James Grant: Nobody Knows Anything

James Grant, editor of Grant’s Interest Rate Observer

Recorded: March 24, 2020

[T]his introduces the possibility of everything that gold bugs have been praying for.

INTERVIEW TRANSCRIPT (EDITED)

Albert Lu: It’s another day of volatility for investors, as hope for a government stimulus package pushes the Dow Jones Industrial Average back above the 20,000 point mark. But how long will [it] last?

Joining me now is the editor of Grant’s Interest Rate Observer and the author of several books, including The Forgotten Depression: 1921: The Crash That Cured Itself.

Jim Grant, welcome. It’s a pleasure to have you on and I promised you just now that I will not require you to answer that question but I’m sure we’ll have plenty of things to talk about. How are you?

James Grant: I’m fine. Thank you, Albert.

AL: Something tells me that the story of 2021 is going to be a little bit different than that of 1921. So, where shall we begin?

JG: How about 2020?

AL: [laughs] Okay. What are your thoughts on what’s going on [over] the past week or so?

JG: Well, it is a light show. I guess the big question is whether Mr. Market has ceded operating control of finance to Uncle Sam in the shape of these quite gob stopping interventions and, in the face of things, it looks as if that were possible. Only September, before the pandemic, the Fed intervened in response to a kind of anomalous, unscripted spike in the so-called repo rate. That’s the rate at which you can borrow against the apparently spotless collateral of the United States Treasury. But on that particular day — was it September 7th maybe? — in early September that rate spiked above 9[%] and got close to 10[%], and that was a cue for, what was then seen as, a rather sizable succession of Fed intervention to tamp down that rate and to facilitate the continued funding of our outsized boom time, then boom time, Treasury deficits.

So what has happened in the past two weeks has been the most outsized and stunning succession of interventions in the history of modern central banking. You know, it’s not unprecedented that central banks do unconventional, even radical things, in the face of extreme turbulence. In 1825, in England, there was a very, very severe depression and financial panic, and the Bank of England did all manner of unconventional things — actually lent against physical merchandise, which was an extreme step — mortified the more orthodox among the directors of the Bank of England.

But in six hearings in 1832, I guess, one of the directors [of] the Bank of England was asked about this. How does he explain what had happened? And this guy, named Jeremiah Harman, a long-serving director, said that, “We lent … by every possible means, and in modes that we never had adopted before … seeing the dreadful state in which the public were, we rendered every assistance in our power.” And he added that, “we were not upon some occasions over nice.”

I love that: over nice. So one could invoke that historical precedent as kind of a calming fact to dampen one’s anxieties about the apparent federal takeover of price discovery. One could — I just have, I guess to a degree — but I myself am not mollified. I think what has leapt out of Pandora’s box of intervention will not be so easily returned there.

AL: Jim, how different is the Bank of England’s approach to lending against physical goods to what, apparently, the Fed is going to do with a mainstream lending program or the relaunched Term Asset-Backed Loan Facility where they’re going to try to get money and credit into the hands of merchants?  Isn’t that essentially the same thing, maybe with some …

JG: Well, no, but it’s never [the same], of course, one cycle to the next. One episode of financial improvisation to the next, it’s never exactly the same thing. I don’t mean to be pedantic; you didn’t mean it was exactly the same thing. Certainly the spirit of innovation is comparable, one cycle two hundred [years] ago compared to this one. You know, another point of comparison is the Bank of England then was, in part, a commercial bank; it was doing its own commercial discounting of trade bills and the like. It was lending and taking deposits.

So the Fed, with these interventions, has become, or is becoming, a kind of commercial bank, right? It’s undertaking direct credit infusion into the economy rather than through intermediaries. It is also acting with unimagined hundreds of billions of dollars to buy more or less everything that’s not nailed down: commercial mortgage-backed securities, residential mortgage-backed securities, [backstopping] commercial paper money market funds, Treasury securities themselves, ETFs, [housing] investment grade bonds. It takes a while to get used to it all, but it is a fact.

And, you know, in my country, in America — I think you are calling from Canadia [sic] right? Aren’t you, Albert?

AL: I’m calling from California.

JG: Okay, that’s a different country too, you know, in some of the ways. But Bernie Sanders is evidently no longer even a low possibility for the Democratic nomination of presidency, but his ideas seem to be winning today, certainly his ideas in finance. Among those ideas of course is so-called Modern Monetary Theory, which is that body [of] thought which holds that the government will do no lasting harm if it monetizes deficits directly — if the central bank prints lots of money — as long as those obligations are not owed except internally, and if there is no inflation at the checkout counter. That’s the basic bare-bones proposition of Modern Monetary Theory which Bernie Sanders endorses and would implement.

But what are we doing if not that? We were doing that really in effect before. The Administration’s program was to borrow and spend, without let or hindrance, with no thought at all to orthodoxy and conventional Republican fiscal practice and mores. The other term for Modern Monetary Theory is functional finance. If it works, that’s great. No remote consequences of these improvised actions. So that program was in progress, in fact if not [in] name, and with the Fed’s actions this week, my goodness, it almost seems as if it were here. All we need is another press release called Modern Monetary Theory, right?

I’m fully aware that the provocation is that of, seemingly, an act of God or at least a viral mutation or something so we ought not to begrudge the Fed its humane impulses. But how do you not mobilize every single possible tool in your kit or bomb in your arsenal next time there’s a downturn in anything? I think this introduces the possibility of everything that gold bugs have been praying for. Are we going to talk about gold? I can’t wait.

AL: But one point though, I wasn’t meaning to imply that it was exactly the same thing … but what is the actual difference in reality and function of the central bank directly purchasing something and, instead, putting it in some kind of special purpose vehicle and buying that instead or buying asset-backed …?

JG: Oh, I think there’s not much difference functionally. I think it’s the Fed conforming to the letter, if not the spirit, of the Federal Reserve Act and to the somewhat restrictive legislation put in place in the aftermath of the last crisis, the Dodd-Frank Act. But as to outcome, I’m not sure there’s much difference.

AL: What about the practice of buying BBB- credits that are, perhaps, soon to become junk and just buying junk? It looks like we’re falling into that trap as well.

JG: This is another nicety. Is the Fed going to blow these things as soon as there’s a downgrade or is it going to lean on Moody’s and S&P not to downgrade the things it has purchased? We are so far down this road already, especially in Europe. The ECB has been monetizing corporate debt for many a fiscal quarter and in doing so has utterly corrupted, as far as I’m concerned, the very point of the pricing of credit, the very point of interest rates, which is to allocate capital. These interest rates, both on our side of the Atlantic and theirs, have been suborned into the public service. They have been commandeered.

So these prices, which ought to be discovered, I say, in the marketplace are, instead, administered. And they are administered for the very purpose of instituting a desired financial outcome. This goes back a long way but it goes back from one important observation point to 2010.

Remember November 4, 2010, when Ben S. Bernanke, PhD, published in The Washington Post an op-ed in which he said the following. I have it right here, Albert, because I’m a prepared kind of guy. Here it is. He’s talking about QE, then novel QE.

“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment and higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

So that was the great asset lift. That was the portfolio balance channel approach to central banking in which they would manipulate asset values higher [and] thereby induce happy outcomes.

Well, it turns out that many outcomes were perhaps unintended. One of these outcomes was to impoverish state pension funds which have discovered what Ben S. Bernanke, PhD, no doubt knew, at least in the back of his mind, which is if you beat down interest rates and if you do that you require much more capital to generate a given stream of income. At 5% per year, a $1M earns you $50,000 but at 1% a year you need $5M to generate that same $50,000 of interest income. So it’s kind of chasing your tail a little bit. So you make it on the asset appreciation but you lose it on the liability side — balance sheets having both liabilities and assets.

So one of the other unintended consequences of this 10 years of suppressed interest rates and predictable financial interventions by the Fed, well they’ve given us near record-high equity valuations — they did about 15 minutes ago until it ended or at least paused. We don’t know. They gave us, perhaps, more corporate debt for unit of corporate earning power than ever before, and much of this debt is very low quality. They have given us unicorns. They have given us zombies. They have given us all manner of things, some pleasant to be sure but many corrosive.

What they have not given us is any economy wide or political community wide new revelation into the dangers of the manipulation of the most sensitive prices and capital, namely interest rates. That’s my hobby horse but I think it’s a very dangerous road. We haven’t even talked about inflation. Nobody talks about inflation, right?

Imagine we were even in this conversation, like 35 or 40 years ago, when inflation was still at thing, and I said, Albert, what do you suppose the consequences might be of an immense infusion of new bank credit and to the fiscal program that is likely to reach 10% of GDP? How will you guess that would affect the price level?

And you would think to yourself, that idiot. And you would say, because you’re polite, Jim, I suspect that might lead to above higher inflation. But today no one thinks that. You can look at the futures curve and various interest rate derivatives that reflect current thinking on the likely course of rates and inflation and they’re flat.

Nobody is anticipating any adverse inflationary outcome from this, which I find is a remarkable commentary on the complacent thinking. You’re not thinking of complacency with, on most days, VIX readings at 75 and 80. But with respect to inflation and its prospects, there is certainly complacency rampant[ly] so.

AL: My suspicion, Jim, is that people who manage money have more urgent matters that they’re dealing with right now. One of them is a topic that I wanted to discuss with you. You asked about what is to be done in the face of extremely low interest rates — I think leverage is another thing that people have discovered that is helpful in bringing yields up. If you look at the commercial mortgage market right now, it’s melting down. The Fed pledged to begin purchasing agency MBS but that hasn’t been enough.

So what are your thoughts on that market? What’s happening there, and what’s going to happen if people stop paying their rents?

JG: Yes, exactly what we think is going to happen, and that something is more. Once you have said, without let or hindrance, we’ll do all we have to do, there is no check, is there? I mean Chairman Powell cannot now say a $5 trillion balance is making me a bit queasy. Yeah, I think we’re going to just lay back the oars here for a few weeks to see what … no, no, well that’s not going to do it. So if the announced scale of operations to tamp down [commercial MBS] … and besides that it’s residential mortgage-backed securities that are also in trouble. These mortgage real estate investment trusts, one or two of them, forcible had to deleverage and sell assets. So if what they had done and announced is not enough, there will be more. And, again, precedents are being set.

AL: The white paper from the chairman of Colony Capital suggesting familiar things, actually. When you hear things like systemic failure colliding with mark-to-market and margin calls, the solutions are often similar, which is suspend mark-to-market, freeze assets in their place, extend liquidity.

I’m just wondering if we do it again where is this all going to end?

JG: Well that’s a great question. Where does it end? And, unfortunately, it’s a great rhetorical question because we don’t know. We have our conjecture as we gold bugs — I used to count myself as a gold bull because I thought gold bug was just a little bit undignified for such a dignified fellow as myself. I’ve just come to throw my lot in there with all the other guys. You know, alright, alright, fine — gold bug. But where were we? — bemoaning leverage, yes.

Well, the invitation to borrow and lend at interest rates pitched below the rate of inflation and with the assurance that those rates would not be meaningfully adjusted higher, that state of affairs has called forth all sorts of networks of leverage, the existence of which we are discovering day by day, to the company of the sound of popping rivets, you know our finances. And you can hear those rivets pop in the residential mortgage-backed securities market. You hear it pop in CMBS. We can hear it, of course, in corporate bonds. And it is most disquieting and, also, it is most out of the intellectual tradition of sound finance which the word, sound finance, of course, the modernist disparage.

I’m going to read you something [from] Graham and Dodd that speaks to the very nature that’s one great corporate bond, I think. This speaks to the shock value of the state of the corporate debt markets now, the investment-grade market in particular, and the shock value that these securities should be kind of bid wanted, that the discontinuity should be as great as they are, that … Anyway, the spread should be gapping so much.

Okay, so here is Graham and Dodd on the nature of bonds.

“The soundness of straight bond investment can be demonstrated only by its performance under unfavorable business conditions. If the bondholders needed prosperity to keep them whole, they would have been smarter to have bought the company stock and made the profits that flow from prosperity.”

So it’s adversity that tests the merits of a bond, not some debt-fueled, leveraged, enhanced, modern central banking jive, boom. And Graham and Dodd published the first edition in 1934. So they were writing at 1931, ‘32 and ’33, which by the way was a great feat of moral courage because Graham was, himself, getting blown out of the water in his own leveraged partnership during the Depression.

AL: It seems like in this situation, in the most trying circumstances, we will really not get to see our grade on that test because we’ll never get to that point — the bailout will come first.

JG: I guess, yeah. I don’t know how there is no bailout. We have demonstrated this week that it is possible, who knows we’re speaking on Tuesday. But market is up 10% or something. So maybe that’s the bottom. We can’t know. I don’t think so but sure could be. So if that is the demonstrated efficacious use of amassed central bank power without, supposedly, any adverse consequence awaiting us, that, I think, solves mankind’s age-old dilemma of scarcity, right? If this is possible, if you can conjure, without adverse effects, trillions of dollars of new credit and everything is better because of that, net better, you know? Wow, I suppose we wish that had been discovered in the Iron Age. We would be a lot richer by now.

But, as you can tell by my sarcastic tone, Albert, I do not believe that’s the case. I do not believe that this is consequence free or adverse consequence free and I think it’s time for people to give some thought to that topic in finance which is paradoxically given almost no attention, namely what’s money and who says so? That is the fundamental question. These billionaires go around talking, begging the Fed to do these things, and there are many of them, including some professed libertarians.

Well, what’s their wealth dominated in? Are they not concerned, a little bit, about the nature of the money that is holding their own life’s work? That’s what it amounts to.

AL: I know that you’re not in the business of prescribing things but the suggestion box is wide open [with] all kinds of people giving the President advice on what he should be doing and what the Fed should be doing. Like it or not, we are in this situation.

So given where we are, what is, in your opinion, the best course of action for the fiscal authority and the monetary authority?

JG: I don’t know. I think the country ought not to be shut down. I think that that life goes on and that the order to stand still, to suspend commerce is probably ill-advised. But that’s not the question you posed. I was on CNBC a while ago and somebody asked me this and somebody said, there’s no trade-off between health and commerce. Of course there is. We suffer, collectively, 40,000 deaths a year on the highways. We could reduce that substantially by posting a 20 mile an hour speed limit. We don’t do that, not because we’re callous but because we live our lives. We take chances. You get up in the morning, you’re taking a chance.

I speak, as few talking heads do speak, with certifiably no epidemiological knowledge at all. I skipped that course entirely. So I don’t pretend to speak from anything more than newspaper reading prejudice on this matter. But I think that the go-hide-in-a-hole approach is probably not well advised.

AL: What about bailouts?

JG: No. There is a bankruptcy system and if the airlines have levered themselves up to the point of vulnerability, they can’t survive this well. They can file. I don’t think they should get direct infusions from the state.

The cost of the direct infusions will be the greater socialization of business activity. I’m not sure what Boeing, the stockholders, will have left over if they take the government’s money. But I really have got no advice for the President and that’s the reason I’m not elected to Congress.

I think the job for investor is not so much to prescribe an enlightened course of action — we all have our ideas I guess, even if we don’t want to talk about them — but I think the thing you do is take the measure of the policies in place, take the measure of the precedents that are set, and ask, if you are in the business of speculating and money, to ask what is going to be the strongest monetary asset in which to house your wealth?

That to me is the question, not what President Trump ought to do.

AL: So let’s answer that question then.

JG: Gold!

AL: We’re back to the beginning of the interview. Gold has performed well but it’s not acting as if the Fed’s balance sheet is headed quickly to $10-$15 trillion. So, is patience in order here for the gold investor?

JG: Yes, yes. Patience is absolutely in order and also gold is … you know, I confess I’m a gold bug and I blurted it out — gold — before you even asked the question. Yes, but it’s not to the end of emulating Scrooge McDuck. That’s not the point.

The point is to have liquid wealth available when opportunity presents itself. Gold is many things but it’s not regenerative. And there’s nothing as an investment like a well-priced, successful, profitable well-financed business. So what you want is gold for opportunities. You also want it, not so much as a hedge against monetary disorder because we have that, you want it as an investment in monetary disorder. That’s a second reason. So I guess that’s a little bit of Scrooge McDuck reason but I hold it for those two reasons. I think that it’s going to be helpful for both.

I look forward to liquidating some of my gold bullion, as modest as that stack of coins is. I look forward to, at some point, liquidating that, if I have the nerve and the opportunity to accumulate something that is going to be yielding dividends and cash flow. But the other portion, well I think, I hope, I’ll never sell — that’s the bottom dollar: an investment in the evident tendency of monetary affairs. The arc of monetary evolution points to greater and greater interventions, more radical policy which begets still more radical policy, financial repression and more of that. We got more QE this week than they did under the Bernanke Fed.

So to me the arc of this is very clear and you want gold, both for the inevitable spills in the market for financial assets as well as for the seemingly inevitable destruction, or certainly impairment, of the government-issued money. Those are my reasons.

AL: Every crisis is a little bit different. I’m wondering, over the last few weeks, has anything surprised you? Has this crisis taught you anything that you didn’t know going in?

JG: I’m thunderstruck. So many things are new. I was just on the phone with Russell Napier who wrote a book long ignored but now so timely. Russell is a student of the dynamics of bear markets. He studied the one of 1920, 1921, 1932, 1949 and I guess a couple of others, 1982. And he reflected that the very speed of this, the violence of it, is something new under the sun. The scale of government response is something new. So these things are unprecedented and so one must be very careful about drawing lessons from the past. And Russell is indeed careful about doing that.

But for me, the lesson I have learned, or reinforced, is that …  I’m going to quote a screenwriter from Hollywood. You’re in California, right? So you know all the screenwriters. William Goldman, who I think wrote Butch Cassidy and Sundance Kid, apropos of the predictability of box-office receipts, William Goldman, from his lips fell one of the great quotations pertaining to all attempts at forecasting and prognostication.

“Nobody knows anything.”

We can know tendencies. We can observe patterns of behavior. We can project. So what the events of the past, the violent events of the past two weeks, have reinforced to me is the necessary humility to stay relatively diversified, relatively liquid and to choke down any thought that begins to resemble certitude. We can’t be immobilized by our ignorance of the future.

We can understand how complex the future is and how predictably, indeed predictably, it can surprise you.