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Stop the Presses: An Interview with James Grant

Flickr. Former Chairman of the U.S. Federal Reserve Benjamin S. Bernanke, Ph.D.

 

Octavian Report: Did you ever think you would see interest rates this low?

James Grant: No. In fact, I’m on record saying it would never happen. When I started doing what I do now, the U.S. was in the last throes of the great bear market in bonds that began in 1946 and would end in 1981. At that time, long-data treasuries were yielding about nine percent. In came Paul Volcker, to rescue us all from inflation — and he proceeded to do that. As he did what he did, interest rates went up in the face of a great deal of objective evidence. They ought to have gone down, but long-term yields rose as high as 15 percent. One lives in a world of wonder and upset and humility on Wall Street, but the move from, say, five percent to minus something or other is even more startling and astonishing and wondrous than was the move from, say, nine percent to 15 — the highest yields then seen. It’s been quite a ride.

OR: These are multiple-century lows, correct?

Grant: They have records in the Netherlands going back to the 1500s and nothing like this has ever been seen. The Chancellor of the Exchequer was going to refinance perpetual debt related to the South Sea Bubble in the early 18th century.

Walter Bagehot, a wonderful Victorian journalist who served in the 1860s and 70s as the editor of The Economist, once said that John Bull — the proverbial personification of Great Britain — can stand anything, but he can’t stand two percent. Meaning very low interest rates. Why? Because they instigate a lot of unwise speculation and a lot of misallocation of resources: people who find that money costs nothing to borrow do silly things with it. And when Bagehot said that, he meant positive two percent. In Denmark, for example, they now pay you to borrow and you pay them to save.

OR: In subzero bonds, are there any shorts you think are interesting?

Grant: I’m not a bond investor. So I speak now not as a practitioner but someone who’s talked to people in that business. I gather that it’s operationally difficult to put on bond short sales. Certainly there are options, but what makes this difficult, I would guess, is not so much the administrative hassle in getting off the bond short sale but the deepening sense that interest rates only go in one direction. Down.

In that sense it’s very much like the prevailing sentiment in the late 70s and early 80s that interest rates only went in one direction: up. Then they had been going up for 35 years. For the better part of 40 years bonds had been in bad odor. That’s a long time to solidify sentiment. Interest rates have now been going down in the U.S. since 1981. That’s thirty-three-and-a-half years and counting.

OR: I think we would agree negative yields cannot be healthy.

Grant: No, they can’t be. Mario Draghi is fond of using the phrase “uncharted waters.” He uses that phrase in regard to Greece: if Greece were to leave the euro we’d be in uncharted waters. Well, some of these waters are very well-charted. Price controls, for example, are a very well-charted body of water. The history of price controls shows they don’t work. They backfire on the governments that impose them because they misallocate time and capital. They misallocate imagination: people do the wrong things because the price signals are wrong.

Negative interest rates, certainly, are to my mind a species of price control. They occur because people are front-running, getting ahead of the European Central Bank to own the bonds that the Bank has pledged to buy. The ECB is going to buy $65 billion of these things every month until it runs out of patience, time, or conviction. In the meantime, they provide a more or less free ride for speculators. There’s a perverse element of misregulation in this: insurance companies in Europe are penalized for this kind of behavior. If they sell bonds and raise cash, that cash carries a heavier, less-advantageous capital requirement than do sovereign bonds.

Regulators say that sovereign bonds are safe, as if they were intrinsically safe. But the truth about assets is that nothing is intrinsically anything. All things are safe or not, or value-laden or not, depending on price and earnings and perspective. Yet the world has quietly acceded to the idea that bonds are inherently safe. You read this in the Wall Street Journal, language like “super-safe treasuries.” Huh? I can guarantee that in 1981, when they were going to 15 percent, nobody was calling them safe.

OR: Right now, every chart on the money supply reveals us as being completely off any historical norm. Have you ever seen anything like this?

Grant: No. This is unique. “This” being the creation of new currency through digital means by central banks operating under the theory that more currency is stimulative and that lower interest rates raise the value of assets such as real estate and common stocks. The rise in asset values then emboldens and encourages asset holders to spend more. And thus, through the means of so-called quantitative easing or QE, we will all be richer and the economies of the world will somehow, together, build up enough velocity to escape from our slough of despond.

But if creating unprecedented amounts of paper or digital currencies were the answer, then humanity would have chanced upon this already and perfected the technique and we would have all been a lot richer a lot sooner. So I look on this as a kind of quackery. It’s important to imagine how posterity will look back on us. What will our grandchildren and our great-grandchildren regard as our salient misconception and error? I think they’ll ask: can you believe those people entrusted the monetary fortunes of the world to a bunch of former tenured economics faculty? Can you believe our ancestors elevated these people as a class to positions of the highest administration and the highest and least-balanced power?

In the U.S., there’s now really no check on monetary action. If you go back and compare the present day with the 1950s, when McChesney Martin was running the Fed, there were several checks on the central bank’s freedom of action. There was the definition of the dollar as one-thirty-fifth of an ounce of gold. Americans couldn’t own the stuff legally, but foreign central banks and treasuries had the right to exchange green pieces of paper for gold at the statutory rate of $35 an ounce. A second check was a related check: the international payments position of the United States, which held that a chronic balance of payments was something to be avoided because that constrained our economic lives. This meant that interest rates had to be higher. It was something they had to navigate around at the Fed. They were also concerned about any show of inflation. When the inflation rate got to one percent or two percent, they were worried that it was accelerating. Martin and most of the brethren at the Fed thought this was a clear and present danger to the integrity of the dollar.

Contrast this to the present day. I can’t see any constraint. They say that they want inflation, that they won’t settle for less than two percent. Over a long and healthy life, that means the price level rises by five times. There’s no particular constraint on America’s foreign balance of payments. With the dollar being undefined, certainly there’s no call on the collateral supporting the dollar –because there is no collateral. The Fed has almost uniquely a free hand in doing what it’s doing and the other central banks share the same body of economic doctrine. As we speak, we are digesting the news that China has sent up a trial balloon, that it too might do a little bit of quantitative easing.

OR: Do you think this is a currency war?

Grant: I don’t think it’s a war. I think that the central bankers are in alliance against the people: the people are the holders of the money. Nowadays, money is no longer principally a store of value — it is the instrument of public policy. That’s something new and different as well. Money turning out to be, I mean, actually just a bunch of promises denominated in a currency that can be materialized and dematerialized by a keystroke. How could anyone have thought that this was a store of value? It’s not a store of value necessarily. The nature of currency is that it’s non-corporeal, it doesn’t exist to the touch. You can touch the paper but that’s not where the money really is — the money is in the cloud, a digital entry on a server somewhere.

But the problem is not even so much the disembodied thing we call money. The problem is, I think, a problem of ideas. It’s that central bankers now have a mandate — one we have collectively given them and one against which we don’t protest — to manipulate this thing we all agree to call money in the interest of another abstraction we call the gross domestic product.

OR: Do you think that the idea that we can actually measure the economy with precision is something of a fallacy as well?

Grant: Yes. I invite the learned economists who would dispute this to reread a book called The Accuracy of Economic Observations by Oskar Morgenstern. First published in about 1950, subsequently revised. The new edition is even more helpful. This book contends that there’s a great deal of pretense in the collection and a great deal of gullibility, of credulousness, in the reading of these data.

I think it’s important to at least to recognize that the idea of “the economy” did not exist until the 1930s or 40s. I think Paul Samuelson really brought it into the mainstream. There was no “economy” before that. When people referred to “economy,” they were talking about essentially budgetary economy: government, don’t spend so much. The idea of a macro-economy as something to be measured and manipulated is a very new thing under the sun.

OR: You wrote an exceptional book about that period of time — i.e., before the “economy” existed — called The Forgotten Depression. Could you explain what happened in 1920-21 and what was done about it?

Grant: World War I gave rise to a terrific inflation, which lasted through 1919. It destroyed currencies that had been not only as good as gold, but were gold. The German currency among them, and the French franc. Those it didn’t destroy, it severely wounded. This was followed by a violent deflation and the titular depression, which took the form of a twenty-odd percent decline in industrial production. Unemployment rates — not then measured — almost certainly reached the double digits. Stock prices were sawed in half. Commodity prices were down more than 40 percent, faster and more violently than they even were in the 1929 and 1933 depressions.

So what did the authorities do about it? Essentially nothing.

The government balanced the budget with no thought of fiscal stimulus (that concept was not invented). The Federal Reserve actually raised rates. If you listen to the weather reports on the radio, you’re likely to hear something called the real-feel temperature: the temperature adjusted for the force of the wind. The real-feel interest rate, adjusted for falling commodity prices or falling prices generally, was much higher than even the seven percent rate the Fed imposed in 1920. Closer to 15 percent or even 20 percent. A terrifically contractionary set of policies, as we would now describe them.

So how did we get out of it? Because prices moved more or less freely. Prices collapsed but wages also fell enough to restore the profit margins of businesses. If wages had stayed where they were and selling prices had gone down, businesses would have been unprofitable and millions left insolvent. There were a number of bankruptcies anyway. Harry Truman’s haberdashery in Kansas City failed. But because prices and wages were allowed to be flexible through the downside as well as the upside, the economy righted itself. Money came into the country in the shape of gold. Labor was cheap, assets were cheap. Equities, real estate: all beaten down. People seeking their own best interests organized themselves in the form of a prosperity brigade. By the time of the automobile in 1921, there were labor shortages in Detroit.

My publishers called this book The Forgotten Depression. I’m hoping future editions might be less self-effacing and appear under the title: The Previously Forgotten Depression.

OR: So, coming back to today, you’ve said the logical investment is gold.

Grant: A logical investment. Certainly not the only one.

You can’t really sell short the shares of a central bank. Nor do you actually want to be short the Federal Reserve when it is making — and I use the word advisedly — tens of billions of dollars on its riskless purchase of treasury bonds.

But the reciprocal of the success of our monetary policies, the reciprocal of the world’s faith in the people who manage the central banks, the Draghis and the Kurodas and the Yellens, is the price of gold. The higher the price of gold, the less the demonstrated or expressed faith in these institutions. The lower the price of gold, the greater the expressed complacency in these institutions and their management.

I recently read Nouriel Roubini’s critique of the poseurs, hacks, and morons who criticized the mandarins running our monetary affairs. He is right, to a degree, that some of us expected a much greater reaction against QE. More inflation, a much higher price of gold, or a much greater sense that this was the wrong thing to do. Not a verbal sense but visual evidence that the thing had failed. But by the lights of the world, QE has succeeded. So, an investment in gold — “speculation” is the better word, because gold returns no earnings or interest — a speculation on gold is a speculation on the eventual demonstrated failure of these policies.

The reason I’m so bullish on gold is that I am of the staunch conviction that these monetary policies will go down in history as a terrific fraud. Not the fraud of corrupt or evil people, but a fraud perpetrated by people who thought they knew more than they do. These same academics, these same creators of monetary models indecipherable to the layman, were all in power in 2004 (and 2005 and 2006 and 2007 and 2008). They missed the biggest monetary event of their professional lives. They have demonstrated conclusively that they can’t see into the future.

In fact, the more we talk, the more bullish on gold I get. I’m going to place a quick call now to buy some more of this stuff.

OR: Do you prefer gold stocks, or gold itself?

Grant: Yes.

OR: Both. Got it.

Grant: I buy gold bullion as a cash-management asset here at this mighty publishing enterprise we call Grant’s Interest Rate Observer. I buy also for myself: gold mining shares. I’m most keen lately on Barrick Gold (NYSE:ABX), which has, in my mind, all the attributes of a promising investment. People despise it. It has a very checkered recent record and people are projecting that recent record out into the future. It is overly financially leveraged. This leverage is heaped on top of the geological leverage that’s part and parcel of mining operations. The people who manage it have succeeded in alienating all the gold bugs in the world because they went out and bought a copper mine with a lot of borrowed money, outbidding in the process one of the state-owned mining businesses of the People’s Republic of China. So Barrick has done everything wrong. However, as I see the situation, it is about to do everything right. New management, great gold properties in more or less friendly countries. They are going to dispose of some non-core assets. It seems to me as if Barrick is going to do itself proud and make its shareholders a very happy bunch.

OR: You spoke once before about a different ABX, and people were wise to listen. Wasn’t that the short prime ticker?

Grant: What a kind memory you have.

OR: And now you’re giving them another ABX at $12?

Grant: You have to come in more often. But I want to transition from the mortgage problems of the early and mid-Oughts to the present-day global market in sovereign debt. In 2004, 2005, 2006, 2007, and 2008, everyone owned mortgage-backed securities because they were deemed safe, because the regulators wanted you to own them, because the ratings agencies pronounced them to be an investment-grade product. So the world was in for a very wrong price, as it turned out. People who saw this as a great prospective short sale observed that these mortgage-backed securities were priced at 102 cents on the dollar. If everything went well, you might get 103 cents. If everything went the way it should have gone, based upon the trend and housing prices and the like, you would have gotten zero cents on the dollar. The risk-reward was phenomenal.

Fast-forward to the present day. You asked about negative interest rates. Now, owing to (among other things) arbitrary regulatory capital ratings, sovereign debt is the most advantaged asset class. The world’s banks, especially, have to own these because they’re deemed to be intrinsically safe. And remember: there ain’t no intrinsically anything in asset value. It’s all a matter of cash flows and price.

It seems to me there is a haunting parallel between the mortgage problems of the mid-2000s and the sovereign debt opportunity, as they call it, of the present day. People are buying that stuff because a greater fool (or a greater central bank) is going to buy it after them. At the current Grant’s conference, Paul Singer — one of the voices of the big short then — proposed that the bigger short is in sovereign debt now.

OR: Why do you think people hate gold so much? Is it because they’ve lost money? Is it political?

Grant: They haven’t made money. The bull market in gold, I say, is still going strong. It was a $19 stock, as it were, at $1,900, and it’s pulled back to a $12 stock. But the move in gold from 1998 to 2011 was a relentless move up, much better than the stock market. Nobody believed it. Gold is, first of all, an object of scorn for the clerisy of central bankers and academics because it is the legacy money that was in business thousands of years before the birth of John Maynard Keynes. The successor currency, the government-conjured kind, affords employment to the chattering classes. The Fed is the biggest employer of Ph.D. economists in the world, I think. The gold standard worked without economists.

So gold is not just in the crosshairs of the short sellers and of the bears, it’s an object of derision. It’s risible. Let me point out to you that stocks were risible at all the major lows. During the Depression people made the most bitter jokes about Wall Street and about equities. In the grueling and terrible bear market of 1974, people couldn’t bear to utter the word “stock.” Bonds were the same way, scorned and derided as certificates of confiscation at the lows in 1981 and 1984.

OR: So gold feels that way to you now?

Grant: It does. At the investment committee I serve on, you cannot bring it up without people just — they can’t look up, they check their shoeshine, they can’t bear to look you in the eye.

OR: So what will turn sentiment?

Grant: The price going up.

OR: Where else do you see value? Do you still like Russia?

Grant: Yes. I became interested in Russia last year, before it was advisable to become interested in Russia. A more self-exculpating person than me might say it was the perfect storm. What I’ll say is I was wrong. Russia ran into the meat-grinder of Vladimir Putin’s politics and the collapsing oil price. I think it was December 17 when everything went down and looked like it was never going to come up.

Sberbank is the biggest bank in Russia. It’s one of the really fine banks in the world. At its lows, it traded for maybe half of book value and at trailing normalized P/E ratio (if the word “normalized” applies) it traded at six times or so. This yielded four or five percent. It was just being given away. It’s not quite so cheap now, but it’s still very cheap. Russia and the West have been at each other’s throats for three hundred years. This happens to be a period of intense antagonism. I don’t think it’s going to last. Value to me ultimately trumps geopolitics. Phil Fisher, the great apostle of growth-stock investing, told us not to sell on war scares. He might have been a little more explicit on that advice last year. I would have appreciated something from beyond the grave. Such as: don’t buy ahead of a war scare, either. Anyway, I bought, for me, a fair amount of Sberbank in December. I own it and I expect it to go up a lot. A good bank will remain a good bank. Sberbank sailed through 2008 more or less unaided by the Russian government. It will weather this. I attach a low probability, not a zero probability, to its insolvency and permanent loss of capital.

OR: You were early on India, which has had a big run. Are you still bullish on what’s going on there?

Grant: Yes. India is an interesting and inspiring prospective long-term growth story. The British left in 1947. They left, unhappily, their Fabian socialism on the docks when they boarded ships to clear out. So the Indians have been laboring under a very bad set of economic ideas over the past sixty-plus years. But Narendra Modi, who came in as P.M. in 2014, is the great white hope of us India bulls. What he stands for is not pure capitalism by any means; he stands for modernity and efficiency and a level of enterprise that Indians have not seen in a long time. The Indian market is no longer exactly cheap, it’s kind of an average valuation — but I’m a long-term bull on India.

OR: Do you think there’s a better entry point than now?

Grant: Yes. I’ve invested half of what I intend to invest in India. I’m holding back. These markets invariably pull back. I hope Mr. Modi serves for a long time. I hope his administration is unsullied by scandal. I hope there’s no war with Pakistan. I hope there’s no global depression. But something will happen to afford you a better entry point than we have now.

OR: Do you think that we’re seeing inflation or deflation in the current economic landscape? Or both?

Grant: Let me try to define terms. We know what inflation is — too much money, a symptom of which is a generalized rise in prices. Deflation is not exactly a generalized fall in prices. To me it is a crisis of debt, a symptom of which is falling prices. But falling prices might also be a consequence of the improvement of technologies, such that it costs less to make things and therefore costs less to buy things. They call that deflation, too. But why not call that progress?

We are embroiled today in what central bankers insist on calling a near-deflation. But if prices are going up one-and-a-half percent a year, is that not inflation? It seems to me it is. There are reasons to worry about a generalized debt problem because we have so much of it, and thanks to the central banks so much of it is mispriced. In Europe, if you buy a junk bond, the yield is likely to begin with the number three. That would not seem to be a great rate of compensation for the risks inherent in a very heavily encumbered business.

So interest rates are low. There’s a great deal of debt. There is a risk of a genuine deflation, meaning a fall in prices brought about through the forced liquidation of positions, of debts. And I think that there’s so much talk about deflation because I think that there’s a great deal of unexpressed anxiety about the debt problems of the world. If you look at the United States government’s P&L, if you assign a more or less normalized rate of interest to net federal borrowings, you’d find a bigger interest bill than what we currently pay for the Defense Department. The central banks are certainly mindful of how disastrous a rise in the cost of borrowing for the Treasury would be. As Bill Gross, the king of bonds, noted at a recent Grant’s event, the Fed remits almost all the interest it receives from the Treasury back to the Treasury. Isn’t that, he asked, a kind of default already?

I don’t know about the rest of the audience, but I thought: if this idea is working in the mind of one of the public faces of the bond market, it’s likely to be active in the minds of politicians and financial bureaucrats as well.

OR: The world’s central bankers talk about pulling all the money they’ve created out of the system. What do you think the odds are that they time and execute it properly?

Grant: About 25 years ago, I would have assigned those odds at less than zero. Having blown out some birthday candles since then and having seen some surprising things, I will give it a probability of greater than zero: one-half of one percent.

The central bankers could suddenly be both smart and lucky. But what’s so precarious, so worrying, about our present-day finances that the prospect, mind you, the mere prospect of a rise of one-half of one percent in one little interest rate has Wall Street shaking in its wing-tipped shoes? Are we so leveraged? Are the values so precarious? It’s really kind of a puzzle. Nobody asks the question. I was talking to a young person recently about bitcoin. He wanted to know what, exactly, it was. I think anything you need an instruction manual for isn’t money. Money is like love: it has to be self-explanatory. I think this proposition also works on the scale for the bullish-on-gold case. What is the polar opposite of today’s money, money which is conjured in the pursuit of macro-economic ends by intellectuals laboring over their dynamic, stochastic, general equilibrium model? What’s the opposite of that? The opposite of that is the atavism called gold. It comes out of the ground, you can touch it, you don’t need an instruction manual. It’s obviously valuable. It glints in the sunlight. It doesn’t rust.

OR: You wrote a book on Bernard Baruch, a titan of American finance. Would he be massively long gold right now?

Grant: He was massively long gold in the 1930s. Yes, he lost a fair amount of money in the great crash and the subsequent liquidation. But his losses were contained: he was disciplined and savvy. A survivalist kind of a speculator. He wasn’t going to get run over because he had convictions about this or that political thing. He just got out. One of the things he did not get out of was something called Alaska Juneau Gold, his big mining stock. He owned a lot of bullion, too, in the shape of plate. There is a conversation recorded in the U.S. Treasury archives between FDR’s Secretary of the Treasury, Henry Morgenthau, and Baruch, in the early or mid-1930’s. Morgenthau had no use for Baruch and was quizzing him about why he had held this gold. I think by then Baruch had turned it in, as one had to do in 1933 or 34. Baruch said the following. (I’ll never forget this quote.) He says, quote, I was commencing to have doubts about the currency. Close quote.

Consider how obvious — to me, at least; perhaps to you — it is to have doubts. And in fact I don’t have doubts. I know that these currencies are going to be, if not worthless, then hugely impaired in value. Meaning there will be inflation, meaning there will be an administrative action to negate bonds out. And it won’t be the continuous production of trillions of dollars. So people ought to commence to have doubts about the nature of their currency and about the manipulation of interest rates and about the overall conduct of monetary policy in the 21st century.

Do they have those doubts? No. Ben S. Bernanke, comma, Ph.D., was awarded the Chicago Mercantile Exchange’s Financial Innovation Award last fall.  The Merc, the CME Group, is in the business of administering free markets the world over. It confers its innovation award on this central banker — this thimble-rigger, as they used to call it in Baruch’s day. The guy who came in and made sure the markets wouldn’t clear. In the interest of the survival of the capitalist system. So, yes, I’m commencing to have doubts on the currency.

OR: Thank you. This is fantastic.

Grant: You’re welcome.