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Interviewed by Alex Daley, Chief Technology Investment Strategist, Casey Research
Alex Daley: Hello. I'm Alex Daley. Welcome to another edition of Conversations with
Casey. Today our guest is former Reagan Budget Director and Congressman
David Stockman. Welcome to the show, David.
David Stockman: Glad to be here.
Alex: So we're here in Florida talking at the Recovery Reality Check Casey Summit. What do you think: is the United States economy on the road to recovery?
David: I don't think we are at the beginning of the recovery. I think we are
at the end of a disastrous debt supercycle that has gone on for the last
thirty or forty years, really. It started when Nixon defaulted on our
obligations under Bretton Woods and closed the gold window.
Incrementally, year after year since then, we have been going in a
direction of extremely unsound money, of massive borrowing in both the
private and the public sector. We now have an economy that is saturated
with debt: $54 trillion or $53 trillion 3.5 times the GDP way off
the charts from where it was for a hundred years prior to the beginning
of this. The idea that somehow all of that debt is irrelevant, as the
Keynesians would tell us, is fundamentally wrong and the reason why
the economy can't get up off the mat.
We're doing all the wrong
things. We're adding to the problem, not subtracting. We are not
allowing the debt to be worked down and liquidated. We're not asking
people to save more and consume less, which is what we really need to
do. And so therefore I think policy is just making it worse, and any day
now we will have another recurrence of the kind of economic crisis we
had a few years ago.
Alex: You paint a very stark
picture, but if people just stop spending, start saving, won't
companies like Apple see their earnings hurt? Won't the stock market
then start to tumble, people's net worth fall? Isn't that a negative
cycle that feeds on itself?
David: Sure it does,
but you can't live beyond your means because it's pleasant. It's not
sustainable. Clearly the level of debt that we have is not sustainable.
We have a whole generation the Baby Boom that's about ready to
retire, and they have no retirement savings. We have a federal
government that is bankrupt, literally. Its [debt is] $16 trillion and
growing by a trillion a year. Something's going to give. We can't pay
for all these entitlements. There won't be the revenue generation in the
economy to do it.
So as a result of that, we are deluding
ourselves if we think we can just continue to spend. Look at the GDP
that came out in the first quarter of this year. It was only 2.2%. Most
of it was personal consumption expenditure, and half of that was due to a
drawdown of the savings rate, not because the economy was earning more
income or generating more real output. It was because of a drawdown of
savings. That is exactly the wrong way to go an indication of how
severe the crisis is going to be.
I'm not saying the economy
should stop spending entirely. I'm only saying you can't save 3% of GDP
and spend 97% if you are going to get out of this fix. As the savings
rate goes up both in the public sector (which means reduction of
spending and the deficit) and the household sector (to seriously reduce
debt burden, which has not really happened) we are going to, on the
margin, spend less, save more. It will slow down the economy. It will
undermine profits, I agree. But profits today are way overstated.
They're based on a debt-bloated economy that isn't sustainable.
Alex: So we can only live beyond our means for so long, as any family knows.
David: Yes.
Alex: Now, the government can reduce its expenses at any time by simply
reducing spending, and it can reduce debt if it brings in more tax
revenue. That's austerity I think that's how they refer to it. But
won't austerity cause massive joblessness? Won't there be millions more
people in this country not receiving a paycheck?
David: Yes, but the critique, the clamoring and clattering that you hear from
the Keynesians (or even mainstream media, which is pretty clueless
economically) that austerity is bad forgets the fact that austerity
isn't an elective course. Austerity is something that happens to you
when you're broke. And yes, it is painful and spending will go down and
unemployment will go up and incomes will be impaired, but that is a
consequence of the excess debt creation that we've had for the last
thirty years. So austerity is what happens when you break the rules.
And
somehow we have this debate going on. They're making a mistake. They
chose the wrong strategy. Do you think Greece chose the wrong strategy
with austerity? No. No one would lend them money. That's why they ended
up in the place they were. Do you think that Spain today is teetering on
the brink because they said, "Oh, wouldn't it be a good idea to have
austerity?" No, they had a gun to their head. They were forced to do
this because the markets would not continue to lend, and even now their
interest rate is again rising. The markets are losing confidence, and
unless the ECB prints some more money and bails them out some more, they
are going to have austerity. So the austerity upon us is the backside
of the debt supercycle we had for the past thirty years. It's not
discretionary.
Alex: Austerity hasn't been forced
upon us yet. The dollar is up, people are continuing to buy Treasuries
both nations and banks are buying Treasuries. To all extents and
purposes, people are continuing to show massive confidence in the US
government, lend it money at extremely cheap interest rates, and letting
it build up its debt.
So you are advocating that, unlike Greece
or Spain taking it to the edge and having austerity forced on them, we
should volunteer for austerity today? Instead of just kicking the can
down the road and living high a little bit longer, until the bill
collectors finally come knocking? Why go today, why start austerity now
instead of doing what Greece did and going as long as you possibly can?
David: Because Greece is a $300 billion economy. Tiny. A rounding error in the
great scheme of things. It's last time I checked about eight and a
half months' worth of Walmart sales. Okay? That's a little different
than when you have the $15 trillion heartland of the world economy, and
the $11 trillion Treasury market which is at the center of the whole
global financial system buckle and falter. That's the risk you're taking
if you say, "Maρana. Kick the can; let's just wait for something good
to happen."
This market isn't real. The two percent on the
ten-year, the ninety basis points on the five-year, thirty basis points
on a one-year those are medicated, pegged rates created by the Fed and
which fast-money traders trade against as long as they are confident
the Fed can keep the whole market rigged. Nobody in their right mind
wants to own the ten-year bond at a two percent interest rate. But
they're doing it because they can borrow overnight money for free, ten
basis points, put it on repo, collect 190 basis points a spread, and
laugh all the way to the bank. And they will keep laughing all the way
to the bank on Wall Street until they lose confidence in the Fed's
ability to keep the yield curve pegged where it is today. If the bond
ever starts falling in price, they unwind the carry trade. They unwind
the repo, because then you can't collect 190 basis points.
Then
you get a message, "Do not pass go." Sell your bonds, unwind your
overnight debt, your repo positions. And the system then begins to
contract exactly what happened in September and October of 2008. Only,
that time it was an unwind to the repo on mortgage-backed securities
and CDOs and so forth. That was a minor trial run for the great unwind
that is going to happen when the Treasury market is finally shattered
with a lack of confidence because, on the margin, no one owns a Treasury
bond: they just rent it on borrowed money. If the price starts falling,
they'll get out of that trade as fast as they got out of toxic CDOs.
Alex: So when people run away from the US, they will run away all at once.
David: Well, if they run away from the Treasury, it sends compounding forces
of contagion through the entire financial system. It hits next the MBS
and the mortgage market. The mortgage market then scares the hell out of
people about the housing recovery, which hasn't happened anyway. And if
there isn't a housing recovery, middle-class Main-Street confidence
isn't going to recover, because it is the only asset they have, and for
25 million households it's under water or close to under water.
Alex: We saw something much like that in 2008. All the markets correlated.
Stocks went down. Bonds went down. Gold went down with them. It sounds
like what you're saying is that the Fed is effectively paying bankers to
stay confident in the Fed, and that the moment that stops either
because the Fed stops paying them or something else shakes their
confidence this all goes down in one big house of cards?
David: Yes, I think that's right. The Fed has destroyed the money market. It
has destroyed the capital markets. They have something that you can see
on the screen called an "interest rate." That isn't a market price of
money or a market price of five-year debt capital. That is an
administered price that the Fed has set and that every trader watches by
the minute to make sure that he's still in a positive spread. And you
can't have capitalism if the capital markets are dead, if the capital
markets are simply a branch office branch casino of the central
bank. That's essentially what we have today.
Alex: Last night you told our audience that if you were elected president,
the first thing you would do is quit. Or at least demand a recount, I
believe were your words, which I thought was telling. Are you saying
there are no policy changes we could make today that would get us out of
this? Or at least that wouldn't get you assassinated?
David: Yeah, there is a paper blueprint. People who believe in sound money and
fiscal responsibility, that you create wealth the old-fashioned way
through savings and work and effort and not simply by printing money and
trading pieces of paper there is a plan that they could put together.
One would be to put the Fed out of business. You don't have to "end the
Fed," although I like Ron Paul's phrase. You have to get them out of
discretionary, active, day-to-day meddling in the money markets. Abolish
the Open Market Committee.
The Fed has taken its balance sheet to
$3 trillion. That's enough for the next 50 years. They don't have to do
a damn thing except maybe have a discount window that floats above the
market, and if things get tight, let the interest rate go up. People who
have been speculating will be carried out on a stretcher. That's how
they used to do it. It worked prior to 1914. That's the first step:
abolish the Open Market Committee. Abolish discretionary monetary
policy.
Let the Fed, if you're going to keep it I don't even
know that you need to do that, but if you are going to keep it be only
a standby source. As Badgett said (Walter Badgett, the great 19th-century British financial thinker): provide liquidity at a penalty rate to sound collateral.
Now,
that's what J.P. Morgan did in 1907, in the great crisis of 1907, from
his library. He didn't have a printing press. He didn't bail out
everybody. He didn't do what Bernanke did and say: "Stop the presses,
freeze everybody, and prop up Morgan Stanley and Goldman Sachs and all
the rest of the speculators." The interest rate, the call-money interest
rate, which was the open-market interest rate at the time, some days
went to 30, 40, 70% and they were carrying out the speculators left
and right, liquidating margin debt, taking out the real estate
speculators. Eight or ten railroads went bankrupt within a couple of
months. The copper magnates got carried out on their shields.
This
is the only way a capital market can work, but it needs an honest
interest rate. And we have no interest rate, so therefore we solve
nothing and we have the kind of impaired, incapacitated markets that we
have today. They're very dangerous, because they're all dependent on
twelve people. It is what I call "the monetary Politburo of the Western
world," and they are just as dangerous as the Politburo in Beijing or
the Politburo of memory in Moscow.
Alex: A
twelve-person Open Market Committee determining the future of our
economy by manipulating rates. Sounds like central planning to me.
David: It is. They are monetary central planners who are attempting to use the
crude instrument of interest-rate pegging and yield-curve manipulation
and essentially buying debt that no one else would buy, in order to keep
this whole system afloat. It's Ponzi economics. Anybody who had
financial training before 1970 would instantly recognize this as Ponzi
economics. It is only because of the last twenty years we got so inured
to prosperity out of the end of a printing press and massive incremental
debt that people lost sight of the fundamental principles of sound
money, which, there's nothing arcane about it. It's just common sense.
It is not common sense to think that 50, 60, 70% of all the debt that's
being created by the federal government can be bought by the Federal
Reserve, stuffed in a vault, and everybody can live happily ever after.
Alex: So the government has certainly put us in a precarious position, but I
don't think they alone have put America in this position, have they? You
mentioned consumer debt becoming a major burden on the economy. How do
we shed ourselves of that? I mean, the federal government can repudiate
its debts if we walk away from it. We might see a few wars or something
from that. It could inflate its way out of it. It can tax its way out of
it. But how do households get out from under the debt burden that they
have today?
David: Well, it's very tough, and
they were lured into it by bad monetary policy when Greenspan panicked
in December 2000. The interest rate was 6.5%; we had an economy that was
threatened by competitors around the world. We needed high interest
rates, not low. He panicked after the dot-com crash, and as you remember
in two years they took the interest rate all the way down to 1%, and
they catalyzed an explosion of mortgage borrowing, which was crazy.
When
they cut the final rate down to 1% in May, June 2003, in that quarter
the second quarter of 2003 the run rate of mortgage borrowing was $5
trillion at an annual rate. That was nuts! There had never been even a
trillion-dollar annual rate of mortgage borrowing previously. In that
quarter the run rate was $5 trillion, 40% of GDP. Why? Because the Fed
took the rate down to 1%. Floating-rate product got invented everywhere.
Anybody that had a pulse was being given mortgage loans by the brokers.
The mortgage brokers didn't have any capital or funding. They went to
Wall Street. They got warehouse lines, and the whole thing got out of
control. Millions of households were lured into taking on debt that was
insane, and now we have a generation of debt slaves.
There are 25
million households in America who couldn't move if they wanted to,
because their mortgages are under water. They cannot generate a down
payment and the 5% or 6% broker fee that you need to move. So we've got
25 million households immobilized, paralyzed, and worried every day
about when they are going to lose property, because of what the Fed did.
It's a terrible indictment.
Alex: Mobility
itself is the American dream, isn't it? It's the ability to pick up and
find work and then move and do all that. So now we have people who are
slaves to their debt. How do we get ourselves out of this? Is this just a
matter of personal financial discipline? Is there a policy move that
can happen?
David: It's policy. If we don't do
something about the Fed, if we don't drive the Bernankes and the Dudleys
and the Yellens and the rest of these lunatic money-printers out of the
Federal Reserve and get it under the control of people who have at
least a modicum of sanity, we are just going to bury everybody deeper.
It's
unfortunate. The American people are as much a victim of the Fed's
massive errors as anything else. People were not prudent when they took
on debt at 100% of the peak value of their property at some moment in
2004 and 2005. They were lured into it. But now we're stuck with
something that didn't need to happen.
Alex: The
Federal Reserve was founded in 1914, and it saw America through World
War I, World War II. It saw America through Vietnam, saw America through
the biggest boom in the economic history of the world. Yet now, today,
you are calling for the abolishment of the Fed. Wasn't the Fed here the
entire time that America was a prosperous, growing, wealthy,
technology-driven nation? What's changed?
David: The greatest period of growth in American history was 1870-1914 the
Fed didn't exist. Right after 1870, when we recovered from the Civil War
we went back on the gold standard. It worked pretty well. World War I
was a catastrophe for the financial system. The Fed financed it, but I
don't give them any credit for that, okay? We shouldn't have been in
that war. It was a stupid thing to get involved in. But once we got
involved in it, the Fed printed money like crazy, it facilitated
borrowing, set the groundwork for the boom of the 1920s and the collapse
of the 1930s.
Even then though, we had great minds who coped with
reality in a pragmatic way in the Fed. Even Marriner Eccles wasn't all
that bad. He stood up to Truman in 1951, when Truman wanted to force the
Fed to continue to peg interest rates at 2% or 2.5% when inflation was
5%. Then we had William McChesney Martin: brilliant, pragmatic. He
wasn't some kind of gold-standard guy in a pure sense, but a pragmatic
guy who understood that prosperity had to come out of private
productivity, out of investment, out of risk-taking, and the Fed had to
be very careful not to allow speculation to start or inflation to get
ignited. In 1958, he invented the phrase, "The job of the Fed is to take
the punchbowl away." And we had a small recession. Six months after the
recession was over he was actually raising the margin rate on the
stock-market loans in order to quell speculation, and raising interest
rates so that the economy didn't start to inflate again.
Now that
was the regime we had until, unfortunately, Lyndon Johnson came along
with his "guns and butter," took William McChesney Martin down to the
ranch, and beat the hell out of him and forced him to capitulate. But
here's the point I would make: In 1960, at the peak of what I call the
golden era the twilight of fiscal and financial discipline we had
$30 billion on the balance sheet of the Fed. It had taken 45 years to
build that up. Then, as they began to rapidly expand the balance sheet
of the Fed during the inflation of the '70s and the '80s, even then it
took us until September 2008 the Lehman collapse to get to $900
billion. Had the balance sheet only grown at 3%, which is what the
capacity of the economy to grow, I think, really is, it would have been
$300 billion, so they were overshooting.
Alex: We're three times where we should be.
David: Where we should have been by the Lehman crisis event. In the next seven
weeks, this crazy lunatic who's running the Fed increased the balance
sheet of the Fed by $900 billion, in seven weeks. In other words, they
expanded the balance sheet of the Fed as rapidly in seven weeks as it
had occurred during the first 93 years of its existence. And that's not
all, as they say on late night TV: in the next six weeks they added
another $900 billion. So in thirteen weeks they tripled the balance
sheet of the Fed.
Alex: Wow, that's an incredible
David: So no wonder we are in totally uncharted waters, and it's being run by
people who are clueless as to how to get out of the corner they've
painted this country into. They really ought to be run out of town on a
rail.
Alex: I think you'd find that a lot of our
viewers would agree with you on that one. You know, the average American
is suffering. It looks like the average American is going to have to
suffer more to get us out of this, but it seems like the only thing the
Fed is interested in these days is propping up the stock market. Why is
that? Where does that come from?
David: The Fed
has taken itself hostage with this whole misbegotten doctrine of wealth
effects, which was created by Greenspan. In other words, if we get the
stock market going up and we get the stock averages going up, people
feel wealthier, they will spend more. If they spend more, there is more
production and income and you get a virtuous circle. Well, that says you
can create wealth through speculation. That can't be true, because if
it is true, we should have had a totally different kind of system than
we've had historically.
So they got into that game, and then the
crisis came in September, 2008. They panicked and pulled out the stops
everywhere. As I said, tripled the balance sheet in thirteen weeks,
[compared to what] they had done in 93 years. They are now at a point
where they don't dare begin to reduce the balance sheet, begin to
contract, or they'll cause Wall Street to go into a hissy fit. They are
afraid to death of Wall Street going into a hissy fit, so essentially,
the robots and the boys and girls and the fast-money traders on Wall
Street run the Fed indirectly.
Alex: So, in the
1960s, the Fed is taking away the punchbowl. Sounds like in 2010 the Fed
is the one adding the alcohol. They are afraid to stop, lest everybody
riot.
David: Yes, they got the party going, and they're afraid to stop it. As a result of that you have a doomsday machine.
Alex: At some point we are going to be forced to stop. Market forces will
kick in and Europe and China and India will stop lending us money.
David: Yes. As I say, when the crisis comes in the Treasury market, it will be
the great margin call in the sky. They'll start unwinding all of the
carry trades, all of the repo. Asset prices generally will be affected,
because this will ricochet and compound through the system.
Alex: When does this happen?
David: People looked at the housing market and the mortgage market way back in
2003 there were some smart people looking at this. They looked at the
run rate of gross mortgage issuance, the $5 trillion I was talking
about, and said: "This is insane, this is off the charts, this is so far
beyond anything that has ever happened before, something bad is going
to come of this." It's obvious, if you pour debt into markets
I mean a
lot of people leveraged 98%, or whatever they were doing at the time
with so-called mortgage insurance, and just high loan to value ratios.
They were driving up prices, and so there was a housing-price boom going
on. It was sucking the whole middle class into speculation. So that's
the nature of the system, and now they don't know how to unwind it.
Alex: That's a pretty stark picture. So as an individual investor, what are
we to do? How do we protect ourselves in this type of situation? Should I
be owning bonds and staying out of stocks? Should I be owning stocks?
David: No, I would stay out of any security markets. These are unsafe markets
at any speed. It's all tied together. As I was saying when the great
margin call comes and they start selling the Treasury bond, they'll take
everything else with it. Real estate is priced off Treasuries.
Mortgaged-backed securities are priced off Treasuries. Corporates are
priced off Treasuries. Junk bonds are priced off Treasuries. Everything.
The stock market will go into a panic. We don't know when the timing
will come we've never been in a world where there is $15 trillion
worth of central-bank balance sheets, like we have today. The only thing
I think you can conclude is preservation is the only thing you are
about as an investor. Forget about yield. Forget about return. Just keep
yourself liquid and preserve your capital, because you can't predict
the day when, as I say, the great margin call in the sky comes down.
Alex: So if it's not about coming out ahead, it's about coming out not behind
everybody else. It's just losing a little less. What's the most
effective way to do that? Do you want to hold cash? Alternative options?
David: Yes. I don't even think there's nothing wrong with owning Treasury
bills. I mean, if you want to get, for a one-year Treasury, what is the
thing now? Twenty basis points or something?
Alex: So when the great Treasury crash comes, I should own Treasury bills?
David: Well, it doesn't mean the price of the Treasury is going to crash, no.
Alex: Okay, so we are just going to see interest rates skyrocket on new issues. The US government is not going to be able to borrow.
David: That's why you're short. If you're in a thirty-day piece of paper, you're not going to lose principal.
Alex: What happens to the dollar in all of this? If I'm holding dollar denominated assets ?
David: Well, the dollar, in theory, people would think is going to crash. I
don't think it is because all the rest of the currencies in the world
are worse.
Alex: So once again, America is not that bad off.
David: Well, we're bad off because when the financial markets reprice
drastically, it's going to have a shocking effect on economic activity.
It's going to paralyze things. It's going to finally cause consumption
to come down. It's going to cause government spending to be retracted.
You
know, the Keynesians are right. Borrowing does add to GDP accounts. But
it doesn't add to wealth. It doesn't add to real productivity, but it
does add to GDP as it's calculated and published because GDP accounts
were designed by Keynesians who don't believe in a balance sheet. So
they said, "If the public sector and the household sector are borrowing,
let's say, $10 trillion next year, run it though GDP, you'll get a big
bump to GDP." But sooner or later your balance sheet will collapse. They
forgot about that one. So my point is that we've gone through a
thirty-year expansion of the balance sheet, an artificial growth in GDP;
now we're going to have to be retracting the collective balance sheets.
That means that GDP will not grow. It may even contract, and no one's
prepared for that.
Alex: So the economy will
collapse. The dollar will be okay, because we still need a medium of
exchange and the dollar is the least-bad currency in the world. How does
gold fit into the picture? Do you think that gold is a good asset?
David: Yes, I think that gold is a good asset. It's the only currency that anybody is going to believe in after a while.
Alex: Okay, so maybe hold that as an insurance policy. Do you own gold yourself?
David: Yes, as an insurance policy.
Alex: Where else do you invest in today?
David: I'm preserving capital. I'm in cash. I don't think the risk of the system is worth it.
Alex: So you are practicing what you preach, 100%?
David: Yes.
Alex: That's great. It's good to hear. This is excellent advice for our
subscribers as well, to consider that there's a lot of potential energy
built up in the system. You've articulated it well, a lot of painful
policy moves ahead of us, and probably something that makes 2008 look
like a preview, if you will.
David: It was just a warm-up.
Alex: Just a warm-up. Thank you very much.
David: Thank you.
