Financial Sense Newshour
The BIG Picture Transcription
June 10, 2006
- Inflation vs. Deflation
- Other Voices: Emily Thornton, BusinessWeek Online
- Emails and Q-Calls
- For Good and Evil
- Other Voices: Kelley Wright, IQ Trends
- A Conversation With a Mining Executive
- More Emails and Q-Calls
Inflation vs. Deflation
JOHN: Ah, yes, those good times are going to keep rolling as we inflate our way into a wonderful bubble. But you know what Jim, the inflation versus deflation debate is still afloat. Some people are saying that the Fed’s credibility is on the line because of that if we go into an inflation it will ultimately undermine its authority, and ultimately possible destroy it. And they say, therefore the Fed will circle the wagons and defend it down to the last dollar. I’m not as enthusiastic – I think they could just reinvent themselves to be really honest with you. Anyway, what’s your take on it?
JIM: I think what we’re doing is we’re referring back to what Paul Volcker did at the Federal Reserve back in 1979. Now, once again, in 1979 the US currency was dropping like lead; gold was heading towards 850; oil was heading towards $40 a barrel. With the US [dollar] as the world’s reserve currency, basically Volcker went to a meeting of the central bankers at the Bank of International Settlements and they said, “hey, if you keep this up we’re going to be looking for another currency.” And of course, you remember John, one of the things that came out at that period of time was the move towards the euro as a currency.
So Volcker came back and ratcheted interest rates up; cut the money supply – and we got 18 to 21% on the prime lending rate. Now remember, the US financial condition back in 1979 was much different: we didn’t have as much debt as we have today; we were also a stronger manufacturing economy – in other words most of our manufacturing base had not been gutted as it became in the latter part of the 80s and 90s and into this century.
JOHN: You mean we had real wealth is what you’re saying?
JIM: Yes, we were creating real wealth. Companies were investing in plant and equipment and we were still running a surplus when it came to our trade deficit. Fast forward about 25 years later and here we are today running monstrous deficits. Our manufacturing base is half of what it was 30 years ago. And there’s what? $44 trillion of debt in this country collectively, and that’s not counting unfunded debt. So we’re in a much different situation.
So Volcker defended the currency with interest rates. He cut back and he cut back on the supply of money and he really put the economic system through a shock period. In fact, the 1981 recession was probably one of the worst recessions that we had on record – probably you would have to go back to the Great Depression in terms of unemployment, and in terms of what happened to the drop in economic growth.
But the other thing that happened –and Peter Warburton has written about this in his book Debt and Delusion – is the central banks came to basically advise governments, and they said, “look, don’t monetize debt, use the financial system to fund debt through the bond markets.”
So, basically what we got was inflation because the money supply continued to grow, governments continued to run deficits. In fact, beginning with Reagan our deficits really began to escalate because government spending was growing at twice the rate of tax revenues. And what we did however is we transferred that inflation to the bond markets and the financial markets, and what we got were asset bubbles. And at the same time as global manufacturing expanded during that period an increase in our manufacturing base globally brought more units of production on line which lowered the costs. And so this was mistakenly viewed from the perspective of deflation: “Hey, the cost of a computer was going down.”
I can remember when we bought our first big computer it was a Compaq computer. Gosh, looking at it today it looks like a dinosaur but I think it had 640K, it had a 30MB hard-drive, and a 10 MB tape backup system with an orange monitor – and it cost $7,000. I can get that computer today for under $1000. So, the cost of manufactured goods have come down as production has increased which is exactly what you would expect.
But getting back to this inflation argument, under the Volcker Fed, Volcker came out and said we’ve got to defend the currency. But he was able to do that because the United States was nowhere in the situation as it is today: consumer debt wasn’t like it is today; savings rates were much higher; business spending, business saving; government deficits were much lower. And you compare that to where we are today. So I think people hearken back to the age of Volcker when they say the Fed’s credibility is at stake and they will defend it – yes, they’re going to try to create the impression that they’re going to be inflation fighters, but really in order to understand where we’re going you really have to understand what inflation is. [5:37]
JOHN: Well, obviously we have talked about that here continuously on the program. We take an Austrian view on the whole situation that inflation has and always will be a monetary event; it’s caused by expanding the money supply. The rise and fall of prices that you see, usually on a delayed basis from when the original monetary expansion happens, is a result of the expansion and the contraction of the money supply.
JIM: Sure. And you also have to understand the condition that we’re in today. In the last couple of weeks we’ve been talking about the fractional reserve system in this country, and the Fed’s role really in a fractional reserve banking system is the lender of last resort. Its job is to keep the system liquid in case of a banking crisis. And you’ve seen it play this role throughout its history. And more recently over the last 20 to 30 years whenever there was a liquidity crisis or a run on the banks in the banking system from Penn Central to Continental Illinois to Long Term Capital Management it would ride to the rescue with cheap money.
And so the reasons I believe the Fed is going to opt for inflation is – there’s probably four or five – and chief among them is government spending and the government’s deficit. We’re going to put a link with this weeks radio show to the government’s annual financial report. Just as you would look at a company’s annual financial report every year usually in the 1st quarter the government produces all of its financial results. And I’m just going to go through and highlight a couple of them.
Number one, we’ve got massive trade deficits: 782 billion last year – another record in the year 2005, up 18%. That means $782 billion of US dollars was transferred to foreigners, and they have to do something with that money. But let’s just take a look at the governments budget. If we look at for example, in 2005 the revenue to the government was –rounded off – 2.2 trillion. The cost of operating the government was close to 3 trillion. The government had a net operating loss of 760 billion. In other words, they spent 760 billion more than they took in in terms of revenue. The previous year, the government in 2004 had total tax revenues of 1.9 trillion versus government spending of over 2.5 trillion – so they had a net operating loss of almost $616 billion.
And if you take a look at that increase in spending during that period of time it is incredible. For example, defense spending has gone from 2004, 650 billion to 677 billion –an increase of 4.2%. The department of Health and Human Services have gone from $550 billion to $584 billion an increase of 6.2%. And here’s the killer and the Achilles’ heel of where we’re going. Social Security went from $532 billion in 2004, to $574 billion in 2005, an increase of 7.9%. Interest on the public debt went from 159 billion to 181 billion. So if you take a look at it just from 2004 to 2005 interest on the debt went up 14 ½%. Overall, between the two years, spending had increased 16.8%.
And there’s no way, I don’t care if you’re going through the government’s budget and you’re looking at all the departments – you know, we have the Department of Defense, the Department of Health and Human Services, Social Security, Department of Veteran Affairs, interest on the debt, Agriculture, Treasury, Education, Homeland Security (which is getting very big), transportation, labor, energy, housing and urban development, Department of Justice, Aviation, Interior, State Department, Railroad Retirement Board, Environmental Protection Agency. And you just go through on page 36 of the government’s financial statements, all of their expenses, and John, have you ever heard of the Government or Congress cutting a program? [10:29]
JOHN: Well, I’m glad you mention that because if you remember the debate this week was all over the death tax as a matter of fact – inheritance taxes. And in all of the conversations, the way it’s spun is that why, these people are cheating the government. There’s never once a talk about the fact that by the way that’s their money, and that the government really needs to be fiscally responsible. And all of the discussion that we’ve heard, over how many months now, since we began to say there’s a problem especially with inflation has anyone ever said let’s cut it back? It’s singularly missing and none of the commentators calls them on it.
JIM: No, in fact anytime somebody raises the idea that we’re going to cut funding or scale back on the spending – you know what a budget cut is in Washington?
JOHN: It’s one where you didn’t raise it as much as you intended to before. [11:16]
JIM: Exactly. So if I’m the head of the Department of Defense or Health and Human Services and I put forth my budget for the new year and I want to increase spending 10% for various programs, and all of a sudden some Congressmen or politician proposes: “Look, you guys are spending way too much money. We have to cut some corners in the budget. We are only going to give you a 6% budget increase.” The thing that you will see – and this drives me nuts in the media is budget cuts this president cut spending on this. They didn’t cut spending actually increased, but in Washington terms if you don’t get all the increases you asked for, and only get part of the increase you asked for, that’s a budget cut. [12:08]
JOHN: Well, we also heard under the last Administration if you remember where President Clinton was supposed to have deficits allegedly under control. And then the simple question you ask is: really, then why did the national debt go up? It’s the same question.
JIM: Sure, it’s just like Enron. A lot of the government’s expenses are taken and put off budget. The Iraq war is off budget. You know, you get relief for the hurricanes or rebuilding New Orleans – that’s off budget. And you can really see these extra expenses that are coming in every single year when you take a look at the increases in the government’s total debt – the national debt – and compare that to the reported budget deficit. Obviously, we’re keeping two sets of books here because the increase in the debt figures never match the reported budget deficits.
So, reason number one, that the Fed is going to opt for inflation is we’ve got the largest retirement population in history heading into retirement in the next two decades. I think I’ve mentioned that just year over year spending on Social Security went from 532 billion to 574 billion – an increase of 7.94%. And of course many of our listeners will remember when we interviewed Professor Laurence Kotlikoff who has written a best-selling book called The Coming Generational Storm and Kotlikoff was talking about $54 trillion of unfunded Social Security, Medicare and retirement liabilities. And as everybody knows, John, there is no Social Security trust fund. [13:48]
JOHN: Well, not everybody, some people still think it’s out there, but the intelligentsia – those of us who are here – do.
And basically if we look at the history of government anywhere in the world they never downsize in power, they never contract they only expand and to fill whatever vacuum is out there. And you can have obsolete programs going for years, year after year after year and they will still continue in existence. I remember working in college districts which are government funded in many cases there was a thing called use it or lose it. Right at the end of the year, we’d come down to the budget and lo and behold we had a big pile left in certain account categories and the word went out: spend it. And you would run around looking for anything you could possibly spend it on whether you needed it or not. Rather than rewarding them for saving money they penalized them if they didn’t go out and spend it. And that’s the name of the game, that’s how it’s spent.
JIM: Yeah, I would say about the only cost containment efforts that we’ve seen come out of Washington was done through the Boskin commission in 93 where they said inflation was overstated and so they had this study and then they started tinkering with the CPI rate because by bringing the CPI rate down that means the cost of living adjustments to pension plans, government retirement, military retirement programs and also Social Security you could limit the COLA increases. But that was about the only attempt we’ve seen by government to contain the cost of entitlements.
And John, have you ever heard of a politician that is recommending that we cut programs and how far he goes? If he does he’ll be vilified by every special interest group which will be impacted by those cuts. And have you ever met a politician that’s going to level with the citizens by saying, “look, we’re spending way beyond our means. We can’t afford Social Security. We can’t afford Medicare.” And what I predict that we’re going to end up doing is eventually Social Security will become a welfare system and they’ll go to means testing.
Just as today if you receive Social Security once you reach a certain level of income they begin taxing your Social Security benefits. So if you have one level of income they tax 50%, and then if you reach another level of income they tax 85%. Eventually, I think they’ll go to 100% but secondarily I think they will go to elimination. In other words, if you have adjusted gross income of one amount then you give up your Social Security benefits; if your adjusted gross income reaches another level what they’ll do is they’ll start phasing out your Social Security benefits. And that’s about the only way they’re going to be able to contain it.
The other thing and this is rather interesting and we haven’t seen it yet – because it hasn’t sprung up yet – and that is wage and price inflation because that’s coming down the road, but this week as reported in the Financial Times:
Gordon Brown last night put the government on a collision course with millions of public sector workers when he called for a 3 year pay freeze as part of the fight to control inflation, and cut the budget deficit. In a speech designed to show he would not slacken the pace of New Labour reform, as the likely successor to Tony Blair the Chancellor insisted this year’s 2 ¼% pay deal would be the start of a long, prolonged period of belt tightening. [17:33]
JOHN: Those things never go very far Jim. Like you say in Social Security the whole retaxing of Social Security is basically already a limitation of what you can draw based on your incomes, so we’re already seeing denial of benefits. That’s what it is, it’s just in a different form. The wage and price stuff never flies. Do you think that this is going to fly at the polls when the baby boomers in this country arrive at Mother Hubbard’s cupboard only to be told that at Mother Hubbard’s been giving them a line all these years?
JIM: Yes, do you want to be a politician that’s running for office? You will never see them in their campaigns in order to get elected, maybe they do that in the first year after they do elected and they might do something like Chancellor Brown is talking about in terms of wage freezes. But you know eventually that will come. Right now we’ve got wage rates that are lagging. Part of that is because we’ve lost a good deal of our manufacturing base in this country. If you go to what I call a lot of the retail type jobs, a lot of service type jobs they just are not high paying jobs. And about the only way they go up is we’ll get somebody who’ll say, “hey, inflation is out there, people can’t live on minimum wages,” and so you’ll have government’s go in and increase the minimum wage which eliminates jobs as we know. And then secondarily it will create an increase in the wage index and then the Fed will say, “ah, we’ve got wage inflation,” and they’ll take some kind of action against that.
But my number one argument here is one reason why we’re going to inflate our way out of it, if you take a look at that 158 page report of the government’s financial statements, just take a look at all those departments and just take a look at graphs of government spending and take a look at some of their graphs of the growing gap between revenues coming into Social Security and also what they’ll be paying out. There’s just no way that they’re going to back away and tell some guy, as you just mentioned John, a baby boomer who’s spent 40 years of his life working and contributing to the Social Security tax, and then you’re going to tell the guy that he’s doesn’t get it. [19:45]
JOHN: Yes, and so what will the down shot be then? How do we get there?
JIM: You inflate.
JOHN: And basically that’s still a denial of benefits because you’re basically paying them with money worth far less than what they paid into it, but the only difference is that it’s probably not a frontal attack on that whole process, so people don’t catch it.
JIM: Yes, and the other thing too is they’ll tax more of it, so on one hand they’ll give you part of your money back, and then they’ll tax it and take part of it back, and that’s assuming that you get it. If your income is high enough, mark my words they’re going to go to means testing and phase out Social Security for many. That’s the only way they’re going to be able to bring this under control. They’ll have to deny benefits and then they’ll have to inflate the benefits. So the number one issue here facing the government is spending is now growing at such a rate it’s uncontrollable. There’s just no way of going back, you’re just not going to see a $3 trillion government spending budget go to 2 trillion or 1 trillion. It’s just not going to happen. [20:51]
JOHN: Alright we’re on a roll here. Let’s sort of do a resume of where we’re headed here. We have an outline of several reasons. Reason number one was why we’ll opt for inflation because government spending is out of control and the deficit situation. It has liabilities it is going to have to meet and it has to camouflage the fact that it cannot meet them, and actually will meet them by inflating dollars and paying it with worthless dollars.
Reason number two is the banking system.
JIM: Yes, the reason that they will also inflate is remember the chief purpose of the Federal Reserve was to protect the banking system from a bank run because of a fractional reserve system. We’ll talk to Emily Thornton on Other Voices here in a moment. Emily Thornton wrote a piece on the front cover of BusinessWeek this week called Inside Wall Street’s Culture of Risk, and Wall Street is leveraged to the hilt today in debt and derivatives. In addition to Wall Street, that is, the investment banking firms, the banking system is leveraged to the hilt, here I’m talking about the big money center banks. Not only are they leveraged to the hilt in real estate loans in mortgage loans but also in the ownership of mortgage securities, and also their derivative position.
And remember, once again going back to our whole banking system which runs on a fractional reserve system: 90% of the money that is in demand deposits has been lent out; the money isn’t there. So what happens when you get a debt default? When you get debt defaults the money supply begins to contract because the loans are taken off the books, it causes a contraction within the banking system; also it causes severe losses to the banking system. Banks are highly leveraged and if you have a crisis in real estate you would have the same thing that you had for example in 1989 to 91 when we had this savings and loan crisis – the equity base is wiped out because banks in terms of their capital compared to their liabilities is way out of proportion, in terms of their liabilities exceeding their equity. [23:12]
JOHN: Wait a minute. It’s getting a little fuzzy here. Why don’t you give us sort of a definition or an explanation of what you’re doing because deflationists would say if you have a bank crash that brings about deflation. You don’t think that’s going to happen, so explain that mechanism.
JIM: Ok. Let’s go back to the last financial crisis we had, which was back in 91 with the savings and loan crisis. What happened? Real estate started to go down in value because of Fed rate hikes; the Fed created the 91 recession, and they created the banking crisis. As interest rates went up, as we headed into a recession real estate prices went down people began to default on their real estate loans. In addition to real estate loans, savings and loans had speculated into business. And so what happened is the government came in, and they created the Resolution Trust Corporation. They basically took over all these failed savings and loans, rolled them up, took their properties, and liquidated these properties for 50 and 60 cents on the dollar. We were buying properties during that period of time and I can remember negotiating with banks and offering them basically 60 cents on the dollar on a loan.
At the same time, while they were doing that and liquidating the real estate they were increasing the supply of money in the banking system. They injected reserves in the bank, they brought short-term interest rates down. And there was a spread – the first carry trade was really banks borrowing from the Fed’s discount window. They could borrow at extremely low rates, invest the money in Treasury bonds, and that was the first carry trade spread. And they reliquified the banking system and basically liquidated the property. Yes, the property prices went down, but remember, falling prices is not deflation. A contracting money supply is deflation. So it never happened.
And I can see that once more happening if the Fed pushes things too far. You would just come up with a new RTC, take the failed financial institutions, roll them up, you could even see the government take over a Fannie Mae, or a Freddie Mac. You could see them then reliquefy the banking system, inject money into the banking system and then allow the banks to buy Treasury bonds and once again reliquefy the system. This is exactly what we did in 91. We had zero deflation in 1991. [25:50]
JOHN: Ok, that was reason two. Basically, the banking system itself is leveraged to the hilt, we’ve covered that. We know that the government isn’t going to stop spending. Reason three, it seems like they’re not the only people leveraged to the hilt.
JIM: Well, reason number three is the whole economy is leveraged. There’s a piece on the front page of our site, it’s called Target the Challenges: Foreign Trade & International Debt Report. It’s by Michael Hodges, who hosts the "Grandfather Economic Report." It’s about our foreign trade and international debt report, and it was updated for this year. I highly recommend it if you haven’t read it, please read it, and take a look at our growing debt imbalances. We have $44 trillion in debt in this country, and that’s not even counting the unfunded liabilities we have for pensions, Social Security. I had mentioned in a previous show that since 2000 we added $12.7 trillion in debt. Debt is growing faster than income. I’ve talked about $6 of debt for almost $1 of income growth. There’s too much debt in the system, and one of the relief valves for debt is to inflate it away.
And going back to the banking system, which is more dangerous for a bank, to see their equity wiped out in a real estate crash where they lose all their equity because of losses starting to have an affect on a bank’s balance sheet; or to have those loans inflated away? And one of the relief valves in any debt ridden system, and you can see this throughout history, is that debt is inflated away. [27:21]
JOHN: Alright, that’s reason number three. Number four, we can look outside of our own shores.
JIM: Foreign debt. At some point in time those dollars held overseas are going to be exchanged for other currencies, or be sent back home to the United States. One of the luxuries that the United States has had as the world’s reserve currency is we could export our inflation. A good example of which is what we’re doing with our trade deficit. In other words, let’s say the Fed was to create dollars, and the US was a closed border system: you couldn’t buy goods any place else you could only buy them domestically. Well, what would happen is if you would increase the supply of money that would create more demand for goods than there would be if the money supply didn’t increase. The greater demand for goods would drive the price of goods up, and so prices would go up. But today, one of the relief valves for us has been that excess demand has been channeled into foreign imports. So a rising trade deficit is another manifestation of inflation.
And at some point, John, all those trillions of dollars that are being held overseas are going to be sent back to the US, and when that happens you’re really going to see a jump in inflation, especially as the dollar declines. And we have examples of this already where the Chinese are exchanging their large hoard of dollar assets for real assets. They’re buying oil, they’re buying iron ore, they’re buying raw materials; OPEC buying gold; other central banks now starting to diversify out of the dollar. At this point, it’s been a diversification out of current reserves but what happens when they start taking down their current reserves and selling? The Fed will be forced to monetize that debt. [29:22]
JOHN: But you could also see at this state if that were to ever happen, couldn’t we see some kind of not necessarily currency exchange controls but more slamming a window shut – meaning that those foreign dollars would not be able to come back. But that wouldn’t bode very well for the currency in the long run.
JIM: No, it wouldn’t bode well for the currency, and then I think what happens is you’ll get what you saw in Germany during the 20s. There’ll be a mad dash to get out of dollars and exchange them for anything tangible. And when that happens you’re increasing the velocity of money which also helps the inflation rate to spiral. [29:56]
JOHN: This probably leads us to reason number five. And you’re hearing more and more and it’s not just in the United States –I interviewed a gentleman from South Africa for a different show this morning – and people are getting the profound impression that their governments are no longer representing them, and their ideas aren’t being listened to, and that a small cadre of people are driving what’s going on. That the majority’s input has very little value anymore.
JIM: No, I would say the real danger in a democracy is where a majority can vote itself benefits at the expense of the minority.
JOHN: Ah, but what happens if the minority can do that forcing the majority to go along with them.
JIM: That’s what you have when you have a dictatorship.
JOHN: OK. The reason I’m asking that is right now, let me give you an example, the middle class is under duress right now. Say, for example, we look at the whole issue of the estate tax. People who really do have a lot of money can create all sorts of trusts and other little gimmicks to get them around that. But people who have a moderate amount of money who might come under the influence of that cannot do that. The lower end of the people don’t pay anything anyway, so there’s just one group of people who seem to carry the biggest burden, or takes the brunt of it all the way along. And they feel like a whole other bunch of freeloaders are riding along on their sweat and blood – literally siphoning it off as they go. You see what I’m saying. And that breeds civil instability, as far as I’m concerned.
JIM: I believe the Republic is dead in this country, we’re moving further and further away from the Republic. The problem too in any kind of democracy is the majority can vote themselves benefits at the public trough at the expense of the minority and that never goes away. You can study this but a good example, John, is the rise in gasoline prices. Ever since oil first hit $70 a barrel in last Summer’s hurricane season with Katrina and Rita, there’s been this blazing cry to politicians to do something about it. Anytime there’s a crisis people turn to government which created the crisis to fix it.
It’s like we saw them parade the oil executives and everything was blamed on the greedy oil companies, although we get the majority of our oil from national oil companies rather than international oil companies. I mean international oil companies like ExxonMobil are increasingly counting for a smaller percentage of the world’s oil production. We import 70% of our needs today with either the raw energy in the form of natural gas or oil, or finished refined products such as gasoline or diesel fuel. And we have the public always crying out, so you saw some silly things done by certain Congressmen: some wanted to disband the oil companies, break them up; others are wanting to slap on a windfall profits tax; some Congressmen wanted to give the voters a $100 tax rebate for gasoline. Now, when you ask yourself what would $100 do – nothing. I mean it would help, but it wouldn’t do anything. [33:00]
JOHN: In 5 years, it’s going to do even less.
JIM: And the other thing, ask yourself, OK, let’s tax the greedy oil companies if that’s the way you feel, what’s that going to do for the price of gasoline at the pump?
JOHN: It’s just going to go up one way or another.
JIM: Yeah, an oil company’s not going to go out and say, “Ok, you get 3 times the amount of revenues in the form of taxes that we do in profits, now you want 4 times the amount of revenues from taxes.” Do you think that’s going to create an incentive for an oil company to go spend shareholder money to go to explore and try to find oil? Oh heck, you won’t even let them explore for oil.
So once again, in a democracy, there’s always this temptation to expropriate assets for the benefit of one group at the expense of another. And when you start doing that you start losing your freedoms and if you study history –throughout all of history, whether you take the Egyptian empire, the Greek empire, Rome’s, Spain, the French, the British and now the US empire – the root cause of a nation’s decline can be traced back to its history of taxation and inflation. Monetary policy is behind the rise and fall of all empires, and the US will be no different.
I’m reminded of a quote above the IRS building, in Washington DC, and it was from Oliver Wendell Holmes and it says: “Taxes are what we pay for civilized society.” And then I’m reminded by Charles Adams who we’re going to get into in this next section, “how we tax and spend determines to a great extent whether we are prosperous or poor, free or enslaved, and most important, good or evil.” [35:26]
Other Voices: Emily Thornton, BusinessWeek Online
JIM: Well, has Wall Street become a culture of risk? Investment banks are placing bigger bets than ever and beating the odds at least for now. Joining me on the program is Emily Thornton, she’s written a new piece for BusinessWeek called Inside Wall Street’s Culture of Risk.
And Emily, Wall Street has always been taking risk, let’s face it that is what Wall Street is about, but never before has this risk taking risen to such a prominence. And unlike let’s say the past, never have the investment banks had to reconcile so many bets made on so many fronts.
EMILY Thornton: Yes, that’s absolutely true, because of course in the past we’ve seen banks that were engaged in trading for their own books. However, right now they’re trading for their own books, they’re using their capital to trade on behalf of their clients, and they’re doing things as risky as buying companies.
JIM: You know many of these firms such as Goldman have made so much money from trading and leveraged bets, but it doesn’t appear that there are any signs anybody is willing to ease back. In other words, even with this shakeout we’ve seen in stocks, and commodities and markets around the globe, it doesn’t look like people are pulling back.
EMILY: No, it doesn’t. Well, one thing that got me interested in this story in the first place is that basically every quarter we’ve seen these banks come up with record profits. So I started to wonder how that could be. And it just became apparent that they were putting more and more risks in their balance sheets and making bigger and bigger bets that were paying off. And as you point out the markets are changing now, they’ve been relatively calm now until the last several few weeks. And we have second quarter earnings coming from the banks in the next couple of weeks and I think they’re going to be very interesting. [37:17]
JIM: You know this cycle, which has been fueled by cheap money is much different than the past. We’ve been talking about for example in the 1990s few banks were willing to put at risk their own capital, but now – you know, in the past they were mainly acting as brokers, maybe they were doing transactions for clients – virtually all the banks are making these huge bets with not only their own assets on the many fronts that we’ve talked about but they’re also using increasingly larger and larger amounts of borrowed money.
EMILY: Yes, that’s true, I think though we’ve seen this kind of go in waves. In the 90s, many of these banks weren’t public, they were private partnerships, so the ones that were engaged with trading on their own books – like Goldman Sachs – were slightly more conservative because it was their partners money – so their own checkbook. But what’s happened now is we have all these banks that are now public and they are taking bigger bets with shareholder’s money basically. [38:17]
JIM: Would you say the investment banks have morphed into what we could call the ultimate hedge fund? I mean they do more trading today than all but the biggest hedge funds.
EMILY: I would say that this is a little bit of a mixed bag because on the one hand with Goldman Sachs leading the charge we have some banks that are doing quite a bit of trading on their own books for their own books, but on the other hand we also see this explosion in trading using their own capital for clients. So it’s not exactly a hedge fund, although they’re definitely doing more trading than many of the big hedge funds out there. [38:56]
JIM: You had just mentioned previously another avenue that they are pursuing which is this private equity where you may have a company which they may take private. That places an asset on the balance sheet that is illiquid. And one of the things that we’ve always seen in the past whenever banks have ever gotten themselves in trouble they could always unwind a position, maybe go to cash. It’s pretty hard to do that when you’re in the business of private equity.
EMILY: Yes, well, one other trend that we should probably mention that has happened since the 90s is that every banks has also invested a lot of money into advanced risk management systems which have become quite sophisticated. However, I don’t anyone has a model that can truly gauge what kind of risks are embedded in their private equity investments, so I think that’s becoming a matter of concern and debate at the banks as to how they should treat that. [39:52]
JIM: This reminds me of something you quote in your article a comment made by Paulson: “No one can predict where the next disaster will come from. The one thing we know when there is another shock, things that you hope wouldn’t correlate or trade in tandem are going to correlate.”
Isn’t that where the real risk lies here, because you are in an opposite position – maybe another asset class – but in a meltdown sometimes you start seeing all assets correlate.
EMILY: Right, this is definitely the question and of course what Paulson is referring to is the blow-up of a hedge fund called Long Term Capital Management which occurred in 1998, and resulted in a bailout by the banks to the tune of $3.6 billion. And in that case, basically the different assets that the hedge was trading appeared to be diverse but because of [events] –in that case it was Russia devaluing its ruble which triggered such a series of events that all of a sudden everything was going down, and it was impossible for that hedge fund to recover and it basically almost took the banks with it.
And at this point these banks are so much bigger than they were in 1998, and they are trading in so much more diverse commodities and other assets around the world, I mean almost every corner. And the argument is because of that we won’t have the kind of meltdown situation that almost occurred at that time. But I think it’s untested territory and I think Paulson hits it on the head that that is the risk, that if there were something very extraordinary like an outbreak of Avian flu you could see everything trade similarly and in that case all of these hedging strategies may not work. [41:49]
JIM: You know this is the one thing that comes to mind Emily is that you never really completely get rid of risk – all you do is transfer it. And I can’t help but believe when the music stops somebody is going to be holding the hot potato. We can’t believe, even though you’re diversified today, that everybody comes out even when things go wrong.
EMILY: Right, well I think when you talk to people at the bank –their experts in this industry – I think they all agree with you. Nobody can say how or who but inevitably when we’ve seen Wall Street go in cycles of excess there is always one firm that seems to miss the turning point and gets into trouble. So people are betting that this is what will probably happen this time. [42:35]
JIM: You know in addition to the investment banks you also talk about how individuals today are bidding up prices, accepting thinner safety cushions than in the past whether it’s commodities, international stocks or shares of the risky US companies. Whatever happened to Ben Graham’s margin of safety?
EMILY: Yes, what ever indeed. Well, I guess it’s very hard to explain why people are so into speculation recently, but that does seem to be the case whether you are looking at penny stock trading, or gambling casino stocks that have risen sharply. And then of course many home buyers are very leveraged. So, we can’t explain it but it does seem that everybody is behaving as if there is very little risk. [43:23]
JIM: You have to ask, and you ask this question in your article, why are the banks racing ahead building bigger more complex trading options, risking huge losses and perhaps long term damage to their reputations if things blow up?
EMILY: Right, and I think, well, this is the other side of the coin that because the businesses that they have traditionally been in are not growing, or even worse sometimes the margins are being compressed. For example, just trading single stocks now is not considered a practice that’s going to get bigger fees in the future, so the banks basically have a choice: they can stay in the traditional businesses that they are in – and shrink; or they need to find something else. And they are very aggressively trying to grow and the way they are doing it is by taking more risks on their balance sheets. [44:18]
JIM: There was a comment you made that really struck me. You said that there were twice as many technologists crunching analytics and market data as there are traders on the floor. And you have to wonder how many different models can you come up with that are going to give you the edge, and do all these models account for what we call the fat tails at the end of the bell-shaped curve?
EMILY: Well, I think all of these different models could account for the fat tails eventually, but right now I think it’s important to mention that the traders are looking at very complicated models that on a certain level you really have to respect, in the sense that they are so complicated. And basically what traders are doing is trying to find a place to make a nickel but on a very large scale so they will make a very large profit. And these models are helping them analyze how you could for example make that nickel between credit default swaps on Japanese mortgages versus some option on volatility of US Treasuries – you know, very complicated trades. But at the same time we also have to acknowledge that as more trades are being developed, and more derivatives, and there is a new derivative everyday, or a derivative of a derivative, it’s becoming so complex that you do have to wonder if at some point the banks are going to cross the divide where they cannot manage all the risks that they are taking on. [45:54]
JIM: This reminds me of a quote from Roger Lowenstein’s book When Genius Failed: The Rise and Fall of Long Term Capital Management what he talked about what Long Term did when they took those nickels and turned them into billions but when things turned against them they lost billions. And I suppose [that’s where] we should end because at the end of your article you talk about at some point in the future when this cycle comes to an end what are the chances that one of the big investment banks takes things too far?
EMILY: And I think I say they might have more reserves than in the past but don’t bet on it. [46:30]
JIM: Alright. Well, Emily, a fascinating article into the world of risk and especially now that one gentleman coming from one of the big risk banks is now our Secretary of the Treasury. Fascinating article about risk on Wall Street by Emily Thornton, and it’s this week’s cover story oN BusinessWeek – recommend you go out and pick up a copy and read it. Emily, thanks so much for joining us on the Financial Sense Newshour.
EMILY: Thank you.
Emails and Q-Calls
JOHN: Jim, it’s that time on the program when we head to some of our Q-Line calls before we move on to the next topic right here on the Big Picture. And the first one comes from Brian in Colorado:
Hi Jim, this is Brian from Colorado. I have a question why you expect hyperinflation, and how you think we can avoid this debt overhang without a collapse of that debt, and resulting depression. I think you’re giving the central bankers too much credit and implying that they have too much power. I don’t think that they can stop this. I think we will deflate first, then hyperinflate. I’d appreciate your thoughts, thanks. [47:40]
JIM: First of all, we have to get back to the definition of inflation or deflation and if you’re looking at a contracting money supply, if you listen to the last segment when I talk about how they avoided a contraction of the money supply with the S&L crisis in the early 90s. So you’re never going to see the money supply contract. Now, you may see prices fall in one sector of the economy, let’s say certain sectors to do with credit you could see real estate prices come down, and the first thing would be is Ok, that’s deflation because it’s prices going down. But the real definition of inflation is an increase in the money supply.
You could very well see the price of real estate come down, which would be a sort of deflationary type event –meaning falling prices – but at the same time as they expand the money supply you’ll have to ask yourself where is the next inflation taking place? And as the NASDAQ, or the stock market bubble, which was a vestige of inflation from the 90s was deflating from 2000-2002 –I mean when you consider the NASDAQ lost 75% of its value – the Fed was reinflating and we got a real estate bond market and mortgage and consumption bubble to take its place.
And I would submit to you that the united States has gone from a manufacturing society to a service society to now a financial society. And if you create an arbitrage spread as we did in the 1991 S&L crisis, and you lower interest rates and allow financial institutions to borrow at a lower rate and reinvest that at a higher rate you can get reinflation.
The trouble is as we’ve seen in this economy is so much of this economic recovery took place in the bubble portion of the economy which was the financial sector and the real estate sector – those being the two bubbles. And that’s where most of the jobs were created. What I think we’re going to have this time –I don’t think we’re going to be able to avoid a depression – but what I think you’re going to see is a hyperinflationary depression very much like what we saw eventually in Germany in the 20s, and more recently in Argentina and Russia. [50:00]
JOHN: Don’t forget you’re listening to the Financial Sense Newshour at www.financialsense.com. These weekly files are posted by 0700 hours Universal Coordinated Time on Saturday mornings. That works out to 4:00AM Eastern Daylight Time. And to call into the Q-Line it’s 1-800-794-6480 for the US or Canada, that’s toll free. It does work internationally – drop the ‘1’ – but you’ll have to pay for the call: 800-794-6480.
Hi, my name is Howard I’m from North Carolina. I’d like to ask Jim if he sees over the next few years what one would call a significant buying opportunity in the mutual fund bond market arena. In other words, I’ve been watching the bond market –the mutual fund bond prices – sharply decline here the last year or so, and I don’t want to buy into this type of investment too soon because I’m concerned about protecting my principal, but I’m wondering if one of the things he tries to take advantage of or [sees] a buying opportunity in mutual funds that invest in bonds.
Well, I can tell you anywhere Howard, if I were going to be in the bond market, number one, the interest rates that you’re seeing on Treasuries, let’s say a one year Treasury note is the highest paying instrument right now with a yield of 5.09 this Friday, compared to a 30 year bond at 5.02, and a 10 year note at 4.97. I would only be going in short term instruments –a one year Treasury bill or a 2-year Treasury bill – because I think you’re going to see the Fed pause and then eventually hike again, very much like what we did throughout the 70s, as inflation will not go away. And remember, the inflation rate itself is being understated. In other words, the real true rate of inflation today is somewhere between 6 and 8%. So if you look at the return on a one year Treasury bill at 5% back out the taxes that you’re going to have to pay on that you’re falling further behind on inflation. But if you do want to be in bonds right now, I would be in very short term instruments – a one year Treasury bill, or let’s say a two or three year Treasury note. [52:22]
Hi Angela, calling from California, and I was wondering about Henry Paulson from Goldman Sachs who is going to be the new Secretary of the Treasury if you think he was brought in to rescue the dollar and maybe gold might go down because of that. Thanks a lot, bye.
Sure, I think he’s been brought in as "Mr. Fixit" because Bernanke just doesn’t have the weight that Greenspan did, he doesn’t have the credibility. In fact, the flub-up that he had with Maria Bartiromo he’s lost a little bit of credibility right now. So yes, Paulson’s in there right now because he’s going to understand how to pull the levers, and as I’ve contended they would not go on pause until they could hammer the commodity markets: get gold prices down, and get oil prices [down]. Although I think they’re going to have a difficulty getting oil prices down unless they can make peace with Iran in which case they could remove a good deal of the political premium that’s embedded in the price of oil. But you’re absolutely right he’s been brought in to manage the dollar decline, and also to help manage the financial markets. [53:24]
Hey Jim and John, this is Philip in Dallas, Texas, and I really appreciate your show and I’m glad you’re able to maintain your objectivity despite all the criticisms and all that, so keep up the good work. My question is I was wondering if you or one of your guests would be willing to comment on the grain markets, and just kind of give an overview of what moves the demand and the supply from year to year. I realize that analyzing those markets is a lot different than something like oil or metals where you don’t plant a crop of those types of things every year. Keep up the good work and hope to hear something about that in the future. Bye.
You know, Philip, I’m going to have to sort of back away from that. I’m not an expert in the grain markets. I can tell you though, however, there’s a real great resource. It’s published by the Commodity Research Bureau which is the CRB Index – it’s the CRB Commodity Yearbook – it’s published once a year. Jim Rogers calls it his bible on the commodities market because that really gets you into the fundamentals of what drives a market, what the supply is for a particular market, how the market works, and it’ll give you a better understanding. So once again, I’m going to refer you to the CRB Commodity Yearbook that’s published once a year. [54:41]
For Good and Evil
JOHN: You know I’ve been thinking about something you said earlier about taxes and that during all of the discussions on the tube never once has there been the slightest wisp – I’ve been watching for weeks now – that maybe government can cut back taxes. What is amazing to me is if you really begin to sit down and list all of the ways that taxes are collected from phone bills (so-called fees) to property taxes to sales taxes, income taxes and they don’t think that’s enough. And I can’t quite figure that one out.
In the county where I live in Jim, we’re one of the top two fastest growing counties in the country – our state legislature is considering an emergency meeting this Summer – they’re already out of session – and the outcry is already so bad because people’s property valuations are going up so fast that say I bought a home for 100,000, the home’s worth now 350K, and rising. It’s not stopping. And that’s what they want them to be taxed at, and they’re being taxed on unrealized gain, and they only paid 100,000 for it. They haven’t seen the benefit of the 300, and people are screaming. But once again ,there’s never this discussion about maybe we just need to stop.
JIM: You know that brings us to our second subject, John, which is For Good and Evil. And I took the topic of this from a book that I read several years ago. In fact I interviewed Charles Adams who’s considered probably one of the foremost authorities on tax history. And he wrote two books Fight, Flight and Fraud which is out of print. And I was fortunate when I got to know him he kept a box of these books in his basement and he sent me a copy – just a classic book. But his follow up book was called For Good and Evil the impact of taxes on the course of civilization, so I guess John you brought it up so let’s move right into our second topic. [56:38]
JOHN: Taxes are going up, we just reiterated that. Everybody’s screaming for tax cuts meanwhile there are further calls to raise taxes even higher. And the debate this week on the estate tax was really interesting: there was a filibuster by the Democrats to block but it didn’t succeed as a matter of fact from going through.
So let us look at the taxes with which we are most familiar, starting of course with our good old friend Uncle Sam.
JIM: Well, Aaron Russo in his new movie America: From Freedom to Fascism which he was kind enough to send me a copy. The movie begins off with 78 or 80 I forget what the figure was – different taxes, and that wasn’t even the income tax. And as you pointed out fees on your phone bill, fees on your utilities – all the permits that we have to pay and the little different fees that are assessed against us. And he just listed them –it was a rolling screen going across and it was just one tax after another – it just really blew me away and made me think, “yeah, you’re right, I hadn’t thought of that.”
But let’s talk about some of the popular taxes that we’re familiar with. I’m going to focus mainly here on income taxes. Right now, until the year 2008, because if Bush’s tax cuts aren’t extended or made permanent then we’ll go back to the old 39.6%, and the 7 or 8 different tax rates. But right now the top tax rate is 35%. Now if you live in California, last year in 2005, the California government through an initiative raised the income tax from 9.3 to 10.3. So if you’re a California resident you can also pay up to 10.3.
And by the way John this last Tuesday there was a initiative on the ballot to increase the income taxes to fund universal pre-school another 1.7%. So they were trying to raise the income tax rate here in California from 10.3 to 12%, but right now they’re 10.3.
Then if you’re self-employed you pay 15.3% Social Security tax on the first 95,000 or whatever it is, and if you’re an employee you pay half that amount – 7.65%. And then over the Social Security limit of taxation there’s an additional Medicare tax of 2.9% kicks in if you’re self-employed, or 1.45% if you’re an employee.
Then of course like here in San Diego our sales tax is 7 ¾%, and most of the property taxes in the newer developments of the city are because of Mello-Roos taxes that was one way they got around Prop. 13, they made the developers pay for the schools, and made the developers put up the fire department, the streets, the sewer. Well, the developers didn’t want to pay those expenses themselves so they would raise the money through a bond issue. And then what would happen to the 1 ¼% property tax they would add Mello-Roos taxes, so they would go to up to 1.8%. Where I live they’re closer to 1.9%, because in addition to the Mello-Roos taxes they put on sewage assessment taxes, open space taxes – all kinds of little fees like that.
But those are just the taxes that we know, and there are people that are screaming that the rich aren’t paying enough taxes. I don’t know what’s enough for these people, maybe the government takes 75% of what you make. [1:00:13]
JOHN: Yeah, I always like the argument I’ve always heard you start to hear in local municipalities when, say, you have to make use of the fire department or this or that, and they say if they determine that this was a frivolous call we’re going to charge for the time that we spent etc, etc., but wait a minute isn’t that what our taxes go for. They act like, “oh, doggone it there’s another alarm I guess we gotta go respond to it, shoot we were just so busy doing something else, you know.” It’s an attitude. What is the impact on the population right now anyway?
JIM: Well, you know, there’s another tax that was debated this week which was the estate tax which is the most egregious tax in my opinion. Look at somebody here in California, where an average middle class home is 750,000. If you’re in LA it’s probably $1 ½ million. Just a small town house here is over 600,000. This last inflationary bubble pushed real estate into the stratosphere and the result is state coffers all around the country are rolling in money from property tax inflation. I mean here in California one of the reasons our budget deficit has shrunk so much is because of the high cost of real estate, and the turnover of real estate. Remember, if you bought a house for 600,000 a couple years ago, and you just turned around and sold it for a couple of million dollars, the new owner starts paying property tax at $1 ½ million.
So once again, the increase in the property means increased taxes to the government. And some states are reporting anywhere from 30 to 40% increases in those property taxes. One state a couple of years ago – Maryland – hiked property taxes by 57%.
The other impact of inflation and where I’m going with this is one of the reasons why I think it’s so unjust with the estate tax which is really assessed against people as a result of inflation. Governments benefit from inflation because they can understate the cost of living adjustments on Social Security government and pension plans. And because they do that by understating the CPI, that means there’s less indexing of the tax rate so as your income goes up you go into a higher tax bracket. Property taxes go up as you just mentioned, John, and then also estate taxes.
And here’s the issue. Right now in the year 2006 the estate tax exemption just got raised another ½ million last year in 2005 the exemption was 1 ½ million meaning that if you died and had only a $1 ½ million estate you would pay no estate taxes. That figure was raised this year to 2 million. It will stay there until the year 2009 when the exemption will go to 3 ½ million. Then, under the current law in the year 2010 we have one year where there are no estate taxes. So, if you have a large estate and are not feeling too good, if you could live to the year 2010 it would help your heirs. [1:03:36]
JOHN: I could just see Grannie or Grandpa timing this one for her kids.
JIM: Hey, I’ve got people looking at this who are saying, “hey, I’ve got to stay in good shape here.”
JOHN: Why couldn’t they roll it into some kind of trust here at that point and then have the estate trust disburse it at that point?
JIM: You know that might be a strategy if the law stays on the books as it is, is just give away your assets in the year 2010. But here’s the funny thing, in the year 2011 we go back to the old tax rates of around 600,000 and the 55% tax rate. [1:04:07]
JOHN: But I heard this this week during the filibuster the democrats saying that only a small sliver of people at the top pay this tax, and how outrageous it is that they should deprive the government of it etc. But there’s a double-edged little sword coming in here, and that is the demon of inflation is gobbling up the bottom line of what’s yours from the bottom.
So let me give you an example here. Say I sell my house today for $500,000, I would be exempt from the estate tax but by the time we get to the year 2010, a $500,000 house – and you know this in California, I mean your state is par excellence for this – that may not be worth very much. That may be a 2 bedroom condo. And so I will literally not be able to pass on what I own to my kids – at least the value of it. And the rates themselves are just incredibly outrageous.
JIM: And you know, one of the reasons that we had some state tax reform with Ronald Reagan everybody remembers the inflation of the 60s and the 70s where real estate prices were going through the roof; land prices were going through the roof. Under the old estate tax system prior to Reagan’s tax reform what would happen is the exemption was about $250,000 – that was the amount you could give without any estate tax. And the estate tax rates were confiscatory 70%. And the reason I’m familiar with this is because I was a certified financial planner, I came into the industry in 1979.
And what would happen is the tax was due on the death of the first spouse, and this was really devastating the nation’s farming community because you might have had a hundred acre farm that’s been in the family for generations but with the inflation in the 70s all of a sudden that 100 acre parcel was now worth a million dollars.
Well, what would happen is when the first spouse would pass away – let’s say you’re in a community property state (depending on what state you’re in), half of the estate – let’s say that you had a million dollar farm and let’s say the husband passed away – 500,000 of the assets would be considered in the husband’s name, the exemption was 250,000, and the estate tax went up to 70%. So what happened is there would be an estate tax that was due on the death of the first spouse, so a lot of farms were being lost as the husbands passed away. And the small farms were beginning to shrink because they were disappearing; a lot of businesses were disappearing as a result of the estate tax.
So Reagan came in, in 1981, and he said, “look, we’re going to allow between a husband and wife whoever dies to pass all their assets to the surviving spouse and there will be no estate taxes on the death of the first spouse. Because what we used to do, from a financial planning point of view, is we tried to split the assets as much as we could between both spouses, because usually you didn’t want it all in the husband’s name because logistically he would be the first person to die because women outlive men. And so we used to split the assets in two so there wasn’t a big pile there. So Reagan came in and said: “No, we’re going to change that. First of all, we’re raising the exemption from 250 to 600,000. Gosh, look at all the inflation.” And with a living trust between a husband and wife, you could double that because you could put one in the husband’s trust – one in the husband’s trust when he passed away and one in the wife’s trust – so you were able to shelter 1.2 million from estate taxes. That’s why trusts became very popular as an estate tax savings vehicle.
The other thing that Reagan did in addition to allowing each spouse to pass all their assets to the surviving spouse – that was the first thing that he did. He also got rid of the double taxation. This is how bad it got, John. Let’s say you had this farm that million dollar farm that you maybe inherited at 50,000, now was worth 1 million and you had to pay the estate tax in addition to probably paying the estate tax you had to sell the farm, and you had a capital gains. So the government would come back and tax you again for capital gains. So there was a double whammy from both estate taxes and also capital gains taxes.
Well, Reagan gave us the step up in basis which meant that the value of the property was worth $1 million at the date of death that became the new cost to the survivor, so if the survivor had to sell the asset to pay the estate taxes they would only pay one tax –the estate tax – and they wouldn’t have to pay a second tax – the capital gains tax.
Then the other thing that Reagan did is he brought the estate tax rates from 70% down to about 50%. He also instituted an indexing of the tax brackets every year because what was happening is people were getting cost of living increases because of inflation but all it did was put them into higher tax brackets so they had less take home money than they did before.
So, if we can just summarize what he did: first of all he indexed tax rates so you didn’t get hit with inflation putting you into a higher tax rate; on the estate tax side he allowed between a husband and wife they could pass all their assets to the survivor so there was no longer a tax when the first spouse passed away; secondly, he raised the exemption to $600,000; third he gave us the step up basis, so you wouldn’t get double taxed from estate taxes and capital gains taxes; and fourth, he lowered the estate tax rates.
Well, I hate to tell people when they eliminate the estate taxes in the year 2010 for that 1 year period guess what they get rid of, John? They get rid of the step up basis in cost. So once again they’re going after appreciated assets.
You have a government that is looking at an aging World War II population that is going to be passing those assets onto a baby boomer generation and they’re looking at this giant wealth transfer as a new source of revenue, and especially in an inflationary era that we’re in right now. The current rate of inflation is putting one again putting more couples in the AMT bracket, and unless it is repealed more middle class families are going to be paying higher tax rates.
Secondarily because of inflation more and more people are going to be subject to estate taxes due to inflation, especially if they don’t repeal the estate tax because remember by 2011 it refers back to the old system. [1:11:27]
JOHN: It’s incredible that we still argue for more tax money in Washington when you see what the level of this is.
JIM: Well, it gets down to on estate taxes the premise is during your lifetime you are a renter of those assets not an owner. In other words, your assets don’t belong to you –the concept of estate tax is it belongs to the government. You merely rent the assets during your lifetime and they revert back to the state at death. It’s really not your money. [1:11:54]
JOHN: Gee, this is the stuff of which Lenin would be absolutely proud if he could have implemented something as draconian as this. But as you make that money coming in, look at the way you were taxed on every level practically as you earned the money. So theoretically you’ve already paid tax on it, and now they don’t want to let you keep it, and something that’s essential for a free society is the ownership and the security of property. It’s why we had a 4th Amendment.
JIM:Yeah, if you look at it they tax you when you earn it; they tax you when you save it – if you put money in a bank and you get interest you’re going to pay taxes on that interest; they tax you when you invest it – because you pay capital gains if you sell an asset even though it may be an inflationary gain, and they also tax your dividends. So if you think about it, they tax you if you earn it, save it, use it, sell it, and then once again they tax you when you die.
I once talked to somebody on this theory and they said it gets down to the concept of renting versus owning. From the government’s perspective and you saw some of the arguments about how much rich people would basically defraud the government out of taxes because the argument was made this is our money, it’s not your money, it belongs to us, you merely rent it during your lifetime. [1:13:20]
JOHN: But this is it again. We have moved in this country over 50 years from the mentality especially in academia of a capitalist free-market society to a socialist, communitarian society. They are two fundamentally different world views, and remember we talk a lot of times about the connection between the three legs of a society – and you have the three legged economic model as well: one is the economic; one is the political; and the other is the world view, philosophical religious system of a society. And they all interact. And we have radically shifted that over to the point where people think they have a right to do that. In other words, it’s become a right. That’s astounding.
JIM: Yeah, I have a right to your assets at your death, or I have a right to your income. If you’re making more money than I am then that’s unfair, and in order to make this fair we have to take more of what you make. [1:14:14]
JOHN: Well, the standard reaction to this then are the 3 F’s, Ok (and they’re clean words by the way): and they are fraud, fight and flight. And who was it who first came up with that?
JIM: You know I had the privilege of interviewing Charles Adams, he is as I mentioned earlier one of the foremost tax historians in the world, and his first book was Fight, Flight and Fraud. And when he wrote that book he came to three conclusions: number one, good tax systems go bad unless citizens are able to restrain their governments which have a normal propensity to adjust their spending to their innate voracious, appetites but not their wallets; secondarily, civilizations tend to self-destruct from excess taxation; and third, moderation is an important principle in the design and implementation of any tax system.
In his second book. which was his Magnus Opus, he carried these thoughts further and I’m just going to summarize here, and he said:
Taxes are a very powerful mover of people, more than governments either care to admit, or realize. Angry tax payers can be a lethal threat to a government that institutes oppressive taxation: tax payers instinctively rebel. The first warning phase of rebellion is rampant tax evasion and flight to avoid tax
– here he’s going back to his first book Fight, Flight and Fraud –
the second phase produces riots, and the third phase is violence. Life ultimately could be catastrophic for any government that taxes its people into slavery.
And he talks about the first casualty of excessive taxation has always been liberty. And it’s one of the theme’s behind Aaron Russo’s new movie America: From Freedom to Fascism. Adams goes back historically and says that the Greeks gave us our concept of liberty, and to the Greeks they believed tyranny was the consequence of a wrong kind of taxation. Now, he’s got an addendum because what we have now is a Roman system because the Romans added an addendum to the Greek thesis. And the Roman thesis was this:
In any conflict between liberty and taxes, liberty will give ground.
And then of course, the second casualty of excessive taxation has always been the wealth and strength of a nation. As a nation goes into decline when its government spends excessively which leads to higher taxes, higher inflation, and John, that’s where I believe we are today in the US. [1:16:53]
JOHN: Yes, but if people try to bail out now we have a change coming too because with the modern technology now it’s harder and harder to bail out, you have more and more rules, and so the ability to preserve yourself against abuse becomes less and less right now. As I said once before I think the ship is sinking if we look at the dollar and they’re shackling us to the bulkhead at the same time, making sure we go down with it.
JIM: Yes, one of the problems I think if you look at Western society is we’re trying to have our cake and eat it too. We want socialism and at the same time we want capitalism. And so what we have today are really a hybrid between capitalism and socialism, but just like in Russia under the communist system, or China under Mao, where you had a central government with a centrally planned economy, so in the Western countries today because we have a central bank you have a centrally planned economy and market.
And one of the things that I can just tell you and I’m going to highly recommend this book. I think you can still get it through Amazon – the name of the book is For Good and Evil by Charles Adams. And Adams had a couple of conclusions at the end of his book, it’s about 500 pages. And I’m just going to go through a couple of these.
Many great nations tax themselves to death; conversely many nations became great because of the right kind of taxation. He talks about here going back to liberty and taxation, the ancient Greeks produced the first civilization without despotism, and they achieved this by discovering that tyranny is the product of the wrong kind of taxation.
When wars and other great emergencies demand great revenues then all the citizens should be taxed according to what they are worth by equitable principles not odious arbitrariness. And all citizens, from recruits in the military, to the chief leaders of society should serve the state unselfishly, and if possible without pay, motivated by love for their country and an obligation to serve.
And that’s something you certainly saw in probably the first 100 years of our Republic.
Here’s one that he also talked about: tax exemptions. And he said,
Tax exemptions are inherently unjust unless they actually apply to everyone. If the constitutional principle of equality before the law is ever applied to taxation then those in control of tax making must bear the same taxes as those on the outside. This means in an aristocracy or oligarchy the few would have to bear the same taxes as the many, and in a democracy or republic the many should bear the same taxes as the few.
And here’s one I found rather interesting which applies today:
Wars produce new taxes and high tax rates. But when the emergency ends governments will always try to maintain their newly enlarged taxing powers. [1:19:57]
JOHN: Oh, by the way, Congress doesn’t pay into Social Security. So there’s the application of that principle.
JIM: I’ve always heard that. When I was back in Washington in fact I was debating this with an actual Congressman at the time – this was back in 1995. The Contract for America was going on then, and there was a big debate in terms of the tax increase that Clinton had put in, in 1993, and this Congressman was against higher taxes. I said, “why don’t you reduce Social Security taxes, you think taxes are high, you don’t pay Social Security taxes.” And he went on and on, and it was like trying to justify “well, you know, we don’t make that kind of money.” Poppycock. [1:20:41]
JOHN: The bottom line is you make money. People who make $10,000 have to pay Social Security don’t give that garbage.
Well, having said all of this, I guess we should take what I call converging trends. In other words, different not necessarily unrelated not directly linked trends and extend those lines out. Let’s extrapolate that and say where you think we’re headed.
JIM: Well, there’s two problems. Number one, in a fractional reserve system you always had the danger especially in a debt ridden society of a run on the bank. In other words people lose confidence in the financial system and the banking system or the currency. Second when taxes become oppressive, there’s Charles Adams' first book, people fight, there’s flight, and fraud. Fraud increases because people feel they’re unfairly taxed. And also there’s generally a loss of liberty.
So we’ve got two problems right now, bank runs and higher taxes of inflation. And where we’re moving John is towards a debit card or a cashless society. In other words, if you can no longer use cash, let’s just say we use a debit card or a national ID card, then what happens is you don’t have to worry about taking money out of a bank, you get rid of the problem of a fractional reserve system and you can inflate at will.
Second with a debit card system or cashless society, it’s easier for the government to monitor all transactions and keep track of all revenues and spending. One of the things that we’re already sort of heading in that direction is if you ever had a grocery store card where if you sign up for that card it’s used for data mining. What the store’s actually doing is mining on what products you buy, what products you spend money on. Walmart uses this system to determine what kind of merchandise moves in and out of their stores: what’s selling, what’s not selling. And so if you get rid of cash as we move away from cash, and I predict we’re getting close to that time because I mean if we take a look at the cost of minting coins today whether it’s a nickel or a penny – I think the metal content is worth more than the coin itself as a result of inflation. And so as you get to a cashless society a debit card gives you greater control of taxation and also gives you greater control in case of a bank run. [1:23:11]
JOHN: And I want to stop you before you get to number three, bartering to evade taxes it wraps that one up, it prevents you from hiding things, eliminates cash transactions –you know, avoiding reporting – all of those issues. That almost totally locks down that whole segment right there.
JIM: Sure and then the third thing that it helps avoid is flight. If you see that your currency is being debased and that it’s falling in value you’re going to try to get your money out of the country, you’re going to try to get it in a foreign currency or a foreign safe jurisdiction. But when you go to a cashless society where all the movement of funds are controlled by the government through the banking system you may no longer be able to do that.
So you’ll solve 3 problems: you solve the bank run problem; you solve the flight out of the currency problem; and then you solve the taxation problem. [1:24:00]
JOHN: You’re solving the government’s problem, not the people’s problems. The people’s problems are still there – it’s called excess taxation.
JIM: Yeah, but the end result of that is you have a loss of liberty. What you’re really doing here is corralling the sheep, and so you’re trying to corral the sheep in a pen and give them no escape route. [1:24:16]
Other Voices: Kelley Wright, IQ Trends
JIM: Well anytime you talk about long term results for the stock market you hear figures like 9 or 10%, but most people don’t realize that a good majority of that return that’s come to stocks longer term has come from dividends. And speaking of dividends, joining me on Other Voices this week is Kelley Wright, he’s editor of Investment Quality Trends.
Kelley, what a day. We closed up 8 points but the Dow is down somewhere in the neighborhood of over 800 points here since the last Fed meeting, but the dividend stocks have been holding their own.
KELLEY WRIGHT: They sure have, Jim. It’s kind of interesting that when you buy a stock that doesn’t pay a dividend you really have to ask yourself what are you buying. And what you’re buying is someday the hope that you’re going to be able to sell it for a capital gain. With a dividend paying stock on the other hand what you have is an immediate return and evidence that you’ve bought into a profitable concern. What you’re doing for all intents and purposes is you’re getting paid, while you’re waiting to get paid at some point down the road. [1:25:52]
JIM: Well, I tell you on a day that we’re talking where we saw the stock market swoon in the morning and then of course, by the end of the day it bounced back, but looking at some of the dividend paying stocks on your recommended list they did pretty well today. A stock like Wal-Mart up 26 cents at 47.30; some of the drug stocks like Abbott Labs up 28 cents. That’s not bad – when it’s stormy outside it’s kind of nice to be safe within the harbor.
KELLEY: No question, Jim. The thing about our approach is that the stocks that fall into our universe have to go through a pretty intense qualitative screening process. So from the get-go we know that they are very high quality. Secondly, we look for long term historic patterns of dividend yields, and one of our qualifications is a stock that’s paid uninterrupted dividends for at least 25 years. So we have a pretty good sense that when one of the company that’s in our universe is at what we call the undervalued area that it’s highly unlikely that an even lower price is going to happen because that would just result in a higher yield and that simply doesn’t happen with these types of stocks. [1:27:09]
JIM: You mentioned one of the criteria and I know you have a pretty strict criteria that you go through, it’s pretty thorough. But the one about a stock paying dividends for 25 years, talk about that for a moment because Kelley, that seems to me that that tells you a lot about the business itself. You don’t pay dividends and you don’t raise dividends if the business isn’t doing well, and I guess secondarily if you’re trying to juggle your books to meet the latest quarterly earnings report you can see these accounting scandals that we went through and it looks like we’ve got a few more on the options coming up here. But it’s very hard to do that with a dividend paying company, because you either make the money or you don’t. And if you don’t make the money you can’t pay a dividend.
KELLEY: That’s pretty simple stuff there, Jim, and you know you get your dividend check in the mail, you put it in the bank, it either clears or it doesn’t. You can’t really discuss much about that. The purpose of looking at a stock for 25 years though and you hit on some of it is that over the course of 25 years a company will have to make adjustments. They’ll probably have to make adjustments in their products or services. They’re certainly going to have turnover in their management ranks. And what 25 years shows us –and all companies have their own little cycles which are independent of the economy and sometimes their own sectors – and so 25 years of an uninterrupted dividend shows is that they know what their products and services are, they know who their customers are, they know how to transition from one management team to the next, they know how to manage their dividend policy in such a way that they don’t have to cut or eliminate the dividend. And so that type of a long term view just shows a concern that is serious, and knows how to manage itself, and knows how to give value out to its shareholders. And that’s really all we want is to get value and to get paid for making an investment into a company. [1:29:15]
JIM: I want to talk about something that you wrote about in your recent newsletter called The Opening Bell and that was the change of heart by the three big bears, just as the Dow was about ready to reach a new all time record: three of some of the biggest bears on Wall Street – David Rosenberg at Merrill, Stephen Roach at Morgan Stanley, and Bill Gross at Pimco.
KELLEY: Yeah, pretty interesting. Number one they’re pretty big names at pretty big firms, and these gentlemen have a stage whenever they want one – the press provides one to them. They’ve been stalwart in their concerns about not only the underlying strength of the economy, but they’ve been wary of Fed policies and the Administration’s fiscal policy. I guess what happens is when you’re on Wall Street and the pressure starts to get to you when it looks like your opinion may be wrong. For whatever reason these were the final three that just threw in the towel and said, “Jeez, you know what, maybe the economy and everything is just better than we thought, and you know maybe all these things about trade deficits and structural deficits, maybe all this stuff doesn’t matter. You know we’re just going to change our outlook for the earnings of the S&P 500, and maybe everything’s just going to work out fine and we’ve been all wet.” Well, from a contrarian’s perspective, Jim, and you know this I mean that’s a classic sign right there when the last 3 of anything throw in the towel. That’s usually a sign that times are going to change and that things are going to turn. [1:31:01
JIM: Let’s talk about something else you wrote and I’m quoting you here:
My thoughts on crude oil are simple: supply is down and demand is up. I mean when you look at energy that’s basically the story.
KELLEY: you know it’s not really much more complicated than that. You have emerging markets; you have economies in China and India with huge populations. You can make the comparison that China is today what the United States was post World War I – 1917 going forward. They are the provider of high tech low cost goods and services, and they’re starting to gain economic strength. You know, India might surpass them later on. But they’re developing middle classes and those middle classes are starting to buy things, one of which is automobiles. So they don’t want to just sit and look at them they actually want to drive them, and that requires gasoline and their growing industries require energy as well. And you know we have an interesting approach to energy in this country in that we want it, we want to use it but certainly don’t drill any oil or gas wells, and for godsake don’t build any refineries. So it’s kind of a curious approach to acquiring and having energy from a nation that desperately needs it. [1:32:21]
JIM: You know it’s another interesting aspect to your newsletter I see your favored undervalued list quite a bit of your companies –a good percentage as part of the total is in the drug sector – and Kelley I can’t think of another time perhaps going back to 93 or 94 where you’ve been able to buy high quality dividend paying drug stocks at prices this cheap.
KELLEY: I agree that was back in the days of HillaryCare when that was the last time we had a really big buying opportunity in this sector. You know certainly Merck had their issues, and Pfizer almost had some but they dealt with the publicity a lot better then Merck did, but the fact of the matter is that we have a growing demographic in this country which is over 65 years old. And we have more and more of the baby boomers are entering retirement every day, and this is just a demographic reality. These folks have gotten used to feeling good, and they’ve gotten used to the fact that the pharmaceutical industry is going to come up with products that are going to help them to continue to feel good and stay healthy longer. Why Wall Street has turned its back on the pharmaceutical just absolutely floors me. [1:33:41]
JIM: And the other thing going back to oil for a minute. I just have to wonder sometimes when you take an oil stock that’s not only producing record profits – I mean let’s face it this is the longest I can remember oil prices have stayed up above $70 a barrel, although they’re below 70 now – but when you have a company that’s paying a 2 ½ or 3% dividend and is selling at 6 times earnings, I don’t know, you’ve been in this market as long as I have that doesn’t sound like a bubble to me.
KELLEY: No it doesn’t. And I think what’s more reflective is I think the companies would pay out a greater percentage of their earnings in a dividend if they had some guidance from our elected representatives. I can almost buy into and understand their reluctance to cut loose with their cash, because they don’t really have any clear guidance on what policy is going to be about energy exploration and development in this country. So I don’t blame them for keeping their powder dry but you’re right, those PEs and growth patterns in Exxon and Chevron-Texaco are still around what? 8 or 9 times earnings, something like that. [1:34:56]
JIM: Yes, and you take a look at Conoco-Phillips at 6 times earnings. What is amazing and this comes back to something you said about energy in this country is if you’re Exxon and you’re sitting on this cash and you’re thinking, “Ok we’ll build another refinery, the price is up” – good luck trying to build one. And does a company really want to spend the next 10 years fighting suits that will automatically be filed the day you announce that you’re going to build one?
KELLEY: You know Jim, it’s really intellectually disingenuous to say that, as an elected representative, that you’re all for energy exploration and development when on the other hand all you do is put up walls for energy companies to do just that. And I don’t know if it’s because this is where we’ve gotten to after 200 some odd years of history, and that this is the way that the government works but from a business or investment standpoint when the bottom line is getting a return on investment, and having your money make money, it’s just really, really silly. [1:46:07]
JIM: You know I saw some of the hearings that took place last year after Katrina where they paraded the executives and they were literally lambasting them for not building refineries and I think it was Lee Raymond that said, “we’d build ‘em if you’d let us.”
KELLEY: Yes, got out of our way, let us do what we do. But I think the process just to get a permit to build takes a very long time and then to build a refinery to all the EPAs specifications just takes an exceptionally long time. So from the time they draw it up on the board to the time it actually goes operational my understanding is you’re looking at close to a 10-year process for a refinery. For a nation that is as dependent on carbon fuel as we are something has to change. Either we develop some new technology, or some new fuel from some source which we simply don’t know or understand today, and it happens fast; or we’ve got to come up with a lot more supply from somewhere or demand has really got to go away. And Jim, here in Southern California these freeways I’ve got company everyday, these folks don’t look like at anytime soon they’re willing to park their cars in a garage and do something else. So, we’re going to have to do something. [1:37:50]
JIM: The other thing when you talk about investment, if a company is going to spend a lot of money –and let’s say it costs a couple of billion dollars to build a refinery – one of the things that you have to do as a business is – as you’re well aware of Kelley – is you’re having to say, “OK, what’s going to be the rate of return. How much is it going to cost me?” And when you’re starting day one and it’s 10 years later to completion you have no idea what kind of economy you’re going to have 10 years from now; what kind of Congress you’re going to have; who’s going to be in the White House. I mean that’s a long, long time. I don’t anybody that can give out a 10 year forecast and be halfway accurate on it.
KELLEY: You know those are excellent points, and if you’re running an energy company and you’re serious and you’re competent at what you do, you have to have those discussions with yourself. Am I going to spend – the owners, the shareholders’ - money to do x given all these multiple variables. And look, I think these guys are doing the right thing almost by sitting on their hands and saying, “give us some guidance, give us some assurance, that if we go this way you’re not going to pull the rug on us and change policy or something down the road, because you’re asking us to spend too much of our owner’s money to do something where we’re not assured we’re going to be able to give them a reasonable return on their investment.” [1:39:03]
JIM: Well, Kelley, as we close why don’t you tell people about your newsletter, what you focus on and if they’d like to get information how they could do so.
KELLEY: Ok, Jim, Investment Quality Trends is a newsletter that we publish twice a month, generally around the 1st and the 15th. We have a very stringent, qualitative criteria which we pour the marketplace through and end up with about 300 stocks that meet our criteria. In other words, we eliminate about 96% of the tradable market. Of the stocks that fall in our universe we divide them into four categories based on their historic dividend yield: they are either undervalued which is our buying area; the rising trend which is our hold; the overvalued area where we sell; and then the declining trend where a stock is making its way to undervalued. So we identify value and this is how our subscribers find those stocks which will give them a return on their investment. We can get the newsletter to you the old fashioned way where we print it, put it in an envelope and send it to you in the snail mail; or we can send it directly to you over the Internet in a pdf document right to your mail. And our website is of course www.iqtrends.com. [1:40:19]
JIM: And I might just add that Hulbert’s Digest ranks your newsletter at the top of the charts over a long term period. Once again, keep up the good work, and Kelley, when you re-release Dividends Don’t Lie, which you’re working on now, please come back because we’d love to interview you. In my opinion it was one of the best investment classics ever written.
KELLEY: Well, we appreciate that, Jim. It’ll be our pleasure and we’d love to be on, so thanks for having us.
JIM: Alright, thanks for joining us. [1:40:47]
A Conversation With a Mining Executive
JOHN: And with our indefatigable aggression we proceed forward into the third segment of the program. Now is a good time to be in mining compared to what it’s been over the past two decades or something like that.
JIM: Well, let’s put it this way, with gold prices at $600, and staying firmly above $500 every $25-50 increase in the price, and especially if you’re a mining company and you’re not hedged, eventually that translates into your bottom line. You see a lot of talk today, and there’s been some prominent articles written by people on Wall Street that commodities are in a bubble. And one of the things that you have to have a bubble is a supply glut. Now if prices go up to a point where it brings on all this new supply, and you have excess supply overhanging on the market that’s what usually bursts the bubble.
And the other thing that you have is the general public when everybody and his brother is into commodity investments. You remember in the late 70s when silver got up to $50, and you saw reports in the media that people were taking their silverware and trying to sell it – every guy in the street was into commodities in some form or another. You don’t see that today.
And good grief, how insane, the media’s focused on these bubbles and they see bubbles everywhere but in stocks. For example there’s a bubble in copper, there’s a bubble in gold, there’s a bubble in housing, there’s a bubble in oil prices. And they’re all supposed to collapse in a heap of ashes but then listen to Wall Street and you’ll hear stocks are expected to wind their merry way back from the depths and briefly get back up.
Now, I’ll be one of the first to admit that I think that they’re going to inflate enough that we will see a new record on the Dow this year. We came very close to that a little over a month ago, and I still believe that we will see that and I don’t think we will see new records – maybe 5 year records on the S&P – but I don’t think you’re going to take out the old record of 15-something on the S&P. And certainly you’re not going to take out the record of 5000 on the NASDAQ, but on the Dow I do think you will see a record.
But, if you’re talking about where stocks have gone since the bottom of the bear market in October of 2002, and compare it to commodities are, it’s really looking with mixed analysis in terms of where you think the market is going. How can you say one’s a bubble and one’s not? Name the supply glut that we have in commodities. We don’t have a supply glut in gold. Gold producers are still running a supply deficit. If you take a look at 4,000 tonnes of demand for gold versus about 2500 tonnes of production. By the way, production was down last year. This 1500 tonnes of production is being made up with either gold scrap or central bank sales – so you certainly don’t have a supply glut. [1:44:03]
JOHN: You know Jim, I know personally anyway that you get involved with mining companies in talking to executives but there was a conversation you had this week with a mining executive that is really worth relaying to listeners.
JIM: Yes, the gentleman I was speaking with is the President of a junior mining company who has been involved in the mining industry for going on close to 3 decades now. This company I think is going to be the next Yamana or the next super growth story. And we got talking about commodity glut, and of course he asked where the price of gold was when we began our meeting as I had these big monitors and one of the charts just happened to be gold.
And we got into this conversation about a commodity bubble in gold, and he kind of just shook his head, and he said nothing could be further from the truth. And he said, “let me tell you about the fundamentals of the gold mining industry and there’s 4 things going on right now.”
And the first thing that he said is to begin with you’re going to see in the future fewer and fewer prospects. In other words, John, it’s almost like oil today where we know where the major oil reserves that are remaining lie – you know, the bulk of them are in the Caspian and the Middle East. And there hasn’t been a patch of Earth that hasn’t been mapped geologically for oil and so you know we’re almost in the last frontier right now. Most of the new oil discoveries are being made offshore in deep water. We also know about up in the Arctic but environmentally I don’t think you could get to that oil.
But he said that there are fewer and fewer good prospects that are available now, because if you take a look at the last 5 years in this bull market run that we’ve seen in the price of gold, companies have been scouring the globe looking for new deposits. We have these big behemoths that resulted in terms of the bear market from the consolidation that we saw in the gold industry in the 90s, when you saw companies like Barrick gobble one company after another, or you saw Placer or you saw Newmont. And so now you have Anglo, Goldfields, Barrick, Newmont, companies with production – Barrick now with its swallowing up of Placer 8 million ounces – where are they going to find new deposits that are going to replace their 8 million ounces of production this year? So one of the things that he had mentioned to me is that a lot of the prospects or new prospects are getting harder and harder to find.
It’s a very similar story to what we see happening in the oil business for the major oil companies that there’s just fewer and fewer places where you can find today where there’s good enough prospects where it’s worthwhile to drill and bring a new well on line. And the same thing is going on in the gold industry. In fact, Ralph Bullis a noted geologist did a study and I refer to this study in several pieces that I’ve written on my site over the last – I think it was 2 years ago, 2004 – where he did a study of all the major gold finds that were out there that either were in production, in development, or at the discovery stage, and there were just a handful of those that were at the 10 million ounce – the giant elephants. There was a handful of the 5 million ounce deposits; handful of the 3 million ounce deposits. So the big gold deposits are going to be fewer and fewer going forward. That’s the first thing he talked about. [1:47:37]
JOHN: But the situation here is virtually the same to what we’ve discussed in oil, say you found a major deposit of one of the metals because of all the rigmarole – the regulation, especially the environmental issues, not to mention lawsuits – you could be over a decade before that mine begins producing.
JIM: That was the second thing that he mentioned to me. He said, “today, it’s not just that you can go out and stake a property, poke a few holes in the ground.” He said the minute that you do that and word gets out that you want to start a mine and bring a project into production he said you’re going to get hit with lawsuits. He said that the other thing that happens is you’ve got NGOs showing up on your site, and they will try to block development of that mine.
And even if you were to bring a mine into production – in other words, you go through the permitting process, you go through all the hearings and you show that you’re going to be a good steward of the land, you’re not going to poison the water and you’re going to take steps to protect the environment – it doesn’t matter it can still take you well over a decade to bring a mine into production. And so it’s not like: well, Ok, we discovered a mine and you see a company announce, Ah major gold discovery. Well, what does that mean?
And you can talk about how the market gets excited by how many million ounces the project has and especially if you get good drill results, but from getting good drill results, from discovery from a mine to raising the capital going through all the environmental hurdles, going through all the permitting processes you’re looking today at anywhere from 7 to 10 years minimum to bring a project versus let’s say if you were going back 3 decades ago, and it might have been no more than 2 or 3, maybe maximum 3 to 5 years at the most, and you would have a mine in production. Today you’re looking at least a decade. [1:49:35]
JOHN: But Jim, there are other factors affecting this as well. There was a story recently that Caterpillar was having trouble producing equipment because they were having trouble getting tires. Inflation is raising costs as well. So it would seem like the cost of operating is getting higher and higher, and it’s getting harder and harder to get the equipment that you need as well to do this. And that is a major factor in this whole play.
JIM: Sure. If you take a look at it, mining is a very labor intensive business, it’s a capital intensive business today, and you see this even at the junior level. One of the reasons why a junior always wants to be cashed up is because you don’t want to say, “Ok, we’re running out of cash let’s cut out the drilling,” because the minute you stop using that drill the company that owns the drill has got another mining company that’s begging for one. So, it’s getting harder to get equipment; it’s harder to get drills; harder to get pipes; the cost of steel is going up; earth moving equipment which you need to bring a mine into production, especially if you have an open pit operation, to get the ore to the mill or even get it over to a leach pad; there’s a shortage of tires because of rubber.
And so the third factor is despite the run-up in the price of gold you take a look at a company like Newmont mining, as Newmont has been very good at maintaining their margins, but their cost factor has meant the price of gold at 450 or 500 hasn’t meant extra profits. Well, actually Newmont’s profits were down in 2005. So a third factor that he was talking about is costs are escalating. And you have to put this into perspective, and sometimes people say, “and you know the price of gold is up over 600” – one of the problems that mining companies have outside the United States is that they sell their product –gold – which is denominated in dollars, but the mine may be located in [another] country. This is one of the problems that the South African miners faced. Their costs were going up in Rand while the price of the product they sold in dollars was going down. And so you had a currency factor that was driving up costs. Labor costs were going up. So here once again cost factors going up and this is one of the third factors.
And then the final thing, the fourth factor that he talked about was that today you have a very hard time getting qualified people in the sense that the current crop of people that got into the mining business: geologists went to school to become geologists and the same thing for the oil industry – a lot of those people now they’re going on now 30 close to 40 years being in the business and they’re getting older, they’re getting closer to retirement, and you don’t have a new bunch a big bunch of new people to replace them. Who wanted to go and become a geologist in the 80s or the 90s? You wanted to be a technician, go into technology as a software engineer in the 90s because of the technology boom in the 80s also. You wanted to go work on Wall Street as well as 90s, a lot of people got into the financial services industry because that’s where the high paying jobs were; that’s where the big growth in the economy was taking place.
During that whole entire period we were going through a bear market in commodities and then also the rise of the environmental movement which discredited natural resources as you know, if you work in that industry you’re basically a polluter responsible for global warming, and polluting the planet. So it was frowned upon and looked upon as sort of like a taboo job area. Well, you don’t want to do that. People that do that and exploit the planet etc. So you didn’t have a lot of people coming through the college system. You had a number of colleges here in the United States that closed down their geology and mining departments. I think there are what only 5 or 6 colleges or universities that offer degrees in geology. It’s probably more prominent in Canada than it is in the United States. [1:53:48]
JOHN: Well, it would seem like if we summarize this: obviously good prospects are harder to find; we know that if you do find something it’s very difficult to bring something on line; and then even if you get it that far costs are escalating, equipment’s hard to get; and because of the lack of people that entered into this profession experienced people are getting scarce. That sets the fundamentals for where the prices of these metals are going to go I guess in the future.
JIM: Yes, I just do not buy the concept that this is a bubble. If it’s a bubble then what do we call everything else. Name me where all the new oil discoveries are that are going to bring this oil glut on line; name for me all the major new copper mines, zinc mines, lead mines, gold mines, silver mines that have been discovered that are going to create all this glut of minerals, base metals or precious metals in the market. You just don’t see it.
And I think if we’re realistic, John Q. Public is not in the commodity market: he’s not trading commodities; he is not buying commodity stocks. Heck, you have a lot of institutions – I have a client who runs a business and he has a precious metals account with us and of course when he was listing his assets for a business loan they’re looking at the size of his portfolio and it’s rather substantial. But when they were looking at what was in the portfolio it was like Ok, they could live with the oil stocks, you know having some of the major oil companies but it was like eww, mining stocks. It was like the bank was looking at mining stocks like they were sort of taboo. He had to explain why he had mining stocks, and at the same time why so much, and he said, “well, they’ve gone up.”
And so it’s still not on the radar of institutions, although it’s picking up. You’re seeing as I mentioned in previous weeks the California pension system, the Harvard and Yale endowment plans are now starting to put a portion of their money into commodities. So the commodity markets are gaining some recognition but ultimately it is going to take a long bull market and rising prices that are eventually going to bring supply on line.
However, I think there’s going to be something unique when it comes to energy because I’m a big believer in peak oil. I’ve looked at it, gosh, I’ve read well over 70 books now on oil. In fact, I’ve just read 5 books on oil and we hope to get some of the authors on this show. One of them is rather optimistic, he’s the head of the Italian oil company ENI, it’s a history of oil and that will be an interesting interview. But I think oil is a rather unique commodity right now as is water. And I think oil is not going to be subject to a lot of – ultimately it’s subject to laws of supply and demand, as the price goes up eventually demand will be reduced as we were talking with Joe Duarte earlier. And we’re going to see, however, in the next 5 years a dramatic change in the landscape as a result of higher commodity prices.
But the point I was trying to make here as we began this conversation talking with this mining executive we’re far from a bubble: the public’s not involved; there’s not widespread acceptance quite yet in the financial community.
And then I think another factor is there isn’t a supply glut –if you produce oil today you can sell every barrel of oil you produce. If you produce natural gas you can sell your natural gas; if you produce copper you can sell your copper. And there’s not huge warehouses and stock piles around the globe. These oil inventories that we move and talk about each week, remember these are statistical estimates based on seasonal factors – they’re really guesstimates in terms of what our supply is. We’ll never really know what those inventory levels are until we get a demand surge, or a supply cut-off as we did last year with Katrina and Rita.
So, I mean John we’re far away from this. This gets back to the interview we had with this week with James O’Shaughnessy, you know I saw the inventory numbers come out Wednesday, and I saw the oil stocks get hammered and many of these stocks are only selling at 6 or 8 times earnings, low PE high dividends. And it just goes to show you our short term focus today we’re not thinking through what’s actually going on with oil, what’s going on with gold, we’re simply reacting. I mean why would you sell something at 6 times earnings with a 2% dividend because there was a report that came out this week, you may get a different one next week. [1:58:50]
More Emails and Q-Calls
JOHN: Well, Jim, having said that it’s time to return to the Q-Line and see what we have in – I guess it’s an electronic grab-bag here.
Hi Jim, this is Joe from New Jersey. I have two questions for you, the first is everyone seems or is talking about inflation being between 3% and 4%, including the Fed. I happen to believe it’s probably 7 or 8% if not higher, so I’d like your opinion on that. Number two, if the dollar were to fall say by 8%, which I hope it doesn’t, and you have an equity fund, say a mutual fund, would the price per share drop because the dollar declined by 80%, or would the value of your money be worth less at the time when the dollar does decline. I’d like your take on that, thank you. [1:59:38]
JIM: Ok, let’s answer your first question, Joe. First of all the 3 to 4% inflation rate is a bogus number. Everybody knows that the CPI is jerry-rigged. If you want to take a look at where the inflation rate is it is closer to 6 to 8%. If you go to www.shadowstats.com, that’s John Williams’ site. And he computes the CPI before they jerry-rigged it for hedonics and substitution and geometric weighting and all the other goofy stuff that get it down, and Williams is showing an inflation rate closer to 7 and 8% as it is, than the 3 or 5% that is widely reported in the press.
The second part of your question what would happen if the dollar fell 80%. The purchasing value of your stocks would decline in value. In other words, whatever value your stocks would have would be worthless –their purchasing power. So if you were to sell your stocks and then go out and try to buy something it wouldn’t buy as much because the dollar had depreciated. [2:00:44]
This is John in Waynesburg Virginia. I have two questions actually. The first one is are you recommending that we stop contributions to our 401K plans along with the tax advantages that that offers, and divert that money that we would be putting there into buying physical silver or physical gold. And then the second question is what are the laws, what are the rules, how does the government react to taking physical gold, physical silver from the United States and putting it into a safe deposit box in an institution in Canada, thanks.
You’re probably responding to somebody, John, I had answered a question and if you cannot save, you have no ability to save and the only methods of savings that you had was a 401K program, and also you were going into debt each month – in other words, you were racking up credit card bills but at the same time you were putting money into a 401K program, I felt that you shouldn’t contribute to a 401K program, you should pay off your debts and pay off your bills.
And then secondly if your only method of savings was a 401K program and you didn’t have the ability to put money into bullion I felt that was a mistake. Maybe you cut back a little of what you’re contributing into the 401K, and then personally buy bullion, maybe probably silver would be the most applicable in that way. And what are the laws in terms of if you bought bullion and shipped it outside the United States. Right now it’s still legal to do that, but maybe in the future we may not be able to do that, especially when we get into a severe dollar crisis, because at that point I think we’ll be implementing capital controls. [2:02:25]
My name is Kevin, I’m from central California. My question is if precious metals and their stocks were an inflation hedge how come every time we start talking about inflation our precious metals stocks are going down. Thanks.
That’s all part if you’ve been listening to the program is in order for the Fed to go on pause they’re going to have to hammer the commodity complex, and so they’re taking the precious metals complex down. Bullion is going down, and your precious metals stocks are going down right now because bullion is also going down. Remember we’re down on gold here for almost close to $100 from its high of 728, so that’s that. But it’s still an inflation hedge, just take a look at your growth stocks or a chart of bullion, and that should speak for itself. [2:03:15]
JOHN: This one comes from Anthony, and he said:
My best friend owns 10,000 shares of Goldcorp, his broker Smith Barney called him and said saying Citicorp wants to borrow the shares and pay him 9% interest for the right to do so. This happened today being June 9th at 12am.
- I think he means 12pm.
Is this desperation or what? My friend says that this has never occurred previously.
JIM: No, that’s going on right now. The shorts are in trouble right now, and so they’re trying to cover and so a lot of people that own gold stocks aren’t getting rid of them. I’ve heard this story repeated before so thank you for sharing that with us, but this gets into my point about trying to hammer the markets and drive it down to accomplish a political objective. [2:04:00]
Hi Jim, this is Greg from Sydney, Australia. First a big thanks to you and John for providing the show, you guys are doing the community a huge service. On last week’s show you indicated the Fed and/or central banks were hammering down commodities including gold. As a gold investor I find this a bit frightening given all their tricks and resources. What’s to prevent them from permanently suppressing the price of gold?
In the end, Greg, markets always win out. They tried to do this in the 60s with the London Gold Pool days, but as we were forced to go off gold and then President Ford made gold available for buying and eventually the price of gold went from 35 to 850. So, eventually the markets are going to win out. They’ve been trying to do this with silver, and they’ve been trying to do it with gold, but then once again look at the price of gold, and look at the price of silver. In the end, the markets are going to overcome that. All they can do is sort of try to keep its rise to a minimum, but in the end they too will fail. If you look at a chart from 2001 on gold. So don’t worry, hang in there and if you heard the previous email they’re in a desperate situation right now, which is why you have a major money center bank asking their clients to borrow their shares and they’re going to pay them interest. [2:05:13]
Hey, Jim and John, this is Ed calling from Toronto. A great job on the show I listen religiously every week. My question is related to the perfect financial storm. And it seems that you’re saying that the Bush Administration is going to be successful in delaying the storm yet again for another 12 to 24 months – it sounds like you’re saying. My question is can any US government basically delay indefinitely or at least delay to a point where perhaps they’re weathering the storm would be not so bad to do? Or, if that’s not possible how long do you think that they can delay this. The other side of that is what conditions would need to exist such that the Federal government would no longer be able to delay this storm any longer? Please let us know, I’m looking forward to the answer.
OK, government’s have been able to delay these storms every time you get intervention into the financial markets, for example, the Fed slashing interest rates as it did from 1991 to 1992; or when the Fed slashed interest rates from 2001-2003. What they do is they sort of extend the business cycle, or they start a new cycle again. They never allow the malinvestments and the maladjustment of the economy to correct themselves, because nobody wants to go through any pain, so what they do by intervening in the markets as they do by lowering interest rates, cranking out the printing presses, expanding money credit in the system, what happens is we go from one crisis to the next, from one hangover to the next, and each hangover gets a little worse, eventually you’re coming to an end game.
And one of the ways that they’re able to extend this and the way that they do, is that you have all central banks cooperating in unison today, and they’re all inflating in unison. You heard me talk last week about call rates in Japan rising faster than what the Bank of Japan wanted to see, and so you had an injection of 1.5 trillion yen into the system to bring rates down; you saw the stock market heading down in a swoon this week, and then all of a sudden we got this miracle rescue on Thursday just right when it touches a key support level. So, I think we’re entering the end game right now. And you’re starting to see it begin to unravel.
And what I talk about is central banks have been inflating, I mean that is the nature of a central bank. They got away with inflating in the 80s because number one we were increasing manufacturing world wide. That brought new supply online which drove down prices, and that sort of gave the central banks the shield to inflate. The inflation took place in the financial markets. Now, however, there’s been enough inflation in the system and we’re doing it at such a level –I think in the 4th quarter last year, annual debt increases on an annualized basis was 3.7 trillion in the United States – but now it’s spilling over into the real economy. So you’re seeing it being reflected in higher oil prices, higher commodity prices, higher service costs. No one I know believes that inflation is only 2%.
And so, unlike the previous past where you would go through a recession, and then the Fed would panic and then all of a sudden they would start slashing interest rates, this time around, unlike 2001, we’re not dealing with $20 oil, we’re dealing with $70 oil. And we’re not dealing $255 gold, we’re dealing with $600 gold. It’s not going to be easy so we’re down that final stretch approaching the end game. How long can they postpone this? Like I said, maybe another day, another year but certainly we’re entering the end game which is the rise in commodity prices and inflation is telling us. [2:09:35]
Hi Jim, Marty here in Woodstock, Maryland. I guess I’ve listened to every broadcast and some of them twice. My question is the premium on the Central Fund of Canada currently at the close of today I think it’s 13%. At what point do you think this particular issue is a good buy as far as premium to Net Asset Value not counting that I’ve been buying all along at less than 3% when it gets down to 3% that’s when I’ve been buying. But up at 13% it’s a little pricey right now, and I’d like your comments and thanks for being here for us. God Bless.
I think you’re going to see that premium go down a little further as the price of bullion comes down to its final low point. But if you take a look at Marty, say you’re buying gold eagles I mean the premium that the government puts in on the eagle, the commission that your coin dealer makes we’re almost in that very same range, but I think the premium’s going to shrink here a little bit more but I think I like what you’re doing you’re accumulating it, you’re doing some dollar cost averaging, and at this point gold at $600 when gold is going over $1000 and $2000 I think is going to be irrelevant. But in the short term I think this premium will get squeezed a little bit more. [2:10:34]
JOHN: Well, Jim, that is this week. As always we’ve had an interesting program hopefully staying on top of things which is our goal here. What are we looking forward to in the weeks to come.
JIM: Alright, next week Ike Iossif will join me for Ahead of the Trends. Then on the 24th Gary Weiss would be my guest he’s written a book called Wall Street versus America.
And then also at the end of the month we’re trying to put together a gold roundtable, and I’m going to put together a different roundtable this time. I’ve already got a commitment from James Turk, he’ll be one of my roundtable panelists; I’ve also got a commitment from one of the former mining analysts on Wall Street, and a partner of Solomon Brothers and now with her own company, Leeann Baker. And we’re looking for a newsletter writer and also a fund manager. And so hopefully we’re going to have a roundtable discussion with a mining analyst, a fund manager, a newsletter writer and of course, James Turk. And that hopefully will be the last week in June. So, looking forward to that. That’s what’s coming up, John.
And in the meantime as always we’d like to thank you for joining us here on Financial Sense Newshour. Until you and I talk again, we hope you have a pleasant weekend. [2:11:48]