A failure to understand the credit cycle:
Any further fiscal and monetary expansion will begin to create …. Economic Overheating.
From Alasdair Macleod:
If the economy was on its uppers, Trumpenomics could be reasonably compared with Reaganomics. But that is not the case. The economy is operating close to capacity, ….any further fiscal and monetary expansion will begin to create …. economic overheating.
A failure to understand the credit cycle
Few, if any macroeconomic commentators, seem to be aware of how the global economy is performing. Their selective reliance on duff and out-of-date statistics forces them to anticipate what lies ahead by looking backwards. This approach to economic forecasting and planning gives as little hint of what lies ahead as it does for driving along a winding country road, and has only encouraged closer scrutiny of the past. Ignorance itself is increasingly ignored as the causative factor behind the manifest failure of modern macroeconomics.
Even perfect knowledge of the past and present is no substitute for understanding that it is unpredictable change, the dominant characteristic of progress and regress, that makes the past barely relevant. The modern reliance on statistics, most of which are produced by government agencies with vested interests, is nonsensical. Instead of understanding this, we rely on the opinions of the great and the supposedly expert. Nearly every pundit’s introduction nowadays starts with a list of his or her academic achievements, as if they mattered. Indeed, to be believed in macroeconomics requires PhDs, professorships and the all the rest, as cover for the lack of a true understanding of economics.i
That the cream of the economics profession is clueless was admitted this week by a rate-setting member of the Bank of England’s Monetary Policy Committee, in evidence before the Treasury Select Committee of the UK’s Parliament. The BoE’s forecasters have not only got the performance of the economy over Brexit horribly wrong, but it is now admitted that “….there are large forecast errors, and we are probably not going to forecast the next financial crisis, nor are we going to forecast the next financial recession.”ii
Opinion, which is what these macroeconomists possess, is inappropriate for economics, being built on the quick-sands of Keynesian wishful-thinking, as opposed to the firm ground of sound reasoning. The combined intellects of all the panjandrums in all the central banks, in all the top universities, and in all the smart investment banks have consistently failed to foresee any financial crisis. And they now underestimate the degree to which the global economy today has progressed, aided by human nature and buoyed up on a sea of financial credit. They also underestimate the consequences of today’s events for price inflation, which is approaching a confluence of events on the demand side, against a backdrop of a marginally unresponsive physical supply. When the purchasing-power of fiat currencies declines, measured initially in rising commodity prices, the purchasing power of sound money, which is gold, rises, undermining confidence in fiat money even further. That is the background, in place for a year now, to a rapidly approaching train-wreck. Only a handful of prescient analysts, those who understand the considerable risks posed by unsound money, are gradually becoming aware of the consequences for prices measured in fiat currencies.
China is the world’s locomotive
For these reasons, nearly all that we read in Western commentary about China emphasises the risks from her overblown credit bubble, such as in property speculation, misallocation of resources, and capital flight. China’s government is cast as an economic villain, while we in the West are the good, responsible guys. This is blatantly biased. In discussing China, it is as if we are proto-Austrian. In analysing our own welfare-committed economies, we remain stubbornly Keynesian.
To understand China, you must first accept that it is a tightly controlled, command economy. The state owns the banks, so controls both money and credit, unlike in the West where credit expansion is devolved to the private sector. The banking crises we face in our welfare states do not happen in China. Instead, the Chinese government, through its banks, selects the indebted enterprises that survive and those that fail. Some very respected investors in Western capital markets have lost fortunes through not grasping this fundamental point.
Control over all forms of monetary creation and the prosperity, or otherwise, of indebted businesses is the foundation of China’s five-year plans. It allows China to be the ultimate mercantilist, directing money, businesses, and people in the interests of the state. A purely communist economy fails, as has been demonstrated under Mao, and in the USSR. But a communist economy deploying directed capitalism is a powerful force. It has taken China from being a sleeping, backward subsistence economy to the world’s largest trading nation in less than forty years, while the communist apparatus has broadly survived.iii
For this reason, China is less of an immediate threat to global economic stability than the welfare states in Europe and America, whose finances are deteriorating rapidly. China has become the locomotive engine driving the global economy, but because macroeconomists in the West don’t trust China and its statistics, while swallowing those of their own governments without question, China does not feature as much as it should in their analysis. The fact of the matter is China’s five-year plans are unleashing enormously positive economic forces, encompassing the world’s largest land mass and its populations. It is a gross mistake to ignore them, and their consequences for prices in all currencies.
There are two main thrusts in the current five-year plan, which will also be the basis for the ones that follow. Firstly, domestic demand is being redirected towards services and high technology, away from manufacturing cheap consumer goods, which has been China’s export staple so far. It involves the urbanisation of some 200 million more people, moving them into newly-built accommodation in expanded cities, while raising their living standards. Furthermore, the plan includes a significant upgrading and extension of China’s infrastructure. It is no coincidence the current bull market in commodities commenced at the beginning of 2016, roughly the same time as the commencement of the current five-year plan.
Secondly, China is progressing with her plans to revolutionise the whole of the Asian continent, creating an industrial transformation for the whole area. Most analysts have heard of the two silk road projects, but fail to grasp their scale and of their associated developments. One is overland, tying together the countries to the north of Tibet with the Mediterranean. The other is the sea route from China through the Indian Ocean, to link the populous countries south of the Himalayan ridge. The sea route ends in East Africa, where a new Uganda railway is to be built, shipping both agricultural products and other resources from the heart of Africa back to China. To finance the Silk Roads and associated infrastructure, China set up the Asia Infrastructure Investment Bank, which no Western financier can afford to ignore, because it will be raising the equivalent of many trillions of dollars. These plans are already well advanced, and China is aggressively acquiring the necessary raw materials.
All this is overlooked by Western data-watchers in their day-to-day analysis. If they got off their butts and went to Shanghai, they would see how incredibly busy that port is today. If they travelled round South-east Asia, they would see that China’s supply chain, comprising the whole region, plus South Korea, Japan and Taiwan, is booming. Yes, even the Japanese zaibatsu haven’t had it so good, at least since the 1980s. And if they travelled further afield to Europe, they would see British services and German engineering are being exported into China and the Far East in increasing quantities. Yes, even Europe is benefiting, putting the EU on the road to economic recovery.
Missing in this picture is America. Well, not entirely, because private Chinese capital has been deployed into the United States. But at the government level, China sees Canada instead as her natural North American partner. Trudeau père first went to China in 1983, and there is today a natural preference for dealing with Trudeau fils. Canada also has much-needed resources, and a history of freely exporting them, unlike the US which often trades resources with attitude. And that was before Trump.
Being business-like can damage your economic health
Trump was elected on a promise to revitalise America. But unnoticed by both Trump and the massed ranks of Western macroeconomists, the US economy has been tramping along quite nicely, with bank lending expanding above trend all last year. True, it’s nothing spectacular, but unemployment, if you believe the figures, has fallen to below the Fed’s target rate of 5%, and price inflation measured by the CPI is rising and is already over the 2% inflation target. Yet the Fed so far has refused to normalise interest rates. With sound money, risk-free short-term interest rates historically averaged roughly two per cent, perhaps a little more. With an unsound dollar, it is likely to be a moving target, rising higher at times of enhanced currency risk. Allowing for the debasement from officially-admitted price inflation, a normalised Fud funds rate should arguably be about four per cent.
Turning from monetary policy considerations, President Trump seems to believe that old manufacturing industries should be regressively revived, ignoring the cost to the consumer and manufacturing itself. Coal and cars were yesterday’s staple, but no longer. He is bullying American manufacturers to stop manufacturing the latter abroad. He promises to restrict imports to protect domestic manufacturers, threatening to tax importers’ profits at a higher rate than for domestic producers and exporters. These measures, if followed through, are likely to lead to the market dislocations experienced in the days of Smoot-Hawley, eight decades ago.
It seems we have learned little since. But does anyone in Asia care? Not the Chinese, that’s for sure. They have other fish to fry. China has a far larger market for itself in Asia, extending from the Bering Strait to the Gates of Jerusalem and beyond. Make America great again? Nice thought in a retro sort of way, but retro it is. That is the reality of Trumpian economics.
While we have yet to see the true colour of Trump’s fiscal plans, he has been raising expectations that he will introduce substantial tax cuts. He has been less believable about cutting government spending, excepting Obamacare. Trump has promised to reduce regulations and red tape. It will be a miracle if he manages it, and we can’t be sure how much money will be saved by axing Obamacare, allowing for unintended consequences. It is therefore a fair bet, assuming even some of his plans are implemented, that the budget deficit will escalate sharply, and also outstanding Federal debt, already standing at $20 trillion.
Trump has also been talking foreign currencies up, which is admittedly more patriotic than talking the dollar down, but amounts to the same thing. He expects a trillion dollars to be invested in decaying infrastructure over the next ten years as well, without much thought about the marginal effect on industrial commodity prices priced in dollars, at a time when China has already cornered much of the market.
These are just some of the upcoming challenges facing America at the macro-level. If the economy was on its uppers, Trumpenomics could be reasonably compared with Reaganomics. But that is not the case. The economy is operating close to capacity, by which we mean that any further fiscal and monetary expansion will begin to create supply bottlenecks and economic overheating. Commodity prices are already rising, driven by Asia’s regeneration. An accelerating US budget deficit, at this stage of the credit cycle, seems certain to lead into a dollar crisis, not in the distant future, but brought forward to later this year, taking US Treasury bond prices down with it.
Bond yields will rise
The potential for rising dollar nominal bond yields, being suppressed too low for this advanced stage of the credit cycle, is great and brings systemic dangers. American and international corporations rated at or close to junk will be threatened with bankruptcy. Investment-grade bonds will in turn become junk. Today’s level of private sector debt is simply unaffordable at much above zero interest rates. The effect of higher bond yields on government finances will be most unwelcome at a time of escalating US budget deficits.
Worse still will be the effect on euro-denominated bond yields. A rise along the euro yield curve of not much more than one or two per cent could force the ECB into recapitalising itself at a most embarrassing juncture, and the survival of some major Eurozone banks, which have accumulated mountains of Eurozone sovereign debt on slender capital bases, will also be threatened. And this is before we consider the financial consequences of a European Union that’s threatening to split up, raising questions about the euro’s own future.
It is hard to avoid the conclusion that Trump’s tax and infrastructure plans will bring forward the end of the dollar’s current credit cycle, and those of the euro and sterling with it, into a new crisis phase.
A falling dollar will drive the gold price
Whether or not the dollar rises or falls against other currencies is not the point, the point is its purchasing power is already declining against a basket of industrial materials, and therefore gold. This remains true even if Trump wises up to the risks he is creating, because China’s demand for natural resources and energy is already driving commodity prices higher.
Given the risks the dollar now faces in the coming months, it is hardly surprising the gold price is rising, after its weakness in the final quarter of last year. It has surprised many market observers that a higher interest rate outlook, accentuated by Trump’s plans, has failed to stop the gold price rising. And here we come across something else that most Western-centric market commentators fail to appreciate. At the margin, Asian governments and their peoples prefer physical gold to dollars. Dollars are for transactions, when you take them in payment and then pass them onto someone else in exchange for goods and services. Gold is for keeping, and saving for the financing of capital projects, the collateral of last resort for borrowing depreciating dollars. Looked at that way, it is understandable that Asia will continue to dump its excess dollars for gold.
China has been expecting the switch out of dollars into gold for a considerable time. Indeed, it has contributed to it by setting up the Shanghai Gold Exchange, to give its own citizens the chance to protect themselves from declining fiat currencies by accumulating gold. More recently, it has introduced an international futures contract, pricing gold in yuan. It intends to do the same with oil futures but has deferred that part of the plan. China’s energy suppliers, receiving yuan, would be able to sell the yuan forward against oil, buy gold futures and take delivery of physical gold. This would badly undermine the dollar, and China is not yet ready for that eventuality, because she has too many dollars in her reserves.
China still has about $1 trillion of US Treasuries and T-bills, which it is converting into commodity and energy stockpiles. Obviously, it will want to reduce its UST and T-bill holdings further, before it effectively pulls the plug on the dollar by launching the oil futures contract. Furthermore, China will probably wait to see what a meeting between Presidents Xi and Trump yields before launching the promised oil futures contract anyway.
The global economy recovered during 2016, driven by China’s mercantilist plans. So massive has this stimulus been, that in the near future a danger is developing of supply bottlenecks in key commodities. The US economy has finally begun to perform reasonably well, despite what the doomsayers have been telling us. The Trump stimulus, if carried through, is not only too much too late, it is conflicting and downright dangerous.
US interest rates should have already been raised by now to more normal levels, but the normalisation of rates risks triggering a crisis through a mass liquidation of malinvestments. This may be the reason for the Fed’s reluctance to raise them to the correct level. Furthermore, with a widening budget deficit in prospect, it is hard to see how US Treasuries will avoid tipping into a vicious bear market. The risk is of a perfect storm.
Therefore, the current bullishness for the dollar in Western capital markets is based on out-of-date assumptions, only discounts first-order effects, and is likely to evaporate rapidly. Instead, its rally following the presidential election looks increasingly like an uptick before a very big fall. And if markets wrest control of term interest rates from the Fed, as seems increasingly likely, the Fed will become powerless to curb price inflation, without triggering a major credit and systemic crisis, for which the Lehman failure will just look like a warm-up act. I would not be surprised if the macroeconomic community in America, when it recognises the danger, begins to discuss the option of introducing price controls, as the only option left. If it doesn’t, it is likely Trump himself will.