An Interview with Economist Gary Shilling

By Lloyd Graff

Gary Shilling, the noted contrarian economist, predicted the Internet bust in the late 90s, and the recent housing depression. He believes China is at the same point today that Japan was at in the mid-1980s.

LG: Gary, I have watched you numerous times on TV, and you’re always telling us news we don’t want to hear.
GS: Guilty, Your Honor, with an explanation. One of my long held principles is to add value in this trade by finding something out there that’s nowhere else, strange and exotic. In other words, the consensus view of the world in my [opinion] is fully built into business plans and into markets, so rehashing the popular view doesn’t add anything.

LG: I am running this interview in conjunction with our annual survey, which is primarily done with people who are smaller manufacturers in the metalworking field. Tell us what you think will be the effect of this housing downturn or depression in the real world our readers live in.
GS: Of course, it’s housing itself, and there are a lot of manufactured products that go into houses: copper tubing, appliances, hardware, fittings, fixtures, a huge number of manufactured products in construction. Then there’s the bulldozers that prepare the site, the saws and drills and all the hand tools that go into building the house. Our estimates are that we now have two million extra houses in the country. I think within the planning horizon of most manufacturers in this area, they ought to be looking at a pretty subdued picture. That’s only the start, because the next step is the rollout to other consumer spending areas. On average, people have reduced their saving rate a half percent a year, which means their spending has grown a half percent a year faster than their after-tax income.

LG: Do you see the housing disaster spreading across the gamut of the American economy?
GS: I think so, because we’re not only seeing this affect the sub-prime slime, but all of housing, and that’s happening because of the credit crunch. Even the jumbo mortgages, those over $417,000 which cannot be bought by Fannie Mae or Freddie Mac, are affected.

LG: So what’s the good news, Garry?
GS: I think the good news is a lot of Midwest manufacturers have been conservative with their finances. They have strong balance sheets. They have not gone wild on borrowing and expansion. They’re probably better positioned to handle what lies ahead than some
mortgage lender who’s now filing for bankruptcy.

If we’re right that the downturn leads to mild deflation, we’ll probably see 3 percent yields on long Treasuries versus 4.9 percent today, and the shorter rates will be comparably lower. Commodity prices have been run up by two factors. One is global economic strength.
The second one is all these pension funds and balance funds and so on were told that commodities are an investment class, so they invested very heavily in that and pushed up commodity prices. If you look at non-ferrous metals today, in a lot of cases they are selling at twice the cost of reproduction. So I think increasing supply is going to devalue commodity prices tremendously, and that certainly does work to the advantage of users.

LG: Where does China play into this?
GS: China is very interesting. A lot of people think China is the growth engine of the world, and that consumer attitude is what we saw in Japan in the late 80s. That was one of the reasons we then came out with a well publicized forecast that Japan was going to enter a depression, which they literally did, as you know, in the 90s. What we now see with China is what we saw for Japan in the late 80s. If you remember back then, people thought everybody would be working for a Japanese company or run out by one, and that to me was one of the signs that something was going to happen.

LG: I remember Crichton’s book, Rising Sun.
GS: Yeah, you’ve got it. I think China is the same today. Our analysis of China is that, yes, they are industrializing; they’re moving ahead, but there’s a couple factors to consider. One is that their use of a lot of raw materials today is over exaggerated because they’re doing manufacturing that was previously done in a lot of other places – Europe and North America, in particular. In other words, it’s not really net new manufacturing activity. It’s simply moving it to one area of concentration in China, where it’s very visible to everybody. Beyond that, we’re convinced that China does not have a big enough middle-class to sustain domestic growth yet. I think the biggest gain from the industrial revolution was the development of middle-class. Before that the guys on top had infinite wealth and were actually big savers despite their fabulous lifestyles, and the guys on the bottom had nothing; they spent everything but they didn’t have anything. The reason I say the guys on top were big savers is because that was the era of mercantilism; that was the era when everybody wanted to export to everybody else, and what they wanted in return was gold. Japan and now China are marketing to us the same way. They don’t want gold, they’ll take U.S. Treasuries. But it’s the same policy.

Another thing that’s important about China is that they’re building capacity helter-skelter. It takes a lot of steel and cement to build steel and cement plants, and that’s what’s going on there. The government is very aware of this; they’re trying to slow it down. But the
point is when this whole thing breaks, they’re going to end up with a lot of excess capacity and no one needs to build any for quite some time. Direct foreign investment will dry up; exports will be under pressure. I think in a few years or up to a decade China will end up just like Japan did in the 1990s and into this decade.

LG: When is it likely that the Chinese buying to build infrastructure will abate? Do you think it will be after the Olympics?
GS: That’s an interesting point. If we’re right and the U.S. is close to or maybe is already in a recession, I think it will affect China before the ’08 Olympics. Next year things could look pretty dicey. Maybe it won’t really be apparent until after the Summer Olympics, but that would be an added reason for China to take a nose dive.

LG: Do you look at politics as being a part of this?
Yes, a little bit.

LG: Why have things have been quiet politically in China since Tiananmen Square in 1989?
Number one, they’ve got a combination of a free economy and a very highly controlled political structure. Number two, they are trying to look very good going into the Olympics. To cut down on pollution in Beijing today, if your license plate ends in an odd number, you get to drive on Monday, and if it’s even, you get to drive on Tuesday. They’re also trying to keep political dissent down and corruption down by resorting to their age old practice of simply shooting people when they are convicted of corruption. By the way, the family pays for the bullet. It’s a very interesting strategy.

LG: What do you mean?
GS: If a young executive is convicted of embezzlement, he’s executed by shooting him in the back of the head, and they send a bill to the family to pay for the bullet that was used to shoot him.

Another factor of course, is that China has had this rapid growth and rapid growth covers a multitude of sins. They probably need 5 percent or 6 percent growth now just to keep even with the number of people moving from the hinterland to the coastal cities. Their economic growth of 11 percent a year is going a lot beyond that, and the government is concerned, I think rightly so, that it’s building too much excess capacity.

LG: Is the world economy more dependent on Chinese growth than it is on American consumer spending?
GS: No, not at all. I think it’s exactly the reverse. You start with a spendthrift American consumer and the rest of it pretty much unfolds from there. I just don’t see that independent growth. There’s no question that the urbanization of China is an important factor, and all the growth takes place to accommodate the people streaming in from the countryside. But you ask, “What finances that? What allows it to happen?” Again, the prime mover in my estimation is exports directly or indirectly to the U.S. consumer.

LG: In a recent article in the Wall Street Journal they talked about the shift in the U.S. trade deficit from the huge deficit that the United States is currently running to either breaking even, or the U.S. actually running a surplus. Do you think this is a trend? Is this something we should look forward to or be afraid of?
GS: Both, because what’s happening is that the U.S. economy is decelerating, and that means the growth in everything is subdued, including imports. For every 1 percent growth in GDP, imports grow 2 percent to 3 percent. So as the economy grows more slowly, imports are affected with a multiplier. That is happening at the same time that exports are still strong. But that’s only a timing issue, because if we’re right that there’s a usual six-month lag between the U.S. slowing and the rest of the world, then the rest of the world will catch up. It’s not what you would hope. You would hope that the trade gap gets reduced by the rest of the world buying more of what we have on a long-term basis as opposed to us buying less of what they’re selling. But so far, and I think into the next couple of quarters, it’s going to be a matter of softer U.S. growth in imports as opposed to strength abroad.

LG: So if you’re correct and things are potentially going to get as bad as you think they’re going to get, what should we do? Should we sell all of our stocks? Sell our companies? Invest in long-term Treasuries and hide under the bed?
GS: Well, you never want to bet the ranch on any one forecaster’s strategy because there is that slim, remote, infinitesimal, tiny probability I’m dead wrong, and I have been. I would certainly run a business with extreme caution right now.

LG: Do you own your own home? From a strictly rational point of view, do you think it’s smart to own your own home?
GS: I do own my home, but it’s probably not [smart]. My wife and I bought our place in 1968. We raised our four kids there. I’ve got the pride of homeownership. I do everything; clean the gutters, trim the trees, mow the lawn. I’m also a beekeeper. So I’m not rational at all on this. But I think a rational individual, and I know a few who’ve done this in the last couple of years, would sell their house and rent.

LG: Is it difficult to get work when you’re constantly bringing people bad news?
GS: Good question. Obviously what we do doesn’t appeal to everybody, and there’s no question that our clients tend to be people who have similar views. Ours at least are sympathetic or have a very open mind and want to hear all sides. Of course, there are a number of those people around that were able to do well. I’m regularly on CNBC every week on the Larry Kudlow Show, and he always has me debate bulls, and there are people who, in my view, just deny reality and now they’re sucking a lot of wind because they said, “Oh, this sub-prime thing is a tiny confined area.

LG: Are you a positive person?
Oh, I hope so. I’m still alive.

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