The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“We’re talking about a new world of rates at the zero bound, more or less globally, and then you’ve got the old tool which Keynes recommended being brandished in a fight against deflation. You are fodder for the system. And one of the only means of escaping that said category of fodder is redenominating a portion of your assets in a private and portable form of wealth – gold.”
– David McAlvany
Kevin: Greece is the word again, Dave. It’s amazing. One of my favorite stories is a story about a Greek – Zorba the Greek – and it’s interesting, it’s a story full of life. That’s what you think about when you think of the Greeks, full of life. It’s sad these days, I’m looking at their potential defaults, continually, on debt. But in a way I can’t help myself. I can’t help but think of Zorba the Greek, a man who lived life, but strangely convinced this other man in the story to give up his inheritance so that Zorba could spend it however he wanted, and then, when he was broke, and the man who gave up his inheritance was broke, as they sat on the beach, Zorba got up. What did he do?
David: He danced.
Kevin: He danced. That’s right. I guess that’s the Greek way.
David: Well, hedonism is something that certainly isn’t lost on the Greeks – living well, good food and wine, enjoying the sunshine. These are things that certainly have played well into it being an attraction for all of Europe and all of the world as a tourist destination. But they do have a hard time with a few things, like paying bills, and that’s what has caught up with them here in the last few years, spending more than they brought in and not being willing to adjust, make structural adjustments. Because that is what some people know as austerity, and that would be like telling Zorba, “You should not dance, you should not eat, you should not drink. You should not live.”
Kevin: Austerity? What’s austerity?
David: That’s the opposite of living. So, what we have now, this week, following one of the largest debt restructurings in history, we have Greece going back into that fray and we will be looking at our third restructuring of debt there in Greece. What they want is to, unlike what they did last time, sort of extend and pretend that there was an issue, they want their old bonds replaced with bonds that are tied to economic growth, and if they don’t have economic growth, then they don’t have to pay. And if they have economic growth, then they pay.
And the second thing they want to do is create perpetual bonds, which is funny because in the United States, after the Great Depression, before World War II, we did something similar. Actually, we’ve done it several times, what we called perpetuals. What they are asking for is perpetual bonds. We’ve done that. We pay 2% interest on the bond and there isn’t a return of capital at the end of a specified period, which is what you expect with an IOU.
Kevin: So, it’s almost like an immediate annuity, or something, where you just give the money up and they just pay you for – indefinitely.
David: Indefinitely, they’re going to pay X percent, and again, it’s like making minimum payments on a credit card, forever, with the debtor choosing sort of a non-penalty interest rate. And that’s what they’re going after. I think the most interesting thing about the transition in the last week, having a new finance minister – his special interest and special study as a Ph.D. student, was in game theory, and it’s going to be very interesting to see how he brings his academic and financial experience to a group who expect things done just such a way. We’re talking about Brussels and the folks in the EU, as they hammer out a restructuring. I wonder how much game theory he is going to apply from his side of the negotiations?
Kevin: And is it not a little bit like a prisoner’s dilemma? If you’re in Europe and you’re seeing Greece, Greece knows that if they were to break away from Europe, it’s not going to hurt Europe that bad, but Spain, Italy, you could see the dissolution of the European Union, by a simple domino falling, and that’s the prisoner’s dilemma, is it not? Game theory.
David: Yes, and in addition to that, you have the domino effect, if you will – the French have come out in support of a restructuring of debt for the Greeks, and I thought to myself, I don’t know if you call that birds of a feather flocking together, or what, but you’re going to see a number. If this was sort of a democratically approved thing, Spain is going to think that’s a good idea, Italy is going to think that’s a good idea, Portugal is going to think that’s a good idea, Ireland already had much of their debt restructured and forgiven. You could see the same thing from France, as well. Verbally, they’ve already said it.
And what does that portend? What it portends is that all of these countries, at some point, and I think France is front and center, may very well need debt restructuring in the future, too, so pun intended, let’s get the first olive out of the jar with Greece and then it’s ready for us when we need it.
Kevin: Do you think that is maybe what Switzerland was looking at a couple of weeks ago when they decided that they just couldn’t afford to continue to support the euro?
David: If it’s going to go from bad to worse, and the euro may, in fact, decline further in value, that’s sort of like tying your last hope to a sinking ship. And I do think that there is a limit to the downside. And if you will recall – this was about five years ago – we had a very good conversation with Otmar Issing, who developed and ran the Central Bank. He was the longest-standing member of the European Central Bank.
Our comments before and after that were, if the countries who really can’t afford to be in the union leave the union, it leaves the union stronger than it was before. And so, it may be that Grexit, or some other exit from the peripheral countries, if that were to happen, is a euro-strengthening event. What you could have in the interim is a tremendous amount of weakening in the euro, given the anticipation of unknown events, and what not, but then with a major move higher in the euro, shaking off some of the weak contributors to the union.
Kevin: Talking about weakness, you were talking to me the other day and saying, “You know, Kevin, there are people who are calling me who have never considered gold.” Business owners, people who are traders in the market, they’re calling and they’re starting to get concerned. They’re seeing cracks. And I don’t know if it was what Switzerland saw that they are seeing now, but they’re calling you and they’re saying, “Okay, tell me one more time because you’ve driven me nuts in the past and I haven’t cared, but tell me one more time about gold.”
David: Right. What’s interesting to me is it is multiple conversations. I am having multiple conversations with people I’ve known for decades that, in essence, define the words optimism and optimistic. These are the comeback kids. If something bad happens in business they’re right there to patch it together. Never bet against America, never bet against innovation, never bet against…
And here’s what interests me. They are both selling their privately held businesses – I’m thinking of two in particular which happen to be interest rate-sensitive businesses – and they’re sitting on cash while at the same time seeking out non-economically sensitive private enterprises to own. Keep in mind, non-publically traded enterprises. That is interesting to me, as well because it reminds me of Bill King’s comment that once you rig the market, people leave.
So, it’s not as if they think, “Well, I’m going to have this 7, 8, 9-figure amount to work with, I’m going to put it to work in bonds and stocks in a typical 60/40 split between the two, or vice-versa.” No, quite the opposite, they want control, they want to be out of the public arena, and they don’t want to have to deal with the SEC. Additionally, and intriguingly, they are also asking about gold.
So again, moving out of businesses that are interest rate sensitive into businesses, if they can find them, non-publically traded enterprises, which are not economically sensitive, and in addition to their cash holdings, are interested in gold. We are talking about people who in 50 years have not looked at gold once with any degree of interest and there is something in their bones that says, “It ain’t right.”
Kevin: Like you said, Bill King says that when a market has been rigged, the players leave. A big part of that rigging has to do with quantitative easing. This thing has been supported by something false, now, for years. Now that they are talking about easing quantitative easing back, or tightening the policy, what does that do for this rig?
David: Well, that’s just it. If you recall, 2011, there was a Bank of England report that highlighted what typically happens at the end of quantitative easing, and their conclusions were three things. You have a long, steady, and deep decline in asset prices. It is steady, it is long, and it is deep. We’ll circle back around to that later, but I think it is important to realize that there are a number of very smart and sophisticated business people looking and saying, “It’s all well and good that we’ve had asset price appreciation. We know from the management of businesses that we haven’t had follow-through in the underlying economy to the extent that you expect, given the trillions of dollars spent, both by the Fed and other central banks, so something is clearly not functioning the way it should, it’s expected to, intended to, etc. Maybe it’s time to trim the sails a bit.”
Kevin: Loyalty is an interesting thing, Dave. The Swiss were supposed to be loyal to the euro, and they said, “You know, we have been, but we’re going to step aside.” But the Danish people right now, for whatever reason, somehow believe that they can go ahead and continue to peg their currency to the euro, and that they can afford it. The Swiss said they couldn’t, but can the Danish currency stay pegged?
David: A week or so ago we talked about the SNB, the Swiss National Bank, caving, having committed to the market to keep a peg, 1.2 to the euro, and that gave them added trade competitiveness. And lo and behold the SNB’s balance sheet grew from 80-odd billion to 400 billion and they realized this was an unsustainable track to try to manipulate their currency lower. It was costing them tremendously, ultimately, may cause financial panic in Switzerland if they continue down that path, so from a prudential standpoint, they probably made the right decision, but they shocked the market.
The Danish came out that same week and said, “Listen, here’s the deal. We are going to maintain the peg,” and this is kind of what we would consider the latest installment of the currency war chronicles. In essence, the Danish Central Bank has stepped in and reiterated the kind of commitment that the Swiss had been making previously, and that was to defend the peg to the euro and keep it within a 2.25 percentage point band. And the Danish Central Bank is reassuring the market that they have the resources and the backbone to defend their peg to the euro.
Perhaps they were thinking of possible steps that they still have open to them in order to do that, but as of last week, they’ve used up at least two of those resources, and they happen to be pretty considerable ones, if you are looking at caches of financial fire power. Number one, they moved their interest rates to a negative level, so new buyers of Danish bonds basically have to pay to play. You don’t receive interest when you are investing in Danis kroner, you pay to sit in kroner. They charge you half a percent.
Kevin: And that is to discourage buyers who are trying to hedge in a currency that is stronger than the euro.
David: Right. And also, the second thing they did is they quit selling government bonds altogether, so if you were thinking of buying, they’re simply not available. Not on the market. So, in essence, what they’ve done, the Danish Central Bank, and this is my opinion, of course, they’ve painted a target on their back, basically, for all the speculators around the world to aim at. You have examples of this with the exchange rate mechanism where you basically made an unsustainable commitment which was ultimately broken.
Kevin: We talked about that a couple of weeks ago, back in 1992. They had to break it.
David: That’s right. This is what I mean by painting a target on their backs. The ideal unsustainable commitment is one that isn’t noticed and remains below the radar. And of course, they just said, “Hey, look, we’ve got the resources and the commitment. We are going to maintain the peg.” So for every trader in the world, it’s like, “Okay, well, how much money do they actually have, and how much are they going to spend before they have to cry political uncle and call it off?”
Kevin: It’s like bleeding in the water when you know there are sharks nearby.
David: Yeah. Well, and speculators don’t mind chumming, if you will, throwing a little bit more blood to bring the sharks in faster. That’s what I’m talking about. They can endure longer, we know that, but that kind of a project where you make an unsustainable commitment but no one knows about it, ultimately it is unsustainable. That won’t last forever.
But what you see is the half-life of an observed unsustainable commitment, shrinking with every speculator’s observation and sort of fancy for profit. Maybe this is breakfast table conversation, but the Danish will be broken. (laughs) The Danish will be broken, they set themselves up for failure here because they are dealing with a limited set of resources.
Kevin: Just to explain to the listener, if the Danish is broken, basically, what they are doing is, if they disconnect, the krone will go through the roof like the Swiss franc did.
David: That is the suggestion, that they are holding things at an artificial level, and an artificiality of all sorts, over the next few years, will be revealed for what it is – a farce. And anyone who is making bets in the asset markets on the basis of artificial pricing will pay a very severe penalty for assuming that those commitments by central bankers were being made as if by god-like figures who had the power to control all things, whether it is rates, asset values, etc. When in fact, the market has, for 5,000 years, ultimately trumped petty bureaucratic gerrymandering.
Kevin: Over and over, Dave, you’re talking about the market taking over the market. The true market is based on true prices, not nominal values. One of your favorite authors that you read, as far as a newsletter goes, is Alan Newman. He brought something out that I thought was fascinating. Even though we are seeing record levels in the stock market right now, when you really weigh it out, take the nominal value out and actually weigh that against just inflation-related numbers, we’re going backward, Dave.
David: Right. So, when you look at growth in a given asset, you have to ask yourself the question, how much of the growth was attributable to the asset, on its own merits, versus money-printing, which may have boosted the value of the asset as a component part of its growth? And if you take inflation out, if you subtract CPI from U.S. equities, so you are adjusting for inflation, we have yet to exceed the 1999 peak level. We are still below it by about 1%.
In other words, the increased household net worth which seems significant over the last several years, when you factor in CPI, which is a very standard measure of inflation, that puts us at levels slightly below what we had 15 years ago. In this way, you realize how inflation is deceptive. The numbers are bigger, but are less meaningful and less potent.
Kevin: And look at inflation, how it’s rated, even taking into account, Dave, all you’re doing is counting CPI the way it’s reported. CPI, Consumer Price Inflation, is already under-reported, for political reasons, so even taking their number, we’re not up to what we were in 1999.
David: Let’s go back to that idea of nominal prices being pushed up. The Dow is at all-time highs in nominal figures, not in inflation-adjusted terms, but who bears the brunt of adjusting to higher levels of inflation? That burden is borne by the middle class. You have low wage growth, and you could look at that in several ways. When you’re thinking about inflation, low wage growth is its own issue. When you’re thinking about inflation, it’s either prices going up, or people in the marketplace adjusting to higher input costs and shrinking the cereal box, or making a smaller Snickers bar but charging the same amount of money for it. And what this ultimately triggers, between low wage growth and the inflationary inputs for the middle class, is political populism, and an outcry of unfairness due to an exaggerated wealth gap.
Kevin: Boy, that sounds familiar, even this week, just what is being played on from the political side.
David: And this is where it’s tempting for government officials on both sides of the aisle to misdiagnose the increase in wealth and deliberately avoid the connection to Fed monetary policy. Part of the reason they want to do that is because they then want to turn around and call for an increase in taxes on the rich, when in essence, nothing is changed in the net worth of the wealthy, net of central bank targeted inflation.
So you might conclude, and this is, again, perhaps borderline cynicism, but you might conclude that the Fed and the Treasury are in bed together, conspiring of ways to increase taxation, either via inflation, via rate repression, financial repression, we’ve talked about before, via actual tax increases, given the nominal wealth distortions largely attributable to the inflationary policies they, themselves, put in place. Or, as we will explore in a minute, you also have alternative means of taxation, and these, like inflation and rate repression, are also outside the legislative process.
This is where it drives me crazy. It is outside of our political representation. We revolted over less in terms of unrepresented taxation 200 years ago. And again, it goes back to that issue of taxation without representation. It is all well and good to be taxed, as long as it is disclosed, agreed upon, and our representative government has said, “Yes, we’ll pay our fair share, and I will march to the music if my constituency doesn’t like what I’ve just approved.” But we’re talking about the Fed and the Treasury basically doing workarounds around the legislative process to introduce new and creative ways of taxation.
Kevin: Yes, but Dave, let’s face it. John Maynard Keynes was right in many ways, and one of the things that he talked about – of course, part of his policies and part of his economic writing is what creates inflation in the first place, yet he said, inflation is a form of tax that not one in a million really understand. Whether he was being nefarious about it, or whether he was just observing it, he was right. The public doesn’t understand.
This weekend, Dave, I was looking back at the history of Isaac Newton, whom we know as the physicist, the man who also wrote a lot of religious papers and books analyzing biblical prophecy. But Isaac Newton also was head of the Royal Mint. They brought him in because there was cheating going on with the money. I didn’t know this until this weekend, but Cambridge had all of Isaac Newton’s papers – 30,000 pages. Isaac Newton never destroyed anything, it seems. Guess who bought it?
David: John Maynard Keynes.
Kevin: John Maynard Keynes bought it. It may have been to preserve it, but it is interesting that the papers of a man that was brought in to restore equal weights and measures to the treasury in England were purchased by the man who has taught us that you really shouldn’t save, you should print money, interest rates should be zero, and the repression that is occurring right now only one in a million understands.
David: And it is interesting because the general public has an affinity for the Fed, and I think, in large part, it ties to a confusion of identity, with who and what they are. And I don’t mean any offense to anyone in the listening audience, but on the surface it seems strangely like an environment of fear that we, the public, behave like the subject of domestic violence.
Kevin: Yes, it’s interesting. I don’t understand the domestic violence thing, but there are a lot of commercials right now because the NFL has egg on their face for some of the actions of some of their players on domestic violence. You have people get on TV and they are basically unable to really talk about the power and the pain of domestic violence. But it’s based on a fear, a need for continuing security, continuing relationship, continuing something, that really can’t sustain itself.
David: It’s funny, because I think Joe Public looks at the Fed as protector, and not abuser, and if they were connecting the dots, they would see that monetary policy is the primary culprit in the creation of this wealth effect, which is distorting the divide between rich and poor, and ultimately then the government comes in and solves the problem which they created, and it is a very twisted reality, but one that government is able to take advantage of, again, because of the confusion of identify, and because of the fear in the environment where people are looking for that, clinging to that stability and predictability in terms of outcome. “Can you give me safety?”
I know that seems weird, but if you look at the market cap of U.S. equities, you adjust for inflation, and if you are looking at that as a chart, you know what you see? You see what appears to be a multi-generational double top in the market, which would imply mean reversion and loss over the next 5, to 7, to 10 years, of anywhere from one-third to half of the value, in real terms, in U.S. equities.
Kevin: And how can those losses come? Is it always a stock market crash, or does it come just simply quietly with this inflation that one in a million understands?
David: Well, that’s why I say in real terms, because the real losses may come from either an increase in inflation, or from a more obvious drop in the nominal value of equities. The inflationary losses, grant you, seem unlikely given the deflationary pressures that are all around us today, but these losses are no less catastrophic for an investor. They do impact the value of wealth, as it is utilized in the service of daily life, household management, etc., but they are no less probably on the horizon.
Kevin: One of the guests that we have, Richard Duncan, we quote often, but one of the things that he says is that we have to be able to outgrow our debt, or else we are going to have to print money, but U.S. growth may be some of the best growth right now in the world, save China, but it is pale. It is not really growth at all, is it?
David: No. I was talking to my wife last night about a chart which the Heritage Foundation had put together. It was a picture of a dollar bill, and it showed how government spending occurred and what it was going to. And all of your mandatory payments, Social Security, Medicare, Medicaid, all of these things – you’re looking at the dollar bill, and it is basically 80-90% of the dollar bill, and there is K-12 education, which is 1% of government spending.
And I’m thinking to myself, what are our priorities? We’ve made commitments to an older generation of voters and we cater to those voters. We certainly are not looking to our future. I don’t know that our education system as it is fashioned today has all the answers, whether it is K-12 or the way college and university is structured today, at such a high cost, and quite frankly, very little value delivered for it.
So, I’m not suggesting that throwing money at education is an answer, but it does show you what our priorities are, when 18% of GDP is spent on defense and 1% is spent on education, and greater than 60% is spent on entitlements to the general public, which is, in one form or fashion, a little bit like bread and circuses.
People don’t ask questions about the political structure as long as they are kept happy and entertained, and I really do think that there is something reminiscent of Rome and the bread and circuses at that time, if you begin to analyze the budget, and how, basically, our constituents are bought off to be quiet and let politicians do what they do, which is nothing more than taking from some to give to others.
Kevin: Dave, that brings us right back to growth. You have to have growth in the overall economy, it’s called the GDP, to be able to have and service these liabilities and allow them to grow.
David: Right, so one has to move in lockstep with the other, and the world is expecting outperformance of the U.S. economy, and that may or may not be the case. Listen, China is still leading the pack in just raw percentage terms. Unfortunately, their trend has been in decline, and now their 7.4% growth rate is at a 24-year low. So, the trend is not looking good, although the number still beats ours.
We listen to business news networks around the globe, and the consensus view is that while global economic growth is today not good, the U.S. is the one bright spot. And again, Q-3 GDP was certainly a shot in the arm for that idea, you had something like 5% growth; however, full-year growth and Q4 GDP growth disappointed pretty considerably, 2.4% for the year, GDP growth in the U.S., 2.6% was the actual for the fourth quarter, 3% was expected, and this is what is particularly interesting when you dig into the numbers, you know the inflation factor used in GDP? They used a negative number, which, in essence, kept GDP at an elevated 2.6. Even though 2.6 was a disappointment, it would have been worse had the deflator not been a negative number.
Kevin: So, they used a negative number, claiming deflation at this point?
David: Yes, that implies negative inflation, not low, but negative, and the estimate going in was that it was going to be low, probably about nine-tenths of a percent, which would have put Q4 GDP at 1.6%. And of course, everyone on the globe would have panicked – panicked – with that kind of a number. Caroline Baum is a great writer at Bloomberg. She’s great on bonds. She noted that that negative deflator has only been used four times in the last 50 years.
These are details that are very salient if you are paying attention and the GDP number was disappointing, but it wasn’t that bad, and the whole world thinks that we’re the bright spot, but are we? Particularly when you look at something that is arbitrarily placed in the equation and happens to give us a better showing, you begin to realize just how politicized a number like GDP is.
Kevin: And you talk about politics, but Dave, perception seems to be far more important than the truth at this point, because the GDP number was supposed to give us the perception of growth and encourage consumer spending. We seem to be one of the slowest-spending, most optimistic groups in the world, at this point. We’re very, very happy about the economy, supposedly, optimism-wise, but spending is not showing up. The GDP number shows it.
David: And you know the great claim today is that cheap oil is already showing up in consumer sentiment.
Kevin: I’ve been eating a lot more cereal, and I’ve been going to a lot more movies since gas prices have fallen. How about you, Dave? Just spending hand over fist because the gas price went down?
David: Moving up the food chain. I’m not doing barbecue chicken anymore, it’s only filet mignon. (laughs) No, the U.S., it is assumed, will see retail spending and consumption rise to match the increase that we have seen in consumer sentiment numbers. Just think about that. The most recent December consumer spending numbers diverge from the sentiment numbers in a major way. So, you have sentiment going off the charts. Everybody is saying, “We’ve been told by the Fed and by Wall Street that happy days are here again, and what is not to like about that meme? We love it! We hope things are better. We believe things are better!” We think, therefore it will be – sort of a punt to Descartes.
Consumer spending fell three-tenths of a percent, while consumer sentiment was sky-rocketing. They’re moving the wrong directions; they should be moving in lockstep. Stop and think about that. Actions on the street are not reflective of the feelings expressed as the folks who are doing the sentiment interviews call on the phone to talk to the general public and ask, “How do you feel?” They say, “I feel great!” And maybe we should also look at Budweiser’s numbers. Maybe they feel great because they’re catching the interview after a six-pack or something.
This is, unfortunately, very consistent with the divergence that we see between the University of Michigan sentiment numbers from one year ago to the next. And GDP growth, where again, sentiment is increasing considerably – GDP is flat. Sentiment is sky-rocketing, in fact, but economic activity, measured by GDP, is disconnected. It’s not moving higher.
So, either feelings in the marketplace, that is, sentiment, is ahead of the economy, and the economy is about to catch up in a major spurt of growth, or feelings have gotten ahead of the facts, what our friend Bill King refers to as, getting too far out over your skis. For anyone who skis, you know that is a very dangerous place to be. Doesn’t take much of a hiccup, much of a bump, to throw you off your momentum, and throw you into the snow.
Kevin: Dave, I want to move to the Fed here in a minute, but let’s go ahead and look outside of the United States. Let’s look at global GDP numbers, because that is what we’re being compared to right now.
David: When you combine, let’s say the EU, Japan, and the U.S., just in those three units you are talking about a full 52.4% of global GDP, as referenced, again, by Alan Newman. So you have these countries, a small block of countries, which is the cornerstone today of monetary accommodation and experimentation, money-printing on a scale never witnessed in human history outside of your major money panics. And we know those, whether it was Zimbabwe or Hungary in the last 100 years, or Germany, what have you.
And for all of the monetary accommodation, which, again, is supposed to boost the economic activity in over half the world’s economy, guess what is happening? Alan Greenspan observes just a week or so ago, effective demand is dead in the water.
Kevin: And isn’t that interesting that Alan Greenspan observed that when he truly created effective demand all through the first decade of 2000 on, to 2007?
David: Yes, we were talking about the central planner’s target. Essentially, when you are talking about aggregate demand and propping up aggregate demand, money-printing, asset price inflation, they have yet to move the needle that matters the most to central planners – aggregate demand. Of course, what is their conclusion? Their conclusion is simply, “Well, we haven’t done enough yet.”
Kevin: It is interesting, the Federal Reserve does so much to influence the market. I remember when we were in Argentina, Dave. There was a crisis back here in the United States. The stock market was falling pretty dramatically each day that we were down there until Bullard came out and basically made statements that pushed the market right back up again.
David: Right. The market seems to, in that sense, look for good news, which was Bullard accommodating verbally, and ignore the bad news. Just this last week he was commenting in a very different fashion. He is basically saying, “Now we’ve got to stop what we’re doing and start to raise rates. Otherwise do you know what we are going to end up with? We are going to risk inflating another asset price bubble.” Full stop. Wait. Listen to a central banker saying, “If we don’t change our policy of low rates, we are going to potentially cause an asset bubble.”
Kevin: Isn’t that strange that they have gotten us to fear deflation, yet they’re telling us now that we might need to fear inflation again?
David: He is also connecting the dots between loose monetary policy and asset price inflation. But again, bubble dynamics? Think about this. Central bankers are loathe to admit that they are in any way connected with asset bubbles and they will tell you, hand on Bible, they will swear, it is impossible for central bankers to identify a bubble in its formation. And yet he is connecting all the dots. He is saying, “We’re creating a bubble.” He goes on to say, “There is nothing like the housing bubble or Internet bubble, but perhaps bonds, government debt, and other kinds of debt would be a candidate.”
Kevin: Well, you remember Bill King.
David: No kidding!
Kevin: We quote Bill King. Bill King said, “The last great bubble is the government bond bubble.” Let’s face it. There has always been somebody to bail the other bubbles out, but the last bubble to go is that.
David: It is the bond bubble. It’s the great corner. Listen, I appreciate his candor. He is stating something incredibly obvious. You have prices of bonds which are a function of yield, and vice versa. If yields are at near-zero levels, where do prices go from here? In the U.S. there is room for yields to drop down. We have U.S. treasuries, which today, in the United States, yield more than the French ten-year, the Spanish ten-year, or the Italian ten-year. You tell me, just sort of a measuring contest, one against the other, French economy against the U.S. economy – which is more stable?
Kevin: Italian.
David: The Italian economy. The Spanish economy against the U.S. economy. I think there are plenty of problems within the United States economy, but to say that they are a better credit risk than we are – not a chance! And that’s not to mention the Canadian, the British, the Swiss, the Dutch, the Danish – there are at least five to seven others, in addition to the ones I just mentioned, which are well below ours in terms of yield, and here I was under the assumption that the U.S. treasury market represented the risk-free benchmark and that our treasuries, because they are the most liquid, are considered to be the best credit on the planet. That should show up, in terms of interest rates; and yet, it does not.
Kevin: So, Dave, you are talking about the rates in France and Italy, and some of these countries that we know are just basket cases, and yet our rates are a little bit higher than that on the ten-year. The problem is, at this point there really is no real rate of return anywhere you go, if it’s in paper, if it’s supposedly safe. Whether we consider Italy safe or not, or the United States safe, let’s face it, we’re just talking a couple of points, just a couple of interest rate points. When does a person say, “Okay, it’s not worth putting money in a bank or a bond, and I’m just going to go to assets that are real, like gold?”
David: Well, that was a part of the Summers-Barsky thesis, and actually, that was a part of those conversations I had mentioned earlier in the program, that my friends who are optimists, family friends who are optimists, would generally look at gold as a bad place to put money because it doesn’t give you any return and they want their money working for them, and better to sit in cash and at least collect something. And now they’ve got to take their old argument against gold and turn it on its head and say, “Well, why are you sitting in so much cash in the bank, because it’s not yielding you anything, either?”
Many years ago, we suggested that the gold buyer of this generation would be remembered in financial history as a market vigilante. And before you think vigilante is a bad thing, recall that the bond vigilantes of the last generation basically were those investors who stepped in and corrected the price errors in the marketplace, forcefully, and they did it well. And we would hold to that today, that the price errors in the marketplace today, in both fixed income and assets, will not be played out in a battle against the Fed, in the fixed income and equity space, but will be shown to be victorious, if you will. The bond vigilantes will win in the gold space.
Kevin: What you are basically saying is, gold will begin rising from a price level. What we have seen is incredible demand, actually, Dave, over the last few years in gold. It’s very, very strong. Yet, the paper markets still incorrectly relay prices both in interest rates, bonds, I would say, even stocks, wouldn’t you, at this point?
David: Yes, and that brings us back to, again, the price and yield relationship in bonds, if the price in bonds is pushed up or down by interest rates, which is one perspective. In fact, you could say it the other way around. Theoretically, you could have rates go to negative 10%. You could have rates go to negative 20%. Negative, as in, you pay to play, 20% of your principle, just to be there. Practically speaking, that seems absurd to imagine, but it remains theoretically possible to have rates driven so low into negative territory that a huge amount of capital is called away for the privilege of ownership, and of course, the price of the bond goes higher and higher and higher.
Nonetheless, I’m going to assume that with all of this talk about price and yields and bonds and mispricing and everything, and certainly, some industry jargon, that you, as a listener have your head spinning already. So, I’m going to take the opportunity to just spin it a little bit more. And this is something that might seem absurd, but if you want to avoid the negative yield of a government bond – remember we talked about the Danish earlier? You have to pay 50 basis points to own their government debt?
If you want to avoid negative yields, either in real terms adjusted for inflation, or in nominal terms, bear this in mind. The Fed, here in the United States, is prepared to tax your cash position for the amount of time you take it out of the economy and keep it in the mattress. For many people, you think, “Well, if we’re heading into a deflation, perhaps we should sit in paper and just wait. Cash is king, in the context of deflation. A deposit could be sitting at the bank, or it could be sitting in a coffee can in your pantry, I don’t know.
Kevin: How could that practically be done, Dave? How would you be penalized for holding cash outside of actually spending?
David: Okay. You need to invest the time in reading a working paper from the Richmond Fed, dated October 2000, the Federal Reserve Bank of Richmond, titled, “Overcoming the zero bound on rate policy.” We’ve attached it to this commentary, and you can also find it in the resources section of mcalvanyica.com, and by sheer coincidence, the author’s name has an Orwellian ring to it. His name is Marvin Goodfriend.
Kevin: Well, he must be a good guy, then. Marvin Goodfriend. My friend.
David: Good friend. Goodfriend details how a magnetic strip in each Federal Reserve note could be used to register the date of last deposit or withdrawal from the banking system with the objective being imposing a holding tax, or what he describes as a carry tax, on your currency. I’m indebted to Bill King for the reference here, to the paper. But after reading the paper, you know what you’re going to be tempted to feel like? A patsy. You’re going to be tempted to feel like an involuntary part of the solution to a problem that our central planners have created. And in fact, you may resent the Fed’s closed door discussions, this being one of them, “Overcoming the Zero Bound on Interest Rate Policy,” the working paper done in August of 2000. You may resent the Fed in a new and enlightened way.
Kevin: Well, let’s face it, Dave. How many people actually get on a Federal Reserve website, download a working paper written by a bunch of economists? Even if they were completely open about what they were doing, which it sounds like they are, most people are not going to understand, or even bother with it.
David: Well, in fact, I would like to have a conversation with Marvin Goodfriend just to see what his perspective is beyond this paper. How can he think in terms of a currency with a sell-by date? Do you understand what that means? So, you don’t like the system, you think there is financial instability, and you want to put some money in the mattress, you want to get conservative, and yet, the central planners know that the economy doesn’t work unless your money is in the market, working, and being turned over and over. That’s called the velocity of money. So, to increase the velocity of money, they’re going to basically put a financial gun to your head and say, if you don’t spend it today it’s going to be worth less tomorrow, because we put a sell-by date on your cash.
Kevin: It’s a little bit like putting milk in your mattress, if you put cash in your mattress. It’s going to go sour.
David: You’ve got to use it. You’ve got to use it. If you don’t use it fast enough, your cash, if you are tempted to hold or hoard the currency, you get that carry tax. Listen, we’ve talked about an inflation tax, and in this paper he candidly refers to inflation as a policy choice, and a means of increasing taxes on a non-legislative basis. Again, this is very convenient for a central planner.
Kevin: This is the Federal Reserve admitting it.
David: I find the arrogance and presumption sickening, but again, perhaps I’m one that has a weak stomach for such things. As I was saying, you have this carry tax. It is an applied Keynesian principle. It is the pry bar to increase velocity of money, overcoming the zero bound on interest rate policy measures. Keep in mind, when he wrote it in 2000, we were not in a zero interest rate policy environment.
Kevin: What were they, 4-5% at that point, right?
David: Yes, so basically, if we get stuck at the zero bound, and interest rates are at zero, how do we make sure that money comes back into the system? Thus, the title of the paper. Keynes introduced the idea, but technology did not support the tracking of gold and silver coins. Now, in the world of fiat paper, it is possible. So, you have the complex digital payment systems where every dollar bill can have a digital fingerprint recording the ownership and the transfer date and time. God forbid, they can record the place. I don’t think we’re there yet.
But we’re talking about a new world of rates at the zero bound, more or less globally. This is not just in the United States. And then you have the old tool which Keynes recommended being brandished in a fight against deflation. And just when you thought things couldn’t get more weird – I apologize if your head is spinning, let me just summarize it this way. You are fodder for the system. And one of the only means of escaping that said category of fodder is redenominating a portion of your assets in a private and portable form of wealth – gold.
Kevin: Yes, it’s amazing, Dave. Again, we talked about stepping outside the system, and still, so few people are doing it here in America. Overseas, gold outperformed every currency in the world last year, except the U.S. dollar. Talking about that, though, you had likened this to the Fed dishing out a form of domestic violence. It is similar. You had used it as an analogy. But Dave, how long can they print limitless amounts of money, give us not interest rates, and then force us to spend the money, or it becomes less and less valuable? So, people just continue to take this abuse, they continue to accept paper? When they go into gold, no wonder central bankers hate gold. It’s really the only exit.
David: It makes sense why central planners and central bankers don’t like the metal. They remain hamstrung. They lose flexibility in addressing the crisis, but now you understand that flexibility includes policy measures which are a threat to your capital. Depositors are a means to an end. Savers are a means to an end. Other people’s money is a means to an end. And I pray I’m not overly cynical here, but when I read my good friend Marvin’s proposal, I cringe.
This is where I think, again, reflecting back, you mentioned why Newton was hired by the royals in the first place. The money guild was corrupting the system. Essentially they were shaving coins and inflating the system, to their own benefit. They were enriching themselves at the expense of the public and the crown. So, they brought in Newton to figure out, scientifically, what the problem was, and then come up with a solution, and he put Britain on the gold standard. He knew the problem with the money guild and it was that they were not strictly on a gold standard, and he could enforce and create financial stability, monetary stability, by rolling back the clock, introducing gold again into Britain.
Kevin: Where we hold our money could be perceived as a bet on the future. We have to try to predict a little bit where it’s going to go. If you are betting against the Federal Reserve and you’re betting against this paper system, what would your bet be, other than gold?
David: I will just echo back to the Bank of England’s paper in 2011. They reported it. They said very clearly, “We know asset prices are mispriced. We know they are artificially high. We know that eventually they are going to return to a real and non-propped-up value. Is that 2015? Is that 2016? As we have said for some time, lower your equity exposure, increase your cash, hedge risk in cash with physical metals. You don’t have to operate on blind faith in the money mandarins.
The last note on gold. I mentioned last year on the commentary the comments of Stanley Druckenmiller, one of the greatest investors of my generation – of your generation. He worked for Duquesne Capital. That was his group, working alongside George Soros, and doing a lot of the trading, specifically for the Quantum Fund, outsourcing the trading, if you will, because of his trading prowess. He said that his biggest wins as an investor were betting against central bank policy.
Now, obviously, that goes against the conventional wisdom of don’t bet against the Fed, but you are talking about a man who has several more zeroes behind his net worth than mine or yours combined. You could combine many millionaires together and he would still dwarf them in terms of wealth because of the success he had in trading, and he said this: “My biggest wins as an investor were betting against central bank policy.”
Gold, in addition to its insurance qualities, represents a short on modern central bank policy. And here is what you have to imagine. The magnitude of the trade is more than sufficient to compensate for the patience required, the volatility suffered. When you look at gold, yes, it is a bet against central bank policy. Yes, it is an insurance. And yes, I do think you should stick around, because the best is yet to come.
