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  • Household debt up 19 quarters in a row, $1 trillion above previous peak
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  • U.S. on China: From positive engagement to active containment


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Last 5 Years: GDP Would Be Negative If U.S. Debt Had Not Increased
May 22, 2019

“The issue goes back to the Chinese Communist Party dealing with the U.S. posture having moved from engagement to containment, and it doesn’t have to be just because of trade, it can be just to push back on that idea of control. If we try to put China on a leash at this point, we change the nature of the relationship, the dynamic, and potentially, the danger involved.”

– David McAlvany

Kevin:It amazes me what we call growth these days, which is, really, what you can buy with debt.

David:If you go back to the history of corporate America, you have Woolworth’s, who was a retail giant, and they got upset by someone who was doing something different. Sears came along and offered the ability to buy things, and you didn’t even have to have the money to buy them. There were layaway programs, there were all kinds of new ways to approach retail and consumer habits.

Kevin:As long as you had months or years ahead that you could suck from you could actually have it today.

David:Now, Sears is almost a historical footnote anymore. Things do change, times do change, and Amazon has sucked away anything that you would ever expect from a Sears outlet.

Kevin:But another thing that you can buy with debt is the sentiment of consumers. Consumers right now have never been happier because they feel like we have robust growth. They are even told we have robust growth. Yet we have robust growth of debt. Now, there is a difference between robust growth and robust growth of debt.

David:So, in the 21stcentury you are talking about a different kind of haves and have-nots. The haves are the ones who have gone ahead and put it on a credit card. The have-nots are the ones who are a little bit more cautious and are not willing to spend beyond their means. So you do have, in this kind of period, U.S. consumers as happy as they can be, I don’t think it’s a coincidence that you have consumer debt, that is, household debt, reaching all-time highs at that same time U.S. consumer sentiment jumps to a 15-year high. This was in early May – the University of Michigan sentiment index shows off the best reading since 2004. Happy days are here again.

Kevin:Happy days are here again. I remember when that show came out back in the 1970s. Fonz would say, “Step into my office,” and the office was the bathroom. But yes, happy days are here again. The difference between the happy days that they were showing, which was the 1950s, that was purchased with real things, with real productivity, in fact, some of the greatest productivity that America ever had. At this point, happy days are purchased a little differently. I think the Fonz is more like the Feds, right? Instead of the Fonz, the Federal Reserve.

David:“Step into my office.”

Kevin:“Step into my office.”

David:Jim Grant – you know I am a fan of his writing. I’ve read his books and his monthly newsletter. He says that science is one thing, finance another. In science, progress is cumulative. We stand on the shoulders of giants. In finance, progress is cyclical. We keep stepping on the same rake.

Kevin:It’s funny how economists love to use long equations to confuse people, but when you really look at the long equation what they are trying to explain is something that is not science at all, it’s human nature. And when you have sentiment at a 15-year high at the same time that you have household debt at a high, you don’t really need an equation to figure that out. I get it.

David:Right. So, the reality of finance and economics, and I think Jim’s point is an important one, when you look at finance and economics there is a difference between perceptions and the reality. When you look at the way they do their work, economists and financial gurus, they include more and more mathematics. As you know, math legitimizes anything. If we are having a conversation about the difference between males and females – you probably know the book Men Are From Mars, Women Are From Venus.This is a story of differences. You can talk about the differences, but if I start talking about equations and math, all of a sudden that has the tone of authority.

Kevin:Oh yes. “Let me show you this. Oh, you don’t understand? Then trust me.”

David:“Here’s the math that support its.” And that’s the illusion that we have with economics and finance. The progress is now cumulative, as if it were a science versus cyclical. So the equations get longer, they are getting more complex, the models suggest a greater amount of knowledge. We have that. Now we have a greater amount of certainty. We have that. We have greater control. Well, at least these are the perceptions. These things don’t truly exist. And this is why we not only step onto the rake again, we step boldly onto the same rake each time.

Kevin:Well, let’s call the rake was it is. The rake is always debt. Always. Always debt. Never anything other than debt. So the rake is the debt, yet the debt is always how they tell you to avoid the rake. It’s a vicious cycle.

David:And to me, I think the debt is the step. The debt is what you do right as you are stepping onto the rake. The rake is the reality that there are limits, and you come face to face with those limits.

Kevin:That’s a good point, because the rake really does end up causing the damage to the nose (laughs).

David:Yes. Jim Grant asks: “So what can be done?” An overhaul of the Ph.D. standard for starters. He says, “The 700 Doctors of Economics on the Fed’s payroll seem not to understand the limitations of economic modeling, or the relevance of the financial past. Send them to NASA, which is where they wanted to work in the first place. Replace them with a half-dozen historians, a couple of philosophers and a physician. The historians will study recurring patterns of economic and financial affairs. The philosophers will contemplate the true nature of money. And the physician will repeat, at intervals, ‘First do no harm.’”

Kevin:Financially, the philosopher actually is needed in money because money is a philosophy. It’s the storage of energy. We have talked before about this. And when one man can create it out of thin air, and another man has to work eight hours a day, there is a difference, philosophically, in what money actually is.

David:You can have the lifestyle that you want, you can have it now, and you don’t have to pay for it. We can put it on the installment plan. Do you know the average interest on credit card debt is now above 17%? If you think about it, this is a world of zero interest rates, so for Chase and J.P. Morgan and the credit card issuers – they are beyond knee deep in clover. This is a good time to be in the business.

Kevin:And not all debt is equal. Sometimes you have good debt, with someone who will pay, but as that gets further and further out, you’re talking about 17% being paid on credit cards. Why is it 17%? Because those people can’t go get a loan for 5%, or 6%, or 7%. The debt, itself, gets worse and worse as you go further down the trail.

David:So you look at the folks who are promoting it, not actually the banks, but the central bankers who make it all happen, taking rates to the zero bound, and ignoring that phrase, “First, do no harm.” Instead, you have debts proliferating. You have lower and lower levels of debt quality, and that is subsidized by central banks and their historically low rates. We see financial market speculation increase as the rate of interest is set at those artificially low levels. Speculation becomes very, very commonplace in that environment, sort of cause and effect. You can see the implications of global central bank liquidity excess in places like the art market.

Kevin:Did you see what sold last week? It was a bunny – 91 million dollars for a bunny.

David:Right. Well, we are in the season. Isn’t it the Easter season somewhere?


David:The Monet I could almost understand.

Kevin:I get that.

David:Haystacks, 1890 – 110 million, if you have an extra 110 million laying around. What’s the size of the building and the security system that you need for that 110 million (laughs)?

Kevin:Listen, if you can afford the 110 million I’ll bet you can afford that. But the bunny – stainless steel bunny – the guy is still alive, Dave.

David:That’s the amazing thing. This is the highest price ever paid for a living artist. Jeff Koons, bless his soul – he has to be thinking to himself, “Why didn’t I make two or three of those three-foot stainless steel bunnies? A couple here and a couple there and I could be a billionaire.”


David:So, yes, we see balance sheets more and more out of balance. You have the permanent side, which is the debt side, the liabilities – they’re growing, and of course, they are moving up with asset prices. That is a part of the Fed’s equation. They want to see asset prices go up. What is easy to forget is that the asset side fluctuates. It goes up and down. Today it is at a high level. It can go down, but that leaves the entities, whether it is a household or a business or a government, indebted. That is the part that stays. Asset prices fluctuate, debts are permanent. The indebted entity then is in an unsustainable position when your asset and liability structure is so out of balance.

Kevin:Let’s go back six months ago when we were talking and the Federal Reserve was saying, “You know what we’re going to do? We have had artificially low rates for a long time.” They didn’t say “artificially low rates” but they said “unusually low rates” because they needed to normalize. That was six months ago. We’ve had a couple of experiments since then, and they found they couldn’t raise the rates at all.

David:The language was fascinating. You’re right, six months ago it was let’s get back to normal and normalization was the language, so two more rate increases were expected…

Kevin:And the market gave back almost 20%. They stopped it right before they called it a bear market. A bear market is 20%, right?

David:19.8 was where they called it.


David:It was the threshold for pain. That is in the fourth quarter. Powell softens his objectives, the market swings back in the other direction to positive territory. In a six-month timeframe you go from yes, we’re going to see two rate increases to – think about this, in the last week we have gone from a 59% probability of rate cuts to a 75% probability of rate cuts. Six months ago it was hikes, and this was an appropriate tightening of credit conditions, and now it’s cuts (laughs) because the market couldn’t handle a marginal increase in the cost of capital.

Kevin:Talk about cuts. Death by a thousand cuts, right? Do you remember when they used to call it the Greenspan put, which was the guarantee that Greenspan was going to keep money easy? And then it went to the Bernanke put, which Bernanke guaranteed that the money would be easy. And then the Yellen put. Now it’s the Powell put. So I guess we had hope, and I remember even Doug Noland had hope. He thought, “Maybe Powell’s going to be the guy.” But so far, Powell has been the put.

David:And you have Trump, who is hammering everyone at the Fed to do a little bit more. We talked about this two months ago. Kocherlakota, Regional Fed Chief, was echoed by Evans and Dudley just before Dudley retired – “We need to fight the next recession before it emerges.”

Kevin:“Yes, don’t worry, we don’t have a recession, but we are going to lower rates, just in case.”

David:“We’re going to fight it before it emerges, not when it emerges.” It gives me this weird feeling like, “Hey, why don’t we just go to an oncologist for the heck of it. No, I don’t have a diagnosis of cancer, but just in case, why don’t we do chemo just in case. Let’s get ahead of any potentiality.” Does that suggest desperate times, or does that suggest desperate people, that the Fed would be getting ahead and lowering rates in advance? I think, really, what it suggests is they are desperate to maintain the status quo.

Kevin:Have we seen a picture of what we are going to see in the future then? In quarter 4 of 2018 and quarter 1 of 2019, we saw Powell weaken immediately – immediately. Is that something, looking forward, that we can count on?

David:Well, the Q4/Q1 U-turn tells us everything we need to know about the Fed’s economic fears and their concerns. There are levels of sustainability that have to be maintained, and the balance between massive quantities of debt and the interest that you are paying on them – they have adopted a growth model which assumes an infinite growth in debt, which means they cannot allow for normalization of rates because the interest component would crush the economy.

Kevin:But we are at a threshold already. They were barely moving those rates and already the stock market came off – how much would you say?

David:It was either .6 or .8%, but just shy of 20%. What it says is the system can’t handle interest rate normalization. The wheels were coming off, the Fed backed off very quickly. There is too much debt out there to be repricing it. And for those that owe the trillions of dollars which ultimately comes due, it means that a lot of the debt gets rolled over, a kind of perpetual debt, if you will, and it increases the cash flow requirements on those entities as the debt is rolled over at higher and higher rates. Unless, of course, this is one of the ways the Fed maintains “sustainability” by keeping rates at a low level for an indefinite period of time, because if rates go higher it is a company killer, it is a jobs killer, and it is an economic killer.

Kevin:We talked government debt, and it’s huge – trillions and trillions of dollars. Then we talked corporate debt, because that also has doubled since the great global financial crisis. We went from 4 trillion to 9 trillion during that period of time. What we haven’t talked about is household debt, the stuff that Joe and Suzie lunchbox have. That is huge right now and it just continues to grow.

David:For the 19thquarter in a row we are a trillion dollars above the previous peak. This goes back to the University of Michigan sentiment index. Not a surprise – 15-year highs on the sentiment index. At the same time, households are leveraging up again. Households added 124 billion dollars to their debt in the 1stquarter. That brings them to 13.67 trillion. Delinquencies are not a big deal today. They are on the rise, but they are nowhere near troubling levels, and nothing like what we saw just prior to the global financial crisis.

Kevin:Which means that the household debt will probably continue to grow – when you start seeing delinquencies start coming in the debt starts shrinking, but the growth is still in there. It amazes me how we measure growth. We have talked before about how to kill dandelions. I actually had a farmer call after listening to the Commentary and we talked about this. He said, “You were right. This is how it’s done.” In fact, I just did this two weeks ago in our yard. For broadleaf plants you put something on that doesn’t kill the grass, but it accelerates the growth of the dandelion.

Now, if I were measuring growth based on the fact that I put an accelerator on there that ultimately will kill the dandelion, I’m measuring something wrong. Here is what I am tying this to – the way we look at GDP. Let’s say we look at GDP in a nominal way, where all we are really wanting to do is measure dollars. If we are borrowing money to make that GDP accelerate, that is the nominal GDP growing, but that in no way is true, fundamental growth.

David:I think, like the rest of the world, I love reading the Trump tweets. I don’t know if it is for the entertainment value or shock value – sometimes it is both. He started talking this last week about how he wants GDP growth of 5%. He said, “We would be there if the Fed would do a little QE.”

Kevin:(laughs) We’d be there if they would just print some more money.

David:Right. And in fact he said something like, “If the Fed would do a match.” I’m not sure what the President meant by that, but QE and conflagration do enter my mind. So when I think of the match, I’m thinking of match, fuel, light, problem. And somehow he’s thinking, no this is like kumbaya – we all gather around and stay warm, and we’re happier with 5%…

Kevin:What is he talking about? Are you talking about the Treasury possibly printing and matching the Federal Reserve’s credit? That doesn’t make any sense? How do you do a match?

David:The Fed needs to do a match. If we just did a match, we’d be fine. I don’t know. I don’t know if it’s a match for the BOJ and we’re copying the Bank of Japan, or copying the liquidity provisions of the People’s Bank of China.

Kevin:Let’s go back to GDP. GDP targeting, if you’re trying to do it nominally – and for the person who is listening who doesn’t understand that, if you borrow a bunch of money and you count it as GDP and then your GDP goes up, then you’re nominally increasing, but you’re actually going into debt. You’re not producing anything.

David:And where you can cheat the system is to do that, and then under-report inflation to where you show a very positive GDP figure, and the reality of inflation gets lost in the shuffle. So nominal GDP targeting – we’ve talked about it – is here. At least, the President wants it to be, and he just needs to get Powell on board for a little QE. Does anyone care about inflation, and what that factor does? When it is unwatched, inflation is an element that sucks the life out of the consumer. It sucks the life out of real economic growth.

Kevin:Yes, but do we really have inflation? We’re told that we have virtually no inflation, especially if you’re a social security recipient because your cost of living increases really don’t match anything anymore.

David:I loved reading some comments by Jeff Gundlach. He kind of took the crown from Bill Gross, the old bond king. Jeff is the new bond king at DoubleLine. This is what he says: “U.S. growth appears to be based exclusively on government, corporate and mortgage debt. And the economy would have contracted if the United States had not added trillions in debt.”

Kevin:This is important. We would have shrunk. We’re not growing, we’re shrinking if we’re not adding debt.

David:But we have the perception, an economic perception, that all is well, and it is because we are increasing the amount of long-term liabilities, things that we have to pay back. Again, I get to buy the piano or the set of tools, or whatever it is from Sears, and my life improves, forgetting that I actually have to pay for that at some point. Do I have to pay for that at some point?

Kevin:It’s like a cash advance on your credit card. You do have more money in the wallet for a period of time, but it’s a cash advance.

David:And it’s not your money to begin with. Again, Gundlach says, “U.S. growth appears to be based exclusively on government, corporate and mortgage debt, and the economy would have contracted if the United States had not added trillions in debt. Nominal GDP growth over the last five years would have been negative if U.S. public debt had not increased significantly.” One thing everybody seems to miss when they look at GDP numbers – they seem to not understand that the growth in GDP looks pretty good on the screen, but it is based exclusively on debt – government debt, also corporate debt, even some growth in mortgage debt. This is what he said in a Reuters interview.

Kevin:Do you remember Pippa Malmgren? You interviewed her a few years ago. She talked about two types of people. There are the saltwater people, who always believe more in socialism, printing money, that paper money is going to be the best way. Then you have fresh water people who are more conservative. They would be more hard money-minded. They would also laugh at nominal GDP numbers.

David:They would. They would say it’s just not reality. Let’s not kid ourselves, let’s not joke about these factors. We know what they are, and we know what they mean. So let’s have a real conversation about the real economy and real, or the lack thereof, growth. So you write salt water, fresh water – sometimes that’s a difference of geography. It’s sort of the thinking or a mindset that reflects priorities for a region. Sometimes it is economists. Sometimes it is politicians. In the last election it has been the contrast between the heartland versus the coasts.

Kevin:In Washington, D.C. that is how they are referred. She referred to them as a saltwater person or a fresh water person.

David:(laughs) I was thinking saltwater crocodiles when she said that. Esther George is one of the Fed Chiefs from Kansas City, and not as confident that lowering rates will have a positive outcome.

Kevin:Maybe a little more of a fresh water because of where she is from.

David:Maybe because of where she is from, or maybe it is just the mindset that she has adopted, but she was actually giving a speech in Kocherlakota’s back yard last week at an Economics club even there in Minnesota. She says, lower interest rates might fuel asset price bubbles…


David:Create financial imbalances…


David:And ultimately, a recession.


David:You’re right. So is this humor on her part, is this confession on her part, or is she seeking some sort of absolution? She says, “In current circumstances with an unemployment rate well below its projected longer run level, I see little concern about inflation running below its long-term objective. As I listen to business and community leaders around my region, I hear few complaints about inflation being too low. In fact, I am more likely to hear disbelief when I mention that inflation is as low as measured in a number of key sectors. This leads me to the observation that inflation as experienced by households and businesses is fundamentally different from inflation as viewed by financial market participants and many economists.”

Kevin:Oh horror, could it be possible that inflation is higher than what the Federal Reserve or the government is telling us it is?

David:Imagine the real inflation rate being above what economists and financial market participants calculate.

Kevin:Oh, it couldn’t possibly be.

David:It’s shocking. So, at least Esther has her ears open and is spending time with business leaders in her region, and is sensitive to that. So the on-the-ground reality is far from the measures taken by our statisticians. I think this is one of the reasons why the Fed is not hitting their 2% target. It’s almost like they have forgotten that they are working with B.S. They work with the core PCE – that is their favorite inflation measure – and it understates inflation. It strips out a lot of very relevant data.

And so, yes, real world inflation by the business community and households is higher than officially documented. Yes, regional business leaders are in touch with that reality. And yes, now with rising wages, labor costs going up, I think it is fair to say that the Fed is approaching this in a dangerous way. Have you ever come into a tight corner? What do you generally do? Do you tap the brakes before you drive into a tight corner, or do you accelerate right into the curve? That is what it feels like they are doing. They are accelerating into the curve versus slowing down and testing it first.

Kevin:We had John Taylor on the program a few years ago. The Taylor rule is that you have interests rates at a certain level higher than what the actual inflation rate is. The Taylor rule just doesn’t apply right now because, of course, interest rates are below inflation.

David:Think about this. If you look at the entire bond market – entire global bond market – they don’t reflect credit risk. And they are obviously not reflecting inflation risk. Nobody is concerned about inflation. Even as inflation is creeping up, no one is concerned about it because everybody is fixated on the official number.

Kevin:Business leaders are worried about inflation but the financial markets are not. That’s what you are saying.

David:Right. So what you have in the financial markets and with the pricing of bonds is an under-estimation of inflation which is already entering into the system. You could have a massive repricing in the bond market because there is a total lack of appreciation for what is developing from an inflationary standpoint. Again, inflation and higher expectations of it, will force interest rates higher, and this is an end-game trigger for the bond market that Powell has no control over.

Back to what we were talking about earlier, where you have in the 4thquarter, interest rates start creeping up and the wheels start coming off in the financial markets. And he says, “Oops, no way. We’re going to keep rates low.” Well, what if you have a repricing of the bond market that is in light of an increasing inflation concern? That all of a sudden strips the power out of Powell. It is no longer the Ph.D.s at the Fed setting rates, it’s the market setting rates in light of real world risks that are becoming obvious.

Kevin:We have spoken so often about perception management. If you were trying to manage what you are talking about, Dave, to keep people from worrying about interest rates, you are going to manage three things. CPI – you’re going to manage what you tell people inflation is. You’re going to manage interest rates artificially low. And you’re going to manage what we see on a daily basis – the price of gold. I’m not trying to be too conspiratorial, but people watch gold. Paul Volcker, himself, said in the 1970s, his regret is that he didn’t manipulate the price of gold.


Kevin:Remember when it went on up to $800 an ounce? Well, his regret at the Fed was that he didn’t manipulate gold. So there is an admission right there, and then, of course, we have had admissions further on down the road. So when we look at what is going on internationally, we are now hearing that inflation is probably going to start rearing its ugly head, not because of what we are doing, but because of what the Chinese are not yielding to.

Speaking of that, we’re going to have Russell Napier on in a few weeks. Great guy. I loved what he had to say. He is seriously concerned that we are entering a new cold war, and his point is that instead of positively engaging with China like we have for the last few decades, we are now having to actively contain China. Now, there is a big difference between positively engaging and having that symbiotic relationship that we have had where they loan us back the money that they have surplus. We are now containing this rising super-power.

David:That’s the approach that we are taking. It reminds me, two weekends ago for Mother’s Day, we were on our way to church and I stopped at the park and we just exercised the dog a little bit because the dog was with us – Belgian Malinois – very active, very well trained. And so, I was engaging with the dog.

Kevin:Positively engaging with the dog.

David:I’m positively engaged with the dog and she’s getting her treats, and I take her off the lead and she does exactly what I tell her to do. I don’t know if you have ever seen a cow dog working cattle, but you can practically wink at them and they know exactly what that means and they do their job. Well, I can do that with my dog. She is very well trained. All of a sudden this guy comes up on a bike and he starts yelling at me. “You can’t have a dog off the leash!” And I’m just thinking, “What business is it of yours? This dog is not hurting anyone.” Well, it could, I suppose.

Kevin:It’s actually highly trained to hurt people. It’s part of the training, right?

David:Depending on how I wink, right? Or not. So, I’m just thinking this is crazy. He’s asking me to contain an animal and it’s not necessary. And I’m getting indignant over the fact that he is uncomfortable with there being a lack of control in this environment, and I’m thinking, “No, I’m engaged with the animal, she is responding to me. We’re good here. She doesn’t need to be on a leash.”

Kevin:Here’s the difference, Dave. You’re not threatened by that animal. He is threatened by the animal. Whether right or not, we talked last week about hegemony. The United States has not been threatened by China until now.

David:I think that is a key point because we have engaged with them. We have benefitted them, they have benefitted us. It has been a mutually beneficial relationship. We talked about Deng Xiaoping and the change back in 1976-1978. We talked about the Nixon administration coming in in 1972. What we now have is an aspirational developing nation meeting an incumbent hegemonic power. And yes, you have tensions above the surface, and yes, you have tensions below the surface. Trade tensions are the above-the-surface issues.

Kevin:Right. That’s what makes the news.

David:Yes. But I think what is happening is that he tweets and says things that are not particularly diplomatic. Trump is giving the Chinese a rallying point for a domestic audience. It is something to unify a nation. If you look at their math, they are on the brink of a financial and economic disaster.

Kevin:So they are looking for an excuse, or they are going to need one.

David:As and when there is an economic retrenchment in China, Trump has positioned himself to be the scapegoat. Right now, of course, he is getting some help from the Chinese media, and he is getting some help for Xi Jinping. The Chinese state media this last week said, “If you want to negotiate, the door is open. If you want a trade war, we will fight you until the end.” After 5,000 years of wind and rain, what hasn’t the Chinese nation weathered?

Kevin:How many people listened to that – “We’ll fight you to the end.” That’s a rallying cry. It reminds me of something that Churchill would say.

David:Exactly – 3.3 billion views on that video clip – “We’ll fight you until the end.” And it goes back to – what are we doing here? You have Trump who wrote the book, The Art of the Deal. You have Mao Zedong who wrote the book in 1938, On Protracted War. Do you understand? They are used to suffering and are willing to go the long road. Are we? We want the deal, we want to get it done, “This is going to happen now.” And they are like, “We can out-wait you. We will exhaust you.”

Kevin:I wonder, though, if this still isn’t a gamble – that Trump already knows what he is doing. He does know the deal, he does know how to negotiate. He does have, like you spoke about last week, the idea that he wants to expand the franchise and make America great again. I have no doubt about any of those things. Could he also be positioning for a war that would be politically popular until we get close to the election and then possibly have a – sorry for the pun – a trump card?

David:Right. Well, it appears that in China we have struck a nerve. And I think there are some dominos falling as a result of the tariffs. And certainly, you look at corporations here in the United States, moves by corporations here in the U.S. that are being legitimized by the presence of tariffs. You have Walmart raising its prices and they are saying it’s because of tariffs. I appreciated the comments from the Del Monte CEO much more than what we had from Walmart because they just laid it at Trump’s feet and said, “We’re raising prices because of tariffs.”

Del Monte – this was Greg Longstreet – said, “It’s not just the tariffs. Transportation costs are up, labor costs are up. It is an inflationary environment. The consumer is going to have to pay more for a lot of critical goods.” I think that is pretty realistic. I think that is a good take on things. Walmart can blame it on the tariffs. Tariffs are one factor, but prices are on the rise.

Kevin:And technology – the competition for intelligence in technology. Look at cell phones.

David:You have the legitimate concerns of the Trump administration that you roll out a 5G wireless network and prominently positioned in that is Huawei, the Chinese cell phone company, the number two smartphone seller in the world. Could that pose security threats with back channels to Chinese intelligence? Listen, this is not unreasonable. If Israeli security firms can hack virtually any existing phone using native apps and software on the phone, could designers of the Huawei phones create the hardware to have comparable benefits? I think so.

I’m not questioning what he is doing, but there are consequences for some tech companies here in the U.S. Certainly Micron is not too appreciative right now of what is going on, and there are a few other names. But the larger issue is not security threats, in that sense. So you can focus in on a specific company or specific sector, but the larger issue is not security threats, it is the incumbency as the global super-power. The U.S. has it today. And you have the Chinese in this weird historical position because the mercantilist growth model has worked for them up to this point. Can that mercantilist growth model work forever? Probably not.

Kevin:But let me ask, because we just spent the first part of the program talking about all the problems that we have created for ourselves in the future. It’s that rake – with the debt, stepping on the rake again and again and again. But every time we step on that rake, Dave, we always find something to blame that is not called debt. It’s always something, someone, some regulation. The Chinese are needing this, too. Look at how much debt the Chinese have been running on and they are starting to show the effects. They look like they are about to step on their own rake without us.

David:We mentioned it last week, just a few simple choices that they have. They have chosen the way of debt. And I think the massive quantity of debt taken on by the Chinese state is an indication that the mercantilist model is not working. That was a past tense success story. Just create a 40 trillion dollar bridge loan from the past into the future, and that is what the Chinese need. They need to transition to a different economic model. They have not been able to successfully do that. It doesn’t change their level of aspiration. It doesn’t change the fact that they are intent on success.

But I think you have a very rocky road directly ahead for the Chinese if history tells us anything about how debt is treated in the international markets. So if history has anything to say about economic fragility, and if history has anything to say about statecraft, then the Chinese will use the scapegoat in a key way. The U.S., Trump – who are we today in the world if Xi Jinping and the Chinese Communist Party? We’re the international bully. We’re the abuser of sovereignty rights.

Kevin:Again, this is propaganda, right? We’re not necessarily that.

David:But propaganda ties to some degree of truth. There are aspects and elements of truth, but there is no doubt that this serves as a great PR campaign, and the foundation for a propaganda campaign in the context of a naturally deteriorating economic fundamental.

Kevin:Stepping on the rake.

David:So credit and capital flows – these may be the first weapons used in a new cold war. But you have some other things changing, too. The regional power dynamics shifting in Asia – we have talked about how we use our fleet in that area in the contested waters around the South China Sea. But as soon as July the U.S. may pull out of the INF treaty. It has at least threatened to do so. And what does that do to tensions?

Kevin:What you are talking about is intermediate nuclear weapons. There is a treaty that Russia and the United States signed years ago, back when it was the Soviet Union. There are clear signs that Russia is not playing by rules, and we’re saying, “If you’re not going to play by the rules we’re going to pull out.” But once you pull out of that treaty there are Asian nations that probably could use the United States’ missiles for protection against their neighboring enemies.

David:Right. So what the INF limited was the development and testing of these medium-range missiles. By 1991 they also destroyed 2,000-3,000 missiles – the U.S. and Russia did.

Kevin:These are not inter-continental. These are hundreds of miles, up to a few thousand, right?

David:Right. This goes to the Reagan/Gorbachev era. This was ground-based ballistic missiles with a range of 300-3500 miles. Russia has been out of compliance, according to the U.S., and now this last fall NATO confirmed, yes, they are not in compliance with the INF treaty, and the Russians were testing new missiles that fall under the INF ban. The U.S. now has to either seek enforcement, or we drop the treaty altogether, and it is convenient that we consider dropping the treaty because China never signed the agreement to begin with. So the U.S. is bound to keep it while the Chinese are not.

This happens in July, potentially July 12thto the 17th. Pulling out of the INF would allow for the U.S. to deploy medium-range missiles with its allies in Asia, like you said. And it doesn’t take much imagination to foresee a version of the Cuban Missile Crisis where we are moving U.S. firepower into the region, and you tell me if that would be appreciated by the Chinese, or how that would go into that PR and propaganda spin campaign, even as we watch their economy move into regress, not progress.

Kevin:We look at China as a communist nation, but it’s not really. You said it was like a mercantilist nation. But one of the things we are seeing, and we see this, usually, before there is a major change, geopolitically, worldwide, all through history. Instead of a rule of law we’re starting to see a rule of man. This is something that Russell Napier brought up as well. I really can’t wait until you talk to him because he is saying that there is a consolidation of power. Xi has already been chosen as the guy who is going to take China into the next phase.

David:That’s right. So in terms of global leadership and the role the Chinese play in the 21stcentury, he has already consolidated power within the Communist Party – within the Politburo. So you have domestic, economic and political concerns in China, and those can be converted to positive energy. Those can be turned to positive outcomes, from concerns and problems to positive benefits for Xi if he can redirect the potentially negative energy somewhere else – like toward the U.S.

This is not without historical precedent. You remember we talked to Minxin Pei a number of years ago? He was a guest on the Commentary. He reminded us that the Chinese purchases of U.S. treasuries were not correctly thought of as a financial investment, which is different for us because we tend to think, you buy an asset because of the merits of the investment and you want to make money.

Kevin:But he said it was a political leverage event.

David:It served political ends. So at the same time we look at the amount of U.S. treasuries that the Chinese own, and those treasuries at one time were a very large percent of our debt outstanding. Again, we have talked about the growth of debt here in the United States. In percentage terms, the amount that they own, in total, keeps on a shrinking as we expand our total stock of debt. Today, I think the Chinese hold about 8.6% of U.S. bonds outstanding.

The question is, can they weaponize them if need be? Can they weaponize that bond holding? This is a financial market reality because you’re talking about a significant impact if you have too much liquidity or too little liquidity. In the case of too many treasuries, too much treasury supply coming to market, you discover that you may have a lack of buyers to purchase them – a lack of liquidity driving prices lower, driving rates higher, and squeezing out private market financing.

We’ve talked about inflation, we’ve talked about things that are outside of the Fed’s control in terms of driving rates higher, and we have also suggested that there is a critical element here. We only keep the wheels on if we keep the rates low, and the wheels come off if the rates go higher. What I am also saying is that we don’t control everything that relates to our treasury market.

Kevin:And isn’t it ironic that we have used the treasury market worldwide for leverage ourselves all through the years. Look at Iran and some of the countries that we have been able to manipulate with money flow and movement in the U.S. treasury. When you take your concealed carry training, one of the things they warn you about is that if you have a gun you had better be careful that it is not used against you. In a way, the U.S. treasury has been able to use that as a gun for a long time – our leverage worldwide. At this point the Chinese could use the leverage back. It is fascinating who can pick up the gun and point it at whom, at what time.

David:It’s a matter of timing because if the Treasury is issuing a larger amount of debt than usual, which they did last year – we talked about a 1.4 trillion dollar issuance last year and they are going to do something like that this year, too, an outsized amount of Treasury issuance – what you assume when you are pumping all that debt into the market is that there is an appetite in the marketplace. That appetite has to be robust.

If the Chinese all of a sudden are flooding the market with hundreds of billions in treasury bonds, can that pressure rates higher? Can that pressure the dollar exchange rate lower? Do you have, with those treasuries that they hold, an effective means of retaliation? Again, not because of the strictures in trade, but let’s say we move our missiles into the region. That is something that no president since Reagan signed the INF pact has considered. We’re not moving missiles around, we just don’t do that. Chinese media is already talking about this as the nuclear option.

Kevin:Yes, but it is the treasuries that they are calling the nuclear option, so do we want to not mix…?

David:I know. I know. It’s awfully close because the media is talking about dumping treasuries in response to trade, but the issue goes back to the Chinese Communist Party dealing with the U.S. posture having moved from engagement to containment. And it doesn’t have to be just because of trade, it can be just to push back on that idea of control. If we try to put China on a leash at this point, I think you look at a very, very upset animal. I’m not trying to be demeaning in any way here, I’m just saying if we presume control instead of engagement, we change the nature of the relationship, the dynamic, and potentially, the danger involved.

Kevin:We’re not completely isolated. There is an overlap. We have Chinese companies that are listed on U.S. exchanges. What kind of impact is there?

David:That’s a different kind of weaponization if you think about it, because your state-owned enterprises, many of them are listed in the U.S. markets. Many of them trade in your main indexes. There are a thousand Chinese companies spread across the three main indexes, 650 state-owned enterprises on the New York Stock Exchange, 62 listed on NASDAQ, 500 in the over-the-counter markets very unregulated.

What threat is there to the U.S. markets, what threat is there to the pricing of a particular index, if these state-owned enterprises are weaponized? A state-owned enterprise doesn’t have the same market solvency or liquidity limits that a normal company does because you have access direct to the government coffers. But volatility and price can get very, very crazy.

Kevin:As we talked about last week, when we watch the news, this is not just about trade talks. It can involve everything from the ability to put short-range or intermediate-range nuclear weapons nearby, or what the Chinese media is calling the nuclear option, which would be the dumping of U.S. treasuries. There are a lot of threats, there are a lot of layers to this onion, that have far more to do with hegemony, like we talked about last week, than it does with actual trade.

David:And the X factors, the unknown factors, are how the market engages with specific market pricing. We have this presumption of control by the central banks who believe that they can control the price of bonds. And if you can control the price of bonds and the cost of capital, you are going to influence the price of every other asset out there. If you begin to lose control of that, it gets very ugly very quickly, not only for the Chinese, but for the U.S. Again, we have set up this side conversation where Trump can blame the Chinese and the Chinese can blame us, and we can have an inflamed conversation pretty quickly.

Ford plans to eliminate 7,000 salaried jobs between now and August. Is this going to go over well as we come into the election season? Do you think he is going to say that the economy is weakening? No, he will scapegoat with the Chinese just as the Chinese will scapegoat with us. This is where you are going to have to be very, very careful – very, very careful – because in a time like this, not only do you need stupidity insurance for Fed maneuvering, but you need stupidity insurance for our statesmen.

Kevin:This takes me back to earlier in the program when we were quoting Jim Grant on what can be done. And he said, just replace all those Ph.D.s with half a dozen historians, philosophers and a physician, the physician so that there is no harm done. But I go back to the philosophy because a person listening to this program might throw their hands up and say, “Okay, there are too many variables.” That always drives me nuts, as well.

When there are too many variables, but there is a consistent historic norm, which is this failure of debt, you have to step aside and say, “Well, I’m not going to play. There are too many variables. I’m going to step aside.” This is where the philosopher comes in, Dave. This is what your degree is in. So I’m going to yield to the philosopher of money here and say, “All right, what is real money? Where do you protect yourself from the variables?”

David:Right. And this is where gold has been a constant through time. It is no longer a constant within our money system, but people should engage with it as a constant within their portfolios. You don’t get to an environment this chaotic and complex when you have the limits of the gold standard in place. If governments will not voluntarily step into the gold standard, you have to do that for yourself, for your family.

The ramifications of this chaos and complexity are too great as it applies to asset classes to not have stupidity insurance. Again, we’re talking about stupidity insurance that goes back to D.C., that goes to the heart of our statesmen, leadership, as well as central banking cohorts. The Ph.D.s don’t have this figured out, and I don’t think our statesmen have it figured out.

Kevin:What you are talking about is, philosophy comes from looking back. It is almost, also, being a historian, you talk about historians, philosophers and a physician. The historian would tell you that there is no generation in the entire framework of history where gold didn’t preserve the buying power through the crisis.

David:And now we expect there to be some great new surprise, that in this era of modern monetary theory and this era of spend and print and don’t worry about it because we can get our 5% GDP…

Kevin:This time is different.

David:If we’ll just do a little QE, that this time is different. I think the surprise is in the inflation area. The surprise is in the solvency area with particular borrowers. The surprise is with the Chinese. There are areas and pockets of surprise where if you don’t have insurance you have missed the big picture.

Kevin:And with gold, there is no surprise. It always preserves the buying power.


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