September 24, 2014; Too Big NOT to Fail!

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: Dave, we live in a complex society, and there is a book that you turned me on to a couple of years ago by Joseph Tainter. It is called, The Collapse of Complex Societies. In that book he was looking at the Roman Empire, of course, the one that comes to mind right off the bat, but he looks at a lot of other societies and he sees patterns in the collapse of complexity in a society.

David: We started our conversation about five years ago with Richard Bookstaber, looking at complexity, and how the financial system had become very much like the complex systems that you would have in a nuclear power plant, or other complex systems where you have all these interdependent relationships.

Kevin: Like the shuttle. He used the shuttle as an example, as well.

David: Exactly, and how, when you get variables askew within a complex society, there is a series of knock-on effects, which frankly, can become uncontrollable in terms of the consequence. So yes, we have lost shuttles, yes we have lost a nuclear power plant – actually, one since our conversation with Bookstaber.

Kevin: Right. How do you plan for a Tsunami, like in Japan?

David: Exactly. And yet the complex system that they had there at the Fukushima power plant was not sufficient in terms of its redundancies, its backups, etc. Once one thing goes wrong, you tend to have a spiraling out of control. The complex societies that Joseph Tainter talks about, this is next week’s discussion, if you will. What I do is, I look at books that I am interested in, people that I am interested in having conversations with, and when I get to read a book, writing in the margins is a little bit like having a conversation with the author, so a couple of years ago I started having a conversation with Joseph. He just didn’t know I was having the conversation.

Kevin: (laughs) It was marginalia, right?

David: That’s exactly right. And so, ideas have been brewing there, and he does a great job looking at 20 different societies of varying complexity which have all followed a similar trajectory. These are topics that, frankly, are of interest to, not only an archeologist, which he is, but all sorts of social scientists, historians included, and that particular book, originally published in 1988, is now in its 23rd printing. One of the things he points out is this: Collapse is recurrent. Why is this of interest to us today? Are there variables that loom as a potential threat for us? You could have said that any of these societies of the past would have considered themselves exempt, and somehow new and different. That phrase “It’s different this time” would have been a phrase that tripped off their tongues very easily, as they looked and said, “We understand what happened to so and so hundreds of years ago, or thousands of years ago, but not to us. We are of a different caliber, a different quality. Technology has improved, we have indoor plumbing. Things have changed such that we don’t have to worry about it. Technology is constantly on the rise and we are a part of that.

Kevin: He says there is a consistency, too, of the suddenness of the collapse. Most societies don’t slowly fade into the sunset. There is a suddenness to the change.

David: This is something that has clearly been on our mind and we will have the actual conversation, not the theoretical and margin conversation that we had with Joseph over the last couple of years as we have read his book. But what are the elements of fruitful growth? Of expansion? What goes into increasing trade? What goes into improved information flows? What are the common elements among the societies that represent the greatest human achievement, and which, frankly, have subsequently died out? For years, I have had, just to the left of my desk, on a notecard, I wrote out this poem many years ago by Percy Shelley called Ozymandias. It is a short version of the entire book. In a matter of six or seven lines it captures everything in Joseph Tainter’s book. It goes like this:

I met a traveler from an antique land
Who said: “Two vast and trunkless legs of stone
Stand in the desert. Near them on the sand,
Half sunk, a shattered visage lies, whose frown
And wrinkled lip and sneer of cold command
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them and the heart that fed.
And on the pedestal these words appear:
‘My name is Ozymandias, King of Kings:
Look on my works, ye mighty, and despair!’
Nothing beside remains. Round the decay
Of that colossal wreck, boundless and bare,
The lone and level sands stretch far away.”

Kevin: What an amazing poem. It gives you that vision of great societies of the past. If you have been back to Greece, or if you go to Egypt, what you see are relics in the sand, but you have to imagine what their grandeur was at a given time. And at the time, like you said, these societies had no idea that collapse was coming. But there seems to be, and you’ve talked about this just over the last few weeks, we have programmed into the markets, we have programmed into the news, perfection, right now. You have virtually no reaction of feeling any kind of fear.

David: It makes me smile when I find someone who has a curious fascination with details, details that most people just don’t care about. It is a little bit like watching the TV series CSI. There are all these things that you are trying to unpack, and who done it, and how was it done? Obviously a crime scene is different than the archeologist’s world, but it is very similar in that regard. I read Tainter and there is this sense of an investigative work. You are trying to piece together who did what, and how did it come about, and what were their reasons? What were the precursors, what were the events, what was the environment? And in my mind, it is absolutely fascinating.

Kevin: And your view of history, Dave, comes from your father, as well. Just look at the office over at Wealth Management. There are maps all over the walls, various empires. Your dad loved to study the Roman Empire. You have to know history to understand the time you are in, don’t you?

David: Sure. We have at least a dozen maps of great empires, all of which are no more. Certainly, there is the subtle reminder that past performance is not a guarantee of future results. The Romans have made their mark on history, but they are not exactly the same culture today as they were then. Tainter argues that complexity is a common quality of societies that collapse. Complexity is a part of that. Complex societies are problem-solving organizations. Complex societies organize themselves, and that requires energy. Once they have been organized, it takes energy to maintain that system of organization. When you increase complexity, it also carries with it an increase in per capita costs, and these costs can reach a point of diminishing returns, where, again, you continue to expand in complexity, but it is not really offering benefits to the constituent parts within the society.

Kevin: And Dave, being citizens of the 20th century, we have a tendency to think that society has always been complex, but actually, if you look at complexity in the view of history, it is a relatively rare thing, isn’t it?

David: He would say that less than 2% of all human history, and of all human experience, is defined or marked by high-complexity societies. Most of human history is marked by low-complexity societies. And so what we have today is actually quite rare. He suggests that there is a point, and granted, I guess I am getting ahead of myself, these are conversations we will have with him next week, but he suggests that there is a point where the marginal benefits of bureaucratic management are no longer justified and that those in power seek to maintain the status quo at ever higher costs.

Kevin: Boy, doesn’t that sound familiar today?

David: It sure does. And there is this point where what he describes as the declining marginal return makes collapse a mathematical likelihood. It is interesting. As you say, there is something of a reflection into our own culture today. Those in positions of power can become coercive in an attempt to maintain sociopolitical structure and pay for the complexity. Yes, the complexity has some benefits. But part of the benefits, for those in the administrative class, is that they have job security.

Kevin: Exactly. They want to keep the status quo. Let’s face it. Look at a family. Let’s say that your budget, at some point in your life, affords you quite a bit of luxury, and you really get to liking that; drinking fine wine, eating filet mignon. And then the budget doesn’t afford that any more. There are only a couple of ways to go about that. You can either cut back, like you are saying about these administrations, or you borrow money and try to maintain that status quo for as long as possible. The problem is, there is always a collapse when you borrow money to try to maintain a status quo.

David: Right. So, Tainter is pointing out that the real risk in a collapse is actually for the administrators and the bureaucrats, who may, in fact, experience change as, in their life, a real catastrophe. But he also reflects on, and says, that for the majority of a population this may actually be the outworkings of a rational economic choice, which is simply to do that – simplify – and say, “Wait a minute, I just don’t think that the costs are worth it anymore.

Kevin: Don’t you think that happened in the American depression back in the 1930s? You listen to people who lived through that, there are still people alive, and they will say, “You know, they were tough times, but we really learned how to survive. They learned the effects of simplification.

David: Right. Perhaps the difference is, he is suggesting that it is bureaucracies which take a complex society past the point of delivering an economic advantage, bureaucracies which tend to grow in an effort to protect power, to control influence, and this is ultimately problematic. In some respects, it reminds me of Thomas Kuhn’s idea of a failed working model which continues to be perpetuated longer than it needs be, because the academic community, and in this case the academic community is a substitute for the bureaucracy – the academic community maintains its textbook bias, which is the way Thomas Kuhn describes it, and they perpetuate their view of the world, their paradigm, through those who are exposed to the traditional educational environment. They perpetuate it by requiring it as reading.

Kevin: You are talking about, of course, The Structure of Scientific Revolutions, which Kuhn wrote. Looking at science right now, there are an awful lot of paradigms that are being taught in school, that the scientists on the leading edge of the research would dismiss at this point. They would say, “No that’s a bad model, don’t teach that anymore.” But it takes about 100 years to get through the system, to get that paradigm changed.

David: I guess, as a cautionary qualifier, the collapse of a complex society, specifically ours, is not something that we are anticipating, in part because one of the things that Tainter points out is, in stark contrast to a paradigm shift, where you have a replacement theory to come in and substitute for the old, unsustainable theory, you only have a societal collapse when there is a power vacuum. Rome, for instance. Even though, in theory, the invasion of Rome represented an influx of a substitute power, frankly, the invaders lacked the ability or experience to manage a complex society. They could not have replaced the administrative genius of the republic. And of course, the back story to that administrative genius was that it was a juggernaut; it was too big to not fail.

Kevin: It is interesting that you bring that up, because we hear about too big to fail, but too big to fail really is not the biggest thing. The reason you have banks that are too big to fail is because you have a bigger government that can print money. The problem is this, Dave: The government isn’t too big to fail, because there is nothing bigger.

David: And this is the strange symbiosis we see today, almost a parasitic relationship between big government and big banks, where one is a conduit for the other. One controls the capital flows to the world, and of course then the policies which benefit from those capital flows … it is sort of an “I scratch your back, you scratch mine.” It takes me back to our conversation with Robert Higgs in 2012, when we were discussing the personality of a leviathan-sized state, and really, the role of crisis in its growth.

Kevin: It becomes a very, very large parasite, Dave, larger than, actually, the organism that feeds it.

David: Right. So combining these ideas, the collapse of a complex society with the growth in complexity, and size, following crisis, which is what Robert Higgs was saying. His theory is the ratchet theory. He was basically saying that you have this ratchet theory, where on the other side of crisis government and complexity both mushroom in size. What was his conclusion? His conclusion was that the only way to optimize his freedom was to get out of Dodge, move to a small village in Mexico, not exactly where I would want to be, but it is the opposite of a complex society. He has made the volitional choice to say, “Not for me, not for me. I don’t want to see where it goes from here.”

Kevin: Dave, there is something I want to go back to, because you had made the comment that you are not necessarily anticipating the collapse of today’s current society because of the power vacuum; is that what you were talking about?

David: The way Tainter positions that is that it doesn’t happen unless you have a power vacuum, and so I guess it is fair to say, I don’t know that we would or could see, a power vacuum, although I do see the frailties of complexity all around us, and it seems like there is a high likelihood of, whether it is decay or devolution, in the context so described by the complex society, with the preconditions for collapse that Joseph Tainter talks about in his book. So I will have to ask him if he really thinks that that is a prerequisite for collapse, because one of the things that we do see is massive change within culture and society, without it being an utter collapse.

Again, we look at The Fourth Turning, and in that book the idea is that there are significant changes, and essentially, cultural revolutions which take place, which redefine a given context where people are living, making choices, making business decisions, making family decisions. It can be destructive or helpful to wealth-building, depending on what season you are in, as described in the book, The Fourth Turning. But again, maybe that is different than a complete collapse, because what he is describing is just 100 miles south of us, and really, less than 1,000 years ago, we had a culture which thrived, had some degree of complexity, obviously not the kind of technological innovations that we have today, but they had a system of organization which disappeared, completely. Look at the Mayans. Where did they go? They disappeared. Where did the Romans go? Again, these are things where you just scratch your head and say, “It was so successful; was it too big to not fail?” Borrowing from the current vernacular, too big to fail, what if it is too big to not fail? I think there is this thing which acts as a governor to optimize freedom and balance complexity, and prevent bureaucratic overreach and the inefficiencies which Tainter described as, ultimately, the death knell for a society. Frederic Bastiat talks about that in his book, The Law.

Kevin: I think it is important to point that out because, actually, a society becomes complex because it is bringing energy into the society. It may take energy to run a society, but as cooperation increases, as trade increases, as information flow increases, all of those things are good, and actually, an organization of those things, a little bit of centralized control, is not a bad thing. But it has to be regulated by a law that doesn’t allow, like we talked about, the organization to become the parasite on those who bring the energy in, right?

David: That is exactly right, and that is what Bastiat really talks about, the role of the law controlling the controllers.

Kevin: And that is the name of the book, too: The Law.

David: It is a must read. It is essential reading, and it discusses the role of law in society in order to maximize, or optimize freedom. With the expected increase in coercion and control which comes as a part of a complex society, how do you keep that coercion and control, the controllers, if you will, from impinging on free men, and the privileges of a free society? While you introduce complexity, how do you balance that complexity and the wanting to monitor, whether it is water flows or traffic lights, or whatever else that represents organization and somewhat of “control,” how do you keep that from happening? Bastiat’s key point is that the law should protect the individual. It has to protect the individual. And if the law is perverted, you will know when it is perverted because it becomes an excuse to plunder the individual, instead of protect the individual.

Kevin: Dave, it reminds me of when Thomas Jefferson was writing, “Life, liberty,” and he chose to put in “the pursuit of happiness,” which is sort of a vagary, but actually, I think it was Locke who said, “Life, liberty, and private property.” We have talked to Hernando de Soto a number of times, and he says, “The secret of our success is that we have had law that has guaranteed life, liberty, and has protected private property.” Contract law in America, is really better than just about anywhere else in the world, still. That allows people to operate with individual freedoms. I think we are losing that a little bit with an administration and an organization, a very large, in-debt organization, feeding off of that.

David: Right. You have this lynchpin, the lynchpin for a functional, and for a free, society, which is inherently complex, and it is the administrators and bureaucrats, and individual citizens, all firmly on the same footing of the law. And vigilance is imperative in making sure that the law does not become either burdensome or an excuse to plunder.

Kevin: Why don’t we do that? Why don’t we look at the good law versus bad law, because you need some law for protections. Let’s contrast the two. What’s a good law, and what’s a bad law? And let’s use the financial world as an example.

David: I was asked just the other day by a friend what I thought about laissez-faire capitalism and really, won’t the market just figure it all out and self-correct? I don’t think that the market has the laws of God written on its heart. I say that to qualify what confidence I do have in capitalism, which is strong. I have a lot of confidence in capitalism, but I realize that there have to be some guardrails put up around the edge of it, to govern certain behavior.

Kevin: Even if it is just to keep monopoly from occurring. Bastiat talks about how business will move toward monopoly, and then monopoly toward socialism, and then socialism to communism. He was way ahead of his time.

David: Right. Good laws versus bad laws: Functional, practical, helpful. Contrast that with overbearing, debilitating, and, at least following Tainter’s idea, a contributor to collapse; that thesis, which is what we have just said.

Kevin: So, a good law is one that puts barriers up, but it doesn’t necessarily shut down freedom. I am thinking of the law that came about during the 1930s called Glass-Steagall. It actually tied the hands of the bankers who had over-abused their power.

David: Let’s look at what had happened prior to that. The reason Glass-Steagall came about in the early ’30s was because investment bankers had the ability to put together financial products that were akin to dog crap, and they were then able to hand them across the aisle to their co-workers in the commercial banking side, and they took those pieces of garbage and sold them directly to the public. Packaging garbage, selling garbage. Regulators came in and said, “Wait a minute. You are making tons of money at the expense of the general public, and you are feeding off of the general public’s ignorance of complexity within the world of finance. This can’t happen. Here is a simple solution. You can either be an investment banker, or a commercial banker, but you cannot be both. There has to be a firewall between the two, because we have seen that you are going to prioritize self-interest over the interests of the common man and the common good.”

Kevin: And that firewall worked from the 1930s until 1999, and they dropped it, and I remember your dad saying, “You’re kidding me. Glass-Steagall has been dropped?”

David: Look for a repeat of the 1920s, and a repeat of the 1930s. Why? Because if you give capitalism free reign, no regulations whatsoever, do you know what happens? Individuals with a selfish bent will work the system to their own advantage and make as much money as they possibly can.

Kevin: And this is the banksters, in this case.

David: And this is where, if you assume that we live in a world that is, according to the evolutionists, progress by tooth and claw, and there are no boundaries to your actions, why should you respect the boundaries of others when it is just a question of survival of the fittest? And that is what you end up with, capitalism without any boundaries. It is nothing more than market-driven evolution, where I assume that I will survive, even if it is at your expense. There is this regulating, a law, if not in the heart of man, expressed from the heart of man, from God, that needs to be impinged upon – the selfish nature of man. And that is what we had. Glass-Steagall, less than 40 pages long, it separated commercial and investment banks and protected the man on the street from the 1930s wolves of Wall Street.

Fast forward to its very poor replacement, the Dodd-Frank bill. It started at 848 pages, not like the 40-page Glass-Steagall. It was expanded to 2300 pages of legislation, and now is bumping up against 14,000 pages of regulations, still in the process of being finalized. Some estimates are that on completion it will encompass 30,000 pages of regulations. How long is Leo Tolstoy’s War and Peace? This would be the equivalent of about 32 to 32½ volumes of War and Peace. This underscores the idea of loss of marginal return on complexity. It underscores the law being transformed into what Bastiat described as a tool for legalized plunder, and not for the protection of individuals and individual freedoms.

Kevin: One of the things that Bastiat points out, and again, this is a book written in the 1850s, is that larger law usually shows that a society is falling apart, it has less control, it is more of a centralized type of government. Going back to Tainter, The Collapse of Complex Societies, that is when you start to see this centrally controlling unit feeling like they can force every issue.

I am going to jump over to Europe for a second, because talking about forcing an issue, remember Field of Dreams, if we build it they will come? I think the Europeans are saying, “If we offer it for lending, they will borrow.”

David: Right. The ECB lending program, this is the one that was introduced a month or so ago for small businesses where cheap money would be given to banks with one condition, that it go to small business lending. It was introduced with a bit of a whimper, not so much a bang. There was very, very little interest, and maybe because European businesses only want to take on new debt if they foresee growth in the economy on the horizon.

Kevin: And they aren’t. They are seeing shrink right now.

David: It reminds me, I was probably 13 years old, I bought an iguana. The person who sold us the iguana said, “Change of environment, radical change of environment, he may not be interested in eating, but he needs to eat. So, you take your cucumber strips, cut them into small pieces, and for the first week to ten days, you are probably going to have to force-feed him. I was a little uncomfortable with that because I thought that if he was hungry he would eat, if he was not hungry, he won’t eat, and eventually he will get hungry enough that he solves the problem himself; he’ll start eating.

But the iguana technique of force-feeding the lizard, that is essentially what the ECB is assuming, and maybe they up the ante and start force-feeding the market with that capital, but right now, the capital that they have promised is not getting into the economy. Why? Because the honest appraisal in Europe is that things have not recovered and there is no reason for them to take more debt and obligations if the income from their business expansion isn’t going to be sufficient to make the debt payments.

Kevin: And you mention income. Let’s just look at the income tax revenues here in America. That is one of the best ways to see whether we are in a recovery, or whether we are actually shrinking, and haven’t we been losing the last couple of quarters on tax revenues? Isn’t income, at this point, shrinking?

David: That’s what they’re telling us. Data from the April to June quarter is showing a significant decline in personal income taxes and this is very important. This is the second quarter in a row showing declines, according to the Rockefeller Institute. This is the first time, actually, since 2009, that state personal income tax revenue has declined two quarters in a row.

Kevin: Isn’t that an alarm bell?

David: I would suggest so. For all the fuss about a reviving economy, incomes are the driver of long-term economic growth trends. Artificially, yes, you can have credit growth that fills the gap. The ECB is trying to do that, the Fed has tried to do that, and they will continue to do more of the same, but artificial credit growth, while it can fill the gap, is not ultimately sustainable if incomes are not growing at the same time.

Kevin: One of the things that most households look at, though, is the price of their house. What is happening with real estate? Is my house value rising? Is it falling? I know for a period of time there, Dave, a lot of people were negative on their loans to the banks. Their house was worth less than what they actually owed.

David: I think this centers our attention on the Fed’s promise to raise rates and take actions which, again, they can talk about doing, but I think they are fairly well constrained. Why is that? Values, on average, in real estate, the average family home across the country, we’re back to 2004 levels; we’re not at peak levels. Of course, everybody who was late in the game, buying in 2005, 2006, 2007, you still have a lot of people under water. We will talk about that in a minute. But, it is volumes right now, which are considerably lower than the 2004-2007 period, the volumes of homes being sold. So, just like we were talking about volumes in the stock market last week, the prices are rising in both the equity market and the real estate market, but on fairly tepid volumes. And it is very curious to me that volumes are really not reflective of the Fed’s best efforts in the real estate sector. So, what happens? It becomes very difficult for the Fed to drop its accommodative monetary policies without pressuring home prices lower and rates higher. And this still in the context, you mentioned negative equity, 17% of homes are still under water. That has improved considerably since 2012 where the worst number registered 31.4%, with negative equity.

Kevin: Put that in perspective, though. How many homes would that incorporate, at 17% of the homes?

David: RealtyTrac says about 9.1 million homes with property values currently less than their mortgage, by about 25%. So, 9 million homes are under water, again, the mortgage is 25% higher than the current value of the home.

Kevin: What is concerning to me is that you can go and get a mortgage for just about as low as you ever could right now. It is not at the all-time lows, but you can still get a mortgage at about the 4 to 4½ percent level. How come we are not seeing more of a pickup in volume?

David: Right. I like reading [Robert] Campbell. If anybody has an interest in real estate, and particularly, Southern California real estate, I would suggest subscribing to [Robert] Campbell’s newsletter. It is excellent on that topic, The Campbell Real Estate Timing letter. What he highlights is that rates have been dropping from a year ago on 30-year mortgages; last year 4.57, now 4.1. They have declined, which should help volumes, right? But over the last eight months we have year-on-year growth which has been losing momentum, and in his opinion, this is not a good sign. When you have the benefits of lower rates, and you also have record mortgage-backed securities being purchased from the Fed, they are keeping the gears greased, and yet, you are seeing declining momentum. According to Campbell, the next downturn in real estate, in his opinion, will span 2015 to 2017.

Kevin: Which is interesting because we have clients who are still waiting to buy a house. There has been this small bounce recovery; it is not huge. But what Campbell is saying is that there is going to be another decline in 2015 to 2017.

David: And off of whatever the current peak is that we put in, maybe we have already put in the peaks for this particular cycle, he says you could subtract another 20-25% off of those levels. Here is a particularly interesting element. Stimulus from the Fed, if it is ending, will cause considerable problems in the real estate sector. Campbell sees this coming true in the first half of 2015, that being the front edge of the decline. First you have Fed monetization of mortgage-backed securities and treasuries. That is scheduled to end in October.

If you will recall, it was QE-1 and QE-2 where we had a decline immediately following the cessation of Fed intervention in the market. Will markets operate differently with less artificial wind in the sails? No, I think they will operate the same way. When you take the artificial wind out of the sails, you are going to see the same kind of behavior you had at the end of QE-1 and QE-2. If we were to guess, then we have a decline in the stock market and a softening housing market by mid-year next year, which will have the Fed exploring all of their options all over again.

Kevin: Which means another possible round of quantitative easing, or whatever it takes.

David: And it just reinforces the notion that the Fed is actually in a liquidity trap. They are using language, and talking about the issues, in a very effective way to convince the market that they have more flexibility and more options than they actually do

Kevin: Dave, there are people out there talking about deflation, and they feel like they are being justified because the price of gold has been dropping. The real actuality is that until prices, as a whole, start falling, we really don’t have a deflation. In fact, what we have is monetization of the debt that is waiting to somehow get into the economy. The central banks have somehow hidden the crisis that we are in by printing trillions of dollars, but aren’t they just monetizing the debt?

David: That’s all QE is. QE is nothing more than debt monetization. The historical record is pretty clear on this. It tells you that that is a terrible path to go down, and everyone seems to ignore the fact that this is debt monetization because of the euphemism QE, or quantitative easing. If you ask the average bloke who has some reference to economic history, he would you say “No, you can’t spend more than you bring in and then have the government print to make up the difference.” That’s going to cause inflation. That is called monetization of a deficit. Everyone in academic circles is in agreement that that is inherently inflationary, although not everyone is in agreement that QE will cause inflation. Why? Because somehow they think QE is not debt monetization.

Kevin: Even Ben Bernanke said it wasn’t monetization, but it is, Dave.

David: That’s balderdash. It absolutely is.

Kevin: It is sort of complicated, though, to understand where that QE went and how it works. You hear these terms: Repo agreements, reverse repo agreements. Can you bring a little clarity, without going into too much complexity?

David: The Fed creates money out of nothing, takes that money and it buys IOUs in the form of treasury bonds and mortgages. The money created went from being just a conceptual credit to being actual credit in the marketplace. And there was no off-setting transaction to this, so now we have a Fed balance sheet which was 4½ trillion, 4.42 if you want to be more precise, 4.42 trillion dollars. And they don’t have the ability to shrink their balance sheet. They talk about it, but what does that look like? They have said, “Well, we’re going to use repo agreements to do that.” What?! What?!

Kevin: That’s a shell game, Dave.

David: Do they even understand what they are saying? Do they assume that the general public is so ignorant? I think, actually, they don’t understand the market operations of a repo agreement. A repo agreement is just this. Let’s play this out, you and me. I’m the central bank, I’ve got 4½ trillion dollars in mortgage-backed securities and treasuries, and you are a bank. You’ve got cash, I’ve got fixed income securities. I go to you and I say, “I want you to take this paper. I promise I will buy it back from you in the future.”

Kevin: So, do I have to give you my cash?

David: Sure.

Kevin: Okay, so, I’ll give you a little cash, you give me the mortgage agreement.

David: Right. Now, I’ve removed one asset, but all I did was replace it with cash. Now what do I do with the cash? The Fed can basically swap one asset for the other, a fixed-income instrument for cash, but a repo agreement is not going to shrink their balance sheet. And by the way, it’s like a boomerang. A reverse repurchase agreement is a promise to, at some point in the future, buy that asset back from the bank. So it’s a boomerang, it’s coming right back at me! It’s going to be right back in my balance sheet; it doesn’t solve anything. And yet, this is Janet Yellen’s comment last week. “We have an exit strategy and it is going to include repo agreements.” What is she walking about?! That doesn’t even work! Does she even know what she is talking about?! And this is where you begin to realize, people have confidence in Ph.D.s, and they are insane to have confidence in people with Ph.D.s. I am not suggesting that these aren’t smart people, but they are out of their element. Central banks have done the unconscionable, and the best they can do is pretty up the pig. This is like the whitewashed tombstone. They have just covered it over.

So, why am I comfortable owning gold? This is really what it boils down to. Why am I comfortable owning gold?

Kevin: Okay, Dave. We have gold, right now, looking like it is about to make a double bottom, at about $1180, something in that range.

David: Or break through the floor, on its way to oblivion – zero. No, I’m kidding. Why do I feel confident owning gold? Why am I comfortable owning gold? There is a question that seems to me, very reasonable. What are the odds that between government bureaucrats, Fed officials, and leading economists, something stupid happens in the next 6-12 months, something stupid for the history books? We’re talking about monumental stupidity. We’re talking about monumental as in, Ozymandias monumental, on a scale never seen before. Something stupid for the history books like Havenstein stupid. You remember. He thought that there was a solution to rising prices. This was in Weimar Germany. The solution to rising prices was to print and distribute more money.

Kevin: You had said that you did not see, necessarily, a vacuum being created in society, but actually, isn’t the power that comes from printed money the vacuum that could actually raise its ugly head?

David: True. And so the question is, if there is a high probability, if the odds favor these geniuses doing something stupid, do you want stupidity insurance? You want ounces! You want as many ounces as possible! This is the point. We are in an experimental game where they are pretending, with a very cock-sure attitude, to convey to the general public that they have everything under control. They not only don’t have a plan, they don’t have a clue what they are saying when they are saying it. And this is what the Fed is relying on. The Fed is about talk. The Fed is relying on their communications.

Kevin: It is all about managing perception. It is interesting. Probably, people’s hearts dropped when they heard that you think that gold could go down to zero, but you are being sarcastic. Gold has never gone to zero. No one has ever gone broke in gold. The problem is, what these guys are propping up with perception and talk has gone to zero. Dave, you talked about in McAlvany Wealth Management’s offices, about the maps of all the ancient empires, and how they don’t exist anymore. But we also, in my office, have had for years, currencies that at one time, when I hung them up on the wall, had value. And at this time, none of them have any value. That can happen with paper money. It can’t happen with gold.

The Fed is talking about raising rates, trying to give faith in the dollar. They are talking about shrinking the Fed balance sheet, but can they really do that?

David: This is where I think that thinking people need to stop and say, “How is it that the market assumes this is all going to end well?” Raising rates, shrinking the Fed balance sheet. These are the topics of conversation. These are the pipe dreams. Kevin, just do the math. Raising rates brings the cost of national debt to unbearable levels. What are the interest payments on 17.76 trillion dollars? By the way, that is up a trillion dollars this year. Again, I digress, but you are talking about 6% growth in debt, and you don’t have 6% growth in the economy.

Kevin: That is about 2% I think, isn’t it?

David: And yet, we are recovering, right? We are in a recovery. Then why the heck – why is debt growing at an exponential rate compared to growth in the economy? This is not sustainable. What they are talking about doing is not even possible. If you raise rates by even 1%, you are at the outer edge of what we can tolerate. Raise rates by 2%, which they are talking about doing over about a five-year period, and it is game over for our fiscal picture. Game over.

Unless you go back to Tainter’s idea of it, no, your vested interests, all they are going to do is raise taxes, and basically bleed out the most productive parts of society. Again, everyone in society has the decision to make, and you know what that decision is? It’s an economic decision to pass or play. And if the leviathan grows to the point where it is no longer a sustainable or intriguing offer, then they will say, “No. We’re done. We’re gone.” This is the stuff of flight capital. This is the stuff of mass migrations. This is the stuff that ultimately is reminiscent of the collapse of a complex society. What do we have today? We have an increase in asset prices.

Kevin: The excuse for quantitative easing was to create a wealth effect, where people would feel like there is more liquidity, there is more flow of money. That wealth effect really never caught on, did it? Other than in the stock market, the equities have been going up, but other than that, no.

David: Right. The contrast between the average median net worth, which is down a third over the last ten years, as opposed to, basically, the 1% of society which have had a major benefit, an extra 26 trillion dollars registered as a result of an increase in property values and equity prices. These are the uneven consequences of monetary policy. And yes, they saw a wealth effect, but not on a broad base. The wealth effect, and an increase in consumer spending, that was the goal of all the rounds of QE. And do we have that? Not on a broad base.

So, what other options are there? It is interesting, Martin Wolf is one of the guys I will read occasionally in The Financial Times, and he has just published a book. He is now suggesting that if consumer spending is what you want, you know what you do? You print the dough, and you give it to the man on the street. You hand it out.

Kevin: (laughs) I read that.

David: These are his words: “Permanent helicopter drops.”

Kevin: Just hand people money.

David: Permanent helicopter drops. Again, going back to Bernanke’s 2000 speech, which was basically reiterating something from the Chicago School and Milton Friedman, “permanent helicopter drops.” Perpetual deficit financing by central banks. Perpetual deficit financing by central banks. This is serious!

Kevin: It makes me wish that Dr. Seuss was still alive. He could write a book about the ridiculousness of the man who just handed out money for free, saying that it was going to actually increase economic growth.

David: In Wolf’s new book, he did have an interesting suggestion of eliminating fractional reserve banking.

Kevin: That’s a good idea.

David: Yeah. But again, I go back to this question, and it seems reasonable. What are the odds that between governmental bureaucrats, Fed officials, and the geniuses with a Ph.D. in the economics department, that something stupid happens over the next 6-12 months? Because we have one of the brightest economists who writes for the Fed saying that we just need to implement permanent helicopter drops and perpetual deficit financing by central banks. Is that what we are left with? Because if that is a set of solutions, let me tell you what I want. I want more ounces. Do you see what I’m saying, here?

Kevin: That was the same solution that Weimar Germany used and it turned into a hyperinflationary complete collapse of the German mark.

David: I understand full well that what Martin Wolf is suggesting is a possible solution for maintaining the system as it is. If you want to maintain a complex society, and you are willing to pay a very high cost to do so, so that complex society does not collapse, I understand that you may consider all alternatives. But I can tell you that as an individual within that complex society, I do not intend to be grist in the mill. I will not. I refuse to have my family subjected to the consequences of these kinds of ideas.

This is called devastation. This is called financial devastation for the saver and for the fixed income class. Is it a reasonable solution if it saves the system? I guess at one level it is a reasonable solution if it saves the system. But now you are talking about some sort of greater good ethic that somehow takes my values, and my specific individual interests out of the equation. I’m sorry. I can’t do that.

Kevin: I think this is a good reason why we shouldn’t value gold in dollars, because the dollar may not even be in existence, or especially at the value that is at. We have talked about valuing real estate relative to ounces of gold. We have talked about valuing stocks relative to ounces of gold.

Gosh, Dave, when you look at the Dow-to-gold ratio chart where you take the Dow and divide it by how many ounces of gold it is worth, there are patterns that are repeating right now when we have seen the Dow-gold ratio go all the way to 1-to-1, but on the way to 1-to-1 you have corrections the other direction. I think, percentage-wise, we are getting pretty close to matching the last two times that the Dow-gold ratio narrowed to a 3-to-1 ratio.

David: Ultimately, I want stupidity insurance, because there are consequences to stupidity, and those consequences will show up as cheap asset prices. And so, to have something that has been real money for 5,000 years, and doubles as stupidity insurance, something that takes me out of the fray, what it allows me to do, going back to the Dow-gold ratio, is employ my ounces at an opportune time when my purchasing power in ounces is magnified. It used to be, it took 43 ounces of gold to buy one cross-section of the Dow. Now it only takes 14 ounces of gold to buy one cross-section of the Dow. It got as low as 6 in 2008-2009. What is interesting is that with this counter-trend move in the Dow-gold ratio, we are exactly at levels that we saw in 1976, a 24% retracement. Before, the Dow-gold ratio collapsed to a 1-to-1 ratio and gave you the opportunity, again, to move from physical assets into paper assets, and basically expand your footprint, in that instance, from the very peak to the very trough, in your purchasing power. You multiplied your financial footprint, doing it perfectly, 28-fold.

Kevin: You used the word, collapsed, to a 1-to-1 ratio. Holding the mirror to that, the collapsing of the Dow-gold ratio is actually the explosion of the price of gold relative to the Dow.

David: That’s right. In terms of purchasing power, that is exactly what you get. So, what’s the bottom line? We have had the Fed manipulate the anchor rate. The world central banks have caused a gross over-pricing of assets. The inherent problem is that there is so much debt tied to these inflated assets that now the central banks have put on an all-in bet. They are trying to save the system with these radical central bank policies. And here is the consequence: If you stop manipulating the rates lower, you won’t be able to keep asset prices at elevated levels. This is how it plays. They can talk all they want about raising rates and shrinking the Fed balance sheet, but the knock-on effect is that the asset prices which you just blossomed, or bloomed, or created into a bubble – guess what? They toppled; and guess what comes with it? The debt that is associated with them, as well. So, between now and mid-year 2015, we may see the mother of all margin calls. What do you want to own, as others are forced to liquidate assets?

Kevin: I think you have to have cash, and gold, and that’s it.

David: Cash and gold, cash and gold, cash and gold. The markets are reflecting a classic prisoner’s dilemma scenario. Borrowing from game theory, the system works as long as no one breaks from the system.

Kevin: Right, Dave. It is a gentleman’s game at this point. Everyone is looking at each other, with guns pointed at each other, saying, “No one shoot.”

David: But to avoid being in the system as it is breaking down, you have to be the first one to break out. That is the prisoner’s dilemma. That is the game theory we have today, and the world’s central banks are doing everything that they can to keep everyone in the game. You have to stay in the system. If you don’t stay in the system, the system begins to break down. So, what do we have to do to manipulate the mind of the market in order to convince them that staying in the system is the only right thing to do? It is a classic scenario. We were, years ago, moving into gold. Yes, $300 an ounce, $250 an ounce. My dad owns gold at $35 an ounce; never did sell an ounce of gold.

Kevin: You thought he overpaid when he paid, I think, $37.

David: And do you know what he did last week? He bought more ounces. Do you know what he is doing this week?

Kevin: Right. I know what you guys were doing yesterday.

David: He is buying more ounces. Does he mind if it drops $100 from here? No, because, really, what he is saying is, “I don’t have confidence that this is going to end well. I don’t have confidence that governmental bureaucrats, that Fed officials, that economists, have all of this well in hand. I think they are playing for keeps, and I think this is an all-in bet on their part to save the socialist system that we have.” By socialist system, I am just saying, a complex society that, at this point, can hardly justify all the bells and whistles that we have, and yet, they are trying to, and they are trying to make it work. If you want stupidity insurance, I think the decision is really, really easy. You want ounces.

By | 2014-09-25T18:54:30+00:00 September 25th, 2014|Transcripts|