INSIGHTS: THE WORLD HAS GONE MAD AND THE SYSTEM IS BROKEN
GUEST COLUMNIST: Ray Dalio, Co-Chief Investment Officer and Co-Chairman of Bridgewater Associates, LP. Reprinted with permission.
I say these things because:
Money is free for those who are creditworthy because the investors who are giving it to them are willing to get back less than they give. More specifically investors lending to those who are creditworthy will accept very low or negative interest rates and won’t require having their principal paid back for the foreseeable future. They are doing this because they have an enormous amount of money to invest that has been, and continues to be, pushed on them by central banks that are buying financial assets in their futile attempts to push economic activity and inflation up. The reason that this money that is being pushed on investors isn’t pushing growth and inflation much higher is that the investors who are getting it want to invest it rather than spend it. This dynamic is creating a “pushing on a string” dynamic that has happened many times before in history (though not in our lifetimes) and was thoroughly explained in my book Principles for Navigating Big Debt Crises. As a result of this dynamic, the prices of financial assets have gone way up and the future expected returns have gone way down while economic growth and inflation remain sluggish. Those big price rises and the resulting low expected returns are not just true for bonds; they are equally true for equities, private equity, and venture capital, though these assets’ low expected returns are not as apparent as they are for bond investments because these equity-like investments don’t have stated returns the way bonds do. As a result, their expected returns are left to investors’ imaginations. Because investors have so much money to invest and because of past success stories of stocks of revolutionary technology companies doing so well, more companies than at any time since the dot-com bubble don’t have to make profits or even have clear paths to making profits to sell their stock because they can instead sell their dreams to those investors who are flush with money and borrowing power. There is now so much money wanting to buy these dreams that in some cases venture capital investors are pushing money onto startups that don’t want more money because they already have more than enough; but the investors are threatening to harm these companies by providing enormous support to their startup competitors if they don’t take the money. This pushing of money onto investors is understandable because these investment managers, especially venture capital and private equity investment managers, now have large piles of committed and uninvested cash that they need to invest in order to meet their promises to their clients and collect their fees.
At the same time, large government deficits exist and will almost certainly increase substantially, which will require huge amounts of more debt to be sold by governments—amounts that cannot naturally be absorbed without driving up interest rates at a time when an interest rate rise would be devastating for markets and economies because the world is so leveraged long. Where will the money come from to buy these bonds and fund these deficits? It will almost certainly come from central banks, which will buy the debt that is produced with freshly printed money. This whole dynamic in which sound finance is being thrown out the window will continue and probably accelerate, especially in the reserve currency countries and their currencies—i.e., in the US, Europe, and Japan, and in the dollar, euro, and yen.
At the same time, pension and healthcare liability payments will increasingly be coming due while many of those who are obligated to pay them don’t have enough money to meet their obligations. Right now many pension funds that have investments that are intended to meet their pension obligations use assumed returns that are agreed to with their regulators. They are typically much higher (around 7%) than the market returns that are built into the pricing and that are likely to be produced. As a result, many of those who have the obligations to deliver the money to pay these pensions are unlikely to have enough money to meet their obligations. Those who are recipients of these benefits and expecting these commitments to be adhered to are typically teachers and other government employees who are also being squeezed by budget cuts. They are unlikely to quietly accept having their benefits cut. While pension obligations at least have some funding, most healthcare obligations are funded on a pay-as-you-go basis, and because of the shifting demographics in which fewer earners are having to support a larger population of baby boomers needing healthcare, there isn’t enough money to fund these obligations either. Since there isn’t enough money to fund these pension and healthcare obligations, there will likely be an ugly battle to determine how much of the gap will be bridged by 1) cutting benefits, 2) raising taxes, and 3) printing money (which would have to be done at the federal level and pass to those at the state level who need it). This will exacerbate the wealth gap battle. While none of these three paths are good, printing money is the easiest path because it is the most hidden way of creating a wealth transfer and it tends to make asset prices rise. After all, debt and other financial obligations that are denominated in the amount of money owed only require the debtors to deliver money; because there are no limitations made on the amounts of money that can be printed or the value of that money, it is the easiest path. The big risk of this path is that it threatens the viability of the three major world reserve currencies as viable storeholds of wealth. At the same time, if policy makers can’t monetize these obligations, then the rich/poor battle over how much expenses should be cut and how much taxes should be raised will be much worse. As a result rich capitalists will increasingly move to places in which the wealth gaps and conflicts are less severe and government officials in those losing these big tax payers will increasingly try to find ways to trap them.
At the same time as money is essentially free for those who have money and creditworthiness, it is essentially unavailable to those who don’t have money and creditworthiness, which contributes to the rising wealth, opportunity, and political gaps. Also contributing to these gaps are the technological advances that investors and the entrepreneurs that I previously mentioned are excited by in the ways I described, and that also replace workers with machines. Because the “trickle-down” process of having money at the top trickle down to workers and others by improving their earnings and creditworthiness is not working, the system of making capitalism work well for most people is broken.
This set of circumstances is unsustainable and certainly can no longer be pushed as it has been pushed since 2008. That is why I believe that the world is approaching a big paradigm shift.
ON THE ECONOMY: TIME OF MY LIFE
John Dunham, Managing Partner, John Dunham & Associates
I knew my rent was gon’ be later ’bout a week ago. I work my [butt] off, but I still can’t pay it though. But I got just enough, to get off in this club. Have me a good time, before my time is up. Hey, let’s get it now, ooh I want the time of my life. Oh baby ooh give me the time of my life. These lyrics suggest why one should not take financial advice from Armando Christian Pérez, better known as Pitbull. Actually, Pittbull is the godfather of a ship that I saw named a few years ago, and he is extremely successful. But I’m not sure that lyrics like save, save, save your pennies would work in his genre of music. This song was written by: Armando C. Pérez, Lukasz Gottwald, Henry Walter, Shaffer Smith, Vinay Rao, Stephan Taft, and Michael Everett. It was released in 2014 as a single, and went to number 9 on the Billboard Hot 100.
While Mr. Bull obviously does not take the advice in these lyrics, the Federal government, and governments throughout the US certainly do. So to, do American businesses and consumers, who have together racked up about $73.4 trillion dollars in debt. That is trillion with a “T.”
Debt is not necessarily a bad thing. In simple terms, debt is future work consumed today. On the other side, savings is today’s work held for future consumption. There are many instances when future work should be consumed today. For example, when a company builds a factory that it plans to use for 40 years, it is sensible to borrow and pay off the debt as work occurs over time. The same is true for a road, a house, and even a home appliance. The product will produce output for a long period of time, so the work consumed today to pay for it will be made up for during the life of the good.
On the other hand, using future work to pay for today’s consumption (basically what Pitt was doing in the lyrics) can be extremely dangerous. If I borrow $10,000 to pay for a vacation to Mexico, I consume work today that I will have to perform over a long period of time, thereby reducing future consumption by at least $10,000 (assuming zero interest and inflation). If I consume too much today, I may never be able to pay it off. For a company, a person, or even a municipality, this can lead to bankruptcy. For a country, it can lead to a collapse in the value of its currency and inflation – even hyperinflation (see Venezuela, Zimbabwe, Argentina for example of this).
Historically, debt levels in the United States were humming along at below 1.5 times GDP. In other words, the accumulated amount of future work spent was less than one and a half times the work produced. Most financial advisors suggest that the debt on a house (a mortgage) be no more than a third of income (work produced), over a period of 30 years. So, in 1982, the last year when the debt to GDP ratio was under 1.5, the country’s debt load was very manageable. Even at the high interest rates of the time, the country’s “mortgage” payment was about $523.6 billion, and a third of income was just under $1.0 trillion.
US DEBT LEVELS
But then things changed, and the debt to GDP ratio began to climb, and to climb fast. By 1988 it had reached 2 times GDP, by 2000, it was 2.5 times GDP and by 2006, 3 times GDP. Today, the debt to GDP ratio is 3.28 times GDP, down from over 3.73 percent in 2009. What does this mean. Well, look at the same calculation. Today, with low interest rates, our mortgage payment is almost $4.1 trillion, and we have about $6.5 trillion to pay it. So from a financial advisor’s perspective, as a country we are not borrowing too much – but that is because interest rates are very low.
Things look worse when we balance the amount of work that we are saving for the future against the amount of future work we are spending. Back in 1982, the amount of debt owed by all entities in the US was equivalent to 16.8 times the amount saved (using the current savings rate of 8.8 percent). Since the country was still consuming more than it produced, if that new debt were added to the accumulated debt, the country was only saving enough to pay down the nut in 27.5 years.
Since then, this has risen dramatically, particularly during the early 1990s and 2009. By then, the payback period had increased to nearly 70 years. Today, with the current increase in US borrowing and accumulated debt added together, it would take about 61 years of savings to get back to even. In other words, the next generation is inheriting so much debt that everything that they save during their entire working life (and then some) would be needed to pay it off. (see chart)
This would be ok if the next generation were inheriting the assets to match the debt. This would include productive factories, businesses, infrastructure and housing. However, the sad state of American infrastructure alone suggests otherwise. In fact, the entire capital stock of the US is just $64.35 trillion, or only 87.6 percent of the accumulated debt. For those keeping track this means that the country’s retained earnings after nearly 250 years is negative $9.1 trillion. Each of us holds a debt of nearly $28,000 on top of everything that we own including our house, our car, our stuff, our roads, our downtowns, everything Bill Gates owns, everything Jeff Bezos owns, everything Elizabeth Warren and Donald Trump own, the White House and the Capitol, and even the Hope Diamond. If the country were to sell itself lock, stock and barrel to China, we would still – each of us – still have a debt of about $28,000.
What makes this even more scary is that back in 1982, we each had assets equal to almost $30,000. In just 25 short years, America has consumed almost double its accumulated wealth. Maybe its time to get outta this club.