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The Fed’s New Social Justice Mandate
June 28, 2022

“We already have the zombie companies that even today can’t pay their interest expense from current cash flow. We may then reflect on the rates, which for so long they propped up these zombie companies. They were not reality. They were an expression of a policy preference. Right? And that’s the danger of policy preferences guiding the market forces. These companies shouldn’t exist. If they can’t even pay interest on their debt, what are they doing? They won’t be around long.” — David McAlvany

Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. 

Gravity’s an interesting thing. Physicists are still trying to understand where it actually fits in the whole scheme of things. But if you have two bodies, let’s say two stars that are circling each other, that’s a pretty easy problem to work out. It’s called the two-body problem. You start with just the initial condition and you say, “Okay, what’s the mass of these stars? How can they circle each other? What will that look like in a thousand or a million years?” It’s actually a pretty easy problem to solve. You add a third star, or let’s just say, even here with the earth and the moon, let’s say you add a second moon.

David: Harder to predict.

Kevin: Hard to predict. It creates chaos. There is no closed system, closed mathematical problem that can solve the problem because it creates a chaos, Dave, where if you had to make a decision based on that third body down the road, you would have terrible information and really would not be able to make a decision.

David: For at least the last decade, the third body seems to be central banks within the global economy.

Kevin: No doubt.

David: We could sort things out in terms of market pricing and the directional flow of capital, but then you introduce central banks and things get a little bit more complex.

Kevin: Well, I wonder, we think best intentions, “Oh, the central bank’s here to just solve the problem.” But strangely, Dave, a lot of times, you add politics to that, and it’s just amazing to me that the politicians get rich once they get into office and start to add different constraints to this third body problem. I’m looking at the economy right now, Dave. We’re not quite in a recession yet, but I’m looking at two groups of people. Unfortunately, there’s a huge divide between the rich and the poor right now. The rich seem to be still chugging along, thinking the economy’s doing just fine—unless they’re employers and they’re trying to figure out exactly how they’re going to give raises this next year to match the inflation rate. So the rich are going one direction, but the poor, they’re feeling this inflation right now. So, are we slipping further into a recession, as well as the constraints that we have right now with inflation and the pain that’s being felt by people who just barely make it anyway?

David: Yeah. The economy, at least if you look at last week’s release of the purchasing managers’ indices, the PMIs, show a slowdown in growth in the US. So we’re not in a recession now, but you’ve got these same PMI measurements around the world. The eurozone is in fact edging towards recession. The UK is unchanged, in sort of a low growth mode. Germany is definitely slowing as well. And perhaps not surprising, given the degree of currency decline this year, Japan had the strongest PMI numbers out of the G7, and that’s pretty characteristic of a major currency move lower, is there are some benefits to your exporting companies.

Kevin: Okay. So the thought on the two groups of people, Dave, there are those who are barely making the bills, and they’re seeing the inflation rate right now running eight to 10% if we just even used the government’s numbers. That’s not 8 or 10% that they necessarily had, but there’s still an awful lot of cash left over from COVID. I mean, we’ve seen ex-Fed chiefs basically saying, “Oh, we’re not going into a recession because we’ve still got trillions of dollars of unspent capital.”

David: It’s true, but I think that points to there being two consumers in the US economy. There are those who still have the balances because they didn’t need the money in the first place and it remains unspent. There are those who needed the money immediately, and it was a helpful stopgap and in fact paid bills, but that is gone.

Kevin: So they’re still flying. They’re still taking trips. They’re still buying things.

David: The first kind. Yes.

Kevin: Yeah.

David: Yeah. So those that have no problem absorbing higher costs at this point, they’ll travel regardless of fuel inflight costs. And then there are those who are pressured by every penny of inflation.

Kevin: Mm-hmm.

David: So the tale of two economies, two consumers. It’s remarkable that employment is strong and economic activity continues to find channels to flow through, whether to goods or now even more so towards services. But the seeming contradiction of economic strength set next to a very extreme anxiety over inflation. And the polling on our future financial outlook—decidedly negative. Again, it points to not an inconsistency, but two different audiences altogether, two very different households.

Kevin: So it’s a measurement of anxiety, actually. Those with liquidity right now probably don’t have the anxiety the people who are just not making their bills have.

David: None. Now they might be more concerned about volatility in the stock market because typically if you’ve got cash to spend and it’s growing in your bank account, you probably have assets too that are riding alongside it. So the fact that the NASDAQ’s off 25, 30% and your other indices in the teens to 20s—again, if you’re making it just fine, there’s less anxiety than if you’re barely making it. 

Some things that you hear in the last week, US retail foot traffic is off 4.9%. This is actually the fifth week in a row. Bloomberg reports 16.6% decline in traffic to home improvement stores, decline of 12.7% to malls and department stores. And again, supporting the idea that there’s just another household we’re talking about. 

You look at Dollar General and you look at Aldi, discount European grocer that’s now here in the US, they’ve seen the opposite—an increase in traffic in sales. Again, that supports the University of Michigan numbers being at fresh all-time lows. The anxiety is there. The consumer is being pressured, particularly the household who’s now having to look for substituting items, shopping at a cheaper place. Again, Dollar General and Aldi being a case in point. And some people are still shopping at Whole Paycheck—I mean Whole Foods. And then others are having to go to Aldi instead.

Kevin: Well, and we’re starting to see even here in Durango, I’ve got some friends who put a house on the market. Well, you could barely keep a house on the market for seconds just a couple of months ago. And with interest rates increasing, the Federal Reserve’s been raising interest rates, that’s playing over into the mortgage rates. We had some friends put a house on the market for probably what would’ve been the right price or even underpriced a couple of months ago. They had a showing on Sunday, and that’s it. I mean, they’ve got nothing else planned. There are houses, if you look at the market right now, that are coming onto the market and lowering their price from several months ago. But let’s go to the Fed because they’re moving interest rates up. We know that they have a lot further to go. They moved the federal funds rate up 75 basis points this last time. They’re talking about doing that again, but are they shrinking their balance sheet?

David: No.

Kevin: I mean, are they doing anything other than that?

David: No. And there’s even more chatter about the next 50 to 75 basis points on tap for July. But the balance sheet has in fact grown, not shrunk. Most recently up another 1.9 to $6 billion. And so yes, they can shrink their balance sheet, and yes, they’ve given us a timeline for that, and no, it hasn’t happened. And I think the consequences are there. Bloated balance sheet, is it of no consequence, is it of some consequence, is it of serious consequence? Survey says that the Fed’s inactivity on that front implies that it’s serious.

Kevin: But you have mixed messages coming out from the Fed. I mean, former Fed guy Bill Dudley, he’s saying that there’s a recession coming, but we’re not in a recession yet. Right? I mean, according to the numbers, we’re slowing down, but we’re not in a recession yet.

David: Right. Yeah. I mean, Larry Summers and Bill Dudley, previously Fed president in New York, sound like they’re either having dinner together and comparing notes or just come from a similar perspective. Not in a recession yet, but it’s fascinating to see how strongly Dudley’s views are being expressed on recession’s inevitability over a 12-to 18-month period, unavoidable in his view.

Kevin: Mm-hmm.

David: So what he does is, he gives four reasons why that’s the case. First being that employment as one of the Fed’s mandates is now being placed in the subservient position to the inflation mandate. So you’ve got those two mandates. Sometimes it’s difficult to pursue both, and they have the employment rate at 3.6. Now that’s subservient to an inflation rate which has gone wild, and so the inflation mandate is going to have to cause a compromise on the employment mandate. So jobs will be in jeopardy. That’s the conclusion. And that’s actually where Larry Summers goes. You’ve got to have years of 5 to 7% unemployment rates to solve the inflation problem, is his conclusion, because again, these mandates aren’t necessarily compatible. Second thing that Dudley argues is, the inflation focus has the Fed’s full attention. And in his opinion, they will be relentless. We’ll see if that’s actually the case.

Kevin: Volcker relentless? I mean, is that what he was trying to say?

David: Yeah. The third thing that Dudley points is that the current economic expansion is uniquely vulnerable to a sudden stop. And there’s three variables in play. You’ve got tightening financial conditions, which we talk about regularly and Doug does too in Credit Bubble Bulletin; a more restrictive fiscal policy. I guess any fiscal policy is more restrictive compared to what we had during the COVID largess. And then household savings, which is tapped out. And again, this goes back to there being two separate households. There are some who are just fat and happy, flying, nothing’s going to take them out of the post-COVID stretch your wings, get out, see the world, take your mask off, et cetera, et cetera. And then there’s others who are like, “We’re done. We spent what we had, and anything that we have to buy now—” And you can see it in the consumer credit numbers where all of a sudden—

Kevin: Well, how about savings?

David: —you’re seeing increase in credit cards.

Kevin: And savings. People just don’t save like they had.

David: Both in lockstep. So the savings rate now at 4.4% down from 26.6 in March of 2021, plus the consumer credit number is on the increase where people are having to use their credit cards more aggressively. Again, it’s not everybody, but that’s the second version of the household. And finally, Dudley argues that a hard landing is far more likely than a soft landing. So yes, a recession is coming, and no, it’s not going to be a nice one. It’ll be a rough and tumble recession given the historical precedence of rising unemployment as a consequence of meaningful inflation fighting by the Fed. And that’s again where Summers comes along, again, previously at the Treasury and in the Obama Economic Advisory Committee. This is just how the math works. So you’re going to have to have unemployment of between 5 and 7% for multiple years in a row to destroy excess demand, which is driving inflation.

Kevin: Okay. But I talked about the third body problem. Let’s take it to the Fed for a second. The Federal Reserve, just to have the mandate for price stability, to control inflation and employment, you’ve already got a number of mandates that we’ve talked often in the past. How in the world do you juggle those third bodies? But really, this is not a comment on Maxine Water’s body, but what if Maxine Waters was the third body, the politics of things? Right now, she would like to see the Fed completely change their mandates and focus.

David: Well, you’ve got a potential recession.

Kevin: Yeah.

David: You’re right. You’ve got a potential recession. You’ve got actual inflation. And into that mix of something on the horizon and something really under our nose that’s unpleasant, Maxine Waters introduces a bill.

Kevin: The third body. Yeah.

David: Already pushed through the house, by the way, and fully supported by the president. It assigns a new mandate for the Fed, coming from the actual document, to amend the Federal Reserve Acts to add additional demographic reporting requirements, to modify the goals of the Federal Reserve system for other purposes. And true, they’ve taken on other mandates in the past on a very unofficial basis. That is the Federal Reserve. And they’ve even stretched, too. We’ve been critical of this. We’ve talked to Paul Tucker about this, the fact that central banks really have no business addressing climate change.

Kevin: Right.

David: It’s not their lane.

Kevin: How about the stock and bond market? They don’t need to make it go up and down.

David: No, but that’s one of those unofficial mandates that they’ve taken on, price stability of a different nature, not just currency stability, but also stock and bond viability as a market. So they bring in something of a stabilizing factor.

Kevin: But now race and gender identity? That’s the new mandate.

David: Yeah. H.R. 2543 won’t take you long to read, it’s worth reading, makes the third operating objective of the Fed: racial equity, inclusion, and economic justice.

Kevin: How do you do that with the Federal Reserve, Dave? We’ll just give free money to the right people?

David: This is, again, Maxine Waters, to ensure the expansion of credit into select communities according to sexual orientation, gender identity, ZIP code and ethnicity.

Kevin: Huh. Wow.

David: It’s a reverse discrimination credit test, where lending quotas are implicitly mandated and driven by data collected that has nothing to do with financial status or ability to repay a loan. It’s no longer about math. In order to prove that no discrimination has occurred, new initiatives to lend and subsidized lending are being put on the Federal Reserve’s list of mandates. Social justice via monetary policy. What is this really?

Kevin: Well, and somebody’s got to pay for any of these special provisions. Whether it has to do with climate change, greening up the world, or racial equality, what you’re really talking about is political control of credit for a particular voting base.

David: Yeah. This is one of the reasons why we talked to Charles Calomiris back in 2019. Go back to that interview and the book that he wrote, Fragile by Design.

Kevin: Right.

David: It’s a must read. The conversation we had with him in January is that banking crisis is a choice. A banking crisis is the result of policies which are designed.

Kevin: Okay.

David: This is not as a plot to destroy the markets, but as a political preference played out. Dollars doled out to particular constituents with embedded consequences. And that’s where you end up with banking crisis because you end up with a misallocation of capital. So it is driven by politicians who would rather sacrifice future stability for a present tense political win.

Kevin: Right.

David: Controlling the flow of credit is the biggest racket in town.

Kevin: Talk about a powerful tool. If you have the flow of money, I mean, you’ve got everything.

David: Yeah. Credit has been a tool used, if you want to say abused, by politicians to solidify their base. Both Republicans and Democrats abuse it.

Kevin: Yeah.

David: So you get now a third rail for the Fed. If this does pass, already passed the House, president’s all for it, we’ll see what happens next. A third rail for the Fed where racial equity, inclusion, and economic justice—sounds consistent with the current zeitgeist—and is just a massively, massively complicating mandate that will inevitably run in conflict with the two existing mandates. You can already see they’re having a hard time squaring employment with price stability. Now, add a third complicating factor to employment and price stability—racial equity, inclusion, and economic justice.

Kevin: Wow.

David: That’s not hard to accomplish.

Kevin: And you said that this is already passed in the house?

David: Yeah. I mean, it was like, I forget, 214 to 207. It was not a huge margin, but a win is a win.

Kevin: People are scared to vote against stuff like this. Anytime you mention race or sexual preference, they’re scared to death to vote against it. It’s amazing how insane this is.

David: The implications of what this does to the central bank, I mean, for those who don’t like the central bank, you may cheer in a sort of

Kevin: Because it’ll end. This will end their run.

David: It will end the Fed.

Kevin: Well, good for that.

David: But I mean, the reality is, if you look at the system that we have and the way it functions and the requirement the Fed be a part of that, it is a bad idea.

Kevin: The chaotic third body problem.

David: Dudley has already pointed out how inflation concerns and price stability— Now price stability has to take center stage. Unemployment’s going to take a backseat with the two mandates. It’s not always possible for them to be equally and simultaneously achieved.

Kevin: Right.

David: I mean, talk about the politicization of the Federal Reserve. Recession is the means by which inflation will be addressed. Jobs will suffer. There’s no way around that.

Kevin: That’s economic justice.

David: Now try running a racial and inclusiveness screen on that scenario.

Kevin: Wow.

David: Run a racial and inclusiveness screen on every Fed decision and see how effective they are with any mandate, which is not to say that race and inclusion are not important social concerns. It just isn’t in the purview of the central bank and of monetary policy to resolve those social concerns. It literally is a redirection of capital. This is what Calomiris was talking about. Fragile by design. We don’t end up with banking crises accidentally; they are chosen. And again, it’s not even that the consequences are unintended. It’s that they’re so far down the line that no one cares. Take your political victory laps today and let the next generation deal with the chaos that you’ve created. To me, it’s angering, it’s galling because it’s so selfish.

Kevin: Well, and it’s political. We’ve talked so many times, Dave, about how a politician goes in without a lot of money oftentimes, and they rarely ever exit their political position without being millionaires. So this is not just for the good of racial inclusion. I’m sorry. There are people getting rich on this.

David: Oh, absolutely. Well, I mean, if the Fed was honest— Let’s back up a little bit. Because I think if the Fed was honest about credit creation and the operations of the Federal Reserve that had been in play for the past four decades, certainly since the serial crises from the late 1990s to the present, economic disparities have grown because of their inflationist policies.

Kevin: Right.

David: Democrats should be howling about how the Fed has created a problem. Yes, the divide between rich and poor has been exaggerated by their asset purchases and easy money. Waters, rather than pointing out the frailties of the Fed, would like to layer in more frailties and faults by redirecting credit and capturing more of the existing flows. It’s not fair that someone’s winning and I’m losing, now someone has to lose so that I can win. This is no way to solve problems. By the way—

Kevin: Well, and this is how they get rich. This is how they get rich.

David: Absolutely.

Kevin: Watch them.

David: The paths to riches for politicians: create a private market opportunity that’s mandated by law, then attach yourself to the income stream. Maybe it’s a board seat, maybe it’s family involvement. It’s corruption. Plain and simple.

Kevin: Yeah.

David: Show me a politician that hasn’t made millions since being in office. I’m okay if somebody makes millions and then enters the political fray, but the propensity to corruption and self-dealing is off the charts in DC. I’d say the last 15 years has put this in sort of dramatic relief. And credit flows are uniquely lucrative. So back to the Fed.

Kevin: See, that’s the unfortunate thing. We’ve talked about this division between the rich and the poor. A strong middle class in any country shows that you’ve got a good market. And when you eliminate the middle class, what you really have is preferential treatment in politics. And artificial pricing does that with the Fed, just the movement of markets, whether it’s trying to buoy up a stock market where the rich are getting richer. Or what about bonds? I mean, do the poor benefit when the Fed artificially controls bond rates?

David: No, of course not. But of course, the rich do. Right? A lower cost of capital allows not only for broad-based asset price inflation, but it also promotes dealing that is very class centric.

Kevin: Yeah.

David: The leverage buyouts, which we now refer to as private equity deals, work well, particularly when you’ve got capital costs which are subsidized. And this is an indirect subsidy, indirect via the Fed’s balance sheet expansion. It’s not a direct handout. Right? So it is slightly different. But who benefits? There is a difference, who benefits and who doesn’t, in the context of easy money policies. I’m a critic of involvement that benefits the rich, as well as Fed involvement that particularly targets the poor or some other micro-constituency.

Kevin: Right. And you’re not talking— we do not validate discrimination.

David: Not at all.

Kevin: I mean, you can’t control that with the Federal Reserve.

David: No. What I’m saying is that special treatment is discriminatory. It is prejudiced and it’s wrong, regardless of particular identity features. So enshrining that as a Fed mandate will be, as I said earlier, or would be, the death of the Fed.

Kevin: Well, it isn’t their job.

David: It’s not the job.

Kevin: Yeah. What is their job?

David: It’s not the job of the Fed to determine market pricing. When they have in the past, and as they have continued to in the present, it promotes malinvestment. It promotes bad decisionmaking. And with that, comes an eventual social cost. The taxpayer ultimately covers over the mistakes through higher taxes. Right? This is the reality. Or through higher inflation, which is another form of taxation.

Kevin: Well, in a market economy, you would consider that natural flow of capital from correct investment decisions to— Well, even incorrect investment decisions help the market ultimately, just based on adjustment of price. Is it the job of the Fed to determine market pricing?

David: No. There’s room for critique of the Fed’s disruption of the natural flow of capital.

Kevin: Okay.

David: Because clearly there have been benefits to Wall Street and the owners of assets. But the answer, the answer to that, if you want to critique the Fed’s disruption of the natural flow of capital with those benefits, the answer is not to double down and further entrench a bad idea by promoting credit flows according to some non-financial metric. Right? And this is the part that’s galling, is yes, special treatment is discriminatory, prejudiced, and wrong regardless of particular identity features, but look, lending is about financial metrics. You borrow a certain amount of money, what are the odds of you being able to pay it back? Good odds, low cost of capital; low odds, high cost of capital. There is a natural part of market— Let’s just use that word again in a different sense. That’s discrimination, and it’s appropriate. Why? Because a lender is saying, “Am I going to lose my butt here giving you money? I need to know that if I give you my money, I’m going to get it back plus interest. What is my judgment? I have to discriminate between high risk and low risk. I have to determine whether or not my capital is at risk and whether it’s justifiable. And by the way, if I can’t determine that, you know what I’m going to do? Take my marbles and go home. I won’t lend to anybody if I can’t quantify my risk.” In steps the government to say, “Well, don’t worry about that. We’ll cover the first loss.” 

But let the markets determine the difference between a good bet and a bad bet. Will I get my money back with interest or face default? That’s the deal. Do you need another layer of politicization in the sphere of monetary policy? Does the distribution of credit really need to be according to the color of your skin, the ZIP code we live in, sexual preference? Think about this: Straight Dave may or may not get a loan, but if I include gay Dave on a loan application, it becomes a matter of discrimination if I’m turned down? And in fact, I may get preferential terms as gay Dave? This is really intriguing. This is really intriguing because it’s remarkably more difficult to disprove gay or straight than it is being Black. Because guess what? You can look at me and tell. Right? Well, some things, you can’t tell. We’re getting into this weird zone of who’s saying what for what benefits. You’re creating incentive structures for people to— I don’t know.

Kevin: Can you believe we’re even having this conversation? I’m sitting here in disbelief that this bill even exists.

David: This is enshrining the third mandate of the Federal Reserve. This is the best we can do as a third mandate, enshrining things in law which are the exact opposite of our values. I’m not saying that discrimination is in fact our value. That’s not what I’m saying at all. Right? It’s done repeatedly by politicians who gladly appropriate narratives for their own benefit.

Kevin: Wow.

David: We’re creating an absurd carnival-esque world. I’m not objecting to equal opportunity. I’m not objecting to equality in lending. I am completely opposed to special banks, special lending facilities, special terms, special anything for extra special people.

Kevin: Because what that does is, everyone else is not extra special at that point.

David: Well, that’s right.

Kevin: So isn’t that discrimination?

David: It is. And I would say, we share a common human dignity as human beings. We share a common dignity. And respect for individuality should be a given. But an unbalanced approach to rebalancing the scales of justice is not justice.

Kevin: Right.

David: It’s just a reaction of inequality and a justification of social injustice as a means of writing perceived wrongs. Right? And I think this gets to the heart of why we had such contentious politics between 2016 and the present.

Kevin: Yeah.

David: Resentments are stirred by preferential treatment. If I tell one son, “I love you,” I look at my other son and I say, “I really don’t like you at all.” You know the damage that does?

Kevin: Yeah.

David: Resentments are easy to create if you’re careless. You can be a careless parent and communicate things that shouldn’t be communicated. But preferential treatment is a bad idea. I’ve read 80% of the Federal Reserve Act amendment. And if passed, it will be the undoing the Federal Reserve as an independent policymaking body. And like every other money and credit Frankenstein monster, it’ll be a terror to the financial market and its stability.

Kevin: Yesterday when we were meeting, when we were having our Talisker, I was sharing with you that I had been looking at several metanarratives. We all have sort of a worldview or a world philosophy. You’ve got different religious views. You’ve got different economic views, political views. And my question in my mind was, how do you get a world to cooperate when they think so differently? And strangely enough, you brought something up that really made sense. You said, “You know, Kevin, diverse views is really what the market is made of.” And in a way, that’s really true. When you’re buying something, that means somebody felt it was good to sell. And when you’re selling something, that means somebody said, “Well, I think it’s a better buy than you probably think it is.” And so this diversity of views is actually solved and peaceably maintained, no matter what your religious beliefs are, political beliefs. With the market, we can say, “You know what? We agree to disagree, so here’s the price that I’ll pay.” And what you’re basically saying at this point is, you’re eliminating that market factor, trying to politically manufacture this peaceable agreement against diverse views.

David: You think of monochrome, you think of monotone, you think of monotonous. It’s the same. It’s all the same. And somehow that’s what we’ve got into our mind, is everything has to be the same in order for there to be respect. And that’s not true. You can have different views and operate just fine. And the market has been that way for centuries, decades, millennia. The market has made diverse views. This is how pricing of any asset is established. One person buys, thinking and believing they got a good deal.

Kevin: Right.

David: One person sells, equally convinced they got a better deal. This diversity of opinion drives price fluctuation. It determines current value. And it conveys information.

Kevin: Yeah. Unless you’ve got the third body that steps in and says, “You know what? No, we’re going to change the price on you.”

David: That’s right. So you bring in a third party. That steps in and changes the calculus. Jim Grant reminds us to beware of the data that embody the intentions of policymakers rather than objective facts in the marketplace.

Kevin: Right. Well, last week you talked about anti-fragmentation at the European Central Bank. What they’re basically doing is, they’re selling good bonds, which are German bonds, and going in and buying Greek and Italian bonds, which are just crap bonds, to be honest with you. And I hate to say it, I would imagine some of those people in the ECB went long Greek and Italian bonds, right before they went in and bought them. That’s part of this whole thing.

David: When the exchange rate mechanism broke down in the ’90s, you had the Italian lira which was priced in the 700s, the exchange rate to the German mark. And the exchange rate mechanism broke down. It traded to almost a thousand, almost a thousand to one. The Italian market has always been weaker, both the bond market and the currency market. When you start mandating prices, either due to the need for a defined structure, like the anti-fragmentation scheme of the European Central Bank—

Kevin: Or look at Japan. Yeah, look at Japan trying to keep the interest rate at one level.

David: Price fixing in Japan.

Kevin: Yeah.

David: It confuses the issue of there being a diverse set of opinions in the marketplace. And what it does is it eliminates the information flows between parties because price becomes eclipsed by the third body involved. It’s dangerous.

Kevin: It sounds dangerous. I mean, because what you’re actually doing is, you’re creating pain for the people who can’t afford to pay their bills.

David: So whether as a discriminatory lending standard, again, artificially shifting the terms and the pricing of credit to favor one group over another, or as a balance sheet boost where prices are artificially maintained and the real value, the real signal, the real signal of value is obscured by policy preferences.

Kevin: Yeah. Pay no attention to the man behind the curtain. It’s just a complete false front.

David: It creates a full reality. And that’s what we’ve had for years with the European bond market, where, again, you could buy Greek debt. It was yielding 70 basis points, and it was cheaper than US 10-year Treasurys. Actually, the price was more expensive and the yield was lower than the 10-year US treasury. Tell me in what world it makes sense for the “benchmark” for risk-free rates, US Treasury, to be priced that much more below Greek and Italian bonds. I just told you that there was a footprint in the market which had created a full reality.

Kevin: So what’s your friend Jim Grant say? I mean, there’s a saying that he goes by, and that is, wrong rates lead to—

David: Wrong decisions.

Kevin: Yeah.

David: Wrong rates lead to wrong decisions. So again, you need the diversity of opinion in the market. And that brings about the terms of exchange. Without that diversity of opinion, when something is mandated, you begin to have the malinvestment problem. You begin to have wrong rates leading to wrong decisions. So as we progress towards tighter financial conditions, ultimately tip into recession, what will we have here in the United States? We already have the zombie companies that even today can’t pay their interest expense from current cash flow. You realize there’s one fifth of the 3,000 listed companies here in the US, one fifth of them do not have enough in terms of current cash flow to meet their interest expense. That’s over $900 billion in cumulative debt.

Kevin: Well, and this is in a rising interest rate market. It’s only going to get worse.

David: They’ll disappear. They will disappear. We may then reflect on the rates which for so long were not reality. They propped up these zombie companies. They were not reality. They were an expression of a policy preference. Right? And that’s the danger of policy preferences guiding the market forces, directing the market forces. These companies shouldn’t exist. If they can’t even pay interest on their debt, what are they doing? What are they doing? They won’t be around long.

Kevin: I remember when the exchange rate mechanism failed in Europe and the bloodbath that that was because they were artificially controlling prices. And there was an awful lot of “safe money” that was bet on their ability to maintain those artificial prices. That broke down.

David: The attempt was to set a policy in place. And the policy was to make sure that there was less volatility amongst the European Union countries. 11 countries at the time, started in 1979. And by the time the Berlin Wall fell in ’89, people could see that this was going to be difficult to maintain, this exchange rate band. It’s a narrow band. It required each of these national central banks to intervene in the market if their currency was falling out of that bond.

Kevin: Right.

David: It got very expensive.

Kevin: I remember. You could get 10% on a Spanish peseta bond. It was not a bond that was probably going to last, but you could get 10% on it at the same time that Treasurys were much lower. So people were like, “Why not?”

David: Right.

Kevin: We’ve got the ERM, the exchange rate mechanism, let’s just go ahead and put our safe money, the money we can’t afford to lose into this ERM band.

David: Yeah.

Kevin: And that band broke.

David: September 16th, 1992. It took between ’89, the fall in the Berlin Wall, and ’92 for the policies to be revealed as completely untenable. And yeah, it works until it doesn’t. This is the problem with stepping in and being the third body. You leave it to two market operators, and they’ll figure out what the price should be on a particular asset.

Kevin: Well, is this peg going to last in Japan now? You already have seen that the future’s market is saying, “No, we don’t think that that peg is going to last.”

David: Yeah. Well, I mean, in ’92, just remember, this became an obvious thing for your sophisticated hedge fund investors. Paul Tudor Jones, he made $300 million betting against the pound.

Kevin: Really?

David: George Soros made a billion and a half in one month.

Kevin: That’s right. That’s right. He bet hard against the pound.

David: He did. He bet hard against the pound. He bet hard for British equities.

Kevin: I think he helped it along a little bit, if I remember right. Not only did he bet hard, I think he also sold hard to make that bet work.

David: Yeah. Well, I mean the ERM failed because the prices were not real.

Kevin: Yeah.

David: The JGB, Japanese Government Bond, peg will fail because the prices are not real. The ECB artificially buying down the rate for Italian debt and boosting the rate for German debt is not real.

Kevin: Wouldn’t you have loved, however, to have purchased Italian bonds and Greek bonds last week before they just did that?

David: Oh, yeah. Two-week trade. The effects are felt. Obviously I say it’s not real, but the effects are felt. Italian and Greek yields are down between 50 and a hundred basis points in two weeks.

Kevin: Right.

David: In each case you have an official that has chosen to elevate something they deem valuable, and they’re willing to ask society to pay for that commitment. A price today and a price tomorrow. The price today is calculable. Tomorrow the price is chaos because that’s—

Kevin: Right. It’s the third body problem. Chaos math basically tells you cannot predict. It’s chaos.

David: And that cost is incalculable. So when the ERM broke, it unleashed radical volatility. When the Japanese Government Bond peg breaks, whether that’s weeks or months from now, it will unleash radical financial market volatility.

Kevin: Yeah.

David: The end is already showing how damaging and consequential that peg is with the exchange rate reaching new lower levels each week. We’re now at 136 in change. We haven’t seen this since September of ’98.

Kevin: Yeah. Boy, aren’t you tempted just a little to bet against the Japanese yen peg?

David: Sure.

Kevin: I mean, there’s a temptation. Now the problem is, when you do that, you take a huge risk. But how about China?

David: Well, I mean, going back to the ERM, there was a point where Soros knew that he could make the bet because he determined that the Germans’ political resolve to maintain the bond and to sacrifice the mark to do so was limited. Resolve was limited. The head of the Bundesbank said, “Nope, not our problem. If the pound’s going to suffer, it’ll suffer on its own. It will not cost us stability in the mark.” As soon as Soros knew there was no willingness to defend it—

Kevin: He bet against the Bank of England.

David: Bet against it and won.

Kevin: Yeah.

David: You don’t bet against central banks and expect to win unless you’ve figured out— I guess it’s kind sitting across the table. Have you seen the whites of their eyes? He saw the whites of the Bundesbank president’s eyes, and knew he could bet big. And he did. Really big, really big. 

Chinese debt markets, they’re being subsidized and controlled by the People’s Bank of China. Ultimately, that will convey radical volatility to the global financial markets. Racial equity is easy to sell. I mean, who doesn’t want that? But every past initiative where credit was politicized has ended in a banking crisis. Don’t be surprised that politicians don’t care. I mean, and this, I know, is my cynical expression of politics, politicians, and our engagement with them. But I think we’re useful fodder for some point of view. We are useful fodder for some point of view. Politicians end up harnessing the energy of people, leveraging feelings and frustrations and frictions in order to entrench their own power. Right?

Kevin: And parasitically. Yeah. They’re like parasites.

David: To standardize the extraordinary, that’s the common theme for us these days. Right? We emerge from extraordinary financial circumstances using extraordinary tools. And now we think of them as ordinary. If Powell has to go back to QE, it’s not going to be extraordinary. We’ve done it twice before. And it’s now just one of the tools in the toolboxes, whereas it’s only been done twice in history, and we have yet to see the— By the way, using it twice in history within the last decade has given us the worst inflation in 40 years, or it’s promoted, helped, supported and buttressed the worst inflation we’ve had in 40 years.

Kevin: We’ve got George Orwell on our shelves, and we’ve both read Animal Farm. I just can’t help but think of the words. That was written 70, almost 80 years ago. And all animals are created equal, Dave. They’re all created equal, but some are a little more equal than others.

David: I mean, you think about those dystopian novels. Everybody wears the same clothes. Everyone needs to come to the same conclusions. You think the same.

Kevin: Monochrome.

David: You believe the same. Monotone, monotonous.

Kevin: Yeah.

David: It’s monotonous. Everyone will be the same. The differences won’t matter. We’ll all be equal. But yes, with some being more equal. So it is straight out of Animal Farm. We want to be fair to everyone, but perhaps more fair to some.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at, And you can call us at 800-525-9556.

This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.

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