The Golden Age of Fraud in Finance

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Transcript

Rob Johnson:

Welcome to Economics and Beyond. I’m Rob Johnson, president of the Institute for New Economic Thinking.

I’m here today with an extraordinary man, well, I’ve known back to the days when I worked in finance, but knowing him and being able to keep up with him are different things. This is Jim Chanos, he has his own investment firm, has been involved in the markets now for over 40 years. Recently, he’s been teaching a course, not just recently for the last 13 years he’s been teaching a course called A History of Financial Market Fraud: A Forensic Approach. Jim has written things on the INET website and in many other places related to financial instability. He’s written about China and he is one of the people that when I look at who is successful, independent, high integrity, courageous and practices what he preaches, Jim Chanos fills that bill as well as anyone I’ve encountered. Jim, thank you for being here today.

Jim Chanos:

Well, thank you for that over-the-top introduction Rob, it’s good to be here.

Rob Johnson:

Well, you got to have a bubble before you can have a crash, but we don’t quite have a crash today. But let’s start talking about recently the phrase the golden age of greed. You’ve talked about what you’re observing, what kind of things are happening in the United States and perhaps in the world economy. And with a global financial market it’s not even clear where the sovereigns are sometime. Paint the picture for us, what is the golden age of greed.

Jim Chanos:

It’s actually worse than that, it’s the golden age of fraud. And so I coined that term a couple years ago as I started to see post pandemic the excesses really begin to build in the financial markets, both public and private, culminating in 2021, which was the most speculative year that I’ve experienced in the markets in over 40 years. And one of the things I teach in my class, Rob, is that the fraud cycle follows the business and financial cycle with a lag.

That is the longer you have an expansion, the longer a bull market goes on the more incidents of fraud occurs as it matures. And then of course once things turn down you begin to get fraud exposed, because many frauds are at their basis a Ponzi scheme and need to raise new and new capital. And so the poster child for that obviously is what we saw happen in crypto last year, which was the red hot culmination of speculative frenzy, lack of oversight, lack of law enforcement, and just pure unadulterated greed that got caught up, and then exposed in all kinds of schemes that at their very nature simply Ponzi schemes.

And I think that now we see another aspect of what I teach in the class, and that is when people ask where’s the regulation? Where’s law enforcement? One of the things that is as old as financial markets is that we don’t see oversight or new laws and regulations until after people lose money. And that is certainly now the case in crypto where after the fact we’re going to see much more regulation. As we speak the SEC is cracking down now on both onshore and offshore crypto firms and so on.

It dovetails with what I teach in real time. In fact, last year anecdotally the now infamous interview in Bloomberg with Sam Bankman-Fried was released on a Monday afternoon in April, and I teach my class at Yale on Monday afternoons. And I was reading this while I was having my coffee before class, and I ran up to our audio video guys to ask them if they could put this interview that I was reading on my smartphone up on my PowerPoint for that afternoon’s class. Because it’s very rare that in real time you see an industry luminary discussing his industry by describing it as a Ponzi scheme, which is exactly what SPF did in that interview in late April with Matt Levine and Joe Weisenthal on Bloomberg.

And so it all came together last spring and summer in this particular subspace of the financial markets to prove what we’ve been talking about and what I teach about these cycles of greed and fraud that occur in financial markets when things go too long and oversight becomes lax.

Rob Johnson:

And do you see what you might call a recipe or a vision for a corrective structure of governance, that would diminish these what I call overreaches or these calamities that follow excess?

Jim Chanos:

Yeah, it all depends and I know that’s a weasel answer. But in past cycles where we’ve seen large amounts of speculation and large amounts of fraud the evidence is mixed. So for example, if we just look at the market since the 20th century, after the crash of ‘29 and the resultant amount of fraud that was exposed, and people forget about that. If you look over my right shoulder back there there’s some stock certificates of Ivar Krueger’s firm, the great Match King as written about by Frank Portnoy. And the Securities Acts of ‘33 and ‘34, which came after the crash, was not really about the crash, it was about all the various different pieces of paper that were floated on American investors through state regulatory vehicles and so-called Blue Sky Laws that ended up basically being worthless.

And so that was the real impetus to get the framework for the SEC and the securities laws that we still use today, so there the backlash was tremendous. But if we go to say the global financial crisis, we got Dodd-Frank, but there was a lot that was undone or not done after that wave of fraud and excess that we saw in the residential real estate market. And of course, part of the problem there politically was that lots of everyday people were committing the fraud. People were relying on their mortgage applications and then Wall Street was going in on the lie or looking the other way, or did willful blindness and looked the other way as these things were packaged into leverage securities and then distributed throughout the global financial system.

So it became very, very difficult to prosecute the bad guys when we were all the bad guys. And then you could look at the corporate waves of fraud in the.com era with Enron and WorldCom. And then also go back to the savings and loan crisis where George Bush Sr. put thousands of bankers into jail for simple loan fraud back in 1990 and 1991. So it all depends, we’ve seen pendulum swing where the public gets outraged, loses lots of money and demands change and justice. And then there are other times where the public shrugs and says, “They’re all crooks, what are you going to do?” So we’ll see.

Rob Johnson:

I would guide our audience to look at this or listen to this podcast, it’s a six or seven part series by Alex Gibney and David Sirota called Meltdown. And it was not about the meltdown of the financial markets in 2008, it was a meltdown in the confidence of governance, regulation and expertise that fostered Tea Party, fostered Occupy Wall Street, a Republican house, a Republican senate, and Donald Trump.

Jim Chanos:

Well, and the feeling and that everything was rigged, right?

Rob Johnson:

That’s it.

Jim Chanos:

Rigged on behalf of the rich guy and market participants and not rigged to the detriment of the public. But what’s really crazy, Rob, is that in the 10 to 12 years that followed, that the public decided the way they were going to get even was to speculate themselves in crazy securities in 2020 and 2021. So they started buying crypto, they started buying worthless meme stocks, they started buying SPACs and to get back. And if you get on social media and read what’s in the mindset of these small investors is they want to get back at the man, they want to get back at hedge funds and regulators and the SEC. And not understanding that in fact they’re the ones that are being basically duped again to buy these securities. It’s a remarkable experiment in human psychology.

Rob Johnson:

Yeah, it’s almost a imitation of the person that harmed you. There’s got to be a Freudian term identification with the aggressor I think was the Freudian phrase for replicating the practices of those who abuse you.

Jim Chanos:

I kept pointing out to a number of them on social media during the meme stock crazes, and there’s been a few of them that overpaying for worthless pieces of paper is not going to stick it to the man, it’s going to stick it to your portfolio, and making these statements in the markets can be dangerous. And so it really has become a bit more of the wild wild west and certainly so in 2020 and 2021. And I think we’re going to be paying for that going forward in maybe some unspecified ways.

Rob Johnson:

In the middle of 2021 I was down in Coronado Island for an event celebrating the life of a man that was extraordinary. And one of my friends came up to me and said, “You used to be really interested in all these financial markets.” And he said, “I’ve been making lots of money.” And I said, “I didn’t know you were a financial guy, I thought you were a surfer.” He said, “In these financial markets you get your toes on the nose and you ride the front of the board.” And I said, “Be careful there’s sharks out there with their jaws open.” But it was just a silly thing, he was so enthusiastic, this is June of 2021. And he was very what I’ll call emotionally intoxicated by the momentum.

Jim Chanos:

We’re still seeing the echo chamber of that, option trading is hitting new records. And what has a lot of people like me concerned is that now the volume is all coming in what’s called zero DTE options, zero days to expiration, meaning people are buying options for stock prices on that day that expire. And so this is literally gambling going down and just betting on red and black. And so we’ve really gotten a casino like culture coupled with the equity culture that is a bit frightening in terms of market structure. And again, regulators have kept their hands off this, I don’t want to date myself too much, but if we go back far enough, one of the ideas was that the Fed was supposed to not only take away the punch ball, but was supposed to warn people when things were getting overheated by such indications as raising margin requirements, that are completely quaint and antiquated in today’s markets, but nonetheless would send a message.

And as we know really since Volcker, the Fed and others have had as their third mandate financial market stability and some might say maintenance, and that’s now the unlegislated third mandate for all central banks. And in and of itself after enough years where people get used to that, the so-called Fed Put, it breeds its own instability because people take more risks than they otherwise would, assuming that the government has their back. And every once in a while they find out to their horror and misery like 2002 and ‘08, that it doesn’t necessarily happen that way and so it’s concerning. And then of course we overlay on that the fact that in this golden age of fraud as I’ve called it, we’re seeing all kinds of egregious corporate actions that I think really should be cracked down on an arch. The most prominent when people say, “Well, where is the fraud occurring right now?”

The most prominent is right in front of our faces by the aggressive use of proforma reporting metrics by corporate America. If you look at most corporate reports right now they do not publish at first and foremost and front and center their gap results, they report adjusted metrics. So GE, stogy old GE is a great example of this. GE put its earnings out two weeks ago. And GE had 16 pages of adjustments in its earnings report for the fourth quarter, to get you to the number that they wanted you to get to as to what they thought their profits would be adjusted. Not what they were, what they were adjusted if you take out a bunch of bad stuff. And Silicon Valley has taken this almost to an absurd level. I have companies that are going to report that have 80% of their revenues are share based comp expense, where they’re just issuing stock instead of cash to their employees.

And under the current guise companies add that back to their P&L, they say that’s not an expense. So increasingly, it gets to this equity based world that we’re in, more and more companies, particularly aggressive companies are paying their employees lavishly in stock because they don’t consider it an expense. And the SEC has guidelines on this that it is just not enforcing. And so routinely you’ll hear someone like an Uber or a company like that talk about, “We are now adjusted profitable and this is the first time in 10 years we’re a prof-” And then you look at the financial statements closely and you realize they’re still losing money. And that is to me kind of black is white and white is black. And I think it’s something that the SEC and other regulators should have cracked down on a long time ago. I’d love to report to my partners our investment results without the bad stocks. I’d get thrown in jail if I do that.

Rob Johnson:

Yeah. No, it’s an interesting dilemma to see all these machinations that you can be because of your expertise alert to. We’re also seeing a lot of the public that you mentioned a few minutes ago wanting to catch up, but they don’t have that insight or that equipment. And then you have let us say the large number of people that don’t do much beyond subsistence. And as the despair in all these categories starts to rise in the loss of faith in governance, like you’d said, system is rigged, which was a mantra of Donald Trump’s 2016 campaign.

And I always encourage people to look at the video of the three minute speech that he made on the night of game seven of the World Series, which was the Sunday before the Tuesday election when the Chicago Cubs were striving to overcome. I think they hadn’t won since the early like 1904 or something. And the turnout for those games were huge. He played this ad six or seven times over the course of the game to the national audience, and he kept saying, “The system is rigged and the only people strong enough who could band together to fix it are the American people.” And it was this piece of propaganda that showed Lloyd Blankfein with Hillary Clinton, or Hillary Clinton with Xi Jinping, or George Soros and others in the background, and he’s casting all of this we call discord and them saying, “We’re going to fix it.” And a lot of people bought into that.

Jim Chanos:

The guy who took six or seven of his companies bankrupt, and I was short a number of his securities in the ’90s and the early millennium in the junk bond market and the equity market. And being short Donald Trump’s companies was like watching numerous slow moving ocean liners hitting multiple icebergs for kids. I said that on a fundraiser and President Obama loved that and stole the line. But it’s true, to have Donald Trump give us a lecture on the system being rigged is high comedy in my eye. And that has nothing to do with his other politics, it’s just as an observer of financial markets he was a master of that. And so it really is ironic, but what’s even more frightening as we’ve alluded to is that the outrage of 2009 and 2010, which was Occupy Wall Street and Tea Party as you mentioned, has turned itself into, “Well, I’m just going to go to the casino myself and put it all on red.”

That to me is even more frightening because it’s as if, and someone said this the other day at a meeting I was at, he said, “It’s kind of like the public is that guy at 3:00 AM in the casino at the roulette table with eight or nine drinks in him, and half his stack is gone, but he’s going to be damned if he doesn’t get his money back before he goes to bed. You know he’s going to lose everything.” And I just worry that where this is going to put us politically come the next true bear market where a lot of these small retail investors who are in the market like never before they get wiped out and they’re going to get wiped out. And so I think that that would worry me as an observer of political economy through the lens of finance. And then what will the backlash be? What will people want to do at that point? And so will it be anti Wall Street? Will it be anti-corporate America? Will it be some combination of both? And how will the politicians on both sides of the aisle stoke that fear?

Rob Johnson:

Yes. Well, Martin Wolf, the famous columnist for the Financial Times has just released a book on The Crisis of Capitalist Democracy. And I worked with him quite actively on the book, and we just did a podcast a couple weeks ago that just came out on 7th of February. And he comes from a family, not his mother and father, but relatives who were destroyed by the Nazis. And the ominous sense that he has it’s not even what will the government do, it’s what kind of government will people submit to in the despair, say after the fall down of the markets in the next recession or bubble breaking deeply? And then the last piece I want to add to make this tension even greater is we have the baby boom aging out now and those people with 401ks or whatever, if those all evaporate, given the cost of elder healthcare, what kind of crisis are we going to have when the people who need support money evaporated, and the size of the working age population relative to the retired population is it an all time low? There’s a lot of stress on the horizon.

Jim Chanos:

So two thoughts there. So the first one on Martin Wolf’s book, and I look forward to reading it is that what was really terrifying and what brought forth the ’30s, particularly in Germany and Italy and even Soviet Union was the first crisis of the early ’20s and then amplified by the global crash in ‘29. And so you had in Germany and Italy and of course through Civil War and Soviet Union, you had this horrible wipe out of savings in capital in the early ’20s in Germany through hyperinflation, and in Italy through economic depression and in Soviet Union through civil war.

And then just as things were sort of maybe trying to right themselves, even though politically it polarized those countries, well, certainly Germany and Italy, then you had the crash for ‘29 and ‘32. And that’s what brought Hitler in for example, was the fact that not only did people lose their life savings in the hyperinflation in ‘23, but then everybody hit the breadlines in 1930, ‘31, ‘32. And at that point people said, “I have nothing to lose. I’m going to either vote communist or National Socialist,” and we know what happened. And that’s what worries me is that if this occurs within anyone’s memory of ‘08, ‘09, and then the backlash is going to be I think significant, number one.

Number two, as in terms of 401ks and healthcare costs, I really do think that one of the other aspects of what we’ve seen in the equitization of society and the financialization of society is beyond just the Fed Put in the markets, is now a general sense particularly post pandemic that, “Well, if worse comes to worst, “The government will send me a check, will make me whole, will open up the floodgates and we’ll get national healthcare,” or whatever it might be. And that is the flip side monetarily and inflation deflation side of what happened post pandemic. We now have a belief in light of what the government did to stem the pandemic, what makes people rationally think they won’t open up the floodgates in the next depression or recession.

And probably they will, and that’s fine. But I’m just saying that we now can see a different script from the deflationary 40 years from 1979 to 2020. When I got on Wall Street in 1980 rates were 14% going to zero, and that’s not going to be repeated. And so we saw labor ascended in the late ’70s. I was earning $14 an hour working in a steel mill in Milwaukee, Wisconsin to pay for my college education. And I got all the hours I wanted at night, weekends, holidays because the union workers there were making a lot of money and all had lake homes and whatever. And when I got on Wall Street in 1980 I made more money in two months in the summer of ‘79 working in steel than I made in my first full year on Wall Street. Imagine that today.

Rob Johnson:

Upside down.

Jim Chanos:

That was the peak of labor, that was Thatcher’s election in ‘79 and Reagan in ‘80, and the pendulum has swung back. And now of course it’s all capital and no labor. And if that pendulum swings back the other way, we’ve seen it happen a couple times in American society in the last 150, 200 years, people are going to be wrong-footed. And there will be like we’ve seen when those things change, wholesale societal changes and political changes, so it will be very interesting.

Rob Johnson:

And the movement they now are calling deglobalization may play a role in that.

Jim Chanos:

It might indeed, which gets to our friends in China.

Rob Johnson:

Yes. Well, how would I say people like Branko Milanović and others have made a good point, which is God wasn’t necessarily born in Pittsburgh and Detroit, and the globalization development did create a rising tide for living standards for many, many people on planet earth. But that process perhaps was maturing, but also with some of the breakdowns related to adversarial nationalism and the pandemic and so forth.

Jim Chanos:

I would edit he may not have been born in Detroit or Pittsburgh, but he ended up vacationing in Davos.

Rob Johnson:

Yeah, man, Peter Goodman will have to put that on the jacket of his paperback edition of Davos Man. But I think the sense that I have now is that we are in a what I’ll call an unstable dynamic, and there is all kinds of tension directed at governance. I know a lot of people the other night who said, “The State of the Union Address was brilliant, but can we practice what we preach?” And I said somebody said to me later and it reminded me of your comment moments ago, “Trump preached what he practiced but with a mask.” And Biden has put out something whether it’s dealing with the cost of medical care for elders or financial transparency, he just went through a whole laundry list of things. But the sophisticated people I know are saying, “How is he going to implement that in the world of money politics?”

And I don’t want to fan the flames of cynicism and drive us further towards that authoritarian alternative. And I do myself find myself grateful that the president of the United States did, what you might call shine a light on directions he would like to see us go for better balance, not necessarily every single thing he said, but the thrust of it. But nonetheless, his stepping out like that made me think we really are in a treacherous place, the impetus to his breaking away and making that speech is probably related to concerns of despair within the White House.

Jim Chanos:

I can’t speak to that, I don’t know. But I would say that the inability now… obviously, like most presidents he got whatever legislation he’s going to get through, he got through in the first half of his term and now it’s going to become incredibly difficult with the Republican house. So it has to be via executive action and the regulatory system. And so that’s why you see the initiative about things like junk fees and things like that. But even then it becomes more and more difficult and politicized as we get closer to a presidential election because if the White House does do that, and I think they should in many cases it will be painted as regulatory overreach and big government stomping down on business. And so it’s a tough road to hoe without a doubt politically.

Rob Johnson:

Yeah. Well, as I mentioned Bill Greider used to say, “The Fed is independent,” and he’d say, “their independent from whom?” And now people are saying, “How are we going to protect freedom when the only freedoms that seem to be protected are things like a space program for Elon Musk or Jeff Bezos on his own? And where’s the common good? Where’s the protection of students from the profits of gun makers?”

Jim Chanos:

I’ll go one step further with Tesla, and that’s the company we’re short in the interest of full disclosure.

Rob Johnson:

Sure.

Jim Chanos:

Is NHTSA allowing them to test their full self-driving beta software on roads that you and I are on. Where other automakers legitimately use test tracks and test for years, he’s testing them on our highways. And I think if it was any other company, if it was Toyota doing this, the federal regulatory apparatus would’ve told him to stop it immediately. But because it’s Elon Musk, he gets a pass. And part of that gets back to the equitization of this country and the financialization of this country that I talked about. He’s held up as a hero and Tesla is the most owned stock by retail investors in the world, and so he’s going to get I think special treatment.

Rob Johnson:

I think that’s an interesting hypothesis. I hadn’t thought about that broad-based retail coalition that might be underpinning it, and he can play the common man in the theater of the financial markets now. Wow. Let me reach back a little bit in history. My former wife was the head of Japan analysis in the ’80s for the Federal Reserve under first Volcker and then Greenspan, and we watched that bubble burst and we watched that country aging. And yet when you look at satisfaction in life, you look at surveys, longevity, whatever measures you want, the Japanese didn’t collapse. And I want to contrast that with some of the ominous things that you and I have put on the table. How was Japan and how would I say these are still dynamic things, the downturn could still be tomorrow. But were they able to step aside and have a US-China positive multiplier be the rising tide that raised all boats and sustained them to avoid a crash? Or are there things we can learn from them, so that we don’t you may say fall off to cliff?

Jim Chanos:

Well, one thing that everyone forgets about and the Japan analogy is somewhat apt, but I think it’s more apt as it applies to China than the US. But what everybody forgets about that the 30, 40 years, no, 35 years at this point that Japan has stagnated, is that Japan has had declining population. So it’s flat GDP over that period are up slightly on a per capita basis is actually up in line with the EU and the United States or not far off. So because the country is shrinking, again the way the math works is people really haven’t individually felt it.

And so that’s a really important point people should consider. However, Japan in 1989 at its peak had is eerily similar to China in terms of the economic model. I have a slide in my China deck about this. Japan was heavily an investment driven GDP model although nothing like China. It was at its peak, it was investing about 30% of its GDP in investment. China is in the mid 40s and has been for better part of 15 years, it was investing in greater Asia. Now in China’s case they’re investing internally, but greater China is supporting that in terms of Hong Kong and Singapore and South Korea. It had a basically government driven economic model. If you remember MITI and METI were directing investments by corporate Japan in many cases.

It had an export driven economy with a pretty controlled currency. So there were a lot of similarities between the Japanese economic model of the late ’80s, which was the miracle and the Chinese economic model from say five to 10 years ago when it was still putting up those big numbers. And then the final similarity, which is the most ominous, was Japan had a real estate bubble and had a banking system that peaked out at about 400% of GDP in terms of assets. And now let’s go to China and take a look at what happened in China over that period. So when China entered the WTO in 2001, it had an economy about $1 trillion US in terms of GDP, it had a banking system that was about 1 trillion US in assets.

40% of those assets were bad, they were loans to state-owned enterprises that ultimately had to be worked out over time. They wrote some of them off over time, because they had to recapitalize their banking system in the western financial markets in Hong Kong and New York. And so it took them a while to work that out of their banking system. Fast forward to today, Rob, and China’s economy is about $15 trillion US and assets in their banking system are roughly, well, actually over 60 trillion. So they’re four X, that’s very similar to where Japan was at the peak. It’s very similar to where some of the bad European countries were in oh ‘07, ‘08 like Ireland and Spain and Iceland.

And so you start to get up to a banking system that’s four or five times the size of your economy, and it’s the banking system tail that wags the economic dog. And how does this happen? Well, it almost always happens because of real estate, which is a leveraged asset class. I joke that Chinese apartment prices are the second most important price you got to know other than US treasury rates, because it’s roughly a quarter of China’s GDP is residential real estate. And China is still building 20 million flats a year even though it doesn’t need them.

Rob Johnson:

And a declining population.

Jim Chanos:

And China, I’ve joked long that China’s the only advanced country that knows its annual GDP on January one of that year.

Rob Johnson:

They can preset it.

Jim Chanos:

Well, and legally, and it’s an accounting identification. If half of your economy’s investment you could literally direct investment to make a GDP number if you never write off the bad investments.

Rob Johnson:

But I guess what you’re saying in a dynamic sense, these buildings or what you might call excess apartments don’t add to productivity and therefore income to service that growth in the balance sheets of the banks or the financial institutions. So if they were investing in productivity enhancing resources, human capital or physical capital or whatever, you might have a more optimistic sense.

Jim Chanos:

Which they were in the Deng Xiaoping reforms after Tiananmen Square and even in the first 10 years of the new millennium after they entered the WTO. It wasn’t until after the GFC that this went crazy. And we’ve seen this massive increase in banking assets and apartments and apartment loans driving GDP and a lot of it was government driven, they needed to make numbers. The way the communist party worked was the local party was set targets by the National Party, you need to grow seven or 8% this year. Well, what’s the easiest way to grow seven or 8%? Stick a shovel in the ground. Now the problem with this is that you can’t segue into a consumer driven services economy, which is what most modern economies are because you remember your macroeconomics, Rob, S equals I. So the fact that if you’re going to invest 46% of your economy every year, you’ve got to save 46%.

And thus the problem, the segue to a consumer driven economy will create speed bumps, the like of which no Chinese premier wants to encounter. And every time that they try to reign this in, and they’ve tried three times since I’ve been following China closely in ‘09, three times they’ve tried to hit the brakes and all three times they’ve let up and hit the accelerator again. Because the economy immediately goes into stall speed and they panic, and I’ve called it the treadmill to hell, they can’t get off it, and there’s no other playbook. And so the inevitable reset is going to happen, it’s just a matter of when and from what level.

Where Japan hit this reset in ‘89, and Japan’s alternative is to muddle through for 40 years with no growth. I don’t know if China has the cohesion internally and politically and they might to do that. And that is either that or you’re going to have to face a severe downturn, clean out the system, clean out the bad debts and start over. I don’t know if they have the stomach to do that. And/or if they don’t try to find foreign adventures to offset that risk starting 2019 in Hong Kong, now the Sabre-rattling over Taiwan and that’s always a possible response policy-wise as well.

Rob Johnson:

Ominous for all parts particularly with an end game of nuclear threat. It’s interesting to me I spent a lot of time going back to the time of Tiananmen Square in China. And I remember there was a place probably around 2012 where a lot of professors at universities were saying to me, “We had this old model where you’d run around the country say the equivalent of high school students and test who are the best and the brightest. You bring them in and teach them to be the government.” But now in the advent of the digital age there’s a whole lot of what I’ll call private sector potential. And there are a lot more people who want their children educated, whether it’s in engineering or skills, the three Rs or what have you.

And these professors were talking to me about their frustration that the economics of the support for the universities by the state wasn’t what I will call working to upgrade human capital where all the potential lied. And they said, “We’ve had a lot of people migrate from the farms to the cities, and they work many times with their hands. Then they moved in manufacturing in the beginning, then they’ve moved to construction of infrastructure and construction of real estate, but we’re not building the human capital.” And I think just to conclude that vision, the way in which Jack Ma has been dethroned is sending a very negative signal about technology is creating what I’ll call freedom and independence that maybe the government doesn’t want the society to inhabit.

Jim Chanos:

Well, as we know from our own wrestling with big tech, big tech becomes a power center literally in and of itself. And that’s the one thing the Chinese Communist Party won’t broach, it won’t broach any political power by a new power base. Technology, entrepreneurs, big technology companies like Alibaba, Baidu, Tencent and so that’s why we saw that. Those companies and those executives were getting fabulously wealthy, and that became a political threat that the CCP was just not going to tolerate, so that’s number one. Number two, it’s coincided with the deglobalization as you’ve called it, and a little bit more hard-headed look at Chinese technology through the national security lens. And whether or not we want Huawei equipment or TikTok on our phones, and so increasingly that’s going to be an issue. And so it’s tough because the Chinese labor market having gotten wealthier has priced itself out of making sofas and bicycles and things like that.

Those are made elsewhere for Walmart. And really they were supposed to go up the value chain through technology and more advanced products, but with this deglobalization trend that’s going to be more problematic for China. And so they have a series of issues on their table that are not pleasant and alternatives that aren’t that pleasant right now. And that’s what makes me worry a little bit about the Sabre-rattling, because one of the classic misdirections for any authoritarian government is to set up enemies outside the border, that’s the cause of our problem not our own policies.

Rob Johnson:

And I know my friend Orville Schell, who’s spent a lot of time studying China, and he wrote a book with the John Delury called Wealth and Power. And it was about what he saw as a coming crisis between the US and China, they call the Century of Humiliation from the opium wars through the Japanese invasion. The idea that China has to what you might call regain its stature at the head table is very powerful. At the same time you have the United States leading a Western system doesn’t want to be a partner, it wants to be the captain. And the United States comes from what I’ll call a Cartesian enlightenment system, the Daoist, Confucius… the Eastern philosophy. In China it means that it’s quite possible for the two sides to misunderstand each other, because they make projections from their own imaginative mindset onto the other that Zbigniew Brzeziński talked about this a great deal in 2010 and ‘11 that it was going to be very hard to have a G20.

But as this distrust is reinforced by what you might call a stammering or sputtering economy and discord within both the United States and China, that Bismarck recipe, find something that you can dislike outside and unify the people behind you. As a matter of fact one of the other teachers at Yale, Stephen Roach, formerly at Morgan Stanley, I did a podcast with him a couple of months ago about his new book on these questions. And I read something by Chas Freeman last week about what you might call a lose-lose framework, unnecessary losses that might be on the horizon.

Jim Chanos:

But don’t underestimate also the fury that China has toward our ally Japan who’s announced a rearmament program.

Rob Johnson:

Yes.

Jim Chanos:

Because for whatever differences between west and east there are in philosophies and the ability to misunderstand each other in any kind of policy square off, there is just outright hatred in China for the Japanese, much of it legitimate I might add for what happened in World War II. And we forget that there was a massive land war while we were fighting our way across the Pacific via our Navy and Marines. There was a massive land war going on in China between the Japanese army and the Chinese army replete with many of the atrocities we saw from the Third Reich. And so that has not been forgotten in China, I can assure you. And so the fact that Japan is now embarked upon a new policy to re-arm itself is raising strategic issues in Beijing, that heretofore it didn’t worry that much about, it worried about the US. But a re-armed Japan is a different animal in the Pacific. So it’s something they talk about a lot more than we do, obviously.

Rob Johnson:

Yes. And it’s hard to figure for me what the Chinese government thought it was doing in siding with Russia when so many of their trading partners are on the other side. I’ve wondered if that decision, while it’s a way of showing how do say beating your breast or stiffing your spine in some simple way, if it’s not going to exacerbate the economic stresses because the Australias, the EU and others are going to step back themselves.

Jim Chanos:

Well, keep in mind that Xi Jinping the first thing he did when he became the leader back in 2013 was given a speech about the weakness of the Soviet Union in allowing Perestroika, and how it was one of the biggest disasters of the 20th century was the fall of the Soviet Union. And there’s actually an institute for the study of the fall of the Soviet Union in China. But perhaps more interestingly and ominously remember that the only major foreign leader that attended the Sochi Winter Olympics that were Putin’s showcase was Xi Jinping, and this was well before the Ukrainian invasion. So there has been a growing warmth between Russia and China I think because of shared interests against the west for a while now.

Rob Johnson:

Yes, I think that’s right. In my own work when I was running the Quantum Emerging Growth Fund, I used to ride around all of these countries in emerging Asia and read their novels and watch their movies. And seeing from that how we say I like to read the analyst reports, but I also like to get the kind of what you might call the cultural vibe that’s coming forward. And one of the things that haunted me in recent years was the movie Wolf Warrior 2, which absolutely characterized China as the savior of the global south from the global north of it led by America, but America and Europe oppressors.

And all kinds of things including the national museum exhibit in China were emphasizing more and more and more what you might call pride on their side and defiance. And it feels to me like at a very subtle level, but that’s now accelerated that these tensions that Orville Schell and you and others have foreseen, are quite ominous, they’re really coming to the surface. What would you do if the president called you in tomorrow and said, “What do we got to do to take the steam out of this? How do we come back to a win-win situation?”

Jim Chanos:

Well, it’s tough because we have one major obviously issue sitting there right in the South China Sea called Taiwan. And Taiwan is important not just because we have backed Taiwan, but because Taiwan along with South Korea and to a lesser extent Japan is the center of the most important commodity in the global economy right now, which is semiconductor chips. Semiconductor chips are to the economy today what oil was to the global economy in the ’70s and ‘80. And it’s crucial that we keep that supply going now we are trying to build up domestic production, but if there were to be a shooting war in Taiwan and or Korea that would disrupt the global chip supplies. It would make the pandemic look like child’s play in terms of how quick everything would collapse and so that’s a problem. And I think that first and foremost, I think the West needs to buy time to deglobalize in effect and onshore the importance of semiconductor chips that are essential to our economy, that’s number one.

So Taiwan is everything and how you diffuse that, I don’t know, because the rhetoric is getting more and more bellicose. What if China does a naval blockade around it? What do we do? There’s lots of scenarios that are at pay grades above my level, that I’m sure the national security apparatus is trying to think through. As it relates to financial and economic policy China has got the best of all worlds with access to Western financial markets without being a full participant. One of the things I rail about in finance is the Chinese VIE structure, for example, which has enabled companies like Alibaba and others to raise billions of dollars in the West in what’s basically a fraudulent structure, governance structure. The Chinese courts do not recognize the VIE structure and for the listener and the viewer, what it means is that Western investors cannot own the corporate assets inside of China by law for the most part, there’s some exceptions.

But Elon Musk, for example, owns his plant in Shanghai, so go figure. But for the most part you and I can’t own Alibaba’s actual assets within the People’s Republic. So what they’ve done is they set up this artifice where they set up a holding company in the Caribbean, in the British Virgin Islands or Cayman Islands, and you can buy the stocks and bonds of that holding company. The only asset you have is a piece of paper in a safe in the British Virgin Islands that says you will share in the economics of this enterprise in some unspecified way going forward proportionate to your ownership, but it doesn’t really mean anything legally in China.

So to the extent that something happens in China to those corporate assets you have no recourse, the Chinese courts won’t recognize you. So for example, years and years ago when Yahoo and SoftBank owned a piece of Alibaba, and one day they woke up and they found out that the financial arm of Alibaba had been stripped, and sold to a group of affiliates of Jack Ma for a bargain price. And the company said, “Well, the Chinese regulators told us we can’t have Western indirect investors in financial services, so we had to do this.”

Well, to this day they’ve never told people or shown those people what those regulations were or what the order was. And the Western investors in Alibaba were left holding the bag with no recourse. And so this is the problem that they have access to our financial markets, but we have no governance on their companies. So all these kinds of things are going to play into any future increasing level of conflict with China. Obviously, I tell my clients to be as disassociated with China as you possibly can in any case because the risks aren’t worth the rewards.

Rob Johnson:

It is interesting to me, I’m thinking about directions of innovation. When Silicon Valley starts and it starts moving towards China, but not just the plants for assembly but the use of, I don’t know, things like smartphones or laptops or what have you, you can see the benefit to the consumer. Then I remember meeting with Chinese leaders who said a little bit like the movie that Tristan Harris and others made The Social Dilemma, you are the product. And they started saying, “Okay, these are platforms for commerce, but they’re also data sets for intelligence. And we got to figure out how those are governed, how those are blended.” But what I’m seeing now is there are things, for instance, some of the things Huawei’s created with the 5G stuff and so on, that the direction of this tension has reversed. Now, some of those things could be deployed in the continental United States, but is it opening a window to espionage and surveillance on the part of the Chinese?

Jim Chanos:

Well, look at just two big examples. TikTok, which is owned by a Chinese company, which is now one of the largest social media platforms. And of course we’re not on it right now, but Zoom, how many Zoom calls have you been on since the pandemic?

Rob Johnson:

I don’t have enough fingers and toes to count, over and over and over again,

Jim Chanos:

A lot of those calls get routed through China, through Chinese servers, so it’s interconnected in many ways. And these are all issues that people are thinking about in terms of the deglobalization and our interconnectedness with China as you point out.

Rob Johnson:

But what I’m alluding to is there are potential losses for the wellbeing enlists, what you might call a technological firm an American can imitate those things and put them into the marketplace very quickly. The source of all innovation in the early Silicon Valley days was largely the United States. Now the source of innovation is more what you might call is more spread around a little bit what happened with the auto industry, where Japan and Korea started to take the lead in some respects.

Jim Chanos:

The good news is that like Japan the Chinese financial situation is probably not a huge contagion risk. Unlike the US and EU financial situation in the global financial crisis where we were all interconnected and lending to each other, and distributing highly leveraged products to West German Landesbanks and Norwegian pension funds, that’s not the case by and large with the real estate debt in China, that’s held on the Chinese banking system for the most part. There’s some bonds that are held offshore, but for the most part the contagion risk is like Japan it’s basically centralized in their banking system. So they can deal with it internally by flooding their own economy with currency, but there’s not as much a transmission risk as there was in ‘08 between Western banks.

Rob Johnson:

Well, Jim, I remember I just wanted to, how do I say take our audience on a broader voyage. They can look at your reading lists and so forth vis-a-vis Yale and your course. I listened to a podcast with an Irishman, I think his name was David McWilliams that you did recently that explored some of the things we have, but other dimensions also quite vivid. And I particularly want to encourage our young scholars to engage in following your writings and your interviews and so forth, and think about the financial markets with the what you might call depth and breadth that you do. Because there’s a whole lot of pressure to just be a member until like you’ve said several times until the boat goes over the waterfall and then you find out you got hoodwinked again. We all have to take responsibility for not getting hoodwinked, and you’re about as good at smelling a rat and also seeing the prize as any financier I’ve ever met.

Jim Chanos:

Well, thank you, Rob.

Rob Johnson:

Thank you for being here today. And I look forward to another episode and how would I say in guiding our young people, Young Scholars Initiative to learn from your example and from your ranks.

Jim Chanos:

My pleasure.

Rob Johnson:

And check out more from the Institute for New Economic Thinking at ineteconomics.org. (singing)