Understanding Debt and Credit Cycles In Investment Planning
The Catch-22 of the Century | Read as a pdf
“The Credit Cycle is the most important and least understood thing in the markets” – Ray Dalio
With the lowest interest rate environment in 3000 years1, investors are being lulled into complacency. As people look back at how the stock market has performed over the past 6 years, many feel relieved, assuming the “Great Financial Crisis” is finally behind them.
Yet, in the background, there is an undercurrent of concern. While some people look at how expensive financial assets are—and worry about returns going forward—others look at the record stimulus produced by hyperactive central banks and wonder what the side effects of this medicine will ultimately be.
The focus of this paper is on what the credit markets and escalating global debt are telling us. In addition, we will examine the potential consequences that are looming on the horizon today as a result.
The Catch-22 of the Century
The central banks of the world have no doubt pushed us into a corner. There is over $200 trillion worth of debt accumulated in the world currently2, while the global economy hovers around $773 trillion. The catch-22 of the century is this: The central banks of the world must maintain debt friendly policies to protect our highly leveraged economy. However, these same debt friendly policies are what motivate us to pile on more debt!
History would indicate that large debts can create a violent and potentially dire deleveraging cycle. The larger the buildup of debt becomes—and the longer the cycle continues—the more dangerous the deleveraging scenario becomes.
Howard Marks once opined that the seven scariest words in the world for the thoughtful investor were “too much money chasing, too few deals.” Debt growth globally has created $57 trillion4 of “money” since 2007. This has created sky-high prices for most asset classes in the world.
People who view the last eight years of economic growth as “healthy” growth and extrapolate it indefinitely into the future are kidding themselves. Therefore, now is a prudent time to review the dynamics inherent in cycles of credit and debt.
Debt Cycles – The Bridgewater View
Ray Dalio and the team at Bridgewater run the largest hedge fund in the world. They have publicly posted some of their research on debt cycles and have created a 30-minute video explaining their view on how the credit cycle and resulting economy work. I highly encourage you to view it. (www.howtheeconomicmachinworks.com).
Below I have simplified and summarized some of the most important concepts from Dalio’s research.
Dalio argues that the economy is driven by 3 major dynamics:
Productivity – This is our ability to learn and produce more efficiently. Over long periods of time, our productivity growth has increased at about 2% a year. This growth figure fluctuates some, but over time, it has been remarkably constant. And while we are introducing better technology every year, we are also solving increasingly difficult problems—so that these cancel out over the long term and our learning remains relatively constant. Our financial guides and government leaders explain that we are doing things better than before—because we are smarter and have learned from the mistakes of the past.
Short-term debt cycle – The short term debt cycle is associated with a business cycle that runs about 5 to 8 years. Essentially, decision makers get increasingly optimistic which lowers the quality hurdle in order to fund a project. Invariably, their optimism makes them fund bad projects, thereby eventually throwing us into a recession. Debts are then written down, which clears the way for the next growth spurt. One of the key features of the short-term debt cycle is that when we finish one cycle, we have a little more debt than when we started.
Long-term debt cycle– This cycle is not readily noticed by a majority of people because it typically occurs only once in every 75-100 years, when debts are sky high and central banks have already juiced the economy as much as they can. In this instance, because rates are at zero, a recession occurs that cannot be contained—launching deleveraging—a period of time where debts are reduced significantly.
Four Ways to Deleverage or Reduce Debt
Cut spending―This is austerity, where governments, corporations and individuals spend less relative to their income and pay down their debt. This is deflationary.
Write-off debt ― Debts are renegotiated so borrowers owe less, or they default. This is deflationary.
Wealth redistribution ― Wealth is distributed from the haves to the have-nots through taxation. This is deflationary.
Money printing― Central banks print money. This is inflationary.
According to Dalio, these four strategies have been employed in every deleveraging cycle in modern history, including:
- The U.S. in the 1930s
- The U.K. in the 1950s
- Japan in the 1990s
- Spain and Italy in the current decade
The Great Depression is an example of deleveraging that was handled quite poorly. On the other hand, a strategy where positive economic growth (albeit slow) is maintained while governments balance the deflationary forces is called “beautiful deleveraging” by Dalio. By printing the right amount of money, this strategy can enable a country to work off its debt amid a slow, but positive, economy. This, however, is a very difficult task.
More Thoughts on Debt Dynamics
Good and Bad Debt
When a country is building up debt it is critical to assess whether that debt will be helpful or hurtful. I like to do this by organizing new debt into the following categories:
- Productive debt― Productive debt is a concept where you invest in something of value that will increase your income—so that you can repay your debts and earn a profit beyond debt repayment. For instance, if you borrow money to get an M.B.A at a highly prestigious University you will create substantially more debt than you initially began with, but your income should also be significantly higher over your lifetime.
- Unproductive debt― Unproductive debt is where you invest in a project that you think will earn you a higher income, but your projections are too optimistic. In this case, the income earned from the finished project can’t even pay the debt, much less earn a profit. In that circumstance, the borrower often is left with nothing. The lender can often salvage some value, but the difference between the value of the loan and what the lender recovered is lost economic value.
- Consumption debt ― Consumption debt is where you borrow money to spend on consumption. Most consumer credit and credit card purchases, as well as government programs such as food stamps, fall into this category. Here, you’re not even hoping to earn a higher income, but instead are increasing present as well as future costs, through interest.
While consumption debt is quite easy to identify, the difference between productive and unproductive investment is a matter of opinion in the short run. In the long run, as you see the results of a given project, they become crystallized into one of the two categories.
Speed of Debt Growth
It seems intuitive that the faster the debt growth, the more possibility there is for a higher percentage of that debt to be unproductive. After all, it takes careful planning to create a project that will increase future income. Even the most sophisticated and prudent decision makers in an economy often get it wrong. It’s not a stretch to say that during booms, when making money seems easy and prudence is unpopular, a higher percentage of projects being seeded turn out to be unprofitable. There’s an old saying in banking – “The worst loans are made in the best of times and the best loans in the worst of times.”
Law of Diminishing Returns
It also seems logical that – as with everything in the natural world – there is a law of diminishing returns to debt growth. As an economic recovery gets going, there is a lot of ‘low-hanging fruit’ to invest in. As the boom grows older, projects with good returns have already been invested in—and decision makers are stretching to find new projects that are as profitable as the old ones. When a recession hits, it is often the projects funded latest in the previous boom that are the unfortunate example of excesses.
Interest Rates Are a Zero Sum Game
For every borrower, there is a lender. It has been said that one man’s liability is another man’s asset. And although lowering interest rates can result in the short-term stimulation of an economy—as projects on the margin are now deemed profitable with a lower cost to fund them—it amounts to a case of robbing Peter to pay Paul over the long term.
There is about $60 trillion worth of debt in America today5. A 1% fall in interest rates is, very roughly, a $600 billion annual transfer from savers to borrowers. In addition, low interest rates decrease the income for all prospective and current retirees. Of course, lower interest rates help consumers in the area of mortgages. Does a lackluster economy and a hot housing market sound familiar?
Most Money Isn’t Really Money
What we think is money is primarily credit (or debt). As mentioned before, the U.S. economy contains roughly $60 trillion of debt—but how much real money do we have? Since the only entity in the world that’s allowed to create dollars is the Federal Reserve—and they’ve created approximately $4 trillion of actual money5—there is about $15 worth of credit outstanding for every dollar. So, when you hear people say our economy is “leveraged” this is what they mean.
China as a Poster Child of Debt Growth
According to McKinsey Global Institute (MGI), China has grown their debts by the equivalent of $21 trillion since 2007. That is an astonishing number considering that Chinese GDP was $2.7 trillion in 2007. To put that number into perspective—for the U.S. to grow debt as fast as a percentage of starting GDP—we’d have to layer on about $136 trillion over the next eight years! Is it any surprise China’s economy grew with that kind of spending? Is there any doubt that the U.S. could have full employment and grow our economic activity at a supercharged rate over that time?
Of course, if we did that, we'd have to worry about the quality of that growth and what kind of debt hole would have been dug for ourselves. With “growth” that fast, how many projects would fall into the “bad debt” category? If we agree that a command economy is less efficient then a capitalist one, then the odds of efficient capital deployment are even worse in China.
The main counter argument, and one that is undeniably true, is that in 2007 there were a lot of projects in China that fit the category of “low-hanging fruit”. While this is undoubtedly true up to a certain point, everything in nature abides by the law of diminishing returns—and I assure you, dear reader, it applies to Chinese debt growth as well.
The Developed World
In the developed world, there are very few countries where the current path of debt growth is sustainable. Our lack of concern has been reinforced by the fact that we have not had to pay the piper for our profligate ways—not yet.
In many countries like the United States, it is reasonable to think our problems are 10 or more years away. Maybe so, but then again, maybe not. Some countries such as Japan and Greece are facing problems now and swing countries like France and other European periphery countries seem to be on a collision course within the next decade. Remember that in countries like France, there is no desire to make the sacrifices necessary to balance the budget. In France, they call social benefits “les droit aqui” meaning “attained rights”. Time will tell whether those "rights" continue to be seen as such when the federal piggy bank runs dry. As Margaret Thatcher put it, "socialism is a wonderful system until you run out of other people's money."
What Does This Mean for Me?
This debt growth, which has been a strong tail wind, has to turn into a headwind at some point. While timing this with any precision is an exercise in futility—this becomes a powerful argument for being more cautious than you would otherwise be. When a deleveraging starts the tide flowing in the other direction you can expect a severe downward reset in asset prices.
Warren Buffet likes to say “predicting rain doesn’t count, building arks does.” I believe anybody managing a portfolio today should be in the business of building arks. Reinhart and Rogoff wrote a celebrated book on the topic of financial crisis titled, sarcastically, “This Time is Different”. The following quote from this book sums up our topic well.
“Our immersion in the details of crises that have arisen over the past eight centuries—and in data on them—has led us to conclude that the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that “this time is different.” That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation and good policy.” We hope that the weight of evidence provided in this book—which examined more than 200 financial crises in 66 countries over a span of 800 years—will give future policy makers and investors a bit more pause before next they declare, “This time is different.” It almost never is.
- Bank of England’s Andy Haldane
- McKinsey Global Institute
- McKinsey Global Institute
- Federal Reserve Economic Data, St. Louis Fed