The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“I don’t believe capitalism can survive in a zero interest rate environment, so this is one of the limiting factors as to how long this can go on. The longer they keep the bubble inflated, the more excess capacity we have, and as soon as they stop inflating it, the prices will fall, and lead to even more deflationary pressure. They will probably be able to keep doing it for a while, but it is hard to see how this can go on forever.”
– Richard Duncan
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Kevin: Our guest today, Richard Duncan, is a regular, Dave. We had him on about a year ago. The thing that really hits me when I read Richard Duncan is, the hair stands on the back of my neck, because he understands where the money comes from, where it goes, and how the equations sometimes don’t add up.
David: There are a number of contributions he has made over the last decade or two, to the whole investment community, which have been fantastic, and being a part of our conversation and dialogue here on the McAlvany Weekly Commentary, has also, I think, been insightful at critical junctures. His book, written a good 10-15 years ago, The Dollar Crisis, was my first introduction to him at the turn of the millennium, and then more recently, The Corruption of Capitalism. That, too, was insightful in terms of what was changing the way the whole global economy was working, and really, how we have moved toward a credit-based system, and away from anything real, or substantive, but that creditism is really the way we have headed.
Kevin: He brings to the conversation a grave sobriety. He says, “Look guys, you may not like the system we are in, and we are not growing the way we used to grow, or actually, the way that is organic. We are growing only because we are increasing debt.” Now, you don’t want to kill the messenger on this because a lot of our listeners are not going to agree with his strategy. His strategy is, “Look, we’ve gotten ourselves into this mess. Let’s try to extend it as long as we possibly can because the outcome on the other side, he doesn’t believe we can survive.
David: We just recently spoke with Ian McAvity, and every time I see Ian it is wonderful to spend some time visiting with him, sage-like insights into the marketplace. But he has been a chain-smoker his entire life, and his doctor told him, “If you quit now, you will die.” And that is, essentially, where we are. It is Richard Duncan’s view of the U.S. economy and our addiction to debt, if you quit now, you will die.
Kevin: That’s what he thinks.
David: And I’m glad we had a conversation a week or so ago with Ian, but that is the state of affairs. As much as I would love to see Ian stop smoking, his body is so addicted to it, if he quits now, he will die.
Richard Duncan is, again, a part of the commentary today, to look at research that he has put together recently on his Macro Watch service, richardduncaneconomics.com. Without further ado, let’s look at where we are, and where we are going.
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Richard, it has been nearly a year since you have been on the program, and if I recall correctly, we were looking last year at a number of things. Number one, to grow an economy, there are a variety of factors that need to be in place – growth in the labor force, growth in income, in credit expansion. And one of the things that we explored then, and you will continue to explore in your research, is how labor force growth has not been sufficient. Even though it has grown some, it hasn’t grown sufficient to be the generator of broad-based economic growth. Nor has income growth been sufficient, so we have relied heavily on credit growth and credit expansion, and frankly, there has not been enough there, either, ergo QE has been necessary.
We are at a very interesting juncture because here in the last few weeks, we have had the end of the third round of quantitative easing. Why don’t you lead us through your current research, and as you bring us into that, let me just mention one thing about your project called Macro Watch. I look at a variety of resources to inform my perspective, and Macro Watch is one of them, and it is one that I simply wouldn’t do without, and I would encourage anyone who wants to have access to your thought process and your research to go to richardduncaneconomics.com.
You mentioned just before we were on the air that they could put in a coupon code and use “commentary” as the coupon code when they are subscribing, and you would offer them a 50% discount. Let me just say that you don’t need to discount it, and it’s worth every penny. The fact that you are discounting it for our Commentary listeners is profoundly generous. So, putting in “commentary” in the subscribe button when you go to richardduncaneconomics.com, these are videos series that you do on a quarterly basis, looking forward and anticipating major changes, to me, your research is invaluable. So without further ado, let’s talk about your research, and let’s address this issue of credit expansion and the role that QE has played, and the need for global liquidity, here, into the future.
Richard: Thank you, David. That’s very kind of you. The focus of this video newsletter research, Macro Watch, is my belief that since we broke the link between dollars and gold in the late 1960s, early 1970s, credit growth has been driving economic growth, and if we don’t have enough credit growth – in fact, going almost all the way back to World War II, any time the United States has not had credit growth of at least 2%, adjusted for inflation, the U.S. has had a recession. And that recession didn’t end until we had another big surge of credit expansion.
And so the U.S. economy has been fueled by credit expansion, and a growing U.S. economy drove the global economy. So just to put that into perspective, total credit, relative to the size of the U.S. GDP, increased from something like 150% of GDP in 1980, and it went all the way up to 370% of GDP by 2007, and that drove the U.S. economy. And the U.S. economy drove the global economy. But since the crisis started, 2007-2008, credit has not been growing by 2%, and that has meant that quantitative easing has been necessary. The Fed has had to print money, buy financial assets, 3.6 trillion dollars’ worth now, push up the price of those financial assets, and create a wealth effect. They have pushed up household sector net worth by 25 trillion dollars since 2009 doing that, and that is how the Fed has driven the economy.
But looking ahead, this is a very interesting time. As you just mentioned, QE-3 has just been wound down now, finally, at the end of October, but as I look ahead, I don’t believe we are going to have 2% credit growth in the U.S. for the foreseeable future, so I think that without another round of quantitative easing, QE-4, I think, give it a few months, and the U.S. economy is going to visibly weaken. I think there will be a significant stock market sell-off, and that will cause household sector net worth to decline, consumption to decline, and the U.S. will head back into recession. And at that point, the Fed will have to announce QE-4 because they have to make the economy keep growing, and that is the only tool that they seem to have at their disposal to make the economy grow.
Now, perhaps they will come up with some new tool. That’s always a possibility. But as of this point, I can’t see what that would be, so I think we will see QE-4. After all, we have seen QE-1, 2, and 3. There is a reason they number these things. It is because they keep doing them again and again.
David: We have seen an interesting interaction between the world’s central banks. It has almost been like a relay race. The ECB expanded their balance sheet for a few years and has subsequently allowed it to contract. Then the Fed expands their balance sheet. We haven’t seen it contract yet, but we don’t know – at least, their stated intention is to allow it to contract. We will have to see. As you say, QE-4 may be just around the corner. Now we have the Bank of Japan, and clearly the Bank of Japan, and the People’s Bank of China, these are two other significant world central banks, and I’m just wondering: Is it sufficient, in terms of the liquidity created by an individual central bank, to float and benefit from that liquidity on a global basis? Is the global economy going to be supported by a single central bank’s printing activities and asset purchase activities?
Richard: That is a very important question, and I have been doing some work on that just over the last couple of weeks. What I have done is, I have looked at the five largest central banks, the People’s Bank of China, which is actually the largest central bank in the world, the Fed, the ECB, the Bank of Japan, and the Bank of England, and I have projected out their total assets until 2016, based on the information that they have provided us about what their intentions are. The ECB has announced that they intend to ramp up their balance sheet again back to the peak level that it reached at the end of 2012, and the BOJ was printing between 60 and 70 trillion yen a year, and they have just upped that now to 80 trillion a year. And the Fed has indicated that they are ending their quantitative easing program. Adding all those balance sheets together gives us a very good proxy for global liquidity. And with the Fed ending QE, obviously the Fed was printing so much money last year, a trillion dollars, now that they have brought that to an end, if we extrapolate the growth and the combined balance sheets of these five largest central banks, extrapolating out on what they have told us, then we are not going to have very much growth in global liquidity. In 2016 global liquidity will only grow by 6%. That compares to more like 20% growth in 2012, and as much as 30%, or even 40% growth in total global liquidity back in 2009. In fact, at 6%, it is even lower than the growth in global liquidity that we were seeing in 2004 and 2005, in that period leading up to the global economic crisis.
So, with only 6% growth in global liquidity, that is going to create a very difficult environment for financial assets, I believe, and it suggests that we will be faced with even more deflationary pressures. I just don’t think it is enough to keep the global economic bubble inflated, and I really think it is going to force the Fed’s hand to come through with yet another round of QE so that global liquidity will grow more, and they will be able to keep the global bubble inflated that way. That is their goal, to prevent this global economic bubble from ever deflating.
David: We have the Bank of Japan as something of a test case for a disinflationary, or deflationary, trend. And it is the proverbial – central banks prefer the stallion of inflation and challenging that, taming that, as opposed to the deflationary dead horse, because it is very difficult to get that horse up and running again, and the Bank of Japan is doing all that they can. As you mention, they were buying significant assets in the Japanese stock market, denominated in yen, and now, here more recently, they have announced an even larger bond purchase program for the Japanese government bonds. Again, this smacks of desperate measures, and radically inflationary implications long-term, and I guess this is sort of the conundrum. We sit as investors, and we look at the mountains of debt which need to be serviced, and the system of capitalism, which, as you say, has been co-opted by credit, going back to the 1960s and 1970s, and has only grown on the basis of 2% adjusted for inflation, 2% credit growth, and yet, the central banks of the world, in order to prop things up and keep them going, are creating money/credit out of nothing, on a scale never witnessed before in human history, outside of the rare instances of hyperinflation where, of course, the numbers got even more radical. We have this interesting sequencing of deflationary trends and the inflationary machinery used to fight them. Maybe you can help us square this, because certainly, the Bank of Japan’s most recent activity got everyone excited. Global equity markets have gone bonkers in light of the idea that central bank printing presses are the way toward a brighter and fresher tomorrow.
Richard: Yes, I think, to begin with, we need to compare the period we are in, at the moment, with what happened in the 1920s and the 1930s. The earlier period, in the 1920s, we had a global economic bubble that came about because the European countries went off the gold standard in World War I, and they printed a lot of paper money to finance a lot of government bonds to fight the war, and that created a worldwide credit bubble that we called the Roaring 20s. And in 1930 the credit couldn’t be repaid, the policy-makers didn’t know what to do, the global economic bubble imploded, and we had a depression that lasted for ten years until World War II started, and then the government had enough money to reflate that global bubble and to take us into a new era altogether.
This time, we once again have a massive global economic bubble that has been inflating for decades, and in 2008 when the credit couldn’t be repaid, then rather than repeating what occurred in 1930, allowing the global economic bubble to deflate, this time the global policy-makers are doing absolutely everything in their power to keep this global economic bubble inflated. And so far, they have succeeded in keeping it inflated. But it has been fascinating to watch. Just look at the events of the second half of October. I could barely sleep – as you know, I am in Asia, I have to watch the U.S. market at night – but on October 15th the market was actually panicking. The Dow was down 450 points, the ten-year bond yield had collapsed during just that one trading session, from about 2.2% interest down to 1.86% interest on the ten-year government bond yield. It was absolute panic in the markets. Even Rick Santelli, the CNBC bond man, said he had never seen anything like that. And then the next day, the market opened again down 170 points, and it looked like the panic was really setting in, until St. Louis Fed President, James Bullard, on a live Bloomberg television interview, said that he recommended that the Fed extend quantitative easing, and by the time he finished that sentence, the market had rebounded by 120 points. And then, the next day, the chief economist of the Bank of England said that, well, after all, they probably wouldn’t be increasing interest rates as soon as they had expected. Then the next day, the ECB said that it would begin buying assets outright in the next week. Then Sweden cut its interest rates to zero for the first time in history, and then on October 31st the Bank of Japan really shocked the world by announcing that they were upping what they call their QQE program, by somewhere between 20% and 30% a year. So, clearly, these moves were coordinated, to a very considerable extent, to make sure that global asset prices keep inflating, and inflating they have been.
One of the main issues with all of this, though, is how low can interest rates around the world go? The Japanese government bonds, the ten-year JJBs are yielding something like 43 basis points. The German ten-year government bonds are yielding 82 basis points. And a few weeks ago, the ten-year U.S. government bond was down to 1.86%. If the central banks all keep printing more and more money, and buying more and more bonds, the bond prices go higher, the bond yields go lower, and at some point, the bond yields are going to be so low that the pension funds simply aren’t going to be able to earn enough interest to make their pension obligations, and it is the same with the insurance companies. I don’t believe capitalism can survive in a zero interest rate environment. So this is one of the limiting factors as to how long this can go on. Meanwhile, the excess global capacity around the world, most obviously in China, continues to become more and more excessive. The longer they keep the bubble inflated, the more excess capacity we have, and as soon as they stop inflating it, the prices will fall, and will lead to even more deflationary pressures. So, they will probably be able to keep doing this for a while, but it is hard to see how this can go on forever.
It would be very useful if the government, on the fiscal side, would step in with some fiscal stimulus. For the year ending September 30th, the U.S. budget deficit was down to, I believe, 2.8% of GDP, so the deficit has come down very radically. We need to expand that budget deficit to provide more global demand, and that would create more demand for more products, absorb some more excess capacity, create jobs, and provide more stimulus. The central banks, by themselves, can’t keep inflating this global bubble forever, just through monetary policy. It is going to take some more fiscal stimulus, as well.
David: Then we have the challenge between national interests, between the Japanese Central Bank looking after the interests of the Japanese, the European Central Bank, I guess, in theory, looking after the interests of Europeans, although there are certainly a number of divided interests throughout Europe, peripheral and core. The Bank of England, the United States, and the People’s Bank of China, each of these institutions is defending turf, to some degree. They may be interested in the global economy and global growth, insofar as it benefits their countries in trade and what not, but on the other hand, if you push hard enough, they are there to defend the interests of their individual countries. So, for instance, we see the Bank of Japan wanting to lower the value of the yen. We see the ECB wanting to lower the value of the euro. Not everyone gets to devalue, and succeed. So, how do we square these natural interests which are at cross-purposes with each other?
Richard: Yes, that is a very big problem. For a very long time, it was the U.S. trade deficit, expanding steadily, year after year, that drove the global economy. Clearly, as the U.S. bought more and more from the rest of the world, that provided enormous stimulus to the global economy. And, as you know, the current account deficit, the trade deficit, peaked at something like 800 billion dollars in 2006. Well, once the crisis struck, that fell by about half, and then it started growing a little bit again, but now the U.S. current account deficit is shrinking again. Last year it was only about 380 billion dollars, and so that is providing a lot less stimulus to the global economy now than it did in the past.
And looking forward, it is probably going to keep shrinking because of the U.S. shale oil revolution. The U.S. is importing much less oil, and is exporting much more petroleum-related products, so this was the driver of global growth, the U.S. trade deficit. It was the driver of global growth, but now it is going into reverse and it is not driving the global economy anymore. And so, look around the world. What’s happening? Brazil is in recession, Russia is in recession, China’s economy, it is hard to know exactly what the truth is there, but clearly, their economy is growing much more slowly than before. Europe is in recession. Japan hasn’t grown the last 12 months.
So the whole world economy is very weak. Why? The main reason is because the U.S. trade deficit has become so much smaller than it was before. All of these countries would love to devalue their currency as much as possible against the dollar, and that is what is going on at the moment. With the Fed ending QE, and the DOJ and ECB ramping up their monetary expansion, then we are seeing the dollar strengthen quite significantly. And so, if it were to strengthen much more, then the U.S. current account deficit would start becoming larger again and acting as the driver of global growth.
But then that could also have all kinds of unexpected consequences that people have not anticipated. If the dollar strengthened much more, then oil prices would probably fall very sharply, which would not only cause a crisis for Russia, but also many of the other oil exporting countries around the world. And gold would also probably fall quite sharply, which would make a lot of people very unhappy. So yes, the world economy is very weak, and if you look at the U.S. economy, the most recently reported GDP growth number was 3½ percent for the third quarter, but that was a little bit odd. Consumption was weak, business investment was weak, but government spending jumped very sharply, and most strangely of all, perhaps, was that U.S. imports actually declined by almost 2%, while U.S. exports surged by about 8%.
That is very odd, given how weak the global economy is, and how much stronger the dollar has been becoming. So, that is not likely to last. The U.S. had a horrible first quarter, so these most recent numbers really overstate the strength of the U.S. economy. And now with QE-3 over, the chances are we are going to have a significant correction in the stock market. The property market has already slowed down quite significantly. And if we get a big correction in the stock market, then that will take the wind even further out of consumption. The latest consumption numbers were unexpectedly weak. Personal consumption expenditure contracted by 0.2% in September, which took the markets by surprise.
So, the economy is still weak, but the main problem is that U.S. wages are not growing, and that is because globalization is driving down U.S. wages. That hasn’t changed. So, we have a big problem globally, and in the United States, and I am afraid that without more QE, then this global bubble of ours is going to deflate. But I don’t think the Fed will allow that to happen. I think they will step up with another round of QE-4, and when they do, it will push the stock prices higher. So, while we may have a big correction between now and the end of 2015, I would still expect stocks to end higher at the end of 2015 than they are at the moment, but only because the Fed forces them to go higher through more QE.
David: At what point do investors begin to look at the amount of liquidity that is being created as something of an artificial input into the valuation of equities, rather than looking at fundamental growth in the business sector. We have already seen companies move toward financial engineering to pretty up their numbers a bit, and that helps. When people are looking at earnings per shares number, investor have been consoled and encouraged, and they are able to focus on that, and not exclusively on central bank activity. Does there come a point when people say, “Actually, the reason that we are here is because of printing press money, and otherwise prices are not justified at this level?”
Richard: You know, I have worked in the investment industry all of my career, and I was initially shocked to discover that the investment managers, while they may understand that fundamentals are weak, if the stocks are going up, for whatever reason, they must buy them, because if they are not in, if they don’t own stocks when they are going up in a rising market, they will lose their jobs. So, it doesn’t matter what their view is of the fundamentals of the economy, or what is pushing up stock prices, as long as the stock prices are being pushed up, they will be fully invested, or as fully invested as they can be. It is only when they think that the tide will turn that they will panic and try to get out, and that is what they were starting to do on October 15th. But then James Bullard, of the St. Louis Fed, reassured them that the Fed would be there for them, and extend QE if necessary, and that resolved the panic, and by the end of the month the market had recovered.
David: This brings up the idea of perpetual bliss through printing press money. It doesn’t seem sustainable, and yet it has gone a lot further than perhaps some pundits, and I would include myself in that, I suppose, could have anticipated, or did anticipate, the confidence that people place in printing press money as a substitute for real economic growth.
Richard: Yes, I always antagonize so many people who I would like to agree with in the following way: I honestly believe that the Austrian economists were absolutely right in explaining how credit creates an artificial boom, and the boom normally busts and ends in a depression; the bigger the boom, the bigger the bust. So yes, I think all that is right. But, as you have heard me say in the past, and which the Austrians all hate to hear me say, I think that this boom that we have now has been going on for four or five decades, and it has become so large, if it actually busts, if we allow market forces to work, then we are going to collapse into a depression from which probably no one alive today will live to see the end of. And as I have said in the past, I just don’t think our civilization could survive that.
So, instead of just stepping back and allowing market forces to work, as the Austrians would recommend, I am totally opposed to that idea. I don’t want to have a 20-year depression, and I think we should look at the opportunities that exist within this system, as it is now, and the opportunities are like this: We have global excess capacity; we have insufficient global demand. The government can borrow money for ten years at 2% interest. If it just borrows the money on a big scale, and invests it sensibly, in new industries and new technologies, it could create new industries, millions of new jobs in the United States that would employ millions of people, boost consumption, fundamentally strengthen our economy in every way, create new industries, new technologies, medical miracles, technological marvels, and we wouldn’t have to collapse into an Austrian-style depression. At least, not in my lifetime.
That is more or less what happened in World War II. We were in a depression for ten years, and then the war started, and then the government increased its spending by 900% on war materials and war machines. This time, instead of increasing our spending 900% on war, let’s have a radical increase in fiscal deficit spending on investing in new industries and technologies, because we can afford to do this, because we can borrow the money at 2% interest for ten years. And we are not confronted with the threat of inflation. We are facing the threat of deflation if our global bubble deflates. But my Austrian friends really hate for me to say that, so I don’t always talk about that. I stick more to the nearer term investment implications of Fed policy, and how it will likely impact asset prices over the next quarter or two.
David: What you describe, Richard, is a reasonable patch. I think the one word that I might take umbrage with is the word, sensibly, because I don’t know that the folks in Washington put that in their intellectual grid. When they start spending money, it is not necessarily along sensible and strategic lines. My eight-year-old son and I drive under a bridge here in Durango, Colorado, almost every day, and he points up and he says, “That was the last effort at government spending.” It’s the local bridge to nowhere. Literally, it does not connect anything to anything, but they did spend about ten million dollars building it. So yes, it created some economic activity, for a very short period of time. Ultimately, the dollars invested, and the long-term return on that investment, will end up being negative, not positive. A short-term shot in the arm, but the critical variable that was missing there was strategic and sensible investing, and I think that has to do with who represents us in Washington. Perhaps there are others in the world, in other jurisdictions, where you have statesmen and not politicians, but our politicians, on both sides of the aisle, do tend to focus on re-election, and who to give the money to, in terms of their rolodex, in order to ensure re-election.
But let’s go back to one thing that I think is really critical in terms of international conflict and international relations. It is this idea that, as you suggest, as and when, not if, but as and when QE-4 is announced by the Federal Reserve, there is an implication for the ECB and there is an implication for the bank of Japan. It dramatically impacts what they are trying to do. Again, we are at cross-purposes in terms of trying to create domestic recovery. Global recovery is less important, at the end of the day. Europe wants European recovery, Japan wants Japanese recovery, and the U.S. wants U.S. recovery, and the methods and means, again, seem to be at cross-purposes. What happens, specifically, when we announce QE-4 for the Europeans and the Japanese?
Richard: Again, if we go back to projecting the central bank balance sheets out to the end of 2016, what we are told to expect now is a sharp expansion of the total asset size of the Bank of Japan and the ECB, so their total assets will be growing sharply, whereas the total assets of the Fed will almost be flat, and that is what the market is currently focused on. The market moves on what it expects to happen. And so, the more that a central bank prints, the more its currency should depreciate against other central banks. So that is why the euro and the yen are depreciating relative to the dollar.
But if we get the announcement of QE-4, then suddenly, instead of the total assets of the Fed being flat for the next two years, the projected trend will also move up very sharply, until suddenly, the euro and the yen will strengthen. All of their losses will go into reverse and the dollar would weaken. So, this would have very significant implications. So, let’s first talk about what happens if the Fed really doesn’t do any more quantitative easing. I think that the euro and the yen would depreciate further, but also I think that because global liquidity would dry up, I think we will have a big stock market crash, and the global economy will weaken further, and commodity prices will weaken much further.
But on the other hand, if we do get another round of QE, and I believe we will, probably somewhere at least 500 billion dollars next year, and the year after, each year, probably somewhere between half a trillion and a trillion of QE next year, and again in the following year, then everything reverses. The dollar would fall, the euro and the yen would rebound, and the global stock market would jump because the global liquidity would expand, so the global economy would strengthen, and global commodity prices would get a good bounce. So, it would be enormously significant to all the asset classes when they do announce QE-4.
But it is also very interesting, I mentioned at the beginning that based on current expectations, global liquidity will only grow by 6% in 2016, which is very low relative to the past many years. Even if we did 500 billion dollars money creation from the Fed in 2015, and again in 2016, even then we will only have an 8% increase in global liquidity, and that is with half a trillion dollars of money being created in QE-4 in both 2015 and 2016. So 8% growth in global liquidity is better than 6% growth in global liquidity, but even that is still very weak to the 15% we were seeing in 2012 and the 25-35% we were seeing in 2009, and the 15-20% we saw in 2004 and 2005. So, even that would suggest that we would still be confronting pretty significant global deflationary pressures. They may have to come up with even more than half a trillion dollars of QE for the next couple of years, maybe a trillion a year like last year, or maybe 1.5 trillion a year. That is the problem, when you start creating so much paper money, you have to keep creating more and more of it to have the same impact that you did in the past. You have to keep growing the assets of the central banks even more each year, to have the same impact on asset prices. So this, ultimately, will end very badly, but the key word there is, ultimately. It could go on for quite some time.
David: So, the deflationary pressures, you would argue, will persist, regardless of the Bank of Japan, the ECB, and the Fed’s activities for another couple of years, and as a response, these central banks will have to implement greater and greater liquidity measures, and it seems, then, that we are still in a very confused state, from an investor standpoint, from a financial standpoint, because on the one hand you have a mountain of debt which is begging to collapse in upon itself, you have a mountain of credit creation and money being printed by the world central banks to try to offset that and keep that from happening, and you really don’t have any clear road ahead in terms of resolution for the fundamental and systemic problems that we have which have brought us to this point.
Richard: That’s right, and David, you and I are not the only people who are aware of this. Policymakers around the world also understand this, to a considerable extent. In the past, when this sort of problem has occurred, the easiest way out was to have a war, and that way you could have a lot of fiscal deficit spending, and there would be no criticism of that in a war, because everyone has to be patriotic. And that revs up the economy, that gets rids of the excess capacity, and you have a good excuse for government spending. Okay, a lot of the government spending is wasted on unnecessary bonds, unnecessary equipment, or stolen by this party or that party, or this group or that group, but no one can criticize it because there is a war, and you have to be patriotic.
President Reagan was very clever about it. He didn’t actually have a war, he just ramped up military spending by fighting the “Evil Empire,” the Soviet Union, and of course, it was an evil empire, and he ran very large budget deficits of more than 5% of GDP for five years in a row, during his early years in the presidency, and that was very successful in revving up the economy. That is where the prosperity of the 1980s came from – Reagan’s massive budget deficits. Now, our budget deficit is almost half the level of what Reagan’s were during his glory years, and that is unfortunate, because for the next couple of years, at least, it doesn’t seem that we are likely to have a war. Not that I want to have a war, of course, but the point is that these days, it is hard to find the right sized partner to have a war with these days. If we have a war with a little country like Venezuela, they are way too small to spend enough money to stimulate the economy. But if we have a war with a big country like China, they are way too nuclear, and everybody dies. It is hard to find the right-sized partner to have a war with in the modern age, so this just doesn’t work very well, as it did in the past, because we can’t have wars because of nuclear weapons. That worked in the past, it doesn’t work now, we need to find another way, so maybe the policy-makers are going to come up with another plan to stimulate the economy other than having a war, and they could do that through very aggressive spending on global infrastructure, or global technology investment. That would be the sensible approach. As you have pointed out, policy-makers often don’t do the sensible thing,
But I’m sure they are thinking about this, and we are going to have to have some sort of fiscal stimulus sooner or later. Monetary policy can only carry us so far, and we will collapse into a depression. And at that point, will we stay in a depression for ten years as we did in the 1930s? Will we have a war right away with some country? Or will we come up with some new sensible approach other than fiscal deficit spending? Those are all open questions, but something will have to give sooner or later.
David: Your concern in the more immediate term with equities, global and here in the United States, seems to be related to this drop in excess liquidity. Looking at the liquidity theory of asset pricing, we had a drop in excess liquidity in 2000, a drop in 2006, and we began to see, the periods where we had excess liquidity were 2000, 2006, and 2013. Thereafter, the contraction in liquidity led to major market corrections. And where are we now, third quarter, fourth quarter, coming into 2015 – is liquidity growing sufficiently? I guess what I am hearing you say is, no, not enough.
Richard: I have developed something I call the liquidity gauge. It measures how much money the government is sucking out of the financial market to fund its budget deficit, against how much paper money the central banks are creating, and pumping into the financial markets. So, when the central banks are creating more money through fiat money creation than they are sucking out to finance their budget deficits, in that case there is excess liquidity, and asset prices tend to go up. In 2013, for instance, the Fed created more than a trillion dollars and pumped it into the financial markets, but the government’s budget deficit is only 700 billion dollars, and so they only sucked out 700 billion. So the Fed printed more than enough money to finance the entire budget deficit, and all of that excess liquidity went elsewhere into the financial markets and pushed up asset prices. That is why the S&P went up 30% last year and why property prices went up 13% last year.
But now, everything is changing. Because QE is ending, next year and the year after, the government will be borrowing something like 500 billion dollars a year, and the Fed won’t be pumping any new money at all, we are told, since QE is over. That means the government will be borrowing a lot more, and this will be akin to old-fashioned crowding out that they taught us about in business school a long time ago. When the government borrows money, it tends to push up interest rates, and that crowds out the private sector, so that is what we are looking at now for the next few quarters, and in fact, into the foreseeable future. The liquidity gauge, in other words, has turned negative, and that is going to create a very difficult environment for the financial markets, I believe, until QE-4 is announced, and then they will provide more liquidity, that will provide excess liquidity, and the stock market will rebound again. And that is how they will make the economy keep growing, because there are no other drivers in the economy other than that, because U.S. wages aren’t going up, because globalization is driving them down.
David: As we wrap up, let’s return to where our conversation started, which was, looking at the breakdown in the global monetary system in the 1960s and 1970s, and the de-linkage between dollars and gold. Implicitly, the dollar, today, is the world’s gold standard. That is not on the basis of anything backing it. It simply is confidence, and confidence can change rather rapidly, but that is perhaps a different discussion. We have growing discontent with the global monetary system. We have national interests which are aligning, as you might expect, in ways that promote growth, and really, displacement of the existing post Bretton Woods monetary system. Maybe you can explore with us what you think the monetary system looks like on a three, five, and ten-year basis.
Richard: Five years is only 2000 days. It sounds like a long time, but it is really not. Global monetary systems don’t collapse in five years. One of the weak points people are aware of is that the U.S. has a large trade deficit, especially with China. In fact, almost all of the United States’ trade deficit is with China. Last year the U.S. trade deficit with China was about 330 billion dollars in one year alone, which made up significantly more than half of the entire current account deficit. So, people are always worried that China will get tired of accumulating dollars, and stop accepting dollars, but they won’t. The reason China accumulates the dollars is because it has a trade surplus with the U.S. It needs to keep exporting more and more to the U.S. every year to keep its people employed in factories, making things to sell to the Americans. If China stops accepting dollars, then the Americans just won’t be able to buy any more Chinese goods, and so tens of millions of Chinese factory workers will lose their jobs, and China’s economy would implode.
China is not going to stop accepting dollars, because they have no alternative to accepting dollars. But what they do is, they take as many of the dollars as they can, and they use those dollars to buy raw materials, like copper and iron ore, and they stockpile those, instead of stockpiling U.S. dollars. They build up this stockpile of copper. They have a choice. Do you want to hold a lot of U.S. dollars and treasury bonds, or do you want to hold a lot of copper? They’ve tried to accumulate as much copper as possible. This is what they are going to continue doing. They are going to keep taking the dollars, because they have no choice, and the global monetary system is probably likely to remain in the same situation as it is now for the foreseeable future.
But the flaw in this global monetary system is that the dollar standard is unlike the gold standard. The gold standard has an inherent adjustment mechanism that made trade deficits between countries impossible, because if England had a big trade deficit with France, then England would have to pay for its trade deficit with its gold, and gold was money, and gold would leave England and go to France, and as the gold supply shrank in England, the money supply would shrink, and England’s economy would go into severe recession, and it would stop buying things from France because they didn’t have enough gold. So, countries couldn’t have big trade deficits under a gold standard.
But now, in this post Bretton Woods era that we have all lived through, it has been possible for the United States to run massive trade deficits with the rest of the world. They didn’t have to pay with gold. They could just pay with debt denominated in dollars. And that has created a very big global economic bubble. It also created a very big global economic boom. The choice is to allow this global bubble to deflate and collapse into depression, or to keep this dollar standard alive, and to keep the U.S. trade deficit growing.
And the way to keep the trade deficit growing? Well, American wages aren’t going up, so how are they going to buy more? The only way the Americans can buy more is if asset prices keep going up, if the stock market keeps going up, and if home prices keep going up. And the only way that is going to happen is if the Fed keeps creating more fiat money and injecting it into the financial markets and pushing up the asset prices. So, I think they will have to keep doing that, and I think they will keep doing that, and therefore, I think the global monetary system, the dollar standard, will survive intact for the next five to ten years.
David: What are the implications for the gold market, if it is not a part of the monetary system, and the dollar system continues on, we continue to see the Fed substitute, instead of gold payments, debt in our own currency, as you say? It seems like a bad deal for those receiving debt in a currency that they can’t control, nonetheless, it is what it is. Where does gold go, in the context of this grand monetary experiment, not just a monetary experiment by the Fed, but by every central bank around the world?
Richard: If I am right, if the Fed does launch another round of QE, then gold prices will move higher again. And just now, in discussing China, I mentioned that rather than accumulating dollars and treasury bonds only, they also try to stockpile copper and iron ore. I should have also said that they also stockpile gold. These central banks will accumulate more and more gold, as they have been doing. Of course, if the central banks keep creating more and more paper money, which I expect that they will, then over time, gold prices will keep moving higher. Now, if I am wrong, if QE really does stop, and all of this paper money creation stops, then what I would expect is that we will have a depression, and we will have deflation, and all asset prices will fall, a lot, including gold, but some will fall more than others. Gold will probably fall less than many other asset classes, so owners of gold will still be relatively better off than owners of many other kinds of financial assets. But I think that we will continue to see more fiat money creation, so over time, I think gold will keep appreciating.
David: Every quarter that I log on to richardduncaneconomics.com and look at your Macro Watch, the first quarter was fantastic, second quarter, third quarter. Your video series are very informative. The charts that you provide with them illustrate the points that you are making in a compelling fashion. And I just want to reiterate again what we started with in this conversation, it makes sense, if you are interested in keeping in touch with Richard Duncan and Macro Watch, that you go online, go to richardduncaneconomics.com, on the subscribe button use the coupon code “commentary,” and by all means, subscribe. And if you don’t have Richard’s book, most recently, The Corruption of Capitalism, I would strongly recommend that, as well. Between reading one of your recent books published through CLSA, The Corruption of Capitalism, and looking at your regular research, it is very generous of you to offer that to our commentary listeners at a 50% discount. It’s peanuts, in terms of the cost, compared to the value received, so we appreciate your generous offer on that.
Richard: David, thank you, it is always wonderful talking with you. Thank you for having me on your show again.
David: We look forward to seeing you out in Asia next time we are there, and we wish you well.
Richard: Thanks, I’m looking forward to that, too.