The Placeholder in Debt Cycles

Economy? It is basically built up of transactions done over and over, these transactions can be categorized in Money and Credit.

The sum of money and credit is what we call Total spending, this spending is what drives the economy. As one person’s spending is the income of another, very important to understand.

One person’s spending is the income of another.

How is credit created?

When a Borrower promises a Lender to pay the principal amount plus the interest, with this promise credit is created. Thus any two people can agree to create credit out of thin air.

As soon as credit is created it turns into Debt for the borrower. Credit is an asset for the lender and debt is a liability for the borrower.

Money Vs Credit

A transaction done with money is settled immediately, whereas credit transactions are settled when the principle along with the interest gets paid.

What does borrowing money mean?

Borrowing is a way of pulling spending forward. When you borrow money today, you increase your buying power today at the expense of the buying power of your future self. So you essentially borrow from your future self. Thus creating a time you will spend less in order to pay it back.

The CYCLICITY of Debt

Borrowing allows more spending, as spending of one is income for another we see a transfer. A person with more income can borrow more, thus can spend more today, ideally which should go into increasing his productivity, which in return should increase the income.

A creditworthy borrower is one who has more income and assets as collateral, can borrow more, thus increased spending leading to someone else’s income.

This self-enforcing pattern leads to economic growth. That is why we have cycles, cycles of debt.

Productivity & Debt cycles

Productivity matter more in the long run as it does not fluctuate as much as debt does, thus credit matter most in short term.

In an economic system built on credit, expansions and contractions of credit availability serve as drivers of economic growth/activity and contraction/recessions, respectively.

How does this happen?

Central Banks! They control the money circulating in the economy in mainly two ways, interest rates and printing money. Thus the flow of money.

Whenever there is excess liquidity in the markets it can cause Inflation as people have easy credit availability increasing their spending power, when this inflation goes beyond a certain threshold central banks increase interest rates(repo rate). This reduces the borrowing but the debt repayments are still high due to past borrowings, which in result reduces the spending, which is someone else’s income, thus incomes drop. So we see a period of deflation.

Economic activity then reduces and we have a Recession, and if the recession is severe and we don’t have inflation as a problem anymore, the central banks again lower the interest rates, thus we see another expansion.

Let’s combine these graphs and look at some interesting insights…

Short-term debt cycle

• Interest rates at the cyclical peak and trough are lower than those at the peak and trough of the previous cycle.
• Every cycle has higher growth than the previous one, till the long term peak.
• The debt keeps increasing till the peak.
• Lasts 5–8 years

How does the long-term debt cycle form?

As discussed interest rates at the cyclical peak and trough are lower than those at the peak and trough of the previous cycle. This process repeats until the interest rate reductions that enabled each subsequent expansion can no longer continue, as interest rates reach the lower bound of zero.

In such easy credit scenarios, asset values rise thus incomes rise resulting in more creditworthiness of the borrowers, thus debt rises faster than income as people borrow more than they can repay. This forms the long-term debt cycle. This ratio of debt to income is defined as the Debt Burden.

Over the long term, the debt burden slowly increases, causing

• Debt repayments start growing faster than incomes
• Due to which people are forced to cut spending
• Thus the whole short term cycle also reduces in momentum and the economy moves down.

Deleveraging

Due to cuts in spending, incomes fall. This reduces the creditworthiness of the borrower and credit disappears, which results in a drop in asset prices and banks get squeezed.

So low incomes with still higher debt repayments, force people to sell assets at low prices thus the collapse of the market as there is high sell pressure and people have low income. With lowered asset prices, creditworthiness drops further.

Now, this may sound similar to a recession but in deleveraging interest rates are already bottomed out.

Thus very high debt burden!

Interesting thought: During the times of deleveraging everyone of is over-leveraged in their positions in the markets will get wiped out, then the central banks come in they lower the price of money which essentially is a bailout, thus socializing the losses of the top few over the population.

Our timeline

• Leveraging takes about 50+ yrs, the time when the interest rates keep declining and debt keeps increasing.
• After which we see a Depression for 2–3 years, caused by deleveraging
• 7–10 years of reflation, which we will discuss in the end.

Looking at the last 80+ years it is clear that we are at the end of the leveraging of the debt super-cycle. Especially over the last 4 decades, the interest rates have been on a downtrend, debt loads have continued to pile up across the economic system. Every economic boom that has occurred since 1981 has been aided by stimulus in the form of looser monetary policy.

Let’s have a look at recent short-term cycles…

• 1980 to 1986 : 19% to 6.5%
• 1989 to 1993 : 9.8% to 3%
• 1995 to 2003 : 6.5% to 1%
• 2006 to 2011 : 5.25% to 0.07%
• 2019 to present : 2.4% to 0.08%

Interest rates peaked at 19% in 1981, and over the last 40 years, they have been on a downtrend. Also, notice how the interest rates after each short term cycle just get lower and lower. Bonds, equities, and real estate have all been appreciated by orders of magnitude based on the valuations supported by ever-decreasing interest rates.

Since the interest rates are so low, they even reduce the treasury bond yields. Which when coupled with the inflation caused by Quantitative Easing(“printing money” to buy debt securities/financial assets) now gives a negative yield.

Shown below are the Daily Treasury Real Yield Curve Rates of the last few days…

Quantitative Easing(QE) itself places cash in the hands of investors, who then seek to redeploy it into other financial instruments. QE positively affects investors and asset values but does very little to help those without assets.

Now when the real yield of treasury bonds goes negative, the risk-free rate of return is negative thus investors look for alternative avenues for parking their funds. As a result, asset valuations soar, and the holders of said assets get exponentially more wealthy.

The wealth divide has been further exacerbated since the 2008 financial crisis. Below is the S&P 500 Index, which has risen nearly 550% in just 12 years, fueled by the ZIRP (zero-interest rate policy) and QE.

We have discussed how the interest rates have gone down and now we shall look at the debt side of the curve, as during the leveraging period with an increase in productivity, and continuously falling interest rates there is a gradual build-up of debt.

Shown below is data of various sectors…(Since 1980)

Corporate Earnings — 472%

Corporate Debt — 1164%

Household Income — 30%

Household Debt — 844%

GDP — 689%

All Sectors debt — 1740%

Federal Debt — 4240%

Looking at the percentage rises I don’t feel the need to make an argument about rising debt.

Another metric I will like to show is called Money Velocity, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.

The argument I am trying to make is that with excessive QE, every dollar floating in the market slowly has a lesser and lesser impact on the GDP, Calculated as the ratio of quarterly nominal GDP to the quarterly average of MZM money stock.

Since 1980 we see a downtrend in the effectiveness money has to positively impact the GDP.

With this what happens is that fiat currency becomes the error term to solve the growth problem in the Debt to GDP ratio, to show growth we have to increase the debt and the numerator outstrips the growth of the denominator, which means you need to print the money to solve the debt spiral again and again. (READ AGAIN!)

Till now we have discussed the economy from the lens of Ray Dalio and tried to understand our current position in the timeline of debt cycles and also how we have reached such fragile branches.

Placeholder's Thesis by Chris Burniske

The idea behind this is that open standards collapse the cost of existing technologies which then allows a new layer of value creation to come in.

IBM dominated the hardware market until microprocessors came around in the 1970s which was the open standard and we saw the collapse of the costs of producing such machines which around the 1980s led to the fall of IBM.

This new open standard of microprocessors led to the entrance of Microsoft in proprietary software, which was later undone by free open-source software movements and the internet(Web 1.0). Which was around the 2000s.

Interestingly the timings of fall and rise of the open standards are somewhat related to the debt cycles we discussed above.

Then the next thing was the proprietary aggregation of the data layer, which is where we live today the Web 2.0, where private companies control our data. Now the next open standard is the Blockchain. Which is Web 3.0, so from here on I see a stark rise in this technology.

Thus in the world today, technology continues to drive the costs of many aspects of life to near zero, our monetary system necessitates that everything continues to increase in cost in nominal terms in perpetuity. Even though technological advances should be giving everyone the gift of a higher standard of living for less real cost, the incumbent monetary system must avoid deflation at all costs as it is in an over-indebted state. Thus with exponential technological growth, exponentially more stimulus and debt are needed to keep the system glued together.

The Solution

We are seeing this play out today. The global economic system is so over-indebted that there would be a deflationary collapse without ever-increasing liquidity injections/stimuli. As a result of rates being stuck at the zero lower bound and exponentially increasing debt monetization, a mass default is occurring not explicitly but implicitly. The error term is the value of the currency itself, which in this case is the dollar.

During a period of debt monetization, the rational economic incentive is to protect one’s wealth by seeking out assets that cannot be devalued or “printed,” like bitcoin. There will only ever be 21,000,000 bitcoin. With its perfectly inelastic, programmatic supply issuance, it is the logical choice for every rational economic actor to adopt as a primary store of value.

Now I am not only making a case for bitcoin over here, what I want to explain is that there is coming a tectonic(pun intended) shift in how we are going to view blockchain in our daily life and how it can fix a lot of problems of the current financial system, eg. stable coins, even RBI has called digital currencies as mixed blessings.

In the next decade the largest wealth transfer will occur, from bond holders to digital asset holders,

Bitcoin will be a hedge against the odds.

Devain is an SN Mentoring Young Futurist under the guidance of Saurabh Nanda.