Hey, simple passive cash listeners today is going to be a foundational podcast for a lot of you folks. We’ve with a repeat guest, Richard Duncan who wrote four books, analyzing the causes and the effects of the economic crisis. Now we’ve had him on the podcast in the back, but I brought Richard back and the way we’re gonna run this today is we’re gonna split this up into a couple of podcasts.
So this first podcast you guys are gonna be hearing is a little bit more evergreen. It’s a lot of his understanding and a lot of the stuff I’ve adopted in my understanding of the economy. And I think it’s gonna be very important for a lot of you guys, maybe replay this podcast again and.
There’s just a very different thought process and like how sophisticated people see different news articles in the media talking about the economy and how things really work today stay tuned and the second half or the next podcast, we’re gonna be talking a little bit more timely, current events.
What I say is learn the foundations that we’re gonna be talking about here today, because whatever happens in the world last time we talked to Richard, it was 2019, and I’m sure we were talking about the Koreans bombing Hawaii at that time or something.
I think that was the black Swan event at the time today in Ukraine, but whatever it is in the future by knowing these fundamental ideas, I think it gives you a better way to take everything in and not just be paralyzed and take into the fear mongering of the news media.
Thanks for jumping on Richard. I appreciate it. Lane, thanks for having me back. It’s a pleasure to be here. Yeah. So for people who are not familiar with Richard he runs a paid newsletter called market watch, which I subscribe to along with a lot of the other founding office members in our community.
And, he’ll come up with a, it is about a video a week, or no, every yeah, every month, I think you come up with a new one and a lot of it’s very timely, but a lot of it is more foundational. So we’re gonna be just, hitting the tip of the iceberg today. Let’s get started Richard.
For a lot of the investors, they’re new to how the economy works, how the fed works. Where should we start out first. The most important thing I think for everyone to begin with to understand is that the economy no longer works the way it did in the past.
The big break came when the United States stopped backing dollars with gold. That happened between 1968 and 1971. And afterwards our economic system evolved in a very different way. So the economic theory that everyone is still taught in university, all of the classical economic theory that was developed in the 19th century and before that was all based on the initial foundation stone, the initial premise that gold was money.
And it was all built on that foundation stone gold was money and therefore the economy had to work in a certain way because the gold was money, but after gold stopped being money in 1968, then things started to evolve. And now our economic system works in a very different way than it did before. And so it requires a different kind of economic theory to understand the way it works.
Because after all, I think everyone’s pretty convinced now that the old theory just can’t explain the way things work in the modern world. That’s why there’s been so much confusion about what’s going on in the economy for the last several decades. So let me explain in a little bit more detail. Up until 1968 the US central bank was required to own gold.
To issue to back up all the dollars it issued. That’s the way it had been since the Fed was created in 1913, but by 1968, the Fed didn’t have enough gold left to allow it to issue any more dollars. So this was a huge problem because if the money supply couldn’t grow, the economy would have a crisis.
So Congress changed the law and they removed that requirement for the Fed to hold any gold backing for the dollar whatsoever. That happened in 1968. And then just a few years later, Richard Nixon destroyed the Brett and woods system because that was based on allowing other countries to convert their dollars into US gold.
But by 1971, the US just didn’t have enough gold left to allow other countries to convert all of their dollars into US gold. We would’ve completely had no gold left whatsoever had that occurred. So Nixon renewed that promise for the US to allow other countries to convert his dollars into gold.
And so afterwards there was no longer a link in Melink whatsoever between dollars or money and gold. And afterwards the economic system started to evolve in ways that no one had anticipated or planned on. It just evolved naturally once these gold golden feathers were removed, things started to change most obviously.
The one thing that changed was the Fed was suddenly free to create as much money as it wanted, as long as it didn’t create high rates of inflation. So the next thing that changed was because the fed was free to create a lot of money. This enabled the US government to run larger budget deficits than it could be before without pushing up interest rates.
In the olden days, since there was only a limited amount of money, if the government had very large budget deficits, then it would’ve had to borrow a lot of money. And there was only a fixed amount of money. So the government borrowing would push up interest rates and that would, they say, crowd out the private sector because the higher interest rates made a lot of investments unprofitable, and that was bad for the economy.
But once the Fed was freed to create a bunch of money, as it pleased, it enabled the government to have larger budget deficits because the Fed created money and bought a lot of this government debt and financed the government budget deficits at low interest rates. So more that allowed more fiscal stimulus and that allowed the government to direct the economy more by having larger budget deficits and spending more.
Now the next, very important thing that changed after dollars ceased to be backed by. Was the trade between countries no longer balanced? It seems odd to think that before 1971 trade between countries was balanced, we had such enormous US governments and such enormous US trade deficits. Now, for instance, this year, the US trade deficit is going to be something like 1 trillion.
And we’ve all grown up in this world over the last three or four decades where the US has run these extraordinarily large trade deficits. But before 1971, that just didn’t happen. Trade was in balance. And the reason it was in balance was because, for example, if the US had a big trade deficit, let’s say with China, as it does today, it would’ve had to send its gold over to China to pay for the trade deficit.
And so US gold, which was money. The money supply would’ve contracted, and that would’ve caused a very severe recession in the United States. So unemployment would’ve gone up and there would’ve been deflation. And pretty soon, the Americans wouldn’t have enough gold left to allow it to continue buying things from China or any other country.
So trade had to come back into balance. There was an automatic adjustment mechanism under the bread and wood system. And before that, under the gold standard that made sure that trade between countries had to balance, because if it didn’t balance, you had to pay for your deficit with gold and gold was money.
You’d run out of money. And so you’d stop having a trade deficit was very simple, but once gold was no longer money, it didn’t take the United States very long to discover that it could start running very large trade deficits with other countries and it no longer had to pay with gold. It could just pay with paper dollars or treasury bonds denominated in paper dollars.
And there was no limit as to how many of these the US government could create. So starting in the early 1980s, the US started having a very big trade deficit for the first time ever. And by the middle of the 1980s, it was equal to 3.5% of GDP. That was just something entirely unprecedented, unimaginable.
But that was just the beginning in 1990, around 1990, China entered the global economy. And so the US started having larger and larger trade deficits with China. And by 2006, the US trade deficit was 800 billion in that one year alone. That was 6% of US GDP. Now, of course, this was fantastic for global economic growth.
Because with the US having an $800 billion trade deficit in that one year, that meant the rest of the world could have an $800 billion trade surplus. In other words, it could, the rest of the world could produce $800 billion worth of goods, more than it would’ve otherwise been able to do and sell it all to the United States.
And so this was a thing that, you could say, was globalization as the US trade deficit exploded between 1980 in 2006. This globalization, this huge US trade deficit created a global economic boom that allowed one country after another, around the world to grow through export led growth.
This had really started a bit earlier after world war II with Japan and being able to industrialize by selling a lot of goods to the United States and then Korea and then Taiwan. Then later Thailand and Indonesia, Malaysia, and more recently Vietnam and China. So in particular, all of Asia has been able to industrialize largely because it’s been able to make manufactured goods and sell them to the United States.
So this was great for the developing countries in Asia. It, in fact, pooled hundreds of millions of people around the world out of poverty. But from the US perspective, why this was so important is because when the US started buying more and more goods from low wage countries like Thailand and Indonesia and later China and Vietnam.
This by buying goods from low wage countries, this pushed down the cost of manufactured goods in the United States. It was disinflationary. It drove down the inflation rate and it also drove down wages in the US or held wages down. And so this is the reason that the inflation rate came down so sharply from the early 1980s up until very recently, globalization was extremely deflationary and it kept the inflation rate very low and that allowed interest rates in the US to go to very low levels.
So for example, because the inflation was so low, that meant that the interest rates could be very low. Between the year 2000 and the time when COVID started roughly a 20 year period, the average rate of inflation in the United States was 1.7% in that 20 year period. So that was below the Fed’s 2% inflation target for two decades.
So the Fed’s biggest worry was preventing deflation during those decades, rather than worrying about inflation. So the reason this is so important is because back say in the 1960s and 1970s before, while trade was still in balance, if the us government ran very large budget deficits and over stimulated the economy, and if the fed created a lot of money to help finance those trade deficits, then that always led the very high rates of inflation.
And the reason that led to very high rates of inflation is because all of that government spending and stimulus and money creation, would’ve created such a strong economic growth in the United States that everyone would have a job. And also all of the factories would be working at full industrial capacity.
The car factories would be working flat out. The steel factories would be manufacturing all the steel that it could possibly manufacture. And so we hit domestic bottlenecks, and these domestic bottlenecks resulted in prices moving up, both wages and the cost of manufactured goods. And this led to a wage push inflation spiral that we experienced throughout the 1970s.
So then everything changed though in the 1980s, because we started running these very big trade deficits with the rest of the world and they were very deflationary. So the deflationary forces from globalization completely offset all of the inflationary forces that were being caused by the very large government budget deficits and all of the paper money that was being created by the fed.
And we still ended up in a situation where. The inflation rate was lower than the fed wanted. And interest rates were very low and the very low interest rates, then there were two results from low interest rates. One credit expanded very rapidly, and the credit growth started to drive economic growth.
And also the low interest rates meant that asset prices inflated when interest rates moved down, asset prices like property and also stocks and all the asset classes tend to move up. So our economic system started, it evolved over these past many decades after dollars ceased to be backed by gold. And we moved into an economic system where credit growth became the most important driver of economic growth.
This was something quite so Richard, let me, before we move to creditism, yeah, so check my understanding here of Globalization like globalization is like a disruptor in a way. The way I see it, to use it in a modern day analogy, it’s like the apple M one ship.
It’s like a disruptor technology. It runs cooler. It’s a lot quicker. This apple, silicone, I don’t know all the things, but like for the time being it’s a total game changer and that’s what globalization was. It was the ability to get cheaper labor elsewhere. And that helped both sides of the equation, which is why India and China the, they came up in terms of network or worth, and America was able to outsource a lot of these jobs.
But in a way, is it like the apple, one ship getting old, five years, 10 years in the future? Is that kind of what’s going on with globalization? It’s been around for a while. You’re right. So globalization really produced a paradigm shift. And I’ve written about this in my new book, which is called the money revolution.
So what I’ve been describing so far since we’ve been talking is this money revolution that has occurred since dollars used to be backed by gold. The catalyst for the revolution was when the US stopped backing dollars with gold. And now what we’re experiencing is a partial reversal of globalization.
And this has occurred over the last couple of years first because COVID resulted in global supply chain bottlenecks. And more recently Russia’s invasion of Ukraine has worsened the global supply chain bottleneck. And this has caused inflation to spike. So for all of this time, from the early 1980s, inflation moved lower and lower until COVID hit.
And then once COVID hit well at first prices actually fell for a while when everyone was locked down. But soon after that, because of the government stimulus and the supply chain bottlenecks. Now we’re experiencing very high rates of inflation and this is a, so this has been a double blow to globalization that has represented a partial reversal of this paradigm shift that we’ve lived through as a result of globalization and the higher inflation rate poses, a very dire threat to not only economic growth, but wealth as we’ve already seen.
A great deal of wealth has been destroyed. This year stock prices have fallen and cryptos have crumbled and other risky asset prices have crashed. That’s because the reversal of globalization has driven up the inflation rate and that’s forced the Fed to tighten monetary policy very aggressively or begin to tighten it policy very aggressively with much more tightening to come.
Yeah, so that it’s not so much, globalization is getting old. It’s just that globalization has dealt various severe blows and it’s reeling. It is on its back feet. And it’s not certain how long we’re going to suffer this reversal to globalization. We’d like to think that COVID is going to come to an end sometime soon, but we can’t be certain about that.
In fact, the headlines just today are that, COVID, once again, is spreading around China. China has a zero COVID policy. So they’re shutting down their factories again and imposing new lockdowns. And so this winter, we may have an even worse variant of COVID than we’ve had thus far.
We just don’t know how long COVID is going to last and how long it’s going to continue disrupting its supply chains and how long it’s going to continue to hammer globalization. And likewise, we don’t know how long the war in Ukraine is going to go on. Hopefully it will end tomorrow. But on the other hand, in a worst case scenario, it could spread to other countries in Europe or even become a world war.
So we just don’t know how this is going to play out. And that’s what makes it so frightening today for investors and for economists and analysts trying to forecast what’s going to happen with stock prices and other asset prices. And the outlook for the economy is very uncertain. Yeah. Those two headwinds, you just mentioned one would assume that it would go away in the next decade, let’s just to have there’s some point where it, the impact ends, but globalization, to me, I feel still feel like there’s that’s still gonna keep ticking for a lot, much longer than that. Maybe even several more decades, like how, we said at one time the United States has no more oil fossil fuel, but apparently there’s a boatload of it, right?
That’s right. If COVID goes away, I believe it will. Not that I’m qualified to discuss that, but I hope that war will end sometime soon and not become World War II. Those, it probably will. COVID probably will go away. The war probably will end and things probably will go back the way they were in 2019.
For example, the last time we spoke. And if that occurs, then we’ll be back in this world where globalization is exerting very strong, downward pressure on us prices. And we’ll, it probably won’t take very long to get back to the point where inflation in the US is once again, below the Fed’s 2% inflation target.
And if we move back in that position, that is ideal because it allows the government to manage the economy pretty effectively through large budget deficits when necessary and through quantitative easing with the Fed, creating money and buying government bonds to help finance the government spending at low interest rates.
And of course the low interest rate, environment’s very positive for asset prices. So hopefully we will return there before too many more years have passed. Let’s back up cuz I, some people, so we don’t leave anybody behind here. Some people slow down to absorb a lot of this, which is makes a lot of sense to me as you go over this and this is what a lot, a lot of this content is actually taught through, a large module in Richard’s market watch content on his website, but maybe probably go to creditism and quantitative, easing, quantitative, I think people hear about it, but maybe not all together.
They hear it spoken about in the news here or there, Okay. So again, once dollars cease to be backed by gold, our economic system evolved and it evolved into a system that requires credit growth. Our economic system, our economy became dependent on credit growth. For example, going back to 1952, every time total credit in the US grew by less than 2% adjusted for inflation.
The US went into recession and the recession didn’t end until there was another very big surge of credit expansion. So that tells us that the US economy requires at least 2% credit growth adjusted for inflation to stay out of recession. That happened nine times between 1952 and 2009. And every time that credit grew by less than 2%, there was a recession.
Now let me add this total credit has accelerated so radically during my lifetime, what I mean by total credit? Total credit is the same thing as total debt. Because one person’s debt is another person’s asset. A credit that they’ve extended is debt to someone else. So you can look at this as all the debt in the country, not just the government debt, but the household’s debt, the corporation’s debt, the financial sector’s debt, all the debt in the country.
First went through 1 trillion in 1964, by 2007, just on the Eve of the financial crisis. It has expanded to more than 50 trillion. So that was a 50 fold expansion of credit in just 43 years. And now total credit is 90 trillion. So 90 trillion of credit expansion in just 52 years and credit growth became the main driver of economic growth.
As I’ve said, anytime credit grew by less than 2%, the US went into recession. Then, the crisis of 2008 occurred because the private sector had taken on so much debt. The households in particular had taken on so much debt that they couldn’t repay it. They couldn’t continue paying interest on their mortgages.
And so they started defaulting and the private sector started defaulting and the banks started to fail, but the government intervened very aggressively with multi-trillion dollar budget deficits, and the Fed helped finance those budget deficits with money creation. So between 2008 and 2014, the US government dead increased by 7 trillion.
And the Fed created three and a half trillion dollars through quantitative easing. To finance that government debt at low interest rates and the combination of government fiscal stimulus and money creation by the Fed prevented a new, great depression. It reflected the global bubble that started to pop in 2008 and it carried on, it carried us on up until 2020 when COVID started.
So I described this news, the way the economy works now is driven by credit growth. So rather than calling this capitalism. I call it creditism. Capitalism was an economic system that was driven this way. Businessmen would invest. Some of them would make a profit. They would save their profits. Or in other words, accumulate capital, hence capitalism and repeat.
So it was driven by investment and saving and then more investment and more in saving. And that’s what drove economic growth under capitalism, but in recent decades, that’s not the way our economic system works at all anymore. The growth driver for our economic system for decades now has been credit growth and consumption and more credit growth and more consumption.
So our economy has become dependent on credit growth. And as long as credit keeps expanding, everything’s fine. But when credit slows down and grows by less than 2% adjusted for inflation, we have a recession. And if credit starts to contract, as it almost did in 2008, then we would go into a great depression.
The government understands this and it now manages the economy as best it can to make sure that credit keeps expanding one way or the other. So after 2008, the private sector really couldn’t take on a great deal of additional credit. So the government had to drive the economy by borrowing and spending, and even with the government borrowing and spending on a multi trillion dollar scale.
For the first four years after 2008, that still wasn’t enough to make credit grow a lot more. It wasn’t enough to get credit growing by 3%. In other words, adjusted for inflation. It was even with all the government stimulus and the government debt credit growth was still weak. It was just barely above the 2% recession threshold as I call it.
So the Fed stepped in and through very low interest rates and round after round of quantitative easing, the Fed drove up asset prices and this created a wealth effect. The wealth increased and that allowed the Americans to consume more. And this, so this wealth effect engineered by the Fed supplemented the weak credit growth and allowed the economy to keep expanding.
So from between 2009, the end of last year, total wealth in the United States expanded by 150%. Total wealth grew by 90 trillion in those 13 years from 60 trillion in 2009 to 150 trillion at the end of last year, 150% increase in household sector wealth in the us. And of course the creation of 90 trillion of wealth was very helpful in making the economy continue to grow.
It allowed people to spend more money, more consumption, and consumption’s 70% of GDPs. So that helped fuel the US economy and that made the economy grow. But the problem was that the wealth, the asset prices were moving up much more rapidly than income. So the asset prices became extremely inflated.
There’s a very good measure, a good index that I look at called. I call it the wealth to income ratio. And when the wealth to income ratio goes very high, that tells you that asset prices are too expensive and they’re likely to correct. So what this wealth income ratio actually is the household sector net worth, which I was just talking about.
Household sector, net worth, hit 150 trillion at the end of last year. This household sector net worth is divided by personal disposable income. So it’s wealth to income. Now, the average for this ratio, going back to 1950, this wealth income ratio has averaged. 550% since 1950. But during the NASDAQ bubble, it hit a record high of 620% because the NASDAQ stocks were so expensive and that bubble popped, and it went back to its average of 550%.
Then during the property bubble, the wealth income ratio shot up to a new record, high of six hundred and six hundred 70%. And then the property bubble popped in 2008. And this wealth income ratio went back to its average 550%. But by the end of last year, because of this extraordinary frenzy, in all of the asset markets, the wealth income ratio went up to 820%.
That was 23% and above its previous all time high at the peak of the property bubble. This was telling us that asset prices were extremely stretched. And very vulnerable to anything that could go wrong. And the thing that went wrong is inflation went up and the Fed had to start tightening barriers aggressively.
And so now we’ve had the first half of this year has been the worst year for stocks going back to what the 1960s and in the second quarter in particular was particularly harsh. So we’ve seen NASDAQ down more than 30%. The S and P’s have been down more than 20%, two thirds of all the value of crypto has been destroyed and other expensive asset prices are crashing as well.
But even after this, the wealth to income ratio based on my calculations is still 730%. So it’s still. 10% above its previous, all time peak in, at the peak of the property bubble. So this is telling us that asset prices are still very expensive and potentially have a lot more downside to go. For instance, if the wealth income ratio were to fall back to its 50 year average of 550%, a total of 50 trillion of wealth would have to be destroyed between the end of last year.
And by the time we hit the average at the end of last year, total wealth in the US was $150 trillion. It’s now down because the sell off in the stock market is now probably about 135 trillion. But to return to its average, it would have to fall to 100 and $100 trillion. And that suggests that up to another $35 trillion of wealth could be destroyed.
Before we return to the average. Now it’s not certain that we are going to return to the average, but much of that is going to depend on how high the Fed increases interest rates and how much money the Fed destroys through quantitative tightening, which just started last month. Yeah. I think that’s a kind of a fascinating ratio right there.
How, but I’m thinking that there’s a wealth gap, right? Part of that is taking in the average consumer out there, which is getting worse and worse than the top 1% or 0.1%. How does that factor in wouldn’t there be even wouldn’t their percentage getting less and less over time if that’s the case, that’s the overall trend?
You’re right. The income inequality has become very much worse and over the last few years, but over the last couple of decades as well, if a lot of wealth is destroyed, a lot of that wealth will be wealth belonging to people who have more than a billion dollars, but at the same time, if we see, so if that’s the case, then you know, it might not be so terrible because someone who has $15 billion, it’s probably not going to spend a lot less money than when he had 20 billion.
He’s still going to keep spending a lot of money, but whereas someone who’s at the bottom of the income distribution spectrum, if they lose a little wealth, they would have to probably spend much less money. But now of course, a lot of Americans own stocks and a lot of Americans own crypto as well recently.
And with stock prices down so far already, these people are probably going to feel less wealthy. They’re probably going to cut back on their spending. Of course, all of the government stimulus over the last few years has helped boost savings and has enabled the American public broadly to spend more money.
But of course, those stimulus programs are over. Now. The first one was in March, 2020, the second one was December, 2020. And the third one was in March, 2021. That was 15 months ago, so that there aren’t going to be any more big stimulus packages. So that source of consumer spending is going to dry it very quickly as well, that, combined with the big losses in their 401k plans.
And once they realize how much money they’ve lost in the stock market this year, that’s likely to deter them from spending as much. So it’s going to be a real drag on the economy and soon property prices are also likely to begin to fall. As interest rates keep moving higher. Of course the property markets enjoyed a wonderful run.
I think it’s up to something like a third. Property prices on average home prices are up something like a third over the last two years, and they’re still going higher on a year on year basis, but that’s likely to reverse before long. The Fed has just now started tightening interest rates and they’re going to keep tightening rates.
They increased the federal funds rate by 75 basis points last month. And they’re expected to increase another 75 basis points at the end of this month. And they’re likely to keep increasing the federal funds rate every time they meet through the middle of next year. So it’s not the federal funds rate now; it’s roughly in a range between 1.5% and 1.75%.
But by the middle of next year, it could move up to four and a half percent. And if it does, then the 10 year government bond yield is going to be at least four and a half percent and mortgage rates are going to be significantly higher than that. And so property prices are likely to begin falling and a lot.
And of course, most Americans are nearly most of all the Americans own their own homes or the majority at least. And so if they start feeling that their home prices are following, this is also going to curb their consumption, right? And with the fed increasing, the fed inflation rate now has shot up to 8.6%.
These are CPI headline numbers. The core numbers are lower, but they’re still well above the Fed’s 2% inflation target. So the Fed’s going to have to keep hiking the federal funds rate and pushing interest rates higher. The Fed’s mandate is stable prices and maximum employment. While employment’s extremely low, 3.6%, the Fed’s going to have to concentrate on bringing down the inflation rate.
Now, inflation is driven by supply and demand. If there’s too much demand and too little supply, then you get rising in prices. And the fed can’t do anything on the supply side, the fed can’t go out and drill more oil Wells or plant more wheat. They only can operate on the demand side. And so, what that means is they have to make demand go lower.
If they’re going to bring the inflation rate down. And the only way they can bring the demand side lower is by increasing interest rates so far that they throw millions of Americans out of work, and also destroy a lot of wealth by making the stock market and the property market fall. And by that makes demand lower by making demand lower, that makes inflation lower and so that’s what they’re intending to do now. They’re intending to drive up the unemployment rate, they’re intending to destroy wealth so that the inflation rate comes back down.