Financial Sense Newshour
The BIG Picture Transcription
February 17, 2007
Part 1
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- Ben Bernanke on Capitol Hill, Don't Worry, Be Happy
- Economics of Inflation, Part II, Public debate, Weimar Germany, parallels
Part 2
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Part 1
Ben Bernanke on Capitol Hill, Don't Worry, Be Happy
Here's a little song I wrote song. Don't worry. Be happy. Every life we have some trouble, when you worry, you make it double. Don't worry. Be happy.
JOHN: Jim, I don't know. I just feel good. I watched Bernanke this week and the economy is growing.
JIM: You have no worries any more, right?
JOHN: No. I don't. Inflation is moderating he told us, economic growth is good. I mean, if I feel any better, they'll have to make it illegal or something. Didn't you get that from watching Ben Bernanke? I don't know. I did.
JIM: Yes. It was a rather upbeat assessment that the Chairman gave before both Houses of Congress this week. And the market seemed to like what he was saying because we hit a new record in the Dow, passing 12,750.
So the market liked what he said, and if you listen, what he was saying is inflation rates are moderating and also economic growth continues. In fact, he gave a rather upbeat assessment on economic growth. And so it was like, okay, these things are going great, but like any good economist here are the caveats. And that caveat is, “well, if inflation doesn't moderate as we expect, we stand ready to raise interest rates.” And I would suspect the reason that he's talking about raising interest rates has a lot more to do with what's happening to the value of the dollar, as the dollar is approaching key technical levels. And what they don't want to do is see the dollar break down because if the dollar began to break down, then they'd have a whole crisis on their hands including rising interest rates and rising inflation rates. And so what he's doing here is saying, “okay, everything is going great, it's going the way we expect.” And we're going to get into why things aren't really going the way they expect in one of the later segments in this program. They are saying it now, but they are looking through the rearview mirror, whereas we're looking forward in front of us; and we're going to tell you about some indicators and markers that we think you're going to see the Fed change its tune in the next three or four months. But let's go down to the one comment, John, and I want to start out with Congressman Barney Frank, when the Fed was talking about the productive capacity of the economy being below expectations and it was almost like gobbledygook double talk and Congressman Frank really called him on it:
Sen. Barney Frank: Your report says production below potential rising the potential, but then you say well, you think it might be more than you think. I mean, if you think it might be more than you think, why don't you think it. It does seem to me a little odd to say here's what I think, but I also think it might be worse than I think. That is literally double think. And what particularly concerns me, I read these two sentences, production now below potential and prediction only to get to potential and not above it and inflation moderating, and I don't see how that computes with as I noted earlier the FOMC has continued to view the risk that inflation will not moderate as the predominant policy concern. I can understand it being a concern. I don't understand how given this it outweighs the other. [3:56]
JOHN: I think he knew what he thought there.
JIM: Well, you know, it's funny. And this is something that I just don't think Bernanke has the same ‘babble effect’ that Greenspan did. And John, you remember the Greenspan testimony and you would have a Congressman that would ask Mr. Greenspan, remember, he was considered almost like an economic god. You can remember the testimony between '97 and '99 when the NASDAQ was going up 20% a year and we were in the new paradigm economy. It was just like adulation. They were all fawning over him. But the one thing I always liked and I always enjoyed about Greenspan versus Bernanke is when Greenspan was asked a question, he would take them in so many different directions it was like, “well, do you think GDP growth will continue to remain strong, Mr. Chairman?” And he would say, “well, if you take a look at productivity rates and then you factor economic phenomenon such as the disintermediation of markets, and if you take that by nominal GDP and look at the core factors of inflation versus the savings rate differential between…” And by the time he got done answering, you could see the Congressmen how kind of like their eyes were glazing.
And it was like, “I don't want to appear dumb that I didn't understand what he just said” – but the real problem was nobody understood what he said. So he could baffle them. Bernanke is getting better. He's getting better on the baffle technique when questioned by these Congressmen, but he hasn't quite finessed it the same way that Greenspan did. That’s because Greenspan always left you hanging scratching your head, like “what did he just say?” – where Bernanke tends to be a little more direct. You can tell there's a real nervous edge in his voice when he talks. You can tell he's uncomfortable being up there, and is not quite at home and at peace, and that's because he hasn't learned the baffling technique. And hopefully he'll get some coaching by Greenspan. [6:04]
JOHN: Of course, as Ron Paul pointed out, the Congress has virtually abdicated all of its oversight over the Fed anyway.
JIM: Let's go to some of the other contents in this report because if you take a look at the Fed in the last month, there's been several important Fed speeches given by Mr. Bernanke and other Fed governors, but for example, they are hammering this thing, the Fed warns of widening inequality. Well, the reason we have widening inequality is because of the Fed's inflationary policy. That was a speech that Bernanke gave on the 7th of February and then on the 10th, the Fed officials are wary of inflation pressures. But at the same time look at what they are saying. They are saying inflation is moderating, core rate of inflation is going down, headline inflation is going down. In fact, as we got the PPI numbers for the month of January, they were actually negative. So the Fed would appear – like any economist – that they are talking out of both sides of their mouth. One of the things that he is highlighting – (and we have been speaking about this on the show since the beginning of the year) in fact the last time was before a Congressional committee just a couple of weeks ago, he hammered the same theme – and that is we've got an aging retirement population in this country with the baby boomers. And we're right around the corner from that – the first batch of baby boomers are going to be heading into retirement in the next couple of years. So all of the surplus revenue that the government is taking in in Social Security taxes is going to be far below what they are going to have to start paying out. And so he's talking about them needing to fix this. And if they don't fix this, we're on the road to destruction. And let's go to that clip:
The federal growth I'm most concerned about is sort of the implicit debt that is associated with our promises to future retirees for Social Security and Medicare. If we were to stop here in some sense, it wouldn't be quite so bad. The amount of government debt held by the public currently is about 37% of GDP, which is fairly normal across industrial countries – it’s lower than some in fact – but the situation is going to get a lot worse as we have retirements of the baby boomers and so on and medical care costs go up. According to the Congressional Budget Office in the intermediate scenario by 2030, the debt instead of being 37% of GDP, will be 100% of GDP, and the deficit will be 9% of GDP instead of being a little under two as this year. So if we allow things to continue, the debt-interest cycle will continue to build up and we will hurt our fiscal position to the detriment of our children and grandchildren. [8:50]
JIM: Well, there you have it, John, the Social Security problem. And just as a couple of weeks ago you had Congressman saying, “how do we get around these obligations and promises that we've made to people because we can't fulfill them.” And as the Fed chairman just made a remark there: if we were to stop today, we might be okay, but as we continue in the same way that we are doing today, there is a train wreck coming here around the corner. Now, they are talking about this train wreck occurring in somewhere around 2030, but believe me it happens in the next decade. That’s because as more people retire and start collecting Social Security benefits and also go into the Medicare system, it is just going to be overwhelming. It's an overwhelming strain on the system, and the system is going to implode. [9:38]
JOHN: Why is it that they extend this to 2030, 2040 versus what you're saying because that's a logical question I think listeners would to ask themselves?
JIM: You have to understand the way the Social Security system works. We pay in every month or week. When you get your paycheck, money goes into the Social Security trust fund, and what happens is out of that it's a pay as you go system. And what they do is pay out current benefits to current retirees. And then the surplus, which should have been invested in corporate bonds, maybe equities to provide a pension pool to draw on in later years – that didn't happen. What happens is the money or the surplus goes over into the general fund for government. And the government spends the money, and then turns around and issues an IOU to the trust fund. And so the trust fund is sitting with a whole cookie jar full of these IOUs. Okay, well what happens when these IOUs come due? Where do they get the money to pay off those bonds? [10:46]
JOHN: I’m assuming taxation is the answer to that one.
JIM: It's either they have to raise tax revenue, or they have to monetize those bonds, because those bonds are worthless. There's nothing behind them. They are just simply an IOU – a special zero coupon bond that has been issued to the trust fund because the government has borrowed several trillion dollars of surpluses. So that's where you get this 2030 figure, they are saying, “well, these bonds have a theoretical value.” Well, who pays for these bonds when they become due? They are going to have to go into the capital markets and refinance them to get the money to pay off Social Security recipients. That's where you're going to put real pressure on the bond market and the capital markets with these huge financing needs that the government is going to have. And that's why you heard reference when the Fed Chairman said at the present rate by the time we get to the end it will be over 100% of GDP versus when we actually get over to the crossover point – and what I'm talking about here, John is that point where the revenues that the government is taking in on a current basis is less than what them be paying out to beneficiaries – and we crossover that point in the next decade. [12:05]
JOHN: And that's the real world crossover rather than the artificial one.
JIM: Yeah. The artificial one is the 2030 date which assumes these IOUs are worth something.
JOHN: Which we know they are not going to be.
JIM: Right.
Now, the other thing that was rather interesting in his testimony is that you've got to lay out and cover your tracks because remember, the message was “don't worry, be happy” – upbeat both on growth and inflation: growth is going to moderate somewhat and it's going to be close to 3%. I think he's wrong on that assumption. The Fed's forecast is the gross national product should be between 2 ½ and 3% this year and two 2 ¾ to 3% next year. So that's all the happy talk. Then you have to come in and give all of the caveats to cover your tracks in case things don't turn out as you expect.
John, I want you to archive these clips that we're playing here in February because I predict – I'm making a prediction on the show – they are going to be completely opposite of what he's going to be saying in July as the economy starts to slow down dramatically, as consumer spending slow down, as the real estate market continues to worsen, as it leads to financial difficulties in the financial sector, especially with subprime lending. In fact, covering his tracks he already cautioned that the risk to this outlook are significant. So what does that tell you, John, when I say, hey, things are going well, but the risk to this outlook is significant. How comfortable would you feel with that? [13:44]
JOHN: Yeah. You always want to know, remember it's the “there's some good news and some bad news,” that argument. And you hear the good news, but there's always a ‘but’ coming, and it's the ‘but’ that worries you, you know.
JIM: Yes. And he said the risk to the outlook is significant and what he's talking about is the housing sector remains a downside risk – and it’s despite tentative signs of stabilization. And here was a number that we got out on Friday: housing starts are down 14%. Housing starts have gone from 1.6 million to 1.4 million on an annual rates and we're down to levels we haven't seen since 1977. And then he goes on and gives another caveat and he said, “now with the risk in housing there's also a risk that delinquency rates for subprime mortgages and variable rate mortgages have increased appreciably. But then he comes back and sues you and he says, “but in the meantime, the business sector is in excellent financial shape.” [14:41]
JOHN: You know, last week we were talking about the fact that the country has a negative savings rate – it came up briefly in our conversation last week – and one of the things you have to recognize is it's not because people are necessarily being spendthrifts but simply because of the fact that they can't save: they are living paycheck to paycheck and what come in goes in and goes out. That’s it – they have no choice. So there is no capability again because taxes and inflation are chewing them up alive. Here was a comment by Congressman Robert Menendez who is a Democrat from New Jersey:
Menendez: I am very concerned about the economic squeeze that has been put on the middle class particularly since the turn of the 21st century. Since the beginning of 2001, middle class families have experienced increased levels of debt, economic growth and real wages, all the while essential costs for food, housing medical services have increased at levels drastically higher than inflation. As a result of the financial security of middle class households has suffered, and more and more American families are unable to afford life emergencies, such as an unexpected health problem or unemployment. Unemployment opportunities are at their lowest levels since the Great Depression; since the recession ended in November 2001, job growth has averaged a mere 0.8% per month – less than a third of the 2.7% average growth, we experienced in previous recovery periods since World War Two. For the first time since the 1950s job opportunities have actually decreased from a 16% growth rate in the 1990s to a 14% decrease since March of 2001. I look at that and I add to that factor the family seems to be living on thin ice. I hear these stories of families in New Jersey that are only an unexpected illness or layoff away from sinking into perpetual debt. I think one measure of this economic insecurity is the percentage of middle class families that have at least 3 months of their salary in savings, the percentage of middle class families that had 3 or more months salary and savings rose 72%, from 16.7% in 1992 to 28.8% in 2001. So middle-class families are becoming more secure year by year. But unfortunately, in the span of less than four years, that percentage dropped by over 36% down to 18.3 in 2004. And finally, I noted with interest on page 2 when you were giving your opening statement, you said consumer spending continues to be the mainstay of the current economic expansion. That's true, but when you add that reality to economic anemic growth in wages and sharp increases on the cost of necessities, household debt in America has risen to record levels over the past five years. By the third quarter of 2006, outstanding household debt was 130% relative to disposable income. That means the average family’s debt is $130 for every $100 it has to spend. And additionally, the average household savings rate has actually been negative for the past 7 quarters averaging about a negative 1% rate for 2006. So I look at all of this, and I say to myself, you know, I have my friends and colleagues who are heralding this great economy. I don't get the sense that people back at home and in other parts of the country feel that good about it. [18:15]
JIM: You know, it's amazing to hear that Congressman talk about really what is going on underneath, John. And the Fed also made reference to this – Bernanke in his speech about income widening inequality – in his February 7 speech. But it's taxes and inflation that create inequality. And one reason most families are struggling today is because take a look at what it take to make it as a family today. And if you are working in a salaried job and the cost of bread, milk, meat goes up and the cost of eggs goes up, your utilities go up, your gasoline costs go up, your kid's tuition goes up, your visits to the doctor goes up, your prescription drugs go up if you're taking them if let's say you're retired today or your medical insurance premiums go up. So what you have is a situation where you can't go into your boss – if the inflation rate is running between 6 and 8% a year with tax rates being what they are today, then you can't go in and say, “look, boss, I need a 12% cost of living increase just to keep me even.” What happens – as we'll get into the next topic on the economics of inflation – is it gets harder and harder for families to maintain their lifestyles. So the wife went to work in the 70s as we inflated; and then in the 80s the savings rate went down and in the 90s we turned more to debt. And so we have two people working now, we have a negative savings rate and then we also have debt substitution to maintain a standard of living – and that's where we are today. [20:00]
JIM: John, we're going to go to that next clip where they talk about the savings rate and what he's basically saying, if you interpret it, is why it no longer became necessary to save in the 90s is because we had asset-bubble inflation. So if we had asset bubbles such as equities going up to 20% a year, you didn't need to save. So if you had $10,000 invested in equities, it grew by 20% a year and it did that for almost a five, six year period, so why save when asset bubbles (either the appreciation of your home or equities) was doing the work. So let's go to the clip and try to explain this.
SENATOR: I'm curious to know what the factors are that go into that steady decline in savings rate. We know it means that people are consuming more than they are earning – or a greater proportion of what they are earning – but what's contributing to that trend and is this something that the Fed is worried about?
BERNANKE: Several factors have been pointed to. One is demographics – different cohorts or different generations have different propensities to save. The baby boomers have not been particularly impressive in that respect, and as they have become the biggest recipients of income their savings rates have shown through.
SENATOR: Have there been an evaluation of the propensities of different cohorts currently, and how much of this declining savings rate can be attributed to that one cohort?
BERNANKE: A number of papers have looked at this demographic issue and viewed it as being important although not necessarily the whole story. The other important part of the story is that personal savings rates are out of current income and they do not include capital gains – many kind. So the general strength of the stock market, and then more recently the housing market, has meant that people could increase their wealth without saving. That has been, I think, an important factor in leading to lower savings rate, you know, more recently.
The other sort of technical point to make is that private saving actually consists of the sum of the household or personal savings together with the savings done by corporations. And savings done by corporations has become a larger share of the private saving done overall and in a sense, though, that is – the corporations ultimately belong to the households whether you're a small business owner whose keeping profits in their business, whether you're an investor receiving – enjoying capital gains in their stocks, some of that savings is not appearing in households because it's taking place in corporations. It's sort of a measurement issue. But I think it is an issue because the national savings rate has come down and contributes to issues like the current account deficit we talked about. Our anticipation, as was even mentioned in the testimony, is that the household savings rate should rise a bit in the next couple of years partly because housing prices are not rising as fast and people will turn back to saving from their current income. But we don't anticipate anything like the 12% in 1985 anytime soon. It's going to be a slow process.
SENATOR: Thank you very much. Thank you, Mr. Chairman. And I would note as I am not a member of the baby boom generation, and you are, I look at every possible opportunity to blame something bad on your generation. Thank you. [23:07]
JOHN: One of the themes that came up regularly, and you could hear this over and over and over again, was this theme that we have this inequity in wealth and we need to raise taxes to somehow solve that inequity. This is Congresswoman Gwen Moore who is a Democrat from Wisconsin.
MOORE: I guess I want to ask you if you account for this stronger gain in personal income, as many of us do perceive that it's all aggregated kind of at the top, that this increase in consumer spending is a very narrow numbers of consumers and that imposes some kind of risk unless we spread the purchasing and consumer spending power a little bit broader.
And secondly, in leading into that sort of executive compensation, if we were to again – if we were depending for our economy is depending on consumer spending, wouldn't it be better if we sort of spread the wealth a little bit? And in keeping with your testimony, resist raising prices by narrowing corporate profits?
BERNANKE: Well, as I've discussed, there has been a long term trend towards increased inequality in the United States. That's been going on for a long time, but it's certainly an issue. I think most recently there has been some improvement just in terms of general earnings in the broader economy – I mentioned the statistic of the average hourly earnings which are for production workers, so that's not…excludes the top 20% of wage earners and that has grown recently at a pretty reasonable pace. So I think that a real wage gains currently are going to help support consumption spending but I agree that we want to see a broad-based consumption in order to make this sustainable. [25:15]
JOHN: You know, if you notice there, Jim, she was really calling for a transfer of wealth, wage controls and price controls all in one breath.
JIM: Yeah. Very much the failed policies of what we used in the 70s. And this is something, by the way, John, you're going to hear more and more as certain prices continue to go up and they can't control it. The next step – and even though it doesn't work, it causes shortages, hardships and higher rates of inflation – will be wage and price controls as we had throughout the 70. President Nixon put them in, Jimmy Carter put them in and they didn't work – it failed. But those are typical responses when you go into an inflationary cycle. There are many members in the inner party that are talking about raising tax rates over 50%; and the theory is if we can take from somebody, that, let's say take all of their income over a certain level and redistribute it, then everybody's income goes up. And that's not the way the system works. And we'll get to that when we get to our third topic in the Big Picture here.
But yes, you're going to hear more of this. You heard it throughout both days of testimony, both from the Senate and the House. You're going to hear this topic rise to the surface. A clarion call to raise taxes back up again, get them back up to the 50 and 70% rates that they once were prior to let's say Ronald Reagan coming into our office in 1981 when he brought the top tax rate from 70 down to 50, down to 28 – just as one of his predecessors in an earlier generation, President Kennedy, brought the tax rates from 90% down to 70%. [27:08]
JOHN: What happens when it typically blows apart? I mean if they impose, say, wage caps, what happens then?
JIM: Productivity goes down, job creation goes down. Inflation goes up. I can remember that very well in the 70s, because when I got out of graduate school, President Carter asked for a 7% wage cap to control wage inflation. It did not work.
And here’s what you did get – I worked for a Fortune 500 company at that time, and what they did is let's say you had 100 employees, the most of valuable employees to you got higher pay increases because the corporation needed them, whereas what happens is lesser employees take the brunt of it and they get a lower increase – so that the overall average for the corporation was 7%. So what will happen is high end executives will get a higher bonus or a higher percentage rate, especially for key technical people, whether they are engineers, heads of marketing, VPs because they don't stay around. If you don't keep them, don't pay them, they go elsewhere. And that's exactly what happens – it just backfires.
And the same thing – notice that she said she was also implying raising taxes on corporations as well, and then also putting some kind of price cap on what they could raise their products. And we all know that that creates shortages. [28:36]
JOHN: I would also assume that you can play certain games at the corporate level, like instead of salaries you can do it in stocks, options, perks.
JIM: There's all kinds of ways that you can get around it, but let's say you're a pharmaceutical company and you need a top notch PhD in your research lab and if he's a top notch research person, he can go anywhere he wants; and if he's not going to get paid in compensation, then he's going to go elsewhere. And it applies to anything – whether you're looking at sports teams, if you don't want to pay a star quarter back or a star running back, what he thinks he's worth, then, you know, when his contract is up, he's gone. He's to another team where he's going to get that increase. So it doesn't work. [29:16]
JOHN: Ultimately, though, every government all the way going back to Ancient Rome through Napoleon on forward, their appetite for spending is immense. They will not control it unless forced to do so. So since they are going to do that, then ultimately, Chairman Bernanke’s job is going to be to fund the deficit that they create. They’re running around with their Visa and Master Card charging up things for all of the perks and spending programs, and the only way that he can ultimately deal with that is to monetize it all which we see as monetary inflation; and then that comes right around to the tax payer and the little guy again, who suddenly finds even what he has is becoming worth less and less as far as what he brings home.
JIM: And that's why we need to be talking about helicopters.
JOHN: And Jim, since we know that is what Chairman Bernanke is going to do, if you listen real carefully, you can hear the helicopters coming.
Economics of Inflation, Part II, Public debate, Weimar Germany, parallels
[Robert Duvall: Apocalypse Now]I love the smell of napalm in the morning. The smell! You know, that gasoline smell. The whole hill. Smells like victory.
JOHN: And of course, that was from Apocalypse Now and we're moving on. The economics of inflation. That's our next topic here on the Big Picture.
JIM: Last week, John, we started part one of the economics of inflation. If you have a chance listening to the program to pick up a copy and you want to see the effects of inflation, what it does to an economy, how it distorts the production process, what it does to markets and the tragedy of what it does to individuals, you know, you just heard in the previous segment about how it's harder for middle class families to get along. And there are two reasons why: taxes and inflation – they go hand in hand. And the book was called the Economics Of Inflation, and it is by Constantino Bresciani-Turroni. He was on the War Reparations Committee after World War I in terms of what was going on in Germany, and he was an observer. And so a lot of this that we're taking, we're going to try to relate it to where we're heading, but last week we covered a number of issues.
Now, what happens when governments begin to spend more money than they are taking in, they have to make up that difference with debt or by printing money. If they can make it up with debt, eventually, they have a problem later on; but if they can finance it with debt, it is less inflationary because you're not expanding the money supply as much. But when you start expanding the money supply as we're seeing in this country, where credit inflation is growing at double digits a year, when the money issued is greater in quantity, then the sole effect of that is inflation. And what it does is it directs dollars the employment of existing resources into different channels in the economy. It creates mal investment; it creates distortions in savings; it creates distortion in wages; it creates distortion in the productive capacity as well as the business activity of an economy. So what we're going to get into now is some of the outcomes of what happens when you start inflating an economy and all of these distortions that arrive out of it. [32:51]
JOHN: It's even to me irksome because I hate it when you have the wool pulled over your eyes by anybody, or when somebody tries to do it. And this is a monetary phenomenon. It's caused by the central bank of the country, because it’s not just limited to the US alone, but the inflation is primarily caused by that entity – government coupled with the central bank. But when the ravages start to become apparent, they try to offload the responsibility for that by demonizing entities – you know, it's oil companies doing something or it's something going on in this corporation, or individuals. And in doing so, number one, it diverts the blame on somebody who doesn't deserve it. And two, it prevents you from really dealing with the issue because the public, as a rule, is generally not educated as to what caused inflation. Just ask anybody on the street, Jim, and ask them what causes it. They won't be able to tell you that.
JIM: Oh, absolutely not. And you saw a bit of it that's going on with the minimum wage. They want to raise the minimum wage by 40%, but to counteract that for a business, they are saying, “well, let's give the business some tax break to offset a 40% cost increase.” That’s because with competition, if your costs go up 40%, you may not be able to go out and raise your prices 40% to your customers to recoup the cost or increase in your labor cost. And you just heard that Congressman from Wisconsin talking about perhaps some kind of price controls on companies to prevent them from raising their cost, or raising their prices according to her, in order to make more profits. No, they are not trying to make more profits. What they are trying to say is, if, look, if my profit margin that I need to earn on sales to pay my bill is 10% of sales or it's 15 or 20%, whatever it is, if my costs go up, and I'm to maintain that same profit margin which is what I need to pay fixed overhead, pay insurance costs, rent, you know – whatever expense that you have as a business – you've got to be able to raise prices. And if you don't raise prices, then there's a couple of things that are going to happen. Either, one, you're going to have to start cutting costs, and usually what will happen is businesses will cut labor costs because they are the most expensive. That is why if a business cannot recoup a 40% increase in their labor cost, what they will invariably do is start cutting their labor. That’s why when you get these minimum wage increases, you usually see job losses as a result. [35:38]
JOHN: Yeah. It's really key to recognize that this does create distortion in the economy. It just simply slashes things in favor of one group away from another group, but maybe we out to talk about specifically how this looks, how it affects the economy and what it does.
JIM: Well, the first thing it's going to do is it's going to create distortions. Those who are dependent on fixed income, or in many ways fixed wages, are the first losers. So you heard the Congressman saying, talking about plight of the middle class. You heard the Fed talking about in his speech, about the inequalities that are widening. What he's talking about are the problems in an inflationary economy, if you are a wage earner, a salaried employee. And let's just do this for illustration purposes, let's assume that your salary is $10,000 a year. And let's assume that the real rate of inflation is about 8%. So if you were to maintain – let's exclude taxes for a moment – but let's assume that if you were to maintain the same standard of living. In other words, at the end of the year, if inflation went up 8% that year, by the end of the year, you would have needed an 8% cost of living increase to keep you even with inflation. The other thing is you do know if you did get an 8% salary increase that you don't get to keep it all. You have to pay taxes. The average American pays between 7.56% Social Security tax, probably pays anywhere from a 15 to 25% federal tax; and then here in California, just about everybody pays a 9% state income tax. So, you know, by the time you back out your taxes, you only get to keep about 60% of that 8% salary increase –assuming your boss would give you that 8% salary increase. The problem is that isn't reality. Bosses aren't giving after-tax cost-of-living increases that maintain workers with a real rate of inflation, so as a result, workers fall further behind.
And even if you did get an 8%, or let's say a 12% increase, in order to have enough afterwards to have 8%, actually, John, to have 8% after tax, you would need a 13 – almost a 13 ½% pay raise to have 8% after tax. That just isn't reality. If you've got a 13 or a 14% pay raise, you just got promoted. That's more indicative of somebody that would be moving up and would be getting a job promotion. You almost have to get a job promotion every year just to keep even with the inflation rate. So one of the first outcomes of an inflationary environment is the middle class and poor get squeezed because they cannot keep up with the rate of inflation as a salaried worker. Even union workers are always bargaining from behind. In other words, let's say, union has a three year contract and then that three year contract – let's say the inflation rate goes up at 8% a year, you're talking about a 26%, or almost 30% increase, compounded in your cost of living by the time your union contract is up. So then you get into the next round of negotiations, so you're already ready falling behind because you cannot put through immediate pay increases. So one of the first distortions in the economics of inflation is fixed-income people usually end up getting poorer if they are living on fixed income – whether it's a fixed pension or if they are in the bond portfolio. And as I recall a couple of weeks ago I talked about, when I first got into this business, of the executive that retired in 1969 with a pension, Social Security and a million dollar bond portfolio of which $750,000 was in bonds; and he suffered a dramatic reduction in the style of living because of the inflation that occurred at the end of the 60s and throughout the 70s. [40:77]
JOHN: Well, also the other ravage of inflation is that the currency begins to decline in value. If we take just a real world example in Venezuela right now with what Hugo Chavez is doing down there, the real inflation rate is right about 20% there. The value of the currency has been what? Halved?
JIM: It's declined by well over 50%. And the inflation has gone from low double digits now to high double digits and will probably be going up to 50, 100% a year, so Venezuela's economy is going to be hyperinflating.
But another distortion that is introduced here is what happens is foreign and home demand for goods intensifies because their costs start to rise. And this is what happens when money velocity starts to increase. The other thing too, John, is foreigners can profit as a result of a declining currency. In other words, if the U.S. dollar is declining against the Euro, which it has – the Euro was worth I think at one time in the low in 1998 or 99, about 72 cents on the dollar – now the Euro is worth about 30. So what happens is foreigners profit by greater purchasing power of their money. So what they have – and will start doing is they'll start making important acquisitions. In fact, by the end of the great German inflation, foreigners own nearly 10% of the share capital of all German businesses. So inflation also increases the real incomes of numerous classes of beneficiaries in the economy – and one of them is foreigners. They can benefit because if your currency is depreciating against theirs, well, then, their dollars (or Euros or Yen or whatever it is) can buy more goods, more businesses, more land and assets in the United States because their currency keeps appreciating – and this is something that we saw in Germany. And at the same time, you have this wealth disparity that is created in society with those who can speculate and profit from inflation, and those who cannot profit from inflation such as the wage earner or the people on fixed income. [42:30]
JOHN: It's interesting to note that because of that, Jim, the first thing that happens there as well, is the fact that control of a country transfers to foreigners, to people who have not necessarily that country's best interest at heart because of the fact that the control transfers offshore because of the currency. But the second thing is because of the distortion in what's going on in the economy, suddenly we began to see almost pools of money being concentrated in the hands of relatively few people rather than homogenized.
JIM: One thing that was clearly evident in Germany in the 20s – and you're seeing the same repeat here in the 80s and 90s, and of course this new decade of the United States – inflationary cycles lead to industrial concentration. As the value of the currency depreciates, it leads to a strong impetus to the centralization of industry. For example, in Germany, during the 20s, international German corporations who had sales overseas got paid in dollars ( the dollar was the strongest currency at the time), what they could then do is use those foreign currency earnings from foreign exchange holdings to come back and buy industrial companies throughout Germany. So what happened is you saw a consolidation of Germany's industry. And what you see is as this concentration and profit grows thanks to what becomes monopolistic practices, and as inflation goes stronger as these companies get also stronger financially, they no longer have the need for the banking and the credit system. In other words, they are generating so much cash internally, that they become their own banks. And then what happens is as their market capitalizations increase, as their stash of foreign-earned income increases overseas, which continues to appreciate against the domestic depreciating currency, they have more cash in currency to buy up assets. So what you have seen restructured in the American economy over the last two decades is not only the outsourcing (so, in other words, a lot of the manufacturing capability of the country is transferred overseas) where it earns foreign income overseas – they can use that, the corporation gets more profitable; then they buy and use their stock and market capitalization to buy other companies. So what you have is – as the currency depreciates, you have unproductive work acquiring a greater proportion in the economy. You see the rise of middle men. You see the rise of bureaucratic agents.
We just remodeled an office building that we purchased because we've grown. And it was amazing, John. It took us two-and-a-half months to get a permit to do some minor improvements to the building. And the delays and the bureaucracy. I was talking to the foreman because we purchased the building in July. We were going to move in the first week in November. Then it got pushed back to the first week of December. Then it was pushed to the second week in January, and then we finally moved in on February 2nd. We had things like an OSHA inspector inspecting our elevator and they said there was no phone for an emergency. And right on the elevator plate it said “press button to call.”
JOHN: And the lady didn't press the button; right?
JIM: Yes. She didn't press the button so we had to call AT&T. AT&T had to come out, check the elevator. And they said: “What's wrong? You press this button, it dials a number, the call system goes through. It's working.” So what we had to do was bring back the OSHA inspector with the AT&T person to point out to the OSHA inspector, “see, it’s here on the plate where it says push button to call.”
You get this rise of middle men, bureaucratic agents, and a lot of unproductive work. The foreman on the job had moved here from another state, I'm not going to mention where he moved from, but he said he had never seen anything like it in his life in California in terms of going through environmental permits we had – and granted the building already existed. There was nothing that we were doing. The disagreement between the fire marshal and the way he wanted something done in the remodel versus what other inspectors. I mean, it's just very unproductive. [47:04]
JOHN: I should point out too, Jim, when that happens, you've created another class here. And so to then say, “all right this is a big mess.” Say for example we were to go to a national sales tax, and we didn't need to file returns every year for businesses, all the businesses had to do was file a sales tax return which takes about 15 minutes for a business to do, and it's no big deal. Now, you would have immediately an army of CPAs and tax accountants who would instantly be out of a job, so do you think they are in favor of reforming the tax code? And the same thing happens when you create this whole army of people who are then dependent upon the system – and they are darned if they want to see it reformed.
JIM: Oh, absolutely. And you know, the other unfortunate thing as inflation rates begin to rise, what you see and this is happening, and this will happen here eventually. I mean, the United States has been able to export its inflation by selling debt and financing its prolific spending ways, but eventually, the game ends and what will happen is the Fed will have to monetize that debt and that's where you get into the hyperinflation. But here was an interesting thing. In Germany, as the economy inflated its way, you virtually had debt being monetized at all levels of society and the complete disappearance of bankruptcies because the inflation rates got to be so high that if you had a $100,000 mortgage that you took out – let's just use this for illustration purposes, let's assume you bought a house for $120,000. You put 20% down and financed the house with a $100,000 mortgage. Well, if inflation starts running 20, 30, 40, 50, 60, 100%, hundreds of percent a year, in a year, if inflation is running at 20%, your housing value has gone up and your debt depreciates in value. So what happened in Germany during this period of time was the virtual disappearance of bankruptcies because all debt was inflated away. [49:16]
JOHN: I'm for that. Mr. Bernanke, turn on those presses. Get those helicopters revved up. I want to see my debt inflate away. There have got to be some other distortion that's this thing imposes on the economic system. By I way, I would add, if I'm guessing right, Jim, there is never an easy way off of this once this giant distortion and superstructure has been created. The only way you get off of it is by some kind of spectacular event, I would guess.
JIM: Well, the spectacular event in Germany, is eventually by the time you had three stages of inflation you had the initial stages of inflation that began in 1914 when the Reichsmark was severed from gold backing. And so between 1914 and I think it was 1919, that was the first phase of inflation. Then you had a second phase of inflation from 1919 to 1922. And this was where what we called – we'll get into some of the behaviors. You had severe asset inflation during this period of time. And then between 1922, you had a third phase of inflation. In 1920 alone, where now inflation is really starting to go parabolic; and then 1923, you had the fourth and final phase of inflation where it just went bonkers. And that's where you had that hyperinflation state where you couldn't even print out the currency fast enough before it was depreciating, as is occurring in Zimbabwe today where I think you have 1300% inflation. And so one of the other distortions that also comes into this is Germany wasn't self sufficient of raw materials when it was energy, base metals or other things that it needed for its industrial capacity. So they had to import a lot of goods from overseas and regarding that trade deficit, German officials were always battering the trade deficit blaming foreigners for Germany's plight – when really what was distorting it all was what government was doing with the printing presses.
And we see a similar event in the U.S. today. In the last six years, America has grown its trade deficit by $4 ½ trillion. You are witnessing one of the largest wealth transfers in the history of the world – a wealth transfer from the West to the East. Of that $4 ½ trillion, we've given oil producers $1.2 trillion. I mean, John, we're leaking like a sieve here. And like Germany which was very dependent on raw materials, very much dependent on capital from overseas, so the US finds itself today unlike the way it found itself in the Great Depression where you had a deflationary-type depression because the US currency was first of all backed by gold. We were self sufficient. We were the world's largest creditor nation. We were self-sufficient in manufacturing; and we were self sufficient in all raw materials including the most important one which is energy.
Today, America is not self-sufficient in capital – we’re the largest debtor nation. We are no longer self sufficient in manufacturing. Look at anything you buy at the store. It's not made here. We're no longer self sufficient in raw materials. We are no longer self sufficient in energy. And we're no longer self sufficient in capital: we have to import $3 billion of foreign money into this country to pay our bills. And so like Germany in the 20s, foreigners are buying up our assets. They own over 50% of our treasury debt. They own close to 30% of all mortgages in this country. I forget what the percentage is of corporate bonds, I think it's 25%. They own nearly 20% of all capital stock in this country compared to, let's say, Germany and its hyperinflation, foreigners only owned 10% of the capital stock. So you are seeing this giant wealth transfer that's taking place as a result of these inflationary distortions. [53:38]
JOHN: Well, it would also seem that another consequence is that if inflation is wrecking the ability to plan because things are unstable and the values are constantly changing, then instead of investing it would seem better just to sort of absorb other things that are already out there.
JIM: Well, that's exactly what happened in Germany in terms of production which fell precipitously. Instead of building new plant and equipment, the industry consolidated. And you can see that in the US today. My son wrote an article this week called a Bird's Eye View Of The US Consumer and there was an interesting statistic he had – since the year 2000, John, if you look at employment in the manufacturing sector in the United States, what would you say, in other words, an increase in the percentage of jobs or a decrease in the percentage of jobs? Since 2000, what would you say has been the best case for manufacturing job creation?
JOHN: I don't know.
JIM: It peaked in 2003 at zero percent. Meaning, in 2003, there was net – if you take the jobs added and the jobs lost, there was zero growth in manufacturing. Other than that one year, we have had job losses in manufacturing every single year. And this is one of the distortions that takes place. And you heard the comment as we did in the first segment where Barney Frank is berating rating Bernanke when he makes the comment that the economy is operating below its productive capabilities. And this is something that you will see continuously going forward and it will get worse. We will lose more manufacturing jobs. Heck, this week on Thursday, Hershey Foods – the makers of Hershey’s Kisses, those little chocolate things – announced they are closing down one of their plants, laying off 1500 workers, transferring the plant to Mexico. So 1500 manufacturing jobs just got lost, and are going to be transferred to Mexico. So once again, we're seeing this trend and dislocation that you see in the productive factors of an economy. [55:56]
JOHN: And of course, we don't want to forget a very core question which is what we are preoccupied with here, what about the investing factors in this kind of environment?
JIM: Well, during an inflationary environment, what happens is you see a continuous process of reevaluation of investments as the inflation rates escalate. People don't want to have paper type assets. They start gravitating towards real assets, as you're seeing foreign central banks now do – especially led for example by the Russian Central Bank, the Chinese Central Bank, the South Korean Central Bank – more and more of the central banks around the globe are diversifying their assets. And at the upper end, the smart money is diversifying their assets into tangible goods. But what you will see now is eventually fixed-income investments, people will finally wise up to the fact that the fact that they are depreciating, they are not increasing in value and they’re losing their purchasing value. [56:59]
JOHN: Yeah. But during the time of the great inflation in the 20s, didn't the German stock market hit all time sales records as well, and that is why people were saying, “it's really okay, look what's going on in the market.”
JIM: Absolutely, because what happened, John, is if you take the year 1919, the German stock market index it’s main stock market started the year at 126 in paper marks. At the end of the year, in 1919, the German stock market fell to 88. So 1919 was a bad year. They lost the war. Fast forward to when the hyperinflation begins, and in 1920, the German stock market started out at 97 at the beginning of the year; and at the end of the year, it ended at 127 – so a nice double digit gain for the German stock market.
But if you adjust the German stock market in terms of US dollars, and the US dollar exchange rate, that's why you’ll often hear and let me just stop for a moment, you'll hear commentators like James Turk or Marc Faber on my program say, “yeah, the Dow was up, but if you adjust the Dow in terms of euros or in terms of gold, the Dow was actually down.”
So as I mention, in 1920, the German stock market went from 97 to 127. But in dollar terms, because of depreciation of the mark, it went from 49 at the beginning of the year down to 11. So you saw a great deflation effect of the stock market compared to other currencies. Now fast forward to 1921. Now, we're really starting to step up the level of inflation. The German stock market starts out at 166 on the index at the beginning of the year. It finishes the year at 274. In dollar terms, we actually saw a reversion as foreigners began to get rid of their dollar holdings and start buying up assets in Germany during this phase. So in dollar terms it went from about 11 to almost 16, and that was kind an almost a rare occurrence there because what was happening is people could see that they could buy German companies and German real estate, so they dumped their dollars, exchanged them into Deutschmarks and started buying Germany's assets. In 1922, the German stock market starts out at 278 – and this is going to blow your mind – at the end of the year, the German stock market went from 278 to 731. The public is now catching on as the third phase of inflation really starts to take off and nobody wants to own paper goods of anything. And if you do own paper goods, people are going into industrial shares as a way to try to maintain their standard of living. In 1921, the stock market there from 743. Any guess where it went at end of the year? [1:00:05]
JOHN: I would imagine it goes to the sky.
JIM: Yeah. In 1922 it goes from 743 and it finishes at the end of the year at 8,981.
JOHN: Jeez.
JIM: But in dollar terms, it went from 16 down to five. Okay. Now, let's talk about the last year – the year the German inflation ends when the inflation ends in November of that year. It starts out – you'll love this – in one month from the month of December 1922 to January of 1923, the stock market goes from 8,981 (as it ended December 22), it opens up the first month the year of 21,400. Any guess where it goes to at its peak?
JOHN: It went to the Third Reich is what it did.
JIM: Well, the Third Reich wasn't around. Any guess – and if you're listening to this, this is going to blow your mind. John, just take a wild guess. I’ll give you three tries at this.
JOHN: 50,000.
JIM: Nope.
JOHN: 100.
JIM: Two more.
JOHN: Is it up in the millions or what?
JIM: You know, whatever come to mind, 50,000 way too low.
JOHN: Put it at a million.
JIM: A million. Nope, too low. Last guess.
JOHN: Too low. Too low. Okay. It starts out the year at 21,400. John's guess was 50,000.
JOHN: Yeah.
JIM: A million, and what was your final answer.
JOHN: 10 – 10 million.
JIM: 10 million. Wrong.
JIM: You know what it gets? Final answer.
JOHN: You're going to tell me.
JIM: 531,300,000.
JOHN: Now, you know why I don't win the lottery. My guesses are never any good.
JIM: Yeah. And then they put the Rentenmark in November of 1923, the great inflation ended. What you began to experience then was deflation of all of these paper assets. And we ended the year in December 1923 at 26,000,890 on the German stock index. And remember, it started January of 21,400.
JOHN: Maybe it's good to reiterate, what was the ending phenomenon. What did they have to do to stop it?
JIM: They went to the Rentenmark where they took the land assets of the country to back the currency, and the Reichsbank finally stopped printing paper. And that’s what stopped it. [1:02:40]
JOHN: But they came out with a new currency, right?
JIM: The Rentenmark. They had to go to a new currency backed by land assets and then they stopped and they made a public pronouncement, we finally get it, we're not going to print money.
JOHN: Wunderbar.
JIM: I want to read something here and we'll just end on this because this is what happens. And I'm going to read from Bresciani-Turroni's book, and he said:
The public once more began to have confidence in shares [JIM: meaning the market. This is like in 1920.] Also having learned from the very rapid depreciation suffered by government securities mortgages and debentures, in short, all securities with the fixed yield, the public began to consider shares as the representatives of an intrinsic value of a gold value, whose price in paper marks must increase when the German change depreciated
So they began to figure [it out]. What he's saying here is the average German woke up and said our money is becoming worthless. One way to protect against that is to go into stock shares which would appreciate in the opposite direction of the depreciation of the currency. Then he goes on:
As the depreciation of the mark proceeded, this phenomenon began to be understood by the public, who for a long time, assured by official explanations, had attributed the decline in the purchasing power of the paper mark not to the continuance of note issues, in other words, money printing but to the rise in prices caused by the war, the revolution, and the economic crisis. The public now saw that the paper mark could no longer fulfill the function of the store of value. In 1919, there began that speculative furry which characterized the Bourse [JIM: meaning their stock market] during almost the whole of the remainder of the inflation period. Because of the dearness of living which lowered real incomes, many classes of people were forced to try to supplement their incomes by speculation in the stock market. Also, industrial and commercial firms considered the purchase of shares not only as a form of investment for reserve capital, but also as a temporary use for liquid resources. A use which guaranteed the preservation of the working capital which was threatened by the continual monetary depreciation. [1:05:16]
A couple of key things that he's saying here – number one, the public finally woke up that they didn't believe what government was telling them. The government up until this time had blamed all of this on foreigners, war reparations, an appreciating dollar, everything but what was really causing it which was monetary inflation. And once the public woke up, then they began to shed any kind of asset of fixed income value and they began to speculate. The exact same thing that you're seeing today where our stock market has turned from an investment market to a speculative market where not only investors don't invest any more, they just speculate trade short term, but also companies are doing likewise. Instead of building plant – new factories in the US that would create jobs – what they are doing is buying other companies, consolidating the industry. We are going through the same phases that Germany went through. It's just being stretched out over a longer period of time, but we're heading in the same direction.
Part 2
The Road to Serfdom
JOHN: Well, just like dueling banjos, ultimately, the fight between the government central bank and the people comes to a point where the people themselves become aware of the fact that their currency is not a store of value – that’s important – because by about 1921, Germans didn't want their marks any more and at that point, the hyperinflation took off. Now we're going to segue into our next segment here on the Big Picture because there are sociological consequences of what happens to this. There are three legs of a society: one is the economic; the other is the legal and political; and the third is what we call the world view – or the religious or philosophical base of a culture. All of those three are necessary for any culture to exist and they all interact. But the whole hyperinflationary thing led directly to the Third Reich and to transformations in the society. And we're going to look at parallels today with things that happened almost a century ago. It really started in 19 – well, the hyperinflation started in 1921 not quite a century ago, but the parallels are getting to be very haunting in a number of different areas.
JIM: We're entitling this segment the Road To Serfdom and it parallels the work that was done by Friedrich Hayek. He wrote a book in the 40s which was almost banned here in the United States because it criticized the New Deal program in terms of its extending or creating a greater depression. Also what it would do to taxes. You've got to remember that Roosevelt raised the tax rate to 90% during the Great Depression and essentially extended the Depression; and government meddling in trying to cure it is what gave us our Great Depression which Hayek and others have written about. And that's the road that we're on now because John, you heard it in very subtle testimonies a couple of weeks ago in Congress: you hear about wealth redistribution, higher taxes, wage and price controls that we heard with that one Congress lady. So the stage is being set for the next stage of inflation that is coming, and our governments will respond in the same wrong way causing and making the situation even worse. And what you also began to see in Germany, especially prior to Hitler's take over, is the rise of what we call political correctness very similar to what occurred with the Spanish Inquisition. And what you’re seeing now is the end of free speech. In other words, if this is the popular viewpoint socially, on environmental issues, socially on mores in a society or on economic issues, it becomes immoral to oppose any views other than that which is propagated by the government. [3:15]
JOHN: Yeah. We should also talk about race issues, religious issues. And what happens in this environment as I'm watching is is all you have to do is brand your opponent as being, well, a homophobe, you brand them as being a racist, a global-warming denier, whatever that happens to be, and that is an attempt to shut down the debate. In other words, at that point because of political correctness whether he or she is or not is immaterial and this is not good because the concept that we had in this society was that I may disagree with you, but we both recognize the right that we both have the right to speak.
JIM: Yeah. And what happens as this trend becomes more pronounced, then what happens is those who espouse a viewpoint are ostracized and eventually as happened in Nazi Germany, and is now happening in Venezuela, is eventually those people are shut up and bottled up. In fact, even imprisoned. I just finished a three part documentary, three CDs on the rise and fall of Adolf Hitler, and it was a rather unique documentary in the sense that it broke it up in time periods. Hitler the diplomat, Hitler the seducer, Hitler the military strategist and it looked at one of the most important phases from the time that Hitler took over. And they showed a speech given by his propaganda administer Joseph Goebbels, and he said “the most important thing for government control in achieving our objectives is absolute propaganda to control the thought process.” And that's what political correctness is. And what you're seeing – and we're in the beginning stages here – is a growing intolerance for opposing viewpoints. In other words, as political control, or political correctness, tightens its grip over society, the thought process becomes more restricted as it progresses; and it finally gets to the point that there is absolutely no tolerance allowed in the public arena for opposing view points. [5:32]
JOHN: No dissent is allowed anywhere else. And then at one point it starts out from a philosophy, then it becomes one that runs culturally and finally it's one that runs legally. In other words, whether a person can legally be shut up. And it's interesting that most Western countries are going through this process. It's a process, it’s a road – it's not a simple event overnight. There are five steps in persecuting any group, or trying to shut down any group, and they’ve been fairly well established by people who have monitored this in the past. The first step is to identify the target group by some type of stereotype. The second step is to try to marginalize that group, to push them out of the mainline social intercourse where they can defend themselves, interact with the ideas of the culture, defend their view points against contrary viewpoints. Now, once they are marginalized –say, this is what they did to the Jews in Germany: they no longer had access to the newspapers, to the airwaves to things like that – then step number three is to vilify them because they can no longer defeat them, and to marshal everyone else's opinion against that group. And the fourth step then is once everybody's upset about the group to pass laws against the group. And the fifth step is to enforce the laws. It's really important to recognize that the Holocaust was a legal event. It was a totally legal event.
JIM: The one thing that is surprising to me and I got exposed to this, is one thing that you find out when you're in the public arena as I have been, I spent a year and a half in television here locally. I've been on radio locally here since 1987 although I went off radio in 1999 when I was literally thrown off the station for warning people about what was going on in the stock market. I mean hate calls like “this guy doesn't know what he's talking about” – people were really getting ticked off at me. And I was talking about the earnings game that was being played by corporations to juggle their earnings. Well, lo and behold a couple of years later all this stuff came out. But at the time it was very unpopular. And one of the things that happens is whenever you take a view that is not common, that is not prevalent with the current thinking, it becomes unpopular.
Now, one thing that I noticed in the past is when I did television news, for example, this was back in 1991, we would do segments on the news and my segment was very popular because it was the first time a local news station had devoted four minutes to a one hour news cast covering financial aspects of the economy. So it became very popular, but any time I strayed and talked about a concept that was not very popular, we'd get a couple of nasty calls at the station and the producer could would come in and say, “boy, you hit a nerve with that one.” But it was very subtle – it didn’t happen too often. But I did begin to see it as the 90s progressed, and especially between '97 and 2000 where the pressure was put on companies to juggle their books, to keep coming up with quarter after quarter of double- digit earnings growth – the new paradigm concept.
Coming from an accounting background, I began to write pieces and talking on the radio that they are cooking the books. And I remember I hired the head of the accounting department from the university here to come and teach us a private course on forensic accounting because companies were just getting more clever in the way they could distort sales by stuffing inventory channels. This happened with several of the drug companies that got called on this in the latter part of the 90s. All kinds of various mechanisms such as inventory manipulations.
And I remember one day in class, and there was a comment that was made by one of her students, and she was talking to him and telling him how they need to dig in to the financial footnotes, reconstruct the financial statements to get the true income statement and the true balance sheet because of all of this cooking the books that was going on. And the comment was made why do we need to go through this. She said well, if you want to know if they are cheating or telling the truth and the comment the student made was who cares as long as the stock goes up – and that was the thinking in the 90s. I’d get all kind of nasty calls sometimes on radio: “Who cares, you don't know what the heck you're talking about, the stock is up 25%,” on these bogus earnings – and that's all people cared about. Well, they did care, and began to care in 2001 and 2002 when all of these scandals got exposed to the public and the NASDAQ lost 75% of its value.
So as long as things are going up, people don't really care, but it's amazing to see this change in attitude and how these things get distorted in a society as a result of this great inflationary asset bubble that was being created in the NASDAQ in tech stocks – as long as things were working out, people didn't really care if they were cooking the books. Hey, if they cooked the books and they pumped up their earnings and it makes the stock go up, that's all they care about. [10:44]
JOHN: Yeah. I think what has bothered most of all. You and I are not afraid – we're stupid: we wade out into controversial territory. What has always been interesting to me is it the volume level going up on what we call nasty grams, but also when people write nasty grams they say nothing of any intellectual substance – and that bothers me more than anything else. It's not the fact that people don't have the right to disagree. I believe that. I believe in Voltaire’s principal: I may not agree with you, but I'll defend to the death your right to say it. But now because of the decline in the quality of education in the US in the last 40 years, the concept of critical thought has almost disappeared, and people are thinking much more with their emotions rather than with just intellect, [rather than saying], “okay, let's work this one through and temper our whole debate.” And I think more than anything else that's what disturbs me as I see that.
JIM: That's something that just absolutely astounds me, and we've seen this John especially in the last two years – it has stepped up. Well, the show is much bigger today, so that's part of the reason, but if I have somebody on the show, like last year, first show of the year, I said the Dow was going to hit a new record and they were polite nasty grams: you're a shill for Wall Street; you’ve sold out; you know, you've become the devil – those were the nice ones. And then remember in May of last year when the market corrected severely after the Bernanke flip-flop, and I went on and said the Dow will hit a new record – it will probably hit 12,500, and can go as high as 13,000. And at that point it went from, you know, you're Satan, you're the devil, to – as we say here, we classify them here in three categories: four-letter words, body parts, and family members – and all of a sudden we began to hit all three levels. So I said, “oh my goodness this must be a bottom,” because we hit all three levels.
But you know, the other thing too if I have somebody on my show and he's bearish on the market, then the people that are bullish say don't have that jerk back on the show, or you're an idiot for having that person on. It's like I don't want to hear anything that's different from what I believe. Or, if you're bearish and I have somebody bullish, you get mad if you're bullish and I have somebody bearish, you get mad.
And even during the peak oil debate – as I’ve mentioned, I've read close to 80 books now, and we've interviewed over 40 authors: we've interviewed the environmentalists; we interviewed the socialists; we’ve interviewed the geologists, the investment bankers, the scientists – it was just absolutely amazing in terms of the kind of feedback because what we were trying to do is say: “Look, I believe in peak oil – that's my own opinion – but what we're going to do is we're going to look for a different kind of opinion.” Like for example, the guys that wrote the books on abiotic oil, I've invited them, I've emailed, one of them sent me a nasty e-gram. I said come on the show and let me do an interview of your book. He refused to come on the program. It’s the same thing that we extended to the CERA folks last November.
And the other thing, remember when Katrina and Rita hit, and global warming just went hysterical. And we said, “all right, we're going to do a show and give you an opposing view from scientists, from climatologists, people with PhDs – in fact one of them who was in on the environmental conference in Rio. He's got a PHD, he teaches at the university of Tucson. We had William Gray the foremost hurricanologist in the world – we had him on the program. Do you remember what that was like, John? [14:24]
JOHN: Yeah, we got about 50 emails from it, and as I said, none of them had anything substantive to say. Let's take the global warming issue. This issue kicked off about 1986, 1987. The IPCC grabbed onto it. It really accelerated after the onsite conference in Rio. Up until that point they had virtually no science backing them, so they were moving in that direction. And I said okay, this is obviously politicized at a very early stage, and now we're hearing pronouncements that the debate is over because of the IPC's latest report. But a lot of the people are noticing that the IPC's report is based on modeling rather than some real world issues. Don't email some nasty grams I don't need to hear them all. I’ve followed this issue for 20 years almost. And it was interesting as the report came out on that this week, I don't know if you saw a report from the university of Ohio that came out and said, you know, Antarctica is not heating up. They said we have a problem here. They said the ice shelves are going off but that seems to be more directly related to the change in ocean currents rather than global warming. And they are trying to figure out what that is all about. So my bottom line is it's not that we don't take a position, it's not that we don't debate, it's that the sense of urgency behind it and rationality seems to be disappearing. Usually at that point, whenever I have tracked these events I just finally shut up because nobody's going to listen to anything you say on either side of the argument; and as soon as one side sees that you're leaning one way or the other, they go crazy. It's literally a blah, blah and you can see it in the emails that you get when that kind of type comes back.
JIM: And we also got the same kind of response to taxes. And John, you and I have the same view: we have socialist party D, which believes in tax and spend, raising taxes and spending money – and we're seeing that unfold now; and we have socialist party R which agrees in cutting taxing and spending. Both sides produced deficits. Both sides produce pork. Both sides produce distortions. But if you're a member of socialist party D, if I say something about socialist party D, you get upset. On the other hand, if I say something and you're a member of socialist party R, then you get upset and it doesn't matter. And I think we need to go through here. And that's why I always recommend people read Charles Adam's book For Good Or For Evil, the history of taxation through history because it will show you what happens to societies down this road. And you're hearing the argument now, they want to go back to 50 and 70% tax rates – that’s the ultimate objective. Some people believe that's going to be good.
And let's go back to the last major tax increase which was in 1993, when George Bush senior went back on his pledge of no new taxes. Ronald Reagan brought tax rates down from 70% down to 28%. He got rid of deductions. He got rid of all kinds of things in exchange for that. And the way it was sold to the American public, we're going to lower tax rates so you don't have to go out and do all of these tax shelters and all of these things that distort the productive capacity of a society, but in exchange for lower tax rates we're going to take away all of your tax shelters. That's the way that was sold. The tax deductions were taken away up front, the lower taxes were phased in over three years. George Bush I comes into office, and he reverses his no tax pledge, raises income tax rates from 28% to 31, slapped on an additional Medicare tax that was levied against the first $125,000 of income. He's voted out of office. Bill Clinton is elected president in '93. He passed the largest tax increase that we'd seen in history, I think. And it was so large they gave you two years to pay your bills because they phased it in. What he did is he raised the income tax rate from 31% to 39.6%, and then he took the 2.96% Medicare cap off. And it was leveled or capped at 125,000, and he said it's against all of your income. And then what he did was he also raised the amount of Social Security that was subject to income tax from 50% to 85%. So taxes are increased. This was supposed to be a wealth transfer vehicle, but John, you're middle class, did you get any of that benefit or that tax increase? [19:03]
JOHN: No. I did not feel any of that. That's important too. All of the talk about benefiting the lower classes. They generally don't feel that it gets absorbed in the bureaucracy.
JIM: That's exactly what happens. Now, there are new proposals on the table that would affect the majority of small business owners in this country – and this would also affect major corporations. And that would be to limit executive pay to a million dollars a year. Now, if you're going to limit pay to a million dollars a year, why not carry that through all levels of society? For example, let's say, all right, we're going to limit executives or entrepreneurs to earning a million dollars a year – let’s carry it over to athletes, so if you're a star running back or a star quarter back for a football team, the team can't pay you a million dollars. Or you're an all-star pitcher for a baseball team or you bat .350, you can't earn more than a million dollars. Let's carry it another – what if you're a rock star or a country singer. You can't earn more than a million dollars. Anything you own over that goes to the government. Or if you're an actor, if you're Tom Cruise, you can't make $20 million a picture – let's limit what you can make to a million dollars; or if you're a Hollywood producer, we're going to limit what you can make too. Or, if you're a law firm heading a class action lawsuit that wins a billion dollar judgment, or a hundred million dollar judgment, your pay is limited to a million dollars. So why not carry that all of the way across society. And people think that, okay, if we can take a corporate executive, let's say his pay was $20 million, if we can take everything over $1 million, somehow that $19 million the government takes will be redistributed. So if I have a job, and I'm making $3000 a month, the government is going to give me a check for 250 a month because of all the money that they take from these other people. How many people benefited from the massive tax increase in the 90s? Nobody did. [21:18]
JOHN: If we bring this sort of full circle in the whole thing…by the way this is what Barack Obama was talking about in his kick off speech at the old Illinois state house when he threw his hat in the ring for candidacy and that is people have got to start listening again to what people are saying rather than the nonsense. That is number one.
Number two, there's no such thing as an ideologically free position on economics or anything else. Occasionally people will write us an email or send things into the Q-Line and say, well, you know, you have this neutral show and blah blah blah blah blah. Well, not really, because everyone comes to the table with a certain world view relating to economics, relating to politics et cetera, and then that’s what the process of politics is all about is enforcing those world views as law – so that's number one. You and I tend to be free market. I have a real heart. I'm always asking – I don't know about you – what's true. I don't care if we're talking about economics, taxes global warming – I'm always asking what's true, what's hype, what can I discern out of this whole thing.
So having said all that we bring it back to full circle: here we have this thrust now, more taxes, gobs more inflation. History shows that a country that has high inflation and high taxes becomes impoverished and savings and production are how you basically make a country wealthy – not by taxing the bejeebers. It's one of the things that holds some of the Third World countries back: the tax rates, the government system, the corruption present in them. And by the way, it also destroys their environment because the countries that are able to respond fastest to economic and environmental challenges are those which are free market. Look behind the former Iron Curtain and see the devastation that occurred there as a result of top down management. And yet that's the way we seem to be pushing everything in the West in a way that say, for example, the former Soviet Union demonstrated failed clearly and categorically, but we're doing it again. [23:16]
JIM: It's absolutely amazing. This week I had a conversation in my office with the president of one of the country's largest economic consulting firms. And we're going to have him on the show here. And we were talking about market views and somebody suggested that he contact me because we have and share similar philosophies on economics. I come from more of an Austrian background and to see someone that comes at the market from a consulting point of view that bears some resemblance to Austrian thinking – that got my attention because you just don't see this in the mainstream today.
But one of the things that he brought to my attention that was so true is in the 20s after passing the Federal Reserve Act and distorting the economy (because it was money printing in the 20s that led to this great economic boom, and then led to the bust), and then when the bust came, we were in a recession (and we were in a small corrective cycle) the market was actually starting to correct itself until Hoover began tinkering with the economy. And then of course Roosevelt came in and really messed things up and extended the Great Depression. Government ended up taking a stock market correction and a recession and turning it into the Great Depression. And what happened was there was a complete loss [of faith] in the market system at that time, and it was like you cannot trust the market to work – so what happens is we need government to come in and plan the economy. And so what happened is when John Maynard Keynes wrote his treatise, it became the foundational work that justified basically anything the government wanted to do. And Keynesian economics justifies deficit spending; Keynesian economics justifies monetary inflation. And it became the philosophical justification which basically gave the government carte blanche to come in and master plan the economy. And we've all seen the results.
And the unfortunate thing is from the time that you enter grade school and take your first history class, Keynesian economics is instilled throughout our history books that's taught in the classroom. If you go on to high school and you take your first high school civics class or American history, Keynesian economics is taught in the classroom textbooks. If you go on to college and have to take an economics course it's taught to you there. If you go on to major in economics – you know there's only two colleges I believe in the country that teach Austrian economics which are a private college Hillsdale College, and then Auburn University. People are taught to think this way. If you get a CPA you're taught Keynesian economics, so if you work on Wall Street, you work for government, you are taught Keynesian economics. So it's like people are taught that the world is flat and if somebody comes out and says, “no, the world is not flat, the world is round,” it just discombobulates everybody because they say, “no, if I look out my parking lot it's flat. The world is flat.” And they talk about things that they can only see on the surface level and not what is going on, the distortion that we talked about, and the great inflation that is occurring underneath this. And this is one of the reasons why you'll have people that think if we could raise tax rates to 90%, we're all going to be more prosperous. Take a look at the Soviet Union. Take a look at the former China before they opened up after Mao’s death. Look at China that's today in terms of its prosperity as it opens its markets, lowers its taxes – as Russia has. Look at what's happening to their economies, and take a look at what was formally there and you really get a grip on this.
My wife and I support a lot of programs in Romania today, and missions work in that area of the country; and my wife had a chance to go over there a number of years ago ,and she said you really don't know what poverty is until you walk into a country that has been impoverished under communism or socialism where you don't have running water, you don't have toilets, where you have to go in out houses, where young girls have to sell themselves in to prostitution in order to survive. It's amazing until you've experienced that to see the harmful effects and what all of this causes. And that's why we're going to be covering the economics of inflation here because we're going to get in to some of the social dysfunctional aspects of society from speculation, to crime, to all of the other things that go along with this as these distortions ripple through the entire economy, from its production processes, to its market process, to the government process, to the laws of the country itself, to eventually the loss of freedom itself. That was the ultimate outcome of the great German inflation which paved the road for a dictator like Adolf Hitler. [28:35]
Economic Analysis: What's going on in the economy?
JOHN: Well, it's time that we look at an economic update. I guess if we're doing an economic update, we have to do something about the economy right.
JIM: I think so.
JOHN: I'm starting to sound like Barney Frank: if I thought what you thought what I think you thought then I'd know what you thought.
JIM: Yeah. But I few what you were going to think and what you were going to ask so that's why I thought the way I did.
Well, what we're going to do in this segment, we wrote a couple of pieces in January called forecast 2007, and one of the points I was making in that forecast is these one time events such as the drop of interest rates from the summer of 2006 to December where long term rates dropped from 5.25 down to 4.4, and oil prices went from 78 all of the way down to 50 in the warm weather – these were one time events. And John, you remember when the first pass at GDP for the fourth quarter came and it was 3 ½%. Now, as they are saying that the trade deficit was bigger than expected and other information comes in, they are saying that the GDP growth is going to be revised downward somewhere around in 2 ½ to 2 ¾% range, and already the Fed is even lowering its own forecast. So what I said going forward in 2007, there were three things that I expected before the Fed was going to have to get around to cutting the interest rates; and by then, they would be doing so in a way that they are in a panic way – they would slash them.
And I said three things have to happen. First, one was the continued deterioration in the real estate market leading to some sort of financial crisis or difficulty. Problems with subprime lenders which we're seeing weak after weak now. In fact, Bernanke made mention of it in his testimony this week before both houses of Congress. Also, a rapid increase in delinquencies and foreclosures and we’re already beginning to see that. So that was step number one.
The second thing that you would begin to see is a slowing down of the economy itself. So the economic growth rate –we could be getting into the second quarter where you could see the economy slowing down to 2%, or even below 2%.
And then the third fracture would have to be some form of capital market corrections: something hits the market – either it's a real drop off and disappointing earnings, or it's a derivative event – it's something that happens. And then you would have all three factors in place and you would have the financial markets screaming for the Federal Reserve to take action.
And what I really want to do, John, and I asked you to do this, and we are going to keep this tape of Bernanke's testimony in February, and we'll play this in contrast when he's before Congress when he does it in July, because it's going to be one different Fed Chairman speaking a totally different scenario – and that's the forecast. And so what we want to do is sort of update you where we are along this scenario.
Well, one of the things that I said is watch credit expansion breakdown. And the thing that we're starting to see and you can see this graphically if you go to my son's Wednesday Wrap Up, where he did a birds-eye view of the consumer. And he has a graph there that shows consumer and corporate debt growth breaking down. Whenever you have both of them go down to a certain level, you always have a recession. So at one point, in order to avoid this the route that this is taking is going to be either one of two ways: you're going to see an implosion in the credit market or you're going to see an explosion in the credit market. And we've been talking about economic cycles here. In order to avoid the day of reckoning, you must create larger and larger amounts of credit, and credit must increase at a faster pace in order to avoid the day of reckoning. And what I think we're going to get is what I call a short-term reckoning here between the first quarter and by the time we get to the third quarter. And you're already starting to see that. So we talked about credit. The other thing that I talked about in my forecast was the real estate market needs to continue to deteriorate; and one of the reasons that inventory levels have stayed high is not only is the product not selling – homes are staying on the market, there's a lot of inventory out there – but also there was a continuation of new product being added to the market such as housing starts. Well, we just got a number this week and the January housing starts slumped by 14.3% to an annual pace of 1.4 million units – the worse that we've seen since 1997. So here's another continuation. The other thing that we talked about is consumption in debt growth. My son has a graph in there, and John, we've been talking about these inflation distortions. [33:58]
JOHN: Yeah. They want people to keep the economy going by continuing purchasing et cetera, but now because of the way things are, the only way that people can do that is to go further and further into debt. And that's precisely what figures are showing is happening.
JIM: Yeah. So what you have now is this consumption and debt growth are going hand and hand, and it’s one reason why, for example, as our savings rate went down as consumption increased so did debt levels. And now consumption makes up 70% of the economy where at one time it had made up only 60% of the economy. And with this increase in consumption and debt that this Congressman was talking about, you can trace it back to the severance of the dollar from gold. And from that point forward, it wasn't just the government that began to run deficits but American families began to go deeper in debt as a means of keeping pace with inflation. And also it was that time period, after the severance of the dollar from gold, when inflation really took off, that it required the second spouse to go into the job market and earn an income in order to pay for taxes and inflation. So you're seeing this parallel on a graph of increased debt, increased consumption and increased inflation levels all going parabolic. [35:32]
JOHN: You know, one of the things that Bernanke was talking about this week amidst all of the happy talk we were talking about, he did issue some warnings. It's amazing the warnings are there if you listen clearly: they are there about Social Security; they are there about everything else. But he did talk about the possibility of the housing market throwing this thing down into a spiral. That was one of the caveats that came out this week.
JIM: Well, you are certainly seeing a lot of it. Not only are bankruptcies and foreclosures beginning to leap off the charts, you're seeing every single week now subprime lenders either missing their earnings or riding a larger portion of their portfolio. I can't think of the name of a major lender this week that announced they were no longer making piggy-back loans. A piggy-back loan is used as – let's say you're going to buy a house, John, for 100,000 for simplicity’s sake, and the bank says you have to put 20% down to get a favorable rate on your first mortgage. Let’s say you're getting a conventional mortgage. So you put 20% down which is $20,000. You really need that money to buy the drapes, the curtains and the landscaping, so no sooner do you take out a first mortgage on the house, you get a piggy back loan from the institution; and what they do is they come in and give you a loan for that 20% so they give you in essence the money you put down back. Now you have a 100% loan on your property with no equity. And so there was another institution, a major lender mortgage lender, saying that they were no longer making piggy-back loans.
The other thing is there's a couple of graphs that my son used in his article in terms of the birds eye view of the consumer. There was one showing household mortgage year over year rate of change which is falling off a cliff; there was also a chart of equity extraction which is falling off a cliff. And then there's also a chart of banks’ willingness to lend. In other words, when banks start losing money, when they start having to foreclose and as delinquencies in mortgages, as foreclosures start to increase, all of a sudden bankers reverse themselves. And what was a very loose lending market is now turning very cautionary and there's a graph of that. So that's going to be slowing down the real estate market.
The other thing that is – there is a group called Westpac [ph.] that produces an economic data series and you know, John, like you always hear this in the stock market, so-and-so company beat analyst expectations on earnings. Well, what Westpac does is track economic data in terms of expectations. In other words, expectations for interest rates, expectations for inflation, expectations for unemployment or GDP growth – and they track the surprises. In other words, does the data come in better than expected indicating an improving trend in an economy that's getting stronger, or does the data come in falling short of expectations showing a deteriorating trend. And there's a graph – this will be probably put in next week's wrap up – but what it shows is there is a deteriorating trend in the economic data in the United States, which basically is sort of backing up a conclusion that we made that the fourth-time pop in GDP was sort of a one-time event; and that as we move forward from the first quarter and second quarter you would see gradual economic deterioration and a slow down in the economy. And already now they are talking about revising the fourth quarter data. [39:12]
JOHN: If we look at some of the projections you've been making along about what we will probably face here: an economic slow down which is happening; real estate deterioration, that is a slow spiral down to the ground so to speak. Some economic crisis in here, capital market correction is the third stage in this whole thing
JIM: Yeah. So far what we're seeing is a confirmation of two of these three trends that I've outlined. What we aren't seeing is we haven't had the capital market correction yet; and also what we're looking for in terms of market indicators is a breakdown of the emerging markets – and we're not seeing that. I mean, if you take a look at the Mexican market, year-to-date, it's up about 7 ¾%; the Brazilian market is up about 3%; if we go to the Asian Pacific index, it's up about 5%. So those markets are still continuing in a strong trend. The Dow Jones Industrial Average, our major markets in the U.S. are up 2% for the year. But we are getting a topping process, so what we need is further deterioration in real estate leading to further financial deterioration especially with financial institutions. That continues. In other words, as that trend gets worse, then that's also going to lead to continued slow down. So, as factors number one and two continue to deteriorate, eventually that is going to lead to a capital market correction.
So we've got the economy deteriorating, real estate deteriorating and here's two other factors. We're seeing that retail sales were flat in January. Falling sales for cars, gasoline, electronics, clothing and home improvement. So I expect that to weaken further as we go forward; and then also on the corporate earnings front S&P says that companies are falling short of earnings expectations at a pace that they haven't seen in more than 22 years. They said 22% of the companies in the bench mark index including Advanced Micro Devices, Ford, bond insurer MBIA, Circuit City stores had fourth quarter results below expectations. S&P said 368 companies have reported; 227 beat expectations. Now what they are saying based on what companies have said in their conference calls, fourth quarter earnings growth for the S&P is under 10%, indicating that the 18 quarter string of double digit gain earnings is likely to end. Already their projections are being pared for the first quarter, according to Thompson financial analysts polled, and are projecting only a 4.6% increase in first quarter earnings year-over-year – that's down from just 8.7% two months ago, So already things are beginning to be ratcheting down. Watch what the Fed Chairman said. The Fed is ratcheting down now their expectations; economists are starting to ratchet down their expectations; and already now we're starting to see analysts on Wall Street starting to ratchet down their expectations. So as these earnings surprises as we get more earnings misses, you know, the market is just waiting for some kind of catalyst to trigger the sell off. [42:45]
JOHN: Is there anybody looking at this from the same prospective as you are, Jim?
JIM: Yeah. In fact, this week Moody’s chief economist – I don't know if he's starting to sound like me or Marc Faber – and his comments are on the macro outlook potentials for a financial crisis. He said investors are euphoric over the economy's performance and prospects sending stock prices soaring, and credit spreads narrowing. That's the amazing thing that we're starting to see. He said that investor exuberance is running thick again, and the likelihood that investors will make a large collective misstep are on the rise.
The other thing that he pointed is sub potential growth and lower prices for energy goods and commodities have sort of taken the edge off of inflation so people think the inflation is licked. But he's talking about stock prices have gone up almost parabolically since last summer. They are up about 15%. The VIX (which measures expected volatility in stock prices) is traded at some of the lowest record levels. And the other thing is if you take a look at the credit markets, bond investors are equally upbeat: credit spreads have narrowed sharply and they are about as narrow as they have ever been. If you take a look at the difference in yield between BBB corporate bonds (which are the lowest rated investment grade bond) and 10 year Treasuries that spread now is only 150 basis points– and on junk bonds it's only 300 basis points.
Now, if you go back to 2002, when the bear market bottomed, the spread between BBB and Treasuries was almost 400 basis points; and the spread on junk bonds was 1000 basis points – meaning that junk bonds paid interest rates that were 10%, a full 10 points above Treasuries at that bottom, compared to only 3 percentage points today. And then the alarming thing that he's talking about is the derivative market largely reflects sky high investor optimism: the benchmark CDX derivative index which tracks 125 investment grade corporate credit default swaps is poised to break another record. It's like, you know, people don't see any – it's like Tim Woods said in the first hour on his radar screen, he's looking on his scope and the radar says boy, there's something nasty out there about five or ten miles offshore, but in front of you, you know, the sky is sunny, the sees are calm and you don't see anything. And he reaches a conclusion. He says global financial events characterized by falling asset prices, widening credit spreads and a surge in volatility are rare, but they often happen at this point in the business cycle when the global economy is operating near capacity, and central banks are building in inflationary-cautionary expectations in the marketplace. And he said there are two potential triggers for a global financial event. The first is a sustained tightening effort by the Bank of Japan. Another is a more pressing potential catalyst that lies in the US residential mortgage-backed securities market – and I think this guy is dead on. The credit performance of these mortgage loans is eroding very quickly now, and that's one thing that we're tracking. The downturn in the housing market combined with poor underwriting is driving soaring delinquency and default rates; and the erosion in credit conditions is up-ending a growing list of lenders. While the security markets have so far weathered this storm, but you're starting to see stress cracks in the system all of the way around. So I think maybe some of this tough talk that the Feds were going to raise interest rates, the only reason I think they are doing that is trying to keep the dollar up because the dollar is starting to go down. So we haven’t had the capital market correction that I expect to see this year, but let's put it this way, of the three factors that I'm talking about two are in place right now. [46:44]
Q-Calls
JOHN: Now comes the part of the program that I enjoy absolutely most, believe it or not. It is time to take calls from our Q-lines. And the line for our Q-line – I forget how we got the name Q-line but anyway we call it that – is toll free U.S. and Canada 1(800)794-6480. It does work from the rest of the world but we're too cheap to pay for it, so if you call from anywhere outside, you're going to have to pay for it. Please leave your name, just your first name is fine, and where you're calling from, we like to know.
Hello, Jim, John, this is Richard calling from Lazy Smith, British Columbia. And I have a question about gold as it relates to gold stocks. As of close today, gold is up over $102 above where it was of last year at exactly the same time. Yet out of my basket of about 30 stocks (which include juniors, junior producers and senior producers) they are all either flat or in the red. I don't understand this. Why would a good basket of stocks, including two thirds of my position being junior producers and senior producers, all be flat or a negative with $102 in gold appreciation over the past 2 months. Thank you and keep up the good work. [48:27]
JIM: Well, there's a number of things that can happen in the market at the time, and one is disbelief in the rise of gold. And number two, sometimes if you’re a hedge fund, Richard, let's say you're going long the bullion (which is what is happening), then what will happen is to hedge that risk of going long the bullion, you can short the stock. So you also have to take a look at the short position in these stocks. And right now, out of disbelief there just isn't a lot of interest in the gold markets by individuals or fund managers. Yeah. Maybe some money might go into, let's say, one of the ETFs, like the gold ETF, or the silver ETF, and trade in and out of it, but there just isn't any interest in the stock right now. And so it's not until buying in gold really takes off that interest in the stock market comes in. And remember, a lot of these stocks that you're talking about have through some severe corrections, so that chases a lot of money out of the sector. So there could be a number of factors all going on at the same time, but right now it represents a divergence which makes a lot of people cautious in terms of the near term rise of the bullion itself. [49:38]
This is Tom from South Field, Michigan. I was wondering part of your retirement plan you seem to be building fairly extensive house. I'm just wondering what state are you building it in because California goes the way of socialism, it's going to be very difficult to pick up the house with the solar power, and maybe move it to a cloudy clime or something or how, or how do you plan when the house is usually the biggest investment; and with the real estate bubble, how would you incorporate your retirement home (or maybe even a retirement RV) into your retirement plan because that's going to be the largest thing – and reverse mortgages might not be available or who knows what. How do you handle the real estate because usually it’s an illiquid investment at most times, and also usually the largest portion of where your savings would have to be? Thanks.
JIM: In terms of my building an extensive house, I'm just making improvements, Tom; and my house is the smallest part of my portfolio or net worth. So I have kept my house or the value of my house within a small limit of my overall portfolio, or let's say, my net worth. So it represents the smallest portion of it. One of the reasons that I've made these improvements is – in my concept of peak oil: “live work and play” – I now have my home and my office, and everything that I need to get, to within either 10 to 15 minutes walking distance from my house, or five to literally as little as three minutes from my house. So if California goes socialist – we've been going socialist, and we've been getting even nuttier – but you know, it's a place of the world that we have energy here. In other words, California produces a lot of oil. It also produces a lot of food, and it also has a climate that requires very little heating or air conditioning. [51:34]
JOHN: I have a question: the federal government can monetize its problems. What's California ultimately going to do as it continues along this track? What are it’s options?
JIM: It will have to eventually reach for some kind of bail out, restructuring of debt, much in the way that you saw problems with New York City and New York in the 70s, and they'll have to go to some kind of federal sharing program. They'll probably raise taxes here which will make the situation even worse. But the best thing that will happen is if this thing start to fall apart, you eventually get citizens upset with the press of taxes, then there is a tax revolt as we had here with Prop. 13. Everybody remembers Prop. 13 originated in California, and there was a tax revolt, and all of a sudden government changes and you get fiscally conservative politicians that come in and start straightening things out. [52:25]
JOHN: Yeah. But they don't seem to learn the lesson, do they?
JIM: No. We just go through another cycle as every generation does.
Hello Jim, this is Keith, calling from Canada. I listened to the inflation talk today and I found it really fascinating. However, I'm really conflicted regarding the hyperinflationary outlook. There’s no doubt that credit is inflating worldwide, but it seems to me that in the past just, examples such as France and the German hyperinflation the money was actually printed. Now, we have a situation where the credit is created, but the money is not printed. And it seems to me that this works by fooling the citizens of the world, but unfortunately the loans have to be paid back; or they’re defaulted on and the money disappears from the system which is deflationary. I know you believe Bernanke will never let this occur, but at some point, the Fed will have to either monetize the debt and actually print it or the cost to service to debt will become too prohibitive. How do you expect hyperinflation to take shape? Will we see it when the Fed finally starts to print money to buy the US debt or monetize the debt that no one wants. I guess it really comes down to this. Everyone expects inflation and knows how to profit from inflation, but deflation would be the real killer in what, from the contrarian point of view, no one expects. Sorry – that's about as concise I can be with this complicated topic, but I'd really be interested to hear your thoughts on credit inflation versus actual money inflation.
JIM: Well, Keith, going back to, like, this week's segment where we talk about when we got to the great inflation in Germany, the great thing about it is all defaults ceased to exist including delinquencies because they inflated the debt away. What we've been able to go over the last two decades is export our inflation and finance our deficits with debt. That is not inflationary. They moved away from monetizing the debt at the beginning of the 80s under Volcker. In the end, they will go right back to it, just as we are going full circle now to many of the same things that got us in this predicament in the 70s: the money supply, credit supply is growing – it's now starting to check the real economy; rising wage that we're seeing; we’re seeing rising goods inflation; you're hearing Congress talk about wage, price control and raising the minimum wage. And in the end you will see the Fed begin to monetize. When foreigners no longer give us the $3 billion a day that we need to finance our debt, that's when the Fed will come in, but they will try to hide it and disguise it which is one of the reasons they are not reporting M3. [55:11]
JOHN: It's amazing what a game it is, isn't it, when you think about the quantity.
JIM: I think right now we're just more sophisticated in the 21st Century. We have a better means of propaganda – of hiding things and using propaganda to convince and turn people's attention away from the real issue. [55:26]
JOHN: Yes darling, I'm not going to tell you what I'm doing next, you know.
Hello, Rod calling from Calgary, Canada. My question is on the 10 year Treasury note yield – symbol TNX. What market forces control long term interest rates? Also what is the main driving force behind long term interest rates? Also, how much control does the Fed have over long term interest rates? And I wonder if you could comment on the effects global inflation on long term interest rates; and also what would be the effect on long term interest rates if the Fed lowers short term interest rates?
JIM: Well, the Fed controls short-term interest rates. The market controls long-term interest rates, but one of the strange phenomenon that we have with globalization today as America exports its deficits, its trade deficits, its dollars. The 4 ½ trillion that we've given to foreigners in the last five or six years, that money gets recycled back into our economy as foreigners purchase our debt. And that's what's keeping the longer term end of the bond market down and keeping it artificially low. So supply and demand factors control long term interest rates. And right now, there is a big supply through America's trade deficit, into the foreign central banks which recycle that money back into the U.S. by buying our debt securities, our mortgage securities. And it's not just foreign central banks, it's also countries such as OPEC who are running a greater current account surplus than Asian countries because of the price of oil. So that money gets recycled and it's only when foreigners start demanding higher money – in other words, they have pulled back and stop buying our debt – that interest rates will start to rise. And then what will happen it will force higher interest rates in order to entice buyers back into the market. Ultimately, supply and demand. Right now, big supply through America's trade deficit into foreign coffers and then that money gets recycled back into the United States. [57:35]
JOHN: Jim, we've had a lot of inquiries about a particular subject, so rather than read some more emails or do some more Q-line before we get on to the rest of the Q-Line, you wanted to talk about something here.
JIM: A number of you have sent me a lot of emails since last week, regarding particular chat rooms and I guess in one particular chat rooms there appear to be one or two individuals that are attacking me and saying very false things; and also about false things about the company that I'm involved in. And a lot of you are upset, you want me to sue these people, find these people. Let me just say this. If you are a person in the public arena – and you're in the news like we are with this radio program, or my website or prior to this when I was in television, or local radio here – anybody can say anything they want about you as long as it isn't libelous. One particular individual known as Uncle Bigs was an individual that was saying libelous things – I think he's changed his moniker as we look into him now. But in a free market, on a free internet, a person can say whatever they like. If they think Jim Puplava stinks, they can say Jim Puplava stinks and that's their right to do so. It is only when they are doing so in trying to manipulate the price of the stock that it becomes federal security fraud. In other words, if somebody just comes on a chat room and says, “you stink, Jim.” You know, they can do that. They can say whatever they want. They can use swear words. They can say all kinds of nasty things. [59:18]
JOHN: Body parts.
JIM: We haven't gotten to body parts yet other than personal emails, but they are certainly free to do whatever they want. However, when a person does something like this to discourage other shareholders from buying stock or selling their stock, then what they are doing is committing federal security laws. They are committing a security felony under US rules – and it's also under Canadian rules.
And this is done professionally – so some of these people are hedge fund people, they are fund managers, and their purpose is to manipulate the price of the security. They may have two alternative motives for doing so. Either one, they may be shorting the stock. And if they short the stock and they can scare people into selling, they can drive the price down lower and make more profits; and as people dump the stock then they can pick up the shares at a profit. Another reason they may be doing it is trying to accumulate shares in the company. So, as long as they have not bought, sold or shorted the stock, as long as they don't say anything that's libelous, then can say whatever they want. That's just part of being in the public.
However, when they start doing something with manipulation, there are three things that you can do. And a couple of you have said that you've seen some of these characters do this to other stocks and you've seen stocks you’re involved with in a similar type of activity. I'm going to give three numbers out there. One is the NASD investor complaint center. And it's in Washington DC. It's area code (301) 590-6500. The other one is the SEC, the Securities and Exchange Commission office of investor education assistance in fraud. That number is area code (202) 942-7040. And finally, the state regulatory – there's the North American Securities Administers Association. They are in Washington D.C., so you can also have state regulatory authorities look into it, and that number is (202)737-0900. So once again, the NASD number is area code (301)590-6500. The SEC investor fraud division (202)942-7040. And North American security administrators which will hook you up with state is (202)737-0900. And if you see these kind of individuals show up and you see them – they do the same thing, they are in what they call their attack mode – and what they try to do is manipulate investor behavior and alter outcome on a particular stock. And that is a federal crime. It's security manipulation, and just simply use those numbers and turn those people in, as we have now hired a lawyer and he's investigating with the NASD, and also the SEC. So, enough said. [1:02:56]
JOHN: You’re listening to the Financial Sense Newshour at www.financialsense.com. These files are posted by about 7 am Greenwich Mean Time every Saturday morning. Back to the Q-line.
Jim and John, hey, this is Greg from the banking capital of America, Charlotte, North Carolina. Thanks you for a great show and adding your transcripts to the website. I don't think I've heard you say anything incorrect for the four years I’ve been up on the show. A real quick question. I'm a little confused, I know in reading your website and listening to your show there are a lot of reasons as far as why real estate could and should decline in the coming months to years. Where I'm confused is if we want to be in hard assets and I agree I think we should, I guess what I'm trying to understand is if hard assets is where you want to be, why wouldn't you want to be in real estate in the hyperinflationary period that were are running into. I look forward to hearing the answer and your thoughts around that. Thank you for all of your help in making this country a better place.
JIM: Greg, regarding real estate, it was an asset bubble that got inflated so you're seeing a partial inflation right now. But is it going to be a severe real estate crash and the end of the world? I don't see that – because of inflation. But you will see it partially deflated just as you saw the stock market partially deflated between the years 2002 and 2003. I don't think they'll allow the real estate market to fully deflate in the same way that the stock market did.
The other thing that happens in an inflationary psychology coming, and you saw this in Germany. Real estate has a certain value in terms of preservation to it in an inflationary period. But real estate investments in an inflationary period do not do as well as other assets, and one of the reasons is the same concept we talked about in wages where, for example, if you're leasing out property and you sign a one-year lease or a three-year lease and you can only raise the rent once a year and it's tied to a phoney CPI index, what happens is as a land owner, your ability to raise rents opinion immediately to counteract the effects of the inflation are limited because you can only raise rates once a year. And then also with the phoney CPI index that we use too, you're really not going to get full capture in terms of the real cost of operating rental properties, so real estate tends to fall behind. It still appreciates, it still holds value, but it doesn't do as well in an inflationary cycle as other hard assets do. [1:05:23]
Hi Jim this is Russ calling from Rochester, Minnesota. I recently told my financial planner that I'm keeping my money in Treasuries until the over bought stock market deflates. His question to me was when, what you call that “hot money,” leaves equity, where do you think it will go? I didn't know how to answer him, Jim, because the same people whose advice I’m taking were predicting a correction in the stock market are also predicting a bear market for bonds and real estate. His question has me stumped Jim, and I'm wondering how you might answer such a question.
JIM: Well, Russ, one thing that does happen with this rotation that we see in musical chairs in the market, the stock market falls all of a sudden the large players go into Treasuries – and he's absolutely correct when he says that. But your purchasing power of Treasuries, you've got to be careful that you don't get yourself in a situation where initially it goes into Treasuries as a safe have as a way to, you know, where do we land on next, but then as the inflationary picture begins to unfold and people really pick up on it, that's when the bond market gets hammered. So in terms of a short-term stop, the best place is short-term treasuries where you don't have to worry about market depreciation if interest rates were to go up. [1:06:47]
Hi, Jim, this is Clarence from Chicago, Illinois and I do love your show. I’m interested in the theme that you have of investing in infrastructure. But I'm not sure exactly what you mean by that. Are you referring to investing in energy stocks which seems to be already a little bit over heavily invested in; or are you talking about such things as railroad companies or utility companies, I'm just wondering if you could be a little more specific on what you mean by investing in infrastructure? Thank you so much.
JIM: Clarence, we'll be doing a program on that in the coming weeks and I’ll go into some more detail. Oil service companies that help and clean up and rebuild the energy infrastructure would be one area. Water companies that build water infrastructure; road, bridge, construction companies that can rebuild the infrastructure in this country in terms of our bridges, our roads; and then also companies that are getting into light rail would be one method. And also our communication system. And we're going to get into more detail in the next couple of weeks, but unfortunately, the kind of question that you're asking is going to take much, much more of my time to explain all of the different aspects. But I promise you this, Clarence, we'll be doing a more detailed show about that in the future. Railroads is one concept. [1:08:16]
Hello, Jim, my name is Christian and I'm calling from Des Moines, Iowa. And my concern is you have expressed about the future of the US dollar given the propensity our politicians have to borrow, spend more money than they have, and also our Federal Reserve bank just to print money. And I'm wondering, I have two strategies which I have heard about, and I'd like to get your opinion on each of them if I could: the first one is to invest in a sort of a money market account which is denominated in foreign currency; and then those foreign currencies rise against the dollar, then your investment would do better. Or of course if the reverse would happen, then you would lose some of your investment. How do you feel about this? I'm not talking about the futures or anything like that. I'm just talking about a sort of a money market account which you can set up denominated in foreign currencies. And then my second question would be I know that real estate investments trusts for the United States are very bad (from what I’m hearing) to invest in now, but I have also heard the possibly the same sort of investment trust in companies overseas such as in India and such might be very good investment. Can you please give me your opinion on each of these things. Thank you very much.
JIM: Oh, boy, I tell you, Christian, investing in money market accounts and foreign securities, I wholeheartedly agree with that concept. As far as real estate investment trust, I don't think they will do as well, and especially the current evaluation levels in terms of where they are. You might also want to think of in terms of investing in money market accounts denominated in foreign [currencies], you might want to consider investing in bullion. In any great inflation, bullion, gold and silver resort to becoming money again. And right now we're on a world fiat system where nothing is backed by gold and silver. It's all fiat and gold and silver in the rise that we've seen, gold and silver once again are resuming their historical role as money. So you might want to consider owning gold and silver and also owning that in foreign accounts. [1:10:37]
Jim, this is Jerry from Sioux Falls, South Dakota. I’ll tell you, you got my attention a little over a year ago when you predicted higher valuations for 06 despite your somewhat bearish outlook long term overall. All of the bears that going into 06 predicted it would be a bad year for stocks, that the market would turn back – you were the only one that stood up and said I think it's going to go higher – and it did. I'm just wondering now that you seem to be forecasting a downturn in the US stock market for 07, do you see oil and precious metals stocks turning down in the same way as the Dow, S&P in the financial sector; or do you think they will stand apart during this downturn that you are forecasting?
JIM: Jerry, the downturn that I'm forecasting is mainly going to occur in the first part of the year. By the end of the year, I think we'll be seeing, as I said at the beginning of the year, we'll see a new record in the S&P 500 this year, as well as –it's obvious it's no brain power to predict that we'd see new records in the Dow. So it's only a first half prediction that we will see this downturn. I think oil stocks can weaken in this, but I think they'll hold up much stronger because by the time we get to summer, and especially the gasoline driving season, assuming we don't go to war in Iran, the oil, and the gold stocks will stand apart. They'll hold up much stronger and you may even see the gold stocks or oil accelerate as we did between 2001 – especially the gold stocks. [1:12:18]
Hello, this is Kent calling in San Francisco. A week ago I was listening to the Nightly Business Report on Public Television and I took a tip from the chief investment advisor for Oppenheimer who said that his favorite pick was Anadarko petroleum. He had bought it at $13 a share and a week ago it was at $44 a share, and he said it would go much higher, or it would be bought out from some other petroleum company. And now it's a week later it's lost 3 dollars a share, it went from 44 to 41. Is this kind of the trend for these oil stocks? Have they just basically been over bought?
THE WITNESS: You know what, Ken, basically, there's a disconnect between the physical market and oil. If you listen to the guest experts in the first hour, Andrew McKillop, and the futures market in oil, so there is a disconnect. You get people coming out every week and telling us why oil is going to $30 a barrel. The only way they could get it to $30 a barrel would be an absolute crash in the world's economy. So one of the things when you make an investment as you have and Anadarko, is you can't buy that just looking at what's going to happen to the price of the stock in a week. If you like the stock at 44 and it's at 41, I would add to your position. But plan on holding this as an investment because he's absolutely right: the big oil companies – whether you’re looking at Exxon Mobil, Chevron Texaco, Shell, Phillips – these large companies are nothing more than investment banks at this point. There's no way these companies can replace their reserves or increase their production. The only thing that they can do at this point is take their large cash reserves, and just buy other companies – and that's what you're going to see. You're going to see the Anadarko’s bought up just like you saw Burlington Resources bought up. You're going to see the Apache’s bought up. All of these second-tier, below-the-majors are going to be scooped up because that's the only thing the major oil companies can do. So Ken, take a long term view with your investment. Don't go in all at once. If you like it at 44, add to your position. [1:14:37]
JOHN: Jim, we still have a lot of Q-Line questions remaining but the show has run very long this week, so we're going to hold those over until next week on the program. And speaking of next weak what is it we're going to be engaged in?
JIM: Okay, for the rest of the month put on your get your Maalox out because, you know, John – we ran what was the clip with Robert Duvall – the remainder of February is apocalyptic, because we have two authors Michael Stathis who will be joining us with a very thought provoking book American Apocalypse. So February 17th we’ve got Michael Stathis joining us with America’s Financial Apocalypse. And then we have another apocalyptic book coming up on the 25th of February. March 3rd, Mr. Hero has written a book called Blood Of The Earth. It's about oil. And March 17th, Ben Stil: Financial State Craft. A rather interesting book in terms of how a superpower in decline manages that decline – and especially when it's so dependent on the rest of the world for capital. So Ben Stil will be my guest on March 17th.
In the meantime, John, you're right, we've gone a little long. We just had a whole slew of Q-lines and my apologies that we can't get to all of them. We'll try to get to the rest of those next week. And I want to tell – and I’m trying to think which caller it was – but we will be doing in the week ahead probably a Big Picture segment on infrastructure and get into some more detail in the types of things that are involved in infrastructure and the companies that are involved with them.
In the meantime, on behalf of John Loeffler and myself, we’d like to thank you for tuning into the Financial Sense Newshour. Until you and I talk again, we hope you have a pleasant weekend.
