The Breaking Point

by James Dale Davidson

  I believe he is right. The days of the status quo are numbered. Even before Brexit, it was ripe for a fall. The United States, along with most of the world, is already in recession, and the central bankers, along with the other mandarins of statism, haven’t a clue what to do about it. Incomes for nonelite workers have been falling for about half a century. And even in a quasi “sort-of” democratic system that was eventually bound to have consequences. As Faber underscored in a CNBC interview, the revolt against the establishment “is already well underway. Brexit is a huge boon for Trump and a wake-up call to Hillary that ordinary people are sick and tired of being lied to and cheated by the crony capitalistic system.”14

  Or “Time for the Elites to Rise Up against the Ignorant Masses”?

  Battle lines are drawn. Foreign Policy magazine has published an article by James Traube proclaiming, “It’s time for the elites to rise up against the ignorant masses.” According to Traube, “It’s not about the left vs. the right; it’s about the sane vs. the mindlessly angry.”15 He seems to think it is entirely appropriate for bankers and the high nabobs of crony capitalism to use the powers of government to empty the pockets of the “ignorant masses.” But woe to those ignorant masses who dare to repudiate “the bankers and economists and Western heads of state” who instruct them on the boundaries of permissible anger. Perhaps one of the reasons for the virulent reaction against the “ignorant masses” is the instinctive understanding by Traube and other defenders of the status quo that anything that encourages people to think more deeply is subversive.

  Why Uncertainty Is a Solvent Dissolving the Status Quo

  The status quo is an engineering marvel, a convection erected on the flimsy footing of fake statistics, unfunded liabilities, preposterous growth forecasts, and funny money accounting. Upon inspection, it is evident that national debts (sovereign paper), far from being high-quality “riskless assets,” are predestined to become little more than souvenirs of lost causes like Confederate money.

  All the advanced economies are Looney Tunes productions at risk of a Wile E. Coyote moment. They are all suspended in thin air, resting on nothing but an ill-placed confidence that could be wiped away as investors contemplate this or the next Black Swan.

  The status quo has been collapsing for decades. Evidence of this is apparent in decelerating economic growth and the fact the governments of all advanced industrial economies are unable to pay their way. You need only consider the astonishing, previously reported fact that $11.7 trillion in government debt is trading with negative interest rates.

  Thanks to the growth stall, insolvent governments cannot afford to pay honest interest rates on their rapidly metastasizing debt. In other words, conditions are so weak and the options for deploying large sums in investment seem so uncertain that people are prepared to pay governments for the privilege of lending them money. According to Fitch’s, the credit rating agency, the total value of bonds trading with negative yields has soared by $1.3 trillion in June 2016 alone.16

  This tells you that the deflationary dynamic characterized by Exter’s Pyramid is already at work in a big way. It calls into question all the derivative illiquid investment categories at the top layers of that unstable, inverted structure, including ultimately the purportedly safe government bonds themselves.

  That is why I think anyone with the capacity to do so would be well-advised to prepare for the worst and put a few hundred thousand dollars aside in actual gold bullion in a repository outside the banking system. I believe we are headed for deflationary collapse. But it is also possible that elites desperate to teach “the ignorant masses” a lesson could also engineer hyperinflation as the whole economy collapses.

  Either way, the real price of gold is destined to go higher. This is obvious for hyperinflation. But gold should gain relative value in a deflationary environment precisely because the deflationary liquidity pressures may force the sellers of paper gold claims to buy large quantities for delivery. Or default. Be that as it may, it underscores the drawbacks of relying on the leverage in futures trading to profit from “paper gold.”

  I doubt that you would go wrong in a worst case circumstance if you purchase actual gold and warehouse it in safe vaults outside the banking system in Switzerland. For more information, contact Johny Beck, partner, Matterhorn Asset Management AG at jb@goldswitzerland.com. Their websites are www.goldswitzerland.com and www.matterhorngold.com.

  Meanwhile, keep your eyes open for other precious metals investment opportunities for a world in crisis. As legendary trader Jim Rogers says, “This is going to be worse than any bear market that you’ve seen in your lifetime.”

  Rogers forecasts, “The EU as we know it will not exist, the Euro as we know it will not exist . . . I’ll tell you what I’m doing, people have to make their own decisions, going into this I’m long the U.S. Dollar, I’m short U.S. stocks, I own some Chinese shares, I own agriculture around the world. These are things that might do well no matter what happens . . . these are going to be perilous times, I hope I get it right.”

  You should be entertaining similar thoughts.

  For better or worse, anything that cannot go on forever will inevitably come to an end. The Black Swans fluttering overhead are omens of deep tectonic disturbance. For decades, pressures have been building along the fault lines of our civilization. One fine morning, something will give way and the rickety edifice could tumble down.

  Notes

  1 Greenhalgh, Hugo, “Bordeau Vintners Raise a Glass to Brexit Effect as Wine Sales Reach Five-Year High,” Financial Times, August 13/14, 2016, 1.

  2 https://goldsilver.com/blog/china-the-next-crisis-kyle-bass/.

  3 Tett, Gillian, “Now Watch the Shift in Interest Rates,” Financial Times, July 1, 2016.

  4 Durden, Tyler, “North American Life Insurers ‘Accidentally’ Pile Up Massive Distressed Debt Holdings,” Zero Hedge, August 12, 2016.

  5 Popper, Karl, The Logic of Scientific Discovery (London: Routledge, 2002), 19.

  6 Taleb, Nassim Nicholas, The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007).

  7 https://peoplestrusttoronto.wordpress.com/2016/06/26/china-devalues-yuan-most-in-10-months-as-premier-li-warns-of-brexit-butterfly-effect-on-financial-markets-economy/.

  8 http://www.zerohedge.com/news/2016-06-19/nigel-farage-brexit-we-had-momentum-until-terrible-tragedy-here-are-latest-odds?page=1.

  9 http://sgtreport.com/2016/06/assassination-the-conspiracy-theory-to-prevent-brexit-vote/.

  10 http://www.usatoday.com/story/money/business/2016/06/24/greenspan-brexit-euro-eu-greece-oecd-economy/86336802/. Note: USA Today editors chose to narrow the allocation of Greenspan’s comments in a way that they do not apply to the United States. Read them without those brackets. They do.

  11 https://mises.org/library/nafta-myth#.UppdJ83nE1A.reddit.

  12 http://davidstockmanscontracorner.com/bravo-brexit/.

  13 http://www.zerohedge.com/?page=2&feed_me=Conventionally.

  14 http://www.zerohedge.com/print/564731.

  15 http://foreignpolicy.com/2016/06/28/its-time-for-the-elites-to-rise-up-against-ignorant-masses-trump-2016-brexit/.

  16 http://finance.yahoo.com/news/fitch-brexit-vote-pushes-negative-150600583.html.

  Chapter Twenty

  The Idiot Principle of Deflation, and Why I Am One of the Idiots Who Sees It Happening

  It should be patently obvious to anyone with two synapses to rub together that the Idiot Principle of Deflation is utter gibberish, and cannot possibly add up, when one simply views the economic dynamics (and definitions) in their proper context . . . Sadly, this infantile error in logic/arithmetic of which all the Deflationists are guilty cannot be attributed to mere ignorance. It is (has been) nothing less than abject stupidity.

  —Jeff Nielson, “Hyperinflation Cannot Be Prevented by Debt/Deflation,” Sprott Money

  The last time it seemed so certain that my IQ had receded into double digits was after I forecast t
he collapse of the Soviet Union. That made me really stupid for a while. The few authorities who admitted giving any heed to my unconventional prophecy were absolutely convinced it was, as Newsweek put it, “an unthinking attack on reason.”

  That experience should have warmed me up for the rant from Jeff Nielson of Sprott Money, who has been unleashing double-barreled insults against anyone with the temerity to suggest that the bankrupt status quo could collapse in debt deflation. I suppose it would be churlish to point out that “idiot” is a noun, not an adjective. But equally, we are entitled to wonder what it means that ungrammatical insults carry a greater punch of authenticity at this stage in the credit cycle. Perhaps it is a quasi-indicator of things coming unhinged, like the “hemline theory” that supposes the length of women’s skirts are strong tip-offs to prosperity, or the lack thereof, with shorter hemlines being more bullish.

  Dark Nail Polish and the Future of the Economy

  Then you have the closely observed alternative theory posited by Forbes contributor Lee Shepard. She argues in “Fashion’s True Leading Economic Indicator” that dark nail polish colors foretell a dark economic future.1 She says, “Dark nail polish would qualify as a leading indicator—telling people things were headed into the porcelain plumbing before it was otherwise evident.” She also notes that “ballet-slippers pink” was in style in the boom years of the 1980s, and it remains popular with denizens of the upper East Side because “economic life is always good for them.” Unfortunately, Ms. Sheppard doesn’t give us any hints about whether fingertips adorned with Chanel’s reddish-black Vamp are pointing toward hyperinflation or deflationary debt collapse—or perhaps both. To understand that, we have to put the ungrammatical insults aside and figure it out for ourselves.

  Nielson’s argument in “Hyperinflation Cannot Be Prevented By Debt/Deflation” turns on some definitional slight-of-hand, as it defies an incontrovertible principle of alternative medicine. There is no telling how many cancer deaths have been prevented by heart attacks. It is possible that deflationary collapse will quench the country’s thirst for artificial monetary stimulus and thus forestall the launch of helicopter money that otherwise seems likely to hover like a dark cloud on the horizon.

  Nielson is eager to tell you that every unit of currency came into existence through “our bankrupt governments literally borrowed every unit of currency into existence.” This means that these units of currency are/were literally the IOUs of our governments—our bankrupt governments. He asks, “What is the value of an IOU issued by a bankrupt Deadbeat?” His response: “Zero.”

  A nice, tight little syllogism.

  But not so fast. I agree that the government is bankrupt, especially when viewed in terms of GAAP accounting. As you may recall, two leading congressional budget experts, former congressmen Chris Cox, one-time chairman of the Task Force on Budget Process Reform, and Bill Archer, a past chairman of the House Ways and Means Committee, admitted in a Wall Street Journal editorial, titled “Why $16 Trillion Only Hints at the True US Debt,” that the government would have to raise revenue by $8 trillion a year to achieve solvency. Not an easy task. That targeted tax raise was greater than every penny of adjusted gross personal income for persons earning $66,193 per year, $5.1 trillion, as well as all reported corporate profits, $1.6 trillion, for a total of $6.7 trillion in 2006, when corporate income peaked before the recession.2

  A path to solvency that requires taxing away more income than people earn is a dead end. So I agree wholeheartedly that the government is hopelessly bankrupt. Where I beg to differ is with Nielson’s heavy-handed conclusion that there can never be a deflationary collapse. Mr. Nielson has led himself, and others, astray by missing the fact that values in the market are set by the price mechanism, not by arbitrary definitions. You can’t resolve the question of whether the Breaking Point is more likely to take the form of a deflationary collapse or a hyperinflationary one by enlisting a better lexicographer. It isn’t a matter of definitions; it is a matter of market dynamics.

  Investment Syllogisms Run Amuck

  For my part, I see lots of drawbacks in an investment strategy formulated on the basis of tautological definitions and syllogisms. I can easily postulate a similarly misleading construct that could inform a highly unprofitable investment.

  Take this example. Say that the major premise of your syllogism is that the shares of bankrupt companies are worthless. Then say that the minor premise of your syllogism is that you believe that the Framus Corporation is bankrupt. Therefore, you could leap to the conclusion that if you sell short shares of the Framus Corporation at $43.44, their price must immediately fall to zero and you will make a lot of money.

  Sounds pretty simple and quite logical. It is a proposition exactly like that of Jeff Nielson’s assertion that the value of an IOU issued by a bankrupt deadbeat government is zero. But one little hitch should be obvious to anyone who thinks for a moment about Nielson’s deduction that money is worth “zero” because “these units of currency are/were literally the IOUs of our governments—our bankrupt governments.” The hitch is that the deduction that money is worthless is remote from the facts.

  Market Realism over Rhetoric

  Money is not worthless. And I very much doubt that Mr. Nielson would take his own conclusion so seriously as to convert his monthly paycheck into cash and scatter the supposedly worthless currency along Bay Street, Queen Street, or any other street, for that matter.

  If he did, the resulting commotion as passersby scrambled to collect the currency would prove to anyone who can’t fathom it otherwise that currency is not worthless. Far from it. Yes, the government may well be bankrupt according to rigorous standards of accounting. Indeed, I would say that the US government, with a fiscal gap of $205 trillion according to Professor Laurence Kotlikoff, is arguably the most hopelessly bankrupt government in history.3 But the value of currency is not established by definition. Lexicographers have no influence in determining the value of money. None. Value is determined by the market.

  The market tells us that $100 bills are emphatically worth picking up off the street and, indeed, even working hard to earn, the aggravated Mr. Nielson notwithstanding. More to the point, there is ample evidence as I write that the value of the dollar has been appreciating.

  The Supposedly Worthless Dollar Soars

  If you followed the currency markets in 2015, you would have seen that the trade-weighted value of the dollar had been soaring for two years at the time. Bloomberg reported that the dollar was in the middle of its strongest rally since 1984, when it surged 32 percent in two years, and there was likely little anyone could do to stop it. It surged 20 percent against the yen and 17 percent against the euro. The Fed’s dollar index climbed more than 18 percent between the end of 2013 and 2015, approaching the record high of February 2002.4

  Such developments, while not dignified by Nielson’s syllogisms, reflect market dynamics. They certainly run counter to the notion that the dollar is a worthless IOU of a bankrupt government. In fact, it is an increasingly valuable IOU of a bankrupt government.

  Why? What accounts for the dollar’s strength? How could the IOUs of a bankrupt government be soaring? To better understand what is afoot, let’s go back to my alternative syllogism where I warned that you could not necessarily expect to profit by selling short the shares of the Framus Corporation, even if you were convinced that Framus was actually bankrupt. Although it may not be obvious, there is a close link between the market dynamics that sometimes raise stock prices of bankrupt companies and the dynamics that underlie the rally in the US dollar, an intrinsically worthless fiat currency.

  As another step toward realism, let’s change the name of the bankrupt company in our example from the fictitious Framus Corporation to Enron. As you recall, Enron was a real company that filed for bankruptcy on December 2, 2001, in what was then the largest corporate bankruptcy in US history. The Enron story was not just the account of a business failure; Enron’s collapse involved a ma
jor scandal.

  The essence of the Enron scandal was that company executives, particularly CEO Jeffrey Skilling and CFO Andrew Fastow, used inaccurate financial reporting, accounting loopholes, and special-purpose, off-balance-sheet entities to disguise billions of dollars of debt in failed deals and projects.

  You could see this as similar to the way Congress hides unfunded liabilities and complicates understanding of the federal budget. Indeed, this is why Professor Kotlikoff has solicited the endorsement of fifteen Nobel Prize winners in economics for his The Inform Act. Dr. Kotlikoff and his fellow economists contend, “The country needs to do honest accounting.” The professor charges, quite rightly, that the government is “disguising the true problem.”5

  Shades of Enron. The authors of one best-selling book, Enron: The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, put it this way, Enron executives “created off-balance sheet vehicles, complex financing structures, and deals so bewildering that few people could understand them.”6

  Unfortunately, it is not far-fetched to draw an analogy between Enron’s finances and those of the federal government. One eluded the understanding of investors—the other eludes the understanding of citizens. In both cases, the books were kept in a fishy way. In both cases, the public was misled with a constant stream of data detailing fake successes. In Enron’s case, fake profits piled up. For the US government, the malpractice of measurement involves overstating employment and economic growth. Those of us who look more closely at the numbers know that they depict a fake prosperity animated by an unsustainable growth of debt.