What If China Was In Charge of The World?

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• RAND Corp: Taliban running Afghanistan shows that Beijing is setting agenda of regional order
• China’s “Common Prosperity” is all about redistribution
• Seeing U.S. weakness, North Korea restarts plutonium production

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

What If China Was In Charge of The World?
August 31, 2021

“This is not a high-quality economic expansion. This is a feel-good moment. It’s artificially stimulated. It’s not particularly sustainable, and now you have the suggestions of change. Will we be successful? Will the Fed bring about reform in terms of our monetary policy? Or, inadvertently, are the Chinese and the Americans, whether it’s the folks in DC or at the Federal Reserve, introducing us to common poverty?” — David McAlvany

Kevin: Welcome to the McAlvany weekly commentary. I’m Kevin Orrick, along with David McAlvany. 

Being an American, being from the United States all these years, I think I’ve grown blind to what it feels like to be not from the United States. What I mean by that, Dave, is this. I have lived in a country where the dollar has been the reserve currency of the world, and I’ve enjoyed the benefits of that. I have lived in a country that has actually somewhat controlled a lot of the Western world order, maybe the whole world order if you think about it, as far as various countries intervening in time. Rand Corporation coming up with different methods of power control. 

Rand Corporation. I bring that up because Rand Corporation just tweeted this week that if you really look at this Afghanistan situation, you would almost think that Beijing is now controlling the order. I thought about that, and I thought, gosh, what if we didn’t have the reserve currency of the world? What if we were no longer the superpower, but it was another superpower that was administrating the chess pieces of the world. What would that feel like, and what if it was Beijing?

David: I find the role as father sometimes challenging, when I sit at the dinner table and explain to the kids that they can’t assume what has been assumed in previous decades and in previous generations. That the dollar will be stable, that we’ll live in a world which is largely peaceful, and that they’ll have as ample a set of opportunities as previous generations have had, the most recent generations have had. We do have those sober conversations, and the challenge for me as a father is to find something encouraging to say in that mix. You talk about the dollar, you talk about China, and certainly the events in Afghanistan make us reflect on our role in the world and whether or not it will be sustained.

Kevin: I think the world is losing faith that the United States still is the hegemon of the world.

David: Yeah. We try to blend our thinking, whether it’s on the political, geopolitical, or very specifically the economic and financial, blend it together so we have a comprehensive and cohesive view of the world, and as we make decisions, we continue to do so from a top down perspective, as well as a bottom up perspective at this. Special thanks to our asset management clients. This last week, we had a quarterly call, and exclusively for them the transcript is out and available. Again, it’s important to blend thinking. Some of it’s defensive in nature, some of it’s positive in nature. It’s almost the same challenge I mentioned sitting around the family dinner table, how do you prepare, you’ve heard this phrase. Prepare for the worst, hope for the best and be ready for anything. But that’s essentially what I want to see the next generation of McAlvanys embrace.

Kevin: I wonder if we should be preparing now. This last two weeks has been a wake up call for a lot of people who have looked at Afghanistan. Dave, I asked you the question last night as we sat and talked. We have a Talisker and talk before the commentary, and I just said, “How long can we call a lot of the things that are occurring in Afghanistan— just chalk it up to ineptness of government leadership? It’s not ineptness of the military. The military certainly can be commended for the many things that they’ve done right through the years, but the government that’s ruling, right now continually I’m hearing how inept they’ve handled Afghanistan. When do we actually ask the question, is some of this deliberate?

David: Yeah, there is the point of whether it’s deliberate. We found it necessary this last quarter to kick one of the companies that we invested in to the curb because they missed guidance, but they had made a series of mistakes and it began to look like a pattern. You can ask the question, whether it’s deliberate or if it is just clearly the wrong people in the wrong seat.

Kevin: Leaving black Hawk helicopters in Afghanistan, that was an accident?

David: We’re pulling out of Afghanistan. There’s a couple of things about that that bother me. Yes, I do think that we should have had a different engagement in the first place. I’m not sure I buy into being a global cop. And that’s, again, there’s a whole series of things that we could talk about to relate to that. But we left billions of dollars in military hardware. Yes, we left at least a few hundred American citizens behind, and that may create this generation’s version of the Iran hostage crisis, except that the enemy knows we don’t care. We won’t allow American lives to be leveraged, so rather than see Americans paraded through the streets of Baradar City, as we might’ve seen in Iran 40-something years ago, quiet executions are probably more the order of the day. Yes, you’re right, we left several dozen black Hawk helicopters behind, which are already being flown. That says something in itself. Someone had previous training.

Kevin: But you and I, both, I don’t want to divulge, but you and I both have given money toward getting some of these Americans out using private enterprise. A lot of these private enterprises trying to get people out are being blocked by the United States State Department. They can’t even get to the airport.

David: Here’s something that really is bothersome to me. I wonder if the $18.6 million paid to McKinsey. You’re familiar with the consulting company. $18.6 million paid to McKinsey to help the defense department define its strategic focus in Afghanistan. Was it really worth it? Nice PowerPoint, guys. But this is the real world where, yes, challenging decisions have to be made. I’m not in a position to really question what is going on tactically on the ground. But from a strategic standpoint, you can see the unembrace of the porcupine was not done well. It’s going to be difficult any way you look at that. That’s a conversation my dad and I have often had. Embracing the porcupine is one thing. It’s equally challenging to disembrace.

Kevin: Yeah, but we did make the choice to go in. Whether it was a good choice or not, we made the choice to go in, and we created a dependence so that when we pulled out, it’s creating chaos. Like I said, some of it seems to be deliberate. One of the questions I would ask you, because I can’t ask Biden, none of the press can ask Biden any questions. I’m wondering if McKinsey, if they have a PowerPoint presentation, maybe McKinsey would do a press conference.

David: It’s funny to watch. It’s almost like a passive aggressive behavior watching Biden introduce some of the press conferences, and be like, “No, I’m allowed to answer your question today.” Or “No, I’m not allowed to take that question.” It’s like, who’s on the other end of the leash? The fact that he’s giving comment to it, almost is like he resents the fact that he’s not the commander in chief. There’s a power beyond the power. 

But yeah, he pulls out of a press conference when questions go off script, like he’s pulled out of Afghanistan. Deadlines are arbitrary. Looks a little cowardly to not address the specific questions on the table. 

Here’s the consequence. The big deal is this. We’ve sent a clear message to global leaders. It’s not a coincidence that last week North Korea restarted its plutonium production. Again, this is reported by the Wall Street Journal. That was last week. You got John Kerry flying over and interacting with the Chinese about Taiwan. Taiwan, beware. John Kerry’s not your friend. The Chinese know that this is a time to increase pressure. Why do they know this is a time to increase pressure? Because what’s been on display is not strength. The Rand corporation—which you mentioned, Kevin—tweet this week saying “Recognizing Taliban run Afghanistan would contribute to the perception that it is Beijing and no longer Washington that is now setting the agenda and shaping the future regional order.”

Kevin: Let’s just look at this again. This is Rand Corporation. These are the people who came up with mutually assured destruction, MAD, as a policy back during the nuclear age when we were growing up.

David: Right, and it’s not much of a stretch when you get to the Economist and the title is “Biden’s Debacle: What it Means for Afghanistan.”

Kevin: Those are large letters. You’re holding it up right now. I know our listeners can’t see it, but those are very large letters. It’s something you can’t really laugh at. Again, this is not about those patriotic Americans who actually were there trying to fight for a cause. They’re frustrated right now.

David: No, and it’s not about Biden either. It’s about what is a deterioration in standing. We go back to the earlier comment on what this has to do with the dollar, and some of the things that we’ve presumed about economic and financial market stability in light of the dollar. I am not a fan of Eric Prince, though he may have some great stories serving as a SEAL and running Blackwater. Again, I’m not a fan of Eric Prince. I guess you can set aside this irony since he is a military contractor, but he made a comment this last week, which I partially agree with. Something to the effect that the dollar strength is only possible because of the military strength the US has to maintain its influence globally. That would reflect a view of international politics and money that stretches back to the 19th century. You could see that it was the military might of the British that allowed them to project and bring a certain financial market stability to London.

Kevin: Look at how many of our clients have British sovereigns? That coin was minted on five continents. The sun never set on the British Empire, but it’s because the British Empire had a Navy.

David: Again, I set aside the irony and him being a military contractor and wanting to get paid for sustaining “the US dollar hegemony.” But as we leave Afghanistan, this is the point: Our creditors may be asking if both our currency and military might’ve seen their better days.

Kevin: The thing is, this may not be a soft transition. We were talking about Beijing. I just think back to the Shanghai exchange a few years ago, Dave. Nobody has been allowed to buy oil in anything but dollars for all these years. But remembering the Shanghai exchange, what was this, three years ago? The Chinese put futures contracts out there to buy oil in yuan, Chinese yuan, that were gold backed. It was an interesting challenge to the dollar because anytime before it had been challenged, we pulled the military in. Were the Chinese testing this transition?

David: I think there’s a lot of transitions ahead, but for the time being, what do we have? We’ve got all time highs with stocks.

Kevin: The stock market’s not worried, is it?

David: Keep in mind, Gensler is talking about banning the payment for order flow, which may kill the bull market dead in its tracks.

Kevin: What does that mean? What is he talking about?

David: If you work with a company and you transact, you buy yourself stocks and you’re not paying a fee to do that, it’s because your order flow has been sold to a high-frequency trading firm and they get to front-run your order.

Kevin: What he’s talking about, actually, it would be nice to remove that from the market. It’s just dangerous right now.

David: But you look at Robinhood, and you get free trading with Robinhood. You get free trading with Schwab. You get free trading with all these companies.

Kevin: Because they’re getting paid for front running knowledge.

David: I remember looking at TD Waterhouse’s numbers a while back. This was probably six years ago, and it was like $400 million. I forget if it was the half year, if that was the full year payment from Knight Capital, Citadel, and these other high-frequency trading firms that were buying their order flow. They process the orders, but they get to do something that they want to do before they place your order.

Kevin: They’re front running. Nope. Never mind.

David: Gensler, again, state of the union, stock markets are at all time high. Wait a minute, could Gensler banning the payment for order flow kill the bull market? Maybe. Home prices, all time highs. Wait a minute. Rates are expected by several Fed chiefs to rise next year. Would that be a turning point for housing? Maybe. We’ve got job openings, all time highs. We’ve got wages, all time highs, but inflation is transitory of course. Court PCE, that is the preferred measure of inflation by the Fed, inconveniently is at the highest level since 1991,

Kevin: Yeah, but it’s transitory.

David: Also note, this is not just a US phenomenon, so it’s not like US monetary policy, fiscal policy is the only driver here. We’ve got German inflation at its highest levels since 2008, and it’s worth noting that the Germans, who were particularly inflation sensitive— Bloomberg put an article out, talking about the long history of inflation fear in the DNA of the Germans, and how the sale of coins and bars—this is gold—coins and bars in Germany, this is setting records.

Kevin: What’s the German word for transitory then? Because that’s the only way they’re going to get away with this.

David: I can tell you the German word for transitory would be about 32 letters long because that’s just the way they roll.

Kevin: Yeah, but the Germans are going to say no, gold. Gold is the German word for transitory.

David: Included in the word transitory would be the technical definition of this is BS, just so you know, and that’s why it takes 32 letters, because that’s the way Germans—

Kevin: Very precise.

David: The Fed is still saying we need zero rates through 2023, trillions more in bond buying to boost asset prices and increase inflation. That’s the state of the economy. Gallop, on the other hand, is touching base with real people, and not just a few of those ancillary statistics, people are not statistics. 60% of US adults say that the economy is getting worse. 37%, according to the Gallup poll, says that it’s getting better.

Kevin: But Powell speech last week, people wondered if he was going to be hawkish or dovish. The markets at least reacted as if it was a dovish speech, which means “mo money.” “Mo money coming.”

David: His cohort of Fed presidents were all saying, leading up to it, we need to go ahead and get rid of QE, we need to go ahead and reduce our balance sheet, we need to go ahead and raise interest rates. It’s almost like they were creating a social pressure on Powell. You look at the price action of the markets, it seemed to confirm that, yes, it was taken to be dovish. No fast changes soon. The market agreed to look past any concerns of tightening liquidity in the system, and we’ve continued to see the surge in enthusiasm in asset prices, which are very much alike today.

Kevin: Look at commodities. You talked about the drop in commodities last week. Well, we got it all back. Didn’t we?

David: We did, and what was funny is you look at Larry Summers commentary on Jay Powell’s meeting. This is from Jackson Hole, and he asked the question. He’s like, I was struck by the fact that he didn’t talk about the housing sector. We’ve got rent going up 17%. If a tenant leaves and has to come back to a new place, they’re paying 17% more than when they left. Summer says that suggests a lot of rental price inflation. Why did Powell not even comment on that?

Kevin: Because it’s not transitory. How often do you see rent fall?

David: That’s right, a gift. You’ve been here long enough, let me cut you a break. What commodities gave up the previous week was returned last week. What equity indices gave up the previous week was also returned, in some instances to even higher prices. Gold and silver is still not out of the woods. They obviously rebounded, but we’d like to see them still get above some key technical levels, but we’re closer to confirming another leg up. Metals miners, they’re the cheapest relative to gold that they’ve been since the year 2000. 

It’s interesting that European bonds sold off, not last week, the week before, and big, big move in yields. They didn’t see a recovery in price. They did not come back down. Yields are still higher than they were. Significantly so, there were some changes. We’ve talked about risk off two weeks ago, risk on last week, and yet in the European debt markets, it wasn’t that way, which I think is just worthy of note.

Kevin: Last week you brought up the Chinese credit markets, and there’s still concerned there.

David: That’s right. The coincidence of the global markets coming under pressure as the asset management companies and developers and education companies and big tech and other market segments. There’s a number of segments that have been targeted for reform, and those sold off. In the case of the asset management companies and the developers, it’s not just policy reforms that are pressuring prices lower, it’s debt. It’s debt that has them on the brink. Once the Huarong recapitalization occurred, then market pressures largely subsided in the global markets, in the US small caps, in commodities. But every asset class that has been under pressure, that had been under pressure, rallied strongly. It reminded us of how interconnected the world of finance and banking is, and how sensitive the markets are to leveraging, and of course de-leveraging.

Kevin: Then command and control economies like China. Winners are picked and losers are picked. Huarong just happened to be the winner.

David: That’s right and it’s evidence of being too systemically important to fail. We think of too big to fail, but Huarong since the late nineties has played a role in processing bad debts and bad bets. So, not good news for Evergrande, which was the apartment and property development company, but very good news for Huarong. So you’re right. The winners and losers were sorted last week, and it’s the apartment and property speculation that remains directly in the bulls-eye of Chinese policy targeting. Yields tell it all. Evergrande is still north of 45% in terms of the yield on their debt. I’ll say it again. 45% is the yield. Default is assumed. Picking winners and losers is a bureaucrat’s job. You can see that the AMCs, again, the asset management companies, are the designated winners. Huarong’s credit default swaps traded as high as 1400 bps. This week they were 900 bps lower, to 450, roughly. So the cost to insure against default for Huarong was down significantly since the recapitalization. And that same action was the case for all your other AMCs as well, [unclear] and all the rest.

Kevin: I asked what it would be like to actually have what Rand corporation was talking about, and that is policy starting to be set by Beijing instead of Washington, DC. Do you remember when Bloomberg wanted those supersize drinks? He said, “Let’s go ahead and legislate those out. You can’t have those anymore.” But you look at China right now, they’re looking at video games. They’re like, “How long are we going to allow, as a government, children to play video games? Why would they want to control that?”

David: Yeah, it’s interesting because it ties directly to that theme of common prosperity, and you think, video games and common prosperity, is this really a part of redistribution? You look at the news, and you look at what they’re legislating, it’s time kids can play computer games and we might be impressed that that’s jurisdictional overreach. The issue is Chinese elevation of common prosperity. They always put that in quotes. That is the new buzzword. What they’re doing is they’re recognizing the ever-widening gap between rich and poor. The Chinese are dealing with a social phenomenon, what sociologists would call Involution. It’s like a social implosion. Another way they’ve described it is lying flat. 

Kids have experienced such fierce competition in schools and getting into the next high school or college or program, getting the best jobs, and then they want that, because that’s the only way you can join the ranks of the rich, but it’s become a seeming impossibility. Disaffected youth, they’re taking jobs just to earn enough money so that they can feed themselves, not starve, spending the rest of the time playing computer games. For kids, it’s like, “Well, what’s the point? Why should I go to college if I can’t land the job?” There is that disaffection which is occurring. So much so that the Chinese government has decided to step in. Banning minors from playing on school days and cutting weekend hours, so that on most weeks, total play time in terms of computer games is not to exceed three hours. You thought Bloomberg and the supersized soft drinks was heavy-handed.

Kevin: We had Pippa Malmgren on, and she brought something up that I thought was really interesting. The way she described economics was you had the saltwater fish and you had the freshwater fish. Salt water had to do with command and control, basically coming from the government, and then freshwater fish, the way she described it, was free market. 

You as a father, Dave, let’s face it. You as a father, it is your responsibility to control. I know you hate screen time, your kids sitting and looking at a screen. You have certain demands, but you’re a freshwater fish. What China’s doing, and this was the question that I asked before. This is the question I asked before. If we have a large-scale change here, where it’s Beijing, they believe that they can control. Yeah, we joked about the supersized soft drink, but that was an overreach on our side. The video games is an overreach. You as a father, think about your kids. It’s your responsibility, not the government’s to control how much video game time they have.

David: I will say one of the things that we have misaligned is economic incentives, where if you want to not take care of your body and then just let, whether it’s Medicare or Medicaid, or emergency medicine, deal with the consequences of that. You have an insurance company, which is there to pay all of your health bills in case something goes wrong, so you can abuse the system, that is your body system, as long as you want, again, supersize everything, and then just know that your long-term health concerns are going to be someone else’s problem, not your own. We do have a serious economic misalignment of incentives, and I think Bloomberg’s attempt was to bring a realignment. It just came across as somewhat totalitarian. I have to agree—

Kevin: Can you identify with the Chinese? Okay, can you identify with the Chinese?

David: As a father, I can identify to a small degree with the Chinese government. Again, this is a father of four speaking. I do hate screen time, and I routinely threaten device destruction.

Kevin: You are David Xi McAlvany?

David: Xi McAlvany?

Kevin: Yeah.

David: I will routinely threaten the destruction of device if the kids don’t get out inside and play or go read a book. In our house, for any screen time to be earned, you got to finish your daily readings, you got to exercise, and I have a great regimen for skiing and leg strength, as reported, both are being done, as reported. There’s a self-reporting that occurs, and I’m somewhat suspicious that— 

Kevin: Honor system.

David: It was a 20 minute regimen for exercise that’s been cut to, I don’t know, eight to 12.

Kevin: It’s hard to have a dad that’s a triathlete though. Come on, Dave. Come on. What is the regimen for you?

David: It’s usually a couple of hours a day. Mandates limiting the number of hours of weekly playtime are coming into effect. That’s in China. Again, it’s as a symptom of inequality. Again, despair, involution, lying flat, that’s what they’re trying to address. I mentioned the education companies. They, too, are being regulated as the cost of special tutoring has gone through the roof. What that is, is an expression of changing accessibility to the best schools, tilting the application process in favor of those that can afford or are willing to sacrifice more, to get more tutoring. Involution is on the other side of the equation where people are burned out. People are resigning to a hopeless state, and essentially— think of it as doping. Dopamines are incredibly addictive. The scientific journal Nature, back in the late ’90s, published an article where video game stimulation of dopamine release. Again, this is the feel good neurotransmitter. They found that, when playing video games, you’re releasing the same quantity and to the same effect of dopamines as you would from sex or from intravenous amphetamine usage.

Kevin: In other words, you’ve got addiction. There are a few books by Cal Newport that I’ve read that are fascinating, how that dopamine is being actually scientifically as these companies designed video games, they design them for addiction. That’s the bottom line, or a lot of the types of things that we actually encounter when we’re on social media. But again, this goes back, this common prosperity, that’s the quotation, common prosperity.

David: Just let me ask you a question. Did you see the movie Social Consequences?

Kevin: I did not.

David: You have to see it.

Kevin: Because it’s what I just talked about?

David: Yeah. It’s a documentary by people who designed Twitter, Facebook, Instagram. These are retired engineers who would say, “I will not let my children spend time in front of a screen because I know what I put into it. And I know that I am addicted to my own product, and I don’t want that for my children.”

Kevin: I wonder. I read them quote in one of Cal Newport’s books, by the gal who came up with the like, you know the like button? She actually talked about how detrimental it was. She regretted coming up with the like button because of the dopamine release that occurs.

David: But my point is the common prosperity, that’s what they’re trying to address, and it’s the new version of economic rebalancing.

Kevin: It’s the new version of communism, isn’t it?

David: To some degree, yes. To some degree, it’s about redistribution. It’s also about more than redistribution. Michael Pettis explains that in the ’70s and ’80s in China, labor was in surplus and excess savings were scarce. In order to encourage investment, inequality was designed into the system. Inequality was designed into the system, favoring capital over labor. He quotes Deng Xiaoping. This is what he meant when he said, in 1985, that our policy is to allow some people and some regions to get rich first in order to stimulate and help the backwater areas. 

He did this by putting into place policies that lowered wages and subsidized capital. Pettis says, “These are classic supply side policies aimed at boosting savings, because rich people save a larger share of their income than the non-rich, to the extent that the rich receive a disproportionate share of any increase in GDP, the country’s savings rate would automatically rise.” He goes on to point out, Kevin, that the rising share of income to businesses and governments was a part of the net result in that timeframe. Just as Deng Xiaoping chose to favor capital, we have a new era. We have Xi Jinping who’s now attempting to revert back to favoring labor. Believe it or not, there is a growing labor scarcity in China, and so much capital that a great part of it has in recent years gone to non-productive activity. What we might consider malinvestment.

Kevin: Isn’t it fascinating to look at that? It reminds me of someone trimming a bonsai tree and just making every little bit of it work to their control. If the government could do that, you could see that that actually would be advantageous, but I think history has proven you can’t do it from the top down.

David: I think the apartments in China are prime example. You’ve got 25% of the total quantity, which sit empty. As a greater percentage of investment has been funded by debt in recent years, you’ve got debt burdens, which have grown the fastest of any country in history. They’re in China. Again, you’ve seen the acceleration of debt over the last six to seven years that has no historical precedent. This brings us back to the recent volatility tied to the potential unwind of debt within the overburdened Chinese system, where we’re talking about Evergrande, the developer, and Huarong. A lot of these debts have just gone bad. Huarong’s been the hoover for sucking up bad debts and holding them on the balance sheet.

Kevin: This whole thing, though, using the word rebalancing. Rebalancing sounds to me like redistribution.

David: No, as long as I’ve been talking to Michael Pettis and reading his books and articles— he published The Volatility Machine back in 2001. In that book, it’s really focused on corporate finance theory, looking at capital structures, their strength, their vulnerability to collapse given capital structures. But the idea of rebalancing he spent a lot of time on over the last decade and a half, rebalancing in China, and he comes back to it over and over again. Really, it’s rebalancing the total economy towards households and consumption, and away from export-led and government-promoted mercantilism. That rebalancing has been elusive, the consumer share of GDP, they wanted it to increase as a share of GDP. It has not. It has not gone as expected or as hoped.

Kevin: You can’t trim the bonsai tree from the top. That’s the thing, because I know, I remember when you interviewed Pettis, the idea behind it was Pettis and it was Stephen Roach, who spent an awful lot of time over there as well, that there would be a rebalancing over to consumerism or to promote that type of thing. But it’s not worked.

David: Part of that is because the inequality which was designed into the system, which Deng Xiaoping mentioned back in 1985, those incentives which created the inequality, the incentives haven’t been changed. They haven’t been changed. Is this time different? Again, it’s just new language, common prosperity added to the vernacular of rebalancing, but will the Chinese risk the ire of the business elite? The super wealthy, are they going to come onto the side of government in favor of labor over capital?

This has certainly been a long road. It would seem that there’s been a recasting of vision for China in Xi Jinping’s time in office. Go back to, I think it was 2012, and there’s not a lot of rebalancing or common prosperity on display today. He set the conditions, though. I think he set the conditions for a broad-based redistribution. 

You had a gentlemen, which Michael Pettis quotes, from the [unclear] Research Institute, [unclear], and he says this, I think it’s very helpful: “The key to achieving common prosperity is to deepen the reform of the income distribution system and correctly handle the relationship between efficiency and equity. In the August meeting, it was pointed out that it is necessary to build a basic institutional arrangement that coordinates the primary distribution, redistribution, and tertiary distribution. There are two major highlights. First, it was the first time that the concept of basic institutional arrangements was clarified, and second, it was the first time the concept of tertiary distribution mechanism was mentioned since the fourth plenary session of the 19th central committee of the communist party of China.”

Kevin: I don’t know. This sounds complicated.

David: Let’s break it down. Primary distribution is actual income. If you’re talking remuneration, now we’re talking about defining limits, setting wages. That’s the primary distribution, which is on the table and creating policies to address primary distribution that will occur.

Kevin: So wage control, let’s just call it what it is. Just wage control. What’s the second one?

David: Secondary distribution is more of what we think of as the fiscal side of things. Truly redistribution via taxes, transfer payments, property tax implementation, which has not yet occurred. Do you realize that you can own property and you’re not paying any taxes on it? Imagine that. We have a different tax structure here in the United States. You never truly own your property. Today in China, you buy a property, you own it. You don’t owe anyone anything, unless you owe the bank, but you’ve got title and that’s it. There’s actually one county in Alaska that, when you own a piece of property, you don’t pay any property taxes on it. That’s the only county that I’m aware of in the United States. 

Property tax implementation is a part of secondary distribution. That hasn’t occurred, and I think it’s going to cause a major property heart attack, because look, the cost of carrying properties goes up. We already said earlier, 25% of all apartments in China sit empty. You’re happy to sit on a property if you think it’s going to go up in value. It’s like a land bank. You’re hoping that somebody moves into the city from the country and is the next buyer of your apartment. But if you have to start paying property taxes, are you willing to sit on that property? There is a major game change afoot with secondary distribution as it relates to property tax in China. They don’t have an inheritance tax, but that’s going to get implemented. It’s not there yet.

Kevin: There’s wage control, there’s taxes. What’s the tertiary distribution?

David: Tertiary is donations. Donations to charity.

Kevin: Right out of the heart, these are donations. It’s like, you’re going to donate or I want to donate.

David: From the heart or from the head. However, you make your decisions. Sometimes you think through the options and realize that you’re limited in your choices and therefore you give. I was reading the Financial Times this weekend, Bloomberg reported on this as well. Seven of China’s billionaires have already given $5 billion to charity so far this year. This is all being highlighted right now because of the encouragement of tertiary distribution. My daughter, who was reading over my shoulder, asked who is Jack Ma? She said it about like that. I’m not sure why she brought French pronunciation into it, but she does have a flare for the dramatic.

Kevin: But the billionaires are giving billions. I wonder, was it just philanthropic reasons or was there a gun to their head?

David: As I understand it, these charities are mostly government-run organizations.

Kevin: So gun to the head?

David: Yeah. At this stage they’ve been encouraged to be generous.

Kevin: Gun to the head.

David: Right, while equalizing income and assets. So we go back to the primary and secondary forms we talked about a minute ago.

Kevin: Let’s just simplify this because this is complicated, Dave, but it’s really not. They’re going to control wages. This is all redistribution. They’re going to control wages. They’re going to raise or change taxes to favor some, like we’ve seen before, and they’re going to force the billionaires to start giving money back to government run organizations. That’s really what they’re saying. As long as we look at this, we can call it primary, secondary, tertiary, it’s just redistribution.

David: Right. Pettis’s most compelling comment came at the end of his report. This is the August 26th report for Global Source Partners. He’s skeptical that the Chinese can succeed. He has been talking about rebalancing for a long time, knows that it’s necessary if they want to continue to grow and have a more expansive role in the world. We start today by asking about America and losing ground to the Chinese in terms of public policy, foreign policy, military, US dollar hegemony, all those things factor in. But in the end, the only country that really looks to take our place, Pettis would say, “Actually, I’m not sure that they can succeed.” He’s skeptical that the Chinese can succeed. Yes, they will try, and yes, there will be a huge conflict between the business elite and the political elite. I can see tax evasion and capital flight becoming more popular than table tennis in China over the next few years. But the scale of the project is huge, and the place they need to go for true rebalancing is quite simply off the table. When Pettis comments that if every year the donations, we go back to the tertiary distribution, if donations of the super wealthy were 10 times this year’s number, it would still represent one third of 1% of Chinese GDP.

Kevin: So it doesn’t even make an impact?

David: No. To rebalance, or as the new phrase expresses it, seek common prosperity, they would have to be a shift of greater—it would have to be between 10 and 15% of GDP. Assuming you can hold on to two to 3% GDP growth rates, it’s simply a bar too high to get over, unless you shrink the size of government.

Kevin: Doesn’t that always help an economy when you shrink the size of a government?

David: That’s the problem. To quote, “above all requires a significant reduction in the role of government and the economy,” says Pettis. If that is what it would take, and the government is not likely to shrink back from its current level of social and political and financial engagement, the Chinese are more likely on a path to another P word, not common prosperity, but poverty, common poverty.

Kevin: I love the fact that through the years we’ve been able to interview guys that we can go back and remember, and these are experts in the area. Higgs, when he wrote Crisis and Leviathan, he says, you never go backwards. The government never shrinks itself purposely.

David: The business elite do have something to be concerned about, and you’re right, I don’t think the government is going to shrink. In this conflict between the business elite and the political elite in China, to see if there can actually be reform such that they could take their place in the world stage in a more significant way. The business elite do have something to be concerned about. You might not recall, but the former chairman of Huarong, do you remember the asset management company, which was recapitalized last week by CITIC?

Kevin: Mm-hmm, but they didn’t have the same leader, did they?

David: No, because the chief executive was charged with corruption and bribery on January 5th of this year, and the execution sentence was carried out on the 29th of January, giving a brand new definition to swift justice.

Kevin: That also brings a brand new definition to the tertiary, which is, you will give, okay. Or you will be executed. China does things different.

David: In the United States if you’re charged with a crime, it may be decades before sentencing and whatever else. There’s all kinds of things. You can get lost in our system. I don’t know that our system is any better. In some senses it’s better, in some senses it’s worse. But think about that. Charged on the 5th, executed on the 29th.

Kevin: Think about the situation we’re in right now, David, and you were even talking about dopamine. It’s really hard, once you’re addicted to something, to move away from it, whatever causes that dopamine rush. And the growth of both the Chinese system and, look at our system, our system is just huge and growing larger and larger by the day. Higgs was right, that’s not going to be given up. It’s an addictive type of thing, but it’s also something that’s almost impossible to pull out of. When we talk about the Fed pulling out of QE, we also understand, we talked about it last week, the taper tantrum. You pull out of Afghanistan after building dependence, you’re going to cause problems. You pull out of QE after causing dependence, you’re going to cause problems, but the economy it’s already showing signs of slowing. How big do we have to get to keep the economy growing?

David: The economy is showing signs of slowing. One crack in the financial system, which may remain unnoticed a short while longer, is that the July margin data shrank by 4.3%.

Kevin: Which is how much people borrow to buy stocks.

David: Yeah, so stocks are up, everyone’s happy. Day traders are experiencing their dopamine rushes.

Kevin: That’s not a bad thing. Margin debt is at all time highs right now. Isn’t it good for all of us if margin debt were to shrink some?

David: Deals with dependency. I think the answer to the question deals with vulnerability that comes with the dependencies that have been developed, and you’re still over $840 billion in margin debt. That’s 76% higher than it was March of 2020, from the market COVID shock lows. Sure, you could argue that it’s healthy for the number to come down, but we had this in our Hard Assets Insights this last week. Bank of America noted this, potentially bearish peak in margin debt in June. Because again, the numbers came down in July. “Rising leverage tends to confirm US equity rallies,” is their comment. “Rising leverage tends to confirm US equity rallies.”

Kevin: Shrinking leverage means the opposite?

David: “It’s now record highs for margin debt that we worry about,” says Bank of America. “We get concerned when margin debt stops rising to suggest that investors have begun to reduce leverage.” Alan Newman points out that margin debt to GDP has blown past—has blown past—the 2.5% level that we were at in the year 2000 and the year 2007.

Kevin: Which breaks all records?

David: Yeah, it is now between 3.7 and 3.8% of GDP. The highest ever relative to the engine of growth, GDP being that representation of the engine of economic activity and growth. He still suggests that in equities we will see a decline to 14,000 on the Dow, roughly 60% lower from current levels. 

We have this notion of the Fed suggesting they’re going to shrink back from their activity, when in fact the system is structured to require more, not less, activity. We face a similar dilemma to the Chinese. If we wanted reform, if we wanted change, I’m not sure that it’s possible without paying a very, very extreme price. The Federal Reserve balance sheet expansion has gone from $850 billion to $8.33 trillion.

Kevin: That is tenfold.

David: Right. In over the last six to seven years, again, we’ve seen massive credit expansion in China. Stocks are priced for perfection, houses, bonds, too, also priced for perfection. This is not a high quality economic expansion. This is a feel-good moment. This is a feel-good moment. It’s artificially stimulated. It’s not particularly sustainable, and now you have the suggestions of change. Will we be successful? Will the Fed bring about reform in terms of our monetary policy or, inadvertently, are the Chinese and the Americans—whether it’s the folks in DC or at the Federal Reserve—introducing us to common poverty?

Kevin: You’ve been listening to the McAlvany weekly commentary. I’m Kevin Orrick along with David McAlvany. You can find us at mcalvany.com. M-C-A-L-V-A-N-Y.com. You can call us at (800) 525-9556.

This has been the McAlvany weekly commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany weekly commentary.