June 22, 2016; Brexit: The Vote Heard Round the World

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick


“We have a number of tinder-boxes which are the set-up for massive fiscal spending, which are the way of saving the system, but there has to be the cover. It is actually going to have to be front page news – tragedy, chaos, loss, conflict, war – and then all of a sudden governments get to move from their monetary policy motif to their fiscal policy spend.”

– David McAlvany


Kevin: David, a funny thing happened on the way to the bank Friday here in Durango. People couldn’t get their money out. I’m talking Wells Fargo, Bank of Colorado – big names. People were being turned away because the bank could not give them money.

David: Generally when you see a line out in front of a bank you think, “We need to figure out what is going on, and maybe even get in that line. We don’t want to be at the very end, but if it keeps on growing maybe we’ll be somewhere in the middle.” And of course, we have had recent lines out the banks in Cyprus and Greece, and other places, where you understand that there are solvency and credit quality issues where the banks literally don’t have the money to pay.

Kevin: But in this particular case it had nothing to do with the solvency of the bank, it had to do with the Internet processing that would allow them to actually verify that you were a client or not.

David: So we are dealing with an issue of technological dependency where if you wanted to withdraw funds from a bank and there was something wrong with the Internet service provider, lo and behold, because banking is now all digitally based, there is no way to confirm that you even have money on account with that institution. It doesn’t matter if you show up with an end of month statement, it doesn’t matter if you, just five minutes ago, deposited $50,000, $2,000, or $5, it doesn’t matter. They don’t have a digital way of saying, “Yes, this is the person, this is their account, this is their current balance, and they can withdraw funds.”

Kevin: And it wasn’t just the banks. Here is the irony of it. My son went to a movie with a friend of his on Friday night. He came back and he said, “CenturyLink is down.” That’s the provider that went down, there was a line that had been cut in a nearby town, and all the movie theater was accepting was cash. They turned away anyone who had a credit card. So let’s say you can’t get cash out of your bank and you want to function. You don’t have cash, so you say, “Okay, so what we’ll do is, we’ll just go ahead and use our credit cards.” No, it doesn’t work that way because those businesses were only accepting cash. This was right here in our little 15,000-person town of Durango.

David: Ordinarily when we think of a bank, and a problem that you might have with it, we’re thinking, “Are they C-rated, D-rated, F-rated?” Where literally they have made so many bad loans that they are going to be taken over.

Kevin: And it’s worth knowing that information.

David: It’s absolutely worth knowing where your risk lies, but in this case we’re dealing with two institutions, and my assumption is that we don’t have direct experience with every bank in our area, but with these two institutions you are talking about C or better rated banks. And that wasn’t the issue. The issue was technological dependency. The issue is, there is no way to do banking without the computers on. That is an interesting thing to consider because there are other areas in our lives where we have high levels of technological dependency. If I want to talk to my father and mother in the Philippines, if I want to talk to my brother in Indonesia, if I want to talk to my sister in Tennessee, if I want to talk to anybody in my family, I don’t know their numbers anymore.

Do you know why? It’s stored in my Smartphone and all I have to do is pick it up and dial, but it means that communication, something that you think is fairly basic, is really not that basic, and is dependent on a number of things working, and working very well. Gone are the days of rotary phones and a phone book that you keep all of those numbers recorded. Nothing is recorded. Actually, outside of my laptop and my Smartphone, I don’t have phone records for anyone or anything.

Kevin: Think about it. How many people still have a land line? I still have one, but my wife and I have discussed if this is really worthwhile. Very few people actually still have land lines. Something you said in a meeting just a few minutes ago before we came into the studio, to all of us, and it’s true, as a company, for the last 40-some-odd years we’ve asked people to try to be early and to prepare rather than stand in line. This is what you said. You said one reason that we ask you to be early is that we know what it looks like to stand in line. There were lines on Friday, and of course, the issue got resolved, but what really does it look like when you have a national incident like an EMP go off, or you have a solar flare. Or let’s just say, like the SWIFT [Society for Worldwide Interbank Financial Telecommunication] system, the International Transaction System got hacked recently, and Janet Yellen was talking about it. What happens when you cannot access what it is that you function with?

David: From a sociological standpoint what we are talking about is avoiding conflict areas. We travel enough to have missed flights, or have had flights canceled, and have been forced into long lines where everyone has to be rebooked. And as long as there is a solution, there is usually relative calm in a long line of 50-100 people. But if there is no solution, and nothing can be done, people get angry. I’ve watched it. I’ve watched people in line trying to get home for the holidays, or trying to get to a business meeting where a major deal needs to be signed, or an agreement needs to come together, and the temperature rises.

Kevin: They go into fight or flight, which is that emotional state that actually helps us in the right situations, but it becomes very, very dangerous in that kind of situation.

David: It is interesting to me that very few people actually have something as basic as a gallon of water and a space blanket in the back of their car.

Kevin: Or a little bit of cash in a box.

David: Or a little bit of cash in a box in their home, or a few cans of soup extra, more than they need. The reality is, we live in the Four Corners area of Colorado, and we have two highways that come in, and if something were to happen to the normal supply lines where produce and groceries which are coming from Denver or Albuquerque can’t get here, we assume that there is a solution within 24-48 hours. What if it’s 72 hours? What is it’s a week?

Kevin: Are you just working yourself up? Are you talking like a prepper here, Dave?

David: It’s interesting that you go to the bank on a Friday and you say, “I need a couple hundred bucks for the weekend, cash, to do this and that, and they say no, and you think, “I wasn’t expecting that. Is there something wrong with the bank?” No, there is nothing wrong with the bank, but there is something wrong with the system when you have high levels of dependency and there is nothing that you can do to work around it. So, the solution to this theoretical problem is, deal with it ahead of time.

Kevin: Right. You mentioned this in the meeting, too. Independence is an important thing. You can’t be completely independent in life and to think that you are ever going to be completely self-sufficient is ridiculous. But, you can have a degree of independence and not have to answer to whoever is giving out the solution at the end of that line.

David: We watched the crisis in Greece unfold, and as things were in the gold business one of the things that we noticed is that all of the supplies of British sovereigns, which we normally source from Europe, disappeared from Europe, and they were all funneling to Greece. Why? Because it’s a small fractional gold coin and in the context of the banking crisis, they went to a particular coin which they were familiar with, minted on five continents, it was compelling to them, it was something that they had seen, they had known it through World War II and many decades of just being around. So, it was in the context of crisis that people said, “We have to have something other than euros or exposure to our banking system because it may get taken from us. We don’t know what we are going to end up with.”

Kevin: On a larger scale, we are seeing this move toward independence occurring worldwide. Look, this week, at the vote on Brexit. We have what was an empire, the British Empire, that is saying, “You know, maybe we don’t want to be submissive to a system that would take away our independence when we need it the most.

David: Right. It’s probably the most important vote of 2016, and I think I can legitimately say that. Yes, we have to vote in November here in the United States, and yes, it’s important, but in terms of something that has ramifications for the whole world, I think this is maybe the vote heard round the world.

Kevin: Right.

David: It may come to nothing this week, but under review is the involvement that Britain has had with the European Union which they formalized in 1972, 43 years ago, and this is where you find that a particular perspective on an issue means everything. You have those who are proposing leaving this close tie to the EU, leaving it behind, and there is a deep sense that British national pride is a part of that, prioritizing Britain.

Kevin: That is beyond patriotic pride. We’re not talking about redneck runaway, what we’re talking about is people looking at the last 1,000 years in a nation that has established what we know as Western law, and ultimately, even our own Constitution here in America.

David: To just add to that, yes, there is a degree of patriotic zeal, but it goes beyond that. There is an appreciation of the difference – the difference in the way laws were written in continental Europe versus those laws written and determined by the history which came from the Magna Carta. So, beyond patriotic zeal is the gradual usurpation of the judicial and parliamentary system in Britain. And that usurpation is by the European Court of Justice. You’re talking about a Brussels organization stepping in.

And from the exit perspective, if you will, this is where the real danger has lurked, simply by treaty, the ECJ, the European Court of Justice, has gained the strange cross-border role, and that cross-border role subjugates British judges to a lower rank beneath the international body, that is, the ECJ. And the Brussels body is claiming jurisdiction over areas that really should be the domain of domestic and national interests alone.

Kevin: Let’s look at this from an American perspective. I know from a constitution basis that I have certain rights that are protected by our U.S. Constitution. Let’s say there was an international body that told me I didn’t have those same rights. At that point I would say, “You know what? I want the Americans out of that. I want the United States to vote to get out of whatever that organization is.”

David: Right. In the past the U.S. has gone down a similar path where international and maritime treaties have obligated us to rules which were never put through the legislative gauntlet. But there is a liability created if we don’t comply. So we now, as U.S. citizens, have to comply with these international treaties. And again, it’s not the legislators who have made these rules which we have to comply with. Again, there are different ways of looking at the issue in Britain, but in Britain, the folks that want to stay, want to stay deeply imbedded in the EU, or the economic project, and they are willing to overlook this political issue, the judicial and parliamentary concessions which have been made, quite frankly, because the arrangement has been lucrative.

Kevin: Look at who is really the proponent of staying in the EU. You and I both receive The Economist magazine, which is an establishment magazine out of London, and the cover this week says, “Divided we fall.” I got several texts, I don’t know if you got them, too, early this weekend – early reports that were coming out trying to influence the decision of the British people. This is not a publication that is saying, “We’re going to cover both sides fairly and justly.” It’s saying, “Look, the establishment wants to stay in the EU.”

David: I was very fascinated. Tragically, the assassination of the MP which occurred a week or so ago, tragic that that occurred, but I was fascinated by how quickly the momentum turned from pro exit to pro stay with the status quo.

Kevin: Right. It was almost instantaneous. The British pound surged, the gold price dropped. It was almost as if somebody was doing something to the market to influence the way people looked at the situation.

David: And the rhetoric – it was almost prepackaged, and so readily available in the news report, literally, within minutes of the assassination. It, to me, suggests that the establishment is very concerned about losing ground.

Kevin: There is a tremendous amount of wealth that has been created by this union with the Europeans.

David: And arguably, wealth would be destroyed if the Brits walked to the exits. London would lose a lot of international prestige, and you would see flight capital. So, the pound sterling, there is no question it would be devalued, not unlike what we saw in the last six or seven years. There was another pound sterling devaluation in the 1990s, and of course, in the 1930s, as well. And in each case, the devaluation was bad for the financial sector, but very good for the export sector – they didn’t mind at all. So again, it suggests that the base level contentions between those who want to remain and those who want to leave may simply boil down to an atavistic self-interest. So, beyond the rhetoric, it is always important, with both sides in the argument, to ask, who directly benefits monetarily?

Kevin: One of the guests that we have on a regular basis, Ambrose Evans-Pritchard, was part of this whole European project. He spent five years in Brussels, Belgium, while they were putting the euro together. He wrote a very interesting piece in the London Telegraph a few days ago saying, “As painful as this is, and as much as this is going to cost, I’m voting that we go out because it’s worth the cost.” I was out running this morning, Dave, and I thought, not to sound quippy, but it’s more like, “You Brexit, you bought it.” Basically, there is going to be a cost. If they do exit, there will be a financial cost. But look at the price that was paid for freedom and for independence in the past in this country, and even going back to early England.

David: You certainly see some parallels in terms of having an external body who is calling shots far, far away from the people who are interested in what is happening, with the business right under their noses. King George certainly wanted to tell us what, when and how to do what we were going to do in the colonies, and the colonies said, “That’s fine, as long as we are well represented.” And we didn’t have the representation, so without the representation we felt it necessary to flex our political muscle.

If you look at the Scottish initiative some time back, they did not go the route of independence, in part, because of the scare-mongering which occurred, which was very effective in creating this sense of, “We can’t calculate the losses. We don’t know.” And I think, in part, they didn’t want to know, because if you could calculate it, then you are making a decision based on fact, and it’s easier to create a context of fear wherein people just say, “We’ll deal with the status quo, the devil we know, rather than the devil we don’t know.”

Kevin: Right. And as sad as that murder was last week, that seems to be what the emotional shift changed, the fear of possibly being tied to something that looked radical.

David: Maybe the debate is, in fact, more than who gets what. As this plays itself out, this may be a very fascinating test case for whether that issue of the threat of financial loss or economic chaos, if that is sufficient to hold voters to one side, or do the British wish to pay that price in order to maintain the ties to a legal tradition dating back to the Magna Carta? What allowed them to become a great power? You could, in large part, say, the British legal tradition set them on a trajectory, and there were a number of technological innovations along the way that supported what was an idea, and a radical departure, from what had been common to the world, and certainly, continental Europe. And that, to me, is, I think, what is sort of a subtext here.

Kevin: Dave, the first time my daughter and I went to London I told her, “There are only a couple of things I really need to see. In the British Library, I wanted to see the several copies of the Magna Carta that were there, because talking about a price to pay, up to that point there was the European feel, the French feel. I hate to say it, but it was the French European continental feel of law where royalty had all the rights, and the people did not. Now, the Magna Carta, there was a price to pay, even with the royalty and the wealthy at the time, that was a defining document that began giving the people the rights that they actually were given by God.

David: Yes, you go to London, and visiting Churchill’s war rooms is a must. Going to the Imperial War Museum is a must. Going to the British Library is a must. And going to the British Museum – the British Museum used to have the Rosetta Stone, and the Rosetta Stone was not behind glass when I was there in the 1990s. For those of you with a curatorial inkling this will, I’m sure, shock and horrify you, but just behind this red sash was the Rosetta Stone and I felt compelled to touch the Rosetta Stone.

A thousand years from now, probably the oils on my hands will have destroyed one of the most important archeological pieces in the British Museum, but now it’s behind glass and you can’t touch it. I would like to think that I’m not the primary cause of that. But you have to go to these places, and you have to go to the British Library and you have to see the document which not only set in motion the way that Britain does law, but the way that we do law because we borrowed all the best ideas from the British in that respect.

Kevin: But it takes a perspective that goes before 1972, which you brought up was when we started to see more of a unified Europe, which we talked to Otmar Issing about, and there is nothing wrong with a more unified Europe, but it is very, very difficult to accomplish and still maintain an independent nation like Britain.

David: Right. So, with the whole issue of Brexit, it is that some Brits think that the greatness of Britain predated 1972, and some see it now as dependent on being tied to Europe. Again, that dependency ratcheted up with intensity starting in 1972, and then subsequently, they became even closer via the Treaty of Lisbon. How close? Sort of, in your knickers close. You wouldn’t believe how involved Europe is in the minutiae of what happens in the U.K., and it was Ambrose Evans-Pritchard who has argued this stark contrast between the Napoleonic legal tradition of the continent, which the ECJ, the European Court of Justice, is in tune with, and the British code, which is based on the Magna Carta. And it is the latter which has encouraged far more enterprise, and it is the former which has created far more bureaucratic red tape, as long as it has been around.

Kevin: When we talked to Otmar Issing, who, for those recall, was the head of the European Central Bank for seven years. He was one of the originators of the thought process of the euro as a currency. He had an honest desire to see Europe and that region never go to war again, because he remembered the wars that had destroyed Europe up to that point. So there are some very good reasons why there should be unity. But what is interesting is that people are willing to give up almost anything when times are good. When the credit cycle is moving you can borrow money. It’s like, “Yeah, the European Union is not that big a deal.” But that credit cycle, Dave, is tightening, and people’s money belts are tightening, and now they are starting to look at things that they hadn’t looked at before, in a different light.

David: I love the guys that study socioeconomics and social trends, and what those social trends tell you about the markets and what is taking place in an economy. To me, Brexit is indicative of the thought process, perhaps the regrets which go along with the end of a credit cycle. As a credit cycle accelerates, as you said, there are the hallmarks of cooperation, there are trade agreements, there is generous cross-border integration. But then you get to the end of a credit cycle and sentiment changes radically.

You have, arguably, a larger force than central banks can manage, that is, as the credit cycle begins to unwind. And you see the opposite of those qualities. You see disintegration, you see the prioritization of national interests, you see a return to viewing the global economy as a pie which is only finitely divisible. And so, a grand super-cycle ends when self-interest, when national interests, are no longer cloaked, and partnerships convert to competition, when you have outright conflict.

Kevin: Sometimes you look at the European Union and you think it is everyone equal, but if you really look at it, Germany has been the financial backbone of the European Union. Now, they have very, very high stakes in this vote that occurs on Thursday.

David: Sure, because it is the German banks which have huge exposure – direct exposure, indirect exposure via the derivatives books, and that is the part that is below the waterline, so to say, their derivative exposure. You know that they have a good amount, and you can watch the share prices of both the German and Swiss banks, but the German banks – you have Deutsche Bank trading at levels it hasn’t been at since 1992. There is pressure, there is a lot of pressure, and a lot of assumptions that if Brexit goes through you are going to see a breaking in the financial markets in Europe.

So yes, the ties are there. Brexit would no doubt topple the share price of the German financial players, even more than it has already. And yes, it could threaten insolvency, which quite frankly, already pre-exists, it is just in a managed state. So this week, at least through Thursday, this is the most active which central bankers have been behind closed doors since the global financial crisis. And so, you have liquidity deals which are being penned, you have emergency supplies of euros and dollars, credit, that is, which is already being arranged.

Kevin: Right. And here is the thing. If it goes either way, it doesn’t necessarily bring peace. If Britain stays in the euro, financially, there is still a lot of costs that have been outlaid.

David: That’s right. To a degree, you have all of the hedges, you have the protections put in place to protect from the financial ramifications of leaving the EU, and those would be quickly unwound. Again, if you have been covered, fine. But there are always two sides to a bet, so someone is going to experience pain either way, Brexit or no Brexit. It was Bloomberg that was noting on the 16th of June that money market funds in Europe are already flashing “warning signals” as the rising credit risk is being spurred, in part, by fears of the Brexit, and it is making it harder for big banks to obtain U.S. dollar funding.

So, as you might guess, just as we saw in 2008 and 2009, and then again in 2011 and 2012 when it began to really intensify in Europe, the Fed opened up its swap lines and were able to wheel and deal overnight and create liquidity in Europe. And my guess is, the swap lines are open. The question is, will liquidity be sufficient to avoid a replay of 2008 and 2009 in its entirety in terms of a step sequence of liquidity translating into, ultimately, a solvency crisis.

Kevin: Don’t you think, Dave, oftentimes when you see a major political paradigm shift like what we are possibly looking at, it almost always boils down to the elite, the people who are well embedded in the current system, being out of touch with the rest of the people?

David: It is. And I think you create that sense of elite. A City Group analyst, a guy by the name of Gregory Marks, had an interesting commentary this last week. He basically asked if negative rates have allowed, because of an intellectual free pass – again, there are the monetary elites, there are the folks who are, from their balance sheet perspective, perhaps, considered elites, but then there are the intellectual elites, too, the ivory tower, white glove crowd, who doesn’t really like to get dirty because their ideas are so pristine. And Gregory Marks of City Group is asking the question, “Are these folks, these smart people, are they being allowed to work under false assumptions because they are smart? Are central bankers doing the same thing as Rudolph Havenstein, which is a familiar name to our regular Commentary listeners, doing the same thing that he did in Germany in the 1920s?”

Kevin: He was given a pass because he was considered so intellectually above the central banking community at the time.

David: This is where intellectual conceit is a very, very dangerous thing. He is asking if negative rates are not the modern version of Havenstein’s misguided intellectually blinded approach, where we put something in motion, and yet we have this strange dependency on the elites in our culture, and yet there is this growing sense that we can’t stand it, either, because no, we don’t know what we don’t know. On the other hand, common sense would tell you, there are certain things that you just do know, and you don’t have to go with the most complicated, complex solution. Sometimes the most elegant solution is the simplest.

Kevin: The central bankers seem to be telling us that the whippings will continue until your attitude improves, and I’m speaking of negative interest rates at this point. The intellectuals are saying, “You know what? If they’re not spending money, we’ll just whip them some more.”

David: So, that’s Gregory Marks asking the question, and I want to quote from a Fed official to answer that question in the affirmative. Federal Reserve, Daniel Tarullo, who heads the committee on bank supervision said this, this last week. “Has what we have done been effective? If we say no, then maybe we need to return and do more, and intellectually, I am totally open to that.”

Kevin: Well, there you go.

David: It is Havenstein, 2016, Exhibit A. And Gregory Marks goes on to say that the lesson here is that, unfortunately, people believed in the efficacy of a completely irrational policy because it was put in place by a qualified and experienced policy-maker instead of questioning the common sense merits of its possible outcome.

Kevin: It reminds me of Nero fiddling while Rome burned. Rome seems to be burning. The central-bank-held-together policy is not working. Yet what we are seeing in the East is a little bit different. What had been dollar dependency, and what that basically says is not just dollar dependency, but central bank dependency, reserve currency status of the dollar dependency.

David: Trade with the West dependency.

Kevin: Trade with the West dependency. Now what we are seeing is China saying, “I don’t think we want to be dependent anymore. Maybe there is another ally that might cinch up a little bit more power without the West being in the picture.

David: It is interesting because Russia has made huge overtures and China is very responsive, and it is trade cooperation deals which they are moving forward with in a big way. They have some big deals on the table, 6.2 billion dollar high-speed rail deal. If you remember, things like roads and rails and when you open up trade routes it does something to open up cultures one to another.

Kevin: Even the Silk Road 1000-1200 years ago. It changed the whole landscape.

David: You shared goods, you also shared ideas and ultimately some cultural norms began to shift as those cultures moved toward each other. You, to some degree, had that with France and the U.K. when the Chunnel was put in, where there was a more interesting cooperative perspective between two countries that for centuries have really not enjoyed each other. So this joint transportation project, 6.2 billion dollar high-speed rail – it will be interesting to see how that developed. You have 30 different trade deals which are being discussed between Russia and China and on top of that Putin is now searching for a strategic partnership in Rosneft. That is the state-dominated oil and gas producer.

Kevin: They’re bigger than Exxon, aren’t they?

David: They produce more energy resources, oil and natural gas, than Exxon Mobile. And Putin would like to have some sort of a deal with India and with China, and swap a 19.5% stake for about 11 billion dollars. That will help them pay off some debt, but more importantly, it creates this allegiance which we are watching disintegrate in Europe, where Otmar Issing wanted to create so many ties that bind, so to say, economically, and they are slowly becoming unhinged because there are other things that were never conceded, now being questioned as concessions not legal, that you have in another sphere geographically, the same kinds of ties being put into place.

Kevin: Now we are starting to see some geopolitical tensions forming, as well. We’re not just talking about monetary, financial, or oil types of connections, or even high-speed trains.

David: No, it makes me think about the Scarborough Shoal and the tensions in the South China Sea, if in fact, we are now at the end of a period of Chinese glasnost. That is a concept, maybe, that our listeners aren’t familiar with, but if you look at contemporary Russian history during the Cold War, 1917 to the late 1980s, you have this continual opening up – reforms, we want to change, we want to cooperate, we think we can do things different, glasnost, perestroika.

Kevin: Usually, it relieved financial tension and military tension long enough for the West to go ahead and feed some money into the region, and then they would tighten up.

David: That’s right. What was fascinating was, I was reading the Financial Times June 14th. They were discussing how the Chinese Communist Party is tightening control over the state-owned enterprises. And in terms of their management profiles, instead of being board-controlled, following a U.S. or European model, they are going back to having a committee, part of the Communist Party, a committee embedded in the state-owned enterprises, who have to approve any strategic choices that are being made by the SOEs.

Kevin: That sounds like a return to Mao.

David: Exactly. So, you have a tightening of control over state-owned enterprises. They are tightening control over the media – no surprise there – over the military, as they are kicking out the generals who wouldn’t necessarily comply and are starting to think in a more innovative fashion. And now you also have the civil society, more broadly, which is being tightened down on. And it is Xi Jinping who is consolidating power and moving back to, if you want to call it, the Mao management model. They are moving away from the Chinese capitalist experiment of the last two decades.

It reminds me of one of those frequent openings in the Soviet Union that allowed for an influx of foreign capital – glasnost and perestroika – the promise of change. Everyone could get stars in their eyes and say, “It’s a new area. We will create wealth and cooperation, and we don’t have to worry about the bear anymore.” And then there was the subsequent return to hardline communism after foreign funds had been captured.

You have the tensions in the South China Sea, which may very well propel us backward and reinforce that issue of the Mao management model. Right now, we have the UN tribunal, which is hearing the Filipino case against the Chinese, and they are close – they are very close – to determining which of the maritime disputes they have jurisdiction over. To me, that sounds just absolutely bizarre anyway. How does the UN and the Hague Convention have anything to do with what is happening in the South China Sea, but lo and behold, there are treaties that have been signed, and enough people have signed on the dotted line that we are talking about, does the UN have jurisdiction on this issue in the China Sea?

Kevin: Do you really feel like if the UN goes against anything that China is doing that the Chinese are going to pay any attention to it?

David: No, the Chinese will reject a negative ruling and I think they will become more aggressive in asserting their nine-dash line. I looked at this with my wife this week. Look at a map of the South China Sea and look where the Chinese have put their nine-dash line, and they are claiming water which is within spitting distance of the shores of Vietnam, Malaysia, Indonesia, the Philippines, Japan. And look how far it is from the coastline of Japan, and it is absolutely, patently absurd.

So what will we see? We are going to see us, the U.S., respond indirectly. How does the ball bounce from here? If the UN favors the Philippines in this case, then you have a hardline response and it goes back to the Scarborough Shoal. The Scarborough Shoal is what we have defined as our red line in the South China Sea, where we will take action. Will we take action? Do we have the guts to take action?

Kevin: And by whose authority? Who is we these days?

David: The U.S. I’m speaking specifically of the U.S.

Kevin: Okay, I gotcha.

David: What it will probably look like is the U.S. responding indirectly, supporting the Japanese, the Vietnamese, the Malaysians, the Indonesians, the Filipinos, supporting them via arms deals, and of course, all kinds of hackles will be raised because of that. And what is this doing? Back to the trade agreements and the closer ties between China and Russia, we are pushing the Chinese and the Russians together because on one flank we have all of these sanctions against Russia.

On the other flank, we are pressuring China, and saying, basically, we’re going to tell you what to do in your own back yard. Arguably, I don’t know that we are the arbiter, but if you look at the map, it’s really not their backyard. It’s not their backyard at all. And yet, we are the world’s policeman because we are the ones with the biggest tanks, bombs, guns, the largest navy, etc., and that’s why we are inserted in someone else’s backyard and their business.

Kevin: I hate to sound conspiratorial, but your dad handed me a book written by a Russian defector who was part of a 50-year plan think tank. His name was Anatoliy Golitsyn, back in the 1980s. It is called New Lies for Old. Let’s put this in context for a moment because I know this was a defining moment for you when the Berlin Wall came down.

David: That was high school reading for me, and dinner table conversation leading up to the fall of the Berlin Wall in 1989, a very defining moment in my life.

Kevin: And it was in the plan. It was in the 50-year plan, because Anatoliy Golitsyn said – I read the book in 1988, you probably read it about the same time. That was years before the Berlin Wall fell, but in all of our minds, that was an impossibility for the Berlin Wall to come down. But there was something else he talked about. He said, over this 50-year plan, the strength of Russia and the strength of China will start to grow together.

He called it the pincer movement. He said, from the Russian 50-year plan, it was always part of the plan. Russia wanted to make sure up to that point that the United States always armed itself only to the degree that Russian had armed itself. But they didn’t want them to look at the two as possible allies. And now that is what we are seeing, whether it was part of the plan or not, and you are saying maybe it is being caused by the end of this credit cycle, that these things were inevitable as things tightened up.

David: Like the Brexit vote, these are indicators. They are signs of the end of a grand super-cycle. You have the credit cycle, which is cooked, and there will be hell to pay. The Chinese have just completed the world’s fastest super-computer using only Chinese components. You have nationalist pride, which only needs to be fed by a sense that the country is being attacked by outsiders. And what will we have in the wake of that? The “next great leap forward,” which will be positioned as something that is being undermined by the U.S. and its proxies.

This is the makings of global conflict. Yes, the financial is tied to the economic, the economic to the political, the political to the geopolitical, and we are now dealing with basic human insecurities. We’re scratching deep. And we’re going to find that when you scratch deep enough, you have transitioned, knowingly, or not knowingly, into a world of tooth and claw.

Kevin: Yes, but there would be some people who would look at you, Dave, in their high-minded way and say, “Yes, but Janet Yellen has got this, and Bullard, and some of these other top-notch Federal Reserve people. They will provide the peace that they have promised.”

David: This is, I think, a very fascinating thing, because you are dealing with the common man, who is looking and saying, “The master plans of the last 50 years – what have they amounted to? Yes, they helped for a while, but what are they doing for me now? And no, people don’t have a very long attention span, so what has happened in the last six, 12, 18, 24 months, is an eternity.” And so the common man would say, “Look, I’m still fearing unemployment, and I’m concerned. I just don’t see it.”

It’s the common man everywhere. It is the common man in France, it is the common man in Italy, it is the common man in Greece, it is the common man in Britain, it is the common man in the U.S. So, sure, you have a Bullard, and he does a mega-flop in the last week, going from hawk to uber-dove, where essentially he says, “Yes, we are going to tighten monetary policy, we are going to raise rates, this is what we are going to do, this is our path forward.”

And then this last week he converts to being actually the biggest dove on the FOMC committee. The Financial Times on June 17th described, when they were looking at the dot plot, which is the visual layout of who is likely to vote what, out of the FOMC numbers. There is this singular dot which is set apart from everyone else, which marks the most distinct uber-dove position, and it turns out that it is Bullard. “We’ll have one hike and that will be it until the end of 2018.”

One of two options exist for why rates are not on the rise after all the verbal commitments which have been flowing freely from the Fed. There are only two options here. One is that there is terror in the hearts of the Fed members over the general malaise in the global economy and they look at things like what is happening in terms of international tensions and they say, “We just can’t add any pressure here.” They look at the South Korean central bank, just in the last couple of weeks, lowering rates, citing weakness in global trade. And they say, “Okay, we’ve just got to be on hold.” Or, this is the other option, perhaps the issue is, the alternative set of Fed data points, the internal data points, not the ones that are so frequently trotted out by the financial news media, suggests to the Fed that all is not well here in the U.S., as well as in Europe.

Kevin: Look at employment. We keep being told that employment is getting better and better and better, but actually, that’s not the case.

David: Again, it depends on your measure, so what is trotted out as the improved number is U3. So, if you sit between 4.5 and 5%, things have gotten significantly better. But the Labor Market Conditions Index, the LMCI, which is the internal measure of labor markets and employment that the Fed has created, and they created it in 2012 in large part because they didn’t like U3 and U6, it didn’t tell them what they needed to know – it has declined six months in a row, Kevin. The LMCI is down six months in a row. And so, yes, you have the public good news which you can share. Hoorah, U3 is down to 4.7%. But the LMCI registers a six-month negative reading. And this is a problem. This is a real problem.

Kevin: So, pay no attention to the LMCI behind the curtain. They pulled it out when it worked, and now they’ve put it back behind.

David: Right. So that leaves them with the sense that maybe they’re stepping into a 1937 bear trap where the economy is not strong enough to support tightening, and in 1937 that is when the Fed raised rates in an environment where the economy was not robust enough to handle tighter monetary policy. And the Great Depression aftershock was what followed. And it was only resolved by an increase in government spending, justified by entry into World War II. So pray we don’t go down either the path of raising rates at the wrong time, or spending when the public feels compelled to.

And by the way, that is when politicians have natural cover to do so, when there is so much fear and a nation is responding to international conflict or war, that the government has carte blanche to spend. To fiscal policies, there is no such thing as constraint. Fiscally, you can spend whatever you want. So to me, look at the South China Sea, look at the Middle East, and we have a number of tinderboxes which are the setup for massive fiscal spending, which is the way of saving the system, but there has to be the cover. This is actually what keeps me up at night, thinking that it is actually going to have to be front-page news – tragedy, chaos, loss, conflict, war. And then all of a sudden governments get to move from their monetary policy motif to their fiscal policy spend.

Kevin: As we have found through the years, just because you can say, “See, I told you so,” and you are right, there is no pleasure in that. I think of the Commentary that we were doing back in December when we were talking about the expert consensus of economists saying that we were going to have four interest rates increases here in 2016. You immediately said, “No, there probably won’t even be any.”

David: (laughs)

Kevin: Bill King said something like that, too. He said, “No, just give that one up.”

David: That’s patently absurd. Well, we got the one. But I am reminded of what my dad used to say, and this is an adage I grew up with. “The majority are always wrong.” And so, the majority of economists said, “Look, we’re going to raise rates, the economy is okay, it’s on the mend.” So they thought. And you have the data-dependent Fed, which has hit its targets – why aren’t they raising rates? Yet, it didn’t happen as it was anticipated, or it hasn’t yet, anyway. We just had the June meeting, and instead of the non-hike in the rates driving prices higher, what did it do? It brought them lower.

Kevin: Right. That was a completely different reaction.

David: It rose. And it says to me that the currents are shifting. It says to me that there is some subtlety in the markets today which is going to be high drama tomorrow.

Kevin: Very different than the consensus in December on The Economist. The Wall Street Journal just said this week that the closely watched indicators are sour right now, as economists are scrambling to assess risk.

David: Yes, they said that hiring is slowing, auto sales are slipping, business investment is dropping, America’s factories remain weak, and corporate profits are now under pressure.

Kevin: Dave, this is the thing that you have talked about so often and it is discouraging because the numbers that we get from the government are always revising and changing. But the news that came out just the last couple of days that GDP is going to be reduced for the Obama administration tenure, which is 2008 until now. They’re going to knock 2% total off the GDP. It’s phenomenal.

David: Right. Well, he was already averaging 1.55%, so it was already at the low ebb. If you’re looking at GDP measures, he is the fourth lowest out of 43 presidents in U.S. history.

Kevin: Right. They were other depression presidents, weren’t they, like Hoover?

David: That’s right. So, he’s at the low end, and he’s about to be taken down a notch in terms of what was accomplished. But also, what the Commerce Department is basically saying, whether they know it or not, is that what the news pundits had been talking about, recovery was weaker, still, than had been discussed over the last three, five, seven years.

Kevin: But we’re only being told at the end of the tenure.

David: So, a market practitioner would say this. “If you’re going to see a major increase in economic activity, if you’re going to see a rebound in equities, a major leg forward, where you are going to see the greatest improvement in terms of wealth generation, is within the financial sector. They have leverage to any real growth. So, you will generally see financials lead on the upside. You will also see financials lead on the downside. So, if you look at European banks, they are trading at the lowest level since the worst part of the European crisis in 2011 and 2012. Does that suggest that Europe is out of the woods? No, just quite the opposite. It suggests they have another round of decline ahead.

We have growth here in the United States which stalled in mid 2015 and prices have been in decline ever since in the U.S. financial sector and in the U.S. banks. You have this year’s year-to-date performance, going back to Europe. It’s the worst, of course, in Italy – bank shares are down 44% on average. Deutsche Bank – gosh, wouldn’t you like to know what is going on behind the scenes at Deutsche Bank? They’re trading at levels they haven’t seen, as I mentioned earlier, since 1992. Credit Suisse – down 48% since the beginning of the year. This is across Europe, and it is extending across the Atlantic to the U.S. financials.

Kevin: This is what happened in 2008 before the crisis, is it not? That was the late, not so great, 2008. But we’re now probably going to have to come up with a rhyme for 2017.

David: Right. The distinction amongst the financial players – there are weaker players, and you are seeing stock charts which would suggest that there some who have far more leverage, who have far more toxic derivative exposure, whose loan books have already soured, or are rotten to the core. And those are the ones who stand out like a sore thumb. Maybe that’s Credit Suisse, maybe that’s Deutsche Bank. Maybe here in the U.S. we could pick a few to pick on. In Italy, it’s the entire sector. You have close to 200 billion dollars in bad loans in the Italian banking sector alone that have already soured. You’re not talking about what goes from here.

Reflecting on the Brexit issue, and just wrapping up, the central bankers have been given carte blanche to apply theoretical models that have never before been tested in the real world, and I go back to this sense of discontent around the world with the elites in every culture. I want to end with a quote from a Bloomberg article that I read this week, and just see if what they say might reflect what is going on with this Brexit vote, what is going on with the rise of the five-star political party in Italy which has just upset the Rome mayoral votes. You have the Nationalist French Party which is led by Le Pen. You have Trump here in the United States. Ponder this as a sociological exercise.

Kevin: So Dave, what you are saying is, I’m pondering the out of touch nature of the elite system at this point.

David: And it comes at a very awkward time because it comes at the end of a credit cycle where a rise in nationalism is a natural effect.

Kevin: Right. They’re not providing bread and circuses anymore and that is the problem. Where are the circuses? Where is the bread? Now let’s go ahead and make a decision.

David: So here is what the Bloomberg commentary had to say.

“Over the last half-century, Western elites managed to convince themselves that nationalism was not real. Perhaps it has been real in the past like cholera and telegraph machines, but now that we are smarter and more modern, it would be forgotten in the due course of time as better ideas supplanted it. That now seems hopelessly naïve. People do care more about people who are like them, who speak their language, eat their food, share their customs and values. And when elites try to ignore those sentiments, or banish them by declaring that they are simply racist, this doesn’t make the sentiments go away. It makes the non-elites suspect the elites of disloyalty. The rest of the population is outraged that the elites running things feel no greater moral obligation to their fellow countrymen than they do to some random stranger in another country.”

That is what you get to ponder as your weekly sociological exercise.