The AI Reckoning: When a Trillion-Dollar Bet Meets Rising Rates

0:02David McWilliams: Coming up on the podcast today, we're back to the AI question. You might think, well, why are they coming back to this? I'll tell you why we're coming back to this. It is by far the most important question at the moment. Why? Because literally a trillion dollars have been gambled on AI this year alone. If this thing bursts, all hell's going to break loose. So it's all going to be about AI. Is it overvalued? And finally, we look at what happens if the rate of inflation in the United States and globally remains high, interest rates have to go up, and that exacerbates an already atrophying and unraveling AI story.

0:37So that's all coming up in a couple of minutes.

0:58Just personalized AI for the way we work. That means less time on the work around the work and more time finding the stories worth talking about. Get AI tools for work. Upgrade to Google Workspace with Gemini at go.gle slash workspace with Gemini. That's go.gle slash workspace with Gemini. The holidays bring brand new gadgets, bigger spending, and even more on your to-do list. Good thing Verizon gives you more than just a great network. We give you a whole lineup of products and services, Like a protection plan for your family's home tech that covers everyday mishaps. A credit card that rewards holiday shopping with real savings.

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1:48To understand the economy, you have to understand human nature. This podcast is powered by Acast.

2:00David McWilliams: How you doing there? It's time for the podcast. The podcast goes out to you on the eve of Kilkenomics, where John and I will be on stage on Friday morning at 12 with the great John Byrne Murdoch of the Financial Times. As I've said before, one of the most incisive young writers on all things economics. That will be Kilkenomics. If you're coming down, seek us out, particularly John, go and annoy him. Find him in a bar when he's on his tod, when he's trying to have a pint. Having a little me time. He's looking at his toasted cheese sandwich. He's on his own, particularly if he's got his headphones in, right?

2:39David McWilliams: Which is John singing to the rest of the world, I don't want to talk to you. And what I advise you is go up and tap him on the shoulder and say, hi, and then go up and just blast him with questions. But more importantly, if you are going to go up and talk to John, give him some ideas for the podcast. Simply because after two a week for years and years and years, we're probably running out of things. So this will be like a sort of a crowdsourcing. Never, Mac, never. Crowdsourcing of ideas for podcasts and all some things. Bring my notebook. Yeah, exactly. Bring your notebook. Take the notes. That has us out the door this week.

3:18David McWilliams: and if you're coming down, I hope to see you. And if you're not and you can't get down or you can't get to Ireland if you're outside, put it in your diary for the first weekend of November next year because it is an absolute hoot. In fact, I really think it's the way economics should be digested and explained and discussed with an element of comedy, an element of humour, not taking ourselves too seriously, an element of humility. And if we get a bit too uppity, the comedians can slap us down. I really believe that that's the way economics should be digested and should be consumed. Absolutely. Economics is fun.

3:56David McWilliams: It puts the fun in economics. And as we've said at the top of the show, economics is really more or less the study of humans and human nature, which is by definition, John, quite funny. But today we don't have a funny topic. Today we're trying to make sense of the last two weeks' data coming out of financial markets, coming out of commentary, coming out of artificial intelligence, coming out of signals from the markets that maybe we are in for a massive turn in AI. Now, we've spoken about this before, but what I want to add this particular week is the data that we've seen in the last couple of days and weeks, number one, and number two, the monetary tightening that may well come in the United States because inflation was supposed to be coming down.

4:51Now it's spiking up again. And the question is, does the Federal Reserve stay as a patsy and basically lean into the inflation problem? Or does it actually try and eliminate inflation, bring inflation down to 2 %?

5:07David McWilliams: And what sort of interest rate response would be necessary for inflation to go down to 2%. And if the Federal Reserve tried to bring inflation down to 2%, what would be the impact on AI and financial markets? That, John, is what we're going to be talking about for the next half hour. How are you, Ed? Great. And I have a bunch of questions for that. But can I just start, before we get into that, with a question about an issue that cropped up last week about the ECB. Yes. And you were talking about signals and all the rest there. But Christine Lagarde has announced that she's going to be stepping down early from her post as the president of the ECB.

5:53Chief bottle washer. The chief bottle washer of the ECB, John. So why is she leaving early? What are the implications of that? And who might replace her? Okay, interesting questions, right? And actually, Mac, one last question. is this another crack in the EU?

6:11David McWilliams: By the way, you might have noticed over the last couple of weeks, John is on a buzz, particularly weird buzz. And that buzz is the end of the EU buzz. He's obviously been going down some rabbit holes when I haven't been around with him. And he's definitely, because I've noticed over the last couple of weeks that anytime there's a big issue, you know, France or Germany, and John would say, is this the beginning of the EU, right? So we will discuss all this. He's applied for a job at the Daily Telegraph or the Daily Mail or the Spectator, all three of which are entertaining his CV as we speak for an arch-euroskeptic column saying, is this the end of the EU?

6:49David McWilliams: Okay, I will answer that question. First of all, speaking of the EU, a couple of years ago, I remember saying in the podcast that one of the most bizarre eventualities within the Euro was the fact that Italy and France managed to orchestrate a coup d 'etat against Germany. The Germans went into the Euro being top dogs, being absolutely cemented in their reputation as the best central bankers in Europe. The Italians and the French were regarded as Latins, a little bit loose on money, a little bit loose on budget deficits. And the idea was that a German-dominated European Union and a German-dominated Euro would be a hyper, hyper orthodox institution.

7:36David McWilliams: What has actually happened is something quite different. The Italians, first under Mario Draghi, and then the French, then under Christine Lagarde, orchestrated a coup d 'etat against the Germans. So no longer are the Germans the top dogs. The top dogs are now the Latins, the Spaniards, the Italians, and the French. Okay, that's the first thing. And of course, Christine Lagarde was the French finance minister before this, right? Now, another thing to know about France is that France has always prized having one of their own in the top job, in the IMF, the World Bank, the European Commission, and our ECB.

8:17David McWilliams: It's always been part of French foreign policy to have one of their own there, simply because France believes in and operates through large multilateral institutions better than most countries. That's part of their bureaucratic foreign policy DNA. So Lagarde was one of those. So behind the scenes for all these presidents, right, is a massive, massive bonfire of lobbying, counter-lobbying. And so what happens is typically somebody from the big nations gets the job and they tend to be supported by smaller nations and other big nations and they kind of divvy up the prizes together. I am not too sure who is in the running for the ECB job because I know it sounds weird, John, but it doesn't keep me awake at night, typically, right?

9:10It's all right. I'm awake for you, Mac. You're awake for me.

9:13David McWilliams: Exactly. My resident monetary policy insomniac. But I'll give you one thing. The suspicion is, John, the French election. Right. So Christine Lagarde is an international figure with international pedigree and with name recognition in France. Serious name recognition. Right. There is an outside chance that she could well be parachuted in to liven up the French presidential election in April. which might make sense. Right, that's really interesting. If you begin to say, well, why is she leaving early? Hmm, interesting. There's no other job. She doesn't have another job. It's not as if she's going to be the head of the World Bank.

10:01She's going, you know, there's been no leaks about where she's going next. So watch the space that the Macron centre of France do not have a candidate as of yet. Also, by the time January comes around, all the punch and duty effects of the French pre-election scraps on TV will have basically done their thing. And their thing is to tarnish the reputations of people who have been in the race up until then. If you drop in a surprise candidate very late who actually constitutes a significant change and deviation from Marine Le Pen, is there an opportunity in the first runoff of the French presidential election that that person comes out with a tiny majority over, let's say, Mellinchamp?

11:02So imagine a Lagarde got 13%, Mellinchamp got 12 % in the first round, and let's say Le Pen gets 30%, right? or 35%, even 40%, right? It means there is a runoff because Le Pen hasn't got 50%. And that runoff between Le Pen and Lagarde could be very, very interesting because Lagarde would represent not just the centre, but the business centre, the elite centre, the Paris centre. Would she be very much like Macron in that way, wouldn't she? Very much like Macron, but don't forget that Macron has won the presidency twice. So there is a massive sleeping constituency in France, even if we are focused on riots and extremists and whatever, for that kind of centrist, liberal, status quo, European Union, ECB, big institutions, Gaullist France, all that sort of stuff, maybe elitism.

12:05But my point is, there might be method in this particular announcement, which is with one eye on the French election. So let's have a look at that. That could well be what's going to be playing out. Yeah, that's really interesting. And that makes a lot of sense. It makes sense to me, you know. Otherwise, why didn't you just see out her term? The other thing is, maybe, and this is the other little Byzantine interpretation, maybe she realizes that France is going to need an ECB bailout. And what she doesn't want to be is seen as a French president of the ECB, massaging the ECB, compromising its independence, compromising the euro by basically green lighting a bailout of France and green lighting a bailout of Le Pen ultimately.

12:59So all these things are in the mix.

13:02David McWilliams: So I think, dear listener, never, ever, ever take at face value the utterances of a top bureaucrat and say, oh, I'm going to spend more time with my family or whatever they say, right? But usually it's serious politics. At that level of political altitude, John, one is asphyxiated by the conspiracies, okay? Because conspiracies at that level are always, and have always, a grain of truth in them. So we watched this space with Christine Lagarde. Now, John, as to whether or not it is, as the spectator in England would say, the end of the European project? I'm not sure. I'm not sure. But I'm glad you're on this buzz.

13:49David McWilliams: I really am. I am. I am. I am. Rabbit holes galore. Rabbit holes galore. Exactly. So let's talk about another big issue, another rabbit hole that a lot of people find themselves down is AI, the AI market, the financing of AI, the cracks appearing there, perhaps. Yeah, I think that's much more likely than the cracks appearing in the EU. So what is happening in the last week, the AI story has gone from a technology story to a credit story. And by that I mean, up until very recently, the mainline editorial about AI was, this is an amazing technology that's going to change the world. And as a result of that, no amount of funding is too little because it's going to be so transformative.

14:45Late last week, that story changed to AI is a credit story. Elon Musk himself said that credit markets are closed to anything with an AI affix on the back of it. Musk himself, right? And that is a massive story because it means you've gone from the possibility of the future

15:10David McWilliams: to a pragmatic discussion of the present. Because once you talk about credit, it means you're taking the discussion away from the future and the great technopolis we're changing and the world is going to be completely different. And you're basically saying, okay, how do we make money out of this? So the conversation has gone from technology to credit, which means it's gone from the future to the present. And once you're in the present, John, what you tend to do is you look to the past to say, well, have I seen this before? Have we been here before? Have we been here before? If so, what happened?

15:46And of course, you have now, John, online and in the commentary,

15:50David McWilliams: any number of comparisons, all of which suggest that whether it's the dot-com or the canal mania or the dot-com or the railways, We've spoken about this before. In fact, as a result of this, John, those of you who are watching will see I've been reading one of the classics. One of the classics, which is Charles P. Kindleberger's A History of Financial Crises, Manias, Panics, and Crashes. So it kind of gives away what it says on the tin in terms of what's in the book. But Paul Samuelson, who was one of the great economists, says sometime in the next five years, you may kick yourself for not reading and rereading Kindleberger's classic.

16:35David McWilliams: That is from Samuelson. Another, Peter L. Bernstein, one of the great writers of economics, died a few years ago, wrote a history of gold, wrote a history of speculation. He says, one never picks up a work by Charles Kindleberger without anticipating a feast of entertainment. But underneath the hilarious anecdotes, the elegant epigrams, and the graceful turns of phrase, Kindleberger is deadly serious. So for students of monetary economics, I am picking this up again simply because it gives you a framework to look at what happens during speculative manias, what happens when there's an extraordinary monetary expansion after that, what happens to swindlers, what happens to propagation, contagion, all those things, simply because that is in the ether.

17:23If you look at what was released last week, John, in terms of data, it would make you sit up and worry enormously. So, yeah, so this data that was released last week, what's it telling us? What's it all about?

17:36David McWilliams: The first thing is Antropic. Antropic makes Claude, right? Which is, you know, the large language model that most people say is the best, okay? Or is the most dexterous, the most interesting, right? Their bonds have now been denigrated and degrade to junk bond status. And this is a serious, serious red flag. Can I just stop you there, Mac? Because, you know, junk bonds, this term junk bonds, I'm not sure if I fully understand it. I mean, the only time I came across junk bonds was in The Wolf of Wall Street, when Leonardo DiCaprio was selling them wholesale on the phone to people. It's a brilliant movie, I love it.

18:23David McWilliams: So, John, let's reframe this discussion, this podcast. You are Jonah Hill to my Leo DiCaprio, okay? Yeah. So you're Jonah Hill. The two of us are out of our heads. You're Jonah Hill smoking crack in the telephone box saying, come on, man, do some crack with me. Okay, so you're Jonah Hill. And Leo is selling the junk bonds, right? So junk. Now, when we were young, junk meant bad. I think now in common parlance for young people, your junk means something else, John, but we won't go down that particular road, okay? Right? So junk means kind of shite, right? So it's bad. It's contaminated. It's not good, right?

19:03So a junk bond was something that was really unveiled in the 1980s. If anybody's interested in this stuff, there's a great book called Barbarians at the Gate by Connie... It's an amazing book about a takeover of a company. it was a massive big corporate takeover in America. The junk bonds were pioneered by a guy called Michael Milken. And so junk bonds are bonds which are deaths which is issued by a company. And the junk element of it is that these bonds have a very, very high rate of interest, yield, because they are incredibly risky. And the reason they're incredibly risky is that there's two types of ways of raising money, John, equities and bonds.

19:57Now, in the event of a bankruptcy, equity gets destroyed first because equity is regarded as the least secure form of debt, okay? So if you buy shares in Apple, for example, those shares can go to zero and you have absolutely no recourse. If you buy the bonds, Apple, in terms of a wind down or a bankruptcy, bonds are treated more senior to equity. So there's a chance you'll get your money back. And therefore, bonds tend to be more steady eddy. And junk bonds are bonds that look and feel like equity. By that I mean, you may well get your money back. And that is reflected in the fact that the rate of interest is very high.

20:51Now, the reason the rate of interest is very high is the risk is very high. So there are basically things called investment grade bonds. So you know when you hear AAA and BBB and BBB, right? So the best grade is AAA, which means you get paid very little interest, but your chances of getting paid back are almost 100%. It's only in the event of something really crazy happening do you end up risking your capital. So that is why, for example, the risk-free rate is the American long bond because people still say, you know what, the Americans might do all sorts of stupid things, but they're not going to default on their obligations.

21:28So after that, you've got AA. It's like batteries, John. AAA, AA, single A. And then you have BBB, and the more you go down the hierarchy of bonds, the riskier they become. Now, the reason Antropix bonds have now been degraded to junk is now the market thinks there is a chance that Antropix, this amazing company, right, this new AI company, could end up, if it loses the AI race, go bust. and it might not pay back those bonds. So those bonds have now migrated into this nether region of the playground called the junk region, which is fine if you are a highly speculative individual and you're saying, you know what?

22:19This is when the odds go out on a horse to 40 to 1. You say, fuck it, I'd put down a fiver. Because I'm happy to lose that fiver, but if the nag comes in, I'm away in a hack. But most gamblers will always gamble on the near odds, right? And the near odds are where you're playing the percentage games. You're not looking for the one-off, out-of-this-world moment for the 100-to-1 nag comes in, right? So imagine it's the same way. So junk bonds are migrating toward the 100-to-1. Now, what you're doing is if you put your money in there, you're saying, you know what? I'm one of these types of investors.

22:54I'm grand with the risk, and I'm here. I'm basically playing it for, as the Americans say, shits and giggles, right? And we'll see how things go. Yeah, yeah. But the problem is the people who originally bought those bonds bought them on the assumption that they would be investment grade. So they're beginning to worry, right? That's the first thing. Second thing in the background. Now, why are they worried? Because a lot of people say, well, hold on, Antropic has a huge positive cash flow. It's sitting on a huge amount of cash. It's raised loads of money. But there's a thing called the burn rate, which is the amount of money they're burning through every month.

23:28And people are worried. I don't have the exact figures on the top of my head, but people are worried that they are burning so much cash and we're not seeing a massive, massive return on equity there, a return on investment. So basically what you have is, again, the final, I wouldn't say nail because you can be too hyper about these things, but the final issue is the following, which is that Anthropic have just announced an IPO,

23:57David McWilliams: which is a public floatation of shares. Now, what public floatations of shares are supposed to do is raise money for this new company and give people the opportunity to participate in this new adventure. That's when things are good. Give people the opportunity in the new adventure, but also to offload the risk and debt of the company. Of the original investors. So the question then is, does the market move from saying, you know what, this is a great opportunity to participate. This is going to be fantastic. Saying, hold on a second. Is this a Ponzi scheme that the fellas at the top are trying to get out and stuff me with the worthless paper at the bottom?

24:42And so with Antropic and their bankers, I mean, these are enormous, enormous issues of stock. And number one, there is enormous amount of money at stake. So now what you're in, you're in a sort of a conversation between those people who are trying to sell it, saying it's fantastic, buy it now. And those people are saying, wait a second, all these things don't make sense. So what you find is that the mood music is incredibly important and the mood music has changed. And I'll give you another figure. What happened last week, John? Last week, a half a trillion dollars of value was wiped off what used to be called Google and which is now called Alphabet.

25:26Now, half a trillion dollars. Half a trillion? Even the most inflated Irish GDP number doesn't get up to half a trillion. So that was wiped off the stock in one day. Again. Wow, yeah. And what is happening here is people are reassessing. So you have companies like Meta and Google they were so rich a year ago. They had, because of their ad revenue, they had, in effect, it's used too often as a cliche, but a license to print money. They really did. On Google search and meta advertising. And they're sitting on billions and billions of dollars. And the idea that their balance sheet would ever be in peril seemed really outlandish.

26:18but because they have got in reasonably late to the AI game they are spending more than almost everybody else and people are saying are they burning through all that cash on the speculation that AI will change the world and they will dominate so this is causing people to conclude include as Elon Musk said that the credit market is closing to anything with AI on it. And that means that the world has changed dramatically in the last literally two weeks, John. So Mark, that's anthropic, but they're not alone in this. So like what else is happening in the wider market then?

27:03David McWilliams: I'll tell you what's really happening. This is a total, this is a reassessment of the AI story. Now this doesn't mean it won't reassess again next week or the week after. But the key thing is despite massive investment and all the hype about AI, the technology has, if you look at the American economy, delivered almost zero financial payoff to corporate America outside of tech. So this is a hugely important idea. Revenue per worker is rising within what they call the magnificent seven, but it's flat for the other S &P 493 companies. So the S &P 500 is 500 companies, of which seven are tech and tech dominant, and the rest are banks and electricity companies and utilities and retailers and everything, right?

27:53They're called defensive stocks, etc. So revenue per worker is flat. So this means that the productivity gains that AI is talking about haven't broken out of the Magnificent seven. So profit margins are rising in the magnificent seven, but they're flat for everywhere else. And there's no sign of AI boosting productivity growth in any other area of the American economy other than technology. So with no impact on the bottom line, loads and loads of mainstream corporate American managers are kind of pulling back and saying, yeah, I don't know if we should be spending so much in this AI, we're not seeing the enormous increase in productivity that we were told.

28:36So they're now maybe stopping or having a second look at buying these tokens, these AI tokens. And they're looking at the tokens not so much as a source of growth, but actually as a cost that's weighing down on profit margins. This is the idea of you're migrating from the future to the present. So a lot of managers are saying, well, hold on a second. Right, yeah. So corporate America might think to itself, you know what, I'm not sure we need the latest model of AI, and I'm not sure we should bother paying for it, right? And as long as AI tokens and token spending is confined to a very small part of the American economy, the macroeconomic of AI may be very limited.

29:21So is this one of the characteristics of what Kindleberger is going on about? Like, is this the beginning of the bubble bursting? Is it the Hemingway thing of, at first it's very slowly and then very quickly? This description of bankruptcy. Well, I don't think they're going to... Okay, it's a really good question. I think they're going to go bankrupt. But I think what you're finding now is a totally different conversation around AI to the conversation that we were having about a month ago. And that's interesting. Yeah. And the key thing to appreciate is that people might be just saying, well, you know, AI is a great kind of calculator.

30:04It's very good at adding and subtracting and doing these sort of things. But in business, intelligence is mostly about judgment if you actually think about it, right? So what makes a difference between a really good business and another really good business is the judgment of the managers, the individuals, the entrepreneurs. And that depends on human sensitivity. No matter what model you use, underline it, right? And I think one of the key things is, you know, AI doesn't understand. If you look at business, you know, business is all about trust, culture, ethics, accountability, trade-offs, fairness, your reputation, these things are incredibly important, right?

30:54Because these are the sort of things, these kind of unwritten rules of business that ultimately drive revenue growth and profit margins.

31:05David McWilliams: And if AI is just nothing more than a glorified calculator, so do you remember when we were in school, people introduced calculators, and it was such a cool thing to have a calculator. Remember, people arrive at a calculator and they have calculators on their phones. Remember those things, John? Yeah, yes, they do. Yeah. So if AI is just that, and if the data that shows American non-tech companies aren't getting a massive productivity boost from AI, so it just is a calculator, then all those other things, those soft skills that make up business, because business is about, you know, relationships, it's about friendships, it's about trust, it's about brand, it's about all those things, right?

31:51And the question then is if there is no evidence that revenue growth or margins are improving outside of the tech sector, then people are saying to themselves, well, what's the big deal here? So that I think is a huge dilemma. And the key thing is, John, And once the story changes, it's very hard to change it back. Yeah. So, Mike, in all this kind of mayhem that seems to be going on at the moment, is it the interest rates and our friend Kevin Morish, is he accelerating this process of, you know, bonds going to junk status and all the rest? But before you answer that, let's go and do a bit of this.

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34:13Mark, so we're talking about the AI market going a little bit sour at the moment, particularly the likes of Anthropic and their bonds being reduced to junk status and all the rest. But the question is, is American interest rates and Kevin Warsh, are they accelerating and exacerbating this issue in the AI market?

34:37David McWilliams: This is a really good question, John. It's here we will end because we are to get our Kilkenny's clothes on and head down to Kilkenny very shortly. Our best duds. Exactly, exactly. You're a flyer shit. The question is, John, is Kevin Warsh closer to Paul Vocker than he is to Alan Greenspan? So Paul Vocker came into the Fed in the midst of a Iran war inflation crisis in 1980. The deposition of the Shah, 1979, inflation rates go up through the roof. Paul Vocker comes in as head of the Fed and says, we're going to get rid of interest rates. and they put interest rates up to 20%, which is phenomenal.

35:22David McWilliams: But what it did is it crushed inflation, and that set the, at least the neoliberals would say, set the groundwork for the 1980s boom in economies, right? Question is a little worse to the same, because inflation has been stubbornly above its 2 % target for at least a year now, maybe two. So the 2 % target is where the Fed wants inflation to go. Now, the question is, how high would the rate of interest have to go to bring the rate of inflation down to 2 %? And lots of economists are trying to grapple with this. For my money, it would have to go very high to maybe 6.5 % from 4 % today to crush inflation.

36:09that that would, in effect, be the Fed precipitating a recession in the United States to bring inflation down. Have they got the balls to do this? Would that be worth it?

36:22David McWilliams: Well, they would see that inflation, low inflation, is always and everywhere worth it. That's their sort of central banking creed. But the question then is, John, what happens to the AI bubble if the Fed funds rate goes from four to six and a half? In that situation, all of those investments begin to unravel. And that, I think, is where we are at now. That rather than assume everything's going to be fine and the future's going to be grand and it's going to be hunky-dory, the new dispensation in financial markets, in politics, in finance, in economics, in monetary economics is we could well be at an inflection point.

37:09And that inflection point comes when an overvalued asset smashes into the reality of rising interest rates, which are themselves being driven by a war in Iran, which rising interest rates alone cannot solve. And the fallout is unpleasant in the extreme. So I think on that upbeat note, John, we might leave it there and be back on Tuesday.

37:45Thank you.

38:09and our shared Google Doc, the headline hammer. With Google Workspace with Gemini, Google's AI is built right into the premium versions of tools we already use, like Gmail, Docs, and Sheets. No new tools or extra logins, just personalized AI for the way we work. That means less time on the work around the work and more time finding the stories worth talking about. Get AI tools for work. Upgrade to Google Workspace with Gemini at goo.gle slash workspace with Gemini. That's goo.gle slash workspace with Gemini. Shipping, billing, admin, payroll, marketing. You're managing all the things. So why waste time sending important documents the old-fashioned way?

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