Was riding high up on stocks up to 2015, and why did I sold most of my stocks back then and went into hibernation. Or perhaps, I say focus on the most important things in my life aside from money back then until recently when I am back to the blogosphere again.
One of the key reasons for me to abandon most of stocks and keep metals and cash is due to the study and in depth engross study of the Global Financial System and its history. Partly also attributed to Ray Dalio.
Below are articles I written after listen / read about Ray’s explanation of the Global Financial System. Of course there are others like Jim Rogers, Mike Maloney who also influenced my thinking back then.
In this article, I will copy and paste back what I wrote in 2015 to let readers understand what are stages of post Deflation (or post – crisis) in today’s situation.
It will normally not go straight to Depression in a crisis. In fact, to me, 2008 GFC is already the trigger point to possible Depression. I am not saying that 2020 will be Depression, but I am saying we are heading towards that path. It can be 2030, nobody knows, but the trend is always the same:
– Crisis, lower interest, QE (create money out of nothing), Helicopter Money, Inflation, Hyperinflation -> Depression.
Depression is what Ray Dalio described as Long Term Debt cycles. And the 7-10 years crisis are Short Term debt cycles.
Using Ray Dalio’s concept to explain
To understand Dalio’s economic machine, it is paramount to first understand the three main forces of the economy.
1) Productivity 2) Short-term debt cycles 3) Long-term cycle
The economic machine model explains that many transactions make up a market, and multiple markets form an economy. In a transaction, one person’s spending is another person’s income. You can spend either by cash or credit. If you spend by credit, then the lender has an asset and the borrower has a liability. If the credit is repaid, the transaction is settled.
Without credit, an economy can only improve when productivity grows i.e. GDP growth over time is almost linear as shown in the chart above. Productivity growth means, we can produce more output (goods and services) in an economy for the same input. For e.g. it can be due to technology, more efficient systems, or people becoming more savvy or hardworking etc to raise productivity. Now you know why Singapore government advocates Singaporeans to raise their productivity.
When there is credit, the economy creates what we Dalio described as the short-term and long-term debt cycles. The short-term debt cycles normally happens once in every 5-8 years. It is also known as business cycles. During the short-term debt cycles, government can use monetary policy such as interest rates, money supply (or printing money a.k.a Quantitative easing) to inject the economy.
During the GFC, Fed lowers interest rate to zero percent to stimulate the economy. People and businesses can borrow more, so spending increase. And because one’s spending is another person income, income also increased. Imagine you are earning 100k and can borrow 10% of income i.e. 10k. Now you can spend 110k. It means another person who is earning 110k can borrow 11k. He can then spend 121k. This effect spirals up and spending grows, hence economy improves. On the contrary if the spending becomes higher than income growth, there will be inflation and central bank will increase interest rate to deter spending and the spiral goes in the opposite direction.
This normally takes place once in every 50-75 years or more. The last one was seen in 1929-30 during the great depression that causes a “lost decade”, before WWII set in.
In a zero rate environment like today, debts are mounting in many countries. Today there are a lot more debts than actual money in the US economy. US owed more than US$16 trillions and has a Debt to GDP ratio of 300% or more.
So why bother about the increased debts? Just keep interest rate low and ignore the debts and we all will continue to enjoy the prosper of the economy. Is this true? Not quite!
In a zero percent interest environment, there are no incentives to save or to repay your debt. You will spend on goods and services or financial assets. Asset price will rise. This is why stocks and property prices had rally since the GFC. Once asset price rises, yield will become lower for the same asset investment. Investors will then relocate resources to buy other assets with higher yield which is more risky.
You may think that the economy is good. But the reason is due to cheap credit and may not exactly due to productivity growth.
Consider also that most of the money in this world is concentrated in the hands of the few percent rich. There will come to a point when the rich only spend on more financial assets rather than on consumer goods and services. This means that the increase spending is misallocated. Despite debt continues growing in the economy, businesses demand are not keeping in pace.
If debt grows at a rate faster than income, then the burden will become increasingly heavier. People will come to a point that they have difficulty servicing their debts. Spending will decrease. And since your spending is another person’s income, lesser spending means lesser income for another person, so on and so forth. Eventually the debt bubble burst and economy spiral down rapidly.
Interest rate cannot reduce anymore
And because the Fed can no longer lower interest rate since it is already zero percent, they cannot stimulate spending anymore. Everyone will just rush to sell their assets. Supply outstrips demand. Debts are written down, people and businesses declare bankrupt and jobs are cut. This is what Dalio classify as long term debt cycles. It last happened more than 80 years ago during the great depression. The world economy did not turn around until when WWII started in 1939.
Maybe Fed can raise taxes on rich or print more money?
There are two ways a government can have money. Raise Taxes or borrow from the Central Bank. The central bank will then prints money or actually buy government bonds. This is Quantitative easing of today. Essentially it is the Fed purchasing bonds from Banks who in turn purchase the bonds issued by the Government’s treasury. Then banks can purchase assets and in turn boost economy.
If Interest zero, QE too much such that monetary policy does not work anymore, Government may “literacy” hand money to people to spend. This is Helicopter money!
When economy is filled with debts and recession already takes place, the government can also only tax on the rich to re-distribute wealth. Will the rich be happy? No! The poor will continue to leave on social benefits. This is not sustainable.
Creating more money, and more, and with more money around, your existing money will worth less. This is the effect of inflation, which decrease your purchasing power. In extreme cases, money will become worthless just like during WWII when Japanese print so much of their “banana notes” that causes hyperinflation. Another example is in the late 1970s when the Fed kept interest rates too low for too long because it feared that higher interest rates would be economically harmful. That produced double-digit inflation that created chaos for many Americans.
When cost of living increase, debts unable to be repaid and have to be written down, delayed or with lesser interest repayment, it is going to be painful for everyone. The poor will resent the rich and social unrest will take place. In extreme cases, just like in during the 1930s great depression, it can even lead to people like Hitler coming into power and lead to war.
When debts are abundance, an economy needs to go through a process of deleveraging. Typically, an economy can deleverage in 4 ways.
1) Debt reduction which means write down debts! One’s man debts is another man assets, hence this may cause negative wealth effect which can painful also.
2) Austerity measures which means cut spending and pay down your debt. But it will mean lesser spending and lesser income for others, which is deflationary in nature.
3) Tax the rich and redistribute the wealth from the rich to the poor. Just like in Europe, wealth is currently redistributed from Germany to Greece, southern European countries. Ultimately, it will reach a point where the rich will not be happy anymore to redistribute their wealth.
4) Lastly, debt monetization or print money. But all things being equal, more money means inflationary and the cost of goods will increase and causes social unrest.