Norris Bruce
Apr 26, 2019

Quantitative Easing and Tightening With Richard Duncan #640

Bruce Norris is joined this week by Richard Duncan. Richard is the author of three books on the global economic crisis including the international bestseller The Dollar Crisis: Causes, Consequences, and Cures, which forecasts the economic crisis of 2008 with extraordinary accuracy. Since beginning his career as an equity analyst in Hong Kong in 1986, Richard has served as Global Head of Investment Strategy at ABN AMRO Asset Management in London. He worked as a financial sector specialist for the World Bank in Washington D.C. and headed equity research departments for James Capel securities and Solomon broker brothers in Bangkok. He also worked as a consultant for the IMF in Thailand during the Asia crisis. He is now the publisher of a video newsletter Macrowatch, which can be found on his web site. I recommend this web site. He has offered our our listeners a 50% discount coupon if you get to his web site. The word to use for the discount is river. You’ll find out in the next 50 minutes why he recommends it.

Episode Highlights

  • What drove the U.S. economy after 1980?
  • What drives the economy today in addition to credit growth?
  • Is it the Fed’s job to protect asset prices?
  • What is the difference between Quantitative Easing and Quantitative Tightening?
  • What could cause the Fed to begin increasing interest rates again?
  • How do demographics play into the inflation cycle?
  • Where does the U.S. trade deficit stand?

Episode Notes

Bruce got married very young at 17, and he read a book called Rough Times Ahead, and it was Howard Ruff who wrote it. He basically said we’re in for a lot of trouble, and this was in 1970. He said if you’re responsible and have a family, you need to have a water supply and wheat. Bruce bought it, and he bought a thousand pounds a week that he moved for 30 years. It scared him. Whenever he read other people’s opinions now, he takes them seriously but also comes to his own conclusion.

Richard said it is always important to keep in mind that the theories that seem to be true at one stage of history in the past may no longer be appropriate for the conditions we’re living in today. Great economists who had great ideas in 1912 or 1860, for example, may have been spot on for their age. However, what they prescribed then may not be applicable now.

Bruce asked what usually drove the United States economy after 1980. Richard said what we’ve seen in recent decades is that in the United States, it’s been credit growth that drove economic growth. Starting in 1980, credit growth accelerated very sharply in the United States. Credit and debt are two sides of the same coin. You can look at this as all the debt in the country. Government debt, household sector debt, corporate debt, financial sector debt. The total debt of the country really began to accelerate sharply. Total debt or total credit had averaged around 150% of GDP from 1950 up through 1980. But after 1980, it accelerated, and the ratio of debt to GDP rose all the way to 370% by 2007. It was that very rapid credit growth that drove the economic growth.

Everyone had access to more credit, so they could spend more and consume more. It also caused asset prices to go up, so wealth increased. That allowed consumers to spend more as well. The sharp increase in credit growth drove the U.S. economy, and the U.S. economy then imported more from the rest of the world. The trade deficit grew larger and larger year after year, so the U.S. trade deficit drove global economic growth. That was the way things worked between 1980 and 2007. But then, in 2008 the Americans were so heavily indebted they couldn’t take on any more debt. They started defaulting on their debt and were cut off from new debt. At that point, credit began to contract and the world came very close to collapsing into a new Great Depression.

Bruce remembered Warren Buffett being on TV, and he was talking about when they were going to pass the $770-$800 billion package. He said if this doesn’t pass, you need to go to your room and get on your knees and pray. Bruce thought this was a scary statement. At the same time, Treasury Secretary Paulson literally did get down on his knees and begged Nancy Pelosi to pass the bill. After Bruce heard him say this, he went to Bank of America to try and pull out a fair amount of cash. He could get five grand, and it basically was an IOU. There was a line outside that was probably 50 people long with IOUs in their hands to get cash. That was the scariest day for Bruce worrying about economics. Richard also remembered this time. He went up to the bank and got a gold coin. Bruce didn’t think of this, he thought cash might be helpful.

Bruce asked what the driver for the U.S. economy is now if it’s no longer just the credit growth. Richard said going back all the way to 1950, every time total credit in the U.S. grew by less than 2 percent after adjusting for inflation, the U.S. went into a recession. That happened nine times between 1950 and 2008. That’s why it’s so important to monitor credit growth because if we don’t get it, then we have a recessions or worse. If credit contracts, we go into a depression. What we’ve seen since 2008 is that credit growth has been quite weak. It’s been just at or above the 2% recession threshold, but it hasn’t been enough to drive the economy. What has been driving the economy instead is the Fed has stepped in with three rounds of quantitative easing and zero percent interest rates, and this pushed up asset prices in the United States.

For example, household sector net worth in America, or everything the Americans own minus all the debt that they owe, fell in 2009 and was $56 trillion. However, by the third quarter of last year, it had practically doubled to $107. The reason for that was the extremely low interest rates pushing up stock prices and property prices as well as the quantitative easing pumping that new Federal Reserve money into the financial system. This is what drove up the asset prices. Now what we are seeing is that it’s actually asset price inflation that is driving the economy. As a household sector net worth goes up, the Americans feel richer and they spend more money. Their houses become more valuable, their stock portfolios that they hold directly become more valuable, and the money that they have in their pension funds becomes more valuable. They feel more secure, and they go out and spend more. That has been the principal driver of growth for most of the past 10 years.

Bruce asked if it is the Fed’s role to protect asset prices? Richard said if you watch the most recent Fed press conference from their March FOMC meeting, Chairman Powell pretty much said yes it is. If the stock prices fall, then credit conditions tighten and consumption slows. As a result, the economy goes into recession. The reason the Fed did an extraordinary about face in their policy between the end of December and announcing it in January is up until January, the Fed had a signal that it intended to continue tightening interest rates. It was going to continue pushing up the Federal funds rate at least a couple of more times this year if not more than that as well as into next year. They were also going to continue with quantitative tightening, which is the exact opposite of quantitative easing.

Instead of creating money and buying assets, quantitative tightening involved them actually selling assets and destroying money. Then in December, the Stock Market fell so sharply that it actually destroyed an enormous amount of wealth in that one quarter alone. The household sector net worth hit a peak of $107 trillion in the third quarter. In the fourth quarter, it dropped by $3.7 Trillion. In other words, the Americans became $3.7 Trillion dollars poorer in the fourth quarter of last year.

Bruce loves charts, and even he had not seen that chart. That’s an extraordinary plunge. In absolute dollar terms, that’s the largest drop on record. In percent terms, relative to GDP it’s not the largest on record, but it’s still a very large drop. By destroying so much wealth that the Stock Market took a downturn, that is the reason that back in January the Fed said they changed their plan. They were no longer going to tighten interest rates, but instead be patient and leave them on hold. Furthermore, they’re going to stop Quantitative Tightening much sooner than they said they were. We’ve since learned they now intend to stop it in September, whereas earlier it was expected to go on probably a year and a half longer than that. .

Bruce followed this very carefully. The Norris Group has a newsletter, and in October it was pretty definitive that we’re not done tightening nor are we anywhere near where we need to be are are still accommodating. It reversed so strongly and quickly, which Bruce never expected. Bruce asked Richard what would cause the Fed not to protect asset prices. He wondered if there was something that could be more important that they would have to deal with first. Richard said the reason the Fed policy has been so effective in the years after the crisis and why they have been able to get away with creating so much money through quantitative easing was because of what happened prior. Last time, they essentially created $3 1/2 trillion dollars from thin air in three rounds of quantitative easing in order to push up asset prices. This, in turn, drove down interest rates and stimulated the economy. The group truly worked miraculously. This was the reason we didn’t collapse into a new Great Depression.

However, the real reason they were able to get away with that is normally and historically it has always been understood that if a central bank creates a lot of paper money, it leads to high rates of inflation or even hyper-inflation. However, this time that didn’t happen. The reason is that we are now living in a very different economic environment than in the past. Today, we live in a global economy with nearly 8 billion people, and about two billion people out of that 8 billion live on less than $3 a day. What that means is that we no longer have a closed domestic U.S. economy. It just depend on American labor and American industrial capacity.

We are operating in a global economy now with an infinitely large labor pool of very cheap labor. We are also working with an extraordinary amount of excess industrial capacity, particularly in China. Despite the fact that the Fed created so much money, this has been a greater worry than inflation had been over the last 10 years. Even now, the inflation rate is below 2%; and in the most recent month it is dropping again. The policy they have pursued has only been possible because globalization has been so deflationary. With globalization, you no longer have to hire someone in Michigan and then pay that person $200 a day to build a car. You can hire someone in Western China and pay that person $10 a day. That has been pushing down wage rates in the United States and in the other industrialized countries. That deflationary force has completely offset all the inflationary pressures that normally would have resulted from so much paper money creation.

One thing that would make the Fed begin increasing interest rates again is if we saw a sudden spike in inflation. If inflation started moving up from 1 1/2% to 2 1/2, 3 1/2 4 1/2, or even 5 1/2%, then suddenly all bets would be off. The Fed would have to start hiking interest rates very sharply in order to bring the inflation back under control. A present, there’s absolutely no reason to expect inflation to increase. However, if we were to have an all out trade war with China and globalization breaks down, like if we put up 25% trade tariffs on all Chinese goods, then things are going to become a lot more expensive in the United States. This is because the US imports so much from China. In turn, this would lead to higher interest rates. If globalization breaks down and the US economy no longer has access to the ultra low wage global workforce, then the cost of everything is going to move up very sharply.

We will return to the era of high-rate inflation that we saw in the late 1960s and especially 1970s, and the Fed would have to respond by pushing up interest rates and. This, in turn, would cause two things that would severely damage the U.S. economy. First of all, it would cause credit to contract, and people just couldn’t afford to take on more credit. The reason debt has grown so much since 1980 is because interest rates have fallen quite steadily year after year to very low levels.

Now, the yield on the 10-year U.S. government bond is only around 2 1/2% right now, whereas in the early 80s it was 15%. So, as the cost of borrowing became cheaper, Americans borrowed much more, which drove the economy. As the cost of borrowing becomes more expensive, then the Americans are going to borrow much less and credit is going to contract. Credit doesn’t grow by 2%, and as the U.S. goes into recession the credit contracts by 2-3%. When this happens, the recession becomes a depression.

Secondly, the higher interest rates would cause the stock markets and home prices to fall very sharply. This household sector net worth would fall very sharply. Instead of having a positive wealth effect, there would be a negative wealth effect and the Americans would all feel significantly poorer and spend much less. Consumption would drop, and the economy would go into severe recession. You would have two very severe factors driving the U.S. economy down into a replay of 2008 if not worse.

Bruce asked how demographics played into the inflation cycle that we’re in and if the demographics of this world are generally deflationary at this point. Richard said there are not so much demographics in terms of the number of people and the growth in the population or even aging that is the most significant factor. The significant factor is that is when we went from being a closed domestic economy to becoming a global economy that everything changed. That happened around 1980 because up until 1980, the U.S. trade balance was more or less in balance.

The US didn’t have large trade deficits no countries; neither did any countries. They did not have these or large trade surpluses. Under the quality gold standard Bretton Woods system, trade between countries had to balance. Starting in the early 1980s after the Bretton Woods system broke down, the United States realized it could run very large trade deficits with other countries and could finance them with paper dollars or Treasury bonds. It no longer had to hand over gold in exchange for its trade deficits.

The U.S. trade deficit blew out from essentially nothing in 1980 to around more than 3.7% of GDP by 1986 or so. That was something entirely unprecedented for such a large country to have such a large trade deficit. It temporarily corrected after the G7 countries agreed that the dollar would be devalued by 50% against the yen and the mark. The trade then came back into balance; and once China entered the global economy in 1990, the U.S. trade deficit became extraordinarily large. By 2006 it had grown to more than 6% of theU.S. GDP. That was $800 billion dollars that year.

What this means is that after the U.S. started running large trade deficits with the rest of the world, it no longer had to be concerned about reaching full employment in the United States or reaching for industrial capacity in industries like steel or automobiles. This lead to inflation high inflation in the U.S. because by being able to buy so much from other countries, the U.S. was able to circumvent the domestic bottlenecks in employment and industrial capacity by buying from other countries. The US found that it could run large budget deficits and that central banks could create unprecedented large amounts of money without causing inflation in the United States. This was a fundamental change from any other condition that we had experienced prior to this.

Bruce asked Richard if he does not see demographics as a big factor. Japan has an exaggerated example of that, but he wondered if he sees the U.S. demographics as a minor factor as opposed to what he had stated. He said yes and that in terms of demographics, you should think of it in terms of what happened to the size of the labor pool. This went from about 200 million people in the workforce in the United States or 150 million perhaps in 1980. Now, not everybody in the world is old enough to work but the workforce would pay at least five billion people now. That dwarfs everything else that’s happening in terms of demographics in terms of aging or the number of people.

The number of people in the world is still growing, but at a slower rate than in the past. In some countries, like Japan and some European countries, the population has started to shrink. From the point of view of the implications for the U.S. economy, those factors are pretty insignificant in comparison with this opening up of the global workforce of billions of people who are now willing to work or very low wages.

Bruce ended by talking about Richard’s Web site Bruce pays attention to a lot of smart people because he has a high school diploma and some street smarts, and he learns a lot of what he needs from people who are smarter than himself. His son Greg turned him on to his Web site and some of his documents, and I appreciate the studies that you’ve done and so I would encourage people to go to your Web site and take a look at it. To me it’s just it’s a worthwhile piece to add to the education that we all need to make intelligent decisions.

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