Financial Sense Newshour

The BIG Picture Transcription

July 22, 2006

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• High Noon at the Fed
• Emails and Q-Calls
• Making Friends with the 'Amigo'
• Other Voices: Chris Mayer, Editor of Capital and Crisis
• Positioning for the Gain -- Then the Pain

High Noon at the Fed

Musical refrain: Bennie, Bennie, Bennie, Bennie, Bennie

[Benny and the Jets – Elton John]

JOHN: And of course, everybody is saying, “Bennie, Bennie, Bennie,” where there is one question: will they – I wish I had reverb for this – will they, or will they not, raise interest rates in August or September?

JIM: Well, in his latest testimony this week, John, you could certainly see Mr. Bernanke was sounding much more dovish, and I figured he would be, given that he’s raised interest rates two more times since the last time he was on Capitol Hill in April. And we’re getting growing signs that the economy is starting to roll over. In fact, we’re going to get to some sound clips of this week’s testimony.

However, here is something I think is more important, in recently released minutes from the June 29^th FOMC meeting, one member commented as follows:

The decision to raise the target Federal Funds rate at this meeting was a close call.

Meaning that there were a number of people saying, “if we go one more time is this the rate hike that pushes the car off the cliff?” And the minutes also showed the Fed is forecasting a slow economy. In his testimony this week in fact, Bernanke noted and I’m quoting him here:

We must take account of the possible future effects of previous policy action.

That is, of policy effects still in the pipeline – translated, he doesn’t know yet the full extent the damage the Fed has caused on the economy as a result of our rate hikes, because remember, there’s a six to nine month lag effect. So even though they raised interest rates June 29^th we may not see the full effect of that until next year. And on Capitol Hill, of course, Senators and Congressmen were becoming concerned.

SENATOR SARBANES: Chairman Bernanke, do you agree that the rate hikes over the last two years – 17 successive rate hikes – are beginning to bite and reduce long term inflation risk?

BERNANKE: Senator, as you know, we started from an extraordinarily low level of about 1%, and we had to move many times to remove that extraordinary degree of monetary accommodation from the system. I would agree that we have essentially removed that extraordinary degree of monetary policy accommodation, and we’re much more in a more normal range of interest rates at this point. I do think it’s beginning to have some effect. We are trying to judge the effect on both real output and inflation and trying to make our best judgment.

SARBANES: If there were no further rate hikes, how long do you think the negative effects of past rate hikes on growth and output and jobs would continue?

BERNANKE: Well, Senator, the forecast I gave you earlier are based on our analysis of the future of the economy taking into account the policy actions that we have already taken. So based on those actions, or actually based on appropriate monetary policy, more specifically the members of the FOMC see the economy cooling slightly relative to the last 3 years to a sustainable pace consistent with underlying productive capacity. And they also see inflation moderating to a level more consistent with price stability over the next two years.

SARBANES: If there’s a further lag between the slowing of the economy and – is there a further lag between the slowing of the economy and changes in core inflation? If so, how long is that lag?

BERNANKE: Again, our forecasts have tried to incorporate those lags. If you were asking about even beyond the 2007 forecast rise, then my guess would be that we would see some further decline in inflation in 2008.

SARBANES: Well, I’m concerned about this perception that I quoted in my outset that you know, to pause or not to pause, that is the conundrum, and that the Fed has managed to elevate a pause to something that is a pretty major event. What was normal in prior cycles up or down is now something that grabs headlines. The commentator noted the Fed paused twice in the 99-2000 cycle, three times in the 94 cycle – it elicited a yawn from the markets. This time it’s attracting enormous attention. There’s an article in this morning’s Wall Street Journal, in which they quote Alan Greenspan who made this observation after a series of rate increases: “There may come a time when we hold our policy stance unchanged, or even eased, despite adverse price data should we see signs that underlying forces are acting ultimately to reduce inflation pressures.”

He made that statement to the Senate days after the Labor Department had reported the biggest monthly increase in the core CPI since 1992. What’s your reaction to that?

BERNANKE: I absolutely agree with your point, Senator. In fact, in my testimony before the Joint Economic Committee I argued that at some point – a point which I do not specify – the Fed would have to get off this 25 basis point a meeting escalator, and adopt a more flexible approach. Possibly varying its pace of tightening, possibly taking a pause, that has been the practice in the past, that’s the practice of the European central bank, and the Bank of Japan today. They move – not at every meeting – they move based on the state of the economy, and based on the pace at which they wish to tighten. So I did make that point, I think it’s still relevant but we are looking, of course we always look at this meeting by meeting, and we will be evaluating all options when we come to meet in August.

SARBANES: Well, this development in the housing market that I showed earlier, and the drop in the new housing starts, that’s a 22% drop in a matter of months. Now, the National Association of Home Builders, which obviously would be quite concerned about something of this sort, has written to members of the committee about this. And I understand that some forecasters say that this could result in a 1 ½% drop in GDP. Now, we’ve relied on a strong housing market to keep the economy up in recent times, and now this seems to indicate a deterioration in that position.

Furthermore, in your statement on page 5, when you talk about higher core inflation, you reference increases in residential rents, as well as the imputed rent on owner-occupied homes. Now the Association of Home Builders makes – it seems to me – a rather valid point in communicating with us about this measure, saying that the weakness in new housing increases the demand for rental housing. Therefore the price of rental housing goes up, and the imputed value of the owner’s equivalent rent –which they’ re not actually paying, I mean it’s a statistical measure – that goes up, and therefore the core inflation goes up. Then the reaction of the core inflation going up is to raise the interest rates in order to check what’s perceived as an inflation problem. The raise in the interest rates intensifies this trend in the decline in new housing (available housing), greater demand for rental housing, a greater imputed value into the core inflation measure. And you have this vicious circle contributed to by the raised interest rates.

That seems to me to have some validity – that observation. What’s your reaction to that?

BERNANKE: Well, Senator, first, on your first point about housing, we are watching the housing market very carefully. I would point out that there have been some offsets in residential – sorry, non-residential construction – in exports and investments, and so other parts of the economy are picking up to offset some of the weakness we see in the housing market, but we are watching that very carefully. Your point on owner-occupied equivalent rent is a good point, and we’re quite aware of it.

SARBANES: 70% of the housing in this country is owner-occupied. Correct?

BERNANKE: Senator, what I was going to say is that – and I think that’s a good reason – that for example we use the focus more on the personal consumption expenditure deflator which puts a much lower weight on that than does the CPI, for example. And in addition, as I mentioned in my testimony the increase in inflation we have seen is a much broader phenomenon than that single component. If that single component was the only issue, I would, you know, think twice, but I do see movements in inflation in a broad range of goods and services.

SARBANES: Is it worth thinking 1½ times when you see that component doing that sort of thing?

BERNANKE: No, I’ll think twice, Senator. [9:08]

JOHN: Boy, you could just hear, Jim, the squirming that Mr. Bernanke was undergoing, you can hear the twisting, and writhing in the seat.

Basically, what I think he said was, we’ll keep raising it until everybody’s bankrupt and then we’ll quit. A good synopsis.

JIM: We’re watching, while apparently in case he hasn’t noticed, the fall in housing starts, the building up of almost 6 ½ months worth of new homes and inventory – the highest level that we’ve seen in decades. So there’s enough evidence out there that they’re causing a lot of damage to the housing sector. So I don’t know at what point they say uncle, you know maybe when 20 to 30% of the people lose their homes. [9:54]

JOHN: Yes, but you have to have some pity for them, they’re really caught in a corner here, even if they did over the years paint themselves into this corner.

JIM: Sure, they have two alternatives that they can pursue right now. The first is to allow debt growth to accelerate further in order to sustain growth in consumption – in other words, keep economic growth going. This however leads over time to far higher inflation, far higher interest rates, as well as stagflation for the economy. Or, their second alternative, the Fed actually begins to tighten in order to contain debt growth which leads, or could lead to probably the worst recession since the Great Depression. [10:34]

JOHN: Well, let’s bring it back to the question we started with, so which way are they going to go if they’re caught in this?

JIM: Well, I think the evidence of what we’re seeing develop in the economy over the last couple of years has given us a clue because there’s a lot of talk about Fed tightening, but up until they did away with M3, credit growth, money supply growth was at very, very high levels. M3 was growing at over 8% before they stopped reporting it.

And if we take a look at what they’re doing, first of all, they know internally, Fed staff economists are forecasting a much lower economic growth rate this year than what the Fed is saying publicly. [11:17]

JOHN: But basically, you really have to admit, they know that they’re messing things up here, the only difference is they don’t want to talk about it.

JIM: Sure. They don’t want to say it publicly, because I mean you just heard Sarbanes, and you’re going to hear a couple more Congressmen and Senators as we complete this first segment, people are starting to get angry. They’re saying: “What the heck are you doing? You’re killing the economy.” Well, what they’re trying to do is to have their cake and eat it too, they don’t want people to stop spending, they just don’t want the inflation effects of their monetary policy.

They could get away with that in the 90s, when you had foreign made goods that were being brought in to the United States that kept the cost of those goods down, because at the same time we had low commodity prices. Commodities –whether it was energy, copper, any type of commodity was in a bear market. So they could get away with their monetary inflation policies; and they could talk about silly things like core inflation and a low inflation rate when actually they were creating asset bubbles. They’re not in that same position now because you’ve got rising commodity prices. So, internally, they know that the economy is slowing down much more rapidly than is reported, and much more rapidly than what they are stating publicly.

At the same time, they know that credit growth is accelerating rapidly. The numbers so far this year are absolutely staggering. For example, non-financial debt growth expanded at 2.9 trillion annualized in the first quarter, that’s up from 2.4 trillion last year, or in the prior quarter (the 4^th quarter of 2005); financial credit expanded by 1 ½ trillion annualized. And so combined in the first quarter we are expanding credit now at a rate of 4.4 trillion in a 12 trillion economy. I mean that’s incredible.

Here’s another statistic. Since 2000, total debt has risen to almost $42 trillion; in comparison to nominal GDP, debt is now 334% of GDP; and it is 376% of real GDP. In the first quarter alone, it took $4.30 of debt for $1 of nominal GDP growth, and $7.50 of additional debt for real GDP growth. So, back out inflation, it’s taken $7 ½ of debt.

Furthermore, since 2000, consumer debt has risen by 70%. John, they can’t slow down. If they do the whole economic system in the United States implodes. There is really, if you look at it, no way out for the Fed but to hyperinflate. They have no other recourse. [14:17]

JOHN: They’re trying though, let’s face it, they’re trying to do this, and in the process of trying to kill some of the effects of inflation there was all sorts of collateral damage for average Americans. Frankly, there’s going to be damage on either side of this equation. Now as you’ve often said, “first the gain, then the pain.” Well, gang, we’re in the pain.

JIM: Well, let’s go to Bunning’s comments on some of the collateral damage.

SENATOR BUNNING: Do you know how this translates for the average American into higher interest rates, which the FOMC has done, into lower values on their pension plans, –this is average America – lower 401K values by billions and billions and billions of dollars. It seems like a straw horse to use higher energy costs when higher energy costs have been occurring off and on for the last…since 1974. We’ve had an unstable energy market, sometimes to the extreme of $12 to $8 per barrel, to $78 plus per barrel which it hit this past week. So that is not a real factor, that is one that is coming and going. That’s why it isn’t in the core inflation rate. These are real problems that everyday Americans are facing, and your action on the FOMC committee, and your 11 other people that are with you, deciding interest rates on a given day, trying to project 9 months down the road how it’ll affect the US economy is just breathtaking. It’s breathtaking.

Last week, a writer for one of our wonderful business publications, BusinessWeek said, if you as a Chairman of the Federal Reserve expect growth to moderate, and inflation to ease, why do you even consider another rate hike?

BERNANKE: Well, Senator, first, again, I don’t think you’ve made the case that this is not a fundamental set of factors affecting the stock market. If we had stopped raising rates at 4 ¼, or 4.50, I think there would be a lot of concern in the markets, in the economy, about inflation at this point. We’ve tried to balance those inflation concerns against growth concerns, we’re looking at both very carefully.

As far as the future policy, as I said, we have not made any future decisions. We’re going to be looking at the situation at each meeting. We do have to take into account though the possible risks as well as the expected path that we are looking forward to, because if there’s a chance that a very bad outcome might occur there is a risk management approach (which Chairman Greenspan and other central bankers apply) which suggests that you need to lean a bit against that possible outcome. But again, we’ll be looking at all the data and thinking hard about it when the time comes for us to meet again. [17:30]

JOHN: The first voice you heard there was Senator Jim Bunning, a Republican from Kentucky. I would score that one: Bunning 1, Bernanke 0, because he did not satisfactorily answer the very hard core questions there; and he even talked about things that are left out of the core rate. It was almost like accusatory – J’Accuse – you know, you leave these out because they represent a major part of the inflation.

JIM: There’s no question that inflation in average living costs have arrived. Just go to a store, go see your dentist, take a look at your medical premiums, your insurance premiums, your gas bills, your utility bills, your tuition bills, I mean the stuff that you have to spend in order to live – not the stuff that you would like to have, those are luxury type items, but I’m talking about necessary spending, and it’s not reflected in the core rate as Senator Bunning was intimating there.

The average American is starting to hurt, and that’s what this Senator was starting to express. Wages aren’t keeping up with inflation, yet any increase in wages in response to inflationary pressures, they would call that “oh, my goodness, we’ve got wages increasing now, we need to hike rates.” Yet we define inflation in terms of its symptoms, as opposed to its cause, which is Fed policy promoting rampant money and credit growth.

And we’re going to go to Barney Frank on what’s happening to the average American’s wages. [18:56]

SENATOR FRANK: I ask you with regard to…and let’s look at the productivity chart what you get is, and in your statement, it’s, well, frankly the tone is “lucky for us wages have stayed down.” I mean that’s the context of it, because in the context of your statement given the focus on inflation the fact that wages have lagged both productivity, and in fact inflation for the last year, that seems to be a good thing. And we have people writing, and you and I have talked about this, and you’ve said this doesn’t reflect you, but I think we need to make this public. In the financial pages, wages are a bad thing, increases in wages are a bad thing, and people will write, “the Fed is worried that wages may go up.” So let me ask you now, given this chart with regard to real wages versus productivity, and given as you have acknowledged that profits are at an all time high as a percentage of national income, do you believe there is room for wages to go up, at least –not at least – to the level of productivity increases without that having an inflationary impact.

BERNANKE: Yes I do, and I do expect nominal wages to rise.

FRANK: You said nominal wages again.

BERNANKE: Nominal wages to rise and real wages to rise.

FRANK: Ok, but you expect them, but you know, I don’t mean to be rude but nobody can eat your expectations. We have to eat our own words sometimes, but other people can’t get much. And you’ve acknowledged I guess in a question, you know, we were told, “well, it’s the recovery, wages are coming, wage increases are coming.” Well, the recovery is now leveling off, and wage increases ain’t been here yet. [20:23]

JOHN: I love the line there, Jim: people can not eat your…

JIM: …your expectations.

JOHN: Yes, it’s like you’ve been saying, “hey, can I pay the core rate?”

JIM: Yes, it’s like going to the grocery store and your grocery bill’s $150 or whatever it is, and you go, “well, I’ll take the core rate.” Anybody that has gone shopping in the real world knows that the core rate doesn’t apply to absolutely anything in terms of the cost of living. It is a fictitious number. It’s basically a propaganda machine. [20:54]

JOHN: Basically, Jim, it’s real clear. And this was the first time we’ve had this kind of encounter, and maybe this was why Greenspan resigned. He saw the train wreck coming.

JIM: Get out of town before the hurricane arrives.

JOHN: But are we really off the cliff here, what do you think?

JIM: I think if they go again in August that’s it. We’re going to get to this in just a second, but we’re already starting to see the fact that the economy is heading down. You need to understand, John, and our investors need to understand the make-up of the US economy. We alluded to that, for example, this heavy debt by consumers. Between 2000, and 2005, consumer spending accounted for 85% of real GDP growth; residential building roughly about 12%; the balance was made up with business and government spending. Normally over the last, let’s say half century, the breakout of the economy used to be: consumers accounted for 60% of economic growth; business fixed investment 20%; and government spending was about 20%. It was pretty much balanced until you got to the latter part of the 80s and then by the 90s the economy really began to change.

Right now, the economy is lop-sided, it’s unsound, it’s unbalanced, and quite honestly it’s been mismanaged for the last two decades. The US economy transitioned from the beginning of the 70s from a manufacturing-based economy to a service-based economy. And then in the 90s and this century it is now a financial economy. Right now, manufacturing is in recession, just look at technology, look at luxury goods sales from autos to boats to planes, they’re all down, and now look at the drop in retail sales where we’re seeing less than 2%. The consumer led economy is now going into a recession; the service-based economy is also starting to weaken. So the majority of the economy I would say is now in recession. [23:05]

JOHN: Yes, but the real difficulty when trying to convince somebody of that is that the economic numbers don’t really show what it is you’re talking about. And there’s the sort of cognitive dissonance of people trying to understand it.

JIM: Well, I think the guy on the street understands it, and I think the businessman in the corporate boardrooms understands it, because the economic numbers are highly manipulative, they’re more political numbers than they are economic numbers. Let’s start with the obvious, inflation is grossly understated. I mean give me a break – do people really think we’re only experiencing 2% inflation rates, 2 ½. And as a result of understating inflation, it overstates GDP, and GDP is also overstated because of what we call the hedonic adjustments. We also know for example that unemployment is understated because of this birth-death model, and these hypothetical numbers that the Bureau of Labor Statistics comes out with. And business investment is hedonically adjusted by the Bureau of Labor Statistics.

And what they started doing a couple of years ago –because everybody was catching on to what they were just making up hundreds of billions of dollars with artificial, bogus GDP numbers – they now suppress the publication of those absolute numbers, so it’s really difficult to find out the statistical contribution to GDP. In other words, how much of GDP is just hocus-pocus, statistical manipulation.

Furthermore, the Fed no longer tracks ranges set for non-financial debt growth which it used to report semi-annually to Congress. In a nutshell, in real terms we’re in a recession. Just look at the main components or drivers of the economy: big ticket consumer items such as autos, housing – we’re already there. [24:56]

BERNANKE: What’s significant is that this increase in core inflation seems to be a broad based phenomenon, and, so we don’t think it’s a statistical illusion.

CONGRESSMAN MILLER: When interest rates go up any person who owns an apartment complex looks at demand, and what they’re paying for cost of funds. And when you have a market that’s being impacted because affordability has decreased because every time you raise ¼% ‘x’ amount of people are driven out of the marketplace. Not only are people building homes impacted, but people who own homes are impacted. In California, it seems after the recession we experienced in the 90s, as you recall, after 89 some people in California had to wait till 2000 to have their home be worth what it was in 1989. So California’s rather trying to catch up on the stagnant 11 years we experienced there. And you had a robust housing market that has –in my opinion, based on people I know in the industry, and the industry – has solely been impacted recently because of the rise in interest rates. People are being forced out of the market. And as that happens, not only are they impacted trying to sell their home, the cost of land has remained consistent, the cost of government process remains consistent, but this equation you’re using on rents is just making the situation worse than it would otherwise have to be. And not only just rising rents, but you discussed other factors that you think have contributed to this cooling in the market. Why might those be?

BERNANKE: Well, the main factor is that housing house prices have risen at double digit rates for about 5 years, and I think that quantitatively is the main reason people have been getting priced out of some markets, and, you know, that obviously arithmetically can’t go on forever because affordability begins to bite.

MILLER: When supply and demand equal each other that’s true, but right now the demand is huge, rates being reasonable they’re having trouble producing enough product out there to meet that demand. But every time you raise these rates more people are forced out of the marketplace that otherwise, you know, if you go back a year, a year and a half, people who qualified to buy a home, today can’t even dream of it because of the interest rate hike. And I’m not trying to be argumentative but you trying to stop inflation is absolutely devastating to the housing market, and devastating to individuals who own homes who want to sell to relocate, they’re unable to do that.

Congressman Gary Miller, of California, with Ben Bernanke there. And you know it’s interesting everybody’s beginning to perceive this, Jim, especially with the fact that once we get on this band wagon you can’t get off without a lot of pain. So what is there next move going to be?

JOHN: Well, let’s take a look at what the markets are telling us, and the real key here is to take a look at the 2 year Treasury note, the 5 year Treasury note, and the 10 year Treasury note. Prior to the notes and the testimony this week we saw a peak in the 2 year Treasury rate at almost 5.28%; and all of the major interest rates, the 2, 5, 10 year, 30 year bond peaked on June 28^th. On June 28^th we had 5.28% on the 2 year note, we had 5.24% on the 5 year note, and we had the 10 year note at almost 5 ¼.

John, if we take a look at a chart, anybody that would look at that right now, we’ve gone from 5.28 to almost 5.06 on the 2 year note, and that’s a key one because that really tells you shorter term. For example, the 2 year note at the end of May was at 5%, and then it started just rising to 5 ¼ prior to the Fed meeting on June 28^th and June 29^th. So the 2 year note was forecasting or advertising another rate hike. Now, the 2 year note is advertising that rates are coming down.

The 5 year note has gone from its 5 ¼ to below 5%. It’s currently around 4.98%. The 10 year note is just about ready to touch the 5% level. So the markets are signaling that if we’re not in the ninth inning, we’re certainly going to be there after August. [29:13]

JOHN: When we talk about easing and recovery, let’s face it, it would seem that the Fed’s own internal forecasters are themselves acknowledging things are slowing down a lot faster than I think publicly everyone wants to admit. When we did this whole thing in June, we already knew it was pretty iffy, and I think if they go one more time in August as far as a raising event – don’t forget there’s an election coming up just 2 months after that – that will be it. You will have to absolutely, positively be over and at that point live with the consequences.

JIM: Yes, I think we’re right now they may be able to rescue the service sector portion of the economy if they stop right now, but I think it’s too late for the manufacturing sector. In fact, if there is a recovery the majority of that recovery is going to be in the financial sector which is the real driver of the US economy. Going back to my earlier comment with the US morphing from manufacturing to a service and now a financial economy, what the Fed does, whether it’s raising interest rates, or lowering interest rates has a much greater impact today in the financial economy than it does on Main Street in the real economy.

How many times have you heard over the last 3 years this is one of the worst economic recoveries in the nation’s history? Job growth has been anemic, industrial output has been anemic, business investment has been anemic. I think about the only thing that has been strong is consumer spending – with consumers now adding 70% more debt to their balance sheet. You know, that’s Ok in a rising asset market, but it’s not Ok in a declining asset market. So they really have to arrest this trend right now. It’s not just the rate hikes, it’s also the rise in energy prices. We’re looking at Friday where crude oil prices are at $74; we’re over 3.50 a gallon, almost on the way to $4 here in California; you’ve got rising property taxes. I mean everywhere you look people are being squeezed. [31:16]

JOHN: Well, remember, Jim, though, we’ve been talking about this here on the show, the next time that the Fed Chairman got to Capitol Hill after the last rate hike things were just going to get a little more dicey between these people, because at this point they’re beginning to hear from their constituents – whether it’s anything from something as small as property tax to houses to mortgages to state income taxes all the way up. Everyone’s beginning to feel this whole thing.

JIM: And certainly you’re beginning to see that, and you can just tell that Bernanke has been tap dancing here on both sides of the fence trying to sound tough, but you know now the attention is shifting from inflation to what’s happening on the economy. And I predict, probably towards the end of the year as this thing continues to roll over –remember the Fed Chairman’s comments that we better pay attention to the lag effects in terms of reaction to the rate hikes, already in the pipeline – we’re going to see those effects going forward in the next six to nine months. And I think at some point the Fed is going to panic as they always do, just like Greenspan did when he overdid it in 92 and 2000. He absolutely panicked and they drove interest rates from close to 6%, down to 1%. [32:30]

JOHN: Which should get real exciting at some point there if we do. Alright, Jim, let’s tie it all together. We’ve obviously done a dissection here of what the hearings were this week. If we have to summarize it all up why don’t you do it in bullets for us.

JIM: Ok, key points. [There is] an unofficial recession in the main economy, [but] because of the way we jerry rig our statistics it won’t be reported until well after the election. Consumer dominance of the US economy is mainly over. The consumer is tapped out, without another series of asset bubbles there’s just no way to maintain consumption to drive the economy. Business investment will not rescue the economy. Business is buying back stock, I mean just take a look at Microsoft’s 40 billion stock buy back; Cisco, Pfizer and Coke this week all buying back their stock. And if they’re not buying back their stock they’re buying back other companies which means the equity base is contracting, but also means they’re hollowing out the economy; they’re not building new plant and equipment.

The gist of all this now is it’s time to rebalance your portfolio. We’re heading into a whole new cycle here that’s going to be different – a staginflationary cycle. And you had better be prepared for it. And the gist of all of this, in all of the comments, there’s only one guy on Capitol Hill that got it in terms of what’s causing inflation. It’s not economic growth, it’s not oil prices, it’s the Fed’s policy. Let’s end with Ron Paul:

SENATOR PAUL: But if you accept the principle that it seemed to be in this quote, that if you’re worried about inflation, you slow up the economy and then inflation is brought down, it’s lessened, it infers that inflation is caused by economic growth. And I don’t happen to accept that because most people accept the fact that inflation is really a monetary phenomenon. And it also introduces the notion that growth is bad, and yet I see growth as good, whether it’s 3, or 4, or 5, or 6. If you don’t have monetary inflation you don’t need to worry, because if you have good growth in the market place rather than artificial growth, that it is this growth that causes your productivity to increase. You have the increase of productivity and it does help bring prices down but it doesn’t deal with inflation.

And I think what I’m talking about here could relate here to the concerns of the gentleman from Massachusetts about real wages. There’s a lot of concern about real wages versus nominal wages, but I think it’s characteristic of an economy that is based on a fiat currency that is losing its value that it’s almost inevitable that the real labor goes down. As a matter of fact, Keynes advocated it. He realized that in a slump that real wages had to come down, and he believed you could get real wages down by inflation, that the nominal wage doesn’t come on, keep the nominal wage up, have the real wage come down. It sort of deceives the working man, but it really doesn’t work because ultimately the working man knows he’s losing, and he demands cost of living increases. So, could you help me out in trying to understand why we should ever attack economic growth. Why can’t we just say economic growth is good and it helps to lower prices because it increases productivity?

BERNANKE: Congressman, I agree with you, growth doesn’t cause inflation. What causes inflation is monetary conditions or financial conditions that stimulate spending, which grows more quickly than the underlying capacity of the economy to produce. Anything that increases the capacity of the economy to produce, be it greater productivity, you know, greater workforce, other factors that are productive, is only positive – it reduces inflation. [36:30]

Emails and Q-Calls

JOHN: Ok, Jim, time to do some emails. This first one here I rather like, I found it rather cute. Mike in Canada wrote:

Dear Jim, quote, “there’s nothing to replace oil.” Wrong, this is completely false. You obviously don’t want any alternatives to oil, the major one being ‘just say no’ to the mall, useless driving, big cars, useless products, etc., etc. There’s dozens of alternatives to oil.

- at this point the economy just collapsed, but I won’t go into that. He recommends:

…smaller cars, less cars, more mass transportation, less travel, less manufactured useless items, staying home, growing your own food, move to the country from the city, end to globalization, nuclear power, wind power, solar power, organic oils, less military adventurism, less immigration, less population expanse, etc., etc.

Let me add your bit with the astrologer was embarrassing. Yikes! I can’t understand why you’d have him on. Hear we have the age old problem that has stumped all the philosophers namely the problem of causation. Simply because ‘x’ happens at the same time ‘y’ does, or after, or before does not mean it cause it. This is also called in logic and philosophy the post hoc fallacy. It seems most people cannot figure this out. This is the fallacy in your guest’s position.

And I don’t know if he’s listening to the same show we’re doing here, but I thought you wanted to invest in alternatives, and we’ve been talking about the need for nuclear power and alternatives, and deregulating enough to let us get them in there. I could swear we were talking about that on this show.

JIM: Mike, maybe you’re a new listener, but if you go back over the last 3 years, windpower, nuclear power, solar, mass transportation, better fuel economy, diesel – we’ve been talking about that here on this program for the last 3 or 4 years. And you know what? I’ve read over seventy books on peak oil from the experts, to everybody on every side of the fence, and one of the most common messages that comes across is that yes, if we started and we had 20 years to do this we could probably start putting in some of the changes that you’re talking about. But if you look at the United States; you can’t put up a wind farm; you can’t put up a large solar array; it would certainly take at least a decade to get permits and build a nuclear power plant; or even build a refinery to process alternative fuels. So you’re not listening to this program correctly.

And as far as Arch Crawford, well, he studied under Bob Farrell at Merrill Lynch – one of the best technicians out there. He’s been in Timer’s Digest; and he’s listed on a number of different, important programs where he’s appeared. And he had one of the best timing records. So we do bring people with different perspectives which seems to rile some people. Not everybody likes technical analysis, not everybody likes fundamental analysis, not everybody likes investing; a lot of people want to be trading. But we try to get different viewpoints on to this program, and we’re going to continue to do that.

I would recommend, however, you go back and listen to previous programs, because it sounds like you’re a new listener. [39:57]

JOHN: The things that he recommended are not bad, but I don’t think people understand is the bottleneck that we’re in; and that, as you said, trying to get these things online over the next 10, 20, maybe 30 years is going to be very difficult to achieve. The other thing is that people don’t realize is the depth to which oil technology penetrates Western culture. And to remove that just collapses it overnight. So you can’t just do this instantly, and you can’t do it by disregarding the economy.

Let’s go to the Q-Line. This is an audio line we have here, it’s available 24 hours a day – sounds like radio doesn’t it – 1-800 794-6480. That number is toll-free in the US and Canada, it does cost if you call from anywhere else in the world, but it does work. Here’s the first one:

Tom, from Tennessee. I enjoy your program, guys, keep up the good work. What do you think about copper, zinc, mining stocks during this downturn. Paying in, keep, sell? Thank you.

JIM: I would say right now that the base metals are going to have far further to go on their corrective cycle here. I would be more interested in picking up gold and silver equities at this point. That to me appears more attractive. If you look at a lot of the base metals such as copper and lead, zinc, nickel – many of them have had a far stronger run up in their price than the metals markets have, so I tend to be more biased right now towards the metals, Tom. [41:24]

JOHN: And James, in Aurora, Ontario, Canada said:

I enjoy your weekly broadcast very much. I got a big laugh from your Return of the Jedi theme.

You have to be crazy to do some of these, Jim, but we match that description.

Hello Jim and John, this is Paul from New Jersey, and I have a question for you folks. I have committed a large part of my portfolio to energy and more specifically, alternative energy, given some of the analysis that I’ve heard on your program over the past several months. I have become a peak oil enthusiast and I’ve done a lot of my own research.

Now, I’m a bit concerned, however, your recent comments concerning getting defensive and having to do with investing in stocks having a low beta. These alternative energy names, if anything, do not have a low beta, and my portfolio’s kind of getting hit pretty hard lately. They’re basically invested in themes on uranium, coal, coal-to-oil, solar, wind power, geothermal. And these are names that have had quite a run over the last 18 months to 2 years. My question to you is do I go to cash, or do I hold these names? I’m very, very willing to hold them over the long term, but just seeing some of them drop by 10% in one day, for example, is really disheartening. I’d be very interested to know what you guys think in terms of is this the right time, or should I just go to cash? Thanks a lot and love your show. Jim you’re doing a great job. And John, Jim couldn’t have picked a better guy as a moderator.

Jim, I just can’t thank you [enough] for the day that you bailed me out of Happy Acres, too.

JIM: Well, Paul, first of all, one of the things is you’ve chosen the more high beta stocks in the energy sector. The uranium stocks, unless you’re in the big major are very, very high beta. You know, a lot of those stocks have beta of two or more; and I don’t know, some of the coal stocks tend to be on the high beta side too. We like a lot of the low beta energy stocks; we like the international stocks – the Exxons right now.

But you’ve got to be real careful in this recent run up here, in the sense that this reminds me very similar we’ve seen last year with the hurricanes – where we had the big run up in the month of September and then a correction. I’m looking at all the major ownership positions of all the major low beta stocks, and every fund manager has been selling out of– or cutting back – on their positions. And that has been one of the reasons why you’ve seen a little bit of weakness. But you may want to add to your portfolio, and do some substitutions here with some low beta stuff. I like the royalty trusts here, especially the natural gas royalty trust; I like the internationals – you take a look at, for example, Occidental Petroleum just increased their dividend 44%. That’s what I like about some of the big majors, and some of the low beta stocks: there’s less of a risk level.

However, you said something that was very key to me, you said you were willing to hold long term. If you are a long term investor then sit back, ignore the sell off that we’re going through now, because if you’ve done your research on peak oil you know how important those alternatives are going to be, and especially when the world wakes up to peak oil. However, if you want to add to your position I would add some low beta stuff. [45:05]

JOHN: Laurie is in New Sydney, New South Wales, Australia:

Hi Jim and John, enjoy your program every weekend, and I’m now starting to think of setting up a group called FSN Addictions Anonymous. I have tried getting a life, as you both suggested, but the events happening today are better than any John Le Carre or John Grisham novel I’ve read. I simply cannot stop listening to your show every week, as you leave me in so much suspense that I need to hear the next installment of the global econo -political-mafia soap opera, and how the US military-industrial-entertainment comlex will react.

Anyway, I have a question for both of you about gold and silver. I would like to know how well gold and silver will do in a deflationary economic scenario? I understand cash will do well in a deflation but how about gold and silver? How does that work?

JIM: Well, the major deflation that we saw here in the United States, and I’m just speaking from that experience, because most economic cataclysms –with the exception of Japan – have been more inflationary. I’m talking about Argentina, Turkey, Russia – a lot of the things that you’ve seen globally around the world with too much debt and currency problems. But in the 30s deflationary period, where you had financial collapse of almost a third of our banks, gold and silver did very well. In fact, the insiders such as Bernard Baruch, Joseph Kennedy, Crapo Durant, a lot of the Wall Street Bigwigs had sold their positions out of the market. Jessie Livermore. I know for example Bernard Baruch did very well by investing in gold. In fact, had you invested in companies like Homestake Mining, you put $10,000, you got back $10,000 in dividends, and your investment was worth almost 7 to 8 times more than what you put in. Gold does very well in deflation, and inflation because it’s real money. In deflation where you would have a financial crisis, gold responds well because people are looking for real safety, especially when you have credit collapse, or a lot of bankruptcies and defaults such as we had in the Great Depression. [47:11]

Making Friends with the 'Amigo'

JOHN: Well, Jim, let’s ease into the next subject with a story. You were in Vancouver, British Columbia, this week, and something interesting happened to you.

JIM: It was interesting, John, I was up in Vancouver over this week for a board meeting, and I’m involved in a company that’s doing development work down in Mexico, and because we raised our money in the US markets, and the Canadian markets to fund it, that’s where we raise our money, but our expenses are incurred in Mexico. So we have to pay a lot of attention to currencies because every month we have huge payroll bills, and we have to pay the drilling contractors. And so we have to move money around to shift and in some ways we have to follow the currency market. And a couple of the board members were sort of complaining, and I said, “well, you know, that’s all going to get easy in the next 3 years, as they merge the 3 currencies: the Canadian dollar with the US dollar and the peso.”

And John, the look I got – it was just like I had put a Martian cap, and just landed from outer space and said, “I want to eat you people.” I mean they looked at me like where did you get that idea. And that it became sort of a heated debate on items like I want the dollar, why in the heck would I want a peso. And I said, “guys, they’re working on it.”

And anyway, I was telling these guys, I said your former Prime Minister Paul Martin signed this agreement with George Bush and Vicente Fox, and your current Prime Minister, Stephen Harper has been going back and forth to Washington, working on this. And so they just found this incredible, like where in the heck did you come up with something this idiotic. [49:01]

JOHN: Well, we’ve also received emails on the subject asking for more information about the proposed North American currency which is officially going to be called the amero. That may change by the way, just like the euro went through several generations before it arrived. We’re calling it the amigo, here. But it’s tied into an agreement between the US, Canada and Mexico called the Security and Prosperity Partnership. One of the emails said that we’re the only people talking about it. Well, we appreciate the flattery, but that’s not quite true.

LOU DOBBS: The Bush Administration’s open borders policy in its decision to ignore the enforcement of this country’s immigration laws is part of a broader agenda. President Bush signed a formal agreement that will end the United States as we know it, and he took the step without approval from either the US Congress or the People of the United States.

That was the voice of reporter Lou Dobbs, in a recent CNN report. A couple of years ago, Americans were caught by surprise when Mexico suggested the border between the US and Mexico be abolished. And of course, everybody is well aware of the border problem now. There was a small stir of indignation in the US given the ongoing immigration debate. It was also assumed this was just another round in the dispute. However, if you’ve been following the quiet discussions under way during the 1990s this would not have been so surprising. And by the way, if you didn’t hear about it don’t feel badly, because these ongoing meetings have been secretive, and until recently only an occasional article appeared here and there in various newspapers. [50:37]

JOHN: Well, that was until March 23^rd, 2005 when everything took a major lurch toward, when President George Bush of the United States, President Vicente Fox of Mexico, and Prime Minister Paul Martin of Canada signed the Security and Prosperity Partnership in Waco, Texas. Now what this did is create multiple committees who have come into existence to hammer out the details of an action plan in about 24 months, and have the entire plan locked into place by the year 2010.

JIM: A follow up meeting occurred 3 months later in Ottawa, Canada on June 27^th of last year where the US representative, Homeland Security Secretary Michael Chertoff told a news conference that “we want to facilitate the flow of traffic across our borders.” That’s a direct quote. The White House issued a statement that the Ottawa report represents an important first step in achieving the goals of the Security and Prosperity Partnership. But now comes the question: what is the SPP? [51:35]

JOHN: Well, funny you should ask that. Shortly after the meeting in Waco, Texas on the website of the Council for Foreign Relations in New York was released a 59 page report of exactly what was discussed in Waco, which gives us some hints.

JIM: The plan spells out a 5 year plan for the establishment by 2010 of a North American Economic and Security Community with a common security perimeter, and a substantial number of working groups to work out how this and other details of the plan are going to be accomplished. This is to lay the groundwork for our freer flow of people within North America – forget the border issue, guys – a common security perimeter requires us to harmonize visa and asylum regulations with Mexico and Canada, harmonize entry screening and fully share data about the exit and entry of foreign nationals.

This sounds suspiciously like the EU to me, John.

JOHN: Yes. And the plan also calls for calling a ‘North American preference’ – that’s what they’re calling it – so that residents of any of the three countries can work anywhere within the three countries.

JIM:It also calls for massive US foreign aid to other countries, notably Mexico. The burden on the US tax payers will include so-called multi-lateral development from the World Bank and the Inter-American Development Bank, long term loans in pesos, and a North American Investment Fund to send US private capital to Mexico. [53:01]

JOHN: And it calls for allowing Mexican trucks unlimited access to the United States, including the hauling of local loads between cities. It calls for the regulation of virtually everything from food to pharmaceuticals to – well, just think of anything you do, and it’s somehow included in this. Congresswoman Katherine Harris has introduced legislation in to the house which has similar language to this –this is how it’s done by the way – to provide for the US to defend Mexico’s Southern border. That’s Mexico’s Southern border, by the way.

JIM: Here’s a key one, too. The plan also includes implementing the Social Security Totalization agreement, negotiated between the United States and Mexico. That’s code language for putting illegal aliens into the US Social Security system. US taxpayers are supposed to create a major fund to finance 60,000 Mexican students to study here in the US at US colleges. [53:34]

JOHN: Now, all of these details are pretty sketchy as the plan was basically thrown down as a framework for discussion. Most of the details have been left to all of these working committees to fill in. But you have to figure out who wrote the original agreement. After all, when we go back 10 years, and we look at NAFTA, which was over 20,000 pages long, it was most certainly not written by Congress, and it wasn’t done so overnight.

JIM: Another member of the task force was American University Professor Robert A. Pastor. He presented a plan to forge a North American community at a hearing of the Foreign Relations Committee, chaired by Senator Richard Lugar on June 9^th. His theme was that instead of stopping North Americans on the border we ought to provide them with a secure, biometric border pass that would ease transit across the border like an easy pass permit our cars use to speed through toll booths. Pastor provided documentation that proved that President Bush is a staunch supporter of the North American integration even though lately the President has been trying to deny this – [but] this is what the SPP is all about, but he’s also the founder of the amero. [55:02]

JOHN: And perhaps the one reporter who has investigated the SPP the most is Dr. Jerome Corsi who appears on Fox News and has written on the subject for Human Events magazine. I managed to contact him a couple of weeks ago, and here was his take on the SPP:

JEROME CORSI: The problem, John, is if we take a look at the spp.gov working committee, there’s over 20 of them that appear to be organized, and they cover everything from ecommerce, through trade, textiles, any kind of regulation that put products together, steel, energy, aviation, travel, health, environment. I can’t think of an area that one of these working groups does not cover.

And they draw in officials from all the agencies participating in these working groups. There are people from Department of Transportation, Health and Human Services, Homeland Security, you name it. But, yet, nobody knows about them. And the regulations they’re making, even if you look on spp.gov, you’ll see that they’ve got memoranda of understanding, declarations of agreement, trilateral agreements. And they’re making these regulations right now, creating the regulatory structure we’re going to live in for this North American union. [56:14]

JOHN: And then basically these will either be put into effect by our own regulatory body which will simply adopt the recommendations, or in some cases they will have to proposed to Congress, or the Mexican Congress, or something like that, which will then basically rubber stamp it after a limited amount of debate. That seems to be the way these things are going.

JEROME: If it has to at all presented to Congress – I don’t think there will be any presentation to Congress on most of this. And if there is it will be very limited without disclosing to the American Public or even to Congress that the intent is to create a new government structure, which is the North American Union. I mean right now I’ve been up in Congress the last two weeks talking with Congressmen – House of Representatives. Nobody knows about spp.gov.

And I’ve sat down with Congressmen in front of their own computers and showed them this stuff and their jaws drop. They had no idea the executive branch of government under President Bush is doing things like opening up our aviation system to Mexico and Canada. People don’t even know about it. And once we have a North American Union with a new currency which will probably be called what Robert Pastor – who’s probably the architect of much of this – a Professor at American University, it’s probably going to be called the amero, instead of the dollar.

John, you’re going to have a North American Union passport, you won’t even need a US passport, you’ll have a North American Union passport, and a biometrics card. And so will every Mexican. And with that passport card, they can go anywhere. There won’t be anymore illegal immigration because this North American Union out of the Security and Prosperity Partnership will erase the border. And like Vicente Fox said, they’ll be residents of North America and they can go work anywhere they want, and claim that we’ll pay their benefits if they come hear to live – all their social benefits, educate their children. It’ll bankrupt the middle class. [58:07]

JOHN: Well, that was Dr. Jerome Corsi, whose articles appear in Human Events, and you’ll also see him on Fox News from time to time.

Now, if you recall this whole immigration thing, Jim, there’s one figure that stands out as being in the center of the storm over immigration reform. Who would that be, if I just tossed that out to you?

JIM: Gosh, the first person that comes to mind is Congressman Tancredo.

JOHN: Yes, he’s been a high profile critic of the Bush Administration’s failure to support immigration law. So I thought, well, Ok, maybe Lou Dobbs is a little whacked, maybe Jerome Corsi doesn’t know what he’s talking about, let’s see if we can reach Congressman Tancredo. And I did. He was in the Congressional cloakroom on his cell phone, and here’s what our discussion sounded like:

TOM TANCREDO: The issue is not one that is being advanced surreptitiously, they’re very up front about it. We’ve actually written the SPP and asked them for all of the documents that they have that are pertinent to the organization itself and to its mission. It’s part of the Department of Commerce. It’s set up to advance the idea that we will be moving little by little, sometimes slowly, sometimes quickly, towards the creation of the Northern and Southern hemispheric economic bloc. The first stages of it were of course NAFTA and CAFTA – the North American and Central American Free Trade Agreements. The last step in the process, at least for North American, for both continents will be the Free Trade of the Americas.

And at that time you’ll have in place then a model – I mean something that has been modeled after the European Union where we will have these trade agreements that will include political arrangements that will allow for the free flow of goods and services and people across borders. Of course, with these economic models, come political arrangements, similar to what has happened in the European Union, where when it started, virtually most Europeans thought to themselves that here was simply a grouping of states for the purpose of reducing tariffs, and had no idea that it would lead to the creation of what they have today which is the European Parliament which taxes everything that is sold in Europe, that passes laws – recently passed a law saying the United States cannot trace the assets of potential terrorists, or terrorist organizations. [1:00:41]

JOHN: Through all of these – they should be treaties but we call them agreements. We’re really turning control of our governance to unelected, unaccountable, faceless bureaucrats. We don’t even know who these people are.

TOM: That’s right, and you do know why they’re called agreements and not treaties.

JOHN: So they don’t have to be ratified by the Senate.

TOM: That’s absolutely right.

JOHN: And the flip-side of that is now in trying to find out what’s going on with the Security and Prosperity Partnership, it’s being done behind closed doors and they won’t tell us what’s going on. You’re not the only one, but at least you have a little of the weight of the Congressional office there, right?

TOM: Believe me, that has proven in the past not to be all that significant. But then they can tell you to, you know, go fly a kite which is sometimes what they do. But like I say, they say it quite clearly through the reports developed and distributed by the Council on Foreign Relations after the last summit, that the next steps were the creation of this common currency, and the creation of what they call a ‘common defense perimeter.’

I’m a member of the Canadian-American Parliamentary Exchange, and every year we meet, once here, the next year in Canada. And it used to be the only thing we argued about for the entire weekend is softwood lumber, but that has changed and now all we argue about is the creation of the passport system which we had hoped to be in place by the end of the year, requiring everyone, including Canadians in the country without a passport, and they don’t want that. And they keep saying, “why should we be doing that when in fact we’re beginning to integrate our immigration systems.” And that’s all we’re going to need, they say, is an integrated system. If we both had the same system and both had the same concerns about people entering the country then we don’t need a border between the United States. [1:02:33]

JOHN: That was a conversation between Congressman Tom Tancredo and myself.

Let’s go back to that Lou Dobbs report that they did on CNN recently.

BILL TUCKER: When I called them today, Lou, they said I was the first phone call they had received literally since the deal was first signed.

So people are not paying attention, and they’re letting them in fact get away with this.

What I think Bill Tucker didn’t notice from CNN is that’s a fairly common, standard, bureaucratic answer that politicians give – especially educrats by the way – when they’re caught with their hands in the cookie jar. They say, “why, you’re the first one to call on this,” when in reality you know 20 other people have called.

Probably the biggest issue about the whole thing is that it’s being done behind closed doors, and only when it’s finished will it be presented to Congress, Parliament in Canada, or the Cámara de Diputados in Mexico for rubber-stamp approval.

JIM: You know, our best indications at this point are that the SPP is following what is known as the Monet process which was devised by Jean Monet and used to create the European Union. It recalled John that when the European Common Market was established, the proponents responded to the accusations that a super state was in the making were unfounded – and this was just a trading agreement. But here we are following the exact blueprint. [1:03:39]

JOHN: Right, and Monet’s basic premise was the first thing that you don’t do is to tell people where you’re headed from the start, you break it all up, you chop it up into little things that are debated so people don’t have any idea of what the end game is. You simply want to move them in stages.

JIM: So if you’re really going to follow the Monet process here is what we can anticipate as things begin to move forward. And it looks like they’re doing it rapidly. First, establishment of a free –read ‘managed’ – trade area between the three countries and strong, inseparable economic ties. That is what the 2010 target is all about. [1:04:24]

JOHN: Then borders will be open and a common monetary policy will be established. This is where the amero comes in. Now as to exactly when this might be implemented for those of you who have written us emails, understand it’s theoretical and remains to be seen, possibly they’re even anticipating the death of the dollar, but we don’t know yet. Obviously, Europe had to go through an exchange rate mechanism period for a while, trying to lock the currencies together – remember they went through the AQ which fizzled and was replaced by the euro.

JIM: And harmonization of the judicial systems and laws of the three countries comes next. This is done by means of agreements, not treaties, to avoid the constitutional necessity of having the Senate ratify with a two-thirds majority. Then the Congresses and Parliaments of the participating countries must comply with, and modify their respective laws, to match the agreement in a rubber stamping process. This is an end run around the Constitution. The US Constitution at this point no longer exists. [1:05:23]

JOHN: Stage 4 of the process, of which there are 5 stages, there’ll be a united foreign policy, and then this will be administered from a central authority that is not germane to any of the capitals of the three countries. This is pretty much the same as what’s been going on with the UN’s pursuit of a common foreign policy.

JIM: And finally when everybody feels comfortable with the agreements while leaving the governments of the member countries intact, a super national governing organization will be created including – and get ready for this – taxation, regulation, and possible military power. This really becomes an authority in and of itself to which the member countries will be bound. This is the Monet plan as it unrolled in Europe and we seem to be following the same path. [1:06:06]

JOHN: And I guess time will tell whether or not we are right. One thing is certain we are changing the form of our governance without the consent of the governed and most people are –as many of the people have said – unaware of what is going on right now. But that’s the answer to the amero and what the Security and Prosperity Partnership is about – as best we can tell today.

JIM: Now, a lot of these people are probably, you know, if you’re listening to this for the first time, you probably had the same look on your face as the board meeting this week. But remember, here on Financial Sense we try to stay ahead of the curve to keep you informed. Remember, you thought we were nuts talking about gold in 2001, or oil in 2002. Admittedly, we were ahead of the curve but nonetheless look what happened. [1:06:52]

JOHN: I think the question that we ask here is not is it politically correct, or common knowledge, we ask is it true. And that’s what you do when you try to be cutting edge.

And coming up now, it’s time for Other Voices, and this week we have Chris Mayer on.

Other Voices: Chris Mayer, Editor of Capital and Crisis

JIM: Well, everyone’s aware of higher energy prices and the crisis the world now faces in energy, with demand outstripping supply. But there’s another crisis brewing in another valuable commodity called water. To talk about that issue, joining me on the program is Chris Mayer, he’s executive editor of Capital and Crisis. Chris’ articles have appeared on the Mises Institute, LewRockwell.com, Prudent Bear, and Grant’s Investor.

Chris, this is an issue that is not far behind the energy crisis, but yet there’s very few people talking about this.

CHRIS MAYER: Right. Especially in this country. You talk to people, they’re very skeptical when you talk about an emerging water crisis, and they say, “What? What are you talking about?” And they turn on their taps and get water, at grocery stores, and they don’t have any problem with it. But internationally getting clean water is a big problem, especially in China, India, and South America; there are water problems in the Middle East, of course; parts of Africa it’s a big problem. And really when you look at how deadly it is, some of the statistics are really surprising how many people die from being exposed to contaminated water. I read one stat the other day that half of all the hospital beds in the world are occupied by someone suffering from a water related illness. [1:08:32]

JIM: The amazing thing about this too I read some statistics recently where in Nevada the water tables are dropping at one of the major dams, and if that happens you’re going to lose hydroelectric power. Here in Southern California, where California has 11% of the nation’s population, we’re going literally hundreds and hundreds of miles to secure water, and yet the population still is growing in this state. And in the Pacific Southwest with the drought occurring currently I don’t think people are aware that some day we may be close to water rationing.

CHRIS: The Colorado river is heavily overused, and in some stretches it’s actually saltier than the ocean, and you mentioned Las Vegas that’s a classic case in Nevada. You look at a [city] like Las Vegas and the population is growing 20% or whatever it’s grown in the last 5 years they have big problems procuring water.

In this country the water issue is more of an infrastructure problem, it’s getting water to where it needs to be. [1:09:41]

JIM: And what about those areas where if we look at the population movement in the United States there’s been a migration from the East and Midwest to the Southwest, and the Southwest doesn’t have a lot of water.

CHRIS: Right, this is a problem in a lot of parts of the world where you have population growth happens to be in those areas where the water supply is not particularly robust. The American West is a classic case, but also in China we have a large part of the population is in the North where it’s relatively dry. You also see this in South America, places like Peru; they have water problems, most of the population lives along the West and on the coast where the watershed is mostly on the East on the other side of the Andes. So you have these problems where supply and where population is not growing where Mother Nature put all the water. [1:10:34]

JIM: You talk about it being an issue of getting the water to where it needs to go here in the United States, but if you take a look at whether you’re taking a look at the Middle East, China, you’re looking at Latin America, it’s an infrastructure problem. And yet as we’ve seen recently in the headlines, Chris, Latin America seems to be going back to its leftist roots. Sort of what led to disasters in the 70s and early 80s. In terms of handling this problem, I’m not sure the way Latin America is going right now that this issue is going to be solved.

CHRIS: And in South America, that’s an area where we really don’t have a physical shortage of water, it’s an economic shortage and this is a good distinction to make because in some places you have a physical shortage of water. So, Australia’s one of those places where there isn’t a lot of water relative to the population, and yet 99% of the people have access to clean drinking water. Whereas if you look at India, there’s this city in India – the name escapes me for the moment – but it is officially the wettest place on Earth and yet they have recurrent water shortages. So, it’s as much a crisis of governance as an actual resource constraint. So in South America where we have a tilt leftward by a lot of these countries that is contributing to the problem not solving it.

We know that there are a lot of examples where even in South America where the water problem has been handed over to the private sector and it’s been a big success. In Chile, for example, they privatized their water, and I think their statistics were only 25% of the rural population had access to water, and maybe 64% in the cities, but now since they’ve done the privatization those numbers are all in the high 90s. And the water supply has grown faster than Chile than in any other country. We also see the same kind of things happening in Colombia, where there are a couple of big cities in Colombia that handed over the water systems to private enterprise, and have really changed the whole water problem for the better. [1:12:47]

JIM: You can only promise the people something without delivering for a short period of time, but if you can’t turn on the tap and get running clean water or the people are getting sick, there’s a demand by the population to get something done. Is there a growing recognition within governments, maybe with the exception of certain Latin American countries, that turning to the private sector is the solution?

CHRIS: Yes, I think there is. And I think it’s really the government’s hands are being forced in this area because the amount of money required to build out the infrastructure is just enormous. Even in the US, there are hundreds of billions of dollars that have to go towards our water infrastructure. And in fact, if you just look at the EPA’s estimates of drinking water replacement needs, the number is a staggering – $277 billion is their current estimate. These estimates range all over the place, but they continually get higher and higher. And so you look at the United States, there’s 50,000 water systems in this country and most of them are very small, they’re run by municipalities; there’s been a long period of underinvestment. And so there’s a lot that needs to be done there, and rather than raise taxes and do the politically unpopular thing, it’s easier for them to sell to an investor-owned water utility, for example, to bring in private enterprise to help solve the problem. So we’re starting to see that.

And this is part of a much bigger trend because we’ve seen it in water, but we also see it in a lot of infrastructure projects, as only a couple of weeks ago I was reading about how the city of Chicago is going to sell Midway airport to help solve their budget crisis. And they’ve already sold the Skyway toll-road for 1.8 billion. So this is a big trend. I think we’re starting to see the beginnings now. [1:14:38]

JIM: You can certainly see that here in the United States. What’s the best way to play the water infrastructure play or the water shortage play, because at least from my perspective, for example, some of the water utilities in the US are a little bit on the high side in terms of valuation.

CHRIS: They always appear to be expensive. If you look at returns over the last 5 years or 10 years or 25 years they’re really amazing numbers, they just crushed the market. And so there may be some of the smaller ones are not so bad, but they’re definitely not cheap in any kind of classic sense. There is one I like a lot though is San Jose Water – SJW – and they have a lot of real estate and land holdings they inherited back from their 19^th Century roots. So that is an interesting play and I wrote about that for my subscribers recently.

The best way is to look at some of the other infrastructure companies – some of the companies that make the pipes and the pumps that are going to be used to rebuild their infrastructure. And even overseas – a company that has some exposure overseas, so you could look at the pump company there’s a little one called Gorman Rupp, another one called Pentair, Flowserv, these are all pump companies that have a pretty nice looking future – decent businesses. And you can also look at some of the pipe companies, they’re actually involved in water transmission, there’s companies that do irrigation equipment. It’s really – it’s a big, big sector.

When you start to look at the water industry you realize it’s not an industry in a classic sense, like if you were looking at homebuilders they’re all pretty much the same, but when you start looking at the water industry you see filtration companies, you see the pipe companies and they all have different dynamics. So it’s taken me quite a lot of time to get through it all, but I think the opportunities in this sector are going to be pretty big. [1:16:32

JIM: If you’re looking at this sector as an investment, Chris, don’t you think it’s important that investors think long term? So much of what you see going on in the market today is very short term trading oriented but when you’re talking about infrastructure plays, whether you’re talking about energy or water, you really have to think in terms of being a long term investor.

CHRIS: Absolutely, I agree with that 100%. You can’t expect to trade these things. In some ways, we’re still early on in this whole water crisis, so it’s going to be a story that unfolds over many years. And you want to do your research in this space, find some good companies, and you want to hold onto them – you want to let it work out. [1:17:14]

JIM: Well, Chris, if our listeners would like to find out more about your newsletter and get information about what you do, please give out your website.

CHRIS: Yes, I’d head over to www.dailyreckoning.com, it’s a free site there’s a lot of information there – a lot of essays – and you can find out more about my letter: Capital and Crisis.

JIM: Chris, I want to thank you for joining us on Other Voices, this week. I hope we can talk to you once again in the future.

CHRIS: Thank you very much for having me on.

Positioning for the Gain -- Then the Pain

JOHN: Well, as we have always long said here on the program, first you have to gain when you’re going into inflation, and everybody has a good time, and then comes the pain, and nobody wants to have a bad time. But where do we go from here, Mr. Puplava?

JIM: Let’s talk about positioning as the market changes, as the economy slows down, as central banks continue to inflate – and I’m waiting for the central bank panic, that’s when we get the B-52s. But the first place you’re going to want to be positioned is in the precious metals market, and I just want to give you sort of an update in terms of what’s going on in the metals market. As I sort of commented in the first hour with Frank and Tim, and also with Dave Morgan, the short position in the gold stocks is the largest I’ve seen. You have almost a 15.6 million short position in Newmont; 22 million short position in Coeur D’Alene; you’ve got large short positions in Goldcorp, and in Glamis; huge short positions in the silver stocks, relative to the past. And that’s the main reason that you’ve sort of seen the metals markets be sort of weak on the equity side. You don’t know what’s going on but I do know we got a comment from our listeners – he owned a large position in Goldcorp – and one of the major brokerage firms had contacted him to borrow his shares. So you don’t know what’s going on there, whether the hedge funds are long bullion, short stocks which is sometimes a hedging strategy but nonetheless, there’s a huge short position and it’s one of the highest that I’ve seen.

The other thing is taking a look at what the gold markets are telling us, and we’ve now got detailed information on the 1^st quarter production for the major gold stocks. And if we take a look at what’s happened: Barrick Gold moved into the number one spot in terms of production – producing almost 2 million ounces in the first quarter as a result of its takeover of Placer Dome; Newmont’s back down in the second spot at about 1.4 million; Anglo-Ashanti; Gold Fields; Harmony; Freeport; Buenaventura; Newcrest; Kinross; and Goldcorp. Top producers for the last 4 quarters is still Newmont, Barrick and basically the same group with the exception that we would probably throw Kinross and Rio Tinto in there.

The other thing is the production gains that we’ve so far have mainly come as a result of acquisitions. You’ve got Barrick Gold, once again – that was the acquisition of Placer; Glamis has made several acquisitions over the last couple of years – those mines are now coming on stream; Beemer[ph.] Northgate has made an acquisition; Yamana has gone on acquisitions; and Goldcorp. So a lot of the production gains are coming as a result of acquisitions, and I expect we’re going to continue to see that.

Also, rather significantly, there have been some very large production losses: Rio Tinto’s production is down 16%; Anglo-Gold Ashanti is down 15%; Newmont Mining’s production is down 10%; Freeport’s down 24%; Harmony, Gold Field, Kinross, Cambior – all of these large or intermediate companies are starting to see decreases in their production which means they’re not replacing their reserves.

A second key factor here is one of the most profound trends in the gold mining industry today is the cost inflationary pressures that producers are finding themselves under, and just an example just to give you an idea what’s happening: Rand Gold’s cost increase up 107%; Golden Star up 70; Crystallex up 66; Queenstake Resources’ production costs up 50%; Cambior’s production costs up 36%.

And you’ve got some real high gold producers now: for example El Dorado Gold’s cash cost per ounce is $429; Harmony’s producing gold at 470; Crystallex at 495; Golden Star at 522; Rio Narcea at 539; Queenstake at 558; and Emperor Mines at 762. Where are the cost pressures coming from? Rising fuel, power and labor costs. And about the only cost reductions that you’ve seen have been as a result of the high prices of byproducts – like if you’re mining gold and silver, you may credit your silver cost against your gold cost, or your copper cost against your gold cost. And so those companies that experienced cost reductions were mainly producing other side metals whether it’s copper, lead, zinc. And they’re using those cash costs against their cost of gold production. The lowest cost producers once again were all companies with the exception of maybe Glamis, that you have a lot of byproduct costs.

The average gold received in some of these companies, especially those that have hedged, are just terrible. You’re talking about 391 for Etruscan; 388 for Newcrest; Western – 403. [1:23:05]

JOHN: Well, Jim, I would guess in a rising bull market you don’t want to be in the company – as costs go up at the same time – of people who are hedging themselves.

JIM: No, in fact you can really tell the costs are going up that was rather interesting. If you take a look at for example some of Barrick’s large mines: Bald Mountain, a total cost of 431; the Cortez mine, 525 an ounce; Turquoise Ridge, 532; Merrit Gold, 644; Golden Sunlight, 543 an ounce.

And it just wasn’t Barrick Gold, even if you went to Newmont, some of their Nevada mines - $463 an ounce; one of their Australian mines, 535; another Australian mine, $504 an ounces; another one at 588. Yes, their average cost is heading up, but boy, some of their older, operating mines that have been in production for some time now, John, are really starting now to cost money. That’s why when you’ve seen this run-up in gold prices to 550 an ounce or 600, the profit margins haven’t been that great is because their cash cost of producing gold has gone up rather significantly. And that’s why it’s going to take much, much higher gold prices – 750, 850 and $1000 gold – before you really start to see the full impact of high profits in the gold mining industry.

So in summary, you want to be in the gold and silver stocks, but you want to be in those that are unhedged, so you want to stay more with the HUI-type gold stock companies versus the XAU. [1:24:47]

JOHN: Alright, Jim, let’s move on to the energy sector, that’s a good choice.

JIM: What really stands out when you look at the energy sector is where profits have been over the last 3 or 4 years. The energy sector is the top performing sector in the year 2004, 2005, and 2006. And yet the markets are pricing the energy sector like it’s a hard core cyclical stock, let’s say, like an automobile company. So therefore the economy is slowing down, energy use will slowdown, so therefore the price of energy will come down and as a result profits for the energy companies. And you know, if you take a look at the analysts, the media, they have been wrong consistently over the last 4 years. And if you take a look at where the energy stocks are right now, they’re being priced for $40 oil. I just don’t see $40 oil. [1:25:46]

JOHN: Not in our lifetime anyway, Jim.

Do you suppose that this particular outlook comes from more of a United States myopia, viewing our economy as the be all and end all, rather than looking perhaps more at the global economy – other countries, China and India – and how they’re affecting the international prices of oil as well?

JOHN: I really do, and I think that this has taken most analysts by surprise. John, you remember when it ran up to $40, we’ve had $40 run-ups over the last couple of decades: Gulf War, the middle of the 80s, there was a point in the 90s and then of course the Gulf War and the events of 9/11. After the events of 9/11, with the US economy in recession, and a terrorist attack, oil quickly went down to 20, natural gas fell through the floor. And that’s what people keep looking at – if you look back at the past this is what’s always happened. And this is why I think they’ve thrown so many of the analysts off. And let’s face it, if China is going to sell 2 million more cars this year, or whatever that number turns out to be. You know, the guy that buys a motor scooter or a car, that trades his bicycle, he’s not going to leave the car in the garage and say, “the price of fuel is less now, I’m going back to riding my bicycle.” That’s not the way it’s working over there, and I think this is something that we fail to pick up on.

And more importantly, we’re failing to take into consideration the fundamentals of oil, the lack of new discoveries – discoveries peaked over 35 years ago; the multi-decade failure since 1985 to replace what we consume. Yeah, you know we’re spending a lot of money on oil exploration but we’re not finding a lot of stuff to replace what it is that we have. And I think that depletion of the older wells, people were talking about, “well, we’ve got Canadian oil sands, we have oil shale,” but this is the kind of stuff that takes 10 years to come on stream and develop. And the only reason why things haven’t peaked is because alternative energies – whether it’s the oil sands, or shale, or coal-gas conversion – these other methods are bringing on extra supply to make up for what it is that we’ve lost. [1:28:01]

JOHN: I know you’ve taken the year off from writing – for people who used to read a lot of what you put on the website – simply because you’re spending a lot of time researching peak oil. I think you said earlier in the show, so far you are 80 books deep into that. What is the great news out of this whole thing after putting all of this together?

JIM: Gosh, it has to be at least 80 books now. You’re going to see some of this on the show here this month, but you know, I keep looking for the silver bullet, I keep looking for maybe there’s something in the peak oil debate that I haven’t picked up; maybe some author has got a different discovery, or something that I haven’t seen that maybe the pessimists or the early peak people have not seen – and I haven’t found it. I’ve read all the papers on abiotic oil, and I discard that. We’ve had the environmentalists; we’ve had the oil people; we’ve had the geologists; we’ve had the analysts – you name it, who haven’t we had on this program the last 3 years? And I keep looking for that silver bullet. I can’t find it. So my conclusion is peak oil is real and it is really going to have a profound effect.

I think the age of consumerism, especially here in the US is coming to an end. Consumers are tapped out, but even if they tried to resurrect another bubble I think it’s too late because by the time peak oil really starts to impact the economy and the markets, I think we’re going to see a widespread panic. And that’s why I think alternative energy – you know, just as we did Addicted to Oil last week, I’m looking in the not too distant future when we’re going to wake up and you’re going to see it on CNN, it’s going to be on the front cover of Time magazine that peak oil is here. And when that happens, the profound impact when that hits is going to be unimaginable. It is just something we’re totally unprepared for, because it means an alteration in lifestyles. I’m not so sure James Kunstler’s book The Long Emergency is what it ultimately ends up looking like – I’m more optimistic than that. I think it’s going to be tough, and we’re going to have some transitional things.

But the most important thing is we keep delaying it so the longer we see energy prices up at this level at $80, slowly but surely you are going to see people start to resign themselves to it and slowly accept it. Do you notice they are not crying as much, and even now we’re at 3.50 gasoline whereas compared to last year when we first hit that level, everybody was screaming for investigations. So there is some bit of resignation here by people in terms of acceptance. The only thing that we haven’t seen is it implemented into action; we’re still buying motor homes – less so today as the economy rolls over, but you know, you pull in to anywhere in Southern California look around you at the kind of cars people are driving; you don’t see small cars, you don’t see smart cars. You’re starting to see a few more Prius out there on the road but you know you pull in to most parking lots it’s SUVs or large cars. [1:31:18]

JOHN: I saw a lady last night tanking up a very large boat at the gas station while I was there. I was tempted to go up and ask her how much pain are you willing to endure before you put the boat back in the garage. I didn’t have the guts to do it though.

JIM: No, that’s why I stick to sailing.

JOHN: In addition to precious metals and energy, one of the things we’ve been chattering about here regularly on the program are the large cap staple stocks I think. And you think those are going to be a good source of economic revival?

JIM: Yes, I think as money starts to begin to shift and look for a safe place to land, you’re going to see a number of things occur, and one of them that’s occurring right now is the out performance of small cap stocks is starting to unwind. A second thing I think you’re seeing is investors globally are getting out of their high risk positions. A sharp slowdown in housing and an inverted yield curve are quite honestly toxic for small cap businesses, small cap stocks, whose earnings are more tied to the domestic economy. And if you look at global growth which is much stronger overseas than the US, that would favor also large cap international companies. A lot of our growth numbers that we throw out are really meaningless because they’re so statistically manipulated.

And as the Fed ends its rate raising cycle which I think it comes as soon as August, the dollar is going to resume its downward trend. A lower dollar means if you’re a foreign international company your foreign sales get translated to higher dollar sales and higher profits and that’s especially true for the large caps. However, and since we’re ending this sort of the end of a business cycle and a slowdown you need to be very selective I think: consumer staples, healthcare, capital equipment – especially for the mining and energy and the water sector are also a great area to be in; and for the more conservative side of the portfolio you know if you have a pension fund, TIPS are not a bad short term parking place; and short term Treasuries because you can get the yield in a 2 year note or less – a one year T bill – that you can for a long term bond. And I expect this next lowering cycle is going to be as different as the rate raising cycle. So it’s definitely a time to start unwinding your high risk positions whether you’re in emerging market debt, junk bonds especially because I think you’re going to see widening credit spreads. And there’s just not enough compensation in the form of interest rates to compensate you for taking the additional risk. And that’s why I think the staples, the gold, the energy are safer plays; short term T-bills if you want to be extremely safe. And at some point I think some foreign bonds – short term foreign Treasury bills – are going to be appropriate, and my favorite would probably be the Canadian dollar – here, short term, before we merge it in with the amigo. [1:34:27]

JOHN: Well, Jim, it’s been a long and very productive show, and we need to remind everybody that during the month of August, this is not next week, but the weeks following, we’re going to scale down the show; we try to take a lot of time off during that month. It’s been a long standing custom here on the Financial Sense Newshour. We will be doing the Big Picture – if anything big breaks we will do what we have to do to cover what is going on, in other words, we’ll get off the beach, come back from the boat. Whatever has to happen here is the name of the game in broadcasting.

Coming up next week what are we looking at?

JIM: Ok, next week, this is an interesting interview I hope it goes well because he speaks Italian, but Leonardo Maugeri who is executive at ENI, the sixth largest oil company, has written a great book, it’s called The Age of Oil, it’s very well written because it gives you a historical background on how oil developed. It’s kind of a cross between Daniel Yergin’s The Prize and then he goes forward. He’s much more optimistic about finding more oil in the future.

Following that we’re going to have an energy reporter and analyst George Orwel, he’s written a book called Black Gold, that will be on August 5^th. And then Steve Drobny on August 12^th has written a book called Inside the House of Money. So that’s coming up August 12^th which will just be an interview, and John and I with the Big Picture. And then we’ll go on our Summer break and return September 9^th.

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.