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covering monetary, economic and geopolitical news events.

The McAlvany Weekly Commentary

covering monetary, economic and geopolitical news events.


McAlvany Weekly Commentary will provide investors with valuable monetary, economic, geo-political and financial information that cannot be found on Wall Street. With economic expert and host David McAlvany, you will be given a solid strategy of wealth preservation for your financial and retirement assets while living in an unstable economy.

Be sure to visit McAlvany.Com every Wednesday to download your weekly show.

september 29th, 2010

the corruption of capitalism:

an interview with richard duncan

Kevin: Our guest today, David, Richard Duncan, has written probably one of the clearest analyses of what has happened over the last few years to get us to the point where we are, what is happening right now, and what he thinks we need to do with the money that TARP and all this other bailout money is going toward to actually solve the problem.

David: Yes, Richard Duncan has served with ABN AMRO in London, with the World Bank in Washington, Solomon Brothers in Bangkok, and James Capital Securities, and he is also now with Blackhorse Asset Management. He has published two books: The Dollar Crisis: Causes, Consequences and Cures, in 2003, and the conversation today will center on The Corruption of Capitalism, his most recent effort, published by CLSA.

Kevin: I know the dollar crisis had a pretty profound impact on your life back in 2003 when he was analyzing a problem that had not yet occurred in the minds of the people in the economy, but it was coming, and sure enough, the way he laid it out in that book, actually, was the way it played out.

David: I have a lot of books on my shelf, and this is one that, not only have I referred back to on a number of occasions, but which I look at as kind of a mile marker. 2003 was the year that I left Morgan Stanley and came back to work with our family business, and this is one of those books that was sort of an eye-opener, or re-awakening, if you will some concepts and ideas that I had long been familiar with, the kind of things that as a family we would talk about over the dinner table, maybe even breakfast and lunch, but it was a good reminder, and from an objective third party. I said, Okay, these are realities, the realities of our day, and they have to be addressed, and professionally, I am willing to make changes in light of it.

Kevin: We have Richard Duncan on the line right now from Bangkok, Thailand, so why dont we just go to that now?

David: Richard, you wrote, in 2003, a book that was published by Wiley and Sons, by the title of The Dollar Crisis: Causes, Consequences, and Cures. It laid out several of the monetary and fiscal issues which we are now living with as a chronic state of instability. It should already sit on the shelves of our listeners, I assume that they have read it, and it is sitting on the shelf of everyone here in our office.

You published a book more recently by the title of, The Corruption of Capitalism, and we want to discuss that with you today. You have done three things in this more recent project: First, you look at the present global economy, and you assess what footing it rests on.

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Secondly, you have looked at the past, and particularly, the structural and policy-related issues, which have set the stage for the current economic malaise.

Lastly, you look ahead to what might restore U.S. economic stability and pre-eminence. Would you like to start with the past, or the present?

Richard Duncan: Lets start with the past, because I think it is very important to understand what has gone wrong, to understand where we are, and what could be done to resolve this crisis. When I was born, in 1960, policy makers in the United States believed very strongly that it was their duty to balance the U.S. government budget, and to make sure that the countrys money was sound, in other words, backed by gold. They believed in these things just as their fathers, grandfathers, and great-grandfathers before them have believed this, and they feared that if they did not do these things, that something very, very bad would happen.

As it turned out, they were right. By the time I turned 12, in 1972, those core principles of economic orthodoxy, balanced government budget and sound money, had been abandoned, starting in the 1960s, really, under President Johnson. The U.S. started running quite large budget deficits by the standard of the time, and those budget deficits over-stimulated the U.S. economy, and started pulling in more imports, causing a deterioration in the countrys balance of payments, and an outflow of dollars from the country.

At that time, other countries had the right to convert their dollars into U.S. gold reserves, under the rules of the Bretton Woods system, so by 1971, when Nixon broke the link between dollars and gold, there were so many dollars held outside the United States, that he really did not have any choice except to end this link between dollars and gold, because the U.S. just simply did not have enough gold left in Fort Knox to allow the conversion of all the foreign-held dollars.

Once the link between dollars and gold was severed, this really opened Pandoras Box, if you will, to all kinds of evils that have subsequently flown out, beginning with, over time, the U.S. trade deficit started becoming larger and larger. As the deficit grew larger, this was a boon for the gold-linked economy. For decades the United States bought more and more from other countries.

Of course, the global economy grew and expanded, but ultimately, the U.S. trade deficit destabilized the global economy by creating extraordinarily large global imbalances. Those global imbalances are now coming unwound in this new great depression that we are experiencing. In 2008 all of the debt that the United States had incurred, primarily as a result of the trade deficit, could not be repaid by the private sector. At that point, the global economy went into crisis, international trade collapsed, and government around the world had to step in with extraordinary and unorthodox policies to prevent a complete replay of the 1930s Great Depression.

David: Looking back is very helpful. We have, as you mentioned, a new great depression, not just like the depression of the 1930s, but perhaps a slightly different variation on that than today. Of course, the National Bureau of Economic Research has declared the recession over, which I think we can find, if not hilarious, perhaps some comfort in. Maybe they are looking at something that we are not. As an economist, maybe you could comment on that. What are they looking at versus what are you looking at, that you would categorize as not only recession, perhaps a depression?

Richard: It is important to understand that this new depression, as I call it, came about, really, for exactly the same reasons that the Great Depression did. The Great Depression originated in 1914, in my opinion, when all of the European Nations went off the classical gold standard in order to finance World War I.

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At the beginning of World War I, the European Nations broke the link between their currencies in gold. They thought that they could issue enormous amounts of government credit they needed to use to finance the war. All the credit created during that period led to the roaring 20s. It was a world-wide credit boom during the 1920s. In 1930, however, that credit could not be repaid, and at that point, the international banking system collapsed and international trade collapsed.

Exactly the same thing has happened this time. This new depression originated because in 1971 the Bretton Woods system, which was more or less a gold standard, broke down. Afterward, the United States started issuing enormous amounts of dollardenominated debt to finance its government budget deficits and its trade deficits, and all of the credit that the U.S. issued sparked a world-wide economic boom that lasted for 2-3 decades.

But in 2008 the private sector could not repay that credit, and the international banking system collapsed and international trade collapsed. So it has come about in exactly the same way. However, this time the policy response has been completely different. In the Great Depression, the policy-makers believed very strongly that the government had to keep the budget balanced, and they did try, as far as possible, to maintain a balanced government budget. There were no Keynesian stimulus programs at that point.

But this time around, they have completely adopted Keynesian policy, not only in the United States, but in every major government around the world, realizing that if the government does not spend enough money to continue stimulating the global economy, now that the private sector is cut off from any additional credit, and the private sector is incapable of spending, if the governments do not step in, then the global economy will collapse into a 1930s-style depression, with a very significant contraction in the GDP and a return to 20-25% unemployment, so the policy response has been completely different this time.

Coming back to your original question, when you say that the recession has been declared over, what everyone needs to be aware of is that we have a government budget deficit in the United States of approximately 10% of GDP. Last year the U.S. economy contracted by roughly 2%, but had it not been for this 1.4 trillion dollar budget deficit, equivalent to 10% of GDP, this economy would not have just contracted by 2%, it would have contracted by -2, [9:35, unclear] -10, -12, plus the multiplier, there really would have been a complete replay of the Great Depression with more than 20% unemployment.

It is difficult to say the depression is over, when, in fact, the reality is that the U.S. economy, and the global economy, is on government life support, and without the support provided by the massive government budget deficit around the world, and unorthodox monetary policies, then the global economy would actually be in severe recession, if not depression.

David: You describe an interesting transition from that of capitalism to what you call debtism, and then ultimately, to statism the process in play from the 1960s to the present. Early on in your book you suggest that the regime that we are a part of today, a fiat money, or bubble-oriented regime, is, on its present course, moving us toward total collectivization of society. Are there command economies that we should look at as a proxy for performance? You mention that we are now on government life support. Obviously it is not desirable, but what is the next step from here?

Richard: We are now in a very difficult position. Of course, in the United States there is outrage that the economy is in a position where it requires so much government spending. The public does not understand why the government has to have such a large role in directing the economy now, but it is very important that they come to understand why the government is playing this role.

At this point, the U.S. government spending is equivalent to 25% of the entire U.S. economy. In other words, out of every 100 dollars spent in the economy, the government is spending 25 dollars. Every countrys gross domestic product is comprised essentially of four things: First, in the U.S., personal consumption is about 70% of GDP. Next, business investment is about 16% of GDP. Then there is net trade, exports minus imports, and the United States net trade is a negative number, because the imports are

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always so much larger than the exports, so in the United States, net trade actually deducts 5% from GDP. The remainder, roughly 20% of GDP, is government spending.

If we were to reduce government spending, as many Americans would like to see, as instinctively it seems like the right course to take, there is no reason to believe that would result in higher personal consumption, or higher business spending in fact, just the opposite. If the government were to spend less, there would be fewer transfer payments, personal consumption would contract, and with less government spending and personal consumption expenditure, private investment would also contract.

So we find ourselves in a situation where we truly are reliant on U.S. government spending to prevent us from collapsing into a great depression. It is a tragic situation for the United States to find itself in. It has come about as a result of a very long series of policy mistakes, beginning in the 1960, beginning with this abandonment of the core principles of economic orthodoxy that I referred to earlier the abandonment of balanced government budgets and found money.

Nevertheless, here we are, and our options are increasingly limited. In fact, I think there are three ways forward for us: First, the government could immediately balance its budget, in which case, without any question, the United States, and the world, would collapse into a new great depression.

The second option is that we could carry on with trillion-dollar budget deficits, as we are now doing, for the next five years, and perhaps the next 5-10 years, but ultimately, if we spend the money in the manner in which we are currently spending it, this will just ultimately lead to bankruptcy over the long-run and depression a little later, instead of depression now. So that option is a little bit better than the first option of immediate depression, but it is not very attractive either.

The third option is that we could spend the government deficit spending on investments in new technologies, in order to restructure the U.S. economy, to restore the economic viability of the United States economy, because the sad fact is, because of globalization, the U.S. economy is simply no longer viable as it is currently structured. The United States economy has been de-industrializing for decades. Wage rates in the United States manufacturing sector are still roughly $200 a day. Wage rates in China, and other developing countries, in the manufacturing sector, are $5 a day. There is no possibility that the United States can compete in most industries due to this enormous wage-rate differential.

Therefore, we have to face the fact that the U.S. economy is no longer viable. It has been supported for the past 15 years through economic bubbles first the stock market bubble, and then the property bubble. Now both those bubbles have popped. During that period, wages in the U.S. have not gone up, and as time goes by, the existing manufacturing jobs that still do exist in the United States are going to be destroyed.

The third option that I referred to, is the U.S. government, instead of repeating Japans mistake over the last 20 years, of incurring very large budget deficits, but wasting the money building bridges to nowhere, the United States government should learn from Japans experience, and not waste the deficit spending that it is very likely to undertake over the next ten years, but invest in new, very high-tech industries, to restructure the U.S. economy, to restore its economic viability, so that the United States actually can produce goods that other countries want to buy, so that the United States can develop new industries that the government could tax and generate a tax revenue that would not only balance the budget, but ultimately help pay down the national debt.

David: So there are two courses that we could go on from a fiscal and monetary standpoint. Japan might be one example, where we have seen the continual increase in debt to GDP from 60-70%, now north of 200% of GDP, and it is somewhat sustainable, although they have not recovered from a significant correction in 1990, it is not as if they have lived in some sort of an abyss, either.

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The other option might be as in Zimbabwe, where you do not tap the debt markets, but instead, the currency markets pay the price, and there you have inflation, super-inflation and hyper-inflation.

Coming back around to the debt issue, because it seems that that is what you are suggesting is the direction we have to go, not necessarily should go in a perfect world, but we no longer live in the perfect world, in fact, we departed from that in the 1960s. If that is the case, then the question I would have is: How sustainable is an increase in debt relative to our revenues? Not just relative to GDP, but isnt it like the consumer being unable to pay his or her mortgage, the full interest and principle amount, and somehow renegotiating the unpayable portion and just adding it to, and compounding it with, the remaining principle? Is that ultimately sustainable from a revenue standpoint?

Richard: You raise a lot of important issues. That is why it is crucial how the U.S. government spends the money that it will have to spend in the future to keep us out of depression. If they waste it, fritter it away, building bridges to nowhere, or allowing special interest groups to steal it, then the outlook is very bleak. But if they invest it wisely, in new technologies...

Let me back up and lets talk about Japan. I think there are three very important lessons that the United States government must learn from the Japanese experience. When a giant bubble pops, as it did in Japan in 1990, the first lesson is that, like it or not, it is inevitable that the government is going to have to spend enormous amounts of deficit spending to keep that economy from collapsing into depression. So as you pointed out earlier, Japans government debt has increased from roughly 60% of Japans GDP 20 years ago, to 225% today. They have not solved their problem, but they have managed not to collapse into depression.

That is the first point. You can see that the U.S. government and policy-makers realize this, if you look at their budget projections provided by the U.S. Congressional Budget Office, they are more or less indicating that the United States will have almost 10 trillion dollars worth of budget deficits over the next ten years. So that is point number one, the government is going to have these deficits, like it or not, that is required to keep the economy out of a depression.

But point number two is much more encouraging, and that is, it is going to be much easier to finance these budget deficits than people now anticipate. Look at Japan. 225% government debt-to-GDP, and the yield on that 10-year government bond is 1% or less. So that offers a great deal of hope as to what can be financed.

But the third, and the most important, lesson to learn from Japan, is that the U.S. should not waste this deficit spending building bridges to nowhere, as they say was the case in Japan. Instead of having 10 trillion dollars of budget deficits over the next ten years, and accomplishing nothing, if the government took a longer-term view, and realized that it was going to have to have budget deficit spending on such a large scale for so long, surely they could come up with a much more clever plan of how to spend that money, to invest that money in a way that it would not just disappear and become a burden for generations, but to invest it in a way that would produce new industries, new technologies, new jobs, new areas of expertise, new exports, and new government tax revenues.

For instance, instead of spending 10 trillion dollars over the next ten years, and just going deeper down the road to ruin, if the government were to spend an extra 3 trillion dollars over ten years, investing 1 trillion dollars in solar energy, 1 trillion in genetic engineering and biotechnology, and another 1 trillion dollars in nanotechnology, they could completely restructure the U.S. economy, and give the United States an unassailable lead in 21st century technology, essentially locking in another American century.

A trillion-dollar investment in solar energy over ten years would give the United States eternal free energy, which, first of all, the United States government could tax, allowing it to recover the cost of investment, but equally importantly, that solar energy would cut the trade deficit by 40%, because we would no longer have to rely on imported oil, and we would not have to spend money militarily, defending the sources of foreign oil, so we could cut military expenditure as well.

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Again, a trillion-dollar investment in genetic engineering would truly create miracles, it would quite possibly result in a genetic revolution on the same scale as the industrial revolution 200 years ago. That sort of investment would probably yield benefits such as a cure for cancer, or a therapy that reverses aging, and as soon as a U.S. government laboratory starts selling a cancer vaccine, not only would the income from that balance that years budget deficit, it would not take long to pay off the entire national debt.

If we invested the money wisely, we could develop new products to sell which would balance our trade deficit, and new industries bringing in new tax revenues that would balance the budget and pay down the national debt. If we invested the money wisely, we could restructure the economy and remain the dominant economic power well into the future.

David: That is a look ahead at what we might do to restore U.S. economic stability and pre-eminence. You cover that in the last section of your book. I think that assumes that our policy-makers need to acknowledge that there are structural problems, and do not look at Band-Aid solutions for what are very serious issues.

Coming back to Japan and the interest rates in Japan, they have been kept low for a very long time, largely because of the publics willingness to purchase government I.O.U.s. U.S. and global investors might have a penchant, either for rates for currency risk, and that would raise a question for me: How can a low interest rate environment be perpetuated here in the U.S. when, coupled with, for instance, the Federal Reserves inflation targeting of 1-2%, and potentially even higher targets, as the total stock of debt grows? We are looking at a low, to negative, real rate of return environment. Is that good for fixed income?

Richard: There are significant differences between the structure of the Japanese economy and the structure of the U.S. economy, and the implication for interest rates in both countries. It is certainly fair to make the observation that Japan had certain advantages in financing this enormous increase in its government debt that the United States does not have.

For instance, Japan has, every year, a large [s/l train, unclear] surplus, which brings money into Japan and becomes available to finance government debt. Also, Japan has a very high level of household savings. The household debt at the beginning of their crisis is, practically ,18%, and those are advantages the United States does not have.

However, the United States does have one very important advantage that Japan, or for that matter, most other of our major competitors, do not have, and our advantage is, we have the dollar standard. Every year that the United States has a large trade deficit, and this year, the trade deficit is going to be roughly 500 billion dollars, every countrys balance of payments must balance, and when the United States has a 500 billion dollar trade deficit this year, that throws off 500 billion dollars into the global economy, which is accumulated by central banks outside the United States.

Those central banks print their own money, and buy up good dollars and drain their economy, because they do not want their currency to appreciate. And as the central banks accumulate this 500 billion dollars that is the equivalent of their trade surplus with out country, then they have 500 billion dollars which they must reinvest in a U.S. dollar-denominated asset of one kind or another, if they want to earn any interest on those dollars.

In other words, our half a trillion dollar trade deficit this year will finance the first half a trillion dollars of our government budget deficit, and this is an advantage that no other country has.

David: Is that assuming that our foreign trade partners are recycling those trade surplus dollars into government paper, and does

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that mean that we remain dependent on the international markets for soaking up the additional deficit spending and I.O.U.s that we create as a result? I am thinking in historic perspective when Germany was cut off from the international markets following World War I, they were left with only one option and that was issuing I.O.U.s to their local communities, and it was at the point where the German public was choking on government I.O.U.s and debt that they had to resort to quantitative easing, or money printing, which, of course, brought about the 1923/1924 hyperinflation. Is there no risk of soaking the sponge, so to say? Filling to capacity, the appetite for government debt, whether it is international or domestic?

Richard: Eventually, yes, of course, there is. Eventually, that appetite will completely de-saturate it, and when that day arrives, we will be facing a catastrophe, from which there will probably be no exit no happy exit possible. But that day is certainly not going to fall within the next five years, and probably not within the next 5-10 years. I truly believe we have a 5-10 year window of opportunity to come to grips with the severity of the nature of this crisis, and recognize that it is a structural crisis, rather than a cyclical economic crisis.

It is structural because the U.S. economy does not work the way it is currently structured, and we have a 5-10 year window of opportunity to recognize that and to take steps to restructure the U.S. economy so that it does work once again, and other countries have no real alternative except to buy U.S. government debt with their trade surpluses.

Take a look at China. Chinas trade surplus with the United States is the factor that has completely transformed China from the China of Chairman Mao to the China where, today, Shanghai looks like the Emerald City in the Wizard of Oz. In 1990 China did not have a trade surplus with the U.S. Two years ago their trade surplus with the U.S. was a quarter of a trillion dollars.

That quarter of a trillion dollar trade surplus is resulting in tens of millions of Chinese factory jobs. It is bringing in currency into China that is going into the Chinese banking sector as a quarter of a trillion dollars worth of deposits, which fueled a quarter of a trillion dollars of loan growth, which fueled 10% GDP growth and keeps their public employed. They are accumulating dollars and once they have the dollars, they must reinvest those dollars in U.S. dollar assets if they want to earn any interest on them.

You may be thinking, well they do not really have to, they could buy some euros with those dollars convert the dollars into euros with those dollars. Well, yes, they could buy some euros. Of course, that would upset the Europeans, because it would make the euro go to 2-to-1 against the dollar, but the more important point is, whoever they bought the euros from, those people would then have dollars, and those people would then have to buy U.S. dollar-denominated assets.

Dollars are like farmland. The farmer can sell his farmland and that does not make the farmland disappear, someone else owns it. It is the same with dollars. If the Chinese were to sell their dollars, whoever they sold the dollars to would then have to invest their dollars in U.S. dollar assets, so our trade deficit will boomerang back into the United States to finance our budget deficit.

Every countrys balance of payments must balance, so the larger our trade deficit becomes, the larger the capital inflows into the United States will be, and we should take advantage of that benefit created by the dollar standard, and make use of that financing and spend the financing wisely to restructure our economy while we still have time.

David: You are focusing on really prudential options, things that must be done now, with a 5-10 year window. The two questions are: Are we appreciating the recycling of our trade at deficit dollars into U.S. treasuries? And on top of that, what are we doing in terms of budget deficit spending? Are we doing a good job in allocating those assets? Are we allocating them to the most opportunistic investment strategies for our country over the next 10, 20, and 30 years, as you have suggested, into technology, innovation in that area, significant investments, where the two things that we have to be cautious in is that the money that is spent is not wasted?

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That it must be spent is an inevitability at this point, in your opinion, and so the point is, it cannot be wasted, and it should not be stolen by special interest groups. If those two things can be avoided and the money goes to the right places, then the money that we spend we may actually see a return on investment in terms of future tax revenues which solves something that I was suggesting earlier, even more significant than debt-to-GDP, the debt-to-revenue numbers, which continue to be, and may be an even greater issue for us in the future. Perhaps we can solve that as long as we creates new source of revenue and income.

Richard: Yes, precisely, the debate in the United States, about the direction of the U.S. economic policy, has become dangerously unimaginative. On the one side are those people who believe that the government is, and always will be, the problem, and they advocate a reduction in government spending immediately. On the other side are those who hope that somehow, the U.S. economy is going to right itself in the not-too-distant future and return to sustainable growth, and they advocate maintaining the budget deficits for a few more years, and then reducing them.

But both sides are wrong. If we cut the budget deficit now, the United States and the world will collapse into an immediate depression, with untold geopolitical consequences. On the other hand, it is not that the U.S. is going to somehow right itself again in the absence of a massive government budget deficit, because we are being de-industrialized by globalization. Our wage rates in the manufacturing sector are 40 times higher than wage rates in the developing world.

Therefore we are going to continue to de-industrialize and it is only a matter of time it is not going to take very many more years of 10% unemployment for the Americans to come to the realization that globalization is really not working out very well for them, and they are going to vote protectionism. There will be another Ross Perot, who points out that globalization is not working, they will elect that man, and trade barriers will go up that will be bad for America, terrible for the world, and catastrophic for countries like China that are so dependent on export-led growth.

So our challenge is to find an alternative to that very unhappy scenario over the next five years, and the only viable alternative is for the United States to aggressively and boldly take advantage of the dollar standing, take advantage of this ability to finance trillions of dollars in debt, and to invest trillions of dollars on a scale that is simply too large to fail, too big to fail, in new, 21st century technology, to give us an unassailable lead in 21st century technology, and to allow us to make new products that other countries desperately want to buy, that they cannot buy anywhere else, at any price, like a cancer vaccine.

David: There are a number of other topics that are worth looking at, in even greater detail, and I would encourage our listeners to invest the time and, certainly, just a few dollars, into your latest book, The Corruption of Capitalism. It is an excellent read. In fact, I decided to move that into the lineup of books that we read here in the office. We try to look at one book a month as sort of continuing education, and you do a masterful job at looking, both at the past, and the present, and the future, and with an appreciation. In this place, we do look at the past, and say, without it, you really do not know what is coming, and you cannot understand the present. So, there is a similar model, in terms of thinking, in your book, as is reflected by our office here, and it will be an excellent read, and discussion, that we have, and we would invite all of our listeners to enter into that same conversation.

Thank you very much for joining us today, Richard, and I look forward next time I am in Asia, to perhaps having our paths cross.

Richard: Yes, lets do that, and thank you very much for having me on the show. I appreciate it.

David: We look forward to having you on again.

Richard: Thank you.

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The McAlvany Weekly Commentary

covering monetary, economic and geopolitical news events.
2010 mcalvany weekly commentary