevin: (laughs) I don’t think so.

David: Yeah. Nevertheless, what do we have since then? We just recorded the best 50 sequential days, out through last week, in S&P 500 history. You know, coming off of the March 23rd lows. So this major, major improvement…now, what is an improvement? It’s an improvement in stock prices. It’s an improvement in bond prices. We have yet to see what translates into really economic improvement…

Kevin: But that is provided by the Fed, isn’t it?

David: Yeah. And ironically, Powell has some very interesting comments, which I want to get to, on what he sees in the economy. So I think the unique aspect here is, and I’m sure you’ve surmised, that the Fed has been willing to backstop the markets. Powell has delivered in large part because the alternative, if you want to go back to what started in February and unrolled until the third weekend in March, the alternative appeared to be flirting with the apocalyptic. So the Fed credit machine stepped in to smooth things out. The Treasury debt issuance machine went into overdrive and those are, you know, just part way through those chapters. We have more still to come on both of those fronts.

Kevin: You know, we still subscribe to a newspaper, Dave, The Durango Herald. You know, we get it three times a week. That’s all they print at this point. But just about every issue now is about the reduction of tax receipts. They’re seeing that COVID has just pretty much dried up tax receipts, and that’s got to be happening nationwide.

David: Absolutely, I mean, and that’s with a shrinkage of tax receipts and an increase in fiscal commitments. And you know have Trump who’s out this week pressing for an additional $1 trillion stimulus package specifically for infrastructure improvement. And you know, the current fiscal year deficit is nearly $2 trillion to date. So the CBO estimates, that is the Congressional Budget Office, estimates for the full fiscal year, which ends in September, has this getting to 3.7 trillion. We’ll see if we actually make that number. But if tax receipts don’t pick up, not only are you going to have a deficit, a major fiscal gap, but you’ve also got credit rating agencies which are gonna be out to remind the markets that bonds need to, these are your IOUs, these should appropriately price in not only credit risk, the ability to get paid back on the loan extended, but also the inflation risk.

Kevin: Yeah, doesn’t that go against what the Fed wants? The Fed is trying to keep rates low?

David: I think that’s why the Fed is so feverishly discussing management of the yield curve. There’s more craziness with that ahead.

Kevin: So who’s gonna win? Do you think that the markets are going to beat the Fed on this one or the Fed is going to be able to keep rates down?

David: Again Peter Fisher, who’s at Dartmouth now, was at the Federal Reserve, and he finished up actually kind of in the Greenspan era. He was in ’95 through 2001 as the manager of the system open market account at the Federal Reserve Bank of New York. And he said recently, if the Fed is targeting investment grade and high yield spreads, those measures no longer mean what we thought they meant. And he went on to say if the Fed is targeting implicitly an index of financial conditions, and we all know that they’re just proxies for volatility. Then it no longer means what we think it means. And the only good predictor of high volatility is low volatility. That is Minsky’s observation. So, yeah, what we have is, whether it is inflation targeting or ultimately yield curve targeting, this goes back to comments that we got from a guest on our program years ago, who was at the Bank of England. And that is Goodhart’s law,, which says “When a measure becomes a target, it ceases to be a good measure.” And so if the measure of inflation becomes a target it ceases to be a good measure and the same, too, I think, when we start thinking about bond yields and the price and value of bonds, if you start targeting something, you begin to change the value of that measure. The measure of risk, the measure of credit, the measure of lots of things implicit to price.

Kevin: You know what? It reminds me of physics. When Charles Goodhart was talking about that and saying as soon as you start looking at a variable, it changes all the other variables and actually no longer is it a good use of your time. It reminds me of physics because, you know, they learned in the last 100 years that the observer actually affects the experiment. If you observe something, it changes the outcome. That’s similar to when the Federal Reserve is just focusing on, let’s say, stabilizing markets.

David: Yeah, so when you’re looking at the prices of bonds in the bond market, you’re far more likely to see the Fed’s wishes reflected in those prices than the market’s best guess at an appropriate price, which reflects risk and all the rest. So for now, the only price that matters and I say, I think this is temporary, but the only price that matters is the price that Powell wants.

Kevin: Well, the one thing we can look at is GDP, and we can look at the stock prices. You know, that’s the Buffett measure. That is one way that we can see if something’s overvalued.

David: The Fed just released its Z1 report where we get, among other things, the data to calculate that ratio, the Buffett ratio, and it’s just basically comparing the capitalization of stocks against GDP, GDP being the economic engine in the background. Now you have a few speculators who are suggesting that there really doesn’t have to be connection at all between GDP and stock prices.

Kevin: Forget the economy. Yeah, it’s the stock market.

David: Forget the fact that companies have to have sales and revenue to sort of register progress or qualify why they exist in the first place. No, it’s all about the performance of stocks. I think that actually is a sentiment that reveals the kind of gambler that has come into the market today. So know who’s sitting at the table with you. But there is a rampant kind of speculation in the market today, which would say, actually, the economy doesn’t matter at all. Stocks and the economy don’t have to be connected. So, there’s no surprise when you go back to that Buffett ratio. There’s no surprise that we are at or near all time highs on the ratio, and you use the Z1 data if you want to substitute something for more of a daily measure. The Wilshire 5000 is a great sort of broad cross section of equities, and it’ll help you calculate the ratio on a daily basis, but again, it’s a limited universe. Z1 is more comprehensive, but it’s only reported quarterly. So what does owning stocks in an overvalued environment, what does that mean? It really means that your expected returns over the next decade are not likely to be helpful. So if you’re looking for gains, good luck. If you’re looking for windfall, same category. Good luck.

Kevin: Dave, something came to me while you were talking. It’s…back in the late 1990s. You would have somebody put .com behind something and all of a sudden it became a real deal, and it didn’t matter if the company had any profits or if the company even had an office or if they actually even had a product. It didn’t matter. It said .com, so the stock would go way up. Now the idea would be that that company would ultimately make that money in the future. Now I’m looking at the opposite side of the spectrum. I’m looking at Hertz. I’m looking at J. C. Penney and looking at some of these companies that may not even be around anymore. What if we started a speculative fund on companies that no longer exist and see how their stocks do. You know what I’m saying? Just buy them for momentum. Hey, I’m buying Hertz today.

David: Well, and you say that with a smile. What’s kind of freaky to me is, when I conjure up in my mind things that are just not right, one of them is clowns always smiling and really, you know there’s more to the story. Between clowns and sock puppets, I have a couple of weird phobias. I don’t like them. But sock puppets, that was like the deal…

Kevin: That was!

David: Yeah, that was, you’ve got this advertisement. I don’t know if that was on the…

Kevin: It was on the old fashioned telly. Yeah, yeah, back in the old days, it was on the old telly.

David: Well, when people would watch those things. So, yeah, you’ve got the sock puppet talking about and whatnot. It’s freaky, and it’s also gone. I’m glad is gone, and I’m glad that the sock puppet is gone.

Kevin: Do you know the capitalization for that stock got to be larger than all the United States-owned airlines combined? Before everything fell apart that sock puppet was worth a whole lot of dough…

David: …before it fell from the sky. So we approach the markets…I mean, our approach on our wealth management team is quite a bit different. Number one, we’re not interested in chasing momentum. We approach the markets from a total return perspective. And so we’re looking for some of our returns to come from dividend income.

Kevin: The old fashioned way. That’s what stocks used to do is just produce a nice dividend income…

David: …and then capital gains on top of that. So that’s how you come up with your total return equation. How does our approach to the capital gains side of that equation, how does it differ? We’ve chosen to focus in areas that have strong demographic support, looking years and even decades in the future. And I think that the areas of focus for us too are also tied into, yeah, sort of this awareness. One of our key assumptions, is that we are in an era of excess Federal Reserve interventionism, and that’s a part of the thesis that the madness of central bank interventions, that’s going to stay on as an enduring element in the marketplace. Nobody wants to admit failure, and so the mechanisms and the means of trying to create a sense of normal, they’re just going to double down again and again it again. So owning real assets is our cornerstone. We want to own real assets off of which, you know, that cornerstone we build a diversified portfolio that, believe it or not, still has elements of value to it. Value. Can you imagine value being a word that even make sense in the context of market…

Kevin: So not sock puppets, but actual real things.

David: (laughs) So, I mean, in a world that’s more and more expensive and priced to perfection, there are some places that you can find value. And I would say that for that I credit our analyst, Lila Murphy, searching for the needle in the haystack, and she’s able to do that, does it very well.

Kevin: You know, we meet often with Lila. You meet more often than we do, but at least once a month, all of the other guys here in the company we sit down and Lila talks about what she’s looking for, and I love the fact that she’s such a skeptic. Okay, you know she’s looking at the markets. She’s analyzing stuff all the time. But boy, is she a skeptical buyer of anything. And in this particular environment, you combine Lila with Doug. Okay, Doug Noland. And you’ve got people who just plain don’t trust the markets, and yet their job is to play in the markets.

David: Yeah, well, I mean, part of this comes from sort of a studied perspective of what companies do and how they operate. Doug is a previous Treasury credit analyst, and then, you know, finishing both CPA And MBA kind of gives him some intellectual framework to work off of.

Kevin: He saw how the sausage was made.

David: Yeah, and slightly different recipe making or configurations if you’re talking about Lila’s background as a CFA. And this year she finishes her CPA. For whatever reason, she just wanted to get it done. So, she’s got plenty brainpower, which is fun. Both of them. The team is dynamic. But, you know, back to the Z1 report because this is, I think, worth reflecting on. There are a few new numbers you have to ponder. The first quarter was one of the most active in terms of central bank history, particularly the Fed and the Z1 spells it out by the numbers, by the data. Credit Bubble Bulletin did a great job translating the data for you. If you haven’t make sure you look at it. Doug’s credit bubble thesis, which is the basis for the CBB (Credit Bubble Bulletin). It’s written weekly, and it obviously weights credit expansion heavily. What did he do when he was a Treasury analyst? I mean, this is, credit is in his blood. So here are two new records, the first is total non-financial debt, increased 1.597 trillion. It’s almost $1.6 trillion. That was the largest increase ever. It surpassed the previous number 2004 record of 1.23 trillion. And what we saw in terms of the quarterly growth in non-financial debt, so Q1, it was more than total annual growth in many recent years, so just massive, massive credit expansion. As a percentage of GDP, non-financial debt has now exceeded all of your previous cycle peaks.

Kevin: Then let’s go back because when we’re talking about setting records there are strange dates that are all burned into our minds. Those records are usually set during those crises that we can all name.

David: Yeah, so what would you guess is the time frame for the last credit cycle peaks?

Kevin: Well, let’s talk about sock puppets and real estate.

David: (laughs) There you have it.

Kevin: Okay, sock puppets 1999, real estate 2007.

David: Yeah, so if you think about lending standards in decline, if you’re talking about the speculative juices flowing, you guessed it. It’s ’99. It’s 2007. That’s correct. It’s helpful to measure the numbers, not just in nominal terms. We talk about 1.597 trillion. Right, but the economy is now larger than it was in ’99 now larger than it was in 2007. So it’s helpful to measure the numbers, not just nominally, because the aggregate number today is just massive. $54.32 trillion. We’re at the record, but the economy has grown in the interim too. So comparing the two gives you a better apples-to-apples comparison through time, comparing debt to GDP. And so that’s what I think, a helpful thing to keep in mind. In essence, you have the workhorse, the economy, that is keeping the debt servicing in motion. So that’s why we bring those into the nominal debt figures. Fourth quarter of 1999, the same number was at 183% of GDP.

Kevin: Okay, so debt to GDP, 183%?

David: Yep. And again, we’re talking about the non-financial debt. So the fourth quarter of 2007 it was higher, 226% of GDP. And now in the first quarter of 2020 we’re at 260% of GDP. So that’s the first record worth keeping in mind. These debts are growing relative to the size of the economy. And that’s where you kind of, as some like to say, you’re getting too far out over the ends of your skis.

Kevin: Okay, so that’s non-financial debt relative to GDP. What’s the second number you’re looking at?

David: I like household net worth vs. GDP and, you know, with the S&P selling off 20% in the first quarter, household net worth actually was down in the first quarter this year, but I want to look at the fourth quarter of last year. 540% household net worth to GDP. And now we’re down to 514. So 540 to 514 by the end of Q1.

Kevin: That’s surprisingly high still, though, isn’t it? I mean, it’s still over 500% over GDP. Even after this horrible quarter, we just experienced.

David: Yeah. Even with the sharp March decline in stock prices we’re still above all of your previous cycle peaks. Okay so we’re talking about the year 2000 we’re talking about the year 2007. So those numbers were 446 and 492 respectively, we’re still in the nosebleed five hundreds. That is percentage over GDP.

Kevin: So this is household net worth. This is what households are worth over what the annual GDP for the country is.

David: Yes, so we’re talking about real estate. We’re talking about the all-in number. Take all your assets and subtract the liabilities. That’s what you’re getting for net worth figure. And so it’s a massive, massive number. Even with the massive selloff, household net worth was higher at the end of March than any previous cycle peak. That’s worth pondering. So where are we now? I mean, GDP is still in the process of shrinking. Estimates are still coming in on a downgraded basis. Right? But stocks are up. I don’t know what’s gonna happen with real estate, but I’m sure we’re gonna take out the 540 number this year, assuming that liabilities don’t increase significantly. Real estate will be a key variable going forward in that figure and so we’ll just have to see.

Kevin: I remember back in the early 1990s, there were riots in L.A. And when we moved to Durango, that wasn’t why we moved, when your dad moved us from Denver to Durango back in 1992. But I had a number of neighbors that had just come in from L.A. They purchased real estate and real estate prices actually spiked in Durango because of the riots in L.A. So it really had nothing to do with the real estate cycle. There were just a lot of relocations. Do you think the riots and the COVID and all this other stuff is going to do that for residential property outside of a city?

David: Yes, so maybe it’s a wash. I mean, I think it will be a key variable moving forward. We talk about location, location, location. Relocation may have something to do with it this time around. Will we see increased relocations post-COVID and in light of this city unrest? So, you know, maybe it’s small towns. Maybe it’s suburbs…

Kevin: Well, and how about low interest rates?

David: …I wouldn’t stop in a suburb. I’d keep on moving.

Kevin: (laughs) Yeah, hundreds of miles away from the city. But what about interest rates? Because they’re also being artificially kept low. That helps real estate.

David: That’s great support for real estate. From a financing perspective last week we’re 3.18% for a 30-year fixed mortgage and only a few points higher this week. I got a call last night, one of those many thousands or millions or billions of robo calls, but somebody saying, “Hey, you know, we can get you fixed rate mortgage for about 3%.” And, you know, that’s the reality, is there will be some help if people who have been on variable rates or whatever, you can finance it things very inexpensively. But I think it might be like pushing peas around the plate in terms of the aggregate effects of relocation where you see a hit to values in cities and an increase in values in perhaps more rural small town or even suburban areas, like what you were suggesting what we saw in the early ’90s here in Colorado, where people wanted to get out of the metropolis after the Rodney King riots. So certainly places like Manhattan, they’re going to see…they already are seeing a decline in residential property prices and rents are off considerably. Lease rates are coming down like 50%. I mean that there’s a significant change that’s happening in your major city centers.

Kevin: You know, we’ve been talking now for months about how overvalued the stock market is, and even with the decline, the price-earnings ratio is much higher. So the old school of financial management was when you’re young, you buy more stocks. The more gray hairs you have, the more you move into bonds. Or if you’re thinking that the markets high, the stock market, you move into bonds. Is that strategy at all even working anymore?

David: Right, well, it’s something we’ve been skeptical of for a long time, but the classic way, if you’re sitting down with a financial advisor, is you take the number 100 and subtract your age from it, and it gives you the proportion that you should have of equities versus bonds. So again, the classic balance for stocks in a portfolio. The problem is, bonds and stocks have a greater and greater correlation now, and it reduces their appeal as a risk mitigator. It reduces their actual function as a volatility dampener. And you know, that’s the common practice in portfolio constructions is to weight bonds and stocks proportional to age in order to increase income as you need more as you’re growing older. Decreased volatility as the client’s age is increasing, and I don’t think that’s gonna be helpful in this particular era. I mean, we saw bonds with massive volatility alongside stocks in early March, and it spoiled the view that they’re non-correlated and note that the value of bonds only bounced back when the Fed promised to be the market price guarantor.

Kevin: Well, aren’t they buying just the ETFs though? I mean the ETF is playing the index up and down, but it’s not the actual product. The Fed, are they buying the actual bonds at this point?

David: Yeah, and I guess one more point on that, because I think the pragmatist would say, yeah, so what’s the big deal? If the Fed’s gonna play market price guarantor, that ensures that they will in fact be a stable value within a portfolio and then should be considered sort of a ballast asset. And I just I look at that and I think, well, it’s artificial pricing. It will work for a while. I just don’t know that that’s a long-term thesis that is viable because now you are saying what they’re doing is unnatural. It comes at a cost. Where do you begin to see those costs show up? And are they ultimately? Can we live with those costs? And so I would say, you have to keep your eye on that. You can’t simply be a pragmatist and say, Fed as price guarantor means that you’ve got an implicit guarantee like you had with your GSEs back in the 2008, 2009 timeframe. Remember that everyone was loading into your government sponsored entities, Fannie Mae and Freddie Mac on the basis that there was an implicit guarantee. Oops, something happened that wasn’t expected. A bigger market kerfuffle than, in fact, the Fed could handle or any central bank could handle and we ended up with a global financial crisis.

Kevin: So what the question you’re asking yourself is, could they, for the first time in world history, guarantee an artificially controlled market into the future?

David: Indefinite? No. For a time, sure. And you know. So far, the Fed has bought only the ETFs, and that eases the structural pressure on those products. And they have yet to directly buy bonds. That is likely coming, and that again comes back to not only Peter Fisher’s comments about targeting prices, but this is a massive issue on the horizon for the fixed income investor to digest. How much of a market is there when you extract the word free from the equation and insert the word rigged. So you have a rigged market verses a free market. What are you talking about putting money into?

Kevin: What happens to the measure then? The thing that we all watch is the yield curve. I mean, how much more is a longer-term bond going to pay than a shorter-term bond? Or how does that affect the yield curve?

David: And that’s the Fed. They’re in serious conversations about “managing the yield curve,” which is their way of getting comfortable with the idea of setting and controlling prices in the bond market. So fixed prices do not exist. What they’re talking about is a commitment to keep prices in a very tight range, a particular range, and it implies a, well, in my opinion, it implies a fixed trajectory. Trajectory for the U.S. Dollar. Where is that trajectory? It’s not to new heights, friends. It’s not to new heights.

Kevin: You sacrifice the currency.

David: Well, that’s just it. You know, for every, if you want to say action, there’s an equal and opposite reaction, great. If you want to say there is a decision made to target prices, is there going to be a cost to that? Where would you register the cost of an indefinite commitment to yield curve management? Folks, that your currency right there. So to a degree, we already have it. You might say, but aren’t they controlling interest rates already? Yeah, to a degree. But the willingness to engage a market, to manage prices daily on an unending basis to ensure that rates don’t move higher… you know, again, there’s a cost to that. You might remember the exchange rate mechanism in Europe. In Europe, they decided that there was going to be a band and currencies were going to be held within this exchange rate band. And on that basis you managed volatility, again going back to what Fisher said.

Kevin: Until the band broke.

David: Until the band broke. You know, by the way, that was Soros looking at this and saying, oh, so you think you can defend that price indefinitely? Well, it’s gonna cost you something. And someday you might change your mind as the cost goes up. And so he bet against the pound, made a $1,000,000,000 in a day. That was Stanley Druckenmiller. That was Soros showing up on a day that he wasn’t supposed to be in the office, saying “You’re doing what?” Because Druckenmiller had set up the trade. He was a smart trader, and Soros said, “You don’t do this. If you see a trade, that’s this much of a layup. You don’t bet small. You bet everything.” And so, you know, Druckenmiller had a small trade in place. Soros bet the farm, made a billion dollars. It took some serious chutzpah.

Kevin: Well, and that billion dollars came out of the hides of a lot of people who thought that mechanism was going to continue to work. I remember that very well.

David: And that’s my main point is, is that if you look at the exchange rate mechanism, you set up a structure and say, we’re going to defend it, good luck with that. It’s gonna work for a while. And then when it breaks, there will be turmoil. Right? So that’s where I think people like Stephen Roach are getting spooked. He’s at Yale, been on the commentary number times, and he spoke openly about this last week. He said, specifically the era of the U.S. Dollar’s exorbitant privilege as the world’s primary reserve currency is coming to an end. And although Roach is, let’s be honest, he’s never very sanguine. He was the token bear amongst the economists at Morgan Stanley before they shipped him off to Asia, gave him bigger responsibilities, but not so much in the limelight? I mean, again, this is the age of Barton Biggs and I forget all the other guys they had, but there were, like, five economists.

Kevin: And he was the bear.

David: He was the token bear, right. So routinely they would say, we have a unanimous bullish vote. Here are our four economists who are…

Kevin: And Stephen!

David: No, no, no, all of a sudden, he’s not on the list of economists. When they needed unanimity, he just faded into the… they kept him in the closet.

Kevin: So when you’re bullish, the Roaches scattered, right?

David: (laughs) That’s right. So, I mean, what I like is that he’s…while he’s never very sanguine, he’s typically very realistic, and he’s very well-structured in his arguments. And he said this as well, this last week: already stressed by the impact of the COVID-19 pandemic, U.S. Living standards are about to be squeezed as never before. At the same time, the world is having serious doubts about the once widely accepted presumption of American exceptionalism, currencies set the equilibrium between these two factors: domestic economic fundamentals and foreign perceptions of a nation’s strength or weakness. The balance is shifting and a crash in the dollar could well be in the offing.

Kevin: Well you talked about a crash in the offing or Stephen Roach did, but we talked in the beginning of the program, the possibility of actually an official reset of the dollar relative to other currencies.

David: Yeah, and this, I think, when people start thinking about inflation it’s like oh, it’s 1%. Maybe it’s not gonna be a big deal. Maybe it gains a head of steam and it becomes 2,4,6,8,10%. If you look at ShadowStats with John Williams, it’s already at a 9% annual rate. However, you want to calculate that, keep in mind that the big devaluations, many of the big devaluations that have occurred, have been with the stroke of a pen. They’ve been orchestrated. They’ve been overnight. So keep in mind that currency devaluations, if orchestrated, they range from, say, 20 to 60%. And if they are sort of a consequence of a market dynamic, which is kind of what Roach is implying, you know, then you’ve got uncontrolled capital flight, and the range can be minor, 10% to 90%. I think what Roach is thinking is more in the line of 1/3 devaluation. And so if you look at where we’re at as a country, I think it’s worth looking back to the British because they were the last to hold the world’s reserve currency. The British devaluations of 1931, 1949, and 1967. Those years—’31, ’49, ’67—were like mile markers on the long British path to irrelevance.

Kevin: And those were all currency devaluations.

David: Chosen demonstrations and basically what they were, the British were demonstrating in real time. The currency devaluations were a demonstration of British decline in importance on the world scene. They were a reflection in the change that was happening in the global economy, and it reflected that the flows of both goods and capital as the British were taking a step back that there was a lot going on in ’31 and in ’49, ’67 you’re really dealing with decolonialization and the end of what fed the empire. This little postage stamp of an island. How did they collect the wealth of the world into the one place? Well, that mechanism went away by the time you got to the sixties and seventies.

Kevin: Okay, so for the person listening and they’re the skeptic and they’re going all right, well, Dave, but that’s Britain. That’s history. Why are you bringing up Britain right now?

David: Yeah, referencing those episodes in the British, I mean, currency is like a stock in terms of a long-term decline. Only this is the stock of a nation instead of a country, right. So when the currency declines, you’re just seeing the value, the implied value of the country diminishing. And I referenced the episodes in the British rather than the devaluations of the dollar because the consequences faced by the British, that is, of losing that privileged role as World Reserve Currency, is most similar to what we face now.

Kevin: As the United States.

David: Yeah, so I have to say, one of most important resources on the topic is a book that I read years ago by Barry Eichengreen and Alec Cairncross called Sterling in Decline. And this is such a fascinating thing. I think I got the book used from the University of…I don’t know, some place up in the Northeast. University libraries will go through and anything that doesn’t get read very often gets thrown out. So this is one of the discarded that I probably paid $5 for it.

Kevin: It was a treasure. You had Eichengreen on the show, you know, after that.

David: And I rarely find myself in agreement with Barry, but this is really good research that he did on these devaluations. Some of the book that he wrote here, co-wrote with Alec, came from Eichengreen’s Ph.D. dissertation at Yale, and it is a fabulous resource. Again, you have to be kind of a little wonky on this, but if you’re interested in devaluation, if you’re interested in the theme of loss of reserve currency status, Sterling in Decline is an interesting book.

Kevin: Let’s look at Venezuela, okay, just for a second, because when a person says okay, well, if the currency is going to decline, I’ll just move into something else, capital controls always factor into some sort of announcement where you can’t.

David: Yeah, and I think that is of note, is when you look at the devaluations for the British, capital controls and tariff barriers were prerequisites to the orchestrated devaluations. And we did the same thing in the U.S. You remember Smoot-Hawley? That was 1930 when Smoot-Hawley, the protective tariffs, were signed in, Hoover…then we devalued in 1933 after the tariff barriers were in place and after the British had done so the year before. We devalued in ’33 they had devalued, actually, in ’31. So you know, Trump, he’s not afraid to devalue. In fact, I think he’d kind of relished the idea of gaining an edge, improving trade competitiveness and he has suggested that in not-so-guarded terms, not that he’s ever guarded in anything he has said (laughs), but you know. But what does it do for you? Yeah, if the cost of your goods are cheaper than you do gain a trade competitive advantage, and it also allows you to reduce the growing burden of debt. So, I mean, everybody knows devaluation is an unofficial form of default. You’re not gonna breach any contracts, so it’s the way that you subtly default on debt. And if you can do it 1-2% at a time, then nobody really complains, particularly if it’s in line with GDP growth. Nobody’s really thinking about inflation and the consequences as long as the economy is growing. But if you start lopping off 20, 30, 40%—we had a 65% devaluation of the dollar in 1933. But typically 20 to 40 is a healthier range. That’s a big deal. And you look, as our credit markets expand that is, you know, back to Doug’s comments earlier, we’re seeing this massive expansion in debt. It becomes less and less manageable, so your options become more and more limited. And, yes, you control the yield curve. Yes, you take rates and maybe even take them negative at the short end of the yield curve. But this idea of devaluation, you would get closer and closer to that reality because the burden of debt can be substantially reduced, stroke of a pen, through devaluation.

Kevin: But we don’t live in a vacuum. You know the race to the bottom, country by country. If we were to devalue, Dave, I can’t imagine that the euro would be able to hold up. They would have to devalue too, would they not? Or China.

David: Yeah, and I think that’s where all of a sudden it’s whatever trade advantage you gain is temporary in nature because you’re not gonna be the only one doing it.

Kevin: It’s a cascade.

David: The British did it first as the world’s reserve currency. We did it second. Think about the sequence. ’31 for them, ’33 for us, ’49 for them. But look, after World War II it wasn’t required for us to do it. We were in a very different financial position coming out of World War II than the British were. They were decimated, so a little bit different there. But then ’67 for them, again. Another major sterling evaluation. ’71 for us.

Kevin: Yeah.

David: So there’s a, you know, we talk about Rueff and his observations of the pound sterling devaluation in ‘31. But a part of it, too, was the hard lessons learned in France because he had seen evaluations in ‘23 and ‘26. And so, you know, devaluations are not uncommon, stroke of a pen devaluations. What could we see in terms of a competitive devaluation with the Chinese?

Federal Reserve has put, what? Few trillion dollars in fresh liquidity into the in the financial markets in the first quarter. China’s no different, right, so I mean the problems which bring us to the point where that decision becomes a logical one… It’s not as if we’re alone. China, record numbers again,, or close to them and keep in mind they’re a smaller economy than ours but their nominal numbers many times are even greater than ours. Just for the month of May, aggregate financing increased $450 billion. So in the first five months of the year, we are talking about 2.4 almost $2.5 trillion in credit growth in China. Just the month compared to last year same time. The growth in May in terms of credit expansion in China, 86% higher than the same timeframe, May 2019. Then factoring in all that is swirling within the credit markets because you, at the same time, have the Chinese who have extended lines of credit. Not only are they borrowers, but they’ve created some really interesting geopolitical…

Kevin: Debt relationships.

David: …yeah, debt relationships. When you are encumbered, when you owe someone something, they may ask a favor of you. Yeah, I mean, you remember the famous lines from The Godfather. “You come to me on the day of my daughter’s wedding and…”

Kevin: Well, do you remember the book Confessions of an Economic Hit Man?

David: Yeah.

Kevin: That whole idea behind the IMF, the World Bank, it really managing the world politics by getting a country to go into debt way too much and then forgiving the debt at various times to get the country to play your way. China’s doing that now, aren’t they?

David: Bloomberg was talking about this on the eighth of June, they’ve temporarily suspended debt repayments for 77 developing countries.

Kevin: Sounds familiar.

David: Yeah, so hey, don’t worry about it. We’re going to take care of this. We understand your income’s down a little bit, and, you know, we can work something out in the future. So these low income regions are going to be allowed to get back on their feet. The burden of debt is temporarily relieved.

Kevin: Oh, by the way, we are going to need your help on the vote at the U.N. Council meeting. But that’s really no big deal right now.

David: Well, exactly. Is this a demonstration of pure generosity, or is it gonna be remembered? And will it be in connection with the U.N. Security Council vote? I mean gifts with strings. Are you kidding me? You know?

Kevin: It’s how the world is run.

David: So we’ll have to see how it plays out. Again, if you don’t avail yourself of Doug Noland’s weekly commentary, go to You can pick that up over the weekend. We’ve also got the Hard Asset Insight, which is a Friday wrap up for the Credit Bubble Bulletin, settle into a cup of coffee Saturday morning and digest the CBB. You probably will need the cup of coffee, but he ends his bulletin this week saying, I’ve reviewed the Fed’s Q1 Z1 reports, and I was thinking, this is how things look as a system self-destructs.

Kevin: You choked on your coffee.

David: Exactly, like hmmm, either I made it a little strong, but something’s not sitting well with my stomach. Q2 will be worse, is what he says. The point being, credit is expanding at an alarming rate, and it’s inspiring massive speculation that ultimately is what’s not healthy because the bigger the bubble gets, the greater the consequences when that bubble bursts.

Kevin: But the confusion is, if these guys are successful, there’s a lot of gains to be had in the markets that are being back-stopped by the various central banks.

David: Yeah, and so you get these interim periods where it feels really good and the interim periods of growth, it’s like, man, I just wish I participated. Even Stanley Druckenmiller! Last week is like, “Man, I missed the growth of the last three weeks.” Like he doesn’t have enough money from making major macro calls over the last 30 years, right? He’s regretting not making a little bit more over the last three weeks. I have to say that in itself is worth thinking about. If you’ve made billions of dollars and you regret missing three weeks of growth, you have an addiction. You have an addiction.

Kevin: Well, you know, the question that was asked by Bill Gates is how much is enough? And he says a little more.

David: (laughs) Right, and that’s I think, what he actually had. Is there a point where you ever know contentment? And I understand there’s a game to be played, and the playing of the game, there’s an intrinsic reward to the planning of the game. So I understand that. And so maybe it’s more about that in the extrinsic reward, and I’m being too judgmental, I don’t know. But I do think there is the possibility of addiction. You just need a little bit more. You look at last week and this week, the global equities market. Last week’s rough, you see weakness showing itself. Stocks in France, Spain, Italy, Germany, they’re all under pressure. And for good reason. I mean, you look at the April numbers, the most recent reported numbers out of Germany. Imports dropped 16.5%. Exports dropped 24%. This is Europe’s largest economy, right? You’ve got the Germans who are still at odds with the European Central Bank over the ECB stimulus measures. So what hangs in the balance? On the one hand, you’ve got stability of the euro currency as a consequence of massive fiscal and monetary stimulus. Okay, so you got the ECB driving fragilities of the European Monetary Unit, the EMU. On the other hand, you find the potential demise of the European mandate.

Kevin: This is Otmar Issing. If you go back and listen 10 years ago to Otmar Issing, he says, this day would come.

David: Right because you’re talking about a unified, Brussels driven, quasi political mishmash. And that is what is in the balance on the other side of things. So do you tempt fates with a potential currency devaluation just to make sure that we keep the financing going and keep the engines of growth functional? Or do you play with the potential existential threat of the whole political project? Right? So do we find a similar dynamic of competitive global currency devaluation where they have a reason to take away the pressure of debt as well?

Kevin: It’s a race to the bottom, a race to the bottom, each time.

David: And if you’re going to see exports drop by 24% in Germany, I mean this is a country that requires massive exports. Again, is there a temptation all of a sudden to concede and have the Germans, who are generally conservative with their currency, have them concede something, knowing that they must?

Kevin: Do you think this is why intuitively, maybe not even rationally, people are intuitively buying gold in these various currencies with the thought that this is the only direction that they they can go.

David: I don’t think it’s an accident. I mean, yeah, I don’t think it’s an accident that if you look at gold in a dozen global currencies sitting near or setting new all time highs, does that reflect a true collective wisdom, kind of a reasonable appraisal of the choices that the central bank community has with a high likelihood, with a growing likelihood of devaluation, of financial repression or of the continuation of both?

Kevin: You know, we have this unknown right now. City by city, county by county, state by state, and actually nation by nation. People are saying, do we stay shut down? Do we open up? But you can’t stay shut down much longer or shut down again, and really have any kind of an economy worldwide at all, can you?

David: That’s what Mnuchin has already said. So from the Treasury’s perspective, he says, we can’t shut down the economy again, because he knows what the consequences are long-term. And Powell, if you look at Powell, he’s been ultra negative in his comments for several weeks.

Kevin: I noticed that, yeah.

David: Yeah, he’s even said, you know, we’re not thinking about raising rates until 2022. What his attitude suggests is what he sees are deep structural economic problems, which require what we have seen, the triage level flows of Fed credit. You know, money coming into the system, liquidity flowing because of the deep structural economic problems in play. That’s the all-in move in March, and Powell’s recent comments affirm a very aggressive posture moving forward. What’s the reaction of the leverage speculator? They’ve taken it as permission to go wild. But I think if you listen to Powell’s words, you get the sense that, even if the economy opens up, we’re not in the clear.

Kevin: You ought to share some of hose points.

David: He said last week financial sector vulnerabilities are expected to be significant in the near term. The strains on household and business balance sheets from the economic and financial shocks since March will likely create persistent fragilities. He also said a sharp reduction in tax revenue is due to a collapse in income and retail sales tax revenue, is placing significant strain, or stress rather, on state governments. And then two more that I think are worth mentioning: “despite aggressive fiscal and monetary policy actions, risks abroad are skewed to the downside.” So now he’s talking about overseas. Great, okay, “But the future progression of the pandemic remains highly uncertain, with resurgence of the outbreak a substantial risk. In addition, the economic damage of the recession may be quite persistent. The collapse and demand may ultimately bankrupt many businesses, thereby reducing business dynamism and innovation. Unlike past recessions, services activity has dropped more sharply than manufacturing.” Now, Kevin, I have to say that is critical because counting up the percentage of our GDP that’s attributable to services versus manufacturing, this is really the heart and soul of what drives the U.S. Economy. So he finishes by saying, “with restrictions on movement, severely curtailing expenditures on travel, tourism, restaurants and recreation and social distancing requirements and attitudes may further weigh on the recovery in these sectors.”

Kevin: The thing that’s sobering is it sounds to me like you’re reading your dad’s newsletter, the McAlvany Intelligence Adviser. Okay, that does not sound like a Federal Reserve chairman. That may be the most negative set of statements that a Federal Reserve chairman has ever come out with.

David: Well, finally, on May 28th, Bloomberg reported. We missed it. But I’m grateful to Jim Grant for reprinting it, and this is from the Federal Reserve Bank of Cleveland, and this is from their research department. This is what they said: “Monetary policy rules, based on forecasts for economic conditions, suggest a median value for the Fed funds rate, currently set in a 0 to .25% range of minus 2.16% in the current quarter, falling to minus 14.09% in two years. That’s the conclusion of a set of calculations by Federal Reserve Bank of Cleveland researchers released Thursday. The conclusions aren’t official views of the bank president, Loretta Mester.” That’s the Bloomberg summation of the fact that we could see negative rates to the tune of 14%.

Kevin: So currency devaluations and negative rates…think this through listener to this program. You have to protect yourself.

David: Well, Kevin, that’s why I said that we’re talking about the high likelihood of devaluation on the one hand and financial repression on the other. They’re creating the framework that justifies both, right? And what does Grant conclude? Wholeheartedly agree with him. Unofficially buy gold.

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