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The BIG Picture Transcript
December 1, 2007
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  Part 1
  Inflection Point: Goldilocks or Recession
  It's No Longer a U.S. Problem
  Energy Crisis Scenarios
  Part 2  
  What Are They Thinking?
  Q-Calls

 Part 1

 Inflection Point: Goldilocks or Recession

JOHN:  I don't know why everybody wants us to put it all together, Jim.  I don't think they are putting it all together very well as we look at the world out there.  Remember the line from The Princess Bride?  “You keep using that word, but I don't think it means what you think it means.”  These guys keep saying something different every week.  I mean if you just remember, let's go back to the fairytales of just –what would it be – four weeks ago or eight weeks ago?  How far back would you push this? 

JIM:  Probably about two or three weeks ago when everything was just rosy.

JOHN:  Yeah.  Everything –

JIM:  Actually, it was the October 31^st Fed meeting when they cut interest rates a quarter of a point and they said things were equally balanced between growth.  And then immediately you have the Fed governors coming out and saying, “well, you know, maybe we shouldn't have cut.  Maybe we'll have to take that back.  The economy is recovering,” and all of this other nonsense.  And here they are two or three weeks later and it's like they’ve got the fire engines running.  [1:02]

JOHN:  Well, if you look at it, the White House, the Fed and I would guess most economists by now have lowered their economic growth expectations –maybe a better word, rather than targets – for this quarter; and probably for next year as well.  Just before we got on the air here, you were going through headlines; economic news is pointing to a real slow down.  And until this week, we know the stocks have been tanking, credit markets have been freezing up, there was a train collision in Chicago which is due to inflation.  We all know that; right?  When inflation goes wild, trains become unstable.  It doesn't sound like this plan is coming together for the Fed; does it?

JIM:  No.  It's absolutely amazing.  If you just look at the headlines, you don't even have to read the articles, every single day.  Okay.  This is from today's headlines on Bloomberg: US stocks rise as Bernanke signals rate cut; Paulson seeks accord with lenders to stem surge in subprime foreclosures; Florida schools struggle to pay teachers after investments frozen by state; Bristol-Meyers begins eliminating jobs to reduce costs; defaults on insured home mortgages reach highest level since 2001; housing slump enters third year in deepest correction since World War Two – John, this is daily!  It would be different if maybe one out of five days you get headlines like this, but it's almost on a daily basis and I think where we're at right now is we're probably at an infliction point for the economy and the markets.  And I believe what happens over the next two months is going to determine whether we’re going to have a soft landing or recession.  In fact, the recession theme is something I'm working on as an investment theme for 2008.  [2:38]

JOHN:  Let's go back to your predictions at the beginning of the year since –believe it or not, here we are, the first of December, in a bleak December –and we started in January this year talking about the fact that: we'd see slow down in real estate or real estate dropping down leading to a crisis (which it really did because that's what triggered off all of the subprime stuff);  the economy would slow; and finally we would have a crisis that would lead to Fed rate cuts.  And of course they’re right between a rock and a hard place and it's very difficult for them to make any move.  So what is your thinking now?  The last Fed meeting the Fed said the risk for growth and inflation were balanced and this doesn't look balanced to me at all, Jim. 

JIM:  No.  And I think the big question on whether we avoid a recession next year is going to depend on three factors.  One is monetary coordination.  I said for the Fed to get aggressive, they were going to needed cooperation from other central banks; and up until this point that has not happened.  Two, you're going to have to see aggressive Fed easing.  And three, you're going to have to see massive fiscal stimulus.  Now, we're getting some sort of regulatory stimulus.  Friday, one of the big stories that hit the wires was Paulson's attempt, basically, to go to lenders and have the subprime mortgages frozen.  And I think that is raising all kinds of questions.  How do you do that and what happens to people that basically have been paying their mortgages?  I think this is just the beginning, John, of what I think is going to be a massive fiscal stimulus package coming from Washington in order to avoid a subprime and a credit meltdown.  [4:16]

JOHN:  It doesn't reward keeping good payments going and it doesn't punish those who made bad investments?  You know what it looks like is when we go into wage and price controls?  It's the same thing, you're actually going against market forces and ultimately that fails.  And this would just seem to be another form of wage and price control in a different package.

JIM:  Exactly, because what he's talking about is negotiating agreements with banks to stem a surge in foreclosures by fixed interest rates on loans to subprime borrowers.  And so the Treasury Department is working with federal regulators, bankers, lobbyists; major banks are part of this.  And the problem is the median price of new homes fell 13 percent in October from a year ago; and most of the foreclosures that we've seen right now have been a result of bad lending practices. 

But what you're starting to see now is renewed turbulence in the market.  When they thought they had fixed everything, it's getting actually worse.  In fact, one of the regulators, FDIC Chairman Sheila Bair, Comptroller of the Currency John Dugan and Office of Thrift Supervision John Reich, they are talking about a proposal letting borrowers with adjustable rate subprime mortgages who are living in their homes and unable to afford resets get extensions on the starter rate for at least five years.  Also, they could be offered a 30 year fixed-rate loan at a very low rate.  The problem that they are facing –and this is where the fertilizer is going to hit the fan in the first six months of next year – you've got about 100,000 subprime loans that are going to be resetting to higher rates every single month over the next two years. And that was issued by a report by UBS on Friday.  The delinquency rates on subprime mortgages (which account for about 15% of a total of $11.5 trillion in the US mortgage market), homeowners are behind right now on 17% of those adjustable rate subprime loans.  And that was as of June of last year, and I'm sure that figure given some of the recent reports we've had is much, much higher today.  [6:22]

JOHN:  What do you expect to happen?  I mean if we do some of the things that you're talking about that the Fed should be doing, is it going to happen in time in order to avoid a recession next year, or are we sort of over the cliff and fated to go through this? 

JIM:  As I look at it, I think it’s too late – it's beginning to look rather iffy on this one.  The Europeans have not joined with the Fed yet, so the Fed has been less than aggressive, but I think that will probably change next year.  The European economy is slowing down rapidly.  There was an article this week in the Wall Street Journal about tax cuts.  That idea is gaining traction as the economic outlook dims.  And I haven't seen any massive fiscal stimulus spending programs outlined yet by any of the – whether it's the President or Congress.  Everything is just talk at this stage.  And candidates from both parties aren't really focused yet on the upcoming recession – at least from the way I see things.  Just too much evidence indicates that the recession scenario is looking like what is going to be in store for us in the first half of 2008.  Policy on both the monetary and fiscal side has been lagging.  [7:35]

JOHN:  I think you're going to see in the whole presidential debates, as a matter of fact, once the candidates get firmed up in 2008 this re-shaping what the debate issues are.  I would predict like five months from now there will be a radical transformation in a lot of things that are being said in some of these debate issues.  Why do you think the Fed was so sanguine anyway at the last FMOC meeting?  They only cut a quarter point.  Is this a hype or a hope – or both?

JIM:  You know, when they met in October, stock prices were at near record levels, swap spreads were narrowing, reflation assets were rising, the commercials paper market was leveling off, so I think they felt they had fixed the problem or at least hoped they did.  You also had GDP growth also appeared stronger than expected.  Who knows?  Maybe they believed the economic numbers that are reported.  [8:24]

JOHN:  Well, if you just read the daily headlines, it would appear they misjudged the severity of the problem.  I mean I’d like to point out that over 90% of the time, the Fed forecasts are usually wrong.  At least they are consistent, Jim.  They never get a recession forecast right, but they are consistent.

JIM:  That's right.  And you've got to give them an A for consistency.  You know the problems that are coming to the surface are going to get worse in the first half of 2008.  The subprime, the SIV problems will spread.  So it will get worse before it gets better.  That in itself isn't enough to sink the economy, although I think it's going to weaken it.  The size of the problem is manageable, and the ownership of the these debt instruments is dispersed.  So those are some of the positive things, although I think the amount of global liquidity is large enough to absorb the losses.  The problem is you have a lot of money out there right now that's looking to be invested and is imprudently looking for higher returns, i.e., let's say structured, levered or illiquid assets.  [9:27]

JOHN:  So what you're saying then is there is plenty of money sloshing around right now looking for some high risk returns. 

JIM:  Exactly.  Because already you've seen numerous distress funds are being formed and substantial amounts of money, John, are being raised and directed towards purchasing these distressed securities. 

I'm going to digress for a moment, but if you take a look at the last sort of serious real estate crisis that we had in 2000 and 2001 with the S&L crisis, if you look at how they solved this problem, first the Fed cut interest rates aggressively and then what they did is injected a lot of liquidity into the banking system. Banks could borrow from the Fed.  Banks in turn took the low interest rate loans and they invested in Treasuries; that was the first time they have they really had a large influx of what I call the carry trade right here.  So what Fed was doing, basically, was reliquefying the banks.  And then they formed the RTC.  They took mortgages, they took real estate and basically just liquidated it and cleansed the system.  I think in the end that's exactly what you're going to have to do. 

If you look at a lot of the banks and if you look at all of the major brokerage firms, the banks are saying the federal funds rate needs to go down to 3%.  There is even talk of a two handle going down to 2%, depending on how late and how big the crisis gets.  So if they can take the federal funds rate down to about 3%, the cost of loans will remain high, but what they will do is if they bring the federal funds rate down low enough, perhaps the loan write-offs, instead of being 400 to 500 billion end up being only 200 to 300 billion.  And then with the profits the banks can earn on the spread, they can reliquify the banking system; banks can write off these loans and absorb those loans with the profits that they are going to make.  And then at some point, you're going to have to start liquidating the real estate inventory that's out there, whether it's a home builder that suddenly slashes prices by 30, 40%, basically thinking that let's just liquidate this stuff and get it off our books.  But that's eventually what you're going to have to do is to cleanse the system. 

Now, the problem is if you get into this kind of price control system that they are taking right now, this Paulson idea of freezing adjustable-rate mortgages at their teaser rates for a five-year period or giving them a 30-year loan at a 3 to 4% rate, somebody has got to pay for that.  And that's the problem that you get when government comes in.  They create a problem with loose monetary policy and then when the problems surface, they try to fix it with more tinkering and you never let the market cleanse itself and recover.  Instead, you just postpone the day of reckoning.  [12:17]

JOHN:  Well, basically, Jim, is there ever a real solution to this whole thing, or is the only thing they can do just postponing the problem?

JIM:  I think that's all they are able to do with present policy.  And I think what you're going to see as a result of reflation is asset bubbles are going to get larger, inflation rates are going to rise even higher, especially in countries that are running trade surpluses such as China.  The problem is if they don't contain it, it's going to get worse.  If you take a look at as this problem surfaced at the end of the summer, a couple of months ago the estimates were we were going to see about probably 200- to $300 billion in losses.  Now that figure has risen to between 400 and 500 billion because the problem is getting worse as evidenced by the headlines that we've been talking about that. 

But here is where it even gets worse than what it already is and that is if the US economy goes into a recession in the US and growth slows globally, then that 400 to 500 billion dollar loss figure is going to be too conservative.  Then you could be looking at losses in the range of 700 billion and greater and that could become a reality.  Right now, business is the one bright spot in the US economy.  We haven't seen massive lay offs, but there are growing signs that that could be next.  Unemployment claims are rising and the number of mass layoffs are starting to creep up, just little by little right now, nothing big, but it's a warning sign. 

So if the US economy goes into recession, that means well, what follows?  More lay offs, more people losing their job means that mortgage defaults and foreclosures will get even greater.  Real estate prices, with more inventory coming into the market, will fall even more.  You're going to see cut backs in production as businesses cut back and production and producing things; you're going to see less consumption.  So the longer that policy makers delay, the worse the problem becomes.  I just don't think as I look at things right now that we can avoid a recession at this point unless policy response is so massive and it becomes immediate.  [14:35]

JOHN:  Even if you do that, though, you know, the whole thing is the battle ship analogy, it may not be very fast, but it's mass is huge, (force equals mass times acceleration) so when you start to turn a battle ship, it's either a), hard to get it started, or b)hard to stop the momentum once you’re doing it – and that's where we're at.  We're not dealing with fine corrections where the very next day everything responds.  And right now it’s looking more like what?  Recession, I guess, is what we are pointing at?

JIM:  Well, there are a number of indicators out there pointing to this outcome.  You've got Moody's Recession Indicator is close to 50%.  My friend Brian Pretti pointed to the Chicago Fed’s National Activity Index which was published this week and whenever that index moves to a negative point 7%, after an expansion, it indicates the likelihood of a recession that's already begun.  And John, we're almost already there.  So just looking at the credit markets where yield spreads are rising, defaults and bankruptcies are going up; on this Friday, defaults on insured mortgages reached the highest level we've seen since 2001.  Also, production and consumption are starting to fall.  So if you look at it, the odds are tipping in favor of that recession scenario.  [15:53]

JOHN:  You know, I talk to a lot of people around here and a lot of these people if you talk to them about their financial situation, they are just getting by.  And remember that interview we did with Catherine Austin Fitts a couple of years ago?  People are forced to turn to credit just to survive, because basically they get by until there is a non-linearity in their lives –dental bills, visit to the hospital or the emergency room – and then there is just no flex room left in there.  That's the reality of the middle class today.

JIM:  I think that's probably one of the next crisis that you're going to see unfold and if you take a look a lot of installment and credit card debt has been securitized and I think that's going to be the next shoe to drop.  You're already seeing auto loan delinquency rose nearly 4% in the month of October.  Auto loan defaults are up 30% year-over-year and about 12% just in the last month.  And here's another thought:  Most of the defaults this year on home mortgages have been a result of bad lending practices such as no-doc loans, no money down loans, interest-only loans.  Next year, you've got about $360 billion of sub prime loans due for reset and probably about another 150 billion in other adjustable loans set to reset.  That's why I think you're seeing the Paulson move on Friday.  So with interest rates higher today than when those loans were taken out –and also, John, don't forget banks are tightening lending standards – many of these loans are going to go into default.  And it's projected by the Mortgage Bankers Association that the supply of these foreclosed homes that we're going to see in the next six months is equal to about 45% of the existing home sales.  That could add probably another four months of inventory to the supply of existing homes.  And repossessed homes, John, usually sell at 20 and 25% discounts to other properties in the area.  So I think that's why you're seeing this mad scramble by Paulson.  And I think also the Fed has gone completely flip-flopped within three weeks here in terms of signaling that they are going to be more flexible.  [18:11]

JOHN:  Well, Jim, at this stage, I think I'm reaching for eggnog and brandy.  Just drop the eggnog, just keep the brandy.  That will be good.  How can we expect this to unfold and when?  What's the worse case scenario? 

JIM:  You're going to see all of this unfold, John, in the first half of 2008.  By the end of the second quarter, we're going to see the peak in mortgage resets, so by June of next year, most of the resets or the peak of those resets are going to be behind us. Now, what happens after that it's hard to say, but I think most of the damage is going to occur in the first six months of next year.  And I think that's why they are scrambling right now.  [18:48]

JOHN:  Well, here comes the big discrepancy we always talk about.  This week government reported that third quarter GDP numbers were up close to 5%, so if we have a robust economy and things are puttering along quite nicely –despite the fact that I don't think the guy out here in fly-over land feels that – how do we go from here to the scenario that we're talking about? 

JIM:  I think one of the problems and we talk about this, is these Q3 numbers, I think, are somewhat fictional.  They were due to rising exports and a build in inventories.  And here's one I love:  The lowest inflation rates for the GDP deflator that we've seen since Eisenhower was president.  I don't know if people really believe that.  And the export numbers were real.  We have seen that in the trade deficit figures that exports are going at three times the level of imports.  The inventory build, well, that could be a problem.  Is inventory building because manufacturers are getting increased orders, or is inventory building because the stuff isn't moving out the door?  And if it isn't moving out the door, then last quarter's build in inventories could be this quarter's problem, because when manufacturers start to build up inventory and the stuff isn't moving, the first thing they start to do is cut back in production.  So we could see some real problems here, and the other thing too is I think a lot of these inflation numbers that were used, if you take a look at the GDP deflator, it's been declining since the beginning of the year; and I don't know anybody out there that believes that deflation has been declining since January.  [20:24]

JOHN:  You know at the same time, not to be totally gloom and doom here, you do hear stories about bright spots.

JIM:  Well, sure.  I mean if you take a look at the foreclosure problems in real estate, it's concentrated in some of the boom states that we saw real estate prices go bonkers like California, Florida and Nevada and Arizona; these states are bearing the brunt of the housing slump.  But on the other hand, energy producing states like Texas, Wyoming, Alaska, are benefiting from higher fuel prices: the Texas economy is doing well;  farm states, for example, Indiana and Kansas are doing well from exports of agricultural goods. 

But then on the negative side, you've got the Northeastern states are being hit by higher home heating costs.  I think heating costs are up something like – I forgot what figure was – 26 to 32%.  And then yet you've got the Midwest which is taking a beating as a lot of manufacturing jobs are lost; then you can go to Florida that is having some tight problems with investments and also with housing and yet tourism is up in Florida because with the dollar sinking foreign dollars can come here and buy a vacation at a much lower level.  And then also you have some of the border states –and I think you were telling me this, John – with Canada are doing well at least on the retail side with the loonie buying more in the US. 

However, here is one thing that you have.  The common theme to all of these regions is just about every area is being hit by something.  Whether it's housing, whether it's higher energy costs or it's a loss of manufacturing jobs, every single region of the country is experiencing some kind of problem.  [22:10]

JOHN:  What about holiday sales?  I mean they are off to a good start so far.

JIM:  You know, I really don't expect that to last.  And if you look at what retailers are doing, I mean they are trying all kinds of innovative things, put it on sale.  So that's the only way they are moving merchandise.  And here's the problem that the retail market consumption is facing and that's a softening job market.  We're seeing unemployment claims go up.  We're seeing higher oil and food prices.  We're seeing rising mortgage costs.  We're seeing tighter lending standards.  We're seeing falling home and equity prices.  And sooner or later, that's going to take its toll in the first half of next year, so maybe people are splurging, going out on credit for the Christmas season but what happens to retail sales in other aspects of the economy in the first half of next year.   [23:01]

JOHN:  Well, perhaps that's why the Fed is changing its tune.  And maybe we need to listen to something that Ben Bernanke said in a speech he gave on Thursday night.

BEN BERNANKE:  I expect household income and spending to continue to grow.  But the combination of higher gas prices, the weak housing market, tighter credit conditions and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.  Core inflation –that is inflation excluding the more relatively volatile prices of food and energy –has remained moderate.  However, the price of crude oil has continued to rise over the past month; a rise that will be reflected in gasoline and heating oil prices and of course in the overall inflation rate in the near term.  Moreover, increases in food prices and the prices of some imported goods have the potential to put additional pressures on inflation and inflation expectations.  The effect of this on monetary policy depends critically on maintaining the public's confidence that inflation will be well controlled.  We are accordingly monitoring inflation developments closely.  We at the Federal Reserve will have to remain exceptionally alert and flexible as we continue to assess how best to promote sustainable economic growth and price stability in the United States.  [24:13]

JOHN:  There you have Ben Bernanke saying something totally different from what the Fed was saying just 30 days ago; and then we have the government coming in and interfering in the markets.  They floated this balloon out here about freezing the changes in the adjustable rate mortgages.  Number one, I think their credibility begins to teeter and totter because people do have enough memory to go back 30 days if you're looking at it; and number two, it seems to be making everything worse as it flies.

JOHN:  Well, it's more than what Paulson was doing on Friday, John.  You also had a bill that was introduced by Barney Frank in the US house which was passed, called The Mortgage Reform Anti-Predatory Lending Act; and that could make, actually, bank lending even harder because the new law could expose banks to new financial penalties and lawsuits that they will refuse...cause them to, let's say, not make loan to many low and moderate income groups.  Security firms that repackage these mortgages could also become liable; and what you could do is force these people away from the market.  And the language of the law is so loose, it leaves it up to the trial lawyers and the courts for interpretation.  So you've got lenders that are saying, “wait a minute, if I make a loan to somebody that maybe might be at risk here, I could be liable for this loan and get sued for it, so why would I want to take that risk?” 

So once again, you've got government coming in whether it's freezing –price controls, which is what freezing the rate on mortgages really represents; or creating this kind of law – and yet at same time, while they are creating this law for lenders, they want Fannie and Freddie to start absorbing or buying more mortgages when Fannie or Freddie just dropped their dividend and reported one of the largest losses in history.  So it just goes to show you how mucked up things are right now.  [26:10]

JOHN:  Yeah.  Where the cure is actually part of the problem rather than being actual solution to the situation.

JIM:  Yeah. 

JOHN:  It seems like bad law and a bad time.  Okay.  If there is a possibility of a recession next year, then let's turn towards our listeners here and say what should listeners be looking for to give them a clue that we are headed in that direction, and probably in the long run, what they should be doing.

JIM:  Sure.  I think the key thing to watch is whether the whole credit cycle is coming to an end and if those credit problems we've been talking about spillover into the economy, taking the economy down.  So one thing to watch, John, is the unemployment claims.  I don't trust a lot of the job numbers, although even the unemployment rate, has been ticking higher.  So watch the unemployment claims and watch the unemployment rate.  If they worsen, that's going to spillover and create more problems in the credit sector. 

Watch business investment and production.  Especially with those high inventory builds that we had in the third quarter.  Watch what business does going forward.  If investment continue to fall and production drops, then the only strong sector in the economy, which has been business, is beginning to buckle.  Also watch consumer spending:  If the holiday season is weak, that means the first half of next year should be even weaker.  And then watch –and these are all related – watch lending, housing, the credit crunch and Wall Street.  They are all inextricably linked.  If economic growth softens, then banks will begin to cut back on lending.  Watch and see if that happens.  A tougher lending environment will hit housing even harder.  Also watch the commercial paper and money markets.  Right now, banks don't trust each other, which is one of the difficulties the Fed has because of lack of transparency.  So the interest rates they charge each other are stubbornly high.  Watch LIBOR rates which have remained stubbornly high.  And finally watch Wall Street:  When central banks inflate –and we're seeing that globally whether you're looking at Europe, you're looking at here or other countries – when they inflate, that money is going to go somewhere; so expect those asset bubbles to get bigger.  So it becomes a question of what asset class will inflate next and turn into our next bubble?  We've had stocks as an asset bubble in the 90s, we've had real estate as a bubble and mortgages in this decade.  I suspect probably as money becomes worthless or as money dies, I expect commodities are the next reflation bubble.  [28:48]

JOHN:  So if we look at everything that is going on here, real estate is basically down, which of course means a crisis, the economy is slowing.  Now we look at Fed cuts and whether we avoid a recession really depends on coordinated intervention to this whole thing – a massive fiscal stimulus, otherwise you're going to hear a lot about the ‘r’ word next year even though right now there are only harbingers of it. 

JIM:  I think we're going to see eventually coordinated intervention and probably some form of massive fiscal stimulus, but not in time I think to ward off a recession.  We may get stagflation, a mild recession or low economic growth with rising inflation rates.  There is just too much inflation that's baked into this system.  And right now, John, unless they can perform a miracle, I think it's really going to be hard for them to avoid a recession.

 It's No Longer a U.S. Problem

JOHN:  You know, a popular theory today we hear about is the decoupling of the US and the global economies.  The theory is that a major slow down in the US can be shrugged off by the rest of the world.  Is that true or false? 

JIM:  Well, that seems to be the popular theory, and especially as the US economy slowed down in terms of economic growth rates from the beginning of the year that basically the US is no longer the locomotive, but in fact has become the caboose.  If you look at what's happening, now, John, the facts are starting to speak differently.  Signs of economic slow down are evident in Europe and Japan and I believe China's economy will also slow down.  But today, we have two kinds of economies.  We have the developed economies, think G-7 and then we have the developing economies, think China, India, Latin America.  The developed economies, I believe, are going to follow the US with a lag.  And the developing economies probably stand out as probably holding the best chance of weathering a US slow down.  They too are going to be hurt, but they should probably still be in the strongest economies around the globe as you look forward in the next 12 months.  [31:12]

JOHN:  So let's go back to the developed economies.  What you're saying is they should follow the same script as in the past?

JIM:  Sure.  Because there has been a lag factor, because the slowdown in the US up until this point has been confined to the housing sector. But if you look at Europe and Japan's economy, they are beginning to falter.  The Purchasing Manager's Index for manufacturing has been falling, although it ticked up slightly last month in Europe; the PMI Service Index fell, so the drop in the Service and the Composite PMI Index is suggesting the Euro economy is slowing again in the fourth quarter.  And also it's beginning to falter in the face of a credit crunch.  The strong euro, you've got elevated oil prices, higher interest rates and a softer export market.  So the Europeans are deeply concerned about the rising euro against especially the Chinese currency.  The EU’s annual trade gap against China –and here is one to keep your eye on –is on track to surpass the US-China trade deficit for the first time.  You're also seeing industrial production in Japan, the world's second largest economy, has been falling since the third quarter of last year.  [32:27]

JOHN:  Yeah.  But haven't the European trade countries been experiencing some credit problems?

JIM:  Well, sure.  In fact, you remind me of a point.  It was a European bank that was one of the first casualties during the initial round of the US subprime debacle earlier in the summer.  In fact, and here is something that you have to keep in mind:  With global integration of the banking system, it just underscores that a crisis of confidence can spread very quickly from one major economy like the US to another economy.  So it's not like that the rest of the world is isolated.  There is too much integration of banking and financial systems.  As an example, the British Banker's Association is suggesting that a slow down in housing is probably more severe in at least a decade.  The number of mortgages approved in October dropped by nearly 17%, they have a subprime problem too.  And John, just like in the US, lenders in the UK are tightening.  Two years ago, borrowers could get, let's say, a two year variable rate loan at close to 6.6%.  Today when those loans are being reset you're looking at, or more likely to be looking at, a 9 ½% interest rate.  [33:42]

JOHN:  Just like over here in west pond, there's a credit problem in east pond as we call the Atlantic.

JIM:  Yeah.  If you take a look at last week, European banks agreed to suspend trading in almost the $3 trillion dollar market for mortgage debt known as covered bonds to halt a slump that was basically closing off the region's main source of financing for mortgage lenders.  You saw Barclays, HSBC, Unicredit take steps as investors shunned bank debt on concern lenders were facing more mortgage-related losses.  So the credit situation in the EU is deteriorating.  Some banks have agreed to stop providing prices on covered bonds to stem the losses from widening spreads.  And that points out the problem whether you're looking at the new superstructure that Paulson’s tried to put together for buying these mortgages from SIVS; basically, John, what they’re trying to do is forestall the day of reckoning or pricing or having these bonds come into the market at distressed prices which creates a problem for the whole banking industry.  So they are sort of trying to find some kind of limbo to put these things into temporarily so we don't have to deal with them right now.  So the credit situation is deteriorating.  

And if you look at Europe, you've got a housing bubble in Spain, Italy's economy has problems; you have a spike in sovereign bond spreads between Germany and what we call the Club Med countries such as Italy, France, Spain, Greece and Portugal that all border the Mediterranean.  The bond markets in Europe are starting to price in a break up risk for the currency even though that could be remote at the moment.  The problem is the Euro hasn't been around long enough to be crisis tested.  So if everybody says “okay, the dollar has got a problem” –and this is one of my arguments I've had with my peers –“okay, the dollar is experiencing problems, we're inflating, Bernanke is cutting interest rates, go into other currencies.”  Well, guess what.  They've got an inflation problem.  They are inflating.  They have their inflation problem, they are inflating, they have their own economic problems, they have credit problems.  And that's why I think ultimately, John, you're going to see gold emerge as it has as the ultimate currency, despite a lot of bogus recommendations people are saying – and we'll get to this later on about shorting gold, which is just ridiculous.  [36:04]

JOHN:  You know we’ve talked off and on on the program here about how the major central banks are all inflating so it would only be logical to expect that they should have the same problems simultaneously.  You wouldn't want to say one bank is going to have the problems but the others are going to be immune from it.   

JIM:  Sure.  In fact, we often talk about the money aggregates such as M3 which have been growing at double digits since the beginning of the year.  And the latest report as of September in Europe, M3 grew at an 11.3% rate.  Credit growth in the private sector was up 11.6%.  Loans to the non-financial sector was up 14%.  The money supply in the Euro zones suggest, John, that the recent financial crisis up until this point has had a limited impact on credit growth.  In fact, the central banks in Europe are pumping a lot of liquidity into the system and surprise, the inflation rate is on the rise.  [36:58]

JOHN:  Wow.  The opposite I would assume has happened in times past when banks quit increasing the money supply and then inflation quit.  But so far the European Central Bank has talked tough on rates even though they are actually allowing a fast money supply growth.

JIM:  They are basically talking the talk but not walking the walk because they are allowing money supply growth to expand.  It's been doing that at double digit rates.  However, I expect this toughness to change probably in the first half of next year and especially if the Fed begins to cut aggressively because that's going to impact the euro.  The euro will rise.  And already if you take a look at business, consumer sentiment in Europe, it's been deteriorating rapidly.  Recently they've had riots in France.  So Europe isn't a stellar pillar of economic strength right now.  [37:50]

JOHN:  So what we're basically expecting is that the developed economies are going to follow the US lead in experiencing a slow down.  There is going to be a parallel action there.

JIM:  Yeah.  I expect these developed economies are going to be hit hard, not only by what happens here but also in their own economies.  And the best areas globally will be the emerging economies and those that are tied to such things as resource-based economies; and I'm thinking of, for example, Canada, Australia, Latin America.  But that however, assumes, John, that eventually you get some kind of coordinated action by the major central banks to keep the contagion from getting out of hand.  If that doesn't happen in the first six months of next year, then all bets are off.  Then you can see my perfect financial storm scenario unfold.  I'm not sure I want to go there now.  After all, we're talking about the holidays here.  [38:45]

JOHN:  But in the end when we look at it here, ultimately we're going to have to expect that massive reinflationary efforts would kick in to try to rescue this whole thing again.

JIM:  Yeah.  I think we're about ready to see whether Bernanke's PhD thesis unfolds.  Can central banks, if they print enough money, avoid a deflationary depression?  And I think that they will succeed.  But eventually, the day of reckoning arrives, but we're probably two to three years away from that event unfolding.  So I expect it to be enjoined by the arrival of peak oil to give us that perfect financial storm.  [39:20]

JOHN:  And you're listening to the Financial Sense Newshour at www.financialsense.com.

 Energy Crisis Scenarios

GPM:  Tell me about the Hirsch Report and how it came to be?

ROBERT HIRSCH:  The report grew out of a study that I did something like two years ago where I was aiming at trying to identify and evaluate the major factors that might influence the course of energy  events in the future.  And one of the six topics that I considered was the peaking of oil production.  The more I looked at the problem, the more difficult and frightening the issue really became.  So as a result of that work, I proposed to the Department of Energy that my colleagues and I, two economists, energy economists that I work with (and worked with in the past) do a more careful analysis of what it would take to mitigate the problem of peaking –recognizing there was great controversy when the data of peaking was.  And so we left that date open and just looked at what could be done if one waited or if one started early; we wanted to get an idea of how difficult the problem was.

GPM:  Is it true that the report was somehow prematurely leaked?

HIRSCH:  No.  It was not prematurely leaked.  It took a little while to go through reviews in the Department of Energy, which is an appropriate thing, they wanted to be sure that what was being said there stood up to careful scrutiny.  We had a number of people review it, colleagues, simply because we wanted to be sure ourselves that what we were saying made sense and was within the bounds of reasonable estimation.  But there was no leak that I know of.  

GPM:  This report addressed the timing of Mitigation relative to peak rather than directly addressing the timing of peak.  Why this framing? 

HIRSCH:  What we tried to do in the study was to keep things as simple as possible without assuming away the problem, and that's very difficult because this problem has a number of very complicated dimensions.  With respect to the data peaking, I know enough from my own experience in the oil industry many years ago, and from studies I've done recently, that no one really knows the date of peaking.  It is simply not knowable because we have incomplete data.  We don't know and you don't have assurances about what oil is out there in the world available to be produced.  Then of course, we don't know the extent to which countries are going to produce the oil that they have.  So by leaving the date open, we avoided the controversy that's associated with date selection.  And our results are robust because we didn't choose a date and because the way we framed the problem gives results that are essentially independent of when the date might be.  [42:35]

JOHN:  That's an older recording which was done by Global Public Media.  It was an interview with Robert Hirsch right after the Hirsch Report came out back in 2005 about oil shortage mitigation. If you're going to have an oil shortage and you're going to hit an iceberg, what can you do to minimize the impact if you know that it's coming.  And recently Robert Hirsch talked at the ASPO  conference in Houston Texas and that's what we're going to discuss in this part of the Big Picture because obviously Jim, it's coming.  So now that you know it's coming, it sounds like Armageddon, doesn't it?  What are you going to do about it? 

JIM:  Well, that was what he was talking about, the main emphasis of his report is, look, at some point in time, I don't know when, which he was I think very astute in saying, we're going to reach peak oil.  “I don't know if it's 2010, 2015, 2030, whatever, but it's coming.”  So given the fact that we know that this lies ahead of us in the future, what is the best way to prepare for it.  And according to Hirsch, the best way is you start preparing for it two decades before it happens.  It allows you to start looking at alternative fuels, it allows you to start redoing your infrastructure, maybe you go to mass transit, you become more fuel efficient in your transportation system.  But he said the best outcome is two decades before.  The second best outcome would be to plan 10 years before because you're going to have some disruption, it's going to impact economies, but you know, you'll get through it. 

The worse outcome is what happens if you do no planning, you don't realize that you've hit peak oil, and then what happens; and that's the worse outcome.  Now, as many people remember listening to this program, we had Matt Simmons on this program, and he was also at the ASPO conference in Houston and according to Matt, and he said there is about five of them now, feel that we've hit peak oil production in May of 2005 when conventional crude oil production peaked.  It's been declining since then.  We’ve made up that difference with alternative fuels, gas-to-liquids, coal-to-liquids, etc. 

So what we're going to do, John, is pick up on Hirsch’s presentation that he made in Houston which is called World Oil Shortage Scenarios For Mitigation Planning because he goes on and he states in his presentation:  “When world oil production capacity no longer keeps pace with world oil demand, oil shortages will develop.”  And I'm going to add some evidence of that happening right now in China.  “These oil shortages will result in escalating oil prices [Even though it's come back this week, we're still looking at $88.]  And it will have a negative impact on economies.” 

And how many times did you hear this week either if you were watching the financial cable channels or you were listening to Bernanke's speech talking about that the impact of higher oil prices.  It will have an impact on economies globally.  So what Hirsch is talking about here, is look, we know this is here, and it may be sooner than we think.  What should we do when world spare oil production capacity will not meet demand at some point?  [45:57]

JOHN:  You know, if you remember, we were talking a couple of weeks ago on the program here about how the IEA had reversed its position on this whole thing saying basically starting around – I guess; we're wet fingering this, so to speak – 2009 where whatever spare capacity exists out there in the entire global market disappears; future demand continues growing at the very same steady rate.  So that by 2012, we're really in the middle of a crisis at that stage because not only is spare capacity gone, there is no breathing room inside of the system.  So when we hit this, we're in real trouble. 

JIM:  Yeah.  In fact, last week there was an article in the Wall Street Journal that talked about “oil officials see limit looking on oil production.”  And according to the Journal, which is echoing basically what Hirsch was saying, the world is approaching a practical limit to the number of barrels of crude oil that can be pumped every day.  And that ceiling, and they were making reference here is around 2012.  And the amazing thing it's starting to pick up a following now that ranges from, you know, senior Western oil company executives to former officials of major world exporting countries that don't believe the global oil tank is at the half empty point.  But they share the belief on this:  A global production ceiling is coming for other reasons; restricted access to oil fields, spiraling costs and increasingly complex oil field geology.  All of that is going to create a global production plateau.  So a lot of the people that are coming around and saying, “Well, we're not sure we buy the peak oil argument, but you know what, we do see a plateau.”

And that has its own problems too because if you want economic growth and you can't pump out or increase your production, then what do you do, how does your economy grow when you can't get the energy that needs to produce it?  [47:46]

JOHN:  Maybe that's a very important distinction too.  One issue is peak oil.  That's a long term issue etc.  The second issue is simply demand exceeding supply even if there were no peak oil.  And that's what we're facing in the short term.

JIM:  Yeah.  In fact, in Hirsch’s presentation, he's talking about this oil shortage in terms of what impact is this going to have on world economic growth.  And then he gets into the problems that we're seeing arise here is most of the oil –probably, John, the gasoline you're burning in your tank and mine – has come from giant oil fields that were discovered 30, 40, 50 years ago.  Now, these giant oil fields are going into decline.  Whether you're talking about Burgan, Kuwait, whether you're talking about that Cantarell in Mexico, or Ghawar in Saudi Arabia.  And the problem that we have is all of these world economic organizations are projecting –you know, this is what world economic growth will be – and it's all based on these future production forecasts; in other words, demand will grow at  X% a year and they just assume that the oil will be there.  And what Hirsch was talking about in his ASPO conference, we've got a problem here.  Not only are we not going to have the oil to meet this demand, but what will be the impact on economies when you're trying to grow your economy and you can't find the oil or the energy to power it.  [49:13]

JOHN:  People don't remember we said about the buffer area in there too.  It only requires  a small amount of oil out of the system to have huge economic and security implications.  Well, if we're assuming we're coming to a crunch point if we take 2012 as the point where things go critical, the question is what does criticality mean in the whole thing.  And Robert outlined three possibilities.  One is a sharp break meaning production goes up and then production sharply turns down.  Almost at a 90 degree angle.  A second would be a roll over and a roll down meaning it goes up and it slides over the top.  Third possibility would be a plateau whereby production goes up and then flattens off say for a short period of time –a couple of years – and turns down after that, so there would be a breather in there, somewhat.

JIM:  Yeah.  And what he's basically talking about:  Here are the three possible outcomes that we see that are right in front of us.  So given these three kinds of outcomes –either a sharp break, plateau or a gradual rollover – how do we best plan for this right now? And obviously, the best scenario would be the plateau period:  We reach a peak but we stay there, we don't decline; we use enough of either technology, discovery, alternatives and we can mitigate part of the problem.  In other words we have a little bit of the time to plan our way through the crisis. 

But then, he goes further and he talks about one of the problems that we have is these giant oil fields, whether you're looking at the North Sea, if you're looking at Mexico, the North Slope of Alaska, you know, 55 or 56 of the peak oil producing countries in the world have already reached peak production.  So there are not too many areas in the world left – a couple of areas in Africa, perhaps a few countries in the Middle East, Iraq and maybe Saudi Arabia.  But he goes through these giant oil fields and he talks about the actual decline rates –and one thing we're seeing right now is the actual decline rates in the Cantarell for example is running at close to 15 to 20% a year; a couple of the bigger fields in Mexico, 16% a year; Norway’s fields 11%;  the UK fields, 11%; Prudhoe Bay, Alaska 10% a year; a couple of other Norway fields 13, 14%; Oman’s fields, 15%.  So this idea that oil production would be slow and gradual, hence the sort of rollover effect and we take alternative technology and then perhaps we can stay at that plateau and plan our way through the crisis...But as you get into Hirsch’s presentation as he traces the decline rates of these major oil fields, we're finding that these decline rates are actually turning out to be much greater than we've been thinking.  [52:05]

JOHN:  So would that move up the timeline or what?  What would the result of that be? 

JIM:  Well, it not only moves up the timeline but it also creates a larger crisis when it arrives because here is the thing that people need too understand.  Mostly oil comes from these giant oil fields.  That's where most of the oil that we consume comes from.  The problem is if you have a major – these major oil fields start going into decline, how do you replace that production?  I mean it takes maybe a hundred midsize oil fields to replace maybe what was once a couple of large oil producing regions.  And so one of the problems that he tries to outline ahead is this future forecast in terms of, you know, what is it going to look like.  [52:53]

JOHN:  If you look at the forecast of future world oil production and these graphs regardless of who the experts are, they are not very sanguine on this whole thing.  Sometime between 2009, 2010, everybody seems to be centering around that. CERA is the only one who stretches it out further.  But everybody is just trying to do an estimate anyway because we all know that a lot of the reserve figures or somewhat “bogified” as well. 

JIM:  Here's another thing that I think we're not coming to grips with that Hirsch identifies and we've talked about this on the program, is if you take a look at world oil market control, in other words, who produces most of the oil, who owns most of the oil in terms of reserves?  You've seen since 1950 almost a complete reversal in fortunes where you have national oil companies today are the producers of oil, they are also the major owners of this oil that we call reserves that are in the ground.  So the major players today are no longer the Exxons, the Mobils, the Chevrons, the Shells, the BPs.  The major players today are Saudi Aramco, PEMEX, Petrobras, Lukoil, PDVSA, PetroChina.  And the motivations of national oil companies versus the motivations of let's say international oil companies are totally different.  If you're an international oil company you're going to go out and explore and as soon as you find something, you're going to want to it put it into production as fast as you can.  You're going to want to produce as much oil as fast as you can, and then what you're going to want to do is get a return on your investment. 

A national oil company on the other hand which most of the revenue from that oil goes to the state and supports the government, they don't have the motivation; in other words, if they want to keep production up or keep increasing it, that means less money goes to the government and more money is reinvested in the oil sector.  I mean take a look at what's happened to, for example, Venezuela's oil production under Chavez.  It's dropped about 40% because Chavez is bleeding all of those oil revenues to run his foreign policy programs, his welfare programs, he's not investing in the country; and that's one of the reasons the economy is in a shambles today.  [55:14]

JOHN:  That's probably the tragedy of all of that when it happens is that the people ultimately suffer because of that.  If patterns follow times past, I would wager there is some Swiss bank accounts involved in this too.

JIM:  I with say there is probably a lot of them.

JOHN:  So there then are two limiting factors that we can identify.  The first one is what you've been talking about that, Jim, the decline of the oil fields.  That's called the geological limit.  That's a physical proposition.  However, there is also the condition of what is called the oil exporter withholding scenario which means either:  The oil exporter doesn't produce as much for the world because he is using stuff internally; or, as a strategic weapon which we've heard a lot of conversation about that between Hugo Chavez and Mahmoud Ahmadinejad over the last couple of weeks.  So that's also there –using this as weapon upon.  Either way it results in driving up prices and a shortage on the market. 

And the IEA itself is saying there is trouble because there is a recent apparent surge in oil and gas investment is illusory.  The costs have soared.  Real investment in 2005 was barely higher than in 2000.  And they are saying the energy future is not only unsustainable, it's doomed to failure because of the fact that the investment is not there.  And ironically that comes back to countries again, doesn't it, Jim, because if you think your investment is going to be nationalized and bye-bye to whatever you put into it, investors are going to be a little bit skittery about doing that.  So ironically people like Hugo Chavez ultimately shoot themselves in the foot.

JIM:  Yeah.  And if you take a look at, and this gets back to the conclusion of Hirsch’s presentation, we've got three planning scenarios before us, the best is the plateau phase where oil production plateaus for a number of years, let's say a decade and it allows the world to take, you know, start conserving, start taking various step to mitigate the problem.  The other problem is what he calls the middling scenario, which is a sharp fall off in production much like what happened into the US, for example in the lower 48 states, or even the peak of production in the North Slope of Alaska.  The worst scenario is a sharp fall off as a result of these national oil companies withholding oil from exporting.  I just saw a report on Friday that they’re talking about Middle East oil consumption next year is expected to grow by almost 5%.  Almost as much as China. 

And so here's the problem that you have.  In a best case scenario where oil plat toes for a 2 to 15-year period and then eventually you get maybe a two to 3% decline rate.  On the other hand this sharp peak or the worse case where you have oil exporting countries withholding oil, John, we're in a real problem.  And you know, how are you going to mitigate this loss in production or drop off in production, you've got a number of things you can do.  You can put in crash program to produce efficient vehicles.  You can go to mass transportation.  You can go to gas-to-liquids, you can go to heavy oil, shale, tar sands, coal-to-liquids.  But the problem is all of this is going to take time and ideally under the plateau scenario you would have that time to plan for it. 

But under the other two scenarios –whether it's the sharp peak and drop off, or the worse case sharp peak drop off with oil countries withholding saying “holy cow, this stuff is becoming more valuable by the day, we can make more money by producing less” – and at that point, you go to what Hirsch is talking about that, which is basically one energy crisis to the next.  [59:00]

JOHN:  You know it's interesting what really illustrates the disparities that we've been talking about here between real world versus perception, this week you've got some major pull backs.  We almost hit 100.  Everybody was holding their breath, do you remember that, “it's going to be another day, it's going to do it, it's going to do it, and then it pulled back to 88 and the traders were all running around the floor, “pull out the champagne bottles, let's celebrate.”  And it's all on the report that OPEC and other people are just going to increase production a bit and this drops down.  Now, this is small compared to the roll off that we're talking about that.  And if you're celebrating over a little thing like that, what's this going to do to the markets when it hits flat on? 

JIM:  This is the thing that has just surprised me more than anything else.  With oil when we got close to $100 a barrel, John, you remember the congressman beating up on the oil companies after Katrina and Rita hit when oil went into the 70s.  Here we are at close to $100 a barrel.  Barely a mention in Congress or on the campaign trail.  Everybody's talking about everything else:  Global warming, health care, all of this other stuff and here this crisis is right on our door step. 

And I want to talk about a story that's going on in China that should be very alarming to people.  And this was an article in the Energy Bulletin called The Revolt Of The Tea Pot and let me just explain that.  In China, small privately or locally owned oil refineries are called tea pots and these are different than the giant ones that refine hundreds of thousands of barrels each day.  These little guys typically process about 10,000 barrels, but taken together or collectively, they produce between 10 to 15% of China's refined oil products.  Now, the last 25 years China's economy’s come a long way.  They moved from the Soviet-style command economy to sort of this bifurcated system that we have now where it's part planned and part open market.  But the problem it has created is energy prices are regulated in China.  They are subsidized.  So what we have going on in China right now is an actual nationwide fuel shortage. 

And you've heard stories about Chinese waiting in gas lines.  And most people say, “that's happening over there.  That should be minimal concern to most Americans.”  But you know what?  What's happening in China is just a prelude to what could be coming here because these shortages in China may only be weeks or months away from becoming shortages in other places.  Perhaps your favorite gas station.  And because of China's soaring economic growth, which is somewhere between 10, 11% a year, China's oil fields no longer provide large enough increases in output to satisfy domestic demand, so China is stepping up its imports.  And we've all heard stories about, “well, one of the reasons oil prices are this high is, you know, the US and Europe and other countries now compete with China.”  But the problem for China, and this is what happens when you get into subsidized economies, and for the teapots, is the government froze the price of energy and these small refineries had to import oil into their country at higher prices.  The solution for these tea pot refiners is to switch their production mix away from the price-capped gasoline and diesel to non-regulated products such as petroleum coke; or basically simply just to susspend refining until the situation changed.  And lo and be hold, John, it didn't take long to bring the Chinese economy to its knees.  So as world prices went higher and higher, production began to slip so that by October, the situation in China had become critical.  Spot shortages broke out all along the coastal and import regions for fuel oil because the tea pot refiners dropped their production by almost 29%.  And you heard stories about the inability of trucks being able to get diesel fuel; there was one individual that was killed at a gasoline station over a fight over fuel. 

So the first thing the government did was authorize a 10% increase in diesel and gasoline prices and also instructed the two largest national oil companies in China, PetroChina and CNOOC to increase their production.  Basically they said:  “Cancel your refinery maintenance, run your refineries all out because what they wanted to do was get rid of the spot shortages.”  

And here's the thing that needs to concern us:  During this period of time that the tea pots were cutting back on their oil imports, diesel imports which have been averaging 370,000 barrels a month for the first nine months of 2007 because these local refineries were cutting back on their production.  When these problems arose the next thing that happened is imports have now increased to 750,000 barrels.  And why that should concern us is during the month of September and October when Chinese imports were at their lowest level worldwide, world prices took a rather spectacular jump. 

Now, China is coming back into the world market with a vengeance.  They are increasing their imports into the country as they try to make up the difference between lost production from the tea pots and also the demand that's in their economy.  So unless a serious recession hits the Chinese economic growth engine, Chinese demand is going to keep growing and Beijing certainly has –with their cash flow from exports – the money to pay any price.  So China, for the first time has begun importing refined gasoline products.  Just as most people are unaware that the United States only produces roughly about 17 ½ million barrels a day through our refineries, our demand is 20 to 21 million barrels, so we're importing into this country, not only raw oil and natural gas, but we're importing about 4 to 5 million barrels a day of refined gasoline products.  So the gist of this article, some day soon, we in the US and elsewhere could be facing shortages, gas lines and rationing.  [1:05:40]

JOHN:  You're listening to the Financial Sense Newshour at www.financialsense.com.  Don't move that mouse.  We'll be right back. 

FSN Humor

FSN international, we're in the news business and in the business news.  We give you the business. 

When the financial elite gathered at Jackson Hole FSN reporter Studs Glitzer asks the hard questions:

Mr. Bernanke, did you always want to be a Fed chairman when you were a little boy? 

When the markets dropped 400 breathtaking points, studs cornered the insight:

Stocks will go up, and stocks will go down. 

When oil smashed through $50s a barrel, it didn't catch studs by surprise:

Sheesh, it's warm outside.

When markets teetered on the ragged edge of recession, studs had an answer:

If people will just shop, things will be good.  Charge, charge, charge. 

And when the peace process broke down, studs asked why. 

Hey, what's wrong with you people?  Can't we just all get along?  [sound of machine gun] Hey, I said get along. 

Whether it's earth shaking news, tough market insights or political breakdowns, FSN reporter Studs Glitzer brings you news you can't refuse.  Stay tuned and don't move that mouse.

Studs:  Jim, I am so excited to be reporting from the floor of the National Scrabble Championships and you'll never guess whose here, the wordmeister himself, retired Fed chairman Alan Greenspan. 

Alan, I didn't know you knew how to play scrabble.

Greenspan:  You invariably learn how to play the game in this town.

Studs:  I hear from the crowds here in the scrabble stadium that you're a pretty good player.

Greenspan:  It was a learning experience, it wasn't that way when I first started.

Studs:  Did you play scrabble when you were a kid?

Greenspan:  Not many people owned automobiles, passenger cars trucks or anything like that, so we played in the streets.

Studs:  You must have a real advantage playing this game with your massive vocabulary.

Greenspan:  Otherwise known as Fed speak.

Studs:  Yeah.  Right.  Fed speak.  I remembered when you used that on Congress.  It was really funny.

Greenspan:  I thought it was hilarious.

Studs:  You know, I don't even think my grandmother would have understood Fed speak.

Greenspan:  You’re underplaying what your Grandmother knew.  She probably understood me perfectly well.

Studs:  Maybe you're right.  She's was a pretty smart cookie.  She used to try to get scripts of your congressional testimony, but for some strange reason they were missing and –

We just threw the script away.

Well, that explains that, so Jim there you have it, an exclusive interview with former Fed chief Alan Greenspan.  Let me read that again.  With former chief Alan Greenspan – straight from the floor of the National Scrabble Championships reporting for FSN, I’m Studs Glitzer. 

JOHN:  And you're listening to the Financial Sense Newshour at www.financialsense.com.  We shall return.

 Part 2

 What Are They Thinking?

JOHN:  Well, here we are just browsing through some headlines today.  Let me see here:  Citigroup's STV debt valued at 65 billion put on rating review; Montana schools pull quarter of billion dollars from fund as SIV cut to default;  Florida schools struggle to pay teachers after investments frozen by the state.  Why would the investments be frozen anyway, Jim.  So what did they do there? 

JIM:  Invested in money market funds that were involved in mortgage-backed securities. 

JOHN:  So the state is trying to pull itself at the expense of its teachers?  Is that what they are doing here?

JIM:  Basically.  One of the problems is there was a fund that a lot of these school districts had their money invested in and that fund has been frozen.  [0:53]

JOHN:  Right.  US consumers spending and income growth missed the forecast.  That's all we need to say about that one, right?

Bristol-Meyers cuts jobs to trim costs.  Paulson is expecting a recession.  There is that word again.  It keeps coming up, the ‘r’ word. 

JIM:  You know, this isn't Hank Paulson.  This is Ron Paulson.  He runs a hedge fund which has gained an average of 440% this year on bets against subprime mortgages and he's making a big bet that the interest rate cuts will fail to prevent a recession.  Something that I wholeheartedly agree with.

JOHN:  Yeah.  Next one:  Housing slump enters third year and deepest correction since World War Two.  That is rather impressive.  I'll say that.  And finally here:  Money supply growing at double digit rates and accelerating.  Now, here we have economics for 500, Jim.  You should in a condition like this a) sell gold, b) buy Google, c) buy financials or the ever popular d) buy financials and home builders.  And answer is –

JIM:  I’m thinking.  D!

JOHN:  Okay.  And why is it D? 

JIM:  I have no idea, but that's exactly what happened on Friday.

JOHN:  Apparently they don't either.  That's why they are doing it.  All right.  You mean despite everything we're seeing in all of these headlines, the markets don't seem to be jiving.  That's what your point is here; right?

JIM:  Yeah. 

JOHN:  Okay. 

JIM:  Of course there was a – we've seen this pull back in gold and then there was a story that came out on Thursday, which is Goldman says one of their top trades for 2008 is to short gold.

JOHN:  And I know this is a hard question, but what are they thinking? 

JIM:  Well, a couple of things.  They are basically suggesting that one of the reasons that gold has gone up this year is mainly due to the dollar.  So basically, they see the dollar begin to stabilize next year, the credit concerns in the financial sector over the coming months are going to moderate; and all of this is going to benefit the US dollar and of course the US economy.  And according to the Goldman guys, bullion has been one of the main beneficiaries of the financial turmoil. So basically what they are doing here is taking a more sanguine view of the economy which doesn't seem to be adding up to the headlines we're looking at right now.  So on that basis, then they also say that basically from a technical perspective gold has topped out.  So basically they see gold retesting 600 by next summer.  [3:31]

JOHN:  So I guess I'm supposed to assume from this; right, that all of the mortgage resets, the unemployment claims which are climbing and the oil issues we are facing here, all of this is going bye-bye or what?

JIM:  Yeah.  I guess they believe in miracles. [3:49]

JOHN:  Well, it's just like in it's a wonderful life where every time a bell rings another angel gets its wings or something.  Every time a stock bell rings, some financials –

JIM:  Financials get their wings!

JOHN:  Yeah.

JIM:  Despite the $65 billion worth SIVs that Citigroup has which was posted on Credit Watch on Friday, Citigroup’s stock was up nearly 8% for the day.  In fact, it’s one of the leaders in the Dow.  Also American Express, another financial up basically – yeah – In fact, American Express, another one of the financials in the Dow index up 17 points; JP Morgan began also up very strongly on Friday.  So, you know, everybody is saying that the Fed is going to come to the rescue, things are going to be okay, nothing to worry about.  [4:39]

JOHN:  I'm glad you told me that one.  I'm going to go skiing so – somehow this makes me feel very uneasy.  It's, like, what's wrong with this picture, so Jim, I'll ask the obvious question.  What's wrong with this picture? 

JIM:  What's wrong with this picture is, okay, we've got a full fledged credit crisis which was created by loose monetary policy that allowed the mortgage market to expand, the real estate market to turn into a bubble.  Now that bubble is deflating as we're seeing real estate prices down 13% year over year; we're seeing an increase in foreclosures; an increase in defaults which is one of the reasons Paulson is trying to put together this deal on capping these interest rates.  And all of this stuff is unfolding and everybody just assumes that, okay, it's going to get better.  How are they going to make things better or avoid a catastrophe?  Well, it's going to be priming the pump again.  They are going to reinflate.  They are going to reinflate massively.  The government is going to interfere with the market mechanism whether it's freezing mortgages, whether it's putting a lot of these mortgage pools into these super funds.  Whatever it is they are going to do, John, you're going to see massive monetary reflation, which is one of the things we had talked about in the first segment, where you have money supply growth in Europe, 11.3%.  We always talk about these double digit rates and what is happening is money, little by little, is dying or losing its value and people are saying sell gold.  I don't think so.  [6:09]

JOHN:  Oh well, that's what happens when you look at new events through old paradigms, I guess. 

Well, you do have to admit though, even though the price of gold has gone up for five or six years now, one we've always been told is a very dangerous investment, but nevertheless, it's still a rollercoaster ride.  Nothing goes straight up, nothing goes straight down. 

JIM:  You know, one of the problems today is there is a lot of liquidity in the market; and because of that liquidity, John, money moves into a sector, it moves out of a sector.  When it moves into the sector, you see what we saw in the middle of August where the HUI index was at 300 and went all of the way up to a high of almost 460; and now we’ve seen this pull back from that 460 level close to little over the 400 level.  So the run that we saw from August, we had a nice almost three month run up in the price of gold and now we've seen a pull back and a lot of people are saying, “okay.  The problems are over.”  But, you know, when the sector does pull back, it pulls back very quick.  Conversely the surge in stocks can happen quickly.  Conversely, on the downside it happens quickly as well.

And the problem is this market is so small and the financial markets are so big.  If you look at, for example, the HUI index, which is roughly about 15 companies, John, it has a market cap value of, let's say, 133 billion.  You compare that to some of the large companies in the S&P – whether you're looking at an Exxon, a Citigroup or looking at a Microsoft or any of the big tech companies, a General Electric – you know, it pales by comparison.  [7:38]

JOHN:  So it would seem that that any small movement, either buying or selling, you know, in or out of it, is going to have a major impact on the price. 

JIM:  Well, absolutely.  I mean if you look at market capitalizations, I mean you can take a look at a company like Newmont, one of the bigger companies within the HUI, or Barrick for that matter.  I mean Newmont has a market cap of roughly, you know, $23 billion, and this is one of the largest companies in the sector.  If you look at Barrick gold for example, it's probably one of the larger companies.  It has a market cap of $35 billion.  Now, you compare that today and take a look at a company, for example, like General Electric which has a market cap of almost $390 billion, I mean General Electric's market cap is worth more than the entire gold and precious metals mining sector.  And you're just talking about one stock in the Dow 30 or one stock in the S&P 500.  So movements in and out of the sector have a major influence in terms of its price.  [8:43]

JOHN:  But if we go back to the first hour when we you were talking with Jeff Christian and there is a lot of fairly sizable organizations sitting on cash out there and they are basically just waiting for a buy opportunity, they want to see if they can get a little cheaper like today or Friday, which is when we're doing this, or Monday, but basically they intend to jump into this.  [9:01]

JIM:  Absolutely.  In fact, one of the questions I asked Jeff, are these people selling.  And his response was no, they are sitting on a lot of cash and they are simply adding to their positions.  So you know, whenever you get these pull backs whether you see it in the bullion prices or you see it in the stocks, I happen to think right now that the stocks reflect a better value in terms of, you know, the price in comparison to the bullion.  What you do is you just add to your position.  So I love it when stuff like this happens because you just sit there and buy.  And what are the odds, John, that the Fed doesn't reinflate and cut interest rates in December at this point?  [9:38]

JOHN:  They are going to have to do that, so you know we're up for another round.  They are forced on to this game action.  There is no choice. 

JIM:  And I would say probably they cut in December.  I think you're going to hear the same talk in January when they meet at end of the month of January because, John, you're going to see a lot of this mortgage problem accelerate in the first half of the year.  And so the Fed is really going to have to start cutting.  And who knows, they maybe talking about the core rate. Or, look for next in the arguments made is if you look at core rate, it's below the Fed's target rate of 2%, so, you know, we don't have inflation and there is really nothing the Fed can do about oil prices and food prices and, you know, everything is just rosy on the inflation front.  [10:27]

JOHN:  This sounds exactly like remember when we talked about corporations meeting expectations.  If they meet expectations or beat them, everybody says wow! And the question really is did you make a profit or did you make a loss?  I mean these expectations even on the part of the Fed, you know, they are simply estimates and they are not really important in the long run of things. 

JIM:  And I would say probably another important issue right now and this deals with education is most people do not know what causes inflation.  Inflation has and always will be a monetary event.  So when you hear talk about the Fed cutting interest rates, or you hear us talk about money supply increasing at double digits, what is that telling you?  It is telling you that monetary reflation is going to accelerate.  And if monetary inflation accelerates, the real question you always have to ask on these things is:  All right, if they are going to be pumping a lot of money into the system, where is that money going to go?  I guarantee you it's not going to go in a mattress, so one has to ask, all right, what is going to be the next object of reflation?  What is going to be the next bubble?  In the late 90s, it was the stock market from 1995 to 2000 as the Greenspan Fed accelerated monetary growth; and this new decade when we went through a recession, the attacks of 9/11, the Fed accelerated monetary growth by slashing interest rates.  The object of that growth was the mortgage market, the real estate market. 

Now you have to say:  If you are getting ready to reflate massively, where is that money going to go?  In other words, what is going to be the next object of that?  And I would venture to say, John, this time around, it's going to be hard assets and commodities because people, you know, may sit there and wink and say, “yeah, I know, the core rate is a bunch of garbage, but every time I go to the grocery store” – they did a piece on the cable channel on Friday talking about vegetable and fruits and just, you know, the increase.  Avocado prices up 25%, mango prices up 15, 20%.  I mean I don't need to tell anybody listening to this program no matter were you live whether you live in Europe, Canada, the US or Asia what's happening to food prices and energy prices.  We've got rising rates of inflation. 

And I think that when people realize that the value of the money that they hold is losing value, then I think that there is going to be a mad scramble.  Eventually, John, the investment public is going to wake up to the fact that wait a minute, gold is over $1000 an ounce, silver is up over $20 an ounce.  I just don't buy this thing that there is no inflation on the street.  [13:20]

JOHN:  So versus what Goldman Sachs is proposing to do, you wouldn't be shorting gold next year? 

JIM:  No.  In fact, if they short gold, I would sit there and pick it up off them.  In fact, one of the things that I think that what I would encourage people to do, especially with what we see unfolding in the first six months.  Depending on who you are, maybe you can only put away 50 bucks a month or maybe $100 a month; maybe you're more fortunate than that and you can put away $500s a month or who knows, $5000s a month.  You know what I recommend that you do is you pick up some bullion here.  If you don't have a lot of money, start with silver.  If you don't have a lot of money, you can buy, like, a one tenth ounce of a gold Eagle, you don't have to buy a full ounce, but start accumulating while you can while it's still cheap.  And if you want to know where we're going, just take a look at a chart, go back to the 2001, look at the HUI, which is the Amex gold index, look at the XAU, which is the Philadelphia silver and gold index.  Take a look at the price of bullion, gold, silver, platinum, oil; just take a look at that over a five-or-six year period, and yes, you're going to see it's been a roller coaster ride on the way up, but it's very clear which direction the chart is heading and it's still heading up.  [14:25]

JOHN:  Financial Sense Newshour at www.financialsense.com.

I'm Andy Looney.  Did you see the Republican presidential debates this week?  I did.  It was boring.  I did hear one candidate say that China cheated on its trade agreements.  Wow! He said they have an unfair advantage over American companies and then he told us to buy American made products for Christmas.  I thought that was a real good idea and so did my wife Sandy.  So off we went to the local mall built by green card challenged illegal immigrant workers.  Boy, were we surprised?  We couldn't find anything made in America.  Sandy wanted toys for the grandkids.  They were all made in China.  The sweater for my friend Charles came from South Korea.  The electronics I wanted came from Japan.  Even the Christmas lights came from ‘abootabidia.’  Someplace I can't even pronounce.  Sandy said ‘abootabidia’ is in Iowa.  I didn't believe it, but we bought the lights anyway.