Financial Sense Newshour
The BIG Picture Transcription
December 23, 2006
5 OF 10 THEMES THAT DOMINATED THE MARKETS THIS YEAR
- Inflation in goods reflected in rising commodity prices
- A good year for all asset classes
- Rising global liquidity
- Rise in leverage and speculation
- The rise and fall of U.S. interest rates
First Hour Introduction
[montage of voices]
Actually, it's a time machine. We just set it, turn it on, open the door and there we are.
All of the better quality numbers will show that indeed you have a recession, and it's an inflationary recession.
This year we're creating also $4.4 trillion dollars of new credit in our system.
I think inflation is probably one of the most misunderstood words in the English language.
Headline inflation is much higher than core inflation, and the typical household does not live by core inflation.
They have lifted the flood gates, and there's no limit to the amount of fresh money that they are pushing out.
And the Fed no longer counts the money supply.
Actually, you have expansionary monetary policies, and it doesn't take a rocket scientist to see that if money was tight, the Dow wouldn’t make a new high and the dollar wouldn't be weak.
Wall Street has always been taking risks, but never before has this risen to such a prominence.
Inevitably, when we've seen Wall Street go into cycles of excess, there is always one firm that gets into trouble.
The Republicans took a real Texas whipping.
It was a thumping.
The new speaker is a liberal Democrat.
Everyone is real nervous with what's going on with Iraq.
Can we continue to increase interest rates without having a negative impact on our economic growth?
I think we will try to raise rates, if we do, in a way that maximizes the obtainment of our objectives, which is price stability and maximum sustainable employment growth.
We just set it, turn it on, open the door and there we are.
JOHN: Well, Bob Hope, where are you when the country needs you? Thanks for the memories. Indeed this program is going to be a way-back-machine this week and next week. Merry Christmas, everybody.
Welcome to our two-part year-end program on the Financial Sense Newshour. This is going to be a special edition as we take a look at this last year and try to put it all together. What were the key stories what moved the markets and what are the key themes for the year? You have to say this year played out the way it was forecast right here on the Financial Sense Newshour. We had a few misses on the political side, but as a whole our forecasts and scenarios did play out.
And as we looked back, there are several themes that dominated the year. And we're going to get into them over the next two weeks. We'll divide the big picture into two segments. This week we're going to cover the first six months of the year. And next week we'll cover the final half of 2006.
As it turns out, delineating the year into six-month segments works out with what actually did happen in the financial market. The Fed raised interest rates in June for the last time of this year, and the thinking about the economy and the financial markets began to change afterwards. It was almost like a water shed event.
So let's begin. Jim, what were the key themes of 2006?
JIM: You know, John, this year I think there were a lot more crosscurrents in the market, and a lot of it had to do with inflation, rising commodity prices. Is the economy going to slow down and is inflation going to subside? Are we going to be in a recession? Is the dollar going to go down? But if you take a look at the themes this year, I think we can boil them down to 10 themes.
The first was inflation in goods: the things we need to live reflected in rising commodity prices.
Second was rising global liquidity. I don't care where you looked this year – United States, Canada, Europe – money supply was growing all across the globe.
And thirdly, I think it was a good year for most asset classes. Stocks did well. Bonds did well.
And along with this rising liquidity, a fourth factor was the rise in leverage and speculation.
And then what we saw in the first half of the year was the rise in interest rates anticipating higher rates of inflation. Then in the second half of the year we had the fall of US interest rates as people began to anticipate an economic slow down, and as a result we would see a decline in the general level inflation.
We also had a sixth theme was a weakening US economy. It's no question we've gone from above 5% economic growth from the first quarter. And each subsequent quarter, we've seen lower economic growth rates.
A seventh theme has been the rise in energy and precious metals as well as their fall. Just as we saw the rise in interest rates in the first six months of the year, we saw a rise in gold prices when gold hit $750. We also saw oil prices hit $80 by summer. And then since that time, we've seen them decline as interest rates began to come down.
And then also as we saw the elections in November, changes in the war on terror.
Another topic is the Bernanke Fed. Which direction was it going? – remember the early flip-flops when Bernanke first became Fed chairman? And there was a lot of worry as to what kind of chairman is this guy going to be?
And finally the US dollar. [6:11]
JOHN: Well, from the list, it's obvious we have a lot of territory to cover. So that's why we're going to do this over the course of two weeks.
Let's begin with one of the themes of this year that is still with us, which has been inflation. Up until this year, the inflation theme did not resonate with the markets. We saw oil prices hit nearly $80 dollars a barrel this summer. Gasoline prices at the pump soared above $3. Food prices were rising, and commodity prices hit record levels this year. Service cost inflation was rising. CPI year-over-year was at the highest level we've seen in five years. And even the Fed's dummy inflation gauge, the so called core rate, was well above normal trends.
#1 Theme: Inflation in Goods Reflected in Rising Commodity Prices
JIM: Inflation in goods reflected in rising commodity prices was a theme that we saw in the first half of the year, John. It's still with us now. We had inflation. The last time that we had deflation was when Eisenhower was president. The reason I'm bringing that up is there are people talking about deflation or disinflation. We're not going to see it. We'll see disinflation, but we're not going to see deflation. The only difference on the inflation front is that in the '80s and '90s that inflation found itself in asset prices as it continues to this day.
However, what we have now is that all central banks around the globe are inflating simultaneously. So the result has been rising asset inflation – I don't care wherever you look, look at US financial markets, look at European financial markets, and look at Asian financial markets with the exception, maybe, of Japan. What we began to see last year and what happened this year is inflation started to spill over into the goods sector or into things that we need to live. You pointed out food, energy, raw materials for production – the things they really don't count are measured appropriately in the inflation gauges. In fact, the market tends to focus more on the core rate because that's what the Fed and the financial media emphasize. However, it began to rise to such a high level that even the core rate we saw begin to rise above normal levels. I love when the Fed said, “well, it's above our comfort zone.” Hey, no kidding!
Chart courtesy John Williams, www.shadowstats.com
This is a subject that two of our guests highlighted from the beginning of the year. Let's listen to what John Williams had to say in our February interview. [8:29]
JIM: You know, John, one of the things, and you document a lot of this, you keep track of the CPI the way it was before they manipulated it, but when we look at all the government numbers we get today – whether it’s the CPI, the GDP numbers, the productivity numbers, the unemployment numbers – I mean they’re all jerry-rigged statistically. I was even surprised to find out that they’re doing this with oil inventories. That they are done with computer models where most people think, “Oh, they report these inventory numbers,” somebody goes out with a dipstick each week, dips it in a well, says, “OK, this is how much gas or oil that we have.” That’s not the case, it’s all being massaged. It used to be that you looked to economic data to tell you where’s the economy going, where’s the inflation rate going, so that you could plan your portfolios accordingly. It seems to me we now live in an Orwellian economic world where who knows what these numbers mean?
JOHN WILLIAMS: Well, it’s a situation where the politicians with a certain line that they want to sell have full control of the reporting system, and there’s been a lot of changes that have been made – mostly methodological.
Overall the inflation as you mentioned is underreported in the 3 to 4% range; unemployment right now against the way it was reported say coming out of the great depression or at least was measured at the time is being underreported by about 7%. The government reports put out a couple of different measures of the unemployment rate, and they show with their broadest measure, unemployment’s up around 9%. There’s another 3% there that the changes made during the Clinton Administration knocked off. So, you’re up around 12% on the unemployment rate.
GDP growth is overstated by about 3% so that in terms of this last GDP report, which showed 1.1% growth in the economy that in reality was a contraction. But in terms of the way the government reports it, it still was an unusually good report in terms of quality. I mean, forgetting the biases, it was about how you would’ve expected them to report it given the economy actually contracting.
So that I do think as you go along here, there are better measures than the government puts out: corporate profits; government tax receipts; the internal revenue service numbers on people’s income. All the better quality numbers will show you that indeed you have a recession, and what people are already beginning to see is it’s an inflationary recession. And that’s the worst of all worlds for the financial markets, at least the traditional financial markets. [10:57]
JIM: You know Marc Faber also explained why you're seeing this rise in inflation this year and why it's been rising since 2001 in real goods.
MARC FABER: I think we have to distinguish that each economic event has to be taken in its particularity, and what we had is, as I mentioned in earlier interviews, is basically disinflation, since 1980; falling commodity prices since 1980; and falling interest rates since 1981. And that came basically to an end in the case of commodities in 2001, and since then commodity prices have been rising. Consumer prices have not been rising all that much, although we have to say that unintentionally, or intentionally, the Bureau of Labor Statistics is probably understating the true rate of inflation. First of all, headline inflation is much higher than core inflation, and the typical household does not live by core inflation, but lives by headline inflation. And even headline inflation figures probably understate the true cost of living increases because, say, healthcare is underweighted and education is underweighted – items that have increased at double digits in the last few years. Moreover, in the past it has always been the case that interest rates and consumer price inflation have followed commodity prices. So, if we take the low of commodity prices in 2001, and I have to point out that in 2001 commodity prices adjusted for inflation, or adjusted for the consumer price inflation, were at their lowest level in the history of capitalism. So we’re starting from a very low level, and we’ve gone up a lot, but in real terms we haven’t gone up that much. But nevertheless, I think that if we look at long cycles, long commodity cycles – and long commodity cycles, or as some people would call them the Kondratieff cycle, which is basically a price cycle and not a business cycle – if we take 2001 as the low off the peak in 1980, and the long cycle lasts 45-60 years, then in 2006, we’re basically at the beginning of the increase in commodity prices. And I think that this will translate into higher consumer prices in time; and that in time this will have a negative impact on financial assets, especially on bonds. [13:45]
JOHN: Well, as you said, Jim, we've always had inflation. It just manifested itself in other ways, mainly through asset inflation in both the eighties and the nineties. Now, I guess there's enough inflation in the system that we're seeing the spill over effect.
JIM: What I think we're seeing here is the postponing of a crisis, and what I think it's going to lead us into is stagflation. Usually the arrival of an economic recession can be postponed if additional loans unbacked by real savings are granted at an ever increasing rate. And that is what we've seen the past two years. If you take a look at this credit expansion, which began to accelerate back in 2001, we had total credit expanded from about $1.6 trillion back in 2001 to this year where new credit creation will be $4.4 trillion. So from 2004 when the Fed first began to raise interest rates (and they did this 17 times until June in this year when the Fed finally stopped raising rates), during that entire rate raising cycle from 2004 to 2006, credit expansion grew from $2.8 trillion to 4.4 trillion this year.
So in order to delay a crisis, which is what they're trying to do, you have the Fed and the Treasury administrating additional doses of credit through the banking system. Credit is not hard to get today. This credit, which is given to companies who have launched either new investment projects here in North County, residential estate is slowing down here, but the commercial real estate is really starting to pick up.
So what you have is a widening as a result of this additional credit coming that lengthens the stages of the production process. You have credit granted to speculators. Examples of this would be: the continued rise in real estate loans; commercial, industrial and bank credit, which are growing at double digits; and look at the plethora of mergers this year, not to mention a record year for private equity deals. [15:54]
JOHN: And you should recognize that while this process may postpone the inevitable depression, we all know that the Kondratieff Winter eventually shows up.
JIM: This is something that Murray Rothbard wrote about in Man, Economy, and State. Murray Rothbard, if you're not familiar with him, was a very well respected Austrian economist. And Rothbard said that the only way you're going to avert the onset of a depression and adjustment process is to continue inflating money and credit as we're seeing now. He also said as the process continues only ever increasing doses can step up the boom, can lower interest rates further, and expand production itself.
This also gives way to inflation, for as prices rise, more and more money will be needed to perform the same amount of work – just look at what you're paying for things today. And in any case credit expansion must accelerate at a rate which does not permit economic agents to adequately predict it. Since If these agents begin to anticipate inflation, you've got a problem. Indeed, as inflation expectations spread, the prices of consumer goods will soon begin to rise faster than the factors of production.
And moreover, market interest rates will begin to soar even while credit expansion continues to intensify. That is why the Fed is focused on inflation expectations. And we saw a very good example of this with the Open Mouth Committee in May and June as inflation rates were rising, the core rate of inflation was going up, interest rates on the 10-year note backed up to about five and a quarter by June.
John, you remember that period between May and June? It was like every single day, they had Fed governors coming out and giving speeches, talking tough. What they were really trying to do psychologically was drive down inflation expectations. [17:51]
JOHN: You know, it's interesting that quite frequently when governments inflate their currencies, they do so in the name of social programs; and they sell it to people in the name of, “we have to help people, don't you care about people?”
But there’s a fundamental rule of the economic universe, there's no such thing as a free lunch. And sooner or later, usually in the Kondratieff Winter, this really comes slamming down and severely damages the middle class. That's why ultimately it takes at least two incomes to support a family, it’s not even unknown at some point to have both mom and dad working two jobs to make it work. It gets so bad that it not only takes two incomes, but then requires taking on debt just for the family to make it as well.
JIM: That is the real tragedy of inflation. It hurts people financially. It impoverishes the nation, but the root cause is never recognized.
Adam Fergusson wrote about this in his book When Money Dies. And he's referring back here to the great German inflation, he said:
It was the natural reaction of most Germans, Austrians or Hungarians, indeed as for any victims of inflation, to assume not so much that their money was falling in value, is that the goods which it bought were becoming more expensive in absolute terms. Not that their currency was depreciating but especially in the beginning that other currencies were unfairly rising, so pushing up the price of every necessity of life. [19:24]
JOHN: And that is the tragedy of inflation. What really is also tragic is the root cause of inflation is never recognized, at least publicly: that is, it’s government, through it's central banks and treasury operations, which actually create inflation. It's not business raising prices; it's not labor unions demanding higher wages. It also redistributes wealth within that society as well.
JIM: That's a real key point: you often hear, today, about these disparities in wealth. What inflation does is it redistributes income in favor of those that first receive the new injections or doses of money. Mainly the government and Wall Street. And it comes at the expense and to the detriment of the rest of society who find that with the same monetary income, the price of goods and services begin to go up – as we are seeing today in the US.
What you get, in effect, is what you call forced savings of the lower income groups because that latter group, since their income does not grow at a rate to keep up with the prices of goods and services, this group then is obliged to reduce their consumption, all other things being equal. So you're seeing this play out today between, for example, the Wal-Mart shopper and the shopper at Tiffany's and Coach.
Marc Faber also commented on this in his February interview. [20:47]
MARC: One of the consequences of this scenario is that for the typical household the standard of living will go down eventually. It’s happened already for a lot of people. And the second consequence is that as wealth becomes very concentrated in the hands of a few people who are obviously very powerful (because in a democracy the people who have the money basically have more power to bring their people into the government) it creates a very unpleasant social environment. And what it eventually does is it impoverishes the majority to enrich the minority. At that stage you can get social upheaval, and you can of course get situations where the minority is then like a money aristocracy, and things to the detriment of the majority [may happen], such as in future there may be some very costly expeditions overseas military expeditions, or they’ll blame it on the minority.
It’s difficult to tell what the ultimate outcome is, but I would say that in Western society [there is the] probability of having at some point a major crisis where people will have to tighten their belts very considerably whether that occurs in a deflationary environment, or as I believe rather in a very high inflationary environment where salaries just don’t go up as much as the cost of living and so people don’t have the money, then at the same time as inflation picks up interest rates go up, and people can’t meet their interest payments and are bankrupt and so forth. All this leads at the end to a major crisis, and in that situation when things get really bad (of course, after the rich people have moved their assets overseas), then they declare foreign exchange controls. [22:49]
JOHN: You know it's interesting we always hear that the Federal Reserve, for example, Jim, is an inflation fighter. The Federal Reserve is not an inflation fighter. It is the sole cause of inflation because it has been inflating since the very day it was created I think with a little exception during World War II as a matter of fact.
And many of our guests contend, just like you do here on the program, that inflation and eventually hyperinflation is where we’re headed. G. Edward Griffin talked about this when you interviewed him on the program on October 28th of this year.
JIM: There’s a big debate in the financial community today, and it’s whether we’re going to experience inflation or deflation. As I look at it, I don’t think I can remember last when we ever had real deflation. But when you have a fiat system where you are able to prevent defaults, or let’s say a bank loses a lot of money because of bad loans, they can create money out of nothing and just replenish the banks as they did in 90 and 91. As you look at the way the system works today and you see the amount of money that we’re printing – this year we’re creating almost $4.4 trillion of new credit in our system – do you see inflation or deflation on the horizon?
EDWARD: Well, to me, it’s pretty clear – it’s inflation. I don’t see how you can see deflation in any of this because they have lifted the floodgates, and there’s no limit to the amount of fresh money that they’re pushing out. I think there’s going to be more of that in the future. But the question is still good because there comes a time even though they’re pushing money into the economy, people are still losing jobs and losing purchasing power, so these two opposing forces are fighting each other and it’s hard to say which ones will be the most devastating. But nevertheless, in my view, I think that the effects of deflation will be more than overcome by the counter effects of inflation, and that in net, we will have an inflationary experience. [25:03]
JOHN: Ultimately this whole thing spools itself into some kind of a doomsday scenario. There does come a day of reckoning. No country or government or central bank has ever avoided this consequence in history so far. And we are not seemingly avoiding that now. The only difference is perhaps we're blowing this bubble up larger and larger than anything that we've known in history before, which would probably result in a bigger bang. And this is what you and G. Edward Griffin were talking about in the same program.
JIM: I want to fast forward to one of the final chapters of your book where you talk about the doomsday mechanisms. One of the characteristics of our present time is the extent to which the Americans and their governments are mired in debt: you take a look at what the national debt is now – over $9 trillion and still growing; we’re running almost 800 to $900 billion worth of trade deficits. And if you take a look at that today, as you point out in your book, you find some interesting statistics: there are more people working for government than for all the manufacturing companies in the private sector; there are more bank regulators than bankers; there are more farm bureau workers than farmers; more welfare administrators than recipients; and there are more citizens receiving government checks than there are paying income taxes. I see that as a problem that’s very difficult to fix – there’s a vested interest here.
EDWARD: It is very difficult to fix because it looks like it has gone past the point of no return. When you give people the opportunity to vote themselves whatever they want through a majority vote and finally that number has reached more than the majority then that minority is doomed. The minority of honest working people who are not trying to get something for nothing are being pressured more and more, they’re squeezed more and more. I think everybody now knows that the middle class is in great retreat in America.
Prior to the establishment of the Federal Reserve the middle class was rapidly growing, the gap between the top and the bottom was getting narrower and narrower, and we were really moving into a very wonderful system based on free market economies. But since the creation of the Federal Reserve, and some other things too might add, the trend has reversed. So now the middle class is getting wiped out. The middle class is the ones who are paying the taxes, the middle class is the one that is doing the work, and as that gets wiped out and gets smaller and smaller, there comes a time when there’s no heartbeat left in the system. The system will not have the strength to continue and at that point all we’ll have is just raw naked force: government telling you what you must do or else go to prison – that’ll be the driving force. I’m afraid we see it coming closer and closer unless we turn this thing around very soon. [27:53]
JIM: Let's go forward and talk about your pessimistic scenario, because you just mentioned it’s gone well beyond repair. It sounds like your pessimistic scenario is the course that’s going to unfold in the future.
EDWARD: If we go on the basis of the trends, we have to say that is coming. If you just sort of plot this on a mental chart in your mind you can see that line is heading straight toward total government: government is growing every year; new laws are being passed every day; personal liberties are being reduced every day. This represents almost a straight line chart if you were to put it on a piece of paper. So you have to say unless something changes, that line is going to continue to go in the same direction it’s going now, until finally we have more and more and more government, more government, more government – and then all of a sudden we reach the end of that line and it’s total government, which is totalitarianism. So unless the trend changes there’s no doubt that we are headed right smack dab into totalitarianism.
So the question is – and we come to the optimistic scenario – what will it take to change that trend, what is it going to take that line and bend it back down and start reducing the size of government? And I mentioned before, the only thing that will do that is an awakening on the part of the American people that first of all they’re in a mess because of the growth of government – many people think we’re in a mess because government isn’t big enough. You know, “hey, we’ve got a problem – let’s have more laws.” That’s the thinking that’s gotten us into the problem we’re at. And these potential tyrants that are just wringing their hands in anticipation and glee expecting to have total control over our lives, are counting on the American people jumping at every problem that lies ahead, and saying, “oh golly, we need more laws, more government.” They’re just waiting for the Boobus Americanus to vote itself right into slavery. [29:51]
[Song: The Theory of Relativity]
#2 Theme: A Good Year for All Asset Classes
JOHN: A second theme this year has been the rise in all asset classes. And Jim, I know you really surprised everyone at the beginning of the year when you predicted a new record in the Dow. That was a real "what?" Many people thought you were really over the edge on that one. But let's listen to what you said on the first show of the year:
JIM: Another thing is the key beneficiaries, everybody believes, are going to be resource oriented countries: countries like Canada, Australia, Latin America that produce the raw materials and the natural resources that China, India and the rest of the world needs. With the Fed going on hold and Europe saying, “Yeah, we might raise interest rates, but we're not going to do what the Fed has done,” we may raise it a couple of points, but it's not going to be a long string of rate heights; and Japan mumbling that maybe they might go to raising interest rates – basically that's not going to stop liquidity.
In other words, they think that liquidity conditions, credit conditions will continue to expand. And one of the ways to play the market this year is not only the big cap stocks like the Dow stocks, that's why most of the forecast this year are for, for example, a new record on the Dow, but not a new record on the S&P or the NASDAQ. They'll be up, but they won't be at record breaking levels. This is the year that the big caps are expected to out perform the small caps. So that's pretty much the consensus forecast. [34:02]
JOHN: That was from our first show of 2006.
#3 Theme: Rising Global Liquidity
JIM: I want to go back to another show that we also did in May. At the time, the Fed was talking tough on inflation. John, I can just remember almost every single day. I mean there were days you had two or three Fed governors coming out, the Open Mouth Committee scaring the bejeezus out of the market. The stocks were literally getting hammered, and yet we still talked about a higher Dow. And this goes back to a concept that we were talking about – everybody was saying, no, liquidity is tight, but we were seeing just the opposite. The money supply figures – broad money in the US (and globally) – was rising. So the only thing that was happening at this time was inflationary expectations were going up because inflation was spilling over into real goods. But to counteract the rate increases, the Fed was doing coupon passes, the treasury was monetizing. They were doing all kinds of things to make sure there was plenty of money and credit in the system. And as Marc Faber talks about, whenever that money and credit floods the punch bowl, it flows over into somewhere. And that's why we believed here at FSO that it was going to go into the stock market. Let's go back to that May 20th show. [35:16]
JIM: The other factor that is very important here is you've got central banks are inflating. They are creating a lot of money. And as I pointed out in the past, when you create money and credit, there's two forms of inflation. It can take place in the real economy with goods and services; or in a financial economy like the United States, that inflation can take place in asset bubbles whether it was stock in the nineties, real estate in this century. I think that is what is happening because when central banks create money and credit, they can't always control where that money goes.
Last week we talked about it takes $4 of debt to get a dollar of GDP. And we covered [the concept] for one dollar of debt that goes into GDP, you get another dollar that goes into imports and another couple of dollars that goes into the financial markets.
So one of the reasons I'm bullish on the Dow this year, and I do believe we're going to see a new record somewhere in the neighborhood of 12 to 13,000 this year is all of the money creation that we're seeing globally, when you create that money it has to go somewhere. It just doesn't disappear or evaporate. [36:30]
JOHN: That's what you were saying on our May 20th show. Jim, just out of curiosity, what gave you the confidence to predict a higher Dow somewhere in the 12 to 13,000 range, because if you recall the Dow was trading around 10,000 at the time?
JIM: You know, John, this was the misinformation that was being put out. There was a lot of noise at that time about tightening liquidity. I was saying just the opposite. To me, when you're seeing broad money supply grow globally at high single digits (and in many cases as in Europe, Canada and Australia, it was actually growing at double digit rates). You can't have that kind of money and credit growth without that money showing up somewhere.
Marc Faber talked about the analogy of the punch bowl with the spigot. The spigot is the central banks, the bowl is the economy and the financial markets. And when the spigot is turned on, that money and credit flow into the bowl until it spills over. The trick is trying to figure out where that money is going to go. If you can do that and keep the tab on where the next bubble is going to inflate, that's how you make a lot of money.
When the Fed [was] deflating real estate as they did through higher interest rates, they were still applying credit through the system. And what they were trying to do through the rate hikes is slow down the bubble. But when they create that extra credit as they supply it into the system, you have to take a look at where is the next logical bubble? And I believed at that time it would be equities. [38:05]
JOHN: I know the Wall Street crowd absolutely positively does not share your position. These guys regularly trumpet the core rate and all of the other typical government figures. There was a debate on CNBC that echoed this view between Wall Street economist Diane Swonk and Peter Schiff. Let's listen to that debate because it describes exactly the phenomenon that you have been talking about.
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. But 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 of inflation 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 this 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 really how inflation has worked..
CNBC: I want to let it was Diane who was laughing. I think she may be laughing again, I can’t see.
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 your 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: No, let me finish. 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 in 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. [41:29]
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 as she said, “well, that was asset inflation.” My point! Asset inflation. 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 governments 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, 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. [44:07]
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 in terms of rising prices. 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 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.
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 is 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 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 [have been] as well. I mean how long have bonds been…I mean we have Jim Rogers who says 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 of global inflation. [48:08]
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 PE 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 PE 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 a 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. [51:17]
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 phenomenon. 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 is 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 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. [53:05]
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, not 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 from 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. [57:05]
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. [58:20]
JOHN: You know if there was one thing that I found sobering out of listening to the debate, that would be the fact 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 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. [59:37]
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 the way that anybody lives 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, when you have to pay tuition for your daughter going to college, you ask for the core rate of tuition? Or the core rate at the doctor’s office, the core rate at the grocery store, the core rate at the gas station. [1:00:22]
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. [1:01:95]
JOHN: It would be essential there, Jim, to break it very gently to the Pope however.
JIM: 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. 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. [1:02:53]
JOHN:That lengthy clip that you just heard was from our program on June 17th of this year.
JIM: So there you have a debate between a Wall Street economist reflected by Diane Swonk, and a portfolio manager from an Austrian background – Peter Schiff.
It's obvious here that the Keynesian economist doesn't understand what real inflation is, or the consequences of what happens to asset markets when too much money and credit is created. When it shows up in higher asset prices as we saw in stocks or in real estate, Wall Street will call it a bull market.
When all of that liquidity spills over into the real economy and real goods, such as we're seeing now, they belittle the rise in the price increases by emphasizing this nonsense such as the core rate. They then can say there's very little inflation when you look at the inflation through their biases. [1:03:46]
JOHN: That was the question I was going to ask you because these aren't non-intelligent people. Is it strictly just their Keynesian orientation that causes them not to see what's really going on? Anybody should be able to look at the core rate and see nobody in the middle class exists within the core rate. So why do they do this?
JIM: You know, I think, if you've got a masters degree or a PhD and you're taught Keynesian economics, you're taught it in high school civics, you're taught it in college, you're taught Keynesian economics in graduate school, people that study for the CFA. The whole financial economy and the people that work in it are steeped in this kind of educational background.
It's kind of like going back to the 15th century before the days of Christopher Columbus when they said the earth was flat. And that's the way they tend to see things, so they see that from those kind of filters. When things don't work out the way they believe it, they come up with all of this nonsensical thing, “Ok, we've got real inflation rising, we'll just change the inflation index, or we'll come up with something like the core rate of inflation.” Do you know anybody that lives by the core rate of inflation including the people that come up with the index or people that work at the Fed? It's nonsense. [1:05:03]
JOHN: Ben Bernanke does. He lives by the core rate.
JIM: That's because the government pays for everything. No wonder.
JOHN:But just remember when silver was sitting down at $5, $6, in that range and you were yelling, Buy metals, buy metals. And I consistently heard this come back to me when you would say to people: ”Why, that's a risky investment.” And that's that same kind of blinder, so to speak.
JOHN: Yeah, “put your money into paper, which is depreciating versus real assets which are appreciating.” It's just a matter of blinders and education. I mean if you were taught something all your life that this is the way the world works according to Keynesian economic models, that's the filters through which you view the economy and the financial markets. And so that's why things like core rate or adjusted measures on the economy, that's why people buy that. [1:05:51]
JIM: Well, the net result of all of this is that money and credit shows up in asset prices, which is why stocks, bonds and commodities have actually done so well this year. Dr. Marc Faber echoed these very same sentiments when you caught up with him at this year's Gold Show in San Francisco.
JIM: Let’s talk about a couple of issues that are being bandied about in the market right now. There are two I want to address. One is tight liquidity – I don’t see it when the spigots are running full blast at all the central banks around the world. Yes, some are raising interest rates, but in terms of money and credit it’s plentiful.
MARC: Yes, I think you’re absolutely right. The absolute level of interest rates will never tell you whether the monetary policies are expansionary or tight. In Zimbabwe you have interest rates at 600%, and monetary policy is expansionary because inflation is at 1200%. So what has happened is since June 2004, the Fed has increased the Fed Funds rate in baby steps from 1% to now 5 ¼% – but the point is tight money should be reflected in a slowdown of credit growth – a meaningful slowdown. And the fact is, that since the June quarter of 2004 when they started increasing interest rates, at that time credit growth in the US was running annually at 7%, and now it’s running at annually 11%. So actually, you had an expansionary monetary policy, and it doesn’t take a rocket scientist to see that if money was tight the Dow wouldn’t make a new high, and the dollar wouldn’t be weak. If money is tight, the dollar would be strong and asset prices would go down substantially. [1:07:40]
JIM: That’s one thing we’ve seen in this monetary tightening cycle which reflects that, because we’ve seen long term interest rates as reflected by the 10 year Treasury note not move very much in the last couple of years; we’ve seen a rising stock market almost every single year. Then you contrast that to the last time the Fed was on a rate raising cycle in 99 to 2000 and we had a stock market correction – this has played out differently this time hasn’t it?
MARC: Precisely, because monetary policies are still expansionary. And I wouldn’t say that monetary policies were tight in 1990-2000. The last time US monetary policies were really tight was actually in 79-1980 when Volcker pushed up interest rates. And that led to a meaningful slowdown in the rate of inflation and credit growth, and the 81-82 recession. But since then we’ve had actually expansionary monetary policies that led to the very strong debt growth whereby total credit market debt as a percentage of the economy has increased from 130% in 1980, to now 330%. And if you look at last year, total credit market debt increased by $3.3 trillion and nominal GDP by $751 billion – again then, you have much higher debt growth than GDP, and that doesn’t indicate that money is tight. And also, if you look at international liquidity, we have to beware that as a result of the loss of competitiveness of the US – the growing trade and current account deficit – we have these reserve accumulations in the hands of Asian central banks that are then lent back to the US. And we call these reserves (if they’re dollar reserves) ‘foreign official dollar reserves’ – and if they’re international reserves that would include other reserves. And these reserves are growing at a very rapid pace: dollar reserves at 15% per annum; and international reserves at 18% per annum. No sign whatsoever of any tightening there. [1:09:48]
JIM: So in summary, John, one reason I was so bullish on stocks this year and especially large cap stocks as reflected in the Dow was rising global liquidity. And I might add this liquidity is accelerated lately, which is one reason the Dow is at new record levels. And it's happening here in the US. It's reflected in rising asset values in Europe and then emerging markets. And it has resulted in higher stock market values globally and in higher bond prices, which reflect lower interest rates. [1:10:18]
[music by Steve Doré Inflation Nation]
JOHN: The music of our composer Emeritus here on the Financial Sense Newshour, Steve Doré. We will be back with the Financial Sense News Hour at www.financialsense.com, the second part of our special big picture this week.
#4 Theme: Rise in Leverage and Speculation
JOHN: Welcome back into the second hour of the big picture. You're listening to the Financial Sense Newshour at www.financialsense.com. And for this week and next week, we'll be doing a very special wrap up of the year 2006 analyzing all of the trends and events that really shaped us financially and geopolitically.
You know, in the last couple of segments, we've talked about rising inflations into both real goods and financial assets as a result of rising global liquidity. Another aspect of rising global liquidity is the rise in leverage and speculation, and that is our next topic.
JIM: One thing you learn when you study monetary policy and its impact on the economy and financial markets is that whenever central banks crank up the money printing it makes money and credit abundant. It also brings down the real rate of interest because the rate at which you can borrow is lower than the real inflation rate – as we see today. And the impact of that is it spawns asset bubbles.
And because we now have a situation whereby you can borrow money at a rate that is less than what you can earn on investments. Driving into work today, I heard a commercial on one of the smooth jazz stations, and it was a mortgage broker talking about fixed rate 30 year loans at 5 ¾%. That is less than the inflation rate which is running at 7 to 8%.
So what you see is it creates the opportunity to leverage and speculate. That is why you're seeing Wall Street firms such as Goldman or Morgan Stanley nearly double their leverage. You now have Goldman Sachs leveraged by a factor of 27 to 1, and Morgan is up there as well. [1:56]
JOHN: You've really got to ask the question why would they leverage to this extreme because talk about risky investments? This is hanging over the edge.
JIM: The reason the leverage factor goes up is that the arbitrage opportunities get thinner and thinner because you've got a lot more money – you have thousands of funds, investment banks mutual funds – chasing the same opportunity. The result is that the arb spreads narrow. Now, in order to get a higher return, it becomes necessary to employ greater amounts of leverage. And this is exactly what happened with Long Term Capital Management back in the 1990s.
Roger Loewenstein documented this in the rise and fall of Long Term Capital Management – a great book that he wrote called When Genius Failed. In 1995, Long Term Capital Management earned a rate of return (net of fees) of 59%. They were doing this in the bond market too, which made it incredible. They earned that return through leverage. That year that they made 59%, they were leveraged 28 to 1, which is very similar to what Goldman is leveraged today at 27 to 1. They earned 57% in 1996.
However, each year they delivered those whopping double digit returns, they kept piling on greater amounts of debt because it took more leverage to create the return. At the time of their demise, Long Term Capital Management had about $5 billion in equity, $130 billion in debt and a derivative book of about 1 ¼ trillion.
Now, you take a look at Wall Street investment banks today, or the money center banks, and their derivative book, and the amount of leverage they are employing resemble Long Term Capital Management on steroids. So the vast amount of leverage and speculation that you see today with hedge funds, investment banks, money center banks is a direct result of this ocean of money that has been created by the world's central banks. [3:58]
JOHN: Well, we do know that whenever central banks create money as they do today, it has always led to a speculative frenzy. We've seen this many times throughout history. We saw it in the 17th century with both the Mississippi and the South Sea bubbles in England and France. We've seen it in the 20th Century in Germany, Argentina, Russia, Turkey, even Zimbabwe today. And let's face it. History tends to repeat itself.
JIM: This reminds me of something that Jens O. Parrson wrote in his book Dying of Money, and this is a direct quote from that book, and he says:
Speculation alone while adding nothing to Germany's wealth became one of its largest activities. The fever to join in turning a quick buck infected nearly all classes of society, and the effort expended in simply buying and selling the paper titles to wealth was enormous. Everyone from the elevator operator up was playing the market. The volume in turnover and securities on the Berlin Bourse became so high that the financial industry could not keep up with the paperwork.
It was typically true that the Germans who grew the richest in the inflation were precisely those, who like the speculators, the operators and the builders of paper empires, were the least essential to German industry operating on any basis of stability or real value. [5:18]
JOHN: Isn't that what we have today? I mean just turn on CNBC, what do we see? The commercial advertisements all recommending trading; they show people making money in their leisure time living in big houses. I mean watch Cramer or referring back to Parsson. Just look at this year's record bonuses on Wall Street. Isn't this déjàvû? It seems to be a repeat of past inflationary cycles.
And now we have oceans of money being created by central banks, and the result is speculative debt levels that are rising. And right now speculation is running rampant.
JIM: The degree of risk of leverage has been rising so rapidly that it even made the front cover of BusinessWeek in the first week of June. BusinessWeek did a cover story that they called Inside Wall Street's Culture of Risk. We had its author Emily Thornton on the show in June.
JIM: And Emily, Wall Street has always been taking risk, let’s face it that is what Wall Street is about, but never before has this risk taking risen to such a prominence. And unlike let’s say the past, never have the investment banks had to reconcile so many bets made on so many fronts.
EMILY THORNTON: Yes, that’s absolutely true, because of course in the past we’ve seen banks that were engaged in trading for their own books. However, right now they’re trading for their own books, they’re using their capital to trade on behalf of their clients, and they’re doing things as risky as buying companies. [6:39]
JIM: Many of these firms such as Goldman have made so much money from trading and leveraged bets, but it doesn’t appear that there are any signs anybody is willing to ease back. In other words, even with this shakeout we’ve seen in stocks, and commodities and markets around the globe, it doesn’t look like people are pulling back.
EMILY: No, it doesn’t. Well, one thing that got me interested in this story in the first place is that basically every quarter we’ve seen these banks come up with record profits. So I started to wonder how that could be. And what became apparent is that they were putting more and more risks in their balance sheets and making bigger and bigger bets that were paying off. And as you point out the markets are changing now, they’ve been relatively calm now until the last several few weeks. And we have second quarter earnings coming from the banks in the next couple of weeks and I think they’re going to be very interesting. [7:34]
JIM: You know this cycle, which has been fueled by cheap money is much different than the past. We’ve been talking about for example in the 1990s few banks were willing to put at risk their own capital, but now – you know, in the past they were mainly acting as brokers, maybe they were doing transactions for clients – virtually all the banks are making these huge bets with not only their own assets on the many fronts that we’ve talked about but they’re also using increasingly larger and larger amounts of borrowed money.
EMILY: Yes, that’s true, I think though we’ve seen this kind of go in waves. In the 90s, many of these banks weren’t public, they were private partnerships, so the ones that were engaged with trading on their own books – like Goldman Sachs – were slightly more conservative because it was their partners’ money – so their own checkbook. But what’s happened now is we have all these banks that are now public and they are taking bigger bets with shareholders’ money basically. [8:45]
JIM: Would you say the investment banks have morphed into what we could call the ultimate hedge fund? I mean they do more trading today than all but the biggest hedge funds.
EMILY: I would say that this is a little bit of a mixed bag because on the one hand with Goldman Sachs leading the charge we have some banks that are doing quite a bit of trading on their own books for their own books, but on the other hand we also see this explosion in trading using their own capital for clients. So it’s not exactly a hedge fund, although they’re definitely doing more trading than many of the big hedge funds out there. [9:15]
JOHN: It seems with leverage and speculation rising, we've got to believe we're going to get another rogue wave in financial markets whether it's hedge funds or credit default swaps, sub prime lenders.
But somewhere in the financial system, there’s a little catalyzing event and a huge rogue wave lurking that could really probably take the markets by surprise when it lets loose.
JIM: And about that point, John, it's not just you and I that see this potential danger. Our current Treasury Secretary also sees the risk, and he should know. He just came from Goldman where they are levered 27 to 1.
Let's go back to the June Thornton interview because she also picked up on this potential risk.
JIM: This reminds me of something you quote in your article a comment made by Paulson: “No one can predict where the next disaster will come from. The one thing we know is when there is another shock, things that you hope wouldn’t correlate or trade in tandem are going to correlate.”
Isn’t that where the real risk lies here, because you are in an opposite position – maybe another asset class – but in a meltdown sometimes you start seeing all assets correlate.
EMILY: Right. This is definitely the question and of course what Paulson is referring to is the blow-up of a hedge fund called Long Term Capital Management which occurred in 1998, and resulted in a bailout by the banks to the tune of $3.6 billion. And in that case, basically the different assets that the hedge fund was trading appeared to be diverse but because of Russia devaluing its ruble it triggered such a series of events that all of a sudden everything was going down, and it was impossible for that hedge fund to recover and it basically almost took down the banks with it.
And at this point these banks are so much bigger than they were in 1998, and they are trading in so much more diverse commodities and other assets around the world – I mean almost every corner. And the argument is because of that we won’t have the kind of meltdown situation that almost occurred at that time. But I think it’s untested territory and I think Paulson hits it on the head that that is the risk: that if there were something very extraordinary like an outbreak of Avian flu you could see everything trade similarly and in that case all of these hedging strategies may not work. [11:48]
JIM: You know this is the one thing that comes to mind Emily is that you never really completely get rid of risk – all you do is transfer it. And I can’t help but believe when the music stops somebody is going to be holding the hot potato. We can’t believe, even though you’re diversified today, that everybody comes out even when things go wrong.
EMILY: Right, well, I think when you talk to people at the bank –their experts in this industry – I think they all agree with you. Nobody can say how or who but inevitably when we’ve seen Wall Street go in cycles of excess there is always one firm that seems to miss the turning point and gets into trouble. So people are betting that this is what will probably happen this time. [12:35]
JOHN: So let's see, Jim, if I were to summarize here, first of all central banks are increasing the rate of money printing, which is then reflected in a rising broad money supply growth around the world. This results in driving down the interest rates as the money flocks to various asset classes, such as stocks and bonds. And as more money is created, interest rates fall, and leverage rises along with the speculation that goes with it. This creates the potential for the rogue financial event to occur, which is the topic of your latest piece, The Next Rogue Wave. And I might point out that our listeners can search our FSO archives for similar articles that you've written in the past, especially the Rogue Wave, Rogue Trader article which came out in your Storm Series.
JIM: John, I think you summed it up pretty succinctly.
JOHN: So, where does this all take us in the end ultimately? There's an end game of any kind of run like this. What is the ultimate consequence of all of this money printed?
JIM: I think in the end we're going to follow a very similar pattern that we've seen play out throughout all of history. The US is moving from a republic to a democracy on its way to a dictatorship. There's a moral tale here that proves out a revolutionary axiom: if you wish to destroy a nation, you must first corrupt its currency. That is what Fed policy is doing today. And that is why the only protection you really have in a society and its first bastion of defense is a sound currency. We lost that battle in the 30s, and we lost the final battle in 1971 when we got rid of the dollar's gold backing. [14:11]
JOHN: You know, you hear very few people calling for a gold backing of our currency. People almost consider it archaic or passé. That would end the government's ability to inflate by locking the currency into something of real value.
So I guess history is about to repeat itself again. I guess not just for us but some of the other central banks around the world that are doing the same thing. You can already see the press and the government looking at someone to blame because that's the one thing that never happens. It's never a mea culpa when it's all over with. You've got to have a list of scapegoats, whether it's greedy oil companies raising the prices of oil; or foreign governments because of our trade deficits – “why!, it's their fault that we have trade deficits.”
JIM: This is something I hope to be writing next year. I'm working on a piece -- I'm just kind of thinking. I'm going to take some of the pronouncements by some of the notorious central banks’ heads in the past and also treasury ministers, for example in Germany, and they said, “Hey, you know, it's not the money printing that's causing all of this hyperinflation.” And then I'm going to sort of contrast that with what we've seen our treasury secretaries and also our central bank people say here, and it's going to be a reflection or a continuation to my Great Inflation series.
But I want to address what you said with another quote from Fergusson's book When Money Dies. And I'm going to quote here directly and it goes like this:
It is natural that a people in the grip of raging inflation should look about for someone to blame. They pick up on other classes, other races, other political parties and other nations. In blaming the greed of tourists or the peasants or the wage demands of labor or the selfishness of the industrialists and profiteers, or the sharpness of the Jews, or the speculators making fortunes in the financial markets, they were in large measure still blaming not the disease but the symptoms. A few of the financially sophisticated could be heard blaming the government, but a typical view was that prices went up because of the speculation on the stock exchange.
Although the price of the dollar was going up, it still appeared to most Germans that the dollar was going up, not that the mark was falling; that the price of food and clothing was being forced increasingly upward daily, not that the value of money was permanently sinking as the flood of paper marks diluted the purchasing power of the number in circulation. [16:40]
JOHN: But, you know, when you talk about this today, people will say: “Well, this is a totally different time, a different place where a high tech society, things are totally different, that can never happen here.”
But, you know, in the end when inflation rages out of control and the ensuing chaos rages as well, the people vote no confidence in their congress or their parliament, and they usually cry out for some guy wjp is going to step in here, vest him with all of the powers that he needs to do whatever you need to deal with the situation type of thing. They want that strong man. And the last time, of course, we saw that was with Germany Adolf Hitler, or Italy with Benito Mussolini.
JIM: Once again I'm going to go back to Fergusson's book When Money Dies. This is a quote. He said:
The important considerations are that Hitler and the Nazi Party were able to shamelessly use the miseries inherent in a severe inflationary situation to drum up national wide opposition to authority and to persuade many thousands of people that the fault in the blame lay directly in many places where it palpably did not: with men who had signed the armistice, with the French, with the Jews, with the Bolsheviks. Inflation played into Hitler's hands, and it was no more the invention of the communists who were taking advantage of the social wreckage it was causing, than of Hitler and the Nazis. Inflation is the ally of political extremism and the antithesis of order.
#5 Theme: The Rise and Fall of U.S. Interest Rates
JOHN: Well, for the financial segment of today's program, we're going to discuss the rise and fall of interest rates. Interest rates rose during the first half of the year both with Alan Greenspan and Benjamin Bernanke raising interest rates, and then they suddenly begin to plunge beginning in July.
JIM: Well, if you take a look at what was driving this, the first half of the year was all about rising inflationary expectations. The PPI, the CPI and the core rate of inflation all rose during the first half of the year. If we think back to what was happening then, oil was on its way to $80 a barrel, gold hit $750 an ounce in May, the CRB was hitting record levels and Americans were experiencing weekly rises in the cost of gasoline and groceries. Commodity prices were rising. And it was obvious to everybody that inflation from all of that money and credit creation was spilling over into the real economy. It was spooking the financial markets, so the Fed was beginning to lose credibility and especially the new incoming Fed chairman, Bernanke – especially after all of those flip-flops. [20:26] (Table from The Next Rogue Wave.)
CREDIT EXPANSION OUT OF CONTROL
* annualized, ** growth in chained dollars | Source: Bureau of Economic Analysis
JOHN: I remember the testimony that Ben Bernanke did back on Capitol Hill in April hinting that the Fed was almost done. And at that time many of the senators were getting concerned the Fed was going to wreck the economy.
Here's a part of our program from April 29th talking about this whole issue.
JIM: They started raising interest rates in June of 2004, and it was rather interesting because it’s widely expected that they’re going to raise interest rates in May. And John, when Bernanke was on Capitol Hill this week, you really sensed the Senators are concerned, saying, “are you going to drive us in to a ditch again?” Let’s go to the Sarbanes clip:
Sarbanes: Of course, inflation expectations will remain low only so long as the Federal Reserve demonstrates its commitment to price stability. And the question I want to put to you is it in order to for the Federal Reserve to demonstrate its commitment to price stability is it necessary for the open market committee to raise interest rates 25 basis points every time they meet?
Bernanke: Ah, no, Senator.
Sarbanes: That’s all I need is an answer, just so I know we’re not on an irreversible treadmill here.
It just wasn’t Sarbanes. In fact, several of the Senators were really concerned about, “if you over do this, guy, you’re going to take us into a recession.” And there’s a lot more debt out there now than there was during the last one. In fact, you can see this expressed, and I think it was Caroline Maloney who expressed this fear:
Senator Maloney: My constituents are very concerned – I would say even nervous about this continued flip or pace in the increase in interest rates which have been raised 15 times since June of 2004. And there’s maybe a feeling we should step back a few steps and just assess where we are, and there is a deep concern about it, and I wanted to relay that to you. My question is can we continue to increase interest rates without having a negative impact on our economic growth?
Bernanke: I think we will try to raise rates – if we do – in a way that maximizes the attainment of our objectives which is price stability and maximum sustainable employment growth. [22:40]
JOHN: That was from our show on April 29th of this year.
JIM: You know, John, I think we need to insert our Bernanke babble dictionary in terms of his comments to those senators. I mean they put out this economic pabulum out there that makes absolutely no sense. But I think what you were seeing here, the market's interpretation of that testimony is that the Fed was getting ready to go soft. The stock market rallied, and then we got the infamous Maria Bartiromo fiasco, when Bernanke told her at a social function that the markets had misinterpreted what he had said. [23:17]
JOHN: I remember that fiasco because right afterwards we got a series of inflationary reports that really put the Fed in the corner. CPI and PPI were rising, gold was going up, along with oil; and what was really teeter tottering here was the Fed's credibility – it was at stake.
JIM: Not only was the Fed's credibility at stake, but also more importantly inflationary expectations were starting to rise and the Fed really at that time had a crisis on its hands. It needed to stop raising interest rates or they were going to get blamed for wrecking the US economy and taking us into another Fed created recession. At the same time they had a real inflation problem on their hands. [23:54]
JOHN: Yep. And as we always do here on Financial Sense, you warned our listeners what they planned on doing.
JIM: You know, the first thing that they did, and we saw this all throughout May and June is that they mobilized the Fed's Open Mouth Committee. Almost every day throughout may and June you had Fed governors giving speeches and talking tough on inflation.
When it became obvious they would raise rates in May and June, the stock markets corrected and you even had services such as Lowry’s, a very well respected technical service, who proclaimed the end of the Bull Market. They literally scared the pants off Wall Street. And you had a lot of talk back then about the Fed driving the economy into recession, and especially as the economic numbers began to point to a major softening. [24:43]
JOHN: Yeah. But talking tough was only part of the act they did. They also needed to hammer the commodities which you did point out on the June 3rd show in a piece we did called Engineering a Recovery. Let's listen to what we said back in early June of this year.
JOHN: Well, you know one of the things we’ve been talking about too is when you look at the whole total price of oil on the world markets there’s a segment of it which is called the geopolitical premium. Meaning, if everyone is real nervous about what’s going on with Iran, and what could happen there in the Middle East, then this of course has the effect of driving the oil price up.
Now, obviously the Bush Administration can’t do much in the straight market supply and demand area but it could bring the GNI – the Global Nervousness Index – down, and thereby assuage the geopolitical premium part of oil. And that would score at the pumps.
JIM: Sure, absolutely, because you know the supply and demand factors for the price of oil are somewhere around $50 a barrel; you’ve got another $10 premium because of strong investment demand; and then you have a $10 premium that comes in from geopolitical tensions. So, if you can remove part of that geopolitical tension and also part of the investment demand – in other words, if oil prices start to drop you’re going to have a lot of people exit and cover their long positions in the market and take profits.
So, number one, you can see September, October if this can come about, the price of energy comes down, which means the price of gasoline at the pump comes down, so that helps. That helps lower the inflation rate, that helps to take away some of the pain of higher gas prices, and you can imagine the political windfall of the United States announcing for example its first stage of troop pullback in Iraq.
The other hand thing I think they can do –and I think Paulson is going to be good at this – is hammer the commodity markets especially raw materials costs. That brings the CPI down, and also enables and gives the Fed the excuse it needs to go on pause. At the same time you bring down long term interest rates as the price of commodities come down, so there’s less of an inflation premium. You can help refinance part of the debt bomb – this trillion dollars of adjustable rate mortgages that comes due in the next 12 months; and then you also place a stabilizer on falling real estate prices. This enables the Fed to go on pause, they can goose the money supply, they can remonetize the debt, helping to bring down long term rates. And with all of this going on the stock market heads to a new high.
So, John what you have by the November elections: peace with Iran, troop withdrawal from Iraq, the oil premium goes down bringing down gas prices with it. As that happens long term interest rates come down; commodity prices come down – this brings down the CPI. That allows rates to head lower, the Fed goes on pause, the stock market hits a new record. The result: you just checkmated your opposition at election time. [27:50]
JOHN: Jim, where do I get the crystal ball that it's worth the investment?
JIM: Well, you know the scenario didn't play out perfectly. Instead of peace with Iran as a way to bring down the oil markets, I made reference to Paulson, Goldman Sachs redid their commodity index in the first week of August that lowered the weight of gasoline from 8% down to 2%. They lowered natural gas from 8% to 5, and when they did that, they triggered a $6 billion sell off in gasoline, natural gas and oil.
The result is oil prices were brought down from around $80 to around $60. Natural gas fell precipitously as a leveraged hedge fund named Amaranth had to unwind its natural gas positions. So the energy sector fell, gasoline prices came down, and with the way they weighted the CPI headline inflation, headline inflation began to fall. So by early Summer as central banks printed money and expanded the money supply, interest rates began to fall by the end of June. Then talk turned away from inflation and inflationary expectations fell, and the new talk was of an economic slowdown.
And as long term interest rates came down, the rate of decent of real estate began to slow and stabilize. So by September, you saw a new up wave begin in the financial markets and you got the new record in the Dow that we'd been predicting. [29:14]
JOHN: What part of the forecast didn't play out?
JIM: I thought with all of the negative sentiment in the polls that the Republicans would have held onto at least Congress by a very thin margin. In fact, we did a show on that. In the following week, there was a piece in Barron's echoing the very same thoughts that I had. In taking the contrarian position I took – the other side of the trade, so to speak – I was wrong. Although I don't believe it was all anger over Iraq. I believe the inflation that we've been experiencing and the lack of wages keeping up with inflation, forcing more Americans to take on debt to pay their bills, is the other side of the story. That’s because if you look at the Democrats that really won, most of them are conservatives on fiscal issues, so that's why I believe they won. [30:03]
JOHN: I expected you to sound like the Fonz there. I was wr-wr-wrong. But you know, to your credit, nobody gets it all 100%. But you did spell out the scenario. They had to hammer the commodity markets, which you have to admit they did very effectively. They also redirected the market's focus from one of inflation to the goldilocks scenario, slowing the economy, which would relate to lower rates of inflation, and as the economy slowed down... and well, what comes next?
JIM: Well, we're going to cover that in next week's show as we cover the issues that dominated the markets for the last half of the year. We're also going to briefly touch upon what issues are going to be carried over into the next year when we get into the forecast show and roundtable that we're going to start off at the beginning of the year.
This, I believe, is enough, John, to digest in one show. We'll be back next week with our conclusion of 2006. In the meantime, on behalf of John and myself, we'd like to take this time to wish you a very merry Christmas and a happy holiday. And may this holiday season find you healthy, prosperous and among friends and family. God bless. [31:19]