By David Stockman as originally published on Contra Corner and reprinted here with permission
The effect of central banking’s bad money has been to preternaturally bulk up China’s industrial economy and hollow out America’s. It’s as if some accelerated form of economic plate tectonics had broken off large chunks of the US industrial midwest and southeast and implanted them in the Pearl River Delta (Guangzhou), the Yangtze River Delta (Shanghai) and the Bohai Economic Rim (Beijing, Tianjin, Hebei).
This historically abrupt transplantation happened after 1987 because in a world of virtually unlimited central bank credit, there is no settlement process. Deformations do not get culled out on a regular basis by the mechanisms of the free market. Instead, under the tutelage of the state and its central banking branch they metastasize indefinitely until they finally hit a politically-inspired wall of resistance.
At the present world historical moment that wall of resistance is bedecked with an Orange Comb-Over. That is to say, Donald Trump’s real mission has been to crush the 30-year old toxic symbiosis under which mercantilism in China and financialization in the US functioned as two mutually reinforcing peas in a pod.
In effect, bad money caused the substitution of massive household debt and drastically inflated financial assets for the wealth and output of America’s lost industrial provinces. At the same time, and in conjunction with the militant mercantilism of China’s all-powerful post-Maoist state, it generated today’s upside-down global economic order.
We are referring, of course, to the fact that as a relatively poor, developing economy, China became the de facto $4 trillion banker to the rich, developed world. Accordingly, the 21st century to date has risibly mocked the rules of 19th century gold standard capitalism: It’s as if economically backward India had been the banker and the booming industrially advanced regions around London had been the borrower.
The absurdity of this arrangement—–China’s reckless debt-besotted Ponzi functioning as the world’s putatively solvent and sober banker and capital exporter—is lost on the Wall Street/Washington ruling classes owing to the scourge of financialization. That is, they have become so addicted to measuring economic health through the S&P 500 that they are oblivious to the vast economic deformations that bad money has wrought.
In that respect, there is a certain flavor of free market ideologues who contribute—perhaps inadvertently—to the mainstream blindness. Their argument goes that America is such a wonderful place that global capital comes beating on its door.
So if you want to enjoy the fruits of vast capital inflows you need to run large trade deficits; and presumably forever, world without end. It’s just an accounting identity!
Then again, the laws of compound arithmetic do put a damper on the theory of eternal deficits. Since the last US surplus on its international investment account in 1988 ($21 billion), the balance has plunged southward on a virtually uninterrupted basis and now stands at negative $8 trillion.
A polite word for the orange bars in the graph below is “US international indebtedness”, and it has been rising at a 21.5% annual rate for 28 years. Another 28 years at that rate and the US would owe the world $2 quadrillion, and at just one-half that rate it would still be a $150 trillion debtor by 2045.
Obviously, Stein’s Law of unsustainability (it tends to stop) would come into play long before either eventuality, but our point involves more than just arithmetic.
To wit, the US economy’s (positive) +$300 billion net investment balance with the rest of the world in 1980 (you can see it by squinting) represented about 10% of GDP. That figure was not unusual or unreasonable for what had been the world’s leading export economy and creditor nation during the previous six decades (since 1914).
But America most surely did not become rich by plunging deep into debt with the rest of the world thereafter—-such that by 2017 its net investment position amounted to (negative) -42% of GDP. What the academic free traders forget is that bad money and free trade do not play well together; the former destroys price signals and blocs market clearing adjustments.
So doing, it attempts to violate Stein’s Law. But now we know in fact, rather than just in theory, that it’s impossible.
At length, you get Donald Trump instead, and you get his half-baked advisor, Peter Navarro, on bubblevision this morning explaining that protectionism is the new route to free trade!
We are pretty sure it’s not, and that the Donald’s “art of the deal” approach to the world’s giant trade imbalances is a dead end. That’s because at bottom the latter is mainly not the result of bad trade rules, unfair practices or deals that can be re-negotiated in a game of global trade policy poker; it’s overwhelmingly the fruit of bad money.
And insofar as we can tell, our King of Debt in the Oval office made his putative billions on the back of the very same, and is OK with “low interest” as far as the eye can see.
That means, of course, that brinksmanship and Donald-style negotiations are not going to much change a hideously unbalanced merchandise trade account whereby the US exported $130 billion to China in 2017 and it exported $506 billion to the US.
That $375 billion deficit (59% of two-way trade) would never happen on the free market under a regime of honest money because relative prices, wages and costs would have adjusted long ago.
But neither the statists of the Greenspan Fed nor the mercantilist Red Suzerains of Beijing were about to let the law of markets accomplish its good works.
Thus, after the October 1987 market crash Greenspan went all in for monetary central planning. At length, he flooded the world with cheap dollars in order to suppress domestic interest rates and encourage Americans to live high on the hog by tapping their home equity (yes, the Maestro bragged about MEW or mortgage equity withdrawal).
In turn, Beijing reciprocated buy running the People’s Printing Press (PBOC) still hotter.That is, it scooped-up $4 trillion of US, Japanese and Euro debt securities in about 15 years, and not because Beijing was itching to invest in greener capitalist pastures abroad, as our Friedmanite free marketers now suppose.
To the contrary, Beijing devoutly desired to do the opposite: Namely, to foster massive capital investment, employment and income gains at home by goosing their export industries with weak exchange rates and low domestic wages and prices. In order to do so, they bought dollars hand-over-fist to peg their own currencies, and then sequestered these accumulations from chronic FX intervention in the vaults of their central bank and sovereign wealth funds.
An old-fashioned name for this is the “dirty float” and its exactly what Professor Friedman and his errand boy at Camp David in August 1971, George Shultz, did not see coming.
Being freshwater Keynesians with a fondness for free markets everywhere outside the realm of money and central banking, they did not understand that by ash-canning the Bretton Woods gold exchange standard they were unleashing the central banks to relentlessly abuse, exploit and supplant the free market where is it most needed: That is, in the money and capital markets which are at the vital heartbeat of market capitalism.
That’s the essential story from the mid-1990s onward—-after China slashed its exchange rate by 60% and thereafter pegged it to the dollar via massive and continuous exchange rate intervention. Under a regime of sound money in the US, the resulting collapse of the US trade accounts would have automatically generated a sharply higher interest rate, which, in turn, would have fostered a systematic deflation of domestic prices, wages and costs.
At length, US exports would have become more competitive and expanded, while imports—especially from mercantilist dirty floaters like China—-would have lost competitive advantage and declined. But this kind of sound money/free market adjustment never happened.
Instead, pretending that he was the scourge of inflation by keeping the CPI at +/- 2.0%, Greenspan did the opposite. He drove interest rates steadily lower in both nominal and real terms,and thereby generated the antithesis of the classic gold standard equilibrium.
Instead of rising, interest rates steadily fell even as the current account deficit ballooned to historically unheard of levels.
In this context, it is well to recall what real interest rates looked like during the golden era of the late 1950s through 1965— prior to the breakdown caused by LBJ’s “guns and butter” madness.
Under the estimable William McChesney Martin, a chastened veteran of the 1929 Wall Street crash, the spread between bond yields and inflation—-that is, the real interest rates—remained in the 2.5%to 3.5% zone. At the same time, the current account was roughly balanced, and the world complained of a shortage of dollars during most of the period.
The Gold Era Real Interest Rate—2.5% to 3.5%
By contrast, after the Long-Term capital meltdown on Wall Street in September 1998, the Greenspan Fed threw caution to the winds and the rulebook of sound money out the window. By now hooked on the cult of rising stock prices, the Greenspan Fed essentially trashed the dollar, thereby causing the Red Suzerains of Beijing to double-down.
That is to say, as the Fed expanded it balance sheet, China reciprocated: It intervened in FX markets ever more heavily to keep the RMB just as weak as the Greenspan Fed was implicitly making the dollar.
Stated differently, the US needed high interest rates and a super-strong dollar in a world of dirty floats, but the Maestro presided over just the opposite. He put the Fed in the business of basically eliminating (real) interest rates.
Indeed, by encouraging the Chinese and other mercantilist to stock up on Treasury debt at an even more rapid rate than the Fed, Greenspan caused the central banks of the world to become a giant convoy of debt monetization and price falsification across all the financial markets of the planet.
So doing, central banking defeated free markets and free trade. It fueled a continuous enlargement of global economic imbalances and deformations rather than allowing market driven interest rates to restore equilibrium.
One consequence of Greenspan’s destruction of market rates of interest was a household debt binge that temporarily supplanted the domestic jobs and incomes that were being lost to off-shoring with the proceeds of borrowing. Since the GDP accounts were devised by Keynesians way back in the 1930s and 1940s, this substitution was initially invisible.
After all, personal consumption spending accounts for 70% of GDP, and no one at the Commerce Department which compiles it (the BEA) asks consumers whether they earned the dollars they spent during the quarter at hand or borrowed them.
At length, however, the piper has to be paid. Notwithstanding the temporary deleveraging during the great financial crisis and its aftermath, household debt today stands at nearly 6.0X its 1989 level compared to only a 3.8X rise in nominal wages and salaries.
Alas, the debt card has been played and exhausted as demonstrated by the arrival of Peak Debt in the household sector. In Part 3 we will document how the Fed’s wrong-headed pursuit of low interest rates and 2.00% inflation made the American economy increasingly uncompetitive–even as it buried households, business and government in debt.
In the face of those deeply embedded structural impairments we are quite confident that today’s war of dueling tariffs is just a side show. The real crunch will be far more traumatic because it requires the unwinding of the Great 30-year financial bubble that is the underlying cause of the world’s massive trade imbalances.