Credit Bubble; Pabrai Video

What causes a credit bubble to collapse

is not a malfunctioning entrepreneurial impulse, but an artificial lengthening of production and overcapacity in fixed assets induced by the fractional reserve banking system. Everyone who keeps funds in the market or in a bank is vulnerable, since it is cash deposits that banks use to fund the reckless expansion. When the banking system blows up—as it must—conservative savers lose their savings just as surely as ardent speculators: that is the real horror and also why the existence of a dynamic sector in the economy does not change the credit bubble analysis.

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The Bloomberg Investment Summit earlier this month achieved a general consensus among the storied experts that traditional macro indicators are no longer relevant due to the sophistication of the primary market operators. One could summarize: this time it’s different. And a lucky thing, too, because a debt-based economy can only grow with the creation of additional debt, and commercial and industrial loan growth is collapsing. The only times that this series has behaved similarly has been at the onset of major recessions, such in 1974, 1992, 2000, and 2008.

Credit Bubble

Note, as well, that the troughs on the chart above keep getting deeper. As the overall level of debt grows, debt revulsion becomes more pronounced and requires ever greater efforts from the central bank to resist the natural liquidating tendencies of the market.

Another place macro-indicators no longer matter, apparently, is China. Glenn Youngkin, the President and Chief Operating Officer of The Carlyle Group, forged another consensus that there are two Chinas, one public one private—or, as Deng Xiaoping said about Hong Kong: “One country, two systems.” The former, everyone knows, is bloated, debt-laden, inefficient, and unproductive. The latter is dynamic, innovative, and expanding. As long as investors concentrate on the latter, and China lets a billion flowers blossom, then harmonious growth is assured.

This story is doubtless correct in some measure. The existence of a healthy, entrepreneurial class in China should not surprise even China bears. As Adam Smith wrote three centuries ago:

The uniform, constant, and uninterrupted effort of every man to better his condition, the principle from which public and national, as well as private opulence is originally derived, is frequently powerful enough to maintain the natural progress of things towards improvement, in spite both of the extravagance of government and of the greatest errors of administration. Like the unknown principle of animal life, it frequently restores health and vigour to the constitution, in spite, not only of the disease, but of the absurd prescriptions of the doctor.

Smith’s optimism may pervade every time and every place, yet crises do happen, especially when Keynesian doctorates are writing the prescriptions. What causes a credit bubble to collapse is not a malfunctioning entrepreneurial impulse, but an artificial lengthening of production and overcapacity in fixed assets induced by the fractional reserve banking system. Everyone who keeps funds in the market or in a bank is vulnerable, since it is cash deposits that banks use to fund the reckless expansion. When the banking system blows up—as it must—conservative savers lose their savings just as surely as ardent speculators: that is the real horror and also why the existence of a dynamic sector in the economy does not change the credit bubble analysis. Authorities save the system by showering newly printed money on the most visible problems: half-built ship yards and airports and office towers and houses. Printing money cannot create capital or purchasing power—but it can reallocate it . . . from the dynamic and productive parts of the economy, from the private to the “public good.” And how many systems are there now in Hong Kong?

Holding gold is the best way to keep capital out of the “system” in order to preserve purchasing power during credit crises, for there is no means for the authorities to redirect the purchasing power and liquidity of gold, save confiscation—the reason gold has so often been confiscated. We likely remain distant from that outcome. In a more innocent time, such as the 1930s, the general belief that the government was here to help led to a widespread acquiescence of state power. No one believes that anymore. People support the state only in proportion to their share in the spoils, and gold hoarding at present is likely too small a phenomenon to whip the public into enough of a frenzy to jettison the Fifth Amendment (even Roosevelt provided compensation at the thenprevailing price).2

Gold mining shares are the other way to protect against a general credit collapse. On the one hand, they are not as safe as bullion—mining operations have great volatility, mines can be seized or easily taxed, and the very market on which the shares trade can become impaired. On the other hand, their enormous leverage to gold enables a much smaller amount of capital to be deployed for the same protection, making shares an efficient way to gain economic insurance. Nor do gold shares function only during civilizational stress: the annual standard deviation of a portfolio comprised of 87% the S&P 500 and 13% the Barrons Gold Miners Index and rebalanced annually since 1918 is 17.4% versus 18.4% for the S&P 500 alone. This reduction in volatility does not come at a cost—in fact, the return of the rebalanced portfolio is 70% higher than the S&P 500 alone. If we dial up the rebalanced BGMI component to 35%, then the volatility matches the S&P 500, but the excess return increases to 102%.

Credit Bubble

 


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In my peripatetic life I have been a ruby smuggler, commodity trader, securities analyst, investment banker, and entrepreneur. Each role taught me more about value investing. - John Chew - The Editor