A long wave expert shares his “big picture” outlook

David Knox Barker is
one of the leading authorities on the economic long wave, otherwise known as the
Kondratieff Wave (a.k.a. “K Wave”). Barker has had an impressive career both as
a financial market writer and long wave analyst, as well as being an
entrepreneur in the emerging field of nanotechnology.

Back in the late
1980s and ‘90s, Barker was known for his insightful and accurate views on the
U.S. economy and financial markets via his K Wave Report newsletter. Today he
shares his views on the global financial market and economic outlook through his
Long Wave Dynamics Letter.

Barker recently shares with me his thoughts on
what he sees ahead for the United States and the emerging markets in terms of
the inflation/deflation scenario. He also discussed the debt crisis, China, and
the oil price outlook among other topics of interest. What follows is the
transcript of that interview.

Q: David, where are we in the
inflation/deflationary cycle? Do you still expect a heavy amount of deflation
between now and the anticipated long-wave bottom in 2012?

Barker: Yes.
I’m still in the deflationary camp. [The cycle] might be extended out later than
2012 based on quantitative easing and government stimulus expanding. I’m really
looking for a bottom in the long wave in 2013 based on what has been done in the
way of government stimulus since last year. If you look at $600 billion in
quantitative easing, in the long run I don’t think it does anything but in the
short run it juices the cycle. Actually, in the long run the quantitative easing
makes the deflation worse than it would normally be.

Q: How
so?

Barker: There’s a big difference in quantitative easing and printing
money. With quantitative easing there’s always an offsetting debt created.
Ultimately if you’re a large tax paying individual or corporation you know that
ultimately someone has to pay that debt, and it will likely be you. So it does
have a dampening effect on the economy.

There’s another aspect to
quantitative easing that I don’t think Bernanke appreciates and that’s that he’s
feeding deflation by keeping operators and manufacturers in businesses who
probably should be taken out of business, which would provide pricing power for
manufacturers of any goods and services. But by keeping the weaker operators in
business it ultimately has a deflationary effect.

Q: Lately we’ve been
hearing the financial press repeat the mantra “higher taxes are needed” to get
the U.S. out of its fiscal mess. Would raising taxes in a recession be bad
economic policy in your view?

Barker: Raising taxes in the long wave is
an absolute disaster. Maybe if this was going on in the early 1990s you could
make that case. We’ve tried spending and taxing and it’s not working. The only
way to get out of this is a lower corporate tax rate. I’m in favor of a fair tax
but I realize that’s unlikely to occur. The next best thing would be radically
reducing the corporate tax rate to stimulate job growth and business investment.
You’re simply not going to get it without tax rate reduction.

The irony
here is that the media focuses on people paying their faire share but my
argument for a lower corporate tax rate is not because I want to be kind to the
corporations. I want to be kind to the employees. The only thing that a higher
corporate tax gives you is higher prices and lower wages. At some point we’re
actually going to have a politician that can articulate that. It’s not that
complicated to figure out that if you raise taxes on corporations they pay their
employees less and they charge more for their products.

Q: In your
latest Long Wave Dynamics Letter you wrote, “There comes a point with debt where
it reaches diminishing returns, and the developed world reached that point some
time ago.” Would this explain why the Fed’s frantic efforts at providing
liquidity have failed to revitalize the economy?

Barker: Correct. We’re
overproducing everything and we’re doing it with extensive debt. The whole point
of QE [quantitative easing] was ostensibly to create more borrowing and business
activity. We’re overproducing everything we need right now from services to
manufacturing. What we need is whole new industries which come with long wave
innovation and lower taxes. But the stimulus simply isn’t working and the old
phrase “pushing on a string” applies here. The hedge funds want to borrow that
money to buy commodities. The banks are taking that money that’s created and
they’re buying Treasuries. They’re not creating economic activity and true
sustainable growth.

I think Bernanke believes in what he’s trying to do
but it just simply is not working. He doesn’t understanding what’s happening. He
was testifying before Congress recently and he basically said, “I don’t
understand what’s going on with the economy.” What he doesn’t understand is long
wave theory. He doesn’t understand that he’s pushing on a string and that what
we need is to get rid of debt and we need some austerity. The notion that we can
get through this economic problem without some pain is foolish; we need a
painful adjustment to get us on the other side of this.

That being said,
the positive aspect to this is the emerging markets. When you look at the whole
inflation/deflation argument you can see that the developed world is basically
deflation. The emerging markets with the growth of the middle class and the
demand for goods and services there is an offsetting inflationary pressure on
the global system.

Q: You also recently discussed the possibility of a
“soft landing” of the current long wave. In your view, what are the odds for
this and what is required, politically speaking, to engineer a soft
landing?

Barker: If you give me a 15 percent corporate tax rate and you
actually see some real spending, I think you could actually engineer a soft long
wave [bottom]. It would be painful for certain entities. The problem we have is
the large multinational corporations have favorable tax rates because of their
political clout. But the small entities are paying much higher tax rates. For
instance, I’m a large investor in a small entity and I pay a 40 percent tax rate
whereas the big guys aren’t paying that. The small guys can’t afford to pay to
get the exemptions in the tax code. It’s a criminal situation, basically.

I would support Obama if he would reduce the corporate tax rate to 15
percent I’d say abolishall loopholes. Why should a little company that’s
struggling and that has 10, 50 or 100 employees pay a 40 percent tax rate while
the guys are paying nothing? So bring the corporate tax rate down and abolish
all loopholes and I think you’d create a massive inflow of trillions of dollars
into the United States. And you’d trigger all sorts of investment and ideas and
creativity in the system and you would create a boom. And you would end up with
a lot more tax revenues.

Q: Have we seen the end of the credit crisis or
will the process of debt hemorrhaging and deleveraging continue? In other words,
was the 2008 crisis a proverbial “shot across the bow” or was it a one-time
situation?

Barker: It was a shot across the bow. I think there’s a
bigger credit crisis coming. Most of your big U.S. banks are insolvent. We don’t
have a liquidity problem, we have a solvency problem. The Fed can liquify the
system but they cannot create solvency.

Q: Can you explicate on
that?

Barker: By dropping interest rates to zero it’s basically a massive
hidden tax on prudent savers in this country that’s going to the big banks. The
bailout is a lot bigger than people realize. Grandmother Barker is getting zero
percent on her savings. The big banks are paying her zero percent and they’re
loaning to the government at whether it’s a three percent 10-year [bond] or with
a blended rate and then they’re pocketing the difference.

There’s a
massive bailout going on that people aren’t talking about and it’s destroying
demand in the economy. Interest rates would be low anyway, they just wouldn’t be
quite as low and you wouldn’t have the spread that the big banks are picking up.
And that’s how the Fed is liquefying the stem. They’re creating the income there
plus the income for the big banks. Their whole objective is liquidity, not
solvency. They’re hoping the liquidity will solve the solvency problem but as
home prices and commercial real estate prices tick lower the solvency problem is
getting bigger. So at some point the solvency problem will overtake the
liquidity that the Fed is pumping into the system, and that’s when the next leg
of the crisis and deflation hits.

Q: You’ve stated that the only way out
of the global financial mess is austerity. Could you expand on that
statement?

Barker: We’ve all spent beyond our means. We have to pull in
our horns here and we’ve got to focus on capital formation and savings and
investment. You can’t solve a debt problem with more debt. It’s ludicrous.

Q: What are the odds of a third quantitative easing (QE3) and if it’s
coming, when do you see it coming?

Barker: I hope it’s not coming. If the
credit crisis takes another big leg down and we see deflation in the system I
have to believe that Bernanke will be permitted to do additional quantitative
easing. I don’t think it’s politically viable that QE3 can stop the deflation
that’s coming, though. The amount of [quantitative easing] that would be
required to stop the next leg of the credit crisis would create some political
issues for the Fed.

Q: Bill Gross of PIMCO recently made headlines for
his bearish outlook on U.S. government bonds. Does your reading of the long wave
tell you that Mr. Gross is mistaken in shorting long-term bonds? Also, what is
the general outlook for bonds in view of where we are in the long
wave?

Barker: Mr. Gross is a lot smarter than I am but he obviously
missed this call; bonds are still rallying and interest rates are falling. I
think this is the long wave weakness out there. He’s going to be right longer
term but I think between now and 2013 the long bond is going to rally. I think
the U.S. is going to figure out its debt issues and we’re going to address them.
That’s part of why I believe the long bond is going to continue to rally. In the
developed world it’s a debt problem and a deflation problem. That means your
German, your Swiss and your U.S. bonds are going to rally in price and interest
rates are going to come down even lower because there’s going to be even less
demand in the system as the credit crisis accelerates.

Q: Where do you
see the next trouble spot occurring in terms of the next global crisis? Will it
be here or abroad?

Baker: You could conceivably fix up the debt problem
for another year and just kick the can down the road. China has to be at the top
of the list in terms of the big problems that can happen. If China’s economy
gets weaker as this long wave bottoms out into 2013, and I think it will, then
that could be the next crisis. Or it could be a big U.S. bank that gets in
trouble. I wouldn’t name any of them specifically but there’s a few of them
where you have to wonder if the feds can address the bank solvency issue.

Q: What in particular do you see as the major stumbling blocks for China
in the next 1-2 years ahead? Will they suffer a major recession or depression
before the next long-wave spring season begins?

Barker: They’ve been
doing far more stimulus than the U.S. has. You think we’ve been doing QE, China
has done even more. It’s not specifically QE but rather aggressive fiscal and
monetary policies. They have a significant housing bubble on their hands just
like we did in 2006 that could potentially do some serious damage to the Chinese
economy. Plus their economy is still built on exports to the rest of the world
and as the U.S. consumer continues to pull in [spending] it will effect the
Chinese economy.

Longer term I’ve very bullish on the emerging markets
and about the size and scale of the middle class coming into the political
system. I think it’s going to be phenomenal. It’s just that the developed
world’s debt crisis we have to get over between here and there.

Q: In
your view does China need to shake off its Communist government before achieving
true national and international greatness?

Barker: Absolutely. It’s
going to take a while but they need to shift towards a more Republican form of
government. Remember, the U.S. wasn’t form as a democracy but as a republic.
Then hopefully China goes the direction of a republic as opposed to a democracy.
It’s ridiculous when you think about it. They’ve got a communist government
running a central bank. People here complain about the Fed but [China] is
juicing its financial system like crazy. They put out all these mandates about
growth and they don’t care how you get there. The China story is real, don’t get
me wrong, and China’s economic boom is real. And sure, the communist model that
they’ve created could still be productive – it’s really more a type of fascism
or dictatorial system. Yet it has to convert to a freer society, and I think it
will, but I don’t think we need to push it. That’s their internal issue. And I
think they will slowly convert to a non-communist system.

Q: Let’s talk
about the U.S. government’s recent oil release from the strategic petroleum
reserve. Was this another attempt to juice the economy or do you think there was
another motive for this?

Barker: My reading is that there’s panic going
on in high places. They’re asking, “Why is the economy still weak?” And of
course they’re seeing that high oil prices are affecting the American consumer,
so they had to get oil prices down. So it was definitely an attempt to boost the
economy. I don’t think that anything that happens in Washington is political,
per se. I think they’re really just trying to get the economy going. It’s a sign
of panic because at this stage they thought they would see growth and
improvement and so they’re scrambling to see what they can do to generate
growth.

Trying to drop oil prices is obviously at attempt at generating
growth but it’s kind of silly because we’ve got a strategic petroleum reserve
for a reason and that oil has to be added back in there. So you’re just taking
from the future. They’re going to have to purchase from the future to put it
back in there. It’s just an attempt to stimulate the economy.

Q: I know
you’re a big believer in Fibonacci analysis as applied to not only cycle
forecasting but also to market trading. You recently created a new software
product called Market Cycle Dynamics (MCD), which you say is unique to any other
trading system because of its Fibonacci applications. What can you tell us about
it?

Barker: My whole approach to technical analysis is price, time and
sentiment. And I believe that Fibonacci is the pricing mechanism of markets. And
it’s simply a tool that allows you to more quickly uncover where a turn is
happening in a market, either on a short-term basis or on a long-term basis.
There are a number of innovative things about the software but one of the main
things is the Fibonacci drill down grid, where you can get down to a daily basis
and see what’s happening in the market. “Quant X-ray” is what I call it. You’ve
got the quantitative analysts out there writing the code for the computer
programs that their using for the high frequency trading. And invariably they’re
using Fibonacci ratios in their algorithms.

For the first time I think
Market Cycle Dynamics allows you to drill down and see where those turns are
being triggered. And that’s relevant whether you’re a long-term investor or a
short-term trader to see where those programs are going to kick in and either
trigger selling or trigger buying. And MCD acts as an X-ray to the market to see
where those grid structures are. It will startle people to see a level three or
level four Fibonacci grid on an intraday basis where you see the market ticking
and reversing on these grids.

So you use price, which is Fibonacci, and then you use time, or the cycle
approach, and you use sentiment and for that I use stochastics. And you just use
this to find when you could have a market turn occurring. The MCD software,
which runs with MetaStock, combines all three of these elements.

Q: For
the benefit of those unfamiliar with Fibonacci, could you give us a brief
overview of how it’s important for understanding market turning
points?

Barker: I believe that Fibonacci is the pricing mechanism of
markets. When you look at a decent presentation of Fibonacci grids you realize
that where the market turns, big turns, are typically at Fibonacci key points in
the market. The Italian mathematician Fibonacci discovered the Fibonacci
[numerical] sequence and Fibonacci ratios are a function of those sequences.
What they’ve discovered is that Fibonacci appears in all natural forms of
growth, whether it’s pine cones or sea shells or the ocean or the galaxies. We
find that Fibonacci is in all natural systems of growth and decay, and it
governs growth and decay in natural systems. I believe markets are a natural
system of growth and decay and when you use Fibonacci correctly it picks up the
market’s turns.

Note: More information on the Market Cycle Dynamics
software is available at http://www.longwavedynamics.com

Q: What’s your take on the recent stock market rally?

Barker: It
looks like we got the turn of an important Wall Cycle. It’s a phenomenal rally,
which makes you wonder what’s going on out there. But long term it doesn’t
change anything. Short term, I think it’s a function of all the liquidity in the
system.

Q: How long can the feds keep the economy at its current level
before deflation makes its presence known again?

Barker: I think we’re in
a window where the deflationary pressures are overwhelming. I know everyone is
concerned about inflation but if you look at it, Bernanke is actually correct to
be scared of deflation. He knows what he’s talking about and the deflationary
pressures are just phenomenal. It can overwhelm any efforts to kick the debt
time down the road.

With my whole cycle approach the most important
cycle is the business cycle, which I think ideally runs 42 months short or long.
The effect of this quantitative easing and lower interest rates just makes the
cycles run a little bit longer but it actually is leading us toward chaos.
Markets are complex systems and central bank intervention messes with that
system and fiscal policy messes with that system. They can make the cycles run
longer but they can’t stop the cycles. When they do make it run longer they have
a tendency to push the system toward chaos, not toward order.

You have
bifurcation in cycles sometimes. I think the 2002 to 2009 period was a doubling
bifurcation within in a cycle. Anyone who understands complex systems
understands that the doubling effect in a system leads to chaos, whereas halving
bifurcation leads to order. I believe that basically all the intervention is
creating a system that leans toward chaos. But it will be resolved and we will
eventually move into the next advance. I think we’re on the cusp of a major
global boom, it’s just the disasters related to the debt bubble we have to get
past. I don’t think the political will is there to sufficiently juice the system
to get past the deflation. So I think we’re going to have resolution to the
crisis between 2012 and 2013 where we do have a deflationary crack and a real
debt bust crisis but then we’re able to move on to the other side.

Clif
Droke is the editor of the three times weekly Momentum Strategies Report
newsletter, published since 1997, which covers U.S. equity markets and various
stock sectors, natural resources, money supply and bank credit trends, the
dollar and the U.S. economy. The forecasts are made using a unique proprietary
blend of analytical methods involving cycles, internal momentum and moving
average systems, as well as investor sentiment. He is also the author of
numerous books, including “The Stock Market Cycles.” For more information visit http://www.clifdroke.com