Debt plays a crucial role in creating booms and busts in the economy and phases of increasing levels of debt followed by phases when levels of debt are reduced are known as debt cycles.
Two main pattern of debt cycles can be identified in the way the economy works: the short-term debt cycle and the long-term debt cycle.
Almost 12 years have passed from the big crash of 2007-2008, the biggest negative shocks on the economy after the great depression that followed the 1929 stock market crash.
After several bailouts and significant measures to stimulate economic growth and get out of the financial crisis, causing the levels of debt in the economy to rise, we managed to have an economic recovery that resulted in a great decade both for economic growth and financial markets.
The ability to access financial resources in the form of new debt was crucial for the recovery that followed 2008 and, more recently, to contrast the effects of Covid-19 pandemics.
Despite the negative impact of coronavirus, as of the first months of 2021, there are now signs that the economy is starting to recover, like the recent rise in long-term yields in government bonds, the rise in commodity prices and the rising inflation expectations.
While there are always some people that foresee a recession and a stock market crash (and sooner or later they will be right, eventually), financial markets seem to bet on the economic recovery and why not, a little economic boom once we get out from the pandemic.
Is that the case, or is it just one part of the story?
There are certainly good points for both arguments.
Although financial markets are now optimistic about the future (at least this is what they are pricing), it’s good to remember that they are generally shortsighted.
In this article, I’d like to talk about debt in the economy, its role in driving economic growth and generating financial crisis, debt cycles, the long-term debt cycle, and what we could expect for the future but most importantly, what you can do as an investor to make the most out of financial markets.
Economy and Recession Cycles
Is the economy actually recovering or is it just false evidence?
There is an ideal concept in economics called equilibrium, a condition in which economic forces are balanced: supply, demand, prices are stable and economic variables remain unchanged without external influences.
Although the idea of equilibrium might be appealing and is certainly useful to frame the economic cycle, in the real world there is no such thing and history speaks clearly about that.
The closest thing to equilibrium that we can think of today is a steady growth of the economy with a low and stable inflation rate, that is what central banks are generally pursuing.
However, even though we had a similar situation in the last decade (2010-2020), we would be naive investors to expect that to be the norm.
The alternating of expansions and recessions along with the business cycle is natural, it’s just part of how things work and later we are going to touch on how debt plays a crucial role in this mechanism.
No wonders here. Since the beginning of capitalism, we are able to see a sequence of ups and downs in the economy, periods of growth followed by times of recession.
Of course, there are no written rules, however, a closer look at the past shows the alternation of different economic periods that typically last in the order of decades.
In the last decade, we had a nice level of economic growth and low inflation.
In order to understand whether a situation like this is sustainable, it’s useful to understand and analyze what was the source of that economic growth.
What Are The Drivers of Future Economic Growth?
We all talk about economic growth and how it’s important for how our economy to work properly, but we don’t usually take the time to reflect on what’s causing the growth.
Sticking to the basics, the three main factors that drive economic growth are:
Although capital and labor are fundamental factors, just by adding more capital and more labor the additional output obtained will eventually decline, according to the law of diminishing returns.
It’s safe to say that the main driver of economic growth is productivity and there is agreement on that among economists.
It necessarily has to be technological progress because, in a world of finite resources, it allows us to produce more with the same inputs, increasing both the efficiency of capital and the value-added per worker.
When it comes to economic growth, a useful distinction that is often overlooked is the time frame over which the growth takes place. This matters, a lot.
If in the long run, the main driver of economic growth is productivity, over shorter periods of time, another driver is even more important in determining the level of output on the economy. That driver is
In fact, the ability to access (and repay!) debt is arguably the most crucial factor in the creation of cycles of booms and busts in the economy.
Increasing levels of debt were a big driver of the recent economic recovery we’ve seen since 2009. This was possible thanks to central banks’ intervention in the economy which kept interest rates at historically low levels.
Back in 2018, I wrote an article called “Remembering 2008. Ten years after the financial crisis: what has changed?“, you can find it here. That post made a comparison of various economic indicators 10 years later and a substantial increase in debt was very evident.
Right now, everyone is taking debt like there’s no tomorrow, where everyone stands for governments, companies, and consumers.
This can be a major driver of economic growth over the short-term, but at the same time, it’s a double-edged sword when you consider the long-term.
If you have decades ahead of you and you are a long-term investor you are definitely interested in understanding what are the forces that are shaping tomorrow in order to be prepared and position yourself to win.
It’s not about market timing (a really dangerous activity by the way), it’s about avoiding the mistake to project what’s currently happening indefinitely into the future, thus improving your ability to make investment decisions.
Debt Cycles, Recessions, and Economic Growth
The economy works in cycles. Although the very long-term underlying trajectory of a country’s economic growth comes from productivity, along the way the amount of debt in the economy and its sustainability are key variables in the creation of those cycles.
Maybe this chart taken from the work of Ray Dalio explains the concept more clearly.
Productivity growth, the factor that ultimately drives the long-term economic growth, it is represented here as a straight line that grows steadily over time. The larger wave represents the long-term debt cycle and the smaller waves reflect the short-term debt cycle.
According to Ray Dalio, the three main forces driving the economy are:
- Productivity Growth
- Short-term Debt Cycle
- Long-term Debt Cycle
While productivity matters more in the long run, debt matters more in the short run and it’s responsible for the big swings in the economy (productivity doesn’t fluctuate that much).
The reason is simple:
- Taking more debt allows all of us (government, companies, and consumers) to consume more than we produce
- Paying debt back forces us to consume less than we produce
Debt moves in cycles with different durations. The short-term debt cycle takes about 5-8 years while the long-term debt cycle ranges from 75-100 years.
Borrowing money today allows you to increase your consumption, but automatically creates a time in the future when you have to pay it back (consuming less than the income you make in order to pay it back).
This works for the individual as well as the whole economy.
Why should we be interested?
Using the words from Ray Dalio “Understanding credit is so important because it sets into motion a mechanical, predictable series of events that will happen in the future“.
Debt allows to increase the spending by borrowing, that is “we are not paying now”, we are going to pay in the future.
This is one of the main reasons we were able to see an increase in economic growth and that’s also the way we are looking to get out from the negative impacts of Covid-19 on the economy.
Debt isn’t necessarily bad. If it’s used to finance productive investments it will generate the resources to pay it back.
The point is that you can’t expand debt forever, or at least this is what we always think until central banks step in and buy bonds with currency created out of thin air in order to stimulate the economy thanks to cheap credit.
How much credit can expand? Until you can pay it back or refinance it with new debt. Up until now, it seems that we’ve been refinancing everything because it was cheaper and convenient (see the charts in the next chapter).
Debt fosters economic expansion until the economy reaches its maximum level, that’s when the cycle inverts, and lower levels of credit lead to lower consumption, and the economy slows down.
This process is known as deleveraging.
What’s that point? Interesting question, and there’s no easy and precise answer.
Right now, like after 2008, we are seeing an unprecedented monetary expansion coming from central banks that are increasing the amount of money (currency would be more appropriate) in the system.
This is supposed to help the economy to keep growing. Surely monetary policy has real effects in driving short-term movements in the level of economic output, however, it’s not the solution.
This system is working, but everybody knows that sooner or later won’t work any longer. This is when deleveraging happens or when you see a shift in the global monetary system like it happened in the past.
While credit is a powerful tool that helps the economy to grow, at some point people and businesses will reach their maximum. Higher interest rates will increase debt payments and the rate of defaults, the aggregate demand for products and services will drop and the economy will slow down. Given how the system works a recession is inevitable, the question is only when.
There’s nothing strange or surprising about how debt works, this process is part of how the economy works and will likely continue to occur.
What’s surprising, is our ability to forget about that during economic good times.
It’s been a while since the last time we saw a deleveraging, and thinking it won’t happen because central banks are printing money is just stupid.
With that said, let’s move on to see what are the current levels of debt in the economy and get an historical overview of what we are talking about.
The Current Levels of Debt
Debt in the economy is rising. At the current date, following the Covid-19 pandemic, that statement is true almost every country in the world.
Since the United States are (still) the leading economy in the world, the following charts are going to take closer look what’s happening in the US.
Let’s start with government debt. The following charts shows the total public debt of the United States, which at the end of Q3 2021 was over 26 trillions! (that is 26,945 billions, or 26,945,391 millions of dollars, numbers that are hard to grasp).
If you expand the selection an go further into the past you can see how the trend is consistently up and how it increases noticeably after every recession.
The US government deals with economic crisis by increasing public debt. That’s always been the case in recent history and the result is that today the stock of public debt is huge.
To see more detailed information about the composition of the US government debt, take a look here.
Talking about debt cycles and the possibility to spend more than what you make, it’s interesting to see how the United States government has been running on increasing deficits for years.
Looks like a debt cycle? It is. We are still in the expansion phase and that lead to a stock of public debt that is far higher than the Gross Domestic Product of the country.
Those where the numbers and the trends for the public sector. Let’s take a look at the levels of debt in the corporate sector.
The following charts shows the total amount of debt securities and loans of non-financial companies in the US:
I guess it’s easy to spot the upward trend. After the big financial crisis of 2008, there was a short period of deleveraging but after expansive monetary policy stepped in and made borrowing cheap, you can see how in 10 years the level of debt held by non-financial companies doubled.
Do we have companies that are twice as better or productive than 10 years ago? I’ll leave that answer to you.
One fact is that these high levels of debt add an element of fragility for the whole financial system because debt needs to be paid back even if revenues declines, and when a company can’t meet its obligations goes bankrupt.
Easy financing allowed companies to take a lot of debt that was also used to pay for expensive buybacks and acquisitions instead of productive investments.
No wonder that today there is an increasing number of zombie companies around, that is, companies that are barely able to pay the interest on their debt but are not growing and profitable.
Corporate debt is growing and if you zoom out and consider a longer time frame, you can see how it went only up over the last decades.
As for consumer credit, that is debt that people incur to when purchasing a good or service using credit cards, lines of credit or some loan, the numbers confirm an unstoppable increase in the levels of debt.
You can see this number as “debt to buy stuff”, which is another word for consumption.
Most of the debt in this segment falls under the category of bad debt, which is debt that isn’t used to produce something that will create the resources that will pay it back (e.g. Buying a new and bigger TV).
Today, consumer credit is up more than 56% compared to its higher levels back in 2008.
Is The Current Debt Cycle About To Invert?
After looking at the data, it’s hard to disagree with the fact that debt levels are rising.
This is good news for short-term economic growth because more debt allows us to spend what we don’t have, increasing the whole level of consumption and investments we can make.
Increasing amounts of debt means that the debt cycle is still in the expansion phase, here’s a recap of the debt for all sectors of the economy in the United States
Debt is an “I Owe You”, a promise to pay a specific amount of money in the future to the person or institution that gave you the money in the first place.
If you consider that, it’s clear that an endless expansion of debt is unsustainable.
The fact that the long-term debt cycle needs decades to take place doesn’t mean that it’s not happening. Nobody really cares and I think that it is because we (as humans) have an elusive perception of the future.
Just as we can’t intuitively grasp the effects of compound interest growth after 30 or 40 years, we have a hard time imagining the effects of the inversion of the long-term debt cycle.
Also, after World War II we’ve basically seen only economic prosperity. Ok, there were market crashes and few bumps in the road, however the direction was clear and it’s perfectly summed up by this chart of the US GDP
After decades of living in those circumstances, you don’t really consider a dramatically different scenario.
People’s expectation is that, after a short period of crisis, a fresh wave of economic growth will soon come and will fix things.
The point however is that there are limits to economic growth financed by a combination of debt and monetary expansion.
No one knows exactly what those limits are, we are testing them.
Right now, central banks all over the world are stimulating the economy through expansive monetary policy.
In doing so, although they are devaluating currencies, if they succeed they are paving the way for a new wave of debt that will reflect on higher (short-term) economic growth.
Now stop for a moment and think: what happens when this trend reverses?
Up until now, it was possible to refinance the debt at lower interest rates. That gives us some more time, but sooner or later the economy reaches a point where it can’t take any more debt.
Interest rates don’t stay at zero forever. Although they may well stay “at low levels for a long period of time…” as the institutions are telling us, the truth is that the economy evolves and interest rates evolve too.
It’s a huge mistake to think that thing will stay as they are indefinitely.
Although nobody can predict the right time in the future when things will change, we can reasonably be sure that they will change. And this typically happens when central banks lose control of the economy.
If printing money was the effective solution to all of our problems, we would have discovered it a long time ago!
It’s useful to study what happened in the past in order to understand how the economy behaves. History teaches. Every time the manipulation of currency went too far, from the Roman Empire until today, it ended up bad.
To study more about debt crisis and what are the mechanisms behind them, I must recommend checking out Principles for Navigating Big Debt Crisis by Ray Dalio.
You can get to read and download it as a free PDF. If you don’t have time to read everything (which is understandable since it’s 471 pages long), you should definitely read the first part describing the dynamics of an archetypal debt crisis.
When the economy can’t take more debt, or it can’t pay it back or refinance it (maybe because interest rates went up and the cost of borrowing is higher), the process of deleveraging starts.
Deleveraging means an overall reduction of debt levels in every sector of the economy, from businesses to consumers to governments, a scenario that has a negative effect on economic growth.
How To Invest In This Scenario?
Increasing levels of debt are just one part of the cycle, the other part is made of defaults, bankruptcies, and lower consumption as well as less faith in the economy.
The moral of the story here is that a large part of the economic growth of the last decades comes from rising levels of debt, that drove consumptions above the levels of productivity.
We are going to pay for that in the future, although no one knows exactly when. We may not like it, but there is no such thing as a situation of imbalance that goes on forever.
Nobody likes a scenario or recession and deleveraging, and bear in mind that institutions will do everything they can to avoid that.
This thing can go on for another decade or two, nobody really knows, that is why staying outside the market is risky, because you miss the possibility to earn returns.
The most important thing in order to have great long-term returns is to allow compound interest to do its job. To do that, one needs to stay invested in the market.
Your investment decisions should always reflect your goals, time horizon, and risk tolerance. This is what allows you to avoid the mistakes that will seriously impair your ability to reach your financial goals.
Furthermore, realize that if you have sufficient time ahead of you, a market crash is not a bad thing. Indeed, it could be your opportunity to buy at lower prices or spot great investment opportunities if you took the trouble to understand that price and value are two different things and that you can actually take advantage of financial markets’ dynamics.
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