The McAlvany Weekly Commentary
With David McAlvany and Kevin Orrick
Kevin: David, it is times like these when we like to have Bill King on, because on one day we have good news and all the markets are up, and on another day we have what somebody considers bad news, and the markets are way down. There doesn’t seem to be any real continuity right now, and where there isn’t continuity in the short-run, we like to bring somebody in who not only has a long-term perspective, but looks at the short-run, as well.
David: I think what I conclude in this market is that if you are treading water, you’re doing just fine, because it’s tough to tell which direction this is going to go, and as our conversation has unfolded over the last year, the last 12 months, and even more than that, 2-3 years, we have regularly gone back and forth between the ideas of inflation and deflation.
David: And this is an important issue, because we have an outcome, economically, determined by decision-makers in Washington and on Wall Street, and we don’t know what the outcome will be, because we don’t know what the decision they will take will look like.
Kevin: We have a clash of the Titans. We have the Titans on one side who say, “We need more controlled socialism, we need more debt, we need to have more unity in paper currencies. And then we have the other side, which isn’t coordinated. It’s the market, itself. It is this hidden, unseen Titan, in a way, and these Titans are fighting each other all the time.
David: I think what we will end up seeing happen over the next 3-4 years is that battle become real, and ultimately, somebody wins the argument. And just because you win the argument, it doesn’t mean that you were right, it just means that you were more effective in your presentation. It will depend, I think, on what happens over the next couple of years, who comes into office here, in Europe, all around the world, and what kind of decisions are made, and the implications, both intended and unintended, on that basis.
Kevin: Wouldn’t you say, David, that other than it being maybe a scary time for people, because there is so much uncertainty, it is one of the most interesting times to be alive, because you have an entire social order that is going to have to change.
David: Yes, there is so much that is in the midst of changing, and so many interests that want to keep change from occurring. There are entrenched interests that would prefer not to see things change. Meanwhile, the market is speaking, and the market is saying, “We’ve been overcooked, we’ve been overdone now for 12, 15, 20 years. We’ve had too much leverage in the system, too much debt in the system, and we’ve got to let off some steam. We’ve got to see an unwind of this excess.”
Who will be implicated in that, Kevin? We’ve talked long and hard with people both here in the United States and overseas, as to the banking institutions, as to the individual countries, as to how individuals within those individual frameworks can be making decisions to not only survive, but thrive, in this environment.
Thriving in this environment is probably not looking at 100%, 200%, 300% annual returns. That is very unrealistic. Even 10%, 15%, or 20% returns may be unrealistic. Treading water, preserving your capital, keeping what you have, on balance, sitting the fence between a deflationary theme and an inflationary theme, knowing that politicians will choose one course or another, and not knowing, which means that investors have to sit and wait – a very challenging thing for investors to do.
Kevin: David, you talk about treading water, but actually, sometimes treading water is losing a little while you are treading water. There are times when you are treading water when you are not popping up and staying well above the water, you are just not drowning. I think of what Richard Russell has said for years: “It’s times like these that everyone loses. He who loses the least is the winner.”
David: I think when you keep your assets intact in that way, losing the least, and maintaining value, it puts you in a position, as we have discussed many years now with Russell Napier, the concept that in 1932, and 1949, just on the verge of the launch into the bull market of 1949 to 1966, 1982, and perhaps within the next 4-6 years, again, the unwind which leads us to the entry into a very productive period of time and a magical period of investment where you would have established cost basis at an epic low, and that is, for someone who has preserved value during these challenging times, very, very compelling.
Kevin: Bill King tends to give a great bird’s-eye view, and get you thinking on the right track for that timing. I’m wondering what the timing will be, David?
David: Bill, it’s nice to have you back on the program, and lots of questions to cover today, from quantitative easing, monetization, corporate earnings in the first quarter, the election calendar and what happens between now and the end of 2012, and a number of statistics which we should look at in detail. But if there is a big issue, what would you consider the primary concern to be, if you had to just focus on one thing?
Bill King: I think the big issue is, when are the global leaders finally going to do the requisite purging and reforms and restructuring that is necessary in the western world, and Japan. We have been going through this for over a year. Actually, the European situation has been two years. Nothing changes. You could trot out the same headlines and the same headlines are being trotted out, on almost a daily basis. Stocks are up, always because there is encouragement that Europe is going to resolve its crisis. Stocks go down the next day. People are disappointed – they are not going to solve their crisis.
These headlines have been repeated for two years and it is the same stupidity, and it is always some goofy bailout scheme that somebody is going to lend money that they don’t have, and when people call them and say, “Wait a minute, you guys are bankrupt.” “Well, we’ll create a fund, and that fund will be triple A rated.” Well, excuse me – nobody’s triple A rated that is supporting the fund. How can this be triple A rated?” “Oh, okay, we’ll come up with a second fund.” And then stocks rally, and you know, the garbage back and forth.
But you can see from the way the markets react, there is no leadership. Nobody will take the necessary hit or do the necessary restructuring on their watch because the political consequences are severe. So just keep pushing it out in the future.
David: That makes 2012 an enormous year: We have half of the G20 leaders changing next year, including in our country, but you also see the same thing in many countries in Europe, and we have already seen a couple of elections already/ So yes, that’s right, nobody wants to take the hit. What do you mean when you say the requisite purging? Are we talking about in the banks?
Bill: It’s everything. Sure, it’s everything. I’ve been screaming for years that the real problem in the banks wasn’t real estate. Yes, real estate was a problem, but the real problem is derivatives, that are hundreds of trillions, and the CDS, on and on and on, and they’re trading, and nothing is being done about it. In fact, the derivatives keep growing, and the reason they are doing it is to craft earnings. When you put rates down near zero, all the spread lending goes to hell. You are getting the deposits because of the markets being weak.
I just talked to a banker this weekend about it at a Christmas party, and they don’t want deposits because it costs them, because the interest rates are so low, they have no place to lend, and they are getting killed on the FDIC fees, because you have to pay fees on your deposits. It is a mess, because we have central planned markets, with the Fed and the government, and the market is not working. It cannot clear itself, whether it is real estate prices, which are still too high when you look at national income – we either have to get national income up or real estate down, and we have these big zombie banks walking around that government just keeps pouring money into, here, Europe, wherever, and every day it just keeps going on, nothing changes, nobody will take the axe to these guys and break them up, or make them erase capital, or pare down their derivative books.
You hit the key point. Because of the election of 2012 for so many nations, nobody wants to go out and say, “We have to take the hit.” Look, you have to take the hit. Reagan and Volcker took the hit in 1981 and 1982, and that created almost 20 years of prosperity, because they cleansed the system, restructured the economy, and that’s what has to be done. But no one wants to take that hit now, and the longer they delay, the worse it gets. They just tell you lies, and they keep piling up, and it just gets worse and worse, and that’s the problem.
David: So let’s say that 2012 is not the year, because nobody is going to do it on a voluntary basis, and if they can push it to 2013…
Bill: That’s what going to happen.
David: At what point do the issues – talking about fiscal issues, talking about economic issues, leverage in the system, derivatives, as you say – when do these things unwind on their own? They unwound in 2008. You could argue some of it began because of FASB rules and the shock to the banking system that they might actually have to mark things to market, strange as that may sound to the man on the street – counting things at their current market value, versus playing games with the numbers and calling them what you want to, on whatever basis. Is there a change in the rules under new leadership that causes this hit?
Bill: They got away from the marking to market. They are marking to fantasy again. Everything’s been thrown out. Look at what is going on with the banks. Banks have been crafting earnings for the last year-and-a-half or two, by depleting their loss reserves. That is why, this last quarter, even though the banks reported these wonderful earnings, enough people look at it and say, “You know what? This is not only wrong, this is dangerous. They are running down their loss reserves.”
And J.P. Morgan is not reserving against mortgage litigation because they claim that the FDIC is going to eat that. The FDIC is saying, “No, we’re not going to eat your mortgage litigation costs.” Anybody who says, “Buy a bank stock because it’s undervalued,” doesn’t know what they are talking about. You cannot buy a bank stock unless you know all the paper it has on its balance sheet, and the value. And even if you know all the derivatives, all the bad paper, nobody knows the value, because it’s marked by some model. Go out to the market and try to sell it, and see how far you get. You’re not going to get far.
That’s the problem. I’ve argued that 2008 and 2009 was a crisis. It wasn’t the crisis. Because when the crisis appeared in 2008 and 2009, central banks and governments came in and bailed out everything – not the economies – the main thing is they bailed out the banks. But in the process, they have bankrupted themselves. That’s what we are seeing now. Sovereign nations’ debt problems, inability to borrow – that is the game-changer. Because most people, whether they are professionals on Wall Street, or in the financial world, have been operating under the delusion that somebody will always bail them out, whether it was the Greenspan put, the Bernanke put. “The Fed is always going to save us, the government will always bail us out.”
What happens when, as we are seeing in Europe, when sovereign nations, people don’t have confidence in them and they start hammering their debt? Who bails them out? Who bails out Greece? “Well, okay, it will be the rest of Europe.” Well, wait a minute. What if, with the exception of Germany, everybody else is in trouble? “Well, we’ll create some new entity. We’ll create an EFSF fund.” Well, who guarantees that? “Well, all these bankrupt nations.” Oh, okay. “Well we’ll get the money from the IMF.” Wait a minute. The IMF is mostly the U.S., and the U.S. Congress has already said, “No, we’re not going to give you guys any money.”
And you can see, it goes on every day, and then you’re going to create these funds by bankrupt people. That’s exactly what they did with subprime mortgages. They took crappy paper, and threw in one or two good securities. Look at Europe – a lot of near-bankrupt countries. Throw in Germany and say, “Okay, we’ll make it all triple A rated.” That’s exactly what they did with the mortgage securities with subprime. How did that work out? And that was another delusion about, “Oh yeah, they’re triple A rated.” How could they be triple A rated, when it was mostly crappy paper?
It’s the same things that are going on now. They’re trying to create all these bailout funds. And then I saw today, the latest news, the sort of spark over the weekend was that the EU leaders wanted to put 200 billion more euros into the IMF for lending, demanded 25 billion euros from the U.K., and the U.K. said today, “No.” But it’s kind of funny, this is what they are doing. “We’re going to borrow money, put it into the IMF, so that we can then borrow from the IMF.” It’s absurd! That’s a daisy-chain bailout. It’s unbelievable! Who is the ECB? It’s the European nations, again, who are bankrupt, or near-bankrupt, with the exception of Germany.
And this nonsense goes on every day, and the game is to just keep this game going until some magic genie appears that will make everything better. And you can see that nothing is changing. We go day by day, the market gyrates and wiggles, and the rumors come out, and the stories. In the afternoon now, we get a daily rumor, about an hour before the New York Stock Exchange closes, about some new bailout scheme, where someone is going to put up some money into some fund, and then we get a rally until the close. Well, that is totally contrived, because they want to keep the stock market firm going into the close.
For example, last night, the markets were under pressure for all the negative reasons over the weekend, and Asia was getting hit. As soon as Asia closed – I mean it literally closed, and boom! Someone takes the S&Ps vertical by about 16 handles before Europe opened. Well, there’s no question somebody was trying to influence the opening in Europe so that it didn’t go to hell in a handbasket. And it stayed there for about 2-1/2 hours before the New York Stock Exchange opened and it started rolling over. We had a modestly higher opening and we’ve gone straight down.
So, it’s the same nonsense every day. People are fooling around in the markets, people who have vested interests to keep stocks higher. Just like now, the game today is watching Bank of America. As we speak, it is trading 501, 500 being a big threshold, because under 500 a lot of mutual funds and pensions cannot own it, and they are afraid of some kind of collapse. If you remember, we had this exercise a week or two ago where it traded down to 490-something, I can’t remember, and then right before the close, it was marked up above 500. That’s the game today – where are they going to close Bank of America today?
David: Whether it is Bank of America, Goldman, or J.P. Morgan – we are talking about U.S. Banks and financials and European banks, which are really in the same precarious place. Does 2012 represent the point in time where we see 10% of these major banks disappear, or 10% of these major banks get nationalized? We have seen Commerce Bank – that has been a discussion in Germany, the issue of what the state involvement is with running that bank now. Is nationalization the new trend in banking?
Bill: It will have to be, and I argue this is what should have been done in 2008 and 2009. That is the best way to protect the taxpayer. The taxpayer has put all this money into Citi, and other banks, AIG, whatever. Where’s the benefit? They will say, “Well, we sold the stock for this profit.” That’s garbage. Look at the money that these guys took out. It’s the same thing with GM. If you go in there and nationalize, wipe out all the equities, the bonds, wipe out the contracts, what you have done is you have bailed out the insiders, and in the GM case, you have bailed out the unions. If you were to nationalize these banks and then spin them out, you would save your taxpayers a lot of money.
David: What is the implication for pension funds, and insurance companies, with that wipe-out of equity?
Bill: They are going to lose their value, and if you hold those shares, that is exactly what will happen. And that’s the way it should be. These guys are the smartest guys in the world, they get all these fees to make decisions, so why do they own this junk? And then what happens when they make money? These guys extract the money. Goldman, after the crisis ebbed, made 30 billion in one quarter, and they took 20 billion out and paid it to themselves. Why was that allowed?
That’s why this isn’t capitalism. It drives me nuts when people say, “Oh, well, this capitalism isn’t working.” We don’t have capitalism here. We have crony socialism, where you give contracts to your buddies, you bail out your buddies or your friends, or the elites, on the back of taxpayers. Certain people always use the term, crony capitalism, but no, it’s crony socialism. That’s what it really is. Socialism is government control, central planning, picking winners and losers. So they can let your community banks go down and collapse, but they’re going to bail out, not only the big U.S. banks, they’re going to bail out the European banks.
And then you’ve got Dudley, the New York Fed Chief, trying to tell you this is good for U.S. taxpayers, to bail out European banks. Well, by a stretch of logic, what he won’t say is, because if we don’t, then we’ll have problems in our U.S. banks. But again, the problems just keep getting worse. If you nationalize them, wipe out all these stock options, especially for the executives, then you will get people being prudent again. Look what happened with MF Global. This guy was head of Goldman, a U.S. senator, Governor of New Jersey, and what did he do? And what happened to the firm? And what happened to the customers?
David: Let’s talk about rehypothecation. Is that anything other than theft?
Bill: No, I wouldn’t say it’s theft, it’s just that it’s stretching the limit. What a lot of people aren’t talking about, especially, is that what happened to MF Global is what happened to Long Term Capital Management. If you read the book, When Genius Failed, and other press articles, when the Street was talking about bailing out long-term capital, Corzine was in those meetings. He was the head of Goldman. He didn’t learn anything, because that is what they did.
What happens on Wall Street is that when you buy something, or you have money in your firm from all your different trading, you have a money desk there, and they are watching the money come in and go out, and the securities come in and go out. So what you want to do is that when you buy a U.S. bond, you immediately turn around and try to lend it out to somebody, you repo it out, and you get funds back in. Then you buy something else, you repo that out. And so you’re leveraging this up constantly.
What is interesting is that there are limits here in the U.S. to what you can do with your capital. In Europe there isn’t. That’s why this stuff all ends up in London. That’s why when they are saying, “Where’s the missing funds?” – a few articles allege that the funds are in J.P. Morgan, in London, because it is almost limitless what you can do there with this rehypothecation.
All hypothecation/rehypothecation is, is that you buy something, you get a security, you repo it out, and now you have money again. So then you buy something else, and then you lend that out. On and on and on. And this game works as long as your financing stays low. So that’s why the idiot Fed, that says they’re going to keep rates low for two years, or the rest of your lifetime, encourages this kind of speculation, because you don’t have to worry about your financing costs going up.
At the same time, what happens is that when you don’t have collateral, and this is what happened in 2008, why they lost control of the game, even with all of the bailing out they were trying to do and all the facility that was creating, is that people starting grabbing for collateral because they got scared. When you have that many people buying and repledging things, the chain breaks down, and once the chain breaks down, everything starts collapsing.
As the book, When Genius Failed, said, what these guys are doing is picking up nickels in front a bulldozer. In other words, when you keep buying and lending, buying and lending securities, more and more, it’s a very, very, very small spread, especially with low interest rates. But you do it so many times. In other words, if I can make a trade and make 20 cents on it, that’s great. But if the spread has collapsed down to only two cents, I’ve got to do ten times the leverage. If it goes down to one cent, that’s 20 times. What if it is half a cent? As long as I can keep levering that, I can maintain my profit – not the profit margin, but the net profit. So as the profit margin decreases, you keep looking for more and more leverage. That’s what is going on. That’s what appears to have gotten MF Global. And again, that’s what got Long Term Capital, to some degree.
David: On collateral, we have Dudley talking about taking European paper as collateral. Going back to 2008 and 2009, we saw the Fed accept all kinds of stuff, including the kitchen sink, into Maiden Lane I and II. Speak to collateral a little bit, because isn’t that really what we saw, a collateral call, with MF Global?
Bill: Yes, the system is so levered, because of all of this trading and speculation, and all these derivatives, and all this nonsense, that when people get concerned, they grab for collateral, and then the whole thing breaks down. Because they are playing this high speed game of buying and relending, and relending, and all of a sudden a few people pull the securities, and then there are shortages of collateral, and then this whole chain breaks down and it reverses. And when it reverses, you start losing money, and when you lose money, you take capital hits. And that makes you sell other things.
That’s why commodities are getting crushed now, too. The global economy and austerity means there is going to be weaker government spending, which means weaker economies, but also, the grab for collateral. That is one of the reasons, when the dollar goes up, if you remember, the dollar surged in October and November of 2008, and gold just got crushed, and everything got crushed, because that’s what was going on – when people start grabbing for collateral, they run to the dollar, because that’s what they are short. They are short dollars when they borrow. The whole chain breaks down – boom, boom, boom. And we’ve seen that happening in gold and the other commodities over the last month or so.
David: It’s a challenging picture, because as an individual, you ultimately have to make an allocation decision, and it seems really boring to look at the areas where there is not a lot of counter-party risk. Physical gold – no counter-party risk there. Dollars – I suppose you could stuff your mattress with them, but it appears that even if you put them at the bank, they may be rehypothecated. Nevertheless, between cash, or its equivalents, and gold, where else do you go in a period of unwind?
So we go back to that big issue that you mentioned. There is a necessary hit that has to be taken. It was voluntarily done under Reagan and Volcker. They took the hit. It is not now being done on a voluntary basis, which means things are going to get worse, not better, in terms of the ultimate ramifications. When this happens, even on an involuntary basis, where do you want to be? Because there is no good place, there are just better places.
Bill: Yes, exactly. That’s exactly right. That’s why the dollar is surging now, because it is a better place to be than in the euro or commodities, because we have deflation. We have had this ebb and flow of inflation/deflation. The system is trying to deflate. It’s clear. It has been trying to deflate for over twelve years. That’s what the big stock bubble collapse in 2000 was. And then we have central banks and governments trying to stave off the debt deflation, because they think it’s too horrible, and in the meantime, they have bankrupted themselves. And they have bankrupted individuals, they have bankrupted banks, on and on and on, instead of letting the system wash out. Greenspan wouldn’t allow it, because he was afraid that it would take the bank, because there is just too much leverage. So they make it worse and worse and worse.
They could have done this in 1991 when Citibank was down for the first time, the Bank of Boston, Bank of New England, all those banking problems in 1991 and he bailed them all out, leading to the carry trade. And then the Bank of Japan went to zero interest rates in 1995. So this thing has been going on for two decades, trying to stave off the day of reckoning for the financial markets.
David: So, what makes us think that 2012-2016 is the period where there is a forced comeuppance? Because surprise, surprise. At the end of the twelve years, we continue to be able to kick the can down the road.
Bill: You can keep doing it as long as you can borrow, and that’s what is happening now. The real crisis is the sovereign debt crisis, because that is the ultimate guarantor.
David: That is the game changer.
Bill: Right. That is because, “Well, you can always get bailed out.” And that’s what we did. That’s what Greenspan did. Go back to 1987. We are looking at 25 years of bailing out people. So if somebody comes into business at the age of 22 or 23, we are talking about, basically, everybody under the age of 50 has been in a market where they always believed someone’s going to bail out the markets. There’s a lot of experience of that.
At the same token, we haven’t had a bear market in bonds for 30 years, so again, we are talking about almost anybody under the age of 55 hasn’t traded in a real bond bear market. So you might go up for a quarter or two, or a year, but you always get saved, and the reason is because the government has kept buying bonds, whether it was for their own good or for currency intervention.
We have had an unbelievable period of central bank and government intervention in the markets and the economies, to save the socialistic model that developed early last century. Whether it was the European socialism or communism, or the U.S. socialism that Roosevelt created in the 1930s. This is an unwind of 75 years, or more, of this economy and financial system, and it’s going to be very painful. Again, they are just trying to extend and pretend, and hope for some magic genie to show up so they don’t have to take the hit.
But you are right, the market is forcing the hit, and just like it did with communism, when it started breaking up in 1989, 1990, 1991, the weakest nations just kept falling and falling and falling. And now that has spread into Europe, where the weakest nations are going down first there – Greece, Portugal, Ireland, Iceland, on and on, it’s just going to roll through the regions like that. And that’s what we are looking at, here.
And the big problem now is that it’s not just one or two, it’s everybody, because everybody has played this game for decades. And it’s the end game, because when you can’t borrow money anymore, or the rates start going up, then we are going to see the debt defaults. That’s what I see. I see debt default. Just look at history. This happens. You try to inflate, you try to borrow, you try austerity. There’s nothing new here. This has all been done many, many times.
Your only recourse then is either to go Weimar and just print it up and pay it, or you default. And the recent history is, you default. Whether it was Russia in 1998, or in 2001 and 2002 when we had Argentina, and we had other countries in there, too. You default, because that’s what best for your country, and that’s what leaders will figure out, eventually. “Okay, we just can’t pay it.”
And it’s not so drastic. Russia, in 3-4 years, was running incredible surpluses and acquired 200-300 billion in reserves, a lot of which was because the energy business took off, but you can default, and it works for your country, if, when you default, you do the necessary reforms. Then you can get back in the capital markets and borrow again. And they have. Again, the game here is for the elites to try to bail each other out, without taking the hit.
David: Is it any different for a country that has reserve currency status?
Bill: Yes, it would be, and that would be in reference to the U.S. again, that is, if you do the necessary reforms. I would tell you right now, if you said, “We’re going to run a balanced budget, we’re going to have a flat tax, we’re going to get rid of all this nonsense, and oh, by the way, we’re in default. Your T-bill is here, you’re only get this, whatever the number is, two-thirds, whatever it is – and we’ll take that half, and whack!” And at first people would be cautious to see if you follow that plan, but if you followed that plan, you would be fine. Look at how fast Russia rebounded.
Bill: It was very quickly. And what was their history of jurisprudence or business dealing? Please.
David: (laughter) Well, in terms of a default, we have roughly a 50/50 split, if you are looking at our Treasury market, held by foreigners versus held domestically.
Bill: Yes. But who holds it domestically? This was my view of why you should nationalize, that you shouldn’t bail out Wall Street, you should bail out all the bank deposits. When you start looking at the United States, with the average household and what their assets are, there is very little. You are only talking about a handful of people with assets. So when you are talking about Treasuries and you are talking about default, you are talking about the 1%, by and large, and institutions, obviously pension funds and insurance companies, and whatever, in here.
But this isn’t going to impact the average person on the street. Not to his balance sheet. It will have effect on the economy in the short-term, and that is why you will get default eventually, because with the majority of people, their balance sheet and checkbook isn’t impacted, because what assets they do have are in bank accounts. They are in passbooks, maybe CDs. But there aren’t a lot of people holding T-bills, maybe some money funds and that kind of thing. But it is not the same as the big institutionalized money that would get hit, or the big private wealth. That’s why the big private wealth has been a big buyer in gold. That’s their hedge. They buy gold and they are buying bonds, and they are just waiting it out.
David: Hypothetically, if we look at 2012, 2013, 2014, 2015, what do we see? Money market funds? Breaking the buck? Banking institutions?
Bill: I don’t know. See, the thing is, rightly so on the street is the argument, deflation or inflation, and we have been getting periods of both over the last decade. The deflation shows up because the system wants to deflate, and again, the central banks and governments are trying to prevent it by inflating.
David: Inflate it back.
Bill: Right. Right now, we are in deflation again, which you can see in the commodities – they are telling you that. Bernanke moved away from QE-II in May, and nobody listened to him. The FOMC said that the trade-offs of quantitative easing are no longer beneficial. And I’m thinking, “What else do people need to hear?” But yet, the same clowns are running around saying, “Oh, QE-III is imminent. It’s imminent, it’s imminent, it’s imminent.”
And you could see the rallies. When they did the QE-II you could see the bonds went down, the stocks and commodities went up, and then that kind of rolled over, and then we had the twist, we had another little rally, and then in October that all fell apart. And now everybody is running around saying, “Oh, QE-III in January, QE-II in January.”
Well, I don’t think so, but the point here is, we are getting both inflation and deflation on a periodic basis. Now, what’s the next big wave? I don’t know. But the one thing that I’m highly confident of is that we will get both, at some point in the future here, but it’s probably not going to be 2012, probably afterward, maybe a year from now, 2013 perhaps, when the new administration and new congress come in and start doing reforms, we will get the deflation, and it depends how far they will allow it to go before they inflate.
On the other hand, if we have an administration that comes in and tries to inflate right away, we’ll get the inflation, but then that will blow up when we get deflation. So my view is that we are going to get a big wave of inflation and deflation. That’s what history tells us. We just don’t know the sequence. So you have to have a portfolio constructed so that you are hedged against both, and when the wave develops you can jump on and play it, and you won’t get swamped and crushed by it.
David: We have Dennis Gartman saying we are in a new bear market in gold. Is he talking about a talking about a cyclical bear, or a secular bear? Is it over?
Bill: It’s too early to tell. Because what the governments will do – it’s way too early to tell.
David: We have gold up 630% during the duration over the last ten years, silver up 700%. These numbers aren’t the highs, these are current numbers. So, yes, they’ve had a good run, haven’t seen any sort of speculative blow-off phase, which you might expect at a tail-end of a super bull market. Maybe that’s around the corner, maybe it’s not. But yes, inflation/deflation, we know that there are fiscal measures that can be employed, and monetary measures which can be employed.
Fiscal measures are not all that popular with the voter base, unless you are sort of lynching the rich (laughter). Unfortunately, there is not enough money to take, and steal, and reallocate, to actually make a difference there. But fiscal measures really don’t work. I guess we’ve looked at the monetary measures as the only ones that they would employ, because they are not politically volatile – not if they can “control the inflation,” and maybe that is their misperception, that they can actually control it. It tends to move.
Bill: It’s the arrogance of these guys, mostly these Ivy League types, who spent a career saying, “Oh, we’ve just got to make the right policy mix.” No, they’re not that smart. And they’ve proven over the last how many decades that they’re not that smart, so why don’t they just get out of the way and let the market operate? And of course, they are saying now, as well, “We can’t, because it would be so horrible.”
Yeah, that’s the horror they created with their Keynesianism mantras and everything else, that they’re always going to be there to fine-tune and micromanage the economy and the financial system. And it’s not working. That’s another reason why they are digging in. This isn’t just the banks, this isn’t just the country – this is these guys’ lifetime work. It’s their self-esteem, it’s their egos, and they’re going to try to prove that they’re right, at all costs, no matter what the costs are.
And that’s another reason why we have to let the market work and get rid of all these clowns that want to put their fingers in the pie and keep manipulating it. And we are getting revolts all over the world about this type of action, and it’s going to continue. We are starting to get the social unrest. We are starting to see it here in the U.S. We don’t notice it in Europe, because they don’t talk about it as much, but it is going on, and it is probably going to worsen, because nobody is doing the requisite reforms. So they just keep making it worse and worse.
People will take a hit and pain, if they believe they are going to have a better future, which is what 1981 and 1982 was about, under Reagan. Thatcher did the same thing. Nobody here wants to do that, or in Europe. Nobody wants to go in and do what is necessary to reform. And until they do, we are going to play this silly game until the market revolts, like in 2008 when the market revolted. And the market is revolting now, and you can see they just keep trying to stop it.
That’s the only reason they are doing QE. It hasn’t gotten into the economy. It’s not helping. It’s not helping housing. And when people said to Bernanke, “QE is not working,” or “Why did you think QE was working?” The first words out of his mouth were, “Stock prices are up.” The first words out of his mouth! That’s the only thing they could hang their hat on is that they were inflating assets, and the reason they think that helps is that they are trying to get the banks recapitalized.
So this thing comes down to saving the big banks, and saving sovereign debt. And the reason sovereigns and the central banks are in trouble is because they were bailed out. They got too involved in the economy, they got too involved in the financial system, and now they are on the hook. Again, that’s the game changer.
David: So not 2012, 2013, 2014, 2015. We are still talking about a slow burn. It takes forever until it just happens and it’s done.
Bill: Yes, I think there are only two possible outcomes: One is that the market revolts, the second is that you get the right leaders in and get ahead of that, which is like what Volcker and Reagan did. They both saw how bad it was, they understood the problem, both of them. That’s the problem here, is that you have to give the medicine. You have to purge, but you also have to restructure. If the U.S. economy hadn’t been restructured – in other words, if we had just done austerity – it would have been horrible. So you have to do your austerity, but you also have to liberate the private market so it can do its work
It’s similar to after World War II, when everybody thought we were going into this enormous depression, back into the depression, because all the men were coming home, millions of men. There was going to be massive unemployment, on and on, and instead, we had this enormous boom. Now, it took a little bit, it took 3-4 years to purge that out, but then by 1949-1966, it was unbelievable prosperity, because you had pent-up savings, pent-up demand, after World War II. And the restructuring was done, and off to the races, the private market worked, and it worked splendidly.
We did the same thing in 1920. People call it the forgotten depression. The same thing after World War I, enormous inflation crushed the global economies. The scale of World War I had never been seen in history, and the costs were unimaginable at that time. There were problems, of course, like Weimar Germany, but here in the U.S. we had prosperity, because we were supplying grains and materials and supplies in World War I.
We had incredible inflation. We had the same thing, men coming home, and all of a sudden the factories and the farms weren’t as prosperous, the demand wasn’t there from Europe. Warren G. Harding was getting the advice that to get of the depression he should increase government spending and raise taxes. He went the other way. He cut government spending in half. He slashed taxes. It took a year-and-a-half, and then on to the roaring ’20s boom because he did the right thing.
That’s just what we need here, and just like Thatcher did when she started blowing up the British socialism. Of course, she had the benefit of north sea oil coming online too, which helped, but until you get someone who says, “Okay, we’re going to take the hit for a year-and-a-half, but we’re going to do it right, and we’re going to come out.”
That’s the problem in Europe. They want to stick austerity measures on people, but they don’t want to blow up the structure, to unleash the private sector. And unless you unleash the private sector, get the government off their backs, downsize government, you are just going to crush your country, and you are going to have some kind of revolution, because people aren’t going to take the austerity forever.
David: We have two different kinds of revolutionaries to remember this week. Vaclav Havel passed away, and so did Kim Jong Il. On the one hand, with the first, there was freedom which came on the other side of revolution, and on the other, with the second, two million people starving to death, and nuclear weapons. Those are sort of Kim Jong Il’s claims to fame, or infamy. The kind of leadership that we need – can you imagine it? Can you draw a caricature of that leadership, and do you see that emerging this election cycle, or is that something we have to wait another election cycle for here in the U.S.?
Bill: You know what, it depends on the country. The good thing in the U.S., and I was very negative in 2008 about what was happening, and maybe you should get your money out of the country, but I think the reason you see the dollar rallying now is that the people in Europe seem to want more socialism, whereas in the U.S., if you read the surveys, in everything you read, they want less. Most of the people in this country realize the problem is that government is too big – too much government spending.
The Tea Party keeps saying, “We want to cut government spending.” That is so abhorrent to the vested interests of big government and the welfare state that they go out of their minds. But it is coming. It’s going to happen. The mathematics tell you that the spending is going to get cut, it’s going to get slashed, it’s going to disappear in a huge way.
If you have the right leaders, you prepare the country for this, but you also have to prepare the means to get out, which again, is to unleash the private sector. We all know what that means. It means that you crush government – government regulations, the structure of government, government workers, government spending, etc. That’s how you get out of this. Everybody understands this, except, again, the diehard dependents of the state, and if they had any sense they would understand that that is all going to disappear, and that they are better off getting a productive economy.
That’s the thing here in the U.S. The U.S. had such an enormous economic and financial advantage after World War II that it was just incredible. Never in the history of man had we had a nation as powerful and had such an industrial and financial base. So by the mid and late 1960s the welfare state was unleashed, in an enormous way. It was the same thing in the cities – all these deals, it was just ridiculous. And you struggled in the 1970s. Then Reagan and Volcker unleashed the U.S. economy again and you went berserk in the 1980s, and into the 1990s, and you got away with this, and now that all the global economies are rolling over with this massive transfer of wealth from the western world to emerging markets, and you can’t support the socialism anymore.
It’s just like in a family. If you have a family of five, and two are very productive, and the other three live off of them, that’s great. All of a sudden, if you have only one productive, it starts to become a struggle, because you have four living off of one, and when the one that was productive all of a sudden is getting reduced, then the whole thing comes down. That’s the western world. It cannot afford its social welfare state that it has created over the last 70-80 years. We are unwinding a social, political, economic system. That’s what is going on. It’s huge. Beyond secular. This is Kondratiev type of stuff. And that’s why we are stuck in this, and we have been stuck in this for years.
David: Out of that Kondratiev-type change comes either leadership that you are pretty excited about, or leadership that you really want to hide from. We have seen both, the good and the bad. What would you suggest is a way that we could either help, or promote, or get behind positive change, as we see this requisite purging occur? What kind of mindset would you suggest we need to take on?
Bill: I just think people have to be informed. I think one of the reasons they are getting this now is that the elite media has lost control of the megaphone. We have the Internet, and we have other sources of information, and data, so people in the U.S. have begun to understand what the problems are here. Again, what you are hoping is that people vote in leaders that will do what is necessary. Right now, though, I don’t see that happening, especially over the next year, and even in 2013, I still think events are going to force people.
We have seen this in times of war, the same thing, the events force people to do things, and we just hope we have the leaders in charge, that when the real game starts playing, can make the adjustments on the fly, and understand what is happening and can lead the nation and get the people to do what has to be done. That is still a long way in front of us, I believe.
David: It sounds like we are talking about a totally different election cycle, not this one.
Bill: What FDR ran on in 1932 was cutting the deficit. That’s what he ran on – that Hoover was recklessly spending. And he came in and he did a 180. Again, I don’t care what people campaign on and what they say. What do they do? Especially, when the game is being played, when it’s real-time, and there are real situations, and real dangers, and opportunities appearing. Are they mentally and emotionally agile enough, and smart enough, to make the adjustments quickly, and lead the nation on the proper course? We’ll see.
David: What a happy note to head into Christmas with (laughter).
Bill: Yes, well, the good news is, if you are paying attention, and you have a reasonably sound portfolio – you are not levered, you are not in big debt, and you have a nice cash reserve, and you have your hedges against that cash – you can sit and wait and watch. There are a lot of people who are desperate, they are panicky, and they are fighting for their lives. Again, if you are treading water, you are winning right now.
David: Yes, for the laymen, essentially, you are talking about a cash and gold position – cash, and a hedge against it.
Bill: Yes, or something like that. Well, not farmland anymore, that got overpriced. One of the reasons I think grains are in trouble is because if you have a family farm, you don’t care what the price is, and you produce your crops. If you are some hedge fund or private equity group, and you are paying all-time highs for farmland, all of a sudden you start trying to produce every square inch of that property. And so you can see that the size of the crops now are just enormous. That’s how the commodity markets work. Produce too much and the price goes down.
So, again, it’s a game. We just don’t quite know. The information isn’t good out there. It’s being guarded, they don’t want people to know the truth. They are not telling the truth. So you just have to be very, very careful, and you have to be very defensive. If you own stocks, you’d better have verifiably sound balance sheets. I wouldn’t touch a big bank right now, because there is just no way to verify what their real holdings are. Just remember, when Washington Mutual sold for 2 billion dollars, it was carrying a book value of 75 billion, and it sold for 2 billion. How good was all that financial analysis and balance sheet analysis?
There are some great companies, some of the top tech companies, some like Johnson and Johnson, Exxon, these type of companies that have good, sound balance sheets, low in debt, a lot of cash, and a company that is going to exist, no matter what we get first – inflation, then the big deflation, or vice-versa. That’s fine. On a micro-level, you are looking for businesses that are going to be able to generate cash. That’s what you want. You want businesses that can generate cash no matter what kind of environment we have.
David: We look forward to having you back on the program some time next year.
Bill: Okay, great.
David: And looking forward to a dinner in Chicago before too long.
Bill: That would be very nice.
Kevin: David, it is Christmas-time, but that was a sobering talk. When you look back at 2008 and 2009, just so much went on. Bill says that was a crisis, but not the crisis, so we need to hold on for a little bit.
David: Because all of these problems continue to get pushed uphill if you will, and the responsibility is given to someone who has deeper pockets. In this case, we have reached the end game, so to speak, because the sovereigns’ ability to borrow, or inability to borrow, ends up being the game changer.
Kevin: And you know, they are running out of room, because when Europe wants to give the IMF money so that they can give it back to them, as you said, they are just playing games at this point. They are out of money. Now, when people start to realize that, the daisy-chain stops rolling. That’s what Bill is bringing out, isn’t he?
David: Yes, and I think one of the things that he is suggesting is that the voluntary purging is more attractive than the involuntary, when the market forces it – because guess what? You actually put yourself at a strategic advantage.
Let’s say, for instance, that in 2012 we had leadership that came in and was very strategic about what they put in place in terms of policy measures, and they were both austere, and as Bill said, also did something that helped restructure our economy. So on the one hand austerity, and on the other, restructuring the economy for growth.
If those two things were introduced in 2013 as a result of the elections in 2012, then we might, in fact, be the country to lead through the crisis. If we don’t, then the question is – who leads, if they are willing to take the hit voluntarily? Otherwise, we may find ourselves all in one nasty stew pot, all of us dealing with the same things, taking the hit, but the market forcing it on all of us, at inopportune times.
Kevin: Hindsight is 20/20, I know, but we have had Paul Craig Roberts on, and he was with the Reagan administration when they were trying to get some things through that would have continued to make the economy grow, but there was conflict at the time. We had Volcker, who was coming in and tightening things up, and actually, there were certain steps that were taken by the Reagan administration at that time, as well, to clean things up from the Carter years, to clean things up from the early 1970s, even the mistakes that Nixon made before he resigned. Looking back, that was painful. 1981, 1982,1983 – those were painful years, but look at what happened after that. That’s what Bill brought out.
David: And I think even scooting back a little further – 1974 and 1975 – there were painful years that preceded it, but there wasn’t a voice of leadership. So Bill is also correct in saying, “Listen, if this is painful, people will listen, and people will tolerate the pain, if they think they are following someone who is credible, who has the ability to say, ‘Here is where we are going, this is what we are going to do. Watch how I get it done.’”
It reminds me a little bit of Yuval Steinitz, and what he rolled out for the Israeli government, saying, “Listen, here is how we are going to increase taxes, and this is how we are going to decrease taxes, in an orderly fashion, immediately. Yes, we are going to use fiscal tools to solve this problem (this was back in 2008 and 2009), but this is our credible way of both solving the problem, and unwinding it. We are not looking at over-reaching our boundaries, we are not looking at permanently stretching our new-found capital, in terms of revenues to be allocated beyond the crisis, into pet projects. But if we have to increase the pain today, we will decrease it tomorrow – we promise you.” And you know what? Steinitz was right. He did what he said he was going to do, and they have done quite well, actually, in terms of recovery.
Kevin: Then, during this period of unknowns, since most of the people who are listening to us are not policy-makers or decision-makers in Washington, though there may be a few, what about the person who says, “David, it’s Christmastime, I’m trying to figure out what to do with my finances. I’m looking at this last year. I’m confused. What do I do now?” You and your dad, last week when you were talking on the program, came to the conclusion that you really need to keep your powder dry and ride this thing out, so that you can move the right direction when it presents itself. Is that what you would suggest?
David: It is, and it comes back to something that is very simple, along the lines of that back-of-the-napkin conversation, with the perspective triangle, where you have a balanced approach where a third of your capital is powder that is kept dry, a third of your capital is allocated to creating a hedge for the capital that is kept dry. You have precious metals, which are an offset to your currency risk, in your liquid position. And then you also have a productive bet, a play on recovery, if you will, where equities and bonds can be in the mix, selectively chosen. You do have that balance built in.
Kevin, as basic as that is, I think you come back to the basics in these challenging times, because if you don’t have those basics figured out and covered, then you don’t have anything covered.