Weren’t You Bearish And Wrong? or The Hindenburg Debate (Unabridged)

A friend who works on Wall Street (W. S.) recently sent me an email in which he pointed out some areas of strength in the US economy. His intention was to imply that I have been way too bearish. He’s a smart guy and he asks some valid questions. This turned into a multi-email debate. I thought you might be interested in reading our exchange. I have copied it below.

Round One:


I would love to know your thoughts on the following analysis.
1. The S&P is close to an all time high.
2. Job growth continues to grow, see ADP National Employment rate.
3. US PMI just hit a 5-year high. Industrial production continues to trend up.
4. US federal deficit is quickly evaporating: $600bn this year, $300bn next year.
5. Current account deficit shrinking as well on account of oil/gasoline import substitution.
6. US cities are being allowed to bankrupt. (Adios Detroit Unions)
7. The US is developing an “unassailable lead” not in Solar, but in fracking technology. Oil & gas Production.
8. QE will soon be tapered, and eventually ended.


W. S.

My reply:

Hi W. S.,

Great to hear from you.

You will recall my view has long been that the US economy is on “government life support”, in the form of unprecedented fiscal and monetary stimulus. My position has been that the economy is fundamentally (even structurally) very weak, but that the government would have no trouble keeping it afloat for the next 5 to 10 years.

When we last met in August last year, I expected that the Fed would soon have to launch QE 3 and that when it did that stock prices would rise. My advice to equity investors was straightforward: expect stocks to rise when the Fed is printing money and expect them to fall when the Fed stops printing money. I believe this view regarding the outlook for stocks was considerably more optimistic that that of many others during 2012.

In September, QE 3 was launched. In January it was doubled to $85 billion a month (the equivalent to $1,020 billion or 6% of GDP a year). This extraordinary and unprecedented government intervention has produced the anticipated stock market boom. The Dow is up nearly 25% since November. Even more impressively it has also produced a new property market boom, with home prices now up 12% year on year. Combined, these new booms have pushed household net worth to $70 trillion, a new all time high, thus creating a Wealth Effect that has fueled consumption and economic growth.

Despite this Fed-induced wealth creation, the economy remains very weak. The GDP expanded by only 1.8% in the first quarter and is expected to be weaker still (approximately 1.3% growth) in the second quarter.

Disposable personal income is up only 0.8% (year on year) during the first five months of this year. Personal consumption expenditure (which makes up about 70% of GDP) is a little stronger, up just under 2% during the same period. It has only been possible for consumption to increase more than income because the consumers have once again begun to save much less. The personal savings rate is back down to 3%, near the all time low. It can’t go much lower.

Much of this weakness is due to the sharp reduction in the US budget deficit this year, resulting from higher taxes and sequestration. As you mentioned, the budget deficit is expected to fall from $1.1 trillion last year to $650 billion this year. That is creating serious headwinds for the economy – and these should become worse as the year progresses.

Because the US economy is so weak, US imports are not growing. US imports are THE driver of global growth. Consequently, the growth in world trade is slowing to a standstill. US exports are not growing. And China’s export growth is very weak. More importantly, China’s imports have contracted year on year for the last two months. That means that China is now adding nothing to the growth of the rest of the world.

Given the above, it is frightening to think how severe the recession would be without QE.

Nevertheless, so long as QE persists, it will continue to create a very favorable liquidity environment that should continue to push asset prices higher. At its current pace of $1,020 billion a year, QE 3 is 57% larger than the government’s expected budget deficit this year. That means after monetizing the entire budget deficit this year, there is a surplus of another $370 billion available from the Fed’s printing presses to drive up the price of stocks and property.

Should QE stop, the picture would be altogether different. Interest rates would rise (perhaps sharply). And stock prices, property prices, net worth and consumption would fall. Then the US would go back into severe recession.
So the assertion that QE will end by the middle of next year, combined with the suggestion that all will still be fine, is wildly optimistic.

Images of The Hindenburg come to mind. The airship traveled smoothly from Germany all the way to New Jersey. The difficulty was in the landing. That did not go so well. I doubt if QE will end by mid-2014. But, if it does, I expect there will be severe global repercussions, both in the financial markets and in the real economy.

So, my views haven’t changed. Our economy remains on government life support. Of course, while QE is staving off a severe recession (or worse) it is doing so by creating an artificial stock market and property market boom, similar to those leading up the crisis of 2007-08. These are likely to be unsustainable over the long term. Furthermore, the artificially depressed interest rates are causing widespread mal-investment and excess capacity that will not be profitable if interest rates ever return to normal levels. Thus we are storing up new problems for the future.

On the more positive side, I had expected QE 3 to lead to another surge in commodity and food prices. Luckily, that has not happened. Higher prices have resulted in more supply, which (combined with weak demand from China) has pushed most commodity prices lower.

Also, as you point out, the shale oil revolution is a very positive development for the US economy. Over the next five years, it has the potential to sharply reduce the US trade deficit. That would boost US economic growth and should cause the dollar to strengthen. (If so, a stronger dollar should cause commodity prices to weaken further.) Outside the US, the lower US trade deficit would reduce global liquidity and lead to somewhat weaker economic growth, certainly in the oil exporting nations. This unforeseeable development (shale oil) makes me believe that perhaps God really does love America more than other countries (as I heard Senator Phil Gramm once say in a very strong Texas drawl).

With best regards,


Round Two:


Here are my questions for you…..

For the past century, fiscal “pump priming” has been a tool of policy to help cure recessions. I assume this policy works, otherwise they wouldn’t keep doing it.

Think of all the times governments step in with huge stimulus, and then eventually they stop. After they stop, do the economies roll over back to where they were before the state stepped in?

Is it possible for fiscal stimulus to lead to sustainable growth, growth that can exist after you withdraw fiscal stimulus?

By corollary, if it’s possible to stimulate an economy with fiscal stimulus, is it also possible to stimulate an economy with this new-fangled kind of stimulus- Quantitative Easing?

Can you start QE, get an economy growing again, and then withdraw QE?

By the way ISM Manufacturing PMI came out this morning, now at 55.4- highest reading in 2 years. The stock market is now hitting all time highs.

Is this ALL false, all a result off QE, and it will fall back to the lowest levels of the crisis after QE is withdrawn?

Is there any element of the US economy that is now better off and growing independent of QE?



My reply:

I believe it’s all about Credit. Credit growth drives economic growth.

The ratio of total credit to GDP rose from 160% in 1980 to 370% in 2008. That expansion of credit drove the US economy. When the household sector started to default on its debt, the ratio contracted and the global crisis started.

Note: Total Credit = Total Debt. And, I define Total Debt as Government Debt + Household Sector Debt + Corporate Debt + Financial Sector Debt (i.e. all the debt).

Between 1952 and 2007, there were only 9 times when total credit grew by less than 2% (adjusted for inflation). Every time that happened there was a recession; and the recession did not end until there was another big surge of credit expansion.

There is now $57 trillion in Total Credit. The number is so large that it’s hard to make it grow by 2% adjusted for inflation. If we assume inflation is 2%, then it must increase by 4%. That means Credit must expand by $2.28 trillion this year just to stay out of recession.

Over the past 4 quarters it has grown by nearly $2 trillion, but half of that was the government. Now, with the budget deficit falling from $1.1 trillion last year to $650 billion this year, the government will borrow $450 billion less this year. So who is going to borrow the other $1.63 trillion, so that we get to the $2.28 trillion we need for total credit to grow by 2% after inflation?

We need the household sector to take on more debt, but since median income is falling due to Globalization they can’t afford to take on more.

So, Quantitative Easing has been necessary to make up for the lack of sufficient credit growth. Look what happens when you add QE to Total Credit: there is no dip at all.

Our economy has been built around credit creation and consumption for decades. Total Credit expanded 50 times between 1964 and 2007. The problem is that it now seems that Total Credit can no longer expand enough to drive the economy because the household sector can’t afford any more debt and the government can’t expand its level of debt enough due to a political outcry to cut the government debt.

So, let’s keep a close eye on Credit Growth. If it reaccelerates, then the economy will grow. If it doesn’t, I fear the economy won’t grow. And, if Credit contracts, we will have a severe recession.

It seems to me that it is going to be difficult for Total Credit to grow by 2% after inflation for the next few years, so I believe QE will probably continue for longer than expected, i.e. mid-2014. Perhaps much longer.

With best regards,


Round Three:

Let me ask the question in your terms.

Can “artificial” credit growth (QE) lead to “natural” credit growth.

Can an economy sustain itself short term with QE, withdraw it, and see it replaced with bank lending growth, corporate debt, private debt etc…..

Is that possible?

Meanwhile, I am smiling broadly as the US trade numbers for July was just released 30 minutes ago.

The trade gap just narrowed an astounding 22% in July MoM (-$34bn deficit vs. -$44bn forecast. Also down from -$44bn in June.)

• They cited higher exports of gasoline products. Exports were up 2.2%.
• Imports declined 2.2%, again citing less crude imports.

A lot of oil and gas companies in the USA are at all time highs, still expanding production and will need “credit” to finance that expansion. God smiling on Texas, North Dakota, Appalachia (including Kentucky), Alaska.


My reply:

Regarding your question: “Can an economy sustain itself short term with QE, withdraw it, and see it replaced with bank lending growth, corporate debt, private debt etc….. Is that possible?”

Answer: We just don’t know. We have never been in a situation where the Federal Funds Rate was cut to zero and the Fed was also creating a trillion dollars of paper money a year and injecting it into a 16 trillion dollar economy (GDP). That it an incredible and unprecedented (at least since WW II) amount of stimulus.

QE can definitely create a boom and even a very big boom. By buying $1 trillion a year of assets, that will definitely push up stock prices and property prices.

The question is about sustainability. If home prices go up, then people will have to take out larger mortgages to finance them. That will cause Total Credit to grow. That hasn’t happened yet. Total mortgage debt is still contracting slightly. But, it could happen.

But, what then? Will the people be able to pay the interest on their higher mortgage debt? They couldn’t in 2008.

So it comes down to the growth in Real Disposable Income. Here’s the problem. During the first half of 2013 it only rose 0.5% compared with the first half of 2012. Disposable income is not growing because globalization is putting very strong downward pressure on wages.

As I see it, unless Disposable Income increases, then a higher level of debt/credit would be unsustainable. It’s hard to see Disposable Income rising sharply any time soon. That does not mean that we might not have a very big boom/bubble over the next 3 to 4 years if QE continues on a very large scale.

What do you think? Will Disposable Income grow? If so, why? If not, is there some other way for a higher level of debt to be sustainable?


Round Four:


The USA will become an exporting nation again.

This will lead to huge job creation and growth in disposable income.

Most of this will be centered around the oil/gas industry.

• Crude oil imports, which are about half of total needs right now, will fall to 0 in 5-7 years time.

• The US is now the biggest exporter of refined petroleum products, which will continue to grow.

• Cheaper energy inputs will give the US manufacturing machine a defensible advantage vis-à-vis China, Japan, Korea, Germany, none of whom have any domestic Energy capability/advantage. This advantage is manifesting itself now. We are already seeing this in US automobile production versus imports of Automobiles

• The other big advantage of the US Vis a Vis (CJKG) is labor costs. Those countries are all now in population decline and labor costs will only go up. The US still has population growth, thanks to the Mexicans, and still has cheap labor and that will become more pronounced over time. This advantage will start to manifest itself over the next 3-8 years.

The strategists at Citi and CSFB are all talking all about this. I bet if you wrote a book about this, you would get a lot of more airplay globally. (It’s both fun and profitable to be bullish!!)

W. S.

My reply:
W. S.,

If the Citi strategists are saying so, it must be true!

I hope they’re right. I really do.

As for bullishness being fun and profitable, enjoy the ride. New Jersey is still some ways off.

I’m sure (most of) the ride over on the Hindenburg was fun. The passengers would have ultimately found it more profitable, however, if – on that long flight from Germany to New Jersey – they had come up with a way to arrive alive.

Keep me posted on the revival in manufacturing jobs and the rise in disposable income. I’ll keep my fingers crossed. They had better. There is no Plan B.

Meanwhile, I’ll stick to writing non-fiction.




  1. This is why Richard Duncan is my favorite economist. He is unbiased, he knows history, and he focuses on the facts. This was an excellent read!

  2. Richard – I have read your book and follow your column regularly. Unlike others who are selling something your message is based on history, logic and facts. Very glad that you are around. Regards, Russ

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