The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“I prefer the tensions that exist with freedom of choice. I prefer the possibility of people moving on and choosing what they consider to be in their best interest. The transition from debtism to statism is very clear. It is where we are, it is where we are going. We, as individuals, need to choose how we respond to that very carefully, very perspicaciously.”
– David McAlvany
* * *
Kevin: As everyone knows, you do a lot of traveling, Dave. You have spoken at many conferences, we have numerous conferences throughout the year. You are just getting back from a conference with the Hayek group, but I want to talk about something in particular. Last year when you had your conference in Austin, Texas you met Governor Greg Abbott. When you were talking to him, he is a fascinating guy, wheelchair bound, very inspiring, but when he found out what you did and that you were involved with gold, he was very interested, and the last couple of days he wasn’t just playing politics, was he, Dave? He actually put his money where his mouth is with gold.
David: That’s right. It is House Bill 483, which he signed just this week, and what it does is, it calls for the billion dollars in gold which the state of Texas owns to be sent to Texas from the New York Federal Reserve. They want it in their possession and they want to be able to count their ounces.
Kevin: So, it is not just Holland, it is not just Germany, it is not just Austria, Venezuela, it is now Texas that is starting to say, “You know, I think we’ll take our gold in delivery, thank you very much.”
David: And a part of the bill made very clear that this gold, nor any gold of the citizens of Texas could be confiscated by the federal government. It was just an interesting insertion into it. Late last night I’m reading through the entire bill, over 20 pages of it, and I am reading this and thinking, “This is bold. It is very bold, but it makes sense. If you don’t want your gold rehypothecated, if you want to know that it has not been leased out, then just take possession of it. It’s very, very simple, and he has done that.” I wasn’t sure when I met him if he was being emotionally and relationally generous as some politicians are, glad-handing with a warm smile and taking an interest in whatever the person is interested in that you happen to be talking to at the time, but no, he really is interested in gold, he really is interested in the fiscal solvency of the state that he is working for.
Kevin: Dave, don’t you love it when a politician is genuine? There are so many people from the strata of life that can be genuine and actually doing what they believe. You told a story this morning to the group here when we had a staff meeting. You were walking through the Denver airport as you were coming or going to the Hayek group discussion, and there was a shoeshine person who offered a shoeshine to you and I would love you to tell the story because it has life wrapped up in it.
David: I reached into my pocket and realized that all I had was credit cards, and living in a cashless society, apparently (laughs), I looked up at this lady I said, “I’m afraid all I have is credit cards. I don’t think that is going to work for you, is it?” And she looked down at my shoes and she could tell they were in need of being polished and she said, “It works just fine, you need a shoeshine. Get onto that seat.” And I said, “I can buy you lunch, I would be happy to…” And she said, “No, no, no. You just – I’ll take care of it.”
Kevin: She did it for free because she doesn’t take credit cards.
David: And I thought, you know, here is Collette in the Denver airport, doing what she does best. This is what she takes pride in, and she does a great job. Actually, I’ve never had a pair of shoes look better. And the intrinsic reward that she had from just being helpful, I think, was remarkable to me in a world where everyone is driven by extrinsic reward, where everyone is benchmarking success and expecting X, Y, and Z, out of a relationship and out of a person. It was gratuitous, it was generous, it was kind. It left a lasting impression. I have to be honest, I don’t know that I have ever thought long and hard about anyone who has shined my shoes before, and perhaps I should, but Collette left a lasting impression. In her mid to late 60s, from France, and with a lot of life in her eyes, seeing that her story runs deep, some of it glorious, beautiful, and some of it tragic, too. And here she is shining my shoes and I can’t pay her at that moment, and she is happy to do it. Again, I just wonder about a world that is driven by extrinsic reward only, because here is a woman who exemplified for me a deep level of satisfaction in what she did, regardless of what she got for it. I don’t know what else to say.
Kevin: And you were encouraging the guys and gals here at the office, because we all want to be driven to fill a need because there is a need, not to earn money. You have to earn money to live, but that shouldn’t be our driving goal. I am going to shift to the economy here because that is obviously what we talk about often, but I am looking at the actions of the Federal Reserve. I am looking at this unhealthy relationship between Wall Street, the Federal Reserve in Washington, and how there is a very small fraction of the people who are becoming extraordinarily wealthy, but the rest of the people right now are wondering why it is that they can’t meet the end of the month with savings.
David: Well, certainly, when you are dealing with the world and a business and financial environment with a zero cost to money, things begin to behave very differently, very differently. There are those who benefit from there being a zero cost to money, and there are others who suffer from it. And actually, there is some confusion about that point, and as I traveled to Reno last week there was an article in the Wall Street Journal which stood out. It was written by a former McAlvany Weekly Commentary guest, Benn Stiel. Of course, his real claim to fame is working and writing for the CFR. I hear from him several times a month, read him regularly. The article was from the Wall Street Journal, rehashing something that he has been chewing on for a while. The FOMC committee of twelve, the Federal Open Markets Committee, with their much anticipated votes – of course they are meeting again this week, their deliberations – they are no longer the seat of power when it comes to raising rates.
Kevin: They are not really making the decision, are they? There are just a handful of people and almost all of those are leaning toward leaving rates low.
David: His argument, in a nutshell, is that if you look at the interest paid on reserves, that is, excess reserves that depository institutions held at the Fed, that number and the interest that is paid is more important to the rise in rates than anything that the FOMC does, and there is a group of five, the Board of Governors, that makes the decision what will or will not be paid on those excess reserves. Most of those on the Board of Governors are dovish, and therefore unlikely to raise rates anytime soon. And this is important because the market believes that the signal comes from the more balanced group of doves and hawks on the FOMC, the larger group of people, rather than the Board of Governors. So, you have Powell, Brainard, Tarullo, Fischer, Yellen, and four of these members here in the last ten days have been discussing the merits of waiting well into 2016. So, you have the crowd who says, “Oh, no, we will see a raise in rates this September.” Maybe, maybe not, but make sure you are looking at the actual decision-makers as opposed to the puppets in the Kabuki theater.
Kevin: We are getting a mixed message. We both get The Economist magazine and this week’s cover, the June 13th to 19th cover says, “Watch out. The world is not ready for the next recession.” And it shows a picture of a guy walking from one slain dragon into the mouth of another slain dragon and yet, what is interesting is, we are being told we can’t raise rates. Why is that?
David: One of the main articles in this week’s Economist argues that we have every reason to accept the recovery story.
Kevin: I love that they call it the recovery story.
David: Yes, and with good evidence stacking up in favor of it, so against any kind of economic slump on the horizon, we don’t see that. That’s not how the evidence stacks up. It is pro-growth, it is, the economy has recovered, look at the markets, but as they end the piece, it is very interesting, because I felt like 2½ pages was cheerleading for, “Listen, you can’t question the evidence, here it is.” As they close the piece they say, “But let’s keep interest rates on the floor a little bit longer.” And the reasons?
Kevin: Just in case.
David: And it is this: The poor and the middle class need a boost from lower rates. That was how they concluded the article. “The poor and the middle class need a boost from lower rates because they are still in what is known as a balance sheet recession. They don’t have assets that are appreciating, they have debt that is still burdening them, they don’t have sufficient income to make payments on it, therefore we need to keep interest rates low enough to help the poor and the middle class.” Honestly, at times I think to myself, “Either the world is going mad, or I am.” Because right here, there is a true disconnect between the Fed’s actions and the real world consequences of those actions with the obvious dots left to hang detached. How this escapes the purview of economists and writers I don’t know, but the free money line, this is a very, very short line, and the only people in the free money line are the ones who are privileged enough to buy their place in it.
Kevin: I think it is important to understand, too, whenever someone prints money, you cannot create value out of thin air. You can create paper money, and ultimately, the more paper money you create, the less valuable it is. That is just an axiom of nature. But the thing is, it is a form of theft, because for the person who does not get the free money, they are losing, they are not gaining.
David: Right. You have the stimulus created by a zero-rate policy, which flows through to the owners of assets, so here is a multi-trillion dollar boost to the U.S. equity market, the real estate market, the art market, which has had an obvious benefit to some households, but has not relieved the middle class of a sustained balance sheet recession where there is too much debt, too little income, and it is driving households to the point of frustration or even desperation. This article is arguing, “Hey, everything’s fine. We’re good. Two thumbs up. Let’s go. Full systems ahead. But we should probably keep the life support, this regular feed of zero interest rates going a little bit longer because, well, we still want to help the little guy.”
Again, you are boosting the value of assets. That is fine as long as you are the asset owner. But if not, I think you need to be careful. Fed policy is what is, in fact, setting the stage for class warfare. We have seen a number of periods in history where you have two economies existing side by side with massive disparities and what appears to be injustice, and unjust weights and measures. And in fact, that is the cause. It is more than appearance. The world of fiat currencies is fueling the financialization of the economy and it is shifting in emphasis from entrepreneurial wealth creation to currency recycling, investment trading and gambling, where again, you have two separate worlds, the real economy and the financialized economy.
Kevin: I look at societies that get to that class warfare and it becomes revolutionary. It can change the system completely. Look at Czarist Russia, the time of Nicholas II. They were so disconnected, Dave, from the actual strains of the people that it led to a revolution. Unfortunately, it led to communism, and just really had the makings of destroying an entire people that led to tens of millions of deaths over the last century. And really, it boils down to these two economies running side by side until it no longer worked.
David: The French had a common practice. After each meal they would take their extraordinarily expensive dinner sets and throw them out the window, and allow them to crash below because, “We could.” Because the money was no object. And that was the era that saw heads roll. That was the era where the excess was told on the street corners and in the alleyways, and those people were resented, they were hated. They ultimately were vilified to the point where extraordinarily terrible things happened to them in the name of justice, and I understand that that is a perversion of justice, but sociologically, these problems emerge when you don’t handle your money well. And that is, in fact, what we are doing. We are seeing the mishandling of money open up the door to major social dislocation.
Kevin: And we are being told – the same people who are throwing the dishes out the window, so to speak, are the same people who actually report to us what Consumer Price Index is, and how life really is not that much tougher than it was going back to the year 2000. They say, “Judging from the CPI, cost of living has only really increased about 5% since the year 2000.” That is the report.
David: According to George Gilder with the CPI, again, you are right – 5% is the decline in income for the average family since the year 2000 to present if you factor in the normal CPI. What George does is he comes along and references what can be called the Walmart CPI. This is inclusive of the costs that represent a family’s typical consumption needs. According to a Walmart CPI, which doesn’t cut out a lot of the things that American families do, in fact, spend money on, incomes since the year 2000 are down by 17% in the same period.
Kevin: That is more realistic.
David: So again, here you have the two-tier income strata where incomes have never been higher amongst the billionaire class, and incomes are getting lower and lower amongst the lower middle class and the poor in our country. This is not a bleeding heart argument for how to solve injustice, it is just to point out the fact that the injustice is there but it is not there for the reasons that are touted. You have Elizabeth Warren and Hilary Clinton, and they can pretend that it is the hedge fund traders to blame for the wide gap between the rich and the poor.
Kevin: This is actually right after they throw the dishes out the window, right?
David: Right, exactly. But when you look at the causal chain you have financial operators who are simply reaping what the Fed has sewn. And so with a zero cost to money, quite frankly, you would be crazy not to get as much of it as possible and gamble with it while the game goes on. And this, I think, is part of the disconnect. I don’t think you should blame human nature for playing by the rules and getting rich in the process, but you can keep a criticism firmly in place and blame the rule-makers for naively thinking that they can not only govern the economy but more specifically, control human nature and choice via monetary policy. And by the way, there are massive consequences to that, and again, this is the disparity between rich and poor. They are not willing to connect those dots.
Kevin: One of the reasons households are not spending is because they are insecure. They are coming to the end of the month and saying, “You know what? We may not make it next month.” And so when the government says, “What we need to do is drive spending.” Well, spending what?
David: Inflation has an interesting way of playing on our insecurities because it is not something that we fully grasp. You can’t see it in real time but you do feel it at the end of the month or the end of the year, where you feel, and you know, that you have had to make adjustments to your finances and your spending habits because the money is not going quite as far. So yes, households are saving now out of a basic level of insecurity, while on the other hand, the one-tenth of one percent in our economy continue to reap the biggest payday ever as the markets have become something of a casino, and why wouldn’t they put more money into those casino-like markets when the odds have been improved, right? And I think one of the things that we will find is that this is actually wrecking capital formation and stymieing entrepreneurship. Next week we are going to migrate our conversation toward an old equation. MV equals PT.
Kevin: Yes, when you look at it on paper, MV equals PT is one of the most beautifully simple equations. And we are drawn to simplicity. This is Milton Friedman’s famous equation that, really, has been used over the last 30 years or so.
David: You are basically looking at money supply times velocity.
Kevin: And prices times transactions.
David: Exactly, which is basically the economy. So money and velocity equals the economic results on the other side of the equation.
Kevin: Right. And you are going to talk about it next week, but I think it is important to note that any time you have an equation that you want to adjust one area of, you do need to have a constant, something that you can count on, in the other part of the equation, or else it becomes meaningless.
David: Right, and so the central planners have failed to move the economic needle, and a part of that is because they have used M, or the money supply, and focused on what they can do to increase or decrease the money supply to stimulate aggregate demand. That is what they are trying to do is influence M, and they have assumed that V, velocity, is fairly constant. Now, in light of a failed attempt to influence the money supply and thus goose the economy higher, they are shifting their focus to velocity. In recent weeks, we just passed the D-Day remembrance where – I guess if you want to think of it rhetorically – “V is for Victory.” Remember that?
David: Next week what we will do is explore V, or velocity of money as an expression of choice and freedom.
Kevin: Right, because velocity, basically, is a person saying, “Well, yes, I am going to spend on that today, or no, I am going to save and spend on something else tomorrow.”
David: In which case velocity would fall. So I ask our listeners to read the article by Ken Rogoff relating to shifting toward a cashless society because what we have here is an ideologically-driven trend amongst central planners to defend their world view in spite of failure to perform. Again, when you focus on monetary supply and it doesn’t work, when you say, “Hey, listen, it is our job to step in, in an emergency, and spend like there is no tomorrow, create credit, and make sure that we goose the economy to keep things going, the presumption is that you are going to see a tremendous amount of economic activity on the other side, and that has not happened. So where is GDP growth that has matched our monetary expansion? There has been none. So, this is the problem. And this is why I say, they are now shifting emphasis toward a new means of controlling human behavior and thus, the economy.
Kevin: Forcing you to spend. We have talked about this, the cashless society, charging tax, possibly, on savings, zero interest rates or negative interest rates. These are all things trying to force people to spend and not save.
David: And it goes back to that basic equation. They have focused on M for too long, realized it is not working so now they are going to focus on V and see if they can’t salvage their world view in the course of manipulating and controlling human behavior. We are talking about limiting freedoms in the context of a cashless society.
Kevin: It reminds me, Dave, of the old Charlton Heston movie The Ten Commandments, when they took the straw away from the people and made them make bricks, but they got the whips out to make them make the bricks. They are taking straw away, but they are making them produce more. I know that sounds like an aggravation, but it is more than aggravation. Like I said, it is outright theft.
David: We are going to discuss this and a couple of other issues next week with social commentator and technologist George Gilder. We have talked about being late in the business cycle, in other words, having gone through a long stretch and being at the very end of a business cycle. We have discussed the Fed’s attempts to prevent an inevitable, and in fact, what we would view as healthy, decline in order to smooth out the business cycle and prevent a divergence from a path of steady progress, which they assume is theoretically possible. We have discussed the share buyback program as indicative of the inability of corporations to grow organically and so now they are resorting to engineering results which keep shareholders on board and, of course, deliver bigger bonuses to your C suites, you chief executives in the building.
Kevin: And Gilder focuses on – this is not economic productivity, Dave. If you have a healthy economy, you have what they call IPOs, Initial Public Offerings, new ideas, things to drive an economy. When you have a contraction, you have these share buybacks and you have company mergers and acquisitions and coming together. They are not really creating anything new, they are just consolidating and rebuying their own shares.
David: Right. Gilder supports the conclusions that we have come to, that we are very late in a business cycle, a massive credit cycle, in fact. By looking at the number of initial public offerings, new businesses that are going public, in the decade leading up to 2000, he compares that to mergers and acquisitions. And you had 20 initial public offerings for every one merger or acquisition.
Kevin: Which shows new ideas coming into the economy.
David: Exactly. And then what you have now is one IPO for every eight merger and acquisition deals, so it has shifted dramatically from new ideas, creativity, the possibility of failure, to entrenched businesses capturing market share, not being able to grow except by what I would say is cannibalizing existing companies to create a patchwork quilt of corporate value. And it is very different than a new idea, a new company, a new innovation being offered, which is, in fact, what increases employment and brings about the legendary Schumpeterian, creative destruction – keeping markets fresh and entrepreneurial.
Kevin: A business should be willing to succeed, and a business, or the economy, should be willing to let some businesses fail. That is this Schumpeterian creative destruction that you are talking about. When Schumpeter talked about that, you can’t have something unhealthy just continually sustained. It ultimately ends in death. I am going to give you an example. We had a hummingbird feeder.
David: Before you go there, if you guarantee success, you, in essence, are guaranteeing failure, as well. There is no way to come into a market if someone else is entrenched and defended by government largesse. So, it doesn’t allow for new ideas to come in. That is the problem. When you come into a command and control orientation and economy where the powers that be say, “We have to protect this industry, we are going to support it financially, we are not going to allow it to fail,” what is means is, in effect, no new innovative ideas can come into that area. Why? Because they can’t afford to survive with competition that is subsidized.
Kevin: And it ultimately kills even the subsidized business because you can’t do that forever. I was going to use a hummingbird feeder as an example. Living down here in Durango, Colorado, I don’t know anything about hummingbirds, but they migrate, and if you leave the feeder out and continue to feed the hummingbirds, they won’t leave, and ultimately they die in the winter. It is very, very important here, we learned when we moved down here, that you take that hummingbird feeder down about the third week in August because you need those hummingbirds to start to get hungry, start to think, “Okay, it’s time to move on.” Ultimately, it saves the bird’s life. If you would have fed them through the winter, you would kill them. That is where you see in this economy where you have the privileged few who really have no business risk because they are going to be bailed out no matter what they do.
David: Next week, as we talk with George Gilder, part of the inquiry will be to see what role the Fed has had in stultifying innovation and setting the tone for a capitalist malaise where new and fresh ideas are less common than the new versions of cleverness that are required to engineer financial success, for the purpose of keeping up appearances. The corporate sector looks healthy today, in large part because of what has been engineered financially, and the consequence is that we are actually gutting the capital markets. Just think about that again. 20-to-1, the IPOs to merger and acquisition deals in the context of an economy that is going bonkers, and arguably, moving toward a bubble phase. But still, with new ideas being generated, now you have one IPO for every eight merger acquisitions. Again, when you are at the end of a growth cycle and you can’t increase sales or invest in future research and development to seed your success down the line, you resort to corporate cannibalism. Corporate cannibalism is our modern day version – call it mergers and acquisitions, that is certainly more polite, but it is like the LBO – do you remember the leveraged buyout days in the late 1980s?
Kevin: Oh sure.
David: You had massive debt which was allowing for the minnows in a market to swallow whales, and we were then, and we are today, setting ourselves up for trouble.
Kevin: The thing is, we have talked about how dangerous this is that corporations are doing this – the mergers and acquisitions, the buybacks, this cannibalization. But along comes the government and they say, “Yes, you are exactly right. We now need to regulate this. We now need to put a stop to this.” Actually, even though it sounds like it is right thinking, it can actually ruin the whole system, can’t it?
David: Right. And the problem is, they are the creators of the problem, and it is very difficult to be the solver of a problem when you are also the creator of the problem.
Kevin: But now it is time for more regulation to solve the problem you created.
David: And I understand there is a distinction between the Fed and government, but if the Fed is going to create a problem, in terms of mal-investment, and then the government is going to come along and say, “Thank you for creating the liquidity we needed,” and we are not going to assume that that is connected with the consequences of mal-investment, now we are going to regulate the heck out of the markets to solve the problem created by mal-investment, it is foolishness.
Kevin: It is insanity.
David: Our friend, Bill King, reminds us that as Senator Tammy Baldwin and Elizabeth Warren are now beginning down the warpath, their focus is on share buybacks. And listen, it is with good reason in mind. The costs of changing an unhealthy system are very grave. Does it need to be changed? Yes. How and when does it happen? That has to be looked at very carefully and I am not a proponent of regulation to solve this particular problem because I think you are talking about monetary largesse which is driving it, not necessarily bad human behavior. Corporations are going to do what they think is in their best interest to do in light of the context which they live in. That context has been created by the Fed, so they are existing in an artificial reality. Change the artificial reality, take away the Fed’s monetary largesse, and you begin to see a different set of corporate choices.
Kevin: Think about what was created almost 30 years ago, the tax breaks for limited partnerships. And then when Rostenkowski came in and changed all that, it eliminated about 40% of the financial planning community because they had based everything on that model, and then the government changed the model.
David: Changed the model, changed the rules, and everything, looking back, was destroyed. Dan Rostenkowski was the Chairman of the Ways and Means Committee, and in large part he precipitated the 1987 crash when he warned that tax deductions for interest expense would be withdrawn for leveraged buyouts, LBOs, and acquisitions. That, as Bill King has suggested, occurred the Wednesday prior to October 19, 1987, when you had the market crash.
Kevin: Dave, actually, come to think of it, those were two separate events. The Rostenkowski thing preceded the crash of the stock market. But even before that, real estate limited partnerships had been given huge tax breaks. The government gave it to them for a few years, and then all of sudden – whack! They took them away, and they grandfathered back and (laughs) they wanted taxes for the time they had given the advantage. This is where regulation destroys a market, and this is where so many people lost everything.
David: One of our good family friends, a real estate developer, Ferrari-racing, red-blooded real estate developer – he was good at what he did – has made and lost many fortunes, and this was a critical period of time for him, where again, the rules changed and expectations changed and there had to be an adjustment to market values in light of the change in rules. So, you have Tammy Baldwin and Elizabeth Warren who want to explore, right now, the legitimacy of tax deductions on the debt used to buy back shares. Again, this is from a 13-page letter to the SEC and they are crying foul. We have hit this topic all year long with buybacks, and that is, not only is there a manipulation of earnings per share via the buyback schemes, but the huge corporate debt binge which has funded a good portion of those share buybacks – you have Bloomberg who quotes a Goldman-Sachs official this week saying that the deductions on that debt are pretty sizeable. Let’s just look at this as a theoretical sequence in play.
Kevin: Let’s just play a thought experiment. Let’s go from beginning to end on this. Let’s say, “Alright, how did it start? And how did it progress? And now how does the government solve it?” You said they started the problem. How do they solve it? Give me a hypothetical.
David: Yes, if they change tax deductions for corporations on debt, it is a very significant issue, and yes, it can precipitate the kind of market gyrations we had in the late 1980s, with a single-day crash of over 20%. But how does that play out? What is the sequence? You have the Fed. They induce bad behavior or mal-investment via zero interest rate policies and their various rounds of quantitative easing, buying up assets, adulterating their balance sheet to do so. Then you have the system. It gets used to its market. Do you remember in Aldous Huxley’s A Brave New World, what he called Soma?
David: A little bit of drugs to keep things going and keep everyone happy? So, the market gets used to its Soma from the Fed in the form of free money and downside market protection, and that downside market protection comes in the form of either verbal or actual market interventions and as a result of this there is volatility which is completely tamed, and then complacency in the market becomes pervasive. Does this sound like what we already have?
Kevin: Sure, no uncertainty.
David: And then everyone is surprised when a change in rules rocks the naïve expectations of market participants. The Fed actually doesn’t control the market? I thought they set us on an unalterable course toward higher levels and higher prices. And this is the “oops” moment. The “oops” moment is when leveraged players are forced to adjust to the new reality, and in the process of sobering up a little bit, guess what they have to do?
Kevin: They are going to have to sell assets.
David: They do. So, you sell off assets, which in turn triggers a downward spiral in price as you have limit orders triggered and prices decline more rapidly than anticipated. So, now you have institutions and market makers who basically say, “We’re not going to provide liquidity, either stocks or bonds. We’re not interested in being the warehouse for things that are in free-fall.”
Kevin: And don’t forget the margin. The margin just adds to that.
David: Right. The margin buyers who bought assets that they couldn’t afford, and now have to not only pay back the loan, but take a loss on the investment. Add to that, again, this is just a theoretical crisis in play, derivative players take a major hit. And you have a variety of financial institutions that were basically playing the insurance game. What is that, exactly? Playing the insurance game is collecting premiums for protecting investors against a market decline, never expecting to pay out on the claims because, again, it is something of a rigged game. As long as the Fed has your back, as long as you have the Greenspan put in play…
Kevin: There is no such thing as a black swan if they’ve got your back.
David: Right. So, now you have market declines that were never expected and you are actually paying out claims which start to pressure the solvency of those institutions. How? Again, if you don’t have enough liquidity, then you have your solvency put right into question. Liquidity issues, once again, become solvency issues, and this is the second time in ten years. And it circles back around to two things, shortness of memory on Wall Street and the permanence of greed amongst bankers. This is where we continue to see the Fed say, “No, we’re here to fix the system, save the system, help you,” when in fact, they are destroying the capital markets. They are destroying the capital markets by creating a casino-like environment where people assume that they can lever up, borrow money to invest in things they couldn’t afford otherwise to enhance returns thereby, and know that there is no downside in the market.
Kevin: And there are so many moving parts. If you remember our guest that we have had several times, and you have gone out to see in New York, Richard Bookstaber. He wrote a book called, A Demon of Our Own Design. It was a fabulous book, based on complex systems. He looked at the shuttle program and how when you have a million parts that have to work correctly, if you change one it can change an awful lot of other things. And he looked at Chernobyl. One little variable changed everything. And he looked at the market and he said, “You know what? When you have a complex system, one change can bring it all down.”
David: You have to look, and honestly say, the cause of a financial crisis is excess credit. What actually triggers a crisis environment and event can be anything. And that is what I am suggesting is that whether it is Tammy Baldwin or Elizabeth Warren, or a 13-page letter to the SEC, the SEC following through and beginning to look at that, Congress saying, “Hey wait a minute, we are going to disallow a tax break. There is no way we are going to continue to allow corporations to do this, adulterate their balance sheet, compromise the capital markets.” They may not be thinking that reasonably. They may have a different set of reasons. It may have to do with fairness and injustice and the rich and the poor, and how we are just accelerating a trend toward greater income disparity. I don’t know how it is going to be woven into a narrative.
Kevin: Right. So, it’s a good decision, possibly, at a bad, bad time.
David: Exactly. Remember October 19, 1987. Remember Rostenkowski. And remember that Elizabeth Warren and Tammy Baldwin may be the precipitating event, in this case. Again, it doesn’t even matter what the precipitating event is. When you have excess credit, this is the classic Von Misesian boom-to-bust cycle. We are still living off of the boom phase. Again, we talked about mergers and acquisitions, we talked about that being an indication, an increase in mergers and acquisitions being an indication of being, late, late, late in a credit cycle. What happens when you get to the end of a credit cycle like this? If you change one variable – if you change one variable in a complex system, as you mentioned with Chernobyl, the system often doesn’t know how to adjust.
Kevin: We call it a meltdown.
David: There are too many things to change. The system seizes. It is like an overworked engine. All along it is working, and then all of a sudden it doesn’t.
Kevin: The derivatives market is supposed to be this insurance market, but I am looking at the European markets right now. They are still sitting fairly comfortable with these derivative hedges on, saying, “Well, whatever happens with Greece…? Well, whatever happens with Greece…?” Well, what will happen with Greece?
David: Right. The European markets have their own potential seizures, and you are right, because there is insurance against decline. These are the hedges which protect against a market loss in the case that something bad happens triggered by Greece deciding to exit the euro. And I think you need to watch, very carefully, the French and German banks. Watch the French and German banks. There is still at least 160 billion dollars in Greek exposure left, and you may say, “Well, those French and German banks have done a good job offsetting their exposure with derivatives.” You have to remember that derivatives don’t eliminate risk, they just shift it. And this was a part of what we talked about with Richard Bookstaber is that you don’t, in fact, eliminate risk, you just reapportion it, and you say, “Okay, I’m not willing to take this slice of risk, but if you are willing to buy it, I will pay a premium for you to carry that market risk.” And so, it is just an offloading of risk onto someone else. Watch the French and German banks. There is 160 billion dollars of Greek exposure. If something happens to Greece in the next few days or weeks – 160 billion – someone is on the hook for it.
Kevin: And watch what the leaders of those banks are doing – the executives, the upper management. Are they staying put, or are they migrating?
David: Well, right. It is worth looking at the number of executives leaving Deutsche Bank here in the last few weeks, either being asked to leave, or frankly, like rats getting off the ship, it makes you wonder what is happening under the waterline? So, you have national politics in Greece and in Germany. They point to dissolving the bonds of monetary relationship. On the other hand, you have international politics, which still may trump. And this is where you have the U.S. which fears losing a NATO ally, and Merkel, in the end, may need support from the U.S. on a number of issues relating to energy, and relating to Russia, and regional military cohesiveness, and therefore she may step in an appease the Greeks with a massive debt forgiveness or restructuring. And we will have to see how that plays out because certainly it has become very popular amongst the Germans to say, “Just let them go. Let them go.” So, she would have to deflect some responsibility if, in fact, she wants to be re-elected. Maybe the ECB takes its lumps on that front.
Kevin: Dave, before we wrap up I would like to shift to some of the questions that were asked when you were speaking for the Hayek group. We found, in doing this show, that sometimes you find out where the itch is with the people when you just listen to where they need to be scratched. And the questions that they were asking, I would like you to just bring up a couple of the things that were on the minds of the people right after you spoke.
David: Yes, the dollar as reserve currency. That featured prominently as I went table to table and discussed with a number of people who attended, a very engaged, a very politically active group. I was very impressed.
Kevin: So, the question was, “What is the future of the dollar as a reserve currency?
David: That is correct. And with the background thought being, are we witness to a currency regime change in our lifetime, not unlike what we saw following World War I, not unlike what we saw with the collapse of the Bretton Woods system in 1971? Are we, in a 100-year stretch, seeing the third regime change? That would have a direct impact on a U.S. person in this way. You denominate your savings, you denominate your assets, you denominate your income, all in U.S. dollars – dollar instability equals instability to your financial well-being and livelihood. So, I get it, a group of people who are deeply interested in economic theory is asking a market-related question because it deals with their own personal viability. It is where economic theory, the rubber, meets the road there in the marketplace, which is what we have been discussing all day. You do have to connect economic theory with the practice of decisions being made and the consequences that are meted out in the marketplace. The other question that I had come up a number of times was relating to student loans, and the concern with a 1.2 to 1.3 trillion dollar problem.
Kevin: Hillary is talking about this, too. In the last several days Hillary is starting to use this as a hammer to swing during her election campaign walk.
David: Right. When you are competing for the Democratic limelight, you have to prove that you are left of someone, and being too far right is not going to help you in this particular…
Kevin: You have to show that you can feel their pain, because, you know, when you are worth over a 100 million dollars…
Kevin: (laughs) You have to show that you do feel the pain of student loans.
David: Which I am not sure how she does, I am sure her daughter doesn’t, but there is this idea of a forgiveness of student debt which the millennials and generation X, I think, young professionals who are still paying off student loans, would be certainly open to the idea. It is important to realize, again, this is economic theory, which, if you are looking at it from a practical and moral standpoint, if you are paying student loans you may say, “Well that sounds good to me,” but understand how that sounds to everyone else, because it is taxpayers who would end up picking up your obligation.
Kevin: Debt forgiven is merely debt shifted to somebody else’s back.
David: Exactly. Exactly. And so, you have had that amount in student loans more than double in the last eight years, and it doesn’t look like it is slowing down. To me, it is an indication of a generation who says, “I don’t know what I am going to do when I get out of college, there aren’t many job opportunities, and since the 60+ set is concerned about their health care costs, and is, in fact, staying on and working longer, and not retiring because they can’t afford their health care costs if they don’t continue to work – guess what? There are actually not many job openings for my age group. Why don’t I just go back to school?” It advertises well. “What are you getting your Master’s degree in? What is your double major in? Why are you staying on an extra year or two?” It is because there are not very many job opportunities for millennials.
Kevin: I was talking to a friend of mine who is going for her doctorate, and I have talked to a number of people who are continuing in school, they are going on and getting their Master’s, they are working toward a doctorate. But I usually test somebody – I don’t mean to be mean, but I test somebody when they are going for a doctorate, I want to find out what their passion is. What is their thesis? Why are they going for a doctorate? Why are they taking that kind of time? And this friend of mine, it was really impressive, because she knew exactly. She is driven by passion. It had nothing to do with money, it had everything to do with being able to teach people her thesis, and she knew what she was going to write about long ago. Yet, I meet so many people right now that are doing what you said. They are continuing in school because, by gosh, they don’t know what else to do. They can’t get a job – they can’t get a job that feeds a family – and so their thought is, “The more education, I guess, the more chance of moving forward,” with really no passion for what they do. It is a little like your story of Collette in the beginning. She cleaned your shoes for free, David, because she wanted to serve. She wanted to meet a need.
David: Every time I go through the Denver airport I will find her. And my shoes are perfect. I have never seen a better job. And it will be well worth her while. She didn’t do it for the possibility of having a loyal customer in the future. She did it because there was intrinsic reward. She does a great job, and she saw a need, and she took care of it. I think of the student loan issue again, and it is not as if there is an easy solution for debt forgiveness. Restructuring is more likely, putting it on terms that anyone can afford, extending loans for 100 years, and making your payment on a per-month basis, something like ten dollars, something that is non-burdensome to the current generation, allows them to move on and become home buyers and consumers, etc.
Kevin: Living in debt is the new norm, this is the paradigm. In fact, sometimes it is even encouraged. “If you are not going into debt, what is wrong with you?”
David: I think that was a part of the unspoken motivation for expanding house ownership in the United States. I remember my manager at Morgan Stanley. I learned a lot from Fred Martin, I have great respect for him. But shortly after giving me a private office he suggested that I buy a Porsche. It was the car that he drove, and the model that he recommended. Yes, I would have borrowed to buy it if I was going to do it, and of course, I didn’t. But he put it in terms of, “You deserve it.” And the reality within that micro-culture was this. Debt ties people in and locks them down. It makes their choices more predictable. And central planners prefer it as much as Fred Martin preferred it because he wanted to see my future with the firm. You have a slower turnover once you have locked people in.
That is not my preference. That is certainly not how we manage this office or our lives. I prefer the tensions that exist with freedom of choice. I prefer the possibility of people moving on and choosing what they consider to be in their best interest, unencumbered. Unencumbered. But it is interesting that debt features so prominently in our society today and we are at this point where, as Richard Duncan has suggested, and as I suggested to the folks in Reno last week, the transition from debtism to statism is very clear. It is where we are, it is where we are going. We as individuals needs to choose how we respond to that very carefully, very perspicaciously.