Then in 2015, he wrote a book called “Crouching Tiger: What China’s Militarism Means for the World.” 

If you watch these documentaries or read any of these books, it is very clear that Peter Navarro considers China to be a very grave threat to the United States. If you listen to what President Trump has been saying, he also shares that view that China is a great threat to the United States. 

It seems increasingly possible and even likely that what he is doing is not so much trying to just bring trade back into balance as possibly reining in China’s growth so that China will not become increasingly powerful relative to the United States and in fact, will cease to be a threat to the United States. That is possibly what this trade war is really all about.

Stig Brodersen  5:02  

Richard, talk to us about this aspect of currency manipulation. When we talk about this trade war, it seems to always pop up that Chinese are manipulating the currency to take advantage of the US, or the Chinese are manipulating the currency. If they are, how are they doing it?

Richard Duncan  5:18  

China has been manipulating its currency since the early 1990s. In 1993, it devalued the currency by 50%, one month. Then it pegged the currency in the next 10 years. There is no question about this, because you can see that the People’s Bank of China, the Chinese central bank, accumulated $4 trillion of foreign exchange reserves. 

What that means is that the central bank created their money, RMB, and they used it to buy dollars, so that the RMB would not appreciate relative to the dollar. In other words, they depressed the value of the RMB through an intervention on an extraordinary scale through their currency markets. That kept Chinese prices very low and that allowed China to export more and more to the United States. 

Preston Pysh  6:12  

They were able to do this because there was no peg. Correct?

Richard Duncan  6:15  

Well, they created a peg. Under the Bretton Woods system, which ended in 1971, all the currencies were pegged to one another. They were all backed by gold. But once the Bretton Woods system broke down, countries no longer had to back their currencies with gold. This made it possible for the Central Bank of China to create 28 trillion RMB. That’s roughly $4 trillion.

They use this 28 trillion RMB to buy $4 trillion and other currencies as well, in order to push up the value of the dollar and push down the value of the RMB. Their currency would remain artificially depressed. They could continue to grow their economy through rapid export led growth. 

In 1990, China didn’t have a trade surplus with the US. They were a very poor third world country. China’s trade surplus with the US was $1 billion a day, $370 billion last year in the trade surplus. So China exports $500 billion worth of goods to the United States, but the United States only exports $130 billion worth of goods to China.

Preston Pysh  7:28  

So every $5 that’s being spent out of here is going to China and only $1 is coming back to us in generalised terms. Would that be a fair way to look at it?

Richard Duncan  7:36  

Yes, that’s right. To be fair, everyone, I believe needs to be open-minded about the situation we’re facing. It’s not really USA versus China. It’s not Team USA versus Team China. It’s more complicated than that, because there are very powerful interests in the United States who have benefited enormously from this arrangement and who have encouraged this arrangement and have facilitated this arrangement. 

For example, the multinational corporations have moved their factories out of the United States and then to China in order to produce things with very low cost labor there. That has resulted in their profits going up very sharply. Also, the bankers. 

The banking industry, in general, has benefited from this paradigm because this requires the Americans going deeper and deeper into debt, and they finance this. They have also encouraged this arrangement.  

On the other hand, the average Americans, the middle class and the working class, their wages have been stagnant now for 30 years. As long as home prices were going up, up until 2008, they were able to maintain their spending by refinancing their home even though their wages were stagnant. 

However, when the crisis struck, many of them lost their homes and this political backlash against free trade, which has really been to their disadvantage bubbled to the surface, and they voted for Donald Trump. He’s now the president and he promised them that he would protect them in his inaugural address on January 20, 2017. 

This is what he said: “From this day forward, a new vision will govern our land. From this moment on is going to be America first. Every decision on trade, on taxes on immigration on foreign affairs, will be made to benefit American workers and American families. We must protect our borders from the ravages of other countries making our products, stealing our companies, and destroying our jobs. Protection will lead to great prosperity and strength.”

Preston Pysh  9:41  

Richard, what I think is really interesting for people hearing this now whether you agree with that politically or not, that doesn’t matter to us. What matters to us is really kind of understanding how the economics of this kind of shake out considering when a president, they have unique policy tools at their disposal. 

One of those that the President can play is with tariffs, quite a bit without the Congress getting involved and really having to listen to anybody else. That is a tool that the President has. You can see him exercising this, like we have never seen in the history of the US, or at least in the recent known history of the US. 

Talk to us a little bit about how he’s sitting at this as if this was a game of poker. He’s sitting at the table on how he’s playing his cards and let’s talk through how you kind of see this maturing as we move forward.

Richard Duncan  10:32  

Okay, well, just let me add one more thing to this by comments about this not being Team China versus Team USA. 

On one side, everyone in China is on China’s side, obviously. In the US, it is different. You have the middle class and the working class on Team USA, if you will. For lack of a better term, the 1% are on Team China.

Recently and within the last year 10 years, I would say, suddenly, you have the Pentagon on Team USA. The Pentagon has suddenly become concerned about China’s growing military power and China’s expansion overseas, through initiatives like their “One Belt, One Road” project, in which they intend to build infrastructure connecting China to Europe and beyond with Chinese made cement and steel and financed with Chinese loans. 

The Pentagon then has come to see China as a growing threat as well. So it is uncertain which side is going to be more powerful, but we really are at a turning point in history. If this trade war goes ahead, and it seems as though it probably will, this will be a tipping point in history. 

Now, returning to your question, how is this going to play out? Again, we have to ask ourselves, really, what is it that President Trump is after? Does he really just want to help reduce China’s trade surplus with the US and to stop China from stealing technology and advanced technology from US corporations? Or does he intend to stop China’s economic rise all together? 

Well, okay, so really, if he does the former, he will do the latter. One of his demands was that China reduces trade surplus by $200 billion a year. That would reduce the trade surplus from  $370 billion to $170 billion. Well, that would be a death blow to China’s economy. 

China’s economy is already the greatest economic bubble in history. They have enormous excess capacity across every industry imaginable. One statistic that’s just too good not to quote again and again, is that in three years, from 2011 to 2013, China produced as much cement as the United States did during the entire 20th century. That gives you some idea how much production capacity they have. 

It’s not just cement, it’s steel, and every other industry conceivable. Even without this trade war, China is in grave danger of this economic bubble popping because their problem is they have such incredible excess capacity across all their industries.

Within China, the average person only has a disposable income of $10 a day, but the Chinese people simply do not earn enough money to begin absorbing half of what China can produce. So this made it necessary for China to export the rest of all of its production. 

Now, this production has grown to such an enormous scale, that the entire world doesn’t have enough purchasing power to continue to absorb more and more Chinese goods year after year. 

We’ve got this growing political backlash and this paradigm is going to end one way or the other. That’s why their “One Belt, One Road” initiative made so much sense. If they can pave Mongolia with Chinese cement, then at least they have something to do with their cement instead of pouring it into the ocean. They can keep their cement workers employed and they can actually finance. They can use some of the credit they’re creating in China to lend the money to Mongolia. 

Mongolia can afford to buy the Chinese cement. That’s why they have to expand overseas through these sorts of initiatives but that makes them all that much more of a growing geopolitical threat to the United States.

Stig Brodersen  14:37  

The underlying assumption is that the past will also hold in the future, meaning that you will continue to see free trade. That’s really what’s being challenged now. Is that correctly understood?

Richard Duncan  14:48  

That’s right. If suddenly they were forced to reduce their trade surplus with the US by $200 billion, that would have catastrophic consequences for China’s economy. There’s no way in the world that they would ever agree to that. They are not going to give in. They are not going to capitulate. They’re going to fight back. 

It could go something like this. We’ve already seen it progress just in the month. I’ve been working on this subject, but it started out first with how President Trump imposed $34 billion tariffs on China. China retaliated with $34 billion of tariffs on US goods.

Then President Trump said the US would put 10% tariffs on $200 billion of Chinese goods. China responded by saying they would put high tariffs on another $60 billion of US goods. 

Then President Trump upped the ante and said, “We’re not going to put 10% tariffs on Chinese goods. We’re going to put 25% tariffs on the Chinese goods.” And so it goes back and forth. 

President Trump said we can take this all the way to $500 billion, the entire amount that China exports to the US every year, half a trillion dollars a year. 

Well, you can read the Chinese newspapers, their English version. You can read the People’s Daily on the internet and they are beginning to freak out, I guess is the best way to put it. 

What can China do in response? Okay, well, if the US puts tariffs on $500 billion of Chinese goods, obviously China is going to put tariffs on everything the United States sells to China. Ultimately, they will not allow any American goods to be sold in China. 

They could go beyond that and nationalize all the American companies in China such as Walmart and Starbucks. They could default on the debt that they owe other countries.

North Korea will most probably start lobbing missiles across Japan again and testing nuclear missiles. The Chinese military would be put on top alert. Already an article yesterday in the People’s Daily discussed trade wars, hot wars and cold wars. So you can see how this conflict could easily turn into the most serious geopolitical conflict the world has seen since the collapse of the Soviet Union.

Trade wars had the potential to become real wars. For instance, in the summer of 1941, the United States imposed an oil embargo on Japan. Six months later, Japan attacked Pearl Harbor and took over Southeast Asia. So, no one should underestimate how serious an all out trade war between the United States and China could become because China is not going to back down. 

Preston Pysh  17:36  

I think you’ve got a really strong point there with respect to the fact that you’re dealing with a communist country and the fact that they got to save face with their population and not back down. 

Now, with that said, when we look at the US and we look at China, and we talked about the $5 for every $1 and the way that it’s flowing, the US has a lot of negotiating power here with the fact that they’re sending $5 out and only getting $1 back. So, how long can President Trump do the stiff arm that he’s doing here and the threatening that he’s doing because a lot of these tariffs haven’t even kicked in? 

I can only imagine what’s going to happen when they do start kicking into the Chinese economy. I think the Chinese stock market is down 20% since the start of the year, something like that. When you look at the US stock market, it’s pretty flat. 

In terms of the stock market, the US hasn’t even been hurt at all, where China is in a recession at this point because of this stuff. Yet, the tariffs haven’t even kicked in.  

I’m kind of curious how you see the perception in the US. You’re talking about the Chinese population and how the actions they’ve got to take. How do you see it playing out here in the US? Can Trump continue to do this? How do you see the US population reacting to this moving forward?

Richard Duncan  18:58  

Okay, well, as you said these are very early days still. China’s economy is on the weak side but they do say that it grew by something like 6.8% in the most recent quarter. So it’s still growing. 

However, the US also has some very serious vulnerabilities. For instance, the US economy has benefited enormously in some respects, from buying inexpensive goods from low wage countries like China. This has been very disinflationary. Back in the early 1980s, we had double digit inflation. 

However, as we began having running trade deficits with countries like initially Japan and Germany, but later China, as we started importing more and more cheap goods, then the inflation rate came down literally to zero a couple of years ago. Zero percent.

As the inflation rate came down, then interest rates came down to very low levels as well. As the interest rates became cheaper and cheaper, this made it more affordable for the Americans to borrow more and spend more. Their credit growth accelerated very sharply. In fact, credit as a percentage of GDP in the United States, increased from about 150% of GDP in 1980. It increased all the way to 370% a couple of years ago. 

In other words, credit growth is growing much more rapidly than the economy. The credit growth was driving economic growth. 

The reason that credit growth expanded was because interest rates came down so sharply and at the same time, the very low interest rates pushed up the stock market and pushed up the property market. It has created an extraordinary amount of wealth in the United States.

The household sector net worth is now more than $100 trillion. This is 70% more than it was in 2009. So this has only occurred because interest rates have fallen so sharply and also, a big dose of quantitative easing helped push up asset prices. 

Well now, if we put up 25% trade tariffs on all $500 billion of Chinese goods, the inflation rate is going to move from 2%, 3%, up to a 9-10%. Interest rates will move right up along with it and above it. 

Now, the 10-Year government bond yield, the most important number in the world is less than 3%, but if inflation goes to 8%, the 10-Year bond yield is going to be in double digits. If US interest rates go up to 10%, then credit is going to contract and that’s going to throw the US into a severe recession. 

On top of that, asset prices are going to crash. The stock market is going to crash and the property market is going to crash. The US will be in a very severe recession. Unemployment will surge. That’s the US vulnerability and if it survives, can it withstand higher interest rates that would come with the high tariffs?

Stig Brodersen  21:57  

Literally today, Jamie Diamond came out in the Wall Street Journal. He said that we are still seeing interest levels that are probably artificial. Right now, we are in August of 2018, around just short of 3%. He was talking about 5%, as perhaps being a more realistic number.

How do you see the interest level, say, for the next 12 months? How do you see this together with the inflation? We hear so many people talking about inflation is going to come, even though that’s something that we haven’t seen yet. What is the time horizon for that?

Richard Duncan  22:34  

Yes, if inflation comes back, then that would certainly push up interest rates, or other things that can push up interest rates as well. That being the supply and demand for money. Quantitative tightening is occurring now. The Fed is literally destroying $40 billion a month and that’s going to increase to $50 billion dollars a month in October. 

Just as quantitative easing, the Fed at that time, created money and used that money to buy government bonds that pushed up the price of the bonds. Therefore, that pushed down the yield on those bonds and pushed down interest rates. 

Well, now they’re doing the exact opposite. They’re in effect, selling bonds. With the money, they’re retiring the money which literally destroys dollars. It breaks the dollar money supply in the world. 

The supply of dollars in the world is contracting. At the same time, the US budget deficit is becoming very much larger, because in December last year, Congress passed very significant tax cuts. The budget deficit this year is going to be probably above $900 billion, moving above a trillion dollars next year. 

You then have the government borrowing more at a time when the Fed is removing the amount of dollars that exist in the world and reducing the amount. So the supply and demand alone, more government demand, more dollars at a time when there are fewer dollars.

This means that interest rates should rise from the source of funding for US government bonds in other countries like China. China takes this trade surplus money, the Central Bank of China’s, for instance, its own money. It buys all the dollars coming into China so that the Chinese currency won’t appreciate. 

Then, once it accumulates these dollars, it doesn’t just put all these dollar bills in some gigantic safe somewhere. It takes these dollars that are bought and invests them in US government bonds. 

In other words, the larger the US trade deficit is, the more money comes into the United States to finance the budget deficit. However, now we’re talking about reducing China’s trade surplus with the US by $200 billion a year. That’s the initial demand. 

Well, that would mean there would be $200 billion less Chinese investment in US government bonds a year. 

Another reason interest rates should move higher, if we have a major trade war with China, then more things are going to be made in the United States and factories will begin coming back to the United States. We’re already starting at a point where there’s nearly full employment, even though wages have been stagnant. Still, wages are not going up. Wage growth is slightly below the rate of inflation. 

In inflation-adjusted terms, wages still aren’t going up. However, if we have an all out trade war with China, then there will be more manufacturing jobs in the United States and wages will begin to go up. There will be once again, wwe will hit domestic capacity constraints in the United States that will be inflationary. 

For example, let me go back to what happened in the 1960s and 1970s. Back then, we were still on the Bretton Woods system. Back then, trade between all countries was more or less in balance. Countries couldn’t have big trade deficits, because if they did, they had to pay for their trade deficit with their gold and there was only a limited amount of gold. If they had a big deficit, they would quickly run out of gold. 

That meant the trade between nations had to balance. Back in the 1960s, when the Vietnam War heated up, at the same time that President Johnson started spending more money on the social welfare programs, things like Medicare and Social Security, then that government spending overheated the domestic economy. Suddenly everyone had jobs and the factories were producing at full capacity. 

This led to wage push inflation and wages went up and that pushed up prices. The steel companies couldn’t make steel fast enough. Steel prices went up, etc, throughout the economy, and that eventually led to the double digit rates of inflation in the early 1970s. That lasted throughout most of the 70s. 

Paul Volcker, the Fed Chairman at the time, rushed those higher rates of inflation with extremely high interest rates. It caused severe recession and caused unemployment to go up to 10%. That’s how they brought the inflation back down. That was in the early 80s. 

Then President Reagan came along, and he had even larger budget deficits than President Johnson or Nixon had had, much larger budget deficits. You would have expected that those very large budget deficits once again, would have overstimulated the US economy and led to another round of very high rates of inflation. However, that didn’t happen in the 80s. 

Why? Because starting in the 1980s, the United States started running very large trade deficits with other countries, initially, Germany and Japan. So we didn’t hit the domestic bottlenecks. We didn’t run out of US capacity because we could use Japanese capacity and German capacity. 

As we entered the 90s, then we could use Chinese capacity, Taiwanese and South Korean capacity. After 1980, once we started running the big trade deficit, we no longer had a closed domestic economy that was subject to overheating, if the government spent too much money. 

We had a global economy with tremendous spare capacity in labor in particular. Even today, they say, 2 billion people live on less than $3 a day. So we’re not going to run out of labor in our global economy. We’re not going to face wage rate inflation due to a labor shortage in the global economy any time for generations. 

However, if we put up trade tariffs and go back to a situation where we have a closed domestic economy the way we did when President Johnson was president, then once again, we’re not going to have a global economy with infinite supply of cheap labor and an infinite supply of industrial capacity in other countries like India, Vietnam, China, Indonesia. We will be back to a closed domestic economy. We will very quickly be backed into a situation where we’ll have wage push, spiraling inflation heading back into the double digits.

Preston Pysh  29:01  

However, the difference between now and back then is on the fiscal side… Back then we were fiscally responsible relative to where we’re at today. Where now on both sides, Democrats or Republicans, you can’t find anybody who’s saying that they want to try to balance the budget. It’s just like, “Hey, how much higher can we raise the cap on spending?” It’s to the point where now people are saying, “Let’s not even have a cap on spending.” 

How does that play out moving forward because we didn’t see that in the past when we were talking about a US first, or basically, we didn’t have these massive trade deficits that we’ve got now? If we continue to go down the path that we’re on, how do you see that shaking out considering the fiscal side is so different?

Richard Duncan  29:50  

On the fiscal side, I’m not so concerned as many people are about the level of US government debt. We have something close to $20 trillion dollars of government debt in total, which is roughly 100% of US GDP. 

Of that debt, something close to $6 trillion out of the $20 trillion is owned by the government. For example, the Social Security fund. In other words, it’s debt that the government owes to itself, which really cancelled quite a bit of that as well. 

If you look at Japan, back when their economic crisis started in 1990, their government’s total debt was 60% of GDP. They’ve now taken that up to 250% of GDP by having a very large budget deficit year after year. Even the total measure of US government debt is only 100% of US GDP. 

The US is not going to face any sort of fiscal crisis any time within the foreseeable future. If there were any concerns about the government’s fiscal sustainability, the 10-Year bond yield wouldn’t be below 3%. They would be 13%. 

With the US economy being almost $20 trillion in size, that suggests the US government could borrow another $20 trillion before it even hit 200% government debt to GDP. That’s assuming zero percent GDP growth. Whereas if the government borrowed on that scale, even over a 10 year period, the economy would grow practically 10% a year and we would never reach 200% government debt to GDP.  

Therefore, I’m not concerned about any sort of immediate fiscal crisis or fiscal problems in the US. In fact, I believe the US economy did require some fiscal stimulus, which we have had as a result of the tax cuts, but I would prefer that the budget deficit increased not through tax cuts on corporations and primarily the wealthy. 

I would prefer to see a higher budget deficit resulting from increased government investment in new industries and in new technologies. I think that would be a much better approach in stimulating the economy.

If you give tax cuts to the wealthiest people by greatly reducing inheritance taxes, for instance, then okay, yes, those families, they will probably buy another private jet and a bigger yacht. However, they will come at the cost of having a higher budget deficit and higher debt. That won’t produce any other benefits. 

Whereas spend a trillion dollars over the next 10 years, investing in genetic engineering and biotech industries, you could probably have a cure for cancer and Alzheimer’s. That would produce enormous benefits for society, obviously, but also for the budget. 

If the average American worker remained in the workplace for just an extra two or three years, that would solve all concerns about our social security, underfunding, and Medicare underfunding for the next 30 years. 

Rather than wasting the money on tax cuts for the wealthy, blowing out our deficits and debt that way, it would have been far better for the government to borrow more, but use the borrowed money to invest in new industries and new technologies on a very aggressive scale so that we could restructure the US economy and continue to have strong US economic growth. We could also continue to be the world leader in technology, and economically and militarily.

Stig Brodersen  33:18  

Richard, I would like to go back to the China discussion. How do you see the Chinese retaliating, for instance, in terms of the currency? Is there anything that they can do to persuade the US government to stop the trade war?

Richard Duncan  33:34  

Already, you can see that the Chinese currency has depreciated by 8%. Partially in response to that, President Trump has announced that tariffs won’t be 10% on $200 billion of goods. There will be 25% on $200 billion worth of goods.

The more the Chinese currency depreciates, the higher the tariffs are likely to become. As the currency depreciates, this creates problems for China. On one level, of course, the more the currency depreciates, the more competitive Chinese exports become.

On the other hand, anyone in China expecting the currency to depreciate by another 10% is going to try to find ways to get his money out of RMB and into dollars. This would cause capital flight. 

We saw this kind of capital flight in 2015 and 2016. It was on quite an extreme scale. China’s foreign exchange reserves fell by $1 trillion, indicating from 4 trillion to 3 trillion, indicating the money left the country. 

When money leaves the country, that tightens up liquidity conditions within the country. The central bank had to respond to this outflow of money by lending newly created money from the central bank and financial institutions to prevent the money supply from contracting because contracting the money supply will cause China’s economy to slow down very severely. 

They’re concerned that the currency depreciates further, there’ll be another massive wave of capital flight but that is a problem for them. 

Now, going back to your question of constraints facing President Trump. It’s not certain that President Trump’s supporters will continue to support him during the months ahead. If the tariffs are put in place on 25% tariffs on $200 billion worth of Chinese exports to the US, prices are going to go up.

As prices go up and the stock market’s inflation will go up, interest rates will go up, the stock market will come down, property market will come down, unemployment will go up. The US economy will start getting visibly weaker and it wouldn’t be inconceivable that there could be a significant sell off on the stock market. 

Given that, it’s uncertain whether President Trump’s supporters will continue to support him or not. It’s possible that they will. His argument is that we are going to take some short term pain possibly, but if we don’t, China is going to destroy us in the long run.

Preston Pysh  36:08  

I’m curious, Richard, do you think that his best approach, considering what he’s trying to accomplish and considering the fact that he probably wants to get reelected?

Do you think that his best approach is to almost like the Fed use this forward guidance thing where it’s a lot of talk with slow action of the tariffs actually kicking in because as soon as those tariffs do start kicking in, it starts having a major impact on the US economy, simply through the cost of goods going up?

Richard Duncan  36:39  

That’s an interesting question, because we have the congressional midterm elections coming up in November. If the Republicans lose control over the house, and that will greatly weaken President Trump’s power in general. 

Perhaps he won’t impose tariffs on the $200 billion worth of goods before the congressional elections, or maybe just shortly enough in advance of them so that they don’t get higher prices and inflation in interest rates. 

However, it’s hard to know really how this will play out because people voted for President Trump because he told them he was going to do this to China. If he had not done it, he would have broken his promise. This is not something he seems to just concocted to win the election. This really seems like this is something that he believed for decades. 

He’s been very vocal about China’s aggressive trade policies for the US for a very long time. But it seems that this is something that he truly believes in, and that his supporters also truly believe in. 

Again, he didn’t win the majority of the American votes and the election. He won the electoral college vote, but his supporters, even if the 10% of them, abandon him, then he may not be reelected. He may not be an office long enough to actually carry out a significant trade war with China. It’s not fair that whoever follows him would, they probably wouldn’t. 

Having said that, it’s possible that this trade war may end before it really gets started. Even if it does, that probably will not be the end of the story because the American public has lost faith in free trade. They voted for protectionism and they have done it once. They’re likely to do it again. 

This so-called free trade paradigm that we have, which is really not free trade, since other countries manipulate their currencies with the collaboration of large parts of the wealthiest parts of American society. 

Now, the United States could have declared China a currency manipulator at any time in the last 20 years, but they never did. Why didn’t they? It was clear China was manipulating their currency. Why didn’t they? 

Most of that time, the Treasury Department is in charge of calling China a currency manipulator. The Treasury Department was run by a series of people from Goldman Sachs and Citigroup… Return to a time when the so-called free trade paradigm is allowed to fully play out, because the American public has already made it clear that they don’t like it. The Europeans don’t like it either. 

We talked about the impact on China. It would be severely damaging for the US economy as well. However, we also should mention that it would be equally damaging for the rest of the world because since China has had such a large trade surplus with the United States year after year, this has given them money to buy things from other countries. 

Just since 1995, I looked at this the other day, China has imported $20 trillion of goods from other countries, not including the US. So $20 trillion dollars is a very big number. They have bought enormous amounts of metals from Australia and commodities, agricultural products, copper and other metals from South America. They bought oil from the Middle East, Iran, and Russia.

If it were forced to reduce its trade surplus by $200 billion a year with the US, that would be $200 billion a year of not buying things from other countries. So this would be a severe blow to the price of all commodities. 

Now you see, copper has been tanking but it would be a severe blow to all the commodities. Therefore all the commodity producers and the currencies of all the commodity producing countries. It would also be a severe blow to Germany, for instance. 

Germany has been selling China a lot of capital goods. This will be a severe blow to France. France has been selling China enormous amounts of luxury goods. It would be a blow to Japan, Taiwan, and South Korea. The rest of the world would be pulled down with China and the US. There is a very real danger that an all out trade war would lead to a real global Great Depression.

Stig Brodersen  41:06  

Richard, back in March, you wrote this blog post about why the Fed was changing their schedule or why they were behind their schedule on quantitative tightening. Could you talk to us more about why that was happening and what is really happening now?

Richard Duncan  41:21  

When I wrote that blog, there had been a little wobble in the bond market. As I recall, bond yields have moved up quite quickly and significantly. So it appears that the Fed temporarily backed off on this quantitative tightening. 

In fact, they have even expanded this balance sheet in one week, which is not completely unheard of. But it did tweak their balance sheet, depending on what’s going on in the bond market.

Preston Pysh  41:50  

This was Russia, right? Just so people understand. I think it was Russia that was selling off pretty much their entire position, or 90% of their position. Is that when this timing happened?

Richard Duncan  41:59  

At the time, we didn’t know that Russia was doing that. Perhaps that was the reason, but there were other good reasons for the interest rates to go up in the US, a much larger budget deficit. 

I think the thing that really sparked off that jump in the bond yields at that time was new estimates were coming out about how much more the US government was going to have to borrow in the first and second quarter than had previously been expected. That spooked the market. Probably at the same time, Russia was selling a…

Preston Pysh  42:29  

A combination of both.

Richard Duncan  42:31  

Yes. After that, the Fed then got back with the program. They had previously published a schedule of what their quantitative tightening would be. They started off with quantitative tightening of $10 billion per month and the fourth quarter of last year that increased to $20 billion in the first quarter. Then $30 billion in the second quarter. Now we’re at $40 billion. 

They’ve been sticking with that schedule, but even still, the total amount that they’ve produced so far has been relatively small compared to the three and a half trillion dollars that created quantitative easing. 

However, if they move on into $50 billion a month of quantitative tightening starting October. We’ll carry on with that. It won’t take long before those numbers do become very significant. 

However, the thing that has changed recently is we’ve certainly seen some hints from the Fed and the new Fed Chairman, Powell. They are beginning to wonder or consider at what point they should stop quantitative tightening. 

The Fed never comes out with sudden pronouncements and they gradually warm the market up by dropping hints that we’re thinking about this or maybe we’ll do this. So the hints have started. 

Quantitative tightening is not going to go on as long as people had anticipated because quantitative tightening, as it destroys dollars, will push up interest rates. When the dollar goes higher, commodity prices go lower. That includes gold. That’s why we’ve seen gold moving lower, because the dollar has been moving higher. 

If they continue with quantitative tightening, then the dollar is going to move much higher and US interest rates are going to move much higher. Then the problem is whenever the dollar moves higher, that causes global commodity prices to go down, but deals a very serious blow to all the countries in the world that produce commodities. It’s possible that their currencies drop and their economies go into recession. 

The last time we had a big bout of dollar strength was between the middle of 2014 and the first quarter of 2015. The dollar moved up 23% and that sparked a huge sell off and also the global economy essentially went into recession.

Preston Pysh  44:53  

Yeah, that’s when Draghi came out and said he’ll print till the cows come home. Whatever it takes.

Richard Duncan  45:03  

I don’t know if that worked very well. It provided more global liquidity because that statement, but the ECB started printing very aggressively just about the time that the Fed stopped printing.

So the ECB has been providing a great deal of global liquidity. The Bank of Japan, even more so, the Bank of Japan. Now that ECB, they’re still doing their quantitative easing but now that’s been reduced from a peak of 80 billion euros per month. 

Now, I think they’re down. Up until now, it’s probably still 30 billion euros a month. Starting in September, it goes to 15 billion a month and then it’s supposed to end at the end of the year. There’ll be no more money creation coming out of Europe.

However, the Bank of Japan is still creating money very aggressively and holding Japanese government bond yields. Just now, they’re 10 basis points, 10% to 1%, or even though Japan’s government has 250% government debt to GDP, Japanese government can still borrow money for just 10 basis points a year on 10-Year government bonds.

Stig Brodersen  46:14  

The last topic for today is about Japan. We saw this very interesting news just a week ago when the Bank of Japan came out and said they’re not sure if they fully understood the implication of quantitative easing. They will likely not continue, at least not to the same extent. 

Then you saw a huge sell off and then only two days later, the Bank of Japan came out again and said that they would continue to buy and support the market. What is your thought process about that, Richard?

Richard Duncan  46:47  

It should be viewed as one of the most extraordinary experiments in the history of monetary policy. At the peak, they were printing 80 trillion yen a year and using it to buy government bonds. They’ve now bought up roughly 40% of all of Japanese government debt.

When we think that the Japanese government has 250% debt to GDP, a lot of that 250% Bank of Japan actually owns 40% of it. Since the Bank of Japan is essentially a branch of the government, that means the government has acquired 40% of all its debt by printing money from thin air and buying the debt.

The Bank of Japan has effectively cancelled 40% of all Japanese government debt by printing money and buying Japanese government bonds. Now, by buying so many bonds, they had pushed the yield on the 10-year government bond down to zero percent. If you buy enough bonds, you’ll push the price up so high that the yield goes down to zero. In fact, they even push the yield into negative territory for some months. 

Now, that means that this enables the Japanese government to borrow as much money as they want at zero percent interest, which is something the world has never seen before. 

This also has global implications because when the Japanese government bond only yields nothing, then of course, people in Japan would rather buy US government bonds yielding 2.9%. That seems like a lot of money relative to nothing. 

Money coming out of Japan then puts downward pressure on interest rates in the United States, Europe and everywhere else in the world. Some time last year and a half, even perhaps two years ago now, the Bank of Japan found that his program of buying $80 trillion a year was far too much. 

Though, they didn’t have to buy that many government bonds a year in order to hold the interest rates at zero percent. They could buy far fewer bonds, $30 trillion, $40 trillion a year. That would still be enough to keep the interest rates at zero percent. 

You buy the bonds, you push up the price that pushes down the yield. They didn’t have to create $80 [trillion] or $90 trillion a year to hold the yields at zero percent. 

Now, why did they make this announcement in the last week or so? In this announcement, they said, “Okay, the new policy is we’re not going to hold the interest rates at zero percent. We’re going to let them move up a little and we’re going to hold them somewhere around 10 basis points. Certainly no higher than 20 basis points.”

Why did they do this? I think this may be part of a globally coordinated strategy among global central bankers to try to push up interest rates a little bit around the world, because there is concern that inflation is coming back and that the global economy is in danger of overheating.

We have very low unemployment in the US and generally the global economy has recovered. By allowing the Japanese bond yields to move up 10 or 20 basis points that should make it easier for the US government bond yields to move up 10 or 20 basis points, acting as something of a break on the US economy, which many people fear could overheat because of big tax cuts and spending increases by the government. 

My interpretation would be that we saw the Bank of England increase interest rates in the last week or so. The ECB is now winding down its quantitative easing program, as a kind of globally coordinated tightening of global monetary policy. This was just another aspect of that, I suspect.

Preston Pysh  50:34  

All this talk about Japan and how the central banks are buying bonds and pushing rates to zero is absolutely fascinating. There’s an organization called the Yardeni Research Organization. Monthly what they do is they publish a chart that looks at the total assets of the major central banks around the entire world. 

The ones that they look at are the Fed, the People’s Bank of China, the ECB, Bank of Japan. What they do is they overlay all of these balance sheets for all these central banks. They’ve been doing this since 2008, during the start of the last credit cycle. 

What I find fascinating, you brought this up in your response where you said that it looks like it’s a coordinated central banking event. When you look at the way that the assets of central bankers’ balance sheets have moved, it’s almost a perfectly straight line when you combine all of them. 

However, when you look at one or the other, it’s kind of lumpy and all over the place. Though when you combine all of them, you see this perfectly straight line. 

What I find fascinating and this is where I want to hear your opinion, is recently in the last three months, you’ve seen the total assets of all of these central banks combined stop climbing and you’re actually seeing it start to contract for the first time in the last year 10 years.

If that trend would continue, which based on the forward guidance that we’re hearing from all these different central banks, seems like that’s the case. I think that’s a very negative sign for the markets moving forward. I don’t want to be the bear. I want to try to have a balanced opinion. I’m kind of curious to hear what you have to say about that idea.

Richard Duncan  52:22  

Well, you’re right, if this trend were to continue and when that line starts to dip, it’s very likely to be a severe global recession, as global liquidity tightens and interest rates move higher. 

As ECB President Draghi has made clear, quantitative easing was not a one off deal. It has now become a permanent part of central bank’s tool kits. The next time we have a global downturn, then interest rates will once again be cut back to zero very quickly. 

At that point, there will be another round of quantitative easing. Draghi could not have been more clear. This is a permanent part of our toolkit going forward. However, that is only possible so long as globalization persists, because globalization is very deflationary. 

Globalization is putting downward pressure on wages and the cost of manufactured goods. It’s putting downward pressure on prices and completely offsetting all of the inflationary pressures caused by paper money printing by central banks. 

Well, if we now have the globalization reverse, then we will once again be back in a world of much higher rates of inflation. It will no longer be possible for central banks to stimulate the economy by printing trillions of dollars as they did after 2008 because that would be extremely inflationary. It would throw fuel on the already blazing inflationary spiral that would follow the collapse of globalization.  

It’s very interesting to see this. Again, this is why this trade war between the United States and China could be a turning point in history. Not only would it stop China’s rise, but it could also result in a severe global economic depression if it causes a sharp spike in global interest rates or higher rates of inflation.

Preston Pysh  54:23  

Richard, the thing that Stig and I just love about having you on the show is I know I learned a ton every time you come back on so we’d we cannot thank you enough for making time out of your day to come back on the show. I’m sure people listening to this are going to want to know more about you. 

Please tell people where they can find you. Give them a hand off to your web page and all that good stuff.

Richard Duncan  54:46  

Preston and Stig, I always enjoyed talking with you guys, because we allow enough time so that we can actually go into some details on these very important topics rather than just a few sound bites. It makes the interview really much more satisfying. 

Macro Watch is a video newsletter. Every couple of weeks, I upload a new video. It is essentially me doing a PowerPoint presentation. Each video is normally about 20 minutes long. Normally it has 30 downloadable charts. I explain the developments occurring in the global economy and how they’re likely to impact asset prices like stocks, bonds, currencies and commodities. 

Then, of course, on government policy, because it’s government policy that determines the amount of credit growth and the amount of liquidity that’s injected into the economy. So, if your listeners would like to check out Macro Watch, they can go to my website. They can find it at Richard Duncan Economics and there they can subscribe for my free blog, or they can subscribe for Macro Watch. 

Preston Pysh  56:01  

All right, Richard. Well, we really appreciate your time. Thank you so much for coming on and sharing your wisdom with our audience.

Richard Duncan  56:08  

Thank you, Preston and Stig. It’s always a pleasure talking with you guys. We should do it again sometime soon.

Preston Pysh  56:14  

You bet. 

Stig Brodersen  56:15  

All right, guys. That was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro  56:22  

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