The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, there’s something about 70 years. The Bible even talks about that being the length of time of a lifetime. We’re coming into a 70th anniversary of another lifetime of its own, and I think it’s worth noting this week.
David: Yes, although the Bretton Woods monetary system has changed, and frankly, it has devolved from its inception to the present time, the institutions that it created are alive and well. At the same time the dollar was launched as the world’s reserve currency in 1944, you also had the creation of the IMF, and the creation of the World Bank.
Kevin: I think people forget that. We hear about Bretton Woods and the dollar standard being the reserve currency of the world, but we hear about the IMF and the World Bank all the time, especially the IMF.
David: And they were both spawns of the Bretton Woods monetary conference. This week marks the 70th anniversary of the conference. The monetary architecture of the modern world, as we said, was set in motion in 1944 at that conference. The conference began July 1st; I think it ended on the 22nd.
Kevin: And there was a baton passed at that time. You had the empire that the sun never set on, sort of at that time passing the baton to the American generation.
David: The posturing that took place between John Maynard Keynes and Harry Dexter White. The passing of the baton was one of leadership. It wasn’t just of monetary and financial importance, but there was what was obvious British acquiescence in 1956 in the Suez, when it was obvious to the world that the Brits were not really in control of their own destiny. They couldn’t do what they wanted to do.
Kevin: They were not controlling their empire from afar like they had been before.
David: That’s exactly right. But it was really symbolic of the power lost and transferred. Quite frankly, the transfer began a lot earlier than that. It began, and you could say, that the decline of Great Britain started in 1919-1920.
Kevin: Right after World War I.
David: Sure, after World War I. And that’s where Wall Street began its more or less dizzying assent, following on the heels of London and Lombard Street, Wall Street was becoming important. They were starting to lend more, they were starting to issue more in terms of stocks, and after the crash in 1921 on Wall Street, we had about an 8-9 year period where they ramped up considerably, and again, followed in the footsteps of Lombard Street.
Kevin: And Lombard Street in London is the equivalent of Wall Street to us today.
David: Correct, in London. Not the Lombard Street that twists and turns in San Francisco. King Edward I in the 13th century gave land to Italian goldsmiths who had come over from Lombardy, a part of Italy, and this became the center of London’s financial district, with insurance and banking emerging from the gold trade.
Kevin: It sounds to me like that is something that is near and dear to your heart, the gold trade.
David: Gold has always been the precursor for interesting and compelling things of a financial nature. It has served as the backdrop, and frankly, as the substructure for anything of lasting value in the world of finance.
Kevin: Let’s go into that, because actually, we’ve moved somewhat from a gold standard to a gold exchange standard, and then to this Bretton Woods system. There really was a new world of finance that was born in 1944.
David: That’s right. The new world of money and finance was catalyzed by World War I and World War II. It was codified in the Bretton Woods agreement and the U.S. was put, really, in the cat bird seat, in part, by the circumstances of war, and in part because of the smooth operations of Harry Dexter White, as we recently discussed.
Kevin: Right. The Benn Stiel interview was fascinating – to talk, actually, to someone higher up in the CFR about the Bretton Woods system. He is an amazing historian as well, reading his book.
David: Last week the BRICs, that is, Brazil, Russia, India, China and South Africa officially launched their own development bank. This is interesting because it happened basically a week before the 70th anniversary of the IMF and the World Bank, and it competes directly with them. It is worth looking at the timeline for sterling, that is, the UK’s currency, and its decay, and the importance of key events which ultimately led to its demise as a global reserve currency, and frankly, the marginalization of London as the primary financial capital for Europe and the world. I think, to some degree, what you have, with the launching of the BRICS’ own development bank, is a foreshadowing of things to come.
Kevin: I think was should probably talk, just briefly, about what the IMF actually has done for countries, or what they claim to do. The basic idea is that if you start getting into financial trouble, you go to the IMF because that stabilizes things. What that also does is that it creates a dependence that can be used politically, and if you think about it, if you now have competition for the IMF you probably are losing a little bit of that political power that you would normally have, financially.
David: Absolutely, because it is basically gifts with strings attached. It is not exactly gifts, because there is a loan that is set up by either of these institutions, and you have to commit yourself to certain reforms in order to be able to get that money. But it keeps you solvent, it keeps you whole, and it keeps whoever is in power, in power, and not facing the music, so to say, by accessing that capital from the IMF or the World Bank. So, the strings attached are, you reform, and you conform, to our view of what politics and economics look like in your part of the world, and we’ll give you the money.
Kevin: And that has been the post-World War II paradigm. Would you say that there is a paradigm shift that is occurring at this point?
David: Right. We’ve discussed a book written in the 1960s by Thomas Kuhn. The title of the book is The Structure of Scientific Revolutions. He wrote about abrupt change in the world of ideas, where one view of the world is discarded, literally, in a day, and a new one is adopted overnight as its replacement. Kuhn was arguing that the old way of thinking, a paradigm, as he would call it, can quit functioning as a coherent model for a community, and he was, of course, talking about the scientific community, even as it remained a working model for that community. It is no longer coherent, but it is still the working, or operating, model for that community for some time. Why is that the case? He explores how ego and intellectual pre-commitment keep the experts entrenched, what he calls a textbook bias, where, literally, you write the textbook, all your students read the textbook, and you have another generation who believes just as you want them to, and they have a hard time stretching outside the box, so to say, in their thinking.
Kevin: It is amazing how the norm does stick. He talks about this in his book, The Copernican Revolution. It was very complicated, going back to the old days of Ptolemy, where all the bodies in our solar system rotated around the earth. You could still figure it out, the math still worked. You could have retrograde motion, work that all out, but it took the equivalent of a Ph.D. to just figure out where the planets and the stars would be. Copernicus, just by changing the focus changed the paradigm. Let’s pretend the dollar has been this old Ptolemaic system. How do we start transitioning now to maybe a model that is going to be in effect in ten years?
David: I think that is one of the reasons why, looking back at London, looking back at the British system, looking at the British currency, it’s only as a viable alternative, as Kuhn would say, to the old model. As that emerges, and you have new champions, people who are all for it, it is only then that the old model can be displaced by the new. So it’s not as if a failed system is recognized as a failed system, you have to have a replacement in the wings. I think that is, in essence, when you are looking at the BRICS commitment, that is, Brazil, Russia, India, China, South Africa, these developing nations – it may be a long time in coming before they actually do replace the current dollar system as we know it today, but they are creating the alternative. And yes we have problems with the current dollar system, but until there is a viable and working model, the old will remain, and the new will be just something that is just casting a shadow into the future.
Kevin: In a way it reminds me of the old Oklahoma Rush, where the people ran out, picked the piece of land that they wanted to have, and they staked their claim and they put the stake down. In a way, we’ve sort of got a rush toward the new reserve currency. It may take years to get there but people are saying, “Look, we’re staking a claim in not using the dollar exclusively.”
David: Yes, the New Development Bank is one stepping stone in the direction of a new monetary system. We don’t think that the changes are imminent. There are practical limitations to change. If you look at the incumbent power, if you will, that the United States has, not wanting to relinquish control, and frankly, having sufficient coercive power to maintain its position.
Kevin: We still have the largest navy, military, etc.
David: Yes. Even with a diminishing military, we remain the world’s largest and most sophisticated, by many multiples. So the road to a new order is being paved by the developing world, with their intentions being clear. Why is there no immediate threat? Again, let’s consider the details. For all the discussion on creating a new monetary and financial design, you have a 50-billion dollar capital commitment coming into this new bank. And guess what? It’s entirely in U.S. dollars.
Kevin: Isn’t that ironic then? You have a new bank that is going to compete against the dollar, yet it is dollars that are going into it.
David: So breaking out of the dollar dominion, if you will, is easier said than done. When the World Bank was started in 1944, 90% of the capital contributed was in foreign currencies, and 10% was in dollars. Benn Stiel points out a number of these issues, again, his work at the CFR, and in our conversation, these just being some of the details he has put out publicly. Then consider this. Three of these countries in the BRICS, that is, Brazil, India, and China, are the largest borrowers from the existing bank, that is, the World Bank – 66 billion dollars in loans, to China, India, and Brazil. What it suggests is that the new bank is more in the idea stage and not likely to supplant or replace the Bretton Woods institutions yet. So, will you see change? Yes, it’s definite, but it’s on the horizon.
Kevin: So we’re talking now about the banking system, the IMF. That was established 70 years ago this week. But we are also talking about a currency, Dave. We’re not just talking about banking systems, and those alliances. How about the dollar? Let’s look at the shift from the sterling to the dollar, because that was also accompanying that shift.
David: We’ve mentioned in the past that currencies are destabilized by war, and any country that had been on a gold standard prior to military conflict usually drops the commitment to the gold standard for that period of time because they have to print like mad. So wartime inflation is a very common thing. Wartime inflation is the same thing, if want to look on the other side of the coin, as saying, the currency, itself, was devalued in order to finance the war. Well, England was financially destroyed by back-to-back wars that it found itself caught up in, and certainly, the dollar has its own pressures, we have gross financial imbalances in the U.S. today, but they are nothing like the devastating effects of war.
Just one caveat. Time and the tide of events can, of course, change that. We have found ourselves embroiled in conflict very quickly, and of course, there are sometimes precipitating events, whether it is the Lusitania, or what have you, where all of a sudden we find ourselves committed to conflict, where just days before it wasn’t really on the mind, certainly of the general public – perhaps of the powers that be, that’s a different story, but at least with the general public there was no collective commitment to conflict.
Kevin: Dave, sometimes we take peace for granted. We talked about the IMF. There are some ties. When you borrow from the IMF you have strings attached, and a lot of times those strings can actually guide countries away from war with us, or with our dependents, financially. But we’re making foreign policy errors right now. It seems like, even though we’re hearing from Washington that we’ve never had it so peaceably good, we’re actually seeing the fires of war seem to stream up. Foreign policy errors could change that, couldn’t they?
David: Absolutely, and put us outside of the circles of influence which we have enjoyed since the end of World War II. As influence diminishes, our foreign policy is more likely to be aggressive, and less like what some academics have called soft power. Joseph Nye popularized that idea a few years back, where you gain influence and it is less coercive, when in fact, we are losing that influence, and I think it is going to swing toward a more belligerent and demanding and coercive posture in terms of our foreign policy.
And you may see that in direct conflict, whether it is the Chinese, or the Russians, or what have you, where the posture is that we are defending freedom, we are trying to maintain democracy around the world, trying to defend Taiwan, whether it is the Spratly Islands and keeping the shipping lanes open in the South China Sea, or freeing Ukraine from outside tyranny, there are a number of things that may catalyze a change in foreign policy, but I don’t think it is going to be the soft power of the last several decades. Conflict is what appears to be more and more on the horizon, which may be one of those catalysts for the dollar diminishing in terms of its importance, but also its actual value. And why would we say that? Because war has always had that effect on currency.
Kevin: So our M.O. as a country up to this point has been to buy influence because we’ve had money to loan out to countries that needed it.
David: But we’re not the only ones in the field anymore. We have the Chinese who are financing infrastructure projects in South America. We have them going into Africa and building water dams, setting up electricity, systems related to those dams.
Kevin: Russia is doing the same thing. Look at what they did with Cuba last week.
David: Just here in the last few days, 90% of the 35 billion dollars owed to the Russians from Cuba was just forgiven. So whether you are investing in capital projects or you are forgiving debt, which is the albatross around the neck of a particular country, these are folks who are intent, and I think the New Development Bank, as it grows and extends its reach, once it is more mature, competes directly with this notion of influence in the world of ideas, and influence in terms of public policy and international foreign policy. They are vying for influence, not just from the U.N. Security Council, but now with direct financial strings attached.
In our opinion, these are just a few of the necessary steps for the dollar-dominated financial system to be thrown out and replaced. Again, it is as if behind the scenes a new paradigm is being created. And that new paradigm is not particularly relevant today, because it is not going to be used today, but as and when the old system is, through circumstance and the tide of events, shown to be a broken system, and everyone believes that popularly, you will already have new pipes set in place to carry the liquidity, if you will, from one central bank to another.
Kevin: And sometimes it can be subtle, can’t it? There are other ways of getting around the dollar-denominated system. You can slowly change the amount of reserves that banks are holding of your currency. We’ve said before, the dollar was over 70% of the reserve currency just about ten years ago, and now it has dropped down to the low 60s.
David: You’re right, in terms of the importance of other currencies, or the diminishment of importance for the U.S. dollar, we still are the dominant reserve asset held by central banks. But we have begun to see a shift. It is no longer the accumulation of dollars. There is the liquidation and distribution, the flow the wrong direction out of dollars. That is one of the key variables that does still support the U.S. dollar. We have a captive audience from the world’s central banks.
The second area where we are beginning to see change is in the flow of trade invoicing and settlement, again, in those alternative currencies, which makes them more important in terms of global trade and transactions in terms of imports and exports. This week is very worthy of note, with yet another swap line agreement being signed between the Swiss and the Chinese. Earlier this year we had similar agreements signed between the Bundesbank in Frankfurt and China, and then also this year we had signed between London, the Bank of England, and China. Really, what you are talking about is a shifting of the emphasis away from New York and Washington, D.C., in the direction of China’s other significant trade partners.
So as a part of the agreement, the Swiss National Bank now has a quota for buying Chinese bonds. Again, when you are talking about the swap lines, this is the 25th such agreement signed by the Chinese. How many of those swap lines are being used today? Very few of them. Why go to the trouble of setting them up if they are not going to ultimately be used? And I guess we can all speculate as to what the circumstances would be under which they would use those swap lines, but I think we know full well, in the context of crisis, this is where you begin to see change, which might take a long period of time, it can occur on a much quicker time frame.
Kevin: Something that Thomas Kuhn pointed out as far as scientific revolutions is that there was never a paradigm shift unless there was something else in place to replace it, right?
David: Right. Our view would be that changes that repudiate the dollar and the current existing financial system won’t occur except over a 5-10, or even a 20-25 year period. But then, hold that thought in mind. We reflect on the late Frank Biancheri, who, unfortunately died this last year, and his idea that crisis compresses time. And there are undoubtedly unforeseeable events which can take years and shrink them into months. So on a normal devolutionary process, the dollar stays the reserve currency of the world for another 25 years, and it loses, at the margins, in terms of its influence, and we become more frustrated, and financing costs do go up, but only marginally. Crisis is what catalyzes, or compresses, time.
Kevin: Dave, I’d like to play a thought experiment here. Let’s pretend like we are 100 years back right now. It is early in the year 1914, and we are sitting here talking about a change that we think may occur in the future, where countries move away from this grand gold standard that we have used since 1870. Early in 1914 we would maybe be saying that the way politics are adding up, we could see in the next 5-10 or 15-20 years, a move away from the gold standard. And then, the archduke and his wife were assassinated, and sure enough, almost instantly, that paradigm shifted.
Now, I want to move to World War II. We could be sitting, let’s say, in 1940, 1941 even, the early part of 1941, you and I, here in America, saying, “You know, the way Hitler is moving in Africa, the way Hitler is moving in Europe at this point, we probably are going to see an intervention at some point.” And then, of course, December 7th happened. So talk about a compression of time, paradigms can shift very quickly, can’t they?
David: Oh, absolutely, and again, that is a process that might ordinarily take 20-25 years – could that timeframe be compressed into just a few years or even months? I suppose it depends on the crisis, itself. Not that we have anything brewing today.
Kevin: (laughter) Right, nothing’s going on.
David: Just consider the calm in the markets, with geopolitics being anything but calm, frankly, at present. We have Ukraine, we have Russia, we have a coup in Thailand, we have Iraq and Syria, we have Egyptian unrest, we have Gaza and Israel, and questions that linger on each of these. But, for instance, Gaza and Israel, are they testing their ground troops, that is, Israel, in preparation for an Iranian incursion? They are looking at, perhaps, a November drop-dead date in terms of actually having an operable nuclear weapon.
Kevin: Then let’s look at it from the opposite direction. What if Iran is actually testing the iron dome.
David: (laughter) Sure.
Kevin: Any time you are about to go to war with somebody you prod their defenses.
David: We have volatility in the stock market which is near seven-year lows, which indicates that there are no concerns, whatsoever. The stock market is saying that the Federal Reserve and the central banks have the ability to smooth over any crisis. That, today, is a belief which is unquestionable.
Kevin: We talked about certainty last week. It seems that the markets are just programmed right now for pure certainty, as far as the Fed just covering over anything.
David: It was interesting, this morning in a Financial Times article, it started with these words: “It’s quiet – too quiet.” And we agree. It’s too quiet. Volatility this low, with this many things happening in the world, and the markets are basically saying, no, no, no, actually all is well. Our sense is, actually, that you could see things catalyze and speed up in a hurry, whether you are talking about market machinations, or geopolitical issues, which again, create conflagration that brings us into conflict with those in Europe – Eastern Europe, Russia, China, etc.
Kevin: And don’t you think our ability to buy power, the soft hand versus the hard violence, is going away? We were a country that grew for other reasons than we are today. We seem to be needing money, not making money.
David: What is interesting is that our credit grew at such a rapid pace through the 1980s and 1990s, and with that, we had a major growth rate. Productivity was growing, GDP was growing, and we are not seeing the growth rates of the 1980s and 1990s. Productivity benefits that we gained from the IT revolution have already been captured, and in large part, this week’s Economist points out some excellent numbers on this. In large part, those were already captured by 2005. The average productivity growth from 1947 to 2007 was 2.3%. Now, it is about 1%, according to this week’s Economist. Our growth, and what has driven growth in our economy, has shifted from demographic and income growth to credit growth.
Kevin: And I think it is important to point out, there are only three ways we can grow. It’s like an equation. You either grow demographically, or you grow your income, or you borrow money – that’s credit growth. Are there any other sources of growth?
David: Not really. When you look at the amount of credit growth from the early 1990s, household debt was, let’s say, 4 trillion dollars total, and it grew, to about 2007 just prior to the crackup in real estate and in the markets, to about 14 trillion, and it has actually been contracting since then. Household debt from 4-14, now at 13 trillion. Government-sponsored entities, that is, Fannie Mae and Freddie Mac, in that same timeframe, early 1990s, you had about 2 trillion dollars in debt, and it grew, up until the crisis in 2007, to 8 trillion – massive expansion. The asset-backed securities market was almost nonexistent in the early 1990s and was about 4 trillion. So we have seen in just those categories, growth from 6 to 26 trillion, and now we’re not seeing growth in credit.
You may say, well that’s fine, we don’t need any more debt. That’s all well and good, and philosophically I would agree with you, but on a practical basis, we don’t have income growth, we don’t have demographic growth, and we have an economy that has become addicted to cheap money and an expansion of debt. And the belief is, amongst economists today, that if you don’t grow your debt by 2% – I know this sounds obtuse and awkward – but if you don’t grow your debt by 2%, you will land in recession. And we are on track for about 2.1% currently. That is this year. That means we’re not going into recession this year, but we’re not humming along, in terms of a healthy, robust recovery, either. 3.4% GDP growth was the average GDP growth through the 1980s and 1990s, and that was with credit growth of somewhere between 6% and 8%. Now we can’t even hardly move the needle in terms of credit growth. Where do we go from here?!
Kevin: If we factor in inflation, we’re actually shrinking, even now, even with the credit growth that we have. We don’t have demographic growth, like you said. We have a population that is not increasing at the rate that it probably needed to, to sustain what it was we promised.
David: In addition, we have a population that is aging. 2008 was the launching point in retirement for an entire generation, the baby boomer generation, starting in 2008. You are seeing a massive amount of people who are leaving the work force on the basis of – “It’s time. The golden years are here.” You have the largest population subset in America, and you have this implicit in the equation, with a diminished number of workers to replace that generation in the work force, let alone supply the cash flow needs for their safety net.
Kevin: Now we’re talking about Social Security, right? And Medicare.
David: Exactly. So that’s what they are expecting in retirement. The benefits were sold to the retirees as a self-funded benefit. You’re saving this money and it’s going to be used for you. We’re going to be spending your money on you when you get there. Instead, what did we end up with? We ended up with the government pilfering those funds, and using them, in essence, to spend more than they had in order to buy votes, making additional promises to constituency groups, so now you have the number of workers coming into the workforce, and it’s not enough to support the retirees. This, of course, is one of the reasons why immigration is such a hot-button issue, because on the one hand we have jobs that need to be filled, we have jobs that should be created, we have a missing generation, regardless of your beliefs on abortion, do recall that the workforce – and these are just the numbers – would have an extra 30-40 million people coming into it, if it were not for the popularity of that famous quote, “A woman’s right to choose.”
So now we have immigration as a concern, as an issue, but again, we’re lacking 30-40 million people who should be in the workforce, generating an income, helping to offset the costs of a retiring class. This is where Larry Kotlikoff, the economist at Boston University, pencils out the difference between our future income as a country over the next 15-20 years, and our future expenses, all the promises we have already made, and there is a minor gap – the gap between what we are going to bring in, and the gap between what we’ve already promised. It is about a 200 trillion dollar gap.
Kevin: I think you should say that again – 200 trillion dollars. I remember when you talked to Larry Kotlikoff.
David: 220 is his number, to be precise, but once you get above 100, 100 versus 200, 200 versus 220, this is insanity.
Kevin: What difference does it make? It is a little like standing somebody up against a 50-foot wall, or a 100-foot wall, and saying, “Jump over.” It doesn’t make any difference. Once you hit a certain number, you’re not going to do it.
David: Right. Well, that’s a challenge that won’t be a real-time threat for 20 years. I guess the question is, why do we worry about today, what we can ponder tomorrow? This is really the attitude that we have adopted. Listen, Kotlikoff’s funding gap – this is future income and future expenses, and it deals with the future. Listen, we have received a legacy. This country is a rich one. But somehow the great spoiler of all legacies has come into the public square. Any guesses what that spoiler is? In this case, it’s a collective selfishness which prioritizes present benefits over and above future liabilities.
Kevin: And I think I should point out to the listeners, Dave, this has been on your mind for a long time. The word legacy is probably one of the most used words in this office and with your family. I don’t know if I can give this tip right now or not, but I think that’s what you are writing a book about.
David: Yes. Well, what we received was opportunity and wealth, and what we are giving to our children and grandchildren is limited opportunity, unlimited obligation and expectation – basically, the burden of our debts. How can we expect future generations to think as free agents, to create, to innovate, when they are born in, if you want to roll the clock back to Victorian England, a workhouse environment – saddled with debts, born as slaves to an earlier generation’s largesse. I don’t think that this is the legacy that we should be leaving, but it is the legacy that we are in the process of leaving.
And honestly, when I ponder what politicians of both parties have allowed to develop over the last 60-70 years, coinciding with Bretton Woods, coinciding with a longer stretch of time, the existence of the Fed, because we have been able to, basically, get by on a spoonful of sugar, and never take any hard medicine. I’m not frustrated – I’m angry. In our home we often wonder why God made blood-sucking creatures. We wonder about the utility of mosquitoes, the ultimate purpose of leeches. We don’t fully understand the beauty of a tick. And then we’ve got this whole mass of poli-ticks – politicians, as it were, blood-sucking creatures back in Washington, who basically do the same thing. We have sucked the future life, in terms of the debts and obligations we have created, out of America, and it is going to take a lot of work to bring it back in.
Kevin: It is interesting, people who are used to printing money, and taking other people’s money, they find different pots to reach their hand into. We talked about Social Security, and the hand has been reached into that pot. We also look at the Federal Reserve right now, who has been buying virtually all of our mortgages, all of our debts. They have been the customer that has kept the interest rates low. But Dave, I read something that really disturbs me, because if a person was worried about their bank account, they could always go into a money market fund, and that fund had a guarantee, $1 per share, and even though in the fine print they didn’t necessarily guarantee it, it was a standard that they kept to. But at this point the government is changing the rules, and it sounds to me like they are finding another forced customer for treasury bills.
David: It very well could be. There are hearings this week which will determine the fate of many money market funds in terms of how they operate. Will they be treated differently? Following the discussions this week we will know. The $1 constant value of a money market fund share is going the way of the dodo bird. That is what appears to be occurring. As much as 900 billion in the money market funds assets is expected to float and fluctuate in value. That is about 35% of the total, and again, it just means that it is not the same old cash investment of yesteryear.
Now, here is the exemption. There is an exemption for funds that are exclusively funded with treasury paper. Those will continue to operate on a $1 per share basis. We suspect that there might be two birds as the target, with policy stones being thrown. The policy is likely to increase treasury holdings in these money market mutual funds over corporate paper. Otherwise, money market fund companies are likely to see a mass migration of funds leaving them and going into banks. So treasuries may be the beneficiary from the increased purchases by money market mutual funds that want to maintain that status of $1 per share. Of course, with low rates, we suspect that leverage would have to be utilized to keep those money market funds operationally in the black. Because keep in mind, a money market mutual fund is supposed to pay you some degree of interest, but they also have to pay the expenses of operating the fund. In a zero interest rate environment, that means they are under pressure, which means leverage is one way that they can make up the difference, borrowing and creating a loan structure inside the fund to allow for profitability.
Kevin: Let’s just stop for a second and look at this. If you are a money market fund and you are told, “Look, you can go out and buy corporate bonds and earn interest that way, but your shares will fluctuate, which means the customers who need that stability are going to not even buy that money market. Or, your other choice is to do what the Federal Reserve has been doing over the last few years. It is a new form of quantitative easing, granted, in a way, because quantitative easing was printing money and buying our own debt. Now what they are saying is, “We’re going to make one rule for corporate bonds, one rule for U.S. treasuries, and we want you to start buying what the Federal Reserve has been buying. This sounds like such a scam to me, Dave. I can see, on the surface, where a money market fund fluctuating might be, actually, a good thing. Leave those things to the free market. That would force the kind of investing that would be safe.
But they are changing the rules again. The government is giving one rule for their own paper, and the corporations are going to have to compete with that.
David: I couldn’t agree more. This is echoing the conversation we had with Russell Napier a number of months ago where we talked about credit rationing and the fact that the government may ultimately choose winners and losers and if corporations are at a disadvantage here, and the treasury is at an advantage, so be it. There is also something here that I think is sort of intriguing. We have looked at the Fed balance sheet. It has grown to close to 4.5 trillion dollars and the exit out of those positions is going to be very tricky. How do they do that without creating a collapse in the bond market, rising interest rates, major inflationary impact, and probably four weeks ago we were talking about reverse repurchase agreements where the Fed takes the treasury bills that they have and they basically loan them out with a guarantee to buy them back at a set price.
It may be that by going through the SEC and having them change these rules, they are creating the perfect pocket for these reverse repo agreements, where there is a need for paper in the money markets, which can be met with the paper that is coming out of the Fed balance sheet, and if it goes straight from the treasury balance sheet, the Fed balance sheet could then shrink while not creating a mass inflation because the paper goes to a pocket; it basically goes around the marketplace and doesn’t cause a re-pricing of assets.
Kevin: That was termed sterilization by one of our past guests. You just sterilize the money, you’ve got 4 trillion new? Well, that’s fine, we’re going to sterilize it. For the person who doesn’t understand all the mechanisms of that, let’s just put it this way. It’s basically the U.S. government holding a gun to the heads of the money market fund managers, saying, you will buy these bonds.
David: Right. Conscription of capital, so to say. And this is a possibility. This is the other bird which may be taken with this particular policy stone. You may have the SEC saying, listen, we anticipate fluctuations in the value of money market funds because we anticipate fluctuations in the value of fixed income assets that are the stock and trade, the stuff that is owned by the money market mutual funds. And if we see volatility in those funds, we may find insolvency with those funds. Let’s go ahead and change the rules now so that if there is volatility in the share price, it is not going to compromise the solvency of those industry players. It may be that the SEC is acting in their own best interests, and in the industry’s best interests, with anticipated volatility on the horizon.
Kevin: David, each year you have a number of our investors in the money management side of things come out and do an annual review. It is interesting because our clients fly to Durango. It’s a beautiful place to come and stay, but they come, actually, to spend time with you, and ask you key questions about their portfolios, the economy, anything that they need to do from an eye-to-eye basis. You had one of those meetings last Thursday and Friday, and I always love to hear what the questions were, because the best questions are actually asked by people who have money in the game.
David: It was a real pleasure to see our clients here in our neck of the woods. We always enjoy seeing them when we are out and about traveling here and there around the world, but to have them in our own home space and be able to entertain them, be able to be hosts for them, is a real privilege for us; have them in the office, meet one-on-one with them, to bring them up to speed, but also in a larger setting, be able to present and ask questions. We went several hours and would share different insights into the marketplace and immediately have questions. It was very lively in terms of the conversation back and forth, and we did cover a lot of minutiae.
Things to me that are of particular relevance today: Look at the S&P today. The S&P over the last 14 years, starting in the year 2000, in terms of nominal returns, has done pretty well. It is up about 69% from the year 2000. In real terms, if you factor in just the CPI inflation, and again, it is not necessarily the best gauge of inflation, but if you want to assume that that is what everyone is using, just impute that. It is not 69% returns, it is about 21% returns. So what your average return would have been on an inflated adjusted basis being in the S&P 500, about 1.5% per year, not compounded, just annualized. 1.5% per year for this period of time, and in the same period of time, just for an apples-to-apples comparison, we started March 24, 2000, that’s when we started our data points for the S&P nominal in real returns. Gold was at $285. $1000 would have bought you 3.5 ounces, and $1000 in the S&P, yes, now it is almost $1700, but your $1000 invested in gold is still $4620, even with a decline in the metals price. A 1/3 decline off of the peak at $1920 an ounce, and you still, with no dividends paid, with no dividends paid, but keep in mind Wall Street loves to trash gold on the basis of it not having any dividends or income, without dividends or income, your $1000 is still worth $4620. Silver is in a similar parallel track.
One of the things that we like to look at is the macro trends, and what we have here is a long-term structural bull market in gold. It is not done yet. We’ve had a cyclical bear, the price has pulled back. In the same timeframe we’ve had a structural bear market in equities, and a cyclical bull, where we have a short-term uptick in price, but the long-term picture is not particularly positive. If you want to take the nominal yield on your S&P, that is, the 500 companies that are factored into the S&P, some industrials, some transports, some technologies, some financials, all of them in one big basket, 4.8% is your average nominal return, 1.5 if you are talking about an adjustment for inflation.
Kevin: And if you think about the risk that a person is taking, you’ve got to love risk, and you’ve got to love volatility, and still just be happy with a 2% real return.
David: What has us very concerned, particularly when we look at the last cyclical move higher in the S&P and the Dow, in the utilities, if you wanted to say all of the major U.S. equity indexes, what we don’t like is that we’ve seen roughly a 60-67% drop in volume as the price has continued to rise. And that is an anomaly. It really is an anomaly, because generally, a sustainable rise in any asset class is built on additional interest, not diminishing interest. So you’ve had diminishing interest in the U.S. stock market, even as prices have been going up. That’s not healthy.
Kevin: Even with the diminishing interest, Dave, you’ve pointed out, the margin debt, the few people who are participating are mainly participating with a huge degree of margin debt.
David: Right. Six months of all-time record highs, back-to-back, ending in February, from March to the present, we’ve seen a decline in margin debt, and to us, that precipitates on a 6- to 12-month basis, a major crash in the stock market. Why do we say that? Well, again, maybe this is just too backward-looking and what not to be relevant, but we hit a previous peak in the year 200 with a crash in 2001. We hit a previous peak in margin debt in 2007 with a crash in 2008. We hit a new peak in 2014, and I would suggest to you that sometime in the year 2014, or by mid-year 2015, we have a crash in the stock market. Why? You’re pulling the plug on short-term speculative funds that are in the market. Volume has been atrocious already. Again, the S&P 500, a 67% decline in volumes from what used to be the better part of 100-110 billion shares traded quarterly, and now it is about 36 billion shares on a quarterly basis. So the dynamics, the internals of the market are deteriorating even as the price goes up. That is why we are not real impressed with the price, because we don’t think that this is built on a rock, we think it’s built on sand.
Kevin: I know the clientele that come out don’t have to be told this, but I’m wondering, what did you say about gold, because each person who came out has gold, obviously, that is part of the triangle, but what was your thought when asked about gold?
David: In a nutshell, we like it. We look at the comparative returns over the last 14 years between gold and silver and the equities markets, and gold and silver have been the place to be. We think that the timeout which has occurred over the last 2-1/2 to 3 years is a fairly normal one. And we think it is a counter-trend move. The long-term trend is still up. We still see the stock market in a long-term downtrend. You might say, “Well, gosh, we went to new highs, how is that even possible?” We had the same kind of market behavior between 1968 and 1982. The stock market was in a bear market, even though it wasn’t in a 1929, 1931 style precipitous decline. We had a grind sideways with a gradual increase in inflation which took your real returns in the Dow and the S&P at that time deeply, deeply negative, and made it very painful.
In fact, the average stock market investor was eviscerated in that 1968-1982 period. Warren Buffet got out of the money management business in that timeframe. Why? Because he didn’t think there was anything to buy, and you know what? There really was no growth opportunity in that timeframe. We’ve seen the same kind of trend, where basically we’ve treaded, moved sideways. If you wanted to save 4.8%, great. If you want to adjust for inflation, we’re up 1.5% in the S&P during this kind of a timeframe. That trend gets to play itself out. If you are looking at the other side of the coin, it is the same thing that has driven gold to the levels that it is at today. We still see it going to $3500, even to $5000 an ounce, before all is said and done, and that, in our minds, is one of the critical variables driving the major, major multiplication of financial or economic footprint in the marketplace, by our clients, and by those who are looking at the world and saying, “Listen, something is not quite right.”
I don’t know if you watched the CNBC interview with Stanley Druckenmiller this last week, but he said very clearly, “I made my biggest money betting against the central bank and central bank policies.”
That’s not common, and most people don’t like doing that. It is certainly not popular, and it can be painful for a time, but I didn’t think that the laws of financial physics had changed, and somehow everyone else did. They bet with the central bank on the idea of something new, different, and innovative. You know what? Druckenmiller made a great deal of money working with George Soros with the Quantum fund, as one of the chief traders for the Quantum Fund, but they were willing to take outsized bets against central bank policy, and I think, frankly, if you look at central bank policy today, you’d have to say this isn’t particular sustainable. The guys and gals at the Fed who are saying, “There is a problem with the policies we have in place, we’d better fix them before it’s too late,” guess where they are from. They’re from the mid states, they are from the states that have a greater sensitivity to inflation. They’re from the states that have a better in-touch relationship with business-owners, fabricators of products, and not just those who are engineering financial products on the coasts. San Francisco and New York come to mind.
Kevin: Dave, up to this point, betting against the Fed, at least over the last couple of years, would have been a bad idea. The Fed, for whatever reason, has programmed this certainty in, which makes me wonder if in this paradigm shift from the dollar, paradigm shift, ultimately, in the reserve currency, but really, maybe we’re going to have a paradigm shift much sooner than that right here in this country in our own stock market. When you have certainty, we’ve talked about this before, you have panic when it changes, when people realize, “Wait a second, I was planning wrong.” You’ve got everyone running to the exit at the same time. That’s why I asked you about gold, because really, no one ever goes broke owning an ounce of gold. It goes up, it goes down, but no one in history has gone broke owning an ounce of gold.
David: I think one of the things that people often neglect is the patience to be successful as an investor. What do I mean by that? Fed policy was wrong in 2003 and 2004. They were doing the wrong thing at the wrong time, and the consequences didn’t show up until 2007 or 2008. They triggered a bubble in 2005 and 2006 and 2007, but the ultimate price to be paid for bad policy wasn’t until 3-4 years after, so if you are looking for a world of cause and effect that is instantaneous, be aware that the world doesn’t work on your timeframe, it works on its own timeframe, and so to be right on the trend is absolutely critical. Timing very tricky, admittedly, admittedly.
So the policies that we have in place today, we think are going to reap the whirlwind. Is that 2016, is that 2015, is that late 2014? What is the time delay between bubbles created, burst bubbles, and the ramifications of those bubbles as you are in mop-up operations. We already know that the Fed policy is skewed and dangerous today, just as it was in 2003 and 2004. Do we know how all the pieces are going to be scattered? No, we don’t. We don’t. But we do think that gold makes a lot of sense as a means of protecting value in the context of market volatility, in the context of what we were talking about earlier – a change in the world monetary system. These are structural changes, which, if you are not anticipating, by the time you are dealing with the ramifications of them, it’s simply too late.
We talked about a lot of things at the meeting when folks came to Durango. Income growth, contracting civilian work force, debt growth now is inadequate to support an economy in contraction. No passive income without outsized risk, looking at the 400 billion dollars which has been siphoned off from savers and households via repressed interest rates and redistributed banks. There are reasons why people are under pressure financially, and no, it is not fully indicated by the S&P 500 and the Dow trading at all-time highs. You have net worth as a percentage of disposable income. It is at levels reflective of any of the market peaks in the last 100 years.
You may say, well that’s good. It’s only good if it is sustainable, and unfortunately, what we have found in history is that markets tend to mean-revert. They tend to go back to the other extreme. If they reach the extreme on the upside they tend to then go to the extreme on the downside. So where do you want to be? We continue to think that a position in cash, a position in gold, a position in silver, a position in very short-term U.S. treasuries – these are things that do make sense, as you sort out a comeuppance in the financial markets.
