July 28, 2011; Don’t Let Them Bully You! The Debt Ceiling is NOT the Issue

Weekly Commentary • Jul 28 2011
July 28, 2011; Don’t Let Them Bully You! The Debt Ceiling is NOT the Issue
David McAlvany Posted on July 28, 2011

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin:  David, you just came out of a CNN interview, discussing the housing numbers.  Could you restate some of the things that you talked to CNN about this morning?

David:  Kevin, it was interesting, because at the end of the conversation it came down to this:  “So, you are telling me, Dave, that my home is not going to be back to where it once was, in the next few months, or years?”  And I just had to say, “Unfortunately, it is not.”  As I look at the housing market, there are similarities between the housing market, the US debt market, and what we see in Europe.  These three have a common theme:  They are structurally impaired.  There are not small details that you can tweak here and there and make it better.  This is a major issue that is going to take years, if not decades, to really get ahead of.

On the housing issue, the topic of conversation was new home sales, which are about a fifth of the total each year, and this last year was the fifth year in a row of declines.  Since the recession “ended” two years ago, the sales of new homes have fallen an extra 18%.  So we are in recovery, and yet, the primary asset for the average American is still in free-fall.

Kevin, it is interesting, because if you look at these new homes sales numbers, and again, they are less important than the existing home sales numbers, but the data goes back to 1963, and we are, at present numbers, 20% below anything that we have seen since 1963, and that has a lot to do with what happened between 1990 and 2005.  If you look at that chart, it is unbelievable.  It is the kind of growth that we saw in the stock market in the same period of time.  (laughter)  Easy money equals assets going through the roof!

Kevin:  The thing is, with the increase in the price of real estate through those years that you were mentioning, I just read something that talked about US household income and did it keep up with the housing crisis.  This is an interesting contrast to what you are talking about, home prices falling, but only the top 5% of US households have earned enough additional income to match the rise in housing costs since 1975, so in a way, there is a re-correction, or maybe an equalization that is occurring, going back and matching this income that never did keep up.

David:  Another question we talked about was an issue with foreclosures, if that was a concern, and it is expected to see this year’s number come in at about 1.2 million in terms of foreclosed homes.  I think it is going to end up being higher than that, because we have on the balance sheets of banks a sort of a shadow inventory of foreclosed homes that are not being marketed actively today.  In addition to the 1.2 million expected, as much as another 1.7 million in shadow inventory, and that does not include over 5 million that are 90 days late, or in some form delinquent, mortgages which, we think, to some degree, will end up feeding that foreclosure pipeline.

Kevin:  Keep in mind, those foreclosures are the competition for every good citizen out there who just needs to sell his house, perhaps to relocate, get another job.  They are the competition, and the foreclosures are in the millions.

David:  The bright spot last week that we noted on our Wealth Management website was that home starts are picking up, but this is the problem:  Good news/bad news.  Good news is, there are a few more homes being built.  Bad news is, we have such an overhang of supply…

Kevin:  It is just more inventory.

David:  Why do we need more inventory?  Of course, if you are talking about KB or Toll Brothers or Beazer, these guys have got to be getting to work.  They have got to function as an organization, so yes, they will build.  So we do have a major, major inventory issue, both present and future tense.

Kevin:  With the housing situation being what it is, that is a long-term, as you said earlier, structural problem, but in the short run, right now, all eyes are on Washington DC, and the eurozone.  Let’s face it, whether it is a real issue, whether it is a fake issue, whether it is an election issue, whether it is a default issue, and we can perhaps cover that today – all eyes are glued to the television sets for Europe and DC.

David:  Speaking of DC, just before we move off the point on housing, there is one bright spot in the real estate market.

Kevin:  I’ll betcha it’s Washington, DC.

David:  Exactly.  The 20-city price index that Case-Shiller puts together.  Their year-on-year decline announced this week was 4.5%.  So again, we are talking about an over-supply of houses, and we are seeing that show up, not just in inventory numbers, but in actual price numbers, where, yes, that overhang is causing a decline in prices – with really one exception.  That exception is Washington, DC, yet again.

Kevin:  Gosh, I wonder why?  I guess these guys’ incomes come in anyway, whether other people have jobs or not.

David:  The real issue, Kevin, is that we are seeing consumers de-leverage, and we need to see some degree of de-leveraging across the board.  We will talk about DC, we will talk about our debt issues here in the United States.  We will talk about Europe, as well.  But the consumer is no different.  The consumer has made a small bit of progress.  If you look at the work the St. Louis Fed has done on this point in recent months, household debt as a percentage of income peaked in 2007 when it was 130% of income – household debt to income – and with the de-leveraging which has occurred – defaults, foreclosures, bankruptcies, etc., it is marginally improved.  That number has declined from 130% of income to 117% of income.  It is our suggestion that we would probably get back to 2000 levels, where we would see roughly a 90% number.  That is an additional 3-4 trillion dollars worth of de-leveraging in the mortgage and consumer debt areas.  So yes, we do see some de-leveraging that has occurred.  We think there will be more, in the mortgage space, in the consumer space.  The question we have revolves around US debt and European debt, because obviously, there is an overhang.  There is too much in terms of supply of those types of debts – sovereign debt, specifically.  The question is:  Will we see de-leveraging there?

Kevin: You were talking about income.  Right now, the average American household is carrying $75,600 in debt.  I saw these numbers come out recently.  The median average wage in the United States is $26,261.  How in the world do you get $75,000 worth of personal debt paid off – not to mention the trillions that we are talking about with the government?

David:  Relative to Bangalore, or Kuala Lumpur, $26,000 a year – that’s a handsome sum.  But, relative to those debt numbers, you are right, it’s a pittance, and it’s a long journey between paying current bills and paying off the past debts, to get to break even.  So it is a structural issue, and it is in the face of declining asset prices and a burst credit bubble that we had the study that Reinhart and Rogoff put together.  It was post World War II events of this kind where they said, basically, government debt will grow an average of 86%.

Here in the United States, we have only seen our government debt grow by 40%, so actually, the current debt crisis is very tame, by comparison.  But it is likely to continue, and a part of the reason is, we see these guys back in DC, mental midgets, who are not solving the problem at all, and this is one of the things that we want to address today.

Kevin:  Wouldn’t you say that there is a positive side to this, though?  Right now, for the first time in a long time, we have Americans actually looking at, and thinking about, the long-term sustainability of the system.  If you would have talked to them just a couple of years ago, they would have said, “Yeah, yeah, we have debt, we deficit spend, but that’s just the way things go.”  At this point, for the first time, I think, in my lifetime, I am seeing Americans actually take national debt and personal debt seriously.

David:  The question is, what are they being focused on?  Unfortunately, they are fixating on the issues that the news media and our politicians are directing them to.  The debt ceiling is a symptom, not a cause.  I think this is going to end up backfiring on everyone in DC, because everyone, as you say, Kevin, is thinking about debt for the first time in a long time, and not giving DC, and the DC-ites, a free pass to spend and play with whatever sums they get in terms of the tax take.

The real cause, and again, the debt ceiling is just a symptom, is that we have payola going back to constituency groups.  The job of politicians today is to bring home the pork.

Kevin:  It’s pork spending.  They say they cut it, every single time there is an election.  “We’re going to cut all these pork spending projects.”  But in reality…

David:  That’s their job description!

Kevin:  They don’t want to cut anything.  In fact, it just came out yesterday that Harry Reid is now suggesting that they are going to be able to use the savings from the end of the Afghan war and just call that savings on this plan.  Now, do we have a credibility gap here, Dave?

David:  This is the issue, and as you mentioned, we have the whole world focusing on DC and the eurozone for good reasons.  Our hope is that they are focused on the right things, and are not satisfied with surface or superficial solutions.  Do we have a growing credibility issue?  You bet we do.  Do we have a debt downgrade issue?  You bet we do!

Kevin:  Let me ask you.  Do we have a default issue, Dave?

David:  We do not have a default issue, at this point.  The downgrade issue, Kevin, was in the pipeline long before the wrangling occurred over this debt ceiling issue.

Kevin:  So do you think default is being used as a big bat that is actually an imaginary bat right now?

David:  I think it is, and we will talk about that in just a minute.  Again, look at the details of each proposal, whether it is the Democrats or the Republicans, and you can begin to see a strategy emerging on both sides.  The Republicans are playing for a solution that leaves economic and fiscal issues an utter tangled mess in this upcoming election.

Kevin:  2012.

David:  Yes, notice the dates.  Notice the dates of any of the Republican proposals.  It leaves a quagmire still to be solved before the 2012 election, giving them leverage, and an advantage coming into the election.  Temporary solutions with issues still to be addressed in 2012.  Democrats, on the other side, are pushing for solutions in 2013.

Kevin:  Sure.  Let’s not deal with this until after we are re-elected.

David:  And what they are saying is, “We don’t want a temporary solution, we want a big picture solution.”  Balderdash!  They don’t want a real solution.  They want to buy time until they get past this.  They want there to be a solution, they want to be the hero, and not really do anything at all – not address it until 2013.

Kevin:  David, other than the politics that we all know is going on, including the politicians, they almost look at each other with a wink-wink, nod-nod, this is all politics.  The debt ceiling, itself, really is not the issue.  You have been saying this now for a long time, but I want to hear you say it is not the issue, and why, because we are getting a lot of questions right now from our listeners about the very thing that we are seeing in the news.

David:  I’ve talked to a number of people this last week who said they are really concerned about August 2nd.  This is what you call a strawman.  This is what you call a diversion.  It is our long-term fiscal position which is desperately upside down.

Kevin:  Explain that, because it is so much larger than this issue that we are watching on TV right now.

David:  We have a 77 trillion dollar funding gap.

Kevin:  That is a 77 million million dollar funding gap.  That is amazing.

David:  (laughter) And this is the problem:  Everyone is talking about cutting the budget by 1.2 over the next 10 years, 3 trillion over the next 2 years.  They don’t get it.

Kevin:  It’s like what we talked about last week, David.  It is just meaningless in the scheme of things.

David:  Or they do get it, and they know that it is so terrifying that it cannot be brought into the conversation because there is no real solution that will not cost them their political legacy.  That is, I think, what everyone wants to ensure – that it won’t happen on their watch.  So if they can buy time, if they can kick the can down the road, they will do that.  Debt ceiling is not the issue.  It is a 77 trillion dollar funding gap.  It is our fiscal position which is desperately upside down.  Again, it is a structural issue.

Kevin:  Now I’m going to ask you to move across the Atlantic just for a moment, because what we saw over the last couple of weeks is something similar to what we are seeing here in the United States.  The reality is, Greece was not the issue.  There is a much larger issue.  We interviewed Otmar Issing last year.  He was probably one of the key, if not the key backbone supports of the euro coming in.  He was head of the European Central Bank for seven years, and at this point, Otmar Issing is struggling to see the euro survive.  Explain what he has been saying.

David:  Recently, just this:  The present, seemingly unstoppable process toward further financial transfers will generate tensions of an economic, and especially, political kind.  The longer this process is characterized by unsound conduct of individual member countries, the more these tensions will endanger the existence of the EMU.  He is looking at it and saying, basically, you allow for a Greek default, and allow them to maintain a position in the EMU, and you have compromised the integrity of the whole EMU project.

Kevin:  He knows that Portugal comes next, and then maybe Spain, and then maybe Italy, and Ireland.  It is what we have been talking about before.  They have a lot of dead weight right now, just like we have dead weight on this side, and it is not being addressed, it is just being bandaged.

David:  Right.  This comes back to the issue of a downgrade or a default, and everything that is being bandied about here as a real concern.  Our concern is that people are being utterly misled.  A default occurs in the instance like we have just seen in Greece, where we are talking about a missed payment, where interest and principle cannot be made, and because of that, that debt has to be restructured.  Those are forms of default.  So what do we have here with this debt ceiling here in the United States that is anything remotely like that?  Not raising the debt ceiling does not mandate a US debt default.  It simply means that the US government must prioritize payments.  Was there any question that we live in a welfare state?  The problem here is that the Democrats are up against making a very tough choice – who gets paid and who doesn’t.

Kevin:  Well, I’m going to bring up the subject of entitlements.  They pointed the gun right at the older people and said, “You know, Social Security might be jeopardized if we don’t raise the debt ceiling.”  Granted, we don’t want to see Social Security recipients not get their Social Security, but what triggers on paper when they don’t pay?

David:  This is, I think, what we are talking about, Kevin.  There are obligations, and we are using words very loosely in the press these days, but to have a financial obligation in the form of Social Security, Medicare or Medicaid, yes, we have put ourselves on the hook for those payments.  But that is different than having something as a contract, a formal I.O.U.  For instance, with the Japanese, the Chinese, or folks who are holding T-bills, T-bonds and T-notes in the Middle East or Europe.  That is a formal obligation that requires principle and interest repayments.  If you miss payments of principle and interest, then you are in default.  You are in breach of contract, essentially.  You may have a similar breach of contract with a Social Security recipient, but that is not a form of default.  That is simply you not being able to make payment to your constituency groups.

Kevin:  You would be making your constituency group very, very mad, very scared, maybe very hungry, but it doesn’t trigger a default issue, and I think this is a critical point right now for people to understand, because they are discussing this with others.  They are watching it on the news, and they are being manipulated by the politicians, because a default triggers a huge, huge problem.  We have credit default swaps, not just over in Europe, but we have credit default swaps that would trigger here.  We have a lot of funds that would have to liquidate US treasuries if they were downgraded.  It would be a chain reaction if there was a default.  But you are saying it isn’t a default.

David:  No, we are just talking about certain entitled entities not getting what they have been promised.  That is the bigger issue.  The bigger is, every month the federal government has to send out 88 million checks – 88 million checks.

Kevin:  This is the entitlement.

David:  If you want to do the math on that, just the postage to get those out on an annual basis is about 465 million dollars.

Kevin:  Just for the stamp.

David:  Just for the postage to deliver them.  Just to get those checks to you.  I think that we have much bigger issues than raising the debt ceiling.  If someone, at this point, wants to posture around not raising it on the basis of principle, I would ask them, “Where were you last year, the year before, the decade before?  This is 30 to 40 years of a work in process.  There is no way you can whitewash your career as a politician, at this point, and maintain credibility.  Let’s be honest.”

Kevin:  Let’s go ahead and talk about the markets, then.  Suppose our listeners say, “Yes, you’re right, this is all just smoke and mirrors.  This is a lot of politics that is going on.”  Our investors still have investments in gold.  They have investments in dollars.  They have investments, perhaps, in the stock market.  They are affected, whether this is smoke and mirrors or not.  What happens to the dollar if there is a downgrade?

David:  There is major pressure on the dollar.

Kevin:  The dollar, right now, is at an all-time low against the franc, I believe, and gold is at an all-time high, or in that range, so the markets are speaking at this point.

David:  Exactly.  And you have Citigroup now saying there is a 50% chance of a downgrade this year.  I think the idea of a downgrade – it is going to happen.  The debt ceiling debate has just brought my attention to the fact that we have solvency issues here in the United States.  Not just liquidity issues, but solvency issues – real, structural issues where we have deficient payments coming in, in terms of the tax revenues, and excessive payments going out, in terms of entitlement spending.  We have to look at the impact of what happens in the next few weeks or months as the market makes its votes.  What happens in the event of a downgrade?  We definitely see the dollar take it on the chin, and gold gets another bid higher.  If, on the other hand, they come up with a solution…

Kevin:  Which they probably will.

David:  Exactly.  This is the straw man problem, which they will solve, to some degree.  What happens to the dollar?  “Now we don’t have the reasons for there to be pressure on the dollar,” they will say, and so we are likely to see a short snap higher for the dollar.

Kevin:  A mini-rally in the dollar.

David:  A mini-rally in the dollar.

Kevin:  Could you see gold adjust down a little bit?

David:  Absolutely.  Maybe we will give up 50, 60, 70 bucks on the gold price – very temporary in nature, because again, we haven’t addressed any of the structural issues.  This is what we have witnessed for the last two years in Europe.  They have come up with band-aid solutions, provided more liquidity, and added debt to other layers of debt, pretending that was a solution, and ultimately, it is leading to an insolvency end-game.

Kevin:  David, I just read something on a blog, and I think this guy hit it right on the head.  He said, raising the debt ceiling to solve the deficit problem is a little like raising the blood alcohol limit to solve drunk driving.  Just don’t do it.  Okay? (laughter)

David:  (laughter) That’s right, that’s right.  But what we have continued to do, Kevin, is to apply band-aid solutions, something that on the surface appears to solve it, but structurally, doesn’t change anything.  In fact, raise the level in terms of blood alcohol content, and you are going to find a lot more people driving drunk.

Kevin:  Talk about dancing through a China closet.  The European solution has four elements that you talked about in the McAlvany Weekly Recap last Friday.  By the way, that can be found online at the McAlvany Wealth website.  You can go to mcalvany.com and continue to navigate.  Every Friday, if you want to read a brief summary of the markets and the thoughts of David McAlvany, and David Burgess, over at McAlvany Wealth Management, that recap is a great recap.  But David, if you would, restate what that Greek bailout plan was – the four elements of how they were able to dance through calling it a default, because in reality, these guys really are defaulting, but they are calling it something different by restructuring the way they pay.

David:  Right.  I think the two critical things from last week, as they pertain to Europe, were that we saw a default with Greece, and we saw a new architecture for bailout.  This is what Sarkozy was calling the EMF.  Instead of the IMF patching everything up, Europe is becoming more independent.  I have written some great analysis on that, which says this is a step forward for Europe in terms of gaining autonomy and distancing itself from being dollar-centric and anglo-centric.  Great, fine, if you want to think that – think that.

Kevin:  They’re going to miss us, because we are the IMF.

David:  Yes, we are still a major component of the bailout.  But the reality is, even the funds that they are using – the EFSF fund that they put together a number of months ago, 400 billion and change, it is not the right size.  It is enough to solve the Greek issue, because that is about how much Greek debt there is, but it is not enough to solve the Spanish issue.  On its own, it is not enough to stand any pressure in the Italian markets.  By the way, did you see the Italians cancel their bond offering last week?  They are looking at penalty rates and they just decided, “Oh, actually, we have plenty of liquidity.  We don’t need to float this bond issue.”  So they went forward with the bill issue, but the longer-dated bond issue, which is catching major pressure, as interest rates increase, as people are saying to themselves, “Ah, there is a problem with Italian debt.”  They just said, “Oh, we don’t need the money.  We’ve got plenty in the bank.

Kevin:  “We’re going to have to pay too much for it.”  That’s exactly right.

David:  (laughter) Exactly.

Kevin:  Interest rates rose on them, and it hurts.

David:  It does hurt, it does hurt.

Kevin:  Go ahead, tell us how they restructured it so that they could call a default something other than a default.

David:  Kevin, it is not a default, in their opinion, because it is freely chosen, and so they have been given this menu of options.  You can wait and see what happens, and you may get paid on time, with all of your investment dollars.

Kevin:  That’s number one.

David:  If that is option number one, certainly you can sit there, scratch your chin, and wonder: Will this actually occur?  Will I see some return of value, just to par, or some portion of it?

Option number two is, extend your maturities to 30 years, and accept a 4½% coupon with a principle guarantee component.  What is interesting about that is that it is buying time.  What it is not guaranteeing is what the value of the currency is over this 30-year period.  We guarantee the principle, we just can’t guarantee what the euro is worth at the end of 30 years.  (laughter)

Kevin:  Well, look at the dollar.  It has lost 90% of its value in the last 30 years.

David:  I love it, I love it!  I mean it is the greatest scam on earth.  Insurance companies do this all the time.  They say they will insure you for a million bucks.  Thirty years from now they will pay on it, and guess what it is worth?  They have a present tense value, and you got suckered into being played as a fool on the game which favors the house because of one component, and that one component is…

Kevin:  The de-valuation of the currency.

David:  That’s right.  Inflation over a longer period of time.

The third option is to extend maturities to 30 years…

Kevin:  Like the last one.

David:  Yes.  Discount those bonds by 20%, and receive a higher coupon payment.  Instead of 4½% they bump you to 6.42%, and also there is a principle guarantee.  So you are taking a little bit of a haircut.  Again, you look at sitting on a 40-50% haircut, at present, because that is what has happened in the marketplace and you say, “Wait a minute.  I only have to take a 20% haircut?  That means you are giving me principle back.  If I had to trade these bonds in the open market, I would get skinned alive, and you are going to give me some of that back?  That’s a no-brainer.”

The fourth option is, extend, not to 30, but extend to 15 years.  Again, take the same 20% haircut, receive 5.9%, and get a partial guarantee of principle.

Kevin, what they are trying to do is make these offerings so attractive that everyone comes to them, chooses from the menu, on a voluntary basis, and, on that basis, they don’t trigger a credit default swap, a payment in the credit-default swap market, as a result of default.

Kevin:  We have covered these credit default swaps for a long time, especially since 2008 when we started to see the Lehman problem come apart, but that credit default swap issue is so important to understand, because they are calling this something else.  As you said, they are just expecting people to come running up to the window and say, “Yeah, I’ll go ahead and let you extend my bond, and yeah, I don’t mind if you don’t pay me for 30 years.”  But in reality, they have defaulted.  Now, are we going to see these credit default swaps, at this point, trigger?

David:  (laughter) I think, Kevin, this is the beauty of contract law.  You could have this mired in the courts for years, and you could have the parties who bought the insurance saying, “Hey, wait a minute, you defaulted.  You owe me cash.  That’s why I had the insurance.  It’s supposed to pay in the event of a default.  You’re not paying?  This is breach of contract.”

So now you have an interested party who was expecting payment as a result of a CDS trigger, saying, “Where’s my dough?”  So they take it to the court to defend their claim.  How long does it take to sort this out, Kevin?  I have no idea.  No one does.

Kevin:  David, the bottom line is, these credit default swaps are not all just sold to bad guys.  They are sold to all of our portfolios.  Insurance companies buy them, banks buy them.  We talked about this last week.  If there is a default, and there is a change in the payment method for the structure of what is in my portfolio at the insurance company that I am insured with, then that loss has been socialized worldwide, if they don’t call it a default.

David:  This is the classic idea that Walter Bagehot wrote about in Great Britain.  In an event like this, you landed a penalty rate, and against good collateral.  Now we are talking about garbage collateral, and that’s no penalty rate.  At 4½% you are actually giving a free pass, which means that someone is subsidizing the rate somewhere, and that is exactly what we have seen happen here in the United States, as well.  We have a low interest rate environment, an artificially suppressed interest rate environment, and the subsidy to the bank balance sheet is coming from you, the depositor, so it is not as if low interest rates just represent cheap money.  It is not that at all.  It is a redistribution of capital from the depositor to the banker.  In this case, you are rebuilding the Greek balance sheet through an artificially suppressed interest rate.  So, no, it is not exactly fair.  It is utterly a socialized risk, and it is something that we don’t think represents a normal market functioning.

Kevin, what we thought was particularly fascinating this last week was, as the EU ministers were patting themselves on the back for a job well done, for having averted a crisis, for, in their opinion, having averted a default, even though technically they triggered one, the price of gold kept on marching higher, and it was just a siren, saying you are fools.  You are all fools.  You don’t get it.  Nothing has changed.  The structural impairment is still there.  You still have the debts to pay.  In fact, if you looked at what they accomplished – the debt-to-GDP figures in Greece – guess how much they improved?  They went from roughly 156% of GDP, to 140% of GDP!  Going back to Reinhart and Rogoff, this is the same issue.  If you are above 90%, you are up the wrong creek without a paddle.

Kevin:  David, throughout history, gold has always told the truth, and this is where politicians have always hated gold.  We have talked about that last week.  The statists have always hated it, because they have to lie to their constituency about debt, they have to lie about a number of things…

David:  But it’s a plumb line against which they are measured, and they are found, today, all askew.  They are found bent and broken and going the wrong direction, whereas gold is charting a very accurate course.  The only way forward is toward solvency, and these are hard choices that you have to make.

Kevin:  David, I want to broaden the picture a little bit.  Going back to Ronald Reagan and some of the people whose decisions we admire.  Under the Reagan administration, we did see the fall of the “Evil Empire.”  But the behind-the-scenes moves that it took actually tripled our debt.  Under Ronald Reagan, we went from 1 trillion dollars in debt, which it took us from George Washington all the way to Jimmy Carter to get to.  Yet, in Ronald Reagan’s first watch, they had to triple the debt because it looked like we were going into a recession, and he may not get re-elected, and he had a plan, and that plan had to do with getting rid of this Cold War expense and danger.

David:  Kevin, I think this is where Laffer gets too much credit, because, yes, we accumulated the debt, and yes, things did recover, and yes, this apparently did work, but it was the circumstances which made it possible.  You can’t just willy-nilly add debt and have that be a solution to your problem.  We added it then, to a very pristine balance sheet.  You may not like a trillion dollars in debt, but we had a growing economy, nonetheless, and we could actually afford to do it.  It ended up being productive debt, you could say.  The debt that has been acquired, this last bump of 40%, and likely, again, as Reinhart and Rogoff have said, classically, in a credit bust like this you will see government debt go up as much as 86% from its original baseline.  It is nonproductive at this point.  We are not getting any GDP growth for every dollar of debt that we are acquiring, whereas we used to get almost dollar-for-dollar GDP growth.  Now it’s a fraction of that.

Kevin:  And that’s my point.  I asked you this the other day.  I said, “Let’s just pretend for a moment that in this corner, sitting here at the table with us, is Ronald Reagan.”  Let’s pretend like Ronald Reagan is sitting here right now, and he sees what is happening.  Even though they made that behind closed doors decision in 1983 to triple the debt using Japanese money, Ronald Reagan had a mission and a reason for it, but it kept going out of control.

In the other corner is Otmar Issing.  This is an older man, whom you spoke with last year, who had a dream of keeping Europe out of a third world war.  It seemed that Europe continued to fall into war because there was no unity.  He saw monetary unity as a way to keep this from happening.  And now he is starting to say, “Wait a second, this may not work.”  So, are we seeing old men’s dreams gone horribly wrong at this point, turning to old men’s disappointments?

David:  You can see, Kevin, that those two men that you mentioned made an existential commitment.  We had the threat of the Cold War, we had the threat of the Soviet Union, we had the threat of the Great Bear, and that certainly was an emotional motivator for any and all means in terms of defense of freedom in the free world.

Kevin:  And it may have warranted debt under Ronald Reagan’s administration at the time.

David:  Those were certainly the avenues of logic that Reagan pursued.  We have Otmar Issing on the other side who reflected with us that his father was a part of the German regime, and he sat with another banking administrator of the ECB, who was a Frenchman, whose father was on the other side, and they realized, existentially, that there was right and wrong, and that they wanted a better world.  They wanted a better place for their children.  They wanted a better place for their grandchildren.

Their commitment to the EBC was not one of a socialist leviathan, but one in which there was an insurance policy, an insurance where we are so connected that we cannot possibly hurt each other without hurting ourselves.  And you got that sense of, “Yes, we had to give it a shot,” because we discovered what men can do, and unfortunately, it is a very ugly, evil thing.  My wife and I did some studying and reading on Nanking in 1937, what happened between the Japanese and the Chinese.

Kevin:  Yes, Nanking, that was an utter massacre.  The Japanese just came in and wiped out Nanking.

David:  We are talking about hundreds of thousands of people in a matter of weeks, and it was absolute brutality.  When you reflect on what can happen, you realize what kind of existential commitments people do make to an ideal.  So I think you are right, Kevin, we are watching these old men’s dreams become disappointments.  I think what you end up having in both of these instances is, circumstantially, a success.  We saw a ramp-up in terms of the ECB and the EMU, and for ten years, something that would make you say, “How can you do this?  How can you have the world’s reserve currency, the US dollar, challenged by an upstart currency union that did not exist ten years ago?  It is just almost ex nihilo – there it is.  That is pretty impressive, even though it is flawed, and we are finding now that it may be terminal.  We find the same thing, Kevin, with our debt structure.  What started out with, perhaps, a good idea, certainly functional, certainly something that you could do early on, and never was the question asked, “Should we do this? How will this end?  How, if we go from 1 trillion, to 3, to 4, to 5, to now 14 – how will we ever shut it off?”  And that is where we are today, Kevin.  We have the makings of a Frankenstein.

Kevin:  I was just thinking that.  I was thinking of when I was a little kid, we were visiting an aunt in Nebraska.  I was already in foreign surroundings, and everybody went to bed, and I was in her basement, and I saw Frankenstein on T.V., for the first time, and I’m telling you what.  Even telling you right now, it scared me, because in the beginning, I didn’t know what the story was.  I had never heard it before.  I was a little kid.  And here he was, he was creating a man, out of other parts, a little bit like the European Union, creating something that was supposed to work together.

David:  It was brilliant.

Kevin:  It was brutal at the end, though.

David:  In the end.  What is interesting, Kevin, is that this is not a modern concept.  This is not something that, on the basis of technology and innovation and globalization, is a new idea.  You can go back 3,000 years, and in Hebrew literature, you have the idea of the golem, which is the same thing as the Frankenstein monster.  With our hands, we craft and create from clay something that life is breathed into, and then we lose control.  It is a theme that is repeated throughout history and it is a theme that we have to come to terms with.  Debt is the issue.  Structurally unsound fiscal policies are the issue.  We have to address this systemically, and we have to do it very quickly, or this particular Frankenstein will not be controllable, at all.

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