Podcast: Play in new window
- World’s Debt Now 360% of GDP
- 448 Billion Flees Banks Into Higher Paying Money Market Funds
- Gold Is The Best Stupidity Insurance
China Abusing A.I. For People Control
May 24, 2023
“Let’s compare revenue inflows with outflows. You’ve got 4.8 trillion in revenue—inflows—that’s taxes coming in. And now that interest component of 928—well, that’s about 20% of all government revenue going to interest only. That’s not paying down the debt, that’s making interest payment.” — David McAlvany.
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
Well, David, table 30 at Ken and Sue’s, because they now close on Mondays, has turned into— Our table 30 was on the front porch of your home last night as we enjoyed some cheese and some bread and some snacks, and of course a little bit of Talisker. But your son came in, 17-year-old son, and he and I were getting a chance to talk, and I said, “Gosh, you’re going to have to stop by more often because soon you’re going to be in college and I’m only going to see you when you’re back from college.” And it hit me. I said, “Just like your dad years ago.” You remember that?
David: Of course. I’d come home and we could talk about whatever you were reading and whatever I was reading.
Kevin: You were teaching me about philosophy, and I think you and I went fly-fishing before that. And then I was on my way home and I thought, “Wait a second. Right now, Dave is exactly the same age that his dad was, Don, when I first came to work with the family back in 1987.” You just turned 48 years old. Your dad was just about that age when I came, and then you were a teenager. We had a lot of great times together, but now your son is getting ready to go to college. And I think of that because Dave, there’s so much history. I’m sitting there on the front porch and I’m talking to your son who, I remember you when you were that age. I said, “How many lifetimes do I get to live?” It’s an amazing thing. But in 2008, you and I started doing this Commentary. It really forced a lot more time together. And what we’re experiencing right now seems to have a tie-in to 2008 as well.
David: Well, yeah. I mean, the bottom line in advance is that we live in an age of engineered social and political instability, over-engineered financial market frailty. If you look at the debt ceiling debate, and of course, what precedes that: gross fiscal unsustainability and irresponsibility. And in my mind, the case for hard assets is a cinch. Gold has been described as stupidity insurance, and it is. You may need more of that than you think. Just look around.
Kevin: And when we started this Commentary, Bear Stearns had just failed. Remember that collapse when they came out? And of course there was this rescue. We’re starting to see that same type of thing with institutions today again.
David: Well, the world then was CLOs, CDOs, CDSs.
Kevin: All the acronyms.
David: CLO squared. I mean there was all kinds of things and Bear Stearns had its collapse. The rescue was complete. Oh, who was there? It was after JP Morgan bought them for pennies on the dollar. Stock market rallied from March to late May of 2008, and our friend Bill King sees that same kind of trade playing out in a similar pattern today. Rescue, relief rally, hoping to gain enough momentum to top a new level. In this case it would be 4,200 on the S&P. JP Morgan was not done—going back to 2008—was not done with its emergency purchases there in early 2008. You still had Washington Mutual, which was to collapse in September of 2008.
So by that fall, things were getting worse, not better. The real declines in the stock market intensified into the autumn months. The March to May trade was not a marker of the worst being in the rear view, but equity traders just pushing for as much as they could get in the short run. And of course, you’ve got short covering rallies, which are very powerful moves that can generate significant gains in a short period of time for traders.
And today we have some of that. Stubborn shorts are in a position where they may have to cover those positions or get caught in a melt up. Covering their shorts is probably what is a part of the melt up dynamic anyways, not a return to health. But I think again, like the 2008, 2009 period, as 2023 progresses, we’re going to find that as we get to October, November, there’s more to be experienced.
Kevin: So the question, is this the end? I hate to even ask this. It’s tongue in cheek. Is this the end of the bear market?
David: Well, I mean routinely we’ve seen short covering dynamics in play over the past week to 10 days, and so a breakout in terms of an upside move is a real possibility. No, it’s not the end of a bear market. By no means, but perhaps the end of a bear market rally as it exhausts itself on short covering, and with the enthusiasm of a few guppy investors afraid of missing out on the next bull market, jumping in right before we get another turn.
Kevin: And there’s a danger sometimes of saying something is just like, so I want to be careful. This isn’t just like 2008.
David: No, the nature of this market is quite different than 2008 and 2009. The epicenter thus far has been in quality debt instruments with stretched durations. We’ve talked about that. People going out farther onto the horizon, 20, 30 years.
Kevin: They want more interest.
David: For a little bit more interest. And of course, those positions have lost value when marked to market. And that has had the consequence of upsetting balance sheets. Capital has shrunk in some cases to nothing or less than nothing. So the relief came when the government put in their swap program, implemented that on March 12th in an attempt to break the mark to market from occurring. Postpone the inevitable for at least a year.
Kevin: We don’t want to see the real price. Don’t let the market see the real value of something.
David: But there’s no question that we’re talking about quality Treasurys versus non-quality mortgage backed security paper, which we didn’t know how to price. Again, you’re talking about the age of ninja loans. Nobody even verified if someone was employed, and yet they were going to loan them 2, 3, 4, $500,000. That was the speculative fervor and frenzy of the 2005 and ’06 and ’07 period leading up to the decline.
But right now, following the balance sheet squeeze of the first quarter, banks are looking at deposits through a very different lens. How low can we keep deposit rates and not see flight? That’s been the objective of bankers. It’s now shifting slightly to how high must we go to retain deposits? Because if we take them too high, we’re going to be squeezing our net interest margin. And as net interest margin is impacted negatively, it changes the desire of banks to lend.
The lending environment is much more cautious, and of course that’s a significant part of what we see happening in the second half of this year. The SLOOS [Senior Loan Officer Opinion Survey] report we’ve talked about, it confirms that with hard data. So while this period is different than 2008 and 2009, one thing that is similar is that we have an unmanageable quantity of debt in play, and the managers of those IOUs are under acute stress.
Kevin: Well, and you’re talking about credit contracting at this point. We haven’t experienced that. We’ve been seeing debt added by the trillions. I mean, what is it worldwide right now?
David: Yeah, that’s the thing. We’ve seen something of a hiccup in the financial markets, but credit conditions are still incredibly loose. As and when credit conditions truly tighten, then you’re talking about real pressure in the asset markets. So the Institute for International Finance put out its first quarter tally of debt obligations. So this is the global debt monitor. Debt increased on a global basis by $8.3 trillion in the first quarter of 2023.
Kevin: In a single quarter.
David: 8.3 trillion globally in the first quarter of 2023.
David: So we’re retracing the path back to record numbers. We’re just a skosh below the all-time highs. So here we are sitting at 305 trillion. Emerging market debt hit an all-time high of over 100 trillion, and in the emerging markets that 100 trillion is equal to 250% of debt-to-GDP.
David: It’s increased off of 2009. So to go back to pre-pandemic levels of 75 trillion. Quick 25 trillion in debt for the emerging markets. That’s the emerging markets. Global debt from pre-Covid to present, inclusive of emerging and mature markets, is higher by 52.3 trillion. In aggregate, looking at the whole world, we stand at 360% debt-to-GDP.
Kevin: So let’s personalize this. Let’s just take whatever our income is on an annual basis and say, what if our debt was 360% over? I’m not counting mortgage here. I’m just talking about debt. Other than that, what if your debt was 360% over what you were earning on an annual basis? Think of the burden that that would be, and you’re saying at this point, in aggregate, you said, we’re 360% debt to GDP worldwide right now.
David: That’s right. That’s right.
Kevin: It’s incredible.
David: So, not to worry. If financial repression and inflation can both be used, these are the tools that the academics have assumed that they would be able to use. You can manage the variables pretty well. The one problem is that pegging interest rates at zero is no longer an option. Of course, that’s a part of the repression—
Kevin: Because of inflation, right?
David: Yeah, it’s a part of the repression playbook. But as long as inflation has this indisputable presence in the lives of consumers, you can pretend it’s not there and you can tell people that it’s not there. But when people are paying the price and it’s painful, the consumer vote matters, the consumer opinion matters. And of course that changes consumer behaviors. It carries with it some negative knock-on effects—stagflation being all too common. When the consumer remains concerned long enough and then begins to change that behavior—not buy what he used to buy or she used to buy—it suggests that our debt is not as manageable today as it once was thought to be.
Again, losing the tools. Consumer inflation wasn’t supposed to be here. It was not the invited guest. It just showed up. Central banks of the world are still not connecting the dots between their policies. They won’t take ownership or responsibility for this. This is something we talk to our kids about all the time. They do X, Y, and Z, and we ask them what happened. We want them to be able to identify their choices and what happened next. And yes, sometimes there’s logical consequences as a part of the disciplinary function of a parent, but it’s really important for them to mature as human beings by taking ownership.
Central banks of the world will not do that. They’re not connecting the dots between loose money and credit and the inflation that follows. And of course there’s the asset prices. Maybe they can recognize some of that, but with consumer prices, no connection. It’s not a result of their policies that we have consumer inflation. That does not add up for the PhD economist.
Kevin: Yeah, but it does for our wives.
David: For me, for you. We go to the store or our wives go to the store— Buying groceries, anyone who does that can do the math, and we’re probably more aware in some respects than the PhD.
Kevin: One of my favorite guests that we’ve had on was Carmen Reinhart. I remember when you and I both read the book This Time Is Different. You remember she wrote that with Ken Rogoff. And you were just now talking about 360% over GDP. They analyzed, in that book, was it 600 years of debt?, and they said you go into a crisis when it’s about 90%.
David: So this was written in 2011. I think the context is key because we’re past the global financial crisis. I mean, they’re writing it frankly in 2010 and it publishes in 2011, so it publishes in the months right around things being at their worst with Europe. This is just as Mario Draghi is saying, “we’ll do whatever it takes,” right? And the whatever-it-takes promise is a fiscal promise. So they’re creating a context for not only the US, but this global issue of, okay, if you want to solve financial folly with fiscal commitments, there are consequences to that. And they chronicle eight centuries of financial folly.
In looking across those eight centuries, when debt relative to GDP exceeds 90%, that 90% threshold versus GDP, it becomes problematic. Statistically, it most often leads to financial market crisis, right? 90%, not 360%. 360% suggests that the only way to manage this situation globally is to somehow figure a way to grow our collective way out of it. What are the odds of that? Today, pretty low. Repression is a key tool, that’s a lot harder to implement when consumers are inflation-wary.
Kevin: For the person who’s not thinking about the interest that they’re getting on a daily basis— I mean, old habits are hard to break. A lot of people are still sitting in the bank not really thinking about how much more they could actually get just going over to 90-day Treasury bills or two-year Treasurys. Shorter-term Treasurys are offering more than the banks right now. There’s a breaking point where even the guy who doesn’t pay much attention to his interest rates at the bank is going to scratch his head and he’s going to go, I got to move.
David: Yeah, we go back to Rogoff and Reinhart, and they’re doing really good work as academics to try to figure out how to solve static problems. But what you have in real time—we look at the banking sector and pressure there—is real-time adaptation. You have individuals choosing what they view to be in their best interest. Sometimes they’re moving in a mad mob of people, and sometimes it’s just an individual making a choice just for themselves. So the stages of banking sector pressure, which we’ve covered in previous Commentary episodes, reminded of how obvious a shift becomes from being a bank depositor to being a money market investor once the numbers are reviewed. Again, this is adaptation. It certainly was not modeled as the Fed was saying, “Hey, we’re going to raise interest rates to 5%, 6% and that’ll take care of inflation.” There was no model that said, yeah, and you’re going to create a banking crisis thereby.
Kevin: These are banks that are actually highly rated that are under pressure right now.
David: Right. So I had a conversation yesterday with a couple that we’ve known for many decades, clients for many decades, and I’m going to borrow from that conversation. It’s a pretty straightforward illustration. They’re dealing with three banks, all well rated, not likely to have problems, deposits right up to the limit of $250,000 at each bank.
Kevin: So they’ve been playing it safe?
David: Yep. The highest, and this is funny. The highest payment on those deposits of the three banks is at 2%. So for the sake of being generous, let’s assume 2% on all of the deposits. 2% on 750 grand comes out to $15,000 a year in taxable income. Or you could choose instead a money market fund yielding 5% invested in short-term Treasurys and your income jumps from 15 grand to $37,500.
Kevin: That is a big difference, and that’s just interest in the money market. Is this a money market that would have commercial paper in it or would it be—
David: No. See, the funny thing is I know the doubling in income is obvious when you look at the percentages, but the dollar figures speak more compellingly.
Kevin: So 15,000 at the bank or 37,500?
David: Right. And that’s what serves as a motivator for depositors to continue to move money from banks. It’s 1,250 bucks a month in income or $3,125 a month. 3,125, 1,250. What do you choose?
Kevin: Time to move? Yeah.
David: So current rates at TreasuryDirect on three-month paper would actually be a little bit higher than that. 200 bucks a month, so 3,325 because it’s currently running at 5.32%. We do this for our clients already. This is how we manage cash on account. We do this for our clients by rolling short-term Treasury bills to maximize yield on cash equivalents. Money market funds today, if you look at the move in the money market funds over the last couple of years, they now total $5.341 trillion. That’s up over the last 10 weeks by $448 billion.
Kevin: So there is a move going on.
David: Yeah, those are bank deposits coming into money market funds to the tune of half a trillion dollars. Over the past year it’s more than that, of course. Up 19%, $856 billion over the last year. If you make that move, to your point a moment ago, and choose short-term T-bills only, commercial paper, even if it pays you an extra five or 10 basis points more, stay in a T-bill only money market fund. That makes sense.
Kevin: These bankers are under amazing pressure. I know because as I talk to clients, oftentimes they’re moving money. They may be moving money to us, they may be moving money to money markets, but a lot of times that’s done with a wire transfer. And I’ve noticed, Dave, over the last couple of months, especially since Silicon Valley Bank and that happened, that they’re having to explain themselves when they go in to wire money. There’s almost this compulsion by the banks to say, “Hey, do you really want to do this? Do you really want to move your money?” So there’s more scrutiny bank by bank, and you and I were talking about this. This is happening on an international level, too. China. Look at the scrutiny that China has increased. Where’s the money going? What are you saying on social media?
David: What a difference a year makes. Thinking about our local banks, 2021 and 2022, the conversations I would have with multiple parties here in Colorado. We can’t take any more deposits. We have to turn money away.
Kevin: That’s right.
David: We don’t have any place to take them, and it’s going to change our ratios. We don’t want your deposits. We can’t take it inbound. Now they can’t take it outbound. We don’t want your money to go. And we’ve talked to a couple of clients who, the banks have actually said, why are you pulling your money? Can you give us a reason? It’s as if it’s their business.
Kevin: They’re scrutinizing these transactions.
David: Really fascinating. So onto China, when capital controls become a focus for any country, something’s not right. And so here we are again. Bloomberg, May 16th, highlighted the increase in scrutiny, capital controls specifically, and this is in China, on the grounds that national security and financial stability risks could increase without these extra moves. So monies moving from Mainland China to Hong Kong surged significantly over the holiday week. This is the golden week holiday early in May. And so that in itself is worth considering. Capital controls are back on the rise in China. Super important signal. This coincides with the RMB coming under pressure again in a range between 7 and 7.3 to $1.
Kevin: Does the change freely float? They control that, don’t they?
David: No. And this is one of the things that I hear so many pundits—really it’s sort of newsletter writers—that have decided that it’s time to throw in the towel on America. And so it’s very easy to say yes, and look at China. Nothing can stop them. Well, look, the currency does not freely float, which is one reason why you should probably manage your expectations of US dollar usurpation. Manage them to a low level for the time being because you’ve got a group that doesn’t trust the market and won’t take the risk of being priced in real time by the market.
So what do they do? These levels right around seven to one, these levels are managed. They require routine intervention. And despite the interventions, the currency has declined again to this critical level of seven to one. Some would argue between 7 and 7.3. This is where the rubber meets the road. An RMB devaluation has implications for the region, throughout Asia.
Obviously a devaluation of the yuan, RMB, has implications for China, but it also has implications for the US dollar because all of these things do ultimately reflect each other on a relative basis. So Chinese weakness, just like yen weakness, shows up as US dollar strength. And you might say, well, why is the US dollar getting stronger? Look around. It may have nothing to do with the US dollar, just on a relative basis. And so therefore this is something that’s impactful for gold as well. Temporary weakness in the metals reflected by temporary strength in the US dollar. Which is, again, if you’re following the dominoes, that’s just a reflection of temporary weakness or some form of weakness in the Chinese currency and in the Japanese yen in particular.
Kevin: You were talking about discipline with kids, and if you watch parents with their kids, they can either be calm and in control or you can start to see them losing control when they start trying to control. You look at China right now. China, they want to act like everything’s fine. They’re just a superpower of the world, one of them. But we’re seeing not just capital control, Dave, which you said that’s a signal of trouble, but we’re seeing thought control. I mean, big time.
David: And that’s a display of insecurity for sure. And there is a ratcheting up of both right now.
Kevin: Don’t make a joke in China. Don’t make a joke in China.
David: Yeah, you’re talking about the comedian who last week in a standup routine was thrown in jail for making a joke about his two dogs chasing squirrels. And then he brings in the sly comment about Xi Jinping. It’s a slogan that he’s often repeated that refers to the PLA, the military, and so he gets in trouble for making this comment. The company that hired him put him in this standup comedian role. They were fined $2 million, and the comedian just over that. And the comedian’s not laughing because he’s looking at a long-term prison term. Then a 34-year-old gal questions his detention on social media and is immediately arrested. Insecure. We’re talking about, again, when you have to start controlling thought as well as capital movement, something’s not right.
Kevin: How do you immediately arrest somebody for a comment on social media? Unless you’re using this new falutin artificial intelligence.
David: It’s the way of the future. I can promise you the Chinese government has effectively integrated AI into their online monitoring and surveillance of all of its citizens. This was not a prominent or well-known 34 year old, but they instantly flagged the remarks on social media and moved against her. So here in the US, if you’re playing the stock market, you may marvel at NVIDIA’s 106% gains year to date.
Kevin: Which is AI.
David: Wall Street has designated them as a way to play AI. Wall Street last year designated them as a way to play crypto because they sell hardware into the space. But with the enthusiasm for AI hitting a fever pitch, just slow down. Be careful what you wish for. May be a great way to make money, but there are trade-offs to progress with AI.
Kevin: Well, and I asked your son last night, what’s your thoughts? The 17-year-old who’s actually right now in the middle of finals, he’s having to write papers, and I just said, “What are your thoughts on AI?” Because Dave, I know you’ve played around with it.
David: I hope he’s still writing his papers.
Kevin: Yeah. Well, he did admit. He says, “Now I did get a starter for a paper.” And he was careful to say starter for a paper, not the whole paper.
David: Well, right. I really enjoy using it. ChatGPT is really interesting, great conversational vignettes, and in my own use of it, just to get to know it, it’s like having a conversation with an informed party on the New Deal or on Marsilius of Padua, or, what are other things that I’ve done? The difference between the Hussite view of communal ownership and communism. I love going back into things that I’ve studied in the past that I don’t remember.
Kevin: Here’s the difference between you and me, Dave. Okay. Everything you just now named I have very little familiarity with, but when my son showed me ChatGPT, I said, “Hey, have it write a fairytale about princesses and a dragon.” Okay, seriously, and it did. It was impressive. But no, I never did think to ask it about, what did you say, the Hussite view of communal ownership and communism?
David: Was an expression of early communism and Chat GPT would say no, it was not a form of early communism.
Kevin: I’ve realized I am a Pabst Blue Ribbon guy when you’re drinking Talisker. Yeah, I’m just telling you.
David: Well, it’s a launching point for primary source reading. It focuses topics and helps me find direct source references when asking the right questions. But here’s the deal. The tools in the hands of a totalitarian regime or an entirely woke regime, which is nothing more than intellectual totalitarianism, that’s frightening. And you can see it in real time in China. They’re growing insecure, they’re acting insecure, both with monetary currency and the social currency that they trade on.
Kevin: That’s dangerous.
David: Freedoms in exchange for good behaviors. And AI in its nascent state, I think, is a neutral tool. Good or bad ties to AI really in terms of the way it’s used or abused. I think you could make the same case if you’re talking about Second Amendment issues. You have tools which are very dangerous or very useful, and it depends on whose hands they’re in. China is abusing AI as a means of controlling thoughts and opinions, and ultimately the actions of people.
Kevin: I just read a quote last night about a warning that you never want to centralize all information. Once you’ve centralized all information, if it’s in the hands of someone with power, and China has power over its people, it creates problems. But they don’t just do it with information, though, Dave. In their insecurity, they’ve been pressuring property developers who maybe wouldn’t normally invest at this time.
David: Not only are property developers under pressure, but you’ve got the regional governing authorities. The regional governing authorities have for a long time tied their revenues to the repurposing of land for further development. So a major source of revenue for these, consider them like municipalities. That revenue’s diminishing, and it’s making their debt levels even less sustainable.
Kevin: Creating more insecurity.
David: Again, we go back to that 360% relative to global GDP. We get the emerging markets which have added another 25 trillion, 53 and change trillion globally. We talked about this weeks ago, two trillion just in the first quarter of this year in US dollar terms. The debt numbers here are absolutely astounding. But I will say this, if I were Xi Jinping, my chief concern would not be in the real estate sector or pressure within the credit markets that relates to those developers. As significant as those things are for economic activity, I would be far more concerned with my youth culture. The unemployment rate for youth ages 18 to 24, is at a record high 20.4%?
Kevin: Do you remember when Spain and some of the European countries had high youth unemployment, and immediately it was turning into civil unrest?
David: Look, revolution always comes from youth. That’s a reality. But then you educate and manage expectations. Here you’ve got 11.5 million Chinese college graduates hitting the street this spring, 11.5 million new college graduates.
Kevin: While unemployment is over 20% in the youth.
David: So maybe half will find a job, but this could be tied to Covid. A lingering effect of Covid. The jobs market hasn’t opened up fully. Perhaps it relates to a global credit cycle turning down. There is certainly global shrinkage of the economic pie.
Kevin: Isn’t there a new wave of Covid, a new named Covid that’s sweeping over there right now too?
David: Yeah, so when we talk about China, its producer is feeling the hit as global consumers, to one degree or another, tighten their belts. And sure, XBB is the variant, spreading fast. Numbers are currently running at 45 million cases a week. Estimates of a peak run rate of up to 65 million new cases a week will dampen already unimpressive reopening statistics. The recovery story was widely heralded, much anticipated, and you started to see markets move last October with very little follow through in terms of actual economic output.
Tom Hancock was writing for Bloomberg a few days ago. He said China’s economy is at risk of being caught in a confidence trap as the post-Covid recovery loses steam. That is what’s happening. So we’ve got insecurity expressed in many different areas for some very specific reasons.
Kevin: So it could be Covid. It be a slowdown of credit. There’s a number of things that are creating this insecurity.
David: Yeah. And economic activity can shrink back for a variety of reasons. Covid remains one of them, but to have increasing strains in your credit markets, capital flight on the rise, unemployment amongst smart, educated, and ambitious youth, it’s going to be intriguing to see how this unfolds. Just what the policy responses are. And it’s difficult, if I go dark for a moment, the noir side of me would think this is where you put 11.5 million people to work very quickly, and it’s not going to be digging ditches. It’s going to be marching and carrying things that shoot things. I think it’s highly instructive that both Goldman Sachs and Morgan Stanley are cutting back mainland Chinese growth plans. Highly instructive. The geopolitical climate has shifted. Alongside the domestic economic climate, it’s a different business environment today in China than it was even one year ago. Certainly pre-Covid.
Kevin: And these are international movers. I mean, when you say Goldman Sachs or you say Morgan Stanley—
David: They want their slice of a $60 trillion pie. They are there because they believe banking the Chinese public is lucrative.
Kevin: But you say they’re backing away.
David: Cutting back growth plans, eliminating staff, closing offices, and again, it’s easy to see why. There’s reasons for them to consider themselves less welcome than previously.
Kevin: They just don’t want to be over-committed in a period of time of downturn.
David: Years ago, I had a front row seat to Bank of America coming under intense financial pressure following the collapse of WorldCom and Enron, and essentially it was a double whammy in their telecom lending and in their energy lending silos. They were overexposed to both. So who got squeezed? Well, any loan that could be pressured under $100 million was part of the crisis management dynamic. Preserve as much liquidity as you can, call as many loans as you can. It was almost like we experience it here in Colorado. When it gets cold, your fingers start to get cold and lose mobility because your body says, “Shut down. Bring the blood back to the heart. Keep the core alive, preserve the brain and heart and key organs. It doesn’t matter if you lose your fingers.” And that’s really what happens is blood is shunted away from your extremities and kept at the core, and that’s what B of A was doing. The Associated Press on the 18th discussed the kinds of pressure the Chinese are bringing to bear on their debtor relationships.
Kevin: So they’re making the call, saying, “Hey, we need you to send money.”
David: It’s with Pakistan and Kenya and Zambia, Laos, Mongolia. Debts are getting squeezed, with China requiring hidden escrow accounts and getting preferential payment and moving to the front of the line. They may have a dozen creditors, but China’s strong-arming them and saying, “we’ll be paid first.” It doesn’t have to be legally contractible. There’s nothing that requires it. At this point it is sort of the strong-arm that Chinese to get to the front of the payment line. And it feels like BofA, feels like Bank of America circa 2001. Something is not right in China.
As an aside, going back to WorldCom. Verizon ended up buying WorldCom assets. I think it was $7 billion, six and change. Post bankruptcy, WorldCom becomes MCI. Gets bought by Verizon. They traded in bull market fashion to highs of 180 billion.
Kevin: So they had been as high as 180 billion, and they were bought out for $7 billion after that?
David: Just under seven. So 95%, 96%, 97% discount. Let that sink in. If that’s not a reminder of the value of cash, I don’t know what is.
Kevin: I think about bull markets, though, and people who are really bullish about something. There’s always a story. There’s always a reason for a bull market. And you go, “Hey, have you ever heard of cryptos? Have you ever heard of the internet?” That’s the one that’s always used as an example of, Hey, you are such a failure. You had no idea that the internet was going to be what it is.
David: Well, so it’s the cloud. Maybe it’s AI today or last year’s bitcoin and cryptocurrencies. It’ll always be something that captures the unbridled imagination of the bullish investor. WorldCom. Think of them. They controlled 90% of the internet backbone globally as the internet was making its debut.
Kevin: And they were worth 180 billion, but later bought out for 7 billion.
David: Not a bad story except for the fraud involved. Verizon picked it up for pennies on the dollar. Enron, same kind of thing. Enron was the late ’90s Wall Street favorite. I kid you not, from 13 billion to a hundred billion market cap, 750% gains in about a four-year period. You had more people who were sort of like Jeffrey Skilling fanboys at every Wall Street firm. Harvard MBA, McKenzie experience. Like, this is the guy. He’s got the credentials.
Well, just remember that Ivy League credentials— By the way, Harvard’s known for their savagery. They could have a curriculum descriptor, Lessons in Savagery, and that should go along with it. They say, hire a Harvard MBA if you want someone to steal your business, a Wharton MBA if you want someone to run it.
So the big five accounting firms bless the results, right? And as it turns out, something was amiss. And so Arthur Anderson is no more. There’s no big five. There’s only the big four. And it’s just fascinating to me that sound and sober judgment asking hard questions was set aside because there was enough of a pedigree not to care. Sounds like the 2022 version. SBF.
Kevin: Sam Bankman Fried.
David: Not SPF. Not sunscreen. SBF, Sam Bankman Fried. How many fanboys were there? We’re talking about the Clintons. We’re talking about Gisele Bündchen. I mean, it covered the gambit from Wall Street to crypto to the hedge fund community to politicians. I mean this guy FTX, what could go wrong? Until it ended in a fraudulent scandal?
Kevin: And I still have to go back to the commercials with the bull market in crypto at the time, the Super Bowl commercials. I’ll never forget the 2000 Super Bowl commercial. It was a yellow screen and they said, “We just wasted $2 million.” They didn’t really even tell you who the company was. They didn’t care. There was so much money in the tech stock bubble, which by the way, popped in March of 2000. We had the Super Bowl last year. We had this commercial saying that, look, you’re not an innovator. You’re not an inventor. You’re not an explorer—
David: Matt Damon’s on Mars saying you won’t make it here unless you’re getting there with crypto.
Kevin: Unless you’re in crypto. And then of course, we had the bust.
David: Matt Damon.
Kevin: I have a good friend here in Durango who was with Enron. And see, this is the thing. There’s a lot of collateral damage with people who really don’t deserve to lose when you have something happen. This is in the late ’90s, he was worth over a million dollars just in the stock that he was given through Enron because he worked for them. He lost everything. He had to start completely over. Now he’s been successful in other areas, but you can still see the scar when he talks about it. When Enron failed, that was very painful. And it wasn’t his fault.
David: Kind of bringing it back a little bit. Bull markets breed stupidity, right? Bull markets breed blind faith. Those ingredients are still in play in the equity markets today. On the other hand, bear markets tend to teach humility. They tend to be reminders of common sense. And frankly, the importance of lower math, not higher math, lower math. Things need to add up. Two plus two needs to equal four. Tuition in a bear market is not cheap. And what you have at the end of a bear market is complexity, is skewed for a back-to-basics approach. That’s what you find at the end of a bear market.
Could we have a global bear market? Is that a possibility? Certainly you consider the quantities of debt that we have, the strain that represents on the global economy. Global growth leadership from China is foundering. That’s clear. And US economic growth, driven by debt, well, that’s not sustainable. So where does the growth come from?
I read something by Ray Dalio last week, which echoed these concerns. He said, “When debt assets and liabilities reach the point that the amount of debt sold is greater than the amount of debt that buyers want to buy, central banks are forced with a choice. They either have to let interest rates rise to balance the supply and demand, which is crushing to debtors and the economy, or they have to print money and buy the debt, which is inflationary and encourages holders of the debt to sell the debt, which makes this debt imbalance worse. In either case, that creates a debt crisis that is like the runs on the banks that we’ve been seeing, but with government bonds being what is sold, and the run on the bank being a run on the central bank.”
Kevin: So I want to repeat that beginning of the quote because they’ve been getting away with this. The central bankers have been able to get away with this without inflation. They’ve been able to just create debt and not have inflation, but now we have the inflation. So here’s what he said. I’m going to read it again. “When debt assets and liabilities reach the point that the amount of debt sold is greater than the amount of debt that buyers want to buy…” There’s your problem. There’s your problem. You’ve got too much supply of something that’s horrible, which is debt.
David: I know, I know. So our growth rates in debt far exceed the growth rates in GDP. That is, our economy is not keeping up with the quantity of debt.
Kevin: That’s unsustainable.
David: Yeah. I shared a few of these concerns on last week’s client only conference call. The debt ceiling is in the headlines. And so now every American appreciates the headline number, 31.4 trillion in debt. It’s a conundrum. What’s the solution?
Kevin: Well, the Republicans or the Democrats, they’re going to solve that for us.
David: Red shirts, blue shirts, jockey for better position on the field, directing the flow of discretionary funds, while the public is growing more aware of some big issues. Both teams are pretending to take a principled approach. I had one gentleman the other day describe the Republicans as fascists because they won’t compromise. And I thought, I don’t know if that’s the pot calling the kettle black or not, but I don’t think that’s the appropriate definition for the word fascists to begin with. But what it was was this expression of: my team is doing the right thing and there’s no other way forward. Meanwhile, you find just as strong an opinion on the other side. That’s why there’s this intransigence. So while the issues capture the public consciousness, I think it’s a sideshow, to be honest. I think it’s a sideshow.
Kevin: It always ends the same way. They raised the debt ceiling.
David: You’ve got legislators saying, “I don’t know what we’re going to do. We certainly can’t do anything about debt.” Meanwhile, the congressional budget office, oh by the way, that’s a part of the legislature, right?
David: They already know we’re increasing debt by $19 trillion over the next 10 years. We know that that’s the glide path. So the two greater issues are this. One has an immediate impact. The other is going to be played out over many years. And so the first is, in a rising interest rate environment, payment on the debt grows to unmanageable numbers. Congressional budget office estimates 1.4 trillion in annual interest payments by the year 2033.
Kevin: So this is the near-term danger.
David: Yeah. Near-term problem. Bad news is the assumptions used by the CBO, they’ve lowballed inflation and the necessary increase in rates to beat that inflation. So there is the possibility that the interest component, the interest component on the national debt is 1.8 to $2 trillion annually by the time we get to 2033. And as we’ll see, their estimates are not even in line with the 2023 reality.
Kevin: So you and I were talking just a thought experiment here of taking our income and saying, okay, our income plus 360% in debt, that debt-to-GDP worldwide. But think about it, if interest rates are rising, the interest on the debt alone would take us down. Even if we never paid the 360% in debt, it’s the interest that would absolutely eat us alive. And what you’re saying at this point is, 1.4 trillion annual interest payments by 2033.
David: Well, and again, we’re talking 2023, immediately. The CBO website published this in February. “Net outlays for interest rose by 35% last year…” This is what they say. “Net outlays for interest rose 35% last year, and are projected to increase by 35% again this year from 475 to 640.” That’s billion dollars, by the way. But then, Kevin, if I look at the CBO’s website and go over to the Federal Reserve, which is counting in real time, the money that’s coming in and the money that’s going out, so to look at this interest paid. If I compare the estimates with the actual numbers which are reflected on the Federal Reserve website, the annualized rate for 2023 is running at 928 billion. We may go past the trillion mark in annual interest payments this year.
Kevin: Does it scare you at all that the CBO is publishing 640 billion and the Federal Reserve, you said it may be over a trillion in the next year?
David: Right. So there’s a little discrepancy in numbers. Let’s compare revenue inflows with outflows. You’ve got 4.8 trillion in revenue—inflows—that’s taxes coming in. And now that interest component of 928, that’s about 20% of all government revenue going to interest only. That’s not paying down the debt. That’s making interest payments.
Kevin: That reminds you of when you buy a house. Remember when you first bought your house how much was going toward interest and how much was going toward principle, right? It’s like, we’ll never get this paid off.
David: Well, revenue estimates are also off. Revenue year to date is 10% below what was expected. So not only is the interest component going up, but the expected revenue is declining, which makes sense. Since we had a bear market in everything last year, capital gains taxes were down. So that explains at least some of the revenue decline. But the difference gets ignored because you can just throw it onto next year’s budget deficit. So, again, you come back to these principled approaches and everybody’s got an argument for why we’re not increasing the debt ceiling or why we’re going to increase or decrease. It’s a joke. What’s happening in Washington is a joke. We’re going to add more to the debt ceiling. The CBO estimated, for this year, the budget deficit at 1.4 trillion. We’re now on track for 2 trillion. $2 trillion as a budget deficit for 2023. We have no recession to date. We have no depression to date. Just another $2 trillion added to the heap.
Kevin: So how in the world do we sustain payments?
David: This is the critical issue. While you might be tempted to think the debt ceiling is the issue, it’s really not. That’s a game of chicken. Somebody’s going to swerve. The bigger near-term issue is payment sustainability. Again, come back to interest payments. They’ve gone from 6% of revenue prior to Covid to now 19 and a quarter percent.
Kevin: So you’re talking about near term— A couple of weeks ago, I had an appointment with my eye doctor and he sat down and he goes, well, I’ve got some good news and I’ve got some bad news. I’m going to start with the bad news. It wasn’t bad news. It actually was, “you’ve got a cataract. I’m going to have to take that off.” That was good news because I’m not losing my eyesight long term. But there are some long-term things that you talked about near term problems. You remember when you talked to Kotlikoff, and he’s like, you can look at the near term problems all you want. You need to look at the long-term problems here.
David: Well, and again, that’s why the debt ceiling is a joke. It’s a joke because the bigger issue, it’s still a liability. It’s just a slow burn issue. So we’re talking about the mandatory payments. Mandatory payments includes, and these are the things you can’t get out of, Social Security, Medicare, Medicaid. Interest is in that category, but we’ve already covered that. You get income insecurity programs, SNAP, the earned income tax credit, federal employee retirement benefits, unemployment benefits, veteran benefits. That’s where you get your federal student loans, transportation programs, ag subsidies. These are not your discretionary spends. This is the mandatory payments, and they’re all going up.
The debt ceiling debate largely ignores the elephant in the room, or if you want to talk about it, the donkey in the room. In the end, we’re going to have a room full of asses, Because we’re all stupid and making bad decisions as it relates to this issue. Mandatory spending, the mandatory piece, represents an additional 200 trillion in future liabilities. And that’s counting it conservatively. Kotlikoff put the number at 210 when I was at his apartment in Boston. That was years ago, 210. So these are old numbers. It’s well over that. The pay-as-you-go Social Security program is out of money by 2033, and the Medicare Part A is out of money by 2026. And by the time we get to 2023, if you’re talking about inflows and outflows, what we gain from Social Security, that line item that off of your pay stub every— It only covers 78% of what’s going out.
Kevin: These conversations are always so defeating to me because I look forward and it’s like you are bringing up simple math instead of highfalutin PhD math. Simple math basically says, we can’t pay our bills.
David: We can’t pay our bills. And what’s the best guess on the cost of healthcare in future years? Up or down? Up or down?
Kevin: I’m the last part of the baby boom. I get it. Yeah.
David: Could it be an issue that we have more retirees drawing from Social Security versus paying into the program, and that’s only a few years out? The bottom line? The bottom line is that in an age of engineered social and political instability, in an age of over-engineered financial market frailty and gross fiscal unsustainability and irresponsibility, the case for hard assets is a cinch. And come back to where we started the conversation today. Gold. If you want to think of it as stupidity insurance, it is. It is. And you may need a lot more of it than you think you do. Just look around.
Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us mcalvany.com, M-C-A-L-V-A-N-Y.com, and you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.