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The
BIG Picture Transcript
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The Factor's Bill O’Reilly: “The day after Katrina, in Washington State, and Oregon and Northern California, which don’t get refined gasoline from the gulf where Katrina was, they jacked up oil prices 30, 40 cents a gallon. So we know there’s price gouging going on. You can’t deny it, it is happening. And when you say there is increased demand by India and China – Yeah, OPEC's gouging too, OPEC's charging $60 a barrel, but for every barrel of oil that Exxon-Mobil pays that much money for they tack on a surcharge profit. They’re not only passing their costs along to us they’re passing our costs plus 15%, plus 25%, because you couldn’t make $10 billion in a quarter unless you were doing that.” JOHN: Well, Jim, we’ve been talking about the process of offloading. We knew coming into a recession – you and I have been talking about that for quite some time on the program – that when we would get to these these financial crises in the Perfect Financial Storm that they would have to offload the responsibility. The offloading would have a number of effects: 1) since we would be identifying the wrong problem we would invariably arrive at the wrong solution, such as windfall profits taxes, etc, etc 2) if you listen to Bill O’Reilly, the thing I noticed is he is talking about parts of the country that aren’t directly [affected] by Katrina. But what does need to be reflected here is this is a global oil market, and just because the supply doesn’t move from there doesn’t mean the prices of oil are not affected by it. I know you’ve got some other things. Actually you were saying things off-air that we can’t repeat on-air when we were listening to this clip, but they’re going to make all the wrong moves. You can see this one coming. JIM: It’s interesting because we mentioned this a couple of weeks ago that oil profits were going to be up in the third quarter. One reason is the third quarter began in July and the price of oil at the beginning of July was close to $59. It went up in the month of July, so by the end of the month it was at $64. In the month of August, because of all the hurricane problems, it ended at $70. So the last month of the quarter, which was September, the price of oil went from $70 down to somewhere around $65 at the end of the month, but still 10% higher than where it was in July. And furthermore, if we go back to July of last year, 2004, then you have a [better] picture because they’re doing comparisons year over year – the price of oil was at $34 per barrel versus the July of this year it was at $59 a barrel. So, in the last 12 months, year over year, the price of oil has doubled. And what is wrong with O’Reilly’s analysis – and it’s really hard to believe he went to Harvard – because what he’s talking about is absolute numbers. Exxon’s sales were $100 billion, their profits were $9.9 billion. Now, if you take a look at that in absolute numbers, you say wow that’s a big number, but he was making a reference here to tacking on all these surcharges. That is a flat-out lie. The net effect of Exxon’s profit was 9.9% on sales. Now, what I found interesting, and I knew the oil companies were reporting profits this week, on the same day that Exxon reported its profits we also had Conoco-Phillips report its profits. Their sales went up to $47 billion, their net profits were 7.6%. Microsoft also reported profits on Thursday after the market closed, on the same day. Microsoft had roughly about $9.6 billion in sales and they made roughly $3.3 billion in profit; Microsoft made a net profit return of 32%. So, what Bill needs to understand here is the difference between absolute numbers – that’s the gross number of $100 billion in sales and $9.9 billion in profits – and a ratio which [says] Exxon’s profit ratio doubled. They have not! They have been in that 9% range. And what is interesting, even though Microsoft reported record profits, you had banks, brokerage firms, the building industry, the thrift industry, the entertainment industry, all reporting record profits. And speaking of Bill’s own company... Newscorp’s profits rose 67% in the last quarter to $717 million. Now, what I did is just take 10 popular industries - I took a look at the net profit margin after taxes, after all the bills have been paid – [and looked at] what is the net-net bottom line number. Banks earn a profit margin on sales of 15%; homebuilders earn 10%; cement mixers earn 10%; electronic companies earn 14%; semiconductor companies earn 14%; the thrift industry earns 20%; brokers or stockbrokerage firms earn 14%; the movie industry earns 18%; the newspaper and network industry earns over 10%; and computer software earns over 14%. And where O’Reilly is really demagoguing this point is that he’s implying the oil companies doubled their profits. Well, goldarnit, a year ago oil was at $44, a year later it was at $70. And by the way, another thing he doesn’t mention is the reason Exxon’s profits aren’t up 100% is their production has gone into decline. And that’s an issue that relates more to the peak oil theory. The oil majors are experiencing production declines. So even though they got a higher price for the product they sold, because the world market set the price for oil – that’s something O’Reilly doesn’t understand, and alludes to a point you made, John, even though the people in Oregon don’t get their oil from the Gulf Coast their prices went up too – It’s a world market price that is set and the United States government doesn’t set it, big oil companies don’t set it. In fact, the large oil companies are losing more and more of their influence globally because 1) they’re not replacing their reserves – in other words, they are producing more than they are [discovering] 2) the only major reserves left are in the Middle East, South America and off the coast of Africa and China, Russia and India are getting access, getting the business, not the United States oil majors. In fact, if we take a look at the top 20 oil producing – either companies or countries – the top producer is obviously Saudi Arabia’s Aramco, Iran is the second largest producer, Iraq the third, Kuwait the fourth, Venezuela the fifth, United Arab Emirates the sixth, Libya, Nigeria, Mexico, Russia, Russia’s Gasprom, Exxon-Mobil’s right around 12th; Yukos, a Russian company; Petrochina; Qatar; Algeria; British Petroleum is number 17; Petrobras out of Brazil is 19; Chevron-Texaco is number 20. So, the real producers – the people that really control the price of oil in the world are Saudi Arabia, Iran, Iraq, Kuwait, Venezuela, the United Arab Emirates, Libya, Nigeria, Mexico, Russia, not the United States. And this is something Bill doesn’t understand, that if Saudi Arabia decides the price of oil is $61 a barrel based on market conditions they don’t have to sell their oil to the United States. We import 20% of our oil from Saudi Arabia, they can sell all they can to China. China is the second largest consumer of oil, and accounts for the largest percentage increase in the demand for oil, and they are scouring the globe from working out deals in the Sudan, working out deals with Iran, some of the –stan countries around the Caspian Sea, in West Africa, and also in the Canadian oil sands. He plainly just does not understand. The thing that he does is a disservice because instead of educating people. Yes, it’s a big number on the surface. But you know what? Their profit margin is exactly the same. Their profit margin is in the 9% range last year. Historically it’s been in the 9% range and it’s still in the 9% range even though their profits went up. Because, Bill, you need to tell people: one year ago the price of oil was $54 and in the 3rd quarter it got to $70, a 100% increase in the world market price of a barrel of oil. [10:27] JOHN: If we assume that oil is going to go even higher – wasn’t it Matt Simmons calling for $100 a barrel – and moving onwards, now people are going to be looking for scapegoats to deal with this. And a lot of what you’re talking about here is reflected in inflation as well. That’s important to understand, as the value of currency declines in order to make about the same profit the actual numbers will be higher. So that’s going to factor in at the same time. The other funny thing in the calls for windfall profits taxes is that it never seems to occur to anybody how we’ll make those companies pay the tax. Big companies never pay any tax. They simply pass it on through to the people that buy their products. And so, if they get taxed, they’re going to pass it on through. JIM: It’s like in any kind of business. In my business I have to pay a surcharge or fee to every State that I do business in. If I have a client in the State of Texas, they charge me a fee for my broker-dealer [license], they charge me a fee for being a registered investment adviser, they charge me a fee for being a broker in that State. You have States like Tennessee, in addition to charging a fee for the broker-dealer, the RIA and myself – being a broker – they also charge an additional so-called Professional Privilege Tax. These costs, when they get added on to a business are passed on ultimately to the consumer. It’s exactly what happened in the ''70s with the windfall profits tax. It changed the way the oil companies [went about] drilling and exploring for oil, and whatever added costs were tacked on as a result of the taxes. They simply passed this on to the consumer at the price at the pump. And so, any time the government taxes or increases the cost of doing business. it is ultimately reflected in the product price [for] you and me as consumers. [12:30] JOHN: Yes, the other little hidden cost at the pump that never seems to come out is the quantity of taxes being assessed at the pump, but no one talks about gouging there either. JIM: Well, no. Between Federal and State government they’re making almost as much as people involved in the oil business. Here in California we charge a tax on top of a tax. We have a State tax that is assessed on a gallon of gasoline here, then we have a Federal tax that’s assessed on a gallon of gasoline, then on top of that, the State of California charges a sales tax. So, we’re actually paying a sales tax on taxes charged in a gallon of gasoline. And if you look at the solutions that immediately come forward, you always notice that the solution is to add additional taxes, and all that’s going to do is raise the cost of gasoline. What I found ironic is on the day Exxon reported its profits, Senate Majority Leader Bill Frist said oil company executives would be called to testify at a hearing for the reason of high energy prices. They need to take some basic economics. In other words, ExxonMobil has to import 132 million barrels of oil from the Middle East at $61, or $69, or $79 – whatever the spot price is each month – that’s what they have to pay for it. And it doesn’t make a difference that it maybe only costs Saudi Arabia 4 or 5 dollars [to produce], the market price for it is $61. But anyway, getting back to Bill Frist, he’s calling on the oil companies and there’ll be hearings. House Majority Leader Dennis Hastert pleaded the day before with oil companies to find new sources of oil and natural gas and build new refineries. On the very same day that Hastert was begging with the oil companies a partisan fight broke out in the Senate, which doomed a new Federal and Senate [plan] to increase the nation’s oil and refinery capacity and postponed it for another year. According to the Wall Street Journal, the Senate Environmental and Public Works Committee deadlocked over the proposal by 9-9, with one Republican and 8 Democrats voting [against] to make it easier to build a refinery. So here we are, on the one hand, saying, “You are making all this profit. We don’t have enough refineries. We haven’t built one in 30 years. Please, please take some of this money to build a refinery.” And remember there are over 800 permits – they’ve been trying to get a refinery built in Arizona for eight or nine years – and they’re trying to streamline the process because they know we need more refineries, as well as refineries built away from the path of hurricanes, where 50% of our refinery capacity lies. And so they’re going to streamline and pass a bill that makes it easier – maybe we can build a refinery in 3 to 5 years. But due to partisan politics, they voted the bill down. It’s absolutely unbelievable. You’ve got, for example, Byron Dorgan, who’s talking about trying to get a bill passed that would tax oil companies on prices of oil over $40 a barrel. You’ve got Hillary Clinton who’s calling for a $20 billion tax increase on oil companies to subsidize low income home energy assistance programs. Who do you think is going to pay for that when those taxes are assessed? And I go back, John, [to the point that] a lot of people say because of the size of oil profits, you’ve got to look at that, you can’t look at the percentage. Well, let’s turn that around. No other single industry that we have requires as much capital to do business. It costs billions of dollars to build a refinery. It costs billions of dollars to operate one. It costs billions of dollars to build an oil platform in the Gulf of Mexico and to drill for oil. It is one of the most capital intensive, expensive businesses in the entire financial industry today. There is no other industry that has perhaps as much capital outlay to bring its product to the market. So those large profits are gong to be needed. Look at the billions of dollars of repairs that will have to made to the 108 oil platforms that were destroyed and the 340 platforms that were damaged, not to mention the underwater pipelines, and to the refineries. This is a very expensive business to get started in. That’s why you don’t see a lot of major big companies around today. There just isn’t that much oil to be found today and at the same time it costs a lot of money to find it. [17:19] JOHN: Bill O’Reilly says we’re going to have a recession next year and it’s going to be the fault of the oil companies’ gouging. That’s what’s going to pitch us down this, [namely] the high energy prices, resulting from gouging. JIM: Here again is demagoguery. And once again O’Reilly is showing his ignorance of economics. One of the things that is happening is that it’s not just higher energy prices. So let’s take that it’s because of gouging. He doesn’t understand that OPEC sets the world market [price] today. The US government doesn’t, nor does ExxonMobil set the price of oil. ExxonMobil doesn’t have enough reserves, nor could they pump out enough reserves. You don’t have ExxonMobil holding supply off the markets so they can get higher prices. And if they were as powerful as O’Reilly deems them to be, then please explain a 20-year bear market in oil prices where oil went from $40 down to $10. If they were powerful and omnipotent as he would imply, we would never have had a bear market in the price of oil. He simply doesn’t understand it. One reason we’re going to have a recession is because inflation is on the rise; also as a result of that interest rates are rising. It’s going to be more expensive to borrow money and it’s not just inflation in oil – take a look at the inflation in housing where you have no cry directed at the homebuilders to have a windfall profits tax on Pulte homes, or Horton homes, or any of the major homebuilders even though the price of their products keeps going up double-digits a year. Here’s one thing I’ll throw out, and this is aside from what we’re talking about. The real downturn in housing will be caused not from higher interest rates, it’ll be caused by the delay in building homes, and the escalating cost of raw material and labor that go into making a home. And so, we’ve got inflation on the rise. We’ve got interest rates on the rise. Yes, we’ve got oil prices on the rise, but there’s nothing O’Reilly, the US government, or US oil companies can do about it. Now, where I would say there would be a conspiracy is if Exxon, for example, produced 4 million barrels of oil a day and they withheld producing 2 million barrels a day to get the price up. Then you could say, “you know what, they’re trying to get the price up; what are you trying to do?” But that’s not the case. Any barrel of oil they can produce today they can sell anywhere in the world and get current market prices. It is just simply demagoguery. [20:00] JOHN: But you said there is nothing they can do. I know what you mean there, but they are going to do something, and what are the effects of that going to be? JIM: The effects are going to be as the price of oil goes up. Dr. Michael Economides believes that we will be at $100 oil by next Summer. By the year 2010 Matt Simmons thinks $200 oil. And by the way, let me throw this out, and you heard it here first because people are going to be screaming next year: Beginning January 2006 refineries are going to have to change the mix of sulphur content in gasoline from 90 parts per million (ppm) to 30 ppm. That’s going to cost billions of dollars to change. And let me just get to diesel too. Beginning next June new diesel coming into the market will have to have a refinery mix of only 15 parts of sulphur per million vs. 500. As a result of increased regulation and increased cost [they] are going to drive the cost of diesel up to $5 a gallon. It will have nothing to do with hurricanes. It will have nothing to do with world oil prices. It will have everything to do with the new imposed government regulation. And the reason it’s going to cost more is because you cannot mix other kinds of gasoline. In other words, if there’s 30ppm sulphur gasoline and there’s only 15 ppmp diesel, you can’t mix them in the same pipeline, because you’ll pollute the mix between the two. So you have to use a special transport system to put diesel fuel on rail. They may have to put it on trucks to get it to service stations. So the transportation costs of getting the completed product to the market place is also going to go up. And it is all because it is government-induced. We are going to have 50 different varieties of gasoline next year and nobody ever talks about that. [22:07] JOHN: Well, Jim, what we try to do here on the program is anticipate the future based on what we see happening. As I said, they are going to do things – ‘they’ being government and other entities – but what is that going to do to us in the long run, if we can summarize this? JIM: I think in the long run they’re going to make all the wrong moves: #1, there will be a movement afoot to implement some kind of tax on energy because government is just chomping at the bit to find more things to tax and bring in tax revenues. And since everybody uses energy it is one of the government’s favorite forms of taxation. In other words, if you have a product you can put an additional tax on something everybody in the country uses on a daily basis, you’re going to get a lot more tax revenues. So as a result they will put some kind of windfall profits tax, or some kind of surtax on the price of energy, that will be reflected in the cost of energy. You and I as consumers will pay more for energy at the pump. It is not going to make matters any better. It’s not going to create incentives for oil companies to go out and explore for new oil, and build new refineries. I mentioned that the Senate Democrats and one Republican voted down a new refinery bill that would make it easier to build a refinery by getting rid of all the red tape. So we’re not going to see anymore refineries built. So if next year’s hurricane season turns out to be just as bad as this year, or we have political troubles in Saudi Arabia, Nigeria, Venezuela, or in the Sudan, or any place where oil is taken offline, you’re going to see further oil spikes and eventually you’re going to see shortages because none of this will bring new supply online. Raising taxes is not going to bring new supply. It’s just going to raise the price and eventually as you start getting into price controls as they’re also advocating – and remember as the price of oil and gasoline go up government will repeatedly put in price controls – that will end up giving us a shortage. Now, given all that, would I be investing in the energy sector? Absolutely, because eventually sanity will have to come to the marketplace. And remember, a lot of the major oil companies are international. They’re not US companies today. So we’re going to have to buy oil from somebody. So we’re going to have to buy it from Saudi Arabia, Venezuela, Nigeria, or any other country. We’re going to have to pay them that price and if that’s $100 next Summer, we’re going to be paying them $100. What are our Congressmen proposing, or O’Reilly, “Hey, you sell us $40 oil or we’re going to nuke you.” I’m sorry it doesn’t work that way. And so the end result is we’re going to have a series of energy crises. Oil and energy prices will continue to go up at the pump. That’s not going to stop, if oil goes to $100 or $200 in this decade. You’re going to be paying more for gasoline when you go to fill up your tank. And if the government adds windfall profits taxes or surtaxes on the cost of energy, the oil companies are just going to turn [that] around. And if there’s a 20-cent new tax on gasoline, then you’re going to be paying 20 cents more a gallon of gasoline. You did not hear any talk by government of removing some of the high taxes they impose on the price of energy. And so the end result is higher prices, energy crises, shortages, gas lines and higher profits for the energy industry. [25:56]
JOHN: Well, of course what came up in the first part of our conversation here on the Big Picture was the concept of inflation. I have an interesting quote here: “This currency as we manage it is a wonderful machine: it performs its office when we issue it; it pays and clothes troops and provides victuals and ammunition; and when we are obliged to issue a quantity excessive it pays itself off by depreciation.” That was written by Benjamin Franklin in April 1779. He seems thrilled with the concept of an inflatable currency, but of course he was talking about Continental currency, which ultimately became worthless, as given by the expression: I don’t give a Continental. Right? JIM: What was interesting about the founding of this country is this: as our Founding Fathers made the decision to go to war with England over taxation without representation, they needed to raise money for an army and prosecute the war. Well, since the war was being fought about taxation – one of the key issues in the founding of this country – they didn’t want to raise taxes. So they said they would just basically print the money and eventually start to collect some taxes. Upfront they issued $2 million in June 1775. By 1781, roughly about six years later, the Continental Congress had issued $241 million and that’s on top of the individual States which had issued $209 million. Inflation was running rampant. For example, a year after they issued the Continental dollars, depreciation of the currency was nearly 66%. I have a quote of an army captain in 1781, Captain Alan MacLean, who paid $600 for a pair of boots and $10 for a spool of thread. And so what happened is people didn’t want that money. The bad money drove the good money out of the economy. People began to look for Spanish gold coin. We went to a barter system. The whole system broke down. So by 1781 the government realized, “hey wait a minute, we’ve kind of overdone this.” They made some moves to collect some taxes to pay back some of the notes that were issued and they realized they could not issue an excessive amount of money because of the effect on depreciating the currency and inflation. They still continued to inflate, but albeit at a much much slower rate. Ultimately what they found out is any time you create excess money you get inflation and inflation has been and always will be a monetary affair. It’s caused by excess money and credit in the financial system. It is not caused by rising prices in oil. This is often one of the mistakes made when we look at inflation today [where] we have changed the definition to be rising prices. OK, prices are rising, but why are they rising? We’re talking about the symptom rather than the cause. [29:35] JOHN: But that’s part of that process of offloading responsibility. You know it’s interesting that Franklin should say that in 1779 since the whole affair of John Law in France – and remember Franklin had to live in France for a long time – he should have been able to have said, “Wait a minute. That’s what happened to them,. Why will we be exempt?” And the Continental Congress was not. JIM: Franklin wasn’t keen on paying taxes and he thought this was kind of a cool thing. It’s a wonderful machine, because we just simply print these notes and we get the money to pay for all this stuff. So looking at it from a governmental perspective, “Hey, we don’t have to earn it, we don’t have to tax it, and we don’t have to produce it. We can just print it.” [30:20] JOHN: Well, you know it’s interesting because Benjamin Franklin was one of the Founding Fathers of the country, but this week the country has been presented with another Ben who will figure majorly in its history as soon as he takes over from Alan Greenspan. We’re talking about Ben Bernanke. You know what he said is amazing: “Like gold, dollars have value to the extent they are strictly limited in supply, but there the US government has a technology called a printing press, or today, its electronic equivalent, that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of dollars in circulation, or even credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services which is equivalent to raising the prices in dollars of those goods and services. We conclude that under a paper money system a determined government can always generate higher spending and hence positive inflation.” JIM: When I put that quote in my article, I was showing the similarity between the two. Franklin called it a wonderful machine and Bernanke calls it a wonderful invention called a printing press. One of the things I wrote in my Storm Watch Update was to show that what causes inflation is not rising prices, but it’s an increase in the monetary supply in excess of the goods and services produced in the economy. If we take a look at M3 growth in just the last couple of weeks, it’s growing at an annualized rate of 12 ½ %. One week the money supply grew by $35 billion, the following week it grew by $42 billion. Since 1970, when we went off the Bretton-Woods system [that] backed our money with gold, our money supply has expanded by over 1500%. Houses and prices have gone up over a 1000%. I can remember the first house we bought when we were married in 1977. It was a 3-bedroom home. We put in a swimming pool. I did the landscaping and we did it all for roughly $63,000. That house today in Phoenix, Arizona, is probably selling for over $700,000. That’s inflation. What causes inflation is an increase in the money supply, whether you’re doing it digitally as we do today with little x’s and o’s in bank transfers, the Fed just credits the government accounts and monetizes securities. Or you have someone like the Bank of Japan monetizing our debt. Between 1Q 2003, and end of 1Q 2004 the Japanese Central Bank bought more than $325 billion of US debt. Now, that was money they didn’t earn from trading with us, they simply printed the money and bought our debt. And they did that for a reason: to keep the value of their currency from appreciating against the US dollar. [33:24] JOHN: I think an important question to ask at this stage of the game is that if we have been printing money like there is no tomorrow for quite some time, why is it only now that inflation breaks through the radar, so to speak, and becomes visible to the public? JIM: In order to understand that, we’ve got to go back about 25 years ago. At the end of the '70s inflation was running at double-digits a year and we were having a real problem. The dollar was plummeting through the floor. What happened was governments turned to central banks and they asked, “How do we get out of this mess we’re in? We need to finance and we need to raise more money, but we’re creating inflation in the process?” And central banks basically gave the government advice, which was they needed to do three things: 1) raise short-term interest rates and make it very expensive to borrow money, 2) cut government spending, and 3) instead of monetizing the debt, finance the debt through the issuance of debt to foreign and domestic investors. In other words, if debt is financed through existing savings, it is non-inflationary. If it’s financed through the Fed monetizing it, it becomes inflationary because you’re creating new money. And so what happened in the '80s is we began to transfer inflation to the financial system. It’s one of the big theses of a book called Debt and Delusion, written by Peter Warburton, which I’d recommend reading. It’s been reissued and updated just recently. So the result is we transferred inflation to the financial system. The money supply still expanded. The currency still depreciated. Government deficits grew even bigger in the '80s and even the first part of the 90s, and now they’re growing once again. But what we saw, instead of inflation showing up in the real economy, we still had inflation – the money supply was still growing and we had the CPI increase every year – the major outlet of that inflation though was asset bubbles. We had an asset bubble in farm land in the beginning of the '80s; then it was oil, which came to an end in the middle of the '80s; then it was stocks; then it was real estate at the end of the '80s – everybody remembers the real estate bubble in '89, '90 and '91, then of course the Savings and Loan crisis. As those bubbles were deflating, the Fed created more money and we got asset bubbles in the '90s in foreign bonds in emerging markets, the '94 Peso crisis, and then also the '97 Asian crisis. Then we got a bubble in stocks, especially technology. As the technology bubble deflated, we got asset bubbles in bonds, mortgages, real estate and once again stocks and consumption, as reflected in a rising trade deficit in this new century. So all we did is we transferred inflation to the financial system and we called them bull markets. Eventually when they got out of control, we called them bubbles. But now, money creation is so excessive globally. For example, the monetary base is growing 20% a year for the last two straight years, 2003 and 2004 and it’s probably equally as high right now globally for 2005. The monetary base recently in the US over the last 6 weeks was growing at an annualized rate at over 12 ½ %. Overall in the quarter, it’s up close to 8%. European monetary growth is growing at 8%. China’s monetary growth is almost 18%. So we’re creating all this excess money and money has two places it can go. It can either go into financial instruments such as stocks, bonds, assets such as real estate or commodities, or it can go into real goods in the economy. The problem is we’re creating so much money globally that now everybody is reinflating so that the net result is we’re starting to see all of this spill over into the real economy. In fact, I want to quote from Warburton’s book, because of this obsession, about how we measure inflation at the end of the 70s we transferred [inflation] to [the financial] system, Warburton warned that this would create a problem: “The policy obsession with inflation is paving the way for a crisis of immense proportions. In a cruel but familiar twist of logic the only antidote to this forthcoming crisis will be a deliberate and coordinated reflation of the large developed economies.” He wrote this in 1998 and this reflation that he wrote about is exactly what you’re seeing occurring globally in Europe, in North America, and in Asia. He goes on: “This crisis is destined to replace the inflation of the 1970s, as the defining economic event of today’s adult generation. Just as the second great depression of 29-39 became the dominant experience of the generations recently deceased. The ascendancy...” – and here’s where he’s talking about this transfer to the financial markets – “of the financial markets and the proliferation of domestic credit channels outside the monetary system” – and what he means outside the monetary system is outside the banking system and here he is referring to the stock market, the securitization of debt, and he goes on “have greatly diminished the linkages between credit expansion and the money supply and between credit expansion and price inflation in the large Western economies. The impressive reduction of inflation is a dangerous illusion. It has been obtained largely by substituting one set of problems for another.” [39:41] JOHN: Well, we’re still hearing the old stumping. We’re being assured – and it’s not really just in the United States it’s elsewhere – that the Central Banks are going to keep this whole problem contained just like they have before. You’ve heard the term "inflation fighting" when in reality we should be calling it "inflation nation." JIM: I took 3 graphs of interest rates as reflected by the 10-year Treasury Note, the money supply and the Consumer Price Index from 1970 to 1980. And interest rates went up through the entire '70s as central banks raised interest rates periodically. They were raising them throughout the entire decade, while the money supply expanded at an even faster rate than interest rates. So that as a result, the CPI went up. So all this talk, “well, they’re going to raise interest rates!” has no significant bearing on controlling inflation unless you do what Volcker did and you raise interest rates to 21-22%, which they will not do because we will have a depression worse than 1929 and 30-32. It would be an inflationary depression because they would never stop the printing of more money. And that’s what they did, as they were raising interest rates throughout the' 70s, the printing presses were running overtime 24 hours a day, and as a result interest rates went up, the money supply expanded and inflation rose. [41:11]
JOHN: Jim, it’s really important to emphasize the difference, because people a lot of times confuse rising prices with the change in the money supply. In the public mind that is not a very distinct reality. JIM: No, it’s a wrong way of looking at economics and what causes [inflation]. They can all be lumped in what we call the overproduction theories. In essence they wrongfully argue that deflation is falling prices, just as rising prices is inflation. And George Reisman just wrote a piece - he’s a scholar and professor at Pepperdine University – and he calls this the confusion between prosperity and depression. Riesman argues that there can be only two distinct causes of falling or rising prices: 1) an increase in consumption and supply, which causes prices to fall, 2) and the other is a decrease in the quantity of money and the volume of spending in the economic system. And this is where the mistakes are made. Falling prices is what gives us economic progress and prosperity. Aas an economy is able to produce more goods, thanks to an increase in the supply of those goods, the natural order of things is for prices to fall. And John, think of any new product that has come out on the market, whether it’s the invention of radio, TV sets, personal computers, DVD players, or now flat-screen TVs. When the product first enters the market, the price is very high because there maybe only one company producing it. They invented it and there are very few producers. Very few customers can afford to buy the product. I can remember in the' 80s when I had to pay $6500 for an ordinary PC. Or if you look at a 42” flat screen TV, it was $7,000 to $8,000 a couple of years ago and now you can get them for close to $2,000. However as production increases in a good, what happens is a company can amortize their fixed cost over a greater number of units produced and that brings down the cost. As the cost comes down, it becomes more affordable. More people can buy the new product. Also the high profit margins of the original producer attracts other producers into the market place, so you get competition. The supply of goods increases as more companies are making it. As more goods are produced, the price drops, which makes it even more affordable. This is what we call prosperity: the production of more goods at a lower price, making goods more affordable and it’s just like when you have less of a supply and more money chasing that supply, the price of those goods goes up. [44:00] JOHN: OK, Jim, but if you listen to the talkies every night and some of the government pundits, they would like you to believe, for example, it’s OPEC, oil, hurricanes and then to really confuse the mix we’re talking about going into a deflation now. JIM: Yes, as the Fed raises interest rates and the economy slows down, the next thing on the horizon. Already the financial people are already talking about deflation. However, we’ve made this argument before and the facts, John, are this: we have never had deflation in times of war or in times of peace. We’ve always had inflation in war and peace for the last 60 years. We’ve experienced inflation during booms and during busts. The last bust we had was in 2001 with the recession and the bear market of 2000 and 2002. And we’ve had inflation in every bull market and every bear market. We had inflation during periods of high and low employment and we’ve experienced inflation in both recessions and recoveries. I have a table in the article. I show where, if you want to measure inflation as many people incorrectly do, which is rising or [falling] prices, take a look at the CPI by decade. The last time we had a drop in prices was in 1955 where the CPI dropped .04% and Eisenhower was President. The last real great deflation occurred from the years 1930-1933 and then of course 1938-39 when the Fed was back to raising interest rates. But outside the '30s, in the last probably 65 years, we’ve only had 2 years of lower prices. One was in 1949, the CPI was down 1.2%, and once again in 1955 when it was down .04%. So even if you measure inflation incorrectly as rising prices and deflation as lowering prices, we haven’t had it in 65 years. So the thing I always try to bring out is: show me the beef. Where is the deflation? And don’t tell me if I buy a DVD player this year it’s cheaper than say I would have paid in 1998, because that is exactly as a result of increased production and more manufacturers coming on line, making more DVD players. [46:41] JOHN: Jim, let’s go back to last Fall, you wrote your piece on the Great Inflation and that was greatly and hotly disputed at the time. People were saying "no, we’re going back to deflation." But those arguments seem to be evaporating. Everybody’s talking about inflation. Everybody’s talking today about what a wonderful investment gold is – now that the prices have gone up significantly. JIM: You hear and read a lot of erroneous arguments today as to why deflation is inevitable from global wage arbitrage to expanding world production – that overproduction theory – asset bubbles in housing, stocks and malinvestments, the business cycle and so on, and so on. On the surface these arguments appear logical, but they in fact have never produced the inflation they all purport. The last real deflation occurred while we were under the gold standard during the Great Depression between 1930 and 32. In fact, since World War II, deflation has been conspicuous by its absence. Since the second half of the 20th Century, and this new Century I might add, we have never experienced deflation during times of war – the Cold War, the Korean War, the Vietnam War, the Gulf War, and the Second Gulf War – nor have we experienced deflation during the 7 recessions that we’ve had since World War II. Nor have we had deflation during the bear markets of the last half century, including the big bear market of 1973-74 or the more recent one between 2000-2002. We’ve never experienced deflation during periods of high unemployment, for example the '74 recession, the '81, '91, '2001 recessions. We never had deflation during any of those years. Nor have we had deflation for example in the stock market crash of 1974 where the Dow lost 54% of its value, or its stock market crash of 1974 where we lost 23% in a single day, and over 35% in a single week. Nor did we have deflation in the stock market downturn of 2000-2002, nor in the real estate bubble in the late 70s, or the one of the late 80s, or the real estate bubble we currently have now. I predict we will not have deflation. Will the price of real estate come down? Yes. Just as it did in 1991. Will banks get into financial trouble? Yes. Just as they will get in trouble in the future right ahead of us. But what has happened is the Fed came in, drastically slashed interest rates, allowed the banks to borrow from the Fed at these low interest rates, then take the borrowed money and invest it in US Government Treasuries, in effect creating the carry trade. They reliquified bank balance sheets – remember in 1990 and '91. Citibank was on the verge of going bankrupt, as were many of the New York money-center banks – the Fed reliquified them. They rolled up all the bad loans and the real estate into the Resolution Trust Corporation (RTC). They sold real estate – this was a great time to be an investor. I can remember buying luxury homes and an office building during this time for 60 cents on the dollar. But the money supply was expanding at the same time – I remember the comments from an SBA lender when I was buying an office building. I had several lenders almost like the TV commercials where the lenders compete for your business, one lady actually said, “I’ll do a back flip to get your business.” Money was so easy to get during this period of time because the Fed was liquefying the banking system and the government was pouring money through SBA loans. And what they did was reliquify the banking system. Property was disposed of and they created the money and credit in order to allow the system to pay for it. The result was that the real estate crash was followed by another asset bubble in stocks and technology after the crash of the real estate market in '91. [50:43] JOHN: Well, Jim, if we look across the board I guess the one thing we could find everybody talking about finally is the ‘r’-word: recession. Everybody is talking about that. We’re probably headed down to that since even O’Reilly says we’re going to have a recession next year, but that’s due to what the oil companies are doing, not to previous economic things. But not everyone agrees on the outcome or even the disposition of how it’s going to happen. JIM: Where I disagree with the deflationists is, as I have proven in the article – I don’t know how many times I can say it . In peace, war, booms, busts, bear markets, bull markets, high unemployment, low unemployment, [whatever it is] we’ve always had inflation. There is no limit to the amount of money the government can create. Let’s talk about what can happen in a recession. In a recession, government tax revenues go down; people lose their jobs; they’re not paying taxes; corporate profits go down, so the government gets less corporate tax revenues. So the government’s source of revenue goes down. At the same time, government expenses go up because unemployment benefits increase, we have entitlement benefits increases, and there’s always the call from the public for politicians to do something about it. In other words, go ahead and spend a whole bunch of money, give them a tax cut or increase government spending to pull us out of a recession. So government expenditures go up at the same time government revenues go down, which means the government deficit explodes. This means the government is going to have to go into the marketplace to finance that deficit. And if we can’t get others to pay for all of it, what we’re going to have to do is monetize it. The Fed’s balance sheet will grow as a consequence. In the meantime, as America’s trade deficit and budget deficit increases, we’re going to have to print more dollars. The more dollars that we print – that is the greater the quantity of dollars circulating in the global system – the less value [they] have. We’re heading for a dollar crisis and a lower dollar means that you and I as Americans are going to have to pay more for the goods and services that we import into this country. Your clothes are made overseas. Your shoes are made overseas. Most of the electronics you buy are made overseas. The majority of the energy you pay for, whether it’s oil, natural gas or gasoline, is coming from overseas. Just look around your house. Most of the products you have including your personal computer, TV set, entertainment system, none of it is made here. So when the dollar goes down, we have to pay higher prices like everybody else. The net result is inflation is inevitable, not deflation. [53:32] JOHN: Every time we make these downturns into a recession, what happens is they go into their files, they pull out the same scripts they were using that didn’t materialize the last time and make the same arguments all over again. JIM: They’ve always been wrong. I can remember in 2000 and 2001 they were talking about a big deflation coming as a result of a collapse in the stock market and a recession. We didn’t get deflation we got asset bubbles. In one year the money supply grew by almost $1 trillion. After 9/11 the money supply expanded in a single week by $180 billion -- just in one week after the events of 9/11. And as a result we got a bond market bubble, a mortgage bubble, a consumption bubble and the trade deficit hit record after record. And not once did we get a negative CPI. CPI dropped in one year, which was 2001, but it had more to do with the way the government tinkered with the way they computed the consumer price index. They substituted rents for the price of homes and they also substituted the price of used cars for new cars. So used car prices were dropping as were rents, as more people were buying homes and more people were buying new cars because of the incentives. New car prices were going up, housing prices were going up, but the way they were reflected in the consumer price index, we were showing rents rather than the cost of housing and used car prices rather than new car prices. So, we never did get deflation. What people don’t understand is 21st Century banking or 20th Century banking – there is absolutely nothing that backs any of the currencies in the world today. There is no gold backing. There is no limit to the amount of money that governments can print and create. And so as a result of all this excess money – going back to what Warburton was saying – a massive reinflation effort would take place in the global Western economies. And that is exactly what is occurring now with the global monetary base, which is the monetary base in the balance sheet of central banks, growing at an annual rate of 20%. The result is what you’re now seeing in the supermarket, at the gas station. It’s now spilling over into the real economy with rising prices. But it’s not the oil companies or OPEC that are causing it. It is the governments and the central banks, which are simply printing too much money. [56:15] JOHN: How many of the politicians that parade through the halls of Congress really understand this? JIM: I would only say one or two: Ron Paul would be one of them. He understands what creates inflation, when the Fed monetizes, prints money, but you know I would say maybe one or two. Look at the energy issue. Dennis Hastert pleading with oil companies, “Please build another refinery.” And across the hall in the Senate they’re voting down a bill to make it easier to build a refinery. What’s that old saying? It’s like the nuts are loose and are running the country. [56:53] JOHN: The only difference between an insane asylum and the Congress is the fact that the inmates are running Congress. JOHN: Jim, we were talking about consolidations of oil companies, bcause as we began to see a bear market in oil as the prices stay down oil companies consolidated in order to try to economize in that kind of environment. Now we’re going to switch topics a bit. We’re predicting sort of the same thing is going to happen in the drug industries. And this one fascinates me. JIM: If you take a look at what’s happening with major pharmaceuticals and especially pharmaceutical companies in the United States, there are moves afoot to limit the prices that drug companies can charge for drugs that come out on the market. We’ve got the Medicare prescription bill that goes into effect next year. So it’s going to limit some of the pricing power for the drug companies. At the same time, you have a lot of drugs that are coming off patent, which means that the price of those drugs will come down as they will come up against generic competition. So, just like we saw a drop in oil prices, you’re going to see a drop in a lot of drug prices as generics replace the expensive drugs that were originally discovered as they come off this patent process. So what you have in the drug industry right now is shrinking profit margins as a result of 2 things: Government coming in [with] price controls; and also large PPO providers are trying to regulate the price they pay for a drug. So you have large government and large organizations, kind of like a Wal-Mart coming in and affecting pricing power. So that’s bringing down the costs. So profit margins are shrinking. At the same time you’ve got a lot of drugs coming off patent, which means that sales will decline because if you sold a drug for a $1 a tablet, now with generic competition you can only sell that drug for 50 cents a tablet. The price is going to go down. So what you’re going to see is very much what you saw at the large oil companies in the '90s. You’re going to see a lot of the drug companies consolidate, which would get rid of some of the excess capacity in the system. So in the next two to three years don’t be surprised if you wake up one morning and you turn on CNBC and you’re going to find out some of the vulnerable companies, Schering-Plough, Bristol-Meyers, Eli Lilly, Merck, and some of those companies, and even smaller affiliate-type companies come under consolidation. They could be bought out by the large cap pharma companies like Johnson & Johnson, Pfizer, or even some of the European companies. And the other thing that makes it very attractive is the prices of these companies – if you look at these companies on a P/E multiple basis – you’ve got Pfizer for example selling at 10 times earnings, Bristol-Meyers at 14 times earnings with a 5.3% dividend yield. You’ve got Merck with a 10 times earnings, almost a 5 ½% dividend. Many of these companies are looking attractive from a takeover position. Normally when you see anything like this happen in an industry, where sales shrink or the number of product offerings shrink or margins shrink, you see a consolidation. So I would take a look at the companies that are most likely to be taken over. Some of these companies by the way have large pipelines of drugs on the horizon, but unfortunately they are 2 or 3 years out. So it would be a very attractive move if you are somebody like a Pfizer, who has drugs coming off patent to turn around using your large market cap to acquire let’s say another company, even with the shrinkage of Pfizer’s price. Pfizer still has a market cap of let’s say $160 billion. That’s a good size market cap. If you take a Bristol-Meyers, they have a market cap which is only $41 billion, or Schering-Plough $20-30 billion. A lot of these companies are very vulnerable now to shrinking margins, delay in product pipelines, and also a decline in the price of their stocks. One of the big movements you’re going to see in the next couple of years is consolidation of the drug industry. I think what you’re going to see is like what you see now with big oil. It’s almost like if you take a look at Western oil production we’re back to the original Seven Sisters in the oil business. You’ve got about 7 large oil companies today that account for the majority of oil that is produced out of Western countries. And I predict you’ll see the same thing take place in the drug industry where you may only end up with 5-7 large pharmaceutical companies that will control the drug market. [1:02.00] JOHN: What does that mean from an investment standpoint? JIM: I would be looking at takeover candidates, because not only are they selling at low P/Es, but also they’re selling with large dividends compared to the rest of the market. So as you buy them, you’re being compensated in the form of a dividend, which goes up while you wait for the industry to consolidate or for prices to move higher. And by the way, another aspect of this industry, even though profit margins will be shrinking, unit volume will be increasing which will act as a counter to that, because – as the baby boom generation populations of the United States and especially in Europe and Japan – we’re facing an aging demographic trend in the United States, Europe and parts of Asia where you have a large population. And as you know older populations consume more drugs because your fighting cholesterol, heart disease, diabetes, Alzheimers, and all the ailments that come upon us as we age, which are treated effectively through drugs. JOHN: I’m not going to encounter that. I’m not going to age. JIM: You have found the fountain of youth? JOHN: I have indeed and I’m opening shares on the stock market on Monday. It’s called Youth Co. Well, we have chopped out our time for the week. What are we looking at in the weeks to come here on the program? JIM: Well, let me see, unfortunately we didn’t get to emails. We’ll do our best to get to them next week. Coming up in the weeks ahead, next week I’ll be talking to famed commodity trader Larry Williams, he’s written a book called Trade Stocks and Commodities with the Insiders, Raymond Learsy has written a book Over a Barrel. He claims there is no peak oil, so you’ll hear an opposing viewpoint that’s coming up on November 12th, Ike Iossif Ahead of the Trends, Deborah Weir Timing the Market and Eric J. Weiner What Goes Up, and of course in December we’ll also be talking with an author of a new book on foreign currencies. So lots of great stuff and also the San Francisco Gold Show coming up the week after Thanksgiving. In the meantime we have run out of time, on behalf of John Loeffler and myself we’d like to thank you for joining us here on the Financial Sense Newshour, until you and I talk again, have yourself a pleasant weekend. © 2005 James J. Puplava, Financial Sense Newshour |
ALL THE WRONG MOVES
