Gary Shilling: Dr. Doom's Forecasts

Dr. Marc Faber writes a letter to economist and deflationist Gary Shilling on a variety of topics, including deflation, the prospects for a war with Iran, a military conflict with China, and the industrial infrastructure needs of Asia.

Dear Reader,

In this episode of Whiskey and Gunpowder I reacquaint you with Dr. Marc Faber, or Dr. Doom as he is sometimes called on Wall Street. He’s a long-time contributor to Strategic Investment. And his thinking is strategic in every sense of the word.

I’ve excerpted an exchange of letters he had with the economist and deflationist Gary Shilling. In Dr. Faber’s reply he covers a lot of ground.

There is more, of course. But I draw your attention to the last point especially about Asia’s infrastructure needs. You’ll read more about it in the February issue of Strategic Investment. There’s a bullish case to be made for heavy industry despite-and even because of-geopolitical tensions. I’ll make the case in February.

For now, enjoy Dr. Faber.

P.S. Looking for something to do in late February? If so, I’ll be speaking at the Peak Profits Conference in Phoenix, Arizona. I’ll talk about ETF’s, global investment opportunities, and successful options trading in any market conditions. Why don’t you come join me for some mid-winter warmth?

Dear Gary,

Thank you very much for your detailed comments. Before responding to your questions, let me formulate some thoughts on your views. You note that inflation has always been a wartime phenomenon because in wars, heavy government spending creates demand that exceeds supply. Therefore, prices rise to ration scarce goods and services.

In peacetime, however, deflation reigns. In this respect I would like you to consider two points. Don’t you think that, along with the upturn in commodity prices, the war cycle has turned up over the last few years? Take oil, for instance.

I live in Asia and I can see how, over the last few years, traffic has risen very sharply in Chiangmai and Bangkok. The same is happening in China and elsewhere. All over Asia large shopping centers, which require a lot of electricity for cooling and lighting, are replacing mom and pop shops, which hardly required any energy.

Also, in Asia we have a rapid rise in the rate of urbanization, admittedly from a very low level. In China, urban population as a percentage of total population has risen from 29% in 1996 to 37% today, and currently approximately 20 million people are moving from the countryside to the cities every year. Incidentally, this is the largest Völkerwanderung in history. The same trends can be observed in all Asian countries, including India.

What this means is that Asian energy demand will soar and the demand for oil will double in the years to come from 20 million barrels daily to 40 million barrels. (Total world production is 80 million barrels.) Now, we may argue whether this doubling in oil demand will take six years or 15 years, but in my opinion it is inevitable given the rapid industrialization of Asia and the ongoing urbanization.

Urbanization stimulates energy consumption, as people in cities require transportation, air-conditioning, refrigeration, distribution of goods, heating, night entertainment, etc -factors that require far less energy in a rural and household economy. Yes, I am aware that substitution of oil and alternative sources will happen one day, but at what prices?

For now the Chinese government’s top priority is to secure reliable supplies of oil (and other resources) and here I see the potential for rising international tensions. The Chinese have acquired 12 oil concessions in Sudan and Chad, and also in Iran where they will finance the development of large new oilfields.

Gary Shilling: The China-US Collision Course

Now, if you look at a map of the Middle East , it is obvious that China’s move into the Middle East will put it on a geopolitical collision course with the US. China is also embarking on trade and political initiatives in Latin America (Venezuela) and Africa (Angola) in order to secure oil supplies and other resources, which won’t please the US.

I am certainly not predicting the immediate onset of a Third World War, but an arms build-up is inevitable, in my opinion, with rising tension to follow. Another point to consider is that, whereas inflation may largely be a wartime phenomenon, it is also true that numerous countries have suffered from very high inflation or hyperinflation in times of peace, due to expansionary monetary and fiscal policies.

An example would be the Latin American continent in the 1980s. I have to point out that, at that time in Latin America, deflation did indeed occur. But it didn’t come about through a decline in the domestic price level. In fact, domestic prices of stocks, real estate, and goods were all inflating or hyper inflating, but since the currency collapse exceeded the domestic price increases, in US dollar terms – then a strong currency – prices declined and enormous bargains became available at the end of the 1980s in the Latin American asset markets.

The same phenomenon had taken place during the Weimar hyperinflation period. Domestic prices were hyper inflating but collapsed in US dollars or in gold, as a result of a steep decline in the exchange rate of the German Mark. In the German Weimar hyperinflation period, an index of German share prices (1913=100) rose from 126 in January 1918 to 531,300,000 in September 1923, and 23,680,000 million in November1923 amidst extremely high volatility.

But in dollar terms, because of the currency depreciation, the same index (1913=100) fell from 101.55 in January 1918 to 2.72 in October 1922, before recovering to 39.36 in November 1923. So, if governments print too much money, and if credit expands dramatically, as has been the norm in the US in recent times, inflation is certainly also possible in peacetime. So, I am wondering whether you have ever considered that your US deflation scenario may play itself out not by the US price level declining in absolute terms, but by the dollar declining against a hard currency such as gold.

In this instance, US domestic prices would increase, but in strong currency terms (gold, the Swiss Franc, Asian currencies, possibly) the US price level would fall. I mention this because, today, I can buy most goods in the US with my Euros at a much lower level than two years ago. Even real estate would be cheaper in Euros than two years ago, while the S&P in Euros would hardly be dearer than when it was at its low point in October 2002. Similarly, whereas the Indian stock market is making new highs in Rupee terms, but in US dollars the market is still below its 1994 level, simply because until 2004 the Rupee was weak against the US dollar.

Gary Shilling: Increased Military Spending in the Long Term

This, incidentally, is despite the colossal economic improvements that have taken place in India over the period. Therefore, I consider currency issues to be a very important factor when making investment decisions. But now to your questions! You’re assuming that US military spending won’t increase to Cold War levels.

I agree with you, but while military spending is unlikely to increase much in the near term we may eventually get even higher military spending than during the Cold War in five to ten years’ time. Moreover, if we include the cost of homeland security I suppose that total military and security spending is already at a high level. Then, we have to consider the budget deficit as a percentage of GDP.

If this deficit isn’t offset by an increase in private sector savings, it is likely to be inflationary irrespective of whether the deficit arises due to military or other government expenditures. In terms of other big spending by governments other than the United States, I can envision rising military expenditures in Asia, including Japan, which must feel uncomfortable given the rise of China.

In fact, Japan is considering the development of its first longrange surface-to-surface missile, amid a growing concern about threats from neighboring North Korea and China. According to a report in the Japanese daily Yomiuri Shimbun, the Japanese Defense Agency plans to study the new missile “as a measure to counter a possible invasion on a remote island several hundred kilometers away from mainland Japan”.

According to the Yomiuri, the plan to build long-range surface-to-surface missiles would be included in a defense plan set to be approved by the cabinet in mid-December. At present, Japan’s current surface-based missiles are only capable of hitting air or sea borne targets, and not long-range targets. In turn, China will wish to bring its military on par with the US. In July, China launched its new Type 094-classballistic missile submarine. When fully operational in the next one or two years, it will be the first submarine to carry the underwater launched version of China’s new DF-31 missile.

China also recently launched a new attack submarine known as the Type 093, which will carry 16 JL-2 missiles whose range is estimated to be more than 12,000 kilometres, far enough to strike targets throughout the US! (The new submarine will be a major improvement on China’s current ballistic missile submarine, known as the Xia, which is only equipped with medium-range missiles and is very noisy and, therefore, unlikely to survive attack submarine strikes in ocean waters, as it can easily be detected by underwater detection gear.) It is also important to realize that maintaining an army of a million soldiers costs China a maximum of 10% of what it costs the US, since wages in China are so much lower.

Similarly, the production of military hardware, including submarines and ballistic weapons, is much cheaper in China than in the US. I mention this because, in an environment of rising international tensions, comparative cost advantages in warfare expenditures will become a factor to consider. I might add that if you have populations the size of China or India, the loss of a million people in combat is less costly than it would before the US or Europe, not to mention the differences in domestic political pressures arising from losses in combat.

A more belligerent, or at least more foreign policy active, China aside, we shouldn’t forget Russia and Mr. Putin whose friendship with the West has always been opportunistic and may already have come to an end over the controversy regarding the elections in Ukraine. Of more immediate concern is what is happening in Iraq, and especially in Iran.

Gary Shilling: A No-Win Situation

The Iraq occupation is a complete folly and, as I have always maintained, a no-win situation. The sooner it ends, the better. But what is happening in Iran is likely to lead either the Americans or the Israelis to launch air strikes at its nuclear facilities. Details are emerging about Tehran’s ballistic missiles, which are designed to carry nuclear weapons. The most likely delivery system, a liquid-fuelled medium-range ballistic missile (MRBM), referred to in the US as the Shahab 3A, has been flight-tested several times in the past few months, according to a Jane’s Intelligence and Insight report (

Its Washington bureau chief, Andrew Koch, quotes Uzi Rubin, former director of Israel’s Ballistic Missile Defence Organization, as stating: It appears that there are two competing teams in Iran working on its future medium-range ballistic missile. The version that was recently tested [in August] and presented in public already deserves the title Shahab 4, as it is completely different from the previous Shahab 3.

Everything but the propulsion system was changed, the range was increased, as well as the re-entry vehicle. According to the report, the missile has a modified nose section allowing it to hold a larger warhead and thus provides additional room for a nuclear device. Israeli officials have said the larger nose section is capable of separation and visually appears similar to that used on the Russian SS-9 intercontinental ballistic missile. “It is not a copy of a known missile but the new Shahab has a major-league design.

It’s clear that it is the work of seasoned missile engineers, probably Russian, rather than an experimental beginner’s version”, added Rubin. Such extra room is vital as Iranian nuclear engineers would face major technical challenges in making the country’s first nuclear weapon light enough and small enough to fit on its existing missiles, particularly without benefit of having conducted full-scale nuclear weapons tests.

The weapon is believed by US officials to be an indigenous design although knowledge gained from blueprints of a working, but too large nuclear weapon, provided by the Pakistani nuclear scientist AQ Khan would be helpful to the effort. If true, the efforts would signify that Iran is further advanced in its nuclear weapons program than previously known. The Washington Times of August 23 reported that a Chinese company recently supplied missile-related technology to Iran in violation of Beijing’s promises to curb arms-proliferation activities, according to US intelligence officials.

The Washington Times reports: the transfers took place within the past six months and represent a continuation of past Chinese covert arms transfers to countries such as Iran and Pakistan. No details of the missile technology or the companies involved were disclosed by the officials.

However, the activities we reconfirmed by U.S. intelligence agencies, said officials familiar with intelligence reports…. The missile-related transfers, which in the past have included materials used in making missile shells and missile-guidance systems, took place after China’s government issued a report in December pledging not to transfer weapons of mass destruction and missile delivery systems…. A report by the congressional U.S.-China Economic and Security Review Commission made public in June stated that continued Chinese missile and nuclear cooperation with Iran “is extremely troubling.” “Chinese entities continue to assist Iran with dual-use missile-related items, raw materials and chemical weapons-related production equipment and technology,” the report said, quoting a recent CIA report….Caroline Bartholomew, commission member, said that” despite claims that China is helping to halt the proliferation of weapons of mass destruction and related technology, numerous examples of such proliferation from China continue.”

The article further quotes Ms. Bartholomew as saying that there are reports that North Korea has used Chinese facilities for shipping weapons exports to third countries, and that China is also suspected of assisting Iran with the medium-range Shahab-3 missile recently tested by the Iranians. Furthermore, Chinese assistance to the Iranian missile programs has included support for indigenous Iranian missiles, propellant and chemicals used in making missile fuel, missile-guidance kits, gyroscopes, accelerometers, and test equipment.

According to Ms Bartholomew, numerous US sanctions imposed on China for its missile transfers have been ineffective, as the Chinese government makes agreements that it will halt the sales of weapons and missiles to rogue states, but then Beijing officials say that the proliferation is done at a local level and that they don’t have control over the companies involved in the missile-related sales, although it is clear that many of the companies are state-owned enterprises or formerly state-owned companies connected to the Chinese military.

Gary Shilling: Avoiding War

I am very sure that China has not only supplied nuclear technology to North Korea but is actually encouraging North Korea to pursue its nuclear weapons program. So, we are living in a world where the dangers of war are increasing. I suppose that, one day in the future, we in the West will wish we were still engaged in the Cold War, during which the three great powers (the West, the Soviet Union, and China) had divided up the world into their respective spheres of influence and were well aware of the catastrophic consequences of a war and, therefore, never went as far as to really trigger one.

But since we are in the midst of the festive season, let us be optimistic and assume that a major conflict can be avoided for another ten years or so. In this instance, I see pressure on the budgets of Western industrialized countries’ governments arising from health-care and pension benefit expenditures.

To what extent these expenditures will continue to rise at a rapid clip will depend very much on cost containment, which could be implemented in the case of healthcare if there was sufficient political will. But such cost containment for health care would likely dent the profitability of health-care providers, which, given the size of health-care expenditures as a percentage of GDP in the US (about 15%), would have a negative impact not only on the profitability of the health-care industry but also on GDP.

In Asia, I believe that infrastructure expenditures will rise very substantially in future. Entire cities will have to be built. Then, while the physical infrastructure is usually very good in coastal areas and around the Asian capital cities, the hinterland has frequently hardly been developed. This is the next big expenditure for every Asian country because the coastal areas cannot absorb all the people wishing to move from the rural areas into the industrial economy. Therefore, it is the industrial economy that has to move into the rural areas, and this will necessitate huge infrastructure expenditures.

In the same way that the industrialization of the US occurred in the 19th century, first on the east coast, then in the Great Lakes region, and later in California, industrialization in China and India will move from the coast into these countries’ hinterlands. Fortunately for China and India, this infrastructure can be put in place at fraction of the cost we would incur in the US – not to mention in Switzerland, where little can be built due to the impossible Swiss democratic process and bureaucracy.

But while the cost of building infrastructure is low in Asia -particularly in China, India, Vietnam, and Myanmar, since the governments of these countries own all the land – the demand for physical goods arising from these expenditures has put upward pressure on the prices of steel and cement, as well as industrial commodities such as iron ore, copper, nickel, and aluminum. Now, I don’t envision that these upward price pressures are necessarily permanent features for all materials. Steel-producing capacities in China have expanded rapidly and China is becoming a net exporter of steel.

This has already begun to putdown side pressure on steel prices. However, how much supplies can be increased for other commodities such as copper and iron ore isn’t entirely clear, and therefore I would be very surprised if commodity prices ever again revisited their 1999 or 2001lows – certainly not in US dollar terms. Lastly, if oil shortages do occur, huge expenditures for exploration will be necessary.

So, a case could be made that the industrialization of Asia and its rising standard of living will necessitate very large investments, which could at the very least contain deflationary pressure, which as you mention, exists in the system as a result of technological progress, innovations, and inventions. In addition, it is possible that rising Asian infrastructure and consumer expenditures could lead to some inflationary pressures -certainly in Asia.

In any case, under a scenario of rising infrastructure and consumer spending expenditures in Asia and other emerging economies, the demand for capital should increase, which would likely lead to a gradual rise in interest rates. Regarding your question about who might replace the US consumer as the buyer of the globe’s excess goods and services, I am afraid that this is also a real concern of mine.

If, for a change – and this is a possibility we shouldn’t rule out -the US consumer decides to save more, and at the same time the Chinese economy slows down or has a hard landing, then your deflationary scenario, in which the absolute price level declines, becomes almost a certainty. Incidentally, I believe that the external imbalances of the US cannot be corrected by arise in the Asian currencies, including the Chinese RMB, against the dollar. Only a US consumer retrenchment brought about by the consumer’s desire to save more, or by inflation that exceeds his income gains and therefore leads to a loss in real earnings or in his purchasing power, will do the trick in bringing down the US trade and current account deficit.

The market seems to agree with this view, in the sense that when US consumption (hence the economy) is strong, US equities rally but the US dollar declines. Conversely, when the markets discount a consumer retrenchment the dollar has a hardening tendency, but the stock market then weakens. Since 2003, the stock market has had a very negative correlation with the dollar. When the dollar is strong US stocks tend to go down, while when the dollar is weak they rise. This illogical, since a consumer retrenchment and a strong dollar is more likely to occur under a tight monetary scenario than with loose monetary policies. I might add that a strong dollar could be bad for emerging market assets, as in a tight monetary environment money flows back to the US.

In addition, if the US consumer goes into hibernation the economic implications for China and the rest of Asia are dire, since exports to the US are still an important factor for Asian economies. So, in short, I don’t yet see anyone replacing the US consumer as the buyer of first and last resort for the globe’s excess goods and services, because the Asian economies would suffer from less exports to the US and, therefore, Asian domestic consumption would also come under pressure.

In fact, if the US consumer retrenches, China’s capital spending boom will come to an end since no one will wish to invest in industries plagued by enormous over-capacities. This should lead to the hard landing I am expecting for China within the next18 months. Now, turning to gold, my view is as follows. The price of gold should rise if the dollar continues to weakens a result of loose monetary policies and excessive debt growth. That doesn’t mean that the price of gold will rise in Euro terms , but at least gold as a hard currency will maintain its purchasing power while the dollar will lose it.

The question is trickier in a scenario of a consumption decline in the US induced by the desire of US households to save more or having saving forced upon them by much tighter monetary policies. In this instance, much will depend on the Fed. Should, indeed, the Fed suddenly embark on a different monetary policy than it has pursued for the past 25 years and force interest rates up by tightening its policies in an attempt to curb consumption, I have little doubt that gold would decline while the dollar would rally.

But what do you think would happen if the US consumer decided to save more and spend less and bring about a recession contrary to the Fed and the government’s intentions? Would the Fed not print money like water as Mr. Bernanke has indicated? I admit that this money printing exercise on a massive scale may not lead to the consumer changing his mind about saving.

Marc Faber
January 14, 2005

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