EPISODES / WEEKLY COMMENTARY

Richard Duncan: What Will Float The Asset Boat When The Easy Money Tide Goes Out?

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Mar 20 2018
Richard Duncan: What Will Float The Asset Boat When The Easy Money Tide Goes Out?
David McAlvany Posted on March 20, 2018
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  • Guest Richard Duncan concerned that liquidity index will plummet
  • Trade War could lead us to severe recession
  • Can China’s massive borrowing save the world?

Richard Duncan’s Macro Watch Can Be Found Here: https://www.richardduncaneconomics.com/product/macro-watch/ Use coupon code “Commentary” to receive 50% off

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“Looking ahead, I think that U.S. interest rates should keep going higher, for all the reasons we have discussed, and therefore that the dollar should move considerably higher as well. However, that hasn’t been the case so far. Interest rates have gone up, the dollar has gone down, so you can’t really be certain that what normally happens is going to happen in the future. Caution is advised.”

– Richard Duncan

Kevin: We have a guest today – Richard Duncan. For eight years we have been riding the wave of easy money. It has been in the form of quantitative easing, as well as artificially low interest rates. Now, even the Federal Reserve, itself, is telling us that it is time to reverse that tide, tighten the money, and even raise the interest rates. Now, our guest calls that destroying money. Asset prices and household wealth have risen with this tide of easy money, and so after this decade what will happen when the tide goes out and reverses like the Federal Reserve is talking about?

Our returning guest, Richard Duncan, speaks with David McAlvany today to answer those questions, and to pose some intriguing new questions. While we don’t always agree with all of Richard’s conclusions his explanation of our dilemma brings us clarity. It is hard to imagine a world without unlimited credit.

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David: Richard, it has been a little bit of time since you have been on the Commentary, and enough time, I think, for us to say, over the last three to five years, even the last ten years, there have been some definitive themes which we are pretty well familiar with. We would love to look at those in a little bit more detail with you today. Where do you think the next three to five years differ the most from what we have just walked through?

Richard: First of all, David, it’s great to be back on the show. Thank you for inviting me back. I always enjoy our conversations. The thing that looks like it’s going to be very different than the last three to five years over the next three to five years is, in the past, we had very accommodative monetary policy overall, and now that is changing. The Fed, after the crisis, cut interest rates to zero at the Federal Funds Rate level and then created 3½ trillion dollars of quantitative easing and pumped that into to the financial markets, which caused asset prices to move significantly higher and brought about an economic recovery.

And also in the past the budget deficit came down quite significantly, at least in terms of as a percentage of GDP. At one time it was 10% of GDP, the budget deficit, and last year it was below 3% for the last couple of years. So that was a big change, the government was borrowing less and the Fed was pumping a lot of money into the financial markets.

Now, looking ahead, this all changes 180 degrees. Suddenly, after the tax cuts and the February 9th Congressional bill to increase government spending, we are once again looking at trillion-dollar budget deficits for as far as the eye can see into the future. And so the government is going to be borrowing much more. Last year, for instance, the budget deficit was around 670 billion dollars. This year it is much more likely to be a trillion and next year 1.1 trillion, and then 1.2 trillion. Those are rough estimates but it is moving in that direction.

And on top of that, not only is the Fed not printing money and buying government bonds, as it was doing between 2009 and 2014, now the Fed is doing the exact opposite. In effect, they are selling government bonds. Instead of creating money and injecting it into the financial markets they are taking money out of the financial markets and destroying it – literally – particularly since this is going on at the same time that the government will be borrowing much more. This is going to create a significantly tighter environment for money. You have the government borrowing more, you have the Fed simultaneously destroying money, and so it looks as though this is going to push interest rates higher, and that is going to create a much more difficult environment for the financial markets and the economy.

David: So here we are looking at Trump instigating a few things on the trade front – steel, aluminum, solar panels – a few things like that. And if we do, as he has expressed the desire to do, eliminate the trade deficit, what is the likely impact on capital flows into the United States, even as we are facing larger budget deficits and a need for greater financing.

Richard: Right. This could be very significant for a couple of reasons. First, last year, and for many years, the U.S. has had a very large trade deficit, a very large current account deficit. Last year it was roughly 550 billion dollars. What people need to understand about that is that when the U.S. has a trade deficit of 550 billion dollars it will automatically have capital inflows of exactly the same amount from abroad – foreign capital inflows. That is because every country’s balance of payments has to balance. So when the U.S. has a 500 billion dollar current account deficit, it has 500 billion dollars of capital inflow on that capital and financial account.

So were President Trump to really carry out his campaign promise to eliminate the current account deficit, then that would eliminate 500 billion dollars of capital inflow into the United States at the same time. So that would compound our liquidity and interest rate problems that much more. Not only would the government be borrowing more at the same time the Fed is destroying hundreds of billions of dollars a year, but we would no longer have the capital inflows that result from our current account deficit. So this would be a triple whammy.

So as we discussed in the past, I focus on something that I call the liquidity gauge. What the liquidity gauge measures is the extent that liquidity in the financial markets is either abundant or scarce. Now this used to be quite simple in the olden days when gold was money and the government couldn’t create any more money. If the government had a budget deficit and borrowed a lot of money then that would push up interest rates because if there is only so much money and if the government borrowed more of it, then that would push up interest rates. That was called crowding out, because that would crowd out the private sector.

But over time things became a little bit more complicated because after 1980 when we started having these very large trade deficits you also had to factor in the amount of money that was coming into the United States from abroad, from foreign capital inflows. And then, once the crisis started you also had to factor in how much money the Fed was creating and pumping into the financial markets through quantitative easing. So the liquidity gauge now, you have to combine, you have to add together the budget deficit, which is a negative number, and the capital inflows, which is a positive number, and the quantitative easing, or tightening as the case is now. Quantitative easing is a positive number, quantitative tightening is a negative number. When you add all these things together that gives you the outcome on the liquidity gauge.

Now, it sounds a bit complicated when you explain that quickly, but it is really not. Essentially, what is means is how much money is being injected into the financial markets, or how much money is being withdrawn from the financial markets, through those three forces. And when it is a positive number, as it was in the year 2000 when we had the NASDAQ bubble, and as it was in 2006 when we had the property bubble, the NASDAQ prices tend to go up. But when this number turns negative, then that tends to send asset prices crashing, and that is what happened in 2008 until they got quantitative easing up and running and pumping more liquidity in.

Now, as a result of these trillion-dollar budget deficits, and quantitative tightening, which is also draining liquidity out of the financial markets, even with the current level of capital inflows, that means the liquidity gauge is going to become even more negative this year than it has ever been by far in the past, and it is going to become worse next year and worse the year after that. So we are looking at an unprecedented liquidity drain that should drive interest rates higher. And if interest rates go higher, that is really creating a toxic environment, not only for economic growth, but for asset prices.

David: Yes, we wonder about the symmetry within the markets. If we have a rise in rates, does that negatively affect asset prices, and to what degree? We have seen interest rates come down and that has been a part, along with QE, of driving asset prices higher. Does that symmetry hold, and would you say it is even axiomatic that with a rise in interest rates, given these factors – quantitative tightening, the announcements of government spending, the announcements of tax cuts – all of these things factoring in – the elimination of the trade deficit, or current account. The implication is higher rates, and perhaps lower asset prices.

Richard: And also, I would add, potentially credit contraction. So I think we have to look at the dangers of higher interest rates in terms of how they will impact credit growth, and also how they will impact asset prices. Now, on the credit growth side, back in 1980 the ten-year government bond yield peaked at something like 14-15%, and as it steadily came down, moving lower and lower year after year, that made credit more affordable. The ten-year bond yield is now just 2.8% today. And so, as credit became more affordable, the Americans borrowed more and spent more, and that borrowing and spending drove economic growth. So the ratio of total debt-to-GDP in the United States rose from about 150% in 1980 and went all the way up to 370%. The point, now, in that economic borrowing and spending, that expansion of debt relative to the GDP, that drove economic growth in the U.S., and the U.S. growth drove global growth. But now if we start to have significantly higher interest rates, then not only will credit not expand, credit will contract. And if credit contracts, that is going to throw the U.S. into a recession. Every time U.S. credit grows by less than 2%, adjusted for inflation, the U.S. falls into recession, and we’re not far from that level now. So that is one concern.

The second concern is the impact that higher interest rates would have on asset prices. So just because interest rates were cut to zero percent at the Federal Funds Rate level, and because of quantitative easing pumping so much new money into the financial markets, we have seen an explosion in wealth in the United States. Household sector net worth is now almost 100 trillion dollars. That is up 70% from the low in 2009, and it is even 40% above the high in 2007. We now have 27 trillion dollars more wealth than we did ten years ago because of quantitative easing and low interest rates. So this has pushed asset prices up to an extremely high level.

In fact, if you look at something I call the wealth-to-income ratio, it has never been higher. This wealth-to-income ratio, if you take household sector net worth as a percent of disposable personal income – in other words, wealth to income – the average since 1950 has been about 530%. In the NASDAQ bubble it went all the way up to 613% and then that popped and crashed. During the property bubble it went up to 660% and that popped and crashed. Now it is 675%, so it has never been higher, meaning asset prices have never been more stretched relative to income. And this has only been possible because interest rates have been so low.

So if we do get a move up in interest rates, which looks very likely for the reasons we have discussed, then asset prices are vulnerable to a very significant correction. And if asset prices will fall, then we will have a negative wealth effect that will also tend to push the U.S. back into a recession, so it would be a double whammy with contracting credit and falling asset prices. So interest rates are really the key about what is going to happen in years ahead, and the outlook for interest rates is alarming.

David: We had the discussion of an exit strategy from Ben Bernanke, and then we had a variety of times where the idea of normalization was put out there, but it is as if Wall Street and investors have gotten used to lots of talk and no action, and have somehow ignored the fact that interest rates bottomed in the summer of 2016 and have been rising for the last 18 months. The ten-year treasury is more than double what it was. Off of a 136 low it is more than double that today.

Anecdotally, I spoke with a friend the other day purchasing a vehicle and two years ago zero percent financing was common. At present, Toyota wants 6%. So it is not a surprise, I guess, to see a slowing in auto sales, a slowing in the housing figures here recently, but there is, ultimately, an impact in rising rates in terms of the sectors and segments in our economy that are sensitive to the cost of capital, autos being a big part of that, housing being a big part of that. You would say that on the current course, the odds of a recession in the U.S. – again, on the current course – the odds are pretty high.

Richard: Yes, on your earlier point about the financial markets ignoring these warnings so far, I think that is right. It’s like this. If you tell a roomful of intoxicated people that over the next 24 months you are going to suck all of the oxygen out of the room they are inhabiting, then they’re not going to pay much attention. But give it a little while and once the oxygen is removed and they find it difficult to breathe, then they are going to feel entirely different about the matter. So quantitative tightening is destroying money. It is sucking the financial oxygen out of the financial markets, and things are going to become tighter and the markets are going to find this very uncomfortable. And they are going to react. I think we have already started to see them react with this 10% correction in February once it became clear how much money the government would be borrowing.

Now, in terms of if there is going to be a recession, and when, we have to see how this plays out. What we have discussed up until now is the scenario under which policymakers actually do what they say they are going to do. Some of this is locked in. The budget deficits are going to be much higher. Now, the question is, will there be a trade war, which would reduce the current account deficit and reduce the capital inflows in the U.S.? We don’t know about that yet. And will quantitative tightening really continue? Well, the Fed has given us a schedule about how much money they intend to destroy. Right now they are eliminating, effectively selling off, 20 billion dollars of bonds every month. That increases to 30 billion a month in the third quarter, 40 billion in the fourth. Every three months it goes up by 10 billion until it hits 50 billion a month starting in October.

So they have given us a schedule of what they intend to do, how much money they intend to destroy, but the question is if the stock market has another big selloff, are they really going to stick with that schedule? Are they really going to continue with quantitative tightening, or are they going to put it on pause? I think there is a real chance that the Fed would pause quantitative tightening. And if we truly had a, say, 25% correction in the market, or even 20%, then there is a real possibility they would entirely reverse course and launch another round of quantitative easing to push the asset prices back up.

So I think it would be a mistake to just forecast entire doom and gloom based on the current scenario that we are told to expect, because as the environment becomes worse the scenario is likely to change. The Fed will probably stop quantitative tightening and even reverse it if necessary. Nevertheless, it seems likely that the stock market is going to be in for a number of very bad days between now and then, and everyone should expect a great deal more volatility in the stock market, in particular, and an increasingly weak property market.

David: So it may be that what we saw here in the 1st quarter, a significant downside in a nine-day period, could be the first round of that kind of market volatility, and perhaps the market is still needing to determine whether or not Powell, who is not a Ph.D. economist, and has a different view of things, perhaps, than his predecessors, is going to act a little bit more like Volcker, and a little bit less like Bernanke, Greenspan, and all who have come before him. So first round, second round, third round – at what point does the Fed gain sensitivity to market actions as opposed to their stated targets of an inflation target of 2% and unemployment?

Richard: That’s right. And thus far, we have only been talking about the way that the supply and the demand for money will affect interest rates. We haven’t even touched yet on inflation. Now, the reason we have been able to get away with so much credit expansion and paper money creation through quantitative easing in the United States and Japan and Europe, and all around the world – the only reason we have been able to get away with so much paper money creation without extremely high rates of inflation is because we have had globalization, and globalization has been extremely deflationary. It has driven down wages in the developed economies, and has pushed down the cost of all manufactured goods.

This has been going on starting since around 1980. That is why interest rates fell, because inflation fell. But now, if we actually were to enter into a trade war with China, for instance – President Trump campaigned on the promise to put a 45% trade tariff on all Chinese goods and a 30% trade tariff on Mexican goods. If anything like that were to happen, then immediately the price of everything in Walmart would jump 10-20% plus, and we would go from having less than 2% inflation to something closer to double-digit inflation, and interest rates would be right there with the inflation rate, and that would crush the economy.

So that is another factor that we really don’t know how is going to play out. All we can see is that there are warning signals that this is a threat, although it is not at all clear how far President Trump will actually pursue this policy. But in recent days he is moving closer in that direction.

David: And if globalization is the single largest factor in muting the inflationary impact of the past ten years of aggressive monetary policy, and as you say, really, the last 20-30 years of a declining interest rate trend, what does inflation look like should globalization trends regress or deteriorate? Do we begin to see not only domestic inflation, but in fact, a global inflation?

Richard: Yes, we would. Initially, we would see U.S. and global inflation spike very sharply.

David: When you say spike very sharply, let’s say that the target for inflation is hit and then it is surpassed. Is that the Fed just still sort of looking in the rearview mirror, fighting the last battle the last ten years with a deflationary concern on the front of their minds, and are there implications inflation does spike – does a spike to the Fed, is that a move to 3% in a very short period of time, or are you talking about something far more significant?

Richard: If we had a trade war with China we’re talking about a spike in the near term, within a year, to 6%, potentially even 8% inflation, perhaps, because we buy all of our manufactured goods from extremely low-wage countries. If we stop doing that, then we will have to start manufacturing them again in the United States where wages are much higher, and starting from a point where we have what is 4% unemployment. So there is nearly full employment now, perhaps full employment now.

So you would get much higher wages, and we would return to a period like the 1960s and 1970s when too much government spending by President Johnson and President Nixon – those budget deficits of President Johnson and President Nixon led to very high rates of inflation, because at that time the United States had a relatively closed economy. We didn’t have a trade deficit. We didn’t begin to have a trade deficit until after 1980. Paul Volcker crushed the very high rates of inflation that resulted from very large budget deficits in the 1960s and 1970s.

Volcker crushed that inflation in 1980, but no sooner had he crushed it than President Reagan started running even more aggressive budget deficits, much larger budget deficits than President Johnson or Nixon did, but we didn’t have a return to inflation in the 1980s and afterward because something very fundamental had changed. Suddenly we no longer bought everything in the United States. We no longer had a closed domestic economy. We had a global economy with an infinite supply of low-cost labor, and a very large supply of industrial capacity.

So even though the government ran enormous budget deficits under President Reagan and stimulated the economy very nicely that way, it didn’t result in inflation because globalization drove down prices. But if we move back to a period where we once again have high tariffs and a closed domestic economy, then the government stimulus that is resulting from trillion-dollar budget deficits in our future would once again immediately lead to another period of Johnsonian-like inflation rates of the 1960s and 1970s.

David: I want to come back to a discussion on safe haven assets, but if our listeners are interested, Richard, in following your Macro Watch video series and blog on a routine basis, what is the best way for them to plug into that? It has been very valuable for us. We look at it as often as they come out. Maybe you could share with them a little bit about how to access Macro Watch.

Richard: Okay, thank you, David. Macro Watch is a video newsletter that I publish. Every two weeks or so I upload a new video discussing important developments in the global economy and how I think they are likely to impact asset prices. And within these videos there is a lot of focus on credit growth, what drives that, and the outlook for that, but also on monetary policy, and trying to anticipate what the government is going to do next, and how that will impact interest rates and asset prices. So if your listeners would like to check it out, and I hope they will, they can visit my website at RichardDuncanEconomics.com.

I would like to offer your listeners a 50% subscription discount. Normally, Macro Watch costs $500 a year, but if they use a discount coupon code – Commentary – they can subscribe for $250 a year. And with that, they will have immediate access to the 42 hours of videos that are in the Macro Watch archives – they can begin watching those immediately – and they will get a new video every couple of weeks for the next year. At the very least, I hope they sign up for my free blog while they are there, and they will see more about topics that I discuss in my videos.

David: I highly recommend Macro Watch.

There is the issue of rates having been in a declining trend for nearly 40 years, of course, in fits and starts and not on a straight line down. But since the 1980s rates have been coming down. In a rising interest rate environment, and also, potentially, in a rising inflationary environment, I wonder if treasuries get the same safe haven traffic that we have grown accustomed to over the last 30-40 years.

Richard: No, I don’t think they will. Of course, if we start to have more government borrowing, and with the Fed effectively selling the government bonds that it owns, then this fundamentally alters the supply and demand in government bonds. So with the government borrowing more money to finance its budget deficits, then that is going to push up the interest rates on those government bonds. And when the interest rate on the bonds goes higher the prices goes lower. So if we do move into a higher interest rate environment, that means the yield on the government bonds will be moving higher, and that the price on the government bonds will be moving lower. So no, the government bonds won’t be safe haven.

David: In some respects it sounds like an echo from the 1968 to 1981 period. What in that period, and what in this period, would you consider reasonable safe haven choices if, in fact, treasuries don’t fill that bill any longer?

Richard: I really think that what we have seen in recent decades is an explosion of credit as credit, I like to say, has slipped its leash. Once we stopped backing the money with gold that allowed credit creation on a much greater scale than was possible before, and by the central banks. And at the same time, money creation through the banking system also radically expanded, and that is because the Fed reduced the required reserve ratio on how many bank reserves the commercial banks were required to hold. And the lower the level of reserves that the banks were required to hold, that meant the money multiplier expanded, so the banking system was also able to create more money.

On top of that, a third source of money and credit that is a new source started after the breakdown of the Bretton Woods system. Afterward, not only was the Fed free to create as much money as it wanted because there was no longer any gold backing, but other central banks around the world were free to create as much money as they wanted. Of course, they were creating money in their own national currencies, but many of these trade surplus countries like China began creating extraordinarily large amounts of their own currency and using it to buy dollars in order to hold down the value of their currency so they could continue growing through export-led growth. Once they accumulated these dollars they invested them in U.S. dollar-denominated assets on a trillion-dollar scale.

So this became a third source of money, if you will, entering the U.S. The first source was the Fed creating money. The second source was the banking system creating money. But after 1980 you actually had a third source – the central banks of other countries creating their own money, buying dollars, and then pumping those dollars into U.S. dollar-denominated assets like U.S. government bonds. So it was no longer just a matter of the Fed creating money and monetizing U.S. government debt, in other words, printing money and buying government bonds. After 1980 we started seeing other central banks create money, buy dollars, buy U.S. government bonds, and monetize U.S. government debt, on a much larger scale than the Fed has been doing.

So by 2008 other countries, the rest of the world, had bought up 45% of all U.S. government debt. This was an extraordinarily important development that most people have entirely overlooked, that it wasn’t just the central bank of the United States printing money and monetizing U.S. government debt. On a much larger scale, it was foreign central banks printing money and monetizing U.S. government debt.

So this is another reason that U.S. government bond prices went up and U.S bond prices went down, and this is another thing to worry about because this occurred because they had a trade surplus with the U.S. If their trade surplus with the U.S. goes away then they will no longer have the dollars to buy any more government bonds. They would be able to monetize less U.S. government debt and that would be another reason interest rates would climb significantly higher.

David: That underscores why treasuries are less likely to be a safe haven choice. What would you personally consider to be a reasonable safe haven choice in a world where stocks are expensive, bonds are expensive. On a relative basis you could say perhaps the emerging markets are cheaper, but you see an increase in, say, the value of the dollar and you could end up seeing a blistering decline in the emerging markets. Is there a place that you can go, an asset class that you can go to, that you can consider a safe haven?

Richard: I think, David, what I was trying to lead up to was, there has been an explosion of credit creation for all of the reasons that I described, and this credit has created an ocean of liquidity, and all of the assets classes are floating on this ocean of liquidity. As long as credit expands, then all the asset prices move up together. But if credit begins to contract, then all of the asset prices move down together. So if interest rates go higher, then credit is likely to contract, the tide is going to go out, and all the asset prices are going to move down together. So I really don’t see any safe haven, in absolute terms.

David: You may be aware of Doug Noland’s work with the Credit Bubble Bulletin and his management of funds with Federated and the Prudent Bear mutual funds through the years. He joined our team this last year to manage a tactical short, in part because there are so few places to go to safeguard assets and to create liquidity in the context of a downturn. The reality is there is virtually no place to go.

Now, our opinion on precious metals, and particularly with gold, is perhaps similar and perhaps different. We have had a dollar decline over the last 12-18 months, which may have supported a move higher in gold. But we have also had an increase in interest rates, which certainly has not kept the price of gold from moving higher. Are there thresholds where either dollar strength or a rise in interest rates begin to put pressure on precious metals? Because at least in the last 12-18 months, and we certainly saw this in the 1968-1981 period, metals did very well in the context of rising inflation and rising interest rates.

Richard: First of all, let me say that I have enormous respect for Doug Noland. I have been reading Credit Bubble Bulletin for 20 years, even before I wrote my first book, and I learned an extraordinary amount from Doug. So please send him my thanks. I have never actually met him. So yes, congratulations on having him on your team, I think he’s great.

Now, about gold, there is a very close inverse correlation between the dollar and commodity prices, including gold. If the dollar gets stronger, the commodity index gets weaker. And if the dollar gets weaker, the commodity price index gets stronger. You mentioned the 1968 to 1981 period. Of course, that is when gold had its extraordinary surge, but you have to keep in mind that Americans were not allowed to own gold between 1933 and 1975, so gold prices were unnaturally suppressed by that factor. And then in 1975 they were allowed, and at the same time in the early 1970s you had the Bretton Woods system breaking down, where suddenly the dollar was no longer pegged to gold and everyone really expected financial Armageddon and had no idea what to expect. The dollar was devalued initially in 1971 and that drove gold prices higher. People were panicking and that drove gold prices higher.

So I think that was an exceptional period. I would look more to its more normal pattern. When the dollar goes higher, then gold goes lower, and oil goes lower. And so, if we do look ahead where we see higher U.S. interest rates, then under normal conditions higher U.S. interest rates make the dollar move higher. But what we have seen recently is very baffling. We have seen the U.S. Fed, starting at the end of 2015, very gradually hiking the Federal funds rate at the short end, and then more recently, actually reversing quantitative easing beginning in October of last year, which is tightening on the long end, trying to push up the longer-term interest rates.

This has been occurring at the same time when the European Central Bank is not only not tightening monetary policy, last year the ECB up until December was still doing quantitative easing at the rate of 60 billion euros per month. That has been reduced to 30 billion euros a months since January. But they are still creating money, which is a very loose monetary policy. And in Japan, and of course all the European government bond yields, even in Spain and Italy, their interest rates on their government bonds is considerably lower than U.S interest rates, which suggests that the dollar should be stronger as money moves into the dollar to take advantage of those higher interest rates.

And the bank of Japan is still printing money like crazy. They have bought up now 40% of all Japan’s government debt, and Japan’s government debt is now 250% of Japan’s GDP. They bought up 40% of it, and Japanese interest rates are essentially zero percent on ten-year government bonds. Or it you want to be technical, they are 5 basis points. So those large countries have extremely loose monetary policy. U.S. monetary policy is tightening. U.S. interest rates are higher than their interest rates. That should push the dollar higher, but the dollar has not been moving higher over the last year or so. The dollar has actually been moving lower. And this is quite a mystery. There is no fundamental explanation for this.

So let me throw out this possibility. Of course, it is only a possibility, I cannot substantiate it, but I believe there is some possibility that the current administration is acting to depress the value of the dollar. We saw the Treasury Secretary, a month or two ago at Davos, talk down the dollar, and the Treasury Department has an enormous capacity to push the dollar lower if it chooses to do so through the opaque derivatives market. No one can see what is going on in the derivatives market, no one can find out, no one would know. So it really couldn’t be that difficult for the Trump administration to drive the dollar down. After all, all through his campaign he said repeatedly that he preferred a weaker dollar, and a weaker dollar is what we are getting.

So I just throw that out as one possibility for the explanation of this mystery of why the dollar is going down, even though U.S. interest rates are going up. Looking ahead, I think that U.S. interest rates should keep going higher for all the reasons we discussed, and therefore that the dollar should move considerably higher, as well. However, that hasn’t been the case so far. Interest rates have gone up, the dollar has gone down, so you can’t really be certain that what normally happens is what is going to happen in the future. So caution is advised.

David: Looking ahead, there are pockets of investors who sort of rank, in terms of intelligence and interest in anticipating trends – everyone wants to know the future but it seems like the foreign currency markets are particularly sensitive to policy changes. The fixed income markets are also very geared toward shifts in long-term trends and anticipate that far better than equities markets. So perhaps it is not a surprise to see changes in the foreign currency market, also changes in the fixed income market, and very little change thus far in the value of equities, where equities sometimes get it last.

I want to transition, if we can, to China a little bit, because there is this idea that you have written about, and we have talked about in past commentaries together, that if credit growth does not exceed 2% net of inflation, you find yourself in a recession. Now, we look at the United States, but we also consider global credit expansion and the importance of these things on a grand scale. We continue to see the largest amount of credit expansion globally in one country, specifically, in China.

And there is a combination of shadow banking, credit growth, but also official growth within the banking sector. You have 40 trillion dollars of assets in the Chinese commercial banking sector, which is roughly the equivalent of 50% of global GDP, and I wonder if the expansion of credit in China is sufficient to float asset prices globally or if that truly ends up being just a domestic benefit or risk.

Richard: That is a really important factor to consider. Last year I did a Macro Watch video called China’s Credit Tsunami in October, and what is occurring in China truly is extraordinary. For instance, the IMF expects total credit in China to double between 2016 and 2022. In 2016 total credit in China was 27 trillion. By 2022 this is going to double to 54 trillion, so 27 trillion dollars of new credit. Now, if this really happens, then there is a potential for this credit to spread all around the world, particularly driving up asset prices in the major cities. And for asset prices, we know the impact that this kind of money has in London, and Sydney and Melbourne and Vancouver, and all the major capitols.

I think it is also interesting to consider how this money that is created in China actually goes abroad. And here, I think bitcoin plays a role. Why has bitcoin appreciated from nothing to $19,000? I know it is now under $8000, but still, it is very useful for bitcoin to be valued at $8000 because it allows a lot of money to move out of places like China without anyone seeing what is going on. I think this is, potentially, one of the reasons why bitcoin has had such an incredible run, because if it allows money to move out of places like China where money is not really permitted to move freely, as you know.

So the question is, how is this money going to get out of China? But that is just the beginning of the significance of this credit explosion in China. Already, what we are seeing is China has just incredible mind-boggling excess capacity across every industry. You no doubt heard the statistic that over a three-year period, I think 2011, 2012, and 2013, China produced as much cement as the U.S. did during the entire 20th century. So China has incredible excess capacity across every industry. And domestically, they don’t have enough purchasing power. On average, Chinese people earn less than $9 or $10 a day. They simply can’t afford to buy everything that China’s industrial sector can produce.

In the past, as long as China was able to sell more and more to the rest of the world, then they could grow through export-led growth and that worked miracles for them. China now has a one billion dollar-a-day trade surplus with the United States – one billion a day – but this has now led to a political backlash around the world. We are seeing populism in all the elections in Europe and the United States. The discontent of the former middle class and their loss of relative standing, led to their support for candidate Trump, and that played a major role in why he was elected.

There is a major backlash around the world against free trade and against globalization, and of course, against China in particular since they are the dominant player in global trade, and the most competitive. So now we are seeing headlines over the last couple of days that perhaps the Trump administration is going to seek 60 billion dollars of trade tariffs on Chinese goods. Of course, maybe they will, maybe they won’t. But it looks as though it is going to be increasingly difficult for China to continue to drive this economy through export-led growth when there is a global backlash against exactly that.

Who is going to consume everything that China is going to be able to produce if they double their credit over the next five years? If people don’t buy the goods they produce, then the producers will be loss-making, and that will destroy the deposits that people believe they have in the banking system in China, potentially causing a fatal systemic collapse of their financial system.

David: So we have the mercantilist model where export-driven growth has been what has developed Chinese prowess since Deng Xiaoping to the present. And you would argue that globally, and certainly in the United States, economic growth is driven by credit growth. If we used that and said in the next period ahead economic growth would be driven by credit growth in China. There is this question of malinvestment.

It was Jim Grant, in a recent missive, that said, look at the numbers in terms of credit growth in China from 2016 and 2017. They suggest that we would see 3-6 trillion dollars in new bank credit created, this year and for the foreseeable future. We are talking about a 13 trillion-dollar economy. How can you effectively and constructively loan between 3 and 6 trillion dollars per year into a 13 trillion-dollar economy?

And if we have just said that we have capital controls, and the only way out in terms of getting excess credit out of the country is illegally. We know that Xi Jinping has done a tremendous amount to increase capital controls. Aren’t you really talking about just an absolute mushrooming of credit within China, and an absolute – I don’t know how to say it, but one of the greatest periods of malinvestment, perhaps, in all of world history.

Richard: Yes, you are, but at the same time you can look at this from a different angle. If China can really continue with what it has been doing, if it can really carry on and double the amount of credit that it creates over the next five years, credit is power, and just imagine the investments they could make with 27 trillion dollars. The Chinese government is not shy about government-directed investment. They are going to be investing in the most cutting-edge industries they can acquire, and they are going to fund these thing lavishly with the credit that they are creating.

So we are going to see China very quickly moving toward green energy so they will no longer have any dependence on oil. They have more electric cars than anyone else, and they are moving very rapidly in that direction. But you can also anticipate that they are going to be acquiring, around the world, every high-tech industry they are allowed to buy. And at the same time, investing, throwing money into research and development, into education, into developing the best and the brightest Ph.D. students and genetic engineering, biotech, nanotech – all the industries of the future. And if their bubble doesn’t implode sometime soon, these investments directed by the government in new industries and new technologies will make China the superpower of this century. This will be China’s century.

David: You and I both agree that the limits to credit growth are what the borrower is able to pay in terms of interest. So this really begs the question within China – who pays for this massive credit expansion? Who ultimately is paying interest? Or are we talking about something that is irrelevant in a command and control economy? Your thoughts?

Richard: So who pays? One source of funding for this credit that has been the most crucial source up until now has been China’s trade surplus, primarily with the U.S. As long as China has a billion-dollar-a-day trade surplus in the U.S. that money goes into China’s banking system, and that provides the funding that allows this credit to expand. Now, also the banking system, itself, can create credit through fractional reserve banking, and China’s required reserve ratio is still relatively high, roughly 8-9%. If that is lowered, then that gives the banking system the ability to create more credit.

Now, how much of the debt that has been issued – how much of the loans that the Chinese banks have already made are really, truly performing? Well, it is very hard to know because as long as the banking system continues to pump out 15% more loans this year than it did last year, then everyone has enough money to pay the interest on money that they have borrowed in the past. And as far as the banks, banks aren’t bankrupt until the government says they are bankrupt, and in China, the Chinese government has no intention of reflecting how bankrupt the Chinese banking system might be.

So the ability for credit creation to carry on in China is still there, but if we were to have a trade war and they suddenly lost access to this incoming one billion dollars a day on their trade surplus with the U.S., that would make their liquidity situation much less comfortable, and they would find it more difficult to keep credit growing at the rate that it has been, and that could lead to an implosion of the banking system.

David: So we go back to where we started, and perhaps we can end on this point. We were talking about Trump’s trade war and his desire to eliminate the trade deficit, and yes, that does create a funding issue for our budget deficit. It may even throw us into a recession. Could there be some calculus in the Trump administration that if we suffer a little, perhaps our competition around the world suffers a lot?

Because when you look at the nature of, essentially, Ponzi finance within China, their credit expansion which is dependent on growth, and it grows, and it is dependent on the growth that came from the year before, and it just kind of continues until it doesn’t, the lynchpin of which, I think you were suggesting, is the trade surplus, the opposite side of our trade deficit. If that money is not going into the banking system, if it is not feeding their system of credit or Ponzi finance, couldn’t you argue that Trump is actually going to war – not in a trade war, but really in a way that levels the Chinese ability to become a superpower and compete with us for that one position of hegemony in the world?

Richard: Yes, I think on one level they certainly understand that, as he said recently, it is easy to win a trade war when you’re being taken advantage of by all the other countries. Well, it is not exactly fair to say the United States has been taken advantage of because it has been the U.S. corporations, themselves, who made the decision to move to China. As a result, they have driven down their wage cost, and their profits have risen, and their CEOs have all earned very much larger bonuses than they would have otherwise, and the U.S. banking industry has benefitted from this arrangement, as well – the financialization of the global economy. So there have been some sectors of the U.S economy who have benefitted, and that includes the U.S. government, as well, because China takes its trade surplus dollars and reinvests them in U.S. government bonds, which makes it very easy for the U.S. government to finance its very large budget deficits at low interest rates. So the U.S. government can continue to fund its domestic welfare programs at the same time that it maintains its global military dominance. Now, that is one factor that they perhaps have not considered carefully enough in the Trump administration. Yes, China sells the United States four times more than the United States sells China. So yes, if we put up tariffs, that is going to be a real blow to China – a very severe blow, potentially a fatal blow. But that is also going to mean that China will stop having this trade surplus that they can invest into U.S. government bonds, which will push up U.S. interest rates, which will drive down credit growth and drive down asset prices and throw the U.S., and the world, into a severe recession, if not depression.

And another factor that everyone had better take on board is that if China’s economy, which probably is the greatest bubble in the history of the world, if it were really to implode, if we were to have an all-out trade war with China and put up a 45% trade tariff, as candidate Trump said he would do, then China’s economy would implode. Tens of millions of Chinese factory workers would lose their jobs. There would be, potentially, extreme political unrest within China, and the geopolitical consequences of that would be extreme.

What would China do in a situation where its economy is imploding and unemployment is skyrocketing? They don’t have adequate social safety nets. We would see hungry people – very unhappy hungry people in China – and what would be the geopolitical response to that? That is something that also needs to be considered before we enter into a trade war with China.

David: I think history shines a light on what that could look like. I want to come back to your mention of Macro Watch earlier. I know you are going to be doing some real interesting work on the changing nature of money. One of the most recent Macro Watch video series that you did was on “Money – It Ain’t What It Used to Be.” I think that some of the nuts and bolts that you cover there are really vital for people to understand in this changing world of money, credit, and financial flows within the financial system, but also around the world. So please take advantage of the generous offer, the half-off subscription, and dig into the archives, as well as looking at the changing nature of money. I think there were so many things that we could have covered today dealing with fractional reserve banking and required reserve ratios, and what has enabled the growth of credit beyond what the Federal Reserve can actually manage themselves. They have lost control of the credit markets as you effectively argue in the most recent Credit Watch. By all means, tap into Richard Duncan’s resource there on Macro Watch and subscribe if you haven’t already.

Richard: David, thank you. This research that I have been doing recently on monetary policy has been really fascinating for me. One video that I did recently was called, “One hundred Years of U.S. Monetary Policy.” I analyzed the changes in U.S. monetary policy by looking at the changes in the Fed’s balance sheet, the size of its balance sheet, and in the composition of its assets and liabilities over seven different periods of time, starting from the time it was founded in 1914 up until now. It was just fascinating to see the evolution of U.S. monetary policy as it is reflected in the changing assets and liabilities of the Fed. You really see when the Fed begins creating money and buying up government bonds, monetizing U.S. government debt, driving economic growth.

And all this eventually led to the crisis of 2008, but then also it is fascinating how they responded to that crisis and reflated the U.S. economy very successfully after the crisis struck. So really, in order to understand how the economy and the financial markets work in the 21st century, it is absolutely essential to understand monetary policy. So yes, I do hope your listeners will take a look at Macro Watch.

David: We look forward to having you back on the program. It is always great to get a perspective from Asia – you live in Bangkok, and continue to do copious amounts of research in the global financial markets, and we are the beneficiaries of that. I would encourage you to look at Macro Watch and get signed up on Richard’s blog.

Thanks for joining us today, Richard. We look forward to seeing you again. It has been a little too long since we have shared a meal, but hopefully we can fix that here in 2018.

Richard: I hope so, too. Thank you for having me back on. It is always a pleasure talking with you, David.

David: Likewise. Have a great day.

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