GMR 140: How to Avoiding the Next Economic Downturn
Wouldn't it be great if you could predict economic cycles? Knowing when markets will go up or down would be advantageous to investing and protecting our assets. Understanding what causes economic cycles will not only make you better at investing, it will help you avoid financial pitfalls. In this episode of GMR, we discuss how long-term debt cycles occur and what you can do to ensure you don’t get caught up in one.
Show Notes
3 Forces that impact the economy
Productivity Growth
Short term debt cycles
Long-term debt cycles
The short-term debt cycle happens over and over for decades.
When credit available, there’s an expansion.
When credit is unavailable, there’s a recession.
This is controlled by the central bank and human behavior.
The problem is human nature drives people to push it! They have an inclination to borrow and spend more than do paying down debt.
They see that things are going well (focused on the now) and ignoring the rising debt (goes for individuals, companies, and government).
As long as income rises, debt is manageable.
At the same time, asset values increase, and people buy more of them, so they go up even more (this is economic expansion - growing economy).
Increased incomes and increased assets make people creditworthy.
However, debt is increasing, which is a problem.
Debt burdens rise over several decades, causing the debt repayments to be higher and higher, which focuses people on cutting spending.
Remember - One person’s spending is another person’s income.
As income goes down, people become less creditworthy, which causes borrowing to go down.
Debt repayments continue to rise, which makes spending drop even further.
This is the long-term cycle debt peak, which leads to deleveraging.
In deleveraging, people cut spending; incomes fall, credit disappears, assets fall, banks get squeezed, the stock market crashes, social tensions rise, and the whole cycle rushes in the opposite direction, downward.
Difference between recession and deleveraging
Recession can be controlled by lowering the interest rate.
In deleveraging, interest rates are already low and can’t be lowered more to stimulate the economy (spending through borrowing).
1930 & 2008 were seasons of deleveraging.
The borrower’s debt burden has gotten too big.
Lenders realize the debt is too large to ever be paid back fully.
Borrowers have lost the ability to repay, and their assets have lost value. They are squeezed and can’t pay their debts. For the first time, they don’t want to borrow.
Lenders stop lending and borrowers stop borrowing, bringing the economy lower.
The short-term debt cycle deleveraging can be triggered early by bubbles in certain parts of the economy, like the sub-prime mortgage loan bubble that leads to the 2008 recession. This was already a ripe time period for deleveraging, but the housing bubble popping caused an ugly deleveraging for the economy.
Deleveraging
Cut spending
Good because there’s less spending, through borrowing and
Bad because less spending = less income
Reduce debt
When people can’t pay their debt, defaults can happen on multiple levels (individuals, businesses, banks).
This leads to depression - when people discover that what they own (asset) isn't really worth anything.
Debt restructuring ( a way to save some for the asset value) - even though the debt is reduced, it causes income and asset values to disappear faster. The debt burden gets worse.
Lower incomes and less employment mean fewer government taxes while they need more money to support the unemployed.
Deficits explode as they spend more than they are collecting.
Redistribute wealth - from the haves to the have nots through taxes.
Raise taxes on the rich
Social disorder can happen that can be extreme.
This can lead to political change that can be extreme—Germany in the 1920s.
Print money
With interest at 0%, Central Bank begins printing money
The government can buy financial assets and government bonds
Which is inflationary, makes asset prices go up
The government spends on goods and services and unemployment and other programs.
The government can only spend money but can not print money.
The Government and the Central Bank need to cooperate in using the 3 deflationary methods (cut spending, reduce debt, and redistribute wealth) with the 1 inflationary method (printing money) to create a balance, leading to beautiful deleveraging.
Three Rules of Thumb - good for you and for policymakers
Don’t have debt rise faster than income - it will eventually crush you.
Don’t have income rise faster than productivity - you’ll become uncompetitive.
Do all you can to raise your productivity - this is what matters most in the long run.