We Study Billionaires - The Investor’s Podcast Network - TIP624: Studying Financial History w/ Clay Finck

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to the Investors podcast. I'm your host, Clay Fink, and today, I wanted to talk about the lessons I picked up from this book called This Time Is Different by Carmen Reinhart and Kenneth Rogoff, which walks through various financial crises in the past and how they might relate to today's market conditions. I thought this book was quite relevant because I think many in the audience would agree with me that we live in pretty crazy times.

Starting point is 00:00:27 We just came out of a period of over a decade. of interest rates being near zero, the Federal Reserve increased their balance sheet from 800 billion in 2008 to over 7.5 trillion here in early 2024, and the U.S. federal debt has nearly doubled in the past decade as it now sits at over $34 trillion in growing very quickly. There's this quote in the book from Rose Burton that states, I quote, there is nothing new except what is forgotten, end quote. So this book might help us clear up where things are headed for us in the future, given how things have ended up in these various periods in the past.

Starting point is 00:01:03 At the end of this episode, I'm also going to be talking about Lynn Alden's book, Broken Money, which also ties in well with the topics discussed. With that, I bring you today's episode on this time is different and broken money. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Clay Fink. All right. So diving right in here, the book starts out by stating that no matter how

Starting point is 00:01:51 crazy things are in the world of financial markets, we've been here before. As the saying goes, history does not repeat itself, but it often rhymes. Now, this book was published back in 2011, so it'll be interesting to dive in and see what they were right about. And maybe what are of the things that were wrong about given that markets have risen so much in the equity markets at least in nominal terms. After reviewing all of the crises discussed in the book, the one common theme among them is that excessive debt accumulation, whether that be by governments, banks, corporations, or consumers, that debt poses greater systemic risks than it seems during the economic boom times. Especially infusions of cash that are given out by the government can make it look like

Starting point is 00:02:35 it's providing greater growth to the economy than it actually is. So debt is the number one issue in these financial crises because they can make an economy vulnerable to crises of confidence, particularly when the debt is of short duration and that debt needs to be constantly rolled over and refinanced. These debt-fueled booms can bring the illusion that things are good. You know, stock prices are hitting new all-time highs, banking profits are strong, and a country's living standard is stable. But history tells us that most of these booms end very badly. Now, debt is crucial to all economies, but there needs to be a balance between the risk and the opportunities of debt. And this is a challenging balance, and this is something that policymakers, investors, and ordinary

Starting point is 00:03:22 citizens need to keep top of mind. The two primary crises the book covers, which are particularly relevant today, is the sovereign debt crises and the banking crises, and it covers. It covers It covers 66 different countries over eight centuries, so it provides a ton of data and a ton of information on all these different crises throughout history. And what's so powerful about this book is that people tend to forget and lose sight of the rare events that if given of time, these rare events just happen over and over again. These rare events are actually much more common and similar than people seem to think. It's just that we've forgotten about them and it hasn't happened in our life.

Starting point is 00:04:03 Before getting into the middle of the book here, we'll dive into the preamble that touches on some of the learnings from these specific crises. Financial markets, especially ones reliant on leverage, can be quite fragile and subject to crises in confidence. The reason that people believe that their time is different than times of the past is because of the precarious nature and fickleness of confidence, especially in times in which short-term debts need to be rolled over continuously. They write, I quote, highly indebted governments, banks, or corporations can seem to be merely

Starting point is 00:04:39 rolling along for an extended period, then bang. Confidence collapses, lenders disappear, and a crisis hits, end quote. The simplest and most familiar example of a crisis is a bank run. Banks borrow at short-term durations and lend it out at longer-term durations. A bank may have a solid deposit base with a large diversified portfolio of loans, but if too many of those loans are illiquid, the bank is susceptible to a bank run if for any reason there's a crisis in confidence and too many of the depositors want their money back all at once. Countries can also run into similar dynamics due to loss of confidence. Say a country borrows from

Starting point is 00:05:19 external lenders over which they have little influence over and consider that many government investments are highly illiquid. So for any reason, if an external financier decides that they're losing confidence in the country's ability to pay back that debt, then interest rates in the debt go up because the perceived risk is now higher, and the country may now be forced to take on debt that is at unsustainable levels, and they may not be able to really get financing, and then a credit crisis unfolds. These events really don't happen every day, but in the longer context of history, they happen time and time again. And the reason they keep happening is that confidence and trust are inherent pieces of every debt-based system. When a bank makes a loan, they're trusting

Starting point is 00:06:04 that the person they loan the money out to is going to be able to pay it back. When someone makes a deposit at the bank, they trust that they're going to be able to get their money back when they need it. And the way I see it is that credit is the fuel to the economy. And trust and confidence is an inherent piece of credit. So when trust and confidence breaks down, your economy starts to break down with it. To add to that, this makes it impossible to predict the exact timing of such a crisis, because you can't predict when enough people are going to lose trust and confidence in the banks or in a country. The authors explain that the essence of the This Time is Different syndrome is that people tend to believe that financial crises are things that happen to other

Starting point is 00:06:47 people in other countries at other times. It would never happen to us. People like to believe that they do things better. They're smarter than other people and they've learned from the mistakes of the past. So the book goes into detail on what types of crises are covered in the book and what exactly constitutes the crises. The three types that are covered in the books. So the first is high inflation. They set the cutoff at an inflation rate in the local currency exceeding 40% per year. And then the second type of crisis is a currency crash. This is set at a 25% exchange rate depreciation. And the third is a currency debasement, which relates to when a currency is backed by something like gold or silver, and the rate at which you can exchange your currency for that

Starting point is 00:07:32 backing is reduced. And another form of currency debasement is when the government essentially changes the rules or creates a new currency structure, which effectively debases the previous holders of such currency. And then crisis is not closely related to the currency losing value. Those are also three items here. The first is a banking crisis, which you can think of as a bank run or a collapse in the banking system. This is what happened to the United States during the Great Financial Crisis. The second is an external debt crisis, which involves a default on a government's external debt obligations, which is denominated in a currency outside of their local jurisdiction. One example is Argentina in 2001, when they defaulted on $95 billion in external debt.

Starting point is 00:08:15 And finally, third, we have the domestic debt crises, which is, you know, the domestic debt crisis, which debt issues within a country's own local currency. One example of this is Mexico in 1994 and 95, which was resolved by a bailout from the International Monetary Fund and the U.S. Treasury. There's a chapter here on what level of debt becomes unsustainable for a country. It uses debt to GNP figures here, and I wanted to mention that GNP tends to be pretty closely correlated with GDP, which most in the audience are probably more familiar with. In this case, I think they're pretty much interchangeable, so I would refer to GDP here for the purposes of this episode. So the book says that once debt to GDP of a country goes to over 100%, the country runs a significant

Starting point is 00:09:01 risk of default. So for my fellow Americans listening who need a reminder of where the U.S. is at today, the debt to GDP of the U.S. is currently at 121%. It's generally been trending upwards ever since the 1980s. And Japan is in a more precarious situation as their debt to GDP here in early 2024 is 261%. And that's according to data from the International Monetary Fund. But high debt to GDP levels isn't necessarily a precursor to a default. Of the defaults studied in the book, the majority of them did not have debt to GDP levels in excess of 100%.

Starting point is 00:09:42 In fact, more than half of them occurred at levels below 60%. Upon the author's research, the debt in itself isn't the core fundamental problem, but it's the institutional failings that make a country intolerant to debt that pose the real issue. So other factors such as the institutions, the level of corruption, governance, the risk-sharing benefits of capital markets, and capital flows within the country are more important than the debt levels alone. I'm going to skip part two of the book here, which covers sovereign external debt crises, and I'm going to jump to part three, which covers defaults on domestic debts.

Starting point is 00:10:19 All right, so diving into this section here on domestic debt and the crises that arise out of this. In general, the majority of public debt is issued domestically, which means that governments generally get a lot of their funding through debt, through these counterparties within their own borders. A common pushback people give when people mention the possibility of the U.S. defaulting on its debt is that they can just print their own currency if they're ever having issued. with making payments on their obligations. And the book discusses how this is effectively defaulting on your debt because the debt isn't

Starting point is 00:10:51 being paid back in real terms. It's being paid back in nominal dollars that are worth less than they were when the debt was originally issued. And because governments have the ability to print their own currency, outright defaults on domestic public debt are actually extremely rare through the lens of studying history. So governments really have somewhat of a choice when it comes to hand. handling their debt issues when it becomes too large. In the end, they generally want to choose what they believe will be the lesser of two evils. Very few in the context of history have said

Starting point is 00:11:25 that they don't want to go the route of high inflation and they want to see some form of default as the best option. So another example is what the U.S. did during the Great Depression, which was Executive Order 6102. And that was when the U.S. outlawed the ownership of gold. And then they've re-valued the gold, which is really another form of currency devaluation. And the use of inflation as a form of making the debt more manageable can be referred to as financial repression. And you can really think of this as inflation being higher than interest rates. So say a government borrows at 3% interest, inflation, it might be running at 6%. And you have an economy that continues to grow. And so the government's debt burden relative to the GDP would become more manageable.

Starting point is 00:12:12 over that time. And the thing is, though, that there's really no free lunch. The government's lessened debt burden in this case comes at the cost of those lending them money. So like I mentioned, the inflation's running at 6%. If you buy debt, that is 3%. Then your debt is losing value over time when you account for inflation. And also market participants who hold that underlying currency or they earn in that currency are also paying the price in this case. Then the book lists over 70 cases of domestic debt defaults or debt restructurings. Some examples that stand out to me here was the United States in 1933 when they've revalued the gold relative to the dollar. Argentina went through a number of restructurings from 1982 through 2005. Brazil had a $62 billion default in 1990.

Starting point is 00:13:02 And then in the past 40 years or so, there were a number of countries in Latin America, Central America, South America that also fall under this bucket. You can think of Bolivia, El Salvador. Mexico, Panama, Venezuela. So let's jump to Chapter 10 here, which discusses banking crises and their role in all of the crises studying in the book. Many advanced economies have graduated from things like serial defaults and very high inflation, but they've proven that they haven't avoided something like a banking crisis like what happening in the Great Financial Crisis. In both rich and poor countries, banking crises tend to be remarkably similar. Banking crises can be catastrophic for governments, and they usually are. And there's a stat that's just amazing. It says

Starting point is 00:13:48 the average government debt level rose by 86% during the three years following of banking crises for countries in the modern era. The rise in the government debt depends on the policy response after the crises, as well as the severity of the crisis itself. The book breaks out two kinds of banking crises. The first is common in poor developing countries, which is a form of domestic default that governments employ. So this is when the government gets really involved in the banking system to ensure that they can fund themselves without direct taxation. For example, they might force citizens in some way to hold their savings in the banks and then require banks to fund the government at artificially low interest rates. So it's really kind of holding their citizens

Starting point is 00:14:34 captive and keeping them within the banking system so they can implement financial repression. India, for example, in the 1970s, they capped interest rates at 5%, and then inflation ran hot and at some points got to over 20%. So a banking crisis in this example can ensue when a bank hits liquidity issues and it's forced to sell assets on its balance sheet at fire sale prices. This can become a massive issue when you have many banks needing to sell their assets because oftentimes banks hold very similar assets or they might even hold the same assets. And this can just flood the market with sell pressure all at once. So during normal times, assets that can be relatively liquid can suddenly become highly ill-liquid if everyone's heading for the exits all at

Starting point is 00:15:19 once. In practice, if a single bank runs into issues, then they may be able to tap into pools of capital from other private banks in order to stay solvent. But if the crisis becomes more broad-based across the entire economy, then this likely won't be a viable option. The book also, It also discusses how major banking crises can be detrimental to the economy. For example, during the Great Depression, it took a long time for the financial system to rebuild their lending capacity. Based on the crises they studied, the authors also found there to be a high correlation between international capital mobility and banking crises.

Starting point is 00:15:56 So for example, if citizens realize that financial repression is happening within their particular country, maybe you can think about Argentina today, which is experiencing financial repression, then you'd want to hold some of your savings in something like US dollars, for example, which is a much more stable currency. So in the case of Argentina, their local currency is experiencing very, very high inflation. So if consumers don't want their wealth lost via inflation, they might try and go get US dollars. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer.

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Starting point is 00:20:28 That's Shopify.com slash WSB. All right. Back to the show. So the easier it is for citizens to do that, then all else equal the higher the likelihood that an economy runs into issues because citizens might be fleeing to that particular currency system. So if it's difficult for citizens in Argentina, for example, for them to convert to U.S. dollars, then there's less likelihood of a banking currency.

Starting point is 00:20:56 crisis happening. They also found that when regulations are too loose, you can also run into baking crises issues. And this is what happened in 2008 when many institutions were over lever, they were taking too much risk and got into big financial trouble when that crisis hit. Then they provide a bunch of data on GDP growth before and after crisis and how government revenues and debt are impacted. The debt increases following the crisis in particular are enormous in many cases. So to summarize the bank, Banking crisis piece, when a country experiences an adverse shock, say due to a drop in productivity, a war, political or social upheaval, banks suffer in these situations.

Starting point is 00:21:38 Loan default rates go up dramatically, and banks become vulnerable to losses and confidence in bank runs. Due to banking failures in an economic contraction, banks may not be less lenient on making new loans, which only worsens the economic contraction and makes the crisis worse. Credit is the lifeblood of modern day economies, and when that credit growth stalls or seizes up, economic growth slows with it. So managing these banking crises with appropriate regulation is really important for economic growth. So managing the banking sector with appropriate regulations is really important for economic growth overall. It's kind of funny when you see a lot of people, you know, they get upset when the Fed or the government supports the financial system or they

Starting point is 00:22:22 provide liquidity to the banks when they get in trouble, you might think that these regulators, policymakers don't mean well and that the rich are just getting bailed out. But the system we live in today is reliant on a functioning banking system. If you want to have food in the grocery store or you don't want to have mass chaos in the streets, then I think that you want the government to support the banking system in whatever country you're in globally. The U.S. sort of learned this lessened the hard way during the great financial crisis. They were a bit slow to step in and support many of these banks, especially after the collapse of Lehman Brothers, and it seemed like the whole system was just on the brink of total collapse. Then there are two chapters here on currency debasement

Starting point is 00:23:08 and inflation. Two topics, I believe, are essentially one and the same. Currency debasement in the old days is when they start issuing a new currency in circulation, which has less content of the underlying metal, like gold or silver, or maybe they would just shave down the coins in the existing supply, you know, just force citizens to turn them in, shave them down, and then give them back to the citizens. Centuries ago, this was a tactic used to make it easier to pay down debts without directly taxing their citizens, which was about everyone, you know, isn't particularly fond of doing. Back in the 4th century BC, for example, the leader of Greece ordered that all coins in circulation be turned into the government, and those who refused,

Starting point is 00:23:49 would be subject to the death penalty. Once the coins were collected and then returned, presumably prices of goods and services would have increased due to that indirect tax that was done through the currency. Classical monetary theory would suggest that the prices of goods and services should double if there was a doubling in the money supply, and that would be, you know, imply an inflation rate of 100%. And I can't help but think of the Fed's response during COVID in 2020. And just out of curiosity, I wanted to see how the money supply has changed since the start of 2020

Starting point is 00:24:24 and how that affected the home prices where I live here in Nebraska. And the town I live in, it has around 200,000 people, somewhat reasonable home prices, I would say, relative to much of the U.S., especially in the higher populated states like California and the northeast. So based on the Fed's website, from January 2020 through January 2024, the U.S. M2 money supply grew by 35%. So again, based on classical monetary theory, you'd expect to see goods and services more broadly also increased by 35%. I was a bit surprised to see how highly correlated the two were when this oversimplifies things a bit since home prices are dependent on things like interest rates, supply demand dynamics and such. But from January 2020 to January 2024,

Starting point is 00:25:13 while the USM2 money supply increased by 35%, the average price of a single family home in the city I live in increased by 37%. So I pulled in another reference point here. Look at the broader stock market since asset price inflation has been pretty prevalent over the past 10 to 15 years. So the S&P 500, which you compare to these other two numbers, the S&P 500 increased by 54% during that same time period.

Starting point is 00:25:41 And then there's also dividends that we need to consider. and add to that as well. There are different arguments as to why the actual price changes may differ from the change in money supply. For example, companies tend to give their customers more for less over time due to increased productivity and new technologies. And this can bring prices down in some cases. Or the book also mentions that if currency debasement is too extreme, you may see financial chaos,

Starting point is 00:26:08 increase uncertainty, and that can actually lead to higher inflation relative to the the increase in the money supply. The book states, I quote, we do know that the example of the Dionysus included several elements that have been seen with startling regularity throughout history. First, inflation has long been a weapon of choice in sovereign defaults on domestic debt, and where possible on international debt. Second, governments can be extremely creative in engineering defaults. Third, sovereigns have coercive power over their subjects that helps them orchestrate defaults on domestic debt, quote unquote, smoothly, that are not generally possible with international debt. Even in modern times, many countries have forced severe penalties

Starting point is 00:26:53 on those violating restrictions on capital accounts and currency. Fourth, governments engage in massive money expansion, in part because they can thereby gain a segmentary tax on real money balances, in parentheses, by inflating down the value of citizens' currency and issuing more to meet demand. But they also want to reduce or even wipe out the real value of public debts outstanding, end quote. Then the chapter has a chart here on all the different cases of currency debasements over the years. In 1551, the UK performed a 50% currency debasement in a single year. In 1812, Austria experience a 55% debasement. In 1810, Russia experienced a 41% currency debasement, among a dozen other prevalent examples in history. The takeaway from this chapter for me is that the inflation we see

Starting point is 00:27:45 today in scarce assets like real estate, land, stocks, it's nothing new when looking at the longer-term history of how governments handle high debt levels alongside the ability to perform the hidden tax using this tool of currency debasement. I'll repeat that quote I stated at the top of the episode from Rose Burton. There is nothing new except what is forgotten, end quote. Chapter 12 then covers inflation and modern currency crashes. This chapter also highlights the cases of governments abusing their monopoly on the issuance of the currency. Towards the start of the chapter, the author's right, I quote, A key finding that jumps out from our historical tour of inflation and exchange rates

Starting point is 00:28:26 is how difficult it is for countries to escape a history of high and volatile inflation. Then they write, However spectacular, some of the coinage debasements reported, without question, the advent of the printing press elevated inflation to a whole new level, end quote. So throughout history, there's certainly a bias towards inflation of the currency rather than deflation. There are times where deflation is prevalent, but especially since the Great Depression, which happened in the 1930s, we've had practically nothing but inflation when you look at this chart on page 181 that shows the median inflation rate for all countries from 1500 through 2007.

Starting point is 00:29:07 And when you look at the table of defaults through inflation for each continent, you find that many countries are not immune to high inflation. About every country you can think of has had their issues. So I'll just illustrate a few examples here. Since 1800, Germany has had two hyperinflationary events in nine years in which inflation exceeded 20%. Greece had four hyperinflationary events in 13 years with 20% inflation or more. Latin America has had a lot of issues with inflation, especially in Argentina, Bolivia, and

Starting point is 00:29:43 Brazil. Brazil, for example, has had six hyperinflationary events since 1800 and 28 different years of 20% inflation or more. Canada, the U.S. and New Zealand, they seem to be sort of unicorns in the study. Since 1800, for example, the U.S. looks to only have had one year, of inflation higher than 20%, and that was in 1864, and they've had no years with inflation higher than 40%. One of the consequences of sustained high inflation that many countries have experienced is dollarization, which is when the local currency is no longer used as a transaction medium, a unit of account, or a store of value. More governments strive to try and prevent this, as they lose the privilege of being able to print the currency that their citizens are using.

Starting point is 00:30:29 I think when you look at a country like Argentina, for example, they still have their local currency, but local citizens, I think they just know that their wealth is better to be stored in the US dollar over their local currency, if at all possible. The only way the citizens would go back to trusting the local currency as a store of value is if the government is able to sustain a period of lower inflation for an extended period of time. So once that trust is lost with a lot of citizens, it's really, really hard to gain that trust. back. Next, I wanted to jump to part five in the book here, and this part covers the Great Financial Crisis. The GFC happened in the 2007-2008 time frame, and it was referred to at the time as the subprime financial crisis. And as things started to get worse in the fall of 2008, the commentary turned to have a really apocalyptic tone and pointed to the potential end of

Starting point is 00:31:24 the modern economy as we knew it. The book also refers to the great financial crisis as the second Great Contraction, with the first being the Great Depression, of course. The book has charts here which show the proportion of countries in a banking crisis. So it shows a historical chart of, you know, and you can really see when these big crises are happening throughout history. But, you know, none of the big banking crises were as big as the Great Depression. During that time, around 45% of countries globally were in a banking crisis. In 2008, it looks like this reached 30%.

Starting point is 00:31:59 The financial crisis in the late 2000s was really firmly rooted in the bubble in the real estate market. That was fueled by unsustainable increase in the housing prices, a massive influx of cheap foreign capital due to record trade balance and current account deficits, and an increasingly permissive regulatory policy that helped propel the dynamic between these factors. The book also argues that the elevated housing prices in real terms could have served as a potential precursor to the crisis. The Case Schiller Housing Index was at a level around double its historical average. In 2005, at the height of the real estate bubble, real housing prices soared by more than 12%, which was about six times the rate of increase in real GDP per capita for that year. Then by mid-2007, there was a sharp rise in default rates on low-income housing mortgages

Starting point is 00:32:50 in the U.S., and this sparked a full-blown financial panic. The Great Financial Crisis was also a classic example of the This Time is Different syndrome. So instead of the book just simply stating that many people were duped into thinking a crash would not happen to them, they dig into the reasons why so many people were fooled into thinking they were immune to a major market correction. At the time, the U.S. was ramping up their borrowing. I'm not sure if they're just referring to the public sector here or the private sector as well, but the U.S. Treasury Secretary Paul O'Neill, he argued that it was natural for other countries to lend to the U.S. because of the U.S.'s high levels of productivity growth and that the current

Starting point is 00:33:34 account was a quote-unquote meaningless concept. They believed that since many emerging market countries had issues with their own crises in the past, they should be free to invest in the U.S. as it was perceived to be a more developed and safer market to invest in. For U.S. borrowers, this led to cheap funding due to these inflows from these foreign entities. The question that policymakers may have overlooked was whether there could be too much of a good thing. In the midst of this foreign investment, profits at investment banks like Goldman Sachs, Merrill Lynch and Lehman Brothers, these profits just soared.

Starting point is 00:34:11 The size of the U.S. financial sector, for reference, was 4% in the mid-1970s, and it had grown to 8% of GDP in 2007. So the financial sector was really becoming a bigger and bigger part of the economy. Leaders in the financial sector argued that, in fact, their returns were a result of innovation and genuine value-added product. And they tended to grossly understate the risks that they were taking to achieve such high returns. And if I were to put myself in their shoes and if I were getting these enormous multi-million

Starting point is 00:34:45 dollar bonuses. I'd like to keep the parting going as well, and I'd probably say the exact same thing. One quote-unquote innovation was the securitization which allowed U.S. consumers to turn their previously ill-liquid housing assets into ATM machines, which represented a reduction in precautionary saving, which essentially means that your typical American had very little savings and was highly indebted on an expensive mortgage. Policymakers also debated the explosion of housing prices, but the consensus argued that the U.S. was the most developed financial market, which justified elevated prices. Greenspan and Bernanke, who were both chairmen at the Fed, argued vigorously that they should not pay excessive attention to housing prices, except

Starting point is 00:35:30 to the extent that they might affect the central bank's primary goals of growth and price stability. They largely ignored the fact that the rise in housing prices was fueled by cheap debt and supported by very little savings. The household debt to income ratio was around 80% in the early 1990s, and that rose to 120% in 2003 and was nearly 130% in mid-2006. As I discussed in episode 589 with Brendan Hughes, most asset bubbles are fueled by excessive debt financed at low interest rates. There was also signs of lending practices that would have shown that credit was too loose in the economy, and it led to prices getting to these unsustainable levels. For example, there were many subprime or low-income borrowers that were happily given loans

Starting point is 00:36:19 that they just couldn't afford, and they were also initiated with things like variable interest rates or a low initial teaser rate that made the deal potentially look a lot more appealing than it actually was. So once interest rates rose, the economy slowed, and housing prices started to fall, the whole debt-fueled boom started to unravel very quickly. And with the high levels of capital flows in the rising asset prices, the International Monetary Fund concluded in April of 2007 that the risks in the global economy have become extremely low, and that for the moment, there were no great worries.

Starting point is 00:36:56 The authors wrote, I quote, When the International Agency charged with being the global watchdog declares that there are no risks, there is no sure sign that this time is different. So to sum it up, many thought that this time was different because, one, the U.S. was the most reliable system in terms of financial regulation. It had the most innovative financial system, a strong political system, in the world's largest and most liquid capital market. Thus, it could withstand huge capital inflows without worry. Second, rapidly growing emerging markets needed a secure place to invest their funds for diversification purposes. Three, increased global

Starting point is 00:37:32 financial integration with deepening global capital markets, which allowed countries to go deeper into debt. Four, in addition to the other strengths, the U.S. also had superior monetary policy institutions and policy makers. Five, new financial instruments were allowing many new borrowers to enter mortgage markets. And six, all that was happening was just a further deepening of financial globalization thanks to innovation and should not be a great source of worry. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:41:31 The Big Five includes Spain in 1977, Norway in 1987, Finland and Sweden in 1991, and Japan in 1992. In studying the financial crises of the past, indicators that the authors deemed to be important, precursors were rising asset prices, slowing real economic activity, large current account deficits, and sustained debt buildups. This could be private or public. And then it shows a chart of the data from the great financial crisis relative to that of the big five crises.

Starting point is 00:42:01 So it looks at the run-up in the housing prices, the run-up in the equity markets, the ratio of current account balance to GDP, the slowing economy based on GDP per capita, and the growth in government debt. Another reason why crises may have been difficult to foresee is that many of the problems were essentially hidden within the plumbing of the financial system. But you could also argue that the huge run-up of housing prices, over 100%. percent actually appreciation in over five years, should have definitely sounded alarm bells for many. And then there's also a chapter covering the aftermath of the crisis I wanted to include here

Starting point is 00:42:36 as well. In studying financial crises of the past, the aftermath of severe crises generally have three things in common. First, asset market collapses are deep and prolonged. So you have declines in housing averaging 35 percent over a six-year time period with the crash. And equity markets collapsed an average of 56% over three and a half years following the crisis. So second, the aftermath of a banking crisis is associated with profound declines in output and unemployment. Unemployment rose on average to 7% during the downturn, and output falls more than 9% on average. And third, the amount of government debt tends to explode post-crisis. On average, government debt increased by 86% in major crises post-World War II in the three years following the crisis.

Starting point is 00:43:30 The reason for the huge increase in the debt is the costs associated with bailing out the banks and recapitalizing the banking system. Another critical reason is that during an economic downturn, tax revenues tend to decline, and the gap is filled by taking on additional debt. And I'll also reiterate that the numbers for asset price corrections and economic indicators are simply averages. Some cases are obviously much better. Other cases are obviously much worse. The book is very data intensive and shows a ton of charts, a ton of figures from a number

Starting point is 00:44:03 of different crises. So I'm trying to include some of the most important data points here. One statistic that surprised me was that stat that housing declines tend to last around six years. I think a lot of people today would think a six-year decline in housing in the U.S. just wouldn't be possible. And that's, you know, I think it's really just due to recency bias of how housing has performed over the most recent years since the great financial crisis. I think a lot of people just sort of assume that housing only goes up because during the period of time that they've owned a house, it's only gone up. When I pull up the house price index for the U.S. on the Fed's website, house prices, they peaked around the start of 2007 and then they bought.

Starting point is 00:44:44 bottomed around 2011, 2012 time frame. So that's a decline of around five years. And now U.S. housing prices have more than doubled since 2012 up to early 2024. And when I think about the massive increase in government debt in the years following a crisis, I can't help but think of this as being a bullish indicator for asset prices. It's a reminder for me that crises aren't something we should be afraid of from a long-term investors' point of view because they can present some amazing investment opportunities as asset prices decline in the market sentiment is at its worst. The book also shares data around the Great

Starting point is 00:45:23 Depression, which I see is a pretty tough comparison because the government and the Federal Reserve at that time, they were much more resistant to stepping in and supporting markets. So many bank failures were occurring and the downturn was much more severe because of that. For example, public debt during that time period grew by 84%, but it took a six-year period for it to achieve that level of growth, but when you tend to see it take usually around three years. So the policy response to the depression was relatively slow and not as arguably not as severe. That was really what I wanted to cover from the book this time is different. I think this book ties in really well with Lynn Alden's book as well, broken money. And this is just another really wonderful book. Len Alden discussed this book on

Starting point is 00:46:08 We Study Billioners back on episode 574, which I'll be sure to link in the show notes. I got to say, we really live in some interesting times. The whole world is on a fiat currency standard. And now governments around the world are looking into implementing things like CBDCs, which essentially give them more power to implement financial repression and try and keep their local citizens within their reach essentially. And after reading this time is different. I can't help but think about the dynamic that if the government needs to inflate away the population savings in a currency, then the last thing they want is for people to escape that financial repression. You know, that escape valve, it could be gold, it could be Bitcoin, it could be something else that is outside the financial system.

Starting point is 00:46:56 And you've seen some of that happen. Gold bugs have been around for decades talking about the issues of ever increasing government debt. And then Bitcoin has also seen substantial growth in interest and investments going into it. So rather than going off on a gold or Bitcoin tangent here, I'll talk about a few parts in Lensbook that I find interesting. Chapter 16 I'm going to talk about here. I think it ties in really well with this episode and this discussion. She talks about the viewpoints of the issuer of a currency and the user of a currency

Starting point is 00:47:28 and how the interests of those two parties can be at all. odds with each other. Lin writes, a user typically wants to hold money that appreciates in value that is easy to hold and pay with that is private and that is difficult or impossible to freeze or confiscate. A modern currency issuer in contrast generally wants to issue money that smooths out near-term volatility, that pulls demand from the future to the present, that is easy to surveil, that can be frozen or confiscated by authorities easily, and that gives the issuer a lot of flexibility. to spend money even at times when nobody wants to finance them, end quote. So from the government or the policymakers point of view, they want to act countercyclical

Starting point is 00:48:11 to the economy to try and smooth out the ebbs and flows of growth and recessions that occur. So when an economy is running too hot, policymakers want to try and slow it down to prevent too much inflation and too much malinvestment. When the economy slows down too much, they want to try to speed it back up and prevent a major economic downturn. So from the Keynesian point of view, the two ways to influence the economy is through government spending and through interest rates. Lynn then explains that ideally you'd be running a fiscal surplus when the economy is too good, and then running fiscal deficits when the economy needs stimulate it. So this is from the government point of view of spending less than they

Starting point is 00:48:52 make leads to the fiscal surplus, and then spending more than they make leads to the fiscal deficit. But this isn't actually what happens in practice. Instead, governments run moderate fiscal deficits during good times and then pretty large fiscal deficits during the tough times, like the recession during the great financial crisis or during the COVID crisis in March 2020. Since the government doesn't run a fiscal surplus, there are inevitably times when the private market can't fill the demand for treasuries or U.S. debt. So the central bank is forced to print money and fill that gap when there's a lack of buyers for treasuries. Since there aren't any free lunches in markets, society overall is paying the price to try and smooth out these economic

Starting point is 00:49:36 cycles and any external shocks that occur, such as COVID or whatnot. There's also the counterargument from some economists that instead of the government and central banks smoothing out the business cycles, they're actually the major cause of them. So this line of thinking says that smoothing out one recession just ends up kicking the can and delays the pain that's inevitable to come. But the pain will only be much worse in the next cycle because we've kicked the can and avoided it. During the year 2000, for example, the Federal Reserve lowered interest rates all the way down to 1%. And this was the lowest interest rate that they've had in decades. But the recession in the real economy was rather mild.

Starting point is 00:50:16 So some would argue that the Fed had way too loose monetary policy during that time period. The artificially low interest rates encouraged many people to borrow and speculate, and this ended up leading to the 2006 housing bubble. A lot of people got real-cheed mortgages from 2004 to 2006, and then when the Fed raised rates, people started to default, especially those who got the adjustable rate mortgages. So rather than the Fed being a countercyclical force, this whipsaw in interest rates was actually a pro-cyclical contributor to some degree instead of being counter-cyclical. More recently, similar things happened as well. Of course, we had COVID-19 strike in 2020. The Fed cut interest rates to 0% and injected enormous amounts of liquidity into the financial system. And Jerome Powell,

Starting point is 00:51:04 he didn't believe that inflation would come despite the large increase in the broad money supply. And the Fed chairman infamously said that, quote, we're not even thinking about raising interest rates. Fast forward to late 2021, CPI inflation was running at 6%. And the Fed, still held interest rates at 0% and was expanding the monetary base by buying U.S. treasuries. And finally, they started to drastically pivot, raising interest rates to the highest they've been in over 20 years, which led to the second largest banking failure in American history. Now, I'm certainly not in a position to say what the Fed is doing is good or what they're

Starting point is 00:51:41 doing is bad, but I can't say that what they're doing has a real impact on real people and real businesses and we're just forced to sort of deal with them being a key player in the game of business, in the game of investing, and being cognizant of how their decisions might impact our lives. So one example just for me that I can share with the audience is that a lot of our advertisers here at the Investors Podcast are backed by venture capital. And our advertising revenue saw a decline since the Fed raised rates and these VC backed firms they needed to cut back on a lot of their ad spend.

Starting point is 00:52:17 Many retirees listening to the show saw their accounts declined substantially in 2022, whether they owned stocks, bonds, or both. And if these retirees held cash, you know, they also saw purchasing power decline while their investments were also declining. So it's sort of a double-edged sword with the Fed raising rates and markets declining at that time. There's also a section here on stable prices and how the Fed's actions make it difficult for market participants, but I wanted to skip that section here and go to the section titled The Need for Constant Price Inflation with Need, end quotes there.

Starting point is 00:52:53 Historically, the Federal Reserve has at a target of 2% inflation. There have been times when Fed officials have said that even inflation of 1.5% was too low and they were willing to try and loosen things up and bring inflation from 1.5 to 2%. Many policymakers made statements that inflation throughout much of the 2010s was too low. low, for example. So they view inflation that's too low as a problem, just like inflation being too high as a problem. So their target is that 2% range. Lynn shares a different view than policymakers. She writes, if we've replaced the description of an inflation target with a debasement target, which is ultimately what it is, it shows how silly some of these comments are. Using that

Starting point is 00:53:37 terminology, they would be lamenting that the currency that people earn their wages in and keeping their savings in is not being debased as quickly as their target debasement raise says they should, end quote. These comments really remind me of Jeff Booth's book, The Price of Tomorrow. It's one of my very favorites. In the book, he talks about how the natural state of the free market is deflation, and that naturally prices should decline as companies create better, faster, and more efficient ways of doing things.

Starting point is 00:54:08 Another way to think about it is that it's really an entrepreneur's job to give the consumer more for less. So deflation is good from the consumer standpoint because it means they get more for less, but deflation in the eyes of the central bank is actually a bad thing because in a debt-based economy, you inherently need inflation. Len writes, a key reason why policymakers and economists fear deflation is because deflation is bad for highly leveraged financial systems. And yet leverage is exactly what they encourage to exist through their policies. When everything is built on massive amounts of debt, and policymakers keep intervening to make sure debt levels go even higher, then deflation can collapse the system if it's allowed to occur.

Starting point is 00:54:52 Persistent deflation is not compatible with high debt levels and thus not compatible with the modern financial system, end quote. So not only is the Federal Reserve creating money to increase the broad money supply, but they're also doing so to try and offset any deflationary forces created by technology and innovation. Lynn shared this stat that from 1913 to 2022, the broad money supply grew by 6.6% per year on average, which is much higher than the 2% inflation target by the Fed. So this is why you see the value of scarce things like real estate go up by more than 2% per year.

Starting point is 00:55:31 It's more like 6% of more, especially really scarce real estate. When you look at Miami Beach Waterfront property, it originally sold for $100,000 in 1930, and in 2022, it's worth 30 million. So the compounded annual growth rate on that scarce Miami waterfront property is 6.4% per year. Then if you look at non-scarce things like grains, electronics, many foods, software, and other similar items, they have very low inflation or sometimes even have deflation because we've become just so efficient at producing them, and they just really aren't scarce relative to these waterfront properties. When you're Thinking about inflation in your own life, I think you need to consider the inflation of what it is you're needing or wanting to buy.

Starting point is 00:56:18 Maybe that's today or maybe that's some point in the future. If you haven't bought a house yet, for example, think about how much real estate in the area you're wanting to buy tends to appreciate. If you're soon going to have kids, consider the inflation rate of childcare in planning for the future or the inflation rate of college or whatnot. I'd encourage the listeners to not just take the inflation rate the government says is happening, the CPI inflation, don't take it at face value, because every single thing you buy is increasing or decreasing in price at a different rate. And it's oftentimes a very different rate than the CPI inflation rate. Lynn then makes the point that I think many people would disagree with here, I quote,

Starting point is 00:57:02 If the assets that you're saving in are not going up in price at the growth rate of the broad money supply per capita over a long stretch of time, then your purchasing power is being diluted. This is hard to keep track of even for a quantitative person who actively grinds the numbers, let alone a typical person who is just trying to earn income and save money. Since the growth rate of the money supply greatly exceeds interest rates most of the time, it's easy for savers to be diluted. persistent inflation of the money supply allows policymakers and various middlemen to siphon off the purchasing

Starting point is 00:57:36 power of people's savings without them being able to easily keep track of it. And as bad as it is for savers and developed countries, it's far worse for savers in developing countries, end quote. So in my opinion, that understanding of inflation and the money supply growth is just so, so critical for me, at least, in understanding the markets, how prices change, how my buying power changes over time, and not just like my investment accounts. And I just felt that it's so important to share here on the show. So I hope you found it valuable. So I'll leave that episode here at that.

Starting point is 00:58:09 I hope you enjoyed it. And I hope to see you again next week. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP624: Studying Financial History w/ Clay Finck

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