He Who Makes The Rules Owns The Gold

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• Strategic regulation by partisan politicians always creates the next banking crisis
• Winners & losers are determined by those in power, deserving or not
• The 2019 Secular Shift: Beginning The Long, Difficult Road

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

HE WHO MAKES THE RULES OWNS THE GOLD
January 23, 2019

“I’m not sure when we decided that excess was the new virtue, but I’m tempted to say it was when we redefined the nature of money and removed those natural moorings to credit growth. Now we have economics growth, which is the priority of every central bank, seemingly at any cost, present or future.”

– David McAlvany

Kevin:We were sitting and talking and just looking back at winners and losers, Dave, and who makes the winners and losers. Your dad has an old saying that he who owns the gold makes the rules. That is true, but I also think he who makes the rules owns the gold.

David:Yes, if you look back in history you see different political organizations, whether it is an autocrat, a dictator, or a democracy, they make decisions, and things don’t always go as planned. When things don’t go as planned, very rarely, I don’t know that there is a historical precedent for that person or that group saying, “Look, it was my fault. We’ll do better next time.” There is no next time in a very dog-eat-dog world of politics.

Kevin:You have a winner, and then you have a fall guy, somehow, some way. I remember a few years ago, Dave, you got up on stage and you talked about three or four occasions in the past, going back to the Roman Empire, where you had hyperinflations ending great crisis, but the hyperinflations were actually caused by policies of the leaders, and they picked their winners. There were clear winners, as there are in any inflation, and there were clear losers, and the losers ended up losing their life.

David:The Romans were the first instance of that, and as you got into the third and fourth century the destruction of the Roman denarius was occurring, guess what happened? It was this group of people who believed in a singular God who had upset the host of gods, and that’s why there was famine in the land, and price increases for all things.

Kevin:So the Christians were blamed. They were the fall guys.

David:The Christians were blamed. In the 16^thcentury it was the same kind of story where the price of commodities was going through the roof, the ability for the average family to provide for themselves was getting harder and harder as the cost of goods went up and up and up, and it was just easier to blame the witches, and the witch hunts began. There was this group of people who were responsible for undoing the natural order.

Kevin: “She’s a witch, burn her!” (laughs) “How do you know she’s a witch?” “Well, there’s inflation.”

David:That’s right. Well, the 18^thcentury, if you’re thinking of France, it was the royals and those connected to the royals. And again, they were to blame.

Kevin:Intellectuals, as well. They chopped the heads off of the intellectuals, as well. They must have been responsible for the hyperinflation that was caused.

David:Yes, certainly, the period of 1918/1919-1924 we had the hyperinflation in Germany, and it created, or at least set up the context where there was great animosity toward a movement of people, people who were settling into Europe, establishing themselves professionally, and displacing others who had been there. A part of the consequence of inflation was that Jews were somehow to blame for the chaos and the undoing of European culture as they knew it.

Kevin:So in a way, you want to know who the winners are going to be ahead of time and you want to stay clear of the losers. Now, one of the things that made me think of this, Dave, was our conversation. I have a tendency to blame the bankers often because they seem to have come out really nicely after the last financial crisis. But you corrected me. You’ve been reading a 500-page book, and I’ll be honest with you, you got me the same book and it’s still sitting on the shelf. I haven’t gotten into it quite as much as you, but I will.

This 500-page book is basically saying, “No, no, no. The bankers are businessmen. They are going to do what the rules say, up to the very edge of the rules, they’re going to do that.” But actually, it is the politicians that create the crisis. It’s the rules, the regulations, in the setting of who will win and who will lose.

David:A small anecdote there ties to the Indian elections this year. Modi is up for re-election. He lost five states – his party lost five states in the most recent country-wide election, and he is now either going to be elected or not. Is it any surprise that he is slotted to spend 14 billion U.S dollars in his bid to be re-elected? So this is going to blow out all of India’s fiscal projections.

Kevin:Somebody is going to win.

David:And someone will win – he hopes that it is him – and there is a cost to, whether it is a fiscal policy move like that, or monetary policy moves, or legislative moves. And that is really the point of this book I have been reading, Fragile by Design. Next week we have Charles Calomiris joining us on the Weekly Commentary, and together with Stephen Haber they co-authored that book, Fragile by Design. The subtitle is The Political Origins of Banking Crisis and Scarce Credit. And I tell you what – it has been an amazing, amazing read, filling in so many gaps.

This is one of the things that I think is always important, as we learn and we grow, there is a requisite humility with anything that we say that we know because there are details that somehow, some way, we’ve missed. And this is one of those books that has filled in quite a bit.

Kevin:A guest of ours from a few weeks ago, Alex Pollock, is the one who turned you on to that book. You are a bibliography reader, and then you go read what is in the bibliography.

David:There is a certain timeliness to the discussion as we consider not only the ongoing implications of excess credit. That is a reality. But also, we have the House Financial Oversight Committee getting ready to tell us how credit should be created, and to whom it should flow. So along related lines, I would invite you to do a deep dive with us this Thursday with Doug Noland. We have the Tactical Short Conference Call. Register and tune in Thursday this week.

Kevin:That’s always insightful.

David:Doug’s comments are always insightful and provocative, and I think it will be the same as we look at 2019 and the beginning of a long and painful road, one in which many of the credit excesses built into the financial sector, I think, will be unwound in this particular chapter, undressed for the public to see, and I think, to better understand.

Kevin:Speaking of chapters, we are in a new chapter. You have Maxine Waters and Ms. Ocasio-Cortez who are going to be overseeing the financial sector. That’s good. It’s good to have someone who is a proclaimed socialist overseeing the financial sector.

David:With quite a bit of professional experience, I might add, in these areas, so we’re stacking the deck.

Kevin:At 29 years old.

David:Well, the quality speaks for itself. They will be joining the House panel overseeing the financial sector. Maxine is out for blood, and it’s the blood of the bankers. She’s kind of flashing back to the excesses of the mortgage and lending crisis of 2008 and 2009, and she wants to bring accountability to the predatory lending practices, which, in her view, ensnared buyers in the trap of debt slavery. Other people would frame that differently and say, “That’s called home ownership, and it’s called the American Dream.” But again, Maxine is probably less generous in the terminology she uses, or the ways that she presents the issue.

Kevin:If you’re not carefully listening and watching the news and understanding where things come from, you can certainly jump on that boat, because I will say there were a lot of people who did get loans, Dave, that shouldn’t have had them.

David:That’s right. It’s not to say that there wasn’t predatory lending that occurred, but the question is whether it was legal or illegal. I have to say, I’ve reading through Calomiris’ and Haber’s book. There is quite a bit of irony here in the present tense in the witch hunt that is about to commence because without bank regulations changing throughout the 1990s, particularly in 1994, and without the politically motivated mandate to lend to the underserved and the under-qualified, directly through the GSEs, government sponsored entities, Fannie Mae and Freddie Mac, these practices would not have occurred. So you have community groups like ACORN – they made the news a few years ago – but what role do they actually play? It is very interesting how closely they were aligned with banks in the mega-mergers of the 1980s and 1990s. Community groups like ACORN were paid a king’s ransom to participate in the bank merger mania which had the community approvals. It required community opinion and what they would call “good citizen ratings” and you get your good citizen ratings from these community groups by making a certain percentage of loans to that under-served part of the community. That is, how should we say, a euphemism for people who shouldn’t have been getting loans in the first place.

Kevin:Right, but you’re still serving a constituency. We did have a community organizer who was coming into power back in 2008.

David:(laughs)

Kevin:You look at these community organizing groups – well, that was the background of Obama.

David:Think of the interplay here. You have the quid pro quo of billions of dollars going through these community organizations and they would give their approval for major bank mergers if a certain percentage of revenue from those banks would be reinvested or loaned out. And this percentage grew over time, and began to grow exponentially to the point where obviously we ended up with the subprime debacle. But again, was it the banks, or was it actually politicians driving this?

Kevin:And so the book Fragile by Designis actually going back historically and saying, “Look, there’s a pattern here.”

David:And we’re talking about going way back, the 16^thand 17^thcentury. This is not just an exposé on that period of modern U.S. banking and lending. They lead through the legislation, they study the political points scored by offering up subsidized loans, along with massive payments into the hundreds of billions of dollars to these community organization groups – billions, with a B. And they do a great job. These gentleman shine an academic light on the actual relationship between banks and legislators. And again, it goes back a long way. In fact, for the very curious, or downright nerdy, you might enjoy the 500 pages, because what they do is they stitch together multiple centuries and a variety of political expressions, from democracy, to dictatorship and autocracy. You have the autocrats of the past, you have the autocrats of the present – think Mr. Xi in China – as well as democrats, speaking specifically, rather, I should say democracies – modern democracies, which have all benefited from the free flow of credit.

Kevin:Right. Like you said, I’m glad you corrected yourself, because it’s not Democrats, it’s not Republicans, it’s not Independents – it’s everybody.

David:What I meant by democrats is those who are advocates of democracy.

Kevin:Sure, sure.

David:So much more loosely, the term democrat there. So politicians have to have credit. It’s a little bit like the flame needing oxygen. But this House Panel duo between Ocasio-Cortez and Waters that we mentioned – very interesting. They’ve already talked about this. They want a drastic expansion of housing aid. And of course, this would not be a subsidy for the rich and the middle class.

Kevin:That sounds familiar. That sounds like something we heard in the 1990s and early 2000s.

David:It’s sweet, isn’t it? You blame the bankers for a blow-up in the credit markets, and then push for more of the same kind of subprime lending which led to the crisis (laughs).

Kevin:Like you said, this is not new. We were talking about, even going back to the 1800s, and looking for a particular voting group or a segment of the society that you are trying to benefit. The agrarian culture of the farmer was going to favor a gold-silver standard because you could inflate silver quicker than you could inflate gold, and inflation helped those in the commodities markets. Again, it still boils down to winners, losers and voter blocks.

David:Yes, so the way that we could have organized our monetary system around bimetallism, you are right, that was something that appealed to a particular constituency group. It was the agrarians who wanted greater inflation, which increased commodity prices and gave them a boost.

Kevin:And silver was easier to find. So you could inflate using silver before we went on a pure paper standard.

David:So the political inclination to cater to, or to pander to, a block of voters with money that is not their own takes on a lot of different forms. We call it pork barrel spending on a constituency. You could see that in the form of farm credits or crop subsidies, or you could see it in the form of below-market-rate loans, which the VA offers to soldiers who are returning from the field, or Veterans. You could look at it in the form of lowered lending standards to allow for credit accessibility to those who would not otherwise qualify for loans, or if they did get a loan would have to pay exorbitant interest rates, given a higher risk of default.

Kevin:Isn’t all this a form of wealth redistribution? Even if you look at it and you say, “Well, gosh, I want the guys in the VA to get lower loans or rates.”

David:Yes.

Kevin:It could be good, but it’s still wealth redistribution.

David:That’s what it is. In its essence, it is a form of capital redistribution whether you have been on the receiving end of those benefits or not. The politician – this is really critical – the politician governs the flow of capital via the regulations and the rules which mandate the movement of bank credit throughout the economy.

Kevin:Right. So this is just a fact. Some people would say, “Well, favor the small business.” Others would say, “No, big businesses are actually where it’s at – or the poor.”

David:Exactly. That’s where you begin to see political preference. You have some politicians that like small businesses, others that like big businesses, others that like the working poor. So this is not a criticism of partisan priorities, but it is a recognition of what occurs first in the halls of state and federal legislatures.

Kevin:And then the banker reacts because the regulations are geared toward that particular group.

David:That’s right. It impacts the practices of banks and savings institutions with a trickle-down effect being a handout of one sort or another to a desired demographic. So now you have the battleship coming full steam at us as we’re reading the news in the last few days – M.S. Maxine – Ms. Maxine – I like to think of her as the battleship – not battle-axe, battleship – of the Democratic party. She wants to seek redress for the abused and the downtrodden within the financial system. Those who have lost their homes, you could argue that they never should have had those homes in the first place, but again, that would be under normal risk appraisal. And in the same breath – the same breath – she is discussing this drastic expansion of federal housing aid and I think we’re missing the elephant in the room. The problem started as a political problem, and it has come full circle. It remains a political problem, but if you blame the bankers, somehow we can leave the system unfixed. And that is an issue for me.

Kevin:We have the separation, supposedly, of the Federal Reserve and the government. Now, Trump doesn’t like that separation. In fact, most presidents don’t like that separation, and there actually is less of a separation than we would all like to think. But could you imagine if the central bank was the government, if the president had full control just like the Federal Reserve Chairman Powell has, of the money supply?

David:What you’re getting at is the lines are somewhat blurred between the central bank and the political sphere. It’s not the bankers making the rules of the game. The grand bargaining over the creation of rents and of rent extraction which we know as the banking industry as a whole, that’s what they are about – extracting value from other people’s money. Politicians create the rules and regulations, and even create the requirements of lending. And if banks want to continue to exist and flourish, they play along. So the bargain is between banks, between politicians, and then ultimately the desired group that receives the flow of funds in the form of credit, and that circles back around to benefitting the politician because it ensures longevity within those positions of power.

Kevin:But hasn’t banking changed? It used to be just the banks, but now we have the financial markets, just like we’ve talked about how money has changed. It has gone from tangible assets to paper money to, now, actually, just debt and credit instruments. The banks – I’m thinking Wall Street at this point – also can play a role.

David:Well, the nature of credit has changed, that’s right. As Doug Noland has pointed out, there is a growing difference between past and present credit expansions. The past were dominated by banks and thrifts and the present is a combination of the bank and non-bank, what we would call the financial market, credit growth. And sometimes we even call that shadow banking, where it is non-official, it is not within the realm that can be measured by bank credit.

Kevin:You were talking about autocracies, and China sometimes can be closer to an autocracy. They have played this game in the direction of funds for years.

David:Most recently, the wealth management products, which have proliferated there and allowed for an expansion of shadow bank lending – it is non-official bank lending, but nevertheless, has added to massive credit growth there. So we have done it with the proliferation of CDOs and CLOs. Don was speaking of this even back in 2005 and 2006 because they were creatively coming up with CLO squareds, which is kind of a derivative on top of these private loan funds.

And we have other private loan funds today that are for mezzanine debt and other tranches of debt. It is the universe of credit which is rapidly expanding and is not today limited by bank lending. It goes far beyond that. It reaches beyond the regulations and rules that have previously determined the flows of credit. This was a significant transformation in the world of credit.

Kevin:The old days, when we were on a gold standard, you couldn’t just create money out of thin air. You had to give your pork barrel winners and losers the gold. In other words, you had limited resources because the only thing you could do is tax the people, and you could direct the funds that way. What a revelation when John Law and some of these guys came up with something that said, “Hey, you don’t really need the gold, you can just print the money.” That changed politics, didn’t it?

David:That’s right, because limited dollars in equals limited dollars out, equals limited government. So there is a natural limiting factor.

Kevin:So it always existed, but now it’s huge.

David:That’s right. So this is a significant transformation, and that is from the view of the politicians. When you expand the universe of freebies from a very limited pool of tax revenue and include the entire universe of bank and non-bank credit, the tools which a politician has to ensure re-election are astounding. It’s a lot of money. More money is available than would ever be approved as a budget line item for a particular project, but when you can direct the flow of credit, as is argued by these gentleman in Fragile by Design, it really is fascinating.

So the limits, when we think of graft or the more obvious expressions of redistribution, those limits are expanded by venturing into the realm of credit. And so both banking and financial market finance enable a reconfiguration of the political sphere and what their goals, objectives, and the means that they have access to, enable them to do.

Kevin:As you are talking this way, I’m thinking this 500-page book may actually give a person enough of an idea of what the pattern is to look ahead and say, “Where do I invest, and where do I avoid?” Also, I’m thinking ahead, I’m looking at this and saying, “There is no way we will ever go back to a gold standard. Why would politicians ever approve something like that?”

David:And I think that is one of the key take-aways. I would be a proponent of it. Lewis Lehrman wrote a small book which is absolutely required reading. Getting it implemented is quite simple.

Kevin:Even Steve Forbes – remember he was really a proponent, pushing for it.

David:But you would not get the interest, or the ear, of bankers or politicians because it goes against self-interest in both cases. So we have these groups tinkering with the rules of the game – elected officials, non-elected autocrats in some instances – which Calomiris and Haber look at, and what are they doing? Through the centuries they have figured out ways to benefit friends, to benefit family, to benefit cronies, to benefit constituency groups, which adds to the durability of their public office. What do they care about – the common good, or the goal of being re-elected?

I have to say, in nine out of ten cases politicians are more interested – there are the rare exceptions, you could call them the statesmen, which are a dying breed – but again, I look at this book, and if you find yourself in the category of public policy junkie, or student of the credit markets, or business cycles, financial market crises, then this book is for you – not this Bud is for you, this book is for you. I will warn you, it is not light reading, but it is very good reading.

Kevin:There is an environment that a person goes into when they go into the public arena, and we have seen, Dave, people we know, who change when they get there. They have to adapt to this environment where they are directing funds to their constituency, even if they went in as an idealist. Now, I’m not trying to be too down-in-the-mouth on politicians, but politics, itself, forces a politician to become a politician. Whether he is an idealist or not – he may sound like it when he is getting elected – but it is a form of taking from one constituency and giving to another so they will be loyal to you.

David:In 1944, George Bernard Shaw reminded us that a government that robs Peter to pay Paul can always count on the support of Paul.

Kevin:There you go.

David:That’s the essence of the book. You create support with resources that are not yours. Looking at U.S. financial market development, and looking back to an earlier era, the British and the French financial market chaos, as we did with Antoine Murphy when we looked at the South Seas bubble or the Mississippi bubble, and specifically, the role that Richard Cantillon played in that narrative. You find a similar theme because you have one group being enriched at the expense of another. The South Seas bubble – according to Murphy that was birthed out of a competition for power and influence between the Bank of England and the exclusive charter they had been granted. So it boiled down to politics. It was Whigs and Tories fighting for access to credit and one group controlled the Bank of England and one group was pressing for a work-around, a competitive angle, because they couldn’t get a charter to have a competitive bank.

Kevin:So what is the difference between Whigs and Tories and Republicans and Democrats? It seems like we’re there now.

David:Fast forward in time, it doesn’t matter. You can go backward in time, or forward in time – Republicans, Democrats – time changes, the names change, but the parts in the political theater are the same. In my view, it begins with the use – maybe I should say, the abuse – of the nature of money. That’s the starting point. And then once you have redefined the nature of money, to be able to expand the uses of credit, this is not merely a banker’s dream. This is the key insight here. It is politically approved, it is legally mandated, and there are the fingerprints of politicians all over this every time. So as the witch hunt begins, and we see which bankers float and which bankers sink (laughs)…

Kevin:Remember Lehman? Lehman was one of the fall guys.

David:I don’t know if you’ve seen Monty Python recently, but that scene where, “How do we know if she’s a witch? Well, she burns, because she’s the same as wood, and wood floats, and…” Well, anyway, I won’t bore you with one of the worst logical progressions ever.

Kevin:But it’s true. I remember ten years ago we watched some banks get completely bailed out and then we watched Lehman pack up their bags – they left with cardboard boxes of what was in their desks.

David:Again, this comes back to Maxine. The richest irony is that the perpetrators of the crisis are acting as cops on the scene. They are there to kind of clean things up. This is not entirely true, but bankers are a little bit like children in a sandbox. Tell them the rules, they will generally follow them. Generally speaking. You are going to get a little sand in the hair, and maybe in the ears, so it is not entirely in control. And I’m not saying that they are childlike innocents, but the rules are the rules. Change the rules, and bankers comply.

Kevin:Yes, but remember Richard Bookstaber. He was part of changing of rules in the past, and he looked back with regret in some ways. There are consequences but there are also unintended consequences that come along, as well.

David:You are also looking at a group of people who understand what the implications of change are, so as we witnessed with the end of Glass-Steagall, there were advantages pressed, but again, all within the confines of the law. I don’t like that Glass-Steagall was repealed. I think that things that were not to the general public’s advantage occurred as a result of that. But we’re talking about banks operating under the law, the law changing, and bad things happening. Who is to blame? Do you blame the banker, or do you blame the lawmaker who made it possible? Do you see what I’m getting at?

Kevin:You could see it coming with Glass-Steagall. In 1998, I remember when they repealed Glass-Steagall. We all looked at each other in this office and we said, “Well, here we go.”

David:Approved in 1999, I think. So I tend to agree with Ocasio-Cortez and Maxine on this. They want it re-implemented? (laughs) I kind of think it would be interesting to have it re-implemented. Again, nobody likes to think of shackles. Everyone wants to think in terms of freedom and efficiency, as if those are always a good thing. But sometimes limits, whether it is the limits that you have gained by being on a gold standard, or the limits that you have gained by working under a certain set of legal constraints, can be productive and can have a social good. I’m okay with that.

But there are consequences to the changes in those rules. Whether they are unintended or intended consequences, I think you lay both of them at the feet of the politicians who are pulling the strings. So in every case of legislation which has been written, whether it is to fix the financial markets or the banking system, I think when you boil it down, these efforts to change and make better are really a ruse to once again do what politicians have always done, choose a unique set of winners and losers. Again, you’re talking about political favoritism, you’re talking about voters being granted a certain number of wishes, but it is the same through time, and it is not limited.

This is what is very insightful with Fragile by Design, it’s not limited by a particular type of political system. You could say, “Well, this is one of the faults of democracy.” No. The same thing happens where credit creation occurs, and winners and losers are chosen in the context of dictatorship and autocracy.

Kevin:Remember when Trump was campaigning, he was screaming about the stock market being too high, screaming about the Federal Reserve being too loose. Once he got in, he actually was screaming about the stock market being too low, and screaming about the tightening of the Federal Reserve policy. So limiting credit doesn’t seem like it is ever going to happen because the presidents love it when they get it, and they hate it when they’re campaigning.

David:That’s right. You saw his tweet, the President of the United States says this a few weeks ago. He tweets lots of things (laughs) so google it, you’ll find it. “Economic numbers looking really good. Can you imagine if I had long-term zero interest rates to play with like the past administration, rather than the rapidly rising normalized rates we have today? That would have been so easy. Still, market’s up big since 2016 election.” It’s back to this issue. Loosening credit allows for all kinds of fun and games – until somebody gets hurt.

We begin in the 16^thand 17^thcenturies where nation states began to grow in lockstep with the chartered banks, and the banks were provided with a rent-extracting franchise. It was unique. They had, in many instances, a monopolistic charter, and the politician got what he wanted because he had the means of, through credit extension from the banks, paying for an army, fighting wars, and then ultimately funneling credit and money to friends, as well.

So that’s 16^thand 17^thcentury. Fast forward, the 19^thand 20^thcentury and the modern democracy became a means of redistribution to a particular constituency.

Kevin:Let me ask about that because we’re coming into an election year soon. We’re going to get into this election cycle. Blech! It just sort of gags me that we’re already coming into that 2020 period because of all the commercials and everything. But if you’re going to try to buy a block of votes, you’ve thrown this out here before, and when we had the questions and answers we had a question that came to us from someone who had student loans. Do you see where I’m going on this?

David:Oh yes. So again, what you do, whether it is a monetary or fiscal policy, or a change in the way that loans are handled, or who ultimately pays for that, if you have debt forgiveness of 1.5 trillion dollars in student loans, it is not forgiveness, per se, it is a requirement that the taxpayer…

Kevin:It’s redistribution of wealth.

David:Somebody else has to pay for it, it’s just not going to be the person who was obligated, or signed on the dotted line. That’s the issue – it’s a redistribution. We think past tense of the mortgage lending crisis. We think present tense of the 1.5 trillion dollars in student loans is a problem. In fact, all of these were first a political choice. You’re going to give money to somebody else. And then, of course, scale makes them a problem. The problems that we now know, $1.5 trillion in student loans, that’s a bigger deal. It is having an impact on home ownership for a generation.

The future tense issue is most certainly tied to government generated credit and the implicit credibility issues that show up in the currency markets when government credit tests the outer limits of sustainability. So when you are thinking about the sustainability of government debt it ties to two factors. One factor is the total scale, the second factor is the interest component, and if interest rates get out of hand on that large stock, the total scale of debt, that ultimately defines unsustainability.

Kevin:The person who recommended this book to you, Alex Pollock, the banker who was there when Continental Illinois failed – one of the failures of Continental Illinois – he was amazed that we have gone about ten years without a major financial crisis, and he states that, really, we can pretty much count on – in his career, you can count on some sort of financial or banking crisis about every eight to ten years.

David:Because the personal mandate of a politician, to get re-elected, never goes away, the desire to pump credit into a certain area and keep a healthy economy in perpetuity, is there. It’s there. So what we have is this repetition through time of excess credit creation and sloppy distribution, and the unintended consequences of that. Or people just don’t care what the consequences are. Banking crises have been plentiful in the U.S. and this is where it is a little frustrating because there are other countries where it hasn’t been as severe.

Canada, for instance, has had limited financial market turmoil throughout its entire history. Yet, we have created a financial system that runs in a – symbiotic isn’t quite the right word – a parasitic relationship with our political system? Political system, I think, is probably more appropriate. But because of the parasitic relationship between banking and politics and public policy, we have roughly every decade a significant crisis, 14 in 180 years, so a little less than once a decade from our founding forward.

Again, there are countries that strike at different bargains, they use their banks for different purposes, with credit remaining less of a pawn for the executive branch and the legislative branches. But that is our reality. Banking crises are fairly predictable. And it is one of the reasons why we look with anticipation and say, “Look, it’s been ten years.” (laughs)

Kevin:There has been an experiment that has gone on now for almost 30 years. It’s Japan. Japan just continues to print money, buy their own assets. When the stock market starts to fall, the banks buy the stocks. When they need to buy mortgages, or any other type bonds, they go in and just buy them. Granted, it’s not working because Japan has never come back out of the crash that they had back in the late 1980s, but it seems also to be something that can go on for a long, long time.

David:I think Japan is a little bit like the patient who is laying brain dead on the table. You can continue to feed the body and maintain a pulse.

Kevin:30 years.

David:Yes, 30 years of life support, and what do you have? You still have a body, you still have a heartbeat, and you may be able to measure a brain wave. This is a bad analogy because I am in no way trying to be diminutive to the Japanese people, but you have limits which were pushed in the 1980s and 1990s by the Japanese, and people began to say, “This is a new era of unlimited growth.”

Kevin:I remember that.

David:And it was never going to end. And yet, it did end, and the recovery has been 30 years, and going. So the U.S. entered the fray in the most notable way in 1977 (laughs). It was also a very notable year for ports – I know, that’s a distraction.

Kevin:Port wine – you’re talking about port wine. I was listening to you and thinking, “Ports – which port is he talking about, the port of Cadiz?

David:No, no, no. If you ever have the opportunity, you, too, will find it a very pleasant distraction. Port, the 1977 vintage is very good. But I’m talking about the CRA, the Community Reinvestment Act, which was launched in 1977. So again, we had credit excess of the 1980s and 1990s which was focused in Japan, and we actually sowed the seeds of our own credit excess in the 1970s. I say sowed the seeds because the CRA, the Community Reinvestment Act, set the stage for what really gained traction in the 1980s and 1990s. The CRA was designed to encourage banks to serve their local communities.

Great. No problem. And it sat relatively dormant until you had the mega bank mergers of the 1980s and 1990s. State laws which allowed for branch banking and a number of other things had a positive impact on the growth of large banks. Couple that with the political pressure that you began to see emerge directly to your GSEs, Fannie Mae and Freddie Mac. Again, throw it in the blender with the CRA-directed credit and you had something that was just a few billion dollars throughout the 1970s and into the early 1980s.

And then all of a sudden as you launch into the 1990s it goes from a few billion to many trillions in loans. Again, this is the acceleration factor with Fannie Mae and Freddie Mac being – no, required – requiredto buy subprime paper. And they created a dumping ground for loans that would not ordinarily have been made by banks.

Kevin:It’s forcing toxic debt. It’s unpayable.

David:And because politicians created the dumping ground, banks could say, “Look, we’ll originate the loans and we don’t have to maintain the exposure to the risk. We don’t care about the risk. We don’t have to care because someone else is willing to take it off our hands.”

Kevin:“They’ve got our backs.”

David:Who is taking the risk off their hands? Is it the GSEs? Who stands behind the GSEs? The government. Who stands behind the government? The taxpayer. So who ultimately is subsidizing these loans which never should have occurred in the first place? Again, think about this. Subsidized loans with a higher risk profile, mandated through the halls of D.C., to be placed in vehicles that ultimately the taxpayer would be taking the risk of nonpayment on. The mortgage finance bubble has political fingerprints all over it.

Clinton was able to pump up the CRA activity in 1999. He took massive credit for it. He said, “Look, I’ve vastly expanded and implemented the Community Reinvestment Act.” And then Bush comes along and he is only too happy to keep the credit flowing and he is an enthusiastic supporter of the Community Reinvestment Act. We know how the story ended. But a repeat of directed credit is always about to occur because we always have politicians who are trying to buy votes. So on a two-year basis, on a four-year basis, it happens with unfortunate regularity, like the scratch in a record.

Kevin:And that regularity is a little slower in our economy than, say, as you were talking about, autocracies. I’m just going to look at China again. China can react pretty quickly. You see changes in their policy, the same type of motives, but those changes can come as shocks because, really, you don’t need a lot of votes.

David:That’s right. You’re buying stability. When you’re redirecting losses and directing wins toward particular constituencies, even within an autocracy, it is so that you can control social and political dynamics. Very pressing, in the present tense, is China. Why does much of this matter, not just as a historical commentary, but also future tense? Because we have the same thing going on. The PBOC has injected an additional 84 billion dollars into the system here just before the Chinese New Year. For the fifth time in a year, they have lowered bank reserve requirements.

What does that do? Implicitly, it increases balance sheet leverage. Under one set of circumstances that might add to profitability for the bank. Under another set of circumstances it makes the banks and banking system far more vulnerable. But net-net, it does increase credit into the marketplace, and hopefully drive economic activity.

Kevin:Your dad started this company back in 1972, so we’re well into this. I’ve been here for 32 years now, and one of the things that I’ve seen is these rhythms that we are talking about aren’t just political, but they are punctuated by bank crisis. Probably, a lot of the changes that we are talking about won’t occur until the next crisis. When you are casting lots you need to see where the lots fall, and my guess is that these guys are getting ready for the changes after the crash. You have even talked about getting rid of the currency – Ken Rogoff – closing the system so that you are a captive to the system.

David:We certainly see the issues here in the United States, nine trillion in corporate debt, much of that coming due over the next three years, big blocks of it coming due in the emerging markets, in addition to that nine trillion here in the next two years, in particular, trillions of dollars in debt that has to be either repaid or refinanced. So you look at the debt issues, and what is debt other than credit that has been extended at some point? So when we talk about credit expansion and credit crises, we are talking about a problem with debt. Beijing – it’s not like they have things under control. They pretend to have things under control, but bank loans were up 13.5% in the past year, 28% higher over two years. There are consumer loans which expanded in China by 18% over the past year, 44% in two years, 141% in five years.

Kevin:So the debt bubble is going parabolic again, but it’s in China.

David:That’s the issue. When you look at the end of a credit cycle you tend to see, and we actually don’t really see much of a difference between a 13% increase and a 28% increase over two years, but these are year-over-year comparisons. If you took a base year and then put it on a chart, and could see what the base year was, and we’re not just comparing from last year to this, you would see that parabolic rise in credit. Ultimately we know that credit growth is not sustainable. There is not enough money coming in to feed the interest cost, the interest meter, and so it ultimately has to end.

Kevin:It just strikes me that in politics and in banking, you really don’t see anyone keeping it between the lines. In other words, it always travels toward some sort of excess.

David:There is a political motive to drive that, and I think the moral of each of these stories, whether it is the U.S., or going back to Britain, or if it is looking at the Japanese today, the Chinese, probably one of the greatest expressions of credit excess, the moral of each of these stories is about excess. Aristotle, if you want to go back to the ancients, described virtue as the mean between excess and deficiency – the middle point. It’s not too much and it’s not too little. Politicians have a hard time moderating that. If a little is good, a lot is better. We explored some of those issues in terms of excess with Tomas Sedlacek a few years ago. I would encourage anyone…

Kevin:Economics of Good and Evil. Fabulous book.

David:A fantastic read, very challenging. It will challenge some of your economic beliefs to the core, and I encourage you to do it. Go back and listen to the Commentary – it’s in the archives – and order the book.

But Aristotle is looking at this middle point between excess and deficiency. I’m not sure when we decided that excess was the new virtue, but I’m tempted to say it was when we redefined the nature of money and removed those natural moorings to credit growth. We go back to 1971 for that in the United States, and the implications are global. Now we have economic growth, which is the priority of every central bank, seemingly at any cost, present or future.