Back to Square One: Why the Financial System Needs to Reset
If you don’t know about finance and you want to learn, where do you start? Start with the money, says Paul Brodsky of Macro Allocation Inc.
Paul started his career in finance in 1982 and worked as a bond trader, options trader, fund manager, before founding the research and consulting firm Macro Allocation. He said he had to unlearn many of the principles first taught to him and focus on what’s really driving stocks, bonds, and the economy.
As a result, he returned his investors’ money in a mortgage-backed securities fund right before the housing crash in 2007 because he saw it coming. Many of the investment legends like Marc Faber and Bill Gross follow him because of his unique understanding of money, credit, and central banks.
Epoch Times: You have been pioneering the concept that the current debt load can never be repaid. Not because there isn’t enough GDP growth, but because there isn’t enough real money.
Paul Brodsky: The big number is something like $200 trillion in debt obligations worldwide. And then you drill down and you look at the amount of base money out there amongst all the currencies and it’s tiny in comparison.
Debt Versus Real Money
Epoch Times: Base money is what the central banks issue either in coins or bills or what the commercial banks have in reserves at the central bank. Basically the liability side of the central bank’s balance sheet. You say you need base money to repay debt.
Mr. Brodsky: True money is base money. When we’re on a gold standard or a gold exchange standard, gold was basically base money. So that’s true money. Everything else effectively is credit, including the great majority of dollars.
Epoch Times: Like your checking and savings accounts.
Mr. Brodsky: That’s right. And so when you start to tear apart the infrastructure of money and you see that money itself is a liability and an asset, depending on where it’s held in which portfolios or entities, you come to the conclusion when we got too far over our skis in terms of the amount of leverage out there, the amount of credit out there and debt, versus the amount of base money. That defines leverage, you come to the conclusion that it’s irreconcilable.
The banking system—and this is something that a lot of people don’t realize—I think is a closed system. Yes, it interacts with the public. It makes loans to the public. It’s commonly perceived that the growth of bank balance sheets goes hand in hand with demand growth and output. I think that the connection is not that tight and we’re starting to see that.
Epoch Times: How can you compare that?
Mr. Brodsky: Assets—stocks and real estate equity—you see them rising over the last 20 years fairly consistently. Real estate takes a dip and then comes back up. What you see in labor participation rates and the velocity of money, which is the measure of how often a dollar changes hands in the course of the year, they drop.
It shows how wealth and income gaps are diverging or why: Because all of the Federal Reserve’s (Fed) largesse is going into the banking system. The banking system is lending it to asset buyers. And it’s not being used in the formation of capital that drives the productive economy.
Epoch Times: So we are talking about stock buybacks financed by bond issuance instead of building a new factory?
Mr. Brodsky: It’s pretty stark when you take a look at [debt issuance] compared to the U.S. economy. It’s actually shrinking in terms of activity now. GDP can rise at 2 percent, but GDP is comprised of government investment. It’s also comprised of price. It’s not comprised of volume or activity exclusively.
So we see nominal GDP rising and even real GDP rising. But it seems to me that there’s been a divergence over the last 20 years between the financial economy and the producing economy. This is something I think is being manifest currently not only in our economies and markets but also it’s starting politically, and that’s what we’re seeing in the system. That’s something that’s clear to me but may not be clear to other political economists.
Epoch Times: So let’s talk about the debt and leverage. We have $63.5 trillion in debt securities and loans outstanding in the United States as of December 2015. The Fed’s balance sheet is $4.5 trillion as of July 21. According to your definition, that is a multiplier of 14 to 1.
Mr. Brodsky: Over the last 40 years, debt has not been extinguished. And now, we’re looking at record debt to GDP ratios during non-war times. But more importantly, debt to base money ratios which is the ultimate measure of leverage, that is a 45-year phenomenon. That’s not something that we’ve seen previously when we had fixed exchange rates because as a currency you couldn’t get away with that.
We saw in the 1980s securitization. Innovation in technology created a world where debt buyers or creditors became plentiful and didn’t have to be banks. So securitization created a world of shadow banking which—if I’m to be too reductionist—is just bond buyers. And they also have incentive by mandate or by rational investment protocols to continually expand their balance sheet.
So you had this enormous demand for credit, to provide credit, and to assume debt. And no one wants to reduce the size of their balance sheet because if you’re a fund and you’re buying bonds, you collect your fees based on your assets. And if you’re a bank and you have to report quarterly earnings, all your shareholders want them to be higher. And if you’re a central bank and you’re overseeing a banking system, you want them to remain liquid and solvent.
So no one has the incentive to stand up and say, “Okay. Let’s everyone reduce the sizes of our balance sheet so that we can have a more sustainable economy.” It doesn’t work that way because the incentive structure is all wrong.
Epoch Times: But naturally speaking at one point, at least in history, these things have always reversed somehow. And you mentioned in the beginning that you can also de-lever by using inflation.
Mr. Brodsky: I think that’s what it’s going to take and I certainly think we’re getting closer. Zero interest rates and negative interest rates and Europe and Asia are a huge signal that we are almost at the point where central banks have lost their tools to perpetuate a sense of confidence, that things are cyclical.
That this is just a typical cycle business or debt cycle or what have you. Clearly, it’s not. We haven’t seen that before. And for all the naysayers who say “oh, this time, it’s different,” well, yes, this time, is different because zero interest rates and negative rates are very, very different from anything we’ve seen in the past.
And I would argue central banks lost the ability to control the credit cycle. Some relatively minor event could trigger a series of events that creates the need for a sit-down among global monetary policy makers who finally have to acknowledge publicly that their policies are no longer able to control the system, the global economy, which is based on ever increasing demand through ever increasing credit.
And what might occur is a natural drop in output. So you’ll see GDP growth begin to fall. Real GDP growth across the world maybe even going into contraction and that would spell doom for these balance sheets. And this is not something I’m predicting or trying to time at all, but the natural outcome of that would be a sit-down like a Bretton Woods where arrangements are reconsidered.
Fixing the Problem
Epoch Times: Couldn’t they just say “let’s wipe out 50 percent of all the credit and here is how we do it?”
Mr. Brodsky: I think the more politically expedient way is to let the market finally try to correct itself and then come in and save the day. I think the real structural issue I see in jeopardy today is this potential for sudden debt deflation.
Say if I get together at a sit-down and say, “Well, we can’t just pre-empt this thing because a lot of people don’t see it.” I think they would take a more laissez-faire attitude first. Let prices start to settle. It will become uncomfortable. Protect the strongest banks, solid banks, but you start to see markets decline as a catalyst for change.
Let’s face it, every monetary system including a pure gold standard has to be politically endorsed and sponsored. At the end of the day all governments are going to tax consumption and income or some measure of each.
And they’re going to want to have some control over consumption practices within our economies and nations. And so even if you were on a strict gold standard, government would want to keep track of production and consumption. So, what can we expect?
It’s going to have to be a politically managed arrangement amongst the world’s most influential economies. And to get everyone on the same page, I would think you need some publicly recognized event that catalyzes and crystallizes public sentiment so that they would look to government as the central feature in a society to help fix the problem. Without some event, nothing would change.
Epoch Times: What kind of event are you looking for?
Mr. Brodsky: My sense is that it’s going to be a market event. And if Deutsche Bank is the weak link in the global banking system then it couldn’t only be Deutsche. It would have to be Deutsche Bank and maybe its obligations to JP Morgan or Citigroup that would invoke interest in the United States. And it couldn’t only be that but it would have to also extend to Japan and to China.
Something that coalesces public opinion and public fear to then crystallize the government to go on and try to save the system on a global basis. Because we’re in this relative value world now, whether there is no definite value for anything. So it would have to include the United States. And it would have to include the U.S. domestic economy being hurt by whatever is happening abroad.
Creating Inflation With Gold
Epoch Times: So how do we get the inflation that central banks want?
Mr. Brodsky: There’s an easy way to do it. If you want to create a lot of inflation you can do it in the form of adding a couple of zeros to income just with a stroke of a pen. Obviously, that would destroy the purchasing power of the currency for savers before this happens.
One of the methods the Fed could take, would be—if all the conditions are right and it’s negotiated beforehand among other central banks and the Bank for International Settlements (BIS) and other bodies—is to name a higher price for gold in dollar terms and announce that you would tender all gold at $X price per ounce.
And then you would buy all gold up to that price. Just the announcement would not be inflationary, but the process of printing the dollars to buy the gold would be inflationary. In other words, it is quantitative easing but instead of buying debt you’d be buying gold.
Epoch Times: This would benefit gold holders disproportionately.
Mr. Brodsky: There’s no question. And so if you’re going to be cynical about this you would say they’re not going to do that until the right people own gold. You would want China to own enough gold so they wouldn’t become hostile. You would want all central banks that are going to be included in this to own the gold. And obviously individuals or other portfolios that own gold would benefit greatly.
If you take a step back and you say, “Would that be fair?” I don’t think it’s a question of fairness. I don’t think it will be an equitable arrangement no matter how it plays out. Gold bugs are so few and far between and the amount of gold holdings out there are so small at the current price relative to financial assets globally that it would almost be parasitical to the entire process. There would be a few articles written about guys that happened to own a bit of gold.
But if there was a regime change, I think that the people that may be reading this who own some gold, I don’t think they’d be in jeopardy of having that taken away because they’d be an afterthought.
Epoch Times: How high could the gold price go?
Mr. Brodsky: If you were to apply the Bretton Woods model for valuing money today, the number would be up to $15,000 an ounce. Now does that mean there will be a 100 percent backing? Would they have to do that? Maybe it’s closer to 20 percent [$3000 per ounce].
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