In Transcripts

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, there is Greece everywhere.  That’s all the news right now:  Europe, Greece, and really, the dominos that will fall afterward.  There are publications that we read daily, especially Bill King’s publication, and he is devoting, 2, 3, sometimes 4 pages a day to this impending crisis.

David: Kevin, we are at what he would describe as a threshold point, coming into an end-game scenario where the sovereigns have bailed out private interests and now the sovereigns need a bailout, themselves, and there is no one with enough money to do it, so we are digging deep to find solutions in real time, and what we are watching in Europe is a quibbling over something that cannot, in fact, be solved, because they are still not even considering it a structural issue to begin with.

The first of two dominos, Europe, and then the United States and our debt markets.  It is time to have that conversation with Bill King and cover some of these ideas.

Bill, thanks for joining us.  There are so many things to cover, both here in the United States, and within Europe.  Let’s start with Europe because it seems that is where the issues are most critical, as in: If they are not addressed immediately, we are looking at serious, serious ramifications, not unlike what we saw in 2008 with an unwinding cascade effect, if you will, from institution to institution, where things actually were out of control.  We have a number of things to keep in mind.  I think Greece is probably on everyone’s mind.  But as a backdrop, let me ask a question.  You have the crisis and political opportunism, which have seemed to go hand in hand.  If you look back to 1992, the breaking of the exchange rate mechanism ultimately gave birth to the euro.  Let’s start with the question:  What is being birthed in Europe today?

Bill King: What is being birthed in Europe today? (laughter) Probably a gold standard.  The big dynamic that is going on is the collapse of Western socialism.  And when you are collapsing Western socialism you are collapsing your political structure and that socio-economic structure that is derived off of that political structure.  That is what Europe is doing, they are scurrying around and trying to patch these countries together, patch these problems up, by throwing more money at them because they do not have a solution.  Their solution is abhorrent, politically, just like here in the U.S., and that is:  Live within your means and start working more.  But they have created this mess over a couple of generations and there is no easy way to do it.

There are no painless solutions anymore, and the problem is, they have told people for decades that the government is always here to take care of you, bail you out, give you some freebies, give you things you don’t deserve.  It is one thing for Russia to default like they did in 1998, and then be able to get back on their feet within three years, because they have enormous resources and energy markets, and the commodity markets picked up.  Let me ask you a question:  What does Greece produce that the world needs?

David: Um….

Bill: Yeah, that’s right.  That’s right.  (laughter) Tourism, and some olive oil, and some wine.  And that is the problem.  I forget what percent, but a huge percentage of people work for the government there, and they are not productive on a global basis.  But what they were able to do was borrow enormous amounts of money and pay people benefits that they didn’t earn, or deserve, and that includes not only salaries and jobs, but pensions and retirements benefits, on and on and on.

It is no different there than in the United States.  It’s just a matter of degree.  And the whole transfer of wealth to China, India, and developing countries sped up, and accelerated the decline of socialism.  The big difference now is that it is happening on such a wide scale.  It is not just Greece.  Again, they are doing triage.  We are sitting here in the U.S. hemorrhaging badly, but again, it is like when you have a battle, you take care of the worst people first.  They get the attention.  So it will be Greece, and then Spain, then Portugal, you can just go through the whole list – Italy, then the U.K., on and on.  That is just the way it is working through the system.  That is the problem.  There is no easy solution.

For the politicians, they are just scared to death, because their whole world is coming apart, and what are we doing?  We are throwing good money after bad money, which is absolutely something you cannot do.  A year ago, we gave Greece a bailout.  How did that work out?  The problem was, we gave them debt they cannot afford.  They do not have the means to pay for the debt because they don’t have an industrial base to pay for this, and they just kept living beyond their means.  So now the solution is, let’s give them even more money.

But there one thing they did do.  They said, “Well, you have to have some austerity measures.”  The things they did do killed the economy.  They didn’t really cut as much government spending and some of the other things they should have.  Now we are telling them, “We’re going to give you even more money, and we want you to cut and put more hardship on your economy, even now.”  And that is the problem.  Nobody wants to take the hit, take the adjustment, and force people to restructure their economy to be more productive so it can exist in the global marketplace now.

But the other problem, and I have been talking about this since 2008, is that it is not just that you are looking at the bank debt, it is the derivatives.  They are a multiple of the debt.  And finally, about two or three weeks ago, Juncker finally admitted that the problem is the CDS – the big European nations:  Germany, France, the U.K., and even the U.S., have been whittling down their exposure to Greece and the other European lending.  That has been documented.

The problem is that the derivatives on that debt, the credit default swaps, the CDS – that is what they are afraid of igniting.  And of course, the U.S. banks have a big chunk of those, have the majority of that, and that is the same problem, why Lehman blew up, and AIG.  AIG had all these credit default swaps, and all these different financial instruments and companies, and it blew up.  That is the problem.  And we are going to have these problems until the regulators and the officials in the U.S. and other areas finally stop this nonsense.  They had three years to do something about it, and they didn’t do anything about it.  So now that is the problem.

Juncker came out and admitted two weeks ago that they lied – they  lied to the markets because they have to.  That’s extraordinary that the guy came out and admitted that, which is why we had that little bit of a rally yesterday, because he came out and said, “Don’t worry, we will have the solution in Greece.”  When everything fell apart on Sunday, all the meetings with the European officials produced nada, the European markets fell, he stood up before the U.S. market opened, before the New York Stock Exchange opened yesterday and said, “I assure you all, we will come to some solution on Greece.”  So we had that opening rally and after that there was nothing going on, but this is an enormous game and nobody alive has seen what is going on here, the collapse of Western socialism, the political structures, the socio-economic structures, and it is a difficult, difficult environment to navigate right now.

David: We have an interesting issue with the EU leaders having a hard time coming to consensus as to how to solve the problem.  Once they come up with the perfect plan, then you have what I think some have called implementation risk, where the odds of actually executing on that strategy are even harder.  I mean, it is a huge uphill battle.  It is not just coming up with a plan, it is implementing it and getting it done.

Just to back up, you have pointed out something very interesting.  We would agree, this is a collapse of Western socialism, but in some circles in Europe, the crisis is relished due to the doors that it may open, bringing about a closer fiscal and political union.  Could this be a consolidation of economic power in Europe?  I agree from a market perspective, it looks like it is unwinding.

Bill: No, no, it is the opposite.  It is unwinding.  It is just like the universe.  We know about the universe.  It expands as far as it can, then it collapses, gravity into black holes, and then it pops up again, and that is what has happened here.

The other big dynamic here, is that for the last 150 years or so, the key question in continental Europe has always been Germany.  How does continental Europe control Germany?  That is what it comes down to.  Look back to the EMU when they wanted to put this together.  The big reason they put together this euro in 1999 in the EU was to contain Germany.  This was part of the reunification which showed up there in the early 1990s, when Germany had the opportunity to reunite East and West Germany.

Now we know France was against it, and Margaret Thatcher was against it, even though she was not in power, but people worried about that, because it always comes down to Germany.  The German nation is so much stronger than the rest of the continent.  Forget militarily, that was always the problem before – militarily.  But economically, they are not only just so much stronger, but their culture is so much different than the rest of continental Europe.

David: That supports the two things that you said the rest of Europe needs.  They have got to live within their means, and they have to work more.  That describes Germany to a tee.

Bill: As you look at Greece, as you look at Portugal, Ireland, Spain, and Italy, you have to ask, “What is it that they produce that the world really needs?”  And it is hard to find things.  Even France has Airbus which is a consortium of European countries.  It comes down to, “We have tourism, we have some wine, we have some this or that.”  But Germany is the world’s biggest exporter.  They fight with China over that title, but what does China export?  Well, they export toys, and consumer electronics, on and on.  Germany exports, not just autos, but heavy machinery, scientific equipment, machine tools – the most essential things a country needs.  That is why Germany has done well, while China, India, and the developing world are industrializing, because they need the German machine tools, and know-how.

That is the problem.  Germany is doing well.  These other countries have been living off of Germany.  The real story is what is going on in Germany.  If I am a German official I would be giving lip service to, “Yeah, let’s help Greece, let’s hold the CU together,” but privately I would be hoping for the whole thing to blow up, because you see what is going on in Germany.  Merkel’s coalition is just collapsing because of the politics, because the German people are saying, “Why should we work our behinds off, do everything right, so the rest of Europe can take vacations, month-long in August, work 35 or 36-hour weeks, have these ridiculous pension benefits, and they are doing nothing but living off of us?”

That is what is happening.  And you have people in Greece rioting because they don’t want to cut back on their freebies and the things they don’t deserve, and then you have Germany in the political situation of, “Hey, we are tired of bailing out all these countries that are not doing the work, and we are.”  And it is incompatible, it is irreconcilable.

The European officials are playing this game.  It has been no different throughout history, whether it was the Napoleonic Wars, World War I, or World War II, you see this same nonsense in Europe where they are trying to hold together different empires, different coalitions, different treaties, different alliances, and you have incompatible differences, and dynamics, and they blow up.  That is just the way Europe is.  It has been that way for many centuries.

And the bigger problem for Europe is that for 400-500 years they ran the world.  They were the economic power.  The U.S. came along in the last century and became the big factor because of the two World Wars, but now we have this big transfer to Asia, in Japan, India, China, and even some of the other emerging countries like Singapore.  This is what is really hurting Europe.  This is several hundred years unwinding on them, and they just cannot fathom it.

David: So how does this end for Europe?

Bill: It ends up where it is going to blow up.  As Margaret Thatcher said, “The problem with socialism is, eventually you run out of other people’s money.”  It’s over.  It’s over.  We have been going through this for three years, since 2008.  We just do not have the money to support the banks.  The banks got over-extended lending.  A lot of it was at the behest of the government, trying to keep socialism going, so governments stepped in and took over the private sector obligations.  So now the governments are blowing up.

You see, this is what they can’t figure out.  For a hundred years in all the schools around the world, it was taught that the government could always bail you out, or the central bank can always bail you out.  So they did that exercise in 2008 and 2009, but no one got to the point of saying, “What happens if the governments and central banks have to bail out so many people that they go under?”  Nobody got to that point.  So we have this farce now, this daisy-chain bailout, where we say, “Oh yeah, well, the IMF will bail out Greece.”  Well, who is the biggest contributor to the IMF?

David: The U.S.

Bill: The United States.  And they are bankrupt.  You can just go through who is contributing to the IMF and it is ridiculous.  That is why you see gold sitting very firm, while the other commodities are falling, and the U.S. bond market is being held up, because if you are a person of means in Europe, you are trying to figure out where you hide.  And this bad U.S. bond market is a safe haven for now.  They are never going to be able to pay all their debt, but for the time being, again, it is the triage concept.  I think that is why people are stunned that the U.S. bond market, in particular, Bill Gross, cannot understand why the U.S. bonds are holding up.  It is because of Europe.  If you are a person of means in Europe, you had better find a place to hide while this stuff blows up.

And of course, what will happen here is that Greece will probably have to pull out of the EU at some point.  They will start issuing drachmas again, and then it depends on what the individual countries do to get their economic and financial affairs in order.  There is an article in The Economist magazine now that makes a point I have been trying to make.  For the last two years we heard a lot of silver and gold bugs saying, “Well, countries will always paper over their debt, they are always going to hyperinflate.”  And I have said, “No, there are very few instances of hyperinflation.”

What people do is they default.  It has happened recently.  In Russia in 1991, in 2001 Argentina, and you had Indonesia – they default.  As the article in The Economist magazine said, most of the countries do pretty well after they default.  They get that yoke off of their neck and in a couple of years – again, look at Russia, Argentina, Indonesia – they got up and got going again.  But the problem is, if you get default this time, the banks are in big trouble.  The central banks are in big trouble because they took on such obligation.

David: That goes back to the credit default swaps.

Bill: Yes, it does.

David: Because on the one hand you have a stock of debt which you are going to default on some part of, so someone’s assets are going to be impaired.  But you can define what the damage is.  You cannot define the damage in the derivative space, because now you are talking about multiples of the exposure in the fixed income world.

Bill: Right.  And you see, the other problem is, they are trying to stop the avalanche, because if Greece says, “Okay we are just going to default.  Hell with you guys, we are going to default, and we are just going to go back to issuing drachmas, and we will take the hit for a year, or two, or three, and we will be far better off.”  What prevents a chain reaction with Portugal, Italy, and Spain?  “Yeah, well, we are going to default, too.  Heck with you guys.”  That is what they are really trying to stop.  They are trying to stop that first country from saying, “You know what?  We are better off with a default.”  Because then you have a chain reaction.

David: And you are exactly right.  This is what happened in South America.  There are countries that have tried to pay back debt and it has impaired their growth for decades to come, as opposed to the ones that have just said, “You know, 40% off the top.  Sorry.  We will make partial payments, but we cannot afford any more than this.”  And their economies were the ones that snapped back.  Not that that is an ultimately desirable course.  In a picture-perfect world you would not ask for it.  But we have not had credit default swaps then, as we do now.

Bill: You are right, that is one difference that we have not had before, is this multiplier effect from the derivative, and what really raises my ire is that they have had three years to stop this, and I have been screaming, even when we had the subprime problem.  Real estate was a problem, but it wasn’t the problem.  The problem was the hundreds of trillions of dollars in derivatives that the regulators in Congress and the other officials allowed to happen because they were bribed.  The Wall Street hedge funds, big banks, threw billions of dollars at these idiots to let them do this.

And that is the other thing that is happening.  This is the age of finance.  Go back to economic theory, even communist theory, about capital versus labor.  On Wall Street, and we know which firms and banks, in particular, a handful, control the world.  And they have done it, you can see the people they have hired put in government offices, treasuries, central banks, and they have made enormous amounts of money, and created an enormous concentration of wealth, and it is blowing up on them.  And that is the problem.  That is what they are trying to hold together, this structure.  Again, it is the political and socio-economic structure that comes from a debt society.

And yet again, the problem here is the Western world.  This is the game they have played, especially the last 25 years.  They have played this high-finance game, but it was nothing but speculation and debt, borrowed money, where other people – Germany, China, India, and a few others, have actually built up a very industrial economy, while the others had this nonsense, “We are a service economy.”  That is garbage.  What services?  Moi?  They are really talking about financial services, and that was just speculation – derivatives.

I remember in the 1990s Wall Street was telling all the world, “Oh you have to have derivative traders, you have got to get into this stuff, you have got to do this stuff.”  Yeah, how’s that working out?  Well, it worked out okay while they were printing money, and they were rigging markets and doing what they had to do, but now that it is blowing up, everybody is running.  And unfortunately, we have had opportunities to address this stuff over the last 10-15 years, but Greenspan wouldn’t do it, Bernanke wouldn’t do it, and they just kept letting it get bigger and bigger, and bigger and bigger.

Now, since 2008 there has been some retreat in credit default swaps.  They are still enormous.  But where the growth has been, and it has been huge, has been interest rate-related derivatives.  So that is another reason why the Fed is just sitting there.  If the Fed ever loses control of interest rates, oh my God, there is no telling what will happen with the derivative markets.  But from the trader’s standpoint, it is other people’s money, and they make fortunes.  That is what is interesting here, you have people who are making 8 or 9 figures, some people billions a year, in this speculation, on other people’s money.  Why not take the hit?  Why not take that risk?  You are foolish not to.  If you are right, you make unbelievable amounts of money.  If you are wrong, the risks are being socialized.

David: Exactly.

Bill: That is the problem.

David: Let’s talk about the U.S., because the effectiveness of a prescribed course is really correlated to the accuracy of the original diagnosis, and no one questions the intelligence of our current Fed – well, I guess some do question the intelligence of our current Fed leadership – but is the diagnosis correct, and the prescribed course?  Are we following the right course?  We have a zero interest rate policy.  We have ample liquidity provided.  We have Quantitative Easing I already done, Quantitative Easing II which ends in a few weeks.

Go back to Bernanke’s speech in 2002, why deflation will not occur here, and it is a laundry list of things that he can experimentally put into place.  There is no guarantee that they will work, but they have got options, and they have got what he describes in the speech as determination.  He has determination, and that is why we are not going to see deflation.  Now, you have said it is not a guarantee that we are going to see inflation or hyperinflation, but we could see default.  Can we see default, or a throwing in of the towel, with someone like Bernanke in place?

Bill: Sure.  We have had the first hint of it, and again, the marketplace being as dumb as it is, they talk about the omniscient market and what it discounts – that is garbage.  The last few years have proven how smart the marketplace is.  In May, at the FOMC meeting, he said the key thing.  A few people caught it, but most people didn’t because they didn’t want to hear it, because people believe the Fed is always going to pump money.  He said the trade-offs are not beneficial anymore for Quantitative Easement.  What he is telling you is, “Yes, I have been telling you that inflation is transitory, but I am lying, because that is why they are pulling away.  We can’t do this, because you have blown up the economy.”

If you noticed, something hit the economy very hard the second half of February.  That was very clear.  Anybody paying attention saw that something bad hit the U.S. economy the second half of February, and the data has been ugly.  And what most people do not understand is, seasonal adjustments in the spring were overstating economic strength, and they turned negative here in June.  That is why it looks even worse now.  But something bad happened here, and a lot of it has to do with the consumer spending, because of gasoline and food prices.  Worldwide, it caused revolution.  And you can be sure, a lot of these countries were calling the White House and screaming about the idiots at the Fed that are unleashing inflation here, in food and energy and the necessities of life, and causing turmoil throughout the world.

The seminal event was Bill Dudley, old B. Dud, who went to Long Island – why the Fed official is out there publicly is incomprehensible, but that is another legacy of Alan Greenspan.  He had such a horrible career on Wall Street that when he was pumping money and everybody loved him, he wanted to get out there and be a rock star, so all these Fed officials run out all the time to be rock stars, when they should not be heard or seen.

Bill Dudley has this town hall meeting on Long Island.  He is under the delusional thinking that he is talking to some Wall Street crowd who will buy all his B.S., not that they want to buy it, but it is bullish, so they give him the amen chorus.  But now he is talking to regular moms and pops and he is giving him the usual B.S., and they don’t buy it, and they are screaming about inflation.  He says, “Well, but your iPad prices are down,” and they go berserk on him, saying, “We can’t eat iPads, you idiot!” I saw that, and I said, “That’s it. It’s over.” The Fed has lost the public.

David: Their credibility is shot.

Bill: Not only that, they have been so insulated, talking to other academics and Wall Street, who buy this nonsense about hedonic adjustments, and there is no inflation, when the regular person is getting killed, and they told him so.  But not only that, the media ridiculed him, and that was it.  That is when you knew there would be no QE-III for the foreseeable future, and they told you that.  Now, at some point, if things get very bad, then he might have to pump money again, but now he understands that if he pumps money, he will kill the economy, and it doesn’t matter, because the inflation will get so ridiculous it is not funny.

David: It is a Catch 22, because on the one hand, they do not want to do that.  QE-III has very obvious implications for politics and politicians, but on the other hand, you have deficit spending which is propping up between 10% and 11% of gross domestic product.  Without that, we slip into something that looks akin to the 1930s – 1931, 1932.  It is pretty ugly if government does not have the ability to spend, and they cannot spend if they cannot finance it.  So, how do they get it financed outside of a QE-III?  Particularly when Russia, for example, in the last six months has reduced their holdings from 175 to about 125 billion, so 50 billion less there.

Central bankers are moving way from Treasuries, and then you have this bone-headed idea of FATCA, where it is forcing private banking and financial institutions out of U.S. financial instruments, including Treasuries.  We are absolutely shooting ourselves in the foot, at the time where we need to be able to finance more and more of these IOUs.  So clearly, they cannot, for political reasons, move to QE-III, but how can they not do something that still allows for monetization of debt?

Bill: Well, that becomes the problem.  They are in the end game, and they do not know what to do.  Again, this is one of Bernanke’s lies, that we can always pump our way out, but he never reasoned that there is a threshold point.  Anybody who goes to college now and sits in these Keynesian classes has to say, “This is absolute garbage,” and here is why.  The Phillips curve does not exist, we disproved it in the 1970s and the 1980s, yet that is what Dudley was talking about here.  “Well, we have got to do QE-II so we can get unemployment down.”  Doesn’t work.  It didn’t work.

Again, we disproved the Phillips curve in the 1970s and the 1980s, but these guys don’t have anything else.  So you spend your life’s work saying you can always pump money, and there is no consequence to it.  That is horrendous!  We have seen throughout the world, there is plenty of history that it doesn’t work.  But they did not want to believe it.  And now, he is in the laboratory and it is not working.  He doesn’t know what to do.  It didn’t work for Japan, but their view was that they didn’t do enough.  They didn’t pump enough money.  FDR did this.  FDR fooled with gold, he debased the dollar.  They monetized bonds, finally, in 1936, and nine months later there was a mini-crash in the bond market.

As the Bible says, there is nothing new under the sun.  This stuff has all been done before.  Now, they can create all these facilities – TIF, TLSF, primary dealer – it all comes down to the Fed can only do one of two things:  It can extend credit, or it can monetize assets.  That’s it!  That is all they can do, there is nothing else.  You can wrap funny names on it, and you can put certain conditions on it, but that’s it.  That is all you can do.  And that is what they are down to.  The problem now is, it is the end game.  The Fed is facing insolvency, the United States is facing insolvency.  What do you do?  Well, we know what to do.  You have to take the hit.  You have to do the restructuring.

It is no different than what Germany did after World War II.  They were devastated, the United States sent over all these wonderful Ivy League economists to help them out, and they created a command economy and things got worse, people were starving, food prices were soaring, production was collapsing, and then finally, Adenauer, and Earhart, the finance minister said, “No, we’re going to a market economy,” and they took a hit for about a year or so, and then, boom – then you had the German economic miracle that continues to this day.  Earhart said, “No, this is absolutely ridiculous, we will let the marketplace work here.”  That was the big difference there in Germany.  People say it was the Marshall Plan, but the Marshall Plan was not very big, it was only a few billion dollars for Germany at the time.  But that is what they did, and it created that culture of market, of working, with the cooperation of government, and off it went.

David: Bill, it doesn’t seem like we will voluntarily choose that restructure.  Even today we have the Republicans and the Democrats posturing over the debt ceiling, with an amazing degree of self-righteousness, where all of a sudden we are concerned about debt, when in fact, we have ignored it for decades, and are not addressing it with any degree of seriousness, even now.  What kind of a crisis will prepare the public’s minds, or the policitians’, to take the hit, to restructure?

Bill: When it blows up.  You are absolutely right.  There are a couple of interesting things here.  The model is Vallejo, California.  I have been saying this for three years, even before the crisis here blew up in late 2008 and 2009.  Earlier in the year, Vallejo, California was going bankrupt.  I can’t remember which publication, but a major publication went out there to talk to one of the officials and said, “You guys are going bankrupt.”  The guy said, “Yeah, that’s right.”  The reporter said, “What are you going to do about it?”  And the guy said, “Well, what do you want me to do?”  The reporter said, “Well, you have to do something.  How about cutting spending, and creating some revenue somehow, raising taxes?”  And the guy said, “Well, if we do that, we’re out of power.  We’re out of our jobs.  So we’re not going to do that.”  And the reporter said, “Well, what are you going to do?”  The guy said, “We’ll just let some bankruptcy judge sort it out.”  And that is where they are today, in bankruptcy court, and some judge is going to sort it out.

That is what is going on here.   The Tea Party pushes Republicans in office to cut spending, and Boehner looks up there and says, “Well, if we cut the spending the way we should, we are going to go into a depression, and then they are going to blame us, so all we have to do is do a little more than the Democrats want to do, because the voters have nowhere to go.”  So Obama says, “We’ll cut 10 billion,” and Boehner says, “No, it’s got to be 30.”  Both of them are worthless.  That is nothing.  That is not even one week of borrowing, the way we are going now.

And more importantly, the interest expense at these ridiculously low rates is somewhere approaching 500 billion dollars.  Therefore, you cannot have meaningful deficit reduction unless you cover your interest expense, plus a little bit.  You need at least 500 billion in cuts to have anything meaningful, to cover your interest and then some portion of spending.  That is basic math.  For these guys to be talking 10 or 30 billion is ludicrous.

But I’ll tell you what.  If you cut 500 billion dollars right now, the economy is in big-time trouble.  The same thing goes on with the states and municipalities.  Everybody is doing the same model.  Try to position yourself so when this thing blows up, you and your party do not take the political hit.  If leaders would come forward, like we had in the 1980s with Volker and Reagan, who got in front of this thing and changed it, but now it is probably too big even for someone like them to change it, so now the game is all posturing, so that when the market exerts the discipline, somebody else is going to take the blame, not you.  That is what they are doing.  They are going to let this thing go until it just blows up.

David: We have talked about two things today.  We have talked about a detonating mechanism, which is the European government debt, and we have talked about the U.S. debt bomb, which is just waiting for the detonating mechanism.  Well, that is a positive thought (laughter).  What extends this?  I think one of the things that has always been sort of magical is the number of rabbits that seem to be able to be pulled out of the hat.  How far can we press this?  Can we press it to 2014?  Is it 2013?

Bill: No, there is no telling.  The U.S. is getting a reprieve because the European situation is just so bad, so much worse right now.  That is what they are afraid of.  If Greece says, “Okay, we are going to default,” then all of a sudden you start hair-cutting the bonds and their debt, and then it ripples through the European banks, and then now all of a sudden the U.S., with the CDS, you have the problems going through there.  Then it is going to go into the courts, because you can see what they are doing already.  S&P says, “If you do a soft default – extend maturities or whatever – that is a default, and that will trigger the CDS.”  But then you have the other officials saying, “Oh, no, no, no, no, that’s not a default, that’s not a default.”

Why are they trying to parse what a default is so much?  Because they do not want the CDS to get triggered.  So this stuff is going to end up in some courts.  Again, I hate to call it a slow-motion train wreck, because it is wrecking in front of us, but the idiots that run the Western governments have allowed the financial industry to take it hostage.  As I keep saying, it is financial terrorism.  “If you do not give us what we want, we are going to detonate all this crap we have, all the CDS, all these derivatives, all this junk – we will detonate.  So give us the bailouts, on the backs of the taxpayers, keep doing this stuff, or we are going to blow everybody up.”  And they have been doing this for a good 15 years.

David: When does the taxpayer say, “No more?”  Isn’t that exactly what we see in Germany today?

Bill: Oh, yeah, and that is what happened with the Tea Party.  We are seeing it in Greece.  We are seeing it around the world.  That’s it.  That is the end-game.  That is why this is such an intriguing period of history.  This is 100-some years in the making – at least 80.  And the abuse was always just papered over.  Give more power to the financial people, more financial injury, more speculation, increase the role of the central banks.

The whole concept of Keynesian economics was that when the economy suffers from a lack of demand, government should step in and help the economy.  That is not a bad idea.  But that means you get your keester out of there in some short period of time.  It is temporary.  But these guys have perverted and bastardized that concept into government taking over the economy, increasingly, especially in the United States, for 70-some years, and it has blown up, because it is too big.

It is the same with the central banks.  The concept of the central bank was to be the lender of last resort.  When things got bad, they would come in and lend.  That was Bichette, the father of central banks, Lombard Street.  In a crisis, you come in and lend freely, on good collateral, at a penalty rate.  Well, that is not what they did.  They took every crappy collateral out there, and they rated at zero.  The central bank should only have been sitting out there as a lender of last resort, but what has happened over their history?  They are in the marketplace every day controlling the markets.  They are controlling interest rates daily through their operation.  That is not what the central bank is supposed to be.

David: We have the Japanese central bank buying ETFs to prop up the stock market in Japan.

Bill: That is what the was reporting, and who knows?  I don’t think the U.S. does that this way.  They send people in to buy the futures.  I don’t think the U.S. does it directly.  The Treasury, the Fed, I think they send their agents in.  That is the other thing.  It is a cabal.  It is collusion between government, the Fed, and the select too-big-to-fail guys, and they are running the world.  But that is the problem.  The central bank should not be in the marketplace daily, and they are.  Now they have become the market, in many things, and the government has become the economy.  And you cannot do that, and there is going to be a retreat.  The market is going to force this on people, and it is not going to be pleasant.

David: Bill, in one of our past conversations, which was quite candid, in the summer of 2008, if I recall correctly, you said, “I paid off the house, threw a few more Krugerrands in the safety deposit box.  I don’t like what I see.  I do not like what I see.”  And for the last three months I have had this growing sense, in talking to professionals such as yourself, that this is terribly wrong, and sometime between July and the end of the year, you could have a 2008 in the remaking – not exactly similar, different causes, obviously different effects, and perhaps even a larger scale.

But in all candor, let’s get practical.  What do you do now?  These are the dog days of summer, things are pretty quiet, people really aren’t engaged.  How do they need to engage, and what do they need to be thinking in terms of?  This is something that could very well destroy the financial lives, not only of individuals, but we have been talking about nations.  That does trickle down.

Bill: Absolutely.  The first thing you have to do is to get, mentally, in a defensive mode.  And by that I mean, if you put on the television and you listen to the idiotic people that come on these financial shows, and we don’t have to name names, we all know who they are – they are idiots.  They are always drilling you in the head about, “Make money, make money, make money!”  They are playing this greed game.  They are marketing investments to you like it is fast food or beer, where you just have to consume and trade all the time.  That is ridiculous.

There is a time when you have to protect what you have, because nobody knows how this is going to play out.  Nobody alive has had this situation before that is going on in the world.  So the thing you have to do first and foremost is protect what you have.  You have to know where your money is, you have to know what it is invested in, but you have to be defensive.  You have to have some kind of portfolio constructed that you can survive whether you get a big burst of inflation or you get deflation.  That means you want to have an ample supply of liquidity, whatever that is – dollar equivalents.  It could be in Canadian dollars, it could be in Australian dollars, or whatever.

You want to have some gold or silver, preferably bullion and coins in a lockbox, or whatever.  If you want to have some stocks, that is fine, but you want to be in companies that have low debt, very good balance sheets, and no matter what comes in the way of this shakeup, that company is going to survive, whether you are up or down.  Of course, that includes oil companies, you could argue MacDonald’s, you could argue Walmart, service companies like that.

You just have to wait and watch, and the reason you want to be defensive is, we are going to get inflation and deflation.  The problem is, we do not know which one comes first.  That is what happened in 2008.  The deflation showed up.  We had that horrible deflation of November and October.  We saw gold got crushed, everything got crushed.  Then they gave us the inflation, and we had that.

And then it got so bad here, it was killing the U.S. economy and causing revolution in the world, that they have pulled away.  So now the stock market is up the last week, down six weeks.  We saw some of these commodities getting hit, oil down 20%.  They had pulled away, and now we are getting the deflation re-emerging and re-appearing.  And we do not know how long this lasts.

We do not know that even if the central bank starts pumping, if the defaults start or not.  If the Fed jumps to QE-III like some people think, or they go another operation twist where they are trying to push down long rates by buying bonds and whatever, we do not know if defaults from countries would occur and usurp the ability to try to induce inflation.  In other words, the Fed could be pumping money, but the banks do not lend, and you get defaults where people are wiping out assets faster than the Fed can get them into the system.

That is why you want to construct a portfolio, get out of debt where you can, know what your money-market funds are invested in.  Do not get surprises like last time.  Check to see what the mutual funds own.  Do the work.  Just because you are in a government bond fund, it does not mean they have to be all government bonds.  There could be agencies, there could be other things in there.  Look at your prospectus, see what you are invested in.  See where your money is, see who your custodian is.  Have liquidity, have a few dollars in cash, in a lockbox, maybe a few around your house in case things show up.

But this is a time to play defense and wait and see.  Don’t get out there right now.  I have talked to some very large hedge funds, some CEOs of Fortune 500 companies, and they do not know what to do.  That is why the market is acting like it is – no volume.  People do not know what to do, because this is unprecedented, and again, you do not know what comes up first, the deflation or the inflation, so you want to have yourself constructed so that once it starts moving, you do not have to do anything rash, you do not have to get emotional, and then if it looks like you are going to be getting more inflation you could increase your holdings in gold or silver, whatever your inflation hedges are.  If you get deflation, you can just sit there and wait with your pool of liquidity and let things come your way.

That is where you want to be.  You want to be in a position, as we have been saying that history is going to show that the later half of 2009 and 2010 was the eye of the hurricane, and that we are getting the back wall of the hurricane coming now, and you had better be in a protective mode so that once it washes out, you can get back on with your life, but you do not get hit here on the back wall.

David: I can tell you, the complacency is so thick you can cut it with a knife, amongst individual investors.  What you have described with CEOs and CFOs goes a long way toward justifying why they are sitting on over 2½ trillion dollars in cash.  A quick question for you, coming back to the Treasury issue:  When does Obama, when does the Treasury Department, when does the Administration, as it is constructed today, begin to either chase with a stick, or dangle a carrot, to get those CEOs to move out of the 2½ trillion and move it into Treasuries?

Bill: They can’t.  They can’t do either, because it is a political season and it looks like you are caving in to Wall Street, again, which they have been doing.  The public are against that.  The problem is, why do they need a carrot?  GE paid no taxes last year.  In fact, with all the money they tell you they made, not only did they not pay taxes, they got a credit of a couple of billion dollars.  So for all these idiots that say, “Well, we have to cut tax rates on corporations.”  No!  Not the big corporations.  Because of their lobbyists and their tax benefits, they are paying a record low amount of taxes.

Of course, what we should do is put a flat tax on everybody, corporations included.  That is how you stop that nonsense.  And then it does not matter where your money is.  “Just pay your flat tax rate.  We don’t care.  You aren’t going to play these silly games where you book sales and profits in countries where you can harbor taxes.”  These loopholes have all been created by Congress.  Just get rid of them!  Say, “Hey, you owe us the money, the heck with you guys.  We don’t care where it is sitting.  You are a U.S. corporation, you owe us the money.”

Would they do that with an individual?  If you said, “Oh, yeah, I’ve got my money on the Isle of Wight, I don’t have to pay you taxes,” they’d come in and arrest you.  That is the problem.  A handful of people have taken over control of Congress and they are voting themselves incredible benefits.  Go back and look.  The problem is, the average business guy, the backbone of America, small business, and medium business, is getting killed on taxes.

Here in Illinois, this clown we have as governor raises taxes, the biggest tax hike in history, then all the big companies like Caterpillar say, “Well, we are moving out.”  “Oh, no, I will cut you some deals.”  What does that do to all the backbone of your economy – the small and medium business?  You kill them.

That is the same thing that is happening in the U.S.  The big corporations are paying the lowest percent of taxes to GDP in their history on their earnings, because of all these loopholes and benefits that the lobbyists give them.  But the average guy is just getting crushed.  That is where the revolt is.  That is what the Tea Party is.  That is the revolt.

You made a great point when you referred to the complacency, because even people who are looking for the end of the world say, “Oh well, we will get QE-III, and they are going to pump us out.”  So, you are right, that is the scary point.  The complacency, not just in the average guys on the street, but on Wall Street.  Considering what is going on in Europe, the stock market should be getting absolutely trashed due to the seriousness of what is going on.  But everybody believes, “Okay, that is all right, because the worse it gets, that means the Fed will have to come in and just pump more.”

And that is what we are facing.  The key going forward in the market, it is the weekend, you might get a little pickup next week when people try to game their performance for the second quarter, boost stocks up, maybe into July, and then maybe you get another leg down in July.  But in August, the Fed has a meeting that starts today, and then tomorrow they will have their report.  Nobody expects the Fed to say anything.  Anything bad is transitory.  Inflation:  Transitory.  Economic slowdown:  Transitory.  So nobody is expecting much.

What will happen is that if the European situation gets worse, then people are going to look at that August 9th Fed F1C meeting to see if there is any hint that the Fed is concerned.  Depending on what is said at that meeting, you might get a little rally in August in equities, though I think no matter what the Fed says on August 9th, where you might see a rally is at the end of August, because at the end of August, Bernanke is going to go to Jackson Hole and speak again.  It was last year at Jackson Hole when he gave the hint he was going to do QE-II.

If things are bad, people are going to say, “Oh my gosh, Bernanke is going to say QE-III,” and even if they do not believe that, they are going to cover shorts, they are going to tilt their holdings in case he suggests that we might do QE-III.  However, if Bernanke goes to Jackson Hole at the end of August and does not say QE-III, or hint, look out in September.  Looking forward, that is how you have to play this thing.

Earnings are going to come up in a couple of weeks.  They should not be good, because the economy was very bad in the second quarter, so there is probably going to be more disappointment for the downside, especially in revenue.  They can play games with their earnings, like they have been doing, but the revenues will be soft.  But then I would be watching for some kind of equity rally in August, especially if we are still weak in July, because traders are going to start reasoning that Bernanke might say something about QE-III at Jackson Hole, and the Fed might hint at that in the August 9th meeting.  Again, once he goes to Jackson Hole, if Bernanke does not say that, look out in September.

David: I listen to a bunch of hedge fund guys that seem to think this is all well in hand, and we are past the soft patch, and we are just fine, best values they have seen on Wall Street in a long time.  I am struggling to understand what numbers they are looking at.

Bill: (laughter) Yeah, you hear that a lot, about the best values. When Washington Mutual had a book value of 75 billion it sold for 2 billion.  That is the problem with these values and earnings, a lot of these earnings are financial, and the financial earnings have been getting earnings by depleting their loss reserves.  J.P. Morgan, Citi – these guys keep drawing down their loss reserves to make earnings, but if you look at the revenue, it’s soft.

It is the same things with these companies.  These numbers are guesses with these big companies putting out these earnings, but if you look at the revenue, it is not going anywhere.  And of course, what is your value compared to last year, two years ago?  Not historically.  That is when you talk about what value is.  That is garbage.  I have been in this business since 1974.  There are two things people say all the time:  “There is a lot of cash on the sideline.  Stocks are cheap, there are good values.”  You heard this in 1999, when by any reasonable measure, stocks were a bigger bubble than 1929, but you heard people say, “Oh yeah, but based on this, or based on that…”  That is garbage.

David: Isn’t it interesting that about now we have roughly 3.4% cash in the average mutual fund, so not a lot of cash, at least amongst mutual fund managers, and there is a record amount of margin debt above 360 billion dollars?  We are betting the farm that actually everything is just fine, and things are all coming up roses from here.

Bill: Right, and again, the problem is, we have record low interest rates, record government stimulus, and it cannot continue.  So what happens when it is pulled away?  It is astounding.  I said the same thing in the summer of 2008.  I wrote, “If you are not now negative, outside of total global war, we cannot envision a more negative scenario, so if you are not negative now, we don’t understand how you could ever be negative, except for total thermonuclear war or something like that.”

And that is what is going on now, although if you are a person of means, one thing you have to ask yourself is, “Where do I hide?”  I think over the long run Bill Gross would be right, that you would rather own a share of Exxon or Chevron than a U.S. bond, or maybe even a State of Kansas bond, or a Johnson and Johnson bond has a better chance of being paid off than a U.S. government bond.  I think there is no question that the Fed and other central banks have forced people into vehicles where they normally would not go, which makes them overvalued, and you might lose a good chunk of that money, but you will lose less in that than you will in a T-bill or a T-bond.

That is what makes this so hard.  Your whole capital asset pricing model, just throw it away, it does not exist anymore.  These concepts that have been around for decades, investment concepts and principles, are being turned on their heads now because the ability of government sovereign debt to be repaid is in question now.  It really does change a lot of things.  That is why you see farmland going crazy.  That is why you see gold staying firm.

You even see trading in the futures markets not being as active as you would think at these prices, because it is really the big private wealth and other people buying gold for delivery, buying bullion, buying coins.  They want custody.  They do not want to fool around, event with ETFs.  They will trade them or they will fool around with them, but by and large, they do not counter-party risk, and they do not want custodian risk.  That is the one thing that anybody who was paying attention in 2008 learned, that you have counter-party risk, but you also have custodial risk.  Who is holding your T-bonds?  Who is holding your shares of IBM, or Cisco, or Exxon?  That is why people started going for gold and bullion and coins.

When the public figured this out, they went for silver, and that is why silver went berserk, and that was a telling sign.  That got out of control, because the public will go for silver because it is the poor man’s gold, though we have taken a respite on that now.  It is a tough environment, there is no question.

David: There is kind of an expected rotation from equities to bonds, if things get ugly.  We already have, effectively, negative yields in the ten-year bond, looking at current rates.  You are voluntarily accepting negative rates going into the treasury market.  Although somebody might accept that for two weeks, or one month, on the basis of maintaining liquidity, hasn’t the picture changed pretty dramatically since 2008, because of that move from private sector liabilities to now public balance sheet impairment?

Bill: Oh, there is no question.  I think most people understand that, but again, it is triage.  For big wealth, it is triage.  “Where do I hang out right now?  People are dying all around me, everybody is getting shot up, I am just trying to survive for right now, and I will make the other move later.”

That is why you see the U.S. bonds very firm.  You can see we are not really going anywhere.  We are trading, on the futures contracts, really, between 124 and 126, but for how long?  It has been for months.  It is not that they are going to run away, because the U.S. just keeps printing more and more debt, but you have people trying to hide somewhere for now.  And you know what?  For the next three to six months, people reason that they are better off hiding in a U.S. bond than some kind of Euro-bond, or some security over there, and I can understand that.  I absolutely can understand it.

In fact, you see that more and more.  People are buying bonds and gold.  That is the European trade.  So, I think you are okay in U.S. bonds, and I think you should stay short.  The more the bonds rally, the more it forces you to be in the short end, but I think where you have to watch where it will become a problem for the U.S. bonds, is once Europe blows up.  Once all these things start blowing up, and Europe is forced to start addressing the problems, bonds will probably rally at first.  But once that starts getting sorted out, that is when it becomes dangerous for the U.S. bond market, when the people in Europe do not have to run to U.S. bonds anymore for safety.

That will be the same thing with gold.  You want to be in gold here in the U.S. until it blows up, and finally, after it blows up, and then after they are forced to address it, whether it is a default, or a restructuring, and then they get their economic house in order.  Then you want to get out of your gold. That is the same thing with the U.S. bond.  The trade of a lifetime is going to be short the U.S. bond market when it blows up, beyond anything.  It will be comparable, if not better than, being short some of these dot.coms in 2000 when they blew up.  That is the same thing here, especially with derivatives out there.  It is going to be ungodly.

But, you can’t be early.  People have been three, four, five years, waiting for the bond market to blow up, and it is staying up because of this flight to safety, and I think most people do realize that it is just temporary.  It is transitory.  To use Bernanke’s favorite word, it is a transitory safe haven.  But when this bond market does go, when it is time to go down, there is no telling how far and how fast this can go down.  But again, you can wait.  You do not have to run out there and buy puts today or tomorrow, you can let this situation in Europe play out.  After Europe starts blowing up and going through, then I think you can start worrying about the U.S. bond market.

David: That is the next domino.

Bill: Yes.

David: We appreciate you joining us.  We have covered a lot of ground.

Bill: Oh, anytime.

David: We always enjoy having you in the conversation.

Bill: Thank you.

David: It is a fascinating time in history, and it is definitely sobering to realize that we have never been here before.  To different degrees, we have seen this before, but not all of these things combined and in such a tight period of time.

Bill: Absolutely.

David: Well, for wisdom and guidance, these are things that we will need in droves here in the next few months and years.  We wish you the best, and look forward to having you on again sometime soon.

Bill: Thank you very much.


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