Historical article note: This article was originally published on 2019-10-24. Rates, policies, home prices, statistics, product names and qualification standards reflect the environment at that time and may have changed. This archive is for historical record and general education only. It is not mortgage approval, investment, legal or tax advice.
Canada's general election has just ended, and all kinds of analyses, predictions, and strategies have sprung up. One of the scariest pieces of advice is to quickly sell your house. Is capitalism really that fragile? Do you have to sell your house just because someone was elected or not elected? The capitalist system is bound to go through crises, and they are cyclical. People not only survive each time, but their living standards also improve in steps. What causes an economic recession, and how should it be addressed?
Being laid off, stocks devaluing, companies going bankrupt, house prices falling… These shocking things, whose causes are unknown, can very likely strike anyone. For most people, even if they watch financial news every day, they cannot predict when such bad luck will happen to them, let alone take preventive measures. The economics we learned in the past has achieved nothing in terms of predicting when economic disasters occur or how households should guard against economic cycle fluctuations, so ordinary families are almost completely exposed to the threat of economic volatility, without any protection. Whether the economy is rising, recovering, or declining, there are always 'experts' predicting a worse economy, and these 'experts' usually have significant credentials. We are caught between believing them and not believing them; over time, everyone becomes numb and relaxes their vigilance. Economic fluctuations will inevitably come, and affecting our lives is just a matter of when and how severely, so we should still understand the patterns of economic cycles. Even if we unfortunately 'get hit,' we can at least 'die' with understanding.
There are simply too many books and articles about economic cycles, with differing viewpoints, each backed by its own evidence. Last week's article also introduced a perspective on the relationship between economic fluctuations and urbanization. Marx was the first to study the phenomenon of economic cycles. He believed that the evil of pouring out milk instead of giving it to the poor existed only in capitalist societies, and that the all-evil capitalism would soon be ended by the united proletariat. If he were alive today, he would certainly slap himself—capitalism does not collapse so easily. Milk is poured out simply because the price in the city is too low, and no one will cover the transportation costs from farms to the city. As for the wish of proletarians worldwide to unite, well, Lenin already observed that during World War I, the ones fighting the hardest were the proletarians themselves, while the ones making weapons were their bosses. Other self-proclaimed economists also have many grand theories, but they cannot withstand the test of history. At present, there is only one theory about economic cycles that has not been overturned and has repeatedly been proven correct. Credit cycles trigger debt cycles; several short debt cycles stack together to form a long debt cycle, and economic crises usually occur at the peak of the long debt cycle. This theory was proposed by Austrian economists, and Ray Dalio of Bridgewater Associates has demonstrated its validity through investment practice. Economic cycles are essentially credit cycles. If ordinary people understand the characteristics of credit cycles and take corresponding measures, they can avoid the unexpected destruction of their wealth.
01 Artificially suppressed interest rates are not a good sign
There are 7 billion people on Earth, each making 10 economic decisions independently every day, for example, whether to eat a bun or a hamburger, buy a house or rent a house, and so on. That means there are 70 billion economic decisions made in a day. What impact do individual decisions have on the overall direction of the economy? The only economists on Earth who can answer such a question are Austrian economists. Rothbard wrote an article titled 'Economic Depression: Its Cause and Cure,' which is the most concise article I could find that clearly explains the causes of and solutions to economic crises. Reading this article takes at least 45 minutes. I am trying to explain the causes of economic depression in more concise terms. If I am unsuccessful, please read Rothbard's article.
Austrian economics believes that the structure of capital is more important than the amount of capital. Capital must be linked to individual plans in order to be productive; capital that is not incorporated into plans is idle capital and has no value. The structure of capital refers to the combination of different capitals, and different combinations of capital generate different flows of services, representing the profit goals that entrepreneurs aim to achieve by combining different capitals. If entrepreneurs' plans are generally wrong, the structure of capital will become disordered, and this is externally manifested as the 'business cycle.' How could entrepreneurs collectively make mistakes at the same time? The reason is that government intervention gives the market incorrect signals, especially the government's intervention in the monetary and banking system, specifically intervention in interest rates.
Due to time preferences, people tend to overestimate the value of present goods and money, rushing to consume, indulge, and show off, and therefore underestimate the future. Interest can be seen as the cost of restraining current consumption and postponing gratification. Thus, interest rates become a purely temporal phenomenon. The level of interest rates depends on people's degree of impatience: if impatience is low (eager to consume), interest rates are high; if impatience is high (not in a rush to consume), interest rates are low. If everyone can restrain themselves and avoid immediate consumption, that is, if impatience is high, interest rates will be low. When businesses see that people's impatience is high, they invest the cheap, low-interest funds into long-term production projects, which cannot produce consumer goods immediately. But what if this low interest rate is caused by government intervention? Entrepreneurs misinterpret the signal of low interest rates, and as a result, projects that originally had no returns become profitable because of the low borrowing cost. Entrepreneurs then expand production scale, increase the input of capital and labor, causing the prices of capital and labor to rise. Since the true level of impatience is not high, workers spend their wages immediately, pushing up consumer prices, while entrepreneurs are investing in long-term production projects—products have not yet been produced, but costs have already risen. This leads to a widespread mistake by entrepreneurs—the cost of produced goods is too high to sell, yet debts still need to be repaid, resulting in large-scale business bankruptcies, worker unemployment, and economic depression. Raising interest rates at this point would only make matters worse. If the government sees this situation and allows the economy to decline naturally, the market will weed out misguided companies and write off bad capital, causing a chain reaction of stock price drops; if the government intervenes again, artificially keeping interest rates low and letting failing businesses barely survive, it will cause more companies to make mistakes, and although the stock market may stabilize, it harms the future. This is the Austrian School's explanation of economic cycles, which has already occurred in Japan and is the current situation in which the United States is gradually following Japan toward the abyss.
Since 2001, 18 years ago, the Abe government has been artificially intervening in interest rates using quantitative easing policies. For many years, it has persistently kicked a solid iron plate, because Abe believed that the plate didn't move because the kicks weren't hard enough or long enough. Japan's lifetime employment system, along with the government's reluctance to let companies go bankrupt, led to the government lowering interest rates to rescue those "cursed" companies during short-term debt crises, preventing the clearing of excess capacity, and creating the awkward situation of stubborn companies that refuse to die. The short-term debt cycle cannot be resolved through corporate bankruptcy and employee unemployment, so it enters the next short-term debt cycle, resulting in the extension of the long-term debt cycle. And the peak of the long-term debt cycle is the Great Depression, the major crisis.
After the Internet bubble, the U.S. government artificially lowered loan interest rates to encourage Americans to borrow money to buy houses. When everyone was deeply in debt, it started raising rates to reap the profits. This time it didn't just take the profits; it took everything: homeowners even abandoned their houses, triggering the subprime mortgage crisis. Bernanke learned from Japan and used quantitative easing to artificially lower interest rates, saving Wall Street, but also misleading American companies. Powell started raising rates from 2018 to deleverage, initially moving in the right direction, but then Trump pulled them back onto the wrong path, and artificial interest rate cuts began again from 2019.
Whenever the U.S. cuts interest rates, I see a wave of jubilation on social media, and some even ask me when Canada will follow suit. When interest rates are artificially reduced to the lowest possible level, close to zero, the risk of major economic problems is highest. Unemployment and asset price crashes are most likely to occur, and debts still need to be repaid. Seeing interest rates artificially suppressed, I can't be happy; I don't understand why onlookers would cheer. Since I started writing this public account, I have continuously advised readers: invest in additional real estate, and repay your own home as quickly as possible, in other words, transfer your debt to your tenants. But many don't agree, thinking that low interest rates mean there is no rush to repay. I again advise everyone to quickly get rid of your own debts, because artificially low interest rates are not a good sign, and zero interest is the peak of the long-term debt cycle. Just look at the current interest rate levels, and you will know how far we are from the worst-case scenario. Ultra-long-term low interest rates like Japan's are a feature of an economy falling into prolonged stagnation. The economy enters the upward phase when interest rates start rising.
02 How the economic machine operates
Economic theories or reasoning that have not been tested in practice have no value at all. The aforementioned claim that debt cycles lead to economic cycles has been practically tested by Bridgewater, the most successful hedge fund at present. Dalio and his team not only successfully navigated the financial storm, but also profited greatly.
In Dalio's video program "How the Economic Machine Works," the idea is: the driving force of economic development is spending, and out of every 53 units of spending, 3 units are money and 50 units are loans. The credit cycle is the debt cycle; by understanding the debt cycle, one understands the economic cycle, and by understanding the economic cycle, one can stay ahead of the stock market curve.
Since 50 out of every 53 units of money in the economy are loans, credit policy determines the flow, volume, and destination of money. The lender releases the money, and the borrower is the debtor. When the debtor's income cannot cover the loan interest, debt defaults and debt crises occur. Each time a debt crisis is bailed out by the government, the ultimate result is that new money needs to be borrowed to pay the old debts — this is the peak of long-term debt. Henry Ford once said: In business, if problems are solved by borrowing money, it only adds a new problem. Yet after so many years, most people still don’t understand what Ford meant; as long as money can be borrowed, they borrow it, regardless of the source of their problem, just to delay the situation a bit longer. Dalio is a hedge fund owner who clearly understands how the economic machine operates and has fully utilized the characteristics of the debt cycle, as well as government recklessness, to increase his wealth. Shouldn’t we learn from him?
03 Profiting in the Inevitable Economic Recession
After talking so much about the signs of an economic recession, what use is it? Dalio has never explained how he used these judgments. Ordinary people know that an economic recession will eventually come, so they should do something, right? Indeed, the subtitle of the book "Antifragile" is 'Gaining from Disorder,' which is an answer everyone is looking for — profiting in crises and recessions.
Dalio's views on investing can be summarized as follows. Although it is mind-boggling, readers are requested to understand it word by word:
"If one wants the capitalist system to function, an appropriate interest rate spread is essential. Essentially, one person’s return is another person’s financing cost. This economic machine is operated by major central banks, and those who are able to borrow money thereby receive cash and earn returns higher than the interest they need to repay. These spreads cannot be too large, but they also cannot be too small. The reason is that spreads that are too large encourage excessive borrowing, while spreads that are too small result in insufficient borrowing. Since short-term interest rates are usually lower than the returns on long-term assets, people borrow at short-term rates to purchase long-term assets and profit from the spread. These long-term assets include companies, the assets that make these companies operate well (such as factories or equipment capital investments), and stocks, among others."
Under this operation of 'borrowing first and buying later,' assets tend to rise, bringing returns to borrowers. This drives up asset prices and most economic activities, leading to leveraged long positions. In contrast, if the expected return on cash is higher than the expected return on bonds and/or stocks, investors holding cash will earn returns, and economic tightening will follow as banks slow down lending.
Although there is usually a positive yield spread between stocks and bonds, and between bonds and cash, this is not always the case. If short-term interest rates are always lower than the returns of other asset classes, everyone would go crazy borrowing cash and then holding assets with higher returns as much as possible.
The above text is excerpted from Dalio's long article, 'To Help Put Recent Economic & Market Moves in Perspective.' Everyone can search and read it.
Let me briefly translate Dalio's meaning: As long as capitalism continues to dominate the global economy, the return on stocks should be higher than that of bonds, which is also the view of Siegel, the author of 'Stocks for the Long Run'; bonds are a form of debt, their returns are fixed, and their repayment priority is higher than that of stocks, so their returns should be lower than stocks and should maintain a reasonable spread with stock returns. Under normal capitalist conditions, the return on cash should be lower than that of bonds, otherwise, who would lend out their money? After all, lending comes with the risk of not getting repaid. However, what if, but, the return on cash is high? That would be problematic, wouldn't it? The logic wouldn't make sense, and everyone would stop investing in bonds and stocks, right? But how could cash possibly have a higher return? This question is the core theme of this article: If you replace the 'cash' mentioned by Dalio in the text with 'mortgage,' this question has a solution. Let me try replacing it and see if it makes more sense: Although there is usually a positive spread between the expected returns of stocks and bonds, and bonds and mortgages, this is not always the case. If short-term interest rates are always lower than the returns of other asset classes, everyone would eagerly borrow mortgages and then hold onto the higher-yield assets as much as possible. Cash can be borrowed, right? As long as the interest rate is low enough and the investment return is high, why not borrow? Borrowed money needs to be repaid, but as long as you don’t repay it yourself and get someone else to do it, it is a successful investment.
Summary: This article is an explanatory piece that combines basic economic concepts with logical deduction. The conclusions are as follows: There are only three types of investment—equity investment, debt investment, and borrowing to invest. Skilled investors need to make good use of a combination of these three methods. The third method, 'borrowing to invest,' is not covered in any financial management books, and it is not found in textbooks either. However, it was discovered by hedge fund legend Ray Dalio—if interest rates are low enough, cash/borrowed investment can be superior to bond or stock investment. On one hand, governments intervene in interest rates, repeatedly lowering them artificially, providing false market signals, causing countries, companies, and households around the world to continually accumulate debt and risk; on the other hand, people are unaware that a third investment method—borrowing to invest—exists. Thus, when the long-term debt cycle reaches its peak and large-scale debt defaults occur, ordinary people will realize: they are unemployed, their assets have shrunk, but they still have to repay their debts. My personal advice on how ordinary households can remain unscathed and even profit during an economic recession is only one thing—pay off your primary residence mortgage and borrow to buy investment properties.