The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“What do you share as an identity if you are a central banker or a socialist? It’s this issue of, ‘We believe we should control decision-making, and the market is not capable – people in the market are not capable – of doing these things. We will do these things for you.’ Whether it is redistribution of capital or redistribution of income via interest rates, it’s really the same thing.”
– David McAlvany
Kevin: David, I have visions of the horror of when the Berlin Wall came up. If communism or socialism was such a great thing, why was a wall built, and why do we have video of people being shot trying to cross to the other side?
David: When I was in Hamburg just a month or so ago with my son, there was this World of Miniatures and they have this complex set of trains and re-creations of different periods, and one of the periods that they did recreate in miniature was the downtown area in Berlin.
Kevin: Checkpoint Charlie?
David: Checkpoint Charlie. And when you see this development of nightclubs and people out and about, and then within a 6-12 month period of time you can begin to see they have removed some buildings, and there is an open space, and then they begin the wall, and then they begin to point the guns at people.
Kevin: Sort of a time-lapse type of thing. You start to see things coming ahead of time.
David: That’s right. And it was great, my oldest son is nine years old, and we’re looking at this and you see change occur on a gradual basis, but it’s moving toward a terminus. It’s moving toward a point that is very critical. And in this case, it was the loss of freedom. There was no ability for anyone who was stuck on the eastern side to do anything about where they were.
Kevin: Even though they could have possibly seen it coming if they saw the steps ahead of time. They could cross all the way up, probably, to that 24-hour period before.
David: That’s exactly right.
Kevin: The reason I bring that up, and maybe this sounds like it’s a little extreme, but we’ve been talking over the last several weeks about a cashless society and we’ve been pinching ourselves, because the mainline media, Bloomberg especially, Larry Summers, some of the things we can talk about today – they are talking about closing the gap of freedom of the ability of a person to be able to spend money, take money out and do what they would like – they’re talking about closing that freedom very quickly. I refer to Larry Summers’ article this last week, his call to get rid of 100-dollar bills. That’s just the beginning.
David: When you control the currency and try to control people relating to the currency, that’s just not new. You had this happen in the 4th century in Rome, you had it happen in the 15th century in Britain, you had it happen in the 18th century in France, and of course, the 20th century in Germany. This last week I was in Taos, New Mexico over the weekend. I skied with a good friend of mine there. We went to an antique shop in downtown Taos. It was interesting, it was run by a Frenchman, and I found this small cache of notes from 1792 and 1793, and I was fascinated.
Kevin: These were from France.
David: That’s right. These were the assignats just before the hyperinflation, which was just before the blame game started being played and the royals were crushed as a result of this financial catastrophe.
Kevin: It is interesting, because we see volatility in the market, looking at Barron’s here over the last week, Barron’s is correlating the rise of Sanders and Trump, this dissatisfaction with the status quo, and they’re saying maybe that’s what is contributing to volatility. But they’re missing the point. They also had an article elsewhere in the newspaper that says the central banks are losing control.
David: What is interesting is, going back through time you see the same sort of misconnected correlations, inappropriately connected correlations, where something is the explanation for what is happening in the marketplace, and it was the excess of the royals in the case of the 1796 to 1798 period where heads were literally rolling. In the period of the 16th century, the 1500s, where they were burning witches in England, it was the same thing. They had to blame someone for the massive amounts of inflation which were occurring.
And of course, under Diocletian, after setting prices and failure of price-setting in the 4th century, you have massive persecution of Christians where, because this little sect of people were worshipping one God instead of many gods, it gave the Romans the excuse to correlate and say, “Look, we know exactly why the harvest was poor and prices are rising. It’s because there has been displeasure amongst the gods.” So, I look, and I say, “Gosh, this is so frustrating.” And of course, Barron’s correlates the rise of Sanders and Trump with market volatility. It is one more poor connection. Correlation is not causation.
Kevin: In a way, the central banks have been trying to keep order a little bit like the royals did back in France in the late 1700s. It’s falling apart. Economist magazine, just this week, has a banker standing on the front with an empty canon, and it says, “Out of ammunition?”
David: Again, it’s this idea of losing faith in central banks, and monetary policy effectiveness which is driving markets. And you can grasp for other correlations, again, the populist political sentiments on the left and the right, which may be disturbing capital allocations. I think that’s a low probability explanation. It doesn’t have enough meat, to me, to satisfy what is actually the cause. When you look at what has boosted asset prices, and it’s monetary policy, and then look at the monetary policy vacuum that is being created by both a lack of intervention on the one hand, the suggestion of, as you said, are they out of ammunition, or are negative rates the next place to go? These are the issues which are causing disturbance in the financial markets because no one knows if asset prices are going to be backed up as they have been in the 2010-2015 timeframe.
Kevin: Before the central banks rode in on white horses to save Wall Street and the banks that were too big to fail, we also had sovereign wealth funds. These were funds that governments, themselves, ran. And actually, they were buyers of a lot of the assets that fell during the last crisis.
David: They have amassed close to 7 trillion dollars. These sovereign wealth funds are basically like the investment vehicles for the countries which have done well selling resources and goods over the last 15-20 years.
Kevin: China. Right.
David: And it is these sovereign wealth funds that are now in a bind. They have taken their proceeds, they have invested them through the years in U.S. treasuries, in U.S. stocks, in trophy properties, in London and New York and elsewhere. And if you go back to the 2008 and 2009 timeframe, they put considerable money into the bailout efforts, often buying banks and financial assets, or parts of those companies, to stabilize them and to keep them from dropping further. So they were buyers with their excess capital and they have that excess capital from selling natural resources. Now they are turning into sellers. You look at oil revenues which are in decline and that is forcing many of these Middle Eastern companies, in particular, to refocus on short-term domestic priorities.
Kevin: “Bring the money home. We’re hurting right now.” Everybody can relate with that. Just about everyone who listens to this program at some point had to bring some money home because of economic woes. We talk to clients right now, the oil patch going down has affected people’s pocket books pretty dramatically, a lot more than gas prices coming down. Think about for countries that are actually dependent on oil prices being high.
David: This is a considerable shift from the long-term investment plans which have been in play with the sovereign wealth funds, to, again, more of a short-term focus on domestic policy priorities, and it is because they are beginning to see signs of social unrest. We’re beginning to see decay at the edges. These countries, as they look at their neighbors destabilize, it is knocking at their door.
Kevin: And a lot of that money is in the United States that is being pulled back out, so this is a real strain to our own economy.
David: Right. At the end of 2015, of that 7 trillion dollars which is stuffed into sovereign wealth funds globally, 3 trillion of that was in the global stock market, with a very high concentration of it in U.S. equities. So as oil prices have increased, so did the dollars flowing out of Qatar, out of the United Arab Emirates, out of Russia, out of Saudi Arabia, and it was enriching those countries. They took those riches and invested them elsewhere. Now we have the reversal of flows, and that should not come as a surprise. The petrodollar has stood almost like an added verse to our national anthem.
Kevin: It has given us support for 40 some-odd years.
David: Since the 1970s we have been able to bank on that. However, if oil prices remain between $30 and $40 a barrel, even throughout 2016, not only will you see an increase in the supply of U.S. treasury bonds coming back to market from these sovereign wealth funds, but stocks, too, will be coming back to market. The estimates are that around 400 billion dollars, approximately double what was liquidated last year from these sovereign wealth funds, by these entities – I think the exact number was 213 billion in 2015 – so better than 400 billion dollars is expected to be liquidated in U.S. equities this year.
Kevin: I think it is important to understand, if we have U.S. treasury bonds come onto the market, that also means that we require a buyer. It is either going to be our own government, or we are going to have to see interest rates rise to satisfy a buyer who wants to have positive interest.
David: 400 billion – to me that is still a real number. We may be desensitized to the tens or hundreds of billions when we live in the land of trillions, but this is something of a liquidation vortex, and I think we should keep this in mind for the next 6, 12, 18 months. We have Norway, just as an example. They will, for the first time since they started their sovereign wealth fund in 1996, pull money from that fund this year. You have Saudi Arabia and you have Russia, both of which have aggressively prioritized large scale infrastructure projects and social commitments over the asset allocations which they previously held.
And so in a world that is destabilized by falling prices, you have to ask the question, and I think it is reasonable, what would you prioritize, as a politician? And so, go to your imaginary patch of sand or your stretch of countryside in the Urals, wouldn’t you refocus and repurpose those funds toward buying social stability and buying time? And that’s exactly what they’re doing.
Kevin: We talked about saviors on white horses being central banks, but there is a strange development in this land of high tech, high speed. You have the wonderful second by second, or I should say nanosecond by nanosecond high-frequency traders. Are they going to be the guys who can possibly save the market and keep this from happening, or is this the flash crash waiting to happen, as well?
David: Isn’t that interesting, because the components that you have in today’s volume structure, if you’re looking at the stock market, on any given day 50-70% of the volume is nanosecond trading by computers, algorithms…
Kevin: It’s robots.
David: And disconnected from a human element. You have these economic and financial consequences which we are talking about throughout the Middle East, and specifically relating to the petro dollar. These are considerable asset allocation shifts. The general public in the United States and Europe are not in the position to step in and replace those sovereign wealth funds as the new stockholders. The high-frequency traders, the best they can do is fill the void for a nanosecond, but these are not exactly long-term holders as defined by what they even refer to themselves as, high-frequency traders. You are moving from an investor class to a trader class and ultimately what you are talking about is a supply and demand issue, an over-supply of stocks, and inadequate demand. What price dynamic does that have in play?
Kevin: In the long run it drives prices lower. But I remember seeing a YouTube, Dave, that was amazing, that showed in slow motion – it took eight minutes to show, I think, five seconds of trading on HFT. I can’t remember how long it was but what it showed was a number of traders – it was a visual circle of seven or eight traders that were actually buying and selling the same stock over and over, all within a second or two. And you would see these buys and sells, and it was hundreds of them in this five-second period.
David: And each time the purchase was made it was like a light, and the light was brighter in light of the volume being purchased, or dimmer, if it was a smaller purchase. But again, it took a stretch over several minutes to capture what was happening in seconds, according to an algorithm.
Kevin: And you said that is about 70% of the market.
David: 50-70% on any given day. You also have cash that is on the sidelines, and I think this is the other pocket. You certainly have institutional investors, private investors, who may be able to step in and take away some of the oversupply of stocks and bonds that would be coming to market from sovereign wealth funds. The question is, do you have a value in the marketplace which is considered compelling? And if you go back to the backdrop of 2010 to 2015, a period of radical stock market growth, it was central bank stimulus which was writ large in that era.
Is that what a new stock investor in 2016 can take to the bank, that you are going to have growth propelled by central bank activity? If it is not there, you’re asking a different set of questions relating to fundamental value. Maybe that relates to book value, maybe it relates to the ratio of price to sales. Maybe it relates to a 10-year, or as we mentioned a few weeks ago from John Templeton, a 20-year rolling average of price earnings. Where are you in a time continuum? Are you overvalued or undervalued, and are you willing to be the person who starts to take on an inventory of these stocks that are being forced in liquidation?
Kevin: With all this coming to market it reminds me of something very unusual for the markets that has occurred over the last year or two. We have seen it with China, we have seen it with Japan, where the central bank itself just goes in and buys everything no one wants off the stock market. Is that something we could see?
David: Maybe these concerns are overblown. If that is the case, the People’s Bank of China did it, the Bank of Japan did it. They can use their balance sheet to purchase stocks and purchase index positions, which would then buoy the equity markets, in general. And I guess that’s a possibility, Kevin, but it leaves me with the sense of, what signal does that send to you, when the support for the stock market is a central bank balance sheet, and without it you have a cascade in prices? To me it suggests desperation, but maybe I’m just kind of in a world of negativity.
Kevin: There is another option. I remember my Money and Banking class when I was taking economics. Professor John Cochran taught us about Keynesianism versus monetarism. Monetarism, of course, is monetary policy. You raise interest rates, you lower interest rates, or you print money, or you contract the money supply. But Keynesianism adds another element, and that is, if monetary policy doesn’t work, let’s just go to the government. They can start spending money to reactivate the economy. Look at FDR back in the 1930s. Mount Rushmore didn’t just come out of nothing.
David: Right. So, you have an echo of FDR right now with the OECD in Paris, the Organization of Economic Cooperation and Development. They are pleading with central banks all over the world. They are pleading with global fiscal authorities to immediately, and on a large scale, shift to investment projects. In other words, fiscal stimulus. They are suggesting that every government around the world use and leverage the income from taxpayers to keep growth on track. And if there is not enough in terms of current tax revenues, if that is insufficient, you can raise taxes. Or you can engage in massive deficit spending. But the message is very clear. Slowing global economic growth is not being halted by corporate or private spending, and monetary policies which have been tried thus far have failed to halt the decline in growth. That leaves governments of the world to fill the gaps.
Kevin: I can’t help but envision what you and I drive past every time we go east out of town from Durango. Durango is a town of 15,000 people. It’s a nice, small, not even a medium-sized town. Yet we have bridges to nowhere, overpasses that were built during the last crisis, this same kind of fiscal stimulus. They go nowhere, but they look like they should be right downtown Denver, in the heart of a city that would have heavy traffic.
David: You’re right. It’s a 10-15 million dollar bridge just right outside of town and you don’t see any traffic on it because it’s unusable.
Kevin: It goes nowhere.
David: It goes nowhere. Maybe they were thinking ahead, just like the Chinese have been thinking ahead and building ghost cities because if you build it, they will come. This is a theme that Russell Napier developed throughout 2015, that we were in a transition from monetary policy to fiscal policy stimulus. I think he is right. I think he was ahead of the curve.
Kevin: Let me ask you a question then. If the sovereign wealth funds are no longer there to provide cushioning, are you basically telling us now, taxation is the next wave of the future?
David: You are talking about basically two worlds. You are talking about a world where in the case of those countries that have been running massive trade surpluses and building up their sovereign wealth fund resources, yes, they do have a cushion, and they can push off the issue of increased taxation or deficit spending because they have a pool of excess savings.
Kevin: Does that work for the United States, though?
David: If you run trade deficits you are in a slightly different position, so the U.S. would be in a bit of a bind there. Most of Europe, ex-Germany, would be in that same bind, Japan in the same boat. It is about 85% of your G7 countries that do not have a cushion and are going to have to look at immediate increases in taxation or deficit spending because of the lack of a pool of excess savings. So without a cushion I think there is radical action on the horizon in this 2016 to 2018 timeframe.
Kevin: Can fiscal stimulus, though, turn into inflation quickly? The Federal Reserve has said for a long time that their goal on inflation is 2%. Well, guess what? We have more than that. We have a report for 2.2% annualized at this point, so does that factor in? Do they look at inflation and say that would push inflation too much to do go in and do what we’re talking about?
David: I think fiscal stimulus will have some impact on an increase in velocity of money. It is basically pumping money directly into the economy, as opposed to pumping money into the banking sector and hoping that it gets into the economy.
Kevin: Yes, because negative interest rates haven’t worked, zero interest rates haven’t worked, and so what you are saying is, if the government starts spending money, velocity – we’ve talked so often about the equation that says, if velocity increases, the amount of money that has been printed, or created as a number over the last six or seven years would devastate if it actually flowed quickly.
David: Yes, so I am interested in fiscal policy stimulus and looking at that in the same context as the recent CPI numbers, because you have core inflation which is now above the Fed’s target of 2%. It is coming in at an annualized 2.2%. Inflation is creeping ever so slowly in the same context that we have $27-33/barrel oil.
Kevin: Yes, a buck-seventy-five at the pump.
David: Exactly, with gasoline there is a cost reprieve which I think all consumers are grateful for. However, what does core inflation look like if oil should start to recover at all? And I’m not talking about $100 a barrel oil. I’m talking about, say, a 20% increase in the price of oil, which would still put it under $40 a barrel. So someone needs to send the Fed, I think, a very simple memo, which just states, “Be careful what you wish for.” They’ve wanted inflation. Now they’ve gone above their targeted 2%, 2.2% if you’re looking at core inflation.
So they’ve longed for inflation, and they’ve longed for inflation as a means of stimulating the economy and GDP growth. And they have models that suggest that that is wise. What they cannot mathematically model, let alone control, is the psychological shift in inflation expectations. That shift is like a trip wire. If you trigger it, you are not going to even be able to finish your first thought, which is “Uh” and “Oh.” You can’t even get to the second part of that, as the explosion in inflation moves higher.
Kevin: I’m surprised you didn’t say that with a French accent or a German accent, because we saw it in France – you got those assignats at the antique store – and in Germany the same thing happened. If you actually look at mathematical models and you look at true inflation in Germany in the early 1920s before that “uh-oh” catastrophe occurred, inflation was running between 3% and 5%, so this is not something unusual. In fact, they even had deflationary pressures before inflation moved to 3-5% in Germany, and then “uh-oh,” and then if we go back, actually, to France, that’s when the heads rolled. That’s when it was good to not be an academic or royalty.
David: Right. This brings to mind, are we positive on the price of gold? We’re not positive on the price of gold because it has moved up since January.
David: And we’re not positive on the price of gold because it’s near a bull market threshold. We’re not positive on the price of gold because relative to stocks, or even measured on its own, in real terms, it has had a good year. Just in the first two months of 2016 it is up 15%, your gold miners are up, on average, 43% – 43% since the beginning of the year.
Kevin: Well, let’s face it. We’re not positive for those reasons, but it doesn’t hurt.
David: I agree. We are positive on the metals, both gold and silver, because of what lies ahead, not what lies behind us. We’re positive on gold because, as Barron’s highlights this week in Randall Forsyth’s article on the central banks, people are losing faith, and when faith in the money mandarins wanes, so does confidence in credit, so does confidence in the stock market, even confidence in cash balances in the banking system, compliments of your negative interest rate policy, which raises the issue, where does a global investor go if they want to be in the financial system, but not subject to the vagaries of volatility while risk is reappraised in the shadow of monetary policy failure?
Kevin: Right. Let’s face it. We’re losing the ability, at least partially, and then ultimately, like you talked about with the Berlin wall, how you could see the time-lapse photography. We’re seeing the same thing with the banks. People want privacy. They want portability. They want recognizability. They want something that, counterparties such as banks and governments can fail, and still has value. That is gold.
David: That’s right. So as you are looking at the basic characteristics, this is why it is important to own it – private, portable, devoid of counterparties. It is a safe haven, it is a port in the storm, it is insurance against central bank policies and the system which is propped up by those policies. And it is uncomfortable for investors to think of gold as an investment, because it’s uncomfortable. Life rafts should not be mistaken as a cruise ship. They’re not comfortable, you can make a great case against them if you’re talking about every day pleasure cruising, but they do serve a situational purpose, and when you need one, you are grateful to have one.
And I’m not sure that the regular investment calculus, swinging between feelings of greed and fear, promotes gratefulness. But in that moment, when a ship sinks, when you move beyond the feelings of fear or the feelings of terror, I’m telling you there ought to be gratefulness, because you look at the means of safe passage, you look at the foresight of having the vehicle to get you to safety before the need was pressing – yes, for anyone who has done that, you should be grateful for them, to them. I don’t know if that’s how family will respond to those who have thought ahead, but it should be.
Kevin: I had a chance to feel that life raft, or missing life raft feeling. I took an open ocean cruise – I was helping a guy sail a boat – and it was out of sight of land, which for me, I’ve grown up in Colorado, and when I sail I sail on a lake, and in this particular case, I really needed to see the land. But then I realized, and this was a stupidity on my own part, I really didn’t check to see if this boat had life rafts, or if it had any backup plan. We had nothing more than a couple of life vests on there, and I started to get nervous. We lost the motor about mid way through the voyage, so we were just going by sail. That’s not necessarily a problem, but we lost all of our electrical, and I have never seen shrimp boats come so close to any boat as we had that day.
Kevin: But I guess the point is this: Until you need it, you don’t really think much about it, and gold can be like that. We really have had a system that has worked quite well, and quite sufficiently without gold now since the Bretton Woods system fell apart in 1971.
David: And we’ve had a very controlled system. You look at a guy like Larry Summers who popularized the connection between a low or negative rate environment, and the high value that investors place on gold in that environment. That is, again, the Summers-Barsky thesis from the 1980s. And yet, Summers – what is he saying today? He is saying, “Let’s burn the Franklins, and maybe the Grants.” He is saying, “Your 50 and 100-dollar bills, these are the conduits of illegal activity in the marketplace, and we can clean up this mess if we just burn the Franklins and the Grants.” And it’s the same echo you are hearing across the pond.
Kevin: Draghi said something like that, too.
David: It’s the same thing Draghi is saying, “Get rid of the 500 euro bills.” What does this signify? I think we should be thanking these boys for promoting the new Berlin Wall. It’s a monetary Berlin Wall. So what does this signify?
Kevin: I think what we need to do is unpack this a little bit, because even though we’ve talked about it over the last several weeks we have to connect the dots. Just like the eastern Germans could have if they would have seen the time-lapse photography with the end result of a Berlin Wall. We start out with central banks coming in to rescue the economy. They start lowering interest rates, a zero interest rate policy, getting close to zero interest rates, hoping that people would go out spend that money and restart the economy. That didn’t work, so they now go to negative interest rates. But there is a threshold. When a person puts $100,000 in the bank and knows they’re going to get $99,000 back next year, there is a certain threshold where habit alone is not going to keep that person in the bank. And so, what do they have to do?
David: Remove the option. Close the ability for that person to take $100,000 out of the bank and keep it in high-denomination notes.
Kevin: And there is your Berlin Wall.
David: Right. Bloomberg has a little video clip this week on their website that shows what a million dollars in cash looks like in 100-dollar bills, and what a million dollars in cash looks like in 50-dollar bills. It’s the difference between one briefcase and two briefcases. And if you eliminate the two briefcase scenario, then you move into a burden which even a criminal would not want to embrace. So if you get rid of the 100s and 50s, now even criminals will be brought back into the system and 20s will be the new solution. It’s not an entirely cashless society, they just want to bring everything back in.
Well, you know what that is. That is exactly what these boys are promoting. It’s the new Berlin Wall in monetary form. And we saw the powers that be move against gold in 2013 and 2014. Now we have a move against what is a more common opt-out vehicle, which is cash. And I should hope that the general public is aware at this point that burning large bills is not to fight crime or to curtail illegal activity. These bills could have been done away with a decade ago if that was the case, because remember, the war on drugs, this is not new.
What about money laundering? Most of the regulations on the book dealing with money laundering date back to the late 1980s and early 1990s in terms of cash transactions. So why now? Fighting crime is the popular case which is being presented to the general public, and they are assuming that the general public is naïve on this, but it’s totally disingenuous.
Kevin: I’m not a fan of Bloomberg most of the time, but to their credit they did offer a peek underneath the kimono by saying, let’s face it, the elimination of cash is necessary because of negative interest rates.
David: The exact quote is, “It is a necessary predicate for the imposition of a negative interest rate policy.” So why now? That’s the big question. And I think the answer is clear because central banks are increasingly painted into a corner, and with few other options they are exploring strategies that are allowing them to stay relevant and be perceived as a legitimate powerful orchestrator of financial and economic outcomes. My opinion: This is farce, of course. This is farce. But maybe it’s entertaining. I just hope that people don’t fall for it.
David: Kevin, this boils down to an issue of control, and it’s a presumption amongst central planners that they can control outcomes. And it is interesting, because the more economics has moved toward mathematics, the greater the certainty economists have with outcomes, even though, in the classical study of economics, economics is psychology, it is ethics, it is philosophy, as much as it is using the language of mathematics to express itself. But somehow, in the midst of becoming more mathematical, economists have assumed that outcomes are as predictable as an equation. And what they have forgotten, and the jeopardy that they have put themselves in, is that they are leaving aside the things that do still matter. Ethics do still matter. Philosophy does still matter. And psychology within the marketplace, which they cannot predict or control, is still very important to outcomes.
Kevin: Just like philosophy, religion, what have you, people can be selective. Even with mathematics we do have models that can show just how bad and how quickly it can change. Zeman was a mathematician 50 years ago who came up with what he called the catastrophe model. He even made a little machine that would mimic that. What you would have is a stable curve mathematically, and then all of a sudden a snap, and the exact opposite would occur. It reminds me of the bridge collapse. I know I’ve used this as an example before, but when that horrible bridge collapse occurred in Minneapolis, it was a cumulative effect of many, many years of bird droppings – literally bird droppings – that was weakening the bridge. No one knew when that catastrophe would occur, but when it did, mathematically, the model worked just fine. You just don’t know what the trigger is.
David: Looking at Europe, it is interesting, we reached the crisis pinnacle in 2011, and there was a real awareness, a public sensitivity, to the crisis in Europe, in part because there was a change in asset prices and a lot in the news at that time. Stock investors today in Europe are pulling money out of the Eurozone countries, out of those equity markets, at the fastest pace since 2011.
Kevin: Since that European crisis.
David: That’s right. It’s, again, this issue of control amongst central bankers. We have not solved the structural issues in Europe, so it should not come as a surprise that something emerges as a trigger for people to say, “Hey, wait a minute. Maybe Mario Draghi does not control the universe, or the outcomes, in the European economy.” You have European banks which are certainly at the center of the storm. You have new proposals which are emerging for the ECB to step in, in the context of European bank stress, and swap nonperforming loans and bad debt for cash.
It is fascinating to me because that kind of a re-liquification of financial institutions, giving them money and taking the stressed or bad assets off of their balance sheet, I would think that this is concerning for everyone in Europe, except for the institutions that are being bailed out. It is not outside the realm of possibility to see a series of referendums in Europe like we’re seeing in Great Britain, what they’re calling the Brexit, the Brexit referendum, where England may leave the EU.
Kevin: It’s the concept that we talked about before. It’s pull your money home when things are starting to get rough. And the European Union and the euro makes perfect sense when everything is running well, but if you have to devalue your currency, or you have to actually invest in your own country, you can’t play ball with a universal currency that is in trouble.
David: Britain may or may not be a one-off event in terms of a referendum. If you have a series of referendums like you are having in England wherein you have a response to the European Central Bank’s best efforts to create financial stability, but that the unintended consequence is that you have a popular opinion which moves against the entire eurozone project, and that is something that we will just have to continue to watch. But we’re watching those critical things which may actually be the bridge collapse triggers, if you will.
Kevin: Okay, so the old paradigm – we’re still in it right now, but let’s call it old – is the central banking paradigm. In other words, bail out the big banks, too big to fail, government comes in and bails everything out each time. There is a different opinion out there. If this paradigm changes, could we see either just the elimination, or at least the breakup of banks, more regulation, the opposite of what we saw from 2008 to the present?
David: Right. A couple of things stand out. One, if you were in China you might say that the market ramifications of bad debts and the unwind of bad debts, as long as it’s contained within the financial system, and the financial system is essentially nationalized, there really aren’t ramifications, or you have an easier time covering up those ramifications. So, the market dynamics don’t play as neatly when you have a nationalized banking sector. That’s one option.
If you want to obscure things from the general public, nationalize the banking sector. You have Neel Kashkari – this is so fascinating, not a surprise – he rolled through Goldman, now a Goldman alumni, spent a few years at the Treasury during the 2008-2009 crisis. Now he sits as the president of the Minneapolis Fed. And of course, this is my very cynical view – all he has to do now is sit in that seat for five years and then pimp his rolodex to the private sector for that complete round trip from private sector to private sector, through the halls of political connection.
Kevin: Usually you’re worth hundreds of millions when that happens.
David: And that’s what every Goldman alum seems to aspire to. He says that if he learned anything from the bailout days of 2008 when he was doing what he “hated to do,” which was bailing out banks, the banking industry, in his opinion, still requires a transformational restructuring and he thinks that they still pose a “grave risk” to taxpayers and the broader economy. So what he is working up at the Minneapolis Fed is a comprehensive recommendation which will show the cost and benefits to either breaking up the too big to fail banks, taxing the leverage that they have implicit in their balance sheet, or forcing higher capital requirements for those institutions. And there is scuttlebutt in the financial press comparing big banks today to big tobacco of the 1980s – no growth prospects, really, rising regulations, huge cash cows, and the assumption is that because they are cash cows they will be able to absorb regulatory costs and they will still be able to exist at lower levels of profitability. And of course, the justification for all this will be to make it a safer world for us to exist in. If that is actually going to happen – we’ll see.
Kevin: I remember in the 1970s when cigarette commercials were one of the main commercials that you would see when you were watching TV, and then for the health of the public, and rightfully so, they took commercials for cigarettes off. I’m wondering at this point if banks and large insurance companies, the too big to fails, we’re going to not see commercials anymore, or we’re going to see, like drug commercials, where they have smiling older people playing with a dog and they tell you all the horrible things that big banks can do to you. I don’t know…
David: Right. It’s interesting, there is a PR campaign going on from J.P. Morgan Chase, and Jamie Dimon purchases 26 million dollars of J.P. Morgan shares, and it’s either a bold move based on conversations with legislators and an awareness that he is going to be able to anticipate and further consolidate the industry, despite Kashkari’s saber rattling – that whole break up the big banks – or it may be that Jamie Dimon is a reflection of a dying theory, that theory of market efficiency. Maybe he and his decision don’t reflect market efficiency, maybe he is getting ahead of himself. Maybe he is what comes to mind coming from Taos last weekend, maybe he is getting too far out over his skis.
Kevin: Speaking of other places to go, we talked about cash and the cashless society seeming to come about, gold being a reasonable vehicle to move some of that money into. It has been interesting to watch the move into treasuries. Just simple ETFs that hold treasuries seem to be a holding area or one of those life rafts that you were talking about.
David: Right. Investors have been nervous, they’ve moved from equities since January 1, they’ve scampered to safe havens, and it’s the treasuries. You see big inflows into the treasury, specific exchange-traded funds – big influx there – alongside a big influx into gold ETFs. The difference between the two positions, I think, over the next 24 months, will rest on – if we can return to our conversation earlier about the consumer price index – it is going to rest on an upset surprise in the CPI. It could fall. We could see the CPI contract again, sort of a deflationary thematic re-emerging, but it seems to me that the move higher, even with a shrinking energy component, which is exactly what we have had – energy prices have shrunk, and yet CPI is now growing – it seems to me that the upside surprise in core CPI would be a real challenge to those sitting in treasuries.
Kevin: I think it is important to point out, Dave, that inflation, itself, doesn’t have to rise. Talk about a catastrophe model, Zeman’s catastrophe model, it’s just merely the expectation, because there are two types of inflation. There is the inflation that rises slowly because the economy is starting to get back on track, and then there is the moment that people don’t trust their cash to hold its value. That moment moves to hyperinflation very quickly.
David: You’re right. You’re talking about two different causes. The popular version of inflation is that you’re not going to have it unless you see an increase in wages. And so everyone looks at wages and says, “Look, if wages don’t increase, we’re not going to have inflation.” And that’s actually not always the case. You can have a rise in inflation as a result of currency devaluation, which has nothing to do with a rise in wages, and that is what you had in the 1970s, what is popularly known as “stagflation.” With stagflation you had stagnant wages – wages were not increasing – and yet you had, as you described earlier, the transition from low levels of inflation, 2%, 3%, 4%. It ended up being double digit by the time we were in the late, late ’70s.
Kevin: A lot of that was the expectation changing. When Greenspan came out, he was at the Treasury at the time, he had the “Whip Inflation Now” buttons printed so that people’s expectations wouldn’t change based on the button.
David: But those kinds of inflation are, as you mentioned, in stark contrast to a breaking of confidence. I was fascinated by the Barron’s article, because again, last week’s Barron’s said it’s Trump and it’s Sanders who are causing market volatility. Balderdash. On the front cover, upper right-hand corner, they have – page 8 or page 7, I forget what it was – “loss of confidence in central banks” – and they’re not connecting volatility with loss of confidence in central banks. But where you have a rapid increase in inflation is, as you described, when psychology shifts, and all of a sudden it’s a no vote. It’s a no vote on central bankers, it’s a no vote on the currency.
Kevin: Let me ask you just from a price perspective because you had mentioned oil could be a trigger for that – where would you say oil would need to get to before people start expecting higher prices?
David: I think the CPI begins to be moved as you are moving through the 30s, toward $40 a barrel. But as we have been talking about, it is the expectations of inflation which is the driver of assets which are sensitive to inflation. So, you have bonds which are negatively impacted, you have gold which is positively impacted with that change in inflation expectations. And I think oil getting a penny over $40, forty dollars and one cent, and people start to begin to wonder – is it going to stop at $50? Is it going to stop at $65? Will it stop at $85? Will supply and demand or a drop in OPEC production bring it to $100 a barrel?
Kevin: Right. And you’re not predicting a price increase in oil.
David: No, no, no.
Kevin: It’s just the expectation of inflation.
David: That’s what psychology does to re-pricing assets like gold and treasury bonds. You begin to see a much higher hurdle when inflation expectations shift. Right now there are no expectations of future inflation, and that can shift in a hurry. Forty dollars and one cent may be that threshold where people, again, start to say, “Well, what does this mean? How does this translate?” I think, in retrospect, if you could move into the future and look back at a 24-36 month timeframe, with that vantage point, you’ve got the knee-jerk jump from stocks to bonds, which may be seen as a move from the frying pan to the fire. And all of this, Kevin, is in the context of the IEA, the International Energy Agency, saying that we have a glut in oil that is going to persist through 2017 and we don’t know what to do with Libyan and Iranian production, it’s still coming on, and it’s coming on strong, they want to increase their production. And all of this assumes that OPEC sticks to its guns, just as Al-Naimi said this last week—he agreed to cap production at current levels, but that agreement with the Russians was at levels which are at, basically, record highs.
Kevin: Right. And we continue to look over to OPEC to see what they’re going to do next, but actually, I read an article that said here in America the oil shale production industry has actually cut back more than anyone so far, and it still has not necessarily had the effect that they were hoping for.
David: Expected declines for this year, 600,000 barrels, and that should increase through 2017 as well. So again, it’s the supply and demand balance, and in the equation, which has nothing to do with supply and demand, is an emotional or psychological trigger.
Kevin: I think we should look at a little bit of the self-preservation mode that we see. People can pay lip service over in Europe to saying, “Negative interest rates – we’ll all go ahead and suffer just a little bit so that we can restart this economy.” Strangely enough, though, the very banks that are saying that are taking their money and putting it into a still positive interest rate vehicle over at the Federal Reserve.
David: It’s a very interesting development to have foreign central bank deposits – foreign central bank deposits – at the Fed, which have jumped to nearly 250 billion dollars. And yes, they are collecting interest. So first we accommodated domestic branches of foreign commercial banks, and now we are accommodating central banks.
Kevin: These are the guys who are saying, “Hey, negative interest rates are for all of our good.”
David: Behavior, in this case, clearly reflects self-interest. And it is ironic, in a world of negative interest rates, to see central bank flows to the place that is still paying interest on excess reserves, or the program central banks are playing in, which is the repo program.
Kevin: It’s not just negative interest rates that have a painful effect. Obviously, the central banks, themselves, in Europe, like we said, are moving to try to have positive interest. We’ve talked about U.S. banks scrambling to try to find some way to have some sort of positive return. There is pain in the system, yet you still have the people who have claimed to bring about prosperity, claimed to bring about stability. These people still are playing their games, and I’m naming the central banks and the governments.
Earlier in the program we talked about Trump and Sanders and the volatility in the market, but this is feeling pre-French revolutionary. You have the supporters, both of Trump and of Sanders, who represent an angry public, and the public may not know exactly where to put their anger yet, but we are starting to see ridiculousness in the elections based on just fury.
David: And that’s the issue. You end up in a tense situation where people don’t have all the data and specious correlations can be made, scapegoating occurs, and I think there is an interesting parallel between central banks who are participating in their own redistribution scheme via interest rates and the price mechanism, and socialists like – well, what does he say he is? He is a socialist/democrat, or whatever it is that Sanders says he is. But most of his fundraising, a good chunk of his fundraising is coming from, if you will roll the drums, people without jobs.
Kevin: There is the pain.
David: There is the pain, and so you really are dealing with two versions of a redistribution scheme. Socialists have their model of redistribution, central banks have their model of redistribution, and what do you share as an identity if you are a central banker or a socialist? It’s this issue of, “We believe we should control decision-making, and the market is not capable – people in the market are not capable of doing these things. We will do these things for you.” Whether it is redistribution of capital, or redistribution of income via interest rates, it’s really the same thing.
Kevin: And revolution can go one of two directions and we had a perfect timeframe to see that in, in the late 1700s. You can either go toward true liberty, giving man his God-given rights, and the government protecting those, like we have here in the United States. Or you can have the travesty of the French liberté, basically, the travesty of that revolution where, yes, they were overthrowing something that was ridiculous, the royalty had abused the French. The problem was, they moved into socialism and they moved into harder times, ultimately.
David: That’s interesting, as we travel back and forth to Europe for our business, I’ve mentioned this before, but France is the one place in the world that has confiscated gold seven times. And it continues to be a really good source for getting gold and bringing it to the United States.
Kevin: Because they’ve confiscated so many times we can go buy it there.
David: No, no, no, quite the opposite, because people who were subject to those confiscations simply buried it in the ground, and so you have more caches of gold found in France than any other place in the world. And it’s an indication of what? This redistributive tendency, this sense of control, this sense of the enlightened few who will determine for everyone else what exactly it is. Even if it is in the name of Liberty, Equality and Fraternity, it stills boils back to that sort of Animal Farm scenario of, “some pigs are more equal than others, and we will tell you what you need to do and how you need to do it, what you need to think, how you need to think it, and where you need to put your bank deposits, and when we will give you what is left of them.”