The Calm Before a Systemic Reckoning ft. William White

[00:00:07] Bill

We’re just on the verge of that more dangerous state of affairs. And one might say, as I can remember we said at the BIS in 2008, it would be a good idea to have a housing crisis to stop this whole thing out, because if it doesn’t get stopped out it’ll be even worse three years down the line. That certainly would do the same thing with the AI thing. If it goes on for another two or three years and then proves to be a false start, I think that would be a huge problem.

[00:00:41] Intro

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

[00:01:37] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations.

Please enjoy today’s episode hosted by Alan Dunne.

[00:02:21] Alan

Thanks for the introduction, Niels. Today I’m delighted to be joined by Bill White. Bill is senior fellow at the C.D. Howe Institute in Toronto. He has worked as an economist and an advisor to central bankers for many decades. He was previously Chairman of the Economic and Development Review Committee at the OECD in Paris, and also was previously economic advisor and head of the Monetary and Economic Department at the Bank for International Settlements. He’s worked at the Bank of England and he’s been an advisor to the Governor of the Bank of Canada and has won numerous awards in economic academic circles.

So, Bill, great to have you on with us again. How are you doing?

[00:03:02] Bill

Oh, I’m doing just fine. And it’s a pleasure to be here, Alan. It was fun the last time and I hope it’ll prove to be the same this time.

[00:03:10] Alan

Good stuff. Yeah. As you mentioned, you were on, I don’t know, it might have been nearly three years ago now. It feels like time’s moving on. So, if people want to go back and listen to that episode to get more context on your background and your experience, that’s a good starting point. But maybe to get right into it.

I mean, since we last spoke, I suppose, three years ago, it’s been pretty clear that a new macro regime has taken place. We’ve seen quite a different set of circumstances evolve in the last few years from, I guess, the secular stagnation of the 2010s. I mean, to your mind, how would you characterize the regime, the macro environment, now?

[00:03:53] Bill

Now? Well, as you know, during the pandemic… Well, let’s go back to before the pandemic. I mean, we had a very long period of central bankers consistently falling below their inflation targets. So, the big worry was excessive disinflation. And, of course, driven by the American phobia about the 1930s, a huge concern was that the disinflation would turn into active deflation. So, that was really the backdrop for the 20 years preceding the pandemic.

And I think the big thing that changed was that, during the pandemic, of course, we had this big burst of inflation. And the interest rates went up very sharply, delayed, but very sharply. And it surprised a lot of people because they were so used to an easy money environment. And then the interest rates stayed really relatively high, relative to the previous couple of decades, and then started coming back down again.

But really since that time, inflation has always been, in the major countries at least, somewhat above the inflation targets, which is a big change from what was happening before. And so, interest rates have come down. But you can see that there’s a kind of growing concern that maybe, from the inflation perspective, that we’re into a new regime.

And my own personal view, and I’ve written quite a bit about this, is that I think the supply side of things has been important both in the disinflationary period and since the pandemic. And I think supply side issues are going to become even more important going forward.

But here’s the big difference is that prior to really the pandemic, the supply side shocks were all positive and disinflationary. And there’s just a huge list of these things. You know, we had globalization really starting in the 1990s, which had an enormous impact (in my judgment) on prices. We had the demographics, you know, which are very positive for a long period of time. Concerns about energy supply were sort of minimal. There was a big increase in demand, but it was easily met by increase in supplies of fossil fuels. Companies focused like razor sharp on efficiency, and supply chain improvements, and cutting costs.

And so, all of these things were disinflationary. That’s supply side. And on the demand side, with all of the stuff that was coming out of China, companies didn’t feel the need to have much investment in the advanced market economies. So, that was sort of weak. And then there was the defense dividend. So, you know, you cut defense spending. So, all of those things were moving in the direction of increased supply, lower demand, disinflation. This is all going into reverse.

And I don’t think that there’s been anywhere near as much attention paid to these factors, these sort of secular factors. What worries me when I hear people talk about the inflation outlook is their horizon seems to be about 18 months, okay? Which is sort of peanuts in the big scheme of things. The horizon is about 18 months, and they focus on things like tariffs as opposed to the broader question of total rearrangement of supply lines and scarcity. And so, when you run through that list that I ran through before, it’s the same list, but all in reverse.

So, the globalization is turning into de-globalization, and we have no idea how far that’s going to go. There’s been a very worrisome increase in tariffs, not just in the United States, but really retaliatory around the world. This has been going on really since the great financial crisis. The demographics have gone into reverse. You know, in some of the countries, China, Korea, Japan, Germany, Poland, I mean, there are so many of these places where the number of workers is actually going down now, not up, as it was before. Part rates are going down in many places. Young people seem to be rethinking their attachment to the workforce for all sorts of different reasons.

The energy side, whereas before we should have been worried about it, but we weren’t, now of course, people do see the writing, or at least most people do see the writing on the wall. And whether you’re talking in terms of adaptation or mitigation, it’s going to be very costly; sunk assets and things of that nature. And then you’ve got what I talked about before, the razor sharp sort of concern for efficiency. Now, that’s giving way to resilience.

It’s not just China and the geopolitical stuff. It’s the wake-up call from the pandemic that these supply chains are really fragile and they’ve got to be sort of reorganized so that you’ve got some resilience if some country decides that they’re not going to ship to you anymore. And then you get into all this other stuff, you know, the investment demands. So, if there’s no workers, you need more capital.

Globalization needs more investment in different supply lines. Energy, I mean, whether it’s adaptation or mitigation. If it’s adaptation, you know, you gotta rebuild all of those ports that got wiped out. You have to build stuff now with much stricter building codes so that they can resist warmer climates. The mitigation side is when you start thinking about what you need. You need a whole new supply chain based not on fossil fuels, but based on metals. And it takes 20 years to build a mine. So, you can see there’s no easy way out of these supply side shortages.

And then you get into all the other stuff; defense, okay, all this national security stuff, which is going to be very expensive. So, to me I see the secular forces really just sort of reversing from what they were sort of 10, 20 years ago. The environment is going to be much more inflationary and that’s going to create a lot of problems for a lot of people who are heavily indebted because of the incentives that they were given through very low interest rates to increase their debts, both private and public.

So, well, there’s nothing new in this. I mean, when I was at the BIS, we were constantly saying, you’re on a bad path, you know, and so it came to pass with the great financial crisis. And I guess I’ve been sort of saying ever since that the situation is getting worse. And indeed, I think the last few years have really cemented that judgment in my mind, and in the minds of others, that we’ve been on a bad path here.

[00:12:07] Alan

And you wrote a paper, well, it’s over a decade ago now, about ultra easy monetary policy and the law of unintended consequences. And I mean, a lot of what you write about is about the nature of the economy being the complex adaptive system and that we can have corridors of stability, I think you’ve used that term, and then nonlinearity at thresholds and tipping points, etc., which all makes sense. I mean, we did have the rate cycle, the rate rising cycle in 2022, and there was no major accident. Obviously, there was SVB, Silicon Valley Bank, which was contained and it was kind of a localized issue there.

But were you surprised in that period at the resilience of the economy that something didn’t crack with the rise in rates then? And what was your interpretation of that?

[00:13:03] Bill

Well, yeah, I was surprised at the way in which the cracks didn’t turn into real sort of fissures. But I have to tell you that my first and biggest mistake was probably around 1997 when we first observed the Asian crisis. And I said, oh, all that hot money and all that speculation, it’s all come unstuck and that’s the end of that kind of behavior. Well, the hot money just went to Brazil and Russia and it’s been going on ever since.

Each time there’s a crisis in the financial markets, the astonishing thing about it has been the capacity of the central banks to get us to pull the iron out of the fire. And they managed to do that, what, in ‘87, in 2000, ‘87, 1990, 1997, 1998 with LTCM, 2007 with housing. Okay, and here we go again in the pandemic.

The only thing about the pandemic that really sort of makes it different is that whereas previously the monetary easing had been enough to sort of pull the iron out of the fire, this time it was much more extended fiscal easing to go along with the monetary easing. And to my mind, what that sort of indicates is that the underlying problem has now grown great enough that recourse to just one solution is not good enough. We need both of them.

But the difficulty with all of this stuff, and as I’ve been sort of saying for years and years, is that if the answer is print the money, which creates more private sector debt, okay, and encourages more public sector debt, if we then add to it an explicit expansion of government debt, okay, fiscal easing to deal with the problems that emerged around the time of the pandemic, you can see that we’ve now got ourselves into a situation where globally, but particularly, I would say, in the advanced market economies where you’ve got record high levels of private sector debt to go along with record high levels of public sector debt.

And you can see this is not a very good position to be in, particularly because any setback… the way I’ve described it in the past is the thing about debt is that it is dangerous in all states of nature. So that in good times, if you’ve got really big debts, the Interest rates go up and the debt service goes up and you say, ‘Houston, we have a problem’.

Conversely, if you’re in bad times, okay, the interest rates may go down, but your revenues go down too, okay? Whether it’s public or private, your revenues go down too. And Houston, we have a problem.

So, I’ve always worried about debt. And some increases in debt are obviously totally not just acceptable, but desirable, okay? You need to sort of borrow the money to invest productively in things that are going to be so profitable that you can service the debt and everybody else benefits, but that’s not what’s been going on for the last number of years.

You know, the debts are being used to basically finance, on the private sector side, you know, stock buybacks, dividend payments, refinancing of various sorts. And in the public sector side, the big increase everywhere has not been in public sector investment, it’s been in Social Security payments of one sort or another. You know, whether it’s unemployment insurance, whether it’s old age pensions, whether it’s entitlements to healthcare. That’s where the big increases have come. And I’m not denying that these things are important to do. But the point is the people providing the services are rapidly running out of fiscal room.

So, we now have a situation where I think we are very exposed, on both the public side and the private side, to higher interest rates. But the problem with all of this stuff that I was talking about earlier on, whether it’s reduced supply side potential or whether it’s increased investment requirements, all of that is crying out for more inflation and higher interest rates to resist it. So, this is a dilemma that sort of has been coming down the road.

Some of us have been saying we’re on a bad path for a long period of time, but I think now, increasingly, people are recognizing the fact that we have a problem. The point is that we’re so far down the path, our exit path is not so clear anymore. Well, even people talk about that government should be more prudent and they should cut the fiscal deficit. You need to say, well, that’s really something that they should do in good times.

[00:18:52] Alan

Yes.

[00:18:53] Bill

You know, that there should be a kind of rebalancing that deficits that went before in bad times should be replaced with surpluses in good times. That’s what you should have done. But nobody ever did. And now we are where we are.

[00:19:09] Alan

I mean, absolutely. And I guess the question is, you know, coming back to the point about nonlinearity, and thresholds, and tipping points, where is the tipping point?

Obviously, we’re seeing higher yields around the world now in Japan trending higher. Even in Germany, obviously they’ve released the death break and now we’re seeing German yields the highest in probably over a decade. The US, to date, has still been fairly contained. You know, 10-year bond yields are still around 4.10% or so. You know, they’ve been around 4.25% for a few years now.

As you say, the debt to GDP has been rising. I mean, what do you think is the thing that really, what’s the straw that breaks the camel’s back, do you think?

[00:19:57] Bill

Well, the honest truth is you can never know. As I said to you before, I thought people would start to behave themselves back in 1997. What’s going to be the trigger? I do think, I mean, you’re right in suggesting, you know, the bond rates have been, particularly in the States, reasonably well behaved. But it’s still been very unusual the last couple of years because the short rates have been going down and, you know, it just went down again in the US, they’re on hold in Europe for the moment. But it’s very unusual to have a period of time, and I think we’ve had two years of it now at least, where the short rates have gone down quite significantly and the long rates have, if anything, gone up in the face of that short term, that’s very unusual.

And I guess, as I say, I think the reason why you can’t sort of say what the tipping point will be is that, for me, the tipping point is purely psychological. Everybody sort of ignores the problem until all of a sudden they look at something that’s been hidden in plain sight and at last they see. You know, as it says in the Bible, for those who have eyes to see, let them see, and ears to hear, let them hear. There comes a point in time where you can no longer avoid looking at the hidden reality in the middle of the room.

And to me, with the long rates having been sort of reasonably well behaved, but still unusual to be higher when the short rates are down. On the one hand, it could be just the fear of higher inflation. And you can make arguments for that. You know, inflation has been higher than forecast. Some people sort of see the secular stuff come down the road.

Another thing that could be important is fears about the independence of central banks. Increasingly with Trump and the kind of vibes that are going on in the United States and perhaps elsewhere, treasuries are about to take over the central banks again, and that worries some people.

My fear is deeper than that. And it is, all of a sudden people starting to grasp the nature of debt dynamics, which is that if your debt levels are high enough and short enough that interest rates only need to go up a little, relative to the nominal rate of growth of the economy, you require, to ensure debt sustainability (the leveling out of the debt to G and E ratio), you need primary surpluses, as a proportion of GDP, that are so great that you look at them and you say, this is not going to happen.

In which case you’re into a situation where every year you know the debt to G and E ratio is getting higher and higher. And the ultimate end of that is governments find that they can’t finance themselves at a reasonable rate in the market and so they turn to the central bank. And, at a certain point, the market psychology changes and it says that really means rampant inflation and I am out of here. Okay, so that’s the sort of point where you sort of say, they know that the fiscal thing is out of control. First, they grasp that and then, as they say in French, ‘il passe a l’action,’ when you move from the understanding to the reaction, and I’m out of here.

Now, there is a big complication at the moment, and I have no answer to this. When you look at the literature about debt dynamics and sovereign crises, it is mostly a story of individual countries having problems. What I think is unprecedented, although I’m not a sort of great (what’s the word?) student of… I’m not an academic student of economic history, but I dare say that we live in really unprecedented times.

So, you sort of say, you look at the French fiscal situation, for example. You know, a lot of people are worried about, together with the political unwillingness of the governments to do anything about it. You look at the French situation, you say I’m out of here. Well, where are you going to go?

Are you going to go into the US dollar? You have exactly the same situation; very, very high debt levels, no political will to deal with it, underlying problems getting worse not better, political division, the UK, Japan, you know, there’s…

So, this is another element, and I have no idea how that that will play out. I suspect that some country will somehow attract the ire of the financial markets, and the bond vigilantes, absent for some decades, will re-emerge and attack that one country. And then, like Southeast Asia during the Asian crisis, you know, the markets will then sort of look at one country and say, wait a minute, it’s not just this one country that’s got a problem, they’ve all got a problem.

You can see the capacity for these underlying problems to metastasize and regenerate themselves in different places because the underlying, as it were, underbrush in the forest, underbrush of debt is now so great that we’ve set ourselves up for a big problem.

[00:26:40] Alan

I mean I mentioned at the outset, like your career has spanned many decades. I mean we’ve had the era of central bank independence and inflation targeting. But I mean, I think your experience goes back even before then, or at least to the start of that period.

So, you can kind of vividly recall what things were like before that. I mean, what does a world look like where people lose confidence in central banks and inflation expectations, become de-anchored (to use the central bank’s bankers terminology)? I mean, how does that play out? Obviously much greater volatility, as you say, bond yields, much higher currency instability, I guess, is that what we’re facing?

[00:27:27] Bill

I would think that would be the underlying tendency. One of the things that’s sort of interesting is the belief that central bankers seem to have, and I guess others too, that inflation expectations are somehow anchored in the central bank’s target. There’s a guy at the Fed, the International Financial Group. Anyway, it was one of the Fed’s published papers, Jeremy Rudd.

[00:28:00] Alan

Yes.

[00:28:01] Bill

And he asked the question of why do we believe that inflation is anchored in inflationary expectations? And he then goes on to demonstrate that there’s in fact no theoretical ground for believing this to be true, no empirical grounds for believing this to be true, and that inflation in fact is anchored in past inflation and it’s been low for a long period of time.

And my ex-colleague at the BIS, Claudio Borio, presented a paper not so long ago, which is up on the BIS website, that talks about a quarter of stability for expectations. And his contention is that the world, for a long period of time, was in that state of affairs that Chairman Greenspan once described as desirable, i.e. nobody cared. You know, inflation was sort of so low, nobody focused on it at all.

But Claudio’s point, and in a way Greenspan’s point, is that once it goes beyond a certain level on the upside, and I don’t buy the story so much on the, on the downside, but on the upside, but people do start to focus. And when they do start to focus, like I was talking before about the bond market, when they do start to focus, it doesn’t take very long before they start to do something about it and recognizing inflation is higher, then the wage demands start to be higher, etc., etc. And so, the potential for an upside move in inflation, and in interest rates to react against that inflation, is pretty substantial.

So, that is something that… I guess my feeling, I mean, as you look at all of these problems, you know, what is the answer? And it’s not so easy to find. In fact, it’s impossible, for me at least, to find an easy exit ramp from the current problems.

So, when you talk about sort of public sector debt, you know, the standard economic response or the economist response would be, well, you need supply side reforms to increase supply potential, in the face of all of those negative supply shocks that are coming down the road. You know, maybe there’s positives, positive things that you can do to reinvigorate growth. And you need fiscal tightening and say, well, yeah, you could do that and you probably should do that.

But on the supply side, you know, ever since the great financial crisis, the OECD keeps track of this stuff. You know, they’ve got this document called Going for Growth. Structural reforms have been sort of basically sliding in number and importance ever since the great financial crisis. The countries are becoming more and more sort of incapable of deregulation in a really positive way.

And on the fiscal side, as I said to you earlier on, it’s all very well to say let’s have fiscal restraint, surpluses when the economy is growing and generating those surpluses. It’s a very different thing when you’re facing a situation of chronic government underfunding. You know, the economy’s slow and you’ve got a big deficit and now you’re going to cut the deficit.

But the crucial thing is it’s the debt to G and E ratio that needs to be stabilized. So, if you cut the debt, you know, fiscal surpluses, but at the same time it leads to the G and E falling even more, you know, like Greece for example, during the euro crisis, it’s sort of the paradox of thrift, I think, as Kant called it, everybody tries to save more. The government tries to save more, and at the end they wind up saving less because their savings are a cut in somebody else’s revenue and their savings. So, these paradoxes of macro have been around for a long time.

So that’s the recommended way to get out of it. And then you look at it and you say, but it’s not going to work.

Then you can have explicit debt reduction, but the thing to remember about explicit debt reduction is, one, it’s going to come as a hell of a shock if one of the big countries defaults on its debt. I think that’s going to put the cat among the pigeons. And then you have to think who’s on the other side of that.

So, people keep talking about debt jubilees, right? But in the Bible there was the king and a few hangers on, okay, who were wealthy beyond anybody’s dreams relative to everybody else. So, they could cut the debt that was owed to them by the wage slaves and it didn’t change their behavior one iota. But today if you start cutting debt, whether it’s private debt or public debt, sort of saying these debts will not be repaid, write them off. You know, who’s on the other side of it? It’s you and me and all the other poor schmucks that are living off pensions, you know, so this is not exactly recommended behavior either.

So, that’s when you start thinking, well, maybe the inflationary outturn is not so bad, but the debt dynamic thing means it could easily get out of control. So, I think there will be a lot of thinking about financial repression, that you find ways to force people to hold government debt. And in a certain way, low interest rates, forced liquidity requirements, prudential requirements, there’s all sorts of ways in which you could move into that sort of realm. And it was tried in the 1940s, after the war, you know, financial repression. And it worked quite well. Wiped out the wealth of the middle classes, I guess, and you know, the upper classes.

But in terms of dealing with the overhang of government debt, after about five or six years of relatively high inflation and pegged low interest rates, the problem was gone.

[00:35:13] Alan

I mean, we also had strong economic growth in the post war period. And for many people, market participants, economists, I don’t know who, but AI is now the great hope. I mean productivity has improved a bit. I think Powell even references at the most recent press conference.

Productivity had been quite weak prior to Covid and immediately after. So, this is just a bit of a bounce back. But I mean, there is hope that maybe this could be part of the solution. Are you a believer or a skeptic on the potential benefits from AI?

[00:35:51] Bill

I certainly hope it will live up to its potential. But again, I’ve been around long enough, and I’ve been through enough of these moments of enormous enthusiasm about particular technological developments. And in the end, it seems to me the recurrent theme is the idea is actually a good one, but to get the full benefits takes decades. Railways, electrification, you know, in the end these were wonderful things, but they took decades. And the people that originally sort of led the way and were totally enthusiastic wound up losing their shirts.

And I think when you look at AI, there has been a huge bet put on it in the United States in particular. You know, I think AI spending on this… you know, sort of these big data centers. I think last year was something like 6% of GDP. There’s basically nothing else going on, in terms of investment in the US, except these data centers.

And if it works out, and all of the people involved are making money, which is what is required for this thing to be sustainable, that would be terrific. But if it doesn’t work out, then you’ve got huge amounts of investment in data centers that are likely, unlike the cable that was laid, the fiber that was laid during the Internet boom in 2000, around 2000, you know, this stuff with all these chips is going to deteriorate, depreciate pretty quickly. So, there could be a huge amount of what Hayek would call malinvestment, you know, just loss, lost capital. And that would have huge macro implications.

In a sense, the worst-case scenario is that all of this investment continues for an extended period of time using borrowed money. Up until now it’s been mostly the cash flow that people have had, but increasingly people are turning to borrowing. When you get a crash after a long period of borrowed money, it’s much more significant than what happens after a long period of, let’s say, equity financed investment.

[00:38:49] Alan

Yeah.

[00:38:50] Bill

So, we’re just on the verge of that more dangerous state of affairs. And one might say, as I can remember we said at the BIS in 2008, it would be a good idea to have a housing crisis to stop this whole thing out because, if it doesn’t get stopped out, it’ll be even worse three years down the line. That certainly would do the same thing with the AI thing. If it goes on for another two or three years and then proves to be a false start. You know, I think that would be a huge problem. But we’re well short of that yet. We’re well short of that yet. But I’m, by nature, I guess a bit sort of skeptical.

I’m not saying it can’t work out, but I’m thinking, remember that famous book, 2009, from Ken Rogoff and Carmen Reinhardt. You know, which is called This Time Is Different: 800 Years of Financial Folly.

[00:39:51] Alan

Yes.

[00:39:51] Bill

So, their book was really about public sector stuff. The worry we have here now with AI is private sector stuff. But I think the same logic applies.

[00:40:04] Alan

Well, it’s interesting. I mean I sometimes think that the Rogoff/Reinhardt book came out maybe a decade too early because I mean austerity was kind of somewhat inspired by their writing at the time. And austerity was then embraced in 2010, in that period. Whereas now the learnings of Rogoff and Reinhardt seem to be forgotten.

But more generally, I’m just curious, I mean we’re in this era with the affordability crisis in the US, and we call it the cost-of-living crisis over here. You’ve got the K shaped economy, this backlash against neoliberalism, backlash against globalization. Up until, if we went back five years ago, economists might have felt they were doing a pretty good job. Unemployment is low, inflation was low, the great moderation.

I mean where did the economists… What was wrong with the whole model? I mean as you step back now, having been involved in policy circles for 50, 60 years, where did it all go wrong?

[00:41:08] Bill

Well, I think the fundamental problem I’ve described as an epistemological problem. And you get back to the question of what do you know and how do you know? What’s the difference between opinion and what they call justified belief? And I think the models that people have been working off of, for the last 20 or 30 years, have been simplified in order to make them tractable, mathematically solvable.

But they basically have been simplified to a point. Whereas Charles Goodhart once put it in a seminar at the Bank of England, “there is absolutely nothing in any of these models that is of significant interest to a central banker.” So, it’s the simplification and most of the models that you see, that are being used by central banks, and by many others as well, I mean, the IMF and The OECD and whatever. You know, they’re linear, they’re deterministic, they’re based on the idea that the economy is simple, understandable, and therefore controllable. And all of this stuff is false. And that’s the fundamental problem.

And a good example of it, I think, is as you mentioned before, I mean, I’m a big believer in the economy is a complex adaptive system. And there’s huge studies that have been done into systems of that sort in both nature and society. And the odd thing is when you read many of these books about complexity, the thing that they put at the top of their list as a complex adaptive system is the economy. But the economists are the only ones that don’t get it. Well, they’re still working on the assumption that it isn’t.

And so, they’ve made a lot of mistakes. And just two of them, I mean, one of them is the whole of the supply side. In the lead up to the great moderation and even beyond, the importance of globalization, keeping inflation down, the stuff we talked about a little bit earlier on, they totally missed it. That if you’ve got a positive supply side shock, the appropriate answer is not to lean into it with lower interest rates. The appropriate answer is to react to the higher growth potential with higher interest rates.

And they did the very opposite because their sort of simple linear deterministic one period model said we’ve got excess capacity now, so the answer is you have to lower interest rates. And that led to the increases in debt that have plagued us ever since. And they missed the supply side problems during the pandemic. And as I suggested to you before, I think they’re missing the prospective supply side shocks that are coming down the line.

They just don’t think enough about the other side of the economy. The focus on demand side has almost totally driven out attention to the supply side. It’s more complex than they think.

The second thing is that these models don’t include a financial sector. These models sign into something that I thought Keynes had put to bed how many years ago? Gee whiz, 65, 85 years ago. You know, it’s not a loanable funds world where people save money and put it in the bank and the banks lend it out. It’s a liquidity preference world in which banks create money.

When you go in and get a loan, they basically just write up both sides of the balance sheet. Well, capacity and desire to do that is a very important component of how the economy subsequently behaves and functions, but it’s not there in any of the models. And so, when the debt levels go up and financial markets start to, you know, get a bit shaky, all of that stuff is not there. So, you don’t need to worry about stuff that isn’t there.

Another thing, income inequality, which is what you’re referring to the kind of case situation, this has been getting worse and worse for years.

[00:46:07] Alan

Yeah.

[00:46:07] Bill

And, in large part, I personally put it down to monetary policy. Systematically keeping interest rates very low has resulted in a big buildup of asset prices. But it’s the people that are already well off that own all of these things. So, they’re getting, relatively speaking, wealthier and wealthier. And not surprisingly, the people who are sitting there… What was the line Kindleberger used? “There’s nothing so infuriating as watching your neighbor get rich.”

So, you look at the underlying political discontent and the roots are very widespread, but surely this has got to be one part of it. And of course, it has induced a lot of people to sort of go for it. You know, in my own country, Canada, for example, there’s been an awful lot of speculative buying, in advance, of condominium units.

[00:47:16] Alan

Okay.

[00:47:16] Bill

You’re locked into the price that you’re going to pay. And this is before the condo is even built. Then the condo is built. And now, in Toronto at least, the market has just basically disappeared. There’s going to be a lot of people who are trying to emulate their neighbors who have grown rich.

They’ve engaged in a form of financial speculation without knowing it. And they’re now sitting on properties that, you know, they paid $600 a square foot for, that’s now worth $400 a square foot. And somebody’s got to eat that loss. So, on all of those fronts, one shouldn’t be surprised that there are problems arising from, didn’t see the supply side stuff, didn’t see the financial sector stuff, didn’t see the income and wealth inequality stuff.

So, with all of those things having been ignored for such a long period of time, is it surprising we might be heading into a period of both economic and political difficulties? So that’s sort of where I see things at the moment. It doesn’t really make me a happy camper.

[00:48:32] Alan

Maybe, just moving into the international domain. And I know it’s been a focus of your work as well. And, you know, we’ve had, I suppose, Bretton Woods, and then what was called Bretton Woods 2. And then, you know, I suppose there’s a bit of a question mark as to where we’re heading now in the new environment. Is it a Bretton Woods 3 or is it more fragmentation?

And obviously around the world, you know, amongst some emerging markets in China, there’s a disquiet about the ongoing role of the dollar. But equally, the US administration seems keen to continue to promote the dollar as a global reserve currency. How do you see that evolving?

Is that a stress point in the system?

[00:49:28] Bill

Well, I think so. I mean, it’s hard to know what the Trump administration wants to do with the dollar because on the one hand they’re sort of talking up the dollar and it’s got to continue, you know, the dollar hegemon kind of stuff. But on the other hand, they’re basically saying we need a significantly lower dollar.

You know, that every time that the trade deficit or the net investment position of the United States cries out for lower dollar, everybody else shouts ‘currency wars’ and they refuse to allow the dollar to go up. You know, it’s the N minus one problem. So, I’m not quite sure what it is that the administration wants.

I think, I mean, this is something else I didn’t mention earlier on about, isn’t it sort of odd when the short rates go down and the long rates go up and gold goes up? So, I think sort of what’s coming down the road is probably going to be a kind of fracturing. I suspect it’ll be not a total fracturing in the sense of autarky, you know, like the interwar period or something like that. But I think there’s likely to be a kind of grouping into two camps, one around the US dollar and one around the Chinese renminbi. From what I can tell, the Chinese are not working in the direction of, or actively supporting, replacing the dollar with renminbi.

You know, there doesn’t seem to be that kind of imperialist tinge to them. But they have, I mean, ever since Governor Zhou made a speech, I think in 2008, about the dollar dominated system and that it somehow wasn’t right, China has been sort of pushing that idea. And I suspect that, as the dollar starts to weaken for various reasons, not least of which is fiscal might seem out of control, debt levels are too high you know, what we’ve been talking about, that they will certainly seek to capitalize on the weakness of the dollar by pursuing their own objectives.

And I think they’re already, as far as one can tell, already sort of well advanced in a way. I mean, they were working with the BIS on the so-called mBridge platform, which is basically a blockchain payment system that appears to be extremely efficient, cost effective, fast. You know, you hear people talking about the advantages of stablecoin. Well, you can do the same kind of stuff against the blockchain background in the public domain.

[00:52:47] Alan

And this will be a replacement or a competitor to Swift, is that it?

[00:52:53] Bill

Yeah, let’s say 5% of the cost, and exchanges are made almost instantaneously. So, you can see the attraction of this over time. And that will certainly sort of be of help to the renminbi. But there are other things that are going on there too. I mean, the way they’ve been cozying up to people in the Gulf and you know, because oil is still a really big thing to them. The Gulf people, I think, are looking at American (what’s the word?) American fossil fuel independence. And basically saying, well, yeah, that’s good for America, but in the old days America had to support us because they needed our oil, but now they don’t need to anymore. So, are they as reliable a partner as they used to be?

And behind it all too? And I think this is actually… I thought at the time, a really sort of important event was when the US and the G7 coalition basically put all those sanctions on the bank of Russia, Central Bank of Russia. They froze their assets and now it’s gone even further than that. But they froze their assets and then they basically refused access to Swift, to the Russian banks, many of the Russian banks.

And I have friends who are sort of quite involved with reserve management for emerging markets. And that really put the wind up people because I think they, you know, they’d seen the use of the dollar as a geopolitical weapon in the past, but somehow this was a renewed example of it, and it was sort of so scary to people. But I think, you know, what we’ve seen is that a lot of people have been moving to change the ownership of their reserves. You know, the percentage of door holdings have been going down. The Japanese… Well, the Chinese have been basically moving out of treasuries and into gold.

And you hear some people speculating, I mean, I don’t know enough about it myself, but speculating that what you wind up with is Chinese sort of, as it were, cozying up more to the Gulf people and getting oil and perhaps other commodities increasingly invoiced in local currency. You know, whoever’s doing the buying, India, China, but no longer going through the dollar.

[00:55:35] Alan

Yep.

[00:55:36] Bill

People then having a demand to hold more renminbi, maybe more rupees, whatever, with them saying, at the same time, well, of course you can hold the renminbi because it’s actually backed by gold. You can see the Chinese setting up governance procedures for mBridge that basically prevent any country from using that as a geopolitical weapon, which again would totally distinguish it from the use of the dollar. You know, it’s not impossible to do that. It’s all a question of how you write the articles of governance for that whole outfit.

So, you can see a lot of pieces coming together whereby the Chinese would not seek to sort of replace the dollar, but would seek to provide an alternative way of doing things. And you could see a lot of people who, for all sorts of reasons, either because they’re autocracies themselves or because they see themselves so (what’s the word?) embedded in the Chinese supply chain structure. You could see a lot of countries might sort of say, yeah, I think I’ll go with those folk.

And I can imagine that there would be a lot of pressure, both sorts, both carrots and sticks, by individual countries, like China or the US, then to sort of step in and sort of induce people to choose sides.

[00:57:20] Alan

And I mean, you’re talking about this polarity between the US and China, but in the middle, it’s obviously Europe and the euro, which at one point was seen as one of the possible challengers to the US dollar. I mean, Europe has its own problems. You mentioned France already, debt levels there. But equally increasingly you hear from the likes of Macron about the need from Europe as well to bring its capital back to Europe.

[00:57:47] Bill

Yeah.

[00:57:50] Alan

Yeah. Do you see an opportunity for the Euro to take on a bigger role now or not?

[00:57:56] Bill

I certainly think it could. How dangerous that might be, I haven’t really thought about, but certainly it could. I mean, there’s been a big movement, as you know, expansion of euro denominated debt by Brussels. The question of who provides the guarantee for that stuff is another question, you know, whether the nations are prepared to go into (what is it called?), you know, ‘join several’ arrangements to be responsible for that debt, but certainly moving more in that direction.

I think I read a study just the other day that indicated that the differentials between that centrally issued debt which traded above bunds, really for a significant period of time, is still trading above. But the premia has been going down as the liquidity in the market has gone up.

And so, you could see, you know, some people are pushing that as being very helpful. And of course, it would also increase capital market integration, which the Europeans have been desperate to provide, really, now, for decades. There’s been lots of talk but not much action. It’d be consistent with Draghi’s contention about some of the stuff that needs to be done to get Europe going again.

And so, I think, yeah, there’s room if people are prepared to take the risks that are associated with that. There being, as it were, no single government in Europe. I mean, it’s the biggest single issue is how do you spread the risks?

And I’m not an expert, so I wouldn’t profess to know how to do that. But you can see an opportunity. I mean, the big thing people have always said is that there’s not a big enough liquid capital market in Europe and this is a means of trying to provide such a beast.

[01:00:17] Alan

Yeah, well, that was always the argument that there’s not enough supply of European safe assets for the euro to grow. But, you know, there’s certainly enough capital required now if the political will is there. Obviously, at the same time in Europe, we’ve had the Draghi report and a lot of talk about it, but not much action.

And at the same time, as you say, you’ve got the fiscal stresses and that difference, say between the outlook in France and Germany, that’s just taking a current day perspective that ignores how that will evolve over time as entitlement spending. Do you see, we haven’t had a Eurozone crisis for a while, or strains for a while, but now French bond yields did go up for a while amid the most recent political turmoil. I mean, is that a theme that can come back, do you think?

[01:01:11] Bill

Well, it could. And I mean, then what you’re back to is Mario Draghi. The ECB, within the law, will do whatever it takes. And let me assure you, it will be enough. Well, then the question becomes, I mean, it was one thing to have a run on Irish bonds, and Italian bonds, and Greek bonds, etc., but now a run on French bonds. The question is, would the ECB be in a position to do whatever it takes?

And in the past, and, I mean, I’m certainly not privy to their conversations, but before Mario Draghi made his comment, he had been in close contact with Angela Merkel, and with the German authorities, and the other sort of prudent countries to ensure that he could get away with it. And he was assured that he could.

Well, now we’re back into, you know, the political will, I think particularly of the creditor countries, you know, like Germany, and Holland and what they’re prepared to do to keep the whole thing together. I guess, from what I’ve seen, the political will in Europe has been pretty strong right up to the present time, that this Euro thing has been a huge experiment that is worth doing and sustaining for all sorts of reasons. And I don’t see that, really, that willingness to do whatever it takes, I think, is still there.

Whether that might change in the future, I don’t know. In complex adaptive systems… You say this is the ultimate out. In complex adaptive systems, forecasting is essentially impossible.

[01:03:22] Alan

Okay.

[01:03:24] Bill

When you add in all the political stuff, you know. And that makes the problem, in a way, even more intractable because you’ve really got these two systems, the political system and the economic system, each of which is complex and adaptive and fragile. And you’ve got to keep both of these shows running at the same time. And that says nothing about the environment, which is the third system into which both of the above are nested.

[01:03:53] Alan

It’s complicated.

[01:03:57] Bill

Yeah, it’s complicated.

[01:03:59] Alan

Very good. Well, that’s, I think, a good point to conclude. We’re over the hour, but thanks very much for coming on again, Bill. It’s always a pleasure to hear your latest thoughts. People can follow your work. You have your own website, William White, if people search for that, they’ll…

[01:04:19] Bill

WilliamWhite.ca

[01:04:20] Alan

William.White.CA very good.

But, yeah, very much appreciate you coming on. So, from all of us here at Top Traders Unplugged, stay tuned. We’ll be back soon with more content.

[01:04:33] Ending

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