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FRA: Hi! Welcome to FRA’s Roundtable Insight .. Today we have Charles Hugh Smith: Author, leading global finance blogger and America’s philosopher we call him. He’s the author of 9 books on our economy and society including “A Radically Beneficial World: Automation, Technology and Creating Jobs for All”, “Resistance, Revolution, Liberation: A Model for Positive Change” and “The Nearly Free University and the Emerging Economy”. His blog “OfTwoMinds.com” has logged millions of page views and is number 7 on CNBC’s “Top Alternative Finance Sites”. Welcome Charles!

Charles: Thank you Richard, always a pleasure!

FRA: Great, I thought today we’d discuss a couple of topics that are currently on your mind, based on your recent blog writings. In particular there is two. One is called “Politics has failed, now central banks are failing” and the other is “The coming crisis the FED can’t fix: credit exhaustion”. And they’re very much related so I would like to explore that, what’s going on, why are these trends happening, potential implications for the political landscape and the investment landscape. So Charles, can you give an introduction on these two blog posts and how you see them relating?

Charles: Ok, to me these are timely topics as we look around the world, we see that politics is failing in Britain with the whole controversy- convoluted controversy over Brexit. Then we see in France, we see the yellow vest movement and here in the US we have seen Russiagate and all sorts of manifestations of a failed political system.

And so, I think my key point that I want to start with is: If our politics was able to fix what was broken in our economies, then we wouldn’t be relying so much on central banks. But you know, so what’s happened is our political system is dysfunctional and incapable for a variety of reasons of actually solving the problems that are systemic in our economy and society. And so, the politicians have kind of punted- you know, they passed the baton to the central banks and said, ok now you guys fix it with monetary policy and the problem there is twofold: Monetary policy is only at two levers. You can buy assets, and then you can use that mechanism to adjust interest rates.

But you really can’t affect social policy or how money is spent in the economy. It’s a very simplistic limited model and so the central banks have responded to this political pressure, like do something to fix the economy, especially in the great global financial meltdown of 2008-2009. So the central banks did what they could, which was drop interest rates to near zero and then flood the financial systems with liquidity and credit and we have to remember, those of us who are following this kind of thing, we have gotten kind of accustomed to these tremendous amounts of credit and liquidity that were put into the financial sector in the crisis era. I believe the number is the federal reserve basically backstops 16 trillion dollars of credit and liquidity that it put out to other banks around the world and then of course it created almost 4 trillion dollars here in the US which it used to buy mortgage backed securities and treasury bonds.

And so these are immense sums of money and so they have had an effect but they have had a perverse and unintended effect, which is they have created incredibly difficult-to-reverse income and wealth inequality and of course we are talking about financial repression here right, is that they basically made the wealthy even wealthier and by boosting assets because that’s where all the liquidity and credit went. And they actually reduced the purchasing power of the bottom 90% households earnings because creating all this money and credit did create some inflation and we can see it in healthcare, higher education, rents and so on so they basically beggared the bottom 90% and enriched the top 10% and now this is creating political blowback.

FRA: Yeah, it has exasperated the whole wealth inequality, wealth income, just in general as the idea has been to benefit those that are closest to the money more so than others so people in the banking sector, the financial sector, have befitted more through this asset inflation because essentially the financial sector has the ability to go to the central bank window and borrow at very low interest rates and then turn around and do a carry trade that perhaps even just buying a simple 10 year bond at 3% and borrowing at the 25 basis points at the central bank, then you get 2.75% for free essentially. So that has been levered up, it hasn’t really benefitted much of the regular economy, the real economy. Would you agree?

Charles: Yes, absolutely and I think a lot of financial pundits of this sort of conventional sort, they follow the thinking of the FED that the FED’s idea was to create a wealth effect. In other words, by boosting stocks which- let’s face it, have basically quadrupled in the last decade and real estate that this wealth effect would create a sense of confidence if you will, in the institutions and in the economy so that people would borrow more money and spend more money therefore boosting the economy. And because they felt wealthier and they felt that the system was working for them but the problem with that is the top 10% in America, top 10% households own 85% of the stocks so all that wealth benefit, wealth effect benefit only flowed to the top say, 6-7 million households out of 120 or 110 million households.

So, it actually narrowed the benefits into the top tier and of course if we look at income, we see that the same thing happened. Most of the gains in income went to the top 1/10^th of 1% for the reasons you just described. You know that once you can acquire productive assets at bargain basement prices then you get all the income and so I see having living part time in northern California, but you see the same thing in Seattle, Portland, Denver, Brooklyn New York, Boston. In all these really high real estate markets, we see that those with easy access to credit have been able to buy commercial rental properties, commercial properties rental housing, and the rents in these places have gone up 40-50% in the last decade as a consequence of the rapid inflation of those assets.

Because there is money chasing a limited number of rental units and commercial units and so the federal reserve claim that the wages for the bottom 90% have gone up 23% or something in the last decade but then rents are going up 40-50% so the people who are least able to access the benefits of quantitative leasing, they are seeing their wages buy less and less and is creating what I calling a pre-revolutionary state of conditions where the economy is not working for the bottom 90% and is working really great for the top 10% but the bottom 90% are not only losing ground due to inflation and stagnant wages, they don’t own the assets that are skyrocketing and they don’t have political representation. This is what the yellow vest and the Brexit and the Trump supporters are all about. These are people who felt completely disenfranchised by the status quo; you know, ruling elites and so we got this mix of, and since you asked me to tie them together, we have this volatile mix here where we’re seeing the political institutions fail or fall into dysfunction and then there’s a loss of trust that we talked about last time. And then we have that combined with the perverse and unintended consequences of tremendous financial repression, soaring wealth and income inequality and a sense that the system doesn’t work for the bottom 90% which then exasperates the political sense of disenfranchisement.

FRA: And your blog post on the credit exhaustion. Have central banks, do you think, painted themselves into a corner? Are we now at the limit of central bank utility in terms of how much more credit can we create in the system if it is not moving the economy?

Charles: I think it’s a great question Richard and of course we can start with the fact that most of the new money in the economies, the market economies including China is not created by the central bank, it’s created by financial lenders who then create money when they issue a mortgage and so on. It’s very important for the economy, for the FED and the other central banks to stimulate private borrowing. They can’t or don’t anticipate or they don’t consider it a success if they have to create 100% of the credit, and so how can you create private lending?

So they did their part by lowering interest rates which stimulated real estate borrowing and pushed up housing prices and so on. But at some point, in an attempt to normalize it, at least in the US and the FED has allowed interest rates to creep up as they’ve lowered their balance sheet and so now it’s a little more expensive to borrow but there’s also a point at which now so many households can’t afford to buy the house, regardless of the interest rate because of the FED’s financial oppression has pushed housing out of range and if we look at vehicles. Vehicle prices have continued soaring every year, it’s another thousand or two on top of the existing price and so there’s been no deflation in the expensive items in a household’s budget. In other words, higher education costs are continuing to go much higher, healthcare costs continue spiraling higher and vehicles and so all these things keep going up in price and so at some point, people go “I’m not going to borrow, I decided we aren’t going to buy a new vehicle. We are just going to live with the one we have. It’s going to put too much pressure on our budget or we’ve already borrowed too much”.

So, my point here is no central bank can force private individuals or companies to borrow money. If they don’t want to borrow money, then the fed can’t force them to. And so, I think that is the sense of exhaustion. That everybody that has been qualified to borrow money has already done so and there isn’t that many people left who are qualified who want to borrow more or can afford to borrow more. And then on the reverse side of that the feds can’t really force private lenders to lend money to unqualified borrowers, because that’s the whole subprime mortgage situation that blew up in 2008. Is that most of the borrowers in the subprime mortgage sector were simply not qualified to borrow money through the conventional system and so they would wire loans and basically embezzlement and fraud was how the mortgages were initiated and originated, I should say.

In any event, so now how do you force lenders to lend to unqualified borrowers and how can you force people who don’t want to borrow anymore regardless of interest rates? You can’t, and so that is why I am calling it credit exhaustion and as the credit impulse declines, which we are seeing in China as well as other economies then the central banks are really powerless and as you say, they boxed themselves in because they already lowered interest rates and so they can’t go back to that well and there is not really much they can do to force people to lend or borrow.

FRA: So now where we stand if we have a situation where people have lost faith in the political system, government institutions and if they’ve gone to look at what central banks can do and how they can help but nothing is happening there either. Could there be a movement at this point to QE for the people, the so-called modern monetary theory in terms of helicopter money drops to finance infrastructure projects by having the central banks create money out of thin air, or even just direct from the government treasury departments. Could that come into play at this point, given all the backlash especially for helping, using QE to help the financial sector only so could there now be a movement? You know, to push for QE for the people?

Charles: I think you are absolutely right Richard, and we are seeing that with Alexandria…

FRA: Ocasio-Cortez.

Charles: Thank you, yeah, Cortez, AOC. She has come out of nowhere and grabbed tremendous media exposure for a number of reasons but one of which is the ideas she is promoting and QE for the people is certainly central to it because that is part of the new green deal which was to borrow and spend money on socially useful infrastructure as opposed to private assets and there is a certain sense, makes a lot of sense that we can go back through history and find many examples where governments funded railroads and dams and various basic infrastructure either by giving collateral, like land to the railroads so they could then borrow the money privately or by just funding it by deficit spending.

So, another way of looking at this movement I think, is that as credit exhaustion or credit saturation kicks in and private borrowing declines, then really what QE for the people is doing is its substituting government borrowing for private borrowing. As the economy spirals down into recession because private individual companies are no longer borrowing then QE for the people is substituting that private credit for government debt. So now the government should go and borrow another trillion a year and spend it and so that’s the sort of fix. And the problem with that as a fix of course, is the government, the public debt will skyrocket to the point where interest becomes crushing and Japan is kind of a lesson in both debt saturation and debt exhaustion and also what happens even at very low interest rates, now a big part of Japan’s tax revenues are just devoted to paying interest on public debt at very low, a quarter percent, not even a 1% interest and yet if you borrow tens of trillions of dollars or in their case, hundreds of trillions of yen, the interest piles up to where it’s starting to squeeze other government spending. Even if you don’t get inflation, which becomes much more likely once you borrow and spend and pump trillions of new money into the economy, even if you don’t get inflation, you’re going to reach a point where the government can no longer fund all of it’s expected activities and pay this ballooning interest on this tens of trillions of new debt.

FRA: So, you see potentially either the idea that there’s that problem of the interest servicing of debt, or at some point large inflation in the real economy in terms of the consumer price inflation?

Charles: Right, and I think the key dynamic here Richard is QE for the financial sector. That money almost all of it flowed into the financial assets that’s why real estate’s gone up 50% and stocks are quadrupled and so on is that that money flowed into financiers and banks and corporations which then bought assets because wealthy people don’t really spend that much of their income. If they get quote free money, they’re going to buy assets with it. But MMT and QE for the people, the whole idea and basic universal income is to put new money into regular households’ pockets and the vast majority of those households are going to spend that new money. Whether it’s a job for infrastructure, for a new green deal or it’s a thousand dollars a month from universal basic income. That money is going to flow into the real economy and the MMT and Keynesian proponents are working on an assumption that is questionable and their assumption is: There’s a huge amount of slack in the economy and once we borrow and spend another trillion or two a year, then the economy can easily expand and pick up that slack and there wouldn’t be any inflation.

But that I think is a theory, not necessarily practical because there is a lot of bottlenecks and limits in the real economy. There is not much more farmland you can add to the US that isn’t already marginal and there is not much more fresh water for new development. In fact, in a lot of places fresh waters on a very severe limit already and theses are just resource limits but there’s also limits on certain kinds of labor and skills and so we may get real world inflation on top of big ticket inflation that I mentioned before in healthcare and higher education, childcare and rent. And so at some point the federal government will have to, perhaps be forced to start recognizing real world inflation which they sort of suppressed with a kind of jury-rigged CPI calculation so what happens when inflation starts running hot like it did in the late 70s, 10-12% a year. And then you’re forced to raise interest rates and then that kills off borrowing and so there’s a lot of perverse incentive created by this idea that we can borrow and spend unlimited sums and it’s all OK as long as it is flowing through QE to the people.

FRA: So, what are the implications of all this politically, economically, investment-wise? So, let’s take the politics first; do you see perhaps most politicians that are offering to finance new projects and all kinds of spending type of activities?

Charles: Yeah, I think that’s one way that you can guarantee your popularity right, is because if you’re borrowing two trillion dollars a year and you’re blowing it on a bunch of stuff, that is going to be politically appealing and of course the interest on that two trillion that you borrowed and spent, that’s for later politicians and people to worry about. So, it’s one of those things, spend now and worry about it later.

But I also think we should go back real quickly to your comment about last time about Martin Armstrong’s focus on loss of faith in the institutions. As MMT and QE for the people, as it fails as it doesn’t create a zero inflation, high growth economy. As it creates inflation, it eats away at people’s purchasing power, there will be an acceleration in the lost of faith in the institutions because right now this is the big hope for the political system is if we can do this QE for the people, a new green deal then it’s all going to be fixed and everyone will have more money, there will be no more inflation, and it’ll all be good. But so if that goes, if that unravels and creates inflation, then there will be even more loss of faith in the political system because that is the political system’s big fix: Borrow and spend another trillion or two a year and so if that doesn’t work out we are going to see more loss of faith and I think there’s also going to be a tremendous loss of faith in central banks because they have been writing on the glory of having inflated a third bubble here over the last decade and so far it’s like “See, it all worked, we created a wealth effect and we saved the world” in Ben Bernanke’s phrase. So, as that starts unravelling and failing then we are going to see a loss of faith in central banks and the last thing is how do you deal with inflation when it finally does arise and there are no good solutions right?

FRA: Exactly. I mean, inflation could also be made worse with climate change so that’s also what Martin Armstrong has written about recently is the effect of climate change on particular agriculture, which could drive food prices much higher, making the overall consumer price inflation much worse.

Charles: That’s right, that’s absolutely a factor. Look at the flooding in the mid-west and the US, the recent flooding as apparently a lot of people feel it’s going to have a tremendous effect on crop yields and so there’s that factor and I think, I would sort of summarize the situation in this way Richard. When the pie is expanding, which it did in post-war era from 1946 through, let’s say 2005-6, when the pie’s expanding, everybody can get more and so then it’s actually enjoyable to be a politician because you’re basically divvying up a pie that’s getting bigger and bigger so you can always satisfy some constituency with a larger slice of the pie and it’s not a zero sum game because the pie’s expanding so everybody can get a little more and there’s of course trading but it’s all good. But when the pie is shrinking, and I think that’s what’s happening now.

The actual real world collateral and real world wealth is actually contracting, then politics becomes no fun at all because it’s become a zero sum game where to give more to one constituency or some special interest you are going to take it away from somebody else and that is why we are seeing this frenzied enthusiasm for MMT and the new green deal is everyone’s looking around going “how can we make the pie get bigger” because if the pie is shrinking then somebody’s going to lose out and that is how you get revolutions.

FRA: Exactly, and the idea of having loss of faith in government institutions at some point will very likely lead to a currency crisis in terms of having the purchasing power of the currency lower to a dramatic extent, do you agree?

Charles: Absolutely, let’s remember inflation starts running at 10 or 12% a year, people can stand that for a year but what happens over 5 years that’s a loss of over 50% and if your wages aren’t rising by the same amount, you’re losing ground tremendously. It really is robbing people of their income and so that’s I think a very serious consequence of inflation that there’s no simple answer to. And if you raise interest rates like Paul Volcker did in the early 1980s, you basically kill off your economy. And when interests go to 10 or 12 or 15%, the US economy was able to survive that blow because we had much less debt and the economy was more resilient. But the economy is much more precarious and fragile and it’s not going to survive 12-15% interest rates and so once inflation rate kicks in it’s the end of FIAT currencies and so hence everyone’s interest in precious metals and cryptocurrencies.

FRA: And how does your new book fit into this, the suggestions made in your book “Pathfinding Our Destiny: Preventing the Final Fall of Our Democratic Republic”, what are some of the suggestions you have from that book?

Charles: Well thank you for letting me summarize that; the basic idea of “Pathfinding Our Destiny” is: Only resilient, flexible systems that can evolve quickly will survive this revolutionary era that we’re entering and so if you have a static, rigid, inflexible system that is going to cling to the status quo at all costs. That’s the system that breaks and breaks down. And so, the system that is decentralized and more of a network of nodes of semi-independent nodes, that kind of system you can say is a small scale capitalism where capital and control is decentralized so everybody can shift and adjust and evolve as needed. That system is going to be much more survivable than one that is very centralized, very hierarchical, where all the control is at the top. And that’s the system that predominates around the world, both in China and Russia, the US and the EU. Basically 400 bureaucrats at the apex run these entire economies and so that’s the penultimate example of a rigid, inflexible system and so that is what the point of the book is. We need to radically decentralize political control and capital and push down the decision making and the capital so that the people can adjust enterprises and communities can adjust much more freely and quickly as conditions change.

FRA: And will this be possible, to implement some of these suggestions. Do you see this happening or what will it take for people to come to that type of realization?

Charles: I think Richard there is one positive thing, which is kind of drawing upon books, Buckminster Fuller’s insight is you can’t really reform a status quo, you basically obsolete it. So I think the technologies like cryptocurrencies and some of these other web/internet-based technologies, they are basically running an endgame around the status quo and so I think we are going to see a lot more peer-to-peer activity which is the kind of networked nodes that I was mentioning and so as the status quo breaks down, people are going to come up with systems that are decentralized by default because that’s the kind of way you obsolete a dysfunctional centralized system is you decentralize and you obsolete the system. So for instance in banking instead of going to these five money center banks, we may see more and more peer-to-peer limit and instead of relying on a government currency we might be seeing a proliferation of cryptocurrencies and possibly gold-backed cryptocurrencies and there is a lot of ferment out there, in ideas that would obsolete government issued FIAT currencies. And say in healthcare, there could be the rise of cash only small-scale clinics that just completely are outside of Medicare and the insurance sector completely and so that would obsolete all those dysfunctional high-cost systems, so I think we can look forward to a lot of information that would obsolete the dysfunctional systems we have.

FRA: Well that’s great insight and very positive view that we can end the discussion on as we have run out of time today but yes, the idea of a movement towards a more flexible, decentralized sustainable democratic opportunity for all nation.

Charles: That’s right.

FRA: Thank you very much Charles, how can our listeners learn more about your work?

Charles: Please visit me at “OfTwoMinds.com” and there’s free samples of my most recent books for you to download and read and lots of other stuff that I hope you’ll find interesting.

FRA: Thank you very much Charles!

Charles: Thank you Richard!

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.