Will We Ever Recognize the Flaws in our Financial Systems and End Financial Illusion?
I am writing this piece to address concerns that I frequently hear from clients and encounter in discussions about our current financial systems. As the owner of a wealth management firm, I am aware of the significant changes that occurred in 2022, disrupting the previous decade's market upswing that continues to affect us in 2023. While market corrections are a natural part of the financial landscape, the corrections we have witnessed indicate deeper issues that are not aligned with sustained market stability and growth. Investors are understandably concerned about the duration of this situation, the extent of its impact, the possibility of major shocks, ongoing bank failures, financial market volatility, and more. These concerns directly tie to how investments play a crucial role in achieving one's goals, realizing dreams, and securing a comfortable retirement.
In this article, I aim to delve deeper into the underlying factors influencing markets and the economy, which ultimately affect our investment goals and aspirations. I will go beyond discussing the Federal Reserve or bank failures and shed light on the importance of addressing the debt ceiling, real growth ratios, debt levels, and wage growth.
My intention is to provide you with information that highlights how your choices and support for specific policies can influence the outcome of these issues. By gaining a deeper understanding of the root causes at play, we can collectively work towards improving the situation rather than sugarcoating or ignoring it. The reality is that we possess the power to bring about positive change by addressing these root causes and maintaining prudent financial responsibility. Not only will this benefit us individually, but it will also have a positive impact on society as a whole (research substantiates this claim). As we approach the upcoming election cycle, it is essential to recognize that the two key concerns for Americans are the economy and crime. When our finances suffer, it directly impacts our lives, making it crucial to address and resolve the current situation.
Let us begin by examining the prevailing financial illusion that blinds us to the root issues affecting the US and global economies and markets.
We should be genuinely concerned about the increasing levels of global indebtedness, particularly in the United States. If the current trend of surpassing historical debt-to-GNP ratios persists (with GNP growth aligning with or falling behind debt growth instead of surpassing it by a factor of 2.5 or more), the very foundations of our financial systems will continue to face significant challenges. The recent failures of banks are directly linked to this issue, as well as the inflation and interest rate hikes resulting from poor monetary policies and prolonged periods of low interest rates leading up to the rate hikes implemented by the Federal Reserve in 2022-23. There has been a prevailing mindset among the elite to borrow extensively, without limitations, in an attempt to resolve the challenges we face. However, this approach has had adverse effects on balance sheets, real economic growth, productivity, and financial stability, increasing the risks of inflation. For investors, this potentially translates to unpredictable markets, greater shocks, larger market downturns, and the erosion of investment and retirement funds essential for achieving life goals and dreams.
Unfortunately, the prevailing norm has become to defer accountability and responsibility, perpetuating the cycle by pushing problems onto future generations. Politicians often prioritize popularity over prudence and responsibility. Voters tend to shy away from the discomfort associated with financial discipline, even if it ultimately leads to greater economic stability and predictability, benefitting everyone in the long run. As an athlete, I believe in the adage "no pain, no gain." We are already experiencing significant pain due to inflation and the uncertainty surrounding the current situation. A glance at the news is enough to dampen anyone's spirits.
Global debt has ballooned to a staggering $300 trillion, equivalent to 360% of global GDP. Over the past 20 years, US debt has risen by 400%, mirroring the global trend. Let us not forget that the 2008 financial crisis was a consequence of escalating indebtedness for all the wrong reasons. In two decades, the global balance sheet has tripled, comprising one-third of actual goods produced and accumulated, one-third of financial assets held by households and governments, and one-third by financial institutions. It now takes $4 of debt to create $1 of investment, marking a historical record level of leverage that is unsustainable and could potentially lead to dire consequences if left unchecked.
Low interest rates have driven investors to seek higher yields outside of traditional savings, favoring short term speculative investments with high liquidity. Consequently, investment in long term productive growth has declined, while financial and real estate asset valuations have soared. Currently, only 23% of real value created stems from productive investments in real growth, such as infrastructure, machinery, and equipment, while the remaining 77% is derived from pure asset valuation growth (not real growth). In order to steer our economy back towards growth and stability, we must prioritize productive investments that generate genuine growth, rather than relying solely on increases in asset valuations within the financial and real estate sectors, as we have witnessed in recent years.
Net wealth has outpaced income due to monetary policies. Financial assets and real estate have experienced disproportionate growth in comparison to income. In the past, net worth and income increased proportionately. However, in the last two decades, net worth has grown 50% faster than income, while economic growth has halved. It is crucial to find ways to encourage long term productive investments that provide reasonable returns for investors and address the issue of wage growth, aligning it with overall economic growth, as has been the historical norm.
It is important to dispel the illusion that low interest rates alone drive an increase in productive investment. Economist John Maynard Keynes warned that maintaining interest rates too low would discourage savers due to the low rate of return and dissuade them from engaging in long term productive investments. Unfortunately, this is precisely what has occurred. Speculation and quick profits have become the primary objectives for most investors, contributing to bank failures along with poor management.
We must confront our debt crisis head-on, without denial or blame, and usher in an era of accountability and responsibility, benefiting us all with greater stability instead of calamity. It is worth considering that when we were previously tied to the gold standard, we exercised accountability, keeping spending and debt in check. However, since departing from the Bretton Woods system, we have accumulated an astounding $300 trillion in debt, embracing the misguided belief that unlimited borrowing can subsidize inefficiencies in systems, sustain zombie companies, and support failed policies without any consequences. While we cannot reverse the past, we can certainly choose a different path moving forward, learning from history rather than ignoring it. Aldous Huxley aptly noted, "that men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach."
The continuation of bailouts by the government and the perpetuation of wrongs have resulted in excessive risk-taking, reduced anxiety regarding risk, decreased productivity, and undeserved lifelines extended to failing companies. Why? Investors have come to believe that the government will bail out any situation, setting a new precedent.
The ever-increasing levels of debt mean that any downturn can pose a serious threat. The reckless financing practices contribute to the manifestation of inflation. In a healthy economy, inflation would typically act as a disciplinary force on money creation and debt. However, politicians and the Federal Reserve have continued along the same path. While some news outlets paint doomsday scenarios, others present a fairy tale narrative of a strong and resilient market and economy. It would be ideal to tame this wild beast, creating a stable financial system that benefits the majority and becomes more predictable. Unfortunately, the ultra-wealthy elite have reaped the greatest benefits from the regime of valuation increases and imprudent debt containment.
The solutions to this crisis include:
Recognizing the real problem and taking responsibility for finding a solution, rather than denying or deferring action regarding debt and leverage.
Acknowledging that money creation cannot solve all the challenges we face and that artificially sustaining failing entities, such as zombie companies and failed policies, delaying necessary adjustments.
Exercising fiscal discipline to curb government spending, which contributes to inflation.
Strengthening productive capital, both physical (infrastructure, machinery, equipment, etc.) and human, by fostering reasonable wage growth that aligns with overall economic growth.
Considering the elasticity of supply and understanding how supply can change in response to price fluctuations.
Recognizing the influence of interest rates on investment and considering them as a means to stimulate real productive growth and incentivize savings.
Understanding that a historically proven inflation rate of 1% promotes market stability, the Federal Reserve's target of 2% seems reasonable within this context. Inflation erodes spending power and true wealth.
Without recognition, solutions, and discipline, we will face greater geopolitical, economic, and financial instabilities, as evidenced by recent shocks to the system such as with COVID-19, the situation in Ukraine, and the looming conflict between China and Taiwan, among others.
It is essential to recognize that as individuals, we have the power to influence how these issues play out by understanding how various policies impact the market and the economy. We elect officials to represent us, and we must prioritize the economy as a legitimate concern because it directly affects our ability to achieve our hopes and dreams. The economy is intertwined with our aspirations for ourselves, our children, and our grandchildren. We must ensure they do not inherit the mistakes of our time. Our power lies in how we vote, how we spend our money, and how we invest.
I encourage you all to remain committed to diversification and to consider investment risks and time horizons in line with your goals. Despite the volatility, there are still opportunities to be found, and it is my responsibility to identify them for you. Furthermore, I hope to empower you with information because understanding the situation alleviates fears and paves the way for viable solutions. It also enhances your financial insights and intuition, enabling you to make well-informed decisions, particularly in times of increasing volatility. The more we maintain a calm center and make informed choices, the better our decisions will be.
I hope you have found this piece informative and invite you to share it with anyone who would benefit from it. Feel free to contact me if you would like to discuss any of the points outlined here.
In service to you,
Lisa
