How is Doug Casey Preparing for a Crisis Worse than 2008?

By Doug Casey, Chairman

He and His Fellow Millionaires Are Getting Back to Basics

Trillions of dollars of debt, a bond bubble on the verge of bursting and economic distortions that make it difficult for investors to know what is going on behind the curtain have created what author Doug Casey calls a crisis economy. But he is not one to be beaten down. He is planning to make the most of this coming financial disaster by buying equities with real value—silver, gold, uranium, even coal. And, in this interview with The Mining Report, he shares his formula for determining which of the 1,500 "so called mining stocks" on the TSX actually have value.

The Mining Report: This year's Casey Research Summit is titled "Thriving in a Crisis Economy." What is the most pressing crisis for investors today?

Doug Casey: We are exiting the eye of the giant financial hurricane that we entered in 2007, and we're going into its trailing edge. It's going to be much more severe, different and longer lasting than what we saw in 2008 and 2009. Investors should be preparing for some really stormy weather by the end of this year, certainly in 2015.

TMR: The 2008 stock market embodied a great deal of volatility. Now, the indexes seem to be rising steadily. Why do you think we are headed for something worse again?

DC: The U.S. created trillions of dollars to fight the financial crisis of 2008 and 2009. Most of those dollars are still sitting in the banking system and aren't in the economy. Some have found their way into the stock markets and the bond markets, creating a stock bubble and a bond superbubble. The higher stocks and bonds go, the harder they're going to fall.

TMR: When Streetwise President Karen Roche interviewed you last year, you predicted a devastating crash. Are we getting closer to that crash? What are the signs that a bond bubble is about to burst?

Warning Missing the 2014 Casey Research Summit (Thriving in a Crisis Economy) could be hazardous to your portfolio. Sept. 19-21 in San Antonio, Texas. REGISTER NOW

DC: One indicator is that so-called junk bonds are yielding on average less than 5% today. That's a big difference from the bottom of the bond market in the early 1980s, when even government paper was yielding 15%.

TMR: Isn't that a function of low interest rates?

DC: Yes, it is. Central banks all around the world have attempted to revive their economies by lowering interest rates to all time lows. It's discouraging people from saving and encouraging people to borrow and consume more. The distortions that is causing in the economy are huge, and they're all going to have to be liquidated at some point, probably in the next six months to a year. The timing of these things is really quite impossible to predict. But it feels like 2007 except much worse, and it's likely to be inflationary in nature this time. The certainty is financial chaos, but the exact character of the chaos is, by its very nature, unpredictable.

TMR: Casey Research precious metals expert Jeff Clark recently wrote in Metals and Mining that he's investing in silver to protect himself from an advance of what he calls "government financial heroin addicts having to go cold turkey and shifting to precious metals." Do you agree or are you more of a buy-gold-for-financial-protection kind of guy?

DC: I certainly agree with him. Gold and silver are two totally different elements. Silver has more industrial uses. It is also quite cheap in real terms; the problem is storing a considerable quantity—the stuff is bulky. It's a poor man's gold. We mine about 800 million ounces (800 Moz)/year of silver as opposed to about 80 Moz/year of gold. Unlike gold, most of silver is consumed rather than stored. That is positive.

On the other hand, the fact that silver is mainly an industrial metal, rather than a monetary metal, is a big negative in this environment. Still, as a speculation, silver has more upside just because it's a much smaller market. If a billion dollars panics into silver and a billion dollars panics into gold, silver is going to move much more rapidly and much higher.

TMR: Are you are saying that because silver is more volatile generally, that is good news when the trend is to the upside?

DC: That's exactly correct. All the volatility from this point is going to be on the upside. It's not the giveaway it was back in 2001. In real terms, silver is trading at about the same levels that it was in the mid-1960s. So it's an excellent value again.

TMR: In another recent interview, you called shorting Japanese bonds a sure thing for speculators and said most of the mining companies on the Toronto Stock Exchange (TSX) weren't worth the paper their stocks were written on, but that some have been priced so low, they could increase 100 times. What are some examples of some sure things in the mining sector?

DC: Of the roughly 1,500 so-called mining stocks traded in Vancouver, most of them don't have any economic mineral deposits. Many that do don't have any money in the bank with which to extract them. The companies that I think are worth buying now are well-funded, underpriced—some selling for just the cash they have in the bank—and sitting on economic deposits with proven management teams. There aren't many of them; I would guess perhaps 50 worth buying. In the next year, many of them are likely to move radically.

TMR: Are there some specific geographic areas that you like to focus on?

DC: The problem is that the whole world has become harder to do business in. Governments around the world are bankrupt so they are looking for a bigger carried interest, bigger royalties and more taxes. At the same time, they have more regulations and more requirements. So the costs of mining have risen hugely. Political risks have risen hugely. There really is no ideal location to mine in the world today. It's not like 100 years ago when almost every place was quick, easy and profitable. Now, every project is a decade long maneuver. Mining has never been an easy business, but now it's a horrible business, worse than it's ever been. It's all a question of risk/reward and what you pay for the stocks. That said, right now, they're very cheap.

TMR: Let's talk about the U.S. Are we in better or worse shape as a country politically and economically than we were last year? At the Casey Research Summit last year, I interviewed you the morning after former Congressman Ron Paul's keynote, and you said that you hoped that the IRS would be shut down instead of the national parks. There's no such shutdown going on today, so does that mean the country is more functional than it was a year ago?

DC: It's in worse shape now. The direction the country is going in is more decisively negative. Perhaps what's happening in Ferguson, Missouri, with the militarized police is a shade of things to come. So, no, things are not better. They've actually deteriorated. We're that much closer to a really millennial crisis.

TMR: Your conferences are always thought provoking. I always enjoy meeting the other attendees—it's always great to talk to people from all over the world who are interested in these topics. But you also bring in interesting speakers. In addition to your Casey Research team, the speakers at the conference this year include radio personality Alex Jones and author and self-described conservative paleo-libertarian Justin Raimondo. What do you hope attendees will take away from the conference?

DC: This is a chance for me and the attendees to sit down and have a drink with people like Justin Raimondo and author Paul Rosenberg. I'm looking forward to it because it is always an education.
Another highlight is that instead of staging hundreds of booths of desperate companies that ought to be put out of their misery, we limit the presenting mining companies in the map room to the best in the business with the most upside potential. That makes this a rare opportunity to talk to these selected companies about their projects.

TMR: We recently interviewed Marin Katusa, who was also excited about the companies that are going to be at the conference. He was bullish on European oil and gas and U.S. uranium. What's your favorite way to play energy right now?

DC: Uranium is about as cheap now in real terms as it was back in 2000, when a huge boom started in uranium and billions of speculative dollars were made. So, once again, cyclically, the clock on the wall says buy uranium with both hands. I think you can make the same argument for coal at this point.

TMR: You recently released a series of videos called the "Upturn Millionaires." It featured you, Rick Rule, Frank Giustra and others talking about how you're playing the turning tides of a precious metals market. What are some common moves you are all making right now?

DC: All of us are moving into precious metals stocks and precious metals themselves because in the years to come, gold and silver are money in its most basic form and the only financial assets that aren't simultaneously somebody else's liability.

TMR: Thanks for your time and insights.

You can see Doug LIVE September 19-21 in San Antonio, TX during the Casey Research Summit, Thriving in a Crisis Economy. He'll be joined on stage by Jim Rickards, Grant Williams, Charles Biderman, Stephen Moore, Mark Yusko, Justin Raimondo, and many, many more of the world's brightest minds and smartest investors. To RSVP and get all the details, click here.

The article How is Doug Casey Preparing for a Crisis Worse than 2008? was originally published at Casey Research

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Are You Ready for Negative Interest Rate and Pay the Bank to Hold Your Money?

The six members of the European Central Bank (ECB) Executive Board and the 16 governors of the euro area central banks vote on where to set the rate. We watch interest rate changes closely as short term interest rates are the primary factor in currency valuation.
 

A higher than expected rate is positive for the EUR, while a lower than expected rate is negative for the EUR. Today (Thursday June 5th) we expected a rate cut. The cut was not as much as analysts expected which is bullish for the short term, but the rate is still declining and nearing zero, or even worse, negative territory.





A negative interest rate may sound crazy or impossible, but it's already happening in Denmark. Europe is already in a deflationary state and central banks are doing everything they can to bring about inflation by cutting rates and devaluing the euro. This will cause a ripple through multiple asset classes and will drastically alter the outcome of individuals worldwide. Just imagine if you had to pay a bank to hold your money and you do not earn any interest but rather pay interest.

People who have been saving their entire lives will get hit the hardest. Retired folks will stop earning money and start paying for all the money they hold held at banks. Individuals will go more into debt because money will be extremely cheap to borrow. Price of assets like equities, real estate, discretionary goods will rise because the cheap money everyone is borrowing will be used to buy more stuff. While all this happens everyone takes on more dept. It is a brutal spiral leading to increase debt levels, inflation and eventually bankruptcy.

If the euro dollar starts to decline at a quicker pace the U.S. dollar will likely rally. A strong dollar could affect the commodities market including gold, silver and the European stock markets. Todays rate cut led to a pop in the euro, but that is likely to be short lived. I hope this sheds some light on the markets and helps in your trading.

Chris Vermeulen

P.S. In the next few days members and myself will be looking to enter some trades based round this analysis. See Premium Trading Video & Newsletter

Sincerely,
Chris Vermeulen


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10 Ways to Screw up Your Retirement

By Dennis Miller

There are many creative ways to screw up your retirement. Let me show you how it’s done.


Supporting adult children. My wife Jo and I have friends with an unmarried, unemployed daughter who had a child. Our friends adopted their grandchild and are now in their late sixties raising a kid in grade school. The same daughter had a second child, and they adopted that one too. When she announced she was pregnant a third time, they finally said, “Enough! It’s time for a third party adoption.”

Last time I spoke with them, their unemployed daughter and her boyfriend were living in their basement, neither contributing financially nor lifting a finger around the house. What began as a temporary bandage had become a permanent crutch. Our friends love their grandchildren; however, they’ve become bitter.

Jo and I also know of retirees who make their adult children’s car payments. I’m not talking about college-age kids; some of these “children” are close to 50. What’s their justification? “If we don’t make the payments, they won’t be able to go to work.” What I can’t grasp is how these adult children have iPads and iPhones, go on vacations, and do other cool things, but can’t seem to make their car payments.

You are not the family bank. There is generally a brief window of opportunity between children leaving the nest and retirement. Use it to stash away enough money to retire comfortably!

Ignore your health. I served on the reunion committee for my 50^th high school class reunion. We diligently tried to track down our classmates, but many had not lived long enough to RSVP to the party. The number of deaths from lung cancer and liver cancer were shocking. Many of those six feet under had been morbidly obese or simply never went to the doctor for checkups.

I know this sounds obvious, but your health choices really do affect how long and how well you live. Retiring only to become homebound because of health problems won’t be much fun.

Not keeping your retirement plan up to date. In the summer of 2013, the Employee Benefit Research Institute (EBRI) published a survey about low-interest-rate policies and their impact on both baby boomers and Generation Xers, who are following right behind. The bottom line (emphasis mine):

“Overall, 25-27 percent of baby boomers and Gen Xers who would have had adequate retirement income under return assumptions based on historical averages are simulated to end up running short of money in retirement if today’s historically low interest rates are assumed to be a permanent condition, assuming retirement income/wealth covers 100 percent of simulated retirement expense.”

It is a sad day when people who thought they’d saved enough realize they have not. Run your personal retirement projection annually to make sure you’re keeping up with the times. Otherwise you may have to work longer or step down your retirement lifestyle—drastically.

Thinking you can continue working as long as you wish. While age discrimination is illegal, you may not be able to work forever. If illness doesn’t push you out the door, your employer might downsize (we all know who goes first) or buy you out with a lucrative lump sum.

Many companies want older employees off the payroll because their healthcare costs are high; plus, they are often at the top of the salary scale. More than one employer has made the workplace so uncomfortable that an older employee felt he had to quit. Other employers will systematically build a case to terminate a senior employee with their legal team waiting in the wings to help.

Whatever the reason, you may have to stop working even if you enjoy your job, so plan for it.

Not increasing your rate of saving. A surefire way to end up short is to pay off a large-ticket item like your home mortgage and then continue spending that money every month. Start paying yourself instead! Don’t prioritize saving after it’s too late to benefit from years of compounded interest.

Continually taking equity out of your home. Too many of my friends have been duped into taking out additional equity when refinancing with a lower-interest mortgage. If you can secure a lower rate, use it to pay off your home off faster. When you have, start making those payments to your retirement account.

Retire with a substantial mortgage. The general rule of thumb is your mortgage payment should be no more than 20-25% of your income. If you retire and still have a mortgage, it might be tough to stay within those guidelines.

Taking out a reverse mortgage at a young age. Debt-laden baby boomers are taking out reverse mortgages at an increasingly younger age. Just read the HUD reports. Many have very little equity to begin with and use a reverse mortgage to stop their monthly bank payments for pennies in return.

Locking yourself into a fixed income at a young age is a great way to kiss your lifestyle goodbye. Many of these young boomers will find themselves wondering, “Why is there is so much life left at the end of my money?”

Putting your life savings into an annuity. While annuities have their place in a retirement portfolio, going all in is dangerous, particularly at a young age. After all, your monthly payment depends in part on your age.

I know folks who put their entire life savings into variable annuities. They thought they were buying a “pension plan” and would never have to worry again. The crash of 2008 slashed their monthly checks, and they have yet to recover. Retirement without worry is not that simple.

Thinking your employer’s retirement plan is all you need. The era of pensions is gasping its dying breath. We have many friends who retired from the airlines with sizable pensions. When those airlines filed for bankruptcy, their pensions shriveled. No industry is immune to this danger, so we all need a backup plan.

Government pensions are following suit. Just ask anyone who has worked for the city of Detroit! While the unions are fighting the city to preserve their pensions, an initial draft of the plan indicates underfunded pensions (estimated at $3.5 billion) may receive $0.25 on the dollar.

Don’t fall for the trap! If you work for the government, you still need to save for retirement. Contribute to your 457 plan or whatever breed of retirement account is available to you. The federal government has over $100 trillion in unfunded promises, and many state governments are woefully underfunded. That doesn’t mean your retirement has to be.

Reverse mortgages and annuities are often the undoing of many income investors and retirees. They can be used properly, however, if your situation or the opportunity fits with your needs. With all of the misinformation out there about these two products, we decided to pen two special reports to help you decide whether these are right for you. They are The Reverse Mortgage Guide and The Annuity Guide. Check out one – or both – today and learn where, if at all, these fit your needs.

The article 10 Ways to Screw up Your Retirement was originally published at Millers Money

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What are Business Development Companies?

By Andrey Dashkov

Business Development Companies (BDCs) are publicly traded private debt and equity funds. I know that description isn’t terribly sexy, but keep reading and you’ll find there’s a lot to be excited about.


BDCs provide financing to firms too small to seek traditional bank financing or to do an IPO, but at the same time are too advanced to interest the earliest-stage venture capitalist. These companies are often near or at profitability and just need extra cash to reach the next milestone. Filling this void, BDCs provide funds to target companies in exchange for interest payments and/or an equity stake.

BDCs earn their living by lending at interest rates higher than those at which they borrow. Conceptually, they act like banks or bond funds, but with access to yields unlike any you’ll see from a traditional bond fund. The interest rate spread—meaning the difference between their capital costs and interest they charge their clients—is a major component of their business.

Oftentimes, a BDC will increase its dividend when market interest rates have not changed. Like a bank, the more loans it has in force, the more it profits. Increasing its dividend payout will generally have a very positive effect on its share price.

Unlike banks or many other traditional financial institutions, however, BDCs are structured to pay out more than 90% of their net profits to the shareholders. In return, BDCs don’t pay any income tax. In essence, their profits flow through to the owners. Many investors like to own BDCs in an IRA to create tax deferred or tax free income. The opportunity to use them for tax planning purposes, access to diversified early stage financing, and the impressive dividend yields they deliver make them a perfect fit for the Bulletproof Income strategy we employ at Miller's Money Forever.

The Clients

 

As a business model, BDCs emerged in response to a particular need: early-stage companies needed funding but couldn’t do it publicly due to their small size. At the same time, these companies didn’t match the investment criteria of so-called angel investors or venture capital providers. Enter the Business Development Company.

BDC teams, through expertise and connections, select the most promising companies in their fields and provide funds in return for a debt or equity stake, expecting gains from a potential acquisition scenario and a flow of interest payments in the meantime. The ability to selectively lend money to the right startup companies is paramount. It makes little difference how much interest they charge if the client defaults on the loan.

With limited financing options, BDCs’ clients may incur strict terms regarding their debt arrangements. The debt often comes with a high interest rate, has senior level status, and is often accompanied by deal sweeteners like warrants which add to the upside potential for those with a stake in the borrowing company.

In return for these stringent terms, the borrower can use the funds to:

•  Increase its cash reserve for added security;

•  Accelerate product development;

•  Hire staff and purchase licenses necessary to advance R&D, etc.

•  Invest in property, plant, and equipment to produce its product and bring it to market.

Turning to a BDC for funds allows a company to finance its development and minimize dilution of equity investors while reaching key value adding milestones in the process.

What’s in It for Investors?

 

In addition to the unique opportunity to access early-stage financing, we like BDCs for their dividend policy and high yield. The Investment Act of 1940 requires vehicles such as BDCs to pay out a minimum of 90% of their earnings. In practice, they tend to pay out more than that, plus their short term capital gains.

This often results in a high yield. Yields of 7-12% are common, which makes this vehicle unique in today’s low yield environment. The risk is minimized by diversification—like a good bond fund, they spread their assets over many sectors. This rational approach and the resulting income make the right BDC(s) a great addition to our Bulletproof Income strategy.

BDCs and the Bulletproof Income Strategy

 

In short, BDCs serve our strategy by:

• Providing inflation protection in the form of high yields and dividend growth;

• Limiting our exposure to interest rate risk, thereby adding a level of security (some BDCs borrow funds at variable rates, but not the ones we like);

• Maintaining low leverage, which BDCs are legally required to do;

• Distributing the vast majority of their income to shareholders, thereby creating an immediate link between the company’s operating success and the shareholders’ wellbeing… in other words, to keep their shareholders happy, BDCs have to perform well.

How Should You Pick a BDC?

 

Not every BDC out there qualifies as a sound investment. Here’s a list of qualities that make a BDC attractive.

• Dividend distributions come from earnings. This may sound like common sense, but it’s worth reiterating. A successful BDC should generate enough quarterly income to pay off its dividend obligations. If it doesn’t, it will have to go to the market for funds and either issue equity or borrow, or deplete cash reserves it would otherwise use to fund future investments. An equity issuance would result in share dilution; debt would increase leverage with no imminent potential to generate gains; and a lower cash reserve is no good either. We prefer stocks that balance their commitments to the shareholders with a long term growth strategy.

• The dividends are growing. This is another characteristic of a solid income pick, BDC or otherwise. Ideally, the dividend growth would outpace inflation, in addition to the yield itself being higher than the official CPI numbers. This growth can come from increasing the interest rate spread and also having more loans on the books.

• Yields should be realistic. We’d be cautious about a BDC that pays more than 12% of its income in dividends. Remember, gains come from the interest it receives from the borrowers. Higher interest indicates higher risk debt on a BDC’s balance sheet, which should be monitored regularly.

• Fixed-rate liabilities are preferred. We need our BDC to be able to cover its obligations if interest rates rise. Fixed rates are more predictable than floating rates; we like the more conservative approach.

• Their betas should be (way) below 1. We don’t want our investment to move together with the broad market or be too interest-rate sensitive. Keeping our betas as low as possible provides additional opportunities to reduce risk, which is a critical part of our strategy.

• They are diversified across many sectors. A BDC that has 100 tech companies in its portfolio is not as well diversified as a one with 50 firms scattered across a dozen sectors, including aerospace, defense, packaging, pharmaceuticals, and others. Review a company’s SEC filings to see how many baskets its eggs are in.

Wrap up......

 

Right now, BDCs look very interesting to income-seeking investors. They provide excellent yields, diversification opportunities, and access to early-stage companies that previously only institutions enjoyed. They also fit in with Miller Money Forever's Bulletproof Income strategy, the purpose of which is to provide seniors and savers with real returns, while offering maximum safety and diversification.

Catching a peek our Bulletproof portfolio is risk-free if you try today. Access it now by subscribing to Miller's Money Forever, with a 90-day money-back guarantee. If you don't like it, simply return the subscription within those first three months and we'll refund your payment, no questions asked. And the knowledge you gain in those months will be yours to keep forever.


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The Unintended Consequences of ZIRP

By John Mauldin

Yellen's coronation was this week. Art Cashin mused that it was a wonder some senator did not bring her a corsage: it was that type of confirmation hearing. There were a few interesting questions and answers, but by and large we heard what we already knew. And what we know is that monetary policy is going to be aggressively biased to the easy side for years, or at least that is the current plan. Far more revealing than the testimony we heard on Thursday were the two very important papers that were released last week by the two most senior and respected Federal Reserve staff economists. As Jan Hatzius at Goldman Sachs reasoned, it is not credible to believe that these papers and the thinking that went into them were not broadly approved by both Ben Bernanke and Janet Yellen.

Essentially the papers make an intellectual and theoretical case for an extended period of very low interest rates and, in combination with other papers from both inside and outside the Fed from heavyweight economists, make a strong case for beginning to taper sooner rather than later, but for accompanying that tapering with a commitment to an even more protracted period of ZIRP (zero interest rate policy). In this week's letter we are going analyze these papers, as they are critical to understanding the future direction of Federal Reserve policy. Secondly, we'll look at what I think may be some of the unintended consequences of long-term ZIRP.

We are going to start with an analysis by Gavyn Davies of the Financial Times. He writes on macroeconomics and is one of the more of the astute observers I read. I commend his work to you. Today, rather than summarize his analysis, I feel it is more appropriate to simply quote parts of it. (I will intersperse comments, unindented.) The entire piece can be found here.

While the markets have become obsessively focused on the date at which the Fed will start to taper its asset purchases, the Fed itself, in the shape of its senior economics staff, has been thinking deeply about what the stance of monetary policy should be after tapering has ended. This is reflected in two papers to be presented to the annual IMF research conference this week by William English and David Wilcox, who have been described as two of the most important macro-economists working for the FOMC at present. At the very least, these papers warn us what the FOMC will be hearing from their staff economists in forthcoming meetings.

The English paper extends the conclusions of Janet Yellen's "optimal control speeches" in 2012, which argued for pre-committing to keep short rates "lower-for-longer" than standard monetary rules would imply. The Wilcox paper dives into the murky waters of "endogenous supply", whereby the Fed needs to act aggressively to prevent temporary damage to US supply potential from becoming permanent. The overall message implicitly seems to accept that tapering will happen broadly on schedule, but this is offset by super-dovishness on the forward path for short rates.

The papers are long and complex, and deserve to be read in full by anyone seriously interested in the Fed's thought processes. They are, of course, full of caveats and they acknowledge that huge uncertainties are involved. But they seem to point to three main conclusions that are very important for investors.

1. They have moved on from the tapering decision.

Both papers give a few nods in the direction of the tapering debate, but they are written with the unspoken assumption that the expansion of the balance sheet is no longer the main issue. I think we can conclude from this that they believe with a fairly high degree of certainty that the start and end dates for tapering will not be altered by more than a few months either way, and that the end point for the total size of the balance sheet is therefore also known fairly accurately. From now on, the key decision from their point of view is how long to delay the initial hike in short rates, and exactly how the central bank should pre-commit on this question. By omission, the details of tapering are revealed to be secondary.

Yellen said as much in her testimony. In response to a question about QE, she said, "I would agree that this program [QE] cannot continue forever, that there are costs and risks associated with the program."
The Fed have painted themselves into a corner of their own creation. They are clearly very concerned about the stock market reaction even to the mere announcement of the onset of tapering. But they also know they cannot continue buying $85 billion of assets every month. Their balance sheet is already at $4 trillion and at the current pace will expand by $1 trillion a year. Although I can find no research that establishes a theoretical limit, I do believe the Fed does not want to find that limit by running into a wall. Further, it now appears that they recognize that QE is of limited effectiveness with market valuations where they are, and so for practical purposes they need to begin to withdraw QE.

But rather than let the market deal with the prospect of an end to an easy monetary policy (which everyone recognizes has to draw to an end at some point), they are now looking at ways to maintain the illusion of the power of the Federal Reserve. And they are right to be concerned about the market reaction, as was pointed out in a recent note from Ray Dalio and Bridgewater, as analyzed by Zero Hedge:

"The Fed's real dilemma is that its policy is creating a financial market bubble  that is large relative to the pickup in the economy that it is producing," Bridgewater notes, as the relationship between US equity markets and the Fed's balance sheet (here and here for example) and "disconcerting disconnects" (here and here) indicate how the Fed is "trapped." However, as the incoming Yellen faces up to her "tough" decisions to taper or not, Ray Dalio's team is concerned about something else – "We're not worried about whether the Fed is going to hit or release the gas pedal, we're worried about whether there's much gas left in the tank and what will happen if there isn't."

Dalio then outlines their dilemma neatly. "…The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed. So the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions."

The new ideas that Bridgewater and everyone else are looking for are in the papers we are examining. Returning to Davies work (emphasis below is mine!):

2. They think that "optimal" monetary policy is very dovish indeed on the path for rates.

Both papers conduct optimal control exercises of the Yellen-type. These involve using macro-economic models to derive the path for forward short rates that optimise the behaviour of inflation and unemployment in coming years. The message is familiar: the Fed should pre-commit today to keep short rates at zero for a much longer period than would be implied by normal Taylor Rules, even though inflation would temporarily exceed 2 per cent, and unemployment would drop below the structural rate. This induces the economy to recover more quickly now, since real expected short rates are reduced.

Compared to previously published simulations, the new ones in the English paper are even more dovish. They imply that the first hike in short rates should be in 2017, a year later than before. More interestingly, they experiment with various thresholds that could be used to persuade the markets that the Fed really, really will keep short rates at zero, even if the economy recovers and inflation exceeds target. They conclude that the best way of doing this may be to set an unemployment threshold at 5.5 per cent, which is 1 per cent lower than the threshold currently in place, since this would produce the best mix of inflation and unemployment in the next few years. Such a low unemployment threshold has not been contemplated in the market up to now.

3. They think aggressively easy monetary policy is needed to prevent permanent supply side deterioration.

This theme has been mentioned briefly in previous Bernanke speeches, but the Wilcox paper elevates it to center stage. The paper concludes that the level of potential output has been reduced by about 7 per cent in recent years, largely because the rate of productivity growth has fallen sharply. In normal circumstances, this would carry a hawkish message for monetary policy, because it significantly reduces the amount of spare capacity available in the economy in the near term.

However, the key is that Wilcox thinks that much of the loss in productive potential has been caused by (or is "endogenous to") the weakness in demand. For example, the paper says that the low levels of capital investment would be reversed if demand were to recover more rapidly, as would part of the decline in the labour participation rate. In a reversal of Say's Law, and also a reversal of most US macro-economic thinking since Friedman, demand creates its own supply.

This concept is key to understanding current economic thinking. The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! But current policy apparently fails to grasp that the problem is not the lack of consumption: it is the lack of income. Income is produced by productivity. When leverage increases productivity, that is good; but when it is used simply to purchase goods for current consumption, it merely brings future consumption forward. Debt incurred and spent today is future consumption denied. Back to Davies:

This new belief in endogenous supply clearly reinforces the "lower for longer" case on short rates, since aggressively easy monetary policy would be more likely to lead to permanent gains in real output, with only temporary costs in higher inflation. Whether or not any of this analysis turns out to be justified in the long run, it is surely important that it is now being argued so strongly in an important piece of Fed research. 

            Read that last sentence again. It makes no difference whether you and I might disagree with their analysis. They are at the helm, and unless something truly unexpected happens, we are going to get Fed assurances of low interest rates for a very long time. Davies concludes:

The implication of these papers is that these Fed economists have largely accepted in their own minds that tapering will take place sometime fairly soon, but that they simultaneously believe that rates should be held at zero until (say) 2017. They will clearly have a problem in convincing markets of this. After the events of the summer, bond traders have drawn the conclusion that tapering is a robust signal that higher interest rates are on the way. The FOMC will need to work very hard indeed to convince the markets, through its new thresholds and public pronouncements, that tapering and forward short rates really do need to be divorced this time. It could be a long struggle.

On a side note, we are beginning to see calls from certain circles to think about also reducing the rate the Fed pays on the reserves held at the Fed from the current 25 basis points as a way to encourage banks to put that money to work, although where exactly they put it to work is not part of the concern. Just do something with it. That is a development we will need to watch.

The Unintended Consequences of ZIRP

Off the top of my head I can come up with four ways that the proposed extension of ZIRP can have consequences other than those outlined in the papers. We will look briefly at each of them, although they each deserve their own letter.

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