January 15, 2014; Does Money Grow on Trees? – QE failure

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we have Drew Crowell again here in the office with us. Drew, you are just about to leave on your third trip to Europe, and we wanted to talk to you just briefly before the Commentary about why you are going again to Europe.

David: We ended last week with a brief comment on our company’s activities in Europe, and that is where we do want to begin. For those of you who have attended one of our many briefings across the country this last year, you have already been introduced to Drew. For those of you who are not acquainted, he has been with our company in critical roles for over three decades.

Drew, you have been on planes to Europe endlessly, it seems, since the middle of December. As Kevin asked, why are you going back again this week?

Drew: Well, David, just to bring your listeners up, perhaps, we have been introduced to what has proven to be the largest gold coin hoard or release in over a decade. It has been at least 13 years, actually, since we have seen this sort of gold hoard released. As you may know, as things unfolded, we had no idea the scope, the size of it, or anything, some six weeks ago when we first were told about it. We just got a call from one of our very best suppliers over in Europe, saying, “You know, you just need to come over here. I mean, right now!” Just realizing the urgency in their voice, we were on a plane within 2-3 days, and sitting down, and it was just mind-boggling, the scope of this particular deal.

David: Last week you and Kevin had put together some of your thoughts, almost a little briefing, on what you had found when you got to Europe, and I know you are going back, because there is more to look at, and some new things that are waiting for you there. Just in a nutshell, you talked about the scale of it, specifically, the quality. Why is this unique to you? You’ve been in the gold business a long time. Why is this particularly unique?

Drew: David, it is not unusual for there to be coins available. The issue becomes, what is the quality? What is the grade, or quality, or how nice are the coins, because we are very particular, very picky about making sure that our investors end up with just the upper tier, the upper echelon of the graded coins. When we are told that someone has a large coin deal or a gold deal, this has been going on for years now. I don’t get my hopes up because, frankly, I am reasonably disappointed when I go through and find just a very small percentage working out.

In this particular case, our supplier, told us that he was sitting on a huge sovereign hoard. These are the British sovereigns that were minted on five different continents, at seven different mints. It is the most recognized gold coin, frankly, in the world. It is fractional in size. It is a little less than a quarter-ounce, 0.2354 ounces, and it is ideal for our investors. Not only does it have a high gold content, but these particular coins were represented to us as being uncirculated. They are just a highly recognized, wonderful, fractional, European gold coin. So I went over, really, with not that great an expectation, because I’ve been disappointed on several occasions, but in this particular case, David, it was mind-boggling, it was staggering, what they kept bringing out for us to look at.

David: Are you going to see more of the same? Anything different in the weeks ahead?

Drew: Well, when we first went, we were just told that there were five sovereigns, five different heads. There are three of Queen Victoria at her different ages. There is one of King Edward, and one of King George, and they are all represented in this deal, at various degrees. That is what we went for. We sat down, we went through the first group, made the purchase, settled the deal, and then we went to dinner.

And over dinner a couple of things happened. As you may remember, our supplier started letting us in on a little bit more information, and it turns out that this large group of coins I had just been through only represented 20% of the overall deal. That was just great news for us. And then as the evening wore on he said, “You just sell sovereigns, right?” And I said, “Oh, no, no, no, no. Anything that is of a European pedigree, minted by European countries during the years of the mid 1800s through 1933, the end of the golden era, we’re interested in.” So he let us know that there were some other opportunities coming. So that has been equally exciting.

David: That’s great, because really, it is an issue of, supplies have been incredibly tight and we have seen a major shift in demand from Western countries over to Asia. We’ve also seen, with all of the crisis in Europe over the last several years, an increase in local demand in Europe for those same kinds of coins. So very little product has been available, I’d say, for 3-5 years, with it really becoming a critical concern for us here, recently. And so this is a remarkable, remarkable find.

Drew: Well, so critical, David, that we were having conversations about where in the world were we going to find product, because as much as people want to talk about the gold price suffering, that’s merely on paper. We’ve never seen greater physical demand in the gold market. And basically, what we’ve seen is, we went through a period of time, from 1998 through about 2002-2003, where there was a great dishoarding of gold, particularly from the Bank of England, as well as some of the other European banks. They thought that it would be better to sell gold and buy U.S. treasuries that were yielding 4, 5, 6%, and they could put their assets to work.

Well, it just ended up being the most foolish decision ever because they ended up selling gold at below $400, in some cases, a little bit of it below $300, and so they ended up buying a bunch of dollar and paper-denominated assets which have done extraordinarily poorly over these years, and of course gold has gone up at least four times.

At the time, your father, Don McAlvany, had warned that this was one of the most foolish things he had ever heard of, and encouraged our investors, “Look. What do we have, downside risk? 10, 20%, something like that?” And he was saying at the time we probably had a 300-400% potential increase. The exact same math is on the table today. We are at about $1200 gold. There may be a 10-20% downside risk. Even the naysayers are not calling for anything lower than that.

And yet, we do know that it is very reasonable to expect that gold could go to $5,000. The most intelligent math that we have heard on this particular subject was by Jim Sinclair, who back in the late 1970s, predicted that gold could go as high as $800, and at the time is was about $100, I think, when he called for that. And everybody pooh-poohed it, and of course, gold did go to $800, he started pulling out all his assets, gold went a little higher and everybody thought he was crazy for getting out. But he did pick the top, David, and many years later he revealed how he did it. He merely took the monetary aggregates of all the industrialized nations of the world and divided it by the number of ounces known to exist in gold. And he came up with $800.

So, of course, the big question a couple of years ago was, “Well, Jim, how do you do it now? What are the numbers?” So he once again took all the monetary aggregates of all the industrialized nations of the world, divided it by the known ounces of gold that exist today, and do you know the number, David, is $12,500? So whether we see that number any time soon, I can’t say, but $4,000-5,000 is not too much to think of as an interim high.

So, once again, we see maybe a 10-20% downside on gold, with a potential four-fold increase on the upside. So not only are we looking at a wonderful opportunity, time-wise, to buy gold, but we are looking at just a phenomenal opportunity to buy these particular coins.

David: Thanks for joining us, just briefly, today. We look forward to the highlights of your trip when you come back from Europe. I wish you well, safe travel, and get some rest. Hopefully, you can sleep on the flight.

Drew: Oh boy, I hope so. Thank you, David.

Kevin: David, that first interview was Drew was fascinating, but there are a couple of things I wanted to re-iterate from that first interview. Where did the coins come from? They came from an Eastern European bank. We can’t talk any more about the definite area.

David: The key there is that we are not talking about a new source of supply. This is a one-off deal. We get to buy it, that’s great, we’re very excited about that, but it’s one and done, and then we’re back to finding 20 coins at a time here and there and everywhere, all over God’s green acre. This is what makes it so unique. It is a one-institution liquidation, and our normal supply lines have been getting tighter and tighter.

Kevin: And the frustrating thing is, and we talked about this with Drew before we got him on. He was so frustrated that we lost the first one-fifth of this group to the Russians. I don’t think that they were doing it because they had a determining eye on what kind of coins they wanted, they just wanted to buy gold, like they had been doing so much over the last couple of years.

David: You can take a second to listen to that interview, you speak with him for about 20 minutes, and it gets a little bit more granular, what it is, how it works, and everything else, and that link is right here next to the interview. You can click and listen when you are done with the Commentary.

Kevin: David, not only listening to the interview with Drew, but we also have a full-color report with pictures of the coins in the report, and so we will have a link on this particular site that a person can click and look at it.

David: Now, on to market dynamics and our regular Commentary. Kevin, I looked at the NIKKEI this week and it is very interesting, off 1,000 points from its 2013 high. Granted, half of that came on Tuesday of this week, but they announced their 16th consecutive trade deficit.

Kevin: That’s unusual for the Japanese, they were always a surplus nation, as I was growing up.

David: Well, it’s the worst on record. What we have here is Abe-nomics. It was to improve exports and boost the economy, even if it did hit the end rather hard.

Kevin: So Abe-nomics, it’s not working.

David: A 17% decline in the yen. They are assuming that it will work, but the unintended consequence was that imported items, like food and fuel – granted you live on an island, guess what you don’t import? You import everything! You import absolutely everything, and so you have the unintended consequence of all of these imports, the cost of them is going up dramatically in the end terms, and that has exaggerated the increase in the trade deficit.

Kevin: We talked about it last week. The idea was, if they were going to decrease the value of the yen to make the yen more competitive, or exports more competitive, the idea was that the wages would go up concurrent with that.

David: And it hasn’t happened, so the consumer feels it in real-time, and they must adjust to higher prices, or basically, as the Bureau of Labor Statistics has done here in the United States, substitute your preferred purchase for some cheaper good. The big move lower in Japanese stocks this week was triggered by a reverse of this, an increase in the yen, and what appears to be a major re-allocation out of Japanese assets, reversing the 2013 trend. Remember, we said last week that the NIKKEI was up 57% for the year, profit-taking, and we think this may be the beginning of a lot more of this. We could see this 1,000-point decline quickly become 2,000-3,000 points. Again, this may be relief for the Japanese consumer, but it does lead us to conclude that Abe-nomics was, and is, a failure. Economic growth cannot be driven by money-printing. To us, this is axiomatic. But to the powers that be, this is a lie, and it is one that has been told, frankly, too often.

Kevin: And like we’ve talked about before. It’s being told here, right now. Money-printing is not turning into economic growth. But let’s look at another country where we have seen this play out. India is a great example of devaluing your currency, and beginning to ruin the economy.

David: Right, the currency, the rupee fell. It suffered greatly, as well, last year. Far more, actually, than the yen. As the rupee fell, imported goods also increased dramatically in price, and threw the country, more commonly running trade surpluses, into a deficit. The logical conclusion, from the government’s perspective, and just go ahead and put “logical” in quotes there, because this is from the government’s perspective, It was not that currency devaluation was detrimental, but rather that gold imports must be to blame.

Kevin: Oh yeah, that’s what ruined the trade surplus deficit equation, was gold. (laughter)

David: Yeah, so as the rupee fell, the average saver in India was willing to pay hefty import duties and product premiums in order to avoid the massive rupee devaluation. In some instances, for an ounce of gold, bullion bars or coins, they were paying $200-300 over the spot price, for something like a common gold bar. It is also worth taking note of how technocrats and bureaucrats interpret events. I think this is something we need to pause and reflect on. Gold was to blame for the trade deficit. That was the official line. Not the currency decline and the resulting increase in all food and fuel imports. Gold, of course, was included in the import numbers, but clearly, it is not the only item altering the trade balance. We didn’t see import taxes on anything else, however.

Kevin: I think what we see, too, is this instinctive move to gold. There are a lot of people who buy gold when their currency is not going far enough, who don’t know the first thing about the markets, they couldn’t tell you about futures contracts, they couldn’t tell you about spot price, but they move to gold. You had brought up that planes going into India, each person was carrying kilo bars of gold to try to sell it for a premium.

David: Right, so the black market in gold in India exploded this last year, significantly increased, and now they are back to talking about reducing the importation tax on gold into India. Just this week, they are discussing what they should reduce it to, because they have found that, yes, it is actually a failed policy.

Kevin: Do you think this is why they try to change the perception of inflation, they are just saying, “No, your currency is not really falling.” I think of Alan Greenspan back in the 1970s with the WIN campaign, Whip Inflation Now, and really, the whole campaign was, “Yeah, we’ve been printing a lot of money, but don’t raise your prices.”

David: And what they are trying to do, really, is control consumer behavior. You have economists who fear when devaluation occurs and you end up having inflated consumer prices, that households will become very concerned with his, and they will alter their consumer behavior, and this becomes a self-reinforcing issue. Remember that government statisticians love to influence inflation expectations. And that is the key word, expectations. Real inflation does not have to be there, but if inflation expectations are on the rise, then it is almost like a self-fulfilling prophecy. If you expect it, you change your behavior, and guess what happens? Inflation does, in fact, increase radically as a result. So they are constantly trying to shape and mold consumer behavior, and control those expectations and lower them if they possibly can.

Kevin: The other thing that we have to look at, Dave: There are no real interest rates being paid right now on bonds, and so if we actually did report inflation accurately, people wouldn’t want to buy bonds, they would go backwards.

David: Right, so as you can imagine, there is a far more receptive audience for bond purchases, with low interest rates, when inflation is held low.

Kevin: Or the perception.

David: What we would call a statistically tortured number (laughter). It is made low, it isn’t actually low. It is made low, at least on paper.

Kevin: The government, though, really needs, not just the inflation statistic to be manipulated, but they have to make sure that perception is holding for everything from unemployment and growth.

David: There are three really critical things: The ruling elite care more about those three statistics, those variables. Unemployment statistics, inflation statistics, and growth statistics.

Kevin: Which would be GDP…

David: Yes, like last week, we had the unemployment report. It was very important for several reasons. First of all, it was disappointing. The number was disappointing. 74,000 jobs were reported to be created, and 193,000 were expected. So, again, it was a disappointment of expectations. It was the worst monthly number for the year, December’s employment number, but what is really critical is that it was seasonally adjusted, and actually, it was pretty good. If you look at the nonseasonally adjusted number, you were minus 246,000 jobs.

Kevin: So they had to come in and make the number look better.

David: Yes, there is a positive bias to seasonal adjustments in the first half of the year. I feel like I’m a broken record because we talked about this last year at the same time. You have a positive bias in the first six months of the year, a negative bias in the last six months of the year, so people are usually overly optimistic in the first half of the year as they are projecting what growth rates will be for the year, and they are overly pessimistic at the end of the year.

What is amazing here is that the positive bias created a swing, a 320,000 job swing from negative to positive, and it still did not meet expectations. It was negative even with that in mind. So 74,000 jobs created. Now, there was another factor here. First of all, it was a disappointing number. We got there by seasonally adjusting it from -246 to +74,000. Then there is the addition, in that 74,000 mix, there is the addition of 55,000 retail jobs, 40,000 temporary jobs. This is what I am getting at. Most of those have to be factored back out in January, as we get the post retail holiday sales layoffs from companies that bulk up for Christmas traffic.

Kevin: I’ll give you an example of that, Dave. When I was in college, I was a toy store manager, and we had about 130-140 employees going into Christmas Eve. Unfortunately, Christmas Eve wasn’t always a happy place at Children’s Palace where I as the manager, because on Christmas Eve we had to lay off about a 100 of that 140 people.

David: So January’s number, in all likelihood, will be a disappointment, as well, although expectations are now coming down. Last, but certainly not least, you have the bullish contingent out there, whether this is the CNBCs, or the average money manager, the bullish contingent in the market is now becoming frustrated with the U3 employment statistics.

Kevin: Why? Why would they be frustrated with U3, Dave? (laughter)

David: Well, there is confusion, if not embarrassment, over the fact that the jobs report stunk. The jobs report stunk, everyone knows that it stunk, and yet, the U3 number shrank from 7% to 6.7%, leaving some uncomfortable explaining to do by those who have hung their hats on the percentage unemployed as a supporting argument for a broad-based economic recovery. When the jobs report is obviously terrible, but the statistic is screaming, “Yet another improvement!” thinking people have to wonder about the reality of the number, and the methodology used to craft it.

Kevin: It reminds me of the global warming crowd. The global warming crowd, whether you believe it or not, I’m telling you what. This is a cold winter, and people don’t want to hear about global warming.

David: Well, you just change the tune. It’s no longer warming, it’s now climate change as opposed to global warming because we actually have some sequential years of record cold. Well, that’s another point.

Kevin: That’s a different subject. (laughter)

David: Don’t forget that U6 is far closer to the actual employment picture because it includes discouraged workers. I was back at the BLS website and this is what the Bureau of Labor Statistics says about the U6. This is their words. You have “persons marginally attached to the labor force.” Now, what is that?

Kevin: What is that?

David: Persons marginally attached to the labor force are those who currently are neither working, nor looking for work. Okay, so marginally attached to the labor force. (laughter) You’re not working, and you’re not looking for a job, but indicate that they want and are available for a job, and have looked for work sometime in the past 12 months. So that’s what it means to be marginally attached to the labor force. Wow. I would just call that person unemployed, pretty basic.

Then you have the discouraged workers. Again, quoting from the BLS: “A subset of the marginally attached have given a job market-related reason for not currently looking for work. So they are out of work, and they are not looking for a job, so we just call those “discouraged workers.” How about we call those “discouraged not-workers”? Just the language, itself, is confusing. Persons employed part-time for economic reasons are those who want, and are available, for full-time work, but have had to settle for a part-time schedule. This is really where you begin to see the real picture. We are still at 13% unemployed, or underemployed.

Kevin: If you are looking at U6.

David: That’s right. In the U3, this is, again, where the perma-bulls have to look and say, “This is getting embarrassing. We know the jobs report last Friday was absolute garbage, and yet, the unemployment number improved from 7% to 6.7%. How is that possible? Well, I’ll tell you how it’s possible. The methodology is all screwed up.

Kevin: Well, they’re lying, Dave. But let’s look at it from the Fed’s perspective. They have been given two mandates. Monetary policy is to control the stability of the money. But also, the second mandate is unemployment. That came in the late 1970s.

David: This just reinforces the silliness of the Fed choosing the employment statistic as an anchor for their decisions to either QE or not to QE, that is the question. To quantitative ease, or not to quantitative ease. If the number shrinks, they’ll ease up a bit on the asset purchase program known as QE. And so far, that’s by 10 billion a month, and by the way, if you looked at how they operated through the end of the year, they increased December’s purchases far in excess of the 85 billion expected, and I think that was to support a strong year-end finish for the equities market.

But as we have now suggested, ad nauseam, over the last several years, the unemployment number has improved, not because of a broad-based hiring effort, from small to large enterprises, but rather because the labor force is shrinking, as a whole.

Kevin: Right.

David: And the jobs that are being created, again, are in that temp and part-time category.

Kevin: David, we used, as an example, several times over the last few weeks, how share prices are gaining more earnings per share, and that’s just simply shrinking the amount of shares outstanding. We talked about corporate heads coming in and buying, with company money, the shares, reducing the size of the pool, and so, of course, the earnings per share goes up. This is no different. You decrease the size of the workers who are out there, the amount of total workers, and of course, unemployment is going to look like it gets better. The percentage increases.

David: Right. The employed, as a percentage of that smaller number, is more impressive. So why are companies not hiring? I think you have reticence to bring on full-time employees and pick up the added line item, the expenses of health care and the other full-time benefits. And there is also, amongst the business community, a reticence to make long-term commitments. So there is a time element here, too, and that’s because we are still getting mixed economic signals.

On the one hand, the statistic like U3 is showing considerable improvement. It shrunk from over 10% to less than 7%, and that is undeniably better. But Friday drew attention to the credibility of the methodology, which in turn, frustrates the bulls, who largely assume the number is the number.

Kevin: Dave, I don’t think there is any real number behind that. It’s only fuzz. My daughter just pulled some tomatoes out of the back of the fridge in the garage, and she turned her nose because there was very little tomato left, there was a lot of fuzz.

David: Only fuzz, and that’s what we getting with the U3, only fuzz.

Kevin: Then let’s go to inflation, because the politicians and the elite need us also to believe that, really, prices are not rising.

David: Right, so unemployment is the key statistic that they can use to bolster spirits and get us out to consume. Inflation. This is important on its own, just as we mentioned, it influences consumer behavior. Even if there is a general lack of awareness about inflation and the consequences. People don’t have to fixate on it. People don’t think about it. They just experience it and they feel frustration, as you have described many times, running out of money before running out of month.

Governments find that financial stability is upset quite easily if the expectation of inflation changes. So again, it’s about that expectation. Consumers and investors make a different set of decisions with their money and it becomes more difficult for the powers that be to channel savings and spending to preferred ends. Again, think of the bond market.

Kevin: Not just the bond market. Going back to India, Dave, these people are realizing they don’t have enough money to pay their bills so they move to gold so that they can at least hedge or preserve their buying power.

David: It’s a reasonable example, savings being channeled into precious metals with the growing concern of wealth erosion, with purchasing power shrinkage, if you will. I recently read a story about a ponzi scheme in India where there were thousands of people who lost their life savings. There were dozens who committed suicide. One woman set herself on fire, being so distraught over the loss of $482.

I thought about that and I went home and mentioned this to my family and I thought, you know, not only is life, perhaps, seen in a different light, but the desperate nature of loss, with so little on the table to begin with. $482. Self-immolation. It’s unbelievable.

I think in life we discover that there are a variety of ponzi schemes, which we can identify and hopefully avoid. The dramatic ones are like Bernie Madoff, or the instance in India that I just mentioned, where money evaporates quickly, it’s not detected sometimes for years. I want to say, though, it’s no less pernicious to see the evaporation of monetary value via dilution or devaluation, via standard Fed practice or central bank practice today. Trillions swirl around and guess what? All the previous units that existed, monetary units, are worth less, by being made less scarce. And it’s a ponzi scheme in its cumulative effect, and it is no less damaging.

Again, we have financial system engineering which is taking place, and it’s no different. Wealth extraction, either from a Bernie Madoff, or from a Ben Bernanke, it’s just a different method of wealth extraction. I think of a home purchase and this is kind of what comes to mind. If you run a 2% rate of inflation, which is the current target by the Fed, you have to, over a 10-year period, let’s say you are saving for a down payment on a house, and you have a target to save for. At the end of ten years, whatever your target was, you have to increase it by over 20%, closer to 22%, if you are compounding, with that 2% rate of inflation. If you have a 4% rate of inflation, to meet your savings goal, that down payment target on a home, again over a 10-year period, you are going to have to save closer to 48% to make up for the difference of inflation. And if you are running a 6% rate of inflation, and that’s not a catastrophic rate of inflation by any stretch, no one would say that is super or hyper-inflationary, and yet just over a 10-year period, a 6% compounded rate of inflation will force you, in order to meet your savings target, to save an additional 81% to reach that goal. Do you understand what I mean when I say pernicious? So maybe a Madoff is 100%, but I’m sorry, 80% is no less damaging to someone’s life goals.

Kevin: It’s amazing to me how many educated people, and I’m talking about people who are financial writers, or are on financial TV, talk about inflation actually being good. A little bit of inflation is good for the whole, and shows we have growth.

David: That’s hogwash. The natural state of capitalism is one of a deflationary boom. A deflationary boom…

Kevin: Things getting cheaper.

David: You have stable pricing combined with an improvement in efficiency and productivity and over time, that reduces the cost of goods and services, allowing for every dollar that you earn to buy more, and not less.

Kevin: This is what we are being told. We are being told, “Look at the technology that we have. Look at how our lives have improved.” But actually, it’s costing us more and more.

David: We’re in the exact opposite mold, not of a deflationary boom, but we have had an inflationary boom and there have been a few things missing. We’ll get to that in a minute. What we have been locked into is a Keynesian monetary trap, starting in 1913 with the prevailing academic bias being one of a controlled, or engineered growth, via monetary policy, 2% constant rate of inflation, and that target is, in order to increase GDP, year over year, by increasing the cost of goods and services. That kind of economic strategy requires wage inflation running on a parallel track. So wage inflation in complement to price inflation, and GDP growth, is a beautiful thing. But you have to have wage inflation enabling households to afford the Fed-induced price increases.

Kevin: Which is what we talked about with Japan. It’s not happening in Japan.

David: Exactly. So incomes in the U.S. have been stagnant in real terms for over 40 years. That puts monetary policy at odds with economic reality. It’s growth over this kind of a time frame, a longer period of time, that has been perpetuated, 30-40 years, in the absence of increasing income, it’s only been perpetuated by increasing quantities of debt. In the absence of real growth, we have substituted that for leverage in the system.

And this is why we go back and entertain the inflation/deflation debate, but suffice it to say, you have monetary advocates who scream inflation. Drew was talking about that earlier. Monetary aggregates implying a gold price of $12,500. Don’t know that we’ll see that, but listen, that’s what the monetary aggregates imply, and yet you have total levels of debt which are screaming deflationary risk.

Granted, those levels of debt have been increasing exponentially over the last 30-40 years, so, in theory, we could have said that at any time. It’s never been this bad in terms of our total levels of debt. We have one key ingredient in the mix, which is normally there, which multiplies your monetary aggregates.

Kevin: And that’s velocity, Dave.

David: That’s exactly right.

Kevin: This is something that is amazing to me as I read guys who are talking about this massive deflation that we are looking toward. First of all, we haven’t had deflation since we have gone off the gold standard, period. Things have always cost more. But the argument right now is that people are saying, “Look at these guys who talk about hyperinflation. It just hasn’t happened.” But you know, inflation, like you said before, even at 2%, a little leaven leaveneth the whole loaf.” That’s what inflation does. It makes everything cost more. But think about it, Dave. Four trillion dollars now on the Fed balance sheet. And people are saying, “Well, it hasn’t turned into inflation yet.” What happens when one of the two forms of velocity hits?”

David: Can you believe that there is this perception that the economy is healthy when the Fed’s balance sheet is expanding at an average of 24 billion dollars a week? And this sort of regular feed, IV feed, into the asset markets, is now considered normal? I think we all understand that it’s not normal. We’ll look at GDP growth statistics in a minute, but to assume that we are here, and happy, and normal and on our way to recovery, and not somehow dependent on the liquidity, the credit created by the Fed, I think is to miss some major, major issues.

Kevin: But David, the other form of velocity increase is when this stuff has been sitting in bank reserves, it is been printed, it hasn’t come into the economy, and then faith is lost in the dollar. Something happens where faith is lost. That is velocity all at once. That is what hyperinflation is.

David: And it is a psychological switch. And that, I think, is something that may be down the line a ways. We talked about velocity just briefly, being the multiplier of the aggregates, which have already grown, and mushroomed, to unimaginable proportion. The problem with velocity is that it is not a leading indicator for inflation, it’s a coincident. It happens alongside an increase in inflation, so you can’t look at the velocity statistic and say, “Oh, now we can expect to see an increase in inflation.”

As and when it occurs, it’s already too late, inflation is in motion, and then you are dealing with the psychology of inflation expectations creating, as we mentioned earlier, that self-reinforcing mechanism where you think it’s going higher and that’s exactly where it is going, in part, because now what you are doing is trying to get rid of your dollars as fast as you can, and you are buying real goods, and the price of those real goods and services goes up.

Kevin: So it’s like an air bag. It’s not a leading indicator. You’ve already had an accident if you see the air bag coming at you.

David: (laughter) Yeah, yeah, try to make a mid course correction and catch, if you will. This, I think, is where many people want to play the timing schedule with inflation and say, “Hey, when I see a strong indication of it, I’m going to do it.” And whether it is putting on a safety belt or triggering your air bag, there is not enough time in between inflation becoming an issue, and you realigning assets in light of that, to do anything.

We talked about unemployment statistics being one of the key statistics for the ruling elite. We talked about inflation statistics and how important that is, frankly, to massage them lower, and that is, in part, because the third category that is very important to control, if you will, are the growth statistics. So the last critical set of statistics is the growth stats. GDP growth competes with the unemployment figure for the prize in terms of what we will call the most politicized number. If the economy is always growing, and this is sort of always summer, never winter…

Kevin: Right.

David: You see what I mean? It allows for political legacy-building. And I think this is what a lot of people don’t understand, is this enmeshed relationship between economics and politics.

Kevin: And this isn’t Democrat or Republican, because I remember back when Reagan was looking at running for re-election, they were shrinking. Things were slowing down and they made a decision, they actively made a decision in the cabinet, to triple the debt from 1 trillion to 3 trillion. That was a Republican decision, as well.

David: It’s a rare voice that ever is critical of the monetary policy-maker. We’re saying that there is political legacy-building alongside economic growth, but remember that monetary policy has been one of the key drivers of growth for several years, if not several decades, and that is a complement. Monetary policy is a complement to political ambition. If you go back to post World War II, with the introduction of universal suffrage, monetary policy became far more politicized, and then, as you mentioned earlier, as well, following the 1977 inclusion of the second mandate by the Fed, employment, Washington politicians and Fed policy directors started to look like the British Royal family tree. Where does one begin and the other end? It is all a little confusing and sick.

Kevin: It’s a little bit like being in Willy Wonka’s chocolate factory, Dave. You’re always able to eat candy, with no real consequence, but even in the movie the consequences were pretty profound for some of those kids. (laughter)

David: Well, you have had the smoothing effect in the economy that is crafted by credit expansion, and it prevents there being very much economic volatility. That is actually how it is presented, because in point of fact, all that engineering does is prolong and exaggerate a given trend.

Kevin: Candy all the time.

David: Exactly. Longer periods of growth, but on the flip side, far more catastrophic periods of decline. And this is why it is so important for politicians, because they face an easier prospect of re-election if you can smooth the economic cycle.

Kevin: Remember the political phrase, “It’s the economy stupid?” Well, it really is, isn’t it?

David: It’s not just a phrase, it’s a political reality, that if it is not managed, will short-circuit the career of a lifetime politician. Thus growth is managed, and that’s what we find today. We have essentially moved from, if you want to contrast the old socialist era, if you will, an era of scientific socialism with the means of production controlled. We have moved to an era of scientific capitalism where there is an engineering of demand for products, and that is controlled by a monetary policy, asset price manipulation, and the consequent wealth effect, etc.

Kevin: David, just like we talked about before, with interest rates. You are going to choose what you are going to buy and what interest rates you are going to get based on the inflation number, but growth factors into that, as well. You have to look at inflation and contrast that with what the growth number is to actually see whether you are growing or shrinking.

David: Yes, back to GDP. Inflation and employment complement the growth picture, and if real world inflation were factored in, if you are going to net that out of GDP, your GDP growth numbers, you would not have the same growth numbers people put stock in. And this is axiomatic. Understating inflation leads to an overstatement of GDP. The official vocabulary is the “deflator.” That’s what they call the inflation number used in the GDP methodology. But again, if you understate that “deflator,” or the inflation variable, you end up overstating your growth statistics.

Don’t forget this last year what did we add, 560 billion dollars into an economy that didn’t exist prior to? So, very quickly, we have moved past the re-writing of history and now accept in the canon of economic thought, that our economy has always been bigger, we have had fewer recessions than we originally anticipated, and we can look forward to 3%+ growth in terms of GDP this year, next year, etc., etc., forgetting that there was an artificial infusion of close to half a trillion dollars just in 2013.

Kevin: So what you are saying is there is a three-point training course on how to be a successful politician. You understate unemployment, you understate inflation, and you overstate growth. Other than that, you really just have to be good-looking and on TV.

David: Well, I feel like all we’re doing today is sort of crafting the new Machiavelli, so again, it’s kind of combining the worlds of PR and advertising. It’s almost like if you want to go back to Washington you need to read more David Ogilvie, not more John Locke.

Kevin: On advertising.

David: Exactly. Less political theory and more advertising and PR. So you have the employment statistics, which move alongside GDP growth as supporting evidence of economic expansion. This is really the challenge. The long duration of unemployed persons speaks to an economic change that has yet to be factored in. This is, again, where maybe the statistic has improved, but if you look at the number of people who are, today, unemployed, and we looked at the not-in-the-labor-force numbers, and we are up over 3 million from December of 2012 to December of 2013, the Bureau of Labor Statistics Table A16, not in the labor force is now 92.3 million people.

Kevin: That’s amazing. What are we, 300 million, roughly, as a country?

David: And this is how you get to improved employment statistics. The duration of unemployed? Again, this is really critical, because the jobs market is evolving, and it may be evolving away from people. The question being, are the skill sets required in the 21st century radically different from those required in the 20th century? And if GDP growth can’t be maintained via increasing leverage to the household, to companies, to government balance sheets, as it has over the last 34 years, where is this new source of growth going to come from?

Kevin: I think you have to ask some of these graduating seniors in college right now that same question. I’m watching, because my son is a senior in college, I’m watching his friends as they come across the line, and they’ve got a degree. Things are changing, Dave. The entire skill set needed for the 21st century has changed, and a lot of these guys are not able to use their degrees anymore.

David: A lot of their degrees aren’t usable in the first place, but that’s another topic. But I’m glad that we live in an advanced society where we have the freedom to choose what we want to study. I think what many people have mistaken that education for is something that is maybe more appropriate for avocation as opposed to vocation. But again, maybe that is a topic for another day.

The challenge right now, Kevin, is that we are not facing the music.

Kevin: Right.

David: We’re moving, right now, toward extending unemployment benefits. This helps keep up appearances from a consumption standpoint, and again, from an appearance perspective, the bread lines of the 21st century are not as visually disturbing as those of the 20th century.

Kevin: Right, but we’re still paying people to not work, basically. I’m not taking that away from the person who is really trying to get a job. We’re extending a problem and not dealing with it.

David: When I was on the Mike Gallagher show a few weeks ago, there was a gentleman, Lance was his name, if I recall correctly, and he said, “You know what? I’ve been unemployed for a long time, I’ve done whatever I could. Right now, I’m mowing the lawn for the guy who used to work for me, and I’ll do anything to take care of my family. I’ll tell you what, though. Don’t take away my incentive. Don’t put me on the couch and make me a couch potato.” It was sort of confessions of a man who is trying to pull himself up by his own bootstraps. And I listened to, not only his words, but the spirit of what he was saying, and I think there is something very critical there.

Kevin: Well, he’s fighting entitlement. He’s fighting that creation of dependency that the country has sort of built into the system.

David: And that is a fatal mistake, if we are, in fact, creating dependency on the state. Moreover, the economy, if it does continue to change, and new skill sets are required, we are really talking about longterm unemployed people, with outdated skill sets, becoming a permanent impediment to growth. Retooling for the 21st century is critical, and I don’t think that that is necessarily via another college degree and more student debt.

Kevin: So, in review of what we have talked about today, Dave, the unemployment rate is understated, the inflation rate is understated, growth is overstated. And we’re really not feeling the effects, necessarily, of all this printing, other than the life support of the economy. But there is more to come, and there is a consequence to this, just like there is a consequence to every ponzi scheme that ultimately comes to its end.

David: I think, again, if we look at the reality as it is presented to us, and you put a lot of stock in those numbers, the unemployment stats, the inflation stats, the growth stats, you have a good reason to go long stocks and not have a worry or care in the world, but again, the unemployment stats, even the perma-bulls are beginning to look at that statistic very differently, and I think we may have a turning of the tide here in early 2014.

We’ll have to see if this follows through in the first couple of quarters because, again, you are supposed to have a positive bias in the first half of the year. If a positive bias doesn’t get you good numbers, wait around until the end of the year and see what a negative bias does to bad numbers. This is where, again, we are going to see, I think, an exaggerated effect in the marketplace as we move toward the end of the year.

What is an example of an exaggerated effect? People have bet the farm on recovery. We’ve set a new record high in terms of margin debt, 423.7 billion dollars, in terms of margin debt. We are far exceeding anything we saw in the year 2007 and the year 2000, in the year 1987, in the year 1973, the previous peaks of that statistic.

Kevin: Yes, when has that ever been anything other than a precursor to a crash?

David: Again, what exaggerates the trend is, we could have a 5-10% correction, and that would be normal, that would be healthy in the stock market. But when you start compounding a 5-10% normal correction with an additional 200, 300, 400 billion dollars in short-term liquidations, this is what turns you from a market correction into a market rout. Do we have confidence in the inflation statistics? Even the Fed has just increased their expectations of inflation for 2014. Very much? No, not at all, in fact, almost an insultingly small amount.

But the fact is, the needle is beginning to move the opposite direction. If deflation was the concern for the last several years, and if you want to see how many people have loaded on to that side of the boat, understand why the boat is listing, and appreciate that no one is concerned with inflation, and I think that sets us up for an amazing shock and surprise over the next 24 months. Is it 2014 that is the big inflation hit, or is it over the next several years, as central banks intend to pull back from the brink, and no longer print like mad, and yet, find themselves circumstantially obligated to do so and continue the money-printing ad infinitum?

Kevin: So what you would say, Dave, is, continue to protect yourself. Don’t take risks where the masses are right now.

David: Well, and does this bring us full circle to our conversation with Drew? I love the price, I love the product. Frankly, I own more of European coins than any other gold product, and I have a whole universe open to me, and I prefer it. I like it for its fractional size, I like its age, I like its scarcity, I like its condition, and the fact that we also have the price of gold having swooned. We’re a few percentage points off of the low of $1180, and we’ve got the best product available. (laughter) I just think it’s a match made in heaven.

That’s not to say it’s the perfect product for everyone. I happen to like it. That doesn’t make it perfect for everyone, but it is worth considering, and I would listen to the conversation with you and Drew, read through the flyer and consider it as something of an addition to a portfolio. If you are not adequately insured, if there is one thing I want to correct in Drew’s idea today, it is somehow that the growth prospects of gold should be alluring. They’re not at all, because if gold were to see $3,000, $4,000, $5,000, God forbid $12,000, understand the terrifying circumstances that that implies.

We are not talking about a benign environment. We are talking about the most malignant environment you can imagine. We are talking about the breakup of Western-style socialism. We are talking about the failure of the Western welfare state. We are talking about desperate, desperate means, failing at the level of government financing. We are talking about a collapse in the government bond market.

It is issues on that scale, and it’s only issues on that scale which could drive the price, and you are talking about a remaking of a political order, and of a geopolitical order. I don’t want to see it. I don’t want to see it. But at that same time, you look at the probabilities of events, and at least insure to where you are comfortable, in terms of the probability, and the adequate insurance to cover you in that event.