The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“There is always a first. This time could be different. We live in a brave new world where people are doing brave new math and they are coming to brave new conclusions about something old world called cause and effect, and essentially, we are able at this point to say, ‘There is no such thing as cause and effect because we have magic paper, and magic paper operates different than normal paper.’”
– David McAlvany
Kevin: We had a lot of quantitative easing in this country over the last few years, but that has transferred over to Europe at this point. I just read a report, Dave, that Germans are buying 20% more gold than they were last year. There seems to be a rush on gold, at least in the area of Germany.
David: There is an understanding that the more credit you create, the more liquidity you create, ultimately, the more inflation you create. Or at least, that is the concern. And to some, that still seems like a reasonable proposition. If you are diluting the purchasing power of a given currency you can expect things like gold, oil, real estate, fine art, to be going up in price, not of their own merits, necessarily, but just to reflect the devaluation of the currency. I think, certainly, that Germans are sensitive to that, and you look at what the ECB is doing. They are one of the larger interveners in the marketplace today, followed by the Bank of Japan.
Kevin: And it is not always an immediate effect, is it? A lot of times money is created en masse – I’m thinking about Germany back in the early 1920s. A lot of money was created before it actually turned into a hyperinflationary event.
David: I think probably the difference between the United States – and perhaps we can visit about this later – and Europe, is that the liquidity created here never did make its way into the economy. And we see a very different set of behaviors over in Europe where various national central banks do, or do not, pay interest on excess reserves held at the central bank. So, it will be interesting to see if, in fact, the domino effect of credit creation and liquidity creation isn’t a lot faster in terms of inflation creation to follow.
Kevin: So, what you are referring to is the interest here in America that the Federal Reserve pays on excess reserves that are held by banks. There is really not a motivation for that money to come into the economy if you are getting free, no-risk interest just by leaving it in reserve at the Fed.
David: For a bank, the equation is simple. You are getting an overnight rate that reflects, basically, a year’s worth of interest. So, there is really no competition to have liquidity, to have instant accessibility to that money, and be getting an above-market return. Even though it is paltry, and in real terms, may even be negative, it still beats sitting in other forms of short-term fixed-income instruments, given that the Fed has created a zero-interest rate policy.
Kevin: It’s nice to actually see, every once in a while, a central banker that is transparent. Now, Draghi is not always transparent, but this week he did make the comment that quantitative easing is a dangerous thing to play with.
David: (laughs) It’s funny you say that because in a moment of transparency, and I think this might have been the only moment of transparency he has had for years or decades, and certainly coming over from Goldman, and now running the ECB, we will have to see what hedge fund he settles with, see if he follows in the footsteps of Ben Bernanke. Will he end up working for Ray Dalio, or something like that, at some point in the future? Actually, I think Ray has got far too much integrity to hire someone the likes of Mario Draghi.
But Draghi, this last week, is making the obvious observation that quantitative easing in Europe, just like quantitative easing in the United States, as a policy, has a similar effect on both sides of the pond, and that is to increase the value of some assets. Draghi says, and I quote, “Very low rates for a prolonged period might penalize savers to the benefit of debtors.” And I will come back to this quote in just a minute, but I think even that, in and of itself, reiterates something that we have had as a theme for a long time here on the commentary, which is that this isn’t necessarily fair shakes for the common guy, the man in the street.
And the idea that quantitative easing is geared toward creating economic growth, I think you are talking about economic growth in a very thin slice. And maybe it is economic growth within the financial spheres, but clearly – and he is acknowledging this – very low rates for a prolonged period of time might penalize savers to the benefit of debtors. He goes on to say, “Or that easing prices as a consequence of our purchases might benefit the wealthy disproportionately, and thereby increase inequality.
Kevin: Well, the rich get richer, and the retired get completely poor because they cannot make interest. That is repression.
David: Yes, and then he adds that inflation under-shooting, that is, kind of what they have today in Europe, which is a rate of inflation well below their target – he says that “Inflation under-shooting, therefore, results in redistribution from younger to older households.” And then he cautions, “Too prolonged a period of very low real rates can have undesirable consequences in the context of aging societies.”
And I think to myself, I’m pretty sure we’ve said that for about five, six years now, that it is a disproportionate benefit to the rich, it is ultimately of detriment to the middle class, those living on a fixed income, those who are savers and expect some form of interest compensation on their deposits, but it is nice to hear it echoed, again, sort of in a moment of transparency.
Kevin: And it forces the older person who really should not be taking risks into far more risk. What if you were a pension fund manager right now, Dave, and you had to try to pay for a large former workforce of retirees, and you had to do that with no interest rates, virtually?
David: That is, of course, of consequence. When you lower rates as low as they are, you add strain to pension plans that are trying to match their expected outflows with the cash generated from investments. And it is very nearly impossible in a low-rate environment to get those things to match up. Again, the cash outflow for those receiving the benefit, and the inflow from either current contributions, which have to be increased in the event that interest income or returns on the investments are not sufficient. So the question, if low rates make fixed income less attractive for insurance companies and pension funds, how do you compensate for the gap that it can create?
And these are the unfortunate choices I would describe. You are going to push out your duration. In other words, you are going to buy longer-dated paper. Instead of it maturing in one year, or three years or five years, you might be forced to buy 10, 15, or 20-year paper in order to get the higher rate of interest that you need.
Kevin: Which also makes you very, very vulnerable to any volatility in the interest rate market. Any move to further your maturity out in interest is going to affect the principle.
David: And we talked about the Mexican government being able to finance 100-year bonds, at about 4% I think was the number, 4 and change, 4½, 4 percent, something like that. I think it got up to 5.2%, or something like that at its highest rate. But think about that. Who buys 100-year Mexican bonds? And I am not being mean or anything, but it really is your pension fund manager who is just saying, “Hey, listen, we need to have something in the portfolio that yields 4% or better, and that is a government-issued paper.”
Of course that ignores various other risks like the frequency with which the Mexican government has defaulted on paper in the last 100 years, which is above average. Not that we expect anything catastrophic, and maybe the current government improves the prospects, but the one thing we do know from history is that the current government is not the future government. You are not going to have a young man introducing reforms into Mexico 30 years from now because either he won’t be the young man that he was, or he will be long gone.
Kevin: Let’s face it. If the maturity of the bond also came with the Fiesta party for the maturity, you aren’t thinking the party is actually probably going to happen. Don’t plan, right?
David: (laughs) Exactly. I am imagining the benefit to being in Mexican bonds being some sort of a piñata. So, compromise on the quality of credit is clearly the second choice for the pension fund manager or the insurance company that is trying to match up, again, outflows and liabilities, with their current assets.
Kevin: So the portfolio becomes more junk, basically. It may not be junk bonds but it moves toward that direction.
David: Exactly, because the lower the quality of credit the higher the interest rate paid and that is another way of solving that problem. Probably the last way of solving that problem is to shift a higher allocation toward equities or toward alternative assets, and alternative assets may be private equity, it may be hedge funds, it may be alternative assets such as timber, gold, what have you, where it is outside of the norm, and for most investment managers they would say, “Okay, we are willing to give up liquidity, in the case of, say, private equity, or what have you, for higher rates of return.” This is sort of the Yale endowment model, which is, again, “We are willing to take our hands off the money for a longer period of time in order to get a larger rate of return.
Kevin: Any way you look at it, though, those three options increase the risk in the portfolio for people who really, at this point in their lives, don’t want much risk in the portfolio.
David: Well, that is the other side of the equation. It is one thing to look at risk and reward and keep a balance of that in mind, but when you are forced to make the money work and get the income that you need, sometimes the need overrides the reality in the marketplace of taking more risk to get what you need. And at the end of the day the market is not going to treat you well in any sort of price reversal. As people recognize that there is more risk in those higher-risk assets, guess what? There is higher volatility and higher risk of loss. So, I think it is a curious and unfortunate choice that you have to either, on the one hand, accept a funding deficit, or become a purchaser of risk assets, with the increase of volatility in the portfolio, and accepting a new normal as a yo-yo effect, if you will.
If you are thinking in terms of asking someone who is living on a fixed income, let’s say, who is 75-80 years old, to increase their risk, that raises issues, at least if you are the FCC or FINRA, of suitability, and suitability is definitely something that the market has left behind in order to make it work. And what do I mean by make it work? Again, if you live in a zero interest rate environment you are going to have to create some sort of a patch. In a zero interest rate environment for people who need interest, to make it work means you have to compromise integrity somewhere, and I am not talking about moral integrity, I am talking about the integrity of the product in question, either less liquidity, lower credit quality, etc.
Kevin: Just this week Financial Times said in regard to the quantitative easing in Europe, “A ‘comfortable retirement’ for millions of European citizens is now at risk.”
David: That is because the pension system is going to have this mismatch between the interest rates they need and the cash outflowing. While we are on the issue of Europe, I am routinely annoyed by the news media’s decline in, let’s call it, reporting quality, while running almost in a parallel track, but moving in the opposite direction, quantity of conjecture. So, you have a decline in reporting quality and an increase in conjecture, and I read this Bloomberg article this week and it just drove me batty, suggesting that the rise in rates in Europe is because the eurozone is not in as bad a shape as forecast and deflation isn’t likely. Again, it is like plug and play. Somebody has to say something, or maybe this is the new technology where articles are written by a computer, and you don’t have to add much thought to it.
Kevin: It is interesting; interest rates are a measure of risk. And so if interest rates rise, to say that, “Well, that means that Europe is not in as bad of shape as we thought,” is a contradiction, Dave.
David: Well, it is to ignore all of the facts that remain. It is to ignore the lack of structural reform, and it is to presume that a minor rise in interest rates is telling you more than it actually is.
Kevin: It reminds me of what Walmart has come out and said. Their shares are off over 7%, and they are blaming the strength of the U.S. dollar. You have considered Walmart a real bellwether of the economy.
David: And I suppose if a quarter of your earnings come from overseas then there is some effect from a strong dollar, but I think the bigger issue is that the quarterly report for Walmart runs in a perfect track with retail sales. Not only have we had disappointing retail sales month after month, but then for Walmart – which yes, I do view as a retail bellwether – to miss on weaker revenues and weaker sales, it, to me, is just confirmation that the consumer here in the United States is absent. Yes, they probably did take a hit for the currency but I think they are trying to sweep more under the carpet and they have a very reasonable excuse. This is a timeframe when they can say, “Hey, look, everyone is losing money because of a stronger dollar.” But I think there is actually more to the story, and the retail sales figure tells you that.
Kevin: Talking about more to the story, we have talked so many times about how numbers are adjusted by the government, but the government can do it. Walmart can’t adjust the numbers quite as well. If they are down 7% they are down 7%. But the Bureau of Labor Statistics – if you have been watching gas prices – gas prices are much lower than they were a year, two, three years ago, but they have been rising, yet the BLS, or should I say the BS, has continued to show prices dropping. Is that just to manage the overall number?
David: Precisely. Their gasoline prices, statistically, they made them go down 4.7% for the month of April, and yet we have, in the last several weeks of the month, a rise of 19 cents, and you have, on a $2.20 or $2.30 basis, a decent rise in percentage terms, and yet they call that a decline by almost 5%. Over the same period, stretch it back a little bit to late January, we are up 55 cents a gallon, and it is almost like a scene from the Wizard of Oz. “Pay no attention to the man behind the curtain.” And I think of Oz because stranger things only happen in Oz, where you can create a reality and make people believe it. This is a place where up is down and down is up, and I think that is probably going to be the epitaph of this particular period in market history, at least as it relates to the engineering of economic statistics.
Kevin: Probably one of the key indicators, the most important indicator to, say, politicians, is gross domestic product – how much the economy is growing, as a whole, and strangely enough, the White House is now involved in maybe changing the way that is counted.
David: Yes, we mentioned a few weeks ago that Japan accepted a negative deflator, which is to say the component which calculates inflation in their gross domestic product, the measure of their economy, and is supposed to factor out inflation as a contribution to economic growth. By making it negative they essentially goosed their GDP statistics. It is not a problem just across the pond in Asia, it is our problem, too, and rising inflation drops GDP growth. And we can’t let that happen.
As you mentioned, the White House is now pressuring for a new measure of GDP. This is very much like 1987, for those of you who are interested in a historical analogy, the switch in 1987 took us from measuring GNP, Gross National Product, to GDP, Gross Domestic Product, and now there is the strong suggestion from the President’s economic advisors to blend GDI and GDP, Gross Domestic Income, and GDP. Again, it gins up the number, and in a period where GDP is weak, which it has been, in fact, the first quarter was weaker than expected, and I don’t know that we are going to see much of a change there for the year. Looking at the Atlanta Fed’s real time numbers for GDP, they continue to move lower. The point here is that the President all of a sudden is paying attention to the number and is saying, “Isn’t there something you can do to help us? The economy kind of stinks but we would like to keep the Democrats in office as we transition a couple of years from now.”
The economy matters, and it stinks, and this is what our friend Bill King reflects on. He says, “The fact that the White House is involved in the development of a new GDP metric that will show far more economic strength than GDP, which is already configured to show more economic strength than warranted, should alarm the populace. It also clearly demonstrates that the White House is concerned about the economy, and feels the need to spin the economy to the masses and street shills. The street will welcome the new metrics because it will aid and abet its quest to fleece the gullible and the ignorant.” End quote from Bill King.
Kevin: Bill King has been a great alarm-sounder. Continually, he will go back and look at the numbers and say, “Hey, you guys are being lied to.” I think it is interesting that every time they make a change, Dave, if it comes from government statistics, it is always to make a glass that has virtually nothing in it look better than half full. It is always geared toward making things look better.
David: They are right to be concerned at this juncture. We have had industrial production which has declined five months in a row, and by the way, it’s not snowing anymore, so that excuse of winter weather and that slowing growth doesn’t explain the current several months of decline in industrial production. And quite frankly, we have the majority of economic figures coming in well below expectations, with industrial production, retail sales, as we mentioned earlier, suggesting the recession may, in fact, already be here. So, we have import prices we have PPI, we have the empire stats – they are all lower.
If you wanted to say there is a bright spot on the dial, maybe it is nonfarm payrolls, but that is only as long as you don’t dig too deep in the numbers. As we have discussed before, we have seasonal adjustments, birth/death modeling, part-time versus full-time, where the part-time is growing and the full-time is shrinking. And again, it ties well into this idea of industrial production and manufacturing because manufacturing jobs continue to slip while restaurant and bar jobs are moving up.
So, to go from $50 an hour with benefits to $3 an hour and tips, the government is going to say, “Hey, employment is improving.” But I think the economic reality is quite different, and that is where, again, getting into the details, there is a reason why the White House is concerned, because they have to keep their game face on and basically say, “It’s never been better,” knowing full well, for many in the country, it has never been worse.
Kevin: I think about the stock market. You talked about getting into the details. Most people just look at the screen and say, “Oh, the Dow Jones Industrial Average is up today.” But there are other averages to watch. When you talk about the economy possibly being in recession, think about the Dow transports for a while, and the divergence between the industrials and the transports.
David: Jack Schannep writes this in the dowtheory.com, which follows closely as Richard Russell’s Dow Theory Letters. He has been writing since the 1950s and I still enjoy reading him on occasion. But this idea of divergence between the industrials and the transports is telling us something. And this is what Jack pointed out in his research piece, which is that two-thirds of the time when you have the industrial average moving up and the transportation average moving down, two-thirds of the time these divergences lead to very insignificant, less than 10% declines. But a third of the time these divergences lead to declines of greater than 25%.
David: On the Dow Jones Industrial Average.
Kevin: Yes, pretty consistently there is a hiccup and the real question is – is it a little hiccup, or is it a big hiccup?
David: So, to be hit by 25%, for the math curious, that is a tad below 14,000 – 13,700, 13,800, on the Dow, and that is a bit of a sting, particularly for those who are freshly off the bench, off the sidelines, and just back in the game.
Kevin: Another thing that you have brought up numerous times is just how much these companies that we are talking about in these averages are buying back their own shares. That is where the majority of their money is going. It is not in plant and equipment and new expansion, it is just going back in and buying their own shares.
David: We live in an age of trillions, not only single-digit trillions which is a thousand billion, but tens of trillions and 100s of trillions. Global debt is now close to 200 trillion dollars and our unfunded liabilities in the United States, just the unfunded portion, is about 100 trillion, which does not factor into that number. I guess I mention this because we are lost in the trillions and billions and millions, and when it comes to share buybacks, numbers, in nominal terms, really sometimes don’t even matter. It’s like, on yeah, so they have spent X billions of dollars in share buybacks. Well, buybacks and dividends are running better than last year’s pace. I’m just retranslating for you, instead of nominal figures, think of it in percentage terms. 95% of all corporate profits are going to these two categories: Dividends and share buybacks.
And if you think about being an investor in a publicly traded company, you are not investing for the now, you are investing for the future. You want to know how this company is going to grow. You want to know what their competitive advantage is. You want to know what leadership is going to do to expand their market share. You want to know who they are tomorrow, and there is some relevance in terms of who they are today, but only insofar as it is trajectory setting.
So consider this. If 95% of all corporate profits are being spent on dividends and buybacks, what about investing in the future? If investors are looking ahead, you just need to know that the corporate class does not have your back, because they are not looking ahead. They are looking to the here and now only, and share buybacks and dividends basically short-circuit their ability to grow the business in the future.
And it sends a very clear signal to me, which is, there are not very many places where we think we are going to be able to capture growth. Maybe, just maybe, there is a merger coming up, or an acquisition, that might add to some growth, but we really don’t see how we are going to grow in this environment. And I think, quite frankly, companies are trapped in this and are doing what they are doing in response to a zero interest rate policy – in response to a zero interest rate policy. So, you could say that bad behavior amongst corporate executives and corporate CFOs, in terms of how they are spending their cash balances, is indirectly related to Fed monetary policy.
Kevin: Dave, it may seem like we sound skeptical all the time, but there are so many things that are being monkeyed with right now, we really have to be skeptical. I think back last week, we were looking at a report, you were analyzing a report that a very famous investment money manager had put out saying that the risks were really overrated and there really wasn’t much risk in the market. But right after that show aired, our show last week, we had one of our listeners email us and say, “Hey, I lost 40% with that guy back in 2008.” So, I think it is important to understand…
David: By contrast, you have Ray Dalio, who manages about 75 times the amount of money as that other manager we were talking about, the largest hedge fund manager in the world, 150 billion dollars, and here recently, and I think this is worth thinking about, a hedge fund manager who is certainly positive in some regards, and skeptical in others, says this. “If you don’t own gold, there is no sensible reason, other than you don’t know history, or you don’t know the economics of it.”
Kevin: And this is the largest hedge fund manager in the world, Ray Dalio.
David: Yes. You recall the conversation I had with Neil Cavuto on Fox earlier this week. The topic of conversation was, “Why would Bank of America – why would Michael Hartnett – be talking about owning cash and gold? Is this the beginning of the end? Is this the beginning of the apocalypse?” And if you listen to the interview, I basically said, “No, this is a reasonable behavior when you have the stock market trading at the second most expensive it has been in all of financial history.” Somebody out there has their head screwed on straight and is going to take a little money off the table and keep it in cash.
And by the way, if you don’t like what the Fed has done long-term, and you are not sure about the success of their current monetary experiment, maybe you hedge your bets sitting in cash and have some gold ounces right alongside it, so you maintain liquidity in both instances, you have the prudent bet that says, “I shouldn’t have everything in the stock market at all-time highs.” On the other hand you say, “I don’t necessarily trust Janet Yellen and the econometricians at the Fed to get it right while they are going about this new monetary experiment.”
Kevin: Yes, but it is an uncomfortable conversation because what they are doing is, they are saying, “Maybe things are too high,” and nobody likes to be uncomfortable. Most people want to hear the narrative that they are wanting to believe. I think about it – if you see facts that you don’t really like, one of the easiest ways for us, as humans, to dismiss it, is to give it a name. And so, they will call it, “Oh, it’s Armageddon,” or “apocalyptic,” or “it’s doom and gloom.” Well, somehow, some way, that relieves the responsibility of looking at the numbers anymore because it is the doom and gloomers who are looking at them.
David: Right. Bloomberg carried two articles dealing with the topics we covered several weeks ago on Tobin’s Q and on the Shiller PE, and the articles reasonably point out, we are at the outer edge. We have actually only been further than this position in terms of over-valuation once, and that was the year 2000. We have now exceeded 1929, as well, so we are stuck between 1929 and 2000 valuations. But that doesn’t mean that it can’t go higher, and there are always caveats and explanations for why we shouldn’t be bearish. Just understand that we aren’t exactly cheap anymore.” Well, not exactly cheap – that is euphemistic for saying, “Folks, we are really stinking expensive.”
Kevin: Bringing up the year 2000. Do you remember back in the year 2000, CEOs, the people who ran the corporations, were making, on average, 525 times more than the rest of the workers in their company, and it is starting to creep back up to that again, isn’t it?
David: Exactly, and I don’t think we will ever see those numbers. Frankly, I don’t think we will ever see the levels of over-valuation that we had in the year 2000. That was something of a historical anomaly, and I don’t think it will ever be repeated. But you are right, 525 times was the executive’s compensation compared to the rank and file worker and it is indicative of market excess. Historically, we have only pressed the outer limits of executive compensation near market peaks. So, the current CEO is making 373 times the rank and file worker. The outside number is 525, high water mark probably never to be seen again. Let’s say 400 times is about the max you are going to see. It is just little tidbits that would suggest, “Yes, we have gone farther than we probably will for some time.”
Kevin: Dave, on all of these statistics, it seems like the very rich get very much richer, and the poor get very much poorer, and I think about quantitative easing. We had the taper on quantitative easing and it ended, supposedly, I mean there are other loose monetary policies, but it ended in October. Now, we are seeing – we talked about this earlier in the program – quantitative easing being introduced pretty radically in Europe at this point. But quantitative easing ended in October, and we expanded the monetary base faster and larger than any time in history, and yet we are still talking about weakness in the economy.
David: Yes, it is interesting. In our conversation we have kind of adopted the idea that what the Fed is experimenting with is the infinite sponge theory where essentially they can soak up as much onto their balance sheet as is theoretically possible.
Kevin: Four trillion bucks. What is four trillion amongst friends?
David: Could be 10 trillion amongst friends. Arguably, if the Fed is buying treasuries, and then sending back or remitting profits at the end of the year to the Treasury, it is erasing the burden of debt because the interest payments, again, are going right back to treasuries, so you can count that out in terms of the total debt numbers. There are many ways to creatively say, “Well, the debt just doesn’t exist.” But the debt does exist, and the debt does have to be paid back, and if you will recall, it was originally postulated that monetization of this kind would free up liquidity in the banking sector, and as these banks got rid of illiquid assets and had liquidity again to deal with, that they would increase lending, and thus we would see a pickup in economic activity.
Kevin: Yet, that has not occurred. Do you think maybe at this point they are coming up with different types of excuses as to why, or are they happy or satisfied with the quantitative easing?
David: No, I think that is exactly what is happening. They are reshuffling, and before the ink is dry on this period of history, they are already rewriting history. Nearly seven years after the idea was launched, the Fed has had to reshuffle the justification of quantitative easing, this massive program of buying assets with credit created out of nothing, because the liquidity created did not get into the economy as anticipated. So, with each successive round of QE, the possible admission, which they could have done at any time, that the scheme was failing was ignored in favor of the classic central bank coping mechanism. And this reminds me of something that happens in our family. You have heard the phrase, “If a little is good, a lot is better?” Well, that is the way my dad feels about vitamin C. If a little is good, a lot is better. He might take 40,000 mg of vitamin C.
Kevin: That creates a lot of loose policy, but it is a different kind of loose policy, isn’t it?
David: What the central banks do, on the other hand is – well, see, he uses buffered vitamin C.
Kevin: Oh.
David: There is a vast difference between buffered – and quite frankly, that is what the Fed has tried to do here. They have tried to “sterilize” the impact of increasing their balance sheet so dramatically. So, if a little good is no good to the Fed, then a lot more is better, and I guess that is the difference between the McAlvanys and the central bankers of the world. If a little is good, a lot is better for us. If a little is no good for them, then a lot more is better.
Kevin: We interviewed Andrew Huszar a little over a year ago, who had come out and apologized in the Wall Street Journal to the American public for his role in that first round of quantitative easing, that first 1.2 trillion dollars. He was not of a belief that if a little is no good, a lot more is better. He had told them ahead of time that this was not to be a long-term thing, and he stepped away from it, to his credit.
David: Apparently, the Fed has forgotten that official statistics are designed to tell a story. Now, when they judge whether an increase in credit is tied to inflation or not, they simply set aside the changed inflation statistics which have morphed over time, and deliberately understated the number. Now, they believe that increasing credit is not inflationary because the inflation gauges from about 1985 to the present show the opposite. Do you see the problem there? You change the way you measure the number, and you change it to decrease the value, and then you come back and say, “Based on the value that we have, low level of inflation, we don’t see that there is any connection between money-printing and monetary policy.”
And so, in sort of a backward-looking way they are trying to say that the quantity theory of money is bunk. We are learning and applying a new Keynesianism. We’re destroying the monetarist assumption that inflation is always and everywhere a monetary problem. And we are basically saying, “There is no monetary problem, there is no inflation problem, and they have forgotten, in fact, that they have butchered the inflation statistic before they even started doing the re-measuring.
Kevin: Well, it is obvious that anyone at the Federal Reserve doesn’t do any grocery shopping because if since 1985 prices really haven’t risen, and they have been dropping, and no matter what their monetary expansion is it is creating a stable, maybe even deflationary effect, they have not purchased anything since 1985.
David: There is an excellent paper written by the Peterson Institute for International Economics, Quantity Theory of Money Redux: Will Inflation Be the Legacy of Quantitative Easing? And the argument is basically that quantitative easing, the massive creation of liquidity is, in itself, not inflationary at all. And it even makes this point in the paper, even though you see credit creation in other parts of the world leading to inflation, that is not the case in the United States, and our statistics prove it.
And I am thinking to myself, “If the rest of the world is counting inflation as a consequence of money-printing and liquidity creation – credit creation – and yet our numbers show something different, is it possible that there is something wrong with our numbers? Or are we just so exceptional as a country, are we just so special? Do you see what I am saying? This is where there is a disconnect. At some point our foreign creditors will look and say, “It’s artistry. Not just sophistry, not just rhetoric, but what they have done in the statistics department – it is an art form.”
Kevin: You called it an excellent paper, and I read the paper, as well. I am wondering if you are calling it excellent from their point of view, or excellent from your point of view, Dave, because I think it made you angry.
David: It is interesting to me that not only can history be rewritten very quickly after it has occurred, you generally should wait a generation or two before you start writing history just to see how it settles out and to make sure that self-interest isn’t coloring the picture too much.
Kevin: Well, and then make sure that when you write a paper like this, just like in this paper, you put in quite a few equations just to show that whoever wrote the paper knows what they are talking about.
David: Yes. Now, it’s interesting. They put a tremendous amount of faith in the new-fangled equations like the DSGE, the Dynamic Stochastic General Equilibrium model, which is sort of the new Keynesian Phillips curve, including the Taylor rule for monetary policy.
Kevin: In other words, just trust us.
David: Just trust us. That is exactly right. The whole purpose of the – say it again – Dynamic Stochastic General Equilibrium model is for you to say – What? Well, they have Ph.D.’s and they know what they are talking about. Clearly there has been no impact from the expansion of the monetary base, nor will there be into the future because these guys are just that good.
Kevin: Dave, do we ever, in the history of the world, have an occasion where a fiat currency, the expansion of the monetary base and the fiat currency does not turn into the devaluation of the currency? Do we have a single example of deflation occurring to a paper currency in the long run?
David: No, but there is always a first. This time could be different.
Kevin: Which formula is it that made this time different? It’s a dynamic what?
David: (laughs) It’s a long one – Dynamic Stochastic General Equilibrium model. Again, we live in a brave new world, where people are doing brave new math, and they are coming to brave new conclusions about something old world called cause and effect, and essentially we are able at this point to say, there is no such thing as cause and effect because we have magic paper, and magic paper operates different than normal paper.
Kevin: What you need to do then is stop teaching your kids that money does not grow on trees, because it does grow on trees. Could this actually, though, Dave, just be an excuse for the largest power grab in history? Let’s face it. We are now completely at the mercy of the next word that Janet Yellen says. The markets are manipulated, call it what you want, but we are at the mercy of central bankers at this point.
David: 2008 did represent a significant shift from financial market control of pricing to central bank control of pricing, and that is a power grab. I think the idea that they would unwind their balance sheet as one of the most important tools in determining, not only the present circumstance, but perhaps the future outcomes in terms of their success or lack thereof is naïve. I don’t think they are going to give up control, and so the idea that Bernanke several years ago could have suggested an exit strategy – it would have been not only an exit strategy from policies put in place, but from a new role as the powerful elite.
We have talked about the Fed as being rock stars in terms of popularity, but they are actually more than rock stars. They are seeing themselves as wearing a gilded crown. And they are not about to hand back the keys to the kingdom. They rather fancy the fact that Wall Street needs to know what they are going to do next. And they rather fancy the fact that the White House needs to know what they are going to do next. And whatever happens next is going to depend on what they do, on the way they stir their tea, on what they eat for breakfast.
As we mentioned before, this is why Stanley Druckenmiller basically said, “I’m out. I can’t manage – nobody wants to manage money in an environment where you are not dealing with reality, but where you are dealing with the verbal construct of a few econometric specialists.” That is dangerous. That is very dangerous. We want one thing and this is what we are nostalgic for, and that is, markets being in control of prices, instead of being centrally controlled. When does that happen? How does that happen? It happens when there is a loss of face and a loss of confidence because what was proposed as being perfect ends up being anything but.
Kevin: So, in many ways, we can feel either helpless because we are captured by a system where there has been this large power grab, or we can move outside of the system, to a degree. We can at least move to cash. We can move to gold which, really, it doesn’t matter whether the system works or doesn’t, whether there is deflation or inflation. It really reminds me of the quote that you read earlier from Ray Dalio.
David: Kevin, it also harkens back to one of my favorite dinners the last several years. I remember sitting at one of Danny Meyers’ restaurants in New York City, Gramercy Tavern, and sitting with a good friend of mine, an oil trader, and a good friend of his, who professionally spent his entire life trading bonds, developed a bond-trading company and sold it for oodles and oodles and oodles of dollars. And we talked about why he would sell something that was such a good business for him and he said, “It’s unreal.” In other words, we are living in an unreality, and I don’t trust it. I know bonds, I know interest rates, I know pricing, I know credit, and I don’t know what is happening here that is rational in any way.
And so we talked about gold. We talked about gold being a rational move for the investor who looks and says, “This isn’t making sense, it’s not adding up.” No one is playing by the rules because they feel they don’t have to. Essentially, like gravity being suspended, the rules of nature being suspended, that, in essence, is what Fed policy has done. I think going back to that quote by Ray Dalio, “Yes, if you don’t own gold, there is no sensible reason other than you don’t know history, or you don’t know the economics of it.
