SM (ed. 1) Debt constrains our future

Have you ever wondered why economic conditions are challenging, despite easy access to credit for cars, homes and shopping? In this edition of the Sound Money Monthly we cover one the most important macroeconomic trends, debt. (16 minute read)

TLDR: Economic growth, job quality and social mobility are declining. Yet the policy response is the cause of the problem. Authorities promise “economic stimulus” but they have overused debt, mortgaged our future and now we’re wading through the consequences. We can take constructive responses through judicious business strategies, strong relationships, value in non-monetary rewards and seize opportunities in new industries.

Weak economic growth is a long-standing challenge

Long before 2020, the world has been challenged by weak economic growth. Elevated unemployment, low social mobility, high youth unemployment and a declining job quality for the average worker. For example there has been a rise in part time workers relative to full-time.

In the US, unemployment numbers appeared good until 2020 but other cracks emerged below the surface. US real GDP growth has steadily declined during each business cycle since WW2, part-time work relative to full time work is elevated, there are large number of people on food stamps, an opioid crisis and rising homelessness.

In Europe, youth unemployment is a disaster. Each country is dealing with a slightly different variation of the problem, and each has its own scapegoat but something is awry below the surface.

I’m tired of petty political scapegoats. I’d like to draw your attention to the common theme – a deterioration in broader economic conditions, certainly for the average middle to lower class individual.

When the arsonist comes to fight the fire

Authorities argue that the answer to these challenges is economic stimulus. They want to lower interest rates, raise debt and implement bigger government programmes to directly target the challenges and support the afflicted groups. The problem is – debt is the cause and authorities are exacerbating rather than solving it. Let me explain.

Debt is a financial tool to smooth consumption

Before you think “Rob hates debt”, let us start with the positive. Debt is a useful financial tool to smooth lifetime consumption. For example, I want a laptop when I am 21 but I cannot afford it, so I promise to use my potential future income to pay for the laptop. In return, the bank provides me with the $1,000 financing today. I have taken my future income and consumed it at 21. Waiting for the laptop is an inefficiency, which debt overcomes. It’s a fair assumption that I will earn more income when I’m older, a laptop loan is not onerous and the laptop should enhance my productivity making loan repayment loan effortless.

This example is low-risk and shows the useful tool debt can serve in society.

Productivity matters

The logic of the debt arrangement declines, the larger the loan, the less productive the asset and if age becomes a constraint on future earning power. I’m not one to judge individual’s consumption patterns but obviously there is a difference between the productivity, and the repayment implications, between a computer vs. a pair of designer shoes.

Let us say I violate logic and I make the terrible decision to take a $10mn loan, at 60 years of age, for a property development that offers hot-desk services, two months before covid19…

A terrible personal decision which damages my wealth prospects. But at least I am only one individual. As the business goes belly-up, I can get support from family or friends. I may enter bankruptcy but at least there are not systemic risks. My employees will be out of work, but my failure will not negatively impact society. In fact, there could be positive externalities. Maybe someone can purchase my office equipment and repurpose it into a profitable venture. Schumpeter’s creative destructive, the economic process of decay, repurposing and rebirth, can be powerful!

Isolated vs. Systemic Errors

If everyone in America is levered to the hilt with debt at the same time, systemic risks arise. Mistakes can’t be cushioned by successes elsewhere. Under these conditions, the whole of America has decided to take future income and consume it in the present. This could be a reasonable trade-off if we’re building something unequivocally productive for the coming years, perhaps a national transport network. But we’d expect to reap the returns from the investment in the coming 5 to 10 years and repay the debt, right? So, it should temporarily increase debt.

What if it is not temporary? What if debt levels rise for consecutive decades, across all economies in the world?

In this scenario the whole world has taken future income and consumed it already. The continuation of the trends implies that the investments made were NOT as productive as planned. If the investment was productive, we would have earned better returns and paid down the debt.

This is exactly where the world finds itself today. Debt levels are at or near record highs across the globe.

The ratio of advanced economy government debt to Gross Domestic Product (GDP) is above 120%, at its highest levels since WW2. There’s more government debt than the size of these economies.

The continuation of the trends implies that the investments made were NOT as productive as planned. If the investment was productive, we would have earned better returns and paid down the debt. But debt to GDP is at its highest levels since WW2.

It is not just a public sector story. US corporate debt as a percentage of GDP is at record highs.

Emerging Markets are not immune either. South African government debt to GDP is also at record highs.

Bad investments and the zombie apocalypse

It’s clear that society has made bad investment decisions because the investments aren’t providing the returns to pay down debt. Another simple way to view the number of bad investment decisions is the number of companies that are failing to return profits. Non-profitable companies are bad business decisions. These companies should be liquidated, but they aren’t, and the capital should be reallocated elsewhere, but it is not. The jargon we use to refer to these companies is zombie companies, because they’re walking dead! The number of US small cap zombies rises to a new record high during each recession.

Source: FT

Imagine we were able to measure government departments by the same method… Maybe we ARE living in the zombie apocalypse!?! At the extreme’s the inefficiencies are easy to identify but there are tones of businesses and individuals in the murky middle that are not even sure if they are truly adding real value. Debt saturation hides the truth from us.

We’ve mortgaged our future

Record highs debt levels across the globe imply we have mortgaged the future to consume in the present. We have reached the future in the 2020s and we are realising that it has been mortgaged already. Many assess our massive debt levels as a problem for future generations that we will have to contend with in the years to come. As depressing as that is, it is only half of the truth.

We have not started to SOLVE this problem yet, but we are dealing with the CONSEQUENCES already. It is like turning 21 and you’re already saddled with a major business bankruptcy. You’re climbing up Everest, but you’re starting with a 30KG/70LB backpack. You are shouldering this debt burden, which constrains your ability to function freely today. Millennials certainly feel this weight, and there are real reasons for their frustration!

Macroeconomic growth expectations and social mobility prospects will remain weak until we reduce debt. Economic growth rates will almost certainly achieve a technical increase post the coronavirus shutdowns of Q2 2020. It’s not very difficult for real growth rates to increase from -20% towards 0%.  But the trend rate of economic growth will continue to decline – as it has for the last few decades. Debt is a major contributor towards this downward trend in real growth. Economists, business-people and individuals who forecast a return to long-term average growth rates in the coming years are incorrect.

Government is the problem, not the solution

Government stimulus programs are the source of our problems rather than the solution to them. Relying on politicians in a parliament/congress is a hopeless strategy. It is preferable to distance ourselves emotively from their political shenanigans and blame gains. We have to rely on ourselves and take the reins of our future. Here are a few additional strategies I am trying to implement in my life:

  1. Building through adversity: Weak economic growth prospects imply challenging business conditions. This doesn’t imply that we must throw in the towel and stop trying because it is going to be difficult. That is defeatist. Opportunities exist in all economic environments. Successful people and businesses are made during tough conditions. General Motors was founded in 1908 during a 4-year recession, Hewlett Packard was founded in later years of the Great Depression, Electronic Arts during the energy crisis of the 1980s, Uber and AirBnb grew out of the 2008 Global Financial Crisis and Investec was founded during the tumultuous 1970s in South Africa.
  2. There will be sectors of strong economic performance despite broader weakness. There are constant changes in regulation, new technologies and government failure for entrepreneurs to solve. In my opinion, the decentralised monetary technologies of bitcoin and crypto is one of those industries that is blossoming in response to government failure. It is no surprise that young talent is flooding into the space.
  3. Thinking differently and expecting errors: If business conditions are going to be challenging, it implies that we must be judicious with our business strategy, rather than merely follow the tried and tested strategy of the last 10 to 20 years. It’s not prudent to expect broad economic growth rates to reach their 20-year norms and for consumers to recover pre-2019 levels. Unless your producing necessities, low margin and high-volume business will likely face challenges. Real value-add and close relationships with clients are treasured during these times. Strong relationships create the possibility of charging good margins, maintaining business despite setbacks and receiving credit relief.
  4. I expect to make errors. I expect the market to force me intro changing strategy. I need to remain very open-minded regarding the future possibilities and the fragility of my current strategies. 
  5. Success isn’t purely characterised by financial gain. Yes, we all will put bread on the table despite record high debt levels and the negative impact on future economic conditions. But opportunities also emerge in non-monetary guises. Communities will grow, families will strengthen, relationships will persevere and meaning will be found despite challenges.

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