9 January 2021

On today’s show, we bring back investment expert, Cullen Roche, to talk about inflation, the state of the economy, and whether there is a rational argument for stocks trading at 50x earnings.

Cullen is the father of Pragmatic Capitalism, the author of multiple investing books, and the regular guest of Bloomberg and major financial news outlets. He has also minced hundreds of millions of dollars for the past two decades and is always a wealth of information.

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  • Why money supply expansion is not equal to inflation
  • Understanding the new rules of bond investing in today’s inflation and interest rate environment
  • How to protect your portfolio against inflation
  • Whether there is a rational argument for stocks to be trading at 50 times earnings


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Stig Brodersen (00:00:02):

On today’s show, we have a good friend, Cullen Roche with us. Cullen has minced hundreds of millions of dollars for the past two decades, and is always a wealth of information. During the 2008 financial crash, Cullen’s private investment partnership was up 15% for the year. He’s the father of Pragmatic Capitalism, the author of multiple investing books, and the regular guest of Bloomberg and major financial news outlets. 

On today’s show, we’ll talk about inflation, the state of the economy, and whether there is a rational argument for stocks to be trading at 50 times earnings. With that, let’s go ahead and get started.

Intro (00:00:40):

You are listening to the Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Stig Brodersen (00:01:01):

Welcome to the show. I’m your host, Stig Brodersen. Today I’m here with one of our good friends on We Study Billionaires. Thank you so much for joining me here today, Cullen.

Cullen Roche (00:01:10):

Thanks for having me on.

Stig Brodersen (00:01:11):

Cullen, let’s jump right into the first question, and that question is about money supply. What you previously said here on the show is that it doesn’t tell you anything that the money supply is going to grow because that’s just an aberration of reality of the way we structure a debt-based financial system. You also said that the amount of deposits and the amount of loans are always going to grow in the long term. Going into this really also to preface this conversation with you, could you please elaborate more on that, and how the money supply impacts the economy?

Cullen Roche (00:01:47):

Obviously, money is an extremely important component of what goes into the economy, how we measure ablation and things like that. One of the, I think, problems that I have with … For instance, some people might be surprised to hear this, I used to be pretty stricted here and of the Austrian School of economics. Coming out of college, I read a lot of Mises and Hayek. I think that one of the problems I eventually ran into working in the financial industry and working specifically with a lot of bankers and people that were literally the money creators in the economy was that the Austrian School defines inflation as an increase in the money supply. I started to find this problematic because if you look at the money supply over the course of history, it basically always expands. Over any really long time horizon, the money supply will always expand.

Cullen Roche (00:02:44):

The reason for that is basic in that essentially when you look at what really creates money, a lot of people think that the central bank is the money creator, and really what we found coming out of the financial crisis, especially with quantitative easing, was that when the Fed makes reserves, so the Fed makes reserves, which is money for banks, and it’s only in the bank consistent. The reserve money or money at reserves doesn’t get outside of the banking system. We know this whole concept of the money multiplier is misleading. It is best in that when the Fed creates $1 of reserves, this doesn’t necessarily multiply into $10 of deposits or $10 of loans. That’s the kicker, is that loans create deposits. Okay? When a bank makes a loan, they’re creating a new deposit liability for the bank. That’s an asset for the borrower, basically.

Cullen Roche (00:03:40):

The real kicker with this is that as the economy grows over time and expands, people want more money. They need to borrow more to produce things, and the banking system is just the liquidity provider that they create the deposits through a loan agreement essentially, that literally liquidates the economy. It creates the liquidity that makes it possible to go out and say invest in new technologies that we think might create a return on investment or to build a new home or to purchase existing homes, or there’s a lot of bad uses for credit. I mean, you could argue that, for instance, a high rate credit card is … that you’re just buying frivolous nonsense where there’s a really bad use of credit. But even that is an expansion of the money supply. That’s just a function of growing population and growing demand for goods and services over time.

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Cullen Roche (00:04:38):

If you look at the quantity of loans and deposits over any long historical period, they’re always trending up. I mean, always virtually, over any really long time period, and that in a way is actually a good thing because it means that there’s more demand in the economy. There is more output being created because people are using a lot of this. This is the big kicker, is that a lot of the borrowing that’s done is done for real investment, it’s done to innovate, it’s done to build homes. A lot of this is just accounting. When the money supply expands, they’re not upgrading liability. We like to talk in the binary ways where people will tend to focus on only one half of the equation and demean that in a way that has a very negative connotation. The reality is that, yeah, debt can be really bad, but debt can also be really good because the flip side of a liability is an asset.

Cullen Roche (00:05:37):

When somebody takes out a new loan, there are not just liability. There isn’t just the debt. There are the assets that are created and those assets are potentially good, they’re potentially bad. There’s no this or that when someone takes out a loan, and the result of borrowing really depends on, well, what ends up being done with the loan? When I go to a bank, let’s say, I want to build a new home or something, and I go to the bank to take out a new loan, I get an asset deposit that is mine. I have a liability in the loan. The bank has an asset that is the loan and the deposit liability. The balance sheets are just completely balanced right there. The financial balance sheet, they’re completely balanced. But if I then take that money and I take those deposits and I go out, and with just sheer will and hard work, I go out and I build a home, and I let’s say then repay the loan at the end of the terms by selling that home, the balance sheets compress.

Cullen Roche (00:06:41):

The balance sheets go right back to where they were when I repay the loan because loans create deposits, but repaying loans destroys deposits. The balance sheets compress right back to where they were and from the start, but what’s left over? We have a house, we have a real asset. We are demonstrably better off after all of this because I borrowed and used the debt in a way that was productive. That’s the ultimate kicker with inflation and money supply and all these things. It’s not just about how much money is being produced, but it’s more important to understand, well, what is the money really being used for, and are we creating more output, are we creating more goods and services that create demand essentially for future money that makes the whole economy viable in the long run?

Stig Brodersen (00:07:34):

I guess the followup question to that would be now that we seen say from November 2019 to November 2020, we’ve seen a money supply [inaudible 00:07:43] of 25%. Does that mean that we have 25% inflation?

Cullen Roche (00:07:48):

What is money? I like to think of money on a … I call it a scale of moneyness because money to me is really a medium of exchange. It is just the thing that is most liquid that gives you access to goods and services essentially. But there are different things that are good for that in different environments. I mean, for instance, I mean, let’s say that COVID ravages the whole economy. We [inaudible 00:08:10] very well could be an environment where gold, for instance, is literally the best form of money because it’s the thing that people will accept essentially for barter as money. In a modern technologically advanced economy, deposits are basically the ultimate form of money because they’re the thing that is most widely created and acceptable in across the entire economy. You can use deposits for virtually anything to purchase any goods and services in a modern technology based economy.

Cullen Roche (00:08:42):

The problem with the way that a lot of people define money is, for instance, a lot of professional macro economists will define real money as the stuff that the government creates, the actual physical currency, the reserve currency, as in literally bank reserves that the federal reserve creates, things like that that they would argue are the real forms of money. So you have all these conflicting definitions and narratives about what is not only real money, but how will actually filter into causing inflation. That’s a big issue. For instance, in reading six weeks, I’ve seen a lot of charts about how M1 has increased by some huge amount in the last few weeks. If you actually dig deeper into it and you look at something like M2 in the United States, M2 hasn’t actually changed.

Cullen Roche (00:09:32):

The reason why M1 increase in M2 didn’t change it because what essentially happened was you had something that is included in M1, which is basically savings deposits, and it was converted into demand deposits, which at the M2 level there was no change because there was just a conversion. But because of the demand deposit aren’t in M1, you had this technical increase in M1 that a lot of people would look at and say, “Oh, this is going to cause huge inflation,” and really it was just an accounting chain. You have all these sorts of competing narratives and definitions of things, and ultimately I think when we look at COVID, there is no denying that COVID has increased the money supply by virtually any definition. The response to COVID was colossal. We talked last time about how I’m a lot more concerned about future inflation than I was coming out of 2008.

Cullen Roche (00:10:36):

I was actually pretty much not a deflationist coming out of 2008, but a disinflationist, meaning that I believe that the rate of inflation was going to continue to decline. The positive rate of inflation would continue to decline. I’m much more concerned at this time that you could see real inflation just because the response has been so humongous. For instance, I mean, we’re talking about the latest stimulus in the United States here, which was roughly $900 billion. That’s bigger than the entire fiscal stimulus that we enacted in 2008, and people are complaining that this was tiny, that this wasn’t big enough. Putting things in perspective, and this is in addition to the CARES Act, which was $2 trillion plus not including all the Fed policies and things like. The response here has been humongous. By any technical definition, there has been …

Cullen Roche (00:11:34):

Rather than using the term money, let’s just say there’s been a lot of financial assets created, and those financial assets, they are being held by the private sector and they’ve enriched the private sector in financial terms. My big concern with inflation going forward is not just you’ve created a lot of financial assets in the last year, but that we’ve seen a lot of real disruptions in supply chains that we’re seeing filter through the real economy in a meaningful way that in the next two to three years could … I’m not worried about a hyper inflation, but I think you could easily be at an environment where we’re at the 2018-2019 levels of inflation or much higher than that, say 3%, 4% inflation by that point where the Fed is really backtracking. They’re really on their heels jawboning about having to potentially raise rates and concerned that all these big policies worked and maybe worked a little better than they had hoped.

Stig Brodersen (00:12:41):

Let’s continue talking about inflation and some of your thoughts on that, because if we look at the five-year swap rate in the UK, United States, and also in continental Europe, it seems like the inflation expectations have turned upwards. How do we as investors position ourselves accordingly if we agree with you and we agree with the market that this trend of rising inflation continues?

Cullen Roche (00:13:04):

I think that from a domestic currency perspective, you just want to be somewhat hedged against that risk because you … I mean, for instance, in the fixed income markets, the problem with low interest rates when you’re a bond investor is that when you have low rates, the percentage increases and interest rates impact your bond investments a lot more just because the math is so much dirtier about it. For instance, when you have an interest rate that’s 10% and interest rates [inaudible 00:13:37] by 1%, well, you only had a 10% principal impact. In terms of a 1% interest rate, when interest rates rise 1%, you’ve had a 100% principal impact. Mathematically, you’re not earning the same amount of interest, which basically means you’re not earning the same amount of coupon protection from your fixed income payments as interest rates are rising.

Cullen Roche (00:14:06):

That 1% increase in rates has a much bigger impact on your principal because over the course of the year you’re not earning that high interest rate that you would have been, for instance, when interest rates are 10%. You have less interest rate protection when interest rates are low, because you’re just naturally earning a lower coupon from your starting point. Fixed income investors are exposed in an unusually negative way to rising interest rates in a low interest rate environment if they’re exposed to very long duration instruments. Into the fixed income markets, if inflation is your worry, you’re eventually worried about interest rates increasing. So you would want to be for certain shorter on the maturity curve if you’re a fixed income investor. I’d like to think of stocks very similarly to the bonds, in that I like thinking of all financial assets as having a duration.

Cullen Roche (00:15:06):

To me, stocks are just … they’re instrument that basically has either a perpetual duration, or at minimum, a very, very long duration, 30, 40, 50 years. That’s part of what makes them so volatile, is that by definition, because there’s such long-term interest, they are more volatile because their income streams are less predictable. They provide the investors or the underlying financial asset owners with so much less protection from the way that they earn their income over time. Because corporations are just naturally longterm entity, the way they earn their cash flows is very long-term by nature. From a stock market perspective, if you’re right worried about rising interest rates or you’re worried about the way that those cash flows are going to ultimately be repaid, the kicker with that is that if you have rising interest rates, you have probably rising inflation.

Cullen Roche (00:16:01):

Inflation makes managing corporation very difficult because it disrupts supply chains, or you could argue that inflation is evidence of a supply chain abruption. By definition, when you have high inflation, you just have a lot more uncertainty inside of a corporation. This makes the whole management and cashflow management of a corporation much more difficult to predict over time, and so the cashflow streams become less predictable. Stocks should become, not only more volatile, but they should become more volatile in specific types of sectors. If you’re worried about domestic inflation, I think the obvious answer is that you’d want to be globally allocated. Allocating outside of the domestic economy is generally going to be one way to protect against a higher rate of inflation. The obvious one is to own real goods and services.

Cullen Roche (00:16:59):

You want to be the owner of [inaudible 00:17:01] If you can’t be the owner of a corporation itself, you’d want to be the owner of physical assets, whether it’s real estate or even things like precious metals, and then going, looking within the domestic stock markets. You’re someone that say you still want to own a piece of your domestic economy, I would argue that you’re probably better off owning or at least diversifying into something like a value type of stock versus a growth stock because typically what we find with value stocks is that they tend to be safer businesses by nature. For instance, you might argue that the typical … the classical Warren Buffett type of value stocks, the old brick and mortar, the boring, reliable types of businesses maybe the ones that aren’t quite as sexy as the Peloton and the Facebooks of the world, that those are going to do better at rising inflation.

Cullen Roche (00:18:05):

They old boring businesses, they have more predictable cashflow streams. Something like a Facebook potentially becomes a lot less attractive in a high inflation environment just because their cashflow streams are somewhat unpredictable. They’re dependent on things that are not necessarily based on the real economy, but based on this internet-based economy. Whether or not the demand is there for those things consistently in a high inflation environment versus are people going to continue to pay their utility bill, it becomes a less certain bet. Value versus growth becomes the way to diversify within the domestic economy if you’re worried about inflation.

Stig Brodersen (00:18:50):

It’s interesting that you would say that, Cullen, because last time we talked about how growth stocks typically perform better than value stocks in a low inflation environment. Now, if we continue this train of thought, growth stocks also perform better than value stocks with interest rates being so low since the discount rate is correspondingly low. This is also given the assumption that you don’t discount with something like the money supply or something like that, but you would discount with something like the treasury rates are similar to that. I’ve been really trying to wrap my head around this. Can we really consider future earnings being almost [inaudible 00:19:23] earnings today because of the low interest rate, and how should we as investors look at the valuation between your value, and let’s just call that earnings now, and then growth stocks and let’s call that earnings later, giving this way of discounting back with something very close to zero?

Cullen Roche (00:19:40):

It’s always confounded me that the way that … I think people tend to … For instance, they think of the equity risk premium as something as being at least highly impacted by the discount rate. With a 0% interest rate, a lot of people would argue that the equity risk premium, basically the premium that equities deserve to earn over bonds, is vastly superior than it is when interest rates are high. To me, I’ve always found that using interest rates as the central component of a valuation metric can be misleading because interest rates are a function of future inflation expectations. I would say that I prefer to use the term the equity inflation premium, that when interest rates are low, it really means that inflation is low and that future inflation expectations are low. The Fed, for instance, they have interest rates at zero because they expect inflation to remain really low.

Cullen Roche (00:20:45):

If inflation was to rear its head in the next years, the Fed would start raising interest rates over time to try to get ahead, to try to create more demand for money by getting people to basically earn an interest rate that makes them want to hold more money in essence, to oversimplify things. To me, this really isn’t about interest rates. This is about really understanding what is the future rate of inflation going to be, and there’s no ironclad rule that says that when inflation rises and let’s say interest rates rise correspondingly, there’s no ironclad rule that says that equities have to earn more or less premium inside of those environments. I mean, if you were an investor in Zimbabwe in corporations when their inflation was raging out of control and the Zimbabwean Central Bank was raising interest rates, well, no one was talking about an equity risk premium in that environment.

Cullen Roche (00:21:45):

The rate of profit is, for most corporations, inside of an environment like that because your economy is just being completely ravaged by the rate of inflation that’s going on. We have this privilege of, in the United States having not just low inflation, but very stable inflation where we have a great amount of predictability. To me, to answer your question, I think people would be better off looking at inflation rates in the future. When you make an interest rate bet of any type, you’re really making an inflation bet. If you think that inflation is going to remain low in the next five to 10 years, well you’re really making a bet that the Fed is right basically, that the Fed is going to keep interest rates low and that you’re not going to really see a high rate of inflation.

Cullen Roche (00:22:34):

If that’s the situation then, well, I mean, all the trends that have been in place basically for the last 20 years are going to continue. Values are going to continue to be terrible versus growth. The US domestic economy probably continues to outperform foreign stocks, just especially on a domestic currency basis, and real assets do okay-ish versus everything else. If you believe in the opposite, if you believe that inflation is going to be high, then you go out and you diversify into all the things we talked about in the previous segment. But to me, interest rates confuse the whole narrative because the interest rate is just set based on what the future inflation expectations are going to be.

Stig Brodersen (00:23:19):

Keeping that in mind, what you just said, I have to ask, one of the billionaires that we follow closely here on We Study Billionaire is Billionaire Ray Dalio, and he was recently doing an ask-me-anything on Reddit, and we’ll of course make sure to link to that in the show notes. He was asked whether he thought that the current equity prices were a house of cots. He answered with bond interest rates where they are, bonds are trading at roughly 75 times earnings. With the amount of money out there and cash being such a bad alternative, there is no good reason that stocks shouldn’t trade at 50 times earnings. Just to give you the list of some context, we’re trading around 33 times earnings in the US right now. Do you agree with that assessment?

Cullen Roche (00:24:01):

You’re essentially arguing that this paradigm that we’re in is sustainable and going to be prolonged. You’re basically arguing that this environment of very low inflation with really poor demographic trends and rapidly changing technological changes, you’re basically arguing that that is the dominant macro paradigm that we’re not just in, but that we’re going to continue to be in that paradigm. People have been saying, for instance, with the CAPE ratio, they’ve been saying, “Oh, valuations are too high. They’ve got to come down.”

Cullen Roche (00:24:36):

People have been saying that for 20 years. But the real fact of the matter is that as long as we’re in this alternative [inaudible 00:24:45] economists would call it an alternative equilibrium basically, the economy has shifted into a new equilibrium where now the current equilibrium is this low rate of inflation and this stagnant growth period where certain types of firms just do really, really well inside of that type of environment and growth stocks obviously are the big beneficiaries of something like that because their cashflow streams becomes so predictable to a large degree. But if we’re in this new paradigm of permanently low inflation, a sort of Japanification of the entire developed world economy, there’s a justification. You could argue that there’s a rational argument for why valuations are the way they are in that environment.

Cullen Roche (00:25:30):

You could argue that if we were to … Let’s say the rate of inflation was to go lower, and let’s say that we become more Japanese in the next 10 or 20 years, inflation falls to zero or interest rates go negative like they are in a lot of European countries, yeah, you could argue that the corresponding valuations are going to be even higher because the demand for these really high flying crazy expensive stocks become more attractive versus everything else because the rate of inflation is so low that corporate cash flows are just … They’re the obvious beneficiary of all of this. They become the hot potato that everybody wants to own because there’s nowhere else to earn such a reliable, relatively low risk type of return. Is that the environment that is going to continue? I mean, me personally, I think that we are in an environment where you’re not likely to go back to the 1970s.

Cullen Roche (00:26:29):

I just don’t think that there’s the dynamics for say double-digit high inflation. But would I be comfortable being at … Let’s say the ten-year treasury right now is at 1%, from a management perspective, would I be more comfortable betting on a three-year treasury bond versus a 0.5 or 0% 10-year treasury bond in the next 10 years? I would certainly want to be hedged against the 3% outcome because I view it as such an asymmetric bet in my mind, given the way that the politics and the government response seems to be changing. To me, that’s one of the big kickers here, that we do seem to be entering this different paradigm where … This is the thing where Dalio might be wrong about this, is that from a political perspective, you’re seeing a real serious sea change, especially the way that economists view inflation and fiscal policy

Cullen Roche (00:27:30):

Coming out of the financial crisis, you will never see fiscal packages the likes of what Europe has agreed to recently. Austerity was the name of the game. You had to suffer a little bit to be able to grow, and that was the way that macro economists, a lot of macro economists, viewed the policy response in 2008, 2009. The turn environment is completely different. I mean, we just spent … I can’t even keep track of the numbers. Three, four, $5 trillion this year in the United States, and hardly anyone is batting an eyelash at that. The numbers are just so big that the way we’ve seen just a huge sea change in the mentality in the way that people perceive fiscal policy and government spending relative to the risk of inflation is such a huge sea change that that to me feels like a trend that is not only starting, but is going to continue into the next in 20 years.

Cullen Roche (00:28:32):

We just had one of the biggest recessions ever in economic history, and all we did was we slammed a ton of money at it, and what happened? The economy just snapped right back. What do you think policy makers are going to do the next time we have a big recession? They’re going to do the same exact type of thing. Fiscal policy is going to be front and center. The worrisome thing, the reason I say this is such an asymmetric bet to me is that no one knows what really causes inflation. I mean, there’s general theories about, oh, well, more money chases more goods. But that theory to some degree has been debunked in that we printed a lot of money coming out of 2008, and what did we get? We got even lower rates of inflation over time. No one really knows all of the moving parts that really contributes to high inflation.

Cullen Roche (00:29:30):

Then this is just a much more confusing phenomenon than most people have made it out to be, and certainly the way that economic textbooks have made it out to be. That’s worrisome in that let’s say we had this huge explosion in fiscal policy. Well, let’s say we do find out that, to avoid the term money, more financial assets is really the way to create more inflation in certain types of economies. Well, we’re going to find out whether or not that’s true in the coming five to 10 years potentially. That to me, the political sea change makes this a really somewhat asymmetric bet. That if you’re betting on the permanently low inflation, to a certain degree, you’re betting that the politics aren’t going to change. I don’t know. I feel like the politics are starting to change.

Cullen Roche (00:30:19):

The MMT advocates of the world and the Bernie Sanders of the world are going to become more vocal types in creating this, I think, sort of perception that fiscal policy doesn’t have a lot of downside. I’ve been a big advocate of actually fiscal responses for the last 10 years, but there’s something about the sea change here that it starts to make me a little uncomfortable, and from a … Maybe I’m just too much of a risk manager, but in terms of managing the risks, I’d want to be hedged against that risk for certain.

Stig Brodersen (00:30:54):

Let’s continue talking about inflation here, because inflation is seen by many as the savior of the growing public debt to GDP ratio. Many countries have in the past deliberately used this, and this meaning inflation, as a tool to reset the debt situation. Do you think that you saying inflation to erase that or at least minimize that is a viable solution in Europe and in the US, and what would be the potential negative consequences if that was the approach that was taken?

Cullen Roche (00:31:27):

The first thing I would say is that the debt to GDP ratio, I don’t know if there’s anything about that number that is really meaningful. We use it as general barometer of what’s going on, but I don’t know what this number really tells us. There was a famous study back in, I can’t remember, 2009 or 2010. Reinhart and Rogoff came out with a paper and then they later released, I think, the Excel spreadsheet that they used, and they had argued that something like a 90% debt to GDP ratio was the breaking point for government debt basically. A lot of people had a problem with that because there’s … I mean, first of all, there’s a lot of evidence that that’s just empirically wrong. I mean, Japan has a, what? Something like a 250 or 300% debt to GDP ratio and they have crazy low inflation and have for 20 years.

Cullen Roche (00:32:22):

There doesn’t seem to be anything magical about this line. But the funny thing with the Reinhart-Rogoff study was that it ultimately had a spreadsheet error, a basic math error in the spreadsheet where they had come up with this number, not in just a phony theoretic away, but they’d made a basic math mistake within it. I don’t know that there’s anything about this number that is really that meaningful to begin with. Again, going back to the balance sheet accounting of it, to me, people just, I think, talk about debt in a lazy way where they say, “Oh, well, more debt is bad.” Well again, more debt, it doesn’t just mean more liabilities. It also means more assets. I’m by no means a believer in the idea that the government necessarily creates financial assets and does so efficiently, but there’s nothing necessarily negative about creating more debt.

Cullen Roche (00:33:19):

If you have any economy where the underlying private sector is just super, super for productive, well, if you’re creating more debt, in theory you might have a big multiplier effect within that economy where more assets, actually they liquefy the domestic economy in a way where that economy might actually become even more productive because it has an underlying inherent level of productivity already in it where maybe you just didn’t have enough liquidity to begin with. Maybe there were tons and tons of entrepreneurs out there that had great ideas that were going to change the world in really big, meaningful ways, and they just didn’t have the liquidity to be able to enact those ideas. There’s a chance that what we’re seeing here with a lot of this government stimulus and the way that it hasn’t been really explosively inflationary, there’s some evidence that that’s actually what’s happening.

Cullen Roche (00:34:14):

That you’re adding liquidity to the economy, which is just in a lot of ways I think creating a little bit of a multiplier effect where you’re giving liquidity to people that really just needed it, and that the domestic economy might just benefit from having that greater amount of liquidity. But again trying to hammer home the point that there’s nothing necessarily good or bad about debt in and of itself, and that … The other thing is that I think when people look at government finances, they’ll have a tendency to think of them in household terms. So a lot of people talk about, for instance, repaying the national debt. This is basically just a big fallacy of composition and that the national debt will never get repaid.

Cullen Roche (00:35:01):

You literally cannot repay the national debt without again reducing and the size of the balance sheet correspondingly on the assets side. The kicker is, is that the government debt is a humongous portion of the private sectors, financial assets, in that people who have social security or government pensions, or even just bond investors broadly, who own all of these assets, these are assets that they own. In order to repay the government debt, you not just repaid the liability side of the balance sheet, you’d have to shrink the asset side of the balance sheet. At an aggregate economic level, really financial assets, they don’t get repaid and you actually don’t want them to be repaid over the long-term.

Cullen Roche (00:35:51):

I mean, going back to the household sector, for instance, when I talked about that example earlier, building the home where I borrowed money to build the home, you don’t want people to just be repaying all those loans. What ends up happening over time is that, especially as the population grows, you just have more and more debt. But again, you not only have more liabilities, you have more assets. Over the course of any really long economic period, you’re just going to see a natural growth in both the assets and the liabilities mainly because the other component of the balance sheet is equity. The equity opponent is going to grow over time. Our net worths are going to grow because ultimately the value of our assets should in a healthy economy expand versus the value of the liabilities, which creates net worths, which ultimately is the real end non-financial capital that makes all of the economy sustainable over very long periods of time.

Cullen Roche (00:36:54):

To me, I think people are going back to the confusion and the question marks around what causes inflation. I think a lot of people look at government debt and they automatically say, “Well, more government debt is bad, and so this or that ratio will contribute to inflation.” I think the scary thing about inflation is that no one knows what level of government debt causes inflation or causes the economy to start performing worse or not. That’s the problem with big ratios, like a debt to GDP ratio, or this idea that you want to inflate your way out of debt. Because ultimately, we don’t know the actual relationship between government debt and inflation. To specifically answer the question of whether inflation, you can really grow the inflation rate to retire or to erase debt over time, well, inflation is not a good thing.

Cullen Roche (00:37:53):

I mean, in a perfect world, you would have basically a 0% inflation rate. You’d have growing money supply over time because people would be borrowing more money and creating more things. We’d be so innovative and so productive that our technology would put a downward pressure on the rate of inflation to the point where there was virtually zero inflation. Our economy is not perfect like that because there really is scarcity in the economy, especially on the real side of things. We see that. Anyone who’s tried to buy things during COVID knows how true that is. I mean, I’ve looked at the price of a two by four jokingly over the course of the last few years as I’ve been building my house here and just watching the price explode during COVID because of the scarcity of a two by four during the last year.

Cullen Roche (00:38:43):

These dynamics are real and you’re likely to pretty much always have some positive rate of inflation just because real resources really are scarce, and so that’s going to create dynamics where we’ve created this technology that is a double-edged sword, and that we create money from nothing, but we can’t create the corresponding goods and services from nothing. But you would never use inflation to grow your way out of debt because very high rates of inflation are a sign of huge economic problems. I mean, when you have an economy where you go from say 10% to 100% inflation, your economy is essentially broken. I mean, people we’ll talk about the problems that we have in the United States, where we have very low rates of inflation and low growth.

Cullen Roche (00:39:35):

But boy, those things are a blessing compared to very high inflation because very high inflation, it will ruin everyone’s life. We talk about the problems that you have with low inflation, where there’s inequality and things maybe aren’t quite as good as they could be, but very, very high inflation ruins everyone’s life. It doesn’t just ruin the poor people’s lives or certain components of the economy. The whole idea that you’d want to inflate your way out of debt, it’s just … I don’t know, it seems nonsensical to me. Why would you blow your whole body up to save yourself from what you view as a miserable life? It doesn’t make any sense to me, because once you’ve destroyed the domestic economy, yeah, you might be able to come out and say, “Oh, we reduced our real debt levels, but we did so by blowing up the whole system.”

Cullen Roche (00:40:28):

It doesn’t make a lot of sense to me. I don’t think that’s what policy makers are trying to do. I think policymakers, when they’re enacting these policies, I think they’re really trying to grow their way out of debt. They know that inflation is going to be a by-product of increased demand to some degree, just because of the basic dynamics I was talking about earlier, but they’re really trying to grow their way out of debt.

Stig Brodersen (00:40:51):

Let’s talk about that strategy, because another way for a country to repay debt is to grow its economy. As long as the economy grows at a higher normal rate than the normal interest rate, meaning the debt, in time debt will be repaid. That really takes me to the next point about productivity. We often hear productivity mentioned in various debates and read about the need to increase productivity. Let’s first start by defining what is productivity?

Cullen Roche (00:41:19):

Well, this is one of those macro economic debates that nobody really knows the answer to. I mean, productivity at the most basic level is just output per hour. How much stuff are we creating per unit of work basically. One of the things that a lot of people find disconcerting about the last 20 to 30 years, really since the 1970s, is that the rate of productivity has declined and nobody really knows why. I don’t know how much of this is just a natural basic trend that’s occurring in the economy because of … I’ll give you my personal view on the whole productivity debate is that basically, sure, people have become slightly less productive in terms of the amount of real stuff we produce, but the way we quantify whether or not that’s really impacted our lives positively or negatively is very, very subjective.

Cullen Roche (00:42:22):

A lot of people use this as a measure of our living standards over time. I would argue that since the 1970s, for instance, the BLS, the Bureau of Labor Statistics, releases a survey every 10 years. It shows the household share of income expenditures as a percentage of total necessities in the basic, we’re talking very basic necessities. The three big metrics that they use are food, housing, and apparel. If you look at the three of those, the housing component has obviously increased, but the apparel and food component as a share of household income expenditures has declined really significantly. In total, the share of that has declined since 1970 from about 58% to about 45%. The amount of money that we spend on what we deem as very basic necessities has declined substantially.

Cullen Roche (00:43:17):

Sure, even if we become less productive, our living standards haven’t necessarily declined over that period of time. A modern home is a technological miracle from top to bottom. The insulation is magnitudes better. The things you can’t even see, the dry wall is better. When I was building my house here, I couldn’t believe how different every single material was all along the way. I mean, I used things in our foundation construction, the epoxies that have been invented in the last 10 years. These things you couldn’t blow them up with dynamite. I mean, these are things that are just leaps and bounds superior to everything that existed in the 1970s. When people talk about our living standards and productivity, you get a lot of very subjective ideas that go into this.

Cullen Roche (00:44:13):

The BLS, they come under attack a lot because they … Like hedonic adjustments and things like that. This is all very subjective. You could argue they’re very somewhat sloppy, necessarily so about the way they subjectively attribute gains to a lot of these things. But the world’s just become really, really complex in the last 10, 20 years, where I think that the idea of productivity gains and whether or not we’re better off as an entire economy has become so subjective, and to a large degree, a lot of business [inaudible 00:44:49] in that, for instance, in today’s economy, people would argue that a college education and healthcare are now necessities. 100 years ago, you’d never made that argument.

Cullen Roche (00:45:02):

Nobody went to college 100 years ago. Very, very few people did. Nobody had good access to good healthcare 100 years ago. But objectively, we now consider those things to be necessities in a modern economy. That alone is evidence that regardless of how productive we are or how much stuff we create, our living standards have increased over this time. I’m not making excuses for things like inequality. There’s definitely been a lot of winners and losers over the course of time. But in the aggregate, I don’t think you can make a really convincing argument that our living standards have declined over the last 30 or 40 years regardless of productivity, in the way we measure these things, because a lot of it’s just so subjective.

Cullen Roche (00:45:50):

I think that we just have a very hard time objectively analyzing these things because living standards to a large degree, they’re like beauty to some degree. I mean, back in the Roman empire, a big overweight woman was considered beautiful, and today we look at runway models, these pencil-thin women, and that’s the essence of beauty in today’s economy or today’s society. There’s so much subjectivity about the way we perceive these things, and I think living standards are very, very similar.

Stig Brodersen (00:46:27):

Let’s go back to this theme of Corona. It’s on everyone’s minds, assuming they we use 2019 as the benchmark and that the world would have somewhat normalized in 2022, and we can always talk about what a normalized world would look like today, but which countries and regions do you expect that would have weathered the pandemic best measured in economic growth, and how should we as investors position ourselves accordingly?

Cullen Roche (00:46:56):

Yeah. This is the big question coming out of really since the financial crisis was the whole monetary policy versus fiscal policy response. I think one of the things that people missed … I was really vocal in April about this idea that a lot of people thought the stimulus was going to be really bad for the economy. My argument was basically the economy was going to be really good for … Whether or not it was good for households, whether or not it’s targeted really efficiently was meaningless for a stock market investor because the basic math of corporate profits is that when the government spends more money, where does that money go ultimately? Well, if you assume, for instance, that the personal savings rate during a recession, it increases, okay?

Cullen Roche (00:47:48):

If the government’s sending checks to households, households are saving that. But as the economy heals over time, and let’s just say that regardless of what the government is doing, that the economy heals naturally over time, let’s say we get a vaccine, COVID slowly goes away. Well, all that spending went to households, they saved the money. What ultimately happens with it? If the savings rate declines, all else equal, that money ends up going to corporations. That’s where the money flows. Okay? My ultimate argument was basically that when the government spent all that money back in April, that eventually assuming that COVID goes away and that the economy normalizes to some degree, you are going to see all this money hit corporate balance sheets at some point.

Cullen Roche (00:48:37):

It was all going to flow down to the bottom line of corporations, because that’s the basic math of the profits equation when you look at the aggregate economy. Of course, I’m assuming that the savings rate will decline, but that’s pretty much … If I had to bet the [inaudible 00:48:52] on something happening, it would be that Americans will not save money in the future. That they will spend, spend, spend, and ultimately, the personal savings rate will decline as the economy heals over time. That money just all flows to corporations in the end. Yeah, I think that measuring things from a basic metric like that, you’d want to be exposed to the countries that were just throwing money at this thing, because that ultimately … Those are the countries where corporations within those domestic economies are going to perform really well.

Cullen Roche (00:49:25):

From a fiscal stimulus perspective, the countries that have thrown the most money at this thing are Japan, Canada, Australia, and the United States. I don’t know what the updated numbers are with the US after the most recent. But those are the four who have the most money at this thing. So you could make a strong argument that if you’re a stock market investor, those are the four economies where the underlying corporations are likely to perform the best over, not just the COVID period, but the post-COVID period, because as the savings rate decline, the money will ultimately flow to those corporate coffers. Again, you’re making a bet on the virus to some degree, but I don’t know, there seems to be some evidence.

Cullen Roche (00:50:08):

I was also really vocal in April that I thought life would last largely return to normal, or that I thought the GDP would at least recover within 18 to 24 months. It looks like that might be pretty much dead on. Whether or not life will have normalized, I mean, again, that’s subjective term, I guess. We’ve been knocked into a different paradigm to some degree. I think the COVID trends accelerated a lot of the trends that were already happening. That’s probably a whole different discussion. But if you’re looking at this just from a really top down macro perspective, it’s all about fiscal stimulus. Looking at the central bank policies, ignore the central bank policies because the central bank policies, as much as people like to focus on them as the real money printers … I always described, for instance, quantitative easing as being an asset swap.

Cullen Roche (00:51:02):

But the kicker with quantitative easing is that if the Fed creates a bunch of reserves and swaps them with treasury bonds, okay, so they expand their balance sheet, they issue new reserves which creates deposits in the banking system. The bank swaps a treasury bond with a household for a deposit. So the household now holds a deposit, the bank temporary actually owns a treasury bond, which sells it to the Fed. What does the Fed do with that treasury bond? They basically buries it in the backyard. It’s not in the real economy. It has no monitoring impact at all on the economy, except for the remunerations that the Fed ultimately ends up paying to the treasury, which are pretty insignificant in the long run. But the kicker is that this is a clean asset swap. But the big component there is, well, what if the treasury expands their balance sheet by $3 trillion like they did this year?

Cullen Roche (00:52:00):

Well, that changes the way we have to view QE because QE in a vacuum, with just the monetary policy side of it, it’s just a clean asset swap. It’s not money printing in any meaningful way, because all you’ve done is you’ve created a reserve that’s 0% interest bearing and you’ve swapped it with a treasury bond in the private sector. That to me actually has the potential to be slightly disinflationary or deflationary because the household now has a lower interest bearing government asset basically, and the government has for all practical purposes retired the treasury bond from circulation. But if the treasury is actually expanding their balance sheet, well, that’s a whole different dynamic. You have to look at all these other dynamics. Looking at COVID, I think that was the big thing that a lot of people missed.

Cullen Roche (00:52:48):

That when people were calling the Fed’s policies money printing, they missed the fact that the real money printing was occurring from all these treasuries and that the basic math of it was that as much as you might hate the results of all of this government spending, the ultimate beneficiary of it was going to be corporate America. I’ve had big, long debates with people about why, whether or not QE causes asset inflation and things like that. I always say you’ve got to look at the underlying fundamentals, and is there an underlying fundamental rationale for why asset prices have increased? In this case, I would argue definitively there has been because, mark my words on this, you’re going to see record corporate profits next year, and probably in 2022. Yeah, asset prices have gone up, and you could argue that’s all government policy. But you could also argue that there’s an underlying rationale for why that has occurred.

Cullen Roche (00:53:46):

If you’re pinpointing the countries that are the parts of the global economy that are likely to weather [inaudible 00:53:56] have nothing to do with whether or not you did shut downs or not. I think one thing we’ve found with COVID is that nobody knows how to fight this thing, from the management perspective of can we manage the shutdowns and openings? People at times were saying, “Oh, Sweden’s doing so great, and now they’re doing terrible.” At times people were saying, “Oh, look, the United States is doing so great and now they’re doing terrible.” This thing seems like it’s going to get you eventually, and you either ride it out until the vaccine comes and save the day or not. You can shut down your economy and tell everybody to stay home. But at the end of the day, the thing that really matters is how much fiscal policy is being pumped into the domestic economy, and how much is that going to ultimately filter down to corporations in the long run?

Stig Brodersen (00:54:49):

Cullen, I would like to shift gears here at the end of the interview. As anyone can tell, we love speaking with you here on the show because you do such a great job explaining and simplifying advanced macroeconomic concepts. For someone listening to this who is super interested in becoming as knowledgeable as you, but perhaps also feel it’s a little overwhelming to start on this journey, which three steps do you recommend they take to get started right away?

Cullen Roche (00:55:15):

It’s funny, I’m mostly self-taught on all this stuff. It’s so complex I would argue that no one knows a lot of these great big answers. Nobody knows what causes inflation. Nobody knows for certain whether Fed policy causes asset price inflation, things like that. I think a lot of it requires just a super, super open mind. One of the things that I think has been interesting over the learning process that I’ve gone through is that I’ve managed … I think part of this is the fact that I’m directly involved in managing people’s money, is that I have to try to be somewhat objective. I can’t fall victim to political narratives and falling into tribal mentality where I align myself with a group of people that just have a generally a political nature narrative, and they just through any type of environment they have to promote that narrative.

Cullen Roche (00:56:11):

That, I think, really curious open-mindedness is so useful because there’s lots of good components of all different economic theories. MMT’s a lot of attack these days and I attacked it a decent amount, but there’s actually a lot to like inside of MMT. There’s a lot of good components that are really eye opening and somewhat useful. The same is true of any economic theory, and I would argue any financial theory too. You don’t have to be only a value investor. You don’t only have to be a growth investor. You don’t only have to be a domestic technology investor. You can be open-minded about all these different things and understand that there’s a lot of good in a lot of different aspects of all of these things, and I think you just have to explore these things in a very open-minded way.

Cullen Roche (00:57:04):

I did create a page on the Orcam Group website. It’s Orcam, O-R-C-A-M group.com, and under the education page, there’s a tab called understanding money, and I just collected a whole bunch of links in there that are things like my big paper on understanding the modern monetary system. I linked to the … Ray Dalio came out with a famous video back in 2013 called How the Economic Machine Works. There’s a link in there to Bill Ackman’s video on everything you need to know about finance in 30 minutes. There’s so much to learn. I think one of the daunting things, especially with macro econ and macro finance is that the more you learn, the more you learn how little you know. If you’re not open-minded and you’re really, I think, politically driven into certain boxes, I think you just expose yourself to the potential that you’re going to end up being wrong about big, big things.

Cullen Roche (00:58:11):

You need to be more open-minded and just really curious and have this voracious appetite to try to understand other people’s perspectives. Because there’s almost always something useful. Even all of the people’s views that you disagree with, there’s usually some rationale. You might think I’m the biggest idiot in the world, but I guarantee you there’s at least some little bit of rationale in the way that I’m approaching the world from my specific perspective, and that there is some rationale for the way that everybody’s navigating the world. I’m not an efficient market hypothesis believer, but I do believe there’s at least shades of gray in the idea of efficiency, in that you’re better off trying to understand why people either promote a certain theory or the things that they’re teaching, because there’s usually tidbits of truth in there. I think you just have to be really open-minded, and try to really understand all of these different theories from all of these different perspectives.

Stig Brodersen (00:59:15):

Well said, Cullen. Thank you, as always, for coming here on the show. I would also like to give you the opportunity to tell the audience where they can learn more about you, Pragmatic Capitalism, and the Orcam Group.

Cullen Roche (00:59:28):

Yeah, Pragmatic Capitalism is my blog. It’s just where, over the course of the last 10, 15 years, I’ve just vomited all of my thoughts and knowledge or stupid ideas on to the website. That’s pragcap.com, P-R-A-G-C-A-P.com. I’ve listed a lot of different pages over time. Again, there’s an education tab there, recommended reading, understanding money. I have some research papers on there. It’s very top of the page. There’s a new here, a welcome mat that just shows the big, big, broad topics that I think are the most important things to probably understand. You can get pretty wonky, and it takes time to digest and understand a lot of these very, very big macro concepts, and it takes a lot of time and effort, and the ideas change over time.

Cullen Roche (01:00:25):

So you’ve got to keep up with the changing technologies and the changing paradigms and all this stuff. But I think having a good objective first principles based mentalities, it creates a really good foundation for being able to navigate these things, especially because it will help you I think avoid a lot of the politics that naturally get intertwined in a lot of these discussions where bias [inaudible 01:00:54] exposes to big, big risks. Create that foundation. I have a forum on my website. I would love to answer questions there if people have any. You can also email me at cullenroche@orcamgroup.com if you have questions, and I’m always happy to help. So many people have been so helpful to me over the years learning all this stuff and answering my stupid questions that I really, I really love helping people learn and educate people where I can.

Stig Brodersen (01:01:29):

Fantastic. We will definitely make sure to link to all that in the show notes. Cullen, once again, it’s been an absolute pleasure as always. You always have so much fun. We always learn so much from you. I really hope that we can bring you back on the show another time. All right, guys, that was all that I had for this week’s episode of We Study Billionaires. On Wednesdays, remember Preston is back with a specific episode about Bitcoin. Then weekends, we’re doing traditional We Study Billionaires episodes. Next weekend, Trey and I will be back with our interview with Tom Gayner, CEO of Markel.

Outro (01:02:04):

Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. The show is copyrighted by the Investor’s Podcast Network. Written permissions must be granted before syndication or rebroadcasting.


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