By: Nathan Metheny, Managing Principal/Co-Founder
Endgame: The Long-Term Debt Cycle
Endgame is a name depicting the end of this most recent long-term debt cycle – a suitable name for the unprecedented times, last seen a century ago in which the world financial system was restructured; hence, Endgame. With the size and depth of the current system, the next financial system restructure is being termed “The Great Reset.”
Endgame evaluates large scale macroeconomic trends and, more specifically, the long-term debt cycle. The long-term debt cycle is longer than average recessionary/growth cycles which typically occur every 7 years – debt cycles are roughly 50-75 years. As of 2020, the debt cycle is nearing the end of its horizon.
Debt cycles begin/end when there is a large-scale restructuring of the then current financial system.
“The last big long-term debt cycle, which is the one that we are now in, was designed in 1944 in Bretton Woods, New Hampshire, and was put in place in 1945 when World War II ended, and we began the dollar/US-dominated world order.” – Ray Dalio, Founder of Bridgewater Associates
Taken from Ray Dalio’s debt cycle timeline -
‘1) Low debt and debt burdens (which gives those who control money and credit growth plenty of capacity to create debt and with it to create buying power for borrowers and a high likelihood that the lender who is holding debt assets will get repaid with good real returns) to
2) High debt and debt burdens with little capacity to create buying power for borrowers and a low likelihood that the lender will be repaid with good returns.
3.) At the end of the long-term debt cycle there is essentially no more stimulant in the bottle (i.e., no more ability of central bankers to extend the debt cycle) so there needs to be a debt restructuring or debt devaluation to reduce the debt burdens and start this cycle over again.’
Ray Dalio’s debt cycle graph:
The beginning/end of the long-term debt cycles and the debt restructuring that comes with them can clearly be seen within a debt to GDP graph. To be clear, this percentage includes all debt, public and private.
Leading up to the end of each debt cycle, the debt to GDP skyrockets to unsustainable levels. As you can see in the 1920s, the previous debt cycle that began nearly 50 years earlier was nearing its end. In the years following the Panic Year of 1929, the debt to GDP ratio spiked to 300%. As we all know, the end of that debt cycle marked the beginning of the Great Depression. Similar to the Great Depression era in which the US and the entire world experienced a restructuring and forgiveness of debt, a default or devaluation of debt must occur in order to service the current debts today that account for nearly 400% of GDP. In a sense, the reset button was hit after the Great Depression and must/will be hit again.
To view the “stimulant” aspect discussed in the third phase of the timeline, a bird’s eye view of the historical interest rates can be evaluated. When stimulating the economy, central banks have two options; lower interest rates or expand money supply (print money). At the end of debt cycles, lowering interest rates is no longer an option due to the fact that they simply cannot go lower, unless negative interest rates are entered which does not alleviate the issues, as we can see in Japan in the past 30-year deflationary period they have experienced. Basing an action model from Japan’s failures, a negative interest rate policy is not probable. As such, printing money becomes the only option; the US has now printed upwards of $7 trillion to combat the COVID-19 pandemic and in an attempt to stimulate the battered economy.
On August 27th, 2020, the Federal Reserve revealed a shift in a decades long-held policy towards inflation, veering away from the 2% annual target and adopting an average target rate, meaning they are not planning on slowing the money printing for the foreseeable future. This policy shift expresses that we are entering the printing, or debasement, phase of the debt cycle. The printing phase is by far the most noticeable aspect of the debt cycle due to the certainty of blistering increases in the inflation rate. In the 1970s, interest rates neared 20% to combat runaway inflation due to the unlinking of the US dollar to gold. The dollar was always backed by gold and could be exchanged for gold, but in 1971, the US defaulted on that promise which lead to the “floating” fiat money system we have today. A floating fiat money system is a paper money system that the government guarantees as legal tender without the currency being backed by commodity money such as gold. Unlike today, in the 1970s the world was in a much more financially stable place to experience the interest rate increases, a position we are no longer in with the extreme debt levels.
How will the end of the debt cycle play out? There are four ways to restructure debt:
1.) Austerity; i.e. spending less – painful, not going to happen
2.) Debt defaults – painful, not going to happen
3.) Raising taxes – painful but necessary, will happen
4.) Devaluation of currency; i.e. printing of money - already happening?
The first two options to restructure debt levels are extremely painful and deflationary in nature. In the past, this may have been a necessary evil and even unavoidable. Within our modern floating fiat currency system, deflationary outcome is highly improbable because of the potential to print unlimited amounts of money and, in a sense, unnecessary. Rather, the latter two options to restructure debt are much more likely; the devaluation of currency is the only option that is inflationary in nature. The main objective of the inflationary option is to massively print money in a manner to proactively devalue the currency, which in turn, devalues the outstanding debt. To construct an example, say that you owe $100. Now, you print an additional $30. You have experienced an inflation of 30% of the total money supply, so the original debt has also been devalued by 30%. The huge injection of money into the money supply will devalue the US’s debt burdens and, since the majority of the world’s debt is held in US dollars, the total worldwide debt as a whole. These actions are already being witnessed unbeknownst to the majority; COVID-19 may have been the catalyst for the most recent money printing, but it would have been initiated regardless. This printing and increase in inflation will not ensue for forever; once debts are devalued to sustainable levels in order to restart the debt cycle, interest rates will be hiked to control the inflation. As you can see in the interest graph above, after every single period of rates at these low levels, a considerable hike is shortly followed.
The 3rd actionable measure to restructure debt, raising taxes, is painful but unavoidable. When debt cycles near maturity, a large wealth gap is seen between the lower class and the upper classes due to the high asset values that have been pushed upward over the life of the debt cycle. As we see today, politics are increasingly focused on taxing the wealthy – this is no coincidence. Large wealth gaps cause civil unrest and outcry, sometimes leading to revolution. As the 4th measure is implemented, the devaluation of currency, asset values will rapidly increase with inflation, furthering the gap to extreme levels. Taxes will be necessary in order to close this gap back to the sustainable levels needed. Taxes that real estate will circumvent and/or greatly minimize.
Graph from Ray Dalio depicting US Partisan conflict that comes with growing wealth gaps:
So, what does this all mean and how will it affect real estate? It means that the current debt cycle is nearing maturity and financial system is due for a reset, as we’ve seen throughout history time and time again. A debt restructure will be seen, and the latter two options of restructuring will be the probable solution. As the restructuring commences, asset values will continue to rise as inflation increases, opening the door for extreme opportunity. Along with rising asset values, the leverage (debt) on the assets will inversely devalue. A $1 million-dollar loan on an asset will be devalued at a potential annual rate of 10%, or $100k per year, while the value of the asset rises accordingly. As well as debt devaluations, stagnant savings in the bank will experience the same. It would not be out of the question to see 6-10% or more inflationary periods; at a 10% rate, in 10 years, your dollar would be worth 38 cents in today’s purchasing power. That is a potential 62 cent inflation tax on your dollar, on top of visible taxes paid each year. It is imperative to wealth creation and preservation to position your finances in order to exploit the opportunity maturing debt cycles present.
Disclaimer: Information contained herein should not be considered investment advice. Wealthrise makes no representations or warranties and accepts no liability. We suggest that you consult with a tax advisor, CPA, financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and risk implications associated with any investment.
About the Author: Nathan Metheny is Co-Founder and Managing Principal at Wealthrise. In this capacity, his primary roles include acquisition supervision as well as setting the long-term strategy and trajectory for the company.