QE = Debt Cancellation
A Conversation Between Richard Duncan and Peter Coyne
Peter Coyne: Richard, when we left off yesterday you were talking about globalization and deflation. Mind picking up there?
Richard Duncan: Yes. You know, Pete, as I’ve said, the thing everyone should keep in mind is that we’re not starting from some sort of laissez-faire equilibrium state today. We have a massive global economic bubble and its natural tendency is to collapse into deflation.
The natural tendency is for this bubble to deflate and on top of that globalization is very deflationary. Today is not like the old days when we had a domestic economy where trade had to balance. Since the Bretton Woods System broke down in 1971, the U.S. has been able to run very big trade deficits. And so we no longer hit domestic bottlenecks. We can just buy as much as we want from the rest of the world.
That’s why we’ve been able to avoid inflation ever since we started running very large trade deficits. Now on the labor side of the global economy there are two billion people who live on less than $3.00 a day. That means we’re never going to get labor constraints within our lifetimes and probably not for several lifetimes.
In terms of industrial capacity, China has created so much industrial capacity across every imaginable industry that there is far, far too much of it and so product prices are falling. In China they’ve been falling every month for 36 months.
You’ve heard the statistic, no doubt, that during two years recently China expanded its -- I think it was cement production -- by as much as the U.S. did during the entire 20th century.
We have a big global credit bubble that would deflate if left to its own devices. It would deflate into a great depression like the 1930s. But policy members have been keeping it inflated -- very successfully as we’ve been discussing.
They kept the horrific global credit bubble inflated through massive budget deficits and trillions of dollars of fiat money creation around the world. But just barely. Inflation rates are pretty much at zero now most places -- at least in the developed western countries. So it looks like it’s more likely to deflate from here than to inflate.
Peter Coyne: When we spoke yesterday, you explained your raft analogy. I was wondering if the raft represents just one country in isolation or are you talking about the entire global economy. I ask, because even though QE has ended in the U.S., we still have QE in Japan… a new QE program in Europe… rate cuts from many other central banks. What’s the net effect?
Richard Duncan: With every analogy you can only take it so far. But I generally mean it’s global and it helps the global economy when several central banks are creating money very aggressively the way that the ECB and the Bank of Japan are doing at the moment. But of course it has a different impact on different parts of the world.
Peter Coyne: Can you elaborate on that?
Richard Duncan: Yes. Well clearly now that ECB is printing 60 trillion euros a month -- that’s very aggressive. And Japan is equally aggressive and they’ve been at it now for two years. So in both of those cases, they’re actually printing the equivalent of and buying financial assets equivalent to twice the budget deficits of those countries, respectively. So they’re not only monetizing the debt, they’re monetizing it twice over in Japan and Europe.
Now it’s important to understand that QE is debt cancellation. And let me briefly spell out the details of what I mean by that.
The right now the way it works is, okay, the Fed has printed money and it’s accumulated $2.5 trillion of U.S. government bonds. And so the government has to pay interest on those bonds to the Fed and it does.
But at the end of every year, the Fed gives practically all of that money, all of its profits -- which mostly come from the interest income on those bonds -- the Fed gives all of its profits back to the government. So in other words, it’s essentially the same thing as the government paying interest to itself.
The government pays the Fed, which is really part of the government. The government pays interest to the Fed. The Fed takes that interest and gives it back to the government, effectively cancelling those bonds.
Last year the Fed gave $97 billion back to the government and that reduced the budget deficit last year by almost 20%. It would have been $600 billion instead of $500 billion.
Since 2008, the Fed has given the government half a trillion dollars in this way reducing the budget deficit by half a trillion dollars. So, as long as the Fed keep rolling those bonds over when they mature (as they are doing now) and so long as the Fed never sells those bonds, then the $2.5 trillion worth of government bonds that the Fed has acquired has been effectively cancelled.
This debt has no cost to the government. This is going on in the U.S. and also in the U.K. where the Bank of England has roughly 25% of all of U.K. government debt paying interest to itself, effectively cancelling that. ECB is now doing it as well.
But Japan is a particularly interesting case because in Japan, as you know, the Japanese government debt is something like 250% of GDP. At this stage, the Bank of Japan has now accumulated government debt equivalent to 50% of GDP. In other words, effectively they’re cancelling 20% of all of the Japanese government debt.
And it removed 50% of GDP out of the 250% of GDP in total. I think once you understand that QE is debt cancellation, it really makes sense of Japan’s very aggressive QE policy. Because they’re now buying up twice the budget deficit every year.
With every month that goes by, their percentage share of total government debt outstanding is growing. So in a few more years they’ll have 100% of government debt to GDP, and then 150% of government debt to GDP -- if it goes on like this.
This is important because right now in Japan the interest rates are extremely low -- 30 basis points on ten year Japanese government bonds.
People have always worried that if any sort of shock occurs and interest rates there go up say, by, 300 basis points to 3% then it would effectively create a fiscal crisis that the government may not be able to deal with.
But the greater the share of Japanese government bonds held by the Bank of Japan, the less likely such a crisis would be. That’s because no matter how high the interest rates go, the government -- the ministry of finance -- would have to pay interest on those bonds to the Bank of Japan but the Bank of Japan would just give all that money back to the government.
So the more the Bank of Japan acquires, the less government debt outstanding there actually is that the government has to worry about because the debt held by the BOJ has been effectively cancelled.
Peter Coyne: Okay. I’d like to turn to the liquidity gauge that you track. It’s a good indicator for asset prices. I’ve updated your work on it periodically since you and I met in Australia last year around this time. I believe, and correct me if I’m wrong, that the last time we talked about it, you had an estimate for a $200 billion liquidity drain in 2015?
Richard Duncan: Yes.
Peter Coyne: Is that still the case? And can you describe what that means?
Richard Duncan: Things have changed in two ways. There is still a drain in 2015 and as far as the eye can see into the future. Remember the liquidity gauge is quantitative easing plus the current account deficit. Today, there’s no more QE. So it’s just the current account deficit that is supplying liquidity while government borrowing is draining liquidity. Today, government borrowing is higher than the current account deficit unlike the 12 years from 1996 until 2008 or so.
So we’re seeing a liquidity drain. But it is necessary to adjust the numbers for two reasons. The first reason is oil.
We have had a very significant collapse in the price of oil. The U.S. is importing much fewer barrels of oil every year because it’s producing so much more domestically. On top of that the U.S. is exporting more and more petroleum related products. So both in volume terms and value terms, the “oil deficit”, if you want to call it that, is becoming significantly smaller. And that reduces the country’s current account deficit.
That supplies less liquidity to the U.S. economy and it makes the liquidity drain more negative. However, offsetting that you have a very strong dollar now which should make U.S. imports increase. That in turn should make U.S. exports decrease and make the current account deficit worse.
So these two factors are pulling in different directions. So I’m trying to recalculate what all of this will mean for the liquidity gauge. Overall, it’s still negative. But I think it’s not as negative as the last time we talked.
Peter Coyne: Okay, so it’s safe to assume that you think that the Fed increasing interest rates this year would be a very bad decision?
Richard Duncan: Yes, I find it odd that they’re still so aggressively talking about increasing interest rates, given how weak the U.S. economy seems to have become in the last few months.
You must have seen the Atlanta Fed’s GDPNow numbers?
Peter Coyne: I did.
Richard Duncan: At the beginning of February it was suggesting that the first quarter GDP should be growing at something like 2.4% and now it’s showing that it only grew by 0.1%. The numbers have been pretty bad across the board. Some of it may have been weather related.
But that really doesn’t explain what’s been going on in other areas. Maybe there was some impact from the west coast port strikes or work slowdowns, but that ended in the middle of February so that shouldn’t have such a lingering effect either.
Peter Coyne: What then, is a possible explanation for why they’re talking about a rate increase, given what you just told me?
Richard Duncan: You know it’s very hard to guess what they are thinking and it’s hard to know what they really do know. It’s hard to really know if they have the right understanding of the economy or not. Maybe they really believe that we don’t have a global bubble.
Maybe they think the economic imbalances have corrected. Perhaps they think the household sector has paid its debt down from $14 trillion to $13 trillion and now we’re all fine again even though household debt increased from $4 trillion in 1994 and even though wages aren’t going up.
Maybe they really think that we’re at the point where the economy can finally achieve self-sustaining growth by itself, whereas I don’t see it that way at all. Or, maybe with interest rates so low for so long they’re increasingly worried about asset bubbles forming that they would like to control.
It seems, given what we’ve talked about, that they want to talk up the value of the dollar relative to other currencies as if they want the U.S. current account deficit to become larger.
The bigger the current account deficit becomes, the more liquidity -- more dollar liquidity it throws out into the global economy.
Also, when the U.S. current account becomes larger, it allows the exporting countries to export more every year. At the same time the money that the trade surplus countries receive gets recycled and sent back into the U.S. too. But right now the current account deficit has fallen to something like $400 billion last year.
And with oil -- with the U.S. oil deficit becoming smaller and smaller, that suggests other factors being the same, the U.S. current account deficit should be shrinking, which means less global liquidity, fewer opportunities for other countries to export and a greater risk of a global economic crisis since the driver of global growth -- the U.S. current account deficit -- has gone into reverse. Maybe they’re afraid that the current account deficit is going to become so small that it will set off another phase of the global economic crisis.
And so if they can make the dollar go up a lot then that should cause the U.S. current account deficit to stop shrinking at least. It would shrink because of the fewer oil imports. But maybe if the dollar becomes very much more expensive that would prevent it from shrinking as much or even allow it to stabilize or perhaps even expand a little bit.
The IMF is forecasting that the U.S. current account deficit is going to be flat this year but then start growing again quite significantly over the next few years, but I don’t think it will.
In fact, let me mention something that’s happening with global trade. In between December and February, U.S. imports fell by 9% which is really quite a dramatic drop. Imports had been growing and growing for decades. Then in 2009 they collapsed. By the end of 2010 they were pretty much back to where they were in 2008. So they had recovered all their lost ground.
But then, from about 2011 until a couple months ago, U.S. imports were pretty much flat. That is why the global economy has been so weak. U.S. imports used to drive everything. But now just over the last couple of months, U.S. imports have dropped 9% between December and February. It looks very traumatic on the chart.
Chinese exports last year only grew by 6% which is very weak for China. And China’s imports last year only grew by 0.5%. For the last four months, I think, China’s imports have been contracting at practically a double-digit rate.
So, it doesn’t matter how much China’s economy supposedly grows -- at least it doesn’t from the rest of the world’s perspective. What matters is how much China’s imports increase every year. For China to act as a driver of global growth, China’s imports have to increase and right now they’re dropping at a double-digit rate.
China is the opposite engine of global growth. China’s abrupt economic slowdown is acting as a significant break on global economic growth.
Peter Coyne: This is why the Peoples Bank of China recently cut rates...
Richard Duncan: They’re trying to prop up the domestic economy, but that’s hard to do because it’s such an enormous bubble. Their whole growth model is in crisis.
They can’t have export-led growth because there’s no one left to export to. The U.S., Europe and Japan are all in crisis.
They can’t have investment driven growth either -- why invest more when you have massive excess capacity of everything already?
World trade is growing by about 2% in volume terms when normally it grows between 5% and 10%. But if you put that in value terms measured in U.S. dollars, world trade is now down 11% year on year -- far worse than the earlier recessions we had except for the great recession of 2009.
In value terms, world trade is collapsing. And remember, profits are measured in terms of values, not in terms of volumes. This explains why U.S. corporate profits fell last year and why they’re expected to fall in the first and the second quarter of this year.
One of the main reasons that world trade is collapsing is because commodity prices are crashing. That’s reflecting the fact that the global bubble is deflating. And that is because the Fed started tightening monetary policy 15 months ago.
Peter Coyne: We met last year soon after tapering began. Where do we stand now, versus what you were telling me then?
Richard Duncan: My outlook is the same in terms of I expected everything to slow down when QE ended and it has. Nothing drops in a straight line, though, we might get a bounce in second quarter GDP numbers.
Meanwhile, we now have a ten year U.S. government bond yield somewhere below 1.9% whereas of course 12 months ago everybody thought yields would be above 3% by now. It’s not impossible that the ten-year bond yield is going to keep moving lower and lower. I’m not saying that’s my projection but that is a possibility.
If the ten-year bond yield moves below 1.5%, then that should support the economy for longer and it should also support stock prices for longer. If it moves below 1%, even more so. And if it falls to 8 basis points like it is in Germany or even 30 basis points like it is in Japan, then the stock market could double from here and that would support the economy for some time into the future.
So much depends on what happens to the ten-year government bond yield. The Fed keeps talking about trying to make it go up. If they do, then the global bubble is going to sink much more quickly.
“It may require a stock market sell off before the Fed reverses course and launches QE4.”
Then they’ll reverse and launch QE4. So, it may require a stock market sell off before the Fed reverses course and launches QE4. But if it starts to sell off they won’t wait long.
I think what happened in October when the stock market had its mini-crash is a good guide. It was down 10% and it looked like it was in complete panic mode until Fed president Bullard said on live Bloomberg TV that maybe the Fed should extend QE3 longer and not end it as it was scheduled to end at the end of October.
Before he finished the sentence, all the stocks had rebounded very amazingly. The market quickly recovered that 10% loss. But since QE has ended at the end of October, the stock market is more or less flat. Whereas during 2013 when the Fed created a trillion dollars and pumped it into financial markets, the S&P index went up 30%. And in 2014 when the Fed created $450 billion and pumped it into financial markets, the S&P went up 11%.
But now that QE has ended, the stock market is flat. I don’t think it’s going to remain flat -- I think it’s going to correct unless the interest rates go very much lower, although the possibility of much lower interest rates can’t be ruled out.
Peter Coyne: So, inevitably the stock market is headed higher, even if it corrects -- because the Fed will reverse and, if history is a guide, the stock market will go up in lock step with it?
Richard Duncan: I think that’s right. That’s how our government is managing the global economy. I’d just like for everyone to recognize that the economy is being managed. And I’d also like them to understand that if the government stops managing it will collapse into a great depression. If that occurs, a lot of people are going to suffer beyond anything they’ve imagined in their lives.
So they should think carefully before accepting all the anti-government intervention doom porn to which they are exposed. Isn’t that what you call it in The Daily Reckoning? Doom porn? I wanted to ask you that because it’s such a great phrase.
Peter Coyne: Heh… yep.
Richard Duncan: Yes, so, they should stop getting off on the doom porn and look at this realistically and understand that we don’t have a capitalist economy. It’s not the 19th century, it’s not the Wild West.
The government has been managing our economy since at least World War II. And they’ve mismanaged it, they’ve created a big bubble. Now they’re keeping the bubble inflated. If they let it deflate, millions of Americans will be hunting squirrels for a living.
Peter Coyne: That sounds pretty dire. But barring that depression, investors should stick with stocks and if they feel comfortable, buy on the correction?
Richard Duncan: It depends on their risk tolerance and their nerve. Passive investors could probably just stay in the market and ride out the correction and still be up a couple of years from now.
But, for active investors, I think it’s a better idea to be out of the stock market right now. Normally the rule of thumb is when the Fed is creating a lot of money and using it to buy a lot of financial assets, the financial assets go up. And when they stop, they go down.
So I think investors should do what the Fed does. When the Fed is buying, they should buy. And when the Fed is not buying they should be out of the markets and wait for a correction.
They should buy again when they see Janet Yellen approaching the microphone and her lips begin to form the letter Q, because when that happens stocks are going to skyrocket and everybody knows that and she knows that. That’s the way active investors should play it.
I think it's very important for individuals who are concerned about investing their own money them to take an objective look at what is happening.
Whatever they think about government intervention and government budget deficits and quantitative easing, they may approve of it, or they probably disapprove of it, but it's not going to stop. And the reality is that this isn't capitalism.
This has evolved into something else. It is an economic system that still is managing to create economic growth, but in order to create growth, it requires government intervention on an unprecedented scale, and this government intervention is not going to stop.
And the average investor should not hope that it does stop because if it stops, the value of his assets will probably all evaporate, and his job will disappear.
So we need to be practical about this, and, therefore, in order to understand what's going to happen to your investment portfolio, it's very important to anticipate what the government is going to do next because we are on government life support.
Like it, hate it, this is just a reality. So there's no point wishing it were some other way. We're never going back to 19th century laissez-faire capitalism. That died in the world wars.
In World War II, the government took over complete control over the economy. They took over manufacturing, production, distribution, they controlled the prices. They even controlled the labor. When the war started, government spending increased by 900%.
That completely transferred the nature and structure of the U.S. economy, and it never returned to normal, and it's never going to. So you may weep for capitalism or not, but that's irrelevant. In order to know how to invest your money, you have to understand how the economic system works now.
And so I believe that in this new age of fiat paper money that credit growth drives economic growth. Liquidity determines the direction of asset prices, and the government attempts to control both credit growth and liquidity to ensure that the economy doesn't collapse.
So in my work, which I publish in a video newsletter called Macro Watch, I analyze trends in credit growth, liquidity, and government policy to anticipate how they are going to impact asset prices and economic growth.
In this new age fiat money, it's crucial to understand how the government is directing the economy and to anticipate what they're going to do next, and that's what investors need to learn how to do.
I believe this is what they will learn from subscribing to Macro Watch. By the way, I'm offering a 50% discount to readers of The Daily Reckoning who subscribe. They can go to my website right here. Hit the subscribe button and it will ask you if you have a coupon. For a 50% discount, they should use the coupon code: daily. I hope your readers will check it out.
Peter Coyne: Thanks for spending the time to speak with me Richard. Hopefully, we’ll speak again soon.
Cheers,
Peter Coyne
for The Daily Reckoning