Transcript for the podcast: Ben Davies: Greece is Just a Preview of What's Coming For the Rest of Us
Chris Martenson: Hello. Welcome to another PeakProsperity.com podcast. I am your host, of course, Chris Martenson. And today we are speaking with Ben Davies, experienced money manager and CEO of Hinde Capital, a fund primarily focused on the precious metals and commodity sectors. Given his vantage point from Europe, I have invited Ben on the program to speak with him about Europe’s worsening debt crisis, the recent efforts to bail out Greece, of course, and what it all means for the world economy and for individual investors. We will also address his outlook for gold and silver, of course. Ben, it is a pleasure to have you as our guest today.
Ben Davies: Hey, Chris, I am very flattered to be invited on and I am looking forward to a bit of a to and fro. That would be great.
Chris Martenson: I am, as well. We have had a very interesting pre-conversation here. I am hoping we can surface some of that. But here we are with the recent developments in Greece, and I have just been absolutely astonished at what I have seen going on there with the ECB now crowing about how they are going to make a substantial profit on the bonds that they had purchased at a steep discount in the open market. And those bonds magically are going to be repaid in full because, of course, the ECB spared itself from taking any losses on those bonds and pushing those losses off onto private investors. This is just a very interesting dynamic that is going on. What are you seeing from your vantage point? How is this playing in your corner of Europe? And what is your view of where we are going to go with all this?
Ben Davies: Well, I mean, that is an interesting segue to introduce there. I mean, I think it is fair to say that State intervention is the key word here, and the concepts of self determination and the rights of the individual have been thrown out the window. Clearly, the interesting dynamics of the ECB is that all bondholders and all equity holders, in many respects, should have equitability or they should have equities, so to speak – equality, sorry, that is the word I am looking for. And clearly in this case, they have given themselves seniority. The private sector is subordinate, and I mean, quite frankly, it is disgraceful. Clearly, there is a political expediency going on here. They do not want to denigrate that balance sheet. They, bizarrely, are trying to keep credibility of [the] ECB balance sheet, which has been ballooning monstrously and now stands at some almost thirty, thirty-five percent of the GDP of Europe. And that is an exponential growth, something that you talk about extensively in your book and something we focus on, as well. And I would go so far as to say that this exponential growth in the balance sheet is actually going to a rate of exponential of the exponential. And that sounds like a mouthful, but that gets very frightening because it becomes unsustainable. And politicians and the ECB, they totally understand that in the case of Europe.
But if we just circle back to specifics, actually the ECB, they bought a lot of these bonds around eighty cents to par. So I think they bought around fifty billion, so the value they paid was, call it forty billion. Now, they have – as you say – they started to… I would not say they are crowing about it, but what happened is – because a lot of these bonds are short-term maturity – that actually, you get a pull to par. So as you come into the maturity period, which is March 20th when the redemption and roll over of the two-year bond, actually you are getting that pull to par. So in many respects, with the interest payment that they have received on it, they have made this and amortized this return. Now, they have foregone that as is they want to try and help Greece reduce that debt to GDP to a hundred and twenty percent by 2020. But they have done it at the expense of the – as you say – the private sector bondholders, which, obviously, it rips up the legal framework by which we really exist within financial markets and within the rule of law. And this is really going to be an ongoing process. And a word I would really use, it is financial repression, to refer to this.
At the end of the day, capital is scarce. So governments who need to keep funding themselves in order to keep a welfare state going need to find capital. And they will move at nothing to achieve that. And in this case, they have written off the rulebook.
Chris Martenson: Let’s extrapolate, then. If the situation, if I am now a holder of Portuguese bonds, say, or Italian bonds, I am looking at this rule change that is happening in the context of the Greek bonds. Potentially, it is specific to the situation in Greece. But if I am a private holder of Portuguese bonds now, I am wondering if the same rule change won't be coming down the pike. I am going to be slightly less willing to hold these bonds, meaning I am going to want to sell them, I am going to expect the price to go up. Would you expect this action where the collective action clause has been unilaterally and retroactively applied by the ECB to the Greek situation, doesn’t that extend potentially to other bonds? Will this not just make… Are they not solving the problem in Greece – I am putting air quotes up – "solving the problem in Greece" with this rule change? Are they not just then transferring a larger problem to much larger bond markets?
Ben Davies: Very good question. Not an easy answer. I am going to try to answer it – best efforts. But I would say it is very specific to each country and it is very specific to what positions are in the marketplace, not only by investors, but banks. In the case of Greece – so let’s use that as an example – a lot of people have been under the misinterpretation that ISDA has not wanted a credit event to take place there. That is not the case. The market has been pricing it on these two years, which are maturing, to your Greek bonds, which are maturing on March 20th. They have been pricing in with the package, which is your longer two-year Greek bond and your long, some credit default swap on Greece. That package is known as a basis. And the probability assigned of a credit event is ninety-three percent.
Now, that is an interesting dynamic, because clearly people get paid out. The private sector has been holding out in the voluntary debt restructuring because they actually want the credit event to take place. They want to get paid out on the credit default swap, and clearly they make more money in that scenario. And the market is pricing that. And also, I would say about ISDA – seeing as I bring it up – is that ISDA, there are five banks effectively in charge or a committee in charge of the credit default swap market and the derivatives market. They do not want to ruin that market; the CDS market and the derivatives market is a big market. It is a big earner for the banks, and it is what is part of keeping this whole casino credit going. So there is no way they want to endanger that.
So I think people who have been talking about ISDA not wanting a credit event in this occasion are barking up the wrong tree. So I digress slightly, but I think it is pertinent to this, because it then comes down to what are the positions at any time for participants in the private sector.
So actually, it kind of flies slightly in the face, I was saying, about the ECB in terms of the hedge funds. They have not lost out in this at all. They have positioned themselves smartly. But certainly, I think it is very unfair on the Greek banks that they have to experience such a debt restructuring. They get a haircut when the ECB does not. And certainly, that applies to any other banks who have had Greek bonds. But to be fair, this can go on for a long time, and positions have been pared down over that time.
So in some ways, I hope I am answering your question. I think it is very specific to each country and who the holders are, whether it be the private sector or the public sector, clearly a lot of peripheral debt is held, has been held with the public sector, i.e., the bank – sorry, the private sector, banking sector. And it has been paramount for the ECB to make sure that that system does not implode. And so they introduced the LTRO for three years as a mechanism by which they could effectively keep these banks afloat and so they would allow them to fund themselves on an ongoing basis.
Now we have had one LTRO, which is about five hundred billion. We are going to have another one, which I suspect will be bigger, because I think that with all the downgrades we have seen recently, we are going to see actually more collateral will have to be put up by the bank. So I think some of the people will take this free money with all the hands they can get on it. They will grab it and put it onto their balance sheet. It was a very clever piece of work by the ECB because ultimately it stabilized the system, just for the medium term. Because now they have an inordinate amount of liquidity. And as I say, it is for a three-year period. But unfortunately, it just kicks the can down the road. What happens in three years’ time? Does the ECB have to roll over, give back all the toxic assets it has taken on in return the cash? So all that is doing is paving over the cracks in the short term. I hope that answers your question.
Chris Martenson: It does. So I am interested in this kicking-the-can-down-the -road phenomenon. Because as I look at it very specifically again, what the IMF is projecting for Greece and how it gets down to a hundred and twenty percent debt to GDP by, I think, 2020 or somewhere around there. They have them returning back to reasonably nominal two, two-and-a-half percent growth, starting next year and carrying forward. What happens to all of these debt rescue plans if it turns out that the signals that I am reading in the world right now say recession is again stalking the global landscape and certainly visiting Japan, it is visiting parts of Europe at this point in time. How does recession and the debt rescue plans, how do those two come together?
Ben Davies: Look, as I think we are both agreeing here, they are trying to buy time. I think I may first step back here and paint a bigger picture, which is the fact is that we are going to have a cataclysmic end to this. The mathematics does not add up. You have talked about exponential debt trends just as we have and at this point, if the policy prescription is more of the same, you will see that from 2007 that actually we have not deleveraged at all. Actually, the total credit has increased as a percentage of global GDP. Part of that is the common denominator has gone down to over a little bit as the GDP has fallen. But actually, total credit has expanded quite dramatically.
So what does that mean? I have forgotten what you asked me.
Chris Martenson: You are going exactly where I was hoping we were going to go with this. Which is, we started by looking at Greece, and there are some nice specifics there, and we can talk about what is happening in the credit market, specifically, and specific policy tweaks that are being done or whatever the ECB is doing with the collective action clause. This is useful… In microcosm, Greece is a useful way to get at this larger issue, which is what I am really interested in. Which is that if we look at Greece and we try and pencil it out, it just does not add up. Mathematically, there is a problem in Greece. And the problem really centers on the idea that Greece, like much of the developed world – the United States, Japan, OECD in general – has been growing its debts far faster than it has been growing its income. And we have been enabled in this, I think, with the abandonment of the gold standard in 1971, and there has been really no tether. Just it was sort of convention, I guess, in an agreement as to how much we were going to allow ourselves to grow our debts. Well, eventually, that pops, right? A credit bubble always finds a pin at some point in time. Potentially that was in 2008 with rising oil prices. It does not matter; somehow it found its pin and started to collapse.
And so here we are today and looking at Greece. And for me as an outside observer, I cannot make the math work. Somebody is going to have to take extraordinary haircuts and losses on that. And again, Greece, just a microcosm for what I think is a larger systemic problem, which is that we are going to have to take some pretty extraordinary losses across the whole system.
Against that, all of our fiscal and monetary authorities doing everything they can apparently to just paper it over, patch it up, keep the system going, status quo sorts of solutions. But from your perspective – I know you have written about this to some extent – that really, we have to get right into the center of this and look at money itself. The fiat money system, the process of credit creation, the degree to which we, in essence, are fooling ourselves by borrowing from the future on a constant and increasing rate. Are we not, at heart, talking about the idea that we have a systemic problem that needs to be addressed that is really going to be immune to whatever sort of minor policy tweaks can be envisioned, which is really that, to me, is the story of Greece. It is an attempt in small ways and with whatever agreements and sorts of complexities can be dreamed up, it is really still avoiding the larger issue, which has to do with our money system itself.
Ben Davies: Wow. You answered the question for me, I think. But yes, I think it is systemic. I think the monetary regime that exists today which is – let’s face it – has been around for forty years. It is a paper currency system, which means by decree of government, and when we say paper that has no backing to any real assets such as gold or silver. So when we say by decree of government, we mean that you have to pay your taxes, so it is your money.
And I think that really when you talk about Greece, we get lost in the minutiae about tax and collective action clauses, etc., etc. But really, we need to go to the bigger picture and perhaps get – seemingly existential for some people – but actually, we have to understand what money is. And money is created through the debt system. It is created out of thin air. A central bank or the Federal Reserve Bank, for example, creates money on the liabilities side of the balance sheet by buying existing Treasurys off the US Treasury itself onto the asset side. And as an accounting procedure, it puts down some paper money, on the liabilities side against it. That is how you create money.
Now, money creation is one methodology. How does that get into the system through something called fractional reserve banking? Every pound we hold on deposit is lent out multiple times, maybe the base is ten times. Now, this is a very insidious situation, really, that unfortunately, human beings cannot be trusted to keep it at appropriate levels of lending or borrowing. And why is this? Well, if it goes all the way to government, whereby effectively, a democracy starts off with all the right intentions. But if it is predicated on a fair currency system, eventually – in order to get re-elected, welfare will be paid for, wars will be paid for, other Social Security and Medicare/Medicaid as you have in the US, healthcare – will all be provided for. And they will buy their way into election.
So obviously, each year the debts just keep going up and up and up and up. And obviously, there is a servicing to that debt. But eventually, the math does not add up, and doubling rates – as you talked about in your book – is exactly what goes on here. At some point, we actually create so much debt that we are not able to service them.
And today – although we talk about Greece at this particular point – the reality is we have actually hit a debt saturation for the entire world. Now, we have had other situations where, let’s say, Argentina or Russia have had similar situations, perhaps even far worse. But they have been in isolation, so there has not been a systemic fallout. But this time, we actually – I believe – we have got to a situation where rather like, if you take Zimbabwe, Zimbabwe is a microcosm of the world. We actually had hyperstagflation there. We had debt deflation, as we are seeing now. And in order to really try and offset that, they primed the printing presses and they specifically printed paper. The only difference today in the US, the UK, Japan is that they do something called quantitative easing, which is a euphemism for printing money electronically. And quantitative there and qualitative, they are expanding balance sheets at the central bank and also, in this case, I would argue they are denigrating the quality of the balance sheet because they are actually taking a lot of assets at par that are not worth par.
So this is the difference today is that it is a global phenomenon in which case, we actually have a situation where capital is scarce. So every nation is trying to get capital. So this is going to lead to a lot of friction – not only domestically, but internationally. You can see that not only is the private sector being crowded out, but actually, sovereign to sovereign is getting crowded out. And herein lies the problem, and herein is why each central bank is having to step in.
Why is the UK printing inordinate amounts of money? Why is the European Central Bank printing inordinate amounts of money? Why is now Japan started again printing so much money? And actually, I mention Japan and that is interesting. They printed constantly after their credit induced bubble that collapsed in 1989, 1990. And they have been in the mire for over twenty years now. And everyone said, oh, well, we never saw inflation in that country. Well, guess what? Because that was in isolation at that time, the rest of the world was doing just fine, thank you very much. This was a very specific credit-induced bubble. The problem there is they exported inflation to the rest of the world.
Now we have a situation where every country is effectively going down the same routes as Japan and most are following a similar policy prescription, as you can see. Well, Japan is a thirty-trillion size economy, and they definitely have hit the tipping point. They are twenty years down the line. So they are the one to watch, where they cannot service their debts anymore. And if you notice, the Bank of Japan is just back in announcing that they are going to have to ramp up the size of their balance sheet. They are buying JGB, they are buying REITs, they are buying everything but the kitchen sink. They are not trying to tacitly inflate that system. Well, if the whole system is trying to do the same thing, I have to say that once you have debt deflation on one side of the coin, on the other you have gross monetary inflation.
So all those factors that have a finite supply – whether it be oil at the margin, whether it be gold at the margin – and I say at the margin because demographics are rising globally. As you wrote in your book, we have gone from three billion by 1961, and from 1961 to 2012, we have gone to six billion. That is an exponential rate. So there is a strain on resources. And it is not that we are running out of resources, perhaps, in the next millennia. That is not the point. It is the cost, in my mind, of extracting it and making that timely.
So in an era of just-in-time inventory, this is going to put pressure on the price of goods and force them to go up, especially when you are increasing more of the numéraire against a dwindling or not-so-readily available supply. And that is when you get hyperinflation. So people who are calling for debt deflation or hyperinflation, I think both can happen simultaneously.
Chris Martenson: Well, it did happen, as you mentioned, in Zimbabwe, where I have heard people say inflation is really in check because look at capacity utilization. You know, until capacity utilization, the factory really ramps up. We are not going to experience inflation. But in Zimbabwe, I believe, their cap utilization was down to ten percent, even as inflation was in the millions of percent. So you clearly can have a disconnect between those. And this means that, in my mind to widen that out, very interesting time in history right here – anything that we might have formed as opinions or ideas or beliefs around how the world works over the last twenty years, we might have to crack that open or even chuck it out the window. Because here, what we are facing now is –widen it all the way up – we have to ask the question, well, really, what is wealth? Ultimately, money is a marker for wealth, it is not wealth itself. And what it is making markers for? Well, it is the stuff we need, the stuff we want. And as you noted, global supplies of critical resources are strained at the moment in time – China now consuming half of the world’s coal, I believe, last year, and shooting upwards from there.
With other critical resources, maybe we can find ways to adjust and to produce more of these resources for a period of time – maybe decades even – but not in all cases and not in all circumstances, with, for me, the standout story being oil. Very mysteriously, we have not managed to increase production of regular oil – I will call it conventional crude oil – since 2005, despite some very nice hefty market pressures and pricing that it would really encourage, you would think, quite a bit of production.
And it is not just oil itself. We have to look at the different grades. It is light sweet is what the world wants. We seem to be in short supply of that. Plenty of sour crude kicking around. And this is what the data is suggesting to us at this point. And so from my perspective, I see a world where real wealth represented in real resources with the absolute cornerstone of that story being oil – particularly the grades of oil we want – sitting right there in plain sight. And all the central banks just blissfully unaware of that, apparently, and cranking the printing presses because their model says if we can just create enough liquidity, the economy will grow again. It seems like a colossal set of forces that are lining up on two sides of the field here. I am going with reality and oil as the potential winner of this match. How do you see it?
Ben Davies: Well, you know, I think you bring up some pretty pertinent points. I think we are on the same page here. I do think that people will say that obviously productivity will improve, and as a consequence, some of these energy sources will be made more readily available more quickly. And I think that is the pertinent point. But you are up against a very challenging demographic. Obviously in the developed world, we have collapsing demographics in terms of aging demographics in parts of Europe. You have got this monstrous growth happening in the Asian economies, particularly. And as we have already highlighted in just talking now, we just talked about the exponential growth, worldwide growth. Clearly, that rate comes into conflict with the rate of productivity. And for me, that is really the big issue.
Now, I think we are hitting a perfect storm, unfortunately, where you are having inordinate amounts of money created electronically around the world in order to maintain a monetary regime that is clearly beginning to fail. I am under no illusion that this is the start of this particular regime failure. I have seen in history that it is amazing how governments can often band together ultimately to keep the illusion. But I think as people are now really beginning to assess that validity of credit on what – as you have talked about – what is wealth? And, what is the value of my daily labor? Well, guess what? You know, it is really under threat when I see that it is being debased every day. So how do I impute what a value of oil is? How do I impute an ear of corn? What is the value of that when you are constantly changing the yardstick or the currency or that numéraire? That has become the very difficult aspect to ascertain.
And so clearly, we have got this very interesting dynamic where you have got positive demographics and you have just an inordinate amount of money being primed into the system. And they are at odds with each other.
Now, the feedback mechanism there, clearly, for oil, is actually, works as a tax on us in terms of traditional economics as the oil price rises, because we are still so heavily dependent on it worldwide. That actually has an impact on our disposable income.
Now, even if we start talking about replacement energy – natural gas is obviously the… clearly, shale gas, etc. – these are alternatives and I can see that there is a major disconnect between what the price of European gas is and US gas, natural gas. And I am sure that as they realize, find more sophisticated or clever ways to transport liquified gas around the globe that price will move up. So again, all the time, I just see that there is a constant strain.
Now, I know you are rightly fascinated with energy dynamics and I think what they have are hugely pertinent, even in our lifetime. But for me right now, as a fund manager, I am just concerned with trying to preserve wealth for my clients and for myself and for my family. And markets are so distorted today that I really throw my hands up in despair. I cannot with any conscience put people into bond markets, because they are effectively – and wholeheartedly – run by the financial system, which is now run by the government, the US government buys US bonds. The UK government buys government bonds, they buy MBS.
So what we are seeing here in reality is interest rate premiums are being squeezed lower. So interest rates are being set at face value that is really not reflective of the true marketplace. Interest rates are based on human preference of where people want to lend or borrow. And the reality is, when they are so artificially low, it distorts the whole term structure of financial systems.
So to just extrapolate that all and extend that thought process, look at equity markets at the moment. It is just incredulous. They seem to be rallying – I call it the Reluctant Rally, because most people are not invested at this point because there is just a huge disconnect between the credibility of what is actually happening in the real economy, which is effectively events in Greece and people are losing their jobs. Aggregate demand is falling. And globally, there are issues in China. It is not just even that economy is really starting to – I would say – starting to slow down, grinding to a halt, and its terms moving from ten percent GDP down to seven percent GDP. It is a material shift. So things are slowing down considerably around the world.
So I think that you have this dynamic where for equity markets, they are rallying, because the discount rate – which has been set by bond rates, which has been set by government – is artificially low. And so that discount mechanism is driving equities higher, that debasement of the currencies are underpinning these equity markets.
Now at times, you get this risk-on-risk-off. And the reason why we are seeing such high correlation between asset classes is that very reason. The term structure is being shriveled to a very low yield, which effects all markets converge to a return or a yield or a productive asset. And really, when you go to the zero bound, every asset class ultimately moves towards that. So axises [sic] are rallying to such a point in which there will be a zero yield return for you. Likewise, bond assets have gone to actually, they have now gone to a negative yield. So it is absolutely just, for me, there is absolutely, I know I am going to lose not only capital but after inflation I am losing three, four percent. Or whichever bond market in the developed world that I want to invest in.
This is the insidious part of the financial system for me right now, which is what do I turn to? How do I grow my business for my investors? Well, unfortunately, I just keep coming back to gold, which protects me in an inflationary environment and it protects me in a deflationary environment – probably more so because it has zero risk of default. And that is a really important point for me.
Chris Martenson: Absolutely. And so in gold, I assume we are talking not ETFs but physical gold or something where… I guess where I am going with this is MF Global, that debacle really sort of changed my perspective on the safety of assets and whatnot. So a bird in the hand is worth two in the bush, I guess. How do you invest in gold in this particular landscape?
Ben Davies: Well, you bring up a very interesting point, MF Global, and I just want to address that before I talk about ways of investing in gold. But something that we have not talked about but is at the root cause of the problem with our financial system today – fractional reserve banking and excessive credit spending beyond just central bank money creation is the concept of rehypothecation. And clearly, what has happened with – and well, I should probably define what rehypothecation is or I should say what hypothecation is. Hypothecation is where a borrower pledges collateral to secure some debt. So i.e., the borrower retains ownership of that collateral. But obviously, hypothetically, this is controlled by the credit group. A good example would be, I guess, consumers enter into a mortgage agreement, for example, in which the consumers house becomes the collateral until the mortgage loan is paid off. So that is hypothecation.
Rehypothecation is the practice that occurs in financial markets and I think, to some extent, first came to everyone’s attention with the Lehman debacle and the repo 101s. This is where the banks or a broker dealer can reuse that collateral that has been pledged by a client. And they can reuse that collateral as collateral for more borrowing. So this is what’s happened in the case of MF Global.
And interestingly, talking about, we just talked about income and yield. What were they trying to do? Corzine was an ex-Goldman Sachs individual. He was trying to create an income statement just like Goldman Sachs does, which is borrow in the short-term, lend long-term, you get the yield curve pickup. Now that yield curve has been narrowed. So he had an opportunity to purchase high yield and peripheral debt on the belief that he could… that the ECB or governments would step in and save the day, as we have to some extent. You know, they bought them that significant discount, they get a yield so that the likelihood of a default is already priced in to some extent. So they have got some cushion there. But all the time, there are earning that yield and that pull to par, except they were using collateral that had already been placed by clients and placing that as collateral to borrow more. And so you can see the insidious circle here.
MF Global is, again, it is a microcosm but it just exemplifies everything that is wrong with a credit-based system, the who