Dan Amerman: Financial Repression & The New Interest Rate Hike
Financial repression authority Daniel Amerman returns this week to discuss the ramifications of the Federal Reserve's first interest rate hike in nearly a decade:
The key to understand the situation here is that this is not normalizing, and we don’t have a precedent. We really don’t. We’re kind of all being soothed and reassured by the Wall Street Journal and Bloomberg and the financial authorities that we’ve been down this path before, we’ve been down it many times, more often than not we’ve had rising markets as a result and, really, there’s nothing to worry about. The issue with that is there are many things this time that are entirely different, and what is presented as 'normalizing', for instance, is going back to say a projected interest rate cycle like we saw in the 2000’s or the 1990’s. What’s completely different, among many other things, is that we’ve never had rates forced so low before, and they’ve never been so low for so long. So, if you look, say at a long-term graph since 1954, what’s been going on with the Fed funds rates, we’ve had plenty of reversals in interest rate direction, but they’ve been these brief little dips that look nothing whatsoever like this.
The other big issue, and this goes back to our prior conversation on financial repression, is that I don’t think you can take any interest rate increases from the 2000’s, 1990’s, 1980’s, 1970’s as being comparable. Because, we have the greatest degree of national debt outstanding that we’ve had since the 1940’s and the 1950’s. So, you have to go much further back in time to see how a rate increase works when you have a country that’s just absolutely massively in debt. And, it’s a very different process than these recent historicals they’re talking about.
I just read the statement from the Federal Reserve and what they clearly showed was this was not normal. And, one of the clear ways that they showed it is that they made crystal clear that they would be keeping their current holdings of U.S. government and agency debt in roughly the 2.4 to 2.5 trillion dollar range, until this is fully confirmed and they’re sure they’re going forward with the interest cycle and so forth. Now, that by itself tells you this isn’t normal. Typically, if you’re talking about driving interest rates down, you want liquidity in the system, and you provide liquidity through asset purchases. If you want to drive interest rates up, you want to tighten the system and you might remove money from the system let’s say by selling many of those assets. And, they’ve made clear on the front end that they’re not doing that.
And, I think this, again, ties very closely into what we’ve talked about before, with the size of the national debt, with financial repression and so forth. For financial repression to work, for the government to keep a lid on and control of interest rates, they need a large captive audience. One of the largest components of captive audience is the federal funds currently holding such a large portion of the U.S. national debt. So, if they were to follow a true normalizing cycle, they should be selling those and they’re not.
Our national debt is a fantastic sum that most of can’t really understand. How could we possibly be that badly in debt? How can we make the payments on that debt in terms of principle and interest and so forth? And, people are right that if we were in a normal market situation, we would be in a huge degree of difficulty with the national debt. But, again, this is something that’s happened many times over the centuries. And, what governments typically do, their most popular choice when they get deeply into debt is they increase their control over the markets so they knock out the interest rate risk for themselves, they push rates way down as they’ve done to historical lows. There’s more to it than that (we'd need another full hour more to talk about financial repression), but basically, they transfer wealth from savers to the government in the process of paying down the debt, in a process that most people don’t understand.
Click the play button below to listen to Chris' interview with Daniel Amerman (60m:03s)
Chris Martenson: Welcome to this Peak Prosperity podcast. I am your host, Chris Martenson. Well, here we are, seven years into the supposed recovery engineered by the Fed and the only thing we can definitively say about the recovery is that the extremely wealth got even wealthier, and the bottom quintiles got a little poorer. Further, we can note that the Fed is very, very late to the game of normalizing rates as it’s called, which means raising interest rates. But, what does this mean? Is there really, finally some relief for the long-suffering savers, the pensions and those living on fixed incomes? Or, are new risks involved that spring from all the massive market deformations the Fed has spawned over the past seven years?
To help us make sense of this today is Dan Amerman, a chartered financial analyst, author and speaker with over 30 years of professional financial experience. As an investment banking vice president in the 1980s, he did work in security originations and asset liability management, including portfolio restructurings for financial institutions, as well as the creation of synthetic securities for institutional clients. So, he’s got decades of solid financial expertise and he’s been on the show before to discuss the concept of financial repression, an extremely important concept for you to understand. Dan, welcome back to the program.
Dan Amerman: Well, thanks for having me back, Chris.
Chris Martenson: Well, let’s start here. The Fed rate decision—we’re recording this on Thursday, it happened yesterday on Wednesday, December 16, 2015—well, the Fed, it did not so much raise by a quarter percent as commonly presented in the media, but raised the range of the Fed funds rate from existing between zero and .25% to a new range of between .25 and .5%. Was this even really a rate hike?
Dan Amerman: Oh, I would say that it was. We’ve seen an immediate reaction in the fixed income markets. We’re seeing a repricing in terms of particularly short-term Treasuries that’s reflecting this. That is absolutely accurate, it’s now a range. And, we look at the effective said funds rate, which is basically the bend just barely above zero. So, if they pull this off—and that’s not quite clear at this point—it will probably move to 25, 30 basis points, 0.25%, 0.30%, something like that for the effective range.
Chris Martenson: Now, would this actually be like prior Fed tightening cycles where actual liquidity is drained from the market? Or, is the Fed going to use new tools to try and get the rate to move which would be less liquidity draining, such as, oh, just raising the rate that they’re going to pay on the overnight money for the excess reserves that they’re holding?
Dan Amerman: Well, I think the key to understand here is that this is not normalizing, and we don’t have a precedent. We really don’t. When I heard you say the word "normalizing" when you were introducing this, we’re kind of all being soothed and reassured by the Wall Street Journal and Bloomberg and the financial authorities that we’ve been down this path before, we’ve been down it many times, more often than not we’ve had rising markets as a result. And, really, there’s nothing to worry about. The issue with that is there are many things this time that are entirely different, and what is presented as normalizing, for instance, is going back to say a projected interest rate cycle like we saw in the 2000’s or 1990’s or something like that. What’s completely different, among many other things, is that we’ve never had rates forced so low before, and they’ve never been so low for so long. So, if you look, say, at a long-term graph since 1954, what’s been going on with the Fed funds rates, we’ve had plenty of reversals in interest rate direction, but they’ve been these brief little dips that look nothing whatsoever like this.
The other big issue—and this goes back to our prior conversation on financial repression and so forth—is that I don’t think you can take any interest rate increases from the 2000’s, 1990’s, 1980’s, 1970’s as being comparable. Because, we have the greatest degree of national debt outstanding that we’ve had since the 1940’s and the 1950’s. So, you have to go much further back in time to see how a rate increase works when you have a country that’s just absolutely massively in debt. And, it’s a very different process than these recent historicals they’re talking about.
Chris Martenson: Well, let’s, let’s talk about just how unusual all of this is, because I think that’s an important backdrop for all of this story. So, you’re right, the Wall Street Journal is trying to soothe us and say, “Oh, this is a normal process. We’ve been down this road before.” You mentioned there’s additional outstanding debt in the markets, government debt. But, we’ve never had this degree of liquidity in the marketplace before. You know, 2.5 trillion in excess reserves parked at the Fed with even more trillions out floating around in the wild, doing what it’s doing in the markets, with clear, clear signs of speculative excess in the market. With, I don’t know, Triple C junk debt getting down to a four handle at one point in 2014, meaning a 4% rate in there.
So, that all feels very, sort of extreme and excessive, but the Fed is trying to say, at least in every statement I’ve read that this is all pretty normal and they don’t detect any bubbles and everything looks reasonable and stocks are fairly priced, all of that. How do you view this?
Dan Amerman: I just read the statement from the Federal Reserve and what they clearly showed was this was not normal. One of the clear ways that they showed it is that they made crystal clear that they would be keeping their current holdings of U.S. government and agency debt in roughly the 2.4 to 2.5 trillion dollar range until this is fully confirmed in terms of they’re sure they’re going forward with the interest cycle and so forth. Now, that by itself tells you this isn’t normal. Typically, if you’re talking about driving interest rates down, you want liquidity in the system, you provide liquidity through asset purchases. If you want to drive interest rates up, you want to tighten the system and you might remove money from the system let’s say by selling many of those assets. And, they’ve made clear on the front end that they’re not doing that.
I think this again ties very closely into what we’ve talked about before with the size of the national debt, with financial repression and so forth. For financial repression to work, for the government to keep a lid on and control of interest rates, they need a large captive audience. One of the largest components of captive audience is the federal funds currently holding such a large portion of the U.S. national debt. So, if they were to follow a true normalizing cycle, they should be selling those and they’re not.
Chris Martenson: I think this financial repression idea is critical to this, and for the people who weren’t here with us last time and who are listening new, can you briefly describe what financial repression means?
Dan Amerman: Well, there’s multiple components to it. If you want to take a big picture perspective, we have cycles going back and forth between markets and governments that have gone on for centuries. And, these are typically described by economists as being cycles of liberalization and repression. That is that they loosen up on the markets, they loosen on the government controls. There’s a massive creative of wealth. As often as not after a few decades there’s some big bubbles that blow out or something. The financial system is in trouble. And, then they go the opposite direction. They tighten. So, that’s kind of the big picture cycle that goes back and forth. And, what I think many people are not aware of is that we had a reversal that occurred in the early 1970’s where decades of repression was followed by liberalization and kind of everyone thought, “Well, that’s the only alternative. That’s the path forward from here.” But, we’ve had a complete 180-degree turn that occurred at roughly 2009, 2010, 2011, where we’re back to a very classic case of governments increasing control over the markets.
Now, the other more specific issue that people talk about with financial repression is the national debt. This fantastic sum that most of us can’t really understand. How could we possibly be that badly in debt? How can we make the payments on that debt in terms of principle and interest and so forth? And, people are right that if we were in a normal market situation, we would be in a huge degree of difficulty with the national debt. But, again, this is something that’s happened many times over the centuries. And, what governments typically do, their most popular choice when they get deeply into debt is they increase their control over the markets so they knock out the interest rate risk for themselves, they push rates way down as they’ve done to historic lows. And, effectively, there’s more to it than that and we don’t have—it’s, it’ll be a full hour more to talk about financial repression. But, basically, they transfer wealth from savers to the government in the process of paying down the debt, in a process that most people don’t understand.
Chris Martenson: Now, a key component of that, of course, is you need to have negative interest rates in some way, shape or form, nominal or real. We’ve never really monkeyed around with negative nominal interest rates, but I guess they are in Europe. But, a negative interest rate meaning I’ve got my money, it’s sitting in my bank account, it’s earning zero. But, inflation is still 1 ½, 2% by the official statistics. So, I’m actually losing…
Dan Amerman: And, higher than that in real statistics, but, yeah.
Chris Martenson: Yeah. What would you think the real number is?
Dan Amerman: I think we’re at at least four.
Chris Martenson: I would agree. That’s…
Dan Amerman: Possibly higher, four to five at least, maybe a little higher than that.
Chris Martenson: Yeah. And, that…
Dan Amerman: It’s not any seven or 10% like people say. I don’t think that’s reality-based, but it’s certainly higher than the official rate, I would believe.
Chris Martenson: Well, I can justify a higher rate on just one piece, one component of the CPI for myself, which is looking at the effect of Obamacare on my insurance costs for healthcare, which includes a couple of components, rising premiums and vastly increasing deductible limits, which conspire together to raise the cost to me.
Dan Amerman: Yeah, that’s just fantastic. That by itself negates the CPI.
Chris Martenson: I know, and the CPI, they still weight medical care in the CPI at 4.85% of total spend. But, we can just open up our BEA GDP and notice that healthcare spending is 18% of GDP. And, so they’ve weighted it inappropriately, and of course they have, because if you included a full weighting then the full burden of those increases would come roaring through. For the life of me, I can’t get anybody at the BLS to explain to me how it is that they weight healthcare at just 4.8% of the CPI pie. It doesn’t make any sense.
Dan Amerman: Well, they went to a black box in about 2002, 2003, if memory serves. They no longer fully disclose.
Chris Martenson: Yeah. So, at any rate, inflation’s pretty high and a cornerstone of financial repression is that that purchasing power that I am losing on my savings getting zero while inflation is higher, that purchasing power that Wall Street Journal et al, would love to sort of, like it’s a force of nature—"your purchasing power, Chris, it just disappeared." But, your point, I believe, is it doesn’t just disappear, it’s getting transferred. And, an important recipient of that would be the government. Is that correct?
Dan Amerman: Yes. It’s an entirely deliberate process. And, there’s nothing really controversial about it when it comes to professional economists. This concept has been around for a very long time. The name financial repression itself only dates to the 1970s, but this is a matter of national policy for the United States, for the United Kingdom, for Australia, for Canada, for basically the developed world in the aftermath of World War II. It’s a very well-understood process.
And, now the other thing to keep in mind about it is it’s highly effective when we have near-zero interest rates. But, you don’t need near-zero interest rates. It also works fine at 1%, at 2%, at 2 1/2 %, so long as the rate of inflation is higher.
Chris Martenson: Great. So, the Fed has been saying for a long time that they would love to see higher inflation. They never really explain why that’s going to be good for the average person. They just talk about it as if everybody has this prima facie understanding, of course. Of course, higher inflation is what we all need. And, what you’re saying is that higher inflation is not needed by you or myself necessarily, but it is kind of needed by the system.
Dan Amerman: I think that’s a very good way of phrasing it, yes.
Chris Martenson: Okay.
Dan Amerman: The theory is that you promote full employment by having a low rate of inflation. I think that’s very weak in terms of any case there. But, in terms of government tax revenues, in terms of governments dealing with things like large levels of debt, yes, they have a huge incentive to have an ongoing rate of inflation.
Chris Martenson: Now, what we’ve seen, of course, and I think that the absolute confirmation that anybody would need that financial repression is the active program of study—so, Europe’s now slipped into negative nominal interest rates, and of course, it took about a month for them after that for them to start talking about bans on cash. Explain why that would be.
Dan Amerman: Well, if you have cash, you’re not really necessarily losing value. And, the key to financial repression is that it’s not so much that you create a negative differential, but everyone has to be forced to participate through a combination of carrots and sticks. And, if people are holding onto their cash, then they’re not getting the negative interest rate, so they’re not participating.
Chris Martenson: So, there’s this corralling function that everybody has to be forced to participate. And, you know, one of the more solid pieces of statistics I have going back is that negative real interest rates and positive gold prices, a very good correlation. But, that’s broken down pretty badly in the last several years. In your mind, how does gold fit into this picture right now?
Dan Amerman: Gold is a classic element of financial repression. And, so is silver. The issue is that people—if you are forcing a negative yield on them, they want to get out of that, and they want an asset that will keep up with inflation. So, typically, what they will do is, many people try to move to gold and silver and dodge financial repression by doing so. And, if you want to know why it was illegal in the United States, and as well as the United Kingdom and so forth, to own gold for investment purposes between 1933 and the mid-1970’s, that’s exactly the case. Because, it allowed you to potentially escape financial repression.
Chris Martenson: All right. Well, it certainly seems to be the case, and of course, I have another chart here that shows that during the weeks of the FOMC decisions, gold does particularly horrendously. So, there’s—at any rate, whether the market’s been trained to behave a certain way or whatever’s been going on, it’s been very difficult to make sense of the degree of financial excess that exists out there and the behavior of certain assets.
So, Dan, here we are, when I’m looking at this, the question I have is how trapped is the Fed here? And, the way I’m going to sort of build out that question for you is to note that they’ve put all this money in, they and other central banks in combination have created conditions which have seen at least an increase of nearly $60 trillion of new debt created since the 2007 crisis began. And, they’ve created all that debt with this explicit/implicit understanding that that debt could be justified, rationalized and supported if we got back to fast economic growth, or at least reasonable trend-like growth. We’re not seeing that across the world, and worse, when I look into the commodity world, I see very, very clear signs of deflation. It looks to me like the Fed is really scared of that deflationary impulse, so they’re just doing everything they can to keep financial assets elevated. But, commodities really seem to be slipping out the back door and saying, “No, we’re in the depths of a pretty major deflationary wave.” So, let me get back to that. How trapped is the Fed here at this point?
Dan Amerman: Oh, they’re completely trapped. And, if you look at the speeches they make to fellow economists, they acknowledge that. I’ve written a huge amount on various aspects of this and I have a number of articles at my website. But, kind of the heart of the dilemma—and there’s many different aspects to this—is that the Federal Reserve essentially attempted to create a cocoon of sorts to keep the damage from getting too much worse from the financial crisis of 2008. And, they did this by just flooding the system with very low-cost new cash. What that did was that reversed the downward trend that was occurring at the time in asset prices. And, quite predictably—and, again, this is absolutely accepted economics, there’s nothing controversial about it—what they’re attempting to do here is something called "the wealth effect." The idea with the wealth effect is that people watch patterns and that’s what makes us feel good or bad. If we have the pattern going upwards, then we feel good and maybe we change our financial behavior. If the pattern is going downwards, we feel bad and we don’t spend money and we don’t take financial risks, and then this becomes self-reinforcing.
So, what the Fed was very intentionally attempting to do with the wealth effect is that by flooding the market with cheap cash, asset prices would rise, everybody would feel better about where they are. They’d feel better about their savings, they’d feel better about their retirement, and they would go out and spend money in the real economy, as well saving additional money. But, the risk is, if you push up asset prices and the economy doesn’t respond, all you’ve done is you’re created a massive bubble. This is absolutely dependent on very low yields.
And, the other issue that you run into is that the Federal Reserve has very effectively trained, particularly institutional investors, that bad news is good news. This has been true for a number of years now. The institutional investors in the world don’t really worry about bad economic indicators. Instead, as I know you’ve seen, Chris, for some years now, every time we have a bad result markets rise. And, the reason that happens is that the Federal Reserve has essentially trained the institutional investors of the world that "look, we have the trillions of dollars, we can control the asset prices, or at least strongly influence them." And, any time what would ordinarily be bad news that would cause the markets to drop, that just lets the investors know we’re going to take more aggressive action to keep the markets from dropping. So, you have this kind of reverse differential there.
Now, the problem is—and, they’ve known about this from the beginning—that they don’t really know how to do this. If you have elevated asset prices that are artificially high, and they’re based on investors being essentially trained that the Fed’s going to override the market, there’s a so-called "Fed put" that people have been talking about for years, where they’ve always got your back. They’ll come back in and they’ll help you out and so forth. How do you handle that transition from overpriced markets where investors are counting on Federal Reserve interventions to reality-based markets where the investors aren’t counting on the Fed? How do you that without triggering a rush for the exits at some point? Well, that’s part of the grand experiment we’ve got going on right now.
Chris Martenson: Not just a grand experiment, I would suggest. Full disclosure, my grandfather is a banker. He passed away a while ago, and he served on the New York Federal Reserve under Volker for a period in the ‘70s, and I don’t think he would recognize anything about what’s happening at this point. Something went off the rails. I actually peg all this around ’94, ’95. There was a little hiccup in the corporate bond markets and Greenspan responded by doing this crazy experiment, which is known as the "sweep accounts," which basically were complicated too much—I won’t go into it here—but, it removed the reserve requirement for banks so they could flood the world with money. They fixed the corporate bond market, but they also ignited the dot com craze, because there was all this money just like going crazy all over the world. And, that, of course, created the crash, and then we had a response to that, which created an even larger bubble and crash. And, here we are in the third incarnation of this, which the Fed’s gone even further down this path taking us to zero and holding us there. Not just for a little while, not for five or six months, but going on six years now.
So, that’s just an astonishing sort of a pattern, but it’s a highly interventionist pattern. If I had to characterize it—I think Greenspan and then Bernanke echoed this sentiment, which was, “Well, even if we do foster bubbles, they burst and then at least we’re there to help clean up the mess.” So, I think the Fed’s in this pattern of everybody loves the party they throw, and they create this big bubble, and then they get to ride to the rescue by performing heroic things that allow you to write a book like Bernanke’s title, which was The Courage to Act. You know, it’s kind of like, that’s like a drunk driver jumping out with a medical kit and having the courage to help the people that he just injured by plowing into them. That’s how I see it. But, of course, the Fed sees it differently. They do think they’re doing some very heroic sorts of things here.
But, this bubble that they’ve created here, Dan, I’d love to get your impression of this. This one isn’t just in the U.S. housing market. This one’s kind of world-wide. I don’t even know where you could go to hide from this one if it bursts. Do you see this as being global, or is this more localized and just in a few markets?
Dan Amerman: Oh, this is scary, Chris. Our minds were working alike then. As you were talking, I was thinking because I also identified basically the mid-1990’s as being when a major turning point occurred, and it really happened in three different areas simultaneously. These are all important for what’s going on this year, what’s going to happen next year and so forth. One of them was the central bank economists deciding they’re geniuses and they can overwrite the ordinary business cycle through essentially flooding the system with large amounts of cheap cash. And, every time they’ve done it, they’ve created a bubble. But, they’re not really reality-based at this point. They’re not fully accepting that.
There was a second part that was equally important. I would say the mid-90’s were the time when much of the U.S. domestic economy really started to implode and we moved to a much more internationalized world, where, in terms of employment, it became a much more international system. If we look at flows of capital, they became far more international at the same time.
The third component—and, this also very tightly ties into the Federal Reserve—is they are the regulator of the banking system. And, it was in the mid-'90s when we really let the regulations go. We used to have a very strict regulatory structure for institutions that offered federally insured deposits. If you did not have any government backing whatsoever, you could go take whatever risk you wanted to as a true capitalist. But, we had rigid restrictions on the banks that relied upon, effectively, the guarantee of the U.S. government in terms of what they could do. And, those were also released in the 1990’s.
And, we have all three of those kind of wrapping around today, and this is where things get just fascinating, as well as scary, is that we’ve never been through a situation like this in an international world that is so tightly interlocked. A big part of this then comes down to what is referred to as "the divergence," which is U.S. rates rising while they remain very low in Japan and they remain effectively negative in Europe. Because, what that then does is that ties everything in with our jobs as well as our financial security. Because—and this has been, of course, discussed a very great deal. But, what we would expect with a divergence—and we’ve seen this, of course, over the last seven to eight years on a global scale when we have a divergence going the other direction, when the U.S. had lower rates than did emerging markets around the world. That pumped huge sums of cash into the emerging markets. Their currencies appreciated, their asset markets appreciated and so forth.
But, the problem that we’re looking, at and the Fed actually acknowledged this—they didn’t really discuss it, they acknowledged in their statement from yesterday—is that we’re having problems with unemployment because of our currency. And, corporations are running into this in the U.S. right now, too. So a side effect of our increasing rates when the rest of the world isn’t, is that all else being equal, the U.S. dollar should strongly climb over time. And, if that does happen, then the American worker is at an ever bigger disadvantage compared to workers in other nations. And, the worse our employment prospects become, even as spending reduces and the economy does worse. And, this is an international component that your grandfather wouldn’t have recognized. It’s so much more prevalent now.
Chris Martenson: Indeed. And, I think a lot that dynamic has become enshrined in some of the recent trade agreements. I don’t profess to understand them, all, many tens of thousands of pages of them, but what little I’ve seen in the summaries, I don’t understand how this is all supposed to work from a national standpoint. I think from a global standpoint I get it, and from a global international corporation standpoint I get it. But, from a national standpoint it doesn’t make a lot of sense to me anymore.
Dan Amerman: It doesn’t, and the fascinating part is they don’t let it slow them down, though.
Chris Martenson: Yeah.
Dan Amerman: They know perfectly well they don’t have a solution for this. We are, some people would say, in an effective state of currency warfare already. And, we know perfectly well that a really big difference between the long-term history of U.S. interest rate increases and what we’re seeing right now is the very sudden and dramatic effect on United States employment and corporation profits if the U.S. dollar climbs too high. We’re exposing ourselves to major employment and economic risk, but we don’t know what to do about that. There is no solution. There is no magic ring that the economists know about, but yet we proceed anyway because so many people—a small minority of the overall population—but so many connected insiders are making so much money with this increasing globalization.
Chris Martenson: Yes, yes. So, that’s certainly the trend and these long trends have been in play for a while. What I’d like to do is maybe dial this back and let’s think about the average person. They’ve got a 401k, maybe they’ve got some savers, maybe they’re in a pension, maybe they’re trying to figure out when they should retire and begin taking Social Security. How would you even begin to advise people with those sorts of considerations here at this point in time? Is there really anything anyone can do to protect themselves from a government and a system that has boxed itself in, that has no, has no mathematically certain endgame besides ruin at some point, if I would put it in a short term. But, there really doesn’t feel like there’s a way out of the box that we’re in that has a positive outcome, and yet everybody still has to play the game, because we’re trapped within it. Put those two pieces together if you can. I’m just, I’m really struggling with how to play this at this point.
Dan Amerman: Well, this has been a focus of mine for many years. And, what I have become convinced of is that so long as we play the game the way that we’re supposed to, in environments like this there’s no way out other than luck or perhaps being so fortunate as to be in the position of the minority of the population that is just financially thriving in these circumstances, the “1%” and so forth. But, when you have the government overriding markets to essentially move wealth from savers to the government and from the favored financial institutions on a deliberate basis in a manner that the general population does not understand, and the media isn’t really covering, I don’t know the way out. I would say the starting point, though, is education, which is what each of us provide, education. Trying to help people understand what’s going on. If you don’t understand the problems, I don’t think there’s any way of coming up with a solution.
Chris Martenson: Right.
Dan Amerman: The other approach that I take—this goes back to my background, ever since I got out of graduate school, and you talked about a little of that earlier on—is that I used to structure synthetic securities and other things like that. If you look at things from a more, I don’t know, a little more upper level or high tech perspective in finance, there is no such thing as a necessary loss. Rather you always have two sides of an equation. You have a winner and you have a loser. And, if the government intervenes in the markets so that following the traditional retirement investment path is going to cause losses, then it is highly unlikely that you’re going to find a way out of that unless you can find a way to reverse your financial profile such that you’re benefitting from what the government’s doing.
Chris Martenson: So, give us an example? How—is there any one example we can point to?
Dan Amerman: Well, one alternative is to benefit from low interest rates, and that would be to try to do what many financial institutions do—what all financial institutions do—which is they basically create a differential between a very low cost of funds, and then an asset they purchase with that that produces a cash flow. Now, individuals can’t do this the same way that financial institutions do. I would never recommend that. That would be far too risky. But, there are risk-reduced methods for doing so.
Chris Martenson: I’m a big fan of using low interest rates to accumulate cash-flowing assets. Of course, that’s not easy, and of course, it’s not as easy as clicking a mouse button on my E-trade account and getting a few shares of IBM or whatever. But, it’s, certainly, it’s the only way I have personally determined how to deploy my capital at this point, is actively doing the due diligence, investigating cash-flowing enterprises. I understand, typically, much smaller ones, they’ve, we’ve called the small of the small-medium enterprises. And, figuring that out, because I really can’t make sense of the game anymore.
And, so you’re talking, Dan, to somebody who’s quite jaded. I watch the markets extremely closely. I’ve seen how the market structure has changed to the advantage of the co-located, high-frequency trading computers. I see how the algorithms play markets. I watch these thinly traded assets, including gold, but other ones as well, get slammed in the thinnest of moments by what are clearly price manipulating movements, both up and down. The SEC couldn’t care less. And, so I look at all that and I can only conclude: I don’t know how to play the trading game anymore. So, is there a way to invest in this market? And, the answer in many cases is no, because I don’t understand Amazon with a price-earnings multiple of 940. I don’t get it. And, so I’m left with trying to take control of my money as much as I can, but that’s much harder work, of course, to really roll up your sleeves and understand a business from the more granular level. Would that be an example of what you’re talking about?
Dan Amerman: That’s no coincidence. That’s the point. The system, I would argue, is effectively predator and prey, and the rules are written in such a way that when you invest, most of the benefits from that investment—or all of the benefits from that investment—pass through the other parties. That can be the case for decades at a time. And, the easier you make it to invest, the more money that flows to those other parties. A key part of—I think back to when I was in the investment industry in the early 1980’s and IRAs were really exploding, and the way they were referred to around the office was IRAs were the brokers' Full Employment Act. Cynical people. But, the point of the matter was never—if you look at the enabling IRA legislation—I would argue that someone who has worked in the investment industry would understand just fine that every year those funds are outstanding, the financial industry earns money off that account where all we do is we have paper profits that the investor can’t touch over that entire period. They don’t necessarily care what happens to the retirement investor—I hate to say this—30 or 40 years out. What they care about is the fee income they make during that entire period. So, then it gets set up where it is very easy indeed to invest money so long as the real benefits from a lot of that money is going to go to other people.
And, I think we’re seeing the next stage in that evolution right now where the government is really pushing companies, and it’s increasingly becoming the case, where when you begin employment you are by default entered into a retirement program. You have to actually contact human resources and go through a hassle to get out of that. Otherwise, supposedly for your own good, you have an immediate deduction that goes straight into the financial markets.
Chris Martenson: Uh huh. And, all we have to do is look at the bonus pool every year to understand that money’s flowing out of those markets all the time into Wall Street pockets somehow. They didn’t magically create that money themselves out of thin air. It came from somewhere. And, so that’s an important thing that I had to learn over time, Dan, is that trading’s a zero-sum game. There’s a winner, there’s a loser.
And, this particularly applies to the whole concept of derivatives. I know a lot of people and I know you know a lot about them, actually, somebody who designs structured products. So, a lot of fear, uncertainty around derivatives, I think rightly so. But, maybe inappropriately in some cases where people see the notional value and it’s in the multiple hundreds of trillions of dollars. But, the key thing is that a derivative is just a bet, right? It’s a bet between two parties, one wins, one loses. I would love—so, this so-called "Citi Amendment" to, it was tucked into a spending bill, which enshrined the idea that derivative bets between banks would be considered secured loans, as it were. Meaning that you, the depositor, with your unsecured account, would be somewhere back of derivatives should there be an event that causes that bank to get into trouble. This is the bail-in procedures we’re talking about. I’m wondering, have you studies those and do you have a view on that?
Dan Amerman: I’ve looked at bail-ins extensively. And, of course, they are now a matter of law in the United States, as well as Europe and elsewhere. And, it is fascinating that you would think it would be just the reverse. I mean, that’s kind of the idea that bail-ins were sold under, that big institutional investors took their hits first, and the small depositor took their hits last. What we’re seeing is an inversion in many cases there where that's happening.
In terms of the notional value, this is one of those fascinating things, okay. For instance, if you look at interest rate derivatives, which are very topical for what we’re talking about today, and there’s approximately—and the number’s been falling lately—but approximately 500 trillion outstanding, which is about 400 times the size of the subprime mortgage market. It helped trigger the financial crisis in 2008. So, we have a huge amount of risk there, but the flip side of that is that people are told, “Well, financially educated people understand that that’s not actually $500 trillion in risk.” What it is that Bank A entered into a contract with Bank B that entered into a contract with Bank C that entered into a contract with Bank D. And, the reason—so they’re just kind of passing that risk around, and they’re chopping it up into little bits and they’re each taking little pieces. And, then they look at that and they run their spreadsheets and they all agree they’re geniuses and they get great big whopping bonuses. Well, you know, essentially the banks are then at risk in terms of the amount of derivatives outstanding.
But, the problem is—and this is one of those situations where there’s a basic contradiction in how things are explained to the general public—is that when we collapse the exposure of the system down by all those contracts, what we’re accepting is what brought things down in 2008, which is counterparty risk. Each time you do that, when Bank A goes to Bank B, goes to Bank C, goes to Bank D, goes to Bank E and so forth, every time you do that, you say, “Okay, we knocked out our risk, because that other bank is taking most of the risk for us.” Unless they’re not good for the risk. Then you have what the International Monetary Fund refers to as counterparty risk, which can run through the system and knock everything down. Once you understand that, then you see the priority for derivatives and then you see why they are moving to clearinghouses on an international basis as well.
Chris Martenson: I think Greenspan got this badly wrong. He noted that he loved derivatives because they seem to make risk disappear. I think that we need to understand that there’s a law like the law of thermodynamics that states energy can neither be created nor destroyed, only transformed. I think there needs to be a law of risk which applies to derivatives, which is that risk can neither be created nor destroyed, it can only be transferred. Would you agree that the derivatives have helped us mask the risk, but they haven’t eliminated the risk, and therefore it’s allowed actually more risk to accumulate in the system rather than less?
Dan Amerman: Let me comment on that on a couple of levels. First, in the industry, one of the oldest of all games is hedging, okay. If hedging is done properly it leads to a reduction in risk. And, the idea with hedging is that you take an asset that has an exposure to something, it could be price risk, it could be funding risk, whatever, and you go enter into a contract or do something else on the other side of it that has an exposure in the opposite direction, okay. So, when you put the two together, the risk drops out and you’re left with return. That’s the theory. That’s really, really hard to do in practice. Institutions have a great deal of trouble at it. So, what almost always ends up happening is what’s called active timing, where they call it a hedge for regulatory purposes, but they’re actually just taking a massive risk. And, of course, we’ve seen that in the headlines again and again and again with derivatives traders as well as other traders. They’re supposedly hedging risk, and instead they’re doubling down on the risk and taking as much as possible under the pretense of reducing risk. And they get a personal gain for that. You know, they might make an extra $10 or $20 million, an enormous sum for an individual. But, the downside is they may lose their institution, the taxpayers, you know, $10 billion or $20 billion if it goes the wrong direction.
The other core here that we’re looking at with derivatives is that we have what is called correlated risk, which is—okay, I’m a financial geek, it’s interesting stuff—but, the deal is that typically—and this is way Greenspan viewed it—you could look at derivatives as being an insurance contract. Let’s say you are a fire insurance company, and you have policies written in many neighborhoods in California and New York and Texas. The idea is maybe a house will burn down in California, but there’s no correlation with a house burning down in Texas. And, a house may burn down in New York, but there’s no correlation with a house burning down in Illinois. So there’s no correlation there, and you just take your money in from writing the insurance policies, you pay out your statistically predictable amount you’re going pay out and you make money.
Now, what really collapsed the subprime market, which was the trigger—it wasn’t the only thing involved—but the trigger for what happened in 2008 was they ran into correlated risk. The investment banks had been making the same crazy bets on a nationwide basis when it came to subprime lending standards in California, New York, Texas, Nevada, Arizona, Florida simultaneously. When things turned negative, they turned negative for the entire nation simultaneously, like one fire going across the entire country at the same time. The moment that happened, they blew through their reserves instantly. They could not possibly handle correlation. And, that was the problem with how Greenspan looked at it.
This is where the risks really get interesting with what’s going on with interest rates, even with this very tiny little gradual—I don’t think it’ll do it by itself by any means—one quarter of one percent increase is interest rates are by definition correlated risk. It’s not like interest rates just go up for this one contract that you’re looking at. They go up for everyone simultaneously. And, everyone can on a micro level have these interwoven contracts between the banks saying, “We are protected here, we’re protected here, we’re protected here.” But, we have above that this macro level of where does the financial industry as a whole come up with the capital to make the interest payments if they rise for the nation as a whole?
Chris Martenson: Now, we’ve been seeing that a little bit, I think, looking at the high-yield market, high-yield credit. Would this be an example where if somebody’s written credit default swaps and they’ve been writing them out across that universe, you would say that there’s a degree of correlation within that sub market? So that if high-yield credit begins to get distressed and the yields are rising and maybe defaults are beginning to rise that it’s not an uncorrelated event, that junkie company A and junkie company B are experiencing distress at the same time?
Dan Amerman: Yes. If you want to know why the massive intervention occurred in Fall of 2008, that was exactly why. And, the credit default swaps, which are a much less important part of the market now than they used to be were what was really going on. I mean, people talk about Lehman, but it was actually Fannie and Freddie that nearly destroyed Wall Street, until they were taken over in the early days of September. Because, if they had gone under, they would have triggered the credit default swaps and basically all of Wall Street would’ve been destroyed in a matter of days. That risk is still there, although, again, the credit default market is not nearly as important as it used to be.
Chris Martenson: Okay.
Dan Amerman: Interest rates are where the heart of the trouble is right now.
Chris Martenson: All right. So, let’s talk about interest rates for a bit and let me get back to where we started, which is so the Fed just hiked rates. Well, they hiked the range. Do you think they’re going to continue to hike at this point and if so, what does that imply to this interest rate risk that you’re talking about?
Dan Amerman: I think they very explicitly don’t have the slightest idea.
Chris Martenson: Okay.
Dan Amerman: This whole thing is an experiment. They really don’t know how to do this. And, that is why they are taking a much slower approach than they were before, and they’re being very tentative about that. It used to be that in a tightening cycle, an interest rates rising cycle, you might be looking at raising rates say 2 ½% over the course of a year. They’re now talking about a 1 1/4% maybe, contingent on, again, if you look at the statement, multiple different risk factors.
Chris Martenson: Well, they said they’re on a path to raising, but the path might, is dependent on whatever happens next. So, theoretically, the path could go back into a negative slope instead of a positive slope. I mean, they very explicitly said, “Hey, we don’t know. We’re on a path, but the path could change direction.”
Dan Amerman: It’s a three-year path of very gradual increases where they have caveats built into it on multiple different levels. They really don’t know, they haven’t done this before.
Chris Martenson: Okay.
Dan Amerman: No matter how many times you read in some places that, okay, this has been done many times before, nothing quite like this has even been done before.
Chris Martenson: So, in your mind, what would cause the Fed to reverse course and drop us back down to zero?
Dan Amerman: I think the number one risk that they’re looking at is if one of the multiple markets that are dependent on very cheap rates starts to move quickly against them, okay. We’re already in a situation where many people are expecting a recession to occur in 2016 or 2017. We have highly elevated asset prices, and the biggest issue of all is—and many of the leading economists around the world, the leading institutions have been warning of this—we have a particular liquidity danger at the moment in terms of everyone heading for the exits at the same time and there not being anyone to buy them on the other side. We saw a small example of that with some ETFs back in August. The market just disappeared.
Chris Martenson: And, with the bond funds that had to gate redemptions recently.
Dan Amerman: Yeah. And, if you’re looking at the high yield that’s, again, that’s a very correlated factor there because people bid them down to these incredibly low, insane levels because they couldn’t get yield anywhere else. And, if you can get yield somewhere else, and you don’t need them so desperately, then logically, people head for the exits. And, as soon as they head for the exits, prices start to fall, and then this creates the classic liquidity crunch scenario that’s at the heart of most financial crises historically. Everyone looks around and they see everyone else heading for the exits, so they go, too. There’s very limited amount of money to them out, you have a crash and then you have a very bad situation again. And, in my mind, the most likely source for the Federal Reserve reversing course is to see that happen in a real-time basis in a major market over the coming months.
Chris Martenson: Okay.
Dan Amerman: Could be high yield.
Chris Martenson: So, let’s—I think there’s a high chance of that happening—let’s pretend it has happened. I don’t think dropping from the current range back to zero to .25 does much besides a little temporary boost to the market psychology. Maybe if they could walk down expectations that they’re no longer going to do any raising in the future, that’ll have a sort of a low-ish effect. I’ve seen all the trial balloons. I’d love to get your opinion on these in the final question set here, which is we’ve seen them talk about, oh, giving a little bit of money to everybody ala Finland. We have Steve Keen’s idea of giving a big $50,000 per household debt jubilee sort of a payment out there. We’ve seen negative interest rates being floated with a ban on cash. And, then other ideas where maybe more fiscal stimulus with an overt monetization of that debt, which might take the form of, I don’t know, a tax holiday that everybody gets to participate in with the Fed monetizing the debt. Amongst those range of options, do you think one or more of those will be tried in the future? Is that what’s coming next?
Dan Amerman: They very well could be, but I think the more likely thing is that they will continue to go back to what they have been doing for many years now, which is basically set up the playing field in a way that works for them, and accomplish what they want to accomplish in a politically deceptive manner. That’s why we have financial repression. You have four basic ways— and we’ve seen this through history—of dealing with very large national debts. You can have austerity, which is politically very unpopular. You can have high rates of inflation, which people understand and it’s politically very unpopular. You can have default, which people understand and it’s politically very unpopular. Or, you have option number four, behind door number four, which is financial repression, which nobody understands. And, because it’s not understood, they don’t have the political price for doing it. It’s possible they will do some of these very large overt things, but more likely is that they would double down on what’s already working for them.
Chris Martenson: I guess my question is: But, it is really working? It feels a little Japan-like at this point where it works if and only if they can get the rates of inflation and the economic growth so that they can loop all of those pilfered purchasing power units back through door number four. But, that’s not working.
Dan Amerman: But, okay, we got a real basic question here that I think’s very important. What does "working" mean? Does that mean solving a problem or staying in power?
Chris Martenson: That’s a good point. Well, I assume it means, though, that there’s this deflationary wave building, which I think has the chance of being like austerity. I mean, it’s a thing that if it takes hold and really sweeps across the landscape, I think that that would be very politically unpopular, and I think it could sweep people out of power if it comes to pass.
Dan Amerman: And, at that point, you are looking at—that’s what you’re talking about in terms of the Finland example, in terms of just creating large sums of cash and sending it out to people, much like Bush was doing, let’s say, in 2007 on a smaller scale here in the United States. That could certainly work, but the—I don’t want to be cynical here—but, typically when they have… If you do that for the population as a whole, then everyone benefits equally. But, if you instead create $2.4 trillion in cash and you put it out through the Federal Reserve to the banking system, then most of the population does not benefit. Connected insiders do benefit, and nobody really understands where the money is coming from.
So, again, not to be too cynical, but there’s two levels there that I might disagree with you on. Number one, "working" is not solving a problem. "Working" is staying in power where you can keep the flow of money going to yourself and to your friends. And, number two, knowing that this is the case, a screening mechanism that’s going to be used for if let’s say extreme survival techniques are necessary to be deployed by the central bank or by the financial system. They’re going to try to do these in a way that sends ever more wealth to a concentrated group of people, and I don’t see how that works if they send everyone, you know, $10,000 simultaneously or whatever.
Chris Martenson: Right. No, no, I, yeah, I totally understand that and I’ve got a quick quote for you from Bernanke. He’s talking with Martin Wolf of the Financial Times and Martin’s a smart guy, but he just let this statement go, where Bernanke said, “It’s ironic that the same people who criticize the Fed for helping the rich also criticize the Fed for hurting savers. And, those two things are inconsistent.” I guess I’m not a smart guy, because I actually think those two things are entirely consistent and it fits in with what you’re saying, is that Bernanke is in such a position, he feels like he can say that outright. That we haven’t really been helping the rich, and we haven’t really been hurting the poor, and those two things, you can’t really pin those on us. But, of course, as we’ve just discussed over the past 58 minutes here, that’s exactly what the Fed has been doing and on purpose.
Dan Amerman: Absolutely. Yeah, absolutely. They’ve basically been redistributing wealth from savers to the federal government and to people who understand asset liability management.
Chris Martenson: Right. Well, with that, we are out of time. I could keep going with you forever and ever. We’ll have to do this again soon, because there’s so much more I didn’t get to. I’ve got many questions still here. I can’t wait to get those. So, Dan, tell us how people can follow you and your excellent work.
Dan Amerman: My website is danielamerman.com. And, I’ve got just a whole cluster of articles there about the national debt, how that relates to what’s going on with investors, what that does for retirement, impacts on Social Security, possibility of crisis, all those different issues. And, if people are interested, I also have a free book they can sign up for. I find this works best to kind of deliver it over time because this is a genuine process, a paradigm change, that will kind of step-by-step take them to a better understanding of looking at this deeply unfair situation and finding where the opportunities can be, but in a very non-conventional manner.
Chris Martenson: Well, I want to thank you for both the education and the advice that you’re helping to deliver to people. Because, this is a highly unconventional time, and I think it does begin, of course, with understanding. You have to understand the system as it is, and of course, the system may well change on us as we go forward.
Dan Amerman: It very easily could. Well, I sure enjoyed our conversation.
Chris Martenson: Well, thank you so much. And, thanks for your time today.
Dan Amerman: Thank you, Chris.