The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: Our guest today, David, Richard Duncan, has been on numerous times before. You have gone out and visited him with the family and he brings a unique way of looking at economics to the table, even though you have to listen several times. It sounds complicated, but he simplifies it to the point that if you do listen several times, you are going to get something that you did not have before.
David: Born and raised here in the U.S., now based in Asia for a number of decades, many would know him from his best-selling book, The Dollar Crisis, followed on by The Corruption Of Capitalism, A Strategy to Rebalance the Global Economy and Restore Sustainable Growth. And as we’ve talked, it is in his mind to move from authoring books to providing a service that brings prescient insight, just as he has in his books, but on a more timely basis.
So he has introduced a service called MacroWatch. It is a quarterly service, in which you can look at hours of information, data points, charts, and a presentation of his. This service is ordinarily $500 per year. Again, on a quarterly basis you receive it, $500 per year. He made a special offer for our listeners, and that is a 50% discount, which I thought was extraordinary, for anyone interested, and the coupon code for that would be Commentary, just for our Commentary listeners. That is, I think, worth considering. It includes two courses that he has put together, again, hours of research. The courses are Capitalism and Crisis, and the second course is How the Economy Really Works. All of that available to the subscribers, and they can go to richardduncaneconomics.com.
Kevin: I think I would like to mention, David, even though it sometimes sounds like complex economics, what he is basically saying is, years ago growth was created by income and the work force growing, and now that has been replaced by credit growth, and you have to have one of the two. You have to have either the amount of workers coming in, which would raise income, or you have to have credit growing. Unfortunately, we have both shrinking at this point, so you have to add quantitative easing. And he analyzes what that really means in the economy.
David: It is fascinating to see that, as Lord Acton said many years ago, what ends up driving everything is demographics and economics. So, at the core of economic growth today, because there is a deficiency in demographics, again, shrinking demographics, not the income growth, not the job growth, there is a substitute, credit growth, whether we like it or not, whether we think it is sustainable or not, it is what is in vogue today.
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Richard, you would argue that we are flirting with recession, and the Fed monetary policy may be the only thing which has prevented this thus far. The big picture, what is your prognosis for 2014 and 2015, and beyond?
Richard Duncan: Well, it’s interesting, it’s hard to jump directly into the prognosis without explaining how I get there. As you know, we’ve spoken now many times in the past, and I think you know my views very clearly, but perhaps your audience does not. I believe that credit growth has been driving economic growth, now going back, really, to the 1960s. Total credit in the U.S. first went through 1 trillion dollars in 1964, and now, it’s 58 trillion, so in less than 50 years we’ve had a 58-fold expansion of credit.
And the credit growth has been driving the economic growth, but in 2008 the credit couldn’t expand anymore because the private sector couldn’t repay its debts, and at that point, credit starting contracting, and the government had to jump in with both unprecedented amounts of fiscal stimulus, and also monetary stimulus, trillion-dollar budget deficits, topped off with quantitative easing has now increased the Fed’s balance sheet by 3 trillion dollars.
So my view is, we have been on government life support since this crisis started, and it’s really been the Fed, in particular, over the last year, that has been driving this economy forward through quantitative easing. In 2013 the Fed has created roughly 1 trillion dollars of fiat money, and pumped it into the economy, and that has pushed up asset prices. For instance, household sector net worth has increased by 21 trillion dollars from its post crisis low. That is a 40% increase in total household sector net worth, because stock prices have gone up and property prices have gone up, and that increase in household net worth, which, by the way, is 12% above its previous peak. It’s now 77 trillion dollars. That increase in wealth has been the thing that has kept the economy from sliding back into a severe recession.
And so that’s where we are. That’s the starting point. And we still have 85 billion dollars of quantitative easing month after month. And so long as that lasts, that is going to continue to push up asset prices, but we are now on the verge of a Fed taper. Because, while the Fed is still concerned about the economy being too weak, they are also concerned about the development of a stock market bubble.
So the Fed needs the stock market to go up, and the property market to go up, in order to create this wealth effect, because nothing else is driving the economy. However, they don’t want the stock market to go up 50% a year, because if it does, it will create a new bubble, and the bubble will pop, and that will lead to a new systemic banking sector crisis.
So, there is now so much excess liquidity that they are going to have to begin to taper. This is going to be very challenging, because the stock market is driven by the liquidity, and without the liquidity, there will be a very significant correction in the stock market. So I think they will start to taper soon, and that is going to upset the stock market in the U.S. and around the world, but I don’t think that they are going to taper so much that stock prices cease to increase.
I still expect the stock market to go up some another, let’s say, somewhere between 10% and 15% in 2014, and I expect the property market also to go up maybe roughly 7-10%, and that increase in property prices and stock prices will be enough to continue driving up household sector net worth, that will continue to create a wealth effect that will allow the people in the U.S. who actually own assets to be able to spend more money, and that will drive the economy so the economy will keep growing. But it is going to be tricky for them.
David: Before we move past the nature of the growth in question, it is important, I think, to note that it was labor growth and growth in income that were the models of growth in a previous era, and as you point out, now it is credit expansion which has a different quality to it, and again, we don’t have labor growth today, we don’t have income growth today, we are dependent on added leverage in the system in order to drive what you have just described as asset appreciation, net worth expansion, and a wealth effect that spills back into the consumptive habits of at least the upper echelon in society, and hopefully, a larger middle class, but the driver of economic growth has changed in quality from labor in income, now to simply credit expansion. Correct?
Richard: Yes, that’s right. We don’t have the same population growth rates that we used to have in the 1960s and the 1970s. Then the labor participation rate, the number of people in the work force, in other words, grew quite sharply during the decades of the 1960s and the 1970s, as more and more women entered the work force.
But now that trend has completely played out and the labor participation rate, the number of people in the population who are actually looking for jobs, is now back to where – it has fallen very sharply throughout this severe recession, and it is now back to where it was in the 1970s. So we don’t have an increase in the number of people in the work force, and we don’t have wage growth. Median income is still dropping every year, not only because of the severe recession, but because globalization is pushing down wages in the U.S.
So one of three things is needed to have economic growth. Either the work force needs to grow, or wages have to increase, or credit has to expand, and in fact, none of those things is occurring now, on a sufficient enough scale to make the economy grow. And that’s why quantitative easing has been required to push up asset prices and create this wealth effect that drives the economy.
David: You have a target for credit growth which you say is necessary to avoid recession. If credit growth is less than 2% adjusted for inflation, recession is the consequence, and there are at least nine instances of this between 1952 and 2007 where credit growth was less than 2%, net of inflation, and we did, in fact, end up in recession. That’s what we are flirting with here, and it’s becoming a difficult task to increase credit off of such a high base. You mentioned 57 trillion dollars as our total credit. Maybe you can talk about total credit growth, and what would be needed to avoid recession in the years ahead.
Richard: Yes, that’s right. As you said, going back to 1952 there have only been nine times when credit, adjusted for inflation, grew by less than 2%, and every time that happened there was a recession. And the recession did not end until we had another very big surge of credit expansion. So now, after 2008, we don’t have 2% credit growth.
At this point, after the most recent quarterly numbers, we’re up to 58 trillion dollars of total credit, or total debt, in the U.S. In order for that to grow, let’s say the inflation rate is 2%, so to adjust for inflation that means total credit needs to grow by 4%. On a base of 58 trillion dollars that means that credit has to grow by at least 2.3 trillion dollars to hit that 2% threshold, just to stay out of recession. Any growth on top of that, of course, needs even further credit expansion, and it is very hard to get that kind of credit growth on such a large base.
The U.S. government has been the big driver since the crisis started, with its trillion-dollar annual budget deficits, but this year the budget deficit came down quite sharply. It was only, let’s say, 700 billion, whereas the year before it had been 1.1 trillion. So the government is borrowing 400 billion dollars less this year and the other sectors of the economy are not increasing their borrowing enough to allow us to get to that 2.3 trillion dollar level of credit growth that we need to make credit growth drive economic growth. And so that’s why the Fed has been topping us up with fiat money creation that they pump into the economy to create a wealth effect.
David: There is an interesting relationship between our trade deficit and our ability to see either liquidity sufficient to drive asset prices, or as you would describe it, excess liquidity, starting at about 1996 our current account deficit started driving asset prices, and that is an interesting relationship, surplus dollars coming back and either financing our budget deficit, or if our budget deficit decreases, as you just mentioned, then there being an excess amount of liquidity coming back into the U.S. economy, an overage, if you will, beyond what is needed for treasury financing, that spills into, as it were, other assets and drives those asset prices. This contributed to what you call excess liquidity in the system. Maybe you can talk about excess liquidity, and whether or not you see it coming from our trade deficit in the future?
Richard: That’s very interesting. We’ve been talking about credit up until now, and I believe the economy works very differently than it did in the old days. Now, it’s credit growth that drives economic growth, but it’s liquidity that drives asset prices. And the way I define liquidity is that liquidity is fiat money created by central banks. That pumps liquidity into the system, and what takes liquidity out of the system? The government’s budget deficit. When the government borrows to finance its budget deficit, that sucks liquidity out of the system.
So what we want to know is whether the amount of liquidity going into the system is greater than the amount of liquidity the government is sucking out of the system through its budget deficits. So, there are two main sources of liquidity. The most obvious one is quantitative easing. But that has only started very recently. There was a second source of liquidity, in other words, fiat money created by central banks, which is fiat money being created by central banks, not in the U.S., but outside the U.S., in those countries with trade surpluses with the United States.
Now, you can see how much liquidity is being created this way because it is reflected in the central banks’ foreign exchange reserves. Let me give you China as an example. China now has 3.7 trillion dollars of foreign exchange reserves. How did they accumulate these? The reason China’s central bank has 3.7 trillion dollars is because they created their own money from thin air, more or less the way the Fed is doing now. They created the Chinese yuan from thin air, and they bought all of the dollars coming into the China as a result of China’s trade surplus with the U.S.
And they did that to manipulate their currency, to depress the value of the Chinese currency so that they could continue having export-led growth. But in the process, they accumulated 3.7 trillion dollars, and once they accumulate these dollars, then they need to reinvest them in U.S. dollar assets, and so they pump these dollars into the U.S., so that’s liquidity coming into the U.S.
Now, another way of looking at this is, every country’s balance of payments has to balance, so the U.S. current account deficit peaked in 2006 at 800 billion dollars, so that drew off 800 billion dollars in the global economy. That money was accumulated by foreign central banks and they pumped it back into the U.S. and invested it in treasury bonds, Fannie Mae and Freddie Mac bonds, corporate bonds, and stocks.
So because every country’s balance of payments has to balance, when the U.S., let’s say, has an 800 billion dollar current account deficit, it has 800 billion dollars of capital inflows that go into the U.S. into some sort of investment in, preferably, treasury bonds. So, in other words, one measure of liquidity coming into the U.S. is the size of the U.S. current account deficit.
This year, U.S. current account deficit is going to be about 400 billion dollars, so 400 billion dollars are going to be thrown off into the global economy, they will be accumulated by foreign central banks led by the People’s Bank of China, the PBOC, and then reinvested into the U.S. That will represent 400 billion dollars of liquidity coming into the economy this year.
And on top of that, you have the Fed, which has created 1 trillion dollars of liquidity through quantitative easing, so 400 billion, plus 1 trillion, that’s the two kinds of liquidity creation, that’s 1.4 trillion dollars of liquidity, and compare that now to the budget deficit, which this year will only be under 700 billion. So in other words, there is 700 billion excess liquidity. We have 1.4 trillion dollars of liquidity, the government is taking half of that, leaving 700 billion dollars of liquidity that has to go into other assets, like bonds, pushing up the price of bonds and driving down their yields, but also into stocks, and into property. And that’s why the stock market is up 25% this year, and that’s why home prices are up 13% year-on-year. We have a massive amount of excess liquidity.
Compare quantitative easing, which is a trillion dollars a years to the size of the budget deficit this year, 700 billion. Quantitative easing alone is far more than is required to finance the entire budget deficit, so you have an extra 300 billion on top that is pouring into other assets and pushing up their price, so I call this the liquidity gauge. It is very important to monitor the level of liquidity being pumped into the economy relative to the amount of liquidity that the government is sucking out through its budget deficit. When there is excess liquidity, then you can be pretty certain that asset prices are going to be inflating and when there is a liquidity drought, or insufficient liquidity, then the chances are high that the asset prices will deflate.
David: Let me just restate this and make sure that we are on the same page. If the trade deficit shrinks, we’re talking about the recycling of trade deficit dollars as a part of the total liquidity picture, with QE being the, perhaps, easier to understand, Fed fiat money printing carte blanch. The second point, or the first, if you will, the trade deficit shrinks, as the system is currently geared, there are less surplus dollars from our trade partners that are recycled into treasuries, and if the budget deficit, again, were to shrink, less foreign surplus dollars are recycled, or needed, for the financing of our budget deficit, and therefore you have excess dollars driving other asset prices instead.
On the other hand, if our budget deficit grows, it drains liquidity from the system, requiring more of those surplus dollars to be recycled back into treasuries. That is less dollars going into other assets classes, less asset price appreciation. Quick question: What are the conditions under which our trade partners do something else with their surplus dollars, rather than put them into treasuries, or U.S. dollar assets.
Richard: China is our main creditor now, and this year, the U.S. will have a trade deficit with China of something like 330 billion dollars. In other words, China’s surplus with the U.S. will be roughly 330 billion dollars this year. And that means China will accumulate 330 billion dollars in the central bank that they will use to buy U.S. dollar assets.
Now, your question is, will they do something else, what if they do something else? Well, there is nothing else that they can do, because the reason that China accumulates these dollars is because it has a trade surplus with the U.S. It wants to have a trade surplus with the U.S. because it needs to employ all of its workers in the Chinese factories that make things to sell to the Americans.
So what comes first? The trade surplus comes first. Do they want to not have a trade surplus? No. They must have a trade surplus to make their economy grow. And by the way, it’s becoming increasingly difficult to make the Chinese economy grow. China’s economy is verging on crisis now. So they will continue to accumulate these dollars, and once they accumulate the dollars, if they want to earn any interest on them, they must invest them in U.S. dollar assets, like treasury bonds.
Now, you may be thinking, well they don’t have to, they could buy some euros, or yen. Well, they could buy a few, but whoever they bought the euros from, those people would then have U.S. dollars, and they would have to invest those U.S. dollars into U.S. dollar assets. So when the U.S. has a trade deficit, that trade deficit throws off dollars into the global economy, and whoever accumulates the dollars has to reinvest those dollars into U.S. dollar assets.
David: So you could argue that a lot of the chaos that we had in 2008 and really what transmitted a recession here in the United States and a financial crisis here in the United States globally, was a diminishment in our trade deficit, which represented something of a catastrophic impact in terms of trade surplus dollars with all of our trade partners. We instantly transmitted the crisis via our trade deficit.
Richard: That’s right. We had a very significant correction in our current account deficit. The current account deficit peaked at 800 billion dollars in 2006. It looks like this year it is going to be roughly 400 billion, so it has corrected by half. In the past, as long as the U.S. current account deficit became larger and larger every year, that drove the global economy. But as soon as it corrected, with the economic crisis in the U.S., then the whole world went into shock and there was a severe global recession. But they responded aggressively with their own policy.
For example, in China, the Chinese government allowed the Chinese banks to expand their lending at just an astonishing pace. Since the crisis started, total Chinese bank loans have increased by 135%, just since the end of 2008. So imagine what would happen to any other country if their total bank loans grew by 135% in just a few years. You would have an incredible economic boom. Property prices would triple or quadruple, everybody would have a job, wages would go up, but then the problem would come if two or three years later, when no one would be able to repay those loans, and it would lead to a systemic banking crisis, and that is what China is now confronting.
So they have responded with this very aggressive stimulus package of their own, driven by, primarily, the expansion of bank credit, but now that policy tool is running out of steam, and you can see that China’s economy is beginning to falter. As far as all the other BRICs go, essentially, they are all basically in recession. I think the U.S. economy is going to grow faster than Brazil, Russia, and India. Well, India will be a little higher, but the BRICs are all suffering.
So this idea of decoupling from the U.S. economy is, and always has been, a myth. The U.S. current account deficit has been the driver of global economic growth and the thing that drove that was the expansion of credit in the U.S. and now credit is not expanding enough to drive the U.S. economy, so the U.S. current account deficits corrected very sharply. World trade growth has come to a near standstill, and all of the super-charged BRICs are now teetering on the verge of severe slowdown or something much worse.
David: In addition, there is some discussion about the energy boom here in the United States. Perhaps this is short-lived, perhaps it is truly an energy revolution, we will have to see in terms of the resources and the reserves which are being tapped into. But over the next several years, at a minimum, this will further reduce our trade deficit, and again, if the trade deficit is driving surplus dollars that ultimately get recycled back into the U.S., and end up being the driver of global growth, we have considerable challenge between now and, let’s say, 2016 or 2017.
Richard: Yes, it’s the shale oil revolution that is really something quite amazing. David, as you know, I wrote my first book ten years ago, The Dollar Crisis. The theme of that book was that the U.S. trade deficit was destabilizing the global economy and would ultimately lead to a severe global crisis. But at that point ten years ago I could not have imagined that the U.S. would be producing more oil than Saudi Arabia by, what are they saying now, 2016?
David: That’s correct.
Richard: It’s incredible. So not only will the U.S. need to import much less oil, but also, it will be able to export more petroleum-based products, and so this is having a tremendous impact on the U.S. current account deficit. It is going to make it smaller. And that is going to throw off fewer dollars into the global economy, and that’s going to lead to a more difficult global economic environment outside the U.S.
And as you have pointed out in your question, that will mean that fewer trade surplus dollars will be recycled back into the U.S., which means that there would be less upward pressure on asset prices as a result of these current account deficit dollars being recycled back into the U.S. But we have to compare the size of the current account deficit with the size of the budget deficit and the budget deficit also is becoming smaller. Last year it was 1.1 trillion, this year 680 billion, next year it looks like it will be about 500 billion, and the year after that it is supposed to be about 400 billion. So both of these deficits are becoming smaller.
David: And that is according to the Congressional Budget Office estimates, correct?
Richard: That’s right, adjusted for this most recent budget deal that was struck over the last week or so that will slightly increase the budget deficit for the next couple of years. Now, it’s important to compare these two, the budget deficit, and the current account deficit.
Let me use 2006 as an example, that was the peak year. In 2006 the U.S. current account deficit was 800 billion dollars. That drew off 800 billion dollars in the global economy. That was accumulated by foreign central banks, and they pumped that 800 billion dollars back into the U.S. They would have liked to have bought U.S. treasury bonds. But that year the budget deficit was only 200 billion dollars. That means that the U.S. government only sold 200 billion dollars in treasury bonds that year.
So the foreign central banks could have bought every one of those treasury bonds and still had another 600 billion dollars that they had to invest somewhere else into the economy, like Fannie Mae bonds and corporate bonds and stocks, and that’s what they did, and that’s why we had such an economic asset price boom during those years, and for 12 years in a row that was the case.
David: Or bubble.
Richard: The current account deficit was bigger than the budget deficit for 12 years in a row from 1996 up through 2008, and so the current account dollars were not only large enough to finance the entire budget deficit, but they also went into other assets and created the bubble, but it ultimately blew up in 2008, and when that bubble finally blew up, then everything changed in 2009. The current account deficit became much smaller, it dropped to 400 billion dollars in 2009, but the budget deficit tripled to 1.4 trillion.
So suddenly there was a trillion-dollar funding gap, or a trillion-dollar liquidity drain, as I would say using my liquidity gauge, in 2009, and that is when quantitative easing started. That is when they started creating fiat money to fill that gap. Otherwise, it would not have been possible to finance a 1.4 trillion dollar budget deficit at very low interest rates, as they have been able to do. They had to monetize that debt through creating a new source of liquidity, quantitative easing, and that’s what they have been doing ever since.
David: 2013 represents a record amount of total liquidity, that is, the current account deficit as we have been discussing, plus the quantitative easing to the tune of 1 trillion, or just over 1 trillion dollars on an annualized basis. Perhaps this is why some Fed officials are concerned. Asset prices are bubbling in response, so if they are overshooting their liquidity needs and a reduction is in order, on what scale is a reduction in order? Taper, short-term, of 5-20 billion per month? Reducing it to somewhere between 500 billion and 900 billion a year? And for how many years to come?
Richard: This is all one big experiment, and no one knows for sure. They will have to play around with the size of fiat money that they create every year. They want to continue to have excess liquidity, because they need excess liquidity to push up the stock market and the property prices in order to drive the economy, but they don’t want to have so much excess liquidity that it creates a horrific bubble in stock prices and property prices that is unstable and blows up two years from now.
So they are going to experiment, and this is going to be tricky. They have far too much liquidity now, far too much excess liquidity, so they will begin reining it in. But the stock market is going to take a big hit when they do, and that means they are going to be very cautious about how quickly they taper, or the amount that they taper.
I think they are going to continue to create somewhere between half a trillion and a trillion dollars of QE, fiat money, in 2014 and in 2015, in order to keep driving the economy. But it’s going to be very tricky, because not only do they risk frightening the stock market and creating a stock market selloff, but also, if they taper too much, then bond prices are going to go up, and that is going to damage the property market, and on top of that, it does look like quantitative easing is now beginning to generate some better economic growth numbers.
One or two months does not make a confirmed trend, but things are looking better in the economic growth numbers now, but not very impressive. It’s better, but it is still very weak, so if they taper significantly, things will turn weaker again, and of course, all of this is made even more dangerous by the fact that, despite all of this fiat money creation, all around the world we are flirting with global deflation. The Fed’s favorite measure of inflation, the core PCE price index, is up only 0.7% year-on-year. It has very, very rarely been lower than that during the last 60 years, and Japan is struggling against deflation. Europe, even now, seems to be flirting with deflation.
David: As you say, there has been an improvement in a number of these numbers, the unemployment figure came from 73, down to 7%, and it is worth still considering what a trillion dollars buys you. To get to that 7% number, basically for the jobs created this year it has cost us over $450,000 per job created. So again, perhaps in the Yellen-era Fed, between Yellen and Fisher and Dudley, they will find a more effective way of spending that $450,000, perhaps just handing it out on the street corners like Santa Claus, in terms of getting money into the economy. I’m not sure anything can be ruled out. As you mention, all of this is one big experiment.
A question for you on corporate sector cash hoards. If the government is, in essence, via the Fed, managing the economy, can we assume the corporate sector will just hold onto cash hoards the way it did in the command economy period of the 1940s?
Richard: I think we now need to look at our economy as a global economy and the amount of investing in the U.S. is much less than it was in the past, because now the corporations invest in China, and the many other countries with very low wages. But if you look on a global scale, now, really, because of China, we have massive excess capacity across almost every industry, because China has been growing its industrial production, on average, by something like 20% a year for the last 20 or 30 years, and 30 years ago that didn’t make very much difference because China’s economy was very small.
But now China’s economy is very large, and it is rapidly approaching 9 trillion dollars, and the U.S. economy is about 16 trillion. But that has required China to grow its investment in factories and all types of investment in the economy at such a rapid pace of investment growth that has been driving China’s economy, that they have excess capacity across absolutely every industry. And so, there is really very little reason for U.S. corporations to invest more money in the United States.
What are they going to do? Build a steel factory in the U.S.? I really don’t think so. But because China probably has three times as much steel capacity as the world needs, and they are still going to expand it by another 20% this year. So the issue is global excess capacity, driven primarily by China’s incredible desire to keep their economy growing by at least 7% a year, which looks like it is going to be absolutely impossible. And when it slows down, this will have very significant ramifications for everyone, most obviously for commodity producers, and we are already seeing the commodity prices, in most cases, commodity prices are now very weak.
And that is very surprising, given how much fiat money the Fed is creating, and on top of that, look at Japan. Relative to the size of Japan’s economy, the Japanese Central Bank is creating three times as much fiat money as the Fed is, relative to the size of the U.S. economy. The Fed is creating something like 6% of U.S. GDP a year. The Bank of Japan is creating something like 18% of Japan’s GDP and fiat money creation a year.
So this fiat money creation is desperately trying to keep the global credit bubble, the global economy, inflated, but they are not doing it. The credit is getting destroyed, as it gets destroyed the credit bubble wants to deflate, and so they are finding it increasingly difficult to stave off deflation now.
David: Which has required even more central bank money creation, fiat money printing, as it were. One thing also, you mentioned massive excess capacity. Here, in recent weeks, we had improved industrial production here in the United States, and that was heralded as yet another sign of recovery. If we are looking at things not just by country, but also including a global perspective, the global economy, if our industrial production numbers are improving, the problem is, that is in the context of already-existent excess capacity, which just argues for greater margin compression for corporations, and ultimately, a reduction in profits, requiring them to play the games we are all familiar with in order to keep earnings per shares improving, and the advertising flag out there that, yes, you should be buying shares in our company, going.
It seems in some regards like the credit system that we have, where growth is dependent on credit, and now that credit is dependent on this outside source, quantitative easing, it seems to me to be fairly frail. Yes, it’s one big experiment, but it’s one that, again, it seems just very frail.
Richard: Yes, it doesn’t seem that it is going to be able to work over the long run. At the end of the day, the thing that constrains this strategy is that people have to have enough income to pay the interest on the debt that they incur to buy the inflating asset prices, and median income is going down in the U.S. So there is one interesting ratio that I look at. If you compare the size of the household sector net worth, which is 77 trillion dollars now, with the size of disposable personal income, you can download this from the Fed’s flow of funds numbers, and it goes back decades.
The normal average between this net worth, or the wealth, relative to this disposable personal income, has traditionally, typically, been about 500%, in other words, five times higher than disposable income, wealth versus income. In 2007 at the peak, it got up all the way to 660%, in the year before that bubble popped. The prior bubble was in 2000, and the ratio then was 616%. Now, as of the third quarter, it is 615%. So this ratio is now as high as it was at the peak of the NASDAQ bubble, 615%. Now, it is not as high as it was at the peak of 2007, which was 660%, but it is not that far off, and ultimately, asset prices can only inflate so far before people simply do not have enough income to service the interest on the debt that they have taken out to buy these assets.
And so that is why this scheme can’t succeed, it seems to me, over the long run, because income is not going up, and the reason income is not going up is because globalization is driving it down. And so, while in one sense I think we can tip our hats to the Fed and the success that they have had in keeping us from collapsing into a new Great Depression thus far, by reflating our global economic bubble, there is no real exit strategy. We’ve had one bubble inflated after another. One bubble pops, they inflate a new one. That bubble pops, they inflate a new one. That’s better than collapsing into a Great Depression, but it’s really not a long-term solution to this crisis.
David: Median income figures, I think, are very compelling, and this is where, again, you look at the scale of not only individuals unable, ultimately, to expand their credit beyond the natural level, unsupportable by their income, but as a country, as well, we saw, this last year, the interest component, just as one particular example, on the national debt, with an increase in interest rates, the interest component was on the rise, and instead of the White House estimate of 256 billion, came in at 415 billion, an increase of 60%, and a significant adjustment.
In terms of total revenues, again, if you are looking at the national income of 2.6 to 2.7 trillion dollars, we went from 8-9% of revenues to closer to 15% of total revenues just for that one line item, and it really does bring into focus, whether it is the individual household income, or the national income, you can only add so much debt to the equation before the income is insufficient to keep up with interest payments.
So I guess the question is really time frames. Perhaps 2014 is a bit of a walk in the park, perhaps it is not, but as we look out on the horizon, 2015-2016, we are talking about not just a credit system centered on the U.S., which is in question and subject to significant or considerable decay, but we are talking about then the knock-on effects throughout the global economy, the BRICs, the emerging markets, your comment earlier that decoupling is a myth.
As and when U.S. credit begins to move in reverse instead of in the expansionary mode so necessary to avoid recession, but instead into a contractionary mode because income is insufficient to keep that game going, you really are talking about a global unwind. Again, maybe it’s a fool’s errand to say, “Is that a 2014 project? Is that a 2017 project? Is that a 2020 project?” How much time can be bought with fiat money?
Richard: Well, no one knows, but it is interesting, what we may see, and this is not a prediction, but something to think about, we may see interest rates going significantly lower, rather than going higher. Look at Japan. Japan has 250% government debt-to-GDP, and the yield on the ten-year government Japanese bond the last time I looked was 69 basis points. Now that is 2½ times, almost, as much government debt-to-GDP within the U.S. The U.S. has roughly a little bit over 100% government debt-to-GDP now. So there would be no way Japan could finance such a massive government debt if its interest rates were the level ours currently are, which already is very low by historical standards.
So we may see, in the United States, what Japan has experienced, higher levels of government debt, but lower levels on U.S. government bond yields, much lower levels, perhaps. And that would certainly come as a major surprise to almost everyone in the markets, but that may be the way things play out over the next decade or two, otherwise it just won’t be possible for this to work, as you pointed out.
David: Is there a scenario in which you can have ever-increasing levels of government debt and an increasing value to the currency, as well? Or would that be part and parcel, just as Japan has increased their levels of government debt and kept interest rates at a low level, the yen has not exactly been the strongest currency on the planet?
Richard: There are a lot of different factors that affect the currency, the level of the trade balance, as well as what the government is doing with this budget deficit, and competitiveness, so it is hard to say. It is hard to answer in a short reply to that question. But it also depends on what all the other countries are doing, as well, and if all the countries are equally terrible, then the currency rates could remain relatively stable despite how bad each of the individual countries looks individually.
David: And that’s a consequence of having an unanchored monetary system, correct?
Richard: That’s right. In part, that is why the currencies have been as stable as they have been relative to one another.
David: Because they all stink, and you can’t tell the difference between them (laughter).
Richard: That’s right. And, of course, now we are learning also because many of the banks have been manipulating the currencies in the FOREX markets, which should come as no surprise to anyone, given the size of the over-the-counter derivatives market, which is unregulated, and completely lacking in transparency. So what we are seeing now is that there has been manipulation of interest rates, through LIBOR, apparently there has been manipulation of foreign exchange rates in the same manner, so I don’t think people should be surprised if the next revelation is that there has also been manipulation of commodity prices through the derivatives market.
The over-the-counter derivatives market is now maybe 650 trillion dollars, which is almost $100,000 per person on earth. It is completely lacking in regulation and transparency. So, of course, people are going to be manipulating all of the asset prices they can through the unregulated market. That’s another thing about oil. We now have U.S. oil production exploding, but U.S. oil demand is declining because of improving automobile mileage efficiency standards and improving technology in the cars, and now we have Iran probably coming back into the global economy with this oil production, and Iraq has the second-largest oil reserves in the world after Saudi Arabia. They will be coming on-stream.
So why is the oil price still $100 a barrel, or $110 dollars a barrel? Well, we may find out in the not-too-distant future, that it has something to do with the derivatives market. Maybe not, but if they are doing it with interest rates and foreign exchange, I’ll bet they are doing it with everything. And if they actually put these derivatives through exchanges, then that could bring about a very significant shock to many of these commodity prices, because then we will be able to see who is involved in these trades, and what they are doing, more clearly. And that could reveal a great deal of manipulation and fraud, I suspect.
David: Richard, we look forward to the release of another book. The Dollar Crisis was very prescient, and addressed some core issues. Subsequently, of course, you have published, and now with MacroWatch on a quarterly basis, having access to some of your chart work and fundamental analysis, as well, I think is an invaluable offering to our clients, and we look forward to not only keeping in touch with you directly, but also introducing our clients to you more intimately through MacroWatch.
We appreciate your work, and look forward to seeing you, whether it is back here in the United States, or somewhere in Asia.
Richard: David, thank you very much. If I could say one word about MacroWatch, I believe in this new age of fiat money, that credit growth drives economic growth, and liquidity determines the direction of asset prices, and the government attempts to control both credit and liquidity, to ensure that the economy continues to grow. So in MacroWatch, it analyses trends in credit growth, liquidity, and government policy, in order to anticipate their impact on asset prices and economic growth. So that’s what MacroWatch is all about.
David: Wonderful. And you’ve made that available to our clients and listeners, and we do appreciate that.
Well, Richard, we wish you well, and look forward to a new conversation in the new year.
Richard: Thank you, David, great talking with you.
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Kevin: David, over the last several weeks you have been talking about Tobin’s Q, which is one of the measures of how overvalued something can be, or undervalued. You’ve been talking about the Shiller PE and you’ve brought up the fact that each of those indexes right now are at the same levels, or close to the same levels, that we have had before we have had major crashes in the past, 1929, 1999, but the wealth versus income index, that’s interesting. He talked about how we are at 615% of household wealth versus income and in the past, that has been pre-crash level.
David: And that doesn’t mean that it can’t be pushed higher. 2007 levels were marginally higher, less than 5-10% higher than those numbers. You are on the cusp, and that is, I think, what we need to appreciate.
Also, from Andrew Smithers’ interview, maybe you remember him saying, I’d rather look like an idiot now than an idiot in two years. We were asking him, “What does your family think of your advice today?” He said, “Well, my family has been listening to this for a long time. I’m in cash, and maybe it’s an embarrassing position to be in, but I wouldn’t want to be in the stock market today. I’d rather look like an idiot now than an idiot in two years.”
That really is the issue. Can we hold this game together with bailing wire and chewing gum a bit longer? There is this internal frailty to growth dependent on credit, and we are testing the outer bounds of something that not only is an experimental growth model, but now an experimental patch for an experimental growth model via the Fed.
So, fascinating times to live in, in our opinion, a vital time to be focused on insurance in case these grand experiments, both in terms of the new growth model, and the patch to keep that new growth model going, just in case they don’t turn out as rosy as everyone hopes.
