29 October 2022

Trey welcomes back economist Richard Duncan to discuss the current events happening across most asset classes both globally and domestically. Richard is the author of 4 books, the most recent of which is called The Money Revolution, which we discussed back in March, Episode 424. The book explores a contrarian idea that the US could potentially act as a venture capitalist for the American people. The thesis, however, has been blunted from the new high interest rate environment. Richard has worked for the World Bank and the IMF.

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  • Where the economy is heading, now that credit growth has been reversed.
  • The steep decline in the treasury markets around the world and what’s driving it.
  • Why the FED’s net income has turned negative for the first time ever and how it can be reversed if politicians understand the mechanics Richard lays out.
  • England’s pension plan fiasco.
  • The $280B Chips & Science Act that was recently signed into law.
  • And much, much more!


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Trey Lockerbie (00:00:03):
Hey, guys. I’m really excited to share an upcoming event hosted by The Investor’s Podcast Network. Beginning on Monday, October 17th, we are launching a stock pitch competition for all of you to compete in, and the first place winner will receive $1,000 plus a year long subscription to our TIP Finance Tool and more. So don’t miss your chance to win $1,000. If you’re interested, please visit theinvestorspodcast.com/stock-competition for more information. The last day to submit your stock analysis will be Sunday, November 27th. And to compete, please make sure you’re signed up for our daily newsletter, We Study Markets, where we’ll announce the winners. All entries can be submitted to the email newsletters at theinvestorspodcast.com. Good luck.

On today’s show, we welcome back economist Richard Duncan to discuss the current events happening across multiple markets. Richard is the author of four books, the most recent of which is called The Money Revolution, which we discussed back in March, episode 424. Richard has worked for both the World Bank and the IMF, and I always appreciate his ability to teach his ideas very clearly and thoroughly. In this episode, we discuss where the economy is heading now that credit growth has been reversed, the steep decline in the treasury markets around the world and what’s driving it, why the Fed’s net income has turned negative for the first time ever, and how it could be reversed if politicians understand the mechanics that Richard lays out, England’s Pension Plan fiasco, the $280 billion CHIPS and Science Act that was recently signed into law, and much, much more.

This one is a doozy as we explore so many happenings across markets both globally and domestically. I really hope you enjoy it. So without further ado, here’s my conversation with Richard Duncan. Welcome to The Investor’s Podcast. I’m your host, Trey Lockerbie, and today I’m super excited to have our friend Richard Duncan back on the show. Richard, welcome back.

Richard Duncan (00:01:57):
Hey Trey, thank you very much for having me back. I’m really looking forward to this conversation.

Trey Lockerbie (00:02:03):
It was so funny. Someone on Twitter today wrote me and said, “When are you going to have Richard Duncan back on the show?” And I said, “Funny, you should ask. We’re talking tonight.” So good timing on our part, and I think a lot of people are eager to hear from you. A lot’s happened since our last discussion, which I believe was in February or March timeframe and it feels like years.

Richard Duncan (00:02:22):
Yeah. We didn’t know Russia was going to invade Ukraine. The Fed was just winding up quantitative easing, hadn’t started quantitative tightening yet, and interest rates were still very close to 0%.

Trey Lockerbie (00:02:37):
It feels like a lifetime ago.

Richard Duncan (00:02:39):
So a lot has changed.

Trey Lockerbie (00:02:41):
I wanted to start out here by talking about something we talked about on our last episode where you were describing the need to continue to drive credit, and the US is hitting, you predicted, around 90 trillion in total credit by year’s end. We’re actually above that already, over 91 trillion now. We need 2% credit growth after inflation to not go into a recession. So, that’s what we discussed on our last episode. If that’s the case, why is there any debate right now whether we’re in a recession or not?

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Richard Duncan (00:03:14):
I believe that after the dollar ceased to be backed by gold, our economic system changed and it started being driven by credit growth. Instead of being driven by investment in savings the way capitalism had worked forever, suddenly the new growth dynamic was driven by credit creation and consumption. And total credit in the US is also equal to total debt. This is all the debt of all the sectors of the economy, so the government, the households, the corporations, the financial sector, all the debt. It first went through $1 trillion in 1964. It’s now increased to $91 trillion. So a ninety-one-fold increase in credit in just 58 years. And that credit growth has been the main driver of economic growth in the United States and all around the world.

And if you look from 1950, roughly, to 2009, anytime total credit adjusted for inflation, grew by less than 2%, the US went into recession. That happened nine times between 1952 and 2009. Every time credit grew by less than 2%, adjusted for inflation on an annual basis, the US went into recession. So now here we are with $91 trillion of credit. If you need that to grow by 2%, adjusted for inflation, if we assume quite generously that the inflation rate will average 7% this year, then 7% plus 2% means that before adjusting for inflation, total credit has to grow by 9%, and 9% of $91 trillion, which is how much debt we have now, is $8 trillion over the next 12 months. And currently, as of the second quarter at least, total credit was just growing by roughly, let’s say, $6 trillion.

So I always talk about this 2% adjusted for inflation as the recession threshold. If we don’t have 2% credit growth adjusted for inflation, then we go into recession. So I call the 2% credit growth the recession threshold. But we’ve now been below that 2% recession threshold for the last five quarters. And for the last three quarters, credit has actually contracted, this is year on year. In the second quarter, total credit adjusted for inflation was down 1.2% year on year. So this is creating a very perilous moment for our economy, since our economic system, I call it creditism since it’s driven by credit growth, this poses a real challenge to creditism.Creditism is verging on the brink of crisis and is not at all helped by the fact that asset prices are also now following. Credit growth wasn’t particularly strong after 2009. It was just ranging between two or 3% a year after adjusting for inflation, despite the government’s massive budget deficits all during that period and the government borrowing and government debt going up so sharply. Government debts roughly quadrupled since 2008, and that’s been driving a lot of the credit growth, but even still, the credit growth was weak. And the Fed intervened to support the economy through very low interest rates and round after round of quantitative easing, and that pushed up asset prices and that created a wealth effect.

So the total wealth of the Americans more than doubled between 2008 and the end of last year. It rose $80 trillion between 2008 and the end of last year to $150 trillion. But so far this year, $6 trillion have been wiped out. So we’ve got not only credit contracting, we’ve got a negative wealth effect. And moreover, the Fed is tightening monetary policy very aggressively with aggressive rate hikes, which we’ll see more of, it looks like, going forward, plus $95 billion a month of quantitative tightening, which will add up to $1.1 trillion a year if it continues for a year. So little wonder the stock markets have crashed as much as they have, but they’re probably going further down, and now property prices are likely to start dropping at a double digit rate as well.

Trey Lockerbie (00:07:29):
Yeah. In your last Macro Watch, you were highlighting that as the Fed is continuing to raise rates, we’ll see the stock market decline and other risky asset classes. You just mentioned real estate, so I’m assuming that’s what you were alluding to there. But the 20 year treasuries are down year to date more than stocks right now. I was kind of curious why they weren’t included in your analysis there. This was the fourth worse year after 1721, 1865, and 1920. So the fourth worst year in the last 322 years. This is according to Bank of America research. Do you think that we’re just seeing normal market conditions where old bonds are being discounted due to higher paying bonds being issued and Fed now tightening, selling at a loss? Or is there something even more ominous maybe happening here?

Richard Duncan (00:08:22):
I think something more ominous is happening. The major theme that’s run through my career over the last 35 years is globalization and growing US trade deficits, growing US current account deficits. And as the US bought more and more goods from low wage countries, that was extremely disinflationary. That drove down the inflation rate from 15% in 1981 to not too many years ago, it was negative. In early 2015, we had deflation most recently, and that was all because of globalization. And so as the inflation rate came down, then the interest rates came down and moved lower and lower. And the Fed reduced the federal funds rate to roughly 0% and held it there for most of the time now since 2008 until very recently.

But now what we’re seeing is a partial reversal of globalization, both resulting from COVID and the global supply chain bottlenecks that produced. And then just when there was some glimmer of hope that that was going to recede before too much longer, Russia invades Ukraine, causing a very big spike in energy prices everywhere in the world but particularly in Europe and also food price spikes and food prices as well, which another big inflationary surge throughout the global economy. So the most recent inflation numbers were terrible, just not too many days ago. Headline CPI is still 8.2%. That didn’t improve much. And core CPI, it moved up, it hit a new 40 year high of 6.6%.

And so this is creating a disastrous scenario for the Fed. It looks like the Fed is going to be compelled to continue increasing interest rates. They’ve already hiked the federal funds rate by 300 basis points, essentially from zero now to 3.1% on the effective federal funds rate. And come November 2nd, they’re likely to announce another 75 basis points, and then in December probably 50 basis points more, taking the effective federal funds rate up to 4.3% by the end of the year. And they’re probably not going to stop there. I would expect that they’re going to keep hiking, and I wouldn’t be at all surprised to see the federal funds rate move above 5% in the second quarter of next year unless something breaks first.

If we see very disorderly developments in the financial markets that threaten to destabilize the financial sector, then the Fed will have to stop, or reverse course, or at least hint that it will. But unless that happens, and it very well could happen sooner rather than later, in fact, we’re seeing all kinds of problems in the UK now and credit default swaps are rising on the US banks, so something could break, but until something breaks, the Fed’s going to keep tightening because the unemployment rate is still extremely low, a 50 year low, three and a half percent. And the Fed needs to reduce demand in order to bring supply and demand back into balance and bring the inflation rate back down. So I think that’s what they’re going to continue to do.

So even though the stocks have fallen so far, I suspect they’ll fall further, because if you look at the overall asset prices, they’re still very inflated by historic standards. I always talk about what I call the wealth to income ratio. That’s household sector net worth, all the wealth of the Americans minus all their debt, divided by disposable personal income. That’s wealth divided by income. The Fed publishes this every quarter. It goes back to 1950. The average has been 550%. Well, every time it goes way above that average, as in 2000 with the NASDAQ bubble, 2008 with the property bubble, it pops and it goes back to its average.

Well, now, even after the correction in the stock market in the first half of the year, this average is 16% above its previous peak in 2008. So the average since 1950 has been 550. Currently, this ratio is 780. That’s 16% above where it was in 2008. So this is telling us that asset prices are still very stretched relative to income and have the potential to fall much further. Now, that’s probably going to take a lot of decline in the property prices to pull that down, but I would also expect the stock prices to… I don’t think we’ve seen the bottom. So rather than being brave and diving in now, I think it’s best just to wait until something does break, because when it breaks, then we’ll probably see lower lows across all asset classes.

Trey Lockerbie (00:13:00):
This has been a common narrative I’ve been hearing, the Fed’s going to keep increasing rates until “something breaks.” And is it a possibility that something that breaks is actually the Fed itself? Because, as I understand it, if markets continue to tank, it’s fairly inevitable they’re going to have to come in at some point and do some more quantitative easing to shore up the markets. And if they continue to raise rates, then our deficit is just going to continue to go up. And at some point, we’re going to have to fund that deficit, and that’s going to cause the Fed to print more money just to fund the deficit. So they’re kind of in a double bind here, right?

Richard Duncan (00:13:35):
Well, the Fed’s certainly facing a lot of challenges, but the fiscal year for the government just ended on September 30th, and the debt for the year that just ended, the budget deficit, was only half as high as it was the year before. It was still a high number of $1.4 trillion, but the year before it was 2.8 trillion and the year before that it was 3.1 trillion. So the amount of money the government is borrowing is much less than it was a couple of years ago, of course, during the worst of the pandemic.

Trey Lockerbie (00:14:09):
Very interesting. So going back to your point about the market possibly going lower, I tend to agree with you on that because for having seen the everything bubble expand as much as we’ve seen it expand, you would think there would be some kind of Lehman moment at some point, right? I just don’t feel like we have a scapegoat, if you will, or a post sign, if you will, to say, “Oh, that was the moment things went really south.” And now we’re seeing Credit Suisse, as you mentioned the credit default swaps there, they’ve recently tapped the Fed for $6.27 billion. How concerned are we around this issue with Credit Suisse and the credit default swaps we’re seeing at multiple banks?

Richard Duncan (00:14:50):
So I think the biggest point of concern right now is in the UK. The recent budget proposals with very large tax cuts spooked the financial markets there and resulted in interest rates on 10 year UK government bonds, on gilts, jumping very sharply and very suddenly. And we discovered that apparently most of the UK pension funds have been using derivatives contracts to leverage up their potential profitability, but were totally unprepared and vulnerable to such a sudden and unprecedented spike in 10 year government bond yields. Suddenly, they started getting very big margin calls when the 10 year government bond yield spiked, and that forced them to start selling any kind of asset, including government bonds there. The more government bonds they sold, the more the yields on those bonds went up and the greater problems they all faced.

And so at that point, the Bank of England broke, at least temporarily. They had intended to start quantitative tightening just around now, but instead they had to announce that they had to act as the provider of liquidity in the last resort because there was essentially a crisis in the UK pension fund market. So they announced, rather than starting to destroy money, that they would be willing to create an additional £65 billion over a relatively short period of time that they would use to buy UK government bonds to ensure that there was sufficient liquidity available to these pension funds needing to sell government bonds.

So there was a real crisis in the UK markets, and it isn’t over yet. The poor UK Treasury Secretary, Chancellor of the Exchequer, got sacked a few days ago for proposing this budget that resulted in such chaos. But the yields moved down some, but on Friday they were really quite high again, and it’s possible they’ll spike higher again when the markets reopen on Monday. So who knows how much exposure English banks have to that situation, or Swiss banks, or even US banks and what the knock on spill on effects of all of that could be. This could be the thing that breaks. But when it breaks, a lot of damage is likely to be done before the policy makers come to the rescue. So I don’t think pre-break is the time to buy. I think post-break is more prudent.

Trey Lockerbie (00:17:18):
It reminds me of that Buffett quote that, “It’s only when the tide goes out that you learn who’s been swimming naked,” right? And this story, I don’t know how to feel about it, mainly because, I mean, these are pensions, these are people’s retirements. And it seems like the responsibility here is just a lot heavier because of the implications. Is this a canary in the coalmine, if you will, for other pensions across the globe, or you think we would have seen that by now if there are other issues like this?

Richard Duncan (00:17:45):
Yes, to some extent it is a canary in a coalmine, but looking ahead, with some luck, the inflation rate will start coming down everywhere, at least starting in the US perhaps more so than Europe because Europe has such a crisis going on with Russia and the very high energy prices in Europe that’s causing. But in the US, it’s very reasonable to expect that the inflation rate will begin coming down for a number of reasons. Just, for instance, the base effect, the year on year base effect, oil shot up to $120 a barrel. Now it’s $85, let’s say. So year on year, at some point it will appear that there is deflation in oil prices. And even if it stays at $85 a barrel for the next 12 months, there’ll be no inflation in energy if that’s the case. So the base effect will bring inflation down from these extraordinarily high levels we’re experiencing now.The US CPI peaked at 9.1%. We’re also seeing falling commodity prices across most commodities that are pretty significant. And there are a lot of signs that the global supply chain bottlenecks resulting from COVID are being worked out, such as the Baltic Trade Index, which has plunged quite radically. So we should see significantly lower inflation going forward. The one thing that’s holding it up… And, I mean, another example, semiconductor prices have fallen a lot. That means that car prices should begin to drop and used car prices should drop a lot. So all of those things are pointing to lower rates of inflation. And if that occurs, then the Fed will be able to stop hiking interest rates so aggressively and at some point even begin to cut interest rates. So there will be a point beyond which things begin to improve rather than worsening, which is where we are at the moment.

The one thing that’s keeping the inflation rate number elevated, one of the main things, is the house price inflation that is appearing, particularly in the core CPI numbers, and that’s going to take many months to work out any way you look at it. But we’re probably going to see home prices starting to fall quite soon. The 30 year fixed mortgage rate has shot up an astonishing 7%. Clearly, that’s going to be very damaging for home prices. So once home prices start dropping, as it appears that they will, then we’ll see much less upward pressure on rents. And rents too may begin to drop before too much longer.

Trey Lockerbie (00:20:11):
Yeah, I think you’re exactly right about that. I actually saw some data here from Redfin with some percentage changes from May of this year to October, and we’re already seeing double digit declines. It’s actually the fastest crash, they’re saying. So Oakland, California for example, down 16 and a half percent, San Jose, California, 15%, Austin, Texas 14%. So we’re seeing drastic declines in housing happening rather quickly. I found this actually kind of surprising, mainly because I figured a lot of people had very low interest rates on their mortgage, and that’s a big asset right now, right?So I understand maybe they’re getting cash-strapped in other ways, inflation, et cetera, and perhaps it’s leading to selling your home, but I don’t know exactly where the incentive lies, and I’m sure it’s all over the place, but the incentive to sell your home when you have such a low interest rate is kind of surprising to me. Now, one theory I did have is that let’s say you took out a HELOC on your home to buy an Airbnb or something like that, and a lot of people kept rolling this over and doing it over and over again, those HELOCs can get margin called, right? And so that could have a cascading effect. And I’m curious what the driver, I guess, is, if it’s simply the interest rates on mortgages or if it’s maybe there’s some more layers to it.

Richard Duncan (00:21:31):
Well, of course, anyone who’s buying a new home will have to pay the higher mortgage rates, and that’s deterring a lot of new buyers. And that’s the reason we’ve seen such a sharp decline in new home sales. So, that’s taken all the froth out of the market. It’s suddenly changed very suddenly. That alone is enough.

Trey Lockerbie (00:21:49):
Well, speaking of rapid declines, we talked about the treasury market. This is actually the largest and most rapid decline ever, and we were speculating on what is driving it. We’ve mentioned a few things. But you have Japan buying their own sovereign debt, so they’re obviously selling some treasuries. You’ve got Hong Kong foreign reserves declining to the lowest levels in history, making a strong case that the Hong Kong dollar is going to be debased. The Eurozone trade deficit for August was recently published, and given their increased cost for energy, their deficit is now at historic levels, and it’s another strong case for the euro to decline. These are just a few examples. And all the while, the dollar, at least the Dollar Index, is at 113. What are the ramifications you see from the dollar continuing to strengthen while the rest of the world is easing?

Richard Duncan (00:22:44):
So not so long ago, the great chorus echoing across the internet space was the dollar was doomed, the dollar was going to collapse and that was going to be the end of the dollar, right? And now we’ve got the Dollar Index at 113. That’s a 20 year high. And as you suggested, it looks like it’s probably going to keep moving higher. So the first takeaway from this is the dollar swings up and the dollar swings down. If you go back, it started floating in 1971 with the breakdown of the Bretton Woods system. It doesn’t really swing that far in either direction. Now, during some decades it’s down from the place it started in 1971. Other moments, such as now, it’s above where it started in 1971.

And this is what we should continue to expect over the decades ahead. The dollar is not going to collapse, the dollar is not going to go away. Sometimes it’s going to be stronger, sometimes it’s going to be weaker. And if you can forecast those moves, then that’s great because it does have big implications for the rest of the global economy. Normally, when the dollar gets stronger, commodity prices get weaker. When commodity prices get weaker, normally that’s bad for most of the commodity producing countries in the world, which are normally emerging markets. Also, when the dollar is very strong, that tends to be bad for US corporate profits since they earn a significant amount of their profits from abroad. And since weaker profits suggest a weaker share price, so it tends to be bad for the US stock market. So, that’s sort of where we are at the moment.

And it does appear that the dollar has a good chance of continuing to get stronger because, as you mentioned, the yield on the 10 year Japanese government bond is 25% of 1%. In other words, it’s 25 basis points. The Bank of Japan is creating money and buying Japanese government bonds in order to peg the 10 year Japanese government bond yield at 25 basis points. Meanwhile, the US rates are going up very sharply and very suddenly. So the yen is at a 20 year low, and it’s taken some intervention from the Bank of Japan to prevent it from dropping even further. If you look at Europe, they have a disaster with their energy crisis since they’ve been cut off from almost all of Russia’s energy supply. They have high rates of inflation, and their central bank wallet recently did increase interest rates a little bit. They’re not going to be able to keep increasing interest rates as much as the Fed is, just because Europe’s likely to have quite a severe recession. And, well, England’s a story unto itself. But overall, it does look like the dollar is probably going to continue to appreciate.

Trey Lockerbie (00:25:23):
Yeah. That yield curve control in Japan, it seems like inevitable, and a lot of other parts of the world. In your most recent book, we were talking about it in our last episode in March, it was episode 424 for those who want to go back and check that out, you wrote that if the Fed were a corporation, it would be the most profitable corporation in the world, even leading Apple by $30 billion, give or take. And we discussed how the Fed actually makes money. The Fed basically creates money, buys bonds or mortgage backed securities and earns the interest with relatively low overhead. It’s around $8 billion or so, mostly paying probably economists. And in September, the Fed’s net income has, for the first time ever, turned negative. So can you describe exactly what’s going on here and the change with the Fed?

Richard Duncan (00:26:14):
Okay. Well, this takes some explanation. Let me begin by saying that when we spoke in February, the data for last year was not yet available. So when I said the Fed, if it had been a corporation, it would be the most profitable in the world, that was for 2020 data. That year, in 2020, the Fed’s profits were $87 billion. And the Fed is required to hand over all of its profits to the government. So that year, the Fed’s profits reduced the US budget deficit by $87 billion. Last year, the data now is available for 2021, the profits were much higher than they were the year before. Last year, the Fed’s profits were $107 billion that it handed over to the US Treasury Department, reducing the budget deficit last year by $107 billion.

So how this works, as you mentioned, the Fed creates money essentially at no cost to itself, and it buys bonds in order to pump money into the financial markets. Since those bonds pay interest to the Fed, the Fed has a lot of interest income. And since it created the money that it used to buy those bonds for free, it has very little interest expense thus far. And so with a lot of interest income and little interest expense, that’s where all the profits come from. Now, what has changed is when the Fed creates money, it does this by, it buys a bond, for example, from a bank, and it pays for that bond by making a deposit into that bank’s account at the Federal Reserve. All the banks have a bank account at the Fed. And so when the Fed buys a bond from J.P. Morgan, for example, it’s simply deposits money into J.P. Morgan’s bank account, money that it has created. It is not money that existed before. And that expands the amount of money in J.P. Morgan’s bank account at the Fed. In other words, it expands J.P. Morgan’s bank reserves.

Now, what’s happening is bank reserves, because the Fed has created so much money through quantitative easing, starting in 2008, the Fed has created something like… Well, at the end of 2007, the Fed’s total assets were, let’s say, $1 trillion, a little less than a trillion dollars. At the peak, a few months ago, they had increased to $9 trillion. So between 2008 and now, the Fed’s assets had increased by $8 trillion, meaning the Fed had created eight trillion new dollars, and money that it pumped into the financial system, into the banking system, causing bank reserves to expand. Now, there is massive excess supply of bank reserves. People become very confused about what bank reserves are, and it is really a bit difficult to get your mind around it. But on the other hand, it’s not as complicated as you think.

Bank reserves, they’re just money. The money gets transferred around the banking system now electronically. And it becomes very confusing when you think about these digits moving around the banking system and from the banks to loans, and the banks might buy bonds or might make investments in stocks. It all becomes very confusing. But if you think of these bank reserves as just dollar bills and follow where the dollar bills are going, or think of them even, to make it more dramatic, think of this as pennies. Just imagine these mountains of pennies that the Fed is creating and just watch where the pennies move. It’s the same. Bank reserves are the same as dollars, or pennies, or anything you want to look at it. When the Fed creates bank reserves, those bank reserves are not going to go away until the Fed destroys them with quantitative tightening.

So for example, the Fed may buy a billion dollars of bonds from J.P. Morgan and deposit a billion dollars into J.P. Morgan’s bank reserves. Now, J.P. Morgan can do anything with those bank reserves that it wants. Those reserves are money. So it could lend that billion dollars to Trey Lockerbie. But Trey Lockerbie is not going to keep the billion dollars worth of pennies in his backyard. That would be ridiculous. He’s going to deposit them in his bank, Goldman Sachs, for instance, perhaps. And then so the bank reserves move to Goldman Sachs. They don’t disappear. They’re not going to disappear no matter how much the banks lend or no matter what they do with those bank reserves. They could buy a building with it. They could buy pork bellies. The banks, just because the reserves move around, they don’t disappear, and they’re never going to disappear until the Fed destroys them through quantitative tightening, which the Fed is now doing.

Now, so in the past, making a long story even longer, in the past, the way the Fed controlled interest rates, the federal funds rate, there didn’t used to be massive excess reserves. Banks were required to hold a certain portion of their deposits at the Fed, in their bank accounts at the Fed, as reserves to make sure that if suddenly their customers came knocking on the door asking for their deposits back then the banks would have enough reserves to pay the customers their deposit back so there wouldn’t be bank runs. Back in the 19th century sometime the legally required reserve ratio was as high as 20%. The banks were required to keep reserves of 20% at one point. Over time, this required reserve ratio fell and dropped and dropped and dropped. But so you get the idea. These bank reserves were legally mandated, and the banks didn’t keep excess reserves if they didn’t have to. And so reserves were always scarce, and the Fed was able to manage the federal funds rate by making relatively small adjustments in reserve balances.

So for example, if it wanted interest rates to go down, then it would buy some bonds from the banking system. And when it buys bonds, it would inject new reserves into the banking system. So that would increase the amount of bank reserves, and that would make bank reserves more plentiful. And so the cost of borrowing reserves would drop. And conversely, if it wanted interest rates to move higher, the Fed would sell some of the bonds that it already owed to a bank, and the bank would have to pay the Fed by transferring its bank reserves to the Fed. And that would make the reserves in the system more scarce, and that would make the federal funds rate move up.

So by banking relatively small changes in its open market purchases and sales, in other words, by just selling a relatively small amount of bonds or buying a relatively small amount of bonds, it could change the supply and demand dynamic in the market for federal funds, affecting the federal funds rate. And that’s how the Fed moved up and down the federal funds rate, by small adjustments in making bank reserves more plentiful or more scarce. But after 2008, that doesn’t work anymore because the overall level of bank reserves in the system are not scarce anymore. They’re super abundant. The Fed has effectively created eight trillion extra dollars that are floating around in the financial system. So now the banks have massive excess reserves, any way you look at it. And the only way to get rid of the excess reserves would be for the Fed to entirely reverse all of the money creation that it’s done over the last 14 years, and that’s not going to happen.

So the Fed has had to create a new way to control the federal funds rate, and now the way they control the federal funds rate is entirely different than the way they controlled it in the past. Now they control it by paying interest on bank reserves. So before the Fed started hiking interest rates in March, the federal funds rate was about 25 basis points. And so the Fed paid the banks 25 basis points on their bank reserves so that the banks wouldn’t lend money at less than 25 basis points. Why would the banks lend money to anybody else at less than 25 basis points when they can earn 25 basis points interest from the Fed? Well, now every time the federal funds rate moves up, the Fed makes it move up by paying a higher interest rate on bank reserves. So now that the federal funds rate is at a range between three and three and a quarter percent, the Fed’s currently paying 3.1% on all the bank reserves held by the banks, and, therefore, that’s why the banks won’t lend any money at less than 3.1%.

That’s how the Fed is moving up the interest rates. If the Fed didn’t pay interest on these bank reserves, then there’s so many reserves, the banks, there’s excess supply of reserves, so that would put downward pressure on interest rates and the Fed would be unable to push interest rates higher. It would be unable to tighten monetary policy to fight inflation. But by this new policy that they introduced in 2008 of paying interest on bank reserves for the first time ever… Before 2008, it was not legal for them to do this. This is how they make the interest rates go up now. So if they increase the federal fund rate by a further 75 basis points in November, then they’ll start paying something like 3.8% on bank reserves and so on and so forth.

So suddenly, the whole dynamic has changed. Before, until very recently when the federal fund rate was very close to zero, the Fed didn’t have to pay any interest on bank reserves or on the money that it created, and so all of its interest income was pure profit. But now it still has the same amount of interest income, but the problem is it’s now paying a lot of interest on bank reserves. And so paying 3% interest on all of these bank reserves suddenly means that the Fed has a very high level of interest expense. And apparently, as you mentioned in September, if their net profit turned negative in September, it is because their interest expense, 3% on bank reserves, is greater than their interest income on all of the bonds that they own. And so it’s possible now that it seems likely that for this full year they’ll probably still have a profit, but for next year they will probably make a loss.

But of course, you’ve got to keep in mind that the Fed doesn’t have a lot of capital, and it doesn’t have a lot of capital because it gives all of its profits to the government every year. As I think I mentioned earlier, since the Fed was created, it has given the government $1.8 trillion. And just since 2008, most of that has come since 2008 when they started quantitative easing. The Fed has given the government $1 trillion since 2008. If it were a normal bank, all of that would have been in their capital account. But now they don’t have very much capital because they have to give all their profits to the government. So they’re going to make a loss. If they have a loss, they’ll have negative capital. But I don’t think that’s a particularly pertinent issue.

Trey Lockerbie (00:36:53):
It’s not, because I guess my question around that, to your point, was who is the lender to the Fed, right? As far as they run a deficit now, how are they covering that deficit?

Richard Duncan (00:37:05):
So the Fed, of course, can create as much money as it needs, and in the future it will revert to a position where it once again has more interest income than interest expense, assuming that one day interest rates go back down. I think for much of the money the Fed has extended through its quantitative easing programs is guaranteed by the government. So the government debt, instead of being lowered by government profits as it has been practically every year since 1913, the government debt going forward for the next couple of years will probably be higher as a result of the Fed’s losses.

Trey Lockerbie (00:37:45):
Is IOER, the interest on excess reserves, basically the technical term for what you were describing there?

Richard Duncan (00:37:52):
So things become even more complicated because, yes, it is, but in addition to bank reserves, bank reserves are on the Fed’s… They’re liabilities. But suddenly there’s a new big item on the Fed’s liability side that didn’t exist very long ago, and that is reverse repurchase agreements. And rather than that, so banks have bank accounts at the Fed, and that’s where they keep their bank reserves. Suddenly, over the last couple of decades, money market mutual funds have become a big new thing, relatively speaking, over the last couple of decades. And these money market mutual funds also need some place to make a profit. They’ve got, I think, last I looked, nearly $5 trillion of assets. And so this forced the Fed to allow them essentially to all have bank accounts at the Fed also in the form of reverse repurchase agreements. It’s essentially the same thing as bank reserves, except reverse repurchase agreements are where the money market mutual funds can park their money, and they will also be paid 3% interest right now since that’s where the federal funds rate is. And that will prevent them from lending to anyone at less than 3%.

So the Fed now has to pay interest on not only bank reserves but on what are effectively the reserves of the money market mutual funds. It has to pay interest on both of these. Bank reserves are around $3 trillion, and money market mutual funds have about $2.2 trillion at the Fed. So, that’s something like $5.2 trillion that the Fed is now paying interest on, and that is why their interest expenses shot up, and that’s why their profits have dropped from over 100 billion last year to probably a negative number next year. Now, this is a real issue that I think there is a solution to. There is no reason for the Fed to be paying interest on bank reserves because the banks didn’t do anything to earn those reserves. They didn’t make loans, they didn’t speculate in pork bellies, they didn’t nothing whatsoever to earn those reserves.

The Fed’s action created those reserves by creating money and depositing that money into the bank’s reserve accounts. That money is a pure function of the Fed policy, nothing whatsoever to do with what the banks have done. And so all of the profits the banks are earning on this 3% interest payment from the Fed, it’s pure windfall profits which they do not deserve. And therefore, there’s a way to resolve this, right? Over time, I mentioned in the 19th century, the legal required reserve ratio was 20% at some points in some banks, in some cities. But over time in the US, the Fed continued to reduce the required reserve ratio year after year after year after year. And the more it reduced the required reserve ratio that made the money multiplier expand. This may be a bit technical, but through the process of fractional reserve banking, the money multiplier is one divided by the required reserve ratio. And what that means is if the required reserve ratio is 10%, one divided by 10% is 10 times, and that’s the money multiplier.

What that means is for every new deposit that enters the banking system, they can effectively create 10 times that much money through lending and relending and relending that deposit. But over time, the Fed reduced the required reserve ratio again and again and again until it was really in the low single digits. And then in 2020, they reduced it to zero. So there’s no longer any required reserve ratio whatsoever for the United States, meaning that the money multiplier is infinity. The only constraint on how much the banks can create now in money is their reality that if they lend too much, the people they lend to won’t be able to afford to pay the interest on the money that they’ve borrowed.

So the solution to this problem of the Fed having to pay such high interest rates is the Fed should just simply reimpose a required reserve ratio on the banks that is high enough to absorb all of their reserves until there are no more excess reserves left. So right now, the required reserves are calculated by the amount of reserves the banks have as a percentage of the banks’ deposits. The required reserve ratio is how much reserves the banks have as a percent of their bank deposits. In the past, they were required to keep a reserve against their deposits. Right now, their amount of reserves relative to their amount of deposits is about 16%. Right now, the required reserve ratio is 0%, and the Fed is having to pay 3% interest on all of these reserves.

So what the government should do is increase the required reserve ratio from 0% to 16%, absorbing all of these excess reserves so that we would once again be back in the situation where we were before 2008, where reserves were scarce and the Fed was able to control the federal fund rate by making relatively small changes in its bond purchases and bond sales, so we could revert to the old system of having a required reserve ratio. Then, since the banks would be required to keep 16% of all of their deposits as reserves, then it wouldn’t be necessary for the Fed to pay interest on the reserves anymore because the banks would be required to keep these reserves. There would be no need to pay them for them. And in that case, the Fed would become immensely profitable again.

So this is what the government should do is reimpose very significantly higher required reserve ratio to absorb all of these excess reserves. That would immediately restore the Fed’s profitability, and it would ensure that all of the Fed’s profits go to the government, which is, in other words, go to the US taxpayers rather than ending up as windfall profits to the banks who’ve done nothing whatsoever to earn them.

Trey Lockerbie (00:43:46):
If you had to speculate, why do you think that’s not happening?

Richard Duncan (00:43:50):
Well, first of all, just a general lack of understanding. This is not without precedence. In 1936 and 1937, the Fed doubled its required reserve ratio from, I believe, 10 to 20% over a two year period. So there is precedence for this happening. But how many of our policy makers, especially in Congress, in the Senate, are aware of that or are aware of any of what I’ve just explained about? So generally, I think why this isn’t happening is because Congress is unaware that this is a possibility. But if they read my book, The Money Revolution, I spell it out there, and it is a possibility. And as the Fed’s losses begin to mount, I think they’ll become made aware of this and hopefully they will enact this legislation.

Trey Lockerbie (00:44:39):
Wow, makes sense to me. That’s pretty remarkable. You mentioned the $8 trillion that the Fed has created since 2008. The MOVE Index, the MOVE Index, which is effectively the volatility index for the bond market, is now back up to its COVID high. The last time it reached these levels, the Fed injected one trillion every day to unlock the bond market and launched 120 billion in quantitative easing. So let’s say something does break, what would you expect the response from the Fed to look like, given the excess that we seem to be experiencing?

Richard Duncan (00:45:19):
I think the response would be similar to what we’re seeing from the Bank of England. When this dynamic took hold in the UK with the pension funds being forced to sell their government bonds to cover their hedge positions, their derivatives exposure, then that set off a dynamic that pushed the bond yields in the UK even higher and caused the pension funds to sell even more bonds. It was creating an out of control vicious spiral that was driving up the government bond yields in the UK and endangering the pension system in the UK so that the Bank of England…

Central banks are created to be the lender of last resort to prevent banking panics when they occur. That’s their main purpose from the beginning of time. And so what the Bank of England did is exactly that. They became the lender of last resort. They announced that over the next, I believe, is a two week period that they would be willing to buy up to £65 billion of UK government bonds, essentially in order to prevent bond yields from moving any higher and stopping the panic in the bond market. But in fact, they haven’t had to buy £65 billion worth of bonds. I don’t have the precise figure, but I think it’s more like-

Trey Lockerbie (00:46:35):
It’s five.

Richard Duncan (00:46:35):
… they actually only had to spend five.

Trey Lockerbie (00:46:37):

Richard Duncan (00:46:37):
Yeah. And so by just creating £5 billion and buying £5 billion worth of bonds, they showed everybody in the market that they were there and that they would buy as many bonds as necessary to stop the interest rates from going any higher. Well, they were supposed to end this on Friday, and maybe they will, maybe they won’t. If the bond yields start moving higher again, they’ll have to spend some more. And that’s the way the Bank of Japan controls the Japanese government bond. They’ve been doing quantitative easing in Japan even longer than we have.

But what they discovered is just by the Bank of Japan announcing that, “We will buy as many Japanese government bonds as necessary to peg the yield on the 10 year Japanese bond at 25 basis points,” they discovered they didn’t really have to buy that many bonds. They ended up buying far fewer bonds than they had been earlier on when they had set a fixed amount for buying every month. So the amount of bond buying that they’ve had to do is much lower than when they were saying they would buy X amount of Japanese government bonds every month.

So it doesn’t take that much government intervention. It only takes the announcement that, “We are determined to get this situation under control, and we have limitless amounts of resources to do this.” When they say that they’re going to control the bond yield at a certain level, if the markets believe them, they don’t really have to spend that much money to do it. And if the markets don’t believe them and test them out, the central bank creates a little bit more money and burns everybody who tested them out.

So, that’s probably what we would see if we have some sort of financial crisis emerge in the US, that the Fed would make an announcement similar to the Bank of England that they’re prepared to buy 100 billion new dollars worth of US government bonds or whatever is required to support that particular crisis to stop that particular run, whether it’s in the government bond market or the corporate bond market. And by making that announcement, they would calm the markets again. And so in that sort of crisis, that’s what we would most probably see.

Trey Lockerbie (00:48:42):
Switching over a little bit to Russia, they’ve been stockpiling gold since 2008. Their reserves have increased by about 360% over the last decade. There’s some speculation around Russia backing their ruble by their gold in an effort to attract investment and move away from the dollar hedge money. We’ve discussed how hard money is a thing of the past in prior episodes and how it’d be impossible to go back to, or at least without imploding the markets, because trade would have to balance. And right now if the US has 500 billion worth of gold or so, it’ll only cover maybe six months of trade deficits. So as regarding Russia, do you see this as a fool’s errand if they were to pursue this or an actual viable option?

Richard Duncan (00:49:28):
Well, you can see why Russia would like to accumulate more gold since it was preparing to invade his neighbor and try to conquer and eliminate the Ukrainian nation in advance rather than having a lot of dollars, because the US is able to impose sanctions that prevent them from using a lot of those dollars. But it’s not going to do any good for… I mean, first of all, Russia’s economy is going to be in dire straits for decades to come now. Now, they’re very dependent on energy exports to start with. They’re kind of suffering from the oil producer curse. If you have a lot of money from being a big oil producer, the rest of your economy tends to be lazy and not very effective. And we’re looking at a future where 20 years from now, there’s not going to be any need for oil. We’re going to have renewable energies, and you won’t be able to give oil away. Remember when oil prices turned negative in 2020?

So Russia’s future is bleak. They can peg their ruble to the gold if they want to, but nobody’s going to invest there anyway. And if they try to sell their oil in gold, then that’s not going to work because no one has enough gold to buy their oil. And so they won’t be able to sell anymore oil because other countries don’t have enough gold to buy it. So it’s like, the United States has a $1 billion a day trade deficit with China. If China tried to make the United States pay for that with gold, the US would run out of gold in a few months and it wouldn’t be able to buy one more pair of tennis shoes from China, and China’s economy would collapse. So we’re not going back to a gold standard ever, unless there’s some sort of Mad Max disaster scenario where the world collapses and reverts to barter, in which case the warlords would accumulate all the gold. So, that’s not going to happen.

Trey Lockerbie (00:51:14):
You have China’s interest in Taiwan. I’m sure a lot of it has to do with the semiconductor businesses that are coming out of there, a number of the historical references as well. But there was this $280 billion CHIPS and Science Act signed into law recently, which, I got to say, really echoes the book you wrote, right, and almost the strategy, if you will, around trying to stay competitive with China, trying to invest in the technologies of the future and keeping us competitive. So what were your thoughts when you saw this act be signed into law?

Richard Duncan (00:51:51):
I was really thrilled. I mean, this was such a great, positive development for the United States and for our future, because I certainly don’t have any issues with Chinese people. But the fact is, China is on the verge of overtaking the United States technologically, economically, and militarily. In the year 2000, the United States invested eight times more in research and development than China did. Last year, China invested more than the United States did in R&D. And if current growth rates continue in both countries, by the end of this decade, in 2030, China will invest 40% more in research and development than the United States. And if the United States allows that to happen, China is going to develop artificial intelligence before the United States does, in terms of artificial general intelligence, where computers can do anything humans can do. And then immediately after that, the computers are going to become exponentially smarter very, very fast. So whichever country gets to that point first will have the rest of the world at its mercy, and that’s going to be China if we don’t radically accelerate our investment in new industries and new technologies starting immediately.

In my book, The Money Revolution: How to Finance the Next American Century, that’s what the book is all about, and what it calls for is for a multi-trillion dollar investment program to be financed by the US government and carried out by joint venture companies between the US government and the private sector with scientists and entrepreneurs running the company and the government funding these joint venture companies and keeping a 60% equity stake for the government and a 40% equity stake for the entrepreneurs and scientists managing the companies across industries like artificial intelligence, quantum computing, genetic engineering, biotech, nanotech, robotics, neurosciences and green energy, et cetera.

So the passage of this $280 billion act, the CHIPS and Science Act, that allocates $52 billion of money for the development of semiconductor manufacturing facilities in the United States, which America desperately needs because most of them now are located in Taiwan. And Taiwan could be under attack any day, any year, too soon for comfort. And we can’t allow that to happen. Who knows how many of our military parts and equipment would not work without sufficient supply of semiconductors? But in addition to that 52 billion, the rest of the 280 billion in the CHIPS and Science Act is going to be invested in new industries and new technologies, just like I called for in the book. So this was fantastic news. I’ve been calling for this sort of investment for a very long time now, at least 10 years. And people, I mean, they would say, “This is an interesting idea, but you can’t believe the government would ever do anything like that.” Well, now they’ve started to do it.

The only thing is it’s 280 billion. Okay, that’s a big number, and that will probably buy us an extra two years ahead of China. That will keep us ahead of China for two years. That’s not enough. That only takes us to 2032. This has got to be the first installment. We need now to be making plans for the next installment, which should be even bigger than 280 billion. And then we need to turn this into a multi-trillion dollar investment program over the decade. Now, multi-trillion sounds like a very big number, but the US government increased its debt by $2.8 trillion in the second quarter of 2020 alone. So, that’s a multi-trillion dollar increase in government debt in three months. That’s not what I’m calling for. That probably overdid it and contributed to the inflation we’re now experiencing. But what I’m calling for is a multi-trillion dollar program over 10 years. That would not be inflationary in the same way that we’re experiencing now, by any means. And even if it were, that kind of inflation is a price we would have to be willing to pay to ensure that we’re not conquered by China.

Trey Lockerbie (00:55:48):
Well, we’re definitely trending towards a populous world where globalization has been minimized. And I’m kind of curious about how that plays into the headwinds to this strategy you’re laying out there because if a lot of these countries who are net exporters don’t have surpluses, they’re not going to have the money to buy treasuries. And we have to fund our continued deficits and things like this. We’ll just exacerbate that. Does it just run the risk of more monetary debasement in the long run? Or what are some of the risks of doing this, maybe macro and here domestically?

Richard Duncan (00:56:22):
So globalization is really essential to my plan for this government investment in new industries and technologies. It would make things so much easier that way. We didn’t have that in World War II, and the government had to invest on an extraordinary scale to win the war, and that led to high rates of inflation and price controls for a few years. And then when the war ended, all that government investment ended up producing a surge in new industries and technologies that resulted in the United States being the undisputed global leader and a huge surge in economic growth during the 1950s and ’60s and into the ’70s.Now, is globalization going to end? I don’t think so. Now, it’s certainly suffered a setback and a partial reversal because of COVID and supply chain bottlenecks and this war in Russia, but even if our tensions with China become worse, China’s not going to send all the American companies home because they desperately need the money. There’s a lot of manufacturing going on in China and they need that money. So they’re not going to deny the United States the possibility of buying those cheap goods. And meanwhile, more and more manufacturing is going to shift out of China and into places like Vietnam, Bangladesh, India, Mexico, and other places. In India, 1.4 billion people, I would say hundreds of millions of them would work for less than $15 a day. So we’re by no means tapped out in terms of the potential for globalization to bring in very low cost products into the United States.

So my base case scenario is that eventually, within the next few years, we’re going to return to a pre-COVID status quo, more or less, where globalization is quite dominant, once again exerting strong downward pressure on US prices, bringing the inflation rate back down. Particularly since we’re likely to have quite a serious recession over the next year or two which will reduce demand and also bring the inflation rate down, it wouldn’t be at all surprising to see US inflation turn negative again within the next three years. And then we’d be more or less back where we were pre-COVID and everything would be back on track, allowing us to invest on a multi-trillion dollar scale in new industries and technologies and a program that would turbocharge US economic growth, radically enhance US productivity and create a technological revolution and radically improve everyone’s health and life expectancy and create all kinds of new technological miracles and marvels.

Trey Lockerbie (00:58:52):
So that recession you just mentioned there, that’s how we kicked off this whole conversation, and the reason this keeps coming up is because there seems to be some disconnect here. For example, a record number of people were employed in August, which seems to suggest that we’re a long way from the Fed having higher unemployment as an excuse to ease. So are the markets just way ahead of the real economy in this case? Or what do you think is driving this disconnect between the real economy and the markets today?

Richard Duncan (00:59:20):
So as I said at the beginning, I believe that credit growth drives economic growth, but liquidity determines which way the asset prices move. Basically, when the Fed is creating a lot of money and injecting it into the financial markets, then asset prices tend to go up. And when the Fed starts destroying money, as it’s doing now, it takes money out of the financial markets and asset prices tend to go down. And also, interest rates are zero. That makes it very easy for people to borrow and speculate, which pushes up asset prices. But when interest rates start moving up to 3%, as they are now, heading toward 5% as they may well be in a couple of quarters, and suddenly it becomes a whole lot more expensive for people to borrow and speculate and asset prices fall.

So generally, the time to buy is during QE, and the time to sell is during quantitative tightening, which is where we are now. Quantitative tightening at the rate of $95 billion a month is going to destroy $1.1 trillion over the next 12 months if it actually is not stopped before then. And that represents about 13% of all the dollars. So, that’s extreme monetary tightening. And that’s what has frightened the markets, to answer your question. Markets realize that liquidity drives asset prices, and right now the liquidity is drying up and we’re experiencing very aggressive monetary policy tightening. Now, the economy hasn’t quite caught up to the markets. The markets are supposed to discount things in advance. The three rounds of stimulus packages during the pandemic, starting in March 2020 and then December 2020, again in March 2021, that stimulus in total was about $5 trillion. $1.8 trillion of that went directly to households in terms of stimulus checks, and 1.7 trillion of that went to businesses, to paycheck protection programs and such so they wouldn’t fire their workers.

And that money allowed the Americans to keep paying their mortgages and their consumer credit card bills, and so they didn’t default. Had they defaulted, then the US economy would have spiraled into depression and all the banks would have failed. So, that didn’t happen. But as it turned out, all of that stimulus, with that much new money going in, being directly deposited into the consumer’s household’s bank accounts and the corporations bank accounts, this led to a big buildup in deposits, a big buildup in savings. If you look at the M2 money supply growth, it was 27% year on year at the peak, M2, which includes demand deposits. In 2008, the M2 only grew by 10%. So 27% was too much and contributed to full employment and employment rates at a 50 year low.

So the way to think of this, I think, in terms of the monetary policy is we can think about monetary policy like driving a car. If you drive it too fast, you may have a mishap in terms of higher inflation. And if you drive it too fast in hazardous conditions, like global supply chain bottlenecks and the war in Russia which disrupt global supply chains, that increases your chances of having a mishap such as higher inflation. But the lesson to take away from that is not to stop driving the car and go back to riding in horses and buggies. The lesson is just drive more slowly or at least drive more slowly when you’re experiencing hazardous conditions. So we ended up driving monetary policy too quickly in hazardous conditions, and that’s contributed to the inflation we’re experiencing now. That’s given everybody more savings than they had. So the unemployment rate is very low.

Now, the Fed can’t increase demand. I mean it cannot increase supply. It has to bring supply and demand back into balance to bring inflation down. It can’t create more supply. It can’t drill more oil wells or plant more wheat. So it has to destroy demand. And to destroy demand, it has to throw people out of work. And so far, that’s not working. Job numbers are still rising. They increased by more than 200,000 last month. So the Fed is going to have to keep hiking until a few million Americans lose their jobs. The other way they can destroy demand is making the stock market fall and asset prices fall. That creates a negative wealth effect.

So, that’s what we’re experiencing now. Until we get inflation at a much lower level, the Fed’s going to have to keep tightening monetary policy until millions of Americans lose their jobs and until asset prices fall further, and that will bring supply and demand back into balance. This may take a year or two more, it could suddenly happen with some sort of big shock and financial crisis that accelerates everything, or it may take a while. It will work its way out of the system. And a few years from now, we will be back in some sort of equilibrium position again. This is not going to be the end of the world.

Trey Lockerbie (01:04:05):
I’m with you there. I have a feeling that it’s going to take a little longer than people expect. I think people are under-appreciating some of the creative ways that the government has been keeping businesses afloat. Everyone was kind of familiar with the PPP loans around the COVID era. There is now the Employee Retention Credit, which I guess was also originated around COVID, but you couldn’t get both originally. You couldn’t get the PPP and the Employee Retention Credit. And when Biden came into office, he’s now authorized that even if you got a PPP loan, you can get employee retention credit. And that’s about 26 grand per employee that you kept employed.

So if you’ve got 30 something employees, that’s a million dollars, and it’s just free money. That goes a long way for some businesses to keep them afloat and keeping people employed. So I’m with you. It might take a little bit longer than people expect. You threw out the 5% Fed funds rate expectation that we’re creeping up to. Is that the terminal rate in your mind? I mean, if you had to guess or bet, do you think we’ll even get that high, or do you think we’re going higher than that?

Richard Duncan (01:05:02):
Well, so if we have 75 basis point rate hike in November, 50 basis points in December, that takes us to 4.3. There are four meetings in the first half of next year, FOMC meetings. If they hike 25 basis points every time, that takes us to 5.3. That would probably do it. And then the economy would be in recession, and they could start cutting interest rates in the second half of the year. That could potentially bring them back down to 4.6%, which is what they forecast in their dot plot. They said the federal funds rate was likely to be 4.4% at the end of this year and 4.6% at the end of next year. They didn’t say it wouldn’t be higher in the middle of next year. They said at the end of next year, 4.6. So, that may be the way they get to 4.6% at the end of next year.

Trey Lockerbie (01:05:50):
How would you score Jay Powell’s performance through all of this? I’m just generally curious about your assessment of the strategies the Fed have been putting into place so far.

Richard Duncan (01:06:01):
So everyone, so many people on the internet, love to criticize the Fed and the government and the whole American system now. I think this is probably very well-funded by our enemies, Russia and China, through Facebook and all the other social media outlets. But that is a very debilitating attitude for the Americans to have, and it’s not right. Now, these people in the Fed are trying to do the best they can possibly do with the situation they inherited. And the situation that Jay Powell inherited was a world in which the Fed had been unable to make the inflation rate move up to its 2% inflation target. From the year 2000 to 2019, the average inflation rate on the CPI was 1.7% a year for 20 years.

So the situation he inherited was globalization was extremely deflationary. It was putting downward pressure on prices, and it was hard to make the inflation grow by 2% a year. Suddenly, out of the blue, he gets hit by COVID. The US economy entirely recovered from the 2008 response to that crisis. During that crisis, the Fed had three rounds of quantitative easing, increased its total assets by five times, and that didn’t cause any inflation. The highest rate of inflation then was 3.9% in 2011. And by early 2015, we had deflation again. So, that had all passed through the system by then. We were back in a disinflationary, low inflation environment. Then suddenly COVID happens. And with COVID, everyone’s required to stay home. No money to pay their rent or their mortgages or anything else. And so the government decides to give them three big rounds of stimulus packages. And that required the government to borrow. Well, the stimulus programs, they say in total $5 trillion it cost to get through COVID.

The Fed had a choice. If the government had to borrow $5 trillion in the free market, borrowing $5 trillion would have pushed up interest rates to a very high level. And instead of helping the economy, very high interest rates would have crushed the economy. So the Fed really could have decided, “Okay, you’re on your own, government,” but that’s not how it works. The Fed and the government work hand in hand. And the Fed stepped up and agreed to finance essentially 70% of all of that borrowing. The Fed created $5 trillion. So it was the Treasury Department that was the dog just wagging the tail. Fed was responding to the government policy. And like me, they thought globalization, since they’d been able to create so much money after 2008 and get away with it with no inflation, they thought they could probably do it again. But it turned out that there were big supply chain bottlenecks.

And also, with everyone staying home and ordering computers across Amazon, the demand for manufactured goods became very high and overwhelmed the supply of such manufactured goods. So semiconductor prices shot up and shipping rates shot up. And this was a perfect storm for the Fed. And then just when there was hope that it was going to go away, Russia invades Ukraine. You can’t expect Jay Powell to anticipate that Russia’s going to invade Ukraine. That was beyond his control. So overall, with hindsight, it’s easy to say they should have done things differently. But if you were in the driver’s seat at a point where the United States could easily collapse into a new Great Depression if you didn’t provide enough stimulus… And it’s better to provide too much stimulus and live with elevated rates of inflation for a while, rather than having a 1930s style depression with 25% unemployment and deep deflation leading to global economic calamity, leading to third world war potentially as the Great Depression led to World War II.

So overall, I think people need to give them a break and realize that these are good people trying to do the best they possibly can with the very difficult cards they’ve been dealt. And generally, look, the US economy came through this crisis. We got through the other side. In the early months of 2020, it wasn’t sure what the US economy would look like in late 2022. It could have collapsed by now, but it didn’t. The GDP is larger now than it was, and the unemployment rate is at a 50 year low. That’s a big accomplishment.

And, okay, the price we paid for that, increase in government debt, which in my opinion is not that big of a deal, and inflation peaking at 9%, which is painful, but that’s not going to last, and particularly since so many Americans received such a large amount of stimulus that probably covered some of their losses that have resulted from higher inflation. So overall, I think the policy response was very successful. The downside was higher rates of inflation and forcing the Fed into… And of course, we had a huge surge in asset prices, which created a lot of wealth, especially for the wealthiest people. I think in a two year period after, starting in March 2020, US wealth increased by $35 trillion over two years. It was just a mind-boggling increase in US wealth. So overall, the policy worked because our economy didn’t collapse.

Trey Lockerbie (01:11:09):
Richard, I always enjoy your insights and our conversations and feel like we could talk forever. Before I let you go, I want to give you an opportunity to hand off to our audience where they can learn more about you and your videos and newsletters and any other resources you want to share.

Richard Duncan (01:11:26):
Thank you, Trey. It’s really great talking with you. You always ask such good questions and leave plenty of time for your guests to reply to them. So thank you for that. And first, I hope your listeners will buy my new book. It’s called The Money Revolution: How to Finance the Next American Century. And then if they’d like to follow my work more closely, I produce a video newsletter called Macro Watch. Every couple of weeks I upload a new video, a PowerPoint presentation of me discussing what’s happening in the global economy and how that’s going to impact asset prices. They can find that on my website at richardduncaneconomics.com. That’s richardduncaneconomics.com. So I hope they’ll go there and check that out.

Trey Lockerbie (01:12:08):
Richard, it’s always a pleasure and an honor to having on the show. I really enjoy it. So thank you again for coming on, and I look forward to our next conversation.

Richard Duncan (01:12:15):
I hope next time that things have improved radically relative to now.

Trey Lockerbie (01:12:19):
Amen to that.

Richard Duncan (01:12:20):
Thank you, Trey.

Trey Lockerbie (01:12:21):
Cheers. All right, everybody, that’s all we had for you this week. If you’re loving the show, don’t forget to follow us on your favorite podcast app. And if you’d be so kind, please leave us a review. It really helps the show. If you want to reach out directly, you can find me on Twitter @TreyLockerbie. And don’t forget to check out all of the amazing resources we’ve built for you at theinvestorspodcast.com. You can also simply Google TIP Finance, and it should pop right up. And with that, we’ll see you again next time.

Outro (01:12:45):
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.


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