Clay Finck (03:30):

Since credit is a large part of the overall economy, economic activity is largely driven by interest, which are set by the central bank. When interest rates are high, the cost of borrowing is high, so overall people are going to borrow less money. When interest rates are low, the cost of borrowing is low, so overall people are going to go out and borrow more money. A prime example of this is when the COVID pandemic hit, the central bank lowered interest rates to try and stimulate the economy by encouraging market participants to borrow money and then go out and spend it in the economy. So credit in the economy can be kind of a self-reinforcing cycle. When someone borrows money, they have buying power they wouldn’t otherwise have. So they go out and spend the money they borrow and the person or entity that receives that money now has money they wouldn’t otherwise have, which makes them more credit worthy to go out and borrow money. So that person might go out and take out a loan as well.

Clay Finck (04:28):

So that kind of helps paint a picture of how credit or debt has such a big impact on our overall economy, which ends up creating these boom and bust cycles, as we all know, it’s not only reinforcing on the way up, but it’s also reinforcing on the way down as well. The problem with credit is you can’t just have ever increasing debt levels without someday paying the price for that debt. When someone takes on debt today, say they buy a house, they are spending more than they produce when that debt is taking on, but spending less than they produce later on when they end up having to pay back the loan. And this goes for any person or entity taking on debt, as there are no free lunches. Think about it. In order to buy something that you can’t afford, you need to spend more than you make. And then to pay that back over time, you need to spend less than you make.

Clay Finck (05:21):

Because of this, credit creates cycles in our economy. When the economy gets overheated and there’s too much economic activity leading to inflation and prices, the central bank will raise interest rates to try and slow the economy down. Raising interest rates naturally leads to less borrowing and less economic activity. These short term debt cycles that last every five to eight years just continue to grow as each top and bottom of the cycle is higher than the previous cycle, and there’s more debt in the system, and governments and individuals continue to borrow more and more money instead of paying off their existing debt. Put another way these short term cycles would last five to eight years. Eventually they top out and we enter a recession and the policy makers will stimulate the economy and lower interest rates again to allow the economy to pick back up again.

Clay Finck (06:12):

As the overall debt burden continues to grow, eventually it reaches a point where the debt needs to start being paid back as the system has become over indebted, which leads to decreased spending in the economy in the conclusion of what Dalio calls the long term debt cycle. The total debt burden in the US today is as high as it’s ever been. The last time the debt burden peaked was in the early 1930s, which was roughly 90 years ago, which falls in line with Dalio’s timeline of how long a long term debt cycle actually lasts. In Dalio’s video he actually says that the long term debt cycle concluded in 2008 with the pop of the real estate bubble. But what central banks chose to do was simply lower interest rates to zero and allow the debt bubble to reinflate even further to today.

Clay Finck (07:02):

If you look at the long term trend of interest rates, you’ll see that interest rates hit zero around 1930 and they hit zero again in 2008, during the financial crisis. Interest rates have been the tool that central banks have been able to use to stimulate the economy. But once it hits that 0% mark they’ve essentially lost the ability to influence markets using that tool, and it’s another sign that we are at the end of the long term debt cycle. Another big issue is that as more and more debt is accumulated in the economy, this makes businesses and individuals more fragile to the inevitable economic shocks. For example, many businesses will go bankrupt if we lock down the economy because of a pandemic, because most of them don’t have ample cash to make it through this type of crisis.

Clay Finck (07:52):

Today in the US the total debt to GDP is around 340%. During the Great Depression, this peaked at around 300%, and with the de-leveraging in the system, this dropped all the way down to 120% in the 1950s. So eventually this debt needs to be resolved in some way, shape, or form for things to correct, normalize, and revert to the mean, a de-leveraging event is required. Dalio outlines four ways that the economy can de-leverage and allow things to revert back. That’s one, people, businesses in governments cut their spending and pay down their debt. Two, debts are reduced through default in restructuring. Three, wealth is distributed from the haves to the have nots, or in other words, taxes are raised. And four, the central bank prints more money to devalue the debt and make it easier to pay back.

Clay Finck (08:48):

Now, the first two options, cutting spending and debt defaults and restructuring, those are both extremely painful, and my guess is that they are not likely to happen. After digging into some of Lynn Alden’s research, she believes that really the only way for governments to work their way out of this mess is to inflate away the debt. So ideally they will print money, decreasing the value of the dollar to make the debt levels more manageable. Given the incentive structure and the political sphere, as the people in power are in power for four years or so, it’s much easier to take the quote unquote easy way out in the short term and hand the problem off to the next set of people to come into office. Printing money and handing it out to people is much easier than telling everyone they need to start paying off their debt and they’re going to have higher taxes so the government can start paying off its debt. It’s just much easier to print the money and inflate it away and pass the problem along to someone else.

Clay Finck (09:48):

If governments did decide to cut spending or default on their debts, this would be extremely deflationary and would cause a depression probably worse than the Great Depression itself back in the 1930s. So in Lynn’s research, she looked back through history and found that the majority of countries nearing this long term debt cycle ended up resolving it through inflation, and sometimes that inflation got way out of control and eventually led to hyperinflation. So the big question is what can investors do to protect themselves during this environment? Let’s start with what asset classes are expected to perform the worst.

Clay Finck (10:26):

If inflation persists over the coming years, as it’s ran hot in 2022, then cash and bonds will not be a good performer, as their real returns are likely to be negative. As the Dalio saying goes, cash is trash, and he definitely hasn’t been favorable towards bonds either. As for stocks, it’s somewhat hard to say. Stocks did not perform well in prior inflationary periods, such as the 1940s and the 1970s, but there are many sectors of the stock market, so some types of companies will perform better or worse than others. But there are many sectors of the stock market, so some types of companies will perform better than others. Prior to COVID we saw a decade of low inflation and big tailwinds for big tech companies, which carried the S&P 500 to have a very good run. I personally don’t expect the ride to be straight up from here, like it has in the past, at least in real terms, after accounting for inflation.

Clay Finck (11:23):

I would expect cash flowing real estate to perform better than stocks and bonds, especially if you have a fixed rate mortgage attached to the property, as the debt gets easier to pay off over time and the dollars to pay back the loan are worth less and less. And on top of that, you have your rents continuing to go up and up while you have that fixed rate mortgage. Lynn Alden suggests that the assets you want to own during an inflationary period are the scarce and productive assets. Specifically the assets she mentioned were value stocks, commodities, gold, and Bitcoin. She believed that Bitcoin will be the biggest beneficiary of this environment. Her reasons for this are twofold. One, you have a network effect with Bitcoin that is like a tech company that only gets stronger as more and more people join the network. And two, you have the only asset on the planet that has a fixed limited supply as that is what is programmed into the code of the network, as it has a supply limit of 21 million coins. So it could be the perfect storm for Bitcoin in this inflationary environment.

Clay Finck (12:29):

If you prefer real tangible assets, then commodities or commodity producers might be a strong inflation hedge. These tend to do well in times of high inflation, whereas gold and Bitcoin have an eventual correlation with inflation, but not at the same time that commodities would oftentimes. And that’s what we’re seeing right now in 2022, as commodities are running hot and Bitcoin and gold haven’t been performing quite as well. I’ll be sure to include the link to Ray Dalio’s video, How the Economic Machine Works, and Lynn Alden’s article, Fixing the Debt Problem, in the show notes for those that are interested in checking those out. All right, that’s all I had for you today. If you guys have any questions related to anything I discussed during this episode, feel free to reach out to me. My email is clay@theinvestorspodcast.com, and on Twitter, my username is @Clay_Finck. That’s at C-L-A-Y, underscore F-I-N-C-K. Thanks for tuning in.

Outro (13:26):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin, and every Saturday we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to theinvestorspodcaster.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.