QE = Debt Cancellation
by Peter Coyne, Daily Reckoning “So, basically,” wrote one reader after mulling over, “we’re screwed… “More of the same to stay afloat — yay! Stagnation and suffering ahead — oh, boy!! Nothing could be better!! Yipee!!! I’m so glad — let me jump in front of this speeding train to celebrate…” If you’re just tuning in, we’re two parts deep into our three-part conversation with Richard Duncan. In Part I, he outlined why he believes capitalism has died… and where that leaves us. In Part II, yesterday, he went a step further to explain why QE4 and probably QE5 are necessary to stave off collapse. Don’t tell Congress… but Duncan explained that if Japan’s debt-to-GDP ratio was any indication, the U.S. has at least $17 trillion more in borrowing headroom. After having 24 hours to chew on that fact, some of your fellow readers are finding Richard’s point of view… umm… hard to swallow. “I just have to reply to your ‘deep thinker,’” wrote a second reader. “Austrian economists always like to refer to the three people on an island to demonstrate how resources are finite. Duncan’s idea is nothing more than I’ll pay you Tuesday for a hamburger today. Eventually, there are no more hamburgers and everyone goes hungry. This type of deep thinking is what caused the problem we have now. “Substitute money printing for creditism and the brilliance of this line of thinking is reduced to its true essence. They are both the same. There are limited assets on the planet, and creating more credit cannot solve that problem. “His eventual conclusion is the correct one, so bite the bullet, take the pain and deal with reality. Otherwise, this will end in a crisis of incredible proportions. We are simply living the crackup boom, and there are no grown-ups around to end the party.” Our second reader may be right — no one really knows. But Richard, right or wrong, reaches a different conclusion. We think it’s at least worth considering. “The question,” he cautioned in these pages on Oct. 24, 2014, “is not whether we are going to abandon capitalism and replace it with a different kind of economic system. We did that long ago. The question is: Are we going to allow the economic system now in place to collapse?” He then outlined three distinct options for policymakers…
Option 1: The government could sharply reduce its spending. The result would be a New Great Depression. This is the least attractive option. Option 2: The government could carry on doing what it does now — that is, the status quo, borrowing and spending to support consumption. This approach would sustain the economy for at least a decade. Then there would be a U.S. sovereign debt crisis, and the world would collapse into a New Great Depression. This option is preferable to Option 1, but far from ideal. Option 3: The government could borrow and invest in a way that not only supports the economy but actually restructures it so as to restore its long-term viability. This option, rational investment, is the only one of the three with the potential to result in a happy ending. If government is invested in projects that will generate a high enough return to pay the interest on the debt, then it will support not only the economic structure now in place, but also a larger and more prosperous economy.
The part to remember, though, is that you can ignore Richard’s prescriptions if you don’t like them. They’re a moot point, anyway. We’re not crazy enough to debate policy — certainly not on a Friday. Instead, we’re here to serve up analysis of what the Fed and Congress might do next and why and then figure out what the impact might be on your money and investments. To that end, we find Richard’s descriptions of what may happen as a consequence of possible policy actions helpful. We hope you do too. You’ll find the third part of our discussion, below… Peter Coyne: Richard, when we left off yesterday you were talking about globalization and deflation. Mind picking up there? Richard Duncan: Yes. You know, Pete, as I’ve said, the thing everyone should keep in mind is that we’re not starting from some sort of laissez-faire equilibrium state today. We have a massive global economic bubble and its natural tendency is to collapse into deflation. The natural tendency is for this bubble to deflate and on top of that globalization is very deflationary. Today is not like the old days when we had a domestic economy where trade had to balance. Since the Bretton Woods System broke down in 1971, the U.S. has been able to run very big trade deficits. And so we no longer hit domestic bottlenecks. We can just buy as much as we want from the rest of the world. That’s why we’ve been able to avoid inflation ever since we started running very large trade deficits. Now on the labor side of the global economy there are two billion people who live on less than $3.00 a day. That means we’re never going to get labor constraints within our lifetimes and probably not for several lifetimes. In terms of industrial capacity, China has created so much industrial capacity across every imaginable industry that there is far, far too much of it and so product prices are falling. In China they’ve been falling every month for 36 months. You’ve heard the statistic, no doubt, that during two years recently China expanded its — I think it was cement production — by as much as the U.S. did during the entire 20th century. We have a big global credit bubble that would deflate if left to its own devices. It would deflate into a great depression like the 1930s. But policy members have been keeping it inflated — very successfully as we’ve been discussing. They kept the horrific global credit bubble inflated through massive budget deficits and trillions of dollars of fiat money creation around the world. But just barely. Inflation rates are pretty much at zero now most places — at least in the developed western countries. So it looks like it’s more likely to deflate from here than to inflate. Peter Coyne: When we spoke yesterday, you explained your raft analogy. I was wondering if the raft represents just one country in isolation or are you talking about the entire global economy. I ask, because even though QE has ended in the U.S., we still have QE in Japan… a new QE program in Europe… rate cuts from many other central banks. What’s the net effect? Richard Duncan: With every analogy you can only take it so far. But I generally mean it’s global and it helps the global economy when several central banks are creating money very aggressively the way that the ECB and the Bank of Japan are doing at the moment. But of course it has a different impact on different parts of the world. Peter Coyne: Can you elaborate on that? Richard Duncan: Yes. Well clearly now that ECB is printing 60 trillion euros a month — that’s very aggressive. And Japan is equally aggressive and they’ve been at it now for two years. So in both of those cases, they’re actually printing the equivalent of and buying financial assets equivalent to twice the budget deficits of those countries, respectively. So they’re not only monetizing the debt, they’re monetizing it twice over in Japan and Europe. Now it’s important to understand that QE is debt cancellation. And let me briefly spell out the details of what I mean by that. The right now the way it works is, okay, the Fed has printed money and it’s accumulated $2.5 trillion of U.S. government bonds. And so the government has to pay interest on those bonds to the Fed and it does. But at the end of every year, the Fed gives practically all of that money, all of its profits — which mostly come from the interest income on those bonds — the Fed gives all of its profits back to the government. So in other words, it’s essentially the same thing as the government paying interest to itself. The government pays the Fed, which is really part of the government. The government pays interest to the Fed. The Fed takes that interest and gives it back to the government, effectively cancelling those bonds. Last year the Fed gave $97 billion back to the government and that reduced the budget deficit last year by almost 20%. It would have been $600 billion instead of $500 billion. Since 2008, the Fed has given the government half a trillion dollars in this way reducing the budget deficit by half a trillion dollars. So, as long as the Fed keep rolling those bonds over when they mature (as they are doing now) and so long as the Fed never sells those bonds, then the $2.5 trillion worth of government bonds that the Fed has acquired has been effectively cancelled. This debt has no cost to the government. This is going on in the U.S. and also in the U.K. where the Bank of England has roughly 25% of all of U.K. government debt paying interest to itself, effectively cancelling that. ECB is now doing it as well. But Japan is a particularly interesting case because in Japan, as you know, the Japanese government debt is something like 250% of GDP. At this stage, the Bank of Japan has now accumulated government debt equivalent to 50% of GDP. In other words, effectively they’re cancelling 20% of all of the Japanese government debt. And it removed 50% of GDP out of the 250% of GDP in total. I think once you understand that QE is debt cancellation, it really makes sense of Japan’s very aggressive QE policy. Because they’re now buying up twice the budget deficit every year. With every month that goes by, their percentage share of total government debt outstanding is growing. So in a few more years they’ll have 100% of government debt to GDP, and then 150% of government debt to GDP — if it goes on like this. This is important because right now in Japan the interest rates are extremely low — 30 basis points on ten year Japanese government bonds. People have always worried that if any sort of shock occurs and interest rates there go up say, by, 300 basis points to 3% then it would effectively create a fiscal crisis that the government may not be able to deal with. But the greater the share of Japanese government bonds held by the Bank of Japan, the less likely such a crisis would be. That’s because no matter how high the interest rates go, the government — the ministry of finance — would have to pay interest on those bonds to the Bank of Japan but the Bank of Japan would just give all that money back to the government. So the more the Bank of Japan acquires, the less government debt outstanding there actually is that the government has to worry about because the debt held by the BOJ has been effectively cancelled. Peter Coyne: Okay. I’d like to turn to the liquidity gauge that you track. It’s a good indicator for asset prices. I’ve updated your work on it periodically since you and I met in Australia last year around this time. I believe, and correct me if I’m wrong, that the last time we talked about it, you had an estimate for a $200 billion liquidity drain in 2015? Richard Duncan: Yes. Peter Coyne: Is that still the case? And can you describe what that means? Richard Duncan: Things have changed in two ways. There is still a drain in 2015 and as far as the eye can see into the future. Remember the liquidity gauge is quantitative easing plus the current account deficit. Today, there’s no more QE. So it’s just the current account deficit that is supplying liquidity while government borrowing is draining liquidity. Today, government borrowing is higher than the current account deficit unlike the 12 years from 1996 until 2008 or so. So we’re seeing a liquidity drain. But it is necessary to adjust the numbers for two reasons. The first reason is oil. We have had a very significant collapse in the price of oil. The U.S. is importing much fewer barrels of oil every year because it’s producing so much more domestically. On top of that the U.S. is exporting more and more petroleum related products. So both in volume terms and value terms, the “oil deficit”, if you want to call it that, is becoming significantly smaller. And that reduces the country’s current account deficit. That supplies less liquidity to the U.S. economy and it makes the liquidity drain more negative. However, offsetting that you have a very strong dollar now which should make U.S. imports increase. That in turn should make U.S. exports decrease and make the current account deficit worse. So these two factors are pulling in different directions. So I’m trying to recalculate what all of this will mean for the liquidity gauge. Overall, it’s still negative. But I think it’s not as negative as the last time we talked. Peter Coyne: Okay, so it’s safe to assume that you think that the Fed increasing interest rates this year would be a very bad decision? Richard Duncan: Yes, I find it odd that they’re still so aggressively talking about increasing interest rates, given how weak the U.S. economy seems to have become in the last few months. You must have seen the Atlanta Fed’s GDPNow numbers? Peter Coyne: I did. Richard Duncan: At the beginning of February it was suggesting that the first quarter GDP should be growing at something like 2.4% and now it’s showing that it only grew by 0.1%. The numbers have been pretty bad across the board. Some of it may have been weather related. But that really doesn’t explain what’s been going on in other areas. Maybe there was some impact from the west coast port strikes or work slowdowns, but that ended in the middle of February so that shouldn’t have such a lingering effect either. Continue Reading>>>