David Galland interviews Terry Coxon, The Casey Report
Terry Coxon worked side by side with best-selling author Harry Browne for years and is a rare expert in the arcane study of monetary systems. His remarks at this juncture in time, a time that might end up labeled in the history books as “Money Runs Wild,” are especially germane.
David Galland: You were involved with Harry Browne during the last great inflation in the U.S. How does the increase in the money supply that kicked off in 2007-2008 compare in terms of scale to what went on leading up to the inflation in the ‘70s?
Terry Coxon: The comparison is pretty muddled. In terms of the M1 money supply – the total of checkable deposits and hand-to-hand currency – we haven’t yet gotten near the persistently high growth rate that occurred in the 1970s. But the growth in the monetary base has been far more rapid than what happened in the 1970s. There is some time delay between growth in the monetary base and growth in M1, but to make the picture really cloudy, I’m afraid the comparison turns out not to be very useful. Unlike in the 1970s, the Federal Reserve is now paying interest to banks on their reserves.
In other words, the effect is that much of the increase in the monetary base gets locked up and sequestered because banks want to earn the interest on the reserves rather than lending the reserves out or buying investments and increasing the money supply.
DG: You are referring to the excess reserves banks have left on deposit with the Fed?
TC: Yes.
DG: Why do you think that the Fed is paying interest on those reserves? With policy makers and pundits saying that the economy needs a shot in the arm and a dose of inflation, why would the Fed continue to encourage banks not to lend or invest, by paying them interest to leave the money on deposit?
TC: If the Federal Reserve didn’t pay interest on those reserves, the result would be inflation rates far beyond anything the U.S. has ever experienced. The monetary base has more than doubled, and without the Federal Reserve paying interest on the recently created boatload of reserves that is essentially keeping them immobilized in accounts at the Federal Reserve Bank in New York, the M1 money supply would more than double and we would have inflation rates that would make the worst days of inflation in Brazil and Argentina look tame.
DG: I know you can’t give a real number, but what general level of inflation are you talking about?
TC: Close to a doubling in the CPI in a year’s time. Doubling the CPI over the course of a year would be an inflation rate of 100%.
DG: But on the other side of the equation, a deflationist would say that even if they stopped paying interest on those excess reserves, there is no loan demand, so the banks can’t find anybody to loan to. If that’s the case, how does the money get out into the system?
TC: If a bank has excess reserves and the Federal Reserve stops paying interest on them, if the bank can’t think of anything else, it will buy Treasury bills, even if the yields on those Treasury bills are only 0.5% a year. Then the seller of the Treasury bills has the cash.
Whoever the seller of the Treasury bills is, we can safely assume he sold his T-bills because the cash was more attractive to him. And if the cash is more attractive when it’s earning zero, that means the person who sold the Treasury bills wants to use the cash to buy something else, and that’s how the excess reserves would move from the banks to the general economy.
DG: What about the role the carry trade plays in all of this? If banks can’t get a return in the U.S., might they take the money and spend it elsewhere or invest it in countries where interest rates are higher? That seems to be going on today, in which case, wouldn’t we effectively export our inflation?
TC: It does have an inflationary effect all around the world, and it also puts the markets generally on a very fragile footing when you can borrow U.S. dollars at an artificially suppressed rate of 0.5% and buy New Zealand dollars and earn 2%. That has the effect of propping up the New Zealand dollar. And it promises a profit for the carry trader of 1.5%, but actually collecting that profit depends on exiting the trade at the right time.
The carry trade is in just about every market at this point. People are borrowing dollars at ultra-low interest rates in the hope of earning a higher return in something else and also hoping to exit at the right time. Virtually all markets have been propped up by the carry trade, and all the carry traders are telling themselves they are going to jump ship at just the right time. When the time comes, the rails of the ship are going to be crowded, and markets likely will move down very rapidly.
DG: Discuss the effect of the carry trade on the dollar. As you said, at this point in time there is a robust dollar carry trade, with people borrowing dollars and using them to buy, say, New Zealand bonds or whatever. So, what effect does this have on the dollar?
TC: The carry trade is the proximate cause of the decline in the dollar in foreign exchange markets. If you look at the whole process, it starts with printing by the Federal Reserve, but the step that occurs just before the price of the dollar goes down is the decision by traders to borrow dollars and buy other currencies. When the carry trade comes to an end, the process will go into reverse, and the dollar will rally.
DG: So this would again tie back to interest rates. If U.S. interest rates start moving up, then the carry trade begins to unwind.
TC: It wouldn’t even take that, just an expectation that interest rates on dollars are about to move up. That would do it.
DG: Yet, historically gold and interest rates and inflation all tend to move up together. Not to get all tangled up, but if interest rates in the U.S. move up and the dollar starts to strengthen, shouldn’t gold then start moving down? But again, that’s not the historic case.
TC: It’s not as tangled as you think. The answer you are going to come to for gold depends on what is causing interest rates to move up. If interest rates are moving up because the expectation of inflation is moving up, then that won’t hurt gold, it will help gold. On the other hand, if interest rates are moving up because the Federal Reserve is tightening, then that is bad for almost everything that people have been borrowing to buy, which includes gold and silver and stocks generally.
DG: And New Zealand dollars.
TC: Yes, foreign currencies as well.
DG: With the carry trade, the interest rate differential is an important thing to understand, and right now the U.S. is clearly behind the curve in terms of its interest rates. So the question is… could this situation continue for quite a while, with the dollar kept cheap by the carry trade? Can the dollar just keep going down until it evaporates, or are you seeing signs of an alternative outcome?
TC: The road to perdition has zigs and zags and loopbacks, and what causes the loopbacks is a shift in what the Federal Reserve currently perceives as its worst nightmare. For example, in 2008, 2009 and into 2010, the Federal Reserve was worried primarily about a deflationary depression, so it turned on the printing presses.
More recently, inflation has returned as a worry, and that can turn into worry number one on any given day, at which point the Federal Reserve will slow down the printing or just sit on its hands for a while. That’s when interest rates will start moving up, and that’s when the carry trade will get unwound, triggering a big downdraft in virtually all markets. But the prominence of inflation as a worry will eventually be replaced by renewed concern about the economy contracting, and then the Federal Reserve will shift its weight again from one foot to the other.
DG: Which brings us to the 8,000-pound gorilla in the room: the debt. Our readers, and pretty much everyone else, knows that the U.S. government is sitting on the largest pile of debt in history, and that much of this debt has been generated for no real useful purpose.
James Rickards made the point at our spring summit that the last time government debt was anything close to this as a percentage of GDP was in World War II. And he pointed out that the money spent back then essentially bought a victory in World War II, leaving the U.S. with a very strong economy and leverage over other economies. But those advantages have been squandered. Now in exchange for all the debt that has been rung up, Rickards points out that the country has little more than a lot of flat-screen TVs.
I think it was probably our very first meeting after you joined Casey Research, sitting around the table in San Francisco, that I asked, “Is there any way out?” This was back in 2004, and Doug Casey and Bud Conrad and you took turns answering, with the answer being essentially the same, “No, no way out and the situation is going to end badly.”
And here we are seven years later, and the government’s debts have only grown. Obviously, inflation is the standard approach the government is likely to use to relieve itself of its debt over time, but I wouldn’t rule out an overt default of some sort. Regardless, it seems like the country’s economic future is going to be determined by the debt.
So, let me ask you the same question, do you see any way out? Are there any options left to the government that don’t lead to economic chaos?
TC: If by some miracle the people who run the government decided that Big Government was a bad idea and small government was a much better idea, and so they set about ending government programs and pushing the level of federal spending way down, along with the level of regulation over the economy, then there would be a way out.
But how likely is that to happen? The time horizon for people in politics is maybe one or two years, just about the same length of time there is before the next election. Their goal is always to survive the coming election. That means what is rational for the politicians looks irrational to everyone else, and I don’t see any reason to expect that to change. The purpose of a politician examining a problem is not to solve the problem but to find a way for someone else to get blamed for it.
DG: Doug and I have both written about the fact that we are living in a steadily degrading democracy at this point, with the public voting itself all manner of benefits from the public trough. Personally, I don’t see how we get to the point where politicians, where the voters, decide that a much smaller government is a much better way to go. At least not unless and until we’re forced to. Do you think this situation can drag on, or will the size of the debt and deficits force a change sooner rather than later?
TC: That’s a political question. At some point, the situation may become so catastrophic that people are forced to learn new habits and consider new ideas, but things have to get pretty bad before that happens.
DG: And how would you rate the odds of it getting pretty bad before this is over?
TC: Very high.
DG: And the time frame? You typically say these things are variable and unknowable, but can you be a bit more specific?
TC: It takes a long time. It’s not going to happen this year. It’s probably not going to happen next year.
DG: But hasn’t this been a long time coming?
TC: Yes, it has, and that should tell you that the process is a slow one.
DG: So in your view, what are the one or two most important things that readers need to be doing to protect themselves at this point?
TC: I think the most important thing someone can do is to understand what’s going on. That’s what will give the individual staying power when the markets are temporarily moving against them. The worst thing you can do is to just pick a leader and do whatever he advises without thinking it through and understanding it. What makes that a bad approach is that no matter which intellectual leader you might choose, there are going to be periods when he is wrong and when his advice is not working for you. And even if he is right in the long run, you may not stick with him for the long run if you don’t understand why his advice makes sense. So I think job number one is to understand what’s going on, so that you’re not blindly relying on anyone’s advice.
DG: What’s job number two?
TC: Job number two, if you see the world as I see it, is to make sure that a substantial share of your wealth is in precious metals and perhaps in foreign currencies, but without any leverage.
DG: Thank you very much.
Contributing Editor Terry Coxon is the author of Keep What You Earn and Using Warrantsand the co-author (with Harry Browne) of Inflation-Proofing Your Investments. He edited Harry Browne’s Special Reports for its 23 years of publication and all of Harry Browne’s investment books since 1974.Terry was the founder and for 22 years the president of the Permanent Portfolio Fund, a mutual fund that invests in precious metals as well as stocks and bonds. He is currently president of Passport Financial, Inc., and for over 30 years has advised clients on legal ways to internationalize their assets to optimize tax, wealth protection and estate planning goals.
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Ed. note: I am a Casey Report subscriber and affiliate.
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