The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“If I’m looking down a time continuum to what is in store for my family, I have to plan, I have to choose, I have to act. This has nothing to do with someone else who is there to save my bacon. And I have full confidence that individuals, myself included, can maintain that system of protection that you are describing, and I don’t need the elite to somehow protect me.”
– David McAlvany
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Kevin: David, I have this yearning. This yearning is to see fair and just pricing. We talked to George Gilder last week, and what an excellent interview. He talks about growth being something that requires learning. Learning requires accurate data. And we are fooling ourselves to think that there is not manipulation in these markets. We are seeing Greece now being blamed for a lot of things that you have been talking about that were hanging on a thread for months that had nothing to do with Greece.
David: Right. You look at the behavior of the stock market over the last several months and generally, when you press higher, you see an index like the Dow or the S&P move higher, that little drop back can kind of consolidate those gains, and instead what we have seen since the beginning of the year is more of a plateau at higher levels, which is interesting. I think manipulation of prices in the key markets looks and feels like the Fed has held the line by buying index futures and propping up the market in spite of a major loss in momentum. Again, I would say, since the beginning of the year you have really lost momentum.
Kevin: Well, the stock market is still roughly where it was at beginning of the year, Dave. We have been six months in this pattern right now, near 18,000.
David: We have had a little bit a correction this week, but I don’t know that that has changed anything, and the blame on the front pages, at least this morning on four different papers, has gone to Greece. And I just don’t think that is true. You remember that the news media has to come up with some seemingly logical explanation for a market movement, and Greece is there. I would say it is coincidental.
Kevin: Let’s just look at the last five years of our shows, Dave, how many times the word Greece has appeared in the title. Greece has been an ongoing topic. So often people are looking for what they want to call a Black Swan. They have irresponsible behavior, they don’t want to see the consequences, and then when consequences do come, they say, “Oh my gosh, I could have never seen that coming.”
You said something to me last night when we were talking that I have really thought about. Those Greeks that were walking down to their ATM yesterday, to get cash out, as if they didn’t see this thing coming? What is the problem there? Why didn’t they prepare? I think of the Greeks right now, I feel for them, that don’t have cash in hand. How much more could they have done if they could have had some gold in Switzerland, Dave, or in another country, and had some cash set aside? Yet, at this point they are saying they can’t pay their bills this week.
David: Nor can they move money hither and yon. I think what is interesting is that Brussels and the folks from Greece who are in Brussels trying to hammer out these negotiations are stuck on trivial things. It is almost as if they are being killed by the trivial. “How do we define a farmer? Should we extend the shelf life of pasteurized milk? What is the appropriate tax on a movie ticket? These are the things that we can’t come to agreement on, the appropriate tax of a movie ticket. You know what? We’re going to miss our IMF payment.”
Literally, it is bureaucrats fixating on the little details and they are forgetting the context. The backdrop for equity and debt investors and investments really has remained the same for the last five to six years. Both in Greece and globally, you have a gargantuan and still growing mountain of debt that is keeping a full-fledged recovery from occurring.
Think about that. You have tepid growth globally for the same reasons that can be highlighted in the Greek situation. Yes, that is sort of in extremis, but you have other European countries that have the same issues, as well. You can count income, you can count growth in the economy, you can compare these things to the growing list of long-term social obligations and the real-time liabilities, and you can see that nothing in five to six years has changed. You have debt service and a real lack of entrepreneurial risk-taking.
Kevin: Well, Dave, let’s just face it. Who wants to take a risk when it is really just the well-connected whose risks are completely covered by the little guy, and that is through the central bank printing? But nonetheless, why would you take a risk unless you are bureaucratically connected?
David: Right. And so you combine those things. You have the global economy that is stagnating on the one hand and negatively compounding on the other because of the scope and scale of the liabilities that we have. So, you are right. Who wants to take a risk when you realize that the game is rigged? I’ll tell you who does take a risk – your leveraged players who assume that you have upside volatility, but no downside, because the central banks are there to protect you.
So you have, in equities, central banks now actually trying to pretty up the pig and they are buying index futures. We talked about the Japanese doing that. I think the Fed is doing that, as well. You have the same thing in terms of an outright monetary intervention to prop up prices in the bond market and thus suppress bond yields, keeping interest rates low. What is the net effect of that? The net effect is that you lower the cost of capital yields, which end up increasing speculative purchases of both stocks and real estate.
When you are using leverage to make purchases there is this underlying assumption that debt is always benign, and that is a part of the dangerous complacency we see in the market today. You assume that it is normal to borrow money, and markets only go one direction, so your borrowed money is just an easy way to increase returns. You might think, well that’s what the new Chinese investor who was bagging groceries yesterday and is now trading stocks today would think. But no, that’s your average hedge fund manager in Manhattan, too. He thinks like the novice when he thinks that debt is benign.
Kevin: But when you have economic troubles that are not working themselves out naturally, and what I am talking about is what you talked about last week, which is bankruptcies and business successes, when that can’t occur they have to employ monetary policy, but that doesn’t cure anything, does it?
David: No. In the New York Times, this week, Lombard Street economist, Diana Choyleva says that monetary policy can only be a palliative. It cannot be a cure. So here we are, six years on, and heavy lifting is still occurring in the monetary policy arena. Money-printing and credit creation – what have they done? They have bought us time, but not changed a thing otherwise from the crisis period of 2008 and 2009. I suppose you could say the singular exception to that is having created a sense of calm in the marketplace. No one is panicking today, but the structural backdrop and the debt issues which caused financial dislocation in 2008 and 2009 – they are all here – oh, except that it is a multiple of what it was in 2007 and 2008 because what we did was pretend that debt wasn’t the issue and use debt instruments to dig ourselves a deeper hole.
Kevin: David, I don’t know if you have seen the movie Gallipoli, but it is a true story about a World War I battle where the machine gun was being used by the Germans and yet the English and the Australians were still utilizing old-fashioned, storming the trench type of techniques, and the problem is, each time they stormed it another group of men were mowed down completely. I mean, they were completely destroyed.
Yet, I remember there is a poignant scene in that movie. The guys who were going to go out the next day and the same thing was going to happen to them – they are sitting and listening to a beautiful operatic piece on a phonograph and there is this calm. They understand that there is a consequence that is going to come tomorrow, they are all going to die, but they are listening to this beautiful operatic piece. That scene is so poignant in that you know something is going to happen, but not right now.
David: Right. Well, maybe this is a leap, but did you see the movie Open Water?
Kevin: I don’t think I have.
David: There is this moment where you have these two abandoned scuba divers and they are floating, lost at sea. And they are given to panic, but then for this split second they are sort of in positive self-talk, “It’s going to be okay, it’s all going to be fine, just stay calm, we’re going to be fine, it’s okay.” Only it’s not. No amount of positive self-talk can change the dire nature of the circumstances they were in, or frankly, that we are in.
And money printing is merely ginning up the attitude. So, if you’re still sort of floating around in the marketplace, like Open Water, just realize the only thing that has changed is, you feel better perhaps having had a shot of liquid courage or something. “No, that wasn’t a shark that just bumped up against my leg!”
Kevin: So, not seeing the movie, it is a movie about sharks ultimately showing up?
David: Oh, yeah. Yeah. You look at the stock market, and you have volumes which are half of what they were in 2007. Does that tell you something?
Kevin: Yes, but we’re at new highs, Dave. If volumes are half, how are we at new highs unless there is something wrong?
David: An intelligent investor should be asking that question. How can we be at new highs with half the trading volume that we had last time we were putting in new highs?
Kevin: Does it have to do with the automated trading that is going on, this high-frequency stuff?
David: Sure. Robo-trading and Wall Street painting the tape at the Fed’s request. Of course, painting the tape is an illegal thing, but it is what has destroyed the ebb and flow of value and the healthy process of price discovery in the market.
Kevin: Would you explain what painting the tape is, from your perspective?
David: Yes, if you are buying an asset with the deliberate effort to boost the share price and thus bring in more investors to buy it and push it even higher. I grant you, the painting of the tape is more for political purposes now than the old-fashioned manipulations geared toward the growth of illicit personal wealth.
But this brings us back to a growing issue, and this is true on at least six continents. This is a form of corruption. It is a combination of public policy mismanagement now calling in favors from the Wall Street elites to say, “Hey, we need to continue to pretty up the perception that we are in control, as central planners, we are moving forward and our policies are, in fact, working.” If our economic statistics are putrid, we at least need to have a counterweight, and what is that counterweight?
The litmus test for the average man on the street is, “Is the stock market up or down?” If it is moving up, then “Hey, everything is fine, don’t worry about it.” If it is down, you will find coffee table conversations change dramatically when the Dow is off 500-1000 points. “You know there are some funny things going on, I’m really concerned about this and such.” But those concerns are irrelevant and not even in the conversation at all as long as prices are moving higher.
Why do they become relevant with a downtick in price, as opposed to an uptick in price? This is called the manipulation of public sentiment, and this is where Wall Street has a vested interest in doing that. Do you know why? They make most of their money distributing stocks and bonds – distributing stocks and bonds. That is the original purpose in capital formation, to say, “Hey, tomorrow is going to be a great day, do you want to invest in this company? I’m going to give you a first right to buy this particular bond, they are raising capital right now, and you’ve got a guaranteed income of X, Y, and Z.” Wall Street is a paper-peddler, and you can’t peddle paper unless people are thinking positively. How is that for Peter Piper picked a peck of…?
Kevin: (laughs) Well, you know, that’s good. But we’re talking about corruption. Corruption has been in man since the Garden of Eden. This is not new. But when you see a unification of Wall Street and Washington, when you see a unification of the bench and Congress, where legislation is occurring from the bench, you start to see corruption in a different way, because you have unity where there should be separation.
David: Let’s go back to a conversation we had a number of years ago with Robert Higgs. Oxford University Press in the late 1980s published his Crisis and Leviathan: Critical Episodes in the Growth of American Government. It is a brilliant, brilliant book. The problem of endemic corruption grows in lockstep with the scale and scope of government involvement in the marketplace, and in every area of our lives. Governments have always been corrupt, and any student of history knows that. But when the size of government increases, naturally, so does the scope of corruption. Does that make sense?
Kevin: Oh yeah, there’s a guy who we work with here, Dave. He has been in the business since the 1970s and he says, “Listen, Kevin. I’m going to put it in the simplest terms possible. Big is bad. Always remember, big is bad.” And if you really look at it, anytime you have people who can entitle themselves – there is a sense of entitlement – like you were talking about before, coffee table discussions change because a lot of times people feel entitled to a bailout.
David: It doesn’t matter if it is Washington, D.C. – you could go from there to Tokyo, from Sidney to London – you are seeing this enmeshing of business elites with political elites, and it is creating an environment which is destructive to the capital markets, and it is stifling to the risk-taking, which is necessary for an ever-expanding economy. We can ask the question, “Why is GDP growth lagging, why is it coming in lower than expected, why has the IMF lowered their expectations? Why does the Bank of International Settlements say that we’re on the cusp of another major financial crisis?”
Well, clearly, there is a multitude of reasons why GDP growth is lagging, but instead of innovative risk-taking which drives growth, ultimately job growth and spending, do you know what we have? We have substituted a corporatist command and control dynamic, which is then buttressed by the bought interests of bureaucrats.
How do we say this differently? You combine a good Rolodex with easy money policies and you end up with 21st century feudalism. And that is what you have today. If you can master the combination of a good Rolodex and easy money policies you are going to make a fortune. Now, it is going to be at the expense of long-term growth and economic stability, but if the only person you think about is yourself, we have figured out a recipe to do it, to make this work. And this is where, again, I would describe that as taking advantage of a system that is already corrupt.
Kevin: You brought up feudalism. I think it is good to go back and actually look at what that was back in Europe. Anyone who has gone through Germany or France, you can see the old castles. And during the feudalistic times, obviously, you wanted to be a noble, because being a noble, it was your castle, everybody served you and you definitely provided their security. You had four classes of people. You had the noble and the knight, and the knight also had a pretty good life, to be honest with you.
David: But, basically, the henchman of the noble.
Kevin: Right, doing what the noble demanded.
David: “You protect my interests and I’ll make sure that your interests are taken care of.” Again, it is this enmeshed relationship where bad things are going to happen, they are going to be perfectly justified, particularly as you have this closed universe of morality where the elite get to determine what is good, better, and best.
Kevin: And the serfs, who did not live in the castle – of course you had the clergy – but the serfs who did not live in the castle, they were out and in danger all the time. They were doing all the work, they were raising the crops.
David: “And maybe we will lower the drawbridge and let you in at night.”
Kevin: That’s exactly right.
David: “But you will be grateful for the protections that we provide. Don’t you know the world is nasty out there, and you need us to protect you? Don’t do anything to rub us the wrong way that we wouldn’t want to protect you, or keep the drawbridge up at night.”
Kevin: And the central banking community right now, Dave, mainly, connected with the political community, those guys are the ones who control the drawbridge.
David: So being politically connected has never been more important. Now, I’m not saying that that is what you should go do, but you remember, we joked about the idea of having a lobby group on K Street.
Kevin: When we were in Washington, D.C. That’s right.
David: You have this famed place, K Street, where every Fortune 500 company has hired guns to help push through legislation favorable to their bottom line. And I don’t want to play in that neighborhood.
Kevin: Right.
David: (laughs) Partly because I don’t think I look good in lipstick, and D.C., although we know it has always been a whorehouse, do you realize that now you can just pencil out on the back of a napkin what legislation is going to cost you if you want it passed? So, you have business opportunists that buy opportunity and then block the market from its natural course of competition. You remember, this is what George Gilder talked about last week. He described it as one million real-time tests of falsifiability that drive the success of what we know as capitalism, or the market economy. Now, you don’t even need to buy a legislator. A judge will do the trick. Well, I guess I could mean that in more ways than one.
Kevin: Dave, you are a reader, and everyone at the office reads. One of our favorite books is Frederic Bastiat’s book The Law. You don’t even have to read the whole book, it’s a small book, you can sit down in an hour and ten minutes, maybe, and get through it. But even if you just read the first 15 or 16 pages you get the idea that this guy understood what corruption was and what true law was for. The law, itself, is to protect people and ensure their God-given rights, and he brings this point out. He says, “The law should be relatively small and it should just protect the person’s God-given rights.” Unfortunately, we have more law than we actually have paper to write it on.
David: It is fascinating that Bastiat was writing about this 150 years ago. What I find encouraging about it is, this is perennial. The beauty of being in the mountains this time of year is that the high mountain passes and meadows are full of beautiful flowers, and they emerge at about the same time in their season, and then they disappear and go away, and then they re-emerge. And I am not particularly enthusiastic about the law being corrupted, but on the other hand it is pretty common, and Bastiat’s criticism of an abuse of the law in France in the 1850s was also a retrospective, saying “It has happened before, and here is what has to be done to preserve the validity, the value, the strength of, the protections that we get from, the law.” And I guess why I find that encouraging is, it has always been a problem. To keep the law in its proper place has always been a challenge, it will always be a challenge. We have a challenge today, but it hasn’t really changed through time.
Kevin: Right. I think of Bill King. He continually talks about how we are now watching the death of the socialist experiment. And you know, the socialism that Bastiat was talking about always leads to a death march, doesn’t it? It ends badly, because like Margaret Thatcher said, “Socialism works until you run out of other people’s money.”
David: What is interesting is, I don’t think I am really even talking about what is happening here in the United States because I talk to people from around the globe. It is obvious that governmental trends are running in lockstep just about everywhere, with really the only difference being one of pace. You mentioned the socialist death march. It is kind of a question of where it is happening on a slow basis. In some quarters that is the case, and in others it is a virtual sprint.
So, there is King’s comment that, yes, this is sort of the death throes of socialism, and you tie in Robert Higgs’ notion in Crisis Leviathan. You have to be careful, because Leviathan, when it is worried about survival, does very desperate, or what you might objectively say are silly things, ultimately not going to work, but you can quickly become fodder, if you will. You can become the feed for the leviathan.
So, I think it is interesting. You have massive cracks in the system. You have government trying to fill those cracks, increasing the amount of planned solutions to the problems that we have had, both economically in Europe, and of course we have political issues, as well. And Higgs talks about this over and over again. You tend to see an increase in governmental control and interference in the context of crisis. That’s where we have been, that is where we continue to be. Looking at Europe brings us to Greece. Before we transition there, make sure that you write down the names of those two books, because they are worth not only reading, but studying. The Law…
Kevin: Right, by Bastiat.
David: And Crisis and Leviathan by Robert Higgs. Higgs has written some other books but this is, I think, the critical one.
Kevin: And it is published by Oxford University Press, so this is not some fringe book out of a fringe bookstore, this is excellently studied. But really, what he is pointing out is what we are talking about, that the leviathan continues to get larger and larger and larger. The leviathan has to find ways of staying valid. It has to be able to feed the large stove.
I have told this story before on the Commentary years ago, Dave, but when I was a little kid, I had a little yellow plastic record and a little Fischer Price record player, and I listened to a story over and over and over. It was called The Big Oven, and it was about the man in town that had the largest stove that kept his house so warm, but it took a lot of wood. And everybody envied the fact that he had the big oven. But it kept eating more wood than there was in town, and ultimately, the big oven consumed everything around it, including his house, and that was all that was left. And the way the story ends is this big black stove in the middle of nowhere, and it is cold.
David: To some degree that may be Europe over the next 20-30 years, or maybe the next 20-30 days. When you look at Greece, the crisis in that country is really another excuse for European bureaucratic expansion. And in this case you have Goldman-Sachs, which ushered Greece into the euro in 2001 by helping them falsify their financial condition, and now you have a Goldman guy, Mario Draghi, who is there to fix what conveniently he already knew was broken.
Kevin: You need to repeat that because when Mario Draghi was being looked at as the head of the ECB we talked about it here. We said, “Isn’t interesting that Goldman caused the problem, and now Goldman-Sachs is placing its man right there?”
David: (laughs) I think it is more than coincidence. He is there to fix a problem that he knew full well he and his firm had created.
Kevin: Well, let me ask you a question, though. Merkel – she has a lot on the line on this because Germany is still central to the euro. Where do you think Merkel stands on whether there is a Greek exit or whether there is a dismembering of the European Union? Where is she?
David: Merkel is committed to keep Greece involved in the eurozone, and I don’t know if that means they go back to their own currency and gain some sort of monetary autonomy while still being a trade partner of sorts. I don’t know what it looks like exactly, but some way, somehow, Greece stays involved in the eurozone. The political issue is raging on, and it is this. The Germans are continuing to consolidate European power via the eurozone economy.
Kevin: Right, so instead of it being the War of 1870, or World War I, World War II – all three of those wars had to do with German consolidation – what we are seeing now is from an economic standpoint that consolidation is actually occurring.
David: Yes, and if you look at what it would cost Germany, vicariously through the ECB and the other Eurozone members, to restructure Greece’s debt, it is a relatively low cost when you are looking at removing an obstacle for German dominance in the eurozone. So, no, I think Merkel will not allow her reputation to be tarnished. As the leader in Europe she does not want to be the person on task when there is a first exit, if there is an exit, from the eurozone.
Kevin: So, “Not on my watch,” is what you are saying.
David: It seems unlikely. If you go back to the Otmar Issing interview, Otmar Issing, one of the founders of the ECB, one of the only standing members that was on task day to day for eight years, the longest-standing member of the European Central Bank, you might recall that as we concluded our conversation with him he explained the motivations of keeping Europe unified. As he described his first day, I think it was in the lunchroom there at the European Central Bank, he was sitting with a French colleague whose father had been in a war camp that Issing’s father was all too familiar with.
Kevin: Right.
David: And so, avoiding barbarism and the chaos of war was more important than economic feasibility. They identified potential problems in terms of the peripheral countries in Europe getting credit, if you will, from Germany, being treated as if they were a better credit than they should have been and that creating bubbles, and they knew full well that was going to happen. That did not keep them from moving toward this goal of eliminating barbarism and the potential chaos for war. They wanted to make it work, do whatever it takes to make it work.
So, countries joining the eurozone, I think, have long considered themselves to be like those who buy a lottery ticket. “There is upside here. I think I could win.” And you don’t really think, and convince yourself, “The odds are so poor, this is an absolute waste of time and money.” For Greece to come into the eurozone, it was only upside that they saw, none of the downside.
Kevin: They had low interest rates, they were able to operate as if they had the fiscal responsibility that the Germans had gained, and unfortunately, it got them into deep, deep trouble.
David: Right, and I don’t they ever imagined themselves as the first loser. The reality is that Greece could leave, but I think we can’t underestimate the unique kind of commitment by the Germans to the euro project. Part of it is existential, as is in the case of Issing and others like him that tie personal narrative to political objective, but then there is the part which you might describe as power-hungry. It is, again, the Germans continuing to benefit disproportionately from the eurozone.
We have discussed this – and again, I am not being overly critical of a particular people or a particular country, but they made a decision in the late 1990s to suppress wages. They put artificial wage caps in place in the late 1990s and it put them in a very competitive position. Economically, they have flourished, and it has meant for a massive accumulation of savings. That massive accumulation of savings is, in part, why we have disturbance in the rest of Europe, because guess where those savings went? Those savings went somewhere.
That is what we are trying to hammer out is this conflict of who is going to pay the price? Somebody has received a benefit but nobody wants to pay for the admission, and is it the Greek people via austerity? Is it the European banks who have taken excess savings and invested it in Greece, just as they did in Ireland and other countries, as well, and now stand to lose a significant amount of money?
I think, actually, what you find is that this is a rear guard action for the financial industry and the banks, and there is this looming question of what happens in the derivatives market if we see outright defaults? Do we end up seeing an avalanche triggered which is unstoppable? That concern is certainly there by the folks at the BIS and others, and I would say it is reasonable.
Kevin: Sometimes we have to take a birds-eye view on history. Let’s say that rather than work out the details of what is going to happen in the next few weeks, or even few years, with Greece and the eurozone, let’s go ahead and fly above this, like George Friedman did when he wrote the book The Next 100 Years, because all these details look much smaller when you are looking from a larger perspective.
The larger perspective that Otmar Issing was looking for – he saw a crisis in the future because he understood, you can’t have a monetary union without having a political union, and he knew these times would come, but ultimately, through crisis, and we have seen this before, people will call out for a solution that they would have never thought to have called out for before. Do you think, possibly, what we are going to see is the loss of sovereignty of these nations in the eurozone, ultimately, and a centralized form of government?
David: I wouldn’t go so far as to say the current crisis in Greece is scripted, but I do think, just like Higgs suggests in Crisis and Leviathan, if you want to see something grow, you are able to grow on a permission-granted basis much more quickly in the context of war and economic upheaval. Those are the two preconditions for a citizenry saying, “Will you please take care of the problem for us? I don’t care the cost, just make us safe again.” And it is war and economic upheaval that are those preconditions.
Kevin: Let’s look at his numbers. At the turn of the century, back in the year 1900, our federal government represented about 7% of the total economy.
David: Which meant that your only interaction with the federal government was probably your postman.
Kevin: Yes, he brought that out. People didn’t have that much experience with the federal government, but we went through World War I, then World War II, and it rose to 21%.
David: Even in the context of World War I, then the transition from the 1950s to the 1980s, and this is, again, an interesting thing when you usher in the welfare state. And you remember the guns and butter policies that led us to the inflationary 1970s.
Kevin: Sure.
David: The growth of government is tied to those guns and butter policies, and it rose from 21% to close to 38% by the mid ’80s. Now, you throw in Obamacare, you throw in all the ways that government has stepped in to say, whether it is through Dodd-Frank or a whole host of other regulatory regimens put in place in the last 15 years, I think we have blown well past 50%.
Kevin: Yes, so ultimately, in the long run we may see centralization. But going back to the Greek situation this week, these debt negotiations over the last three, four, five years, have been very dissatisfying to both parties, especially so this week. It is going to referendum at this point.
David: And when you are negotiating debt restructuring or debt deals of any kind, it is going to be dissatisfying to everyone because on the one hand you have the debtor that doesn’t want to pay necessarily anything, or the least amount possible, the creditor who wants to be paid everything, nothing short of 100%. And what you really see, what many people don’t realize is that a large part of the money given to the Greek government over the last several years wasn’t to jump-start the economy, it was not going to fix the economy, the majority of it was to keep the banking and financial sector liquid.
Kevin: It is like spending a lot of money making Band-Aids. You are not really stopping the bleeding, you are just basically plugging it for a little while.
David: And insuring that the counterparties, that would be, specifically, the European lenders to Greeks, were safeguarded. French and German banks again come to mind. But without the bailout funds already received, you would have seen investment committees around the world, whether that is asset management firms or banks, having to write down their investment portfolios massively. This has been avoided because the bailouts have continued, but again, the money has not been solely, or even primarily, focused on jump-starting the Greek economy. It has been on making sure that anyone that has exposure to Greece doesn’t get hurt too badly.
So again, what progress have we made in five years? Very little, except that we have created a cushion. This goes back to the notion that we privatize gains and then socialize losses. That is essentially what is happening. The ECB is helping facilitate the socialization of losses by taking European taxpayer dollars and making sure that European financial institutions are not damaged.
Kevin: Something that is interesting to me, Dave, and you brought this out before, is that there have been problems brewing all around the world that, this week, we are starting to see cracks in and people are wanting to use Greece as the excuse. But look at China. The stories that I have read about farmers who were just barely scratching out a living that now are day-trading on their own stock market. The stock market went up 150% in the last year – right now we are starting to see some cracks.
David: Yes, 150% in 12 months – that is an unsustainable rate of change. Any time an asset class is moving up 150-200% per year generally marks the end of a very significant blow-off phase. Vertical moves are corrected with vertical drops, and that is what we have seen, a 22% decline from the peak in the Shanghai Stock Exchange, the Hong Kong Stock Exchange not quite so much.
Kevin: That is just in one week.
David: That’s about ten days, and stabilization efforts you are now seeing from the Chinese government – they have lowered rates, they are encouraging fund managers to step up and “buy the bargains.” Of course, when you look at what they are considering a bargain, again, now the market is only up 120% for the year. You are still in the nosebleed category. But with the amount of margin debt still outstanding, I think lower prices in the Chinese markets can’t be ruled out. I think it is a virtual certainty.
China underscores this very, very important point, that the speed with which a deleveraging can occur is astonishing. You can see an unwind in asset prices happen very quickly when you have an over-leveraged market – 22% in ten days. Late last week you had state-owned firms that were being audited and were found to have been cooking the books. They were misstating revenue, misstating profits, three to four billion dollars here and there, which is actually real money.
And so you have not only cracks in confidence as the auditors have come in, you also have the forced unwind of leveraged money, and it certainly makes me ask the question, “If it can happen in China, can’t it happen in the United States?” Oh yeah, it did in 1929 when our margin numbers got too high. Oh, yeah, it did in the year 2000 when our margin numbers were too high.
Kevin: How about 2007?
David: Oh, yeah, it did in 2007. And now our margin numbers are higher than all of those years, slightly less than China’s, but still in the nosebleed section. The last stated number is 506 billion dollars, an all-time high in nominal terms, and as a percentage of stock market capitalization, or percentage of GDP, depending on which measure you prefer, which makes it categorically more speculative today in the U.S. stock market than in 1929.
Kevin: One of the things that has been very uncomfortable over the last year or two is just how little volatility we have had in the market. We talked about stabilization. If you look at a one-year chart on gold, it is as if they picked between $1180 and $1220 as a median range for gold. If you look at interest rates it is the same thing. If you look at the stock market, the volatility in the stock market has been relatively nonexistent since October of last year, yet the VIX, which you have brought out as something that you watch that shows volatility – there has been a little bit of a jump this week.
David: 33% higher in a day, and it is fascinating to see, the VIX will fall to these low levels where there is just obviously complacency in the market.
Kevin: That’s the Volatility Index.
David: Right. Exactly. Nobody expects anything bad to happen and then boom! Something bad happens and volatility goes way up. It is interesting, last week talking with George Gilder, I forget exactly how he said it, but did he say something to the effect that easy money becomes stupid money?
Kevin: Yes, it makes the market stupid. I think about flying an airplane. You and I both have flown private planes and you can either consult the gauges assuming that they are giving you good information, and you can judge and make judgment calls based on that, or you can just put it on autopilot. Once it is on autopilot, you can become stupid quick.
David: That’s right. I think, if you look at things that are happening just south of us, Puerto Rico, this week you are looking at a reality. Well, you have been looking at a reality for some time now, and just like Greece and other places, it is the same structural issue all over again. They had 72 billion dollars of debt that they couldn’t pay six months ago, and six years ago…
Kevin: Time to restructure.
David: And it really is time to restructure. There is not enough growth in the economy to make payments on something that is negatively compounding. And do you know who is going to howl over restructuring? Anyone who stepped in and bought Puerto Rican debt assuming that they would get paid back and they were just buying a bargain. This is a very interesting thing that I don’t particularly like about Wall Street these days. They like buying bargains as long as they know that the price can’t go any lower than the price that they paid. Does that make sense? (laughs)
Kevin: Right, well it is guaranteed. It is called moral hazard because, really, you are taking no risk when there should be a risk.
David: “I want to be paid billions of dollars for risking other people’s money that had a guaranteed result.” How does that work, exactly? That is how strange this period of time is. You now have fund managers who have stepped up to the plate, gotten involved with Puerto Rican debt. It needs to be restructured. That means somebody is going to lose money.
Kevin: Puerto Rico probably doesn’t have a big brother like Greece had with Germany for so long. I mean, who really is going to come in and bail out Puerto Rico, and are they even calling for a bailout, or are they just thinking of a default restructure and start over?
David: Well, it is not out of the realm of possibility that the U.S. taxpayer just has added on to a list of obligations that we will make good on. And so, could the U.S. taxpayer end up paying your hedge fund manager for taking risks for the last two or three months, buying a bargain and being put at jeopardy? Could the U.S. taxpayer be making that 2-and-20 bonus structure work out? Maybe, and again, I think there is a problem there because what is going to be played up is, if you don’t bail them out and get us out as hedge fund managers, guess what is going to happen?
You are going to see a daisy-chain of liquidations and insolvencies, it is going to be chaos, it is going to be political. All kinds of trouble is going to be knocking at your door there in Washington, D.C. And again, the reason why these issues are taking so long to resolve, whether it is in Europe or just south of us in Puerto Rico, investors would rather have their losses socialized, and they are pulling in all political favors to avoid taking a loss. That is European banks, that is U.S. hedge funds. Nobody wants to play by the rules that operate, and should operate, for the big boys.
Kevin: Let me ask you a question then, because as the stock market does come down here, and Greece is used as an excuse, you have brought this out, it is only an excuse, but if the stock market were to actually continue this correction that we started to see this week, where do you see it going?
David: A break to lower levels, to the 14,000 level, to the 16,000 level, that kind of a range would be normal. Listen, last week you had 200 new lows on the New York Stock Exchange. What you have had is a few bellwether stocks dragging the indices higher with the market internals continuing to deteriorate at the same time. You have some stocks that are off of their peaks by 40-50%, and again, because they are not major contributors to the index, you can ignore them. And I think that looking at a 20-25%, even 30% correction in the Dow, that is pretty normal.
But that gets back to our original idea that, really, the powers that be don’t want to see that happen, and the manipulation of prices in the key markets is not that difficult. If you are willing to buy indexed futures, and I believe the Fed is doing this, you can paint a picture of normalcy, of calm, of stability. And for anyone in the marketplace, do you know what it looks and feels like? It looks like someone in the ICU unit where all the inputs are controlled, the heartbeat is there, it is healthy.
Kevin: It is life support.
David: But it is not actually vitality, and it is not what the capital markets are supposed to be. Volatility is good either way, up and down. When you defend against downside volatility, you are dealing with command and control characteristics that, ultimately, I don’t think can be sustained. Is this fall our comeuppance? It very well could be.
Kevin: That brings me to the one thing that a person can own that really doesn’t matter what the liabilities of anyone in the world are, and that is precious metals. Precious metals are a form of liquidity, a form of cash. We have talked about gold and silver, but I am speaking specifically now about gold. The central banks use gold as cash. The price, like I said before, seems to have been fixed in this level, and probably, a lot of that is done with futures contracts, not the actual physical metal. Where do you see precious metals going over the next few months?
David: They could still come under pressure, but here is where my strong confidence is with the metals. You have an indebted world, with limited economic growth. You have money printing, which continues to be the tool which is filling the gaps and is the only means by which they are trying to prop the system up. It hasn’t been a real benefit in terms of economic growth to them.
And I think as long as you have monetary policy as the primary tool being used to prop up the financial system, not just in the United States, but in Greece, and in Europe, and in Japan, and in China, where every little hiccup is met with a lowering of interest rates and a flooding of the market with liquidity, you have a reason as a private individual to have a financial asset which is conveniently outside of the financial system. You want a cash position which is not tied to the banking system or to the people who are managing that cash, be it the European Central Bank, or the Fed, or what have you. I think it is the perfect place to be, frankly, in a period of growing uncertainty.
How do we solve our structural issues of having too much debt? I can tell you how the monster has, in the past, attempted to take care of itself – nationalization of assets, outright theft, an increase in taxation, money printing. There are only four or five critical ways that a government can bail themselves out at this juncture, and I think we are going to see some degree of all of them. Where do you want to be? Do you want to be entirely in the system? I don’t think so. Do you want to be entirely in the banking system? Ask any Greek family if that is the best place to be this Tuesday or Wednesday morning. I don’t think so.
How do you have a financial asset that is not in the financial system, cash that is not necessarily sitting in the bank and subject to the devaluation of a whimsical monetary policy? I think you find the perfect centerpiece in a portfolio in a period of time like this, in gold, and I would just say make sure that you put it in multiple jurisdictions because you don’t know exactly how nasty your government is going to get. That could be the European government, that could be the Japanese government, that could be the Australian government, that could be the U.S. government. I think you choose gold, and you choose multiple jurisdictions. Full stop.
Kevin: David, you brought up feudalism a little bit earlier. Feudalism was based on someone owning a fortress, someone owning a castle. The more I think about this, the drawbridge has been coming down. The serfs – and I admit, I am one of the serfs, I am not one of the connected few. Serfs need that protection. But I am thinking about this fortress. It is built with paper, Dave. The drawbridge is paper. The fortress, itself, is paper. And it seems like it is holding up, but it is really not. You have to have gold, personally, to have your own solid fortress.
David: This is, I think, probably a philosophical difference. Not everyone is disposed this way, but I am naturally inclined toward self-reliance, and the idea that I have to rely on someone else for my protection, safety, and security, that the ebbs and flows of the market which might destroy me unless someone is there to intervene and make it all better – I recoil from that because my natural ingrained inclination is toward self-reliance. What do I have to do to protect myself? What do I have to do to take care of myself? If I am looking down a time continuum to what is in store for my family, I have to plan, I have to choose, I have to act. This has nothing to do with someone else who is there to save my bacon. I am not trying to rely or create dependence on the system. Quite to the contrary, I think the system is somewhat arbitrary and I have full confidence that individuals, myself included, can maintain that level of security, that system of protection that your are describing. I can have my own fortress, and I don’t need the elite to somehow protect me.
Again, I think we are talking about a philosophical difference. There are plenty of people who would say, “Oh, there is nothing wrong with that, that is the role of government.” I would probably disagree on that. I think there are three very limited roles that government has. We have stretched beyond that with not only the three branches of government, but 13 bureaus, and another 56 administrations directly under those 13 bureaus. It is out of control and growing, and I don’t think it represents much of a solution. I prefer my own personal fortress and I think we have already described what that looks like.
