Below is the transcript to Mapping The Fugly Future with David Collum:
Chris Martenson: Hello and welcome to another PeakProsperity.com podcast – I am, of course, your host Chris Martenson. And today, we are going to be speaking with the author of a piece of work, which appeared on the web and also appeared in our forum areas and it is called 2010, Year in Review – Fugly Gives Way to Muddling. And this piece really caught me when I read it. I didn’t intend to read the whole thing, because it is fairly long and I did. I read through the entire piece. The author of that is David Collum and it's just a really interesting, brilliant piece of work. So we have Dave today and the idea here is to have a discussion around that paper and around other things he sees going on. So first Dave, welcome.
David Collum: Hi Chris.
Chris Martenson: How about a little background about who you are and how it is that you came to write such a paper like that?
David Collum: Well, I am currently an organic chemist at Cornell and I have a number of duties here, including primarily research and teaching. I am also the associate chair and I edit a scientific journal and things like that, so this is a pretty standard job. I got interested in economics actually as a kid. My father was a contractor and he knew economics at the ground level. He really knew how the system worked. We used to talk about it at the dinner table and I remember some amazing conversations we had about inflation and distressed assets and surviving highs and lows in the business cycle. So it always followed me and for some reason, I did not go to Wall Street, even though I thought about it. Maybe it was the 70’s as it was a pretty awful time when I was making fateful decisions.
So in any event, I don’t know something rekindled my interest in the 90’s, maybe it was the bubble, but I started reading about economics and politics and where the two meet. By the end of the 90’s, I started getting very nervous about what I was seeing. A little confession – this started with a concern about Y2K. It wasn’t that I knew anything about computers, but I started paying attention to the question, “What if?”. These are simple questions, what if these guys are right and I dug around and tried to find everything I could. My conclusion was that there were instabilities in the system and not from computer bugs, but actually the system in a much more broader sense. And I think many people who did that – that adventure – came to exactly the same conclusion: something was wrong and something was headed this way.
So in any case, I sort of went to the dark side and emptied my mutual fund voraciously and the computer bug was nothing, but the instabilities remained, so I started paying very close attention to these things as a hobby. So, I pretty much just do chemistry and this stuff. So I started communicating through the miracles of the internet with some incredibly smart people and some were remarkably accessible. I could get hedge fund manager. During my Y2K phase I actually got to the head of the Electrical Engineering Society’s Y2K Committee and spent hours talking to him, trying to figure out what he saw and he is very high up. So these were important. I started talking with all sorts of people and I discovered this connected world. So I discovered Austrian economics in the late-90’s and the principles behind it and the Austrian business cycle theory and things like that.
So after 2000 came and went, I bought a lot of gold. I was nervous about inflation and I held on to it and I don’t quite remember what gave me the stamina to stay in there, because it was pretty awful watching the NASDAQ go up 100% while your gold went down, but over time it paid. I started writing these little Year Reviews because at the end of every year I survey how I have done, because I am definitely off-beat in my views and I want to make sure that it doesn’t hurt. So every year I summarize how my accumulated wealth is doing and what my return on investment was. I started writing these little essays to share with people. I was chatting with on a couple of chat boards online and then they got a little more elaborate. And last year’s, when I put it out there, I thought it was going to an obscure site. I found out it wasn’t so obscure and my email box filled up. I got emails from some amazing characters. Guys who are famous and are hedge fund managers in what I would call the top five. They read the whole thing.
So I wrote another this year and it went out and actually got distributed to all the Bloomberg journalists, as best I can tell according to one of my friends in Bloomberg, Mark Gilbert, who I have had a long contact with, probably over a decade. He runs the London Office of Bloomberg. Again, the email box filled up and I had a lot of exchanges.
So that is the story and I find this fascinating. It's gigantic picture stuff and it's kind of curious. You and I have never actually met, right? But we made contact. I read something you said that really caught me and I sent you an email and through the years we have occasionally chatted a little. I found out we had a Cornell overlap and so you are a great example of just one of these bright people who caught my attention, and especially your Crash Course.
Chris Martenson: Well you know the similar part about us is that we both saw something that caused us some concern. Y2K was sort of a proximate cause for you to start digging into things. I had my own and really it doesn’t matter what the cause was, I started looking into the economy and had to put some framing around this. I am a scientist by training, so that defines a lot of how I approach life. I had discovered that there was just something about how the economy was put together that somehow I had not been taught, right? So I went through an MBA program and I had all these years in business. But once you really start looking at certain things, like the mismatch between liabilities and the assets of the United States in general, it's pretty easy to come to a conclusion that there is something unsustainable in that picture, right? But that is just one element and I kept scratching and scratching and of course, ultimately it led to this body of work that became the Crash Course, which involves energy as well and other resources.
So – but here’s the thing I wanted to talk to you about – what it is like to be on the outside and holding true to what you think is right? Here’s an example of that – I think it was 2007: I was actually short a bunch of homebuilders and mortgage insurers, because I had done a whole bunch of analysis and said, “Ah, this thing is done.” And I found myself in the uncomfortable position of being short a mortgage insurer on the very same day that Merrill Lynch bought them at a premium and so there was me, little ol’ me sitting down and analyzing things and there’s Merrill Lynch analyzing things. I presume that they have great teams of very smart people. I know they do and they have access to better information.
David Collum: This must have been Countrywide.
Chris Martenson: Well, yeah there was that. [Laughter]
But Countrywide is just a mortgage issuer, I was short an insurer.
David Collum: Oh, maybe Ambac?
Chris Martenson: Yeah, MBIA.
David Collum: MBIA, okay, got it.
Chris Martenson: Right and so – but I was short all kinds of things, Pulte Homes, you name it and not to pick on them, I was actually short almost all of the homebuilders at one point or another. It worked out very well for me. But at the time, I remember this uncomfortable position of saying, what did they see that I don’t see? How can we see this so completely differently? It's behind us now and it turns out that perhaps my view was more correct than theirs at that point. But here I am today and I am looking at this whole situation. I am looking at the amount of debt that the United States has. I am looking at the amount of debt that frankly, the whole world has, which I believe in review you called that “debt without borders.” There is just debt everywhere and the strategy seems to be for the Fed to say with the other central banks, what we are going to do here is we are going to dial up the debt, because this is our way out. And I am looking at that and I am having that same uncomfortable feeling of saying, “You know I am positioned against that working. Why is it that I see it so differently or more importantly, what do they see that I don’t see?” There is such a fundamental misalignment between my view and their view. I was wondering if we could talk about that.
David Collum: Yeah, I had a funny exchange actually. So in my contact, I used to read the stuff that Larry Kotlikoff did and Larry was one of the early guys to really dig into this question of unfunded liability. So I think at the time, we were said to have seven trillion dollars in debt and you go that’s a lot of money, but – and what Larry did is he did the math and said, look if you add up all the promises we’ve made and promises eventually have to be paid for, it came to forty-five trillion dollars. And so, one day I sent him an email and it turns out that I had spent the previous Sunday with his brother – a remarkably small world. But Larry was painting this apocalyptic picture and so one day I am talking to his brother. And I said, “By the way, Secretary of the Treasury O’Neill just mentioned these liabilities and your brother should be exonerated because they were remarkably similar numbers.” And his brother said, “Actually those were his numbers. He was commissioned by O’Neill to do that study.” So now, what are those numbers?
Well it turns out that the next thing you know David Walker appears on the scene, the head of the GAO, and he starts quoting numbers of a hundred trillion. So again, I asked Larry, “Do these square with your numbers now?” And he said, “Yeah, that is about right.” And now you are starting to hear numbers of a hundred and fifty trillion. Well you take the taxpayer base and you divide that by the number of legitimate taxpayers and it's a million dollars a piece. And I don’t know about you, but that would take a bite out of my budget, right? That is a serious number.
Chris Martenson: And those were present dollar values, so it's not like this is a million that you have to earn over your whole life, that’s million you have to cough up today into an interest-bearing account that would match the payout structure of that particular obligation.
David Collum: Yeah, no inflation adjustment, no nothing – yeah it's really a remarkable number. So Larry goes to the Federal Reserve and he writes a paper and he says he thinks the US is insolvent. This has happened now twenty times in the 20th Century or something, some number like that – I would really have to dig back deep. And he says, well here’s what happens. It was this very matter of fact, almost sterile presentation. And a lot of people misunderstood it, because they thought it was the voice of the Federal Reserve, when in fact it was Larry Kotlikoff on Federal Reserve letterhead, right?
But then subsequent to that, the Rogoff-Reinhart book comes out, which really matches up beautifully and they go through five hundred years of what happens when countries become insolvent and how does it play out and again, very sterile, very matter of fact, and their conclusion is really one you want to pay attention to. If I could whittle that down to one message it is that when we default on other countries, it will be deflationary. We will basically do what we call the “eat-and-dash” model, where we will basically say forget it, we are not paying.
Chris Martenson: Uhm, hmm.
David Collum: When they default on obligations at home, because of the politics, it will be inflationary. We will pay them, but we will pay them in Monopoly money and so you position yourself accordingly.
Chris Martenson: Well, it's amazing to me though, when I see – to me this seems completely clear that when you say a number like a hundred trillion, some people say listen, it's not really that bad because what’s going to happen of course, is the United States will just – well they won’t pay it. What they are going to do is they are going to raise the retirement age, so we will boost the taxes on it a little bit, we will pay a little less money out, but really I just look at it as a see-saw, right? On one side is the recipient of that money or the taxpayer and on the other side is the government. Everything the government saves ultimately is a cost that ends up being transferred over to the taxpayer. There is no gain in that story. The idea is that what has been promised is vastly out of alignment with what can be delivered. And as you mentioned, Rogoff and Reinhart made it clear – there are only two ways to do this; one is you default on the obligations outright, so raising retirement age and giving less benefits that’s a form of default in essence.
David Collum: Right.
Chris Martenson: Or you print your way out of it, which is inflationary. Those are the two ways that we go about this. In the world of politics, however, the inflationary path is almost always the preferred option, not that circumstances won’t force you elsewhere. But it is preferred because guess what, taxpayers are voters and they really hate knowing that you’ve directly voted them less funding. Inflation – much harder to detect. As Keynes said, not one man in a million can diagnose it. It's trickier, so that is a path that we tend to take. But either way, the bottom line to this is that if something is completely unsustainable, well it has to stop at some point, right?
David Collum: You bet, Stein’s Law.
Chris Martenson: Stein’s Law.
David Collum: The other appalling thing here is as we both dug into this, right? As you sort of left your world in finance that was sort of a comfortable place for you and you started to realize that it was a bit of a bubble you were living in and you sort of stepped outside and saw this very different world. And I discovered the world of finance from scratch – what you discover is that there is just an enormous amount of lying going on. It is so unimaginable the proportions of the lies. One that I was thinking of when you were chatting, were things like the social security lockbox.
Chris Martenson: My favorite.
David Collum: Not only is there not a lockbox, but there is only one mechanism to have with such a lockbox. There is only one that I can think of and no one has ever come up with another. And the only mechanism to have a lockbox is to put in that box, obligations from other sovereign states.
Chris Martenson: Uhm, hmm.
David Collum: Because you can no more claim that you are rich because your wife owes you money. You cannot claim you are rich because people within a town owe each other money. You cannot claim you are rich because you owe yourselves money in a nation state. You are rich when China owes you money or Europe owes you money, then you have accrued credits. So there is no such thing as a Social Security lockbox. QE is not even debatable.
Chris Martenson: Well it's something that I have written about extensively and I chuckle because it's just so patently obvious. If it is not possible for me to owe myself money – in fact, if you are a corporation – in fact Enron tried this.
David Collum: [Laughs] Yeah they did, didn’t they?
Chris Martenson: They went and they had their subsidiaries and they said, “Look, we made this loan to the subsidiary and that’s now an asset on our books, so we are going to record the asset on our balance sheet and then we are going to reverse it after the quarter is over, so that it actually makes sense, but we are going to report all these incredible assets. And look, we are going to use these incredible assets to get these loans out and lever ourselves up.” Dadada . . . this is exactly the same model, but when Enron tried it they went broke and got put in jail. And when the Federal Government does it, it's mysterious why there are just these chirping crickets out there.
David Collum: Crickets, [Laughter] – crickets, yeah.
Chris Martenson: Crickets.
David Collum: You know the funny thing about Enron by the way, you know the guys at Enron themselves were not smart enough to do this. These off-balance sheet accounts were set up by the banking system. There is no way that Andy Fastow set up those accounts.
Chris Martenson: Right.
David Collum: He is just some schmuck and so then the question is why, why at no point did the banking system end up on trial in the Enron case? That’s a fascinating question.
Chris Martenson: Well, they seemed to have dodged that bullet time and time again.
David Collum: That’s right. I hate to go conspiracy, but these guys own the world, right? I mean these guys have the power to create money and they have all the money and you will not see bankers get brought into the light of day, unless it somehow happens by mistake.
Chris Martenson: Well, I have been shocked even when they do get brought into the light of day what happens. So here was one thing that caught me in. I watched it and I watched it just disappear. I am just picking on one thing here and I don’t mean to just draw this one company out, but Goldman Sachs was caught in the full light of day, having helped Greece fraudulently, cook it's books to present a very different sort of a budget deficit scenario situation to the whole world, which was used to secure loans across – from investors and the whole system. They were flat out caught doing that. It was – I looked at it and said, wow this exactly fraudulent behavior. And what happened with that, do you remember?
David Collum: Nothing [Laughter] that is easy to remember, actually. Interestingly, you could actually argue and I don’t know if this is true and it might be a hyperbole, but you argue that Goldman Sachs therefore helped destroy the EOB – we don’t want the EOB destroyed, but bringing Greece in, in that way, certainly put a ticking time bomb in that system and they didn’t care. Goldman did another one that was kind of easier to grasp. They actually got caught on an illegal bond trading scheme that netted them three hundred and fifty million dollars, right? This is just peanuts. But the fine for doing this was nine million. So do the math. It's a 3% surcharge.
Chris Martenson: Yeah.
David Collum: And so this is somehow, I think, this somehow will be corrected. I actually have faith. It may take an unbelievable number of years, but somehow this will sort of rot it's way through the system. It will purge, I don’t know how.
Chris Martenson: Well you know, I have a – I really like one statement of Buffet’s which is that when the tide goes out, that’s when you find out who is wearing swimming trunks and who isn’t. So during a rising economy – when things were really rising, I think there are all kinds of things that got swept under the rug. So here is one of my favorite pieces to look at and you know when Charlie Brown tries to kick the football and Lucy pulls it away – how many times, an infinite number of times. Orange County, California gets completely taken to the cleaners to the tune of billions of dollars by a really, really bad shyster, derivative steal way back – when was that 90s?
David Collum: Yeah. It was a hint that the derivative world was a dangerous world.
Chris Martenson: Right.
David Collum: The first real big shot across the bow.
Chris Martenson: So any municipal manager – some sort of super outgunned individual who is responsible for managing – listen all you are trying to do is tax revenues come in and then you distribute them and you are trying to balance all that out. Anybody worth their weight would have looked at the Orange County thing and said, WOW! I do not want to get involved with these guys. But now you fast forward and look at what happened in Alabama, right?
Yeah, they had this bond deal, which was around paying for a sewage treatment facility. It was way more than they could afford, it doesn’t matter. Here comes the bank – Bank of America is actually caught bribing people – no who was it, Bank of America actually gave money to somebody else to go away – one of their competitors and there were actual bribes and guess what? A couple of the people who were involved in that at the municipal level are in deep trouble and facing jail time. How many bankers are in that same boat?
David Collum: It never – it just – once in a while you will see some guy get hurled under the bus. This is like watching some spy show and ever once in a while they have to off one of the lead characters to keep the show spicy, I don’t know.
Chris Martenson: [Laughs]
David Collum: When Elliott Spitzer arrived on the scene, he was cheered and he still seems to be relatively cheered. But if you actually look at his settlement – they were appallingly benign to the system and a sinister plot line would be if you look in the history of the 30s, when the Pecora commission got put into place and they threw a lot of guys in jail. The banking system, I could have arguably said, okay we’ve had another collapse here with 2000 and now with 2008, we have a mess and we have to put on a dog and pony show. And so here you have this New York District Attorney, whose has political aspirations and the claim is that he is attacking Wall Street. Now, my smell check on that, says that’s not true. No New York City-based politically active guy is going to go against Wall Street. So then you say Well, what is he doing?” and so then what he is running around doing is making a big deal out of surcharges. The 1.4 billion dollar settlement of all the brokerages, the big one, the one that really got the headline on, was 3% of a single year’s profit for those houses. And so I think Spitzer basically front-ran the thing. I know it's sinister and maybe he didn’t know it, right? Maybe he thought he was Mr. Bigshot and the banks are going – we can take this pain all day long, just keep it coming.
Chris Martenson: I think we could carry on this conversation all day long, because it's how the world kind of works. The view I take of it – there is this parable which goes like this – a scorpion comes up to the end of a big river and sees a frog there and says, “Will you carry me across?” And the frog says, “No, no way. You are going to sting me.” Right? And the scorpion says, “Well, I won’t do that because if I sting you, then we both die.” And the frog says, “That makes sense.” He agrees and starts carrying the scorpion across and halfway across, the frog feels this enormous stinging pain in its back and he has been stung. And as they start to slip under the water, the frog says, “Why did you do that?” And the scorpion says, “Because I am a scorpion, it's what I do.”
David Collum: [Laughs] We have to stop reading this damn stuff. All these parables. And that’s what they do.
Chris Martenson: That’s my shorthand, because when you see them do it in Orange County and then they do it in Pritchard and it happens again and again and again or it's Lucy pulling the football away. It's just something I have come to expect now, which was part of my sort of maturation, as before I used to get outraged because I would say, how can they possibly be doing this? And now I have come to just acceptance, which just says that’s because that’s how the system rewards them.
David Collum: Well, if you read a lot of history, you realize that what it really is, is just history repeating itself. It's not like in ancient Rome – the senators of ancient Rome weren’t basically taking the system to the cleaners on a good day. And it's not like various kings and queens and the nobles – one of the reasons the Catholic Church was so powerful, was so important, and I am not a particularly religious guy, but through the middle ages the primary role of the Catholic Church at least at the time, was to keep the nobles in check. So they came up with all these reasons why the nobles would go to hell if they didn’t behave themselves, because they would have their little battles and burn peasant houses down and so this has been happening since the dawn of time. So somehow, I think we thought we had reached a point where the people in the highest levels of power were playing fair and that’s the silly delusion of a peasant.
[Laughter]
Chris Martenson: I had that same delusion for awhile and it was part of my waking up process and you know what – we’ve just come off of what I think we have to recognize as a really wonderful unique period of history. When there were ample resources to go around so that there were no big squabbles over them. We had abundant energy and there was plenty of food. All the usual stuff. And so one of the big pieces of my framework is thinking that there are enough warning signs that there is an inflection point coming, that there won’t be quite enough – there certainly won’t be as much as we used to have. Whether we look at that purely through just the economic “E” and we say just on debt basis alone and viability to asset mismatchs as we can make a story that says, oh there is going to be a period of having to get by on less. Or if we decide to start putting in the resources story and particularly with energy at the top of that, then we can say oh that’s another headwind to this story.
Okay we put those two together and we go, wow this could be a period of less. And what I think we are lacking at this point is that the muscle memory might have gone away or just become flabby for sure – how to fairly go through this next period of time. And the early returns are not promising is the way I look at it because I come from a long line of bankers – my family still is involved in banking in upstate New York in Canandaigua. So I understand what small regional banking looks like. It's very safe, very solid. One of their complaints at this bank is that they are now being forced to compete with the big banks, who by the way have a cost of capital that is a fraction of their own because they don’t actually have to raise the money, it is handed to them by the Fed. They are too big to fail, which means that in many cases these small well-run regional banks are too small to succeed and that just sets up a really uncomfortable dynamic that I think is corrosive and is something that I actually would put a judgment on and I think it's wrong. And it doesn’t feel right and so to me, that’s part of the whole moment that we are living in right now. This is why this all feels so uncomfortable, because there are some things happening, which appear in both – no matter how far down you want to scratch at it, if you think about it from a cultural angle, a sociological angle, a political angle, or an economic angle – it just doesn’t feel right. What are your thoughts on that?
Chris Martenson: I think if you ask economists or money guys from the past, you only have to go back to Paul Volcker probably and you say, okay – hypothetically, let’s assume we give the dominant banks in the global banking system unlimited capital at zero cost. And it is zero, right? It is not low cost, it's zero and that they can take as much as they want – what would happen? I think anyone from looking at this from a historical perspective or someone from the past being handed this hypothetical – would have said “total catastrophe” – I am certain they would have said total catastrophe, because that is a system that is unmoored, right? That is a system for which there are no checks and balances. The most important free market in the world, bar none, is where people who save and people who borrow meet to exchange capital at a price. There is no question that is the core of capitalism all the way back to the guys who handled money in Christ’s time, right? And now that has been subverted. It has been subverted by the guy who is just despicable in my mind – Greenspan. I mean there are just not enough bad things I can say about Greenspan and I have asked through the years of hedge fund managers, “Does he know what he is doing or is he just so swallowed with arrogance and hubis that he is clueless as to what is going on here?” And it splits, no one knew. No one knew. They all knew he was a problem, but no one knew whether it was premeditated or whether he was just a fool. I don’t know which. But this will work out poorly. There’s no time in history that this type of system has worked out well. It won’t happen this time either.
Chris Martenson: Well you know the bubble dynamic or however you want to define a bubble. I loved your definition, by the way. A bubble is something that is rising significantly in price that I don’t currently have a position in. But a bubble represents ultimately the mispricing of something, right?
David Collum: Right.
Chris Martenson: And however we got to that mispricing, you actually need a number of factors to have a bubble, right? So you have to have a story that is compelling and by story, I mean it has to be something where there is no track record yet on that particular story. You know eyeballs during the internet piece, tulip bulbs at one point, railroads, whatever. But you have to have the ample credit. You just can’t do this without – you can’t create a bubble out of income or earnings, it's not possible. So you need this credit, right? And then you need sort of a compliant structure where there is no regulatory oversight or nobody preventing it from happening that is in a position to do so. All of those things are absolutely in place, under the Greenspan Fed and now I think we still have it obviously under Bernanke and the way – there are obvious things that get mispriced, right? We had a housing bubble, which was fostered by driving down interest rates to 1% and holding them there for a whole year in 2003. Thank you for that one Greenspan, right?
David Collum: &n