About this week’s show:
-Bernanke to Japan “Try Perpetual Debt”
-Credit Suisse warns that stocks are too high
-Nobel Prize winner Obama leaves 20 trillion debt legacy
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About this week’s show:
-Fed is causing deflation by killing income
-Tapering is now off the table
-Real assets provide quiet wealth
About the guest: Market Strategist, Bill King, has authored “The King Report” for over 18 years. It is an independent view on global, political, financial, and economic factors that influence world markets. As author of the firm’s daily market commentary, Bill’s candid observations and forecast on the economic, financial, and political forces that are impacting the markets have been extremely accurate.
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Posted on 22 September 2011.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, as promised, we talked about looking at Keynes again, even though it is an ugly picture. We have as our guest today Hunter Lewis.
David: Kevin, I think the importance is this: We see experiments over, and over, and over again, with bailouts, both here in the U.S., and in Europe, and around the world, and they are predicated on the same things – basically, Keynesian economics. We are now into the third round of bailouts for Greece. The first didn’t work, the second didn’t work, and the third – of course it will work. At least that is the belief, and we do the same thing over and over again, believing, not that the method was wrong, but that we were only wrong by degrees. We should have done more of the same. We didn’t do enough of it. We didn’t spend enough. Billions weren’t enough, we needed hundreds of billions. Hundreds of billions weren’t enough, we needed trillions. Trillions weren’t enough, and this is the same kind of insanity that led to the Havensteinian nightmare, if you will…
Kevin: Back in the early 1920s.
David: Exactly. Dr. Rudolf Havenstein was a very smart man, a national icon in Germany, and he had the full support of the academics of the day, saying, “If things are getting more expensive, just print more money, and that way it will be more affordable,” and everyone loved the idea, and no one questioned some basic assumptions. I think that is what I love about now turning back and saying, “Let’s pause, let’s think about this. We need to reassess the way we view economics.”
This is a dismal science. Nobody particularly likes economics, but listen, your life is being predetermined for you by economic, fiscal, monetary policies, not only here in the United States, but around the world, where there is collaboration, and everyone is agreeing that we should do the same thing. This is the definition of insanity, Kevin, in which you do something, it doesn’t work, and yet you do it again, and again, and again. I want to explore that a little bit with Hunter Lewis today.
Kevin: David, it defies common sense, and that is the thing that Keynes was known for, defying common sense. Last night I was grilling steaks on the grill and we were talking to my son. He doesn’t live here, he is up in college in Boulder, and he said, “Who do you interview tomorrow?” I said, “Hunter Lewis. He wrote the book, Where Keynes Went Wrong.” Then I started to say, “Okay, here is what Keynes believed,” and he cut me off, and he said, “Dad, I know what Keynes believed – spend more.”
David: It is interesting. I think it is becoming more common knowledge that the guy was a bit of a quack. He agreed with Sylvio Gesell’s idea that you print money with an expiration date on it. In other words, you don’t save it. If you own it, you need to get out there and get it moving.
Kevin: Penalized for saving, basically.
David: He loved progressive taxation where you take more from the wealthy and redistribute it to those who have to, or will, spend every bit of it, rather than save and invest. He loved the idea of setting interest rates at zero and keeping them there permanently.
Kevin: How in the world would anybody retire? I don’t understand. If you set interest rates at zero, what is your CD going to do for you?
David: It is the issue of price controls, central planning, government monopolies, the role of the state being bigger and bigger because they are better and better, in his mind, and you do see shades of a world view that puts the state in control of everything. In fact, that was a part of Keynes’s ideals, not just in economics, but in politics. If you go back to Plato’s Republic, you find that Plato really fancied the philosopher king as the person who should be making all the decisions, and you couldn’t trust the hoi polloi, the average voter. “Well, just what do they really know? And really, things should be centralized around one person.”
Ironically, you find this figure, the philosopher king, being at the center of the universe. Keynes was no different. He created a structure of thought which propelled him to the very top. Basically, it should be central planning, and I am your consigliere. I am your advisor. I am the philosopher king from behind the scenes who is dictating, not only political issues, but economic, as well.
Kevin: David, with that in mind, when we have taken economics classes in the past, we have had these ISLM curves, and we have had a lot of different equations. It becomes so amazingly complicated, when in reality, really, all that is being taught is that you need to make sure that you don’t spend more than you make, and you spend productively what you spend. I would just say, when you had us read this book a couple of years ago, Where Keynes Went Wrong, the entire office, and then we discussed it, it was a way of condensing voluminous material on Keynes, and I wouldn’t encourage anybody to just go sit down and read all of Keynes’s material. Not only does it not make sense, but it is unnecessarily complicated so that the person actually is intended not to understand what he is reading. But this book, Where Keynes Went Wrong, is a great summary of Keynes, and why it doesn’t make sense, and then what does make sense, wouldn’t you say?
David: I would, and Kevin, I think this is one of the things that gets to the heart of it for me, and I think for our listeners, too. The fact that Keynes did not take a look ahead, he was not concerned about the future, he did not care about future generations. It was not in his equation at all. Everything was about the present moment, and that is reflected in his own life, it is reflected in his personal decisions, it is reflected in his orientation to an economics which is driven by success today, irrespective of what happens tomorrow.
Kevin: Like the cavaliers. “Eat, drink, and be merry, for tomorrow you may die.”
David: And he justified it by saying, “In the end, we’re all dead.” So by putting that finality out there, he concentrated on the here and now, so much so, Kevin, that he betrayed future generations. I think that is what we have to be cognizant of, as thinkers, as actors, in the marketplace today. We cannot afford to betray future generations as our current body politic has done, and will continue to do, to the degree that it continues to hold Keynesian ideas in its stock of beliefs. And this is why Hunter Lewis is joining us today.
David: Joining us again today is Hunter Lewis, and the discussion is Keynes, his book, Where Keynes Went Wrong. I have gone through the book, yet again, and this is a book that we read in the office, nearly two years ago, and benefited from immensely. It is on the shelves of every person in the office and we had some in-depth discussions, not only about what Keynes said, but just how confusing, at times, it can be, and almost incoherent, except the man was truly brilliant, and that was how he got away with saying what he did. No one really wanted to challenge him.
What Hunter Lewis has done in his book, Where Keynes Went Wrong, is to parse out some of the things said, and what has been misconstrued, what has been put into place as policy, and assumed to be good economic theory. I couldn’t recommend the book more highly. You can either get it in hardback or paperback. Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles and Busts.
Thank you for joining us, Hunter.
Hunter Lewis: It’s a pleasure.
David: In some respects, Keynesian economic theories were simply a justification for his own personal choices and ethical leanings, really, as a rejection of 19th century social conventions or values, what was conventional morality at the time, including things like thrift, savings, maybe even an orientation to the future, the 19th Century certainly had that, predicated on traditional family structures, and again, savings for future investment. He really had a focus on the here and now, maximizing the present, whether it was present pleasure, or present economic stimulus. Maybe you can look at where we are today. We had this conversation, to some degree, two years ago. Has anything changed in the last two years in terms of the government pursuing a more or less Keynesian solution to the current economic malaise?
Hunter: Not only has our government not changed, but every government in the world is continuing to follow the same Keynesian policies, and of course, they haven’t worked, they aren’t working, but we just keep doing more of the same.
David: We find ourselves looking at the classic phrase, “A spoonful of sugar helps the medicine go down. In this case, that simple shot of sugar helps the system feel better, although it doesn’t necessarily bring health. The criticism of Keynes, and this is a self-reflective criticism by practicing Keynesian economists, seems to be that 2008 rolled around, and we gave it a spoonful. Now, we have found that we needed a cupful. Now we need a wheel barrowful. Now we need a dump truck-full. The only criticism seems to be that we didn’t do enough, and there doesn’t seem to be a preceding criticism of, “Does this actually work?” Maybe you can comment on that.
Hunter: First of all, back in 2009 when we were coming out of the crash, in the first interview I had about the book with the BBC, they said, “Are you proposing to take the patient off life support?” And I said, “That’s the wrong way to look at it. It’s not life support, it’s just more alcohol for the alcoholic, or it’s more heroin for the drug addict. Then of course, you need more and more of that to keep an addict from being in withdrawal, but it doesn’t help the problem, it just makes it worse, and that’s essentially what has been going on.
Moreover, the most interesting thing to me is that as time has passed and these solutions have not solved anything, but, in fact, they’ve made it worse. None of the Keynesian economists who were propounding, “Let’s have more stimulus,” are providing any justification for it, on a theoretical basis, or an evidence basis. They just take it for granted. In every article you will read, even the recent one by Robert Shiller, in which he said, “It’s undeniable that we need more stimulus now.” He doesn’t explain why it’s undeniable, because the truth is, there is no logic and there is no evidence for it.
David: One of the things you point out in your book, Hunter, is that that actually was the force of argument that Keynes used, himself. It was stated so emphatically that there really wasn’t evidence that was provided, and he got away with it. In his General Theory, it’s not as if he built a case, he just stated emphatically, “Thus so,” and everyone went along with it. That has been, I think, one of the particularly insightful things about your book is that, really, it is just a statement, there is nothing there that supports it.
Maybe we can look at some of the things that you and I would share in common a criticism of, but maybe the listener doesn’t know just what it is that gets under my skin, and I think perhaps yours, as well. Ideas like the rate of interest, set by the market. We are used to that. We look at the bond market as market practitioners, and see that people judge credit risk, people judge ability to pay. People judge all of these things, and give you, basically, a market grade. How do you fare in the pecking order? A junk bond may be 10-12%, and someone who is considered to be a good credit risk is maybe 2, or 3 or 4%. So there is that grading in the marketplace. As far as Keynes was concerned, the rate of interest, if it is set by the market, is always too high, with the ultimate target being zero. Why would Keynes target a zero interest rate policy – which frankly, sounds very familiar today – why would he target that as a perpetual ideal?
Hunter: This goes absolutely to the heart of what is wrong today. We have a market system which is based on prices and profit, and yet, the government keeps interfering with the price system, and it is the price system that tells everybody in the market what they need to do. So they are really shutting off the flow of information that is essential to prosperity.
When you have high unemployment, that tells you that there is something wrong with the price system, that there are prices that are not in the right relationship to each other, and yet, the government keeps messing up the biggest, most important prices of all, one of which is interest rates. The system really can’t function if the information that the market is providing in the form of the interest rate, is not available.
And of course, it makes no sense at all, as Keynes advocated, to keep driving interest rates down to zero and hold them there. That is essentially giving away money. And of course, we are giving away money, today. The Federal Reserve provides newly printed money to Wall Street, to firms like Goldman-Sachs. They are getting virtually free money, and of course, they make a lot of money with that money, themselves. So then we have this problem of crony capitalism that goes along with it – all these people who are getting rich off these government policies which are not helping the economy as a whole.
David: You raise an interesting point. The market system is dependent on an information feed, and prices tell you what is happening, whether it is healthy or unhealthy, and for governments to step in and play with the price system, via interest rates, is distorting the information feed, and it confuses investors. It also, with a zero interest rate policy, disincentivizes savers. That is also at the heart of Keynes, is it not? That you really don’t want there to be a saving, or using the 19th Century language, a rentier class?
Hunter: That’s right. He basically suggested that the government could print new money. That money would flow into the economy in the form of debt, and that would take the place of savings, but there is just no evidence for that at all, there is no logic behind that. In fact, if you want a good economy, what you need is savings, and you need then to invest those savings, and you need to invest those savings in a wise way.
Of course, Keynes completely ignores the issue of how you are investing. For him, not only is any investment equivalent to any other investment, but spending is equivalent to investment. It just doesn’t make any sense at all. If you want to restore the economy, you have to save, you have to invest, and above all, you must invest wisely.
David: And he went even further to say, whatever means necessary to use up those savings. You bring this out in your book. He argued that natural disasters, earthquakes, even wars, were a way to increase wealth by using up savings. I have to scratch my head on that one – the more you use up savings, even if it is for something like what just happened in Japan – that is productive? That is a move toward an increase of wealth for the Japanese? Help me understand that.
Hunter: It’s a complete logical fallacy, because the idea is that after the disaster, the Japanese have to spend a lot of money, and that will help the economy, but what that ignores is that they then can’t spend the same money on something else which would have been more productive. Obviously, just restoring what they had before is not the best investment they could make. The best investment they could make would be something new and productive. It’s illogical. It’s just a logical mistake on Keynes’ part, and yet, he made lots of logical mistakes.
David: It sounds awfully like the broken window fallacy.
Hunter: It is the broken window fallacy, which Henry Hazlitt wrote about a long time ago, back in the 1950s. Here we have the world’s governments basing their policies on Keynesian economic theory that just makes no sense.
David: We oftentimes discuss, here in the office, Thomas Kuhn’s book, The Structure of Scientific Revolutions, and the idea that there is no real evolution, but there is revolution within a theory of ideas, a theoretical framework. Whether we are talking about a scientific framework, or an economic framework, or even something relating to literary theory or philosophy, there tends to be a textbook community, a group of people who have agreed what is acceptable and true knowledge, and the educational system then perpetuates what is “real” or “true” or “reliable” information. Up until the point where you have problems that cannot be solved by the prevailing paradigm, people just accept it as common knowledge.
It seems we’ve done that with Keynesianism. Keynesianism is economics, largely, and as you said earlier, it is not just the U.S. government, it’s not just the Fed and Treasury, but if you go to any central bank or fiscal or monetary authority around the world, they have the same bias because, largely, they have studied at similar universities, and share that same textbook knowledge.
The point with Kuhn was, really, you get to the point where there are too many problems that can’t be solved by the existing paradigm, and then something replaces it. Do you see that as a possibility? And is the replacement a better one, or a worse one, given what we have in the social milieu today?
Hunter: Yes, there are, in effect, intellectual bubbles, just as there are economic bubbles, and Keynesianism is an intellectual bubble which is underlying the economic bubbles that we have had and that have gotten us into trouble. These things are very hard to change, but they do change, and an idea gets bigger and bigger and bigger, but eventually it does explode, the change comes very rapidly, and then it’s all put behind.
Some people have observed that there is a process in which these ideas change. First of all, an idea is ridiculed: Anti-Keynesianism, in recent decades, has been ridiculed. Then it is ignored – it is getting around, but you don’t want to give it any publicity: The major media today, in general, tries to ignore anti-Keynesian ideas. Then it is fought ferociously. Then, at the end of the process, everybody who fought it says, “Oh, I knew that all along.” That is the typical way that these ideas change. But, eventually, they do change, and they change dramatically. I have no doubt that Keynesianism is on its last legs, but in the meantime, billions of people are suffering as a result.
David: Yes, there is real human suffering, which is far more important than something that is, perhaps, catastrophic to one’s portfolio. Tying in something that you mentioned in your book, negative real rates, this is a chief consideration for everyone, and a consequence of that manipulation of interest rates, keeping them too low, too long.
Negative real rates – there are some practical considerations. You quote Peter Fisher, former Undersecretary of the U.S. Treasury, and New York Federal Reserve Bank. It is not as if officials at the U.S. Treasury or Fed are unaware of these issues, but he says capitalism is premised on the idea that capital is a scarce commodity and we are going to ration it with a price mechanism. When you make short-term funds available essentially free, with negative real rates, and you say rates lower than inflation have happened, for example, between 2001 and 2004, crazy things start to happen.
This is where we are today. We have negative real rates of return. There are different ways of constructing the inflation number – the models in the 1980s, the models in the 1990s, the way we count it today. Today it is less than 3%. If it was counted by the old model in 1990, it would be over 6. If it was counted by the Volker view of inflation, it would be double digit today. We have deeply negative rates, and it forces major misallocation of capital. Maybe you can talk about the consequences of being in a negative real rate environment and the bubbles that are perpetuated. Really, what was set forth in 2008 is the seed of a future problem. Would you agree with that?
Hunter: Yes, absolutely. But first, I want to stress the point you just made, which is that the way the government calculates inflation and unemployment today has changed a lot over time. Some of the biggest changes came during the Clinton administration. If we calculated unemployment the way we did in the 1930s, we would have depression levels showing right now, a lot more than what they are saying, and we would certainly have more inflation showing, as well.
We do have an environment of both inflation and unemployment and that, again, is just the result of these bubbles that have been blown up since the mid 1990s, and they have been blown up, just as you said, by holding interest rates too low, printing way too much money, in an effort to keep interest rates down. A combination of too much money and too low of an interest rate just creates a bubble. Meanwhile, again, the Keynesian economists – and that means most economists – say, “Oh, bubbles are just natural. Bubbles are just part of the market system.” If that is true, why is it we have had nothing but bubbles since the mid 1990s, and we didn’t have bubbles before that for decades? Again, it is just nonsensical to say that these kinds of bubbles are normal, when they are so evidently abnormal, and they are the source of our problems.
David: The business cycle is something that Keynes was not particularly fond of – abolish slumps, and instead, seek to maintain a perpetual quasi-boom, to paraphrase him. There was, in the 19th Century, a period, let’s say between 5 and 10 years, where it was more or less two steps forward, one step back, and a regular, if you want to call it, mini-boom and mini-bust cycle. Nothing deeply catastrophic, but surely painful to those who were on the wrong side of an investment, and those messes got cleaned up pretty quickly, again, in a two steps forward, one step back process. Keynes’s response was, “No – perpetual bliss.” And wasn’t his view really that of a utopian?
Hunter: Absolutely. As in any other utopian thinking, it just doesn’t make sense. It doesn’t recognize reality. The truth is that mild recessions are the price you pay for avoiding deep recession. When you try to eliminate mild recessions, as Alan Greenspan did, and Bernanke did, all you do is create the kinds of problems we have today.
But even in the past, when you had deep recessions, or even depressions, they didn’t last long. The market cured them in fairly short order. The early 1920s depression is a good example of that. The government did nothing and it was over in about 14 months. Contrast that to the Great Depression, or the kind of problems we have had since, where it just goes on, and on, and on, because the medicine the government applies actually just makes the patient worse. It provides temporary relief, but then it doesn’t solve the problem and makes it worse in the long run, or even in the short run.
David: You are talking about Harding, and his response, essentially, to Herbert Hoover. Hoover suggested they pump tons of money into the system in a very Keynesian fashion. Harding said, “Go fly a kite,” and he cut the budget significantly. If I recall, he cut spending almost in half, and we went from a 12% rate of unemployment, to 2%, by 1923 – 2% and change. A very different response, and it was, as you mentioned, a deep recession. It just didn’t last that long, because a different solution was offered by the Harding administration.
Hunter: Right. And there is more recent evidence of that sort, when the East Asian economy got into trouble in the late 1990s, they did not have the resources to apply Keynesian policies, they acted more like Harding and they got over it very quickly. They had a very strong rebound in no time at all, and that is in contrast to the countries that have practiced Keynesian responses, where they don’t get a rebound. They don’t fix the problem, they just make it worse.
David: Is it going to be a surprise to the average man in the street, or woman in the street, who comes to terms with this bankrupt ideology – will it come as a surprise to them just how nonsensical it was to believe in it? And how Ph.D.’s, very, very bright men, have held to these views, which are utterly nonsensical, and very against common sense? I go back to the Redbook article that was from 1934, in which John Maynard Keynes wrote in answer to the question, “Can America spend its way into recovery?” He answered, “Why, obviously, the very behavior that would make a man poor, could make a nation wealthy.” Is it going to pass muster with the voting public that politicians of both stripes, that academics, that Wall Street geniuses, to some degree, rely on Keynes as an intellectual pillar?
Hunter: Keynes was always the smartest kid in the class. He always had his hand up, and he was always telling the teacher, “No, everything you are saying is wrong.” He loved to provide what seemed to be a paradox. If too much debt causes a crash, load on more debt. It’s okay to grow debt faster than income, indefinitely. If debt becomes too burdensome, just cut interest rates. If low interest rates are causing bubbles, just lower them further. He was a specialist in these kinds of paradoxes.
And it is generally thought today that economics shows us that it is an area, it is a discipline, where common sense is actually wrong. But that in itself is wrong. Real economics, which is completely violated by Keynesianism, does reflect common sense. That’s what you need, you need common sense. You cannot violate common sense and expect to do anything for the poverty in the world, or to help the middle class. You have to have common sense policies. And it is just incredible that brilliant people, like Robert Shiller, a Yale professor and greatly respected, just keep clinging to these views, even though there is no logic, and no evidence offered to support them. They are just completely assumed.
David: In recent weeks we have talked about the Fed getting very aggressive in providing liquidity to Europe. It is just within recent days that they have done that, that they are providing ample liquidity through currency swaps and short-term lending via the EC in a coordinated effort with the ECB, the Swiss National Bank, the Japanese. We are re-liquefying the system yet again, and the amazing thing is that the markets love it. The markets absolutely love it. Are the markets really that bright, that they should be saying, “Hey, this is fantastic?” To me, it looks like the smile on the face of the dope addict who just took another hit, and “Boy, isn’t this grand?” Am I seeing this accurately?
Hunter: When we talk about the market, in this case, we are really talking about Wall Street, and Citi and people like that, and as I alluded to earlier, Wall Street has gotten rich off of all these bubbles. Wall Street gets rich off the printing of the money, and keeping interest rates low. They love this kind of thing, and they are only concerned with how much money they make in the next quarter, or the next year, and they are certainly not concerned with the long term. So it is not surprising that the stock market goes up when these fallacious policies are pursued even more intensely.
In terms of Europe, one of the big factors is that the European Central Bank operates under rules in which, if there is any default of the bonds that they hold, they have to sell them immediately, or not count them as capital. So the European Central Bank is faced with technical bankruptcy unless they just completely refinance, if Greece defaults. Just for that reason alone, they are doing everything possible to avoid the default. What a default actually is, is just a recognition that there is way too much debt, it cannot be repaid. That is called reality. That is called common sense. And throwing more money, more money, and more money, after bad, is not common sense.
David: I did a radio interview here in the last day, and the gentleman in Houston said, in a somewhat unrefined manner, “I look at gold as my stupid politician insurance.” I was thinking to myself, “You know, I might have said it differently, but we are really talking about insurance against Keynesian economic policies when we look at a money substitute like gold. Combine negative real rates of return, combine poor policy and the fact that this is really ideologically driven, and there really is a commitment to the ideal. Someone wrote a thesis, they have staked their professional career and reputation on it, there is ego involved, and no one is going to recommend a different course until we have actually gone off the cliff. Is there a reason to assume a different investment thesis at this point, that, really, insurance is unnecessary? Or should we still prioritize insurance in the equation, perhaps not against stupid politicians, but ideas that are bankrupt, themselves?
Hunter: No, I think insurance is even more important. Every day that passes, it just gets more important. There are different scenarios of where we go from here. We could head into a major depression, or deflation, or we could head into a major consumer price inflation, or a combination of the two, but protecting yourself against both is extremely important. In the old days, you could protect yourself against depression by owning bonds, and the longer the bonds, the higher quality, the better, but that doesn’t work right now because the chances of inflation are so great, that could destroy the value of bonds. So the only things you can really rely on now are cash as a deflation hedge, gold as somewhat of a deflation hedge, and gold also is also a great inflation hedge, so gold is really the prime asset. And the irony about gold is that the trouble of holding gold is that you don’t earn any income on it. That would normally make it seem disadvantageous to do so, but because the politicians are holding interest rates so low and refusing any kind of return to the saver, it makes the lack of income return on gold seem not so bad.
David: That is the issue of negative real rates, and going back to Gibson’s paradox and the Summers-Barsky thesis: Low-to-negative rates drive investor interest into something that represents almost a sideline position. “If there is too much risk and no reward, then just count me out until I can look at productive assets with a keener eye to benefit.” Again, we go back to our original point. This is a market system, based on prices and profits, and if profits are taken out of the equation, then people look to opt out, so to some degree, gold is an opt out.
Hunter: I just want to add that Keynesians, of course, say that if you buy gold you are hoarding, if you just keep a savings account, you are hoarding – you are not investing, you are a hurting the economy. But actually, you are helping the economy, because you are keeping capital available for future investment when the opportunity finally arises to make a good, sound investment.
David: It seems, though, if people look at the price of the insurance – you have credit default swaps, for instance, an insurance against default, against a particular underlying asset. Let’s take Greek paper, as an example. It is trading at records of 3 million dollars for every 10 million dollars of underlying paper, or over 3000 basis points, and that is even with the new ECB and U.S. interventions. That insurance seems expensive, and yet, it also seemed expensive at 2000 basis points, it seemed expensive at 1000 basis points, it seemed expensive relative to other types of insurance at 500 basis points. The argument is being laid similarly against gold. It was expensive at $900, it was expensive at $1200, it was expensive at $1500. This insurance continues to get more expensive. At what point does it just not make sense to buy the insurance, because it is just flat too expensive?
Hunter: Again, the Keynesian argument would be that gold is in a bubble, that it is going to burst, and every time gold retreats a bit, you read, “Ah, the gold bubble is bursting.” But I don’t think it is a bubble at all. I think it is still just insurance, and it is still sensible insurance at this price, and that it has potential to go up a lot more because, unfortunately, politicians are not going to change what they are doing anytime soon.
David: With the existing stock of thinkers, we probably won’t see remonetization of gold, but with a different stock of thinkers and policy makers, do you see the potential for a partial remonetization?
Hunter: Yes, I think that there is a great potential. In fact, I am sure that is what will happen, eventually, and it might come sooner than people think, because as the monetary system breaks down, they are going to have to find a new monetary system, on short notice. Monetary systems do tend to break down every 40, 50, 60 years. And when they do, they are doubtless going to bring gold back. The danger is that they will bring gold back in an inadequate way. People talk about the gold standard being a problem in the Depression. Well, we didn’t really have a gold standard then. And you can have a phony gold standard, as we did after World War II. But what you really need is a true gold standard, of the sort that existed before World War I, before the Federal Reserve was created. But it is less likely that they will do that.
David: It seems that it is less likely because it limits government spending, and certainly, the gold exchange standard, as a quasi-gold standard, that you just mentioned, allowed for greater flexibility, so to say, and freed politicians to spend wantonly. You are suggesting bringing it back in part might now be enough, going back to the old gold standard, circa 1860 to 1914, or what the Brits had from 1717 forward, with the exception of wars here and there. What is the political context that would legitimize a full return to the gold standard?
Hunter: I think the present monetary system will collapse, and when it does, they will bring back a so-called gold standard, but it will be something more like Bretton Woods, what we had after World War II. They certainly won’t bring back a full gold standard if they can possibly avoid it. I don’t expect that to happen, but that is what is needed, because that is the only way to really control government, as you said, and prevent more and more of the same Keynesian policies of print money, spend money, borrow, spend, and bailouts. All of that would not be possible under a true gold standard.
David. We had an interesting conversation with Giulio Gallarotti, and his comment was that under a system of universal suffrage, it is very difficult to maintain those disciplines. Politicians are inclined to spend more on their constituency groups than under a gold standard, or what a gold standard would allow for, so perhaps a return to disciplines reflective of the gold standard, but certainly not a return to the full gold standard. And he said the era of post World War II was different. We have moved toward universal suffrage, and politicians won’t allow for it, and frankly, neither would constituency groups, because it would mean less money from the government trough. Would you feel like that is an accurate assessment?
Hunter: No, because the problem is not the universal suffrage, the problem is the special interest groups.
Hunter: The special interest groups, the big businesses, the unions, the trial lawyers, and so on – they are the people who are active in Washington and Wall Street, who are actually deriving benefits from all these Keynesian policies, and the country as a whole is not, the average voter is not. If the average voter really understood what was going on, they certainly wouldn’t support this kind of thing.
David: That’s a very good distinction.
Hunter: There is nothing about democracy, I think, that leads us to this problem. In fact, we need more participation from the average voter and the average person, not less.
David: You see the present monetary system unwinding. Any thoughts on the euro? Any thoughts on a basket of currencies? Certainly, Keynes was fond of the Bancorp idea. The IMF and the SDR structure is certainly being bandied about a bit. What do you see as the world’s money system 3 or 4 years out? What would you speculate would be our reality?
Hunter: The most likely outcome would be to try to go back to the system that Nixon destroyed – the post World War II system. But certainly, we don’t need Bancorp, we don’t need the SDRs. That is just an international organization printing money, in addition to individual governments printing money, so that just magnifies the problem and makes it even worse. What we need to stop is all the money printing. That certainly doesn’t take us where we need to go.
David: Something very similar to Bretton Woods where currencies relate to a particular sound, or more sound, currency. That was the dollar. Do you think that is the dollar still? Barry Eichengreen would argue, probably not, it will have to be a duopoly, certainly not a dollar monopoly, any longer.
Hunter: Yes, it is quite hard to imagine that the dollar would remain the sole reserve currency under a new system. That certainly is not very likely. In terms of the euro, I was just hearing on the radio yesterday, a distinguished commentator saying, “We have a choice here, either the European governments will intervene and rescue the euro and save the day, by basically bailing out Greece, and other countries, or they will let the euro collapse and that will be a disaster, and that will cost the European government much more money in the long run – six times as much money.”
But that is just all fallacious, because bailing out Greece, or bailing out Portugal, doesn’t solve anything. Again, you have to accept the reality that their debts simply cannot be repaid, you have to accept default, and you have to rebuild from there. The idea that those are the only two choices is just basically ridiculous. And we also have to keep in mind that, actually, if they kicked Greece out of the euro, the euro could appreciate considerably, so there actually is the possibility that if the Germans don’t buckle under, and they kick bad performers out, they could actually make the euro a very attractive currency again, more attractive than the dollar. No one is talking about that possibility.
David: That has been our position, that if you take the barnacles off the underside of the boat, you have much smoother sailing.
David: What you said about the distinguished commentator from Europe giving those two alternatives, I just want to come back to your book, because this is one of the gifts that you have, Hunter, in pointing out the logical inconsistencies. Here is one example of the fallacy of false alternatives. You look at Keynes and you say, “Come on, he is misusing technical language, he shifts definitions, he misuses even common terms, he confuses cause and effect, he creates things that are representative of false determinism. And I think it is a very fair portrayal. You let him speak, and then you add some comment to it, and say, “Guys, come on, wait a minute. Does this make sense to you?” It is not just common sense, but also a keen criticality, a real insightful, logical appraisal of where Keynes went wrong.
I want to encourage listeners, if you don’t feel like you know what is being done to you, not necessarily for you, but to you, under the current administration, the past administrations, and as we have pointed out in this conversation, not just here in the United States, but globally, by the fiscal and monetary authorities, you should know Keynes. You should know him on a first-name basis. You need to get to know him. Make your introduction to him. Get a copy of Hunter’s book. If you have interest beyond that, then certainly, order an original copy of Keynes’s writing, and dig into the primary text, as well, but this is a great introduction.
Hunter, I want to thank you for opening up the conversation and getting people thinking. We don’t know, in the future, what will have turned the tide, but you have offered an opportunity. You have set something out there that I think critical thinkers, people who care about our country and the direction it goes, and frankly, the world, can look at and say, “Wow, I didn’t think about that. I need to reappraise. I need to check my assumptions. As logical as my macro-economics class in college seemed, it appears that the professor, and myself, didn’t reassess our assumptions, and that needs to be done.” Thank you for raising the questions, and presenting that for the average American to take a look at and say, “We need a different set of ideas. Let’s see if we can get that done.”
Hunter: Thank you, it’s been a pleasure.
David: We look forward to our future conversations, and again, you can find Where Keynes Went Wrong at amazon.com, or at any of the media outlets, in either hardback or paperback. We ordered it by the case, and hope you will, too.
Posted in TranscriptsComments Off on September 21, 2011; The Final Days of the Keynesian Utopia: An Interview with Hunter Lewis
Posted on 21 July 2011.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, you are just getting back from the conference in Las Vegas. I know you had a chance to spend a little bit of time meeting Herman Cain.
David: Kevin, while I enjoyed the interview that we did with him here on this program, I have to say that I enjoyed meeting him even more. To take the measure of a man is to shake his hand and have a reasonable conversation with him in person. You get to look into his eyes. You get to hear the real timbre of his voice, and I was very impressed, Kevin – impressed by his stature as a person. I can see why he was an effective CEO.
Kevin: David, when you came back and told me about it, the first thing I thought was, when you meet a person with integrity, where they don’t have something to hide, you can sense that. It rings true with your own integrity, and I think that is probably what you sensed when you were talking to Herman.
David: It is certainly a confidence that runs deep, a man of authority, a man of internal strength and power, and someone that I don’t know that I would necessarily want to tangle with in a boardroom. I think he is very self-assured and, if proven wrong, not so frail as to run and hide, but to accept where he has been wrong, and move forward.
Kevin: Something that really makes me laugh about Freedom Fest. It is in Vegas each year, and I know Vegas is seen as a fun town, but the guys who are actually up there speaking, for the most part, don’t fit in Vegas. “What happens in Vegas,” they say, “stays in Vegas,” but a lot of people stay away from Vegas.
David: And I probably would prefer to stay away from Vegas, too. It is not my favorite place in the whole world, and as far as places to stay, Bali’s, as you have suggested, is sort of the boxed wine of Vegas.
Kevin: You do get a lot of square footage for the money.
David: Exactly. Quantity over quality is certainly true, and I am grateful to be back in Colorado breathing fresh, non-recycled air again, after four days in Vegas. I feel like I must have been training intensively for some sort of smoking competition. I am now ready for a pack a day, because I think that is what I must have been inhaling in terms of secondhand smoke.
Kevin: I know a lot of people wanted you not to lose your voice because of the smoke, because you were talking, again, about why you feel gold at $5,000 an ounce is a reality. But David, you have said this before, and it seemed like it was an extreme reality, an outside chance. At this point, it seems like it is coming into something that is much more acceptable as a reasonable amount that gold might rise.
David: The first thing I did when I got to Vegas was a CNBC Asia interview, and it was televised within Asia, and they were surprised by that $5,000 an ounce suggestion. I think what they don’t realize, is that it is becoming more common by the day. Standard Chartered has recently issued the same opinion – $2,000 in the immediate, with a long-term projection of closer to $5,000 an ounce.
Kevin: Jim Sinclair has said, “Now that we have topped $1,600, and if we punch through a couple of other levels that we are fairly close to, we could be looking at 5-digit gold prices before this is over.”
David: Today, as we spend some time looking at the European debt markets, and the U.S. debt markets, as well, I think we will come to something of an agreement that $5,000 may, in fact, be conservative, versus an aggressive estimate.
Kevin: Let’s go to that. You said something that was compelling to me yesterday. The bond markets, which is really now people price risk, that tells us so much, and you had made the comment that you believe that the bond market in Europe is actually defining what the new Europe will look like, as far as who will still be participating, who won’t be participating, and what the outcome will be after all these debt talks have gone through.
David: Correct, Kevin. What we are looking at, in the European debt markets, is that capital is flowing, and bond yields are now giving us an indication of who is likely to remain as a part of the euro project. If you are watching the difference between what is happening, people buying French sovereign debt, buying the debt of the Netherlands, buying German paper, as opposed to people walking away from Greek debt, and Spanish debt, and Portuguese debt, and the yields rising in those countries. Greek bonds collapsed this week, as we have seen yields now surpass 39%.
Kevin: 39%. That is something that, if it was safe, we would all just sign on for.
David: This is where bargain hunters are beginning to feel not like the hunters, but the hunted, and I think it is important to remember that old Wall Street adage: “Never catch a falling knife.” What was a value two weeks ago, or two months ago, is now representative of an investment slaughterhouse.
Kevin: So, if Greek debt isn’t a value, then how about Portuguese debt?
David: Their two-year paper is pressing 20% this week, after the fresh discovery of a 2.74 billion dollar hole in the budget, so we basically had a gift which was left by the outgoing socialist party, and this, to us, is a replay of what we saw in 2009 in the Greek drama, where the deficit was found to be two times the previous estimate, and they had sort of an ah-ha moment, more like an uh-oh moment.
Kevin: Speaking of ah-ha moments, David, we all know in the back of our minds that the euro is not going to look the same in a year as it does today, nor the European Union, as a matter of fact. The secession of the PIIGS countries has been suggested, which would actually be initiated by the Germans, the Finns, the Austrians, the guys who actually have their financial houses somewhat in order. Do you feel that it is the northern countries, the people who are actually somewhat disciplined, that are going to force this issue?
David: I disagree. I think that the southern secession is more likely, and it is going to be, in my opinion, driven more by the popular discontent with Brussels and with Frankfurt than driving the austerity measures. We have individual countries which are already in the throes of rapidly rising unemployment.
Kevin: Yes, unemployment. Spain – 40% unemployment for people who are less than 30 years old.
David: It is clearly something that is a rising problem in terms of a populist issue to be addressed by local politicians. They stand to benefit. Those individual countries stand to benefit from a monetary devaluation, from a partial default, and frankly, from independence from the euro body.
Kevin: Let me ask you this, Dave. Is monetary devaluation ever a good thing? If you were in a country and you knew you couldn’t pay your debts, and you could no longer stay with this particular union that is forcing this, what else would you do? Is it ever a good thing?
David: I think, Kevin, philosophically, you can look at issues like that and play the role of the idealist and say, clearly, we don’t think that is a good idea. We don’t like the idea of default because it is a measure of dishonesty in your business dealings where you have gone against what you originally obligated yourself to, and I think, in practice, you are faced with circumstances where you must choose measures of expedience. I remember my brother being in Banda Aceh. He was dealing with people who had been injured in the tsunami.
Kevin: Of course, this was right after the major tsunami that Christmas a few years ago.
David: Yes, within 48 hours he was on the ground and there were people whose limbs were going septic and very quickly could have had their bodies going septic, and he was dealing with issues which were growing by the hour – someone who could be dead within six hours if an arm or a leg was not immediately amputated. Again, in principle you could say, “Let’s try to revive this body in a healthful fashion.”
Kevin: Sure, like you would here in the United States. We were talking earlier about a great friend of yours and your father’s, Patricia Bragg. This is a lady whose father was an amazing model of health, and she is an amazing model of health also. She wouldn’t say, “Let’s cut the arm off,” right off the bat. She would say, “Drink apple cider vinegar and let’s make it better.”
David: Let’s make it better, let’s see what is wrong with the system, let’s fight it at the level of the system, and in that circumstance, there is something that circumstantially precedes the ideal, which is, “We may not have the time to solve the body or the systemic issue if we don’t take immediate action.”
Kevin: This would be monetary devaluation, this would be a breakaway from a union, these types of things that would have seemed just out of the ordinary five years ago, and at this point, are ordinary thoughts.
David: And it is something that I think would be of benefit to these countries. I have spent a lot of time studying the Latin American debt defaults, and the countries that did, in fact, default and devalue, were the ones who had their economies back on a normal growth trajectory much, much sooner. In this case, I think the race goes to the swift. The first to leave the EMU and devalue will be the first to return to regional competitiveness two to three years from then. I am not saying that devaluation is part and parcel to a healthy economy. I am not presenting that as an ideal scenario, at all.
Kevin: No, but the tsunami has hit and there are arms and legs that are rotting at this point.
David: If you don’t deal with it as triage, you won’t have the privilege of fixing the systemic issues. I think, ultimately, the systemic issue might even include something like a gold standard in Europe, and we can talk about that in a few minutes, Kevin, as it applies to the U.S., but the issue is, we don’t get to get there if we don’t take a strong view and know that time is not on our side.
Kevin: Okay, Dave, let’s play a thought experiment here. Scientists do this all the time. They will say, “Let’s think this through. What would be the ramifications if….” Have you thought about, or has anyone actually sat down and thought about, what would happen to the currencies of the euro that are still part of the European Union, that are still part of the euro, versus the currencies that would break away? Has someone done the math and seen what would balance the equation?
David: Yes, and essentially, there ends up being two collections of countries – the strong ones and the weak ones, if you want to put it in those terms. Right, Kevin, those are the previously mentioned stronger states – Germany, Finland, Austria, the Netherlands, maybe even France. They could perhaps find some sort of a tolerable fiscal union as a “closer to equals euro mix.”
Kevin: Quite a bit different than Greece, Spain, Portugal, Ireland, etc.
David: Right. You could call those the peripheral euros, if you will. HSBC’s currency team has already estimated that that core euro mix could see a currency swing to the upside, an appreciation of roughly 29% from current levels.
Kevin: That would be the euro, basically, that you are talking about. The core countries that would stay in the euro would rise almost by a third, 29%, in value, because it would take the stress of these dragging countries off.
David: Have you ever gone to the pool and taken a large, inflated ball, and tried to suppress it under water? You are what is holding it down. As soon as you release it, as soon as your weight, as soon as your drag, is no longer in the equation, guess what happens? There is an immediate buoy, and that is the potential of a 29% or 30% buoy to the euro.
Kevin: So what would happen to the currencies that broke away?
David: Probably at 50-60% devaluation of the peripheral euro, again, those countries being unhinged, and you say, “Well, devaluation, that’s terrible.” Yes and no. Think of what happens to the tourist trade in those areas where, now, Northern Europe and the rest of the world can go to Greece and have basically a beach vacation for pennies on the dollar. We discussed this with Bill King a few months ago. They don’t export anything. They really don’t offer much to the EU in terms of a strong, productive component. But if you go to Italy, if you go to Greece, if you go to Spain, these are great tourist destinations, and all of a sudden, a vacation to Rome, from Colorado…
Kevin: It is half of what it was before.
David: Exactly. Or a vacation to the Greek Isles, again, is quite reasonable once you’ve paid for the airplane ticket.
Kevin: Okay, so Dave, we did this thought experiment, sort of in an isolated container, because, in reality, as we have talked about for months, the real risk right now is the credit default swaps that would trigger, when that occurs. Can you address that? The banks that are over there would be affected by a default, but how about the banks in London and New York?
David: To rephrase that, the banks on the continent would stand to lose if sovereign paper were simply marked down, not that it defaults, but they have a lot of that paper on their books, and what they are protected against, what they have bought insurance for, is default. So, in fact, in the case of default, a lot of European banks are okay. It is in the case where they have to mark their assets to market and we can see that the Greek paper, the Spanish paper, the Italian paper, is trading at an extreme discount, that their balance sheet today is impaired. In fact, if there is a default in any of these countries, they get a free pass by having insured against the default to a certain degree, and the risk gets shifted from them to the Anglo banks. So you go to New York, and you go to London, and that is where the plot begins to thicken.
Kevin: And that is very, very, close to home for the Americans who are listening right now, because it is the insurance companies, it is the banks, it is pretty much everything.
David: Right. Look at the main wirehouse firms here in the United States and say, “Well, how can they possibly be impaired?” Because they were the counter-parties, if you will, to these insurance contracts, which guaranteed that the person holding the sovereign paper would not get into trouble if, in fact, there was a default.
Kevin: We have been using the Lehman crisis from 2008 as an analogy, but are there differences at this point from back in 2008?
David: I think there are huge differences, and it is just that the market has matured a bit in seeing that sovereigns and central banks don’t have all the answers to these problems. We have had creditors who have lost a degree of faith in sovereigns and their ability to address, not only the short-term issues, but also larger structural issues as well. That was not the case in 2008. You looked at one degree of corporate incompetence and you said, “Bear Stearns and Lehman Brothers. I can’t believe they mismanaged… can’t believe the amount of leverage… they should never have gotten to this place. But at least we have a formal bailout from the big brother, and actually in this case it was, truly, Big Brother. We don’t have that same confidence, because, essentially, we used up the Big Brother balance sheet, and the next bailout – you can’t push that one up a notch in terms of the ladder, because we have gone as high as we can go.
Kevin: That brings me to an interesting thought, Dave. Last week, Ben Bernanke looked Ron Paul right in the eye and said, “Gold is not money.” Now, you have been talking about this loss of faith in sovereigns and that there really is no next step. There is no sovereign above a sovereign. They are the top of the ladder. But when you get to the top of the ladder, and you have nowhere else to go, you go to gold, and as of this moment, gold is trading in the $1600 range.
David: One more point on the bond market, and this comes from a recent Jim Grant interview, a very bright guy in the interest rate markets. He said, basically, that the bond market is operating on muscle memory today. The operative principle in the bond market is that which has driven it consistently for 30 years. We have been in a 30-year bond bull market here in the United States and it is not being driven by fundamentals.
I have wondered, and we have suggested in this program before, if a new form of bond vigilantism isn’t, in fact, found in the gold market, not in people making a strong counter-attack move against the bond market, shorting the holy heck out of it, but, in fact, saying, “I don’t know that I can play in a rigged game. As a bond trader, I don’t know that I am going to win in a rigged game, but I do know where the pressure outlet will be, and that is going to be in the gold market.”
Kevin: A little bit of explanation for those who have not heard the term, bond vigilantism before. The bond market is so gigantic. I remember your dad, one time, explaining it when I first came to work here 25 years ago. He was explaining the stock market, and he showed me a little cup of water, and he said, “This is the stock market.” Then he said, “Imagine your bathtub. That is the bond market.” It is so much larger, and it is so much harder to manipulate, because people are buying and selling based on what they perceive as the risk of repayment. Bond vigilantism simply means, and correct me if I am wrong, Dave, that the bond market is going to do what it is going to do, and it really cannot be manipulated long-term by any kind of federal official.
David: That is the truism that most people familiar with the bond market are aware of, that the short end of the curve is controlled by politicians and political interests.
Kevin: But the long, 20-30 year…
David: That is market-driven. The market determines the price. So, if there are concerns about credit quality, if there are new concerns about solvency, then the market will determine the direction of the interest rates, and the other side of that equation is, the price of bonds.
Kevin: Then let’s talk about the gold revaluation. If you are saying that this is where we are actually going to see the impact this time around, tell us about the gold revaluation, not just here, but you made a comment last week that it was hitting new highs also in the euro.
David: What that is indicating is, essentially, a fiat free-fall, with some currencies seeming to have more gravitational weight than others. If you look at the euro, it is over 1,100, about 1,125 to 1,140, in euro terms. In British pounds, it is nearing £1,000 an ounce. It sounds funny to say it that way. (laughter) In Swiss francs, it is over 1,300 francs an ounce. Then the U.S. dollar is well over 1,600 an ounce. And everyone is surprised that we are getting to new highs, but we have been getting to new highs for the last year-and-a-half to two years. Only now is it entering the minds of investors that something is really wrong, because it shouldn’t be this high, in their humble opinion.
Kevin: David, you were talking about a breakdown in sovereign faith, but there is really a breakdown in faith in paper assets as a whole. Let’s face it, many years ago, there were so many options, a person would say, “I have gone to my financial planner, and he has me in bonds, he has me in mutual funds, he has me in stocks, he has me in various currencies.” We were all taught, maximum diversity was maximum benefit. It seems like the options are being narrowed very, very precisely at this point.
David: If you look at market practitioners today, Kevin, they have grown up in an era of nearly infinite options. It was just a question of good, better, or best. There was no good, bad, and ugly. Today we have ugly, uglier, and ugliest, as really, the investment options of the day, with a few standouts. It’s not good, better, and best.
In a trust-building environment, where things are positive, you have innovation, you have change that is rewarded, you have new financial products that proliferate, and there are, however, very limited options for investors, when on the other side of the coin, sentiment begins to change and trust begins to break down. That is the era that we are in. We have practitioners looking at the old days, more recently, 1980s and 1990s, and saying, “We have so many good options and they are all really well priced. I think we need to be buying stocks, I think we need to be buying bonds, I think we need to be buying real estate.”
Kevin: The other options that were created in the 1980s and 1990s, and the early 2000s, were to eliminate risk, but all they did was add complexity. I think about the person we interview every so often who wrote, A Demon of Our Own Design – Bookstaber. He talked about how complexity was added to the markets to the point where they were unintelligible.
David: Unintelligible. Now we are in the back to basics reversion, as people cut anything that is “fancy” or “complex.” Those complex, previously, just recently, viewed as very sophisticated, products, are now something to avoid, and all of a sudden all those many options that you have, traditional asset classes, and their many derivations, are something to be protected against, preservation of assets, protection of assets, becoming the real priority for a truly sophisticated investor, identifying the right trends and taking a clear appraisal of what is happening in the world today.
Kevin: Yes, and speaking of a clear appraisal, back when the stock market was just shooting up every year, nobody really paid any attention to what the real rate of return was, because they figured, “Well, inflation is a couple of percent, but, hey, I made 11% this year, or 15% this year.”
David: Or 25%, or 54%.
Kevin: Exactly. But at this point, when people are trying to squeeze out 1% or 2% out of their asset, but they know they are losing 3% or 4% to inflation – that’s what the government says, it’s probably twice that – negative real rates of return right now seem to be the norm.
David: This is one of the core themes that need to be understood by investors if they really want to understand the gold picture. Why would everyone be moving to gold? Not everyone is moving to freeze-dried food, and not everyone is moving to AR-15s. I just read an article in Harper’s magazine that says you have to be a crazy, rightwing fanatic to be buying gold in this environment. In fact, you are one of the causes of destabilization of the world financial system, if you happen to be buying gold. Read the article. We’ll get to the Harper’s article in a minute.
Kevin: Yes, I’ve been feeling pretty guilty myself, Dave, that it’s my fault that our government is deficit-spending, and this thing is falling apart.
David: My point is simply this: There is a contingent in the financial system, and in the news media, that does not understand basic, fundamental investment thematics. That is why harping on a negative real rate – there is nothing extreme about this. This is just the facts. Why are people buying gold in China? It can be boiled down to this simple fact: The official rate of inflation is 6.4%, and deposit rates are 3.5%.
Kevin: That sounds negative to me.
David: You’re negative! What about in the U.S.? We have an official inflation rate of over 3% and there is a deposit rate of less than half a percent, closer to a quarter of a percent. We are deeply negative, in terms of our rates of return. And investors have to look themselves in the mirror every day, or whenever they have a CD coming due, and say to themselves, “How does this make sense?”
Kevin: What do you say to the guy who bought gold at $300, and he bought gold at $500, he bought gold at $700 or $800. Now he is looking at it at $1600, and he is saying, “Gosh, this is higher than I’ve ever seen it before.”
David: I would say, Do-Not-Sell-Your-Gold-And-Silver. They have not solved the fundamental problems of our day. We spent just a little bit of time today talking about the European debt issues still in play. The U.S. debt ceiling is an utter political farce. It will be solved – it will be solved at the last minute.
We have bigger issues which both parties have failed to address, going back over a 40-year period – debt obligations and entitlement payments, which have basically put future generations in hock. Kevin, it is deplorable, it is unethical, what we have done to future generations. But it is both parties that have been complicit in this crime, and both parties that should pay at the polls and in the 2012 elections.
My point is this: We have not solved any of the fundamental issues which are driving the financial markets today. The instability in the debt markets, the very frail earnings that are coming out on Wall Street today. Look at the bank earnings in the recent week or two. It is fascinating to watch. “So-and-so is beating estimate, so-and-so is missing estimates.” All of them are borrowing from loan loss reserves to pad results for the quarter.
Kevin: That was an amazing fact, looking at Citigroup, when they had shown a profit, but actually, they didn’t have a profit, they just moved money…
David: Out of their loan loss reserves, reducing their loan loss reserves, and bumping their earnings on that basis. And everyone seems to think that is healthy.
Kevin: That was 50% of their gain, wasn’t it?
David: That is balderdash, and anyone who is investing in Citigroup, on that basis, needs to have their head examined. This is the point, Kevin. There are fundamental issues that have to be addressed, and up until that point, you have good reason to take evasive action, to do something to protect your assets. To address someone whose concern is that gold has gone too far, too fast: If we were at the tail end of the gold bull market today, if we were there already, the rate of change, the rate at which the price of gold is accelerating, would be, just as in every other bull market, regardless of asset class, between 100 and 200 percent per year.
Kevin: So $1600 gold, going to $3200 dollar gold.
David: Or $4500, within a 12-month period of time.
Kevin: At that point we might be getting close to a top.
David: Ding, ding, ding, ding. You are ringing the bell, if you are seeing that kind of ROC, a rate of change, in a condensed period of time. But if it is between 12 and 18, as much as 25 or even 50 percent, it means that you are in a very strong market. That is what I am saying, Kevin, is that a blow-off phase is marked by that 100 to 200 percent annual rate of change. We have not seen it, at any point, during this bull market in gold.
Kevin: David, I would encourage any of our listeners to go back, you can go to chart programs on the Internet, and look at gold for the last ten years. It is amazingly regulated. I don’t mean regulated by the government, I am talking about regulated by the market. It has gained about $100 a year, average price, for 10 or 11 years. Granted, it is starting to steepen at this point, but for the guy who did buy at $300, $500, $700, or $1000, who is now looking at his real rate of return on his other paper assets, not only should he hold the gold that he has, but within reason, he probably should continue to add to his portfolio.
David: Let me just give this as a confirmation, as an affirmation, as an encouragement to our listeners. It is not like we are going to be silent when it comes to that period in time where we think a reduction in your holdings makes sense. We have prepared an exit strategy. We have the next 25 years, as best we can, theoretically, mapped out for our clients. It is not as if we will be silent. You just have to stay tuned in.
Kevin, and staying tuned in, to some degree, is also tuning out some of the noise. I would encourage any of you listening to at least get a copy of the Harper’s article. Frankly, I wouldn’t encourage you to buy the Harper’s magazine, because after reading this article in the airport the other day, I was appalled, and thought, “Why did I spend the money for this magazine? This is ridiculous.” If you look at the lead article, it essentially is saying, why, what they very disparagingly call metal heads, are buying gold and how wrong-headed it is. It is a classic political blunder, in their opinion.
Kevin: Gold isn’t money. That’s what Bernanke said last week.
David: And I think what we are seeing is, actually, in that article, a classic media bias, driven by political views, and what they are failing to recognize, is their inability to remain objective across asset classes. Their assessment of the markets is so blind, given their political predisposition. It is tragic, because you are talking about good people who read that article and will conclude that it just doesn’t make sense to own gold.
I think, Kevin, this is where we come into conflict. We have a conflict brewing between the statists, and those who see the free market playing some role in the solutions to the problems we have today. Let me just borrow from Alan Greenspan. This is early-era Greenspan. “An almost hysterical antagonism toward the gold standard is one issue that unites statists of all persuasions. They seem to sense that gold and economic freedom are inseparable.”
Kevin: This is Alan Greenspan. I believe it was 1967 when he said that, David. But this is Alan Greenspan before he finally went over to the paper side, the dark side. Yeah, I think of Darth Vader. (laughter) I don’t mean to make him out to be that bad, but this was a guy who wrote really well about gold, economic freedom, and non-deficit driven economics.
David: Kevin, I hope our listeners of any political persuasion would see that this is not driven by party loyalty, that if you take a birds-eye view, one can see that history is littered with fiat currency experiments gone haywire. This episode is no different. What we are looking at in Europe will be solved, ultimately, by a correction in one or more currencies. What we see here in the U.S. will ultimately be solved by a correction in the currency.
How do we know this? Because we have already seen the intransigence to do the right thing fiscally. We have already discussed, for the last two years, how politicized the budget is, how unwilling politicians are to cut their political throats in an effort to cut the budget, because that is essentially what would happen. They would not be re-elected if they didn’t bring the bacon home. So we have this naturally corrupt system. Unfortunately, this is the nature of a democracy. It starts very clean and very neat, and ultimately becomes corrupted as politicians figure out how to redistribute wealth to their own constituency groups.
Kevin: I think of the verse from Ecclesiastes. There really is nothing new under the sun. When you were talking about this being an experiment with paper currencies, this is not the first time. You and I were talking the other day about, “What if we lived 4,000 or 5,000 years, and we could actually take a real bird’s-eye view?” We would have seen paper currencies and other types of experiments, with non-real things as money, come and go. I think of 700 B.C. when the Greeks went off the silver standard and it went so horribly wrong, it meant the death penalty, once they re-established the standard.
David: If you corrupted the system again, you would be killed.
Kevin: And then the Romans did the same thing. Julius Caesar paid his troops with real gold.
David: And you can look at different eras of the denarius and they changed the silver content over time to be able to fund an over-bloated budget. They had too many entitlements, too many outgoing obligations and not enough tax revenue.
Kevin: But what always happened after that? There was a return to a real standard.
David: There was a return to a real standard, and Kevin, I think for the first time in my adult life, the gold standard is, in my mind, not something that could or should be entertained, but will be entertained in our lifetime. Put it in a ten-year time frame, or a twenty-year time frame, maybe it is even a five-year time frame, but reasonable minds will discard the unreasonable criticisms that you will find in a Harper’s article, and see that there is only one way to elegantly balance an economy and manage a currency system.
Kevin: David, sometimes we are thinking privacy is everything. On other occasions, we think, “Well, gosh, if everybody is private about their gold holdings, and saying nothing…” We have the Harper’s Bazaar out there, and a lot of different people who are saying, “Oh, well, gold is not money, don’t even bother with it.” Is this the time to become vocal about the way to solve the problem?
David: Kevin, this is the time that your voice needs to be heard. This is the time where if you have an opinion, you need to make it known. Coming into the 2012 election, this may be the most important election we see in our lifetimes, because we are at a tipping point. We will either go the way of the statist conclusion, and that is, toward greater and greater controls, or we will allow free market forces to solve these problems, and one of the greatest ways to empower free market forces is to take away the Ph.D. standard and go back to the gold standard.
Kevin: A man on the street, several hundred years ago, owned a printing press and he created brochures that talked about the British influence on the American colonies. He had such a profound effect, just because he was vocal, he was bold, but he was simple. These were simple brochures. Of course, David, I am thinking of Thomas Payne’s vignettes, out of the series that he called, The Crisis.
David: “These are the times that try men’s souls. The summer soldier and the sunshine patriot will, in this crisis, shrink from the service of his country. But he that stands it now deserves the love and thanks of man and woman. Tyranny, like hell, is not easily conquered. Yet, we have this consolation with us, that the harder the conflict, the more glorious the triumph. What we obtain too cheap, we esteem too lightly. ‘Tis dearness, only, that gives everything its value. Heaven knows how to put a proper price upon its good, and it would be strange, indeed, if so celestial an article as freedom, should not be highly rated.”
Kevin, think of the willingness to put into word and to give a voice to what they believed 200 years ago. It needs to happen. This crisis will either be solved, with greater controls by an incompetent system of bureaucracy that brought us the crisis in the first place, or we will solve it – we – every man and woman of this country.
Posted in TranscriptsComments Off on July 21, 2011; Infinite Investment Options Now Being Reduced to One – Gold
Posted on 17 June 2011.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, just as there are moving plates and continental drift, and they change the geology of the earth over time, or sometimes very quickly, you have events in the geopolitical realm that also shift geography. I am speaking right now about Turkey. Things have really changed in Turkey, and we have talked about it for the last couple of years, but this last election was really a decided outcome that is going to change the face of Middle Eastern politics.
David: It was last year, in our interview with Kamran Bokhari from STRATFOR, that we looked at Turkey, we looked at the implications of a revival of the Ottoman Empire, we looked at the regional balance of power which was upset by the U.S. involvement in Iraq, and the regional balance of power which shifted after the Cold War. We talked about a number of different things that related to the Middle East, and one of the things we looked at was the election, upcoming, June 20, 2011. We have just had the election in Turkey. Erdogan and the AKP, or the Justice and Development Party, want a third term. Again, as we discussed quite a bit in that interview with Mr. Bokhari, the direction of Turkey, both nationally and regionally, hangs on this election.
Kevin: David, what Bokhari was talking about was this void that had been created in the Middle East when we took Saddam Hussein out. Now, Saddam Hussein was a bad guy. You take him out, but you create a void that only can be filled from one direction or another. It either is filled by Iran, or it is filled by Turkey.
David: And in fact, there was a third option, which would have been Egypt, until Mubarak was overthrown. So, exactly – this power vacuum has to be filled, and who will be the regional player? Who will be the dominant voice within the world of Islam? And it is pretty easy to imagine the Ottoman Empire reborn.
Kevin: Turkey is not necessarily just a dictatorship. In other words, Erdogan doesn’t have open season on being able to do anything he wants. There still has to be a vote.
David: You’re right Kevin, they have a parliamentary system in which they have 550 seats, and it has to be a multi-party cooperation unless one of two circumstances occurs. If during this election you end up with a super-majority, which would be 367 seats out of the 550, or just a majority – not the supermajority, but just a regular majority, 330 seats – then you can approach politics very differently. With a supermajority, Erdogan could have done anything he wanted without any recourse.
Kevin: Did he get that?
David: No, he didn’t, and he didn’t even get the majority, so there were two things communicated. One, Turkish people really like the fact that they have had close to a decade of economic growth, this last year between 9% and 13% GDP growth.
Kevin: Do you think that’s why the incumbency worked for him? Let’s face it, when you have economic growth, remember the Clinton years, he got back in partially because the United States was on an expansionary cycle, and it really didn’t have anything to do with him.
David: If you want to talk about American politics for a second, it has been in U.S. history that any incumbent president who comes into that final stretch, if unemployment is above 7.2%, they’re out – they’re out. So that employment number is very critical.
Kevin: Even in Turkey?
David: Even in Turkey, so he has brought about a great social success. At the same time, there are a diverse number of people, groups within Turkey, who aren’t so sure that they wanted him to have sort of dictatorial or autocratic power, so he did not get the super-majority, and he missed the majority, 330 votes, by 4. He got 326 votes.
Kevin: He missed it by that much.
David: And the difference is just that he would have had to go to the people in a direct referendum. If he had gotten the 330 votes…. he can’t do anything he wants. Here’s the concern that investors have had. You know what he wants to do? He ran on the platform of, “I’m rewriting the constitution.” “Okay, well, how are you going to rewrite it? Is it going to be more, or less, Islamist?” That is the critical point.
Kevin: Do you sense that this is a shift toward more radical Islam for Turkey?
David: Ultimately it is, but not having the majority or supermajority, he is going to have to focus on regional, not just domestic, politics, and when he focuses on regional politics, that is going to include his relationships with Syria, with Iran, and with Russia.
Kevin: Let’s face it, on the other side, it also includes Israel. This is the guy who was in power when the flotilla floated last year, and you went to Israel to find out really what that meant.
David: And that defines his role in the region, because what is he trying to do? Is he trying to upset the balance of power in Israel? No. Does he really think he can change anything in terms of the Israel/Palestinian relationship? No. But by making a strong and public stand in support of the Palestinians, he communicates to the rest of the Islamic world the role that he intends to play as a regional leader. He is being very vocal and it is for a very clear reason. If he had been given the supermajority, we would have seen a rewritten constitution, and Shari’a law being something that was just commonplace in practice within Turkey.
Kevin: So we came dangerously close to a dictatorship in Turkey that would have moved toward radical Islam.
David: Right. One last point: He, recognizing that Egypt was a potential filler of that balance of power, that power vacuum, if you will, was nonsupportive of Mubarak. Just a few months ago, with the uprisings in Egypt, we saw Erdogan condemn Mubarak and jump on his ouster immediately. But, he has been very quiet, without initial comment at all, on Bashar al-Assad in Syria, and also on the bombing of Khadafi, and what we have seen in Libya.
Kevin: He is seeing the removal of competition in the Middle East. Let’s face it. He was looking toward Europe for a European Union membership just recently until Europe just continually shut the door in his face, so now he is looking East.
David: Exactly, exactly. Looking East brings us to China, because that is the other thing that I think is particularly significant right now. Jeremy Grantham, at GMO in Boston, points out that China is the world’s second largest economy. They consume 53% of the world’s cement, they consume over 47% of the world’s iron ore, almost 47% of the world’s coal, 45% of its steel, and they are huge consumers of lead, nickel, aluminum, zinc, and copper.
Kevin: Really, it’s almost half of what the world produces that you make things out of: Copper, lumber, zinc, and even what they eat.
David: That’s right, Kevin, we are not just talking about industrial metals, we are talking about consumables, as well. As a percentage of the world’s pork, they are consuming 46%. Of the world’s eggs, 37% disappear into the Chinese hole, (laughter) 28% of the world’s rice, 24% of the world’s soybeans. Of course, this has been a major boon to Brazil, to Australia, to New Zealand, both on the industrial commodity side, and in terms of the consumables. These are interesting times, because what we have seen so far is the reward. We think there is going to be less reward and a lot more risk realized in coming months, both for China and their trade partners.
Kevin: David, you’re singing the song of Bert Dohmen, who last week said, the real surprise is probably going to come out of China. I think about these people who are supplying these materials to China. What occurs to them and the investors that are investing in those countries, if something does happen to China, and that consumption goes down?
David: Australia is a great case in point. 25.3% of their total exports go to China. Anything happens to China, guess who is in trouble? Yes, the Australian market takes a hit. In fact, when the Chinese economy hit the skids in 2008, the Australian dollar dove 39%.
Kevin: Currency diversification isn’t always a positive, it can actually be a negative.
David: I guess this is a point worth belaboring, because as people look, with reasonable concern, at an inflationary environment, there is the idea that, “I need to be in commodities. That will give me diversification.” Or, “I need to be in foreign currencies. I want to remain liquid, but I don’t necessarily want to be in dollars.” All I can say is that you have a number of choices directly tied into the Chinese thesis, and if anything is impaired in that thesis, so are you.
Kevin: It was interesting. We got a couple of calls after Bert Dohmen, last week, called for a dollar rally. Callers were saying, “What are you saying? Are you saying the dollar, now, is going to go up, it is going to start buying more?” That’s not what he was saying at all. The dollar can continue to fall in buying power, but fall slower than some of these currencies that you are talking about, so it is relative.
David: It’s relative to other currencies, so it may rally relative to the Euro, because there, you are talking about who has the greater chicken pox. “I’ve got two dots, and you’ve got twelve.” Really, you are just talking about relative maladies, you are not talking about relative strength.
Kevin: Okay, let me ask you, because this means a steak dinner between you and your dad. You guys have talked about this. Your dad is convinced that China is going to be the thing in the next couple of years, and you guys disagree on that. Your real feeling is that there are some cracks in the dike. What are some of the things that you are looking at that would make us think that maybe things aren’t as rosy in China as is reported?
David: I think the thing that you can bet on, is the hard work, the work ethic, the desire to succeed, amongst the Chinese people. Don’t underestimate that. But what I do remain suspicious of, and this probably reveals some philosophical bias – I don’t have confidence in a command economy. I don’t have confidence in the ability of bureaucrats determining the best allocation of assets, and I think we’ve got plenty of historical precedence for how exactly poorly this works.
Kevin: Name a good communist country, as far as an economy goes. When you go to the communist country, you say, “My gosh, this is such misallocation of assets.”
David: “Why is everything gray? Why are they making only left shoes?” When you move into production, it is interesting what happens in a command economy. You have 17 state-owned enterprises that, according to the Chinese National Audit Office, have misreported their financial data, so you have this command economy which is misconstrued as a new form of capitalism, and it is running out of creative fixes.
Kevin: So when they say 5% inflation, it is probably not 5%.
David: No, it’s 11-16%. It is twice, to three times, the stated inflation. Let’s talk about gold for just half a second. Last year, they quadrupled their imports of gold, and brought in, for the year 2010, 245 more tons than they actually produced. They are now the world’s largest producer of gold – 245 tons all of last year.
Kevin: So they produce the most, yet they consume even more, so there is nothing coming out of China when it comes to gold.
David: In the first four months of 2011, they are already at 200 tons, according to the World Gold Council, so they are on pace to triple or quadruple last year’s imports of the metal, and the question might be, why? Is it because they have some speculative energy? Is it because the stars are in alignment and they’ve looked at all their astrological charts? The Chinese do like the year of the rabbit, and the year of the dragon. Is it the year of gold? No. It is the year of, “How do we save ourselves from understated inflation?” And this is becoming a global issue, where individuals say, “How do I create an insulation from monetary policy being foisted upon me by our central bank, whatever central bank that is. Pick whichever one you like.
Kevin: And the crazy thing is, we actually just import that inflation right off the bat, because they tie their currency to the dollar, so we print a dollar, and they have to print something, and it creates inflation for everybody.
David, another thing that I know you watch is leverage, both with the banking system, and in the private sector. Leverage for central banks right now has been skyrocketing.
David: It has, and China is no stranger here. Let’s start with Europe because that is where everyone has current concerns. The central bank of Greece, for instance, has 159-to-1 leverage, if you are talking about their balance sheet.
Kevin: Wow, you had better not lose that bet.
David: Again, just for frame of reference, we are talking about Bear-Stearns and Lehman, between 36 and 40 times leverage before just a little hiccup caused bankruptcy, because they didn’t have enough capital to cover the liabilities.
Kevin: Let’s put this in perspective. The average person who buys a house is either at 10-to-1, if they put 10% down, or they are at 5-to-1, if they put 20% down. What you are talking about is 159-to-1 for the Greeks.
David: Pennies on the dollar, in terms of assets to liabilities. At the Fed, we have been reporting that it has been 71-to-1 for some time, but it is not 71-to-1 anymore. We thought that was a reasonable number, and it was for 2010. Now it’s up to 103-to-1.
Kevin: So we are rolling the dice just as much.
David: Exactly. The Federal Reserve Bank of New York is at 103-to-1, Ireland is at 122-to-1. These are the central banks’ leveraged assets compared to liabilities.
Kevin: Okay, we were looking at China. Is China leveraging right now?
David: (laughter). “I have no concerns about China, I think they are the world’s greater story” – 1200-to-1!
Kevin: Which means your dad better win that steak.
David: (laughter) With a huge amount of nonperforming loans in the system, opacity that you can cut with knife! We are talking about more numbers being obscured. The fact that it is now coming to the attention of the audit office in China, and they are saying, “Guys. Oh guys. These SOEs have been lying to us. The numbers aren’t adding up, they are misreporting the numbers.”
Kevin: SOEs are state-owned enterprises. This is out of China, this is the command economy.
David: Yes, and it’s not just 1, it’s 17! This is like saying, out of the Dow 30, 17 of them are lying about their numbers. Would that be a news item? That would be a news item, wouldn’t it be? We are talking about 17 of the most significant organizations in China that are being caught red-handed. What are the consequences? You tell me.
Kevin: Yes, but David, you are talking command economy. You can’t trust that, but we are in a, supposedly, capitalist, free-market economy. Now, I am saying that tongue-in-cheek, because we have moved so far away from that, but there is leverage in our stock market. In fact, it is one of those things that if you watch, and understand the past numbers, it can actually, in a way, to a degree, foretell the future direction of the market.
David: Anytime we have gotten margin accounts – this is what stock investors are borrowing from the house, so to say – anytime we have gotten a cumulative margin number above 350 billion, the next one-year period and two-year period following, are disastrous in the stock market. It is ugly.
Kevin: That’s amazing. 350 billion just seems to be the magic number for a down market the next two years.
David: And we are at just over 360. Let’s recall the last two times we were near 360. Let’s see: 2007 – Oh, 2008 wasn’t too pleasant, was it? That was painful. What about before that? 2000? Oh, 2001, that wasn’t so pleasant.
Kevin: March of 2000 it really started hurting.
David: What margin tells you is that, basically, the little guy who thinks he is going to maximize his returns, the few little guys that are still in the market, they are the last ones in. They are the last ones to make a purchase. There is no one else to buy.
Kevin: Is that a time, also, where you would watch junk bond purchases to see if speculation is increasing?
David: Speaking of last ones in, this is where Wall Street is enjoying the easy credit available to them. They are putting together products that aren’t just lending to the big companies. You can see a billion here, a billion there – there is a lot of money flowing in the fixed income space right now, so the credit markets are flowing, if you are a major corporation. They have also started flowing to worst-credit bets, what we would consider junk bonds – high-yield fixed income, and now they are redefining junk bonds. If you have a company that generates 5, 6 ,7, or 8 million dollars in gross revenues, now you can go to Wall Street, and you can borrow directly from Wall Street, too, and we are not talking about a local bank loan. We are talking about going to Wall Street and financing 5 or 10 million dollars here and there. Five to 10 million! The requirement used to be 50 million for a small loan, if it is going to be financed and issued in the debt markets – 50, 100 ,150, 250.
Kevin: But you are talking about small, unproven enterprises going out and just being able to borrow in the junk bond market.
David: What we see in the junk bond space does look a lot like the leveraged market in equities, where the last guy just got in.
Kevin: It seems like we continue to make the same mistakes over and over. It is like the model itself is flawed, the historic understanding of the model. It is hard, as a human being, because we only have a limited history to maintain objectivity, and it seems that that is the most important thing. Most of us like to think that we are objective, but in reality, we are formed by what you have called, in the past, first-order questions. Our second-order actions are actually based on the very things that we learned, maybe, when we were young. You have talked about the copybook, the old attitude of the things that you know are fundamental truths, you have the kids write over, and over, and over, out of the copybook.
David: Right, the distinction between first-order and second-order questions. The first order questions are the things that you assume to be true. You assume that gravity holds. That’s why you don’t go jump off buildings because it is a pretty safe assumption that you are going to hit hard. So there is the practice of, “I’m not going to defy gravity,” and there is the understanding of the law, and a predisposition, or a presupposition about the nature of the universe. So you have the first-order questions, the things that you assume, and the second order, which are the things that you do on the basis of those assumptions.
Kevin: Let’s just jump in there. You brought up gravity. Let’s look at Aristotle. For several thousand years people were following what Aristotle said about the earth being the center of the solar system, though they didn’t call it a solar system, and there were amazing mathematical models built on a false first-order premise. It caused a lot of confusion, as anybody who has read Dante’s Divine Comedy will know. This guy was an astronomer extraordinaire. He was able to explain the movements of the planets, but it was from an earth-centric point of view. Until Copernicus, or Keppler, or Galileo, we didn’t have an accurate rendering of that. We really would not have had a Newton without that. So the changing of that first-order misunderstanding changed everything over the last few hundred years.
David: I sat on a plane this last week, traveling from Seattle to Denver. There was a young man that I sat next to who had just finished a Master’s Degree in geology. We got to talking and I pointed out the fact that what we did was very similar. The issues that he faces are very similar in his field, the field of geology, to ours, finance and economics. A very bright guy, an enthusiastic young man, interested in folds, and interested in the impact of time and pressure on the earth’s crust.
Kevin: What is a fold, geologically? Are you talking about the Rocky Mountains?
David: Sure, that would be an example of a fold. That’s maybe an example of a broken fold. Or if you look at geologic formations that haven’t broken, you can actually see some curvature, where it looks like an ox-bow in the river, only it is actually rock layers which have been bent through passage of time, pressure, and maybe even heat. I am not a geologist, I don’t what causes them.
Kevin: That was this guy’s area of interest.
David: He is fascinated by them, He is enriched by looking at them. He loves the metamorphosis that he sees in these rock layers. As we discussed the school of thought in which he had been trained, there was an acknowledgement – and the word that he used was faith – there was an acknowledgement of faith placed in the great names of science that had laid the groundwork for his intellectual explorations. Their work was, in his mind, legitimate, even if their assumptions were, on his side of things, assumed to be correct, and admittedly, he had left them unchallenged.
Kevin: That goes to the Aristotle example. It was unchallenged, even by the church. The church gets a bad rap for following Aristotle, and rightfully so, but let’s face it, that was years and years ago. How about in geology? These men that he is reading, you have to challenge the assumptions, do you not?
David: Right. We are not here today to discuss the differences between uniformitarian gradualism and catastrophism. We did have a good discussion about that on the plane, but we are not laboring the point of the probability studies that support or detract from one or the other of those theories. We have a topic that we have covered before, and considered before. It is the significance of perspective in judging or reading the world around us. This is what we are driving at. How is it that two people can read a poem and walk away and surmise different content? How is it that two observers in an art gallery can stand side by side and seemingly describe two different works of art while looking at the same thing? Voters can listen to a political debate or a speech at a rally and some are enthralled and others are disgusted.
Kevin: Wouldn’t you say then, first-order questions determine their judgments? The things that they grew up with and learned, and their predisposition, is how they are going to look at either art, poetry, or let’s face it, science.
David: Right. So your first-order questions serve as the assumptions upon which your daily life gets lived. Even if those questions never see the light of day, they are the baggage that you bring into relationships. It is the bias that you have in conversations, whether it is philosophical, or theological, or political. Those are the things that you are not supposed to talk about down at the pub.
Kevin: With that being said, you were talking to this gentleman about how your job, and what you do in the financial world, is relative to what he is doing. How do you see the similarities working out?
David: We have two professional groups that practice, whatever they practice, whether it is finance and investments, or science, specifically, geology. Whatever you may have studied at school, whatever exposure you may have had of a theoretical nature, you get to a certain point in life where you are just flat busy, and you are doing the work right in front of you. You show up at 8:00 and you have a task to complete immediately.
Kevin: You don’t have time to go back and challenge the very foundations of what makes you think the way you think.
David: So it is the work of science, it is the work of an investment house, and there really isn’t a lot of allowance for those philosophical discussions, or a re-analysis of assumptions.
Kevin: Then let’s look at a couple of assumptions. Let’s look at paper currency. Is that an assumption that may be going away? Is the assumption that paper assets versus physical assets are a better way to go, just because they are more convenient? There are assumptions that our generation has become very comfortable with, but we are starting to see shaken.
David: We are witnessing what Alan Newman describes as a sea-change – a sea-change in the fundamental case against paper assets and the case for hard assets – the long-term secular shift that could conceivably keep gold in the superior position for quite some time to come.
Kevin, you remember freshmen psychology – well, maybe not (laughter). Okay, psychology 101, Gestalt theory: What is that? Is it a bat? Is it your mother-in-law? Is this your worst nightmare? Is it your best dream? You see all these ink blotches, and what do they mean? As a part of Gestalt theory, now you bring out these ambiguous pictures. In the ambiguous pictures, are you looking at two ducks, or are you looking at a rabbit? Are you looking at two vases, or are you looking at a face? You look at it, and you look at it, and you look at it, and you only see one thing, because of your predisposition – whatever your predisposition is, not to add judgment to what your predispositions are – and then all of a sudden there is a perspective change.
Kevin: And then you can’t see anything else. I remember those old pictures from the late 1800s of two women talking, or it’s a couple of faces.
David: A Gestalt switch is when you go from seeing one thing, one way, one second, and then the very next, seeing it completely differently. I think that is what Newman is getting at – a sea-change in the fundamental case against paper assets and the case for hard assets. I include real estate as a paper asset, because if it has debt against it, you have something floating out there which is out of your control. It is not as hard as it would seem. It is not as basic as the dirt that may be under your fingernails.
Kevin: Let’s face it, Dave, if, really, the world was able to see clearly that there was a shift to, for example, gold versus paper assets, there would be a massive void that had to be filled, because the whole world is into trillions and trillions of paper assets, and they are seeing them wither away, but they are really not truly reacting. Let’s face it. China is buying a lot of gold. America? Not really.
David: And there is no reason for our perception to have changed, because it is in these developing countries where inflation is acute. You talked about the recent number – it went from 5.4 to 5.5%. That is the official inflation rate in China. Well, it’s not. It’s closer to 11-16%. The reality is, the average Chinese man, the average Chinese woman – guess what? They know what real-world inflation is, because they don’t make enough income to be cushioned from the increase – this marginal increase in food prices. It impacts them dramatically. They look at the rest of their assets and they say, “If this is what is happening to our paper currency, what do we do with our savings?” Any wonder that the imports in the last four months have already nearly rivaled what we saw, in total imports of gold into China, last year, for the entire year.
Kevin: In a way, what you are saying is hunger, itself, forces some of these switches. David, this brings me back to a book by Thomas Kuhn that you had me read years ago. You said, “Kevin, this is an absolute classic, you have to read this, everyone who has any sort of education needs to understand how the structure of scientific revolutions occurs.” What you are talking about is a scientific theory, or a financial theory, or maybe even a relational theory, being challenged to the point where people don’t just slowly shift, but you actually have a cusp event where it snaps to the other side, but it almost takes a new generation.
David: It was interesting in this conversation with the young geologist. It doesn’t matter whether you are a Wall Street professional, young or old, neophyte or battle-hardened, these are irrelevant. One of the things that he said was very interesting. He assumed that these leaders, these innovators in science, had, in fact, evolved in their thought processes over time, and I said, “No, no sir, what you don’t realize,” and I suggested that he read Kuhn’s book, “is that you create a community of belief, or a community of thought, and it becomes very intransigent. It is the world as we know it.” You are talking about daily practice within a community. You show up to work at a Wall Street firm and you don’t challenge the status quo. I remember Don originally going to work for Dow Chemical. This was an internship, he was studying chemical engineering, and he was in his last year, and decided to take a summer internship with Dow Chemical. His manager said, “Don, imagine your life as a calm, glassy sea. Don’t make any ripples.” When you show up to work, you are not supposed to be the person who is throwing down the gauntlet and saying, “Here’s how we are going to innovate and change. This is how things are going to be different. Here’s how we are going to make our mark, as a company. Here’s how we can be different. Here’s how we can innovate.”
No. In fact, if you want to be a healthy participant within the community, you learn the rules of the community, you learn the beliefs of the community, or you can step outside the community. Invited, or we’ll throw you out on your keester.”
Kevin: It’s the flat earth of society. Basically, you just go with the flat earth theory until it absolutely doesn’t work anymore.
This does bring me to a memory of a guest of ours just a few weeks ago, who wrote the book, The Fourth Turning. You have these cycles when people starting realizing there is a problem, but you really have to have an event, in a particular generation, to change the thinking radically. He pointed out that we are in that period of time right now. It seems to me like you are paralleling this with the Thomas Kuhn work.
David: The point I was making with that young man was that finance professionals are no different than scientists. There are operative models that are generally accepted, that are utilized up until they are forced out due to either cumulative small failures, or utter bankruptcy of the idea, itself. Practice ends up being the crucible of an idea, and when it’s no longer workable, assuming that it was internally coherent and verifiable externally to begin with, then all of a sudden it is no longer considered to be true, so you have a revolution of ideas.
Kevin: That brings me to a question. We have had a paper currency paradigm most of our adult life. Nixon closed the gold window completely in August of 1971.
David: And there was some concern about that. With the run-up in gold up until 1980, there was an immediate reaction that said, “Hey, this is not good. This can’t be good for us.” But there was a paper solution that was offered, and it was, “Let’s show you more wealth than you can imagine, beyond the dreams of avarice. You will succeed. Just invest in the Dow and the S&P.”
Kevin: Then let me ask you the question: Are we nearing the end of the age of paper?
David: Having enjoyed a clear benefit from 1980 to 2000, paper assets have been more and more challenged since then, since the year 2000. Problems are arising, solutions are being attempted, further problems are being followed up on that. So, as a paradigm, when you look for a revolution of ideas, this is just it. Where is the explanatory power of the Keynesian system? How do we solve this particular issue? As Ben Bernanke begins to experiment with different monetary mechanisms, if any or all of them fail, we are getting to the point of community acceptance that it was a bad idea to begin with. We just lived with it for a long time because we didn’t realize how many fleas were down under the fur.
Kevin: And actually, the problem is, going back to these first-order, and second-order movements, that if they are wrong, and they are unchallenged, you can run yourself right into a wall not changing your thinking. If you have a singular vantage point, and you are going to stick to that no matter what because that’s how you’ve earned an income for all of your life, then, if it’s wrong, it’s going to be a rude awakening when you find out.
David: I think it’s going to be a rude awakening for some, and an expected reality for others. The sea-change described by Alan Newman, may, in fact, have been underway for the last ten years, but who has perceived it? The reality is right in front of you, why can’t you see it? It, again, comes back to those predisposed ideas or conceptions of what you are seeing and how you interpret it, how you read it. It is, in fact, easy to ignore, if you are trained to see investment realities from, as you described, a singular vantage point. We have Wall Street practitioners who have ignored the bull market in gold, largely because it didn’t fit their model. It couldn’t be integrated without, in fact, destroying some part of their zeitgeist.
Kevin: They are almost blind to it.
David: If your livelihood depends on a perpetually positive outlook, a hopeful view of the world encouraged by the Keynesian smoothing, or elimination, of the business cycle, an attempt of that, anyway, then the rise in gold is an anomaly which you can easily explain away, you don’t have to address as an issue, because frankly, your system is better. “We know it’s better, it’s been better, let me show you the past history, the last 20 years,” again, going back to 1980 to 2000, the age of paper.
Kevin: This could be a debate. In one chair you could have the guy who is the Wall Street guy. In another chair you could have the guy who is the banker, who says “cash only.” In another chair you could have the gold guy. At some point, each of those three guys is going to be right, and at some point, each of those three guys is going to be wrong.
David: In terms of ultimate realities, I’m anything but an agnostic, but when it comes to financial realities, I’m much more so. We have, for years, taken, not a singular, but a three-part, or tripartite, view to investing. If you look at the perspective triangle, we’ve realistically, at least by our reading, anticipated positive outcomes due to growth in the business cycle. That’s why one-third of an allocation should be toward growth and income. We’ve anticipated what can be positive outcomes, even in the event of deflation, by having an adequate allocation on the right side of the perspective triangle, to cash and cash equivalents, our liquidity mandate. And we have encountered positive outcomes even with the extreme encounters of inflation, or superinflation, looking at the insurance component, which are precious metals.
Kevin: Gold – the foundation of the triangle.
David: At the end of it, it’s an agnostic allocation. It is driven by the assumption that no one knows the future. We can know human behavior. We can know the workings of a political machine. We can know something about history. We can judge what might come next, again, going back to Neil Howe’s book, The Fourth Turning, but what we know with cold certainly is on a pretty short list.
Kevin: That’s the thing that I’ve loved about the triangle for the last 20 years. It has allowed us to be sort of healthily schizophrenic. In other words, we don’t have to commit to any one first-order question to be right, because we are allowing for, with those three allocations, things to happen outside of what our predictive power can bring, and still gain.
David: It is interesting, just considering, and I’m kind of fixated now on the conversation I had with this young man, the uniformitarian view, or the gradualist view…
Kevin: Billions, and billions, and billions of years.
David: Billions, and billions, and billions of years – that’s what it took, Darwinian evolution, or uniformitarianism being the substructure for Darwinian evolution. It’s an excellent theory. It offers a narrative explanation of our beginnings and perhaps current placement in natural history. Ignore the fact that the probabilities are low, given even billions, and billions of years of random chance and sequential mutations are productive and additive and progressive.
Kevin: And ignore the fact that you really have no example of it actually occurring, biologically or geographically.
David: I feel like the modern equivalent is Jeremy Siegle’s book, Stocks for the Long Run, because it is a sort of progressive view of the markets, where, over a long enough period of time, everything comes into alignment, and there is nothing but profits, and it is like, “Wait a minute. Jeremy. My friend. What about 1966 to 1982? Was that particularly productive, in your averaging of 7% per year, or are you, in fact, looking at something that is more akin to catastrophism, wherein in a market cycle you have years of boom and there is a lot of money to be made, and you have years of bust, where if you aren’t careful you can hand it all back? And then guess what? You go right back to the boom and bust, and boom and bust. If you average it out, or if you are able to avoid some of those down years, then you can cast it as something that is very uniform in nature, progressive, and growth-oriented, and in that case, we should all be invested in equities from heretofore, and forever. But, there are these events which really can’t be taken into account by the sort of gradualist, or uniformitarian, view of the markets.
Kevin: They are called long-tail events because they weren’t supposed to happen, but it makes me think of Velikovsky, a friend of Albert Einstein’s, a brilliant scientist. He took an exception to this whole gradualism theory, as far as how the earth was changed, and actually, how the solar system was changed. He really believed that things actually went along in fits and starts, like you say that modern finance does, and now that we have sent probes out we are seeing the solar system, and we are realizing, that was a very violent, unpredictable place, and it wasn’t gradually formed. When we are talking about forming, many people would say, and I would agree with this, that it was just created intelligently, but there are things going on out there that a human being cannot predict.
David: Kevin, coming back to the markets, there are periods of exceptional progress and advancement, and there are periods of destruction and deterioration. That is largely what we have had for the last ten years. It looks more and more like that 1966 to 1982 period. But as much as we would like to conceive Wall Street as progressive, which it is at times, it’s equally regressive. The low probability interruptions in sort of a financial saga, those black swans that you mention, or multiple standard deviation events, are like the catastrophic landscape, being altered by a singular event – a meteor, a flood, an earthquake, a volcanic eruption – low probability, and yet, they do occur. Without allowing for the highly improbable, there is this tendency by most investors to assume that tomorrow will be as good as yesterday or today, and that hindsight bias can keep you in a defunct science, or an already disproven finance.
Kevin: Taking into the account the improbable, what you are basically saying, if I can restate it back to you, is that you have to protect yourself, from yourself. Bert Dohmen, last week, was saying you have to be prepared for the impossible to happen. We really cannot be fully prepared for, or predict, the impossible, but you’d better not be where you shouldn’t be when it does.
David: What Alan Newman describes that sea-change, which I think has been occurring for a decade, really is a system of Ponzi finance, and it’s running out of confident participants. Equities, bonds, real estate, they are all going to get a reappraisal. They are all going to see that moment where investors have the Gestalt switch, where at one moment, it’s two rabbits, and the next, it’s a dish. What is it? They were good investments yesterday, and now they are shunned today. What changed? Nothing changed. The only thing that changed was perception. Newman assumes that a return to a Dow-gold ratio of 6-to-1, roughly the average from 1975 to 1994, is a given. I would argue that in an attempt to reach equilibrium, the averages, 6-to-1, or the actual number is 5.67, serve as a general and safe target to estimate, “this is where we’re going.”
Kevin: But markets almost always over-reach their boundaries, and then come back to an equilibrium number, do they not?
David: Exactly. Going back to Aristotle, it is the idea that virtue is the mid-point between excess and deficiency. The markets may want that mid-point, that may be an ideal, but what ends up happening, both in our moral lives, and in the marketplace, is a swing from one extreme to the other: Piety – profligacy. Excess – negativity. What will ultimately take the Dow-gold ratio to a 3-to-1, or a 2-to-1, or a 1-to-1 ratio, is not fundamentals that justify those numbers, but market participants panicking out of paper assets and moving into the one thing that they consider to be trustworthy, namely, the one thing that is no one else’s liability.
Kevin: David, going back to the triangle, if a person has a third in an insurance policy of a gold type, physical gold, and a person has a third in growth and income types of investments, and then a third in cash to pay the bills, there really is that balance from excess, because each of those sides of the triangle, at some point, is going to move toward excess or reduction, but overall, they seem to compliment each other.
David: I think the best acknowledgment in some sort of a practice like that, where you have a balanced approach, is that you don’t know the future, and you should do something reasonable.
Posted in TranscriptsComments Off on June 15, 2011; A Gradual Sudden Catastrophe
Posted on 11 March 2011.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, today, our guest is Tom Hudson. He is on PBS, and speaks about the news every night.
David: Kevin, it will be an interesting conversation today. We are looking forward to discussing a whole broad range of issues, whether it is the role of media, the impact of dot.frank, dividend-paying stocks, versus the interest rate environment we are in today and tomorrow. We can go a lot of different places in conversation with Tom. He is used to asking the questions, actually, so our roles are a bit reversed today.
Tom, thanks for joining us. Most of our viewers would know you from the PBS Nightly Business Report. You are in an interesting position. You are in touch with a broad cross-section of investment analysts and professionals. Rarely do you get to explore issues extensively on air, given the time constraints of programming. It is particularly interesting, with that in mind, for us to get your perspectives on a variety of issues, with time being less of an issue. You sit in a sort of information nexus, with access to a broad array of these investment experts. How do you filter the data that you have available to you? What particular matrix? Are there chief influences that you have, intellectually, which allow you to organize all of the data that flows your particular direction?
Tom Hudson: That is a great question, David. First of all, thank you for the time and the opportunity to talk. I am really looking forward to our conversation. I am certainly humbled, and lucky, to sit at exactly the unique position which you describe, which is a nexus, a kind of crossroads of information coming my way and my true privilege, really, to present that to people, on a national and international basis every night on Nightly Business Report on PBS.
One of the things that I start with every day is that the market is not wrong or right, it just is. And price matters. And price action matters. That tells us, really, what is going on. Everything else – geopolitical talk, politics in Washington, local politics, and state capitols – all of that kind of talk is great for flavor and color, but the play-by-play is on the ticker, itself. I usually try to let the market tell me what is going to be most important, in terms of price action, and in terms of volatility. Those are the places, really, that I begin every day when I prepare for my program, to really let people know what has happened today in the market, and perhaps most importantly, begin to let them know about how tomorrow may be shaping up.
David: It sounds very similar to Charles Dow, Hamilton, Rhea, and the modern practitioner of Dow theory, Richard Russell, who would say, absolutely, price action is all that you have to go on. That is the language of the market.
If we want to dive in on that particular point, Russell has mentioned recently that should the Dow break below 11,823, that he would consider a confirmation of a long-term bear market, that being the context that we are in. But he is agnostic at this point, because we are not there. Again, he is looking at price action and saying, well, we will have a confirmation of a further downside move. Do you look back at history and use some of those kinds of ideas?
Tom: I do. I think history, obviously, is a great guide for what is going to happen in the future. It clearly does not have a monopoly on what is happening in the future, but we clearly have to know where we have gone to hopefully get a better idea of where we are going.
Throughout my career in financial journalism, I will be honest, I have tried my best and darndest to explain to people why the Dow Jones Industrial Average is probably the least important of the major equity averages and indices to pay attention to. But I might as well be talking to a brick wall, because people always want to hear about the Dow Jones Industrial Average, always want to measure the mood of the market by using those 30 stocks, even with all the shortcomings of the Dow – it is price-weighted, it is somewhat actively managed, not on a daily basis, but clearly, there are stocks that come in and out of that.
The Dow 30 today is very far from the Dow 30 that hit the recession low back in 2009 and is still a very different index than hit Dow 14,000 in the fall of 2007. It is a much different index today than the one that we are going to be talking about, perhaps in the next couple of years, be that either a Dow 11,000 or below, or Dow 15,000 or above.
David: So you are looking for a broader cross-section and something that is perhaps a more adequate sample size.
Tom: Exactly. I think sample size is interesting, and Dow Theory is clearly one of those ideas that does come into play in the market, because it is just that. It is a theory, but it is one that has been time tested, and there is a lot of literature on it, and a lot of acceptance of it. But clearly it is not the only market theory that we have when we prepare our broadcasts every night, nor is it the only market theory that folks use when trying to prepare their portfolios.
I think that, getting back to the idea of this nexus of information that I am able to sit at every day and have the pleasure to take all that information and make it meaningful, accessible, and useful and actionable for people, the Dow is one of those, clearly, that we always have to watch, probably more out of habit than necessity, but I think the broader S&P 500, or the Russell 2000, gives us a much clearer picture of what is really going on within the equity markets.
David, I began my financial journalism career on the derivatives floor in the options exchange in Chicago and the Chicago Merc and the Board of Trade, and that is why I always get back to that price action. The futures guys and gals that I began covering would always want to look at the book, look at the liquidity, look at the depth of the book, and look at the transparency of the book, to really get a feeling for where the market is headed.
David: Then, if it is not equities – obviously that gets the most attention in broadcasting, that is probably where people have most of their money tied up, and to some degree, bonds as well – but today, derivatives dwarf the size of the traditional investment markets by a factor of 3 to 5, and if you have, globally, roughly 200 trillion dollars worth of paper assets, on the derivative side you have somewhere around 600 trillion. If we can even conceive of the number, a quadrillion, at one point I think they said about 1.4 quadrillion. It is a lot less than that now.
Tom: But those are usually nominal figures, and we can explain nominal figures away by saying those are the numbers on the papers. Perhaps all of those things do not wind up with that kind of value out there, but I agree with you, David. I think that the media pays attention to the equity market, in part, because there is a physical place for it, in lower Manhattan, and in mid-town Manhattan, both the New York Stock Exchange and the Nasdaq. So that is helpful for a lot of people, because we are able to put these concepts into a physical space into our physical 3D world, whereas the derivative space, while there is plenty of action on the exchange-side derivatives, much of the derivatives space, including FOREX, is all over the counter, and it gets to be much more conceptual, and, quite honestly, concepts are difficult to put on television, David.
David: Does it tell you anything when the side bets, again, coming back to the relative scale of the derivatives market, far surpass the underlying assets, both in terms of the revenue importance to, for sample, an NYSE, and foreign exchanges, as well. The scale is different. Revenue importance – derivatives are now more important than the underlying assets.
Tom: Right. More important in terms of the size, perhaps, but those derivatives clearly would not exist without the underlying asset. Maybe it is a chicken or the egg kind of argument, but the underlying asset clearly has a lot of importance, and needs to exist in order for the derivatives markets to exist and flourish like they are.
When I would bring visitors in to the derivatives exchanges in Chicago where I began, they would look at them and they would say, this is one, big, loud casino, with no slot machines. I would consistently say, no, the big difference between the derivatives market and a casino is, the casino is creating risk where there was none, and the derivatives market is merely pricing risk that already exists, and allowing folks to mitigate it, to trade it, to profit, and to lose from it.
David: It brings in, certainly, the concept of counter-party, because on the other side of every transaction is the assumption that the counter-party can stand up to the requirements to pay. If you have hedged out the risk and that has been passed on, that person who has accepted it has to be able to maintain liquidity sufficient to pay. Is counter-party the big risk in the derivatives market?
Tom: It is over the counter, but it is not when it comes to the exchanges. Think back to the spring of 2008 when Bear Stearns essentially collapsed, and then fast-forward from March to September of 2008. We had Lehman Brothers collapse. We had AIG collapse, which was a counter-party risk, to some degree. We had a number of investment banks wind up becoming bank-holding companies so that they could have access to Fed liquidity, so that their capital structures would not collapse under the pressure of counter-party risk.
But we did not have exchanges. Derivative exchanges have those same financial problems, because they step in as the intermediary between the buyer and seller, to guarantee, on exchange-traded derivatives, that the two sides do have the liquidity and the depth of capital, to put up the capital necessary in order to make a transaction complete.
One of the things that we can look at in the derivatives space, we need to separate between those derivatives that were contributing to the problems that happened in 2007 and 2008, which were over-the-counter derivatives and those that were happening on an exchange, and we did not have counter-party risk, we did not have clearing problems, there were not exchange-traded derivatives in 2008, and even 2009, at the height of the financial collapse. That got busted, because counter-parties were unable to fulfill their obligations, as long as they were trading on an exchange.
The same cannot be said for over-the-counter trading of derivatives, and to some degree, that is where regulators ought to be focused, and that is why the exchanges really want to grab a lot of that business that has been going on over the counter, bring it onto an exchange, because, clearly, it is very profitable, and the exchanges will point out that they, acting as an intermediary, as a clearinghouse, can essentially step in and protect from that counter-party risk which you talk about.
David: We have had a gentleman named Richard Bookstaber on our program a number of times. He wrote a book called A Demon of Our Own Design, and has been a part of the risk management infrastructure at groups like Smith-Barney, and other groups as well, in Manhattan. In all the Senate hearings that he has done, that is what he has pointed to, that regulation should focus on bringing these things onto exchanges. Do you think that has anything to do with this merger between NYSE and the German Boerse? And coming back to that idea of the physical space, here in the U.S., we think of the U.S. capital markets as one of the deepest, richest capital markets in the world, and yet we are seeing an icon, essentially, shift to another continent.
Tom: Right, to the Germans. Remember the last time the Germans bought an American icon? Daimler-Chrysler, I will bring you back to that merger vehicle in 1998. Let’s hope, for the share-holders, this one does not wind up the same way.
I think in terms of the New York Stock Exchange, Eurex, Deutsche-Boerse deal, while it is not entirely about derivatives, it is a big part of it. The biggest slice of the New York Stock Exchange, Eurex revenue, I believe over 35% comes from derivatives, maybe 30% comes from trading of equities, so it is as much a derivatives exchange as it is an equities exchange, despite its long, long history as the icon of American equities. That is what Germans are after, and it is becoming an international market, clearly.
The challenge that not only U.S. regulators have, but European regulators and other locations have, is the standardization of derivatives contracts. It may be easy to do that for corn. It may be easy to do that for oil, although we are seeing a little bit of split in terms of the different types of global oil markets, between West Texas and Brent and Oman, trying to put a credit default swap, or some kind of debt obligation on a standard basis in order for it to get on an exchange, has been proven very difficult in the U.S., and to do it internationally, has been proven, thus far, pretty near impossible.
David: We have legislative attempts and regulations which are coming out of Washington which are supposed to address the problems which caused the financial crisis in the first place, a monumental effort by Dodd-Frank, at least legislation in their names. I chatted with a gentleman down in the Bahamas, at the same conference you and I were attending, Richard Rahn, from the Cato Institute. He describes Dodd and Frank as fundamentally corrupt. You may not agree with that, but is the legislation actually addressing the issues which played a causal role in the financial crisis, or do we still have a second shoe to drop, perhaps, because the fundamentals have not really changed?
Tom: In terms of the legislation, let me address that first. I think that so much of the legislation has been left to the rule-making bodies. What I mean by that is the legislation directs regulators to write rules that are designed to avoid or minimize the buildup of systemic risk. We will take that as it is, so much of the legislation is going to be written in the regulators boardrooms and their conference rooms.
I think, quite honestly, it becomes a matter of resources, and we have already seen the new Republican House begin to try to take financial resources, or limit the growth of financial resources for the commodity futures trading commission, or even the Securities and Exchange Commission, that could limit their ability to not only write the hundreds of rules that need to be written under the Dodd-Frank legislation, but then, of course, comes the question of enforcement should those rules actually be put into place.
I think when it comes to legislation, whether or not it addresses the systemic issues that came up during the collapse, it is going to be a matter of what the rules are, and then, honestly, the regulators’ financial wherewithal to monitor and adjudicate those rules. I think the final chapter on Dodd-Frank clearly is far from over, and in terms of even the ability to go after the systemic problems, there is a lot within Dodd-Frank that does not really have to do with derivatives, per se, there are some consumer financial protections and those kinds of things, and it does wind up getting to how much we want regulators and rules to try to protect financial markets from not only the ability to profit, but the ability to loss, and I think that is a root question that still remains unanswered on the part of regulators, and on the part of a lot of investors, as well.
David: With a few minutes left to discuss things today, maybe we could talk about interest rates, commodities, oil, Quantitative Easing I and II, and a few other things. Maybe we can give about 20 seconds to each.
Tom: Lots to talk about, certainly.
David: Starting with the big picture, with interest rates. If you step back from the quarter-to-quarter analysis of interest rates, and focus on that big picture, I remember Alan Shaw and Louise Yamada doing an extensive study back in 2004 with Smith Barney, on the duration of interest rate trends. It appears, from a technical perspective, the downtrend in rates which began in about 1980 is reversing. The question is this: Should interest rates adjust higher, are corporations geared for a sustained period of higher capital costs?
Tom: I think that corporations are clearly preparing for that, and we have seen it throughout the downturn, and now the relative up-swing that we have seen since the March 2009 equity lows. Corporate balance sheets have been increasing. Corporations have been launching stock buy-back efforts, and that clearly has an impact on earnings.
You have also seen a lot of corporations continue to issue a load of debt, both short-term, floating debt, trying to take advantage of some of the variations in interest rates here lately because of quantitative easing and some of the other Federal Reserve programs that have been going on, but also issuing loads and loads of longer-term fixed rate debt, taking advantage of these low rates.
We have even seen talk finally surface on the largest issuer of debt out there, the U.S. government talking about a Methuselah bond, of sorts, to try to take advantage of these low long-term rates, almost in a tacit acknowledgment that, yes, the generation-long bull market in fixed income is likely over, and likely to turn itself around. I think the capital structure of companies is prepared, at least in the medium-term, for that, but we are also seeing some private companies begin to turn away from the public markets for some reasons, and part of it may be because of the longer-term concern about the cost of that capital in the next several decades.
David: It has been encouraging to see corporations, CEOs and CFOs, get very serious about their maturity structures. The concern that may remain is at the municipal and at the federal level, where our maturity structure is pretty awful – 36 months, 70% of our debt, nationally, coming due. It is a little bit different because we do have a printing press, we can continue to finance ourselves, if no one else will. But at the municipal level, that is an interesting issue. We do have debt that is going to be maturing, and the question is, how will these individual states and cities cope?
Moving onto commodities, we had a run from 2001 to 2008. We now have the CCI and CRB again pressing higher. Are we seeing inflation, in terms of prices reflecting monetary policy, in your opinion? Or are these truly supply and demand dynamics?
Tom: I think that when it comes to agriculture commodities, when it comes to energy commodities – oil, heating oil, gasoline – we do see supply and demand. Maybe part of this is my upbringing in the Midwest, just outside the corn fields in Iowa, and spending a lot of time at the Board of Trade in Chicago, and watching how these things are priced on a daily basis. But these are global markets for agricultural commodities, there is no doubt about it, as it is a global market for oil, and we are seeing global demand continue to up-tick.
We know that the emerging market, GDP growth, is certainly going to outpace global GDP growth, which is certainly going to outpace developed world GDP growth. So demand is there. The weather has not been behaving too well over the past couple of years in various parts of the world for some of these agricultural commodities, and we have not seen a whole new swath of oil supply come onto the market, even though inventories are very full in the United States and elsewhere. We are not dealing with a supply issue, it truly is a demand curve.
And then I think on the inflation side, if you look at the metals, not only just the precious metals, but even industrial metals, you do have a sense of concern about longer-term global inflation, in part, fed by the Federal Reserve, but also, in part, fed by other central banks, in Europe and elsewhere, and even in China, to some degree, that have provided cheap money to help either keep their economies invigorated, or try to re-spark an economic boom like we are trying to do in the Western World.
But I think when it comes to the inflation side of things, we also have to keep in mind that the developed world, the U.S., especially, has still lots and lots of utilization, lots and lots of aggregate demand to pick up from. So, while we are seeing commodities move here, and we saw a move from 2001 to 2007 and 2008, as you mentioned, I think similar to the generation bull run in interest rates, the generation bear run in commodity prices that ran through 2001 or 2002, and seeing that bottom, we seem to be continuing that general up-trend over the past 6 or 8 years, due, in part, to supply and demand, but also, fed more recently by inflation concerns.
David: If oil today was at $175 a barrel, it would be the talk of the town. Notable, in recent weeks, has been silver at a 31-year high, and gold also closing at an all-time high. It seems that it is lightly discussed, and I am wondering if the public conversation about gold is something like Eeyore showing up at a cocktail party. Nobody really enjoys the negativity. What does the price of precious metals imply? Is that, perhaps, why The Financial Times, The Economist, and other notable news venues, remain somewhat dismissive of the metals? Is it just kind of a downer?
Tom: You have hit the head of the pick in the goldmine, I guess, David. I think you are absolutely right. The implications of the rise in gold prices, just as the implications of the drop in gold prices that we saw throughout the 1980s and 1990s, will continue to be debated, but the fact is, holding a mirror up to that rise in the gold price, especially, and silver, as well, portends concerns about monetary inflation, concerns about geopolitical risks, no doubt about it, and real worries about the value of the paper currencies that the world has embraced over the last generation-and-a-half. None of those things are real happy-go-lucky conversation starters, no doubt about it.
David: It seems there is a little bit of a disconnect between the stated inflation rate, and the implied understanding of inflation by the guy in the street. If you go back to the Summers-Barsky thesis, Gibson’s paradox, Larry Summers writes that in a negative real-rate environment, that is when people opt to take risk off the table and move to precious metals. It tends to outperform in a negative or low real-rate environment. But if you look at the official numbers, we are not in a negative real-rate environment. We have really tame inflation, the cost of living adjustment has not been raised the last two years, signaling that CPI and inflation does not exist, and yet, the man-on-the-street says, “I am wondering if that is balderdash!”
Tom: Right. They use stronger language than that, by the way.
David: Yes, of course. So this is an issue. We do have a drive toward the metals as a preservation tactic. We saw QE-I come around. Mortgage-backed securities were the primary effort there, and that was deemed acceptable by the U.S. and international market. Then you have QE-II, and the market has judged that intervention in the treasury sector unacceptable. You have had yields which have moved aggressively higher since its announcement – the opposite of what was intended. This is an issue. QE-II, monetization, quantitative easing, these concepts all wrapped up in one, spell inflation to somebody.
We certainly have seen a move by David Einhorn and John Paulson into the metals as a currency position, not a commodity. Transitioning from our original conversation about commodities, supply and demand, inflation impacting gold and silver, we actually have a number of fairly significant investors saying, “I am just looking for an opt-out, I am just looking for a currency that is not tied into the fiat world of either the euro, the British pound, or the dollar, where monetary policy makers are going to determine my ultimate outcome of success or failure.” What do you see with QE-II? Do we carry that through to June? Do they cancel it because inflation becomes a concern? Is QE-III even an option?
Tom: Ben Bernanke, last week, when he was on Capital Hill, as part of his semi-annual testimony, was asked just that question about QE-III, by a congressman. He essentially ducked the question by saying that would be a decision by the Federal Open Market Committee. That is clearly a firm grasp of the obvious, but not really an answer to the question, Mr. Chairman.
I think that the Federal Reserve is being more transparent now about its ultimate strategies than it ever has been, and part of that is because the market is still on tenterhooks. It is still very sensitive. Certainly, the interest rate market is, let alone the metals market, and the equity markets, and real estate all tied in here together. I think that the Federal Reserve has drawn this line in the sand about June winding up its Quantitative Easing II program about buying U.S. government bonds. Should the Fed decide that the goal of that program needs to be retained, or has not been met and needs to continue, I think we would begin hearing some talk about that from the Federal Reserve regional presidents, let alone the Board of Governors, in speeches and elsewhere, really, now, to get the market prepared for that.
We have not been hearing that. Instead, what we have been hearing is quite the opposite, that Federal Open Market Committee members seem to be more and more in tune, that they are going to stick to their guns, that they are going to continue with this quantitative easing program until it is due to expire, and at that point they will begin to assess the relative success or not. But let’s not kid ourselves here, David. The Fed is assessing the success and failure of this program on a daily basis, and clearly, on a monthly basis, they need to see unemployment rates come down, and the real unemployment rates, not talking about the 9% that we see printed almost every month.
We need to see the real unemployment go down, the U5, The U6 numbers. We need to see jobless claims continue to move lower, and they would love to see the official inflation number being to tick up, and to your earlier point about the man-on-the-street, and the woman-on-the-street, their real inflation does continue to pick up. There is a program called the Billion Prices Project at MIT. It is bpp.mit.edu. This follows hundreds of thousands of products that are sold online in many different countries, and you can drill down to specific geographical locations. Over the course of the past couple of years it has been seen to be a leading indicator to the CPI, and it is beginning to go parabolic, and that becomes, I think, a big concern for the Fed. But does inflation become a bigger concern than unemployment? I honestly do not think so. I think the bigger concern is unemployment, rather than price stability, at this point.
David: It seems like we are in that classic stagflation scenario. It is interesting, though, coming back to the interest rate environment, because with record, unprecedented funding requirements, you have rollover risk in the treasury market, on top of current deficit spending – a trillion was projected by the CBO, it ends up it is 1.65 trillion for this year, on top of 1.5 trillion last year. Maybe they can rein in spending, maybe there are cuts, but the reality is, we have both the rollover of existing debt, with new debt being piled on. It seems a safe assumption to see rates going higher. That is not to say, moving parabolic, but certainly an adjustment higher, if nothing else, because of those market constraints.
Tom: Yes. And let me add kind of a macro concern on top of the accounting that you talk about from the federal government level. For generations, the U.S. has been able to grow itself out of these really awful debt-to-GDP ratios. We are beginning to hear continued talk about the U.S. needing to grow at 3.5%, 4%, maybe 4.5%, to really begin to make a dent here. But at what point are we going to have a realization on the part of our federal government and voters, for that matter, that a 2.5%, even a 3%, or 3.2% annual GDP growth, may not be enough in order for us to grow our way out of this debt-to-GDP ratio, let alone begin to work down that debt load that we have incurred over the past 60 years?
David: Well, we will tune in tonight to listen to the PBS Nightly Business Report with great interest. The only thing we have not discussed, and maybe we can end with this, is that there seems to me to be a difference between commercial broadcasters and what you do at PBS, and maybe it is just the nature of why commercial broadcasting exists. What is their reason for existence versus the venue that you professionally participate in? Is there a different tack taken because of the audience constraints and business model?
Tom: Yes, there is. There absolutely is a difference in the business model, and there is a big difference in our audience. We have the privilege of being able to be on the air in millions of homes every night and have a half hour to tell the story of business, finance, and money, to America each night. Some of my colleagues in financial broadcasting journalism have eight hours to fill, or twelve hours to fill, and it becomes much more of a play-by-play, and much more of a focus on the box score scenario than what we are able to do with The Nightly Business Report, which is clearly, always keeping our eye on the prices.
To wind up our conversation where we began it, David, price action does matter, but we are able to distill out of that, hopefully, some larger trends in how some of these policy discussions that are going on in the nation’s capitol and in state capitols, wind up impacting either the paycheck that you receive, or the prices that you are seeing at the store, or the portfolio that you have to save for tomorrow.
David: Tom, thanks for joining us. Great to be in touch with you again. We look forward to it in the future, and we look forward to your insights nightly.
Tom: It has been, really, my pleasure, David. I really appreciate the time and the opportunity to speak with you and your audience.
Posted in TranscriptsComments Off on March 9, 2011; An Interview with Tom Hudson from the Nightly Business Report with PBS
Posted on 17 February 2011.
with David McAlvany and Kevin Orrick
Kevin: David, as promised, we are talking to you right now in Nassau, Bahamas, but you are there after having been at a conference in Orlando. I know there were 10,000-12,000 people at the Orlando conference. Tell us a little bit about that before we move to the Bahamas conference.
David: Kevin, I think there are several things that are worth mentioning. It was an excellent conference. We had a fantastic time meeting with clients, McAlvany Weekly Commentary listeners, the newsletter subscribers – just a wonderful, wonderful group of people. We had about 140 of our people who showed up to the conference, out of that 10,000-12,000.
I had a room that we packed out. Seating capacity was about 175, and there were well over 200 in the room, with standing room only. But the scale of that, I think, is worth mentioning, because this was a conference of very interested investors, people who are trying to figure out what is happening in the world, what is happening with their portfolios, what they can do to either preserve or grow their capital. Of the 10,000-12,000 people, if you take out the 140 people who already know us and would, of course, be interested in the topic that I was speaking on, specifically, precious metals, that leaves between 60 and 70 people, out of the 10,000-12,000, who have even a passing interest in the metals. I think that is very, very telling.
It was encouraging to me, and I guess when I say it is encouraging, that probably needs some explanation. It is encouraging to me because, for that few people to be interested in metals, after a 10-year move in the metals, ten years of an average of 12% gains per year, some years a little bit more, some years a little bit less, it is surprising to me that the general public still has no interest whatsoever in gold and silver. That to me is a strong indication.
Kevin: From a bull market perspective, that is very, very encouraging to the owner of precious metals, because that shows, as you have said many times, we are definitely not in that third phase of the bull market where shoe-shine boys are coming in and buying gold and silver coins. We are still at that phase where the general public is wanting to know how you day-trade tech stocks, I think.
David: I think probably the greatest success at the conference was folks selling software platforms for how to trade your way into millions – exactly what you just described, Kevin. “How can I take my $5000 thousand in savings and turn it into $5 million over the next 18 months?” Not only is this an unrealistic appraisal of how money is made and grown, but it is completely unrealistic in terms of an assessment of risk in the market. Really what it boils down to is that people want to be told exactly what they want to hear, which is, “You can make your millions without blood, sweat, and tears. You can do it with a subscription of $39.95 a month to our software package,” or something like that.
It was interesting, if nothing else, from a sociological perspective, and just as an anecdote I thought I would share that as we open this morning. The breath of fresh air was the remarkable people that we got to spend time with, both at the main presentation, and then in the subsequent questions and answers, a private session with about 30-40 people, and then also the consultations which we had with a number of our clients. We were busy for four days, back to back.
Kevin: Let me go ahead and reduce this broad scope down to the fine point. Out of 10,000 to 12,000 people who were looking at software platforms to quickly trade, there were, as you said, this 200 or so people who really were interested in maybe taking a reality check and saying, “Okay, where are we really?” Let’s take that and put a fine focus on that and talk about some of the questions that came out of that select group – that 200 people. I know you did question and answer sessions, both in the general sessions, and then also privately, when you met with clients one on one. What were some of the predominant questions that were coming up at the time?
David: I think it is important to look at those questions and share them. John Maynard Keynes used to compare the market to a beauty contest. He basically said that what is being determined is not who the prettiest girl is, but the market is essentially betting on who the judges will determine the prettiest girl is. It is one step removed from reality.
The reality of the market, the reality of the economy, is secondary in some sense to how the participants are going to bet. It was interesting, with 10,000-12,000 people betting uni-directionally, with great confidence, that the economy had already recovered, I opened up the presentation by saying, “While I have my prepared remarks, I am very interested in what is on your mind. Why don’t you ask a few questions and I will include the answers to those questions in my presentation today.”
The very first question that was asked was this: “If the economy is recovering, why do I need to own gold, and why would you expect the price of gold to continue higher?”
Kevin: If the economy is recovering, David, and we do not feel, necessarily, that that is the case, but let’s say it is. If the recovery is truly in action right now, what was your answer as to why a person would own gold?
David: Kevin, as you have pointed out, our case would be that it is not recovering, that there are, on a very surface level, indications of recovery, but when you scratch beneath the surface, and it does not take much scratching at all, you find that the real story is nothing like that, that recovery is not anywhere close. A lot of that has to do with the discussion of our fiscal status, what is happening on the U.S. balance sheet, the fact that in recent hours, we have gotten the fiscal year 2012 budget, and it is a blowout. Instead of 1.5 trillion in deficit, we are looking at 1.65 trillion in deficit.
We are looking at greater headwinds, in a time period when we are rolling over 70% of our debt, we are adding to our total stock of debt, not what the CBO estimated at 1 trillion per year, but between 1.5 and 1.75 trillion per year. This is the reality. The economy is on life support, but it sure does not appear that the patient is having any problems, whatsoever, mainly because government spending has stepped up to the plate and is filling the gap that the consumer once filled. Basically, 10% of GDP disappeared, the consumer went away, and the government stepped in.
Something we have talked about in the past is what Richard Duncan described as the shift from capitalism to debtism, which was destroyed in 2008, and now we move toward statism, wherein the state plays a greater role in the marketplace, and certainly, a predominant role in the economy.
Kevin: If it is truly a shift from capitalism, to debtism, to statism, there seems to be, as you said, this perception of a numbing that we have talked about in the last few weeks, of the body apparent, as far as the economy goes. This numbing is allowing people to think that it is a recovery. Let’s just hypothetically look at something, David. Just pretend with me for a moment, that we truly are in a recovery, that it does not grate against your nerves that we are completely ignoring the facts, but let’s just hypothetically say we are in a recovery. Is there a reason or a place for gold, if truly, a person believes we are there?
David: A part of the issue with us being in a recovery is that you then have to fall back very heavily on the skill set that the Federal Reserve has. They have created a massive amount of liquidity over the last few years, and in fact, if you look at the total amount of government liquidity provisions and guarantees, since 2007, 50 different initiatives have been put in place, and since 2007, 23.7 trillion dollars has been committed. Only about 3 trillion of that has been spent, but 23.7 committed to hold up the economy. On par with 1932? Not by a long stretch. We have seen the government be more active here than in that 1932, 1933, 1934 period where the alphabet soups were launched, all the government agencies which came into existence in the FDR period.
But you ask a good question. Let’s assume that we are recovering. There are certainly things that we can point to that would indicate there is a recovery. Auto sales have been stronger. GM reported a 22% increase in January. Retail sales in January were strong, and that is one way of looking at it. Again, with retails sales, if you take out an inflation component, you realize that retail sales actually did nothing, whatsoever.
But this is me digressing, and perhaps deconstructing the recovery argument. Let’s stay on track and assume that it is recovering. If it is recovering, you really have to have faith that Ben Bernanke is going to take away the liquidity and shrink the amount of liquidity in the system very aggressively, and, if he does not, then what we will find is an inflation that is out of control. He is running on the assumption that he has the reins in hand, and that inflation, like a mighty stallion, is something that he can rein in and control. Better the inflationary stallion, than the deflationary dead horse, in his book, which he cannot do anything with.
But there is a grand assumption there, Kevin. It is a grand assumption, and it would be the first time in Fed history, in fact, the first time in central bank history anywhere in the world, where inflation was, in fact, fine-tuned, and the Fed was able to contract liquidity at precisely the right moment to prevent a super-, let alone hyper-inflation, but more probably a super-inflation, as a result.
Kevin: It seems like an anomaly that a recovery at this point, a true, honest-to-goodness recovery, with all the money that has been created, could actually become the Fed’s worst inflationary nightmare. Is that what you are saying?
David: It could become an inflationary nightmare. The problem, again, with the idea that there is a recovery, is that the statistics used to support that notion are, themselves, flawed. As I mentioned, with the retail sales figure, if you take out inflation, the inflationary impact, there really is no improvement in the January numbers. If you are looking at GDP growth, with an understatement of inflation, you are overstating GDP, and on top of that, you have to subtract out the amount of government spending that is taking the place of private sector consumption – propped up aggregate demand.
Is it healthy for government to take a permanent place in the economy, larger by 10% of total GDP? Is that normal? Is that healthy? Is that the sign of a true recovery? I do not think so. That does not mean that money cannot be made, and I think this is the big difference. The financial markets can behave very differently than the underlying economy.
This is where bankers, whether it is bank bonuses or bank profits, or the financial sector in general, moving toward some sort of recovery internal to themselves – that is possible, when you create the kind of liquidities that Bernanke has created. When you create that liquidity it has to go someplace.
We are talking about a misallocation of capital. To the degree that that capital is misallocated, you will see someone benefit, because that money is going to end up in somebody’s pocket, but it is not Joe and Suzy lunchbox, it is not the man on the street, it is not the woman on the street, it is not the family out there in middle America trying to make ends meet, experiencing real world inflation, in spite of the CPI lies. This is the disconnect.
We do see the stock market rising. Why is it rising? Is it because of fundamentals which are supporting a recovery in company profits? Absolutely not. It is simply because you have money flowing from the Fed into the financial system, and it is distorting values.
Kevin: David, we have talked so often about the negative effects of inflation, but you just mentioned something that is interesting, that the underlying economy may not be necessarily pointing to the way the financial markets react, at least in the short term. Of all the negative effects of inflation, what would you say would be deemed a positive effect, even if it had a long-term bad outcome? What are some of the positive effects of inflationary policy?
David: Kevin, there is an issue in defining what I mean by positive, because there is a positive effect for speculators and short-term investors, because there is this distortion of money going places that it really should not go. There is “money to be made” as a result, but it really is of a speculative nature, and ultimately, we still have the debts to pay.
Ultimately, our debt-to-GDP numbers, when you factor in Fannie Mae, Freddie Mac, and our off-balance sheet items, are well over 140% of GDP. If you factor out Fannie Mae and Freddie Mac, and the off-balance sheet items, we will exceed 100% by the end of the year. We are well beyond the Reinhart and Rogoff threshold of 90%, wherein the red lights are going off and you have caution signs everywhere.
The economy is, in fact, in an ugly place. But that does not mean that money cannot be made because of misallocated capital, because of the liquidity pushes. That is what we are seeing show up in the commodities market. That is what we are seeing show up in the emerging markets, to a lesser degree, now.
Kevin: I have been to carnivals in the past where I get suckered into playing the darts game where you throw the darts at the balloon, and most guys think that they can either shoot hoops or throw darts, so you pay your buck and you throw the dart and you pop the balloon, and they say, “Wow!” and they hand you some little thing that is probably worth a quarter.
Then you pay another buck and you throw the dart and you just keep doing that, and by the time you are into this thing, you may be $25 or $30 into a game where you are winning a stuffed animal that probably cost the carny all of $3. In a way, you may feel like you are coming away with something, but as far as what was being taken away to get that stuffed animal, you have lost $30 to get a $3 stuffed animal. Is that a little bit like what we are talking about here, where we feel like there is recovery, we feel like these things are occurring? But you were talking about the government stimulus actually making up far more than the consumer spending deficit in terms of GDP right now.
David: If we are talking about the positive effects of inflation, because it is stimulus, which is artificial in nature, I think you have to question the enduring nature of it, and what is its long-term impact? That is where it becomes much more questionable. We had many questions while we were at the conference which related to the direction in particular markets, whether it was gold and silver, the dollar, emerging markets, lots of questions there, U.S. equities, bonds, municipal bonds, things of that nature, a number of questions which relate to a reduction strategy.
These are people who, at least those who attended that we knew and had a relationship with before, were interested in a reduction strategy in their metals position on a 3-5 year time frame. Not today, but as the market matures, and as gold and silver see higher prices, they wanted to talk about our plans and our strategies – what our organizational strengths are, and what we have been discussing with clients now for a couple of years, in anticipation of a transition in the marketplace. Again, not here, today, but something on the horizon.
Kevin: That seems to be one of the things that distinguishes you from a lot of the other precious metals dealers at these various conferences around the country. You have a tendency to want to start talking about when they should sell their gold, oftentimes before they have even bought their gold. For the new listener, for the person who is not familiar with the reduction strategy, could you give, in short order, a little bit of what you tell these audiences, as far as what to do when it is time to sell some of the gold?
David: Yes, and that is certainly in the context of what we think is the market direction for the precious metals. We will look at some of the other asset classes in question, too, but for gold and silver, we remain in a bull market. The notion that CNBC, and MSNBC, and the Wall Street Journal, and the Financial Times, and the Economist, have written about with great frequency, is that the bull market in gold is near an end because it is in a bubble stage, and there are so many people in that trade, and it is such a crowded trade. I think they just need to go to the money show. As writers, they need to do a little bit more due diligence in terms of the man-on-the-street, and the investor-on-the-street, out there trying to make these decisions. There is virtually no one interested in the metals.
It really was surprising. I would guess that if that kind of a financial conference was held in Europe, in the Middle East, or in Asia, you might find something very different in terms of interest. But I don’t know. I have seen other reports. Recently Marc Faber was at a conference in South Korea, and he asked, out of a thousand people, who owned gold today, and two people raised their hands. This is hardly a crowded trade, if you are talking about an investor with, whether it is 100 thousand dollars or 10 million dollars – very tepid interest, at this point.
We see gold as in the second of three stages, with it maturing, probably over the next 5-7 years, maybe on a shorter time-frame, maybe even on a little bit longer time frame, depending on how many people come into the demand side of the equation. We know that supplies are even more limited today with mine supply continuing to taper off, even while some demand is increasing here and yon. It will be interesting to see what happens when the average consumer decides that they want to own a few ounces of gold or silver.
You are right, though, Kevin, when we talk to clients, it is with the idea that we want them to see the end from the beginning. Making the decision to invest in any asset class entails a very thorough process of, “What am I going to buy? What is the reason why I am going to buy it? Is there a time and place that it makes sense to sell it? What would be the environment? What would be the background information that I would need? If I am wrong about this purchase, and it actually goes down significantly, is there something that I should consider as an exit strategy as a means of preserving capital?”
In other words, we embrace the client’s perspective, saying, “Don’t you want to know when it is time to sell?” Being a full-service company certainly helps with that, being on the asset management side and having an appreciation for equities, for bonds, for foreign currencies, for the traditional asset classes. Gold and silver, for us, is an asset that we understand in a larger context.
Kevin: That being said, because of course, you never tell a person to put 100% in any one direction, it takes me back to the triangle where you have it broken into three different mandates. One is a preservation mandate, one is a growth mandate, and of course, one is a liquidity mandate. That brings the attention to the other markets. Could you give an idea of what direction you think the various markets are going? You mentioned municipal bonds, you mentioned equities, you mentioned the emerging markets, of course the currencies, and then you have been talking about gold and silver. So take your pick, the order that you want to take them in, but those are all asset classes that I think people would like to have your read on right now as to where you think they are going.
David: We will have to start with U.S. equities, because I think that is where there is the most confusion, with the introduction of liquidity, QE-I and QE-II, with the accommodation that the Fed and the treasury have provided to the marketplace. The stock market has responded very strongly to the upside and I think that may continue for some time, but that is the problem with artificial stimulus. You have no idea when it runs out.
Literally, we, today, are running on fumes. The question of when we simply run out of steam altogether, I do not know. I really do not know. But the reality is, it can continue in this vein, and certain market participants are factoring in the inflationary impact and trying to hedge themselves by owning equities, as a partial hedge against inflation.
My own view is that we should look at the corporate managers and corporate executives who run these businesses, and it is still astounding to me that in any week in the last six months, we have had corporate executives jumping ship, and not on a small scale. With great frequency, we have talked about the buying versus selling in these companies, those ratios, and they remain off the charts.
Kevin: Corporate executives are still selling more shares than they are buying, of their own companies?
David: I think they realize that the economic headwinds have not gone away. I think they realize that their businesses are not, in fact, in recovery, and they are doing everything that they can, personally, to clean up their own balance sheets. Selling off equities as they are being driven to higher prices by the current lemmings in the markets is an opportunity for them to take some profits and pay down debt. If they have a third, or fourth, or fifth home, which many of the corporate executives do – guess what? They want to pare down that debt and own them outright.
If we shift over and look at the liquidity mandate in our perspective triangle, the dollar is, you could argue, due for a rally. Whether it ever gets one or not is something that remains to be seen. The dollar has been weak relative to the Japanese yen. The dollar has been weak relative to the Swiss franc. The dollar has been weak relative to a handful of currencies. We will have to see if 2011 holds a rally in the dollar, but not on the basis of fundamentals. I think as we look at the balance sheet of the U.S., it is something that is insolvent. We are talking about short-term versus long-term trends. Short-term, the dollar could rally. Long-term, I think it pays a severe price, with a 30%, 40%, or 50% reduction from these levels.
Kevin: Wouldn’t a dollar rally actually be, partially, because of the weakness of the other currencies that it is being based on? Europe is not out of the woods yet, and that is one of the major currencies that weights the valuation index of the U.S. dollar.
David: That is correct, and when we look at the emerging markets, also as an asset class that people were asking about at this last conference, if you look at the underperformance of most of the equity markets throughout Asia in the last 6-12 months, I think you have a telltale there. They were overheated on the upside coming into 2008, never fully recovered, and remain anemic in their growth, and that is in spite of a massive amount of liquidity which has been thrown into the market.
If you look at how tepid the response has been on the Shanghai exchange, just as an example, with the trillions of dollars which the Chinese government has provided to the marketplace, I think it is very telling. I think it is very telling, and it says to me, if that is the best you can get for the equivalent of a 4-trillion dollar stimulus, 1 trillion in actual point of fact, but on scale with a 4-trillion dollar stimulus here in the United States, as their economy is one-quarter the size. What you are really talking about is a market to run from – run away from as fast as you can.
The story of the emerging markets is a story that will continue to emerge over a 15-20 year period. Difficult to play the patience game as an investor. The emerging markets will be very rewarding if you have 20 years to wait. I think they can be very punishing if you want to stick around for another 12-24 months.
Kevin: That has been one of the points that Stephen Roach has made in the past when we have interviewed him. Stephen Roach is very bullish on China, and Asia, in general, as a potential, but again, he said, “Patience,” just like you did.
David: Transitioning to municipal bonds, I think that is an area that has been sold off very heavily with concerns of defaults, with concerns of bankruptcy, with concerns that the same kinds of fiscal woes that the federal government has, the state and municipal governments have, as well. The difference is, they do not have a printing press.
Having said that, we have seen a severe decline in those municipal bonds. For probably 18-24 months we have encouraged clients to limit, or eliminate, exposure to municipal bonds. They have been sold off severely. I would guess that over the next 6-12 months they may see a recovery in value. Our encouragement to clients is that they take the next 12 months, and if we do, in fact, see a recovery in value in the municipal markets, sell into that strength, exit any large municipal positions at this juncture. Because just like the federal government issue, the state and municipal issue does not go away.
I mentioned this in the context of my comments, but if you took the State of Illinois and fired every state employee, where you basically had no current cash outflow to pay employee salaries, you would still have, in the State of Illinois, a 5-billion dollar annual deficit, because of all the pension liabilities, and medical liabilities, to former employees of the state. The municipal issue is not something that goes way. You may see a dead-cat bounce in the muni market, and then I think you still have to face the music when we get into 2012 and 2013. So I would be aggressively, aggressively cleaning up a muni portfolio should we see a recovery here.
Kevin: That takes us, then, to the people who actually can print money. We talked about municipal bonds not being able to be funded with printed money by the state, because the state cannot print, but the United States can print, so that takes us to government bonds. What is your thinking on long-term, mid-term, and short-term bonds? Maybe you could explain that a little bit, and where we are going from here, from a yield-curve perspective.
David: When you look at the bond market, you have to wonder how many hats exist, and how many rabbits can be pulled out of them. The bond market and the currency market have been a real question mark. What is going on there? How do we understand it? If there is something that will allow us to preserve reserve currency status, and the IOUs which we have issued, can we maintain them? Can we actually make payments on them? Will we ultimately pay our creditors back, some value, or full value? These are all questions that swim around in the backs of our minds when we are contemplating the U.S. treasury market, particularly.
When you look at the bond market today, it is worth looking at our current liabilities, north of 20.7 trillion, and our total unfunded liabilities, which bring us closer to 70 trillion, and you certainly do not see those liabilities showing up as a weighty issue when you look at current yields. They do not factor in the risk of default. They do not factor in anything at all, really, when you are looking at 4.5, 4.6, on the 30-year treasury.
Kevin, you and I both know that we have lived beyond our means as a country for the better part of 40 years. You could probably trace that date back further, but at least the 30-40 years of the last credit cycle, we have lived well beyond our means. The bond market is the way that we have supported our lifestyle. It is the way that we have maintained dominance on the world scene, and you have to assume that a capitulation of the bond market would be really a sign that we have reached the end of the things that we have taken for granted for many, many decades, whether it is dollar reserve currency status, or the U.S. equity markets being the most liquid and deep financial markets in the world. Some of these things could begin to be called into question if the bond market collapsed.
You have to know that the Fed and the Treasury will defend that market tooth and tong. I just want to tie this into another question that was asked about IRA assets and whether or not the government would confiscate or utilize IRA assets to prop up the bond market. My response, I think, took several people by surprise, and it was that I do not believe the federal government will utilize IRA assets to do that because they are yours, they are mine, they are “self-directed,” they are the individual retirement accounts of individuals all across the country. When you begin to toy with those things, I think you create a lot of, shall we say, political volatility? That, I do not think they can afford to do.
But what they can afford to do is capture 15 trillion dollars from the pension funds and do so as a knight on a white horse. We have suggested this in the past, but it is becoming much more crystal clear to me, that the bond market will ultimately be defended with a very large resource to back it, and interest rates could very well be defended at low levels and prices propped up in the bond market, well beyond the time frame that would be natural or normal, with 15 trillion dollars’ worth of a war chest. I think that is where you look at the pension funds, and with some volatility in the stock market, if you assume sort of a step-sequence, the first shoe to drop may be a 10%, 15%, 20% correction in equities, which creates an even greater problem with underfunded pensions.
Then I think the government has an excuse to come in and blame pension fund managers for mismanagement. Whatever the scapegoat is, whatever the justification that is given, they will plead their case with pensioners, saying, you can either have 40%, 50%, or 60% of your pension as it is on track to give you now, or we will guarantee 100% of your pension, but we do need the 15 trillion dollars in assets to manage appropriately.
Kevin: That would be done in the form of some sort of an annuitized payout? Is that what you are saying? They would give you a longer-term guarantee as long as those pension fund monies would go into treasury bills?
David: That is exactly what happened with the Social Security Trust Fund. It got spent on whatever it needed to be spent on, and got turned into a long-term liability. They captured a present asset and turned it into a long-term future liability. For them to do that – this is the government doing what is normal to them. Theft is not new, but you have to do it under the right guise, and there has to be enough desperation to get away with it. I think the pensions are the perfect place where they will actually be able to justify it.
The reason I mention it is, in answer to the question if IRA assets are at risk, I would say, not they are not – not up to, or until, pension assets have already been taken, and then we might revise our view on the vulnerability of IRA assets. The pension assets are the low-hanging fruit, and that is what would be grabbed first, but it has huge implications for the bond market, because I think you could spend quite a few of those trillions in supporting the bond market, and again, distorting the notion of risk or the indication of risk in interest rates and the long-term treasury market.
Kevin: In other words, it is a form of carry-trade. It is saying, we can keep interest rates unusually low to stimulate the rest of this economy, as long as there are funds, as you said, the low-hanging fruit, that we can force through the machine. We have talked about the need to sell debt worldwide. But in reality, we have grown less and less dependent on international buying of our debt, at least through this crisis, because we have just been buying our own debt with whatever assets, or what looks like assets, that are hanging around.
With that being the case, there is an end to that game, and that takes us finally back full circle to where we started talking: Gold and silver. The direction for the market in gold and silver this year is something you have not really addressed, necessarily. We have talked about the long-term direction, but what are your thoughts about the market as we sit right now?
David: To the degree that the government defends the bond market, I think they have more ammunition than the “bond vigilantes” do, and the assumption is that the long end of the curve will steepen and you will see interest rates spike. This is the devil’s advocate position on a spike in treasury rates, which I think would be normal and natural at this juncture, but could be contained. If they are willing to defend the bond market and keep mid-to-long rates down, I think the bond vigilantes really take on a different complexion, and instead of seeing high interest rates and low bond prices, where that market becomes utterly manipulated and a non-market, I think you see the same sort of vigilantism show up in the gold market.
If you do not have interest rates indicating real risk in the bond market, it is going to show up someplace else, and that is where I think you see gold and silver as a barometer – a barometer for instability, a barometer for insolvency, a barometer for inflation, a barometer for a lot of things, and I think you could almost consider the gold market and gold investors to be the new bond vigilantes.
Kevin: Let’s say we are looking at gauges on a dashboard, and the bond market is one gauge of rising risk and rising interest rates. Then we have another gauge that is the gold price, but it is actually probably one of the smallest gauges on the dashboard. What you are saying is, better to artificially manipulate the big gauge, the bond market gauge, the interest rate gauge, and go ahead and let that gold gauge spike, because not too many people are actually paying attention to that. Is that what you are saying? It is robbing Peter to pay Paul, but nobody is paying attention attention right now to one of the gauges.
David: I think you are exactly right, Kevin, and that brings us full circle to the original observations about the Orlando conference and the fact that investors today could care less about the direction of the price of gold. After ten years of a sustained bull market, it really factors in as irrelevant in their minds. It is not something they have had interest in, nor will they in the future, until it is something that they are forced to purchase by necessity.
Kevin, next week we have Marc Faber on our program. I would like to quote something that was in his recent newsletter, a quote from Joseph Schumpeter: “The modern mind dislikes gold, because it blurts out unpleasant truths.” I think, Kevin, that is essentially why you have investors today still tied up in a world of hope, which is normal, it is human. I think that quote goes a long way toward explaining why people neglect the gold market, because it is unpleasant to consider the reasons why gold has moved higher in the last ten years, and might continue to over the next 3, 5, 7 years. It is more of a psychological blindness. It is something that people do not want to come to terms with, because it means that the world we live in is not quite as stable, safe or beautiful as they want it to be.
I certainly agree with them, I would like to see it more stable, more safe, and more beautiful, and maybe we will see those transitions in the next 3, 5, or 7 years. That has been our contention, and that is one of the reasons why we are here in the Bahamas today, to look at things from a global perspective, looking ahead, exploring different ideas as we consider transitions away from the metals in future years, with a very global perspective, we look at asset management and have to consider the direction that the world is going from a demographic standpoint.
We mentioned earlier that we consider emerging markets to be a huge bull story, just something whose time has not yet come. To be early on that theme has been painful. Fortunately, it has not been painful for us, nor do we intend it to be.
We are here in the Bahamas considering what it means to be a participant in the global financial markets, looking at asset management, at individuals’ lifestyles, in an international context. That is what we call our inner circle briefing. We have joined our partners from Switzerland, from Wealth Management and BFI Consulting, for an excellent two-day seminar. Perhaps next year some of our listeners would like to join us. We have a packed house this year, and look forward to the audience next year.
Kevin: David, I know you are heading to one of those conferences right now, so we will go ahead and wrap it up.
Posted in TranscriptsComments Off on February 15, 2011; Are Gold Buyers the New Bond Vigilantes?
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