July 6, 2011; Felix Zulauf: Marching Full Speed into Calamity

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we often take an international perspective. Sometimes we have to go overseas to get that perspective, be it a founder of a European central bank, or, in this case, a Swiss banker. We do have a guest today who can bring some insight into what is going on, don’t we?

David: Kevin, we do. Felix Zulauf is with Zulauf Asset Management in Zug, Switzerland, and a regular contributor to the Barron’s Round Table, where he, along with Bill Gross and Fred Hickey, and a number of other experts in their field, diagnose and prognosticate about the direction of the market. In the case of Felix, what you will find is someone who understands the complexities of the world economy, and from a global macro-perspective, brings some keen insights, both into Europe, but also into particular asset classes.

Kevin: One of the things we have enjoyed about reading Zulauf is his interest in the short-term, the middle-term, and the long-term. Very rarely do you find somebody who has the whole picture, and he really has insights, and he actually talks about dates and times.

David: Whether it is looking at a monetary framework, considering valuation metrics, looking at momentum trends, or as contraindicators, considering sentiment in the marketplace, he does a very good job, as you said, of looking both at the big picture, but also drilling down into the details, as well.

If it weren’t for government deficit spending, the U.S. financial landscape would be radically altered for the worse. No one is searching for structural solutions to structural problems of debt and deficits, more paper seems to be the sufficient substitute for harder decisions, which are likely to come anyway, just somewhere down the line. The consumer is on strike in America, as wages stagnate, the cost of basic goods is rising, and asset values have plummeted, dragging down the average American net worth. Thus the government has had to step in and spend, and print to do so, if necessary.

Today we are joined by Felix Zulauf from Switzerland, to bring both an international perspective to the global markets, the U.S. markets, and also to look at the variety of different markets, whether it is equities, fixed income, commodities, gold, or currencies. There are so many things in play today that it seems never in history have we had so many things converging at once, when you think on a global perspective.

Felix, let’s go back a few years. You have considered the equity markets to be selectively opportunistic. There are a few areas that you have thought it made sense to allocate capital. You have projected, really, a 2-3 year time frame in which greater bargains could be had, going back to interviews with Barron’s in 2009. That would make 2012 an interesting time. Would you extend that time frame any further at this point?

Felix Zulauf: Oh, I think we are really entering very difficult territory here. We have had two years of a tremendous rally, probably the most powerful rally on record within a short period of time, and the market is optimistic, and the money managers running other people’s money are all more or less fully invested, because they have no choice. When a market rallies like it did, even the skeptics have to join the bandwagon or they face a severe career risk. That is the name of the game.

Today we have the majority pretty fully invested in equities and the economy beginning to stutter, and there is a clear reason why the economy is beginning to stutter. Most of the observers, economists, and strategists I read and speak to believe that central bank monetary policy has been the main driver of the asset markets and the economy recovering. I agree, only when it comes to the asset markets. There, the central bank policy, easy and highly aggressive stimulative policy was the main driver, but when it comes to the economy, I think the main driver was fiscal policy.

When you look at the situation today, and it is actually not only true for the U.S., it is true throughout the industrialized, developed world, the fiscal policy has been extremely stimulative, and turned stimulative at the point when the inventory swing was turning around for the better, for the positive. I think all those positive factors have been spent, and now we have entered a situation where fiscal policy is turning negative. It is becoming less expansive, or more restrictive.

It is certainly the case in Europe, where we have austerity programs going on at the periphery, but it is also true in the U.S., where fiscal policy, net-net, turns to become a net-negative from early this year on. The disappointing economic trends that we see in the U.S. economy have to do with that, primarily, and not with monetary policy. I do not expect that fiscal policy can become more stimulative from here onward, and that is why I do believe disappointments in the U.S. economy going into 2012, as well as in Japan, and Europe, in particular, are going to come, and will surprise the investment community. I think that is the main factor that is driving the equity markets.

David: Speaking of disappointments, as we come into the third and fourth quarters of this year, we also have an adjustment of expectations off of unreasonable levels. We had a tremendous amount of seasonal adjustments in the first quarter, and so when we look at economic data now, it looks like it is getting worse and worse, when in fact, it was already bad, we just had seasonal adjustments which were covering over that in the first quarter of this year. With a suspension of quantitative easing II, might we expect some unpleasant volatility in the equity markets coming into the third and fourth quarter?

Felix: Yes, that’s true, and actually, when you look at the typical recovery numbers since World War II, we are extremely far below those numbers, and this tells you that there is something wrong with the whole economic setup. As you mentioned in the introduction, those are the structural factors. The consumer is basically spent out. 80% of the consumers are under water. They work hard, when they have a job, if they have a job, and at the end of the month they have nothing left, and once you have built up a debt that we have seen in the U.S., and then you cannot continue to accumulate that, it weakens final demand by the household factor on the structural basis.

That is what the situation is like, and there is nothing the authorities can do. You cannot force it even with further money printing. You cannot do it with further fiscal programs, except you can do that, but then you create all kinds of other problems, and hell could break loose. So we are really trapped here, and we have to expect, at best, a very stagnation-like, low-growth sort of environment in coming years.

At some point, the authorities will respond to that, particularly, in an election year like next year, they will probably try to stimulate again, because the employment situation is unsatisfactory due to the low growth or stagnation-like growth, and that may stimulate the portfolio managers or some investors to buy some more stocks, but there is nothing one can do. We have to sit it out, if it is several years that we have to go through, and that is why I think we have another maybe five years or so until this secular sideways or bear market environment in stocks will be over.

David: You have argued that we have seen the cyclical lows in the equity markets back in March of 2009, but you mentioned the word secular. That could be something that is 4-5 years on the horizon. In terms of valuations, we saw in the 1930s, the market trading at half of book value. Do you think we will see things get that extreme, à la the 1930s, or 1949, or 1982 period? What would you expect as we grind, or stagnate sideways? Is this catastrophic, or do we just grind sideways like the bear market in equities in the U.S. between 1966 and 1982?

Felix: The main difference to the 1930s is that in the 1930s we had a fixed exchange rate system in currencies that was based on the gold standard. You could not print as much money, unlimited, as you would like to. Today, we are in a fiat currency system, not linked to a gold standard, or any other standard, and there is no disciplining anchor. That is the main difference, and therefore I would expect that we do not reach those extremes that we have seen in the 1930s in terms of valuation.

But even during the 1970s and early 1980s, the last major secular lows in the stock market, we were trading slightly below book value at maybe 90% of book value or something like that. I did expect the stock market to decline into a secular low to around a book value of slightly below that. Book value is roughly 500 or a little bit over 500, depending on how you define it.

David: On the S&P 500.

Felix: That is still a possibility, but I do not expect that to happen over the next two years. I think we are too close to the major crisis calamity. It is too early. I would expect it to happen closer toward the middle of this decade. The next 2 or 3 years, I think authorities will do everything necessary to extend the recovery attempt in the economy, and from time to time, come up with stimulus, and that will limit the downside, and I said maybe the downside is around 1000 in the S&P, or between 1000 and 1100.

Once we get to that territory, I think the authorities would get very concerned and come up with interventions and all sorts of tricks, another rabbit out of the hat, to provide support. They can do that with monetary ammunition. They cannot do that by kicking the consumer in a major way. But they can support it for a while. Therefore, I think we are in for some very frustrating years where we trade in a range, maybe between 1000 and 1500 or so on the S&P, and lots of traps and mine fields, and at the end of this period, I would say 1400-1600, we have a major disaster coming, and then they cannot support it, and the dam breaks, and then we get another washout.

That is what my working hypothesis is. For an investor, in such an environment, you should have a defensive basic position, and trade, medium-term, on the bullish and the bearish side, in the stock market. That is what you can do. I do not believe we are in an environment in which you can really frame a long-term investment policy where you are primarily long equities. I think that is too risky.

We are living in an environment where the risk-free returns are below the inflation rate, where the risk-free returns for one year can get wiped out in an hour move in the stock market. We have never seen such an extreme situation. Most people tend to add more risk to the portfolio, not recognizing the sort of risk they are taking, because they want to achieve a return that they are used to, that they need for retirement, or future retirement, or for living. That is the situation we are in, and it is very complicated, very challenging, very difficult, and the layman investor is hardly going to come out as a winner.

David: It seems, just to summarize, that we have used up much of our fiscal ammunition. Coming into the 2009-2010 period, we had that boost from inventory restocking, and the fact that there was fiscal stimulation and inventory restocking at the same time leaves little in terms of options on that side. We have experimented with the monetary side. Certainly the developing world is experiencing more acute inflation than the developed world, although there are growing concerns there. And yet, in that apparently inflationary environment, you still have a tremendous amount of debt and deleveraging which is still to occur. It appears that the process which began in 2008 has much further to go.

The question we would have for you is this: What asset classes get sucked into that same deflationary, or deleveraging, vortex? Has the market matured at all? Certainly, gold felt the impact of the last period of deleveraging, along with almost every other asset class. Correlations went to 1 across the board. Have the markets matured or changed in the interim? Might we expect shorter corrections in the metals, or is deleveraging something that is a vortex that you simply cannot escape?

Felix: First of all, I do not know the future for sure. I do expect some further forced deleveraging, but I do not expect that the de-leveraging process will continue at the same speed as in the past few years, because most of the decline in the housing market is behind us. We may go a little bit lower, and there may be some further deleveraging, but not to the degree we have seen.

Therefore, I do not see an immediate calamity in the economy so that it spirals down 1930s-style or so, due to an Austrian policy imposed. I do not see that. I think it is just a very choppy, sloppy, economy, with underemployment. You could actually call it an inflationary depression, because we know that the true consumer price inflation for the average household is probably 5-6%, and if you take that number, it means that you have a shrinking economy, in real terms. That is how the average person really feels, because their financial situation reflects that reality.

What we can expect is that from time to time the authorities will come in and stimulate. I do not believe that the last fiscal stimulus was spent just this year. There will be more in the future, but they will only be able to do it when there is a crisis sort of environment. The same goes for monetary policy. Either the stock market has to come down, asset prices have to come down, housing prices have to come down, or anything that will trigger another crisis prevention, or crisis intervention sort of program, and then we have intervention by the authorities, and what does that mean for the different assets?

I think in the long run, that is not very good news for bonds, because the public sector will continue to go up relative to the economy, and in absolute terms, and that means eventually supply will take over, and it will push interest rates up, although I do think that maybe for another two years or so, they will probably swing bond yields within the extremes of 2008. We had the extremes on the upside and the extreme on the downside, and I think those two extremes will probably set the range for a number of years during which we build a yield bottom, out of which we will eventually break topside.

So bonds are not an attractive investment. Equities will beat bonds, but I do believe that equities will hang around for maybe another 2-3 years in that range I described, 1000-1500 on the S&P, and swinging widely, and toward the middle of the decade I expect that we get close to the lows of March 2009 once more, because I do expect that the way the world is setting up and marching in those different directions, we will march full speed into the next big calamity, and at that time, I do believe that markets will sell off one more time – big time. I cannot say whether we will go below those lows, or just come close to those lows, but I do believe that equities, for the next 4-5 years, will not be a good investment, in absolute terms.

Then we come to commodities. I think commodities are a China’s play. China is slowing down. I do not trust those numbers. From anecdotal evidence, I would say that China is slowing more than is generally expected, but the Chinese will eventually turn around. The pork price cycle tops in early 2012, and we probably have the grain prices topping out here, and getting a little bit softer, because the harvest outlook is improving, as I understand, and so by early next year they should have some room and leeway to become a little bit more aggressive again, and provide support for the economy.

So I think it is a pretty difficult environment. Gold is the one currency that reflects all these problems. I consider gold to be a currency and not a commodity, and I think the authorities, central bankers, as well as fiscal authorities, will continue to do dumb things, and the size of indebtedness by the public sector will continue to rise in the developed world, quite dramatically so, in my view, and this will eventually force central banks to accommodate and help to finance the budgets and the governments.

I think this is just a spiraling debasing of our fiat currencies, and that is reflected in the rising gold price, so I think the major theme of commodities and emerging market equities, doing better than developed markets, is still in place. The emerging market equities have had a pause and a rest, or some under-performance, and I do expect that sometime early next year, maybe even from late this year on, the emerging markets will begin to outperform again, as the inflation rate will moderate a little bit for cyclical reasons.

David: This is a two-part question, one relating to deeply negative real interest rates, and the somewhat oblivious nature of bond holders. I don’t know if they are content with these yields, or just oblivious to how negative they are, but perhaps you can relate that to the gold market, and development in that market, where once you described there being a disbelief of the moves in the metals. Have we changed, where people are now beginning to see the failure of both fiscal and monetary policies, and looking for a way to protect their portfolios?

Felix: Fiscal and monetary policies have not failed. They have helped to prevent a 1930s type of systemic breakdown, but at a price, of course. QE-II was counterproductive. It was not necessary, and it only helped push financial market prices further up, but it really was counterproductive for the real economy. It created more inflation, it created higher prices for food and energy, and it ate deep into the average consumer’s pocket, and this is actually going to slow down the economy. It is one of the factors that is in play.

I think QE-II was really only successful for the financial markets, but at the price of slowing down the economy further. I do believe that, because of this, and because of the criticism, we will not see QE-III very quickly, but eventually we will see it, because authorities will get desperate. They have no solution, and it is clear why. They are looking for a painless solution. There is no painless solution. In a democracy, we cannot go the Austrian way and clean things out. This is impossible. It would be worse than a 1930s style of depression. Therefore, they are trying to muddle through.

The Europeans, under the pressure of the Germans, are trying to put austerity through their public spending programs and their budgets, etc. This will fail because it will lead to recession. It will be very interesting to see how the U.K. will react once they really start cutting expenditures, as they said, namely 25% of the budget. That will create a deep recession, and therefore, I do not believe that they will execute this program in full. You cannot do that in a democracy, I believe, and therefore I think that what you will see is probably higher taxes, particularly for the wealthy.

The U.S., historically-speaking, is at the lower end of the tax rate. When you look at total taxes relative to the economy, the U.S. is at the very low level and can increase taxation, to some degree. The corporate sector is paying very low taxes in many countries around the developed world, and I do believe that you will see those changes.

Whatever you do, whether you tax more, or whether you cut some entitlements, and it will probably be a combination of both, you will eventually end up with lower prosperity for the average citizen of the Western world, and that means less spending power for the private households, and less consumption. And as you have less consumption and less final demand growth, you will probably also have less investment. That is the name of the game, and we are trapped in that situation, and only if we are back to healthy levels, can we dream of a new upswing and prosperity, like we could in the early 1980s under Ronald Reagan. We have a long period of time ahead of us with hard work and falling prosperity for the average citizen of the Western world.

David: Coming into the 1980s, we, as a country, had an average savings rate of between 12 and 14%, so we began to not only leverage our balance sheet, but spend through savings, two very stimulative sources for growth in the equities markets and real estate. To summarize, it sounds like the next 3-5 years will be stagnation, low growth, perhaps even defined as an inflationary depression.

Felix: Yes. That is what I think it is. It is not like the 1930s because we lack the gold standard, we have the fiat currencies. It will be a very difficult time, and the final outcome is very difficult to say. Usually, when you go into such a period, you end up with adjustments that primarily go through the currencies. In the history books you can read about all those adjustments and currency debasements and currency reforms, etc.

The problem we are faced with now is that virtually all the developed world, with a few exceptions, may be in a similar trap. You have all those currencies going down, and therefore, you don’t have a slump right away. If the U.S. would be alone in all the problems it has and let’s say we didn’t have a euro and we had Germany with a strong D-mark, the U.S. dollar would have slumped dramatically already. If the Chinese would not have adopted a Bretton Woods II fixed-exchange rate system, or sort of between the renminbi and the U.S. dollar, the U.S. dollar would have slumped dramatically. Your inflation rates and your interest rates would be much higher, and your financial asset prices would be much lower.

Now, we have a situation where the Chinese, obviously, haven’t done that, but they are realizing that the system of a quasi-fixed exchange rate to the U.S. dollar is becoming counterproductive for them because it creates enormous inflation and too much liquidity in the domestic economy that creates havoc with the real estate market, that is very difficult to control. I feel that the Chinese want to move away from that quasi-fixed exchange rate system. If they do, it means that the dollar has more downside risk against the Asian currencies. And if that is true, you will have more import price inflation. And if that is true, it means the acceleration of the process we are in, and that should eventually lead to some higher bond yields, and that should eventually lead to lower stock prices.

But I think it is a slow process. It is not changing overnight from black to white. It is a process that will probably play out over the next 2-3 years. At the end of the process, you have a big waterfall decline and adjustments in the markets, and you can probably best escape that, or survive, by owning a lot of gold. I say that we are moving into a thunderstorm here, and it will rain and pour. There will be lightning. There will be flooding. There will be mudslides. Everybody will get wet. But the most important thing is, not to stand where the lightning strikes, not to be where the flooding is, or the mudslides. That is now I describe it. It is very difficult to come out as a winner, and actually, if one is smart enough to figure out what exactly to do, and comes out as a winner, I am pretty sure that governments will tax his profits away quite dramatically.

David: There is something very interesting that has happened in the last year with the Swiss franc. The Swiss National Bank, a year ago, tried to suppress the rise in the franc, and that was a very costly effort. As we look at fiat currencies around the world, they are all, relative to each other, in decline. The Swiss franc seems to be a winner for the last year. What are your thoughts? We are in this non-virtuous cycle of competitive currency devaluation. Is this just a question of who is the winner for the year? Or is there an argument to be made for select currency exposures on a longer-term basis?

Felix: In a fiat currency system, all currencies debase, and as you rightly say, it is a relative game. Longer term, those currencies will come out as winners that have sound structural fundamentals. By that, I mean, it has to be a competitive economy. It has to be an economy that runs structurally current account surpluses on a continuing basis, and therefore, structurally, is forced to improve the efficiency of the economy all the time.

Switzerland is a good example. As a youngster, when I entered this industry, the investment business, we had to pay 4 Swiss francs, and 32 cents, for one dollar. The dollar is now 83 cents. Now we have to pay only 83 cents for one dollar, so the dollar has declined by a factor of 5, or by 80% relative to the Swiss franc. The U.S., at that time, was enjoying a trade surplus, a current account surplus, and so was Switzerland. Switzerland still has a current account surplus, but the U.S. has not, and it shows that once you go the way of weakening your own currency, you really take the pressure away from your economy to adjust constantly to that particular pressure.

Switzerland was forced to really force out the low value-added industries and go up the ladder and move more and more into the high added-value industries and sectors of the economy. That is how you create winners. The same is true for Germany. I think Singapore and Asia are doing the same thing. They are extremely well-run. The Swiss Central Bank used to be well-run, but it has had a problem, it made a major mistake lately, unfortunately, although I must say, they handled the situation with UBS in 2009 extremely well.

But the intervention by Switzerland against the euro when there is a fundamentally flawed currency – that was dumb – and the timing was wrong, and the level was wrong, and that has created a situation where the Central Bank has relatively little room for maneuvering right here. But it doesn’t break the Swiss franc as a strong currency. Then when you look around, it is all the same currencies that stand out with those credentials. It is the Singapore dollar, it is the Norwegian krone, it is the Swiss franc, maybe the Chinese renminbi, but that is a little bit intransparent, and therefore I have some question marks about that. But that is what it is – it is a relative raise in currencies.

David: You mentioned Germany, and this is an important point to make. You have already seen the state elections upset the standing party and we are seeing a rebellion, if you will, even today, in Greece, against who is going to pay for what. The Germans have one perspective on that as they carry a certain burden, and the Greeks and peripheral European countries feel a different sort of burden. Looking at European stability, and the European Union as one unit, can you see these peripheral countries remaining a part of the union? Do you think we will ultimately see a few of the weaker hens drop out? Will Germany, at some point, say, “This is our only way forward. Just like the Swiss franc, just like the Singapore dollar, we have the economy, and certainly could have the currency to be a standout and a leader in our own right.” Am I looking at this correctly, or perhaps you can add some insight to the EU issue?

Felix: You have to go back to the point of time when the idea of the euro was born. Europe had a very well-functioning currency system called the European Snake. All the currencies traded in a range against each other, so it was crazy, like a flexible fixed exchange rate system, with a range.

David: That is the ERM – exchange rate mechanism?

Felix: Yes. It worked very well, and after a few years, those who could not keep pace with the high-productivity nations had to devalue their currency, and stayed in the Snake, but at a different level. They just reset the level and devalued the currency; that was functioning very well. The idea of the euro was not actually coming out of the Snake and out of economic circles, it was a political factor.

Concerning the price for re-unification of the two Germanys, the U.S., the U.K., and even the Soviet Union at that time – all three agreed that the two Germanys could re-unite without asking for anything as a price. It was only the French who had suffered under the strong Germans for ever and ever, who thought, “We cannot let the two Germanys re-unite, and then there is a big Germany again, and we will suffer under them, and we are always number two, and never at an even level.”

So they said, “You can do that, but we want to have a further and more deeply integrated European economy, and for that we have to create the euro, a common, mutual currency.” That was the price. The majority of really serious economists saw the flaws from the very beginning, and I said at the hour of its birth that if they stick to the rules, it will be the shortest monetary union on record, and after three years they broke the rules, and virtually all countries except Luxembourg and Finland, I believe, have broken the rules decisively, Germany and France first, without any sanctions. The whole setup is flawed, and it leads to enormous stress within the system.

You cannot have currency union without fiscal union, and fiscal union means political union, and one nation paying for the other, and I do believe that is against the German law and the German high court would probably say no to the parliament if the parliament said, “Yes, we agree to a fiscal union,” because it is against basic German law. That is why it is so delicate. They can create a monetary union, but for legal reasons, they cannot create a fiscal union, and also for political reasons, it is very difficult to sell the German voters and citizens and taxpayers the idea of the fiscal union.

Therefore, the European leaders are somehow struggling to find solutions to survive with the euro. They all think that time will solve the problem. We had the vote today with Greece, and the markets were bullish on that. This is just a postponement and procrastination of the problem. We all know that Greece will default. We all know that Ireland has to default. We all know that Portugal will default, and most likely Spain, and possibly even Italy and Belgium, and the longer they stay in that monetary union, the more likely the default will be, because they have to stick to an austerity that creates a deflationary ongoing recession. You could call it depression at the periphery, and that means you have a shrinking economy, and you have rising debt, and this is a cocktail for disaster.

Therefore, at some point, someone, be it the peripheral countries, the governments, or the voters, will say, “We have had enough.” I think you will see, sooner rather than later, that some countries will say, “We cannot live with that. We cannot do it. Our citizens are better off if we leave. If I were the Greek government, I would ask for as much money as I could get, and I would try to introduce some austerity, and particularly, change some structural issues under that pressure, but then, in a year or two, I would default. I would exit the euro, and I would introduce the drachma, then I would devalue the drachma by 50%, or even a little but more. There would be one more year of problems, and then the economy would recover, and tourism would bloom, and Italy and Spain would lose all their tourists because they would all go to Greece because it was so cheap. And then the next one would come, etc. I think this is an ongoing disaster, an epic drama.

There is only one solution for the euro. They have to make the euro a very weak currency to survive, as weak as possible, so that the weakest links in the chain can live with it, but that would mean a dramatically lower euro against the dollar. The ECB is against that. The ECB will most likely lose the fight against the politics and the ECB eventually has to turn around. The ECB is now the only central bank that has tried to reduce its balance sheet since it has inflated it during the crisis period in 2009. The first time they triggered the Greek crisis, the second time the Irish crisis, and now, the third time, they are reducing their balance sheet, and the whole monetary situation in Europe is extremely tight.

That is why the banks, particularly at the periphery, are refunding themselves via the U.S. money market that is extremely liquid, and half of the money in the U.S. money market funds is really money to fund the peripheral European banks. Once those money market funds get hit by redemptions because investors find out, then you have a funding crisis of major scale at the periphery of Europe, and that is the next step. It is a never-ending drama until it breaks in a big way.

I think the euro will break apart. You will have a few countries leaving the euro and then the center, or the northern part, will continue with the euro, and could probably also live with it. But I do not think that Germany could exit, which would probably be the easiest way, because they think they bear a responsibility for European integration due to European history, World War I and World War II, etc.

David: But as you have said, they can only devalue where they would need to devalue to accommodate the weakest link in the chain, which is at odds with Frankfurt’s stated intentions of maintaining monetary stability.

Felix: Absolutely, and although they have now elected an Italian as the head of the ECB, you will see that Mario Draghi, the new head of the ECB – that Italian will act much more like a German than even a German.

David: Interesting.

Felix: That is why I think they will not hike interest rates here in July when Trichet is still in power, but in September, when Draghi will be in power, he will hike interest rates to prove that he is more German than Italian. The monetary policy course by the ECB is completely unsustainable because it will create another crisis.

David: Essentially, whether it is two weeks ago, or 12 months ago, because the structural issues persist, nothing is different, whether it is the Greek vote here of late, nothing has changed. The problems persist.

Felix: You are absolutely right. In fact, I think, because of the setup as it is, and more austerity introduced, it is even worse than 12 months ago.

David: There is one issue that seems to be in the backdrop and keeps people resisting default, it is almost like tinkering with something nuclear. The credit default swap market, the onion layer of complexity just behind all of this sovereign paper, is what no one really wants to touch. If Greece is allowed to default, or if they choose to, what dominos begin to fall as a consequence of that, and does that trickle back to New York and London, primarily? Who holds that counter-party risk in the credit default swap market? It seems that there is a major defense right there.

Felix: You are absolutely right. The American banks own a lot of the CDS paper, and they will get involved, of course, once Greece defaults. But there is more to it. It is not just the U.S. banks, it is all the European banks. The European Central Bank, by itself, will be completely under-capitalized. By a default in Greece, they will lose more than their equity capital, and I think the same is true for the German Bundesbank, so you move the whole problem to a much higher level.

In 2009 we had a banking crisis, due to the indebtedness crisis of private households in several countries, the U.S., the U.K., France, Spain, etc., and then you had a banking crisis because of that. Then the public sector intervened. You now have a public sector government crisis, you have a central bank funding crisis, an equity capitalization crisis. You bring the whole thing to a new level, and I do not know – in the next calamity, I mentioned I expected to see in the middle of this decade who can bail all those guys out. It will be impossible.

By that time, government debt to GDP will be much higher than today, no question. Central banks will be much weaker, and their balance sheets will be full, and littered with bad paper, and I wonder who will bail the system out then. Then it comes to a major systemic calamity, and I think that is the case for gold, really.

David: To just wrap up, the trigger, it seems, and you mentioned something very interesting, that in the context of democracy, we really cannot go the Austrian way, and yet, it seems that the ECB and the EU have forced austerity measures because the monetary way is not an option. Everyone has given up their monetary sovereignty to be a part of the EMU. It seems that the trigger, in terms of an unwind, whether it is the credit default swap market, or something causing default in an individual country, may be democracy, where people say, “We can’t bear these austerity measures, and whatever government is going to impose them on us is a government that has a very short shelf life. Give us another election and you are all out, every one of you.” It seems perhaps the instability is in the people, themselves, who won’t stand for the pain.

Felix: Yes, you see it going on in Greece. I think that a wealthy Greek today, the guy who has a big villa, or mansion, up on the top of the hill, is in trouble. It is very uncomfortable to live that life there. I think that will go further, throughout the periphery. And the U.S. is basically the same. The only difference is that you have the option of printing money, and in the European setup, that option is gone, or the ECB doesn’t want to do it.

That is the main difference between the U.S., and Europe, and the U.K., of course. As long as you can walk away doing this, and this is going to be decided by the bond market, everything seems fine, everything continues to function. But once the bond market turns around and begins to riot against it, then you are, in the U.S., in the same trap that Greece is in right now. It is not exactly the same, but it is very, very similar.

You have to understand, we are all trapped, and there is no way out. You can postpone it by printing money, by debasing the currency, you can go into devaluing your currency and trying to steal trade from your neighbor, you can try to do that, but we know from history that that usually does not end very well. That is the situation we have.

In politics it is very interesting. I spend a lot of time in Germany because it is my neighbor country here from Switzerland, and when you talk to the average citizen, they have not realized yet what a fiscal union would really cost them. That is why the people, so far, are relatively relaxed. There is a certain group that is against the euro situation, and against fiscal union, but all the political parties, if they could say yes to a fiscal union, would. But if they say yes, they get voted out. There is not one single political party in the German parliament who says, “We are against the euro, we are against the fiscal union. We don’t want that. Enough is enough. We turn around.” There is not one political party, from the extreme left to the right, so those voters who really want to say no, have no means and no tools to say so.

The result of that is when you study European politics, you see that up to about eight years ago or so, we had a situation where in most countries we had two big people’s parties, one included social democrats on the left side, and one included the conservatives, and usually, a few smaller groups, and they were always able to form a government with a solid majority.

During the last eight years, more and more, the classic large people’s parties, on both sides of the political spectrum, have shrunk to a very low level, and you have a splitting up of the whole political landscape, more and more new parties, and it is impossible to form strong majority governments, so all the governments are basically weak, and that is a big problem when you are faced with the challenges that we are faced with right now. This is a little bit like the situation in the Weimar Republic, unfortunately.

David: Felix, there are so many more things that we have yet to talk about, and we are out of time. I love your analogy of the rainstorm. Avoiding the lightning is critical. The reality is, we will all get a little wet. The question is, can we avoid the mudslides? Can we avoid the lightning strikes? Perhaps we can continue our conversation over lunch. I have a favorite restaurant in Rapperswil. If you have one in Zug, next time we are in Switzerland, perhaps we can get together and compare notes.

Felix: That will be a pleasure. Thank you very much, David.

David: I look forward to it. Have a wonderful evening.

Felix: Thank you – you too.