"We’re going to have a debt crisis in this country"
The words of Ray Dalio, the founder of hedge fund Bridgewater Associates, in a month where U.S. debt levels surpassed $33 trillion for the first time, foreshadowed the political battles in the US over the following weeks. A government shutdown was temporarily avoided by a short-term funding deal until 17th November - all it cost was one Speaker of the House.
If we put the political grandstanding to one side, we can consider what government debt and debt in general means for investors.
Fuelling the supply
Source: Parmenion, Thomson Reuters
Broadly speaking, the supply of money in an economy will increase when more new money is borrowed than is paid back, and decrease when less new money is borrowed than paid back. In other words, the growth of debt fuels an increase in the supply of money.
What does this mean? Take a new mortgage customer in the UK as an example. When they take out their mortgage, they’re entering new money into the economy by paying the seller for their house purchase. The money the banks lend to buyers is also borrowed, this time from the Bank of England (of course at a lower rate!).
Each time the central bank lends to commercial banks, it creates new money , and this money is effectively deleted (aside from the interest) when the debt is repaid. The more money a central bank creates by lending, the more the balance sheet of their assets increases. Aside from lending to commercial banks, central banks can also increase their balance sheet by creating money to buy government debt, known as Quantitative Easing (“QE”).
Global central bank balance sheets
Over the last century the supply of money has nearly always increased. One of the sharpest increases occurred over the Covid pandemic, fuelling the rise in inflation, leading central banks to raise interest rates. Those higher rates have tempered the growth of debt, with individuals and businesses less inclined to borrow while global central banks have sharply reduced their balance sheets. As a result, we’re now experiencing one of the rare occasions where the money supply is contracting.
The Cantillion effect
In the 18th century, French banker and philosopher Richard Cantillon coined the term ‘Cantillon effect’ to describe a change in relative prices when money supplies change, often unevenly. A good example is the impact of Quantitative Easing (“QE”) on the value of bonds. An increase in the supply of money flows directly into the bond market, boosting the value of those assets, and consequently risk assets more generally, relative to the wider economy. The theory is that those who receive the new money first (either directly through loans or indirectly through the new money boosting their assets) profit the most from an increase in the supply of money.
Investors should think about the impact on their cash savings and working investors should consider the impact on their salary.
In relative terms, if the increase in the supply of money exceeds the interest earned on cash and your annual pay increase you’ll likely be worse off.
Investing can offer some protection against this by purchasing tangible assets and shares in companies that are more likely to grow in line with the increased supply of money than cash savings or a salary would. Investing in a primary recipient of the increased supply can be a good move, as was the case for those invested in fixed interest assets over the course of QE.
In a bid to combat inflation and reduce the excess monetary supply, most major central banks are employing Quantitative Tightening (“QT”) but we all know they’re famously poor at predicting future actions. It can be difficult to stay away from accommodative policy when living with high and increasing government debt burdens, as The Bank of Japan are showing.
All of which reminds me of another Ray Dalio quote: “cash is trash”. In times where the supply of money is growing, Cantillon would agree with this sentiment. Experience suggests it would be wise to stay alert to the prospect of money supply growth returning in the future, and the role investing can play in such an environment.
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Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.