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Financial Sense Newshour

The BIG Picture Transcription

February 16, 2008

Part 1

The Era of Resource Restraints

JOHN: Here's where we have the grand slam as we put it all together to critical mass, and obviously, if all of the other media were doing their job, we wouldn't have one, but there we are and here we go.

Jim, right now, the markets are focused on I guess what you would call a slowing US economy or the R word – recession – and this is really quite high contrast. Remember the exuberance last year when the Dow hit new highs. It is amazing how fast things turn around from one side to the other. Given the fact that the US economy accounts –for what? – about 25% of world GDP, there are genuine fears that are growing that with our economy slowing down, the rest of the world will slow down as well and then the demand for commodities will slow down and therefore the commodity markets will have topped off. Well, certainly, since the beginning of the year, energy and materials have suffered double digit losses. So we're going to look at the commodity markets today and try to dispel some of the myths showing you other factors that are in here that are not being taken into account.

JIM: Yeah. I think this is one of the big misperceptions that the market has, as you mentioned, if you take a look at the S&P index year to date, although energy has recovered, it’s down about 10% for the year. Materials, another best performing sector for last year, is down roughly about 5%. But I think a lot of the selloff, especially in energy and gold equities, came about because of deleveraging by a lot of leveraged speculators, especially the hedge funds. And more importantly, a lot of the investment banks are curbing their lending to these speculators. So funds that were leveraged started selling or started to unwind that leverage. The two best performing sectors last year were energy and materials, so the specs are taking profits in my opinion. But another myth out there is something that you just hit upon is, wow, if we're the largest economy and our economy is slowing down and global growth is slowing down as a consequence, that's going to mean slowing demand for commodities, which would decrease the need for energy, base metals, steel, iron, ore and other commodities.

However, here is the thing I think the markets aren't looking at a complete picture. Demand is increasing and it's looking more like we're going to see supply constraints in many key markets from energy, especially coal, we're seeing it with platinum with the energy shut down in South Africa and China. We're seeing it also in iron ore, aluminum and steel. Also in the grains and especially in soybeans. And moreover, these supply constraints are going to be long lived in nature. In other words, John, these are things that are not going to be fixed in a quarter or a year and could emerge as a basis for another major ramp up in commodity prices this year.

And if you take a look right now, most of the major commodity indexes from the CRB Index to the Rogers Raw Material Index are at new record levels. And I believe they are heading much, much higher. In fact, this week alone, the CRB Index hit another all time record. It has basically doubled in the last five or six years. [3:27]

JOHN: So basically what you're saying here is there is really a huge misperception in the markets. Another word, it's really a battle for control over the mind set for the commodity markets. I know we've had some various technical views on the commodity markets that are short term bearish as a matter of fact.

JIM: Yeah. The problem as I see it is a lot of these bearish views are coming from what I call a top down macro, more of an industrialized mature economy point of view. All I can say is, John, throw the charts out the window. From a micro or a bottom up point of view and from an emerging industrialized economy viewpoint, we're going to see a lot of the chart breakers this year across the commodity markets wherever you look. You're seeing dislocations, you're seeing rigidities, you're seeing shortages and various knock-on effects.

I mean, most people aren't thinking, “Okay, what do the power shortages in China and South Africa mean?” Well, you know what? Platinum production has been shut down, and that's a very tight market. So instead of a top down macro transmission to the commodity pits, it's happening more from the bottom or the micro-economic side. You look at the gold markets. You now have macroeconomic fears added to the equation. In energy, you have burgeoning demand from key emerging markets butting against tight supplies. I think there are going to be some big surprises in base metals this year that show the resilience to the economic cycle.

Even in a economic downturn commodities, in my opinion, hold the potential to [out]perform a lot of the other asset classes. [5:09]

JOHN: This reminds me a lot of last year when we experienced, remember, warm weather and then oil dropped to $50 a barrel and the experts told us that with a slowing economy, it would drop to $40 a barrel. But instead, we ended up closing at the year to $100 a barrel. So it's the same story this year.

So why don't we take the major commodity markets, discuss the fundamentals driving these markets; and since we're talking about oil, let's start with energy first.

JIM: Okay. Everybody is talking about an economic slowdown in the G7 countries. I mean that's all you hear in the economic headlines: Either it's financial institutions taking losses, it's the year-over-year downturn in real estate sales and prices. And you hear a lot of talk about economic slow down. Especially in the countries like the US, Europe and Japan.

But I think the more relative issue is what's going on in China, India, in the Middle East. I mean if you look at this year alone, Chinese demand growth is expected to accelerate this year. China has energy problems with producing power.

We talked all last year and also on the energy round table about OPEC demand where energy is subsidized by the state. I mean if you're paying 30 or 40 cents a gallon of gasoline, you know, you don't have any concept that we're in a tight market when you have the state subsidizing it. One thing that really also struck me this year is there's an emerging automobile company in India called Tata Motors that's producing cars for $2500. Think of what that will mean to the energy market bringing on almost a whole new class of drivers in that country or elsewhere when they begin to export those cheap cars to emerging markets. I mean this is a very cheap form of transportation. [6:56]

So what we're seeing here in OECD countries will remain weak in terms of energy demand because the economies are weakened. And it's expected that perhaps energy consumption in these countries would decline somewhat, but overall demand – and this is the Big Picture – overall demand globally is going to rise this year between one, one-and-a-half percent. And on the supply side, OPEC is not going to deliver much and non-OPEC production is going to disappoint again. So I expect energy prices this year will be making another record. This will probably be six straight consecutive years of annual energy increases. And you know, John, despite the slowing economy, here we are on a Friday, energy prices are at almost $96 a barrel.

So there are a number of factors that haven't happened. We've seen project delays. And despite rising prices, demand has not declined as the experts told us. And the West has reduced consumption slightly, but you have to offset that and take a look at what 3 ½ billion people are doing on the other side of the planet. So you have strong demand coming from emerging markets and OPEC demand is more than offsetting any slight decreases that we might see and maybe flat consumption demand in the West.

And then the other factor that they're not taking into account is our world's oil fields, which in the major ones that were discovered, what, 40, 50 years ago, we're seeing huge depletion rates, overall about 5%. But think about it: If we lose about 5% of our ability to produce because of depletion, that means you have to come up with more energy just to stay even. [8:45]

JOHN: If that is all the case, why has the Wall Street crowd been so bearish for such a long period of time?

JIM: That is really surprising because when you look at the energy charts, you look at consumption, you know, I think it all stems from that most of the analysts are heavily US-centric, which would make them lean more towards the bearish side.

I mean if you look at the energy markets from the bottom or the micro-side, you begin to think differently. So most of your market commentaries, the stuff you hear on the news, is centered on what is happening in G7 countries. And especially, for example, what is happening to US inventories. It's like inventories in the US are reflective of everything that is happening in the rest of the world. So this US-centric reporting tends to dominate the energy market short term. And this is the news that traders react to. So investors on the other hand are focusing more on the fundamentals. I mean last year three countries with the greatest increase in oil consumption were China, India – and here is a surprise, Saudi Arabia.

In fact, China India and OPEC accounted for virtually all of the net global oil demand growth that we saw in 2007. And this year is looking more like the same. I mean the common view that a slow down in the OECD GDP growth is going to lead to lower global oil demand is naive and probably woefully simplistic in my view.

As the year ends, I think we're going to find, once again, China, India and OPEC will prove to be the demand drivers for energy this year. [10:24]

JOHN: Well, that means then that much of the West is operating under the old economic paradigm for energy here, which basically means the US and maybe some of the other countries in the West are the major drivers in this. So, many in the West (and this includes most of Wall Street and Washington by the way) don't realize that the paradigm has actually shifted and the dynamics don't revolve completely around the US.

Well, at least it was predominately before, but that's just not the case anymore. That has not penetrated the consciousness of these people on both Wall Street and in Washington. So it seems like much of what occurs in the energy market, to quote Matt Simmons, is based on hope and faith rather than a sober recognition of what's going on in the real world.

JIM: Boy, I tell you, you just summed that one up pretty nicely because if you look outside of OPEC, non-OPEC production keeps disappointing. About one out of three barrels of what has been projected to come onstream of new production has actually materialized. We've seen project delays in the Gulf of Mexico and elsewhere. And most non-OPEC fields are now in decline. I mean if you look at where incremental supply is coming from, outside of OPEC, it's mainly Brazil, Russia and Azerbaijan.

Opposite to these increases, you have declines in Norway, you have declines in Mexico, the North Sea, the North Slope of Alaska, the Gulf of Mexico.

So if you look at this, all of the gains have been largely cancelled out by the declines. And this gets back to this depletion argument that they keep throwing out.

So the demand fundamentals aren't changing much. Oil prices could have periods of softness. You get the shoulder months, for example, you get into March, April and May, the weather starts to get warmer, so you're burning less heating fuel. And then you get into another seasonal factor, the summer driving season for gasoline. Then you have another soft month as you get into the fall before you hit winter. So if you take a look at a lot of this, oil prices have these periods of softness, and it's caused by these misplaced perceptions and these seasonal factors I just mentioned. But the main trend is energy prices are heading higher.

John, every single year you and I have been doing this program since 2001, they have told us every year as the price of energy goes up, they tell us why it's going down. You and I started doing this program in 2001. The price of energy went from 20 to 30. They were telling us it was going back to 20 again. Then we got into the Gulf War period and they said as soon as the war was over, the price of energy was going to come down. It was going to go into the 30s and instead it stayed up in the 40s all of the way up to today. Here we are close to $96 and they are telling us the same arguments: Well, the US economy is slowing down, economic growth is slowing down, there is going to be less demand.

Well, I hate to tell these analysts, there are more consumers out there. And barring a worldwide recession in China, in India, I mean a global major downturn, you're going to see increased consumption of oil. And given the tight supply constraints that we're seeing right now, that only tells me prices are heading higher. [13:52]

JOHN: Yeah. So basically, we expect higher energy prices, which is why in your mind you continue to hold your energy position. And then I would assume that in periods of weakness we experience, you're basically in there buying rather than trying to dump out when things are going down when everybody else is running to sell.

JIM: It absolutely fascinates me, and I've talked about this on the program with a lot of our energy experts, but it doesn't matter who you're looking at. You look at the oil industry and they are pricing these companies like they are cyclical stocks. Exxon just made $41 billion, and yet you're seeing at a time, even if you look at the major oils, companies selling for 8, 9 times earnings, 11 times earnings, 12 times earnings and they are growing earnings.

I mean one natural gas play, their earnings were up 136% in the fourth quarter, and they sold the stock off. I mean it's just absolutely amazing. But I have been, and we've expressed this on the program, I'm a big believer in peak oil. I mean I've read, John, too much. I've studied the issue for more than a decade now. We've interviewed or talked to too many experts on this program, people who have a lot more smarts than I do, and what I read scares the heck out of me. Not so much from the perspective that it's a problem we can't solve. We can if we put our minds to it. What scares me is the apathy of our politicians. I mean you remember in the energy roundtable, I asked our experts, what would you do it you were president or elected president; and you remember Matt's comments, he said “the first thing I’d probably do is cry.”

They are taking us into a crisis by their own biases. You see apathy. And another factor, I think, is ignorance, and their lack of focus. Instead they are focusing on global warming, something that may or may not happen 40 years from now when peak oil is right on our door step. I want to just share a couple of thoughts here.

There is a well-respected analyst by the name of Charles Maxwell. He's with Weeden & Co.. And he put down on record, he wrote a piece called The Critical Look at the Next Three Years in the Oil Industry. And he wanted to get this down as a matter of record. Basically he starts out, and I'm just reading from his piece here. He says:

Forecasting the future has never been much of an occupation in the mind of the public in recent years because there were too many options as to what might happen, and too few of them ever turn out to be right. Though this is obstinately true, you, the reader, have crossed my palm with silver over a life time of oil industry analysis, and professional pride now impels me to stand up and tell you what I see ahead. It is a somber outlook because as a society, we appear to be at the early part of a long term energy cycle in which we are sleepwalking right into the trap of coming shortages accompanied by higher prices and we don't want anyone or anything to wake us up. And the critical turning in this situation is going to be evident, I believe, over the next three years.

And he lays out what is going to happen over the next few years. And he said:

One of the most critical things, and this is exactly what we're seeing right now. He said:

The failure of crude to go into a price collapse will likely be a major tipping point this year.

So what he's referring to is what you and I have just been talking about because everybody says, okay, here we are, we're going into an economic recession –the United States is probably in one, Europe could be in one, Japan is certainly in one – and given an economic recession in typical cycles in the past, as we saw in, for example, the last recession in 2001, oil prices came down around 18 to $20 a barrel. And what Charlie is saying here is, this is going to be the tipping point this year that despite economic weakness, oil prices are not going to collapse. And that's certainly what we're seeing here. And then he goes on, and he says:

Ultimately, what we're going to see is we are discussing a reduction in the freedom of mobility by rationing fuel to a lesser number of car and truck users. It's going to be a harsh eventuality for our society to accept.

And then he goes on here:

The implication of all of these points will take years to work through the real economy. Our democratic traditions are likely to be tested again and again. Slower economic growth brought on by reduced oil supplies will make every other deficiency in our system, medical, educational, transportation and financial, etc, stand out as heavier burdens on civil society.

So he's going on record. He says, look, I want to get this on record. I'm leveling it out to you. I'm sticking my neck out, but this is what I see happening. And it is a rather sobering piece that he put out. [19:10]

JOHN: Of course there is always the question about whether Americans are just ignorant or apathetic, and somebody said, “I don't know, and I don't care.”

So basically we're still in the energy area here. Let's talk about electric power. I think this is critical because as we talk about, say for example, hybrid cars that don't just do like the Prius does and convert electrical energy back into battery power as it’s going downhill or something, we're talking about the type where you would come home and plug things into the socket. Basically, for 50 miles you'd have a charge and when you get home, you just charge yourself up again. The problem is, in order to do that you're going to have to have power companies charge one giant passel of cars.

I don't think anybody is thinking in that direction because we're running into energy crises into a lot of places, as a matter of fact. We're having brown-outs in California. Last week we talked about power shortages in China and South Africa as well, affecting the platinum markets. But that's another whole area of energy, and they are interlinked, but like you say, also, you can't drive down the street with an electric cord attached to your car, so you're going to need some liquid fuels there. But at the same time, if you're going to try these hybrids in 10 years or so, there has to be a change here as well.

JIM: Yeah. That was the big thing with the technology boom in the 90s. They thought that energy would be less demanding on our economic system, but we found out all of these devices that we used today, I mean personal computers have become ubiquitous, so there is another appliance that you use in your home. Instead of just a regular television, everybody has big plasma screens, flat panel screens, and you don't watch movies just on television sticking a tape in a VCR; today you're watching it in a DVD player in surround sound. So you're consuming more electricity.

So I think this is one of the reasons why a new theme that we added a couple of years ago is infrastructure. And I think this cycle is set for another boom. The markets have worked off all surplus power capacity that we brought on in the 80s and 90s and are now again in need of a new supply.

There is a moderate amount of power plant capacity coming online, but like oil consumption, demand growth is likely to outpace supply. [21:21]

JOHN: One road block I can see coming is from politicians and environmental groups because they don't want coal, of which we have an abundant amount, even if we could sequester the carbon dioxide,

JIM: Which we can –

JOHN: We can do, the technology is here to do it. Or nuclear. And if we just revise how we're processing spent fuel, the quantity that would have to be stored is really minimal at that point. And also renewables, because you look at all of the efforts that are pointing at every time someone tries to do something, I just read an article yesterday about a big wind farm down in Texas, and sure enough, it's the normal flap from environmental to “it doesn't look very good” – that type of thing.

JIM: And it kills birds.

JOHN: And it kills birds. Although I understand the newer blade units are operating at a much lower RPM, so it solved some of that problem, but we'll see. I can't talk as an expert on that one.

But there is also hydro and wind and solar. And what do you say: You can't quite do this all, and we can't get it running because we're running into so many obstacles, and what's important to recognize given the energy situation we're talking about is the clock is ticking right now. Every day we delay, tick tock, tick tock, you're running out of time. The time to sew your parachute is not when you leave the door of the airplane. At that point you have an emerging crisis you may not be able to avoid; right? And that's what we're doing to ourselves.

JIM: Yeah. The problem is, you know, renewables make great sound bites, but they only provide about 2% of our power. Over 50% of our power comes from coal and another 20% comes from nuclear. And if you're going to exclude those two areas and you want to go to natural gas –a depleting fuel – I mean the whole problem is we're sort of in this limbo period. You have a clear need for new supply because of all of the demand, but yet you have no proven method to attract that supply. Most new power plants coming on stream are natural gas, and natural gas is a depleting resource with a declining production in North America. So despite the efforts to diversify the fuel mix, it's mainly coming from natural gas plants, not a well thought out idea in my opinion.

So if you look at growing demand for electricity, significant capital spending needs by utilities for distribution, transmission and power. And given what we're seeing on rising capital cost, rising labor costs, rising material costs, and significant cost pressures, John, there is just no way that people aren't going to see a significant increase in their utility bill because it's getting more expensive to produce power. It's getting more expensive to build new power plants. And you're talking about billions and billions, tens of billions of dollars of costs that are going to go into creating these new power plants. Otherwise, you know, we're going to experience, as we do periodically every year in California, brown outs. It will just get worse.

What do we do if we start converting the driving fleet over into plug-in hybrids. So okay, where is the electricity going to come from? [24:20]

JOHN: Yeah. That's what we're talking about before. You're going to actually have to provide that energy source somewhere. And can you imagine if the fleet did convert over and everybody was doing that? You know, up in Alaska, when people park, they often times provide electric plugs there because you need to keep heaters going in your car or in some cases people just keep their car running and have a second set of keys because of the cold. They'd never get the car started again in some cases.

But other than that, if we also look at nonpolluting type of sources, especially in the area of C02, you have a limited number of choices: You have hydro, wind power or nuclear. Now, those are your primary, right, that you're going to have right there.

Now, I suspect that looking though at how many power plants are running on natural gas, I mean that's the next hydrocarbon alternative that is still CO2 polluting, but I would expect those prices are going to head higher as well because there is a shut down right now going on in who wants to start building new coal plants.

JIM: Yeah. I mean if we take a look natural gas prices are 8.70. You know, I'm not sure it's clear to me other than political biases why they are looking at a depleting and expensive resource such as natural gas and using that to burn and produce power when other plant types are available.

When demand presses beyond capacity of cheaper plants, the next cost effective group of power plants are usually started. Hydro electric plants are expensive to build, but they are cheap to operate. Ditto that for nuclear and wind and solar. Coal comes next with high up front costs and capital costs, but also fairly low fuel costs.

So we have to look at fuel diversity. To rely on only one fuel only isn't prudent. And that's what we're doing right now. It seems to me a more sensible approach would be to look at coal and nuclear for handling your baseline electricity demand, and then you use your renewables such as wind, solar to handle peak demand because wind power is intermittent. You've got to have wind, and sometimes you don't get it. I can't think of the number of times I've gone sailing. You go out and the winds just die down and there is just nothing out there.

So whatever we do, the trend is very clear: we're going to have to build more power plants. The era of infrastructure spending that we've been talking about is upon us and building new sources of power for electricity is just one element of that. So we're going to need natural gas. Power plants are going to need coal. And nuclear plants are going to need uranium. So there are investment opportunities in all three of those. [26:58]

JOHN: You need a coal plant to use uranium. Oh, well. Just a brief crazy thought.

Let's move on to the next category. A commodity which is base metals. Like energy, the big question hanging over the base metals markets is the economy again. With the economy slowing down, there is less demand for the base metals, whether it is aluminum, copper, lead, nickel, tin or zinc. And what was amazing considering it was just a year ago there was such a premium demand on copper that the construction people were having a hard time getting Romex in on wiring.

JIM: One of the things that we're seeing in base metals – this also applies to energy – is this continued economic gloom, which has caused price to soften since the beginning of the year.

We're running into supply problems. Platinum being one of them. I already spoke about the power shortages, for example, that we're seeing in China and Africa. The other factor is inventories are low globally, and on the demand side, you're still seeing emerging markets have picked up the baton of demand growth from Western countries. [27:57]

JOHN: Well, I suppose like the other areas of commodities, the big issue is what the outlook is for China this year because that's something that, you know, we see articles about China being a power house, but reality, in the minds of people, it hasn't settled in either there.

JIM: You know, I think if there is any risk to base metals, it's probably going to be more important to focus on what happens in China rather than the US. I think what is different in this cycle that analysts are really not focusing on in comparing it to previous cycles, for example in base metals, is that when demand growth slowed, let's say as the economy was heading into recession, it coincided in the past with miners boosting output bringing on more supply because prices were rising. And this led to higher inventories and surpluses, which eventually when the economy slowed down, you’d see prices fall. However, this time around, well, there is obviously acceleration under way in some sectors. Key markets are really tightly constrained with small surpluses and even deficits for some base metals.

We keep talking about South African power shortages. It's resulted in severe cut backs in the mining sector with copper production significantly reduced, for example, in Zambia. You've seen aluminum production hit both in China and South Africa. You've got political problems in Indonesia. You're seeing more governments are becoming rapacious and posing windfall profit taxes on the mining sector. And the mining sector says, “you know what, if you're going to take that much, we won't expand. We'll just keep what we have.”

So the consequences of all of these factors is that surpluses that typically build in, let's say, the late stages of a cycle, they are not taking place. So we could see higher prices for copper this year, higher prices for tin and aluminum and platinum. And if there is anything that's looking on the weak side with a little bit of a surplus, it would probably be, let's say, lead, zinc or maybe nickel.

And I could probably go on to maybe precious metals next, but gold, silver and platinum –and especially platinum right now with shut down in Africa, but we're going to cover this in our upcoming gold roundtable at the first of the month. [30:17]

JOHN: Okay. So let's move on to agriculture next. It is no secret to anybody who eats and goes to the grocery store that food costs have been – I was going to say slowly, but I think the word is steadily rising at this stage along with energy. I mean the public isn't fooled about this one anymore.

JIM: No. But you know, we typically excluded it as if it was some kind of aberration in the inflation index. You know, if you look at the ag-sector this year, this could probably be a pretty interesting year. I mean the grain sector looks extremely bullish. If you look at soybean prices, they are up already 13% since the beginning of the year. You've got sugar prices up about 16%. You've got copper prices up 5%. And I want to go back just to the last section. Base metal prices, John, this year, aluminum spot prices up 19%. Copper prices up 17. Lead up 19. Nickel up 7. Tin up 2% and zinc up a little over 1%.

But you start the year, to begin with, with low inventories across most of the agricultural markets. You also have rising demand from the emerging world, and then you have this enormous demand coming from the biofuel sector. I mean just look at the energy bill that we passed last year mandating more biofuels. So I would expect as we're looking forward in the year, another year of rising prices. I just mentioned what's happening to some of these since January.

And then on the demand side, you still have robust Chinese demand. You have increased biofuel production; and more importantly is you have low global grain inventories. And you see in the past, when you had larger inventories, they sort of acted as a buffer to the market, and they were used as a shield against supply disruptions.

And let me just share with you some simple statistics. Our supply of corn has fallen from 10 ½ weeks of supply 6 years ago to only 6.8 weeks of supply currently. That's the lowest level we have seen in 33 years. Wheat supply has fallen from almost 14 ½ weeks to 9.4 weeks. And that's the lowest level that we've seen since the USDA started to track and publish inventory data going back to 1960. [32:43]

JOHN: So you would think this would be getting people's attention? Let's listen to a clip from Thursday's Wall Street Journal.

The farming community is becoming cautiously optimistic. As the rest of the economy tightens its belt and embraces for recession, farmers are having the times of their lives. Crop prices are setting records, incomes are up, and some people think that the good times can keep on rolling.

Jim Bauer, a grain trader from Lafayette, Indiana is more cautious. A few weeks ago, he and farmers and supply salesmen Brian and Darren Hefty spent three days talking to farmers in North Dakota, South Dakota and Minnesota. They packed churches and casino halls sometimes drawing crowds as big as 350 people. The message was a cautious one.

On this road show the topic of conversation ranged from the rising price of food to ethanol to world hunger. Farmers shared their thoughts about the exciting times along with the anxieties, fear and often times greed that come along with it.

Farmer: It's an exciting time because as they said in the seminar tonight, it's probably one of the best years -- well, the opportunity to have one of the best years ever is now.

Along with the optimism comes fear. One big fear is the D word. Drought.

-There is a lot of people that are talking about that, you know, global warming and the drought areas becoming expanded and more of a Western part of the corn belt, is probably more susceptible. They are talking about the drought in the southeast. And usually the following year that expands up into the corn belt.

-The situation new ahead is so tight it warrants a lot more, what I call, “look at” in order to make some kind of ascertainment of what they are going to do if we have a big weather problem this summer. It a problem that I think needs to be addressed before it turns into a catastrophe.

Prices have been rising briskly for more than two years. That leaves some farmers feeling cheated if they sell too early.

What's happened in the last 12 months have shaken the self-confidence of a lot of farmers because basically almost everyone is getting better prices than they've ever gotten before, and at the same time, they are saying every decision to sell in the last 12 months has been a mistake.

So how did we get here today?

-Obviously, the farmer wants to provide enough food for everybody, but what happens when we over produce food, a person can only eat so much and then that extra, so we'd have just, you know, surpluses continuously which meant very, very low prices in a commodity market.

-To be able to create a new type of market instead of just food, to be able to have a market that we can grow for fuel was just – is just an amazing new paradigm.

The other revolution in agriculture is a function of population growth and rising incomes in the developing world where meat, eggs and milk are becoming staples, not just luxuries. That's good news for farmers.

Everything is higher right now including food and our inputs too. But farming is fun right now. I've been in it for 50 years and it's a fun occupation right now. I see the overall economy with housing and stuff not doing real well. The farming economy right now, my area, is the best it's ever been.

And while many economists believe the crop prices will stay high for a long time to come, there is a fear in farm country that the price of grain could come tumbling back down.

Farmers are still looking at this thing, like, okay, I went 20 years not making any money. Yeah. I may have made money for a year or two, but chances are, it's going right back to the way it was for the last 20 years where I didn't make anything, so I've got to learn as much as I can today so I can survive when times do get tough again. And those tough times could be coming any time. We don't know. It's still supply and demand, so if we oversupply, the demand, if something happens on either end of that thing, then all of a sudden, corn might go back to $2 again. It might go back to $1.50. Just two years ago, locally for us, it was a $1.30 cents. So that's dramatically different than it was today, and I have no illusions of thinking it couldn't get back down to that again, and that's the scary part.

And what about Jim Bauer, the commodities broker? How is he fairing?

There is so much going on right now and the movements are so extreme that it's really, really almost like an operating room. It's a time of high stress right now.

I'm Lauren Etter reporting for the Wall Street Journal. [37:31]

JOHN: So from a bigger picture, listening to this clip anyway, agricultural commodities look like they are actually in a boom.

JIM: You know what is remarkable about this is that we've experienced -- and here is something to consider -- we've experienced 17 years of record harvests and yet inventory levels remain at record lows. Just think, John, if we were to have years of famine what that would do. And unlike Joseph in the Bible, we haven’t built up surplus storage during the years of plenty. If we have problems with water and problems with energy or have a severe drought hit us or bad weather, think what could happen. I mean if we already have low supplies, low inventories now, think what happens if we have problems. In fact, the amount of arable land has actually declined due to urbanization. I mean you have grain demand is being galvanized by feed and industrial use coming from rising Chinese demand. And now we've got this new factor. We're turning ag products into biofuel production. And that is what is undergirding demand. Meanwhile acreage and inventories continue to decline, so that's why we're especially bullish in wheat, soy beans and corn, and we've invested in all of them since last year. [38:52]

JOHN: Yeah. There were some articles recently. The Economist did a front cover issue on food, as a matter of fact, saying that the era of cheap food is basically over.

JIM: The era of cheap energy is over and the era of cheap food is over. And I think the era of cheap commodities is over because the whole topic of what we're talking about here is resource restraints or scarcity.

I mean it's easy to see why wherever you look whether it's soybeans, you see production short falls, if it's corn, it's high demand. And just think about it logically: Farmers plant more corn and less soybeans than wheat. Because what? Because bio fuels, corn prices are going up, so you can't blame them. You have farmers responding to the marketplace.

And just one grain, soybeans for example, Chinese demand has been rising by an average of 12% a year over the past decade. They've got a lot of people over there. And if you look at soybean production, it has gone from 186 ½ metric tonnes of production in 2003 to over 220 tonnes projected for this year. So that is down from 236 tonnes last year. So despite a 20% increase in production, the weeks of supply has remain unchanged or down slightly.

So what we're seeing in the bean sector is lower global production amid record demand, which has led to a large drawdown in stocks. In wheat, we've seen Argentina's exports drop 10% year over year. Canada's exports dropped 26% year over year. European exports down 35% year over year. The only people that are increasing their exports are Russia and the US. We're only two countries. And yet despite the increase that we've seen in production, you're looking at the lowest levels of inventory we've seen in almost 30 years now. [41:01]

JOHN: It's really sobering to see the direction we're taking on this. There is a whole series of potential crises forming but there is no focus on it, like you said, from Wall Street or from Washington, either way. And we don't have time in this segment to cover the whole commodity sector that we're talking about.

And you know, coffee and sugar also look good too. Not just to me personally. But I mean as far as a commodity. Where can investors get information on this area or learn more about it, as a matter of fact?

JIM: Well, you know, you start out with the Bible for commodity investing, which is the Annual CRB Commodity Year Book. Right now, you can get the 2007 CRB book is out there, and I think the 2008 book, which will give us statistics for 2007, that will be available in June of this year. And then if you really want to get into this sector and really learn about it, there is a couple of books out there, one by Jack Schwager called Fundamental Analysis Of The Futures Market is a must read. You can follow that up with Schwager’s Technical Analysis Of The Futures Market and his third book, The Complete Guide To The Futures Market. Those are three books.

If you want something a little bit lighter, less technical, then I would recommend highly Jimmy Roger's book, Hot Commodities. Rogers really does a good job in understanding commodity fundamentals. [42:24]

JOHN: Well, that's it for this segment, and if we summarize everything that we've been discussing here, basically you think commodity prices are heading higher and that this bull market, which I know you've been writing about for the last seven years, is far from over.

From what we discussed it looked like it really does have many years to run before we're going to see the inevitable downturn in the market. You're listening to the Financial Sense Newshour at www.financialsense.com.

FSN Follies: Andy Looney

I'm Andy Looney. Did you ever try to call for help with some large company or bank, or worse Medicare or a credit card? Did you ever get one of those recorded computer voices? I call them automated voice attendants or AVMs. I did. It was crazy. You know like when they want you to speak Spanish. I don't speak much Espanol. Do you? I don't. I'm unolingual. Then they try to get you to explain your problem in words that the computer will recognize. Words like, I have a billing question, or I need to make an appointment.

The only thing the computer doesn't recognize is I want to speak to a real person, which is what I really wanted. Don't you? I didn't get one. Then the computer asked if you meant to say, I want to schedule a payment. When I said no, the computer thought I said dos, and I got Espanol by mistake. You know, the computer doesn't recognize [Spanish] either. Did you understand what I said? I didn't.

My uncle Freddie wanted to get his snow blower repaired, but when he said snow blower, the computer blew his call off to Alaska. What is with that? You've got to be very careful what you say to a computer. Yo soy Andy Looney for [Spanish], or is that Cinco De Mayo?

Other Voices: John Williams, Shadow Government Statistics

JIM: Well, there’s a lot of talk today that given the nature of the economy that we are heading for deflation; non-bank borrowed reserves are in negative territory. And some are saying the SOMA account which has dropped in the last month that the Fed is actually drawing money from the system. Yet, if we take a look at popular measures of money supply, whether it’s M3, M2 or MZM, they are all going up.

And joining me on Other Voices this week is John Williams from www.ShadowStats.com. And John, I want to begin with this story. Let’s begin with non-borrowed bank reserves which are negative, the first time we’ve since this for decades which would tell me from a technical point of view that the banking system is insolvent. Take us through those numbers and what are they telling us?

JOHN WILLIAMS: Let me start first by defining or telling what the Fed’s definition of non-borrowed reserves is, which is total reserves – that’s what the banks put up in addition to the cash they have in their bank vaults to support as back up for the deposit accounts and such that are in the money supply – It’s the total reserves, the borrowing of the banks from the Federal Reserve. And right now the banks have just put out numbers Thursday night which show on a not-seasonally-adjusted basis which is the way that you have to look at these numbers, that for the last two weeks the non-borrowed reserves were something like a negative 20 billion dollars. The banks are borrowing at this point $20 billion more from the Fed than is needed to meet their reserves. And that’s extraordinary. You mentioned that hasn’t happened in a long time. I’ve gone back and looked at the historical record as best they have it and you’ve seen nothing like this since I guess it was March of 1933 when Franklin Roosevelt declared a banking holiday, and even then the net-borrowed reserves didn’t go negative but the borrowing got up to maybe 46% of total reserves. There may have been a time back around World War I and all the financial disruptions there, it might have happened but you’re back basically then to the founding of the Fed. What we’re seeing here is effectively unprecedented.

And what happened – the reason that we have this – is because of the Fed’s establishment of what they call a temporary auction facility (they call it TAF) where the banks can offer certain assets to the Fed, the Fed will say we’re going to put out $30 billion, make an offer of what you want to put up here, they auction off that $30 billion. The banks supply collateral and end up borrowing from the Fed. This is through the discount window. Now, the discount window is usually for troubled banks. The way the system would work, more often than not, is that on a given day a number of banks will have more reserves on deposit with the Fed than they actually need and there will always be banks that will be short. But what the banks do is those that have the excess reserves tend to lend it to those that don’t. That’s the Fed Funds market. The rate that’s charged overnight is the Federal Funds rate that the Fed keeps targeting at the moment. But what happened as this current financial crisis broke and the question of the solvency of banks – major banks – came to a head is that banks were not lending money to each other overnight; they were afraid maybe the bank might not be there tomorrow morning to get repaid. And what the Fed did was to set up this special facility to lend directly to the banks that needed funds for their reserves. It was because the banking system in its normal functioning had ceased to function in terms of the overnight credit market. It was not working. And even Mr. Bernanke in his testimony last week indicated that was an ongoing problem – that was the purpose of this facility. But right now, with the Fed lending more than their total reserves suggests 1) they’re going beyond funding just reserve requirements, but it does indicate there is a very serious problem, that it’s expanding. The Fed recently lowered the loan size that they make so they could get to smaller banks. There’s a major solvency crisis in place with the banking system.

Now, what you have to keep in mind is that Mr. Bernanke is an inflationist. He’s made that clear from way back. He doesn’t like deflation. He would fight deflation and he’s a student of what happened during the Great Depression. The Great Depression you had a terrible deflation along with the collapse in economic activity and the two were tied together. The reason that you had the deflation was that the banking system collapsed. The Fed effectively let it happen. And in the process, the collapse of the banks, you had a collapse in the money supply, which pulled down the overall economic activity and deepened the Depression. So I think what we’re seeing now with Mr. Bernanke is that he’s in the preventative mode here. He’s trying to keep the banking system afloat. And if you go back to comments he made in 2002 when he got the nickname of Helicopter Ben, he basically said that the Fed can always create enough money to create inflation. And if they had to that’s what they’d do. But right now he’s trying to prevent a collapse in the money supply. The money supply is not shrinking. People are misreading the tables there. There’s a fairly easy explanation to it. [50:37]

JIM: Let’s get to that topic next because you had the SOMA account really spike up towards the end of the year. It’s come down a little bit since then and you’ve got all these people out there telling people the Fed has taken money out of the banking system, they’re trying to collapse the system. And my goodness, this is so misplaced.

JOHN WILLIAMS: That’s nonsense. The Fed again, if anything –and I’ll come back to this – I’ll contend that the Fed will create any amount of money that it will have to create to keep the system afloat and to keep it going. And that generally means more money growth, greater liquidity in the system and higher inflation. That’s where this all ends up. But if you look at the chart that’s been floating around on a lot of the internet blogs that shows this plunge in the SOMA account, that’s first of all, the charts shows seasonal patterns in it: you get to the end of the year, the system needs certain liquidity with all of the holiday shopping and such. If you look at the top line – the total line – of all the open market portfolio, basically in January you’re at the same level as you were back in December. If you look back at the components – the standard SOMA accounts – that plunges. But what’s offsetting that is this TAF account that’s exploding. It’s a one-for-one set-off. The Fed is trading off assets that it owns otherwise for the lending that it’s putting in place for the banks. It keeps the overall level of their portfolio the same, it’s just a shift in components. It’s not the reserves are collapsing or anything like that. The reserve levels are normal, they’re stable, they’re just being funded by the Fed as opposed to the banking system and therein is a real problem. It is working so far, you have not had major bank failures; the system appears to be reasonably stable although there continue to be signs of difficulty and I’m sure the Fed will do its best to again address any way that it has to the problems that could threaten the financial system. Of course, in that addressing the problems, again, you tend to create new problems with money growth and inflation risk. [52:59]

JIM: You know, that’s the thing that stands out. And if you listen to his testimony on Thursday I mean he basically said, “look, we’re going to do whatever we can.” He’s basically saying, “I’ll drop helicopter drops if I need to.” And if you look at MZM, M2 and John, you track M3 which is no longer reported but the M3 figures, what rate are they growing at right now?

JOHN WILLIAMS: Well, for the month of January we’re estimating it at 15.2% which is the highest it’s been since Nixon closed the gold window back in 1971. The record level of growth in M3 – it’s not that old of a series, it only goes back to the late 50s or so – you have what was something over 16% and I can tell you in terms of the numbers which were published yesterday or Thursday on the money supply, if those levels for the first couple of days of February held, you could see 16% money supply growth in February. It’s beginning to surge again. We had a little bit of a dip in December. I think it had got up to 15.4 and then it came down to 15.1 and now it’s 15.2 and it’s heading higher. All of a sudden we’re beginning to see a surge in the broad money components.

And when it gets to trying to predict inflation the most important indicator you can take from the money supply is the broadest measure. And that makes sense: that’s a measure of the total liquidity. [When ] people have money, they tend to spend it. If they don’t have money they don’t. And when they spend the money that tends to be inflationary. It’s not the monetary base (which is reserves plus currency) it is no longer the measure it once was in terms of what’s driving the system because there are a lot of accounts such as the institutional money funds that have no reserve requirements behind them. So where the monetary base has been fairly steady – it’s not plunging which it would be if the Fed were trying to contract the system – it is not at all inconsistent with what is happening with the broader money measures which are up right now at near record levels. Again, the broader measures are what indicates inflation not the narrow measure. [55:08]

JIM: John, something else that is very disconcerting is a couple of years ago just before Bernanke came in, I think, they stopped reporting M3. They said because it was getting too costly to provide. And when I see the numbers that you’re reporting at record levels now I know why they don’t want the markets to know that. Now, starting March 1^st, due to budgetary constraints the Economic Indicators Service will be discontinued effective March 1^st of this year. What are they trying to do here?

JOHN WILLIAMS: It’s strange where they find the areas to cut their spending. But surely more of a summary service of economic data published by the government. The basic economic series are still being published as far as I know. It’s just that it’s not going to be as easily as available to the public and is apparently a very popular site. [56:01]

JIM: What do you think their motivation here is? You’re talking about an organization that can print money so there are no budgetary constraints. So what are they trying to accomplish here?

JOHN WILLIAMS: Well, unlike the Fed where I don’t think they wanted the public to see what was going to happen to M3 growth, if this were the reporting of the GDP or the CPI you could say they don’t want people to see the reporting of the recession or reporting of higher inflation. But those numbers are still going to be reported. They’re just not coming through that particular service. And I’ll contend among other things that where they’ve taken care of the GDP is it’s very heavily manipulated. It tends to overstate economic growth; the CPI, again, has been heavily manipulated over time with methodological changes that understates inflation. They do the same thing with the unemployment numbers. The unemployment rate that’s now around 5% really would be over 12 ½% if you used the original unemployment methodology and the way most people would consider unemployment. They’ve gimmicked the numbers enough – at least at that end – that there’s no need not to report them. If they were ceasing to report retail sales or something like that, that would be an effort to maybe hide the recession because you are seeing the recession now in the retail sales numbers. If you take inflation out of the year-to-year growth in retail sales it’s negative. December, which is the month of the year that retailers base most of their business on, after adjustment for price changes was negative year to year. And January’s was negative year to year too. You don’t see that outside of recession. We’re in a recession, we have been for probably a little bit over a year but the markets are very slow to pick it up, and the politicians and Wall Street they don’t start talking about it until it’s absolutely certain and usually six to nine months after the case. [57:55]

JIM: It’s absolutely amazing. Are they just basically saying here, “look, we’re going to make it hard for the public to get information in terms of how bad things are.” I mean it’s absolutely amazing. This almost reminds me of 1984. Maybe what we’ll do is we’ll just get happy numbers every month.

JOHN WILLIAMS: The popular reporting is moving that way. On the other hand, Jim, it keeps both of us in business. What can I say?

JIM: Well, John, you bring up a good point. As we close, why don’t you give out your website and talk about your newsletter because in the world where you can’t get good, straight numbers, I think your newsletter is vital for investors.

JOHN WILLIAMS: Thanks. My website is www.shadowstats.com. And if you go to it you’ll find in the upper right hand side of our webpage a series of what are called primer articles. It gives you the background of the basic economic reporting for the key series where the series have been manipulated or have strayed over time. We have available archives of a lot of material that’s been written that describes where economic and inflation reality is. We have a page that shows graphically our estimates of alternate measures of the CPI, the GDP and the ongoing M3. And of course, anyone who’s interested in subscribing to the current newsletter and the latest Outlook we’re always happy to have subscribers. All of that material and details on subscribing are available at shadowstats.com. [59:32]

JIM: Well, I’ll tell ya, a very essential newsletter at a time when you can’t get straight talk from government. John, thanks for coming on the program and clarifying this nonsense about deflation and the Fed taking money out of the system when we all know it’s just the opposite. I want to wish you a great weekend and please come back and talk to us again.

JOHN WILLIAMS: Sure will, and thank you, Jim, I appreciate being with you. [1:00:12]

How Bad Will It Get? When Will It Be Over?

JOHN: We spent the last four weeks talking about that parallels between today and the Great Depression. And today, just like back then, we're in a full blown financial crisis. And so the question a lot of our listeners have is, is this the big one?

But, Jim, I know you don't really think this is the big one right now. That catastrophe really takes major policy mistakes which we could be moving towards, but we're not at it yet. We really believe this event is probably, what, two years off, and as we've been saying here on the program, we really see a crisis window developing, which frames the years 2009 to 2012 because there is a whole series of converging problems like the oil crisis we've talked about and the financial crisis and other political issues that are all going to happen in that window. And they are not necessarily predictable as to how they are going to exactly come together when they do.

However, we are going to cover here today how big the current crisis is, how bad it will most likely get and what everybody wants to know is when is it going to be over.

JIM: Next Friday.

JOHN: Good. Okay. I'm going out. I'll meet you at Starbucks. Which one? You know, I was in Seattle over the weekend, Jim. Do you know you are never out of sight of a Starbucks around there. It's like Red Cross or something like that. You go into the men's room at the airport. My God, this is Starbucks in the men's room or something like that. You know? But back to where we are. Anyway.

How bad is this going to get, and how many cups of Starbucks will I need to get through this?

JIM: Well, originally when the crisis broke out last August, the estimates first started is losses would amount somewhere between 200, 250 billion depending on who you were reading. But then as the crisis began to unfold and worsen as one domino knocked down another, it was CDOs, then it's Alt A problems, and then it's credit default swaps, it's monolines. And so the problem, it began to worsen. It did not get better. A lot of people criticized the Fed for acting too late. Regulators and congressmen were asleep. So the latest estimates put this crisis with losses between 400 and 500 billion –so roughly twice what they are estimating back in September and October of last year. Of this amount, roughly globally, we have seen 175 billion that has been realized and reported, so assuming the government swings into a bail out mode with Plan B, something we're going to talk about in the next segment, we're probably about halfway through this process. [1:02:49]

JOHN: Okay. So it's obvious, though, I mean having said that we're halfway through it, without looking panicky, our government has finally awakened from the slumber. Now, whenever have you ever known Congress and or the White House to work so closely together to pass a stimulus package this quickly? The last time everybody was on the same band wagon yelling and screaming that we need to get something through that I remember was NAFTA; and that was right after the Republican revolution election but before the new Congress was seated.

JIM: Well, it's no secret. The most important thing that you have to understand here, this is an election year where most of Congress is up for reelection. And I think what they hope is when voters receive their checks, they are going to remember their congressmen when they walk into the voting booth in November. So the stimulus package is, really, John, more about preserving the jobs of Congress than it is about creating jobs in the economy.

I mean this thing, in terms of economic stimulus does very little. In fact, in terms of creating jobs in the economy, it was interesting because they did a survey of people: “Okay. If you get this rebate check, what are you going to do? Are you going to spend it? Are you going to save it?” About 19% of Americans polled said they are actually going to spend the money, and it was amazing because that was similar to what happened when we did rebates in 2001 and we did rebates in 2003. [1:04:14]

JOHN: You know what's amazing is I think you touched on something that has been gelling in my mind, and that is listen to how the politicians are all talking about revenues, etc. They are talking as if the welfare of the government is the same as the welfare of the American people. In other words, if they have their budgets and their money, then the American people are well off. That's not necessarily true, and you really have to make that as a distinction. That's why you never hear talks of cut backs, etc.

But, this is an election year, the silly season is here. And on my Julian calendar, the Julian date tells me that we have to go in silly season...262 days to go before we can breathe a sigh of relief or at least put our seatbelts on before the next Congress is seated and so on and so forth.

Maybe one of the reasons they are saving a lot of the money is they know, and they've already told us what they are going to do, and everybody needs to understand before elections, all of the politicians rush towards the center to look, quote, moderate, end-quote, and then after the election is over, they do what they darn well please. And that's important.

So basically, we know they are going to raise taxes. They've already told us they are going to do that. Some of these plans, I actually calculated how much a small business, Jim would pay. I worked out a small business making $250,000 would pay about 63% of its income, a small business owner in total taxes to the state, to Medicare, FICA and income tax. It's flabbergasting.

I mean the first thing these small businesses do is they lay people off. You know that. The mom and pop shops don't have the buffer in there that they can handle this. [1:05:47]

JIM: We're going to get into this and once we have a clear cut candidate in both parties, then, John, instead of these platitudes, these slogans change. Okay. What kind of change? What is that going to mean for me? They are going to have to start getting more specific.

Obama got into specifics. He's talking about that probably two trillion in tax hikes, $300 billion a year in new spending programs, so a lot of these specifics are going to start coming out from each candidate because up until this time, they have all been trying to distinguish themselves from one another, and they've been going with slogans.

Well, that's great, change is great, but what kind of change and what does that change mean? How is that going to impact me? Who is going to pay for this change? Those are the hard questions that are going to start surfacing as we get closer to the election. And that's probably the topic for another program. [1:06:43]

JOHN: Maybe the reason they are saving money, like we said, is that after the elections they know they are going to raise everybody's taxes, but the credit crisis is an area of focus, so how confident are you that these numbers, can these losses get bigger, and a follow-up question is what happens to these numbers if the US economy drops down into a recession?

JIM: Well, I believe, as do others, that we're already in a recession, whether they admit it or not. I mean they can always -- you heard in that last segment with John Williams how they are not even going to report the economic data. So the reason that we've seen governments spring into action here this quickly is if the economy worsens, these numbers get much higher, so the rate cuts by the Fed are going to continue. There are going to be bail outs and more stimulus programs. I'm predicting, John, the stimulus program they just passed, that isn't the last. “Okay, this appeases the voters and hopefully we get to keep our jobs. Now, let's look at maybe a long term stimulus program that maybe actually does something.”

So what they hope to do now is mitigate many of the problems of a recession and perhaps shorten its duration, which will allow them to postpone the day of reckoning perhaps another year or two. But what worries them now, and John Williams and I discussed this in the last segment is the solvency of our nation's banking system. The elephant in the room that nobody is really talking about here is that technically, the banks are insolvent. [1:08:15]

JOHN: Nah. That would never happen.

You'd better explain that one because that's a pretty big bite for somebody to swallow.

JIM: Well, banks are required to keep reserves anywhere from 3 to 10% in cash to pay depositors depending on the type of accounts that they hold.

JOHN: Okay.

JIM: Okay. So this reserve money is used to process checks, electronic payments through the federal reserve and to meet unexpected cash flows. These reserves can either be held as cash on hand, or as a reserve balance at the regional reserve Federal Reserve bank or both. Right now, these reserves referred to as non-borrowed reserves at the Fed have actually gone negative by over 10 billion; or I think John said the more updated figure is close to 20 billion right now. And that's the first time, John, that we have seen this happen since 1959. And the difference between these total reserves and non-borrowed reserves is nearly identical to the current size of the TAF – about 50 billion dollars. In other words, the Fed is directly financing the reserve requirements of the US banking system. Banks appear, at least right now, they are unwilling to lend reserves overnight. Instead, they are preferring to borrow directly from the Fed. And since it began, the TAF program in December, the Fed has injected 130 billion into the financial system since December.

The program was designed to relieve pressure on interbank lending by providing another venue to obtain financing. And what we've heard from the Fed, and especially Bernanke this week, the Fed will continue conducting these bi-weekly auctions through the TAF program as long as necessary to keep the banking system functioning and solvent. Indeed, the Fed has said, “this is a new tool that we've come up with that we're going to add to our arsenal for fighting deflation.” [1:10:17]

JOHN: You know, overall, Jim, this does not sound good.

JIM: No. It really doesn't. It just shows how things have progressively worsened since when this crisis first erupted last August. It began with falling real estate prices, which led to rising delinquencies and foreclosures, which have spilled over into structured vehicles that we called CDOs, SIVs, commercial paper, ABS, CDS, monoline insurers, the auction rate securities. I mean, you name it, it's just like it has become a domino effect, and it has just rippled through the whole system.

JOHN: Okay. You'd better explain some of these terms for our listeners because it's important that they get their minds wrapped around exactly what the status is here.

JIM: Okay. You think of this. Banks make loans. Okay. In the past, banks would make a loan, the loan would go on the bank's book. But we developed through the progression of the financial industry securitization. So you might have a bank take a whole pool of mortgage loans that they made, and they would package them together, sell them to Wall Street. Wall Street would package them in a CDO, and then what would happen is they would break up these CDOs into different tranches. In other words, the top tranche received the AAA rating, and then the ratings would go all of the way down to BB and then there was something called the equity tranche.

And if, for example, let's say that the people started to foreclose, that would hit the equity tranche first. And this was how, John, they took something that was subprime, which was junk bond rating, and they would turn it into an AAA rating. That was the magic of the markets (and you remember the skit that we played with the Two Johns.) But a CDO is a collateralized collection and pool of securities such as mortgages. It could be corporate bonds, corporate loans or any kind of asset-backed security: Car loans, etc. They were packaged into securities, and then they were broken up into different tranches.

If I can use an analogy, think of this as a ship, and, you know, it strikes an iceberg. The lower decks, the water floods in first and then eventually as more water comes in, it works its way up to the upper decks. Well, the upper decks were on top. That's what received the AAA rating. And it was unlikely that, for example, 100 percent of a mortgage pool would default, and so that's why they got these AAA ratings.

So those are what we would call a CDO.

And then we have another area called credit default swaps. And it was done as sort of, think of it as bond insurance. You own a bond. Let's say it's a lower quality bond – a corporate bond for example. You were worried about it defaulting, so you would go out and buy protection from somebody that was selling you bond insurance protection. You would make a payment to the seller of the protection and then the seller would make you whole if the bond defaulted.

The problem was the market became the primary method for the investors to speculate on corporate credit without having to buy or sell the underlying debt instruments or loans. So the CDS market made it much easier to short a corporate debt, which was difficult or impossible in the cash corporate bond market.

And, John, a lot of these people that were selling these CDS default swaps, unlike an insurance company, which let's say insures your home or insures your car, they have to set aside reserves. A lot of these institutions, whether it was a hedge fund, they weren't required to set aside reserves, so if the corporate bond market goes into default as the economy weakens, this could lead to a crisis. You've had people like Bill Gross that estimates that the losses could be as high as 250 billion from this. So those are credit default swaps.

Then you had things like SIVs, which a bank would go out and borrow money in the short term end of the market, and then they would go in and buy longer term bonds. And they would make the difference on the profit spread, and of course that was paid to investors. Then you had the monoline insurers who wrote insurance on bonds. And the typical business was written on municipal bonds and about 62% of the business was written on, let's say, debt guarantees for public finance (mainly municipal bonds) with about 38% being structured finance, largely CDOs and ABSs. And that’s where these companies got in trouble.

Another thing that has just blown up recently is called an auction rate security. An auction rate security is an unusual type of long term bond that behaves like a short term bond. And it was sort of the keystone of modern finance and it was routinely used for everything from college student loan programs to municipal road and bridge projects. And they were a long term bond, but the interest rate was reset over shorter periods of times so if the interest rates increased, the rate on the bond would increase. And people were using these, John, as cash instruments.

And the problem is all of a sudden buyers stopped showing up for these instruments and some of these issues really dropped like lead, almost like the mortgage backed securities. I mean you've had companies from 3M to US Airways take huge writedowns. Bristol-Myers Squib took an impairment charge of 275 million. There was a story in the Wall Street Journal this week where the debt crisis hits a dynasty and they were taking about the Mahar [phon.] family that sold their business for a billion dollars. Their advisor told them they wanted safe securities, and they gave it to three different brokerage firms. One firm they gave it to was Lehman and Lehman put almost the majority of the amount that was given to them into these auction rate securities. And the family has lost almost 286 million dollars on these things.

So this is structured finance, and it was great when assets were going up, the Fed wasn't raising interest rates. But remember one of the things that we used to say on the program: Whenever the Fed goes through a rate raising cycle, something breaks either in the economy or in the markets. And this is what we're seeing as the Fed raised interest rates, we're seeing this whole thing break down. [1:16:58]

JOHN: That's actually the indicator, believe it or not, that they are sort of looking for. Have we done it too much? And when something breaks, you go: Too much! And then they figure out what they are going to do after that.

So getting back to the loss numbers then, let's look at that.

JIM: Well, there is a number of detailed reports out there, from a number of respected analysts and the figures that they are talking about that – and there is pretty much a consensus building around a 400 to 500 billion dollar figure, which sounds much worse than it really is when you consider the total size of the mortgage market. Now, the one thing I want to point out is as many of these reports have, is this figure is a moving target and could get bigger depending on the length and the severity of the recession.

But the numbers look somewhat like this: If you take a look at subprime mortgages, it's estimated that there is about 1.3 trillion of subprime mortgages out there. They are anticipating a 30 to 40% default rate and a 55 to 65% recovery rate.

Remember, when somebody defaults on a mortgage, let's say they owe 100,000, the bank will sell the house, repossess it and sell it for a loss, but they'll recover maybe 65, 70% of the mortgage. So they are estimating losses in this area could be between 160 and 200 billion. Then you have the Alt A market. That's about 1.1 trillion, and they are anticipating between 10 and 15% default rates in that area with about a 75% recovery rate. So that pegs it to around 30 to 50 billion in losses. So just in subprime and Alt A, you've got 200 to 250 billion in losses.

And then you have asset-backed securities and the CDOs, which add anywhere from another 150 to almost 250 in losses. And that's where you get to this number that we're talking about that here, this 400 to 500 billion in losses. [1:18:58]

JOHN: So the extent of the losses, then, really depends on whether we can limit the damage of a recession because in a recession, the economy contracts. And then people who are meeting their mortgage payments lose their jobs. They end up defaulting on their mortgage payments. So looking at these losses, who is really holding the hot potato when everything come to a stand still?

JIM: From a lot of this, and remember, this market is somewhat opaque. It's not transparent. That's one of the problems of mistrust that you have and why the system isn't functioning. But overall, most banks including investment banks are net long protection, meaning they've hedged. Unhedged insurance companies, hedge funds, pension funds are probably net short. The best example of this is the monoline insurers. According to a study done by Barclays, the monoline insurers have about 2.1 trillion in debt with 62% of that in public finance, mainly municipals; and 38% is in structured finance, the CDOs and asset backed securities.

They have collectively probably about a 13 ½ billion exposure to subprime; S&P's latest estimate is about 13.6. But then you have firms like Pershing Square which estimates the losses for the monoline insurers could be somewhere in the neighborhood of 23.2 billion.

And you have several scenarios that some of the firms have outlined in terms of what is the best case, what is the worse case. The best case is that these monolines are successful in raising enough capital to maintain their AAA rating because if their rating drops from AAA down to AA or A, that means the bonds that they insured, their ratings also drop.

A second scenario is where the monolines can't find the capital. This would mean an end too underwriting new business; they could no longer offer clients or upgrade to AAA status.

The worse case scenario is where the insurers reserves are judged inadequate or the monoline is otherwise deemed to be broken or insolvent. In this case their underwritten contracts are worthless, and the counter parties, on this side the investment banks and other financial institutions would be forced to recognize another round of writedowns. And that's why we're going to get into Plan B in this next segment where you could see the government come in, maybe spin off the municipal bond insurance. In fact, on the day we're talking, FGIC wants to be split up to salvage the municipal bond business, and the New York insurance commissioner Dinallo is working on either a private or a public solution to this crisis. [1:21:52]

JOHN: So when does this all end, and then ultimately where will it take us in the long run?

JIM: Right now, we're in a real credit crunch. I mean you saw that from the survey of lenders in the Fed's latest report. Lenders are tightening standards because they are losing money. And all of this is impacting the economy because as banks tighten lending standards in fear of a rise in default rates, that means less credit is going to be able to go to consumers and business spending. So you do have an increase in commercial and industrial loans, but that has actually accelerated lately, and that's due to the commercial paper market, which has contracted here over the last few weeks. So this is forcing companies to turn to their bankers for financing short term funds.

This is also a bit, I think you're seeing a deleveraging taking place, a scrambling for liquidity that explains a lot of the market selloff that we've seen since the beginning of the year and a lot of volatility that we have seen since last December. Investment banks are curtailing lending to hedge funds. That's triggered asset sales against a whole spectrum of asset classes. So what is going to resolve the crisis is going to be massive monetary and fiscal stimulus. We’ve already got the first helicopter drop coming from the government – a $168 billion stimulus package. Bernanke has basically said he's still going to be cutting interest rates. But a word of caution here, there are many more losses still to be realized and reported, so what we have out there is other unknowns as to who else is sitting on unreported losses.

And I think another domino that we're going to see fall here is losses in credit cards and auto loans. [1:23:40]

JOHN: Yeah. Which was part of the liquidity expansion that went on earlier. Well, overall this doesn't sound too promising. But if we look at it, this is what we've been talking about that since the beginning of the year. You've got your Oreo theory, a rough first part. I always get real hungry whenever we talk about this and start looking for a glass of milk. I'm not sure why.

Anyway, a rough outer crunchy side, and then there will be another rough side in the fourth quarter, which we should point out is going to be largely after the elections. That's important. So we were talking about the center is smooth. Here we are right in the middle of February. What you're telling me is that despite the Fed rate cuts and the stimulus plan, we've got a lot more pain to go through yet. So when do we get to that creamy center? When does all of this turmoil stop?

JIM: It stops with the next stage when the government or the private sector steps in to do a bail out on the monoline insurers. It's going to require additional rate cuts. We know that's coming. We expect the Fed to cut at its March 18th meeting. It’ll probably cut again in May. The Congress is already working on an additional stimulus package. And eventually, you're going to see more tax payer bailouts, which is the next topic which is the government's Plan B.

Incidentally, I want to point out, there is an excellent article at the St. Louis Federal Reserve on mortgages and the mortgage market that was written by Daniel J. McDonald and Daniel L. Thornton called A Primer on the Mortgage Market and Mortgage Finance. And we're going to have that listed on the website with a direct link to it.

It’s written in layman's terms and is excellent reading. You can also find it by just going to the St. Louis Fed and just type in “Daniel J. McDonald” or “Daniel L. Thornton” or type in “A Primer on the Mortgage Market.” So it will sort of explain some of the things we've been talking about here, how the mortgage market is developed, how we got into structured finance. It’s a very, very well written article because, John, it's written in plain English.

JOHN: And you're listening to the Financial Sense Newshour at www.financialsense.com where the Big Picture will continue right after we pause after this.

Part 2

Plan B

JOHN: I always remember the hearings that were held after the disaster at Waco, which was almost really 15 years ago now. And one of the congressmen interviewing members of the BATF that had been there said, “well, did you guys have any kind of backup plan?” This was supposed to be just sort of a warrant for a search. Did you have any kind of backup plan. And I'll use a polite word here. He said, “well, it was an oh shoot backup plan.”

JIM: Uh-oh. Things went wrong.

JOHN: Things went wrong. What do we do now? Run around like, you know, a fire drill and do that. We look at all of the write-offs that are going on right now, what, 3, 4, 500. How much?

JIM: Well, in the last hour we talked about the best range that we have right now assuming that things don't fall apart completely, is somewhere between 400 and 500 billion. That’s probably, oh, I would say double what they were estimating when the crisis first began to unfold in August of last year. [1:04]

JOHN: Okay. Well, obviously, if we're moving towards this creamy center we keep talking about that, somebody has got to have some kind of plan to make this thing smooth out. Obviously, the first part was really a mess. So is there something else in the works?

JIM: Well, let's talk about Plan B. The first thing that kicked in initially was the Fed rate cuts when the Fed cut the discount rate in August. Remember, John, they had the Fed meeting, they came out and said, “no, we're tough, we're worried about inflation.” Two days later, they slashed the discount rate because four big hedge fund managers went into Bernanke's office and said “if you don't start doing something here, you've got a full blown crisis.” And certainly, we've seen this thing just ripple from the subprime markets to the Alt market to all kinds of mortgage securities, the credit default swap, the auction facility.

So the first part of that Plan B is for the Fed to lower interest rates, steepen the yield curve and make it profitable for banks to lend. You've got the Fed kicking in with its TAF or term auction facility, which is facilitating – it's another extension of the discount window. The Fed is financing bank reserves right now. So that's the first part.

In fact, we're going to talk about this in terms of the stimulus package, which was passed this week – $168 billion of fiscal stimulus. So these are the first two parts of the program.

The other aspect to Plan B is the thing that we're dealing with right now with these monoline insurers and also possibly bank bailouts. So what you're going to see here -- and I suspect this is coming – is some kind of government or tax payer bail out of this mortgage problem that we're having and these bad loans. It’s very similar to the crisis that we saw in 1982 and 88 with the Third World debt crisis where the US government actually came in and guaranteed the bonds with Brady bonds.

And then if you go back to a similar crisis, the S&L crisis in 1991 where it ended with the Resolution Trust Corporation using public money to buy up bad banks. And here is an example elsewhere: In 1987 in the Asian crisis, you had the Hong Kong government actually buying 20% of the Hang Seng market in a single day to prop up stock prices.

And you've seen Paulson come up with a couple of ideas, the super SIV fund. You've got various subprime reset proposals. You've got the 30 day extension. But in the end, John, I think you're going to see either some kind of private and more likely a government bail out program. One thing, though, the government is going to get behind and bail out everybody and as the Two Johns say, “then Wall Street will wake up one day, ‘oh, happy days are here again.’” [4:01]

JOHN: Obviously the first part of Plan B is this stimulus –what are they calling it, the helicopter drop? – where everybody is going to get money. I'm always laughing at people saying, “you know what I'm going to do, I'm going to turn right around and send it back to the government as part of my taxes.” I don't think that is going to do the spending thing, is it?

JIM: No. We talked about in the last hour, these rebates, if you look back both under Jimmy Carter and also we had two rebates first in 2001 right after 9/11 and then again in 2003. And it's amazing, John, the public opinion polls are roughly the same where those polled said about 19% plan to spend the money.

But here is the way this is going to work out. The stimulus package is going to be anywhere from 300 to 1200 for most American tax payers, and the rebates are going to go out beginning in May and to low income people, including seniors living off Social Security and veterans who depend on disability checks. Now, here is the way it works: Most tax payers will receive a check of up to $600 for an individual, $1200s for a couple from the Internal Revenue Service with an additional $300 per child. So in order to qualify, people earning at least $3000 and those who owe little or no taxes would get, let's say, $300 for singles, individuals, $600 for couples.

However, they begin to phase out the rebates if your income exceeds an adjusted gross figure of $75,000 for individuals, $150,000 for couples. So they begin to reduce these rebates. And they are hoping, like I said, that if they are talking about creating jobs they are talking about Congressional jobs because they are hoping this will inoculate lawmakers from voter blame should the economy continue to lag by the time of the November elections.

And there are a couple of things here for business. Businesses are going to be able to increase the amount that they can depreciate going up to $250,000, or you can write it off instead of depreciate it. So they are hoping there is something in there that would encourage businesses to buy some kind of equipment. That's about the only thing they've got here that would really be credible in terms of a stimulus because the latest polls conducted after they passed this bill this week basically 19% said they plan on spending it; 45% said that they would use it to pay their existing bills and then – [6:55]

JOHN: This is getting better by the minute. Okay.

JIM: Yeah. And 32%, “hey, I'm going to invest it.” For those of you in that 32%, buy gold!

JOHN: Yeah. Because at least you'll make more out of it; right?

JIM: Yeah. So this is after the rebates were sent out in 2001, now, remember, this is right after 9/11, 22% said that they were going to spend it. So only about one third of the rebate was spent in the short run according to the study, so that is why you are going to see –and you're seeing some of the presidential candidates talk about it – is they are already working on a second stimulus package because these guys know better. I mean they did this in 2001 and it didn't work. They did it in 2003 and it didn't work, and they know this isn't going to work. But more importantly, John, they are hoping that when you have that $1200 check in your hands or if you've got three kids, another $900 on top of that, you're going to think fondly of your local congressman as he runs for reelection.

So part of this Plan B is stimulus coming from fiscal spending. But here is the problem: We already know the candidates have told you, Obama has said it, Clinton has said it, and they are the two front-runners. Next year they are raising everybody's taxes. If they repeal Bush's tax cuts, that means people in the 10% tax bracket are going up to the 15% bracket. People in the 15 could go up to 25, so they already told you, which is probably why a lot of these people say, “no, I'm going to save it because I'll probably need it to pay taxes or something else.”

So Plan B includes more rate cuts coming from the Fed, more injections into the banking system to keep it solvent and functioning. And so far that's working. A third factor is going to be some kind of guarantee or bail out, and then other factors are going to be playing around with mortgage contracts. In other words, you've heard somebody – I think Hillary Clinton – wants to freeze mortgage rates for five years. The President is talking about working with lenders and having them renegotiate the contract. One idea that's being floated around is say for example that you borrow $100,000 on your mortgage and let's just make this simple, and you use that to buy a $100,000 house; but right now because houses have been falling, your house is only worth $80,000, so you owe more than what the house is worth. They are talking about that maybe the banks renegotiate, take 20 grand off the mortgage and then renegotiate a fixed lower rate. Some people are saying why would a bank do that? [9:54]

JOHN: Because we're from the government. We're telling you to do it.

JIM: Yeah. That's part of it. But, you know, from a business part of it, if a bank forecloses on an individual; all right? The price of the home has already fallen 20%, let's say. And if the bank forecloses, that's going to cost money. Then they are going to probably put it on the market and most banks in foreclosures are selling their properties at 20 to 25% below market value. So as a bank, you may sell that $80,000 house, you may sell it in a quick fire sale for $60,000. So you're basically going to take not only the $20,000 loan loss that the existing homeowner has, but also if you foreclose on them and turn around and sell that house because, you know, there is marketing costs, there is escrow costs, there is real estate commissions, you could lose, you know, another 20%. So what the government is arguing with the banks is “look, hey, if you foreclose on these people, you're going to even lose more money and probably sell it at even a bigger loss. Doesn't it make sense to give that break to the homeowner?”

So they are talking about those provisions. So what you're looking at is the next thing coming is bailouts of people that are in this situation and also bailouts of the big boys: Either bail out of the monoline insurers; there is talk, now, about setting up another RTC fund that would go in and buy all of this bad mortgage debt at distressed prices.

Now, remember, part of the reason that some of these mortgages or mortgage pools are selling at distressed prices is that when you get distressed selling, people are trying to get liquid and they are dumping, they are driving down the price of those mortgages below what realistically they may be worth. In other words, they may be worth more.

And that's what happened in the RTC crisis or the Resolution Trust Corporation. They bought a lot of these mortgages, and these mortgages turned out to be sound mortgages that people were making their payments, and you could have bought these mortgages at distressed prices. I can think of a gentleman who has become one of this country's wealthiest people who made a fortune buying these distressed mortgages and distressed properties from the RTC. So they are talking about look for another RTC.

And especially, I think, John, as we proceed and the numbers get worse and we got a bit of that kind of news this week when Bernanke was on Capitol Hill Thursday. He said we're not through the worst of it. There is more bad stuff to come, so look for more of these crazy ideas to be floated forward. [12:20]

JOHN: Well, okay, so here is Plan B, and theoretically that's supposed to keep things from getting worse, but what happens if Plan B doesn't work and things get worser than worse –if that's possible? Is there a Plan C in the works?

JIM: No. I don't. And trying to get the government to think that far in advance, they are kind of making this go up as they go along. But there is some probability out here that if they can nip this, if they can go in and provide some bail out...the problem is nobody knows. It's like our topic in the last hour: how bad is this? Is it going to get worse? When will we see a bottom? And what they are trying to do here with these programs is give people some hope and say, “look, yes, it's problematic at this time, but here are the various solution that's we're working on.” And believe me, they are scrambling right now.

When Hank Paulson cancels a trip to go to Davos to represent the United States to work on a bail out package, that tells you how serious these guys are taking this; and they are working full-time on this. And I think, John, just as we've seen the cooperation on the stimulus package from both parties –I mean, what was it, about three weeks or less than a month from the time they first started talking about it until the time it was on the President's desk for his signature – so they know that this is serious; and it's not going to be a situation where November comes along you can have both parties saying, well, all of this mess is the Republicans or the Republicans are saying all of this mess is the Democrats because the Republicans control the White House, but the Democrats control Congress, so both parties are feeling vulnerable here, which is why they worked expeditiously to get this fiscal stimulus program enacted.

So I would suspect that we're getting to the point of bailouts. We had on Bloomberg news on Friday, one of the news stories was that FGIC wants to be split up to salvage the municipal bond business. They are working with the New York state insurance commissioner. FGIC, which is owned by Blackstone Group and PMI group, applied for a license from New York state insurance regulators to create a stand alone municipal company. And then that would handle the municipal bond insurance. And then they would move a separate, the unit that guarantees subprime bonds and collateralized debt obligations. So that's why they are getting closer to this solution because a lot of these bond insurers are struggling to raise capital, so that's why I think you are going to see bail outs here. But we are running out of time.

And if the markets, the private sector, doesn't come up with a solution to resolve this credit crunch by the end of this month and by next month, by the end of the next quarter, you're going to see some very, very serious problems. Then this could get a lot more serious than we're talking about. And if they don't get to this by the end of March, then even I myself would have to rethink my Oreo theory because then this could get much rougher than anticipated. So we've got probably another three-to-four weeks that's going to be crucial in assessing the extent of the crisis because what's going to happen is in the next month financial institutions are going to have to deliver their first audited results since the crisis started as they release their reports. And that's something that you'd better have a backup plan if it's much worse than you're anticipating because then we could be in some serious problems. [16:06]

JOHN: You mean beating expectations isn't going to cut it?

JIM: No. “We're bankrupt and we lost $100 billion. The good news is that's better than anticipated: $105 billion in losses. Yeah. We beat loss expectations.” I don't think that's going to cut it. [16:30]

JOHN: No. Probably not. You know, if we go back over what we've been talking about in the last four weeks when we did the Next Great Depression, though, when we get rid of all of the machinations and machinery that they used to do, what they are going to do? Basically they are going to just pump more money into the system which creates more inflation, which really just creates another round of a bubble. As we’ve said before, ultimately, there has got to be an end game in this thing because you just can't play the game like this forever.

JIM: No. And that gets back to the Oreo theory that I fully suspect, by the time we get to the end of the year, the headline inflation numbers are going to be higher, interest rates are going to be higher, and as the inflation rates get worse. Then to preserve any kind of credibility, you're going to have to have the Fed or the central bankers, whether it's the ECB or the US Fed talking about perhaps inflation becomes the number one issue.

And so you could see next year a situation where the central bank is raising interest rates instead of lowering them, because when you start seeing inflation, headline inflation numbers like 5 or 6%, Houston, you've got a problem. [17:41]

JOHN: But that problem is going to be after the elections; right? See that's the –

JIM: That's the important thing. Postpone the problem, and then depending on the outcome of the elections, the very policies that are implemented, I do not think raising taxes by two trillion dollars is going to go over well with the American people. And I think what's going to be interesting as we get closer to the conventions, who knows, maybe it goes up to the election time on the Democratic side.

McCain certainly looks like he's got the Republican nomination sewed up. There is no chance that Hucklebee at this point can pull it out, especially since Romney has urged his delegates to vote for McCain. So we could see the Republican nomination sewed up here in the next month. And who knows what's going to happen on the Democrat side. It's going to be a wild card.

But nonetheless, once both and candidates have got the nomination, John, then it's going to be a little bit more on the specifics. Okay. “Change. Change for real people. Change you can trust or change you can believe in;” you know, that's going to go away. What kind of change? Give me some specifics. What are you going to propose? How much is it going to cost? Where are you going to get the money? Who is going to pay for it? Who is going to benefit? Hopefully those are going to be the kind of questions that the media is going to start asking because I've looked at some of these proposals and they would create, in my opinion, a depression, not a recovery. [19:04]

JOHN: Yeah. But you just brought up an interesting point, and that is that the candidates will have been selected by that time, but they will most likely be televised debates en route as we slide into the other side of the Oreo. And that's where, remember how we saw coming around the turn in August here and then down through the end of the year, you saw over the course of –what was it? – four-to-six weeks, the whole substance of the debates changed in their focus. It went to economics from a lot of the other, in my mind, nonsensical stuff they were talking about before. It shifted rapidly. It could shift as rapidly again prior to the election.

JIM: Oh, yeah. Just since the beginning of the year, the whole debate went from raising taxes to giving you a tax rebate and then a stimulus package. Yeah. Remarkable sea change towards the end of the year. And especially if the stimulus package does not produce a strong rebound, you know, there could be a lot of people asking questions and it's going to be interesting to see how the debate turns out. [20:14]

JOHN: And you're listening to the Financial Sense Newshour, www.financialsense.com.

Other Voices: Scot M. Faulkner, Author, Naked Emperors: The Failure of the

We wrote the book Real Change last summer, and I want to thank the people of Regnery for going along with the title and it turned out this February that it was really a good title. But it was also an obvious title. But here’s the question: Are you for the right change or the wrong change?

JIM: That was the voice of former House Speaker Newt Gingrich at a recent SEPAC a few weeks ago referring to his book published last year entitled Real Change. Real change it now seems to have been commandeered by Senator Barack Obama in his campaign for the presidency. Newt’s question is valid: Are you for the right change or the wrong change? Change for change sake isn’t necessarily good. But hey, did Newt Gingrich lead the Republican revolution after the 1994 elections and wasn’t it all about change back then? So whatever happened.

Scott Faulkner was the first chief administrative officer of the US House of Representatives and he’s the author of a new book called Naked Emperors: The Failure of the Republican Revolution. The business reforms he and his team introduced into the US House of Representatives saved over 148 million at the beginning of the Republican revolution and control of Congress, but somewhere along the line it seems reform has stalled out.

Scott, did we get change from Republican revolution or did it just fizzle? If so, what does that tell us about the change being promised by Barack Obama.

SCOTT FAULKNER: Well, first of all, regarding the new wave of change, change is a nice buzzword and people can do a lot of superficial things to make change look like it’s happening. Back in 94 the American public demanded real change because of all the corruption and all the scandals that were bursting on the scene from within the House, the banking scandal, the Post Office scandal, the Gift Shop and Restaurant scandals and so real change happened for a while. [22:49]

JIM: Why do you think everybody doesn’t think too highly of President Bush. He’s got some of the lowest approval ratings, even lower than the President is the approval ratings of Congress. Why is Congress disliked and distrusted by so many Americans in your opinion?

SCOTT: I think that the internet has educated Americans to the point where they realize that the sham really is happening on a daily basis up there on Capitol Hill. In the old days before the internet people could say, ‘well, if you knew what we knew you’d understand,’ but now everyone knows what they know and we don’t understand because what they’re doing is they get elected for change, they get elected on various promises and they spend most of their time hiding the fact that nothing ever gets done. [23:23]

JIM: The Republican revolution came in because of a series of frauds that came about that people just got disgusted, wanted government cleaned up, the revolution occurred, but you know, it never did get cleaned up. What about recent examples? Are they just better at covering it up?

SCOTT: Well, what’s happened is that instead of going after tax dollars in terms of the perks they’re getting more and more perks from lobbyists, plus also they’re getting much better at laundering money to relatives and to former business associates. I mean when you look at Murtha who on one front is touted as this great anti-war activist and moral leader in the Congress by Pelosi but on the other front his brother and former chief of staff formed a consulting firm and have been channeling government contracts to various clients and getting paid royally for it. So, you start to look at things like that and start to realize that the system is fundamentally flawed and corrupt. [24:35]

JIM: You know one thing that the President made reference to in his State of the Union speech is earmarks. They are prolific in Congress. I wonder if you might explain what an earmark is, how they get put in the budget and how abusive it is?

SCOTT: Well, the problem is that all money is earmarked, whether it’s done by a bureaucrat, done by the president or done by Congress. And so the big problem is that when all of this grant money, all of these project funds get appropriated that they are channeled into projects that would not otherwise pass muster, such as the ‘bridge to nowhere’ that a Senator up in Alaska went for – Stevens. And so that’s the problem is that everyone of these programs, no matter which department or agency has criteria set aside for this-is-really-how-the-money-should-be-spent and even bureaucrats abuse that. So the easiest thing to fix is clearly the earmarks from the Congress but even that has been an empty gesture. [25:37]

JIM: You know the thing that probably has been most disappointing to me to see when the Republicans came in they were supposed to be know as fiscal conservatives, what can be done about overspending? I mean the Republicans when they had control of Congress they overspent, President Bush has overspent and if you listen to Obama or Senator Clinton the sums of money that they are talking about; and here we’re running budget deficits, we’re having to borrow from foreigners, when does this stop? Or is it beyond control?

SCOTT: The problem is that elected officials are not managers. Very few have business backgrounds and so think like if you ran out of toilet paper and your bathroom at home or the toilet got stopped up, you fix it. You don’t build another bathroom onto the house. And that’s the problem: Government keeps growing because the elected officials would rather announce a new program or announce even a new agency than fix the things that are already broken. And so that’s how government grows. It grows one press release at a time and nobody goes back and looks at what really is already sitting in place and already falling apart. [26:54]

JIM: You know I was floored, Scott. The government releases its financial reports, in going over the 2007 financials for the government, they had $715 billion unaccounted for that nobody would sign off on.

SCOTT: Right, on obligated balances.

JIM: Yeah. Can you imagine if you invested in IBM stock and they issued their annual report and the auditors issued a qualifying statement saying one-third of IBM’s expenses and revenue we can’t account for.

SCOTT: Oh yeah! There was the results of a report recently on $55 billion worth of erroneous payments that were based on either no purchase orders, no contracts. That’s the kind of thing that’s happening all the time. And one of the other problems that Congress has is the partisanship that when the Democrats were in the White House the Republicans would do some oversight, but when Bush got in the Republicans became lapdogs and just looked the other way. I mean right now you’ve got Laxman who is voracious in his oversight but I bet as soon as a Democrat gets in the White House he’ll be a lapdog too. So it’s really one of these things of saying ‘I will look the other way if it’s my own party, but I will go after the waste if it’s with the other party.’ But waste is waste. [28:16]

JIM: I mean is everyone that corrupt and incompetent?

SCOTT: It’s about 20% of the people on the Hill are good people: they are true to themselves, true to the voters who elected them. But the other 80% are either completely ambivalent or totally corrupt, and even the ones who are ambivalent will look the other way at the corruption. And so that’s the real problem: Across the political spectrum you have 80% who get captured by the system and decide to abuse instead of change it. [28:50]

JIM: Is it a question of – and this was how one congressman explained it to me – I was in Washington in 1995, so a lot of the Republican revolution was starting to unravel, there was negative press about it, they were trying to demonize people and he basically explained it this way. He said, “you come here with these ideals, you want to do good but then the system itself is corrupting.” Is that it?

SCOTT: Yes. There is an awful of enticements. There are lobbyists who are willing to fly you around the world and there are loopholes in the current ethics laws that let them do that. There are also lobbyists who will say: It’s easier to listen to us than to your constituents because we’ll come up with a consolidated package of ideas or legislative initiatives and this way you don’t have to sort out all of what your constituents really think. So it becomes too easy to spend time with the powers-that-be inside the Beltway than being there as a true representative and emissary from your own voters. [29:59]

JIM: You know, as I look at this year’s election, it’s all about change but as we heard that clip from Newt Gingrich: what kind of change, what is it going to mean. Is anything going to change at all. I mean after the President’s State of the Union speech about ‘don’t give me earmarks,’ you know, Nancy Pelosi said “to heck with you!” Basically, what she said is we’ve got the power now and we’ve got the earmarks because we control Congress. Do you favor any of the candidates on either side for President right now?

SCOTT: No. I’m very disappointed by the field. There are a lot of things that really matter in the world and in this nation. And this election matters. And it is a very sad field. [30:41]

JIM: The only guy that seemed above it, who talked about ways to...you know a true constitutionalist individual – liberty, capital markets: Ron Paul. And I mean he just got no traction whatsoever.

SCOTT: Well, Ron has been a great gadfly for many years and of course he’s run as a libertarian in the past. He’s one of these people who, just like in my book the issue of these emperors are naked and he’s the voice from the crowd saying that. You know, the crowd unfortunately would rather look the other way than listen to the truth. [31:37]

JIM: Scott, you mentioned in the presidential election, you know, nobody is asking some hard questions. What has happened to the media. I mean, it’s like, you know, softball questions. The President was talking about Social Security reform, Obama was talking about it. You know the big kind of elephant in the room that nobody wants to talk about is Social Security. There is no trust fund and it was amazing. I think it was the election night in 2006, Brit Hume was making a comment to one of his panelists - somebody was saying about Social Security reform being on the agenda for 2007 – and they were making reference about some of the problems and Brit Hume turned to one of his guys and this slipped out surprising me and said, “well, everybody knows there’s no trust fund!” Why don’t they bring that out in a debate?

SCOTT: Well, part of it is that most newscasters really see themselves as either sportscasters or drama critics. They want to talk about the performance, they want to talk about the race; they really don’t want to talk about the issues because that would tax their brains and the brains of their researchers and the people who write for them. And so that’s the problem is that there is not really any interest in delving into some of these things. And the other part is like you’re mentioning: They know this stuff but they don’t want to basically incite a riot out there by people who realize they’ve been commingling the Social Security trust funds with the federal budget for years in order to cook the books. [32:52]

JIM: That one I guess just surprises me because you’ve got a couple of the candidates who are talking about lifting the caps off Social Security and getting us to nearly 55 and 60 percent tax rates as a way of fixing the system; how about if you just your take your hands off the money and invest it and quit stealing it. That’s the kind of thing I want to see in a debate. I’d love to see these guys squirm up there and try to get around that one.

SCOTT: Absolutely, because these presidential candidates if anyone of them makes it into the White House I mean they are set for life. They will be multimillionaires as will there families for as long as they live. So we really should demand a lot more from them before we give them the keys to the kingdom. [33:36]

JIM: You know, it’s not just people who make it to the White House. I mean you take a look at some of these Congressmen, the perks, their pension plans. And what was it, the year 2000 or 2001, a number of individuals retired because there was something in the campaign laws that allowed them to keep their campaign funds? There was something there. And a lot of these people who retired walked away with multi, multimillion dollars.

SCOTT: Absolutely. And just like Trent Lott this last year retired after only serving two years of his six year term because he didn’t want to be a lobbyist under the new rules, he wanted to cash in under the old rules. So you start to wonder about people’s civic-mindedness when they pull the ripcord just to avoid reform. [34:25]

JIM: Absolutely amazing. I’m reading about the last years of the Roman republic before the Caesars came in. And Scott, this reminds me so much of what happened to the Roman Senate and its own self-interest and corruption in terms of what’s going on in Washington today. It doesn’t matter if you’re Republican or Democrat: if voters change the party, nothing seems to change. Do you have any hope?

SCOTT: I do because, again, the internet is a huge cleansing tool. What we need to do is have people demand more transparency from the government. All of the hearings should be podcast or webcast. Right now, when the House and Senate are in session there are probably 45 meetings a day going up on Capitol Hill and if we’re lucky maybe 5 of them are covered by C-span. And then beyond that, within the Federal government, there are agency hearings going on all the time, setting policy, setting rates, creating case law regarding the regulation of the private sector and not a single one of those are broadcast by anybody. So you have these small rooms with these officials making policy and maybe a few attorneys and lobbyists in the room but the public as a whole is completely closed out and we need to tear down those walls. [35:41]

JIM: I saw something on the news this week that I think is remarkable and I think would go a long way if we could see something like this in Congress. It was in the state of Washington, they passed a bill if you’re a legislator and you are going to propose a new bill in the state, you have to tell people what it is going to cost them. Imagine what people would be thinking about all these free lunches that these presidential candidates are promising if the costs of the bill were put out in front, and what it would mean what it would cost each average American. Do you think something like that would help?

SCOTT: Well, unfortunately, OMB actually does an impact statement on bills all the time and they game the figures. So every single piece of legislation – especially authorizing legislation – ultimately gets sort of an administrative cover sheet with a check-list saying we’re looking at the regulatory impact, we’re looking at the spending impact and if the administration wants the bill they’ll downplay the numbers; if they don’t want the bill they’ll inflate the numbers. But in either case, these things are buried deep in bill reports that move along with the legislation. So even with the Thomas system and other online databases you almost have to have a masters or a PhD in public administration to dig this stuff out. [37:03]

JIM: And you see this, you see it on the campaign trail on either side: “My program spends x amount of dollars and it’s going to create a gazillion new jobs.” I mean where do they come up with those figures. Do they make them up?

SCOTT: Yup, in many cases. In fact, my consulting firm does work in the federal government as well as in the private sector, and we asked them once about this. Many years ago there was this whole issue about outcomes-based management, and what they called the Government Performance and Results Act or GEPRA. I asked them and I said, “where do you get all your numbers?” And they say, “we make them up because we have to fill in the blanks to pass on to headquarters.” [37:42]

JIM: Wow.

SCOTT: And so the problem is everyone is gaming the system and nobody is paying attention.

JIM: You talked about a hope that perhaps getting this information out public for which we have the internet, but you know, there’s a bill in Congress right now that would basically restrict internet. It seems like they would like to shut that down because, you know you’re right, when they do pass these bills or propose them there are people that read these bills probably more so than the Congressman, and immediately it’s out on somebody’s blog on the internet.

SCOTT: Absolutely. And that’s the thing is citizen oversight is really the wave of the future. Having all of these blogs, having people who just are out there trying to hold candidates’ and elected officials’ feet to the fire. And one of the things that should be done in this current election cycle, when all of these people are up at forums, they really should be asking far tougher questions than a lot of these candidates get. I mean the presidential debates have been very superficial. They have never asked one candidate: In 2012 what will this country, what will this world, or what will the White House look like after 4 years of you being in office? Something that basic has never been asked of any of these candidates. [38:46]

JIM: What does it take? Does it take hard times? Or even in hard times, you know sometimes the government, which created the problem –something that Ronald Reagan talked about – is called upon to solve it; and in the final analysis, they created the problem. And what are the possibilities that we get into some kind of economic crisis, energy crisis and government comes in with price controls, more taxes, regulation and they actually make it worse.

SCOTT: That’s really the difficulty is, again, elected officials and obviously the president and his team all want to get that sound bite out there on CNN or MSNBC or whatever and so they are issuing press releases. It’s all management by press release. And so they feel they can just do symbolic acts without really addressing the real issues. That’s why another thing people can do is really start working at the local level. Number one, at the local level you could have a lot more impact on your county commissioners, your municipal officials, your state people, you can hold them far more accountable because there are fewer votes needed to get rid of them. And the other is that’s the farm team for people who ultimately run for Congress and Senate and governor is they start out as legislators, they start out as county commissioners or as mayors. And so if we can get the front end of the pipeline working better, I mean it’s not an overnight solution but on a generational basis it might be one way we can cut the angle on all of this. [40:31]

JIM: Well, you know, Scott, I sure hope you’re right. I hope that we do have some hope out there that people get more involved and retake government because it just seems like these guys go there, they go there for themselves, they’re more concerned about getting re-elected, and even those that are new and proposing change end up going there, maybe 20% of them are legitimate, they do want to do things right for the country and their constituents but by the time they get there they get so corrupted in a corrupted system that nothing seems to change.

Well, listen, Scott, I want to thank you for joining us on the program. The name of the book is called Naked Emperors: The Failure of the Republican Revolution by Scott Faulkner. Scott, thanks so much for joining us on the program.

SCOTT: Thank you. [41:30]

Dividends for the Long Run

JOHN: Well, with the baby boomers getting ready to retire and all of the “volatility” –we'll put that in quotes – that you see going on in economics these days, we really need to move on to the topic of dividends, which is really we should say a much requested topic here on the program. Now, I suspect that with these boomers moving into retirement with fixed income yields below the rate of inflation and adding to that is market volatility, it is no wonder that so many people want to hear about this topic here on the program because people try to get ready to retire and they are looking at a really uncertain future here.

JIM: One of the nice things about dividends is that they account for -- if you look at -- John, you've heard the numbers that last century if you invested in stocks you made 10% compounded a year, well, half of the stock market’s return comes from dividends. And more importantly, whether the market is going up, going down or going nowhere, the nice thing is you're still getting paid. And if you're in a great dividend paying company, you're getting double digit pay raises every year keeping you not only above inflation but also increasing your spending power. [43:00]

JOHN: Okay. Well, having convinced me on that one, what most people don't realize right now is you can get yields equal to or greater than 10 year Treasury notes and in some cases actually higher yields, and unlike a bond trust yield, it goes up each year with dividend increases. So where do you begin? Do you just look in the yellow pages or whatever –the financial pages – for the best dividend yields. What?

JIM: Looking for the highest yield, John, would probably be a mistake unless you're looking at, for example, royalty trusts, Master Limited Partnerships or REITs because of the way they are set up, they pass on all of the incomes to the shareholder. Now, granted, they have no taxation and that will change for royalty trusts in the year 2011. But outside these few areas, high dividend yields may indicate a problem with the company. Maybe their earnings or they are having financial problems and a good example is what we've seen with Citigroup, which had a very, very high dividend yield as their stock price plummeted; and we've also seen this with the auto companies, they ended up cutting their dividends.

One of the examples that we saw this year, John, is the dividend yield still today at 5% on Citigroup, it was much, much higher until February where they cut the dividend from 54 cents a quarter down to 32 cents cutting the dividend by almost 60%. Ford Motor discontinued its dividend in the third quarter of last year, and there is a question whether GM is going to maintain its 25 cent a share dividend given the amount of money they lost. They just lost an incredible $38 billion dollars.

So looking for the highest dividend yield is a mistake. What you want in a dividend is the solid dividend backed by earnings and strong cash flow. So you want to look at dividend yield. You want to look at dividend growth. You want to look at the pay out ratio. And the lower the pay out ratio, the greater the level of margin of safety. [45:07]

JOHN: You know, I'm having a hard time following what that means, so explain that to people.

JIM: Pay out ratio -- let's just make this simple. Let's assume a company makes a dollar in earnings, and they pay out 50 cents in dividends. The pay out ratio would be 50%. They are paying out half their earnings.

And obviously the lower the pay out ratio, the greater the margin of safety you have as a dividend investor because, for example, if a company is paying you see the pay out ratio gradually keep going up and up and up meaning that the earnings aren't growing at a fast enough rate, so the company wants to maintain its dividend-paying trend, but the dividend is presenting a higher portion of their of their earnings, that can alert you that you could have a problem and the company could end up cutting it, as did, let's say, Citigroup and Ford. So coming back to that, the lower the pay out ratio, the greater the level of margin of safety.

I mean there are certain industries that are regulated, for example, utilities come to mind. They traditionally pay out more of their earnings in dividends. These are slow earnings growers, so more of the return is going to come from current yield. That's what utility investors expect. So if you need income, you're definitely going to want to own a few utilities in your portfolio and especially if you can find those utilities with a special niche or they have a good portion or segment of their revenue coming into the business that is unregulated, which means they can grow at a much faster rate than their traditional business that is regulated by the state. [46:45]

JOHN: Well, you've given examples before of 10 stocks and what happens to their dividend over a period of say, five to 10 years. Let's expand on that 10-stock-dividend-achievers thesis.

JIM: A lot of what you do and when you're choosing dividend stocks depends on your age, your health and your longevity. And you also have to think of the age of your spouse because we know from looking at health, women traditionally have a longer lifespan than men do. So obviously the type of dividend portfolio that you're going to have is going to be different for someone that’s maybe in their sixties or early seventies, than let's say, someone that's in their late seventies or eighties.

It also, I think, depends on your income sources. I mean if you're in your sixties and early seventies and you have other sources of income, I would go with a dividend super stock: Companies that are mature, steady business prospects; a company that has had a history of increasing its dividends every year, and especially the dividend super stocks which increase their dividend at 10% a year.

I mean think of it this way. At a 10% dividend increase rate, your dividend yield will increase every seven years. [47:58]

JOHN: Well, I suspect you're making a bit of a trade off here that in order to get higher dividend growth, you're going to have to accept a lower yield starting out on this whole thing.

JIM: You know, in a general sense, that’s probably true, but right now there are a lot of blue chip growth stocks that offer very competitive yields to what we're seeing in the bond market. I mean if you look at bond yields today at two year Treasury notes at about 2%, a 10 year treasury note somewhere in the neighborhood of 3.7, 3.8%.

Surprisingly with this correction, you've had a lot of blue-chip dividend stocks –I think it was a couple of weeks ago when we had Kelley Wright on here from Investment Quality Trends and this has probably been the first time in almost 15, 20 years that they've had as many companies – almost one third of their universe of dividend paying stocks are in the undervalued category. [48:53]

JOHN: Well, if you're looking for something like that, where are you going to find them?

JIM: For starters, you could probably look at the Dow Jones Industrials, which if you're retired, a big blue chip stock, lots of liquidity, established business models, very strong financially. I mean you just take the dogs of the Dow. Look at the top dogs. You can go to our website and look at our market monitor page where we track the top 10 dividend paying stocks in the Dow. [49:17]

JOHN: Well, how about an example anyway?

JIM: I'm going to use the stock –and full disclosure, we own this company, but it's big enough so anything I say doesn't affect trading in this company – but we've often talked a lot on this program about GE. GE's dividend yield currently is around 3.6%. So if you look at 3.6% dividend yield, that's comparable to what you're seeing today in a 10 year Treasury note. And they just increased their dividend, I think it was about 11%. They went from paying 28 cents a quarter to 31 cents a quarter. And here is the remarkable thing about this company, as big as it is, their dividend increases have averaged 12 ½% over the last 10 years and more recently 10% over the last 5 years. So this is just one example and there is plenty of them out there right now that are well established companies, competitive dividend yields. And more importantly, to keep pace with inflation is that many of these companies are increasing these dividends consistently year in and year out over 10% a year. [50:27]

JOHN: Well, I know we can't get too specific on this whole thing, but we should come back to how all of this works. But what are the fundamentals you should look for in dividend paying stocks?

JIM: The first thing that comes to mind, you want to start out with what is the dividend yield and what the PE ratio is. So if the dividend yield is going to tell you is this a company or is the yield something that you can live with and that meets your requirements and also the PE ratio, how many times earnings are you buying the stock. And then what you look at next is you want to know a few things about that dividend.

You want to look at the cash flow per share because that's important because that tells you where the money comes from to pay the dividend.

And then the rest are what I'd call “safety issues” that determine your margin of safety. So we discussed you look at the pay out ratio over, let's say, a five-year period to get an average because you just don't want to look at one year. You could see a year, John, where for whatever reasons a company takes charge-offs or their earnings go down, so for that particular year, their pay out ratio goes up. So you just don't want to use one year. You want to look at a five-year period and actually a 10 year period will give you a better consistency to say that, “oh, okay, it's averaged around here, I feel comfortable with that.” You usually want or don't want to see more than 50 or 60% of a company's earnings paid out in the form of dividends.

Next what you want to do is you want to look at debt and dividend coverage ratios; making sure that a company is earning enough to cover its dividend, it's earning enough to make interest payments on its bonds. And that tells you how strong the company's earnings are and how strong their balance sheet is.

So you start with yield in PE and then you move on to determine how safe the dividend yield is and what has been the pattern –this is very important – what has been the pattern of dividend increases. Dividends are going to tell you more about a company and its earnings prospects than anything you'll see on the earnings picture. Earnings, as you and I know, John, can be manipulated. You can't manipulate a dividend. You either have the money to pay a dividend, or you don't have the money. [52:42]

JOHN: Yeah. And that is really important given all of the scandals that we've seen over the last few years.

JIM: The reason that I value dividends, especially a mature company so much, it really gives you evidence of shareholder interest. I mean company that's pay dividends are more shareholder friendly. It provides evidence of financial strength. It shows you corporate discipline.

One of the problems that we've seen, and this is what we saw at the end of the 90s is that companies were making so much money, but rather than returning it to shareholders, they went out on what I call ‘deworsification.’ They went out and acquired other companies and a lot of this stuff. I mean a good example, remember when AOL bought Time Warner, and look at the $200 billion in write-downs and losses. So dividends show corporate discipline. Boards try and strive hard to maintain them and increase them and also provides a firm basis to value a company. [53:44]

JOHN: So the bottom line that you're wanting to know: 1) is the dividend safe; 2) is it going to grow; and then 3) what will the dividend stream returned to me be like as a shareholder. And I guess you have to sort of project that over future returns as well because if you're talking about retirement, that's what you're looking at.

JIM: Yeah. And you can usually do that with these established companies. You can take a look at, for example, what their earnings trend has been over a 10 year period, what it's been over a five-year period. You can take a look at cash flow per share. You can take a look at their dividend pay out ratio. And then more importantly, you could take a look at what has been the average dividend increase. So that pretty much sums up the more important things that you want to know about a company. [54:28]

And when you see a history or a pattern of consistent dividend increases, that probably gives you the best evidence of dividend safety. And I want to give an example here. Everybody can think of the last bull market in energy, which took place in the 70s, and like today, oil companies were making a ton of money just as oil prices went from a couple of dollars a barrel all of the way to $40 a barrel. But the industry itself, because what was going on in the 70s, John, was more geopolitical than it was geological like today. And so even though the earnings were increasing tremendously for a lot of the energy companies, they did not increase their dividends commensurate with the earnings gains because the industry itself said, “look, there is a lot of things going on in the Middle East now, with OPEC, stuff going on with Iran. These are political things.”

And also remember in the 70s, we were bringing on line two of the biggest oil discoveries that were made in the late 60s, which was the North Slope of Alaska and the North Sea.

So the oil companies, yes, they increased their dividends, but they certainly weren't increasing their dividends 15 to 20% a year like you see many of these companies today because the board of directors said, “look, what's driving the oil price is politics.

And we know for example that huge oil streams are going to be coming online here in the North Sea and the North Slope and that's going to bring more and more supply into the markets.” So the boards were pretty conservative, and you know it's served them well because when the price of oil peaked at $40 in 1980 and then went down (it got down actually to 10 bucks a barrel) the cash flow that these oil companies were earning, they were still able to maintain that dividend during this period of time of low commodity prices.

So it just goes to show you the discipline that management’s focus and the board of directors’ focus on dividends, it really tells you a lot about the company, its shareholder focus and the soundness and the business prospects of the company itself. [56:18]

JOHN: Yeah. We've been talking about dividends for retirement as a way of providing financial independence, and I guess, keeping your golden years golden to a certain degree. But what if you're still five to seven years out from retirement. Is there anything different that you need to do?

JIM: Oh, absolutely. If I was looking at retiring in five to seven years, I'd probably have a portfolio of dividend super stocks, companies that are increasing their dividends 10% or more a year because you don't need the income right now, so you can go with a dividend super stock that pays a decent yield, but has tremendous dividend growth rates.

I mean think of it this way. By the time you do get ready to retire, your dividends would have doubled. Now, think about that. If you are investing in dividend super stocks that are increasing their dividends at 10% a year, at a 10% increase every year in seven years, John, your income is going to double. So by the time you get to retirement, your income is going to be much higher.

And the problem I see, and it's a big mistake I see with people who are retired, all of a sudden they wake up and say, “oh my God, I'm going to be retiring in the next five to seven years” and they panic. The kids have all been put through school, and then what they do is they'll do things like a common thing I'll see people will go into fixed income which is a mistake, especially where yields are right now; or the opposite is they'll start panicking and say I don't have enough for retirement, so they go for the gold.

They get more speculative in what they're doing because they want a larger return to make up for not having enough money. But if you look at what makes the most sense, especially for somebody retired or nearing retirement in five to seven years, they have a 401(k) program or a pension plan, a portfolio of dividend super stocks would be much safer and more prudent in my opinion than trying to hit a home run with betting the ranch on a few stocks.

You know, I use an analogy like baseball. Consistent singles produces a better batting score than, let's say, somebody that's trying to knock it out of the baseball park every time. [58:57]

JOHN: So let's get down to the nuts and bolts about the whole thing. I mean, what would a portfolio look like, what kind of stocks, how many, where do you look to get information about it? I know we're not going to give out names here or trade secrets but obviously we need to make it practical for people so they have some kind of an image.

JIM: Well, I suppose the first thing that you want to start out with is your age and your need for income. I mean if you're five to seven years away from retirement or you retired in your early sixties, I'd probably start out with dividend super stocks. Especially if you're going to have other sources of income when you retire, for example, maybe a couple pension program, government pensions, Social Security or maybe you have rental property or rental income.

So you want to have a portfolio. The ideal portfolio would be about 15 stocks, no more than 20 because you want to keep up with these companies. And if you need more income, you're probably going to have to look at including some royalty trust, some Master Limited Partnerships and REITs and utilities because obviously the yields are much higher in these sectors. And then you're going to look for dividend super stocks. You're going to find them in areas like consumer staples that have a consistent business. Staples are just that, staples. We use them on a day-to-day basis. They are not discretionary.

Energy is another area. Natural resources. REITs are another area. And another area that has been good for dividends has been banks, but I would avoid these right now until we get through this credit crisis until this whole crisis resolves itself. However, there are some promising prospects in this area. Not all of the banks did stupid things like you're seeing reported in the news every day. There are some real excellent prospects if you look at some of the regional banks. And also another area I think is very promising right now is the pharmaceutical sector, which has been beaten down over political concerns.

JOHN: And don't forget, if people need to get information, where can they follow-up on this?

JIM: My favorite source is Value Line. I mean you can find copies of Value Line in most libraries. If you have a substantial portfolio, you owe it to yourself to subscribe to it.

I mean you're going to get dividends per share, cash flow per share, you're going to get dividend growth rates, you're going to get dividend pay out ratios, you're going to get return on assets, return on equity. They do an excellent, excellent job. And most of the information, the ratios, the things we've been talking about here in this segment, you can get most of that all on Value Line.

JOHN: Just Value Line?

JIM: Well, let's put it this way. That's all Warren Buffet uses, and he's a pretty bright guy. I mean obviously Buffet spends a lot of time reading annual reports, and by the way, if you do invest in companies, I highly recommend you get in the habit of reading those annual reports because especially the D&As section, which is management discussion and analysis of the business. They'll tell you about what management thinks of the business. It's going to tell you where they think the business is going. It's going to tell you what their execution plans are to achieve those goals, and you'll find out a lot about the company, their products, what they make, where are they seeing the increases, where are they earning the most money, which segments are most profitable. How much of their business is overseas, how strong is their balance sheets.

And then if you want to do the ratios that I talk about, for example, dividend coverage, debt coverage, some of the things like return on assets, return on equity, those are the things that you can pick up out of an annual report. But Value Line is going to give you a lot of that information at your finger tips.

Part 3

Q-Calls

JOHN: Welcome to the Q-lines for this week. Welcome back to the Financial Sense Newshour. Q-lines are open 24 hours a day to record your calls to take questions for the program. We ask that you give your name and where you're calling from. First name is fine – we don't want to engage in identity theft here, but we do like to know where you're calling from.

Please remember that radio show content is for information and educational purposes only. You shouldn't consider this as a solicitation or offer to purchase or sell securities. And responses to your inquiries are based on the personal opinions of Jim Puplava and do not take into account your suitability, objectives or risk tolerance. We don't know you, and so we can't do that. And as such, Financial Sense is not liable to any person for loss that's result in investing in any companies profiled or other information given here on the program. Always try to find a qualified investment counselor and advisor before you make any moves there so you know what you're doing.

The toll free number here – this is toll free in the US and Canada – 800-794-6480. That is toll free from the US and Canada only, but it does work from the entire rest of the world. You simply have to pay for the international rate. So here we go with the first call from Dave in Chihuahua, Texas.

Jim and John, this is Dave down in the Chihuahua desert of Texas. I've been looking at a commentary by Bill Cara today, which is February the 5th of 08, and he talks about actual data from the Federal Reserve on a H3 report, which indicates in his blog that the Federal Reserve has actually shown the aggregate reserves of depository institutions has gone negative for the first time ever. The non-borrowed reserves are actually showing up at, it looks like, about 8.751 billion, a negative number in the non-borrowed reserves. And I wondered if anybody in your organization has been following that H3 report and if you guys could maybe talk about that a little bit as to what that is indicating, I would appreciate hearing what you have to say. Thank you very much.

JIM: Essentially, that figure has actually gotten worse. The recent report is those negatives are actually about 20 billion. What you're referring to is non-borrowed reserves, the 8.7 billion. Actually, that's the first time it's gone negative since 1959.

The difference between total reserves and non-borrowed reserves, Dave, is nearly identical to the current size of the TAF program. In other words, what this means is the Fed is directly financing the reserve requirements of the US banking system because banks appear unwilling to lend reserves overnight, instead preferring to borrowing directly from the Fed.

Yes, we're following it, and we covered this in some detail in the first hour with my special guest John Williams from Shadow Stats Government, so I'm going to refer you to the last hour where we discussed this at length for about 10 minutes. [3:17]

My name is Thomas, and I'm in Washington state. I went to the Mises website and downloaded America's Great Depression and after reading it and a bunch of the book, I'm really surprised. Have you reread the book? Do you really believe this is the economic solution to the world's problems? I found Rothbard in the book continually do things that would destroy what we have built in this nation, what our whole premise of a nice society is based on.

And the premises that he advocates to me would just be more cycles, more hardship and trouble. It would be just like the movie Amazing Grace. It would bring back slavery because man doesn't really count in this society. It's all about machine and building capital.

And I want to ask why what this capitalism built is in the hands of the few which is what would happen because the cunning always end up with wealth, so then why would the cunning want to build anything else, making any other investments in capital because they would just hoard it because there wouldn't be any market for what they would produce anyway.

This is ridiculous that you would adopt this. I think you have better sense. You offer so much better judgment and you'll find that your information exempt that I don't believe -- have you really read this book and thought it out. There is lots of in there that are very misleading.

He talks about the tax structure during the time of the depression was the fact, I looked it up, the highest tax that the United States had before 1935 corporate tax was 12% and that's the highest tax structure. No individuals that made over 40-something hundred dollars paid any taxes and that excludes almost everybody in the United States from federal income tax in all of this period of time. It just seems to me that this system is built to have man suffering in pain that he advocates.

Now, I think we do need a capital structure, but we need to have balance in things and I'm really surprised that you bought the end of this story. Do you really believe it or have you read what it advocates?

JIM: Thomas, I think you're misinterpreting what he's saying. If you read it and understand it correctly, what was a recession and a correction in the stock market was turned into the Great Depression. The Great Depression lasted for 12 years and it was because of those very same policies. And if you read World War II of what happened, it was amazing towards the end of the 30s and as it looked like the United States would be entering into war, a lot of the New Dealers went off the Roosevelt staff because Roosevelt knew that he was going to have to get the private sector and production going if he was going to fight a war, so he brought in private industry.

You'd better believe I've read this book. I've read others like it, and I believe what Rothbard has said. They took a recession and turned it into a depression by those very policies.

Thomas, if you take a look at, I'm a first generation born American. My parents came from Europe. They came from a country that went communistic, and I can remember my mother going back there 10 years ago and looking at what the country was like compared to America. Socialism, redistribution of wealth creates poverty. It doesn't create balance.

If that would be the case, then you would see Russia and China would have beaten the United States in terms of prosperity. They are starting to beat the United States now, but they've gone away from socialism and have moved more towards free markets. That's why China is one of the most prosperous and fastest growing societies on the planet today where we're regressing and going in the opposite direction. [7:11]

Hi Jim and John. This is Ken calling from the great Northwest. I would like to share an experience I recently encountered. I was exploring potentials of purchasing and storing metal offshore at a particular well known international facility. I encountered the following:

When placing phone calls to that facility, everyone from the client relations manager to the trader who builds product always had time to listen and answer questions at the time of my call without a call back and without being passed off to someone else. If research was required, they always responded literally within minutes of the initial phone call. And I was always talking to the same individual, which greatly facilitated continuity for our situation.

Somewhere through the days of dialogue with them, it occurred to me that I was observing a current and loud commentary of world perceptions of precious metals because all staff from basic phone answering to client relations to the trader who builds product had the time to provide immediate and accurate responses.

All this is good and greatly appreciated, but it occurred to me to rhetorically ask the question, where are all of the buyers? Why aren't these people head over toenails busy? It became obvious to me that their environment was still business as usual. i.e., their doors are not beaten in by the masses seeking their services and they are still glad and receptive to have their phone ring and provide prompt and timely information and service.

Here we are with gold up almost four times above the lows of only a few years ago, and it is still business as usual with product readily available at this international metals business. My recent experience certainly supports your continuing commentary of metals not being on the radar screen. Thank you for your weekly sharing of commentary and guests and keep up the good work.

JIM: Jim, I appreciate you sharing that. Your comments have been expressed to me by others as well. I mean you would have thought with gold over 900, we're now looking at silver prices over $17 that this would have got on the attention of even Wall Street, but Wall Street trades it. You've got a monetary environment that is also favorable for gold with inflation, and it's absolutely amazing. It's still not on the radar screen, but that's good for investors like you and I. [9:34]

Hi. This is Peter from Durham. Two weeks ago, you were saying that Matt Simmons went out and looked at the top 100 oil wells in the world and 70% were in decline. I think you meant 70% because the percent sign is right above the five.

JIM: Well, Peter, if I've misspoken in terms of that, then I apologize. In fact, he's got a graph of that, and I think that's about right. The figure is about 70% of the world's fields are in decline. And I think it's 54 out of the 64 producing countries are actually past peak. And if you take, what is it, 54 out of 64, it's actually over 80% of the countries that produce oil are past peak. [10:23]

Hi, Jim and John. It's Peter calling from Toronto. I just had a comment. A fella had called from Toronto a couple of weeks back saying that it's a great idea to buy gold certificates from a local bank and put it in your RSP. You know, he was claiming that they were allocated, and I'm calling to suggest that a certificate from a bank is nothing more than a promissory note from the bank and it does not represent gold at all. It's a promise that the bank will pay you back whatever the gold price is some day in the future; and they probably have purchased a derivative to back up their position in that certificate. And it's not buying bullion at all. What if that bank was CIBC, which happens to be in trouble right now? What if they went down one day? Your certificate would only be worth as good as the bank that issued it, and it is not like having bullion, the real thing. Thanks and thanks for the great show.

JIM: Peter, point well taken. And I agree with you. Whenever possible, purchase the physical. [11:22]

Jim and John. This is Nigel calling from the UK. I have been an avid listener over the past year, and I feel that your topic of inflation or deflation is really important. I've looked at several opinions, and I was leaning towards the hyperinflationary scenario, until a listener pointed out on Bob Hoye’s podcast that in the Weimar Republic there was a bond market which would reprice assets and makes it incompatible to what we’re facing. In short he made the case that since there would be no one left to buy the bonds, assets would have to repriced downwards. Perhaps you can invite Bob Hoye, Bob Prechter, Richard Russell, Peter Schiff and others to have an inflation-deflation debate to examine both technical and fundamental aspects of both scenarios. Thank you.

JIM: We've done that, and we haven't gotten a good response from many on the deflation front. I'd like to point out if you take a look from our bond market in the 70s, which was rather extensive, even with 14% inflation rates, people were buying bonds. It's just they were buying bonds at higher interest rates to compensate for the inflation. And then the other thing that you've got to remember, and this is written in several Fed papers is ultimately, when there are no buyers to show up, then you have the central banks buy them and they begin monetizing debt. [12:48]

Jim and John, this is Brian in Johnson city, Tennessee. I've got a question for you. I listen to your program. Jim, lately, you've been saying that every time you hear Chairman Ben Bernanke speak, you want to go buy gold and silver. And frankly I do too. But if I'm remembering right, the most aggressive approach that I've heard suggested on your show to gold and silver is 25% of your portfolio. And with everything that's been coming down the road with the recession and/or depression, and then after hearing your series on rogue waves and black swans I'm really surprised that you take such a passive approach to gold and silver. I mean to me it makes sense to do everything in gold and silver because you don't know what is going to happen. But I'd like to have your thoughts on that and why so little in gold and silver right now. Thanks. Bye.

JIM: Brian, there are a couple of things here. Number one, sometimes things can be delayed for quite some time, so you don't want to come on the air and say, “hey, put all of your eggs in one basket.” That just wouldn't be prudent, even though I think gold and silver are going to be superior performers. If you look at what I've written going all of the way back to 2000, I said if you want to make money, given what I saw coming, there were four areas. I said precious metals. I said energy. I said food and I said water. If you take a look at the agricultural commodities, they are up 45, 50%. They've outperformed gold. If you look at the gold stocks, they've been under performing bullion. I mean the gold stocks don't know that gold is at 900. The gold stocks are acting like gold is at 600.

So obviously, you don't want to go out there and say put all of your eggs in one basket. I could be wrong about my scenario. Who knows? Maybe we could have deflation. I don't think so, but you're never going to want to have me tell people. I just think it wouldn't be prudent to say bet the ranch and put everything in one basket. [14:40]

Hola, Jim and John. This is Richard calling from Buenos Aries, Argentina. Jim, on a very serious note, from where comes your FSN theme music? I love it. It gives me a very calming feeling. I love to play it over and over again. Can I get it on CD? It's a lot better than Maalox. And John, is that you in the introductory remarks before the music starts?

JOHN: Well, are we going to give away our secrets here?

JIM: Richard, the theme music is the movie theme from the movie Broadcast News. And you would have to rent the movie, or I don't even know if you can get the sound track.

JOHN: You can get sound tracks for it. You can get everything in there, I think. Check online.

JIM: Yeah. Check online to see if you can get the sound track. The name of the movie was Broadcast News, and I picked that out because to me that was a key movie because it described what was happening to evening news. I had read three or four books back in the 80s, and then having been in broadcast news being an anchor man here locally for about a year and a half, seeing some of the things that were happening in the news business. But anyway, that is the theme that is from the movie Broadcast News.

And John, you want to tell him the secrets or – [16:06]

JOHN: What? That you're mad as heck and you're not going to take it anymore? Is that it?

JIM: No. That was another movie.

JOHN: Well, no, that I'm not the -- I don't know what Richard is referring to. The gentleman we have do the opening, we call him Tonsils around here because he does a lot of voicing for network and other programs and his name is Steve Sobalski [phon.]. So that is the voice prior to the beginning of the music. That's who that is.

JIM: Oh, the you're listening to the -- sort of deep –

JOHN: That's why we refer to him as Tonsils. Here we go. Next question.

Hi, Jim. This is Joe in New Jersey, and I am just wondering if you happen to know if the accounting problems that the federal government has that Larry Kotlikoff has highlighted regarding accruals and unfunded liabilities and the tens of trillions that are essentially off of our books, would you happen to know if that is also the case for the other industrialized nations? You know, particularly in Europe. And I'm asking because I'm reading a lot of commentary and there is actually a lot of people trying to make a case that the dollar is really getting a little bit undervalued vis-à-vis the euro right now. And I just think that that would be considering that we think there is going to be hyperinflation due to these unfunded liabilities and money printing, if that is also the case in Europe. They might have a point at these levels. Thanks.

JIM: Joe, that is a point. They have unfunded liabilities. Especially on pensions in Europe as much as we do, they have problems like that in Japan and other countries, especially the socialistic countries where they have, and especially as their populations age, you're going to find that these entitlements aren't going to work well because the entitlement problem that we have, same problem that they have. [17:53]

Hi, Jim and John. Duncan from Auckland, New Zealand, I listen to your show every week and really love it...

JIM: Duncan from New Zealand you called in here and your voice didn't come in very clearly, so I can't get to your question. Maybe you can try calling, there is a lot of static, so my apologies, but I couldn't really hear what you were asking. [18:13]

Jim and John, this is Al from Jefferson city, Missouri. First of all, I want to thank Kevin from BC for advising me of that book. Of course that guy, Nathan Lewis, was interviewed on your show, Jim, and I'd already read that book, and it is a great book. For anybody listening, hey, these guys that Jim interviews, they are great. I've got seven or eight books on my shelf of people I've read from this show, and I'm getting a great education in economics.

But my question, Jim, was about contrarian investment. You had a gentleman who called in earlier, and he was talking about basically saying that the US economy is a buy right now from a true contrarian view point because everything is so low. And I actually had a couple of contrarian investments that I wanted to ask you about. It hasn't really turned out. I'm thinking of selling them.

The first one I got was – actually, I bought it in 1932. It was Weimar Germany. Weimar Republic I think is what it was called. And the second it was the Confederate States of America. I got that in 1862 and neither of those have actually turned out very well for me. I haven't looked at the stock pages. My biggest investment, actually, is one that I thought you might be interested and I haven't looked at the stock pages to see how this was doing. It was Roman Empire. I bought that in 475 A.D. I probably should check on it to see if it's getting ready for a turn around or what's going on. I wanted to get your opinion on some of those investments. Hey, great job, you guys. Thanks a lot.

JIM: That's absolutely amazing, Al, what happens to fiat currencies and governments. They will always in the end depreciate their currency. And it's been that way throughout much of history. [19:45]

JOHN: I think they had a stock split too when they moved the capital from Rome to Constantinople; didn't they?

JIM: That's right. You know, Al, maybe you missed that, the two for one stock split that occurred in 300 AD there.

Hi, this is AJ from Staten Island. I just started listening to your show. You guys have a great show. I was wondering if you guys were familiar with Webster Tarpley's view on peak oil. His last name is spelled T-a-r-p-l-e-y. And you can see his comments on U-Tube that are interesting, I'd like your take on the matter. Thank you.

JIM: Yeah. I've seen Tarpley's work. He's author, lecturer, and he maintains that the events of 9/11 were engineered by the military-industrial complex. I just don't share those views. [20:32]

Yes. This is Mike from Bridgewater, New Jersey. How are you doing, guys? I always love your show, Jim and John. It's excellent. I've benefited a lot over the last year and have done well with precious metals and commodities. I just about agree with everything that you say. I just wanted to bring up a couple of points here with respect to what has created these macroeconomic problems that we have, and that's centered around regulations and what I call the global elite class.

With respect to regulation, I know you guys are saying that, you know, the Fed should step aside and let the market play out. But by the same token, I'd be curious to see what you're thinking in terms of regulation, particularly in the financial banking and mortgage industry. Wouldn't you say that it's the lack of regulation that has actually helped cause all of these problems? Non-regulation of derivatives and credit default swaps, interest rate derivatives, what have you; and also non-regulation of mortgage banking rules, terms and conditions, that have allowed the lower middle class and middle middle class predominately to get into all of these predator-type loan situations. So we are seeing it now with lending standards getting tighter, would you say that regulation, would that be a benefit?

My other question has to do again with the leadership in government and the leadership in business. Clearly I think you guys feel that we have a lack of leadership in government, but how about on the business side. I know you've talked about entrepreneurs and people like Steve Jobs coming in and creating jobs, and I agree with that rather than pumping the money into government and having jobs created there. But yet, there is clearly a view that we're in the Robber Baron age. We're in the gilded age right now, where in 1960 the average CEO-level executive was making 50, 60 times the average person; now we’re well over 5-, 6-, 700. Wouldn't you agree that there is a major imbalance among our top leaders both in business and government in terms of their compensation and that this has affected the overall macroeconomic economy to the negative side, particularly your middle class or in upper class. Thank you. Appreciate your response.

JIM: You know, Mike, let's answer the issue on regulation. Given the kind of society that we operate now with the Federal Reserve, regulation would probably help the system. But quite honestly, the best way to help the system is to go back to gold standard. And I guarantee you, you wouldn't have had the banks creating this kind of mess to begin with because any bank that would have done something as stupid as these banks have done would have failed. And that's a problem that you run into: the moral hazard. When you have government coming in and supporting, as we're going to bail out a lot of these homeowners and financial institutions that made these mistakes and there was also a lot of criminal activity that was going on.

There were a lot of people that were in – in fact, last year, most of the mortgages that went into default had a lot to do with people overstating and lying on their income. So in my mind, going back to the gold standard and honest money would be one problem that would solve it.

Now, and this is related to your question about the discrepancies that you see today, you're saying robber baron. I don't see it that way. In an inflationary period, those who get the money first benefit the most. And those who get the money first is the government, those who get the money first are the investment bankers and the bankers as money is created. And what you have in an inflationary environment is those who can speculate, who have excess income, can take that income, save it, invest it and make money from inflation.

On the other hand, what you have in the lower end of the spectrum with the poor and the middle class is taxes and inflation eat up your purchasing power. And yet, the lower income, the middle classes always vote for those that will create more inflation. It was like when Bernanke was on Capitol Hill and we're in this mess and Ron Paul said, you know, your solution to this problem is more inflation. So if you think about the average middle class person working for a company, receiving wages right off the bat, 7.65% comes off in Social Security taxes. Probably add another 25 to 30% in federal taxes depending if you're in the state of California, 9% in state income taxes. And you know, that the real inflation rate here is probably close to 8 to 10%. Well, you can't go into your boss or your employer and say, “look, inflation is up 10%, given that I'm paying over close to 40% of my income in taxes, I need a 15 to 16% to keep me even with inflation.”

So this disparity of wealth that you're talking about is a product of government created inflation. And that's something that the vast majority of people never realize, and that's why they'll continue to vote in politicians that will promise them a better life. But in reality, promise them a lower standard of living through the inflation policies that they implement. [26:09]

JOHN: Yeah. Plus the tax payer is made the guarantor of last resort for all of this stuff. That's how the whole Federal Reserve system was set up. It left the tax payer holding the bag for any type of default. I think the other thing, and you know this as well, Jim, is when you start a project of regulation, that's what always happens after one of these. People come in and say “let's regulate.” Well, how did the IRS code, for example, get to get as huge as it is? Because way back in 1913, somebody said let's tax income; right? Then you had to define what was income, so then people began to put things in trusts and legitimate means of dodging. And then they began to call those abusive trusts. They had to write more regulations. You see what I'm saying? And before you know it, the thing was so convoluted like I think it is even today, people almost have to operate illegally just to get along. And everybody could be guilty of something because now there are so many regulations. It just doesn't work.

But like I say, the phenomenon is government-caused to start with, and that's why people keep voting in the same people and they can never figure it out, why doesn't it ever get better. We keep in voting more people, but it never gets better. Well, it’s the same group of people. [27:20]

JIM: And the point that once we went off the gold backing of the dollar, look at government debt, look at government deficits, look at our trade deficits. And as a result of that inflation that came into play, when the government began manufacturing and printing money to pay its bills, and was no longer fiscally restrained, that was when inflation started to escalate. That's when in the 70s, John, it took the wife going to work to pay the bills; in the 80s, the savings rate went down in this country. And then in the late 90s and 2000, it has taken debt to make ends meet. So all of this is a product of inflation and the genesis of all inflation is created by government. [28:40]

JOHN: So when you have inflation, let's paint this picture, Jim, since we went down this road. When the inflation happens, who are the first people to benefit from the funny money?

JIM: The government.

JOHN: Meaning the Fed and the government together; right? That’s a cartel?

JIM: Yeah. Because they are the first one to receive the money. Remember, it takes a while for inflation to work its way through the system, so he who receives the money first; the next is the banking and financial community because remember when the Fed expands money, or we have various ways of doing it outside of the banking system, it's been referred to as the shadow banking system through securitization, they benefit. And that's why you see these huge salaries and billion dollar salaries on Wall Street because they are a beneficiary of inflation. [28:57]

JOHN: But by the time it filters down to the working class of all groups, we can talk about the middle class, lower class, that's where the ravages of inflation kick in; they take all of the risk and get almost none of the benefits.

JIM: Yeah. Because they are on the bottom of the chain by the time the inflation really hits the economy, it impacts middle class, poor people, they see it in the rise and the cost of their utility bills. And it's going to get worse with more government regulations.

I mean take a look at the ethanol initiatives. What's that doing to the price of corn? And how that's impacting feed stock for animals, dairy products, things of that nature. So you're seeing food inflation. Well, who created it? I mean it was created with the Fed allowing the money supply, but also it's even if you create inflation, you don't see it hit one area unless there is a demand and supply factor also involved. And if you reduce the supply of corn or feed stock to farmers to ranchers you're going to see higher prices.

And you're seeing it in the store. But once again, I go back to my example, you can't go to your boss and say, “look, real inflation for me is running 10% a year, and you guys take about 40% of my income in various forms of taxes, so I need a 15% pay increase to keep me even.” It doesn't work that way.

In fact, the pay increase that you get may even push you into a higher tax bracket. [30:22]

Hi, Jim and everybody at Puplava Securities. My name is Tom from Newport Beach. Really appreciate your show. My question is and I heard Barack Obama refer to it, you guys have implied to it this weekend and the weekend before and that entering World War Two somehow brought us out of the Great Depression. Logically, I think this is a huge myth. I would think that war and destuction of capital and labor in employment towards war is going to result in lower economic output for all countries and all parties concerned. Granted the spoils go to the victor, but I would think all in all war generally is a huge, massive drag on the economy; and I don't believe World War Two is what pulled us out of the Great Depression. I would think that it would have cost us a lot of things, sure we could argue about final treaties and where America stood at the end of that, but all in all, it was a net loss. And every time I hear that, it makes my skin crawl that people actually believe war is still beneficial to an economy. Love to hear your thoughts on that. Keep up the great work. Thanks a lot, guys.

JIM: Tommy, if you look at what had happened, we had –I forget what figure is. It was 25 or 30% unemployment rate before the war started, so the minute that the draft started and we put men in uniform, we took about 12 million people that went into uniform, so the lower dollars the unemployment rate. It also increased production in the United States because all of a sudden factories were humming, they were building tanks, planes, ships, ammunition, rifles and things of that nature. And it didn't impact us as much because other than the battle ships that were destroyed at Pearl Harbor, most of the damage was inflicted in Europe and Japan because of the bombing. I think if we had a war today, you know, even the war that we have right now going on in the Middle East, it hasn't occurred here, we did have the Trade Towers taken out. That's being rebuilt, but war is destructive. The fact that it helped us is because our property, our plants, our cities weren't bombed. It occurred elsewhere. But it did put half of the unemployed work force into uniform with a paycheck and it got factories rolling again in the United States. [32:41]

JOHN: A question, then. How was it financed then? Was it inflation again?

JIM: Yeah. It was debt finance and inflationary financing. I mean just look at the government's budget deficit that was virtually...well, I shouldn't say virtually nothing because it began to expand in the 30s and then increased substantially in the 40s to fight the war. [33:02]

JOHN: What about the New Deal? Let's play devils advocate on this. Did the New Deal do anything to getting us out of the situation?

JIM: No. It extended it. And we're going to get into this. One of the things that it did, it was so hostile to business that business spending and investment actually froze. And when you create uncertainty –and we’re seeing the beginning signs of this right now, you've got businessmen that are reluctant to buy capital equipment to build factories because they don't know what tax rates are going to be, they don't even know what interest rates are going to be. When you create that uncertainty, people basically say that I'm going to sit in cash. I'm not going to do anything. And you just show me where the Great Depression...the unemployment rate got worse. Tax revenue fell. The GDP dropped in half. So if you were to say that all of these programs were great, then how can you call a 50% drop in economic output great or an unemployment rate that rose from, you know, a couple of percent all of the way up to 25%. [34:13]

Hello, Jim and John, this is David from Cleveland, Ohio. On February 9th, I believe, Reuters reported that the group of G7 approved IMF gold sales, (International Monetary Fund gold sales.) And when I saw the news release, I thought to myself, man, on Monday, gold is going to take off, but it was a non-event. It didn't seem to have any impact at all on the price of gold. I would appreciate your reactions and thoughts on the potential IMF gold sale. Thanks.

JIM: You know what? There are two sides, David, in terms of gold sales; and first of all, when you were saying okay, they are going to sell gold, the other side of the question is if they are selling, who is buying. And with the gold sales, central banks have been selling throughout this decade and it has had very little impact because the demand is growing much greater and its investment demand that's coming in here and that's why it had very little impact. I mean, they'll try to do this when gold is spiking. They'll say, they'll make announcements, for example, the Swiss government is going to sell its gold two years from now. What's the purpose of making an announcement and telling the market you're going to sell something two years from now? You're doing that to manipulate the market. And as they’re market manipulating the gold market they are having less and less effect. In other words, they are losing control. A lot of people say they can control this market. I don't think so. We were looking at 255 gold in June of 2001, and today we're looking at gold at over 900. [35:50]

Hi, this is Marv calling from San Antonio, Texas. This isn't a question. It a compliment. So many people call and say, “gee, your show is great, but they don't go into any details.” I wanted to be a little more explicit. Jim, I’m stunned at the depth of your knowledge and breadth of your knowledge and how much time you spent reading and you do a wonderful job of explicating the things that you know and turning it into terms that people who don't have the kind of information you have available can understand. Also, the guests you select and interview are absolutely superb. You do a very good job of interviewing. Obviously, your radio background is really helpful. John, I want to say that I'm sure there is a lot that goes into this production that you don't know anything about. It's obvious these programs are produced very, very well and I'm sure you're behind it. You also do some really clever and witty stuff with music and Andy Looney and all of that sort of thing. So you guys do a fantastic job. You've educated enormous numbers of people and you certainly have helped me make some money and many other people in the world. Thanks.

JIM: Marv, you're very kind and thank you. [36:52]

You know, the investment business is the only business I can think of that always keeps you humble. You think you can be on top of the world one day or have figured it out, and then all of a sudden the market throws you a curve you don't expect or see, so – [37:08]

JOHN: And then it smacks you right back in the face again.

Hi, this is Ray from Delaware, and I'm calling in response to some of the discussion that was on the daily updates. And with the energy crisis of which are long term expected to increase, with some of the volatility in the stock market recently when you believe you're going to go through sharp market corrections, in your opinion, does it make sense to selloff a third of the oil stock to rebuy them at a lower price, or is it better just to hold on given the uncertainty of those predictions for the market down drafts? Thank for your program and I appreciate everything you guys do.

JIM: You know, Ray, if your background or expertise in investing come from the technical side of things, that's what you would do. You would trade or take some profits off the table. I don't. I'm a long term investor when it comes to energy because why do I want to sell something now when oil prices are at $95 a barrel when I think they are going over $200 a barrel and even higher in a crisis. But I think that has more to do with a person's background, whether they come at it from a fundamental point of view or a technical point of view, you'll see a lot of technical oriented people saying “hey, we've had a nice run off in energy, take some profits off the table and get back.” And the idea is you sell something for $10 and you hope you can pick it back up at $8, but you know, when you're doing that and you're doing it short term, those gains are short term oriented and that means they are taxed as ordinary income. So depending on your tax bracket, you could pay here in California 10 percent in state taxes and up to 35% on the federal side. [38:51]

This is Andy from Wilton, Connecticut. Hi, guys. Thanks for the great service you provide. I would like to ask you for your opinions regarding the pros and cons and investing in precious metals, royalty type companies. The one I'm most familiar with is Royal Gold, RGLD, which has significantly under performed to other gold and silver related investment alternatives the past few years.

Other than some company specific issues relating to their stream of royalty, what would cause this type of poor relative performance in a precious metals type royalty stock? Are there any other US listed pure precious metal royalty stocks worth a look at that you can just mention? Thanks.

JIM: There is a spin off from Newmont, which is the old Franco Nevada. I think that's available on the Canadian side. You know, the thing that I would tell you, Andy, is most of the stocks, I mean if you take the HUI, for example last year it's 15 stocks. Most of the performance of that entire index was six stocks. You had five stocks that were virtually flat for the year, and then you had three or four of them that actually lost ground. And the vast majority of stocks –and this has been the case for almost 18 months now – have underperformed bullion. The juniors have been down for two years in a row; and even the mid-tier producers were not doing well, so it's not just the royalty companies as a general class, I would say most gold securities whether you're looking at hedged, unhedged, small producers, silver stocks, junior stocks or royalty stocks for that matter. [40:33]

Hi Jim and John. I'm Frederick calling from India where I now live. I'm from Sweden originally. I have two questions for you. The first one is I have some doubts about oil prices. I am generally bullish but generally worried about well, mid-term dynamics. As you say, sure enough the US has not contributed much to oil demand goes, but as I see it, that's from a nation state perspective. If we look at oil consumption that’s consumed by US citizens much of that consumption takes place in China on behalf of the US. Couldn't the US consumer-led recession give a substantial although temporary slack to demand so prices move down. What do you think about that?

Second question, the only way I found to participate in commodities outside of shares and funds is through what the banker call open end certificates in various commodities. What's your opinion on such investment tools. What risk do you see with that that's compared to, for example, real bullion?

On a final note, the Swedish central bank has got the increase of the repo interest rates by a quarter of a percent today on February 13, so no guts, no glory. Any way, thanks so much for a great show. I've learned so much from you guys. Bye.

JIM: You know, Frederick, and let's answer the first question about, let's say, a pull back in the US economy: Would it impact the rest of the world? Sure. It will impact Europe. It would even impact Asia, so instead of China's growth rate at 11%, maybe the China's growth rate this year is at 8%, and we talk about this in the first hour. When you take somebody, let's say where you're at in India, and Tata Motors comes out with a car that's $2,500, there is going to be some people in India that are going to be able to buy a car for the first time. And once they have that car, if they can afford to buy it, you now have an energy consumer. Same thing in China. If you have somebody that maybe 10 years ago was riding a bicycle, five years ago they were riding a motor scooter and today they are driving a car, at each one of those levels of transformation, they are consuming more energy. You take a look at some of the largest producers. Where do we get most of our oil? A good portion of it is OPEC, and OPEC is subsidizing energy. You pay 45 cents a gallon in Saudi Arabia. So OPEC, one of the points that we've been making on this show is everybody wants or expects that all of this extra oil that the world is going to need is going to come from OPEC, but OPEC has done very little to increase its production over the last decade; and especially Saudi Arabia. More importantly, they are consuming more of their own product. I mean in Saudi Arabia today, they are building four new cities; they are going to built the largest aluminum smelter plant; and what they are going to do is start building refineries, petro-chemical complexes. In other words make more money out of the product they produce out of the ground.

And the second question on another way to participate in commodities, I like, if you're dealing with precious metals, I like owning the bullion. Next, I like owning the stocks and then aside from that, if you want to participate in other commodities, there is just, I don't know what you have in India, but there is just a plethora of ETFs in various commodities from oil to the grains. I mean we've been using one that participates in the grain markets and have done quite well with it. [44:06]

Pepe: Would you say I have a plethora or --

Wapo: A what?

Pepe: A plethora?

Wapo: Oh, yes. You have a plethora...Pepe, what is a plethora?

Pepe: Why Wapo? You told me I have a plethora, and I just would like to know if you know what a plethora is. I would not like to think that a person would tell someone he has a plethora and find out that that person has no idea what it means to have a plethora.

JOHN: And so Senor, that is where the world plethora comes in. You idiot. You don't even know what a plethora is. Where were you, Jim, the first time you heard the word plethora?

JIM: I was in junior college.

JOHN: Were you really?

JIM: Yeah.

JOHN: Wow. You actually remember that.

JIM: I specifically remember that word.

JOHN: Did you try it on a girlfriend or something? Did it work?

JIM: No. I don't think that would impress too many babes in college. You have a plethora of beauty effects, madam.

JOHN: Slap. Well, Senor, we've had a plethora of things here on the program today. So what are we doing for the plethora of the next few programs?

JIM: Next week, my special guest will be Mike Stathis, he's written a new book, Cashing in on the Real Estate Bubble. And then March first, we're going to have our gold roundtable with James Turk, Jean-Marie Eveillard, Bill Murphy, Leanne Baker and Rob McEwen. And also we'll be doing some interviews of two mining companies, so they'll be coming up on March first. Sy Harding will be my guest on March 8th. His new book Beat The Market The Easy Way. Alex Doulis Lost On Bay Street. Josh Peters, The Ultimate Dividend Play Book on March 22nd, and Steve LeVine March 29th, The Oil And The Glory, a story about Caspian oil and the politics involved with it.

In the meantime, on behalf of John Loeffler and myself, we'd like to thank you for joining us here on the Financial Sense Newshour. Until you and I talk again, we hope you have a pleasant weekend.