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Financial Sense Newshour

The BIG Picture Transcription

November 15, 2008

Part 1

Dinner in Zimbabwe - Part II: Monetary Policy

JOHN: Well, here we are. It seems like we can’t get away from this restaurant in Zimbabwe. We seem to like it a lot, so we spend the money, fly over here. And I can never figure out why the bill is the same price as a Lexus every week.

JIM: Or a fleet of Lexus’s.

JOHN: Is the plural of Lexus’s ‘Lexi’? You know, if it’s hippopotamuses and hippopotami? I have several ‘Lexi’ sitting in my driveway. How’s that?

JIM: Oh, okay.

JOHN: Actually, I’m a Camry fan, but that’s all right.

JIM: Central banks – we keep hearing that the central banks – and of course, the central bank here in the United States is the Federal Reserve Bank – that these institutions are fighting inflation or seeking to keep this under control. But the central banks were created to create inflation. They are the ones who create inflation; the definition of inflation being not the rise in prices, but rather an increase in the money supply, which later on results in an increase of prices. And that’s important because judging on the Q-Lines and emails we're seeing here, Jim, a lot of listeners to the program still do not understand that. All right.

And right now, for the first time in the history of the world, all of the currencies in the world are fiat currencies, meaning they have nothing backing them or behind them, which means there is no limitation or restraint on the currencies and how much they ‘print’ (although most of it is done digitally nowadays); and the solid history of all fiat currencies is that they all crash and burn at some point or another because inflating ad infinitum cannot be sustained. And ironically, Keynesian economics – a product of John Maynard Keynes – is now the thing taught in colleges everywhere. And in reality, it is simply the Bible or the theology of economies required to justify inflation. And when you talk to a Keynesian, even though the ravages of inflation is going on as you watch it, they will be there justifying its needs and its means. So, you’re stuck; and we're stuck right now as a world here because everybody is doing it.

JIM: The problem is you have too much debt, which was what was driving consumption in the economy. Now, the solution if we were to allow market forces to come into play, the solution is to 1) liquidate the debt; 2) increase savings and 3) increase investment. And what happens is we get these boom and bust cycles; the Fed inflates, injects money into the economy, the economy recovers, it heats up; you have all this malinvestment that is created because the Fed can’t control where it is. And in the 90s it was in technology, and this decade it has been in real estate. And the problem that is very important to understand is we've moved from a manufacturing to a service to a financial economy; so much of what you see in the US economy is just a bunch of institutions trading paper nothings.

But getting to where the root causes; now we’re in a recession. We've been in a recession. And according to a Keynesian, consumer spending is the driver of the economy, not savings and investment, and what happens is when you get into a recession, consumers pullback on their spending patterns; and as a result of pulling back they’re buying less, and the corresponding reaction to that is prices fall. If there is demand for things, prices go down. And according to the Keynesians you can’t allow this to happen. If you take a look at the components of GDP in our country, you have four factors. You have fixed investment, which is the most important and that has been on decline and it has been in a very narrow trading range over the last decade. It really hasn’t increased that much. You have consumer spending, or consumption which has risen over the last couple of decades from about 60 percent of GDP to 70 percent of GDP. Then you have government spending. Then you have exports. Now, the one bright spot, until recently, has been exports.

According to Keynesians, if consumer spending (which represents 70 percent of GDP) starts to fall, then what you have to do is you have to increase consumer spending. You have got to get people to start spending again because what the Fed is worried about is that deflation (which according to them is falling prices, not falling money supply) is very dangerous because it could become a self-reinforcing process and it’s very difficult to reverse once it begins. And so what happens is – and you see this, John, the economic news goes out there, it’s not looking good, the economy is contracting, people are losing their jobs – and when you have rising unemployment, what happens is people become increasingly reluctant to spend because there is so much uncertainty. And as they begin to pullback and rein in their spending, people hoard cash because they’re worried that they may need a safety cushion; and that’s where we talked last week about the drop in velocity. So the less people spend, the more prices fall and the more that people begin to hoard and hold onto cash. And so Keynesians will look at that and say, No, we can’t have that, we've got to reverse that. So according to the Bernanke Fed and Washington, recessions and depressions are caused by insufficient consumer spending. [6:18]

JOHN: It might be worthwhile to review the definition of recession versus depression. But right now we've plowed into a recession, and really what the Fed is trying to fight off is a depression in 1930 style; and it remains questionable whether or not they’re able to do that because the normal tools that are available to the Fed (which is adjusting the amount of money that is going out there by the means of interest rates) isn’t really working right now.

JIM: No, and you know, when you've had these business cycles that we've seen over the last probably half a century, typically recessions were caused by and brought about by Fed rate tightening, and the recession ended when the Fed eased interest rates which reduced the debt burdens, it stimulated demand for items brought for credit and it raised the value of assets because interest rates were lower. But the problem where really what is going on right now is depressionary, because a depression is a deleveraging process and that’s exactly what you’re seeing occur in our financial economy, if you’re looking at hedge funds deleveraging, if you’re investment banks deleveraging, or money center banks. And that creates an economic contraction and the traditional monetary policy is to lower interest rates – just exactly like what Greenspan did in the recession of 91 and 2001, they lowered interest rates and then the economy turned around.

But this time around, the Fed has brought interest rates down from 5 ¼ percent down to 1 percent, and it still isn’t working. Now, we are seeing interest rates come down but what has happened is long term interest rates are rising, the yield curve is steepening and we've got this self-reinforcing asset sale; as people lose income, as their creditworthiness declines this makes it harder to get credit. So what the Fed and the government is trying to do here is get people to start spending, get people to start consuming because in their mind the real problem here is not the debt problem or too much debt, it is that people aren’t consuming enough and that was what got us here. It was too much consumption and too much debt taking. So what the government looks upon, John, is deflation is a very dangerous process because once the process begins it is hard to reverse. So you start from the fact that people consume less, prices fall, there is less demand for goods and they err when prices fall because they’re reluctant to spend (they hold onto cash and that’s where we talked about money velocity – meaning less spending and less consumption) and so they look at prices falling, they look at deflation as an illness. If you take a look at deflation in the way that they describe (which is falling prices), we should always see falling prices because there is a natural evolution that comes from production; the more that you invest, the more that you increase production, it brings down prices. So true deflation, which is a contracting money supply – if you think about it, when the money supply contracts (and by the way, it isn’t contracting so we’re not seeing real deflation here) falling prices are the antidote because when there’s less money available, it is contracting prices that allow a lower supply of money to buy the same goods and services. But they never, never do that, John. They always interfere. [10:12]

JOHN: If we look at Chairman Bernanke’s PhD thesis, a number of papers as a matter of fact when he was a student, he studied the Great Depression and during that time he said he came to three basic conclusions. Number one, preventing a deflationary situation is much better than trying to cure it; in other words, never let yourself get into it. In doing so, he said we learned lessons of history, notably from Milton Friedman, whose basic theory was that the Great Depression was caused by not printing enough money. So that’s the lesson that theoretically Ben Bernanke learned from Milton Friedman. And finally, when you get into these types of waters, conventional methods don’t work and you must resort to unconventional measures in order to keep the whole thing afloat. Although, I might say on this one, Jim, when you do that, it begins to introduce a lot of confusion into the private sector because they’re trying to figure out what you’re doing.

JIM: And the thing that Bernanke, also – he wrote a paper and the Fed has written a paper and we’ll mention these papers at the end of this part of the Big Picture, but Bernanke also studied Japan; and according to Bernanke’s study of Japan and what happened there is the Japanese government used conventional measures – typically, like we mentioned earlier, what you would use in a recession. It didn’t work. Conventional measures only work with recessions, not depressions because in a depression you have too much debt; and we’ll get to the four steps that you take to fight depression. We have embarked on three of them, and number four, which will be a whole topic in itself today, is devaluation. Now, the problem with conventional measures is you can’t get to zero interest rates because who’s going to finance a bond when it pays zero interest? John, any idea what one month, three month and six month T-bills are paying currently? [12:15]

JOHN: No, I haven't been watching it.

JIM: Just picture this – you know what the yield is on a one month Treasury bill? 6 basis points. It is less than one-tenth of one percent. A 3 month Treasury bill pays 13 basis points, or basically, for 3 months, it’s a little over one-tenth of a percent; 6 month Treasury bills are 90 basis points (less than one percent); and a one year Treasury bill right now has a yield of 1.1 percent. So there are lessons from Japan that our Fed came away with as, look, you can’t use conventional measures when you’re trying to thwart an approaching deflation. [12:59]

JOHN: But look at everything that they’re doing right now, Jim. I mean, what’s your greatest fear? That Treasury Secretary Hank Paulson is going to get up and say something, right, because suddenly something new and unconventional is going to hit the wall as we watch it. So we've got all these acronyms that everybody is throwing around right now, and I guess we should look at some of those because when you deal with politicians you always have to ask when they say something: What does that mean?

JIM: Yeah, I mean if you take a look at originally when the crisis began, the Fed expanded its open market operations, it began traditionally, which is lowering interest rates, which it began last August and September. Then they lowered the discount window hoping banks would borrow. When banks were reluctant to do that, they created the Term Auction Facility where it was a special facility that banks could have access to. And when that wasn’t going well, they created the Term Securities Lending Facility, then they opened up the discount window to securities dealers; then they got to asset swaps, then they lent money to prevent bankruptcy, for example, Bear Stearns. If you take a look at what they’re doing with AIG. Then they extended swap lines to European and Swiss and other banks; then they lent to European banks, then they got into the commercial paper markets; now they’ve got into the money markets, backstopping them. Then they are also now getting into the credit card market. I mean, John, every time I see Paulson get on TV or the Fed, it’s the announcement of a new program, and a lot of this stuff is just kept off balance sheet. [14:36]

JOHN: Well, speaking of the Fed’s balance sheet, last week we were talking about the fact that it was expanding rapidly. Has there been any change this week?

JIM: Just in the last week, this is as of Tuesday, the Fed’s balance sheet is now 2.2 trillion; they added another 200 billion. It is up 148 percent year over year. And as several Fed governors are saying, we are increasing by over 200 billion a week, so by December 31st, we are going to be close to 3 trillion. So when you consider that in mid-August, before the Fed began expanding the monetary base and its own balance sheet, we were at 900 billion, which was up from 700 billion last year, but now we're at 2.2 trillion. And they’re stilling coming up with new programs. They’re going to backstop General Electric’s bonds, American Express because [they] can’t securitize credit card debt anymore became a bank this week, and they’re going to access the Fed’s window for 3 ½ billion dollars. I mean there are so many companies that are at the trough for handouts, we're going to declare just about everybody and here is Paulson making another speech today. So it’s like every time these guys talk, here is Bernanke, who spoke in Europe on Friday and he said, Central banks around the globe stand ready for further action – meaning coordinated interest rate cuts. And gosh, who knows what new programs they are going to come up with. [16:06]

JOHN: And it looked like last week, what, American Express virtually became a bank; they’re having problems securitizing credit cards so now it looks like the Fed is going to jump in and provide some security on that one. Maybe we should need a National Trough Day or something like that.

JIM: Well, they’re actually coming up with a new program; Fast Action Response Team, or FART. I mean literally it’s every single week. And there are so many people that are lining up at the trough; you’ve GE, you’ve got Fannie, you’ve got AIG which is asking for more money now, it looks like 150 billion; Fannie’s going to need more money. Also, Bernanke made a speech talking about the market for mortgage-backed bonds are going to require some form of government support through either guarantees or insurance programs to weather the times of heightened stress. I mean you take a look at the Fed’s balance sheet – from securities to repos to loans to TAF, the PDCF, they’ve got another one called Maiden Lane, which is where the Fed is actually losing money on some of these assets it’s buying. For example, this week, American Express became a bank; they’re tapping the Fed for 3 ½ billion dollars. Monday, Fannie Mae reported a 29 billion dollar third quarter loss; the Treasury is going to inject 100 billion there. AIG has now gone up to 150 billion in terms of the bailout. They’re also looking at a credit line for the automobile companies; they’re going to be asking for close to 50 billion dollars – that’s on the way.

Just to give you an idea of the amount of money that we're talking about here. In the current quarter, the fourth quarter, the Treasury is set to borrow 550 billion dollars; in the first quarter of next year, they’re looking at 368 billion dollars; and John, if we're looking at the Treasury’s borrowing for fiscal 2009, which began October 1st of this year, we're looking at the Fed or the Treasury borrowing between 1.5 and 2 trillon dollars. And also, look for next year, you remember the TARP, the 700 billion dollar program; they’re expecting that they’re going to have to come back for another trillion. So if you take a look at TARP which is 700 billion, if you look at next year’s budget deficit there’s 500 to 750 billion, if you look at our current account deficit, there’s about 700 billion; and then they’re estimating, just from preliminary talks, that the Obama administration is going to go with a 500 billion dollar stimulus program and which will also include a couple of hundred billion for FDIC. The point of all of this is the private savings in the US and foreign purchases of our Treasury debt is going to be insufficient to meet the cash needs of the government, and that leaves the Fed to take up the slack, and what that means is the Treasury is going to issue debt. What it can’t finance in the market, the Fed is simply going to monetize it which will mean issuing money out of thin air to buy that debt. [19:31]

JOHN: Well, here’s the dilemma we're facing in trying to understand all of this right now, we've been talking about some of these unconventional measures, but it’s still questionable whether this is all working or not, so are they going to have to pull out some more tricks out of their sleeves or just pump more of what they’re doing here and that’s it, and if it doesn't work, well, tough nougies?

JIM: Well, you know, if you read the Fed papers, both going back to 1999, 2000 and 2002 and 2003, they talked about these unconventional measures, and we mentioned everything from the TARP to asset swaps, all the different things that the Fed has implemented to fight this crisis. When you take a look at these Fed papers, there’s one in particular, Monetary Policy in a Zero Interest Rate Economy, this was the Dallas Fed in May of 2008, and there have been others written since then; they expand the menu of assets that the Fed can buy from short term Treasuries to long term Treasuries and just take a look at what they’re doing now: they’re buying commercial paper, they’re going to be buying credit cards, they’re going to be buying mortgages. Then they can also intervene in the exchange market to drive the dollar down, and you’re going to see a dollar devaluation here. (We’ll get to that in a separate topic by itself.) They can also purchase private securities or sector securities such as stocks and bonds; take a look at what the Treasury has done, for example, in investing in the banks. I think they’ve expended what, a quarter of a trillon dollars doing that, buying the shares into the banking system. They can also loan money and accept anything as collateral which they’re doing now from the private sector; also, they can extend loans to depositories or financial intermediaries and eventually to households.

And so there are a number of things that they can do and they’re showing their willingness – they’ve done a lot of them. I mean even Paulson came out and he keeps changing the TARP program. He made a press conference, and of course he’s speaking as we're doing this show, so who knows what happens. Maybe he’s going to introduce the FART program – the Fast Action Response Team – but what they’re doing is by making loans, what they’re doing is taking assets that individuals, financial institutions, whether it’s a money center bank, a former investment bank or a large corporation that deals with making loans to finance of purchases of equipment, like General Electric or even the automobile companies, they can take these illiquid assets from these lenders and turn them into a liquid asset by buying them and giving them cash. And so what they’re essentially trying to do here is spur demand in the financial sector which is under duress and has a need to liquefy assets. And so, you know, as we mentioned, we've gone through almost an alphabet soup of new programs and this week, they introduced another one to buy credit card debt; that’s the next sector in this. We're just getting started here, so there are more programs to come. [22:41]

JOHN: The deflationist argument would rotate around the fact that if you’re going to have a willing lender, then theoretically out there somebody has to be a willing borrower or it’s not going to work. What happens if you don’t get that willing borrower due to conditions?

JIM: Well, we've already seen part of that. When you have this debt default and you have this credit crisis as we’ve seen over the last year, the problem that they have initially is they have to print enough money to absorb all the bad credit that’s been out there; and that’s what they’ve been doing with TARP and all these other programs, whether it’s buying commercial paper, buying credit cards, backstopping money market funds, that’s the first stage of this; and that’s where you get low velocity which counteracts all of this money printing. The second stage in terms of what they can do is they can print money and distribute it. We already saw a bit of this in the first quarter of this year with the stimulus program where they got the checks to consumers and the consumers went out and spent the money. And that is what they’re talking about in the first quarter of next year with this half a trillon dollars stimulus program. And so what you’re going to see next year is probably Stimulus II, and Stimulus III; another word for them is ‘helicopter drops.’

Let me get to another argument that the deflationists would make which is that people won’t spend the money like they did in Japan where they just hoarded it. Well, actually what they did is they saved it and then the money went outside the country and they invested it outside. So the money flow, or the creation of money, left the country and it gave us the carry trade; and also, Japanese citizens said, Why should I invest in our banks here which pay next to nothing when I can go to the United States, I can go to Brazil, I can go to Europe where instead of getting maybe a quarter of one percent on my deposit, I can make 5 or 6 percent. So you can always push – and then the Fed even talked about getting to negative interest rates. Take a look as I mentioned earlier – 6 basis points on a one month T-bill; 13 basis points on a 3-month T-bill; 90 basis points on 6 month. And so there are a number of measures that they can use, and the strategy is to make money pay a negative nominal interest rate. And we’re already there. So where we're at, John, is the final solution is going to be the monetization of goods and services; it will be coordinated with fiscal policy where the government will go out and purchase goods and services and the Fed will buy the government’s debt. And at this point, the Fed can buy anything.

The problem that we have in these crises – we had the same kind of deflationary arguments that were made in 2003, and they were citing at that time a drop in the CPI where it went from 3.1 to 1.6 percent, but as the Bureau of Labor Statistics admitted, part of the drop in the CPI was simply a statistical measure where they reconfigured the way they measured CPI with used car prices versus new car prices; and so, really, you had a statistical anomaly that was created by the government. But even if you look at inflation and deflation in the way Keynesians look at it, which is inflation is rising prices and deflation is falling prices, we haven't had negative prices, you would have to go back to, I think it was either the first or second year of the Eisenhower administration where you had deflation as described by the Keynesians and you haven't had a contraction in the money supply; and right now the money supply is going crazy. [26:48]

JOHN: So as they attempt to then reinflate right now, we are going to get enough of this to actually give us the effect we want. And it should be observed as we do this, by the way, that the Fed’s policy is to be a reinflationary position; so they’re going to try to keep doing that because that was the theory that Ben Bernanke derived from looking at the last Great Depression: If we just keep pouring enough money into this we can beat it. Is that a pretty good summary of it?

JIM: I would say that within the next three to six months you’re really going to see the effects of this reflationary effort kick in.

JOHN: Let me stop you there. When we say ‘effect,’ are we talking about in prices or are we going to see maybe a leveled-off period, of what seems to be chaos, settle down for a while, or what?

JIM: Both effects. You’ll start to see prices start to go up, you will probably by the middle of next summer, by July, you’re going to see GDP turn from a recession, we will be on the mend to recovery, and then also I think you’re going to see assets reflated as reflected through the stock market. And so there are a number of things that I think are going to take place. However, I think one of the things that will confuse people is (and this gets back to the definition of inflation and deflation) if you take a look at items bought with credit or manufactured goods, you could see prices fall because as you get more production your unit costs go down, the price of what you manufacture goes down; and then on top of that as you see, let’s say, a contraction in the economy as people spend less, merchants and retailers and manufacturers cut the price of their goods. So in the things that you don’t need or don’t have to have, you could see falling prices. At the same time, in the things that you have to have, which is food, essential services like medical services, your utilities, things like that, you will see an increase there and also I think an increase in energy. And so the result is you are going to see another asset bubble and I think the asset bubble is going to be in resources and emerging markets because it’ll be the emerging markets, especially the BRIC countries that you will see the strongest growth in. So there are a number of things that I think are going to happen. But they will be successful because you’re going to have global reflation as we're seeing now, it’s not just us that are putting in trillon of dollars into their economies; it’s China, it’s Europe – all nations are doing this at the same time. [29:27]

JOHN: There’s a lot of material we can’t go into right here on the program, but if people would like to see what theory is in action right now, sort of looking at the playbook, there are articles that have been written by people that deserve attention because this will give us a roadmap of where we're headed.

JIM: Yeah, there are a number of papers – maybe what we’ll try to do is list the links to them, probably the easiest way is to google “Monetary Policy in a Zero-Interest Rate Economy.” [link]There was a May 2003, Dallas Fed paper by Evan Koenig, vice-president Jim Dolmas; this was the Federal Reserve bank of Dallas. There was a 1999 paper – Monetary Policy and Price Stability. There were Bernanke’s speech from 2002, Preventing Deflation: Lessons from Japan. That’s the famous “Helicopter Speech.” I talked about the 2003 – there’s also 2004 paper that was authored by Bernanke himself called Monetary Policy Alternatives at Zero Bound, meaning when interest rates get to zero. There were also two academics form I think Princeton, a 2003 paper called Zero Bond. There were also a number of other papers.

Also, I might also want to recommend, there’s an article on our site, written by an Austrian economist, Robert Blumen, and it was called Bernankeism: Fraud or Menace so if you go to the front page on our site and just look at ‘FSO contributors’ on the left hand side, find ‘Robert Blumen’ and he wrote a couple of papers, Bernankeism: Fraud or Menace and another one that he wrote is the End Game Hyperinflation – both of these articles he wrote back in 2005; very prescient in terms of what they said in these articles as you can see them actually unfolding through official Fed and Treasury policy today. [31:26]

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

Dividend Investing - Attractive Yields in a Zero Interest Rate Economy

JOHN: You know, we're going to talk in this segment, Jim, about the subject of how do you invest in an era where interest rates are close to zilch. In looking at what the Fed is trying to do right now, drive nominal interest rates down so people don’t save (which, of course, is what builds wealth), but then take their money out and do something with it so that the velocity of money picks up. This may be nice for keeping the economy going; it’s a nice game. For the individual it’s damaging to them. This isn't in their best interests. It really becomes obvious when you watch it.

JIM: Yeah, when you’re looking at saying, oh my goodness, I’m a little afraid right now or frightened by what I see occurring in the stock market, so you know what I’m going to do is I’m going to put my money in the bank or in savings or in Treasury bills and you take a look at the yields. Once again, John, one month Treasury bills, 6 basis points. That’s less than one-tenth of one percent. If you go in 3-month Treasury bills, 13 basis points; barely one-tenth of one percent. Even if you look at two year Treasury notes, 1.23 percent; and even if you look at 10 year Treasury notes, 1.7 percent. So obviously, keeping your money in cash is a direct strategy; and a lot of this has been a process of deleveraging, people coming out of the market saying, “Oh my goodness, I don’t want to be in stocks because of what’s happened in the market this year. I’m putting my money in something that’s safe.” But eventually, think if you had a 100,000 dollar CD and you’re making a half a percent or one percent; that’s 1,000 dollars on a 100,000 dollar investment, plus you pay taxes on that and by the time you pay taxes if you have the means, you’re probably getting a little over a half a percent, maybe 60 basis points, or 0.06 after taxes. And so they’re making it unattractive at a time they’re inflating like I’ve never seen anything in my 30 year career. [34:05]

JOHN: So what’s happening here is the fact that, number one, there is no incentive to keep your money in savings because nothing is being paid on it – your money is not doing anything – and even while it is sitting there, inflation is chewing up its value, literally devaluing the money as you sit there and look at it. So as I made my earlier comment, this is not in the interests of citizens here in this country, especially – let me give you an example, retirees – right? – they’re on fixed income, they have contributed x amount into whatever their money is, and now this is just destroying what it is they’ve worked for all their lives. I think there is a moral issue here as well.

JIM: Yes, not only is there a moral issue but remember what they’re trying to do is get money into the economy and force consumption and spending to counteract this drop in velocity and turnover of money. In other words, the Fed is creating all this money but they need to get more of this money into the economy. And so they’re driving down interest rates to the point where it’s basically negative effect. In fact, in the month of October during the turmoil that we saw in the selloff in the markets, at one point, the yield on Treasury bills was negative, meaning that you had to pay the government money if you wanted a one-month T-bill to keep it there. So it was costing you money. [35:25]

JOHN: So then we have to ask the real question – so if you’re in this fix and you want to do something with your money, the stock market? Are there areas where right now the dividend yield is actually looking good compared to what savings would be?

JIM: Oh sure. I mean if you take a look at the major indexes, obviously when prices come down, dividend yields go up. I mean we're looking at dividend yields right now at about 3.6 percent. This is on the Dow. This is very close to the yield on the 10 year Treasury, and remember, if you buy a 10 year Treasury at 3.74, let’s just call it 3 ¾ percent, that’s going to be stationary over the next 10 years. It’ll never increase versus you could take a look at some of the stocks in the Dow and you’re talking blue chip companies where the yields go anywhere from let’s say 8 percent all the way down to, let me see, yields in the 3 percent range.

Now, you've got to remember, you've got to look at how secure these dividends are and you want to make sure the company is earning enough profit, so you want to look at dividend coverage. But I don’t care if you’re looking at consumer staple companies, if you’re looking at drug companies, if you’re looking at, let’s say, telecom; if you’re looking at industrial stocks, if you’re looking at consumer stocks, I mean you have yields here that range from, I don’t know, close to 4 percent all the way up to 7 percent. And I’ve seen yields in the energy sector that are approaching 14, 15 and 20 percent. And I’m talking about yields that are tied closely to the price of energy. So you've got tremendous opportunity here to offset this.

So one of the good things about this correction or this bear market that we've seen in stocks is that we've made the dividend yields very, very attractive; in fact, if we take a look at the newsletter, Investment Quality Trends, that’s Kelley and Geraldine Weiss’ newsletter, this is the largest percentage of their 350 blue chip base of stocks, that they’ve seen – you’d almost have to go back to 1982 or 83 to see this many stocks undervalued on a dividend basis. . In addition to the coverage of those dividends, meaning that the company is earning and you want to make sure that they’re earning enough, not only in earnings but also take a look at the cash flow, that there’s the cash flow there to cover the dividends.

But you also want to look at the dividend growth rate and especially if it’s a company that has a business franchise that can increase its dividends, and that’s one of the keys that you want to look at when you’re looking at dividend yields (go back and listen to some of the interviews that we did earlier in the year, I can’t think of his name right off hand, from Morning Star, where he wrote on dividend investing) and those dividend yields are very important; that you look at a company that has the ability to increase those dividends because remember, inflation is going up. You don’t want a company that has a nice attractive dividend yield but they haven't increased the dividend for a long period of time. So look at companies that consistently raise their dividends each year, in addition to the cash flow and the dividend coverage. [38:51]

JOHN: If we look at government bonds right now, they’re not looking very attractive in any kind of an inflationary environment, but is there anything anywhere in bonds that would work during this type of an environment?

JIM: Two areas I like are investment grade – when I say ‘investment grade’ you want to look at, at least A, and AA rated bonds. But I especially like the convertible bond sector because not only can you get a yield but you also have the convertibility. Meaning that if the stock market goes up and they reinflate the market and in fact, they just did it as we're speaking; we just went from being down 300-something points to, thank goodness, for the PPT, we’re up nearly 50 points. We’ll see if we stay there, as we're speaking here it’s 12 noon on west coast time, so we still have an hour to go.

But I like convertible bonds because not only do you get the interest income which you can live on – and you can get some very attractive yields here, and especially if you’re looking into the right sector – but also, you have the ability if the stock market goes up, you can convert these bonds into common stock. So you have the upside of convertibility into the common shares. So you have a bit of a growth aspect. And so convertibles right now are, I think, a very attractive play here because you can get yields of 6 and 7 percent, kind of doing what Warren Buffett is doing when he invested in General Electric and Goldman Sachs. He invested through convertible preferreds. So Warren is getting paid interest income, but, if the stock market turns around and goes up, as he’s expecting and I believe that to be the case, especially next year, and I think will rally into the end of this year, maybe not enough to recoup the bear market completely, but maybe a rally into end of the year, and then next year I think is going to be a very good year for the stock market. So what is Buffett doing? He’s buying convertible preferreds and that’s another area. So convertible preferreds and convertible investment grade bonds which allow you to have your cake and eat it too because you’re going to get the interest income that’s going to pay you income during this period of time while you’re waiting for this kind of sideway consolidation period that we're going through in the market, and then at some point when the market recovers…and we could have a very strong market next year, as the market will begin discounting the recovery and then what happens is when the market takes off you can convert these bonds into the common stocks. So you still have some upside. So I think in addition to high paying dividend-paying blue chips, and I would look in areas that are going to be least affected by the economy: technology, industrials from infrastructure; I think also the energy sector; I think the agriculture sector; these are areas that look very attractive; consumer staples. And these are the kind of things you want to look at also when you’re looking at either convertible preferreds or convertible corporate bonds. [42:08]

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

Part 2

Mission Impossible – Part II : Depletion & Investment

JOHN: This starts the point, Jim, where things may become just a little impossible because in the last hour of the Big Picture we talked about the fact that the Fed is committed to this constant inflationary effort to ward off a Great Depression. So you can keep creating money theoretically, ad infinitum, though it never works because historically all fiat currencies go crash-boom at some point or another. But you can’t make something that isn’t physically there or necessarily available. A lot of energy issues are a flow issue. And last week we began talking about Mission Impossible, Part I, and this is Mission Impossible, Part II; and the IEA report (the International Energy Agency report) came out at almost 600 pages, and every time they manage to get more and more hard data on this whole situation, the picture looks a lot worse. And we may be facing an impossible situation here, at least in the short run, as far as energy is concerned.

JIM: This report that came out this year was rather controversial because what the IEA finally realized, they had all these projections in terms of future demand growth and of course they revise them every quarter based on economic growth, and then they had the supply. And for years the assumption was made that the supply would always be there. Well, what they were finding was that in this decade, despite almost a 14-fold increase in the price of energy from 1998, that supply was struggling to keep up with demand. So they did something that Matt Simmons did and they took a look at 800 of the world’s largest oil fields and they wanted to take a look at the real depletion rates were and then, given that, they updated their computer models in terms of demand.

And by the way, as you mentioned, John, it’s almost 600 pages in length and we're going to cover this over the next three weeks and we’re going to end our discussion of the IEA World Energy Outlook on December 4th when we're going to have a roundtable, and at that roundtable we're going to have Dr. Robert Hirsch, Matt Simmons and Jeff Rubin from CIBC. But what was really amazing about this is in the opening page of the report, they said the energy system of the world is at a crossroads. And they said that the current supply and consumption patterns that have been around for decades are unsustainable. They are saying something has got to give here. Either we kill consumption, or we reduce consumption through conservation dramatically, which I think we're going to have to do anyway, or we invest massively in order to maybe turn this thing around.

What the IEA does – and the reason this one was so long this year is on even years their reports are more extensive. I get these reports each year. I think last year was about 400 pages. This year we're talking about 600. And there were two themes to this year’s report. One was securing a supply of reliable and affordable energy, and second, transformation to a low carbon environment world. In other words, they’re addressing climate change. And as they have to point out, and which is obvious to everybody is oil is ultimately a finite resource. It is limited. And the real risk here, and this is a theme we're going to drive home, is the lack of investment where it is needed. The bulk of the world’s oil is in OPEC countries or the former Soviet Union, and they are not making an adequate amount of investment to arrest the decline rates that we're seeing in the world globally. So that’s a very, very important term. And you know, you've heard from the oil industry, you've heard from energy experts that with the price of oil going up, investment has been rising. I think globally we invested about 390 billion last year. But the problem is that most of that cost is simply going to pay for the higher cost of finding energy. In other words, the increase in operating cost in the energy field has been going up between 15 and 25 percent a year, so a lot of this upstream investment that you've seen is mainly keeping up with inflationary cost. It needs to go much, much beyond that. [5:06]

JOHN: The IEA report developed what they call a base case scenario and that means: what if everything stays baselined right at where we are now, given what we know about the availability of fossil fuels, where will we wind up – again, assuming that everything stays at a baseline right now?

JIM: The scenario that they’re talking about is from 2006 to 2030. Now, they said with economic growth slowing over the next couple of years, you’ll see less of a demand for energy. It’s still going to increase, but not at what their baseline case is. In other words, they’re saying by 2010 – or the end of 2009 – we could be out of the recession; the economies around the globe start growing again, so they’re calling for an average of about 1.6 percent increase in the demand for energy. So the demand globally will go from 11,730 tonnes of energy, to 17,000 tonnes of energy. And that’s an increase in demand over this period of time of 45 percent. And even by the year 2030, fossil fuels are still going to make up 80 percent of the world’s primary energy, whether that’s coal, natural gas, or oil.

And here’s the key point: China and India are going to count for over 50 percent of that demand growth during that period of time. And also, next to China and India, the Middle East becomes a greater consumer. So if you look at non-OECD countries, they account for 87 percent of the increase in energy demand and their share of world energy goes from 51 percent to 62 percent. But if you take a look at a low demand period for the next couple of years where they say demand is going to be growing at roughly close to one percent a year. So we’re going to go from around 85 million barrels a day of consumption, which is what it was in 2007, to 106 million barrels of consumption by the year 2030; and four-fifths of that increase is going to come from India, China and the Middle East. [7:29]

JOHN: What is also interesting as we do this is these are countries which are not really saying they are concerned about global warming, full speed ahead with the fossil fuel use.

JIM: Not only that, John, but it’s also the area – these are the producers – I mean especially the Middle East and OPEC countries and countries like the former Soviet Union, they are the fastest areas of growth in terms of oil consumption. You’re going to see increased demand for oil, there’s also going to be increased demand for natural gas. The demand for natural gas is expected to grow at 1.8 percent; and coal demand is expected to grow at 2 percent a year and 85 percent of that is going to come from China and India because Barack Obama has basically said with cap-and-trade, if you’re in the coal business and a utility, it’s going to get pretty darn expensive. [8:23]

JOHN: Obviously you have very large increased demand. Where is the supply going to come from? And we’re talking across the board here, in natural gas, coal, oil – those are the primary ones right now because again, the alternatives are not going to be online in full viability for 10 years or better.

JIM:Well, if you take at what they’re saying that we need to invest between now and the year 2030, we need to invest 26 trillon dollars (and that was an increase of 4 trillion over last year’s report). The power sector – that’s providing us with electricity – is going to need to invest 13.6 billion, that’s roughly 52 percent of the amount, and the other 48 percent is going to need to go to oil and gas. So it’s not just the fact that we need liquid fuels to power the transportation system, we're also going to need to upgrade the power system because eventually we’re going to be going to alternatives – whether it’s hybrids, electric cars, plug-insurance, whatever it’s going to be. But here’s an interesting case, and there’s an investment theme here too – the world’s current energy infrastructure of supplying oil gas coal and electricity will need to be replaced completely, 100 percent replaced between now and the year 2030. So in the next 20-plus years, we're going to need to invest at a massive scale, almost equivalent to a Marshall Plan type investment. It’s going to be required unless we're going to go without electricity and we're going to go without fuel.

I find this amazing because I think they’re wrong here, but they are talking about the price of oil between 2008 and 2015 is going to average 100 dollars in ‘real’ terms (by that, I mean ‘less inflation.’) And between 2015 and 2030, it’s going to be about 120. In nominal terms, (that’s what you see at the pump or what you’ll see in the paper) the price of oil is going to 200. So already the IEA is talking about 200 dollar oil; you've got Charlie Maxwell talking about 300 dollar oil, you've got Matt Simmons and some of the people in the peak oil camp talking about eventually 500 dollar oil; and John, it’s going to represent – I’m sure our listeners have seen, if you live in the United States, T. Boone Pickens’s commercial talking about the United States alone transfers 700 billion dollars a year to oil exporters, and in the next decade or so you’re going to see OPEC revenues rise to nearly two trillon dollars a year in what represents probably the greatest wealth transfer in history.

But here’s the investment theme; if we don’t start investing in new power plants, new energy – alternative energy – and the existing energy infrastructure from rigs to oil platforms to pipelines this thing is going to start falling apart. So 26 trillon dollars in today’s dollars and I’m sure that figure will go up next year because of inflation is an awful lot of money, so if you want to look at a long term investment theme (by that I mean will extend beyond decades) it’s going to be energy infrastructure as an investment theme. So I think this is a real opportunity here. [11:58]

JOHN: In the report they’re talking about the concept of depletion – of course that’s nothing new for here on the program – but again, the question is: where is the oil coming from and oil production right now, the availability has plateaued, and barring new drilling and – I don’t even know if infrastructure per se would help – but more exploration, more drilling, it doesn't make a difference even if you do have the infrastructure or the demand, the supply can’t match it.

JIM: No. Conventional crude oil only increases modestly and most new fields that will be coming onstream are going to offset the older fields which are depleting rapidly. And here’s the other thing – much as the world’s oil is concentrated within OPEC, the same thing when it comes to natural gas. And a good portion of this increase in fuel is going to come from natural gas liquids. OPEC will be supplying from 44 percent today to nearly 51 percent; the same problem that we have with oil, it’s all concentrated, the bulk of the world’s energy is within OPEC.

And here’s the problem – non-OPEC conventional oil has already plateaued at 2005 and has actually been falling; and when you take a look at all of these increases that the IEA is talking about over the next couple of decades, all hinge on, 1) adequate and timely investment – and when they say adequate and timely, that means we need to start right now; the world is going to need 64 million barrels of additional gross capacity or the equivalent of six Saudi Arabias just to supply what we're going to need from either increased demand, where demand goes from 85 to 106 million and then also to account for depletion. For example, they even break it down; they say by 2015 we're going to need 30 million barrels a day of new capacity to come on line to meet demand and one of the fastest dropping rates in depletion. Remember, when they came out with the midterm report, which was issued in August, they raised the depletion rate from 4%, I think to 5.1; now it’s over 9 percent. So what they’re saying here is what is currently being built and what needs to be built is going to widen sharply after the year 2010. And we need an additional – when you take that 30 million barrels a day by 2015, roughly about 23 million barrels of that is to account for depletion, and then 7 million barrels a day is just to account for economic growth.

Natural gas – we need almost 46 percent projected growth in production. Most of that is going to come from the Middle East and the Middle East is consuming 60 percent of what it is it produces. That’s because the Middle East uses a lot of natural gas to produce power. So what they’re saying is we're not running out of oil yet, we're projected to have 1.2 trillion barrels of oil, but what the peak oil camp will argue – and I agree with this 100 percent – the IEA cited the biggest increase to the world’s reserves occurred within OPEC during the late 80s, and that’s when OPEC was allocating production (when oil was at a low price) based on what your reserves were. So in a two year period, you had OPEC countries increase their reserves by 300 billion barrels with no new oil finds. And that was just a bogus number. So the 1.2 trillion that the IEA cites here, they believe as Gospel this 300 billion increase in reserves that was added to OPEC countries without any significant discoveries ever being reported.

Then they get into proven and probable and possible discovered fields could be 3 ½ trillion; and of course the peak oil people say, Where do you get that number from? These are done with computer models and then maybe 1 to 2 trillion in the oil sands between Venezuela, shale in the United States and the Canadian oil sands, and as everybody knows, when you’re talking about shale or talking about oil sands, you’re talking about a mining operation and there are many experts saying right now the Canadian tar sands are losing money with oil prices where they are. They need to get 85 to 100. So you’re going to see a slowdown in production coming out of the oil sands. John, I mean, you get the picture here: where is this stuff going to come from? [16:56]

JOHN: How long is it before they think it’s going to be noticeably acute? Not at the peak of where all of this is going to, but right now, people seem to think the issue is, “Oh, well, the price of oil went up, or gasoline, now it’s down again. Hooray. Hooray. Hooray.” But there is no sensibility right now that we're in a shortage; like shortages haven't hit, the price hasn’t become astronomically high. So how long before we start to feel some of that; any idea?

JIM: They’re talking about 2010, so we've got about another 12, 15 months of a free ride before it becomes an acute crisis because even when it comes to natural gas, I mean 56 percent of the world’s natural gas reserves are in three countries: Russian, Iran and Qatar. And you've already seen Russia use natural gas as a political weapon, and it has a very strong hold over Europe and especially over Germany, which is very dependent on the Russians for their energy. So the real problem, in a nutshell, gets down to this: After studying 800 oil fields, and this is where most of the gasoline in your car comes from, the depletion rate is 9 percent currently. That’s what these fields are depleting at and that’s what we have to replace each year, so we need to find a Saudi Arabia every single year just to replace the depletion that is coming from existing oil fields; and then that depletion rate rises into the double digits as we get into, let’s say, from the year 2020 to the year 2030. So these faster decline rates that we are seeing now, after they studied the actual decline rates of these oil fields means that we have to make substantial upstream investments; and last year we invested 390 billion, but the problem is the unit cost of finding energy is going up. And even though upstream costs are up 90 percent from 2000 to 2007 – you never hear the government talk about that – we're going to need to be investing 600 billion a year by the year 2012.

And if you look at the developing world where most of the demand for energy – between the Middle East and the developing world, it accounts for 87 percent of the increase of energy demand – so one of the problems I have with the suits on Wall Street, John, and you see it in the American media, they’re talking about US inventories, they are so irrelevant. Number one, as we have pointed out on this show over and over again, it’s not like you have a utility meter reader every single week with a dipstick and saying, okay, we measured the stuff in the tank. No. These are just hypothetical computer models that are seasonally adjusted. But if you take a look at the bulk of the demand, 87 percent comes from the Middle East and the developing world; they need to invest 8.4 trillon dollars or the equivalent of 350 billion dollars a year not only just to arrest the decline and depletion, but also supply the increase in energy that the rest of the world is going to need because they hold close to 90 percent of the world’s reserves and natural gas and oil. And if we're going to increase our demand for energy it has to come from these guys.

Well, what happens if they don’t invest this money? They don’t arrest the decline rates, they don’t bring as much new production online; at the same time, the other problem that you have, which we're seeing over and over again today, is they’re consuming more of what it is that they produce. [20:42]

JOHN: And maybe a big question over all – we're going to look specifically at national oil companies. But right now the atmosphere is very hostile to them, so it’s like biting the hand that is going to feed you because if the amount of investment that’s required is really out there (and right now, let’s look at the new administration that’s going to put it into alternatives, but remember, alternatives won’t be usable for 10 years – right? – as far as a large scale operation) then we have a problem called incentive. And the same thing exists for the national oil companies. International ones have investors who invest in it, but will the investment be there and available? That’s the issue that we're facing right now. It seems like in everything we're looking at when we talk about here on the program, if we should be doing A, we're doing B; if we're doing C, we're doing D. All the way down.

JIM: And the other problem too is the dominance of the national oil companies, the IEA says, What’s the risk to all of this not turning out well is that the national oil companies are unlikely to make the needed investment. John, here’s the thing: If they invest this 300 billion dollars a year, then the decline rate goes from 9 percent to about 6.4 percent. So even then assuming they were able to invest this amount in real dollars every single year, and make this commitment, you’re still looking at almost a 6 ½ percent decline rate, and they’re saying that you know, it is very unlikely because national oil companies are saying, “Why should we take all of the money that we get each year and invest it in order to increase production at a rate that would bring it down to sell it to you guys. Since it’s a finite resource, wouldn't we be better of husbanding these resources for ourselves and future generations rather than trying to crank out as much as we can as fast as we can in the way that an international oil company does?” And so, when you get to their summary, they go: The time is running out; the clock is ticking. And they emphasize that we must act now, today. And John, I just don’t see that happening. [23:01]

JOHN: No, not in the current climate. This is what bothers me. And even if we get to a period of pain, typically when people feel pain, the Congress people feel their pain and then something happens. But in this case, by the time you feel the pain it may not be in time to avoid the iceberg, I guess is the best analogy. That’s what you see building and gathering here. There is no discussion of it at this level in the political scene right now, today. None. None that I see.

JIM: No. And this drop in price which is being driven by huge short positions; there’s large options taken at 30 dollar oil, they are far out of the money options and you've got this huge shorting that is going on in the energy sector where you have all the major energy indexes that are down 40 and 55 percent this year. Part of that has been driven by deleveraging and then also by shorting. And also when you do risk arbitrage and you do dynamic hedging you also might be, let’s say, long a sector and short the stocks. And so there is a lot of stuff that’s going on that’s driving the cost of energy down, and at some point if we keep it down like it is, not only are we going to see wells start shutting down, investment dry up, but also OPEC getting more dramatic to the point where they just say, All right, we’ll just stop producing substantially until we can get the price up because the marginal cost of producing is between 70 and 75 dollars, and in the tar sands it’s between 85 and 100. [24:38]

JOHN: Well, obviously too, the IEA was talking about a new mathematical model, but these again are models, and that’s important because a lot of times in the political circles and the media, they start talking about these models as if they were the real world. For example, even the assumption you’ll hear when people talk about the situation – I’ll talk to them and “I’ve got great faith in American technology.” And I will say, You don’t understand. It’s not a matter of technology, it’s a matter of whether to ‘technologicalize’ in the first place. This all takes time, and like I said, the clock is ticking.

JIM: And you take a look at some of the assumptions, and once again, these are models, but one thing that – and we’re going to get into this in just a minute, but right now there are about 6 ½ billion people on the planet and that was based on the UN study as of 2006, and population growth grows to 8.2 billion by 2030, assuming we don’t have a war. And the average growth is about 1 percent, and we’ll tell you about where it’s going because this fits in well with what they’re assuming about where the investment needs to be made which is the emerging world. They’re talking about world GDP averaging about 3.3 percent during this period of time, with the largest growth coming from the BRIC countries and the highest growth rates in China, India and the Middle East. They’re talking about real prices for oil between 100 dollars a barrel between 2008 and 2015; those are real prices, in nominal terms it could be 200 dollars. They’re talking about natural gas prices begin to climb as we head towards 2010 and start to rise thereafter. Now, they’ve made several improvements – the main improvements they’ve made is they have a better understanding in terms of growth rates in terms of where the oil is consumed, where the growth in demand is going to come from both looking at the economy and population growth; and also what the decline rates are. But once again, so many of these assumptions that they make on this is that these things are going to take place that the added investment.

And what I find rather fascinating, and this goes where energy demand is; they mentioned that population growth rates are going to average about 1 percent. Okay. Where does this population take place? Well, the biggest jump in population are going to be in Africa, China, India and Asia, Latin America; the population actually declines or grows very slightly in OECD Europe and also in North America. Some of these rates, just to give you an example: In North America, population is expected to grow in the United States at about 0.8%; in Europe it’s expected to grow at about 0.2%; in Japan, the population is expected to decline; population is also expected to decline in Russia – that has very negative economic impacts; population in China is expected to grow at 0.9%; India, 1.1%; Africa, 1.7%; the Middle East, 2.7%; Latin America, about 1%. So once again, this sort of ties into the question of where is all this demand from energy going to come from. It’s going to come from the fastest growing economies, and also those areas of the world where the population is growing the fastest. Actually, what we're going to see in Russia and Japan is actually a decline in population. So this fits in. And so once again, this all gets back to the point of you know, will these countries be willing since oil – these are state-run oil companies – oil is the main source of revenue for the government. So they have social programs they have to maintain, benefits for its population and that comes from this oil revenue and it’s one of the problems that a lot of these countries are screaming right now at these low prices because they have all of these government costs, social programs and the cost of running government at the same time they have declining revenues. So where is the excess money going to come from to make these investments in order to arrest the effects of a decline of 9% coming from the world’s major oil fields. So stay tuned folks, this is going to get interesting.

And the other thing too, John, is here was an interesting thing – this is from a UN study – for the first time in history, in the year 2008 urban population is equal to rural population and from this point forward, most of the population growth is going to take place in urban cities where the demand for energy is going to be much, much stronger. And so one of the reasons I think we've been ill-prepared for this is since 2003, what we've seen is a slow motion oil shock that has taken place from 2003 to 2008 and I think this also has a bearing on world economies and recession. I mean everybody keeps citing the credit crisis, but as Jeff Rubin talks about, it’s not just the subprime crisis; four out of the last five recessions have been attributed to higher energy prices, so higher energy costs – John, you remember July, when we had oil prices get up close to 147 and we were paying over $5.00 at the pump here, it negated all the effects of the stimulus program; and so the one good thing about energy prices coming down from where they are right now, you've got gasoline prices back in the $2 range nationally, so that's equivalent to one of the greatest economic stimulus packages than anything the government has done. [30:33]

JOHN: You know what really strikes me about this, I mean based on my own profession, but when all of this information comes out when say the pain starts to hit, the media never get it right. They are always seeing it through political filters rather than seeing it through real world filters and so now the public becomes very, very confused as to exactly why things are the way they are and confused ideas on the part of the public lead to confused ideas in terms of solving the issue and then we make another bad decision. And it's unfortunate. It seems to me the curse of a democracy. We can't finish this whole topic today. What we're going to do is continue this discussion into December where the energy roundtable will conclude that, so we've traced it so far looking at the IEA report right now. Where do you want to take this next week, Jim?

JIM: Next week in the Part III, we're going to take a look at oil and gas production prospects. In other words, where is the oil, who owns it, what are the prospects? We'll also relate this to investments. The following week we're going to have our annual gold show, and then the first week in December, we'll conclude this discussion with the round table with Jeff Rubin, Dr. Robert Hirsch and Matt Simmons. [31:46]

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

20/20 Vision

JOHN: Now comes time for the great reneging. Actually, the great reneging has been under way for quite some time. That is where politicians have to live up to the fact that there is not a prayer’s chance in heck that they are going to be able to deliver everything they have promised to you, simply because the resources don't exist out there to enable them to do that. But even if the resources don't exist out there, ladies and gentlemen, prepare yourself for shock because no matter what they promise long term, the government is going to grab more of your money more intensely. Remember that as governments come into more and more fiscal trouble as taxes and inflation run away, they begin thrashing around looking for people's property to seize, increasing taxes and decreasing on delivery. This is sort of the worse of both worlds here, Jim, because they increase what you're having to kick into it and decrease or basically renege in one form or another on what it is you have to put out. And we're centering our discussion here on an article in the November 17th edition of Forbes magazine, 20/20 Vision, and it was a very sober assessment on exactly what politicians want to do and what this will mean if they do it.

JIM: And what they were doing, John, is during the election, you heard now-President-elect Obama talking about basically only those who make 250,000 or what we call the Henrys, ‘high earners, not yet rich people.’ But as Forbes talks about – and I'm reading from this article –

The government is destined to extract a pound of flesh from the middle class because this is where the money is. There simply aren't enough millionaires around to pay for everything, but ordinary folks pay more too. They will pay as tax burdens diffuse into costs of things we buy. They will likely pay more for fuel and electricity as the cost of carbon permits and renewable fuels mandates get built in. They may be asked to pay a European-style value added tax. That's where we're going next. And they will pay on the other side of the ledger. Their retirement benefits will get clipped. [34:21]

JOHN: You notice you can already see this, Jim, as Medicare is running into trouble, although they'll promise you, “No, it's going to be there, it's going to be just fine.” Basically they are reducing what benefits you're able to pull out of this and the quantity that people now or the future are going to be expected to put into it continues to go up. Say for Social Security, we're talking about moving the goal post there, you know when you can retire, when you can collect, pushing it further and further back and taking the caps off of it. So more and more expense, less and less benefit.

JIM: Yeah. They are talking about for those of you who are retired and eligible for Medicare, beginning in 2009 when premiums are fully phased in, the wealthiest seniors will be charged $7400 a year per couple for the same outpatient and doctor visit coverage other seniors will get for just 2300. So they're already reducing Social Security benefits in terms of payments based on income, and also they are going to be charging those who earn more for Medicare. So that begins, John, next year, so there is another reneging. And then they talk about in this Forbes article, during the last 50 years, federal government revenues have averaged 18% of gross domestic product, but if growth and health care cost isn't slowed and Congress doesn't renege on its promises by 2050, the government's cost for the big three entitlement programs (Medicare, Medicaid and Social Security) will exceed 18% of GDP, leaving nothing for defense, homeland security or anything else, not counting paying interest on the federal debt. So then they talk about let's get into taxes because despite what they are telling you, there is no way. I mean we talked in an earlier segment where the government is going to need to finance between 1.5 and 2 trillion in the 2009 fiscal year which began October 1st. [36:23]

JOHN: As we look at it, Jim, the 2001 and 2003 tax cuts are expiring at the end of 2010. Now, this is if Congress did absolutely nothing; right? Right now also the Democrats now who are in control of the House and Senate including President-elect Barack Obama have been itching to push marginal income tax rates for couples earning $250,000 or more back up to the level at the end of the Clinton administration.

Now, I might point out, by the way, Jim, that that threshold level of 250K has been dropping downwards here. I don't know if you've been noticing that. I think we're down to 120 now is where we're at.

JIM: Yeah. It went from 250 and then it was 200 and now it's 120. And what they are doing there, John, is going back to the Clinton tax rates as they would be capturing more and more people in the 28, 31, 33 percent brackets and the 25 percent brackets, and that's what they want to do because there are a lot more people in those brackets. [37:24]

JOHN: What happens, by the way, when inflation, you know inflation is now pushing this up, the inflation that doesn't exist (remember that one!) that is now going to force people upward into what they are going to have to make, so what might have seemed back in 1970, 1980 as a really heavy-duty income is really just going to become right in the middle of the middle class very quickly, so we're taking a whole class of people now and shoving them upwards into that ceiling.

JIM: Well, we're doing two things. We're going to shove more people up into higher brackets and we're going to shove the other half into not paying taxes because if you take a look at, and we had a graph of this on last week's show, politicians of all stripes are vowing to preserve the tax cuts for the middle class and to add to them. Already currently, 38 percent of America's households pay no income tax. Now, I want to distinguish income tax versus Social Security tax. If you have a job and you're paid by your employer, you are paying Social Security tax, but you may not be paying income tax. So Obama's proposal would increase the no-pay share to 48 percent while transferring an additional 650 billion over 10 years to families who don't pay income taxes through what is called a new or expanded refundable credit for such items as child care costs, college, mortgage payments and retirement savings and then also there is a program they've already talked about, there are two or three which the FDIC is working on, Fannie is working on and the government is working on where they would come in and based on if you made your recent payments, they would adjust your mortgage down and your payment down and give you a new interest rate. So if you take a look at this, this is a give away of 80 percent. Who is going to pay for that?

And it's not, John, just raising the tax rates back up to 39.6. If you take a look at the denying or the phase out of itemized deductions for those who make more income, you're talking about a 40.8 percent income tax and then of course the Social Security limits this year are 102,000. Anything over 102,000, if you work for somebody else, you pay an additional 1.45 percent in Medicare tax. If you're self-employed, you would pay an additional 2.9 percent, so you're already talking about roughly a 44 percent income tax rate on higher marginal income taxes. But then the other kind of tax, in other words, all of these bailouts that you hear them talking about, the expansion of the Fed's balance sheet, the guaranteeing of all of these organizations that are losing money, who is going to pay for that? Well, you’re going to pay for it in another form of taxation that is called inflation, and that's the invisible tax. What you can't collect or extract from somebody's paycheck, you extract in the form of inflation in terms of devaluation and depreciation of the purchasing power of the monetary unit. And that's what's coming up next. [40:31]

JOHN: You know, the other problem that we've got right now, Jim, if we look at income tax and maybe that's slewing us into VAT taxes here because Europe has a VAT tax (value added tax) which is a taxation at every level of production. In this country, we have around right now I think 35 percent of the working class pays no tax and that number is creeping upwards. Now, of course, this class is always going to vote politicians into office who want to go tax somebody else and/or give this class benefits. You know when you're robbing from Peter to pay Paul, you can always count on the support of Paul.

JIM: The thing about it too is they don't realize that they are going to be impacted by an invisible tax. And as the Forbes article talks about, the coming shakedown is this Social Security Obama wants to talk about. They go: By 2041, the government will be able to pay only three-fourths of the promised benefits with the current Social Security tax, which is 12.4 percent of the first 102,000 in wages (for next year that limit goes from 102,000 to 106,800). The cost is ostensibly split between worker and employer. Looking at it another way, to fund all of the benefits promised for the next 75 years, the Social Security tax would have to be raised immediately by 1.7 percent of payroll. And this concept, John, that people have had in planning and I started out as a certified financial planner, we always would tell people to defer paying taxes. And it worked real well because remember when Ronald Reagan became president, his first stimulus package was to bring the tax rate from 70 percent down to 50 percent and then eventually with the 86 reform bill, he brought it from 50 down to 28, phasing out a lot of the itemized deductions, the tax shelters, the benefits immediately and then a three year phase-in where we got the tax rate down to 28 percent; and then George Bush Sr. came in and then Read My Lips, well, guess what, he raised taxes and he raised taxes to 31 percent; and then of course Clinton raised them up to 39.6 and plus added the Medicare tax on all income. So the net benefit and the net as we sum up what Forbes is saying, if you think it's just going to be rich people that are going to get caught up in the vice, think again. If you add it all up, taxes are going to go up, your benefits are going to go down, there is nothing to do but save more, spend less and work longer. You're already doing this to put your kids through college. Now, you're going to do it to pay for your own bacon. And that's 20/20 vision. A very sobering assessment of where we are. You cannot spend the kind of money this government is spending and you cannot bail out all of the institutions that we are bailing out without adverse consequences. [43:35]

JOHN: I don't know if I told you this or not, but I found a tax free environment on which to live. I'm buying property on the moon. I have some beach front property, Jim. It's right on the edge of the north end of the Sea of Tranquility. That should be -- but, you know, ironically that is what causes the flight. Remember in Europe when they had tax inequity. They always keep talking about tax normalization, and I should point out as I say this as well that with this new economic conference going on, there are calls for a new international economic order, a new international bank, a world bank type of thing, not the World Bank of the International Monetary Fund we have now, a new international currency; and of course, tax normalization because that prevents people from fleeing from one taxation area to another. They want to have it all level so everybody is shackled to the same bulkhead. So anyway, I'm getting my sun tan ready for the Sea of Tranquility. We'll be back. We're listening to the Financial Sense Newshour at www.financialsense.com. So be calm during all of this.

Reflation – Devaluation

JOHN: You know, last week we were talking about things that you do during a depression, typically from a historic perspective of what Roosevelt did during the Great Depression, but also what Bernanke is talking about doing right now is a series of unusual measures that are taken. The last of these always seems to be some kind of a devaluation of the currency and right now, there is all of the talk of not only a possible international currency (which I think is a little ways away, we're not quite there yet), but a new Bretton Woods agreement ignoring the fact that the first one fell apart. But if we have that, what are the potential for devaluation of the dollar and any other related currencies that jump into this basket?

JIM: Well, you know, if you take a look at – we've been making the distinction between a depression and a recession, and a depression is a deleveraging process created and brought about by too much debt. And the problem, if you take a look at the G-20 that are getting together this weekend in Washington, is all debts are rising around the world. And it's not just debt problems that are going bad here in the United States. They've got debt problems in Europe, they've got debt problems in Asia, they've got debt problems in Latin America, so the best way to get rid of debt is devaluation.

Now, if we take a look at how Roosevelt came in and fought the Depression, he did four things.

One, he created a bank holiday and came back with government guarantees. We already did that. We just raised almost the equivalent of FDIC from 100,000 to 250,000.

Two, he severed the dollar from gold. In a way we're doing that indirectly by slamming the price but not making the production of it available, and so you've almost had a severing of the two purposes of money: a store of value and as used in transactions. So people still need fiat currencies for transactions, but gold and silver are fulfilling their monetary role as a store of value.

Three, massive money printing. Oh, my goodness, have we seen that! We talked about in an earlier part of the program that the Fed's balance sheet just increased by another 200 billion dollars. So the Fed's balance sheet is 2.2 trillion and it's estimated it will be 3 trillion by the end of the year.

The fourth thing, and this is very effective in getting rid of debt, is devaluation. And that was something that Roosevelt did in 1933 with Executive Order 6102 where he not only confiscated gold, but he raised the price of gold by 69.3 percent, effectively kick starting asset reflation and it worked. You can take a look at charts of the economy, the CRB, and it worked for about four years until he raised tax rates to 80 percent – another dumb move. Only this time it won't be just the US because remember other countries are in the same boat. The world is too interconnected today, so instead of the world's leading countries, I think could propose simultaneously universal currency devaluation. And in that case, what would happen is gold would be revalued overnight and currencies would be devalued overnight. So there are two ways that they are either going to do this and dollar devaluation is coming, folks. That's step 4.

We've seen three out of the four and up until this point, we still have some problems. They are not getting enough. There is still too much debt out there, so you've got to make that debt worth less and one of the best ways to do it effectively and almost do it very quickly is devaluation of the currency.

And who knows? We could wake up one day and it could be decided on a weekend before the markets even open that the dollar is devalued and all currencies are devalued and then what we would do is go to some kind of new sort of semi-fixed rate system and eventually, they would like to have a global currency, but I think you're going to do it in stages. You're going to have almost three or four currency units. You already have the euro and I think what is coming to North America is the Amigo, and then of course you get the miso, and then eventually you would have these three currency units and you would get the globo. Who knows what they'll call it, but you're going to have to do it and you're going to have to revalue gold in the process. And I've seen estimates in terms of what it would mean for the price of gold, anywhere from 5000 dollars an ounce all of the way to over $10,000 an ounce, but you're going to see a devaluation coming as we’ve mentioned. We've already seen three of these four steps take place and when it happens, it's going to be like a thief in the night. It will be very quickly and the currency markets will begin to sense this before the formal declaration.

But right now, John, it is in nobody's interest to see the dollar collapse, but the US needs to get its currency down. It's up today not because of deflation but because of the dollar carry trade and also because as the world's reserve currency you’ve had a lot of currency swaps where the Fed is loaning out dollars, a lot of people borrowed in dollars and they've got to pay back loans, there are margin calls and there is a scramble for dollars and that's what's increased this value of the dollars. So if you look at the two strong currencies in the world right now, it's the currencies that were used in the carry trade and it's the dollar and yen with the two lowest interest rates in the word. I mean if I take a look at – just call up my bond screen up here on my Bloomberg. If you take a look at interest rates, short term treasuries 1.2 percent in the United States, 10 year treasury is 3.7. You go to Europe, they are over 4 percent. You go over to Asia, they are over 5 percent. You go to Latin America, they are at 7 and 8 percent. You go to New Zealand, they are much higher there, New Zealand interest rates are over 6 percent.

And so what a lot of these people that have been playing the carry trade have been borrowing short term in the US dollar and Japanese yen where the interest rates are the lowest and as this deleveraging is taking place, as these loans have had to be paid back, you've seen the value of the Yen rise, you've seen the value of the dollar rise, and so that's short term. And it's really harming US manufacturers. The one strong sector of the economy has been exports, so the fourth factor coming up here is going to be devaluation of the currency. You make debt worth a lot less and it can be done very effectively. Now, they are going to have to sell this to people, but it is coming. And I don't know if it comes in stages, if it comes gradually, but this is what is coming next and it's going to be the ultimate way of fighting any deflationary effects that would come from contracting debt. Right now they are printing the money faster than debt is contracting and it's still keeping prices up on things you still need.

I'm always amazed, John, and I don't know if you've seen this how the packages are getting smaller in the store. I've even seen with canned soft drinks now they have half sizes that are very expensive. The packages for cheese are getting smaller, the dog food bags are getting smaller, the cereal is getting smaller, so you're already seeing this take place right now. But the next factor that's going to hit the market and this is the one I think most people are going to get caught unaware of is going to be devaluation of the currency. And it's just a question of what this Bretton Woods II as they converge and they are looking at maybe an international accounting system, they are looking at international leverage standards, a whole bunch of things that they are going to be looking to come out of this, but the one thing that the Europeans have, you have a central bank that really is just devoted to the euro currency. It really can't affect national outcomes and if you look at even the euro, the yard sticks that they set (budget deficits must be 3 percent and less of GDP, inflation rates have to be under a certain level), just about every country has exceeded those limits. So those bands are becoming a joke, but when it comes down to economic problems, you know, the individual countries, the power to do things economically is still back at the individual level and not in Brussels or the ECB because they have very limited power. So they still want a global system tied to the dollar because the euro can't replace it, the yuan can't replace it and the yen can't replace it. But it's going to have to be a devalued dollar, and if they devalue the dollar, they are also going to devalue other currencies as well because it's in their best interest to do so. [53:52]

JOHN: Let's ask the obvious question that people typically do in this case. When we do a devaluation, how does that affect what's going on inside of our currency. How will we feel it? In prices or anything? Or virtually no change within inside of the closed economy here?

JIM: Well, one thing, you would get immediate asset revaluation. You would make assets worth more immediately. The things that we import in this country would also go up immediately too, so you would see it in higher costs. But one way to stop this asset deflation is devaluation, because that's exactly what happened in Germany, what's happened in Argentina and immediately assets get revalued in nominal term to make up for the lower purchasing power of the currency unit, so it would be one way to stop the depreciation on real estate and especially if it continues over the next 12 months. [54:41]

JOHN: Well, having said all of that, you're proving to me it's going to be a wild ride over the next – well, we're calling it the crisis window, aren't we? And it looks like we've got another 1452 days to go until the next presidential elections, 66 until the change takes place, and we'll see whether or not by the time we get to the end of this crisis window how the voters feel about everything. I would predict, Jim, it's going to be a radical change again from where we were at this election just based on all of the issues that we're forecasting; and the average American, the average media people, don't have a clue where this is all going.

JIM: No, they don't, and I think that especially when these reflationary efforts and devaluation really start kicking in. You remember what public, John, we were Boomers, so you remember what it was like in the 70s. When they started doing all of these things, the money printing, the separation of the dollar from gold, budget deficits, and remember Reagan called it the Misery Index and by the time you got to the end of the 70s, you saw double digit inflation rates and that's exactly where we're going to be going again, and maybe even worse depending on what they have to do to restart this thing. So at some point people will start feeling it because not only higher taxes, California is proposing a 5 percent increase in all income tax rates, they are proposing a one and a half percent increase in sales taxes, so you're over 10; and you're right, John, what they are going to do next is VAT, and that way they can disguise it into the cost of goods, so when you go to buy something, you won't get mad at the government which is raising the cost of those goods through either sales tax or a VAT tax, you'll get mad at the merchants. It's like the poor gas station owner.

Remember when fuel costs were up over $5.00 this summer, I saw a lot of gas stations had big signs showing how much was going to taxes just to make sure that people know, Hey, it's not us, this is what we have to pay for this stuff; and it's the main reason that gas stations sell all things from Pepsis to corn nuts. They make more on the corn nuts and Pepsi than they do on a gallon of gasoline. But once you start throwing a VAT tax, look for that to surface next year and talk about it. There are already proposals to consider it and you're just not going to be able to go to your boss and say, Look, my real inflation rate is over 10 percent and with taxes that I pay, I need a 15 to 18% pay raise to keep myself even. So eventually you do get a revolt. But in the first place, we've got to get there first but as we talked about in the last segment, about the 20/20 Vision article in Forbes magazine, a very sober outlook of what's coming.

And remember, folks, when you watch your evening news and you see the government is bailing out the credit card holders now, they are bailing out American Express, you know, John, I just got an idea. I think we need to turn our brokerage firm into a bank and then I can apply for Fed loans. I can go to TARP and say, you know what, I'd like to borrow money at the Fed discount window at 1 percent or less. You know, I'd love to do that. I could arbitrage and go in and buy high dividend paying stocks or royalty trusts and make the difference. But unfortunately I don't think they care about people like me. You've got to be big and then you're big and then they take care of you. [57:59]

JOHN: Yeah. I don't know. Maybe I could go into farming. We do a little here but go into farming big time and I can have the government pay me not to raise things.

JIM: There is an idea. Buy farm land and don't do anything with it. Great investment. Good pay. Gosh, they are handing out everything. They are going to pay off mortgages for people, buy bad assets, you might as well – we've got to figure out a way to cash in on this.

JOHN: We'll work on it over the weekend and then if somebody gives us a suggestion, we'll give you a cut.

JIM: If you're listening to the program and have any ideas on how the average guy can cash in on TARP or something, please email us or call us on the Q-lines.

JOHN: All right. You're listening to the Financial Sense Newshour. Speaking of Q-lines, they are coming up next here at www.financialsense.com.

Financial Sense Newshour

The BIG Picture Transcription

November 15, 2008

Part 1

Part 2

Part 3

Part 1

Dinner in Zimbabwe - Part II: Monetary Policy

Dividend Investing - Attractive Yields in a Zero Interest Rate Economy

Part 2

Mission Impossible – Part II : Depletion & Investment

20/20 Vision

Reflation – Devaluation