Financial Sense Newshour

The BIG Picture Transcription

June 17, 2006

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• I'm scared... What do I do?
  1. Historical Perspective
  2. What's different this time?
  3. What do I do?
• Emails and Q-Calls
• Confusion: What IS Inflation?
• More Emails and Q-calls
• Debate on CNBC with FSO Contributor, Peter Schiff, and Diane Swonk
• Other Voices: 'Zapata' George, Market Analyst

I'm scared... What do I do?

Historical Perspective

JOHN: Well, quite a white knuckle roller coaster ride for a lot of people this week I hope you like positive stress as it’s called where you go “Wheee!” and enjoy the ride. Let’s face there was a sell-off in gold, silver followed it on down, stocks went down. People are sort of rattled, at least, that’s the impression we’re getting from both the Q-Line and the question line. And so we’re going to try to put all of this into perspective on the Big Picture today. Let’s start with an email written to us from Mark from Safety Harbor, Florida and he says:

Dear Mr. Puplava, I have a thousand questions, none of which I will ask. You know what they are already. Something of great magnitude is happening in the world financial markets, and I’m scared. You’re the only one I trust. This coming week’s podcast may be the most important one you’ve ever produced. I just wanted to let you know we’re counting on you, don’t think that one man can’t change the world, because that’s the only thing that ever has.

So, what we’re going to do in this segment here is divide it into 3 sections looking at what we’re going through right now. First of all, we’ll take a look at the history to put everything into context. We really need to set a background on this, otherwise a lot of the flurry this week doesn’t make any difference. What is different this time and what has changed between other cycles that we’ve gone through. And then number 3, something very pragmatic: what do we do?

So, Jim, why don’t we start out by having you giving us a backgrounder on this. Let’s frame where we are today based on where we have come from.

JIM: You know, John, I wanted to start the Big Picture today from a historical perspective: how did we get here, in other words why are we talking about inflation today; why is gold rising to $728; why is oil at $70 a barrel; why are copper prices at $3 and as high as $4? You have to understand that if we take a look at the last recession, the last cycle that ended in 2000, 2001 we didn’t have the high commodity prices that we have today. Back in 2001, when we went into a recession, and even at the peak of the economic cycle we did not have $70 oil prices; gold prices were back in the $200 range; copper was selling at 60 cents. So, why inflation now? And unless you understand how we got here, or what led us to this inflationary cycle that we’re in now, then none of the answers that you’re going to get in the media [will make sense.]

We’re going to play a media debate that was conducted on CNBC to kind of show you all the confusion that is out there. But if you take a look at the 60s and 70s inflation, it hurt government’s credibility. John, you remember Ronald Reagan’s misery index; Gerald Ford – gosh I almost wanted to go get my whip inflation now campaign; and remember a fireside chat that Carter gave on what caused inflation, and it was all these unusual and mysterious events… [3:20]

JOHN: …interacting in strange and mysterious ways is what I think he said.

JIM: Yes, and I thought of that because of this debate this week. Other than the one gentleman who argued what is the true root of inflation which is an increase and expanding money supply, the people on Wall Street don’t get it.

But what happened at the end of the 70s, governments were stung by inflation and they basically said, “my goodness, nobody trusted government.” Money velocity was increasing, we had wage and labor strife. We had people complaining, they were miserable because their cost of living was going up, their wages weren’t keeping up with inflation.

Governments turned to their central banks, and they go, “how do we get out of this mess?” And the central bankers basically gave governments three pieces of advice. One, raise short term interest rates high enough that it will restrain bank borrowing by individuals and business. Everybody remembers Paul Volcker’s Saturday Night Massacre where he raised interest rates two full percentage points. Just imagine what would happen today if Bernanke raised interest rates two full percentage points. It would make 1929 look like just a minor correction. So the first piece of advice was raise short term interest rates high enough to restrain lending.

Two, cut government borrowing. In other words, you guys are monetizing all this debt, you’re running these deficits that came about as we went off the Bretton Woods system because you no longer had to keep your books balanced. And therefore, if you cut government borrowing you won’t have to monetize as much debt, we won’t have as much inflation.

And the third piece of advice they gave governments is stop monetizing debt, finance debt by selling debt instruments to the financial markets. [5:18]

JOHN: Ok, that was what started the capital market revolution, because it made all of this possible.

JIM: Sure, had they not sold bonds to the market to investment funds and institutions, in other words, had they continued to monetize debt eventually what we would have seen is the inflationary fires would have been rekindled again. Eventually this excessive money creation that we even saw throughout the 80s and the 90s would have resurfaced again in consumer goods inflation following the very similar pattern of the 70s. So it was the capital market revolution that made it possible and gave governments an easy option of financing their deficits by selling bonds to investment funds and individuals. And remember, we are actually basically financing the deficit through existing savings, then you’re not creating inflation. When you’re creating and expanding the money supply that’s what creates inflation.

So the implications of the capital market revolution is there were five events that really stand out in this capital market revolution that we saw over the last 25 years. Number one, and everybody remembers this in the first part of the 80s, the incapacity problems of banks due to non-performing loans. John, remember all the major banks lending to Latin America, basically they were recycling a lot of these petrodollars that were created during the run up of oil in the 70s to developing and third world nations.

I can remember today, I was in graduate school at that time and I was interviewing with the major banks in New York. I can remember a guy on the phone, I don’t know if he did this to impress me because we were having an interview, and for whatever reason he took a phone call. He was talking to one of his correspondents down in Latin America, and they were doing like a $300 million bridge loan to Brazil. And as everybody knows, a lot of those countries had a lot of difficulty paying back those loans because they just didn’t have the money, they weren’t generating it, they would have to raise taxes. In fact, those hard times in the 70s is what caused the leaders in Brazil to embark on energy independence to where we see today over half of the fuel in Brazil is generated through ethanol, and basically their own oil reserves.

But anyway, these five events. The first one being the incapacity of banks –problems of non-performing loans, especially recycling these petrodollars. The second thing that happened was the adoption of liberal credit policies by governments. We really saw John what changed in the '80s and '90s was credit became easier to get. I can remember my kids getting offers for credit cards in high school. In fact, one of the issues Congress is addressing today is teenage credit card debt. So, there were liberal credit policies by government.

Also the displacement of discretionary consumer borrowing by government borrowing in the 80s. Everybody remembers the huge government deficits. To kick start the economy the government was going to spend a lot more money. And of course, look what we did following the events of 9/11 and the recession of 2001. The government deficit has gone from a little over 3.3 trillion to 8.4 trillion in just six years.

A fourth factor that we’ve seen is the concentration of private wealth in the hands of large funds, and institutions, and the increase of the use and acceptance of financial derivatives. When we were on a gold exchange standard you didn’t have the risk of currency debasement. You had very little interest rate risk because all budgets were balanced. If you borrowed money the borrowed money had to come from savings. Well, guess what? When you got rid of the gold exchange standard or what we call Bretton Woods, what happened is that now you had to worry about currency risk because governments could debase their currencies; you also had to worry about interest rate risks because of currency debasement.

And so originally the use of derivatives came into play as a means of protecting oneself. In other words, let’s say you were a Toyota dealer here in Carlsbad, and you ordered Toyotas from Japan. Well, if the dollar was going down you would have the risk that you would end up paying more money for those cars than you originally thought because the value of the dollar would go down. So, you might go into the currency market, and go into the futures and hedge your currency risk and at the same time interest rate risk. So we saw the development of derivatives during this period of time.

And as a result the processes of inflation was transferred to the capital markets. The consequence is that individuals and governments became addicted to borrowing, and no longer care about the consequences. [11:01]

JOHN: Was one of the side effects of this is the fact that it didn’t go into the main economy the average person didn’t see it, it went into other areas?

JIM: Sure, the inflation took place in the financial markets, and we’ll get to that in just a second.

But what happened is individuals and governments became so addicted to borrowing they no longer cared about the consequences. And the thing that comes to mind was in a press conference, a reporter asked Cheney about the deficits and his comment was, “deficits no longer matter.” That’s a perfect statement of the way that we think today: we can keep spending, we’ll just keep financing this stuff in the financial markets.

The result of that is we’ve seen access to personal and business credit have actually skyrocketed. Financial activities have been deregulated and new financial instruments have emerged to extend credit – just look at the different forms of mortgage. I mean 25 years ago you might have had adjustable rate mortgage, today you have negative amortization loans; you have all kinds of adjustable rate mortgages; you have interest only loans. You also have the ability of banks today to lend money, package all those mortgages – whether it’s mortgages on a home, installment debt on furniture, car loans, or credit card debt – package it in a security and sell it in the financial system. So, at the center of the universe of this transference of inflation is the global bond market which today is anywhere from 40 to 50 trillion, compared to maybe 5 or 6 trillion in 1980. [12:42]

JOHN: One of the fogging factors –I guess is the best way to describe it here – is the public did not see this, and in their minds inflation does not exist because remember in the 80s and 90s the prices of electronics came down. I can remember my first hard drive 10 MB drive – ooooh, you know –

JIM: You almost need that in RAM today.

JOHN: It’s unbelievable, but the prices came down: VCRs, later on DVDs, CD players etc.. We all saw that stuff coming down. And so that, and the fact that the inflationary money didn’t really go into the consumer area directly gave the illusion that inflation was conquered.

JIM: Sure. The second event besides the capital market revolution and transference of government deficits to the financial markets was that we saw an increase in global manufacturing capacity. The US and the West were no longer the center of global manufacturing. Manufacturing expanded in Latin America, then Asia, and now India. And what we know is when you expand productive capacity of the world – in other words, if we increase the ability to produce more goods the result is that manufactured goods prices fall. In other words, if you only had one widget maker, let’s say the United States was the only widget maker in the world, well then you would have a monopoly. But in addition to the United States as a manufacturing center, you saw Latin America, Mexico, Brazil turn into manufacturing power houses; then in the 90s it began to move to Asia where you saw China, Japan, Taiwan, Singapore – all these became large manufacturing centers. So with more people producing widgets, you have more competition now, so the cost of producing widgets comes down because you get more efficient – you can amortize your fixed costs over a larger number of widgets. So the cost of widgets comes down.

And John, that’s what we saw: the cost of computers came down. I often remark that one of the first big computers that we bought was this Compaq computer which had nothing but it was like $7,000. I can get that same computer today for under $1,000. You mentioned VCR machines came down, DVD players came down, TV sets came down, then we invented new technology – plasma TVs, you’re seeing those prices drop as more manufacturers come on line.

However, during all of this, inflation was transferred to the financial system, that’s where you saw inflation manifest itself. And how did it do it? If you have more demand for something than there is supply then the cost goes up, and that’s what you saw. As the price of bonds went up, bond yields went down; as the price of shares went up dividend yields went down and PE ratios went up. So in the latter part of the 80s and 90s we began to experience asset bubbles in the financial system – first in stocks, and then in this century in real estate. Well, actually we experienced a real estate bubble in the late 80s – everybody remembers the S&L crisis as the Fed burst the real estate bubble in 90 and 91 when Greenspan really raised interest rates. So we saw asset bubbles in stocks, asset bubbles in real estate, and we saw asset bubbles in the bond market. There are asset bubbles today in mortgages, asset bubbles in consumption – which the trade deficit is the manifestation of excess demand in the United States created by excess money and credit. What we can’t produce here we channel that excess demand into foreign-made goods. [17:00]

JOHN: Well, basically what we’re saying here is that inflation did flood into the system but in places where the consumer couldn’t see it, but it was there nevertheless. And basically what you’re also saying – remember we’ve been quoting this the last few weeks on the show, Jens O. Parsson’s quote that first there is the gain: whenever the first people to get the new money, who always benefit, there’s a great euphoria. So you get the benefit first but there’s a horrible withdrawal on the backside of that.

JIM: Sure, because what Parsson said in his book: everyone loves the early inflation, the effects at the beginning of the inflation are all good, there is steepened money expansion – we’ve seen that with the M3 – rising government spending – we saw that in the 80s, 90s and especially in this new century – increased budget deficits – we saw that under Reagan and Bush Sr. And then the budget deficits came down under Clinton as we expanded the money supply and the economy boomed, because what we got in the 90s was an acceleration of money supply growth. Just look at a graph of M3.

And what Parsson’s talking about is it gives the illusion of general prosperity because what happens is you’re in the midst of stable prices – everyone benefits and nobody pays, that’s the early part of this cycle. In the latter inflationary stages the effects are all bad – and this is what I call first the gain and then the pain. So what we’re seeing today is the inflation genie is out of the bottle and the first signs of pain are what we’re seeing today with goods inflation. There’s so much money creation today: M3 was growing at over 8% before they stopped reporting it; it’s growing at 10% in Europe; it’s growing at more than 10% in China – almost 20%. All around the globe central banks are inflating, and I’ll get back to this in just a moment. So what we’re seeing right now is we’ve just entered the beginning stages of the pain, and we’re heading for this crisis but these rising prices that you’re seeing on the street right now are really the first signs of this. [19:16]

JOHN: Yes, unfortunately, when you talk about this pain because the public didn’t see it coming. Pain doesn’t sell well at the polls in politics.

JIM: No, and so what you’re getting is the blame game. And you’re seeing that with Bernanke giving a speech on energy. When energy prices spiked up you had blame shifted to the oil companies – “Gosh, these greedy oil companies are responsible for this.” So the impression is given to the general public that it’s not the money printing that’s going on that’s creating the inflation, [instead] let’s focus on a symptom of that inflation which is rising prices.

And what you’ve seen so far is really blame shifting: “It’s not us, it’s OPEC, it’s the oil companies. It’s act of God for example, the hurricanes in terms of what that did to the price of lumber after Katrina and Rita last year.” So it’s acts of God, it’s greed by businesses. So far what we haven’t seen is cost-push inflation as it’s described which is labor unions or workers demanding higher pay to keep them even with inflation. [20:24]

JOHN: Yes, so basically what we’re doing here is we’re going through a major paradigm shift which means a change in everything, and I guess what we could call the sins of the past or spending into the future have rolled forward upon the banking system and now they’re splattering over into the general population, who weren’t aware of the fact that they were there in the first place.

JIM: Sure, because what we’re really heading for, John, is a crisis of immense proportions, where the only policy antidote will be a coordinated, deliberate reflation of all the large, developed economies. That’s what you’re seeing take place today with all governments –especially in the western world – reflating through expansion of money and credit. This crisis which I have labeled The Great Inflation –a piece I wrote back in October of 2004 – is in my opinion destined to become the defining economic event of our lifetime, John, or the current adult generation, much in the same way as the Great Depression of 1929-39 became the dominant experience of the generation recently deceased. [21:36]

Emails and Q-Calls

JOHN: For some reason I always liked that period, I liked the hairdos of the women of the 20s and 30s and into the 40s. I think they got a little weird in the 50s. But anyway, time to look at what is coming into us by way of emails and on our Q-Line, don’t forget our Q-Line is 1-800 794 6480. It works toll-free from the US and Canada it does work all around the world but you have to pay for it anywhere else. And you drop the ‘1’ by the way if you’re calling to the US, use the country code here then 800-794-6480.

Also, Jim, we did get an email from one of our listeners who pointed out that one of us – either last week, or the week before – made a statement that the Congressmen and Senators don’t pay Social Security taxes. The Cato Institute on its site says that since 1983 Congress has been part of the Social Security system, and they do pay social security taxes. So we need to do an editorial correction on that particular one.

Alright, let’s go to our Q-Line, see what is waiting for us there.

Hi Jim this is Brian from Denver, Colorado. And I had a question regarding your inflation hypothesis, I don’t hear you ever recommending shorting bonds. Shorting long term Treasuries would seem to be an effective way to play it as the inflation coming plays out, and I’d be interested to hear whether or not this is anything you advocate. I enjoy the show, thanks a lot. [23:09]

JIM: Well, Brian, that’s an excellent strategy, but you’ve got to be real careful here because you better be a master technician, because for example we saw interest rates rise to almost 5 ¼, and then we saw a bond market rally that took place very quickly. It’s a good strategy, but you have to be very technically adept with your technical analysis, so that you get yourself out of that position.

Where I think the ideal shorting opportunity is going to come is when the world wakes up and the bond market vigilantes reassert themselves, and discover that inflation is upon us. But right now, the bond vigilantes are asleep with such concepts like “there is no inflation” or “it’s moderate,” or “you’re talking about core inflation.” Until the world wakes up to the idea that inflation is really upon us I think it’s going to be more difficult to short the bond market. I mean there’ll be short term moves in and out of the bond market, and if you look at it over the last year and a half long term interest rates are definitely on the upswing, but you have to very careful technically to do that. [24:15]

Hi Guys, John here recognizing there’s a lot of stress in the economy I want to zero in on one. How much stress do you see in the housing bubble? I do recognize that the contraction in housing means less jobs, less earnings, and ultimately less tax revenue which is certainly bearish. However, people have been calling it a bubble for a long time, and usually what people are worrying about they should not be worried about because it’s already priced in. Further, I wonder if the inflation is actually helpful to housing. If the general price level rises 10% a year for the next 5 years, and house prices flat line then you have had almost a 60% crash in real housing prices but nominal prices stay the same, and people fixed multipayments stay the same so they’re able to make their payments. Further for those on adjustable payments maybe they go up but perhaps the rise in nominal wages would cover that. So maybe it could be engineered as a soft landing with further inflationary consequences down the line, but I wonder if you could comment on the exposure of housing to the general economy. Thanks.

I think we’re not going to have a real estate crash as many people are saying. I think they’re going to try to engineer something here. They already talking about 40 year mortgages, now they’re talking about 50 year mortgages. Don’t be surprised if you hear about 100-year mortgages. And actually inflation is very good for the housing market, and especially for debtors as you just said. They might be able to stabilize housing prices much in the way they did in England and Australia. When their housing markets came down they stabilized them, and that’s what they’re hoping to achieve here. If you do that, and let’s say you can engineer a downward trend in interest rates, and you allow people to roll over their adjustable rate mortgages, [then] the price of housing stabilizes so you don’t have a downturn, you preserve the financial system and you keep that in order. At the same time, what you can do is you can reinflate because in an era of inflation eventually when it plays itself out you want to be in something that’s tangible. And so that’s why I’m not as pessimistic about housing bubble busts. They realize that banks are up to their eyeballs in mortgage debt, and that the whole financial system would implode right now if they burst the real estate bubble. So I think the Fed is getting close to coming on pause here, and engineering a mid-cycle slowdown much in the same way they did in 1994. They can’t afford to let the housing market collapse. [26:47]

Hi, this is John, from Minneapolis. As you said on the show, every time the Fed has gone on a rate increase cycle, they’ve broken something, there’s been some sort of financial accident or crisis. Given the fact that we’re overdue for one now what do you see as the top 5 or 7 possibilities, maybe some less than obvious that we should be watching?

Well, the first area I’d watch is the derivative market, but they even have a way of fixing that. If you recall, last year when everybody was buying credit default swaps on GM bonds the hedge funds were selling a lot more default swaps than there were bonds that these default swaps were written on. And so what happened is when GM bonds really dropped, and people came to collect on their insurance well what they did is allow for cash settlement rather than for somebody to turn in their bonds.

And I want to give you an example of that. Let’s say that you own a car, you buy auto insurance, alright, you get in a car accident and your car gets wrecked. So you call up your insurance company, and you say, “my car’s wrecked.” They say to turn the car in, and they give you a check. Now, notice the key word, you had to turn the car in – the insurance company took your wrecked car and wrote you a check. Well, in a credit default swap what theoretically should happen is you would submit those GM bonds which you had bought insurance on and which have lost all their market value, or a good portion of their market value to the person who wrote the credit default swap, and then they would make you whole. So, because they were writing all these credit default swaps – it was just a way of earning premiums like writing calls on your stocks – the problem is more premiums were written than there were bonds. And so rather than have a financial crisis because some hedge fund couldn’t deliver, what they did is they allowed for cash settlement. They’ve done this also when there’s been shortages or run-ups on the commodity exchanges: rather than come up with a commodity contract, and come up with the actual silver, or platinum or palladium they went to cash contracts. So, one area I’d look for is a derivative blow-up. Although, if there was you would probably here rumors about it and they would hush it and keep it quiet.

The second may be an intermediary financial institution which gets into trouble, that would be an area I’d look at, especially one that’s writing aggressive loans to the marginal real-estate buyer. There’s an area I’d look at. So, a financial institution getting in trouble, a hedge fund getting into trouble, or some kind of derivative mishap. Those are the areas I’d watch rather closely, but don’t be surprised if they have occurred they keep it quiet. [29:34]

JOHN: Don’t forget that our website is www.financialsense.com. That’s s-e-n-s-e on the internet, making sense of things not as in monetary cents, but anyway you can find these programs the new programs are posted every Saturday morning every 0700 hours Greenwich time, that’s Universal Coordinated Time. So you can coordinate your own local clocks to that – that’s around 3 o’clock Eastern Standard Time.

Confusion: What IS Inflation?

JOHN: It is time that we look at why people are confused in terms of what is inflation. There’s a great inflation debate going on there was one on CNBC this week, explaining to people what is inflation what it does. And unless you understand this and which economic school you’re coming from as well, and that’s why a lot of this conversation is confusing because these two sides are talking from two different financials world view positions, and a whole different set of assumptions. If you notice, Jim, on these debates quite often they’re taking past each other. It’s like there’s something not mixing in the middle, and then the average viewer says, “Gee, this economic stuff is rough.”

JIM:To understand, why we have inflation today, you really have to understand this inflation debate. Where we have gone we no longer look at the root of inflation which is an increase in the money supply. We define inflation today in terms of its symptoms, in other words, “rising prices, aha, that’s inflation.” Or falling prices, that’s deflation. These are symptoms rather than the cause and we’ve abandoned all monetary restraint. It’s one of the reasons we got rid of M3. The government doesn’t want people to see how much actual high-powered money is being inflated into the banking system and financial system which is measured by M3. So what we’ve got today now globally is rampant money supply growth. You often hear it referred to as liquidity – global liquidity. All you’re talking about is global money printing.

So, today, instead of blaming inflation for what it really is, which is rampant money supply and credit creation, we’ve come up with alternative causes of inflation. And I wrote about this in my great inflation piece, and I’d recommend if somebody wants to gain a further understanding of this they go back under ‘perspectives’ and look at The Great Inflation and also The Two Bens which was the second part of that debate.

But there are three alternative causes of inflation today: one is cost-push inflation as a result of let’s say arbitrary demands of labor unions. So eventually the average middle class person is going to see that their cost of living is going up, their wages aren’t going up and they’re struggling to make ends meet and there’s going to be labor unrest. And you see strikes, you see calls for union negotiations for higher wages; you see Congress trying to put in a higher minimum wage. And as a result of that the reason we have inflation today is because people are demanding more wages. And we’re already seeing that as a sign, I mentioned last week Chancellor of the Exchequer Gordon Brown in England is basically calling for a freeze in government wages over the next 3 years. And he stressed that as a means of fighting inflation. So in other words it’s not the fact that the Bank of England printing a lot of money, it’s this cost push inflation that’s being caused by the arbitrary demands of labor. [33:05]

JOHN: Yeah, but that doesn’t last very long either, Jim. Obviously, when your wages are frozen historically people begin to scream as the inflation actually continues to push upward, and so they’re caught up in a horrible squeeze in the middle.

JIM: Sure, and you will continue to have labor unrest, the misery index will start to rise, and you’re going to hear calls on government as government begins to lose its credibility.

The second alternative cause of inflation is what we call profit-push inflation resulting from the greed of businesses raising prices. And John, you recall the Congressional hearings, with O’Reilly who still goes into fits of rage talking about these evil oil companies. Prices are rising in energy not because there’s greater demand being created by growing economies which are being fueled by excess money creation, it’s being caused by greedy oil companies. [34:02]

JOHN: Do you have examples of when this has happened historically before. When this was offloaded in previous decades?

JIM: Well, sure. In the '70s, they blamed it on 3 things. [One was] crisis driven inflation from acts of God or weather. We just saw that with Katrina and Rita more recently. But what did you hear in the 70s? Gosh, it was cost-push inflation; it was labor unions – do you remember, John, Jimmy Carter calling for 7% wage price freeze in his Administration; President Nixon putting in wage and price controls; Gerald Ford’s whip inflation now campaign. And also remember, the blame on OPEC and oil companies in the 70s, where “gosh those evil oil companies are causing all of this – those evil people in OPEC, we’re going to slap a windfall profits tax.”

So, what government does is rather than admit that they’re the cause of inflation –by spending more than they take in revenues and then financing that through an inflationary money supply, and increased taxation – they look to offload the blame onto somebody else. Look what happened this week. You noticed the Fed talking about the high cost of energy, working its way through the economy into higher cost in inflation. And so one would think it is higher energy prices which are causing this inflation, rather than the money supply increase which is growing at high single digits, twice the rate of economic growth. And it’s happening globally.

And then we always have to bring in – and you saw this as a result of the hurricanes lumber prices went up, gas prices went up, oil, natural gas – all of that was going up. Remember we got natural gas almost to $15. And the explanation being given during that period of time, “well, this is all a result of hurricane, and Katrina working its way in the system. In other words, it wasn’t the money that we were creating it was an act of God or weather. [36:07]

JOHN: Sometimes you hear price gouging. You know, all these opportunistic people taking advantage of this horrible tragedy on people.

JIM: Sure. It’s the old profit-push and cost-push. And we haven’t seen the old cost-push inflation because we’re in the beginning stages of this great inflation right now, and wages are lagging. One of the big comments made in this recovery is how wages have fallen further and further behind the increases in the cost of living. But what you are hearing a lot about is the profit-push inflation, and then the crisis driven inflation – for example, these storms. And I’ve even heard mention this week on one of the financial stations: “Well, if there’s a little bit of a tick of inflation, the Summer’s where it’ll be because we’re in that hurricane season. Energy prices are kept high today because of concerns over this energy situation as a result of this years hurricane.” So once again, acts of God, and profit push inflation are what are mainly being given as the cause of inflation today. [37:09]

JOHN: Well, given the fact if we go into the popular jargon that inflation really is a rise in prices, when it’s talked about on the media that’s what you’re hearing – let’s go back to the great inflation and look at 3 different ways that actual inflation –monetary inflation – results in price inflation.

JIM: The main source of price increases is increases in the supply of money and credit, because that’s what gives people the extra money and creates the demand that drives up prices. If we haven’t invested in new plant and equipment to increase supply to meet that demand you have price increases. And also the demand for goods and services can increase. By the same token prices can increase by increasing the supply of money, a decrease in the supply of goods and services, and an increase in demand – in other words, the population increases.

Conversely, you can see prices fall by the supply of money declining, or the supply of goods and services increasing. And this is what I refer to what took place in the 80s and 90s as global manufacturing increased globally we had more people making widgets, what was the result is we saw an increase in the supply of goods and services which also brought the price down.

Also, another way that prices can decrease is demand decreases. Watch what’ll happen for example to big SUVs as the price of gasoline heads to 4 or 5 and eventually $7 a gallon. You will see demand decrease for SUVs. We are already seeing a sign of that where GM has said they’re no longer going to make their Hummer 1 anymore because the thing only gets like 7 or 8 miles a gallon. There’s no demand for it. So they have to sell those things at a steep discount to remove them off the lots. [39:20]

JOHN: That’s why my wife kept telling me, “no you can’t have one of those” every time we’d pass the car dealer.

More Emails and Q-calls

Hi, my name is Chris, I’m from Ontario, Canada and I was just wondering if the interest rates were going to be going up in Canada as much as they are in the States with what you’re saying. I know we usually follow US policy, but I was wondering if it was a good time to lock in fixed rate mortgages for everything. The other thing I was going to ask about was if you were going to be doing a review on this book, Money, Bank Credit and Economic Cycles – you mentioned that in one of your earlier broadcasts and I’m still looking forward to hearing the author of that. Anyway, I enjoy your show and it’s been very informative to me and my friends and saved me a lot of money. Thanks.

Chris. Let's answer your question: will interest rates be going up in Canada? Yes, will they be going up as much as they are in the US? No, Canada is one of the few governments that has a balanced budget and a trade surplus. So, even though Canada’s money supply is growing at almost 10% right now, but I don’t think you’ll see interest rates go up as much as they’ve gone up here in the US, because remember, we took our interest rates all the way down to as close to as zero as possible and we brought them down to 1%. So I guess if I was financing something I would lock in on an interest rate right now because I do think they’ll be heading a bit higher.

In terms of your other question, will I be doing a review of Huerta de Soto’s book Money, Credit and the Business Cycle. Eventually, I will be doing a review of that and we will be talking about it on the show. The book is a little over 800 pages, and it’s the kind of book that you have to sit down and you read a chapter at a time and you really have to think about what it is you just read because there’s a lot of conceptual things in it, you’re not reading a novel like you would at the beach. So, as soon as I get done – I’m half way through it right now I think I’ve read over 450 pages. It’s taken a little bit longer because once again it’s one of those books that really makes you think, and gives you a better understanding of what’s going on today. In fact, I think it’s one of the best books to come out of the Austrian camp in years.

Another book I’d also recommend if you’re thinking of reading is Debt and Delusion by Peter Warburton. He gets into the first part of what we talk about in this Big Picture about central banks transferring their inflation over to the financial system, and how the capital market revolution changed what we were doing. That will give you a sort of a good stage in terms of what happened in the 80s and 90s, and why we weren’t seeing inflation manifest itself in the goods economy, rather than what we did see which was the financial economy inflation of the stock market bubbles – the asset bubbles that are so prevalent today that you see mentioned all the time. But that’s a good book to sort of set the stage, and I would complement that with the Huerta De Soto book.

This is David, from Napa California. My question is about peak oil and running out of oil which I believe according to what you’ve been saying is probably something we can anticipate happening in the future . But one of the things to offset this I think is nuclear power. I see where China plans to build 32 new nuclear power plants, it already has 11 it wants to go 14 more. The Europeans, South Korean Ukraine are all adding plants. Also some other countries as well, I’m just not sure which ones. How will this impact the oil shortages that we’re looking to have come about in the future? Thank you.

It’s one of the transitional alternative energies that we’re going to have to go to. It’s not just nuclear. We’re going to have to go to solar, we’re going to have to go to wind. We’re going to have to go to clean coal, and that will help mitigate, in other words instead of running an oil fired plant to create electricity, nuclear power does an excellent job for that. And we should really be doing that here in the United States. So all of these alternative fuels are going to play a transition role until we come up with whatever that magic bullet’s going to be some time in the future, when we invent a new alternative source of energy, whether it’s cold fusion or whatever it’s going to be – I can’t say right now, and a lot of the experts really don’t know, but it will definitely play a mitigating role. The unfortunate thing is everybody else in the world gets this. As you mentioned you have Europe using it, 75 to 80% of France’s power comes from nuclear energy; China and India get it; Japan gets it; the rest of the world gets it, the only people that don’t get it are we in the United States because we haven’t built a nuclear power plant here in at least 3 decades now. [44:10]

Debate on CNBC with Europacific's, Peter Schiff, and Diane Swonk

JOHN: Let’s continue this line of thought we were on previously in the segment here and that was the misunderstanding of what inflation is. There was a brief debate this week on CNBC between Peter Schiff, who is a contributor here to Financial Sense Online, and Wall Streeter Diane Swonk. And this probably lasted about 9 minutes and what we’re going to do here is play this for you and then stop at different points to make commentary, and show you how these two conflicting paradigms or worldviews are interacting with each other.

CNBC: …investors bracing for today’s CPI release in about 90 minutes. The CNBC Dow Jones survey expects it to rise 4/10ths – that’s the regular CPI – ex energy and food, the core up 2/10ths. Before we get to that government data we’re turning to a panel of experts to ask the question: inflation – fact or fiction. These two weren’t really together …a little bit…we want to bring them back: Diane Swonk an economist at Mesirow Financial; Peter Schiff, President of Euro-Pacific Capital, welcome to you both.

CNBC: Peter, great to see you in the studio. Diane. Just want to say do you take offense at the Dr. Doom moniker? Do you remember the last guy who had that was just a huge economist, a household name?

PETER: I know, Henry Kaufman. No problem.

CNBC: So you embrace it, alright. Well, let’s get started. We talk off camera the minute Time magazine or someone gets on the inflation band wagon we’re back to 5.50 in a month. What about that?

PETER: Well, that’s just temporary, but what I really wanted to talk about first is the whole definition because I think inflation is possibly one of the most misunderstood words in the English language. I brought with me a Webster’s definition of inflation which properly defines inflation as an expansion in the supply of money and credit. It mentions the result of inflation which is rising prices but they’re the result, not inflation itself. In fact if you get an earlier definition from Webster’s it doesn’t even mention prices.

CNBC: Does the have to do with Diane taking issue with something yesterday…

PETER: Yesterday, when I mentioned I look at money supply as an indication she was happy with inflation and it produced laughter which I think is indicative of the misunderstanding with respect to inflation. Let me explain how inflation has really worked…

CNBC: I want to let it was Diane who was laughing. I think she may be laughing again, I can’t tell.

DIANE: And I did apologize for laughing but the reality is we can’t count that money supply very well especially in a global economy, even the Fed no longer counts money supply and relies on it as a reliable indicator. Although in theory all you talk may be correct in application it’s not very useful for monetary policy.

PETER: It’s extremely useful in application. Let’s go back to the 1990s, the Fed created a lot of inflation in the 1990s, what Americans did with…

DIANE:Asset-based inflation.

PETER: What Americans did with that money is they spent it on imported products because America lacked the industrial capacity to produce those products ourselves. So money went abroad. That kept the lid on prices, but it didn’t end there. Foreigners used those dollars that we created to bid up US stocks, they invested in our stock market, that produced rising stock prices. That was inflation. When the stock market bubble burst foreigners then recycled those dollars into the bond market, that produced a rise in bond prices, it dropped interest rates allowing Americans to bid up real estate prices. Americans then used their added home equity to borrow more money and send more dollars abroad which foreigners then used to bid up natural resource prices that were necessary to the production process. So rising stock prices, rising real estate prices, rising commodity prices are all a result of the inflation that the Fed has been creating. [47:43]

JOHN: Ok, so as we listen to the opening of this debate before it started to heat up just a bit, basically Peter is trying to say pretty much what we’ve been saying here on the program: you had the inflation, the inflation zigged into assets. He was able to show what it did and what it didn’t in the different markets like the bond markets etc, etc., but then there’s a challenge to that.

JIM: Yes, the challenge was she said, “well, that was asset inflation.” My point! Asset inflation. See, when Wall Streeters say, “hey” that’s kind of what Jens O. Parsson kind of talks about - the good kind of inflation. In other words the gain before the pain. And so what Peter was saying, “look, inflation is a monetary event.” And basically, although he didn’t say it is when the Fed creates inflation through expansion of the monetary supply they can’t always direct where that money goes. Well, in the 80s and 90s with the capital market revolution that was set in place when government stopped monetizing debt and went to financing debt the inflation took place in the financial markets, and that gave us the asset bubbles that Peter was talking about: the stock market bubble, and then the bond market – he didn’t mention the mortgage bubble. But the bond market was related to the mortgage bubble which was related to the real estate bubble. Basically Diane Swonk was saying, “well, that was asset inflation,” which is like, “well, we don’t count that.” Well, you know, I’m sorry but when you expand the supply of money that money and credit is going to find an outlet somewhere. It’s going to be in financial markets, it’s going to be in real estate and if you have enough of it it’s going to be in goods inflation which is what we’re seeing now. And who creates that money and credit is the Fed.

Let’s go back to that debate because from the Wall Streeters' point of view they naively believe the Fed is not responsible.

Diane: No, but wait a minute, you’re talking about that being inflation for the Fed. The Fed does not fight asset based inflations. So it has come out very strongly in saying we cannot fight asset based inflation, so for definitional purposes and for people in the market we have to be very clear about what the Fed is willing to challenge in terms of asset based inflation versus goods based inflation, and they’re not. And all this neat little picture you’re talking about is almost absent of the fact that profit share was rising during the 1990s, as it has been in the 2000s, which tends to lead to more asset based inflation rather than goods based inflation. You have inflation resistance in the economy when you have rising profit share versus rising wage share. [50:24]

JIM: Do we have the Bernanke Babble dictionary? What she was basically saying was, “well, first of all the Fed doesn’t fight asset inflation.” In other words, she’s almost saying, “well, they’re not responsible for that, how can they fight that?” In other words, from Diane Swonk’s point of view the only inflation we recognize is when it starts showing up in goods and services. But if it shows up in the asset markets, hence an asset bubble, that’s really not inflation. Well, it might be asset inflation, but really it’s not caused by the Fed. And here she totally shows her complete ignorance in terms of what happens when excess money and credit are created in the economy. And let’s go back to that debate because what Peter is going to make the case for here is: “look there is no special kind of inflation, there’s just inflation.” Let’s go back to that. [51:25]

PETER: There’s no such thing is asset based inflation or goods based inflation, there is just inflation. Inflation can show up in asset prices.

DIANE Not according the Federal Reserve, and if we’re talking about what it means for financial markets, you need to be very clear about how the Federal Reserve defines inflation, not how you define inflation.

PETER: I don’t care how the government defines it inflation. I care what inflation actually is. The government is trying to confuse the public, the government has a vested interest…

DIANE: They’re not trying to confuse the public.

PETER: Of course they are.

DIANE: That’s just ridiculous. This is a Fed Chairmen. Have you ever talked to the Federal Reserve Governor? Do you know where they’re coming from?

PETER: I don’t have to talk to them. I don’t have to talk to them. I know what inflation is.

DIANE: You don’t have to know [where] they’re coming from.

PETER: I know what inflation is. I know what their agenda is.

DIANE: Know where they’re coming from, given that they’re the experts in inflation.

PETER: No, they’re not experts.

DIANE: Oh, they’re not, Ok. Well, then we do have a fundamental disagreement. [52:13]

JIM: Oh my, they’re the experts on inflation. And the Fed doesn’t recognize that as inflation. Of course the Fed is not going to admit that it’s inflation because it would be admitting it’s the cause of that inflation. So once again I go back to the three causes of inflation that you’re hearing the Fed talk about: higher energy prices, or acts of god – for example after Katrina and Rita last year when the CPI and the PPI went up in the months of October, November and December we had this carry-over effect as a result of those hurricanes, because we had a third of our natural gas and oil production down. The price of oil went up in the month of September, it came down in October, went right back up in November and December and it started to show up in the Wholesale Price Index and the Consumer Price Index. And of course it was blamed for what was causing inflation: it was the oil and it was the events of Katrina and Rita. Once again, going back to the 3 alternative causes of inflation: profit-push inflation of the oil companies, crisis driven inflation from acts of God, or weather. And as far as the Fed, the experts on inflation, let’s go back to that debate.

CNBC: Back in the '90s if we used your definition.

PETER: it’s not my definition, it’s Webster’s definition.

CNBC: Alright, but if we’ve been fooled all along, then the financial market which value stocks based on inflation and inflationary expectations, and the bond market as well. I mean how long have bonds been I mean we have Jim Rogers say they’d never fall below 6%, so the entire global financial system has been fooled by what inflation really was based on what the US

PETER: See, now you’ve got it. You can get an honorary doctorate in doom.

CNBC: Is it likely that the markets can be so wrong for so long.

PETER: That’s one of the problems of inflation, it creates malinvestments, it creates overinvestments, it distorts economic thinking. And ultimately we’re all going to pay the price for that. But the US economy, rather than being the engine for growth is simply the engine for global inflation. [54:20]

JIM: Remember in our earlier discussion we talked about what was the results of the asset inflation that we saw in the 80s and 90s. Remember when you have a lot more money chasing something and there’s less supply – remember the buy-backs and things like that – the price goes up. As a result of the price going up we saw PE ratios at levels we had never seen before. You’d almost have to go back to the late 60s, and maybe the late 20s. The average PE ratio you could just see it. Here you had the anchor in that discussion arguing that: “gosh, you mean to tell me the markets have been fooled all this time. Why would the markets have gone up, and why wouldn’t we have had problems in the financial markets if there was really inflation.” Well, we did have inflation. The PE ratio went from a low of 12 to 14. And beginning in 1990, the P/E ratio got as high as 36 on the S&P 500. So what was happening is with more money being created finding its way into the financial markets people were willing to pay more and more to own a share of stock. At the same time, people were bidding up the price of bonds and the yield of bonds came down as the price increased.

These were two manifestations of inflation. We had never seen P/E ratios quite this high as what we saw in the latter part of the 90s. I can remember when AOL was selling at 600 times earnings; when companies like Cisco were selling at 100 times earnings – that was the manifestation of inflation. Here Joe Kernan is answering, “Oh no, that couldn’t have been – the markets would have picked up on this. Do you mean to tell me that the markets would have gone up all this time had there really been inflation.” What he was arguing I guess is what we call the asset inflation side.

See when assets inflate we view that as a bull market, not inflation. If your house went from 100,000 to 500,000 that’s not inflation that’s a bull market. I’ll give you an example. Let’s say you live in a cul-de-sac and there’s 10 homes in your cul-de-sac, and when the models were built the homes were originally in the low 300s. Today, those homes are going for over $1 million. They were built in 1998, they are million dollar plus homes today. The problem, John, if you were to sell your house for a million dollars, and let’s say you wanted to buy one of the other models in the development you’re going to pay a million dollars or more. In other words, you can’t take that million dollars and go buy a bigger house for the same amount of money because everything is inflating, but we call it a bull market.

Now, let’s go back and talk about all this saving glut and the debasement of currency because this tells us more where we’re going. [57:31]

DIANE: Now wait a minute here, you did mention in terms of you’re talking about foreigners somehow created the asset based inflation.

PETER: We created it.

DIANE: Bernanke has done a lot of work looking at foreign net saving coming into the US. We also know that the real estate boom that we saw –the housing price boom – was a global phenomena. And in fact other countries like Spain and the UK saw much more signs of national housing market bubbles than we ever experienced in the United States.

PETER: That’s true, but…

DIANE: So this is a global phenomena this was not a US phenomena this was something that happened across all countries.

PETER: Again, there was inflation all over the world as foreign central banks debased their own currency and inflated to prevent the dollar from falling. So inflation has resulted in real estate prices rising world wide. I’m not saying that that didn’t happen.

CNBC: Why isn’t gold on an inflation adjusted basis, I mean even that market has not reflected what you would call 20 years of hyperinflation?

PETER: Well, it’s beginning to. It rose from… it was $250.

DIANE: And it’s gone back [down] again as well. And demand from China has nothing to do with commodity based price inflation?

PETER: Well sure, but where was that demand coming from? We’re creating the money but we’re exporting it. A lot of the demand is inflationary. Now certainly part of the demand, part of the reason…

DIANE: Market reforms had nothing to do with this structural change? Productivity growth.

PETER: Oh no, there has been a lot of…

DIANE: The situation that you’re talking about here is devoid of a whole context of structural change globally in the context of the world economy.

PETER: No there has been a lot of..

DIANE: I just find it a little bit unfair to tell viewers that this is a…

PETER: Well, stop.

DIANE: …simplistic way to look at the economy. Yes, it is.

PETER: It’s not unfair at all. There has been productivity growth in China, no doubt about it. In fact, one of the reasons…

DIANE: And in the US, some remarkable growth.

PETER: I would disagree there, I think that’s more sleight of hand for the statisticians. [59:21]

JIM: Here she’s saying, “Gee, it’s not just the US.” That’s correct. Let me just put this in perspective. The US inflates its money supply. It creates demand, more credit. People borrow money. We want to buy goods and merchandise we don’t produce at all here; we buy foreign goods. When we buy those foreign goods we give them dollars. Those dollars are deposited in the banks of China and Europe and Japan. And then what will happen there is those merchants who sold us the merchandise they want their own currency – that’s what they pay their bills in. What’ll happen is the central bank will then create money, they’ll take those dollars, send them back into the US, and drive our asset prices up which drove down interest rates. The so-called conundrum or Greenspan conundrum was basically nothing more than the recycling of the US trade imbalance – which by the way last year was over $800 billion.

Now, in terms of asset inflation in England, asset inflation elsewhere, they were printing money too. You know, one of the things that you’ve heard me talk about on this program is the money supply is not just growing here. And as we alluded to in the first part of the Big Picture the result is we are seeing global reflation. We’re the heart of it, but we’re seeing money supply expand globally as all central banks have to reflate their economies because of huge budget deficits. Governments are spending more than they’re taking in so they have to inflate part of that. And at the same time they’re also trying to debase their currency so they don’t want their currencies going up because that would drive down their exports. So this is all a circulatory route that this inflation is taking place. It’s taking place globally.

And the other final comment the sleight of hand about the productivity if you overstate GDP by understating the CPI rate or the true rate of inflation you get an overstated rate of GDP, and as a result you get an overstated productivity rate – just as we had these bogus numbers of unemployment. And here’s a gal that basically believes everything she reads in the paper.

DIANE: Excuse me, I’m from Detroit. Have you been in an auto plant recently?

PETER: Well, I can see where our trade deficit is. If we were so productive why would we have a trade deficit. So where’s all the merchandise that we’re producing.

DIANE: We still produce a lot of merchandise.

PETER: But why do we have a $65 billion a month trade deficit.

DIANE: We have the highest propensity to consume and invest of any country in the world. We’ve been growing more rapidly than other countries in the world.

PETER: You’re right we have the propensity to consume, but not invest, to produce.

DIANE: And as a result we’re going to be sucking in more imports than exports all else being equal.

PETER: That’s not true.

DIANE: We have an economy… yes.

PETER: We don’t have a more efficient economy.

DIANE: Yes we do.

PETER: We have a bubble economy. We’re borrowing abroad to consume that’s not efficiency. [1:02:22]

JIM: Here she’s making the comment that as a nation we have the highest propensity to consume, but as Peter came back with, “yeah, we’re borrowing money to consume, and we’re not investing.” The savings rate in this country is zero, and you compare that to high single digit, double digit savings rates in Europe, and Japan and China that’s what’s building real wealth. We have bubble wealth here, and that is an illusionary wealth.

And we measure things from a Keynesian perspective. Rather than looking at our ability to save, and as a result of saving, to invest and to create new plant and equipment – that’s what creates wealth – what we’re measuring as wealth today is asset bubbles. In other words, if your house went from 100,000 to 500,000 that’s wealth. All that is is just hot air wealth created through inflation. And we’re not saving. [1:03:21]

JOHN: It’s not real wealth. It’s not real created wealth in the hand, it’s all based on a chimera that sooner or later comes home to roost. Let me see if I can sum this up, tell me if I’m right about this, Ok. When you listen to these two people talking it’s obvious that Peter was coming from a much more Austrian position, and the lady obviously had all of her training in Keynesian economics. The Keynesians see this problem as more just tinkering with the system to readjust it. The Austrians see the Keynesian system as being the flaw by itself. In other words, the Fed doesn’t fight inflation it creates inflation, it is the cause, and the only cause ultimately of inflation that we can attribute. And that’s why, if you notice they were just constantly disagreeing because their starting assumptions are fundamentally different from both schools.

JIM: Absolutely. She doesn’t want to recognize inflation in terms of an asset bubble, nor did the moderator who said that, “you know, you can’t have rising financial markets if there was inflation. Like the 70s we wouldn’t have had that kind of market if there was real inflation.” But you know something, what it really boils down to, let’s go to that one email from Robert which explains what is really happening on Main St. versus what’s happening on Wall Street. [1:04:38]

JOHN: You know if there was one thing that I found sobering out of listening to the debate, that is looking at the fact to say for example neither the moderator, nor the lady Diane Swonk wanted to see asset bubbles as inflation, they don’t believe the Fed creates inflation. And the public looks at all of this and can’t understand it but you know what? When it finally comes down to the bottom line, they understand that inflation’s not a very good thing. Here’s an email we got from one of our listeners, Robert in Sioux Falls wrote us this week, he’s seventy-seven, his wife is sixty-four:

We’re seniors our income is fixed at about $4,600 a month, it consists of two pensions, two Social Security checks, and a small annuity. Other than that, the minute increases in Social Security our income has not changed since we were married in 1995. We cannot understand why food and fuel are not included in this calculation. These are two major factors in our cost of living. The fuel prices hurt us as we live full time in a motor home, no house and the thousands of 18 wheelers we meet in the fuel stops are hurting, and the surcharges they add on are carrying right on through to our food costs.

So once you get it out of intellectual heaven and get it down to real life, there’s where it hits.

JIM: Sure, and this is the thing that just drives me crazy that whenever we get a bad inflationary number, they’re talking about core inflation. The core inflation level does not relate to anybody the way that we live in this country today. I always joke around, every once in a while I amuse the checkers at the grocery market, you know, they ring up your final bill, and I go can I please have the core rate. I mean can you imagine that John, you have to pay tuition for your daughter going to college, you ask for the core rate of tuition, the core rate at the doctor’s office, the core rate at the grocery store, the core rate at the gas station. [1:06:37]

JOHN: Most supermarket [clerks] wouldn’t know what you’re talking about, anyway.

JIM: Yeah, they’re going to look at you like you know what planet did this guy come from.

JOHN: Yeah, we don’t have any discounts this week, sir, do you have any coupons?

JIM: In this email Robert is reflecting a lot of these people on Wall Street are in la-la land. And once again John I think you hit it on the nose. If you go to any MBA program, or get a masters in finance, a degree in finance, MBA, go to Harvard, Stanford or become a CFA, this is the nonsense they’re going to teach you from economic theory. So, consequently, it’s like you were raised a Catholic or something and then somebody tells you there’s no God. [1:07:20]

JOHN: It would be essential there Jim to break it very gently to the Pope however.

JIM: Yes. When you’re trained in one method of thinking, you tend to see everything through that one method of thinking.

JOHN: Yes, through that filter. It’s basically a frame, an assumption you have assumptions built in about things and you see everything through that frame, so that even if the data contradict it, and are telling you something else, that frame determines how you’re going to see things.

JIM: And that’s why the economists are always getting the economic growth rate, the inflation rate and the market rates wrong because they start with the flawed assumption, and what happens is well, if my assumptions don’t turn out to be true well, we’ve just got to go back and tinker a little bit. Well, we need to expand the money supply a little bit, we need to go a little bit more on the deficit spending side; maybe we need to go to a tax cut; the Fed needs to bring interest rates down, flood the markets with money and credit. And so we just need more tinkering.

But it was the tinkering that has gotten us in this mess in the first place, and it was the tinkering that turned what might have been a market correction and a mild recession into the Great Depression that lasted a decade. And that’s the real risk that we run here is with all this tinkering eventually this whole house of cards is going to come tumbling down, but this time it’s going to be a hyperinflationary depression. This is the ultimate outcome we’re heading for. But as long as you’re dealing with these myopic beliefs in terms of what inflation is, what causes it and what it isn’t you never deal with the root problem. Thank goodness we don’t have Fed officials becoming health officials. Can you imagine what your health care plan would be like? Because what they would be doing is essentially is they would be saying we would not be finding the cause of what’s ailing you we’re going to treat the symptom. [1:09:15]

What's different this time?

JOHN: Music of Steve Doré taking us through the break, right there.

So, Jim, we need to move on to the topic of what’s different this time around on the merry go round cycle versus before. And you’ve been talking about the fact that the Fed needs to go on hold, they can’t keep raising interest rates before something is going to break but they need an excuse to be able to do that. So what they’re going to do is hammer the commodity markets, we starting to see that, they just definitely cannot go on hold as long as you’ve got $700 gold, $75 a barrel oil, and $4 for copper, that will just not happen. So commodities have to really take it right here to give them an excuse to be able to stop raising the interest rates.

JIM: Sure, because if they can bring down the price of energy which I think they’re going to have difficulty doing but I think they’re going to engineer a way to do that which we’re going to get to in just a moment. But, the one thermometer that things are heating up and one that every central bank does not want to see is rising gold prices, because when gold rises it’s a thermometer that tells you there’s trouble in the financial system. And that was the key thing that they had to do: they had to take down the price of gold. We know that the bank of England was selling its gold and we know that they were using derivatives to hammer that market – that one day swoon that you saw $40. Because the Fed knows it needs to go on pause. I’ve given the analogy that they’ve driven the economic car the front two tires are hanging over the canyon, this next rate hike in a couple of weeks will probably drive the car so that half of the car will be hanging over the canyon and they better bring this thing to a stop here pretty soon or the car’s going off the cliff, because what we need to explain to people is there is a lag effect between raising interest rates and the time it works its way through the entire economy.

Let me give you an example. Let’s say that it’s June of 2005 – let’s go back to last Summer. And let’s say, John, that you are getting ready to buy a new home, and so you put down your $10,000 deposit, to hold the model, and lock the price in, and the home is going to take 9 months to build. Now, in the meantime, last year at this time you were looking at variable rate interest rates on ARMs in the 4% range. So you’re thinking, let’s say, I’m going to buy it for $750,000 [in California prices]. So, I’m going to buy this $750,000 home and you’re thinking at the time that I’m going to add options as we go along, and it’s going to take 9 months to a year to get into that home. So you start out at a $750,000 home, and interest rates are 4%. The problem is as months go buy, as the home is being built, the Fed is meeting and every time the Fed meets, it’s raising interest rates a ¼ point, so your adjustable mortgage rate is also rising during this period of time. So by the time you take possession of your home and close escrow, meanwhile interest rates have gone up a full percentage point and a quarter, you can no longer afford to buy the home at today’s current interest rates. Either you will have to go to a negative amortization loan, or you’re going to have to go to an interest only loan, or some alternative form of financing because you can’t afford to buy that ¾ million dollar home, now that interest rates have gone up, let’s say, 1 ½% from the time you first purchased the home.

So, let’s say you back out of it, and you walk away from the deal. We’re seeing more and more as you read in the newspapers the deal falls through because [people] can’t qualify, they can’t save it. So now you back out of buying that home, and now the home builder has more inventory than he wants, and as that inventory begins to build –as we’ve seen now there is about a six month supply where the highest that we’ve seen in over a decade of new homes for sale – what happens is the builder says: “Holy Cow, my inventory are building, the sales department tells me that there are more people falling through at time of close of Escrow and we better cut back. Maybe we’re not going to expand into that next additional land as we had planned, or we’re going to slow the rate of construction. We no longer need to keep our guys at over time.” So, all of a sudden you’re seeing builders build less, there’s less overtime for workers. And let’s take it another step, let’s say that you’re an automobile dealership, you’ve been selling these cars with incentives, you’ve been selling at 0% interest rates, or very low interest rates, now all of a sudden gas prices are at 3.50, and people aren’t walking into your showroom.

What we’re starting to see, John, is the front end of the economy start to slow down. And what I mean by that is I have a couple of friends that are in the mortgage/finance industry – I have one friend who’s a home equity loan officer and another friend who finances boats. And last weekend when we got together he was telling me usually when we have these boat shows the dealers are putting special incentives to move the boats, and they sell a lot of boats at these boat shows. He said last week was the first time that he had written a boat loan in 3 weeks, he said people in the boat industry are just scratching their heads, we’re getting scared right now because they don’t know why sales have fallen off a cliff. They don’t know if it’s rising gasoline prices if you’re a power boat, they don’t know if it’s rising interest rate costs because it does cost more to finance a boat, or they don’t know if this is really the beginning of a recession. Because in the last recession they didn’t hurt because consumers spent a lot of money in 2001 during that recession. There wasn’t a consumer slowdown. So we’ve got boat sales that have fallen off a cliff. I have a client who owns an automobile dealership and in the words he described he said, “in the evening you can hear the crickets chirp in the showroom.” There’s nobody buying boats, there’s nobody buying cars. And my accountant is a pilot and we’re seeing aircraft sales go down – I’m talking about small aircraft. This is the front end of a recession, or the front end of a hurricane. This is what you see goes first when the economy starts to go down. The discretionary goods are the first area of the market to suffer. You’re also seeing real estate sales go down. We’re also seeing at this time retail sales starting to slow, but the big luxury items are starting to slow down and what will follow is a slowdown in retailing. And so we’re heading into a recession unless they can turn this thing off right now – stop raising interest rates and begin a massive reinflation. [1:17:11]

JOHN: Well, Jim, we were talking during this part of the segment about the fact that they were going to hammer the markets down in order to give themselves an excuse to go on pause – remember we have to offload this. And the problem is now that the inflation genie has finally gotten out of the bottle, and they’re very busy trying to jam it back in, and ignore that man behind the curtain – that type of thing right there. I would say if I looked at it that the Fed’s credibility is at stake because they’re always presented as the organization that manages the economy, the monetary supply and fights inflation.

JIM: Yes, because you know you can’t get up there every single month and talk about the core rate when you’re seeing goods prices passed on –just a couple of weeks ago Dupont said they were putting through high single digit price increases for the second time within a year, because they said they hadn’t covered their cost increases since the 4^th quarter of last year. They said, “we keep doing this we’re going to be out of business.” So we’re starting to see this push through of higher prices through the economy.

The Fed knows that the inflation genie is out of the bottle, and the one problem that it was having is its credibility is at stake. So hence, after the Bernanke flip-flop we’ve just got about every Fed governor going “doggone, we’re worried about inflation, we’re worried about inflation, we’re worried about inflation,” in every single speech. And so what it’s doing is it’s scaring the bloomers off the financial markets that the Fed’s going to go too far and break something. And they had to do that is because one of the things that was not happening in this rate raising cycle, first of all it was different, throughout the cycle we saw all asset prices rise; credit spreads contracted instead of expanded. And normally in a rate raising cycle you get a lot of nervousness in the bond market – junk bonds, risky bonds, emerging debt bonds start to go down in value; the interest rates offered on these bonds go up, credit spreads start to widen. And also as the Fed raises interest rates in past cycles well heck the last one was in 99 and 2000 the stock market went into a bear market. That did not happen: stocks went up through this cycle. And throughout the majority of this cycle bond prices appreciated: yields came down. So we had a lot of unusual things and also volatility in the stock market as measured by the VIX dropped to a low level.

So the Fed wasn’t getting any credibility with the financial market, basically people were ignoring them so what they had to do is really sound tough and create and instill an element of fear into the financial markets. And that’s what they were doing this last month. The Bank of Japan withdrawing liquidity from the system, although in one day they added more liquidity I think they added 1 ½ trillion [yen] of liquidity, and we’ll find out what that looks like when we get the month of June monetary base figures out of Japan. So what we saw here is they had to take down the financial markets. In fact there was a comment made by one of the individuals responding – the Fed got exactly what they wanted, the commodity complex has been taken down. And remember if you can bring down the cost of copper or the price of natural gas, or if you can bring down commodities in general that gives you a little bit of leeway because if those prices go down then it’ll show up in lower prices going forward, in terms of wholesale prices or CPI prices.

The other problem that they have right now that’s causing the core rate to go up is this bogus owner’s equivalent rent concept: now that housing is going down, rents are going up. So what they’re already talking about is redoing and maybe rejiggering the CPI. Bernanke gave a speech where he said that the CPI is overstating inflation by a full percentage point. The last time we heard that kind of talk in Washington in 92 and 93 they redid the CPI rates, so mark my words, they’re going to jigger this CPI, and they’re going to bring the CPI down statistically.

In the meantime, they’ve hammered commodity prices because that’s sort of going to give them the cover when they go on hold when they need to do that, because if they don’t do that they’re going to push the car off the cliff. And I think that’s why they had to create that sort of, you know it’s kind of like you see a madman, and you say oh my gosh crazy people scare people. Well, right now, the Fed is acting pretty crazy and it’s scaring the financial markets, but they had to do that because if they didn’t they need to bring down inflation expectations. And that’s what all this open-mouth committee stuff has been going on over the last month has been doing because they’re paving the way for the Fed to go on pause. [1:22:01]

JOHN: But if we look at what inflation does, at least there are benefits during the gain part of the cycle, let me put it that way. Number one, for governments, inflation is a hidden form of taxation. It allows them to transfer the wealth of the people to the government without them really knowing it directly. In other words, they don’t file any forms and they don’t feel they’re ripping off their wallets or purse. And nevertheless, the value of what they have worked for moves from the government to the people, that’s number one. So that’s a gain for government. For working households, when you do go on the inflation ramp, let’s face it, it does some positive things from their point of view anyway. It erodes the value of their debts, simply by making the debt a smaller part of what they have to earn to keep the whole household going, especially if they’re on fixed rate mortgages or whatever they have.

Number two, it allows them to borrow money at low rates financed by the inflationary value of their home. So they’re actually taking the inflation out of their homes and elsewhere and able to turn that into ready made cash right there.

The third thing it does for companies with large stocks of unsold, finished goods, or large overseas sales it almost represents an instant accounting profit, like presto-chango there it is.

JIM: So right now, we’re still in the latter stages of that gain phase. We’re seeing asset inflation in real estate; we’ve seen some asset inflation in stocks. Stocks have gone up through this cycle; bonds have gone up through this cycle; real estate has gone up through this cycle; mortgage rates have come down – they’re still at historically low rates, even though the Fed has been on this rate raising cycle for almost 2 years now.

For companies, if you can bring the currency down, let’s say you’re an international company today like Coca-Cola, if you’re selling Coke in Europe and getting paid in euros, and the euro is going up against the dollar that translates into higher profits. On the other hand, if you’ve got old goods lying in inventory and you have accounting profits of inventory profits that you can book into your income statement, just by jiggering around with how you account for inventories. So we’re still in the initial stages of that gain, and so that’s why governments will continue to do this, because what’s the alternate choice? The alternative is for government to tighten its belt, and for the life of me I do not see government spending dropping $3 trillion down to $1 trillion; I don’t see them cutting Social Security, I don’t see them cutting Medicare; I don’t see them cutting defense spending; I don’t see them cutting welfare spending; I don’t see them cutting salary increases; I don’t see them cutting department expenses, foreign policy expenses. None of these things are going to decrease. In the words of Dick Cheney, deficits no longer matter. [1:25:06]

JOHN: Well, let’s talk about this little downdraft, this faux pas that we saw go by this week. Obviously, things are still pretty jittery as we round out the bottom of the week here.

JIM: Well, as I mentioned the Federal open-mouth committee has been working full time to instill a little bit of fear and regain some credibility that the Fed is an inflation fighter.

Bernanke: relatively speaking, looking at oil prices and interest rates in the more recent episode, even though oil prices have risen quite significantly they haven’t had nearly the effect on overall inflation, and therefore there’s not been nearly the response in terms of interest rates that we saw in the 1970s. this illustrates as I discuss in my remarks, it illustrates the importance of keeping expectations of inflation contained and keeping the credibility of the Federal Reserve strong.

Well, let’s face it the Fed’s credibility is at stake now, now that inflation has spilled over from the asset financial economy over into the real economy. So they need to convince people that they’re serious about fighting inflation. Meanwhile they’re chopping down the trees and running the printing presses as they turn the inflationary spigots up full blast, which is the reason they got rid of M3. What has changed though – this is a question though because we have a lot of people calling, “oh my gold is down $45; the oil stocks are down, the gold stocks are down, I’m standing on the ledge of the window, I need to jump overboard.” And the one thing I think people are going to find helpful, anytime you see large market movements as we’ve seen this week, the thing you have to understand today is there is a lot more volatility because our markets are interconnected today through globalization. You’ve got the same eyeballs in Tokyo, Beijing, London, Paris, Toronto, Vancouver, Washington, New York. Everywhere everybody’s watching the same stuff with out computerized screens so news is instantaneous. That’s one thing.

Secondly, today, most market transactions most volume on the exchange is accounted for by institutions.

Thirdly, today, institutional trading has never been higher. If we were to go back 30 or 40 years ago the average turnover for a mutual fund portfolio was 20% a year; the average portfolio holding period for stocks in a mutual fund was 3 to 5 years. Fast forward to the year 2004. At the end of 2004, the average turnover rate for most mutual funds was between 110 and 120%; in fact one out of every four mutual funds had a turnover rate of 200%. On top of that the average holding period is less than a year, it’s probably about six months to nine months for most mutual funds, and money managers – not to mention what hedge funds are doing. So you’ve got a lot more trading today. All of a sudden the stock market goes on a down tick, that triggers all kinds of computerized trading programs. If you look at Wall Street today a good majority of the revenues of these investment banks from Goldman Sachs to Merrill Lynch to Lehman Brothers is being generated by trading.

So let me give you an example. There was an inventory report this week where the supplies of gasoline or oil went up and all of a sudden everybody sold off all the oil stocks. Well, does that really make sense next week when the inventory figures can be different? And the other thing that happens is once this sale starts taking place it generates a chain reaction and all of a sudden the computer sell programs kick in and that generates selling, and that drives down prices and prices go down even further. People that are on margin are forced to sell out their positions whether they are in stocks or they’re in futures. And so the whole downdraft accelerates. In other words, the downturn happens much quicker, it is much, much more violent today as a result of this interconnectedness, as a result of all the leverage in the system, and as a result of all the instantaneous communications and then lastly the short term focus of the market. We have moved from an investment market to a trading market. Primarily today people, institutions are no longer investors they’re traders. [1:29:21]

JOHN: So basically, standing on the edge to use a respected time honored Wall Street analogy. You’re watching your gold stocks go down, your oil stocks are going down, before taking a jump maybe you should consider what has changed?

JIM: You have to ask yourself are trade deficits going away, are government budget deficits likely to get bigger or smaller? Are entitlement costs going to wind down? Is the supply of money expanding or contracting? Are we going to see more inflation as a result of bigger budget deficits, trade deficits, money printing, credit expansion? I mean they’re already talking about the 40 and 50 year and soon I predict the 100 year mortgage. And so, when we take a look at commodity prices today, give me a break. Commodity prices double, or gold prices double and triple, and they’re calling it a bubble? Then what would you call the Dow going from 780 to 11,700. I mean we’ve got a lot further to go.

And the one thing that you usually see in a bubble is you see surpluses because as prices rise additional supply is bought into the market because people are encouraged to bring additional supply because of the higher prices and the higher profits that are worked by the market. But name me where the surpluses are in oil, natural gas, copper, silver and gold. True, all the gold that’s ever been produced still exists today, but what is it going to take to let that loose. I can tell you if you’re a gold bug you’re not selling your gold. Maybe at some price you will if you’re a trader.

And then the other thing is the public fully invested in precious metals, energy and commodities? Go out on a golf course, and start talking to people about gold, or energy. Now, they might relate to energy. They might relate that hey, yeah, I can relate to that because of the price of the pump. But I can guarantee you, if you start bringing up the topic of precious metals, or gold or silver, they’re going to kind of look at you with glassy eyes like, “oh you’re one of those guys.” [1:31:29]

JOHN: But there again is that collision of world views we were talking about.

JIM: Yes, because you have people debating the core rate, and as Diane Swonk was saying, “oh no, the Fed’s not responsible for asset bubbles, it’s the expert on inflation, it’s not the creator of inflation.”

Bernanke: Still, as global economic expansion continues substantial growth in the use of oil and other energy sources appears to be inevitable. How readily the supply side of the oil market will respond is difficult to predict. In a physical sense, the world is not in imminent danger of running out of oil. At the end of 2005, the world’s crude reserves of conventional oil that is oil in the ground that is viewed as recoverable using existing technologies, and under current economic conditions stood at more than 1.2 trillion barrels, about 15% higher than the world’s proved reserves a decade earlier, and equal to about 4 decades of global consumption at current rates. These figures do not include Canada’s vast deposits of oil sands which are estimated to contain an additional 174 billion barrels of proved reserves. In addition, today’s proved reserve figures ignore not only the potential for new discoveries but also the likelihood that improved technologies and higher oil prices will increase the amount of oil that can be economically recovered. [1:32:49]

So, I literally saw Tuesday or Wednesday when the oil stocks were getting hammered and it was an inventory report – I don’t know how many times I can say it on this air – there is nobody out there with a dipstick every week that sticks the dipstick into the engine and says, “ah, we’re down a quart of oil.” In fact, these are all statistical guesstimates, seasonal guesstimates that are put into these figures. Nobody is going out and holding an actual inventory. And the other thing is their counting in the area natural gas: if we still have part of the Gulf of Mexico gas production offline, and a good portion of it has been offline close to six, almost 9 months now, if Canadian natural gas production is down, if US natural gas production is down, we’re not building a lot of LNG terminals where are all these increases in natural gas inventories coming from? Well, what they’re starting to do is count the natural gas that is pressurized in a well as inventory, but it really isn’t inventory because if you remove that natural gas your well pressure goes down and you can’t get the natural gas. So, the inventory statistics themselves are being massaged and manipulated – really the only time we’re going to know what it really is, is when we get into like a severe winter, and an energy crunch and then you’re going to see the prices spike – as we did with Katrina and Rita. If we had all this surplus inventory that they were talking about then why did prices spike in the way that they did in the month of September of last year. And if we have all of this excess surplus, as everybody would claim, then why are oil prices at 68 and 69 dollars. I know you’re going to get conspiracy buffs that are going to say it’s Exxon’s evil plan, or it’s the Bush plan to keep oil prices up. These are the questions that you need to ask yourself before you jump out of the window.

My son [Chris Puplava] did a piece on the energy sector and what he did is he took a look at the S&P energy sector in terms of valuations of PE ratios, price to sales ratios, price to book ratios, price to cash flow ratios, and this is the lowest they’ve ever been. Not only are PE ratios low, but also price to sales ratios for the energy industry is the lowest that we’ve seen in over a decade; price to book value is the lowest that we’ve seen in almost a decade; price to cash flow is the lowest that we’ve seen in the decade. And if you’re looking at the commodities market, name me all the silver surpluses where our warehouses are booming with silver supplies? Has the government got another stockpile as it once did as a result of buying silver during the Great Depression? Those stockpiles no longer exist; we no longer have large stockpiles of food; we’re at the lowest levels of food inventories globally; we’re at the lowest levels of copper inventories globally. All of this at a time because of all of this excess money creation which is creating these booming economies globally which is creating the demand and we’re seeing the inflationary side effects.

You know what it reminds me of John is the quote by Rudyard Kipling when he said, “if you can keep your wits about you while all others are losing theirs, and blaming you, the world will be yours and everything in it.” And that’s the thing I’d like to emphasize here. When they did a study of the most successful money managers and they said what were the traits and I think this applies to the most successful investors: number one, they were long term investors; if they were in a long term bull market they held things long term; they didn’t have a high turnover in their portfolios; they were focused and concentrated. And they tend to hold onto their investments; they bought things at a cheap price and then held them until the prices were dear; and when the prices became dear for what they owned that’s when they unloaded and sold to the public. And I would submit to you that oil prices and oil stocks are cheap; oil is going higher; copper is going higher; gold is going higher; silver is going higher; lead, zinc, all the things we do not have excess supply today because as the world population grows, as economies expand, the only thing that would bring this thing down is a worldwide depression. And unlike the depression in the 20s the currency is not backed by gold today. There would be no limitation to the amount of money that governments could print. [1:37:40]

JOHN: It’s time to hear from other voices right now. We’re going to hear from Zapata George this week sitting at his home overlooking the border between the US and Mexico.

Other Voices: 'Zapata' George, Market Analyst

JIM: Well, Zapata George, my friend, how have you been?

GEORGE: Very fortunate, thank you.

JIM: George, on the day you and I are speaking which is Thursday of this week we had Fed Chairman Ben Bernanke talking about energy. I want to talk before we move into the area of energy, let’s talk about inflation because the bureau of Labor Statistics talked about for example before seasonal adjustments the Producer Price Index for finished goods increased at a rate of 4 ½%. Now over the same period the index for finished energy goods increased by 20.6% - all of this they said translated into intermediate goods increasing at an 8.9%, and crude goods index increased by 8.6%. So, here we have the Bureau of Labor Statistics admitting an 8-9% inflation rate down the pipeline.

GEORGE: Well, you know, they don’t index, they don’t have housing, they have rent. And of course, they put that in there for a reason. Well, guess what, rents are going up. So now they’ve gotten trapped by their own whatever you want to call it. I love it.

JIM: I wonder if they’re going to talk about free public housing, throw that in to the index and get rid of equivalent rents.

GEORGE: I talked to some folks in Europe, the Karma [ph.] Bank people, have you ever talked to Max and Stacy?

JIM: No.

GEORGE: He has a concept of how inflation is related to other subjects, and it’s really interesting to talk to this guy. You ought to call him up and hear his point of view. Now, it’s weird but it’s interesting. And I guarantee you it isn’t any weirder than the government’s ideas.

JIM: Well, you know George, I have this theory that in the 80s that when government went to the bond markets to finance their debt, instead of monetizing the debt like they did in the 70s they transferred inflation to the financial markets. And then I think they got a free pass. I think as globalization took off in the 80s and 90s, and we got more companies in the world producing goods, the cost of goods came down, and everybody was saying, “see – deflation.” Well, now, there’s so much money sloshing around the globe it’s spilling over into the real economy. And I think it’s really all the past sins of monetary policy are now coming back to haunt the central bankers.

GEORGE: We are at the edge of something really nasty. You notice that the central bank of China for the second time in 10 years raised their interest rates. I think that may have a little bit more significance than sixteen ‘¼’ points in a row. I suspect the era of exporting deflation is over in China. They’re changing their mode, in fact I wrote a little paper about this – I’ll forward it to you – they’ve changed their mode of export from deflation to inflation, because believe it or not they’re having trouble finding skilled workers. [1:41:20]

JIM: And not to mention they’re having trouble securing all the natural resources that they need.

GEORGE: Well, let’s put it this way, I suspect they’re going to be highly much more successful at doing that using a suitcase full of money rather than sending some marine to stand in your backyard.

JIM: You know it was interesting because the front cover of BusinessWeek, two weeks ago, had the front cover and it was all about Big Oil, and why Americans should be worried and the gist of the article was that Big Oil today represents the smallest fraction of global production compared to where they were 30 years ago.

And the second factor is almost 85-90% of where the world’s remaining oil reserves lie our big oil companies aren’t welcome there, so you see for example the Chinese oil company doing deals in Algeria, Nigeria. And Congressman Lugar went on a fact finding mission after Katrina and Rita after the price of oil was going up, and he was in Nigeria in these hotels, and lo and behold, he’s seeing the Chinese there, he’s seeing the Indians there, he’s seeing the Europeans there, but he wasn’t seeing Americans.

GEORGE: The Shanghai [Cooperation Organization] – the SCO – this thing that China and Russia formed about a year ago and embraced the four ‘stans in between them, in essence it was a mutual defense pact. Well, I’ve been following that and today for the first time on television they acknowledged the fact that the SCO has 4 new members. Well, how about India, Iran, Pakistan and I forget the fourth one but the point is they just joined the thing that is the equivalent of NATO. Look at all the members that already have the bomb. This is the greatest alliance of atomic bomb holders ever created. If we attack Iran now Russia and China are going to come to their defense. I think we’re ignoring what’s going on around us. [1:43:32]

JIM: It’s not only that we’re ignoring it George it’s like here’s a country – the United States – that imports 70% of its energy needs. We’re bashing our big oil companies instead of treating them like a national treasure; we’re not allowing them access – we know oil reserves and natural gas reserves here they are prohibited. And at the same time George we’re so dependent on a lot of people that don’t particularly like us and we have greater competition, you would think that we would be doing something very quickly here to try to figure out OK, let’s get nuclear working – we know that works; clean coal –we know that works, let’s try that; let’s get some wind energy. You can’t get anything like that done here.

GEORGE: It is apparent that in the history of the world the United States of America will take the prize as the country that waited until it gets backed into a corner before it before it ever does anything. We are the greatest procrastinators in the history of the world. And it’s going to hurt us.

JIM: In the meantime –and I was just reading a newsletter – to me this sounds somewhat ominous when you have Venezuela buying 100,000 barrels of oil a day – a $2 billion deal that they struck with Russia – because they aren’t producing enough oil to meet their commitments. Then you read that Saudi Arabia admits that its natural decline of its oil fields is now running at 8% a year – they’re scrambling to get as many drills as they can over there, and start trying to find other oil finds to make for what their production is doing in terms of its decline rate.

GEORGE: I’m glad to hear you say that because about 10 days or two weeks ago I heard a rumor that their rig fleet was 60% above the 5 year average, and I wasn’t going to say anything about it until I could confirm it – and you now confirmed that, thank you.

JIM: The other thing is the market got all excited and hammered oil for just a couple brief days because the Paris Energy trimmed its 2006 global oil demand growth by 10,000 barrels per day – whoop-de-doo. It is still growing at the current projection of 1 ¼ million barrels a day.

GEORGE: Well, Bernanke admitted that instead of 2% annual world wide increase it’s up to 4. That was in his speech.

JIM: Well, all I know is if you turn on the media and these problems that you and I are talking about and problems that we as Americans are now facing – I mean, I don’t think anybody enjoys paying $3 at the pump, but I don’t think they’re going to particularly enjoy when they’re paying between $5 and $7 at the pump.

GEORGE: And by the way, that is within sight, so folks better get used to it. It’s going to be a reality, it’s not going to be that long.

JIM: Now I want to talk about when we talk about buying gold stocks, oil stocks, commodity stocks I don’t see any evidence of that at all, do you?

GEORGE: Well, I’ll define a bubble for you. If the electronic media in the United States recognizes a bubble you can be sure that it is not. How’s that?

JIM: I like your definition. It’s a lot easier.

GEORGE: And if they don’t see it there’s a distinct possibility that it is there. In 1998, 99, and early 2000, you never heard the word bubble. And we were sitting on the biggest bubble ever created but you didn’t hear it.

JIM: No, it was a new era.

GEORGE: Yes, it was a new era –that’s right. You see you don’t hear them talking about the new era in commodities – you and I talk about the new era in commodities, they don’t talk about it. So we know we’re right for that reason alone. We are facing the largest increase in consumption in the history of the world. We are now facing for the first time in the history of the world finding out that there are limitations on dear old Mother Nature’s resources. Her cupboards are growing bare, while we never faced that before. If you want to talk about something new this isn’t something new it’s just a realization of the truth, but they will view it as finally something new, but for them that’s a long ways down the road till they get there. [1:48:23]

JIM: I just wonder I mean we’ve been fortunate enough over, let’s say the last decade, we’re bringing on more alternative forms of energy: heavy crude; we’ve got the tar sands; now they’re talking about shale. But George, you and I have had this discussion in the past, even if you take a look at the major oil discoveries in the late 60s – the North Slope in Alaska, the North Sea – it was a full decade before that oil was brought on-stream and we could pump it out. So even if by some miracle we could find a new large oil field that would somehow arrest a decline we were seeing through depletion you and I know that it’s going to take a long time especially today.

GEORGE: The two largest oil fields in the world –Saudi Arabia and Mexico – are under heavy, heavy water flood. They are now making 37 to 40% water cuts. If you’re a petroleum engineer you know that that’s the danger level – 40% is where breakthroughs start to occur. Well, the thing that they don’t tell us, and I know for a fact that it’s true, they have some horizontal wells up in the oil cap that are 100% oil at this time that they’re fudging in there to fudge the number down to 37 to 39. And of course, the important thing that proves is they’re lying to us again. [1:49:51]

JIM: You know, I saw an interesting statistic along those lines and that was like, for example, in natural gas – and we’ve seen natural gas get clobbered it went from 15 down into the 6 range on these so-called inventories, and you and I have talked –once again in the past – that there’s nobody out there every Friday with the dipstick that’s sinking it down the well – but what this story said is that you know what do you call the natural gas pressure that they have to keep maintaining in the well they were counting this pressurized gas in these wells as inventory when you know you can’t take that out of the ground because if you do you lose your well pressure and your production.

GEORGE: And people don’t realize how stark it is. I saw a picture of people going through the mud and the mire to get to location, I said people in the oil industry for years have batted the weather, they’ve battled the elements, they’ve battled time in order to bring energy to the world and all they get for it is criticism. I said look it’s a dangerous business, people die in the oil fields, it’s not an easy place to work. Then you get all of this malarkey –that’s a nice word for it. But there are no big new discoveries, this thing they came across down in the Gulf a few months ago the 34,000 foot well, not too far from Destin, and they drilled a well to 34,000 feet, and claimed – and I talked to everybody that was a party to it – and the ones that would talk told me it is oil we are producing. I said I never heard of oil below 16,000 feet; they claim it is. Well, of course this is what the USGS has been touting for years is going to be the savior. But haven’t heard anybody announce an offset, have you? [1:51:53]

JIM: No. So, what are they trying to do, make the case for abiotic oil?

GEORGE: Well, this was supposedly supposed to be a Miocene sand, well that’s a fairly young formation, and if they had Miocene sands at 34,000 feet and they claim they had 600 feet of pay, well, I want to see somebody [put] an offset. And until you do that you don’t have anything.

JIM: George, why don’t you explain for our listeners, because you come from a geology background what an offset is.

GEORGE: Ok. When you make a discovery well what you do is to confirm what you have is you drill a relatively close well for several reasons but not the least of which is to prove that the thing has more than just a limited extent. And besides you have to get…when you’re drilling wild cat wells you take cores, and analyze them and you learn a whole lot more with an actual core in your hand. Yes, you know, porosity and permeability but you also know the mineralogy and the clays in an oil producing are just as probably more important than the sand grains or the dolomite or the limestone. You learn a lot from core analysis and you can even determine direction, extent – a whole lot of things when you have these cores. So, when you have a discovery the idea is to get fairly quickly a very nearby location, and drill another well to confirm what you found in the first one. And everybody does it, and that’s why I want to see an offset to this big new discovery. And I haven’t heard anybody announce one. [1:53:48]

JIM: Well, you know, George getting back to oil, we’ve seen a sell-off in the price –oil is no longer at 75, it’s close to 70 but the oil stocks have been bashed, and many oil stocks are down 20%, some down 30%. And George, if you look at where the price of oil is today, I mean if we look at the 2^nd quarter this is the longer I’ve ever seen oil stay above $70 a barrel. So I would not be surprised if 2^nd quarter earnings are going to surprise a few people on the street. What would you tell an investor over the sell-off we’ve seen in commodities in the last month? A lot of investors have been panicked, many people got out, sold their gold shares, they sold their oil shares and you know, they’re hearing talk about bubble and it’s all over for commodities. What would you tell those people?

GEORGE: Well, in the long term what I do is this. I say we’ve figured out whatever this thing is we’re talking about x many years down the road is going to be at this level. Now, it’s here, substantially below that. So, we need to start to accumulate. Now, as it makes its journey from where it is now to where it’s going to be obviously it’s going to go on both sides of the straight line in between them – sometimes it’s going to be down, sometimes it’s going to be up. Well, I issued a bulletin on Tuesday with gold down at $40 and silver at $10, and I said buy. And I gave the folks two stocks to buy to take advantage of that condition. Well, when they are giving them away you must be a buyer. You may already have a whole bunch but that’s why we keep cash reserves. When opportunity is presented we want to take advantage of it. Now, I don’t care if you’re talking about gold, silver, oil gas, coal or whatever the long term trend is up. Now, if you want to hedge yourself every once in a while and I think you remember back on the 13^th of April I was on your program and I said I’m a screaming bear for the market not for commodities, well I was able to hedge my position. I didn’t sell any of my oil, gas, copper, coal, any of that stuff. Now, I did put on some short sales and I did use my proprietary system to tell me when I thought the market was topping, and you and I know that none of us get any place by doing things by ourselves, and I’ve told you in the past that I steal from the best. I’ve gotten ideas from you and during the short position I got some ideas from an old buddy of mine, Doug Clarke down in Florida that runs Torch Lake Partners. Now he’s the king of the short sellers. Well, he was kind enough to help me out. So I have protected myself, but I have not sold my core commodity positions. I mean let’s face it, back in March you and I traded ideas on a couple of low gold and silver stocks, and I know I can’t mention yours but I can mention mine- Kindrick [ph.] SK Mining. Man, all I did through this collapse was buy more. When you have an idea you’ve done your homework you understand the situation then you do what you have to do, you don’t panic, you don’t give up, you don’t change your mind, you stay the course. Is that clear enough? [1:57:48]

JIM: I say Amen to that. Well, George as we close why don’t you tell people about your website, or if they wanted to find out about your newsletter how they could do so.

GEORGE: Ok, well, just go to ZapataGeorge.com, and by the way the website’s been overhauled again, and I’ve got a young man who’s just done a really wonderful job, and he’s cross-linked everybody I think in the world, but the information is there and of course the phone number is there - I talk to folks that’s one thing I love to do, and you know I learn from everybody just like I hope they learn from me. [1:58:19]

JIM: Well, that’s great. Well, George, as always it’s a pleasure to have you here on the program, you have to come back and talk to us again.

GEORGE: Yes, you ring the phone, I’ll answer.

JIM: Ok, my friend, all the best to you and thanks again.

GEORGE: Yes sir. [1:58:36]

What do I do?

JOHN: Well, Jim, we’ve come to that part of the program when I think we need to fulfill the promise we made at the beginning of the show and that is tell those who are clenched with white knuckles out there what it is that they actually need to do in this case in the environment that we are in right now.

[Saturday Night Live]

Client: We’re entering the 4^th year of a down stock market. Is it time to sell?

Have we hit bottom yet. What can you tell small investors who are really starting to worry?

Stockbroker: Just this. Relax. The market goes up, the market goes down but over the long haul the market goes up. Yes

JOHN: Of course, that was from Saturday Night Live.

JIM: Yes, remember when Charles Schwab was running… that was a spin-off of the Charles Schwab commercials when we were going through that bear market in 2000 to 2002, and just relax.

JOHN: The markets go up, the markets go down. That was great.

JIM: But the one thing that you have to ask yourself and why we’ve been taking you through this history of inflation, what are the odds that inflation will continue given the fact that every major government in the world is inflating their money supply? And if you accept the premise and definition of what inflation is – like Peter Schiff when he came on to the show in the middle of the debate he opened up that debate with a definition from Webster’s dictionary, which is: “inflation is an expansion of the supply of money that results in higher prices.” So, the cause is expanding the money supply; the symptoms are rising prices. Now, if you accept that and then look at the money supply growth globally then you have to ask yourself are we going to see continued inflation. And my answer would be yes, there is no way out for governments now – for the US government. Debt is too big today in comparison to where it was in the past. And if you look at that the demand fundamentals, we beat this thing to death in the program in terms of what’s going on in energy but we haven’t replaced what we’ve consumed in energy since 1985. Zapata George was talking about Venezuela having to import oil, and we’ve talked about all the major oil producers that have now gone past peak production. So even the Federal Reserve trying to offload the cause of inflation is saying the era of cheap energy is over.

Bernanke: Thus the supply demand fundamentals seem consistent with the view now taken by market participants that the days of persistently cheap oil and natural gas are likely behind us. [2:01:26]

Then you have to say, “well, they’re printing money, what are the chances they’re not going to print money, there’s nothing to prevent them from not printing money.” So what you do is you hold your positions if you think you’re in a bull market. And we could do a whole new program talking about all the fundamentals of gold, all the fundamentals for commodities and energy and tangible assets; and all the studies that have been done by Harvard and Yale about commodities as asset classes itself that has gained widespread legitimacy.

So what you do is you hold your positions, and what you do is you continue to accumulate so when we get these downdrafts as we saw this week you buy on this weakness. Last week I went in and I bought shares of juniors, this week I bought silver bullion, and I’m adding to my bullion positions; I’m adding to my junior positions; I’m adding to my energy positions. And one of the things, we’ve often done this during the Dave Morgan segment is if you want to take the emotions out of your business decisions investment decisions start dollar cost averaging. Rather than saying, Ok because when you start dollar cost averaging if you’re buying shares of an energy company, well guess what you’re going to start thinking about, “aha, this month the price of the energy stock I’ve been accumulating is down this month. The money I’m going to put into the market to buy shares I’m going to buy more shares this month than I did last month.” If you’re buying shares of let’s say natural resource mutual fund, an energy resource mutual fund, an energy ETF if the prices come down and you’re saving each month what you’re going to be able to do is add to your positions this month, and own more shares than what you were able to buy with your money last month.

The other thing that you have to keep concerned about, let’s talk about debt for a minute. If you have debt, debt on your house, credit card debt or things like that, if you have more debt than you can afford to pay then you need to think of getting out of debt because if you have a house payment that’s much too large, you can’t pay for it, you either sell your house now, or you lose your house when you can no longer meet your payments. But if you have a supply of debt that you could easily manage, or you have the income or the means to pay off through either asset sales then you keep that debt because it’s manageable. What I’m talking about is unmanageable debt, and that’s where you get yourself in trouble where you have mortgage payments, credit card payments, or installment debt you have to figure out a way, either debt consolidation, go see a credit counselor, get out from underneath the heavy mortgage payment if you stepped up to a bigger house. Think about if you’ve got a lease holding on and if you’re not upside down maybe downsizing; if you are upside down ride out the lease.

And the other thing is if you’re not earning enough income maybe the wife goes to work – we counseled a couple just about a couple of weeks ago where the husband has been downsized and as a result of being downsized he’s not making the same level of income, but their kids are pretty much grown up they have one son left in high school, and the wife used to be a teacher, and she stayed at home. And so I suggested, you know, go back to teaching to supplement your income. There’s ways you can handle this problem, either cut your expenses, or find ways to increase your income or a combination of both. So you’re going to have to look at that.

And once again if you have manageable debt, you have assets to pay off the debt then if you can manage it you keep it because you’re going to benefit from inflation because inflation is going to erode the value of your debt, and especially if you’re in a position where you can see your income go up. As your income goes up and you have a fixed payment then it’s going to be much easier for you.

Then the other thing is if you have variable rate debt I highly recommend that you find a way to convert it to fixed rate debt. Maybe you do a 10 year ARM where you fix the rate for 10 years of 5 years to buy yourself some time here, but what is going to happen is we’re in a period where you’re gradually going to see the price or the cost of debt go up over time. We’ve seen a 30 year cycle where interest rates have gone up. We saw a 30 year cycle beginning in 1980 where interest rates began to come down, we’re now back to where we were when we started the rise of interest rates, and we’re going to start climbing that mountain again, so convert your fixed debt. [2:06:24]

JOHN: The hardest thing to do is it takes a certain amount of intestinal fortitude to take a position, and to say I know this to be correct and I’m going to stand here, especially when everybody else is going “moo” and running in the opposite direction, because there’s a psychology about that: “why, they couldn’t all possibly be wrong could they?” That’s what you’re thinking to yourself.

JIM: Yeah, because everybody’s jumping off the cliff, and you’re thinking you know there’s been a lot of psychological studies where they’ll feed wrong information to people, they’ll ask them a question and the obvious answer is the right answer is not what they’ll tell they’ll have like a control group and all of a sudden everybody will start giving a wrong answer, and then you’ll get the other people in the crowd who don’t know the control group is a plant and they’ll see them making the wrong decision. Their gut feeling will tell them gosh that’s the wrong decision but they’re seeing everybody make the wrong decision, so they’ll go along with the crowd even though their gut feeling tells me their decision is wrong.

And that’s really the hardest thing to do, John, is learning to control your emotions. And one of the things I think that will help you is anytime you see a sell off like you’ve seen this week, ask yourself what has changed. Just as we mentioned earlier: have the deficits gone away –the budget deficit, the trade deficit, our governments are going to print money, do we have a large supplies and surpluses of commodities? In other words ignore the noise of the marketplace. One of the most valuable lessons I learned about 5 or 6 years ago – I had a mentor who for a while mentored me and one of the most important things he taught me this gentleman was a very astute trader and he taught me learn to manage your emotions, your emotions are going to be an investment killer. And if you can’t control your emotions you’re going to make mistakes you’re going to sell when you would’ve wished you had held on, or you’re going to buy when you wished you would’ve stayed in cash or pat. So learn to control your emotions and handle it. [2:08:34]

JOHN: Ok, Jim, let’s take a real pragmatic example, physician heal thyself on Tuesday when everybody was panicking and watching what was going on what were you doing.

JIM: I actually stayed home on Tuesday now. In my study I have a flat-screen TV, and I have a four panel Bloomberg. I had my Bloomberg turned off; I had the TV on with the mute button, so I could look up, but I literally had a stack – I must’ve had research papers, newsletters and I literally had a stack that was probably 5 or 6 inches thick of stuff I wanted to get to and read. So what I wanted to do I wanted to isolate myself, I didn’t want to have interruptions. I have a sort of inner circle group I confer with, and we’re getting ready for what we think is going to be a strategic move here. And I just wanted to isolate – in other words, separate isolate all the noise –because you could see the panic that was out there – and that’s what I did. I sat back, you know the TV set was on occasionally I’d look up but I had the mute button on, and I sat home and I read the whole day. I got very focused and came away with a lot of the insights that I thought I needed but I was ignoring the panic that was going on in the street, and that’s what I think people need to do. [2:09:56]

JOHN: Well, Jim, I think we’ve stepped through the 3 stages so far, and we’ve certainly run out the time this week. What are we looking at in the weeks to come? Some interesting things as a matter of fact.

JIM: Ok, coming up next week Gary Weiss is going to be my guest he’s written a book called Wall Street versus America; and then the last week of June as promised I said we were going to have another gold roundtable. This is going to be special. Joining me for this gold roundtable is going to be John Hathaway of the Tocqueville Fund, James Turk, Lee Anne Baker, a former managing partner at Solomon Brothers, and their head metals analyst, she is now with her own firm; and then also newsletter writer Peter Grandich. And so hopefully this will be an interesting gold roundtable as we take up the issues of gold. That’s coming up and of course as we get into July we’re working on The Age of Oil written by Maugeri he’s actually an oil executive with the Italian oil company ENI. We’re also – this is the one I’m excited about because this is the one I want Bill O’Reilly to listen to: Valerie Marcel has written a new book called Oil Titans and it’s about the national oil companies that have become the key players in the area of oil. So a lot of stuff coming up and as everybody knows in August Financial Sense will go on recess, so this year we’ll be taking our usual Summer holiday but hopefully we’ll have some guests lined up. But a lot of great stuff coming forward, and I know a lot of people have been saying, “you haven’t had a gold roundtable since really you did the San Francisco gold show,” and so we thought it was long overdue and hopefully you’ll enjoy this one because we’re going to kind of bring different experts. Also one of the things I’m thinking about putting together is a junior roundtable – I want to talk to geologists and one in particular Ralph Bullis he did a study of the world’s gold fields so we’re going to do a company roundtable discussing the gold market from the company’s perspective and hopefully that’ll give you some insight. We’re also going to have a geologist talk about what are the key things to look for in junior mining stocks so we’re going to have a couple of great shows that are going to be somewhat different so I hope everybody’ll enjoy them.

In the meantime we’ve gone over time here but once again judging by all the email questions that we were getting the panic button that we were getting we thought we would devote some time and hope to put this into historical context. And once again if you wanted to follow this debate there are a number of books and people are asking what are the best books to read. If there are two books that I would recommend that you pick up is pick up debt and delusion by Peter Warburton, and that just tells you how this transference of inflation into the financial markets took place and capital market revolution that’ll give you sort of an insight into what happened in the 80s and 90s and how we got to where we are today. Then I think I would read Jesús Huerta de Soto's book and it’s going to take a while to get through because you’re going to have to digest what you read but Money, Bank Credit and Economic Cycles probably one of the best books to come out that I’ve seen from the Austrian perspective in a long time. And we’ll be sharing some of the insights.

So in the meantime on behalf of John Loeffler and myself we’d like to thank you for joining us here on the Financial Sense Newshour until you and I talk again have yourself a pleasant weekend.