by Peter Coyne, Daily Reckoning
Imagine our surprise when our biggest heckler emailed us last night to say,
“Yesterday’s Daily Reckoning was one of the best issues in years.”
We were concerned that if this particular reader was giving us thumbs up, it wasn’t a good sign… but then another reader named Mireille chimed in too, saying, “That was outstanding.”
If you missed it, we featured Part I of a conversation we had with our friend economist and author Richard Duncan.
His main point? Capitalism died long ago. Love it or hate it, he says, it doesn’t matter, that’s the way it is. Today, we have a system of creditism – wherein economic growth only follows credit growth. Put the Fed on a leash – God forbid, return to a gold standard – and the whole system comes crashing down. Scoff if you wish, Mr. Duncan is a deep thinker…
Added a third reader:
“The real tragedy is that true, laissez faire capitalism never lived in this country – the only country in the world where it could have found safe haven. Then again, the average man on the street is a socialist at heart. If you don’t believe me, watch his/her antics at election time. They will be gravitating to the loudmouth snake oil salesman who promises them the most for least effort.”
“There’s one thing that I see missing in this discussion,” observed yet a fourth reader.
“Where does the credit come from? I never see people like Mr. Duncan acknowledge that this credit or money is created out of thin air by the central bank of the United States, which is nothing more than a consortium of the private banks.”
“This would be a really interesting conversation if you brought in G. Edward Griffin of The Creature From Jekyll Island fame. Great information as always, guys!”
Muchas gracias. And we’ll add Griffin to the list of people to talk to in an upcoming reckoning. In the meantime, read on for Part II of my discussion with Richard Duncan.
We pick up where we left off yesterday. We’ll have Part III tomorrow, too, so be sure to read on. Each part builds on the previous one. After tomorrow, you should have an all-encompassing understanding of Richard’s point of view. From there, we’ll let you form your own opinion…
The dollars flowed into their economies and caused rapid deposit and credit growth along with an economic boom and then bust. Japan in the 80’s was one example. But those same trade deficits can affect the trade deficit countries, like the U.S., too, correct?
Richard Duncan: Yes, it’s also important to understand how these dollars that were thrown off into the global economy through the trade deficit actually boomeranged and came back into the United States and blew the U.S into an economic bubble as well. So let me discuss that now.
One way of thinking about this is every country’s balance of payments has to balance. In other words, when the United States has an $800 billion current account deficit as it did in 2006, it will also have $800 billion of capital inflow on what is called the capital and financial account. (The current account deficit is similar to the trade deficit.)
The way to think about this is that, just like a family, the books have to balance one way or the other. If a family spends more than it earns, then it either has to borrow money or it has to sell something so that in the end it balances. It’s the same with the United States.
When we buy $800 billion worth of goods, then we have to borrow $800 billion to pay for them or sell $800 billion worth of something to pay for them. The current account deficit is exactly equal to the inflow of money coming into the United States.
We think a lot in the United States about how much paper money the Federal Reserve is creating, but the Fed is by no means alone in creating massive amounts of paper money. In fact, what we’ve seen is that the trade surplus countries like Japan in the 70’s and 80’s and more recently China, their central banks have been printing even more money in total than the Fed has done. So here’s an example.
Let’s talk about China because China has, by far, the largest trade surplus now with the United States. Last year, China’s trade surplus with the United States was 330 billion dollars. What that means is that Chinese exporters sell their goods in the US. They’re paid in dollars.
They take these dollars back to China, and they want to convert them into the local currency, the Chinese Yuan. But if they bought up $330 billion of Chinese Yuan, of course, the Yuan would appreciate very sharply. That would kill China’s export-led growth, their economy would stop growing and it would probably collapse.
To prevent that from happening, the central bank in China, the People’s Bank of China, the PBOC prints Yuan from thin air, just like the Fed does. Then it buys the $330 billion that came into China last year.
Whoever brings the money in gets to convert their money into Chinese Yuan, and they can do anything they want with it. But that money will sooner or later end up in the banking system in China. That will cause rapid deposit growth, and that will force rapid loan growth, and that will create the economic boom that turns into the bubble that turns into the depression.
The point here is the central bank ended up with an extra $330 billion US dollars last year by printing $330 billion dollars’ worth of Yuan. Now once they have this $330 billion US dollars they have a few choices. What are they going to do with it?
They could burn it… they could bury it under the Great Wall… or they could buy US dollar denominated assets with it.
It doesn’t do them any good to keep it in paper money. So, they want to buy US dollar denominated assets of one kind or the other. Being a central bank, they tend to be conservative. So they would really like to buy US government bonds because they’re considered to be the safest. The problem is that they’re not always enough US government bonds to go around.
Let’s think about 2006. That year, as I’ve said, the US current economy deficit was $800 billion dollars. Now that threw off $800 billion into the global economy, and those dollars were almost all accumulated by foreign central banks in the surplus countries in the manner I’ve just explained, through fiat money creation of their own. And they then wanted to reinvest the $800 billion into, preferably, US government bonds. But in 2006 the government’s budget deficit was only $200 billion, meaning the government only sold $200 billion of new bonds that year.
That means the foreign central banks could have bought every new Treasury bond that our government sold that year, and they still had another $600 billion that they had to invest somewhere else into US dollar denominated assets. Somewhere else like in Fannie and Freddie bonds or corporate bonds or stocks or bank deposits.
My point is, as long as our trade deficit is bigger than our government’s budget deficit, the trade deficit actually finances the budget deficit at very low interest rates, and the gap between the two, this extra money, has to go somewhere else.
That extra money coming into the country is what blew the US into a bubble, and this went on for 13 years in a row, starting in 1996.
Peter Coyne: Can you explain what happened then?
Richard Duncan: Starting then, the trade deficit was bigger than the budget deficit, and it went on for 13 years until 2009. That gap between the trade deficit and the budget deficit, all that money made it very easy, for instance, for Fannie Mae and Freddie Mac to sell trillions of dollars worth of bonds, in exchange for which they obtained cash which they then used to buy trillions of dollars of mortgages. That pushed up the property market and created the asset price property bubble here.
This is how the US trade deficit boomerangs back and blows the US into a bubble. The money coming in to the United States has often been called, by Ben Bernanke in particular, a “global savings glut”. But this isn’t piggy bank type savings. This was not money that was sitting around just in someone’s backyard or their bank account.
This was newly created paper money, money created by central banks. You can measure this by looking at the total foreign exchange reserves. China now has four trillion dollars of foreign exchange reserves.
That means their central bank has created four trillion dollars of their own currency from thin air. Globally, there are now 12 trillion dollars of foreign exchange reserves. These have gone up ten trillion dollars just since the year 2000.
You can see this dwarfs the amount of paper money that even the Fed has created so far. Quantitative easing only adds up to something like $3.7 trillion, and you can throw in maybe a half a trillion more for the Bank of England and something over $1 trillion for the Bank of Japan, but it’s this money creation that really explains why we have such a global bubble to start with.
More accurately, there are two parts to this process. First, the US trade deficit throws the dollars off into the global economy, and, secondly, the central banks in the surplus countries create enough fiat money to buy all the dollars and then pump them back into the US, and this is why we had a global economic bubble that popped in 2008.
None of this would have come about had we remained on a gold standard. Our trade would have remained in balance, and the rest of the world would have grown very much more slowly. The United States would have grown much more slowly because we wouldn’t have developed the housing price bubble and a stock market bubble and all the jobs that were related to that.
So this fiat money creation that allowed trade imbalances to occur has resulted in much more rapid economic growth than would have occurred under a gold standard in a capitalist economic system. That’s been great for decades up until 2008, but now the private sector, i.e. the household sector, is incapable of bearing more debt, and so that’s why we are on the verge of collapsing into a New Depression.
Peter Coyne: You talk about total credit as a specific measure to gauge how close we are to a collapse. Can you talk about that a little bit?
Richard Duncan: Total credit and total debt are two sides of the same coin. One person’s debt is another person’s asset, but what I mean by total credit is basically all the debt in the country – government debt, household sector debt, corporate debt, financial sector debt, and all the debt.
Total credit first past one trillion dollars in 1964 in the United States, and over the next 43 years, it expanded from one trillion to fifty trillion. This explosion of credit created our world. It made us all much more prosperous than we would have been otherwise.
The ratio of debt to GDP went from 150 percent in 1980 all the way up to 370 percent in 2007. So it’s easy to understand how rapid credit growth drives economic growth as long as credit’s expanding very rapidly and everyone gets a new credit card in the mail.
They go shopping, they spend a lot, this increases corporate profits, and the businesses hire more people, they expand their capacity, they build a new headquarters, and they even pay more taxes. Then the government has more money to spend. Meanwhile, asset prices keep inflating upward higher and higher, creating more collateral for the households to borrow against.
But the day always comes, as the Austrian economists remind us, when credit can’t expand any further. That’s when the Depression begins, and that’s what started to occur in 2008. That’s what would have occurred. We would have had a New Depression had the government not intervened. The government then started borrowing and spending trillions of dollars every year, and that kept the total credit expanding.
Today we have a total credit base of $59 trillion. As I mentioned earlier, looking back between 1950 and 2008, every time total credit adjusted for inflation, grew by less than two percent, we had a recession, and the recession didn’t end until we had another very big surge of credit expansion.
Since 2008, though, credit hasn’t been expanding by two percent, and that’s why the economy’s been weak, and that’s why the Fed has felt it necessary to intervene by creating trillions of paper dollars and pumping that into the financial markets to cause the stock market to go up and property prices to reflate. At this point, the question is will credit ever begin to grow again enough to drive the economy because we now have such a large base, $59 trillion.
If we assume that the inflation rate is two percent, then we need total credit to grow by four percent so that total credit, adjusted for inflation, will hit this two percent “recession threshold” as I call it. Four percent of $59 trillion is $2.4 trillion of credit growth that we need this year just to stay out of recession.
Well, the government budget deficit this year, deficits coming down very rapidly. The government budget deficit will be $600. That means the government’s going to borrow $600 billion. Who’s going to borrow the other 1.9 trillion needed? Is it going to be the household sector? No.
Is it going to be Fannie Mae and Freddie Mac? No. The corporate sector? Well, the corporate sector has been borrowing quite a bit. Last year they expanded their debt by about $750 billion. Even if they do that again, that takes us part of the way there, but not to $2.4 trillion. You can see that none of these sectors is going to expand its debt enough to make total credit grow by two percent.
Creditism needs credit growth to survive, and without the credit growth, the system is going to collapse. The thing is, if it collapses into a New Depression, this is not going to be something that involves some pain for a year or two and then takes us back to some sort of laissez-faire Garden of Eden.
After a five-decade long, sixty-fold expansion of credit,if this credit bubble collapses now, we’re going to have an equally protracted crash, and it’s not going to be a matter of taking a little pain for a couple of years. It would involve such horrific consequences that, I think, it would be a replay of the 1930’s and the 1940’s, but this time with nuclear weapons involved.
So, yes, there would be a recovery. When Rome fell, there was a recovery, but it took a thousand years. So I don’t believe anyone alive today would still live long enough to see the recovery that would follow a New Depression now.
Peter Coyne: Is that really how bad the New Depression would be? Akin to the fall of Rome?
Richard Duncan: I think the best way to think about it is to consider what happened with the last Depression. After all the two occurred for the same reason. A fiat money credit bubble formed when we broke the link between dollars and gold both times.
What happened in the 1930s? International trade collapsed and the international banking system collapsed; 1/3 of all the U.S. banks failed.So people lost all of the savings they thought they had.
This time, without very aggressive government intervention to save the banks, in other words if we allow a laissez faire solution, then all the saving in the world would be destroyed and trade barriers would go up as they did in the 1930s. That would mean global trade would collapse. What would that mean for a country like China?
China’s economy is entirely dependent on exporting to the United States. If the United States stops taking China’s imports into the United States, China’s economy would not have a recession, it would implode. There would be starvation in the cities and in the countryside.
With the complete collapse of government revenues, the United States could no longer afford to maintain a string of military bases around the world so our global economic dominance would evaporate. We also couldn’t afford to continue paying Social Security or Medicare and so once again the old people in this country would be on the verge of starvation if not starving as they were in the 1930s and it would be more or less a collapse of civilization as we know it.
Unemployment would be at least 25 percent in this country and how would those people vote? They would vote for parties that promised to give them money and food. In other words, we would take a very hard turn to the left and that may be met with the response from the right that involved a military coup.
It’s not at all certain that democracy could survive this sort of new Depression and that’s why our government is so keen to make sure that that doesn’t happen. That’s why they’re going to continue supporting the economy with very large budget deficits when necessary and finance those deficits with quantitative easing when necessary.
Peter Coyne: That’s scary stuff. Your last point – about government’s doing whatever it takes to keep the system afloat – is a good segue into the “raft analogy” you’ve often told me about. Can you explain that for readers?
Richard Duncan: I think it’s very useful to think of the global economy as a big raft. But instead of being inflated with air it’s been inflated with credit. On top of the raft you have all of the asset classes; stocks, bonds, commodities including gold, plus you have the world’s population of 7 billion people.
The problem is, the raft is now fundamentally defective. It is full of holes and the credit keeps leaking out (when people default on their debt). The natural tendency of the raft now is to sink and when it starts to sink, the stocks, property, commodities, gold all go down and the people start to get their feet wet.
Policy makers understand rightly that if the raft sinks it’s not going to be a matter of simply a stock market crash, people are going to die as they did in the 1930s. And so there’s only one possible policy response and that’s to pump in more credit. That’s what they’re doing through the large budgets and through the Fiat money creation, quantitative easing.
When they do that, the raft reflates and all the asset prices move up together and the people, once again, have their dry feet and are happy.
But then once they stop with the quantitative easing, with the liquidity injection, the credit starts leaking out the sides again and the raft starts to sink and so they have to repeat quantitative easing. We’ve had QE1, QE2, and QE3; when QE3 stops, we’ll have QE4 and probably QE5.
Now the reason why the raft is fundamentally defective is because at this stage of creditism, so much credit has been created globally that the income of the 7 billion on earth, at least as it’s currently divided, is not adequate to continue paying interest on all of the debt that they have borrowed and so they keep defaulting.
Whether it’s in Ireland, or Greece or the subprime disaster here, the banks in Japan or soon the banks in China, someone defaults and the credit leaks out and the raft starts to sink and the only way to respond to this is by pumping in more credit. And that’s why we’re on government life support. Take away the government life support and the world as you know it won’t be here.
Peter Coyne: Are there limits to how much credit can be pumped in? How many times can the raft deflate and be reflated before it sinks altogether?
Richard Duncan: It’s useful to think of this in terms of fiscal policy and monetary policy. At the moment, we’re very dependent on monetary policy because congress has decided to reduce the budget deficit very quickly. But a few years ago the budget deficit was $1.1 trillion.
This year it’s only going to be about only $500 billion – removing a great deal of fiscal stimulus from the world. As a result, that’s put a great deal of pressure on the Federal Reserve to pump up the raft by itself through fiat money creation. But it looks like there may be some limit as to how long the Fed can continue inflating the global economy just through paper money creation.
One ratio that I like to look at is called the “ratio of household sector net worth to personal disposable income.” You can more or less think of this as a ratio of wealth to income.
Going back to 1950, this ratio of wealth to income has averaged about 525 percent. But during the NASDAQ bubble, when the wealth was inflated, it went to 616 percent. When that bubble popped, it went back to the normal average.
And then the during the property bubble of 2005 and 2006, it went all the way to a record high of 660 percent. When that popped, it went back to the average. But now because the Fed has pushed up asset prices and household sector net worth to $83 trillion, it has gone back to 640 percent.
That’s probably a warning signal to us that there is some limit as to how high or how long the Fed can keep driving the economy by itself. And that’s because wealth can only grow so much relative to income. Eventually, the asset prices, of homes, for instance, become so inflated that it becomes impossible for the people to earn enough income to pay the interest on the debt that they had to borrow to buy their home and they default. That’s when everything crashes.
So there may be a limit as to how long the Fed can keep driving the economy by itself. That takes us back to the fiscal side; how long could the government borrow and spend and drive the economy if it chose to do so? Here I think we need to look at Japan.
Japan has now been in crisis for 25 years. They had an enormous bubble. When that popped, Japan would have gone into a Great Depression but Japan’s government ran very large budget deficits year after year after year and they’ve taken their government debt from 60 percent of GDP in 1990 up to 250 percent now. This is how Japan has stayed out of a Depression.
What does that tell us about what the United States could do?
Well the U.S. government debt now is only 100% of GDP. Our GDP, the size of our economy, is $17 trillion. This suggests that the government could borrow and spend another $17 trillion before we even hit 200% government debt to GDP. That’s assuming that the economy doesn’t grow at all too.
Whereas, of course, if the government spent $17 trillion, the economy would grow by 10% per year every year, meaning the ratio of government debt to GDP would never reach even 200%.
That means there’s almost no limit as to how long the government could go on borrowing and spending and supporting the economy through fiscal stimulus before it ran out of the ability to borrow and spend.
This seems so counter-intuitive. This must sound shocking to anyone reading this interview but the reason this is possible is because something completely new in the world is occurring simultaneously; something new and completely separate from what I’ve described so far.
Peter Coyne: What’s that?
Richard Duncan: The new thing is globalization and globalization is extremely deflationary. This deflationary pressure from globalization is completely offsetting all of the inflationary pressure resulting from this massive government borrowing and spending and this extraordinary fiat money creation by the Fed.
The reason globalization is so deflationary is because it’s driving down wage costs. Businesses no longer have to hire a worker in Michigan and pay that person $200 dollars a day to build a car. They’re going to hire that person in China and pay that person $10 dollars a day or in India and pay that person $5 dollars a day. That means the cost of the next worker hired will be 95 percent less.
In other words, the marginal cost of your next employee will fall by 95 percent. This is extraordinarily deflationary. Nothing like this has ever occurred in human history before and this is the reason that we’ve been able to go on this long with our system of creditism. Otherwise, we would have already had very high rates of inflation and perhaps hyperinflation.
But at the moment the deflationary pressures from globalization are completely offsetting the inflationary pressures. This is creating what’s almost a nirvana-type moment where, as we have seen over the last 5 years, it is possible for our government to borrow and spend trillions of dollars and to finance it with trillions of dollars of fiat money creation without resulting in very high rates of inflation.
Peter Coyne: That’s a perfect cliffhanger to stop today. Tomorrow I want to pick up on this globalization and deflation theme.
But before we wrap up, I want to remind readers about your service again, because I personally find it very useful. It’s called MacroWatch. It’s a video newsletter you produce twice a month that analyzes trends in credit growth, liquidity and government policy in order to anticipate their impact on the financial markets.
While we publish this conversation in the Daily Reckoning, you’ve been good enough to extend a 50% discount to any of our readers who subscribe. To do so, readers can click here and use the coupon code: “daily”.
We’ll circle back with part III of our discussion tomorrow. Thanks again, Richard.