January 9, 2013; The Rise of Global Ineptocracy

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we have democracy. We have republic. We have fascist socialism. We have a lot of different types of governments, but there has been a new term coined in Zero Hedge, and I think it probably is the most appropriate for where we are right now.

David: It is ineptocracy. Ineptocracy is a system of government in which the least capable to lead are elected by the least capable of producing, and where the members of society least likely to sustain themselves, or to succeed, are rewarded with the goods and services paid for by the confiscated wealth and the diminishing number of producers. That is ineptocracy.

Kevin: Ineptocracy (laughter).

David: I found this in a thread on one of my favorite blogs, and it was very interesting, we are looking at one statistic that supports this notion of ineptocracy. The U.S. borrows between 43 and 52 cents of every dollar it spends. The variance has to do with the outlays and receipts, tax revenues, changing from month to month. Remember the comments from David Walker.

Kevin: Right, and he didn’t stick around. David Walker was there for ten years at the GAO, but he said, “You know what? You guys are not listening to me. We’re not going to be able to pay our bills. I’m going to go tell America, since you won’t change anything.”

David: Former comptroller general, head of GAO from 1998 to 2008. Double-digit GDP growth is what he said is required, double-digit GDP growth, uninterrupted, for 50 years. That would get us back to being in front of our debt obligations.

Kevin: When has that happened in our lifetimes, Dave?

David: It hasn’t. That’s the point, he is saying that there is a way back to normalcy, but it’s not very feasible.

Kevin: And we haven’t had a single year of double-digit growth, not since we were born.

David: No, and so it does come back to some combination of tax increases and spending cuts. It comes back to fiscal responsibility. It comes back to a democracy that is of the people, by the people, for the people, not an ineptocracy, and that is exactly what we are dealing with.

In the new year we have the farcical fiscal cliff behind us, we have the debt ceiling below us, we’ve already passed it, and the question of national solvency is on the table. The only thing that would compound foreign creditor stresses at this point would be further demonstration of the previously mentioned ineptocracy.

Kevin: You’re talking about debt ceilings, but this is a multi-story building ineptocracy that we live in, so your debt ceiling may be somebody else’s floor, maybe somebody else’s ceiling, maybe somebody else’s floor, maybe somebody else’s ceiling. Do people really take any of these talks seriously any more, whether it is the fiscal cliff, or debt ceilings? They just raise them.

David: That has been the classic case up to this point. We will see major wrangling over the fiscal cliff and that is a question, the question of if rating agencies step in and say, “Given this political ineptitude, what will the outcome be?” Will we see a downgrade? Will we see two downgrades? Will we see foreign creditors begin to, as they already have, if you are looking at the TIC flows, exit Treasury positions, begin to move to other asset classes as a preference? We are already seeing that here at the beginning of 2013.

Kevin: That would cause another financial crisis, though, Dave. We have had a fiscal crisis, we are in a fiscal crisis, but that would cause a financial crisis like we experienced in 2008, or worse, because interests rates would have to…

David: And I think it is worth going back and looking at 2008 and comparing it to what we have now in the making, because 2008 was sort of an accident. Somebody dropped a hand grenade, the pin fell out, it blew up, there were bodies all over, and we said, “How did this happen?” And somebody said, “Well, gosh, you shouldn’t be walking around with hand grenades.” So somebody did see it coming. It wasn’t completely a “black swan,” but it was messy, it was ugly, and it didn’t have to happen.

Now, this scenario is slightly different, in the sense that we have a fiscal crisis, and following almost every fiscal crisis is a financial crisis. Greece is a real-time study of this. Argentina illustrates changes in the banking system and in monetary policy. When you are moving through the stages of fiscal, and then, ultimately, financial crisis, there is a similarity between Argentina and Greece, and some of these southern European countries. Recall, Argentina is not done with their crisis. It is 11 years on, and, of course, they had their bank accounts restricted. All this came from disconnecting from a dollar peg.

Kevin: They started with the dollar peg, and then they disconnected, and it created the crisis that they have continued in.

David: Exactly. And what it led to was printing beginning in earnest once they left the dollar peg, because they didn’t like the tough talk of austerity. They kept paying their obligations, but they were paying their obligations with newly-printed scrip, and of course it didn’t buy what it once did, but don’t let that confuse the issue. Today, southern Europe is going down that Argentine path, and putting the burden of correction on creditors, with austerity being more or less discussed, more discussed than implemented.

Kevin: I remember as a kid hearing about the little boy who cried wolf, and it got to be where no one listened to him because he cried wolf all the time. Austerity is the new wolf. They talk about it all the time, to the point where it has absolutely no impact or follow-through.

David: In southern Europe we have the same currency straitjacket which Argentina had with the U.S. dollar peg, with those ties to the euro. We could see a second shoe drop, in Spain, in Italy, in Portugal, and Greece, particularly in the wake of the last month’s Argentine cases being heard in New York, which recently determined in favor of U.S. creditors. They re-established a claim on Argentine assets and they established that claim all over the world, so we just had a U.S. hedge fund that laid claim to a ship owned by Argentine in North Africa.

Kevin: So it was collateralized, whether Argentina knew it or not.

David: And this is very disconcerting for those in Europe, because we have just gone through a cycle of “voluntary haircuts,” and here you have this negotiated peace with creditors in Argentina, and it being undone. If those voluntary haircuts are reversible, you can undo any restabilization which you have had in the eurozone in the latter part of 2012.

Not to mention the more mundane issue that revenues had actually been declining more than predicted, in the context of southern Europe. Financial crisis takes center stage, and businesses and individuals go into survival mode. They don’t quickly re-emerge, and when they are in survival mode, you have two things that happen: One, you have greater tax evasion. You also have less taxes to pay as businesses just slow down in terms of a volume of trade.

Kevin: So what we should expect is not just one F. I think of going back to school. You get an F, that’s a bad deal, but what you are saying is that these Fs come in twos, financial and fiscal, or fiscal and financial.

David: All that to say, the two Fs, fiscal and financial, go together like a one-two punch, and if 2012-2013 is the U.S. entrée into the fiscal crisis limelight, you might expect another round of financial crisis around the corner.

Kevin: You are talking about 2014, 2015, 2016, something in that neighborhood.

David: How soon? What we can do is watch the dollar and watch Treasury yields. As go Treasuries, so goes the entire fixed income complex, across credit qualities, across maturities. Moving the benchmarks is either helpful, as it has been over the last 2-3 years, with artificially low rates set by the Fed, or harmful. Is that 2014, 2015, or 2016? I think there are some external variables which will likely determine the timeframe, but foreign purchases of Treasuries may be telling us all we need to know right now.

Kevin: One of the things about financial crisis and fiscal crisis is that if it plays itself out completely, you actually come back strong. A lot of the problems that we had in 2008 were caused by having junk loans that most people knew could not be repaid, like mortgages. Now what we have is a reliquefaction of the banking system under Basel-III. Basel-III right now is supposedly going to strengthen the banking system, but it seems like it is just a replay of the past.

David: So again, the comparison between 2008 and the present. In 2008 we had over-leveraged financial institutions and all of a sudden there was a revaluation of the assets on their balance sheets and they realized that they were under-capitalized, and so the effort since then by the folks in Basel, the Bank of International Settlements, has been to create liquidity requirements, a liquidity buffer, and that is what you are talking about, Basel-III.

Kevin: That sounds good to a person who says, “What’s wrong with liquidity in the banking system?”

David: This last week, the Basel-III liquidity rules fixed the banking system, which, for anyone clued in, really means that time is the primary commodity which banks wanted, and that is exactly what they got. Nevertheless, we have these long-awaited issues which were determined this week, for what is the first ever global baseline for banks concerning their liquid assets, and thus, a capital cushion for those banks and the entire banking system, and therefore, safety and stability should those banks ever come under stress. That is what Basel-III was all about.

Kevin: But I guess the question is, who is really the winner? Basel-III, they are coming in and putting this baseline in on banks, but it sounds to me like it is just to create more and more leverage in the future, and like you said, buy time, rather than them having to pay the bad debt off that they already have built up.

David: The technocrats would argue that ultimately it is for the public’s good that the financial sector is strong, and there is an argument there that I would agree with, but to some degree, Basel this time seems to have clearly defined decorum for all the foxes, in terms of hen-house conduct and what is considered sort of the safe and acceptable plucking.

We have had two things: One, we have had a change in the time frame. This is the phase-in for liquid assets. They have a four-year phase-in. What is called the LCR, or liquid coverage ratio, measures how much liquid assets the bank needs to have in place to absorb a shock, and furthermore, what assets can be used as “liquid assets.” So they need to be at 60% of the goal in four years, and then they have a full six years, until 2019, to add 10% per year thereafter, again, until that 2019 period to be at 100% of what they want as a liquid coverage ratio.

Kevin: Let’s define what liquid assets are. You and I, when we are thinking safe liquid assets, we are thinking U.S. Treasuries, cash, gold. What is included in the safe liquid asset category?

David: Up to this point, banks were assuming the same thing, and this is where they were loading the boat with quality assets. Now, all of a sudden, they have been given a new lease on life, so to say. The second change was to the acceptable liquid assets, and this one is curious. You have triple-B-minus paper, you have corporate paper, you have some equities, you have healthy residential mortgage-backed securities. All of these make the new list of acceptably liquid assets that can serve as a capital cushion.

Kevin: And when you are saying healthy residential mortgages, you are talking “healthy” residential mortgages.

David: And this is just it. You’ve already taking a multi-step down. It was going to be double-A paper, some corporate paper accepted. I don’t think equities were really on the table. And then, of course, you have the residential mortgage-backed securities. They are liquid until they are not. I think this is what people learned in 2008.

The entire stock of assets in question outside of Treasuries and gold are just straight cash, which is boring, and bankers don’t earn anything on it. That’s why they don’t like it. These boring assets are what they need, and yet Basel told them, “Listen, we understand that’s going to be a tough target to reach if we limit you to just what you need.”

Kevin: I think it is worth pointing out that had they not started counting some of these assets like triple-B bonds and residential real estate notes, what would they have to do?

David: They would have had to raise 2.4 trillion dollars in new capital, at a minimum. That’s the top 200 banks. And of course, Basel-III is meant to apply to the whole banking universe. What is the bottom line with Basel-III and this week’s announcement? Leverage will re-enter the financial system, the banksters will be back operating on the streets, in the light of day, with the blessing of the rest of the banking community.

That’s the sick irony here, that it is a banking regulator who is saying that it is okay for banks to do this. You have structural reforms in the financial system which are tough, very tough, to pencil out, even tougher to implement, and that is not what we saw. This leaves banks, and of course this is the healthy side, with the flexibility to organize aggressive balance sheets, and increase profitability. Yes, this is good for banks in terms of their rate of return in the next 6-12 months, but they have avoided the strictures of scarce quality assets. The bottom line again: Risk remains. That’s the bottom line.

Kevin: I think what we have found with the banking system as a whole, worldwide, and here in this nation, is that there is moral hazard. It is moral hazard because these guys can go do these things and not really need to get paid back, because there is always a bailout coming from the taxpayer.

David: And then the banking community, when they were told that they would have to raise capital, and only use the highest quality paper as a liquid cushion, basically said, “Oh, we can’t do that.” And the regulators of the banking community said, “You’re right, you don’t have to do that.”

It’s the “enforcer” basically saying, “Yeah, yeah, I know, we had really high expectations, we were just kind of joking about that. Really cleaning up your balance sheet and introducing structural reform into the banking community – maybe we were a little aggressive, maybe we were just acting out of panic, given our experience from 2008 and 2009.” But again, everyone is assuming growth from here forward.

Kevin: Speaking of growth, we had listened to banter about the fiscal cliff that was coming. After the election it really came front and center. Now we have a deal, whatever the deal is, and it really doesn’t solve the problem, but I think it is important that our listeners understand some of the basics of this cliff deal that came about in Washington.

David: To save some time, there was a brief listing of the main points on our Wealth Management website. If you look at our Friday comment, which we put up every Friday for our clients, we did include some of the highlights of the changes in terms of taxes, not all of them bad, and some of the limitations as well.

On the surface, it is set to reduce the deficit by raising 620 billion dollars in revenues. In contrast to that, you have the Congressional Budget Office, which predicts a drain on revenues from the economy by 3.63 trillion dollars over ten years.

Kevin: Six times what the revenues, supposedly, are going to be. That’s what the drain is going to be.

David: And then throw in an extra 333 billion dollars in spending over the same period and you are talking about roughly a 4-trillion-dollar reversal to the bad, even though what is being publicized is, “We’re all good here.”

Again, this is not some third party group who says, “We want radical reforms, we want extreme austerity measures.” This is the Congressional Budget Office, and they are saying, “We’re not quite in agreement with that 620 billion dollars in increased revenues, and that being sort of a straight boost to our fiscal position.”

This is the issue. In D.C. it’s the case of, the last liar in wins.

Kevin: And it’s not just that. I always get worried when D.C. says they are going to solve a problem, because usually what they do is just increase the problem. You have crony capitalism right now that was built into that system, and there are people who walked away smiling, saying, “Wow, we even got more.”

David: Yeah, I have a hard time controlling my blood pressure on this one. The cliff deal included 76 billion dollars in special interest tax credits. If you are wondering how GE and others, big businesses, multinational corporations, don’t have to pay taxes, and you think, “That’s absurd, of course they have to pay taxes. Everybody pays taxes.” No, that’s not true. You find a former senator, you find a rainmaker to lobby on your behalf, and allow your profits to be held in off-shore accounts, avoiding the U.S. tax man. Remember, GE has a very incestuous relationship with government.

Kevin: Can I just interrupt here? GE was originally brought about by Thomas Edison, and it was placed on the Dow Jones Industrial average, the very first one, when there were 12 stocks back in 1896. There is only one company still on the Dow that is represented by that original list of stocks, and that is GE. So I’m guessing, if you want to survive as a company, you’d better have lobbyists in Washington.

David: I’ve always thought of General Electric as a company that represents the market. It is essentially a mutual fund in one company. They are in everything, whether it is wind energy, or turbines. What don’t they make? What are they not involved with, including finance? But the reality is, they do represent the market today, but not because of their broad representation of business interests. They represent the market today because they represent the trend in the market, which is toward fascism, which is toward corporatism, which is toward government sponsorship, and the fact that they rarely pay taxes should not surprise us. That’s what you get when you cozy up.

Kevin: Well now, David, you run a company. Do you pay taxes?

David: 50% plus. The tax burden, if you are not a corporatist giant with hundreds of CPAs and paid lobbyists negotiating a different treatment for you, is a real burden.

Kevin: David, in Animal Farm, Orwell talks about how all pigs are equal, but there are some pigs that are more equal than others.

David: I may be over-stepping my bounds here, but I look at Trent Lott’s role as a former Republican senator, lobbyist, who put this deal together, along with another Democratic senator, retired, but now lobbyist. It would do us, as a country, some benefit, if he would practice the discipline of a Samurai and disembowel himself. (laughter).

I’m serious. If this is not fascism at its finest, I don’t know what it is. Maybe it’s less complex. Maybe it’s just corruption without the whitewash. So, okay, I take that back. Hara-kiri is not as imperative as, if you’ve named your son or dog Trent within the last 20 years, could you change the name?

The man is a disgrace. There are Democrats who are equally disgraceful, as Washington whores, but they never claimed a higher level of integrity. They never claimed to have fiscal virtue, so to some degree, they are less culpable.

In all seriousness, Kevin, at a minimum, I am sending a copy of G.K. Chesterton’s book What’s Wrong With the World? to Trent Lott’s office. The opening lines of the book: I am, yours truly, G.K. Chesterton (laughter). Obviously, he writes an entire book, but that’s how he opens it, and I think it would do Trent some good to reflect on this, for his benefit and ours. “What’s wrong with the world? Trent, you are. Yours truly, David McAlvany.”

Kevin: David, I know your blood pressure is boiling right now, but one of the things that we have talked about over and over is that we have a lot of retired clients that have saved all of their life to live off of a reasonable amount of interest on their money. That, of course, has been taken away by the Federal Reserve, and by the policies of trying to hold up the banks.

Interest rates are zero, virtually, on anything safe right now, but what that has done is to force those people who would normally not be in a position to take a risk, into bonds that we would have called junk just a couple of years ago. Granted, they’ve renamed them. It is no longer politically correct to call them junk bonds, but that’s exactly what they are, because at some point, they will probably fail.

David: For 2012, it is worthy of note that one of the best performing asset classes outside of Greek bonds – its own irony, I realize – but outside of Greek bonds, junk bonds performed 15% for 2012, outperforming the equity markets. And there were 425 billion dollars worth of junk bonds sold worldwide last year. For 2013, in the U.S. alone, not worldwide, they are expecting to sell another 300 billion, according to Barclays. Again, this isn’t a junk bond space.

Kevin: But David, back in the old days a junk bond would yield 10%, 12%, 14%, because the risk of default was so high. With the popularity of junk bonds right now, they’re not having to pay hardly anything.

David: Which makes last week’s record low yields on junk bonds amazing: 5.89%.

Kevin: That’s what you could get on U.S. Treasuries in the last decade.

David: I know, I know. The opposite side of the equation is that you have record-high prices in the junk bond space, which is giving you your 15% return. Junk bonds generally trade at a discount, implying that there is credit risk well above normal corporate issues. That is just the way they normally trade. Most today, though, are trading at premiums. So effectively, as you were suggesting, the Fed, having set the Fed funds rate at nothing, has collapsed yields across the fixed income universe, erasing any real content, any real substantive meaning, or implied data that you can draw from yields. Credit market risk is not being well accounted for.

Kevin: David, the investors were talking about seeking yields. Most of these people should not be taking these risks, but they are in a corner right now. They have to pay their bills, or dip into their principle.

David: And this is the problem. They’ve decided to eschew the volatility in the equity market and they are choosing the lesser of two evils. On the one hand, you can either eat into principle, as you suggest, in the absence of a return on assets, unless they are searching for yield. Unknowingly, they are taking on liquidity risk, and they are compromising the safety profile of their portfolios.

Kevin: David, what you are saying is that a person has two choices with their money, especially when they have to have an income. They are either going to dip into principle, or they are going to chase a yield. The only problem is, the danger of getting that yield has a bite-back.

David: Unknowingly, they are taking on liquidity risk and they are compromising the safety of their portfolio in that search for yield. Chasing yield is a little bit like hunting a lion with a toothpick. It is absolute guaranteed entertainment. You just have to ask the question, “Can the audience stomach it?”

When you move out of equities, what we have seen over the 18-24 months is a mass move out of equities, particularly the equity mutual funds, into junk bonds. You mentioned this earlier. They have renamed them high-yield and it is clearly moving from the frying pan into the fire. Our recommendation is, don’t be the last one out of the fire.

Veterans to the bond market know that you don’t get to sit back and clip a large coupon when you buy junk bonds. You don’t just buy it, it’s yielding a fat 6%, 7%, 8% yield, if you were buying it a year ago, and just collect that interest willy-nilly. In fact, there are major swings. The volatility in the junk bond space is fairly radical. It’s a trader’s gig, and the price swings are perpetual. It is either the best of times or the worst of times, and we have just put in record high prices, record low yields. You be my guest. Where do we go from here?

Kevin: Sure. I doubt that the yields are going to go much lower than they are now, which means the value of those bonds is probably topping out at this point.

David: So brush up on your Edgar Allen Poe. The pendulum will swing back.

Kevin: The pendulum does swing back. Now, okay, not all corporate paper is junk, however. There are good corporate bonds, and there is corporate paper coming due in large amounts right now that is being restructured.

David: And this is very healthy. If you are looking at corporate America and the actions that they are taking, refinancing paper, not just what is coming due, but actually calling some of their existing bonds at higher rates, it is pretty impressive. Last year it was over 620, I think close to 640 billion dollars for 2012, paper that came due and got refinanced. 449 billion is due in 2013, for this year. Then in 2014 the maturity schedule bumps up to 484 billion dollars, with a slightly larger year for 2015, 495 billion.

These are funding requirements, or the money that has to be rolled over, and we do need a healthy financial system in which to roll paper. You lose your ability to roll paper, that rollover risk exists if there are constraints in the financial markets and concerns about credit quality, so if things are getting better from here, then clearly 2013, 2014, and 2015 will not be an issue for corporations. But, with close to a half-trillion dollars in refinancing needs, each year for the next three, we really need the financial system to be clipping along at a healthy pace.

Kevin: David, unlike our government, which is doing it exactly opposite, you have corporations right now taking advantage of the low rates. They are calling their higher-paying bonds. They are lengthening maturities, they are calling bonds, they are re-issuing at a lower rate, which is just advantageous for the corporation. If our government would actually take a lesson that way, we could be cleaning things up right now.

David: Sure. Refinancing debt at lower rates is a boost to corporate America. That is going to be a long-term benefit in terms of stability, survivability. What about the U.S.? Are we reducing our interest payments? To some degree we are, but we are not taking advantage of those long-dated maturities. The U.S. should be taking advantage of low rates, and financing as much of it as they can in 20-year and 30-year paper, and it is not happening, which increases, over the same time frame, 2013, 2014, 2015, rollover risk, specifically in the Treasury market, which is something we will have to explore in years to come.

Kevin: David, part of the news of this week is that the Federal Reserve all of a sudden is finding religion. They are starting to say, “You know what? Maybe we’re not going to do the QE as long as we thought we were going to do it.” Is that a reality?

David: We seriously doubt this. Consider the ramifications to a reduction of asset purchases. If the Fed quits its current program, the impact is going to be felt across every asset class. We’ll give you a list, in terms of an order of severity. Treasuries, particularly 10-year paper, and higher beyond that. Mortgage-backed securities. Mortgage rates will rise, even as some have been suggesting a nascent housing recovery, if you begin to see a rise in the cost of capital.

Kevin: That will be over, yeah.

David: You can squash something that was just getting going. Equities. Like a crack addict in need of another hit, equities would give up 10%, 15% at a minimum, in short order, if the Fed were to do more than just talk about this issue. If they were to pull back and not be buying assets, not re-liquefying the financial system through asset purchases. Major ramifications there.

Kevin: Well, if the Fed tightened up or slowed down on QE, wouldn’t that put pressure on gold and silver, though, on the downside?

David: Short-term pressure would remain, but remember that the metals story over the last ten years was not primarily a Fed activity story, but a Fed nonactivity story. By taking rates to zero and leaving them there, you have driven investors out of a negative-yielding asset, whether that is stocks or bonds, into a holding pattern, and the safest holding pattern is one where you don’t have to choose a denomination. In other words, you don’t have to choose yen, you don’t have to choose euros, you don’t have to choose dollars, and that has been the pattern, where discouraged investors the world over, in a negative-to-low real-rate environment, have been shifting their emphasis to gold. Reducing asset purchases would have little effect on the metals.

Also, consider the timing of their announcement. Just as the consumer is seeing a diminishment of available resources via higher payroll taxes and will likely be recalibrating their consumption, the Fed is going to find religion under these circumstances? No. This is ridiculous.

You need to watch what the Fed does, more than what they say they are going to do. They talked tough about buying everything on the planet last year, and they expanded their balance sheet virtually nothing. We started the year at around 3 trillion, we ended the year at around 3 trillion. The Fed was largely inactive. In terms of all of the measures they put in place, they were mostly balance sheet neutral.

Now, all of a sudden, they are talking tough, and want to tell you that inflation is not going to be an issue. We are not going to see balance sheet expansion, and yet, that is exactly what is happening, even as we speak, even if on a small scale. We think that 2013 is defined by an increase in Fed balance sheet. A half-trillion? A trillion? We should be coming close to 4 trillion in terms of the fed total balance sheet, and of course, that puts their leverage at well over 60-to-1.

Kevin: David, we have often talked about the dual mandate for the Federal Reserve, which in this way, they are absolutely speaking out of both sides of their mouths, because they are talking about tightening up, yet they have changed the mandate from price stability and keeping employment high, to now, employment reversing places. Employment is their number one priority, and price stability is second. That came out early in December.

David: This is even more important than whatever they happen to be talking about today. We had the election hullaballoo, we had the fiscal cliff cacophony year-end, and I think a lot of people missed what was announced in early December. December 12th the Fed shifted, and it was a remarkable one. The mandate swap, if you want to call it that, is significant because they took what was their primary mandate, price stability, and swapped that out for employment. They haven’t always had a dual mandate. They used to have just price stability.

Kevin: But since the 1970s they have had a dual mandate.

David: And then they brought in employment. The significant upset is that price stability now takes a back seat to the employment concerns, and the mandate swap here is what Mohamed Al-Arian at PIMCO has called the reverse Volcker moment. You remember, Volcker came in at the latter stage of the Carter administration in 1979 and introduced monetary policy reforms to break the back of inflation. The real important thing here, and I think why Al-Arian is very concerned, is that this is, in fact, a radical shift.

Kevin: Right. David, I think it is important to also point out that price stability really is the fight against inflation. In other words, price stability is to say, “We’re worried about inflation, we’re not going to let it run rampant.” When they say that employment now is a higher priority than price stability, what that really is saying is that inflation is coming.

David: And you could argue that is actually a failed mandate, that the price stability which they were charged with, they have failed at, and they have seen a 95-96% decline in the value of the dollar in the last 100 years. This is their 100-year anniversary. We could all celebrate the existence of the Fed, celebrate their great successes and a few of their failures.

The reality is, you can do that. You can have a rate of inflation and slowly degrade the value of your currency as long as your economy is growing in lock-step, and incomes, critically, are growing at the same time. When your income component goes stagnant, and your inflation component continues to rise, that is where you end up in a major quagmire. That happens to be where we are.

Going back to Volcker, we think the Fed gave up on price stability a long time ago, but not explicitly, and that is what changed in December, this explicit move from price stability to a very explicit description of what they want, 6½% on the unemployment number, and we are not going to quit until we get it. Volcker, in 1979, began the process of breaking the back of inflation. We see the “reverse-Volcker moment” as a sea-change for asset classes. You have Ben Bernanke and company targeting 6½% unemployment, they have replaced a specific timeframe for stimulus, with an employment target that may have been, in our opinion, the opening act of an American tragedy.

Kevin: Not just an American tragedy. We seem to export things, and the U.K. and Japan are recentering around the same priority. We have talked in the past about how you can’t just have inflation in one country. You export inflation, and it actually builds on itself, country by country.

David: It’s not surprising to hear that the Japanese pension system is discussing a doubling of their gold allocation over the next two years in the age of Abe. This really interesting. You have a group if people who are managing assets, saying we understand what this looks like. If you are going to “stimulate the economy,” if you are going to focus on “growth and employment,” then we need to own more gold. That’s the Japanese pension system which has always piled in, hand over fist, into Japanese bonds.

There are a number of sea changes within a variety of asset classes that need to be noted and it goes back to that December 12th note from the Fed. Don’t neglect it, because it is probably one of the most important things coming out of 2012 to mark our destination and our journey for 2013 and 2014.

Kevin: So in this case, do as the central bankers do, do as the Japanese do, start buying gold.

David: (laughter) That’s exactly right.