December 4, 2013; Andrew Huszar: Confessions of a Quantitative Easer

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: You are joining us tonight, for you David, it is 11:00 at night, I know it is 8:00 in the morning for myself, I’m still here in Durango. Tell us about Shanghai.

David: Shanghai is a place where I have not spent a lot of time in prior to this trip, in part, because our focus on China up to this point has had to do with the policy center, that is, Beijing. A year-and-a-half to two years ago, as we spent time in Beijing, it was to wrap our minds around what was going to be changing in the political landscape, and there are, of course, ramifications into the financial marketplace, and into the economy, depending on what happens with the politburo, with the folks in Beijing, in particular.

Now, Shanghai is the financial center and it is very competitive with Hong Kong for that status, but understanding the direction of the economy and the financial markets, this is really the place to be, and so, we have our work cut out for us this week in the various meetings. Shanghai is one of those cities that if you went back 20 years, maybe we all feel this way, even Durango has changed over the last 20 years, but the landscape here is radically altered, going from, basically, zero skyline to a sprawling skyline and 23 million people, as a city. It’s a very large city, very high concentration of people, and again, the center focus in this city is really finance, at least in contrast to Beijing.

Kevin: Dave, when talking to clients who own gold they are watching the prices of gold. Every time New York opens it seems like gold is manipulated in the paper markets, yet we see the numbers that are going into Asia, especially Shanghai, over 1000 tons this year, and it’s hard for people to get their heads around the fact that gold, right now, is being purchased at a greater rate than any time in human history, but it’s from the region that you are in right now. Why don’t you explain to the listeners, as well, why you are there, who you are going to be meeting with, and what you are looking for right now by being in Asia looking at the gold flow into Asia.

David: That is the primary reason we are here. Although we are interested in the financial markets in general and we hope that there is greater transparency and better bookkeeping, and all of these things, those things may develop over the next 10-15 years. The primary focus of our trip here is to meet with the folks at the Shanghai Gold Exchange, to meet with the folks at the World Gold Council, their branch office here in Shanghai, to meet with a number of banks who are in the process, and have already set up programs where they sell gold directly to the man in the street, and are putting together financial products and savings accounts which have gold as their backing.

It’s a fantastic contrast. What you see here in Asia in terms of the hunger for something solid, in contrast with what we have in the West, which is really just keeping up with the Jones’s. We want to make profits as quick as we can, and if that is in paper assets, so be it, but who really needs to own that barbaric relic, gold?

I had a conversation with a gentleman this morning and it was interesting, he asked me what I did. I told him that we had, as a family, been in the gold business, brokerage and trading business, for over 40 years. He said, “What a fantastic business!” His wife was with him, and she piped in to the conversation. It was interesting, just the smile on both of their faces and the enthusiasm as they both said, “We love gold.” And I said, “Are you saying that you love gold individually, or you love gold as Chinese people?” He said, “No, I grew up here in Shanghai.” He said, “You’d be hard-pressed to find a person that didn’t like gold, and didn’t want to own more of it if they had the chance.”

And I just asked him, “Why? Why do you like it, and we in the West really have no affection for it?” And he said, “David, it boils down to this. We know, and we have a belief, that ten years from now paper money won’t have held value, and the gold will have held value. We don’t have confidence in our paper money. When we work hard, when we diligently set aside a day’s labor and that wage, we don’t want it to dissipate, we trust gold more than we do our money mandarins.”

And I thought, “That’s interesting, because we really do have quite a bit of confidence in our money mandarins over in the West, but they, I think, have a few scars on their backs. It’s not just that they’re concerned about this year’s inflation rate, which is going to be about 3%, and that’s just under the Chinese target of 3.5%, but they’re looking at an appropriate time frame. They’re saying, if you run a 3-3.5% inflation rate for ten years, your savings are being decimated, and they won’t stand for it. He was just expressing the sentiment, Kevin, and I thought that was interesting, his time frame is right. You really begin to feel the bite of inflation, not in one day, not in one week, not in one year, but the cumulative effect of years, and of course, it gets even more dramatic when you start talking about decades. But encapsulated, that was, I think, just a snapshot into Chinese culture, why they like gold, why it’s so important to them.

Kevin: There has been such a change, David, here in America, since financial TV and media have become so accessible. It seems that the view of buying and owning gold has shifted. I met your dad, Don McAlvany, back in 1987, and that was revolutionary for me because I was in school, taking economics at the time, being taught the black box theories, being taught how the market rises, efficient market theory, all the Keynesian economics, you name it. And Don just basically said, “Look, you need to be able to preserve your buying power.” And in 1987 that’s when I bought my first gold from the company and have been with the company ever since.

But the mindset of the clients that are the most stable through the ups and the downs of gold is the same as what the Chinese have, what you just expressed Dave, over there. And that is, they’re buying it to preserve money. I have seen, through the last two years, and I know you have, too, that the Chinese buy gold and they don’t look at the price. They don’t care. They’re not speculating on rises and falls, that’s not why they’re owning it. They’re buying it to accumulate it because the paper assets won’t carry their value.

David: Only one thing I would add to that, Kevin, is that they do look, with some satisfaction, when they get to buy it at lower prices. So, there is, not really a price consciousness from last year to this year, but when it is lower, they certainly like it. It is interesting, Kevin, because for us, I think the public in the West is missing the obvious. We have short-term monetary patches which are being applied to long-term structural debt issues. The valuation has been, and will continue to be an easy way of addressing our debt overhead, and it’s staring us in the face, but we are choosing to ignore it.

Let me just give you a couple of examples. We have home prices which have risen at about a 12-13% year-over-year rate, and that’s according to the S&P Case Shiller index. And yet, the housing component in the U.S. CPI, that is our inflation measure, the housing component that goes into our inflation mix only registers a 2.2% gain, that is, owners’ equivalent rent. That’s the real estate portion of inflation and how it’s factored in.

Then you have things like airline tickets. I just bought a fairly expensive plane ticket to be here in Shanghai and according to the international air transport association, prices on tickets are up, on average, by a minimum 5.5%, and yet, when you look at what is factored into inflation, into the CPI, it’s 0.8. That’s 8/10 of 1%. Is there a difference between 5.5% real world and 8/10 of 1% in the world of the Bureau of Labor Statistics? I think there is. You could go on and on and on. We have, staring at us, what is obvious, what is plain as the nose on our faces, inflation in front of us, and yet we choose to say, no, it’s not that big a deal, and I think, again, you go back to that issue of the cumulative effect, death by a thousand cuts, the cumulative effect of inflation over a decade, like this couple that I met with today, and I think that’s where you begin to see real, real damage done to an individual.

Kevin: David, we’re living in the age here on this side of whistle-blowers, people are finally coming out of the woodwork and saying, “You know what? I can’t do this anymore. I can’t lie to the American public.” Of course, we have the Snowden thing and it has awakened the world to just how much the government has snooped, but I’m thinking about a couple of weeks ago, in the Wall Street Journal, November 11, Andrew Hussar, who was responsible, he was brought to the Federal Reserve to manage the quantitative easing program and the way he starts the article, I know you’ve read it, but it says, “I can only say, I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into bond-buying known as quantitative easing. The central bank continues to spend QE as a tool for helping main street, but I’ve come to recognize the program for what it really is, the greatest back door Wall Street bailout of all time.”

You were talking about putting patches on things. The people overseas can see this patch. Even the person responsible for managing quantitative easing has stepped away from the Fed and publicly apologized in the Wall Street Journal. Why is the American public, David, still continually focused on what they are doing to the price of gold, or to the price of stocks and buying into this CPI number?

David: Yes, that’s a very good question. I think a lot of it has to do with the way our minds have actually been re-engineered, if you will. Look at what the gasoline prices have done over the last several years. If you take the decade view on gasoline prices, we’re up 250-300% on a per-gallon basis, and yet, we are only too happy to pay $3 per gallon for gasoline instead of $125 because $3 is not $4.50, and we’ve come close to $4.50 here recently. It’s almost as if we have a re-engineering of our minds and we’re very comfortable with low levels of inflation.

The Chinese, their policy is intended to create 3.5% inflation. You’ve got the Japanese trying to target inflation, as well. You’ve got the U.S. trying to target inflation, and actually, they are not getting their number. We’re slipping into a disinflationary period, yet again, and of course these are the Fed’s numbers anyway, so according to their numbers we’re slipping into a disinflationary environment. The same thing could be said of the budget deficit. Now we can be enthusiastic about the U.S. budget deficit shrinking to 700-800 billion dollars, when just 5-10 years ago, that would have been setting all-time records. The only reason you can be enthusiastic about a 700-800 billion dollar budget deficit is because of late we’ve been running a 1 to 1-1/2 trillion dollar budget deficit. So by comparison we are now doing a very good job managing our household with a 700-800 billion dollar budget deficit.

Kevin: David, it reminds me of the monetary dialectic, two steps forward, one step back. So the deficit was 400 billion, 450 billion, for years, and then it jumps to 1.6, 1.7 trillion, and then we clap when it drops back down, like you said, to 700-800 billion. The problem is, we weren’t affording it when it was 450 billion.

David: Yes, that’s very true. We have some things that I think are very important to key in on in this market here in China, and I think one of the issues, and again I mentioned earlier meeting with the Shanghai Gold Exchange, the World Gold Council, and a number of banks here in Shanghai, our effort here is to understand whether or not this radical demand for physical gold is central banks only or individual demand for gold, as well, and what we have found so far is that individual demand is, in fact, very, very robust, but this combination of central bank purchases, as well as individuals throughout China, throughout Hong Kong, throughout Asia in general, but we’re focusing on China on this particular trip. This is important for us to wrap our minds around, particularly when you think about the economic challenges that China is facing right now.

Kevin: Talking about the challenges that they face, speaking of the Third Plenum that you had been mentioning a few weeks ago that has now completed, that is mainly a Beijing type of problem that is being solved. You had given an analogy to me one time, David, and I really liked it, and that is, for the person who has not been to China, how do we differentiate Beijing from, say, Shanghai? You had mentioned Shanghai as a financial center, a lot like maybe New York City, even though population-wise, it’s twice what New York City is.

Beijing is more like Washington, D.C. It is where the policy is made in China, and do you see, David, the policies that have been discussed and brought out over the last few weeks actually having an effective impact on the changes that they need to make, going from an export-driven society to a consumer-driven society, and investment-driven society?

David: Precisely. I mean, this is the rebalancing that they are attempting to do. They have gone from a once mercantilist, or export-oriented, economy, to being dominated by state investment and that state investment is really just a stop gap measure, in part because as demand drastically dropped for their products in the 2008-2009 period, and really has not fully recovered in the five years since, the Chinese government has had to step in, with unprecedented stimulus.

Again, that started in 2009, but here you have the state’s footprint in the economy at record levels, you have the household consumption level at records lows, as a percentage of GDP, and they need to rebalance, they need to regain some autonomy from the export-oriented economy dependent on the West. And of course, it’s not sustainable for the state to just be spending, or eating their seed corn, so to say, spending all of their money just to keep up appearances.

The rebalancing will occur, and I think this is what is really important to remember. We have seen this before in our own country. We were, in the 1920s, running the same kinds of trade surpluses that China has over the last decade, and it’s very important to remember, the 1920s really got us going toward our independence, and gave us tremendous stature on the world financial team. The 1920s built up these huge trade surplus dollars, we had deficits elsewhere in the world, those two things always balance out, and lo and behold, we found that debt was growing at an exponential rate. In fact, debt was growing at a rate that ultimately was not sustainable, and those inherent, intrinsic weaknesses played out very poorly in the early 1930s, starting with the stock market collapse of 1929. It is not improbable, and it’s not unlikely, to see the same kind of financial panic and financial chaos here in China, and it’s not to say that china then becomes a backwater country. In point of fact, they are in the process of going through that maturation process that we went through in the 1920s and 1930s. And by the way, it was only in the 1940s, 1950s and 1960s that we began to see a very, very interesting growth dynamic.

If you look back, Kevin, we have gone through two distinct phases or periods of growth in the United States, from 1949, so basically after World War II, once we got through the command economy period, World War II, 1949 up through the late 1960s, that growth in the economy was driven by a radical increase in income. Income growth ended up driving the economy, ended up driving the stock market. It was an absolutely fantastic period of time.

The second period of growth was from the 1980s to the year 2000, and perhaps if you want to stretch that to 2007 you could describe the second period of growth as a period of growth that was driven by credit growth, by leveraging of corporate balance sheets, by leveraging of personal balance sheets, by leveraging of the national balance sheets. These two distinct phases of growth are very interesting because we have not, in the United States, had follow-through with that income component. In other words, households are now dual-income dependent, instead of one income growing year after year, after year, after year. We now have such a disparity between the economy, as it were, and income components in the economy. You are almost required to have two people in the family working.

What is really telling, coming back to China, is that as they attempt to rebalance their economy, it is to that end, it is to the empowerment of households, it is to see households increase their percentage of the total economy via consumption. And guess what? If you don’t have the money, you can’t spend it. At least, that’s the way a lot of the world still exists. Again, you go through different phases. Once we spent on the basis of what was in our back pocket, or front pocket. That was that period that I just mentioned, 1949 to the mid to late 1960s, you saw growth in consumption, and it was based on growth income.

As soon as incomes began to decline, the only way we could keep up with the Jones’s was to borrow to spend, and we continued to consume and spend, but it was with someone else’s money. We were borrowing from the future to enjoy more in the present. We’re really not at that credit growth phase for individuals here in China, but it’s worth noting that they are in a very tricky transition point, again, exactly where we were as an export-oriented economy in the 1920s.

And it is our sense that we probably will see a major financial crisis here in China before they really get their act together and have the same kind of growth trajectory, and ultimate success story that we saw in the United States, something I think is long-term, very, very bullish, but in the short-term, could be deadly for a portfolio.

Kevin: What you are saying can be crystallized when you talk to someone who is in their 70s, 80s, or 90s. There are people that age listening to the program right now who are nodding their heads. They are saying, “Yes, I remember American productivity coming from productivity from income, from growth, and then I remember the generations that followed coming and believing and living as if they were still productive, but actually, they were borrowing.

To bring something up, Dave, you have looked at the financial moving to the economic, the economic moving to the political, and then the geopolitical or the geostrategic, and I was thinking about the trajectory you are talking about in China. The 1920s comparison to the surpluses that China has today, and then of course followed by the 1930s, which was a worldwide depression, which we are still looking toward, even though we may be in it right now.

But then, the 1940s, America, because of the 1920s, because of surviving the 30s, America was a world-dominant power, militarily, strategically, politically, economically, and the Bretton Woods system infused that with a gold-backed currency guarantee through the Bretton Woods system that the world went under, and so, with this trajectory in China, people are looking at the forward motion of China. We’ve talked to Stephen Roach, and he says, “Not now, they’re not ready.” But as far as world dominance over the next several decades, it seems like that trajectory is very similar, like you’ve pointed out, to what the Amrican trajectory was back from the 1920s on.

David: And this, I think, is where gold enters the picture with a very intersting twist. As the state designs the next steps forward and moves toward the consumption-oriented economy, remember that conversation I had with that couple earlier today, where with great enthusiasm and with smiles on their faces, they would gladly own more ounces of gold as a part of their savings strategy, not trusting the local currency as much as they do, good old faithful ounces of gold in their pocket, or in their banks in a savings deposit box. They like gold, and they like it for a reason. If they had more income, yes they would improve their lifestyle, they might be a house, they might buy a car, they might buy another cell phone, but they also have that ingrained tendency to save, and to save in terms that are lasting, that are enduring. I think the biggest issue for me is, if the government is successful in this rebalancing effort, I think you are going to see a radical increase in the amount of ounces drawn out of the marketplace for gold ownership here in China. Does that make sense?

Kevin: So as we see this income increase in China, which is the stated goal of the Chinese government, they want to see the income come up, they understand the economics of that, they’ve seen that model work in other countries. So as that income comes up what you are saying, Dave, is the demand for gold can only increase. Now, before you say anything, I just want to point out that China already produces more gold than any country in the world.

I mentioned in 1987 when I met your dad, he was going to South Africa several times a year with groups of people, doing what you are doing in Shanghai right now, but he was going to South Africa because they were the number one producer of gold, and they were selling it to the world. Here’s what’s different. China is now producing far more gold than anyone else, yet they are not selling a single ounce. Instead, they are buying about double what they actually produce, so the demand can only increase yet the supply.

David: That is interesting, isn’t it?

Kevin: Yeah, the supply is not coming out of the Chinese country.

David: No, it’s the combination of being the largest producer, as well as the largest consumer, far beyond what they produce themselves, importing, again for these dual purposes, both central bank balance sheet purposes, that is, the central bank, People’s Bank of China buying ounces or tons of gold, and individuals on the street doing the same thing. It’s very important to watch this transition and why we spend time, both in Beijing, as well as Shanghai is because you are really talking about a political issue here.

It’s one thing to state your economic goals and aspirations as a country, understand that there are vested interests in this place. There are more billionaires created in a short period of time, here, than anywhere else in the world. And I have to say, this is not capitalism, it’s connectedism, if you will. Connectedism is where you are tied into the state apparatus, and on that basis, you have made a bloody fortune.

This is the crux of the changes that have to be made. Who wants to give up the franchise? We’ve got state-controlled assets, which have benefited the state, and individuals who are connected to the party, and now they have a deliberate policy to enfranchise household and individuals, not just a select few thousand in the country, shifting these advantages away from the politically connected, but a household.

This is where, again, income is a major issue, and I think the unintended consequence, and this is not a stated policy, but the unintended consequence is that the man and woman on the street here in China with an improved income is adding to the demand side for gold in a very, very significant way.

Kevin, I read a quote recently from one of the Fed economists, and he was talking about BitCoin, you probably know the digital currency which has traded over $1000 per BitCoin here recently, and then dropped 40% in one day, and recovered 27% the next day, radical volatility. He said this before. He said, “It’s hard to imagine a world where the main currency is based on an extremely complex code understood by only a few, and controlled by even fewer, without accountability, arbitration, or recourse.” This was Chicago Fed Senior Economist, Francois Velde. Just think about this. He is talking about a digital currency and saying there is no accountability, there is no arbitration, there is no recourse, it’s complex, no one understands it, and I’m thinking to myself, maybe he needs to look in the mirror. This is what the Fed does all the time.

Kevin: (laughter).

David: They manage this complex riddle of a currency and do it in such a way that there is no accountability, there is no arbitration, there is no recourse, and we will wake up to what the Chinese already know, which is that the central bank is not their friend. The central bank, that is the Fed, is their enemy. They are the enemy of savings, they are the enemy of resources sitting in the bank, in money market funds, sitting uninvested and unspent, because they are, in fact, deliberately chipping away at their purchasing power, year after year, year after year.

And on an intergenerational basis, this is a game-changer. When you begin to think about managing assets on a long-term basis and you capture major trends over long periods of time, what you have gained is immense, but if you’re not looking at the long-term impact of things like inflation, you’re missing it. I think this is one of those things where it’s just flat obvious. It’s flat obvious what the rest of the world is addressing, particularly those in Asia who have long experience with currency devaluation. We see it live, right now in India, and to a lesser degree in China today, but in their past, they are riddled with currency collapse. They know what they know, what they know.

And for us, well, we’ll know it soon enough, I suppose, but I think it’s going to be one of those tragic tales of woe where the average middle class family, the average person who has done their best to save for college, to save for retirement, save for their daughter’s wedding, to save for whatever it may be, the cost of what they had saved for has moved far beyond what they were able, with all their effort, with all their intention, to muster, and put aside. It’s unjust. It’s at the intersection here where, again, economics, finance, and politics all meld.

To be in China, we have to look at what’s happening in Beijing to understand what will ultimately happen in Shanghai, and we have to do the same thing in the United States. You can’t look at the Affordable Care Act, you can’t look at the various means of taxation, whether it is financial repression, low levels of inflation being put in place deliberately by the Fed, with 2% rate of inflation which is targeted. You can’t look at these things that are being put in place by D.C. and not ultimately calculate their effect into the financial markets and into the asset market. This is what we would ask people to do, step back and look. What are the consequences of the policies being put in place today, over the next 2, 3, 4, 5 years, even 10 years. You will find that we have major structural stresses and strain and no number of small monetary patches will address these core long-term structural challenges.

Kevin: Sometimes memories, Dave, are made, not necessarily on economic numbers or charts, but they are made just with simple pictures, and I’m going to use a couple of movie allegories here just for a moment. You’re in China because the dragon is now entering. You remember the movie Enter the Dragon? This is really what we need to understand as Americans, that the dragon has entered, the incomes are rising. But I think also of a movie that is about to come out here in a couple of weeks, which is the second installment of the Hobbit movie, and we’re going to see the dragon enter on that one, as well, but he’s sitting on piles of gold, and I think as people listen to this program they need to understand. The dragon has entered, and it’s sitting on piles of gold, and it’s accumulating more, and that’s what you are looking at at this point, Dave.

David: Kevin, I asked my dad to join me here in Shanghai, so we will be meeting here with lots of folks in Shanghai. We will also be spending a lot of time just father and son, and talking about what’s happening in the world, what’s happening with our business, what’s happening with our clients, and it’s really important, I think, something I was raised with, something that I heard around the dinner table from the time I was 3 or 4 years old, at least that’s the earliest recollection I have of it, is a phrase that he always used. “He who owns the gold makes the rules.” He happened to be the authority in our family, and he had the gold, and I had none, although by the age of 6 I certainly wanted all the ounces that he had.

But that is true in the international and the geopolitical sphere, as well. As you look at the dominant currencies, whether you are talking about the Portuguese, the Spanish, the Dutch, the British, the U.S. currency, the U.S. dollar, these countries and these currencies gained pre-eminence in the world financial picture and the world monetary system because of the gold, which was the backbone of solidity for those currencies. It was the legitimizer of those currencies.

And I go back to that phrase and I look forward to revisiting it with my dad as we walk through the streets of Shanghai this week. “He who owns the gold will make the rules.”