EPISODES / WEEKLY COMMENTARY

Consequence Of The Loss Of Confidence

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Mar 15 2022
Consequence Of The Loss Of Confidence
David McAlvany Posted on March 15, 2022
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Consequence Of The Loss Of Confidence
March 15, 2022

“This is exactly what we saw between 1968 and 1982, where inflation endured and it ground us down. And it was painful, particularly as you saw the impact of compounding negative rates. Here we are just at the front edge in terms of time for inflation. And I think we have a lot farther to go. If they’re not going to own the mistakes, then you’ve got to own the only thing that can preserve your purchasing power through what is going to be a long stretch of pain.” — David McAlvany

Kevin: Welcome to the McAlvany Weekly Commentary, I’m Kevin Orrick, along with David McAlvany. 

You know, David, one of our listeners sort of knows my interests. He knows that I like celestial navigation. He also works at a bookstore that has very rare books. And he contacted me and he said, “I think I’ve got something that you might like.” And I did. It’s a navigation book, a French navigation, celestial navigation book. You know, it’s got the ephemerides of the movement of the stars and the sun, the same thing that I have for current almanac, but it’s from 1794, from Paris, and it is fascinating to get it out. I can’t read French, but I can read the numbers and I can see the maps. And what’s interesting is, that was during the time of the Reign of Terror. Okay. 1794 was when the heads rolled, you remember that? 1793, 1794 in France. That was a very, very volatile time. And war was being fought in many different ways at that time. Part of it had to do with the guillotine.

David: Yeah. I collect some currencies, and I’ve got assignats from the 1790s, the French currency before—well, actually during the process of devaluation. Reign of Terror, no surprise. There’s political volatility in the same context as essentially a hyperinflation. What weapons of war? Weapons these days, somewhat unconventional, shall we say? One thing that every country now understands if they’re watching the interactions between the US and Europe and Russia and Ukraine, is that reserve assets, if they’re held outside of your own country, or if they’re tied to another country’s currency, they can lose reserve status quickly. 

Yeah, so on display is the case of the $300 billion out of the $640 billion in reserve assets of the Russians. 300 billion basically lost. At least inaccessible. Maybe owned by Russia, but if not controlled directly, it’s not currently a part of their actual liquidity position. So, we’re running out of munitions, maybe running out of money. And certainly we have the Russians, at least according to the Financial Times, crawling to the Chinese for greater assistance. So what’s becoming very clear is that Ukraine is bleeding Putin. And because the invasion was not wrapped up inside a week, the world can see how thin Russia’s resources truly are.

Kevin: You know, you see that in war. I think of 1914 really being the end of this wonderful period of the gold standard, where people were operating well. But you know, we came out of that and we saw Germany fight a war that they just plain ran out of money. You know, Hitler was fighting in World War I as a soldier. And when he heard that the Germans had surrendered, he was furious because he was like, “Wait a second, from where I sit, looks like we’re winning.” But no, the truth of the matter is they ran out of money. Now, similar, they printed a lot of money afterwards to make it look like it really wasn’t a problem, and turned to hyperinflation.

David: But the blitzkrieg of World War II similarly was about speed. And even though there was massive resources to be found with the capture of Switzerland, it was determined that six months of fighting in the mountains would’ve precluded victory because they had speed, which was the critical variable in the cash burn.

Kevin: It’s like hitting somebody cold-cock. You may knock a guy down twice your size if you just get him quick.

David: And so, as far as reserves go, it will not be a surprise to see central banks all over the world—to see sovereign wealth funds all over the world—adding to gold positions.

Kevin: Yeah.

David: We’re talking about a reserve that is outside of the banking system. That is a reserve that preserves agency. While I’m not keen on Russia’s use of its agency, specifically in the invasion of Ukraine, the main point is that other countries see a US-led sanctions regime as evidence of the need for reserve diversification. So like it or not, demand for gold from central banks is not likely to diminish in the years ahead.

Kevin: Well, can you blame anybody? I mean, either on the ally or the access side, if we have allies or access, I mean, if this SWIFT, S-W-I-F-T, exclusion, everybody’s got to be looking and saying, “Should I have something outside of something that can be controlled by someone else?”

David: Well, we suggested a few weeks ago that SWIFT exclusion was a part of motivating many countries around the world to look for an alternative to the Western money transfer system. Headquartered out of Brussels, but obviously deep ties to the US banking system. And so creative alternatives emerge as a solution is sought for an obvious problem.

Kevin: Yeah. So the dollar reserve status at this point may still be intact, but it’s questioning.

David: And that’s how we concluded the argument a few weeks ago is that dollar reserve status was, in the long-term, in the long-term, being chipped away at by reminding other countries that an alternative for trade and business contract settlement would provide options and less need for compliance with a unipolar, US-centric view of the world. 

So the second factor underscoring the imperative of a multipolar currency regime is the ease with which the US Treasury, the Bank of International Settlements, and a collection of Western-centric central banks can together restrict the flow of central bank reserves. So again, $640 billion in reserves for the Russians, that’s a nice little “war chest” except that half of it they don’t have access to because it’s stuck with other central banks who aren’t going to give it to them.

Kevin: So going back to Bretton Woods, 1944, okay, one of the reasons why the dollar was seen as a good reserve currency rather than the British pound was we had it backed by [gold], we had it backed by oil to a degree, and it was agreed that we probably were the least impacted from World War II, as far as the major countries. So, you had those three pillars, we became a reserve currency, it was backed by gold, and the oil side of things. 

That didn’t at that time come across as if it was going to be weaponized in the future. At this point, with the weaponization of the reserve currency, there’s no gold standard behind it, the oil buying is questionable going forward. Does this affect the viability of the reserve currency, and how quickly would there be a shift to something else?

David: Yeah. We leveraged our strength in the context of other countries’ weakness. That was the launch of Bretton Woods I, 1971, when we closed the gold window. We basically came into a second era of Bretton Woods with no gold backing the currency, call it Bretton Woods II. And it’s being speculated that perhaps this is Bretton Woods III. You’ve got the reserve currency weaponized. And once weaponized, it’s seen differently from that point forward. I’m reminded of a short sequence in a Pink Panther movie. My mom and I used to love watching Pink Panther movies. So, you’ve got Inspector Clouseau who asks a man if his cute little dog bites.

Kevin: Oh, I remember that. Yeah.

David: And the man says, “No.” And so Clouseau reaches over and he’s bitten.

Kevin: Yeah. Yeah.

David: He reaches down to pet the dog and he says, “I thought you said your dog did not bite.”

Kevin: You got to do the accent. Do the accent.

David: The strong Austrian accent you hear, “No, that is not my dog.”

Kevin: That is not my dog. That’s right.

David: Well, this one is our dog.

Kevin: Yeah.

David: The dollar. And once bitten, the memory does not quickly fade.

Kevin: Okay. We talked about oil. The rise in the price of oil has given Russia somewhat of a windfall. I mean, it was what? $19 billion that you mentioned last week?

David: Sure.

Kevin: But there are other factors at play. He can’t just move that oil easily, can he?

David: Yeah. So we mentioned the windfall. If you combine January and February, you come out with a $39.2 billion current account surplus. It’s two and a half times what it was for the same period last year.

Kevin: For the same amount of oil. Yeah.

David: So will sanctions and the cessation of energy imports from Russia change the flood of hard currency to Putin? Because obviously he’s gotten a big benefit from it. And that unfortunately is likely to continue, compliments of other trade partners only too willing to step in and buy Russian energy. Even if the US says no, which we’re still buying it for the next couple of months through the end of contracted periods. But you’ve got the Chinese. If you look back, the Chinese backstopped the Iranian market in spite of sanctions. So, too, they will backstop the Russian market.

Kevin: Well, how do they move that oil, though? I mean, there are pipelines at least to Germany, but how would they move it east?

David: And there’s pipelines to China as well. The issue is, those pipelines are at capacity. So tankers will be required. The pipeline capacity to China is fairly well maxed out. Maybe you’ve got naval sanctions that are next. Shipping company restrictions in particular countries that are targeted who would carry the oil for them.

Kevin: Okay. But let’s look west now for a second. So Germany, how is Germany impacted if they do shutter the oil coming in from Russia?

David: Yeah. So we know that they have one version of a supply shock now, and it only grows as we move towards next fall and winter because they will not have been able to top off reserves coming into a winter period. So the economic consequences of a complete shuttering of Russian energy imports is significant. A third of German oil needs come from Russia, 55% of German gas needs come from Russia, 26% of German coal needs come from Russia. So, the best estimates are that this kind of supply shock would impact German GDP to the tune of about 3%. You know, worst case scenario coming in at 5% of GDP, as modeled by a group of a dozen distinguished economists from around the globe, from Notre-Dame to London School of Economics, to a whole host of German economists. And now you’ve got, independently, the same conclusion coming from Goldman Sachs. 5% is your worst case scenario. If you’re interested, we’ll include the link to that research paper. I was very discouraged at first because I didn’t realize the first half was in German, and then they offered an English translation afterwards. So, I downloaded and I thought, “Oh great.” Yeah. Sprechen sie Deutsch? Not so much.”

Kevin: Well, we’re entering a day and age where you can actually have Google translate a lot of this stuff. Now, it doesn’t always work quite right. But let’s go back to Germany for a second, because all the hopes for actually the world economy was that COVID— let’s put COVID in the rear view mirror. We said that COVID really had an impact, and now let’s just hope for an expansion. Now you’ve got this thing with Putin, the Ukraine, with oil. It’s like one torpedo and then the second torpedo, the COVID torpedo, and then the Ukrainian torpedo.

David: Yeah. And just for frame of reference, the lockdowns trimmed German GDP by about 4% if I understood the figures correctly, 4% each year from 2020, 2021. So, just shy of $360 billion US. So, this energy supply shock is on par with the cost of the pandemic. Low single digits for as long as the supply issues remain. So there’s the issues of substitution, where do they get oil? How are they going to replace it? It’s a huge, actual economic cost. And of course, following on the heels of the pandemic recovery, that’s less than ideal. 

But it’s not as catastrophic as you might think, in large part because they can have substitutions. And as we move closer to 2030, there is more Qatari LNG to supplement the US LNG supplies that they can get from us. These are much higher costs in terms of the energy that can be supplied. But I think hidden in the figure, again, 3, 4, 5% of GDP lost, hidden in the figure is the disproportionate share born by the poor and the middle class. You got massive government subsidies, which are going to be necessary to fill those gaps. And all this goes into the decision to completely boycott Russian oil and energy. What does it cost to do so? Will it be effective? The cost analysis from the European side suggests that a long economic war with Russia can be carried out.

Kevin: So, I’m going to speculate and think out loud here, Dave, was it in the first year, back in 2008 or 2009? When did you interview Otmar Issing, the first head of the European central bank for seven years?

David: It was 2008. It was basically at the end of his term.

Kevin: Yeah.

David: He wrote The Birth of the Euro. And at the very end of his term— I think he had finished his eighth year, so he was the longest standing member on the ECB board.

Kevin: Well, okay. So do you remember, okay, the big debate in Europe, going up to that point, because Europe had been working toward a unified monetary system. The problem is you’ve got different countries with different ideas fiscally or governmentally as far as how the governments function. So, Greece is very different or Spain is very different from Germany. And what Otmar said, because you had asked him, he said, “Is this going to create a conflict that ultimately will have to be dealt with?” And he said, “Well, yeah, we sort of counted on that,” that there would be crisis at some point between the financial side of things, unifying a currency Europe-wide with very, very different countries and different debts and different structures, ultimately would come to a crisis where they would have to look at possibly unifying the governments. Now, are we seeing this at this point? Do you think possibly this Russian threat with the Ukraine and the huge impact that it’s going to have on Europe, especially Germany, there’s going to be an acceptance possibly of some sort of unification politically?

David: Yeah. What Issing was suggesting, what he implied was that the unification, a more thorough, complete, top to bottom unification, not just monetary, but fiscal and even political, was only possible with crisis. So, if it was going to happen, that’s kind of baked into the plan for unification is that crisis becomes a catalyst. So, now we’ve got Germany with these associated costs, and again, for them, it’s the equivalent of the pandemic all over again, and they’re the primary ones to bear the brunt of this. 

Germany’s willingness to remain front lines in an economic conflict with Russia, does that persuade Europeans generally to accept common bonds? And I don’t mean bonds of friendship, I’m talking about debt obligations. Is the door opening to a fiscal union where debt is shared across borders? Crisis has always been a catalyst for previously unacceptable or unthinkable policies. So here time will tell that there are other reasons to think that fiscal union is improbable except this one factor, who’s going to pay the bill here? You know, the Germans are paying a big price on the front-end, the benefit of potential squeezing of the Russian empire, moving them towards bankruptcy. Remember this is an interesting strategy that was employed in the 1990s and even the ’80s. If you look back at the Reagan administration, we were willing to go and do the unthinkable, massive deficit spending. I mean, I remember my dad was appalled by the increase in the national debt from 1 trillion to 2 trillion dollars, a doubling of the national debt. We actually had the capacity for it, right?

Kevin: Yeah.

David: But to keep up in the arms race—

Kevin: And it went to three by the time, 1984. By the 1984 election, it went from one to three.

David: Right. So, you’ve got Russia, who’s now trying to spend to keep up with us in the arms race, the space race, star wars, the whole bit, and we bankrupted them.

Kevin: Yeah. Reagan was basically saying, “We can crush them economically, and it’ll be the end.”

David: Right. So think about what we said originally about speed and the importance of this working for them if it happens fast. If it doesn’t happen fast, we’re back to an economic crucible. The Russians cannot afford a long-term financial engagement. The Germans, the math bears it out. Follow that link, read the paper if you want to.

Kevin: Can they afford it? Can they afford it?

David: They can afford it. The question is politically, will they assign losses to some segment within their culture, or will those costs be born by sort of a pan-European project, say we’re all in it together?

Kevin: So, could they afford alternate energy sources and not do that? In other words, in Jurassic Park, the guy who starts Jurassic Park, he kept saying, “Spared no expense, spared no expense.” Well, when you’ve got money, we’ve seen if you can print money and you can do it without a lot of inflation, if you can spare no expense, are there other energy substitutes other than what’s coming from Russia that Germany could use rather than doing what you’re talking about, this common bond type of thing?

David: Yes, they have the latitude, but no, I think the common bond is what helps them finance the higher costs. So, they have latitude. Europe can substitute energy sources, but it’s at much higher costs.

Kevin: And it’s not— Germany can’t do it on their own, they’re going to need the help.

David: It would appear so. Russia is more significantly impacted. As I said earlier, you’ve got the China-Russian pipelines basically at max capacity. Tankers and rail would have to move the rest eastward.

Kevin: Well, can Russia continue to do what they’re doing without China?

David: Not without the support of China. This week the Financial Times reports a request from Moscow to Beijing for direct military aid. And to me, that’s a somewhat embarrassing revelation for a country on the cusp of incapability. I mean, can they do it on their own? Maybe they don’t want to do it on their own, maybe they just want to show a unified front. No, I think it’s actually that they have a problem. I think there’s been so much grifting by the elites that the Russian military is finding that what they thought they had in reserves is floating in a half a dozen harbors around the world as a 100, 200, 500 million dollar yacht.

Kevin: Okay.

David: So literally, money that was supposed to fund the military has gone into private excess and graft. And now you’ve got Putin saying, “Wait a minute, I thought we could pull this off.” And he can’t.

Kevin: Okay. He can’t, but it’s lasting a lot longer than the predictors would’ve predicted. The computer models, whether it’s RAND Corporation or the Pentagon or whatever that said that this thing could be over in as short as 96 hours, they didn’t take into account these guys in their yachts. Huh?

David: The money went somewhere, but it wasn’t all tanks and bombs and guns. So, reality is not always reflected in algorithms and models. Thank God for that. But I think that’s where, again, 96 hours, 72 hours, they were supposed to conclude this very swiftly and to be shown as a very powerful source of military might.

Kevin: And do you think the leadership was actually telling the truth? I mean, a lot lies in a narrative. You can see people who just actively lie and give a narrative. And who said that if you tell a lie long enough, it’ll be believed? But that’s sort of what was happening in Russia as well. Wasn’t it?

David: Lies in a narrative or lies in a narrative, which do you mean?

Kevin: And maybe a little vodka as well, right?

David: That’s right. Well, I mean, the vodka soaks telling of the tale as captured by Russian foreign minister Sergey Lavrov. He literally said, “We do not plan to attack other countries. We did not attack Ukraine either.”

Kevin: Huh, well, they didn’t attack Ukraine?

David: No, I mean, in that statement, he sounds as connected to reality as sort of the distilled essence of Nancy Pelosi. Also vodka soaked. But when either of them ask for proof, I think we know what they mean.

Kevin: Well, and so, not to be too light about this subject, because Putin, you talked about this several weeks ago, he’s got an ego and he does have a reputation to keep. And he also does have very, very dangerous tactical and strategic weapons. I’m talking nuclear.

David: And that’s a remote possibility that Russia sets the world stage ablaze. So there’s a number of ways that this can come unglued. It’s an instability factor that the North Koreans have used, it’s almost the crazy factor.

Kevin: Right.

David: You don’t know what I’m going to do, and I’m going to keep you guessing. And the more crazy you think I am, the more you are going to be willing to make concessions. So, the conveyance of crazy is a strategy in and of itself.

Kevin: Was it George Friedman who said that the North Koreans had figured out a way of being treated like a superpower just for that very reason?

David: Yeah. And so, they can threaten to set the world stage ablaze, and they’ve brought in the nuclear drama. What may be interesting is Xi Jinping then solving the arsonist problem, right? Putin says, “I’ll set it all on fire,” and Xi Jinping says, “I’ll bring in the fire hoses.” So, I’m still not clear on how Xi Jinping wants to achieve his ambitions, what does he want?

Kevin: We ask ourselves, what do various players in the world want? Because that’s important. What is the motivation? What does Putin want? Well, we’ve talked about that. Okay, there are things that Putin wants and that may coincide also with what the Russians want or not want. What does Xi want, Dave? The question is, because I mean the reliance between Russia and China, the two really do rely quite a bit on each other. You talk about Germany, but China gets an awful lot of its energy from Russia as well. So, what does Xi want? And is he in a position to increase his power dramatically through this?

David: You know, in some respects, it’s well defined. In the 21st century, China wants a multipolar world where Chinese leadership is globally respected. It’s essentially a return of grandeur, and it’s a return to the global stage, which is more reflective of the long history of Chinese importance and dominance on the world state. So, the step sequence could be autocratic displacement, where you have sort of regional support for ruffian dilettantes. Plenty of countries resent America. Plenty of countries resent Anglosphere dominance in the world order. And so perhaps you just partner up and create chaos. It could be diplomatic, like what we just talked about, the Russian arsonist theory. That’s a potential diplomatic route to higher international standing. Solve the world’s problems as a leader, organizing peace that is seemingly unachievable. And again, let’s not forget, Putin cannot operate without Chinese permission. We’re talking about Chinese trade, the exports from Russia to China, over 50% of all Russian exports.

Kevin: Wow. Yeah.

David: I mean, so they’re already in a very healthy economic relationship. If Germany decides to cut them off— Part of the problem with sanctions is that they’ll just pick up the slack. And if the Chinese want to do their version of quantitative easing, create money out of nothing, and take fictional value and turn it into a hard asset, they’ll just buy more Russian gold. They’ll buy more Russian oil. They’ll buy more Russian coal. And it’s not like they don’t need it. They depend on commodity imports in every category for their growth.

Kevin: So, a question that comes up all the time, especially over the last decade, is, does China want to be the reserve currency? They were included in the mix of the SDR a few years ago. Okay, the special drawing rights. They requested that. That was granted. That still doesn’t put them in reserve currency status. We are creatures of habit. You remember when you had me read Thomas Kuhn’s book on scientific revolutions?

David: Mm-hmm (affirmative).

Kevin: And how long they take to go from what a common habit was in science, the theories start breaking down when science starts finding out that the old theories are wrong, but it still takes about a hundred years. That’s what he estimated for an old scientific theory, even though it’s been disproved, to actually be replaced. Now, let’s just apply that to reserve currency status, because there have been other currencies than the dollar. There was the pound. We talked about other dominant currencies throughout history. But how long does it take to replace the dollar with the RMB or the yuan or— How does that look, and will it happen, and is it quick or is it slow?

David: The life cycle of a reserve currency is roughly a hundred years.

Kevin: Okay.

David: So, we’re not there yet. And I think to bookend the idea of dollar hegemony and it being lost, it’s worth remembering that revolutions are a long time in the making.

Kevin: So, 1944, if we want to start what we’re talking about. 1944, a hundred years from there. And like you said, revolutions are a long time in the making.

David: Yeah, but then they transpire quickly.

Kevin: Okay.

David: So, we’re going to anticipate and anticipate and anticipate and nothing happens, and then it’s already happened.

Kevin: Yes.

David: So, I think as we march towards 2050, there’s a greater probability of it happening. But Kuhn would argue that for incumbency to be lost, a realistic replacement must be waiting in the wings.

Kevin: Is the Chinese currency that replacement?

David: Not now. I mean, some are tempted to think of the RMB as the alternative to the dollar and as the most viable alternative, and it’s not. You’ve got the Chinese capital markets that are not liquid, they’re not deep enough at this point, they still have capital controls, they have unequal property rights depending on who you are, citizen, non-citizen, and there’s an unwillingness to run current account deficits the way the US has, which allows for tremendous influx of foreign currency into the economy. The Chinese are not able to displace the US dollar. So, when I said earlier that that status is being chipped away at, it is being chipped away. But I’m talking about a multi-decade process, I’m not talking about something that happens overnight. 

Now, can crisis compress time? Certainly. So, something that should take another 20 or 30 years may be compressed, but there’s still no viable substitute for the US dollar. And so, a rattled global currency market is once again underscoring the relative strength of the US dollar. And again, this is despite the structural and absolute pressure points that the dollar has.

Kevin: But that’s not keeping the central banks from buying gold. They’ve been buying— What was it? Almost a hundred percent more gold this last year. I think it was 80% more gold this year than the year before.

David: And it’s not just the usual players, it’s a broader cross-section of central bankers, who again, I think are looking and saying, “The way the game is structured, we have to comply unless we don’t have to comply.” Greater freedom— freedom comes in many forms, and gold is a form of economic freedom. That was made very clear by Greenspan. He wrote a paper on it, and I think there’s an idea there that transcends culture. It also transcends scale, because you’re talking about something applicable to a person, a nation, and the world. 

So I come back to this idea that you can immediately displace the dollar without a viable alternative. Central banks continue to diversify holdings to gold. And now we’re in a context where you have the global inflation and you have the continued theme of disaffection towards Western influence, Western culture, and that US unipolar monetary system. And it points to gold acquisition. Disaffection is pointing to gold acquisition far more than it would suggest a migration to the RMB or to the Euro.

Kevin: Okay. So the dollar doesn’t get displaced quickly, but all eyes are on the Fed this week because the reserve currency of the world is in a high inflation mode right now. Everybody’s watching, is the Fed going to have the courage to actually raise interest rates enough to make a difference?

David: Well, I mean, this is where— Obviously, nobody has a crystal ball, nobody knows the future, we do know that crisis compresses time and we don’t know the nature of crises as they unfold over the next few years. We could certainly have financial market crises, more political and geopolitical crises, so that how this takes shape, we could see a tremendous acceleration. Today, this week, it’s the bond and currency markets that are watching the Fed. They’re watching to see what the tightening cycle is going to look like. They’re also watching to see, this week, how Putin handles $117 billion in bonds, which are due on March 16th. That’s Wednesday, right? A default is not out of the question. Next week there’s an additional $65 billion in Russian debt coming due. How do you refinance when you’re under sanctions? Who bails you out? Well, let me think.

Kevin: Xi-whiz? Xi-whiz?

David: Xi-whiz. One Belt One Road, one answer to that question. It makes me think of Mordor actually, and that may not be fair, but “One ring to rule them all, one ring to find them, one ring to bring them all and in the darkness bind them.” To me, I see China as a major answer for Russian ills, but it’s the only way forward if you’re talking about refinancing massive amounts of debt and avoiding another bond debacle. Now, maybe that’s not a bad thing to have a bond debacle because now you’re raising the temperature, you’re raising the pressure to Western financial centers, and you’re saying, “If you’re going to inflict pain on us, understand we can inflict pain on you as well.” You want to see your financial system crumble, you want to see cracks emerge because you’ve got various banks and money management firms who are overexposed to Russian debt? Watch it burn. Watch it burn. So, who holds the key, who holds the fire hose, if you will? If the Russians are going to say, “Let it burn,” whether it’s nuclear or in the bond market, the Chinese may be the only ones with the fire hose.

Kevin: It just strikes me how dangerous the time is right now, Dave, because you talked about war being fought in many different ways, but the way we’ve been able to fight the war worldwide and maintain empire worldwide since 1944 has been this reserve currency status. But we’ve reached a point where we really don’t have economic activity to pull us out. We’re not in an economic recovery right now. In fact, some people would say this is going to be stagflation. We can’t just print money and have no inflation. 

We can print money and spend money. And Biden would say, “Let’s just spend more because that’ll knock inflation out,” but I don’t want to go there. The problem is, we don’t have the economic activity to pull us out of this inflation with economic growth right now. That’s called stagflation, when you have inflation and an economic downturn, that’s the worst of all worlds. And so, the question would be with this, what’s affected with the stagflation? Because it’s not just in the United States, it’s global. Global stagflation is what’s occurring. Slow down in Europe, slow down in China, slow down here. Japan never sped up.

David: Well, I can’t help myself, but go back to sort of boozy Pelosi. Apparently government spending is the way to reduce inflation. That I read. Fascinating economic ideas.

Kevin: I can tell— You’re twitching right now. So, I see that that possibly grates on you.

David: Well, global stagflation is not just coming, it’s here.

Kevin: Right.

David: And so, you start with the emerging markets and you migrate to the United States. Inflation is a fixture. Then when you mix it with slowing global trade and continued supply chain and material sourcing disruptions, recession is a step away, right? So you’ve got one ingredient already there. We’ve seen an initial pop in commodities prices. You’ve also got the downside in commodities prices which is likely to coincide with a shrinkage in demand. Supplies are tight, commodity prices have risen dramatically, in large part because of tight supplies and what we described many months ago as excess demand as part of a COVID recovery theme. Essentially, you had an underconsumption theme playing out through 2020 and 2021, and then an overconsumption theme at the end of ’21, as we head into 2022. And it’s a mismatch again of supply and demand. Supplies were tight, demand was increasing. 

Demand is not however a constant factor, right? So, between the naturally corrective forces and slowing in demand for materials, I think we have the stag catching up to the flation. Commodity prices are not down forever, I think the trend is, over a longer period of time, up, but post-COVID excess demand, that’s finding equilibrium. I still think you have a long-term supply constraint and that that issue drives commodity prices higher over a longer period of time.

Kevin: So often you’ve brought up the pain of inflation. We all experience the pain, but it’s the lowest rungs of the ladder that experience it the most because the difference between three meals a day and two or one or none oftentimes has to do with the inflation in the overall economy.

David: Yeah. So looking at the lowest economic rungs in Germany, that’s where the impact is. And that’s where the greatest pain is felt if you’re talking about the energy supply shock. So, too, if you look at the emerging markets, the inflation side is now obvious, and the central bank community is somewhat constrained in their ability to fight inflation. A great article from Bloomberg, with Mohamed El-Erian laying out a series of conditions, what can Jerome Powell do this week? And what are the consequences to each of his choices? Very well articulated. And the central bank community does have constraints that they are bound by. And part of this is the scale of leverage in the system, right? There’s other limitations that sort of mirror that leverage. Sensitivity to a sizeable derivatives market. Just to illustrate, this week $3.3 trillion in options expire. Don’t be surprised if there’s radical volatility in both directions. $3.3 trillion worth of derivatives meeting their maker is an interesting thing. You’ve got counterparty risk. These are all the constraints that you have as you go towards fighting inflation.

Kevin: Don’t you also have a loss of confidence? I mean, I want to talk about what happened in the commodities markets with nickel this week, but we talked about losing confidence in the dollar because it’s being weaponized, but you’ve got exchanges now that are changing rules. We’ve talked for so many years, Dave, that confidence is the only thing holding this whole economic scheme together. With a loss of confidence, either in the currencies or in the trading operations of these markets, people are going to have to run for the hills. They’re going to have to buy bags of rice and just hide, I guess.

David: Well, the unwind of confidence in institutions certainly shows up if you’re looking at recent polling. People are concerned about the legitimacy of elections. US voters are concerned about inflation. US voters are concerned about violence and being protected in their communities. If you’re looking at the Rasmussen polls, these are the top three things that voters are concerned about. And to be concerned about those three things suggests that you don’t have a lot of confidence in the powers that be to solve those problems. 

So, the further unwind of confidence with institutions, I mean, this is happening more and more routinely. Central banks— the move in gold certainly reflects a loss of confidence in central banking and their ability to manage the economy and manage the financial markets. It’s not that they ever were supposed to, but that is the presumption, that is the role that they’ve stepped into. And now I think it gets very interesting as we see central bank tightening. And again, the confidence factor in institutions. Is the tightening necessary? Yes. Is it late? Obviously.

Kevin: Yeah.

David: And will it be consequential? I think more than ever. But on the issue of loss of confidence in institutions, this week, last week, actually, exhibit A is the London Metals Exchange. The LME, it’s a 145 year old institution that sacrificed its credibility for one connection, JP Morgan. The LME suspends trading in nickel and then unwinds the unwanted trades. JP Morgan was the counterparty to Tsingshan, the Chinese group that accumulated an $8 billion loss in nickel. Now, how nice is it that you can come in and, with a pencil, decide what trades stick and what trades don’t? Relief pressure on the Chinese firm on an obligation that was unpayable to JP Morgan, the pressure that JP Morgan has on the other side of that, “You owe us money, we’re not going to get paid.” Well, how can we pretty this up? And how can we just clean things out?

Kevin: You know, it reminds me of a casino that the large player gets bailed out, even though he’s lost, and the small players are asked to leave. Take their free drinks and leave. The chips don’t all cash out the same, do they? When you have exchanges changing the rules midstream.

David: Well, and that’s a real challenge because you’re talking about the viability of markets, you’re talking about significant commodity traders looking at these kinds of transactions and saying, “Well, maybe I want to be long, maybe I want to be short, but one thing I want to be sure of is that when I place a bet that there’s something that is honored, the transaction is honored.” I took risk, how does that play out? I was either right or wrong in the bet that I put on.

Kevin: Is it any wonder why our clients buy gold and hold it and take possession of it versus just play a market, just playing contracts?

David: Well, even this last week, one of the jokes that kind of surfaces on a routine basis, not a funny ha ha joke, but kind of a laughable point in the financial markets, is the idea that markets are both liquid and continuous, liquid and continuous. And that somehow hedging strategies and derivative insurance, those kinds of products that they actually work when put under pressure. They’re designed and based on an assumption baked into it that is simply not true. So you’ve got Russian assets, that’s another current example, you’ve got PIMCO, you’ve got BlackRock, they’re stuck with billions in exposure that is essentially untradable. How liquid are those Russian assets? How continuous is the trade of anything that was on the MICEX exchange? But when the LME erases history, it also erases confidence that any obligation has meaning. I think that’s—

Kevin: The London Metals Exchange, yeah.

David: That’s right. So, any contract, does it have substance? Does it have legal enforceability? The LME in my view committed suicide last week.

Kevin: Yeah.

David: And I just— I don’t know. Was nickel worth dying for?

Kevin: Wow. So penny for your thoughts and a nickel to die, basically. 

So, do you remember 20 years ago? It was about 20 years ago, Buffett, who’s not really a metals guy, took a huge position in silver, but he had all of it delivered and stored. So his position in silver had nothing to do with the contract market. He warehoused it, and then sold it. Do you remember that?

David: Well, yeah, that’s right, because anyone with a long enough memory knows that the CME did the same thing that the LME did. And the Hunt brothers are banned for life from trading silver, but it’s kind of because they know something that everyone should remember and doesn’t. The CME changed the rules on the Hunt brothers.

Kevin: Yeah. So they’re blamed for running silver up, but nobody ever talks about the CME actually running silver back down with— some of those people took positions ahead of time, too.

David: Who in their right mind trades on an exchange, where the rules are changed in the middle of play? And again, so we may have forgotten that CME reserves the right to do that whenever they want, but these are the games that speculators play. Speculators play in that market. Investors play in the physical market, where you take it off the exchange, you remove it from the banking system, you get it away from someone who could encumber it, right?

Kevin: What you say is you need to be able to trip over it, right?

David: I like that.

Kevin: Yeah. And that’s not the— So, I’m going to move to interest rates for a second, because in our adult lifetimes, Dave, we’ve seen interest rates falling. And you know, that interest rate cycle that we’ve talked so often about, that 30, 35, in this case, 40-year interest rate cycle where we’ve seen interest rates overall dropping. That now is reversing. Now the question would be, what does that look like as far as, do we have a soft landing in this recession or does it turn into something that could be really, really horrible?

David: Well, this week is the beginning, technically, of a tightening cycle. I mean, if we’re going to bring interest rates higher, if we’re going to reduce the Fed balance sheet, if we have— I mean, we just recently ended these massive infusions of capital in the mortgage-backed securities market and Treasurys market, the buyer of first, middle, and last resort was the Federal Reserve.

Kevin: Right.

David: Fascinating. But here we are moving into a different part of the interest rate cycle. If it tightens, what are the implications? Dario Perkins, who writes for Lombard Street Research, leaned heavily on Alan Blinder’s work. And Blinder, if you don’t know the name, he worked for Alan Greenspan in the ’90s, is Vice Chair at the Federal Reserve, and is now an economics and public policy or foreign policy, I forget what policy, professor at Princeton. But the hard conclusion is that you don’t get a soft landing. You know, soft landing is when you’ve got a cyclical downturn, but you do avoid a recession. No way.

Kevin: Right.

David: And this is worth pondering this week as we look at the version of tightening put in place by Jerome Powell. Is it going to be 25 basis points? Is it going to be 50 basis points? There’s arguments for the rate at which, or the severity of the tightening, but there’s only two times out of 11 tightening cycles that we avoided a recession, 1966 and 1994. Nine out of 11 landed us in recession. And when inflation is already entrenched, it’s not difficult to avoid recession, it’s impossible to avoid recession.

Kevin: So 0%?

David: Right. I mean, what do we have coming? We have stagflation. Of course we have stagflation because we’ve got a recession that is not just on the horizon, it may already be unfolding, plus inflation. What are we going to do? Because you see, if inflation is already entrenched, it takes even more tightening to tame the inflation beast. And so, of the three varieties of tightening explored in Blinder’s work, the most consequential matches what we have today. Inflation is already a problem. There is no way to avoid recession. So to tighten monetary policy is necessary. And at this point highly consequential.

Kevin: So in other words, you’re removing the punch bowl. Was it William McChesney Martin who said, “Remove the punch bowl before the party— before they get drunk”? They’re removing the punch bowl while people are starting to die of thirst. That’s what you’re saying at this point. Timing-wise, this is a terrible, terrible time to have to remove the punch bowl.

David: I don’t know. I mean, I think the analogy breaks down at this point, because I think they’re removing the punch bowl and everybody’s already passed out.

Kevin: No, no, maybe that’s the truth.

David: I mean, a recession is baked into the cake. There’s no way to avoid stagflation at this point. So now financial market chaos is a different matter. Will volatility be amplified, or will it be muted by the degree of tightening?

Kevin: Well, Dave, really for credibility’s sake, okay, 25 basis points, 50 basis points, when inflation is tens of times that. I mean, how much are they really going to have to raise rates to maintain credibility?

David: Yeah. We’ve got the recent PPI number at 10%. Yeah.

Kevin: Wow.

David: And CPI—

Kevin: This is price index, 10%?

David: And CPI last week at 7.9. Keep in mind these are February numbers, they don’t include a $20, $30 spike in the price of oil, they don’t include the consumer paying a record high gas price at the pump. Like, so—

Kevin: We’re a quarter of a percent interest rate increase or half of it. We’re not even close.

David: It’s not enough. It’s not enough. So, Mohamed El-Erian is right. He says, “The Federal Reserve is in a deep hole of its own making.” Yeah. And so to effectively fight inflation and to recoup some credibility, rates should be increased substantially so that the Fed funds rate more accurately reflects what is already priced into the bond market. But there’s consequences to that.

Kevin: Yeah.

David: There’s consequences. You tighten too much too soon, and you crater a whole bunch of markets. Equities aren’t happy. You know, so the market’s view that inflation is already a problem, it’s permeating the corporate credit markets. And this is, I think, one of the most critical things we have to talk about today, which is the change in tone since the beginning of the year in LQD, in HYG, this is again your investment grade bonds, your high yield, what used to be called junk, bonds. They’re both already in the toilet. They are already reflecting massive inflationary concerns. And what the Fed is doing, what little they can do this week, is woefully inadequate catch up to where the markets already are. In our office we often talk about migration of concerns. And once the migration has made its way into corporate credit, you’re in real trouble. And we’re there now.

Kevin: Well, maybe we have hope, Dave, maybe there’s hope, because I know the Biden administration right now is halting oil and gas leases and they’re counting carbon credits, and I don’t know what they’re trying to do, but I do know this. Inflation’s high, interest rates are artificially low and coming up, and we’re in a recession or we’re going to be in a recession. So, stagflation almost understates what we’re talking about, doesn’t it?

David: Right, because once these trends get started, they follow through, they continue on for a longer period of time. So, circling back to supply constraints, you get oil production in the US, which has been limited by political pressure, limited by actual permitting and leasing issues. As recently as February 22nd, we had Biden iterating that we were halting all oil and gas leases until we could determine the social cost of carbon. So, we have to figure out what the climate costs are, we have to figure out how we can stay on track with a green agenda. So, just put a freeze on oil and gas leases, okay?

Kevin: Buy Russian oil, but put a freeze on.

David: Tough timing, unfortunate timing. I don’t think he knew February 22nd that we were going to be embroiled in something that would certainly inspire a little bit more oil production. Rig counts are half of their recent peak at present, in large part because drilling is, number one, being restricted, number two, it’s shown to have politically challenged economics. Would you want to go risk drilling if you thought that the reward of what you could recoup from the flows was somehow going to be penalized? Now, it’s penalized in a couple of ways. One, banks are being discouraged from lending to oil companies so that the capital structure is changing and fossil fuels are now out of favor, right? But you also might recall, just this week, Elizabeth Warren bringing out the proposal for a windfall profit tax for oil companies. So, how inspiring is that? We’re going to take more capital, put it at risk, be unsure of the outcome, potentially increase production, but if we do win, we don’t win. 

Again, this is where politics and economics, you’ve got to think more holistically and realize that they’re connected. The interconnections are important. You know, I appreciate the heart behind Warren’s suggestion that you take the windfall profit tax, divert those dollars to lower income consumers as an energy subsidy. I think her heart’s in the right place, it’s just that her mind is addled. That doesn’t work. It’s not good business. I’m not saying that you should have oil companies drill wherever and whenever, but you can’t just blame the Russians. 

I mean, it was nine months back that Biden suspended oil leases in Alaska’s Arctic Refuge. And if you look and say from an environmental perspective, this is a priority, fine. If that’s the decision that you make, then own it. Say, “We chose to have a reduced production profile and we recognize that that’s a contributing factor to higher oil prices.” I can’t just blame the bad guy across the pond. What I’m getting at is that while Russia accounts for at least 35, maybe $40 of the recent move in oil prices, we were firmly established at 75 to $80 per barrel prior to the uncertainty that Putin infused into the market. 

So, yes, you’re talking about 30, $40 and that’s a consequential move. And no, we have yet to register peak inflation. Keep in mind, we’re at 7.9%. That’s the February number, almost completely booked prior to the incursion, Russia into Ukraine. Inflation that we have here in the US prior to Ukraine? The timelines don’t match. Putin did give us an inflation ramp, but prior to that, you’ve got massive, massive fiscal policy largesse layered on top of record monetary policy stimulus, a multi-year, bi-partisan, bi-partisan gift. It gave us inflation. That’s the inflation that we have. Pandemic emergency stimulus only ended a few days ago. Keep that in mind. Pandemic emergency stimulus only ended a few days ago. It ended basically about the time that Putin’s adventurism began.

Kevin: Okay. So, we started this program with me talking about the Reign of Terror back in 1793 and 1794. In a way, Putin is being blamed for a reign of terror of his own, but is it a different kind of reign, Dave?

David: I do. I think it is.

Kevin: Is the problem really not Putin’s reign of terror, but the reign of error?

David: It is a reign of error. The public’s not as stupid as most politicians assume, and that’s what will cost the Democrats their one party reign of error. And I think we have significant challenges coming into the midterm election, but when you begin to point and redirect and not take ownership of particular policy mistakes, the best thing I’ve ever seen in relationship, when someone’s done something wrong, is to just own it.

Kevin: Yeah.

David: We have this conversation with their kids all the time. Did you do this?

Kevin: Right.

David: When they say, “No,” or when they blame a brother, or when they— It just gets maddening. Everybody knows what happened. Just own it. Own it. That’s the adult thing to do. So, the reign of error is really— the adults left the room. I don’t know when they left the room. I don’t know that the adults have been in the room, if you’re talking about DC, for maybe a couple decades. I mean, but please don’t think that the reign of error is limited to the Democrats, but I think credibility is at stake. Credibility is being lost, our faith in institutions is being challenged in part by the stupidity that’s put on display every day.

Kevin: So Dave, when they won’t own it, I think the moral to the story is that we need to own it. In other words, we were talking about owning physical property. You know, we talk about gold, we talk about these things. The people who are in charge are not owning it, and even the commodities exchanges, like you talked about with nickel, the London Metals Exchange. We’re at a point where we need to own what we think is valuable, and we need to hold to the truths that we know are true.

David: Yeah. If you’re not going to recognize the inputs to what is a multi-year stretch of inflation pressures, if you’re not going to recognize that it’s monetary in nature, it’s fiscal in nature, yes, it’s geopolitical in nature, but that’s just one aspect, one of many aspects. If you don’t recognize the inputs, then you can’t go towards solving the problem, which means the problem endures. The problem endures. It’s anything but transitory. What we embrace is a certain kind of pain that has a recycling to it. 

This is exactly what we saw between 1968 and 1982, where inflation endured and it ground us down. And it was painful, particularly as you saw the impact of compounding negative rates. And you really only felt it as you got to the late ’70s and ’80s. Here we are just at the front edge in terms of time for inflation. And I think we have a lot farther to go with the metals market. So yeah, if they’re not going to own it, you need to own it. If they’re not going to own the mistakes, then you’ve got to own the only thing that can preserve your purchasing power through what is going to be a long stretch of pain, unfortunately.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at 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.

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