The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Yes, we have stagflation. No, there is no stable equilibrium. Yes, there are inputs into companies that are tagging the bottom line for corporations, and have been cautious in terms of business spending, which leaves us with one conclusion. Guess what? Early 2017 the markets are likely to be roiled because the only Hail Mary is fiscal policy spending, and you can’t snap your fingers and make it happen.”
– David McAlvany
Kevin: David, I’m still simmering from the Carmen Reinhart interview. I’m ruminating on all the things that she said. It was amazing to me to have somebody from, what I would call sort of behind the curtain, sort of from the ivory towers, from the Jackson Hole meetings, the meetings with central bankers and the giving of and taking advice from. This is somebody who shared with you last week what people really need to be looking forward to because these are the people who will probably make the policies.
David: So, it’s just reality. Whether you like it or not, this is the way the direction of policy-making is going. These are the kinds of things that policy makers are thinking and being advised upon, and it should come as no surprise, when there are realities which you encounter within the financial system reflective of the kinds of conversations we have been having, really for the last couple of years, but it comes into focus when it’s not you and I saying it, when it’s actually an advisor to the policy maker, who says, “Hey, this is the conversation we just had, and it’s coming down the pike.”
Kevin: I mentioned to you last night when we were talking, it used to be fun when we would call something a conspiracy and try to prove why something was happening. But when people are actually looking back and saying, “It’s not a conspiracy. This is truly the plan, and it’s for your own good,” it’s definitely worth taking note.
David: The question is, how do we respond? Is our response one of just taking it in stride and saying, “Oh, okay. Well then, I guess that’s the way it is.” Or do we look and say, “Why is it that we object to this? Is there something fundamentally missing from the equation? Something like permission granted? Something like the freedom to opt out?
Kevin: Right.
David: Things that correspond to our basic notions of political philosophy, and the role of government in our life, where we would say, actually, these are very fascinating ideas, but just so you know there are two ways to approach – of course, there are many more than two – but there are at least two ways to approach public policy choices and what makes these decisions so difficult to swallow is that they are really not consistent with anything that we hold dear in terms of our being agents in the system, making choices freely.
Kevin: Well, yes, freedom. Let’s get to that in a little while. I’d like to talk about Carmen Reinhart’s comments, and then I’d also like to look ahead to Kenneth Rogoff’s book, The Curse of Cash, because the details of what we should be looking for are both in the Reinhart interview and in The Curse of Cash. But I want to get to some of what the Federal Reserve, speaking of central bankers, have been dependent on here recently. We call it data dependence, but is it really data dependence, or is it just coming up with a number dependence?
David: Data dependence conveys that what they’re doing has rhyme and reason. The issue is, of course, is that the goalpost that they’ve used, what they’ve defined as data dependence, or the goals they have in mind, have shifted. They’ve shifted very frequently throughout the last five years, so many times that it’s almost not worth counting. And so, what does the Fed do now in this environment, where again, data dependence, they should have raised rates several years ago and they didn’t, because again, those goalposts have been moved. Now all they can do is make blanket promises. And to what effect? What is the effect of making a blanket promise?
Kevin: It creates investments in places that normally would not be invested in.
David: Right. And that’s exactly what we saw following the Mario Draghi blanket promise of “I’ll do whatever it takes.” We saw risk reflected in interest rates all of a sudden move from very high numbers over the course of three to four years, to negative numbers, in many cases, where the problem countries in Europe, the peripheral European countries, which had been called the PIIGS, using the acronym, sort of unceremoniously, these are the ones that, all of a sudden, their ten-year treasuries were yielding less than the U.S. ten-year treasury, as if they were a better credit than the United States. Again, you make a blanket promise, and as you say, what’s the effect? You have mal-investment, which is to say, a misallocation of capital toward riskier and riskier assets.
Now you look at the markets and you have to say, well, where do we go from here? The Fed is very much along for the ride, from this point forward, and arguably, they have been up to this point, as well. If the markets swoon, what are they going to do? They’ll reverse course instantly, and which led? What it the market or the Fed? Was the Fed decision-making what drove the markets, or was the market actually driving what the Fed was doing?
Kevin: I thought that was interesting last week when you asked Carmen Reinhart if possibly price stability, which is one of the Fed mandates, has moved from prices of apples, oranges, milk, that type of thing, to just stability of the market. Have you noticed how the stock market, every time it gets near 18,000, somebody steps in and says, “Oh, no, no. We don’t like 17,990, we want it above 18,000.” That’s a new form of price stability, I think.
David: That’s right, because it’s basically taking that notion of price stability into the twilight zone. It used to be that price stability meant prices of goods and services, and the stability mandate was dealing with the value of the currency as it was reflected in the price of goods and services. Now the price stability mandate has to do with asset prices, specifically, stocks and bonds. And that was clear as we talked to Carmen Reinhart last week, that somehow there has been some confusion in terms of the language, but price stability now means broad financial stability, which means controlling the prices within the financial markets. That’s a far cry from “price stability as it relates to goods and services reflected by the stability of the currency itself.”
Kevin: And, you know, price stability comes in a lot of different forms. They can actually intervene on a market and buy stocks these days, and we can talk more about that later. But literally, verbal manipulation seems to be the major way that they go about it. The Fed is meeting with the Bank of Japan this week. We’ll probably have some surprise statements coming out. One may move the market up, one may move the market down, but they seem to balance their statements to balance the market.
David: Right. And that’s what we have on the docket for this week. Fed meets, will announce a rate increase, probably of a quarter of a point. Or maybe they’ll do nothing. But the Bank of Japan will also meet, and will they promise the sun, moon, and stars, or will they acknowledge that negative rates are crushing the financial system. Some of the biggest banks in Japan, just like the biggest banks in Germany, have been crying foul. The consequence of negative interest rates is that it is stripping profitability and putting them in a very precarious place, where if they continue down this road much further, the very viability of those firms is in question.
So, you have those two meetings, the Bank of Japan and the Fed this week. Wednesday and Thursday will prove to be very interesting in terms of market dynamics. There is potential for a lot of volatility. After the meetings, what do you have next? Very little except the unannounced, or unscheduled speeches from various monetary policy makers…
Kevin: To balance perception.
David: To balance perception, and to correct the direction of a market and sort of guide it a little bit more. Look at what happened a week ago. We had the markets falling apart Friday, week before last, and that was on the discussion of higher rates. That was Friday. The market closed weak, but by the time the market was closing, there was a last-minute announcement that Lael Brainard would be speaking on Monday. One of the reasons you would do that is so that there is not panic that carries over from Friday into the Monday trading market.
Kevin: Well, they’ve trained people that if the markets go down somebody’s going to talk about something that might be dovish, what they would call dovish, that would push the market back up.
David: Right. So, Lael Brainard makes the unscheduled speech on Monday, leaves the markets with dovish insinuation, and really, talk is all they have after the 21st of this month. Here is a direct quote from Brainard’s speech last Monday. “Japan remains greatly challenged by weak growth and low inflation. Indeed, it is striking that despite active and creative monetary policies in both the euro area and Japan, inflation remains below target levels. The experiences of these economies highlight the risk of becoming trapped in a low growth, low inflation, low inflation expectations environment, and suggest that policy should be oriented toward minimizing the risk of the U.S. economy slipping back into such a situation.”
The interesting thing is, this is a person who would be more than happy to do negative interest rates, and they’re saying, “Look, what happened is, it’s not that negative interest rates are not helping Japan and Eurozone countries, it’s that they didn’t implement them fast enough and to the degree that they needed to, and that’s why they’re still suffering.” There is an inability on their part to recognize that it may be the policy, itself, which is reinforcing a negative deflationary or disinflationary trend. Again, I’m talking about a paradigmatic blindness. They cannot see what they do not want to see because it challenges the paradigm from within which they operate.
Kevin: Dave, if your whole life is a particular paradigm, it’s very hard to see outside of that paradigm. There’s job security, there are a lot of other things, you have papers that have been written for the last few decades. So you have to stick with the paradigm and make everything else fit.
David: Right. The challenges of weak growth boil down to one thing. Whether it is the U.S. economy, Japan, or Germany – the eurozone – it’s too much debt. There is too much debt in the economy and there is not enough economic activity to stay on top of, or ahead of, that mountain of debt.
Kevin: Carmen Reinhart brought up last week the debt overhang and you two both discussed the fact that now that they have allowed this debt to get as large as it is, the growth may be stalled for the next 24 years.
David: That’s right. I’m looking at a number of papers sitting here in front of me, “Anatomy of Credit Booms and Their Demise,” “Under What Circumstances Can Inflation be a Solution to Excessive National Debt: Some Lessons from History,” by Michael Bordo, one of our previous guests, “The Liquidation of Government Debt” by Carmen Reinhart. These are National Bureau of Economic Research contributors, and they point to two primary solutions, supported broadly by most academics today. Number one, you inflate away the burden of debt, or number two, you use financial repression as a means of passing the burden around. Because it is, after all, the debt, stupid. This is where Ms. Brainard would do well to say, “Look, it’s not policies new, inventive, creative that will solve this problem. It’s the foundation upon which our financial system is built, which is excessive debt, which has to be re-analyzed. This is simply unsustainable.”
Kevin: Reinhart brought up, you use both. That’s what you’re looking for. They were talking about possibly changing the inflation target from 2% to 4%, but what is that? That is to inflate away the debt while continuing negative real rates of return, and possibly even nominal rates of return.
David: The assumption is that the general public is too stupid to understand, and so they can discuss these things very openly. They don’t need to be guarded, because Monday night football trumps all, or whatever it is that keeps people distracted, where public policy matters not, entertainment matters everything.
Kevin: All right, now, you’re hitting me where it hurts, because last night I was watching Monday Night Football with the clicker set to go back to Dancing with the Stars, back to Monday Night Football, Dancing with the Stars, Monday Night Football. But I was reading Ken Rogoff’s book, The Curse of Cash.
David: That’s right. Well, sometime in October we expect a visit with Ken, and you may wonder, why do we have these conversations if, in essence, we’re not learning anything new? Well, here it is. I may have formed opinions, and I may have begun discussing some of these ideas like financial repression, two, even three years ago, with our clients. But at that time the ideas were sort of locked away in the ivory tower. So, sure, reading through countless academic papers, it was just as clear then as it is now what the options for central planners would be, and that those options were narrowing, that they would either have to inflate away the burden of debt, or re-distribute the costs of debt quietly throughout the economy using regulation, using rate policies. And these are the only courses the world’s central bankers had available to them that were politically viable. There are other things that they can do, but these are the most politically viable.
Kevin: Dave, at those times you were coming to your own conclusions, not based on what they were saying, but what you could see as a natural outcome of their policies. Now, can you believe the candor? They’re just coming right out, bold-faced, and saying, and I’m going to use Carmen Reinhart’s word, “We’re going to need to find an opaque way to pick your pocket.”
David: Right, so what’s novel is the candor and openness on these topics, now expressed by the advisors to policy-makers. It’s important that you hear it from the horse’s mouth.
Kevin: Right.
David: The Fed is trapped. The central banking community is desperate, and they are in hopes of a miracle. But in case that miracle does not arrive, they’re going to do what they can to keep a game face on and say, “Well, here’s exactly what we need to do in the context of the next crisis.” Central bankers do have options. Yes, they do have options. What are those options? Well, to a large degree, it’s socializing the negative costs associated with economic re-balancing.
Kevin: It’s on your back, Dave. That’s what it means.
David: That’s right, we’re going to take over indebtedness of the system, again, which Lael Brainard would say, “Debt’s not the problem, we just have to figure out the right policy to deal with our current environment.” Well, it is the debt, stupid!
Kevin: I want to roll back the time just a little bit, here. Let’s go back to Princeton back in the early 2000s. You have a paper that is being released by a guy I had never heard of, Ben Bernanke, and he’s talking about helicopter cash, and he’s also talking about how we can avoid the next depression. Now, little did I know, he wasn’t just talking about something he was interested in, but I think he had a future event in mind, a future position, possibly, at the Federal Reserve. Do you think Rogoff is gunning for some sort of position, himself?
David: It certainly seems that way to me. If you look at most of the papers and most of the books that he has ever published, they are co-authored pieces. He is a major contributor, of course, but so are the other co-authors. The Curse of Cash, there is no other name on that cover but his, and I think he is basically saying, “In the context of the next crisis, I will be the policy implementer. I will be, not only the Grand Master Chess Champion who wins privately, but I’m going to win publicly for everyone. And by the way, this is not just a policy advertisement, this is a personal advertisement. Ken Rogoff is for hire for Treasury Secretary.”
Kevin: So, let’s look at this, possibly, because just reading his book, he brilliantly writes about something that I, personally, don’t care much for seeing happen, which is the elimination of cash, which Carmen Reinhart brought up last week as a way of creating a captive audience. Speaking of captive and captured, you passed over something that I think people may not know. Ken Rogoff is one of those few people in the entire world alive right now that is called a GM, a Grand Master. I don’t know how many there are, but there are thousands of Masters, but there are only hundreds of Grand Masters.
David: Maybe 150 alive in any given decade (laughs). Don’t trifle with his brain, it’s a good one.
Kevin: Right.
David: What is this again? We’re talking about economic rebalancing, we’re talking about paying the price of having too much debt in the system. And we’re talking about there being an involuntary assignment, that is, payment by other people that had no connection with the debt being accumulated in the first place. They are now being asked to take some of the burden, themselves. Again, we come back to this issue of surprising candor, there is openness that suggests that some are seeking official positions in the new administration and they want to publicize not only their ideas, but themselves as the correct implementers, and it is Rogoff’s dream of a cashless society which is, in his mind, noble. What is it, in reality? Maybe it is noble. Maybe we’re wrong in picking it to pieces, but to us, it seems to be the conjuring of a priest, that doesn’t realize how deeply involved he is in the dark arts.
And what are those dark arts? They are otherwise known as the dismal science. Everyone acknowledges that economics is a dark science. But if you go back to our conversation with Tomas Sedlacek, who was the economic advisor to Vaclav Havel, another very bright man – by the way, he attained that position under Havel at the age of 23. He was way too smart for his britches at a very young age, but that was all after communism fell in Czechoslovakia. What he said was that central bankers are the high priests of a religion that promises perpetual growth, that that is not actually natural or normal – you cannot accept perpetual growth as a state of nature, and to try to perpetuate it means that you bring in outside things that may ultimately be harmful to the system.
Kevin: I was thinking about this the other day, Dave. The Reinhart/Rogoff book in 2009 called This Time Is Different actually outlines eight centuries of the creation of debt, and then the passing of that debt, basically the default on that debt, over those eight centuries. Without exception, the governments go into debt. They then somehow default. Like Carmen said, it can be reworking the terms, or it can be an outright default, like we saw with all the countries that were in Europe in 1934, on America. Now, with that being said, these systems really are designed for future theft. That’s what debt is. If you go into debt, or let’s say you borrow money from me with the understanding that you will default on that debt, that’s the same thing as theft.
David: I’m taking your money today with the awareness that it’s not all going to be paid back (laughs). It’s certainly not fair dealings.
Kevin: This has become policy. After these studies they said, “Well, this is how we’re going to do it next. We’re going to default on this debt. Now, the default will be done in a way, in this case financial repression, higher inflation, lower interest rates. Over time, that inflation eats away at that debt and it just supposedly goes away through correct management.
David: Or lower nominal rates altogether. So Ken, as an academic, operates from within the paradigm that accepts this. The Ph.D. management of the economy allows for perpetual growth. That’s the paradigm. That’s the world he lives in. And he is amongst the growing cadre of neo-Keynesians that borrow from Knut Wicksell, the Swedish economist, a very legitimate idea, the idea of the natural rate of interest. But then there is this presumption that is brought in, much more than Wicksell ever did. It’s a presumption, both of their abilities as market tinkerers, as well as, I think there is some presumption in terms of the market’s reaction to their tinkering. But it’s based on believing that Ph.D.s can redefine the natural rate of interest, and thus engineer growth in the economy.
Kevin: I think we have to look at how a person thinks, Dave. I’m a musician, so I think a certain way. I play trumpet, I like jazz, classical. One of your traits is to think in legacy. You reverse engineer everything. You look at how you’re going to be as a gray-haired old man and you say, “What can I do today to get to that point?” That’s a way of thinking.
Now, think about Rogoff for a second. This is not a criticism. But chess is a very, very unique game. When you study game theory in its different incarnations, there are games that can have unexpected inputs. A backgammon player is going to be able to handle surprise, even though there is an element of strategy, there is an element of chance in it. Chess has none of that. You have to close the system. You have 64 squares. The pieces can only move a certain way. You have absolutely no surprise, unexpected events. And isn’t it interesting that this is a man who is saying, “If we close the system, if we make cash unavailable to people, we’ll just get these equations right.”
David: But this is what I’m getting at. There is a presumption that there is only a set number of moves that we can make, or that if we consider ourselves the opponent in the match, that there are only a few outcomes that are in front of us. Choose A, choose B, choose C. And I would say, well, life is not chess, and that would be representing the fallacy of false alternative. We don’t have A, B and C, we have A through Z, in terms of the choices ahead of us. So you and I think of interest rate disequilibrium when we look at rates at zero or below. That’s what we see. We think, “Gosh, if you take rates below a natural level,” which to us would represent risk and credit appraisal, right?
Kevin: Well, and we might march with our money.
David: And so you lower that and we would say, “This is not normal.” That’s not so with the priesthood. The priesthood sees a mathematical equation that unlocks perpetual growth. So, to an engineering mind, it’s like the perpetual motion machine. To the chemist, it’s like the promise of turning dirt into gold through some new alchemy. But there is something missing in the equation. What is one key variable left out of the economist’s “elegant equation?”
Kevin: You have humans and they do not act rationally.
David: Right. So, if you boiled it down to human action, you would say, “If monetary policy becomes coercive, and requires a captive audience, within a contained financial order to thereby be implemented, they’ve neglected a variable rooted in our nature as people. Call it a penchant for freedom. But coercion sets in motion a very different mood amongst individuals.
Kevin: To them it may be a variable. To me, it’s a constant. I love freedom. To you, it’s a constant. And so, the only way you can take away that constant, or subdue that constant, is to create force, or coercion, or some sort of penalty that would force me to play ball.
David: It’s a central planner saying, “What you consider to be a constant, I consider to be negotiable. It doesn’t have to be there.” So let’s call us the economic agents. We’re the economic agents. To be at the receiving end of a coercive monetary policy may very well alter our behavior in unforeseen ways. You cannot assume that individuals will act normally, or do more of what is considered normal or desirable, when you create an environment of financial duress. And that is exactly what coercion is.
Kevin: Let’s just look at a story from back in the 1700s. Lavoisier, who is the discoverer and measurer of oxygen. A great chemist. If you look him upon on Wikipedia, most of what you will see is his brilliant mind in chemistry, but he also, just like Rogoff plays chess and has economic policy, Lavoisier proposed a wall around Paris so that no one could come out or go in without some sort of tariff or tax.
David: That’s right. So, if you’re going to import goods into the city limits of Paris you have to pay the tax.
Kevin: He ultimately lost his head when France – you were talking about how behavior changes when freedom is taken away – part of his behavior, as far as trying to create captive audiences cost him his head, and it actually cost science about 100 years of new discovery because he was a brilliant man.
David: Right. I think this is what ends up being dangerous. This is by no means threatening, it’s just a reality. When you begin to corner people and say, you only have options A or B, if they are not in their best interests, if they feel that their survival or well-being is challenged by the limited options you have provided, you may find that they force option C. And if they have to go through you to get to option C, that’s Lavoisier. The wall fell apart. The Revolution destroyed what was a nice, closed system of massive taxation. This was a 27 kilometer wall around Paris. Do you know the expense that they went to, to capture the tax franchise, to make sure that they had a solid means of taxing individuals as they came and went?
Kevin: And once the people rebelled, anyone – anyone – that was considered elite – there was no one above losing their head on the guillotine.
David: Right. So the problem is, you can lose a lot in terms of academic talent when there is a revolution of that kind. Carmen noted last week that the key to operating the dark arts of neo-Wicksellian Keynesianism, which is what we’re talking about when we’re talking about redefining the natural rate – it’s a combination of Keynesian demand management, on the one hand, and Wicksellian redefining the natural rate management. That’s what they’re blending. How do you do that? How do you operate in those dark arts? Opacity. If you’re going to pick someone’s pocket you cannot let them know you’re doing it. Again, consider the genuineness of her concerns. Yes, she is an academic. Yes, she is in the ivory tower. And yes, she is calling a spade a spade. And I really respect that.
Kevin: She sounded concerned to me. She may be within the walls talking about these policies, but I think she understands them and is concerned.
David: My guess is that she probably is thinking more about the future, more about her son, her retirement, than she is the next political appointed position.
Kevin: Yes, you’re right. I was listening to her thinking, “What is it that drives her? What drove her to do that massive amount of research for the 2009 book with Ken Rogoff?” And really, I think what drives her is, her fascination with debt overhangs. These debt overhangs are always created, and then always transferred.
David: Yes, she wrote a paper – this is one we did not mention last week, but this was back in 2011 – The Liquidation of Government Debt. It was also something that she used as a presentation for the Bank of International Settlements, June of that year. It’s a fascinating study. In a period of debt overhangs, that is, when a country has too much debt, which we discussed last week, relief comes in a number of forms. The two that are targeted now, negative rates, like high rates of inflation, it reshuffles the debtor deck, and it disburses the costs of debt across a much broader audience. You heard this notion discussed a long time ago from our friend in Edinburgh, Russell Napier. Again, it’s a question of choosing the winners and choosing the losers. We’re in the phase where winners and losers are being sorted, they are being designated, and for you to hear this from me you’ve probably heard it too many times, and quite frankly, who cares?
But for you to understand that our analysis reflects the real world, like it or not, and that real world is being shaped by policy advisors and policymakers, you need to hear from someone other than me that you should – and I’m going to quote Carmen – “Never underestimate the government’s ability to create a captive audience.” Never underestimate the government’s ability to create a captive audience. For those who are not tuning in, it reminds me of Buffet’s comment on playing cards. Do you remember when he said “If you can’t figure out who the patsy is at the card table, it’s probably you.”
Kevin: (laughs) It is me.
David: So what is our preference? Our preference is that you, as a listener, avoid the patsy status, that you avoid being financially corralled into assets that will separate you from your hard-earned money. That’s it.
Kevin: I’m going to roll back, also, to something that Carmen said. I mentioned the 24 years of slow growth. With this debt overhang, debt creates slow growth over time because you have stolen from the future. I’m thinking about some of the things that are in the news right now where you all these tankers that are just floating and not able to deliver goods. Imports into Southern California ports are in free-fall at this point.
David: This is the time of year when major product shipments are made from Asia, China specifically, but from Asia, and they come over to the United States.
Kevin: Gearing up for the holiday.
David: Gearing up for the holiday selling season. So retailers are bringing in the goods at this time of year for holiday buying, and you have imports into Southern California ports which have declined this last month by 4.3%. You have L.A., which is actually up about 1%. Long Beach is down 10%. I don’t know if you’ve ever been through the Long Beach port, but it’s huge.
Kevin: Massive.
David: It’s huge. So, at the same time, you couple that with restaurant traffic, which is also falling, what it communicates to me is that the consumer is cautious, and retailers who are running their businesses are looking at foot traffic and saying, “We need to be cautious, too.” So, back to the food chains, you have massive discounting with the food chains, promotions with free food to bring in customers. Those promotions accounted for 25% of all sales into fast food restaurants this last quarter. It just tells you that in order to get people to even show up you have to create an incentive. We’ve talked about central banks creating incentives, carrots and sticks. Retailers have to do the same thing. What happens? What is the consequence? Fourth quarter earnings reflect the fact that they’ve had to basically give it away, margins have been squeezed, and earnings are ugly because of this. Do we expect retailers to suffer in the third and fourth quarter? Actually, we do.
Kevin: Okay, but let’s say you’re a policy-maker. Let’s say that you’re with the Federal Reserve and you see these numbers and you see that things are falling. There are some equations that are going to tell you that you can stimulate that economy. Forbes brought out something that I thought was interesting. You talk often about the early German hyperinflation from 1920 to roughly 1922-1923. It was the intellectuals back then that said, “You know, we can beat this thing just by printing money.”
David: That’s right. There wasn’t enough economic activity, and they said, “Well, that’s because there is not enough money in the system. But if we put more money into the system, if we were to create liquidity, that would improve wages, that would improve economic activity.”
Kevin: And it worked.
David: And it did work, very well.
Kevin: It worked initially.
David: It worked too well. So, in the 1920s the hyperinflation, Forbes recollected in their most recent issue that the professors could not recognize the ill-conceived policies until it was too late. And the system blew up. Then the elegant solutions that had been proposed were intellectually tarred and feathered as absurdities. But from within their paradigm the professors could not conceive of what might go wrong. Does that have echoes of history into today? I think so.
Kevin: Carmen actually touched on that just briefly, if you remember. She said that the trick is going to be to not let that inflation get too high.
David: That’s right. The challenge for a central banker is always looking at two horses. The one horse is a dead horse, and that’s the deflation horse, and it’s difficult to get that horse back up and trotting, right? It doesn’t matter how much you beat it, a dead horse is a dead horse. The other horse is a stallion, which they assume can be reined in. So they fear inflation less than they do deflation because inflation is a stallion to be tamed, and they recognize that they’re skilled at taming virtually anything, whereas it takes something of a necromancer to raise the dead, and they’re not claiming to be quite into those dark arts.
Kevin: In economics there are so many moving parts, because if you have a slowdown in growth, you may have a slowdown in buying from other partner countries, like Mexico, or what have you.
David: Sure. So not only are imports declining into the Southern California ports, but you look at the ancillary data. The Mexican peso has dropped to an all-time low. Think about that. The Mexican peso has dropped to an all-time low. They are a primary U.S. trade partner. And of course, their currency is going to be impacted somewhat by lower oil prices. But we are not currently at the low end of the range, nor have we been at the low end of the range for oil for some time.
Kevin: So, what you’re saying is, Mexico’s peso has dropped because our buying from them has dropped.
David: We’re buying less, their economy is not as strong. Their currency is weaker consequently. The Canadian dollar is weak, as well. I met with a precious metals mining CEO this past week, and we discussed, specifically, the declining Canadian dollar as a very positive factor in Canadian miner performance in the present. It’s like adding 25% to the gold price.
Kevin: Because their employees are paying for everything, it brings it out of the ground in cheaper currency.
David: That’s right. Labor costs are in loonies. Just like for the miners who are down in Mexico. They’re paying their labor in the cheapest currency, vis-à-vis the dollar, you have the Mexican peso which has tanked. Those expenses are very, very inexpensive relative to the gold price at $1300. It increases their profitability considerably.
Kevin: Is this a reason why Ford is moving one of their plants down to Mexico at this time?
David: No. Ford is announcing that they’re moving all of their small car manufacturing to Mexico.
Kevin: All of it?
David: All of their small car manufacturing. And I’m sure we’ll have comments from Trump on that. I’m also sure that Ford is making political contributions which are predominantly DNC-centric.
Kevin: Dave, without being political, which is really hard to do this time of year, I just want to hear the numbers, because you said Trump might have something to say about that. Honestly, it’s horrible, to me, to see Ford moving all of the small car production down to Mexico, but on the other side of the equation, it’s also horrible to see Ford go out of business because they can’t sell cars. Businesses have to do what they’re going to do. Now, Trump has made some statements that when he becomes president, if he becomes president, he may not be able to carry out. But let’s say you’re China, and you’re looking at a possible Trump win. Let’s say you’re Mexico, and you’re looking at a possible Trump win. What should we look at economically, from a global participation standpoint, or global trade standpoint?
David: I’m reading a fantastic biography on Alexander Hamilton. I’m about halfway through. And one of his suggestions – he was about 30 years old when he was sort of trying to fix the world, and do it more or less according to a British paradigm. He had a lot of respect for the Bank of England and a number of the things that were obviously more centralized and less dispersed through the states.
Kevin: You would probably have interviewed him on the Commentary, had we had it at the time.
David: I would have enjoyed that conversation. I feel like I’m having one with him right now, in fact. But 5% is what he wanted to see as a tariff on all imports. And 5% may be tolerable. Trump is suggesting anywhere from 15-45% tariffs on imported Chinese goods, and if there is anything that has the ring of Smoot-Hawley and the protective tariffs that we saw back in the 1930s, we may make America great, we may make America greatly poor, if we implement those kinds of policies.
Consider this. This is not only an international relations gaff, but in an interconnected global economy where we’re throwing on 45% tariffs on imported Chinese goods means that the Chinese GDP basically goes to the slaughterhouse. Kevin Lai at Hong Kong’s Daiwa Capital Markets has done the numbers, and a 45$ tariff on the goods that are imported from China into the United States would cost Chinese GDP 4.82%. In other words, close to a 5% markdown in their total economic activity, gross domestic product. And I can tell you, that is beyond catastrophic. If it’s not 45%, the tariffs from Trump, but it’s 15%, then you’ve got a hit of 1.8%. Minus 1.8% of Chinese GDP would be cut, and you have to know, that is not something that inspires kindness and gentleness on the part of the Chinese. That kind of economic pressure experienced domestically is going to find expression internationally, and I don’t think we’re going to like what we find.
Kevin: I have to think sometimes things are said for political reasons because people just don’t understand, and then things are done quite differently when the person takes office. I was talking to Senator Kent Lambert, who we have had on this program. He had a meeting with Trump’s economic advisor, who is very libertarian in his thinking, and non-tariff in his thinking, so I have to wonder what actually will happen if Trump actually takes the White House. I would imagine a lot of the strong things that he is saying right now are probably going to have to be softened up as they run the numbers.
David: It reminds me of what Cicero said: “You can’t hold me accountable for what I said yesterday. So much has changed since then.”
Kevin: Right. “I’m a free agent,” is what he said (laughs).
David: That’s right, that’s right.
Kevin: Well, Dave, talking about Trump possibly changing his mind once he gets into office, if he does, red tape seems to be one of the things that really slows businesses down. Republicans and Democrats, both, a lot of times create red tape. But Trump being a businessman, he has said that he would cut red tape, and right now businesses seem to need it.
David: You just look at things differently if you have some operating experience in the world of business. You look at healthcare costs, you talk to anyone who owns a business, and since Obamacare has come on board – last year up 20%, the next year up 60% – healthcare costs are ratcheting higher and higher and higher, and that’s a significant burden that many business owners say is pressuring their business viability. So there is that aspect. That’s just an illustration of, you bring somebody on who has some business experience, who has actually made a payroll payment, and there is a different perspective that is brought.
The world is different. Different countries operate differently, and there are ideas of the way things should be. You try to start a business in India and it will take you years to cut through the red tape. There are other places where it’s a matter of days to get a business license, and boom – you’re up and running and going, and you’re good to go. We still have one of the more free places in the world to start a business, with relatively limited red tape. But what is interesting, I was reading an article from Business Insider, and it suggested this: The number of new businesses in the U.S. is collapsing. And it’s a bit of an issue, and I don’t know what really is causing the collapse in new business startups. I don’t know if that’s a demographic issue. I don’t know if it’s a perspective issue, people coming out of college today are less risk-prone. I really don’t know how to wrap my mind around it.
Kevin: But most activity seems to be in mergers and acquisitions, not really creating something new.
David: There is not a lot of new creation. There is a lot of gobbling up. Mergers and acquisitions, you’re right, 30,000 a year is what we’re averaging these days. In the 1990s, it was about 11,500 a year. And so, bigger firms continue to get bigger and bigger and bigger. And that’s true whether you’re talking about manufacturing or banking, or what have you. Top five in banking, in the year 2000 they had 25% market share, and today the top five banks have 45% market share. This period where Dodd-Frank was supposed to address too-big-too-fail, it’s actually doing quite the opposite. And here we are coming up against a deadline with money market funds and a mass exodus thanks to Dodd-Frank. Guess who is actually being hurt, not helped, by this action?
Kevin: It’s the businesses.
David: Banks and corporations, which says to me that Dodd-Frank was just ill-conceived from the get-go. There is 700 billion dollars which has come out of money market funds since January of 2015 – 700 billion – and it’s expected that another 200-300 billion is going to hit the exits before October 14th. And this is money market funds that were investing in commercial paper and certificates of deposit, that is, bank CDs. So the short-term funding needs of banks, and the short-term funding needs of corporate America, are being cut off. And who is the beneficiary? The beneficiary, when you count the 700 billion that has already left, and the 200-300 billion that is likely to come, this is an extra trillion dollars.
Kevin: It’s the monopoly treasury department.
David: It’s going straight into treasuries because there is an extra benefit, and extra measure of safety. And again, that recalls last week’s discussion with Carmen Reinhart. Corralling investors into certain assets classes – it’s done by carrot, it’s done by stick, in this case, it’s a blend. But you now have this audience of treasury buyers, and what has happened here? Macroprudential rules – that is what the Dodd-Frank legislation is called – macroprudential rules – they are creating a world in which money is fleeing one asset class, going to another, and again, it’s by design. To me, it’s a little bit eerie.
Sorry, that was tangential on the money market funds. My real point was that Trump may cut through a lot of red tape, and Trump may introduce a risk-taking entrepreneurial environment, which is very healthy for the U.S. economy. That’s about all I can say that would be positive from a Trump administration. That is kind of obvious given his CV because, quite frankly, he doesn’t have experience doing anything else, except getting things done in the world of business. So maybe, just maybe, he could create an environment where that’s possible. And economic growth, from that standpoint, is intriguing.
Kevin: I think people have to weigh the issues very carefully because you look at the way the establishment people are leaning. Establishment is leaning, whether you’re Democrat or Republican, over on the Hilary side. This morning George Bush Senior announced that he will be voting…
David: Voting for Hillary.
Kevin: For Hillary. Well, of course, he’ll be voting for Hillary.
David: Did he, really?
Kevin: He really did.
David: I was joking. You’re kidding me.
Kevin: No, I’m not kidding. Because there is an establishment that really doesn’t want to see things shaken up, and Trump scares them. Now, again, I’m not campaigning for either side.
David: No, but that’s what my dad would say. My dad would say, “Look, I’m interested in Trump because he’s not the establishment, not because of anything else. I’m not saying that he’s a good person, I’m not saying that he’s a Christian, I’m not saying that he is talented or he is the best man for the job. We’re already proven that we’ve put on the table two people who are not qualified for the job, but between the two, who is anti-establishment? Who is not establishment? It’s Trump.”
Kevin: He’s scaring the status quo.
David: (laughs)
Kevin: And I’m thinking also of Greenspan. Look at what Greenspan said just recently.
David: (laughs) It’s fascinating. What do we have ahead of us? Greenspan says we have stagflation, no stable equilibrium, rising Social Security and healthcare costs which are crowding out private investment, which means corporations can’t spend their cash because they expect to see their budgets go up in areas that they are not able to control.
Kevin: Yes, but he still says he fears the crazies might take over.
David: “I fear the crazies. I fear the crazies taking over.” And I’m, frankly, not sure who he is talking about. He was around under the Clinton Administration and things were not exactly sane. But he could mean Hillary’s Deplorables, as well (laughs). I don’t know. Listen, when Greenspan reflects and says, “We have stagflation,” do you know what he said? He said, number one, inflation rates are higher than you expect, higher than they’re being reported. And number two, growth rates in the economy are lower than being reported. “We have staglation.” That is very significant.
Love him, hate him. Remember his idealistic days, remember his more pragmatic days. However, you think of Alan Greenspan, I think he’s hitting the nail on the head. Yes, we have staglation. No, there is no stable equilibrium. Yes, there are inputs into companies that are tagging the bottom line for corporations, and have them cautious in terms of business spending, which leaves us with one conclusion. Yes, we have to see more fiscal spending if we’re going to see the economy not go into freefall, and that’s a politically contentious idea, which means, guess what? Early 2017, the markets are likely to be roiled. Roiled. Because the only Hail Mary is fiscal policy spending, and you can’t snap your fingers and make it happen.
Kevin: Well, it’s going to happen on either side, too. It’s going to be either Republican or Democrat. Whoever you vote for, there will be fiscal spending.
David: That’s right. Maybe you heard it here first. If Hilary is elected, six months into her term, guess who the Treasury Secretary is? Who is appointed?
Kevin: You wouldn’t be thinking of Ken Rogoff, would you?
David: Anything’s possible. The Curse of Cash is maybe just the beginning of a brave new world. Just a walk down memory lane, this month 87 years ago the stock market reached a level that it would not return to, that it would not see for 25 years. After posting record highs on September 3rd the market became very volatile. It registered valuation levels that were suggestive of low future returns, which is a polite way of saying that if you had overpaid for something in the late 1920s, you were going to take your lumps, you were going to take some big ones, over an extended period of time. And it was over a month later than the market had its October crash.
Kevin: But there were the detractors. There was somebody out there at that time that was crying foul, and he was saying, “Watch out.”
David: Babson, among others, but Babson was a budding economist of the day, and this would have been in stark contrast to Irving Fisher, who would have said, “Look, now is the time to back up the truck, you want to own stocks. He was recommending stocks up until – up until – Black, Monday.
Kevin: Isn’t is amazing that when you talk to central bankers, they almost always quote Irving Fisher as the guru.
David: But Babson, who a college is named after back on the east coast, had said for two years that there were bubble dynamics that were brewing, and that ultimately the market was going to burst. And then in early September he really narrowed his focused and he came out and said, “Sooner or later, a crash is coming, and it may be terrific.” I think those are words that echo with relevance into the present day.
Kevin: What about buy and hold, Dave? What about buy and hold, you’re always going to make money if you just hold it long enough?
David: Well, that’s kind of Jeremy Siegel’s notion, that you buy stocks for the long grind and hold them, and ultimately they outperform. And ultimately, we’re all dead, too, so ultimately, I’m not sure that it matters. But if you live long enough to see a recovery…
Kevin: Well, how long did it take the last time?
David: That’s what I was getting at, 25 years is a long time to go from buying an over-priced asset to seeing it just get back to break even.
Kevin: And that’s how long it took – 25 years from 1929 – to get back to break even.
David: That’s right, about 1954. So, 87 years later, reflecting on the market turmoil of the Great Depression, in this environment, two assets make a lot of sense – cash and gold. And if you give me a break, a decline in the market, a significant decline in the market, and lower valuations in equities, considerably lower, then there are all kinds of assets which would be compelling again. Until that time being, I think the sidelines is advisable. If you have the skills, as a portfolio manager, to hedge risk in your portfolio, that’s fine. Otherwise, being in the market today, if you’re not actively hedging those risks, it’s like putting snakes in the sandbox and then letting the kids go play. Sometimes it’s better that you just don’t play.
