RAOUL PAL: Felix, my friend, great to see you.

FELIX ZULAUF: It's my pleasure, and thank you for having me, Raoul.

RAOUL PAL: It's a really complicated world out there. So I wanted to pick your brains and what the hell you think is going on, where we are in this whole phase, because we seem to have restarted an economic cycle straight into a bubble, which is something unusual for us. And so I want to see what you think this is. Is this a bubble? What's really going on? How are you thinking about it? So what are your top level thoughts on this?

FELIX ZULAUF: Well, we have certain signs of a bubble-- excesses in speculation, et cetera-- that is late cycle material. But at the same time, we have the economy that is slowly coming out of a recession and still pretty depressed. So that's certainly not late cycle. So it's a mixed bag.

You have certain industries that are in a deep recession depression, like travel, and restaurants, and events industry, while at the same time you have semiconductors running very hot with all sorts of shortages, et cetera, et cetera. It's a very mixed bag. I think what we are witnessing is really a structural shift in how policymakers are guiding or setting the framework for our system.

I've been a deflationist or disinflationist for most of my life. And I always thought the end game would be a deflationary problem of some sort. And if you had free markets, that would be the most likely outcome. But I think over the years, our policymakers have moved away from free markets. When you think about our system, our system is built on growth. So the system itself needs economic growth to function.

And we have structural factors like demographics that is very bad. Demographics, population growth is the best in the US with half a percent growth, and the trend is declining. In Europe, it's 0.2% growth, trend is declining. Japan is below 0, China is at 0, and the trend is declining everywhere. The labor force is actually shrinking. And when you look at the demographic setup over the next 10 to 15 years, the trend is accelerating downwards.

And as it accelerates downwards, it means that you have less and less population growth. And economic growth is population growth plus productivity growth. And productivity is another problem, because we create ever more zombie companies. And zombie companies reduce productivity growth. The US, the latest statistic I have seen has about 17% of the companies are zombie companies. Europe is at 20% already.

So we won't have the economic growth that we need. Over the last 10 years, central banks tried to create the growth by pushing money-- creating more and more money, cutting interest rates to or even below, and it didn't work. And I think now, the next thing is wherever you go and talk to government officials, the slogan is the great reset, or build back better, or whatever that means.

I think it's the conclusion that the government has to spend more money because the private sector doesn't do it to create growth. So I think we are seeing a shift from a free market economy to a planning economy. And instead of having a free market resolution to the deflationary side, we get a changing shift in how the economy works. We are moving away from a free market economy to a planning economy where the government share keeps growing.

The government share in the US before these pandemic crisis, the lockdown, was about 22%. It is now in the upper 30%. In the EU, the average is 59%. So more than half is government. France is at 64%. Germany, the best, is at 54%. So we are moving into more government type of planning economy. And the bear market and the deflationary collapse you see in freedom.

The individual freedom and corporate freedom will be in an ongoing structural bear market. And that's how they try to save the system. And I think this is what I didn't understand for a long time-- that instead of letting the free markets run into the deflationary washout, they shift the system, they change the system to prevent that. And of course, this means that we will have more government involvement, we will have less efficient economies, we will have less growth, we will have more regulation, we will have more inflation of some sort due to not well-functioning free markets anymore, and things like that.

So we are moving towards what Eastern Europe had for so long. And most of the people alive today in the Western world never experienced that. The Cubans know what that is. The old people in Eastern Europe know what that is. But others do not know what it is. So as a young guy, I traveled to those places, and I saw the queues in front of shops.

A shoe store, they had two models and three sizes for each men and women. And the people were standing up and queuing up just to get a pair of shoes. And if they couldn't use them, they traded them barter for something else and things like that. And you had shortages because it was a planning economy. And that's my biggest fear-- that our children and grandchildren will end up living in a planning economy.

And I think the guys who really didn't see that coming were the guys who initiated that, and those were the central bankers. The central bankers tried to steer the business cycle and smooth it. And by doing that, they structurally weakened our system, pushed it ever deeper into debt, et cetera, et cetera. And here we are, and we cannot let the business cycle work itself out.

And therefore, we have this sort of planning economy situation we are just about to enter. And they are using this pandemic-- the politicians, of course, love it, because they will get more important, they will have more decision power, et cetera. A deflationary outcome is a no-go for any politician who needs to be elected. That's clear.

In a crony capitalist type of economy or planning economy, you can hand out gifts to this and that group, and therefore makes you an important person. And this is what I see is in the early stages of developing. That doesn't mean that equities should be bad investments. They should not necessarily-- they can be very good investments, because we will have plenty of liquidity-- probably more than plenty of liquidity around.

They will provide whatever extra liquidity is needed to keep the system going. And they need high asset prices to keep the system going. The world economy today, GDP is about $90 trillion in size, and risk assets are about $500 trillion in size. So basically, if risk assets decline by 10%, that chops off about roughly 1% of GDP growth.

So therefore, they are afraid of letting the market to run down into a full-blown bear market. And therefore, they are intervening. And that's the world we are seeing structurally. That's the structural change, I believe.

RAOUL PAL: So do you think there's another outcome, which is the other power I've been looking at is the kind of 1940s and '30s with the New Deal. And it actually didn't generate long-lasting inflation, and it actually set off an economic boom. Is it possible that the governments allocate capital in this massive fiscal giveaway in ways that are potentially productive? Or you think it's going to be not productive?

FELIX ZULAUF: Well, I would say my guess would be that probably half will be productive and half will be unproductive and has to be written off over time. I see what you are saying about the 1940s and then entering the 1950s. The difference to that period is that we have a very different demographic setup. You had the baby booms there.

And the baby booms created the population growth on which our economies could thrive and grow. This is just about the opposite what we are seeing right now. So that's why I doubt that's a repeat or a similarity to the 1950s. I see that we had high government debt after the war, et cetera, et cetera, and we had easy money for a while to help overcome the problems. And then the government's brought down the debt levels because of inflation-- they inflated, which worked out very well.

Our governments and central banks have tried to inflate for, what, 20 years? And it doesn't work. It doesn't work. There are some shifts that could bring on inflation in the short run. On a structural basis, I don't think we have a major shift yet because of demographics and the high debt situation also in the private sector. That means the private sector cannot go beyond a certain limit of the debt they take on, because they need to borrow from somebody, and that somebody needs to check their balance sheets.

You have technology that is very disrupting and very deflationary. Of course, you have the movie of the globalization running backwards. And you move more to regionalization, and that will bring on some inflation. The supply chains will be not the more efficient ones, but the ones that are the safest which are in your region. And that makes it more expensive.

In the short period, we have disruptions in shipping. We have shortages of shipping capacity. We have disruptions in some supply chains. We have some disruptions and destruction of supply capacity in some industries. So in the short run, I think we have a setup for a rise in inflation. And we have a change in the behavior of the Chinese companies.

The Chinese companies, like the Japanese companies in the old days, they didn't care about profitability. They cared about market share and conquering the world. And that's what the Chinese companies did. Now, I think the Chinese companies have so weak balance sheets that they need to restore their balance sheets, and they need profits.

And as they need better profits, I think they are going to raise prices. And combined with a declining dollar and rising Asian currencies, you get a swing from constant and chronic import deflation to import inflation. And this gives a swing effect that could carry CPI inflation to 3% this year at some point. I don't know whether that will stick or not. That could only stick if the governments came out very quickly and very soon with infrastructure projects with all sorts of infrastructure and investment type of programs to really create the demand out there.

So far, they are just talking. There is a European recovery fund, and the biggest effect it had so far was a collapse of the Italian government, because they are fighting how to spend those $200 billion they get from the EU. So they do not even know yet how to spend the money. And I think the same is with Biden. The Biden administration wants to move in that direction, but there are no concrete plans yet. We need to see them. And if we don't see them for the next 12 months and we don't get them for the next 12 months, it won't do much good for the economy.

RAOUL PAL: One of the things that I've thought about-- I'm sure you're probably in the same camp as me, because we have very similar macro frameworks-- is in a very highly indebted economy with low productivity, if inflation picks up, it actually acts like a tightening on people. And so I find that these inflationary impulses tend to deflationary waves-- so one of the reasons we see bond yields keep falling over time.

So let's say you're right and inflation picks up to 3% over the course of this year, it probably doesn't increase demand. It's not demand-led inflation. So in fact, it probably reduces demand. What do you think?

FELIX ZULAUF: Yeah, that could very well be. I think the consensus scenario right now is that with the vaccination in place, the economy will normalize, and you have a bounceback of the economy-- 4% growth or whatever the number is-- above-trend growth for a few quarters. That's the consensus view. However, if the vaccination doesn't work as expected and the infection fears stay high, and due to the mutation of the virus, et cetera, et cetera, it may very well be that there is a caveat emptor, and that the economy does not recover, and that the bond yield does not jump up, and that all what they have been talking about and doing about to get the economy moving does not work. Then we have deflationary problems and the deflationary risk. And then I think this will just move forward very quickly infrastructure projects by the government.

RAOUL PAL: Yeah, part of me feels that for them to get these things across the line-- these big fiscal stimuluses-- they actually need another bout of weak economic growth.

FELIX ZULAUF: That could very well be. So the risk is that there could be a window of deflational risks, and they drop in the stock market for a while, particularly by cyclicals-- not by growth stocks, because bond yields would not go up. They would stay low. But I think if that would be the case, I would expect the governments to panic and come up with infrastructure projects very quickly.

Our governments all panicked in a way. The only government that didn't was the Chinese government. They kept calm and quiet. They handled the virus situation relatively well, aside from not letting the world know that something strange was going on. But they handled it very well.

They recovered. They didn't go into a major fiscal push. They actually even tightened monetary policy. They hiked interest rates. It's the only place in the world, major market, where you have positive real returns in the fixed income area. So they've stayed calm. They didn't panic. Our governments all panicked, and many are still in panicky mood, so to speak.

RAOUL PAL: Yeah, because we noticed that split between the Asian economies and the Western economies, where the Asian economies, just because a more compliant society, they were able to get rid of the virus quicker-- just how society acted. And they didn't rack up debt. It's pretty true of South Korea, Taiwan, all of these countries.

The West, on the other hand, as you said, this is unprecedented outside of World War II now. This is the largest budget deficits all of these nations have run. So a, it feels like there's a competitive advantage to Asia coming. We'll come into that in a bit. But I want to think about this debt load now, right? We've got these bloated central bank balance sheets that can never be reduced. And now we've got massive fiscal deficits, and we're about to spend more. How does this play out? It's kind of unprecedented for all of us to look at this and think, OK, what happens?

FELIX ZULAUF: Well, most of the increase in government debt ended up on the balance sheets of the central banks. And central banks, as you know, cannot go bust. That's the first point-- they cannot go bust. And when interest rates and bond yields are as low as they are, you can at some point switch all your bonds you hold on your balance sheet and go and change that into a perpetual. A perpetual has a 1% coupon or a coupon-- doesn't matter much.

So then you save the system. And you save the balance sheet of the central bank. And then you can just build on that again, the next tower of debt in the economy. So the box is pretty deep where there are all sorts of new tricks and gimmicks they can come up with. They want to keep the game going, and I don't blame them. Of course they want to.

They feared cleaning the situation over the last 30 years. And because of that, we have ended up in a situation where we cannot do it anymore. We cannot clean the system and clear the system anymore. All we can do is freeze what we got with the perpetual, for instance, and then go from there and behave as it wouldn't be there, because it doesn't bother you due to low interest rates.

RAOUL PAL: So you kind of issue a massive x trillion perpetual bond at 1%, and then try and run the economy slightly hotter than that. And over time, it diminishes the debt.

FELIX ZULAUF: Yes, and you repeat that a few times so that in 10 years' time, the Fed balance sheet is, instead of $7 trillion, is $40, or $50, or whatever.

RAOUL PAL: So obviously, there is a payback. Nothing comes free. And what is that? That's the devaluation of fiat currency overall? What's your view on the payback for this?

FELIX ZULAUF: Yes. Well, the payback is that you lose more and more. Prosperity goes downhill in such an environment, and you lose an ever-increasing number of your people to the government-- that they have to rely and be supported by the government. So they become victims and prisoners of the government's policies, and the government has to take care of them.

So this is the slow move back to the communist system, in a way. And I think that is the big backdrop. Our prosperity for the broad mass of people goes down, and our freedom goes down, and those are the structural bear markets.

RAOUL PAL: On that topic, there's two other areas. One is coming hand-in-hand with that is going to be regulation-- whether it's regulation of monopolistic enterprises in technology, regulation of oil businesses and polluting industries-- there's a lot of regulation to come in all of this.

FELIX ZULAUF: Absolutely. It's a bull market in regulation-- absolutely. Trump was just a correction in the trend.

RAOUL PAL: Yeah, that's right. It feels like that is going to reduce some of the supernormal profits that many of these businesses have made, because governments are going to come after that, right?

FELIX ZULAUF: Yes. But until they attack, let's say, the social media or things like that, it will take a while, because the politicians need somebody to support them. And they have bought the media-- Germany hands out 250 million to the media, to the print media every year. And Merkel basically bought the media. So the mainstream media has become a loud-speaker for the government's policies basically.

Social media always said, we are free. You can say what you want. That's over. As we know that during the US election, that changed dramatically, and that's over. But I think the politicians will not immediately go after them. That will come some day, but I think that is probably a few years down the road.

RAOUL PAL: And the other pillar of all of this, in government trying to get out of this mess, is obviously a rise in taxes.

FELIX ZULAUF: Yes, of course-- yes, of course. We, Switzerland, we are one of the few countries with a wealth tax. So whatever you own worldwide is taxed. And it depends on the canton where you live how much it is. It varies between about half a percent to 2.2%. But it's very unpleasant in an environment of very low or negative interest rates, because then it really turns into confiscation.

In Switzerland, we have our 10-year bond, the government bond yields, are negative-45 basis points or something like that. And then if you live in Zurich, you have 0.4% wealth tax. So you cannot make it