Financial Sense Newshour

The BIG Picture Transcription

August 9, 2008

Part 1

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• Blood in the Streets: We've Been Here Before
• 90% Psychological - 10% Logical

Part 2

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• Inflation vs. Deflation: Predicting the Outcome
• Running Out of Water
• What to Do Now

Part 3

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• Q-Calls

Part 1

Blood in the Streets: We've Been Here Before

JOHN: Well, there’s a difference between practicum and reality when you do things like, well, let’s say lying, because in ground school you learn that this works and that works and you do this and you do that, and when you’re flying upside down the thought occurs to you that I could get killed doing this. That’s a lot different. That’s reality. Instead of what you read in the books.

And the same thing applies to the market. Last week on the program, we talked about the whole subject of learning to keep your head when everybody is losing theirs – or don’t go chasing after where the herd is running. And of course, this week, we have seen commodities seemingly to go down. Look at the price of oil at week’s end, the price of the precious metals – all heading downwards. Everybody is saying, “why it’s over, the bull market in commodities is over, we’re going back to business as usual.” But it really isn’t over, is it?

JIM: No. And I think the real key that you have to understand if you’re looking at the commodity complex is the amount of leverage that is employed in commodities. I mean, if you’re going into the futures market and let’s say, you’re going to buy a futures contract on oil, typically you put 10% down. So if you’re going to buy a million dollars worth of oil in the futures market, you’re putting 100,000 dollars and then you’re borrowing the rest. And actually the amount of leverage can be even greater because let’s say I’m a hedge fund and I’m taking a position in the oil markets, in addition to the leverage that’s employed in the contract, I also may be borrowing money. I could be borrowing money in Japan. I may be borrowing money elsewhere, or I can get cheap credit, and then I’m employing that debt into the capital markets, you know, buying stocks, buying commodities et cetera. And so the thing you have to understand about commodity markets, they are driven by leverage. And any time you have a pull-back – or in this case, a severe pull-back and correction – you have this unwinding because remember, when you’re leveraged 10 to 1 or 20 to 1 or 30 to 1, as many funds are, it doesn’t take much of a decline in the price of any kind of commodity or contract that you’re involved in the derivatives market for it to see a dramatic shift in either direction – either on the way up or on the way down.

And so, if you take a look at the amount of hedge funds that are out there today, the amount of leverage in the financial system, you see these huge price swings in either direction. And you can see it, whether you’re looking at the stock market, or you’re looking at the commodity market. And if we take a look at the day you and I are talking right now, the Dow Jones Industrial Average is up roughly 300 points on the fall of oil. And so you have to understand the role that leverage plays, and at the same time you have to understand the role that institutions play in this market because it’s institutionally driven. Everybody is watching the same charts around the globe, whether it’s London, New York, Tokyo, Bonn Germany, or even elsewhere around the globe. When you’re looking at the same charts, everybody responds to the same kind of charts; “okay, the price went down, we’ve got to cut our position” and all of a sudden the markets can change dramatically in a very, very short period of time. [3:26]

JOHN: Well, last year if we look at the trend, everybody was going long on commodities and short on financials and now it seems like everyone has done a flip-flop, “we’re just the reverse, we’re going short on commodities and long on financials.” It’s like this giant change in psychology going on.

JIM: And John, you just hit a key word, you said change in psychology – and we’re going to get into that in a second topic that we’re going to do today. But if you look at a chart of all the key commodities – whether you’re looking at the CRB Index, the Dow Jones Commodity Index, the Reuters, some of the other mainstream commodities, the Rogers Raw Material Index – you know, if you look back last August when the commodity sector really began to take off, you’ve seen a tremendous pull-back whether you’re looking at the price of wheat, you’re looking at the price of corn, you’re looking at the price of even gold (although gold has held up much better than some of the other commodities), but all of the commodities have pulled back here and they’ve done so violently. And once again, the reason for that violent pull-back has to do with the amount of leverage in the system. And as you pointed out, what people were doing when this – I think it was about one year ago today as a matter of fact – this is the one year anniversary of the credit crisis that began around this time last year – it was called risk aversion. All of a sudden people rediscovered risk, you had lenders that began to tighten lending standards, you had a pull-back on the amount on what I call liar loans, and the credit crisis unfolded. People went into Treasuries, they shorted the financial sector as every quarter a lot of the financial companies – whether it was investment banks or money center banks – began to report horrific earnings losses and they began to raise capital to remain solvent. And that was the trade. And then we got to July and we had another bailout program; we just had – what was it, last week – we had a 300 billion dollar bailout; you had the government step in standing behind Fannie and Freddie. They’re going to get in there and inject capital. On the day we’re talking, they just cut their dividend but what we’ve seen here is a reversal and a lot of people are saying, “well, I don’t have to worry anymore because if they can bail out Bear Stearns, they can bail out Fannie or Freddie or they can bail out the big banks, then you know what, I can get back to risk taking. I can take risks. I can go in there. If something goes wrong the government or in this case, the taxpayer will end up bailing me out.” So what you have here is a reversal of a trade. Whereas at one point they were long commodities and commodity stocks and short the banks, now it’s just reversing. [6:07]

JOHN: But Jim, this is not new. We have been here before. I mean if you go back to 2004, we had what we call the ‘China growth scare;’ 2005, Katrina and Rita hurricanes – demand destruction; 2007, the same thing – warm weather on the east coast, you know, people aren’t buying energy for heating and related issues. This is nothing new.

JIM: You notice, John, as we’ll get into this second hour, a lot of the markets are driven by psychology. Somebody puts out the term ‘demand destruction.’ For example, you made reference to 2004. There were worries that China’s growth was going to slow down because the central bank was raising interest rates and we had a huge sell-off in the spring and summer in commodities in 2004; by the time we got to the end of the year it turned out that the slowdown in China’s growth story was actually just the reverse. Actually, growth accelerated in China.

You have a little bit of that today because people are worried about all of this economic activity in China has been driven by Chinese spending for the Olympics. But you know, if you take a look at the size of the Chinese economy today –probably the third largest economy in the world behind the US and Japan – the amount of spending on infrastructure for the Olympics is insignificant if you take a look at the total economy. It’s somewhere I think – China spent somewhere close to the neighborhood of close to 50 billion dollars. So once again, we have the China growth story worries.

Then if you look at 2005, John, you remember in the month of gosh, I think we were on our holiday during that time when Katrina and Rita hit and you had a huge spike upward in the price of oil in the month of September; and then in October you had a huge sell-off in energy prices, you had a huge sell-off in gold prices; and the story that was coming out was demand destruction. Well, the only demand destruction was not having availability of energy because remember, the Gulf coast refineries were shut down, one of the pipelines broke down in getting energy and gasoline to the southeastern United States, and it turned out there wasn’t demand destruction. And that was 2005.

Then we got to 2007 and we had two or three weeks of warm weather in New York and oil got down to 50 dollars a barrel, and they were talking about demand destruction, there was no longer going to be a need for energy, and energy was going to 40 dollars; and some people were saying back then, 30, it was unnatural. And of course, by the end of the year instead of 50 dollars we were at 90 dollars.

The same thing happened in the first quarter this year. The US economy weakened in the fourth quarter; it was weakening in the first quarter, which is one of the reasons why Congress within 30 days passed a stimulus package. And demand destruction – but despite that the price of oil hit. And remember, we were forecasting 125 oil, and then we hit 125 and I raised the forecast to 145 and I think we hit 147 intraday, and we’ve been pulling back since then. So the same kind of concept about demand destruction and slower economic growth so there’s less need for commodities. And we’ve seen this over and over again. Anytime there’s a sharp spike upward and then we pull back, it’s the same kind of repeated stories. They repeated these stories in 2004, 2005, 2007 and they’re repeating them again in 2008. [9:36]

JOHN: So if we look at this pull-back, if you’re leveraged in the commodity markets and the price goes down, you basically just unwind position. And what it really starts to look like is a change in stability, like people are on one side of the boat and everyone says, “no, it’s over there,” and they all rush to the starboard side of the boat. And you can see the list go cre-eeek to the other side as it rolls over.

JIM: Yeah, and that’s exactly why you see these violent swings where one day the stock market is down 300 points, today it’s up 300 points. One day the oil markets are up and the next day they’re selling off. In fact, the oil markets and the stock market are trading in reverse directions. So, if you have a sharp downward drop in oil prices, you have a sharp upward rise in the stock market which is what we’re seeing right now. So, if you’re leveraged – you’ve got to remember there is only a small group of people who are in the commodities sector. I have a database not only in my Bloomberg but also a database on S&P that tells me where positions are – in other words, if I want to take a look at a mutual fund company what their holdings are – the energy sector, even though its weight within the S&P is climbing, within the fund industry you’re still talking about a small group of people that are in the commodities sector and a small group of people who are in the commodities themselves. And so, when you have selling or reversal as you do in the commodity futures, then what happens is this is a pool of capital and a large selling that comes in and it’s deleveraging and you do it very quickly, which is why when you look at the commodity markets – whether you’re looking at oil, gold, grains – you see these violent swings in both directions – both up and down – and it’s because of the amount of leverage that’s employed in the sector. And then what happens is a lot of times the stocks will follow suit. [11:37]

JOHN: Let’s see if we can dissect some of the assumptions and things being said in the market – largely rumors. The biggest one right now on the horizon is demand destruction, but based on what Matt Simmons said last week here on the program, I don’t think he buys into that. Where do you stand?

JIM: I don’t buy into it either. Now, if you look at demand destruction in terms of a pull-back of consumption of energy or the amount of energy that is consumed globally, you have to take that story and divide it into two sectors. If you look at the developed world, like Europe, the US, the OECD countries, yes, the demand for energy year-over-year has come down. I mean if you take a look at total vehicle sales in the US of SUVs and trucks, they are down. In fact, total vehicle says I think peaked roughly around 2005 at around 18 million units, and now they’re down to 13 ½ million units. If you look at the amount of vehicle miles traveled that is negative this year versus where it was a couple of years ago. So in the developed world we’ve seen demand destruction a little under one percent in 2006; in 2007 you saw a pull-back of roughly less than half a percent and it’s estimated – and remember, this is just an estimation – that it would be down by one percent this year and down by one percent next year as energy prices stay high.

However, the rest of the world where you have the majority of the population – I’m talking about the developing world, China, India, Latin America, OPEC countries themselves – that is where you are seeing the biggest increase in energy consumption. And we’ve been seeing 4 percent growth globally in the rest of the world. We saw 4% in 2006, 4% in 2007, close to 4% this year, and it’s projected 4% next year. And so if you take the rest of the world and then you put that together with the decline in consumption in the OECD, then if you take total world demand for energy, it’s going up at one percent a year. It was up 1.1 in 2006; it was up 1.4 in 2007; this year it’s going to be up one percent; next year it’s going to be up one percent. So the demand for energy globally – and that’s why when you want to look at the energy sector you have to look at global demand not just western demand.

We get so myopic in the way that we think here that we think everything revolves around the United States. Well, the United States is no longer the key developer in economic growth. In fact, if you look at economic growth over the last, let’s say, five years, a good majority of the economic growth has been driven by the developing world and I think that would still remain in place as we go forward. So in terms of demand destruction, if you take the entire demand for energy globally, there hasn’t been any. [14:35]

JOHN: You know, one of the things that I wonder about if you watch the talkies or read the headlines, when we started into the bull market in gold, when energy began to rise, it was really clear that the talkies weren’t getting the point. And if you look at this whole situation we’re discussing this morning, that’s very much the same thing. People don’t seem to get what’s going on. Why is that? Are they not looking at it, are they operating from a different set of assumptions?

JIM: You go to college, you go into the workforce, whether you’re on Wall Street or you’re working in the press, you grow up in a period of time where there’s a paradigm of how the economy works, there’s a paradigm of how the world works. And for much of the last 30, 40 years, and especially going back to the beginning of the 80s, the last 30 years, the dominant force in the world was the United States. We had the largest economy – we still do – we had very fast economic growth in the 80s and 90s. And then of course you had the fall of the former Soviet Union, and so were looked upon as the superpower, the lone superpower in the world and everything evolved around the United States. And it’s amazing because we’ve been talking about these paradigm shifts and The Gloom, Boom & Doom Report, Marc Faber’s latest piece, he wrote about how change occurs and occurs over time and people don’t notice it. And I’m just quoting here:

My point here is that big changes can and do occur. Usually they occur very, very gradually. And so they go unnoticed by most people and investors, whose focus is on weekly performance results.

And that is what you basically have going on here, John. You know, people can tell you everything about price but not what is going beyond the price. And everything is so short-term oriented in the world today and especially the financial markets – we’re worried about what the price is today, what the price is this week, or what the price will be next week, or next month, and we don’t understand these subtle changes. So if you look at the price of oil, which has been going up every single year since 2002, where we had the price of oil – actually, since 1998 really, if you look at the bottom of oil where it got down to 10 dollars a barrel in 1998 and it moved its way up to 20 dollars a barrel – and from 2002 we’ve gone from 20 dollars a barrel to 147 before the pull-back that we’ve seen. This change has occurred every single year. it’s been going on every single year. We’ve seen the demand for commodities, if you’re looking at the CRB Index, that has been going on every single year; if you take a look at the rise in gold prices and silver prices that has been going on and is up each – and I predict by the time we look back, if you and I were having this conversation December 31st, I would suspect that the price of oil would be higher this year than it was last year; the price of gold and silver will be higher this year than it was last year, and the CRB Index will be higher this year than it was last year.

And once again, these changes are occurring and because they are so gradual and they are so unusual in the sense that we didn’t have these kind of oil prices, these kind of gold prices in the 80s and the 90s. Yes, we had a brief spurt in energy during the Gulf War in 1991, we had a brief spurt in the year 2000, especially in California with natural gas. But you know, after these price spikes, the price of energy would come back.

But remember, John, remember how people were complaining how oil and energy got to 3 dollars and then it got back down to 2.50 after Katrina and Rita and people breathed a sigh of relief and they said it’s over. Well, guess what, we’re still looking at higher oil prices, 115, 116; we’re still looking at gold prices at 860 in this range. And what is occurring here, once again, I go back to Marc Faber, these changes are occurring at such a subtle level.

And it was amazing, I saw an interview this week, I just happened to catch it as I woke up in the morning and I was watching – surfing the cable channels – and they had a fund manager who proclaimed to be a value manager and he was sort of bemoaning the fact that he had missed out on the energy surge over the last three or four years. Yet given the fact that he had missed out, he was then saying that well, you know, the energy play is over. So “I missed it, but now that it’s over I don’t want to get back in it.” Yet, if you take a look at if you were a value manager and you wanted to take a look at where the value is, you look at the energy sector where earnings yields and PE ratios are approaching 18 and 20 percent (and you’re looking at companies that are one of the few industry groups that have pricing power) it’s absolutely amazing that they still at this point do not get it. And that’s a point that’s a real key to understand here, when it comes to the commodities sector and you want to talk about the bull market in commodities, the real believers in the commodity bull market are still in a minority and that’s why we’re still in the early stages. [19:59]

JOHN: At this point then we have at least addressed demand destruction. If you look globally, demand is going up even if in some parts of the world, say, for example, in the West or the US it’s dropping a bit given prices and related issues. But now let’s talk about the whole growth issue in China because this affects this and it also affects the whole global warming issue. Look at the amount of CO2 and other issues that are related to it.

JIM: The one thing that people are looking at, Chinese growth has pulled back. Last year it was growing at over 11%, and the latest quarter China reported economic growth in the high 10% level. Now, you have to understand for the Olympics which start this Friday, in order to clear the air in Beijing, they shut down a lot of the coal plants, they shut down the steel producing plants and they shut down a lot of manufacturing in order to clear the air for the Olympics. Obviously, if you’re going to have field and track events you can’t have a polluted sky because people would be getting sick. And so they shut down a lot of manufacturing in China. And then there was another story that was going out too - because China was spending money to get ready for the Olympics, you know, they spent close to 50 billion dollars. But if you look at the third largest economy in the world, the 50 billion dollars that China spent on infrastructure for the Olympics is small in comparison in terms of what’s going on in the rest of the country. And so, just like in 2004, where they were talking about a tremendous slow down in China where it turned out growth accelerated, I think the real key when you’re looking at China is what happens after the Olympics. In other words, when the factories get restarted, the power plants get restarted.

And I just talked to somebody who had just gotten back from China and they probably won’t restart things until probably September and October because even though the Olympics will end here in the next couple of weeks, you know, there’ll be a lot of people that will be there for holiday and vacations; and so just because the Olympics will end in two weeks that doesn’t mean they flip on the switch and the factories start up. It takes time to restart a factory. And one of the reasons that I know about this, I went to a trade show in March and I ordered some specialized exercise equipment and the company that makes this – it’s a US company, but their factory that makes the equipment is actually in Beijing. In March they told me because of shut downs I probably wouldn’t get the equipment until May and then in May they told it was going to be June, and then in June they told me it was July, and then in July they told me, well, maybe August or September. Well, you know, just this week, checking in with the company that I ordered this equipment from, they said realistically probably not until the end of October and November.

So once again, I think these worries over China and some of the developing countries in that are the economic growth rates slowing down? Absolutely. A lot of the intermediate goods and trade between Asian nations are intermediate goods, and then eventually they’re shipped elsewhere in the world such as Europe or the United States. But will the economic growth rates slow down and be in a recession? I don’t see that happening. I can a recession in the US. I can see a recession in the European countries. There’s probably a recession developing in Japan, but I think that what you’ll see is moderating growth rates – and we may get down to 8 and 9 percent growth rates in China, instead of double-digit growth rates like 10 and 11 percent that we’ve seen over the last couple of years. [23:41]

JOHN: So basically what we’re looking at is just what we would call a flip trade. They’re rushing out of commodities into financials or into certain types of discretionary stocks, but that’s all that is going on right now. This is simply a flip.

JIM: It’s simply a flip, and once again, if you look at the fundamental trends that were in place going back to last August, they were still in place. For example, if you look at the banking crisis, the financial crisis, look at Fannie cutting their dividend – and in the next segment we’ll get into some of these fundamentals – global food and fuel inflation, that’s not going away; recessionary conditions in the developing world, that’s not going away; geopolitical threats, whether it’s Iran or what you’re seeing going on now with a possible war between Georgia and Russia which is taking place on this Friday, and also the things going on in Pakistan and India – there’s another area that you need to keep a close eye on. And so none of those have changed. So what we’re doing is seeing a short-term change in psychology and I think that this will be proven to be short-lived. [24:46]

JOHN: One of the factors that probably mixes into what we’re saying here right now is the geopolitical situation because the anxieties over that will have an effect on oil prices among other things, not to mention global markets. But in Pakistan, Pakistan is pretty shaky right now and they have nuclear weapons. So the question is if something happens to the Pakistani government, what’s going to happen to those weapons, what will happen in terms of the fact that for now the US has more troops going into Afghanistan? Tensions between Pakistan and India are not doing great. As of this Friday we have Russia and Georgia at least having a skirmish – let’s put it that way – just at this stage. Well, I don’t know how to describe it right now if you look at everything going on between Israel, Saudi Arabia, Syria, Lebanon, the Hezbollah and Hamas everything is in motion and it’s away from the paradigm that we all knew right up until and probably through the end of the Oslo peace process. But it’s all new. It’s a big pitching deck. And this all affects the markets as well because it raises what we call the global nervousness Index. [25:52]

JIM: Well, it’s building a lot of nervousness index. You know, you’re talking about these geopolitical tensions that seem to be accelerating, and I would suspect that we would see that continue because there’s a lot of instability, not only throughout the Middle East but also through something that – whether you’re looking at that corridor between the states bordering the Caspian, you’re looking at Afghanistan – I mean the conflicts are heating up. They’re also heating up in parts of Africa, and especially in parts of Nigeria where Nigerian oil is very critical because it’s the light sweet crude oil and that is very much in demand because that’s what most of the refineries in the West are designed to process – not the heavy sour crude. These conflicts I expect are going to continue to heat up and if not probably accelerate as the price of energy – once again, at the end of the year if you and I were having this conversation on the December 31st, I’ll go back to my original premise: the price of oil will be up this year, just as it was last year; and all whole commodity complexes. So we’re going through a short term correction here based on a perception of demand destruction and slower economic growth coming from the developing world. [27:06]

JOHN: That said, you’re listening to the Financial Sense Newshour at www.financialsense.com.

Remember that when you’re dealing with the markets a lot of the way the herd runs is 90% and only 10% reason. Why is that important? We’ll be back.

FSN Humor: Andy Looney

I’m Andy Looney. Did you ever have your kids ask you one of those difficult questions you can’t possibly answer without embarrassing yourself and them. I did. My kids, Candy and Randy, asked me why all the grown-ups were worried about a bunch of stern bears running around Wall Street. I decided to take a page from the Children’s storybook, and I told them about the goldilocks economy and the Stern Bears. It went something like this. Once upon a time…you know, you have to start kids’ stories that way. I did. Didn’t you? I did. Anyway. Once upon a time, there was a goldilocks economy. It wasn’t too hot and it wasn’t too cold. It was just right. The goldilocks economy was skipping down the road to prosperity – not the Yellow Brick road because that’s a different economy, kids – and everything was going just fine. But the big, bad subprime wolf frightened the goldilocks economy into the recessionary woods. <bark> Boy! She was scared. Goldilocks economy wondered through the recessionary woods until she found a house of the Stern Bears. She knocked on the door, but the bears were out foraging for financing. So goldilocks went into the house. <creak> Opened the door wide where she saw three bowls of bailout porridge. She looked at Papa Stern Bear’s bowl but it was too big, and then she looked at Mama Stern Bear’s bowl and it was too small. But when she saw baby Bennie Bear-nanke’s bowl of bailout porridge, it was just right and she ate it all up. About that time, all the Stern Bears came home. They tried to give her a bear hug, but goldilocks economy is afraid of bears too, and she ran away. Thank goodness for me, Randy and Candy didn’t wait for me to say “And she lived happily ever after...” because I don’t think she’s gonna live happily ever after. Do you? I don’t.

Anyway, try to keep your kids away from news programs because it will save you from having to explain embarrassing stories.

For Financial Sense, I’m Andy Looney.

[29:56]

90% Psychological - 10% Logical

JOHN: Well now, Jim, something that we know has become true in recent days is that the government is going to bail everybody out when we get into trouble nowadays. I could use a bailout, couldn’t you?

JIM: I kind of like to add leverage to everything I do and then if what I buy goes down, then have the government bail me out. Not a bad idea.

JOHN: I wonder how we enact that. Oh well.

Well, here we come back to the herd mentality again. When the herd is running one way, what makes you want to follow it. There’s a strong urge to feel security in with a crowd of people, even if they’re running over a cliff. At least you feel secure about running over the cliff. So in this segment of the program we’re going to look at the fact that basically a lot of what you see going on out there in the market is about 90% psychology and only about 10% of clear thinking. And right now, for example, we’ve gone through the whole issue of the government bailing people out, and the psychology is “Well, they’re going to bail everything out. If we make a mistake, they’ll bail us out. They can’t afford not to bail out.” But in reality, what is going on out in the real world, how much of what we’re seeing happening in the market is being driven by their interpretation of what you call the Big Picture. And we’re referring to retail sales, unemployment, GDP, rate hikes by the Fed, mortgage defaults – all of these things are interconnected. How is the market seeing that?

JIM: Well, the trade right now is because the government is stepping in behind Fannie and Freddie, because they bailed out Bear Stearns. There is this moral hazard argument that has come into the market place once again: If you’re too big you won’t fail, because if you’re too big the government will bail you out. And so what that does is it encourages speculation, just as people are going into financials. Why anybody would go into financials given the amount of horrendous losses that have been written off to date, the amount of capital raising that many of these companies are going to have to get into, the amount of dilution that that’s going to mean for shareholders in terms of earnings going forward; and then also, what is going to be the next driver? I mean the driver for a lot of these financial firms, whether it was money center banks or investment banks were all these repackaged mortgage derivatives, CDOs, CDO-squared, SIVs – all of these things which were tremendous amounts of revenue that came into Wall Street. I mean that has died. So you’re going to have to look at going forward not only horrific dilution on the part of a lot of these financial companies as they work to deleverage and replenish their balance sheet which means more share issuance, then at the same time, you’re going to have to take a look at what’s going to be the financial driver that’s going to drive earnings.

So I mean if we just take a look at this concept that the worst is over; you know what, the worst isn’t over. In fact, one of the trends that we’re seeing – and I’m going off an article – this was in the BBC News – America’s House Price Time Bomb. And what they were talking about here is the walk-away mortgage. And not since the Great Depression of the 1930s have we seen legislation pave the way for massive – and I mean massive – new government intervention designed to slow this slide in housing. And one of the problems that you have, and we’ll get to this in just a moment is what he have is the walk-away mortgage, now in the BBC article they were talking about a couple who bought an apartment or a condominium for half a million dollars in California. And most of this was bought with no money down, so they have a half million dollar mortgage on this condo. The problem is the price of the condo has dropped by 200,000, so this couple owes $500,000 on their mortgage and the value of their property is only 300,000. And as they interviewed this individual, they said, “you know what, it just makes good financial sense.” And this is a quote: “Is the bank going to pay for my retirement because I was a good girl and paid my mortgage.” And so what this individual has decided to do is walk away and give the keys to the bank and that’s what’s happening throughout all of California. We’re going to get some of the default and bankruptcy statistics in just a moment. But there’s a very powerful incentive for homeowners to walk away from their mortgage, and because of some recent legislation and a legal quirk that goes back to the Great Depression of the 1930s, banks cannot pursue borrowers for the outstanding balance on their homes. In other words, this individual who walked away and gave the condo back to the bank and the bank is $200,000 underwater. The bank can’t go after this individual and say, “you know what, you walked away and you still owe us the $200,000 between the value of the condo and the value of your original mortgage and you’re going to have to pay that back to us over 10 to 20 years.” They’re walking away.

And so what is happening, and what individuals as a lot of astute commentators on the credit crisis are making statements, it now becomes a business decision that the smartest decision that many of the homeowners who came into the market between 2003 and 2007, is turn the keys over back to the bank. Yes, it might hurt your credit in the short run, but over the long run rather than get stuck with an obligation that is $200,000 more than the value of the prop, it just makes more financial sense to walk away; and you’re seeing this, in the amount of foreclosures. Seventy percent of the volume of foreclosures right now are taking place because homeowners are upside down in their mortgages, and they’re also doing this by the way with car loans as well because a lot of people bought big SUVs or trucks, there is just no way you can trade any of these vehicles in today and get any realistic value or any equity out of them, so people are just turning in cars. So if you look at the used car lots, they are just piled up with big SUVs and trucks. [36:13]

JOHN: If this is what seems to be happening, I don’t know whether it’s becoming a real serious trend – obviously it’s serious, but how far will this trend actually go – and then the question remains how badly will this affect bank balance sheets in terms of bad loans. Well, there was an article in the Wall Street this week and it was called “mortgages made in 2007 go bad at a rapid clip.” And they were talking about the mortgages that were issued in the first part of 2007 before the credit crisis sort of hit, and according to the Wall Street Journal the mortgages that were issued in the first part of 2007 are going bad at a pace that far outstrips the 2006 vintage, suggesting that the blow to the financial system from the US housing problem will get deeper than many people earlier estimated. And John, this goes back to – remember, when the credit crisis hit in August, it was estimated losses would be 200 billion and then a couple of months into the crisis it was 400 billion; and now the latest estimate is about 1.6 trillion.

Now, there was a study that was done for the Wall Street Journal by the FDIC that shows roughly about 0.91% of prime mortgages from 2007 are already seriously delinquent after 12 months, or either in foreclosure or at least 90 days past due. By comparison, if we take a look at equivalent prime mortgages from 2006, we’re about 0.33, or one-third of one percent were delinquent after 12 months. So you’re talking about a tripling in the amount of mortgages that are either in foreclosure, delinquent or in default right now. And this data, which is coming from the FDIC, suggests that lenders didn’t substantially tighten their standards until probably maybe the second half of 2007. So if you’re taking a look at this tracking of loan performance, 95% of mortgages that were bundled into securities by financial institutions and later securitized by Fannie and Freddie, the amount of defaults are

Increasing. So it doesn’t matter whether you’re looking at banks. And if you take a look at Freddie Mac, it reported this week that 1.4% of their 2007 vintage loans purchased are seriously delinquent after 18 months compared to 0.4%. So you’ve almost seen an almost four-fold increase in delinquent loans just at Fannie. If you take a look at money center banks, JP Morgan Chase reporting that losses on their prime mortgages that were securitized and remain on their books – especially jumbo mortgages originated in the second half – are at triple levels than they were from the current year. So, a lot of people are saying the crisis is over, the government is coming in to bail us out. John, we’re not even close to the amount of damage that is still going to be forthcoming.

And if take a look at for example, Washington Mutual, here is one to pay close attention to. Washington Mutual is reporting that over 27% of their subprime mortgages originated in 2007 are at least 30 days past due at the end of the second quarter and that compares with 24 percent of loans originated in 2006. And some 65% of the subprime loans originated in 2007 are going to end up in default compared to 45% of these subprime loans that were originated in 2006. And then you also have jumbo loan problems that are occurring at the same time where you have a lot of the jumbo loans were done with piggy-back loans, meaning that maybe the homeowner put a 20% down payment but then they took out a second. And you’re taking a look at almost 33% of these loans were done with piggy-backs as homeowners stepped up into buying more expensive homes because it was all about the amount of down payment, it was all about the amount of interest rates that were tied to low loans.

So it doesn’t matter whether you’re looking at Wachovia, JP Morgan Chase, Washington Mutual, Fannie and Freddie – I mean the headlines just on Bloomberg on Friday, we’ve got Fannie Mae which said it will not accept new Alt-A loans after December 31st – the mortgages, which make up about 11% of their 3 trillion dollars which was financed by the company, accounted for almost half of their second quarter credit losses. And so this concept or this idea that the mortgages, the rate of defaults – whenever you have a moral hazard you encourage more of the behavior that got you into the moral hazard to begin with. With people thinking that they are going to be bailed out or financial institutions are thinking that they are going to be bailed out and the way the laws are set up right now in terms of banks being unable to go after individuals that walk from the mortgages there are greater incentives to do that. I mean it’s just easier to say, “Look, I’ve got a half million dollar mortgage, my house is worth only 300,000, why am I going to get a second job, work overtime and try to make my payments when I seem to be in a no-win situation here, so it’s better just to wipe the slate clean and just walk away.” And you’re going to see more of that and that means as more people walk away, that brings more homes, condominiums into the market. And when financial institutions take back these loans on the book, the first thing they do is turn around and try to dump the properties on the market at a discount below current market value, and what happens is it brings down prices of not only resales but also brings down the price of new construction. So the financial conditions that are in the industry right now are going to worsen as we go forward here. [42:34]

JOHN: All right, the next subject then is the economy and we’re being told we had economic growth in the second quarter, but I get the feeling you’re probably not buying into that for some reason or another.

JIM: No. I mean if you take a look at the GDP numbers in the second quarter – remember, the way they measure GDP is they take the gross dollars, or what we call the nominal dollars in the production of goods and services, then they back out the inflation rate. And one of the kind of ironic things that we saw in the second quarter, even though the headline inflation numbers were going up at a much, much higher rate where you had headline inflation year-over-year was at 5% – and even those numbers are even questionable the way they measure them. We had headline inflation numbers rising and we had the price deflator used to subtract out inflation to arrive at real GDP falling.

John, I don’t know about you but anywhere I’ve looked in the second quarter, whether it was gasoline, it was my utilities bill, services. We employ a lot of services, not only in our business but around our household – everybody is raising prices, whether it’s the pest control people, the people who do yard work, pool services – everybody is raising prices because energy – anybody who has a service business who has to drive around in a truck, fuel costs are up, wages are up. Everything from benefits are up. And I don’t know anywhere...John, did you see prices come down in the second quarter? [44:07]

JOHN: No, nowhere, as a matter of fact. I will say, I have to admit, gas prices have been drifting down slowly. Not to a large degree but slowly.

JIM: Yeah, but I mean I don’t what you’re paying, we’re still paying $4, over $4.30 for a gallon of gasoline. What are you guys paying in your neck of the woods?

JOHN: Yeah, it’s about 4.05 if you’re close to the freeway, about 3.90 – this is not for premium, what do they call the mid-grade of gasoline? It’s about 3.90 if you move away from the freeway.

JIM: Okay, so you’ve seen – whether it’s gasoline, food costs, you’re seeing the price of goods and services that you pay for on a day-to-day basis – in other words, the cost of living, the things on Main Street, you’re still seeing those prices go up, other than the fact that gasoline has pulled back.

JOHN: Yeah, everything is going up everywhere. And the other thing, you know, you mentioned earlier I think in the first segment, you were talking about earlier what was going on on San Diego Bay, I remember sitting out, we were with friends on their dock on Haven Lake on the 4th of July and usually it’s boat central on the 4th of July on the lakes in the north part of the country here and that was just not the case. Everybody was commenting on it as a matter of fact.

JIM: We’ve been racing in the bay and actually once – let me see, we’ve got one more show to do – I’m going to be racing the final couple of weeks of August. And John, it’s amazing because this is the tourist season in San Diego – I mean San Diego is a very nice place to visit this time of the year. You’ve got pleasant temperatures, you don’t have the humidity as you do on the East coast; and because it’s the height of tourist season it’s amazing when you go out in the bay, not only during the week but also on weekends compared to a year ago, you saw a lot more power boats; I’m talking to just individuals around here in the marina where we’re at right now – we’re at our beach place for the rest of the summer – and it’s amazing just talking to people. You just don’t see the motor boats. Yeah, the sailors are out there because it doesn’t cost anything to use wind, but the big power boats when you’re looking at upper-five dollars now. I filled up a tank in my sailboat – 20 gallons – this was just about a month ago and I paid 6.15 on the bay. Of course, prices were higher; they’ve come down to around 5.75. But still, when you take a look at these power boats and sporting boats, you’re paying 5.75 a gallon, you’re just seeing the kind of activity that we’ve seen.

So, getting back to the economy – and remember, during the second quarter that was when we saw over 200 – I forget what the number was – I think it was between 230 or 240 billion dollars that went back in refund checks back to taxpayers; on top of that you had that 150 billion dollar of rebate checks, and right now we’re seeing the tail end of those rebate checks being spent. So the question going forward is what’s going to drive the economy in the third quarter and the fourth quarter now that the rebate checks have been spent and tax refund checks have been spent. And that’s why I think you’re going to look at weaker numbers going forward. There’s corroborating evidence that we’re seeing that in the unemployment rate. We saw a jump in unemployment claims arise this week, we’re seeing the unemployment rate jump to 5.7%; and they’re anticipating that the unemployment rate will rise to 6% by the end of the year and that means as more people lose their jobs that’s going to also put pressure on people that let’s say had a job and were making their mortgage payments and now they’re put out of work. So if anything, the economy is going to get weaker as we go forward. [47:39]

JOHN: Okay. Next item in this would then be the retail sales. In May and June were theoretically, you know, higher than normal and that was heralded as an important increase. But in reality, how much of that had to do with the stimulus checks that were coming out from the government – part of Bush’s stimulus package?

JIM: Well, that’s when the rebate checks were designed to start hitting in May and yes, we did see an uptick in retail in May and June, but what is interesting is if you look closely at retail sales, okay, what retailers were doing well during that period of time. Well, the discounters – the Wal-Marts, the Sam’s Clubs, the Costcos – and even if you’re looking at Wal-Mart’s sales, if you take a look at where people were spending money, it wasn’t on a lot of consumer discretionary goods. They were spending it on groceries, they were spending it on healthcare. There was some spending on entertainment. But I predict what people are doing now is instead of going out to eat, or the movies, a lot more people are going out to, let’s say, it’s much cheaper to go to a Netflix or a Blockbuster or even buy a DVD where you can buy a regular DVD today for less than what it costs to send two people to the movies today. Even at Costco, they reported almost a 10% gain in sales. If you look at that 10% gain in sales, four percentage points of that 10% gain in sales came from an uptick in higher gas prices.

I mean have you ever pulled into a Costco with a gas station, I mean there are lines as people are trying to cut down or shave 10 to 15 cents off the price of a gallon of gasoline. And so, even at the Costco and the discounters, a lot of the money that’s being spent is being spent on essential goods. And then once again, the increase in sales has a lot to do with higher prices for food, higher prices for gasoline.

If you look at department stores – I love always talking to the merchants and the merchants are saying unless we put the stuff on sale, we can’t get people to buy. One of my friends’ wife – they’re empty-nesters – and she works at a woman’s clothing establishment and she was telling us that one of the assistant store managers has left. Instead of replacing that assistant store manager, they’re going to leave the position vacant, and also her hours of 20 hours have been reduced to 16. And she says, you know, it’s really starting to impact the level of service in the store because you walk into a big department store during the week and there’s one person having to cover two or three departments within a store. John, you get no service.

So I was in a large department store and they had three sections in the men’s clothing. They had a Nautica department, they had a Tony Bahama department and they had Ralph Lauren department, and they had one sale person that had to cover all three of those departments and so there were a number of people who were ringing up things at the Ralph Lauren, and I was in the Tony Bahama section and there was nobody there to wait on me, nobody there at the cash register. So basically I had to take the items that I was buying and stand in a line at the one register over at the Ralph Lauren department.

So there’s cutbacks. If you look at retail sales, they’re on basic necessities. If you look at GDP numbers, GDP is overstated; if you look at the unemployment numbers, the unemployment rate is rising and that’s not going to be good for financial companies, it’s not going to be good for banks, it’s not going to be good for home builders. It’s not going to be good for financial companies in general. [51:20]

JOHN: Well, you know, the market was expecting the Fed to raise interest rates but once again, the question is whether it’s more bark than actually doing anything. I take it you’re not too optimistic about them doing that.

JIM: No. I mean when the dollar was weakening in the month of July, you had a lot of Fed governors –you know, I call them the open-mouth committee – they were talking about we need to raise interest rates sooner. The sooner we can do that the better. You had Plosser and a couple of the Fed governors who were going out and telling – to raise the inflation story. But if you look at what actually happened in the Fed meeting this week, they basically did nothing. Once again, a lot of talk, very little action. And I can tell you, with the unemployment rate at 5.7%, with unemployment claims – even if you look at a moving average of four weeks which is over 400,000 and the trend in unemployment in terms of job losses and rising unemployment – there’s no way they’re going to be raising interest rates. In fact, you even had somebody like Bill Gross that say I doubt with the financial crisis – which many believe now, and there are many such as economists out there like Gary Shilling, Roubini and others that think this gets actually even worse as we get towards the end of the year and into next year – they may not even be raising interest rates then. You had the European central bank making statements that hey, we raised interest rates, we’re done. And so if anything, this worsens as we go forward. [52:44]

JOHN: So finally, when we come to, what, energy or food, there’s a lot talk about demand destruction, but on a global basis it’s really not there.

JIM: Oh I don’t even see it. In fact, the Energy Information Agency just revised their monthly data and revised downward published estimates going back to 2002, with the biggest revisions in 2007 and 2008. And they revised down the production going back. And you have to understand this data that we get in the energy field – I mean nobody has ever audited it, OPEC production, OPEC reserves. And John, if anything, if you take a look at the decline rates that we’re seeing in large producing oil fields, especially the older, mature fields like Cantarell –Cantarell’s oil production dropped by 34% in the month of May – so we’re still seeing increase in depletion and I think that’s a story I don’t think people pay much attention to.

And in terms of demand as we talked in the previous segment, if you look at oil demand globally, oil demand is rising about one percent a year. So when you look at demand destruction, the only demand destruction that you’re seeing is in the developed economies, whose economies are now in recession and if you back out real inflation numbers, the US economy has probably been in a recession since the fourth quarter of last year. Some would argue – like John Williams – it’s been in a recession since the second quarter of 2007. So you had a negative quarter of economic growth in Japan, you’ve had declining economic growth in Europe, you have declining economic growth, despite what the numbers say, in the US. And so that is where you’re seeing a fall back in energy consumption.

As far as the rest of the world is going, you’re seeing an increase in demand for commodities and I anticipate that that’s going to continue. [54:43]

JOHN: Financial Sense Newshour continues at www.financialsense.com, as we look forward to the next part of the Big Picture.

Part 2

Inflation vs. Deflation: Predicting the Outcome

JOHN: I don’t believe this. Some thing’s never go away. It’s like the night of the living dead. Let’s go back to the fall of 2004. Remember the big debate back then, Jim? Is it – I wish we had some echo for this – inflation versus deflation? And you wrote a piece back then, I remember, on The Great Inflation is what it was called as a matter of fact. And boy, you really found yourself in the middle of a buzz saw on the whole thing. But guess what, it turned out to be totally inflationary. Now, here we are, we’re in a pull-back again, a weakening economy and out of nowhere the deflationistas have crawled out of the woodwork. And they’re back.

JIM: You know, when I was looking at this issue, John, back in the fall of the tech market in 2000 and 2002, we had the events of 9/11, a recession in 2001 and we had sub par economic growth as we came out of the recession. We had tax stimulus. Remember the original Bush tax plan where tax rebates – that failed. And then in 2003 we saw a downward revision of headline CPI, down to 1.5%. And everybody was talking about deflation deflation deflation. And I took a look at it and you were seeing falling asset prices, as we saw in the stock market from 2000 to 2002. But remember, as the stock market was deflating we saw the commodities start to rise and the housing bubble inflate in its place. And I think a lot of the confusion that takes place today relates to definitions. Today, the modern definition of inflation is rising prices and the modern definition of deflation is falling prices.

So, if you see, for example, today, as we’ve seen the pull-back in commodity prices, the fall in housing prices, you’ve got the deflationistas are back on the forefront and they’re talking about deflation. And yet, they’re referring to it in terms of prices. And I look at inflation more from an Austrian point of view, and that is, inflation is a monetary phenomenon. So if you take a look at various measures of the money supply, whether you’re looking at the monetary base, MZM, M1, M2, M3 – which we no longer track; or the Mises Institute has begun to publish what they call the true money supply which is unlike the monetary aggregates published by the Federal Reserve. It includes accounts that are money and excludes forms of credit that resemble money but are not – for example, money market mutual funds. And if you take a look at the true money supply, that figure continues to go up and it has been increasing and has been increasing over a period of time. And the other thing that you have to understand – we’re going to get into this in just a moment in terms of what the Fed is doing now – but if you look at the money supply figures, those money supply figures are continuing to increase; and as you increase the supply of money and credit in the system, it’s just a measure of where it goes. Does it go into asset markets, creating an asset inflation as it did in the tech bubble in the late 90s, or real estate or the bond market as it is currently occurring now.

Right now, you've got a lot of money going into the bond market. But there’s an outlet that money goes and when the Fed creates money it can’t control where that money goes. And the expansion of the money supply really takes place through the banking and credit system because, John, if you, for example, deposit monetary at a bank and let’s say you put a thousand dollar check in a bank, it really does not expand the money supply until the bank through the lending process and the fractional reserve system takes your dollar and loans it out to somebody else. And it’s only when loans are made that the expansion of the supply of money and credit increase in the economy. And right now you still have an expanding money supply and you have expanding credit. And the best example can be just this week the latest figures on consumer credit, for example, consumer credit expanded by 14.3 billion in the month of June, to almost 2.6 trillion – it’s highest level since June of 2001; and the June credit growth topped Wall Street’s predictions which suggested only a 6 billion increase. And what is happening is people aren’t being able to tap, let’s say, home equity lines or some of those home equity lines are drying up. They’re turning to credit cards. In fact, consumer credit increased all across; non-revolving credit grew by almost 8.9 billion, to 1.62 trillion. That follows a 1.9 billion rise in May. Revolving credit, which reflects credit card financing, grew by 5.5 billion, to almost 970 billion. That follows a 6.1 billion increase in the month of May, which was originally estimated at 5.7. So right now, revolving credit is growing at an annual rate of roughly 7%, after 7.6% revision in the month of May. So you’re still seeing the money supply increase and you’re still seeing credit increase.

The rate of credit increase has slowed down. Obviously, when banks tighten lending standards, there are a lot of people who are locked out of the credit system. So banks are being more cautious. I have a friend who works in the home equity division of a major bank, and he’s telling me, you know, he’s still processing loans. Now, he’s not processing loans at the rate he was a couple of months ago, with the fallout of a lot of Countrywide and some of the other credit problems that were being created with some of the major lenders. And the only reason that he’s processing a lower amount of loans is the bank that he has worked for has tightened their lending standards; they want to require more money down, they want to require more equity and so they have tightened. But as a result, loans are still being made, the money supply is still growing and that’s why I think there is a lot of confusion here. You know, if I walk into a store and I can buy a plasma TV or a big screen TV at a cheaper price, or a computer at a cheaper price people are calling that deflation when in fact it really isn’t. The price of goods and services are only an outlet for the price of inflation. [7:17]

JOHN: You know, we talk a lot about off-loading the cause of things. It was interesting – Ambrose Evans Pritchard in the Telegraph was talking about this very same thing; where do we lay the blame for this debacle? And he said, you lay it at the feet of the banks and governments for the credit that they’re creating. But politicians can sort of hide behind this, can’t they? In other words, you can actually mask the real reason why things are happening.

JIM: Sure, because if you look and define inflation as rising prices or deflation as falling prices, what in essence you’re doing is detaching the root cause of inflation and you’re looking at the side effects which is an increase in the price of goods and services – whether it’s food or it’s energy. So it’s much easier to talk about, oh, we have food inflation, or energy inflation, or goods inflation, or commodity inflation. What I find rather fascinating is we’ll define inflation as rising prices when it occurs in things like commodities, food, or it occurs like in energy; but when you have asset inflation such as we did in the stock market in the 90s, real estate in this market, notice that we never referred to rising home prices or rising asset prices as inflation because once again, that gets back to what Jens O. Parsson talks about is the good form of inflation, and that’s where I think we’ve got people so mixed up that they don’t really understand – once again, we’re able to offload the cause of inflation onto other extraneous events. Whether it’s rising labor rates say, such as we’re seeing in Germany, or whether it’s rising prices such as we’re seeing at the store or at the gas pump. But the root cause of all of this is a monetary phenomenon and it’s the expansion of money and credit which is behind inflation. [9:15]

JOHN: So as we’re watching it, the money supply continues to expand, and with it the supply of credit – that’s expanding as well – but the real generator of all of this inflation in the United States anyway is the Federal Reserve and I would say the central banks of other countries as well.

JIM: Sure. And you know, if you take a look at the two main tools that the Fed can do, it can inject large amounts of money and credit into the economy through various means, but it mainly does this through injecting reserves into the banking system. But if it does that it runs the risk of leading to hyperinflation because of the multiplier effect in the banking system. In other words, with a fractional reserve system, if the Fed injects a dollar into the banking system, banks can use it to expand credit at ten times the amount. So if reserve requirements for banks remain constant, what would happen is, if they increased the monetary base, they would run the risk of increasing the rate of inflation. Now, you can do it through other measures and I’ll talk about that in a minute. But another method that the Fed does is it’s trying to, let’s say, cajole banks into making loans to businesses by lowering interest rates, creating a spread between long term and short term interest rates for banks to make those loans; and if they do that then you still have the expansion of credit. And what the Fed has chosen to do, what they’re trying to do is – remember, when you have a contraction of credit, if for example, a bank makes a mortgage – let’s say they make a 100,000 loan and let’s say because the price of real estate softens and the value of that property that stands behind the loan has fallen by 20%. Let’s say that the bank made a $100,000 loan on a house that was worth $100,000 – and we’re just using this for an illustration’s sake. If the value of the property drops to 80,000 or 75,000 and the mortgage is 100,000, and somebody walks away from that mortgage –as we talked about in the previous segment – then you run into a real problem here because what happens is now the bank’s equity base begins to contract.

And one of the things that the Fed has done, in order to keep the base of the bank – the monetary base from contracting, the Fed has exchanged Treasuries on its own balance sheet for this toxic debt on the balance sheets of investment banks and money center banks. And what they’re trying to do is if that toxic debt was left on the bank’s balance sheet, you would see most of the financial institutions in the United States – both the money center banks and the investment banks – would have a negative net worth. Just as today, if you take a look at the losses at Fannie and Freddie, they really have a negative net worth because the losses are greater than the equity that Fannie and Freddie has. So what the Fed has been trying to do is they’ve been taking extraordinary measures here to keep the financial system from contracting and real deflation from taking place by swapping debt – and that’s what they’ve been doing for half the Fed’s balance sheet and it’ll probably even be a lot more of that when we get into the third and fourth quarter. So whether it is taking over the debt of Bear Stearns, when the Fed bailed out Bear Stearns in the JP Morgan takeover, what they’re trying to do is take those losses and reduce those reserves from contracting so they have the ability to extend credit elsewhere. So that’s what we’re seeing right now with these facilities – whether it’s the TAF, the TSLF or the PDCF – and what they’re trying to do is prevent deflation from occurring. [13:17]

JOHN: But in the long run it would seem that what the Fed is doing is taking rather extraordinary measures to prevent deflation; at the same time, trying to keep the monetary base from contracting so that loans can keep going to keep the whole game going. But as more and more of these loans go bad, as things turn worse, are they going to be able to keep this game going for very long?

JIM: No, because eventually - you know, we’re very fortunate right now – and this gets back to Peter Warburton’s theory that he wrote in his book Debt and Delusion. When you had central banks monetizing, like the Federal Reserve was doing monetizing a lot of government debt in the 70s, we were looking at 14% inflation rates and commodities were going up, energy had gone from a couple of bucks to 40 dollars, gold hit 850, silver was at 50 dollars. What happened is when Volcker came in and began to raise inflation rates and began to cut back the supply of money, then what we had was a disinflationary period of time. And the advice that was given to central banks to get around inflation – and this is real key in understanding this – if you finance your debt through existing savings – And really, there’s sort of a delusionary effect of what we call ‘savings’ out in the world because all central banks are printing money today – but if you finance it with debt it’s non-inflationary, it’s only when you get down to the final stages of inflation, when a central bank begins to monetize debt – and remember, right now, we have rising prices and so the Fed knows the minute it starts monetizing debt then we get into what we call hyperinflation. We’re not there yet. And what is happening is a good amount of the trade deficit, a good amount of the government’s budget deficit is being financed by foreigners. And because you still have a lot of countries in the world that peg their currencies to the dollar, whether it’s the Gulf States, or it’s countries like China, Hong Kong that are keeping their dollar pegged – in order to keep their currency even or keep that pegged, they have to print money which means they sell their currency and then buy dollars. And that is some of what why the US has been able to avoid monetization because we’re importing between 3- and 4 billion dollars a day into this country – foreign capital that comes in and refinances our debt.

And so in a way you have foreigners monetizing a good portion of the US debt, and the real thing to keep your eyes on – and we’ll get into this maybe next week when we talk about what’s happening with the trade deficit and what is happening to foreign dollars because remember, just in energy alone we’re transferring over 700 billion to OPEC countries; we’re transferring a lot of money to Asian producers – take a look at what you see on the shelf and where it’s made. You know, when I was in the department stores this week, I mean the labels on anything I was looking at, it was not made here, it was made overseas. So right now the US is fortunate in the sense that you’ve got foreigners doing the Fed’s job of monetizing a good portion of the debt, and so what has happened here is the Fed has been able to avoid the ultimate problem it is going to end up facing is when foreigners start reducing their demand for dollars – and we’re going to get into this next – and that relates to the stages of inflation when velocity starts to increase; that is what you need to keep your eye on because it’s already the velocity of foreigner dollars is starting to increase because the demand for dollars is declining and that’s where I want to go next because I think that’s important to explain in understanding this inflation/deflation debate. [17:28]

CONGRESSMAN: It appears to me that if one of these highly interconnected investment banks were to fail in the near future that the Fed’s balance sheet then has limited or no room left on it. Coupled with there being no legislative framework in place going into this, would the Fed in essence have to monetize the situation to bail them out? Would the Fed have to deal with new Treasury paper to bail out the bond holders, which is what really occurred with the Bear Stearns situation, if another situation came?

So, my question to you are three. Can you assure us – and I think I know the answer to this question – but can you assure us that you will not conduct any similar Bear Stearns transaction if another investment bank or GSE gets in trouble without the prior explicit authorization of Congress via some sort of enabling legislation?

Two, if you decide that there is no alternative to conduct another bailout or support – however you want to call it – to one of these troubled organizations, will you be willing to monetize the debt to finance such a transaction due to the current limitations on your balance sheet.

And thirdly, on your claim that the – your actions with the Bear Stearns transactions are granted to you under Section 13 of the Federal Reserve Act, are there any limitations within that section or elsewhere as to your abilities, subject going forward to deal with these situations?

BERNANKE: Let me try to address those range of questions. Over the weekend when we were working on the Bear Stearns issue, I was in touch with congressional leaders, kept them informed, and the sense I got was that you know, there was not an objection to pursuing it. I also of course worked very closely with the Treasury and with the SEC and other authorities to develop a consensus for the actions we took. And as I’ve argued before I think they were necessary. So you know, I don’t want to make any commitments. I don’t think a situation like this is at all likely. But unless I hear from Congress that I should not be responding to a crisis situation, I think it’s a long-standing role of the central bank to use its lender of last resort facilities to address…

CONGRESSMAN: So the first answer is yes. So the second question then is would you potentially monetize the situation with the balance sheet.

BERNANKE: There is no monetization. This is a sterilized operation, there is no effect on the money supply. And in addition, I would add that our lending, not only to this Bear Stearns issue but more generally to our – to the banks and so on, is not only collateralized with good haircuts, it’s also recoursed to the banks themselves. We have not lost a penny on any of this lending, and it is just lending, we’re not purchasing any of it, it goes back to the bank when the term of the loan is over. [20:07]

JOHN: Well, basically when the demand for money begins to fall, that’s when you see velocity of money increase and what causes that? What are the dynamics of this because when you talk about the velocity of money people don’t always understand what that means.

JIM: Well, velocity of money means the turnover of money in the economy, and the Austrian school has talked about this when it comes to the various stages of inflation. In fact, Mises talked about this in his book Money and Credit. And in the first stage of inflation what happens is prices are rising slower than the supply of money, and what happens is people restrict their spending, they’re waiting for prices to fall and this has the same effect as taking money out of circulation. And you have that right now because you know, you’re seeing this in the stores. A lot of the merchants when I was talking to a lot of the people in the stores this week, they were saying, “you know what, unless we put things on sale, you know, we can’t get people out to buy goods.” And so you have a lot of people right now, especially the consumer that is saying, “all right, I’ll keep and hold my dollars and I will wait for prices to go lower.”

In other words, when the fall merchandise comes out I’m not going to pay full retail price for it, I’ll hold my dollars because I know that if I wait the price of those goods will come back because the economy is weakening – and this is certainly what we’re seeing at the retail level. So, you know, in the first stage, people don’t recognize that real inflation. You’ve got a lot of confusion about the core rate of inflation, you’ve got stories out in the press about real deflation. It’s not until people wake up and discover – and remember, John, if you take the inflation story – when the US economy began to slow down in the second quarter of 2007, what was the Fed telling you, what were the financial pundits telling you? “Well, with the economy slowing down, you’re going to see inflation is a lagging effect, and we’re going to see lower rates of inflation because as the economy slows, there will be less demand for goods and services and therefore prices will come down.” We’ve been hearing this story since probably the second quarter of last year. And so a lot of people right now are confused by the root cause of inflation. So you hear, well, we have food inflation, we have energy inflation.

You don’t have anybody talking about the root cause of inflation which is the expansion of money and credit. So right now people are in what I call Stage One recognition of inflation, and what has happened – and this is what Mises talked about in his book money and Credit where he said: The ignorance of the public towards the political cause of inflation is the indispensable basis of the inflation policy. Inflation works as long as the average person thinks I need, let’s say, a new good to buy. Let’s say I want to buy a new refrigerator or washing machine, but the prices are too high today, I’ll wait to buy because I know they’ll mark them down. And that’s what you’re seeing at the retail level right now. [23:22]

JOHN: All right. So when we get to Stage Two and the guy on the street begins to figure out, hey, something’s wrong, I’ve been hoodwinked, what’s his response and where does it go from there?

JIM: Well, you know, in Stage Two, people begin to discover that inflation is going to continue, and that’s when you start seeing the rise in prices and prices really start to rise at a much, much faster rate. This is a critical stage when the average person on the street begins to change the way they think. At this stage you see a psychological change that occurs and people say “wait a minute, that refrigerator, the washing machine – whatever I was going to buy – I better buy it now because if I wait, the price will actually go up and will be much higher down the road.” Remember the inflationary expectations? – a gauge that the Federal Reserve uses – that’s the gauge that you need to watch and that’s what the Fed pays attention to because that’s what I call the “I keep them fooled” gauge of inflation. When people begin to go to Stage Two, in other words, when inflationary expectations begin to rise that’s when you have a real problem for the Federal Reserve because then people are saying, “Wait a minute, I don’t want to keep this money and hold onto it because prices are not going to go down, they’re actually going to go up.”

And that’s where you have the real danger because now we’re at the second stage of inflation and then eventually you get to what I call the third and final stage of inflation where you actually have the end-game of inflation, and that’s where you have the guy on the street says, “You know what, I’m going to buy something I really don’t need and the reason I’m going to buy it is because money is losing its value.” It’s what we saw in Germany in the 20s where you had people buying just any kind of tangible good in the hope that the price of inflation or whatever you were buying would maintain its value because the value of paper is depreciating.

Now, if we look at this from a larger perspective – from a global perspective – money is depreciating at a global level. The dollar is losing its value against real goods such as commodities or gold. The euro is losing its value against real money such as gold. And that is what is happening. It makes it a little bit more difficult for people because it’s not like Germany in the 20s where you had the German Reichsmark at that time losing its value, or currencies elsewhere were actually increasing in value because Germany was experiencing inflation where the rest of the world in 1929 and 21 was experiencing deflation. In other words, there was a contraction in the supply of money, governments reversed their monetary policy, the price of goods (and especially commodities) began to contract, the money supply began to contract as Europe, England, the United States experienced a recession – or actually, a depression in 1920 and 21, where Europe at that time was experiencing a recession, but Germany was experiencing an economic boom as it expanded its supply of money. And so the final stage of inflation was not experienced in Germany until 1923 when all Reichsmarks came back into the country and you witnessed the terminal stage. So we’re not there.

We’re in Stage One right now, in the first phase of inflation in the United States. Although, I think you’re seeing a second stage of inflation occur globally. In other words, as these excess dollars are accumulated in oil-producing regions of the world where they’re taking in over a trillion dollars for the price of oil, or you have sovereign funds which are taking in hundreds of billions of dollars because of trade, what you’re seeing now is the second stage as the holders of those dollars overseas begin to buy real goods. And you’re seeing it from foreigners buying goods in this country. They’re buying companies, properties. And as foreigners get out of dollars and start buying tangible goods in many ways – and you’re seeing this reflected in the rise of sovereign wealth funds where they’re buying tangible resources around the globe, whether you’re seeing Chinese companies buy oil sands deposits, they’re buying natural resource companies, they’re investing in other natural resources. You have companies buying US companies. Ford sold off its Jaguar division and you have a British hedge fund bidding for railroad companies. So foreigners are in Stage Two – in other words, they’re divesting themselves for dollars and looking to buy tangible goods, but in the United States we’re still in the first phase of inflation here. [23:33]

JOHN: So if we look at all of these cycles that we go through periodically, some people link them inevitably or inescapably to the capitalist system, though I’m not really convinced of that, Jim. I think if we didn’t have inflation you might not have the boom-and-bust cycles – at least not as radical as you would. But we have boom-bust and bear-bull and given all of that we don’t really see deflation here at this stage, do we?

JIM: No, and this was an argument that I made back in the fall of 2004 where the deflationistas were out in full force, and you had a period of time where you had a declining CPI. But if you take the definition used by the financial pundits, used by let’s say the press corp and people in Washington, which is inflation is defined as rising prices, deflation is falling prices. If you go back over the last probably 60 years, we have had a rising inflation rate every single year. In other words, we’ve experienced inflation as measured by the CPI. We have had inflation during periods of war, we have had inflation during periods of peace, we have had inflation in a booming economy, we have had inflation in a contracting economy during a recession. We’ve had inflation in periods of rising asset markets, bull markets in stocks; we’ve had inflation during declining periods in the stock market. We’ve had inflation when the unemployment rate was falling; we’ve had inflation during the period of rising unemployment such as we’re experiencing today. So here we have – we are a country at war. Just take a look at what we’re doing in Iraq and Afghanistan and other parts of the world; we have an economy that in a real sense is contracting; you have a market right now that’s going up because oil prices are going down, but you have rising unemployment. We have had inflation in good times and bad times and that’s because the root cause of inflation has and always will continue to be a monetary phenomenon. And as long as you have a rising supply of money and credit in the system and you have a Federal Reserve system that is preventing the contraction of credit by taking on debt onto its own balance sheet by exchanging its supply of Treasuries for toxic debt on the balance sheets of these money center banks and investment banks, you will have inflation.

The only thing that we have not seen yet is the third stage of inflation; and here in the United States we’re still in phase one of this inflationary process. So, yes, I expect rising inflation rates as we head into the fall and into next year, as we go through one financial crisis after another. And I’ll tell you another financial crisis we haven’t even confronted yet and nobody is really talking about is what’s going to happen to credit default swaps – that is bond insurance that has been written on corporate bonds. That market is somewhere, I think, depending on which figures, somewhere like 50 or 60 trillion dollars and that’s the next crisis to unfold. And remember, as the unemployment continues to rise then you’re going to see more defaults take place. So, John, no, I expect inflation. Not deflation. [32:06]

JOHN: Financial Sense Newshour at www.financialsense.com.

Running Out of Water

JOHN: In all of the discussion about peak oil, one of the things that many, many people are not even thinking about – although there is adequate information coming out upon it – is peak water; that the world is generally running out of available potable water. So the water isn’t there. Let’s face it, the oceans are full of water – but rather, that getting the water from where it is to where it is needed is the core issue. The estimates we have, on present growth trends, is that by 2050 the world population will be at 9 ½ billion people, but the water again is not where it’s going to be needed. And ironically, a lot of the shortages are turning up in river basins. I mean look at the whole issue of say for example the Jordan River which starts at the Sea of Genneseret or the Sea of Galilee, as it’s called, and runs down to the Dead Sea and all of the people who are trying to use that water; or the Euphrates which is starting in Turkey and running down through other parts of the Middle East and down through Iraq right now. All of these rivers – the Tigris, the Euphrates, the Ganges in India, the Yellow River in China – they’re all facing a water issue; and of course, that begins the fight over water rights as well.

And there’s a saying that says that water runs downhill. Duh. But in actuality it runs uphill to money – meaning those people who can afford to put in the infrastructure to deliver the water to themselves are the ones who tend to get it first, at the expense of everybody else. And that you can see becoming a source of international tension, as much as the oil crisis that we’re facing right now. The large demand for food and energy and water is growing population.

JIM: It was interesting – I was in the grocery store picking up some goods and on the shelf – this is a store kind of similar to what we know as Whole Foods – organic food and et cetera – and on the register right in front of the counter was a copy of the current (August) issue of Scientific American and the front cover of it was called Running out of Water: A Six Point Plan to Avert A Global Crisis. And what was rather interesting – I thought the job they did on water was very well done. And they begin the story in a neighborhood in New Delhi where a blare of a megaphone comes over and announces that fresh water will be available for the next hour. And they talk about one of these residents rushing to fill the bath tub and other receptacles to last the entire day. And this is in New Delhi’s – which is a pretty good-size city, but there are just a series of endemic shortfalls that are occurring largely because water managers decided years ago to divert large amounts from upstream rivers and reservoirs to irrigate crops. And what is a key concept that they talk about here, it’s like anything else, John, whether we’re talking about energy, as you mentioned food and related is water, the world’s growing populations – I mean as the population base increases you need more water for drinking, for hygiene, for sanitation, for the production of food, and also the production of goods – it’s used in industry. And what is amazing here is that we have allowed – or the politicians have allowed irrigation water to be shifted away from let’s say farming operations to cities and suburbs while permitting recycled waste water to be employed for landscaping and other non-potable applications.

And as they were talking about here, this is where we’re at right now.

According to Scientific American one out of six people, more than a billion, suffer from inadequate access to safe fresh-water. And the United Nations in a report - in fact, I read this a couple of years ago and we did a story on it and it was a lengthy book that was published by the United Nations as they took a look at water globally – by 2025, they’re talking about half of the countries across the globe will undergo either stress, where when people demand more water, and they won’t be able to get it due either to the water supply will not be considered clean enough (one of the problems that they’re running into in China right now because of industrial pollution) to outright shortages. So by mid-century as much as three-quarters of the earth’s population could face some kind of scarcity of freshwater as the world’s population continues to expand and especially as it rise more rapidly in the developing world where you have the largest increase in the population base.

and it’s amazing that you look at some of these statistics and it’s fascinating in terms of what we’ve seen in the last 30 to 40 years, John, where we have – and you’re more knowledgeable on this – I wonder if you might talk about the decadal oscillator – the 70-year cycle where we saw for example, I think it was in 1965 where went to a cooling trend. and as a result you saw a migration from the Midwest and the eastern coast of the United States to the western side of the United States. I mean, what is it, California has 11% of the country’s population now. You have a huge influx of migration into areas that are pretty arid and lack sufficient supply of water such as for example, New Mexico, Arizona, Las Vegas, and even some parts of Colorado; but you’ve seen a population shift in the United States. Now, beginning in 95, the decadal oscillator moved into a warming cycle and we’re experiencing drought all over the country right now. [38:31]

JOHN: As we said earlier here in the segment, Jim, it’s not the issue that there isn’t enough water on the earth. I mean if we took – got rid of the seawater, which you say well, you have to convert that to freshwater. Just on the surface of the earth, 110,000 cubic kilometers of precipitation falls annually onto the earth’s surface; and that’s freshwater, it’s potable and directly usable. The problem is even though that’s enough to fulfill the requirements for every man, woman and child on the planet, quite frequently a lot of that is directly accessible. And then even if you could collect it in one part, you can’t get it to somewhere else where somebody else needs it, look at the desert regions of the world.

JIM: Yeah. And I’m quoting here from Scientific American where they talk about roughly about 56% of the total precipitation flows through into landscape. They call this greenwater. It’s about 61% and it’s absorbed by soil, plants and then it’s released back into the air but it’s unavailable for withdrawal. Then the other roughly – we’ll round this off to 39% is called bluewater and that’s collected in rivers, lakes, wetlands, groundwater and that’s available for withdrawal before it evaporates or reaches the ocean. The problem is more than half of the precipitation that falls on land is never available for capture or storage because it evaporates from the ground or transpires from plants. And this fraction is what the scientists call greenwater. The remainder is channeled into what we call bluewater. It goes into areas like lakes, rivers and then our aquifers.

And then if you take a look at the part that humans use roughly about 5.1% is used crops, livestock, farm irrigation, about 1.4% is used by people, then we have a little over another one percent that’s evaporated in open water. So the average human being on an annual basis uses about 1,000 cubic meters of water per year; that’s for drinking, that’s for hygiene and that’s for growing food. And I don’t have the statistics in front of me, but in another article that was done in another magazine where they talked about how much water is used in the production of, for example, cattle. When you think of all the grain that you feed cattle, think of all the water that goes into producing that grain. It’s incredible in terms of the amount of water usage that we use each year.

And the problem with – as they talk about in this article is that the way that we manage water we’re doing it inefficiently and there’s a lot of water but it doesn’t necessarily exist where people live. And you’ve got a huge population center in the United States right now that lives on the west coast or in places like Las Vegas and Arizona where they don’t have ample supplies of water, and what is happening is the aquifers are dropping. In fact, in this article in the Scientific American they had a picture of the Colorado River, and also about Lake Mead, and you can just see where the water tables keep dropping. In fact, they’re saying that you could have actually hydroelectric problems in the next couple of years if the water tables keep dropping, in the same way that they’re are doing today.

And they have a number of suggestions, but just like in the conservation of energy, it’s going to be conservation of water and it’s one of the things that we’re not used to facing in the industrial world. I mean you get up in the morning, you open the tap, you fill the coffee pot with water, you expect water to run out of the tap. When you go to take a shower you expect the water to flow out of the shower head. If you have a lawn, a plant, you expect your sprinklers to go on, your water to be there. And just like the same thing with energy or when it comes to food, you expect to go to the store and you expect to see the shelves on the supermarket filled with food. And I think what we’re going to see as we go into the next decade is this huge paradigm shift – whether it comes to energy, whether it comes to food, whether it comes to water – is you’re going to have to see great efforts at conservation and redirecting the way we manage our scarce resources because we’re going to find that they’re not as plentiful as we thought they were. [43:01]

JOHN: If you look forward to the future, and I know you just talked about this in your client newsletter in an article called The Age of Scarcity, we really are coming through that paradigm change whereby things will become more scarce, and that is not necessarily directly an economic factor; is it? In other words, it actually ties to the physical availability of things. Sometimes you and I have talked about the fact here on the program that economists tend to look at – what would you call it – static world issues such as, “Well, okay, if there is increased demand then we just go increase supply.” You may not be able to do that all the time, there may be some physical limitations to that.

JIM: Yeah, they look at when it comes to resources like widgets, the higher the price, well, you get more widgets that are produced. But when you have a scarce resource like oil or water, you know what, higher prices don’t necessarily mean that you’ll get more of it. And it was amazing because they talked about a number of issues and like the area of energy, right at the top of the list, they’re saying, you know what, when people don’t have to pay for a resource they tend to waste more, so a lot of municipalities need to start charging more for water because freshwater in the US and other countries is priced so low that users have little incentive to save it. In other words, people don’t have the incentive to turn down the tap and conserve water and use it sparingly because the price is so low. So higher prices would promote conservation. So that’s one of the fixes that they talk about.

Another one they talked about is changing the way that we use water in irrigation. In other words, most of the water that is consumed by humans is used in the production of food. And so if they could change farm irrigation to conserve, a 10% drop in irrigation water would save more than enough used by all consumers in you know, whether it’s drinking water. Also, they talked about plugging the leaks in irrigation water delivery systems; and then instead of you know, when we get this run-off from precipitation instead of collecting them in areas like dams where there’s a good chance a good portion of it evaporating, they’re talking about building underground water storage centers where the water would be stored during the months, let’s say, during the rainy season and you would have less problems with evaporation; and then also changing farming going more towards drip irrigation and modifying crops that, let’s say, could withstand less moisture and require less watering. And this is something that we’re going to have to do besides desalination.

And it’s amazing if you talk about investment opportunities. They were just adding up here the amount of money that is going to have to be spent. The consulting firm Booz, Allen and Hamilton has projected that the US and Canada alone will need to spend 3.6 trillion dollars on their water system over the next 25 years. And just going down – in the next 25 years, Asia will have to spend 9 trillion dollars; Latin America, 5 trillion; 4 ½ trillion in Europe; 3.6 trillion in the US and Canada; a ¼ trillion in Africa and ¼ trillion in the Middle East. [46:18]

JOHN: In the Scientific American article, one of the concepts they talk about is ‘virtual water.’ Now, that probably doesn’t do much good if you’re virtually thirsty, but what are they talking about there?

JIM: Well, what they’re talking about virtual water is a concept – it’s the amount of water that you use to produce food or any other product which is embedded in the production of that product. So, for example, a kilogram of wheat for instance takes 1,000 liters of water to make, so each kilogram contains a certain portion of water in that quantity. And what they’re talking about here is virtual water is exporting trade shipments of wheat to let’s say an arid country means that that arid country would need to use less of its own limited water supply to produce things that require a lot of water. So that’s what they call virtual water. They’re talking about the content of those goods. If you’re in an area like, let’s say, the desert that doesn’t have much water, it doesn’t make a lot of sense that you’d use a lot of your water to produce wheat or some kind of crop that requires a lot of water usage when there are places in the Midwest or Canada or other regions where there’s lots of rain that falls, where they have the water that you produce the goods there. Therefore in arid climates and in desert-type climates where you have limited water supply you could use the water for human consumption. So that’s what they call the concept of virtual water.

The other thing they talked about is adopting low water sanitation methods and it was rather interesting, they talked about a city in Stockholm – and this is where – whether it comes to water conservation or energy conservation, the Europeans are so far ahead of the United States. In one of these areas – this is a city in Sweden – they used what is called low-water toilets, and the residents of a particular housing project, the system separates excrement from urine which is used as liquid farm fertilizer, and the remainder is recycled into fertilizer by a microorganism in a compost bin. And so here you are, you are taking human waste and turning it into fertilizer and it’s just amazing what they’ve been able to do that, and you’re talking about a time today where a lot of fertilizer comes from you know, potash and natural gas. Also, they talk about the technology that we’re using in advanced desalination technology. And I think sooner or later, that’s what we’re going to have to use in California here because we’re so dependent on a lot of our lakes in northern California. Once again, where the water – where we get the precipitation isn’t where a lot of the people live. Most of the population in California is in the southern part of the state; most of the water is in the northern part of the state, and so eventually we’ve been drawing water – I mean I think LA has to go two or three hundred miles to get its freshwater, and so eventually we’re going to have to go to desalination plants.

But the important point here is if you add the numbers, nearly 25 trillion dollars are going to have to be spent on water systems, irrigation systems, sanitation systems, farming systems and technology to make sure we have adequate water, or otherwise we’re going to run into the problem that the United Nations talks about, that by the year 2025, where you’ll have half the countries in this world will be facing severe water shortages and by mid-century, nearly three-quarters of the earth’s population could face scarcities of freshwater. [50:00]

JOHN: Well given the fact that water is going to become more and more critical, obviously the investment in infrastructure for water worldwide will become an ever growing area for investment. We’re going to talk about that coming up very shortly and basically what are we going to do with a lot of the information we’ve passed here on the program today.

And we’ll come back with that in just a second, when we discuss, well, what to do now.

This is the Financial Sense Newshour at www.financialsense.com.

What to Do Now

JOHN: Well, Jim, this is one of those “funny you should mention” moments because my statement came from a thing called PFS Group today. You may be familiar with that organization and actually I have been a client of yours for, how long now, anyway? Eight years, nine years? Something like that. I can’t remember how long it was. And I’ve steered family members in; and one of the typical things that we hear come back at us, say, for example, when there’s a time that markets are all in chaos and people will look and say, “well, the balance here has dropped on assets.” And I had a family member call up one time and go, “oh my gosh, look at this whole thing. It’s from Puplava – it’s dropped this much. We’ve got to get our money out of there.” And I said, “whoa, stop! Time out.” I said, “first of all, stop listening to the tube.” That was the first thing that I told them.

The second thing was, Jim is always buying when things pull-back. So you’re going to see that happen. We were just talking about that here during the station break as a matter of fact. And that’s the way you do it. When things pull-back that’s when you jump in. So you’re going to see things dip, and then go up again. So don’t freak out, go somewhere else, go to the movies tonight, go see Batman or something, but for Pete’s sake stop freaking out every time your statement comes to the door. Just give it a month or two and watch what happens. And typically, if they do that, they’re a lot happier when they’re done, which is talking about the whole philosophy we have here for investing that you buy when there are pull-backs. Back up the truck and do what you need to do.

It’s also part of that concept you spoke about last week and this week, and this is keeping your head when everybody else is running around yelling the sky is falling. You have to ask yourself when you get into trouble or when you think things are dipping and the world’s coming to an end, is there anything in the fundamentals that has really basically changed. Has anything changed? If not, you better hold the course because there is no reason to change the course. [52:45]

JIM: It’s amazing that we’ve been doing this show, John, for seven years, and in that seven year period we have seen the price of oil go up every single year. We have seen the price of gold go up every single year, we’ve seen the price of silver go up every single year. And it’s always amazing, whenever you see sharp run-ups – whether we saw the sharp run-up in metals up until 2004, and especially the run-up in energy to 2004, and you get these pull-backs and all of a sudden you’ve got people “this is over, people are losing money” and the price goes down.

And it’s almost like the attention span of a child where everybody is so short-term focused; you know, “what’s the price of the market today, what’s the price of the market next week,” and they never look at a long term picture. And that’s one of the things that one of my mentors taught me earlier in this decade – and I don’t pretend to be a technician, but one of the things that I do do is I look at long term charts because I’m more interested in a long term chart than I am a short term chart. You know, I could care less what the market does today, what it does next week, or what it does next month. I’m more interested in where it’s going to be three years from now, five years from now and what are the fundamentals that are driving that long term chart.

And John, gosh, I mean you’re hearing the same rotation and why these people have these people have any credibility is beyond me. When oil went from $20 to almost $40 during the second Gulf War, people were saying, well, oil is only going up because of the war premium, there’s instability in the Middle East, the US was in a short term war, and then after the war was declared over or at least the battle was, and the price of oil went from $40 down to $30 and everybody was saying, okay, it’s going down to $20. And I remember right at about that time I had Jim Rogers on the program and he had just written his first book after his three-year tour around the globe, and he was talking about I will never – and I still remember – in fact, John, we are going to have to get that clip and find it. I believe it was in the 2002, or 2003 archives when he came back about his book and he said you will never, ever, see 25 dollar oil again in your lifetime. And I remember the hate-emails we got, “I can’t believe you had this idiot on your program.” And he was telling people to buy commodities. He was saying, “buy commodities now.”

He started the Rogers Raw Materials Fund and people were laughing at him and saying, “what an idiot. Get the idiot off the program,” because people wanted to hear: Is it time to go in and buy tech stocks. And then we had the war was over and then the price of oil went back up and we began another upward spike in oil, where oil prices got up to 50; and when they got up to 50 they pulled back into the low 40s and then they began to tell us, well, it wasn’t going back in the 20s, but we’ll definitely see oil in the 30s because in 2004 the Fed began to raise interest rates and they said, “well, with the Fed raising interest rates, the economic growth in the country was going to slow down and therefore the demand for energy would slow down and the price of oil would go down.” Well, guess what? It didn’t. And then we got to 2005, the price of energy went from 50 to over 70. They were going crazy. They had investigations in the month of October and Congress brought the oil companies, charged them with price gouging – they never found anything. And when the price hit 70 it pulled back after a sharp run up and then we had all the experts telliing everybody why the price of oil was going to go back into the 40s. And then we had another sharp run-up in the price of oil, it got up to the upper-70s and 80s, and then it was in the 70s and then it pulled back again as it did in late December and January of 2007 because we had warm temperatures, and what were they telling us? Oil got down to 50 dollars a barrel and they were screaming the price of oil is going down, it’s going back down to 40 and what happened? At the end of the year, we ended up with oil prices over 90. So we began this year with oil in the low 90s and today it’s close to 114, 115, after hitting my price targets of 145. The same story keeps regurgitating. It keeps coming out in the media and you’ll have experts who’ll tell you: The price of oil is going down to 75, the price of oil is going down to 80 dollars; and I don’t care if it’s people like Daniel Yergin at CERA saying that we’ve got more oil up the Kazoo and we’re going to have a glut of oil, well, you know what, it’s not showing up in the statistics; the inventory levels of energy in this country are declining, the natural gas build up going into the winter is behind schedule.

And it’s amazing, but people have such short term memories that all they focus on is this constant barrage of noise and nonsense that is echoed by illiterates in the financial world, like what do we have coming out, we have “it’s a bubble,” “it’s burst,” “it’s going lower,” “we’ve got deflation.” We’ve got all these other stories. And I don’t need to tell anybody listening to this program of what they’re seeing in their day-to-day cost of living expenses, and yet the same idiots trot out the same stuff that they talk about just because the price pulls back. [58:32]

JOHN: This argument if you notice, Jim, resurfaces all the time. It comes back up. It’s the same argument. They make it about oil. The talkies make it about gold. But this is very common because there are times – you know, the summer doldrums, whatever you want to call them when suddenly there’s a weak demand and that happens both in the gold market and also in the oil market and so this is very, very common. This doesn’t mean any significant change in the fundamentals or the direction of everything.

JIM: No, but every time there’s a pull-back, and once again going back to something we talked about in the first hour, blood in the streets, you have these pull-backs and because of the markets are leveraged and especially in the commodity markets where in the futures market you’re leveraged – if you don’t borrow money just going into a futures contract, you’re leveraged 10 to 1, and if you’re borrowing money you’re leveraged even more than that. The average hedge fund is probably 20-to-1, some are even 30-to-1; and so it is not unusual. But you notice what happens, and then they seem so perplexed when the price of energy goes right back up, when the price goes right back up, and the thing that I think that is most important and one of the things that we try to do is always talk about fundamentals here because fundamentals are what drives long term charts, whether you’re talking about stocks, whether you’re talking about commodities. If people would only look at a long term chart, I think they would be much, much better off. I mean I can’t believe the kinds of values that are out there. I don’t care if you’re looking at the energy sector where you can buy a lot of these companies at four and five times cash flow, and most of Wall Street still doesn’t recognize this; earnings yields of 20%; and also in the area of the gold sector, there are a couple of companies I was buying this week. One company they almost have 25% of the price of the stock they have that in cash, and if you back out the 25% that’s in cash, you take a look at what the rest of the company is worth, they’re going to have nearly one million ounces of a resource coming here on the way to 2 million ounces, and that company, if you take a look at its mining operation, you’re buying one million ounces of resources for close to 28 dollars an ounce; and then on top of that they have a mine that’s going into production here in the next 12 months which they are going to be sharing with another company and they’re going to be getting 10 million dollars a year in cashflow which is equal to one-third of the value of the market cap of the stock if you back out the cash. And it was funny because I was in there trying to buy and you see this where they go in there, they’re trying to drive the price down and somebody had some offers there so I said, okay, let’s test this guy and see if this is a real offer. And within a second I took out all of the offers and the next thing I know, the offers disappeared and then at a much higher price. And of course, I withdrew my offer because I know what they’re going to do; they’re going to wait until a weakness comes in and then they’ll start driving the price down lower and then what I’ll do is I’ll sit there with my bid and I’ll pick up shares. But you know, I’m going to buy a million shares of this company, and it’s amazing that these kind of values – whether you’re looking at the junior mining companies, the up-and-coming producers, you’re looking at natural gas producers, companies that are growing their production, or oil companies, you’ve never had better bargains. So you’re right, John, during this period of time we’re buying and we’ll continue to buy. [1:02:18]

JOHN: Well, when we are in these periods of pull-backs and first of all, you’re not panicking, but in actuality using these pull-backs as an opportunity to pick up stocks or whatever it is we’re investing in in that particular period of time. Is there anything in particular you look for, the markers that you know you’re pretty well where you want to be?

JIM: Well, there’s two sectors that I’ve been looking to pick up and add to and one of them is water – we just got done in the previous segment talking about running out of water. A lot of the water stocks got overpriced so we’re looking to pick up more water companies. And then I think another area is agriculture because if you take a look at – I don’t care if you look at this year’s corn crop which got planted late, and then if you’re also talking about some of the disappearance of the sunspots we could get an early frost this fall which could damage the corn crop; and the supply of grains around the globe are at 50 year lows. We haven’t seen grain levels or storage levels this low since you’d probably have to go back to 1960. So we’re looking to pick up some stocks in the agricultural sector; we’ve been waiting. Some of these stocks got overpriced and we’re going to be adding not only our food stocks; we’re also taking a look at once again metals, and the precious metals stocks because once again just as I predicted 125 oil, 145 oil, when we get to December 31st if you and I were going to have this show we’d be looking back – I do believe that the hard outer shell of the Oreo is going to unfold. Actually, it’s going to get much worse from what I’ve seen some of the economic statistics unfold.

But anyway, we’ll be looking at higher energy prices. And if I’m wrong – let’s say that all this noise that you hear on Bubblevision that oil does go down to 75 and 80 dollars a barrel, then you better start saying your prayers because it’ll mean the world has gone into a global depression; and for the life of me I just don’t see that happening – not right now. [1:04:18]

JOHN: All right. Let’s take it now from the point of view of an individual investor. What are they going to do?

JIM: Well, first of all you have to understand what drives volatility. Part of it is leverage, which we talked about on one of the earlier segments and so one of the things you might want to do is if you want to be in the energy sector you want less volatility, you might want to look at the larger energy stocks that pay a good healthy dividend where you can get a 2 ½, 3, maybe 3 ½ percent dividend; and they tend to be less volatile than let’s say some of the smaller or mid-tier companies. So at least while you’re going through a correction, you can collect the dividend and that’s something that’s bankable; you can take that dividend, you can cash the check, you can use it to live on. More importantly with energy prices where they are today, you’re seeing tremendous increases in dividends in these companies. So, if you’re risk adverse then what you do is you go into the higher dividend paying stocks; if you want to go into the water sector you might to go into the higher paying water utilities that pay a higher dividend, so you’re going to have something that keeps the stock a little bit more balanced and you have less volatility. So that’s one thing that you can do.

Or if you want to get into alternative energy and infrastructure – a lot of these infrastructure companies, many of them are paying good dividends now that are close to 4%. So at least, while you’re waiting for stock prices to improve in this sector, especially with the amount of money that’s going to have to be spent on infrastructure, not only just water but the energy infrastructure. And John, If you want a real opportunity here one is going to be in the energy infrastructure space because this country the tide is shifting. It’s moving away. 80 percent of Americans want to see domestic drilling, they want to see the United States become less dependent on foreign oil and they want to see these jobs created here. So anything that has to do with increasing the capacity of domestic energy, whether it’s natural gas, whether it’s shale oil, whether it’s deep-water oil, whether it’s pipelines, whether it’s anything that’s going to produce energy, building power plants – anything in that kind of infrastructure space is going to do very well because the tide is starting to shift. [1:06:44]

JOHN: And just as we predicted by the way, you can even see that tide begin to shift among the politicians. Remember when we were predicting this 18 months ago? First of all we said there would be a resistance to the reality of the situation, but even now Senator Obama, if you’ve noticed, is beginning to shift his position because the exigencies of reality are going to win out ultimately over almost any other considerations.

JIM: And as Matt Simmons was talking about what also you’re going to see, and one of the bright spots in the American economy right now is exports out of the United States. The United States is becoming more competitive. You’ve got a lot of foreign companies that are relocating their plants to the US, and you’re going to see a bit of reverse globalization as it becomes too expensive. Jeff Rubin did an article on this – probably one of the most astute economists out there because he gets the peak oil and he was talking about these cargo containers where the price has risen to almost $9,000 to ship a cargo container from Asia to the United States west coast; and at 200 dollar oil that price will double again, so it’s going to be 18,000 dollars a container. So globalization was based on cheap energy and you’re going to see a process of reverse globalization. In fact, I’ve read some reports about some companies are maybe talking about opening up plants in some of the Midwestern or southern states where you have a more hospitable environment when it comes to tax policy. But anyway. Energy infrastructure is going to be another key area. [1:08:19]

JOHN: Well, Jim, I know you basically participate in individual stocks, but let’s take people who for example, small guys, and they want to participate in this whole thing, how are they going to be able to do that as far as their own personal portfolios?

JIM: As I mentioned here, I’d recommend if you don’t have enough money to invest in a portfolio of stocks, I’d recommend that you invest in ETFs. And I highly recommend that you pick up a copy of the ETF book by Richard Ferri – very well written – it’ll give you a complete understanding of how ETFs work, how you can use them to put together a portfolio; and the five key areas that we have emphasized here on the program over the last decade, metals, precious metals – there are ETFs for precious metals, energy – there are ETFs for energy; water – there are several ETFs for water; food – whether you’re talking about commodities or the companies that help produce it from either tractor companies to fertilizer to seed companies, there are some ETFs for there; there are ETFs for infrastructure. So you don’t have to have a lot of money to do this, and you can do so through an ETF if you don’t have the money for a stock portfolio. [1:09:20]

JOHN: You know, the natural tendency for people is just to get very flustered when they begin to see these short strange things go up and down. They’re wondering: Should I do something, do I need to get in there and control it and make some moves. But in reality you need to take a longer term view of what you’re doing, ignore the short term static and noise and it makes for a much smoother ride.

JIM: John, you’re absolutely correct. It’s very easy to get frustrated by short term movements. But remember, there is a lot of noise out there and that’s why we always tell people to stick to the fundamentals, always look at a long term chart, not what the little wiggle is this week or what the wiggle is in let’s say a daily chart because if you take a look at a long term chart –whether you’re looking at energy, whether you’re looking at commodities, whether you’re looking at precious metals – it’s very obvious where these have gone. And we’re still at the early stages as I mentioned because there aren’t a lot of people – whether you’re looking at fund managers or you’re looking at institutions that are heavily weighted and invested in this sector. And I can remember towards the end of the tech boom in the late 90s where it was not unusual to take a look at a mutual fund and see almost 50 to 60 percent of the weighting in the fund in technology. And I can tell you, even though the weighting of energy has gone up within the S&P, we’re not even close to where it was when the energy markets peaked in 1980, where energy was anywhere from 25 to 30 percent of the weighting of many major indexes.

And one thing that I think about as I look at this – and we interviewed Matt Simmons this week, and Matt was a key figure for turning around a lot of my thinking because I came across peak oil in the late 90s when I read Colin J. Campbell’s book, but then of course in 1998 everybody was focused on the tech sector and of course oil prices dropped around 10 dollars a barrel. But I still remember to this day very vividly press releases – and of course the front cover of BusinessWeek where Richard Rainwater was putting all his money into energy and real estate. And of course, this was 1998, and if you had looked at what Richard was doing you would have said this guy was an idiot for buying real estate and energy prices; the same thing was said about T. Boone Pickens who was putting a lot of money into energy. Now, you look at these guys, T. Boone Pickens a very, very wealthy man; Richard Rainwater an extremely wealthy man, a multi, multi-billionaire – both of these individuals. And remember, they were doing this John, back in 1998 when who would have wanted to buy oil when it’s at 10 dollars a barrel.

And if you look at what T. Boone Pickens is doing today: he made the front cover of BusinessWeek, he’s investing in water, he’s also investing in alternative energy; and one of the reasons he’s doing that is he knows that peak oil is here. In fact, the IEA and EIA are revising a lot of their energy production figures to much lower levels. And so that’s why I think this is one of those rare opportunities in time, and it reminds me very much of the correction that we saw in the bull market in stocks in 1984; the Fed raised interest rates, there was a pull-back in stocks, institutions were selling, and a lot of people didn’t believe – even at the institutional level; and if you looked at the individual level, they weren’t even in the stock market at this point because back in 1984 you could have got double-digit interest rates at the bank. And I can tell you very clearly when it comes to the commodity market, we’re not even close in terms of what institutional participation will be as this market plays out. And I can tell you, the public is not into gold. If you mention gold, people look at you cross-eyed. They’re not into energy. They may be able to understand it, maybe they own one or two dividend paying energy stocks but it’s not even close; and that’s why I think that if you take a look at these great investors – even look at Warren Buffett who’s started buying energy early in this decade and still owns a major position in energy and was also buying some natural resource companies. These are the great investors that have stood the test of time. They don’t get shaken if you get short term fluctuations in the market.

Buffett has always said he could care less if the market were to shut down for two years based on the companies that he was investing in. And that’s one of the most difficult things to do is we’re in that shakeout phase right now where the bull market’s going to try to throw you off the saddle; there’s a lot of cross-currents and noise coming at investors but I think if you look at fundamentals as we stress here, look at a long term chart – not a weekly or a daily chart – and take a look at those investors, people like Pickens or Warren Buffett or Rainwater and then I think you can take some solace in terms of the short term fluctuations and begin to look at them as opportunities rather than look at them and be shaken out as all these babbling idiots are out there telling people, you know, they’ve resurrected the deflation story, just as they did in 84; they’re talking about a commodity bubble peaking; they’re talking about precious metals peaking – and John, we have had this conversation two or three times every single year since you and I began doing this program for 2001; and why people listen to the same people that told that oil was going to back into the 20s, the same people who told you that oil was going to back into the 40s and 50s. Actually right now, they’re saying it’s going to 100, and down to 70 and 80. Why people listen I have no idea. But once again, take the long term view. [1:15:12]

JOHN: And to reiterate, when you talk about areas like energy and precious metals, which have soared if we look back at 2001 when we began talking about these in 2001, 2003, they’ve soared. But there are pull-backs, nothing goes straight up. So what to do in these periods? Some people with the metals are always watching with a certain acid stomach trying to figure out what they should be doing during the upsy-downsies.

JIM: Well, you know, there are a number of books out on the gold market out there. There’s one by Frank Holmes that’s just come out, and the first thing that you want to do is you have to decide what kind of investor are you; and if you can’t take the volatility that you might see in, let’s say, the precious metals that move up at a faster rate than the price of bullion but also decline at a faster rate than the price of bullion, then you know what you might want to do is pick up start buying the metal itself. You can do so, you don’t have to have a lot of money to go into your local coin shop and buy let’s say gold Eagles; and you can buy a gold Eagle – that they have gold Eagles – in other words, you can buy a one-tenth of an ounce of gold. So. for example, where you have the price of gold right now at roughly 860, a one-tenth ounce is about the size of a dime, you can pick those up for a little over 90 dollars right now. Or you could buy for example, silver Eagles or silver rounds. You get the best value in my opinion by buying silver rounds because you don’t have to pay the 8 or 10 percent premium that the US government gets. Or you can buy even junk silver. Right now, junk silver is selling at a little bit of a discount to the price of regular silver, so you don’t have to have a lot of money. And at least, John, you’ve seen it – have you ever shown anybody a gold coin or a silver coin, you know, when you look at it you understand it’s real money.

And last – what was it – a couple of weeks ago, Eric and I were doing a show together and he was at my son’s birthday party and one of the presents I gave him was 20 silver Eagles; and as everybody was opening up and looking at it and saying, “Wow, look at that. That’s money.” And even the waitress and the servers were looking at – “what is that!?” They were looking at it, “this is actual money.” But it really caught everybody’s attention. And that’s something that every time the price goes down, you can think, you know what –because you’ll start thinking differently if you own the metals – and you look at a silver coin and you say, last month I had to pay 18 dollars for a silver Eagle, this month I can get it for close to for a little over 15 dollars for a silver Eagle. And what you begin to understand is if you’re putting money aside in an investment program your money is going to go a further distance. And so instead of paying 18 dollars for a silver Eagle, maybe this month you get one for 16 dollars. And that way, for people who cannot handle the volatility then I always recommend the bullion, and then also continue to build your positions if you’re going into the stock market – whether you’re buying securities or you’re buying ETFs, you just sit there and if the price comes down this month and you’re putting 100 bucks away, 200 bucks away, maybe you’re contributing to some kind of self-employed pension program or an investment program, well, guess what, you’re going to buy more shares this month. [1:18:34]

JOHN: So your prediction I would assume by the end of the year is that we’re going to be looking at higher prices at the end. That’ll come back.

JIM: I’ll give you the same prediction I gave in January where I said we would hit 125 and then I said 145. By the time we get to December 31st you’re going to see higher natural gas prices; you’re going to see higher oil prices; you’re going to see higher precious metals prices and you’re going to see higher commodity prices. [1:18:59]

JOHN: And so to sum it up, I would assume we go back to an age old piece of wisdom: Buy low and sell high. But at the moment, I don’t think you’re selling.

JIM: No. I don’t think so. In fact, we’re doing some shopping.

JOHN: And you’re listening to the Financial Sense Newshour at www.financialsense.com.

Part 3

Q-Calls

JOHN: Time to do this. Time to go to the Q-lines. We call them the Q-lines meaning ‘Question Line’ because they are open 24 hours a day to record. This is not during the program that you're listening to, but you record your question or comment for the following week's program based on something that we said here. We ask that you give your name and where you're calling from. We like to know where people are listening, and your comment, objection or affirmation, and please try to keep it at a minute. We have to do that because of the number of people calling in now on the Q-lines.

Please remember as we answer questions here that the content you hear on the Financial Sense Newshour is for information and educational purposes only. You should not consider anything here as a solicitation or offer to purchase or sell securities or other instruments, and responses to your inquiries are based on the personal opinions of Jim Puplava and because we don't know enough about you, we cannot take into account your suitability, your objectives or your risk tolerance. You always need to consult a qualified investment counselor before you make some moves, especially somebody who shares your philosophy of investing. And as such, Financial Sense Newshour is not liable to any person for financial losses that result from investing in any companies profiled on or anything else here on the Financial Sense Newshour. Toll free line in the US and Canada is 800-794-6480. That's toll free US and Canada. It does work for the rest of the world, but your standard international rates do apply.

The first caller today is from a state I've spent many years in. Colorado.

Hi Jim and John, this is Andrew from Colorado. A question I have is regarding credit card debt. I have a lot of friends who have got the zero percent balance transfer credit cards. Now, let's say if you have one of those cards with a certain bank and they are offering you zero percent for the life time of the balance and then that bank goes bust or they are taken over by another bank. Now, if the bank goes bust or it gets bought out by another bank, does the new bank have to honor that credit card agreement, or would it all be reassessed?

JIM: You know, Andrew, I think if another bank takes it over, providing the conditions and terms of the contract remain in place, you know, if it's a zero percent interest rate for some period of time, they would have to honor it for whatever that term is and, you know, depending on conditions of what that contract, but nobody charges you zero interest rate for a long period of time. Usually, these are teaser rates on cards that only last for a limited period of time. [2:38]

JOHN: Plus, if you notice, Jim, when you roll into those things, they have a 3% transfer fee is the nominal charge. They used to put a $100 cap on it, but I noticed from Bank of America now – I get flooded by these things all of the time. But I think the cap is – there is no cap, so it's 3% of whatever you do, so basically you're paying a 3% interest rate just for making the transfer to start with, and then you start paying the compounding on top of that whenever it happens to kick in. We did get an email from some listener who said the bank rolled over their supposedly fixed interest rate loan into something else and they had to start paying interest on it, so I don't know the details of that, and you really have to read the fine print, I would think, in terms of this.

Hey Jim and John. John in Silicon Valley. This is more of a heads up than a question. Look on the Reg SHO on the short list and find ETU silver, symbol ETUXF. I guess the question is what do we do now, folks?

JIM: You know, John, I've seen this and I've seen this in my own buying in the last couple of weeks. It's a lot of short selling that is taking place, and we follow the Reg SHO list, and it's amazing the number of juniors around the Reg SHO list that have been naked short, meaning there have been failures to deliver. These shares sold weren't actually real shares.

But those shares that you own will have to be honored, and eventually, in fact, I don't know if it's this week – we're working with a law firm that's going to bring one of the first class action lawsuits against the bad apple investment banks. They had listened to the five part series that we did on Crime of the Century where I think it was either the second program or the third program where we laid out if I was a regulator how you would convict the crooks, in other words, the trail of evidence, and they've been using that. And it's amazing what they've been able to uncover and we hope to have this law firm – and also which will be bringing a class action lawsuit. And I can tell you this: My prediction and here's the prediction I'm going to make in the show. Just as you're seeing these huge settlements with the money center banks and the investment banks over these auction rate facilities, you have seen nothing to the class action lawsuits that are coming to Canada because this is going to be the first giant class action lawsuit. They've been in touch with the law firms of Christian and Jewell, and John O'Quinn in Texas and I tell you, there is going to be hell to pay by the bad apples and it's coming, so judgment day is coming. And because once again, like I said, unlike a regular crime scene where sometimes the criminals wear gloves and you don't see the finger prints, unfortunately for the bad apple banks, their finger prints are all over the place. [5:41]

Hi Jim and John. This is Gary from Michigan. Been enjoying Alan Newman and Eric King. Alan Newman told me a hundred different reasons why we shouldn't be buying stocks, especially small caps. And Eric King and you are telling me that this is the best thing going for the future. Now the question is when you're buying these, especially on the dip, aren't you buying counterfeit shares and if you are buying counterfeit shares, doesn't this depend on the ability of the naked shorts to cover in the future? And if they don't cover it, what do you really have here, especially if there is a take over of a large company of a small cap, they only pay people with certificates? So what does one person do? This is my quandary.

JIM: You know, Gary, Eric and I were talking about the value that are in up-and-coming producers and late stage development plays, and because of the incredible value, I could go on and on. I mean I'm buying values that I haven't seen in probably over six or seven years, but I want to correct you on something. If you buy a company, let's say a company has 50 million shares outstanding and somebody naked shorts shares to you, in other words, the shares that you bought were shorted to you by somebody that didn't have the shares to short. It doesn't matter. They have to go in and cover, and that's going to be a real risk for a lot of these guys because in a takeover, only the outstanding shares that have been issued by the company – in other words, let's say a company has 50 million shares and let's say five million shares have been sold naked short, so there is 55 million shares outstanding. Now, a company comes in, they buy the company and they buy the 50 million shares outstanding. What happens is it forces those who have gone short, and especially those who have gone naked short, into a real predicament. They have to go in the open market and buy those shares and cover. And that's the real predicament that I see coming to a lot of these guys.

I see several of these hedge funds and some of the bad apple investment banks getting trapped here, and there is going to be some horrific losses because there are more takeovers that are coming to the area. In a takeover, only the legitimate shares, in other words, the 50 million. And that's why you'll see sometimes in a takeover where, let's say, just let me give you an example, let's say a takeover price of a stock was, I don't know, 17, 18 or $20 a share, and all of a sudden you see the stock trading for 20.50 or $21 a share. The reason being that's the shorts that are going in the market that are having to cover. [8:30]

Hi Jim. This is Matt from Denver. I've recently been accumulating bullion and as I wait patiently for it to resume its rise as real money, I was thinking of using it as collateral in secured notes and using that money to invest in the themes that you guys talk about on your show, buying on the dip. So if you could give me your thoughts on that and how that would work and if there were potentially any problems with that.

JIM: You know, Matt, the only problem I would say with leverage is exactly what we've seen in the sharp pull back in commodities that we've seen since the middle of July. When you're leveraged and you might have even a margin call or interest, you know, as long as you have the cash backing to closeout your position, but you know, the thing I don't like about leverage, when you own something free and clear, you can ride out these bumps that we periodically get every single year in the energy and precious metals market and some of the areas that I'm talking about. But when you're leveraged, you know, that's what happens, that leverage can move against you. That's why I would prefer to see that you pay cash because these markets are volatile especially because nobody is really picking up on the trend and there is a lot of noise right now and you don't want to be forced to sell a position and take a loss just because of the amount of leverage that you've employed, so I would not recommend leverage. [9:54]

Hey Jim. This is Rob from Nebraska. Quick question is to diversify out of the United States dollar devaluation, would United States farm land, if it’s purchased correctly, be a good way to invest, and how would farm land ownership reacted to 2 to $300 oil? Would the government provide firm rights to farmers if rationing came into view?

JIM: You know, Rob, in this kind of market that we're going to and with higher energy prices and the scare of scarcity that I've been talking about, good farm land with rich soil it could be going for a premium; and obviously in a scarcity situation, and this is one of the reasons why I'm sort of moving away from diesel right now because we don't produce enough diesel in this country and if there is a scarcity issue, a shortage issue, then the diesel fuel and the energy is going to go to the farming sector. It's going to go to the transportation sector to make sure that food is produced and goods get to the stores. So good farm land, I would definitely be looking at good farm land. [11:04]

Hello there, Jim and John. This is Nathan from California. I've noticed that platinum sort of led the charge for the precious metals on the way up in the last six months to a year, and that now it's been especially weak to possibly be leading the charge on the way down, and I was just hoping you guys could comment on this.

JIM: You know, it has led on the way up, it's led on the way down. A lot of it probably has to do with unwinding of positions, profit taking and also the decline in automobile sales because a lot of platinum is used in catalytic converters. [11:43]

Hi Jim. Hi John. This is David from Victoria, British Columbia. Listening to your Obamanation, I've got to say I'm a little bit disappointed in the point of view you've taken. First of all, Obama hasn't taken office yet, and we really don't know what kind of solutions he's going to implement in the way of solving a very bad problem that was created by a Republican administration which pretty much basically has its philosophy and really got us into a bad situation. And really, I think your work was a polemic. You should be very careful in giving – their airing of other people's point of views. So do better. And again, as far as socialism or Marxism or whatever you want to call it, look at Scandinavia. They are not doing too bad, so be fair in your analysis.

JIM: Dave, I disagree with you. What I read last week were position papers taken in the Wall Street Journal comparing the candidates. These candidates, whether it's Obama or McCain, have position papers on their websites and they spell out if elected, this is what I want to do. And those are specific programs. And we listed from the Wall Street Journal article where tax rates are now, and also where they would be under Obama. And in terms of greed, my goodness gracious, look at the greed in the 90s that occurred and to say that it just occurred in a Republican administration is entirely false. I mean if you take a look at the crooked accounting that went on in Fannie and Freddie under a Democratic administration with the accounting scandals, the Enron scandals, the WorldCom scandals and talk about greed, you know, I don't think you're being fair in your analysis. It occurred both in a Democratic administration and Republican administration; and if a guy says that he's running for office and they are going to say “if I'm elected, here is my program on taxes, here is my program on energy,” these guys have to get specific. And when they get specific, we will talk about it. And just as I scolded John McCain when he – he's been claiming that he would not raise taxes, and then when he was faced on some specifics about not raising taxes, he flip-flopped a little bit, we took him to task. So right now McCain says he will not raise taxes. Obama says I will raise taxes, and here is how I'm going to raise them. Now, those are facts and we listed them.

Secondly, and in terms of socialism, you know what, when you do go to those countries that have raised and driven business out, they have put a lot of this in terms of debt. Borrowing a lot of money, printing a lot of money and trying to pay for it, so all they've done is postpone the day of reckoning much in the same day that we have postponed the day of reckoning here. In a bit of analysis, the other thing that I have and reserve the right to do is if you have somebody that's a socialist and would like to come on the program and explain to me how 70% tax rates, number one, is moral; two, how that helps the economy, then, you know, fine. Give me a recommendation and I'll be glad to interview them on the program. And finally, one of the things that we do is we have opinions ourselves. I do not believe in high tax rates. I do not believe it works and if you take a look at high tax rates, look what happened to England in the 70s as people in business fled the country. Take a look at the Soviet Union when it was a Marxist country and take a look at China when it was a Marxist country. Take a look at Soviet Union today and China. Anyway, David, I think in terms of balance there, I disagree with you. [15:40]

JOHN: Plus he mentions Scandinavia and Sweden. If you recall, what, about 20 years ago, they jammed the corporate income rates up around 90% and businesses said – how do you say goodbye in Swedish? –Goodbye. We can't handle this anymore, and they went elsewhere. So you're right. The day of reckoning has simply been rolled forward. Hey, if I can live off of a credit card, I can live like a king for a while.

JIM: Yeah. For a while until somebody stops giving you credit.

Hi Jim and John. This is Bob from Berkeley, California. Love your show which I've been listening to for years. I want to correct one thing, though. At the beginning of the last few broadcasts, Jim has been quoting the Canadian dollar and Swiss franc incorrectly. He's been saying that both are worth more than the US dollar and that they are continuing to increase against it. Actually, it's just the opposite. Both were worth more than the dollar for a short period within the last year, but as of today, August 2nd, they are worth less and continuing to decline. I'm thinking, Jim, they are maybe because of the convention use for expressing bulk currencies exchange rate which is the opposite of, say, the convention used for the euro. Just wanted to make that correction.

JIM: You know, Bob, you're absolutely correct. The Canadian dollar is worth about 94 cents and the Swiss franc is worth about, roughly, 92 cents. Thanks for the correction. [16:52]

Hi guys. This is Mark calling you from Houston. I am bullish on the precious metals. However, I was wondering if you had an opinion as far as the fiat currencies on who would win the so-called race to the bottom. And I guess my point is would it be possible that we could see the dollar index actually go up along with the precious metals in kind of a, like I said, a loser victory. Would the dollar depreciate the slowest against the euro, yen, pound, the krona, and franc, while gold and silver were to continue upward.

JIM: If you want to know who is winning the race to the bottom, I would probably have to say right now, Mark, that's Zimbabwe where they have, I don't know, what is it, gazillion percent rate of inflation and could you see a period of time where the dollar index would go up along precious metals? Yes. We've seen it in this decade. [18:00]

JOHN: I think Zimbabwe just revalued their currency, as I recall, to try to equalize everything.

Hello, Jim and John. This is Matt calling from Newcastle-upon-Tyne here in the UK. Back home on the east coast it is 12:13 p.m. on a Monday. I saw MarketWatch just announced that inflation is at a 27 year high and that gold dropped $13. I mean this is getting ridiculous. But my question, gentlemen, is regarding your last show where Frank Barbera described his doubts regarding the mining stocks and how they will react when gold goes up in price but the stock market drops, I'm concerned about this aspect because half of my gold position is in mining stocks. Primarily that's from Global Investors run by Frank Holmes. If you can please expand upon that, Jim and John, and maybe get Frank as well, I'd really really appreciate it.

JIM: You know, Matt, Frank was reserving some doubts in terms of what might happen with the mining stocks. I think the real critical period is going to be when we get to what I call the second phase of the inflation, when people begin to realize that prices are going up, and then you have a flight out of paper assets and then you start going into tangible assets, very much like what we saw in Germany in the 20s, Argentina in this decade, Turkey and Russia in the last decade, and then also what you saw in the 70s here when we had an inflationary period when people finally realized that there was real inflation out there and people dumped their paper assets. But right now, we're probably only in the first phase of an inflation where people are thinking because retailers are having a tough time, companies are having a tougher time raising prices and people are holding onto dollars saying, “you know what, I'm holding onto my dollars because I think prices will go up,” but it's not until you get into this second phase of inflation that you start seeing assets rise. And the best example I could give you is in 2001, we were in a recession. You had a stock markets falling and it was in the summer of 2001 in the middle of that bear market that the commodity stocks really started to take off, even though they were going down in 2000, the first year of that bear market. [20:29]

Hello, Jim and John. This is Peter from New York. Great program. My question is: If we do enter this financial crisis window with an extreme credit contraction, it seems certain that long term loans and credit in general granted to energy companies and precious metal mining companies are probably going to become less available. It's either this would accelerate an awareness of peak oil by bankers and others rises in the coming months. So if this is the case, world financial markets will be in turmoil and credit availability will be greatly reduced. It seems to me that mining and discovery operations as well as energy companies, perhaps it reduces, not ceases operations during the severity of this credit crisis. So I'm wondering how do you think this will factor into gold and metal mining shares and energy company valuations and energy company shares. What kind of energy companies will survive under this scenario of ever tightening credit and a scramble to keep oil flowing. Don't most of these companies’ stock values collapse along with all of the others in this kind of environment?

JIM: You know, Peter, I don't see that happening. Can they pull back when the price of the underlying commodity pulls back? Yes, they can. But if you're an oil company right now, you are minting money. If you're a natural gas company right now, you are minting money. You know, most of these companies are self-financeable. What I do see coming to the junior sector and the precious metals sector is there is thousands of juniors that are out there, and a lot of these juniors are not going to survive. There are too many of them and the stronger ones that have developed deposits that are more defined, further along, these are going to become more valuable.

And then the other thing that you're going to see is consolidation within the sector. You're going to start seeing a wave of consolidations just as companies start, you know, who knows, it will be either a company like a Goldcorp that came in and started consolidating the sector, or it's a Yamana that comes in and starts buying a series of companies or it's an even a junior-type company, a late stage development play, that turns into a consolidator, but the industry is going to contract. It's going to consolidate. A lot of the up and start-up juniors will not be here and that's why I think you want to stay in the more developed deposits because the industry is going to go through a consolidation. That's coming and it's starting and it's occurring as we're speaking. [23:04]

Hi Jim. This is Dave from Sydney, Australia. Love the show. In your last show you indicated that the next shoe to drop would be the CDS, the credit default swaps. When do you expect that shoe to drop? In a couple of weeks, a couple of months, a couple of years? Can you give us an estimation on that, please. Also, I read that Merrill Lynch and some of the other investment banks are organizing a clearing house for the CDS at the end of the year. Do you think that would work, and what do you think the effect when the CDS shoe drops, what will be the effect on the banks that hold the CDS?

JIM: You know, Dave, when this default thing starts to unwind, I see that taking place over the next 12 to 18 months. If you look at corporate bond defaults, they are expected to double from roughly about 3% to roughly about 6% by next year, so that's going to start a wave and it will start out with one company, a big company, and then it will be some hedge fund that wrote a bunch of credit default swaps that doesn't have the reserves to pay off, then you might have a merger of some companies, and eventually you're going to have some kind of bail out or some kind of – the Fed will start stepping in, the federal government will start stepping in. But this thing is the next shoe to drop here and I expect it probably in the next 12 to 15 months.

If you look at what's going on in the economy, you've got rising unemployment; after this stimulus package wears itself off, you have to ask yourself what happens in the third and fourth quarter and also in the first quarter of next year, what are going to be the drivers especially with the developing economy starting to slow down. So it's not going to happen at once. Remember when the credit crisis first started to unfold, it began in the beginning of 2007 with intermediate lenders. In February of 2007 and we had a six week crisis, and then we thought it was all over and then the thing really began to blowup and accelerate as we got into August and I think you're going to see further acceleration of this crisis window. I mean I think the amount of money that banks and financial institutions are going to have to raise is going to be so phenomenal that you're going to see government take over a lot of these institutions and you're going to see the folding and merging of several others. [25:33]

Hi Jim and John. This is Rodney calling from Virginia. In anticipation of more takeovers in the precious metals junior mining companies, I was wondering if there are any tactics to take in order to maximize the profits. Assuming that I don't want to hold the large cap miner after the takeover is complete, when is the best time to sell? In other words, what mistakes do you see an experienced trader make during the takeover process that result in them leaving money on the table.

JIM: You know, Rodney, one of the problems that you have sometimes there are a number of bids out there and those bids can change, as we saw in the 2004 and 2005 period where, you know, one company wanted to take over another and then another company would up their bid. And one of the things that you also have to bear in mind in a takeover, if you're in a junior mining company and if it's taken over by a good growth company, you might want to hold the shares and then hold them long enough to make sure you pay long term capital gains. One of the things that you don't want to do and especially with all of the talk about raising income taxes is be faced with short term capital gains. So some of the times people sell too early and, you know, you can sometimes if there is a takeover and there is an exchange of stock as several of these deals are going through now where it's not a cash takeover, the underlying mining company, the acquirer, usually goes down on the announcement of the takeover but if the gold market continues to go up, the value of both shares will tend to rise because it's based on a per unit exchange. So if the takeover company's stock rises, the value of the shares that are going to be given to the acquired shareholder also rises too, so that's some of the mistakes that you make that as soon as the takeover is announced, sometimes people ditch and get out of a position. [27:26]

Jim and John. This is Bob from New Jersey. Last week, you commented that we seem to be moving in the direction of socialism, and in other shows Jim has remarked that severe economic turmoil could produce fascist government. In my view, the development that we're seeing today looks more like fascism than socialism. Remember, Jim and John, that the bedrock of socialism is the redistribution of wealth from rich to poor, but the bailouts of the investment banks and hedge funds, Fannie and Freddie along with the tax subsidies that we give to our largest oil companies are not distributions of wealth from rich to poor. They are, in fact, distributions of wealth from the middle class to the wealthiest segments of our society. Basically, mom and pop middle class America are being forced to bail out hedge fund managers and investment bankers. That's what we're seeing today. Here is an interesting and scary quote from Benito Mussolini. It’s all about fascism. Quote: Fascism should be more properly called corporatism because it is the merger of state and corporate power, unquote. This sure sounds like where we're headed.

JIM: You know, Bob, I agree with you. I think the ultimate outcome in this country is going to be fascism. But John, you and I were having this talk. You see these polarized shifts that take place over time, and right now there has been sort of a shift to the left, but if these looneys implement the programs that they are talking about and wreck havoc with the economy, then what will happen is there will be a lurch to the right. And John, do you want to make a comment on this because you follow the political issues closer than I do with your radio show. [29:11]

JOHN: I agree with Bob that we're more likely headed into fascism, but he said something that I would challenge and that is the bedrock of socialism is transfer of money from the rich to the poor. That isn't the bedrock of socialism. That is simply its public position. What invariably happens in socialism, especially if you go read the article I read a few weeks ago on our website called The Sad Legacy of Socialism is that the rich are able to insulate themselves in that time, and therefore the transfer of wealth rapidly moves into the middle class and in the third and final stage of socialism, you have a small group of people at the top who are fabulously wealthy and the rest of everybody at the bottom who are fabulously poor and broke. The middle class is wiped out. So Bob, you're right about that. It's also important to remember that the name of the Nazi party, the NSDAP was [German] The National Socialist German Workers Party. And probably one of the biggest myths, Jim, is there is really a lot of difference between, say for example, Marxism and fascism. Very slight difference because if you view this as a circle starting at the top where we have free markets and a free society, that's unstable. You have to work at keeping it free. Freedom requires effort.

Now, if you slide around the left circle or you slide around the right side of the circle, it doesn't make any difference. When you get to the bottom, the government and the economics looks pretty much the same either way. There really wasn’t a heck of a lot of difference between Soviet Russia and Nazi Germany once they all got down to the bottom. But I tend to agree that I think we're going to make a hard lurch to the left here, and then there will be a reaction to that because of all of the pain Americans are feeling, and there will be a hard lurch to the other ditch on the opposite side of the road. All in all, it makes for very unstable times and I get nervous during unstable times for obvious reasons. [31:06]

Hi Jim and John, this is Steve calling from London. My parents retire in a couple of years, they’ve got about 200,000 dollars all in cash savings and bonds. I’ve been nagging at them for a while to divest right out their fiat currency, so they’ve finally agreed and started to buy Krugerrands from a local bullion dealership. My question is what with portfolio weighting would you suggest that would do well in the coming Kondratieff winter?

JIM: You know, Steve, I would suggest a minimum position of 10% in the precious metals and then what you might want to look at since your parents are going to be, you know, I assume if they are going to retire, they might want some income, you might want to look at putting some money in the energy sector – especially some of the dividend paying stocks and also some of the natural resource stocks.

If you take a look at the dividend income increases that have come from such companies such as BHP Billiton and some of the other natural resource companies that have just been fabulous going up at over 20% a year, and then probably for a little bit of stability you might want to be in some hard currencies, short term paper, government paper that is, of hard currencies. I like the natural resource currencies because I think in the long run they'll do much better. Countries like Brazil, countries like Canada, countries like Australia that have a lot of natural resources in the next 10 years as we enter this period of scarcity. [32:25]

Jim, this is Pete calling from Philadelphia. Jim, the drop in precious metals stocks over the last three weeks has been nothing short of breathtaking. Is this a nefarious plot here, or should it be that your long term projections on gold are simply optimistic?

JIM: Pete, remember, gold stocks are leveraged to the price of bullion. When you have the price of bullion go from 960 to 860, you had a hundred dollar an ounce pull-back and the stocks themselves pull back even further. If you're talking about the larger cap stocks, they pull back less. If you look at some of the juniors, they pull back more because there is not a lot of liquidity, so when you have a lot of panicky sellers – and plus you have a lot of short selling and that's occurring in the sector with panicky sellers so that's what makes them a little more volatile. The thing that I would tell you, Pete, is just take a look at a long term chart of gold, whether you're looking at gold, silver, the HUI or the Amex Gold Index or the Philadelphia Gold and Silver Index or even the XOI or some of the oil indexes and you'll see exactly that these pull backs are very sharp, they are violent, they are very quick, they are double digit in nature. I don't care if you're looking at energy or bullion, that's just the way the sector works. It's a very small sector. It's a very small microcosm of the world markets. The market of precious metals, whether you're talking about bullion or the stocks themselves are so small when you compare the market cap of – you know, you could take all of the total market cap of all of the world's mining stocks and it doesn't even equal a Microsoft. And so when money moves in, it moves up at an accelerating pace and when money moves out, it moves down at an accelerating pace. [34:20]

This is Bill from Virginia, love your show. I wanted to know if a bank goes under and you have a brokerage account with that bank what the impact of that is. Please let me know. Thanks.

JIM: Usually if the bank goes under, they are going to be taken over by FDIC. If you have a brokerage account that should be covered by SIPC, and if it's a bank that has a brokerage firm, I suspect it will be merged into somebody else. But if you're in a situation like that, you could be inconvenienced depending on who you're with. If they go under you might not be able to have transactions or the ability to execute transactions for a short period of time. [35:03]

My name is Brian. I'm calling from South Carolina, and I'm just wondering if I'm out of my mind. Like the headline today says: Greenspan says more financial institutions may face insolvency, USA Today. Gold just went down to $890 an ounce. Who is selling it? Are central banks suppressing gold or propping up the dollar? If they are, how would we know that other than reasoning backwards from the declining price of gold?

JIM: You know, one of the things that you're seeing, Brian, and this is the advent of not only the leverage that's in the sector, but also don't forget there is a lot of money that goes in and out of ETFs, whether it's the silver ETF and the gold ETF and if the price begins to drop and is orchestrated. In other words, there is a bear raid on the sector, selling begets selling and with the advent of so much gold being held in the ETFs, a lot of this action that you're seeing in the gold and silver market today has a lot to do with the trading in and out of ETFs. [36:04]

Hi Jim and John, this is Donald calling from the UK. I just heard one of your callers in a Q-Line talking about Gordon Brown selling off the Bank of England gold about years and years ago when it was about 250-odd dollars an ounce. The bank of the UK is not run by Gordon Brown, it is run by an organization called the civil service who run this country. The Chancellor of the Exchequer does not tell Mervyn King of the Bank of England what to do. Gordon Brown when he was Chancellor of the Exchequer did not sell the Bank of England gold. That’s not his position and he does not have the authority to do that. However, the Bank of England and the director of the Bank of England was Sir Edward George. And they’re the guys who sold the Bank of England gold. It was the Bank of England who sold Bank of England gold, not Gordon Brown, Chancellor of the Exchequer. And if you look at a chart, you'll see when that happened gold was the all-time bottom. But if you break out at the very bottom of a chart there’s a line weeks ago, that’s the time the Bank of England did sell all that gold, trying to really, really break gold. It failed but anyway that’s my take on it.

JIM: Donald, thanks for bring that to our attention and giving us the facts. [37:14]

Eric here in Chicago. I have a question. One has to do with the silver coins they are beginning to advertise on television. They claim a 99.9% purity and they advertised with the certificate of authenticity going along with the purchase. Now, do we have any way of checking? Is there some website or some authoritative source where we can tell if these assurances they are making about the certificate of authenticity is accurate?

Another thing, I have a question about a comment that Peter Schiff made, not on your program, but in an interview he did on one of the financial newsletters. He said that as long as the Fed, the central banking system here, can manipulate the interest rates, there is always going to be a problem with the economy. He said he felt in this comment, at least he was quoted as saying. that the free markets should determine the interest rates. And I'm just wondering, I'm a little confused about that because the federal board is an authoritative body that can issue statements about what the interest rates will be, but how can markets make an announcement, how can the markets determine interest rates? I don't quite understand it. If you would comment there, I would appreciate it if maybe you can give some insight into it.

JIM: Eric, in terms of, I don't know what kind of TV ads, usually if you're talking about buying a silver coin, you might want to check with a reputable dealer, how long they've been in business, check the Better Business Bureau. You know, we've had a number of companies on this program and just look up gold dealers and bullion. Check around. Check around prices and do a little bit of background. I haven't seen some of these commercials. I don't watch much television, so I'm going to let that – that bit of advice would be I would only do business with a reputable dealer.

Secondly, in terms of Peter Schiff talking about the free market determining interest rates, I agree with him 100 percent. And how the free market would determine interest rates would be this: If there is a lot of savings in a society, it is the savings that determines the level of interest rates. When people are saving a lot of money and depositing money in banks and banks have a lot of money, more money than there is demand for money, then the interest rate would be determined by the market. In other words, if there is not a lot of demand to borrow and there is a lot of savings, a lot of money in the banking system, then the interest rate would go down. On the other hand, if savings, the level of savings went down and there was more of a demand for money than there was supply, then the rate of interest would go up, in other words, to ration the price. That's how the free market works, and that's how a free economy works.

But in an economy that's run by a central bank, it's just another form of central planning. Rather than determining interest rates based on a level of savings in the country and the real demand for money, the interest rate is distorted through the central bank creating money that doesn't exist. In other words, there was no productive development that went into the production of those savings that the bank lends out. It just creates the money out of thin air. The central bank injects reserves in the banking system and then through the fractional reserve system, that money is multiplied 10-fold through the lending process. [40:37]

Hi. I'm Jim in the San Francisco Bay Area. I love your program. I download it to my iPod every week. I had something very interesting happen to me today. I was interested in my bank, how much cash they would need to keep on hand compared to the amount of loans that they make out, that they produce, and they could not give me that information. They had no idea what I was talking about. I called my brokerage that I actually also have a bank account with, Charles Schwab, and they said that was confidential information. And so I have a call in to the San Francisco Federal Reserve to see if they can answer my question, that is: how much loans can you make compared to the amount of cash you have on hand? Is there any limit or percentage? We'll see what they say.

JIM: Jim, typically, they are supposed to keep 10 cents for every dollar of deposit and then it also depends on what kind of deposit. Certain kinds of deposit are exempt from keeping reserves, but demand deposits such as checking accounts, they have to keep 10 cents and that's what the law is. Now, there are ways that banks can get around that in the way that they manipulate money in a 24-hour period between accounts, so there is even a way that they can get around that 10% reserve fraction, which is probably one of the reasons why they don't tell you. [42:04]

Hi guys. This is Lynn from Connecticut. Quick question regarding something that you talked about last week on the Q-Lines. You told another gal to have 10 to 20% in precious metals of your portfolio. My question is: Is that of total assets? Do you see – why, quite frankly, is that percentage so low because if we expect hyperinflation, so 80 percent in fiat currency doesn't really seem to make any sense. Anyway, if you could kind of expound on your answer a little bit more, I'd appreciate it.

JIM: You know, Lynn, right now, I'm talking about 10 to 20 percent because we're only in the first phase of the inflation process. By the time we get to phase three, where you get the complete collapse of the currency, obviously, that figure is probably going to be closer to 65 to 75 percent, but we're not there yet. [43:04]

Hi Jim. Hi John. This is Dave calling from Vancouver, British Columbia. I'm a Canadian investor and use Royal Bank of Canada's direct investing as my online broker, as I guess a lot of other Canadians do. However, I got a little nervous this week after hearing that another online broker, E-Trade, reported a huge loss in the first two quarters this year in part from their exposure to bad mortgages and home equity credit lines. My fear is that my brokerage firm will go bankruptcy and my investment capital will be lost or at the very least be tied up for a very long time. Do you guys have any information regarding Canadian brokerages’ exposure to the subprime mess, and more specifically, RBC direct investing? If not, how do I go about finding this information out?

JIM: You know, one of the best ways, Dave, if you know to read financial statements is to get the current financial report from RBC and then also ask them – you see, we do it here. It's tier 1, tier 2 and tier 3 capital because a lot of well known Canadian investment banks have gotten badly burned in this mortgage mess as so many other banks around the world have. I would find out, if you could, through financial statements what their debt exposure is, and then I would simply try to talk to somebody at the bank and ask them if they can tell you or put it in writing for you what their exposure is to bad mortgages and so on. A lot of that is going to be buried in their quarterly financial reports where they have to disclose where their money, where their profits came from and where their losses came from, and I suspect just like financial statements here in the United States, the devil is in the detail in those footnotes. [44:47]

Jim, John, Mike from London. Great show. Thanks very much for all your efforts. Quick question. I was listening back to a show a few weeks ago and you talked about a woman who you said her net worth was about a million dollars and you were talking about putting her money together, a fund together to generate some more income better than fixed income. Anyway, I'd be interested to know without putting too much risk into it, and obviously some dividend stock point of view, what was the return on that amount would you be looking for? Are you looking in the range – dividends can be 3%, 4%, but obviously with some of the royalty trusts and things like that, obviously, they are a little bit higher. What would you be aiming for as a percentage in terms of that sort of amount of money?

JIM: You know, Mike, we're looking at 3 ½ to 5 percent with a mixture of high dividend paying stocks. Obviously, some of the Royalty Trust and some of the other areas that are paying much, much higher, but between 3 and a half to 5 percent is what we're looking at right now. [45:45]

Hey Jim and John, Rocco from New Jersey. A quick question on silver, the paper market versus a physical market. I've been involved in the paper market for a while with stock ownership and that kind of thing and I just bought the dip over the weekend on silver and decided to go physical and bought some bars and then again yesterday, meaning Tuesday –this call is being placed on Wednesday morning – ordered some additional bars at a higher caliber, meaning ounce-wise, 100 ounce bars and some others. And I can't seem to get a delivery date on this from the people I'm ordering them from, and I've heard numerous times, you know, the paper market is quite different than the physical market and I'm sort of experiencing it first hand when I'm going to get my delivery of the silver. So I'm wondering if you guys could elaborate a bit on that. What is the cause behind this? I'm starting to wonder if in fact there is something to this theme of trying to obtain physical silver versus the paper markets and if you guys could elaborate and share your thoughts on the subject, I'd be grateful. Thanks very much.

JIM: You know, Rocco, what you're experiencing in silver, I too am experiencing. We did a show on this, gosh, John, a couple of weeks ago when we talked about the US Treasury was putting a lot of the silver dealers on allocation for silver Eagles because they were running behind, that the demand – they had sold more silver in the first quarter than they did the entire year of 2007. In fact, I was just checking with a couple of the firms that I do business with, and they were telling me, one firm in particular, that the demand that they are doing in precious metals is up four-fold this summer versus where it was last year that that demand is increasing. And as that demand increases, they are having a hard time getting delivery. Now, if you're a large institution, you're talking about 1000 ounce bars, you probably don't have a problem, you can get it. But when you get into smaller denominations, especially at coin level, there is great difficulty because the demand is out stripping supply. [47:44]

Hi Jim, it's Peter from Toronto and love your show. I'd like to know where you can find the true inflation rate on the internet. I'm in a union and we're going into negotiation next year, so I'd like to basically get a higher pay raise based on the true inflation rate.

Second point, in the future, I see great opportunity for technology and related items to get us out of the current energy problem, and economic problems, so maybe you see a tipping point in that direction, whether it be policy change etc, I sure would like to see some stuff like that covered on your show.

JIM: You know, Peter, in terms of true rates of inflation, I'm more familiar with the United States, where our inflation numbers are sort of doctored, they don't really reflect the true rate of inflation. I use Shadow Stats, John Williams, who covers the way we used to measure inflation. I would Google “Canadian inflation” rates or something. Use Google and just type in different words, “inflation,” “Canada,” “CPI,” “Canadian CPI,” where you can probably be led to stories where you can see what the real inflation rate is there. Of course, your government plays games with the inflation numbers much like ours does.

And then the other thing that you talked about, alternative technology that can help us out of this energy crisis, I agree with you 100 percent. The tipping point is going to be when we get into shortages and the price of energy gets high enough where people start screaming. I'll give you a good example. Last year at this time, gasoline was at $3 and it wasn't until energy or oil prices crossed $125 and we were paying 4 dollars at the pump that there was a major sea change in the investment public. I mean just take a look at the stance by our political candidates here in the US, both Barack Obama and John McCain who were both, you know, originally, if you were looking at a year ago, they were against drilling, now they are for limited drilling in the case of McCain, or some kind of drilling in the case of Obama. So as the price of energy goes up, as we experience shortages which I expect in the next 24 months, then you can see that sea change – a cry to get something done and fix it; and that's where I think technology is going to come into play, whether it's wind, batteries, solar, you know, ammonia, liquid. There are a number of inventions going on right now and there are a lot of smart people moving into this area because they see it as an opportunity. [50:18]

John and Jim, this is Sam from Raleigh, North Carolina or, aka to my good friends, the doomsday prophet.

I enjoyed your recent segment on how fragile our oil infrastructure is and how it is susceptible to hurricanes. But I want to paint another picture of our oil infrastructure that does it in a more comprehensive fashion. A better way of understanding the situation is to imagine our infrastructure in this manner: The loop, or Louisiana oil offshore platform, is the heart of our system. The Texas City in the Louisiana area where the refineries are its lungs. The oil rigs and platforms are the mouth that feeds it all. The pipelines are the veins. And unfortunately, Congress is the head. And naturally, it could have impact at any location, however, our system has a major flaw or jugular vein as I would like to put it. Most of the oil and gas that flows through our pipeline system runs through the most active earthquake zone in America, the New Madrid seismic zone. It is the strongest earthquake ever recorded in America in 1812. A major earthquake in the same area today could devastate most of the pipeline's abilities to supply the US with petroleum. It would be nice to have Zapata George or Matt Simmons comment on this the next time you talk to them.

JIM: You know, Sam, I wish I would have got your call much earlier because I talked to Matt on Monday, and let me see, Zapata George, we probably won't have Zapata probably until September. Do me a favor… [51:43]

JOHN: You can always dial him up. He's at Brady’s mule barn as he answers the phone. Most people don't know that, but Zapata answers his phones “Brady’s mule barn.”

JIM: Yeah. You know what? Go to Google “Zapata George” Sam, and Zapata has a website out there, and I'm sure he has a contact form with a way to get in touch with him, and go to his website and contact him. I'm sure he'll be glad to answer that question for you.

JOHN: I just looked it up. www.ZapataGeorge.com.

Hi Jim. This is calling from Luxembourg. I have a question regarding the anticipated increase in M&A activity in the junior mining stocks. Basically, as far as I can see it, there are three options when a company gets acquired. The first one is to sell your funds or your shares in the open market and that would be so with Aurelian, the price actually goes above the bid price. The second option is to take a cash payment and the third is to take shares in the acquirer. I was wondering if you could just run through the pros and cons of each of those and perhaps give us an idea of what you might be doing in that kind of scenario.

JIM: You know, Paul, usually there is a couple of considerations. You're in Luxembourg, but here in the United States, anything that's held long term has a favorable tax rate if you sell it. And then secondly, you'd have to take a look at the acquiring company. If it's in a company that is in a growth spurt, has the ability to grow its reserves or grow its production much like Goldcorp or Kinross or an Agnico-Eagle, I would be almost inclined to hold onto the shares. Number one, you avoid the tax. Number two, you don't have to figure out what to do with the money. And number three, you can enjoy the upward movement that the company being acquired will add to the increase in the production figures of these emerging growth companies. So if it was being acquired by a growth producer –and by that, I mean a company that is growing its production and growing its reserves – then you might want to hold on because if the gold market goes higher, the shares will also go higher as opposed to, let's say, some of the lumbering giants who are seeing their actual production numbers and their reserves actually decline. [53:56]

Hi Jim and John, this is John from Utah. I'm calling on Wednesday, August 6th. Oil has fallen to $118. Gold is roughly $880. Silver is 16.60 and the Canadian dollar is 95.25. Gold, silver and the Canadian dollar seem to be going down in sympathy with oil. What are the chances that the oil run up and the other commodity run up recently, had to do with China and the Olympics and we will suffer a retreat now as we did in Y2K in these commodities after the Olympics? I also have a comment. Jim, you've been quoting the Canadian dollar. I think you've been inverting it. The Canadian dollar is now around 95 cents, and I think you've been saying what it would cost to buy a US dollar with the Canadian dollar, so you may want to change that.

JIM: John, I have been doing that. You know, it's one of the last things we do on the show late in the evening and I've been quoting at 103, 104 when it's actually roughly about 94 cents. Same with the Swiss franc. My apologies.

In terms of your question about oil and gold going down, we're in the soft period of time for both commodities, both the shoulder month for the area of energy when the weather is nice outside, people are consuming less energy; and then also the gold market, it starts to heat up probably beginning in mid-September. And in terms of actually the Olympics, you know, one thing you have to understand is for the Olympics, a lot of the production of energy and also the production of manufactured goods were shut down to clean up the air in the city. And so Beijing and around that area is a major manufacturing sector. And a lot of that has been shut down, so the air would be clean enough to breathe for the Olympics and I think they still have some problems there. Especially with the humidity there. Right now, there is a report out on Bloomberg attesting to that.

But I think the real question is what happens after the Olympics are over, the tourists are gone and the factories start up again, what happens to the Chinese economy. Will China slow down its growth rate? Probably. They'd probably like to get it down into the 8 and 9% growth rate, rather than the almost 12% growth rate that we saw in the fourth quarter of last year. And also, if you take a look at infrastructure spending, it's estimated that spending for the Olympics by the Chinese government was somewhere in the neighborhood of 45 to 50 billion dollars, and that's a drop in the bucket if you take a look at overall spending going on in China, and China now having the third largest economy in the world. [56:47]

JOHN: You know, I was chewing on something that David said in British Columbia, and because we got an email from another listener to the effect of socialism seems to be doing well in a lot of countries, but the comment that he also made in the email was that socialism would be better than this corporate welfare and I've been wanting to write an article that says it ain't capitalism because they are blaming capitalism for what really ultimately is the result of the two things which socialists always need to make things work: Number one, an inflating money supply and number two, a heavy taxation system. And it creates the type of bubble that allows for exactly the types of thing you're describing as we’ve said before, that socialism leaves you with a small group of people at the top that are very wealthy and everybody else at the bottom who are bankrupt. Unfortunately, Ambrose Evans Pritchard at the London Telegraph beat me to it this morning. He has an article there, government caused the credit crisis but capitalism gets the blame, so it's a worthwhile read. And that is it for today. I'm sorry. For the London Telegraph, not the financial telegraph. What are we doing aside from playing hooky?

JIM: All right. Well, coming up next week, my guest will be Jeff Christian and we're going to discuss the CPM Platinum Group Metals Yearbook for 2008. On August 23rd, Dave Sterling will be my guest, a book called Green Gone Wild. And then finally on the 30th, we're going to have a series of interviews. One of them will be an interview that I'm going to be doing with WD Lyle Jr. and A. Scott Allen, A Very Unpleasant Truth. And then, John, we're going to have -- most people are aware that John has a radio program that he does, Steel on Steel, and you're going to have an interview with James Kunstler and somebody else we're going to play.

JOHN: And Paul Mladjenovic who wrote Precious Metals Investing For Dummies, but he grew up in a communist country. With everybody talking about socialism, his family has seen the ravages of socialism first hand, so he's a passionate advocate for capitalism. And I've been chiding him because his name is -- he grew up in Croatia and it took me a while to learn how to say his name. I've been calling him Paul Eyechart because you can actually give that to your optometrist and let him use it. So anyway, that's what we're going to be doing as we take some time off on August 30. We're going to be out and we'll put a bunch of interviews in the can for you to listen to because if you're going to take the time to listen to the show, we should take the time to put something worthwhile to listen to out there.

JIM: All right. Well, listen, 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 between, we hope you have a pleasant weekend.