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Richard Vague on China, debt write-offs, the meaning of Trump

The ex-credit card mogul told you so

Richard Vague, the Philadelphia marketing mogul (Chase credit cards, EnergyPlus) turned investor (Gabriel Investments), political donor (to prominenti of both parties), philanthropist (Penn medical research, Haiti development), and global policy wonk, argued in The Next Economic Disaster, a book I reviewed in the Inquirer last year, that high private debt -- not government spending -- marks economies in decline.

Last winter, while the China stock market was still at record highs, Vague said China's debt-fueled, government-led development had already stalled what had lately been the world's growth economy -- and predicted other countries will slow, too. See my March summary of his article in Democracy Journal here.

On Tuesday, after U.S. stock markets followed China's down for six days, I took Vague to lunch near his Center City home and asked him about China, credit, the threats and opportunities the market slide creates, and why U.S. politicians all sound so backward about what to do. Highlights:  

What's wrong with China? Demand for their exports collapsed, so they turned to private debt (state-backed banks funding developers and industries). Since 2008, China's private debt has grown by $15 trillion. That's the largest growth for any country in history. They have amassed overcapacity, across the board. They have 50 million empty houses. And way too much iron, steel, aluminum...

All of a sudden the stockpiles of thiggs that aren't being used are beginning to (lose value, dragging down company stocks). They built too much stuff. They need to slow down production and let demand catch up. That's what happened to Japan. Since the 1990s their growth has approached zero. That will happen to China. And I don't think anyone has prepared for that.

Who does that affect, outside China? The world has way too much of many things. That means price pressure will be down for years. The drop in demand from China is one of the big factors. China's growth is going toward zero. And prices will be low, not just for months, but for a long time.

Anyone who's been borrowing money to build their exports to China, anyone who has been living off China's empire, has been decelerating rapidly. That's almost all of Pacific Asia -- Thailand, Australia, Korea. And Latin America -- Brazil, Peru. Most of Africa. The commodities companies who leveraged up, they are hurting badly. They are in a near-crisis environment.

China now has the most bad debt ever created -- more than $2 trillion. It's a little bigger than ours in 2008-09. Now, China can handle that.  But Thailand, Australia and Brazil don't know how to handle that. They're going to have trouble. For Europe, for the U.S., it will be a softer impact.

Who gains when China loses and prices head back down? Consumers are winners. $2 a gallon gas, $3 a pound beef... Right.

There are both winners and losers in the U.S.  Energy companies in the U.S. are in trouble. Pharmacy companies and car manufacturers who have material exports to China, they are in trouble. BMW, their 500 series, which has become their big seller, that will start to unravel. But mostly (China's troubles) will be muted in the U.S.

How can China grow again? The problem is at this point they are already stimulating as much as they can. Private debt growth in the last two quarters is as high as it's ever been. So (the China central bank) is doing repurchase agreements. They are cutting reserves. They are doing everything. But it looks like China's GDP growth is already near zero.

The government and its apologists still say China is growing 7 percent a year... Analysts are telling us that smartphone sales are down 4 percent (from last year) in China. Car sales are down 3 percent. How can you grow 7 percent (as China has projected for this year) if all the components of growth are near zero?

Won't the government order banks to keep lending? They are getting almost no return. After having already done too much lending. More lending can't help.

But their Communist Party can't let the banks blow up? I think they will get through it just like Japan got through theirs in 1991, like the U.S. did in 2008: with pain. Workers are protesting in factories, there has been a big increase from last year. 

Republican presidential candidates have blamed Obama's China policy for the stock market drop. I don't think the U.S. can dictate policy in China. We can monitor what's going on over here.

Are American banks in danger like China banks? We don't have a rapid buildup of private debt in the U.S. The Fed reports that business debt, compared to GDP, has been flat. Consumer debt, which had been down, is still flat. Despite student loans and auto loans -- there are problems --

Are commercial, credit card, mortgage loans back up, too? -- No, nothing of such magnitude that it approaches the capital and reserve levels of the lending institutions.

Back in 2008 we created a lot more bad loans than we had capital. But this time the U.S. will be fine. It's China and its partners around the world, that will have a lot more suffering over the next few years.

How will U.S. businesses profit from China's troubles? I think there's a lot of business opportunities. Remember, China is a $10 trillion economy -- but we are a $17 trillion economy, the dominant player in the world.

Things like this show, once again, that relatively speaking we have a more solid, durable system than anyone else in the world.

Does this help America win back trade partners, and bring governments to our side? I think it can be parlyed into beneficial trade, as long as we can refrain from being overly bellicose.

You have urged that the U.S. strengthen business and academic ties in Arab and Muslim countries as a way of isolating terrorist and extremist groups. Is Obama's Iran nuclear treaty an example of how we should try to extend our influence? Regarding Iran, I'm at least a little optimistic. This is a difficult treaty. I don't have particular expertise. I do see that Iran is a country full of talented young people. Their top selling books are medical and engineering texts. Their number-one TV show is Baywatch. It will be a disappointment if we can't make our bad (relations) better.

But that's not what we are hearing from a lot of the presidential candidates, from Senators, from U.S. Sen. Pat Toomey, R-Pa., who you've given money to. They attack the Iran treaty, they say Israel is our only friend there, they sound like they want to drop more bombs... Right now folks are wary of all our entanglements. And the political dialogue is very Manichean (you're either with us or against us). Over the long haul I can't help but be optimistic.

The Wall Street Journal reports there are many Chinese traders in Egypt: while we argued with their past and present governments, their traders move in; they ignore politics and religion, and target the market; noting how Egyptian Muslim women buy separate wardrobes, for husband, family and public, the Chinese sell lots of lingerie --  Right. And while we were building up our military in Afghanistan the Chinese set up mineral extraction programs. 

Where is China headed? Population is one of the really key things to understand in every country. Probably the most fundamental thing. Decelerating propulation growth is not good for GDP growth. Our greatest periods of per capita economic growth came when our population growth was high, such as in th elate 1800s.

China with that one-child policy is tipping toward that period when they will have more retirees than any country in the world. And that is a problem for them.

Look at Japan. Demographics is sometimes wierd... We're hearing stories about the huge number of young people in Japan who won't have sex... About zero population growth. And then zero (economic) growth.

How about your kids' contemporaries, young, privately-educated adults in the U.S.? (Laughs) Well, young people here are having sex. But they are not forming a lot of households at that age here either.

My thesis is that GDP growth is in inverse propoertion to your private-debt-to-GDP ratio. (Low population increase) has a stultifying effect on growth. Once you get past (debt as one and a half times) gross domestic product, we don't have robust growth. We'll just have this kind of sideways growth.

2 or 3 percent GDP growth, people say that's a good year now! That used to be a terrible year. In the 1950s and 60s, private debt to GDP was 50 percent. It's 150 percent now -- three times higher for the size of the economy. I see that as an ongoing suppressant to growth.

Thank you and the credit card and mortgage bankers...  The world is structually different than it was two generations ago.

How do we grow stronger? More babies? More immigrants? If you wanted to do one thing to make a meaningful difference in economic performance in the U.S., you would allow banks to restructure their underwater mortgages. Get a regulatory dispensation.

Politically that won't happen. But I guarantee you growth would jump and household formation accelerate.

The Fed wants to accomplish all that another way: by inflating asset values. But that's not enough. It hasn't really changed people's economic picture. It's just marginal change.

Will China allow its banks to write down a lot of those bad loans? They should! They should preemptively reapitalize the banks. They know how to do that. They did it in 1999. It worked unbelievably well.

Back then their bad (mostly real estate) debt to assets ratio was 30 and 40 percent. For a bank here to have 3 to 4 percent is catastrophic. The China (regulators) rode right through that by rolling (the bad debts) into 'bad banks' and treating (these discounted loans) as 'tangible equity!'

They should also intentionally decelerate (industrial production and business lending), which they are not doing. You have to allow demand to catch up with supply. You can't just keep priming the pump; it's not working.

Countries need to allow the banks to restructure debt with their corporate borrowers, so the borrowers are in better shape to lead the next phase of growth.

Isn't that what bankruptcy is for? Bankruptcy is constrained because it requires (the lender to) take a loss on the bankruptcy.

Paul Volcker had a better idea: He believed you could put that writedown into a special budget and (spread the loss) over, say, 30 years. That is a magic ingredient. He did that (with U.S. banks) in the Latin American debt crisis in the early 1980s. Big (U.S.) banks had made more bad loans to nations, than they had in capital. They were going to fail. It would have been a disaster.

So Volcker said, 'Write it off over a long term, and we'll look the other way.' It worked. Time passed. Earnings restored the banks' capital (faster than old loans had to be written off). They were able to lend (right into the 1980s U.S. economic boom).

Could the Fed get away with such an ad hoc arrangement today? No! It would get tweeted out in 30 seconds. There would be a reaction (in Congress.)

(Later I messaged Vague with a follow-up question): For the Vague solution -- writing down mountains of bad debt, forcing the lenders to take a 'haircut' on debt payments, easing terms so both banks and borrowers can invest in new deals -- that sounds a lot like the surprise media hero of this early presidential race, Donald Trump. Trump's business career has been sustained by bad debt. He's had four bankruptcy restructurings. Whenever he felt he was paying his casino investors too much interest, he just stopped payment and dared them to offer him less. Maybe Trump really is a man of our times.

I'm no fan. But Trump definitely knows and has benefited from restructurings!