(This interview with economist and fund manager Richard Duncan, on the prospects of a trade war, and its implications, was published in DNA edition dated November 29, 2010.)
In his first book, The Dollar Crisis, published in 2005, fund manager and economist Richard Duncan offered an amazingly prescient analysis of the risks to the US and global economy from the flawed international monetary system since the collapse of the Bretton Woods arrangement. “The principal flaw in the post-Bretton Woods international monetary system,” he wrote, “is its inability to prevent large-scale trade imbalances… Those imbalances have destabilised the global economy by creating a worldwide credit bubble.”
Last week, Federal Reserve Chairman Ben Bernanke, in a speech in Frankfurt, acknowledged – in language that reflects Duncan’s spot-on analysis – that “the international monetary system has a structural flaw: it lacks a mechanism… to induce needed adjustments by surplus countries, which can result in persistent imbalances.”
To Duncan, Bernanke’s acknowledgement that the Dollar Standard is flawed signals the direction of US economic policy going forward. “They’re going to take steps to correct this flow, either through international cooperation or through unilateral action” – such as imposing trade tariffs on imports, principally from China.
In an interview to DNA Money’s Venky Vembu from Bangkok, Duncan explains the implications of US efforts to remedy trade imbalances, and why China – being the foremost trade surplus country – would be “massacred’ in the event of a “trade war”. But Duncan isn’t just a bearer of grim tidings: as he did in his second book, The Corruption of Capitalism: A strategy to rebalance the global economy and restore sustainable growth, he outlines a scenario in which the crisis could have a “happy ending”: the redistribution of wealth and purchasing power – through higher wages globally – towards the ‘bottom of the pyramid’ as a way to remedy the demand-supply imbalances. “Income redistribution may sound ‘Marxist’ and alarming,” he notes, “but I’m not coming at it from that angle: it would be good for billionaires and for poor people. Billionaires could be even richer five years from now if they play along; but if they don’t, they’re going to be worse off.” Excerpts from the interview:
You’ve called Fed Chairman Ben Bernanke’s speech last week his most important speech since his 2002 ‘helicopter money’ speech. What makes it so special?
The ‘helicopter money’ speech was important because it outlined what the Fed policy would be in the future when the property bubble popped. In that speech, Bernanke said the Fed would create dollars and buy up Treasury bonds and monetise the government debt – and that’s the most effective way to stimulate the economy. And that’s exactly what the Fed did.
In his speech last week, Bernanke came out and said that the international monetary system has a flaw. This is extraordinarily important. For the Fed to say that the international monetary system – which is the Dollar Standard – has a flaw is shocking. Never before has a senior US government official even suggested that there was a flaw in the Dollar Standard. The mantra has always been that the US is for a strong dollar policy. To have a strong dollar means to continue to have larger and larger trade deficits and more and more global imbalances that ultimately blow up into greater and greater crises. Bernanke’s speech represents a complete about-face in terms of US economic policy and an acknowledgement that the current arrangement is to blame. That was the subject of my first book The Dollar Crisis.
What does it mean for the Fed to acknowledge that the Dollar Standard is flawed – and what are the alternatives?
For them to acknowledge that it’s flawed suggests that they now realise that the flaw must be fixed. Otherwise, there’s no need to discuss it. And it should also be seen as a complementary speech to Treasury Secretary Timothy Geithner’s position that the current account deficits and surpluses of countries should be capped at 4 per cent. That was the goal of the Treasury Department at the G20 meeting in Seoul recently.
But that didn’t fly at the G20 meeting, did it?
The other countries would not agree. But, following up on that, you have not only the Treasury Department stating that, you now have the Fed too stating a similar position: that the monetary system is flawed because it doesn’t prevent imbalances. The implication is that something must be done to correct this flaw and the imbalances. And that, I think, represents the direction of US economic policy going forward: they’re going to take steps to correct this flaw. Either there’s going to be international cooperation – or unilateral action.
Specifically, what kind of policy action options does the US have: tariff barriers?
Yes, tariff barriers. That’s really the only effective one.
Over what time-frame might that pan out?
It’s hard to say. In macroeconomics on a global scale, everything takes much longer than journalists would like for their headlines (laughs). It’s not something that I expect in the near term. It’s just that they will increasingly use this threat. At the same time, as the US economy continues to be afflicted with 10 per cent unemployment and 17 per cent underemployment, there’s going to be a growing domestic political backlash against free trade. Congress has to be re-elected every two years, and the President every four years. I’d say that before the next Congressional and the Presidential elections in 2012, there will be increasing – even alarming – protectionist tendencies on display in the US. Give it another two years beyond that, and the threat could be very pronounced if not already enforced.
Are trade tariffs the first shot in an inevitable trade war, as some have concluded?
It’s a possibility. If the US raises tariffs on these goods, then China would raise tariffs on US goods. But I wouldn’t really call it a war: it would be more like a massacre because China exports six times as much to the US than the US exports to China. So China can go tit-for-tat for the first one-sixth of its exports, but after that China loses the remaining five-sixth of the battle. It has much more to lose than the US from a trade war. It’s a war that China cannot win, although it can certainly lead to all kinds of unpleasant global repercussions on numerous levels.
But isn’t unilateral trade action a contributory factor that could set off a downward spiral that could in turn set off Great Depression II?
It wasn’t the trade tariffs that caused the Great Depression. Both the Depression and what we are currently experiencing were caused by the boom that preceded the bust. The boom of the Roaring Twenties and the boom of the last 15 years were created by an explosion of credit denominated in paper money. The Depression was caused by a paper money credit boom in the aftermath of the breakdown of the Gold Standard during World War I. This current crisis was also caused by the breakdown of the Bretton Woods system and the explosion of paper money credit afterwards. Ultimately every boom busts, without exception.
So, it was the boom that caused the bust, not the adoption of tariffs, which was more or less a political response to the bust that was already happening. The tariffs were introduced only on a very low level in the early 1930s – and after the crisis got under way.
But, yes, it’s certainly not going to help the global economy if countries start putting up trade barriers. But what needs to be recognised is that the current arrangement, which created the crisis that we’re now experiencing, cannot persist. Global imbalances have created this crisis, and as long as US trade deficit is becoming larger and larger every year, it was great for the global economy. But that trade deficit was financed with credit and in 2008 the private sector in the US couldn’t repay the credit. And so the private sector went bankrupt which caused a systemic banking crisis in the US – and similarly (but on a smaller scale) in Greece and Ireland and Spain and Portugal.
We now have high rates of unemployment and massive budget deficits, unlike anything ever seen in peacetime. And it’s only those budget deficits that are keeping us from collapsing into a Depression. That’s good, but they’re unsustainable over the long term. Now, in addition to the large fiscal deficits, there’s also been an extraordinary amount of paper money creation again. In 2009, the Fed created $1.7 trillion, which they used to buy up assets from banks and keep them from going bankrupt. Now, they’re about to create another $600 billion. Before the crisis started, their entire balance sheet was only $800 billion; now it’s going up to $2.9 trillion. This paper money creation is nothing but debasing the currency.
In Bernanke’s ‘helicopter money’ speech, he said: “Like gold, US dollars have value only to the extent that they are strictly limited in supply.” In other words, by creating more dollars, you are reducing its value.
Let’s think of what happens next. The purpose of this latest round of Quantitative Easing is to drive up stock prices. Higher stock prices have boosted consumer confidence in the past two months, and that’s stimulating the US and the global economies. But this asset price increase is artificial and unsustainable. When this program stops in mid-2011, there isn’t going to be any new miraculous driver of global growth to replace this. If they stop buying assets, asset prices will fall – and consumption will fall, and we’ll plunge back into a worse recession.
So they won’t stop: they will do this again, with QE 3, 4, 5… to infinity. And that’s going to be very destabilising because it will create inflationary pressures on commodities – for things like food. And much higher food prices could lead to food riots, even starvation, for some of the 2 billion people who live on this planet on less than $2 a day.
Has the market missed a trick? Has it been less than sensitive to the import of Bernanke’s message?
In general, the media has missed a trick in terms of not recognising the importance of his speech. The market doesn’t think for itself anymore; its driven purely by the amount of liquidity injections it’s given.
We talk in general terms about correcting ‘trade imbalances’. But specifically, is it directed at China?
Yes, primarily China – because China has by far the largest surplus and it’s growing, and there’s every reason to expect it to continue growing rapidly.
But there are those who would argue that ‘China-bashing’ and going to currency war and raising tariff barriers is wrong; that an appreciation of the Chinese currency, the renminbi, won’t rebalance trade distortions; that it will only stoke inflation in the US – and prove counterproductive by dampening consumption. Isn’t there any merit in that argument?
Yes, there is some. I try to look at this objectively, and not lay blame on any one side. There’s plenty of blame to go around, beginning with the US for not abiding by the rules that it created in the Bretton Woods system, and allowing it to collapse in 1971. Afterwards, they were no rules, and so it was pretty much fair for any country to play by its own rules in any way that it saw fit. And that’s what countries have subsequently done. But it’s now brought us to the brink of a new Great Depression by creating a worldwide credit bubble.
Specifically, trade imbalances can be corrected by currency appreciation – but that depends on how much a currency appreciates by. If it appreciates by 2 per cent, it’s not going to be corrected. The precedent for the situation we’re in is the Plaza Accords. At that time, the participants agreed that the dollar would depreciate by 50 per cent against the yen and the mark; that’s what happened over the next few years. That brought the US current account deficit back into balance by 1990. A 50 per cent devaluation in the dollar against the renminbi may probably not fix these imbalances, but it would be a big step in the right direction.
But that’s not going to happen: China isn’t going to allow its currency to appreciate by that magnitude. When China sees tariff barriers go up in the US, how might it respond? What are the weapons in its armoury?
The most sensible way for China to respond would be to let its currency more rapidly – and they probably will do that, because that’s their best option. A recent commentary in a financial daily suggested that the US should put the China on notice that will put up barriers equivalent of 1 per cent every month until the Chinese currency appreciates significantly. If China was finally threatened with real barriers like that, it would give in. It could do many things and cause many problems, but all of those chess moves have a worse outcome for it than just allowing the currency to appreciate.
Is there any merit in the widely articulated market fears that China will dump the dollar and grind it to dust?
No, there’s not. China has $2 trillion worth of dollar assets. What does it mean to ‘dump the dollar’: if you mean sell the dollar assets, you have to ask: who do they sell them to. If they sold them to the Europeans, it would mean China would have $2 trillion worth of euro which they would have to invest in European assets. And there aren’t $2 trillion worth of euro assets that they could accumulate. It’s impossible to do that. Even if they tried to destabilise the US Treasury market, by provocatively trying to cause problems with Treasury bonds, it wouldn’t work.
When I spoke to you the last time, you outlined two laws of macroeconomics: ‘If you don’t prevent the boom, you can’t prevent the bust’ and ‘The bigger the boom, the bigger the bust.’ You then made the point that China was the only exception to the rule in 250 years, and won’t remain so for much longer. From what you’ve seen in China since then, do you still hold that opinion?
Are you not persuaded by the perception that the Chinese government is successfully engineering a soft landing: cutting back on credit growth marginally, taking administrative measures to deflate the high-end property bubble?
No, they’ve had just the reverse of what you’ve just described. They prevented the bubble from imploding in 2009 by expanding their bank loans by something like 40 per cent of GDP in a year and a half. If you grow your bank loans by 40 per cent of GDP and only get 10 per cent GDP growth, that’s a pretty poor performance. It just makes the Chinese economy even more bloated and unsustainable and prone to crisis than it was before. And we’ll see how it works out for them.
What is your assessment of how it might work out?
It won’t be pretty.
The problem with the US is that it cannot produce as much as it consumes. China’s problem is much worse than that: it cannot consume as much as it produces. And what they’ve just done by expanding their bank loans is to create a lot more production capacity, which they still can’t consume. The reason they can’t consume it is because they have such a large population and the wage rates of 80 per cent of the people at the bottom of the pyramid are like $5 a day. They don’t earn enough money to buy the things they produce in their factories. Up until now, they sold all their surplus to the Americans, but now the Americans can’t afford to buy any more, and China is stuck with massive excess capacity across industries and they don’t have income at the base of the pyramid to absorb the capacity.
But haven’t we seen the beginning of a transition in China – promoting consumption as a driver rather than fixed asset investment going forward? We’ve seen wage increases of the order of 20-30 per cent, a gradual move into high-value manufacturing rather than just sweatshops….
We saw 20 per cent wage increase in a couple of Japanese and Taiwanese factories, in some of which there were a lot of suicides. If you look more closely, you’ll find that most people in China’s factories are 19-year-old girls making less than $5 a day, just as they were 10 years ago.
Of course, given that food prices have doubled in the past three months, if there isn’t some increase in Chinese wages, people are going to start becoming unruly. But given the boom that China has experienced, it is regrettable – and potentially fatal – that they haven’t managed to make their wage rates go up much more rapidly than they have. When the boom pops and unemployment emerges, wages will fall again, exacerbating their problems.
In Europe, just when we thought it was safe to go back into the water, the contagion seems to be spreading. How might it end?
Countries like Greece, Ireland, Portugal and Spain are similar to the US in the sense that they borrowed a lot of money to finance their deficits and when they couldn’t repay the money, they had banking crises. The difference is that there’s also Germany, which is a big surplus country, just like China. But whereas China allowed most of the money to come into China and stay there, Germany lent its surplus out without having the central bank accumulate it. The countries they lent it to are the European deficit countries as well as the US. So China blew itself into a bubble by allowing its central bank to create too much paper money; Germany didn’t blow itself up into a bubble but it now can’t get back the money it lent out to countries that are defaulting.
This is a big problem. If the banks in Ireland and other parts of Europe aren’t bailed out, it could mean that some large banks in Germany, France or even England would take such large losses that they could go bankrupt. That’s why they are having again to be bailed out by the EU and the IMF.
If you notice the pattern, it took policymakers quite a long time to come up with a sensible rescue bailout for the banking system following the Lehman Brothers crisis. It took them much less time to bail out Greece. And hardly any time at all to bail out Ireland. So the bailouts are going to happen – and in the end the taxpayers are going to get stuck with it or central banks are going to monetise it. Especially in the US, there’s a kind of hope that the euro will blow up. But if anything, I think that seeing how the problems in Europe have been resolved, it shows how durable the euro will be.
Is the chatter about the break-up of the euro ill-informed?
In the worst case, it’s not inconceivable that a couple of small countries will drop out. But even if they do, there will still be a euro. In the very worst case scenario, where we see some big European banks go bankrupt, it will no longer be just a European problem. If one big European bank goes bankrupt, banks around the world are going to be hit through the counter-party exposure to the $700 trillion derivatives market. In that scenario, there would no longer be a euro, but there would also no longer be a dollar either.
Over the next few years, what milestone events might affect the global economy?
The most important one is what happens in mid-2011, when the Fed’s QE 2 wears off. The markets will look to the Fed to tell them what the next move will be. The Fed will have to say, ‘We’re going to have to do it again’. If it doesn’t, the markets will sell off in a big way. But the Fed will probably reassure the markets that it’s going to keep on doing it. There will be a QE 3 or perhaps a QE 2A (laughs). That’s the first milestone.
The greatest danger is that the Republicans in the US launch an effective campaign to stop the Fed from doing QE 2A. If there’s no more QE, everything implodes in the near term, as opposed to it imploding a little later. Effectively, the policy thinking now and for some time has been: “It’s better to die tomorrow than to die today.”
What might we look out for in Asia? China successfully managed to avert attention away from the renminbi to the fact that QE 2 was distorting capital flows.
I don’t think China was as successful. Bernanke had the last word a week ago, in his speech, pointing more directly than ever at China and noting that the Dollar Standard is flawed. For Asia, if Republicans stop further QE, there’s no other growth driver – and markets will crash simultaneously. Republicans have already made ‘stimulus’ a dirty word in the US; it’s not possible to have any more fiscal stimulus. If they make it impossible to have any more monetary stimulus, the crisis will restart at the previous low, and get much worse from there.
From the perspective of the 2012 presidential elections, the Republicans perhaps might gain politically from a crisis, won’t they?
Exactly. That’s part of their strategy: they want the economy to be really bad to win back the presidency. But then they will have a real problem because unless they are completely hypocritical, they won’t be able to do any fiscal stimulus or monetary stimulus. We’d then be stuck in a Depression and that, sadly, would suggest that the only stimulus that the US could then utilise would be ‘military Keynesian’: in other words, war.
Whoa! Isn’t there a happy ending to the crisis at all?
There could be a happy ending if people understand that this crisis is all about imbalances. On the supply side, there’s too much supply, because credit has been expanded without limit using paper money. On the demand side, we can’t keep pace with the supply because wages aren’t going up in the world. Globalisation has meant that wages in the Western world have stopped rising – and wages in the developing world aren’t rising fast enough. We can solve this problem – and it can have a very happy ending – if we find a way to redistribute the income away from the wealthiest people on the planet: the Billionaires Club, wherever they are, and the $100 Million Club and the $10 million Club. Redistributing some of their income will be good for everybody: it will be good for the billionaires, and for the poorest people on the planet – because then the game can continue.
In my first book, The Dollar Crisis, I advocated higher and steadily rising global minimum wage, so that the bottom of the pyramid would earn more money and buy the stuff that they are making; that would improve aggregate demand and resolve these imbalances between supply and demand. So it’s not just about redistributing existing wealth, it means redistributing purchasing power in terms of higher wages for the people at the bottom of the pyramid. Income redistribution can make this have a happy ending.
‘China’s economy is dangerously addicted to cheap money‘: Interview with Prof Patrick Chovanec
‘This is a very dangerous time for China’: Interview with Dr Jim Walker
‘China’s biggest risk is that it doesn’t change its economic model’: Interview with economist Stephen Roach
‘Much of China’s GDP vanishes into thin air’: Interview with David Scissors
Why China needs to change: Interview with Arthur Kroeber
‘Bigger the boom, bigger the bust: China is no exception to that rule‘: Interview with Richard Duncan
‘China’s nuclear bomb is a dud’: Interview with Michael Pettis