The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: Dave, we’ve been talking about Greece, but now it’s Spain. The dominos seem to fall in line with what we are talking about. I can’t help but think that these guys, the Greeks, and now the Spanish, are using the fear of Europe falling apart to their advantage.
David: I think politicians are certainly prudent to do so. That is one of the cards that they can play, and they are playing it very well. When you look at catastrophes, you have this idea that they are somehow once in a blue moon, or like a 100-year flood, if you will. We have had 1995, we have had 1997, we have had 1998, we have had the year 2000, we have had 2001, and we have had 2008.
What we have seen happen in the last 30 years, really, since the end of the Bretton Woods period, the closing of the gold window, and the destabilization, the free-floating of all currencies, has been an increase in catastrophes of a financial and economic nature. Is it any surprise that there is a greater concentration of catastrophes in this particular era than in a period of time where currencies had been – had been, past tense – related to something more solid and reliable?
Kevin: You are talking about catastrophe, but the potential for catastrophe gets to be so large when you continue to throw bailout dollars or bailout euros, in this particular case. The New York Times just had an article that said there is brinkmanship going on, that Prime Minister Mariano Rajoy of Spain has delayed seeking outside help, to increase the fear of an economic disaster, a contagion, so to speak, so that they can get better terms than Greece did. These guys understand that the consequences are so great that it actually helps to make people fear the consequences to get better terms.
David: That harkens back to the movie, Dr. Strangelove and the doomsday machine. We have something similar with Europe. We have the core European banks which are at risk if the peripheral banks go away – Bankia, and the smaller banks relative to Deutsche Bank, etc. If banks based in the peripheral countries fail, there are ramifications into not only those domestic markets – Spain and Italy – but also into the larger banking community throughout Europe.
On the one hand, there is the idea of the threat of mutually assured destruction, and on the other, a very different kind of problem, more like Y2K, wherein it is an unbounded problem, there are variables that you can’t know, can’t control, can’t figure out. But there is the potential for contagion, as you just suggested, the potential for demise, the potential for a trigger in the derivatives market, not knowing what the outcome could be.
That uncertainly in the marketplace has people behaving as if we were, in fact, looking at the doomsday machine, and mutually assured destruction, where, as you have suggested many times, one has to have perfect information. We have anything but perfect information, and certainly not complete information.
Kevin: Talk about complete information, it was sort of a stunning text message between the prime minister and his finance minister. He was basically saying, “Look, it’s going to take 500 billion, not 150 billion, but it’s going to take 500 billion for us, and it’s going to take another 700 billion for Italy. So the numbers continue to grow.
You brought up mutually assured destruction. Most of us who are in our 40s, 50s, or 60s remember that that was actually a decision made by the Rand Corporation and the government to make everybody realize that this thing was just too horrible to contemplate, and what I am talking about is [Cold War era] nuclear mutually assured destruction. In this particular case in Europe we are talking about economic mutually assured destruction, but there is a point where somebody is going to say, “You know what? I don’t care. I’ve gotta default.” And when that happens, then we are going to really see what the cost of these bailouts is.
David: For today’s program we are going to look at two things. First, just a recap on Greece and Spain, and the issues particularly relevant right now in Europe. That will take about five minutes. And then the rest of our conversation will be a preview of coming attractions, both with some of the interviews that we have lined up for the rest of the month, but also our second thematic in this year’s DVD, which is Asian ascendance, and the implications for the U.S. dollar and bond market.
Before we go there, we obviously have Greece as the weakest link in Europe. They have the election on the 17th, which is this week, which will reinforce either the “we stay” or “we go” attitude there in Greece, and could potentially destabilize Europe further, or stabilize it. The Spanish bailout is certainly in the headlines after the weekend, 100 billion euros, which is about 125 billion dollars.
Kevin: That’s about one-fifth of what they are saying they really need.
David: Yes, the Royal Bank of Scotland, J.P. Morgan, Chase – there are estimates anywhere from 350 billion euros to 370-450 billion euros and that is what they believe will stabilize the banks.
Kevin: Is that predicated a lot on the real estate market finally stabilizing? But that is still falling in value.
David: That’s right. Coming up with a solid number – there is really no evidence that stabilization within the real estate market has occurred, implying that we may have lower prices in real estate there in Spain, and, on that basis, an even bigger hole on bank balance sheets.
This is a moving target. It’s not as if we know exactly what the problem is with Spanish banks. We know that they have, according to the New York Times last week, between 250 and 300 billion dollars in liabilities that are souring, and thus, the solvency of the institutions which hold those liabilities – that’s in play, that’s in question. But it is a moving target, not unlike what Bankia needed a few weeks ago when they needed 9 billion on Wednesday, and 19 billion on Friday.
Kevin: You had brought up in the past that this isn’t really just even a banking issue in Spain. There is also a municipal issue. There are 17 regions that also have a funding problem, I think, to the tune of around 45 billion euros.
David: That is the amount that they have to refinance this year, so we do have pressure on the banks, we do have pressure on the municipalities, let alone on the sovereign debt, and of course, we have seen rates come back down from closer to 7%, now closer to 6%.
This, to me, is a little bit like a scratch in the record, Kevin. Whether we are talking about Greece, Spain, Italy, Ireland, or Portugal, when you have a scratch in the record you can move away from it, but because of the cyclical nature of the record, you are going to return to that same point of pain again. The fact that we are not at 7% with Spanish yields or with Italian yields, I would just say, wait 60-90 days and let’s see, because it is going to take us about that amount of time to get back to the scratch.
Kevin: It’s robbing Peter to pay Paul, because consider that 22% of the bailout funds are coming from Italy, which is the next 700 billion euro problem.
David: Right, so what you are talking about is the EFSF bailout fund. The bailout fund is a commitment by a number of countries in Europe to pool assets or resources in the case of a demise, whether it’s a banking crisis, or an individual sovereign crisis that needs to be addressed. The problem is, the ones contributing are also the ones that have problems, so in the case of Italy, as you mentioned, they make a 22% contribution to that fund, and yet, if it is an Italian problem, how do they contribute to their own bailout? Spain is in the same place, of course.
Kevin: David, it is interesting, when Spain is loaning to Greece, and then later Italy is loaning to Spain, yet they are all bankrupt, it reminds me that you were talking about how it comes back around, but there has always been the problem of a perpetual motion machine. It always takes a little bit more energy than what it produces. We don’t have a perpetual motion machine, physics says that it can’t happen, and with this European situation, you can’t take a bankrupt country and have them loan money to another bankrupt country and then continue that around and have it last.
David: The physics of debt, like the perpetual motion machine, and not having enough energy to perpetuate it indefinitely, we have that. We have that now with this 100-billion-euro bailout. The debt-to-GDP ratio increases for Spain north of 145%. Again, this is not a gift, this is a loan, and after that loan is in place, their debt-to-GDP ratio skyrockets to 145%. They have already lost their credit rating, several notches last week, to Triple B…
Kevin: Which is junk. That’s a junk rating.
David: Two ratings above junk.
Kevin: Oh, well, okay. (laughter)
David: But on the slippery slope, so to say. Again, this is, to us, a replay of what we have already seen in Italy, a replay of what we have already seen in Ireland. Oh, by the way, speaking of Ireland, the 100-billion-euro bailout to the Spanish banks comes with very few strings attached, and not very much austerity. Within hours of its announcement over the weekend, Ireland was calling up and saying, “We want a better deal. We want a new deal. The old deal is too punitive. Why do the Spanish get a better deal than we did?”
Kevin: It’s like ants at a picnic. As soon as you drop a couple of crumbs, they are all there. (laughter) None of these countries can pay their debt, they know they can’t pay their debt, and they know that if they continue to keep Europe worried that they may go do something else, then they are going to continue to get more money.
Speaking of more money, are we going to see intervention? Central bank intervention has become sort of the norm. Everyone just sort of expects that next quantitative easing to come from somewhere. Are we going to see the political pressure applied so that we see more money pumped into the system?
David: We have argued for a long time that both the Fed and central banks around the world are not independent from the political system, but I think we are at an interesting inflection point. I would say, yes, we will see the Fed and the ECB intervene if, and it’s a big, qualified if, the catastrophe is severe enough that they are worried about the survivability of the financial system as we know it.
Kevin: Otherwise, we might wonder where they are, because we are seeing people on the financial TV saying, “Well, you know, Bernanke is going to give us something here soon,” but every time he doesn’t, it seems like there is a reaction in the market.
David: The issue is that we have both Mario Draghi and Ben Bernanke, respectively the presidents of the ECB and the Fed, and they are looking at politicians who are not implementing any fiscal reforms. They continue to pump money into the system, they continue through QE-I, QE-II, and Operation Twist, to accommodate, and accommodate, and accommodate, and yet, politicians are not doing their fair share of the heavy lifting in terms of fiscal reform. I think central bankers are beginning to look around and say, “Listen, if there is a question of survivability, we intend to survive, and we frankly don’t care if you get re-elected. So you either do the heavy lifting, or we are going to let this fall on your shoulders.”
I think we are seeing a line drawn in the sand. Yes, Draghi, and yes, Bernanke, will get very active, but if, and only if, the circumstances are severe enough to require it. Otherwise I think we are going to see a pretty significant decline in the equities markets as they are disappointed with Draghi’s inactivity, and Bernanke’s inactivity.
Again, in light of what? In light of the fact that the liquidity that has already been provided has done little to nothing to solve the employment issues, or to stimulate growth in the economy. As you look at those excess reserves at depository institutions now held at the Fed, and we mentioned this last week, this is liquidity which was intended to stimulate growth, and in fact, it just got redeposited with the Fed. What good did it do? There was sort of this circular nature, and it was ineffective, it was muted, it did nothing, not what it was intended to do in terms of stimulating growth in the economy.
Kevin: David, this is one of the reasons why the first segment of the DVD was about Europe, so that we could look at that issue, but actually, there probably is a larger issue. In fact, I know that it is a large issue than Europe. It’s our issue, but it’s actually how China factors into our issue. We, as Americans, have a tendency to think that we just sort of run the ship.
We have dominated economically for years, but that domination has come at a cost. It has come at the cost of great, great debt, and actually, what we have been consuming, and the reason we can have so many products is because we have been paying China, basically, for undervalued goods, and we have been borrowing money to do it. They turn right back around and loan us the money. It’s a circular motion. The second segment of the DVD, which you are going to be working on over the next few weeks, and going to China, is going to be about China, and why it matters.
David: I just want to quote Stephen Roach, because he stated this very simply. He said, “Don’t confuse prognosis with advocacy.” As we discussed for several weeks, the issues related to Asian ascendancy, and China, in particular, we are not building either a bear, or a bull case for investment in the region. We are looking for broader implications entailed in the changes that are afoot in that part of the world, and we want to discuss a point of view.
Again, not to endorse the point of view, but rather to fully appreciated the consequences of what is unfolding, and the ramifications into the U.S. debt market and the U.S. dollar market. For anyone who hasn’t seen the most recent segment of the DVD, we released it online and you can go to YouTube and view it, or view on our Web site.
The issues, primarily, concerning us today are the U.S. debt markets, and the dollar, and concerning us over the next 1 to 3 to 5 year periods. Asia centers prominently in these concerns for what are, at least to us, obvious reasons. We should look at a couple of those issues today, again, the dollar, and the U.S. treasury market stability, in anticipation of what the next 3-5 weeks will be in terms of the theoretical exploration, and then, as you mentioned, as I go to Beijing and Hong Kong and Singapore, for some boots-on-the-ground exploration of these same issues.
Kevin: Some of these changes that we are talking about are earth-shattering changes, because China has been our greatest customer for debt, we have been their greatest customer for goods, and it has been a symbiotic relationship. We interviewed Paul Craig Robertson and he said, “Guys, this is simple. We, basically, would run a 400-450 billion dollar deficit, and we would give China a 400-450 billion dollar surplus, and they would turn around and give us the money to run that deficit the next year.”
David: Again, that deficit the next year is a different deficit, because we’re running a trade deficit with them, and that trade deficit creates a trade surplus. It creates reserve currency assets in their pocket. The question is, how do they continue to be the leading source of manufactured goods in the world, a low-cost, competitive source of goods for the world’s consumers? It is by keeping a low currency value, and thus, they can’t take their extra cash, their spare change, and reinvest it into their own economy.
They did take those funds, and instead, put them into U.S. Treasuries, into Fannie Mae and Freddie Mac, mortgage-backed securities. They did so much for us over the last 10-20 years, particularly the last 10 years, recycling their trade surplus dollars, and funding our budget deficit! We’re spending too much as a country. We don’t have the revenue to support it, but that’s okay, as long as we have a creditor who is willing to give us money. Oh, by the way, that’s our own money, they are just giving it back to us, as a result of us spending too much money in the first place. It is a very interesting enmeshed relationship we have had with the Chinese.
Kevin: And that is changing. Our guest next week, David, you have been looking forward to talking to Pettis for a long, long time. Pettis writes about these things. He is not necessarily a bull or a bear on China, either, but it is a complex enough issue, and it does play into the U.S.’s ability to continue to function as a dollar-denominated currency, that we need to look at it.
David: First and foremost, the U.S. has benefited from the privileged position of world reserve currency since 1944 with the Bretton Woods agreement, all currencies related to U.S. dollar, and the dollar was, in turn, related to gold. Again, whether this is by muscle memory or by shrewd foreign policy, the U.S. dollar has continued to maintain its stature as the primary world reserve currency, even without that legitimizing relation to gold. On more than one occasion there has been a consideration given by OPEC and other trade partners as to the fairness of that arrangement, and also the privilege it affords our country. So the issue of reserve currency status is one of the issues we are going to pursue in the context of our Asian exploration.
Kevin: Let me ask you a question about that, though, now that we are talking about China. There is this conference right now that they have been having on the internationalization of the RMB, and so, are we going to see a Chinese currency, either as part of a basket of currencies, like Barry Eichengreen talked about, or are we going to see the renminbi at least turn into a currency that is internationally traded?
David: Kevin, this conference you are making mention of was at the University of California, San Diego, where the keynote speaker was Barry Eichengreen. There was quite a layout in terms of speakers, presentations, research that is being done. In one sense it is inevitable. In the other, it may not happen, because there is, as they say, “many a slip twixt the cup and the lip.”
We will have to see if the RMB can become one of the dominant currencies on the world scene. It is significant that they have become the second largest economy in the world. It is significant that they do a tremendous amount of trade regionally, that there is not a lot of transparency in their financial system. There are a number of reforms which will have to take place in their economy before the RMB, the renminbi, can be fully internationalized, and that is what is being discussed now. What are the steps that need to be taken, again, both economically and politically, for their currency to become more prominent in the world currency system?
Kevin: David, it is amazing to me, just in my adult life, watching China go from something of a communist country that was so backward in most Westerners’ opinions to, over the last 20 years, we are now talking about them possibly becoming a world power, possibly an internationally traded currency. Their poverty levels have dropped. The growth in the global economy has really benefited China, as well as everyone else.
David: Yes, both the developed world, and the developing world, have benefited from growth in the global economy. This is another critical element in the expansion of trade relations, which have blossomed in the context of the last 20th century, and certainly on an accelerated basis, following the collapse of communism and the fall of the Berlin wall.
Globalization has changed the face of the developing world, and it has introduced a new audience to modern conveniences and luxuries, which we take for granted here, and frankly, were never within reach in parts of the developing world, but they are now as a result of increased employment, consistent wages, and things of that nature.
Kevin: Look at the last three decades. The World Bank has said that the poverty rate has gone from 65% of the population in China to now about 10% today. The World Bank is also seeing this. They came out with a report that is just voluminous on the future of China. One of the things that you have to see in a country is the rise of the middle class, and you have to see a decline in poverty.
David: Certainly, on an apples-to-apples basis, 20-30 years ago our poverty rate was 14%. Lo and behold it is still about 14%, so we haven’t made a lot of progress in the United States, but we’re not comparing apples to apples with Chinese poverty. On a per capita basis, our poverty level is just under $6000 per person per year, and theirs is about a 15 times difference in terms of the threshold for poverty, underneath ours. We are in a much better place when all is said and done, but the progress is being made. We are talking about folks who once were on a dollar-per-day existence, and are now in the 3, 4, 5 dollars-per-day existence, as a result of mass migration from the agrarian economy to a more industrialized economy, focused with major cities on the coastal parts of China.
Kevin: And hasn’t manufacturing of all sorts migrated to the lowest cost areas around the world?
David: That’s absolutely critical. That’s what we would call a labor arbitrage, and it has allowed for the cost of production to drop dramatically for almost all consumer goods. We have had manufacturing of all sorts, which, as you just mentioned, has migrated to the lowest cost areas around the world, and even regionally, within those countries. So while that has cost American jobs, what it has also done, lest we just pick on the American jobs piece, is that is has significantly reduced the cost of goods, and to some degree, services, boosting the lifestyle for virtually all Americans.
Kevin: Just thinking about that, look at the cell phone, David. At one point, not too long ago, you knew a few people who had cell phones…
David: At least five people. (laughter) And it was as big as a briefcase.
Kevin: But now, it’s not uncommon for kids to have them. It’s an item that we would not have probably had in the kind of quantity that we have, for the price that we have, if it weren’t for this migration of jobs.
David: Yes, kids. Not 18-year-olds heading off to college, but kids – 10, 11, 12-year-olds, whose parents want to keep in touch with them, and want to know when Johnny is walking home from school and that sort of thing. Certainly, communication has improved, we like that, we are not being critical on that point. It’s just that this would not be possible if it wasn’t for this major labor arbitrage that has resulted from globalization.
Kevin: It not only causes prices to go down on new technology, but it actually hides inflation a little bit, David, because really, the cost of everything should be much, much lower to us if we weren’t printing money this whole time.
David: You’re right. The middle class across the developed – not the developing, but the developed – world has had the equivalent of a boost in income. Or as you mentioned, it has at least hidden the inflationary trends within the deflated pricing of imported goods. Imports, and lots of them, have fed the consumers’ penchant to have one of everything, or ten of everything!
Kevin: Look, you have an iPhone, and then you have an iPad, and then, of course, you have to have a tabletop Apple, just using Apple as one example.
David: How about the number of families that have five televisions throughout the home, because you want one in the living room, one in the kitchen, one in the bedroom? We have one, and frankly, that’s enough, but there are families that have 3, 5, and 10. Again, it’s not an issue of criticism on that point, it’s just that we have had consumer largesse on the basis of globalization, on the basis of the unit costs of labor going down, and thus, the unit costs of goods going down in lockstep, and that has actually been a huge subsidy for us in the West, in the developed world.
Kevin: David, just recapping, our largest trade partner has been a significant creditor, and we have gotten all these goods, but they have benefited as well, and turned right back around and loaned us the money. We went from a society that produced things to pretty much a materialistic consumer society.
David: It’s been a fascinating shift over a 30-year period, to watch this backwater country barely surviving its own system of beliefs, specifically, communism, actually on the verge of social and economic collapse, to watch them become America’s largest trade partner, and most significant creditor. This is where the irony is immense. We owe a large part of the modern capitalist “American Dream,” or at least the materialist consumer orgy of the last two decades, to the credit extended to us from a communist country – from a communist country!
Kevin: That’s pretty ironic.
David: Did we sell them, or did they sell us, the noose we hang ourselves with? This is a fascinating relationship, but it is this trade relationship that has been good for all of us, and has, at the same time, been out of balance for a long time.
Kevin: Just like a machine. You were talking about going circular, anytime you have something out of balance. A lot of people who are listening may still remember the old record players, where a record would go around and around, but if you put something out of balance on it, it would ultimately fly out of control.
David: It’s that balance you were talking about earlier of trade deficits – deficits where we import far more than we export, versus our trade partners who are running the reciprocal surpluses, and we can roughly get caught up via printing more dollars, or by issuing more I.O.U.’s in the forms of bills, notes, and bonds. It is about as close as we will ever get, as a country, to a free lunch, and it is on that basis that it has been criticized as the deficit without tears, and that goes back to the 1960s and Jacques Rouffe. That’s what he called it. Considering the massive surplus of currency reserves which have now been accumulated over the last 20-30 years by our trade partners, they have, in turn, developed their own fiscal and economic imbalances in their own countries.
Kevin: But let’s face it, David, the reason we have been able to do this is because ours has been the reserve currency of the world. It goes back to what you were mentioning earlier, the Bretton Woods system, which we have pretty much drifted away from. The Bretton Woods system was based on a gold standard, and like you said, muscle memory and the size of our reserve currency, have kept us in the front of the race.
But before we discuss the Asian economic imbalances, why don’t we go back and point out where we started, and why we are here?
David: The dollar is vulnerable to displacement as the singular reserve currency in the world. We made that point in this most recent DVD presentation, and we have previously discussed the euro. That does, in fact, remain a dollar alternative, and may emerge as stronger from the current crisis, following a reconstitution of membership. Certainly, it is doomed to failure if something doesn’t change in terms of the membership of the EU, but to the degree that the membership is switched, frankly, we may even see the re-emergence of the deutschmark. We will have to see.
Kevin: But if we didn’t see that happen, could we see an Asian currency do the same thing?
David: The RMB may also take a path toward being internationalized. That is what is being discussed. Eichengreen is certainly a proponent of that, as well as many people who view that as almost an inevitability. We have to have a multipolar currency world instead of a unipolar world focused on the U.S. dollar. As the world’s second largest economy, it is easy to see why the RMB, the renminbi, could be in that mix. It’s the journey toward that goal which is both a long, challenging one, and one that we are not sure will be successful.
We will look at this as close as we can, and certainly as critically as we can, with the guests that we have in the coming weeks, because the implications are grave – they are grave – for the average standard of living here in America. Whatever the merits may be for having a multiplicity of currencies to trade in, it will come at a high cost to the U.S. consumer.
Kevin: David, not just the imbalances in our model, which worries us, because we now realize we can’t just continue to borrow and spend into infinity, but that imbalance is now going to be showing up with China. These guys know that they are going to have to become internally consumptive, or not survive the way they have in the past.
David: The Chinese imbalance has fed the growth in the economy and this imbalance has allowed for a double-digit rate of growth in GDP for more than a decade.
Kevin: It’s been an explosion.
David: Yes, and only recently has this rate of growth slowed, and it has slowed because the success of China has been rooted in exporting goods to the rest of the world, with Western Europe and the U.S. being the two best customers for Chinese goods. Anyone in business knows that if you have concentrated your business around one primary customer, you also have a tremendous amount of embedded risk in your business plan.
Kevin: Sure, David. We’ve all known some salesman who has lost his largest account and literally just lost virtually all of his business.
David: As European and U.S. consumers have retrenched, the vulnerability of the Asian growth model has come fully into the light. You can only continue to grow if others continue to consume, and in the case of Americans, it was not merely consumerism, drawing from savings or current income, but consumer borrowing as well, for even more imported goods.
Kevin: Consumption on steroids, is what you are saying – when you can borrow and consume, borrow and consume, and there really is no consequence.
David: In reality, the best rate of growth in China was artificially high due to the credit bubble in the U.S. and European marketplaces, and the long and the short of it is that China has to rebalance. They are rebalancing away from being so export-dependent, and toward being more internally growth-generative. Domestic consumption in China – this is a growing priority.
We certainly saw this outlined in the 5-year plan put out by the politburo in the spring of this year. They like to do this. They like to say, like a good chess player, “I don’t want to know what the next move is, I want to know what the next 50 moves are, and let’s work backward. We know where we want to be five years from now. What do we need to do today to get there?” There is, again, “many a slip twixt the cup and the lip.” Can they accomplish what they need to?
If you recall our conversation with Stephen Roach about a year-and-a-half ago, it related to the success variables driving China toward this goal and why he believed that it would be achievable. His one concern, if you recall the conversation, was that it will take time that they don’t have, or that they are running out of.
Kevin: David, time is one thing, but the other thing, too, is to drive economics, politically, on a regular basis, which is the communist mindset. The communist mindset is to always go political first, and then you basically fashion the world the way you want it fashioned. The problem with this transition is that the politicians have purposely given an advantage to manufacturing firms and exporters, but they have suppressed the currency, and that, of course, has its effect on the public.
David: Not only suppressing the currency, but giving advantaged borrowing rates… Basically, when you control the banking system, when the government is the banking system, there is an unfair advantage given in a loan process. It depends if you are one of the select few who have been blessed from on high. If the politburo likes what you are doing, if you are a part of one of the seven select areas in the economy, you will have favorable terms given to you in terms of the borrowing and lending.
Kevin: But David, what does that do to household income and purchasing power of the normal person on the street?
David: Financial repression is always at the expense of households. In this case, a suppressed currency is at the expense of household incomes and purchasing power. The household in China has, for 20-30 years, suffered, so that industry could be built successfully. You could argue that households are more employed and more households have moved out of poverty as a result, but you have not seen a commensurate growth in household income along with growth in GDP.
Kevin: Anybody who is retired knows that they are feeling that here in America. We have talked about repression quite a bit, because when you keep rates artificially low, the average person cannot live on the interest of their savings.
David: No, and it turns out to be a subtle form of redistribution of capital, and as we are observing, it is not an American phenomenon, exclusively. It is not an Asian phenomenon, exclusively. It is actually quite common, because it is one of the more common ways to steal, without advertising it as such, or I guess you could say, increase taxes without advertising it as such, or with permission. Industry is now vulnerable to the unreliable buying habits of the American and European middle class.
Kevin: But David, even though those politicians have purposely given advantage to industry and manufacturing, that industry is vulnerable at this point, because the people who were buying from them up to this point were the Americans who could borrow money. We’re starting to work our way out of that, and they are having to try to figure out, with these people who had been repressed within their own borders, how they are going to get them to buy a microwave, and a washing machine, and a cell phone.
David: Yes, the vulnerability in the economy is that because industry has been so reliant on American and European middle classes and their purchasing habits, the Chinese now have to scramble to implement and rebalance their economy and reduce their export dependence, reduce government investment, and increase the household share of GDP. They have to increase their incomes, which, by the way, by gradually allowing the renminbi to appreciate, they are giving more and more advantage, on a gradual basis, to households, where one renminbi is buying more than it was a year ago, or two years ago, or three years ago. That is basically increasing the purchasing power of the average household, and empowering them to become more consumptive.
Kevin: I guess the fascinating thing to me is that politicians don’t like to give up power, and this manufacturing base is like a fascist system. A fascist system, really, is corporatism, as Mussolini said, and there are large corporations in China, and in America, and around the world, that have politically benefited from being the chosen ones. The politicians are also the chosen ones. When you are talking about building a base in China where the average man on the street now has consumptive power, you are going to have a power struggle from the top, because the money has to come from somewhere.
David: I think this is the fascinating contrast between the brilliant piece the world bank put out earlier this year, 200-300 pages of a detailed economic plan to be implemented by the politburo and by the new leadership later this year in China. The challenge is immense, as merely an economic problem to solve. But with a one-party system, politicians who have long benefited from the existing economic model, which, as we have described, is losing efficacy as we speak, they are hesitant to allow for change, at their expense, because they have been the ones able to wet their beaks in the system.
Kevin: I have to say, after knowing your dad for 25 years, and I have known you for 25 years, your family is suspicious of communist systems.
David: Well, it’s just this. As a family, we have reflected on one of the great challenges of communist utopian ideals. We’re all in it together, with some of us offering leadership, according to our ability, and in light of social needs. But, when the time comes, and it never seems to come, for power to be shared, for power to be collectivized, if you will, (laughter) who steps down? Those in power prefer to keep it. Thus, the most kind-hearted socialist or communist falls prey to the temptation of power.
It’s the recycling in a different environment of that old ring of Gyges from Plato’s Book II of The Republic, wherein you are given ultimate power, and once you have ultimate power, are you willing to cede it to the next? You are not. In fact, the abuse of power becomes more the norm.
The economic transitions are required – they are required – in China, and yet we have, potentially, political obstinacy toward making those changes. Will we see the changes necessary for China to remain on a growth path? Will they rebalance toward a sustainable growth path, or will they continue to buy time, and will the leadership try to enrich themselves at the expense of the people, knowing that they have an end game on the horizon?
Why is this important to us? Because it is the old economic model which is in question, which is now broken, which they cannot rely on any more. There are no more trade surplus dollars coming from Europe and the U.S., to the degree that they were, funding, ultimately, our budget deficits here in the United States.
The strange coincidence is that the 5-year plan which the Chinese have set out to accomplish, which includes moving away from being export-dependent, comes at a very inconvenient time, because over the next five years we have to roll over almost the entire stock of U.S. Treasuries, that is, refinance nearly all of U.S. Treasuries, and at the same time, meet current funding needs, that is, the deficits that will run this year, and next, and the year after, which spells extreme pressure for the U.S. dollar and the U.S. debt markets.
We are concerned about the U.S. dollar and the U.S. debt markets. This is where we live, this is where we raise our children. And isn’t it interesting that our ability to thrive and succeed in this environment is tied to our chief creditor, China?
Kevin: It is interesting, too; China has to be taking note, because even though they are still growing, they are slowing. We saw the first rate cut since 2008, so we are starting to see China try to stimulate its own economy from within.
David: And they are realizing that this old growth model is, in fact, past tense. We are seeing a slowdown in credit. Banks are falling woefully short of their loan targets for this year, so yes, People’s Bank of China has recently, last week, cut rates – the first rate cut since 2008 – 25 basis points. If you look at the Shanghai composite, it has failed to recover even half of its losses since 2008. There certainly are a number of canaries in the coal mine. In terms of a growth thematic for China, there is not the same growth thematic, because the macroeconomic picture, globally, has changed over the last three years, and they have to retool, at some high political cost, as well as economic cost.
Kevin: David, let’s put this back in terms of how this affects people right here in America. There are newsletter writers out there, there are commentators, financial planners, who have been very, very bullish about China over the last 4, 5, or 6 years, and so far, they are coming up short. This is something that we need to communicate to the people who are listening, that we are not pro, we are not against, something so complex, something so large, as this China issue, but we have to understand it before we start throwing money at it.
David: If they are successful, it will be one of the great growth stories of all time, and that hangs in the balance. Will they be successful in this major transition? Our concerns about the success of this retooling and rebalancing in China relate to what we know about how human beings respond to having power, and if they willing to give it up. It relates to what we see as both political and geopolitical realities. As they are developing now, and in the future, will they be able to make this economic transition? It is more than just economics that applies.
Kevin: David, someone that we could probably talk to and get more information in a short period of time on China than anyone is Michael Pettis and you will be talking to him next week.
David: We consult him on a regular basis, Professor of Finance at Guanghua school of Management, Peking University. He is also a part of the Carnegie Endowment for International Peace. He has some very thoughtful, thoughtful insights into the Chinese rebalancing options, and predicting what the next few years will hold for China. We will bring him into the conversation this next week.
Following a conversation with Michael Pettis, we will also invite Minxin Pei, who is a professor of government at Claremont McKenna College.
This goes beyond finance, it goes beyond economics, it goes beyond politics. There is a strange crossover amongst the issues that are in play in China, in Europe, and certainly, ultimately, this does have an impact for us here in the United States. If you are concerned about the status of the dollar, the stability of the dollar, and if you are concerned about pricing of bonds and the stability in both the bond and equity markets, you have to understand that Asia features very prominently in stability in these areas.
Our conversations with Minxin Pei, Michael Pettis, Stephen Roach, and others on this issue, and then of course, the research that we do on the ground in coming months, will be a part of our move toward the second installment of our DVD. If you haven’t watched the first, avail yourself of that opportunity, and the second will be available this fall as we explore China’s role in Asian ascendance, and its impact on the U.S. bond and dollar markets.
