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A Look At This Week’s Show:
- We have not had true capitalism for 100 years
- The new economy: Expand credit or die
- Debt: From 1 trillion to 50 trillion in 5 decades
About the Author: Since beginning his career as an equities analyst in Hong Kong in 1986, Richard has served as global head of investment strategy at ABN AMRO Asset Management in London, worked as a financial sector specialist for the World Bank in Washington D.C., and headed equity research departments for James Capel Securities and Salomon Brothers in Bangkok. He also worked as a consultant for the IMF in Thailand during the Asia Crisis. He is now chief economist at Blackhorse Asset Management in Singapore. Click here to purchase: The New Depression
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, today our guest is Richard Duncan. We have had him on before. He is a fascinating guy. As far as analyzing the problem in the economy, I don’t know that we have interviewed a better author as far as the analysis goes.
David: Frankly, both the problem and the solutions offered are very intriguing, because as he notes in The New Depression, the Breakdown of the Paper Money Economy, there are a number of things that have changed over the last hundred years. We have moved from a gold currency standard to a fiat currency standard. But more subtly, there has been a shift away from just simply fiat money to a massive expansion of credit instruments, and in fact, he argues in the book that we have moved to a situation that is hyperinflationary, in terms of our credit expansion. The only thing that masks that hyperinflation is one key component – globalization – and a tremendous drop in labor rates.
Kevin: Whenever I read Richard Duncan, especially his latest book, The New Depression, I have to admit, it is hard to fight depression because what he is basically saying is that it is a little like sitting down with a terminal disease doctor, who is saying, “Now listen, you already have the disease,” and Richard Duncan would say the cancer that we have is actually this new “creditism” instead of capitalism. Now, this can be very controversial, and we will just warn the listener right off the bat that Richard is saying, “Now that you are going to die, how long do you want to extend that life, and if we take radical procedures that are not what we started with, maybe we can survive this thing.”
David: Very specifically, if you look at a drug addiction, Kevin, there are hard drugs which are actually difficult to break the addiction to, but possible. If you are addicted to alcohol, on the other hand, trying to break that addiction can kill you. That is the interesting relationship we have with credit. He looks at the quantity theory of money which was put forth by the great monetarists at the Chicago School and he says that actually we have shifted from the quantity theory of money to the quantity theory of credit.
Kevin: In other words, how much credit can we take out so that we can grow? No longer does it depend on money, like it used to.
David: He does a great job looking at what happened with Quantitative Easing I, Quantitative Easing II, specifically the policy responses put in place by the Federal Reserve. He compares and contrasts our future policy options, what was past tense possible with capitalism, sort of the Laissez Faire model, and what we have adopted, and I think he is right to point out, we left behind capitalism a hundred years ago.
Kevin: We have talked about that before, David. 1914 was a critical date for all of us, even though we weren’t alive at the time.
David: I think this is a healthy thing for all the Occupy Wall Street folks to acknowledge, to recognize, or at least to be taught, and it certainly may not be reminded because I’m not sure they were aware of this particular nuance, that what they are objecting to, what they are angry about – “capitalism” – is not capitalism.
Kevin: It’s cronyism.
David: It certainly is. And what they don’t know is that they are asking for the government to “solve the problem” when in fact, and ironically, they are going to get exactly more of what they already have, which is the state running things, and running things on a very corrupt basis. Richard Duncan looks at the difference in his book, The New Depression, of the outcomes – hyperinflation, hyperdeflation, and the role that credit plays in the system. I think this is a very important book. I would encourage our listeners to look at it and analyze, re-appreciate the role of credit in the business cycle, because without an expansion of credit, you don’t have growth in the economy.
That goes back to one of the things that we left behind – credit expansion being vital to the business cycle, what used to be, in its place, not credit expansion, but capital accumulation. We see this great transition away from savings and investment toward consumption and borrowing in order to consume. In fact, we are seeing that same theory of credit being expanded into places like China, where capital accumulation is not the future growth model. The future growth model is, in fact, very similar to what we have had over the last hundred years, for the better, or for the worse – credit creation replacing capital accumulation.
Kevin: David, as we go to that interview, I must say that you often recommend books, and sometimes you say one of them is a must-read, and they are good books. A lot of them can be quite deep. A lot of them can be quite technical. Richard has a way of writing and telling you ahead of time what he is going to tell you. He tells you in the introduction what the chapters are going to do. He gives you great conclusions that are no more than about a paragraph or two long. If a person were to say, “Guys, a 2012 book, please, that tells me how we got here, and where we are probably going,” I think this is probably one of the best books to recommend.
David: On a number of occasions, we have spoken with Richard Duncan, and whether it was a book that he wrote many years ago about the dollar, and concerns that he had about the dollar, or his more recent book, The Corruption of Capitalism, which as an office we have read. Fifty-odd people, in-house, read and discussed the content in The Corruption of Capitalism. Now transition to something that he has been working on, his newest project, the title of his latest book. The New Depression, the Breakdown of the Paper Money Economy. We want to look at some of the themes there, because he highlights and contrasts the monetary system that we thought we had, with one that is actually far more important.
Let’s look at that. Looking back at the last hundred years, you would say that many things have changed in our monetary system. In fact, one of the gradual moves was away from gold, and that was initiated during the first several decades of the century with fiat money becoming more and more prevalent. We eventually emerged with a system that was not even recognizable, where money as we think of it, greenbacks, is actually far less important than the expansion of credit.
That will be one of our primary themes today, a change in what constitutes money. There is, along with this change in what constitutes money, a change in the U.S. business model. As you note, this is a radical shift away from savings and investment, and toward credit and consumption. Can you give us, in a nutshell, Richard, this move toward a credit-oriented money system?
Richard Duncan: Thank you for having me on the program again. The big change, I think, happened in 1968 when the U.S. changed its laws and no long required the Federal Reserve to back dollars with any gold, whatsoever. At that point, the nature of money changed. Up until then, we had been on a commodity-backed monetary system. In other words, gold backed up our money. Afterward, we moved to a pure fiat monetary system, or pure paper money system.
Afterward, the nature of money changed. Before, if you took a dollar bill to the Treasury Department, at least in theory, they were meant to give you some gold in exchange for that. Now, if you take a dollar bill to the Treasury, they will just give you another dollar bill. So, what is the difference now between a dollar bill and a ten-year treasury bond? They are essentially both credit instruments. In the past, there was a clear difference between money, which was gold, and credit. Now this difference is blurred, or perhaps there is no longer any difference. Money is credit. So the nature of money changed. That was the beginning of the big change in our economic system.
David: So money is now credit, and simply, perhaps one of the differences is that it is credit that does not pay interest. That is a helpful distinction for us because as we look back, we remember the riots of 1969 and we know Nixon changed the relationship between the dollar and gold, to the detriment of our foreign creditors, closing the window in 1971. You are suggesting 1968 was a critical date, and certainly the French were aware of what was happening, as we were degrading the value of the dollar, and you are saying that there were actually policy moves that were made, even before Nixon closed the gold window, that began suspending that relationship.
Richard: Yes, Nixon, in August of 1971, ended the Bretton Woods system by refusing any longer to allow other countries to exchange their dollars into U.S. gold. Before that, President Johnson, in 1968, had asked Congress to remove the requirement that the Fed maintain its gold backing for dollars. Up until that time the Fed was required to keep 25% gold backing for each dollar. Johnson made a speech to Congress, saying, “We don’t need to keep gold to tell us what our money is worth. We’ve moved beyond that.”
But oh how wrong he was. Once we broke the link between dollars and gold, everything began to change, and the most important thing that changed is that credit absolutely exploded. Debt and credit are really two sides of the same coin. Total debt in the United States, and by that I mean government debt, household sector debt, corporate debt, and financial sector debt – all debt – first went through 1 trillion dollars in 1964. Over the following 43 years, total debt expanded 50 times, to 50 trillion – from 1 trillion to 50 trillion in less than 50 years.
This explosion of debt completely created the world we live in. Our world was made out of that credit. We have all been much more prosperous than we would have been had we remained on a gold standard. This ushered in the age of globalization. It allowed Asia to pursue its very successful strategy of export-led growth and transformed China from a very third-world country into the China we know today.
This explosion of credit completely changed our world, and I would really suggest that it created a different kind of economic system, which I will discuss a little later, I hope. But in 2008 we hit the limit, it seems, for credit to expand any further, at least on the private sector side, because in 2008 the private sector effectively went bankrupt. It couldn’t repay its old debt and was cut off from any additional debt, and it was at that point that the New Depression, as I call it, began.
David: The new depression. We are approaching that period, or arguably, we are in it today. You are assuming that credit expansion is the hallmark of growth in a credit-dependent economy, and therefore, if credit is contracting, naturally, the economy is getting off the rails. You have just suggested that the private sector credit expansion ended in 2008, but perhaps there is something else that can fill the gap. My one concern would be, and maybe this harkens back to the title of your book, The Corruption of Capitalism. How do you avoid public sector debt expansion, and having that be legitimate in terms of going toward real needs and growth-oriented projects, as opposed to the crony capitalism that we have seen, where perhaps the debt expansion or the credit expansion is just to the “friends” of those in Washington, D.C.
Richard: Yes, well, a very good question. In Chapter 9 of the new book, The New Depression, I describe how our system evolved from Laissez Faire capitalism into this new system which I call creditism, for lack of a better word. I think the starting point for everyone in the United States, and what we all really need to understand, is that our economic system hasn’t been capitalism for decades. Laissez-faire capitalism died in World War I, when Europe went off the gold standard and when in all the European nations the government took over their economies to fight the war, followed by the U.S. jumping in and taking over the U.S. economy to fight World War I.
And then, not that long after, the U.S. government took over complete control of the economy again during World War II, controlling all aspects of production, prices, and distribution to fight the war, and effectively, the government has been spending between 20-25% of GDP every year since World War II, so we haven’t had capitalism now for going on a century. And that was the starting point. We don’t have capitalism.
To move to something else where we are discussing a better way for the government to spend money, this isn’t abandoning the economic system we have now, this is adapting the economic system that we have now to make it work better. The economic system we have now is creditism. First, let me explain. In capitalism, the growth dynamic was driven by the private sector. Businessmen would invest, and some of them would make a profit. They would save that profit, or in other words, accumulate capital – hence capitalism – and they would repeat the process. Investment, savings, capital accumulation, investment of savings – that was the growth dynamic. It was very difficult, and it took a lot of hard work.
That is not the way our system has worked now, for decades. The growth dynamic in our economic system has been driven by credit creation and consumption, and more credit creation, and more consumption. And that has worked miracles. That has created very rapid economic growth now for 4-5 decades. The problem is that this new economic system seems to have hit the full extent of its potential to create any more growth, and actually, it quite possibly has collapsed into a very protracted depression, because the private sector can’t bear any more debt. That means only the government sector can bear any more debt, so the real issue is, how is the government going to spend the debt that it is going to accumulate to keep the economy from collapsing into a depression?
David: Before we move to that, because that is a very important point, it was the GSEs, the Government-Sponsored Entities, that played a vital role in credit expansion in this 40-50 year period. The household sector witnessed a major balance sheet addition. As home values increased, as stock market values increased, there was this extension of cheaper and cheaper credit. It seems that, in fact, those circumstances may not be repeatable. I want to talk about one thing that is important, I think, to the private sector or individual investor. Discuss real estate and home values. Without a 40-50 trillion dollar credit expansion, what would fuel the next housing boom? Perhaps you are not so sanguine in this area.
Richard: Ideally, we want to avoid creating credit-driven booms, because they always bust. Every boom busts. That is the first law of macroeconomic cycles. The second law is, the bigger the boom, the bigger the bust. We don’t want to just fuel one boom after another. That really seems to be what the government’s policy has been for the last 15-20 years – the stock market boom, followed by the property boom. That is understandable, and we should avoid that.
We need to think of ways to invest the debt so that we can grow the debt and grow the economy, not just creating boom and bust, but actually, accumulating debt, but using the debt that we accumulate to invest in new industries, so that through that investment, we can generate a return that will be sufficient to repay the debt. It needs to be about investing in what I call transformative 21st century technologies on a very aggressive scale so that rather than just wasting this money, we can invest it and generate fantastic new technologies and new industries to keep the United States the dominant economic power far into the future.
David: We are aware that in the private sector there is a very large multiplier in terms of credit creation and there is almost a building in, a multiplying, or a compounding of that effect, in the economy. With government sector credit expansion, is there the exact same kind of multiplier, or is it a different effect in the economy?
Richard: I fear that I will sound like a heretic by what I am going to say, but I think we really need to keep an open mind and look at this rationally, and understand that almost every major industry in the United States is already subsidized by the government in one way or the other. Agriculture – the farmers, and the corporations that own the agribusinesses – get government subsidies. All the industries that make weapons get government subsidies. The pharmaceutical and hospital industries are subsidized by Medicare and Medicaid. The universities are subsidized through these processes also. Already, all the industries are getting government support. We need to understand that, and we need to change the way that the government is supporting the economy, because already, the government is driving the economy. Once that is understood, it doesn’t seem so radical to suggest the government should drive the economy in a more rational way.
David: The question I would have is, if the growth dynamic from this point forward is related to the credit markets, you are talking about an expansion of government debt, and it really does require future monetary intervention in order to keep interest rates at a very low level. At today’s number, we can, at 2.18%, finance a tremendous amount of debt, over 15 trillion dollars, and it costs us a mere pittance, 300 hundred billion dollars in interest payments. Of course, that is tongue in cheek, 300 billion is no longer a pittance.
But if that rate were 3½ or 4%, now we are moving into a range where we may have a growth-oriented model based on the expansion of government debt, but can we actually pull that off, so to say? I guess this is where I would ask: we have looked at the lost decade here in the United States, but how is our lost decade different than that of the Japanese? They have actually been able to keep rates low, so how have they accomplished that, and will we be able to accomplish the same thing, and are we looking at a different dynamic in terms of a lost decade, ours versus theirs?
Richard: Right. When we first spoke two years ago, we discussed at that time the Congressional Budget Office projections for U.S. government debt going forward, and it was already clear that we were going to have trillion-dollar budget deficits for as far as the eye could see. And, indeed, this year the budget deficit is going to be 1.3 trillion. It has been roughly that amount in the preceding three years, as well. So it is really not a question of whether we are going to have these budget deficits or not. We are definitely going to have these budget deficits. It is just a matter of what the deficits are used for. It is not a question of whether the money is going to be spent or not. It clearly will be spent. The question is how it is going to be spent.
In terms of the interest rate, and comparing the U.S. with Japan, yes, Japan’s bubble popped in 1990 and their interest rate on their government debt is less than 1% for a 10-year government bond. In Japan, they have been able to take their government debt from 60% of Japan’s GDP, to now up to 240% of GDP, and they have been able to increase that government debt. The reason they have increased the debt is because they had to have very large budget deficits to prevent their post-bubble economy from collapsing into a 1930s-style depression. They have managed to finance these debts at very low interest rates. They have managed their spending and they have kept Japan from collapsing into a depression.
The U.S. is going down the same road. Our big bubble popped in 2008 and interest rates have collapsed ever since. The 10-year bond yield is now, I think, less than 1.9% this morning. When big bubbles pop, the people who made all the profits during the bubble years realize that they have to do something different with their money than they did before, because if they keep speculating as they did during the bubble era, their profits are going to be destroyed. So they move their bubble profits into government bonds, and that pushes up the price of the bonds, and pushes down the yields.
It is the same with the corporate cash flow. Every year, corporations have a lot of cash flow. If they continue to invest and build new industrial capacity, their money is going to be destroyed, because there is already excess capacity across every industry globally, and capacity utilization is low. As a result, they don’t want to build more capacity, so they put their annual cash flow into government bonds, as well, and that is another reason that bond yields are so low, both in Japan and in the United States.
Additionally, Japan has had some paper money creation by the central bank, but not on a huge scale, or at least, not on a huge scale by current standards. The Fed has been more aggressive in creating paper money, and now the European Central Bank also, with its most recent LTRO, which created something like a trillion new paper euros. These have been very aggressive moves of paper money creation, much more aggressive even than Japan. But as a result of those moves, with paper money creation and buying government bonds, in the case of the Fed, this has driven down interest rates even further.
The reason they have been able to get away with this, and one of the main reasons that this hasn’t already led to very high rates of inflation, is because of globalization. Globalization is putting extreme downward pressure on wages, globally. In fact, this resulted in a 95% drop in the marginal cost of labor. Before, if you wanted to hire an industrial worker to build an automobile, you had to pay someone in Michigan $200 a day. Now, you can pay someone in India $5 a day.
This collapse in wage rates is creating extreme disinflationary or deflationary pressure that has enabled the central banks to get away with massive paper money creation without creating high rates of inflation. They won’t be able to continue doing this forever – running trillion-dollar budget deficits and financing with paper money, but they should be able to do this without too much more difficulty for another five years, perhaps even ten years. The problem is that ten years from the U.S. government is going to be just as bankrupt as Greece, and at that point, then, very, very bad things will begin to happen.
It is crucial to change the way the government spends money between now and then, and actually have the government spend money in a sensible way through investing that restructures the economy and generates new technologies that restructure the U.S. economy, eliminates the global imbalances that have led to this crisis, and actually prevents us from collapsing into a new severe or great depression ten years from now.
David: When we look at innovation in the market, we are often reminded of the private sector filling gaps and discovering niches and driving innovation. Do you think it is possible that government can take on that role of innovative thinking when the tradition is quite the opposite? I think looking back at history we would see pet projects chosen rather than dynamic and growth-oriented projects.
Richard: Once we all agree that it would be a good idea for the government to change the way it spends money. For instance, the government has spent 1.4 trillion dollars invading Iraq and Afghanistan. I think it would have been a better idea if the government had spent 1.4 trillion dollars developing solar energy, or perhaps developing genetic engineering or biotechnology. But going forward, they are going to spend this money, and once we agree that it would be better for them to spend it in a different way, rather than wasting the money on unnecessary consumption, once we have that understanding, once we agree on that principle, then there are many ways the government could distribute this money.
Once it was decided the government should invest, or spend on investment purposes, they could certainly involve all of the innovative capacity of the private sector. They could distribute the money in a variety of different ways, to the most innovative, or to the best projects, or the best managers, or they could allow the private sector to do the actual innovations. It would just be the government funding it, and of course, sharing in the profits of the successful innovation.
David: That’s healthy. Let’s assume that we do end up propping up aggregate demand that is deficit spending, and we have an economy that is rolling forward on that basis, we are not moving toward a 12, 13, 15, or 20% contraction in gross domestic product. Stocks and real estate benefit from the expansion of credit. To what degree are these asset classes impacted by a slowing in credit growth, a contraction in the credit markets, at least in those areas? We are not taking about a total contraction in credit, but we have seen a benefit directed toward these two asset classes, and I don’t know that we can assume that just an expansion in government credit would have that same sort of positive impact for housing and the stock market, per se.
Richard: I think the Austrian economists, Von Mises, specifically, were right in their explanation for how credit creates an artificial boom. Von Mises famously described the process through which credit creates an artificial boom, but the day always comes when credit stops expanding and at that point, the boom doesn’t just flatten out at some permanent level of prosperity. All the good things that happen during the boom, then go into reverse, and the depression begins.
In terms of what now happens if credit stops expanding, the difference between our world and the world Von Mises lived in is that he lived at a time when there was a gold standard. In his world, credit, the money supply, gold, could only expand for a relatively limited, short period of time, because there was a limited amount of gold. You could expand the money and credit based on that money for a short period of time, but then you ran out of new money and so the credit expansion had to stop and the boom turned to bust. But this generally created relatively mild boom and bust periods, and from his point of view, they should have been avoided completely.
The difference between his world and our world is that in our world, there was no limit, it seems, for how long credit could expand. For 4½ decades credit went from 1 trillion to 50 trillion, creating an unprecedented global boom. But the danger is now, if this credit actually begins to contract, that we won’t just have a temporary mild boom and bust, or bust phase, our bust could be as protracted as the boom was. In other words, this could be a depression that goes on for decades, just as the great depression in the 1930s went on for an entire decade and did not end until World War II started and government spending increased by 900%, and that put an end to the depression. Of course, that war also put an end to 60 million lives.
If you are talking about asset prices for houses, the credit begins to contract and it is going to become a very protracted depression and house prices will fall much further. As to your question of whether expansion of government debt would be sufficient to keep house prices from dropping, I think that nothing drops forever, and we have to have some equilibrium between asset values and income levels.
Ultimately, the median income of a country determines its economic growth. Median income has to go up in order to create sustainable economic growth. If asset prices become overly inflated relative to the ability of individuals to finance those inflated asset prices because their income is not high enough, then sooner or later the asset prices have to contract. There must be a sensible relationship between the income of society and the asset prices in society. There is no way to maintain a disequilibrium there for too long.
Property prices have already dropped now 34% on average in the U.S. They may drop a little bit further, but we are going to get closer and closer to the point where the equilibrium between income and home prices has been re-established. We have a 1.3 trillion-dollar budget deficit this year, roughly 8% of GDP. This isn’t going to go away, but the spending is the thing that is keeping the economy from collapsing into a great depression, and it is going to persist. It is just a question of how we spend the money.
David: That raises the issue – it is a budget-related issue. We have had the credit markets which have begun to contract. There are signals that it is sort of game over for an era of credit expansion. And of course, we have, in this cast of characters, Ben Bernanke, who is likely to continue his stimulative policies, the zero interest rate policies, or various forms of quantitative easing. The problem is, successively, the quantitative easing measures have less and less impact, so that brings us back to your point of, on the fiscal side, how do we spend the money, and can we spend it more effectively? Do you expect to see Ben continue with some of his monetary policy measures?
Richard: I do, yes. I think a useful way of looking at this is to imagine the global economy as being a big rubber raft, but instead of being inflated with air, this raft is inflated with a lot of credit. On top of this raft which is floating on top of the global economy we have all the stocks, all the bonds, and all the commodities, including gold, and we have 7 billion people.
The problem is, so much credit has been inflated into this raft, the raft has become defective. It is full of holes, and the credit is leaking out numerous holes all around the side of the raft. As the credit gets destroyed, it can’t be repaid, because people just don’t earn enough money to repay the debt, so the raft is defective, and its natural tendency is to sink. As it sinks, all the stocks and bonds, commodities, and gold, start to go down together. And for that matter, the 7 billion people start to sink.
So the policy response has been, and is, and will continue to be, to pump in more credit every time that happens, to pump in more credit through budget deficits and paper money creation, either by the Fed, or by the ECB, or wherever necessary, to reflate the global raft. When they do pump in more credit, the raft floats up again, so stocks and bonds, commodities, and gold, they all go back up again.
That is what we saw in the first round of quantitative easing, that’s what we saw with the second round of quantitative easing, and that is what we saw with LTRO. In order to prevent the raft from sinking, this is what they are going to continue to do, again and again and again, because they are absolutely terrified that if they don’t do this the raft will sink, and it will be an absolute replay of the 1930s and the 1940s.
In the 1930s we had the credit bubble that began in World War I, when the gold standard broke down and blew up during the 1920s, the Roaring 20s. The next credit bubble popped in 1930 and that depression started, and the government just stepped back and let market forces determine a market-determined equilibrium. Unfortunately, that equilibrium was at a level of GDP that was 46% below what it had been in 1929 in the United States and at a level of unemployment that ranged between 15% and 25% during the decade, a decade in which Europe turned fascist and Germany took over Europe, and Japan turned fascist and took over Asia, and then World War II started, with, of course, disastrous consequences for everyone.
Policymakers are absolutely terrified that exactly the same thing is going to recur this time, and for that reason, the only policy response they have is to create new credit to replace the old credit that is being destroyed. So yes, there will be a QE-III.
David: It seems, to some degree, that we are just repeating the mistakes of the past. Massive credit expansion led to the situation that we have now where our options are limited. We are forced into a pragmatic position of either continuing with the same course, to a slightly varied degree, perhaps a degree that is maybe on steroids, but really, we are just talking about an expansion of credit.
Politics was less in play during the gold standard era, in terms of consequences. You noted that there was a mild boom and bust cycle, and that did have an impact. Minor deflations did impact the constituency groups that were in the lowest tier of society economically and socially. Yes, there were unemployment issues, but again, they were mild boom and bust cycles. Now, we are in a boom phase, we have been in a boom phase since the end of the Bretton Woods era, circa 1968 to 1971, and we need to continue that boom cycle.
The question is, was Von Mises right? Can we continue to artificially inflate? We are in a position where, pragmatically, we have to say, we must, or the results could be dire. But if we don’t seek a mid-course correction, and look at a radically different alternative, as painful as that may be, even if we accept a GDP at a 20% lower level today, what if the market forces a massive contraction in credit, destruction via de-leveraging, and it is on an out-of-control basis? As you said, maybe that is 5-10 years out, but what does that horror look like, as opposed to a more moderated and chosen course today, which is simply that we can’t do this, we can’t continue on this course of credit expansion forever? We know that. Let’s not just kick the can down the road. How would you respond to that?
Richard: I would say it is like debt. It is better to kick it down the road for ten years than to have it occur today, and that is the situation that our economy is in now. If we allow the credit to begin to contract, and we spiral into a new great depression, then our civilization very well may not survive, and there is nothing that could be any worse than that. So there is no deader than dead.
If our economy now spirals into a new great depression, this economic crisis will become a severe political crisis, globally. It is very likely that we would have a breakdown in globalization. It is very likely that there would be a trade war, and the geopolitical consequences of a trade war would quite easily lead to a real war, and who knows how that would end up.
I propose that we don’t try to find out. Rather than allowing this collapse into a new great depression today, let’s try something different. We know that the U.S. government debt is now roughly 100% of GDP, whereas Japan’s government debt, 22 years into their crisis, is 240% of GDP. I think that the U.S. would have no problem taking its government debt up to at least 150% of GDP, which would carry us quite easily 5-7 years into the future, and we may be able to take it up even to 200%, who knows, which would take us 10-15 years into the future.
I think that is what they will do, because unlike in the 19th century when we were on a gold standard, most people didn’t have the right to vote, no women had the right to vote, and very significant portions of the men at the end of the 19th century didn’t have the right to vote. Now everyone has the right to vote, and it is democracy, and if we have very high rates of unemployment, these people are going to demand additional government spending, and the politicians are either going to give it to them, or they are going to lose their jobs, and the next set of politicians who come in will spend more money, so I am almost certain that the money is going to be spent.
That gives us the option, then. The money is going to be spent, so our only real choice is not between austerity now or austerity later. In other words, the choice is not between collapse now, or inevitable collapse later. The choice is between austerity and collapse now, or what we will actually have going forward, that will either be ten more years of wasteful government spending, supporting the economy, and then we collapse, or the alternative is that we spend the money differently, and actually don’t collapse, because we are clever enough to actually invest our way out of this crisis this time, and not have to repeat the mistakes of the 1920s, 1930s, and 1940s.
I hope that we can learn from our past mistakes and invest our way out of this crisis, but even if we don’t, I am certainly in favor of postponing the collapse as long as possible, because it will be no worse ten years from now than it will be today, and in the meantime, we will have enjoyed another ten years of life and prosperity.
David: Richard, I agree with you. I think in terms of the spending, what I would love to see, and perhaps you can also suggest something to this effect, is that there needs to be an accountability, a return from the pork barrel politicians of today, back toward something that looks and feels more like statesmanship, because the tendency has been for politicians to line their pockets. You can’t go through Congress today and find someone who is not worth several million dollars, if they are not worth ten million, or a hundred million dollars, and you don’t make that kind of money in Congress. You are paid $100,000 to $200,000, and yet, as a lifetime politician, they have figured out ways of making mass fortunes.
It looks like the same kind of corruption that we have in North Africa, or anywhere else, where money is spent, but there is not a real constraint or accountability put on it. Essentially, we have politicians who are using their rolodexes and political influence for personal gain. What you have set up here is an accurate picture. The stakes are incredibly high. The geopolitical consequences of a trade war turning into a real war – that has been a topic of conversation for us for several years now, looking at a crisis that morphs from a financial to an economic, from an economic to a political, and ultimately, escalating to a geopolitical. At least, in theory, we can go there.
And yet, we have politicians today, and I think, in some sense, big business leaders, who are basically of the opinion, “I’m gonna get mine now. I don’t see this as working out in the long run, and better my personal gain than the long-term success or viability of this company,” and we have seen that in a number of companies in the past, whether Enron or WorldCom, or at the national level, where politicians are, as fast as they can, lining their pockets. How do we prevent that from happening? If, in fact, we need to spend a trillion dollars, frankly, I don’t want to see a lead cent go in the direction of a politician who is looking after his self-interest, rather than the state’s interest.
Richard: You have a fair point, indeed. Of course, politics has always been corrupt, and throughout history, government officials have lined their pockets. It is part of human nature, I suppose, or at least, that is certainly the way it has always been. Throughout the history of the United States there has been episode after episode of public corruption. We just have to take that as a given, I am afraid. We don’t have time to change human nature during this particular crisis, so we need to get everyone incentivized to move in the right direction.
By everyone, I mean the Occupy Wall Street people, the Tea Party people, the lobbyists, the corporations that the lobbyists represent, the bankers, and the bureaucrats. We need all of them to realize that we need to make this economy grow, or we are all going down together. If we make the pie grow, we are all going to be better off. If we let the economy collapse, then we are all going down together.
We don’t have time to sort out human nature and make sure that not a single red cent lines any politician’s pocket, or any corporation’s pocket, or any banker’s pocket, or any poor person who is too lazy to work, as some people would view it. We don’t have time to sort that out now. What we have to do is to make our economy grow. All of these interest groups need to work together to make sure that happens, to make the pie bigger, and, over time, we will then have the leisure to be able to make sure there is less corruption all around, and perhaps a more fair system, or more just system, from everyone’s perspective.
David: Richard, I know you can’t give the perfect asset allocation model, not knowing every listener who is out there, wondering, “What does this mean for me? What actions am I supposed to take? Obviously, we are in desperate circumstances. Some sort of insurance policy is necessary. How do I sit on the fence between the success of this particular project, if government is able to hold this together and create growth, how do I position for that? And if they should fail, how do I position for that?”
Is there a watertight approach, a balanced approach, if you will, as you look at the next 5-10 years, perhaps only the next 2-3 months, but in some sort of a time frame – short term, intermediate term, long term? What are the rules of the road, do you think, for the global investor?
Richard: In the short term, I think the rules are pretty clear. Because our global raft’s natural tendency is to sink, we know what the policy response is going to be. It is going to repeatedly be to pump in more credit, through more and more rounds of government spending, and more and more rounds of fiscal paper money creation. And so, before long the raft will begin to sink again, stock prices will go down, and asset prices will all go down, and the global economy will look very endangered, and about that time, Chairman Bernanke is going to go on CNBC and tell us that there is going to be QE-III.
That is the time for everyone to go long risk assets. That is what it is designed to do. It will make all the risk assets go up. When Chairman Bernanke goes on TV and announces QE-III everyone should be long risk assets. But he will also tell us when they are going to stop QE-III, and when that date arrives, that is the time to take your profits and get out and wait for the raft to sink again and asset prices will all go down again, and you can wait for a little while for the correction to occur. And then there will be QE-IV.
So the short term is just risk-on, risk-off, based on paper money creation by the club of central banks led by the Fed and the ECB. So that should be relatively easy. You can bet on bailouts, in other words.
In the longer run, it is far more difficult to say exactly what is going to happen. Realistically, while I believe there is good cause to fight for what I am advocating for, government investment on a very large scale and transforming the 21st century industries to resolve our crisis, realistically, that is probably not going to happen. Looking out 5-10 years, the global economy will still be directed by government policy. What the government policy does will determine the direction of asset prices five years from now and ten years from now.
But we don’t know who the government is going to be five years from now, or ten years from now. So if you had to lock in an investment portfolio that you couldn’t touch for the next ten years, for example, then the course that I think would be most sensible for most people would be to have a very broadly diversified portfolio that could survive either high rates of inflation or severe deflation, because if the government spends too much money, and prints too much money, we are going to end up with very high rates of inflation.
On the other hand, if, for instance, Ron Paul is elected and bans the Fed, and implements government austerity, then we are going to collapse into severe deflation. So the truth is, it is very hard to preserve wealth. If it were easy to preserve wealth, the families who were wealthy 200 years ago would still be wealthy today, and normally, they are not. In the kind of environment that we are going to face over the next ten years, a great deal of wealth is going to be destroyed.
If you have to lock in a portfolio today, you want to have a portfolio where you would accept the inevitability of part of it being destroyed, and the compensation for that would be that not all of it would be destroyed. If you have a broadly diversified portfolio, for instance, with Blue Chip stocks, preferably with a good dividend yield, and even government bonds and Blue Chip corporate bonds, next commodities, mostly gold, and then you could have residential property as the fourth part of your portfolio. For instance, if you had a great deal of money you could buy residential buildings in a good location that you could let out to people. The fifth part of the portfolio would be to borrow money at fixed interest rates to finance your residential property, but it must be at fixed interest rates.
With that kind of diversified portfolio, part of your wealth would be preserved, any way it goes, either high rates of inflation, or high rates of deflation. If we have lots of inflation it would be bad for your bonds, it would be bad for your stocks, but it would be very good for your gold, and your rental property would still be intact, and the higher rate of inflation would basically make your fixed interest rate debt evaporate.
On the other hand, if we have a severe deflation, then that would not be good for stocks, but it would be very good for your bonds. It wouldn’t be good for your gold, but you would still have your rental property, and the rent might adjust down, but the price of everything would adjust down, so you would still be relatively better off. With that kind of a diversified portfolio, you can preserve some of your wealth into the future, despite almost any possible scenario. If we have extreme deflation, the trick is to make sure that your assets deflate less than your neighbor’s assets, so you will still be richer.
David: It is very similar to a simple model that we have suggested for many decades where a part of the mandate that you adopt is liquidity, which is cash and cash alternatives. A part of the mandate, on the other hand, is growth and income, which is stocks and bonds. And a part of the mandate, the third mandate, if you will, is insurance-related – commodities, specifically, precious metals.
It is taking a balanced approach, acknowledging that A) you don’t know exactly how the future will look, and B) you don’t want to put all your chips on one number, one color. This is the circumstance we are in today. It is difficult to preserve wealth, but it is vital to do, and to make a best effort to take a balanced approach, not knowing exactly what policy measures will be implemented, and what the market response will be.
Richard, I have to say, yet again, we will be reading your book as an office read, The New Depression, and we go back to the conversations that we have had over the last several years, and we have discussed the exit strategy from the current monetary policy some months back. We have discussed the creation of money and credit, and again, the government’s rescue tools, whether that is nationalization, money creation, debt acquisition, debt guarantees, forbearance.
I feel like our conversation continues and you have played a vital role in what we continue to offer for our listeners and our clients as they seek to understand the times that we live in, and take perspicacious action, asking “What should we do”? We thank you for your opinions today just on that point, and we look forward to a continuation of the conversation over the years and months ahead. Keep up the good work.
Richard: I look forward to continuing this conversation, too. Thank you, again.
Kevin: David, the stakes really are high. Listening to Richard, I think of the period of time when someone is shocked and has to adjust to a new norm, as we were talking about, as with possibly a terminal disease that may or may not end well. They go from denial to anger, and then slowly, to acceptance, and then action. Action is so important. We have talked now for five years about things moving from the financial, to the economic, to the political, to the geopolitical. We are talking about life and death here. We are not talking just about plain old economics.
David: Exactly. What we are talking about is the potential for the end of globalization. As we suggested, with Harold James, this idea of the end of globalization, what that brings with it is very, very harrowing – very, very ugly – from a geopolitical standpoint, obviously. But when you enter a trade war, you are on the cusp of real war, with all the consequences that has for human life. We have seen the body count grow in this century following the previous periods of globalization contracting, and trade and conflict between nations emerging. We really don’t have a good set of options, and even with the set of options that Richard Duncan suggests, there is no guarantee that it works.
Kevin: David, listening to that though, both of our concerns would be, how in the world do you get a government that has acted so poorly in the past, and padded their pockets in the past, to all start coordinating toward something that is productive for the future?
David: That is exactly the issue, as I see it. We have the political elite today who have entrenched themselves as lifetime politicians. Now they have aspirations of not only having political power, but lining their pockets and creating monetary wealth and power for themselves, as well. We need to create a system of accountability in Washington and perhaps it is via social media that we can keep politicians accountable.
Last year we witnessed just how powerful social media was, as Twitter and Facebook defined and redefined political groups, and I think there is a measure of accountability which we can see and should see, and perhaps we should, as individual citizens, explore how to hold Washington accountable via social media networks.
Kevin: But if we can’t, then we’d better protect ourselves individually – our families and our communities.
David: And certainly, the balanced approach that Richard talks about is vitally important, with the insurance component being, perhaps, the only thing that you truly control.