Economic Cycles and Debt- The Cause of Recessions

I'm going to take a step back here and talk a bit about macro-economics. Macro-economics shouldn't be relevant to a value-investor's decision making process, but it is fascinating and interesting to study and speculate on. One of the most interesting questions facing economists is what causes economic cycles? As far as I know, mainstream theorists don't have a clear explanation for this. Keynesians would say that recessions are caused by a decline in spending and investment and monetarists would say the cause is a reduction in the supply of money.

Neither of those are explanations. Yes, spending and investment declines in recessions and so does the supply of money, but what causes the reduced spending and supply of money? They don't happen in and of themselves. In my opinion, the best answer is debt. Simply put, increased debt allows us to spend more in the short-run, leading to increased incomes and 'booms'. Of course, debts must be repaid (or defaulted on) which will lead to reduced spending and incomes - 'recessions'. Recessions naturally come with decreases in the supply of money as credit is repaid and 'destroyed'.

Ray Dalio is the manager of the largest hedge fund in the world which has done extremely well by making large macro-economic bets since its inception in 1975. He created a simple but highly explanatory video to explain all of this. It is about 30 minutes long, but it will certainly be worth your time. 

Major points to take away from this:

1. Both private and government debt increase short-term demand and spending, but cycles are primarily caused by swings in private-debt as consumers and businesses take on and repay debt. These changes in the level of debt cause changes in total demand and spending. As private debt decreases, spending drops, leading to reductions in GDP and the prices of financial assets, aka recessions. In the long-run, government debt likely plays a role as well if it leads to reduced government spending. A mainstream economist would say that debt repayment cannot reduce demand because one's debts are another's income. The problem is that debt is destroyed as it is repaid since banks essentially create credit out of thin air. The Bank of England described this process in a 2014 study.  Contrary to mainstream economic beliefs, banks are not intermediaries which lend the funds of others; they create debt and directly influence total demand and economic growth. As a result, debt directly influences total demand, and so reductions in debt reduce total demand. This isn't a difficult concept- if I cannot afford a house without a mortgage, but a bank lends the money so that I can purchase the house, total economic spending has increased as a result of that debt. If banks suddenly stop lending to potential home-buyers, much fewer homes would be purchased.

2. In an economy without debt, cycles wouldn't exist. Increases in GDP and wealth would be based on productivity growth and entrepreneurialism. In the long-run, our cycles follow our productivity growth path but with major short-run differences in spending and wealth. 

3. The U.S., as well as many other developed nations, are currently at the end of a century-long leveraging cycle. The Global Financial Crisis did not fully deleverage the global economy. The developed world very briefly deleveraged from 2008-2009 with disastrous results, but private debt has once again been rising and it is higher now than it was at that time. If the world were allowed to fully deleverage to the long-run average private debt to GDP ratio, the impact would have been at least as severe as the Great Depression of the 1930's. The chart below shows private debt to GDP levels for a few nations since 1740. It isn't the prettiest chart, but it should be clear that depressions coincide with massive reductions in private debt. 


pd2gdp (1).png

The numbers may not mean much to you, but just know that countries usually get into trouble when private debt to GDP rises above 150%. The deleveraging process can happen rapidly such as the U.S. in the 1930's, or over a longer period of time such as Japan's 'lost decade' from the 1990's until the present. In 1989, Japan's Nikkei Index traded at around ¥39,000. As of right now, it trades at around ¥20,000. Over this period of 28 years, investors holding the Japanese index would have experienced horrific returns of approximately -50% in total. Clearly, Japan has experienced productivity growth over this period of time, but the drop in private debt wiped away significant demand and reduced asset prices.


japannikkei225 (1).png

This is something that has worried me for a while now, as our economic growth over the past 100 years has been fueled by an increase in private debt relative to GDP (both for the U.S. and globally). After 2008, we have maintained a slow but steady GDP growth rate and as usual, it has required an increase in private debt to do so. Although the chart above excludes government debt, when you include it the situation seems even worse. Total debt to GDP is over 300% for nearly all developed nations- going as high as 1000% for some countries. The point of this is that growth in spending and GDP cannot continue at this rate, since growth in debt cannot permanently increase at this rate.

I don't mean to be pessimistic or incite fear mongering, but the data looks bleak for GDP growth and the returns which will accrue to financial assets over the next 30+ years. Our countries will of course, make massive productivity gains over this time, but whenever a full deleveraging occurs, GDP worldwide will drop in spite of those real productivity gains. When this will happen and how long the process will take to complete is anyone's guess. Hopefully this analysis will be incorrect, but it will be an interesting few decades, economically speaking.