Richard Duncan, The New Depression
The Breakdown of the Paper Money Economy
Show transcript of Richard Duncan, The New Depression
JIM: When the United States stopped backing dollars with gold in 1968, the nature of money changed. All previous constraints on money and credit creation were removed and a new economic paradigm took shape; economic growth was no longer driven by capital accumulation and investment as it had been since the beginning of the Industrial Revolution. Instead, credit creation and consumption became the new drivers of the economy. And over that period of time, the United States debt increased fifty-fold to 50 trillion dollars.
In 2008, however, that debt could not be repaid and the new depression began. And that’s the topic of today's discussion, the title of a new book, The New Depression: The Breakdown of the Paper Money Economy; and its author joins me on the program Richard Duncan.
Richard, you argue in your book when the United States went off gold backing from the dollar in 1968, the nature of money changed and the result was a proliferation of credit. As you document in your book, we went from almost 1 trillion dollars to today we’re now over 50 trillion. Let’s talk about that. [1:54]
RICHARD: Right. In the past, up until 1968 it was a law that the Fed had to maintain gold backing for every dollar that it issued. It had to keep 25 percent gold backing for each dollar. After World War II, the US central bank had no difficulty meeting that requirement because the US had so much gold at the end of the war, but in 1968 they came up against that constraint and they would either have to have stop issuing more dollars or somehow acquire more gold.
And in the end what they did is they changed the law and they removed that requirement, and afterwards there was no longer any requirement for the Fed to keep gold backing for the dollars it issued. And at that point, I believe that the nature of money changed. We moved from a commodity-based monetary system, a gold-standard system to a paper-money system, a fiat-money system. Before that time if a person took a dollar bill to the Treasury Department, at least in theory, he was meant to receive some gold in exchange for it, but now if you take a dollar bill to the Treasury Department, they will just give you another dollar bill in exchange.
So before, there was a very clear distinction between money and credit: Money had gold backing. Well, now that distinction has been blurred. If you take a dollar bill to the Treasury Department and they give you another dollar in exchange. Well, what’s the difference between a dollar bill now and a 10-year Treasury bond? In the sense that they’re both credit instruments, the 10-year Treasury bond pays interest, the dollar bill doesn’t pay interest. So we've moved from a system where there was a clear distinction between money and credit to a system where there is really no distinction at all between money and credit. Money, in a sense, has become credit and that really changed everything. [3:45]
JIM: You know, credit-induced boom and bust cycles aren’t new. The Austrian economists Ludwig von Mises and Rothbard wrote extensively about them, but before we went off gold backing, we had several restraints on credit. One was the legal requirement that the Fed back its monetary base with gold, and the second is banks hold liquid reserves to back their deposits.
Richard, explain the changes that were triggered by going off gold backing of the dollar. [4:17]
RICHARD: In 1968, when this requirement for the Fed to hold gold backing ended, afterwards, after 1968, the Fed has issued 20 times as many dollars as it had up until 1968. It issued roughly another 900 billion paper dollars and that 900 billion paper dollars acted as a foundation upon which this 50 trillion dollars of credit was created; that was the most important change.
The other change you referred to was over those last four decades the amount of liquidity reserve requirements that banks were required to hold against their deposits has steadily diminished.
Now, through the system of fractional reserve banking, banks are able to create money essentially, create deposits. Now, the way that works is that when someone deposits, let’s say $100 into a bank, that bank is required to set aside those liquidity reserve requirements. The liquidity reserve ratio is 10 percent and that first bank sets aside $10 of reserves and lends out $90. The $90 then circulates through the economy and it’s redeposited and Bank B then has to set aside 10 percent and lends out 80 — $81.
And this reoccurs again and again until in the end you have more or less 10 times as much deposit and credit as you started out with through this system of fractional reserve banking; in other words, the banks create credit and create money.
Now, the thing that has changed is that over time the liquidity reserve requirement that the banks were required to hold came down very sharply from roughly 14 percent — a ratio of 14 percent down to roughly 1 percent. And as the ratio became smaller and smaller, as the liquidity reserve requirement became smaller and smaller, the amount of credit that the banks could create became larger and larger. In fact, it moved toward infinity. And that was the second reason 50 trillion dollars of credit was possible, to create so much credit, was because the liquidity reserve requirement was reduced again and again by the Federal Reserve itself. [6:36]
JIM: You know, something you point out in the book, it’s not just that credit expanded but we had a whole new host of actors in the credit market; we had a lot more lenders with not enough reserves. And some significant things really happened in terms of total market credit debt and I think one was an increase in the financial sector from 64 percent in 1945 to 73 percent; the drop in commercial banks from 33 percent to 18 percent.
But then we had a whole host of new actors that played a significant role in the credit crisis in 2008 and this was government sponsored entities, Fannie Mae, Freddie Mac and also the issuers of asset-backed securities.
Let’s talk about the role that they played in the crisis that unfolded or began in 2008. [7:31]
RICHARD: Right. You were just now talking about fractional reserve banking and how the banking system can create credit and money depending on the level of liquidity reserves that the banks are required to maintain. Well, over time, as the banking sector became — or the financial sector became more liberated, deregulated, new entities entered the industry. Many of these new entities were not required to maintain any liquidity reserve requirement whatsoever. They did not face the same sort of constraints that the commercial banks faced, and they were free to create much more credit as a result and that was another reason that credit expanded so radically.
It’s interesting I think to keep in mind that credit and debt are two sides of the same coin. One person’s loan — one person’s debt in other words is another person’s asset. So when you create $50 trillion of credit, you create $50 trillion of debt. They are two sides of the same coin. Now, in 1964, for the first time, the total amount of debt in the United States — or the total amount of credit, whichever way you want to look at it — this total debt first exceeded one trillion dollars in 1964; that is government debt, household-sector debt, corporate debt and financial-sector debt.
Now, over the next 43 years that expanded 50 times from one trillion dollars to 50 trillion dollars and this explosion of credit that came about, it only was possible for this explosion to occur because we broke the link between dollars and gold. And this explosion of credit really created the world that we live; it made our world much more prosperous than it would have been otherwise. It ushered in the age of globalization. China, for instance, would look nothing like it does today were it not for this fact that US credit has exploded. [9:37]
JIM: Something Fed Chairman Bernanke has come up with is this theory of a global savings glut to explain the flood of foreign capital that has flown into the country over the last decade. Richard, you believe a lot of this is nonsense.
The real explanation you believe is a dozen or so central banks printed $7 trillion worth of fiat money between 1971 and 2007 in order to manipulate the values of their currencies in order to achieve strong export growth.
Let’s talk about that because over and over in the last decade, when you heard about all of this money that was coming into the United States because there was excess savings, for example, you’d give that China had I think a trade surplus with 269 billion, but they invested more in this country.
And what they were doing is as those dollars that they earned from selling goods to the United States were brought back home to China, when Chinese manufacturers exchanged those dollars for the local currency, the Bank of Japan simply printed the money and a lot of that money was then, as they bought those dollars, then brought back to the United States in the form of let’s say asset purchases. [10:57]
RICHARD: Yes. That’s right. Let’s use China as an example. Last year, China’s trade surplus with the United States was roughly $300 billion. So Chinese exporters sell their goods in the US; they’re paid in dollars, they take the dollars back to China. They would like to convert their dollars into the local currency, the Renminbi. But if they did that in a free market that would push up the value of the Renminbi to a very high level and that would kill China’s export led growth. So the government doesn't want that to happen, the government instructs the central bank to intervene and the central bank buys all the dollars coming into China at a fixed exchange rate; the local currency doesn't appreciate. In other words, it manipulates its currency to hold down the value of the Chinese currency.
Now, but the important thing to understand is where did the central bank of China obtain $300 billion worth of Renminbi last year that they used to buy the $300 billion coming into China? And the answer is they just created that money from thin air. They are a central bank so they can create money and that’s what they did. They created $300 billion last year worth of Renminbi and used it to buy the $300 billion that came into China.
Now, once they have accumulated that money the central bank has to invest those dollars back into US dollar assets of one kind or the other in order to earn some interest on them and so that’s what it does. It likes to buy Treasury bonds but if there are not enough Treasury bonds then it will buy the bonds issued by Fannie and Freddie or the corporate sector or even stocks or other assets.
It’s really absurd to suggest that a country with in China’s case their economy has been growing 8 to 10 percent a year or more for two decades, it’s absurd to suggest that they have so much savings that in a booming economy like that they can’t find any viable investment opportunities and that they must invest their excess savings in the United States. This is not the case at all. It’s not the savings that they’re investing in the United States, it’s the paper money that their central bank has created in order to manipulate their currency that they’re investing in the US, that’s flooding into the US and blowing the US into an economic bubble. And that’s the debunking of the global savings glut theory. [13:57]
JIM: Something also changed during that part of time from 1945 to 2007 is the composition of the country’s debt changed. In 1945, most of that outstanding debt — 71 percent — was the US government’s. By 2007, it had fallen to 10 percent. The household sector had grown from 8 to 28 percent; the corporate sector pretty much stayed flat at 13. But a real major change took place in the financial sector, which really speaks of how the US economy changed. The financial sector debt went from one percent to 32 percent; the GSE’s — government sponsored entities like Fannie and Freddie — went to 15 percent, and mortgage-backed securities which were zero in 1945 ended up at 9 percent. So by the end of the century, the financial sector had become the country’s largest borrower with Fannie and Freddie the principal agents behind that change. That was a major composition change of debt within the country. [14:28]
RICHARD: That’s right. Over the last 20 years the debt of the GSEs, Fannie and Freddie, rose from roughly one trillion dollars to 8 trillion dollars. Now, 8 trillion dollars is an enormous amount of money. Before this crisis started, the US government total debt outstanding held by the public was less than $6 trillion. With $6 trillion the US government had fought World War II, the Korean War, the Cold War, the Vietnam War, two Gulf wars, launched numerous social welfare programs and sent a man to the moon with $6 trillion over a 70 year period.
Now, over the last 20 years, Fannie and Freddie have increased their debt to 8 trillion and as they sold that debt they obtained 8 trillion in cash and they used that cash to buy mortgages and that pushed up the US property prices and created the US property bubble and that allowed the Americans to extract more and more equity from their homes and spend more and consume more and import more, so that allowed the rest of the world to export more and this drove the global economy. But then in 2008, Fannie and Freddie went bankrupt and had to be put into conservatorship, as they say, by the US government and that game is over. [15:43]
JIM: As a result of this credit build up, you talk about this credit helped to boost the economy, number one. As the economy expanded we saw this surge in debt, we saw a surge in asset prices and spending generated strong growth in profits. As a result of that strong growth in profits and an expansion of the economy, government’s — both at the Federal level down to the state and local level — tax revenues went up, but more importantly, it radically changed the composition of our economy.
We went from a manufacturing economy coming out of World War II to a service economy because we found out as Americans, Richard, we could buy manufactured products from overseas at a lower cost and pay for it with credit. So what we saw was the, let’s say, the creation of a new service economy that was dominated by services such as legal, law firms, accounting, rating agencies as the financial sector expanded, education, health care, social assistance. So we really saw a radical composition re-change in the US economy.
Explain how it was credit that was driving all of this. [17:01]
RICHARD: Two things were going on and they affected each other. First, we had this ongoing explosion of credit, but at the same time we also had globalization gaining traction. In around 1990 from when China entered the global economy, this really changed the global economy dramatically. It became increasingly apparent that all the manufacturing jobs would be relocated outside the United States to countries where the workforce only earned something around $5 a day. So US manufacturing couldn’t compete with low wage manufacturing outside the United States. So Americans began buying more and more goods from countries like China or Vietnam or Indonesia, Thailand, Malaysia, Korea and at the same time this resulted in the manufacturing jobs leaving the United States.
However, while this was occurring, credit was expanding in the US for reasons we discussed earlier and the expanding credit pushed up asset prices, pushed up home prices. And so even though wages weren’t increasing, the lifestyle of Americans could continue to improve because if they owned a home, their home became more valuable and they could extract equity from their home and keep spending more and more.
So this created a smooth transition which allowed the United States to deindustrialize without the pain actually being felt by anyone. Because as home prices went up that provided for more and more available money for the American public to spend, and that allowed the economy to transition from a manufacturing-based economy to a service-based economy. But the service-based economy required this credit expansion to continue in order to be sustained, and when credit stopped expanding in 2008, then that’s when the crisis started because many of these service-sector businesses were no longer profitable once Americans were cut off from additional credit. And then it became obvious that we were suffering from a lack of a manufacturing industry as well.
And really that’s where we are now without a manufacturing industry and with a severely handicapped service-sector industry as well. [19:34]
JIM: In your book you talk about the relationship between money and credit. There’s really nothing that distinguishes the two and you talk about Irving Fisher’s book where he talked about the relationship of the purchasing power of money, its determination in relation to credit, and in it was the quantity theory of money where money and velocity equals price and volume of trade or basically GDP. You reconstruct that in your book and you come up with what you call the “quantity theory of credit.”
Let’s talk about that because basically the change or the make-up of the nature when we’re going from one trillion of debt to 50 trillion in debt, this quantity theory of credit goes a long way to explaining that. [20:24]
RICHARD: Let’s discuss the quantity theory of money. I have heard this is the oldest surviving economic theory. It supposedly dates back to the 1500s. It is the foundation upon which all of monetary policy has been built and it boils to something which is called the equation of exchange. It is relatively simple. The equation of exchange M times V is equal to P times T. M is the quantity of Money multiplied by the Velocity of money. That is equal to P, the Price level, times the volume of Trade.
Now, when you multiply the price level times the volume of trade that is the same thing as GDP. And what the quantity theory of money boils down to is this: when you increase the quantity of money in any country for whatever reason, say you discover a new gold mine or you start printing a lot of paper money, initially what happens is this causes the volume of trade in the country to pick up. In other words, you begin to have an economic boom because everyone has more money to spend. But after a little while, the price level also goes up. In other words, you have inflation and that causes the volume of trade to slow down again.
So you get a temporary boom and a temporary bust and at the end of the day all you end up with is a higher price level. It all boils down to the idea that if you increase the quantity of money in a country, you get inflation and that’s all you get. And that’s why Milton Friedman famously said, Inflation is always and everywhere a monetary phenomenon.
Now, what I’d add to this is after 1968 when we broke the link between dollars and gold, the nature of money changed, and as we've seen, the amount of credit in the country exploded from one trillion to 50 trillion dollars. Well, that explosion of credit was so enormous that it left the quantity of money irrelevant. It’s no longer the quantity of money that is the key economic variable; it is the quantity of credit. So we can change the quantity theory of money and make it applicable to our age of this new age of paper money. All that’s required to do that is to change it to the quantity theory of credit.
And here you replace the quantity of money with the quantity of credit and you get what I call the quantity theory of credit. Now, this is very similar to the quantity theory of money but with one important difference. With the quantity theory of money in the old days, there was only a limited amount of money and you could expand the quantity of money for a little while and this created a temporary boom followed by a temporary bust. But what we've seen in this new age of paper money is for the last four decades we've expanded the quantity of credit non-stop from one trillion dollars to 50 trillion dollars and this has created a four-and-a-half decade long global economic boom of enormous proportions.
The problem now is that this new credit-driven paradigm seems to have hit its potential to create any more growth because the private sector in the US cannot bear any additional debt, and therefore the danger is that the four decade long boom is about to collapse into a very protracted depression.
Now, the Austrian economists were very clever in their views on credit and they believed that credit creates an artificial economic boom, but the day always arises when credit stops expanding. And when that day comes, that’s when the depression begins and hence that’s the name of my new book The New Depression: The Breakdown of the Paper Money Economy. [24:16]
JIM: You know, something that I think that has baffled a lot of economists and also financial analysts on Wall Street with the expansion of the Fed’s balance sheet over the year, the creation and increase in the money supply, you talk about there’s three kinds of inflation. We have asset price inflation, commodity price inflation and consumer price inflation. And when this credit was expanding, especially during the ‘80s and ‘90s and the ’00 decade, the stock market, for example, went up 14 times between ’82 and 2000 and the average price of an American home went up from 64,000 in 1980 to 257,000 in 2007.
But one of the reasons that we did not see a large increase in the CPI, even though it went up, was what happened as a result of globalization it resulted in 95 percent drop in the marginal cost of labor by bringing a billion people from the developing world into the global industrial workforce, and that has never happened in history where the price of labor has fallen so far, so fast.
And you would hear this in comments made by Federal Reserve chairmans, whether it was Greenspan or Bernanke, they would talk about labor prices remain subdued and contained. And central banks began to take credit, but really what was keeping CPI down was the globalization force of labor which brought the cost of goods down because you could make something in China for 5 bucks a day versus let’s say 200 bucks a day in Detroit. [26:04]
RICHARD: Yes. That’s exactly right. Because of globalization, we have experienced continued disinflation since around 1980. Had it not been for globalization and the collapse in wage rates, all of this credit creation we've been discussing and paper money creation, it would have led to very high rates of inflation, perhaps hyperinflation, a long time ago. But because of this collapse in the marginal cost of labor — something entirely unprecedented — we've been able to avoid that.
Now, Irving Fisher in his book The Purchasing Power of Money, which, by the way, was published in 1912, it really is probably the most eloquent expression of the quantity theory of money. It’s so well written and so easy to read, everyone should take a look at it. For instance, what he explained was that while the quantity of money causes inflation — if you expand the quantity of money, it creates inflation — that is not the only factor.
The quantity of money is not the only factor that affects price levels; there can be other factors that could affect price levels. He gave the example if you drop a feather from a skyscraper, the force of gravity will pull it to the ground, but other forces perhaps the wind will cause it to blow around before it hits the ground.
And so the other factor at play here has been globalization. The quantity of money and credit has expanded and that’s pushed up inflation, particularly for those things that don’t require labor as an input. For instance, stock prices and bond prices and commodity prices have all risen as credit has expanded. But for industrial goods, things that are made on factory lines, their prices have tended to drift lower or not to increase because the wage rates have collapsed around the world. And that’s the explanation why we haven’t had an increase in CPI, ex-core CPI, excluding the [food and energy] prices. [28:04]
JIM: I want to talk about what has transpired since the credit crisis unfolded. We've seen the Fed initiate a series of programs from TELF to TELP; it was an alphabet soup. But then in the spring of 2009, when the recovery began, the Fed announced QE1 and QE2. Now, they got a lot of criticism for this, but explain, Richard, had they not done this, what might have happened.
So share with our listeners your views of what QE1 and QE2 accomplished. [28:38]
RICHARD: When the crisis started, the government responded very forcefully with both very aggressive fiscal policy, in other words, budget deficits, and very aggressive monetary policy. Now, QE1 was launched in late 2008 and it ended at the end of March in 2010. Now, during that time, the Fed created from thin air $1.7 trillion and used it to buy financial assets from the banking sector. This allowed the banking sector, it was one of the key elements that prevented the banking sector from completely failing; it allowed the financial sector to deleverage. And that was one benefit.
Next, by the Fed printing so much money and buying these assets, it pushed up the price of those assets which made everyone better off because that held the prices up for these financial assets to a higher level than they would have otherwise.
And finally, during this period of paper creation, the stock market went up quite sharply and that created a positive wealth effect that allowed more consumption. And this went on up until the end of the first quarter in 2010, and then QE1 — we didn’t call it QE1 then, we didn’t know there were going to be multiple rounds, but QE1 stopped and soon afterwards, in fact it was only about five weeks later when we had the flash crash, mysteriously the stock market plunged 10 percent before recovering. And it wasn’t very much longer before the stocks were down roughly 15 percent and the US economy was heading back into a recession.
And in response to that QE2 was launched in November of 2010. And during QE2, the Fed pumped in another $600 billion from thin air and used it to buy government bonds. By buying government bonds, this was very helpful to the US government because the US government budget deficit has been running somewhere around $1.2 trillion a year for the last three years, and the Fed printed $600 billion and essentially financed half of one year’s budget deficit. But that allowed the government to sell its debt at very low interest rates and the low interest rates were very helpful to the overall economy because the rates of the 10 year government bond determine the rate for mortgages and all the other interest rates throughout the economy.
But by printing money and buying government bonds, that pushed up the value of the bonds and pushed down the yields and the low yield helped the economy. And at the same time during QE2, the stock market all went higher again because there was much more liquidity in the country pushing up asset prices. And the higher stock prices also created a net wealth effect again that allowed more consumption in support of economic growth. And that continued until the middle of 2011 last year when QE2 stopped.
And not too much later, stock prices started going down again and the global economy and the US economy started weakening. And at that point, we got help from the European central bank. They launched what we now call LTRO; in December the ECB printed roughly 500 billion euros and they printed 530 billion in February. And that has been the reason global stock prices and asset prices have been soaring since that time, and that’s created another positive wealth effect that’s carried us to where we are now. [32:24]
JIM: In your book, you talk about going forward there are very few sectors left in the economy that could keep credit expanding going forward. The household sector is tapped out; the private sector is sitting on cash, but it sells to the household sector, so if the household is deleveraging, there is no incentives to create. And you talk about the only sector left that is able to initiate and let’s say expand credit is the government sector. Now, in it, you basically give three scenarios. I’d like you to discuss them. And that is, one is we basically do nothing; there is no more stimulus, either fiscal or monetary. I’d like you to talk about that consequence.
The second scenario is we only do quantitative easing, there is no fiscal stimulus especially with the gridlock in Washington in an election year, so it’s the Fed and you believe we’re likely to see QE3.
The third scenario, which you think is more likely to occur between 2013, let’s say after the elections is we get a combination of massive fiscal stimulus combined with monetary stimulus to make it effective.
So let’s talk about those three possibilities. [33:45]
RICHARD: Okay. Let me give a little background information. I really think it’s important for everyone to understand the influence, the importance of credit expansion over the last four decades. It has been credit expansion that has been driving our economy. For instance, going back to 1952 on an inflation-adjusted basis, there have only been nine years when credit did not expand by at least two percent or more. Every time credit grew by less than two percent there was a recession and the recession didn’t end until there was another big surge of credit expansion again. So again, going back to 1952, only nine times credit grew by less than two percent, every time there was a recession. So this begs the question: what about the future?
Our economy has been driven by credit growth. It’s easy to understand that as long as credit is expanding, everyone has more money to spend; the consumer spends more money, that makes businesses more profitable, the businesses hire more people and they expand their capacity and pay more taxes, so the government has more money to spend. And meanwhile, asset prices keep going up and that allows even more equity extraction from homes and more borrowing and consumption and profits et cetera, et cetera. So our economy system has been driven by credit expansion.
We now seem to have hit the point where the private sector cannot bear any additional debt; they are defaulting on the debt they have already. And at that stage, in 2008, the government had to jump in and the government started expanding its debt by more than a trillion dollars a year. Over the last three years, the government budget deficit has [been] $4 trillion. Had it not had these massive government budget deficits the economy would have collapsed into a great depression.
The budget deficit last year was roughly 8 percent of GDP. Had the government had a balanced budget — and that’s last year, in other words, the GDP would have been 8 percent smaller than it was; that’s a big negative multiplier. So it’s only been the government budget deficits that have kept us from collapsing into a great depression. So here we are. We are on government life support. The government is supporting us through these trillion dollar budget deficits to finance this paper money creation as and when necessary.
Now, what are our options going forward if you spell them out? The first one, the government can balance its budget immediately, in which case it would certainly collapse into a mini depression. The second option really is for the government to continue spending money at where it is now, which is largely on consumption-related purposes and they can continue and continue spending, and they can probably continue running trillion dollar budget deficits certainly easily for the next five years and maybe even for the next ten years. But ten years from now, the US government is going to be just as bankrupt as Greece and at that point very bad things begin to happen.
So the third option is for the government to continue borrowing and spending, but to, rather than spending the money as it does now on consumption-related purposes, it should spend the money in a different way: It should invest the money. Invest it in what I call transformative 21st Century technologies that would generate massive profits for the government, investment returns. For instance, I would like to see the government invest a trillion dollars over the next 10 years developing solar energy; and 10 years from now the United States would have free, eternal, limitless energy and the cost of energy to the private sector would drop 90 percent and that would unleash a wave of private sector innovation that would ensure generations of future prosperity.
That’s just one example of how the government could change the way it spends money from wasteful consumption and in some cases unnecessary foreign wars and spend the money in a different way, actually investing in things that generate investment returns that would create profits for society for generations to come. [38:00]
JIM: Richard, you also have a disaster scenario. And the one that you just mention is let’s say that we got monetary expansion accompanied by a large fiscal stimulus. The United States has been in debt before and I’m thinking of the 19th Century where we borrowed from abroad; we were building railroads, we were expanding our canals, we were building infrastructure that would improve the prospects for the economy.
Up until this time, we've been sort of, I guess if I use the analogy, we've been giving people fish instead of creating fishing industries. And you’re basically saying is what the government needs to do here is create a fishing industry, or in this case, in your example, a new energy in the United States which would also, by the way, cut down on our deficits; we would need to import less. But given the political makeup of Congress, the divisions that rest in the country — we have the Tea Party, we have the Occupy movement — as you see this scenario playing out, what do you think happens? In other words, what’s the most likely scenario, do you believe? [39:09]
RICHARD: Well, again, let me give a bit of background. I think the political debate in the United States would benefit enormously if everyone understood just this one simple fact, the economy is made up of — you can break it into four components. Personal consumption expenditure, that’s how much normal people spend. That’s about 70 percent of the economy. Business investment is about 16 percent of the economy. Net trade is a negative number because there is a big trade deficit; that deducts about 4 percent from the economy. And the rest, about 20 percent, is government spending.
So if we radically reduce government spending, by whatever amount we reduce government spending, that’s the amount by which the economy will shrink compared to what it would have if we don’t reduce government spending.
Now, in the old days when gold was money, there was only a limited amount of money. If the government had a big budget deficit and borrowed a lot of money, that would push up the interest rates and crowd out the private sector. So it was always a good thing if the government spent less money because if it spent less money the interest rates would drop and businesses and individuals could borrow more and probably spend more efficiently. But that’s not the world we live in anymore.
In the world we live in, the government already has trillion dollar budget deficits and interest rates are at rock bottom levels already. They’re at rock bottom levels because in our world there’s not a limited amount of money; the government is free to create as much money as it wants and that’s what it’s been doing. So it’s been financing the massive budget deficits by massive paper money creation.
So in our world, if the government spends less money now, interest rates are not going to go down; interest rates are already at rock bottom levels. So if the government spends less money, the GDP is going to shrink, not only by the amount the government spends less, but because when the government spends less, fewer will have jobs so that personal consumption will shrink and therefore business investment will also shrink. In other words, the economy will spiral into a severe recession/depression.
Now, that’s where we need to begin this national debate. It’s terribly unfortunate we've gotten ourselves into this situation where our economy has been fueled by a $50 trillion expansion of credit denominated in paper money, but it’s created a US and a global credit bubble that has been fueled by credit expansion. Now the credit can’t expand anymore and it’s only the government sector that can take on additional debt; the private sector cannot take on any additional debt because they don’t make enough, their salaries aren’t going up anymore because of globalization so they can’t afford anymore debt. So this means we're dependent on government spending whether we like it or not. This is truly regrettable but this is the truth.
So what you asked me is how do I really think it’s going to play out. Well, unfortunately, there’s no indication that anyone recognizes that there’s a tremendous opportunity. I really think that what we have, we have a new economic system. This system is not capitalism anymore.
Capitalism was a system that was dominated by the private sector and the growth dynamic of capitalism worked like this: businessmen would invest, some of them would make a profit, they would save that money through capital accumulation and they would invest and profit and capital accumulation, investment, profit, capital accumulation. And that drove the economic dynamic. That’s not the way our system has worked for decades. Our system has been driven by credit creation, followed by consumption, credit creation and consumption; and that’s driven our growth dynamic. And it’s worked wonderfully. It’s created very rapid economic growth all around the world. The problem is this new system is not capitalism. I think “creditism” is a better name for it.
Creditism now seems to have hit a standstill in the potential to create any more growth because the private sector can’t bear anymore debt. Now, while it’s not recognized that we have a different economic system, I think everyone generally agrees there are various serious problems with whatever this system is that we have.
The faults of this system are completely obvious, but we're overlooking the opportunities inherent in this system. The opportunity is the United States government can now borrow massive amounts of money at 2 percent. If it just borrowed on a very aggressive scale and invested aggressively in 21st Century transformative technologies such as solar energy, nanotechnology, genetic engineering and biotechnology, they could transform the world. They could restructure the US economy, they could create medical miracles, they could generate new industries that would generate new taxes and balance the budget. They could balance the trade deficit. All our problems would be solved if we just grasped the opportunities that are available to us within this new economic system.
But are we going to do that? No. We're probably not because we're caught up in a very toxic debate where we're told our government, our elected officials and our democracy are incapable of doing any good.
Well, I don’t believe that’s true. I think in a democracy we are responsible for our elected officials and that it’s the responsibility of the people to make sure the right officials and right policies are put into place.
Now, if we cut the government spending, we are facing a very dire future. If we radically cut government spending as the Tea Party would have us do, then our economy could fly into depression just like it did in 1930 when we faced a very similar situation in the aftermath of a credit bubble at the point when the debt could no longer be repaid.
Now, there is a chapter in my book called Disaster Scenarios, in which I try to be really as frightening as I can be to make it clear to everyone just how bad things could become as things really go badly from this point forward. To imagine how badly things could go, well, I think the best way to imagine that is just to reconsider what happened in the 1930s and the 1940s.
In 1930 when the credit bubble of the 1920s and the debt bubble couldn't be repaid, the international banking system collapsed and global trade collapsed and the United States economy shrank by 46 percent relative to 1929 and unemployment ranged from 15 percent to 25 percent for a decade. In Europe, Europe turned fascist. Asia turned fascist. The Japanese took over Asia. The Germans took over Europe. And this depression didn’t end until World War II started. At that time government spending did increase. In fact, it increased 900 percent; not 9 percent, not 90 percent. 900 percent.
And that massive expansion of government spending, that ended the depression, but World War II also ended 60 million lives.
Now, we have to understand what went wrong in that credit bubble and that credit bust that was followed by depression and war. We have to understand what went wrong and we have to understand how to do better this time. And I think we could — we can do better. We have a tremendous opportunity. We do not have to collapse into the Great Depression, but there is a very real danger that we will.
I think people should consider this. You can look at the global economy now, it’s a giant rubber raft. But instead of this rubber raft being inflated with air, it’s inflated with credit. The problem is the raft is defective and the credit is now leaking out of all the sides as credit is being destroyed in the subprime disaster and Europe and the European banks. Credit is leaking out all the sides of this raft.
Now, on top of this raft — this global economy of ours — all the asset prices, all the assets are floating: all the stocks, all the bonds, gold and other commodities. And furthermore, seven billion people are on top of this raft.
The natural tendency of the raft is to sink because it’s defective and credit is being destroyed is leaking out over all the sides. And as it sinks, that’s why all the asset prices tend to move together now, move down. And this explains the policy response. The policy response is to pump in more credit, so this is the only policy response policymakers know what to do. When the raft starts to sink, they pump in more credit. When they pump in more credit, either through large budget deficits or through QE1 or QE2, through LTRO or some other mechanism, the raft begins to float higher again; all the asset prices move up together again. This is very unusual for all the asset classes to move up and down together, but this is the explanation for why they do. And this is the explanation for the government policy response. They can’t let the raft sink because if the raft sinks, this is going to lead to geopolitical calamity, catastrophe. And so all they know to do is to pump in more credit to keep the raft from sinking. And this is what they are going to continue doing because they have no choice.
Luckily, they can continue to do this for the next five years with very little difficulty. The US government debt is roughly 100 percent of GDP only. So that’s quite bad, but in Japan, Japan’s government debt is 240 percent of GDP. The Japanese government has been doing this for 22 years now and so there is no reason the US government couldn't increase its level of debt up to at least 150 percent of GDP, which takes us another five years into the future. So this is what everyone should expect to happen. One way or the other, the governments have no choice, [but] to keep pumping in more credit so that our raft doesn't go down. So if stock prices get too weak, investors should expect the government to respond somehow and pump in some more credit and push them back up again.
So as investors, I think we really have nothing to worry about because the government can’t afford to let the raft sink, so they’re going to pump in more credit. Every time the stocks are too weak, the government will do something to push them back up again. Every time the economy gets too weak, there’ll be more stimulus at one time or the other to push it back up again. But the next five years, there’s nothing to worry about.
The problem, however, is somewhere five to ten years out. And at that point, the US government then will truly be as bankrupt as Greece. And at that stage, unless we have taken advantage of this five to ten year window of opportunity to restructure the global economy imaginatively, then we’re looking at a very dire longer term future.
But between now and then, eat, drink and be merry; we are on government life support. They are pumping in credit and they are not going to stop. [49:51]
JIM: Well, I’ll tell you, Richard, you have written a very thought provoking book. And I’d like to give my compliments to you. It’s probably one of the best books I’ve read on macroeconomic matters since Reinhart and Rogoff’s book This Time Is Different.
The name of the book is called The New Depression: The Breakdown of the Paper Money Economy by Richard Duncan, who’s been my guest.
Richard, I want to thank you for joining us here on the Financial Sense Newshour and I wish you all the best with this book.
RICHARD: Thank you very much, Jim. And it’s been a pleasure talking with you. [50:23]
When the United States stopped backing dollars with gold in 1968, the nature of money changed. All previous constraints on money and credit creation were removed and a new economic paradigm took shape. Economic growth ceased to be driven by capital accumulation and investment as it had been since before the Industrial Revolution. Instead, credit creation and consumption began to drive the economic dynamic. In "The New Depression: The Breakdown of the Paper Money Economy," Richard Duncan introduces an analytical framework, The Quantity Theory of Credit, that explains all aspects of the calamity now unfolding: its causes, the rationale for the government's policy response to the crisis, what is likely to happen next, and how those developments will affect asset prices and investment portfolios.
About Richard Duncan
|04/10/2012||Capitalism Died Decades Ago||story|
|01/09/2010||FSN In Depth: Richard Duncan, The Corruption of Capitalism||bcast|