Tag Archive | "Wall Street"

The Day After – Half of the Electorate Shocked & In Disbelief



About this week’s show:
– New President Inherits Consequences of an 8 Year Economic Illusion
– Wall Street Shows Hand & Found to be in Bed With Hillary
– 650,000 Emails “Carefully Reviewed” in 690,000 Seconds!?

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Felix Zulauf: What comes after Currency Devaluation?


About this week’s show:
-Individuals can hedge, but you can’t hedge the entire system
-In an ideal free world, gold would be the ideal currency
-The Euro will break, and it will be a chaotic process

About the guest: Felix Zulauf; born 1950, is the owner and president of Zulauf Asset Management, a Zug, Switzerland-based hedge fund, which he founded in 1990. Zulauf Asset Management has $1.7 billion assets under management, according to MacroAxis. Read more on his blog: http://felixzulaufblog.blogspot.com/

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Swiss Franc Shock!



About this week’s show:
-Most significant currency move since 92’
-Flight capital flees to gold and Swiss Franc
-Chinese stocks plunge 8% in a day

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Valuing Wall Street with Andrew Smithers


Gold Ratio

About the guest: Andrew Smithers founded Smithers & Co in 1989. Before that he ran S G Warburg’s asset management business for many years (now part of Merrill Lynch Investment Managers/BlackRock). A regular financial commentator and columnist, and author of several academic publications, he co-authored Valuing Wall Street: Protecting Wealth in Turbulent Markets

 

His most recent book was published in September 2013 and is entitled, The Road to Recovery: How and Why Economic Policy Must Change

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China Calls for “De-Americanized” World



About this week’s show:
-Pattern of gold manipulation becoming obvious
-Erosion of trust moves to a breaking point
-Wall Street fines & litigation through the roof

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December 21, 2011; When Will the Requisite Purge Occur in the World Economy? An Interview with Bill King


The McAlvany Weekly Commentary
With David McAlvany and Kevin Orrick

Kevin: David, it is times like these when we like to have Bill King on, because on one day we have good news and all the markets are up, and on another day we have what somebody considers bad news, and the markets are way down. There doesn’t seem to be any real continuity right now, and where there isn’t continuity in the short-run, we like to bring somebody in who not only has a long-term perspective, but looks at the short-run, as well.

David: I think what I conclude in this market is that if you are treading water, you’re doing just fine, because it’s tough to tell which direction this is going to go, and as our conversation has unfolded over the last year, the last 12 months, and even more than that, 2-3 years, we have regularly gone back and forth between the ideas of inflation and deflation.

Kevin: Sure.

David: And this is an important issue, because we have an outcome, economically, determined by decision-makers in Washington and on Wall Street, and we don’t know what the outcome will be, because we don’t know what the decision they will take will look like.

Kevin: We have a clash of the Titans. We have the Titans on one side who say, “We need more controlled socialism, we need more debt, we need to have more unity in paper currencies. And then we have the other side, which isn’t coordinated. It’s the market, itself. It is this hidden, unseen Titan, in a way, and these Titans are fighting each other all the time.

David: I think what we will end up seeing happen over the next 3-4 years is that battle become real, and ultimately, somebody wins the argument. And just because you win the argument, it doesn’t mean that you were right, it just means that you were more effective in your presentation. It will depend, I think, on what happens over the next couple of years, who comes into office here, in Europe, all around the world, and what kind of decisions are made, and the implications, both intended and unintended, on that basis.

Kevin: Wouldn’t you say, David, that other than it being maybe a scary time for people, because there is so much uncertainty, it is one of the most interesting times to be alive, because you have an entire social order that is going to have to change.

David: Yes, there is so much that is in the midst of changing, and so many interests that want to keep change from occurring. There are entrenched interests that would prefer not to see things change. Meanwhile, the market is speaking, and the market is saying, “We’ve been overcooked, we’ve been overdone now for 12, 15, 20 years. We’ve had too much leverage in the system, too much debt in the system, and we’ve got to let off some steam. We’ve got to see an unwind of this excess.”

Who will be implicated in that, Kevin? We’ve talked long and hard with people both here in the United States and overseas, as to the banking institutions, as to the individual countries, as to how individuals within those individual frameworks can be making decisions to not only survive, but thrive, in this environment.

Thriving in this environment is probably not looking at 100%, 200%, 300% annual returns. That is very unrealistic. Even 10%, 15%, or 20% returns may be unrealistic. Treading water, preserving your capital, keeping what you have, on balance, sitting the fence between a deflationary theme and an inflationary theme, knowing that politicians will choose one course or another, and not knowing, which means that investors have to sit and wait – a very challenging thing for investors to do.

Kevin: David, you talk about treading water, but actually, sometimes treading water is losing a little while you are treading water. There are times when you are treading water when you are not popping up and staying well above the water, you are just not drowning. I think of what Richard Russell has said for years: “It’s times like these that everyone loses. He who loses the least is the winner.”

David: I think when you keep your assets intact in that way, losing the least, and maintaining value, it puts you in a position, as we have discussed many years now with Russell Napier, the concept that in 1932, and 1949, just on the verge of the launch into the bull market of 1949 to 1966, 1982, and perhaps within the next 4-6 years, again, the unwind which leads us to the entry into a very productive period of time and a magical period of investment where you would have established cost basis at an epic low, and that is, for someone who has preserved value during these challenging times, very, very compelling.

Kevin: Bill King tends to give a great bird’s-eye view, and get you thinking on the right track for that timing. I’m wondering what the timing will be, David?

David: Bill, it’s nice to have you back on the program, and lots of questions to cover today, from quantitative easing, monetization, corporate earnings in the first quarter, the election calendar and what happens between now and the end of 2012, and a number of statistics which we should look at in detail. But if there is a big issue, what would you consider the primary concern to be, if you had to just focus on one thing?

Bill King: I think the big issue is, when are the global leaders finally going to do the requisite purging and reforms and restructuring that is necessary in the western world, and Japan. We have been going through this for over a year. Actually, the European situation has been two years. Nothing changes. You could trot out the same headlines and the same headlines are being trotted out, on almost a daily basis. Stocks are up, always because there is encouragement that Europe is going to resolve its crisis. Stocks go down the next day. People are disappointed – they are not going to solve their crisis.

These headlines have been repeated for two years and it is the same stupidity, and it is always some goofy bailout scheme that somebody is going to lend money that they don’t have, and when people call them and say, “Wait a minute, you guys are bankrupt.” “Well, we’ll create a fund, and that fund will be triple A rated.” Well, excuse me – nobody’s triple A rated that is supporting the fund. How can this be triple A rated?” “Oh, okay, we’ll come up with a second fund.” And then stocks rally, and you know, the garbage back and forth.

But you can see from the way the markets react, there is no leadership. Nobody will take the necessary hit or do the necessary restructuring on their watch because the political consequences are severe. So just keep pushing it out in the future.

David: That makes 2012 an enormous year: We have half of the G20 leaders changing next year, including in our country, but you also see the same thing in many countries in Europe, and we have already seen a couple of elections already/ So yes, that’s right, nobody wants to take the hit. What do you mean when you say the requisite purging? Are we talking about in the banks?

Bill: It’s everything. Sure, it’s everything. I’ve been screaming for years that the real problem in the banks wasn’t real estate. Yes, real estate was a problem, but the real problem is derivatives, that are hundreds of trillions, and the CDS, on and on and on, and they’re trading, and nothing is being done about it. In fact, the derivatives keep growing, and the reason they are doing it is to craft earnings. When you put rates down near zero, all the spread lending goes to hell. You are getting the deposits because of the markets being weak.

I just talked to a banker this weekend about it at a Christmas party, and they don’t want deposits because it costs them, because the interest rates are so low, they have no place to lend, and they are getting killed on the FDIC fees, because you have to pay fees on your deposits. It is a mess, because we have central planned markets, with the Fed and the government, and the market is not working. It cannot clear itself, whether it is real estate prices, which are still too high when you look at national income – we either have to get national income up or real estate down, and we have these big zombie banks walking around that government just keeps pouring money into, here, Europe, wherever, and every day it just keeps going on, nothing changes, nobody will take the axe to these guys and break them up, or make them erase capital, or pare down their derivative books.

You hit the key point. Because of the election of 2012 for so many nations, nobody wants to go out and say, “We have to take the hit.” Look, you have to take the hit. Reagan and Volcker took the hit in 1981 and 1982, and that created almost 20 years of prosperity, because they cleansed the system, restructured the economy, and that’s what has to be done. But no one wants to take that hit now, and the longer they delay, the worse it gets. They just tell you lies, and they keep piling up, and it just gets worse and worse, and that’s the problem.

David: So let’s say that 2012 is not the year, because nobody is going to do it on a voluntary basis, and if they can push it to 2013…

Bill: That’s what going to happen.

David: At what point do the issues – talking about fiscal issues, talking about economic issues, leverage in the system, derivatives, as you say – when do these things unwind on their own? They unwound in 2008. You could argue some of it began because of FASB rules and the shock to the banking system that they might actually have to mark things to market, strange as that may sound to the man on the street – counting things at their current market value, versus playing games with the numbers and calling them what you want to, on whatever basis. Is there a change in the rules under new leadership that causes this hit?

Bill: They got away from the marking to market. They are marking to fantasy again. Everything’s been thrown out. Look at what is going on with the banks. Banks have been crafting earnings for the last year-and-a-half or two, by depleting their loss reserves. That is why, this last quarter, even though the banks reported these wonderful earnings, enough people look at it and say, “You know what? This is not only wrong, this is dangerous. They are running down their loss reserves.”

And J.P. Morgan is not reserving against mortgage litigation because they claim that the FDIC is going to eat that. The FDIC is saying, “No, we’re not going to eat your mortgage litigation costs.” Anybody who says, “Buy a bank stock because it’s undervalued,” doesn’t know what they are talking about. You cannot buy a bank stock unless you know all the paper it has on its balance sheet, and the value. And even if you know all the derivatives, all the bad paper, nobody knows the value, because it’s marked by some model. Go out to the market and try to sell it, and see how far you get. You’re not going to get far.

That’s the problem. I’ve argued that 2008 and 2009 was a crisis. It wasn’t the crisis. Because when the crisis appeared in 2008 and 2009, central banks and governments came in and bailed out everything – not the economies – the main thing is they bailed out the banks. But in the process, they have bankrupted themselves. That’s what we are seeing now. Sovereign nations’ debt problems, inability to borrow – that is the game-changer. Because most people, whether they are professionals on Wall Street, or in the financial world, have been operating under the delusion that somebody will always bail them out, whether it was the Greenspan put, the Bernanke put. “The Fed is always going to save us, the government will always bail us out.”

What happens when, as we are seeing in Europe, when sovereign nations, people don’t have confidence in them and they start hammering their debt? Who bails them out? Who bails out Greece? “Well, okay, it will be the rest of Europe.” Well, wait a minute. What if, with the exception of Germany, everybody else is in trouble? “Well, we’ll create some new entity. We’ll create an EFSF fund.” Well, who guarantees that? “Well, all these bankrupt nations.” Oh, okay. “Well we’ll get the money from the IMF.” Wait a minute. The IMF is mostly the U.S., and the U.S. Congress has already said, “No, we’re not going to give you guys any money.”

And you can see, it goes on every day, and then you’re going to create these funds by bankrupt people. That’s exactly what they did with subprime mortgages. They took crappy paper, and threw in one or two good securities. Look at Europe – a lot of near-bankrupt countries. Throw in Germany and say, “Okay, we’ll make it all triple A rated.” That’s exactly what they did with the mortgage securities with subprime. How did that work out? And that was another delusion about, “Oh yeah, they’re triple A rated.” How could they be triple A rated, when it was mostly crappy paper?

It’s the same things that are going on now. They’re trying to create all these bailout funds. And then I saw today, the latest news, the sort of spark over the weekend was that the EU leaders wanted to put 200 billion more euros into the IMF for lending, demanded 25 billion euros from the U.K., and the U.K. said today, “No.” But it’s kind of funny, this is what they are doing. “We’re going to borrow money, put it into the IMF, so that we can then borrow from the IMF.” It’s absurd! That’s a daisy-chain bailout. It’s unbelievable! Who is the ECB? It’s the European nations, again, who are bankrupt, or near-bankrupt, with the exception of Germany.

And this nonsense goes on every day, and the game is to just keep this game going until some magic genie appears that will make everything better. And you can see that nothing is changing. We go day by day, the market gyrates and wiggles, and the rumors come out, and the stories. In the afternoon now, we get a daily rumor, about an hour before the New York Stock Exchange closes, about some new bailout scheme, where someone is going to put up some money into some fund, and then we get a rally until the close. Well, that is totally contrived, because they want to keep the stock market firm going into the close.

For example, last night, the markets were under pressure for all the negative reasons over the weekend, and Asia was getting hit. As soon as Asia closed – I mean it literally closed, and boom! Someone takes the S&Ps vertical by about 16 handles before Europe opened. Well, there’s no question somebody was trying to influence the opening in Europe so that it didn’t go to hell in a handbasket. And it stayed there for about 2-1/2 hours before the New York Stock Exchange opened and it started rolling over. We had a modestly higher opening and we’ve gone straight down.

So, it’s the same nonsense every day. People are fooling around in the markets, people who have vested interests to keep stocks higher. Just like now, the game today is watching Bank of America. As we speak, it is trading 501, 500 being a big threshold, because under 500 a lot of mutual funds and pensions cannot own it, and they are afraid of some kind of collapse. If you remember, we had this exercise a week or two ago where it traded down to 490-something, I can’t remember, and then right before the close, it was marked up above 500. That’s the game today – where are they going to close Bank of America today?

David: Whether it is Bank of America, Goldman, or J.P. Morgan – we are talking about U.S. Banks and financials and European banks, which are really in the same precarious place. Does 2012 represent the point in time where we see 10% of these major banks disappear, or 10% of these major banks get nationalized? We have seen Commerce Bank – that has been a discussion in Germany, the issue of what the state involvement is with running that bank now. Is nationalization the new trend in banking?

Bill: It will have to be, and I argue this is what should have been done in 2008 and 2009. That is the best way to protect the taxpayer. The taxpayer has put all this money into Citi, and other banks, AIG, whatever. Where’s the benefit? They will say, “Well, we sold the stock for this profit.” That’s garbage. Look at the money that these guys took out. It’s the same thing with GM. If you go in there and nationalize, wipe out all the equities, the bonds, wipe out the contracts, what you have done is you have bailed out the insiders, and in the GM case, you have bailed out the unions. If you were to nationalize these banks and then spin them out, you would save your taxpayers a lot of money.

David: What is the implication for pension funds, and insurance companies, with that wipe-out of equity?

Bill: They are going to lose their value, and if you hold those shares, that is exactly what will happen. And that’s the way it should be. These guys are the smartest guys in the world, they get all these fees to make decisions, so why do they own this junk? And then what happens when they make money? These guys extract the money. Goldman, after the crisis ebbed, made 30 billion in one quarter, and they took 20 billion out and paid it to themselves. Why was that allowed?

That’s why this isn’t capitalism. It drives me nuts when people say, “Oh, well, this capitalism isn’t working.” We don’t have capitalism here. We have crony socialism, where you give contracts to your buddies, you bail out your buddies or your friends, or the elites, on the back of taxpayers. Certain people always use the term, crony capitalism, but no, it’s crony socialism. That’s what it really is. Socialism is government control, central planning, picking winners and losers. So they can let your community banks go down and collapse, but they’re going to bail out, not only the big U.S. banks, they’re going to bail out the European banks.

And then you’ve got Dudley, the New York Fed Chief, trying to tell you this is good for U.S. taxpayers, to bail out European banks. Well, by a stretch of logic, what he won’t say is, because if we don’t, then we’ll have problems in our U.S. banks. But again, the problems just keep getting worse. If you nationalize them, wipe out all these stock options, especially for the executives, then you will get people being prudent again. Look what happened with MF Global. This guy was head of Goldman, a U.S. senator, Governor of New Jersey, and what did he do? And what happened to the firm? And what happened to the customers?

David: Let’s talk about rehypothecation. Is that anything other than theft?

Bill: No, I wouldn’t say it’s theft, it’s just that it’s stretching the limit. What a lot of people aren’t talking about, especially, is that what happened to MF Global is what happened to Long Term Capital Management. If you read the book, When Genius Failed, and other press articles, when the Street was talking about bailing out long-term capital, Corzine was in those meetings. He was the head of Goldman. He didn’t learn anything, because that is what they did.

What happens on Wall Street is that when you buy something, or you have money in your firm from all your different trading, you have a money desk there, and they are watching the money come in and go out, and the securities come in and go out. So what you want to do is that when you buy a U.S. bond, you immediately turn around and try to lend it out to somebody, you repo it out, and you get funds back in. Then you buy something else, you repo that out. And so you’re leveraging this up constantly.

What is interesting is that there are limits here in the U.S. to what you can do with your capital. In Europe there isn’t. That’s why this stuff all ends up in London. That’s why when they are saying, “Where’s the missing funds?” – a few articles allege that the funds are in J.P. Morgan, in London, because it is almost limitless what you can do there with this rehypothecation.

All hypothecation/rehypothecation is, is that you buy something, you get a security, you repo it out, and now you have money again. So then you buy something else, and then you lend that out. On and on and on. And this game works as long as your financing stays low. So that’s why the idiot Fed, that says they’re going to keep rates low for two years, or the rest of your lifetime, encourages this kind of speculation, because you don’t have to worry about your financing costs going up.

At the same time, what happens is that when you don’t have collateral, and this is what happened in 2008, why they lost control of the game, even with all of the bailing out they were trying to do and all the facility that was creating, is that people starting grabbing for collateral because they got scared. When you have that many people buying and repledging things, the chain breaks down, and once the chain breaks down, everything starts collapsing.

As the book, When Genius Failed, said, what these guys are doing is picking up nickels in front a bulldozer. In other words, when you keep buying and lending, buying and lending securities, more and more, it’s a very, very, very small spread, especially with low interest rates. But you do it so many times. In other words, if I can make a trade and make 20 cents on it, that’s great. But if the spread has collapsed down to only two cents, I’ve got to do ten times the leverage. If it goes down to one cent, that’s 20 times. What if it is half a cent? As long as I can keep levering that, I can maintain my profit – not the profit margin, but the net profit. So as the profit margin decreases, you keep looking for more and more leverage. That’s what is going on. That’s what appears to have gotten MF Global. And again, that’s what got Long Term Capital, to some degree.

David: On collateral, we have Dudley talking about taking European paper as collateral. Going back to 2008 and 2009, we saw the Fed accept all kinds of stuff, including the kitchen sink, into Maiden Lane I and II. Speak to collateral a little bit, because isn’t that really what we saw, a collateral call, with MF Global?

Bill: Yes, the system is so levered, because of all of this trading and speculation, and all these derivatives, and all this nonsense, that when people get concerned, they grab for collateral, and then the whole thing breaks down. Because they are playing this high speed game of buying and relending, and relending, and all of a sudden a few people pull the securities, and then there are shortages of collateral, and then this whole chain breaks down and it reverses. And when it reverses, you start losing money, and when you lose money, you take capital hits. And that makes you sell other things.

That’s why commodities are getting crushed now, too. The global economy and austerity means there is going to be weaker government spending, which means weaker economies, but also, the grab for collateral. That is one of the reasons, when the dollar goes up, if you remember, the dollar surged in October and November of 2008, and gold just got crushed, and everything got crushed, because that’s what was going on – when people start grabbing for collateral, they run to the dollar, because that’s what they are short. They are short dollars when they borrow. The whole chain breaks down – boom, boom, boom. And we’ve seen that happening in gold and the other commodities over the last month or so.

David: It’s a challenging picture, because as an individual, you ultimately have to make an allocation decision, and it seems really boring to look at the areas where there is not a lot of counter-party risk. Physical gold – no counter-party risk there. Dollars – I suppose you could stuff your mattress with them, but it appears that even if you put them at the bank, they may be rehypothecated. Nevertheless, between cash, or its equivalents, and gold, where else do you go in a period of unwind?

So we go back to that big issue that you mentioned. There is a necessary hit that has to be taken. It was voluntarily done under Reagan and Volcker. They took the hit. It is not now being done on a voluntary basis, which means things are going to get worse, not better, in terms of the ultimate ramifications. When this happens, even on an involuntary basis, where do you want to be? Because there is no good place, there are just better places.

Bill: Yes, exactly. That’s exactly right. That’s why the dollar is surging now, because it is a better place to be than in the euro or commodities, because we have deflation. We have had this ebb and flow of inflation/deflation. The system is trying to deflate. It’s clear. It has been trying to deflate for over twelve years. That’s what the big stock bubble collapse in 2000 was. And then we have central banks and governments trying to stave off the debt deflation, because they think it’s too horrible, and in the meantime, they have bankrupted themselves. And they have bankrupted individuals, they have bankrupted banks, on and on and on, instead of letting the system wash out. Greenspan wouldn’t allow it, because he was afraid that it would take the bank, because there is just too much leverage. So they make it worse and worse and worse.

They could have done this in 1991 when Citibank was down for the first time, the Bank of Boston, Bank of New England, all those banking problems in 1991 and he bailed them all out, leading to the carry trade. And then the Bank of Japan went to zero interest rates in 1995. So this thing has been going on for two decades, trying to stave off the day of reckoning for the financial markets.

David: So, what makes us think that 2012-2016 is the period where there is a forced comeuppance? Because surprise, surprise. At the end of the twelve years, we continue to be able to kick the can down the road.

Bill: You can keep doing it as long as you can borrow, and that’s what is happening now. The real crisis is the sovereign debt crisis, because that is the ultimate guarantor.

David: That is the game changer.

Bill: Right. That is because, “Well, you can always get bailed out.” And that’s what we did. That’s what Greenspan did. Go back to 1987. We are looking at 25 years of bailing out people. So if somebody comes into business at the age of 22 or 23, we are talking about, basically, everybody under the age of 50 has been in a market where they always believed someone’s going to bail out the markets. There’s a lot of experience of that.

At the same token, we haven’t had a bear market in bonds for 30 years, so again, we are talking about almost anybody under the age of 55 hasn’t traded in a real bond bear market. So you might go up for a quarter or two, or a year, but you always get saved, and the reason is because the government has kept buying bonds, whether it was for their own good or for currency intervention.

We have had an unbelievable period of central bank and government intervention in the markets and the economies, to save the socialistic model that developed early last century. Whether it was the European socialism or communism, or the U.S. socialism that Roosevelt created in the 1930s. This is an unwind of 75 years, or more, of this economy and financial system, and it’s going to be very painful. Again, they are just trying to extend and pretend, and hope for some magic genie to show up so they don’t have to take the hit.

But you are right, the market is forcing the hit, and just like it did with communism, when it started breaking up in 1989, 1990, 1991, the weakest nations just kept falling and falling and falling. And now that has spread into Europe, where the weakest nations are going down first there – Greece, Portugal, Ireland, Iceland, on and on, it’s just going to roll through the regions like that. And that’s what we are looking at, here.

And the big problem now is that it’s not just one or two, it’s everybody, because everybody has played this game for decades. And it’s the end game, because when you can’t borrow money anymore, or the rates start going up, then we are going to see the debt defaults. That’s what I see. I see debt default. Just look at history. This happens. You try to inflate, you try to borrow, you try austerity. There’s nothing new here. This has all been done many, many times.

Your only recourse then is either to go Weimar and just print it up and pay it, or you default. And the recent history is, you default. Whether it was Russia in 1998, or in 2001 and 2002 when we had Argentina, and we had other countries in there, too. You default, because that’s what best for your country, and that’s what leaders will figure out, eventually. “Okay, we just can’t pay it.”

And it’s not so drastic. Russia, in 3-4 years, was running incredible surpluses and acquired 200-300 billion in reserves, a lot of which was because the energy business took off, but you can default, and it works for your country, if, when you default, you do the necessary reforms. Then you can get back in the capital markets and borrow again. And they have. Again, the game here is for the elites to try to bail each other out, without taking the hit.

David: Is it any different for a country that has reserve currency status?

Bill: Yes, it would be, and that would be in reference to the U.S. again, that is, if you do the necessary reforms. I would tell you right now, if you said, “We’re going to run a balanced budget, we’re going to have a flat tax, we’re going to get rid of all this nonsense, and oh, by the way, we’re in default. Your T-bill is here, you’re only get this, whatever the number is, two-thirds, whatever it is – and we’ll take that half, and whack!” And at first people would be cautious to see if you follow that plan, but if you followed that plan, you would be fine. Look at how fast Russia rebounded.

David: Right.

Bill: It was very quickly. And what was their history of jurisprudence or business dealing? Please.

David: (laughter) Well, in terms of a default, we have roughly a 50/50 split, if you are looking at our Treasury market, held by foreigners versus held domestically.

Bill: Yes. But who holds it domestically? This was my view of why you should nationalize, that you shouldn’t bail out Wall Street, you should bail out all the bank deposits. When you start looking at the United States, with the average household and what their assets are, there is very little. You are only talking about a handful of people with assets. So when you are talking about Treasuries and you are talking about default, you are talking about the 1%, by and large, and institutions, obviously pension funds and insurance companies, and whatever, in here.

But this isn’t going to impact the average person on the street. Not to his balance sheet. It will have effect on the economy in the short-term, and that is why you will get default eventually, because with the majority of people, their balance sheet and checkbook isn’t impacted, because what assets they do have are in bank accounts. They are in passbooks, maybe CDs. But there aren’t a lot of people holding T-bills, maybe some money funds and that kind of thing. But it is not the same as the big institutionalized money that would get hit, or the big private wealth. That’s why the big private wealth has been a big buyer in gold. That’s their hedge. They buy gold and they are buying bonds, and they are just waiting it out.

David: Hypothetically, if we look at 2012, 2013, 2014, 2015, what do we see? Money market funds? Breaking the buck? Banking institutions?

Bill: I don’t know. See, the thing is, rightly so on the street is the argument, deflation or inflation, and we have been getting periods of both over the last decade. The deflation shows up because the system wants to deflate, and again, the central banks and governments are trying to prevent it by inflating.

David: Inflate it back.

Bill: Right. Right now, we are in deflation again, which you can see in the commodities – they are telling you that. Bernanke moved away from QE-II in May, and nobody listened to him. The FOMC said that the trade-offs of quantitative easing are no longer beneficial. And I’m thinking, “What else do people need to hear?” But yet, the same clowns are running around saying, “Oh, QE-III is imminent. It’s imminent, it’s imminent, it’s imminent.”

And you could see the rallies. When they did the QE-II you could see the bonds went down, the stocks and commodities went up, and then that kind of rolled over, and then we had the twist, we had another little rally, and then in October that all fell apart. And now everybody is running around saying, “Oh, QE-III in January, QE-II in January.”

Well, I don’t think so, but the point here is, we are getting both inflation and deflation on a periodic basis. Now, what’s the next big wave? I don’t know. But the one thing that I’m highly confident of is that we will get both, at some point in the future here, but it’s probably not going to be 2012, probably afterward, maybe a year from now, 2013 perhaps, when the new administration and new congress come in and start doing reforms, we will get the deflation, and it depends how far they will allow it to go before they inflate.

On the other hand, if we have an administration that comes in and tries to inflate right away, we’ll get the inflation, but then that will blow up when we get deflation. So my view is that we are going to get a big wave of inflation and deflation. That’s what history tells us. We just don’t know the sequence. So you have to have a portfolio constructed so that you are hedged against both, and when the wave develops you can jump on and play it, and you won’t get swamped and crushed by it.

David: We have Dennis Gartman saying we are in a new bear market in gold. Is he talking about a talking about a cyclical bear, or a secular bear? Is it over?

Bill: It’s too early to tell. Because what the governments will do – it’s way too early to tell.

David: We have gold up 630% during the duration over the last ten years, silver up 700%. These numbers aren’t the highs, these are current numbers. So, yes, they’ve had a good run, haven’t seen any sort of speculative blow-off phase, which you might expect at a tail-end of a super bull market. Maybe that’s around the corner, maybe it’s not. But yes, inflation/deflation, we know that there are fiscal measures that can be employed, and monetary measures which can be employed.

Fiscal measures are not all that popular with the voter base, unless you are sort of lynching the rich (laughter). Unfortunately, there is not enough money to take, and steal, and reallocate, to actually make a difference there. But fiscal measures really don’t work. I guess we’ve looked at the monetary measures as the only ones that they would employ, because they are not politically volatile – not if they can “control the inflation,” and maybe that is their misperception, that they can actually control it. It tends to move.

Bill: It’s the arrogance of these guys, mostly these Ivy League types, who spent a career saying, “Oh, we’ve just got to make the right policy mix.” No, they’re not that smart. And they’ve proven over the last how many decades that they’re not that smart, so why don’t they just get out of the way and let the market operate? And of course, they are saying now, as well, “We can’t, because it would be so horrible.”

Yeah, that’s the horror they created with their Keynesianism mantras and everything else, that they’re always going to be there to fine-tune and micromanage the economy and the financial system. And it’s not working. That’s another reason why they are digging in. This isn’t just the banks, this isn’t just the country – this is these guys’ lifetime work. It’s their self-esteem, it’s their egos, and they’re going to try to prove that they’re right, at all costs, no matter what the costs are.

And that’s another reason why we have to let the market work and get rid of all these clowns that want to put their fingers in the pie and keep manipulating it. And we are getting revolts all over the world about this type of action, and it’s going to continue. We are starting to get the social unrest. We are starting to see it here in the U.S. We don’t notice it in Europe, because they don’t talk about it as much, but it is going on, and it is probably going to worsen, because nobody is doing the requisite reforms. So they just keep making it worse and worse.

People will take a hit and pain, if they believe they are going to have a better future, which is what 1981 and 1982 was about, under Reagan. Thatcher did the same thing. Nobody here wants to do that, or in Europe. Nobody wants to go in and do what is necessary to reform. And until they do, we are going to play this silly game until the market revolts, like in 2008 when the market revolted. And the market is revolting now, and you can see they just keep trying to stop it.

That’s the only reason they are doing QE. It hasn’t gotten into the economy. It’s not helping. It’s not helping housing. And when people said to Bernanke, “QE is not working,” or “Why did you think QE was working?” The first words out of his mouth were, “Stock prices are up.” The first words out of his mouth! That’s the only thing they could hang their hat on is that they were inflating assets, and the reason they think that helps is that they are trying to get the banks recapitalized.

So this thing comes down to saving the big banks, and saving sovereign debt. And the reason sovereigns and the central banks are in trouble is because they were bailed out. They got too involved in the economy, they got too involved in the financial system, and now they are on the hook. Again, that’s the game changer.

David: So not 2012, 2013, 2014, 2015. We are still talking about a slow burn. It takes forever until it just happens and it’s done.

Bill: Yes, I think there are only two possible outcomes: One is that the market revolts, the second is that you get the right leaders in and get ahead of that, which is like what Volcker and Reagan did. They both saw how bad it was, they understood the problem, both of them. That’s the problem here, is that you have to give the medicine. You have to purge, but you also have to restructure. If the U.S. economy hadn’t been restructured – in other words, if we had just done austerity – it would have been horrible. So you have to do your austerity, but you also have to liberate the private market so it can do its work

It’s similar to after World War II, when everybody thought we were going into this enormous depression, back into the depression, because all the men were coming home, millions of men. There was going to be massive unemployment, on and on, and instead, we had this enormous boom. Now, it took a little bit, it took 3-4 years to purge that out, but then by 1949-1966, it was unbelievable prosperity, because you had pent-up savings, pent-up demand, after World War II. And the restructuring was done, and off to the races, the private market worked, and it worked splendidly.

We did the same thing in 1920. People call it the forgotten depression. The same thing after World War I, enormous inflation crushed the global economies. The scale of World War I had never been seen in history, and the costs were unimaginable at that time. There were problems, of course, like Weimar Germany, but here in the U.S. we had prosperity, because we were supplying grains and materials and supplies in World War I.

We had incredible inflation. We had the same thing, men coming home, and all of a sudden the factories and the farms weren’t as prosperous, the demand wasn’t there from Europe. Warren G. Harding was getting the advice that to get of the depression he should increase government spending and raise taxes. He went the other way. He cut government spending in half. He slashed taxes. It took a year-and-a-half, and then on to the roaring ’20s boom because he did the right thing.

That’s just what we need here, and just like Thatcher did when she started blowing up the British socialism. Of course, she had the benefit of north sea oil coming online too, which helped, but until you get someone who says, “Okay, we’re going to take the hit for a year-and-a-half, but we’re going to do it right, and we’re going to come out.”

That’s the problem in Europe. They want to stick austerity measures on people, but they don’t want to blow up the structure, to unleash the private sector. And unless you unleash the private sector, get the government off their backs, downsize government, you are just going to crush your country, and you are going to have some kind of revolution, because people aren’t going to take the austerity forever.

David: We have two different kinds of revolutionaries to remember this week. Vaclav Havel passed away, and so did Kim Jong Il. On the one hand, with the first, there was freedom which came on the other side of revolution, and on the other, with the second, two million people starving to death, and nuclear weapons. Those are sort of Kim Jong Il’s claims to fame, or infamy. The kind of leadership that we need – can you imagine it? Can you draw a caricature of that leadership, and do you see that emerging this election cycle, or is that something we have to wait another election cycle for here in the U.S.?

Bill: You know what, it depends on the country. The good thing in the U.S., and I was very negative in 2008 about what was happening, and maybe you should get your money out of the country, but I think the reason you see the dollar rallying now is that the people in Europe seem to want more socialism, whereas in the U.S., if you read the surveys, in everything you read, they want less. Most of the people in this country realize the problem is that government is too big – too much government spending.

The Tea Party keeps saying, “We want to cut government spending.” That is so abhorrent to the vested interests of big government and the welfare state that they go out of their minds. But it is coming. It’s going to happen. The mathematics tell you that the spending is going to get cut, it’s going to get slashed, it’s going to disappear in a huge way.

If you have the right leaders, you prepare the country for this, but you also have to prepare the means to get out, which again, is to unleash the private sector. We all know what that means. It means that you crush government – government regulations, the structure of government, government workers, government spending, etc. That’s how you get out of this. Everybody understands this, except, again, the diehard dependents of the state, and if they had any sense they would understand that that is all going to disappear, and that they are better off getting a productive economy.

That’s the thing here in the U.S. The U.S. had such an enormous economic and financial advantage after World War II that it was just incredible. Never in the history of man had we had a nation as powerful and had such an industrial and financial base. So by the mid and late 1960s the welfare state was unleashed, in an enormous way. It was the same thing in the cities – all these deals, it was just ridiculous. And you struggled in the 1970s. Then Reagan and Volcker unleashed the U.S. economy again and you went berserk in the 1980s, and into the 1990s, and you got away with this, and now that all the global economies are rolling over with this massive transfer of wealth from the western world to emerging markets, and you can’t support the socialism anymore.

It’s just like in a family. If you have a family of five, and two are very productive, and the other three live off of them, that’s great. All of a sudden, if you have only one productive, it starts to become a struggle, because you have four living off of one, and when the one that was productive all of a sudden is getting reduced, then the whole thing comes down. That’s the western world. It cannot afford its social welfare state that it has created over the last 70-80 years. We are unwinding a social, political, economic system. That’s what is going on. It’s huge. Beyond secular. This is Kondratiev type of stuff. And that’s why we are stuck in this, and we have been stuck in this for years.

David: Out of that Kondratiev-type change comes either leadership that you are pretty excited about, or leadership that you really want to hide from. We have seen both, the good and the bad. What would you suggest is a way that we could either help, or promote, or get behind positive change, as we see this requisite purging occur? What kind of mindset would you suggest we need to take on?

Bill: I just think people have to be informed. I think one of the reasons they are getting this now is that the elite media has lost control of the megaphone. We have the Internet, and we have other sources of information, and data, so people in the U.S. have begun to understand what the problems are here. Again, what you are hoping is that people vote in leaders that will do what is necessary. Right now, though, I don’t see that happening, especially over the next year, and even in 2013, I still think events are going to force people.

We have seen this in times of war, the same thing, the events force people to do things, and we just hope we have the leaders in charge, that when the real game starts playing, can make the adjustments on the fly, and understand what is happening and can lead the nation and get the people to do what has to be done. That is still a long way in front of us, I believe.

David: It sounds like we are talking about a totally different election cycle, not this one.

Bill: What FDR ran on in 1932 was cutting the deficit. That’s what he ran on – that Hoover was recklessly spending. And he came in and he did a 180. Again, I don’t care what people campaign on and what they say. What do they do? Especially, when the game is being played, when it’s real-time, and there are real situations, and real dangers, and opportunities appearing. Are they mentally and emotionally agile enough, and smart enough, to make the adjustments quickly, and lead the nation on the proper course? We’ll see.

David: What a happy note to head into Christmas with (laughter).

Bill: Yes, well, the good news is, if you are paying attention, and you have a reasonably sound portfolio – you are not levered, you are not in big debt, and you have a nice cash reserve, and you have your hedges against that cash – you can sit and wait and watch. There are a lot of people who are desperate, they are panicky, and they are fighting for their lives. Again, if you are treading water, you are winning right now.

David: Yes, for the laymen, essentially, you are talking about a cash and gold position – cash, and a hedge against it.

Bill: Yes, or something like that. Well, not farmland anymore, that got overpriced. One of the reasons I think grains are in trouble is because if you have a family farm, you don’t care what the price is, and you produce your crops. If you are some hedge fund or private equity group, and you are paying all-time highs for farmland, all of a sudden you start trying to produce every square inch of that property. And so you can see that the size of the crops now are just enormous. That’s how the commodity markets work. Produce too much and the price goes down.

So, again, it’s a game. We just don’t quite know. The information isn’t good out there. It’s being guarded, they don’t want people to know the truth. They are not telling the truth. So you just have to be very, very careful, and you have to be very defensive. If you own stocks, you’d better have verifiably sound balance sheets. I wouldn’t touch a big bank right now, because there is just no way to verify what their real holdings are. Just remember, when Washington Mutual sold for 2 billion dollars, it was carrying a book value of 75 billion, and it sold for 2 billion. How good was all that financial analysis and balance sheet analysis?

There are some great companies, some of the top tech companies, some like Johnson and Johnson, Exxon, these type of companies that have good, sound balance sheets, low in debt, a lot of cash, and a company that is going to exist, no matter what we get first – inflation, then the big deflation, or vice-versa. That’s fine. On a micro-level, you are looking for businesses that are going to be able to generate cash. That’s what you want. You want businesses that can generate cash no matter what kind of environment we have.

David: We look forward to having you back on the program some time next year.

Bill: Okay, great.

David: And looking forward to a dinner in Chicago before too long.

Bill: That would be very nice.

Kevin: David, it is Christmas-time, but that was a sobering talk. When you look back at 2008 and 2009, just so much went on. Bill says that was a crisis, but not the crisis, so we need to hold on for a little bit.

David: Because all of these problems continue to get pushed uphill if you will, and the responsibility is given to someone who has deeper pockets. In this case, we have reached the end game, so to speak, because the sovereigns’ ability to borrow, or inability to borrow, ends up being the game changer.

Kevin: And you know, they are running out of room, because when Europe wants to give the IMF money so that they can give it back to them, as you said, they are just playing games at this point. They are out of money. Now, when people start to realize that, the daisy-chain stops rolling. That’s what Bill is bringing out, isn’t he?

David: Yes, and I think one of the things that he is suggesting is that the voluntary purging is more attractive than the involuntary, when the market forces it – because guess what? You actually put yourself at a strategic advantage.

Let’s say, for instance, that in 2012 we had leadership that came in and was very strategic about what they put in place in terms of policy measures, and they were both austere, and as Bill said, also did something that helped restructure our economy. So on the one hand austerity, and on the other, restructuring the economy for growth.

If those two things were introduced in 2013 as a result of the elections in 2012, then we might, in fact, be the country to lead through the crisis. If we don’t, then the question is – who leads, if they are willing to take the hit voluntarily? Otherwise, we may find ourselves all in one nasty stew pot, all of us dealing with the same things, taking the hit, but the market forcing it on all of us, at inopportune times.

Kevin: Hindsight is 20/20, I know, but we have had Paul Craig Roberts on, and he was with the Reagan administration when they were trying to get some things through that would have continued to make the economy grow, but there was conflict at the time. We had Volcker, who was coming in and tightening things up, and actually, there were certain steps that were taken by the Reagan administration at that time, as well, to clean things up from the Carter years, to clean things up from the early 1970s, even the mistakes that Nixon made before he resigned. Looking back, that was painful. 1981, 1982,1983 – those were painful years, but look at what happened after that. That’s what Bill brought out.

David: And I think even scooting back a little further – 1974 and 1975 – there were painful years that preceded it, but there wasn’t a voice of leadership. So Bill is also correct in saying, “Listen, if this is painful, people will listen, and people will tolerate the pain, if they think they are following someone who is credible, who has the ability to say, ‘Here is where we are going, this is what we are going to do. Watch how I get it done.’”

It reminds me a little bit of Yuval Steinitz, and what he rolled out for the Israeli government, saying, “Listen, here is how we are going to increase taxes, and this is how we are going to decrease taxes, in an orderly fashion, immediately. Yes, we are going to use fiscal tools to solve this problem (this was back in 2008 and 2009), but this is our credible way of both solving the problem, and unwinding it. We are not looking at over-reaching our boundaries, we are not looking at permanently stretching our new-found capital, in terms of revenues to be allocated beyond the crisis, into pet projects. But if we have to increase the pain today, we will decrease it tomorrow – we promise you.” And you know what? Steinitz was right. He did what he said he was going to do, and they have done quite well, actually, in terms of recovery.

Kevin: Then, during this period of unknowns, since most of the people who are listening to us are not policy-makers or decision-makers in Washington, though there may be a few, what about the person who says, “David, it’s Christmastime, I’m trying to figure out what to do with my finances. I’m looking at this last year. I’m confused. What do I do now?” You and your dad, last week when you were talking on the program, came to the conclusion that you really need to keep your powder dry and ride this thing out, so that you can move the right direction when it presents itself. Is that what you would suggest?

David: It is, and it comes back to something that is very simple, along the lines of that back-of-the-napkin conversation, with the perspective triangle, where you have a balanced approach where a third of your capital is powder that is kept dry, a third of your capital is allocated to creating a hedge for the capital that is kept dry. You have precious metals, which are an offset to your currency risk, in your liquid position. And then you also have a productive bet, a play on recovery, if you will, where equities and bonds can be in the mix, selectively chosen. You do have that balance built in.

Kevin, as basic as that is, I think you come back to the basics in these challenging times, because if you don’t have those basics figured out and covered, then you don’t have anything covered.

Posted in TranscriptsComments Off on December 21, 2011; When Will the Requisite Purge Occur in the World Economy? An Interview with Bill King

When Will the Requisite Purge Occur in the World Economy?: An Interview with Bill King



A Look At This Week’s Show:
There are only two possible outcomes of this ongoing crises:
1) New and bold leadership will force a purge of debt and overspending (Paul Volker on steroids?)
2) The market will force the purge destroying everything in its path.
-For now, the only relatively sound action an investor can take is to stay liquid with cash and gold until one of the two forms of purge occur.

About the Guest: 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. Bill’s candid observations and forecast on the economic, financial, and political forces that are impacting the markets have been extremely accurate.

Posted in PodCastsComments Off on When Will the Requisite Purge Occur in the World Economy?: An Interview with Bill King

August 31, 2011; The IMF Has Effectively Pronounced the US Bankrupt: An Interview with Laurence Kotlikoff


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin:  David, today, before we go to our guest, I think one of the problems that we have is that our system privatizes the upside.  There is an awful lot of profit made by the big banks and the brokerage firms, but we seem to socialize the downside, and it’s breaking the bank.  Our guest today is someone who is at least coming up with some solutions, whether you agree with him or not.

David:  Yes.  We have enjoyed reading a lot of his articles.  He writes for Bloomberg with some regularity, has been a professor at Boston University for years, and is really an interesting guy.  I have enjoyed spending personal time with him in Boston.  He was surprised, in fact, that we didn’t see more of a downgrade here recently with the U.S. debt.

Kevin:  Right.  You’re talking about Standard and Poor’s.

David:  Correct.  From AAA, to AA+.  He is asking himself the question, “The numbers are far worse than S&P was even alluding to, so why are we, in fact, not at a BBB, instead of a AA+?”  That brings him awfully close to the perspective that we would have as market practitioners, I think probably more practical in our judgments than a purely academic perspective.  But on the other hand, that is his stock in trade.  He is a Ph.D. economist, and does rely on a very deep insight into the financial market for both his conclusions, diagnostically, as well as prescriptively, definitely an academic approach.

Kevin:  The thing about Laurence Kotlikoff is that this is a man who truly does feel a responsibility as an economist.  He has said, and he really believes, that economists who understand the problem have a responsibility to speak out.  Many economists don’t understand the problem, they chase false religions, but there are economists who are looking at this and they are saying, “You know what?  We have Ph.D.s in something that tells us that we can’t spend more than we actually bring in.”  He says economists have a responsibility in this area that politicians don’t really know how to handle and can’t solve.

David:  Kevin, it was a fascinating conversation.  This goes back several months when I spent about 2-1/2 hours with him there at his apartment at BU, and we began the conversation with the assumption that there is a moral overlay, not only to the work of an economist, but of a politician, as well.

I just stopped him right there, and I said, “Dr. Kotlikoff, you realize what you are assuming is anathema in the ivory tower?  We are talking about something that is undergirding judgment, and it does include a moral ought?” He said, “Absolutely.  This is the issue.  An economist has a responsibility to tell it like it is, not to fabricate numbers, not to play with statistics and put something that can then be presented to the general public as acceptable, but in fact, to see the real issues ahead of time and make sure that economic policy is addressing those things, ahead of time, so that crisis is not an issue.”

Kevin:  David, we have talked before about your time at Oxford, which has a unique program that addresses things that don’t always seem to coincide:  Politics, economics, and philosophy, which brings in the issue, morality.  I will say this about Kotlikoff’s book, Jimmy Stewart is Dead, an excellent book, that he is trying his best with his solution to not make it Democrat, to not make it Republican.  In fact, he is taking those two colors and turning them into what he calls the purple solution.

David:  What I love about this is not that these are the perfect solutions, but that he has taken a stab at it, and I appreciate him doing so.  It means that he is open for criticism.  But guess what?  Better the creator open to criticism than the person who always criticizes and never offers something for consideration.  I appreciate that.  I do like his critique, and in the first half of the book, that is where he lays a tremendous amount of energy into what has happened in the economy and what can be done about it.

Kevin:  For a person who wants to understand what has occurred up to this point, especially, and actually, a lot of the guys who have dirty hands in this, morally, ethically, and probably criminally dirty hands, he does just a fabulous job of outlining the history of how we have gotten here so far.

David:  Between some combination of political collusion and insider manipulation, you have this sort of Wall Street and Washington – it’s just a witch’s brew.

Kevin:  It’s a power complex that, absolutely, you can’t get to.

David:  Right.  It’s untouchable in its current form, and that’s where he is really calling for risk-takers to assume the responsibility of the risk taken.  As you said, no more privatizing the upside and socializing the downside.

Kevin:  And no more too-big-to-fail because the big guys aren’t going to be allowed to go ahead and give everybody else their risk.

David:  Exactly.  If you can lay that off on the taxpayer, coming back to that moral issue, you have created moral hazard, wherein these large institutions can do whatever they want, and pass along the consequences, if they err, to you and I, the taxpayers. He is saying, “Listen, this is just not the way you run an economy.  This is not how you encourage growth and capital formation.  In fact, this is ultimately destructive to capital formation.

So we have a devolution, a de-evolution, in the financial spheres, as a result of this corrupt combination of Wall Street and Washington, and he’s basically saying, “Can’t we parse this out and have it better regulated?”  That’s an interesting concept, Kevin, for someone who is not particularly keen on regulation of any sort, but listen to this:    There are rules that need to be followed, and certainly, laws that need to be respected, already on the books, if, most basically, you just want to go back to the Constitution and say, “Do we have a proper appraisal of what exists already?”  That certainly is a part of our conversation with Dr. Kotlikoff today – What needs to be put in place, and how exactly did we get here?

Kevin:  David, I would like to hear some of those solutions right now.

David:  Professor Laurence Kotlikoff from Boston University joins us to look at some of these issues.  The fiscal disasters that have been developing not just over the last 24 months, but arguably over a 20, to 30, to 40-year period, that is certainly a topic to discuss today.  The debt ceiling – is that really the issue, or do we have more substructurally unsound issues that need to be discussed?  This is the case, not only in the U.S., but in Europe as well.

Mr. Kotlikoff, thanks for joining us.

Laurence Kotlikoff:  My pleasure.

David:  Maybe we can start with just a brief overview of some of our fiscal problems.  You discuss a 77 trillion dollar funding gap.  How do we get to that number, and what can we do about it?

Laurence:  David, the number is actually a lot bigger than 77 trillion.  I am not sure, but that might have been an older calculation, and by somebody else, but the true fiscal gap right now is 211 trillion dollars, based on the most recent congressional budget office projections.  The fiscal gap refers to the difference between all of the spending that is projected, and all the taxes that are anticipated, all measured in present value, so we are talking about 211 trillion.  The official debt, in comparison, is only 10.3 trillion, so the official debt is a small mole hill relative to the big mountain which is the unofficial debt.  The unfunded liabilities for Social Security, Medicare, and Medicaid, are, in large part, the source of that difference.

David:  With either the 10 trillion, or the 211 trillion in mind, is it any surprise to you that S&P would downgrade the U.S., reflecting both the political shenanigans of late, but also, I think, bigger picture and longer term issues as well?

Laurence:  It isn’t surprising, actually, that they would downgrade us, but I think what is surprising is that they didn’t downgrade us a whole lot more, because we are in worse fiscal shape, I think, than Greece, or Italy, or any of the other developed countries, even the ones that are viewed as in trouble.  Why do I say that?  Not because of the official debt, it is because the unofficial debt that we have is so much larger as the share of our GDP than is the case, for example, in Italy.

Italy, today, is under attack.  They have a lot of official debt, but they also have a pension system that was substantially reformed about ten years ago, so that is in good long-term shape.  They have a health care system that is not going crazy in terms of its cost.  In our case, Medicare/Medicaid expenditures total about a trillion dollars, and that bill went up by 10% in one year.  In the last year, it grew by 10%.

We have entitlement obligations, unfunded commitments, unofficial debt, if you would like to call it that, that are just enormous, and we are not facing that as an immediate threat because the baby boomers that are going to be receiving these much higher benefit levels, the annual increase in these things, are not yet fully retired, they are just starting to retire.

When you take 78 million baby boomers 20 years from now and look at what they are going to be receiving, it will be $40,000 in today’s dollars, per head, on average, from Social Security, Medicare, Medicaid.  That will be about a 3 trillion dollar bill each year in today’s dollars.  So, unless we get these obligations under control right away, we are going to end up with a fantastic crisis, and people haven’t quite figured out how big the problem is, to really be looking at the long-term fiscal problems of each country, and in our case, there should be understanding that they are much deeper than those in Greece, and we probably should have been rated more like CCC rather than AA+.

David:  Well, it is interesting, we have, certainly, some grandstanding on that issue today, on both sides of the fence, with folks saying, “We think that we should be AAAA, and others agreeing with you whole-heartedly, that AA+ is generous when you begin to look at the details.

Laurence:  Warren Buffet said that we should be AAAA.  Warren Buffet holds some treasury bonds, I’m sure, and bills, and wants to see his assets go up in value, but I don’t know if Warren Buffet is looking at any of the current fiscal problems that I am, and other economists who are really serious about the fiscal situation are looking at, so I don’t know where he is coming from.

David:  Deficit spending in the present tense is going to be somewhere between 1.5 and 1.7 trillion dollars this year.  The CBO has said their best guess is that for the next ten years it will be north of a trillion dollars, so it is not like our current stock of debt at 10 trillion is diminishing.  Fast forward a decade from now and we have just about doubled it again.  What is our best bet between spending cuts, or increasing taxes, or some combination of the two?   And do you think we have the political will to do the right thing?  It appears that we don’t, but maybe I am looking at things from too cynical of a vantage point.

Laurence:  Our best bet is to adopt the policies that I have been proposing.  One is called the Purple Health Plan.  At thepurplehealthplan.org you will see a very simple reform for health care that could give everybody a basic plan at 10% of GDP cost, which is what we are now spending.  We can fix that at 10% of GDP, and set up a budget.  This is something I came up with back in 2007 in a book called, The Health Care Fix.  It is very similar, in a lot of ways, to the president’s health reform, his health exchanges.  It is very similar to Paul Ryan’s proposal for fixing Medicare, very similar, frankly, to what the Germans, the Dutch, the Israelis and the Swiss have in their health care systems.  That is a system that could keep our health care bill at the federal level from going from 10% up to 25% of GDP, which is what the CPO is projecting.

If you go to thepurpletaxplan.org, you will see a very simple proposal for fixing the tax system and getting about 2% more of GDP in revenue.  We need more revenue, but we don’t necessarily need higher tax rates.  This plan is a very broad-based reform, in which, instead of having a very broad-based tax base, it entails getting rid of the federal income tax, the corporate income tax, the state and gift taxes, and replacing those with a highly progressive payroll tax…

David:  A consumption tax.

Laurence:  …and also a retail sales tax with a rebate to make it progressive, and also an inheritance tax.  All the tax rates on these three taxes, the payroll tax, the consumption tax, and the inheritance tax, would be 15%.  We would have a 15% solution.  The effective tax rates for these things would be 15%, and that would be a system that would really be much more efficient.  It would generate, as I said, 2% more revenue, and I think, much more progression than what we now have.  What we now have is invitation for the rich to avoid taxes entirely, through different gimmick loopholes.

And then the social security reform plan is going to be going up tonight on the web.  It will be thepurplesocialsecurityplan.org.  Social Security, actually, is in worse shape now than when the Greenspan Commission met in 1983 to fix it.  It is 29% underfunded, according to Table 4B6, the Social Security Trustee’s report, even taking into account the 2.6 trillion dollar trust fund.  So, Social Security is in really bad shape, despite what everybody seems to be saying.

Also, the system is just incredibly complex.  You cannot build a more complex system, with less information.  Nobody has any idea what the system is really about, it is incredibly inequitable.  We need something that is very simple, transparent, and progressive, and that will help people save, and know what they have.  You will see this proposal up on the web tonight or tomorrow.

David:  These three sites:  thepurplesocialsecurityplan.org, thepurpletaxplan.org, and thepurplehealthplan.org.  It sounds as if you are basically taking the red and the blue, the Republican and Democratic ideas, and finding a middle ground, something that can be bipartisan, agreed upon, so that it can be adopted.  It is a workable solution, regardless of what side of the aisle that you are on.  Is that why you have called them all purple?

Laurence:  Exactly, it is the combination of the red and the blue, and the point is that economists have an obligation to try to come up with simple solutions here, because what we have is the making of a soup in Washington by 535 members of Congress.  Suppose you told 535 members of Congress to build a bridge across the Hudson in New York.  Well, they would build something that surely would collapse.  They would all want to have their input, and it would be a mess.  And that is what we are doing here.  We have economic institutions we are trying to build, and you are asking 535 people each year to build it, or rebuild it, and consequently, they make a total mess of it, and they are broken, and the tax system is just a disgrace.

The Social Security system, if you really look at the details, it is incredibly inequitable and inefficient.  Nobody has any idea.  They can’t even afford to send us our annual benefit statements anymore.   We are not going to get them in the mail anymore.  It is our primary savings system, and we can’t learn what we have put into the system.

David:  In all fairness, they would say that they are not fiddling while Rome is burning.  In fact, exhibit A, in defense of how busy they have been and how productive they have been, is the Dodd-Frank bill.  Any thoughts on how Dodd-Frank either adds to, or complicates, the matter?

Laurence:  Dodd-Frank, I believe, runs 2700 pages.

David:  Missing the definition of simple, I suppose.

Laurence:  Yes.  It misses simple.  It maintains the current system.  I have a book called, Jimmy Stewart Is Dead, which plays out a financial reform called Limited Purpose Banking, and endorsed by five Nobel laureates in economics.  The head of the Central Bank of England, Mervyn King, has said extremely positive things about the plan.

David:  Our endorsement is not as critical, but we would certainly endorse it as well.  We have read it in the office, and would say that it is definitely worth reading through.  The first two-thirds are an excellent explanation of what has happened in terms of the corruption of Wall Street, the corruption of the banking system, and complicit to the crime, D.C. is not far off.  And then some very practical solutions which you describe as limited purpose banking.  Tell me, in a nutshell, is it sufficient to say that limited purpose banking is, in some regards, a return to Glass-Steagall, just maybe with even a few more controls on the financial markets?

Laurence:  David, it is really quite different, and it is simpler.  Glass-Steagall says that you should be regulated one way, and put one name on your business.  If you call yourself an investment bank you should be regulated one way, and if you call yourself a commercial bank you should be regulated a different way.  We would carefully regulate commercial banks and let investment banks do whatever they want, but we won’t rescue them.  As we saw with Lehman Brothers, that was not possible.  These things are too interconnected and they become too big to fail.

What limited purpose banking says is, “Look, banks, and also insurance companies, are not here to gamble for us.  They are not here to borrow from us and say, ‘Don’t worry, we will make a killing,’ and then go gamble with our money, and then turn around and say, ‘Well, we lost it, but the taxpayers will bail you out.’”  Basically, that is setting this thing up to try to make a killing, to take the upside, and then to socialize the downside.  They are privatizing the upside and they are socializing the downside, in terms of leaving the taxpayer to pick up any losses that they make.

Limited purpose banking says that the banks and insurance companies cannot borrow to invest.  The only thing they can do is issue mutual funds.  They can become active mutual fund companies.  Mutual fund companies issue mutual funds we are familiar with through our 401k plans and IRAs.  They are like little banks.  Each mutual fund sells shares.  We buy the shares in the mutual fund.  The mutual fund takes the money and invests in whatever it is specializing in.

There are about 10,000 different mutual funds in our country already.  What happens is that if there are investments that don’t do well, we lose money, the value of our mutual fund shares go down, but the mutual fund company, itself, and the mutual funds, individually, do not fail.  So the financial intermediary, if it is a mutual fund company issuing mutual funds, never experiences financial failure.  It can never go bankrupt.

I am talking about a banking system that consists just of mutual fund companies that can never go bankrupt, so you can never have bank failures again.  You can never have a Lehman Brothers collapse, you can never have a Bear-Stearns collapse, you can never have an AIG collapse.  You can never have all the different collapses that we have experienced.

David:  Part of that is because they wouldn’t be allowed to leverage themselves, say, to 40-to-1, or like a Fannie Mae or Freddie Mac, to 65 or 70-to-1.

Laurence:  They would not be allowed to leverage themselves, at all.

David:  Yes, so leverage is gone.

Laurence:  Right.  Exactly.  It is equity-based banking.  It is not debt-based banking.  And there is also an economic theory that suggests that we need to have the intermediaries, the financial middle men, borrow and leverage to go into debt, and engage in the kind of risk-taking that they are doing.  Their job is to connect savers and investors, and borrowers and lenders.  That is their job.  Limited purpose banking limits them to that job.  They have to just play the role of intermediation, of connecting individuals with companies, individuals with individuals, but not to gamble and then leave us with their losses.

David:  It is interesting, because it also sounds like there is a component of the special purpose banking which would put responsibility back in the owners’ hands, whereas we have limited liability ownership today within the banking community.  A CEO can take outsized risks, but is not directly responsible.  The older partnership model, wherein there was unlimited liability that flowed to the directors of the business, really did keep people with an awareness of risk when they knew that the buck stopped with them, as opposed to the buck stopping with the taxpayer.

Laurence:  Yes.  Under limited purpose banking, if you want to run a traditional bank like we now have, you have to have unlimited liability.  Any financial intermediary that wants to operate with limited liability has to operate as a mutual fund company, solely, whether it is an insurance company, a hedge fund, a private equity fund, a commercial bank, or investment bank.  They all have to operate, if they want to have limited liability and not have their yachts and their villas on the line if they lose money, just as mutual fund companies.  If they want to borrow money and gamble, then they have to operate as unlimited liability.

In fact, if limited purpose banking had been in place, Lehman Brothers would have had to operate with unlimited liability, and consequently Dick Fuld today would be on the street, penniless, and Jimmy Cayne, who ran Bear-Stearns down to the ground, would have to be on the street, penniless, and Joe Cassano, who ran AIG into the ground, would be penniless, and Anthony Mozilo, who ran Countrywide Financial, would be penniless, and also the guys who ran Merrill Lynch down the tube.

David:  And with less of a tan.  This is interesting.  In today’s marketplace we finally see a comeuppance with the reality that maybe our house is not in order, maybe the folk in D.C. are not solving the problems.  Perhaps you could speak to this last point.  Politics will become a significant issue here between now and 2012.  Do you think there is going to be an alternative to the two-party system that we have, not necessarily the Tea Party?

Laurence:  Yes, I’m pretty confident we are going to have a third party candidate.  I have been talking to one, and working closely with him, and he is very interested in these purple plans, so I think we will have an option for the voters come fall a year from now, and they can really choose, not so much personalities, as plans.  What kind of policies do you really want?  That is what we are trying to offer them in the next election, and that is why I am putting up these purple plans for people to actually focus on, and they can go there and endorse these plans within the url.  If we can get millions of people to endorse these plans, we can make a difference.

David:  Well, let’s do our homework on that:  thepurplesocialsecurityplan.org, thepurpletaxplan.org, and thepurplehealthplan.org.

Laurence:   And soon we will have The Purple Financial Plan up, as well, which will concern limited purpose banking, and a bunch of other plans, as well.

David:  Clearly, we need to fall in love with something more than personality.  It has not served us well under any administration in probably the last 30 years.  If you have something strategic to offer, then by all means, put it on the table.  I think our society, as a whole, will become more results oriented.  Show us that you can do the job, and not just speak in platitudes.

Any other thoughts, either market-related, equity or fixed income-related?

Laurence:  Well, it is a really volatile time, I think.  We have a lot of collective panic striking, what we are seeing today, as we speak on the phone in this interview, and the market crashing because of the downgrade, and the concern about Italy defaulting, and the market has a long way to potentially go down, so I can’t say for sure.  I think the market is overreacting to these particular events.  We will be able to get through these things eventually and work them out, but there is no guarantee.

David:  Well, for both the U.S. and Europe, we have a long road ahead, if and when we choose to face the actual issues and stop grandstanding politically, those issues have to be addressed head-on with a very strong strategic plan, and I hope that the clarity of your thoughts holds sway with anyone who is in office, both in the present tense and future tense.  Thanks for joining us, Larry.  We look forward to visiting with you again.

Laurence:  Same here.  Take care.

Kevin:  David, one thing that I just bristle at is when I hear that the government is going to regulate something, because almost always there are special interests involved and the regulation doesn’t pay off. He basically said it:  The Dodd-Frank bill, 2700 pages, is not the solution.  But the solutions that he is offering, these purple plans, part of what makes me hesitant to think that they are actually going to work, is that the power structure, the Goldman-Sachs, and the big power structure that influences Washington to the degree that it does, would have to give up that power.

David:  Right, and on a voluntary basis it’s just not going to happen, but I think that over enough time, and maybe not even in this election cycle, but if you move a goalpost back, to four years beyond…

Kevin:  You mean the Goldman post?

David:  The Goldman post (laughter).  Kevin, you hit an interesting point, because there really is a political charade between the Republicans and Democrats.  We have been defined as one or the other, across the country, and we really don’t think in terms of being Americans, looking for an American ideal.  It really is defined by the party loyalty – what document did you sign?

Kevin:  What radio program do you listen to?

David:  “Oh, you’re one of those.  I pity you, I pity you,” if you are on the other side.  So, that is where we are, Kevin, where we really don’t have the ability to think as Americans, but we think as Republicans or Democrats.  I find it refreshing to think in terms of the purple plans that blend and say, “Beyond the document that you have signed and the oath that you have taken, the secret handshake that you have learned, and the party that you have joined, are you more basically an American?  And if so, is there something that we can all agree to?”  It assumes a cooperation, and it assumes an end to the charade, not driven by policy makers, but by the American people.

Kevin:  David, it reminds me of a decision point that my wife and I had to come to, back in the mid 1980s when we got married, where we sat down and we cut up every one of our credit cards.  We went back to a 100% capitalization plan, and in a way, these purple plans are saying that.  They are saying the too-big-to-fail guys have been using leverage, knowing that they don’t really have to pay.  Anytime they lose money, they don’t have to pay, it just gets transferred to the taxpayer.  What we are saying is, “No, you are going to have to have the money.  In fact, anybody who does any of this investing is going to have to have the money.  Otherwise we are just going to cut the credit cards up.”

David:  Exactly.  “We, the people, determine the credit cards are no longer accessible.  We operate off a debit card system only.  Got the money?  You can spend it.  Don’t have the money?  Sorry.  So, so sorry.”  I like the realism that is in that, and I like the hope that is written into it, too.

Is there a perfect plan?  No, but here is again where we started the conversation today, where I think Dr. Kotlikoff should be praised.  He took a stab at it.  If you think you have a better solution, write it up, and be willing to take the criticism that comes with not having it perfect.  But that’s great.  He is doing something that represents a replacement system.

As we have talked about, in Thomas Kuhn’s Structure of Scientific Revolutions, one of the things that has to be in place for there to be a paradigm shift, is an alternative system.  So whether it is this one, or whether it is a different one, we are going to have to come up with an alternative system before the old broken system is replaced.  There is no evolution within the spheres of politics and economics.  There will be a revolution of thought, where one system is displaced by another.  So, again, if this isn’t the best – no problem.  Maybe it is the best, but we have to have the alternative in place to substitute for the old and broken.

Kevin:  David, we have been talking about fourth turnings.  We have been talking about how pain needs to be felt before there is a change.  Herman Cain said, “When they feel the pain, they will see the light.”  (laughter)  That’s what he has been saying.  But when we do feel the pain, it sure would be nice to have rehearsed a couple of solutions so that they would be available to be accepted.

David:  That’s right.  So we keep an open mind and continue to explore different ideas and different thoughts, and are appreciative of both the issues and potential solutions.

Posted in TranscriptsComments Off on August 31, 2011; The IMF Has Effectively Pronounced the US Bankrupt: An Interview with Laurence Kotlikoff

June 15, 2011; A Gradual Sudden Catastrophe


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

February 9, 2011; INFLATION: No Surprise to Anyone Except Americans


The McAlvany Weekly Commentary

with David McAlvany and Kevin Orrick

Kevin: David, we are talking to you via phone in Orlando, where you are meeting with clients, and you are on your way to the Bahamas next week for private consultations with clients.

I wanted to mention something. There was a Wall Street Journal article just a couple of days ago, speaking of manufacturing firms going long on the products that they think they are going to be using over the next 3-6 months.  Did you see that article, David?

David: Kevin, it was interesting, and we talked about it a little bit on Friday in our comments on our Wealth Management website.  The point was this:  They are increasing stockpiles, and to look into the details of that, I think, is pretty important, because essentially, the rise in commodity prices has turned the major manufacturing firms into speculators.  It may be prudent for the CFOs and CEOs to be organizing the purchases this way, but it is worth discussing, anyway.

Kevin: Speaking of speculators, what are they speculating on? Is it that their sales are going to be increasing, or is it that the costs of making those things that they sell will be increasing?

David: It is the latter, Kevin.  When you have resources that are increasing in price and these are your basic input costs going into manufacturing goods, what they are doing is stockpiling, both those resources, and the finished products themselves, so you are seeing inventories get quite bloated.

What someone may describe as strategic, others would describe as opportunistic, if they are speculating on the price of the commodities that they are stockpiling.  Some might even view it as a necessary precaution, to avoid having to pass on those higher costs to a very wage-constrained middle class. That is, I think, the real cost to be looked at, being unhedged from a rise in input costs, because it can very quickly squeeze your margins.

Kevin: We do not usually think about spices going up, for instance, but the McCormick spice company has pre-purchased a lot of extra spices.  Cotton has been skyrocketing.  You mentioned last week that the price of wheat was contributing to the unrest in the Middle East and in Asia, so it seems that we have price inflation right now, though it does not seem that the consumer here in America is really feeling it.  But manufacturers, at least the smart ones, are seeing something ahead of time, and they are looking down to the end of the horizon and saying, “I’d better buy it now, or I am going to have to raise my prices later.”

David: It is a bit of a balancing act, because if they do not do something to hedge those input costs, then they are looking at absorbing those higher costs and impacting profitability significantly.  It is eating into profitability.  If the price move is considered short-term in nature, or something very cyclical, then generally, they will just absorb it and try a very reasonable increase if they can get away with it, in the cost of the consumed product.  We have seen that with the Snickers Bar shrinking in size.  We have talked about the cereal boxes, my favorite of course, also shrinking in size, and changing the color scheme so that you will not perceive the change in the size of the box.

There are those games which can be played, but the real risk is to be the first to raise prices and shock the consumer, leading to a shift in purchasing habits, and a loss of market share, because those have long-term consequences.  If you end up driving away the consumer that you have spent so long fighting for in the marketplace, the odds of getting them back are pretty slim.

That is the great risk, losing competitive advantage as they move from one product to another.  Successful marketing is about bringing those consumers into the marketplace to buy your product, as opposed to someone else’s, even though there is not very much difference between the two of them.  Price can be something which is very disruptive, if that price increase is noticeable, so if nobody wants to be the first to raise the price, and there is the idea that perhaps they can just hedge it out by buying or stockpiling it.

So you see corporations doing something quite similar to what we have seen several Asian and North African countries doing – stockpiling significant quantities of commodities.  In some cases they are consumable, and in some cases they are industrial and will be consumed, but not by the belly, as they are put into products.

Kevin: Is this something that we can consider to be a cyclical price increase?  We all know that there are seasonal cycles, and sometimes supply and demand cycles, and they come and they go, oftentimes they will go away, or could this be a portent of something longer-term?

David: It is interesting, if you look at a chart of the CCI today, the Continuous Commodities Index, or the CRV, they are both moving up significantly, CCI to recent highs again.  To me, we are looking at a short-term inflection point, perhaps lower.  We have everyone who is now going “long the commodities” and it is a good time for those markets to take a step back.

We may, in fact, have had the reason for that here in the last day or two, with the central bank in China raising rates, yet again, the third time in a very short period of time, trying to cool off their economy.  We will see if that has an impact.  Certainly, at least here in the first couple of days since that decision, we are seeing a bit of an impact into the copper market and some of the industrial commodities.

It would be normal to see the commodity index drop back, but I think what the CEOs and CFOs of the Fortune 500 companies are considering, is not a cyclical move higher, but maybe even a structural move higher, in commodities.  It would be very similar to what we saw in the 1960s when, finally, copper stepped out and broke out to new levels, and as we moved into the 1970s, it got into nosebleed territory, but it was a new plateau.  Up until the 1960s and 1970s, it had been range-bound, that particular commodity, and it finally broke out into a new kind of stratosphere, and we really have not gone back since then.

Is that what we are in the process of doing?  That is probable.  How probable, we will see, but I think the odds are pretty strong.  There are some issues to be dealt with, though, and some details to consider.

Kevin: That takes me, then, to the retail sector.  We have inventories seeming to be expanding right now.  That also would be interpreted by the mainline media as people looking ahead and saying, “Hey, business is back, we are in a recovery, let’s go ahead and expand our inventory.”  Is that what we should read from expanded inventories, or is there something else behind the curtain?

David: To me, it seems they are taking on a significant amount of risk, because we are still in an environment, and we will talk about this in a few minutes, where the two elements of unemployment and housing are really significant, still.  It is worth considering, if you are manufacturing new goods to be sold, what is the likelihood of turning that inventory over quickly?  If you are not going to turn it over quickly, then you have issues of that inventory either being rendered obsolete, or you have to sell it at a steep discount.

Instead of stockpiling the commodities, manufacturing the product, accruing your costs on that kind of product now, with the idea that you are going to save yourself billions, or add to profitability in the billions of dollars – guess what?  In fact, you end up taking it on the chin, so what looked like a smart equation ended up not being so smart, simply because there was not enough inventory turnover.

Kevin: What we are seeing then, both in the manufacturing side of things, and the inventory side of things, may be a little premature, because we are not necessarily seeing a pickup in consumer spending, are we?

David: Not adequately, and I think when you look at unemployment and housing, you can clearly see why.  To recap, we do have a pickup in manufacturing, which, in our opinion, does not relate directly to the return of the consumer to the marketplace, or a robust economic environment, but we feel that the next wave of product that will be available will be at a steep discount.  If you are talking about retail products in the second half of 2011, or the first half of 2012, you are talking about a steep discount, as retailers try to move products that they were filling the pipeline with, maybe a little too early.

Kevin: Maybe what we are seeing is a prediction from you that this next Christmas shopping season, there are going to be steep, steep discounts on items, a little like we have seen in the last year or two, with the so-called financial crisis, where prices are cut so dramatically that it looks like there is an increase in sales, but really, the profitability of the companies has just gone right out the window.

David: I think for 2011 and 2012, giving gift cards could be pretty smart, because not only will you get the after-Christmas discount with those gift cards, but you may even get a pre-Christmas surprise in terms of discounting.

Kevin: That leads me to the question of employment, because the unemployment numbers they have been publishing have been much better numbers – in fact, suspiciously better unemployment numbers.  A person cannot really go Christmas shopping unless he is employed.  We have talked about this before.  You can only get so many government bailouts.  How about the unemployment numbers?  Are we seeing an increase right now in the job market of employed members to that market?

David: I think this is where something definitely needs to be clarified, because while we look at U3 and U6, the standard unemployment numbers, those numbers seem to be improving, from 9.6 to 9.4.  Now U3 is 9%.  That would imply that people are going back to work, when, in fact, that is not the case.  As we pointed out on this last correction from 9.6 to 9.4, the change had to do with people coming off the unemployment rolls.  In other words, they had just been on so long that they fell off, and were no longer counted.  That did not mean that they actually had jobs.

You can see that reflected, if you look at recent Gallop polls, there is quite a different story being told in the unemployment numbers, and we can talk about that in a minute, but the biggest issue with this last correction, down from 9.4 to 9%, which seemingly, is a spectacular move in the right direction, is that there is really one significant factor which contributed to that, and that was seasonal adjustments.

When statisticians put these numbers together, there are extraordinary things that they want to take into account.  For instance, in the fall you have a seasonal adjustment, which is applied, because you have an excessive amount of purchases made in light of kids going back to school.  In wintertime, of course, you have Christmas, which is out of the normal buying pattern for people to be buying as much as they do, coming into the Christmas holidays.  These kinds of things tend to distort economic activity, so what the statisticians have done it to create these adjustments to accommodate that.

Here is the real issue:  We had John Williams on the program a number of months ago.  He has done some of the work looking at both the benchmark revisions and the seasonal adjustments.  The point that he makes is that these seasonal adjustments are particularly healthy, and helpful, in the context of a growing economy, but when you are in a recession, they are using the same seasonal adjustments that they would in normal times, and it tends to distort the numbers greatly.

In fact, the U3 unemployment number would have risen to 9.8% from 9.1% in December, if it were not for the seasonal adjustment.  So we actually have the opposite thing happening.  The unemployment situation is getting worse, not better, and yet the number is saying that it is actually getting better, which is going to be heralded, and has been advertised broadly by Wall Street, as further significant evidence that we are, in fact, in recovery.

Kevin: That reminds me of getting in the car, in the past, not necessarily knowing the direction that I was driving, and for a period of time (this has probably happened to many people), driving the wrong direction thinking that I am perhaps driving east, when in reality I am driving west.  It is pretty embarrassing when you do it, but it is not devastating.  What we are saying right now is, we are really heading south on the employment numbers, yet the people who are listening to the statistics right now are thinking that we are headed north.

David: That is exactly right, and I think this is one of the things that really skews an investor’s judgment, is that they are assuming they are working with legitimate numbers.  The more I study China, and the issues of investment opportunity there, the more I realize how important solid information is, and there is virtually none, particularly on that front.  Having good, fundamental analysis on Chinese companies is impossible.  We just got China’s GDP numbers and they were, in fact, better than 2009.

Kevin: Weren’t they over 10% this time?

David: Yes, 10.3, up from 9.2.  Things seem to be humming along nicely in China, but there has to some suspicion laid on the veracity of the numbers, themselves.  The error measurements that I think can be applied to the Chinese GDP numbers could be anywhere from 2-4%, which, again, if you are moving out over the next 2, 3, 4, or 5 years, or even looking back over the last 2, 3, 4, or 5 years, if you were off by 20, 30, even 40% on your total numbers, then no, the economy has not grown quite as interestingly as some think.

I think one of the things that came out of the recent numbers from China had to do, not just with the main GDP number, but particularly, retail sales.  The highs were into something we will talk about in a bit, which is banking issues here in the United States, but retail sales in China fell, in the early 1990s, and have never recovered.  They fell from 45% of GDP to 36% of GDP, and everyone is hoping, and assuming, that we will see the consumer in China be the next great driver of bull markets, both here in the United States, and around the world.  They are supposed to be the driver of recovery.  They are supposed to be the growth engine of tomorrow, as the lead in the emerging markets, and we are just not seeing it, and the most recent GDP figures from China would say so.

The areas that saw significant growth in terms of retail consumption were, interestingly enough, gold, silver, and jewelry, which rose by 46%, and of course, right in line with the real estate bubble in China, furniture is up 37%, appliances and audio/video equipment also up 27.7%.

A major boom being real estate, which to our minds, is clearly in a bubble mode, not unlike 2005 and 2006 in the U.S., but with inflation comes an increased demand for investment dollars flowing into gold and silver.  We saw that in India, where the investment component in India, the growth there, was shockingly high for 2010, and it is not a surprise that in China, as well, the investment demand for gold is off the chart.  Those in the World Gold Council actually think that China’s consumption of gold could exceed India’s this year or next year.  We are talking about massive quantities, between 600 and 800 tons of gold per year, in terms of consumption per country.

Kevin: We have talked about this in the last few weeks – China has now become the largest producer of gold in the world, surpassing even South Africa, yet they are consuming twice what they are producing, or more, so we are not really even seeing this increased production.  It is never even really coming to market, is it?

David: No, in fact, over 300 tons is produced and consumed.  In addition to that, 209 tons was imported this last year, on top of what they produced.  So the numbers are moving significantly, and the investment environment is such that people are sensitive to inflation.  They are sensitive to gold as a real asset class, whereas in the West, as a result of generations now, certainly decades, of indoctrination and re-education, investors look at paper, and paper only, as a legitimate asset class, whether that is stocks, bonds, insurance products, or what have you, whereas in other parts of the world, with a little bit more connection to history, and frankly, less developed financial markets, they still have a deep appreciation for the metals, themselves.

Silver, right in line with gold, has seen a massive increase in imports and in consumption in China – both metals, the story of growth in China.  If it were me, I would not be looking at the Shanghai Stock Exchange, as much as I would the consumer demand for the metals in light of monetary policy, starting here in the United States, and being very impactful throughout the world.

Kevin: David, it seems to me like we have a theme running through this, both with what we were talking about when we first started the show, with manufacturers buying goods now in an effort to try to defray inflation in what it is going to cost to manufacture their goods down the road.  We have the Chinese, and we are being told there is huge growth in GDP, but a lot of that growth in GDP is inflation hedging – people buying gold and silver.

There is a thought, in the Chinese markets right now, that whatever loans that these banks are giving out, and there is a tremendous amount of borrowing in China right now, whether they are nonperforming or not, it can just be evened out over time, a little bit like it was a decade ago.

David, the people who were here in the 1990s and saw the Chinese banks come back out of the 1990s relatively unscathed – is that something that we could see again, or is the consumer someone who loses this time?

David: I think, just in review, if you go back ten years, 20-40% of loans in the Chinese banking system were nonperforming loans.  That is a massive, massive amount of nonperforming loans, but ultimately, the two things that helped them out of that dilemma of a vast number of nonperforming loans, was aggressive recapitalization by the banks, in addition to gross domestic product, which grew at an average of 10% per year.

Kevin: And that was funded by our consumption on this side of the Pacific, wasn’t it?

David: That is correct.  The U.S. consumer, in essence, was partially responsible for helping bailout the Chinese banking system.  There are several things, though, that I think are worthy of note, because it really is the Chinese household which has been behind the curve for 10-15 years now, and it is worth mentioning because I think the U.S. household, and the European household, is in a very similar position today, because we have some similar themes going on – incredible fragility in the banking system, both in the ECB, and in the U.S.

That partially explains why the European Central Bank and the Fed are keeping rates so incredibly low.  They are keeping rates incredibly low so that they can rebuild the balance sheets at the significant banking institutions.  Again, that has echoes of China circa 1993, 1994, 1995.  If you were looking at the crisis in banking in the 1990s in China, you realized that a tremendous amount of wealth was transferred from the household sector to those banks in order to repair the banking system.  They did that primarily through the difference in interest rates, keeping rates incredibly low, and basically robbed the household, or depositor, of interest income, and that spread, the interest, instead went to the bank directly.  How similar is that to what we have today?

Kevin: I think about the older people we talk to who thought they were going to be able to retire on CD or interest income, and at this point they are having to go and get jobs, perhaps in their 70s, perhaps in their 80s, because interest rates have been kept unnaturally low for so long.  You are saying that this is really just a bailout straight to the banks.

David: Yes, there is a finance professor at Peking University, I have mentioned him before in past shows, Michael Pettis.  He is a fascinating character.  He writes a regular piece for private institutions, and we are fortunate enough to take a look at that.  Some of this thinking was distilled by him.  There basically were three or four different solutions that the banks had in China, and our banks have, too.  One was what we saw in the 1930s where you just simply default on paper, that 20-40% of nonperforming loans, or the loans which we are currently keeping off balance sheet, which the FASB has allowed us a free pass on, and is just completely ignoring in terms of current market value.  Thus, the credibility of the banks remain intact, and the balance sheets appear to be healthy, we are just not looking at any of the bad loans.

What we saw in the 1930s is not likely to happen, where you simply default, and the depositors absorb the full loss.  That is not likely to happen.  An alternative is a government bailout, followed by an increase in taxation.  We have certainly had our fair share of that in the United States, and that does tend to spread the cost evenly.  This is what we have referred to in the past as debt being democratized, and then in the context of collapse, the consequences and risk being socialized, where all households bear an equal weight of the loss through an increase in taxation.

But where banks begin to come ahead on this is where you manage interest income and instead of that interest, short-term rates, going to the depositor, they go to the bank instead.

Kevin: That question has come up many times, when a person says, “How come I am only getting 1%, or maybe 2% on my CD?  But when I go to take a loan out, even a mortgage loan, which is being kept unnaturally low, it is 4, 5, 6%?”  That seems to be quite a difference in the profit from the saver, the person who is putting money into a CD, and what the bank is making on interest.

David: Yes, not only does the banking industry benefit, but our whole debt structure benefits from rates being kept artificially low.  It is an interesting concept if we can explore it a bit, the idea of there being something of a resolution to our debt, and an absolution of our debt, by these rates being kept so extraordinarily low.

Again, I credit Michael Pettis with putting these numbers together.  If your rates are too low by 4%, or 400 basis points, over a one-decade period, you are looking at the equivalent of a 25% debt forgiveness.  If your rates are too low by 8%, which is of course an extraordinary amount, but assuming that the risk implied in a certain market is something like 9%, and the current going rate is 1%, that 8% differential where the debt is being price 8% too cheaply, in a matter of a decade, you are looking at a 50% forgiveness of the total stock of debt.

You have to wonder, is that what Bernanke has in mind, a rebuild of the bank balance sheet?  Certainly, he is not only head of our money system, but also of our banking system, so you would expect him to defend, tooth and tong, the system which he serves, and certainly rebuild it first, even if it is at the expense of the consuming middle class, even if is at the expense of Joe and Suzy Lunchbox, and the interest income, or the retiring class, which depend even more heavily on their interest earnings.

Kevin: So what you are saying is, this debt forgiveness is actually paid for by the common man, and even still, the common man who has done things correctly, who has saved money, who has put money in the bank, who is trying to earn interest.  These are not people who are necessarily going further and further into debt, these are people who actually have saved a little bit of money and are trying to find some way of either preserving it or making it produce growth or income.  That common man is basically shifting any interest income that he would normally get over into bailing this system out.  It is not true debt forgiveness for the person, it is debt forgiveness for the bank, isn’t it?

David: Exactly.  We are talking about a direct transfer of wealth from household depositors to banks and borrowers.  As that wealth is transferred, the unintended consequence is into household consumption.  I think that is where you can look at the Chinese and say they went from 45% of GDP being tied to consumption, to 36%.  Why?  Again, they have rebuilt their banking system and put themselves on a different trajectory, but at the cost of households, and to realign their economy now is going to be difficult.

We are at the front end of that, where we are seeing the direct transfer of wealth from depositors to banks, and the question is, can there be anything but a contraction in consumption as a percentage of our own GDP?  This implies a very significant step-sequence.  There is no way for the U.S. Treasury to issue less debt in the next couple of years.  They will be issuing more and more debt.  As we look at 14 trillion and consider throwing in Fannie Mae, Freddie Mac, student loans, and other off-balance sheet funding, this brings our total national debt, instead of the 14.3 trillion, which it is capped at, to actually 20.7 already – 20.7 is our official public debt.

You can even get that from the Treasury’s website, where they do, in fact, count Fannie Mae, Freddie Mac, the student loans, and off-balance sheet funding, as a part of the total stock of debt.  We are playing games with ourselves if we assume that we are only in debt to about 100% of GDP.  We have far surpassed that already, and we will need to continue to issue IOUs to make up our difference in spending versus income.

Again, if it is the household that is contracting in their consumption, you know that government has to step in and spend that much more to make up the difference, so that our GDP numbers do not, in fact, go into the red.

Kevin: You are talking about the issuance of treasuries.  It would be far healthier if we were issuing treasuries and actually selling them to people who were buying them, other than ourselves.  The Federal Reserve, which is our own people, our own government, basically, even though it is not a government entity, is the largest holder of treasuries right now in the world.

David: That is the scary point.  You would like to think that it is a real market, but it is not a real market.  Other central banks, which typically have bought treasuries for political reasons, not as an investment, but because it opens up trade agreements and things of this nature, are a large component of holders of the treasuries that we have issued, but the single largest holder of treasuries is the Federal Reserve.  It is scary when you realize how much of a non-market the treasury market actually is.

But it underscores one other point, which is this:  We saw massive buying in recent weeks in euro bonds.  We had the issue of European Financial Stability Facility bonds.  This was about a 61 billion-dollar offer, which was bought up largely by Asian banks and central banks.  There were 500 bidders, and this was the first bond of this type – 61 billion dollars worth of bonds snapped up with quite an appetite.

When we talk about the treasuries that we have in the United States, when we talk about the dollar and how fragile it is, you realize just how important the euro is to our foreign creditors.  The fact that Asians were buying up these bonds, left, right, and center, should send a very clear message to investors that they have no intention of letting the euro fail.  They do not want it to fail because they do not want to remain with the dollar-centric monetary system that we have had since the 1940s and Breton Woods.  There are radical things occurring, both in the debt markets and the currency markets, but it is telltale when the Fed becomes the largest holder of treasuries.  In my mind, that is a significant tipping point.

Kevin: I was just thinking: what an irony.  We just talked earlier about how China is not only producing the most gold, but they are buying the most gold.  And yet, at the same time, we are producing the most debt, and we are buying it back from ourselves, because we cannot sell it to other people.  It makes you wonder how sustainable it is when somebody is producing paper out of thin air and then buying it from themselves, and on the opposite side of the ocean they are producing gold and buying it from themselves.

David: I think it is worthy of note that just here in recent weeks, the Industrial and Commercial Bank of China, the ICBC, penned a deal with the World Gold Council to create what was called the ICBC Gold Accumulation Plan – ICBC GAP, as it has been called.  This allows investors to buy as little as 1 gram of gold per day, into the equivalent of a savings account, and they can either take delivery of that in gold, or they can just accumulate it in the plan, as a savings program.

When you have the government encouraging investors to buy gold and silver in that economy, as they deal with being tied to the U.S. economy, our consumption, our export of inflation globally, and the implications into the foreign currency markets of our inflation being exported globally, this is an investor base that says, “Well, we have to do what we have to do.  Even if it is 1 gram at a time, we are going to save our personal balance sheet.”

I think it is fascinating that we are on the cusp of changes in China – we are not there yet, but we are on the cusp of significant changes in China, where the consumer has more money to spend, where instead of the household taking it on the chin within China, instead of the household paying the price for manufacturing growth in China, we do have shifts taking place, shifts we talked about in recent weeks.

In early January we talked about one of the largest provinces in China raising their minimum wage between 18 and 26%.  These are massive, monumental shifts, because what it means is that for the U.S. consumer to now buy those same Chinese goods, exported from China, imported into the United States, we have one more version of inflation on our side of the pond.  Not just monetary inflation stoked by the Fed, but now price inflation stoked by rising wages and rising costs to the goods that are being exported from China.

The U.S. consumer ends up getting squeezed on several fronts.  Not only on the backs of the U.S. consumer is the banking industry being rebuilt, but we are also going to face higher prices with consumer goods, as well.  The one area we were sort of on balance – seeing deflation, if you will, because even though we might see monetary inflation on the one hand, it was offset by cheaper goods being imported and made available to us at distribution centers like Walmart – no longer.  Those prices move up, too, in lock-step.

I wonder when the U.S. consumer is going to wise up, as the Chinese consumer and the Indian consumer already have, to the necessity of owning gold – the necessity, not the option.  It is not another asset class that maybe is in favor, maybe it is out of favor, maybe you want to own it, maybe you do not, maybe you believe in the long-term story of gold, maybe there is no veracity to it, whatsoever.

But we are moving to the point where it is simply necessary, as an insurance policy.  That is the way we have always looked at gold, as an insurance policy, but one that is absolutely critical to any portfolio in any quantity.  I look forward to the day when the World Gold Council can accomplish the same thing that they did with the industrial bank in China, and do that with an HSBC or a J.P. Morgan, here in the United States.

I just noted that J.P. Morgan, here in the last week, is willing to take your gold.  Interestingly enough, J.P. Morgan is willing to take your gold and silver as collateral on loans, so they can appreciate the value of gold, but they would like it as collateral to loan you money.

Kevin: That is the kind of collateral that I would take.  I have no problem loaning almost anybody money right now if they want to put up the same amount of collateral in gold, how about you?

David: (laughter) That is right, that is right.  It is a different arrangement when the ICBC is encouraging ownership of gold, and not putting your gold in hock, so we are making progress here in the United States, but not much.  I think it is going to take something radical, either in the interest rate market, or in the currency market, to have U.S. consumers wake up to the fact that gold is, in fact, a necessity.

Kevin: There is a fascinating chasm, just talking to people here in America, versus talking to people overseas, in the understanding of gold and what role it plays in preserving assets.  Here in America, there seems to be just almost a dearth of buying of gold.  The price of gold, when we see it fluctuate on a daily basis, we all know, has virtually nothing to do with American buyers or sellers.  They seem to be asleep.

It is the Asians, the Middle Easterners, the Europeans, who seem to understand at a much quicker pace, probably because they have seen currencies fail before and do not have the luxury of a reserve currency, but they seem to understand, and be moving this market.

This market correction that we are in right now, I would like to hear you comment on it, because it has been shallow, at best.  We really have not had a true, good old-fashioned market correction in the gold market in a long time.

David: It is fascinating, because the average correction over the last ten years, off of new highs, has been a minimum of 15%.  The largest was in the fall of 2008, a 30% correction before gold recovered and finished the year positive for the year by about 5-6%.  Even in the worst-case scenario, the drop was overdone to the tune of 30%.

If you look at this as a correction, you almost have to say,
“What correction?”  It is down 6½ to 7% off of its peak.  I would relish the opportunity to buy at much lower prices, and the market has been stubborn.  Often, we look at the platinum group metals and silver as the leading indicator for how deep the correction would be, and, look at palladium, look at silver.  Are they taking a nosedive?  Is silver off $1.25, $2.00 per day, five days in a row?  Whereas we have covered 25-30% in a very short period of time.  That is classic silver moves on the downside.  Haven’t seen it.

What about platinum and palladium?  Palladium is still north of $800, off of a low of $160, and it is not giving up any ground.  It has been very, very, very stubborn.  These, again, are generally very volatile metals, metals that give up a lot on the downside very easily.  The question we would have is, are the market dynamics changing?  Are we getting closer to moving from what we have described as a linear movement – two steps forward, one step back – to a parabolic move in the metals?

I think we could see prices move much higher, and for anyone considering the gold market, I think your risk is not being in the market, I do not think your risk is on the downside.  But the charts that you need to be looking at are the charts of tomorrow, not yesterday, where we look at price action moving higher, and not lower.

Kevin: So what you are saying is maybe to back away from trying to micro-time this market.  This may not be the timeframe to be out of this market just to save a few extra percent.

David: What a shallow correction in gold, the correction that we have had being incredibly shallow, means, is that the market is just remarkably strong – absolutely strong.  Certainly, we have gotten some support in recent weeks from the events happening in the Middle East, but if you will note, oil has sold off significantly as the headlines have waned, and they are less sensational, and gold has not given back any at all.  Neither has silver, neither has platinum or palladium.  The stress metals are not under stress, themselves, even as some of the pressure and tension is being relieved in the international political market.

I think the bottom line is simply this:  We have inflation globally.  We have inflation in the United States, and have for years, but it has been covered up by cheap goods that have been imported from China and the third and developing worlds, and that is largely going away, as the input costs are on the rise, and as the minimum wage costs are also on the rise.

In China, we have gold, jewelry, premium tea, stamps, calligraphy, art, jade – everything is surging, as you would expect to see it surge, in a classic inflationary environment.  We have not seen the classic inflationary environment here in the United States, largely because people impute so much value to official government statistics.  We talked a little bit about unemployment.  We talked about those numbers being adjusted.

In the past, we have talked about the CPI weightings in the United States.  It is absurd.  We look at health care and as a part of our inflation number in the United States, it is 6½% of the health care number.  Meanwhile, it is 17.6% of GDP.  Health insurance, which is something that we all look at and generally absorb 20-30% increase in costs every year, makes up less than ½% of the CPI index.  It is patently absurd.

This is the issue:  Inflation is sneaking up on Americans.  It is not sneaking up on the rest of the world.  So you have people buying gold and silver, as a defensive posture against the consequences of inflation, everywhere else in the world, why is it not happening here in the United States?  Because we actually believe that it is not happening to us!  And it is.  It is.  We just happen to have so much undying faith in the Bureau of Labor Statistics, the Ministry of Truth, if you will.  It is frankly mind-numbing to me, Kevin.

Kevin: David, I hope that it does not sneak up on you and me, and our client base, so let’s just make sure that as we see the inflation coming, we take care of business before it happens, like the rest of the world.

Thanks for joining us today, David, from Orlando, heading to the Bahamas.

Posted in TranscriptsComments Off on February 9, 2011; INFLATION: No Surprise to Anyone Except Americans


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