[00:02:29] Clay Finck: Especially infusions of cash that are given out by the government can make it look like 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.

[00:02:52] Clay Finck: These debt fueled booms can bring the illusion that things are good, 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.

[00:03:15] Clay Finck: And this is a challenging balance. And this is something that policymakers, investors, and ordinary citizens need to keep top of mind. The two primary crises the book covers, which are particularly relevant today, are the sovereign debt crises and the banking crises. And it covers 66 different countries over eight centuries.

[00:03:34] Clay Finck: 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 enough 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.

[00:03:58] Clay Finck: It’s just that we’ve forgotten about them and it hasn’t happened in our lifetime. 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.

[00:04:17] Clay Finck: The reason that people believe that their time is different from 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 rolling along for an extended period, then bang, confidence collapses, lenders disappear, and a crisis hits, end quote.

[00:04:46] Clay Finck: 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.

[00:05:11] Clay Finck: Countries can also run into similar dynamics due to loss of confidence. Say a country borrows from external lenders over which they have little influence over. And consider that many government investments are highly illiquid. So if 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.

[00:05:36] Clay Finck: 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.

[00:06:00] Clay Finck: When a bank makes a loan, they’re trusting 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.

[00:06:20] Clay Finck: 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 this time is different syndrome is that people tend to believe that financial crises are things that happen to other people in other countries at other times.

[00:06:48] Clay Finck: 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.

[00:07:05] Clay Finck: So the first is high inflation. They set the cutoff at an inflation rate in the local currency exceeding 40 percent per year. And then the second type of crisis is a currency crash. This is set at a 25 percent 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 backing is reduced.

[00:07:32] Clay Finck: 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 crises not closely related to the currency losing value. There 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.

[00:07:53] Clay Finck: 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 the currency outside of their local jurisdiction. One example is Argentina in 2001, when they defaulted on 95 billion in external debt.

[00:08:13] Clay Finck: And finally, third, we have the domestic debt crisis, which is debt issues within a country’s own local currency. One example of this is Mexico in 1994 and 1995. 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.

[00:08:33] Clay Finck: 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 risk of default.

[00:09:01] Clay Finck: 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%, and 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.

[00:09:28] Clay Finck: 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 the excess of 100%. 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.

[00:09:55] Clay Finck: 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.

[00:10:17] Clay Finck: 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 US defaulting on its debt is that they can just print their own currency if they’re ever having issues with making payments on their obligations.

[00:10:44] Clay Finck: And the book discusses how this is effectively defaulting on your debt because the debt isn’t 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.

[00:11:07] Clay Finck: So governments really have somewhat of a choice when it comes to 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 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.

[00:11:30] Clay Finck: 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 revalued 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.

[00:11:52] Clay Finck: And you can really think of this as inflation being higher than interest rates. So say a government borrows at 3 percent interest inflation, it might be running at 6 percent and you have an economy that continues to grow. And so the government’s debt burden relative to the GDP would become more manageable over that time.

[00:12:10] Clay Finck: 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 is running at 6%. If you buy debt, that is 3%, then your debt is losing value over time when you account for inflation.

[00:12:29] Clay Finck: 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 revalued the gold relative to the dollar.

[00:12:49] Clay Finck: Argentina went through a number of restructurings from 1982 through 2005. Brazil had 62 in 1990. 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.

[00:13:12] Clay Finck: So let’s jump to chapter 10 here, which discusses banking crises and their role in all of the crises studied 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 happened in the great financial crisis.

[00:13:32] Clay Finck: 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 the average government debt level rose by 86 percent during the three years following a banking crisis for countries in the modern era.

[00:13:55] Clay Finck: 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.

[00:14:19] Clay Finck: 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 holding their citizens captive and keeping them within the banking system so they can implement financial repression.

[00:14:36] Clay Finck: India, for example, in the 1970s, they capped interest rates at 5 percent 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.

[00:15:03] Clay Finck: 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 illiquid if everyone’s heading for the exits all at 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.

[00:15:24] Clay Finck: But if the crisis becomes more broad based across the entire economy, then this likely won’t be a viable option. The book 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.

[00:15:43] Clay Finck: Based on the crises they studied, the authors also found there to be a high correlation between international capital mobility and banking crises. 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.

[00:16:03] Clay Finck: 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 high inflation. So if consumers don’t want their wealth lost via inflation, they might try and go get US dollars.

[00:16:21] Clay Finck: So the easier it is for citizens to do that, 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 US dollars, then there’s less likelihood of a banking crisis happening.

[00:16:43] Clay Finck: They also found that when regulations are too loose, you can also run into banking crises issues. And this is what happened in 2008 when many institutions were over leverage. 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 a crisis and how government revenues and debt are impacted.

[00:17:05] Clay Finck: The debt increases following the crisis in particular are enormous in many cases. So to summarize the banking crisis piece, when a country experiences an adverse shock, say due to a drop in productivity, a war, a political or social upheaval, banks suffer in these situations. Loan default rates go up dramatically, and banks become vulnerable to losses in confidence and bank runs.

[00:17:29] Clay Finck: Due to banking failures and 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.

[00:17:48] Clay Finck: So managing the banking sector with appropriate regulations is really important for economic growth overall. It’s funny when you see a lot of people, they get upset when the Fed or the government supports the financial system or they provide liquidity to the banks.

[00:18:09] Clay Finck: When they get in trouble, you might think that these regulators’ policy makers 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.

[00:18:34] Clay Finck: The U. S. sort of learned this lesson 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.

[00:18:57] Clay Finck: 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, just for citizens, turn them in, shave them down and then give them back to the citizens.

[00:19:14] Clay Finck: Centuries ago, this was a tactic used to make it easier to pay down debts without directly taxing their citizens, which everyone, 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 would be subject to the death penalty.

[00:19:36] Clay Finck: 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 imply an inflation rate of 100%.

[00:19:57] Clay Finck: 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 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.

[00:20:19] Clay Finck: S., especially in the higher populated states like California and the Northeast. 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 increase 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.

[00:20:53] Clay Finck: But from January 2020 to January 2024, while the US M2 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.

[00:21:15] Clay Finck: So the S and P 500, which you compare to these other two numbers, the S and P 500 increased by 54 percent during that same time period. 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.

[00:21:34] Clay Finck: 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. The book also mentions that if currency debasement is too extreme, You may see financial chaos, increased uncertainty, and that can actually lead to higher inflation relative to the increase in the money supply.

[00:21:58] Clay Finck: 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.

[00:22:21] Clay Finck: 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 on those violating restrictions on capital accounts and currency.

[00:22:40] Clay Finck: Fourth, governments engage in massive money expansion in part because they can thereby gain a generous 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.

[00:23:00] Clay Finck: 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 experienced a 55% debasement. In 1810, Russia experienced a 41% currency debasement among a dozen other prevalent examples in history.

[00:23:24] Clay Finck: The takeaway from this chapter for me is that the inflation we see 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 as stated at the top of the episode from Rose Burton.

[00:23:48] Clay Finck: There is nothing new except what is forgotten. 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 authors write, I quote, a key finding that jumps out from our historical tour of inflation and exchange rates is how difficult it is for countries to escape a history of high and volatile inflation.

[00:24:15] Clay Finck: 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. 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.

[00:24:42] Clay Finck: When you look at this chart on page 181, that shows the median inflation rate for all countries from 1500 through 2007. 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.

[00:25:02] Clay Finck: 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 Brazil.

[00:25:26] Clay Finck: Brazil, for example, has had six Hyperinflationary events since 1,828 different years of 20% inflation or more. Canada, the U. S. and New Zealand, they seem to be sorta unicorns in the study. Since 1800, for example, the U. S. looks to only have had one year of inflation higher than 20 percent, and that was in 1864, and they’ve had no years with inflation higher than 40 percent.

[00:25:51] Clay Finck: 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.

[00:26:12] Clay Finck: 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 U. S. 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.

[00:26:36] Clay Finck: So once that trust is lost with a lot of citizens, it’s 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.

[00:26:56] Clay Finck: 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 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.

[00:27:14] Clay Finck: Of course, the book is charged here, which shows the proportion of countries in a banking crisis. So it shows a historical chart of, and you can really see when these big crises are happening throughout history, none of the big banking crises were as big as the great depression during that time, around 45 percent of countries globally were in a banking crisis.

[00:27:36] Clay Finck: In 2008, it looks like this reached 30%. 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.

[00:28:01] Clay Finck: The book also argues that the elevated housing prices in real terms could have served as a potential precursor to the crisis. The Case Shiller 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.

[00:28:25] Clay Finck: Then by mid 2007, there was a sharp rise in default rates on low income housing mortgages in the US and this sparked a full blown financial panic. The Great Financial Crisis was also a classic example of this time of 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.

[00:28:55] Clay Finck: 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 account was a quote unquote Meaningless concept.

[00:29:17] Clay Finck: They believe that since many emerging market countries had issues with their own crises in the past, they should be free to invest in the US as it was perceived to be a more developed and safer market to invest in. For US borrowers, this led to cheap funding due to these inflows from these foreign entities.

[00:29:35] Clay Finck: The question that policy makers 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. The size of the U. S. financial sector, for reference, was 4 percent in the mid 1970s, and it had grown to 8 percent of GDP in 2007.

[00:30:00] Clay Finck: 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.

[00:30:20] Clay Finck: And if I were to put myself in their shoes, and if I were getting these enormous multi million 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 us consumers to turn their previously illiquid housing assets into ATM machines, which represented a reduction in precautionary saving, which essentially means that your typical American had very little savings.

[00:30:48] Clay Finck: 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 to the extent that they might affect the central bank’s primary goals of growth and price stability.

[00:31:17] Clay Finck: 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 percent in the early 1990s, and rose to 120 percent in 2003, and was nearly 130 percent 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.

[00:31:45] Clay Finck: There were 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 that they just couldn’t afford, and they were also initiated with things like variable interest rates.

[00:32:03] Clay Finck: or a low initial teaser rate that made the deal potentially look a lot more appealing than it actually was. Once interest rates rose, the economy slowed, and housing prices started to fall, the whole debt fueled boom started to unravel very quickly. With the high levels of capital flows and the rising asset prices, the International Monetary Fund concluded in April of 2007 that the risks in the global economy have become extremely low.

[00:32:32] Clay Finck: And that for the moment, there were no great worries. 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.

[00:32:54] Clay Finck: It had the most innovative financial system, a strong political system in the world’s largest and most liquid capital market. which allowed countries to go deeper into debt. In addition to the other strengths, The US also had superior monetary policy and institutions and policy makers. Five new financial instruments were allowing many new borrowers to enter mortgage markets.

[00:33:30] Clay Finck: 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. The book then dives into an overview of five severe banking crises in the past and what parallels could have been drawn to help foresee the potential trouble ahead.

[00:33:48] Clay Finck: The big five include 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.

[00:34:10] Clay Finck: 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. 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.

[00:34:29] Clay Finck: 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 a hundred percent actually appreciation in over five years should have definitely sounded alarm bells for many.

[00:34:48] Clay Finck: And then there’s also a chapter covering the aftermath of the crisis I wanted to include here 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.

[00:35:11] Clay Finck: In equity markets collapsed an average of 56 percent 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 percent during the downturn and output fell more than 9 percent on average.

[00:35:33] Clay Finck: And third, the amount of government debt tends to explode post crisis. On average, government debt increased by 86 percent in major crises post WWII in the three years following the crisis. The reason for the huge increase in the debt is the cost associated with bailing out the banks and recapitalizing the banking system.

[00:35:55] Clay Finck: Another critical reason is that during an economic downturn, tax revenues tend to decline and a 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.

[00:36:15] Clay Finck: The book is very data intensive and shows a ton of charts, a ton of figures from a number of different crises. So I’m trying to include some of the most important data points here. One statistic that surprised me was that state 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.

[00:36:35] Clay Finck: S. just wouldn’t be possible. And that’s, 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 assume that housing only goes up because during the period of time that they’ve owned a house, it’s only gone up.

[00:36:52] Clay Finck: And 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 bottomed around 2011, 2012 timeframe. 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.

[00:37:16] Clay Finck: 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 investor’s point of view because they can present some amazing investment opportunities as asset prices decline when market sentiment is at its worst.

[00:37:36] Clay Finck: The book also shares data around the Great Depression, which I see as a pretty tough comparison because the government and the Federal Reserve at that time, 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.

[00:37:53] Clay Finck: For example, public debt during that time period grew by 84 percent, 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.

[00:38:14] Clay Finck: 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. Lynn Alden discussed this book on We Study Billionaires back in episode 574. I gotta say we really live in some interesting times. The whole world is on a fiat currency standard.

[00:38:36] Clay Finck: 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 to 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 you 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, that escape valve, it could be gold, it could be Bitcoin, it could be something else that is outside the financial system.

[00:39:11] Clay Finck: 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. Rather than going off on a gold or bitcoin tangent here, I’ll talk about a few parts in Lynn’s book that I find interesting.

[00:39:32] Clay Finck: Chapter 16, I’m going to talk about here. I think it ties in really well with this episode and this discussion. Lynn. She talks about the viewpoints of the issuer of a currency and the user of a currency and how the interests of those two parties can be at odds with each other. Lynn writes, a user typically wants to hold money that appreciates in value.

[00:39:52] Clay Finck: 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.

[00:40:20] Clay Finck: End quote. So from the government or the policy makers point of view, they want to act counter cyclical 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, policy makers want to try and slow it down to prevent too much inflation and too much malinvestment.

[00:40:40] Clay Finck: When the economy slows down too much, they want to try to speed it backup 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. Lin 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 stimulated.

[00:41:05] Clay Finck: So this is from the government point of view of spending less than they 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.

[00:41:29] Clay Finck: 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 is 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 cycles and any external shocks that occur, such as COVID or whatnot.

[00:41:55] Clay Finck: There’s also the counter argument 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.

[00:42:18] Clay Finck: 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. So some would argue that the Fed had way too loose monetary policy during that time period.

[00:42:37] Clay Finck: 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 cheap mortgages from 2004 to 2006. And then when the Fed raised rates. People started to default, especially those who got adjustable rate mortgages.

[00:42:54] Clay Finck: So rather than the Fed being a counter cyclical 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 percent and injected enormous amounts of liquidity.

[00:43:16] Clay Finck: into the financial system. And Jerome Powell, 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 percent and the Fed still held interest rates at 0 percent and was expanding the monetary base despite buying US treasuries.

[00:43:41] Clay Finck: 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 doing is bad. But I can say that.

[00:43:59] Clay Finck: What they’re doing has a real impact on real people in real businesses. And we’re just forced to deal with them being a key player in the game of business and the game of investing and being cognizant of how their decisions might impact our lives. One example just for me that I can share with the audience is that a lot of our advertisers here at The Investor’s 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.

[00:44:31] Clay Finck: 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, they also saw purchasing power decline while their investments were also declining. So it’s a double edged sword with the Fed raising rates and markets declining at that time.

[00:44:52] Clay Finck: 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. Historically, the Federal Reserve has had a target of 2 percent inflation.

[00:45:10] Clay Finck: There have been times when Fed officials have said that even inflation of 1. 5 percent was too low, and they were willing to try and loosen things up and bring inflation from 1. 5 percent to 2%. Many policymakers made statements that inflation throughout much of the 2010s was too low, for example. So they view inflation that’s too low as a problem, just like inflation being too high as a problem.

[00:45:33] Clay Finck: So their target is that 2 percent 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 terminology, they would be lamenting that the currency that people earn their wages in and keep their savings in is not being debased as quickly as their target debasement rate says they should, end quote.

[00:46:03] Clay Finck: 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.

[00:46:21] Clay Finck: Another way to think about it is that it’s really an entrepreneur’s job to give the consumer more for less. 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.

[00:46:40] Clay Finck: Lynn writes, a key reason why policy makers 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.

[00:47:05] Clay Finck: 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.

[00:47:24] Clay Finck: Lin shared this stat that from 1913 to 2022, the broad money supply grew by 6%. 6 percent per year on average, which is much higher than the 2 percent 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 percent per year. It’s more like 6 percent or more, especially really scarce real estate.

[00:47:48] Clay Finck: When you look at Miami beach waterfront property, it originally sold for a hundred thousand dollars 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 percent per year. Then if you look at non scarce things like grains, electronics, mini 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.

[00:48:23] Clay Finck: 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. 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.

[00:48:41] Clay Finck: If you’re soon going to have kids, consider the inflation rate of childcare and 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.

[00:49:06] Clay Finck: And it’s oftentimes a very different rate than the CPI inflation rate. Lin then makes the point that I think many people would disagree with here I quote 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.

[00:49:35] Clay Finck: 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 policy makers and various middlemen to siphon off the purchasing power of people’s savings without them being able to easily keep track of it.

[00:49:53] Clay Finck: And as bad as it is for savers in 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 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.

[00:50:14] Clay Finck: 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. I hope you enjoyed it. And I hope to see you again next week.

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