350: Reagan’s Budget Director Forecasts Rocky Roads Ahead
Buck: Welcome back to the show, everyone, today. My guest on Wealth from your pFormula Podcast is David Stockman. David is a bestselling author, Washington insider and a former director of the Office of Management and Budget under President Ronald Reagan. He is the author of multiple books, including the most recent one, The Great Money Bubble. Protect Yourself from the Coming Inflation Storm Trumped a Nation on the Brink of Ruin and How to Bring It Back, and The Great Deformation, The Corruption of Capitalism in America. David, thanks so much for joining us today on Wealth Formula Podcast.
David: Happy to be with you.
Buck: Oh, gosh, yeah. Yeah. I’ll tell you. And, you know, we’ve had some interesting people on that. You probably know the Jim Rickards and some of the guys who who have I think a little bit of different take from what you have. So it’ll be interesting to contrast that. But one of the things I wanted to start with, you know, is knowing this unique perspective that you have, which is, you know, essentially being a Washington insider and then also being in the Reagan administration, particularly in the times of hyperinflation and Paul Volcker. And I’m just curious, you know, what what is different? What’s the same and what’s different about what’s going on with inflation right now?
David: That’s a great question. And, you know, I have spent half of my career in Washington on Wall Street, so I have that kind of unique blend. But the part in Washington began in 1970. So I was there during the entire sort of super inflation of the 1970s, that double digit the fact that even though he didn’t want to do it, Jimmy Carter was forced to bring in Paul Volcker, who then administered some pretty severe monetary Castor oil. It finally did bring the inflation down. But the key point is, I think there’s a fundamental difference between then and now. In the 1970s, the world economy had not yet become globalized and fully integrated. There was no real supply chain. Yes, there was a lot of trade in basic commodities or even iron and steel and some automobiles. But basically the U.S. economy was an isolated kind of island unto itself, so that when the Fed, you know, lost control in the early seventies, when Burns ate the accelerator because Nixon wanted to be reelected with an overwhelming majority, that immediately translated into a roaring domestic inflation, too much credit creation, too much demand. There wasn’t enough supply. Prices rose rapidly. Then on top of that, we got the second oil crisis and commodity prices soaring again. Now that I think people are roughly familiar with that. But that was the sequence in the 1970s. And remember, it was centered largely in the United States. It spread to the rest of the world, but it was centered here.
Now, what’s different is that after the mid eighties, when Greenspan became chairman of the Fed and really, you know, he turned on the printing presses and something new appeared in the global economy, and that was the Chinese economy. That was the process of massive offshoring of domestic production. And the effect of that basically was to create a period of time in which we were actually exporting inflation because of all the money being created by the Fed.
But importing deflation in terms of the huge increase in goods that were coming in from China, Vietnam, Mexico and so forth. So we had a salts, a kind of salts, deflation or false loans ation for about two decades in which the central banks thought they could run the printing press with abandon and there wouldn’t be any consequence because the measured inflation rate anyway, was only 2% or 1.5% or 1.4%. And we got all this business going about low inflation and the Fed was missing its targets from below and a lot of things which would have been inconceivable in the 1970s became, you know, par for the course core to the mainstream narrative in the last 10 to 15 years. Now, my key point is that’s all over and done.
You know, that calls it the global COVID disruption, totally dislocated the supply chain, the deflation that we were importing in goods quickly and in the year a year and a half ago. And suddenly the inflation that they’d been missing actually just came out of hiding. And we were off to the races with seven, eight, 9% inflation and the highest levels in 40 years.
Buck: Real, real quick, David, when you say when can I just clarify something that deflation you mentioned, the deflation that we were getting, sort of the false deflation or expectation, you know, exporting our own inflation in exchange for deflation? Why did that go away? I mean, I mean, certainly there has been a slowdown of of, you know, the supply chain, etc., in the last couple of years. But why why did that go away the way you’re talking about it?
David: Okay. That’s a good question. And let’s just put a couple statistics on it. If you go back to 1995 through 2019. That’s right. Before the COVID hit, right before the supply chain got totally disrupted, the supply for durable goods or the p C deflator for durable goods, which is what the Fed goes by, declined. And this is startling by 40% over that, you know, two and a half decade period. And it was that 40% decline in the index for goods that more than offset, you know, the 2 to 3% inflation we had in services and led to the I call it split screen inflation led to the delusion that there wasn’t any inflation problem. But then what happened was obviously the supply chain got disrupted and as a result of that, import prices have soared tremendously in the last year and a half.
So now you have the worst of both worlds. You have the same services sector inflation that we had before, but it’s accelerated. And on top of that, you have goods rising and they have that now. They’re starting to cool off but have been rising by double digits when for 25 years they were going down at 2 to 3% a year. So that’s the big shift.
Buck: Is that temporary?
David: No, I don’t I don’t think it’s temporary because you can only off shore your economy once. Yeah. In other words, when we said production to China for, you know, shoes and apparel and electronics and toys and all the rest of it, you can only do that once in that brought the cost level down on a one time basis.
But now China is in the same boat that we were like 35 years ago. Their costs are rising and they have a real scarcity of workers. Actually, their labor force is actually shrinking and will continue to shrink quite substantially in the decades ahead. So the one time gain, it was kind of a labor arbitrage, the one time labor arbitrage is over. And now even if we continue to import at high rates, probably not as high as we did prior to 2019, but at high rates, we will not have -2% inflation and the goods coming in, it’ll be positive inflation and therefore the central banks are really in a totally new ballgame.
Buck: Talk a little bit about, if you would, the, you know, compare and contrast the the Volcker approach to the problem of hyperinflation that you’ve saw with the way the Fed is currently managing the situation.
David: Yeah, the Volcker was not nearly as tentative as the Fed had been. Well, you know, the inflation became pretty evident about March 2021. If you look at the data, you can see there’s a clear acceleration in the early 2021. By the spring of 2021, we were above 5% and it was off to the races from there. But it took them, as you recall, almost a year until March 2022 before they raised interest rates from the zero bound QE. Now, Volcker wasn’t even in that, you know, he wasn’t in that league. I remember when he became Fed chairman August 1979, the inflation rate was already running ten 11%. But here’s the key thing. The real rate of interest, let’s say, on the ten year U.S. Treasury, which is kind of the benchmark for everything, including real estate, stock market, everything else, the real rate was about negative to the -3%.
In other words, inflation was running above even the yield back that in Volcker said this can’t stand. We will not get inflation subdued. We will not bring it to heel until we have positive real rates. We can’t allow speculators and, you know, businesses and households to borrow at a rate below the rate of inflation or we will never bring the excess demand under control.
So he moved aggressively and by the spring of 1981, which is, you know, maybe a year and a half, the real rate on the ten year that is inflation adjusted was positive 9%. In other words, it went from negative to 2009. That shocked the system and the whole inflation psychology was broken, was punctured. And then once people gain confidence that there wasn’t a inflation spiral continuing to feed itself, behavior changed and prices came down. It didn’t happen overnight, but they came down far more dramatically than people thought at the time. At the time, they said it’s going to take a decade to bring inflation down from double digits. Actually, by 1983, 1984, inflation was back to Tunis repossession. And then he drove it even lower than that as we got into the mid 1980s.
So that was that was a totally different said that was a Fed played and sound money and that was a Fed run by a chairman who really understood that it wasn’t his job to pacify Wall Street, it wasn’t his job to make politicians happy or speculators or investors stock traders happy. It was his job to bring inflation to a halt and allow the capitalist economy to function on a non-inflationary basis. And he did that. And for a while we had a pretty good economy. Until then, we got Greenspan and we went into a new cycle of money printing that, you know, we’ve been talking about here.
Buck: So the you know, going back to a recent interview I did with Jim Rickards, his you know, his take on the current situation was maybe the Fed continues to raise rates another, you know, another 50 basis points. And then the net effect of that raising rates for is rapidly as they did. I mean for for now at least that that would drive us into a fairly deep recession and that in turn would trigger the the Federal Reserve to reverse course and become dovish. Whatt’s your take on that?
David: Well, I think that something like that will happen. But in slow motion, if I have any difference with Jim, that would be and I usually don’t. In other words, probably the Fed is nearing the peak of its hiking cycle. But what’s going to happen, in my judgment, is a long pause. In other words, it won’t be a pivot where they go from raising rates.
I think it’s going to be a long pause because we’re going to be stuck with what will appear to be a severe stagflation. That is an economy that is weakening and maybe even technically in recession. But inflation rates on the headline and on the PC deflator that are still running five, six, even 7%, and therefore not in a condition to permit the Fed to pivot.
So therefore, we’re going to have the worst of both worlds. I think for the next year or a year and a half. That is a macro condition of stagflation of Fed that has raised rates high but is not showing any sign that it’s going to come to the rescue of the stock market or investors and bail everything out. Now people say, yeah, but when the recession hits, won’t they? You know, won’t they panic? Won’t they reverse course? The answer is, if you look at the past, it takes a while for people to come to an agreement that we are in a recession. So the data is really complex. There’s a lot of noise in it. The first take on a lot of this so-called incoming data is, you know, been revised substantially over time, particularly on the unemployment rate. And so therefore, it takes probably six months, even a year for a deep inflation to manifest itself, prove itself and create pressure on the Fed. And that’s where I think we are now. In other words, we’re going to slowly sink into recession. It won’t be like a sharp V-shaped collapse. It will likely be a extended period of very weak growth or even moderate, you know, modestly negative growth. And that’s why, you know, I call it stagflation and why the Fed’s going to be between a rock and a hard place. It won’t be able to stimulate, and yet it’ll be reluctant to break the economy even more for fear of compounding the recession.
Buck: Your timeline, you’re saying, is, you know, maybe 12 to 18 months. But we’re looking at when you talk about stagflation, isn’t part of stagflation higher unemployment? I mean, right now we don’t have that problem, right? Is that something that you anticipate? We we start seeing a problem with the next several months or.
David: Yeah. All year I think we’ve already peaked in terms of employment. You’ve seen the big controversy recently where the Philadelphia Fed did a re read analysis of the BLS data for the second quarter of last year, April, May and June, and concluded rather than one and a half one point old 5 million new jobs. It had been something like 12,000. That’s that’s a heck of a difference, right? 1000. You know, that’s like that 99% error factored. Yeah. I don’t know whether the Philadelphia fans analysis is totally correct or not, but I do know from past history that the Fed are that the BLS overestimates the job count and turning points in the economy. And the reason for it is that a lot of what’s in the below us data for the initial you know, the initial data this month, next month, the month after is basically modeled data.
It’s not something they go out and count hands and count payroll checks and so forth. It’s a model data and then the models get updated, they get revised and you find out there was a lot more unemployment then you thought, that’s the first thing. The second thing is we’ve gone through a period where there was an artificial scarcity of labor because of the COVID, the lockdowns, all of the stems, you know, the stimulus, I call them the stimulus money that went out to people. And so as a result, employers suddenly found themselves scrambling to hire people. And as a result of that, I think there’s a pretty good case that they’ve over hired that they’ve been hoarding labor because they went through a kind of traumatic experience in 22nd half of 2020 and 2021, where they needed to hire people and couldn’t. And so therefore, as I say, they’re hoarding or accumulating labor.
Now, what’s going to happen as is as demand continues to weaken and their order books get softer, they’re going to relax that posture and they’re going to start either stop hiring or they’re going to actually start laying off people. And we’ll be in a new unemployment cycle. But that’s going to be slow developing. That’s what people don’t see. And, you know, you’re not going to have 8% unemployment overnight. The Fed panicking and cutting rates aggressively. I think it’s going to inch its way up slowly because there’s been so much artificial retirement from the labor force. I mean, in other words, what should be the first wave of unemployment that would occur in a normal cycle are people that have already left the labor force.
They’re not counted, you know, by the BLS because they took early retirement. They’re on welfare of one type or another, or they’re living in mom and dad’s basement doing gig work. That doesn’t even count in the statistics.
Buck: Let’s talk a little bit about if we would, about the markets and specifically the equity markets and, you know, the real estate market. Obviously, they have benefited tremendously from the cheap money in. And so essentially we had a type of asset inflation well before the consumers ever saw that. Right. They are what first. So like I’m curious is that as this market starts to decline, is it clearly the case, in your opinion, that the equity markets, for example, will decline as well? I bring this up because another person I interviewed, Nomi Prins, has been talking about this great distortion between real markets and, you know, real economy and markets. And so to a certain extent, I wonder, you know, even looking at COVID as an example, where all these businesses were shut down, but the stock market was going crazy, what do you see as what’s really going to happen? Do you do you feel like they’ll be will necessarily have to be a maybe a reversion to two reality and why if that’s the case?
David: Yeah, well, I think the Fed made a gigantic historic mistake when it panicked in March 2020 and just opened up the printing press and took its balance sheet from 3.8 trillion to 9 trillion in the course of about 16 months. Okay. And it was on the theory that since the economy dove into a deep recession in the spring of 2020, that it had to pull out all the stops to try to rescue the real Main Street economy. But that was a total error because the reason the economy took a nosedive was there was a supply side contraction ordered by the government, i.e. the lockdowns. COOK And when you tell restaurants close, when you tell shopping malls, don’t let anybody in the front doors. When you tell gyms, you know, not to be in business, then, you know, millions of people are going to be laid off.
But that was not because of inadequate demand or because credit was too expensive or any other thing that the Fed could do something about. But it was because of Dr. Fauci and what they called the virus control, and then the panic that they unleashed among the public that basically, you know, went out of circulation, so to speak, exited that commerce. And so therefore, we had an economy that came to a dead stop from the supply side, not the demand side. So what did the Fed do? They printed money like crazy, but it didn’t end up in the real economy. It didn’t end up on Main Street creating credit demand. It ended up on Wall Street and tremendous inflation of financial assets. And as a result, during 2020 and most of 2021, all of that inflationary credit that was being created by the Fed and it’s a lot $5 trillion. I mean, if we could round it here, they went from 4 trillion decide to 9 trillion in that short period of time. That ended up in the speculative precincts of the bond market, the stock market, the tech sector, the crypto verse and anything anything that was going up.
Speculators were by in pushing up even higher. So now we have to face the music that that great aberrational bubble is got to be punctured because it wasn’t real, it wasn’t sustainable, it wasn’t linked to the real economy. It was a giant mistake by the central banks, the Fed and the others swallowed, and now they’re trying to reverse the damage that they’ve done and they really don’t know how to get out of the mess that they’re in.
Buck: Yeah, you know, it’s it’s curious because I guess the you know, there’s also this perception, I think, amongst people on about this idea that the great distortion that effectively the Fed or government policy will intervene no matter what right And that creates this almost this game of chicken between the investor the investor world and, you know, the policymakers, you don’t see that game of chicken being won by the investors again though.
David: They yeah I think that’s the big change the Fed is now realize that it’s got a tremendous stagflation era crisis on its hands and that it’s going to have to administer some pretty tough medicine. I’m not saying that Powell is the new Volcker. You know, I just don’t think he’s that tough. I don’t think he’s at it. You know, he’s got that kind of backbone. But I think he’s going to go a lot farther than people think. You know, I was very critical of him during that whole period when he was talking about the transitory inflation that during the period before that, when he was talking about inflation being too low, that was completely wrong. But I think he’s come to his senses and there is a developing consensus at the Fed, even among the Keynesians, which I think is important to note, they actually believe and when I call painting by the numbers, they do believe they’re 2%.
So I think there should be 0% target, but they believe in 2%. And they’re going to one way or another attempt to maintain and preserve their credibility by getting to 2%. But getting there is going to be a lot harder. The embedded inflation is a lot stickier than people realize. I think maybe a lot of people may have seen the data the Lantos Fed put out a couple of days ago showing wage gains on a year over year basis in November as between people who kept their job over that period versus job switchers, people who changed jobs or changed employers or changed industries. And if you look at that second category, wages were up by plus 7.7%. And that’s the category to look at because on the margin, that’s where wages were being set in the economy, not by the people who weren’t going anywhere, but by the people who were moving on because they saw better job wage prospects in with other employers.
So when you have wages rising on the margin at 7.7%, that’s going to come through in the service prices, even domestically produced goods. And you’re not going to get this sudden overnight collapse of inflation that they’re all dreaming about. It’s just not going to happen. And I think we’ve got more and more evidence that what’s built in is a way is a price wage cost spiral that’s going to take a several years to purge from the system.
Buck: When I guess the one question I think would be very useful is for an investor who is involved with these markets, how do you protect yourself against, you know, the onslaught of all the things that you’re talking about?
David: Yeah, very good. I think the first thing is to recognize is it’s a new ball game. In other words, the things that have worked for ten or 15 years I think will no longer be working. In other words, buying the dip where there’s no doubt about it, from the fall of 208 to the recent peak last fall, the Nasdaq 100 was up 1250 percent. Okay, during that same period of time. So if you bought the dip all the way through that, you know, 12, 13 year period, you were up 1250 percent. At the same time, the GDP was only up 55%. Now, what people need to recognize is there is no way that the Jedi that the stock market can rise 23 times faster than the GDP.
So for a sustained period of time and expect that, you know, it’ll have happy ending, it won’t. So what we’re in now, I think is a great period of, you know, catch up, a great period of paying the piper for the tremendous excess and bubble that we’ve had in the past. And therefore the stock market in the bond market are not safe places to put your assets.
Now, you can put your money in short term treasuries like six treasuries, one year treasuries, even two years. There’s not that much price risk. And now you’re starting to get a decent yield of four or 5%. But the idea that you can, you know, make 25% return year in and year out, or you can double your money by taking the right tech stocks, I think all of that is gone and people are going to have to now recognize that we’re back to sort of a not even normal environment, but a catch up environment where it’s going to be very difficult to make any serious appreciation. And therefore, the issue has to be capital preservation, not capital appreciation. Now, that is such a big change for most people that is hard to really grasp or to accept. But I think if you only needed one word in terms of an investment slogan, let’s say an investment concept, it would be preservation of capital rather than looking for, you know, high returns because we’ve got too much catch up to do.
Buck: David The book is again, the newest book is The Great Money Bubble Protect Yourself from the Coming Inflation Storm. I assume it’s available everywhere as all your books are. And I would definitely encourage people to pick up a copy of that. Thanks so much for being on Wealth Formula Podcast today.
David: Okay, Very good.
Buck: We’ll be right back.