April 22, 2020
As governments around the world borrow more and more money to protect markets, a natural question would be ‘how does that affect me?’. The answer can be extremely complicated, but a fundamental understanding of money, debt and valuation can help. That is too much for one post so this post focuses on the current crisis and how an investor might behave.
You Need to Understand What Money Is
Money is effective as a transactional entity. Instead of trading a goat for two bushels of wheat, we can trade two bushels of wheat for two dollars and then use one dollar to buy goats milk and one dollar to buy a pig. If we have enough dollars, then we can perhaps buy a wagon or a horse . . . you get the picture. The money is for transactions. It’s easier to carry a coin or note than a herd of goats or a wagon of wheat.
Coins carry a promise of value. To this day we consider gold and silver valuable, not because they are used in coins, but because they are base elements which have measurable value even if the face printed on the coin can no longer guarantee its value. Current coins have no precious metal in them, by the way.
But what about notes? They have almost no value EXCEPT the promise printed on top of them. In Canada, our bills say “This note is legal tender”. That’s it, that’s the promise of a note’s value.
It is much easier to carry a bag of coins or a ‘bill fold’ full of notes with a promise of value. This brings up another important question in uncertain times, what if you have Canadian notes and take them to a foreign land? Will they still have value? Modern finance offers currency exchange in a snap. This is important in unsettled times like we are in currently.
The key point is that money itself is not a store of wealth it is transactional. This is clear when you see a long term chart of the value of a (US dollar in this case) . . . a dollar (it is currently worth about 4% of what it was worth in 1913). Here is an excellent chart.
The featured image is money from a museum in Vis, Croatia. That currency spans cultures (Greek and Roman) and time (405 BC to 138 AD). Today, we may say those coins are priceless, but only as a historical artifact. It is not used in commercial transactions.
A Brief Understanding of Debt
There is much more to money, but let’s move on to debt. Governments, corporations and individuals borrow money which can be handed out to suppliers for products and services, which are ultimately traded down to wages. They promise to pay it back later, typically with interest. The borrower usually has a lien against their assets to encourage payment (this is the moral hazard I mention elsewhere). In the case of a home mortgage there is a lien against the home. If the borrower fails to make payments, the lender can take the home and STILL demand any difference in value.
When the world is humming along, lenders provide money (capital) to government, business and individuals to improve the productive capacity of their community, country or the world at large. Normally lenders require borrowers to have sufficient equity to ensure there is something to recover if a borrower fails to pay. For centuries, lenders took assets from borrowers who failed to pay. This was how moral hazard was reinforced. By way of example, home foreclosures were a key motivator for most people until this century when banks become unable to take back all of the homes during the 2008/2009 collapse. Anyone who watches mob films will recognize the other end of the spectrum where unscrupulous lenders offer more gruesome forms of moral hazard. In any case paying back your loan was important and in today’s world, your credit score actually defines how dependable you are as an individual borrower.
In the corporate world, debtors are also tracked. There are bond rating systems such as Fitch who rate bonds on the likelihood of them being repaid. Bonds span the spectrum from junk bonds (typically have little protection if anything goes wrong, often there are limited or no assets backing up the loan) to sovereign bonds, those issued by government. Government has no finite life span and has the power of taxation as a proxy for a promise to provide payment.
One final aspect that is important is interest rates. When money is borrowed, it is lent out at a rate that pays the lender for their risk. The lender doesn’t typically participate in the benefits of the project being undertaken (that would be an equity investment, commonly now a shareholder), rather they want the promise of repayment with a bit of income for taking the risk.
In modern finance, central banks use this interest rate to encourage or discourage economic activity. Higher interest rates result in banks reducing their lending, as well as fewer borrowers being willing to borrow (because the rate of return on a venture may not be high enough to overcome the interest burden). Lower rates encourage lending by banks and reduce the hurdle for borrowers.
Governments are generally offered the lowest possible interest rates because they have the right to tax the population to make payment on their debts (bonds). When governments pay, the faith in that nation increases. Not all nations pay their debts. Argentina, Venezuela and Greece have all suffered economic collapse after failing to make payment on their bonds at least once over the last decade.
Today Japan is the most indebted country in the first world using debt to GDP metrics, but other countries have mounting debts, including Italy, Greece, France and the USA. The COVID crisis will increase that debt load in a relatively significant way.
Over the past 12 years central banks around the world have reduced interest rates to near zero and in some cases, below zero in an effort to spur investment. The idea being that the economy, and particularly inflation will pick up by increasing the amount of money in the ‘system’. This approach is based on the fact that the other financial shocks were made worse due to TIGHTENING credit during a crisis, namely the great depression. Unfortunately the approach has not worked well. It has increased asset prices quite dramatically without significantly increasing productivity, at least in the G7 economies.
If this wasn’t complicated enough, things are about to get even more complicated. After the last mortgage crisis of 2008/2009, ventures that may not have been financially viable were able to sustain themselves. Plenty of other ventures of questionable financial value were created. In many instances these companies were not covering their costs (think Theranos or Uber), even with low interest rates, in other instances, low interest rates spurred demand creating opportunity (think air travel and tourism).
Now central banks are borrowing massive amounts of money and central banks are transferring troubled assets onto their balance sheets to prevent those asset prices from declining.
Isn’t This About Inflation?
When the size of debts becomes very large, one way to reduce the impact is to increase inflation (which reduces the value, or purchasing power, of a dollar). If inflation can raise the value of goods (essentially, increase GDP by increasing the cost of services and asset prices) and interest rates can be kept low, the value of the debts will be reduced relative to the size of the economy.
If this plays out as planned, then the dollar value of debts (incurred in the past, devalued dollars) is reduced relative to current dollars.
And so we are back to the question ‘how does this affect me?’ The answer is quite complicated.
Currently, many asset prices are well above long term averages. That means that the ‘reasonable’ value of assets is almost certainly lower than what you may be paying. Of course many of the things we buy, we MUST buy. Using shelter for example, when you purchase a home (or pay rent), the higher than normal values are being supported by interest rates that are lower (beneficial) than they would be if there were moral hazard. Low taxes (beneficial) don’t cover the cost of government (deficit spending) and therefore the spending power of individuals and corporations is higher than it normally would be. This means that individuals end up paying more for housing (detrimental). These measures also have the benefit of reducing unemployment and thereby increases aggregate demand for housing.
Traditional economics tells us that over supply of goods should result in lower prices. With the lower interest rates provided by government intervention, many goods and services are abundant, and yet prices have not declined. Individuals will recognize cars, food, fuel and entertainment as examples. The reasons for this varies. In the case of cars (this is a great video with all the details), the key reason is that cars are made significantly better regularly. In the case of fuel, prices (until this month anyway), they have been held up by the oil cabal called OPEC by controlling supply. Entertainment is broader in scope, but the key here is that ‘star power’ and real estate are the two primary drivers of high costs. These aren’t valuable on their own, they require mass appeal (using the phrase irrational exuberance would be judgmental).
Of course some things have gone down in price substantially. Much of mass produced technology has been on a downward trend for years but have now stabilized. Televisions, telephones and computers, to name a few. These items have enjoyed the benefits of mass production, mass adoption and improvements in services. One can question the necessity of these things but they all contribute to measuring inflation. The decline in the price of televisions and microwave ovens contributes to keeping inflation down despite these being infrequent purchases for most consumers. It is notable that the services they rely on (part of that entertainment component measured above) have continued to rise in price.
The current environment suggests that many of the assets that are overpriced due to artificial government stimulus (low interest rates, quantitative easing, etc.) will moderate in the near future, but only to some lower bound supported by that central bank intervention. It could take months or years to find out what that lower bound looks like.
But ultimately it is reasonable to expect that the difficulties presented by the COVID-19 collapse in demand will render some supply uneconomical. Smaller suppliers and those heavily burdened by debt will be less likely to recover from the burden of lost income and excessive costs. This will reduce supply and lead to the rising prices as the remaining suppliers raise prices.
Some point down further out in time, taxes will need to be raised and costs will increase, putting further upward pressure on prices. Inflation will make its way back into the system and reduce the value of debt.
These processes can take many years to play out and much can change in politics, in business and in finance during the process. But inflation is, essentially, the only way out at this point, for the majority of society and is therefore a highly likely outcome in the long term.
These observations lead to some hard decisions.
- Should you save money (if money has no intrinsic value)?
- If assets are overpriced (they are, almost universally) what should you do with money?
- Should you borrow like crazy?
- What happens if there is inflation? What about deflation?
Answering all of these in one post will be too much. I will add further insights in subsequent posts.
In general terms, these questions have been confounding economists for at least 15 years. Alan Greenspan, the former chairman of the US Federal Reserve was confounded by the lack of inflation at the turn of the century. The best answer to why inflation did not show up after the market was flooded with money was that the G7, and the US specifically, had just started ‘off-shoring’ manufacturing, IT related jobs and more to China and India. Using their very cheap labor to provide products and services meant that the US’s key import was deflation. That is over. In the past 10 years, Chinese labor rates have gone from about $9,000 per year to about $70,000 per year. In the process the world received a robust customer for their goods, but wiped out millions of low wage (in the US and Canada) jobs.
With virtually all assets priced above their long run averages, the search for undervalued assets is a focus for hundreds of professional managers in all areas. But not investing is difficult, particularly when money loses its value over time. It is imperative that you invest. Of course this begs the question . . . into what and the corollary, when. Sometimes timing matters a lot.