by Peter Coyne, Daily Reckoning
“If this 50-year, $59 trillion credit bubble were to pop now, most likely, civilization as we know it wouldn’t survive.”
Such a strong claim turned our head. The scene: Last year, in the lobby bar of the Grand Hyatt Hotel in Melbourne, Australia. There we met author, economist and publisher Richard Duncan. We were both attending the World War D investment conference .
Over drinks, he made his point to us in no unclear terms. Without credit growth, society might fall apart. More uncomfortable than his proclamation was how much sense Richard seems to make, even though some of what he says goes against everything that sounds right. You’ll see what we mean over the next few days…
The next morning, he delivered his conference speech titled How Capitalism Died and Where That Leaves Us.
If the bubble were to pop, he told the room:
“most of the world’s banks would fail. That would destroy most of the world’s savings. The economy will implode. Globalization would collapse. The developed world could no longer afford welfare, so goodbye to Social Security or Medicare. The U.S. couldn’t maintain its global military dominance with its ring of bases around the world. China’s economy would absolutely implode. There would be widespread starvation, chaos and probably war.”
People shifted in their seats. I remember one rumpled looking Aussie shuffle out of the room afterward. He looked right at me and said, “Sheesh… well, now I’m depressed!”
Heh. Since then, we’ve kept in regular contact with Mr. Duncan. This past Monday, we had a long conversation with him encompassing everything from his perspective on how capitalism has died… to why we have “creditism” today… to where the U.S. financial markets stand now that QE3 has ended… and much more.
We feature the first part of our discussion, below…
Peter Coyne: Welcome to The Daily Reckoning, Richard.
Could you explain what you mean by the “new depression”? That’s the title of your last book, The New Depression. What is it and how does it compare to something like the Great Depression.
Richard Duncan: I think that this New Depression as I call it originated for more or less exactly the same reasons as the Great Depression, and it evolved in the same way up until the policy response. Let me explain.
In my opinion, the Great Depression originated in World War I. In World War I, all of the European nations went to war. They didn’t have enough gold to fight the War.
They went off the classical gold standard and their governments started issuing tremendous amounts of government debt. At the same time their central banks started creating tremendous amounts of fiat money to finance the government debt.
That led to a worldwide credit bubble that we call the Roaring 20’s. They say the Roaring 20’s were fun, but in 1930, the credit couldn’t be repaid and at that point the international banking system collapsed, global trade collapsed, and policy makers really didn’t know what to do.
They believed in laissez-faire and market forces. They more or less stepped back and let market forces reestablish a market-determined equilibrium.
Unfortunately, that equilibrium was at a level of GDP that was 46% less than it had been in 1929 and at a level of unemployment between 15-25% all through the decade of the 1930’s.
During that decade, Germany turned fascist and took over Europe, Japan became militaristic and took over Asia, and then World War II started, and sixty million people died. The United States increased its spending by 900%, and that radical expansion of US government debt and spending finally ended the Depression.
The same pattern has occurred again this time.
It started in 1971 when the Bretton Woods system broke down. It was more or less a gold standard, and, afterwards, governments around the world started issuing more and more government debt and financing it with more fiat money creation.
This has been a five decade long global economic boom that we’ve really enjoyed all of our lives. But in 2008, that credit couldn’t be repaid, and the international banking system and global trade started to collapse.
Though this time, instead of letting market forces re-establish a market-determined equilibrium, the policy response has been to do everything possible to prevent market forces from re-establishing a market-determined equilibrium.
Policy makers are terrified that that equilibrium would once again be at a level of GDP that would be 40% or 50% lower than it was in 2006 with all of the implications that would involve for employment and geopolitical crises.
The policy response this time to prevent the New Depression has been to have trillion dollar budget deficits and trillions of dollars of fiat money creation to finance those deficits. And so far, as a result of that policy response, we have not collapsed into the New Depression we would have otherwise.
Peter Coyne: In our previous discussions, you’ve told me you think capitalism hasn’t existed for a long time and won’t exist in the future. Can you explain why you think that?
Richard Duncan: Capitalism was an economic system that existed during the 19th century. Let’s think about how that worked. The government played very little role in the economy. Up until 1930, the government spent something like 3% of GDP.
Back then, gold was money. The government had nothing to do with it. And at that point, here’s how capitalism created economic growth…
Businessmen would invest. Some of them would make a profit. They would save that profit or in other words, accumulate capital, hence “capitalism,” and repeat. Investment, saving, investment, saving. It was very slow and difficult, but that’s the way capitalism created economic growth.
The economic system we have now doesn’t resemble capitalism at all. Consider the government. The government now spends something like 21% or 22% of GDP. That means one out of every five dollars is spent by the government, and then there’s a multiplier effect on top of that.
The Fed creates the money from thin air and uses it to manipulate interest rates to push up asset prices and create economic growth. Well, that doesn’t resemble capitalism.
The growth dynamic has also changed completely. Rather than being driven by investment and saving, our growth dynamic over the last several decades has been driven by credit creation and consumption and more credit creation and more consumption.
This has created very rapid economic growth for decades now. I call this system “creditism” because it’s driven by credit creation rather than capital accumulation.
The problem is the system of creditism is on the verge of collapse because the private sector can’t bear anymore debt. The household sector started defaulting in 2008, and their income is not going up. So how can they bear anymore debt?
Peter Coyne: Maybe this is a good place to talk about the “wealth effect” the Fed’s trying to create…
Richard Duncan: What we have seen going back to World War II is that credit growth has been driving economic growth.
Going back to 1952, there were only nine times when total credit, adjusted for inflation, grew by less than 2% in the United States. And every time credit grew by less than 2%, there was a recession. The recession didn’t end until we had another very big surge of credit expansion.
Once the crisis started in 2008, credit hasn’t been growing by 2%, and the economy’s been weak. But it would have been far weaker had the Fed not intervened. The government, of course, has had trillion dollar budget deficits many years since then.
On top of the government debt that made credit grow the Fed financed that increase in government debt by printing money and buying government bonds through quantitative easing. That “QE” has resulted in pushing up asset prices.
The best measure perhaps of asset prices is called Household Sector Net Worth. That just means how much wealth the household sector – or people – has.
It’s now gone up by more than 81 trillion dollars. The reason net worth has gone up is because the Fed’s been printing money and buying financial assets with it and pushing them up, and that’s created wealth. This creates a so-called wealth effect that allows the Americans to keep spending even though their income is flat to dropping.
And so in this way, this system that we have has continued to generate economic growth. Going back, say, 250 years, let’s just call it capitalism to make it easy. Capitalism has completely transformed this planet.
Year after year, or at least decade after decade, there have been some hiccups along the way. This economic system has completely transformed our world. One way or the other capitalism has made profits grow, allowing capital to accumulate. And then it is reinvested, creating more profits and more capital and more profits and more capital.
For 250 years, this has grown and grown and grown. Now sometimes in order for this system to generate new profits, it’s been necessary to come up with new production techniques, such as the factory system in northern England and Scotland 250 years ago or the steam engine.
At other times, it’s been necessary to develop or find new markets as when England took over and colonized India. Other times, it’s been necessary to drive down wage rates by finding new sources of cheap labor.
We’ve done that in recent decades by outsourcing all of the manufacturing jobs to China where people will still work for ten dollars a day, and in the future to India, where several hundred million people would be happy to work for five dollars a day. The problem is that once we moved the production into cheap-labor countries, income stopped going up in the United States. And for capitalism to grow, effective demand must increase. All effective demand means is demand backed up by the ability to pay. You have to have an increase in income or an increase in some sort of ability to pay to generate profits and growth.
Well, when we moved all the factories to China, that destroyed the labor unions in this country and wages stopped going up. There was no growth in effective demand from increasing wages.
Instead, the system, capitalism, found a way to provide more and more credit to the public. And so, overall, the level of debt rose very sharply. Back until 1980, total of debt to GDP in this country was something like 150%. It then went all the way to 370%.
That expansion of debt provided the effective demand that allowed capitalism to continue to grow profits and accumulate capital. But then this phase I call creditism blew up in 2008, and at that point, this system demanded and received government support in the form of trillions of dollars of budget deficits, government borrowing, and spending.
That borrowing and spending was the next thing that generated economic profit growth and capital accumulation and it had to be topped off with quantitative easing to make it possible. And so that is how our system has created profits and capital accumulation over the last 250 years, and that’s where we are now, on government life support.
Peter Coyne: Where do you think demand growth will come from now?
Richard Duncan: Okay, so, now of course, the question is, is how will our economic system find the next source of effective demand growth? Where will the growth and effective demand come from next? Recently, the government’s budget deficit has actually coming down very rapidly.
That’s providing considerably less effective demand than it had in the last few years and at the same time, quantitative easing, the fiat money creation by the Fed has ended and has cut off a very crucial source of the growth and effective demand. So, where will the growth and effective demand come from?
How is our economic system going to be able to generate profit growth, roughly 3% a year that will allow capital to continue to accumulate?
Well, as I look around the world, it’s very uncertain where this growth could possibly come from. When you remove the two main sources of growth over the last 5 years, the budget deficits and quantitative easing, it’s much more likely that in fact when you remove those, the stock market will start to fall, property prices will start to fall, net worth will fall, therefore consumption will fall and we’ll move back into recession.
Then, I think the Fed will then be forced to come through with another very large round of quantitative easing, QE4, to provide the effective demand this economic system requires to grow and in fact survive.
Peter Coyne: The gold standard limited how much credit could be created. We don’t live in that world anymore, as you said. Could you explain how we got from there to here… and what the implications are?
Richard Duncan: I believe that the nature of our economic system changed in a very fundamental way when we broke the link between dollars and gold in 1968.
Up until 1968, there was a law that required the Federal Reserve to maintain at least 25% gold backing for every dollar that it issued. That wasn’t a problem after World War II because the U.S. had most of the world’s gold supply after the war.
But by 1968, we’d actually reached that point where the U.S. didn’t have enough gold to allow the Fed to continue issuing more dollars. It couldn’t back them up with 25% gold backing.
President Johnson asked Congress to change that law and the Congress did so in 1968. Afterwards there was no longer any requirement for the Fed to have any gold backing whatsoever.
We moved from a commodity backed gold standard, monetary system, to a pure Fiat, more paper monetary system.
This radically changed the way our economic system works in two important respects – first of all, in terms of international trade. Bretton Woods broke down a few years later in 1971 and under that arrangement, other countries had the right to take their dollars and convert them into U.S. gold.
By 1971, so many dollars had been sent overseas that they say they were four times as many dollars overseas as the U.S. had gold left to convert the dollars into. When Nixon finally closed the gold window the U.S. had no choice – we just didn’t have enough gold left to allow that conversion to occur.
That’s why I say 1968 and 1971 were the two crucial dates that took us from a gold standard to a paper money system.
Under a gold standard there was an automatic adjustment mechanism that insured the trade between countries balanced. Let me give you an example.
If England had a big trade deficit with France 150 years ago, England’s gold literally would have been put on a ship and sent over to France. Gold was money.
England’s money supply would have contracted sharply and this would have caused a very severe recession there. Unemployment would have gone up and there would’ve been deflation.
The opposite would have happened in France. The money supply would have expanded, credit would have expanded, the economy would have boomed and they would have had inflation. But pretty soon the rich French would start buying more cheap English goods and the poor, unemployed English, would stop buying so many expensive French goods and trade would come back into balance again.
That’s the way trade worked.
When Adam Smith and David Ricardo wrote all of classical economic theory, their world was a world in which gold was money and trade balanced. But it doesn’t work like that anymore.
Once Bretton Woods broke down in 1971, it didn’t take the United States very long to figure out that it could buy things from other countries and pay with paper dollars instead of gold.
So, starting in the early ’80s, the U.S. started running a very large trade deficit for the first time ever.
It grew to 3.5% of GDP by the mid-’80s. Most of that deficit was with Japan. Japan, meanwhile, had a very large trade surplus. Japan was like France in my earlier example, it wasn’t being paid in gold, it was being paid in dollars, but the dollars were almost as good as gold and they were exogenous to Japan’s economy and banking system.
As those trade surplus dollars went into Japan’s economy, Japan started to boom just as France had done in the example.
But the U.S. didn’t deflate like England because it wasn’t paying with a limited amount of gold reserves. It was paying with paper dollars or treasury bonds denominated in paper dollars and there was no limit as to how many of those the United States could create.
For that reason the U.S. trade deficit kept getting bigger, Japan’s trade surplus kept getting bigger and Japan’s economy kept booming and booming and booming. It boomed until they said that the gardens around the Imperial Palace in Tokyo were more valuable than all of California and then that bubble popped. The same thing has happened again and again as the U.S. trade deficit has become larger and larger.
The next round was during the mid-1990s, when all of the Asian crisis countries were blown into bubbles as a result of massive amounts of U.S. dollars entering their economies and into their banking systems.
It caused rapid deposit growth and rapid loan growth, the fuel that fired the boom and the bubble. I was living in Bangkok from 1990 until ’96 and I watched Thailand blow into a bubble. I had the opportunity to try to understand why this bubble was occurring.
It was because of all of the exogenous dollars coming into Thailand and blowing it into a bubble. When this bubble popped in 1997, it wasn’t just Thailand that blew up, it was South Korea, Malaysia and Indonesia as well.
The thing they all had in common, their foreign exchange reserves had gone up very sharply.
Peter Coyne: Can you explain what you mean by that?
Richard Duncan: When a country foreign exchange reserves go up, that means that more dollars are coming into their country than going out of their country. And so you could see that the same thing that happened in Thailand had happened in all of these other countries as well. So, it was at that point that I started focusing very much on countries foreign exchange reserves because that’s a very clear signal of when those countries are likely to bubble. That blew up in ’97 and after that the U.S. trade deficit, our current account deficit, became larger and larger and larger still until by 2006, U.S. current account deficit with 6% of U.S. GDP, it was 800 billion dollars that year alone or roughly 2 million dollars a minute, that the U.S. was going into debt to the rest of the world and paying for it with paper money. Now, this expansion of the U.S. trade deficit was the driver of global economic growth.
Clearly with the U.S. buying so much more from the rest of the world and the rest of the world was buying from the U.S., this was enormously beneficial to the rest of the world. The problem is, is that as I’ve just described, all the countries, but the trade surpluses, are all blown into bubbles.
Sooner or later, those bubbles pop because credit does create an artificial boom and the day always arrives when credit can’t expand any further. And when that day arrives, the depression begins.
That’s what we’ve seen again and again. By 2006, that was when the current account deficit peaked at $800 billion. By that point it was no longer just a single country or even a single region that had been blown into a bubble. It truly had become a global bubble with China being the most obvious example of a country that had been blown into a bubble that just hasn’t popped yet.
Adam Smith could not have conceived in a world where a country could have an $800 billion trade deficit and pay for it with paper money. So, in the trade aspect of everything changed because we broke the link between dollars and gold. That made this massive and destabilizing current account deficit possible and that deficit destabilized the world.
Peter Coyne: Thanks Richard. Tomorrow, we’ll return with part two of our conversation. We’ll pick up on that note… and talk some more about where we stand today.
But before we go, I want to make an important note. Richard, you’re the publisher of a great site called Macro Watch. It’s video newsletter for investors produced twice a month that looks at the impact of credit growth and government policy on financial markets. You’ve been gracious enough to extend a 50% discount over the next three days to Daily Reckoning readers who want to join. Simply click here and use the coupon code “daily” to get that discount.