AI Deflation: The New Railway Crash?

0:00Big podcast coming up, scary one, it's on debt deflation. AI is going to cause wages and prices to fall. Wages and prices will fall at a time when governments and the private sector have never been in more debt. What does that mean? It means an unwillingness and an inability to pay back debt. We are looking down the barrel, ladies and gentlemen, of debt deflation. Welcome to the 2030s.

0:55and use code audio for 20 % off your first purchase. That's B-O-M-B-A-S dot com and use code audio. Hi, this is Paige from Giggly Squad and today's episode is brought to you by McDonald's. Honestly, Caesar sauce and a Diet Coke at McDonald's might be the perfect girl dinner. And McCrispy strips dipped in Caesar sauce, no notes. Right now at participating McDonald's, the$2.99 Caesar snack wrap is making me rethink my entire go-to order. Caesar sauce is at participating McDonald's for a limited time, so go try it before it's gone. Prices and participation may vary.

1:30David McWilliams: To understand the economy, you have to understand human nature. This podcast is powered by Acast.

1:43How are you doing there? It is time for the podcast. The podcast today is going to be along a similar theme that we have been exploring, extrapolating, interrogating, investing over the last couple of weeks, which is this AI bubble, this AI miracle, this extraordinary transfer in the global economy that is promised and presaged by AI evangelists. Now, that's all well and good. But one of the reasons you listen to this podcast is that we are not particularly evangelical about anything. And we are drawn by a number of truisms. We're a bit wishy-washy. We are watery, John, watery. No, but we are anchored by a number of truisms, which are the lessons of economic history, the application of crowd psychology to markets, and the adage that can be explained by the following statement, which is, when economists see a price, they see a number.

2:51When real people see a price, they get a feeling. And it's that feeling that animates optimism, greed, effervescence, giddiness. And it's that feeling that also animates depression, pessimism, fear, etc. And it's those twin characteristics, optimism and pessimism, greed and fear that drive financial markets. And they particularly drive financial markets at times of great technological change. Why? Because technological change always brings out the speculator rather than the investor, because the speculator is in for a quick book. And a quick book is always much more attractive in life as a general rule than a slow, hard, difficult book.

3:41It's easier to make money gambling than it is working for a living. That's why gambling is so attractive because the money falls out of the sky if you get things right. If you get things wrong, you end up, and you did end up for many, many centuries, in a debtor's prison. Now you end up bankrupt. Well, it also depends on where you get your tips from. I'm just talking about horses there. That's very, very true. and we are not tipsters. So what I want to do is I want to take you on a little journey. The theme of this podcast is that the long-term ramification of AI will be global deflation, as it is always the case when technology changes and shifts gear.

4:24You always get a fall in prices. That's the first thing. The second thing is a fall in prices, such as happened after, for example, the 1873 boom that we touched on last time or a couple of weeks ago can go on for a long, long time. It's called debt deflation. It was highlighted, if you're a real nerd, by fellow co-irving Fisher in a paper, 1933. Google it and get a strong cup of coffee, put on your headphones and get deep into the weeds of debt deflation. But... Sounds like fun. No, it's not bad, John. It's not bad. But at a time, Johnny Boy, when the world has taken on more debt than ever, both public and private, if we are going through a period of deflation, which has been precipitated by a technological shift in the economy, what you have to get is massive, massive defaults on the existing debt, because you cannot pay back debt when prices are falling.

5:28When your wages are falling, when your prices are falling, you can't pay back the debt because your rate of interest will always be higher than your ability to pay, than your income. So I think what we're doing is if we look forward to the 2030s or maybe the second half of this decade, so 2028, 2029, what we're looking at is an AI-inspired deflation which comes up against the reality of enormous debts which have to be paid. And the only likely outcome is going to be significant defaults and the bankruptcy of one or two of the main AI players. Now, this sounds crazy for people to imagine that some of those Silicon Valley companies with buckets of free cash flow and a huge problem could go bust.

6:22But bear with me, bear with me. So I think we're moving into a very, very difficult, different, slightly alarming world. I kind of sat back and I thought to myself, okay, where does all this AI stuff lead us? And where I think it leads us is into a serious, serious escalation of bankruptcies. Yeah. Those bankruptcies will need to wash through the system and therefore the system, i.e. the global financial system, will lead to a massive, massive series of contagious defaults in financial markets, number one. And number two, unlike 2008, where it was assessed that the banking system, because it led through to people's savings and to their housing wealth, and therefore millions of people were affected, the banking system was systemic and the Fed and all the European governments came in to bail it out, it's highly unlikely that the governments will bail out AI tech companies simply because those AI tech companies are not systemic, right?

7:34Yeah. So what we will get is something much more, John, like the railway boom bust of the late 19th century. So that is our framework. And I think it's really important. Now, just you might remember about two weeks ago, I quoted you the day which was Friday, the 9th of May, 1873, which was the day the Viennese stock market began to wobble. And everybody thought, well, you know, Vienna is a sort of a hunky-tonk city. It was a big real estate boom. There was kind of a massive amount of immigration coming in from the rest of Eastman Central Europe. It was basically a city on the lash. So you know what?

8:15If there's an adjustment in financial markets in Vienna, it's not a big deal. Within three months, John, the biggest bank in the United States was bankrupt. Okay? So keep that in mind,

8:29David McWilliams: and we're going to go to the benighted country of South Korea. Right. Why? What's going on in Korea, South Korea, apart from K-pop? I think South Korea could be the canary in the coal mine, which is the trigger that begins this reassessment of the massive risk in AI. And the reason is there have been hundreds of billions of dollars spent in AI, hundreds of billions. The stock prices of AI company and AI chasing companies have gone through the roof, right? And that money needs to be paid back at some stage. Yes. And what people are realizing now is, hold on a second. Yes, AI, like the railways, can change the world, but maybe just not yet.

9:18David McWilliams: And is there too much risk in the system? Have we thrown caution to the wind? Have we believed our own hype? Have we believed the tech bros' hype? Have we believed the banking system's hype? And are we looking at an amazing, unbelievable bubble that is bursting in front of our very eyes. And remember I said that sometimes things happen in one part of the world and because there's contagion and because markets are interrelated and because they're driven by feelings rather than fundamentals, an event in a far off place like South Korea can have a profound effect on the rest of the world. Yeah, I mean, it's a bit like the butterfly wing effect.

10:03Philopsis rings and a hurricane over the other side of the world.

10:05David McWilliams: Imagine the Korean War, right? The Korean War, 1950 to 1953, changed the world. If you had said to people in 1939, there's going to be a war in Korea, and America and Russia are going to be involved, there'll be communists on one side and capitalists on the other, and there'll be the West against the rest, and China will be involved, and we'll be sucked into a war in Korea. People said, that ain't going to happen. But context is everything. and the context of the world had changed between 1938 and 1950. Yes, yeah, yeah. And the context means everything. And right now, the context has changed in South Korea.

10:47So I'll just give you the... Just before you go there, you know, the kind of obvious difference between the railway boom that you referred to and the AI boom is that railways, while AI is a physical thing as well, but railways was, you know, it was an idea that you could see working. It had a very particular purpose. Whereas AI does have a very particular purpose, but its implications haven't been fully worked out yet.

11:16David McWilliams: Well, you know, the interesting thing about the implication of the railways, they haven't been worked out either. So, for example, the railways were a hugely significant part of people's changing perception of time and distance. And this changed culture. It changed art. It changed the way people lived. People began to become much more mechanistic. And mobile, I suppose. As a result of the railways, because railways were all about time and timetables and going from A to B and all sorts of... So I think that your point is right. Railways were a physical thing. And you could see them, and they were trains on a physical thing.

11:56David McWilliams: But my point is that where we are now is the same sort of psychological attachment to the new and to the future and betting and gambling on the future. And this has led to extraordinary changes in financial behavior. And the epicenter of that is South Korea. So let's talk about South Korea. Yes. The Korean stock market, right, has been crashing for a couple of weeks now. But I'll give you the very, very quick and easy story. Around March, South Korean stocks started to go into an epic one-way upward rise, right? The South Korean index went from 5 ,000 to over 9 ,000. So it almost doubled in two months.

12:43David McWilliams: And then a month ago, things started to turn badly wrong. And it's now down at 5 ,500. thousand. So it went up to 9 ,000. Nearly halved. More or less it is halved, right? Now, why is that? Because you can talk about stock markets all you like and all day, but what actually happened in South Korea? Well, not only why did this happen, but why in South Korea as opposed to Wall Street or anywhere else? So this is the thing. The South Koreans have two massive memory stock companies, right? One is called SK Hynix, which you probably haven't heard of. The other is called Samsung, which everybody's heard of, right?

13:23David McWilliams: And what they are, they are both leaders in memory chips. They started out making memory chips for phones, as we know, and then they got into memory chips as a general product. Now, of course, what uses memory chips? Data centers. Yeah. Computer memory is unbelievably important for AI data centers. So the AI data center boom, which has been ongoing for the last 12 months, kicked off this extraordinary boom for memory chips and companies that are in the memory chip game. And only a few companies are at the scale necessary to actually meet the demand for this huge surge in demand for data centers.

14:11And those two companies are located in Korea. So SK Hynix, its profit went in the first quarter of 2025

14:22David McWilliams: to 35 billion in the first quarter of 2026, right? Samsung similarly, Korea's exports of memory chips rose by 70 % in one year. So what you're seeing is a massive, massive bet on memory chips driven by a massive bet on data centers, right? And of course, this led to a huge increase in the value of these two stocks in particular. And as always happens in these situations, once things start to get effervescent, people who are usually on the sidelines get FOMO, right? Yeah, yeah. So what happens is your average taxi driver, your barman, your school teacher, all in the last three or four months in South Korea got sucked into this vortex of, in effect, greed and easy money, right?

15:15David McWilliams: Yeah. And normally, South Koreans have been known as very, very extreme savers. Like most Asians, they've saved a huge amount, and their savings ratios tend to be higher than Europeans and much higher than Americans, which is why they have massive current account surpluses, because, in effect, they export their own money. Yeah. But as always in these booms, something was introduced that changed the game. And it was called, John, a leveraged ETF. So an exchange traded fund. So an exchange traded fund is the following, John. If you wanted to buy, let's say, 100 euros worth of Samsung stocks, an ETF allowed you to put down a tenner, borrow 90.

16:02David McWilliams: And as long as that stock was going up, you could pay back things. So if you bought it for 100 and your borrowing was 90 and the next month it was worth 200, you were flying, right? But the problem with ETFs and leveraged ETFs is they are in effect telling people to borrow money today to buy the stock and you will be able to pay it back next year or next month. And because the stock price has been rising, you'll have no problem paying it back. But if stock prices fall, you end up carrying the can, right? So this is essentially the same thing that happened in the housing crisis in 2001. Exactly the same thing.

16:44So, you know, the banks are just throwing money at people and people are going, great, it's more or less free money and they get leveraged up the yin-yang. And then things collapse and we're all banjacked.

16:57David McWilliams: So that's exactly what happened in Korea. So what you've found now in Korea is that the ordinary Koreans began to get infected with this stock mania, right? And because of the ETFs, now, of course, what happens then in all these cases is swindlers and chancers and spoofers and dealers and brokers come in, and they are very good at sucking money out of gullible people. So all the while, a huge amount of ordinary Koreans got involved in these, in effect, derivatives trading. Now, of course, everything was hunky-dory until about June. And you can never understand why this happened, right? But people start to get nervous.

17:43David McWilliams: They start to think, oh, really? Are these things really worth that much? Right. So people start to sell. And the problem is in leverage situations, liquidity is essential. and liquidity disappeared and the stock prices have been falling. But, John, the key thing is, is this a canary in the coal mine? Is it a harbinger of what was likely to happen in the United States? Because what we know about financial markets is that there is no real cultural difference. So once people get a feeling and that feeling is positive, people all over the world react in the same way. Now the question is, if that is negative, what's going to happen?

18:24Right. Then the question is, if these AI stocks were to fall, what is the net position of the economy after AI? And this is where we come to the deflation argument. And this is then where we come to the debt argument, both of which are enormously consequential for politics, for economics, for finance, for people's careers, for people's lives. capital savings over the course of the next five years. Right. Can I just ask you, just before we go there, what was the role of the South Korean Central Bank? Were they not keeping an eye on this? And, you know, were they not getting worried about the level of debt that people were taking on as individuals?

19:10Well, what we know about central bankers is that they are unbelievably poor at administering and regulating systems. And if there is an outbreak of optimism, central bankers are loathe to do what they should do, which is raise interest rates immediately. And the South Koreans only did that belatedly. Now, in fairness, South Korea had a coup last year. So this is not the most politically stable place in the world, okay? They've already jailed their prime ministers, etc. So they just had their eye off the ball and maybe they were suckered in to the general belief that financial markets know best.

19:52The reason I say this, John, is only this week the new head of the Fed made a statement,

19:59David McWilliams: which basically, he's a guy called Warsh, Kevin Warsh. Yeah, yeah. He basically said the Fed's job is to do nothing and watch financial markets because financial markets know better than the Fed where interest rates are going to go. And he decided to call the Fed a referee. and I'm like, hold on, dude. The Fed is no, as a former central banker, the Fed is not only a player, it's the main player in the game. It's not a fucking referee, right? So just keep that in the back of your head, dear listeners, right? We are in a really strange world, but I want to come back to this fundamental point, right?

20:35The fundamental point is the following, John, is that all technological innovations are deflationary because what drives all technologies is efficiency. And efficiency is only a fancy word for getting more stuff out of less. Yeah, yeah.

20:51David McWilliams: Forefront of every period of technological innovation is falling prices. That's what getting more out of less actually means. Which is generally a good thing. Yeah, as long as your wages don't fall. Yes. Right? But the main price in the market, in any market, in any society, is the price of labor, which is wages. So the whole point of AI is to take humans out of the equation, because not only are robots going to be better at doing this than us, they don't go to sleep, they won't get pissed, they don't fall in love, they won't skive off, they won't have a sick note, the robots will turn up 24-7, they will drive down the cost of doing stuff that humans used to do.

21:33David McWilliams: Yeah. But that means wages for humans fall or in some case disappear. Disappear, yeah. Because if the problem of AI is to replace wage earning humans with robots, the impact is fall in wages. And it'll be much more pronounced than anything we've ever seen. But as most people's income comes from their wages, because most people don't have assets, right? Because of their wages, it means a significant destruction of ordinary people's income. And in terms of debt dynamics, income is the font of solvency. If you don't have any income, you are insolvent, because without income, you can't pay back your debts.

22:13And in a world that is now carrying more debt than ever, the first victim of AI is going to be solvency.

22:20David McWilliams: This is something I don't think people grasp just yet. Well, I think this is the kind of the fundamental fear. I think in general, like us, to a certain extent, we're excited by the possibilities and the promise of AI. But having said that, if one of the main purposes of AI is to drive efficiency and productivity at the cost of wages and employment, well, then that efficiency makes society inefficient in itself. it overpowers and overwhelms services and they become even more efficient. So you kind of got to ask the question, like, what's the point then if you have an unstable society? You are, John, as always, going down the philosophical route, okay?

23:09David McWilliams: Right, but I think, as I said, we said in the last podcast, we're too sober for the philosophy. Yes, yeah, yeah. I think let's stick to the narrow gauge and quite predictable and forecastable financial and economic consequences. because the point of investing enormous amounts in any technology is that you will make and reap enormous profits in the future. Now, profits in the future are a combination of two things. One is increased output, which is what economists call a supply-side deflationary shock, which is what we're seeing. And the other one is reduced wages because you can only, in any unit of output, there are profits and wages.

23:53If the share of profits is rising, because the share of wages

23:58David McWilliams: is falling, these companies may well be very profitable. And that is the bet. But the bet also comes with the caveat that if wages are falling and prices are falling, the ability to pay back the debts that the private and the public sector have incurred, even in the last five years, becomes untenable. And in that context, we can safely predict a financial meltdown, which is quite different to this philosophical and psychological and communal idea. So, let's stick to what we know, right? Okay, so let's have a look at it from that perspective then. You were saying that this has happened before. Give us a few figures as to the parallels that we can draw between what happened in the 19th century and the railway boom and what's happening now.

24:57So the railway boom collapses in the early 1870s. It doesn't mean that railways don't continue to have a massive impact, but it means that the effervescence on railway stocks disappears. There's a hell of a lot of defaults. There's lots of bonds going to default. This is why I think some of those big companies will default eventually. Those Magnificent Seven. Yeah. They have gone from making money to burning money in about five or six quarters. They have gone from extravagant profitability to the evisceration of huge amounts of money. They are possessed by this mania. And I think that always leads to one or two major casualties.

25:46But I'll give you an example. From 1870 and 1900, wages and prices across the globe fell consistently. This is what economists call, as I said just a minute ago, supply-side deflationary shocks. Because prices don't fall because demand falls.

26:03David McWilliams: They fall because we actually get better at making things cheaper. and that period was marked by rapid improvements in key technologies like rail and steel. So the freight rates, the cost of carrying stuff on railways in the United States fell from around three cents a tonne per mile in 1870 to less than one cent in 1900. Right. Massive fall, right? Steel also saw a major boom in output over the same period. American steel production went from 10 ,000 tonnes in 1870 to 1 million tonnes. Think about that. In 1880. That's where you have those, you know, Pennsylvania, Scranton, when Joe Biden talks about being from the Steelers and la la la.

26:48David McWilliams: That's where it comes, right? And 90 % of all that steel went into the railways. So there's a symbiotic relationship between railways and steel. In the same way, there's a symbiotic relationship between data centres and memory chips. It's exactly the same, right? Yeah, yeah, I get that. The price of steel dropped by 50 % from 1867 to 1876. In farming, because of the increased use of steel, meant to increase use of mechanized agriculture, this pushed up yields, pushed down prices. In America, corn sold for 83 cents a bushel in 1881. By 1890, it was 28 cents a bushel. So you can imagine how many farmers went bust.

27:32David McWilliams: Now, of course, Europe was not immune to this. Why? Because the Europeans suffered from huge productivity increases in refrigeration we've talked about before and a significant reduction, transatlantic travel costs, stemming from the same impetus. Huge amount of steel means ships are cheaper. technology, new ways of looking at engines, the beginning of the use away from steam, the use of petrol makes everything cheaper, right? So all this surplus American grain floods into Europe, which massively reduces the income of European farmers in the 1870s, right? For example, the value of agricultural land in Ireland and England fell by 50 % in the 30 years to 1900.

28:24David McWilliams: it. Now what this did, John, this impoverished the landlord class. We in Ireland tend to look at this as the Land League and Parnell and la la la. And we think it was a great national movement. You cannot be seen in isolation of what was happening to the price of land. Price of land was falling because farm incomes were falling. And the reason that the Irish tenants, I think, chose the 1870s to strike at the landlords wasn't that we, the Irish tenants, were very brave and very clever, but it said that landlords were banjoed, right? Because their value of their wealth was based on land. Land's value is always driven by the price of agriculture.

29:06David McWilliams: As the price of agricultural products fell, wheat and corn, et cetera, the landlords went bust. And one of the great things that comes out of landlords going bust was a massive increase in posh British and Anglo-Irish landlords, gentry, marrying American heiresses for large dowries. Right, okay. It was called a cash for coronet deal. Winston Churchill is a product of one such arrangement. Really? This was like a real strategy, was it? Yeah. Let's go get ourselves some dowries. This was the posh Brits and Anglo-Irish decided to turn themselves into a large stud farm for rich Americans. Right. The Americans got the title and the legacy.

29:53David McWilliams: The Brits and the Irish got the loot. This was actually illustrated in Downton Abbey, actually. There you go, John. Yeah, yeah. Downton Abbey, right? I'll give you one Irish example, which is very interesting. Lord Fermoy, John. Fermoy in County Cork. There was a geezer called Lord Fermoy, who was a big Anglo bigwig. The family might even still be there. I don't know. He's going bust. He marries the daughter of an American stockbroker. Her name was Frances Ellen Work. Her dad was an amazingly rich American stockbroker. This couple, Lord Fermoy from Cork and Frances Ellen Work, ended up being the great-grandparents of Princess Diana.

30:34David McWilliams: Oh, right. Which means that they are the direct ancestors of the next king of England. So there you go. Right. Wow. The mad shit you learn on this podcast, John. Okay, so what I'm saying is that marrying rich Americans was an anti-deflationary strategy by posh lads with lovely waxed nostalaches and property in Ireland, which they couldn't afford. And I believe that one of the reasons the Land League emerged, we were told in our history books, because it was all about us and all that, was actually the landlords needed to sell because the price of land was falling and they hadn't got the same resentment towards selling to the local Fenians that they would have had if they were cock of the hoop.

31:19But now they were basically beggars in fancy clothes and they had to either sell to the local Irish people

31:28David McWilliams: or marry a Yank or preferably do both. But to come back to my story... Sorry, hang on back. But are you saying that the Irish landleaguers were fully aware of the goings-ons in the American stock market or the Vienna stock market? Everyone was because we had, for the first time ever, John, we had the cables under the sea which emerged at Valencia Island. You know those cables? Ah, yeah, yeah, yeah, yeah. So in the old days, before the cables, right, before Marconi, and Marconi was all over the west of Ireland, Clifton, Valencia, all those places. Yeah, yeah. It would have taken days or weeks for news to get from America.

32:09Yeah.

32:10David McWilliams: Now it just took minutes. Yeah. So everybody was aware of everything. This was the first real period of globalization. But they were all tapped into it. They were all tapped into it, you know. It changed the world, right? So I know that's a little interesting little detail, but marrying the rich Yanks was an anti-deflationary strategy, right? Mm. I come back to the big issue. So back then, wages and prices fell during a period of relatively modest debts. Yeah. And the reason I say they're relatively modest was the great bond and share price collapse of the early 1870s was the event that reduced the amount of debt because it was reneged on.

32:55David McWilliams: So by the 1890s, there wasn't that much debt in the system. Right. Today, it's a different story. Okay, so just on that point then, if AI is deflationary and wages are going to fall and in some cases disappear, who is going to pay this debt? But before we answer that, let's do a bit of this.

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35:27So, Mac, we're talking about the AI bubble and comparing it to the railway bubble of the 19th century. But like the railway bubble, if AI is deflationary and wages are falling and sometimes disappearing, who is going to pay this massive debt that the world is saddled with at the moment? That's the key question. I don't think anybody's going to pay it. That's why I think we're going into very choppy waters. Jesus, and then what happens then? Global debt, private and public, recently hit a record high of$353 trillion.

36:06David McWilliams: $30 trillion of that has been added in the last year alone. and 60 % of global debt has been incurred by rich countries and the governments of rich countries, which are trying to soften the blow of losing competitiveness to Asia. But we know that borrowing to cover lost income can only last so long because that's not a viable strategy. Of course, of course, yeah. I think the most likely trajectory is that the AI bubble bursts very soon. Some of those big companies go bust. And what is happening in South Korea is a canary in the coal mine. It's a leading indicator. It's a signal that people are getting nervous about AI boosterism.

36:52David McWilliams: When that happens, there will be wealth destruction in the United States because, as we said the other day, a huge amount of American 401k pensions are wrapped up in a concentration of bets on those seven big, magnificent seven companies. In effect, Americans have bet Wall Street or the Wall Street house on Silicon Valley. Thereafter, after that happens, the productivity rises associated with AI ensures that deflation sets in. And also unemployment will rise as AI replaces services jobs just at that time where we have that wealth destruction. So the clerical class, what I would call the lanyards class, John, you know, people who walk around with lanyards.

37:42David McWilliams: You know that type of consultants, lawyers, administrators, the lanyards, right? The corporate lanyard class get eviscerated by AI, which leads, of course, to what? falling tax revenues. And if tax revenues are falling and government debt is rising, nobody pays it. So we get into a debt deflation vortex. And I think, John, that is the most likely short to medium term prognosis, technological, financial, political, and economic, that anyone can honestly arrive at understanding economics, psychology, economic history, financial markets, and most important, as we say always at the top of the show, John, to understand the economy, you have to understand human behavior.

38:42And when human behavior switches from optimism to pessimism, every single assumption goes out the window and you're facing into debt deflation. And I think that's where we are going. When humans go bad.

38:58David McWilliams: When humans go bad. We'll talk to you on Thursday.

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