“Creditism” and the Death of Capitalism, Part I

“I don’t think the outlook is encouraging at all.”

We recently had the opportunity to interview the thought-provoking economist and author Richard Duncan.

Richard captains the highly influential economics blog Macro Watch. He’s also written best-selling books like The Dollar Crisis, The Corruption of Capitalism and The New Depression. Richard keeps his being in Thailand these days.

When we asked Richard for his take on the global economy, he gave the cheery answer that opened today’s reckoning. Below, you’ll see why.

You’ll also see why Richard thinks laissez-faire capitalismis long dead — and why there’s no going back. He argues it’s been replaced by what he calls “creditism,” which he says is the only economic system that can lift the world out of depression. His explanation might raise your eyebrows.

Gold is not the answer to our economic woes, in Richard’s view. Far from it. Want to slash government spending? Then prepare for an economic collapse that will dwarf the Great Depression. Here’s a brief sketch:

When the world stopped backing money with gold in the late 1960s, our economic system changed in a fundamental way. In this new age of fiat money, credit growth drives economic growth, liquidity determines the direction of asset prices and the government controls both through aggressive policy intervention to ensure the economy does not collapse.

You may not agree with Richard’s arguments. But you cannot afford to ignore them. Read on for the first part of our discussion…

Brian Maher: Good morning, Richard. Good evening actually, since you’re in Thailand, which is 10 hours or so ahead of us here in Baltimore. And welcome back to The Daily Reckoning.

We read your blog, Macro Watch, all the time. It’s fascinating.

Richard Duncan: My pleasure. Thank you for having me on, and it’s nice to speak with you from the other side of the world.

Brian Maher: Richard, you argue that capitalism as it was historically known, is now dead. In its place stands something you call “creditism.” Can you explain briefly what creditism is and how it came to replace capitalism?

Richard Duncan: Yes, and this is very important. Capitalism was driven by investment, savings, capital accumulation, reinvestment, and capital accumulation. Hence the term, capitalism. Economic progress was more gradual, but the economic system in all likelihood would have been much more stable had traditional capitalism remained in place.

But history got in the way. We no longer have capitalism.

I really trace the breakdown of the capitalist system to World War I, when the European countries went to war with each other. They didn’t have enough gold to fight the war, so they went off the gold standard and printed money to finance government debt used to buy war materials.

The Allies won the war. But all the government money that was created at that time, all the government debt, set off a worldwide credit bubble called the roaring ‘20’s. Then in 1930, the mountain of credit collapsed since it couldn’t be repaid. The international banking system collapsed. International trade collapsed. The Great Depression started. That went on for 10 years.

There was no end in sight until World War II started, largely as a result of the depression. At that point, what was the U.S. going to do, let Germany and Japan take over the world? The Germans were already taking over all of Europe and Japan was expanding throughout the Pacific.

U.S. government spending increased 900% in 1940 to prepare for the war. Then the U.S. was attacked by Japan in late 1941. The government then took over complete control of the economy to run the war effort. Manufacturing, production, distribution, pricing, labor, everything.

And it’s important to realize that we never really went back to a capitalist system once the war ended. The government was so terrified that reducing spending would lead us back into the Great Depression, which it probably would have, that they maintained high levels of spending. The economy has remained heavily government-directed ever since. So if you really want to know when creditism began in earnest, it was 1940.

Were there alternatives? I’m not really so certain that there were. You have to keep in mind that first of all, during the Depression, fascism and communism swept across Europe and Asia. And when World War II ended, the Soviet Union was in control of half of Europe.

A few years later, the communists took over China. Communism was spreading everywhere. Did U.S. policy makers really want to return to a laissez-faire type economy and risk having the U.S. fall back into depression? And potentially go communist? Most people today don’t realize the dilemma policy makers faced in those days.

It seemed too big a risk at the time. They didn’t take it. So they kept spending and spending.

Later on, this came down to a showdown with the Soviet Union. President Reagan dramatically ramped up government spending and government borrowing by cutting taxes to go along with the increased military spending.

It’s really from that point in the 1980’s that the level of debt-to-GDP started moving up very sharply. Where it had been 150% of GDP for decades, it very rapidly started accelerating. Eventually by 2007, it appreciated to 370% of GDP. That credit growth became the lead driver of global economic growth.

We won World War II and defeated the Soviet Union on the back of this new economic system, which I call creditism. Again, it’s not capitalism in the traditional sense. We haven’t had real capitalism in many decades. And we probably won’t again, at least not anytime soon.Our system is now almost completely driven by credit creation and consumption.

Brian Maher: But doesn’t the type of system you describe, creditism, lead to a series of artificial booms and busts? It seems highly unstable compared to traditional capitalism and an international trading regime backed by a gold standard.

Richard Duncan: I really do think that the Austrian school of economics had it right, that credit creates an artificial boom. Things would’ve been certainly more stable if we remained on the gold standard throughout. I don’t disagree with that. But World War I didn’t permit that. World War II didn’t allow it. We were overtaken by events. It’s hard to see how we could’ve played it any other way.

Brian Maher: We went off Bretton Woods in 1971, which severed the dollar’s tethering to gold. Debts and deficits ballooned afterwards. Wasn’t that the final nail in capitalism?

Richard Duncan: I think that most people are very familiar with the Bretton Woods System breaking down in 1971. That was certainly the final end of the gold standard, or the gold-backed monetary system. Actually, an even more important date in my opinion is 1968, when President Johnson asked Congress to pass a law that the Fed would no longer have to maintain any gold backing for the dollar. Up until then at that stage, the Fed had to maintain 25% gold backing for every dollar that it issued. Congress did change the law. Afterwards, the Fed was free to print as many dollars as it wanted without any gold backing whatsoever.

But yes, once they stopped backing dollars with gold, it removed one of the major constraints on how much credit could be created. Afterwards, credit absolutely exploded.

Brian Maher: Ever since the breakdown of Bretton Woods, the U.S. economy, and the world economy, have become so completely dependent on credit growth, which is really another term for debt, it needs to constantly expand to sustain economic growth, correct?

Richard Duncan: Yes. In fact, one of my major themes for a long time now has been that credit growth drives economic growth in the United States. That’s very important to understand. For decades, the U.S. drove global economic growth, fueled by very rapid credit expansion.

And this is also a very important point, one readers should chew on for a minute. Since around 1950, any time that U.S. credit growth, adjusted for inflation, grows by less than 2%, the U.S. has gone into recession. I refer to that 2% figure as the “recession threshold.”

Now, the credit’s no longer expanding. Since 2008, when the crisis started, most of the time credit has grown bless than 2%, or just barely 2%. Therefore, the U.S. economy’s very weak. It’s too weak to drive global economic growth and consequently, world trade is contracting sharply.

Keep in mind, this is adjusted for inflation. Last year, there was only 0.1% inflation. Still we barely got above the 2% credit growth level. And debt grew 3 times more than the economy.

So we’ve had very little real growth for the past six years or so, despite a 140% increase in government debt, $3.6 trillion of quantitative easing, and interest rates near zero.

Looking ahead, it’s hard to see how credit growth is going to pick up significantly in the U.S. Look at all sectors — the household sector, the government sector, the financial sector, and the corporate sector. Project them forward, it just doesn’t look like we’re going to have significant credit growth at all. And that means little economic growth. For example, the Atlanta Fed’s GDPNow forecast places first quarter GDP growth at just 0.3%

And based on my credit growth projections, I see little relief in sight.

Brian Maher: If you say the U.S. requires 2% credit growth just to avoid recession, that’s a lot of credit we’re talking about. You can grow credit 2% fairly easily when an economy’s starting from a low debt level, even though it might be artificial. But total levels of government, business and personal debt in this country today exceed $60 trillion. To keep generating 2% credit growth on a consistent basis with that amount of existing debt, the amount of new debt required to keep the ball rolling soon becomes astronomical.

Richard Duncan: That’s right. The total credit in the U.S. first went through $1 trillion in 1964. By 2007, it had expanded 50 times, to $50 trillion. In 2008, Americans had so much debt and their income had been stagnant for so long because of globalization, they just couldn’t repay it. They buckled under the debt and were cut off from additional credit. Credit started to contract. At that point, the government had to step in with extraordinarily aggressive fiscal and monetary policy.

Since that time, government debt has increased by $9 trillion. Almost all of the increase and debt on a net basis has been an increase in U.S. government debt. And total U.S. debt now is up to about $63 trillion.

And yes, that $63 trillion base is so enormous that it’s very hard to grow credit 2% a year, adjusted for inflation. And since credit needs to grow at least 2% to avoid recession, as has been the case since around 1950, I’m not optimistic at all.

Brian Maher: Would you then say, Richard, that what you call “creditism” has been a net positive for the U.S.? And the world?

Richard Duncan: At least for two generations, it created a very powerful global economic boom. It ushered in the age of globalization. It allowed countries like China to go from being very poor third world countries into where they are now. China’s now the second largest economy in the world. None of this would’ve been possible if we had even stayed on the Bretton Woods System or a gold-based international trading system. Under the Bretton Woods System, trade between countries had to balance, or one side faced severe consequences.

The whole purpose of the system was to insure that trade balanced, as it did under a gold standard. Under a gold standard, if one country had a very big trade deficit with another country, they had to pay for the deficit with their gold. If they had a deficit for long enough, they would run out gold. They would stop buying things from other countries. Trade would return back into balance again. The Bretton Woods System was designed to work the same way.

Once the Bretton Woods System broke down, the old rules went out the window. After it broke, the United States quickly discovered it could buy things from other countries without having to pay with gold anymore. That was the beginning of the dollar standard the world’s been on ever since. It ushered in globalization. It created a massive global boom.

The U.S. could pay for foreign goods with dollars and Treasury bonds denominated in dollars. There was no limit to how many of those it could issue. The U.S. started running large trade deficits with first, Japan in the 1980’s. Later, with almost everyone else, especially China.

Brian Maher: Richard, can you briefly explain how the new dollar standard created that massive global boom?

Richard Duncan: It prevented the automatic adjusted mechanism of the gold standard from working properly. Trade didn’t return to balance. The world sent America goods, but the world didn’t get American goods in return. It got paper dollars. Under the dollar standard, central banks accumulated hundreds of billions, ultimately trillions of U.S. dollars in this way.

Suddenly, it became possible for countries like Japan to manipulate their currency to keep it more depressed than it otherwise would be. They accumulated dollars in exchange reserves. That benefited them by allowing them to keep their currency undervalued so that they can continue to have a trade surplus with the U.S. The huge inflow of dollars also created investment booms in those countries. That seemed like a great deal for the trade surplus countries. Look at the boom in Japan in the mid-’80s and China until recently.

Brian Maher: The dollars flowing into nations like Japan and China led to massive booms in those countries. But they also led to a massive bust in Japan’s case. And now China could be unraveling in the same way.

Richard Duncan: That’s true. You could really call the dollar standard the great dollar boom and bust standard.

The abandonment of a gold-backed international trade regime fueled an explosion of credit creation that has ultimately destabilized the global economy. That credit creation, backed only by paper dollar reserves, led to a worldwide credit bubble, with economic overheating and severe asset price inflation. So the credit creation that the dollar standard made possible led to over-investment on a massive scale in almost every industry.

As countries like Japan and later China accumulated those dollars, they ended up having to reinvest them back into U.S. dollar assets like Treasury bonds, Fannie and Freddie bonds, or other corporate bonds. This pushed up the price of those bonds and drove down their yields. The U.S. economy became overheated and heavily indebted as a result. It also caused the Fed to lose control over U.S. interest rates. These depressed U.S. interest rates, fuelling the U.S. property bubble that popped in 2008.

This happened largely because the trade imbalances that came about from the automatic adjustment mechanisms inherent to a gold-based system broke down.

And for many of these countries, the rapid accumulation of dollar reserves proved to be a curse, rather than a blessing. That sharp growth in reserves created a domestic investment boom, accompanied by rampant asset price inflation that eventually ended in financial disaster. The bubble economy that developed in Japan during the ‘80s is a perfect illustration, as is the Asian Miracle bubble that followed in the ‘90s.

I wrote all about this in my 2005 book, The Dollar Crisis.

All these booms blew into bubbles, and ultimately all the bubbles popped. China has been an important driver of global economic growth for two decades. Now, China’s popping. The world has never seen an economic boom like the one that transformed China over the past 25 years, made possible by the dollar standard. Between 2011 and 2013, China produced more cement than the United States did during the entire 20th century, for example. But after the U.S. went into crisis in 2008, it became the driver of economic growth.

Now that the Chinese bubble is bursting, the global economy is very weak. Neither China nor the U.S. has the ability to drive global growth. Consequently, the global economy is in danger of falling back into severe crisis and political tensions are reaching the breaking point. So where is that growth going to come from?

The global economy certainly would have evolved very differently if Bretton Woods, or some other form of gold-based system, remained in place. We wouldn’t have these dramatic boom/bust cycles that we’ve had under the dollar standard. But we’re far beyond that point now.

Of course the dollar standard also had a number of other undesirable consequences. It caused the United States to de-industrialize, which has kept American wages stagnant. In the U.S. now, the 70’s, the middle class is losing ground. This arrangement was very good for corporate profitability because the corporations could move their factories to ultra low wage locations in China and other countries.

That caused the share of profits going into capital to become much larger than it traditionally had been. It squeezed the share of profits going to labor by holding down wage rates. That caused income inequality to become much worse than it had been since at least the 1920’s.

Now, we’re beginning to see the political price of all of this. There’s a huge backlash against this loss in the standard of living and the downward momentum of the middle classes. The Republican elite has just lost control of his party. His party has been conquered by Donald Trump.

Brian Maher: Thanks Richard. Tomorrow, we’ll return with part two of our conversation. We’ll pick up on that note… and talk some more about where we stand today.


Brian Maher
for The Daily Reckoning

P.S. Are the central banks out of ammunition? Why will America’s economic and political problems multiply if we don’t take the proper steps now? When will America’s day of reckoning arrive?

These are some of the questions Richard explores in his highly influential blog, Macro Watch. His blog is read by hedge fund managers, policymakers and other serious investors looking for an edge.

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