The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“In essence we went from a banking crisis in 2008 and 2009 to an even larger issue today, and it makes sense why Larry Summers would suggest an active participation in purchasing stocks, not just bonds, and Yellen would echo that saying the Fed needs new tools in the future. Why? Because if we can’t keep asset prices elevated, then you’re talking about a liquidation of the banking sector.”
– David McAlvany
Kevin: These are exciting times, they’re confusing times, Dave. If I’m Donald Trump I’m sort of hoping for a little bit of a crisis here over the next few weeks, maybe with Deutsche Bank or something in the markets, because then possibly the Democrats would be blamed. If I’m Hillary Clinton I’m hoping for exactly the opposite and I’m probably calling in favors right now to say, “Look, don’t let anything happen for the next 30-40 days until I quietly walk into the White House.”
David: It’s a unique dynamic when you’re looking at things in play, specifically relating to Deutsche Bank. You have the entire European banking system that is under a lot of pressure.
Kevin: And a lot of that pressure is coming from our side, the Department of Justice, right?
David: That’s right. This is sort of a cleanup operation, mop-up from the 2008-2009 period, and before, where Deutsche Bank, amongst many others in the financial community were distributing mortgage-backed securities and now the Department of Justice is saying, “Yes, but you knew that there were not good things in those little packages that you put together and you were selling them without the adequate disclosures they needed and we need to hold you to account. Look, we’re not going to take this to court, you just pay us, settle up now, and everything will be fine.”
It’s really an interesting thing, because massive amounts of money have changed hands from Wall Street to the Department of Justice in recent years into the Treasury Department where they basically said, “We could make a very big deal of this or you can pay to make it go away.” And they’re like, “Okay, so basically we admit no guilt and pay Vinny and the problem disappears, right?”
Kevin: Right.
David: And that’s exactly right. Vinny will not massage your knees, just make the adequate payment and everything will be fine.
Kevin: For the person who actually is looking at this and saying, “Well, that’s Deutsche Bank. That’s over in Germany,” that’s really not the case. They’re closer to home than any bank, actually, here in America, closer to Wall Street, anyway.
David: In 1792, under a Buttonwood tree, which if I’m not mistaken is the same thing as a Sycamore tree, at 68 Wall Street there was a signing of a document by 24 stockbrokers. What they did at that point was launch the New York Stock Exchange and decide the rules for trading securities because it had been fairly unruly prior to that. Now, Deutsche Bank is in the building closest to that site. They are a German powerhouse, as you say, but they also occupy a very important place in the American financial landscape, not just because of their real estate position, but because of the role they’ve played in a lot of issues here in the United States financially, they’re a very, very important player.
Kevin: They’re an important player in Germany, too. Merkel is looking at this very, very closely. She has to make the right choice politically for herself, as well. It’s not just Trump and Hillary looking at this, it’s her political career on the line.
David: That’s what makes this issue of Deutsche Bank more intriguing than a mere Department of Justice settlement. The question facing Merkel and the current White House, Obama and his crew, believe it or not, they’re involved, too, is can they allow a financial debacle to be precipitated, right now, at this moment, by the Department of Justice?
Kevin: It’s 14 or 15 billion bucks. Did Deutsche Bank set that aside for a potential fine that they are looking at?
David: No, they have litigation costs which they have set aside a couple of billion, but nowhere close to the number that the DOJ suggested. So what you’re talking about is a proposed fine which is a bank killer. That wouldn’t ordinarily be the case, but given the high leverage of that institution and the low level of capital and cash that Deutsche Bank currently has – here’s the situation. Merkel can’t bail them out or she loses political standing. And this is a very important German institution. But if she bails them out it’s a real issue. She may even lose her office. Now, ordinarily, I don’t think Obama or any outgoing president would pay attention to the details of this kind of settlement, but I’m guessing that it’s Merkel and Obama that are informing the Department of Justice right now where to settle so as not to trigger a global financial crisis heading into the U.S. election.
Kevin: I think it’s important to look at a global financial crisis because it’s usually not just one bank. It’s one bank sometimes that can trigger the next and the next and the next. The whole European banking system may be on shaky ground depending on how this turns out.
David: You’re right. It’s the Department of Justice pushing, and the question is, if they push for too large a number you are talking about the European banking system, the entire European banking system which comes under a tremendous amount of pressure. And it goes beyond Deutsche Bank. Commerce Bank is in an even worse position. You’ve got the Italian Monte dei Paschi. Really, what we’re talking about is the underbelly of the European banking system which is exposed.
TARGET2 is the clearing system for commercial banks and TARGET2 coordinates the capital flows from the commercial banks through the national central banks and ultimately, through to the ECB, the European Central Bank. And what you see in the TARGET2 system is increased stresses. It is now a concern, from one commercial bank lending to another commercial bank, you have the ECB standing in the gap. There is basically a growing concern and a breakdown in the interbank lending which continues to be cut to a minimum here in recent months.
Kevin: Dave, you’ve brought this out before. There are really two Europes, when we look at the European Central Banking system. You have the northern countries, especially Germany, that are the supposedly stronger countries. Then you have these weak countries, we sometimes call the PIIGS. Those countries, a lot of times, benefitted from, early on, having European Central Bank membership because they were getting low rate loans at that time, the same kind of low rate loans that, say, a German would get with a stronger system. But at this point you can see the money flowing right out of those PIIGS back up into the north, and that could cause, I would imagine, stress for Spain, Portugal, Italy, these countries that just can’t hold it themselves.
David: There is a European think tank, the acronym is GEFIRA, and they basically said, “Look, the imbalances that we see have nothing to do with the trade imbalance. That actually is getting a little better. This has nothing to do with the trade balance. The balance is, in terms of capital flowing out of the southern countries into the northern countries, has to do with actual deposits leaving the southern banking system. Balances are getting out of whack again as capital is disproportionately flowing to Germany and to Luxemburg and the Netherlands and to Finland.
Kevin: Is that flight capital – safety flight capital?
David: Essentially, and it’s leaving a disproportionate liability with countries like Spain and Italy, again as capital is going from the southern European to northern European countries. The ramifications for southern Europe are perhaps more grave than for Germany if Deutsche Bank were, in fact, to fail, or to need a significant bailout. As I said a moment ago, Hillary Clinton has a dog in this fight. Another round of crisis prior to the election could seal the outcome of the election with a negative tone for the Democrats.
Kevin: Right.
David: And if Merkel can’t politically afford to bail out Deutsche Bank then you can guess what kind of conversation she is having with Mr. Obama. And he, in turn, the kind of conversations he would be having with the Department of Justice. Sure, a settlement needs to occur quickly, showing that the Department of Justice does have teeth, but also that there is enough sense being applied to not push the financial system over the edge.
Kevin: Yes, but we do have vulnerabilities. I remember the Lehman crisis, and right up to the moment that Lehman closed we kept hearing that all was clear. The financial system could go over a cliff that they’re out of control on.
David: Right. It speaks to the vulnerabilities of the system with a mere few billion dollars in liquidity, which can make the difference in a system that represents tens of trillions in paper assets.
Kevin: Right.
David: What it boils down to is DOJ says 14 and change, and there’s a crisis tone set at Deutsche Bank. Deutsche Bank says we can’t do that, let’s come up with a more reasonable number. And it goes back and forth. It’s like a street haggle, right? What number do you ultimately end up with? Is it 3, is it 5, is it 7? We’re talking about the difference of a few billion dollars, which puts at jeopardy tens of trillions of dollars in paper assets, in part because of the daisy chain of derivative exposure with this particular entity.
Kevin: And they know they can’t trigger that.
David: That’s right. And the frailties tying the southern European banking system together there in Europe. It reminds me, Dick Fuld, was the CEO at Lehman was sort of indicating an all clear just days before the Lehman collapse.
Kevin: Yes, be careful when somebody says everything’s fine.
David: Monday, We’ve got plenty of liquidity, not a problem.” I think they were gone by Friday. Actually, I think it might have been lights out by Thursday. But that’s how quickly a liquidity crisis becomes a crisis of confidence and ultimately translates into a solvency crisis.
So let’s go back to May, 1792. You had the founding of the New York Stock Exchange. That was to codify the trading of securities, and they did that in response to the first stock market crisis earlier that year in January.
Kevin: Isn’t it interesting that it goes back to the first year?
David: Yes. As one of the best-connected speculators of the day, William Duer, who was so over-leveraged that a decline in prices in bank shares – interestingly enough, it was bank shares – five weeks down, it wiped him out. He had done these short-term loans, hundreds of thousands of dollars, with investors, with businesses, with bakers and butchers and the common man, but literally, hundreds of thousands of dollars.
It was fascinating because there was this comment of, “Everything’s fine, not to worry, I’m on top of the world. I defy the world.” This was sort of the day before he was hauled off to debtor’s prison. He said this: “I’m now secure from my enemies, and I’m feeling the purity of heart. I defy the world.” Again, that is what he said the day before he was hauled off to debtor’s prison. He had no idea what was coming.
Kevin: Well, let me ask you a question then, Dave. Sometimes we talk about politicians – Hillary, Merkel, we talk about central bankers this way, too – as if they are in total control, and they’re going to get exactly what their choice is. How much control do they really have? Do they exercise full control or do you think that this is just sort of a way of maneuvering to make it look like they have control?
David: This is a good reminder of that. They’re not really in control of the markets, they are just constantly maneuvering after the fact to appear as if they are. I think politicians are in tune with the cost of doing nothing, but I also think they’re in tune with the cost of doing something, and that’s what Merkel has to weigh, that’s what Obama has to weigh. Who’s side do you prove that you’re on? Again, I think events can take place which speed up rapidly and throw them into a real quandary where all of a sudden this mirage of, “I am in control” – they’re really not, and it becomes very painfully obvious.
Kevin: You’ve talked so often about thinking very long-term – legacy – yet there is a strange anomaly going on, Dave. People are living day by day with this negative interest rate environment and in what you would think is long-term thinking, they’re going out and buying 50-year bonds with countries like Italy. In a real-life scenario, I wouldn’t buy a five-year bond from Italy because Italy changes much quicker than that.
David: No. Buy shoes from Italy. They’ll last a lifetime. But if you’re expecting a bond investment in Italy to last a lifetime, you’re in that class of investors that Warren Buffet would call the “patsies.” You’re just asking, “Are they going to be monetarily and fiscally responsible? And you would basically have to ignore all of Italian history. You’re going back to the first, second and third century. You’ve got to ignore from then until now, to assume that there is going to be price stability in Italy over a 50-year period.
Kevin: This is a country that has had dozens of leaders over the last 50 years. Dave, aren’t they launching a 50-year bond?
David: This week. This week, for the first time, they brought 50-year bonds to the market, at rates that the U.S. was financing its paper at just a few years ago for 30-year paper.
Kevin: So you’re talking, at the highest-quality rates you can get.
David: Take any 50-year period in Italian history and I think you can guess what the outcome will be for those bond-holders in real inflation-adjusted terms. It’s mind-boggling to me that this opportunity for them to finance long-term debt at very cheap rates is only there because of central bank intervention, because the European central bank has driven rates so ridiculously low, a natural level in Europe.
Kevin: It’s nothing new for a government to try to come in and intervene on a market. When we talked to Carmen Reinhart, you go back and look at her book written in 2009. She has documentation for seven centuries of defaulting on bonds. She called it default, I thought it was interesting. Default doesn’t mean somebody just completely defaults. Sometimes they just negotiate at lower terms.
David: And it’s not as if open market operations which we see on a weekly and monthly basis today with the European Central Bank, with the Bank of Japan, and have seen with the U.S. Fed in recent years, it’s not as if this is new, either. The first open market operation was by the Bank of the United States in 1791. Hamilton was actively stabilizing prices in the government bond market, quietly buying up bonds at a discount.
Kevin: This is 1791. I know you’re reading a biography on Hamilton right now.
David: (laughs) I’m loving it.
Kevin: It’s almost like you’re reading about somebody today, right?
David: This is precisely what Trump was suggesting several months ago when he said, “Look, we’ll just buy back our own debt at lower than par. If a bond is sold at $1000 dollars and I can buy it for $700, or $800, or $900, and extinguish the debt for lower than the face value, that makes good business sense.
Kevin: That’s a negotiated default.
David: It is a negotiated default, and he actually received some flak for that. But listen to this. That’s exactly what Hamilton did in 1791. He was retiring debt early, taking money that had been set aside in what’s called a sinking fund to do it. Again, the reason he did that – let’s just contrast what was happening then versus what is commonplace today, because what was happening then is he wanted to establish a floor in prices at the low end. So yes, the bonds sold off, he was trying to create a floor, and basically say, “Look, they’re not going to go below this level. We’re just going to support the level that we’re at now.”
Kevin: And he’s doing it in the name of stability. Look at what is happening with the stock market now. I don’t think our government would have ever intervened on the stock market in 1791, but at this point it’s just common knowledge that that’s part of their stabilization.
David: Well, we’ve got the Plunge Protection Team, which certainly intervenes at critical junctures, and we have the Bank of Japan and ECB who are all over the corporate bond market with Bank of Japan entering into the equity market, as well.
Kevin: And we have the wise council of Larry Summers.
David: Right. According to Bloomberg, suggesting that the U.S. government, actually the Fed, should consider sustained purchases of stocks, not just bonds. Think about that for a second. Of course, Yellen echoed the same comments last Thursday. I don’t know if you saw that. She described it as the Fed’s new tools.
Kevin: Ah, the Fed’s got a new tool chest.
David: Well, she wants new tools, and she understands that the Fed has not given permission to buy stocks yet, but she wants to include that in the ingredients. And I’m thinking to myself, “Ingredients.”
Kevin: Grandma Yellen.
David: Grandma Yellen. This is different than pecans as an option to add to your chocolate chip cookies, Janet (laughs). This is a big deal. But back to Summers. It raises this question: Does he mean that he wants the U.S. government to be buying stocks at considerably lower levels?
Kevin: In other words, bailing them out during a crisis.
David: Well, and stabilizing prices. So let’s say that it is a price stabilization mechanism. I guess you can say I understand the rationale for it.
Kevin: That’s why they call it plunge protection. Are they really waiting for the plunge?
David: That’s the question. Is he suggesting that asset price levitation be coordinated nearer to peak prices for the sake of asset price stability? This is a key question because if he is not saying, future tense, lower levels to set a floor, and he’s saying, levitate prices, keep them levitated near where they are, this is really how it translates.
Kevin: Isn’t that what we’ve been seeing, the Dow above 18,000 now for an extended period of time. It seems like there is already that kind of action.
David: We know that one of the explicit mandates of the Fed is price stability and we also know that that two-word mandate, price stability, has migrated. It has migrated from a simple understanding of currency stabilization to a much broader definition of activities that include market stabilization. So now when we talk about asset price stability, it’s not just price stability, but asset price stability. Does that make sense? All of a sudden it’s not just the currency in question but it is the markets. I don’t know, but it is clear that when you have an over-leveraged financial system, just like Deutsche Bank is an over-leveraged financial entity, when you have an entire system that is over-leveraged, if you have a move down in the prices of assets you are reducing or eliminating your collateral cushion.
And all of a sudden you can trigger a myriad of liquidity events. So the contrast between now and that earlier period of central bank intervention going back to the 1790s, it would appear that we now need to maintain values at the current levels, near peaks, rather than stabilize markets at lower levels, establishing a floor. Again, what has changed? Since the global financial crisis we’ve layered in an extra 60-70 trillion dollars in debt.
Kevin: That’s right. It’s come at a price. I don’t think people realize, we haven’t had a normal market stabilization. All we’ve done is, we’ve gotten out the credit card and said, “All right, we’re not going to let everybody know in the family that Daddy’s bankrupt, we’re just going to go ahead and charge and live as we’ve always lived.
David: But the way you just stated that, that means that Daddy has a liability. To someone else that’s an asset. He borrowed the money from the bank and the bank looks at that as an asset they’re collecting interest on. If something happen to that asset, it will hurt the bank. So in essence, we went from a banking crisis in 2008-2009 to an even larger issue today, 60-70 trillion dollars larger. And it makes sense why Larry Summers would suggest an active participation in purchasing stocks, not just bonds, and Yellen would echo that, saying the Fed needs new tools in the future. Why? Because if we can’t keep asset prices elevated, then you’re talking about a liquidation of the banking sector.
Kevin: That takes us back to this Deutsche Bank question because Deutsche Bank is not more highly leveraged, necessarily, than a lot of other entities. What they are is, they are right smack in the middle of trillions and trillions of dollars of derivative exposure, and that could pull everybody down. It’s like a net that has been cast across the entire financial world.
David: You remember Carmen Reinhart’s comment? I think this was an interesting insight – fairly obvious, but on the other hand, not something that I had connected the dots on. When we were talking about derivatives, she immediately said, “Well, that’s basically debt that will someday be added to the balance sheet. It’s a hidden debt for the time being, but it’s not hidden forever. It will come into the light of day. And so, when you look at a Deutsche Bank and you say, “Okay, well, they’ve got a 1.8 trillion dollar balance sheet, and their entity derivative market connectivity, if you want to talk about it, that in those terms is between 50 and 70 trillion dollars, what’s the issue here? They actually are tied into a mountain of debt, which relative to their capital (laughs) makes them a very dangerous entity. Will they go away? I don’t think so.
This is yet one more reason why there has to be favorable terms made for Deutsche Bank immediately because not only does it jeopardize the financial system if the Department of Justice pressures them too much, we’re talking about the entire financial system because it’s not a 1.8 trillion dollar balance sheet we’re talking about, it’s a 50-70 trillion dollar liability structure which ties into hundreds of trillions of dollars of derivatives, and thus, instability into almost every financial entity in the world. So do you think that the conversation is very clear? Is the translation clear from Merkel’s office to the Obama Whitehouse? Call off the dogs. We understand they have to keep face, but make sure that it’s nowhere near 14 trillion because if you jeopardize Deutsche Bank we jeopardize your election.
Kevin: The ship may be going down whether the Department of Justice does anything or not. Deutsche Bank has had trouble now, and it’s been an ongoing problem.
David: (laughs)
Kevin: The large hedge fund managers here recently have looked at this thing and said, “Okay, a betting man may say that it doesn’t go down, but I’m pulling my money out anyway.
David: That’s right. And this goes back to that issue of, “I think politicians are aware of the consequence of inaction, and they’re certainly aware of the consequence of action, because that’s why Merkel is dragging her feet. She knows that if she intervenes too early, and it’s not in the context of crisis – even if it’s in the context of crisis – she may lose her job, which is why Obama has to be the one to pull the trigger with the Department of Justice, and make sure that that pound of flesh is maybe just under a pound of flesh (laughs), certainly not over, but maybe slightly under.
And you see the concern with large hedge funds. This last Friday they were moving collateral out of Deutsche Bank, and that is a very significant thing. When you start to say, “Look, we have concerns with the financial entity we’ve been doing business with, and we want to make sure that our collateral is protected, I just want to remind you of one thing. That’s behavior that we last saw in the fall of 2008. The fall of 2008. And we’ve already had this conversation in terms of the instable baton pass from one party to the other. If we do see the move from Democrat to Republican we will be repeating the same kinds of market dynamics that will create the same backdrop that gave us the market dynamics of 2000 and 2008.
What was different in 2008 from 2000, and I think will be mirrored yet again in this environment, is this particular point: You had massive gold purchases in 2008 and 2009 from what I would describe as constructive interests. We’re talking about very large family offices, we’re talking about very significant hedge funds, we’re talking about institutions who basically said, “We now have something that is on our radar that hasn’t been on our radar since, let’s say, the collapse of Long-Term Capital Management, and prior to that, maybe the derivative implosion of 1987 when things got really out of hand in the fall of 1987. This is what they’re concerned about. You have hedge funds pulling collateral from Deutsche Bank so that they don’t have their assets tied up if something does, in fact, happen to Deutsche Bank.
The only way to remove counter-party risk definitively is moving into ounces, because even moving into cash you have to leave that cash, unless you’re warehousing things. For the private individual, unless you’ve secured your public storage space, just down the street, your public storage space, and are filling it with pallets of 100-dollar bills, which Ken Rogoff does not want you to do, unless you’ve moved it out of the banking system altogether you still have your counter-party exposure. That’s why gold does so well in this kind of environment. 2008 and 2009, there is an echo of it into this immediate – immediate – period and it’s absolutely ironic that this week we have gold selling off. No basis for this sell-off.
Kevin: I want to talk about that a little bit because it was interesting, back in 1989 as the Saudis saw a coming invasion from Iraq into Kuwait they would bear-raid the market. I didn’t know what a bear raid was, I had only been here a couple of years, but we called the markets when they would come off about $30, just all of a sudden, for no reason. Charts didn’t show it, what have you. And the guys on the trading floor were basically saying, “Oh yeah, it’s the Saudis. They’re bear-raiding the market.” In other words, they were trying to accumulate gold at a lower price.
David: Drive it down in the futures market [unclear].
Kevin: To throw some futures in. And yesterday felt like that, Dave. Yesterday you were talking about, you were just cruising along, working on your notes…
David: For the Commentary.
Kevin: Yes, for the Commentary. And you looked at gold, and I looked at gold.
David: It was down two bucks.
Kevin: Three, four bucks, yeah.
David: And then it was down $30 – boom – in a second.
Kevin: In a second. Do you think, possibly, with this Deutsche Bank thing going on, and with this potential move to large amounts of liquidity, you have large interests who were saying, “Give me a sale price.” I mean, these guys never pay retail price. They knock the price down first before they buy twice or three times what they sold.
David: All I can tell you is that gold is a preferred liquidity vehicle. When institutions become suspect, when counter-party risk is on the radar and live as a threat, you don’t want your assets tied up in a derivative counter-party daisy chain. And gold gives you the option of stepping out, of opting out, of being in a financial asset without being tied to the financial system.
Kevin: I want to go backward a little bit, Dave, because most people look at 2007, 2008, 2009 as a real estate crisis. It was a real estate crisis and a lot of times people would say, “Oh well, that was caused by this or caused by that,” but I think you have to roll the tapes way, way back, to when laws were changed to force banks to give people who could not pay their loans back, mortgage loans so that they could have a house even though they didn’t have the money to own one.
David: I want to go back to the presidential debate, because what really frustrated me was not listening to two people, potential politicians, lying their heads off. That’s par for the course. They’re politicians. That’s just a part of the job description. “What do you do for a living?” “I lie to the general public and I tell facts conveniently positioned to support my positions in order to promote a particular agenda. What’s next?” We already know that. What galls me is the media bias.
Kevin: Right, where it’s not fair, balanced reporting.
David: Right. And I saw that on that whole fact check thing. “So, here’s the facts.” Well, half the facts that they were checking didn’t represent enough background for you to understand, and thus to appraise it.
Kevin: There was a lot of propaganda in the fact-checkers, themselves.
David: It ties into real estate because, it’s a minor point that Hillary tried to score in the debate. It was that the Bush tax cuts led to the global financial crisis. That was her contention, that the Bush tax cuts brought us that crisis, when in fact, it was her husband, it was Bill Clinton’s use of the 1977 Community Reinvestment Act which forced banks to lend to under-served communities. That’s the language that was used by the Clinton administration, the under-served communities.
Under Andrew Cuomo at HUD, this was subsequent to Clinton’s turning up the pressure, they set a goal in 2000 of one trillion dollars in loans to minority and low-income households, and it was communicated loud and clear through the late 1990s that Fannie Mae and Freddie Mac were to start moving their loans, and at least half of them needed to go to lower and moderate income borrowers. So again, the context of the global financial crisis was set in the late 1990s by Clinton pressing the Community Reinvestment Act. You had subprime loans that didn’t even exist prior to 1997. Well, they did exist, but they were first securitized.
Kevin: That’s where you chop them up, bundle them up and sell them to people, and you have no idea where the originator is.
David: They were securitized in 1997. And then, of course, you had the distribution mechanism for those loans which Clinton was pushing for. Fast forward to 1999 and you take away Glass-Steagall. Clinton and company did that with the help of the ex-Goldman-Sachs co-chair who they had appointed as the Treasury Secretary by the name of Robert Rubin.
Kevin: Familiar names.
David: And now investment banks could basically not only bundle the garbage, but they could sell it directly to the general public. And you go back to the 1930s and the abuses of Wall Street, and the reason why Glass-Steagall was put together was so that investment banks and commercial banks would be separated, and those kinds of shenanigans could not happen.
But you have this fast order of events between the Community Reinvestment Act of 1977 being pushed heavily by the Clinton administration, the securitization of subprime loans in 1997, and the repeal of Glass-Steagall, which then allowed for Wall Street – Wall Street was doing what they thought they could do! They had just been given license to put crap into a bag and sell it with the imprimatur of a raiding agency, as Triple A. And now all of a sudden we’re talking about Deutsche Bank being held responsible for distributing this garbage. Guess who said it was okay for investment banks and commercial banks to do this stuff?
Kevin: It was the Clinton administration.
David: Right. In the face of the historical record, which is, “Don’t trust Wall Street. This is why we have legislation. And this is how we keep Wall Street accountable.” And all of a sudden you remove accountability and you expect human action to be any different than the 1920s?
Kevin: Well, strangely, too, if Hillary comes back into office we’re probably going to see some names that we thought of sort of as criminals probably coming back into new administration positions.
David: That’s right. Speaking of FDR, not Franklin Delano Roosevelt – Franklin Delano Raines. Do you remember who was at the office of management and budget under the Clintons? I think he was vice-president at Fannie Mae. They grabbed him from there, brought him over to the Office of Management and Budget. He was a Rhodes Scholar, same as Bill. And then they moved him over to be the CEO of Fannie Mae in 1999.
Again, a guy who was a yes man for pushing loans to minorities. African-American – I don’t think it is a coincidence. Very well educated – Harvard, Harvard Law. Then Rhodes Scholarship – I don’t know if he was there at the same time that Bill was. But yes, let’s welcome back a fellow Rhodes Scholar to the public stage. He has been retired since 2004, kind of in disgrace, forced out at Fannie Mae because of accounting irregularities, if I recall correctly.
Kevin: But maybe this is a little bit like the Blues Brothers – “We’re putting the band back together.”
David: Well, the Clintons are hiring again. If they get back in, they need an FDR in their administration (laughs).
Kevin: We’ve been talking about politics, Dave, but really, politics is driven by – and you brought this out last week – it is driven by the favors of the central banking community. I remember back in 1992 that the Federal Reserve did not support a second term for Senior George Bush, and so they did exactly what it would take to push us into a recession, which we needed to go into. They had delayed the recession. But the Fed gave George Bush Senior no favors. And of course we had two terms of Bill Clinton.
So Dave, what the central bank does, you brought out last week, if they don’t like Trump and he’s in, they can actually just contract the economy. If they want Hillary in they can hold off, like we’ve been talking about, the Deutsche Bank thing, possibly keep the stock market above 18,000. There are things they can do. Woodrow Wilson saw through this early on and I’d like you to just read a couple of quotes from presidents that, we may or may not like, necessarily, all the policies, but they could see the incredible power that the central bankers held, starting with Woodrow Wilson.
David: Every month one of my favorite things to do is read the quotes that Marc Faber draws. This is where I find that he is not just a Ph.D. in economics, but he has a deep philosophical bent.
Kevin: He sort of has a Ph.D. on life, yes.
David: Right. And they span all of history. I love the fact that he is dipping into 3000 years of recorded history, as he’s thinking about current economics.
Kevin: I’m sure as you read them you hear his strong Swiss accent.
David: He quotes President Woodrow Wilson expressing regrets for having signed into law the Federal Reserve Act. Wilson says this: “I’m the most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all of our activities are in the hands of a few men. We’ve come to be one of the worst-ruled, one of the most completely controlled and dominated governments in the civilized world, no longer a government by free opinion, no longer a government by conviction and vote of majority, but a government by the opinion and duress of a small group of dominant men.” He’s talking about the central bank.
Kevin: Franklin Roosevelt saw the same type of thing. He saw the power that was instilled in that one institution.
David: That’s right. In 1933 he was reflecting on this. He said, “The real truth of the matter is, as you and I know that a financial element in the large centers has owned the government of the U.S. since the days of Andrew Jackson.” This is FDR, by the way, saying this. “History depicts Andrew Jackson as the last truly honorable and incorruptible American President.”
Of course, Andrew Jackson is known for one thing, and perhaps hated for one thing in particular if you’re talking to folks from the Fed. It’s that he killed the second central bank of America, and that’s just about how it reads on his gravestone. Many people eulogized themselves and say, “Here’s how I want to be remembered.” He wanted to be remembered as the guy who killed the central bank, which is what I was talking about earlier, created in the late 18th century by Hamilton.
Kevin: Those are what two prominent presidents saw the central bank doing. Even Federal Reserve chairmen saw the lack of their ability to restart an economy. We’ve seen eight years of trying to spend our way and borrow our way out of this financial crisis. That’s not much different than the 1930s.
David: That’s right. And by the end of the 1930s, after they had transitioned from monetary policy to fiscal policy, in order to buy themselves time, the Secretary of the Treasury at that time, 1939, Henry Morgenthau, said, “We’ve tried spending money. We’re spending more than we ever spent before and it doesn’t work.” We’ve never made good on our promise. I say after eight years of this administration we have just as much unemployment as when we started, and an enormous debt to boot. Kevin, what it reminds me is that there is a cyclicality in politics and as I look on the book that I just finished dealing with family legacy, there is this idea of legacy baggage, the things that, unfortunately, we do leave to our children which we are not proud of, and it’s like the pain and wounds and dysfunctionality within a family system.
Imagine a scratch in a record player. I realize that we don’t even use record players anymore but if you’re into old vinyl you know what happens when you get around that scratch. You go full circle, you hit the scratch, and you’re off track again. And you go full circle, and you hit the scratch, and you’re off track again. And that cyclicality in politics, that cyclicality in fiscal and monetary policy – we’re doing it all over again. We’re just at a different point in the cycle. I guess that fiscal policy will buy us two, three, four, five years, but we have major issues ahead of us which have not been resolved because of the structural element which is now the dominant theme. We started out with banks who had loaned out too much money, and not on good terms. And now we have even more loaned out money on terms that are absolutely asinine.
Consider. We talked about Italy. How can anyone in their right mind invest in Italian bonds for 50 years and expect that they’re going to receive principle and interest and have actually benefitted from that transaction over a 50-year stretch?
Kevin: People do what they’re trained to do, though, Dave, and people have been trained over the last couple of years that the central banks have supreme power. This is a perfect time to talk about going onto cruise control versus having a real management strategy, whether you hire a manager for your money or have a strategy yourself. There are so many people at this point that are moving into just pure, passive investment style where it’s like, “You know, the central banks, they’ve been able to keep the stock market going. I don’t really care whether we have growth or if we have financial prosperity as long as I’m just continuing to stay steady and rising in my stock portfolio.
I think, Dave, about you and I, we both drove back separately from Phoenix this weekend. I don’t know about you, but I think you do – I use cruise control on those long stretches through the desert, driving through Monument Valley, the long, straight stretches of road. That’s perfectly fine, cruise control will do me just fine. But when you start getting near a change, a town, somebody pulling out onto the road, you have to go off cruise control, and you have to go into active management mode. Right now it seems that people are on cruise control when active management mode is being called for.
David: Yes, actually, the cult of our day is Vanguard, and the leader of that cult is John Bogle. I introduced my oldest son to John Bogle at a conference we were at this last year. He is one of the most influential directors of thought, if you want to call it that, in the investment community since 1975. What was an interesting and intriguing, but unpopular idea in the 1970s has become the dominant theme.
Kevin: Which is, just buy it and leave it.
David: Buy an index fund and forget about it. Don’t pay for management. You’re overpaying. You don’t get anything for it. It is interesting, a Wall Street Journal article last week describes the triumph of Bogle, and I’m very aware of when the media begins to talk about victories and failures it’s usually when that particular market has gone as far as it can possibly go because honestly, what the media does is talk about the obvious.
Kevin: It’s a sign of the end of the idea, when they think it’s the idea that will last forever.
David: You’re exactly right. And about the same time, when you see the news media saying that gold is the absolute best investment in the world…(laughs)
Kevin: Sell some.
David: Sell some.
Kevin: (laughs)
David: Sell some. That’s exactly right.
Kevin: Yes. That’s right.
David: And as long as they hate it, it’s okay to buy some. But there is this herding into passive investments, and I think it’s at exactly the wrong time. The Wall Street Journal article says that Bogle has won. Passive investing is the only way to approach the investment markets. Manage the one thing that you can manage which is your expense side and you’ll come out the victor.” It’s fascinating because Bogle has just said in recent weeks that he expects, because of how stocks are priced today that you’ll average 2% per year over the next decade if you’re investing, even in the index funds. That mirrors what John Hussman would say, which is, “No, you’re probably closer to 1%.”
Kevin: Which is amazing because Carmen Reinhart was talking about how the inflation target for the Fed will probably be raised to 4%.
David: Oh, and by the way, 2% and 1%, from Bogle and Hussman – those are nominal returns, those are not real returns factoring in inflation. So consider this. If we leave the inflation target at the Fed at 2%, then Bogle has basically said the best you’re going to do for the next decade is a zero return because you’re going to earn 2 and have 2 taken away from you via inflation. Of course, he’s not talking about the inflation piece. And Hussman is basically saying, 1% positive, minus 2%, you’re going to be upside down 1% every year for the next decade. And that’s if inflation is 2%. What if it’s 2, plus 2, plus 2, plus 2?
Kevin: Like Carmen said – she said the real trick now is to not let it get out of control.
David: And that’s exactly what happened in the late 1970s. It went from a benign level of 2, to all of a sudden 4, to 6, to 8. And that is where your real returns went – oh, did they get nasty. They got really nasty. And it’s the same setup. We have the same setup. I think the next three to five years for the gold investor is perfectly primed. We could go back to the Summers-Barsky thesis, but it’s when your real returns are low-to-negative that gold is a great opt-out, particularly when people are not convinced that inflation can be controlled, and they don’t want to just sit in cash.
They say to themselves, “I’m not going to take that hit. I don’t even know what the hit’s going to be this year. It was worse than the year before, and maybe it’s worse the year after.” When that inflation concern grows then the prospects of negative real returns drive huge interest into gold. At the same time you’re having institutional money flow in, not because of a concern about real returns, but because of financial structural stability. You’re talking about a completely different animal when you’re talking about counter-party risk.
Kevin: Dave, when you’re talking about a 1% or a 2% nominal rate of return, that also doesn’t come without a lot of volatility. That could be a 20% down year, and then maybe a couple of years of 10-15% on the upside. So talk about emotional stress to come to the end of the decade and say, “Okay, look, we made 2% but we really didn’t make 2% because inflation was 4, so we lost that entire decade, and we lost sleep.
Now, I want to go back to gold for a moment because one of the mistakes that people make is looking at it as if it’s a stock, as if it’s something that could go out of business, that you could go broke on. No one has ever gone broke in gold. One of the best ways of looking at gold is as a place to hold buying power, and before we finish the program I want you to just express the Dow-gold ratio and the thinking behind that one more time, because in a decade where we’re going to have a lot of uncertainty, the Dow-gold ratio plays a very, very important role.
David: I want to say one more thing about the herding behavior in the markets today because not only do we see exactly what Reinhart was talking about in our interview with her a month ago, you have people moving into not only passive investments, but people moving into large cap, low volatility stocks, as an alternative to fixed income because rates are so low.
And you have central bank buying of assets in Europe and central bank buying of assets in Japan which then liquefy an investor base and allow them to put their money someplace else, too, and I think that money is being herded into just a select few things. What Reinhart said is, “Look, you just can’t let them know they’re being coerced. A captive audience is captive, and the key to pulling it off is making sure that they don’t know that they’re being coerced.
Kevin: It has to be opaque.
David: That’s right. So it appears that the most logical place for people to go is to index funds like the S&P 500 – high-quality, dividend-paying stocks, these kinds of things. And that herding is continuing to happen. I think the way we get to a Dow-gold 2-to-1 ratio, or 1-to-1 ratio – we’re currently at 14-to-1 – the way we get to a 2-to-1 from here, or even a 1-to-1 – by the way, from the 1840s to the 1870s it was pretty common for that ratio to trade at a negative number – a negative number – if you can conceive of that. Yes, 1840s for about a decade, and then the 1860s also for about a decade, it traded at those negative numbers.
Kevin: That’s a pretty huge boon. I mean, 1-to-1 will be fine with me. If it was 1-to-1 today it would $18,000 gold.
David: And here’s what that means. It means that you have the ability to expand your financial footprint to a multiple of what it is today. It means that for someone who has saved their dollars in ounces rather than in greenbacks, you’re talking about moving it into other assets. In this case, the ratio relates to the Dow, but it could be a number of other assets, as well. You’re talking about increasing your purchasing power on an exponential basis.
Kevin: Right. What you’re talking about is, it’s 14-to-1 now. If a person purchased at 14-to-1 now and held on until it got down to, say, 5-to-1, let’s just be conservative – 5-to-1, 3-to-1, 2-to-1 – and then went out and purchased the things that they should be selling, not owning, right now, like equities, the financial footprint – you can turn a small amount of money into a very large holding of assets.
David: Right. And I think we’re having the perfect setup put in front of us. You have herding behavior driving people into what they consider low volatility, which translates, in their mind – low risk, allocations.
Kevin: Index funds.
David: And they’re doing it – this is now a generation of do-it-yourselfer investors.
Kevin: They’re on autopilot.
David: They’re on autopilot. They’re on autopilot and they’re heading into a storm. And I’m telling you, if you’re flying a plane on a sunny day, autopilot is just fine. But when you hit a storm, drawing on experience is a pretty good idea. And I think the kind of money flows that you’re seeing into index funds today, and into the kinds of stocks that you would consider the big boys, it’s the same kind of disturbance which will occur as you see cash coming out.
Hot money flows are always destabilizing. It doesn’t matter if it’s emerging markets or a particular stock or a particular sector within the stock market. When you have a crowding effect it’s fine as people come in. But it was one of the Bonners that said, “Yes, emerging markets are like a five-lane highway going in and like a goat trail getting out.” Good luck in terms of that liquidity thing.
And I think that’s what we’re setting up for today through index funds – massive mindless investing which has pushed prices to an extreme and on the other side of it, that money coming out will go somewhere. Some of it will go to cash, some of it will go to gold, and as you see that ratio switch from a 14-to-1 down to a 2-to-1, maybe even a return to the 1870s and a negative number.
Our team on the Wealth Management side has actually argued effectively for a negative ratio on this particular go-round because of the kind of asset liquidation which they expect to occur in this particular cycle. Asset liquidation – what are we talking about? Too many loans, too much debt, and it having to be liquidated. That’s what they’re talking about.
Kevin: The question was, how do you preserve what you have? How do you make it grow? You certainly don’t want to be part of the herd when the herd finds out they were wrong.
David: I think the benefit is not in nominal terms, but in purchasing power terms, how and what you spend your cash on is critical. How you denominate your cash? Smart money is already deciding how to do that. I think we know that already.
