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Transcript for Steve Keen: Why 2012 is Shaping Up to be a Particularly Ugly Year

Below is the transcript for Transcript for: Steve Keen: Why 2012 is Shaping Up to be a Particularly Ugly Year

Chris Martenson Welcome to another PeakProsperity.com podcast. I am your host of course Chris Martenson and today we have the good fortune of speaking with Steve Keen, Professor of Economics and Finance at the University of Western Sydney, and author of the popular book Debunking Economics and website Steve Keen’s Debtwatch.

I have long been an avid reader and follower of Steve’s work over the years, because it is logical and starts with the data. Steve’s research focus is on the dynamics of debt and leads him to believe that debt deflation is the key issue that will continue to dictate what happens in the global economy. I am really looking forward to discussing deflation, his new book, maybe something of his recent debate with Paul Krugman, and whether the global markets are rolling over as we are speaking today. Steve it is a pleasure to have you as your guest.

Steve Keen: It is great to be back on again Chris.

Chris Martenson: Oh, fantastic. So, listen let us start right at the outset if you could give a summary for those who are not familiar with your work. You say debt deflation is the key issue. Can you give us a summary of your views?

Steve Keen: Yeah. Well, a capitalist economy necessarily has banks that is news to conventional economists, but as we use that as a risk to that and banks create spending power by creating debt. So, you can actually have a boom being driven by banks lending money at a faster rate than the economy itself is growing, which gives you an accumulation of debt that is getting to be a higher and higher ratio of debt to the GDP.

You get to the point where that can not continue any longer, where you cannot get new borrowers, and when you reach that point you go through a turning point then where people who have normally been enticed into debt to borrow money to gamble money on rising asset prices. Instead finance prices are falling and trying to liquidate, you then have a period where debt levels are reduced and rather than rising debt, adding the demand as a it does during the boom phase.

During the depression phase, it is not as slump its a depression, people are spending less than the earn and therefore the aggregate demand is less than income and you have a declining level of demand all the way through as asset prices collapse and debts gradually paid back down.

That is what gave us the 1930’s and we began the 1930’s process with an American debt to GDP ratio of roughly 175% and thanks to Greenspan and Co we began this particular downturn with a peak level of debt of 303% of GDP. So just as it took about 15 years to get out of the last Great Depression, this one which American’s are still calling a lesser depression now I noticed, it could last even longer than great depression 1 did.

Chris Martenson: This time with 50% more extra debt. In this story then, there is a math problem and the math problem is that you cannot borrow more than your income. If you debts are growing at a faster rate than your income, eventually you have a math problem. You are saying we reached that math problem in 2008 I guess, do you agree with that? In addition, secondarily, was there a trigger in events that precipitated that or did these things just somewhat happen randomly?

Steve Keen: It is an endogenous thing. It does not require an external event, because to continue having more and more debt being taken on, you have a ton of people who are willing to acquire that debt. Initially the level of debt the household had back in the 1990’s was relatively low, about 40% of GDP. They were then enticed by the subprime bubble and the debt levels for the household was about 100% of GDP. To keep the bubble going, you would need not just people to keep raising their debt, but accelerating debt.

This is why it always has to break down, because for debt to accelerate indefinitely you have to get to the stage where debt to income ratios were infinite. Now, of course that can happen. So, as soon as you start to exhaust the supply of people who are willing to go into debt, as we have more and more of society becoming indebted, a simple slow down of the rate of growth of that is enough to turn the acceleration negative. That is what drives the whole economy down.

So, we take a look at the data, I think you have to look at three factors of debt, the absolute level, the rate of growth of debt, and whether that rate of growth of debt is acceleration or decelerating. In fact, the process begins as soon as the rate of acceleration consistently decelerates and goes from getting faster to growing more slowly. That is what sets the process off.

It actually began pretty much at the beginning of 2008, but of course part of the other triggers as well was that a large part of the debt that was created was then put into ventures, which themselves were losing money. Therefore, you had the subprime crisis where we know people were borrowing amounts of money they could never pay. They were unnecessarily going bankrupt, there were losses being made by speculative ventures elsewhere as well, but those losses accumulate and have to be serviced or they have to go bankrupt and write the debts off. Therefore, those triggers were all sitting there, but they were truly internally. It does not take a meteor from mars to create this crisis.

Chris Martenson: So, I plant the seeds of this stretching back a long ways, I am the most familiar with US debt. At this point, I know that starting in the 1970’s through the next four decades, over those four decades total credit market debt, which includes financial and non-financial. That doubled five complete times in that period of time and of course the economy did not double anywhere close to five complete times.

So, that rolled over around in 2008, so just to get back on that trajectory, to get back to what people would call normal for budgets to operate like we expect them to, capital markets, and the whole shebang. I would estimate that we would have to double again, what is calling in a decade. Therefore, from 2008 to 2018, the US has to figure out how to accumulate fifty some-odd trillion dollars of new incremental debt. I do not know what we would even possibly lend it to ourselves for, the total housing bubble was still only a ten or eleven trillion dollar market. Do you see any opportunities out there for us to take on the kinds of debt that seem to be required to rescue this system?

Steve Keen: No. You cannot go back to business as usual. This is the real trap of the debt bubble, because the thing that actually entices people into that much debt is the expectation that asset markets are going to continue rising. If you look at the debt that people have with respect to their income, you know personal lines, and stuff like that. Despite all the enticements to charge up credit cards, would you like an increase in your credit limit with that like if you are going to McDonald’s and getting extra fries.

Banks are trying to pump out higher credit limits all the time. Deals on buying cars, you know buy now and pay later, etc. Despite all of that, the ratio of unsecured personal debt to income has not been flat lined, but it certainly has not gone on an exponential rise. The only form of debt that rises exponentially compared to income is debt, which is being used by an asset were you believe that the asset is going to increase in price and you can sell it for a higher amount of money that what you paid to buy it in the first place.

If you can get a capital gain, which really is a ponzi game. You do not do anything, but you get money for it. That is what drives that prices up, you have the biggest bubble in stock market history and the biggest bubble in housing market industry simultaneously, having reached that peak because you can longer have accelerating debt driving up those processes further they are now falling and that it is going encourage people out of debt. Therefore, far from saying in a way it will get people back in again, the asset market bubble being over that is going to drive people out of debt rather than getting enticed to take on more. So, what was usual over the last 40 years cannot be restored.

Chris Martenson: Very interesting in that. I note that, one of the places that I date sort of a recent stumble in all of this, yes it is a four decade long credit bubble, but in 1994 we had a real issue in the credit market particularly corporate bonds. Greenspan took that moment to implement something called the Sweeps Programs, which enabled banks to effectively dodge the reserve requirements as minimal as they were entirely.

That enabled a brand new gigantic round of liquidity to take off, so they had the stock bubble and of course, that met its fate, and then that led to another round of ultra cheap money. Ultimately that led to a housing bubble. Therefore, my view of this is that we started with a relatively small crisis, but with the application of more sugar, monetary heroin, or whatever metaphor we are using here, that beget an even larger problem that required an even larger stimulus.

Therefore, here we are now globally looking at coordinated central bank interventions where in the past six years the balance sheets of just the six largest central banks have expanded by ten trillion dollars. Do you think that they can realistically keep this game going much longer?

Steve Keen: Well, they can prevent people from going insolvent by giving somebody who is bankrupt cash. That is pretty much what they have been doing. They have been bailing out the banks and bailing out the bondholders. They can continue doing that indefinitely, because it costs. Just as banks can create money, the commercial banks can create money by double entry book keeping. So can central banks, so they do not face very many limits at all.

There is not a limit to their profitability of course. So, they can keep on doing this indefinitely, but what they are hoping to have happen and this is what is going to fail, is by doing it the system will suddenly kick start itself. It will be like a lawnmower in which you continue pulling on the cable to try to get it to start, pull it a few more times, put a bit more fuel in, and it will finally fire up and then it will go off of it’s own.

That is what is not going to happen. They are going to have to continue pumping money back in again and of course each time they stop it will spot into life itself, because the basic trainings for the public safety is reduced its debt levels. It will always fall back into a slump. Therefore, they can keep on doing it indefinitely, but I think we will continue indefinite succeeding and filing as soon as they hear that the system can take over on it’s own.

Chris Martenson: So, spell it out for me. Why exactly is it that this engine will not sputter back to life?

Steve Keen: Because too much debt is already in there and because people no longer see a way of rising debt. Meaning, a gain on the asset markets for themselves they are going to be trying to reduce their debt. Particularly if asset markets are in fact falling. They are going to be reducing their gearing, reducing their leverage, and every time you kick start to go the system with a lot of extra money and hope to get it started once more.

Once you stop injecting that government created into the system, the system will then go to this stage where it takes money out, because to pay your debt down you have to take money out of circulation. Therefore, the economy will fall again and rather than booming, it will go back to faltering once more.

Chris Martenson: So, perhaps in a micro causing, if we look at what is happening in Spain today where we note that they have an extraordinary debt to GDP ratio, they have really dismal economic prospects, they have a banking system that is really weak if not mortally wounded, and they have just nationalized Bankia. Is Spain a good metaphor here for what maybe the larger world is going to experience?

Steve Keen: I think American can still apply to this metaphor, because as a point I think metaphorically we are talking about the actual story. Because, Spain is part of the Euro and the Euro is another catastrophe on top of all the overall catastrophe of private banking funding ponzi schemes. Therefore, the real story is the commercial banks generating money and making profit for themselves by creating debt and persuading us to do far too much debt by the asset bubbles that actually caused the prices to rise.

In addition, of course, Greenspan’s rescue is making this process go on for far longer than it would have without that particular government intervention. But, Spain is caught up with the Euro where just as neoclassical economists are responsible for the scale of the crisis by making us turn a blind eye to rising debt. They also drafted the economic component of the treaty to bring about European Union.

That treaty embodied the neo-classical fantasy that a market economy works best if there is no government intervention and no government policy. Therefore, they set up a system in which the governments could not do an exchange rate policy, because they are all part of the one currency. Therefore, they cannot devalue against each other.

You cannot do a monetary policy, because the European Central Bank is in control of that and sets an interest rate for the entire continent of Europe. You cannot do a fiscal policy either, because the master treaty said the maximum deficit that you can run is 3% of GDP and the maximum accumulative deficit that you can have is 60% of GDP. They are talking about public debt there.

So, to push Europe together and said you can have neither the fiscal, monetary, nor exchange rate policy and we are going to have the most wonderful world. Well, look at what has happened. It is the greatest catastrophe on the planet. Therefore, Spain is an additional catastrophe. Like in some ways it is America squared.

Chris Martenson: America squared. However, America is maybe the better metaphor, because it is not a metaphor we can talk about it directly.

Steve Keen: Yeah, it is the real story. Yeah. America is big enough even though it is being industrialized masterly through the last 30 to 40 years to under the cover of this financialization of this economy and even though it has a much larger import bill than it used to have because of that, it is still pretty much a self contained economy. What is going on there is an entirely endogenous process of the banks creating too much debt, funding an asset market bubble, and now we are caught up in the deleveraging from that and we are back in another Great Depression.

Chris Martenson: So, start to spin over in the great debate that has brewing with the neoclassical economists, who by the way have been just spectacularly wrong. I have yet to hear a qualified reasonable mea copa from that crew. If I could summarize, they seem to be saying any failures in policy and traction that we are not seeing so far, is simply because we did not do enough. Enough of what?

You have mentioned that some of the strategy here was sort of delay and pray, so we just kick the can long enough and pray and maybe the economy sputters back to life all on it’s own. However, there have been a number of other dynamics driving this with taking what were private debts and pushing them over on to the public side of the balance sheet with direct monetization of government debt by central banks in particular the Federal Reserve, very large quantities. What exactly is the strategy here?

Steve Keen: Well this is the intriguing thing, because the strategy is panic. The neoclassical economists believe that the economy is self-equilibrating, that it will return to the equilibrium after the minor shock and they really regard the global financial process as just a big shock. However, for some reason they continue to remaining negative and they cannot work out why.

In fact, if they have had their drothers, they would have drovened on nothing back at the time of the 2007 crisis. Except that according to their theories that crisis should not have happened. So, what happened when the crisis hit? You had people who were neoclassical and vehemently anti government spending; suddenly became born again Keynesians. They threw as much money as they could at the system hoping that would get it over this temporary process.

Then, when they did that and they got a bit of a recovery for a while, the scale of the government spending was far greater than the Great Depression. Therefore, you had a boost of aggregate demand coming out of the government’s behavior. Then, they thought they could sit back and watch it start booming once more and rather than booming of course, we have had an economy, which splatters.

Normally after a standard post second World War recession where you know growth is negative for a couple of quarters, you normally get a rebound where it bounces up between five and six percent on an annual basis per quarter for a few quarters at least after the slump. The best they have managed so far is about three; of course we are falling back to the stage where one may even hit negative again.

Their response was to abandon their principals so called and go for government spending, and then pray that would be enough to get the system started again. They are basically flummoxed as to why it has not worked.

Chris Martenson: You know I am going to note that I think Keynes is getting a bad wrap in this.

Steve Keen: He is getting a bad wrap, yeah.

Chris Martenson: I have read some of his works and he is clearly a very intelligent person. I am going to go out on a fat limb and suggest that he would not ever support the idea of trying to exponentially grow and increase your debts faster than your income. He was clearly too smart for that.

Steve Keen: No, Keynes was aware of the dangers there. I often said people like Paul Krugman call themselves new Keynesian’s, him and Woodford and so forth.As I read Development of Economics, if they can call themselves Keynesian’s and I can call myself a duck, because I can say the word quack.

There is no way in which they reflect what Keynes actually wrote. Ironically you read them and they do not care what Keynes actually wrote. They call it research, I am sorry but knowing what somebody said is essential before you can use their name as a label of what you do. However, in fact they do not do that, they simply think oh this looks like what I think Keynes said according to a textbook I read a few years ago and I will call myself the Keynesian. I am sorry, but they are better off calling themselves ducks, because they really are quacks.

Chris Martenson: Way to bring it all together. If we could just for a minute here, there was a very public debate with a New York Times economist, I am putting your quotes up here on this. I guess he is an economist but Paul Krugman. I was reading his blog and he was defending the idea that banks cannot create money out of thin air. He may have backtracked a bit on that, but it was a very odd debate. I did not quite understand ultimately what was being argued there. Can you help us out?

Steve Keen: Yeah. Well, the basic neoclassical attitude is that banks do not matter. Banks are simply intermediaries between savers and borrowers. All the bank does is act as a conduit; it does not actually create money. Now you then argue of course, it does create money and the money multiples then. So, the government gives a unemployed person a check, they go bank the money at the bank, the bank holds onto a bit of it, and lends out a bit.

There is the money multiplier process that they ultimately get to the stage where they finally have a ratio between their deposits and their reserves, which is the maximum level they can get to and then they cannot lend anymore until the government creates more reserves. That is the sort of money creation model that Krugman believe, that neoclassical economists in general believe the banking sector is capable of. However, they argue that the bank cannot simply create money beyond what the reserve systems allow it to do. I think that is the conventional belief they have.

Now, the position that I come from is to say that banks are unconstrained by the reserve system. There are a number of reasons behind that. One of the simplest is and the European Central Bank actually states this, the way the reserves are calculated is as a lagged response to what has happened in the lending market. So, the reserves are based on the deposits that were credited two weeks earlier in some cases. In America’s case, it is 30 days earlier.

Therefore, in other words it is after the banks have created new money, then the reserve they need to match the new money they have created are determined. Therefore, rather reserves creating it first and deposits coming later, it is precisely the reverse way around. That is the big mistake; it means that banks can create money by double entry bookkeeping.

If you go to a bank and ask for a loan, the bank asks you what the money is for, I have this idea for this new hydrogen powered iPad, the bank says that is a great idea, here is one hundred million dollars, and by the way you own us one hundred million dollars. They simultaneously create a loan and a deposit without having to take the money out of the account of any other savers. Therefore, that means you get to spend one hundred million dollars building this new hydrogen powered iPad does not reduce the spending power of other people in society, it adds to it.

Therefore, banks play an essential role in the real economy and in the models that I build of it as well. They are actually adding to aggregate demand. What they add to aggregate demand generally goes on two things, investment, which would be a good thing if indeed a hydrogen powered iPad was a good idea which is not, but nonetheless that would be a good investment.

However, it also goes on speculation, which means buying existing assets and using the borrowed money to bit up the prices. That role of banks is an essential element of why we got into the crisis in the first place. But Krugman is quite amazing at having said this, his is all for putting in banks where they matter, but why do banks matter in a story about debt and leverage? To me that was a bit like saying I am for it with considering wings on birds, but why do I need to worry about wings and why birds fly?

Chris Martenson: It is mysterious. It is just mysterious to me that there can be such a disconnect between what appears to be obvious conclusions from lots of data. You do not have to dig hard; it is all right there. Help me understand something then, I do something very arcane, I look at the monetary aggregates, because I think that there is still some information in that. My prediction is that someday the velocity of money will turn around like it always does and that will be a moment to behold.

I am watching say M2 or MZM it does not matter; they are still trending up at an almost unbroken clip throughout this entire crisis. In fact, they even have some sharper up sloping periods during part of this crisis. On that basis, it looks like there are still plenty of money sort of entering the system by hook or by crook, even as credit is declining, mostly it is financial credit, that has declined. How do we explain that?

Steve Keen: I have to plead ignorance there but first I tend to look at the debt levels. To me the central act in creating new money is the creation of debt, because debt and money are created as a bonded pair when they begin and then after the creation process they are separated. So I am looking at the level of new debt being created and that is still declining. The level of debt in the economy is still falling very slowly; it was falling very rapidly when the crisis first began. That is the main metric I look at.

The monetary aggregates on the other hand, I tend to regard them as being caught up in the whole shadow banking sector and what is being done by the government in it’s rescue attempts. I think there are so many black ops going on there that I just do not find the data reliable enough to worry about too much.

Chris Martenson: Yeah, I understand that.

Steve Keen: It does puzzle me; I have to defer to you on that one.

Chris Martenson: All right, well back to your earlier point then, one of the other things about this double entry bookkeeping and credit expansion really does enable as well. If I am looking at the inflation adjusted expenditures of all the major OECD governments, they are all upwardly sloping lines for the past decade.

Therefore, the other enabling feature of creating all of this money is to allow governments to not really have to figure out how to balance their books all that carefully. So, everybody got to participate in this party I assume?

Steve Keen: Well, it is a bit different. There is a reason why debt should rise over time, but it should rise roughly at the same pace as income, faster sometimes and slower at other times. I was talking about private debt there, because when you have a growing economy because the growth is financed largely by the increasing debt financing investment, which then gives you technological improvements, new products and so on. That is a reason to continue borrowing money.

We should normally expect the banks to be creating new debt most of the time and only when the economy is actually in a recession is when we should see the level of debt falling. That would be a healthy economy if we did not have financing ponzi schemes and therefore rising exponentially faster than income.

The same thing applies for the government, if you have a mixed economy you have a combination of private sector spending and government spending, private sector created money, and government created money, you have to have the government creating additional money over time as well. The major way it does that is by running a deficit. Therefore, the normal situation for a growing economy should be a deficit that means the level government money in the system remains roughly comparable to the level of private money.

Instead what we have with this fixation on balancing of the books, which would be the right thing to do if you had a static economy. That has actually led to the level of government money plunging over time. If you go back to the 1960’s and I have some memory of the levels of aggregates back then, back in the 1960’s M Zero was about 15% of the total money supply. If you fast-forward to just before the crisis, we were down to about three percent.

That was the government, actually because of the obsession with running surpluses during the boom times and even during some slump times. Reducing the amount of government money in circulation, letting the credit system go crazy, and then when the crisis hit what does Bernanke do? He doubles the base money supply in four months from the previous doubling took 13 years. We got back to pretty much the same ratios as 1960 by the time we finished the pumping into the system, but it actually helped stabilize it in the period before that.

Chris Martenson: Interesting. So, let us imagine then when you see what is going on right now, you say credit is slowly falling and it is not growing at all. If credit is falling slowly at this point, would you say then the pressures on the global financial system, on markets and the larger economy, are those pressures still growing at this point.

Steve Keen: Yeah, the reason that we have this trauma for the asset markets is because of this whole relationship that rising debt has to the level of asset markets. If you think about the best example is the demand for housing, where does it come from? It comes from new mortgages. If you want to sustain the current price level of houses, you have to have a constant flow of new mortgages. If you want the price level to rise, you need the flow of mortgages to also be rising.

Therefore, there is a correlation between accelerating and rising asset markets. That correlation applies very directly to housing. You look at the 20-year period of the market relationship from 1990 to now; the correlation of accelerating mortgage debt with changing house prices is .8. It is a very high correlation.

The boom and bust is obviously too. It is not quite so clear for the stock market, but it is about .35. And then given how volatile the stock market is, I find that to be a remarkably high correlation anyway of aggregate debt to the change in the stock market.

Now, that means that when there is a period where private debt is accelerating you are generally going to see rising asset markets, which of course what we had right up to 2000 for the stock market and of course through 2006 for the housing market. Now that we have deceleration debts, debt is slowing down more rapidly over time rather than accelerating. That is going to mean falling asset markets.

Because, we have such a huge overhang of debt, that process of debt acceleration downwards and decelerating, negative, is more likely to rule most of the time rather than going positive. We will therefore find the asset markets traumatizing on the way down, which of course encourages people to get out of debt. It is a positive feedback process on the way up and it is a positive feedback process on the way down.

Chris Martenson: Do we also have something else contributing here where any market, whether it is an asset market or a fish market, if you have more buyers than sellers prices tend to go up in the reverse more sellers than buyers and prices tend to go down. When I look at the demographics of the United States and of Europe, people enter their peak earning years between the ages of 30 and 50 and then when you have more retirees that people behind them. If you have some sort of a demographic bulge you generally will find, well whom are they going to sell their assets to, as they want to fund their retirement?

Japan in many respects is almost exactly 10 may be 11 years ahead of the United States in terms of it’s population demographics. They have been experiencing just horrible asset markets for a very sustained period. Bernanke certainly studied that and promised we would not turn Japanese. Have we just turned Japanese?

Steve Keen: Oh well I am sure. That sort of work is the sort of stuff that Harry Dingey entertained of course. It is a genuine product of the whole dynamic that I tend not to include in my modeling. If I include the demographics, it would pretty much swamp everything else. I want to focus on the contribution the financial sectors made to it is own suicide.

But, yes when you have a demographic bulge, such as the baby boom and so on, passing through the system and they are trying to liquidate their assets they get and get their retirement funded. Of course all doing it at once and then having finding asset markets driven up through high levels of debt, now they are trying to capitalize that and come out with an income for the future. They are going down again.

Now of course, when you have a declining population, you do not need to have more houses being built and you can therefore have houses becoming empty. That of course is going to have a downward pressure on housing prices. Which maybe a reason why Japan’s house prices have fallen, I think now more than 70% from their peak in nominal terms. So, an enormous decline over time.

We may face a similar think in America, such as the demographic bulge of the baby boom is all the way through on which targeting to the dinks part of society turning up. That is a secular trend in addition to the cyclical phenomenon and bubble phenomenon of the stock market of the financial sector funding a ponzi scheme.

That is something we have never had to cope with before. As well as cross-global warming and peak oil. All these things coming together at once is an incredible cacophony of problems that makes me wonder whether I am actually on planet earth or am I caught on an episode of Star Trek.

Chris Martenson: Well, it certainly explains why the strategy is panic. If we cast into that cauldron of things that you just put out there, what I see is that we are trying to preserve the status quotes, we have dumped trillions and trillions of dollars, and it does not seem to be working.

As I read the current economic statistics, so here we are it is June 4, 2012 I am looking across the global landscape last, horrible week. So, China is decelerating strongly, Japan is in a recession, Europe is in a recession, and the PMI statistics are down horribly, and in a contractionary territory. The United States is at stall speed and against that backdrop we have to sort of conclude maybe that printing efforts one, two, and LTRO one and two, and all those other things have not worked.

If you put on your prediction hat, where are we in this story right now and what are the chances of rescue at this stage? Well, let me start here, what do you see going on in the global economic landscape right now?

Steve Keen: Well, Europe is imploding under its own volition and I think the Euro is probably going to collapse at some stage or contract to being a Northern Euro rather than the whole of Euro. Again, we will probably see every government of Europe be overthrown and quite possibly have a return to fascist governments. It came very close to that with Greece and fascist getting five percent of the vote from zero. Maybe left wing groups as well, so political turmoil in Europe and that seems to be Europe’s fate.

I can see England going into a credit crunch this year, because if you think America’s level of debt is scary, you have not seen England’s level of debt. America has a maximum ratio of private debt to GDP adjusted over 300%; England’s is 450%. America’s financial sector debt was 120% of GDP, England’s is 250%. It is the hot money capital of the western world.

Now that we are finally seeing decelerating debt that is turning up over there, plus the government running an austerity program at the same time, which means there are two factors pulling on the demand of that economy at once. I think there will be a credit crunch in England, so that is going to take place as well.

America is still caught in the deleveraging process. It tried to get out, it seemed to be working for a short while, and the government stimulus seemed to certainly help. Now, that they are going back to reducing that stimulus, they are pulling up the one thing that was keeping the demand up in the American economy and it is heading back down again. We are now seeing the assets market crashing once more. That should cause a return to decelerating debt for a while you were accelerating very rapidly. That gave you a boost in employment, so you are falling back down again.

Australia is running out of steam, because it got through the financial crisis by literally kicking the can down the road by restarting the housing bubble with a housing policy of what I call the first time vendors boost. Where they gave first time buyers a larger amount of money from the government.

China got through the crisis with an enormous stimulus package. I think in that case it is increasing the money supply by 28% in one year. That is setting off a huge property bubble, which from what I have heard from colleagues of mine. A friend of mine Craig Tindale is publishing a little piece of that on my blog this week. That is also coming to an end.

Therefore, it is a particular ugly year for the global economy and as you say, we are still trying to get business back to usual. We are trying to rescue the creditors and restart the world that is dominated by the creditors. We have to rescue the debtors instead before we are going to see the end of this crisis.

Chris Martenson: What does deflation really look like? I remember in 2008, Hank Paulson marched in to Congress, closed the door, and said, “if we do not fix this Lehman crisis what we are going to have is Martial Law and Mad Max.” I do not know, he was really using scare terms and then I think it was a year after that or more. Mervin King came out and said “oh yeah by the way we are just a few hours away from a really major banking snafu over here in England.” It was a dicey touch and go.

Again, with the implication that would be the systemic failure. Everybody seems to be afraid of systemic failure and I do not know if that just means just all on their own the banking system sort of dominos it’s way down and we have a lot of institutional failures or some larger cataclysm involving derivatives that create some sort of black hole of finance. In your mind if deflation really takes control and the central banks are impotent to really do any thing next, what happens?

Steve Keen: Well, the deflation is lower. We have certainly had deflation, but it is lower than the last time around. In the 1930’s, we had deflation running at ten percent per annum for a couple of years there. The major reason for that I believe is that in the 1930’s the nonfinancial business sectors were largely in debt. It’s debt ratio in the crisis began was 125% of GDP and therefore businesses were the ones who were insolvent when the crisis hit. Their reaction was to cut their prices to try to drag customers in through their doors rather than their neighbor’s doors, because they all did it and therefore there was this dramatic falling of prices. That debt was paid down, but the prices fell faster than the debt fell. Therefore, you had serious deflation.

This time around, the nonfinancial business sectors peaked in America to about 70% of GDP. A large, but far less than the great depression and sustainable. The household sector is deleveraging from a much higher level of debt than they had in the Great Depression. Roughly, 25% of GDP was the household level of debt back in the 1930’s, it rose because of deflation but it did not get to high.

This time we are starting at four times that level and the trouble for households is they cannot de-lever anywhere near as rapidly as businesses can, because businesses can get out of debt three ways. They can go bankrupt, they can stop investing, and they can sack the workers. Households find it very embarrassing to go bankrupt, it is very hard to stop consuming, and they cannot sack the kids. Therefore, consequently it is a very slow grinding deflation.

When it comes to what the central banks and the governments are doing about that whole process, they are afraid of a systemic break down in what you can pretty much call the repo market. They repurchase agreements that are a major part of how banks fund themselves by selling a bond or a financial instrument of some sort to another bank and agreeing to buy it back at a higher price and at a later period. That is such a fundamental part of the whole chain in the payments between banks.

The scare that all the central banks have is that the chain breaks down and it breaks down when a bank says I am not going to buy a bond off somebody and expect to sell it back to them for a higher price in 30 days time, because I know my bonds are shonky and therefore their bonds are likely to be shonky. Therefore, the whole repayment scheme that existed at that level stops and suddenly the whole banking system freezes.

That is the real fear that they have and the other fear, which we accessed at the time that the Lehman Brother’s Collapse, was that the Lehman Brother’s had cornered the commercial paper market and that is how these days unfortunately, because the banks have been seen so derelict in their duty. That is how nonfinancial corporations mainly fund themselves by issuing very short term paper to pay the wage builds and to pay for the material inputs and so on.

When the Lehman’s failed, because they cornered the market, the commercial paper market failed and that meant they literally did not have the money to pay wages that week. Now, that is what really put the bejesus up at Hank Paulson. They are afraid of a repeat of that. It is quite possible that we would see a repeat if you had a series of banks folding courtesy of what happens with the Euro or what is happening with unsuccessful plays on asset markets, which we saw with J.P. Morgan recently.

Chris Martenson: To continue this on then, if the repo market falls apart it is really a sort of domino theory. The BBC put out this extraordinarily beautiful and very helpful graphic where they had a big circle and the countries were arrayed around and occupying portions of the circle and the fatness of the arrows going from one side of the circle to the other showed the amount that each country owed to the next country. Everybody owes everybody in one giant circular piece. If everybody owes everybody and one person cannot pay, it sort of knocks the whole thing off.

I like to study bubbles and there are many historical examples such as railroad bubbles, tulip bubbles, and all kinds of wonderful bubbles. They have a remarkable set of symmetries to them. One is a time symmetry; about as much time as they take to develop, that maybe just a little quicker they unravel. The second is they tend to sort of return from whence they came in terms of price levels.

If we just nominally said okay, we are just going to pick a number and say this credit bubble started just even ten years ago. Let us start it in 2000. In the US that means that we would have roughly twenty to twenty five trillion dollars of debts that would have to be unwound. We have done I do not know, maybe three trillion of that, maybe something like that. Is it possible that in this unwinding we are talking about a wholesale destruction? There must be something that central banks can do that they have not done. I have not yet received a time sensitive check for one hundred thousand in my mailbox.

Steve Keen: Well, that is actually what you want them to do. I think the mistake they are trying to make is to continue honoring debts that should never have been created in the first place. We really know that that the sub prime lending was totally an irresponsible lending. When it comes to saying who is responsible for bad debt, you have to really blame the lender rather than the borrower, because lenders have far greater resources to work out whether or not the borrower can actually afford the debt they are putting out there.

They were creating debt just because it was a way of getting fees, short-term profit and they then sold the debt onto unsuspecting members of the public as well and securitized their way out of trouble. Then they gave the hot potato to the public. So, you should not be honoring that debt, you should be abolishing it. However, of course they have actually packaged a lot of that debt and sold it to the public as well, you cannot just abolish it, because you then would penalize people who thought they were being responsible in saving and buying assets.

So I am talking in favor of what I call a modern debt jubilee or quantitative easing for the public, where the central banks would create central bank money. We cannot destroy or do the abolition of debt, which would also destroy the incomes of people who own the bonds banks have sold. We have to create the state money and give it to the public, but on conditions that if you have any debt you have to pay your debt down with no choice. Therefore, if you have debt, you can reduce the debt level, but if you do not have debt, you get cash injection.

Of course, this would then feed into the financial system, the financial sector, which would have to reduce the value of the debts that it currently owns, which means income from debt instruments would also fall. So, people who had bough bonds for their retirement and so on would find that their income would go down, but on the other hand, they would be compensated by a cash injection.

The one part in which the system would be reduced in size is the financial sector itself. That is the part we have to reduce and we have to make it smaller.That is the proposal that I am putting forward and I think there is a very little chance of implementing it in America for the next few years. Moreover, in my home country, because we still think we are doing brilliantly down under. But, I think at some stage in Europe and possibly in a very short time frame that idea might be considered, because the crisis in Europe as we know is giving countries like Spain with unemployment rates of 25%. Social cohesion cannot hold with unemployment at that level.

Particularly when the other policies the government is trying are battening on the poor people that never benefited from the bubble in the first place.

Chris Martenson: Right. No, I completely understand your proposal. It makes more sense to me, on a number of levels including the whole moral hazard level of basically making whole banks that never learned their lesson in all of this? One thing that we know about banks is, if they do not learn their lesson they will not learn their lesson. I see J.P. Morgan’s recent activities just demonstrating that business as usual be returned to as soon as possible without some sort of corrective event of some kind.

Steve Keen: Yeah. They have to suffer and suffer badly. They will have to suffer in such a way that in a decade or so they will be scared from never behaving in this way again. You have to reduce the financial sector to about one third of it’s current size and we have to also ultimately set up financial institutions and financial instruments in such a way that it is no longer desirable from a public point of view to borrow and gamble in rising assets processes.

The real mistake we made was to let this gambling happen as it has so many times in the past. However, to let it go on for far longer than we have ever let it go on for before. Therefore, we have a far greater financial parasite and a far greater process.

Chris Martenson: Understood. So, let us imagine for private individuals, how would you recommend protecting ones assets, wealth, purchasing power, or ones future?

Steve Keen: Well, in a situation like this I think dealing in cash is the safest way to survive. If you are dealing with cash, you are not going to be hit by debt problems and you can be a vulture shopper so to speak if assets come on shapely. Being in cash is the best idea, but of course you can also make money by gambling on assets like gold, but the great danger is I really do not trust that there is as much gold out there that people have bought. There are people who will find plenty of fraud there too.

Bill Black keeps on reminding we have to concern ourselves about fraud and I think people who thought they had gold and gold certificates actually might find have gold fraud on their hands. I think the safest option is to be in cash in your national currency. Of course, the great trouble about that is if you liquidate or you are in debt and go into cash instead by selling assets, you help cause the process that brought the overall system down.

So, we cannot just do it at the individual level, we have to get together, we have to campaign, and change society to stop the thing dominated by the finance sector. I think that means collectively, which is a rare event for Americans, but I think it is about time they try it.

Chris Martenson: Well, we are going to try everything else first, but I am with you. Therefore, I understand you are finishing up a new book. Can you give us its title and a quick overview of what is in there?

Steve Keen: I am actually thinking about writing a new one. I know Paul Krugman has got a book called End This Depression Now and I think he has the naïve belief that you can end the financial crisis with a big enough government deficit. He is ignoring the impact that private sector deleveraging, because he ignores all of the debt.

I am thinking of writing a book and I have not quite thought of the title yet but it will be going from the way that I model endogenous money creation and simulates the financial system and so lets try a few different options here and see which one works best in the hypothetical economy while also talking about the real levels of debt and the impact of private sector deleveraging. I am hoping to have that book started in about August and finished by the beginning of next year.

Chris Martenson: All right, maybe a working title could be It’s The Banks Stupid.

Steve Keen: That is not bad Chris. I might even owe you for one on the copyrights to that. Yeah.

Chris Martenson: That will sell well in America anyway. Well, fantastic. So, how can people follow your work and where are they going to find your book when it comes out?

Steve Keen: Okay. Well, because Debunking Economics is the second edition is around and alive right now they can buy that on Amazon if they felt like it, and on Kindle, and of course at the local bookshop. I have a blog called www.debtdeflation.com/blogs and I am about to rationalize those websites by the way and change the way I interact with the public a bit. It get’s a bit rather complicated with my current system, but that is the main blog that they can go to, www.debtdeflation.com/blogs. You might listen to the broadcast of the BBC radio for analysis program, which is going to air in about ten minutes. When we are recording it will be up on the podcast site for BBC radio for this week.

Chris Martenson: Fantastic. We will put a link to that as well at the bottom of this when this loads up at chrismarteson.com. Thank you so much first for the work you are doing and second for taking as much time as you do to explain it and make sure that you spread the word as widely as you can. It is such an important dialogue and debate to be having, and thank you for coming on this program.

Steve Keen: You are welcome and I am glad you are there.

Chris Martenson: Thank you.

Steve Keen: Okay Chris, yeah.

 

Transcript for Alasdair Macleod: All Roads in Europe Lead to Gold

Below is the transcript for Transcript for Alasdair Macleod: All Roads in Europe Lead to Gold

Chris Martenson: Welcome to the PeakProsperity.com podcast and your host of course, Chris Martenson.Today we are going to take a quick detour back over into Europe because as you know, I just wrote a report talking about how this might be 2008 all over again. Of course what I am looking at in that report is the deterioration that I am seeing across Europe, thinking of Europe as a potential trigger point for a liquidity crisis whereas last time it was an institutional liquidity crisis centered around some dodgy debts that went bad and some derivatives thereupon that made it worse. This time similar dynamic, of course different players, different focus. Maybe it is happening in the sovereign debt side. Here to discuss that with us is our very own Alasdair MacLeod who has penned a couple of nice pieces for us and is sitting over in Europe; welcome Alasdair.

Alasdair Macleod: Thank you Chris.

Chris Martenson: Oh, so happy to have you again and I know I described you as our very own with a stretch, but I like to think we have a nice relationship going.

Alasdair MacLeod: It is nice to be part of the family.

Chris Martenson: Thank you for that. So, here’s the situation, Greece has elected a new government comprised of more powerful elements from both the left and the right, neither of which seems to have any interest, apparently, in honoring the prior bailout and/or austerity agreements. Spain seems to be under increasing fire, its banks were rudely downgraded recently by the ratings agencies, and Bankia specifically seems to be needing some help right here. Maybe has already experienced something of a bank run of sorts... maybe if we are reading between the lines right. GDP in Spain was just announced, dropped point three percent in the first quarter, so that confirms a return to recession there for Spain, I believe.

Let’s go to Italy, twenty-six large and medium banks just downgraded recently. GDP just announced contracted by point eight percent through the first three months of the year. That would give it its fourth recession since 2001; now pretty much in the bag. What is going on over there?

Alasdair Macleod: Well, I think you actually described it pretty well. Every horror you could imagine that we discussed last time we spoke about this is really, I am afraid, coming about. The Greek situation is entirely predictable: when you force enormous pressures on an economy and try and raise taxes from the private sector -- a private sector which isn’t used to paying taxes because usually they find away around it -- you start cutting pensions, you start cutting this, cutting that and the people revolt. They haven’t a clue what they are doing, but we get the revolt none the less and it looks like nobody can form a government; and it looks like there will be another election there and that will be probably in June. That won’t resolve anything unless by some miracle, some sense gets knocked into people’s heads. I wouldn’t like to say it gets knocked into people’s heads because it is not quite implied violence, which actually may not be too far beneath the surface in this one. No, it is not good and the French election with Hollande getting in tells us that the pressure is going to be to not go for so much austerity, so some sort of new middle way will have to be found. Not just there, but I think around Europe, which implies that the Germans are going to have to give a bit. I know it is not a fashionable thing to say, but I feel quite sorry for the Germans because it is their savings being chucked as good money after bad. That’s a mess and I think that the Spanish situation suddenly comes upon us. The yields I don’t think quite reflect this yet. I think they are only about what, six and a half percent or something.

Chris Martenson: Yeah, that is about right.

Alasdair Macleod: The yields should be north of ten, I think; the way this is going. So, we will see higher yields, which will equate to a turn of the screw on the rack and Italy as you point out; things not going so well there. The whole thing is a nightmare. I think the only thing I can say about this nightmare is that the overall debt situation is not quite as bad as America.

Chris Martenson: Well, so...

Alasdair Macleod: But that is small comfort and actually, causes further faults, which might make you, reach for the whiskey bottle, if you like. Really, Chris, I think all this is really coming to pass as we discussed. Bank runs, certainly the Spanish situation, we know the Greek banks have had a run on them. We know also that the Spanish banks have had a sort of run because this has been reflected in TARGET II. The TARGET II imbalances are reflecting as much as anything is capital flight and that is built up quite rapidly over the last two or three years and the build up has been accelerating as we discussed the other week. That is where we are, it is at least as bad as we said, and I think it is at least as bad as you read and probably even worse.

Chris Martenson: Right, so let’s unpack this little... the real question I am interested in addressing is what happens next. How does this unfold? I have read everything from let’s just focus it down to Greece for a minute. So, Greece leaves the Euro... I have read everything and they said that’s it, it is all over you can just put a fork in the Greek banking system, it will be an immediate run and collapse, they will not be able to get financing, it will just be a complete horrid mess, losses for everyone. To other people... other analysts who sort of toss their hands up and suggest, well it will be a little rough, but maybe not all... and uncertain... but they will get through it. So, what is the mechanism here? Lot of moving pieces, let’s start here.

We have heard about Greek bank withdrawals. People presumably are finally waking up and yanking their money out of their banks. I presume, either if they can’t get their hands on cash, that means they are pulling it out of one bank it is going into another. I am going to have to guess some of those banks are probably outside of Greece. Otherwise why would you pull your money from a Greek bank other than to avoid the potential losses that might come if Greece does decide to go with the Drachma and does some sort of a re-valuation? Which by definition of course, will result in losses for anybody who’s in an enforced part of that conversion. So, is that part of the mechanism here? Banks only have... first of all they’re fractional reserve banks, like banks everywhere, so yes, they have not only a bunch of assets on the books and a bunch of liabilities and they match roughly. But, when people are pulling money out, there can be an extraordinary mismatch developing because of course the loans are locked into fairly longish terms and the cash has to be produced on demand. For now, the ECB has said we will help you through that process, but there are concerns now that maybe the ECB saying we won’t even help you with that.

How does... I don’t even remotely understand how a bank survives that, but what do you see in this mechanism? Is that about what is happening here?

Alasdair Macleod: Well, let me first... your last point first. Let’s just address the ECB. The ECB can counteract any bank runs for banks within the Euro system, but it cannot recapitalize banks. That is down to individual governments working with their own national central banks. Therefore, ensuring liquidity is available is a short-term fix while more permanent arrangements are being put in place. Unfortunately, we don’t see the more permanent arrangements being put in place. That is where the ECB is and why it has a problem. It can’t continue to chuck money at keeping these banks afloat forever. There has to be, if you like, an exit plan.

If we look at Greece, a lot of money has left Greece. The estimate’s I have seen is roughly seventy-two billion in deposits has disappeared from the Greek banking system over the last two or three years. That must have been accelerating in the month or two. If you look at the Bank for International Settlement’s figures, at the end of 2011, Greece’s banks had foreign assets of a hundred and ninety-five billion and liabilities of a hundred and three billion. That is indicative of the amount of money, if you like, that has gone out into bank because normally you would expect those two figures to more or less balance. If you are running a bank, you do try to put that sort of discipline into your balance sheet and the Greeks would have done that as bankers anyway. The shortfall between those two is an indication of the stress that the banking system in Greece feels.

That indicates about half the foreign position as being unwound but it rightly makes a point. While foreigners can maybe unwind their positions as much as possible in terms of Greek exposure, it is not necessarily so easy for the Greek banks to do the same, and indeed, they won’t have quite the same motivation to do the same. The cash withdrawals that are going on at the moment are against a background of balance sheets which are already very, very badly skewed. The thing is really quite nasty there.

The other thing, which nobody has mentioned, is that there are about ninety billion dollars in derivative contracts involved in the Greek economy. This is not just government, but also local governments and towns and cities and all the rest of it. The counter parties to ninety billion must be getting a bit worried about that, I would think because that looks as if it will default. That is something that has to be caught worldwide. The people who have been most active in getting these derivative contracts going over time have been people like Deutsch Bank, Goldman Sachs and I suppose JP Morgan, I don’t know but anyway, that’s... so you can see the problems aren’t just limited to the government and some unfortunate Greek citizens who are caught in the middle of this.

Chris Martenson: Right, so let me take one point... a little diversion here. There is a lot of confusion around derivatives and how they operate and many times I hear it and sometimes I even talk about it this way, that in large measure a lot of derivative contracts are a zero sum game. These are the things that JP Morgan was caught up in, right? You and I might decide to exchange a billion dollar credit default swap with each other and neither of us owns the underlying. At the end of the day, that zeros out, my loss is your gain or vice versa. Where this doesn’t zero out is if I actually am holding the underlying. I have Greek debt, I have a billion dollars worth of it and what I want to do is protect that. You decide to go ahead and insure that for me so you do a credit default swap with me. You issue it, I buy it, I pay you some rate, let’s call it seven percent; seven hundred basis points on that. Then the underlying goes 'poof'. Those billion dollars actually go away. I want to be made whole on that, so you now owe me that billion dollars when actual... when the underlying actually goes sour, those losses are very real and those derivatives are the armature, they mechanism by which those losses get pushed out into the system. Is that right?

Alasdair Macleod: That is absolutely right. We are looking at potentially up to ninety billion dollars worth of derivatives which one side of those transactions is going to default. One side; it is not a balanced figure is it? You are absolutely right in pointing that out. I don’t know that it is necessarily as bad as that, but it is a problem that needs to be dealt with, addressed and contained. I think what they have to do as much as possible, is to try to work for a sensible outcome in this, which probably will involve Greece leaving the Euro zone, but maybe obtaining help from the ECB to set up a currency board. The reason I say that is that I think for Greece to return to the Drachma would be complete destruction. You would have a situation where people who owe money in Euros would still owe money in Euros. If the Greek government tried to change that by law, for starts, that could only apply to loans taken out in Euros in Greece; whereas a lot of these have been taken out in Euros elsewhere in the European Union. In any event, I think if they tried to do a law on this, it would be a retrospective, which would be open to legal challenge.

Meanwhile, if you have deposits in a Greek bank, you can be sure the Greek government would say we are going to redesignate those into new Drachmas, which would impoverish the depositors. When it comes to trade, I think everybody would just stay well clear. To go back to a new Drachma, I think is the most destructive path Greece can have. Now, they could do that on the basis that, if the European Union wanted to make an example of Greece, then this is a way in which they could just let them go hang. The importance of that would be that the situation for Greece should be so bad that no other member of the Euro zone would contemplate leaving the Euro zone. That is a possibility, but I think that is less likely than coming to terms in such a way to give Greece an exit. But if they do get an exit, again, they’ve got to have an exit in such a way that it hurts enough and anybody else who wants to take that exit would see, well it is actually probably more painful than staying where we are. It is a very difficult balance to achieve.

The people who will do this, I don’t believe are the politicians. It would have to be the sensible people in the ECB and perhaps some of the more back room boys who could put together some sort of face saving mechanism without this becoming too much of a political hot potato. It is very, very tricky Chris, it really is and quite honestly, the way political governance has been going in Europe, the chances of them getting some sort of orderly withdraw in the interest of continuing relationships, et cetera, et cetera, I think are actually probably slim against. That is what we are up against; this is not easy. There is no precedence for this at all and I know that lots and lots of people are saying it is got to return to the Drachma and you wrote I thought a quite well argued piece, sort of going in those lines. I just think that a new Drachma would collapse almost immediately. I think that a currency board in the Euro is actually a more sensible result given where we are. In order for that to happen, Greece would have to have the Euros, if you like, to back its own currency issuance. Then they would have to run it properly, so everything would have to be put in place, and this would actually work. I don’t know anyone thinking this way. This is the other trouble.

Chris Martenson: The only other thing I can think about would be some sort of a jubilee where the ECB just pays off Greek’s debts and says lets start over here. As I read it right now, if Greece does fully exit the Euro and then punts on all of its external liabilities, there are still three hundred and fifty billion of losses lurking out there potentially. It is quite a large number and as you say, the contagion fear is the one where if Greece gets away with it and Spain looks over and says that seems easier than trying to pay all these things off, they might do that too.

Alasdair Macleod: Yes, that is right and in Spain, you are looking like... it is a worse situation. Government debt alone is just under a trillion. A trillion dollars equivalent I should say and that is a lot of money. That is a lot of money. Italy is over two trillion dollars. That really is a very, very big one, so this contagion must not be allowed to happen. I just don’t know how this is going to pan out. I can’t see where the exit is. I can’t see where the happy ending is in this. This is the problem.

Chris Martenson: Right, so let’s talk about that for a second because you mentioned Hollande gets elected in and so there’s this general anti-austerity fervor in the political elections going on if we can interpret it that way. What really could Hollande or anybody really do to say I am off the path of austerity besides engage in deficit spending at the government level? They still have to fund that in the bond markets in some way, shape, or form. They don’t have their own printing presses. They don’t have a compliant Fed over their monetizing their sovereign debt to the tune of sixty-one percent of on the run issuance or anything lovely like that. Where and how would they even fund the opposite of austerity if it were their political desire to do so?

Alasdair Macleod: I think this is... you have come up to the nub of it because the answer is they can only provide it by an easy money policy from the ECB. In order to achieve that, there has to be some very serious arguments, if you like, between the Bundesbank representing the Germans in terms of monetary policy and the ECB itself and I see no alternative to an outcome where there is a far more expansionary policy. I don’t know, it might be QE but I think it is probably more likely that the ECB will be given a lot more fire power to try and keep the banking system going. Through the banking system, the bank is allowed to lend to the governments and to buy more debt to pay for the redemptions so the rollovers can continue. Now, here is something, which I think, does become quite important, and that is... this explains, I think, a little bit of the weakness that we have seen in the Euro in the last week and it would justify yet more weakness in the Euro. I would see the Euro going down quite a bit on this. I think that is a likely outcome.

Chris Martenson: Interesting, well I am going to propose that instead of LTRO3 that the ECB promote the HMSPP, that is the Hail Mary Speculative purchase program and they should just issue a trillion, which can be put into Facebook stock. I think that would solve a lot right here.

Alasdair Macleod: Yeah, well as a speculative proposition, it is a lot less speculative than chucking it at Spain and Greece perhaps.

Chris Martenson: You might be right. Oops.

Alasdair Macleod: We must not joke actually, because it is an extremely serious situation.

Chris Martenson: Well it is and the question of course is how does this all unfold and so, I hear you describing that there are a lot of political difficulties and realities, all of which imply there is a certain pace at which the potential solutions can be proposed, vetted and worked through the system. It is my sense that perhaps events are running a bit faster than that process can engage. Do you share that view?

Alasdair Macleod: Yes, I would agree with you entirely. It is... as so often happens in these things, they start slowly and the pace rather quickens. It is almost like it goes at an exponential growth rate if you could chart events. I think that this is going to accelerate now very rapidly. There is one positive outcome and that is if Greece leaves and they manage to work out sensible terms on the sort of lines perhaps that I suggested just now, then there may be a recovery in the markets, a sort of sigh of relief if you like. I don’t think I would put money on it. It is rather like betting on how far a dead cat might bounce. We might get a little bit of a pause in the increasing pace of events, but it would be a pause. I think it would only be a matter of a very short time before things start deteriorating again. You cannot have the banks getting into such difficulties without really very, very adverse consequences unless the ECB comes in very quickly and somehow manages to nip that in the bud. Ideally, as I have said before, if you can get governments perhaps to face up to the facts that they are spending more than they attract in income tax and can borrow in the markets, and actually do something about that, at least keep the banks going, then that is probably about the only way out. I have to say, the politicians are showing great reluctance to face up to reality of any sort and they have to problem of course, that as they do that, the people just chuck them out of office. It is a very, very difficult situation.

Chris Martenson: I suppose that... I have read a number of commentators who have asked what I think is a very logical question, which was; instead of feeding funds to banks and hoping that, they would do the right things with it, and of course, they don’t know what to do with it. Growth is not part of the equation right now, so the normal credit mechanisms are not operating quite the same. I think it was obvious, well; it was obvious to me that our credit markets after a sustained forty-year bubble, were probably going to be moribund for a period of time, but in Japan in the eighties through the nineties could have taught you the same lesson. It is confusing that the authorities gave... both in the U.S. and in the U.K., following Japan’s model I believe, gave one toss at this. Let’s just make credit and liquidity very easy for the banks and cross our fingers, close our eyes and hope for the best, when there’s another strain of thought, which said, if the banks were having so much difficulty with bad loans, why didn’t you make the funds available to the people? Now, people would have gotten the funds. What would they have done with them? Well, they would have paid off their debts and put them into the banking system. It would have gone to the banking system anyway, but it would have taken a tour through the populace first, which arguably might have had a different impact on demand if that is what you were targeting. Not that I am promoting that would have been a good idea either, I am just saying it was perplexing what they chose to do and more perplexing now that it is provably not working. All I hear so far are strains of doing it bigger and better this time. Are you seeing different strains out there?

Alasdair Macleod: I think you have summed it up right. There is this sort of extraordinary situation where for the amount of money they throw at the problem, you’d think if they had just distributed it around the citizens, it would be a far cheaper solution. I think there are two things that mitigate against that, one is if you just distribute money around the citizens, then prices go up accordingly for everything very, very rapidly.

In other words, it would be instantly inflationary. You distribute it through the banks, then what you are doing is you are doing something that you learned in university as you read Keynes, was the sort of thing to do to try to rescue an economy from further deterioration. They are all just actually working off the textbook. If you talk to any central banker about what his worst nightmare is, and he will tell you it is the debt deflationary collapsing spiral. That is... we are so close to that, they will tell you. That is our nightmare and we will ensure... do everything we possibly can to ensure that doesn’t happen. That is why they chuck the money at the economy through the banks, because they are worried about assets and I am sure that is a lot to do with why interest rates are where they are is to keep assets from falling over and therefore the bank’s balance sheets from falling over.

That’s the way they do it. It is a combination I think of if you just distribute it through people, rather gave everybody... helicoptered some money at people, and then the inflationary consequences will be certain. If you go through the banks, you sort of hope that you have got a theoretical solution. Which, incidentally as I think you are aware, I believe is no solution at all? The real problem is that we have built up such mal-investments over the years that the whole system is really falling over. It can’t take it anymore and it is time there was a debt reconciliation. That’s the end of the Keynesian experiment, that’s the trouble.

Chris Martenson: Right, so as we look forward... I follow a variety of things, what do you think people should be following if they are interested in getting an early read on whether something is developing or breaking or shifting in the story? Are we watching sovereign bond yields? Are we watching credit spreads? Are we parsing the language of the output from the next ECB meetings? What is it that really bears watching here?

Alasdair Macleod: I think the clearest indication is yield spreads because that is what the market it trying to discount. I would also say that in a bear market, which is really what rising yields are, you tend to have investors being positive and yielding to the bad news. In other words, the ability of the market to discount bad news is considerably less than a good market anticipating good news. A bear market is always open to nasty surprises. A bull market always discounts the good. If you think in bear market terms, then the yields of today that we see aren’t really discounting anything coming up. As you see those yields rise, that will give you a very, very good barometer of what is actually going on in the totality of the mess. That to me would be the thing to follow.

Chris Martenson: Well and unfortunately that signal has been somewhat degraded in its utility by all the official intervention, the non-economic layers, the central banks stepping in and depressing the yields below what the markets would be delivering. I share with you the idea that if the markets were able to decide on their own, what appropriate yields would be, they would be a lot higher than they currently are.

Alasdair Macleod: Chris, sorry if I could interject just a second. My comment really in this was with respect to the European yield situation.

Chris Martenson: Well, there too, hasn’t the ECB sort of stepped into a variety of Italian/Spanish auctions over time and through its LTRO didn’t it, wink, wink, say we wouldn’t be too upset if you took those funds and parked them in your sovereign debt. Isn’t that a lot of what happened in Spain, for instance?

Alasdair Macleod: Yes, that is certainly true. We saw the yields for these governments, government bonds fall very substantially on the last LTRO and there was no doubt the Italian and the Spanish banks and all the rest of it, whether they gave into pressure from their governments, or whether they did it willingly, I think is of no consequence. The fact is that they did it because yields went down. That is now no longer the situation. Those banks do have money, I guess, on deposit still at the ECB.

They are going to need them for their own debt maturities because those aren’t going to get rolled easily. They also have to have a certain amount of safety net there because the deposits are tending to walk out the door. The banks are now getting very, very limited on this, which should push yields up even more, I would have thought for their respective governments. We should see these yields rise in Spain and Italy. Greece I think we treat as a special case now, but of course, there is also Portugal and Ireland too, which has rather gone very, very quiet. It is gone quiet there because they are out of the headlines.

Chris Martenson: Right, where do we go from here do you think? Is this just the situation where we watch the yields? Is there a magic point beyond which the situation breaks for Spain? They go Greek in essence and we watch things unfold very rapidly?

Alasdair Macleod: I think the markets tell us. If yields go up over seven percent then it is curtains. If that is right or not, I honestly don’t know. If the market thinks it, then this is going to be important because everybody is going to watch that. I think it is only a matter of time probably a very short time, before we see yields reach the seven percent level. My view is also that one of the more dangerous situations is France itself. I am not surprised that the socialist has been elected, a socialist who incidentally is very much part of the establishment, so the compromises that Hollande is going to obtain from Germany and all the rest of it, will be I suppose broadly acceptable in the context of where we are in Europe. I think it will probably be taken generally quite badly by the market. France is a mess. They have outstanding debt of about I suppose one point three trillion Euros, something like that. Their debt GDP is around about eighty-five, ninety percent going on a hundred quite rapidly. That is a very liquid and nasty situation. Unemployment is running close to ten percent.

It is almost impossible to employ anyone in France because the taxes are so high. Do you know the total tax that you pay as an employer, more than doubles the salary that you pay an individual. This is absolute craziness, but it is been like that in France forever and a day. The result is an awful lot of the market is black market. It is quite hard to find any area in Europe, which is free from this mess. Germany is okay, they are all right in a sense. Their economy is performing reasonably well, but it is not performing well because they are doing well for Europe, they are doing well because they are selling the most cars, machine tools and everything else to China, to Brazil, to Russia. Africa’s a great growth area. Europe, as far as Germany is concerned is dead. Which of course brings us on another question; that is why should Germany continue to support all these bust Europeans?

There is a sort of conscience if you like about the last two world wars, but there is going to come a point where that wears pretty thin I would have thought. The trouble is that it is all very well, everyone turning around and saying, Germany has to help. Actually, what they are saying is that Germany’s citizens should give up their savings, their hard won savings to rescue a project, which is obviously dead or deceased. I think Germany really should bust out as soon as possible and I am sure that there are an increasing number of businessmen and bankers in Germany who are beginning to feel that way.

Chris Martenson: I agree and from my view, I think that the difficulty here is that nobody quite knows how to go about doing this. Politically, obviously it is a hairball. Just from a financial system standpoint, it is quite tricky. Even if you say all right, here’s how we start to cleave these things apart; what we have learned through watching Warren Buffet attempt to unravel the derivatives positions of a single company; or noting that they are still I think somewhere in the vicinity of three hundred thousand derivative contracts still parked around. They are trying to figure out how to undo them from the Lehman collapse.

These things just take time. It is not as simple as it used to be. It is very interconnected, so the idea here is it might be fashionable to say let’s just isolate these things. Let’s go back to some sort of Chinese firewall between these different entities, but that’s a very, very difficult prospect. Again, I see the political reality of this as requiring time, patience, care and I see the events accelerating and going faster as you might expect on the tail end of a forty-year exponentially growing debt bubble.Those two things are just sort of in collision at this moment. That is kind of how I am interpreting it at this point and the bottom line summary I have is nobody knows. This is rather uncertain; we are just going to have to watch. Part of us is just going to have to be spectator on this I think.

Alasdair Macleod: I think that is right. Of course, the other side of the German problem is the bank indebtedness on their bank’s balance sheets. All around Europe, some of the numbers, which Germany is paid, as far as I am aware, my numbers aren’t complete, you are looking at about one point three trillion Euros, something like that, owed to the German banks from around Europe. Admittedly, that also includes a figure for the U.K., but if you look at Spain, they are owed about a hundred and seventy-eight billion. The Netherlands owe them a hundred sixty-seven billion. Now that is a quality borrower; Italy, about a hundred and sixty-five billion; and France, about two hundred and ten. These are big numbers and that’s just owed to Germany. Then, of course we have the TARGET II imbalances, which are rapidly moving towards three-quarters of a trillion Euros as well. The financial impact on Germany is actually, I think likely to make them say; well we don’t want to rock the boat unnecessarily here. That is an argument in favor of that. The only thing I feel certain is likely to come out of this from the German end is an increased demand for gold. If you think, German citizen, my savings are getting chucked out against to keep all these other countries going, how do I protect myself? I think the only protection they have is to go back to gold and the German’s actually are quite naturally keen on gold. That’s an interesting thought.

Chris Martenson: Right, if I was over there, A - I wouldn’t have my money in certain banks at this particular juncture and B - I would certainly have as much out of the system as I felt I could prudently hold. That might be a hundred percent depending on the country I was in. I absolutely agree. If realistically, the option here is on the one hand we are the ECB, we are going to toss our hands up; we give up, we are just going to let the chips fall where they may; and we are facing the utter dissolution of entire countries, political systems, financial institutions. It is chaos, been down that road before within living memory, it is not pleasant but we are going to go it. Or, we are going to try this printing thing which will delay things, maybe pass the time on my watch of this job, or it might turn out. As far as I can tell the plan in Europe so far, which is the plan everywhere in this exponential money system we have is, cross our fingers. As long as we can get back to growth, this whole thing will start working itself out. Not that we will get smart and say, "Phew! Dodged that bullet...", we will actually work our debts down.

What will happen is growth will turn and everybody will go see, that’s how it is supposed to work and can continue accumulating debts at the old faster than income pace until it blows up again at some point in the future. I think we are at that point in the story where enough people have looked into the future and started to ask... in all good scenario planning, you should always be asking the alternative... where are my assumptions? Where might I have it wrong? The primary assumption that we will return to growth being potentially a flawed one, is something that is seeping in and with that comes the idea that we fundamentally have to do things very, very differently. So far, I haven’t seen that seep into the highest policy levels yet in terms of really trying something brand new.

Alasdair Macleod: You are absolutely right on that because ever since the 2008 financial crisis, the Keynesians in charge of the central banks have chucked out money on the basis of economic recovery will happen. Budget deficits will come down and we will all be all right. It is the Keynesian textbook response, but this is getting a very tired story. Here we are now three or four years later, still no sign of a recovery and as we discussed last time, the puffing up of GDP by just throwing money into is it... it is a money total don’t forget and there’s no real recovery there. The result is that there are doubts creeping in and I don’t know whether the doubts are at the intellectual level in the Federal Reserve Board, for example, but I can’t help but notice that Bernanke seems to be quite reluctant to do forced QE3. He is sitting on his hands a bit there. Whereas I am sure that two years ago, in these current circumstances, he would have printed like billy-o. But no, they’ve shot a few bullets. They know their ammunition is running a bit low and they have achieved absolutely nothing. I think there is a level of... they are perplexed if you like. It is the Keynesian thing, it is not working at all and they are all very, very confused. It is almost like you can see a Picassian picture of central bankers looking at each other all asking the same question, what now?

Chris Martenson: Sure, they have done the rain dance, they shook the rattles and the skies are still clear. Something is broken. The magic isn’t working. It is very confusing. Totally perplexing moment here.

Alasdair Macleod: Not to you and me though.

Chris Martenson: No, no it is all fairly predictable actually.

Alasdair Macleod: Exactly.

Chris Martenson: As we go forward, I do believe that it is my view that the next round of QE is still all but inevitable and because this road they see it has a bifurcation, they only see two paths. I think there are other paths, but I believe they see it as either we win this or it deflates and we lose this and so they are not going to lose if at all possible.

Alasdair Macleod: That is right but I also think there are very good practical reasons for QE; that is it is the way in which government borrowing is funded.

Chris Martenson: Yes, there you go.

Alasdair Macleod: And in an election year in America, I think it is a no-brainer really.

Chris Martenson: Sure, so it brings us to my favorite topic of where to invest. I have this conversation a lot and I still don’t see any way out of gold as being a preferred, monetary like or money like asset in which you can park yourself into while we watch all of this and spectate and speculate as to what’s going to happen next. It is just a safe place to hang out until we know where the risks are, who is holding them and what the next actions are going to be. I really don’t know what else to do at this stage.

Alasdair Macleod: I am totally in agreement with you on that one and people who have gold or silver, I think actually had a very rough ride over the last couple of months. A lot of them are wondering what on Earth is going on because every time you get good news, gold seems to rally along with equities, but every time there’s bad news and gold actually should be giving you some protection, it goes down the swanny. I think the problem there is that the whole system is run by people who went to college and were taught Keynesian economics. In my day, when I first went into the stock market and I enjoyed that first bull market in gold when it went from thirty-five bucks to eight-fifty, the traders and investment managers were all practical people. They all cut their teeth, all learned their trade the hard way. Some of them had degrees in college, but generally it would have been something like classics or history or something like that. If they got a degree in economics, they probably would have left because they never would have understood it in those days. But now it has changed.

Everybody who is employed has a degree and if they are anything to do with investment strategy, or the investment business, it is all economics degrees. So they have been brainwashed in the keynesian thing. This sort of near classical approach where gold is yesterday’s story, paper money is the future. They really do believe it and it is the opinions of these people who drive the markets in the short term. The result is that gold and silver have become very, very seriously mispriced. I don’t think I have seen a stretch like this as I can remember; by stretch, the difference between perhaps where it should be. We must be careful not to tell the market what the price should be, but it is so underpriced at a time of enormous systemic stress, that I think when gold and silver snap back into a more sensible, logical valuation relationship with the markets, the move actually could be very, very sharp and quite large. If gold ran up through the two thousand level very quickly, which I think is a very strong possibility, because it is been held down so much, that could bring other problems.

The central banks, who might have sold gold and not told us about it will find that they are embarrassed. I think also the bullion banks in London who operate a fractional reserve system with gold, exactly the same way as to do with any paper currency, will be hurt very, very badly on the run. Any shorts in the futures market equally could be hurt very, very badly. We have a situation, where there is a potential for a huge run in gold and I personally wouldn’t be surprised to see it.

Chris Martenson: I agree with you completely on that one. It is still a subject of great inquiry, discussion and parsing where we have a community of people trying to figure out what truly is going on and the gold market is fairly opaque. We know there is this stuff called leasing because we read about it in the footnotes of the central bank balance sheets and because there is a quoted lease rate that’s really how much and who’s got it and where it is. That is very difficult information to come by in a way, which I find I can analyze and be comfortable I know what’s really transpired there. Of course, that discomfort extends deep into the market to the point that the people of Germany said, you know, about all that gold we allegedly have that the Fed’s holding for us... maybe we should just bring that home.

Alasdair Macleod: Exactly and in fact, I don’t know if you noticed, but the Bundesbank did actually release some statistics as to... they released a statement as to where their gold was being held. I have been traveling recently so I am not totally up to date on that, but I know some of it is in the Bank of England, some is at the Fed and there’s a third bank, I think it might have been the Bank of France.

What was not clear to me is whether this is held in what they call an earmarked account. In other words held at those banks segregated out as the Bundesbank’s own assets, or whether they are held in site accounts. In other words, just part of the daily mix, the stock of bullion that they hold in the basement of the Fed or the Bank of England, which they are free to use at any time they see fit. Meanwhile there is a diary note that they owe this to the Bundesbank because that’s the way they sell gold into the market without having to account for it. It is not just the leasing, it is the operation of the site accounts and that could mean central bank ownership amongst the central banks of the advanced economies could be as little as half of what’s stated quite easily. We don’t know because as you say, there are absolutely no statistics released on this and the truth is deliberately concealed from us. It could be quite a serious shortfall.

Chris Martenson: It could be, and of course, I don’t think we will find that out until the moment of crisis and then, we will find something out and we will probably see that in rapidly rising prices. We are at the end of our time, thank you so much for your time. Very generous again and how can people read you on a more regular basis?

Alasdair Macleod: I have my own site, which is financeandeconomics.org, and I do a lot of writing for Gold Money and that is really the Gold Money Foundation, which you can find them through goldmoney.com. That is James Turk’s, he’s chairman of that and what we are trying to do is educate people about the importance of sound money, not just gold and silver. There’s got to be a future after all this and if we are going to have any valuable input as to how that future is going to transpire, I think people have got to understand the virtues of sound money, so that’s what we are trying to do, educate people about that.

Chris Martenson: It is very worthwhile work, and of course, I do believe that we are going to need that sage counsel and advice in an historical framework sooner than later.

Alasdair Macleod: Yes and I agree with you entirely. It has been a great pleasure for me to talk to you as well and we will keep watching the situation.

Chris Martenson: Indeed, we will thank you so much.

Alasdair Macleod: Not at all, my pleasure Chris.

Transcript for Tom Murphy

Trancript for Tom Murphy: Time to Be Honest With Ourselves About Our Looming Energy Risks

Chris Martenson:  Hello. Welcome to another PeakProsperity.com podcast. I am your host, of course; Chris Martenson. And today we have the very good fortune of speaking with Tom Murphy, Associate Professor of Physics at the University of California, San Diego, and an avid writer on energy and growth-related matters on his website, Do The Math, which I believe is found at physics.ucsd.edu/dothemath. Tom uses simple, easy-to-understand math -- yes, that four-letter word -- to logically -- I say quite logically -- make the case that simply extrapolating past trends in energy and economic growth is not going to cut it. Instead, we face gigantic challenges and significant risks to our current model. Not least of which is, when asked what we will use when fossil fuels dwindle away, the most typical answer is I’m sure we will think of something. That is, our future of energy is a question mark right now. Here today to discuss that question mark with us is Tom. A real pleasure to have you here.

Tom Murphy:  Thanks, Chris. A real pleasure to be here.

Chris Martenson:  First, your background for listeners, please, so they know how you came to write so eloquently about economic and energy matters.

Tom Murphy:  Well, I don’t know if I can really explain that. That is really sort of a fluke. My background is in science and physics and astronomy. I have been an avid fan of astronomy since high school. I built a large telescope in high school and was hooked on exploring the universe right away. Went to graduate school at CalTech where I had the fortune to work on the venerable 200 inch telescope -- the Palomar Telescope -- and built a spectrograph to look at colliding galaxies. It was the first cryogenic, integral-fueled spectrograph ever built. So that was kind of fun to do. After grad school I saw the PhD as a license to have fun. So rather than take the safe route of doing the same kind of infrared instrumentation for telescopes that I had been doing -- and I had lots of opportunities to do that -- I found a fledgling that really I could start with a couple of guys at the University of Washington to do lunar laser raging at the millimeter precision. And this is really about measuring the earth-moon distance to one-millimeter precision as a test of general relativity, because we can map the shape of the moon’s orbit and ask the question, does the moon’s orbit follow a prescription provided by general relativity, Einstein’s theory of gravity? This was the perfect thing for me. It involves building instrumentation, optics, lasers on a telescope, but for a really interesting physics fundamental question.

So I had all that I wanted. My dreams were satisfied. And then my big hit came. I took an assignment at UCSD in 2004 to teach a course on energy and the environment. I went in bright-eyed and thinking our future is going to be fantastic, that much I’m sure. I want to piece together what it was going to look like. I was vaguely aware that fossil fuels would play a diminishing role into the future. But solar, wind, geothermal, nuclear, all of these things surely would be enough. I came out fairly confused by the process. Because as I applied my physics and estimation skills to sort of set the scale of different things, how much tidal power provide or wind or wave, the theme was disappointment.

I became really worried and spent years in this state. Finally, I decided I had to do something about it, for no other reason than for myself to write down what I had been thinking about, some of the calculations I had done, and that is where Do The Math was born.

Chris Martenson:  Fantastic. So the themes I am getting at here are, you have rolled up your sleeves and used technology. You love technology. You know what it can do. You have built instrumentation. So you have hands-on, real-world experience of what technology can -- and in many cases can’t -- do. You ran the numbers and the numbers here are really the important part of the story. Most people are, I think, unaware of just the extraordinary throughput of energy we are getting from fossil fuels, which I believe in one of your posts you liken to the fossil fuels we are using like a battery. The sun was raining all of this energy down on the earth and it was being slowly, carefully, accreted away and stored up to these things that we are now discharging in what, historically speaking, has to be a rather abrupt period of time.

Tom Murphy:  Almost a short circuit.

Chris Martenson:  Almost a short circuit. Done. Right? There was this huge potential energy, and a live grounding wire wandered over and touched it. That was our species. So there we are. Al lright, let’s do some numbers then. I am convinced you and I, everybody alive today, is at a very unique, very critical point in human history, not just US history or Asian history or European, [but] human history. Here are some numbers: 7 billion, heading to 8 billion, 100 quadrillion BTUs per year for the US alone. Depletion rates of underground liquids of all sorts running at 3%, 4%, 5%, maybe even 10% or more, depending on what we are talking about. Are these the sorts of numbers you were looking at, and if so, why are these important? Why should average people suddenly concern themselves with this?

Tom Murphy:  I agree with the statement we are at a very special time. The way I like to visualize this in my own head is to be if you plot the use of fossil fuels over a very long period of time, say go back 10,000 years in the past, plot 10,000 years in the future, most of that is absolutely devoid of activity on the fossil fuel front. We just have a local blip that only lasts a few hundred years around now. I think just on the fossil fuel part of the story we are absolutely at a special time. This is the time where humanity has discovered the earth’s battery, and you know, I also like to think we hooked up Las Vegas and there is your short circuit and it's profligate this energy we use. And we have made good use of that energy. I am a huge fan of what we have accomplished as a byproduct of using this source of energy. We have the tendency to extrapolate our future based on even a few generations, which is too short, end of story, because of the special blip of fossil fuels. So I think, in my mind, stuff out to the right of this blip is a gigantic question mark. I am careful not to predict that the future will be brilliant or dismal, but the main message I want to get across is [that] we really do not know. And to try to delude ourselves. We know what is coming is a very dangerous, a very dangerous position. And we should approach this uncertain future with a lot more trepidation than I tend to see in the world around us.

Chris Martenson:  I agree. I think there is a certain logical case, almost like a prosecutor, that can be built out, which starts with, well, listen. There are some very clever things we can do with technology and we are hoping that we are going to apply some great technological solutions and maybe even some disruptive brand new technologies that nobody has thought of that will really give us a bright future. Deductively, we come one step back and say in order for that technology to exist it is very complex, all the moving parts required and all the knowledge necessary to build that technology requires a complex economy. And for the economy to function therefore, one step from that, we are going to need constant throughputs of energy to maintain that complexity. And so as we rather build this string through everything to me, sort of hinges on we need to have not just energy flowing through but high net energy flowing through.

So to get at this conversation, I want to start all the way out at that far end, back at the beginning of this. So to talk about just the economy for a minute. You had an excellent blog post entitled “Can Economic Growth Last.” You posited that perpetual economic growth it is just not mathematically improbable, but it is impossible. Let’s start at the highest level. Why is that so?

Tom Murphy: I think fundamentally, economic activity is tied to energy and you can have certainly activities that use. Some use more energy some use less energy and you have a lot of the bright future believers thinking that well our answer is simply to transition to low energy economic activities. And sure, there will be pressures to do those things. But you can’t do 100% of your economy on low energy things, not to mention no energy things. And so the point and it is almost silly. It is mathematical. Energy can’t grow forever and I think most of us would agree that on a finite planet we can’t just keep ramping up the raw energy use. Then the fraction of our economy that is devoted to energy would have to trend toward absolute zero in order to keep the economy growing on top of a fixed energy supply. And that is just a non-starter for actual real activities that involve, for instance, eating. Nothing will ever go to zero energy. And as long as that is finite and occupies a finite fraction of our economic activity, then the economy is capped.

Chris Martenson: Right. Well we get out to some future point where we hit some steady state of energy usage and I’ll get to the excellent post you had about the silliness of thinking we will just grow energy forever. But what a lot of people would say a rejoinder to that is what about efficiency? Yea, even if we have less energy we are going to use it more efficiently. So maybe we can just count on us tinkering our way to a better future.

Tom Murphy: Yea. And I think certainly, here is another case where yes, that will happen. And that is absolutely valuable goal to pursue. But it is not going to become the entire story and it can’t’ go forever. There are lots of examples if you just think what are typical efficiencies of devices today you are going to come up with numbers between 10 and 90%. How much can you grow that before you cap out at 100? So right away, you can see that efficiency just doesn’t take off and it can’t grow exponentially. Typical rates of efficiency improvement are something like 1% per year. We have maybe a factor of two or optimistically four or something in that neighborhood to achieve and have efficiency improvements. But there are real physical thermodynamic limits to all of this. So you can’t expect at 1% per year you double in seven years. So we are talking about no more than a few centuries at most of progress at a 1% clip and that rate would likely, actually diminish over time because it gets harder and harder to improve efficiency. The low hanging fruit is already gone.

Chris Martenson: Right. And to already improve efficiency it is a slog, right? So this is very careful work. It takes a lot of people. Let’s start with electric motors already 90% efficient. So there is really not a lot of either impetus or probably opportunity to really expand this much further. We could, but you know we are getting very, very incremental changes there. So this 1-2% efficiency game which is per year that seems reasonable. Where are we in the fossil fuel story in your mind?

Tom Murphy: Well, I would say a typical heat engine is how we tend to use fossil fuels -- we burn them. And the heat engines have realized efficiencies going from maybe 10% for a generator at Home Depot, up to 15, 20% for cars, and 30 to 40% for power plant. The highest kinds of numbers I tend to see are maybe 50% for a large diesel engine in a submarine or a ship. That is kind of where we are. The thermodynamic limit if you just look at an entropy kind of let me see – an entropy controlled process, the total entropy in a whole system cannot decrease you end up with a thermodynamic limit that is proportionate to a thermodynamic difference between a hot source and a cold source divided by the temperature of the hot source. You have to do this all in absolute temperature. If you just do that calculation for a typical fossil fuel heat engine you max out at something like 70 or 80%. Engineering practicalities tend to pull us back to half of the theoretical mass. You know, even if we slogged our way through the engineering practicalities and ended up at the thermo dynamic limit we have a factor of two to gain. Even that I think is unrealistic.

Chris Martenson: So fact of two. For the sake of argument we stop all production of new combustion engines today. Whether they are for ships, cars, trucks, or trains, whatever. We stop it today and we just start slogging along assuming we could swap these engines out. We might be able to cut our fuel use in half over a pretty significant time with a lot of effort. And so let’s cast back to the economy for a minute, which is constantly growing. So even if we were developing these fancy, fancy new engines, which were much more efficient than current. I will note that China just increased its car consumption by 12.5% over the prior year and that their projections, if you just keep going at their current rate linearly they will be buying 30 million vehicles per year by 2020. Just almost twice what the US was consuming at its highest clip.

So we see this massive growth in these combustion engines going on just as the rest of the world wants to catch up with US standards. So the idea to me here is that additional incremental growth in the ways in which we traditionally consume energy in this part of the story I’m using standard internal combustion engines bought by Chinese citizens for cars. That the rate of growth of that 12.5% more cars this year and last year will swamp in a 1 or 2% improvement assuming those are happening.

Tom Murphy: Yea, absolutely. You know the numbers you put out are very scary in the sense that we are really having trouble holding it together at today’s world energy consumption levels. The US uses about a quarter of the world’s energy 20%, 25% somewhere in that range and with 5% of the population so that means that the US uses typically about five times the average energy use per person. And if the rest of the world wanted to come up to the United States standards we would see the world using five times as much energy tomorrow as we do today. It is just not clear where that prosperity comes from, that energy prosperity. So we can maybe dream of that future, but right now we really don’t have a road map to go from here to there.

Chris Martenson: I notice that all the projections for fossil fuel or liquid fuels growth in the world maybe by the next 10 years will expand by about 9% not 500% as you are describing. So yes, there are some constraints happening there. Now, to me, the thing that is the risk in this whole story is that economies don’t have to grow. There is no law written down. No world convention got together and cast it in stone and this is how it has to be, but in truth our money system because it is based on debt based money does reasonably well when it is expanding and does extremely poorly as soon as it stagnates, let alone declines. To me that is a lot of the metaphor of what we see happening in Europe; the pie stopped expanding and the whole thing sort of fell apart. That is true for every exponential system like this that I have examined. It is like kind of the reindeer on the island are expanding exponentially or they are you know, collapsing exponentially. These systems tend to have you know, two states up or down. They have a very hard time transitioning to that steady state in between.

So here we are. I want to get to the blog post you had that I love the most which is sort of this existential disconnect between you and an economist. And the blog post is “Exponential Economist Meets Finite Physicist”. Everybody should go out and google that, find that article, read it. Because in there you had some really good points. Just before I get into those I just wonder you had some time to reflect on that conversation and can you just characterize, set the stage for people what that conversation was all about?

Tom Murphy: I was at a conference and there was a keynote dinner -- a banquet dinner. I happened to sit next to a guy by random chance, that I had seen earlier that day give a talk where he even talked about the chess board with grains of rice and how quickly that got out of hand and I was really excited when I saw the talk about he was going to deliver the punch here. And he didn’t. He didn’t then claim, for instance, that economic growth would continue forever which I thought would have been fantastic coming from an economist. He stopped short of that. Finding myself next to him I decided to see what he would do with the statement you know a blunt statement from me that economic growth can’t last forever. So he had the predictary response woah, woah. So we got into it and had a very interesting conversation. I think we were both very much engaged and doing our best to make our case. Now I should mention for people who read the blog post that I tried to recreate his points of view and that of course is not going to be a perfect process. I didn’t have a recorder at the time. He did send me an email. He happened upon it and said he commended me for a job well done. He said he thinks I captured it very well. He said maybe not all the points I made the way I made them or you know, but the essence was there. So I was very pleased with that.

Chris Martenson: Excellent.

Tom Murphy: So in the end – yes, there are disconnects. I have been thinking about those disconnects. I think it is very important to try to understand what they are. In fact, this economist and I are going to try and work on a project to try and sharpen up that conversation. So I hope that goes forward. But the disconnect, there is several. One is that the economist speaks of growth and utility. And that utility doesn’t have to be connected to physical form necessarily so that you can make improvements in the way your life is run. The way your house is configured, whatever that don’t necessarily require more energy. Some could require less energy, but are more pleasing in the end. So this gets very subjective very quickly. What might be pleasing one person may not be pleasing the other. Fundamental question and he and I touched on this during the conversation is that someone 400 years in the future do they have a lifestyle or elements of their lifestyle that are unambiguously better to someone 400 years in the past. So are there objectively – objective improvements in utility that can continue to essentially promote continued growth. I would say that there probably are some of those things. So I am trying to wrestle with how important are those? What fraction of what we do – we still have to eat, we still have to consume energy. What fraction of our economy can be in this form of unambiguous utility gain?

Chris Martenson: Well, now this is an interesting conversation and it is very important because as I cast back I am thinking back to the Monty Python movie, Holy Grail and you got the two serfs slopping around in the field and they were living a very low energy existence at that point. I would argue that when we say better one of the defining characteristics of our current lifestyle, that people would defend to the death I think is that it is easy. We have this energy subsidy quietly, so quietly and so ubiquitously surrounding us that it is like being Neo in the Matrix. It is like you can’t even see it. And to me I am often filled with gratitude and very thankful of how many energy slaves I have humming around quietly unseen, but certainly not unfelt in terms of the ease that is delivered to my life. Where I carry this is to cast 400 years into the future I understand we are going to make some improvements that will be energy neutral. Maybe even require less energy, but on balance. Staying warm. Moving myself from point A to point B and being fed are extraordinarily energy intensive endeavors today.

Tom Murphy: And important. And will never cease to be important.

Chris Martenson: Those all are in body work. Protecting myself from the elements so I am comfortably warm or cool is work being performed? Just very unseen and very quiet.

Tom Murphy: As a physicist I have to point out that it will never take less energy to heat a coffee mug by 60 degrees C. In the future it is going to cost the same number joules as it does today to inject thermal energy into that coffee mug. So there are some things that are just in violet in that sense.

Chris Martenson: So any story of the future then really has to articulate where are these quadrillions of BTUs going to come from, right? I mean fundamentally that is the story. And so as we look into our current energy landscape we see that, yes, we have this extraordinary flow coming from fossil fuels. Deposited over call it 400 million years. One of my favorite statistics is that in the last 22 years so that somebody who is listening to this today is 22 years old they have been alive when half of all the oil ever burned has been burned. So even in the last 22 years that is a very different experience from all of the years preceding those years. That is an extraordinary throughput of energy and that energy per capita has been rather explosively expanded in just the last 100 years, 200 years for sure and so if we are going to maintain that same number of say however we want to measure that kilowatts per person per day however we want to look at that. And we include the idea that the rest of the world, in order for the rest of the world not to. One of the arguments for why population is going to auto-stabilize is because living standards will come up across the whole world. And that is one of the only and probably the strongest correlating factor to why family sizes go down is economic opportunities improve, infant mortality declines. People feel safe in having smaller family seizes. Bing. That happens. In order for that to happen we have to imagine that energy use in the rest of the world as you mentioned a few minutes ago, that will also have to expand rather extraordinarily.

When we are talking at this scale though, I am glad you had that course on energy, talk to me about the gap that exists currently between what we might get from let’s call it renewables, but it is anything, geothermal, solar, plus wind so we got and tidal. I think that is everything except for nuclear that doesn’t come from fossil fuels. What is the gap that currently exists between the number of BTUs we are currently getting from that and what we would have to embark on in order to significantly and then entirely replace from what we get from fossil fuels?

Tom Murphy: Yea the gap currently is huge. Almost all of our energy comes from fossil fuels. But you know, the optimist would say that is just because it is easier and cheaper right now. We could easily transition to solar, for instance, which is super abundant in its delivery of energy to the planet’s surface. The numbers there are quite impressively large. Wind, less so. That is a secondary manifestation of solar power. Waves are a tertiary manifestation of solar power through wind. So as you cascade down you get less and less energy in hydro-electric, for instance. So all of the neat and fancy ideas that we hear about are maybe clever but just don’t stack up in terms of abundance. There are some that are truly abundant in nature, solar being one of them. But there is a real disconnect between what solar offers and what we are trying to replace. It turns out we don’t have much trouble generating electricity. There are loads of ways to make electricity. What we are really missing is the liquid fuels. It is very difficult to transition from solar, nuclear, whatever you want into the liquid fuels which allows us to move ourselves around, it is very important in agriculture. And it is I think that is where the pinch point will come. There are certainly sources that can be labeled as abundant.

The gulf is really one of practicality more than one of the sheer energy scale. That is a little bit harder to quantify. So you can quantify the abundance and how much you might get out of a certain source. But it is very hard to quantify things like public acceptance or how difficult it will be to pull off things like intermittency, how to deal with the storage, practical storage solutions. All of these are very tricky. And I guess, you know, one perspective is that we have known since 1970 roughly that fossil fuel peak was coming at some point. We knew that we needed alternatives in the 70s. We had lots of discussion of alternative energies. Forty years later we really aren’t that much further along. We sort of don’t have any new players and it feels to me that if the liquid fuels decline in the next few decades, which I think is likely, we have already got the players on the stage right now. And so all of these technologies take a long time to develop and mature and scale. Even though I am a fan of technology, I am not a fan of gambling on the sense that an entirely new source will come along that is as yet unappreciated. The fact is that our alternatives are deficient in various ways compared to the ease and abundance and convenience of the fossil fuels.

Chris Martenson: Right. I want to just take a moment here to note that you ran the calculations and said that if we grow our energy consumption at a steady 2.3% per year, which gives us a handy little device, which I believe, is what in 100 years we increase our use of energy by a factor of ten?

Tom Murphy: Right.

Chris Martenson: That is very modest, 2.3% is less than we have been expanding since the 1600s. So 2.3% per year from here on out. In 440 years say the surface of the earth is now at the temperature which water boils just because of the waste heat of the energy that we are consuming. Let’s imagine for a moment this low energy nuclear reaction is real or some other fancy thing where we can actually get unlimited energy. In fact, if we just that in a status quo way of expanding on a constant basis we hopefully, we would figure out well before the earth’s surface reached the temperature of boiling water we would say this is a bad idea. We have to change something here. And that within less than a thousand years the earth’s surface would be at the temperature of the sun if we were going to continue that process out.

Those might sound like big sweeps of time oh 1,000 years we have time to figure that out. I want to mention that historically, it is not a huge amount of time. Here is a fact that sort of caught me short when I heard it: Cleopatra was born closer to the launching of the space shuttle than she was to the building of the Great Pyramids, by 500 years. So it turns out if you are talking to an Egyptian that several thousand years of history is actually nothing. There is you know, so historically speaking we know that somewhere between here and there we have to find a way to get to a steady state model of some kind.

Tom Murphy: At best. So that implies a gigantic transition. It is not a transition that many people are talking about. The fundamental assumption that seems to on is that it is more of the same and we just extrapolate.

Chris Martenson: Exactly. So here we are -- I just read in the paper, very disappointing piece of news to me, that some senators are very excited by pushing an idea to build some more LNG terminals because Asia is really hungry for LNG, particularly, Japan. Right now we have got a lot of gas so we will build these terminals. Disappointing to me because the mindset embodied in that is to say look, we have these resources. Our job is to build it up as fast as possible. And since we can’t use it fast enough on our own soil is what we will do is we will liquefy it, at great energetic cost. It costs a lot of energy to take a gas and turn it into a liquid, especially when we are talking about methane. You might lose 25% of the embodied energy that was existing in that gas before you ran it through that process. And so this makes sense to us. It makes sense economically. It makes sense politically. It might even make sense socially from a jobs perspective, but it doesn’t make energetic sense and it doesn’t make historical sense. So the question becomes how do we start to reshape that narrative so we can start at least having the right discussion it has got to involve these numbers. What sort of a reception do you have in trying to get these numbers out there? Do you just end up talking to other numerate individuals? I like the success you have had with the economist but I consider them to be very numerate. That is their profession.

Tom Murphy: I don’t think I would characterize it as success, actually. I don’t really think I would change the economist that I talked to; I don’t really think I changed his mind fundamentally. I think he sort of understood that okay maybe energy is capped. And he did sort of make some progress during conversation in my view. I don’t think, fundamentally, he walked away thinking growth doesn’t go on forever. I don’t think I changed his mind on that at all in the economic sense. I think that is fundamentally important that we need to get over the notion that growth is just a constant of nature; it is part of who we are. It is part of who we have been for quite a few generations now.

I would like to throw out a couple of examples of cases where that is not really true. In the early part of the 20th Century, we had this amazing pair of technological progress. From the time it was conceived that a nuclear reaction could take place in the late 30s or the time that maybe it was earlier – the time scale from the discovery of that process of fission to a reactor was less than a decade. And so then it was thought that nuclear fusion was the next big goal. Okay, we have achieved that in nuclear bombs but not in some steady, controlled sense. That has been 60 years since the first attempts at fusion with no success. We sort of hit a wall. Some of our expectations haven’t been satisfied. When we broke the sound barrier, people thought okay there is the next step in transportation, we even got the Concord, but that doesn’t fly anymore. It was beyond our means to sustain that expensive mode of travel. I will also point out that we went to the moon in the late 60s and thought that this was our destiny to be a space race of people. And the US no longer has the capability to launch a human into space. Those should be red flags waving at us. That our assumptions about this ever up trajectory are sometimes extraordinarily wrong.

Chris Martenson: Great point. We have the Moore’s Law, which gets waved at me quite regularly because we have had tremendous success at pushing these boundaries with one aspect of technology, which is on silicon chips. And so I guess the extrapolation from there is therefore we don’t experience boundaries on anything we do. You just identified a number of places where we ran up against some walls and found that pushing beyond those walls was, for whatever reason, extraordinarily expensive in some terms that caused us to have to back off of that and say you know, maybe 500 miles an hour is a good speed for a plane and that makes sense.

As I look at this I am just looking at the time, the cost of just trying to meet the scale and see the predicament of declining net energy and soon to be declining over all amounts of aggregate forms of energy from fossil fuels. Whether that is this year, 10 years or 20 years blink of an eye historically speaking. And certainly given the level of implications of what that repercussions of that might be, extraordinary. And there are opportunities embedded in that story and there are challenges. But given the challenges, one of the things I have come to in my life you know, very high chance, I am a betting man so I’m throwing a six-sided die. I think five sides of that die -- say higher energy prices going forward. There is a chance maybe I will be surprised and energy becomes less of my disposable income. But my response to that was to make my house as energy resilient as possible. Air sealing, figuring out how we use energy. Putting some solar thermal panels on, manage to without really a whole lot of effort cut my energy use a lot without noticeably impacting my standard of living or quality of life in particular.

Tom Murphy: I’m down the same road and I agree exactly with your conclusion.

Chris Martenson: Tell us what you have done there?

Tom Murphy: Most of it really comes through consciousness. Realizing that energy is a precious thing that we can’t rely on it being ever abundant, every cheap. So I wanted to understand what does it mean to reduce energy use. Most of it was just kind of waking up, looking at what I do, measuring, metering, I’m a huge fan of data collection and measurement. So that formed a baseline against which I can judge my actions. So we stopped heating our house. I live in San Diego and many people might get angry hearing that is a bit factor but it is unusual in San Diego for someone to not use heat in the house. We line dry our clothes, I take the bus to work, I put on some solar panels that I built up this system myself with batteries, it is off grid. I have a dual electric system in my house. Some things run on solar, some on utility. But overall, including those I am at less than 5 kilowatt hours a day and a factor of five or so below the national average and a factor of maybe three or four below the San Diego average. There are lots of places where I have made large cuts factors of two or three or four or bigger compared to even my local cohort. And yea, I still live the same basic life I did before. That has given me a lot of encouragement. Large cuts are possible. That can have a tremendous sort of purchase power if you will when we are hit with an energy decline scenario.

Now, my changes were voluntary, your changes were voluntary. I think these things feel a lot different when they are not which is part of my reasoning for deciding to take control of it rather than be controlled. But you know there is this one phenomenon that I call the energy trap that I think we really need to pay some attention to. Which is once we enter into a say energy decline a year by year decline and realize that oh shoot, this is fossil fuels are peaking out. Liquid fuels will be first, petroleum, we really need to invest heavily in an energy infrastructure, new infrastructure to replace our fossil fuel use. That is going to take a lot of energy. And if you are already running short on energy that demand for a new significant influx of energy has to come from somewhere. It makes your perceived energy decline steeper. That is politically very difficult to affect.

Chris Martenson: Yes. But if we had the right story we could do it. One of my favorite examples is people, what today would be considered sacrificed a lot for World War II, they didn’t call it sacrificed at the time. It was the war effort and they were all behind it because we had a narrative that said we were going to defeat Nazi’s and it was worth it and we did it. Right now I don’t think anybody is really looking at the story and saying this is something that we really have to do. In fact, we are still talking about how we can use our energy up as fast as possible instead of saying where do we want to be in 40, 50 years and how are we going to get there? And that is what every good business has to do every –we should do that in our own lives. But as a former strategy consultant we would wander into businesses and say where do you want to be? How are you going to get there? That is all that is required for a good strategy. And I don’t know that we have either of those two conversations happening at the national level right now. Which is I guess why you do what you do and why I do what I do.

Tom Murphy: Exactly. I do think it is physically possible to navigate ourselves to a steady state and technologically advanced future. But it is psychologically very difficult to make the sacrifices that in near terms are going to be needed. I think the other difficult here is that when we rose to gigantic challenges in the past, World War II, we had an enemy with a human face. And that human face could be demonized, that is what we tend to do during war time. If it is a problem of energy and energy use we are our own enemies. That is the psychological problem. We have to acknowledge that we are our own problem and the changes that we need to make are directed at our own habit. So in World War II you might have somebody motivated to go work in a bomb factory and painting “Die you”, whatever - fill in the enemy at the time on the side of the bomb shell, how are we going to mobilize people? In World War II, we have hate on our side. That is a very powerful motivator. How are we going to learn to hate our own energy use enough to do something significant about it at that scale.

Chris Martenson: I agree. And that is why the narrative has to be framed around the hope side. We can wrap in legacy, we can talk about what is being responsible. We can talk about ultimately I see us as the larger metaphor here is that we as a culture came through our adolescence, right? And like all good adolescents we were growing. That is what your body does. But sooner or later your body stops growing and you have to adjust to that or you will end up being very heavy. And so here we are at the point where there are no more horizons to go over. There are no more big untapped resources. We pretty much have it all mapped out so the question is how are we going to manage that now? So ultimately we are talking about a transition into adulthood and so that I think is a very hopeful conversation because it says what was important to us in the past as teenagers, might not be the same things that were as important to us as adults. And that is okay. That is perfectly normal. It is natural. We got analogs for it. Ultimately, my personal story around this is I cut my standard of living in half. I probably doubled my quality of life. I am pretty sure that if I can do it anybody can do it. That this consumptive treadmill I was on turned out to be something I was very good at. I was born, bred, raised and trained for it. When I got off of it it initially motivated by some anxiety if not fear about what I saw coming. I realize now I would willingly jump into that landscape because of what I find there. That is I am getting pulled rather than pushed towards it.

And so to me, that is my motivation is to say not only can we get off of this ridiculous treadmill we are on, which has no future, by the way, unsustainable. And step into this new life. But it is actually something we want to do and it is time to do that. We either do it or we don’t. I am a scientist at heart. Trained in the physical sciences, natural sciences and I just know that limits are limits. And we will, like any organism discover our limits. And we will either discover that on our own terms or on some other terms.

Tom Murphy: Well, I think part of my difficulty in all this is I have the sense and the intuition that we face unprecedented challenges that will prohibit us from continuing our pace, from growing. And I have the sense that the technologies that we would like to use to replace fossil fuels are impractical from the point of view that it is easy to make electricity and we can make that in all kinds of renewable ways that don’t involve fossil fuels, but getting that into the transportation fleet requires electric vehicles. And yes, we can do that, but how many people can afford them? Do we price ourselves out of a post fossil future that looks much like today’s world. And so I have a sense that all of that is very, very hard and may be a challenge that humanity is up for. But the awkward aspect of this that as a scientist I can’t prove that. I just have an intuition that same intuition has been very useful and an extremely powerful guide for me as a scientist to pick problems that are approachable and to pick technologies that don’t have show stoppers. I have explored plenty of possibly projects in science that I just had an uneasy feeling about the technological state and shied away and in hindsight, those were all very good decisions. I think I have to trust my own intuition at some level. And feel that if this is a really hard, unprecedented time in the progress of humanity. And we should just pay attention to that. It is a message that most people don’t want to hear. So it is a real challenge to get people to accept that maybe we should slow down. Maybe we should aim for steady state even if it is just a temporary phase and then we realize oh, was it really necessary in the most optimistic of scenarios.

I am realizing I have conservative tendencies here. I want to take the lowest risk approach to the future. So much is riding on it. And personally I feel that the scientific progress I have made over the last few hundred years is astounding. I don’t want to lose that. I think that is a gift to the future and I don’t want to run the risk of a collapse that could destroy all that we have. Even if you think the collapse is a low probability. Let’s say it is 5%, 10% probability. It is an asymmetric risk. The downsides of not treating it seriously are huge. I mean you buy fire insurance for a house even if it is a .1% probability that your house will burn down in your lifetime. But the consequences are so negative that you do it. And I think when you are talking about the accomplishments of all civilizations, we need to buy insurance and treat that with the respect it deserves.

Chris Martenson: Very well said. I couldn’t agree more. We are going to have to leave it at that today. I do wish you the best with the economist. I do hope that you two can continue your conversation. I would love to be privy to whatever comes from that and hear about it. It is a very important conversation. We have to start having it. And I want to thank you for our conversation today. Just incredible stuff you have done. I love your blog. Just quickly, tell people how they can follow you more closely?

Tom Murphy: I would just say google Do the Math you will find my blog. I have kept a weekly pace up for the last almost a year, but I am dropping off to once every two weeks for a while while I get other aspects of my life in order. It is a very time consuming thing it turns out. It has been a nights and weekends deal because my job is very demanding. So I am sort of I feel like I just ran a marathon. I will continue to post on all of these same kinds of topics.

Chris Martenson: It is an important body of work that is already there. I would invite people to wander over and read through it. It is very good. Do the Math. Tom, thank you so much for your time today and an engaging conversation.

Tom Murphy: Yea, thanks. It’s been fun.

Transcript for Alasdair Macleod

Transcript for Alasdair Macleod:  Why the Europe Situation is Certain to Get Worse

Chris Martenson:  Welcome to another ChrisMartenson.com podcast. I am your host, of course, Chris Martenson. Today, we have the good fortune of speaking with Alasdair Macleod, publisher of FinanceandEconomics.org and a recently-introduced contributing editor to ChrisMartenson.com. I had the pleasure of meeting Alasdair for the first time in Madrid, Spain when he interviewed me. So, we get to turn the tables here today and return the favor.

Then we went out – he and I – to several extended meals over the next few days, when I was over there in Spain, and I was really impressed with his ability to understand and articulate what’s happening at the macroeconomic level globally. And, given his vantage point from Europe, I’m keen on discussing his latest observations of where we are with the situation over there. The European sovereign debt crisis has been muted somewhat in the news lately, but it is by no means resolved. It poses perhaps the greatest single risk today to global financial markets.

As we ponder which event might progress from the outside in to stir up another round of financial disruption, we’d do well to keep Europe in sharp focus. Alasdair, a pleasure to have you.

Alasdair Macleod:  Chris, it’s very, very nice to speak to you again.

Chris Martenson:  Wonderful. Can you give our listeners a quick sketch of your background, please?

Alasdair Macleod:  Yes, certainly. I started off at the late age of about 21 in the stock market. And I became a stockbroker, a member of the London Stock Exchange. I became senior partner of my firm at the grand age of about 29. Since then, I’ve not only been stockbroking, but also I’ve managed funds, I’ve been a director of a bank, I’ve done consultancy work for a wide range of financial services companies. I come at it from that end rather than having gone to university, got a degree in economics, had to unlearn everything, and then start again. So, I do have the advantage that I’ve been a practical economist in adverted commerce as part of what I’ve been doing since my early 20s.

Chris Martenson:  That sets you very, very apart from your average central bank member, I would suggest.

Alasdair Macleod:  It certainly does, and I learned very early on that governments in particular, central banks also, really have very, very little clue of what goes on in the market. It varies, and some central banks are better than others. But, generally, you know things are driven by political considerations rather than economic considerations, and that creates a certain tension in the markets.

Chris Martenson:  That’s a really important point, which I hope to unravel here now. You recently penned an excellent overview to the European credit crisis to our readers on ChrisMartenson.com. But for those who have yet to read it, can you summarize quickly for us how things got to this state?

Alasdair Macleod:  The history of this particular case goes back to the beginning of the euro, the birth of the euro. You could argue it goes way back to the last war really when the European iron and steel federation got together. The idea being if you got desperate countries in Europe together politically, then they wouldn’t fight each other in the future. That gradually evolved over time to the point where they decided to go for the common currency – the euro – and that came in 1999. But ahead of that, the countries had to converge their economies so that they could stick together. Part of that convergence was for the European Monetary Union, whereby the various currencies would be stuck in a channel and managed so that they would work alongside each other. That was meant to bring economic stability.

The other aspect of it was that these countries had to get economic convergence, and that meant things like levels of debt had to be within certain parameters, budget deficits had to be less than three percent. So, as you may imagine, before the euro convergence – which was 1997 – the countries going into euro at that time had fiddled the books quite a lot in order to qualify. And so, we had a lot of issues like off-balance-sheet stuff which really dates all the way back to 1997, even though the euro came in 1999.

Since then, virtually all the countries – with the exception of Luxembourg and, I think, Finland – have breached rules by having too large a level of public sector debt or indeed having too large a level of budget deficit. The result of that is that instead of being fined, it was all just generally ignored. Once the euro got going, of course, that de-risked it, from the bank’s point of view, because they could then lend to countries like Spain or Italy – Greece joined later, so after they joined, Greece.

Knowing that the rate of interest, let’s just say, on a bond, the German government bonds, it would be, say, 3%. And, therefore, given the whole system had a sort of guarantee, rather like a Fannie Mae guarantee from the overall European Union, you could effectively borrow at rates which equated to German government bond yields and lend it out to the Italians or the Spanish or the Greeks or the Portuguese for a spread of two or three percent. You geared it up through fractional reserve banking. It was money for old rope.

The result was that there was a huge great sea of bank credit created in the wake of the invention of the euro, even though the ECB itself ran a relatively tight monetary ship. So, it was really a sea of credit, and that inevitably ended up with property bubbles quite similar to the one you had in the United States. And when that burst, of course, the whole thing started falling apart. Of course, when the private sector starts going wrong and the banks come under huge great pressure, inevitably, governments are asked to take up the running and guarantee the banks. That’s roughly where we got to, I think, in 2009.

Since then, the crisis has been playing out, because it is quite obvious that the weaker countries cannot support all this debt and implied off-balance-sheet debt in the form of bank debt, various guarantees to nationalized industries, and so on and so forth. So it’s good ole crisis, which has got a lot of lengthy mixture that we’re familiar with in the United States and in the UK, and perhaps even in Japan. But, I think the reason it’s become so much more obvious in Europe is because the individual national banks can’t resort to quantitative easing to pay their government’s bills. They actually have to go and borrow it. It’s sort of like we’ve got to go to the bank manager and convince the bank manager. And, that is proving very, very tough.

That’s roughly where we are. I don’t know if that gives you enough of an overview, Chris?

Chris Martenson:  That was an excellent summary. I just recently interviewed Bill Black – former regulator over here in the States – and he said that the seeds of the subprime crisis were really just sown-in regulatory failures that allowed certain behaviors to go forward. So I am going to tie this in by suggesting that back in 1997, then in 1999 when the union was coming together forming and the euro was birthed, there were certain, let’s say, structural conditions that were in play, right? Everybody had to sort of fit within these parameters, but they were allowed to fudge, in essence. I believe even Goldman Sachs got caught – I don’t know what the summary of that was – but they were caught helping Greece hide certain debts off-book so that their deficit ratios would look better than they actually were.

Alasdair Macleod:  Absolutely true, yes. That’s right.

Chris Martenson:  I’d like to hear more about that in a minute. But, what I am getting at here is that this was almost designed to fail, in the sense that when you put in a structure that allows nation states to cheat and then gain access to cheap credit, what happens next really shouldn’t surprise anybody, should it?

Alasdair Macleod:  I agree with you entirely. I don’t think I would say it was designed to fail. It was like a design with not enough attention being paid to how it would actually work going forward. The reason for this is quite simple. You had all the politicians from the different countries all beating their own national political drum. Meanwhile, you have the umbrella of the European Union, which everybody pays lip service to. But again, they were pursuing the domestic agendas rather than working together at the European level. So, it was never really going to work effectively. The politics of it were too divisive for the system to survive. I think that’s the way I would put it.

Chris Martenson:  I agree. Maybe I could have spoken more clearly. When I said designed to fail, it wasn’t that people designed it saying yeah this is going to fail. But, in its design there were certainly risks of failure embedded.

Alasdair Macleod:  Exactly. It demands the same thing effectively.

Chris Martenson:  It does, if we’re being adults about this and can learn from past experience. So what I am really interested then in the political differences. You mentioned one. There’s an extraordinary difference in how this all plays out, because the local or regional banks, as they were cannot just quantitative ease on their own. I mean, Greece is certainly stuck with us. We contrast what’s happening in Greece today with what’s happening in Iceland, which did have the ability to ease or to base its currency as a means of rectifying the imbalances. But Greece doesn’t have that opportunity.

So, here we are, and I’d like if you could to explain some of the politics that are involved in how the maneuvering happens or where it leads to types of sclerosis that prevent activities from happening that ought to be happening. But there’s a very different political flavor and tenor, obviously, to what’s happening with the ECB and in the member states in the EU, as compared to what’s happening in Japan or in the United States.

Alasdair Macleod:  I think the overriding characteristic of politics in Europe is the shape of the parliaments. They are horseshoe-shaped. By that, I mean that you’ve got different degrees of opinion amongst generally disparate parties. Therefore, governments are generally formed by coalition. What this means is that a dominant party who needs a smaller party to come on board will get that party on board by effectively bribing them. And it’s not actually bribing the individual politicians, which is the sort of thing that’s happening in Greece. The bribes would be in the form of, okay, well, we will introduce this tax or that tax, which suits your political platform.

So, you have this sort of constant shuffling of trying to appease by bribes. And the bribes are all paid effectively either out of taxes, or, in the old days before the Euro, as inflation. Once the euro came in, if you need to raise some money to buy off a political party, then that was quite easy. It would be the BNP or the Italian equivalent or the Spanish equivalent would come up with the money one way or the other to help government in its efforts.

So on the domestic level, you do have this sort of political theme, which is fundamentally dishonest in the way it works. I don’t mean that as a criticism of the individuals. The individuals and their behavior, I think, is secondary to it. The order of events is that if you’ve got a bad system, then you end up with bad people, and that’s the way around it has really happened in Europe.

At the European Union level, that has been a different problem. That has separate parliaments, as your listeners are undoubtedly aware. That is the most extraordinary fudge. It’s part of the year in Strasbourg and part of the year in Brussels. At great, great cost – the whole of the political machine migrates backwards and forwards. This is an example of a sort of political compromise that you get in the founding of an institution like the European Union. What the European Union does is it has an unelected body, then commissioners who will propose perspective legislation or regulation, and then that is brought to the parliament. The parliament either endorses it or throws it out. In practice, what happens is that parliament endorses it. It has become, therefore, a huge great machine for the production of regulations.

But, I don't know – 9,000 regulations; I’ve heard that figure since they started. It wouldn’t surprise me if it was even doubled that. The result is, Europe has become a place where a business can only operate if it’s a friend of the government, if it manages to work its way around the taxes, if it manages to work its way around national prejudices, even though those are not meant to be there because the idea of the European Union is free trade. Alternatively, it’s got to be able to comply with an absolutely extraordinary raft of anti-competitive regulations.

So, the whole system has really become pretty inefficient and works very much against free markets. So, the only thing that has really been keeping it going – as I said – since the euro came in was the expansion of bank credit. Of course that’s the other aspect of it. The banks are really political. They’re very much in the hands of the politicians and the politicians are very much in the bank’s pockets. It might be familiar to your listeners in other jurisdictions as well.

Chris Martenson:  Yes, we recognize that theme very well. So, here’s what I’m interested in: This EU body has member representation. I want to understand the practical reality. Let’s imagine I’m Spain for the moment. I am Rajoy and I have this extraordinary funding need. I maybe need a hundred billion euros to get through the next funding cycle. How do I go about getting that? Is this an act of lobbying that happens at the EU level? Tell me the process.

Alasdair Macleod:  Well, there are two sorts of funding. There’s a sort of funding which the EU can help with. That is, regional substance, in one form or another. So, you’ve got EU-funded infrastructure projects. That is about as far as the EU can really go. They spend most of their time demolishing markets rather than facilitating them. It’s really predominantly a machine for the production of regulations – all obviously with the best intent, but very much with a political incentive in it as well.

A very good example of this is that the EU constantly tries to knock London as a financial center off its perch. I think they are rather miffed, for the real markets dealing in euros happens to be based in London rather than anywhere in Europe, like Frankfurt or Paris or wherever. And London keeps on trying to fight a rear-guard action to stop this type of regulation. And, to a degree, they succeed. But you can see that the tensions are there the whole time. The other sort of funding which is a major source of funding for a country like Spain is really through the bond markets and also through the banks. The two things are obviously inextricably linked, because most of the lending to the Spanish government tends to come from the Spanish banks.

If you go back to pre-crisis, particularly before the credit crisis of 2007-2008, the banks all around Europe were lending money to countries like Spain. As I said earlier, they were picking up on the interest rate differential between the bond yields in Germany and the bond yields in Spain. The fact that they are only 1-2% different just basically meant that all the bank did was it geared it up even more so that it was effectively doing a reverse repo. It would gear up that 1-2% differential and walk away with 20% per annum for doing nothing. It really was money for old rope. Of course, countries like Spain became completely dependent on financing of this sort.

Chris Martenson:  All right, so I am Spain, and I’m obviously relying on the bond market. Obviously I’ve spent wildly beyond my means for a period of time. It was credit, and like all good credit bubbles, they come to an end. As the Austrians say, your choices include either the voluntary abandonment of your credit cycle or the destruction of your currency. Neither of those actually seem to be an option for Spain. They seem to be struck in some sort of a nether world in this moment. So they have to rely on the bond market.

One of the things that certainly become quite obvious is that the ECB is stepping in the bond markets, quite often routinely. They’ve got the Italian options and also the open market, Spanish options and open market. In your estimation, if we were to speculate a bit, are there people in the ECB who are tasked with watching these bond markets? And do you think they have marching orders, as it were, to maintain price levels and/or market stability and liquidity?

Alasdair Macleod:  Well, the ECB obviously watches the bond markets extremely closely. I think, if I can just take a step back in your analysis, the ECB really has one overriding problem. That is in the context that individual nations are effectively standing behind their banks. The ECB has an overall responsibility for the European banking system. Therefore, its primary focus is to keep the banking system from hitting a banking crisis. So, that’s the basis behind all these long-term financing, the LTRO financing, which is, I think, run to nearly a trillion euros now. That is to support the banks.

But what the banks are doing is, they take some of that capital and they put it aside because they’ve got their own bond redemptions which they’ve got to meet on their own balance sheet and they can’t see who is going to lend them the money at this stage. They’ve also got deposits walking out of the door and going to other banks within the euro system. So they need to reserve something back from there. But once they’ve made that estimation, they have something left over which they can lend to their governments.

So, it was never the intention of the ECB to bail out the governments. But what we did see, obviously, since you referred to, the yields of the bonds for the Spanish government and the Italian government fell really quite sharply as these long-term financing operations were put in place by the ECB suggesting there was bigger leakage going into financing those governments. Now that is over, the yields are beginning to rise again. But, I think that if the ECB is going to succeed in this mandate of supporting the banking system and stopping that falling over, it really cannot bail out the governments as well.

So, it’s gotten so it’s stuck, in a sense. It’s got to concentrate on what it’s got to do. But, equally, if the governments get into real difficulties, it’s going to make it even more difficult for the ECB to stop certain parts of the European banking system [from] failing. They are damned if they do and damned if they don’t. Now, I think under Trichet, who was the previous chairman of the ECB or president of the ECB, he took quite a hard line. He recognized quite clearly that he has to keep the banking system going and he’s not going to make money available for the government.

Now, when he retired, I think Draghi has taken the softer line. He has condoned – if I can put it that way – two things: Firstly, national banks’ lending to their governments and taking money up to three years maturity from the ECB in order to do so. That is sort of a temporary fix for governments in difficulty. The second thing is that he’s turned a blind eye to the imbalances that have built up in the national central banks, into banking settlement systems – which is called TARGET.

I haven’t referred to this in this in this interview, but this is actually very important, because at the moment it has built up huge imbalances, which explain why the bank runs that we’ve seen in Greece in particular, Spain, Portugal, and Italy have not produced the sort of bank-run crisis on the surface, which we are familiar with. The reason for it is the way the settlement system works. So, if I can just explain this to you, Chris, for your listeners?

Chris Martenson:  Please do, yes.

Alasdair Macleod:  It’s slightly technical, but I’ll try to keep it as simple as possible. Let us assume that a tour operator in Greece wants to order some Mercedes buses. He will buy those buses from Mercedes Benz in Stuttgart, which is fine. He will pay Mercedes Benz in Stuttgart. Now, in the process, what he has done is he has taken the euros away from the Greek economy and moved them into the German economy. This is balanced by the national central banks. And, in this case, the national bank of Greece will issue sufficient euros to replace the ones that have left the country. So, there is no net monetary effect.

The Bundesbank will withdraw euros from circulation for the same reason – to keep the level of euros in Germany stable, notwithstanding the fact that Mercedes has manage to get a hold a whole load of euros as a consequence of selling buses to Greece. Now, within the books of the central banks, this is balanced out by a loan that appears in their books to the effect that the Bundesbank has a loan due to it for those euros from the Bank of Greece. Then, the Bank of Greece’s books, it has an obligation, a loan, to pay the Bundesbank. So that balances out. Now, the effect is that an imbalance arises across the central banks – in this case, the cost of the buses – and suddenly you’ve got money owed by Greece to the Bundesbank.

Now normally, over time you would expect these things to balance out, because capital flows will be going one way while trade flows go the other way. But, since you also have not only the trade flows going whichever way they go, but you have capital flight, this has led to a huge rate imbalance across the national central bank’s books. And it’s got to the point now where I think the most recent figures for the Bundesbank indicates that it is owed getting on toward $700 billion euros by the other national central banks. Obviously, this is not just Greece. It’s Greece. It’s Portugal. It’s Ireland. It’s Spain. It’s Italy. It’s France. And so on and so forth.

The only central banks which have loans out to them on a net basis – and remember, this is a net basis because it’s a complete sort of settlement system we’re talking about – are the Bundesbank, you’ve got the Netherlands Central Bank and also Luxembourg. I think Finland just about in balance, but that is it. So, the reason that the system hasn’t fallen over is because the ECB has turned a blind eye to this development. These are the sort of problems that we have in the background.

None of us would have known about this if it hadn’t been through a research paper that was produced by the IFO Institute, in Munich I think it is, going into this sort of very arcane boring subject. It has now become quite an issue in Germany. The German people are beginning to think, now hold on a minute. Our central bank here is owed a heck of a lot of money by all these other central banks. Are they ever going to be repaid? So you can see this is now becoming politicized.

That’s sort of roughly where we are on where the central banks are and what they’re trying to do. What I would contend is that if the ECB tried to get into the business of supporting government finances as well, or overtly supporting government finances, then I think it wouldn’t be very quick before it would be “game over” for the euro. But so far, they are resisting that. They are doing it under the counter.

Chris Martenson:  Great, I want to talk about that a little bit later. Right now I am interested in maybe six months ago, I am guessing here, the BBC had this really nice interactive chart which was a circle and it showed these arrow flows of who-owed-who-what. You don’t have to click around the circle very many times to see that with Ireland owing all these countries, and then Spain owing all these countries, and the U.S. owing all these countries, that everybody owes everybody.

Alasdair Macleod:  More than that, Chris, it’s the private sector banking system that owes these things. So for example, you’ve got French banks owning Spanish bonds, and Spanish banks owning Irish bonds, and German banks owning Irish bonds, and so on. It’s really government bonds being held within the private sector banking system.

Chris Martenson:  Right, and you just described a second device in this target system which sounds to me like a current account imbalance, but within a single currency. So a sort of official set of imbalances exist. Fundamentally, this was a predicament of insolvency and, of course, predictably; the ECB has a mandate to protect a banking system. The way you do that is you provide liquidity. They’ve done that in ample amounts. But liquidity and solvency are two very different concepts, usually. So, here we are at this moment where if you have a mental image, maybe it’s of fingers being put into a dike with leaks coming out. So, they’re limping along.

But, at the fundamental level in terms of what really needs to happen, there’s some sort of an adjustment process that has to happen. So, step forward, it turns out that a number of countries are being rather unwillingly – I would suggest nudged – towards the idea of austerity, Greece being the first candidate or victim, and Spain pretty far along that trail. Of course, lo and behold, it turns out austerity in the time of excessive government expenditures leads to economic contraction, which only adds another set of pressures to an outstanding pile of debt and indebtedness.

So, taking all of this into account, seeing where we are in this landscape, what if there was going to be some sort of resolution to this that was going to work, what would that look like? Is it austerity? Is it just more printing? What, if any, resolution exists here?

Alasdair Macleod:  I like your use of the little word “if.” The problem I am afraid is even more complex and deeper than we had discussed so far. There is one big element of this which nobody had addressed because they don’t understand it. If you’re an Austrian economist, you will understand it. If you not, you won’t. And because governments are populated by economists who are not Austrian, then they don’t understand it and they won’t understand it.

That is this: If you try and measure an economy by GDP, all you are measuring at the end of the day is the amount of money in the economy. It is not a measure of economic progress. It’s a very, very important point. And, the reason it is relevant is that so long as you say we need GDP to not fall – which is roughly what we’re talking about as far as the problem that the officials see; they don’t want the economy to fall because it threatens taxes and all the rest of it – if they’re measuring it by GDP, then they are using the wrong metric to come up with any solution. Does that make sense?

Chris Martenson:  Well, it does because one of the things I’ve harped on continuously is that with GDP, if a country goes deeper and deeper into debt to fund itself, GDP only measures the so-called economic activity that happens as a result. It doesn't measure the offsetting debt. If you strip out the debt effect, you will find that many economies have actually in fact not been growing rather at all. And, so we’re measuring something that is illusory because it provides a gain when it’s there, but it’s going to do the opposite when it’s not there.

Alasdair Macleod:  Yeah, it is, in effect, no more than an accounting identity. Now we’re in the real world and we’re trying to seek a solution to the problem. You don’t do that by concentrating on an accounting identity. This is the point that nobody in the system seems to understand. So far as I am aware, nobody is yet discussing, but this is why I think virtually anything they do is almost certain to fail. Now, if we take a step back, the one thing that is wrong with the European Union – and most of the other advanced nations by the way; it’s not just them – is the size of government. There is a myth that government can intervene and improve things. It can’t.

As you rightly point out, one side that isn’t looked at is that government spends money on subsidizing this industry. You know, whatever…paying out welfare and so on and so forth, but that money’s got to come from somewhere. Is it being taking away from the productive economy and being injected into something less productive or not productive at all? They’re destroying savings and therefore the ability of an economy to actually progress itself.

So, at the accounting identify level, governments can do this and actually push up GDP because GDP incorporates government spending at cost in the provision of services and all the rest of it. That is part of GDP. So, if government increases its spending, GDP goes up. You rightly say, it excludes the other side, and that is where does the money actually come from?

So, we actually do have a huge problem in understanding what the problem is and therefore how to resolve it. I think that the consequence of that is that the crises is likely to drag out a lot longer than it would otherwise because they are bound to resist the obvious and that is to cut government spending. You really need to slash it the whole way across the board. So, they will resist that because – the economist will tell them, and by this I mean the near capital economists – that if you cut spending across the board, then you’re going to cut GDP, which means that your tax take is going to go down and you’re just going to make the problem worse. Unless you print money to offset it, you’re going to create a huge great deflation. But actually, what they need to do is to cut the government spending, remove the distortions from the economy so that the economy can actually recover itself.

Now, you mentioned Iceland earlier. I think you know that what the currency did is a slightly separate thing from what happened in Iceland itself. The government hadn’t resorted to do anything. It couldn’t interfere. It stood back and everybody understood, We’ve got a problem. It’s a huge great problem. Somehow we’ve got to look after ourselves. We can’t expect the government to pay our welfare, pay for this, pay for that. We’ve got to look after ourselves.

They’ve done that and the result is the economy has turned around. That is what we need to happen in Europe. But they are going to resist that process till the politicians’ dying days, and that is really the problem. They are now getting in the way of the solution.

Chris Martenson:  So, what you’ve described is really that there was a sort of a structural risk that was embedded into this entire construct starting back in 1997. It was exploited for temporal gain, and it worked really well while it worked as long as the pie was expanding and nobody was looking too carefully at the mounting imbalances as it chugged along beautifully. Everybody was getting rich on their Spanish villas going up in price almost daily. This whole thing was bound to work until mathematically it couldn’t work. Leaving out of this story the impact of rising energy cost, which is a big component I usually weave in at this moment, just all on its own this was bound to have a mathematical problem. It has encountered that mathematical sort of limit, as it were. Obviously it could have limped along further, but for one set of reasons or another, it ended.

And instead of saying Wow, that’s over. How did we go wrong? Where should we repair this? The very natural systemic response is to perpetuate the status quo of let’s get this through the next quarter, let’s get it through the next election cycle, let’s see if we can keep the bond markets alive another week – whatever those things are that we’re all looking at. So you painted a picture for me of a whole lot of very well meaning, very interested people who are diligently applying the wrong solutions to the incorrect diagnosis.

Alasdair Macleod:  I think you have summed it up extremely well.

Chris Martenson:  Well, thank you for that. So, with that excellent summary, I want to end this part of the interview, and we’re going to move on to Part II for the enrolled members. I want to get in that part very specifically what the key risks are, what the scenarios might look like as this plays out because it has more room to play out here, and I want to talk about specifically what individuals can do in that circumstance, specifically for those of us who live in Europe who are listening to this, and as well, maybe generally around the globe.

So, with that ending, can you tell people who are interested in following you more closely, besides the articles you write for Chris Martenson.com, where would they do that?

Alasdair Macleod:  Well, I have a website, which is financeandeconomics.org. I also write for Gold Money.  I go around and speak at various conferences and so on and so forth. But my writings can be found really on those two sites. I tend to put the longer articles on financeandeconomics.org. Gold Money’s clients like a sort of 500-word thing. I try on that one to do a fairly straightforward subject, because 500 words doesn't give you a lot to develop something which could really be understood. But those are the two sites where you would generally find me.

Chris Martenson:  Wonderful. Well, this is Chris Martenson. We’ve been talking with Alasdair Macleod. You can find out more either on PeakProsperity.com or financeandeconomics.org.

Transcript for Bill Black

This is the transcript for Bill Black: Our System is So Flawed That Fraud is Mathematically Guaranteed

Chris Martenson: Hello and welcome to another www.PeakProsperity.com podcast. I am your host, of course, Chris Martenson. And today, we have the pleasure of speaking with Bill Black, associate professor of economics and law at the University of Missouri, Kansas City, and a former bank regulator and a central figure in prosecuting – there’s a strange work – the corruption associated with the savings and loan crisis of the late 80s. He’s been since a prominent voice against financial and political fraud. And in 2005, authored the excellent book, The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. So I’m sure he has a lot to say about our current situation. I’m really looking forward to Bill helping us understand why there were nearly two thousand convictions resulting from the S&L crisis but hardly any so far from the mortgage fraud and other criminal activity that caused the 2008 near system collapse, the one that made the scope of the S&L losses look positively quaint in comparison. Bill, I’m so glad you could join us today.

Bill Black: Thank you.

Chris Martenson: Well, let’s jump right in. For many today, what they’re experiencing is a crisis in confidence, confidence in our entire system, that it's fair and fairly regulated and adjudicated. Perhaps even that if you make both your financial crime wither large enough or complex enough or both, that you can get away with it. Perhaps maybe paying a fine that’s a fraction of your illicit gain but never facing criminal charges, at least that’s the common experience today. So let’s begin here. What is the basic definition of fraud, and more specifically, what is the form of fraud that we seem to be enmeshed in today?

Bill Black: Well, fraud is both a civil wrong and a crime and what it is is when I get you to trust me and then I betray your trust in order to steal from you. And as a result, there’s no more effective acid against trust than fraud and, in particular, elite fraud, which causes people to no longer trust folks, economies break down, families break down, political systems break down and such if you don’t have that kind of trust. So that’s what fraud is. But what my work focuses on is, well, what kind of frauds are the most devastating? And it turns out that the most kind of problems that we’re seeing, as you said, systemic problems and such, arise when we have, what we call in criminology, control fraud. And control fraud simply means when you have a seemingly legitimate entity and the person who controls it uses it as a weapon to defraud others. And so in the financial sphere the weapon of choice is accounting and these losses from these kinds of control frauds exceed the financial losses from all other forms of property crime combined.

Chris Martenson: All other forms combined – well, I can believe that. I mean I saw what happened with Worldcom, with Enron, it took down Arthur Anderson, I guess, but most of the people that worked there ended up going to work other places. All of the – there seems to be – it's not just the person at the top, the CEO, saying I’m going to really shuffle some deck chairs here and hide what the true state of my operation here is, what my risks are, what my liabilities are, whether I have the assets I claim I have. That requires a willing partner on some level, does it not?

Bill Black: Well, that’s the thing. I mean if you have this person at the top being a crook they get to choose their partners. And they get to incentivize their partners and, as a result, you’re quite right. They’re very good at spreading frauds. And we call those echo epidemics. So for example, in the current crisis, as with the prior ones, if you’re a lender there’s an easy recipe for maximizing your accounting, fake accounting income, if you’re a lender. And it goes like this, four ingredients. One, grow like crazy. Two, by making really, really crappy loans but at a premium yield. Yield just means interest rate. Three, while employing extreme leverage, and four, while setting aside only the most trivial reserves, allowances for the inevitable losses this kind of behavior produces. So George Akerlof and Paul Romer wrote the classic article in economics about this in 1993. And their title really says it all in terms of the dynamic. It's, Looting: The Economic Underworld of Bankruptcy for Profit. So again, the idea is you have a seemingly legitimate entity; the person at the top is looting it. They loot it by destroying it but they walk away wealthy. Of course, in the modern era we may bail out the entity. So it may not even fail in that sense.

But here’s what Akerlof and Romer also said that was so critical as an understanding. They said these four steps, these four ingredients, it is just math. It is – and I’m quoting them now “a sure thing.” So you’re mathematically guaranteed if you do these four things to report, not just substantial income, but record levels of income. And that’s when Akerlof and Romer said, now that’s the next thing that comes in that’s really important and that is modern executive and modern professional compensation. Because with modern compensation, first at the executive level, the CEO level, I can guarantee with modern executive compensation that if I follow this recipe I will personally be wealthy almost immediately as the CEO. Because I’ll base my compensation as CEO, and that’s the nice thing about being CEO, you get to make the rules for yourself. You’ll base it on short-term reported income and you’ll make that compensation extremely large for supposed superlative results in jargon in the industry, stretch goals. So you’re going to say, hey, if I double my income in just a few years, which is what the Fannie Mae goal was, then I get an off the charts bonus, huge compensation except, of course, that goal is easy to meet. You just have to cheat. It is a sure thing.

Chris Martenson: Now Bill, is it possible to follow this four-step prescription and remain within the letter of the law?

Bill Black: No, not within the letter of the law although it is in places that – it may be - this is the question right now that’s up for grabs – in places where international accounting rules apply. Because under international accounting rules they’re being interpreted by many folks as saying you are not permitted as a lending institution to establish any meaningful allowances for losses, loan losses now, even though it is absolutely certain that making – you don’t remember what the ingredient is, the first to grow extremely rapidly by making really, really awful loans at a premium yield. Well, that’s guaranteed to produce massive losses down the road. The international accounting rules – some people are, actually many people are interpreting as you are not permitted to establish any reserves. So that could create the perfect crime in Europe in particular.

 

Chris Martenson: The perfect crime – now, so even if you stay within these four though, the parts that get me confused are what happens when say your supposed third part auditing company comes in and performs their yearly due diligence audit and then signs off on the financial statement. So this company then says these have all been fairly represented and the risks have all been adequately explained and we think this company is fairly representing itself. And then surprise, surprise, like Lucy pulling a football away. I mean we always seem to be surprised when it turns out that there are glaring, overt gross material misrepresentations of risk, of assets, of liabilities, of all kinds of things. And somehow that happens again, and again, and again. Where – I’m really interested where the letter of the law is on this. Is there no responsibility here?

Bill Black: Well, the letter of the law in the United States under general accepted accounting principles is that you have to establish the loss reserves now if you make large losses inevitable in the future. So in that if you actually establish the appropriate loss reserves, of course, you would show under this recipe that you are losing money, not making money, and you wouldn’t get any bonus. So under the letter of the law there’s a fraud in the United States. It turns out there are many frauds in Europe as well because people get greedier. Now, let me approach your more basic question. And your more basic question really has two areas, and that is, so again why are these control frauds unique. Why are they much more dangerous than regular frauds? And what is this thing that I alluded to and that is professional compensations. So that’ll bring in your question about the auditor. So if we back up, what’s special when you have a seemingly legitimate entity and the person at the top of the food chain is the crook the joke that actually many cultures have like China is, of course, the fish rot from the head. And that’s designed to capture precisely this point.

Well, so the big thing is about the seemingly legitimate entity when the CEO is the crook, first, everybody reports to the CEO ultimately, right. So the CEO is the point failure mechanism where if he or she goes bad, almost everything may go bad as well. So all those things that we call in controls, internal and external controls, all report to the CEO and the CEO therefore can, as I’ll describe, use compensation, hiring, firing, praise, and such to produce the environment that will commit, create allies for his fraud. Now, note that what I’m saying. The CEO, the art of this is not to defeat your controls. The elegant solution as in mathematics is to suborn the controls and turn them into your most valuable allies. And therefore, for example, when you’re running accounting control fraud where your weapon of fraud is accounting and that weapon of choice in finance is accounting. You’re going to want to hire the most prestigious accountants as your outside auditors because it is precisely their reputation that is most valuable when you could suborn them. And, they give you that clean opinion that you just described that will help you deceive other shareholders. So one enormous advantage is internal and external controls come to the CEO level.

A second incredible advantage is the CEO can optimize the firm as a weapon of fraud. And the CEO can do that. Basically, this falls into two big categories. One, you can put it in assets that have no readily verifiable market value because then it's a lot easier to inflate asset valuations and to hide real losses. And the second thing you do is grow like crazy. And, of course, that is the essence of something your listeners have all heard about, and that is a Ponzi scheme. And so these accounting control frauds have – give strong Ponzi scheme like elements, which is why they tend to cause such catastrophic losses.

Chris Martenson: Well, if the fish rots from the head then you’re talking about a culture issue. and I’m wondering if the head of the largest fish that we could talk about here is what is substantially different about the type of control fraud you’re talking about that’s happening at the corporate level versus, say, oh I don’t know. What happens when I examine the federal government’s balance sheet and look at its accrual liabilities expanding by four to five trillion dollars per year once you factor in the actual entitlements and the government’s reporting. It's cash balance deficits, which are shocking enough, but on an accrual basis there’s absolutely no possible chance that we can square this circle. Are companies following sort of a – is this – are we talking about American culture now? Is this something that extends really broadly? I’m really confused…

Bill Black: You know this is human culture.

Chris Martenson: Human culture – oh okay.

Bill Black: And it is not limited to corporations. We’ve been focusing on corporations but these frauds occur in the governmental sector, they occur in the non-profit sector, and of course, they occur in combined, in combination. And so crony capitalism is all about the combination of public sector and private sector control frauds working together as cronies.

Chris Martenson: So this is interesting because what you’re saying is something I believe, which is that human nature does not change and it's always human nature to try and game the system, get an advantage, have a free lunch, however we want to put that. And so we’ve known – we’re sophisticated enough that we’ve seen these happen often enough that we know what the dynamic is, you’ve just mentioned this paper, these two gentlemen where there’s four steps. We know what these all are. It is my view that we had tighter regulatory structures that were around the concept of saying listen. These things are going to happen. We’re going to put a basket around this as best we can, and then do what we need to do in order to assure that these things do not flourish. Maybe we’ll have prosecutions. So fast forward, I’m looking at a chart here that shows federal prosecutions for financial fraud are at an all-time low. And my personal perception is that the amount of fraud is probably at an all-time high. They seem potentially correlated, those two pieces of data. Is that true and how did we get here?

Bill Black: Well, you have really interesting phraseology. You said, you talked about we know and you talked about we’re more sophisticated. So this was part of, an important part of, what Akerlof and Romer were talking about in that paper. They chose to include the following paragraph, which I’ll get approximately right from memory. And to make it their last paragraph for emphasis. They said, look, in the savings and loan crisis economists and the public had no theory of this kind of fraud, control fraud. And, as a result they were not in a position to give strong support to the examiners in the field, the regulators, banking regulators, actually savings and loan regulators in the field who recognize from the beginning that this kind of deregulation was bound to create widespread fraud. Now we know better. If we take advantage of this knowledge we need not repeat this kind of crisis. That was written in 1993.

Chris Martenson: Right

Bill Black: And what happened, of course, is right around the same time we did get allegedly more sophisticated in a small part of we. And that small part of we dominated and continues to largely dominate policy. And that small portion of we had exactly the opposite conclusion on the basis of this alleged sophistication. And they said, and this Easterbrook and Fischel. So your listeners need to know that George Akerlof goes on to win the Noble Prize in economics in 2001. So we’ve been talking about one of the most prominent economists in the world. But in the law of economics world a generation of American lawyers has been taught when they study the economics of corporations by a treatise writ in 1991by Judge Easterbrook of the seventh circuit, and Fischel, who was then professor at the University of Chicago Law School, eventually the dean of the University of Chicago Law School. And Easterbrook and Fischel, and again, I’ll get this virtually word for word, say famously, “a rule against fraud is not essential or even particularly important in the securities context.” Now notice how radical a statement that is. It isn’t that we don’t need laws, that we don’t need prosecutors, that we don’t need FBI agents. U.S. attorneys, those kind of folks, we don’t even need a rule against fraud. We don’t need the ability to bring civil suits. We don’t need the securities and exchange commission. Markets, securities markets, are so efficient that they automatically exclude any meaningful accounting control fraud. And we know that they’re efficient because we’ve hypothesized they’re efficient in a wonderful circularity. This was, of course, the efficient market hypothesis that was the centerpiece of all of modern finance theory. And even the weakest version of efficient market hypothesis requires that there be no systematic errors in pricing because if there’s any systematic error in pricing, well, then somebody would correct it. They would make money by correcting it. Therefore, financial bubbles are impossible as well. Fraud is impossible.

Now all of this is insane. And indeed, Fischel was the outside expert for three of the most notorious accounting control frauds of the savings and loan debacle era. Lincoln savings, Michael Milkon at Drexel Burnham Lambert And this incredibly sleazy Florida one as well where the headquarters building was shown in Miami Vice for people who are old enough to know that. And then after he tried his theories in the real world and ended up praising the worst fraud in America, Charles Keating’s Lincoln Savings, as the best saving and loan in America. He wrote those words that I’ve just quoted without ever telling the reader, hey, by the way I tried this in the real world and it was the most embarrassing disaster conceivable. So there’s a strong element of intellectual dishonesty as well that went along with all of this. But anyway, if you believe that fraud’s impossible in the financial sphere, if you believe that markets are inherently efficient and self-correcting, then there’s a clear answer about what you should do about regulation, financial regulation. Financial regulation, A, is unnecessary, and, B, is potentially very harmful because it will potentially stop or interfere, at least, with the self-correcting efficient nature of the marketplace. And therefore, you must be a lead jihad against regulation if you want the country to prosper. and that’s precisely what these folks did.

Well, okay, now that’s academics and, yeah, they’ve trained a generation of lawyers who are now out there in key positions in business and regulation. But surely no one, the adults, right, can’t believe this. But, in fact, they did and, in particular, Alan Greenspan had this view. So he famously, in his first meeting, first person-to-person meeting with Brooksley Born, then the new chair of the commodities future trading commission, invites her over to meet her and says, in the course of the lunch, but of course we’re going to disagree about things. Now, you know, they’ve never had a substantive discussion like this and Brooksley’s wondering what. And he follows up and says because you, for example, believe that fraud provides a basis for regulation, preventing fraud.

Now that’s how extreme and that was, unfortunately of course, the most powerful financial regulatory position in the world was held by someone who believed in this insanity. But it gets worse because Greenspan was also involved, hired by Charles Keating. In fact, Charles Keating hired Greenspan in multiple capacities and one of those capacities was to, as lobbyist, to walk the floors of the senate to recruit the five senators who would become known as the Keating Five. When thirty – I’m sorry, twenty-five years ago on April 9th, 1987, they intervene on Keating’s behalf, those five senators, secretly to try to get us not to take enforcement action against Lincoln savings. Keating also famously put in writing to our agency that Lincoln Savings should be allowed to do hundreds of millions of dollars of these direct investments, which is what we provide the information to do, and they did anyway. That was the violation of rules that the senators were trying immunize by their political pressure. Well, Greenspan opined in writing that we should allow it because, and I’m quoting again, “Lincoln Savings poses no foreseeable risk of loss.” Gosh, he almost got that exactly right except for the fact that it was the most expensive failure of the entire debacle at 3.4 billion dollars, which as you say now, sounds quaint. But back in the day used to be considered a substantial amount of money.

Chris Martenson: Well, if I can turn the phrase around, it looks no bad deed goes unrewarded in this story. And Greenspan is somebody that I’ve been – I wrote about him extensively going, stretching way back because I really, really disagreed with his understanding of risk. He thought the derivatives markets made risk go away. So since you didn’t have risk anymore you could just let people expand their balance sheets and just go hog wild and use that, his view of risk, for as the justification for allowing the sweeps program, which allows banks to effectively hold zero reserve requirements against demand deposits, which I thought was a bad idea at the time. At any rate, so he had some failings, this guy.

Bill Black: But see this is related.

Chris Martenson: Okay, tie it in.

Bill Black: Right, if you believe that fraud is possible then derivatives are a possible problem. If you believe that fraud is impossible and that these people are sophisticated – remember your sophistication illusion again?

Chris Martenson: Yep.

Bill Black: Then it is unambiguous with neoclassical economic theory that the greater the choices the better the results because people will only make good choices for themselves. And as a result, by definition, the purchaser of the derivative will be the one who finds it most valuable and since asset valuation and risk are inversely related it will be the entity that perceived holding that derivative as least risky. In other words, you will get derivatives held by the ideal people for whom they’re in idiosyncratic conditions that reduce the holding, the risk of holding, that derivative for them. And so you will optimize throughout the entire financial symptom the placement of risk in the ideal fashion where the people best situated to have that risk. And not only do you have that advantage, but on top of that it means you will broadly diversify the risk such that there is very little concentration of risk. And therefore, your entire financial system will systemically be far less risky. So they knew all of those things as soon as they started with the assumption that there couldn’t be any frauds.

Chris Martenson: Well, if you’re going to risk that on the efficient market hypothesis there is one other little assumption baked into that, which is that we have even flows of information. There are no information asymmetries. And the very definition of fraud is that it has an asymmetry of information. I can’t square that circle either. There’s an intellectual hole in what you’re describing that’s just gigantic.

Bill Black: Well, enough to drive the world’s largest financial bubble through and the greatest epidemic of the elite fraud in the history of the world, yeah. This is what we call – you know, America is just gone through this recognition that it was being scammed by merchants who were secretly adulterating our hamburgers by adding pink slime, right. And pink slime turned out to be added to a level that maxed out at about fifteen percent. And the reason that it was maxed at about fifteen percent is that it tended to smell and taste bad.

Chris Martenson: Uh-huh

Bill Black: But in the financial end, by the way, pink slime starts out with these ultra-fatty tissues, which are much more susceptible inherently to being, to having strong contamination by e coli, I mean in particular in sense of other things. So they give it an ammonia bath, right, they put Mr. Clean in in gaseous form to try to reduce how infectious pink slime. And it turns out there’s a tradeoff. That’s why it stinks. If you put enough ammonia to really make it close to safe them it really smells and tastes bad. So they don’t put enough ammonia in to really keep it safe. So it's also an unsafe, but it's – I’m not – if you eat a burger you’re not typically going to get sick. In fact, it's quite unusual if you order it at least medium. But that’s not true in finance. In finance it wasn’t a maximum of fifteen percent of some areas were fraudulent. We had whole areas, liars loans, where the fraud incidence, when the people measured it, was ninety percent, nine zero. And we had whole areas like collateralized debt obligations in which the most typical CDO, collateralized debt obligation, was backed overwhelmingly by fraudulent liar’s loads.

Chris Martenson: And we knew about this at the time. There were open articles about ninja loans and this was a very open secret, at least it was to me. I was shorting them of this matter of public record. I was shorting a bunch of mortgage insurers, and homebuilders, and what not, all the way down through this piece because it was so obvious to me that this was a problem. And I’m just an outsider, right. I’m just some guy. I read stuff and I understand a few things. But it was so painfully obvious to me that we had this huge, gigantic issue going on, and it was to insiders too. Michael Lewis and the Big Short details very carefully about how Goldman Sachs with John Paulson went out and handpicked the worst things that were designed to blow up. And, then Goldman Sachs went out and got a so-called independent thirty party’s position saying, hey, this portfolio is randomly selected to succeed when it was actually, I believe, selected to fail. And, then misrepresented that to clients and sold these toxic bundles off because needed somebody on the other side of that trade, often maybe a German bank or somebody like that. So when I look at that, to me that, I can’t find a more clear-cut definition of fraud than that. And yet, I’m not aware of any prosecutions or criminal activity that resulted from that. I believe there might have been a fine but that’s all I can recall at this point. How does that skate through? Did I have the essence of that story right?

Bill Black: Yes, but it goes farther back, so, and there’s a more basic economic problem as well. The definition after all, the defining element about what makes something a liars loan is that you don’t do adequate underwriting, underwriting as a process of evaluating whether you’re going to get repaid when you make a loan. And what are the risks of is so that you can price, decide whether you should make the loan and what conditions and at what price you should do that? And because when you don’t do underwriting on this kind of loan, a mortgage loan, you inherently create something that we call adverse selection. So if you thought of running a health insurance company or life insurance company, and you weren’t going to do any evaluation of your customer’s health or their parents, genetic relatives’ health, you were just going to charge a high price for your insurance to compensate for the risk. Which customers would come to you? Well, obviously, only the sickest. It's the same thing if you couldn’t determine loan quality and you said just charge everybody a high rate of interest as a result, which customers would come to you? Only the worst. And so in this kind of loans, if you create adverse selection you create from the lender’s perspective a negative expected value of making a loan. In plain English that means you will lose money. It's equivalent of betting against the house. And therefore, honest lenders don’t engage in adverse selection. So it's a wonderful natural experiment as to which entities were clearly engaged in fraud, entities making liars loans were clearly engaged in fraud, mortgage lenders doing that.

Okay, so we realized this as regulators in 1990 and 1991. Now let me emphasize those dates again, 1990 and 1991. And America being America, liars loads being the fraud, began most heavily where all financial frauds tended to develop in America and that would be Orange County, California, right. And we were the regional regulators for California, Arizona, and Nevada. And eventually a broader who one-third of the west, one-third of the United States that’s the west. So we looked at these and we said this is insane. These liars’ loans are becoming common. They must lead to fraud. In fact, they only make sense from a lender’s perspective if the lender is engaged in accounting control fraud. And so we use normal supervisory means to drive them out of the savings and loan industry. The leading entity making these liars loans also targeted minorities particularly blacks and Latinos families who couldn’t speak English as well – blacks because they have fewer connections and few choices in the financial industry. So this is a real pernicious place. It was called Long Beach Savings. And we – they were one of the entities we cracked down on. So Long Beach Savings had voluntarily gave up federal deposit insurance, voluntarily gave up his charter to run a savings and loan, and became a mortgage bank for the sole purpose of escaping our regulatory jurisdiction. And as a mortgage bank he was subject to no federal regulation in that era other than active discrimination against minorities, right, this is not community reinvestment act. This is active, I’m out discriminating against minorities, the truth, the fear of lending laws.

Now, his leading competitor is another entity run by a husband/wife team that we removed and prohibited from the savings and loan industry, the gen X. To ease this fraud the head of Long Beach Savings also changes the name of the organization to now mortgage bank and names it Ameriquest. So for people who know this industry they will now be nodding. So Ameriquest becomes the biggest and the baddest, and as it's going out the door we make this referral for discrimination. And the justice department follows up and finds active discrimination. So that’s their second strike, right. The first strike that we went after them for the liars loans, the second strike is the justice department goes after them, and, of course, they make nice, nice, and they promised that they will – they approve things and, of course, the justice department doesn’t bring a criminal action, just a civil action and gets a settlement. Then, of course, Ameriquest does absolutely the same thing targeting blacks, targeting Latinos, outride fraudulent loans, forges people’s signatures, the whole nine yards just completely out of control accounting control fraud, following the recipe that I talked about. And at that juncture, forty-nine state HEs, plus the attorney general of the District of Columbia sued them. Why not the fiftieth? Well, because there was Virginia and at that time Virginia actually had some rules. And so they avoided making mortgages in Virginia. But everybody else sues them, they settle for hundreds of millions of dollars, the biggest settlement of such a kind. Again, no criminal action where upon we make the head of Ameriquest our ambassador to the Netherlands.

Why? Well, because, of course, he was the leading campaign contributor to George Bush. Now that’s politics as usual, the same as I know. But if you want, again, the antecedent of this crisis, two entities rush to acquire Ameriquest from our, now, ambassador or now, about to be, ambassador. Now, again, this place is absolutely notorious. It has a thousand employees, there about, who everyday go in and, if they’re doing substance, what they do is engage in fraud. And, a particularly pernicious fraud where they look for the most vulnerable people in society to defraud. And Citi Corp and Washington Mutual rushed to acquire its operations. And therefore, we are shocked, shocked, that Citi Corp and Washington Mutual made tens of billions in the case of Washington Mutual, hundreds of billions – actually in the case of both of them, hundreds of billions of dollars of fraudulent loans and loan sales. So yes, that just brought us up into the 90s and the early 2000s. So again, we knew in spades, and we not only didn’t bring criminal action we rewarded the frauds, we left them wealthy, we allowed them to sell. They were treated as respectable by the most elite financial institutions in the world, Citi Corp and Washington Mutual being among them. And we discovered our highest honors on the leading frauds. What happens next is by 2004 the FBI warns two things. One, that there is an epidemic of mortgage fraud. Epidemic was their word. And two, warns that it will produce a financial crisis, crisis being their word, if it is not checked, 2004. And here’s a key thing. The FBI person in charge of the effort against mortgage fraud was interviewed by the financial crisis inquiry commission, that inevitable national commission to investigate the causes of this crisis. And he reported that the federal banking regulatory agencies never got in touch with him once either before or after he made this warning about an epidemic of fraud.

Now, can you imagine that? You’re the federal banking regulators, the FBI, publically, and this gets reported all over the place, trade press, general press, says epidemic mortgage fraud is going to cause a financial crisis and nobody in the financial regulatory center says boo, and follows up on it in the least. And here’s a footnote also about the financial crisis inquiry commission. So Eric Holder, the attorney general of the United States of America under Obama, and therefore the head of the FBI as well, in other words, the bureau is part of the justice department, is called to testify in front of the financial crisis inquiry commission. Now what is the most famous thing the justice department/FBI did? Issue this warning in 2004, and Holder’s the head a huge department filled with incredibly bright people who prep him for a testimony like this so the agency looks good. And so Holder looks good, right. That’s your job, prep the guy so he looks good and doesn’t get embarrassed. And what does the first question have to be out of the financial crisis inquiry commission. It's got to be, hey, what did you do in response to your own warning? So that is, in fact, the first question asked to Holder. And Holder, at that point – and Holder is accompanied by his staff and by Lanny Breuer, the head of the criminal division – and his answer is what warning. I’ve never heard of this. Which means nobody up there is passing the note saying I’ll take this Eric. There was no answer. None of them had ever heard of the warning. That’s how big a priority elite financial frauds had in the incoming Obama administration.

Chris Martenson: You know my – this makes my blood pressure rise just a little and I can hear in your voice that you care very much about this too. You know, justice and fair play need to return to our system, and I want to talk about this for a minute because it's very important. The potential corrosive impact this has on society. I had a recent interview with Gretchen Morganson and I asked her about accountability because she’s been, obviously, following this very closely as well. And she had this to say. She said, “the idea that forging signatures, that notarizing very important legal documents really improperly in thousands of cases, maybe millions, the idea that this is somehow going to be allowed to go on with just sort of a penalty of some kind, or a fine, and not prosecuted in the criminal courts, I think is amazing. It really is counter to what we’ve all been led to believe was the course of action in such a case. You have many smaller people, smaller mortgage fraudsters who are in jail. I mean we are talking about the people who are straw buyers for home who defrauded banks. They are in jail for a reason because they perpetrated a fraud. These banks, who’s employees were forging signatures should also have been prosecuted with vigor and they were not. They were simply allowed to negotiate their way out of trouble and negotiate their way with shareholder’s money. They are not paying it out of their own executive’s pockets. They are paying it out of the shareholder’s pockets. There really is no accountability here whatsoever.”

So, in your words, why is accountability, or its lack, so important to each of us? I know some people aren’t even paying attention to this particular issue. To me it's incredibly important because I’m detecting, very powerfully, two sets of rules. I just did my taxes so maybe I have a little ire here because if I don’t follow the letter of the law perfectly there’s a little box on my tax document that says if I sign there and I’m signing with knowing material misrepresentations it's a felony, right. I daily face very serious consequences of my own actions at my level but I’m a little guy. Is that an unfair, sort of summary of this that there might be two sets of rules going on here?

Bill Black: Yeah, and it's what people have always warned about in crony capitalism. So there’s a very conservative French economist, long dead. The name’s pronounced something in French like Bastia, that looks like Bastiat in terms of English spelling and pronunciation, who said – and again, I’ll get pretty close to exact, when plunder becomes a way of life a legal system becomes adopted that legalizes and a moral code is adopted that glorifies it. And so that what crony capitalism, when you fully descend into it, and it's clear that the United States has descended into a version of crony capitalism. So let me tie together this accountability point and these warnings. Let me do the 2006 warnings and the reaction of the industry to both the 2004 and 2006 because that portion that you’re talking about, Gretchen is talking about by far the smallest frauds that the lenders engaged in, which is at the foreclosure stage. But well before the foreclosure stage you have a multiple levels of massive fraud that drive the entire global crisis. So in early 2006, the industry, the lending industries, own antifraud experts, a group called MARI, an acronym, M-A-R-I – issue a report that goes in writing to every member of the mortgage banker associations so thousands of entities, everybody involved. And, says first loans where you don’t underwrite are “an open invitation to fraudsters.” Second when we’ve studied them the incidence of fraud is ninety percent, nine zero, so they’re virtually all frauds. Third, these loans deserve the phrase that the industry itself uses to describe them. They are liar’s loans. Fourth, you apparently have forgotten the experience of the early 90s. Remember when I was telling you about 1990, 1991 when these loans caused hundreds of millions of dollars of losses, hundreds is even more quaint, right.

Chris Martenson: Yep.

Bill Black: And, fifth, the federal banking regulatory agencies – remember this is the Bush era. banking regulatory agencies are warning against making these kinds of loans. Okay, so you have all those warnings from the FBI, you have them the industry’s own experts, you have the fact that inherently in economics you will lose money that this creates adverse selection and that no honest lender would do this. What happens? What’s the industry reaction to hearing all this? Between 2003 and 2006, liar’s loans expand over five hundred percent, and this is the perfect natural experiment. You may have heard this stuff, the claims of this community reinvestment act or that was Fannie and Freddie, the affordable housing requirements that drove the crisis. This is the favorite mime. No, nobody ever required any lender to make or any entity to purchase a liars loan. In fact, Fannie and Freddy were not permitted to count liars loans towards their affordable housing goal. So the reason they did massive amounts of these loans was because of the fraud recipe. Remember, grow ready rapidly by making really crappy loans but at a premium yield. And liar’s loans are perfect for that because in the old days the things we used to prosecute people we had actual rules, and they were really simple rules on underwriting. In essence, they could summarize it in this brief statement. One, before you make the loan you have to underwrite. Two, you have to document that the borrower has the ability to repay the loan. And, three, you have to keep a written record of this underwriting.

Now, if you have those three simple rules, which any honest lender would do if regulators never existed, right. They do all three of those things. So it imposes no cost on the honest portion of the industry. You can see there’s a bind if you want to lie, if you want to do liars loans, right, because if you are going to loan to people who make really crappy loans you’re going to put in your files documentation that you knew you were making bad loans that people couldn’t repay. And if you document that you knew that your regulator is likely to say even under the Bush administration, well, maybe you shouldn’t make those loans and maybe it's my job as a regulator to order you to stop them. Also if you put the – if you try to change the paper trail so that the regulators don’t see that, if you either forge documents or destroy documents, well, that is an additional level of fraud that we can prosecute and we can introduce to show what you’re underlying intent was in making these kinds of loans. So that’s really good for establishing a fraud case. But with a liars loan you don’t have to as the lender document any lies on your part, right, because you don’t do any underwriting so you don’t create a paper trail that shows you knew it was a bad loan because the definition of liars loan is you don’t verify. And so it's perfect device for doing a fraud. All right, so that’s one thing we had done. And by the way, that rule change occurred in the savings and loan industry in 1993 under the Clinton administration and that was part of reinventing government. And I was personally there to witness this, the regulatory regulators were instructed that we were to refer to the industry and to think of the industry as our, in quoting, “client.” There’s no more devastating mindset for ruining regulation than to define the industry you’re supposed to regulate as we’re supposed to serve that industry instead.

Okay, so in response to these warnings the industry massively increased liars loans with nobody requiring and indeed, the federal government warning against it even under the Bush administration such that by 2006 one out of every three new home loans was a liar’s loan. And remember they’re ninety percent fraudulent. And we also know that it was overwhelmingly lenders who put the lies in the liar’s loans, and did so by creating those incentive structures to make sure the mortgage bankers and the mortgage brokers would bring them loans consistent with the recipe, incredible numbers, really crappy, and a premium yield. Okay, so back in the day in the savings and loan crisis, as Akerlof and Romer said, the examiners in the field recognize that this was looting and fraud from the beginning. And so the reregulation of the savings and loan industry begins in 1983. Now that’s really important because the deregulations, the big axe, are 1982 and 1983. 1982 by the federal government, the Garn-St. Germain Act, and then 1983 by California and then followed by Texas. What this created was what we call a regulatory race to the bottom or economists call sometimes a competition in laxity, who can have the weakest rules to attract the industry to come because the industry that’s committing fraud really loves weak rules. And, California and Texas “won”, where obviously won should be in quotation marks, this race to the bottom in the savings and loan crisis. And between just those two states, their savings and loans produced two-thirds of total losses for the entire savings and loan debacle. Think of that. Two states that deregulated the most produce two-thirds of the total losses.

 

 

This is the transcript for Bill Black:  Our System is So Flawed That Fraud is Mathematically Guaranteed

Chris Martenson:  Hello and welcome to another www.PeakProsperity.com podcast. I am your host, of course, Chris Martenson. And today, we have the pleasure of speaking with Bill Black, Associate Professor of Economics and Law at the University of Missouri, Kansas City, and a former bank regulator and a central figure in prosecuting – there’s a strange work – the corruption associated with the savings and loan crisis of the late 1980s. He’s since been a prominent voice against financial and political fraud. And in 2005, authored the excellent book, The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. So I’m sure he has a lot to say about our current situation.

I’m really looking forward to Bill helping us understand why there were nearly two thousand convictions resulting from the S&L crisis but hardly any so far from the mortgage fraud and other criminal activity that caused the 2008 near-system collapse, the one that made the scope of the S&L losses look positively quaint in comparison. Bill, I’m so glad you could join us today.

Bill Black:  Thank you.

Chris Martenson:  Well, let’s jump right in. For many today, what they’re experiencing is a crisis in confidence, confidence in our entire system, that it's fair, and fairly regulated and adjudicated. Perhaps even that if you make your financial crime large enough or complex enough or both, that you can get away with it. Perhaps maybe paying a fine that’s a fraction of your illicit gain but never facing criminal charges; at least that’s the common experience today. So let’s begin here. What is the basic definition of fraud, and more specifically, what is the form of fraud that we seem to be enmeshed in today?

Bill Black:  Well, fraud is both a civil wrong and a crime, and what it is is, when I get you to trust me and then I betray your trust in order to steal from you. And as a result, there’s no more effective acid against trust than fraud and, in particular, elite fraud, which causes people to no longer trust folks, economies break down, families break down, political systems break down and such, if you don’t have that kind of trust. So that’s what fraud is.

But what my work focuses on is, well, what kind of frauds are the most devastating? And it turns out that the most kind of problems that we’re seeing, as you said, systemic problems and such, arise when we have, what we call in criminology, control fraud. And control fraud simply means when you have a seemingly legitimate entity and the person who controls it uses it as a weapon to defraud others. And so in the financial sphere, the weapon of choice is accounting, and these losses from these kinds of control frauds exceed the financial losses from all other forms of property crime combined.

Chris Martenson:  All other forms combined – well, I can believe that. I mean, I saw what happened with WorldCom, with Enron; it took down Arthur Anderson, I guess, but most of the people that worked there ended up going to work other places. It's not just the person at the top, the CEO, saying I’m going to really shuffle some deck chairs here and hide what the true state of my operation here is, what my risks are, what my liabilities are, whether I have the assets I claim I have. That requires a willing partner on some level, does it not?

Bill Black:  Well, that’s the thing. If you have this person at the top being a crook, they get to choose their partners. And they get to incentivize their partners. And, as a result, you’re quite right. They’re very good at spreading frauds. And we call those echo epidemics.

So for example, in the current crisis, as with the prior ones, if you’re a lender, there’s an easy recipe for maximizing fake accounting income. And it goes like this. You need four ingredients:

  1. Grow like crazy...
  2. ...by making really, really crappy loans but at a premium yield (yield just means 'interest rate')...
  3. ...while employing extreme leverage, and...
  4. ...while setting aside only the most trivial reserves or allowances for the inevitable losses this kind of behavior produces.

 So George Akerlof and Paul Romer wrote the classic article in economics about this in 1993. And their title really says it all in terms of the dynamic. It's Looting: The Economic Underworld of Bankruptcy for Profit. So again, the idea is, you have a seemingly legitimate entity; the person at the top is looting it. They loot it by destroying it, but they walk away wealthy. Of course, in the modern era, we may bail out the entity. So it may not even fail, in that sense.

But here’s what Akerlof and Romer also said that was so critical as an understanding. They said these four steps, these four ingredients, it is just math. It is – and I’m quoting them now, “a sure thing.” So you’re mathematically guaranteed, if you do these four things, to report not just substantial income, but record levels of income. And that’s when Akerlof and Romer said, now that’s the next thing that comes in that’s really important, and that is modern executive and modern professional compensation.

Because with modern compensation, first at the executive level, the CEO level, I can guarantee with modern executive compensation that if I follow this recipe, I will personally be wealthy almost immediately as the CEO. Because I’ll base my compensation as CEO – and that’s the nice thing about being CEO, you get to make the rules for yourself – you’ll base it on short-term reported income, and you’ll make that compensation extremely large for supposed superlative results, in jargon in the industry, “stretch goals.” So you’re going to say, hey, if I double my income in just a few years, which is what the Fannie Mae goal was, then I get an off-the-charts bonus, huge compensation – except, of course, that goal is easy to meet. You just have to cheat. It is a sure thing.

Chris Martenson:  Now, Bill, is it possible to follow this four-step prescription and remain within the letter of the law?

Bill Black:  No, not within the letter of the law, although it is in places that – it may be – this is the question right now that’s up for grabs – in places where international accounting rules apply. Because under international accounting rules, they’re being interpreted by many folks as saying you are not permitted as a lending institution to establish any meaningful allowances for loan losses now, even though it is absolutely certain that making – you don’t remember what the ingredient is, the first to grow extremely rapidly by making really, really awful loans at a premium yield.

Well, that’s guaranteed to produce massive losses down the road. The international accounting rules – some people are, actually many people, are interpreting as, you are not permitted to establish any reserves. So that could create the perfect crime in Europe in particular.

Chris Martenson:  The perfect crime – now, so even if you stay within these four, though, the parts that get me confused are what happens when, say, your supposed third-part auditing company comes in and performs their yearly due diligence audit and then signs off on the financial statement. So this company then says these have all been fairly represented and the risks have all been adequately explained and we think this company is fairly representing itself. And then surprise, surprise, like Lucy pulling a football away – I mean, we always seem to be surprised when it turns out that there are glaring, overt, gross material misrepresentations of risk, of assets, of liabilities, of all kinds of things. And somehow that happens again, and again, and again.

I’m really interested where the letter of the law is on this. Is there no responsibility here?

Bill Black:  Well, the letter of the law in the United States, under general accepted accounting principles, is that you have to establish the loss reserves now if you make large losses inevitable in the future. So in that if you actually establish the appropriate loss reserves, of course, you would show under this recipe that you are losing money, not making money, and you wouldn’t get any bonus. So under the letter of the law, there’s a fraud in the United States. It turns out there are many frauds in Europe, as well, because people get greedier.

Now, let me approach your more basic question. And your more basic question really has two areas, and that is, so again, why are these control frauds unique? Why are they much more dangerous than regular frauds? And what is this thing that I alluded to, and that is, professional compensations? So that’ll bring in your question about the auditor. So if we back up, what’s special when you have a seemingly legitimate entity and the person at the top of the food chain is the crook? The joke that actually many cultures have, like China, is, of course, the fish rot from the head. And that’s designed to capture precisely this point.

Well, so the big thing is about the seemingly legitimate entity when the CEO is the crook – first, everybody reports to the CEO ultimately, right? So the CEO is the point failure mechanism, where if he or she goes bad, almost everything may go bad as well. So all those things that we call in controls, internal and external controls, all report to the CEO, and the CEO therefore can, as I’ll describe, use compensation, hiring, firing, praise, and such to produce the environment that will commit, create allies for his fraud.

Now, note that what I’m saying. The CEO, the art of this is not to defeat your controls. The elegant solution, as in mathematics, is to suborn the controls and turn them into your most valuable allies. And therefore, for example, when you’re running accounting control fraud, where your weapon of fraud is accounting and that weapon of choice in finance is accounting, you’re going to want to hire the most prestigious accountants as your outside auditors, because it is precisely their reputation that is most valuable when you could suborn them. And, they give you that clean opinion that you just described that will help you deceive other shareholders. So one enormous advantage is internal and external controls come to the CEO level.

A second incredible advantage is the CEO can optimize the firm as a weapon of fraud. And the CEO can do that. Basically, this falls into two big categories. One, you can put it in assets that have no readily verifiable market value, because then it's a lot easier to inflate asset valuations and to hide real losses. And the second thing you do is grow like crazy. And, of course, that is the essence of something your listeners have all heard about, and that is a Ponzi scheme. And so these accounting control frauds give strong Ponzi-scheme like elements, which is why they tend to cause such catastrophic losses.

Chris Martenson:  Well, if the fish rots from the head, then you’re talking about a culture issue. and I’m wondering if the head of the largest fish that we could talk about here is what is substantially different about the type of control fraud you’re talking about that’s happening at the corporate level versus, say, oh, I don’t know. What happens when I examine the federal government’s balance sheet and look at its accrual liabilities expanding by $4-5 trillion dollars per year, once you factor in the actual entitlements and the government’s reporting; its cash balance deficits, which are shocking enough, but on an accrual basis there’s absolutely no possible chance that we can square this circle – Are companies following sort of a – is this – are we talking about American culture now? Is this something that extends really broadly? I’m really confused…

Bill Black:  You know, this is human culture.

Chris Martenson:  Human culture – oh, okay.

Bill Black:  And it is not limited to corporations. We’ve been focusing on corporations, but these frauds occur in the governmental sector, they occur in the non-profit sector, and of course, they occur in combination. And so, crony capitalism is all about the combination of public-sector and private-sector control frauds working together as cronies.

Chris Martenson:  So this is interesting, because what you’re saying is something I believe, which is that human nature does not change. And it's always human nature to try and game the system, get an advantage, have a free lunch, however we want to put that. And so we’re sophisticated enough that we’ve seen these happen often enough that we know what the dynamic is. You’ve just mentioned this paper, these two gentlemen where there’s four steps. We know what these all are. It is my view that we had tighter regulatory structures that were around the concept of saying listen, these things are going to happen. We’re going to put a basket around this as best we can, and then do what we need to do in order to assure that these things do not flourish. Maybe we’ll have prosecutions.

So fast forward, I’m looking at a chart here that shows federal prosecutions for financial fraud are at an all-time low. And my personal perception is that the amount of fraud is probably at an all-time high. They seem potentially correlated, those two pieces of data. Is that true, and how did we get here?

Bill Black:  Well, you have really interesting phraseology. You talked about “we know” and you talked about “we’re more sophisticated.” So this was an important part of, what Akerlof and Romer were talking about in that paper. They chose to include the following paragraph – which I’ll get approximately right from memory – and to make it their last paragraph for emphasis. They said, Look, in the savings and loan crisis, economists and the public had no theory of this kind of fraud, control fraud. And, as a result, they were not in a position to give strong support to the examiners in the field, the regulators, banking regulators, actually saving- and-loan regulators in the field, who recognize from the beginning that this kind of deregulation was bound to create widespread fraud. Now we know better. If we take advantage of this knowledge, we need not repeat this kind of crisis. That was written in 1993.

Chris Martenson:  Right.

Bill Black:  And what happened, of course, is, right around the same time, we did get allegedly more sophisticated, in a small part of “we.” And that small part of “we” dominated and continues to largely dominate policy. And that small portion of “we” had exactly the opposite conclusion on the basis of this alleged sophistication. And they said, and this is Easterbrook and Fischel – so your listeners need to know that George Akerlof goes on to win the Noble Prize in economics in 2001. So we’ve been talking about one of the most prominent economists in the world.

But in the law-of-economics world, a generation of American lawyers has been taught, when they study the economics of corporations, by a treatise writ in 1991by Judge Easterbrook of the seventh circuit and Fischel, who was then professor at the University of Chicago Law School, eventually the dean of the University of Chicago Law School. And Easterbrook and Fischel – and again, I’ll get this virtually word for word – say famously, a rule against fraud is not essential or even particularly important in the securities context.

 Now notice how radical a statement that is. It isn’t that we don’t need laws, that we don’t need prosecutors, that we don’t need FBI agents. U.S. attorneys, those kind of folks – we don’t even need a rule against fraud. We don’t need the ability to bring civil suits. We don’t need the Securities and Exchange Commission. Markets, securities markets, are so efficient that they automatically exclude any meaningful accounting control fraud. And we know that they’re efficient because we’ve hypothesized they’re efficient in a wonderful circularity. This was, of course, the efficient market hypothesis that was the centerpiece of all of modern finance theory. And even the weakest version of efficient market hypothesis requires that there be no systematic errors in pricing, because if there’s any systematic error in pricing, well, then somebody would correct it. They would make money by correcting it. Therefore, financial bubbles are impossible as well. Fraud is impossible.

Now all of this is insane. And indeed, Fischel was the outside expert for three of the most notorious accounting control frauds of the Savings and Loan Debacle era. Lincoln Savings, Michael Milken at Drexel Burnham Lambert, and this incredibly sleazy Florida one, as well, where the headquarters building was shown in Miami Vice, for people who are old enough to know that. And then after he tried his theories in the real world and ended up praising the worst fraud in America, Charles Keating’s Lincoln Savings, as “the best saving and loan in America,” he wrote those words that I’ve just quoted without ever telling the reader, hey, by the way I tried this in the real world and it was the most embarrassing disaster conceivable. So there’s a strong element of intellectual dishonesty as well that went along with all of this.

But anyway, if you believe that fraud’s impossible in the financial sphere, if you believe that markets are inherently efficient and self-correcting, then there’s a clear answer about what you should do about financial regulation. Financial regulation, A, is unnecessary, and, B, is potentially very harmful because it will potentially stop or interfere, at least, with the self-correcting efficient nature of the marketplace. And therefore, you must lead a jihad against regulation if you want the country to prosper, and that’s precisely what these folks did.

Well, okay, now, that’s academics, and, yeah, they’ve trained a generation of lawyers who are now out there in key positions in business and regulation. But surely no one, the adults, right, can’t believe this. But, in fact, they did, and, in particular, Alan Greenspan had this view. So he famously, in his first person-to-person meeting with Brooksley Born, then the new chair of the Commodity Futures Trading Commission (CTFC), invites her over to meet her and says, in the course of the lunch, but of course we’re going to disagree about things. Now, you know, they’ve never had a substantive discussion like this and Brooksley’s wondering what? And he follows up and says because you, for example, believe that fraud provides a basis for regulation, preventing fraud.

Now that’s how extreme – and unfortunately, of course, the most powerful financial regulatory position in the world was held by someone who believed in this insanity. But it gets worse, because Greenspan was also involved, hired by Charles Keating. In fact, Charles Keating hired Greenspan in multiple capacities, and one of those capacities was, as lobbyist, to walk the floors of the Senate to recruit the five senators who would become known as the Keating Five.

When, twenty-five years ago on April 9th, 1987, they intervene on Keating’s behalf, those five senators secretly to try to get us not to take enforcement action against Lincoln Savings, Keating also famously put in writing to our agency that Lincoln Savings should be allowed to do hundreds of millions of dollars of these direct investments, which is what we provide the information to do, and they did, anyway. That was the violation of rules that the senators were trying immunize by their political pressure. Well, Greenspan opined in writing that we should allow it because, and I’m quoting again, Lincoln Savings poses no foreseeable risk of loss. Gosh, he almost got that exactly right, except for the fact that it was the most expensive failure of the entire debacle at $3.4 billion, which, as you say now, sounds quaint, but back in the day used to be considered a substantial amount of money.

Chris Martenson:  Well, if I can turn the phrase around, it looks no bad deed goes unrewarded in this story. And Greenspan is somebody that I’ve been – I wrote about him extensively stretching way back because I really, really disagreed with his understanding of risk. He thought the derivatives markets made risk go away. So since you didn’t have risk anymore you could just let people expand their balance sheets and just go hog wild and use his view of risk as the justification for allowing the Sweeps Program, which allows banks to effectively hold zero reserve requirements against demand deposits, which I thought was a bad idea at the time. At any rate, so he had some failings, this guy.

Bill Black:  But see, this is related.

Chris Martenson:  Okay, tie it in.

Bill Black:  Right. If you believe that fraud is possible, then derivatives are a possible problem. If you believe that fraud is impossible and that these people are sophisticated – remember your sophistication illusion again?

Chris Martenson:  Yep.

Bill Black:  Then it is unambiguous with neoclassical economic theory that the greater the choices the better the results, because people will only make good choices for themselves. And as a result, by definition, the purchaser of the derivative will be the one who finds it most valuable, and since asset valuation and risk are inversely related, it will be the entity that perceived holding that derivative as least risky. In other words, you will get derivatives held by the ideal people for whom they’re in idiosyncratic conditions that reduce the risk of holding that derivative for them. And so you will optimize, throughout the entire financial symptom, the placement of risk in the ideal fashion where the people best situated to have that risk. And not only do you have that advantage, but on top of that, it means you will broadly diversify the risk such that there is very little concentration of risk. And therefore, your entire financial system will systemically be far less risky. So they knew all of those things as soon as they started with the assumption that there couldn’t be any frauds.

Chris Martenson:  Well, if you’re going to risk that on the efficient market hypothesis, there is one other little assumption baked into that, which is that we have even flows of information; there are no information asymmetries. And the very definition of fraud is that it has an asymmetry of information. I can’t square that circle either. There’s an intellectual hole in what you’re describing that’s just gigantic.

Bill Black:  Well, enough to drive the world’s largest financial bubble through, and the greatest epidemic of the elite fraud in the history of the world, yeah. This is what we call – you know, America has just gone through this recognition that it was being scammed by merchants who were secretly adulterating our hamburgers by adding pink slime, right. And pink slime turned out to be added to a level that maxed out at about 15%. And the reason that it was maxed at about 15% is that it tended to smell and taste bad.

But in the financial end, by the way, pink slime starts out with these ultra-fatty tissues, which are much more susceptible inherently to having strong contamination by E. coli, in particular, in sense of other things. So they give it an ammonia bath; they put Mr. Clean in, in gaseous form, to try to reduce how infectious the pink slime is. And it turns out there’s a tradeoff. That’s why it stinks. If you put enough ammonia to really make it close to safe, them it really smells and tastes bad. So they don’t put enough ammonia in to really keep it safe.

So it's also unsafe, but– if you eat a burger you’re not typically going to get sick. In fact, it's quite unusual if you order it [cooked] at least medium. But that’s not true in finance. In finance, it wasn’t a maximum of 15% of some areas were fraudulent. We had whole areas, liars’ loans, where the fraud incidence, when the people measured it, was 90%, nine zero. And we had whole areas like collateralized debt obligations in which the most typical CDO, collateralized debt obligation, was backed overwhelmingly by fraudulent liars’ loans.

Chris Martenson:  And we knew about this at the time. There were open articles about ninja loans, and this was a very open secret, at least it was to me. I was shorting them of this matter of public record. I was shorting a bunch of mortgage insurers, and homebuilders, and what not, all the way down through this piece because it was so obvious to me that this was a problem. And I’m just an outsider, right. I’m just some guy. I read stuff and I understand a few things. But it was so painfully obvious to me that we had this huge, gigantic issue going on, and it was to insiders, too. Michael Lewis in The Big Short details very carefully about how Goldman Sachs with John Paulson went out and handpicked the worst things that were designed to blow up. And then, Goldman Sachs went out and got a so-called “independent” third party’s position saying, hey, this portfolio is randomly selected to succeed when it was actually, I believe, selected to fail. And then misrepresented that to clients and sold these toxic bundles off because needed somebody on the other side of that trade, often maybe a German bank or somebody like that.

So when I look at that, I can’t find a more clear-cut definition of fraud than that. And yet, I’m not aware of any prosecutions or criminal activity that resulted from that. I believe there might have been a fine, but that’s all I can recall at this point. How does that skate through? Did I have the essence of that story right?

Bill Black:  Yes, but it goes farther back, and there’s a more basic economic problem, as well. After all, the defining element about what makes something a liars’ loan is that you don’t do adequate underwriting as a process of evaluating whether you’re going to get repaid when you make a loan. And what are the risks of it, so that you can price, decide whether you should make the loan, and what conditions and at what price you should do that? And because when you don’t do underwriting on this kind of loan, a mortgage loan, you inherently create something that we call “adverse selection.”

So if you thought of running a health insurance company or life insurance company, and you weren’t going to do any evaluation of your customer’s health or their parents’, genetic relatives’ health, you were just going to charge a high price for your insurance to compensate for the risk, which customers would come to you? Well, obviously, only the sickest. It's the same thing. If you couldn’t determine loan quality and you said just charge everybody a high rate of interest as a result, which customers would come to you? Only the worst.

And so in this kind of loans, if you create adverse selection, you create from the lender’s perspective a negative expected value of making a loan. In plain English, that means you will lose money. It's equivalent of betting against the house. And therefore, honest lenders don’t engage in adverse selection. So it's a wonderful natural experiment as to which entities were clearly engaged in fraud, entities making liars’ loans were clearly engaged in fraud, mortgage lenders doing that.

Okay, so we realized this as regulators in 1990 and 1991. Now let me emphasize those dates again, 1990 and 1991. And America being America, liars’ loans being the fraud, began most heavily where all financial frauds tended to develop in America, and that would be Orange County, California. And we were the regional regulators for California, Arizona, and Nevada. And eventually a broader one-third of the United States, that’s the West. So we looked at these and we said this is insane. These liars’ loans are becoming common. They must lead to fraud. In fact, they only make sense from a lender’s perspective if the lender is engaged in accounting control fraud. And so we use normal supervisory means to drive them out of the savings and loan industry.

The leading entity making these liars’ loans also targeted minorities, particularly blacks and Latinos – families who couldn’t speak English as well – blacks because they have fewer connections and few choices in the financial industry. So this is a real pernicious place. It was called Long Beach Savings. And they were one of the entities we cracked down on. So Long Beach Savings voluntarily gave up federal deposit insurance, voluntarily gave up its charter to run a savings and loan, and became a mortgage bank for the sole purpose of escaping our regulatory jurisdiction. And as a mortgage bank, he was subject to no federal regulation in that era other than active discrimination against minorities. Right? This is not a community reinvestment act. This is active; I’m out discriminating against minorities, the truth, the fear of lending laws.

Now, his leading competitor is another entity run by a husband/wife team that we removed and prohibited from the savings and loan industry, the Gen X. To ease this fraud, the head of Long Beach Savings also changes the name of the organization to a mortgage bank and names it Ameriquest. So for people who know this industry, they will now be nodding. So Ameriquest becomes the biggest and the baddest, and as it's going out the door, we make this referral for discrimination. And the Justice Department follows up and finds active discrimination. So that’s their second strike. The first strike that we went after them for the liars’ loans, the second strike is the Justice Department goes after them, and, of course, they make nice-nice, and they promised that they will – they approve things, and, of course, the Justice Department doesn’t bring a criminal action, just a civil action, and gets a settlement.

Then, of course, Ameriquest does absolutely the same thing – targeting blacks, targeting Latinos, outright fraudulent loans, forges people’s signatures, the whole nine yards, just completely out-of-control accounting control fraud, following the recipe that I talked about. And at that juncture, forty-nine state HEs plus the attorney general of the District of Columbia sued them. Why not the fiftieth? Well, because there was Virginia, and at that time Virginia actually had some rules. And so they avoided making mortgages in Virginia. But everybody else sues them, they settle for hundreds of millions of dollars, the biggest settlement of such a kind. Again, no criminal action – whereupon we make the head of Ameriquest our ambassador to the Netherlands.

Why? Well, because, of course, he was the leading campaign contributor to George Bush. Now that’s politics as usual, the same as I know. But if you want, again, the antecedent of this crisis, two entities rush to acquire Ameriquest from our, now-ambassador or now-about-to-be ambassador. Now, again, this place is absolutely notorious. It has a thousand employees, thereabout, who every day go in and, if they’re doing substance, what they do is engage in fraud. And a particularly pernicious fraud, where they look for the most vulnerable people in society to defraud.

And Citicorp and Washington Mutual rushed to acquire its operations. And therefore, we are shocked, shocked, that Citicorp and Washington Mutual made tens of billions – in the case of Washington Mutual, hundreds of billions – actually in the case of both of them, hundreds of billions of dollars of fraudulent loans and loan sales. So yes, that just brought us up into the 1990s and the early 2000s.

So again, we knew in spades, and we not only didn’t bring criminal action, we rewarded the frauds, we left them wealthy, we allowed them to sell. They were treated as respectable by the most elite financial institutions in the world, Citicorp and Washington Mutual being among them. And we discovered our highest honors on the leading frauds. What happens next is by 2004 the FBI warns two things. One, that there is an epidemic of mortgage fraud – epidemic was their word. And two, warns that it will produce a financial crisis – crisis being their word – if it is not checked, 2004.

And here’s a key thing. The FBI person in charge of the effort against mortgage fraud was interviewed by the financial crisis inquiry commission, that inevitable national commission to investigate the causes of this crisis. And he reported that the federal banking regulatory agencies never got in touch with him once, either before or after he made this warning about an epidemic of fraud. Now, can you imagine that? You’re the federal banking regulators, the FBI, publically, and this gets reported all over the place, trade press, general press, says epidemic mortgage fraud is going to cause a financial crisis and nobody in the financial regulatory center says boo and follows up on it in the least.

And here’s a footnote also about the Financial Crisis Inquiry Commission. So Eric Holder, the Attorney General of the United States of America under Obama and therefore the head of the FBI, as well – in other words, the bureau is part of the Justice Department – is called to testify in front of the Financial Crisis Inquiry Commission.

Now, what is the most famous thing the Justice Department/FBI did? Issue this warning in 2004. And Holder’s the head of a huge department filled with incredibly bright people who prep him for a testimony like this so the agency looks good. And so Holder looks good, right? That’s your job, prep the guy so he looks good and doesn’t get embarrassed. And what does the first question have to be out of the Financial Crisis Inquiry Commission? It's got to be, hey, what did you do in response to your own warning? So that is, in fact, the first question asked to Holder.

And Holder, at that point – and Holder is accompanied by his staff and by Lanny Breuer, the head of the criminal division – and his answer is, What warning? I’ve never heard of this. Which means nobody up there is passing the note saying I’ll take this, Eric. There was no answer. None of them had ever heard of the warning. That’s how big a priority elite financial frauds had in the incoming Obama administration.

Chris Martenson:  You know, this makes my blood pressure rise just a little, and I can hear in your voice that you care very much about this, too. Justice and fair play need to return to our system, and I want to talk about this for a minute because it's very important, the potential corrosive impact this has on society. I had a recent interview with Gretchen Morgenson and I asked her about accountability because she’s been obviously following this very closely as well.

And she had this to say. She said, “the idea that forging signatures, that notarizing very important legal documents really improperly in thousands of cases, maybe millions, the idea that this is somehow going to be allowed to go on with just sort of a penalty of some kind, or a fine, and not prosecuted in the criminal courts, I think is amazing. It really is counter to what we’ve all been led to believe was the course of action in such a case. You have many smaller people, smaller mortgage fraudsters who are in jail. I mean we are talking about the people who are straw buyers for home who defrauded banks. They are in jail for a reason because they perpetrated a fraud. These banks whose employees were forging signatures should also have been prosecuted with vigor and they were not. They were simply allowed to negotiate their way out of trouble and negotiate their way with shareholder’s money. They are not paying it out of their own executive’s pockets. They are paying it out of the shareholder’s pockets. There really is no accountability here whatsoever.”

So, in your words, why is accountability, or its lack, so important to each of us? I know some people aren’t even paying attention to this particular issue. To me it's incredibly important because I’m detecting, very powerfully, two sets of rules. I just did my taxes, so maybe I have a little ire here, because if I don’t follow the letter of the law perfectly, there’s a little box on my tax document that says if I sign there and I’m signing with knowing material misrepresentations it's a felony, right? I daily face very serious consequences of my own actions at my level, but I’m a little guy. Is that an unfair sort of summary of this, that there might be two sets of rules going on here?

Bill Black:  Yeah, and it's what people have always warned about in crony capitalism. So there’s a very conservative French economist, long dead. The name’s pronounced something in French like Bastia, that looks like Bastiat in terms of English spelling and pronunciation, who said – and again, I’ll get pretty close to exact – when plunder becomes a way of life, a legal system becomes adopted that legalizes and a moral code is adopted that glorifies it. And so that is what crony capitalism is, when you fully descend into it, and it's clear that the United States has descended into a version of crony capitalism.

So let me tie together this accountability point and these warnings. Let me do the 2006 warnings and the reaction of the industry to both the 2004 and 2006, because that portion that you’re talking about. Gretchen is talking about by far the smallest frauds that the lenders engaged in, which is at the foreclosure stage. But well before the foreclosure stage, you have a multiple levels of massive fraud that drive the entire global crisis. So in early 2006, the industry, the lending industries, own antifraud experts, a group called MARI – an acronym, M-A-R-I – issue a report that goes in writing to every member of the mortgage banker associations, to thousands of entities, everybody involved. And says first loans where you don’t underwrite are “an open invitation to fraudsters.” Second, when we’ve studied them, the incidence of fraud is 90%, nine zero, so they’re virtually all frauds. Third, these loans deserve the phrase that the industry itself uses to describe them. They are liars’ loans. Fourth, you apparently have forgotten the experience of the early 1990s. Remember when I was telling you about 1990-1991 when these loans caused hundreds of millions of dollars of losses – hundreds is even more quaint, right?

Chris Martenson:  Yep.

Bill Black:  And, fifth, the federal banking regulatory agencies – remember, this is the Bush era –banking regulatory agencies are warning against making these kinds of loans. Okay, so you have all those warnings from the FBI, you have them the industry’s own experts, you have the fact that inherently in economics you will lose money that this creates adverse selection and that no honest lender would do this. What happens? What’s the industry reaction to hearing all this?

Between 2003 and 2006, liars’ loans expand over 500% and this is the perfect natural experiment. You may have heard this stuff, the claims of this community reinvestment act or – that was Fannie and Freddie – the affordable housing requirements that drove the crisis. This is the favorite mime. No, nobody ever required any lender to make or any entity to purchase a liars’ loan. In fact, Fannie and Freddie were not permitted to count liars’ loans towards their affordable housing goal. So the reason they did massive amounts of these loans was because of the fraud recipe.

Remember, grow ready rapidly by making really crappy loans, but at a premium yield. And liars’ loans are perfect for that, because in the old days the things we used to prosecute people – we had actual rules, and they were really simple rules on underwriting. In essence, they could summarize it in this brief statement. One, before you make the loan you have to underwrite. Two, you have to document that the borrower has the ability to repay the loan. And, three, you have to keep a written record of this underwriting.

Now, if you have those three simple rules – which any honest lender would do if regulators never existed, right? – they do all three of those things. So it imposes no cost on the honest portion of the industry. You can see there’s a bind if you want to lie, if you want to do liars’ loans right, because if you are going to loan to people who make really crappy loans, you’re going to put in your files documentation that you knew you were making bad loans that people couldn’t repay. And if you document that you knew that, your regulator is likely to say, even under the Bush administration, well, maybe you shouldn’t make those loans and maybe it's my job as a regulator to order you to stop them.

Also if you try to change the paper trail so that the regulators don’t see that, if you either forge documents or destroy documents, well, that is an additional level of fraud that we can prosecute and we can introduce to show what your underlying intent was in making these kinds of loans. So that’s really good for establishing a fraud case. But with a liars’ loan, you don’t have to, as the lender, document any lies on your part, because you don’t do any underwriting so you don’t create a paper trail that shows you knew it was a bad loan. because the definition of liars’ loan is, you don’t verify. And so it's perfect device for doing a fraud.

All right, so that’s one thing we had done. And by the way, that rule change occurred in the savings and loan industry in 1993 under the Clinton administration, and that was part of reinventing government. And I was personally there to witness this; the regulatory regulators were instructed that we were to refer to the industry and to think of the industry as our, in quoting, “client.” There’s no more devastating mindset for ruining regulation than to define the industry you’re supposed to regulate as we’re supposed to serve that industry instead.

Okay, so in response to these warnings, the industry massively increased liars’ loans with nobody requiring, and indeed, the federal government warning against it even under the Bush administration such that by 2006, one out of every three new home loans was a liar’s loan. And remember, they’re 90% fraudulent. And we also know that it was overwhelmingly lenders who put the lies in the liars’ loans, and did so by creating those incentive structures to make sure the mortgage bankers and the mortgage brokers would bring them loans consistent with the recipe, incredible numbers, really crappy, and a premium yield.

Okay, so back in the day in the savings and loan crisis, as Akerlof and Romer said, the examiners in the field recognize that this was looting and fraud from the beginning. And so the reregulation of the savings and loan industry begins in 1983. Now that’s really important, because the deregulations, the big axe, are 1982 and 1983. 1982 by the federal government, the Garn-St. Germain Act, and then 1983 by California, and then followed by Texas. What this created was what we call a “regulatory race to the bottom” or economists call sometimes a “competition in laxity” – who can have the weakest rules to attract the industry to come, because the industry that’s committing fraud really loves weak rules.

And California and Texas “won” – where obviously “won” should be in quotation marks – this race to the bottom in the savings and loan crisis. And between just those two states, their savings and loans produced two-thirds of total losses for the entire savings and loan debacle. Think of that. Two states that deregulated the most produce two-thirds of the total losses.

Transcript for Khosla Ventures: The US is Massively Underfunding the Innovations Critical to Its Energy Future

This is the transcript for the podcast Khosla Ventures: The US is Massively Underfunding the Innovations Critical to Its Energy Future.

Chris Martenson:  Welcome to another PeakProsperity.com podcast. I am your host, of course -- Chris Martenson. Today we are going to look at where we are in the energy story. It is clear that the age of cheap and easy oil is over. This represents a monumental change into the operating practices of the world, a predicament, really, that is almost certain to prove disruptive and therefore will require our very best efforts. Yet, when we scan the political priorities and note that the Department of Energy is only 8% of the total budgetary pie, and then within that budget, what we might term alternative energy funding, such as for solar and wind, are each commanding less than 0.1% of total budgetary pie, well, it becomes clear the transitioning to non-fossil fuel future is simply not a federal priority at this time. 

So, if our nation only has one plan, let’s call that Plan A, and that is nothing more exciting than a perpetuation of the status quo. That leaves the job of finding the promising technologies, and funding them through implementation and marketed option, largely up to the private sector. This is an extremely important discussion to have. The good news is that today we are joined by Andrew Chung, partner at Khosla Ventures, one of the best known venture capital firms in the world and arguably the most knowledgeable about next-generation energy projects. Andrew and I will be talking about world energy supply outlook and the role technology will play in meeting our ever-rising global demand for energy. We will talk about which technologies hold the most promise, what we can expect from them, , perhaps more importantly, what we can’t. Andrew, it is a real pleasure to have you as our guest today.       

Andrew Chung:  Thanks for having me, Chris.

Chris Martenson:  Let’s start at a high level. At our site, we look closely at the energy data ,and it seems increasingly clear that the age of cheap oil is over. Does Khosla have the same view?

Andrew Chung:  Yeah. I believe that you are right. I think that the scarcity of oil, hitting Peak Oil, the increasing cost of being able to extract and discover new oil deposits, is making it more and more costly. And importantly, the demand for energy and oil is going up dramatically with a lot of the emerging countries like China and India, just exploding in the demand as the countries develop into more urban economies. If you look at the demand for electricity and energy in China, that has gone up tenfold over a period of about 15-20 years. India has gone up about fivefold, whereas the U.S. has only doubled in that period of time. So, you can see that with these emerging economies being very aggressive in their domestic growth the demand for oil,  the demand for electricity is just going to go up dramatically and that is going to make the cost of oil at a minimum, stable, if not going up over time.

Chris Martenson:  Yeah. I think we can almost stop calling them "emerging" economies. China has certainly in the last ten years come on [like] gangbusters, and is now in either the first or second or third position for a lot of things. First for coal, coming rapidly second on oil, and certainly consuming energy. The numbers you have just mentioned are really startling. A tenfold increase? That is astounding. 

Andrew Chung:  Absolutely.

Chris Martenson:  To even say the U.S. has only doubled in that same period, it is still a doubling. So, let’s talk [about] these big numbers for a minute. The U.S. consumes roughly 18 million barrels per day of petroleum, and that pencils out to about 100 trillion BTUs a day. Obviously a big number. With coal and natural gas included, about 80 quadrillion BTUs of fossil fuels are consumed in the U.S. each year. So, what if we said we wanted double that, even over the next 10, 15, or 20 years, from 80-160 quadrillion BTUs. I want to talk for a second here. What is it really going to take to make meaningful dent in those kinds of numbers? These are extraordinarily huge numbers. I have a very hard time conceptualizing them. Where does alternative energy play a role in here? What does the energy landscape look like to you as you look at it through the investors’ eyes?

Andrew Chung:  Absolutely. Well, I think it is going to be a portfolio solution. I think most people do not realize that alternative energy today is still only a very tiny percentage of the overall energy usage and output. Solar is less than 1% of overall electricity output out there. Even if you add in geothermal or hydroelectric power and so forth, nuclear, you are talking about a 4 or 5% share of the overall energy pie that is made up by alternative energy. So, there is a significant, massive upside opportunity across all of these sectors. When you say alternative energy, it’s a very, very broad umbrella, even though it is still a small piece of the overall pie today. Most people talk about solar and wind, but there are a lot of different techniques and certainly in the biofuel area, in the storage area. Energy efficiency is a very important area that we need to consider. Geothermal. Very broad portfolio solutions will be required in order for us to be able to really leverage alternative energy as the way to double that type of output, or quadruple or even more than that over time.

Chris Martenson:  So, really broad portfolio meaning there are going to be lots of different technologies. Are these going to have to compete with each other? Are they going to have to interact? I mean, are we waiting for a VHS Betamax sort of award to settle out before we can figure out which system we are going to go with? How does this portfolio come together?     

Andrew Chung:  Yeah. I think that is the beauty of this sector, that even if you look at one very specific sector like solar or biofield, there is room for many, many winners in the area. Khosla Ventures in the biofield area has invested in over ten different companies that are all trying to tackle the problem of replacing existing oil and hydrocarbon infrastructure with an alternative and sustainable one. It is our fundamental belief that all of them could be wildly successful and still be scratching the surface on the overall market. The same could be said for solar, wind, storage, other types of generation, energy efficiency, and so forth. So I think in each of these sectors, there is room for multiple winners. Then, as you look at solar versus wind or wind versus nuclear versus geothermal, there are different geographies, different situations, different political systems where one might be more interesting than the other, but certainly all can live in harmony and contribute to the overall solution. 

Chris Martenson:  So, in this overall solution, this is something I guess that you just mentioned, some of the complexities involved. So obviously, solar is a little bit site dependent; so is wind. There are geographical differences, political differences. So, we are really looking at an energy future that in many ways sounds more complex to me than the one we are currently inhabiting.

Andrew Chung:  Yes and no. I think it is complex in the sense that there might be many more sources of generation, but many of the technologies that we are looking at today are trying to help simplify that. So, whereas, today’s energy infrastructure in the U.S. is probably 40 or 50 years old and is used to a very select viewed sources of energy. Coal-fired plants being one of the most obvious; nuclear and other natural gas plants and so forth. In the new world that we are trying to invest in and aspire towards, different smart-grid technologies, grid-scale energy storage. Other types of techniques on a software side will make all of these different sources of energy look the same. It will be a matter of software and storage appliances that will regulate when these sources of generation are going to come onto the grid and when consumers like us are going to take it and actually utilize it. So, I think depending on how some of that infrastructure develops over time, you might find that in a 10 or 15-year period, it is actually much simpler to dispatch and utilize energy than the kludgy way that we do it today.   

Chris Martenson:  Interesting. So, could you summarize a big trend in that for us? Is there going to be more centralization or more decentralization of power as we go forward?

Andrew Chung:  I think there is going to be increasing decentralization. So these are rough numbers. But if you looked at the energy infrastructure, say, 20 years ago, there might have been tens of thousands of generation points around the country. As you look at it today, it is probably maybe a couple of hundred thousand points of generation. But with every solar panel that goes up, every small-scale wind turbine that goes up, and every farm that is launched, you are increasing that number of generation points by orders of magnitude. Such that in a ten-year period, you might have tens of millions of different generation points that are all above the nominal scale that are all trying to contribute energy to the grid. So, that rationalization that I was talking about over the next ten years is going to be in some sense a software and storage layer that goes in between the generation sources and consumers like you and me that will be able to manage this type of decentralization and hopefully make the grid much more efficient and much more effective in delivering energy to each of us.

Chris Martenson:  Interesting. So can you help tease apart for us the difference between efficiency, then, and conservation? They sometimes get a little bit conflated, I see, in some of the things I read. If we just get a efficiency alone, I think somebody way back in 1800s, named Jevons, pointed out that there is a paradox in just becoming efficient. Sometimes efficiency leads to greater energy use, paradoxically, and there it is. So, Khosla is working on both things that can promote this efficiency, the efficient use of existing resources, and as well in conservation? 

Andrew Chung:  Yes. So, I would say that conservation is more of a behavioral change. That is convincing whether it is an individual or a local government to compel people to reduce the usage of energy. Right. So, instead of turning on the heat at night, I am going to have my kids put blankets on and save that energy. Right, so it is a saving mechanism. It is a behavioral change. Efficiency, I think, is a super-set of that. Efficiency can include different techniques, like what the OPower folks are doing to compel folks to compete with one another to reduce their electricity bill and drive towards conservation. It can also be something that does not require any behavioral change at all. If you look at the existing infrastructure for generating energy, there are a lot of inefficiencies in place. 

If you are talking about a coal-fired plant, an efficiency technology could be something that makes a coal fire plant run more efficiently such that for every unit of coal that comes in, you are either releasing less carbon dioxide or other types of greenhouse gases, or you are able to generate more energy per unit asset that you have. Another source of efficiency can be the redirection of power. So, for example, right now in this aged infrastructure that we have, we often don’t do a great job of matching supply with demand. So, some customers in certain areas might be using more electricity. Because we do not have house-to-house level of granularity and understanding realtime what is happening on the grid, we do not necessarily dispatch energy to the right places at exactly the right time. So, there is electricity, if you will, that is left on the table. 

Another inefficiency is related during the times of peak power. We have these generators that sit on standby and wait for the days where there is a major heat wave, everyone has their air conditioner tuned on, and this big monolithic plant spins up for three days in a year to supply the energy for the households during that day. It is a very inefficient use of a plant. It is also a very inefficient use of energy that might be created at night three days before that you could have stored and dispatched at the times where there was that type of heat. So, I think efficiency if a very broad term that comprises many things that include conservation. But there is just a lot of different ways to redirect the electrons that are being created by today’s infrastructure in a more efficient way and reduce the waste. 

Chris Martenson:  So, I am going to assume that we can peer into our system and say there is some bloat – there is some low-hanging fruit for us to capture here. Noting the difference in energy consumption patterns between the U.S. per capita and other nations, it feels like there is a little wiggle room in there, maybe, too; no behavioral changes required, I would suggest, and we can still find some pretty substantial gains there?

Andrew Chung:  Absolutely. Absolutely. Again, we are looking at an energy infrastructure that is 40-50 years old. If you have ever been to an actual power plant or looked at the inside of a transformer substation, it is a spaghetti of wires that was designed in an era where we don’t have the computing capability and the circuitry and so forth that we have today. So, a lot of the initiatives right now are really around making the software on the backside much more up to date. The sensing capability, like the smart grid and smart meters that you would have at your home up to date, and then adding additional infrastructure like storage capability that did not exist in a cost-effective form 10 or 15 years ago, or even, frankly, two years ago. So, there is a lot of opportunity over time to upgrade that infrastructure in a massive way to make more efficient use of the energy generation that we have right now.

Chris Martenson:  Excellent. So, let me focus this down just a little bit. I want to talk about transportation because when we talk about Peak Oil, we are actually talking about a liquid fuels emergency, not an energy emergency of any form. I think there is still lots of energy out there, but liquid fuels, another story. I think we have enough experience under our belts to look at corn-based ethanol and say, well, that was a boondoggle. Let’s toss that one out. But there would certainly have to be other ways of coming up with liquid fuels we need. Right now, we know that 95% of everything that goes from point A to point B does so because of petroleum-based liquid fuels. Where is Khosla playing in this field? How do we make a meaningful dent in that 95% figure of transporting things because of petroleum?

Andrew Chung:  Absolutely. One of the hallmarks of our portfolio is a very broad investment across a number of different technologies that can be replacement fuels and chemicals for today’s market and, importantly, ones that can be done in a cost effective fashion. So, one of the companies that I am on the board of is a company called LanzaTech. This was a technology that was developed in New Zealand a number of years ago by a group of scientists. Essentially, it is a synthetic biology platform that enables once-convert waste gas into fuel and chemical alternatives. So, if you can, imagine any plant that has a smoke stack on it. So, if I am at a steel mill and I am manufacturing steel, I am producing a significant amount of carbon monoxide that comes out of the smoke stacks of the plant. Today, that gas is just released into the atmosphere. Tomorrow, with LanzaTech’s technology, what we believe we will be able to do is to take that waste gas, take that carbon monoxide, and use that as food for microorganisms that we have discovered that can take that waste gas and in their biology convert that into different types of chemicals and fuel output. So, if you can imagine, not only are you addressing a major waste issue in terms of greenhouse gases that are being spewed into the air, but you are creating a sustainable, reproducible way and a very cost-effective way to produce high-value chemicals and fuel alternatives on the backside. So, that is an example of a type of technology that we are investing it. We are leveraging synthetic biology and other types of chemical techniques to create a replaceable fuel and a replaceable chemical that can be used across other types of markets.

Chris Martenson:  Now this technology you are talking about, is this at the pilot or demonstration phase yet? 

Andrew Chung:  It is, actually. They have a pilot that has been running for a number of years in New Zealand, which was the basis for the next phase of commercialization. They have eight Fortune 500 companies that are in various stages of agreements with them to commercialize the technology, one of the examples being the largest steel manufacturer in China, Baosteel, which has entered into a joint venture with them to commercialize the technology. So, if you think about it from there prospective, it is a very difficult process for them to continue growing as number one, when the Chinese government is giving them pressure on the amount of waste gas that they are releasing into the atmosphere. With LanzaTech’s technology, what they are able to do now is to address that waste problem. 

Then, as an interesting byproduct of it, also create an economically valuable product on the backside. So, they were the first company to really get excited about what LanzaTech was doing. If you think about a large multi-billion-dollar corporation, the largest steel manufacturer in China, taking a bet on a mid-stage startup based in New Zealand. You can see why the technology is very important to them and why they think that it is very economically profitable for them to invest in technology like this. So, down the road, what is going to happen with them is they will essentially fund the development of various plants that we would come up on this and we would snap onto their existing steel manufacturing facilities. The groundbreaking for the first commercial pilot was several months back and we are hoping to produce a product for them over the course of 2012. 

Chris Martenson:  So, in some part of this story, then the Chinese government is supporting or propelling the adoption of this technology?

Andrew Chung:  Well, that is separate conversation altogether. We should spend some time talking about that. In this case, without revealing too much because it is a private company, the Chinese government has in many of these types of joint ventures, they definitely have a hand in approving and supporting the development of these types of technologies. In this specific case, Baosteel, which is a large, obviously a large enterprise within, they would be funding a significant portion of this from their balance sheet.

Chris Martenson:  What I am really sort of sideways getting myself into in this conversation is that through the lens I look at, where I see energy, and particularly the efficient and effective use of energy, is going to be a real determinant between winners and losers across the globe landscape. I noted that China made, at the national level, made the decision that they were going to become number one in green energy technologies, alternative energy technologies. They have been obviously scouring the globe with their magic checkbook for oil supplies. They seem to be, I am getting at, very focused on the energy story in ways that both promote access to resources, technology, whatever they need to do; they are on the game. I am contrasting that with what appears to me to be a slightly less energetic response on the part of the U.S. government in that front, where I think we are taking a more hands-off, let-the-market-figure-it-out approach.Do you think that "the market" – I am putting air quotes around "the market" – can "the market" respond in time to the challenges of more expensive oil, noting that, and historically speaking, all energy transitions have taken, through market forces, have taken 40-60 years? Do we have 40-60 years in this story?  

Andrew Chung:  I think with the market by itself, it is going to be difficult for the market to solve the problem alone without government intervention and capital dollars, just because of the massive scale of the problem. If you look at manufacturing, whether it is solar panels, or producing biofuel, manufacturing LEDs, I mean, these are all large manufacturing businesses that if you want to even scratch the surface on the amount of energy that we need, fuel that we need, it requires substantial, substantial investments. 

One of the issues with relying solely on private capital to fund these exercises is that you have multiple values of gas, if you will, for these companies. We are talking about fundamental science here. LanzaTech is a company that is developing some interesting science such that they are going to be the only ones in the world to do what they do. It is not a commodity process. It is a commodity product, ultimately, but not a commodity scientific process. So, for them, they have required significant funding to be able to get to this stage. Over time, luckily, they have been able to do it with relatively low reliance on public capital. Many of their counterparts, however, have not been able to say the same thing. There are companies that will reach a certain stage where they need to get a loan guaranty or a subsidy or some sort of support in order to build their first pilot plant. In other cases, once they get to a full pilot plant, if they are not able to get the funding from the private sources, a loan guaranty or other type of full-commercialization planned support just could make a major difference in whether or not a company could prove whether their technology is going to work at scale or not, before they tap into say the public markets to go IPO or to get strategically involved as well. So, I think the government can play a very important role in the commercialization of these very complicated, very difficult technologies. 

When you are talking about the scales that you need to reach in order to make a real difference, again, source of capital can really help here. I think the government needs to really help support and foster these types of technologies so that promising entrepreneurs and promising startups don’t get lost in a capital, private-capital-unfriendly environment today. China, as you mentioned, is really trying to lead the way here, in a very aggressive way. They already are number one today in terms of the amount of capital that they are committing to alternative energy sources, electricity production, and fuels production. In their most recent announcement on their next five-year plan, they are essentially pledging 80 billion every year for the next ten years to help support the development and commercialization of alternative technologies and cleantech. That is a massive number, 800 billion, that is being committed over a period of a decade to do this. 

If you kind of look back at what we were doing in Washington just several years ago with the stimulus package, there was a lot of excitement and strain and stress about putting several tens of billions into the stimulus package for various types of renewable energy, energy infrastructure improvement. Today, some of that money has gone out; some of it may not get fully deployed. Then with a lot of negativity in the press today, a lot of the folks in Washington are actually pulling back a bit in terms of their support of the clean technology ecosystem. So, if you think about us putting the brakes on a relatively modest level of investment in clean technology and you compare that to what China is doing and other countries are doing, there are a number of countries in Europe, for example, that are investing a significant amount per capita in clean technology, it just puts us at a disadvantage relative to the long-term viability of scaling up alternative technologies in the U.S.

Chris Martenson: ,Well, if this energy predicament at the scale we are talking about is truly as monumental as most people think, incremental efforts are probably not going to win the day. It is not just public money that I am talking about. I was at a conference recently where this gentleman had this big long map; it took a whole table to unroll it. He was showing where his company was working hard to try and string a new power line from a power source to the markets. He had two lines on that map. One was a very direct line. He said, “That is our preferred route.” Then, here was the one that they had to come up with given all the nimbyism and the re-routes they had to do to avoid this and that. The other line was this big long sort of spaghetti. It was 150 miles longer than it needed to be and it has transmission losses. When I asked him about it, he said, “That is just the reality. It is going to take years to get this thing sited.” He said, “Just thank goodness we don’t have to cross state lines with this thing, because then we have a whole other state that we have to work with.” So, I hear people say, well we will just cover a portion of Arizona with solar panels and there you go. Like well, not unless you can string a line from Arizona to New York City, you are going to have trouble with that idea. So, there is also the idea that the regulations involved need to be sort of re-examined in light of where we are in this story, I would think. But as far as I can tell, we are having incremental efforts at those discussions so far. 

Andrew Chung:  Right. Right. I would agree with that. 

Chris Martenson:  So, do you see a period, then, for which it is possible that we might actually have less energy production than we want to grow in the way that we have been accustomed to growing? Is there a possibility of a shortfall in this story?   

Andrew Chung:  Well, I think that it is possible, although there is a fair bit of idle capacity, again, sitting out there in the form of peaker plants and other types of capacity out there that might not be fully utilized. I think that at least in the short-term, we should be okay there. There is a lot of investment into traditional forms of energy production in the U.S. So, I am not sure that that would be the issue that I am worried about. I think it is more around the balance of how quickly we are scaling up alternative energy options, and if we were reliant on that to meet the type of demand that we are looking at, then we probably would have a shortfall relative to the demand over time. So, one of the things that I think is very important for policy makers and everyone to realize is that with a lot of the more experimental or earlier-stage technologies, those need to get the right type of funding to continue to develop. If the ones that are ready for primetime, again from a policy and investment prospective, the more that the government and other large corporations and strategics can help in the development and commercialization process, the better.

Chris Martenson:  So, let me ask this: I know that in Europe they have had some experience with a lot of alternative energy platforms. They have decided that, particularly in the UK, they came to the conclusion that it is a lot more expensive. I believe that electricity rates in the UK are going to have to go up a lot to fund their prior alternative, particularly wind investments. Is that the case that, on a pure dollar basis, alternative energy right now is more expensive than fossil fuels? I know there are other reasons that we would invest for national security. It gives it us extra resiliency because we have additional nodes of generation. There are a lot of other high-value reasons. But on a pure dollar basis, is there still a barrier here?

Andrew Chung:  I think that there is – that answer is that it depends. It really depends on the geography you are talking about. It depends on the local energy production capability in the geographies you are talking about and the different rates and usage and so forth. So, for example, for all of the discussion around solar being the most expensive renewable alternative, there are a number of locations in the U.S. today where solar is at grid parity or better and is already a good option. It is more of an issue of whether you can get enough panels or enough developers to meet the demand there. I think on the wind side, of course, the low price of natural gas, of course, affects wind deployment, besides the NIMBY piece. Right? But, there are definitely locations in the U.S., again, where wind makes a lot of economic sense, and it should be deployed more aggressively. I think what is more important to look at is what the cost change over time will be. So, for example, a solar cell cost 100 times more to make 30 years ago than it does now. 

It has been following a very predictable cost-reduction curve over the last three decades. So, the folks who are listening from Silicon Valley, you know about Moore’s law, which talks about how the performance of semiconductors and transistor chips and so forth have been improving dramatically in a very predictable form over time. There is a similar type of law in solar. There is a similar type of law in LED manufacturing and a lot of these other sectors that we have invested in clean technology. So we are very close to a point where over the next three to five years the cost of the solar panel and actually installing it is going to reach grid parity, which I think is a very exciting notion for a lot of folks who are both investing in the market and staring companies in this face. So, that I think is a very important point that this is a very predictable technology-based improvement in cost over time. 

LEDs are another great example here, where if we were talking about replacing all incandescent lighting with LED lights ten years ago, folks would be thinking that it is crazy. People are not going to pay ten or 20 times more for a light bulb and plan ahead for the type of efficiency gains that you can have over time. But again, LED lights have been following a very predictable cost-reduction curve. In this case, it's cost per lumen of light output. That has been following a very straightforward law, Hysys law, for many years. So, as we look at the next five to ten years, will there by a point where LED lighting is going to be economically far cheaper than incandescent relative to the efficiency? Absolutely. So, I think that it is hard to look at this as a static question because of how much technology is changing the economics in many of these fields. And again, we are seeing it across all of these sectors, whether it is solar or energy storage or even when, which is very mature, LED lighting, certainly the fuels and chemicals side. So, from an economic standpoint, I am very excited standing here looking at what is going to happen in the next two to five to ten years across all of these sectors on the economics. 

Chris Martenson:  I am excited as well. I am also mystified, and part of my mystery stems from having installed solar thermal panels on my roof. I live in Massachusetts. It is not one of the most ideal solar areas of the world; however, these panels have managed to cut my oil use, because I have an oil-based hot water heater and furnace, and so it cut my oil use by about half, just on a pure economic basis, nothing sexy about this technology, 1970s right? There is a circulating pump, and there are some boxes that hold some tubes. That is it. This make perfect economic sense regardless of whether I believe in Peak Oil or whether energy prices are going to become an increasing proportion of my disposable income. Leaving all of that aside, I can just put this on a spreadsheet that requires about 30 cells to calculate and say this is a good idea. Yet I am a very unusual person in my neighborhood, because hardly anybody has these. So, the question becomes.

Andrew Chung:  You also write books on this stuff.  

Chris Martenson:  Yeah, I know, but if something makes economic sense and it is existing technology, the question is then one of adoption, rather than one of it making sense. How do we move to adoption in this story?

Andrew Chung:  Well, I think – you’re right. Right now, again, going back to the LED case, it is a very complicated value proposition in that the consumer has to figure out. The very basic idea that an LED light bulb is going to last ten times longer than your incandescent and so you should be, rationally speaking, you should be willing to pay ten times more for LED light bulbs than an incandescent, people cannot even do that simple calculation and make that type of investment. A similar thing happened with complex fluorescents and so forth.

What is going to need to happen in these sectors is that there can’t be a complex calculation. There can’t be a behavioral change in order to get the consumer to do something. So, when I say that over the next three to five years an LED light bulb could potentially approach the cost of an incandescent light bulb, that is what is going to be needed for it to be an automatic purchase. No spreadsheets needed.  No forethought needed. I mean, it is a similar type of thing with solar. Right? If you look at how much solar has come down in cost just in the last five years, and now some of it is a bit unnatural because of the Chinese competition and so forth. But we will say five to ten years, you look at the amount of cost reduction has happened with solar panels. There is going to be a point in time in the very near future where it is not going to be a matter of a spreadsheet calculation anymore. It is going to be a no-brainer because of the cost of putting a solar panel up on your roof and the type of return payback, it is going to be a lot better and a lot faster. So it becomes no-brainer decision as opposed to one that requires a lot of selling, a lot of spreadsheets, a lot of analysis. Consumers just aren’t going to view that kind of thing, as we have seen, most notably in the lighting segment.

Chris Martenson:  Well, absolutely. So, let’s fast forward then and let’s again just focus down on liquid fuels. This is where I want to talk about what technology really can and can’t do. One of the things that I argue towards is that people should hold in their mind the possibility that the ways in which we have been using energy can’t be sustained and that changes are going to result from that. If we choose not to look at these changes before they arrive, we might experience them as disruptive. They don’t have to be, but they might be. So, here I am looking at our 18 million barrels per day of petroleum usage and noting that our domestic production is about a third of that. So, as I look into that, of all the possible biofuels that I have looked at, the algae-based ones, it’s a thermal depolymerization process where...

Andrew Chung:  Oh, okay. Yep, yep. I mean there is basically thermochemical processes. There is biochemical processes, and your standard fermentation process. There is a pretty broad range of ways to do it. 

Chris Martenson:  Exactly. So, out of all of these ways, the number of these that are actually producing, let’s pick a number, 10,000 barrels per day out of a given process, I don’t know if I can point to a single one at this stage. So, here’s what I want to talk about. What is really going to be involved if we were sort of imagining for ourselves we are going to have a disruption-free future, meaning gasoline or some equivalent that we drive up to a station, pull out a handle, use our credit card, it goes into our tank in whatever quantity we want at a price that is reasonable? What stands between us today and that future where say half of that is coming from an alternative biofuels or whatever fuels process we are using that is not petroleum-based? How big of a gap is that?

Andrew Chung:  I think it is a big gap until we have a sufficient amount of project funding, corporate funding, as well as government funding to make some of that a reality. So, the optimism that I have is that there are a number of technologies that I believe can be commercialized in that regard.  With Khosla Ventures, we have had three companies that have gone public in the last 18 months and we believe each have a very strong shot of being able to accomplish that. Other companies have also been successful in going public. In many of those cases, they will be able to show a commercial plant that can produce the type of volumes that you are talking about and show the type of economic value proposition such that it becomes a high return type of project such that other markets will be willing to invest. We need to get there. 

I mean, there is no question that this is a long journey. We are talking about impacting this in 2030, not in 2013. So, we need to be able to show success stories across these industries. Some of these companies that are at the forefront right now that have gone public, they need to be able to show this at full commercial scale and be able to show the economics, which we believe many of them will. The new emerging technologies need to structure the right type of partnerships such that the moment that they show it, whether it’s at a pilot scale or a commercial pilot or a full commercial scale, the next plug of capital is there ready to fund the next stage. So again, you are going back to LanzaTech as an example. We have partnership opportunities with eight Fortune 500 companies that have massive, massive balance sheets. So, for them as they show this, for example, with Baosteel; if they are able to show this functioning at a commercial level and Baosteel decides to take the plunge and build the next plant, we believe that others will follow very quickly. Because this is such a strong need, the level of disruption for some of these technologies is so massive that it really helps the partners achieve something that you might not otherwise be able to achieve. So, I think in order to bridge the gap, as you pointed out, it needs to be very disruptive technology. 

It needs to have partners that are interested in taking the technology risk because it addresses a problem that they cannot solve. So whether it is, in LanzaTech’s case, being able to do something with waste gases and eliminate smoke stacks and many of the other cases, whether it is an Amyris or Solazyme or an LS9, where you are able to create synthetically types of chemical or fuels options that a company can’t do on their own, these are very, very high-valued disruptive technologies. Again, if you are the only one that can do it in a specific way, then you are going to be able to get balance sheets and corporations to work with you to try to commercialize them. So, that I think is what is the next phase of biofuel and biochemical development is going to be, which is being able to create a product that is so interesting to these corporates that they are willing to put up balance sheet money and help you bring on other sources of funding whether it is project finance money or government funded in order to fully commercialize. But make no mistake; it is not a two-year effort. It is going to be more like a ten-plus-year effort where these technologies get proven at this commercial scale and then get replicated again, and again, and again in order to meet your goal.

Chris Martenson:  Excellent. I love hearing that companies are coming to the table around this, particularly anything that can take what was formerly a waste product and say, wow, there is value in this, and we can actually use this. That’s an incredible thing and a good thing. So, as we wrap up here, what I am hearing you say is that there is interest. There is funding in this area. As you look in the future given the enormity of the scales involved, would it be fair to say you think that this is an area where a lot more capital is going to have to come towards? A lot more interest, whether that is public or private, in some way or another, this is an area of growth as it were?

Andrew Chung:  I think it is going to be an area of massive growth, Chris. I think that we are in the second inning of an extra-inning game. I think we just had the first crop of companies from a venture-backed model successfully go public. I think that there are many, many in the hopper. Khosla Ventures by itself has 60 different clean technologies in its portfolio that we are really excited about. I think in each one of these cases, in Khosla Ventures case, we are betting on technologies that transform the paradigm of a given industry. So, if successful, we do think that it can really change the balance of energy and fuel production and we are very excited. 

I think that one of the – in inning number 2 and 3, what folks are realizing is not only do have to invest in interesting technologies, but you need to invest in ones that can be scaled up in an as capital-deficient and capital-flexible way as you can. So, in many of our more recent investments in the cleantech area, we have had examples where we were able to raise one-tenth of the capital of competitors in order to reach a similar point. So, a lot of money does need to continue going into the space. But from the investor perspective, both financial investor and corporate investor, you need to look for technologies that can be scaled up in a more efficient way, ones that can leverage existing manufacturing infrastructure and ones that are so disruptive that other folks are willing to use their balance sheets to help fund plant development.   So, I do think that a lot of money will continue to come into the area, especially as more and more success stories emerge. We are hopeful that Khosla Ventures will be at the center of all of it.

Chris Martenson:  This is an excellent place to close. We have a lot of people who look at this story of change that is coming, look at the rising energy costs, and I think rightfully note that there are certain sectors and segments of society where jobs are going to become more difficult. This isn’t one of them. This is an area where if I had a child who was thinking about going into a field, I would somehow want them to be getting into this field of energy, whether it is through the efficiency side, the engineering side, the implementation side, the maintenance side. There are so many different ways around this, but it is absolutely a shifting area that we can’t ignore. You can’t possibly function as a society without good high quality energy at your fingertips. As the old models sort of fall away, the new ones are going to rise up. That is the opportunity. And of course, we have challenges on the other side. 

Andrew Chung:  Absolutely.

Chris Martenson:  All right. Well, Andrew, thank you so much for your time today. It is really exciting stuff you guys have going on there. If people want to find out more about what you are up to, can you direct them to your website where I have found you have some really nice presentations that people can look at too.  

Andrew Chung:  Absolutely. It is www.khoslaventures.com.

Chris Martenson:  Excellent. If you cruise over to the presentations, there are PDFs and videos and stuff there that really talk about, in much greater detail, in some cases, around what the specific opportunities that are being chased and what the portfolio looks like. Really good stuff.

Andrew Chung:  Great. Thank you, Chris.  

Chris Martenson:  Thank you, Andrew. 

Transcript for Charles Biderman

This is the transcript for the podcast Charles Biderman: The Problem with Rigged Markets

Chris Martenson: Welcome to another Chris Martenson.com podcast. I am your host of course, Chris Martenson. The issue before us as investors are as daunting today as they can possibly be. And my position has been that today, we are all speculators, not investors. Because we have been placed in the uncomfortable position of trying to guess what the Central Banks are going to do next. Also weighing on investors today is the fact that our official data is what I call fuzzy. That is, it is often statistically massaged to make things look a little bit rosier than they otherwise might. To help us sort through both of these investment challenges, is Charles Biderman, Founder and Chief Executive Officer of TrimTabs Investment Research, an independent investment research firm based in Sausalito, California. He is routinely interviewed on all the big financial media, and is someone I follow quite closely because his approach is to follow the base data and let that tell the story. Founded in 1990, TrimTabs Investment Research is the leading independent institutional research firm, focused on the supply and demand of shares and stock and money available for investment, that base data, I really want to get to that today. Welcome Charles, it is a real pleasure to have you as a guest today.

Charles Biderman: Well, good to be with you.

Chris Martenson: Thanks. Hey let us begin with your background so the people can appreciate first the depth of your knowledge and experience, and then why it is, that you follow the fundamental data sources that you do.

Charles Biderman: You mean you want me to fess up that I am really very old.

Chris Martenson: If that is how you want to approach it, sure.

Charles Biderman: Well my first job after graduating Harvard business school was not what everybody does. I became Alan Abelson’s Assistant at “Barron’s Financial Weekly.”

Chris Martenson: Hmm

Charles Biderman: And so as the terrific post graduate education in how the markets really work, and from there I ended up having to become an entrepreneur because Harvard wanted me to repay my student loans at the time, which you could not do on a journalist salary.

Chris Martenson: They did

Charles Biderman: So I actually had been predicting a collapsed in the REITS market in the early 1970’s so all the money had gone in and then a huge amount of construction and interest rates in 1973 went from 7% to 20% as the first energy price shock hit, and oil prices went from $3.00 a barrel to $30.00. And so I participated in the collapse of the Real Estate Market and then bought bunches of properties, six shopping centers, a thousand apartments, two office buildings out of foreclosure in the south when I was in my late twenties. And I moved back to New York, whatever, ended up going broke in ’87, when the real estate market, I had reinvested, sold most of the south, reinvested in Jersey, and when the REITS and the banks collapsed, the S&L’s collapsed, I mean in ’87 my banks went under. I had a positive net worth but I was forced to declare bankruptcy. And I realized that price as a function of liquidity having nothing to do with value. And I was not foreclosed on, and I could have sold my properties for a nice profit but my banks went under and the banks, and all the loans were called. So using that background, I decided to look at the market based on supply and demand and realized no one had ever been looking at the stock market in terms of well there is not a market, it is shares of stock, and there is money available to buy those shares. And so that is what we have been tracking ever since.

Chris Martenson: Well, I like that idea a lot, that price is a function of liquidity, not fundamental value. So let us move now to some of that data and what it is telling us. And that might be different from what, both I guess, two things I want to track today if we have the time. One is how our official unemployment numbers maybe are tracking differently from the based tax data. But for now, I would like to start with what stocks are signaling. Hey they are just 10% away from their all time highs. We are looking at that, is this truth or fiction.

Charles Biderman: Well, it, if the Fed and the other global central banks had not created ten trillion dollars of paper money in the last, since ’09, we would not be talking about a stock market 10% below the all time high. Since last October, last six months, the value of all stocks is up like almost four trillion dollars. And since last October, the increase in take home pay for everybody who pays taxes on a job, is up maybe 200 billion, at a 200 billion annual rate of increase. So we are talking about a huge increase in wealth, only for people who own stocks. And why did that happen, we the Fed pumped huge amounts of money into the economy, companies ended up with huge amount of cash on their balance sheets, and starting in August, they have been spending huge amounts of money, billion eight a day net of all new share sales, buying back their own shares. In other words they are reducing the number of shares out there, giving shareholders cash for their holdings, and so shareholders, 80% of the Russell 1,000, the largest companies, are held by institutions. And those institutions typically have 3% cash so if someone buys back their shares, they have to replace those shares, so there is more money chasing fewer shares. So supply and demand, more money chasing for your shares, the price of the remaining shares should go up.

Chris Martenson: So many of these companies have been tapping the capital markets as well for debt, obviously generational interest rate lows, so they have had access to this liquidity which is coming through the Fed. What did you say, a billion eight a day?

Charles Biderman: A billion eight a day since August.

Chris Martenson: Wow, where had the retail investor been in this story?

Charles Biderman: Taking their money out and spending it probably on living.

Chris Martenson: And what, how does those money flows track, how do they compare.

Charles Biderman: Well we see out flows of U.S. Equity Mutual Funds. I was just talking before we spoke with Bob Pisani from CNBC, him wanting to know, when are individuals coming back. I said well, they came back in the first quarter of last year and then got slammed as the market sold off in April. Last year the market was up over 10% the first four months and then got slammed, this year the market is up over 10% and individuals are saying, hey I have seen this movie already, I do not want, this sequel is not appealing to them.

Chris Martenson: Well in the work I do, I get to interact with a lot of people who are investors and they have, there is a fundamental lack of faith out there. There is actually more than that, there is fear. There is concern that the markets are rigged in some important ways, that there is asymmetry of information that the computerized bots, what ever it is that is going on out there, maybe that the regulators are not really watching out for everybody with equal interest. Whatever the source of fear is, I know a lot of people have lost faith in the markets, but not the institutions apparently and not the companies who are buying back shares, huh?

Charles Biderman: Well the market is rigged. I mean in January of ’10, I went on CNBC and on Bloomberg, that there is no money coming into stocks, and yet the stock market keeps going up. The law of supply and demand still exists and for stock prices to go up, there has to be more money buying those shares. There is no other way in aggregate that that could happen. So I said it has to be coming from the government. And everybody thought I was a lunatic, conspiracy theorist, whatever. And then lo and behold, on October of 2011, Mr. Bernanke then says officially, that the purpose of QE1 and QE2 is to raise asset prices.

Chris Martenson: Uh-huh

Charles Biderman: And if I remember correctly, equities are an asset, and bonds are an asset. So asset prices have gone up as the Fed has been manipulating the market. At the same time as the economy is not growing, or not growing very fast or growing roughly at the rate of inflation, and I am talking about wages and salaries, I totally ignored GDP because it is a ridiculous number if anybody looked at it. And the only reason everybody uses it is because everybody does not understand what they are talking about, and no one wants to do the work to understand that GDP is a useless indicator. So we look at wages and salaries, real time income, to me is the best indicator of income.

Chris Martenson: What a preposterous notion, but since we are there, what are wages and salaries telling us right now?

Charles Biderman: Wage and salaries are growing at between a half, you know, under 1% faster than inflation. Wages and salaries, and our most recent data, like 3.5%, 3.7%, in that range, and inflation is whatever, 2.93%, pick a number. So if nominal wages and salaries for everybody who has a withholding, who has income taxes and employment taxes withheld from their paychecks, which is all 132 million people on the payroll, included in the payroll survey by the BLS, and emphasis on the word survey, that wages and salaries are barely growing. In reality, we are at about at $6.3 trillion after tax income for everybody. While that is up from $5.9 trillion at the annual rate of the early 2009 low, it is still well below the $7.1 trillion peak. In ’07, $7.1 trillion take home pay for everybody who pays taxes and the gap between the two right now is still a capital gains have disappeared as the real estate market disappears. And you know, the bureau of economic analysis does not include capital gains in their income data, because it is only dirty capitalists who have capital gains I guess, I do not know.

Chris Martenson: Uh-huh alright so, in this…

Charles Biderman: I do not know why they do not include it.

Chris Martenson: Alright well we do not include the increase in debt when subtract that off of our GDP, so I do not know, maybe we just ignore very big things sometimes.

Charles Biderman: Well they use that bogey again, GDP.

Chris Martenson: Yeah, I know, with the fourth quarter deflator at .8% I was, that was all I need to know about that number. It just, obviously very far off of my personal experience, but also what I think a lot of very solid inflation data is coming to us through the companies that actually have to buy things and report their cost of goods sold. It is, we are seeing some extraordinary inflation, especially on the commodity exposed companies out there, you know, double digit, 10%, 11% kind of stuff, it is amazing.

Charles Biderman: Yeah, well you know, if you think about it, the dollars being debased by the printing of hundred you know, U.S. Government is spending $300 billion a month on everything. It pays bills, salaries, it collects $200 billion a month in taxes and everything else and it borrows $100 billion a month. But it does not really borrow $100 billion a month, because the $100 billion is added to the debt. It prints $100 billion and calls that debt.

Chris Martenson: Uh-huh

Charles Biderman: And then, you know, I would like to be able to run my business by printing money to pay my bills, a third of them, that would be good.

Chris Martenson: I would too, I would too. So in their collection, you mentioned the $200 billion a month that is coming in, talk to me very quickly if you could talk to us about the tax receipts and what those are signalling. And can we compare those to the unemployment figures that have been released.

Charles Biderman: Well the Bureau of Labor Statistics, the Bureau of Economic Analysis, and the Department of Census, use 1960 technology, surveys of the present compared to hard data from the past. The same way they have done this for 40 years, to determine income, sales, consumer discretionary spending, the savings rate, all those numbers are fudgy at best, to use your phrase. Since they ignore real time data like they do, the bureau of labor statistics does a survey of 400,000 employers, of which say 70%, only 70% is backed by the time they report the number of jobs for the month. And they true that survey to hard data that comes from state quarterly unemployment insurance collections, which is a quarterly number that gets to the BLS. The soonest is five months from the end of a certain quarter. Five months later, the BLS gets the valid number and then it benchmarks the past to that data. So in other words, the real numbers that they use is just a survey, and it can get 50% to 100% modified with, nine months, a year later and nobody even realizes or even, those numbers are pretty much ignored, but everybody focuses on their initial guesstimate, which even they say is not meant to be considered a real number.

Nevertheless, the Wall Street Journal says oh, 200,000 jobs have been created, like that is the truth, and not even that it is a seasonally adjusted number, which is another chance for mischief. Because to do seasonal adjustments, you have to, you know, why do you not use year over year numbers and forget seasonal adjustments, and why do you not use, and so, I am sorry, I am going all over the place. But to go back to the wages and salaries we track, when anybody who is on a job that gets a W-2, when the amount of income and employment taxes are withheld from our paychecks, it gets wired to the treasury from our banks. And when that money gets wired to the treasury, they report how much they collected. And so we track that data to report in the daily treasury statement with a lot of other daily treasury activity. However, embedded in that income and employment tax, collection package is how many people were working, what was gross pay, what was take home pay

Chris Martenson: Uh-huh

Charles Biderman: And by zip code, and by industry classification. So you have this huge amount of real time data on what is really going on in the economy, available, but ignored. And when I have been, for six years I have been saying, why do you ignore this, and their answer pretty much is mind your own business, we do not care what you think, and this is the way we have been doing it. And we like our paychecks, thank you very much.

Chris Martenson: So this data though, I love the idea of real time data, are there flaws in this, what are the wrinkles in this data set or are these wrinkle…

Charles Biderman: Well there is a lot, it is a survey.

Chris Martenson: No, no, no, not the BLS one, but in the daily treasury statement, the W-2 flows.

Charles Biderman: Well it has to be, we only get what the actual amount withheld. There are three reasons why the amount withheld, year over year would change. One is, that the people with jobs made more money so the amount of withholding goes up. Two, the people with jobs might have changed brackets because they made more money and so they are at a higher bracket, that is called bracket creep. Three, there might be more employees or less employees as people get hired and fired. So each month, on average, 4,000,000 people enter and leave the job market. In other words, on average, four people are fired, 4,000,000 people are fired, 4,000,000 are hired, and then in January and February, there are huge seasonal adjustments because of the weather. And so based upon like 1.7 million seasonal adjustment adds, in other words, there is, according to the geniuses at the bureau of labor statistics, they add a 1.7 million phantom jobs to those people working in February to balance, to make it like a level number with the rest of the year. And why 1.7 million, well based on the past, that is our best guess. And the fact that the weather was so great this winter, that does not, they will factor that in next year where in the numbers will be worse, whatever.

Chris Martenson: Uh-huh, so on the one—

Charles Biderman: Does that make sense what I am saying?

Chris Martenson: --absolutely, so on the one hand we have this survey which is seasonally adjusted on top of that, and on the other hand we have this base data, which might change for a number of reasons, bracket creep, people might actually be earning more in that case, or hiring/firing, things like that. But generally speaking we have these two things that we can compare. One is a survey that is adjusted, and the other is this W-2 income flow statement stuff that comes through the daily treasury statement. What is that data telling us right now?

Charles Biderman:  Well, that the economy is limping along, it is barely growing, and if it was not for levitating equity and very low bond prices it probably would be even slower than it is. So in reality, all it looks to me what this $100 billion creation of new money a month, has been creating $200 billion a year increase in take home pay. Now, is that not weird, $100 billion, it takes $100 a month of newly created paper to boost take home pay by or a trillion deficit this year is going to be a $1.3 trillion I think is the current estimate.

Chris Martenson: Uh-huh

Charles Biderman: And it takes $1.3 trillion of newly created money to boost take home pay by $200 billion? What is wrong with this.

Chris Martenson: There is some sort of hole in the boat I guess.

Charles Biderman: You know, and if they stop the deficits, or and then now they want to increase taxes next year by about $200 billion to plug the deficit so wait a second. So incomes are up by $200 billion, and these smart people want to reduce incomes by $200 billion to raise taxes. And the stock market is within of 10% of all time highs, there is logic there isn’t there?

Chris Martenson: Well so this creates that growing sense of anxiety in the investor class, because obviously there is something that just does not quite add up here. And just to switch, open our view up just a tiny bit, jump across the pond for a second, is Europe fixed?

Charles Biderman: Well if by fixed you mean guaranteed to go down the toilet, yeah.

Chris Martenson: Okay,.

Charles Biderman: Yeah, Europe is the problem, I mean and Greece, the numbers I have read, doing some Google, is that of the little over 11 million Greeks still left who have not immigrated, close to 3 million are retired, and half of everybody else work for the government.

Chris Martenson: And of course with the austerity they are talking about slashing pensions and squeezing government salaries and thing.

Charles Biderman: And in Spain and Portugal, half the teenage, half the people under 25 apparently are unemployed. And what does that say for the future stability of that region.

Chris Martenson: Well, a generation lost, I do not know if that is a good thing or not. You know, my prescription on all of this, years ago, was that we suffered from something I can summarize in three words, which was too much debt. And this is a decades long phenomenon that this could build up.

Charles Biderman: Well I do not think it is really too much debt, I think it is the fundamental belief that government can be effective at providing cradle to grave, or even any services for its people. And all, even at that, name me one activity that government has ever been cost effective at providing one service. I mean the Post Office, fighting a war, look at these horrible tragedies, thousands, hundreds of thousands of people are being killed because this government thinks it knows how to fight wars.

Chris Martenson: Uh-huh well so when I say too much debt, what I mean is, well I do think an aggregator was too high, but I was watching our economy both at the private and the public levels, increasing its debt loads at a faster rate than nominal GDP growth, if we wanted to use that bogey right there. But however we track national income, we are increasing our debts faster than our income was increasing, and that is a math problem. Sooner or later that thing runs out of steam. And it was not just the U.S., it turns out a lot of Europe was doing that and Japan was a poster child for that. And it seems to be a phenomenon that is quite easy to fall into at the national, even the global level.  

Charles Biderman: Well I do not disagree with the facts as you state them, but if you go back to why, if you go back to like starting in ’82, when the IBM PC or the personal computer first showed up, through ’07 you had a period of very rapid economic growth globally, and incomes grew very rapidly. You know you had PC, the internet, broadband, all that stuff. So when incomes grow rapidly, people take on more debt because oh look, my income is going up, I can borrow more. So you take on more debt and then all of a sudden, incomes crash and you have taken on all this debt because we kept assuming that our incomes would grow so we could handle the debt service. But the problem with assuming incomes are going to keep growing, if they stop growing, you are broke.

Chris Martenson: Uh-huh, well sooner or later you are going to have a slowdown, right, that is…

Charles Biderman: Yes, so that is my point, my point is it is not just income growth by itself, but it was income growth, I mean debt growth supported by rapid income growth. But then the income growth disappeared.

Chris Martenson: Yeah, so let us pretend I am an investor, which I happen to be. What does an investor do in this market, particularly if they have kind of, I have lost faith in a number of dimensions, one that our official data is telling me useful things that I can trust. And the second would be that the markets are operating in a fundamentally fair way, meaning you know where I lost it, was when I watched the big banks turn in 100% win ratios off of their trading desks, for whole quarters. Anything that has even the slightest bit of risk in it, you cannot have 100% win ratio in it, it is statistically off the charts.

Charles Biderman: Unless the market is rigged. 

Chris Martenson: Unless the market is rigged. So I could go on, I have many other data points that suggest rigging is happening, so if we take that as an opening proposition, that the Fed is basically saying listen, we are going to do whatever it takes to get higher asset prices. Should an investor just say okay, I am along for the ride and follow, or how does somebody protect themselves against what seems to be a very, very risky proposition. If the Fed either succeed or fails at this, and if they fail, it is easy to conjure up some fairly dark scenarios for wealth destruction I think.

Charles Biderman: Well, we are going to be starting a retail newsletter where we are going to sell, I am going to sell my $10 a week, $9.99. What is Charles Biderman buying, selling, and thinking about the market. And so, if this were that, and the preamble to all of this is right now, well you have a situation where in reality the economy is not growing very fast but the government, but money is, paper money is, so a third of my assets are in gold and a small percentage of that in Silver, but mostly gold. And then given all that money printing, has to end up in inflation at some point in time. I have about a third of my assets in inflation-protected securities. And then since companies are shrinking the float, we started a fund called Trim Tabs Float Shrink ETF, traded on the New York Stock Exchange, ticker symbol TTFS, and it invested in 100 companies that are shrinking the trading float the most, and growing free cash flow and not borrowing to buy. So the average company in our portfolio is growing free cash flow at 11% a year, shrinking the trading float by 6.5% on an annualized basis, and while maintaining strong balance sheet. So we believe that the price of the share should go up by, in my opinion by 6% a year, even without more than the market, simply because those companies, the value of those companies, has not been diminished by the float shrink, if that makes any sense.

Chris Martenson: It does.

Charles Biderman: So I would dollar, if you are a long term investor, and I think that we are three to five years from the market bottoming, but I would still recommend buying stock if you have longer than a five time horizon on a monthly basis. And that is the type of equity exposure I would want. I also own some apple and some salesforce.com. Apple because you know the social media trends use it, everybody is using Apple, and salesforce.com is the most effective cloud participant. And those are two big growth areas, because I think the globe is going to continue to expand economically, but it has got this albatross of government created messes around our necks.

Chris Martenson: Uh-huh

Charles Biderman: And so I think I would have, I still have, even though I have a big loss, I have a small position and shorting the big banks. Shorting Europe and shorting the emerging markets, but totaling my 15% of my portfolio. So I am a little bit leveraged and the leverage is short, which I am losing money on but I am also making money on the other stuff.

Chris Martenson: Right, so that is your hedge in essence.

Charles Biderman: Yeah, I think at some point, when companies stop buying back shares and start selling more than they are buying, the market is going to crack regardless what the Fed does, at least initially.

Chris Martenson: Uh-huh

Charles Biderman: And so I just want to have some shorts in the water just in case I want to increase my exposure.

Chris Martenson: Okay, big macro question then, because a big exogenous risk here is that the U.S. Government has to fund $1.3 trillion a year, the Fed has been enabling that with their liquidity. Do you see anything out there that could force the hand of the Fed and the Federal Government, meaning is there any circumstance you can imagine, coming in the next year, where the wanted bond market could rebel. But what I really mean is that foreign participation in our bond markets would dry up and there would be some set of pressures that would prevent the Fed from doing QE3, QE4, QE5, whatever is necessary. Is there anything you could see that could create that kind of a risk. Because I still note that roughly 10% of our current GDP is deficit spending by the federal government. Maybe 8% I guess if I am being a little bit more accurate. But it is a pretty high number. Do you see anything that could possibly upset that gravy train as a real risk?

Charles Biderman: Yes, I think it will be, at some point the world is going to recognize the Emperor is naked. The only question is when, will it be this year, I do not think it will be before the election, I think there is too much vested interest in keeping things rosy and positive. And I just do not see it happening soon. However at some point, hard money wins out over phony money. And of the investor class or the capital, those with capital, which right now seems to be the emerging markets, they are buying gold and bouillon and they are not buying dollars. Or China appears to have slowed their buying of dollars, even though China might be having their own growth problems, or their own bad debt problems. But Singapore and all those other countries with huge cash flows, the emerging world, I would not be surprised maybe by 2013 of 2014 a non-US Dollar alternative currency by those countries might, you know, something will happen.

Chris Martenson: Uh-huh so you know, a market that is fundamentally running on fumes or in this case liquidity, which you call the funny money coming out, this is not a market my grandfather would recognize at all.

Charles Biderman: This is a totally unique market, we have never before had a market officially rigged. And acknowledge as such, and what is amazing to me is when you watch CNBC or even or Bloomberg TV and these guys come on bullish, the look at PE. Well the PE from or, when was the last, what was the PE the last time the market was rigged.

Chris Martenson: Hmm, we do not know, do we?

Charles Biderman: And what happens when the market is un-rigged.

Chris Martenson: Right.

Charles Biderman: You know, we are in strange, un-charted territory. You know the last thing I want to say, that I think is very important for people to realize, in 1981, before the market crossed 1,000, the Dow crossed 1,000 in early ’82, and stayed above that, the value of all U.S. Stocks was about $800 billion. And in October of ’07, it peaked at $22 point something trillion. And it is back up to $19.4 trillion. So in 1981, there was maybe 100 hedge funds or less, I am sure less. And maybe 100 or so equity mutual funds. And 3,000 stocks, you know, institutional size and sorts back then. Now there is still 3,000 stocks, but there is 4,500 equity mutual funds, 10,000 hedge funds. The real wealth created in the last 30 years has been in the equity market, not in earnings. I mean earnings are up several times, yeah, four or five times, take home pay is up, but the market is up 19-20 times.

Chris Martenson: Yep, on the back of all those boomers entering their peak earning years and pushing all that money into equity markets was one force.

Charles Biderman: Yeah, and we had technology breakthroughs.

Chris Martenson: Uh-huh

Charles Biderman: You know, the internet, broadband. Broadband, you know more people in the last 30 years have gone from calorie insufficiency to calorie sufficiency as a percentage of the population than going back to the first time we industrialized in the 19th century. So it is like this huge increase in wealth and calories and our goal across the globe, all that money went, a lot of that money went into the real estate markets and went into the equity markets, and boosted home prices, and stock prices dramatically, and now it is unwinding. All booms create excesses and excesses are painful as the excesses from the boom are worked off and worked out. And that is the process we are in, and in the past it has taken 13 to 17 years to work off those excesses. And we are still not even through year five.

Chris Martenson: Well in the past I think we also allowed some of that creative destruction to happen and this time we are fighting that tooth and nail and so…

Charles Biderman: Yeah well you cannot fight that forever.

Chris Martenson: Right, cannot fight that forever. So as a final question then. I am wondering, it feels like we are kind of, at least when it comes to deficit spending and then also with the QE efforts and the central balance sheet expansion of the Central Banks, that we are on a treadmill I do not know how we get off of. So the question is, if the Central Banks were going to get us back on a right path, what would they be doing that are not doing right now?

Charles Biderman: Well, they would have cut mark to market early on, and kept reserve currency at a dollar and kept the financial markets going, but let the big banks go bust. And then if the top five had gone under, then the next five would now be the, be the big banks. And the real estate market would have recovered. You have got to mark to market the bad stuff. We have been reluctant, like Japan, which still has not mark to market from its 1990 debacle. We are refusing to mark to market so when you maintain phoney levels, you restrict overall growth and you harm the overall economy. But you save the jobs of the big bankers and the politicians who created the messes. And so that is where we are at, the only people benefiting are equity holders and it is temporary as well as the big banks. And at some point, you know, gravity does work eventually. Even Wile E. Coyote had to come back to earth sooner or later. For those of you who are old enough to remember that cartoon character.

Chris Martenson: Everybody knows Wile E. Coyote, I hope, no matter how old they are. What you are saying then, is that you think we are going to perpetuate the status quo until there is some sort of a forcing function, gravity in this case of some kind, right.

Charles Biderman: Yes

Chris Martenson: Okay well this has been a very fascinating insightful and actually very pleasurable interview for me. And I am hoping we can do it again sometime. How do people follow your work and in particular find out about this new newsletter that sounds real intriguing.  

Charles Biderman: TrimTabs.com/blog is our blog site. I do a video three or four days a week and there is other stuff on our blog site, including access to our ETF for more information. And we will be posting information about the new market letter sometime in the next month.

Chris Martenson: Well fantastic, I am looking forward to that personally, and this has been very interesting and I am thankful that you look at the data the way you do and make it available to all of us.

Charles Biderman: You are welcome.

 

Transcript for Gretchen Morgenson

This is the transcript for the podcast Gretchen Morgenson: Wall Street Really Does Enjoy A Different Set of Rules Than The Rest of Us

Chris Martenson: Welcome to another PeakProsperity.com podcast. I am your host of course, Chris Martenson. Today we have the pleasure of speaking with one of the most well respected financial editors and journalists of our time, Gretchen Morgenson. Many of you know Gretchen from her Pulitzer Prize winning work at the New York Times in which she has written cutting exposes of the corrosive conflicts of interest on Wall Street as well as the reckless practices that led to the 2008 correction and its aftermath. I am looking forward to discussing with her how concerned we should still be about the stability of our financial system; what likely lies ahead and what solutions and safeguards a concerned society should be demanding most at this stage.

Gretchen it is a true honor to have you with us today.

Gretchen Morgenson: Well thank you for the invitation Chris, I am happy to be with you.

Chris Martenson: Well fantastic. You know to this observer, in 2008 the Federal Reserve and the Treasury Department scanned the wreckage of their failed policies and regulatory indifference and entered a form of triage. Only able to save one class of patient, they chose the big banks and other well-connected financial institutions and threw another class of patients under the bus. Those other patients represented savers and the prudent, retirees, pension funds, seemingly anyone who was prudent in perhaps knew how to defer gratification were asked to pay up in the form of negative real interest rates to help get the big banks, not only back in the black, but in a position to hand themselves record bonuses. At least that is how it appeared to me and continues to appear to me today. I think I represent a fair proportion of society. How do you see this?

Gretchen Morgenson: Well you could not have put it more succinctly Chris. Honestly the transfer of wealth that has been created, that has been taken from the saver and from the taxpayer do not forget to “mend the financial system” or to keep it from falling off the cliff is extraordinary. When you talked about savers, these are the people as you point out that really had nothing to do with the crisis. They were in fact, doing the right thing, not buying more house than they could afford, putting away money for college education, etcetera. They are the ones who are really paying the price now. I think that has led to a very angry populous but also a sense that there are two sets of rules in the country that one set applies to big and powerful institutions that when they go awry are rescued quickly. Then there is another set of rules for the rest of us who do what we are asked to do, do what we are supposed to do and really then become victims of the situation. It is very unfortunate and I think it is as you say corrosive.

Chris Martenson: You mention that there are different sets of financial rules apparently. I would like to talk about another set of apparently two sets of rules that exist. As I understand the Robo Signing scandal, forged signatures were applied to everything from loan applications to court affidavits. When I sign those documents there is a stern little boxed warning me under there that if I materially represent anything in that document it is considered fraud and subject to some pretty serious criminal penalties. Yet the recent mortgage agreement with the banks settled for, I do not know roughly twenty-five billion, seemingly removes criminal penalties entirely from the remedy. If a forged signature is not a material misrepresentation, I do not think anything can be. Is anyone at the top even slightly concerned that both the appearance and the even the application of the Rule of Law are vital components of our social fabric? Is this part of the conversation?

Gretchen Morgenson: It sure should be Chris. You again, really put it perfectly. The idea that forging signatures, that notarizing very important legal documents really improperly in thousands of cases, maybe millions. The idea that that is somehow is going to be allowed to go on with just sort of a penalty of some kind or a fine and not prosecuted in the criminal courts. I think it is amazing. It is really counter to what we have all been led to believe was the course of action in such a case. You have many small people, small fry mortgage fraudsters who are in jail. I mean we are talking about the people who were straw buyers for homes who defrauded banks. They are in jail for a reason because they perpetrated a fraud. These banks whose employees who were forging signatures should also have been prosecuted with vigor and they were not. They were simply allowed to negotiate their way out of trouble and negotiate their way with shareholders money. They are not paying it out of their own executive pockets; they are paying it out of the shareholders pockets. There really is no accountability here whatsoever Chris. I think that has just been a theme that has been very troubling to many people.

Chris Martenson: You know Gretchen, one thing that really caught me as well is if you do take a tour back through some of the prior settlements that have been negotiated often it is found that there is a pattern of what looks like an ironclad agreement, a settlement. It has money involved; it has certain actions that are agreed to be taken. The banks in many cases have been found to just sidestep those or ignore those and have to be re-sued or taken back to the courts in an attempt to get the remedy finally enforced. It is not just that we are allowing them to skate around some of it; it almost feels like they feel entitled to skate around every possible piece. There is no I do not know how I would put this, but there is no attending to the spear or the letter of the law in some cases.

Gretchen Morgenson: I agree and this is all done as you know in the framework of protecting the financial system. Many people are wondering why there have been so few criminal prosecutions of people who are centrally involved in the years leading up to the crisis. It is really quite an interesting question. You hear over and over again from those in positions of power whether they are regulators or prosecutors, we had to protect the financial system. Well if you are going to do that that is fine. Conduct the triage as you describe it during the years or moments when you must. Then you have to exact a price from the people who brought us to the cliff and almost over the edge. You cannot let them get away with this and expect them not to do it again in a few years in an even bigger way.

Chris Martenson: It has happened again and again and it seems to be more pervasive than ever. It is almost like if I look back through the history of financial crises they have just sort of grown increasingly larger and a little bit more abundant. As well though when we look all the way back to savings and loan crisis, what was it nineteen hundred people I think and many of them executives went to prison for their actions then. Today the number if it is not zero it is darn close at the executive level.

Gretchen Morgenson: Actually Chris the numbers are that we found in doing reporting on this very good, I think, comparison is that there were eleven hundred criminal referrals in the S&L crisis and there were eight hundred and thirty-nine convictions. That is a sizable number and far, far, far more than we have seen. I mean I think I can name one senior level person at a mortgage company who is in jail at the moment and that is Lee Farkus who was at Taylor, Bean and Whittaker, which is nobody’s idea of a household name company. It certainly was not at the center of the mortgage crisis.

Chris Martenson: How is it that this is occurring now? Is this sort of the natural endgame that happens when we have a system that begins to take care of its own? Is this just a function of the revolving door between regulatory bodies and the industries they are meant to regulate? How did we get to this point where so little interest and activity is happening in holding people accountable?

Gretchen Morgenson: I ask this of prosecutors whenever I meet them and they are as confounded as I am. I think the mentality among many of these people is that you do want to bring cases and you do want to have success and something to show for your years of effort. It really is the record is really dismal. I think you can only conclude that either there has been this sense that we had to save the financial system and therefore, put off doing anything until it was far too late to collect the material, the Statues of Limitations may have run on many of these crimes. Or some prosecutors have suggested to me that during the years leading up to the crisis the regulators were so inert and inept that they did not even collect the information that is needed to make cases after the fact. The regulatory failure it seems was twofold. It failed to reign in the practices in the years leading up to the crisis. Then by so doing, it failed in the aftermath by not being able to supply the information necessary to bring cases. It really is an extraordinary situation and the idea there is no penalty for these failures is again pretty discouraging.

Chris Martenson: Where does that leave us then? As I look back I think you have done one of the most outstanding jobs summarizing the various abuses and excesses that led up to the bursting of the mortgage market and the global economic chaos that resulted. Here we are several years later and to my assessment I think that we find many of the root causes have not been adequately if at all addressed. In some cases, the fundamentals of the system have only gotten worse. We have more debt today, derivatives are larger, imbalances seem to be there, and transparency is not quite where we were promised it might be. How much more less cure do you see things being today given the fact that we have allowed these transgressions, not only to transpire but also go unpunished if I could use that word. What are the concerns we should be aware of here?

Gretchen Morgenson: Again, I think you are dead on. The resolution to this crisis was supposed to be the Dodd Frank Legislation of 2010. Unfortunately, it was I think not even, close to what was needed to proscribe this kind of thing from happening. Again I think that first of all Dodd Frank did absolutely nothing about Fannie Mae and Freddie Mac. It was completely silent on those mortgage companies who were very central to the problems and are in to the taxpayer for a hundred and eighty three billion dollars. The fact that it was silent on that issue is very, very important to remember. We do not know, we have no resolution in place, no suggestion of one for either of those companies.

The second thing that I think is a big failing of Dodd Frank is that it did nothing about too big to fail

Institutions. That’s the powerful, politically interconnected financial institutions are not allowed to fail when they get in to trouble. If it had been me, I would have liked to have seen something that cuts these institutions down to a more manageable size and yet we did not force that on them at all. In fact, if you take a look at the assets at the top ten banks in the United States they are bigger; they are larger than they were before the crisis. Those are two elements that I think have absolutely not been dealt with that and leave us really vulnerable to another episode like this in the future.

Chris Martenson: I think what you are talking about then is that there is some failure of introspection here at some level to really stand back and ask the hard questions, what went wrong and why. At the macroeconomic level, I can summarize and I have summarized our global economic plate in just three words – too much debt. It was a very long multi-decade sort of expansion of credit, far faster than the underlying economy. As any family know when you take on debt faster than your income rises sooner or later you get in trouble. At the moment debt servicing as manageable for the U.S. but only barely and that is with interest rates at multigenerational lows. However when we include entitlement obligations not even a zero rate of interest can balance the books. We therefore find our options, if we peer into this, are limited to some form of default or printing. Do you come to the same conclusion and how do you see our situation playing out in the U.S. given what is happening politically?

Gretchen Morgenson: I think you are absolutely right that this was a crisis built on debt. For that very reason it is taking us way longer to get out of it than let us say a crisis built on internet stocks that were basically equities that people had made bets on. That was a large devastation of wealth when the internet bubble burst. It was by no means as devastating as this debt crisis because as you know the assets shrink in value but the debt that you carry took out to carry them does not. This is where you have people living in homes that are underwater that are worth less than the mortgage outstanding on them; people drowning in college education debt. So yes, we are in a really bad situation and with very slow income growth or slow job growth, you see how difficult it is to dig out. I think that is why we are in this long slow march out of the mess. It is very, very difficult to see how it is going to change any time soon.

Chris Martenson: In your recent book Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon that was co-written with Joshua Rosner, you wrote that “you felt compelled to write this book because we are angry that the American economy was almost wrecked by a crowd of self-interested, politically influential and arrogant people who have not been held accountable for their actions.” And that obviously stands true today of course I think MF Global sort of puts that into sharper relief than ever. At the same time, there are these structural issues which are caused by too much debt which are really, a lot of people are concerned about, but we do not know how to get traction on these because we are not actually having the discussion at the, what I will call the national debate level yet. It is certainly happening very vigorously in books, between individuals, on the internet, on blogs. It is happening all over the place, but kind of at the margins. What will it take to push this to the center? Does this require a crisis or can we get there on our own terms?

Gretchen Morgenson: Chris I am shocked that it has not led to a really honest dialogue already, this crisis because it was so large and so devastating and it hurt so many people that I thought wow this is really it. This is going to force the issue to be brought in to the open, to be discussed intelligently and to be resolved. It just has not been. I mean I lay it at the feet of Washington because I think they were crucially involved in the crisis in the years leading up to it. There is a reason why they do not want to deal with it. There is a reason why they do not want vigorous investigations because it could very well lead back to an understanding that they were major contributors to the crisis. You have this weird disconnect where the populous at large, many people are angry and concerned and discussing and dialoguing as you say on the internet and in coffee shops. Washington - it just rings hollow for them. They just do not want to address it. This is the failure I spoke of earlier about how no dealing with Fannie Mae and Freddie Mac. No resolution for the big banks that are too big to fail. It is a deep, I think, dysfunction in Washington that may be a result of their understanding of how deeply involved they were in laying the groundwork for the crisis.

Chris Martenson: It would be fair then for a prudent adult who is fairly rational to peer in to the systems, see its dysfunction, understand some of the risks that are then unaddressed, maybe even mounting in some cases and come to the conclusion that waiting for Washington to see the light and ride to the rescue is maybe not the most dominant strategy in their lives.

Gretchen Morgenson: I think they will be waiting a long time. I just do not see it happening. Even in an election year, we are not having these important conversations. As you said what is it going to take. Well I was shocked that a crisis of this size did not generate that discussion already.

Chris Martenson: Here we are, what would you advise say individual citizens to do in this particular landscape. Do you have any particular views on investing or just let us say return of capital rather than return on. How does one navigate this landscape?

Gretchen Morgenson: It is very difficult for people to not go out on the risk horizon to gain the kind of income that they are used to getting. Even on Treasury Securities for that matter relatively risk free. It is really an excruciating difficult time for people especially those living on fixed incomes, but also those who are saving for retirement. Again I would just say do not take risks, even though the Federal Reserve is essentially encouraging you to do so, we know how that can end, it can end badly. I think that is a pursuit that must be maintained at the ‘be safe not sorry’. Also pay down debt to the degree that you can because that would protect people from being hurt and being put in the situation where they really in vise and cannot get out.

Chris Martenson: I think that is very sage advice and it is advice that I have been promoting myself for a while. This is all the time we have today. I would encourage everyone to pick up a copy of Reckless Endangerment because knowing where we are and how our current system is dysfunctional is an important edge and because it is a very good read. Gretchen thank you for your time and insights today.

Gretchen Morgenson: Well thank you Chris I really enjoyed myself.                        

Chris Martenson: The pleasure was mine.

Transcript for Chris Answers Your Questions (Part 2)

Transcript for the Podcast Chris Answers Your Questions (Part 2)

Chris Martenson: Welcome to another PeakProsperity.com podcast. I am your host, of course, Chris Martenson. Today we have a very special interview guest: me. This is Part 2 of a series where you ask the questions and I respond to them. I have again, Adam Taggart, my partner here with me today, to ask the questions.

Adam Taggart: Hi, Chris. Good to be with you again.

Chris Martenson: How is everything out there in California?

Adam Taggart: It’s finally getting sunny and dry. Believe it or not, while it’s been pretty warm and sunny your way, it's been a little bit wetter out here.

Chris Martenson: It was wet when I was there last. You know, we have Summer here right now. We just skipped the whole Spring thing.

Adam Taggart: I heard. It’s 80 degrees in Chicago this week. Crazy.

Chris Martenson: Yea, it is crazy, but here we are.

Adam Taggart: All right. Are we ready to dive back in?

Chris Martenson:  I am.

Adam Taggart: All right. Well, we’ve got a number of questions that we didn’t get to last time, plus we had a bunch of new questions come in after people heard the first interview. Again, we will get through as many as we can. Something tells me that we are going to make this a bit of a regular occurrence going forward.

Chris Martenson: Excellent.

Adam Taggart: All right. Question number one comes from user shepvideo: What is the likely course for the Great Contraction? Do you see a financial crash and chaos, or gradual de-leveraging through inflation as energy costs rise?

Chris Martenson: The most likely course, the most probably course, is exactly the course that we are in right now. I’ve always held that if we hold the mental image of a bowling ball rolling down some stairs that will probably be pretty close to what will transpire. The reason for this is that we have a pretty large, inter-connected, gigantic world economy and it has got a lot of inertia, like a flywheel does. Things tend not to change too dramatically all at once. So my 80% probability has always been that we are going to see long periods of relatively steady decline, then where the sharp drop and then there will be these recovery periods. We have had a rather remarkable recovery period for the last oh, year and a half or so. It’s the best recovery that approximately $6 or 7 trillion of freshly printed money can buy. I expect to see more of that as we go forward. In this story, the resources don’t run out all at once and the oil doesn’t suddenly go to $200 or $300 a barrel and shock the system. Those are fairly rare events. The much more probably outcome is exactly what we are in the middle of right now. We are going to have these apparent recoveries, they are going to get truncated for whatever sets of reasons. We are going to have financial media that is going to try and pin the blame on something other than what is really the case, which is we just have too much debt and our energy costs are really high. Again, that is the most probably outcome.

We also spend time around here preparing for maybe the improbably, or the less likely outcome, which has a fairly high chance. It’s not zero. Where there could be a rather sudden break that really does throw things into a bit of turmoil for a while that could be some attack on Iran that comes forward that does vault oil by a factor of two perhaps. It could be some sort of a disaster in the derivatives market that ends up taking out a couple of big key players. That has almost happened a couple of times as we go along here. It could just be some ill-timed words from the Chinese finance minister. Who knows. There is always a possibility that in this global, hyper-interconnected system that we have of something much more dramatic happening, but it’s not the most likely outcome.

Adam Taggart: Got it. But presumably that is why investing now for resiliency is so important, because you can’t forecast those unexpected events. You want to be as prepared as possible when they do happen.

Chris Martenson: Why not? It’s very cheap insurance. It does not cost a whole lot compared to the benefit you would receive from that insurance if it ever had to pay out that is the absolute definition of good insurance.

Adam Taggart: Question number two comes from user PDeB: One of the things that attracts this user to you, Chris, is your positive outlook on the future. They write asking to learn more about your plans for future Crash Course chapters and hoping that they include a discussion about community-focused actions that might help people envision a future worth working towards. Can you share those plans? And who are the people you turn to for inspiration around that type of topic?

Chris Martenson: Great question. You know, we have a set of seminars coming up; one at the end of this very week, over this weekend of March 23rd through 25th at Rowe. Then one later out at the end of June, stretching over that final weekend of June to the 1st of July at Kripalu. Both of those seminars are designed exactly to talk about how it is we want to incorporate the information, the implications of the crash course into our lives. What we really care about here is not so much that everybody figures out how to maybe protect a little more of their wealth than the next guy or finds a way to squeak through. We want people to be happy, healthy, living into this period with as much purpose and joy as possible. There are really so many examples out there in history, Russia being a prime one, when the USSR broke down economically and became Russia and the satellite states again. What happened there, what we saw, was that most people of the deaths that were recorded, over half of them were because of alcohol consumption. People had housing and they had food. What they didn’t have what a sense of purpose. What they didn’t have were jobs. What they didn’t have was that other thing to live for. What they had was the narrative that said I need a job in order to feel purposeful. I need to be plugged into the system in order to have something that I can attach myself too. If that goes away there is no reason if that being your job or the larger infrastructure somehow changes, that shouldn’t lead you to, personally, collapse inward on yourself. We spend time really thinking about how we want to be. This is one of those great moments in history where we get to ask some of those awesome fundamental questions, which is what gives me a sense of purpose. How do I want to be remembered? What kind of jobs do I want to work in? Which ones do I not want to work in? Where do we find hope and inspiration?

My personal inspiration lately, the people I have been turning to are those who can really help guide us on our inner journeys to find out how it is that we can become the masters of our own domain. Meaning that whatever happens in the outer world, I want to have the calmest, most centered mind-frame so that I will be in the best position to react and respond to whatever is going on around me. I don’t want to be full of anxiety, I don’t want to be freaked out. I will come into this whatever is going to happen next. Whether it is a really positive future or one that is going to require a lot of attention. Whichever future comes, I want to be standing there with as much calm certainty and purpose as I can. There are a variety of books and teachers out there, we will go over some of those at these weekend seminars. I will be happy to tell people about some more of those. These are not, I don’t think, for everybody, but they certainly fit for me at this particular stage of my life right now. Some of them are Eastern and some are Western, others sort of hodge podge at this point.

Adam Taggart: Great. For those people that are looking to learn more about these upcoming events -- you mentioned the one at Rowe and the one at Kripalu -- they can go to the front page of PeakProsperity.com and look at the Upcoming Events module on the page there. You will find links to both of these seminars and be able to get more information about them.

I will make a quick plug that the Rowe seminar is actually this coming weekend. If you are listening to this and potentially have an interest, it's something I would recommend looking into quickly.

Chris Martenson: For a more recent example as somebody who has also given me inspiration right here on our very own website; search out a podcast with Charles Eisenstein.

Adam Taggart: That was a good one.

Chris Martenson: He was very much in the vein of what I am talking about in response to this question.

Adam Taggart:  Next question comes from user aggrivated, who writes: What’s your advice for those who live or work in cities? This is when we get a lot, the urban prepper.

Chris Martenson: Absolutely. Well, if I lived in a city the first thing I would want to do is make sure that I’m as prepared as I can possibly be. We think of three types of preparations; there are physical preparations so there you are going to do what you can across the bottom of Maslow’s hierarchy of need; you want your shelter, your food, your warmth, things like that as attended to as much as you possibly can. With the idea of building a little resiliency a little buffer in there. There are financial steps that apply to everybody. It doesn’t matter if you are rural or urban, those steps should be taken as well. That’s primarily about moving your money into safe locations and places where they have a much better chance of your wealth and your funds, they have a chance of withstanding whatever might come. Knowing that that is hard in the post MF Global world of really knowing what is safe and what isn’t.

Then the emotional preparations, which I just talked about prior; those are very important. They apply again, equally, whether you are rural or urban. The idea here is that what you want to do is get yourself into a position where you are ready for whatever is going to come mentally. The first step of that for us has always been around making sure you have a good, clear understanding of what is really going on. What the predicament really is. That means we have all sorts of tools around that. The crash course is a tool it is a way for us to get a lens that we look through. That is just a high-level lens. We have other lenses built in there that we talk about at these seminars which is how you interpret the news and what you filter out and how to separate facts from opinions and these are all things that are just designed to get us and our minds wrapped around the idea of what is really going to come, how we know who we can trust and who we shouldn’t trust. Ultimately, what I would like to promote here is that for anybody, city or rural dweller is to trust yourself. Your gut will tell you when it is time to shift gears. You will know what to do if you really listen carefully. In the meantime, I want everybody, rural or urban, we have this incredible, wonderful resources still exist. The economy is still chugging along. The sun still rises every day. It’s still – there are a lot of opportunities out there. I guess I am saying be sure to stop and smell the roses. Make sure you are still living, that you’re happy and that you’re not anxious. If you find yourself in a city just being anxious all the time because you are in a city, well, then you are probably a candidate to consider relocating.

Adam Taggart: Good advice. I think it is probably worth saying, as well, that we have many readers on the site that are from cities. One of the complaints we hear about living in urban centers is that building community is difficult. While I think that very well might be the case, it is certainly not impossible. Don’t dismiss it out of hand as something that can’t be done. We have lots of examples from people on this site that have worked hard at building community even though they are in an urban center.

Chris Martenson: Great.

Adam Taggart: Next question comes from user cnbbaldwin: What existing technologies do you think will be most dependable in a peak oil future? (for a homestead, apparently). Are there systems you particularly recommend investing in or implementing now?

Chris Martenson: Oh, absolutely. Both solar technologies, photo-voltaic panels, very dependable tried and true. Also the solar thermal panels. People have heard me talk about those a lot. Those are great. With just a couple of hundred watts of electrical power to use a circulating pump you can have 1970’s technology giving you hot water. I consider hot water one of four things that makes being human a really, really good thing. Refrigeration is another. Music is another, there are just a few things, but hot water is one of them.

There are technologies out there that I’m actually quite excited by which really do break the mold of the centralization that we have seen of everything, but power generation in particular. I love these combined heat and power systems, the CHP systems, Co-Gen systems which will allow a small scale electrical generation to be conducted onsite where the heat that comes out of these systems is no longer a waste product that is actually a very useful product, in winter, obviously, but in summer you can use a heat differential to drive cooling as well.

There are a number of technologies that are out there. What I would like to say here is that we don’t need any new ones to be developed. It is entirely possible to build a zero footprint house now. Meaning just footprint in terms of needing energy to be imported on site. There are a number of things we can do that are really simple. Think of how much differently our company would be positioned now if we just said this; every new house that is going to be built from, pick a number 1980 onward, if possible needs to be oriented to the south. That’s it. Not oriented to the road, just twist it to the sun, like people always used to do.

There are some things we got away from with our energy abundance, with our subsidy we got from nature. We can re-implement many of those right now. It is not complicated, it is not really sexy because it doesn’t involve nano-particals, it is just simple stuff, common sense and there are, of course, a number of ideas out there that we can implement right now that make economic sense no matter where oil goes, up or down, they make economic sense today. No matter where energy costs go if you can control your cash flows out off of your property to every extent possible and that involves A. conservation, B., some of these technologies I talked about and often C. with very little actual changes to our current lifestyle. Even just tiny modifications can make, in many cases, a huge difference. So those are all things that I would highly recommend people be looking into right now. It’s around changing our some of our habits a little bit of how we do things, investing a little bit in our own homesteads and they deliver some very large returns.

Adam Taggart: Great. I am just going to tack onto that, Chris: Is there anything in particular you have done in your own homestead besides the solar that you mentioned you are particularly grateful that you’ve done? I know one example, relatively recently I think at the end of the last year you got a Simple Pump for your well, correct?

Chris Martenson: I did. We drilled a second well, our primary well is 400 feet deep and we had good information from an old guy who lives up the street who had his well drilled many years back that there was a lot of ample water right down beneath our feet. So yes, we punched a second well in. We have a static water line at about 50 feet down. It is only flowing at around three gallons per minute, but we thought that was sufficient and we put a simple pump on that, which we are going to use a simple pump; for those that don’t know is a very simple stainless steel contraption. You can either hand pump it or in about five minutes you can bolt on, take the handle off and bolt on a solar pump, a DC pump and we are going to use that option for the summer months. It is going to pump into a holding tank and we are going to use that to water our garden with. Should we ever need to hand pump water, of course, five minutes, reverse the process, put the handle back on and we have water. This, to us, is really important. This year we had Irene, a hurricane come it wasn’t a hurricane it was a Category zero when it hit the coast about 100 miles from here. It was barely a tropical depression when it came over. It was sufficient to pretty much ruin our area here and left us without power for about five days. Then we had a freak snow storm in October which left us without power for about another four days here, but up to well over a week in surrounding areas and up to two weeks south of us in Connecticut. We also had another just simple wind storm at some point in June which also left us without power for almost five days.

We have had three incidences this year so far where we have been without power. For people, like myself, who are on a well no power means no water. That was something that we felt was really important to get an independent, water-based system for us so we can at least have fresh water anytime we wanted. We have done that. We put in new windows. We resided our house with a product that won’t need any touching for 25 years. Of all the things I want to worry about over the next 25 years siding isn’t one of them. These are examples of some of the improvements we made and we will be talking some of these at the seminar too.

Adam Taggart: Great. Great. Just doing a quick time check here. I am already going to make the call that we are not going to get through our entire list again this time, just like last time. For those folks who submitted questions that we don’t quite to: don’t worry, we will get to them at a future podcast.

All right, next question comes from mammamia: Do you have plans to present a more European perspective in the future?

Chris Martenson:  Good question. Yes. Absolutely. Certainly want to include the European perspective. We are one world now. There are a lot of interesting things happening over there and I think we are all connected in the story. So when I was over in Spain recently at the invitation of James Turk and attended the Gold Money Conference there. I met a very interesting gentleman there, Alasdair Macleod, who writes just beautifully, really many conversations while I was there with him. He impressed as somebody who really understands the situation, the technical details, but also how to explain it really well. We are going to be working with Alasdair to bring on a European perspective. I really need someone who is living in the system and feet on the ground over there. I think you get such a better view from somebody who is there and he really struck me as somebody who could deliver.

Adam Taggart: Great. Having talked to Alasdair, I am really excited for him to start contributing. I also want to let anybody listening from Asia know that we are not ignoring the needs of Asia, either. One bit of news in that camp is we are going to have our first version of the Crash Course translated into Mandarin Chinese up on the site in just a couple of weeks with the launch of our brand new site.

Next question comes from user GiraffeOK: What is your advice about leaving some money in the system? (e.g., banks, credit unions, brokerages that type of thing) Especially with regard to retirement funds?

Chris Martenson: Well, I still have a retirement fund that is in the system. It’s an IRA, it’s a legacy from my corporate days. I know that for many people they have sufficient funds that and need for cash flows that having money in the system is not just a reasonable thing to do, it is an essential thing to do. I hope everybody was paying attention during the MF Global debacle. There are other warning signs out there that would suggest to us that we really want to be very careful about which institutions we want to be working with. I don’t know if I can say this legally, so I am going to hedge this carefully; but there are certain very large banks out there that I would absolutely not be working with right now simply because of their derivative exposures. In fact, my personal know list is very simply found at the Office of the Comptroller of the Currency, the OCC. OCC plus derivatives, they put out a wonderful quarterly report and if you scroll on down through that big PDF you will find a table, which will show you the top 25 banks in terms of derivative exposures. Anybody who is in the top 10 or 15 of that list would be an institution I would be very leery about working with at this particular juncture. That is just my own personal sort of measure of safety.

As well though, for people who do have money in the system, I understand like this has got to be one of the most challenging, I am putting air quotes up here right now, investment environments that we have every seen.

Adam Taggart: You are putting air quotes around "investment" right?

Chris Martenson: Investment, right. I talk to people who have been in the business for decades who very actively managed and traded funds and some of them are just getting chewed up and the rules seem to be getting changed. What used to work doesn’t work anymore and there is incredible competition and we are all fighting with robots now that are actually, I think about to break into the nano-second trade execution environment. It is just incredible what is going on out there. Against this back drop we have to understand that really all of this is happening because trillions and trillions are being printed out of thin air which means, well, speculating to some degree; this all points to the idea that unless you are really confident, unless you can manage your money on a minute by minute basis, literally, in some cases. Unless you are willing to dedicate that kind of time I highly recommend that you work with financial advisors who A. see the risks that are going on out there; B. understand that return of your principal might be more important than return on your principal. Who are more concerned that your money is safe than beating their peer groups against the S&P. That there are a variety of measures that I would use in selecting and working with somebody who could put that dedication and focus into making sure that my money was as safe as possible. My own family still has money in the markets. Certainly, my relatives all do. Practically everybody I know does. Even I, I got my IRA there and I still got money in the system too. It is an essential part of life and it probably will be for quite a while. So we have to make the best of it.

Adam Taggart: Good answer. I am just going to remind folks as well about the recommendations that we provide to a few financial advisors that we have begun endorsing. Without getting further into it here, since we mentioned it on the previous interview that we did, I will just tell folks who are interested in hearing the financial advisor that we recommend to email us at support@PeakProsperity.com.

Next question comes from user Stan Robertson who asks: Are you concerned about confiscatory taxes or other liquidation challenges imposed in the future when those who have bought physical precious metals today go to exchange them for other forms of wealth?

Chris Martenson: Of course. Of course, Stan. We all have to be worried about that. I am worried a little bit more about other forms of wealth first and foremost. I don’t believe that we will see gold singled out ahead of other asset classes at this point. Where will the government go first for needed revenues? Well, we have already seen I think the future has been played out in a couple of places. We saw Ireland impose a "one time",  let me put air quotes up, one time, because I don’t think it is going to be a one time thing. Air quotes are going around one time, tax on pension holdings. We have seen already there have been little trial balloons that have been floated out that maybe money market funds ought to have special treasury bonds put into them instead of other holdings. These would be the kinds of moves that I would expect to see first. So if the government was really going to start, gets in a pinch and decides to start taxing things, we could do worse than to look at what is going on over in Greece; the sales tax gets hiked first and foremost. Secondarily, we are going to see potentially one-time special taxes on pensions and things like that. We might see the income tax rates, we probably definitely will see the income tax rates get hit and hiked. We will see capital gains get hit and hiked. Maybe we will even see, I saw another trial balloon a couple of congressman I believe, were going to hold a hearing into whether there were undo windfall profits being bestowed upon Apple and other tech companies at this moment in time.

These are the kinds of things that tell you, listen, when a government or any set of governments gets into fiscal trouble they are going to be looking for revenue anywhere and everywhere they can. I’m not that worried about it with respect to gold at this stage because, frankly, it’s such a tiny piece of the pie and it would be a really difficult thing to enforce and would have a lot of unhappy people. It just the trouble to return ratio on that, I think, is rather poor.

Adam Taggart: Okay. Well, good point. I think one thing to keep in perspective, too, is just the size of the precious metal markets versus the size of some of the other markets you have mentioned: retail sales, housing or whatnot. It really is quite small, so if you are in the government and you are looking to extract maximum rents you are probably going to go after some much larger pools of money first.

Chris Martenson: I was trying to make that point; yea, gold is very miniscule at this stage. Thanks for bringing this up; if gold goes to $5,000 or $10,000 an ounce or much worse, if suddenly Saudi Arabia says we no longer accept dollars we would prefer gold, those would be moments where I would have big, red flags waving before my eyes because that would mean that A. gold was no longer a small market or B. that we needed it for national security reasons; getting oil imports is a matter of national security. Finally, if gold gets remuneration I would expect, however, in every one of those circumstances that if there was some form of confiscation that there would be remuneration with that confiscation. Remember, back in 33, a lot of people use the term inappropriately they said gold was confiscated sort of implied it was just taken. It wasn’t. It was exchanged. Maybe not for something you wanted, but it was exchanged for something of value. It was immediately de-valued against that fair value. There was at least some sort of compensation that came along with that. I would be highly surprised if that didn’t happen this time too if gold were to suddenly be needed on a national basis for some purpose.

Adam Taggart: To the spirit of Stan’s question too: if any of those developments happen that you just mentioned, that set off warning bells in your mind, you would be publishing an alert about that to our users.

Chris Martenson: We will be weeks, hopefully months ahead of that development. Absolutely.

Adam Taggart: Great. All right, next question comes from Nichoman who is very kind. He said he really enjoys this interview format of the PeakProsperity.com audience interviewing you. He asks: would we consider doing it regularly, something like maybe quarterly?

Chris Martenson: Absolutely. I love to do this. I love responding to these questions and it lets me know where your minds are at and it gives me a chance to cover some territory that is both new and old. This particular juncture of history I don’t think we can possibly overstate or repeat ourselves too much in terms of what is really important. I would absolutely commit to doing this on a quarterly basis.

Adam Taggart:  Well, from what we have seen so far I think the demand, in terms of questions for you, is definitely going to be there. All right, next question comes from Woodman: He says that you’ve talked a lot about the changes you have made in terms of your vocation, where you live, the type of community you wanted to be a part of and your health. How much more change do you feel need to make or want to make, in your lifestyle going forward?

Chris Martenson: I just want to be in a position where if I come out and work with your trainer, Abdul, again, that I can actually set forth and do the challenges he gives me. It was incredible. Anybody who is out in Adam’s way I am telling you have to go see Abdul. He will make you feel like there is more work to do in life. So it is incredible.

Adam Taggart: I’m laughing, but it hurts because I happened to see Abdul this morning. And I am still sore.

Chris Martenson: I am sure you are still sore. I’ve made all of my really big changes, kind of all at once. Parader rule. I feel, 80/20 rule, I feel like I made most of the big changes I wanted to make in relatively short order and now I am at the position of really poking around the edges. So the things that I care about most right now are really extending well beyond my own personal homestead. We’ve got everything sort of prepped as much as we think we can. I am very happy with where our garden is and the orchard is just going to do spectacular this year. A lot of our systems are operating reasonably well. So I feel good about all of that. My next big area of inquiry is really around and I can feel it coming. There is something like the Crash Course in me, I mentioned this in the first of the series as well, but there is really something here around how it is that we are going to really step into this new future, whatever it happens to be. That is what has really captured my attention for the moment is this sense that something very momentous is happening, that we get to be participants in that. We want to find ways that we can; let me speak for myself, I want to find ways that I personally can step into a higher role of engagement with what is happening out there. This engagement is going to be both at my community level and everything I can possibly do through the website. Maybe through additional books, other videos. Whatever is necessary to reach as many people as I can reach. To add our voice to what I think is becoming a really interesting swelling of voices who are saying wow, the status quo no longer works. We are going to have to figure something else out. Part one of that story is what is broken and why. Part two of that story is well, what are we going to do about it and that is the part that really has captured my attention right now.

In terms of personal advancement, to me, that is kind of like a lifestyle decision because I am the kind of person before I can really talk about something I have to do it first. I am figuring out how to really modify my lifestyle in some very profound and important ways. The good news is I am happier, I am healthier and I feel quite positive about both my personal situation and about the future that we could have.

Adam Taggart: Just to repeat that back to you: it sounds like you are feeling pretty good about where you are on the lower levels of the Maslow’s hierarchy of needs in terms of the main things you have taken care of in your life over the last couple of years. And now you are looking to move up that pyramid, more to sort of a 'purpose' and an 'identity' level. Is that accurate?

Chris Martenson: That’s exactly right.

Adam Taggart: Something tells me that the community here is going to be very interested to hear what you learn as you go through that, and be very eager to begin to get some instruction and guidance for how people can do the same thing in their own lives.

All right, next question comes from citizenman: What would your recommendation be to organizations that direct investments at institutional levels such as pensions?

Chris Martenson: First thing; if I am in a fiduciary role at apension, first thing I am going to do is I am going to knock back my assumed rate of return to something that is actually reasonable and realistic given A. the past 10 years of history that we have gotten. B. what is really likely going forward. Many of these pensions are still holding seven and three quarter - eight sometimes even 9% implied rates of return or stated rates of return going forward. That is just not possible.

Adam Taggart: They are just not going to see that. When you said you are going to knock back I thought you were going to suggest a couple of stiff drinks.

Chris Martenson: I might want to do that first and then I am going to have to knock back my stated rate of return to something more realistic. Is 0% unrealistic? Maybe not in some cases, but it certainly would be at least half of what the current rates are. So that raises a much larger question; the pensions need to get their minds around some very big, large structural forces that are in play. Forget about energy for a minute; let’s pretend the energy tax which is just climbing and been there and absolutely has got many years of trend under its belt. Let’s just look at what we see demographically with the idea that many of our pension systems are for want of a better word, they are pyramid style arrangements where you need more people coming in to pay off the people who came before. We just don’t have that demographic base; not in the US, they don’t have it in Japan, they don’t have it in Europe. So just demographically speaking when you understand that people go through the cycle of life, they go through peak earning years, which translates into peak savings years and then they step into retirement and then they become net dis-savers as they spend what they save that is the save that we are in right now. So, again, set aside whatever concerns we have about what the implications are on peak oil on growth. Just on that one basis alone, I think we could make a very compelling case that we are going to have very lackluster returns. That is if we didn’t have a moving target out there and that moving target is the value of the currencies themselves.

The second big risk that I would be worried about if I was in the pension role would be what is this money going to be worth. Take it very seriously. People have invested and trusted their money with myself as one of the trustees who is going to in the future be delivering that money back to them at some stated rate. Well, if I am going to give you $1,000 a month in the future or $2,000 a month I want to make sure it is worth that or at least just keeping pace. Today, extraordinary risks with how much money the central banks are printing with how much the governments are deficit spending. If I was in a big pension and I had those institutions they got weight. They got really serious clout they could bring to bare. If I was some of them I would be all over the news saying we do not agree with this amount of money printing or this amount of deficit spending because both of those represent extraordinary risks to the future value of their holdings for all of their beneficiaries.

I have really been surprised that the pension funds have been as quiet as they have been. Just sort of taking their lumps and just kind of hoping that they won’t do any worse than their peer group. I think this requires something a little more extra ordinary than that. There is really some extraordinary risks and they should be, and this is a judgment, stepping up to the plate a little bit more with their concerns and being much more public about them.

The final thing is I would really look at how all of this money that has been collected by pensions; let’s imagine I am a county pension in a state and I take all of this money that I collect from people who work in my county and then I ship it out in my county, off it goes. Where? To Wall Street and they do stuff with it. Sometimes fraudulent things. It ships whether they do fraudulent things or not, its irrelevant here, what happens is my money leaves the county. Hopefully, it goes out into the world and does great things. If I was in the position of running one of those pensions I would certainly be considering right now, how I can take that same money and bring it back and have it operate within my own community so that when it’s doing its good work, when people are taking that capital and becoming more productive with it, creating products with it, delivering services with it, building businesses with it, whatever they are doing that then I would get sort of a double or maybe a triple bottom line a benefit to my county. What would happen is not just would people have jobs, not only would services and goods be produced, but there would be these other benefits as well that accrue when you spend your money locally. That would probably be the final thing I would really think about for some of these pensions, absolutely would be where am I putting that money to work in these particularly, given everything we know about how the world is working right now.

Adam Taggart: I’m really glad you brought that up because I was going to ask about that. As you know, we have had several pension funds ask us about our opinions in exactly that matter and I think you described it all very well. I think the only other thing I would mention is that when you are keeping the money within your region rather than just shipping it off to Wall Street, there is also the opportunity to define a return on that investment in a manner other than just exact 'dollars and cents' -- or how much more money it made last year than this year. There can be a measurement of 'resiliency'. If you are investing that money into energy production at the local level, into creating a better food shed, or into creating a better water shed for your territory that you are a steward for; those are all very good things that people who have a trustee responsibility should be thinking of. And obviously, that is just another factor that these local pensions can be factoring into their models.

Chris Martenson: Absolutely and those are very discreet, very definable, measurable sorts of returns. If you invested in a series of farms in your county and you can go out and say look, the soil is now doubly improved or this many inches thicker if you can point to the actual tangible result which says because of the way we have invested this money and what has been done with it, here is how our county has improved meaning that whatever future happens to come, our ability to grow more, high-quality food within our region that is a positive. It could be, again, with the insurance concept in mind it could be a huge positive under certain circumstances that will come. No matter what it will be a positive and it will be more than sending money out into the faceless world of where it heads off to Wall Street and who knows what will happen to it once it is there.

That is the old model. I think it is time to start at least some percentage of those pension assets should come back to this new model which says hey, we would like to A. know where our money exactly is at all moments in time. We would like to know the people who are going to be using it and we would like to understand, intimately understand what that money is doing. It goes in here, this happens, here is where our returns come from. It is often not clear on any of those accounts when it ships out to a big money manager out in Wall Street.

Adam Taggart: I am really hoping that we see much more of this line of thinking as we go forward.

All right, next question comes from robert essian (I hope I am pronouncing that correctly, especially since he is one of our most prolific posters on the site). Robert says: Do you still forecast a hyper-inflationary ending of the story? And, if so, where are we on that timeline?

Chris Martenson: Hyper-inflationary, yes. We are definitely on that path. This is something I have always been, my core belief has been that humans will behave just as they always have. So far, I will not be disappointed in that belief and all the data sort of stacked up. If we look at a chart over the past five years of the eight largest central banks in the world to the Bank of Japan, Federal Reserve, Bank of England, the ECB broken into its member states so that would be Germany and France primarily. When we look at these banks we see that they have grown in the past five, maybe six years about $10 trillion of balance sheet expansion. There is no way they are going to ever be able to reverse that then. I had this discussion with Mark Faber, recently, on a podcast. When I look at that line what is really noticed here, I think the most important part that really came out of that Faber podcast was him noting the observation, which I have heard elsewhere as well and made the same observation myself which is that these crisis, they started kind of smallish you know, long-term capital management that was a gigantic, gigantic problem back in 1998. It was about a $3 billion hiccup, right? Which was huge at the time. It was an unthinkable amount of money. Federal Reserve and Greenspan had to intervene. Now, we look at that and just laugh; $3 billion? Really? Oh, that’s nothing. That’s Tuesday morning for the Federal Reserve now.

It is just extraordinary when we look at the frequency and the amplitude of these interventions and the amounts of money that are being required and the really sort of tepid, lackluster response that happens on the other side of those actions in the economy itself. What we notice here is just that the overall trend is that things are speeding up. We are getting less and less out of more and more. Less and less economic reaction out of more and more monetary stimulus. This is very much what we were expecting to see. This is very much, unfortunately, not a surprise. Where we are on this timeline is that we, the thing that is different about the story is it involves the whole world right now. It is not just one country with nice, defined borders around it where people can scurry across those borders and get away. Much of the world today is dominated by very, very large concentrated players. It’s not you and I that they are really worried about. It is what do they do with the funds that are actually in control of hundreds of billions of dollars. If you are in control of one of those funds like I don’t know Norway Sovereign Wealth Fund, where do you put that money? How do you sidestep what we are seeing out here with the balance sheet expansion of the central banks? AKA money printing. This story right now is one where I don’t see any way for them to reverse those steps? I don’t see anything further for them to do but continue those efforts. I don’t see anything beyond increasing those efforts as we go forward.

In this game this is I’m going to contradict at least a little bit of my very first response which is how does this unfold? For the most part I think the banks print and print and print and everybody kind of says, well, it is uncomfortable, but seems to be working and nobody else seems to have cared so far and where would they go. That will progress along as far as it can and then someday that will change. When that does change it could be relatively radical, by which I mean my expectation would be a fairly profound turn, for example, in the United States, fiscal capabilities at the US Government level or in the value of the dollar changing over a matter of just months. Just a few months. To me that would be break-neck speed in this particular story.

This is – the hyper-inflation one is a tricky one because how do you measure that? Really, ultimately, we live in a faith based system. We have a debt based- monetary system. We have to have faith. We have to have faith that the money has value, it’s a social contract. We have to have faith that not too much of it is going to be created compared to goods and services. We have to have faith given the amount of debt that is out there in the system that the future is going to be a lot larger economically than the present. That is, when those claims come due in the future we would like to trade those claims, debt money, for things. If there aren’t more things in the future, but there is more of these claims on those things, well that is the story of inflation. Maybe even the story of hyper inflation, which to me, goes beyond just monetary excess and transcends into that next stage of loss of faith in paper money. I’ve personally lost my faith, that is why I am such a big holder of gold and silver. Other people, once they see it this way tend to lose their faith as well. This is becoming more and more mainstream as time goes on we are seeing more and more people who are very well respected, very established players in the monetary field. People who have made entire careers on trading for paper. Starting to look at the story and say yea, I would rather be holding something other than paper at this point in time. It is not just gold, it is really in all of the other tangible things that we can get our hands on. I would expect that if and when we start to see a shift away from paper back to things that that shift is going to be fairly dramatic and it is going to unfold in probably less than a year. Maybe in just a matter of months where we would see prices for a variety of things really, really skyrocket.

Adam Taggart: All right, well that is a lot to digest but it provides a good segue into what I am going to make our last question here.

We have done it again, Chris, we made it through another one of these interviews and not gotten to half the questions that we had hoped to, but we will have to take that up on our next podcast.

So with that said, let me take it home here with the last question that probably is a natural segue in many folks’ minds after hearing your answer to the last question. This comes from user Jbarney: How bad are things going to get? Power outages, mass protests, food riots, etc. Do you see things being this bad, this dark?

Chris Martenson: Very important set of experiences for me was living through hurricanes when I lived down in North Carolina, the most potent of those for me in terms of learning was Hugo, came through in 89. I lived oh, what three hours from the coast. It hit as a CAT 4 and by the time it got over us it was maybe still a CAT 2, he was a beast, Hugo was. He had the benefit of arriving after we had already received for other good reason, four or five inches of rain in the prior week so the soil was loose. So here he comes with his 80 + MPH winds and just made all the trees in the area, it was just like Pick-Up Sticks across our driveway. It was a real mess. We were without power for two weeks. I had to use a chainsaw laboriously to cut my way out of my own driveway. What I learned from that experience was that people really pulled together. It was an extraordinary time in my memory to think back on how close people were and how we did pull together. That, to me, was a metaphor that carried forward to the point that when I was looking into the future as I see it right now and when my wife and I were making decisions, where did we want to live? Picking the community that we lived in was incredibly important to us because where we lived in Hugo I will guarantee behaved very differently from parts of New Orleans. That was a function not of the brutality of the hurricane that was a function of how the people responded. So this is really important point to me is that what I care about most is not actually what transpires.

The economy falling apart itself or food coming in tight supply or anything like that, people will respond to that and we will make do. What I care about a lot is how do we respond. How are we mentally prepared and emotionally prepared and how are we personally going to respond. Are we going to be in a position of truly being selfless and helpful in those moments or are we going to be needing help in those moments? That dividing line really is going to be a function of how well prepared you are across these three areas we continue to talk about which are your financial preparations, those are going to count. Your physical preparations are going to count and your emotional preparations all of those are going to count. It is that last one that is really important that we are going to have the opportunity to dive into it at this weekend seminar coming up at Rowe, which again, this weekend and also at Krepolo. That’s a topic that really lends itself and I think requires the kind of intimate face-to-face meetings that we engineer for ourselves when we have these seminars. Because it is very difficult to sort of write about it and it needs to be personally translated and transmitted. Both my wife and I have a lot of facility with really talking through what is it – what is going to happen and how will we react and what will come up for us and how can we best manage those responses? That is something that absolutely everybody can get facility with and I think should. Absolutely should because when whatever transpires whether, again, whether it is a brilliant future that somehow free energy comes out of the zero point boundary or something. Or we have a fairly disrupt – disruption filled future, whichever of those outcomes happens understanding our own responses and stepping into both of those as fully as we can, that is how you win. That is really when I think life comes together.

I’m holding on as somebody who saw how a community can respond if it has in its DNA the idea that it is going to take care of itself, take care of its own and it will do that because that is just how they operate. I think that is the kind of framework that I want to share and talk about and then hopefully people will be able to bring that back into their own communities wherever those happen to be after the seminars.

Adam Taggart: Good. Well, thank you for taking what I had feared was a fairly alarming question and answering it with such positivity and optimism. I feel much better.

Chris Martenson: I have to finish that out, too, around the seminars because we also we will be talking physical preparations there and will be talking financial and will be bringing in some financial experts to go through some detailed questions of whatever people might have on their minds. This is a full weekend that is really around all three of those areas, but we spend a little bit more time on the one that is harder to talk about in writing.

Adam Taggart: Great. Well, with that, let me just make one last reminder that the Rowe one is actually this coming weekend. If anybody is still on the fence, act quickly. Beyond that, Chris, we have now made it through the interview, thank you, once again. I look forward to doing this again with you in probably about a month or two.

Chris Martenson: Adam, the pleasure has been mine and you are a great host.

Adam Taggart: You are too kind. Ouch, don’t make me laugh; it hurts still.

Chris Martenson: All right. See you next time.

Adam Taggart: Take care.

 

Transcript for Jim Rickards

Transcript for the podcast: James Rickards: Paper, Gold, or Chaos?

Chris Martenson:  Hello, this is another PeakProsperity.com podcast. and I am your host, of course, Chris Martenson. Today is February 10, 2012, and the world is in a bit of economic turmoil. Greece is flat out busted, the EU is in recession, Japan is struggling with a too-strong yen, and the US government is spending at least forty percent more than it is taking in revenue for the fourth year in a row.

To help us make sense of all this is Jim Rickards, seasoned financier, risk manager, and author of the recent bestseller, Currency Wars: The Making of the Next Global Crisis. In his book, he describes how currency wars are one of the most destructive and feared outcomes in international economics and that history shows they always end badly. He warns that today we are engaged in a new currency war posing risks that every prudent individual should be aware of. For those of you with smoldering concerns about the viability of the world’s fiat currencies, I sense this interview is going to toss some gasoline onto that fire. Jim, welcome. It is a pleasure to have you as a guest today.

Jim Rickards:  Thank you, Chris. Thanks for inviting me.

Chris Martenson:  Your newest book, Currency Wars: The Making of the Next Global Crisis is doing extremely well. It is sitting this morning at number two eighty on the Amazon booklist, I checked. Congratulations.

Jim Rickards:  Thank you, yes. We have been very happy with the result. It has been a New York Times, a national bestseller and very highly ranked on Amazon. And they have some subcategories in the international economics category. We have been number one for three straight months. Very, very happy with the reception.

Chris Martenson:  Well, fantastic. And the headline summary of your book, if I could, is that the Fed and other central banks are making a very dangerous gamble that might end well. But if history is any guide, as we have said, has a better chance of ending quite badly. Before we get to that endgame, though, can we set the stage? What does history tell us about currency debasement and these sorts of trade wars?

Jim Rickards:  Sure. Well, a currency war in the simplest form, Chris, is basically when there is too much debt and not enough growth. The overhang of debt impedes growth because it clogs up bank balance sheets and clogs up the savings to investment mechanism and has a lot of negative effects. So there is not enough growth to go around. So countries, in effect, try to steal growth from their trading partners by cheapening the currencies. One way to think about it, imagine you live in a small town. There are four stores, they all sell sort of the same thing and one of them has a half-off sale. Well, naturally, everyone is going to go to the place that has the half-off sale.

It is no different in currencies. You know, you are looking out at the world, there are certain countries that manufacture aircraft. We have Boeing in the United States, there is Airbus in Europe, Embraer in Brazil, and China has got an up and coming aircraft industry. Well, imagine you are Thailand or Indonesia, a country that needs aircraft but does not manufacture them. You are going to buy them from one of those countries. And if you can cheapen the dollar, it makes the Boeing aircraft a little cheaper and helps with sales. From that, you get exports, which contributes to growth and you probably get some additional jobs on the Boeing assembly line. So it sounds good. It is very tempting. It sounds like a free lunch, why not do it?

And indeed, the Fed and the Treasury are trying to do that right now. They are trying to cheapen the dollar, probably for the reason I mentioned. The problem is it does not stop at that. It invites retaliation and this is where I give some of the historical examples, as well as analysis.

A couple things happen. Number one – we cheapen our currency but other countries try to cheapen their currency also, so you get into these tit-for-tat devaluations where nobody wins. All you do is unleash inflation, restrict world trade without anyone getting an advantage. I like to say that in the currency wars, all advantage is temporary. You give it up pretty quickly.

The other thing is that for countries that cannot necessarily devalue, they can use capital controls, they can use import excise taxes. Currency wars can turn into trade wars. Ultimately, they can even turn into shooting wars. So you get all these bad effects.

So if the US could cheapen the dollar in isolation, if nothing else happened, maybe there would be some quick advantage. But that is not what happens. But it is a temptation that politicians and policymakers cannot resist, but it ends very badly.

Just to give two specific examples I talk about in the book, I give a history of what I call Currency War One from 1921 to 1936 and Currency War Two from 1967 to 1987. And Currency War One was co-terminus to a great extent with the Great Depression. World trade collapsed, currencies collapsed, unemployment skyrocketed – just a set of disastrous outcomes. And Currency War Two, we had the opposite. We had borderline hyperinflation. You know, when President Nixon took the dollar off the gold standard in 1971, at the time his aides predicted this would create five hundred thousand new jobs over the next two years. Instead, the United States had one of the worst periods of economic performance in its history outside the Great Depression. We had three recessions back to back to back in 1974, 1979, 1981.

So what these historical examples show is that you either get depression or inflation, but either way it is a bad outcome. But you would think the policymakers and the politicians would understand and learn the lessons of history. But they do not and they just attempt to launch these currency wars over and over again, but they always end badly.

Chris Martenson:  You know, right at the beginning, you said the debt is the original reason that we start these currency wars. So maybe in the first period you mentioned in the ‘20s, early ‘30s, that was arguably debt left over from World War I. And so ever since the 1970s, debt levels worldwide – but in the US, specifically – have consistently, year after year, risen faster than GDP. You know, just a few percentage points each year, but debt trumped income. And enabling all of that, I feel, was the steadily falling interest rates from the peaks in 1980 all the way on down through to current. And now, Bernanke has signaled rates are going to stay pegged at zero on the short end until 2014 and be lower than otherwise on the long end because of Operation Twist and whatever else might come next. How long can they keep playing this game, do you think?

Jim Rickards:  Well, they can play it until they cannot. I mean, not to be glib but the problem I see – and Chris, you are absolutely right about the debt, going back to Currency War One – the debt, in that case, consisted of German war reparations, reparations that came out of the Treaty of Versailles that ended World War I and Germany owed un-payable debts to England and France. But England and France also owed un-payable debts to the United States because they had borrowed money to fight World War I. So you had the spectrum of the entire world in debt. None of it could be repaid. Ultimately, none of it was repaid. I mean, eventually, Adolph Hitler repudiated the reparations and the United States forgave the war debt and we ended up in World War II and the whole thing was forgotten. Then in 1944, we rebooted the international monetary system at the Bretton Woods conference. But that was one contributor to the Great Depression. There were others, but that helped to start the currency wars.

And in the 1970s, you had a different set of debt. You had what was known as the Guns and Butter policy really started by President Lyndon Johnson in 1965. But the effects of it were first seen in terms of currency wars in 1967. The Guns part was the massive expansion of the US presence in Vietnam. We had been in Vietnam for a long time, but Johnson started to send tens of thousands and ultimately, hundreds of thousands of troops there and that was very costly. But at the same time, they launched the Great Society program of entitlements and benefits, which added to the domestic spending. The combination caught up with the United States very quickly to the point that we were, as I said, the dollar was suffering and inflation was breaking out in the 1970s.

So debt was the problem in both cases, no different today. I see the same thing today when you look at the European sovereign debt crisis, Japan’s debt to GDP ratio over two hundred percent – far worse than Greece, by the way. The United States, it is officially a hundred percent, but that only counts the bonded debt. When you throw in Medicare, Medicaid, Social Security, Fannie Mae, and Freddie Mac, FHA, and Federal home loan bank systems, student loans, and all the other liabilities that the government has underwritten, the actual ratio is a thousand percent, meaning ten times GDP.

None of this debt can be repaid, by the way. So what will happen is governments are going to try to inflate their way out of it. It is as if we will say to the Chinese, “Hey, we owe you a trillion dollars. Here is your trillion dollars. Good luck buying a loaf of bread because we have completely debased the currency.

So there is no question. It is quite clear that the Treasury and the Fed are trying to inflate their way out of the problem and debase the dollar. The problem I see is they might not get there, and here is why. The Fed thinks they are playing with a thermostat. You know, you can, if the room is too cold you dial it up. If the room is too hot, you dial it down by adjusting the money supply and working a little bit with expectations on the behavioral side that can gradually tweak economic behavior and lending and spending velocity and money supply that achieve a desired result. The problem is they are actually playing with a nuclear reactor. They are playing with a complex system that is in or near the critical state. Now, you can dial a nuclear reactor up and down but if you get it right, the consequences are worse than having to put on a sweater. The consequences are catastrophic. You can melt down a reactor and ultimately, the entire financial world.

So the danger I see is the Fed thinks they are playing with a thermostat. They are playing with a nuclear reactor and they risk collapsing the entire system.

Chris Martenson:  So this idea of complexity and stability, very important, I believe. Our economic and financial systems, they are complex systems, which means they are inherently stable until they are not. At which point, they often – and historically we can find they rather rapidly find a new equilibrium point once we are past some sort of disturbed threshold. How do you see the world financial system going forward? Is it a binary event? Either it survives or it crashes? Or is there some happy slower medium in there?

Jim Rickards:  Well, I do not think there is necessarily a happy medium. I agree completely, Chris, with the way these things play out. You either have a catastrophic collapse or you do one or more smart things to step back from the brink. You know, sometimes in making my recommendations, people say you know, “Hey Jim, you want to go backwards.” And my answer is if you are about to drive off a cliff, going backwards is a very good idea.

But the other thing, you are right about how complex systems collapse. But the thing that is less well understood is that the risk or the degree of collapse in a complex system is not just a linear function of scale, it is an exponential function. And what that means in plain English is that if you triple or quadruple, let’s say, the amount of derivatives on bank balance sheets, Wall Street would tell you are not increasing risk at all because you have long and shorts offsetting. It is very clear that that is incorrect, that is not a proper understanding of the statistical properties of risk. In fact, the risk is not in the net, it is in the gross. So if you increase the gross volume of derivatives – let’s say by five times – you have increased the risk.

But a lot of people would say well, maybe then you have increased the risk by a factor of five. But the answer is no, if you increase the size by five times, you probably increase the risk by a hundred times or a thousand times. In other words, it is an exponential function. This is the way complex systems work. But again, it is not understood on Wall Street and this is why policymakers are surprised over and over.

You know, they did not see the crash in 2007, 2008 coming. When it started, they underestimated the severity of it. When they responded, they underestimated the duration of it. They got everything wrong. Well, again, if you are looking through the wrong end of the telescope, you are going to get everything wrong. It just comes as no surprise because they are using the wrong paradigms and the wrong methods of understanding how the world actually works. You know, I hear these Wall Street guys and they say they have this catastrophic so-called black swan type events. And they say well, you know, I need to go back and fix my models. And my answer is no, your models are fine. Your paradigm is wrong. In other words, you have correctly modeled a false reality. And until you understand how things actually work, you are never going to get it right.

So therefore, that kind of collapse is a likely outcome. You can step back from it, and the key is to descale the system, break the system into pieces so that if individual pieces fail it does not cause contagion and take down the system as a whole. My favorite example is JP Morgan. JP Morgan Bank today is the result of five different banks, each one quite large in and of itself. When I started banking and you had Manufacturers Hanover, you had Chemical Bank, you had the Chase Bank, you had an old version of JP Morgan, and other banks all merged into one. Why not break them up into pieces and why not ban over the counter derivatives? I think exchange trader futures are fine because they have a lot of controls around them. But the over the counter derivatives do not. And get rid of dangerous products, break up the big banks and then move forward. You still have an economy and a financial system, but you have a lot less risk.

Chris Martenson:  So let me ask you something very specifically around this, which has been puzzling me for a while and I have dug and I cannot find an answer that satisfies me. So the ISDA and European regulators bent over backwards in order to avoid triggering a default event, a credit event on the Greek CDS paper that is outstanding. And so I looked at that and there is seventy eight billion notional on it, of which the net exposure was said to be in the vicinity of maybe three point eight billion of which at auction – if they settled that out at fifty cents on the dollar – there is maybe one point seven billion of total exposure. Why are they bending over so hard to avoid such a nominal amount of money?

Jim Rickards:   I would not say the bending over hard, I would say they are utterly corrupt, meaning clearly it is a default. Their failure to call it that just shows how corrupt the system actually is. But to get into your specific question, Chris, the reason is that if you actually did declare a default, the exposure is not the net of you know, kind of one to two billion that you described. The exposure is the whole seventy eight billion because that is taking a single institution. Let’s say I am five billion long and I am four point nine billion short and I am going to lose the entire value of my four point nine billion short. Well, the only way I preserve myself if I can go to the five billion long and collect. But what if I cannot collect? What if it is AIG? In other words, this is not just about market risk and notional risk. It is also about credit risk. So the only way the net is meaningful is if I am certain that I can collect on my long in case my short has lost value. But they are not certain about that. When you start having institution go to institution to collect the entire gross value of the debt, you are going to have failures. You are going to have people who cannot pay, then that will have a set of dominos to collapse the entire system. 

So the reason they are trying so hard to posture the way you describe, which is netting out the longs and shorts, going to the net amount, marking it to market, you know, sum value, etc. It is because the reality of the gross exposure is one that would take down the entire system. But that is the reality and otherwise, it just shows how desperate they are.

Chris Martenson:  So let’s talk about the desperation then. Because if we take this dynamic of the past four decades which, simply enough, was just one of debt growth exceeding income growth, this seems to be what Bernanke, ECB, Bank of Japan, everybody is trying to preserve the system. But I think anybody with a sixth grade math skill and a calculator can tell you that that game ends sooner or later. Does the Fed lack sixth grade math skills? Or what is their end game here? I do not even understand how this game plays out. Sooner or later, you have to get your debt back in line with your income, period.

Jim Rickards:  Right. Well, when you have this much debt overhang – and I think you described the problem correctly, Chris – there are only three ways out. The first way out is default, and we are seeing that increase today. The second way out is inflation, and this is the preferred method of the Fed and the Treasury. Now, you will never hear a Fed chairman say we are working really hard to get some inflation in the system. Although interestingly, Bernanke has said some things very recently that were very revealing along those lines. He said we do not want too much but he is very candid about targeting two percent inflation and has gone on to say you know, we might overshoot the target a little bit and things might get a little bit out of control and we could have something higher. To me, that is revealing because there is no doubt that what they are really shooting for is four percent inflation. They want the shock factor. In other words, they want to guide your expectations to two, then actually produce four so that people will sit up and take notice and say gee, you know, I had better do one of two things. I had better go out and buy that car or buy that refrigerator before prices get out of control, or buy that new house just to prop up asset values. The other thing is that at that point, you will have steeply negative real interest rates meaning if the nominal rate on the loan is one percent but inflation is four percent, then the real cost of borrowing is negative three. The lender is paying you to borrow. You can pay them back in cheaper dollars. So I like to say it is like renting a car, driving it around and returning it with the gas tank half empty without having to pay for the gas.

So that is what the Fed is trying to do. They are trying to get that lending/spending machine going again, get the velocity of money up and kind of inflate their way out of this problem. A couple problems with that. Number one, two percent inflation is not so benign. Two percent inflation cuts the value of a dollar in half – I am sorry – cuts the value of the dollar by seventy five percent in the course of a typical lifetime. So it cuts it in half in thirty-five years and then in the following thirty-five years, cuts it in half again. So now, you are down seventy five percent from where you started. So from the time you are born to the time you die, your dollar is going to lose seventy-five percent of its value. That is at two percent inflation. At four percent inflation, it will cut the value of a dollar in half by the time your children go to college.

So these are cancerous rates of inflation. Two percent sounds warm and fuzzy. It is not. The other thing economists say is, you know, who worries about inflation because your wages are going up and it all comes out in the wash. Well, I mean, this is the kind of thing that only an economist could say. But the fact is some of it does come out in the wash on average. But we do not live on average. We live our individual experiences. And the fact is in inflation, there are winners and there are losers. The winners are people who can see it coming, who understand what you and I and hopefully the listeners are talking about and hedge their position by getting gold or silver or land or fine art or investing in railroads as Warren Buffett is doing, some kind of hard asset play. The losers, those are savers, people with insurance policies, annuities, pensions, retirement plans – anything denominative dollars that are not going to go up when the inflation kicks in.

So inflation is really a form of theft, taking from everyday Americans and giving to leagues, hedge funds, bankers, and other people who understand, again, what we are talking about. So these are not benign numbers, but they do reveal the Feds’ hand. The Fed is out to inflate away the debt.

The third way out – in addition to default and inflation – is growth. And what happened to growth? And the neo-Keynesian economists like to talk about the tradeoff between consumption – which is just individual spending – and government spending. They have this concept of aggregate demand where they say well, gee, aggregate demand is falling short of target, like we are not spending enough money and consumers will not step up. So government has to step up and fill the gap between what consumers are doing and the theoretical aggregate demand. Well, whatever happened to investment? I mean, investment is part of GDP. The economists act as if consumption and government spending were the only two things that mattered. Of course, and exports is another part of it, but that is where the currency wars come in.

But what about investment? Investment is double beneficial. When you spend it, you get GDP immediately. And then if it is productive, you get improved productivity, GDP down the road so it is kind of a twofer. So we are going to move from a consumption driven economy to an investment driven economy. But instead, the neo-Keynesians just want to substitute government spending for individual spending and that is, yes, it is just part of this road to ruin.

Chris Martenson:  Well, I think part of their flaw, as I see, is they were expecting that a couple of trillion dollars poured into the gas tank would have gotten us revved up and moving and it has not. And one explanation for that is when I check out an oil chart, I can find exactly zero historical examples of a recovery happening at the inflation adjusted equivalent of a hundred dollar per barrel oil.

Jim Rickards:   Right.

Chris Martenson:  Do you have any thoughts on peak oil or energy prices and how those factor into this pile of debt?

Jim Rickards:  Well, certainly, high-energy prices are going to impede recovery and we are getting that not just from the kind of the prospect of inflation – which we talked about – but also because the geopolitical concerns in the Middle East. And I think those concerns are going to become more acute as the year goes on, the prices will go a little bit higher. So I am not really an expert on peak oil, but I am an expert on geopolitics and I can see that driving the price of oil significantly higher. And again, the data is unquestionably what you described, which is that is not the foundation or the basis for recovery. So in addition to all of the other headwinds I talked about, which is low money velocity, negative home equity, excess debt at the consumer level, deleveraging – in addition to all that, we have this high price of oil, which is just another headwind.

So again, it is all the more reason to think that the Feds have got their work cut out for them. But what concerns me is that instead of just sort of acquiescing to deflation and letting prices find the level, letting the housing market find its level to the point where people actually want to buy housing or buy stocks for fundamental reasons. Instead, they insist on propping up the asset bubbles to asset price inflation and ultimately, consumer price inflation. That will end badly, but it is hard to say when.

Chris Martenson:  So let me back up, then, to where you said that Bernanke said two percent is what we are targeting – wink wink – but he would not be unhappy with four percent. So they have already got interest rates at zero, they have already got as much liquidity in the system as I have ever seen. It expanded their balance sheet by a factor of three. They have done all these things and we do not have a whole lot of inflation going on by official measures. Do we interpret that as another round of QE is on the way? And if so, when would you think that might happen, given politics or election cycles or anything else?

Jim Rickards:  Sure. I think there are two interpretations, Chris, that we are consistently showing. I would like to say it is a sad thing, a sad sight when the Fed is trying to get inflation and cannot get it. So you are right. We have not – despite printing over two trillion dollars in the last three years – we have not seen much inflation in the United States. But there are two reasons for that. Number one; there is a very, very powerful deflationary vector coming out of the fact that we are in the depression. I do not really think in terms of double dips and recession cycles. I think we are in a depression. I think it began in 2007. It is probably going to continue until 2014; perhaps longer depending on policy. So there is a natural rate of deflation coming from that as balance sheets to leverage, assets are shed, prices get marked down, you know, etc. But then there is inflation, which is induced by the Fed through policy.

So what you have is sort of like two giant tectonic plates pushing against each other. It is the North Pacific plate pushing against the North American plate. Just because there is not an earthquake right now does not mean that tensions are not building up below the surface. I think the same thing is true when I see a CPI report coming in around two percent where it tells me that deflation is probably five or six and inflation is probably seven or eight. And it may net out to two, but the powerful, the underlying forces is very powerful and that could break one way or the other. So that is one reason.

But the other reason is that until recently, until about a year ago, China was maintaining a peg to the dollar. What that meant is that as the Fed was printing more and more money, a lot of those dollars were finding a way to China in the form of direct foreign investment, portfolio investment, and China’s net export account. And the People’s Bank of China said to Chinese companies and others that you cannot keep the dollars, you have to give them to us and we will give you our currency, the Yuan, the Chinese Yuan in exchange and then use that to pay your bills and your payrolls and all that. Well, what that meant was that the faster the Fed printed dollars, the faster the Chinese Central Bank had to print yuan to soak up the dollars. So the inflation actually broke out in China. Inflation took off with a vengeance in 2010 – say 2010, 2011 – which is highly destabilizing and worrying to the Chinese leadership because traditionally, it is the cause of political instability in China. So finally, they threw in the towel and did allow their currency to appreciate, go up, against the dollar. But that just means the inflation is now going to come back to the United States. Those chickens are going to come home to roost in the form of higher import prices.

And this is the flip side of the currency war. You know, currency wars start because people want to cheapen the price of exports. But they forget that the United States imports more than it exports and when you cheapen a currency, the price of all the things we buy from abroad – whether it is iPads, iPods, clothing, textiles, European vacations, etc. – all go up. So I think you can expect to see that inflation creeping in as a byproduct of the currency wars.

But yes, we are going to see QE3. They are not going to call it QE3. They are going to call it nominal GDP targeting, which is a fancy way of saying we want nominal GDP to go up and we do not care how much is inflation and how much is real. We just want the thing to go up because the debt is nominal. And you talked about fifth grade math. This is actually third grade math. You know, one plus four equals five and four plus one equals five. What the Feds are going to say is they care about the five. They care about that nominal growth. If it is one percent inflation and four percent real, that is a very happy outcome. But they are saying if it happens, it will be four percent inflation and one percent real. We do not care; we have to get to the five, one way or another.

So that is a signal that the Fed does not care about inflation. They are just going to print as much money as they have to. And you will see that probably at the April/May meeting, certainly before the summer. So yes, that is on the way.

Chris Martenson:  All right. In your book, you describe the end game as paper, gold, or chaos. Give our listeners a brief summary of what you think that endgame looks like.

Jim Rickards:  Yes, paper would basically be substituting a new global reserve currency. This is sponsored by the IMF, it is called the SDR, which stands for Special Drawing Rights. So basically, people understand that the Fed is a printing press and they can print dollars. Well, the IMS is a printing press, also. They can print SDRs and flood the world with liquidity that way. Except there is even less accountability at the IMS level than there is at the Fed level. This will happen the next time we have an acute stage of a financial crisis something like 2008. You know, the Fed papered it over the last time but the next time is going to be too big for the Fed. You know, the Fed increased their balance sheet to three trillion dollars. What are they going to do the next time, increase it to nine trillion? And there are political and practical limits to that. But the world has no limits, so we can just print this new world money on global money called the SDR.

So it is nothing new. They have been around since 1969 and some of them were issued, a couple hundred billion were issued in 2009. So that will be the new world money. Competing with that would be some kind of return to the gold standard where people do lose confidence in paper money and the SDRs do not do the trick, it is just another form of printing. Countries may have to go to the gold standard – not because they want to but because they have to restore confidence.

Third possibility – chaos – is the one I think that is actually the most likely. Not because anybody wants it or anyone plans for it but because of human nature, denial, wishful thinking, delay, kicking the can down the road, that things just collapse. As we have said before, these catastrophic collapses and complex systems come out of nowhere. They happen very suddenly and when you least expect it. And I think that may be what happens here.

Chris Martenson:  Yes. Certainly, I love the description of the pressures are building because that is what I see. I see the derivatives are actually higher today than they were in 2008. I see debt levels are actually higher, especially at the official or sovereign level. So these are all just pressures that are building. I cannot find any historical examples – maybe you know of one – where a reserve currency has been on the path of trying to weaken itself. I am not quite clear how that turns out and I do not know if the world has a better view how that is going to turn out either.

So here we are and today we have been talking with Jim Rickards, author of Currency Wars, bestseller, The Making of the Next Global Crisis. I highly recommend people read it. Jim, if people want to follow you further after they get your book, how would they do that?

Jim Rickards:  Thanks, Chris. I have a very active Twitter feed. The account is @JamesGRickards, all one word. Rickards is R-I-C-K-A-R-D-S. You can just following @JamesGRickards. You do not have to join Twitter yourself. You might want to, but you can just type in that handle and my account will come up. And I put quite a bit on the international monetary system. So that is one way to follow along and I would like people to do that.

Chris Martenson:  Excellent. Well, it has been a real pleasure talking with you today and we will certainly be tracking your book, how that does, and also what the Fed is going to do before summer.

Jim Rickards:  Great. Thank you, Chris.