Financial Sense Newshour
The BIG Picture Transcription
November 5, 2005
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- Predicting the Rain Isn't as Important as Building the Ark
- Taxes & Inflation
- Changing of the Guard at the Fed: What It Means For Investing
Predicting the Rain Isn't as Important as Building the Ark
Music: Inflation nation...too big to fail...
JOHN: And that someday may not be too far away. Yes, there we are, Inflation Nation, that [song] was written by one of our listeners, Steve Doré, after a comment I made on the show last week where I said, “with the coming inflation nation...” That's the first topic that we're going to be looking at indirectly. Predicting the rain when you’re forecasting the weather isn’t really as important as building the ark. Who cares when it hits. Just make sure when it does, you're ready for it and you'll stay afloat.
JIM: Well, I'm just impressed, John, that you inspire such creativity. What can I say? You say it on the air and It's a song the following week.
JOHN: let's talk here about warning people about inflation. Certain things have become obvious especially to even the Congress people who were talking to Alan Greenspan this week take it from there!
JIM: Well, let's take a look at some of the facts. If you just take a look at year over year [changes in] the major inflation gauges, starting with the Producer Price Index (PPI), which is up 6.7% year over year. Last month It's up at an annualized rate of nearly 15%. Moving over to the Consumer Price Index, which is finished goods, year over year It's up 4.7%, last three months 9.4%. If we look at import prices remember, we're running record trade deficits, the current account deficit this year could be as high as $800 billion year over year import prices are up 9.9%, last 3 months 20.5%. Our listeners can go to our website on The Two Bens article, I have from Gillespie Research all of these indexes from the beginning of the year, and you can just see There's been a steady climb in all of the inflation gauges. So It's obvious we have inflation.
This week, when Greenspan was on Capitol Hill on Thursday, a lot of the questions that were peppering the Fed Chairman dealt with the inflation issue. It's obvious it has arrived and you can no longer hide it: back in April producer prices jumped 4.7%, we had a jump of 3.5% on the CPI, and import prices jumped 18.4%. A lot of people [were] saying, “Ah, this is just temporary, a blip, It's going to go away.” And everybody was talking deflation by early Summer. In fact, I wrote a piece on the core rate, talking about how the inflation numbers were being jerry-rigged, and all of a sudden we got attacked by the deflationists, saying “[There's] deflation, how can you talk about inflation” Well, It's obvious inflation is here, which is one of the reasons the Fed is raising interest rates. And We'll get to that in just a moment. [3:33]
JOHN: Just an abstruse comment here. What rate do you think we're really at The Puplava index.
JIM: I would say, if we're going to use John Williams’ inflation index, which is pre-Clinton because Clinton changed the inflation index by tinkering and [It's] somewhere around 7.4% today. So, if we look a Federal Funds rate of 4% and we look at a true inflation rate of 7.4%, interest rates are grossly under the inflation index, which still makes it profitable to speculate because you can borrow money at a cheaper rate than the rate of inflation. [4:13]
JOHN: One thing that is really clear as you flip around the cable channels, there is a lot of confusion about what actually causes inflation. And frankly the pundits contribute to that. And lately over the last couple of weeks we've heard flaps over oil. Companies gouging everybody, That's causing inflation. Bill O’Reilly said it was the gouging oil companies that were going to pitch us into a recession next year in 2006. Some blame OPEC, others blame acts of nature like hurricane Katrina. I know you believe these are just symptoms, or what I call triggering-events, but They're really not the cause.
JIM: No. As I wrote in The Two Bens, inflation has and always will be a monetary event of excess money and credit in the system. let's talk about the symptoms of inflation, which are rising prices [and] not the cause. If we look at rising prices, some of the most important influences on the way prices can rise are if the supply of money and credit increases, or the supply of goods and services decreases, or the demand for goods and services decreases. In other words, if you've got a lot of product out in the market and there isn’t a lot of demand for it the price is going to fall till you can get the price down to a level where people are willing to buy. You see this for example during the Christmas Season, when the retailers will come out and try to price the goods at full price but a lot of people are saying, “You know what, if I just wait a little bit, and maybe a day or two before Christmas when the retailers start panicking because the inventory isn’t moving I’ll get a better price.” The price drops and you get the buyers coming in. And conversely, the price can decline as a result of the money supply contracting, or the supply of goods and services increases or demand decreases.
But what we see John is many times inflation is always blamed not on increases in the supply of money and credit but on external forces, and I talked about 3 of them. One of them is called cost-push inflation. And That's what happens when unions start going on strike; public employee unions demand higher wages whether It's striking airline workers or striking workers at a British Petroleum or Shell oil plant in Europe demanding higher wages, and people say, “Ah, It's cost-push, we’ve got inflation because the unions want more benefits and wages.” Another one [that is blamed], which is prominent now is what I call profit-push inflation. And that is resulting from greedy business people and in this case oil companies raising prices. In other words, it’s not really too much money and credit out there creating demands for goods and services; [but people do have] access to money to pay for this, money that they normally wouldn’t have, [because] they borrow it, it’s on credit so that raises demand. And as a result prices go up as There’s not enough production to meet this demand. [So] you have the price of oil going up.
you've got O’Reilly blaming inflation and the economy on rising oil prices, you've got Congressman going out there, you even have Federal Reserve officials going out there talking about [this]. If you look at the notes that accompany the Open Market meeting they talk about inflation pressures as a result of hurricane Katrina and rising oil prices. So once again, it’s not the increase in the money supply growing by the way over the last 3 months at an annualized rate of 12% a year [that is blamed]. you've got global monetary base which is the money supply plus the balance sheets of central banks which are growing at the fastest rates we’ve seen since 1975. Globally, It's growing at 20%.
And getting back to the third reason to which inflation is often attributed and these are all erroneous analyses [there’s] crisis driven inflation resulting from acts of God, war and weather. So, what have you seen over the last 2 months. Now, everybody’s talking about inflation but it has always been there if you look at the rising inflation numbers. But now there’s an offloading: we’ve got something to blame, such as rising energy prices and act of nature. [8:53]
JOHN: But obviously the real cause remains that It's an increase in money and credit. I mean that’s what causes it, and it results in downstream price inflation. But I think the things you mention, such as acts of God and nature sometimes they’re triggering events, sometimes they're offloading events. Am I correct?
JIM: Yes, let’s put it this way: prices are rising because there is greater demand for whatever it is: orange juice, coffee, natural gas, energy, aluminum, copper. The demand is greater than the supply. These are economic events. But when you analyze demand, what is increasing demand is increases in the supply of money and credit that allows people or individuals or nations or corporations to consume more or demand more. That's what’s filling it. In other words, if you had no access to credit, and you could only pay for things with cash, obviously demand would obviously be a lot lower than where it is today. The problem that we've had up until this point is, as a result of global production, the amount of goods that are produced globally has increased, and when you increase the supply of goods that brings down their price. For years inflation has been masked globally by increased this worldwide production which brought down goods prices.
So, when we the increase the supply of money and credit which began in the 80s [was] offloaded to the financial system, what we saw was inflation manifesting itself in asset bubbles. In the 80s we started out with bubbles that crashed in real estate, and in commodity prices. Then we had a bubble in farmland, then we had a bubble in energy which crashed in 84. Then we had a stock market bubble that crashed in 87 and 89. That was followed by a real estate boom and bubble followed by the S&L crisis at the end of the decade. In the 90s we had an emerging market bubble for foreign bonds, then we had the technology stock market bubble. Now fast forward into this century we have a bubble in real estate, we have a bubble in the bond market, we have a bubble in the mortgage market and we have a bubble in consumption (or rather excess consumption which is reflected in record trade deficits).
So, we’ve seen extremes in all the markets, especially in paper assets in the last 25 years. And remember, inflation has 2 ways of manifesting itself: this excess money and credit can go into financial assets or asset inflation or it can go into goods inflation. What we are now starting to see with the rise in commodity prices that began in 2001, is inflation spill over into real goods in commodities. And just to give you an example of what some of these figures look like: gasoline prices as of August were up 31%; gas and electricity up 8%; sporting goods tickets up 11%; college tuition the Wall Street Journal did a major article on the cost going up high single digits, almost 8% depending on whether you were going to private or public college; delivery services up 6%; veterinary service up 6%; cigarette prices up 5%; dental services up 6%; household repair [up]; and I could go on and on. These are the kind of things that are going up that are becoming obvious.
Carolyn Maloney: “If the economy is so good and inflation is so well behaved and there is price stability then why does everything cost so much more when you go to buy something. They're feeling pressure in their lives and the questions I hear from my neighbors, friends and constituents is when we have so many economic indicators which are unhealthy how are we having a healthy economy. We have a costly war; the largest deficit in history; the largest trade deficit in history; high energy costs; a weak dollar; huge investment from foreign countries. All of these patterns are troubling to people yet the economy appears according to your testimony to be strong and moving forward, and they question how it can be strong when there are so many concrete problems out there that are unhealthy for the economy.”
Ron Paul: “The government tells us there is really inflation buy you know we could use what we strike out, we can look at medical care costs, we can look at food, we could look at energy, we could look at the cost of government taxes. Who knows the inflation rate might be 12% or 14%.”
That was representative Caroline Maloney, Democrat from New York, and Republican Congressman Ron Paul of Texas talking about all these prices going up, and all the things we cut out giving us really a phony inflation index. This is why the Fed is raising interest rates because It's has become obvious to everybody that everywhere you look you're seeing cost increases on things from basic necessities like food to your utility bill, obviously gasoline prices. And also talk about energy price which everybody in this country is being impacted by [is making the inflation obvious], whether you're a consumer, a business that has to pay for energy, transport goods, or even the government which has to pay for things. So here you have the Congresswoman saying: if It's so good why does everything cost more? [15:05]
JOHN: But of course, we knew the inflation was underway for quite some time, but Congress wasn’t saying anything but it seems to be that all of sudden there is this flurry of activity. As soon as the inflation becomes obvious even to the lowest person on the totem pole, especially at the pump or the supermarket, then you get some reaction. And i’m assuming that’s why the Fed would be aggressively moving on interest rates, is that a fair assessment?
JIM: Precisely, John. They’ve got a wildfire going and they want to keep this from spreading right now. They want to keep it contained so They're raising interest rates. They're going to raise interest rates a point in December, I think Greenspan will go a point in January. Then I think what will happen is when Bernanke becomes Chairman and chairs his first FOMC meeting in March he's got this reputation as helicopter commander what I think he's going to do is go with a point in March and possibly a point in May, where We'll get the Federal Funds rate to 5%. And They'll do that unless we get a 10-sigma event. [16:14]
JOHN: You better explain what that is to people.
JIM: A 10-sigma event is something so out of the ordinary that it is devastating either on the economy or financial markets. It would be for example a 9/11: a major, major terrorist attack in the United States, that either disrupts like a major attack on Washington, or New York, or a major city like Los Angeles, Miami, something of that magnitude. Or on the financial side you get a Long Term Capital Management (LTCM), a hedge fund so leveraged to the point where they are on the wrong side of a trade. [See article: Ten-Sigma]
And let me give you an example, they’re already setting up for this. We can see this with the bankruptcy of Delphi. Delphi had about $2 billion of bonds out there which they basically defaulted on [when they] declared bankruptcy. Now, let's say you are a fund manager, or a pension fund or a large institutional investor and you own $20 million of Delphi bonds. You know they’re speculative, you know They're junk bonds, you want to protect and hedge yourself. So you go into the market and buy credit default swap derivatives and that basically means you’re going to hedge let’s say half your portfolio, half your holdings of Delphi bonds, $10 million, and what you do is you pay an entity either a money center bank or even hedge funds can write them normally a spread over what is called the risk free Treasury rate, and you pay that every single year. And on a $10 million bond portfolio you're going to pay a 2-3% premium every year for insurance protection. Now, Delphi defaults and goes bankrupt and so you exercise your insurance policy. and you call upon your insurance company who ever you bought your credit default swap derivative from and you say, “OK, They're bankrupt, just like a hurricane, my house was destroyed give me the money to replace it.” So, in this case, whoever you bought the credit default swaps from would have to give you the $10 million dollars to replace the bonds. However, in exchange for that, you deliver the ownership of the $10 million worth of defaulted bonds to the person who wrote the credit insurance.
I use this analogy, say you got into a car accident, your car was destroyed, your insurance company writes you a check to buy a brand new car but they may take your car in trade and try to sell it for salvage. And That's what happens with whoever owns the bonds that you deliver, because they paid you for them. The problem is we had $2 billion of bonds that defaulted and we had $20 billion of credit default insurance that was written. So in other words they wrote insurance on $20 billion worth of bonds, when there was only $2 billion worth of bonds outstanding. So how do people deliver these bonds [to] whoever [wrote] these credit default contracts? And so what They're doing, rather than delivering the bonds They're allowing cash settlement, and that is not as good a settlement. For example, let's say you had a contract on silver for $7-8/oz, and the price of silver goes to $10-12/oz. You want to take delivery of silver but whoever wrote the futures contract in other words the person that was short the contract you're going long by buying doesn't have the silver to make delivery. They allow for cash settlement. They would just give you the difference in price, let’s say if you bought a contract for $8 silver and silver was at $10, they would just give you the difference between $8 and $10. So, They're already taking steps for a major derivative mishap. Whether that will be able to contain it, I’m not quite sure, but those are what I would call a 10-sigma type event. [20:45]
Alan Greenspan: “There is no doubt that There's been a very significant amount of hardship, especially with the rise of gasoline prices. And I think people are going to be quite surprised at their heating bills this winter.”
JOHN: Gee, Jim, where have we heard that before here on the program? How does a storm like this unfold. Obviously the conditions brew for sometime, but then There's always a catalyzing event. And so, if we were to look at a storm coming like this, how would this one unfold?
JIM: Well, let's start with what he's talking about, heating bills this Winter, and I'm going to quote here from Evelyn Garris’ Browning newsletter. She is talking about what is going to come this Winter:
“there may be other storms that develop in the Gulf of Mexico but there is no longer enough heat to develop the monster storms that have haunted our Summer...Throughout this Winter cold fronts are going to collide with abnormally warm wet ocean air and the East coast is going to be buried in snow. Additionally, the wind chill factor of these storms will lower temperatures and raise heating bills”
And you have Greenspan referring there, to how these heating bills are going to be shocking when people get them she goes on:
“Historically, years with abnormally active hurricane seasons like we saw in 1933, 1969, 1995 have had cold Winters including the Midwest. Of the future resembles the past, and it usually does, the warmer waters and air in the North Pacific and North Atlantic will block the spreading Polar air mass from expanding over the oceans, instead the cold air will plunge into the center of North America, sweeping cold air from the Northern Plains, the Great Lakes, and Ohio Valley, and into the East Coast. In other words expect this year's stormy Summer and Fall to be a prelude to an unusually cold and stormy Winter.”
So energy demand is going to go up. It was interesting, on Friday the government reported the latest scenario in terms of the damage in the gulf. As of the end of October: 53% of our oil production was still offline, and it would not be fully restored till the end of March; 5% of our refinery capacity was offline; and about 10% of our natural gas. So, we're going to see these higher prices feed into the energy markets. And what we've got is a little perfect storm going in energy, with rising demand obviously. A colder than normal Winter is going to increase demand for natural gas and heating oil, we've got short supplies. And remember, people forget that we import 12 million barrels of oil into this country each day. We also import over a million gallons of gasoline. And so we've got short supplies and both oil, natural gas and heating oil are going to hit new record highs this Winter. And I think Greenspan was already alluding to that when he said consumers are going to be shocked when they see their energy bills this Winter.
So, the way this starts, obviously we have seen the inflation numbers whether we're talking about the 6.7% [increase] year over year in the PPI, or the over 4.7% in the CPI, and then the import prices from 9.9%, but more alarming is the 3 month trend which is 15% for producer prices, 9.5% for consumer prices, and over 20% for import prices. Those numbers are going to get worse so you're going to start seeing those inflation numbers feed into the PPI, the CPI, and the import prices. This is going to spill over into the financial markets, so we're going to see rising interest rates, as we're seeing now, and declining stock and bond prices, and the Fed will have the ammunition that it needs in other words It's going to keep raising rates until we're in trouble- but They'll have the cover of rising inflation to blame it on energy prices. We'll blame it on cold Winter storms, just as we blamed energy prices on Katrina, Rita and Wilma. That is going to produce a crisis in the financial markets both in the stock market and bond market ? although I think you’ll see intervention. you're going to see a currency crisis, problems with the dollar and other currencies; the dollar will head lower; you're going to see gold prices hit $500; silver is going to be close to $10 or over; I would not be surprised to see oil at over $75 or $80 or more, depending on how bad; natural gas for heat will be between $18 and $20; and the CPI numbers are going to increase. This is going to take us into 1Q and 2Q of next year.
By the end of 1Q of next year, the economy is going to go into a tail spin, you're going to see it reflected in probably some of the worst retail sales for Christmas; you're going to see retail sales go down; you're going to start to see the rise in mortgage defaults as interest rates are reset, and as equity credit lines go up with every Fed increase. So mortgages, bankruptcies, delinquencies are going to be on the rise. you're going to see real estate prices start to go over by the end of next May, or the beginning of Summer. The economy will slow to a standstill. They may be able to jigger the economic numbers by lowering the inflation rate, but I would say by between March and May of next year you're going to see the inflation numbers start to peak. Next year, let's say if we were doing this show one year later from today, you would be hearing talk about deflation because real estate prices will be heading down nationally. you’re going to see the economy slow down, [there will be] a slowdown in consumption, [since] consumers will simply not have money with rising energy costs, heating bills, and rising interest rates. It's going to slap the consumer. you're going to see rising mortgage rates. This is going to be the setup for the next reflation. [27:38]
JOHN: I would say It's almost going to be the setup for the next Presidential election too, wouldn't you?
JIM: Yes, because it will be an issue and what you're going to see is a massive reflationary effort, that is going to be coordinated globally.
Alan Greenspan: “Secondarily, as you may recal,l when we ran into what looked to be the beginnings of at least a possible disinflationary set of pressures in the Summer of 2003, another surprise to economists who did not believe that that would be feasible in a world of fiat money, but Japan proved otherwise.”
That was Greenspan talking about the surprise disinflationary period we had in 2003. I think you're going to see more of that as we get into late Spring, early Summer next year.
Congressman: “given the need for the Fed to pre-empt inflation, what extent is the Fed now addressing inflationary expectations, or fears that may not be evident in the currently available data?”
JOHN: OK, a couple of questions, Jim, before we go on any further, is how are they going to offload this one, because It's going to become pretty brutal, eighteen months from now, [or thereabouts], is that [the timeframe] we're looking at?
JIM: Well, I'm looking at, right now, the next 9 months. In other words, by the time we get to a Federal Funds rate of 5%. I think They'll keep the financial markets from really falling over like they did in 87 or 89, because I think We'll see magic in the futures pit, as we talked about in the roundtable. In other words, we could be down 175-250 points, and you'll have some opaque economic statistic in the last 15 to 20 minutes of trading, We'll have a miracle in the futures pi, and the stock market will finish on an upswing. So, I think intervention in our financial markets are now considered part of national security, and a necessity. It won’t get real bad in the financial markets, because they couldn’t have a crumbling stock market, bond market, real estate market, derivative market and declining economy. I mean, the dollar would be absolute toast, literally toast at that point. And I think there would be a coordinated effort too. The last thing Europe, which depends heavily on exports, wants to see is their export market falling apart. That's the one positive thing going for Europe right now, because They’ve got rising inflation and They’ve got rising budget deficits. Nor does Japan or Asia want to see their export market literally collapse. In other words, if the United States went into a recession, if not depression, that would have a major impact on not only Europe with their own difficulties, but also Japan, which is just barely emerging out of a 15 year deflationary trend over there, as well as China. [30:54]
JOHN: Let me see if I can pull this together. First of all, we're looking at a rising inflation rate, a rising interest rate, big turmoil in the oil markets, and we're seeing government intervention across the board. It's almost a factor of national security now like you said. I take it what we're going to see is global cooperation between the US, Japan, China, Europe etc, because they don't want this thing to fall apart. They all sort of lose something here if it does. So where then is the inflation going to run, are we going to see it run away in commodities, or is it going to go somewhere else?
JIM: It's going to go into commodities, and It's going to feed asset bubbles. [31:37]
JOHN: OK, so we're looking at the scenario you just outlined, That's what we're going to see by next Summer. By the end of Summer the economy?s going to be in the tank, and everyone is going to be panicking politically because we're going to be moving towards elections. How are you going to play this, obviously if you're an investor, where are you going to be on the roller coaster ride?
JIM: OK, let's talk about where to position yourself now. Definitely in energy right now, especially after this pull back after the Refco fallout. And [There's] a lot of misinformation, for example demand down year over year when They're measuring the output from refineries which are down as a result of the hurricanes, and then also [we have] the soft shoulder months of September and October when demand is weak. So you've got to be in energy, especially in natural gas, you've got to be in metals and defensive foreign currencies. And I think you're going to be able to play this all the way to around March.
Now, the key is going to be somewhere around March your going to see long term and short term interest rates begin to peak, and what you're going to have to do is switch out of the inflation scenario because by March we should have our oil infrastructure completely restored in the Gulf; we should also be heading at the end of March, beginning of April into warmer weather so the demand for energy should be less. And then you’re going to start hearing talk about all the economic weakness, and you're going to have a disinflation deflationary topic come to the surface. And you're going to want to switch to play the deflation theme, and you're going to play that deflation theme until Bernanke announces the Fed is neutral. There?ll be a Fed meeting ? it may be May or June the Fed goes into neutral, they stop raising interest rates, and so you're going to get a bond market rally. So That's why you want to be out of tangibles and into paper type goods and play this disinflationary scenario.
But that is only going to last so long. At that point you may have weakness, [and a] sell off in commodities, and that is when you’re going to have your second chance to load the barrel, and you're going to see an economic boom that takes off as a result of this massive global reflationary effort. And That's when you’re going to go full pedal to the metal [investing] in: energy; international consumer staple companies, [and] the companies that will have international sales because the dollar is going to start tanking I would not be surprised to see a 20 to 30% drop in the dollar; gold and silver; international drug and healthcare companies; and water. And you’re going to see an inflationary boom. It will be massive, but it will be accompanied by an economic boom and asset bubble just as [when] we came out of the 2001 recession, [with] Fed rate hikes and the events of 9/11 then with a massive cut in interest rates, and the money supply increased by $1 trillion in one year. And you had this boom that took place in the real estate market, the mortgage market and consumption. So you're going to get another inflationary boom that will accompany this part of the good inflationary front, and you're going to want to participate in it, but you’re going to have to be very nimble in the next 9 months. In fact, we're spending next Thursday with a group of money managers. we're all getting together and we're throwing out our ideas in terms of how this unfolds, and what would be the key indicators because this is going to have to be played. You will really have to be on top of things as this thing unfolds, because there are going to be sudden jerks and moves everywhere here. we're going to see some stuff just as Fed Chairman Greenspan was saying, but when consumers get some of their heating bills and natural gas bills this Winter, I think They're going to go through sticker shock, and I mean that literally: sticker shock. [36:06]
Taxes & Inflation
JOHN: And you don't want to be under it when it does finally blow up. You know Jim, we're hearing on the talk shows not on the cables, but on the AM talk circuit and I spent a lot of time this week listening to Air America which is a liberal talk show network, but even on Rush’s show, people are beginning to call for windfall profits taxes. They bought into the argument of how the greedy oil companies are causing all of these problems. No one seems to notice that the government has gotten some of its highest tax receipts ever over these last couple of years. Maybe we should have a windfall taxes rebate back to the taxpayer. What do you think?
JIM: I'd love it. Personally for myself, I would like to hedonically adjust my income tax return. Basically, I made this money but I really didn’t because if you take a look I had to pay more for this and this, my son’s tuition went up this year, I'm paying more for gas, I really didn’t make that much money.
JOHN: Hedonically readjusted. They’ve actually had a process like that: It's called fraud.
Anyway, What's really tragic and one of the hardest things to instruct people in is that and Lenin knew this well by the way, which is why he used to advocate a heavy progressive income tax both income and taxes [are] the biggest wealth destroyers for most of the middle income, the bourgeoisie and the poor as well. In reality, inflation is simply a hidden tax, isn’t it? Somebody helping themselves to your wallet while you don't notice what is going on.
JIM: Yes, It's basically diluting your purchasing power from the money you earned. It's kind of funny, John, I got into this business ? I started out as a Certified Financial Planner in 1979 I became a CFP by 1980 and the two predominant themes in the financial markets of that time were taxes and inflation. We had 70% tax rates, inflation was running around 14%, everybody was just screaming because Jimmy Carter put wage and price controls and capped wage increases at 7%. I remember that I was in corporate life and was so ticked off at that since as a family we had 2 kids at the time and I was a homeowner and my costs were going up everywhere, but working for a company I was limited to a 7% [wage] increase. And if we really understand how this happened, it happened in 1971 when we went off the Bretton-Woods gold exchange standard.
So, by the beginning of the 70s, there was no longer a restraint in terms of government spending and money printing. What you had as a result of the 1970s inflation, [which] got to be double digits a year, is that a working individual could no longer support his family. In other words, mom had to go to work by the end of the 70s to maintain that same middle class lifestyle. By the end of the 80s, a good portion of the inflation rate had been transferred to the financial system. But what we did see is saving start to decline, so that by the 90s, savings were replaced by asset inflation. In other words, why save 8-10% of my income when my stock portfolio is going up 20%? What happened is they took down the level of savings because you needed more of it to maintain your standard of living. And then also, as a result of the reduction of savings people began to take on more debt. So the savings rate went down, people added more debt, and they used asset bubbles in place of savings. Then we get to this new century and the year 2001, and asset bubbles began to supplement two-earner incomes, so that basically your home equity loan became your ATM. That's what has allowed you to pay your bills each month. Maybe you ran up your credit card bills, and every three or four months as interest rates went down, your house price went up. Then you would monetize part of that appreciation by refinancing your home, getting another lower rate, taking out more money to either buy the goods you wanted to buy, or to pay off some credit cards. And so we saw this inflation rise [but] wages weren?t keeping up with inflation. For example, since the 70s you've had housing prices increase by a 1000%, and I doubt seriously whether ? unless you're working on Wall Street wages have not increased by 100%. So most people are getting further and further behind. Beginning in 1984, they jerry rigged the Social Security Reform Bill and they increased the wage base, as well as the Social Security tax rate, and then increased that wage base each year at an inflation rate that was different from the regular CPI rate. So that each year, even if you got a [wage] increase ? let's say you got a 5% cost [of living] increase ? your income put you into a higher level but your wage base went up and you began to pay more in Social Security taxes. For many middle income Americans, and poor people, their Social Security taxes are the highest taxes they pay. And in the meantime we kept telling people all throughout the 90s, and 80s, that there really wasn’t inflation.
Alan Greenspan: “there are structural problems in the Consumer Price Index which doesn't capture the inflation rate, per se.”
See John, there you have one of the points we've been making on this program going back 4 or 5 years, is that the inflation numbers don’t really reflect what most people pay, or the kind of cost increases they face on a day to day basis. That's why we heard whether it’s Ron Paul or Congressman Maloney from New York talking about if things are so good why is it everywhere we look prices are going up? [43:12]
JOHN: One of the interesting things too Jim that came out of that period was the social problems that began to arise from Mom and Dad both having to work and that issue was offloaded onto Mom and Dad as being selfish, and just wanting the good life, and not caring about their kids. In reality, in a lot of cases they were just trying to break even, and it was something that was thrust upon them.
JIM: Yeah, with rising inflation and taxes a single income family with Dad going to work each day and supporting the family was no longer possible as it was when we had a more stable pricing environment. We no longer had a stable pricing environment, inflation was going up, taxes were going up, so Mom had to go to work to pay the taxes.
“Just in the time you've been in the Fed we've had a lot of monetary inflation. we've had a lot of new money pumped into the system. Matter of fact, just over six hundred trillion dollars as measured by M3. It's all new money, That's 3 times as much money as we had in 87. But interestingly enough the total debt, government debt, corporate debt and personal debt has done the same thing: it’s tripled. And it was approximately $8 trillion in 87 and now it’s $25 trillion. So a lot of new money was created, and we have a lot of new debt in the system, but we suffered a consequence our dollar is now worth 55 cents. So that to me seems unfair, because if I'd have saved money in 87 I’m only going to get 55 cents back on my dollar. There's something...I think There's a moral element to this too, as well as an economic argument: why save? And we don't save. If we need more money to take care of our entitlements or fight a war or accommodate the debt, we just literally are able to go and depend on the Federal Reserve to make sure interest rates don’t go up.”
JOHN: I think what the Congressman was saying there as well, Jim, is that in order to just stay par with where you were before that you have to start pedaling faster and faster. And then even, what you do earn continues to erode away in its buying power. It really doesn't erode away does it, It's actually transferred to this combination cartel of the Federal Reserve and the government.
JIM: It would be like if we were all shareholders in a corporation and let's say I'm the Chairman of the Board, and every year I vote to increase the number shares in the corporation to myself as a result of stock options. So what I would be doing is diluting the value of your shares in that company year after year. And like all inflations the people that benefit first are the people that create it, which is the government, and probably the financial industry that takes advantage of it. By the time it trickles down to the guy on the street he's the last to benefit, and like many people working for companies, or even their own business, you can't walk into your boss because the price of gasoline went up, or your heating bill is going to go up this Winter. That just doesn't happen. So, Americans are falling further and further behind and the question is [then], “well, we need to help people, the price of energy is up so let's slap on more taxes.” I heard a debate on one of the talk shows that what we need to do is increase taxes on the rich, because the rich are the ones that are benefiting from all of this. And nobody talks about government as the main beneficiary of inflation. [47:00]
JOHN: let’s examine what tends to be a left-wing argument, that the rich are not paying their fair share of taxes, so There's a call for higher taxes, getting rid of income tax cuts for the rich, and these taxes will fall on both individuals and companies. What is the fallacy of this whole belief that if we just raise these taxes we could redistribute the income to those less fortunate and everything would be OK?
JIM: If you take that to the extreme why don't we just say if somebody makes $100K the tax rate above that is 100%? We’ll just take all their money. You could run the government on that for maybe 30 days. So there isn’t enough money in the system for the government to tax in order to pay all of its bills. So as a result it does so through another way, which is inflating the currency. And in terms of What's fair in terms of tax rates, let's take a look at [the] six tax rates in this country, they go from 10% all the way up to 35%. So let's talk about some evil rich guy out there that is making a lot of money. Alright, his top tax bracket at the Federal level is 35%. Now if he's working in a corporation he's going to pay 7.65% social security tax on basically the first $90K that he earns, in addition to his regular income tax. If you're self-employed then double the 7.65% to 15.3% because if you're self-employed you pay both sides…
JOHN: For being self-employed you're penalized!
JIM: Yeah, you pay double that rate. Then if you're fortunate enough to earn over $90K where your social security taxes end, then you pay a Medicare tax on all your earned income of 1.45%, or 2.9% if you are self-employed. Now, it doesn't stop there. Once you take a look at the income taxes then [there's State income taxes] depending on which state you live in ? here in California, we have several income tax rates: you are at a 1% tax rate if you have income of $5,962 and around $39K you go to 9.3%. So added to a 35% income tax rate, we have a 9.3% State tax rate on top of the 35% tax rate, on top of the 7.65% or 15.3% Social Security tax rate up to 90K, and then over 90K you must add the 1.45 or 2.9% Medicare tax. Then you have for example in California 7% sales tax, and in San Diego It's 8%, or more in other cities. Then you have property taxes here that can go from 1% to as high as 2%, depending on where you bought in San Diego. When do you quit, what is fair? Is 90% tax rate fair, should the government take 90%? And we've got these calls to tax the oil companies, and I mentioned last week that Exxon made 9.9% net income. Remember, when they make $10 billion profit let's not forget the fact that Exxon is going to owe the government 35% of that in the form of taxes. So, 3 billion is going to go to the government.
Now we’re talking about slapping an extra 50% tax on profits above $40 oil. And I just want to remind individuals, there was a Congressional research study that was done and they took a look at what happened if we start doing this tax of 50% on profits earned on oil over $40 a barrel. Democratic Congressman Dennis Kucinich of Ohio and Democratic Senator Byron Dorkin of North Dakota are proposing this; you've also got GOP leaders Frist and Dennis Hastert calling for Congressional hearings on oil profits, and you've got populist demagogue Bill O’Reilly blaming everything on the big oil companies. So, let's go back to the last time we did this. When Jimmy Carter was President he signed a windfall profits tax during the last oil crisis, the result ? It's amazing and It's been this way throughout history- was the opposite of what politicians intended. The first result as documented recently by the Congressional Research Service was that US companies reduced their US domestic production by 1.5 million barrels per day, and remember back then that was a lot, roughly 6%. And the reason was if you explored and found new oil in the United States you would pay a windfall profits tax. So new supplies slowed because the tax by design snatched as much as a third of the profit from these investments. Now They're not talking a 1/3 They're talking about a 50% tax. The second effect was shown, and this was reflected by Harvard Economist Joseph Galt who found that US reliance on foreign oil increased from 8% to 16%, after price controls and windfall profits taxes were put into place. Exxon, for example, could stop producing domestically, shut down its wells, stop trying to explore for energy in the Gulf of Mexico, or Alaska, or anywhere else, and then just simply import oil as they do today from the Middle East, and Venezuela which would be exempt from the windfall profits tax. Because if you pay $61 a barrel to Saudi Arabia, or Hugo Chavez, or Nigeria, or Kuwait or wherever, there is no windfall profits tax. And then what you do is you go explore for your oil in Indonesia and sell directly to the Chinese. And the problem is these super taxers claim the oil companies are immorally profiting. In other words, let's say if you had some inventory of oil that you had in reserve and the price goes up during a crisis. If that is immoral then governments could make it illegal to make money from reserves when the oil markets are squeezed. The consequence would be companies wouldn't have the financial incentive to hold oil in reserve, in other words, why have any inventories at all if you’re going to pay a windfall profits tax at 50% on that, and what we would find is what happened in the 70s that consumers would find themselves in greater misery. What serves the consumer better: a gas station that due to price controls can sell gas at $2/gallon but has no gas to sell or a gas station that charges $3/gallon but has gas to sell?
And here’s the amazing thing that is never brought out about this. If we take the period from 1977 to 2004, the Tax Foundation found that the oil companies made in this period a combined profit of $640 billion [from] oil. However, the government during that same period of time collected $1.34 trillion in taxes: the government made more than twice than that of the people who actually go out, explore and find and develop it. Just as in California, with the price of gasoline going up, the State got more tax revenues because they charge a sales tax on the price of gasoline. They charge a sales tax on the price of gas. Nobody ever says wait a minute the biggest profiteer [is the government. And this is the same story, I don't care if you go back to the tobacco debate when all the States and the government raised taxes on the tobacco companies they were playing both sides of the fence. They were subsidizing the tobacco farmers at the same time. They were the biggest recipients of windfall taxes from an increase in the price of tobacco, just as they are the biggest beneficiaries from an increase in the price of energy. The government makes more in tax revenue than the oil company does, nowhere will you here this in any of the debates coming from the demagogues in Congress or the ones on cable TV. It’s hypocrisy! [55.59]
JOHN: You made an interesting comment: if oil goes above $40 a barrel the oil companies have no control over that. This reminds me of the energy situation in California that got Gray Davis [kicked] out of office. Basically, we uncapped the wholesale rates and we capped what they could charge at the pump and in this case the tax would come through the 50% windfall profits tax. But they are at the mercy of the world oil markets so to speak, other countries are bidding as well.
JIM: Yeah, you just assume if you go to somebody and say: “look, if you go out and spend a bunch of money go out and take the risk of finding oil, if you find it, the first thing we're going to do is penalize you for doing it.” Why do it? When a utility if they have to pay market prices for natural gas and are capped in terms of what they could charge their customers I could just see a board meeting of a utility company, “OK, in the next 3 months we are going to lose $2 or 3 billion because we're going to be buying natural gas for $18/cubic foot but we can only charge $9/cf to our customers.” That is not going to work because eventually the utility goes bankrupt, and so the people that force the price controls, the government, are going to have to go in and take over. Can you imagine what would happen if the government took over the energy industry, they would have to pay these higher prices because the US is no longer energy independent. We don't control the market price of oil, we began to lose our grip on the oil prices in the 70s as we went from being one of the largest producers of oil in the world ? we still are today ? to becoming one of the largest importers of oil in the world today. We must never lose sight of the fact that we have China and India that are scouring the globe to lock in secure [supplies] of energy, whether It's Canadian oil sands, agreements with Hugo Chavez of Venezuela, or in Brazil or in the Sudan. [58:19]
JOHN: we're in aggressive competition with everyone.
The other thing you made a comment about: taxing the rich. Who do you think are the rich people, or when do you become rich, What's the breakpoint, $100K, $300K?
JIM: Well, in California you're rich if you make $39K, and if you're a single tax payer you're rich in the United States if you make between $29K and $70K, or over $70K. A married couple becomes rich at roughly $58K of income. [58:53]
JOHN: OK, having said that, say we took everybody making $300K or more a year in income, and we imposed a 100% income tax rate, take it all, they don't get to keep any of it. And I know I'm throwing this one at you out of the blue, how long would it run the country?
JIM: Roughly about 2 weeks.
JOHN: That’s it?
JIM: That’s it.
JOHN: So everything else is being made up by inflation then? I'm trying to digest this.
JIM: Yeah, and that's why there's no way they’re going to be able to pay for all these expenditures. Government spending next year is going to grow at a rate of over 8%, especially with the rebuilding of New Orleans, Katrina, and the war in Iraq. you've got a lot of entitlements that are going up, and it gets worse by the time you get to the year 2008, because now you've got the first batch of baby boomers that hit the retirement market. They now are retired and collecting social security checks and eventually Medicare benefits. All of this just gets worse every single year, to the point where we may be running $700-800 billion budget deficits. [Add to this] the fact this year we may run a current account deficit approaching $800 billion. There isn’t enough money to pay for this. Remember when we interviewed Laurence Kotlikoff last year when he wrote the book, The Coming Generational Storm. Paul O’Neill, as Secretary of the Treasury, commissioned a study to take a look at the unfunded liabilities of government, just as for example a corporation would do that has promised future pension benefits to its employees when they retire. He came back with a figure of $44 trillion, and they said: “Oh my God! we can't go with that. Table it!” Well, then what we did is pass a drug prescription benefit that kicks in next year, in 2006, and already They're saying the figures for that are 5 to 6 times higher than their estimate. It's the same thing when they passed Social Security and Medicare. All these figures have gone way beyond what they estimated.
So now the liability is $51 trillion. So, if you take a look at the government’s books last year they are now starting to account for that. Government?s unfunded liabilities increased by $11 trillion last year. I can't wait to see what they will look like when we get the full report for the government’s fiscal year that ended September of this year. When that report comes out I suspect you're going to see $2 to 3 trillion of additional unfunded liabilities. We don't have enough money in the system to pay for that. So what you do is you inflate it. [1:01:47]
JOHN: When you talk about a perfect generational storm [as] Laurence Kotlikoff was talking about, realizing that the Baby Boomers ? those who were born after World War II ? are really the first generation to have paid into Social Security all of their lives, constantly being reassured of the fact that when they retired it would be there just like it was there for their parents, and that’s what we’re hearing. Remember that was the promise as well when we refactored Social Security in the early 80s. This is also going to be a large voting bloc that will be able to outvote the genX’ers and everyone else under them for at least 20 years until they die off. I hate to put it crassly like that, but I don't think this crowd is going to take it very nicely to see What's happening when they get there.
JIM: No, and that’s why no politician is going to run for office and say look: “if you vote for me I’m going to cut your benefits, I’m going to cut your Social Security benefits even though you paid in a ton of money for it, I’m going to cut it. And I’m also going to cut your Medicare benefits, you're going to have to pay for that. we're going to have to ration health care, and we're going to ration government services but by the way, we're going to increase your tax rates.” you're not going to do that.
When Clinton raised the tax rates on Social Security and raised the tax rates to 39.96 the Democrats were voted out of office. Look at any politician running for office, how many people would get elected saying, “vote for me, I'm going to be fiscally and monetarily responsible and I'm going to cut your benefits and raise your taxes and you’re going to have 5-10 years of hardship.” [1:03:28]
JOHN: Which is why we're going to see a series of crises because nobody has the will to deal with it. Like you say, massive inflation is the only way off this bucket I can see, and a series of progressive offloading at every point to try to obscure what the real cause is. I see those three things hitting us.
JIM: It won’t be blamed on the inflation the government is creating. it’ll be oil companies, greedy businessmen, it'll be unions, it’ll be acts of nature, whatever it is, but the blame will not be the money printing itself. A good example is looking at any of the money printing and all the crises we've seen whether It's Weimar Republic, and Russia, China, Eastern Europe, Greece, Hungary, Turkey, Argentina, Mexico, Brazil, it’s never the government’s money printing it’s always something else. [1:04:22]
JOHN: Which is why governments start wars as well when they need to divert people from the obvious problems they have created.
So, Jim, having put all of that aside we really need to move on to the next topic. Summarize it for us and let’s move on to the next issue.
JIM: Basically, John, what we've got I don't care how high you raise taxes, it’s not going to pay the bills but what we're going to have I believe is they will raise taxes. Remember the game plan is to always demonize your next victim, just like they demonized the tobacco companies ? it wasn't about getting people to quit smoking. If they wanted to do that [they could] outlaw tobacco just like they outlawed alcohol during the Prohibition years, That's not the point. The point was to raise taxes, so now we're going to vilify and demonize the oil companies because we're going to raise their taxes. In other words, before you fleece and rob your victim you’ve got to demonize him first, and That's where we're at. We are going to raise taxes down the road. The rich people will be evil so We'll demonize them, or some particular group that we're getting ready to slap onerous taxes on. And then in the meantime, you're going to see the money supply and inflation levels [increase] the Fed is raising interest rates now but take a look at the money supply, the growth in the last 3 months is annualized at almost 12%. So you're going to see both taxes go up and inflation go up. [1:06:00]
Changing of the Guard at the Fed: What It Means For Investing
JOHN: Well, obviously we have changed the guard, not quite ? Greenspan is still sitting in his office there but coming up very shortly here, what is the changing of the guard going to mean?
JIM: I think you're going to see different inflationary policies that start to take place, John. I think the Fed is raising interest rates, [but] we’re almost repeating the patterns of the 70s. we're raising interest rates but at the same time goosing the money supply. So it isn’t really the rise in interest rates, It's the availability of credit. It's amazing. I've been doing research because I'm getting ready to write the final installment of The Day After Tomorrow. I've been going through this housing development for a couple of days with the builders, the lenders, [the upshot is] money and credit is available. There is absolutely no shortage of money, I expected to see that the credit standards would be pretty tight right now: lenders wanting more money down, but no, you can get option ARMS, variable rate mortgages, interest only mortgages. Money is plentiful. And That's what the rise in the money supply figures and credit figures are reflecting. Even though interest rates have gone up, about the only difference is that while fixed rates have gone up not as much, They're around 6 to 6, depending on conforming or non-conforming however the variable rates have gone up over 5%. So the short term rates on the adjustable rate mortgages have been creeping up with each Fed rate increase, and will continue to do so. Over the next 6 months We'll probably get a rise in December when the Fed meets on the 13th , then We'll get another rise on January 31st, We'll probably get another rate hike in March when Bernanke takes over, and in the meantime the Fed will be talking about stabilizing prices: In other words, they're doing this to keep inflation in check and prices stable, while simultaneously goosing the money supply. [1:08:10]
JOHN: you’re talking about the fact that every time there’s a crisis the Fed rushes in there like the Valkyries and tries to pump more money, but listen to what Greenspan is talking about in his testimony this week:
Alan Greenspan: “We recognize that it is really price stability that creates economic growth, employment and higher standards of living.”
And at the same time the Congress were asking some rather heavy duty questions, about this very same issue.
Congressman: “Given the need for the Fed to preempt inflation to what extent is the Fed now addressing inflationary expectations, or fears that may not be fully evident in the currently available data.”
we'vetalked about this before on the show, all the good things that can come about from inflation and That's always Part One of the story. There's a lot of loose money and the economy booms, but then the devil comes and demands his due. There's a quote you like from Dying of Money.
JIM: Yeah, if you take a look at Greenspan, he’s been quite candid in the last 6 months about all these problems that are on the horizon that are going to be facing his successor. And basically what we have seen for 20 years is what Jens O. Parsson talked about in his book Dying of Money and I'm going to quote this again, it's one of my favorite quotes:
“Everyone loves an early inflation. The effects at the beginning of the inflation are all good. There's steepened money expansion, rising government spending, and increased government budget deficits, booming stock markets and spectacular general prosperity, all in the midst of temporary stable prices.”
Remember what we saw in the 80s and 90s: low inflation rates but booming stock markets, and booming real estate prices. Parsson goes on:
“Everyone benefits at this stage, no one pays. That is the early part of the cycle, and the latter cycle, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation there is faltering prosperity, tightness of money, falling stock prices, rising taxes, still larger government deficits, and still roaring money expansion. Now accompanied by soaring prices and the ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.”
And That's what I think John you're seeing Greenspan saying. No wonder he's retiring. he's seen all the good parts, the prosperity part, the low prices, the rising stock prices, the rising real estate market, all of the asset bubbles. Now….
JOHN: ... he's retiring.
JIM: Yeah, he saying, “I'm getting outta here! I know what’s coming afterwards, I've seen this before.” he's made comments and speeches that these bubbles never end well, and that's why we’ve got a logical replacement for that, which is Ben Bernanke, Helicopter Commander.
JOHN: Who must be masochistic right?
JIM: Yeah, I would not want this job right now. I think [as] Greenspan goes out, the crises aren't quite upon us, he's been very clever in the last six months, quite candid in the number of warnings from fiscal policy is out of control we've lost control over it to all of these imbalances, whether you're looking at the government?s budget deficit, the trade deficit, the level of debt in this country, the various asset bubbles, all of these things and That's why I think we are going to go from the first part of this inflationary cycle reflected quite honestly by Mr. Greenspan’s theme music on the Financial Sense Newshour.
JOHN: That of course was the theme from Lawrence Welk and his Champagne Bubble Music.
JIM: Now we've got a changing of the guard: helicopter commander who will in his own right have his own theme music here on Financial Sense.
JOHN: All I can think of is some operatic singer singing, “hi yo ho ho ho.” But in reality he's inheriting a thankless position, that would be my assessment of it.
JIM: Yeah, What is interesting about Bernanke he's quite open with the markets but he's very big on using psychological factors to influence the market to do what he wants the market to do. he's big on inflation targeting, he's also big on using whatever means if you watch his speeches or listen to his speeches read them and go back to his research reports he's basically saying, “look if we have to burn the barn down to avoid deflation we’re going to do it.” And the one comment is: the best way to avoid trouble meaning deflation is never get into trouble in the first place. So he's big on dropping helicopter money, a good example is in the Katrina disaster where $2000 debit cards [were issued. he's] very creative in his papers. Basically the Fed has done studies on this: we have got more tools at our disposal than just lowering interest rates. We can monetize anything on the planet. If interest rates start to rise We'll go on the long end of the market and start buying on that end to sort of change the yield curve. And the thing we need to understand today, globally with no currency backed by gold or silver anymore there are no restraints on money creating today as we had in the past. So What's coming John is inflation nation, and helicopter money.
we’ve come to the end of the Big Picture. Coming up we have quite a few things next week we're going to have a guy who doesn't believe in peak oil and he thinks OPEC has got us over a barrel and that is frankly the name of his book, Over A Barrel, and we're going to have Raymond Learsy, We'll also have Ike Iossif Ahead of the Trends, Deborah Weir Timing the Market, and Eric Weiner What Goes Up. So, a lot of things coming up on the horizon in the weeks ahead.
JOHN: And in the years ahead, massive inflation.
