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Nobody really knows what the stock market is going to do in the next 12 months. And so a lot of people try to control it and time the market and things like that. And you just, it's the wrong side of the balance sheet to try to control. And so you have to kind of focus on your liabilities.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today I'm joined by Colin Roche. Colin has a wildly successful financial blog called Pragmatic Capitalism, and he's the owner of Orkham Asset Management. He's best known for his work on monetary economics, and he has a really unique perspective on the financial markets.
I asked him to join me today to share his take on what's going on in the markets today, where we might be headed, what investors can do in response, and the impacts of a $2 trillion stimulus package. I hit record and I told him not to hold back today. You may have to listen to this one twice. For all the links and resources, head over to youstaywealthy.com forward slash 69.
This is probably the most interesting, hopefully the most interesting thing we ever experienced. I made a joke the other day that people say, may you live in interesting times. And I think that's totally wrong. I actually really enjoyed the boring times of the long, boring bull market we were going through. So
But it's interesting in a financial sense because you have this sudden stop in the economy. And most recessions are an exogenous shock to some degree in that some sort of event causes the economy to slow down to some degree. So in 2001, 2002, you basically had way overpriced tech firms that had kind of
been stimulated to the point where they had juiced the economy too much. And when the air kind of came out of the NASDAQ bubble, you had this big price discrepancy that had to adjust. And it took a long time for that to kind of unfold. And the economy went through a recession and you had a kind of standard corporate style recession, two or three years of slowdown, things, prices adjust, things recover, people start putting money back into companies, blah, blah, blah. The
The housing crisis was sort of similar in that you had an asset price bubble again. The prices needed to adjust over time. And as they did, you had a really structural problem in the economy that just took a lot of time to recover. And that one's really interesting because the housing market arguably hasn't even recovered yet. And then you have this
COVID-19, which is totally unique in the sense that it's a completely exogenous shock, almost like a meteor or like a natural disaster. And so
This isn't just causing a recession. It's causing a complete sudden stop in the economy. And this is something that, I mean, this doesn't even happen in 2008 or 2002. So it's totally unique, especially in the sense that I don't think there were very many people except for the weird prepper blogs who thought something like this was even possible. So-
you don't have back tests to prepare for something like this when you're running equity market models or portfolio models and things like that. And frankly, economists just don't really prepare for things like that. But more importantly,
The financial system and the monetary system just isn't designed to be able to withstand an event like this because the financial system is structured across very specific time horizons. Everything is very temporally structured in a very specific way. And so you have
You earn an income and you get paid once every two weeks, or you have rents that are due once a month. You have mortgages that are due once a month. You have tax payments that are due once a year. And everything is structured across these very specific time horizons. And what COVID-19 has done is it's caused the economy to stand still in such a way that
you no longer have any temporal structure in the way that people are able to do anything because there basically is no economy right now. And so the really strange part about what's happening is that you still have all the liabilities. The temporal liabilities are all still there. The rents are still due at the beginning of the month. The mortgages are still due. The tax payments are still due.
but you don't have anybody who's actually generating the incomes now to support these liabilities. And so this financial system just isn't designed to withstand something like that over a really long period of time and of,
A recession is generally just a period where the incomes that are designed to match those liabilities, they slow. And they slow, they adjust. You need to... Maybe some industries need to be killed off or reduced in size or prices just need to adjust a little bit. And you get kind of a structural rebalancing that in the long term works its way out. But what's really sort of frightening about this event is...
If this thing were to persist for, let's say, six, nine, 12, 18 months, the longer and longer it goes, the worse and worse that asset liability mismatch problem gets across really long time horizons. It will start to cause really significant problems in places that
are really unusual. I mean, you're going to start seeing states have problems with cash flows and high-grade municipalities and local governments encountering cash flow problems that they otherwise would never have, even in a regular recession. And so this thing is scary in that nobody knows how long it's going to last. And so from an economic or financial perspective,
It creates so much uncertainty because, I mean, if this thing ends, let's say it starts to, like I put out two scenarios in the paper that I published today. And one scenario was short and painful and the other was shortish and painful. And the short and painful scenario is one where things are going to get a little bit
Things start to kind of peak, let's say, early summertime. The social distancing starts to work. Maybe the weather starts to have a little bit of an impact on the virus. And so you have basically two or three months of this sudden stop, but then things kind of get back to normal. And when they do, I think there's a likelihood that things will start to come back pretty quickly, especially if we develop...
Let's say we develop testing that is very effective in a short time horizon. You could start to bring back a lot of businesses online almost overnight. And so things could theoretically respond really quickly. But the more frightening scenario is the shortish and painful scenario where you go, let's say, 12 months and...
Let's say that things are really bad in the spring and the early summer here, and then maybe things start to kind of subside a little bit. The social distancing is working a little bit, but then in the fall, you get kind of an influenza effect where things really kick up and get bad again. And a lot of people get sick. This is sort of the Spanish flu, 1918 type of scenario where the Spanish flu killed a
but then it decimated people in the fall and it caused most of its economic damage in the fall and spring of 1918 and 1919. And so that's the really frightening scenario here where this thing causes a series of rolling shutdowns in the economy or just a permanent shutdown where you start getting asset liability mismatches that are
they're completely unsustainable and they will start bankrupting the most viable of economic entities out there.
And so that's the thing that makes this all so tricky is that it's all a temporal, I call it a temporal conundrum. It's the problem of trying to match your assets with your liabilities across different time horizons. And so from a portfolio management perspective, we're all trying to basically match our short-term liabilities and our long-term liabilities with the uncertainty of earning our asset cash flows in the short term.
Sure. And I want to just stop you before we get into some of that and the investment management side of things and what to do. I'd love for you just to talk a little bit about where you think that we're headed. You made a comment that you think scenario number one, the kind of shorter outcome is more likely. I'm just kind of curious if you could expand on why that is. You mentioned it being highly contagious and then your Jurassic Park analogy. So maybe you can touch on that quickly.
I don't know. I mean, part of this is I'm an eternal optimist to some degree, so I'm a pragmatist, but I tend to, I think, have a more optimistic perspective on how things are going to unfold. And it seems to me like I think that based on some of the evidence from other countries, I mean, for instance, looking at Italy, the data in Italy is starting to look really positive. The social distancing is working and everything
What we're really doing here with all of this is really we're trying to shut down the economy in the short term so that we basically can buy ourselves some time and we need to get
Again, I'm not a doctor, so I'm not giving medical advice or don't trust anything medically that I say. So from what I've read and what I've heard that's crucial here is that if we can buy ourselves enough time and not overload the medical system in the short term, that we can develop
tests and not necessarily a vaccine, but even treatments that will significantly reduce the negative outcomes of COVID. And if we do that, which it looks like we're making progress towards doing that, then I think it's realistic that within, say, a few months, you have, say, a test that can be done on the spot or even within a few minutes that
Once you have that, you can start to identify, okay, these are the people who are not just asymptomatic, but they are either immune or they don't have the virus. And you can start to, I mean, you can start to really bring back online a lot of the economy just through that. You don't even need to get to the vaccine element of all of this to start doing that. And so
My understanding is that the testing is going to significantly improve in the next few months and that the social distancing is going to start to have a real material impact on the overloading of the hospital systems all over the world. And,
If this turns out to be anything like the flu or the Spanish flu, or even there's some debate over whether MERS and SARS were that temperature dependent, but there does seem to be at least some evidence that the weather is going to have an impact on this thing. And if we can get through...
the early summer, then I think we bought ourselves a lot, a lot of time for all these brainiacs who are working on solving this problem to put together, not necessarily a solution, but at least buy ourselves enough time where the Spanish flu type of scenario, where it decimates us in the fall, that just doesn't happen. So I think it's fairly safe to argue that the scenario one outcome is the more likely outcome. And it's,
I mean, it's still a devastating outcome because you're going to lose. I mean, gosh, we're going to lose something like 50% of GDP here on a year-over-year basis in the next three, four quarters probably. But if you can get through this period without a kind of worst case scenario where you get a 12 to 18 month per
persistent shutdown of the economy, then I think you can start to bring a lot of things back online and the economy will, it'll be somewhat slow, but it's not going to be, I think it's important to understand this isn't like a structural downturn, like the house prices collapsing because once house prices collapse, it's,
You can't really bring back the housing market until you have the cash flows back into the housing market to feed all the businesses that made the housing market of 2006 viable. So this is different in that the infrastructure is still there. The restaurants are still there. The businesses that are closed right now, they're still there. And there isn't this structural pricing problem like you had in the NASDAQ bubble or the housing bubble. So you could...
If you can weather the short-term storm without a lot of these businesses failing just because they don't have the cash flows in the short term, then you can start to bring a lot of this stuff back online. And I think you get something that looks a lot more like a V-shaped recovery in that scenario than...
than you had coming out of 2008, just because it's not so much of a structural problem in the economy. And so, but again, if you get something that looks like the shortish scenario, then it's really bad because it'll be, I say shortish because it's,
These things, I mean, historically, they don't seem to last more than like a year. The virus is, especially if this thing is so contagious, I mean, it's going to do its world tour in the next few months, it seems like. So unless people can get hit with it twice, a lot of people are going to build up immunities to it just because they're going to get it. So-
You've got a somewhat short-term event here, but it's just, it's acute and damaging in a way that we've never seen anything just because it's bringing entire industries offline. I mean, it's arguably, I would be shocked if the cruise industry even comes back from this ever. I mean, this is literally going to kill certain industries. I mean, that's unprecedented, but-
So it's also dependent on what the time horizon looks like. If you get something that's short term, you know, three to six months, then I think 2021 actually probably looks really good. You probably start getting a whole bunch of GDP numbers that are like plus 15, plus 20%.
It's going to be crazy. I mean, and the stock market will come back so fast in an environment like that, that, I mean, your head will spin. The conspiracy theorists about the Federal Reserve and things like that will be, I mean, they'll be going crazy. The stock market will come back so fast. But if we slide into the summer and things are still really bad and you get into the fall and things are still bad, I mean, man, I mean, I made a joke. We're going to run out of Netflix shows and then we're all going to be calling our divorce attorneys. I mean...
Without a doubt, like the next three, six, 12 months is going to be challenging for most people. What do you think people can do to prepare? Like what can people do to take action right now? Things that are in their control to start to put themselves in a better position. And then maybe we can talk about portfolio construction a little bit as well. I mean, from a planning perspective, it's just a matter of, you know, I always say that you need to control what you can control. A lot of people, they, they try to
to control the financial markets and the financial markets, you just, you can't control what they're going to do. Nobody really knows what the stock market is going to do in the next 12 months. And so a lot of people try to control it and time the market and things like that. And you just, it's the wrong side of the balance sheet to try to control. And so you have to kind of focus on your liabilities. I think it's smart to, you know, obviously a lot of people are going to cut back just because they're, you know, there's
I mean, the things are changing so much and you're locked in your house. You just, you can't go spend money on the things you used to, but I mean, control your, your spending and control your liabilities because those are the one things that we can control with pretty, pretty damn near certainty. And that will add a lot of certainty to your overall financial picture, but also control
A lot of regular financial planning, I think, just kind of goes out the window in a period like this. There's nothing wrong with, you're not going to contribute to your IRA this year, maybe. So what? That's actually probably a prudent decision. So things like that, you can do things that you wouldn't normally do just because times are kind of tightening up that
are from a planning perspective, you know, not ideal, but actually in the short term will increase your certainty a lot in a way that will make the next six to 12 months a lot easier to navigate. So how do you view things from an investment standpoint? How are you managing client portfolios through this? Are you making changes? How are you responding? And then let's talk a little bit about the bond market. That's just been absolutely crazy this year.
Yeah. So I run mostly conservative portfolios. So we're generally in my, the strategy I run, I call it counter cyclical indexing. It's really a, I mean, I'm so behaviorally focused. I'm really focused on controlling people's behavior. And so a lot of what I do is I'm constantly rebalancing people's portfolios against this kind of oversimplifies it. But if you have a 50-50 portfolio that
in a period like the recent bull market, let's say it grows into a 75-25, what a Vanguard style approach will do is rebalance right back to 50-50 if that is their benchmark. And my argument is that the new 75-25 that you're investing in or that you hold, if you rebalance that back to 50-50,
I would argue that when the slack in the economy has been pulled out, so when unemployment is really low like it was and when valuations are stretched like they have been, I would argue that the new 50-50 situation
is a lot different, a lot riskier in all likelihood than the original 50-50 that you invested in when you put that portfolio together in say 2012 or something. And so my approach is actually that we rebalance to try to kind of quantify
how much new behavioral risk, how much new risk are you actually exposed to primarily from the equity piece? Because the equity piece is where we get most of our behavioral risk in that portfolio. So my methodology is to rebalance to say something like,
Maybe you have 40, 60 stocks, bonds, or maybe you're 35, 65, something like that, where you still have equity market risk, but now you're kind of accounting for the potential that the stock market is now riskier because of where we are in a market cycle than it otherwise would be. And by doing that,
you create a behavioral buffer. I don't know if this generates alpha. I do not pretend to argue that I can beat the market or anything like that. But what I think is really important for people is to understand the amount of risk they're taking in a portfolio so that they're insulated from, especially from worst case scenarios. Because I mean, nobody predicted this thing, especially not the timing of it, but
Stuff like this happens in the stock market. These really unusual things happen on occasion. And I don't think anybody ever dreamed of something like this, but you still, even when things look like they just can only go up, which was kind of the feeling last year, you can still get lopped over the head by something unusual like this. And if you're not prepared for it and you find out what your real risk profile is during a period like this,
you're susceptible to just making really rash, very damaging long-term financial decisions. And so my whole methodology is kind of designed to, I think, basically take a little bit less risk during a bull market so that you're better prepared in the case of a big bear market so that you're insulating yourself from the potential to making really, really damaging financial decisions. So right now,
I mean, it's so funny because even coming into a year like this, I mean, I'm mostly overweight, money market funds and short-term bonds and things like that. And even stuff like that got sort of hairy in the last few weeks. I mean, that's how unusual this event is, that you can be invested in pretty conservative portfolios and still...
things can still look pretty scary. I mean, the long-term treasury bond ETF, TLT, that thing went from 135 up to 180, down to 140, and back to 170 in the last two months. I mean, insane moves, things that
should not be happening in the treasury bond market, which is generally a pretty stable market, especially during financial panics. What's driving those wild swings? There's so much uncertainty. Nobody knows what these things are even really worth. For instance, municipal bonds are probably a better example in the last few weeks because especially when you look at an ETF or even a mutual fund,
that is made up of underlying municipal bonds, you have a net asset value in these funds. And that's what people are kind of pegging their expectations off of. But the ETF market is really interesting because what people were basically saying in the ETF market in the last few weeks, when a lot of these municipal bond ETFs deviated from their net asset values, a lot of them were trading at huge, huge discounts. The bond market is basically saying that
We think that these things are worth a lot less than what the net asset value actually says. And that's not necessarily wrong because especially in times like right now, like my old college roommate,
runs the municipal bond research desk at Morgan Stanley, he was telling me that half the guys aren't even there trading the bonds and that these bonds, half of them, literally, they have no liquidity. No one's even trading these things. So nobody has any idea what these things are actually worth. And nobody knows the extent of the liquidity exposure that these guys have. What is the actual credit risk that we both live in the city of Encinitas, which is a
financially a really healthy municipality, but they're going to get smashed by the decline in restaurant revenues. You can have these AAA rated municipalities that you don't know if they're actually going to be able to make all their interest payments, especially going back to the worst case scenario here where you have a shutdown for 12 to 18 months and
You're going to have AAA entities that might miss a bond payment if the federal government doesn't step in to support them all. There's so much uncertainty across so many different time horizons that I think the bond market is just starting to reflect that reality that what if this thing lasts a lot longer than people expect, then a lot of entities will
are going to be missing the cashflow that they need to be able to make the payments on bonds that will keep everything supported. So there's just so much uncertainty about the time horizon across which this thing is going to last that it's created a crazy amount of volatility in the stock market, obviously always has a lot of volatility because the, I mean, the cash flows from US corporations or any corporation is they're always uncertain. I mean, even dividends of
I always laugh when people say, oh, I buy XYZ stock because the dividend gives me certainty. And I'm like, that's a terrible idea. The dividend is the first thing that a corporation is going to cut when the, you know, what hits the fan, because that's something that they can control overnight. Basically, it's a liability that they can control right away. And if they need to shore up their balance sheet, the dividend is the first thing to get cut. So it's interesting in periods like 2008,
Firms like utilities and banks, these companies that seemed like sort of big, boring, just high dividend yielding firms, they got smashed in 2008, even worse than the S&P 500 because they cut their dividend. And then the people who owned the stock for the dividend, they sell the stock.
So everything kind of exacerbates based on this behavioral misconception that people have this false sense of security in something that isn't really there. And so, yeah, I mean, you always have this uncertainty in the stock market, but the bond market,
You shouldn't have this degree of uncertainty because the time horizons are always so much more certain. And that's what makes this environment so unusual and just difficult.
Sure. Well, you and I don't manage money for short-term investors. We're taking a 10 plus year approach when working with clients. You've written a series of blog posts on kind of debunking the myths around investing in bonds during rising interest rate periods, especially for long-term investors. Given where interest rates are today, I'd love to just hear your thoughts on investing in bonds or a bond fund today, given the interest rate environment.
if rates rise, let's say 1% per year for the next seven years in your example, what does that look like? Should we be investing in bonds right now? If you're a long-term investor, is it okay to be buying bonds right now? Yeah. Gosh, I mean, it really, this is such an interesting timeframe because you almost are forced to start thinking a little bit short-term to some degree because of the way that the markets have
adjusted so quickly. So for instance, in treasury bond market, you've had this huge collapse in interest rates. I mean, interest rates have fallen basically from, what were they? I mean, 10-year treasuries were 3% at the end of 2018. So inside of basically the
little more than a year, you've had interest rates fall from 3% down to the 10-year treasury as I think it's at like 0.6% today or something like that. So a huge, huge decline. And it's really interesting from a bond market perspective because if you owned those bonds in 2018, then you have huge principal gains because your interest rate
exposure has obviously been beneficial because interest rates fall, prices go up. So those 2018 bonds look really good right now. Whereas the person who buys that same bond today, they own a AAA rated bond. It is for all practical purposes from a risk perspective, credit risk perspective, at least it's the same basic instrument.
But the guarantee is that in the next 10 years, you're going to earn a significantly lower return than the bond that you bought in 2018. Your future expected risk adjusted return, it's way worse than it was just a few years ago. And so it creates a problem for bond investors because
you're now exposed to the potential of a significant amount of volatility and interest rate risk in owning that bond. And all for what? For 0.6%, it almost...
It's easy to look at something like that and say it's just not even worth it. And so the treasury bond market has really priced in the safe haven aspect of treasury bonds. And this is something that this happened in 2008. You had a huge decline in rates where rates fell from something like 5% down to like two and a half or 3% in the worst period of the financial crisis. And then
bonds got smashed in 2009. I think treasury bonds were up something like 25% in 2008, and then they were down like 20% in 2009 as the recovery kind of started to ramp up a little bit. And that's the problem with
the short-term nature of the bond market. I mean, I know that if you buy that 10-year treasury today and you own it for 10 years, you're going to earn 0.6%. And if inflation is pretty low, if inflation is, let's say it's like 1% or 2%, you're going to earn a negative real return. But even if interest rates rise, you're still going to earn your 0.6% every single year. So you own that thing for 10 years, you're not going to lose money on it.
But the risk there is that the ride going forward is significantly more bumpy than it has been in the past if interest rates rise and that your real return, your inflation adjusted return is probably negative. It forces people to be a little bit
riskier. I think we were talking a few minutes before we started recording about how the corporate bond market is this place where you can get 2.5% from a two to three year bond that's investment grade. And so three, four times the return for something that is an investment grade portfolio of, there's a number of ETFs and mutual funds out there that are all investment grade
500, 1,000 bonds in the portfolio. So super diverse and you're earning a significantly higher return and that's still exposing you to some interest rate risk. And it's obviously exposing you to a lot more credit risk, but it doesn't have the same degree of interest rate risk that long-term treasury bonds now have. And so that's the
That's just how unusual this environment is. In a weird way, I often say to people that I manage my bond portfolios in a similarly counter-cyclical way so that when interest rates rise or fall really sharply, what happens is you get this weird sort of short-term event where you're now exposed to a lot of interest rate risk. So in the bond market, the bond market is up, we were saying earlier, TLT is up something like
40% in the last few months. Well, that's an instrument that was basically designed to pay something like 2%. So you've earned basically 20 years worth of returns inside of a three-month period. Your future expected risk-adjusted return, it has to be lower. I mean, mathematically, that thing can't pay 40% every year for the next 10, 20 years. So your risk-adjusted return just
just looks so much worse going forward by owning that thing because mathematically, you're going to see a lot more volatility in that instrument going forward. You might see a lot of negative volatility in that instrument going forward if interest rates rise. So your interest rate risk rises so much. It's really similar to what happens in the stock market. Last year, the stock market was up 30% or something like that.
The stock market is, in my mind, it's an instrument that is like a 30-year high-yield bond that pays out roughly like a 7% coupon. And so when you get a 30% return in that thing, you're earning four or five years worth of returns all inside of one year. That thing can't do that forever. So at some point, either that thing has to earn a lower return than 7%,
maybe a decade or so of 4% returns or something like that. Or it does what it's doing now where you have a humongous price adjustment where you get a big shock. And the bond market weirdly does
it has the same sort of price dynamics that the stock market does in that sense. And so this is an incredibly hard environment to navigate because the stock market is this long-term instrument that if you're willing to hold it for a really long time, will probably generate a really high return. And weirdly, as it goes lower, the expected returns go up. So if you have a long time horizon, this instrument looks better and better
versus the bond market where it's shorter in time horizon by nature and you're going to generate a lower return, but you still, when interest rates are low like this, you just have a lot more interest rate risk exposure than you would when interest rates are high and they fall. I mean, it's sort of basic math to some degree. When interest rates fall from
5% to 4%, you have a 1% decline. If you have a bond that has a duration of 10, you gain 10% basically. Whereas when you own the same bond with the same credit profile, when that thing falls from 1% to 0%, well, you earn 10% again, but now you don't have the buffer of the higher interest rate. You're sitting on an instrument that's yielding 0%.
your risk profile in that instrument, it completely transforms because of the nature of low interest rates. And you could have a Japan type of scenario where interest rates are just permanently low for a really long time and bonds just kind of look like cash and they're a little bit volatile, but not really too much. And people mostly own them for the safe haven nature of them. But the flip side is, I touched on this again in the note that I wrote that
If this thing lasts for a really long time, let's say we have 12 to 18 months of shutdown and the government is, let's say the federal government is coming out with, already talking about a second stimulus package.
You have an environment that is really ripe for stagflation because you're going to have a huge amount of productive capacity that has been brought offline. So no one's really producing anything new. The age of abundance actually starts to turn into the opposite type of environment because we're consuming all of the things that we've become so masterful at creating abundance with and we're
People aren't producing those things to the same degree that they were when the economy was fully online. And if you have the government out here spending two, four, five trillion dollars every quarter, you're basically just paying people to sit on their butts, which is from a humanitarian or healthcare perspective, a great thing because it's going to save a lot of lives and it's going to make the short-term economic stress a lot lower. But
But you increasingly run into the risk where if you do that over the long term and you don't have the productive capacity to support the spending, you create the risk that this is eventually going to create inflation. I don't think that the 70s are coming back or something like that. But from a bond market perspective, I mean, God, if you even got interest rates up to 3% in the next three years, you're
I mean, a 10-year treasury bond goes from 1% to 3%. That bond gets smashed. I mean, your bond portfolio, which is supposed to be this sort of short-term or more short-term safe haven type of portfolio, that thing falls 20% or more in that scenario. That's a huge, huge hit. And that's the big risk with...
Right.
Well, before we run out of time here, I want to shift gears really quick. You are best known for your work on monetary economics. And you have just a ton of resources on your website, which I'll link to. But you just mentioned stimulus packages. The US government just a few days ago passed the largest economic stimulus bill in history. And my wife had just this kind of funny question that I thought I would ask you to answer. Where does $2 trillion come from? I'm
They pass a lot and here's $2 trillion. Where does that come from in simple, plain English? I mean, in simple, plain English, the federal government is really, they're the only entity that can expand their balance sheet, meaning that they can borrow at basically the rate of inflation. They don't have real creditors. There's no one that comes to the US government and says,
you're bankrupt. You are out of money because it just functionally, I mean, the government doesn't run out of money. The rest of us, theoretically, we have a real credit constraint in the sense that, I mean, in theory, I can't run out of money as long as I have creditors.
So as long as I can find somebody to borrow money from, I can go to the bank and I can create as much money as I want to. I can run up my credit cards as much as I want to. But in reality, we're all fairly small entities or economic agents. And we have real credit constraints where other people look at us and they say,
yeah, you're not going to get more than $10,000 per month from me. And that's how banks basically manage the amount of money that they create. And that's all kind of a different rabbit hole. But the way that most of the money exists in the financial system is through the banking system. The banks create loans and loans create deposits and deposits are money. Deposits are every bit as good as the physical dollar bills that anyone has in their pockets. And the government
The thing that makes the government unique is that the federal government is just this great big entity whose credit is basically supported by the underlying productive capacity of the entire economy. And they can expand their balance sheet really easily.
without constraint in nominal terms, meaning that they can go in and they can borrow as much money as they're willing to just print up basically. And the only constraint on the government is the real price of that thing. So it's in terms of inflation, at what point does the government spend so much money that
all this money creation just starts to create inflation. And that's the real constraint on how much money that they can create. But from a,
a really simplistic sort of the stimulus package type of perspective. The government is just basically creating treasury bonds and treasury bonds are very money-like instruments that the government can create from thin air, basically. So, I mean, take a... We constantly have these discussions about how bonds are different from cash and the whole...
term money is kind of a messy concept to begin with. I mean, what is a treasury bill? A treasury bill is just a, it's a super short-term government liability. What is a $1 bill? A $1 bill is basically a perpetual liability of the US government that they can recycle and rip up and reprint whenever they want to. But it's a liability of the US government, just like the treasury bill is. And they can create these things basically from thin air.
And the real value of those things is priced versus all other goods and services in real terms, in inflationary terms. And so there's no constraint on the government being able to create these things nominally like the rest of us, because nobody goes to the government and says, the Fed doesn't go to the US Treasury and say, oh, we're only going to give you guys $10,000 this month. The Federal Reserve just gets orders from the Treasury saying,
And they take their marching orders and they create whatever they're ordered to create. And so the thing that really determines how much money the government can create is, again, it's the inflationary aspect of it. And we are all essentially the creditors of the U.S. government in that sense. It's what price do we price all of these government notes against everything else that we can buy?
And so that's basically the real interest rate that governments are constrained by. The stimulus is really interesting because the... Actually, the last 10, 20 years have been really interesting because the government has been running up basically an ever-increasing debt tab and higher and higher deficits, which basically means they're spending more than they earn in income. And
a lot of people have been really worried that this would create inflation. And they're just, there's been really zero evidence that government spending, government deficit spending necessarily causes inflation. And I've argued that inflation just has, it has so many other factors that influence it that you can't just look at one element like the government spending and say, that's going to cause inflation. Cause if you have a whole bunch of other deflationary elements like declines,
declining demographic trends and technological advancements in this age of abundance where we've gotten so good at creating mass producing so much stuff that you have a lot of deflationary trends in the economy where the government quite literally, you
no matter how much they spend, they haven't been able to create a lot of inflation. Maybe inflation's higher than it otherwise would be, but by no measure is inflation really high in historical terms and certainly not worrisome sense. And so I think that's what's given some people some solace in being able to expand the balance sheet. It was amazing how fast all of the Republicans were so quick
to immediately issue money to everybody, basically. I mean, because I think the evidence from the last 10, 20 years has been pretty clear that the government maybe is creating inflation that's higher than it otherwise would be, but certainly is not worrisome in a 1970s or like a hyperinflationary sense. And so I think what we've learned from this, and this is actually one of the good aspects of the current stimulus, is that we've learned that
the negative impact of government spending maybe isn't quite as negative as a lot of people have assumed. And so, but again, like I mentioned earlier, there's a limit to that. And I, no one knows what that limit is. And I certainly don't know what that limit is, but there's a point where you've got to think that if the economy is offline for 12 months and the government is basically just paying people to watch Netflix, that,
probably starts to cause a little bit of inflation creep. And so...
It's worrisome to some degree. It's not worrisome in the sense that a lot of people think that the government is running out of money. The government doesn't run out of money. The government, if anything, they create too much money. And that's the thing we have to really worry about potentially. And right now, there's no evidence that that's happening. I mean, commodity prices have just been demolished. Interest rates have been demolished. I mean, every
single real-time indicator of what's going on is massively deflationary. This event looks, it's even more deflationary than the financial crisis was. And so
You're going to have potentially a lot of, and this is another aspect of this, you're going to have a lot of money destruction in the next 12 months because you're going to have a lot of defaults. Defaults destroy money. They destroy deposits. And loan repayments destroy money. You're going to have a lot of people who they're going to control their liabilities by repaying loans and stuff. And so that all destroys money. And the government right now is racing to offset all of that. And to some degree, if they can create...
inflation that is modest, it will have succeeded in actually boosting the economy a little bit. The worry is if things stay offline and they continue to do this, that you get sort of a stagflationary environment where you start to get three, four, 5% inflation and people still aren't working. And so in real terms, we're all just worse off.
Well, look, I could ask you questions for hours. I love hearing you talk. You have a ton of helpful resources on your website that I will point everybody to if they want to learn more. You've just written for years and you have really good content. I want to be respectful of your time and thank you very much for taking some time out of your day today to share all this with us. And once this disaster is behind us, I'd love to catch up in person soon. Yeah, for sure. I hope everyone's taking it seriously and being safe and watching Netflix.
Hey, it's me again. I just wanted to say thank you one more time for listening and remind you to please, please, please leave a quick review. If you're on an iPhone, leave a quick review on iTunes. If you're enjoying the show, I'm getting great feedback from listeners just like you. And I really want to keep the momentum going. So if you have a chance on your iPhone, leave a quick review on the Apple podcast app. And thank you so much in advance for all of your help and support.
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