The FED Controlled Market: A Delicious & Dangerous Poison

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About this week’s show:

• Investment Biker Rogers: “Imminent Stock Decline!—Buy Physical Gold”
• Crowds following momentum of markets all the way to the collapse
• True VALUE INVESTORS position and then let the crowd come to them

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“Things start out very complex and sophisticated, and we have a refined language. And then the next thing you know, it is down to name-calling, and ‘I’m going to scratch your eyes out.’ And that’s not just in my living room, that’s on the global scene. So, why the probability of Korean conflict rising every day? Maybe it’s because we’re all too human. Maybe it’s because we’re all too childish.”

– David McAlvany

Kevin:David, before we begin today I think we should mention that you and your dad are ramping up for the next set of conferences. I think it would be worth just taking a moment here and letting people know when each conference is coming. And of course, you and your dad also are offering, for free, private consultations for people who would like to schedule time personally with you the day after the conference.

David:Part of the reason Don is coming back from Asia after ten years of being over there most of the time – this is our 45thanniversary as a company, 45 years of doing what we do. And so we’ve met with clients on the West coast, now it’s time to move toward the Midwest and the East coast. We start in Overland Park, Kansas November 3rd, and then go to the Twin Cities in Minnesota November 7th, Philadelphia November 10th, Charlotte, North Carolina on November 14th. And then just before Thanksgiving, August, Texas November 17th. Naples, Florida after the holiday will be November 28th, and then the last will be Orlando December 1st.

Kevin:I should mention the private consultations with either you or your father, Don McAlvany, filled up quick, and so we’re encouraging people to sign up on the website, mcalvanyica.com/briefing. And you can click a little box that says you would like a consultation. But to make it a little more precise our listeners can call the office at 800-525-9556 [ask for Karis at ext. 118].

David:I would do that. In particular, I know the last series of conferences we filled up long before we got to the date, and we are currently filling up, so if you want to do a consultation with either myself or with Don, please take advantage of that – his wisdom, and the distilled insight that he has. Fifty years of doing anything teaches you a lot, and I wouldn’t miss that.

Kevin:It’s a treat – going to those last conferences that you did on the West coast. It was a treat for me, and I’ve known you guys for 30 years. Dave, I want to transition here just a little bit because this year has been a significant year. Speaking of 30 years of experience, I’ve never seen such a dramatic decrease in American buying of coins, bars, physical gold, from last year to this year. I’ve never seen anything quite like this before. Now, it’s not happening worldwide. Worldwide, you still have very brisk gold and silver buying, but what in the heck is happening here in America?

David:Yes, never a bargain-hunter, averse to value, and nearly always chasing momentum, rather than searching for an asset selling at inexpensive levels. This is what I would describe most investors falling prey to is why they’re their worst enemy, always chasing momentum. And to this point, we have silver Eagle sales which in the third quarter of this year, 81% lower than a year ago.

Kevin:That’s astounding.

David:Gold Eagle sales improved from their abysmal second quarter, still down 80% from the same quarter last year. So roll the clock back. Go to 2011, if you can recall prices were nearing all-time highs and the retail volume in the physical metals space here in the United States was nearly 800% higher. And while global demand for gold still remains robust today, you don’t see that same kind of behavior, in the United States in particular.

Kevin:Look at Russia. They just picked up another 500,000 ounces. That’s amazing.

David:And that’s last month. So they are going to be on target at these paces for the record numbers they hit in 2015, for the record numbers they repeated in 2016, and here we are again in 2017 – it looks like the Ruskies are doing it again, adding as many good delivery bars as they can to their caches.

Kevin:Yes, but did you buy your bitcoin? That’s really the question right now when you talk to somebody, they say, “What do you think about bitcoin?”

David:I think all Russian oligarchs own bitcoin. I mean, they need to, that’s the basis of future wealth. The U.S. market, we conclude, when we look at who is buying and who is not, is more fascinated with chasing the stock market. You’re right, they’re more fascinated with bitcoin or ethereum reaching fresh highs. Buy high, and sell higher. That is the momentum crowd’s cry. And we’ve mentioned before on the Commentary the greater fool theory – again, buy high, sell higher. It’s just too hard to avoid groupthink. Or perhaps it’s just too comforting to know that you’re not alone and the mass mind provides validation to your thinking, or whatever action you happen to be taking, but you’re not alone.

Kevin:Wouldn’t you think that the metals actually would be falling in value? If you have an 80% decline in physical buying here in the America you would think that the price would fall, but that has not been the case.

David:That is ordinarily the case. Ordinarily, the decline in coin demand is accompanied by a slide in price, but not this time. Gold maintains a price 10% improved from January 1, silver about half as much of that. Price action has been constructive, in other words it has been positive. And frankly, it boils down to this. U.S. investors prefer the momentum game to value. And that’s not just today, that’s any day.

Kevin:You mentioned the word comfort. There are an awful lot of things that we will do for comfort. It is amazing what we will sell for security. There is a security in doing what your neighbor is doing, and what that neighbor is doing, and then the other neighbor, but there is little bit of pain if you’re a value investor. I know one of your favorite authors back from the Depression is a man named Benjamin Graham. He talked about enduring short-term pain so that you could buy value, but that doesn’t give you the comfort of doing what the crowd is doing.

David:Right. So, the challenge with value, and the reason why so few modern investors even know the name Benjamin Graham, who, as you mentioned, is the father of value investing. He wrote Security Analysisback in 1934, and obviously he was writing that book throughout the 1920s. You have to search for value. That is one of the reasons why it is unpopular. The search, itself, is arduous, and you must see what others have neglected to see. In other words, you have to have an insight that goes beyond just a surface look at things. And you must take action without the affirmation, or without the approbation of your peers. When you don’t get support from everyone saying, “Oh, yeah, I did that yesterday. Oh, I’m planning on doing it tomorrow.” All the while you have to prepare to wait, and to wait, and to wait, for the crowd to come to you. Because, you see, it’s not that value investors are averse to crowd following. In point of fact, their success depends on it. But the crowd comes to them. It’s a game of chase, all the same, regardless of being in the momentum trade or value trade, but wisdom for the value player or investor places the value investor at the front of the pack, not at the back. Does that make sense?

Kevin:It reminds of something, Dave. I’ve studied navigation in various cultures – Viking cultures, or our own European culture with celestial navigation. One of the most fascinating navigating methods is actually in the islands of the Pacific. You had these men with canoes with just a little sail, and they would have to sometimes go hundreds of miles and find a tiny island. But their method of sailing was a little different than the way we think. When we go to a destination, we think of the destination, we set sail, we look to see if we see it on the horizon.

They do it a little differently. They get on their boat, they basically look at the wind, they look at the stars, and in their own imagination, they let the island that they are looking for come to them. And for some reason, that works. In this Polynesian navigation, the island, over time, appears over the horizon and comes to them. It’s a different mindset, but it allows them to manage what they can manage right there, and not something that is outside of their purview.

David:I think that’s one of the things that a value investor is not trying to control, it doesn’t assume that it can manage or control, which is the time element. Time is a factor for the value investor, but it is one that he can’t control. And I don’t think they really care to. So, it’s patience or lack of it, it’s the artificial clock of personal expectation which determines most choices for the modern investor. Why? Because they are racing toward that financial end point. As you said, they are determined to get there and get there as fast as they can, whether it is college savings or retirement or some other goal, unable to see – this is what they are blinded to in their earnest desire to arrive either on time or ahead of schedule – they are unable to see that the market is totally indifferent to their schedule, and oftentimes the market is cruelly indifferent.

Kevin:Another author that we have interviewed on this commentary, Dave, is Jim Rogers. We have interviewed him a couple of times. I know he is another author that you really enjoyed. You read his book Investment Bikera couple of decades ago. This is a man who doesn’t ask anybody’s advice as to what to buy. Instead, he goes on the road. I didn’t read the book, but didn’t he ride a motorcycle around the world and just observe and then make value investment decisions from that point?

David:Yes, he has taken two trips around the world. Once was in more of a posh 4-wheel drive vehicle, but his first trip was on an old BMW.

Kevin:Like yours. No, yours isn’t old.

David:His was even older.

Kevin:His motorcycle, a BMW, and he observed from the ground up.

David:Right. Rogers, in recent weeks, describes the end of a market cycle and speaks very firmly about his expectation of a significant decline in stocks. And he describes it not as some theoretical thing on the horizon but as an imminent decline.

Kevin:So, soon.

David:Yes. Now, the reality is, Rogers is always early. And with almost anyone I know, including myself, to be aware of macro-related issues is to be aware of the things that ultimately determine the course of the markets. However, you can be early. And he has been, notoriously, as we have, to some degree, been early as well. So I look at him – he is a veteran investor. He retired in his 30s from a lucrative stretch with George Soros and the Quantum Funds.

What is he recommending now? One of the many things he is recommending – of course, he likes agriculture. He started, not a fund, but an index for that, and there will be some remuneration as, and when, there is massive bull market in ag products, so he is well positioned for that. He is also recommending purchase of gold coins, which is interesting because he is a trader by nature. He is someone who would probably be more apt to buy in the futures world, buying futures contracts because of the leverage they provide, and that is consistent with his nature.

Kevin:But he is recommending physical delivery?

David:He is recommending physical delivery. That’s just never been his tune. But one thing that has been his tune is value. Value has always been his tune. So back to what we were talking about earlier with Benjamin Graham and securities analysis and value investing. Gold is curiously juxtaposed between the East and the West, and I think he has an interesting perspective on that. Rogers is always interested in what people hate, as an entry point into an opportunity.

Kevin:I’ll go ahead and take some of that. Remember what Roy said. He said the same thing. He said, “You want to buy it when they’re not buying it.”

David:That’s right. So find what’s hated. I remember thinking three years ago, “A wonderful place to be right now would be in Russian equities.” Tough to sell to clients, actually.

Kevin:You think different than I do, but go ahead.

David:But the reality is, the last three years it has been highly lucrative. And where do you go? You go where the asset is hated and has been left for dead. And it is an entry point. It’s not necessarily when you buy, but that’s where the research begins. But what’s there? And I think that’s one of the reasons why he may be landing on gold today.

Kevin:Do you think just his living in Singapore has had that influence on him, where he thinks a little bit a differently, but he still can see as an American?

David:Exactly, because Roger is, just like the gold market is curiously juxtaposed between the East and the West, and I think it is to his advantage that he is now living in Singapore and he has the perspective of his previous life as a Wall Street trader, and that is set next to the quieter existence today that he has in a sleepier town, a Malaysian city. Singapore is not exactly Manhattan, although it is a real global hub for trade and it’s a wonderful perch from which to note shifts and turns in the region. So, for someone who appreciates Asia, moved there in 2007 or 2008, wanted to raise his daughter there so that she knew Chinese and could see the future trends of the world through that lens. Gold is out of favor in the West, there is no doubt about that. And the mint numbers are the strongest evidence of that. But it is in favor in the East.

Kevin:And that’s why the price isn’t dropping, Dave. Your dad asked me back in 1999 – people would send him stacks and stacks of books, and he’s like you. Doing research is a hard thing, you have to winnow into things and say, “What can I spend time doing?” He handed me a book in 1999 called Irrational Exuberance.The tech market was hitting all-time highs. Nobody saw any kind of downturn whatsoever. But this book was quoting something that Alan Greenspan had said about three years before that, saying that the markets were running on irrational exuberance.

I read the book, and it was very, very timely because it said, “In the next year or two you are going to see a crash in the tech stock market like you have never seen before, because it’s running on irrational exuberance.” Is that where we are right now?

David:The reality is, all markets swing from irrational exuberance to irrational negativity. Gold, too, had a moment of irrational exuberance in 2011-2012, and in retrospect, you look back and read the Barron’s article in that timeframe. It was the first article praising gold as an asset class that everyone should own. It’s the first article of praise that they wrote about gold in 25 years.

Kevin:When it was hitting about $1900.

David:That’s right. So you go from irrational negativity to irrational exuberance. And if you can play that cycle, understand that when you get to the point of irrational negativity, that the risks are fairly well revealed at those cycle lows, and your risks as an investor are fairly well mitigated, to a large degree. So again, going back to the approach that Rogers has taken, finding what is hated – that is the entry point into research. “Why this? What is the reason? Can I find any fatal flaws?” And if you cannot find any fatal flaws, then perhaps you begin to allocate.

You mention he is a motorcycle enthusiast. I am, too. I read his book The Investment Bikerwith glee many years ago, not only from the aspect of traveling the world, and what a great adventure story it was, but as a young man I also had a budding interest in economics. This goes back 25 years ago. His book, to me, echoed the novels of Mark Helprin, that you had these evocative story-telling sessions going through central Africa and Eastern Europe and Russia.

Kevin:Right, so there was an element of the exotic, and that has to appeal.

David:But as you mentioned, it is a boots on the ground approach to economics, which is what you have in at least one of Mark Helprin’s novels, where this Wall Street analyst is the last of his kind. Everyone has moved to quantitative analysis, but the firm still keeps him around. He’s the last of his kind. And he is paid to travel, and he sits in coffee shops and he talks to taxi drivers, and he makes street level observations. He wants to know the true exchange rate – on the street, not at the bank. He wants to know where things are beginning to reveal themselves in terms of fiscal pressure.

And that’s what he comes back and reports, not the quantitative aspects, but the qualitative aspects of an economic environment, and that is precisely what Rogers has as he travels the world, the stories that he tells, the imagery that he creates, again, those evocative pieces where you feel that you are actually riding along with him down a dusty road.

Kevin:It’s a little different than the fancy equations that we see right now that are applied to what we are told is economics by the central bankers.

David:Fundamental factors are really what that kind of an analyst is looking for. Value, for many people, is discovered most often in a bear market because fundamentals are fully revealed in a bear market. Contrast that with today, because again, fundamental factors in stocks, and to a larger degree, in the larger economy, have not played first fiddle, they’ve played second fiddle to central bank interest rate composition, to balance sheet construction, and all of the unique twists and turns of the tools that the Fed and their compatriot central banks around the world have been using. Rogers echoes our concern that we have moved a long way from being able to adequately value risk in the marketplace.

And he echoes our concerns that stocks are not being invested in on that basis. Fundamentals are no longer important because of the index craze. Because people are buying an index fund and gaining a broad exposure, they’re no longer buying an individual company, they’re buying a sector, they’re buying whatever it may be. And the trend has been to purchase blindly with no differentiation, with no value appraisal. And in his opinion and ours, it is not likely to end well. So it is back to those fundamental factors.

Kevin:I was talking to a buddy of mine this weekend. We both had the same instructor when we learned to fly sailplanes – gliders. We were talking about those times when we were just about to stall the plane. Laverne St. Clair was our instructor, and he was sitting behind us because the glider was a tandem seating. He was sitting behind us but you could feel the stick. He would say “my plane” because if I was getting into trouble or if this other guy that I was talking to was getting into trouble, as we were learning he would take the plane over, and he would say, “My plane.” Well, until he handed that stick back, we didn’t touch the stick. When he said, “My plane,” what that meant was, “Hands in the air, you’re done,” until he rights the problem. And then he would hand the plane back and I would say, “My plane,” when it was time to take back over. In a way, in 2011-2012, something happened with the Federal Reserve where we had a free market up to that point. The market was flying along just fine, maybe it was close to a stall. Somebody, for the first time in world history gave all the central markets all the control and they said, “My plane.” Now, at this point they’re saying, “We’re about to hand the stick back.” Is that realistic, Dave? Are they really going to take the risk, after having full control, of handing it back to the free markets?

David:That’s a great way to frame it. We hear that the Fed will reduce its balance sheet, and they have said that they will raise rates, in essence, allowing the market to be the market once again. And that’s after five years of utter control, complete control, nearly ten years of strong influence. And that distinction, I think, is a key one because they were actively engaged in saving the world from destruction in 2008 and 2009, granted, using the same measures that got us into the problem in the first place. But be that as it may, they did bring calm back to the marketplace and prevented utter catastrophe. So they had a number of years where they were intervening. I think it was the summer of 2011 when Mario Draghi said, “I will do whatever it takes.” But it caused a recalibration in the market, to say, “Wait a minute. Did you say whateverit takes?”

Kevin:Whatever. And he has.

David:You’ve got my back, whatever happens from this point forward.

Kevin:My plane.

David:You asked a question. I can only respond with a question. Can you imagine – the rock star status which central bankers have achieved – can you imagine that being retired? And would they be willing to play second fiddle and trust the markets, the natural supply and dynamics, to once again set prices? Again, after determining with, really, authoritarian control, what the natural rate of interest is, is it likely that a community of central bankers is willing to hand back to what for them is a wildly unpredictable investment crowd [the right] to determine what the natural rate of interest is? Again, you’re dealing with a market which amongst these individuals is mistrusted, and authority and control, which is absolutely trusted. They believe in themselves more than they believe in the market. And that’s where I tend to be on the opposite end of the spectrum. I believe more in the market than I do in the wisdom of any one man, let alone the wisdom of a collective.

Kevin:But it’s addictive, Dave. Have you ever seen a tyrant purposely hand a country back to democracy? That just doesn’t happen. It’s addictive. They have had control. How in the world would they give it up at this point?

David:And a part of it comes down to results. Authoritarianism gets results faster and cleaner than the market processes which include risk appraisal and price negotiation. It is just easier by fiat to say, “Wheat, or corn, or soybeans will not sell above this price. You cannot charge more than this for a gallon of gas.” Price controls get you where you want to go instantly. And in essence, they are doing away with that risk appraisal. They’re doing away with that price negotiation. And we see, to a large degree, that price discovery disappeared over the last five to ten years. Our central banks – is that community willing to allow it back, the process of price discovery?

Kevin:Yes, but the central banks are promising something called wishful thinking. One of your favorite poems by Rudyard Kipling, Gods of the Copybook Headings, is a poem about getting rid of wisdom and maxims, and the things that you would record in a copybook, and replacing them with wishful thinking. And those who did, those who promised the replacement of wishful thinking, are in ruins at this time. They’re covered with sand.

David:It’s a poem that points to the enduring value of common sense and enduring befuddlement by those who put trust in higher sense. We read the poem a couple of months ago. Read it sometime from beginning to end if you don’t know it. But the opening lines suggest that these gods of the marketplace, and perhaps we can translate that in our own time and place, the high priests of growth and prosperity, the demigods of Maiden Lane, the folks that work there near Wall Street for the Fed.

They’re not new, these priests of growth and prosperity. They’re not new, and their presumption of control is actually as old as any human endeavor. Kipling says, “As I pass through my incarnations in every age and race, I make my proper prostrations to the gods of the marketplace. Peering through reverent fingers I watch them flourish and fall. And the gods of the copybook headings, I notice, outlast them all.”

So, we reflect on the permanent and perpetual march higher in the equity markets, and we know that there are promises of prosperity. I go back to Francis Fukuyama’s book where he basically claimed that we had reached the end of history, we had reached a period of perpetual peace, that democratic liberalism had reached a point of permanent plateau. And it was, in fact, like Irving Fisher’s proclamation in 1929, that prices had reached a new permanent high plateau. And this was, of course, just before the crash.

Kevin:He could have said the end of suffering. But Dave, whether you are a value investor or whether you are the investor today who is reaping the benefits of just going with the crowd, suffering comes. It either comes as a value investor while you wait – remember, you were talking about waiting. Wait, and wait, and wait. Wait for that island to come to you. Wait for the crowd to come to you. There is suffering involved in that because you look like an idiot until it happens. But then, is there more suffering? And I guess I know the answer to this. The greater suffering comes from the person who was with the crowd, who followed the wrong god.

David:Underneath every social construct, whether it is a political construct or a market construct, is human nature. So when we look at the assumption of the end of history, when we look at the assumption of the end of the markets, or free markets, where volatility is normal because there is a constant push and pull in the price discovery process, you’re right, human nature is what is underneath these things, and why, I think, ultimately, regardless of the assumption of the end of history, it’s just flat naïve. Regardless of the assumption of the end of free markets, and a greater control and a brave new world, it doesn’t work that way, unless or until you’ve altered human nature.

You’re right, the value investor versus the momentum trader – each of them suffers. One suffers now, one suffers later, and I think I’d rather be the value investor. Your suffering is defined, to a degree. The other, for the momentum investors, is undefined as yet by the degree of panic and the stampede to come. And so Graham, this man who was very influential in the 1930s, defined the intellectual framework for Warren Buffet. He may not have actually bought gold at these prices, or at any level. But he certainly would not have entered the stock market, priced as it is today.

Kevin:Benjamin Graham was good at finding value when others didn’t. Could he find a needle in the haystack in the current market?

David:I think it’s possible. I think with rigorous security analysis that is possible. But I think one of the things that also comes to mind is that as a value investor, when he decided to take a time out and move to the sidelines, he grew up, he developed his ideas of value investing, he invested in an age when, by default, if you were out of stocks you were in gold.

Kevin:That’s right, because cash was gold, and everybody owned gold at that time because they owned some cash.

David:The age prior to the 1930s was the age in which cash and gold were the same. The default mechanism, coming out of the equities markets, getting out of stocks, was going into a currency which was 100% gold-backed. How things have changed. Now you have a second decision to make. But at that point it was just common sense, if you wanted to reduce risk in one category you moved to cash, which was the same thing as bullion.

Kevin:Isn’t that amazing? Let’s just ponder that for a second. You were either in stocks or some other investment, or you were in gold every time you were in cash. Speaking of cash, we’ve had a guest on – we have him on almost every year – love him. He is up in Scotland – Russell Napier. Russell is scratching his head right now and he is saying, “Speaking of that cash that is not backed by gold, where is it if the central banks are adding 300 billion dollars a month, in some form or another, of liquidity and quantitative easing, where is this what we call M2 – monetary growth?”

David:That’s right, each month, Russell writes a small missive for institutions. There is a lot changing in Europe, like we had our implementation of Dodd-Frank, approval of a massive set of legislation to help change and improve and maybe even bring safety measures into our marketplace. The same thing is happening in Europe today. And it is interesting, it’s the Markets In Financial Instruments Directive, the MIFID-2, which is their equivalent of Dodd-Frank. And it goes into effect January 1. The challenges, just with Dodd-Frank, it introduces massive amounts of complexity in an attempt to bring greater transparency to the derivatives market and other markets. They may, in fact, be bringing a lot of chaos and turmoil into the financial markets.

Kevin:Maybe creating the next crisis like Bookstaber talks about.

David:Again, just on the basis of unintended consequences, Bookstaber was involved, not in the creation of the MIFID-2, but was involved in the creation of Dodd-Frank and the Volcker rule, in which he says we solved one problem, but we did create the next round of problems.

Kevin:He was part of it, and it scares him. He wrote a book about it.

David:Right. Napier writes for an institutional audience, and institutions. I mention the new directive because his world is changing, and his audience is having to adjust to a new world of regulation and an immense complexity. Napier is looking right now at the Fed’s announcement of normalization, which we have been talking about today. It’s problematic, and first of all, he takes that opinion because he sees bank credit growth in the United States slowing. And so credit is slowing at the same time they want to bring in monetary tightening, he says, “Well, maybe that’s not such a good idea.”

Second, he sees broad money growth, M2, on a global basis, also slowing, which to him suggests that the global economy, led by the emerging markets, is already slowing. And we saw significant infusion of liquidity and capital, 2008 and 2009, by India and China, and not even they are able to help buoy these global numbers, and again, keep M2 moving in a positive direction. So, in the U.S. you have money growth which is, today, at the same levels that it was when the Fed was initiating Quantitative Easing 1, Quantitative Easing 2, and Quantitative Easing 3.

Kevin:Then Europe took over. There is this appearance that there is sort of synchronized easing.

David:And his point is that it is an appearance of synchronized global recovery, and it is an appearance. So the challenge is now when you have the appearance of a synchronized global recovery running into a tightening monetary environment, it’s a recipe for recession, if not disaster. Can we repeat the kinds of disasters we had à la 1987? Absolutely. And his point is also that something just doesn’t add up. You have this massive global expansion in credit and yet you have a slowdown in broad money measures, again, going back to M2. So the central bank community, which is responsible for the creation of money, is failing on the one thing they are supposed to do best, which is influencing the quantity of money.

Kevin:And that’s the equation, Dave. The equation has to create M2 or else the credit expansion has been a failure.

David:On the other hand, interestingly, there is credit expansion but no quantity of money expansion.

Kevin:Right.

David:So quantity of money, as measured by M2 – not happening. Credit? Yes – happening. Asset price and risk asset inflation? Yes.

Kevin:Through the roof.

David:So they’re influencing prices, but they’re not influencing the ones that they traditionally influence, and they can’t figure it out. And I think part of it is, they have this long-term commitment to a theory that failed long ago in practice. In the 1970s the Phillips curve was discredited utterly, but they live in a world of theory, and the theorizers, again, the central bank community, is still in love with the Phillips curve.

Kevin:It’s what they wrote their doctoral thesis on, Dave. You have to protect it if you wrote your doctoral thesis on it.

David:And it suggests that an improvement in employment leads to an increase in inflation. It’s axiomatic, according to the Phillips curve, that an improvement in employment brings an increase in inflation, and yet – and yet – and yet we wait. I’ve tried to ask Claudio Borio onto the program, and he is a pretty busy guy. He runs the Bank of International Settlements, the central bank to central bankers. I’ll continue to ask him to be a guest. But he is one of the few that I know of in the central bank community who looks at the Phillips curve and says, “Yeah, it works sometimes.” And sometimes it doesn’t, so just be willing to set aside some of your underlying assumptions and realize that that one might not be workable.

Kevin:So what they have done is, they’ve left the punchbowl out because they are looking for something that isn’t there, yet the asset price inflation – the price of stocks and assets in general – has just gone through the roof.

David:That’s just it, you’re exactly right. We’ve mentioned William McChesney Martin, who suggested taking away the punchbowl before the party gets started. They’ve left the punchbowl out too long because they’ve been looking for this indication of inflation, and they knew that, if, according to the Phillips curve, you reduce unemployment, that you should then see an increase in inflation. And when they saw an increase in inflation they would know when to toggle back. They would know when to take back the punchbowl.

And they’re not doing it because inflation is not responding – consumer price inflation, anyway. Asset prices are already in the tornado, already spiraling up and out of control. But the central bank community is fixated on the CPI. They’re fixated on consumer price increases and they’re waiting to see them jump before shifting gears.

Napier suggests that maybe they’ve waited too long because now, in fact, you are beginning to see this deterioration in terms of, on a global basis, M2, which to him suggests a slowing in economic speed everywhere. So growth dynamics, globally, are shifting. A downshifting collapse in global money growth may create financial market chaos, as and when the Fed follows through with its recently announced plans to shrink its balance sheet and raise rates.

Kevin:I want to go across the seas because sometimes you see strength in something that is weak only because the thing that it is being compared to is weaker. We’ve seen the dollar rallying a little bit against the euro here recently, and it has to do with these strange goings-on in the Spain Iberian Peninsula region. It is incredible what we’re seeing over there.

David:Yes. There is a number of good things that come from the Iberian Peninsula. One of them is the greatest ham in the world (laughs). But what is in the news this week – we watched a king has no clue – not a king has not clothes, but a king has no clue moment, where Mariano Rajoy, your top dog, the Chief Executive, in Spain, sends in troops to Catalan, begins jailing regional officials, shuttering hundreds of polling stations, destroying ballot boxes…

Kevin:In the name of freedom, Dave. In the name of freedom.

David:And even beating up elderly pensioners. There is about a thousand people seeking medical treatment from police brutality. And then, he had the gall to claim that there was no referendum which had occurred. Now, he was only able to close down about 330 of the polling stations.

Kevin:Several million had already voted, hadn’t they?

David:2.2 million votes were counted at the 1700 polling stations that remained open.

Kevin:But this confused the European leaders. They’re all looking at this saying, “Wait a second. I thought we had the end of history.”

David:“What the Franco is going on?” That was one of those “What the Franco” moments. And he really did – Rajoy is creating something that for most European leaders is appalling – the violence, the non-diplomatic approach, bringing back Franco from the dead. This is from a man who was actually supporting the opposition group in Venezuela. And do you know who was writing in the local paper in Venezuela, saying, “This guy is totally inconsistent. He suppresses any dissent in his own country, but he supports it in mine.” This is the dictator Maduro in Venezuela. He is actually giving political commentary on Rajoy. And again, does this guy have a clue what’s going on?

Kevin:For the person who is not following this closely, this is similar to Brexit, or the Scottish vote. This is if England was a little bit more, oh I don’t know – Spanish – they probably would have had this type of thing happening before the Brexit vote, right?

David:That’s right. We did have, as you mentioned, the Scottish vote, which was the question of do we want to extricate ourselves from the U.K. and be our own country? And that is what the Catalonians are saying, “Look, we have the referendum, we have 90% of the people voting.” And this is 2.2 million people voting out of seven million total in the population – a reasonable turnout – and it opens the door for them leaving Spain altogether.

Kevin:Doesn’t it also affect the euro as a whole? This is just one more chink in the armor of Spain possibly needing to leave the euro, right?

David:It explains why violence is the answer, and why police brutality is the first measure chosen, because Spain cannot afford to have these seven million people secede. That one state represents 20% of the entire Spanish economy. And so, what do we conclude? Populism is not dead in Europe. We do see, as you mentioned, dollar rallies, the euro declines – it is one more chink in the armor in terms of the euro project, dating back to that meeting in Rome 60 years ago which set it all in motion. Can it some unglued? That question is still a reasonable question, and it remains unanswered.

Kevin:Lest we be distracted by violence in Europe and forget the potential real threat. Korea is still brewing, and probably brewing pretty hard.

David:When I listened to the U.N. speech that Donald Trump gave, it made me smile. I also kind of had to shake my head and say, “Oh, no. Oh no.” So, you’re right, on the other side of the world we have little Rocket Man…

Kevin:Those are his words.

David:As our president affectionately refers to Kim Jung Un, and he continues to explore delivering all kinds of weapons into the West, or onto one of our allies, and he prefers the hydrogen bomb. So, I cannot imagine living in Japan the last couple of weeks. In recent weeks you actually could look into the sky and on at least one occasion, see the jet stream created by an ICBM, an intercontinental ballistic missile, flying overhead, launched from North Korea.

Kevin:Yes, but never mind the fear. You have the Bank of Japan saving the day, they’re buying stocks any time they fall, so don’t worry about it. If you’re nervous about that, we’ll buy the stocks. We’ve got your back.

David:That’s right, no real evidence of tension in the stock market there, you’re right, because the Bank of Japan supports the bid in stocks. Hydrogen bombs – I didn’t realize this, but using fusion rather than atom bombs, their cousin which uses fission, are far more destructive, and therefore, don’t need to be as accurate. So, because they cause anywhere from a hundred to a thousand times greater destruction, you just have to lob that thing into the right vicinity, it doesn’t have to be pinpointed, and it will get the job done.

Kevin:Let me ask you – people pooh-pooh sometimes the idea of and EMP, but when you have a nuclear blast somewhere it does fry the circuits of a surrounding region, and we live in a connected age, Dave. I remember my panic when I started to think that I lost my phone on my way back from Israel the other day. It hit me just how much I, too, need connection. Do you think EMP is a real deal, or is an issue that needs to be thought about?

David:It was interesting, every once in a while I’ll read the daily reckoning and Jim Rickards wrote a piece this week about the impact of an EMP burst and how if the North Koreans wanted to, there is not much of a time gap between now and when they could pull that off. And you just have to lob it into the atmosphere, and a large enough EMP burst is adequate to knock out the U.S. power grid completely. Now, you’re talking about a massive logistics crisis. We, in our client conferences, had talked about what it would be like to lose just one part of our electric grid, and how our electric grid is tied together by the equivalent of a couple of very large fuse boxes.

Kevin:You met with a man who was a specialist in that who was hired to identify that problem.

David:That’s right, and try to mitigate the issue. This is, again, from the 30,000 foot view, or maybe it’s the 80,000 foot view – an EMP burst at that kind of an altitude neutralizing our power grid – you’re talking about millions dead in the United States – millions. I don’t remember how far we took our star wars program under Reagan, but it makes you think this is when you need it.

Kevin:You certainly hope they took it far enough, let’s just put it that way.

David:Interestingly, Rickards, with sort of a swipe at crypto-currency says, “This is why I recommend gold,” because it’s not dependent on the power grid. He is right, you have to have connectivity to use your crypto-currencies. In that sense, you are 100% system-dependent. Gold is a standout, not only as no one’s liability, no one’s counter-party risk, but also, tied to no one’s Internet infrastructure, which is a fascinating thing to even consider in this age.

Kevin:Isn’t it interesting? I was flying over Iceland the other day. What an unusual way to get home from the country of Jordan. I was looking down on Iceland and I was thinking, “A huge amount of bitcoins are processed using the formulas there in Iceland because the power is cheap.” China, even more so – don’t they produce about 70% of the bitcoins that are out there at this point?

David:According to the Economist, 70% of new bitcoins are being mined in China, and it is interesting because they can’t get them to market. There are capital control issues, there are trade issues, there are exchange issues, there are new ICO issues. So you can create them and you can own them. It’s not illegal to own them, but you can’t trade them. It makes it very interesting, it makes me think perhaps there is a larger shadow supply, and that shadow supply is continuing to grow and overhang, if you will, within the market. For anyone concerned about price fluctuations, shadow supply is an issue.

But going back to North Korea, it’s the Chinese government which made me think something is getting ready to happen in relation to North Korea. The Chinese government allowed a paper in recent weeks to be published, and it explores how to deal with a refugee crisis in the event of the North Korean government being toppled. It’s the kind of thing where they don’t have open conversation about issues like that. They just don’t. Again, this is a high stakes poker game, brinksmanship, negotiation. Perhaps this is just one way of playing it, letting the other side know that you are considering all options. But frankly, it would appear that diplomatic channels are shrinking, and deterrents, even pre-emptive actions, are a growing possibility.

Kevin:I think sometimes we over-complicate things, and we think that there are “experts” in control. We do that with the central banks, and sometimes we forget that just simple fundamentals will kick back in. We do this with politics and diplomacy, we do this with geostrategic types of things. But really, when you go back and look at history, Dave, it still comes down to just sort of like sandbox kind of politics where, in the end, when one person pushes the other, the other pushes back, and then you start to see another pushing match, and then ultimately, somebody slaps or hits the other, and it really turns into an all-out fight, and it really had nothing to do with high level “expert” diplomacy.

David:We have this conversation routinely in our house, not about little Rocket Man, but about escalation and de-escalation. When my 11-year-old announced the inevitability of conflict with North Korea at breakfast earlier this week, he gave his timeframe within two years. It was like he had some sort of an intelligence contact the way he just said it with such certainty (laughs). “Within two years we’ll be at war with North Korea.”

Kevin:It sounds like he is the son of his father, who was the son of his father (laughs).

David:Well, I asked him if he had learned anything about the process of de-escalation from his siblings that he might offer as advice to bring things off the boil on the Korean Peninsula. And I’m looking at his other brothers and sisters, saying, “You realize how these problems get started, right? You have an argument, and then somebody hits someone, and then someone hits someone back twice, and that’s escalation. How do you de-escalate? If you can tell me how you can solve the problem, I’m going to get you on the phone with someone in Washington.” But his comment, relating to sibling strife, was that it’s just so hard. It’s so hard in the moment to not push back, to not hit back, to not verbally jab back when you’re in the fight.

Again, things start out very complex and sophisticated, and we have refined language, and then the next thing you know, it is down to name-calling, and “I’m going to scratch your eyes out.” And that’s not just in my living room, that’s on the global scene. So, why the probability of Korean conflict rising every day? Maybe it’s because we’re all too human. Maybe it’s because we’re all too childish.