Sound Money

Have you ever wondered how we managed to accumulate so much debt? In this edition we’ll tackle the causes for the biggest debt bubble in history. You’ll learn about short-termism, interest rates and the feedback into politics. Don’t worry, I have no desire to talk about politicians, elections 2020 or go down the Donald Trump rabbit hole. There’s enough of that on Fox and CNN! We must have real political conversations, but this is not the place for that divisive debate. If anything, this article divorces politics from the bipolar political machine, which is useful as US election season heats up.

TLDR: There are dangerous linkages between short-termism, debt, interest rates and political systems. Like a snake eating its own tail, society is mindlessly exacerbating rather than solving problems, inflating our debt bubble year after year. Central banks and governments are at the centre but we’re all part of the problem as we cheer for lower and lower interest rates. This article equips you to understand your place in the puzzle, providing options to assess your freedom, awareness and ignorance.

Households, corporates and governments across the globe are saturated with debt. The US government has >110% debt to GDP, corporate debt hit a new record high in 2020, emerging markets like South Africa are mired with a similar situation. In edition 1 we showed that debt weighs down our economic prospects and makes it difficult to invest in our future. It’s no surprise then that the world is dealing with record low real economic growth rates and record high debt levels simultaneously.

Debt is a major problem, yet politicians ignore it. Budget deficits widen, debt levels rise and excuses are made for fiscal profligacy. How did we get to this point and how can we reverse the trajectory? To understand this question, we need to appreciate the relationship between interest rates, debt, time preference and politics.

Interest rates drive debt

We all prefer to consume today, rather than tomorrow. I’d rather eat at a restaurant today, wear new shoes, go on holiday, drive a new car, and live in a beautiful home today. But as much as we’d prefer to consume today vs. tomorrow, there are constraints. I don’t have the money to buy everything today. I must borrow to transact today. And there are costs to borrowing, interest rates.

Interest rates are a weighing mechanism to balance our preference for today vs. tomorrow. The cost of borrowing prevents me from satisfying every whimsical desire. And that’s a good thing. Your parents might have told you that you can have whatever you want when you were a kid, but this is false. There are 8 billion people on planet earth and only a finite number of resources. Thank goodness there are mechanisms to curtail instant gratification. Imagine if everyone could have the holiday, car and home that they want, as soon as they want it? An entirely impractical outcome, and an environmental nightmare.

Modern societies don’t allow a key weighing mechanism, interest rates, to do its job. We manipulate interest rates to target alternative goals. I’ll get to the reasons in a moment, but let’s conclude the mechanics… As we reduce interest rates, we reduce the cost of debt and encourage people to take out more of it. By contrast, higher interest rates increase the cost of debt, disincentivises new debt growth and potentially causes debt defaults if interest rates rise enough. The strong negative relationship between interest rates and debt is visible below.

Why have we done this to ourselves? Why have we saturated ourselves with debt, mortgaged our future and diminished our economic prospects?

Systematised Short-Termism

Governments are less constrained than individuals and households, their policies influence our actions through altering our incentive mechanisms and they’re short-term focused.

Governments are meant to strategically plan for the long-term future, but this is rare. Rather, politicians promise utopian outcomes to their voters during periodic election campaigns. Once in power, politicians scramble to execute achievable projects to enhance re-election probability. These projects may be filled with wonderful intentions but usually they involve short-term thinking, spending more than income and increasing debt.

I’m not saying that society shouldn’t spend on social services but if government debt levels trend higher for longer than a 5 to 10-year period, this implies that government spending wasn’t productive. I.E. the investments didn’t reap worthwhile returns. Governments should be long-term focused, but they are beseeched with short-termism! They should allocate capital towards effective long-term projects that lay the foundation for a successful future, but governments tend towards bureaucracy, inefficiency, pet projects and favouritism.

Individuals, households and companies take their lead on debt decisions from interest rate policy, which is determined by central banks, and central banks are an arm of the government. Central banking theory tells us that they’re independent institutions, but the background of these individuals proves that they have strong linkages to political bureaucracy. If they can get away with it, central bankers lower interest rates whenever possible. Donald Trump’s recent pressure on the Federal Reserve is the most blatant example, but the only exceptional component of Trump’s pressure is it being blatantly cast across the airwaves.

Some political parties lobby for fiscal responsibility during their election campaigns, but evidence doesn’t stack up in their favour. Let’s look at the US and UK. Republicans and Conservatives are touted as fiscally responsible but look at the growth in government debt under their watch. This is not a partisan issue! Short-termism, debt accumulation and fiscal responsibility are a feature of governments, not a bug.

People are short-term focused, but usually there are constraints on our ability to exercise our short-termism. Governments aren’t constrained by the same forces and central banks distort the market constraint, interest rates. Government loads itself with debt and implements policies that encourage us to follow in their footsteps. The people who we elect every 4 or 5 years have institutionalised short-termism.

Can you see the Snake in the Grass

or as Afrikaners say, “slang in die grass”, which just sounds better…

It’s easy to point the finger at government, and we should, but we’re all strangely complicit in institutionalised short-termism. We buy into this system and there are strong incentives for it to continue.

Banks earn money by lending. They benefit from cheap loans from the central banks, earning interest rate spreads when lending to consumers. Investment houses prefer to report strong investment performance to their clients than weak, so they prefer lower interest rates because these boost asset prices. Big businesses tend to sell us goods and services, and they want us to consume those things sooner rather than later. They benefit from lower interest rates and debt accumulation. And we, the consumers, love it when businesses or banks offer cheap credit for us to buy our favourite car or clothing brand. Most adults’ own houses and their interest repayments are tied to interest rates. The lower interest rates go, the louder we cheer!

I hear the same thing every time a central bank lowers rates; “thank god, my mortgage payments have fallen!” As though there aren’t any consequences…

Short-termism is THE BIG challenge

Who do you hear cheering for higher interest rates? Me, a couple of my friends and a few crazies on twitter? Pensioners, maybe? Who listens to them anyways…! There are untold negative consequences of short-termism, debt accumulation and lower interest rates but it’s often difficult to witness these consequences at first glance. Weak economic prospects, the topic of last months edition, is one example. Income inequality, generational wealth disparities, consumerism and social instability are consequences to cover in future editions.

The disaffected parties from lower interest rates and debt are all around us. The 30-year who cannot get on the savings ladder because house prices are through the roof, inflated by debt and low interest rates… The 20-year old who cannot afford inflated college education prices… The maligned sections of society who don’t experience the social mobility opportunities of the 1980s and 1990s… The average Joe who just wants to do his 9-5, save his money in the bank and play with his kids on the weekend, but is forced to speculate on the stock market to save for college education… These groups are disparate and not politically organised enough to push back against the fundamental cause of their troubles. In fact, many of them are lobbying for outcomes, which are contradictory to their own interests.

Like the ancient Egyptian symbol of the snake (the ouroboros), we’re eating our own tail. More debt and lower interest rates reduce our long-term prospects, they burden future generations with sacks of lead after we’ve mortgaged the future in previous generations. And yet we cheer each time the reserve bank reduces our interest rates and we encourage government to provide more and more social services to “solve” societies challenges. We’re all complicit in this gradual self-immolation.

If there is one thing you take from this newsletter, take this. We require a collective realisation that promoting short-term economic policies is contradictory to our own interests! We must push back against the narrative that debt accumulation and lower interest rates can solve our problems. They won’t. This is THE BIG CHALLENGE.  

Ok, so what do we do about it? First, re-read the last paragraph.

Now, let’s characterise 3 broad approaches to debt.

1. Free Francis

Francis believes that there is an ethical imperative to reject debt due its insidious consequences. Francis lives entirely debt free, which is noble but tough. She rents rather than owns her house, she owns rather than leases her car and she doesn’t earn credit card points. On the positive side, Francis has zero concern that a bank can ever repossess her car or house. She doesn’t have to worry about the eventual bursting of the 30-year debt bubble and indebted governments who will need to raise taxes (including property) to pay for their largesse, because she’s not a participant. Francis considers alternative stores of value because she’s concerned by the impact of debt and low interest rates on the value of her national currency.

It’s intriguing to consider Francis’ approach, but I am not naïve enough to think that we are going to reject debt today. It’s not necessarily in my own interest and it could require painful adjustments

2. Aware Angie

Angie understands that debt is a systemic problem, but she doesn’t believe she has to solve the world’s problems. She tries to follow as many of Francis’ policies as possible, but she utilises debt. Angie does not cheer lower interest rates, but she makes use of the credit on offer in order to advance her financial situation. She understands the low interest rates provide an opportunity for those who can utilise the capital productively and she doesn’t want to miss out on those opportunities. She uses credit judiciously to invest in productive outcomes but tries to avoid racking up large debt balances just because financial institutions are offering it. Angie tries to lock-in fixed low interest rates to mitigate against the risk of higher interest rates at some point in the future. Angie doesn’t support politicians who promote low interest rate, debt accumulation or other short-term policies because she appreciates the negative long-term consequences on society.

3. Ignorant Isabelle

Isabelle cheers lower interest rates. She takes out every last drop of credit and spends it on whatever catches her fancy; cars, bags, holidays and shoes. Isabelle votes for politicians who support her pet project, irrespective of their interest rate and debt policies. She takes no notice of the consequences of short-termism on society. For as long as interest rates are low and the debt bubble continues, Isabelle might avoid the pain from her rash decisions. But when conditions eventually change, her life will be thrown into turmoil. No more cheap credit to fund the lifestyle, a stack of debt to repay, potential default and repossession of assets. Zeus help her, if there are mouths to feed! She will have limited financial resilience, nor will she possess the skills to alter her financial conditions. It’s painful to live within one’s means! One needs to be equipped to make this adjustment, even if one isn’t forced to adjust today.

The point here isn’t to judge, point fingers and get up on a high horse, AT ALL! Humans respond to incentives and all the incentives are heavily skewed towards debt origination. I don’t look down on people who are piling up the debt. In fact, sometimes I’m jealous of their ability to seize momentum, buy a nice asset or live it up. F**k, I wish I wasn’t such a curmudgeon. But I can’t help it that I’ve spent some portion of every day in the last 10 years of my life thinking about this shit. I’m convinced that short-termism, this secular debt bubble and low interest rates are the biggest challenge we face in the coming years. So, forgive me for sounding a little preachy. I merely hope that an articulation of the problem, an understanding of our part in it and a few potential responses gives us a chance to take constructive, sound and confident actions.

Positioning for Regeneration, Re-birth

Like the ancient symbol of the ouroboros modern society is eating its tail. Election cycles and career politicians seeking re-election are a major component of systemic short-termism. Politicians tell voters that they’re working in our interests, but they’ve really got their own best interests at heart. However, it’s not just the politicians. Most citizens would lobby for lower interest rates to reduce their mortgage repayments, more debt and bigger governments, if government supported their pet project. Interestingly, the symbol of the ouroboros is not entirely negative. The symbol also speaks to regeneration and eventual re-birth. Systemic short-termism, lower interest rates and debt accumulation won’t continue forever. The time to re-leverage and refinance is closing. Lock in low interest rates, allocate capital productively and position size effectively, if you’re speculating. I appreciate that it’s very difficult to push back against the status quo, but there’s an ethical imperative to do so. Increasingly, the incentives are shifting too. Ignorant Isabelle’s won’t fair well when the cycle turns.

I’m cognisant of your time so I’ll leave it there for this edition. As an intro to next months note, here is a link to a funny video on a very serious topic of generational wealth disparity. 

I’d like to send a massive thanks for the support I’ve received in response to my first newsletter. It’s great to know that you’ve experienced value. Many readers have implemented investment decisions due to ideas they’re gleaned from my articles. This warms my heart. A particularly big thanks to those who provided feedback. Feedback is critical for improvement so please keep it coming. If you’re uncertain of where to get hold of me, I’m available via email ([email protected]), twitter (@PriceMacro), whatsapp and voice note, and there is a comments section at the bottom of each article on my website (PriceMacro.com). I respect privacy and I value of intimate one-on-one conversations, but I also encourage you to post content related questions and comments on the website as there is also a benefit to open dialogue in a public forum.