Podcast: Play in new window
- Will 2024 Politics Sway The “Unbiased” Fed?
- Federal Reserve Leadership Is 10:1 Democrat To Republican
- I Know, “Let’s Count Debt As An Asset.”
“Be careful what you wish for. Economic stimulus may help you get reelected, but it may also trigger a resurgence of inflation. And if you’re overconfident in what the Fed can do to keep inflation in check, you may find yourself very surprised as a politician in 2024 fighting a dragon and a demon which you thought was already slain.” –David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany.
David, I’ve worked for your family for many, many years, three and a half decades, and what if you just paid me for productivity and counted that as good? So I’ll give you an example. Yesterday morning, we got pounded with snow. Well, it was wonderful. It snowed all night long. I woke up—I have shared this with you in the past—I pride myself in my snow removal productivity. I think it through, I do it the way I like. The more I do it, the more I’m like, I’m going to cut a pattern here for the dog and I’m going to make a wall here. And so yesterday morning, business time, I’m still at home congratulating myself for my productivity. But the truth of the matter is, it’s ironic, isn’t it? Because that productivity really leads to nothing. I would’ve been much better off here actually doing something productive that lasts. But that snow, every wall, every pathway, it’s all going to melt.
David: In the scheme of things, all that work, and it just melts anyways.
Kevin: That’s right.
David: Well, there is a source of money creation that has just gone wild. And it’s not the Federal Reserve, it’s not the commercial banking system creating loans—which in the modern era is the new version of money creation, and thus we have credit as a form of money. Instead, Wall Street has adapted and improved upon the shadow banking, which was a major contributor to the global financial crisis in 2008 and 2009. And that shadow banking has an even greater presence today. It accounts for liquidity in the system, which is actually hard to fully account for. Some organizations can’t recognize it, it is literally in the shadows. Whether it’s structured investment vehicles, leveraged loans, swaps, collateralized loan obligations, collateralized debt obligations, asset-backed securities, credit hedge funds, or purveyors of private credit, dolled-up version of private equity, limited purpose finance companies, or your old-fashioned GSEs.
Kevin: They’re all making money.
David: Fannie and Freddie pushing mortgage-backed securities in that market. Add to that, you even have money market funds and insurance companies which are morphing into the money creation and the money multiplier business.
Kevin: Yeah, Dave. I’m thinking about this because it’s not that they’re just creating money. I mean if the money goes and does something productive, it’s not necessarily a bad thing. But if you’re just creating money and you’re counting that as productivity, it reminds me a lot of shoveling snow.
David: Yeah. And keep in mind, the new version of money includes credit. It’s not just bills and coinage. The Federal Reserve is increasingly irrelevant in the liquidity creation business. If you recall Blade Runner.
Kevin: One of my favorite movies.
David: You’ve got these portrayed snake skins as a rarity, the real ones, but the faux or manufactured skins, much more prevalent. And so you could check for the little insignia or whatever it was. If you were under a microscope you could look at a particular scale and you could see that oh, no, this one was manufactured by so-and-so.
Kevin: Is it real or is it manufactured?
David: Real money is indeed the rarity. And that’s if you’re counting gold ounces, of course. But increasingly, even a stock-in-trade of central banks, officially sanctioned money—this is coins, currency—that’s even rare. And even the credit that central banks create, if you’re talking about counting it in the trillions of dollars, it seems like a lot, but it’s small next to the tens and hundreds of trillions which Wall Street is in the mode of creating, not on a permission-granted basis. The new money has the look and feel of, I don’t know, casino chips, the finger flipping casino chips, purpose built for speculation.
Kevin: Yeah, but it can give the perception of productivity. If somebody asked my wife yesterday morning, “Is your husband being productive?” She’d go, “oh, yeah.”
David: Got a lot done.
Kevin: “He’s been out there for hours.” But if that’s all I did every day, Dave, and didn’t come in, and we were just counting the productivity— But what it does is it creates an illusion. You can create the illusion of busyness and not really get anything done. And I think about what we talked about, McAlvany Wealth Management meets, and you guys discuss, and I love the fact that each of you allows each other to disagree because you have to. Iron sharpens iron. You have to disagree. And the argument this last meeting was recession or no recession.
David: But the central agreement is this illusion of moneyness, where we’ve all agreed, the collective consensus has said, again, whether it’s structured financial products from Wall Street and the shadow banks, or actual bank loans, or liquidity created through swap programs and repo programs from the Federal Reserve, we just agree that it’s money-like and move on. What we disagreed about this week— And I think our Monday was an eventful one, and, as always, the Hard Asset Management and Tactical Short team gathers to discuss market indicators. And these indicators change in real time. So the debate rages at present over recession or no recession. Why a debate? Well, I mean the team processes through multiple lenses, one of the here and now, and the other lens the greatly anticipated future.
So what the present speaks to quite loudly is that we have no recession. 3.7% unemployment, labor pricing which continues to push higher. Given the ongoing labor supply concerns, you couple that with the previous quarter’s 5.2% annualized GDP growth rate, that’s for Q3. Atlanta GDP now has Q4 pegged closer to two and a half.
This is intriguing, right? The no recession camp for now looks to the self-reinforcing economic boost which comes from loose financial conditions, ample money in the system, access to money, and ease of terms on that money. And of course, if you really needed to, you still get cheap credit. You can do it using the carry trade finance, borrowing in yen and then going and speculating wherever you want anywhere in the world. And with that ease of access, it buoys the speculator’s willingness to take risk, it sets off a positive price spiral, ultimately attracting the retail investor into the financial markets to invest and speculate with their chips. But first, it takes the flame burning bright, and then the moth’s resistance disappears and they come flying in. The reality is, liquidity and risk-taking based on positive sentiment, that still predominates.
Kevin: Okay. So that’s on the one hand. I think of the Fiddler on the Roof. Remember when he’s “on the one hand” or “on the other hand.” So we have at least the illusion of productivity right now because of loose financial conditions, but how many leading economic indicator months have we had in the negative? How long have we been with a negative yield curve? All the things that ultimately say well, there’s a 100% chance when this happens that we’re going to have a recession.
David: I’ve had a variety of friends in my life, and I’ve been accused or praised for helping some of my friends live more earnestly in the present moment. Whether that’s because I like to swirl a glass of wine and I lose myself in the nose.
Kevin: Or hanging on a cliff wall. There are some times when I have to say no, I’m not going to appreciate that moment with you.
David: I know, but I think if you divide the world into those who are living very clearly in the present versus those who are living into the future, you can see the difference in prioritization of the data. Where do we live today? What’s the most important decision we can make? The decision that we make right now. But if we fail to account for the future and changes that lead us into the future, then we can find ourselves in trouble. So several things can be pointed out, and have, for those looking down the field a bit, into the future a bit. Yield curve inversion and the un-inversion dynamics, those are in play. So if you wanted to argue for recession—no, not today, but very nearly tomorrow—the game clock is ticking.
You’ve got 20 months of declining LEIs, that is Leading Economic Indicators. What’s in a name? Leading. That’s the key word. Denoting a downfield reality yet to unfold. Is it here now? No, it’s not. But it’s coming soon. And perhaps it is here and now, but, as you well know, recession’s always reported retroactively. So you’re already into it before it’s admitted.
And what would be supporting evidence of that? Well, look at GDI, gross domestic income, versus GDP. Virtually the same measure, except that gross domestic income is diverging notably lower from GDP. So if you are a soothsayer, if you are a tea-leaf reader, this portends a decline in GDP. And as for GDP, you have two standout components. Inventory replenishment added 1.4 percentage points to a strong reading, but by far the largest contributor has been, continues to be, government spending.
Kevin: Oh, no, that’s productive. That’s shoveling snow backwards. That’s shoveling snow into the house.
David: No, I did this at one point. My first snow camping experience, speaking of doing stupid things when we’re younger, but not the climbing walls or— Anyway. Maybe this isn’t— Well, it was stupid.
Kevin: I never called it stupid, I just stay away from you when you do it.
David: That’s what I’m saying.
Kevin: Yeah.
David: My best friend and I, we’re 16 years old, we back-country skied into a remote area in the Weminuche Wilderness, and we built a snow cave. But what we did is we took the snow out and put it in the easiest place to put it, which was right on top of what we were digging out. And it was all fine, we woke up the next morning to a compressed cave. It hadn’t collapsed, but the snow roof, which had been about four feet tall, was only about two inches from our noses. We couldn’t even roll over. And that’s what it feels like we’ve done with government spending.
Kevin: Would you call that the negative growth effect?
David: Yeah.
Kevin: Spending leads to negative growth.
David: Yeah. If the intention was a four-foot ceiling, it’s going to compress on you. So here’s the ultimate slow burn argument for economic malaise, because not all growth is equal. When governments spend, it’s not always on things that have a positive ROI, return on investment, and not all government spending is from cash on hand. Deficit spending has a negative growth effect over time, depending on whether the economic benefits are one-off or if there is a perpetual benefit because, again, it was something productive. You can spend on a bridge to nowhere and on a one-off basis, you can register an immediate economic benefit.
Kevin: We saw that here. We had a huge bridge to nowhere. It looked like it was built for some major city, and we’re in little Durango, and it’s still vacant. They’re working on it now, but it’s been what, 15 years?
David: That’s right. Unless the bridge to nowhere has a toll booth and traffic crossing it becomes inspired, the negative compounding effect begins almost immediately. So this word investment is a word used most loosely by governments all over the world to justify the flow of funds to both pet projects and legitimate game-changing advancement. You’d like to think that dollars spent have a return, an economic return, but to politicians often the return is not economic, it’s a political return. And this is very apropos here in 2024, we’ve mentioned half the global population in an election this year. We’re talking about pork, we’re talking about constituency-driven outlays, fiscal largesse that extends political dynasty. The purpose is not for a positive return on investment, it’s for control and power, preceding and delimiting the budget process. You want to continue on with legacy creation. This is what we have in politics today.
Kevin: So not to name names on the team as to whose recession and who’s non-recession in the argument. I could go either way right now, but it’s a political year, Dave. Like you said, it’s an election year. What’s $34 trillion worth of debt amongst friends.
David: Yeah, we soared past 34 trillion in debt last week.
Kevin: Yeah.
David: Just consider this, we’ve added two and a half trillion since the debt ceiling was lifted seven months ago.
Kevin: Okay, stop just for a second. Your dad used to say it took from George Washington to Jimmy Carter—George Washington in the 1700s to Jimmy Carter—to get to a trillion. We added two and a half trillion in seven months.
David: I think one of the things that is just a general principle of investing in finance and economics is to see and gauge acceleration. A trend is one thing. Acceleration of a trend means something completely different. And you know, when something is reaching an exhaustion point or an un-sustainability point, if you’re talking about stocks or currencies or bonds, there is a—ROC is the shorthand—rate of change. Rate of change is the speed at which something is changing. If a stock goes up 3% per year for 20 years, it’s not a big deal. If it goes up 40% in one year, or 150% in one year, it’s ultimately not sustainable. You can’t do that over and over and over again. A low ROC, a low rate of change is very sustainable. A very high rate of change, ultimately it collapses on itself. And that’s called—
Kevin: That’s calculus, right? Rate of change.
David: Well, so 2.5 trillion in seven months.
Kevin: Wow.
David: One could argue, as one does on our team, that the US economy is not in recession because political operators coming into an election year are only too happy to risk a crisis of confidence in our debt markets to grease the political gears, which feverishly are churning here in 2024. And what does this culminate in? A craziness which is only ever replicated in Novembers—very seasonal craziness—on a two and four year cycle.
Kevin: Okay. So I’m going to take the other side, though—on the one hand, on the other—okay? Because we watch the Federal Reserve, and we’ve gotten used to the Federal Reserve just saying, “Ah, we’re going to do this to interest rates.” And it affects the short-term interest rates. They don’t affect long-term rates quite as well. But fiscal stimulus, Dave, what we’re talking about is spending. You can’t just have a Fed meeting and say, “Well, we’re going to do this, that, or the other.” Fiscal stimulus takes time. Do they have the control that they think they do?
David: It’s more the question of where the flow goes once it’s been put in motion. And for monetary policy, it basically stays within the financial markets and with your Wall Street firms. It doesn’t necessarily get into the larger economy. There’s less of a multiplier effect. But fiscal stimulus is not as easy to control as monetary stimulus. And thus the Catch 22 of 2023 is that when you gin up economic activity with deficit spending—yes, we mentioned 2.5 trillion in spending over seven months— But that’s not money we had.
Kevin: Right.
David: And the interest expense, we’ve already covered this, it’s a material issue, a trillion dollar plus interest expense, you may unintentionally lift inflation statistics—unless of course bean counting methodologies evolve in that period of time to erase that later reality and influence economist thinking on the subject. It’s going to influence only economist thinking on the subject of an inflation increase because they’re the ones who don’t see it. It’s the man on the street that does. But just think about that. Be careful what you wish for. Economic stimulus may help you get reelected, but it may also trigger a resurgence of inflation. And if you’re overconfident in what the Fed can do to keep inflation in check, you may find yourself very surprised as a politician in 2024 fighting a dragon, a demon, which you thought was already slain.
Kevin: Yeah, I think about it. I get here, Dave, and I read some of the economists’ comments, the Federal Reserve’s comments, and it’s like, “Gosh, this doesn’t sound at all what my wife is telling me as far as how much it’s costing to go to the store.”
David: No, there are always going to be two sets of lenses: the official lens, which we can think of as a guided epistemological journey—and that’s the one that we’re supposed to see according to the BLS. We’re supposed to see according to a professional class of economists that see the world through their own lens, right? And then there is the lens of epiphany.
Kevin: That’s my wife’s lens.
David: Yeah.
Kevin: Epiphany.
David: The aha moment where you’re like, “Wait a minute, tuition is what? Wait a minute. Medical costs are what? Wait a minute. Food costs are what?” And even fuel, on occasion, can surprise and frustrate and even anger. And we’ve had a dissipation of that recently. Clearly, fuel costs have come down, and that’s been a saving grace for the BLS. But diverging from the guided, statistically curated discovery process, which is given to us compliments of the BLS, is that sort of epiphany, what we encounter on a day-to-day basis. The unfortunate aha moment.
Kevin: Okay. So because fiscal goes to the political side, and we already know that, being an election year, the government’s not going to have any problem spending money to try to get whoever it is that they want to get into office. Then there’s the monetary side, that’s the Federal Reserve. And the two are really not— They’re not supposed to be meeting, Dave. They’re supposed to be independent of each other. But do we have politics, not just bleeding over from the fiscal side, but over into the monetary side, over into the Fed, over into the guys who actually create this stuff we call money?
David: Well, a few weeks back I quoted from an interview in the Financial Times with Charles Goodhart, and what he was pointing out is the absurdity of political independence in the central bank community. We claim political independence and a separation from it, but it’s really just this sort of rhetorical trope. It means nothing. It means nothing. And those who are operators in the central bank community acknowledge that—at least overseas they do. They don’t pretend. They’re not playing games the way we do here.
Just thinking about the economic landscape and thinking that it’s neutral or that central bankers are fair brokers in the application of their dual mandate—remember, the dual mandate is price stability and full employment. A quote from Bill Dudley, this says it all. He’s now retired from the Federal Reserve Bank of New York, but I want to go back to when he was president of the Fed there in New York. Probably the most powerful of the regional central banks because of its proximity to Wall Street, and this is an inspired thought. He says, “There is even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the US and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”
Kevin: Wow. Wow. That doesn’t sound like independence to me.
David: Oh, doesn’t that sound like the ends justify the means? So yes, that was a 2019 quote. CNBC, August 27th, look it up. It’s not interference if it’s inspired by a Democrat. Everyone knows there is an inseparable link from Democrats and democracy. After all, it’s what you have in the name.
Kevin: Okay. So if we are looking at this and saying, “Well, this is going to become very obvious if the Federal Reserve is actually manipulating rates all the way into the election,” but don’t they usually try to back away to show at least— Maybe they’re not independent, but they try to at least show independence by not messing with things the last few months?
David: Yeah, I mean there’s a sense of decorum. There’s also a sense of political vulnerability. If you get too close to the election, you’ve interfered, and the wrong person gets elected, from your position, from your Perch at the Fed, you could be looking at a job change. You could be looking at unemployment, right?
Kevin: Yeah.
David: So all of a sudden, that elite post that you hold is a was-been post, a has-been post. So here’s the conundrum, the no recession, the no recession scenario presents a reality which precludes the Federal Reserve from cutting rates in the short term prior to March. Why would they need to? If there’s no problem, why are they needing to cut rates?
Kevin: How would they justify it?
David: And as we move closer to the election, this sort of decorum or gentleman’s agreement to not tinker with monetary policy within a six-month window of the election, that window rapidly closes. Within that window, the accusation of election interference might just stick. And while you can verbally rescind a public comment or forward guidance—walking it back, as they like to say—the actions speak louder than the words, and you can’t erase it. So when they lower rates, political odds are now diverging from economic odds. Political odds favor a reduction in rates with no real economic justification.
Look, we could see CPI and PPI this week—and this could be a key reference point, a very key reference point. What happens with CPI and PPI will either preclude the Fed from being able to do something or they will act and act quickly to avoid getting into that election window. Watch the weightings of the component parts. Fuel is clearly helping bring it lower. But if there is any indication of resurgence of inflation, any upset of expectations that it’s going lower and going lower fast, that’s what you need to look for.
But a lower CPI number this Thursday may provide adequate cover for a cut. Not the three suggested cuts that you have implied by the dot plots. And certainly not the six, the cuts which the bond market is just slathering over. But if it doesn’t occur soon, Powell and company are going to have to answer the interference charge. And so, echoing Dudley’s 2019 commentary, to continue to accomplish the dual mandate, you might need to adopt a third unofficial mandate. I’m not talking about the stock market rigging mandate. I realize it’s a little cynical, but the never-Trump mandate. Think about Dudley’s comment. Think about that. In fairness, not all Federal Reserve regional presidents are Democrats. You look at the Board of Governors, the ratio’s like 48:1, so not 100%. To be even more fair, the overall ratio amongst the Federal Reserve leadership in the registered to vote category is a more balanced 10:1 Democrats to Republicans.
Kevin: Okay. Let me stop and just build a little bit of a mind image here. Okay, so the Board of Governors for the Fed, if you had 49 guys in the room, 48 of them are Democrats. Now, it’s much better if you had 11 in the room and 10 are Democrats, which is basically what you’re talking about, this is the leadership.
David: Yeah, that’s right. So if you’re talking about the Board of Governors, it’s the bigger number. If you’re talking about the total leadership across the whole country, 10:1 Democrats to Republicans. And believe it or not, there is one libertarian on the Board of Governors.
Kevin: Well, thank you. Thank you.
David: And I wonder what that’s like to be the lone— Imagine this, one libertarian amongst 789 economists.
Kevin: Wow.
David: Isn’t that amazing? So how does Dudley define doing right?
Kevin: Oh, boo. Dudley Do-Right. Boo! Boo! To thwart the bad guys.
David: Thwart the bad guys.
Kevin: Oh yeah, Dudley Do-Right. He’s there to save the day.
I remember when I was a kid, we would hear about the election and talk about actual policies, and people would pick based on policy. I’m not saying that people didn’t always find their favorite candidate, but I don’t remember elections where we were continually told to be afraid of the guy they don’t want in. “You need to fear this guy.”
David: No, you’re right. You’re right. It was always, you focus on the big policies, whether it’s abortion or gun rights or whatever it may be. And then when push comes to shove, you make the straight party line appeal. It’s no longer a question of the quality of the person in office. It’s a question of the party that you align with most consistently. And you can’t diverge from that on the basis of principle. And I’ve heard that a thousand times.
Once the party’s made the decision, you back the man, you back the woman, but you vote party. You’re right, it’s not about policies anymore. The existential threat to democracy—which frankly you could have understood as a threat to Democrats—that was Biden’s talking point at Valley Forge. And by the way, he’s more entertaining with each social engagement. Just to see this dance on stage with he and Jill, he almost falls over. She’s there to carry him off the stage. It’s really inspiring. I love to see a love story continue to grow over time, and I can see that their intimacy is growing—at least as they spend more and more time together on stage. It’s inspiring. But actually, that speech, you could argue, is also inspiring state attorney generals and state supreme Courts to underscore that point which Dudley made in 2019. Everybody has to do their part. Everybody has to do their part on this.
Kevin: It used to be doing your part was to go vote. Now they’re taking away your ability.
David: Well, listen, ballot boxes are going to be more closely scrutinized in 2024. So change the ballot if you’re going to win this time. Something has to change. Something has to change. You’ve got a 38% presidential approval rating. The incumbent advantage used to mean something. It used to mean something.
I saw some statistics where it used to be that 70% of the time an incumbent would win, and that was the advantage. Now it’s down to about 30% of the time. Time magazine in December said this, “The proven tactic is to run against Donald Trump as a super villain hell-bent on destroying democracy. It worked three elections running now, 2018, 2020, 2022. Will it work again?” This is what the Time magazine asks. “The danger is when you’ve heard the same fire alarm enough times, some people tune it out. Many voters don’t believe it. They’re simply tired of hearing it, or have somehow convinced themselves that Joe Biden is the even bigger threat.’
All of this to say, there is an air of political desperation. And I want to return to a much safer domain now, fiscal policy, which will of course remain accommodative, and everybody wants to spend it. This is not a democratic or a GOP— Everybody wants to spend it. Monetary policy, which is likely to be accommodative as well, that sets up, that sets up for a radical relapse with inflation. Focused on politics more than price stability, there’s going to be a price to pay for that. We as professionals expect a second half resurgence in energy prices. And with help from the Fed via monetary policy, the Treasury via fiscal policy will take real rates negative again, as inflation rates rebound and further sour the body politic.
Kevin: So, we’ve been focusing a lot on the United States, but we’re no longer just the only player in the game. One of the biggest players in the world is China. And if we think we’ve got a debt problem, and an unsustainable debt problem, is China doing something any different than us, or how different are we than China?
David: Yeah, I mean in the present tense, an unsustainable debt problem is coming to a head in China, and our day of reckoning is further out on the horizon. But the dynamics are almost identical. And that’s really what I’m getting at with what’s driving growth and what’s driving the quality of that growth. So we started by talking about structured investment vehicles and leveraged loans and swaps and CLOs and CDOs and asset-backed securities and credit hedge funds. Look, China’s done the same thing and they’ve focused on investing in things that frankly aren’t sustainable.
I was reading Michael Pettis recently, and he makes the case that it’s not a debt problem in China. Now, granted, he’s one part provocateur, one part financial analyst bringing corporate finance insights into the macro landscape. And as I read through his most recent piece, it was very much like his book from 2001, The Volatility Machine, where he brings corporate finance theory into sovereign liability management. And in his most recent missive, does this again by reframing the issue not as a debt problem, but as an asset problem.
Kevin: Or as what you count as an asset problem. It goes back to shoveling snow. Do you count that as productivity or do you count it as something that will melt?
David: Yeah, if debt is used to finance productive assets, the return on investment can be extremely additive to the economy and create a long-term positive effect for the economy. It’s when government investment is in things that have no future return profile that debt piles up and the assets that we’re invested in provide no means of paying off the debt incurred in the building up of the “assets.” Does that make sense?
Kevin: Yeah, definitely. That snow melts.
David: So he’s not afraid of leverage if the balance sheet leverage promotes a sustainable return. This is what he argues. He says, “The real underlying problem in China is years of wasted investment whose cost hasn’t been recognized.” So what Pettis is doing, he provides a chart, and this is constructed from the People’s Bank of China and National Bureau of Statistics Data, which blows away any other debt-to-GDP statistics I’ve seen anywhere else. He brings in all debt, not just direct government debt, but everything under the umbrella of aggregate financing. Aggregate financing-to-GDP, which is, in China, just shy of 300%.
Kevin: Okay, so 300% of their GDP is the aggregate financing.
David: So you’re talking about numbers that are on par with Japan. And if you look at the IMF/World Bank tallies, they have much lower sums, and I think what’s implied is that they’re actually missing a good bit of the data. And he illustrates this by looking at one pocket of liabilities. Local government debt the IMF and the World Bank count as eight trillion in US dollar terms, roughly 50% of GDP. A group of economists in China have said, more accurately the account is 12½ trillion, or 88% of GDP. And this is, again, just the local government debt.
His big takeaway is that if debt is not tied to productive assets, you won’t have the capacity for servicing the debt. And most analysts agree, there is a mountain of unsustainable debt in China, and I ask how different we are in terms of sustainable asset investments, systemic debt intolerance, here in the United States. For decades in China, the misallocation of capital to property development, to infrastructure, and even to manufacturing to a degree, has helped build the modern China that we know. Most of those assets don’t have a cash flow attached to them, making serviceability possible.
Kevin: But they still count it as GDP.
David: Well, that’s because you get the up-front boost to GDP growth from the investment, but without cash generation, without wealth creation as a byproduct, the “asset” is overestimated in terms of its value and the debt burden is thus underestimated in terms of systemic risk. So now in the property sector you’ve got things coming unwound, but the systemic issue remains. The investments are carried on the balance sheet at cost.
And this is a key point that he makes, and again, where he’s borrowing from corporate finance theory, “the investments are carried on the balance sheet at cost, capitalizing losses and maintaining them as fictional assets on the balance sheet, not counting them as expenses.” So, the bill comes due for the bridge to nowhere regardless of what side of the pond you live on, whether it’s here in the US or there in China, the losses have to be recognized at some point. The fictional assets have to be marked to market.
Kevin: So Dave, I want to make sure that I’m hearing what you’re saying here, and I’m going to go back to my simple analogy; the snow. If we know we’re going to get a certain amount of snow, and, let’s say I’m worth 100 bucks an hour when shoveling the snow, if I start counting that as productivity and it stays on the books, or even the snow that I’ve already shoveled, my wife has asked, “Well, was he productive?” “Yeah. And he’s worth 100 bucks an hour.” Well, the problem is I’m putting that on the shelf and counting it as an asset that’s not true.
David: Well, you didn’t actually get paid 100 bucks an hour for clearing the snow, and you actually lost it from being at the office and being productive in a way that actually brings in capital for you.
Kevin: Yeah, yeah. And the snow melts. I mean the whole thing—
David: It’s an allocation of a resource—
Kevin: —we’re counting it as an asset.
David: —that doesn’t have an actual return, and you’re counting it as a bonus to yourself because maybe you’re more muscular or maybe you’re better looking, or—
Kevin: But what if it’s not even that?
David: Maybe it’s not. Okay.
Kevin: What if I’m not better looking?
David: Okay. Fair enough.
Kevin: What if I’ve just got a sore back?
David: Hot, sweaty, and with a sore back. You’re right. Now, so Pettis’s framing is unique. It’s uncomfortable from the framework of credit bubble analysis, because he’s switching it around and saying it’s not credit that’s the problem, it’s the assets that are problem. And again, maybe this is just a personality perspective and a way of expressing it. He says, “in China, as in other countries, it’s usually not the debt itself that’s the main problem. Debt is just a transfer. It does not necessarily entail the assignment of losses. What matters is the value of fictitious assets that back the debt, because these overstate current collective wealth and must be written down.”
So we come back to this concept of capitalizing assets versus expensing them. Capitalizing assets unrealistically inflates the balance sheet. Let me give an example here. This is a close-to-home example. I buy a humidor, a big humidor, you know I like to smoke cigars on occasion.
Kevin: Yeah.
David: It’s part of a triathlon training regimen.
Kevin: I’ve noticed that.
David: Yeah. So you buy a humidor, okay, well, there’s an asset. I can capitalize that. I can carry it on a personal balance sheet. Now the only way I actually change the dynamic is if I start renting space in that humidor to other people. Now, the asset has a return on investment that I can calculate on the basis of the income that’s generated from the space that’s rented.
Kevin: Otherwise, it’s just a humidor with your cigars in it.
David: Right. What would be even worse is if I capitalize the purchase of cigars and then I smoke them, but I still count them on the books as an asset.
Kevin: That’s what’s happening in China and here.
David: Maybe a different way of putting it. A dollar in debt that generates 10 cents of income. There’s enough income there to pay for a 5-cent interest cost on that dollar in debt that remains.
Kevin: Okay, so this is your cigars—
David: And I can do that indefinitely, right?
Kevin: —and you’re renting that space out.
David: I can do that indefinitely. If I have a dollar invested, I’m making 10 cents, I can pay the 5 cent interest cost on the debt, right?
Kevin: Right.
David: What if you’re $1 in debt while it generates a dollar in activity, which counts towards GDP growth? What if it has no future return profile?
Kevin: The cigar’s gone.
David: It’s just a dollar in debt.
Kevin: It’s close, but no cigar.
David: You still have the interest component on the debt. This is what we’re talking about when we think of sustainability. Capitalizing assets unrealistically inflates the balance sheet. What this also implies is that GDP growth is overstated when government spending is into non-productive things. Back to the dollar that generates 10 cents, which allows me to pay the 5 cent interest cost. It has to generate something. Otherwise I’m creating an unsustainable burden.
Kevin: Right. So don’t count it as growth. I mean you missed it the first time, and I’m not going to let you miss it the second time. Close—
David: —but no cigar?
Kevin: Yeah.
David: Okay. Yeah, I did miss it the first time. China has found its equivalent of lactose intolerance. It’s debt intolerance. The market has basically said, “Nope, not going to do it anymore.” There is a gag reflex. The body reacts. Not going to happen. This is a reference from Reinhart and Rogoff 2003 paper on the subject of debt intolerance. They use that lactose intolerance reference, actually.
The system reacts negatively to each increase in credit. We’ve seen that this year in China, where an increase in credit and you’re not getting economic growth. The system is reacting negatively. What once counted as positive is now categorically negative. When will we reach the point of debt intolerance in the US? I don’t know for sure, but my guess is you see the bond vigilantes come out in force and an interest rate spike when interest costs exceed 50% of tax revenue. And think about the progression here, because that would’ve been unthinkable two, three years ago. We went from 5% of tax revenue going to interest to 9% to 15% to 19%. Now, we’re at 25% to 30%.
Kevin: Wow. That’s that increase that you were talking about.
David: That’s the rate of change. This is the course we’ve been on since the global financial crisis. 50% is fast approaching. Then we face the same Chinese reckoning day. What is the true value of global assets in a world where liabilities were capitalized and carried on the balance sheet fictitiously?
Kevin: Richard Duncan has been a guest a number of times, and he always irritates me, but he always gets me thinking because what he’s basically saying is, money has changed. Credit now is money, and we need to just get used to it. And so what his suggestion is, go deep into debt, but just make sure that whatever you’re going into debt for becomes productive and actually brings a paradigm shift of income in the future. So, the problem, though, is, it’s no longer the central banks that just create the money. You brought this up earlier. This credit, if we’re going to count debt as money, it’s coming from all over. You talk about shadow banking, it’s not even in the shadow.
David: If you were to unwind this structure of debt that we have, the political or geopolitical implications are catastrophic. It’s World War material. And to extend a little bit of grace to Richard Duncan, what he fears is the very worst, which has already been written through the 20th and 21st centuries, and a relapse of drawing out the worst of humanity is not on the table. So, he would rather spend any quantity of money, tens of trillions of dollars, on technological innovation, on climate change, remediation, whatever it is—
Kevin: Fusion, nuclear fusion, some sort of—
David: In hopes, on a grand gamble, that we come up with sustainable solutions in the midst of spending ourselves into oblivion because the alternative is insufferable, because the alternative, the unknown is too much to bear. It’s too much to bear. It’s that fear of the unknown.
So, it’s no longer central banks alone that create money. We talked about that earlier. Commercial banks do it, too, in the form of credit loans. Now Wall Street and the shadow banking apparatus, they’re doing the same thing, under the radar money creation where there’s an asset, there’s a liability attached to it today. Perceived wealth creation—that’s what we have in the hundreds of trillions of dollars—perceived wealth creation through the ex nihilo creation of money and credit. Money creation continues without limit, as the control function has been taken from central banks and it now rests with the Wall Street elites. And this is one of these violent permutations which has to be resolved because politicians will not suffer Wall Street to have and maintain that control indefinitely.
Kevin: This is why we have to categorize what an asset is very, very carefully. Because right now, worldwide, there has never been more in the way of assets.
David: Well, what I would say is there’s never been more in the way of perceptions of wealth.
Kevin: Yes.
David: And you’re right, because we do call them assets, but they’re really perceptions of wealth. If you wanted to talk about real wealth, now you’re talking about land, plant, infrastructure, art, gold, silver. You’re talking about scarce commodities which represent warehouses, storage vessels of wealth, and then there’s everything else, which are just perceptions of wealth. They may be worth a billion dollars today and they may be worth zero tomorrow. Ask Sam Bankman-Fried about being worth billions one day and being worth zero the next. That’s called the perception of wealth.
Four years ago, in 2020, global debt totaled $240 trillion. Total assets, again, perceptions of wealth, if you will, 293 trillion. Today, global debt as counted by the World Economic Forum, is 307 trillion. Assets today are somewhere between 455 and 465 trillion. So debt has increased 28%, assets have increased 58%—or these perceptions of wealth have increased at twice the rate our debt has, which, we’re all happy with that, right? This is one of the reasons why, why should we be concerned about a recession?
Kevin: We’ve got so many recessions.
David: Global recession, US recession, we’ve never had it so good, unless the value of those assets, like in China, are overestimated, are ephemeral. To what degree are they a fiction, not actually assets, but just capitalized expenses? To what degree is our national net worth figure overstated? Have we capitalized assets versus expensing those investments? That’s precisely what China has done. And to rectify the imbalance requires assigning losses.
Now you’re talking about choosing political winners and losers. Who’s the designated loser in China? Is it the household as you unwind the inflated wealth effect? Is it the banking system because you control it vicariously through the PBOC and you figure you can spread it out over enough number of years that it won’t matter to the economy? Some other sector in the economy? Is that what becomes the target?
We have to come to terms with fictitious assets, and we have to see just how the distribution of those losses, what it means for someone to pay them.
Kevin: You know how you do that? I’ll tell you, one of my favorite interviews you’ve ever done—and you’ve done some good ones—was with Carmen Reinhart. And over and over in that program, she advises the Fed— You mentioned her earlier. She was a co-author of This Time is Different with Rogoff.
David: In that earlier paper I mentioned in 2003.
Kevin: Yeah.
David: Also written with Rogoff.
Kevin: That’s right. But you know, Dave, she was so direct with you in that she said they will have to create a captive audience. You talked about assigned losses. How do you assign losses? Well, you create a captive audience.
David: And then the fancy term for it is financial repression.
Kevin: Yeah.
David: Yeah, that’s the discussion point in that conversation with Carmen. What distress does that cause within the financial markets? Does that distress get magnified as the owners of debt who consider it an asset all of a sudden consider it an albatross? The owners of assets see the shrinkage of those assets, and, relative to their net worth and their liabilities, are upside down from a balance sheet perspective.
Is this convoluted thinking? Maybe if we just back away from this, Kevin, perhaps we can just extend and pretend indefinitely. Perhaps we can go the Richard Duncan route and what he suggested. Be more afraid of chaos, be more afraid of the unknown than the debt monster.
Kevin: And this is, see, we talk finance, we talk politics, but what we’re really getting to the nubs of is the fear, the fear level of the people, the fear level of Richard Duncan and his solution. Otmar Issing, the somewhat founder of the euro, okay, I mean, along with a small group of guys. You remember when you had your interview with Otmar Issing? He had been the head of the European central bank for seven years. He also was direct with you, Dave. He told you a story, and he said, “I never want this to happen again. The euro may fail, this project may fail, but we have to give it a try because [what we have now] will end in what we had in World War II.” You remember that story, the personal story he told you?
David: Yeah. Otmar Issing to this day is not an active member of the ECB anymore, but he was the longest standing member of the ECB. It was [Jacques] Delors who was the founder, if you want to trace it back multiple decades. There was more at stake. There was an existential threat, and it was the history that he had lived, that his family had lived, that he didn’t want to see relived.
Global GDP is approximately 105 trillion today. Go back to the WEF, their estimation of debts, this is again private, corporate, governmental, 307, nearing 300% debt-to-GDP. The IMF doesn’t count over 72 trillion of that debt if you compare their tabulation, their total of global debt. They’re missing about 72 trillion of that debt because it fits no conventional category. As we said earlier, it’s in the form of structured investment vehicles, leveraged loans, CLOs, CDOs, asset backed securities, credit that’s within the hedge fund community, in the private equity community. The question is, how productive do global assets need to be to make progress in paying back that $307 trillion?
And Piketty pointed this out. I’m not a fan of his book Capital in the Twenty-First Century, but this is a point that he raises, and I think it is a reasonable question. When global growth slows and global debt continues to increase, aren’t you really looking at the point of unsustainability?
Kevin: Okay, let’s just bring it to a personal level. If I go into debt, and I can productively pay that debt off, then that’s one way to handle it. If, however, I have too much debt that I can never pay off, I have to default. I have to default on that debt, and whatever the loss is.
Now let’s just bring it here into America. What do we need to grow? Our GDP is what? 4 or 5%. How much do we need to grow on an annual basis to pay this debt off? What’s realistic without a default?
David: Maybe that’s the 72 trillion dollar question. There’s a paper that Timothy DiMuzio wrote titled “Capitalized Money, Austerity and the Math of Capitalism.” Definitely a critic of contemporary capitalism, but some interesting points along the way. DiMuzio argued back in 2020 when he wrote the paper that it would take a 15% growth rate globally for us to make progress in paying off the debt burden, which at that time was 240. Now it’s 307. And of course, GDP has grown. So if you just counted things and said, “Well, it’s not gotten any worse since 2020,” maybe it has. But China’s artificial 5% GDP growth won’t cut it, won’t cut it. Not if 15% is what’s necessary.
Kevin: Neither will ours.
David: And their numbers, at least according to Pettis’s reference there in his recent paper, 300% debt-to-GDP, they’re right on par with the global numbers. Our 5%, at least in Q3, not going to cut it. It’s not at the 15% that lets us get ahead. We are already behind the curve.
Both cases, the US and China, driven by government investment, “government investment.” Deficit spending is what it is. We didn’t have the money. We spent it anyways. We’re going to have to pay it back at some point or face the music. In a world of too much debt, your options boil down to: grow your way out or default. And default takes two subcategories, either formally by walking away, canceling the obligation, stiffing the creditor, or informally through inflation.
Kevin: That’s the chosen. That’s the loser. That’s the cost of bread going from $6 a loaf to 12 to 24 to 50. Dave, there’s a commercial on right now that, I laugh every time I see it. It never gets old. It’s this lady who looks at things and she can tell whether things can fit or not. And so it’s different scenes where she goes, “It’s not going to fit. It’s not going to fit.” And there’s one scene in particular that I love, where grandma is trying to push this gigantic turkey into a very small oven, and she’s like, “Nana, Nana, it’s not going to fit. It’s not going to fit.” And that’s what I’m thinking of, that turkey right now, it’s not going to fit.
David: This is getting personal. This morning I put on a pair of pants, and of course I haven’t been training in the last seven months.
Kevin: Oh no.
David: I put on a pair of pants.
Kevin: It’s not going to fit.
David: And I cussed.
Kevin: Oh no.
David: It’s not going to fit. I mean, I looked like so much sausage in a casing. It was embarrassing. I was angry.
Kevin: Yeah. But you know what you could do? You could start training and shrink your way out of debt.
David: Actually, there is a way forward for me. I thought about throwing them away, but no, I thought, “No, this is a matter of weeks to months before I can solve this problem.” The hope is still that we can grow our way out, and the research would say 15% is a pretty high bar to have as economic growth on an indefinite basis.
You want to know why I love golden precious metals heading into 2024? It’s because there’s only been one case in the modern era where a country was able to grow their way out. 1985, Swaziland.
Kevin: So Swaziland in 1985, this is it?
David: Yeah.
Kevin: And they grew their way out of the debt problem.
David: That’s right. This is not 1985, and this is not Swaziland. That’s the only case in recent history where organic growth has rectified an over-indebted problem.
This is where, as an investor, you have to make a decision. This is an unsustainable project, and it’s playing out in real time as chaos within the Chinese financial markets, and that is coming to a theater near you. So pick your poison, but the default is coming one way or the other. The central planners will do their worst to assign losses and distribute the costs of an economic adjustment to you and yours. That’s a world where lots of people want real money, real money, the only money that’s existed for 5,000 years, not the forms generated by central banks, not the forms generated by commercial banks, not the forms generated by shadow banks, just real money.
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You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com, and 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.
