Richard Duncan - Ideas Lab Series - October 19th, 2022

[00:00:00] Richard

As we do, we will transform our economy and shore up our national security, and make the economy grow faster, and grow out of the current debt problems. Moreover, it will ensure that Creditism survives. It will keep credit from contracting and collapsing into a great depression. The kicker is that it will result in just the most extraordinary technological and medical breakthroughs. It really is possible that with this level of investment, we could cure all the diseases and expand life expectancy by decades.

[00:00:45] Introduction

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level. Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also, understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:36] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely Kevin Coldiron, to host a series of in-depth conversations to help uncover and explain new ideas to make you a better investor.

In this series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it, so that we can all successfully navigate the challenges within it. With that, please welcome Kevin Coldiron.

[00:02:17] Kevin

All right thanks, Niels, and welcome everyone to episode number nine of the Ideas Lab series. We’re going to try to do three things today. One, Introduce you to a new way of thinking about how our modern economy grows. Some of you aren’t going to like it, you might not agree with it or you might agree with it and still wish it didn’t work that way, but that’s number one. Number two, we’re going to use that as a lens to examine where we are now and what’s likely to happen over the next year or so. Three, we’re going to discuss a proposal that our guest has for putting the U.S. on a more stable and sustainable growth path. The person who’s going to lead us through this is Richard Duncan.

Richard is the author of a new book called, The Money Revolution: How to Finance the Next American Century. He’s actually written three other books, including one called The Dollar Crisis, which became an international bestseller. He was also the head of investment Strategy at ABN AMRO in London. He was head of equity research at James Capel and Salomon Brothers in Bangkok, and has worked for both the World Bank and the IMF. Currently, he publishes a bimonthly videos newsletter for clients called Macro Watch, which he started in 2013. Really the only negative thing that I could dig up about him was that his alma mater, Vanderbilt University, consistently has one of the worst American college football teams out there. Which I can assure our non-U.S. listeners is extremely important. But luckily the coach of Vanderbilt moved to my alma mater Penn. State nine years ago, and has since turned us into a contender. Richard, I thank you for that and I welcome you to the Ideas Lab. 

[00:04:5] Richard

Kevin, thank you very much for having me on, and my apologies for Vanderbilt’s poor performance on the football field.

[00:04:23] Kevin:

As long as it doesn’t affect Penn. State, I’m fine. 

I wanted to start off with the question about your book. It’s called The Money Revolution, and I’m curious about the title. From reading the book, it seemed to me that the word revolution could be a reference to what’s already happened – a revolution that’s already happened. Basically, the decoupling of the dollar from gold back in 1971. Or it could be a reference to a revolution that’s coming. New ways to finance growth. I was just curious, is it one or both of those, or neither? How did you choose the title? 

[00:05:02] Richard

So actually it’s a combination of those things.

I believe that this money revolution was sparked off when the United States stopped backing dollars with gold. Up until 1968 there was a law that required the Fed to maintain gold backing for all of the dollars that it issued. But that year, it didn’t have enough gold to continue issuing more dollars.

So Congress changed the law, and afterwards the Fed was no longer required to hold any gold to back the dollars that had issued. Three years later, in 1971, the United States stopped allowing other countries to convert their dollars into gold. When that happened, the money revolution began, I argue in the book. Here’s why, it fundamentally changed the way our economic system works. So, if I may, let me elaborate. 

[00:05:56] Kevin

Please. 

[00:05:57] Richard

First of all, of course, it meant that afterwards the Fed was free to create as many dollars as it dared. The only real constraint it had to worry about was if it created so many dollars that it led to high rates of inflation.

Now, a second thing changed, once the U.S. was no longer backing dollars with gold, trade between nations no longer had to balance. When the U.S. was on a gold backed monetary system, the Brenton Wood system (or before that the gold standard), trade between nations had to balance. Here’s why. For example, in the 19th century, if England had a very big trade deficit with France, then England’s gold would literally have been put on a ship and sent over to France.

Since gold was money, England’s money supply would’ve contracted and they would’ve had a very severe recession. Unemployment would’ve gone up and they would’ve had deflation. The opposite would’ve happened in France. France would’ve had more gold, more money. Credit would’ve expanded, the economy would’ve boomed, they would’ve had inflation.

England would’ve simply run out of money, so they wouldn’t have been able to continue having a trade deficit. Trade would’ve come back into balance and all the more so, because France would’ve had more money, so it would’ve started buying more cheap English goods. The English, with less money, would’ve stopped buying so many expensive French goods and trade would’ve come back into balance again. There was an automatic adjustment mechanism, under the gold standard that ensured that trade between nations had to balance. That’s the way global trade worked up until the Brenton Wood System broke down in 1971. 

Afterwards though, things changed radically. It took the U.S. a little while to discover this, but starting in the early 1980s, it started running very large trade deficits with the rest of the world. With Japan and Germany in particular. By the middle of the 1980s the U.S. trade deficit, as a percentage of GDP, had gone from zero effectively to three and a half percent of GDP by the mid eighties. This was totally unprecedented. Nothing like this had ever occurred before, and it was so alarming that the global policy makers met at the Plaza Hotel in New York and reached the Plaza Accord and devalued the dollar by 50% against the yen and the mark.

 That was enough to bring trade back into balance for a few years around 1990. But then China entered the global economy, and other very low wage countries, and the United States started running even bigger trade deficits with these new trading partners. By 2006, the U.S. trade deficit had blown out to $800 billion that year. That was 6% of U.S. GDP. 

Now, why this is significant is as follows, when trade had to balance, that meant if the U.S. government had very large budget deficits and over stimulated the U.S. economy, and if the Fed created too much money and over stimulated the U.S. economy, then very quickly the U.S. economy would run up against domestic bottlenecks. There would be full employment and full industrial capacity utilization. All the car factories would be working flat out. Steel factories would be producing as much steel as they could. We would see wages rise and the cost of manufactured goods rise. This would lead to a wage push inflation spiral like we saw in the beginning of the late sixties, but mostly in the 1970s.

Once trade stopped balancing, however, this allowed the United States to circumvent all the domestic bottlenecks. Suddenly we were no longer dealing with an economy, with (let’s say) 100 million people in the workforce. We had a global economy with billions of people in the workforce, most of whom were earning far, far less than the Americans were.

In 1990, the Chinese were probably earning 5% as much as the average American. So, suddenly there were no longer domestic bottlenecks (supply chain bottlenecks) and globalization, it was the age of globalization, occurred. This was extremely deflationary because as the United States started buying more and more goods from countries with ultra low wages, that pushed down the price of manufactured goods, and it also pushed down wages in the U.S.

As a result of this, we saw inflation fall from the mid double digits, 15% or even more in the early 1980s, it fell, and it fell, and it fell, and turned negative in the years leading up to the COVID pandemic. So, this changed everything. What it meant was that the U.S. government was suddenly able to run much larger budget deficits than it had ever done before, and finance them at very low interest rates because the low inflation meant that the interest rates came down to extremely low levels.

In 2008, in that crisis, the government was able to respond with trillion dollar budget deficits for four years in a row, much higher than ever before. The Fed financed much of that with new paper money creation through three rounds of quantitative easing. We still didn’t have high rates of inflation. That’s the second thing that changed – globalization was extremely disinflationary. 

The third thing, that I’ve already touched on a bit, was that with globalization and extremely low inflation, the U.S. government was able to borrow more than it had done in the past without pushing up interest rates. When gold was backed by money and the Fed couldn’t create as much of it as it wanted, if the government borrowed a lot of money, it would (given that there was a fixed amount of money), that would push up interest rates. It would crowd out the private sector. There was only a certain amount of money. So, if the government borrowed a lot of it, that would push up the price of borrowing money and that would crowd out the private sector.

Again, once the Fed was free to create as much money as it pleased, and buy a lot of government bonds, then this enabled the U.S. government to borrow much more and spend much more (for instance, stimulating the economy after the crisis of 2008) without leading to higher interest rates, because the Fed was financing the government borrowing.

Then one final point that’s also very important. At the same time, after dollars ceased to be backed by gold, credit exploded in the United States. Now, it wasn’t just the end of gold backing for the dollar, there were also regulatory changes, but credit growth really exploded, especially after the 1970s. For instance, total debt and total credit are two sides of the same coin. One person’s debt is another person’s asset, right? 

So what I’m talking about here is the total debt of the country; not just the government debt, but household sector debt, corporate debt, financial sector debt, non corporate business debt, all the debt in the country. That first went through 1 trillion dollars in 1964 when I was three years old. By 2008, it had expanded 53 times to $53 trillion, and now is $91 trillion. Credit growth, as a percentage of GDP (total credit to GDP) went from something like 130% in 1950 to 180% in 1980. Then, when these changes kicked in (that I just described), it went from 180% in 1980 to 380% now.

Credit exploded and it became the main driver of economic growth. Credit growth was growing faster than the economy. This, of course, is that more people borrowed money. They could consume more, and businesses could invest more. This also drove up asset prices and created a wealth effect. It was all very positive as long as credit growth continued to grow very rapidly. The problem is in 2008 then, the private sector couldn’t repay all of the debt that it had taken on in the housing boom years. They started defaulting on the debt. At that point, credit started to contract and the U.S. started to go into a great depression, and the government had to intervene with multi-trillion dollar budget deficits, and that reflated the economy. 

[00:15:35] Kevin

So, there’s basically what you’re describing is a transition from the old world (almost the textbook world), where growth was driven by savings and investment, right? People would save, invest, they would make a profit, that profit would accumulate as capital and get reinvested. I think in the book, you actually show, you have this nice graph where you show that credit growth tracked savings growth pretty closely up until 1971. Then gradually they start to go their own separate ways; credit growing much faster than savings and then really accelerating in 1980 (in the 1980s and since).

You call the new system Creditism, and you say it’s a system where credit creation and consumption have replaced savings and investments as the dynamic that makes the economy grow. I know you’ve touched on this, but could you step back and explain exactly what you mean by Creditism and maybe just walk us through an example or two of how credit creation and consumption generate economic growth. I think for a lot of people that’s counterintuitive. We think of (as you said) credit creation is borrowing, and consumption is spending. So, borrowing and spending (although that’s probably been the Republican party’s platform for the last 30 or 40 years), that’s not something that one would automatically think of as being a great long-term economic growth strategy.

[00:17:26] Richard

What you said is exactly right. Capitalism was an economic system that was driven by investment and savings. Businessmen would invest, some of them would make a profit, they would save that profit (or in other words, accumulate capital), hence capitalism, and repeat. It was slow and difficult.

That’s not the way our economic system works anymore. Today our economic system is driven by credit creation and consumption, and more credit creation and more consumption. That has been a lot easier, actually, up until the credit couldn’t be repaid in 2008. The way this works is that as long as credit is expanding rapidly, it’s very easy to make the economy grow.

Consumers can borrow more on their credit cards or extract equity from their homes, and they can go out and spend it. Of course, consumption makes up 70% of U.S. GDP. Similarly with businesses, as long as they have access to more and more credit, they can invest more, and the more they invest creates more jobs, they buy more raw materials, and that makes the economy grow.

The key is that this wasn’t some sort of evil scheme that someone planned. This is just the way things evolved. This is the way our economic system evolved once it was no longer constrained by the requirement for money to be backed by gold, as it always had been up until then. All of classical economic theory was built around premise number one; gold is money. Everything else followed from that. 

When gold ceased to be money, this created a whole new set of circumstances, that I described earlier, that allowed the economy to evolve in a completely new way. The way it evolved resulted in unprecedented global prosperity. It pulled hundreds of millions of people around the world out of poverty.

Look at China. This is the thing that transformed China. I first saw China in 1986, and it was a very poor, developing country. Go there now and things have changed entirely. It has far better infrastructure than the United States does. Shanghai looks like the Emerald City in the Wizard of Oz, and they’re about to overtake us economically, technologically, and militarily. This has resulted from them having an extraordinarily large trade surplus, year after year, decade after decade, with the United States. That has transformed their country. 

[00:20:30] Kevin

That explanation makes sense. I’m just curious and I want to circle back because you’re not saying that in the Creditism world there’s no investment. When I read that credit creation and consumption have replaced savings and investment, I’m thinking how does the productive asset base of the capital of an economy grow in that world? I just want to make sure I understand that. 

[00:20:56] Richard

So, when credit expands, it creates savings and the savings can be invested. Think about that many people are familiar with the idea of money creation through fractional reserve banking. So, the way that works is if the required reserve ratio for the banking sector is 10%, and that banking sector receives a deposit of $100, the bank that receives that deposit has to set aside 10% as bank reserves, and it lends out the other 90%. Whoever receives that money deposits that into their bank account, and it becomes their savings. That bank, let’s call it bank B, it sets aside 10%, and it lends out the next 90%, let’s call it $80. This process repeats itself again, and again, until at the end of the process, there’s 10 times as much credit as there was to begin with. Banks create money by extending credit. People typically think that banks only lend the money that they have as deposits. They must have deposits first that they can lend. That’s the common sense way of thinking about it, of course, but that’s actually not true. It’s the opposite. Banks create deposits.

[00:22:44] Kevin

Banks create deposits with their loans.

[00:22:45] Richard

By extending credit. Banks create credit, that creates the savings, and the savings provides the funding that allows the economy to grow.

[00:22:54] Kevin

Yeah, and you do a good job in the book of explaining that, which I think most people are familiar with, but then also saying, “Hey, actually it’s not just banks.” In fact, banks are far less important in the credit creation process now than they used to be. It’s really the non-bank financial sector, as well as foreign central banks, that are creating a lot of the credit. 

If we could (because you have a fascinating section in the book about how foreign central banks have created credit, and you say that’s probably the greatest failing of modern economics, is the failure to understand that), explain that. Explain how foreign central banks actually create credit, say, in the U.S. 

[00:23:49] Richard

Okay. So, just one more follow up on the way that commercial banks create credit. What I described was the money multiplier. That’s if the required reserve ratio is 10%, then the money multiplier is 1 divided by 10% or 10 times. What we’ve seen in recent decades is that the required reserve ratio has been steadily lowered, and lowered, and lowered, which means that the money multiplier has become higher, and higher, and higher. Now the required reserve ratio in the United States has been reduced to 0%, which means that the money multiplier is infinity.

There are no constraints on how much credit that U.S. commercial banks can create. The only constraint is the ability of the people they lend to, to pay interest on the money they have borrowed. That’s why bank credit has exploded. 

Now, moving on to your question of how foreign central banks have created money and lent it into the United States. This has been a very important factor that has resulted in the United States being blown into an economic bubble.

Total foreign exchange reserves are foreign currency held by central banks. Total foreign exchange reserves in the year 2000, in total, there were $2 trillion of foreign exchange reserves. By 2014, there were $12 trillion of foreign exchange reserves, so an additional $10 trillion of foreign exchange reserves in 12 years.

Let’s go through how this works. Let’s use China as an example. China’s trade surplus with the United States, it’s been more than a billion dollars a day for years. Let’s call it $400 billion a year right now. So, Chinese companies sell their products in the United States. They get paid in dollars. They take that $400 billion back to China every year, and they want to convert it into the local currency, the Chinese Yuan. But if they converted $400 billion into Yuan, in a free market that would drive up the price of the yuan to a very high level. The expense of Yuan would make Chinese exports uncompetitive.

To prevent that from happening, the Chinese central bank buys all of the dollars coming into China at a fixed exchange rate so that the currency doesn’t appreciate. The Chinese manufacturers get to convert their dollars into Yuan, and they can do anything they want with them after that, but they all end up within the Chinese banking system as deposits.

The point here is, where did the Central Bank of China get $400 billion worth of Yuan last year that it used to buy $400 billion? The answer is they’re a central bank. They just created this money from thin air. It is money creation by foreign central banks that results in this build up in foreign exchange reserves.

It’s much like, everyone’s now familiar with quantitative easing where the Fed creates dollars and buys government bonds, and pushes up the price of government bonds in the U.S., and pushes down their yield. What I’m describing is exactly the same thing with one extra step. The People’s Bank of China first creates its own currency. That’s step one. It then uses that currency to buy U.S. dollars, step two. It then uses those dollars to buy U.S. government bonds, step three. It has to put the dollars that it accumulates somewhere. It’s accumulating all these dollars, it’s not just going to bury them under the Great Wall somewhere. They’re going to invest them in the U.S. dollar denominated assets, like treasury bonds, or bonds issued by Fannie Mae and Freddie Mac, or corporate bonds, or even stocks. 

What we’ve experienced is, $10 trillion or $12 trillion, $10 trillion increase in foreign exchange reserves that has far exceeded the amount of the first three rounds of quantitative easing. The Fed created three and a half trillion dollars between 2008 and 2014 through the first three rounds of quantitative easing, and they used that money to buy U.S. government bonds and mortgage backed securities. That pushed up the price of those bonds and it pushed down their yields, keeping interest rates low in the U.S.

The $10 trillion that have been created by foreign central banks, that’s three times as much as the first three rounds of quantitative easing. So by 2007, if I remember correctly, the amount of investment by foreign central banks in the United States, it financed 15% of all the debt in the United States, up from zero, just 15 years earlier. By financing 15% of all of the credit; by financing 15% of the $50 trillion of debt in the United States, it pushed up the price of treasury bonds.

This had a very big influence on creating the property bubble in the years 2004, 2005, 2006, and 2007. At that time, the Fed started hiking the federal funds rate. It was worried about property prices running out of control. So, starting with Alan Greenspan, and continuing on under Ben Bernanke, from mid 2004 to mid 2006, over a 24 month period, the Fed increased the federal funds rate by 425 basis points; 17 interest rate hikes of, I think of 25 basis points each. Pushing it up, I think, to five and a quarter, five and a quarter percent the federal funds rate. The federal funds rate now is 3.1%. This was a very significant monetary policy tightening.

During that time, despite this 425 basis point increase in the federal funds rate, the 10-year bond yield didn’t go up. Why didn’t the 10-year bond yield go up? Normally, when the federal funds rate goes up, the 10-year bond yield goes up in line with it, or more. Not this time. During that 24 month period, the 10-year bond yield rose only about 38 basis points.

So what was going on? What was going on was that the People’s Bank of China and other central banks around the world who trade surpluses with the U.S. were creating their own money, buying trillions of dollars, literally, and then investing those trillions of dollars that they accumulated into U.S. dollar denominated assets, primarily treasury bonds, pushing up their price and holding down their yield.

So, the Fed was unable to make the 10-year bond yields go up, or the mortgage rates go up for this reason. In other words, it lost control over interest rates and was unable to prevent the property bubble from developing, during those years, because the foreign central banks were creating so much fiat money of their own and pumping it into the U.S. economy.

[00:31:40] Kevin

Yeah, that’s a fascinating story, and we actually talk about that in our book, The Rise of Carry. We call it the global circular flow of dollars. Where dollars leave the U.S., go to China, find their way to the Chinese Central Bank, and then come back to finance the U.S. deficit. You’ve got a great (it’s shocking, really), section in your book where you subsequently ask Alan Greenspan about this. 

You called it a conundrum back in 2006 when you weren’t sure why long interest rates were going up, and then (I think it was 2017), you met with Greenspan and asked him, “Was it foreign central banks? Do you recognize their impact?” His answer was indecipherable, just rambling. My question to you is, do you think he was purposefully being difficult to understand or had he really not thought about it? I couldn’t believe that transcript. 

[00:32:57] Richard

Greenspan once famously said, “If you think you understood what I just said, you probably misunderstood me.” 

[00:33:04] Kevin

I remember, that’s back in the maestro days, where we were all supposed to guess what he was saying.

[00:33:11] Richard

So he’s famous for not speaking clearly, or in a way that can’t be understood, on purpose. I have to believe that was the case here. If he didn’t understand that his counterparts in other central banks, were creating the equivalent of trillions of dollars, which they used to buy trillions of dollars, which they then used to buy trillions of dollars of treasury bonds, then it is just inconceivable that he didn’t know that. These central bankers talk to each other on a daily basis. You can’t ignore trillions of dollars of fiat money creation, moving from one central bank into another economy and blowing it into a bubble.

[00:34:03] Kevin

I want to try to take us back to this notion of Creditism. And in doing so, figure out where we currently are in this cycle. Before I do that, the way you just described it, you talked about blowing the U.S. into a bubble and the U.S losing control of its monetary policy. You do say, in the book, that ultimately this process was a good thing. That the world economy is much bigger than it would’ve been without it. Hundreds of millions of people in Asia, in particular, have been pulled out of poverty. So, when you talk through the narrative, one gets the sense that you’re describing a process that you seem worried about. But, on the other hand, you say, in the book, that the end result of this process has been a good thing. 

[00:31:33] Richard

That is the good side of it. The bad side of it is that it’s blowing the global economy into a big economic bubble. If credit contracts, it could spiral into a new Great Depression. If credit doesn’t grow, then the economy will collapse.

So, if you look just at the U.S. going back to 1950, every time between 1950 and 2009, if total credit in the U.S. grew by less than 2% (and this is adjusted for inflation to compare apples with apples), if total credit grew by less than 2%, the U.S. went into a recession. The recession didn’t end until there was another big surge of credit expansion. That happened nine times between 1950 and 2009. 

What that’s telling us is our economy has grown addicted to credit growth, and if we don’t have credit growth, if credit grows by less than 2% adjusted for inflation, we have a recession. By the way, that’s where we are at the moment. If credit actually contracts significantly, we go into a depression. That’s what almost happened in 2008. That’s what almost happened again in 2020. But because of government intervention with trillions of dollars of budget deficits financed with trillions of dollars of paper money creation by the Fed, that caused credit to expand, and that kept the bubble inflated and growing.

[00:36:23] Kevin

Yeah. That’s gone exactly where I wanted to take us. I saw that indicator that you had put together, basically real credit growth of less than 2% equals recession. And I confirmed , that’s right. One of the dangers of your book, by the way, is that I wanted to recreate all the graphs myself, and I think there’s a lot of them. I went down multiple rabbit holes trying to double-check everything. 

[00:37:00] Richard

There are 250 charts and tables.

[00:37:02] Kevin

So, if we look at where we are now, credit growth had fallen below that 2% threshold last year, and it’s actually been negative the last couple quarters. So, I had two questions for you.

One is, should we be averaging that, to take account of the fact that credit growth was exceptionally high during 2020? (So, if it’s low in 2021, really average across the two.) That’s number one. Number two, given that credit growth is now negative, at least it was through the second quarter (again, negative adjusting for inflation), what’s your outlook for the next 6 to 12 months? I can’t imagine it’s very good. 

[00:37:55] Richard

So yes, economic models (like I’ve just laid out), with credit growth of 2% adjusted for inflation required to prevent a recession. They are just models. You can’t bet your life on them. 

The world is a kaleidoscope of moving parts. Everything keeps changing. But as models, they create a framework that, if this is the way it was in the past, this is probably going to be the way it is in the future. But of course, for instance, you could get a very big spike in credit growth in the last two weeks of December of one year, and that would have no impact on GDP growth that year.

It would impact the GDP growth the following year. So you have to take all of this with a grain of salt. So, you asked whether we should average them? I would just say keep an eye on them. What we’ve seen now is credit has adjusted for inflation; has been below the 2% recession threshold now for five quarters. Credit has actually been contracting now for three quarters. In the most recent quarter total credit contracted by 1.7% relative to one year before (this is adjusted for inflation), and GDP has been negative now for two quarters in a row already, and it looks like it’s going to become worse next year. That’s the consensus, and I think that’s true. 

Worse still, or making matters worse still, is that credit growth has really been relatively quite weak since the crisis of 2008 and GDP growth has been stronger than would’ve been expected, given how weak the credit growth has been. I believe that the reason that GDP growth has been as strong as it has been is because the Fed has been very worried about the weak credit growth and the weak economic growth.

After 2008, the Fed used extremely low interest rates, and round after round of quantitative easing to chip asset prices and create a wealth effect. That wealth effect fueled consumption, and that fueled economic growth. When credit growth has been too weak since 2008, the Fed used asset price inflation to supplement that credit growth to ensure that the economy continued to grow.

Now however, we’re in a situation where, because the inflation rate has spiked up to above 8%, the Fed is having to increase interest rates rapidly and they’re now destroying $95 billion a month through quantitative easing, which is adding up.

[00:40:57] Kevin

Quantitative tightening. 

[00:40:58] Richard

Sorry, yes. Excuse me. Quantitative tightening.

Not only is credit now contracting on a year on year basis, but asset prices are dropping very sharply. In the second quarter net household sector net worth declined by $6 trillion. So, you’ve got a combination of a negative wealth effect and credit contraction now creating a very, very challenging environment for Creditism with the outlook for asset prices and the outlook for the economy being very worrying.

[00:41:33] Kevin

Yeah, I noticed you were kind enough to share a couple of your recent client presentations. On one of them you talk about the ratio of household wealth to income. You were saying that to get back to an average level would require a further fall from where we are now of roughly $35 trillion. To put that in the context, wealth has fallen this year by about $15 trillion. So you’re talking something on the order of more than double what we’ve seen this year already. How would you expect that to manifest? My guess is that you would expect real estate prices to account for a fair portion of that.

[00:42:18] Richard

Yes, that’s right. I think real estate prices are probably going to begin dropping at a double digit rate before the middle of next year, or at least sometime next year. That real estate represents the largest portion of household sector wealth. So, the wealth is likely to be destroyed there.

Now the Fed has recently, just in September, at their September FOMC meeting, they came out with their projections for the federal funds rate. And they’re now projecting, at the September meeting, much more aggressive increases in the federal funds rate than they were at the June meeting.

In the June meeting they expected the federal funds rate to be 3.4% at the end of this year. Now they expect it to be 4.4%. So, it looks like the Fed is going to keep hiking until something breaks. That’s likely to mean another big leg down in the stock market and other risky asset classes and also falling property prices.

I think property prices fell, month on month, for the first time in July, but the drops are likely to become much more. I think that the Fed is projecting that the federal funds rate will be 4.6% at the end of next year, 2023. I would expect that the federal funds rate is going to have to go significantly above that sometime in the middle of 2023.

The federal funds rate right now is about 3.1%. That’s the effective federal funds rate. If they hike by 75 basis points, again, in November, and 50 basis points in December (there are only two meetings this year), that will take the federal funds rate up to about 4.3% by the end of the year. The Fed has said that it will be 4.4% at the end of the year, so that’s more or less in line.

From there to get to 4.6% at the end of next year, that suggests only one more rate hike of around 30 basis points. That’s unrealistic. It’s more likely that the Fed is going to increase by 25 basis points at each of its meetings in the first half of next year, and it has four meetings in the first half of next year.

So, that will take the federal funds rate up to 5.3% by the middle of the year. If that is the case, then that will be enough to throw millions of Americans out of work, destroy consumption, and destroy demand. The Fed has to destroy demand to get inflation down. It can’t do anything on the supply side, so it’s going to have to throw a lot of Americans out of work, and it’s probably going to take interest rates of something like the federal funds rate at 5.5%, and that would make mortgage rates significantly above that. Mortgage rates are now already 6.25%, and as mortgage rates go up, home prices are going to start falling. And, of course, the economy is going to go into quite a bad recession. The unemployment rate, which is now 3.7%, is very likely to move very much higher.

[00:45:43] Kevin

It does seem like the ghost of Paul Volcker is stalking the Fed, and they don’t want to be in a situation like he was where he initially tightened, then eased, and then they had to really tighten again. I do wonder, I don’t have the economic expertise that you do, but I wonder if they’d be able to sustain continued tightening in the face of very sharp falls in asset prices. It’ll be interesting. It certainly won’t be easy for them. 

If we can maybe move away from all the doom and gloom and talk about one of the bright spots that’s happened recently, which I know you’ve also written about, which is, I think, a nice segue into the last section I want to talk about, which is your recommendations going forward.

The bright spot is the CHIPS and Science Act passage. If this was one of my classes at Berkeley, I’d probably call on someone in the audience to tell us what it is because we should all know. But just in case any of our listeners don’t know what it is, can you explain what the CHIPS and Science Act is and why you think it’s so important?

[00:46:54] Richard

Okay, just within the last two months, the House and the Senate passed the CHIPS and Science Act and it was signed into law by the President. And what it is, is a law that will have the U.S. government invest $280 billion in new industries and technologies, over the next five years, with $52 billion of that going specifically for the development of semiconductor manufacturing facilities in the United States. The rest will be spread out among other cutting edge, 21st century industries and technologies like artificial intelligence, quantum computing, biotech, genetic engineering, robotics, clean energy, et cetera. 

This is extremely important for our country because the U.S. government, at the federal level, has been investing less and less, decade after decade, since the 1960s. At the same time, China has been investing more and more. In the year 2000, The U.S., as a whole, invested eight times as much in research and development as China did. By 2019, it only invested 20% more. Last year, China invested more than the United States does in R&D. If the current growth rates continue, then by the end of this decade, by 2030, China will invest 40% more that year in R&D than the United States does.

If that happens, China will be the undisputed sole global superpower, and the United States will be a vulnerable, has-been power at China’s mercy, along with the rest of the world. Now, my book, The Money Revolution: How to Finance the Next American Century has three parts. It spans 120 years: 110 years of history, and 10 years looking into the future.

Part one is a history of the Fed, describing how the Fed has evolved since it was created in 1913 up to the present by analyzing changes in the Fed’s balance sheets over consecutive periods between the beginning and now; and the start of the money revolution when the Fed stopped backing dollars with gold.

The second part is also history. It’s the history of Creditism, how credit growth became the dominant driver of economic growth in the United States and how that occurred. The third part draws on the lessons that can be derived from the history of money and credit (explained in the first two parts), to make recommendations about how we can make the future a better place. How we can make the future a better place is for the U.S. government to invest in new industries and new technologies on a multi trillion dollar scale over the next decade.

By doing that, they will induce a technological revolution that would turbocharge U.S. productivity and economic growth. It would radically enhance human wellbeing in numerous ways, including extending life expectancy, and probably curing all the diseases. At the same time, it would shore up U.S. national security and guarantee U.S. national security for generations to come. 

The final part of the book shows how easy it would be for the United States government to finance an investment of this scale, given the new economic environment we’re living in, now that dollars are no longer backed by gold. 

[00:51:04] Kevin

And that’s really, I think the flip side. So you’ve described Creditism as, basically, an evolutionary stage of the economy, and it has some scary aspects. It feels, if not like a Ponzi scheme, it certainly requires continual forward motion. At the same time, I think what you’re saying is, okay, it’s freed us from the shackles (to some extent) and allowed us to potentially finance productive investment.

Explain, just in detail now, or clarify how exactly you imagine this happening. You’re talking about a 10 year, $10 trillion of investment in industries of the future, and if I’m right, you’re suggesting that the government do this through partnerships with private industries. So, the government would hold some equity stakes or licensing fees. You’re suggesting that it be financed by issuing debt that’s purchased by the Federal Reserve. Is that right? 

[00:52:20] Richard

That’s right. So what I propose, in part three of the book, is a multi-trillion dollar investment program. I propose that the government invest as much as possible, as fast as possible. If that starts to lead to overheating the economy and higher rates of inflation, then they can back off for a while until whatever the bottlenecks are, that are causing the inflation, are overcome.

I use an example, in one of the chapters of the book, of a $10 a trillion investment program over a 10-year period (just to illustrate some numbers behind this). Why $10 trillion? It’s just a big round number. It’s a shockingly large number. 

We wouldn’t start off with a trillion dollar investment in year number one. We would have to build up gradually. I think I’d suggest something like $70 billion in the first year, $250 billion in the second year, and building up, after that, until it reaches the final year. That would be a $1.6 trillion investment in 2031. So, that’s the idea. 

Now, under this scenario, and here I assume…

How high would U.S. government debt be if we did that (government debt to GDP)? What would the government debt to GDP ratio be if we invested an extra $10 trillion over the next 10 years? 

In a worst case scenario, where every last cent of that new investment (all $10 trillion) is invested; all that money that is invested is entirely wasted. It produces no economic growth, no technological breakthroughs, nothing whatsoever that is good. It just adds $10 trillion to the debt. In that scenario, in 10 years from now, the U.S. government debt would be 151% of GDP, 151%. That’s considerably higher than the Congressional Budget Office projects that it will be 10 years from now. Their projection is 121% government debt to GDP 10 years from now.

So in this worst case scenario, it would be 150%, 151% of GDP. That’s 10 years from now, in a case where all of this investment is wasted, which is totally absurd. Today, Japan’s government debt is 260% of GDP, almost twice as high as U.S. government debt would be 10 years from now. Japanese government debt hit 151% of GDP 20 years ago, in 2002. 

And is Japan in crisis? Are they experiencing hyperinflation? No, they flirt with deflation most of the time. Are they having trouble selling their government bonds? No, their government bond yield is 25 basis points. So this just is one example of how easy it would be for the government to finance this debt.

Of course, if the government invested $10 trillion in new industries and technologies, over a 10 year period, the U.S. economy would grow somewhere between 5% and 10% a year, especially in the second five year period. It would turbocharge U.S. economic growth. The GDP would be so much larger 10 years from now than it is currently expected to be.

I believe that the ratio of government debt to GDP, 10 years from now, would be lower than it’s projected to be at the moment because of the unending benefits that would result from such a large scale investment program. 

[00:56:19] Kevin

This sounds a lot like modern monetary theory, which you may or may not agree with. I remember talking to a friend about this idea, a decade ago, where I described it that we should call the bond market’s bluff. If the bond market’s going to allow the U.S. to pay (whatever), 2.5% on a 30 year bond, we should just sell a bunch of bonds and invest because surely we can find projects that earned higher than 2.5%.

You are saying, if I get this right, that with the Fed buying the debt, that there are three risks: inflation, asset price inflation creating more inequality, and then a threat to the dollar. You also talk about, in the book, that to make the cost of this more reasonable the Fed should stop paying interest on reserves. Right now, if it bought the $10 trillion, that would create $10 trillion of bank reserves that the Fed would have to pay interest on at a meaningful rate now. So, does the logic of your investment idea still hold up with the Fed paying interest on reserves? 

[00:57:47] Richard

Starting in 2008, Congress changed the law to allow the Fed to pay interest on bank reserves. Before that the Fed didn’t pay interest on bank reserves. and now the Fed has to pay interest on bank reserves in order to make the federal funds rate go up.

It’s currently paying about 3.1% on all the bank reserves and that’s why the federal funds rate is 3.1%. The banks won’t lend money at less than 3.1% because the Fed will pay them 3.1% just by parking their money at the Fed. 

So, the Fed now controls the federal funds rate in a very different way than it did in the past. Now it controls it by pushing up the federal funds rate by paying a higher interest rate on bank reserves. But in the past, before 2008, before quantitative easing flooded the world with bank reserves, the Fed was able to just make very small changes in the amount of reserves that were available through small open market operations – either buying some government bonds or selling some government bonds. That kept the amount of reserves very tight. Banks used to be required to have a level of required reserve, a required reserve ratio. At one time it was as high as 14%. They had to keep that amount of reserves at the bank because that was the law. 

If the Fed wanted to stimulate the economy, they could lower the level of bank reserves. If they wanted to slow the economy down, they could increase the level of bank reserves that were the required reserve ratio. So, in the book, I propose that rather than paying interest on reserves to control the federal funds rate, the Feds should simply just reimpose a required reserve ratio, as high as necessary, to absorb all the excess reserves that have been created by money creation by the Fed.

Now your question is, what if that doesn’t happen? Is the whole plan unviable? In that case, what that would mean, effectively, is that the government would have to finance everything itself rather than as I proposed. If the Fed finances this $10 trillion investment program by creating money and buying government bonds, then that would mean the entire investment program would be cost-free to the American public as long as the Fed is not paying any interest on bank reserves.

If that component is taken out of the plan, then the government would have to finance this $10 trillion of additional government debt. I don’t see that as too problematic. As I said, in a worst case scenario, where this $10 trillion investment creates no growth or breakthroughs whatsoever, the government debt to GDP would be 151%, whereas Japan’s government debt has been at that level, or more, for the last 20 years. So, it could still go ahead. 

So, from the CHIPS and Science side (bringing this back around to that), this is so great because I’ve been talking about these ideas for the government to invest on a very aggressive scale in new industries and technologies for quite a long time. And in the past people would say that’s a very interesting idea, the government’s never going to do that. Hey, the government just did that. $280 billion is not multi-trillion, but it’s a good first step in the right direction, and we need to do more of that. As we do, we will transform our economy, shore up our national security, and make the economy grow faster and grow out of the current debt problems.

Moreover, it will ensure that Creditism survives. It will keep credit from contracting and collapsing into a great depression. And the kicker is that it will result in just the most extraordinary technological and medical breakthroughs. It really is possible that, with this level of investment, we could cure all the diseases and expand life expectancy by decades.

Currently the National Cancer Institute, it’s annual budget is $6 billion a year. Cancer kills 600,000 Americans every year. $ 6 billion a year is not curing cancer. Until just six months ago, nine months ago, all of last year, the Fed was creating $120 billion every month. $6 billion is 5% of one month of quantitative easing. It’s not enough. Let’s expand that by a factor of 10 or 20 and let’s cure cancer. These are the opportunities that now lie in front of us as a result of the money revolution that has occurred over the last five decades. We just have to recognize them and grasp them. If we don’t, we’re going to be overtaken by China, and it’s going to be game over.

If they develop artificial intelligence before the United States does, it will be the 21st century equivalent of China having a nuclear weapons monopoly. They will control the world and we will never catch up with them. 

[01:03:22] Kevin

That puts it in quite stark terms. I want to wrap up with a final question.

I know you were a consultant with the IMF and you worked for the World Bank for a while, so you have, I assume, a contact network within the policy making world. To what extent do you believe your mental model of the economy, as Creditism, is accepted, acknowledged; or to what extent is it still seen as a new idea, an unusual idea?

[01:04:08] Richard

It is a new idea but it’s one that I’ve been discussing for more than a decade now. I believe that as more and more people hear it, and as year after year it continues to be quite valid, that the idea is catching on. In terms of this CHIPS and Science Act, I view that as very encouraging. I would not say that has anything to do with what I have written or what I have talked about, but it does show that the ideas that I have written about, in the book, are spreading through society. 

It was three, or not quite four years ago that Charles Schumer, who was the Senate Minority Leader, made a speech, in Washington before the defense establishment, in which he said that he was going to propose an act to invest, I think he said a $100 billion over five years in new industries and technologies because China was on the verge of overtaking us and threatening our national security.

I was delighted to hear that. So, that was some time ago, but that’s clearly not enough. $100 billion over five years is not going to do the trick. I tweeted senator Schumer, “I’ll see your $100 billion and raise you $9.9 trillion. That’s the sort of investment that is possible.

Okay, $ 10 trillion, like I said, I’m proposing investing as much as possible as quickly as possible. Does it have to be $10 trillion? No. Multi trillion we can afford. In the second quarter of 2020, the U.S. government borrowed $2.8 trillion, in the second quarter of 2020. That was equivalent to 13% of 2020 GDP for the whole year. That was a multi-trillion dollar borrowing plan in three months. If we can do that in three months, then we can certainly do that over 10 years. 

[01:06:21] Kevin

Yeah, it’s funny, the Fed has become this very strange institution where it has the freedom to do these extraordinary things very quickly. Yet Congress, when they debate and talk about things, even small amounts can get bogged down. Hopefully, this is a step in the right direction. 

Richard, I really appreciate you coming on, sharing your ideas, explaining how we got to this place. Thanks, thanks very much and I wish you all the best. 

[01:07:01] Richard

Thank you very much. I appreciate you having me on. It’s been a pleasure meeting you and I hope we can do this again sometime. 

[01:07:08] Kevin

That would be great, thanks Richard.

Now back to Niels. 

[01:07:13] Niels

Thank you so much, Kevin and Richard, for a mind blowing and thought provoking conversation on the topic of money.

Richard has a fascinating perspective on a solution to the problems the U.S. is facing. A money revolution, you could say, which in the end, he believes could cure all diseases, as he explains. 

For me. There were a number of highly interesting topics that Richard explained, such as the new way to think about how the economy grows post leaving the gold standard, and the emergence of Creditism and the role that foreign central banks play in creating lots of U.S. dollars that can be used to buy U.S. debt, and most likely, was the reason why the long end of the yield curve did not rise much during the period in the early 2000s when the Fed raised interest rates by more than 400 basis points.

I also found Richard’s rule of thumb interesting in terms of the real growth in credit needed to avoid a recession, or even a depression, if credit growth goes below zero, and how he expects the Fed funds to go somewhat higher in 2023 than what the Fed is signaling and what the market currently expects. 

And of course, it was fascinating to hear the solution that Richard proposes for the U.S. in terms of a massive investment program: as much as possible and as fast as possible, as he put it.

Make sure you go and follow Richard’s and Kevin’s work as well as getting a copy of their books because, as you can tell from today’s conversation, some of these ideas and topics are not being discussed enough on mainstream media. 

From Kevin and me, thanks so much for listening and we look forward to being back with you on the next episode. And in the meantime, take care of yourself and take care of each other. 

[01:08:55] Ending

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