Erik Townsend - Global Macro Series - 23rd July 2020

[00:00:06] Erik

I published a book in 2018 predicting that the eventual replacement for the U.S. dollar would be a digital currency and I don’t think it’s cryptocurrencies like bitcoin. I think the cats out of the bag that digital currency is going to be the way of the future. The question is going to be what country or block of countries come up with the digital reserve currency that really provides a viable alternative to the U.S. dollar?

How does that event come about? It’s not something that happens next week or next month. In the next decade, I think that we’ll eventually see the emergence of a digital currency that really gives the U.S. dollar a run for its money for the title of Global Reserve Currency. That’s going to be what changes the Fed’s ability to get away with what it has been doing.

[00:01:00] Introduction

For me, the best part of my podcasting journey has been a chance to refine my own investment framework through a series of conversations with extraordinary investors in every corner of the world. In this series, I along with my co-hosts Robert Carver and Moritz Seibert, want to continue our education by digging deeper into the minds of some of the thought leaders when it comes to how the world economy and global markets really work to try and learn how they think.

We want to understand the experiences that have shaped them, the processes they follow, and the historical events that have influenced them. We also want to ask questions outside our normal rules-based playground. We’re not looking for trade ideas or random guesses about an unknown future but rather knowledge accumulated over the course of decades in the markets to try and make us better-informed investors and we want to share those conversations with you.

Our guest today is a global macro investor who, like us, talks to some of the sharpest minds in the financial world on his own podcast, MacroVoices. So, he really is able to provide a unique combination of market opinions and deep insights. So, I’m convinced you will enjoy our conversation today with Erik Towsend of MacroVoices.

Erik, thanks so much for joining us today for a conversation as part of our miniseries into the world of Global Macro where we relax our usual systematic, or rules-based framework, to provide you, the listener, with a broader context as to where we are in the global and historical framework and, perhaps, discover some of the trends that may occur in the global markets in the next few months or even the next few years and, ultimately, how this will impact all of us as investors and how we should best prepare our portfolios.

So, we’re super excited to dive into many different topics in the next hour or so, not least because you are an investor yourself, Erik, but also because you speak to many of the brightest minds on your own amazing podcast, MacroVoices. So, let’s kick off with a kind of 30,000-foot question that, if I may just kick everything off here, where do you think we are in the big global macro picture?

To me it feels like kind of a blend of something we have seen before in the past; in 1929 the Japanese bubble; in the late ’80s the Tech bubble; the Great Financial Crisis as well as a brand new set of challenges we haven’t seen before, and of course, to that we add a global pandemic which makes it a very unique period indeed. How do you see the world, right now, Erik?

[00:03:52] Erik

Well, I think the very big picture perspective that you have to keep is we are ten years into the grandest monetary policy experiment in the history of the earth. We had this big credit boom from, really, the 1980s through the early 2000s. We had the 2008 financial crisis and the response to that has been a very accommodative central bank policy which is completely unprecedented.

To some extent, the policy moves were precedented in the sense that Japan had done them. Quantitative easing had been used in Japan. By the way, it led to decades of stagflation – what was known as the ‘lost decade.’ Now it’s at least a couple of lost decades for Japan.

We’ve tried to use the same tactics of expanding central bank balance sheets to pump more liquidity into the system to rescue the financial system. That has clearly caused a lot of people to fear runaway inflation when those policies were first introduced. I think what almost everybody got wrong (but they kind of got right at the same time) was that they were right to fear inflation but it was not consumer price inflation it was asset price inflation.

Most of that money that was conjured out of thin air by central banks didn’t go to Main Street to provide more money in the pocket of the average consumer, it went to put more money in the pocket of the average investment banker to buy more assets. It has lead to the biggest (what I would consider to be) artificial bull market (but still a very real bull market just the same) in asset prices for the last ten years.

A lot of people said, “OK, that’s pretty amazing that it went for ten years but it’s artificial and therefore unsustainable and it all has to end badly someday.” Now, there are a growing number of people that are taking the opposite side of that argument saying, “No, what it actually is is it is the realization of a better way.”

That’s what leads us to Modern Monetary Theory. A lot of people want to embrace it and say, “What we need to do is more quantitative easing, more central bank policy accommodation.” Perhaps the people are proponents of MMT would like to focus it more on helping Main Street than helping Wall Street but they think we need to do more of that.

There are some of us old school types that have been saying for years that it’s unsustainable. It has to end badly. Somebody is about to be proven right or wrong. When I say ‘about to be’ I mean in the next few years. It has taken ten years of this policy just to get us to this point.

So, how does this monetary policy experiment end? If the answer really is that you can just expand central bank balance sheets forever and there are no adverse consequences, well then, I guess prosperity is upon us. We can forget about taxes and just print all the money that we need and everybody can have three Lear Jets and a Rolls Royce. I don’t think it’s going to go that way.

I think we’re about to learn that there are adverse consequences to everything that has happened. I think that, in many ways, we’re seeing it now. The CoronaVirus crisis has brought us this pandemic lockdown, but really, I think the reaction to the lockdown – what’s being perceived in all the civil unrest as a reaction to both police violence is being perceived as a reaction to the CoronaVirus lockdown, I don’t think it’s any of those things. I think it’s a reaction to this monetary policy intervention of the last ten years where, basically, what governments have done has been to provide a huge amount of policy accommodation that helps rich people. It doesn’t help the average guy on Main Street.

It helps financial markets. It has dramatically fueled the biggest bull market in stocks in all of history, but it hasn’t done a whole lot to help the average guy on Main Street. I think the folks with pitchforks are starting to sharpen them up and say, “We’ve had enough.” That is happening all around the world.

So, we’re headed toward, potentially, an intervention of a different kind – a public intervention where people who are literally rioting in the streets, potentially at some point are going to say, “Enough bailing out Wall Street let’s bail out Main Street.” I think that that probably leads to more quantitative easing or a different form of quantitative easing that is aimed much more at supplying money to Main Street consumers.

Now, the fears of widespread inflation, I think, start to come back into the fray. For years and years, we thought there was going to be inflation from money printing. It didn’t happen in the sense of widespread consumer price inflation. It did happen in the sense of asset price inflation. I think we’re about to get the widespread consumer price inflation but that doesn’t come until we refocus the printing press (the proverbial printing press) on providing a combination that helps Main Street instead of Wall Street.

So, I think probably the next thing to happen is MMT and monetary policy and fiscal policy accommodation directed at Main Street rather than Wall Street, then that leads to an inflationary event like nothing we have ever seen before. But that’s going several years into the future at that point.

[00:09:22] Niels

There’s a lot to unpack, but just before Rob and Moritz jump in with some of their observations and questions, you mentioned Japan, you mentioned that that was one of the things that we had kind of seen before. We learned later on (at least I learned later on) recently, actually, from Richard Werner and the Princes of the Yen documentary based on his book, as far as I recall, he felt that a lot of the bubble was actually created by intent from the BOJ in order to gain more independence at the end of all of that debacle.

Do you think that there are more things going on here? Could the Fed actually be seeking more… Certainly, we know that they are under a lot of pressure from the White House at the moment, but could they be seeking, deep down, more independence by helping create a situation like we saw in Japan in the late ’80s?

[00:10:16] Erik

I think we have reached the early panic stages. I don’t think we’re in full panic yet but I think that we have gotten to the point where the Fed correctly realizes that they can’t stop, they can’t cut off the monetary policy accommodation. The analogy, I think of is, if you’re the drug dealer that is supplying the heroin addicts and their armed and they outnumber you, you don’t cut them off and make them upset because they’ll come and kill you. So, I think the Fed has to continue doing what it has been doing. I think that very soon political pressure will force the Fed to do more that is aimed towards Main Street instead of Wall Street. So, MMT is definitely in our future.

How long can they continue to get away with this, maybe, is the operative question. I think the answer to that hinges entirely on how long the U.S. dollar lasts as the world’s global reserve currency.

The way I look at this, the dollar is (at this point) global reserve currency for one reason and one reason only which is that there simply is no viable alternative today to the dollar. There are a lot of people around the world that are sick of the hegemony that the United States exerts over the rest of the world. They’re sick of the dominance of the dollar and the impact that it has, the adverse impact that it has against other economic systems around the world, but there is nothing that they can do about it because there is no viable alternative. What are you going to replace the dollar with? The Euro? Well, the Euro Zone has got plenty of problems of its own. The Yen has already been debased even more than the dollar has. The Chinese Yuan, I mean look at the challenges that China has.

I published a book in 2018 predicting that the eventual replacement for the U.S. dollar would be a digital currency and I don’t think it’s cryptocurrencies like bitcoin. I think the cats out of the bag that digital currency is going to be the way of the future. The question is going to be what country or block of countries come up with the digital reserve currency that really provides a viable alternative to the U.S. dollar?

How does that event come about? It’s not something that happens next week or next month. In the next decade, I think that we’ll eventually see the emergence of a digital currency that really gives the U.S. dollar a run for its money for the title of Global Reserve Currency. That’s going to be what changes the Fed’s ability to get away with what it has been doing.

[00:12:56] Niels

Yeah. Rob, what’s on your mind?

[00:12:59] Rob

Yeah, I’m kind of agreeing with you. I do wonder whether it’s the central banks that need to have this sort of paradigm shift because, ultimately, central banks are responsible for monetary policy and, clearly, monetary policy hasn’t worked (as you say), conventional monetary policy hasn’t worked; QE hasn’t worked, and ultimately that’s because the (so-called) transmission channel from buying assets to people’s pocketbooks isn’t as efficient as they had hoped it would be.

So, I kind of think that (I think we’re seeing this more now but) if you look at the last ten years, especially in this country in Europe, you have central bankers buying bonds on the one side and on the other side you had austerity and the fiscal response was, basically, pushing the other way. Obviously, in the U.S. things were a bit more nuanced and there was a reasonably good fiscal response.

Isn’t it the politicians that have to say, “You know what, the Corona crisis, they’re doing that now. There is a big fiscal response to the Corona crisis but there is a real (certainly I have noticed here), a real temptation to want to pull back from that as soon as possible and go back to running a balanced budget or something close to it. But isn’t the paradigm really that the politicians should spend the money, the fiscal policy, and the central bank’s job purely, then, is to (if necessary) buy the bonds if there isn’t the open market demand for doing that.

I just think we’re kind of assuming that central banks can do way too much and they really didn’t do a great job. So, isn’t it really down to the government as well?

[00:14:26] Erik

Well, I see it a little bit differently. First of all, you said QE isn’t working. It’s working very, very well for a lot of people on Wall Street. A very small number of people have benefited immensely at the expense of everyone else thanks to these policy decisions that have been implemented.

I think what is happening is that the world is slowly figuring out just how badly they are getting screwed over by this whole system. What is happening now, and I think the big shift for governments is that lawmakers used to have the idea in their head, “You know, we love spending money but the only way to spend money is you have got to tax somebody for it. So, that means we have got to figure out how to make somebody the bad guy. Let’s pick rich guys, make them the bad guys. Unfortunately, there are not enough of those rich guys so they’re pretty good about hiding their money. So, it’s hard to get the taxes that we need. Boy, what are we going to do?”

What they have figured out, and I think it’s a fallacy in some ways, what they think they have figured out is, “Wait a minute, central banks don’t need to tax anybody. They can print money out of thin air and supply us with all the money that we need to spend on whatever we want to spend it on and it’s really not going to blow up the system the way all those pesky economists told us it would.”

Look at what they have been doing for the past ten years. They have created trillions of dollars out of thin air and those trillions of dollars went into bank reserves. But that’s a distinction the average politician doesn’t understand. The trillions of dollars that didn’t exist that were conjured out of thin air, we need to start getting these central bankers working for us. Let’s conjure some more trillions of dollars of thin air without taxing anyone and spend it on what we want to spend it on and that is mostly buying votes by offering policies which may or may not make sense for society but sound good to the people that are voting for them.

So, I think that what the next big trend is going to be is politicians recognizing the opportunity to demand that central banks provide money creation, essentially, to monetize deficit spending without having to tax anyone. Now, in the United States, at least, a lot of people would say, “Oh, no, no, they can’t do that because the way the Federal Reserve Act worked…” Nonsense. The government makes up its own rules. The government breaks its own laws routinely.

If there is a majority of lawmakers, a controlling interest of a political party, that wants to do MMT, the Federal Reserve Act is not going to get in the way. They’ll either find a way to work around it as they did recently buying junk bonds, which was clearly against the spirit and intended meaning of the Federal Reserve Act. They’ll either reinterpret it creatively or they’ll change it.

So, I think we’re headed towards an era of several years where politicians focus on, “Let’s spend lots and lots of money without taxing anybody to do it and maybe we’ll tax some rich guys just for the sport of it in order to make the poor guys feel better. But we’re not going to look at tax revenues as the source of funding all the money we want to spend. We’re going to look at the central bank’s ability to expand its balance sheet as the source of that money.”

That will go on and it will appear to be fantastically successful, at first, because inflation is always a lag function. It never happens overnight. Eventually, that’s going to cause a runaway inflation problem and probably an inflationary Greater Depression someday. But it’s not going to happen overnight and, initially, those policies will be incredibly popular.

They won’t blow up the system overnight, everything will appear to be working just fine and the politicians that are pushing for those policies, that were responsible for bringing them into the light, are going to be on the most epic victory lap of all time when they are saying, “We went for ten years with these stinking central banks working for Wall Street and thanks to me being in office now they’re working for Main Street. They’re working for you and me. They’re working for the people because I’m the one who got rid of those Wall Street fat cats and got the central banks working for us.”

Eventually, they’re going to create runaway inflation that blows up the whole economy but it’s not going to happen overnight.

[00:19:00] Moritz

When I read the summaries, the really great summaries of Ray Dalio, about the big debt crisis, my observation is that (essentially) every currency that has existed has devalued including the U.S. dollar. People don’t realize it because it happens so slowly while they live but most of the currencies that used to be in existence no longer exist and the ones that do exist have devalued massively.

It seems to be the case that, no matter what, the end game is inflation and complete devaluation of a currency and then a reset and a change of system. This is also something that politicians, getting closer to that end game, seem to be a driving force in because it gets them elected.

The MMT, Modern Monetary Theory, aka ‘Magic Money Tree,’ is exactly what gets you the votes right now. If you are saying that we’re doing tax cuts and we’re helping Wall Street and all of that and we’re doing more quantitative easing and debt monetization which causes asset price inflation, that just widens the wealth gap, in my opinion. So, it probably doesn’t get you a lot of votes. But doing the spending on different things, giving it away in a helicopter type of way, that is what probably gets you elected.

I agree with you, Erik, it will probably be a couple of years but, eventually, it will create the velocity and it will create the spending of Main Street so that we start competing for assets, daily livelihood assets, and then prices start rising. That is kind of like when the train has left the station. It becomes faster and faster and faster and, at the end, there’s complete devaluation of the currency and you need to start over again.

Probably this is when you can start with a digital currency. If I put myself in the shoes of the politicians saying, “Hey, let’s do this crypto digital kind of central bank reserve currency right now,” it probably doesn’t get you any votes, right? If it’s any type of hard cryptocurrency you need to make it like bitcoin, there needs to be a cap in the amount of coins so that they can’t be inflated away and all of that.

That is not what politicians want. Politicians want to be able to spend money and expand the budget and react flexibly to things. So, probably they’re not going to do it right now. They first need to crash the currency, the U.S. dollar, or whatever currency it is that we have, and then do it.

[00:21:13] Erik

I agree, and I think we should also make an important distinction about MMT because I have been criticized, legitimately, before for equating what politicians will do with what some of the proponents of the actual theory of Modern Monetary Theory have done.

So, let’s distinguish MMT, Modern Monetary Theory. The PhD.s who came up with that stuff are very smart people. They’re very acutely aware of inflation risk. They really do understand it. They know it is a major concern.

Then there is the ‘Magic Money Tree’ version of MMT, which is the way the politicians see it. They just look at all the work of those PhD.s as, “OK, it’s a body of complicated stuff that I don’t understand, that the voters don’t understand, that I can use to justify why I should just spend ridiculous amounts of money on helicopter programs, whether it be universal basic income, socialized medicine, all of the different things that you want to provide – essentially, free services to everybody to get more votes with.”

That form of MMT, the ‘Magic Money on Trees,’ is really not what the academics who came up with Modern Monetary Theory intended but that’s the way it is going to be bastardized and used. That’s the concern that I have.

So, I just want to be fair to the people who invented Modern Monetary Theory to recognize that we’re making a jump there, not from what they prescribed, but rather to what politicians will interpret from their prescriptions which I think is going to be runaway spending that eventually leads to runaway inflation.

Coming back to the digital currency side of this, I think it’s a question of motivation. In western societies, as you say, there is really no motivation for western politicians to want to say, “Let’s have France come up with a digital reserve currency to replace the dollar.” Why would any French politician expect to get votes from doing that? It doesn’t make any sense.

The motive is for the eastern countries, that are sick of the U.S. having hegemony over the entire global financial system, that the people who have seen that as an injustice for decades, that have been trying to figure out, “What can we do about it?” So, we’re primarily talking about China and Russia.

If you are China and Russia, first of all, you don’t care about votes because you rule through fear and intimidation, not through democracy. What you care about is shifting power from the west back to the east. Certainly, in China, their view of the world is that China has been the economic center of the universe for the last four thousand years with the singular small exception of just the last few hundred years which were an unfortunate anomaly that needs to be corrected.

The way that I think they see (and it’s the reason PBOC is working so hard on their digital currency efforts) they have got a long term plan. They are saying, “OK, what is going to happen here is that Western economies are going to ruin themselves. They’re going to go to the ‘Magic Money Tree’ version of MMT. Both Europe and the United States are going to conjure money out of thin air for helicopter money programs. They’re eventually going to bankrupt their economies. They’re eventually going to get to runaway inflation, destroying their economies.

When that happens (we’ll let them dig their own grave because we don’t have the military wherewithal to put them in a grave as much as we might like to), we’ll let them dig their own grave. Once they have dug their own grave and they’re on the airy edge of falling into it because they’ve created inflation, we’re going to be ready with the new digital currency system which serves as the entire planet’s global reserve system for the next hundred years.

We’re going to start working now to plan to be ready to seize that moment when it comes to us when western society screws itself over by putting itself into a very difficult economic situation as a result of these other trends that we’re talking about.”

So, that’s what I think is going on already. You see, for awhile Russia was fairly outspoken with Sergey Glazyev talking about dedolarization, going to blockchain conferences, giving keynote addresses, and so forth, that has all gone silent now. I don’t think they lost interest. I think they decided to stop publicizing their intentions.

I think that China and Russia are very interested in sovereign digital currency, not tomorrow, not next week, not next month but building and designing the system that they will be ready to use to seize opportunity several years into the future after western civilization has put itself in a very vulnerable position as a result of runaway inflation.

[00:26:02] Niels

There are a few things that I want to come back to, Erik, but just to stay on that point, you were very early on the CoronaVirus and the potential damage that that would do especially with Chris Martenson, I think it was, from Peak Prosperity, where you did a lot of great interviews. As you just said, perhaps China is just waiting for the western world to start introducing MMT and eventually the beginning of the end of the way our capital system works. If that is the case, they have certainly helped along (if we are to at least acknowledge that the virus possibly started in China but we got the worst of it), that certainly has accelerated our adaptation of MMT, you could say, with all of these Care Acts and other things that have been put in place around the western world.

I can’t help wanting to ask you what you think, now that it has been three or four months since you started (or five months) since you started talking about COVID 19, is this part of a bigger plan, frankly? We may not necessarily all get invaded by China but are we headed for the Chinese model? Is that the model that someone around the world wants to impose on other parts of the world if I can put it that way?

[00:27:23] Erik

Well, first of all, I am not aware of any compelling evidence to say that… Although I do think there is compelling evidence that the virus, itself, was lab-made. All the evidence that I have seen suggests an accidental leak of a virus out of a research laboratory by mistake. I don’t think that this was China intentionally unleashing a virus to damage the west or anything like that. I think that that would have been way too risky of a move. It would not be consistent with China’s decision making strategy and everything I’ve seen about the way that they do things. So, I don’t think there is any truth to China released Covid 19 on the world intentionally.

[00:28:03] Niels

By the way, let me just stop you there, Erik, because I kind of agree, so I want to make it clear that some of the theories that you hear about, and people talk about, it’s not necessarily China, as a country, it is the Chinese model. It may be something that people (how should I put it) the people who may want to change the world to a ‘new world order’ (as Ray Dalio talks about) may not be Chinese per se, they could be people sitting around the globe but it’s the Chinese model where the digital currency actually would fit in very neatly because it helps and it makes it easier to control things.

[00:28:43] Erik

Well yes, and I think that the trend that most people don’t even think about, because we tend to think only in the scope of timeframes around our own human lifetime. It seems to us like, obviously, the west – the leaders of the world, and China was this rinky-dink little third world country with guys with funny hats bent over in rice paddies, that somehow came around to develop (probably because we were outsourcing our manufacturing to them) developed a real economy very quickly and surprised a lot of people. That’s not the Chinese view.

The Chinese view is that, first of all, China is an English word. The Chinese word for China, Zhongguo, translates literally to ‘central nation’. The center of the universe is China. That’s what it is all about. For four thousand years China has been the economic center of the world. The big dog in the game has always been China. For the last two or three hundred years something went wrong and China fell off of its perch of leadership, domination globally of the global economy and that needs to be fixed is the way that they see it.

The racism and the superiority complex of the Chinese culture are not at all… They don’t think of themselves as little underdogs that are trying to keep up with the west. They see themselves as the superior culture that, rightfully, is supposed to run the world and something went wrong for the last couple of hundred years and it needs to be fixed. So, it’s a very different perspective than we’re used to.

It’s also a part of the world where governments control through force rather than through democracy. What they’re, at this point, beholding to is that we have a global economy where those currencies, the Chinese Yuan and the Russian Ruble, are not particularly strong. As much as they would like to compete with the U.S. dollar to replace the U.S. dollar with their currency being the global reserve instead of the U.S. dollar getting all of the benefits of being the global reserve currency, there is no way that the Ruble or the Yuan are ever going to replace the dollar on the global stage is what central bankers would prefer to denominate their reserve assets in.

Now, if you can leapfrog all fiat currencies with a technology benefit and say, “Wait a minute, we’re going to come along with this sovereign digital currency stuff which is much better than fiat currency and offers a huge number of benefits that were never possible with paper money, and, all of a sudden, we’re the only show in town. Nobody else has got it.” Well, bitcoin and those guys kind of invented the underlying technologies that make it possible but they’re not sovereign actors.

Russia and China, in a coalition, were working together, “We’ve come up with this new currency.” Maybe they have backed it with gold in order to make it more compelling and it’s a digital currency that offers a whole bunch of benefits that are not possible with any fiat paper money currency.

In my book, I had several chapters talking about some of the possibilities of how they might make, through technological superiority, how they might provide benefits that attract central bankers to want to use their currency instead of the dollar. We need something on that level to create an upset event. Until that happens the U.S. dollar, just through its network effect, it’s got a monopoly. There’s no way to unseat the U.S. dollar as the world’s global reserve currency until you come up with something better.

So, how is anybody going to come up with something better? I think digital reserve currency will be the future but that solves a set of problems that we don’t really have or we don’t perceive that we have quite yet. When we have runaway inflation and fiat currencies are collapsing and somebody has got a digital currency solution that starts to solve those problems and offers other benefits and is backed by gold, all of a sudden it becomes a slam dunk.

I think that both Russia and China are smart enough to see all of this. One of the ways that they beat the U.S. consistently is that they know they can’t win in the short term. It’s the way the Hong Kong deal happened. they said, “We cannot possibly fight with the U.K. in the short term over Hong Kong, Let’s give the U.K. what they want now, and we’ll think in the long term. We’ll make a deal that says we get to keep Hong Kong fifty years from now after Margaret Thatcher is dead and buried and doesn’t care about her public perception anymore. We’ll negotiate the deal that way.” They think in a much longer timeframe.

I think that Russia and China are both thinking, not about how do we compete with the U.S. dollar right now, because they’re smart enough to know that’s a game they cannot win. What they’re doing is they’re trying to get ready to be in a position to seize the opportunity when western fiat currencies start to collapse under their own weight with runaway inflation, which I think is coming in the next decade, maybe even sooner and I think they know that too.

[00:34:11] Rob

So, I’m British and the British pound used to be the world’s reserve currency. It didn’t stop being the world’s reserve currency because we had massive inflation in our country which wasn’t replicated elsewhere, it was really because our share of global trade fell. That is, I think, the channel by which currencies get replaced. If China is doing a huge portion of the world’s trade, at some point they can probably say, “Hey guys, if you want to buy stuff from us you’re going to have to pay in this new currency that we’ve just come up with.” The same goes for Russia.

So I guess… Do you see the direction that China and maybe Russia is headed in where they have taken a larger and larger portion of global trade? So, for Russia, that depends really on where the oil price is. The oil price, now, is pretty low. So, I guess Russia really hasn’t got as much economic leverage as it would have had, say, fifteen years ago. China has benefited from this global deflationary trend that you talked about. That’s really what drove people to buy from China is the fact that it was getting cheaper and cheaper. Again, if that trend reverses will China really have the leverage necessary to actually push through this reserve currency?

[00:35:20] Erik

Well, first of all, I see things a little bit differently than you described. I think trade is very important but, frankly, military hegemony has been the primary determinant of reserve currency status. The British Empire was the unquestioned military authority over the world for centuries. That really, in my mind, is what led to the Pound Sterling’s dominance. It was after World War II when the U.K. lay largely in ruin after World War II and the U.S. had never suffered any attack on its own soil other than Hawaii. At that point, the world’s choice of the U.S. dollar as the world reserve currency, in 1944, was pretty darn clear.

I think that what is happening is that Russia was already a superpower, or I should say the Soviet Union was a nuclear superpower. When the Soviet Union collapsed economically, it was pretty clear that Russia would eventually inherit those nuclear weapons. But, we went through a period of disarray where Russia was just struggling to get its act together and figure out who was in charge of the country. They have got their act together now. The Russian military is very well established. They are a nuclear superpower. It looks like they are a leading superpower in the sense of hypersonic weapons that the U.S. doesn’t have and that Russia, apparently, does have.

China, at the same time, is also not only a leader in some of this weapons development but they’re building out their blue water navy. Their building more aircraft carriers and, particularly, China is reported to have invested very heavily in so-called carrier killer missiles – missiles that are designed specifically to be able to sink a U.S. aircraft carrier. The U.S. aircraft carriers are the mechanism through which the United States military projects force all around the world. It was, generally, assumed that it was an invincible force for the last fifty years or so.

Now it’s believed, by most military analysts, that either China or Russia, by themselves(never mind what they could accomplish if they were working together), have the ability, especially in a surprise attack, to sink U.S. aircraft carriers and disable the U.S. ability to project power and to have military hegemony. So, I think that the military force aspect of it also sets the stage but, mostly, these things tend to change when there is a breakdown when there is a problem.

At the end of World War II with the U.K. very heavily damaged, and the U.S. not damaged, you had a really strong argument, which is that the other central bankers around the world could say, “Look, if we pick U.S. Treasury bonds, or if we pick Guilts, we know the U.S. is not laying in ruin. Now, it looks like the U.K. is going to recover. It looks like they’re going to be fine but we don’t know that yet. We know the U.S. is a safe bet.”

So, there was a really clear-cut choice there. I think it is when you get to that next clear cut choice moment, when could that happen? If the Euro and the Yen and the Dollar are all (who knows what they’re doing relative to each other), crashing relative to gold, and there is runaway inflation and purchasing power of those fiat currencies is crashing; if you’ve got a digital currency particularly a gold-backed digital currency (sovereign digital currency), you’ve got potentially that 1944 moment to say, “Hey, world, look at us. We’ve got something which is clearly a better choice.”

By the way, if they also have those trade benefits that you described of being able to say, “We’re producing most of the stuff that the world consumes and we get to set our terms. You’re going to pay us in this new sovereign digital currency rather you like it or not.” Then they are able to really force the world’s hand at that point. We haven’t gotten there yet but I think that’s where we’re eventually headed.

[00:39:15] Moritz

If the currency is backed by gold or any other asset, the money supply can no longer expand. This is what I think is what most of those central banks and politicians are after. They want that. They want to be able to expand the money supply to direct to changing economic development. So, they’re cutting off their own leg with that. I don’t think it will last long.

[00:39:40] Erik

Well, I couldn’t agree more in the sense that if you were to try to introduce a gold-backed digital currency right now, and introduce it to the west, it would completely defeat the whole ability of politicians to do what they want to do most which is MMT (the Magic Money Tree version of MMT), and providing helicopter money and so forth. So, I agree with you. It completely undermines their ability to do what they want the most. It’s not salable right now.

If you let that process play out though and you allow them to go to Magic Money Tree printing with fiat currency, until you get runaway inflation across all western nations to the point where it’s leading to an economic crisis, then when somebody is stepping in and saying, “Hey guys, that whole unlimited fiat, unlimited money supply thing didn’t work out very well. We’ve got a superior solution over here.”

I don’t think it is necessarily purely gold-backed. I think there’s a way to do a partial backing at gold redeemability without having full backing. So, you still get some degree of money supply expansion capability in a sovereign digital currency. At least by having a gold redeemability, even if it’s not a full backing (kind of like the post Brenton Woods), all of a sudden, there’s not really a backing of dollars to gold but at least there’s a perception that gold can be converted into dollars, or rather that dollars can be converted into gold, then it provides a certain degree of confidence, which in the case of Brenton Woods lasted for thirty years or so before it fell apart.

From 1944 you didn’t have the backing of a certain amount of gold for every dollar. They could expand the dollar money supply but there was still convertibility to gold. Until that system failed because inflation had led to the point where the dollars were just not worth the gold that they were redeemable for, you got from 1944 to 1971 before it all fell apart. I think that there is room for a gold redeemable digital sovereign currency to have an expandable money supply while still being redeemable for gold for awhile, quite a while.

[00:42:00] Moritz

One more thing on gold because I find that really fascinating and interesting, probably, all of us were long gold in some shape or form, either physical or through our trading programs or whatever the case may be. I’m certainly long gold, right? When you look back over history with all the currency valuation that has taken place, gold has always come out as the winner. Hyperinflation happens, you’re long gold, you’re kind of protected. So, gold was never confiscated. It was forced by the U.S. that you should be turning it in at a certain price and those types of things. There are all these political mechanisms going on.

My view for the next… This is just a guess but, say that we’re getting into this inflationary environment and gold will become a strongly performing asset (which is kind of what we expect) say, for the next ten years or so. Let’s be long gold.

But now this new super-strong digital currency, this super government-backed digital currency comes along to replace the U.S. dollar and other paper currencies. What will the price of that gold then be? A hundred years ago, when it happened the last time, you know, the Great Depression, no cryptocurrency existed. Computers didn’t exist, so there was no alternative. Really, the only thing to go to was gold.

Ten years from now, if we’re real about it, we don’t really use gold for that much except for jewelry. Some people get their teeth done. But apart from that, it’s really just this money thing, this money metal which you put in a safe and that’s about it. If you don’t need it for your teeth and if you don’t need it for jewelry that much, maybe the value of gold will become very little once the super currency (digital currency) is with us.

[00:43:41] Erik

Well, I think it really depends. If you have a government-created digital currency system it’s not going to win the favor of the gold bugs in the way that something like bitcoin does, today. I think that bitcoin will still have a role then. The current generation of cryptocurrencies which are designed to be government proof, they’re always going to have a role, at least to the extent that they’re allowed to exist. They’ll appeal to people who want to be government proof.

I think that what governments are going assert is not a government proof digital currency but a digital currency which is designed to do the opposite of what bitcoin does; that’s designed to be traceable, to give the government full visibility into everyone’s financial affairs so that they can trace every transaction, every penny of wealth that exists on the planet. The government knows who owns it, where they got it from when they got it, and under what conditions they got it. That’s what governments are going to want to get to.

I don’t think that that form of digital currency, even though it will be forced on society and it will probably become the dominant money system in the world, I don’t think it’s going to win a whole lot of fans in the gold bug community. There will be a lot of us that are forced to use it, but I don’t think that it’s going to have the bitcoin-like effect of competing with gold as a scarcity asset.

[00:45:03] Niels

Now, in fear of spoiling the gold party, I will just say that I do see some people that I respect, as well in terms of technical analysis, that are not that bullish on gold right now because they see what has happened in the last few years as a big correction from the high of whatever it was (nineteen hundred down to one thousand and something). Then we’ve had this big recovery, almost back to the old highs, but not quite. We need the last leg down (the C correction down) before maybe the party can really start. But I don’t want to go into more gold because we’ve got so many other things and we’ve got so little time with you, Erik, today.

I want to shift gears just a little bit. We talk about that a lot of things are likely to happen in the next decade or so – five, ten years. I can’t help thinking that some of the things (and that a lot of things in general) seem to go in cycles. We talk about that. We see it in the markets and, even though the dollar is the world reserve currency, it can certainly have a period of years where it gets weakened even without it losing that status. So, time will tell.

What I can’t help thinking of, in the world that we’ve been discussing in some of our weekly podcasts here, is the work of Neil Howe and the fourth turning. Of course, I know you, Erik, are familiar with this as well. It fits into what he predicted, some thirty years ago when they wrote the book, that this part of the decade… So, the fourth turning already started in 2008 but it is actually the last part of the fourth turning (so the last ten years, which is from now until about 2030), that does the most damage. Even though the initial part of the fourth turning can be with a huge crisis, as we saw in 2008, the crisis that comes at the end of the fourth turning is usually much bigger. We know, historically, this has led to world wars, revolutions, civil wars, etc., etc.

So, you’ve touched on this already, to some extent. Is this whole reset, is this “just” part (I say just in quotation), is this “just” part of the normal evolution and fits completely into the demography and what is coming in the fourth turning?

[00:47:27] Erik

Oh, I absolutely think it is. I think everything that we’re seeing in terms of civil unrest around the world, I think that the widespread popular rejection of capitalism, mostly by people who don’t understand what capitalism is, they still do correctly understand that something is unjust in the world. I think they’re unfairly labeling capitalism as the problem when it’s not really the problem.

The current system, which is more cronyism than capitalism, the people of the world are pissed off. They’re sick of it. I think that what we’ll see over the next ten years is a major change. It’s exactly consistent with what Neil Howe tells us to expect from a fourth turning.

The resolution of this fourth turning will be probably a new model which is not capitalism as we have known it. It’s not socialism as was practiced by the Soviet Union, say. It’s some new version that I think has a lot more in facilitating wealth redistribution. I think there are a lot of changes that are coming along those lines. Exactly how it gets resolved, I have no idea.

You can’t know at the beginning of the revolution how the revolution is going to play out. But we’re in a revolution scale event. This fourth turning is a big deal, just as every fourth turning is. I think we’re seeing the beginnings of the battle lines being drawn as far as what is going to be fought over and it’s about wealth inequality; it’s about class inequality; it’s about east versus west and the tensions between the eastern societies and western societies. All of these things are going to get resolved in the next ten years and then we’re going to get to a point, one way or another, where it’s pretty clear that we have a new system and the first turning starts around 2030.

[00:49:19] Niels

Yeah, absolutely. One thing I also just wanted to ask you, this is not necessarily from the work of the fourth turning, but another guy that I have certainly followed from time to time, I’m sure you’re also familiar with, which is Martin Armstrong, he also talks about cycles. He has his own business cycle or economic cycle and all sorts of cycles. One of the things that he has talked about and written about extensively for many years is that we, at some point, are going to see this shift from public to private.

Part of the, maybe, resolution or the trigger of all of this is the fact that we will lose faith in politicians; we’ll lose faith in these institutions like the Federal Reserve, the ECB, etc., etc., and against all, maybe, normal intuition where we feel that we’re going to be safe by buying government bonds, government bonds are actually the one thing that is going to take most of the damage, so to speak, which will probably cripple the pension fund system and then that’s going to need another bailout. Actually, it may lead (I don’t know if I believe in this yet) but actually, counter-intuitively, it may lead to people seeking safety in equities. What do you think about that? Also, because I do want to spend the last few minutes we have with you to talk a little bit about the markets and where we may see some of these things play out.

[00:50:49] Erik

Well, Martin Armstrong’s argument, which he has made for several years now, has been that as crazy as it seems the equity market, the stock market, becomes the safety trade where there is nothing else better. I think real estate has the potential to make a comeback too. We’ve been through a pretty big real estate cycle. I think that hard assets ought to benefit better even though, in some ways, fractional ownership of a corporation is a hard asset. A corporation is a real thing that makes money, but still, it’s a financial asset, it’s a stock certificate that’s part of a system, and if that system falls apart the benefit of owning that stock certificate is dubious. Whereas, if you have got farmland that is being used to produce food that everyone’s well being is dependent on, that’s an asset that plays a more strategic role.

I think that as we get more overcrowding of the planet with population expansion, things like farmland, that are essential. Things like water; businesses that provide (whether it’s technology companies that are producing reverse osmosis desalinization equipment, or whether it is actual resources – reservoirs and so forth that are securitized someway) natural resources that are essential to the well being of the planet like farmland, agriculture that are needed in order to produce food for everyone to eat, those are things that are absolutely essential parts of the economy no matter what happens.

On the other hand, things like the phenomenon of tech stocks like Apple and Google being half of the value of the stock market, can that really last forever? I don’t think so. So, I think it’s a question of which parts of the equity market you’re talking about. I do think that we have been through a major cycle for the last fifty years, approximately, of financialization of the economy. I think it has gone too far and the pendulum has to swing the other way.

Well, how do you definancialize a financialized economy? Well, we have never had a financialized economy like this before, so, I think it’s an open question as to what it means to go too far and to see an unwind of the financialization that has occurred since the late ’70s.

I think it has gone about as far as it can go, now, in terms of financial assets really being everything and CDO2, these esoteric bizarre contraptions of holding instruments that hold obligations that are three levels of derivative product away from the actual mortgage loan, which is just a loan on a real property that exists somewhere. We’re so far down this path of finacialization and derivatives. We have to, at some point, get back to hard assets and real stuff matters again. How does that play out? I’m not sure.

Does the stock market win? Does real estate win? Are gold and other commodities the winner? I’m not sure.

[00:53:59] Rob

I think also that hard assets like property are probably also a better inflation hedge than equities. Referring your earlier argument, whereas, equities only really are good inflation hedge if firms pricing power. I just want to pick up on your point about the complexity of financialization. I used to work for an investment bank. One of the things I used to do was hedge and trade structure products that were, obviously, risk for the client. The clients were buying all of these kinds of crazy things. Isn’t this increased complexity of markets just a kind of natural human phenomenon? Is it really something that can be reversed even if, perhaps I kind of agree with you, it should be reversed?

[00:54:40] Erik

Well, I think there is a natural human phenomenon which that, to the extent that there is spare capacity in the economy. In other words, three hundred years ago everybody worked on farms because the only way to produce enough food for everybody to eat was for all of the people on the planet to work on farms. Now we have gotten to the level of societal complexity where only a very small handful of people need to work on farms and the rest of us can do other things.

So, as you have all of this spare cash flow (if you will) what happens is that financialization and also technology are organized to capitalize on it. So, you create these financialized products to basically say (the investment bankers that are doing this stuff), “I want a bigger slice of the pie than the farmers get.”

By the way, the other side of that is the technology guys, who can figure out how to design the next IPad or whatever that fascinates people and gives them social media or something, their basic human needs of water and food and shelter were already met. They have got spare financial capacity. Technology and financialization are the two big trends that absorb that spare capacity of extra money that exists in the economy.

The question is, do you always have that spare capacity of extra money for technology and bankers to absorb? As soon as you don’t have that spare capacity, that spare money, I think that technology and financialization suffer immensely because people are forced back to what is actually important, which is food to eat, shelter to live in. So, real estate does well; real property does well that actually houses people, but financialization and the latest Silicon Valley upstart that’s doing some different version of social media instead of Snapchat with pictures, now it’s videos, now it’s whatever comes next after videos, it’s 3D holograms on the next social media channel. All of that stuff can go away if people are hungry and need to eat. We’ll forget about all of that stuff.

We haven’t had that problem yet, but I think that as we get to runaway inflation and other economic problems and a failure of fiat currency systems, we probably are going to have some degree of depression where we don’t have unlimited amounts of money to feed Silicon Valley and investment bankers with.

[00:57:14] Rob

Maybe, before we close off, let’s get a bit more micro in our macro discussion. We’re living in a pandemic. That’s a fact, but the V-shaped recovery is also a fact, at least as far as the stock market is concerned. A case in point, today, when I look at the S&P 500 it was down more than 2% and then it did a complete U-turn. We’re not trading up twenty basis points. So, no matter what happens in the world, what new type of virus or second wave rumors seem to come up, it doesn’t seem to bother the stock market the slightest. Where do you think are we with equities at the current moment?

[00:57:51] Erik

Well, I think that the V-shaped recovery is in financial markets, it’s not in the real economy. We still have people that are stuck at home. We’ve got a huge number of businesses that are put out of business – something like half of the restaurants in the United States are expected to never reopen again under their current ownership. Some of those properties will become restaurants that somebody else starts someday. There is massive economic damage and the question that you have to ask yourself is, “OK, if there is not a V-shaped recovery of the economy, what the heck is going on in financial markets?

I think the answer is pretty clear. The financial markets have learned to anticipate central bank accommodation and to price assets for the inflation that will occur as a result of that accommodation. When I say inflation I mean asset price inflation.

So, I think that what is going on is the trillions of dollars of both monetary policy accommodation and fiscal policy accommodation, that have already been announced in the wake of the CoronaVirus crisis, are driving a V-shaped recovery of assets which is completely disconnected from the real economy. Now, I would argue that the stock market for the last decade has been, largely, disconnected from the real economy.

So, I don’t see why stocks can’t continue to go much higher, back to new all-time highs, perhaps even accelerating their climb beyond just new all-time highs. Maybe we’re looking at four thousand on the S&P before Christmas. It’s not because we have recovered from the CoronaVirus and everything is fine, it’s because we’re conjuring trillions of dollars out of thin air which will eventually serve to debase the purchasing value of all dollars and lead to, probably, an inflationary depression at some point. But, these things have long lag times. So, for now, what you’re seeing is big asset price inflation.

[00:59:44] Niels

And, of course, there is another V that we’re seeing right now, coming back to make a good comeback, and that is volatility. That’s probably also something that is here to stay. I want to put in a final question to summarize a little bit of the things that we have talked about today, as we want to respect your time. That is, putting all of this together, Erik, you’re an investor yourself besides being a great podcast host, how should people invest in today’s world?

[01:00:13] Erik

I think you absolutely have to love precious metals in the long term with a really big caveat: as you said, there is a good technical argument that we’re way overdue for a major, major technical correction, maybe even down to a new cycle low below a thousand.

So, you can’t afford to be using a whole lot of leverage here and really taking a levered position in precious metals because that potentially is a recipe for self-destruction. Short of that, I think you definitely want to be overweight precious metals.

You want to be starting to think about other inflation hedges like real estate and I think that you have got to expect that the rules of the game are going to be changing. We’re moving from a political backdrop which was generally supportive, at least in the United States, of ‘everybody is entitled to keep the money that they made in their investments and their businesses and so forth’. We’re moving to a political environment where more and more people want to see the government’s role is redistribution of wealth.

So, I think you have got to assume that your tax burden is going to be higher. If you’re fortunate enough to be investing in the first place, you have got more money than most of the people around you in society. I think the rules are going to change and you should start to just accept, whether you agree with it or not, that like it or not the rules are going to change to where some of your money is going to be given to the people around you because they need it more than you do.

Some people, I’m sure, listeners will think that’s long overdue, others will think it’s a great travesty of justice. My point is don’t spend too much time worrying about how you feel about it because you can’t change it. That’s just the trend that society is on whether we like it or not.

I think that productive real assets and productive businesses, there’s an argument for private equity, I think, for smaller companies as we get out of this financialization trend. I’m not sure what the time horizon is for financialization winding down. It may have a ways to go before it peaks but, at some point, I think that private equity as opposed to public equity investments is going to make more sense.

I think, mostly, we need to be ready for difficult times ahead. We are in a fourth turning. This is the same season of history that World War II happened in. It’s the same season of history that the Great Depression happened in. It’s the same season of history that the Civil War happened in. We’re headed for some difficult times in the 2020s and I think that there are lots of reasons to be just uber-duber bullish what starts in the early 2030s. I think it’s going to be amazing. Between now and then put your seatbelt on, there could be some rough turbulence ahead.

[01:03:04] Niels

Yeah, on that note, Erik, we want to say thanks ever so much for spending some time with us. We really appreciate it, as I’m sure all of our listeners do. By the way, make sure that you go and check out Erik’s own awesome podcast, MacroVoices. I’m sure most of you know that already. From Rob, Moritz, and me thanks so much for listening and we look forward to being back with you with the next episode of our Global Macro Miniseries. In the meantime be well.

[01:03:31] Ending

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