Transcription
[Music] The next red flag to go up is when the Federal Reserve and other central banks come in and buy again. And then the next time that is a very risky point is when we have the next economic downturn.
What we have done, my generation, unfortunately, has allowed debt to build up, has allowed infrastructure to deteriorate, has instead borrowed forward. And so if we think about what this debt restructuring and renovation is going to cost and we think about that's not measured in money, it really money just produces productivity. So the work and how we're going to have to be in order to be effective has to overcome that deficit for this giant renovation. So we haven't done it.
But it's very simple. There are debtors and there are creditors and the system has got to work well for both. One man's lending has got to be rewarded to compensate for making that lend. And so you have a process. If you accumulate debt, you are accumulating the need to pay back in real terms. You have to pay back the principle and you have to pay back the interest in real terms. Otherwise, nobody's going to want to lend and the system doesn't work.
And the two issues that you have a choice of is to pay that back in hard money. In other words, money of value that's of comparable value or you have to print money and you pay back in deflated money. And so what has happened over a period of time throughout history, these cycles, by the way, go back to the Old Testament years of Jubilee and the same cycle always happens. And there's a tendency for debt to rise relative to incomes that are needed to service that debt. And so you see different societies.
In our society, we have high debt service costs which then will rise as we have large deficits and large amounts of money to pay back. And if that balance is not well achieved so that the creditor does not receive an adequate amount of compensation, they will sell that debt. They will not hold that debt. And so it's not just the amount of new debt that's created. It is also the amount of debt outstanding that could be sold and therefore create a huge imbalance between the amount to be sold and the amount to be bought. And so in history, it's all repeated in the same way.
When that time comes where they have to do that when they do that selling and central banks come in and they think they're saving something because they're printing the money in order to pay back the debt as has been done, monetization as we call it, that that creates a bad compensation and devalues money. That's the mechanics. So there's no getting it around it. Wouldn't it be wonderful if it was like that? that debt didn't matter and you could keep borrowing. But think of it as just you're borrowing a proxy for stuff and it has to be paid back.
What happens and Japan is the worst. So what Japan has done is to by printing a lot of money they have had their currency go down and so that currency decline is the way it's depreciated. So if you have a bond holder in Japan, they've lost about 80% of their value in their purchasing power and that becomes the dynamic. That's the same sort of dynamic. So the next thing I think that you're going to see in the United States is you're going to see a squeezing of consumption.
So, at the federal government level, as the debt service payments are rising and the debts are rising on those, you're going to see the squeeze. There's very little room between entitlements that are fixed payments and the actual revenues that are coming in. You're going to start to see that squeeze. The real issue will become if you start to see the selling of those bonds. When exactly that happens, you know, I can't tell you.
The next red flag to go up is when the government when the Federal Reserve and other central banks come in and buy again. And then the next time that is a very risky point is when we have the next economic downturn. And I think that that probably will be within the next four years. Cycles. The business cycle lasts about 7 years on average, give or take 3 years. So, I can't tell you exactly when it will be, but I would say it's probably most likely within the next 5 years. Something along those lines.
I think a combination of gold and inflation index bonds would be good. I think that gold also has the benefit of being uncorrelated or by and large almost negatively correlated with other assets. So it's an effective diversifier. So in thinking of stocks and bonds and so on if you bring that in actually you lower the risk of the portfolio. So it's very good from a portfolio construction. It's also as a war option.
In history when we have wars, nobody wants to lend to anybody. Even allies don't want to lend to each other because everybody gets in much more debt and they know that that has to be devalued. And the question is what is the common currency? I think the world is leveraged long assets. That means generally speaking most assets are leveraged long. I think when they print money that'll be supportive to some of those assets as they always do. But I would expect an environment that would be more like the 1970s or in the 1930s in which in terms of real terms that equities does poorly relative to let's say hard assets.
When you think about what is an alternative money, gold is the third largest uh reserve currency. Central banks are now buying it. I think that also in institutional portfolios and in individual portfolios, they're underweighted. Inflation hedge assets are. So I would say, you know, my flyer even though I believe so much in diversification. So I would say I would diversify more. But if I was to say what is it, it would be not just gold but gold in combination particularly with some of the inflation index bonds because gold and inflation index bonds are only 16% correlated and so they balance each other well and they're both uh over the longer term relatively good assets to hold in the kind of environment that I think is more probable than is being discounted and that I worry about. So it would be an effective diversifier.
And by the way, I would say people get fanatical about Bitcoin or they get fanatical about gold. And I think that they have to think more broadly when we're thinking about what is the form of non-debt money. The Bitcoin issue is I believe that you're not going to get privacy in Bitcoin. Governments will follow and so on and can tax and control however that works. And if an alternative money uh of any form is threatening to the system uh they can shut it down. They can operate in that way. And that uh the behavior of Bitcoin in terms of its determinance, past behavior of Bitcoin doesn't make it clear to me how it behaves in relationship to some of these determinants. Bitcoin is also just to put it in perspective it's a relatively small market in terms of uh you know it's like a fraction of you know I don't know a fifth of the size of Microsoft or something one stock and there are many stocks so for all of those reasons I wouldn't heap a lot of money into that I have a very small Bitcoin position I don't but I for those reasons I would say central banks are not themselves going to take on Bitcoin.
Central banks are going to take on, you know, there's a saying, gold is the only asset you can have that isn't dependent on somebody else making you payments. So, I would favor gold over Bitcoin for those reasons. But, you know, uh each to their own and you know, make sure you're diversified because if the type of environment that we're talking about that, you know, comes to pass, I think that's uh crazy. And I think that that's I've been in the markets for 60 years and I've been through many many uh cycles and I know that wonderful technologies large changing of the world technologies throughout history and I can go back to the steam engine and carry it all the way through. They all have a cycle and you also don't know who the winners end up being in that cycle. And there are enormous amounts of risk in that dynamic of operating that way.
If you want to keep money as a storeholder wealth, the holy grail of investing is to find 10 to 15 good uncorrelated return streams. Because if you find a number of return streams, a number of investments that are good and uncorrelated, you will have the average return of those. So you don't lessen your return. Just pick ones that are really, really good that you like, but they're not correlated, but you will eliminate at 15, you'll eliminate 80% of your risk. So you'll improve your return to risk ratio by a factor of five. There is no way you can improve your betting on which one is going to be good by a factor of five. It's a competitive game out there to pick what's going to be a winner. And then also things change in unexpected ways as we know.
I was that person and I remember going through that journey. And I'm so glad that you're asking me the question cuz my purpose of in life now to a large degree and my purpose of being on this show is to try to pass along such things. And I remember when I started to have I was that age and I started to have a family and I started to think about how many months could I live if income didn't come in and then would go to years. And I would take that number and I would take my savings and I would say okay if let me cut that in half whatever that number is because it could go in half with between taxes and performance. I would take that number and I would start to think about what is it that is going to be most important. What's the purpose and use of that money? If I could immunize myself against the type of expenses, if I could prepay my children's education in a sense or my living or whatever expenses, I think that that's the most important things.
How do I build that? I would think about there's liquid savings and then there's your home which is your environment. There's certain things like your environment is very important and so there's how I think about the home and how that works and through improvements and forced savings and also there's taxes. So I would want to take care of the benefits first in that quantity and then I would try to have that element of diversification. I would view investing as being two types of investing. That investing for the safe money that's going to immunize the expenses that I need to pay and then I'm going to speculate kind of money because okay, when you try to beat the markets, okay, don't be naive. You know, at Bridgewater, we put hundreds of millions of dollars, billions of dollars to do research to try to beat the markets. So get the basics down well including the understanding of diversification and take care of your needs most. I think those are the most important things. Maybe above it all is having a saving mentality. The impact of a saving mentality is enormous.
I think it's such a silly bet like 25 or 50 it doesn't make a difference. I think that's the problem with the news cycle and all of this. They're losing sense of the bigger picture. Okay, Fed policy. What does the Fed have to do? Fed has to keep interest rates high enough to satisfy the creditors that they're going to get a real return without having them so high that the debtors have problem. So now if we're looking at this whether it's 25 or 50 basis points, 25 basis points is going to be depend would be the right thing to do. If you look at the whole picture as a whole, if you look at the mortgage situation, which is worse and that affects more people, then it's probably 50 basis points. But let's get beyond that, okay? And talk about these five big forces. The first of those forces is the force that you're referring to, which is the debt, money, economy, dynamic, and force. Okay.
So, we have a big debt increase. We have an enormous amount of debt and it's going to keep increasing and one man's debts are another man's liabilities. Okay. So what is that going to mean for monetary policy? Okay. As you have to sell more and more of those bonds, what will be done? I think the same thing is done in Japan that what happens is there's not going to be a default. Of course, there won't be a default, but increasingly they have to drive down real interest rates so that real interest rates are significantly negative. So, you're going to have in order to service the debt, you have to have a significantly negative real rate and you also have to have then the depreciation of the value of money because inflation rises. So that you have to have a nominal growth rate. In other words, inflation plus real growth that is above the nominal interest rate and you have to have a real interest rate that is negative and you have to have a positive slow yield curve. So that holding bonds is a bad deal.
We have a model for estimating what should be the economy right now is very very very close to an equilibrium level in many ways if you're just looking at what is and you're not looking at the debt problem. And it would look like there should be a modest easing of interest rates and a move gradually to a more positively sloped yield curve. What we would call normal. It's fairly normal. Except it's not normal in the way that it's so skewed. So if we look at the markets and we look at the way the population's income levels are for the various sectors if you look at the bottom 60% if you look at the politics the left and the right and the nature of what is going on the two worlds that we live in in terms of the economy and the values that brings us to the election.
So if we're talking about let's say monetary policy you have to look at the five forces. So back to the five forces, the first force we talked about. The second fourth is the force of internal order and disorder that progresses in a cycle. There is um hard left and hard right. So there's ideological differences that are creating a political situation that leads us to not only have possibly different policies, dramatically different policies which will have an effect on the economy or have an effect on the markets, but even worse or more concerning that it's conceivable that one side or another might not accept losing. Okay. Will we have an orderly democracy in which there's the ability to have disagreement and the resolve of those disagreements? I think that these are really questionable situations. So the second force is that internal order disorder force.
The third force is the great power conflict. In other words, throughout history, there's a time when the rising power challenging the existing power and there's a world order thing going on. And that world order thing going on has to do with China, the United States, and so on. And of course, it becomes even more important than the economy because it's considered national security. Okay. The fourth influence is acts of nature. Droughts, floods, and pandemics. And climate is a big influence. It's going to cost us $8 trillion a year. It's estimated in one way or another in an world economy that has a hundred trillion. And the fifth force of course is technology. Okay? Man's inventiveness of technology. Throughout history, those five forces have interacted. So when we look at things, I think that there's the 25 or 50 basis points. Let's get beyond that. Let's look at the whole arc of that in terms of the changing of all of those five forces and their inter relationship.
Well, as I say, I think that there's two questions. First, the question of will we have an orderly transition of power? That's quite amazing. Will we have democracy work as it is? That cannot be assured. So because behind all of this is that we have irreconcilable differences not just pertaining to taxes and wealth and economic policies and so on but in terms of values uh you know it's how do people raise children related to sexuality and all of those things there are those gaps so I think we hope for an orderly transition in power isn't it quite amazing that we would think could we not have that and then we go beyond that and then we say what about those policies that are going to be dealt with. Nobody's going to deal with the debt policy. That's going to end up being monetized down the path. Then the question is issues of taxation and those issues of taxation will have an important impact on the capital markets. They're bought for after tax returns by and large. It it's the important thing. You lower corporate income taxes. You raise corporate income taxes. It makes a difference to prices. So, we're going to have those issues.
I think when we go beyond that most likely there is going to be uh irreconcilable differences and I think that you're going to see more movement to states. So there'll be a challenge of what does the central government control and what do the state governments control and is there an obedience in a sense. So we are coming more to a fragmented set of circumstances. What we would need, I think, is strong leadership of the middle to bring the country together and leave and isolate more the extremists if that was possible and then to make reforms because we do have a very skewed type of economy. I think that the issue of reforms, strong leadership in the middle, I don't see it.
I think that there are uh real issues in China now and they changed really in the last um four years and that is that they need a restructuring. A lot of the spending had well let's say individuals 70% of their money was in real estate. Real estate has gone down. Stocks have gone down. Salaries have gone down and as a result they're not spending and they're concerned and they're holding money in cash. With deflation, cash is a relatively good asset class. That's kind of the household and the business sector is in that state. At the same time, you have the government sector is a problem because most of the government spending, 83% of government spending is spent by local governments. Those local governments got their money by selling land for real estate. Okay? There are no land sales and they borrowed a lot of money and those that they borrowed the money don't get paid. And so the question is how are you going to get money into the those places to operate? It's a situation that's more challenging than Japan in 1990. It needs a restructuring in order to be able to do that. And then there's also the question is the property ownership is it respected and Deng Xiaoping during his period said it's glorious to be rich. Is it still glorious to be rich? So you have an environment in China which is changing and becoming a more difficult environment. So it's the time right now that you would see either is there going to be a restructuring and a getting past that.
The innovation yes there's fantastic innovation in terms of technology there's nothing likely other than in the United States. Europe certainly isn't a competitor in that. However it's very much government directed. Can there still be entrepreneurship and that inventiveness? I just want to be clear about the investing in China. In all countries, there are cycles and ups and downs and so on. And in no country should you invest so much money that it becomes a dominant portion of your portfolio. So in China, I still invest in China. The question is the size of the investment and how that investment is structured. It's been a good experience for us investing in China as largely a very attractively priced place that now has a lot of questions regarding the issues that I've just referred to. In other words, the economic issues and the political issues regarding property rights and whether it's still glorious to be rich and how that'll work. Therefore, there's a small percentage of our portfolio which is in China and will stay in China uh you know through this process.
Well, for the last 35 years, I've written down principles and decision rules, literally many thousands of those. And they have operated as systems, decision-m systems. And that now I'm very excited about that because but you have to train them very well because it's been all so specified over a period of time. It is very educational. I've then taken a large team of people and gone through asking it questions and dealing with it and training it. And the reason is a lot of people ask me questions. I'm at a phase in my life where my main objective is to pass along what I've had that it's of benefit to others and we interact such as this kind of conversation and I thought it would be great if there could be I could answer all those questions or we could have discussions. How are you doing and all that? So that's what I've created. It's called digital ray. At least that's the tenative name. And we're beta testing it. We're going to have several thousand people test it and see how that goes and then we'll move forward. But I think it's exciting when you have you need to have computerized decision making working with you because the time of making all those decisions in your head that's obsolete. The you know the smart person who thinks ah I can weigh everything in my head they're obsolete. Nowadays you have to have a partner in terms of those decision-m with a computer.
Happiness by and large is how things transpire relative to our expectations, not the absolute level of our conditions. Somebody who doesn't have much money and they get $10,000, they're elated. Somebody's got billions and they lose a h 100red million or something and they're still very rich, they're depressed. So happiness is I think how that develop relative to our expectations. It creates a dilemma because we become very attached to our expectations and as distinct from letting that go and just experiencing the journey which I think produces more joy than being attached to our expectations. ations.