The Road to Ruin

by James Rickards

  The 1990s were a zenith for ostensibly free trade. NAFTA, CAFTA, and other multilateral trade agreements were imposed. Elites bathed in the longest peacetime expansion in U.S. history, from 1991 to 2000, from the end of the Bush 41 administration through almost all of the Clinton years. Russia reached for capitalism, China emerged from a chaotic century, and Asian Tigers were on the prowl. This performance seemed to validate the elite worldview.

  Beneath the surface, rot set in. Corruption was institutionalized in Russia and China, income inequality soared, and the low-hanging fruit of factor utilization in emerging markets was quickly gone. In historical terms, the economic success of the 1990s can be seen in the same way as the apparent success of free trade for the United Kingdom in the late nineteenth century, and the United States in the mid-twentieth. Success was not the fruit of new policies so much as the harvesting of gains created by prior protection. There was growth, but it was not sustainable. Beyond that, the superficial and nonsustainable success of the elite consensus in the 1990s and early 2000s can be explained in a single word: debt.

  The explosive growth of debt—personal, corporate, and sovereign—over the course of the 1990s and early twenty-first century is unprecedented. In the 1990s, debt growth was driven by consumer credit, home equity loans, and corporate debt. From 2000 to 2007 the mix shifted toward developed economy sovereign debt and subprime mortgages. After 2007, growth in developed economy sovereign debt continued while student loans and emerging markets debt grew exponentially.

  Since 2009, emerging markets dollar-denominated corporate debt expanded by $9 trillion. Total securities issued by energy exploration and development firms, much of it below investment grade, exceed $5 trillion. Growth in all forms of debt exceeded $60 trillion with no end in sight.

  A standard gauge of debt sustainability is the debt-to-GDP ratio. From 2000 to 2013, the global debt-to-GDP ratio, excluding financial firms, rose from 163 percent to 212 percent. In the same period, the developed economy debt-to-GDP ratio rose from 310 percent to 385 percent. These trends show no pause or deleveraging as a result of the 2008 financial crisis. While private debt levels declined somewhat after 2008, growth in government debt more than made up the difference and kept total debt elevated. Total government debt in developed economies rose from 80 percent of GDP at the start of 2009 to 110 percent of GDP by 2014. Emerging markets debt, driven largely by China, excluding financial firms, went from 125 percent of GDP at the start of 2009 to 140 percent by 2014. The debt-to-GDP ratio for China alone, excluding financial firms, was over 200 percent by 2014.

  In a definitive 2014 study (the “Geneva Report”), the influential International Center for Monetary and Banking Studies based in Geneva summarized the situation as follows:

  The world is still leveraging up . . . the debt ratio is still rising to all-time highs. . . . Until 2008, the leveraging up was being led by developed markets, but since then emerging economies (especially China) have been the driving force. . . . The level of overall leverage in Japan is off the charts. . . .

  Contrary to widely held beliefs, six years on from the beginning of the financial crisis in advanced economies, the global economy is not yet on a deleveraging path. Indeed, according to our assessment, the ratio of global total debt, excluding financials, over GDP . . . has kept increasing at an unabated pace and breaking new highs. . . .

  These debt levels, while unprecedented, might be sustainable if there were global growth sufficient to support them. There is not. The stagnation of global growth in the past fifteen years is another facet of the failure of the elite consensus.

  Researchers for the Geneva Report compiled a developed economy GDP index set at 100 for 2008 to compare actual growth since the crisis with potential growth based on pre-crisis trends. By 2014, potential growth reached a level of 111, yet actual growth struggled to reach 102. This difference between potential growth and actual growth is called the output gap. In a normal economic recovery, the economy briefly grows above potential (due to slack capacity and above-trend factor utilization), and the output gap disappears. That has not happened in this recovery; the output gap is persistent and growing. Lost output is bad enough if individual well-being and living standards were the only issues at stake. Lost output combined with excessive debt is toxic. The Geneva Report describes this dangerous mix as follows:

  The ongoing vicious circle of leverage and policy attempts to deleverage, on the one hand, and the slower nominal growth on the other, set the basis for either a slow, painful process of deleveraging or for another crisis. . . . In our view, this makes the world still vulnerable to a further round in the sequence of financial crises that have occurred over the past two decades.

  The report shouts alarm at the virulent cycle of high debt and slow growth:

  An important obstacle to recovery from a financial crisis consists of the vicious loop between growth and leverage . . . since paying down high debt levels deters activity, with the slowdown in GDP dynamics making the deleveraging process more painful in turn.

  A useful taxonomy of crises divides collapse and recovery cycles into three types. A Type 1 crisis involves a drop in the level of actual output. If followed by an above-trend or V-shaped recovery, the output gap is made up and trend growth resumes. Economic effects of a Type 1 crisis are painful, yet temporary. Sweden in the early 1990s is an example.

  A Type 2 crisis involves a drop in the level of potential output. In this situation, initial output losses may be small, but an output gap is created relative to the former trend and expands over time. The long-term costs in Type 2 crises are enormous. Japan since 1990 is cited as an example of a Type 2 crisis.

  A Type 3 crisis involves a drop in the level of actual output and potential output. In this situation, initial output losses are large, are never recovered, and the output gap grows over time. This is the worst of all worlds with large losses, no recovery, and continued weak growth.

  According to the data shown in the Geneva Report, advanced economies led by the United States are in a Type 3 crisis. The reason this diagnosis did not appear sooner was due to the use of leverage to mask policy failures. The Geneva Report concludes:

  The observed acceleration in growth from the late 1990s to 2007 was supported by the build-up in global debt . . . and at the same time encouraged the increase in leverage in many economies that fed the asset-price and balance-sheet expansion. This expansion phase ultimately came to an end in the financial crisis of 2008–9.

  The elite dream of globalization and shared prosperity was a mirage fueled by debt. The mirage dissipated in 2008. While the mirage is gone, the debt remains. The paths out of debt are dangerous at best, catastrophic at worst. The safest path involves structural reforms to overturn the elite consensus and return to neomercantilist policies to create jobs and growth inside the United States. The most dangerous path involves more of the same—more debt, more leverage, more derivatives—in a quixotic quest for self-sustaining growth that will not appear.

  As this realization sinks in, the elite herd instinct is heightened. Central bank balance sheets are distended to actuate inflation to provide nominal if not real growth to deal with debt. Still, deflation stalks the herd like a lioness on the savannah. Elites realize money printing may produce not price inflation, but asset inflation, and form new bubbles that could burst and destroy confidence for two generations. The ice-nine solution is standing by if that happens. For now elites push on with reflation like a forlorn platoon neck-deep in the Big Muddy.

  Cul-de-sac

  The elite neoliberal consensus rests on rhetoric about free markets and free trade limned by economists from Adam Smith and David Ricardo to Milton Friedman. Yet free markets and free trade are flawed in theory, nonexistent in practice.

  Notionally, the free market paradigm resembles the popular board game Monopoly, invented in the Great Depression. In Monopoly, each player begins in the same space with the sa
me amount of money, governed by the same rules. As in real life, luck plays a role in the dice toss, yet over time luck evens out. There are differences in players’ skills; that is the point of the game. Savvy players know the orange properties starting with St. James Place are good to own because they are close to Jail; other players land near them with disproportionate frequency. In theory, markets reward this kind of skill.

  What if the rules are ignored? Imagine a Monopoly game where after a few turns one player suddenly declares her money is worth twice as much as every other player’s and casually reaches into the bank to grab a stack of $500 bills. The game would descend into chaos; free market elements would be lost. This is exactly what happens in the course of central bank monetary policy, currency wars, and trade manipulation. The free market model is overturned.

  For the United States and the world, the solution is not to whine about unfairness or chase a chimera, but to adopt policies to ensure growth and jobs in the United States and explore ways for cooperative partners to share that prosperity, while they pursue their own paths. Noncooperative partners should be left to their own devices.

  Viewed from the longer perspective of debt expansion since the 1990s, the financial collapse in 2008 was symptomatic of a more malign condition. Public policy used credit expansion and asset bubbles to substitute for sustainable growth. Workers did not share in the higher returns to capital from globalization. The resulting income inequality is more than a moral issue. Income inequality hurts consumption, and by extension investment, leaving net exports (and associated currency wars) and government spending (and associated debt) as the only growth engines.

  Deflation is the elite’s deepest secret fear. Alan Greenspan’s much-criticized too-low-for-too-long interest rate policy from 2002 to 2005 was an effort to fend off deflation that appeared in 2001. Deflation was deferred, not destroyed. Greenspan’s policies delayed deflation at the expense of asset bubbles, which burst beginning in 2007. Then the deflation, which never really went away, reemerged. The Federal Reserve, a one-trick pony, repeated the Greenspan blunder with Bernanke and Yellen’s zero interest rate policy from 2008 to 2015. The result is larger asset bubbles today. At no point have policymakers dealt with the underlying causes of deflation, which arise from demographics, technology, deleveraging, and neomercantilism from Mexico to Malaysia.

  One rejoinder in favor of free trade and open markets is that the United States is strong enough to absorb the costs of a rigged system while the world is enriched by job creation in other countries. If the world is better off, and if the United States is slightly less better off than it might otherwise be, that’s a small price to pay for a richer, more peaceful planet.

  Apart from the condescension toward unemployed working-class Americans embedded in this globalist view, is it even true? Or does average global growth mask grotesque income inequality where workers may be slightly better off, but the bulk of gains are siphoned by corrupt oligarchs busily buying condos from Vancouver to Mayfair for $50 million apiece or more?

  If U.S. public policy focused on supporting high-value-added manufacturing at home, income gains would be spread more widely because America does not have an “oligarch problem” to the same extent as Asia, Africa, and Latin America. U.S. workers with higher real incomes could afford to buy more imported goods alongside domestic ones. U.S. trading partners would specialize in less desirable jobs while U.S. workers would have access to better ones.

  The political problem in the United States is that Democrats and Republicans march in lockstep on the issue of free trade. Some voices dissent, yet the free trade paradigm embodied in NAFTA, the new Trans-Pacific Partnership (TPP), and the Transatlantic Trade and Investment Partnership (TTIP) agreements transcends partisanship. NAFTA was negotiated by Bush 41 and signed by Bill Clinton. The Trans-Pacific Partnership was proposed by President Obama and supported by Republican leaders. When the two parties join hands it’s more groupthink than an end to gridlock.

  A sensible solution to this political stasis begins by abolishing the corporate income tax, raising the minimum wage, and empowering workers through a version of the German codetermination law that places worker representatives on corporate boards. The left would howl about corporate tax cuts, the right would condemn codetermination, and both would be seen for the ideologues they are. Smart policy—helping capital and helping workers—is the way forward for the United States.

  Elite fear grows with the realization that the world is not in a cyclical recovery, but a secular depression. As defined by Keynes, a depression is:

  A chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.

  Keynes’s view was refined by the Geneva Report, which describes a Type 3 crisis as one in which output drops dramatically and does not bounce back sharply, but plots a permanently lower trend. In the words of the Geneva Report:

  What occurred after 2007 was a debt crisis rather than a recession: the 5% output loss until Q1 2009 was persistent . . . and the loss actually widened relative to what could be considered as the trend prevailing until 2007, as growth slowed significantly.

  Depression cannot be cured, only ameliorated, by monetary policy. The solution to depression is structural change. The Great Depression ended only with massive debt-financed investment and mobilization of labor to fight the Second World War.

  The endgame has emerged. Debt is compounding faster than growth. Monetary policy is impotent except to blow bubbles and buy time. Structural change is impeded by political dysfunction. Substitution of sovereign debt for private debt has run its course; now the sovereigns themselves are stretched.

  Debt, deflation, demographics, and depression are demolishing elite dreams of free trade, free markets, and free capital flows. Elites hope for the turn of a friendly card, but the deck is stacked by decades of denial about income inequality and lost jobs. Some elites are abandoning ship, taking their winnings and buying condos, private jets, even islands, storing bullion and fine art in private vaults. Other elites continue down the cul-de-sac of globalization even as their confusion grows.

  CHAPTER 8

  CAPITALISM, FASCISM, AND DEMOCRACY

  There is little reason to believe that . . . socialism will mean the advent of the civilization of which orthodox socialists dream. It is much more likely to present fascist features. That would be a strange answer to Marx’s prayer. But history sometimes indulges in jokes of questionable taste.

  Joseph A. Schumpeter Capitalism, Socialism and Democracy (1942)

  Show me the man and I’ll find you the crime.

  Lavrentiy Beria, chief of the Secret Police (NKVD) under Stalin

  Schumpeter Reconsidered

  Joseph Schumpeter’s name conjures the phrase “creative destruction,” his best-known intellectual contribution, one of the most powerful economic insights of the twentieth century, with important implications today.

  Schumpeter’s concept was that capitalism is a dynamic force more potent than the enterprises that rise and fall within it. Capitalist progress demands capitalists’ failure. This was succinctly stated by Schumpeter in his 1942 masterpiece, Capitalism, Socialism and Democracy:

  Capitalism . . . never can be stationary. . . . The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.

  The opening up of new markets . . . incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.

  As with many original observations, what seems obvious in hindsight was revolutionary when it was offered. The fact that capitalism is a dynamic, wealth-creating force was lo
ng recognized, starting with Adam Smith in 1776, and by the nineteenth-century classical economists. What was new in Schumpeter’s creative destruction was not the creative force, but the destructive force, the idea that capital must be destroyed to unlock resources for new capitalist endeavors.

  Schumpeter wrote at a critical juncture between the end of the Great Depression and the start of the Second World War. Capitalism was on trial and socialism was in vogue, including in the United States, where it had failed to take root during previous socialist cycles in the late nineteenth and early twentieth centuries. The Franklin Delano Roosevelt administration, 1933–45, was filled with socialist reformers and endeavors from the massive Tennessee Valley Authority power project to agricultural communes like the federal farm camp at Marysville, California.

  Capitalism, widely seen as a failed system during the Great Depression, was associated with big business in the form of corporations such as RCA, General Motors, Standard Oil of New Jersey, U.S. Steel, and other behemoths. Competition was no longer capitalism’s defining characteristic; monopoly was.

  Schumpeter was unfazed by the monopoly charge thrown at capitalism. He admired big business and supported monopoly-type practices. In his view, big business offered consumers wider variety, broad distribution networks, and lower prices. He wrote,

  In analyzing . . . business strategy . . . the investigating economist or government agent sees price policies that seem to him predatory and restrictions of output. . . . He does not see that restrictions of this type are, in the conditions of the perennial gale, incidents . . . of a long-run process of expansion which they protect rather than impede.