Financial Sense Newshour
The BIG Picture Transcription
December 6, 2008
- Recession vs Depression - How Deep/How Long
- Quantitative Easing
- No money - no inflation
- Searching for Returns in a Zero Interest Rate World
Recession vs Depression - How Deep/How Long
JOHN: Well, it is official. The National Bureau of Economic Research pronounced earlier in the week, I think it was on Monday, that we are in a recession and the recession started in December of last year. And I keep thinking, Jim, we should go, “Duh,” when we get done with that; that's something we all knew before that. You just have to look at headlines out there: Employers cut 533,000 jobs, the most in 34 years; mortgage delinquencies and foreclosures rise to record levels. This is the one that I really like: California eyes IOUs for the second time since the Depression. They are going to start paying their vendors with IOUs. Now, this is pending I think. I don’t know when this is supposed to start; we’ll have to find out. Paying vendors with IOUs, delaying payments or paying in registered warrants starting in March. There it is – California will run out of cash by the end of February. Do you remember, Jim, the last time California did that? The warrants began actually trading like currency. That was sort of interesting.
JIM: Yeah. That was actually the 91 recession.
JOHN: Yeah. I remember that. I remember there was one company. I don't have the story in front of me, so don't hold me to this, but they were a major vendor for California, and I think it was a San Jose company. California kept paying them in these warrants, and so it came time for that company to file its sales tax returns, so they filled out their sales tax return, took an equivalent amount of warrants, stuffed it in the envelope and sent it back.
JIM: Hey, if you're going to pay us in warrants, we're going to pay you in warrants. Why not? It works both ways.
JOHN: Well, if we are in a recession, and I don't think there is any dispute here between the two of us that that's the case, this is not an ordinary recession. And the real question is: Are we simply in the slide to a depression? So we need to look at the dynamics of both situations because people will always ask that.
JIM: Well, you know, the one thing that we've been talking about, John, is this crisis window and a depression. And there is a big difference between a recession and a depression and what most economists, a lot of people in the financial sector have been looking at is, well, this is just a severe recession and if you take a look at what a recession is, it's a contraction in GDP. Instead of GDP growing, GDP is contracting. And the contraction in GDP is usually brought about as the economy heats up, as inflation heats up, the Fed comes in and they start a rate-raising cycle much in the way they did in 1999 to 2000. We had a recession, the Fed comes in, they start cutting interest rates as Greenspan did in 2001 and then what happens is as the Fed begins its rate decline, rate-cutting cycle, what happens is then we get a rebound in the economy. As the Fed cuts interest rates, it reduces debt service burdens, it's easier to refinance a home and then another element is it stimulates the economy because credit becomes more available, it's much cheaper; and you know, you take a look at big ticket items like a car, like a home, these are things that are bought with credit, so as the price of credit comes down, it stimulates buying. And that is certainly what we saw after the 2001 recession, we saw it in record buying for cars, we saw it for record buying for homes and then also because of a discounting mechanism that's used whether in real estate or to value assets such as stocks, it raises the value of assets. And that's typically your recession cycle.
The key point to understand – and we're going to get into the series that we're going to cover today in the Big Picture – is really a depression is all about excess debt and it's about a deleveraging process; and how many times have you heard the word deleveraging since last year, and that's exactly what's going on. As people deleverage, meaning they get rid of debt, they sell assets that were purchased with debt. As they sell those assets, the assets decline. Also as assets decline, you've got a lot more problems getting credit, it's less available, credit becomes tighter and as credit tightens, you get an economic contraction; and it's no secret we've been talking about this since the beginning of the year, but the NIBER board dates the recession to December of last year.
And so these traditional monetary policy responses where the Fed cuts interest rates, which they began doing in August of 2007, they cease to work because rising interest rates raise debt burdens and you get this self-reinforcing cycle. As people try to deleverage, they selloff their assets. As they selloff their assets, the assets decline. The more the assets decline, the more you get margin calls and it becomes a self-feeding cycle. So it's obvious from what has been going on that this is more reminiscent of a depression than it is a recession because the typical remedies that we've seen used to fight a recession over the last 50, 60 years clearly aren't working. [5:35]
JOHN: So we're not just talking about the level of economic growth. We're actually talking about a shift in the actual environment where the rules are all changing. So let's look at a depression when you get there, in a nutshell.
JIM: If you look at what depressions are, number one, they are a deleveraging process. You have wealth disruption. You have economic disruption. The economy declines and then you have all prices falling together. And then what happens is assets fall and it makes debt worth more. In other words, let's say that you bought a house with minimal down. Let's just for illustration purposes and we're just going to keep this easy, you bought a house for $100,000 and you put $10,000 down. So you have a $90,000 mortgage. Now, if your house drops by 20, 25% and certainly in areas of California, Vegas, Florida, the hot spots of the real estate boom, you've seen prices drop as much as 30 and 40%. So once your asset value drops below your outstanding mortgage, it makes servicing debt more expensive because now your debt obligations are worth more than the asset. And this leads to greater tightening of credit. It leads to greater selloffs. It becomes self feeding and what it eventually leads to is economic contraction when this first erupted in February of 2007 with financial intermediaries that went under and then of course last August.
So the first part of it hit the financial economy, and there are three parts to the US economy: You have your manufacturing economy, you have the service economy, which is piled on top of that, and then on top of the service economy, you have the financial economy. And up until recently, probably up until the summer, most of this contraction that you were seeing was hitting the financial economy, it was hitting real estate, it was hitting mortgage financing, it was hitting Wall Street firms, it was hitting the banking system, it was hitting insurance companies with all of these write-offs. In fact, I have a table here that shows the write-offs worldwide and as of the latest quarter worldwide, we've written off $978 billion, and the financial system has had to raise about 872 billion and a good majority of that has occurred in this country where we've written off close to $670 billion and there has been capital raising of about 525 billion. So the underlying difference between a recession and a depression is debt levels and deleveraging. [8:22]
JOHN: All right, so Treasury actions in relationship to the recession, which theoretically in a recession should work, but now don't seem to be working as far as a depression.
JIM: No. And if you take a look at typical response when you start getting economic weakness or problems in the financial system, the Federal Reserve comes in, they began cutting interest rates; that began in August of last year. But then we've had these series of almost unconventional moves. We've seen the Term Auction Facility. We've had asset swaps where the Fed was taking and swapping its Treasury debt with financial institutions taking their toxic assets and giving them treasuries. We saw the Fed come in, make loans to security dealers for the first time. We've seen shotgun mergers, both with brokerage firms beginning with not only Bear Stearns but Merrill Lynch. We've seen swap lines that they've given to European banks because the dollar being the world's reserve currency, you've got a lot of borrowing that's done in dollars and then also you've seen the Fed come in and they had to backstop the commercial paper market which runs the credit system in this country. You've seen them come in with backstopping money market funds. And now you've seen the nationalization; the Fed has taken over Fannie and Freddie and if it gets even worse, we may see that in terms of the Fed eventually nationalizing part of the banking system very much in comparison to the Swedish model going back in the 90s where the Swedish government basically just nationalized the banks, took them over and began running the system. And we'll get into this in a later segment. [10:04]
JOHN: Every week we keep hearing these phrases slung around on the news and coming out of C-Span: the Fed is going to buy consumer debt, the Fed is going to buy commercial paper. Look at what's happening right now. The auto makers are queuing up to try to get something. This is giant amounts of money sloshing around. Where is this all coming from?
JIM: A lot of it is going to come from money out of thin air and just to give you the size and this is just as of the beginning of the week, but so far the breakdown of the government's rescue funds, they've committed themselves to $8 ½ trillion. Against this 8 ½ trillion, they have actually issued and spent 3.2 trillion. [10:51]
JOHN: Why don't we run through some of these numbers because this will give people an idea of the size and magnitude of this. And something that I always keep asking people, isn't there a day when all of this comes to an end because if they are really printing that much money, if it gets monetized in one form or another, it goes into the economy, sooner or later, it has to pump out as inflation and I would say outrageously rising prices. Am I right or not?
JIM: No. Absolutely. In fact, there was an article in the Wall Street Journal on Friday that thoughts of deflation may be coming to an end given the size of magnitude. But John, here is just a brief synopsis of what we've committed to. Commercial paper – the Fed has committed to 1.8 trillion dollars. (Commercial paper are short term notes issued by companies which use the proceeds to pay their bills from payroll to inventory.) Against that we've had 271 billion exercised. The Term Auction Facility which provides a negotiated rate for banks to borrow from the Fed. They've committed 900 billion so far, 415 billion has been issued. Other assets, and we'll get to that in just a moment, 606 billion. Finance company debt purchases, 600 billion; this is going to be to buy debt issued by government-chartered housing companies such as Fannie and Freddie. We saw that on Friday where the Fed bought $5 billion of Fannie and Freddie bonds. Money market facilities up to 540 billion. The Citigroup bail out, 291 billion, of which 291 billion is used. Term security lending for collateral of 250 billion. Term asset-backed loan facilities on credit cards and business loans, 200 billion. Loans to AIG, 123 billion. Discount window borrowing is 92 billion. Commercial program number 2 lends to banks so they can buy commercial paper from mutual funds, 62 billion. Discount window number 2, 50 billion. Bear Stearns bailout 29 billion; overnight loans 10 billion; secondary credit, 118. Right now that's 5.5 trillion of which 2.1 trillion is used. Federal deposit insurance commitment loan guarantees for 1.4 trillion. Guarantees on GE Capital 139 billion; another ten billion dollar infusion to Citigroup, so there is one-and-a-half trillion. Troubled Asset Relief Program or TARP passed by Congress, 700 billion; stimulus package earlier in the year, 168 billion; Treasury exchange stabilization fund, 50 billion; tax breaks for banks 29 billion. There is 1.9 trillion. And hope for homeowners, remember the July bill, that's 300 billion, so add it all up, John, 8 ½ trillion dollars and that doesn't include next year's stimulus program, which preliminary talks that we've seen either mentioned in the Journal or press conferences can range anywhere from 500 billion to 700 billion. [13:52]
JOHN: All right. What's interesting is that people here in fly-over land seem to be getting more and more torqued by this because as they are struggling ]to get along, they perceive Wall Street and everyone else to be getting a free ride through this whole thing. You hear it on everybody's lips: Well, why don't I get bailed out, you know. This doesn't seem like it's going to have a happy ending.
JIM: No. In fact, one of the things they are looking at a stimulus program next year would be enough money that would be set aside – this sort of gets back to the Sheila Bair program at FDIC where maybe they would set aside so much money to buy down mortgages. Then what would happen is they buy down these mortgages, they would refinance them at a lower rate. Already they've got a new program where they are talking about driving down interest rates to 4 ½% for purchasers of new homes to get the housing market going. All of this kind of money at some point or another, this is the process that Jens O. Parsson and Adam Ferguson talked about in Dying of Money and When Money Dies, so there is not going to be a good outcome to this kind of money printing. But the kind and scope of the program, the dimension and size of the money tells you, John, this isn't an ordinary recession. It's more like a depression. [15:11]
JOHN: Well, it's going to be quite a while before they admit the D word. Look how long it took them to get to the R word; right? But if we look back in history at the Great Depression and FDR's efforts to end it, first under Herbert Hoover and then ultimately under FDR, the government tried to get the recession to end by means of intervention. How successful was that?
JIM: Well, if you take a look at the first thing that FDR did, he came in, declared a bank holiday. Four days later, they came up with FDIC. Well, we had a similar event take place where the government came in when people were panicking, you had banks going under from Wachovia to Indy Mac and they came in and did the same thing. They bumped the FDIC insurance up to $250,000, they bailed out Citibank with almost 300 billion, and believe me, folks, that's not it. They are going to have to bail out Bank of America, maybe even JP Morgan. But in order to reinflate, Roosevelt severed gold from the dollar which allowed them, that was step number two, which allowed them to proceed to step number three which was money printing and monetization. And we're certainly doing that. They are artificially suppressing the price of gold now, the disparity between the paper market dollars and the physical markets; and there is certainly money printing if you take a look at the Fed's balance sheet on the way to 3 trillion dollars and some people are saying by next year we could see maybe 5 trillion dollars.
And step number 4, and I think this is the nuclear option, and that's coming at some point and that is devaluation. Right now, you've got the swap program that the Fed instituted with 14 central banks where they are loaning them 600 billion worth of dollars, and this is helping strengthen the dollar, which may also be keeping gold weak with the perception of – but that's step 4.
And it's clear right know and the Fed has mentioned this in papers. We talked about it the week before about getting to monetary policy in a zero interest rate environment, we're certainly there today with treasury bill yields of one basis point. But now you have fiscal policy that kicks in to gear and we're going to get into this in another segment, but one of the problems is as fast as the Fed is increasing high-powered money through the monetary base, it is not being multiplied in the economy. Like if you take a look at the ratio between M2 and the monetary base, it's falling off a cliff and that's because banks have been reluctant to lend, so you're not getting the same multiplier effect with this monetary base as banks begin rebuilding their balance sheet, and so that's why the next step that the Fed is going to go to is by-pass the lending system, by-pass the banks and go directly into the economy through the purchase of securities. And that's why we're moving towards quantitative easing. In fact, we already have de facto quantitative easing and it will be a topic we're going to cover next. But if this financial intermediation doesn't improve, then nationalization of the banking system may be next. And the real thing that I think that you're seeing here is when consumers are leveraged, businesses are downsizing. What happens next in this cycle is the government becomes the spender of last resort as well as the lender of last resort. And all of these things that you're seeing and we're basically in uncharted territory here, but it's essentially depression tactics. We're not saying the D word. We finally admitted the R word, but we're really in a depression, because a depression is simply about deleveraging and if you take a look at the events that we've seen just this year alone, there is no longer any investment banks. They are gone; either they've become banks or they've been merged into banks. You've seen the largest insurance company topple. You've seen banks go under. You've seen 300 billion go to Citigroup. Now the automobile bankers are there and the next thing, mark my words, get used to the word quantitative easing, but at some point of this rescue program, you're going to see government bailouts of the states. California, New York, all of the governors are basically saying the same thing, “Look, we can't raise taxes, our economies are heading into a downward spiral. We're going to need a bailout too.” So next year you're going to see the bailout of the states as well as, I predict eventually there is only going to be two auto makers in the US and the auto makers are going to have to get used to downsizing because instead of producing 14 million, 17 million cars a year, we're going to have to get down to an economy that produces maybe only 9 or 10 million cars a year and that means fewer auto makers and smaller auto makers. So we're certainly seeing some kind of things that we haven't seen like this headline on California issuing IOUs tells you that this really is a depression, not a recession. [20:17]
JOHN: But California, I should point out to you as we go out of this segment, Jim, built itself into its corner long before the economy got in trouble. They were heading toward the ship wreck. The ship wreck just accelerated the fall so to speak over the falls and I notice that the governor's conference this week at least one governor voiced opposition to this bill. He said, Hey, the other states here, we've managed to do what we had to do to make the hard choices and now you're going to make all of the states pay for a couple of states that haven't behaved properly with their finances. Look at what's going on in Sacramento right now. They are still not acting in the state assembly like there is a crisis. It's like where can we spend more money. It just keeps on going.
JIM: Yeah. California spending went up over the last five years over 55% and so we've got a budget that is way out of control; we've got too many people on the government payroll and that's certainly one of the problems. One of the other things I wanted to mention in terms of where we are, and this is on Friday, the Federal Reserve bank of New York, it used to see open market operations. Now, they've changed the headline on the Fed site. You can see this at the Federal Reserve Bank of New York. It's called permanent open market operations: monetary policy can be implemented through outright purchases of sales of securities and they have a listing of all of the securities they just bought. So instead of temporary measures, we are now going to permanent measures, so it just goes to show you how much this has changed and this is no ordinary recession. It's more reflective of a depression, and we are certainly in uncharted territory. [21:57]
JOHN: That is to be sure. We are at the Financial Sense Newshour here www.financialsense.com providing some light through what is currently a lot of darkness.
JOHN: Well, to reiterate what we just talked about, we are in uncharted territory. Even if we go back to the Great Depression of 19 -- well, I don't want to say the depression started – but it started with the stock market crash in 29 and became a depression by the time Roosevelt took office in 1933. Some of the things we're paralleling, but we really are in uncharted territory. We can't even look back at that to tell where we are right now. You've talked about quantitative easing and that's going to be a term that people will hear more and more, so we need to explain to them what it's all about.
JIM: This term first surfaced in the Bank of Japan policy to fight deflation. Between 2001 and roughly 2005, Japan embarked on a program where they were maintaining short interest rates at their minimum zero level. They are basically back there again, but what they began to do was flood commercial banks with excess liquidity to promote private lending. In other words, as the monetary base expands, banks have more cash, leaving these commercial banks with large stocks of excess reserves. Therefore, with all of this cash around, there would be little risk of a liquidity shortage, and what they are trying to do is build the monetary base and get money out into the system. And hopefully if you get enough money out there, eventually banks are going to have to make a decision, you know, ‘do we keep this or do we lend.’ Now, so far, we have started officially doing that even though the Fed hasn't come out openly and made a press announcement. Who knows, they could be doing that next week where the Fed's December last meeting of the year they already said instead of a one-day meeting it's going to be a special two-day meeting because there is only so much, John, that the Fed can do with lowering interest rates because already the federal funds rate which is supposed to be 1%, if you look in the open market, it's way below that rate. It's been as low as a sixteenth and as high as three quarters, so if you take a look at late September, the Fed officially began quantitative easing and it's going to crank up further as the Fed goes directly to the economy itself. In other words, they bypass the banks and they try to get this money directly into the economy to kind of break through this kind of stoppage that we've seen in the credit linkage from the banks to the economy because right now banks are losing so much money that there is no incentive to lend because banks are shell-shocked. And we're not done with this yet. So if you take a look at all of the companies that have lost money year to date from Citigroup to Merrill to UBS to Washington Mutual to HSBC to insurance companies, banks are trying to rebuild their balance sheet and deleverage. [25:36]
JOHN: Could we contrast for a second here the traditional way that the Federal Reserve has tried to influence the economy by governing what people borrow and subsequently buy versus what they are doing today. I mean the roles have changed now, as we’ve said before. Not only is it uncharted territory, but we're all trying all sorts of new and innovative ideas.
JIM: Traditionally the Fed has had two tools to implement monetary policy. One of them has been reserve requirements. In other words for every dollar you deposit in a bank, they have to keep so much in reserves; and so by lowering the reserves, that means for every dollar deposited, the bank has use of more money if they have to keep less in reserves. You know, in a fractional reserve system, banks keep about 10% for simplicity’s sake for every dollar on deposit, so you can multiply every dollar almost 10 times and that's what a fractional reserve system, that's a money multiplier effect. And so if they lower reserve requirements, another thing they can do and traditionally have done to influence interest rates is through their open market operations. So for example, when the Fed wants to lower interest rates and create more credit or encourage banks to lend, they can go in, buy treasuries from a bank, they buy the treasuries, the treasuries go on the Fed's balance sheet and in exchange, the banks get cash. Now, with the banks having more cash, they can have greater lending. That is traditionally how the Fed has worked in most of these cycles.
Conversely, if they want to tighten interest rates, they go in and they sell treasuries to banks, meaning the banks now have less cash. Now they have more treasuries. There is less money to lend and this has been the typical cycle. This is what has been typical monetary policy in a recession. In order to cool down the economy, they raise interest rates, they take liquidity from the banking system by selling treasuries. Conversely, when the economy weakens in a recession, they buy treasuries and put cash into the system. But John, that wasn't working, as we talked about in the last segment, and we're certainly into unconventional type programs now, whether they are going in buying commercial paper, whether they are buying assets; and under quantitative easing, what they can do is they start going in on the long end of the program instead of the short end and they start buying mortgages, they start buying bonds. And what happens is they lower the yield curve. It's steepened, but what they are doing is they are bringing the long end of the curve down and trying to drive down interest rates and get that money into the economy.
You've seen this with these unconventional methods that we have. If you take a look at, let's say where the Fed was, let's say, a year ago at this time, where they were in September and where they were just even a couple of months ago, I mean the Fed last year at this time had about $800 billion worth of treasury securities and everybody remembers the swap program where they would swap treasuries with other banks taking their toxic assets and giving them treasuries. The Fed's balance sheet has dropped from 780 billion down to 489 billion. If you take a look at their Term Auction Facility, that has risen to 415 billion. Loans, commercial paper funding facility – and what has really been key here is if you look at the Fed's balance sheet, and there is something called sterilization. In other words, if the Fed doesn't want to increase the money supply and create inflation, they use a program called sterilization where they will go in and mop up by selling bonds. And the Supplemental Financing Program which was the treasury-issued excess treasuries and that was used to sterilize – in other words, all of these treasuries were sold to the market mopping up a lot of these excess reserves; and they do that and they were doing that to sort of sterilize a lot of money that was being created. But if you look at that, essentially, going back to September, that program has stopped. In other words, the SFP or the Supplemental Financing Program that the Fed is using has dropped from 611 billion down to 509 billion. So in other words, as they let that go down, the Fed is pursuing a deliberate inflationary program right now. [30:11]
JOHN: You know something else that's also going on out there, Jim, is that the Fed is loaning money to other central banks in other countries, which, by the way, could explain some of the strength that we're seeing in the dollar right now, but we're talking about again, sizable amounts of money, which also connects all of the world into this very same operation that's going on.
JIM: Sure. Because there is the yen carry trade, there is the dollar carry trade, a lot of loans in the world are denominated in dollars; as you're deleveraging, you're getting margin calls, you're losing money, so the Fed has made available $600 billion of swap lines with other central banks. That's another thing that has sort of expanded the amount of dollars out there and demand for dollars and explains a lot of the strength that you've seen in the Dollar Index.
But you know, the one thing about the Fed creating all of this liquidity, and here is the problem that they have is they are increasing the monetary base, but you're not getting the multiplier effect. In other words, banks are holding on to cash and what has happened is the Fed is paying interest rates now, 1% equal to the federal funds rate and if you're a bank and you have these excess dollars that you've accumulated, banks are saying, Heck, I don't want to loan it out because things have gotten so bad in the economy, I'm just going to keep it at the Fed where I earn interest. And if you look at going back to last year where banks only had about $14 billion on deposit with the Fed, the figure has now risen to 630 billion as of the middle of November and that figure is probably even larger today, so bank deposits just since mid September have grown by $541 billion and this is one of the reasons why you haven't seen a lot of the multiplier effect in the economy. In other words, the banks have got all of this money, but to get the multiplier effect, they've got to make loans and that's one of the reasons why you've seen M2 in its relation to the monetary base has dropped off a cliff and it's not expanding because banks aren't making loans.
And so what has happened is the Fed has stopped sterilizing and now they are really growing their monetary base and especially you can see this sort of de facto quantitative easing take place after the Lehman fiasco which just set off a chain reaction. So if banks aren't lending – in other words, the Fed is creating all of this liquidity, but banks are sort of shell-shocked right now and we've talked about initially when you go through these asset bubble declines as we've seen in real estate, as we've seen in the mortgage markets, as we've seen in the stock market, people are sort of shell-shocked. I mean look at just some of the headlines that we have seen recently; companies laying off, Citigroup laying off 52,000, AT&T and a couple of other companies, Dupont laying off 15,000. So we're seeing these massive lay offs, which was reflected in the unemployment report that we got on the day we're speaking where 533,000 job losses – the most in 34 years – and the unemployment rate went up to 6.7%; one of the reasons it's not higher is the number of people that are now working part-time jobs.
But anyway, what's going to happen is that's why you saw this program that was announced this week where the Fed is going to buy $600 billion. Essentially, what the Fed is doing is it is bypassing the banking system and going directly into the market to try to get money into the economy to expand the monetary base, to expand the money supply because essentially, what you have right now is something that Keynes talked about which is the liquidity trap which means rates are very low, but banks are unwilling to boost lending when the Fed is providing all of these extra reserves. It's referred to as a liquidity trap, so the counterbalance to that under Keynesian philosophy is fiscal policy, and mark my words, we are going to see anywhere from 500 billion to 700 billion, and I actually heard on Friday the first time word: one trillion dollars of stimulus. [34:31]
JOHN: Actually, we're starting to reproduce here some of these alphabet-soup things that FDR was doing because we have TAF and TAFI and now TALF which I guess we should talk about and finally they’ve come up with I think TATW, which is ‘try anything that works.’
JIM: Last week they announced the TALF, I guess is the way you say, TALF, one of the problems the Fed sees is this disruption of the markets are limiting the availability of credit to households and small businesses. You've heard about credit card companies that are cutting the availability of credit because people aren't paying their credit cards just as they are not paying their car payments, just as they are not making their mortgage payments. Friday, there was a Bloomberg story that mortgage delinquencies were the highest that they've been in nearly 34 years. So this new program is TALF is the Term Asset-backed Security Loan facility. The Fed is going to loan up to 200 billion dollars on a non-recourse basis to holders of AAA-rated asset backed securities because the securitization market has basically dried up. [35:40]
JOHN: Well, the crux here, it seems to be, the old mechanism of getting money into the system is that they would provide money available to banks, banks would loan it to people out in the public marketplace and that's how the money jumped into the system. That isn't working now. You know, we've talked about helicopter drops all of the time here on the show. So what is the next mechanism that they are going to be able to use to do that?
JIM: Well, once again, what they do is they just bypass the banking system. There is even talk that they may go in, in addition to this new TALF program, where they are going to buy mortgages and agency bonds as they did on Friday. That's more akin to a helicopter drop because what can happen is Fannie and Freddie make the loans. Instead of securitization which has almost virtually dried up, the Fed can just buy these loans directly from Fannie and Freddie and government agencies and that's giving money directly to the economy. You're seeing Paulson talk about a new program, you've got Congress talking about a new program of getting special fixed-rate loans to new first-time home buyers or people that are willing to buy a home. And another way, John, is something we've seen already which is, remember the rebate checks that we passed in February, and he's already talking about doing that to get money to actually people who even don't pay taxes. In other words, they would get – it really isn't a refund because to get a refund you would have had to pay taxes, but you can get dollars directly to individuals and then the Fed would just simply monetize that kind of money, so there are a lot of things that they can still do. In fact, if you look at the recent Fed governors, they are saying Hey, even if we get to zero interest rates, there are many things that we can do; that we haven't run out of our tool kit. And that's why when we come back in the New Year, we're going to be talking about some of these new tools in the kit that they can try, one would be getting money directly to individuals. I would expect to see on some kind of fiscal stimulus program that they are going to set aside next year – I don't know what that number is going to be – where they would simply buy down mortgages, refinance those mortgages and lower interest rates, in other words, to stop the foreclosures. There would be tax rebate checks that would be sent. I mean they haven't even begun yet with some of these unconventional. I also suspect that one of the problems they've had in the private sector is the private sector has been unwilling to expand because what we've had in this crisis is we've taken a look at spreads between even high grade corporate debt and treasuries and even junk bonds. I mean you've had junk bonds close to 20% right now. You have, if you look at corporate spreads even on high quality debt and Triple-A and double-A debt, you've got 600 basis point spreads and corporations are saying, I can't borrow at that kind of rate. I mean when you have even banks like Wells Fargo that had to issue preferred stock at 9 ¾, how can you borrow at that rate and loan at a lower rate? And so what the Fed can also do and I expect to see this, and this has a lot of implications in terms of what kind of investing you're going to do forward, but they could go into the long end of the corporate bond market and start driving down yields just by saying they are going to do that. So look for a new program that the Fed will announce where they are going to go in and buy long term corporate debt in an effort to drive down corporate rates because as long as you have got high single digit or double digit rates in the corporate lending market, who in the heck is going to borrow at that rate? You simply can't do it. [39:26]
JOHN: What this seems to be is what I call a buckshot approach rather than precise aiming to a target. You know they are just blasting away hoping that something works. Is this going to go on, are they just going to be throwing things out hoping that something sticks?
JIM: Any time you get a leak somewhere it's like the old Dutch boy with the dyke; they get a leak somewhere so they plug that one, then all of a sudden another leak breaks forward and I have this picture of this Dutch boy and that's about where the Fed is. But the one thing that you have to give the US authorities credit for compared to other banks or even other central banks around the globe, John, is the speed in which, you know, once Bernanke finally learned last August –remember when they had the August Fed meeting in 2007, they said No, we're not going to do anything. Two days later, they reverse course as a bunch of hedge fund managers went to Bernanke and said, Look, dude, this is what you're facing if you don't change policy here, you're in a full-fledged crisis. So the Fed has finally got on to that, so the speed at which all of these programs, I mean, John, it's like every single week we've got a new one or there is another leak that has sprung somewhere and they have got a new program, so not only are we reacting and what the Fed is now trying to do is they say We've got a full blown crisis here, we need to get ahead of the curve. So they are acting expeditiously here, so they are acting at a very quick rate.
Second, with this quantitative easing, they are not mopping up or sterilizing a lot of this money creation. They finally realize they've got a problem, so they are actually targeting inflation right now and then the third thing that you're going to see happen is when monetary policy is less effective, it's no longer working, you're going to see fiscal policy replace it, and you've certainly seen Bernanke talk about it this week, you've seen congressmen talk about it, you've seen people in the Treasury talk about it, so you're going to see that happen and so look for massive, massive stimulus programs to be coming as Obama is sworn in. He's already talking about he's going to hit the ground working. They are already working on this package and formulating it because they know the longer that they go, the worse that this gets. [41:37]
JOHN: Okay. Well, let's ask the fateful question, which I think has to be asked. Supposing they do all of this and nothing worse, where are we?
JIM: Then the nuclear option.
JOHN: Uh-oh. That sounds dah duh da da.
JIM: That's when you go through devaluation. If you take a look at the Great Depression, Roosevelt, you know, there were four steps that were taken: 1) as we mentioned, creating FDIC after the bank holiday; 2) severing gold and the dollar; 3) they inflated and 4) is they devalued the dollar, so that's probably the last option. But I've got a feeling that's exactly where we're heading because as we know, the more and more that the government interferes in the marketplace, into the mechanisms of the economy, the worse things get distorted, the more malinvestments you get. And you know, eventually, I think as a result of this, which we'll be getting to our third topic in the Big Picture, is the inflationary consequences of all of this. [42:39]
JOHN: So you're listening to the Financial Sense Newshour at www.financialsense.com.
No money - no inflation
JOHN: It is interesting to realize that our entire monetary system, and you'd be surprised how many people don't know this, Jim, it's all based on debt. In other words, if nobody really borrowed anything in the beginning like the government from the Fed and so on down the line, we wouldn't have any money if everybody paid back all of their debts. There was an interesting paper which was published back in 2001 by Mr. Mervyn King who is currently now the governor of the Bank of England. He was not at the time, I think he was deputy governor, but it was entitled No money, No inflation –The Role of Money in the Economy. And it is money that causes inflation; creating an increase in the supply of money.
JIM: Yeah. It was interesting because the article started about that the role of central banks around the globe has been price stability, and you've always heard that, John, in the 80s and 90s whenever Greenspan was testifying, the role of the central bank is we're supposed to be here to create price stability. And as they did that, if that became the objective, the attention that central banks paid to the quantity of money, the quantity of money creation was actually thrown out the window, and if you take a look at the great inflations of, let's say, the last century and even in this century and certainly America's great inflation in the 70s is money was a causal factor for inflation, but it has been ignored in the economic establishment. In fact, if the United States, the Federal Reserve, used to – and this was because remember the inflation of the 70s where we had the money supply was going crazy, everybody in the financial industry used to watch the M figures, M1, we used to call them the M and Ms every Thursday when they released them. And there was an act imposed on the Federal Reserve by Congress that was imposed in 1978 where the Federal Reserve would have to report twice a year on its target ranges for the growth of money and credit. So if they said Hey, we're trying to get money growth of 5 or 6%, when they reported to Congress, they are saying actual money growth has been 10 and 12%. But even Congress back then began to realize, Wait a minute, you create a lot of money in the system, you grow the money supply at double digit interest rates, eventually you get inflation. And you remember what it was like, John, at the end of the 70s, you know, taxes and inflation; number one, you know, people on the street finally began to get the connection between too much money in the system and inflation, but anyway, this was imposed on Congress and then what happened is the Fed went to Congress and basically said, Look, this isn't necessary, the money supply is irrelevant, we're using interest rates and targets as a rule of controlling inflation. So what happened is the central banks began to abandon the quantity theory of money and nonetheless, even though it's incorporated in the models, and so what Mervyn King did in his article and he said, You know what, there has got to be a cause factor here. And so he was looking at the creation of money and its correlation to inflation and that was essentially that in this article, he goes, Wait a minute, we're ignoring this but if you ignore it, you ignore it at your own peril because there is a direct linkage between money creation and inflation. [46:14]
JOHN: Well, how much of that comes from the Keynesian ideas that people are raised with in, let's face it, almost all economic schools in the various colleges are Keynesian in nature?
JIM: Well, if you take a look at the Keynesians, they tend to look at, and we've talked about this on the program, where they change the definition of inflation and deflation as to the symptoms. In other words, inflation is now rising prices, deflation is falling prices. Well, in a productive economy in a capitalistic economy, deflation should be constant because as more companies enter the manufacturing system, as you get more productivity, in other words, if I can increase the number of widgets I make, I amortize my fixed cost over a larger number of widgets the cost comes down. And you can take a look at any kind of item or invention, when it first came out; when DVD players first came out, they were like 700, $800, now you can get them for probably 50, $60s. When plasma screens came out, I remember the first 42 inch Plasma screen was over $7000. Now you can get them for, what, $700. But anyway, he did a study and he showed that there is a direct link of the amount of money in the system and inflation and he did some correlation studies and it was amazing what he found. [48:08]
JOHN: Okay. So we have a linkage here now. Are we talking about correlation or causality and then if there is this correlation which may be causative in nature as well, what's the level, 60, 70%, something directly that we can measure each time?
JIM: No. In fact, we get back to Milton Freidman. There was actually a 99% correlation coefficient; 0.99 coefficient with money growth and inflation. And you know, a lot of times the government has used other measures in terms of output in the economy and that's why you get all of this kind of goofy stuff that the government does. In other words, Well, if the economy is growing at an above rate, that creates inflation. That's nonsense. When you looked at other coefficients such as output in the economy, in other words, the correlation between growth of money and real economic output growth, there was a negative correlation of .09 and .08; and so that's why you always hear like in Fed testimony when they were talking about when inflation was heating up, especially if you go back to earlier in the year, Well, you know, we had this excess economic growth and excess output in the economy and therefore that was creating inflation. In other words, and you've seen that in some of the speeches where the Fed is before Congress and took the Fed to task. You remember when Bernanke was before Congress and he was saying, Well, the economy’s over-heating that's causing inflation, and Ron Paul would say, Well, you know, you’re acting like growth is bad. And this gets to the way central banks in their economic models where they would measure not money to the rate of inflation, but they would look at, in other words, real economic output growth as a cause of inflation and there was absolutely no correlation when they looked at that, whereas when you looked at the co-movement of money and inflation there was almost a 90.99% correlation coefficient, meaning that there is a direct linkage. [50:14]
RON PAUL: Everything we do in Washington today, whether it's on the appropriation side, whether what the Fed is doing, buying up America, it is all putting pressure on the dollar. And one of these days we're just going to have to wake up and say that we need to liquidate debt. This is a malinvestment.
JOHN: That was Congressman Ron Paul explaining how basically everything that Washington does nowadays contributes to inflation. First of all, Jim, when we talk about inflation or deflation what really muddies the water out there is that some people are talking about price inflation, others are talking about monetary inflation, and so say for example when you predicted on the show we’ve moved towards a hyperinflationary depression, people say, See, the prices are coming down, Puplava was wrong. They don't understand. Okay. That's the first thing. Second of all, symptoms of that, we talk about velocity of money, if we really are looking at an inflationary situation, is it inflation in the short term or maybe over a longer period?
JIM: Well, you know in the short run, and that's one thing that the King paper talked about, in the short run, movements in the velocity of money are apparent. You know, the instability of these short run correlations – in other words, you've got to look at inflation over a period of time because when the Fed creates this money and remember, they just stopped sterilization of money right after the Lehman fiasco, so there is a time lag between when money is created and by the time it works its way through the economy, and this short term timeframe is very unpredictable. There is an instability of the short run correlations; in other words if you measure money growth and inflation over a very, very, very short term period, it is very unpredictable. Sometimes, as in the 70s, it went directly into assets or into things in the real economy and we saw the impact immediately.
Another aspect of that too is in terms of velocity when you're seeing, you know, housing prices going gown, stock markets going down, unemployment going up, people tend to hoard onto their money short term because they are saying, Oh my goodness, the economic landscape is unpredictable, so that's what they do, so the short term effects aren't immediately felt.
And a second very important thing that King highlighted is the key role of expectations of inflation can alter the short term and long term effects. In fact, when he looked at measuring hyperinflations in four economies, he looked at, for example, Hungary, Austria, Israel and Argentina where they experienced rates of inflation of 9200%, 4300%, over 20,000% and 486%. In all four hyperinflations, the importance of expectations – In other words, that has to do with money velocity. If you think prices are going to go up every single day, all of a sudden you start turning over money, money velocity increases and this is why you see in so many speeches that Bernanke has given or testimony before Congress, they talk about inflationary expectations being contained because the inflationary expectations, John, that is the turbo on the engine. That's the thing that clicks on when money velocity kicks in, that's like the turbo on your engine. That really accelerates the rate of inflation, and so that's why I call it the “how long can we keep them fooled index” and that's very important.
And King found that as you take a look at annual inflations and growth of money, the correlations become even clearer over periods of time; and he would look at these economies over a one year, two year, five year, ten-year period, 20 years and 30 year periods and there was just a direct linkage. He even took a look at annual inflation and growth rates of even broader measures of money like M2, M3 and then also he measured annual growth of broad money and the output, which is what the government is always doing. That's what you hear the Fed saying, Well, the economy is heating up. There is actually no correlation between economic growth and inflation. And so once again, you know, it boils back down to bringing this back down to Milton Friedman's statement that inflation has and always will be a monetary event; and that is rather interesting in terms of understanding the role of money.
So the key question is if you get to his conclusions in his paper, you know, you don't create money, you don't get inflation; you create money, you get inflation, and that's exactly what he's drawing here is there is a real danger here when central banks are no longer paying attention to the quantity theory of money and ignoring it which is exactly what happened in Germany in the 20s. So if you want to read for yourself, we just don't have time to cover it in much detail, but just Google “Mervyn King, and then also type in “No money, No inflation – The role of Money in the Economy” and you can read it for yourself and see the direct causal relationship between the increase of money and inflation. [55:44]
JOHN: As things start to sour in the economy, people hoard their money because they are just trying to be frugal. Let's face it. We don't know what's going on, but then as people begin to recognize that the money is becoming worth less and less and less, then they try to get rid of it, that then flips over, and then the velocity of money goes crazy.
JIM: And that's why they place one of their causal effects that can amplify inflation is these inflationary expectations. In fact there, was a period of time in Germany where actually they were reducing the supply or the rate of increase in the money supply, but the inflation rate was moving at much higher rates at that point because velocity was kicking in with inflationary expectations. And that's why I think this is a real key linkage here in understanding. Right now, we are in the low velocity phase because the savings rate, people are hoarding, the banks are holding onto their money, the individuals are holding on the their money, and that's why the Fed is taking these extraordinary measures and bypassing the banking system because right now people are shell shocked, banks are shell shocked. I mean when you have one trillion dollars of losses that have been written off over the last four quarters, you know, you can understand why banks are reluctant to lend; and when you take a look at what's happening to the economy, the economic news, you can understand why people are starting to increase, I mean the savings rate has gone from a negative savings rate to now we're almost up to almost 2 ½%. So we're only in the first phase of inflation where money velocity is dropping faster than the creation of money, which is one of the reasons why M2 and the relation to the monetary base looks like it's fallen off a cliff; and that is just people hoarding onto money, which is what they initially do in the early stages of inflation. It is what happened in Germany, even throughout the war period from 1914 until really about the end of 1921 and 22 when velocity really kicked in with inflationary expectations and that’s when inflation went just sky high in Germany. [57:44]
JOHN: And the radio inflation continues here on the Financial Sense Newshour at www.financialsense.com where the velocity of radio never ceases.
Searching for Returns in a Zero Interest Rate World
JOHN: Well, I've been looking at some numbers, Jim. Like, when do we ever look at numbers here on the program; right? Let's see here, a one month T-bill, return one basis point. That's one one-hundredth of a percent; all together now, three months T-bill one one-hundredth of a percent. By the time we get up to a one year treasury bill, we're looking at one half of a percent return; two years out – nine-tenths of a percent, they almost got it up to 1% there. It's obvious that investing, you know, we talk about dividend investing here on the program, but when the interest rates are driven down this far because of what the Fed is doing as part of its quantitative easing, how do you find anything of worth while return in this kind of environment when you look at these numbers and go, This is awful.
JIM: Yeah. You know, I can remember, John, working with retirees in the 80s where basically during the 80s, we were using fixed income because you could get 12, 14%; I remember in 1982, a utility, the dividend yield on utilities was 14%. You got 9 to 10 percent on tax free bonds and in 1982 you could get 15% on treasuries and throughout most of the 80s, basically until the time we got to the S&L crisis when Greenspan really cut interest rates and slashed them and brought them down into the single digit range, you got double digit interest rates. So people that retired, you know, John, their biggest decision was what bank am I going to roll over my CD and who is going to give me a free toaster. And now you take a look at somebody retiring – I mean think of pension funds that have defined benefit pension plans or you think of insurance companies who have to place their investments to lineup with their liabilities for annuities, what is going on here. I mean, John, this is global when you have central banks slashing interest rates this week with the Bank of England, you had ECB and you're looking at bond rates around the globe. John, these are some of the lowest rates that I've seen. I'm just looking globally, you probably have to go to Colombia or Brazil if you wanted to get anything that was high single digits, but interest rates around the globe on 10 year treasuries in Europe have gotten down to roughly about 3% to 3 ½% in Japan, the 10 year government note is at 1.35. I mean Swiss government bonds, 10 year bonds are less than 2%. I mean we've never seen rates this low at a time when central banks around the globe are hyperinflating. [1:00:48]
JOHN: For a long time we've been talking about dividend investing on the program, but if you look at the market being down, it's between 40 and 60%. How does that now apply? It would seem like again, we've been talking about being out in new uncharted areas. This again is different than we've been looking at over the last few years.
JIM: You know, right now, I would not be going long term into treasuries because the yields are the lowest that they've been, and I think this is going to be a real big issue for investing going forward. And even in the stock market, John, where you take a look at the dividend yield now on the Dow is 3.6%. It's much, much higher than let's say the yield on treasuries which is 2.7% on 10 year treasuries; the same thing with the S&P where we're looking at yields and that's the way it was, believe it or not, after the Great Depression, the stock market downturn, stocks were perceived as being riskier investments so the yield on stocks was much, much higher than what we've got on bonds, and so the markets are shifting in that direction right now where the yields, the dividends from equities are going to comprise a greater and greater portion of your investment return versus capital appreciation. So I think dividend investing and more importantly companies that can increase or maintain their dividends is also going to be more important. [1:02:20]
JOHN: Given the fact that everyone seems to now recognize that we're in a recession, and I think a lot of people suspect we're sliding towards a depression rather rapidly here, companies themselves are beginning to conserve cash and they are chopping dividends, so that's not going to be an area either.
JIM: There is two things that are happening number one, we're getting more towards what we saw prior let's say coming out of the Great Depression where equities were viewed as being more risky so investors demanded a higher rate of return, in other words, cash returns. And the one thing you know about a cash return, John, you don't have to worry about the company cooking the books because either the company’s got the cash and they are earning that to pay that dividend versus, let's say, monkeying around and playing around with accounting numbers or you make the earnings number but their earnings have been manufactured.
But one of the things that you're also going to have to look at is what sectors of the economy and which companies within the economy have a business model that will enable them to maintain or uphold their dividends and so I think you're going to have to get more defensive in terms of the companies that you look at. And that's where I think that companies that provide, let's say, basic necessities like food, consumer staples, health care, those are going to be the companies that are going to be – in some of the telecommunication areas or utilities where the dividends are a lot more stable than companies that are, let's say, in the consumer discretionary sector or the financial sector. Look at how many financial companies, I think there has been about 90 companies within the S&P that have cut dividends, but this is probably going to be probably one of the toughest investment environments going forward because unlike the, let's say, markets that we had in the past, either the bear market recession of 91 or 2001, the alternatives were so much better than what we have available today. I mean if you go back to 1991 if you wanted to get out of stocks, you were looking at high single digits or low double digits if you were looking at the bond market compared to today, where you're looking at rates at one-and-a-half percent or barely 0.01 of a percent on short term debt instruments. But I do believe that the strategy is going to have to change, you're going to have to look at dividend yields.
The good news: the dividend yields are going up. But you're going to have to look at how secure that dividend is, how good the business model is of the company, are they going to be able to maintain that dividend, which sectors of the economy are going to be able to hold up in terms of dividends. And then I also think there is going to be some opportunities in the bond markets in terms of corporate bonds because the corporate spreads between let's say treasuries and corporate bonds, I think there is 5- or 600 basis points where people have been so risk adverse that they selloff these bonds and there are a lot of quality bonds out there where you can buy and get yields of 6 and 7%, and yields of maturity that are going to be double digits. In other words, you're going to get equity like returns from the corporate bonds sector which I think this could be a short term solution, especially if the Fed starts going in and buying or backstopping corporate bonds, trying to bring long term corporate bond rates down to stimulate the economy and also convertible bonds if you're more of a growth type investor. [1:05:52]
JOHN: What is really clear right now is that President-elect Obama realizes that he has a mess on his hands; it was not of his creating but as soon as he steps into the Oval Office, he's going to have a tiger by the tail and of course if you go back over what we've been predicting over the last 24 months, it's exactly what we said would happen is that the new president –at the time we didn't know who it was going to be – was going to walk into just a horrible situation and that would probably cause him to shelve a lot of the things he wants to do when he gets into office because he's just going to be busy with this stuff for quite some time to come, so he's got his task cut out for him.
JIM: Absolutely, and we've always said, you know, whoever the next president was, you know, during the campaign, if I was the chief justice as he put his hand on the Bible and they swear him I would also put a fireman’s hat and wheel the president away on a fire engine because it's going to be one crisis after another, John. And you know, we're talking about economic crises here, but if you take a look at some of the news stories that are out there on the geopolitical front, just this event that happened last weekend in India, it is just unreal in terms of, like I said, who would want to be the next president. [1:07:42]
JOHN: Coming up in the next weeks, what are we going to hear on the program here aside from the rogue waves that come out of from places we know not.
JIM: Next week we're going to have an energy roundtable with Matt Simmons and Robert Hirsch and maybe another special guest; and then finally on December 20th, our last regular program of the year, we're going to be interviewing Danielle Park. She's written a book called Juggling Dynamite, a great investment book of investment strategy and philosophy, and then we'll have our kind of summary for the year and our best of and that's pretty much it for 2008.
And some changes coming to the program in 2009 and the website, so we've got a lot of good things that we're working on for the New Year.
In the meantime, on behalf of John Loeffler and myself, we'd like to thank you here for joining us on the Financial Sense Newshour. Until you and I talk again, we hope you have a pleasant weekend.