Ray Dalio: Billionaire investor and hedge fund manager. He has been vocal about his concerns regarding “Capitalism”( A commonly mis used term to describe voluntary exchange..a term coined by Karl Marx). Recently, Mr. Dalio shared some thoughts in his essay, “Has The World Gone Mad?” I will highlight(bold italic) some of his comments, and I will provide my perspective.
- “Money is free for those who are creditworthy because the investors who are giving it to them are willing to get back less than they give. More specifically investors lending to those who are creditworthy will accept very low or negative interest rates and won’t require having their principal paid back for the foreseeable future. They are doing this because they have an enormous amount of money to invest that has been, and continues to be, pushed on them by central banks that are buying financial assets in their futile attempts to push economic activity and inflation up.” After the 2009 crash, the central bank implemented various types of monetary policies to help boost the economy. Some examples, viz: Quantitative easing, pushing interest rates down to all time lows, increased amount of US Treasury debt purchases, and more. Also, the Fed injected large amounts cash into the financial system, as the banks were the beneficiaries. This was all to give an incentive the banks to build up their cash reserves and for them begin to loan out the funds, as this would help develop more capital investment. At that time, since the market place was “unpredictable”, why would the banks subject this “free” money from the fed at high risk? Especially when it’s being loaned out virtually for free, yet it still earns a nominal amount of interest…on billions of dollars? There is no need to take huge risks under these conditions. The banks did just that—they initially did not lend out funds as expected. With regards to the Fed engaging in US Treasury debt purchases, that took place back then, and that practice still is taking place today. Repo agreements, or repurchase agreements, are when the fed purchases the debt instruments on the bank’s balance sheet to help solidify the banks’ cash reserves. They will engage in reverse repos also. With repos, this has expanded the Fed’s balance sheet exponentially. As a result, thanks to these aforementioned fed policies, there is more inflation, as the primary benefactors are the banks once the money supply is expanded.
Now, some banks and other financial intermediaries have engaged in more “Riskier” lending, e.g. the sub prime auto lending, higher interest credit cards, and unsecured loans. In recent years, there has been a boom lending in this market, however, defaults on these loans are escalating But why? Even though unemployment is at historical lows, individuals are feeling the pinch of rising prices in goods. This opens the door for these types of lenders, and investment opportunities in the secondary market. Since the default rates for these loans are rising, thanks to the ever expanding monetary base, to wit, inflation, it is my prediction that these default rates will continue to rise on these types of loans—as the gap between worker’s incomes and goods will be widening. Soon, this asset bubble is subject to pop.
- “ ….As a result of this dynamic, the prices of financial assets have gone way up and the future expected returns have gone way down while economic growth and inflation remain sluggish. Those big price rises and the resulting low expected returns are not just true for bonds; they are equally true for equities, private equity, and venture capital, though these assets’ low expected returns are not as apparent as they are for bond investments because these equity-like investments don’t have stated returns the way bonds do. As a result, their expected returns are left to investors’ imaginations.“. A slight quibble here with Mr. Dalio, yet I agree with his overall point. Inflation is an expansion of the monetary base. A result of inflation could be an increase in prices, but an increase in prices doesn’t imply inflation. As previously mentioned, The Fed implemented aggressive monetary policy to stabilize the economy following the major market correction in 2009. It simply provided banks with free cash, in order for them to rebuild reserves then loan out. Since then, it has been a mad rush to purchase low risk debt instruments, eg US treasuries, bonds, and the like, which are now becoming overvalued. Same goes with the equities, since the fed has kept interest rates at historic lows. This was all in the hopes that the increased capital build up, from the loose monetary policy, would push the economy forward. Instead, asset prices are over inflated—this could lead to a market correction.
- “At the same time, large government deficits exist and will almost certainly increase substantially, which will require huge amounts of more debt to be sold by governments—amounts that cannot naturally be absorbed without driving up interest rates at a time when an interest rate rise would be devastating for markets and economies because the world is so leveraged long. Where will the money come from to buy these bonds and fund these deficits? It will almost certainly come from central banks, which will buy the debt that is produced with freshly printed money. This whole dynamic in which sound finance is being thrown out the window will continue and probably accelerate, especially in the reserve currency countries and their currencies—i.e., in the US, Europe, and Japan, and in the dollar, euro, and yen. “ Once again, Mr. Dialo asks some questions excellent questions. With regards to The Fed’s balance sheet, it continues to grow exponentially, due to the purchase of US Government debt instruments. This activity begs the question: What is the exit strategy? Raising interest rates too high will be disastrous, since the debt purchased now will crash in value and debt holders will begin liquidation of their debt holdings. Keeping interest rates at historic lows also has leads to pushing up asset prices above natural market levels, as this leads to an inevitable market correction. There is no clear exit strategy. He is correct: Sound finance theory is being disregarded.
When the government deficit keeps expanding, and consequently the debt total rises, inflation happens—all caused by the need to expand the government welfare state. When the term “welfare state” is used here, it’s inclusive of all sorts of wealth transfer programs and government operations outside of the scope of its original charter. Special interest groups continue to lobby for more favors, and they receive these favors at the cost of the citizens who underwrite these programs via taxation and inflation. The government will be willing to sell out the debt, to the federal reserve, foreign nations, and other investors, instead of cutting out many of these programs from Government operations. The incentives are strong to continue this expansion of government, and there is no end in sight in the foreseeable future. The deficit will continue to widen, as fiscal and monetary policies will remain unchanged.
- “At the same time, pension and healthcare liability payments will increasingly be coming due while many of those who are obligated to pay them don’t have enough money to meet their obligations.“ This issue is rooted in the fact that a large segment of the population, The Baby Boomers, are beginning to retire and draw down social security, funds from pensions, and their qualified retirement plans. Also: The probability of us living longer has increased, meaning these payouts will need to go further. With age, comes more demand for health care services. Prices, for health care services, will continue to sky rocket. Medicare will attempt to help offset this issue, but the US Government has a huge shortfall with Medicare along with Social Security. Use of private insurance will be in strong demand, as insurance companies are dealing with increasing regulation due to ACA and other sort of government regulation and mandates. With these variables, the economic costs of health care increase(creating more scarcity), it drives up demand, causing health care prices to rise sharply. People that saved up for retirement, using qualified retirement plans(401k), will be shocked that their money will not last as long to cover all these needs.
Private pension plans are not able to meet, the regulation requirements for their rate of returns. The costs to administer these plans are increasing, and global labor competition has placed downward pressure on labor costs, as domestic firms are unloaded those Defined benefit plans(pension). This has been the trend since the 1970s, shortly after ERISA was passed. Since then, the employee become responsible for his retirement savings. Another consideration: Since these pension funds also are purchasing, like other financial intermediaries, from a similar set of assets, e.g. US treasuries, Mortgage backed securities, and etc, they are desperately attempting to find something to meet their rate of return regulatory requirement. In this low interest rate environment, this has been a challenge while not exposing themselves to high risk.
- “Since there isn’t enough money to fund these pension and healthcare obligations, there will likely be an ugly battle to determine how much of the gap will be bridged by 1) cutting benefits, 2) raising taxes, and 3) printing money (which would have to be done at the federal level and pass to those at the state level who need it). This will exacerbate the wealth gap battle. While none of these three paths are good, printing money is the easiest path because it is the most hidden way of creating a wealth transfer and it tends to make asset prices rise.” All three options are simply a form of risk mitigation. Option 1: This transfers the risk to the health care recipients. Since health care costs are rising exponentially, this option will be more difficult for those on fixed incomes at retirement or those with young families. This market segment may see themselves leveraging more credit, namely sub prime, to ensure those health care needs are met. Option 2: Currently, marginal income tax rates are the at historically low rates. With the confluence all the other macroeconomic issues, it’s a strong possibility that the Government will raise marginal income tax rates. Consider this: There exists, in the aggregate, a large amount of assets waiting to be taxed…in the qualified retirement accounts. It is a possible consideration that these funds may experience more taxation if necessary. Even if income taxes are not raised, the retirement funds, once withdrawn, are subject to taxation. With individuals not at retirement age, tax rates could rise on the “rich”: high income professionals. This would significantly reduce the cash flow pushing up the need for this segment to utilize more unsecured debt to balance out the shortfall. Raising taxes simply transfers the risk burden to those who shall pay more in taxes once those marginal rates increase. Option 3: Printing more money will occur regardless of if the prior two options are exercised. As previously mentioned, Congress can not resist the urge of buying votes to maintain power, and spreading that economic risk to those who have no interest in these programs. As a result, government spending increases, beyond the limit of the revenues received, creating the ever expanding deficit. Inflation will be an economic cost paid for by the non investor class of citizens.
- ”…Because the “trickle-down” process of having money at the top trickle down to workers and others by improving their earnings and creditworthiness is not working, the system of making capitalism work well for most people is broken. “ Although “trickle-down” economics is not a real economic theory or concept, the model Mr Dalio is describing is more about how inflation benefits those who receive the newly injected funds into the money supply. The first recipients, the banks, benefit from this process. The individuals, the working class citizens, pay the economic cost of the inflationary measures employed by the Central Bank. Earnings may show an increase for workers, yet the ability to acquire goods and services requires more and more consumer debt. As more and more individuals begin to draw down on Social Security, their income is more fixed, and their need for credit to cover expenses will begin to increase. As previously mentioned, sub prime lenders will be around to meet that need, but the interest rates charged will be higher due to the risk of default. Unless people being to alter their beliefs regarding money and finance, it will be more difficult for the years to come.
This set of circumstances is unsustainable and certainly can no longer be pushed as it has been pushed since 2008. That is why I believe that the world is approaching a big paradigm shift. It is not sustainable. Most mainstream financial news experts are not providing the full analysis. It tantamount of a great mass of blind people being led off of a cliff..into an abyss.
End note: The use of economic indices such as the consumer price index(CPI), will show that results of inflation are low, but this highly misleading. Again: I would simply point to the increased use of consumer debt to cover the cash flow shortfall due rising prices in many goods.