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About this week’s show:
- 16% of all sovereign debt is at negative interest rates!
- Deflation is only devastating to the highly leveraged.
- Resolving debt crises is nothing more than assigning losses.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Government can pretend it doesn’t have responsibility for creating the wealth distortion via its wealth effect policies of zero rates and quantitative easing. They asked for the wealth effect! They got it! But they just hadn’t realistically appraised the landscape to see that a disproportionate benefit would be accumulated, kept, hoarded, whatever you want to call it, and not recirculated through the economy.”
– David McAlvany
Kevin: Strangely enough, Dave, you had predicted that the Federal Reserve would probably delay raising rates. You, Jim Grant, there were some voices out there that said, they can talk all they want about the economy lifting off, but as far as the lifting of rates, they are looking at the real numbers, aren’t they? And they’re not seeing growth.
David: And this is what we’re going to look at today, not only in the U.S. context, but around the world. Central banks are basically saying one thing and doing another. You had Jack Lew, head of the Treasury, who said that the U.S. economy is very strong, here in recent days. And yet again, we have the latest from the Fed that an early liftoff of rates is unlikely. We have the Fed persisting in keeping the patient on the IV, and if you think about that, it does suggest concern about sustaining any form of growth outside the extraordinary interventions in place from the Fed.
Kevin: Okay, the theory behind this massive monetary and interest rate accommodation, what we call easy money, the theory is that people are going to go out and spend that money. It seems, however, that people aren’t spending the money, they are cautiously saving, or paying down debt, aren’t they?
David: Well, that’s right. So, the theory failed. And the more recent idea, that a drop in energy prices would inspire the consumer to spend like it was 2006, also has failed to materialize thus far. Consumers, as you suggested, are choosing to pay down debt. That has been the actual response, and I think that is the smart thing for consumers to do, which is, unfortunately, what the Fed considers to be a waste, because what they want is for every dollar to be in the system and to be multiplied. They don’t want a reduction of dollars in the system.
Kevin: And to be fair, there are areas of growth. It may not be healthy in the long run, but let’s face it, look at the stock market. For the past 15 years the NASDAQ has been below the levels that it hit in the year 2000. But the NASDAQ is poking back at those high levels that it was at before.
David: Well, right. And when something goes into a bubble mania, it is not uncommon to see a generation go by before that asset class is in recovery again. Certainly, we have yet to see the recovery occur, say, in Japanese equities, and we have had decades. Now, of course, off of the lows of say, 7000 on the NIKEI, it has done very well, but it is still less than half of its previous values.
So, yes, we have the S&P soaring, we have NASDAQ, which is just a stone’s throw away from its old highs, and as Robert Shiller over at Yale has said, the valuations that we have today are a declaration of danger for the long-term investor. So, equities have been very sensitive to the “extend and pretend” policies of the Fed, the print or die policies, which not only the Fed, but other central bankers, have implemented. So, that’s the first area of growth we’ve seen in the last three to five years.
Kevin: It is interesting. The areas that took the most devastation during the real estate collapse – I’m thinking of Southern Florida real estate. We all know jokes about Florida real estate, it used to be swamp land, but actually, any Florida real estate was a problem during the financial crisis back in 2007-2008, but that seems to be an area of the greatest growth at this point.
David: And it’s funny, I think you could write books on the bubble dynamics of Southern Florida real estate because, actually, going back to the 1800s you had your first major bubble in South Florida real estate. But today, yes, South Florida, again, along with California and Hawaii, and at present, you have, in the planning stages, or actually being constructed, again, this is in South Florida, 350 new high-rise condo buildings which are in the works. And to me, that seems reminiscent of the 2007 boom, which at that point had 30,000 condo units under construction. Of course, that was as real estate was reaching its frenzied stage.
Kevin: But from what I’ve read, Dave, a lot of that money is coming in from outside the borders of the United States. It seems like it may be one form of flight capital into the dollar, only instead, into these assets here in the United States.
David: Yes, and depending on what the region is, you are seeing a lot of Chinese buying, certainly in California and Hawaii. South Florida has always been a mecca for Central and South Americans, and of course, Europeans, Russians, etc. But just a few years ago, if you looked at Vancouver, Canada, you were seeing nearly 75% of all real estate transactions coming from Chinese, and in Honolulu, the numbers are similar today, certainly well above 50% of transactions being done with Chinese. This is interesting, because this is flight capital, which is on the move.
Kevin: You know what it reminds me of, remember Minxin Pei, who we had on the show, who was basically saying, the elite in China find ways of walking out with the dishes, basically, and the silverware.
David: Yes, and that is the vested interest that he described in China. They are being purged. Why are they being purged? Because before significant economic reforms are implemented, and it is even possible for them to be implemented, they need to be pushed out. So yes, Minxin Pei joined us a couple of years ago, we explored the power of the political elite, and those that have thus far benefitted. If you look back over the last several decades of growth in China, these are folks who, you might say, cherish the status quo because it has been so good to them, and their world is changing. Those vested interests are being pressured out to make way for the implementation of the third plenum agenda, and what is slotted to be significant wealth transfers guided by the Chinese Communist Party.
You have probably seen in the last week or two, the New York Times articles, the Wall Street Journal articles, which have highlighted the property ownership, particularly in Manhattan, of Russian, Eastern European, and Chinese. These are your 5-15 million dollar properties which are owned, and they set them up, owned by series of trusts so that it is sort of privately owned, and it is basically treating the U.S. as a mattress for foreign money.
Kevin: Dave, in October, when we were in Argentina, we noticed that the poor have to find a way to get their pesos, which are devaluing, turned into U.S. dollars. A $100-dollar bill was very, very valuable. In fact, it was twice as valuable as the government said it would be at the time. The middle class would buy gold, silver or gold, but actually, the upper class, silver or gold wasn’t going to do it completely for them. They actually bought properties, remember that? Apartment buildings, that type of thing, to get into something other than the currency. Now, are they doing that to get out of their currency into another country, in this country?
David: Yes, and it is interesting to note that the currency turmoil in the rest of the world is inspiring a shift to select U.S. cities. You’re right. You remember the gentleman down in Argentina. He preferred apartments in downtown Buenos Aires right along the main streets, considering them to be a much better storage of wealth than, say, bank deposits. It is really a modern phenomenon that we have so much confidence, both in Europe and in America, in not only central banks, but banks in the banking industry as a whole.
The rest of the world, particularly where there is currency volatility, will look at that as a very vulnerable place to be, so not surprising to see safety deposit boxes filled with U.S dollars in Argentina, on a relative basis the U.S. dollar much better than their home currency. But yes, it is interesting, the drive to U.S. real estate is, again, an expression of angst, an expression of turmoil, resulting from the devaluations, so many of them around the world orchestrated by the world central banks.
Kevin: Well, and what else do you do if you have assets, Dave? Look at how many countries right now have negative interest rates? When I try to explain to a client that if they were to buy a bond in Sweden, or if they were to buy a bond in Switzerland, they actually would pay interest back over the duration of that bond instead of getting paid interest.
David: And the only way that makes sense is to ignore the interest rate altogether and say, I so expect apocalypse in other currencies that I prefer a negative rate knowing that I will have a positive rate of return given the appreciation in that currency, that safe haven currency. And again, there are multiple themes here. One is that I don’t like other currencies, so much so that I will accept a negative rate knowing that the currency gains offset. Think of that dynamic, if you will, and keep in mind that this is now the routine. We have central banks which are surprising, announcing lowering of interest rates. This year, so far, we tallied 20 different central banks announcing a lowering of rates and surprising the market with the announcement of a lowering of rates.
Kevin: Aren’t they doing that to stimulate the economy? They are openly admitting that this thing is not restarting, if you watch their interest rate decisions, and yet on paper, when they are quoted in the papers, they’re telling everybody that everything is fine.
David: Well, that’s the point. In terms of global growth, what you’re seeing, what central banks are doing, is very telling. They are lowering rates in order to stimulate growth, when stimulation of the economy is needed because, quite frankly, natural growth is nonexistent. So, this is a broad base, 20, which represents a very diverse geographical mix, and so today you have a total of about 16% of all sovereign debt that is owned by an investor at a negative rate of interest.
Kevin: 16% of all sovereign debt is now paying negative rates?
David: That’s about 3.6 trillion dollars of negatively yielding paper. Again, this is investors voting with their feet in one way or the other. You can talk about properties, you can talk about people accepting negative rates, but you only accept negative rates in light of the alternatives, and this is where I think you are beginning to see multiple versions of flight capital. The lowering of rates below zero is a sign and symptom that growth is not happening fast enough in many economies. It is not keeping up with the exponential growth and liabilities, and therefore, stimulating growth, central bankers are seeking to do that by stimulating inflation.
This is sort of an economic axiom, not one that I hold to, but there is this belief that inflation goes hand in hand with economic growth as long as you keep inflation at a low rate. So, you have targeted rates of 1-3% and quite frankly, you look at the commodities complex today and it is suggesting that you do have broad-based weakness in the global economy. Copper is weak. Iron ore is weak. The industrial metals are signaling that there is slower global GDP growth on the horizon.
Kevin: I think it is important to point out, Dave, that deflation, itself, is not a bad thing. If you are out of debt, and you are watching asset prices fall, all it means is that you are able to buy more with the dollar that you have. But deflation is absolutely a killer for the person who is in debt and can’t service that debt, and that’s what we are talking about right now.
David: That is one of the critical differences between the current context and the 19th century, where there was economic growth at the same time you had deflation. And you are right. The challenge today is that there is too much debt in the system, and therefore deflation takes on a negative element. Keep in mind, the debts are owned, in large part, by the financial operations, and none of those financial operations wants to take a loss on those debts. What is a debt except a loan that you have made. You want your money back, and you want interest along the way, so to you, debt is an asset.
But this is the problem. In an environment where there is deflation, having too much debt puts a tremendous amount of pressure on the leveraged operator, the financial institution. And quite frankly, I guess you could expand that list because it is not just the financial operator today under pressure. It is the household with too much debt, it is the corporation with too much debt. It is developed world governments along with the financial sector that have too much debt and that is one of the reasons why you see everything that is happening in Europe today. The concern in Europe is, because there is too much debt, that you might have a massive ripple effect if it is not handled well.
Kevin: We use the words interest rates, and sometimes people just have a blank stare, but actually, what it boils down to is the cost of money, and if you can control the cost of money, you are protecting one group or another. You are either protecting the debtor, or the asset owner. And unfortunately, if you are a debtor, with interest rates at this level, you are in trouble because deflation is kicking in. Aren’t they protecting the asset owner at this point?
David: Well, in this case, the largest growth in terms of assets has been in leverage, if you will. For 30-40 years we have seen an increase in debts. So the banking industry has helped by being a purveyor of IOUs in the process of expanding this “asset class.” And guess who is defending the banking industry? Central bankers. That seems fairly obvious, but when you look at interest rate policy, which is set by the central bank, who are they defending? Central banks defending the banking system, which they are sort of at the apex of, interest rate policy is one way of protecting the owner of assets. That is, the owners of businesses, and of course, the banks, themselves.
So, first of all, by lowering interest rates you are, in essence, recapitalizing banks with the interest dollars that would otherwise have gone to the depositors. And then second of all, you have a lowering of interest rates which also inflates and keeps elevated the prices of assets that would otherwise move in a cyclical up and down. By up and down I am talking about the normal business cycle, an ebb and flow. Interest rate policy, in essence, is the Fed choosing who will pay the costs of adjustment for the debt accumulation of the last 20-30 years, and I think that is critical.
Kevin: So when we had asked ourselves, all these decades, Dave, all of our adult lives, who is going to pay this debt, because we continue ask the question, when does the day come that this debt actually comes due? And I’ll be honest with you, I think most of us think, including myself, in these one-day, massive, catastrophic collapses, but actually, what we’ve seen since 2008 is financial repression.
We’re talking to people all across the country who tried to retire on their money earning interest rates that are reasonable on their money, and that has been directed, actually, to the people who the Fed and other central banks are trying to protect, so the cost of the debt that we have accumulated over the past 20, 30, 40 years, is being paid, it’s just not being paid by the people who should be paying it.
David: That’s right. What we have described as the magic 5% is today the elusive 5%. In the news, of course, is Greece and the machinations in Europe today. And the question there, the only question, is who will pay the cost of adjustment? A financial crisis is, as our Commentary guest, Michael Pettis, suggested recently in a Financial Times article, nothing more than assigning losses. The way that you resolve a financial crisis is by assigning the losses.
And that, I think, is the simplest expression of what is happening in Europe today and around the world. There are really only two options. Either the owner of assets takes a hit and debt, as we mentioned, is considered an asset to the banker/lender, or option two, the middle class household, or working class, take the hit.
Kevin: And that’s what’s happening.
David: So far, it’s the workers, so far it’s the middle class, that via a combination of low wage growth and financial repression, that is, rates being kept at the zero bound, are paying the prices. I think governments would like to keep it that way, with banks and elites protected from losses on their own balance sheets, and with the message being very clearly that it’s not central bank policy, it’s not interest rate policy that is in any way connected to what is occurring.
The beauty of financial repression is that it is an obscure idea, just like inflation. As Keynes said, the reason why it’s a preferred method by politicians, and ultimately, central planners, is because not one in a million understands it. So, it allows for politicians to do what they want to do without getting caught.
Kevin: And let’s face it. Even Congress – Yellen is going to talk to Congress this week. Most of them don’t understand what she is saying. They think that the Fed is there to help. The old saying, “We’re the government, we’re here to help?” Now it’s, “We’re the Fed, we’re here to help.” I think the sad thing that we’re seeing, though, Dave is that people right now cannot make ends meets based on this financial repression, but it has been sold based on security. In other words, people don’t want to see things change, and they’ve been told that the only way to restart this economy is, really, to do what they’re doing.
David: It’s the same thing with Homeland Security. Homeland Security is sold as a concept because we live with, now, a basic level of insecurity, and notice we are about to run out of funding for Homeland Security, and did you see how conveniently the Mall of America is under attack?
Kevin: My wife said the same thing. She said, “Look at the timing of this!”
David: We’re almost out of money and Mall of America, don’t you know what’s going to happen to the economy if the consumer doesn’t show up? This is so much Kabuki theater, it’s almost silly. And I wonder if the average American looks at this and says, “Do you see how the news headlines are orchestrated?” Back to the banks because I find myself conflicted on this issue. I don’t have an axe to grind with banks or financial institutions. I don’t see the sector as inherently evil, but I do see that their propaganda machine has very effectively inspired both the political right and left to bail them out.
And again, there is this idea that, “If you don’t bail us out, don’t you know we’ll return to the financial dark ages?” So the propaganda machine has played off the fear of the unknown, and as a consequence, you have politicians at the beck and call of financial VIPs. So this is where we now have a new class of businesses in America, and this didn’t exist before the global financial crisis, but we now have the systemically critical enterprise.
Kevin: Almost too big to fail.
David: That’s exactly right. We can’t imagine a world without these institutions, and the loss of them would be far too disruptive.
Kevin: Let’s face it, though. The reality today is interest rate policies are protecting special interests.
David: Precisely. You have financial entities and the largest owners of assets which are protected by interest rate policies, and this is the primary cause of the gap between rich and poor. For all the political discussion of an income gap, keep in mind, it is interest rate policies and it is the Fed, which has created this. I don’t have an axe to grind with the super-wealthy, or the semi-wealthy. I don’t have an axe to grind with the talented surfer. Think of this. If you line up the perfect wave, and carry the wave from out in the ocean onto the shore, being at the right place at the right time, there is nothing criminal about that.
However, what I object to is the notion that government can pretend it doesn’t have responsibility for creating the wealth distortion via its wealth effect policies of zero rates and quantitative easing. They asked for the wealth effect! They got it! They just hadn’t realistically appraised the landscape to see that a disproportionate benefit would be accumulated, kept, hoarded, whatever you want to call it, and not recirculated through the economy.
Kevin: And let’s look at who has the assets, Dave. He who has the assets is appreciating right now. He is appreciating his stock prices rising, he is appreciating his Florida real estate rising.
David: And yes, who has more debt than assets? Now you are describing the middle class. You are describing labor. So, rather than acknowledge that policies are creating a future political nightmare of wealth redistribution, which I comprehensively object to, central banks are increasingly joining the parade all around the world, of low to zero rates, and they are using this as a new mechanism, a new means of modern day currency devaluation, and I guess because everyone is doing it, no one seems to be concerned.
Kevin: So, it is like many illusions, Dave, you can really make it pervasive if everyone is doing it. There must be nothing wrong with it if everyone is doing it. You have every central bank in the world right now lowering rates, it seems.
David: And on that basis, you had the global devaluation of currencies in the 1930s, and I’m sure that was reasonable then, and should be now, in retrospect, if in fact, it is just a question of lining up a parade and everyone does it.
Kevin: Well, let’s go back to what Michael Pettis said, because assigning the losses – that’s a scary thought, because it sounds to me like somebody has the power to just go ahead and say, “You lose; you win.” It doesn’t really matter how you played the game up to that point.
David: But isn’t that what is being negotiated in Greece? You want a haircut taken. This is what Syriza wants. They want to cut the total stock of debt in half. And yet, you have the creditors in Germany and other northern European countries saying, “We lent you the money and we expect to be paid back in full.” Again, this is an exceedingly insightful prescription for financial crisis, from Michael Pettis. Assign the losses. You’re done with the financial crisis as soon as you have assigned the losses.
What you have in conflict is self-interest. On the one hand, you have labor, on the other hand, you have capital, And in that same article he suggests that the imbalances between Germany and the peripheral European countries are just too simplistically and inaccurately characterized as, the north, the thrifty north, the financially responsible north, the savers, versus the spendthrift, “I’ve got a credit card and I’m going to use it,” south.
Kevin: And I’ve been guilty of that, Dave. It’s much easier to try to simplify something and just say, “Look. The Germans were better with their money, the south was spendthrift.” But really, if you look at it, these people were actively and knowledgeably playing for something that really needed balance. And the Germans were going for the low labor costs of the south. The south was taking those great loans from the north as far as the low interest rates, and so, everything was out of balance as it came together.
David: What Pettis argues is that there is no political conflict in Europe today, or there shouldn’t be, because what you are dealing with is different economic interests. So he points out that labor wage agreements that were made in the late 1990s in Germany, which increased the profitability of German firms at the expense of labor income, and in so doing, created a massive amount of savings in the north.
Kevin: Because they were saving on labor costs.
David: Right. Which again, increased company profitability. Where did the cash go? With increased profitability, he argues, compellingly, that the savings glut from Germany was, and is, equally responsible for the debt frenzy the south engaged in. So think about this. You have banks brimming with excess savings. It is then lent to the peripheral countries.
Kevin: And they were happy to take those loans because this was the lowest interest that they had paid in years.
David: Oh, exactly, it fed the appetite for cheap loans. You have lower rates following the inclusion into the EMU. We talked about that a few weeks ago. And then now you have access to credit and lots of it. So this ended up feeding the asset bubbles in Spain, Italy, Portugal, Greece and Ireland. Who is to blame? The person not qualified to take out a loan that receives one anyway? Or is there a shared culpability between the creditor, who is making a bad loan, and the debtor who is taking on an obligation he knows he can’t pay.
Kevin: Didn’t we see this with the subprimes here?
David: Both had a choice. Both exercised the choice with eyes wide open. As is often the case in lending, when there is a trend beginning, again, sort of excessive lending, bankers fear losing market share if they stay out of the lending frenzy, and thus, they are willing to lower lending standards to keep up with the competition. So, no, it’s not just the spendthrift self that holds responsibility. German politicians chose to disadvantage German labor in order to increase export competitiveness in the late 1990s. Politicians gained, thereby, a stable labor pool because you are dealing with a very low unemployment rate, and guess what? They financially shifted away from labor, a benefit from labor to the owners of capital.
Kevin: One of the things economists love to do is talk in equations because they can talk ambiguously because they know nobody understands the equation, but Dave, this is a simple equation. Germany, or the north, has the capital surplus that is lacking in the south. The balance shifted, is what you are saying.
David: Exactly. So, your current account does balance. If you have a positive on one side, you have a negative on the other.
Kevin: That’s an equation.
David: That’s an equation. And the effect was to create a current account surplus in Germany which is matched mathematically by the deficits run in peripheral Europe. This is where you are dealing with Germany being complicit, having gained an advantage over the last 10-15 years, and you can’t at this point say, “Well, we gained the advantage and we were willing to lend our capital, to put it at risk, but we’re not willing to take a loss on the capital we put at risk.
Kevin: Let me ask about Greece, because we’ve talked about it the last few weeks, the game theory, all the play that has gone on, but they’ve been granted an extension. How many more extensions are they going to get, and actually what is the extension for? Who benefits?
David: They haven’t solved anything. They’ve basically said, “It’s going to take us a little bit of time to work this out, so we’re going to, again, sort of go to the ‘extend and pretend.’ We will work this out. We’re making headway.” I think it’s very interesting, Kevin, that through the weekend you had very acrimonious language, and basically what happened on Friday is that they were granted a 48-hour extension. They were asking for six months, and they were given two days.
Kevin: It’s the old line in the sand. “It’s here. No, it’s here.”
David: Yes, and so they were given two days. And then all of a sudden, two days later, Greece is signed on and four months is what’s in the bag. What happened over the weekend? Who called whom? And quite frankly, what we do know is that nothing has been resolved or agreed to at this point.
Kevin: But if we were to weigh the equation out – let’s call one side capital, let’s call the other side labor – right now it seems that capital is winning.
David: At the expense of labor. You have the financial sector throughout Europe, and yes, that financial sector throughout Europe is defended by Mario Draghi at the ECB, and they are loathe to concede a loss of the principle loaned out, so the conflict will continue to rage. Will they get a third bailout June of this year, or ultimately, will there be a percentage debt forgiveness? And again, it goes back to this concept of assigning losses. Who will accept the losses in this financial crisis?
Let me clarify something, because by using these sorts of broad categories to summarize the issues in Europe and in Greece, labor versus capital, specifically, I’m not adopting sort of a soft Marxist critique. I belong to the capital side of the equation. But I think it’s important that you bring self-reflection, self-critique, and objective observations. These are all valid, even if at points in the conversation there is a bit of uncomfortability. Having capital is not wrong. Having assets grow, by any means, including artificial ones, listen, if you are experiencing it, you’re not going to object to that. While that is pleasant, keep this in mind. Artificial growth may, however, have very serious long-term ramifications, and that’s what demands analysis and critique.
Kevin: I think that’s the key, Dave, because a Marxist would actually say, “That’s exactly right. Capital is beating labor so you have to balance things out with communism. But in reality, it’s the ability to create artificial stimulation and artificial retraction, and basically, choose the winners and choose the losers. That’s not free market. That’s socialist control. It’s just another form of communism.
David: Insofar as it has command economy characteristics, that’s precisely it. It’s the artificial nature of growth that I have a problem with. And to me, it seems that there are too many political legacies and agendas served by eliminating the business cycle and introducing artificial growth stimulants.
Kevin: Going back to the equation formula, though, Dave, there is another equation. There are the haves and the have-nots. It seems like it always comes up in any political discussion, any economic discussion. What groups of people do you have in modern democracy?
David: That’s it. Along socioeconomic lines, you can simplify it to haves and have-nots, and you will notice that politics plays to one side or the other of this divide. Politicians focus on labor. They know the difficulties of remaining in office. Let’s see, if you neglect the basic needs of your constituency, if you get caught assigning losses to your constituents – that is, get caught; you can do it, you just can’t get caught – or if you play too heavily to the benefit of the owners of capital. And I think, frankly, that’s where Hilary, in the 2016 election – this is going to be her curse. She has played too heavily to the benefit of the owners of capital. So, if you are looking back in time, austerity and belt-tightening hit households the hardest.
Kevin: And what is interesting is that austerity is the most dangerous thing for a politician to choose. It may be the right thing – let’s go ahead and tighten our belts.
David: But history provides a number of examples that suggest there is a pain threshold, whether it is the middle class, or amongst labor, what have you. Think about the Romanian experiments with austerity under Ceausescu. Ultimately, he and his wife were murdered! You saw the same outcome in Czechoslovakia. The head of the Treasury was Alois Racine – who cares about Alois Racine? This was in the 1920s, right? Two much austerity and pain and the people revolt. Racine was assassinated!
Kevin: Yes, but the party that is in power right now in Greece has chosen the easier method. “Hey, we’re not going to pay our debts. In fact, you want retirements in the 50s? That’s fine! Take retirements in the 50s, we’re not going to cut anything.”
David: “In fact, you deserve a bonus.” Syriza, in Greece, was elected with a mandate of making capital take its lumps. If you think about that, that should be a part of the capitalist equation, right? It was cutting the burden of debt and avoiding more radical austerity measures which was their election mandate. And that is the direction that Syriza is heading. Remember that no economy can grow if it has too much debt, and this is one of the reasons why the folks at PIMCO, there are a number of economists, half a dozen to a dozen different Wall Street companies that are saying, “You’re going to have to lower your expectations in terms of global growth, in terms of U.S. growth.”
Kevin: Because the debt is huge.
David: We have so much debt at this point that the servicing costs sap the resources needed for growth. So you could argue that the best route forward in the case of Greece is, in fact, to cut the burden of debt by some percentage, and if that is done – let me say, I stand corrected from last week. If that is done, then those growth-linked bonds, which I was ridiculing last week, would work. You have to reduce debt to the point where the burden of debt service is not sapping all the potential energy for future economic growth.
Kevin: And this sounds obvious, Dave, and hindsight is 20/20 for all of us, in all of our lives, but in governments, especially. The better thing would have been not to take out the debt in the first place, would it not?
David: That’s right, and that’s where we don’t, really, in the U.S. or globally, have a system of accountability for government spending. In fact, if you put government on a limit, let’s call it a balanced budget amendment here in the United States, politicians don’t look at that as, we get to spend less. That means we get to tax more. The solution to a balanced budget amendment is that we balance the budget by picking your pocket that much the more. We haven’t quite figured out how to control governmental largesse, but if you recall, that period of 1860 to 1914, the Golden Age, the period where the world was on the gold standard, this problem of government spending largesse was solved by the monetary system, itself.
Kevin: The equation balances itself when you are on a gold standard, Dave. I remember when the ship, the U.S.S. Central America, sank with San Francisco gold on it. It actually created a depression in America because that was a monetary loss. They couldn’t just print it out of thin air.
David: It is certainly the case that avoiding the level of debt currently in the system would have been solution number one – just avoid it from the get-go. We wouldn’t have the present financial crisis because we wouldn’t have as much leverage in the system. That was not done. So, setting that aside, we have to remember that it takes two to tango. Lenders were happy to lend, borrowers were happy to borrow, and I think it reasonable that both parties bear the burden of adjustment. Some austerity, but not so much that you ruin a sociopolitical piece, and some debt absolution which is, in effect, taking it out of the hide of the banks which facilitated an over-abundance of sub-par lending. And guess what? They did profit from the debt issuance in the first place. I consider it an axiom of capitalism that capitalists put capital at risk. You should not, then, go hide behind the skirt of a bureaucrat or a legislator when your bet goes bad.
Kevin: Well, and capitalism is about taking risk. The only way the system gets healthier is with creative destruction and innovation that comes afterward. If you don’t have the creative destruction of the things that are not working, what you are really doing is just feeding the cancer that will continue to get bigger.
David: Essentially, what we have in Europe is a massive influx of dollars in a 5-10 year period, and that massive influx of money – not dollars, euros of course, but I’m talking about currency units – came from northern Europe, came from Germany, as we talked about the difference between labor wages which were set artificially low in the late 1990s and it created a massive influx of capital from those countries into the peripheral European countries.
Kevin: We seem to have a historical precedent for that. Years ago, Dave, Drew, our coin-buyer, was able to obtain some first-edition German marks from 1870. These were marks that were minted from French gold that was extracted – it was the French indemnity when Napoleon III lost a war to Prussia, later Germany, in six weeks. They had to pay, I think, 43 million ounces of gold to Germany, which was Prussia at the time, which later turned into Germany. They minted the first Deutsch mark. What is interesting is, that was a huge – talk about a massive movement of capital, very similar to what we are seeing here.
David: And think about what happened in the last 5-10 years in these peripheral European countries. Stock markets went crazy. Real estate markets went crazy. Everything went higher because of this influx of capital. And the same thing happened in Germany. If you get a chance to read Pettis’s article from the Financial Times, it is excellent. He mentions this, and it is, I think, a critical historical reference point. French indemnity, the money coming into the peripheral European countries, it was similar in scale to the 5 billion German gold marks that were coming into Germany. And guess what happened? The Germans experienced a major asset price explosion after the Franco-Prussian war, ending with a blow-off phase in 1873, a collapse in the stock market in Germany. Ultimately, this had ripple effects throughout the world. This was the first experience of the New York Stock Exchange in 1873. As a consequence of the blow-off, and ultimately collapse, in asset prices in Germany, the New York Stock Exchange was closed for ten days.
Kevin: Wow, you don’t hear about that.
David: Closed for ten days. You had 20-23% of GDP, which was the amount of the reparations paid from France to Bismarck to Prussia, the result was the same. Asset price explosion, followed by asset price implosion. And this is what we are trying address here in Europe and all around the world. The real lesson – the real lesson – is that massive liquidity coming into any economy is disruptive, and ultimately dangerous, because on the one hand it inflates asset prices, and then what follows is, typically, the deflation of those assets. We have had a long-term increase in debt liquidity, which has fostered the increase in global asset prices for 20-30 years up until 2008. And now, on top of the old debts we have new government debts which were introduced as a means of propping up the old asset prices, the unsustainably high asset prices, at levels they reached before the global financial crisis.
Kevin: Then let me ask you a question. And this was the title of a book that we have recommended in the past. What would make this time different? They say this time is different, but really, the whole concept is, there is no time that’s different. It always ends up the same.
David: Well, perhaps the degree to which central banks around the world are coordinating efforts – that is certainly different. Perhaps that continues to buy us some time. But as Pettis has suggested, at the end of the day, the only solution to a financial crisis is to assign the losses. So as we mentioned earlier, this is a part, a large part, of why capital is in flight around the globe, because you have in multiple jurisdictions, people who are growing concerned that they may be required to contribute to the solutions. They are concerned that, whether it is legislation, outright confiscation, taxation, what have you, that they may be the assigned loser. And of course, all that’s for the greater good, so they say.