- Gold price is irrelevant – It’s independence from a collapsing system that matters
- Warren Buffet: If interest rates rise asset prices fall
- Implications of being a captive in the closed cashless system
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“We’re talking about volatility. I don’t even care what the ultimate price projections are, but very few realize that creditism doesn’t work in the context of rising rates. And if the Fed chooses to ignore that fact, they will be directly responsible for the greatest financial collapse in recorded history.”
– David McAlvany
Kevin:Oftentimes we get calls, Dave, and people are wondering, obviously, when the markets are going to turn. When is gold going to go up? When am I going to make some money? But actually, I think, as a company and as a family, and for 46 years the point has not been to treat gold like it’s just a run of the mill stock, like we’re just trying to make money on gold. Gold represents something completely different and I think we should probably start the program explaining what it is that really drives our recommendation of gold.
David:Right. The essence of gold ownership is privacy, freedom, autonomy from the system. These are things that are in the category of intangibles. Going back to the book that I put together last year, we look a lot at what legacy is about in that book, and we focus on the intangibles rather than just the tangibles. I think when people are thinking about wealth sometimes they focus in on just the tangible aspect, which is what you just mentioned – what is it doing for me today? Is there growth? What is my profit year-to-date? How am I doing this quarter, this month?
And they forget that some commitments that you make, and some investments that you make – there is an intangible value to them as well. And that may actually be the more important element, particularly in a period of time when governments are seeking to control more and more of the mechanisms and the buttons and the levers within the economy, you have to ask yourself that question – is there a value to metals in that intangible category?
The system would tell you now that, if you’re getting out of the system, whether it is crypto-currencies or gold, that it must be to defend or cover tracks for some criminal-minded behavior. You have to look at the founding fathers and say that the majority of history, and it culminates in some of our early documents, is an expression of the value of human autonomy, the value of freedom, the value of individual choice, and the protection of privacy, so that that can be done, so that coercion is not a possibility.
Kevin:It’s not just a flight to liberty, but it’s also the system, itself, that a person is trying to flee from oftentimes is crushing them, making it impossible to live. We’ve talked a number of times this last few weeks about Argentina and the high inflation there. Venezuela – that was a system where people literally were not eating when they were part of the system. If they had a means of having some assets outside of the system they would have still been able to eat.
I think we should probably move into why the system is crushing people right now. Capitalism, originally, was a system that operates off of money that has been saved, but we have a system at this point that is trying to run, and actually, they are succeeding to a degree, and the only way to succeed further is to control the public. It is succeeding to run without savings. In other words, it’s all based on finance.
David:It’s all based on finance, it’s all based on liabilities and the structure of credit. The savings rate, as a percentage of disposable income, if you look in the post war era – this goes back to the 1940s – the rate steadily climbed from 6% in 1947 to a peak of about 14% in the mid 1970s.
Kevin:These are savings rates – 14% was being saved in the 1970s.
David:And I think there is not a small coincidence that you have a massive bull market. If you recall the bull market in stocks which began in 1949, and it was in effect for most of that time up through the mid 1960s. So you have a massive setting aside of savings and a massive increase in capital investment, and a massive bull market, again 1949 to 1968. But the rate at which households saved ratcheted higher from 10% to 14% as we flirted with recession there in the late 1960s, early 1970s, ultimately entering into a bear market in stocks in 1974. From its peak at 14% we have gradually – again, going back to 1974-1975 – we have sunk from 14% to 2% immediately prior to the global financial crisis.
Kevin:So for every $100 earned, $2 was being saved just prior to the global financial crisis.
David:That’s right. Now in the fourth quarter of 2017 we have returned to those levels again. We’re at about 2.6%
Kevin:And that was prior to the crisis. You would think that that savings rate dropped to 2% after the crisis, but it was sort of a signal, wasn’t it?
David:Yes, and savings matter as a basis for capital investment. That’s the big deal is the way the system has worked, and perhaps this is old school, but savings have been the basis of capital investment. And this seems maybe very old school in the sense that capitalism was once utterly dependent on savings. And now instead of scarcity of capital coming from savings and being carefully measured and allocated according to – what do we do? We look at value metrics and risk metrics. And today, instead, we have finance capitalism. Finance capitalism is a modern iteration of capitalism and it is only known in the history of the world from the 1970s forward to the present.
Kevin:Which requires no savings at all, you just have to be able to print money and continue to throw it into the system.
David:It is a world based on liabilities. Again, this goes back to gold, and perhaps one of those qualities that you think, whether the price rises or falls, it’s no one else’s liability. That may seem insignificant except that we live in a world that is primarily liabilities today. Finance capitalism is, as it sounds, based on the ability to finance growth using debt. Greater and greater quantities of debt have accrued, and that has served as the basis of growth. We can’t forget this. These are long-term secular trends. And this has all taken place in a period of time where interest costs have been shrinking as rates have been in decline for almost that same 40-year period.
Kevin:So when rates fall, the cost to finance that growth falls with it. You can increase debt almost with no limit as long as interest rates are going down.
David:That’s right. So the quantity of debt becomes less significant. The real increase in the pressures comes from the increase in rates. If you see an increase in rates then cash flow required to service that debt becomes an issue. But the flip side is, you can be in a period of time, which is what we have had for almost 40 years, where the pressures have actually been alleviated over time. Cash flow required to service debt actually goes down because rates have been dropping for so many decades.
Kevin:But when rates rise…
David:The cost to finance growth rises as well. So if you are going to see growth in the economy, again, this is an issue that relates specifically to where interest rates go, either up or down. The challenge is now to finance growth in this environment with a mountain of debt already in place, with it already outstanding. And to do so requires a tremendous amount of new debt issuance each year.
And again, there are debt issuers. If you will think about the two people in this equation, the two parties in the equation, you have the debt issuers, and then you have those entities or investors that have to absorb the debt put on the market. That can be a combination of banks and insurance companies, pension plans, mutual funds, ETFs and individual investors.
The U.S. issues billions of dollars in debt instruments each day and that requires on the other side a purchaser to convert savings to a long-term debt instrument. Except in the case, there is that one carve-out which we have learned about here in the age of QE. You have central bank purchases where digital money appears from the digital ether. You purchase debt instruments and infuse the system with more liquidity.
Kevin:You had talked about the United States needing to borrow billions of dollars a day. That’s an incredible number. And in time even of trillions, billions a day – where does that come from?
David:Right. As our old friend – this is a relationship going back 50 years – R.E. McMaster noted recently, the U.S. has to borrow three billion dollars a day to finance its current account deficit. Three billion – is that really that big of a number in today’s world of trillions of dollars of obligations? Well, here’s the thing – it represents 80% of global savings.
Kevin:You said global. So we, the United States, borrow three billion dollars a day, but that represents 80% of what the whole world saves a day.
David:I think that one number gives some perspective on the frailty of how this whole game of growth based on debt actually is. For it to continue we need access to the world’s savings, not just U.S. investor savings, which is what it was, if you could roll back the clock to the 1960s. We financed all of our own debt internally. We didn’t need external debt, we didn’t credit creation, we didn’t need the Federal Reserve. We didn’t need the rest of the world.
Kevin:But doing the math, if that’s 80% of the world’s savings, let’s say the world saves 3.75 billion dollar a day – ka-ching, ka-ching, ka-ching, day after day – 3.75 billion. We, as a single nation, borrow three billion of that, 80% of that. That is unsustainable.
David:Right. So the system as it is now designed, post Bretton Woods, post gold standard, is what we’re talking about. It’s finance capitalism. It’s not free market capitalism. Our system here in the U.S. requires 80% of global savings to stay afloat. We have an anomaly within an anomaly, and I think some history here is important. This 40 years of hyper growth is in the context of 300 years of hyper-growth, and only in the last three centuries have the lifestyles and assets of the average man improved any noticeable degree.
If you go back 2,000 years before Christ up to about the 17thcentury A.D. mankind saw virtually no change in the assets of the average guy or gal, the average Joe, the common man. There has never been a middle class. But in the last three centuries, in three centuries the middle class came into existence. It didn’t exist prior. And in a little more than three decades, just the last three decades, almost four, the gains accrued to the middle class are now being eroded. Some would say stolen, others might say simply reallocated.
Kevin:Let’s put this in a framework. It took three to five millennia to get a middle class that lasted three centuries. And a middle class is now being destroyed in a matter of three decades.
David:Look at it in terms of incomes, incomes relative to asset prices, incomes relative to debt levels, incomes relative to productivity, relative to economic growth. All of these metrics have stagnated from the 1970s forward in an acute way for the middle class. Debt levels continue to rise because what we did in the 1970s was remove the natural monetary obstruction to massive increases in debt, which was the gold standard.
Kevin:When a machine is built – let’s say it’s a motor – oftentimes they will put a limiter on it so that it doesn’t run too fast. I know I use aviation analogies, but I used to fly a glider that was made in Czechoslovakia called the Blanik, the L-13. Right on the panel it had this warning that said, “The never exceed speed is 149 miles per hour.” Now, they had kilometers, but it was translated to 149 miles per hour. This is a glider that would fly apart if you flew faster than 149 miles per hour. And you could – that was the problem.
David:There was no governor.
Kevin:There was no governor, and in a glider you’re going to fly at whatever speed you want to fly at until the thing flies apart.
Kevin:It seems to me like this creditism, without a limiter, is a little bit like that Blanik, that glider. At some point it’s flying too fast. If we’re borrowing, as a nation – I keep going back to this – 80% of the global savings, that’s incredible. We’re getting close to max speed.
David:We don’t have long enough memories to appreciate just what a short period of time we’re talking about. Throughout the 1940s, 1950s, 1960s, 1970s, looking at charts produced by Casey Research with all their sources from the U.S. Census Bureau, you look at median annual income compared to the price of a home, and it has gone from a four-decade average of 51%, now to 21%. So home prices have risen considerably relative to incomes, and that has left households with far more debt, and it has left them indebted for a far longer period of time, if you look at how people manage and pay off that debt.
Essentially, it is income stagnation – that’s one-half of the equation – sucking in global savings, and we’ve done that via the asset-backed securities market, via the mortgage-backed securities market. And that is the other part of the equation. In an era of ever cheaper financing, the world’s capital flows have been toward the U.S. because it has been the deepest capital market, it has been the most stable, it has been a place full of opportunity, relatively speaking.
Kevin:We had the Bretton Woods system. We were the gold standard. A dollar used to represent just a receipt for gold.
David:Right. Now post Nixon closing that window back in 1971 we have unlimited money creation and that is either outright printing press money, or via the credit markets, and you can do that now by digital 1s and 0s. But the world is flooded with liquidity, the whole world is flooded with liquidity, and it is seeking a destination to sell into.
Kevin:But we’re still caught in and old habit. The world is still caught in the old habit of centering in the United States, almost as if we were still on a gold standard.
David:It’s a privilege left over from when we commanded the respect of the world in the post world war era. Again, we go back to Bretton Woods and the agreement which was hammered out at that New Hampshire hotel where we’ve seen the global trends of capital flowing to the United States, the savings coming from afar to finance the increases. And ultimately, what does it do? It boosts the asset prices and boosts the economic growth here in the U.S. Still, that gives us huge benefits that very few other countries experience.
Kevin:We’re not the first to be a reserve currency. There have been reserve currencies that have come before us. They have enjoyed some of the same benefits.
David:Right. There is some popular literature out there. Barry Eichengreen is chief among them to say, “Look, for all the privileges and benefits, there is also a burden, there is a curse, to being the world’s reserve currency. But I see all the benefits that the earlier reserve currencies had. We have a similar dynamic witnessed by those past reserve currencies. We are, today, just as they were in the past, a desirable destination for foreign capital. At least we have been. Foreign capital has financed a healthy percentage of our debt needs, if you look at that period – 1970s, 1980s, 1990s – you had Middle East dollars which were flowing more and more to the U.S. then.
But you begin to see an erosion here in the last 10-15 years where Middle East dollars are flowing more and more to euros, and less to the U.S. market. Asian foreign currency – they’re balancing their flows between their future interests. Yes, there is still some capital flowing to the United States – Japanese, Chinese to a lesser degree. The euro is important, the RMB is important, the ruble is important. Unlike past reserve currencies over the past 40 years, I think one of the things that we’ve seen is that here in the United States, with global dollar hegemony, we have been less careful with the allocation of capital.
Kevin:Because we took it off the gold standard. All these other reserve currencies of the past, I think, had some sort of standard behind them.
David:We started out with some stability, we started out with a rules-based monetary system. Now we have an ad hoc monetary system. And here’s the reality: When capital is finite, every decision is measured carefully.
Kevin:That’s called economics.
David:That’s called household management. It’s called government management. It’s called dealing with scarcity. But when capital is nearly infinite – you know what happens? You have a new issue, and that is you must get rid of it. You must press it into the system. And there is a far less careful process. And that’s where you commonly find capital misallocated. So what has become the byword for the era and our word for the day is malinvestment.
Kevin:Right. And that malinvestment goes back, to repeat ourselves, you don’t have to be careful when you’re unhinged from gold and you can just print unlimited amounts of currency.
David:Clearly, there is a benefit to being unhinged from the gold standard because owners of assets catch the artificial increase in asset prices from the excess liquidity and money which is allowed in that fiat system. Essentially, having too much money in the system is almost a form of artificial demand. It stands in for actual demand and creates inflation in asset prices, just like true demand would if it were driven by demographic expansion or growth.
Kevin:In a way it’s like a caffeine high, Dave. Sometimes I have trouble sleeping, but I also have a really hard time giving up my afternoon double espresso. I’m going to be honest with you. I take that time, I work here for hours and hours, you make me labor like a slave.
Kevin:And when I finally do get out of the office I want to turn my brain back on for about an hour-and-a-half. I just want to read. But the thing is, I know what I’m doing. I’m giving myself an artificially stimulated caffeine high. The problem is, through the week that starts to build up and I go through, at a point – maybe it’s mid-week, maybe further on – a stagnation. And I think, unless you can keep that caffeine high going, or in this particular case, this creating growth through printing money type of stimulation going, you go through a stagnation. And then ultimately, you can dip into a depression.
David:The easiest way to sort of bifurcate this is to say that benefits that accrue are for the few, and the drawbacks are left for the many. And this becomes apparent in periods of secular stagnation or where the economy is not growing. In fact, maybe it is even going backward.
Kevin:The caffeine is no longer working.
David:Yes. But in periods where confidence erodes and savings allocations are more guarded, people become cautious and the money is not flowing as readily, whether it is across asset classes, or even across borders. In periods where the cost of capital rises instead of falls.
Kevin:That’s interest rates rising, right?
David:That’s right. And there is the potential for economic growth which is stifled. It is stifled by the pressure created from that increase in interest rates. Then guess what? The benefits move in reverse and you have what was described by Richard Koo, very aptly, as a balance sheet recession. In a balance sheet recession, you have debts which increase relative to assets, and you have an imbalance on the balance sheet – too much debt compared to assets, too many liabilities.
And then you have the cost of maintaining the liabilities, which drains cash away from other more productive uses. So you don’t see the economic growth you might anticipate because you have this massive cash drain to the servicing of something which was yesterday’s benefit and is now today’s burden.
Kevin:Right. And so the rise of interest rates could also be called the cost of capital.
David:Yes, absolutely. In the end, it is axiomatic that asset prices are revalued in keeping with the cost of capital. So lower rates, and values increase. Raise rates, and of course, values fall. So it’s the combination of virtuous and vicious. And these are two sides of the same coin.
Kevin:We have said over and over and over, interest rates are not some dry, gray area that nobody but economists cares about. Interest rates really say everything about the valuation of assets in the long run.
David:Warren Buffet, just this last week, in a televised interview, reminded listeners that interest rates are the single most important variable in the valuation of stocks. We called that out last week, as well. Remember, we were referencing the discounted cash flow models used by professionals when they are determining the value of an enterprise and ultimately seeing what it should be on a per-share basis, what the share price should be? Interest rates are the centerpiece. But Buffet could have just as easily mentioned that bonds and real estate are equally tied to interest rates, as you mentioned, the cost of capital is the same thing. There are certainly supply and demand gluts. If you want to say, “Hey wait a minute, there are exceptions to that rule,” yes, if you have supply and demand gluts which can temporarily distort the relationship to interest rates, that’s fine. That’s a carve-out. But ultimately, the cost of capital presses the value of assets either higher or lower. Kevin, you referenced that last week. Remember, we were talking about the see-saw? Asset prices sit on the opposite end of interest rates.
Kevin:Right. So when interest rates rise, asset prices fall, when interest rates fall, asset prices rise. Other things occur also, like in the stock market, you have these initial public offerings that come out. We saw this toward the end of the tech boom, as well, where companies didn’t even have to have a profit. You have IPOs with no-profit companies – they’re soaring.
David:I’m just going from memory here, but Doug Noland mentioned this in the comments over the weekend, that IPOs, Initial Public Offerings, when companies are raising capital and issuing stock to do that, back in 2000, roughly 81% did not have profits. They weren’t making any money, but the market was only too happy to give them money in the future hope that they would make money.
Kevin:With the assumption that capital would continue to flow.
David:Yes. Now, it’s interesting, we’re not quite to 81%, we’re at the second highest number on record, 76%, of current IPOs. These are companies that are raising money in the capital markets. They aren’t making anything. There is an allowance where they don’t have to make any money. They just have to have a good idea and the billions roll in.
Kevin:And it’s with the assumption that things are going to continue. But Dave, you’re sounding a little bit old-fashioned at this point. What you’re asking for is a company actually needing to make a profit. You’re also talking to people here on this Commentary. But you sound like an old-fashioned grandpa saying that savings are important. In fact, it was interesting, and this may be just an offhand story, but I was going through a room and found a ceramic that my grandmother had made my wife and I when we first got married. It was a penguin. It was really well-made. She had painted it beautifully as a gift.
Finally, I turned it around a few days ago, and I had never seen that it had a hole cut in the back, and it was a piggy bank. It was a message to us that we needed to be saving our pennies when my wife and I first got married (laughs). We just celebrated our 35thanniversary. I wish I would have known earlier that that penguin was a method of savings. So, why are you talking about savings when we can print money?
David:You’re right, because it is kind of the grandparents’ delayed gratification conversation – “Be prudent.” And it does have an almost pedantic feel to it. 2018 is going to be an absolutely fascinating year for investors and analysts alike. Richard Duncan calculates that we have roughly 2.9 trillion dollars in financing needs this year here in the United States, and this takes into account the Fed’s balance sheet as they are shrinking it, putting hundreds of billions of dollars back onto the market. That has to be reabsorbed. That takes into account the current account deficit and this year’s yawning budget deficit.
So you look at the late 1960s, and domestic savings were sufficient as a source of funding for all of our debt. So you just went to the general public and said, “Hey, buy U.S. treasury bonds.” And the general public here in the United States said, “All right, that’s fine, you’re going to pay me 2%, 3%, and I’m happy to participate.” But again, that was the late 1960s, and we covered our own bases. Over time, we developed more of a reliance on foreign funding from the rest of the world. And then here, introduced more recently, we have the Fed balance sheet which increases, and there also, a means by which we can cover our debts.
And then you have outright credit creation which has been on the increase as well. And that accelerated dramatically with the demise of the gold standard in the early 1970s. What Richard points out is that as a result, today, 56% of our funding requirements for debt comes from new credit creation. You just have to think about that, because it intuitively doesn’t even make sense, and yet, that’s how our system works. We are funding debt with debt.
Kevin:Right. And when we have Richard Duncan on the show, he is a favored guest, but we always get comments because people are infuriated by his answer. He says, “You know what? We’re too far into this thing. This creditism thing – the death of the body economic will occur if you don’t borrow more every year.”
David:Right. We’re funding debt with debt. Several years ago Richard wrote about the transformation from capitalism to debitism, and that is quite similar to what we described earlier as finance capitalism. Again, not free market capitalism, but where debt is the primary driver of economic growth. And I think it goes without saying, when our economic growth is tied to debt, which can only be funded by more debt, the entire system is much more sensitive to interest rates.
Kevin:And this takes us to the point that they can talk all they want about interest rates rising, the Federal Reserve raising interest rates. The system, itself, cannot handle the rise of interest rates.
David:“It is different this time.” Listen to those words – it is different this time. You cannot normalize interest rates when you have layered in debt upon debt upon debt. You are far more interest rate sensitive than you were in the period of the 1960s, 1970s, 1980s, 1990s – in any other period of financial history going back to the beginning of time, because we’ve never done this before.
Net interest expense today is 262 billion dollars versus eight years ago 196 billion, so we’ve more than doubled our debt at the federal level and we haven’t even doubled our interest costs. Why? Because we have been sitting on interest rates. We have been pressuring them lower. It’s the seen hand of the central banker, not the unseen hand of the market, which is at work here.
I know there are academics who understand that rates must not rise. But there are also academics, and some of them are at the Fed, who are saying this is what is going to have to happen. I think raising rates represents a stranglehold on the economy. And it is like never before witnessed in the history of the world, because of those layers of debt on top of layers of debt, and they are all connected like so many multi-dimensional strings. I’m not an expert on string theory, but certainly, you change the rate of interest and you change the economic and financial landscape dramatically. There are reverberations which are going to be felt throughout that interconnected world.
I listen to Jerome Powell who is head of the Fed today, and he is weighing the costs and benefits of tightening or loosening monetary policy in light of reaching his inflation rate targets, and the unemployment rate being at 3.9%, at a very desirable level, and I just hope that he stops to consider the transformation of the system from a savings-based capitalism to a credit-based system, and that whole shift has taken place in his lifetime.
Kevin:I think we’re going to have to talk about this sometime in this program, though, Dave, because if they don’t raise interest rates, inflation will ultimately outpace – it already does – what they can pay. So in reality you are going to be giving people negative interest rates relative to inflation. There is a point where they exit the system.
David:Without the contrast between what was a savings-based system and what is a credit-based system today – again, creditism to quote Duncan, or finance capitalism to quote many other economists – Mr. Powell may miss just how dramatic the impact is likely to be of normalizing rates in an abnormally leveraged financial universe.
Kevin:This isn’t like the Volcker days.
David:No. It’s not like the Burns era. It’s not like the William McChesney Martin era. These guys lived in a different period of time, with different backdrop variables, and there is no other period of central bank operations like this at all. The accumulated liabilities and the requirement of those liabilities to continue to mushroom larger makes normalization an impossibility. It will kill the system.
So in that sense we do echo some of Duncan’s concerns but I think we’re now at a critical pivot, and that pivot is where the central planners say, “Hey look, we haven’t failed, we haven’t quit. The outcome that is required because of these variables is simply to close the system and construct greater controls for future maintenance and operation of the economy.”
I hate to assign intent or assume that this is being done on purpose, but to some degree people do understand that this is a system and it has to be maintained, and it’s for the “good of everyone” that it is going to be maintained in a way that might not be palatable in an ordinary setting.
Kevin:If there is any program that causes me still to lose sleep and get chills, it was the Carmen Reinhart interview that you did, Dave, because Carmen is a person who understands this. And she understands that the people that she is advising – we’re talking central bankers – and her colleague, Ken Rogoff, agrees with this as well, a captive system has to be created.
In other words, you can go through this period of time where you live off the past. That’s what the United States has been doing. We’ve been able to keep the world in the dollar with various means, whether it is stability, or whether it is with our military, to be honest with you. There is a point, though, that rates have to rise for people to continue to want to loan you money. Once that time occurs, if you can’t raise the rates, the only thing you can do – and these are her words, not mine – is create a captive audience.
David:You’re right, Carmen is very keen on that idea of captive audiences and assigning the losses to the most propitious area within the economy, the least deleterious, where you can’t see negative knock-on effects. But in fairness to her, it is really Ken Rogoff, her co-author from a book a few years ago, who is more keen on closure of the financial system.
Kevin:Right. He wrote the book, The Curse of Cash, trying to convince people that we don’t need cash anymore.
David:And he is a much stronger proponent. What is the curse of cash? The philosophical backdrop to that is that by using financial repression, a very subtle form of increasing taxes and extracting value from savers, you must close the system. So you have, basically, a strawman argument that cash is dangerous, it’s dirty, and it’s difficult to operate a legitimate economy, a black and white economy, instead of a world of gray nastiness, when you have cash.
But it’s a bit of a ruse, because really, what he is asking for is the opportunity to move, ultimately, the system toward a system where everything is migrated to the digital, traceable world. It is a system of creditism that we have adopted. But the costs of that system have to, at some point, be allocated away from the core. You have to look at the vital players, you have to look at your key institutions, and not let them get into trouble, and spread out the costs of maintaining the system to the periphery where there is greater expendability.
Kevin:During the global financial crisis what we saw was large organizations that were deemed, ultimately, too big to fail, other than Lehman. So we had a bailout from the government side, but these were organizations that shouldered the burden, and then the bailout, with the Federal Reserve and the Treasury and some of the intervention that occurred there. That bailout can’t occur again. At this point the bailout is us.
David:You have central bank balance sheets which can certainly expand again. We have the European Central Bank balance sheet which every day, every week, every month, we’re going to see new record highs, at least until September, as they continue to expand and buy everything under the sun. The Bank of Japan is likely to do the same.
Kevin:What about a Lehman moment, where all of a sudden you see people walking out with their cardboard boxes?
David:No, I think Rogoff prefers the next crisis to be a moment for the Smiths and the Johnsons and for the common man. Because again, if you can create captive audiences, and if you can allow for the redistribution of pain across the middle class, and in theory, keep that level of pain below a threshold of collective pain that would lead to protest or destabilization, then you have accomplished what you need to.
The system of creditism continues to work, just as you have set it in motion, and yet you have been able to assign the losses selectively, and allow those who need to, because of critical roles within the system, continue to move forward. And by the way, if you’re taking the loss that would have been to one entity and spreading it out over 50 million people, it’s obviously not as big a deal if it is diluted across 50 million people, or 300 million people.
Kevin:And they don’t understand what is happening. It’s like John Maynard Keynes said: “Inflation is a tax that only one in a million really understands.”
David:So then financial repression, and the complexity involved there, it being so opaque, that’s an issue that not one in a billion understands. It puts them in the position to, basically, be unblameable. Blame can easily be reassigned when the real issues are not truly understood.
Kevin:Let’s put into context how we’ve gotten over the last decade with turning our debt from nine trillion dollars to 20 trillion dollars. There are ways that you can buy stability for a short season.
David:Desperate times require desperate measures. Now we’ve grown accustomed to those desperate measures and we’ve normalized the behavior and now consider it to be a baseline for what is an everyday occurrence.
Kevin:And everybody else is copying us.
David:That’s right. You see that in the emerging markets. Following our lead with a massive expansion in credit here in the developed world, the emerging markets have decided to do the same thing. They’ve increased their debt levels since the global financial crisis from five trillion to 19 trillion. And by the way, most of that is in foreign currency terms. You have your major issue in terms of ultimately paying that money back. Your potential for default, because it is not in local currency terms, increases considerably.
Kevin:Isn’t it an interesting parallel that they raised their five trillion to 19 trillion? That is very close to our nine trillion to 20 trillion? That’s the whole of the emerging markets.
David:Right. Reinhart, very sensitive to these issues, particularly emerging market debt. Articles that she has written recently, very critical of ignoring what she considers to be more or less the elephant in the room. You have massive levels of indebtedness in the emerging markets which are unsustainable. Emerging markets have bet, just like we have, on a future where lower interest rates are, for lack of a better word, guaranteed – or can be guaranteed, can be forced. And so again, you can double the debt and you are not going to double your net interest expense if you’re sitting on interest rates.
That assumes that you have the power to control the market and the market does not ultimately reprice risk and take interest rates higher. Rising rates are the real inconvenient truth here. And I’m sorry that Al Gore is not pounding the drums on this one. But if you care about sustainability, rising rates are the real inconvenient truth for the global community as it relates to finance.
Kevin:Would you add volatility of foreign exchange rates to that inconvenient truth?
David:What that represents is the beginning of the end. What causes the first domino to fall in emerging markets is the reality of not being able to make payments on their debts on a cross-currency basis. So increased foreign currency volatility, higher interest costs – it’s game over for the emerging markets. And it’s game over for the current system of creditism as a financial experiment. So will rates rise?
Frankly, naturally, they have been rising, and the Fed has been behind the curve and has been catching up to what the markets have been doing themselves. But there is a war on the horizon. The war on the horizon is between the free market pricing of debt and the command and control desire to again press interest rates lower by necessity.
Kevin:That war is against the person who is caught in the system, because the person who is caught in the system is going to be the one who has to take the negative rates. The answer is not raising rates. We know that can’t happen without the system breaking. If the only answer is greater control and less freedom, what do we do? How do we respond?
David:I think this is what many market participants are assuming, that we are going to operate by the old rules. Old rules go out the door when the leviathan, and its survival, is in question. Yes, absolutely, greater control and less freedom is what you should anticipate. I think you have to focus more on your defensive game. You have to focus more on your defensive game. And so, again, while it can be interesting to talk about the tangible nature of the assets that you have, and the dollar value of those assets, and how we are marking progress through time – we all like that.
But the management of wealth on an intergenerational basis, if it neglects the intangibles, will not be sustainable. It will notbe sustainable. So if you’re not focused on a defensive game here, I’m telling you, you are about to get squeezed. Again, this is through no fault of your own, but the rules are in the process of changing and the financial system is in the process of closing, by necessity, given the math involved in this massively layered debt scheme.
Bill King sometimes references our founding fathers, and I love reading him on a daily basis. He mentioned James Madison earlier this week. He said, “Since the civilization of mankind I believe there are more instances of the abridgement of freedom of the people by gradual and silent encroachment of those in power than by violent and sudden usurpations.”
This is how we are where we are, because you and I are just average citizens and we are going about our lives and we don’t realize that in this 40-year stretch, in the context of a 300-year period, we have had extraordinary opportunity. We have seen the middle class increase. But this really is a carve-out in time, this 300-year stretch. And this 40-year period is another carve-out in time, unique in all of history. And I believe that the market volatility that we see in the coming months, both in the foreign currency markets, the fixed income markets, the equity markets – this year will reveal just how vulnerable our financial system has become.
You have the weaknesses at the periphery. You remember the European crisis sort of culminated in 2011 with a cure-all promise, “We’ll do whatever it takes,” from Mario Draghi there in the June to July period. We have the same thing all over again with the periphery, this time the emerging markets. It adds to the global volatility theme. You have central banks, which will be back in the business of mass interventions. They have to be. The difference is this time is that they will be looking for enough fear to be granted collective permission to close the system.
Kevin:So I go back to James Madison’s quote. He talks about the gradual and silent encroachment of those empowered. Now, there are those gradual, silent encroachments that have been going on, like you said, for decades. But he also talks about a violent and sudden usurpation. A lot of times the gradual encroachment is what causes the people to be entrapped. But what we could have with this financial crisis that is coming up, this closing of the system, is a violent and sudden usurpation.
David:Yes. Anyone who studies history gets this. Look at Kissinger’s quote. I’ll butcher this, but something to the effect of, “Control the food and you control the people. Control the energy and you control the continents.”
Kevin:And Rothschild, “Control the money…”
David:“Control the money and you control the world.” The reality here is that there are greater degrees of control all the time, but we don’t see them as such. You could have a solution – call it a biblical solution.
Kevin:Right, like Jubilee.
David:Right. Debt Jubilee is an option. But the problem today is you have the interconnectedness of liabilities via the derivatives market, which makes that a near impossibility. So we go back to the only options that are available and it is financial repression and inflation. Those will be back on the table. In a closed financial system it is easier to assign the losses and designate the thrivers, the survivors, etc.
Kevin:This takes us back to gold – the way we started this program. Gold is not about trying to figure out whether you’re going to make a buck. It’s whether you’re going to preserve a buck.
David:You’ve lost historical context if you’re just sort of looking at your pro forma spreadsheet and saying, “What am I going to be worth with gold at “X” per ounce. The value of gold is not as a speculation on the price, but as a financial asset outside the financial system. And I think that reality is going to re-emerge in the minds of investors as they realize what is wrong with being inside the financial system, and what it’s like to be trapped inside the financial system.
So again, people have forgotten the importance of privacy. They have forgotten the importance of freedom. They don’t appreciate the nature of autonomy from the system as an agent. These are not evil things. These are not philosophical cover for bad actors. This is not criminal behavior. Re-read the founders, and you will be appalled by the comparison of what motivated them, and what motivates the current bureaucratic leviathan.
Kevin:You can hide that leviathan if you can hide volatility, but the last few months we have had volatility. Do you think that this is going to start exposing what is actually going on?
David:Sure. Absolutely. We have seen market sentiment run to its extremes, and as a result we should see several months of increased volatility here. We should have mean reversion. Interest rates have been marching higher – I think they can reverse. And you will see some recovery in the price of bonds. The precious metals have been pressed lower, and I think you are about to see a reversion in mean and prices go higher there. The dollar – we’re talking about volatility.
I don’t even care what the ultimate price projections are, but volatility changes market sentiment, or market sentiment changes market volatility. Frankly, I don’t know which comes first. But very few realize that creditism doesn’t work in the context of rising rates. And if the Fed chooses to ignore that fact, they will be directly responsible for the greatest financial collapse in recorded history.