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junot we were in a bubble in the housing market in 2008 2007 you saw things that sort of disrupted your model we're talking to one of the most successful hedge hedge fund managers on the planet if not the most successful you have been able to navigate hugely difficult waters take us back to 2007 what did you say tell us about your model and your approach to investing when things really started to turn ugly so I'd like to take ya not just 2007 I just like to take a few minutes and just describe how the economic machine works and my frame of reference pertaining to it and it's just a very basic thing there's a transaction an economy is not a complicated thing it just has a lot of moving parts but the basic is there's a transaction and that transaction means somebody makes a purchase they make a purchase of a good a service or a financial assets that purchase can be made with money or credit if you if money when you make a purchase with money you end the transaction you don't know anything when you make it with credit then there's a liability you have to come up with the money because a credit that debt is a obligation to deliver money so there's a basic transaction they're spending in other words the total amount of money and credits spent on a good or service and then there's the item that you're buying a stock a bond a car bushel of wheat there's that transaction demand is best measured in terms of spending you know I think in traditional economics it's a mistake to measure it in terms of the quantity of goods what is given up in a purchase is is money or credit well we go through as we go through a cycle we go through a credit cycle credit can be created it's not created through the velocity as is commonly believed it can be created out of thin air if I go into a store or I have somebody paint my house and I say I'm gonna pay you later I've created credit that'll count in GDP it'll be an item of production so what we have is a credit cycle if there's not much debt if you don't have much debt then you have the ability to borrow money let's say you weren't a hundred thousand dollars a year and you don't have any debt you can then borrow ten thousand dollars a year you therefore can spend a hundred and ten thousand dollars your spending of one hundred and ten thousand dollars is somebody else's income and of the hundred and ten thousand dollars so it has a positive effect and you go through a cycle and through that cycle you spend 110 thousand a year and a hundred and ten thousand and we and the cycle becomes resale free enforcing through that cycle debt Rises faster than income debt Rises faster than income debt can't rise faster than income forever so as debt Rises faster than income you have a debt cycle as you get as it's what causes it to stop well traditionally as you lower interest rates it creates debt has three positive effects you took if interest rates are too high then you lower interest rates lowering interest rates has the effect of making it easier to service the debt it has the effect of making items cheaper to buy on credit because the monthly payments are less it has the present value effect on assets so if you lower interest rates and you have something that has a cash flow let's say piece of real estate or something they have a present value effect it causes those assets to go up that produces wealth and that allows more borrowing and so when you get to a situation where you can't lower interest rates anymore let's say you hit zero you hit that part of the cycle ends so then you go to a deleveraging now we're de leveraging you can't be de leveraging means that you can't raise that relative to income anymore when you can't raise that relative to income anymore the cycle begins to work in Reverse so I think the people if they don't do a very good job of calculating incrementally what the effects are on demand but let's say you're having debt bro at something like 10% and you go to a 5% that growth instead that has a negative effect on growth it's the marginal change from that level produces a negative effect on growth so traditional traditionally in deleveraging that negative effect that happens on for let's say Europe is a very classic case these the Spanish banking systems very classic case the European banking system as they banks leverage up at a certain rate and they can't leverage up more than that rate and they lessen the rate at which they're leveraging it up it has the effect of beginning a debt of deleveraging deleveraging means then the income the spending all produces sort of a negative cycle that produces the beginning of a depression a depression is the phase of a deleveraging in which there's a combination of austerity and debt restructuring because if you have it's a basic thing if you have too much debt to service you've got to do something about it and when you have too much debt to service and you do something about it there are a limited number of things that you can do you can either transfer the debt but you can transfer resources from the rich to the poor so you can have it transferred from example from Germany to Spain that's one way of dealing with it the other way is to you have a combination of austerity and debt restructurings a debt restructuring means that you lower the debt in one fashion or another you low there the debt burden to something that you can afford to service because of the income that you produce restructurings can take one of three ways you can you actually write down the debt you write down the debt let's say write it down in half because you could service F if you serviced half but the problem is one man's debts are another man's assets so when you write it down in half you have a big negative wealth effect so you have a negative wealth effect you can't borrow money and has that problem so a restructuring becomes a problem you could restructure it either in the form of writing it down or in one way or another you can lengthen the payments or you can forcibly lower the interest rate but some way or another you've got to get the payments in line for what the cash flows are producing so that you can service that kind of a debt that's a very painful process so a depression is the phase of the de leveraging when there's a combination of austerity and writing down debts so classic the Depression 1932 1932 March in 1933 we print money so or the third way that you can deal with it is you can print money essentially what we call print money but the printing of money means that essentially a central bank debt is a commitment to deliver money so if a central bank slips into the system a certain amount of money each year it can make that easier think about the deck write down that something maybe is a debt and you say I'm gonna write it down to a level that could be sustainable and you write it down by 50 percent that has a big negative wealth and effect big deal bad if in that that if it's 10 your debt maybe that's equivalent to 5 percent a year for 10 years if you slip in 5 percent a year instead and to that person who then can pay that debt they can service the debt it's 5 percent a year it's not that big a deal and so monitors in in all deleveraging --zz in the end they print money it's part of the mix now the best deleveraging are ones in which you have a balance of those things ultimately you have to bring down the debt to income ratio so and the ways that ultimately you'll have a balance of those 3 things those 3 things again you're gonna have a certain amount of transfer of wealth you're going to have a certain amount let's call for things a certain amount of austerity a certain amount of debt rights downs and a certain amount of printing of money that the debt writedowns and the austerity are deflationary the printing of money's inflationary if you can get the balance right of those things then you have what I call a beautiful deleveraging the leveraging well you when you look at the de leveraging the debt to income ratios thank you I'm fine if you look at the debt to income ratios and and say how have they come down over time England after World War two or the United States and the Great Depression in all of these cases where the debt to income ratios came down they came down how did they come down they came down with relatively good conditions by trying to get by that mix there's a certain the number one reason is that there's enough of the printing of money that the nominal growth rate in GDP has to exceed the nominal interest rate okay if you're because think about it you have a certain amount of debt and there's a certain debt service cost and if that interest rate on the debt is higher than the nominal GDP rate then that means that it's going to compound unless you're you keep cutting and that produces a negative consequence so the most important thing is in these the leveraging so as the United States is now doing is that you can you have enough of a printing of money to produce a nominal growth rate that's above the nominal interest rate over a period of time I'm oversimplifying but that's the most important single single thing so now when we ted then take 2007 and that's just describing a little bit the template these templates have happened repeatedly they've happened in you you know the IMF restructurings you can go back and study them all they're all deleveraging x' and they're all class of cases and they're all pretty simple so 2007 2007 and also in the European case what we had was rates of debt growth that that were unsustainable rates of debt growth not the mistake of monetary policy I think most the most common mistake of monetary policy is that it's targeting inflation and growth and while inflation and growth are important it it really what it does is it produces debt and what at what it has to pay attention to is debt growth rail to income growth growth relative to sustainability and so what happens is lots of times you have a lot of debt growth that goes into the purchase of financial assets and that's a classic bubble that's worse then that's a riskier situation than inflation so you take 2007 or such periods and you see that there's a lot of debt growth which is accumulating for the purchase of financial assets and then you look at the financial assets and you say they will not be able to service that debt and so that produces a bubble that's what produced the 1929 bubble that's what produced in Japan the 1989 bubble 1990 bubble that's what produced the 2007 bubble are you always looking for this opportunity where whether it be debt is growing faster than they can service it or in terms of your approach to investing are you I'm just looking at what's happening I'm trying to stay one step ahead of it you know that's you know things are happening things are happening I'm there certain things happen for reasons they're cause-effect rate I'm just trying to understand those reasons and I'm saying the same things happen over and over again and if you and you if you see that that's happening I know that in a bubble that that's not a healthy thing that's not gonna work and I just know therefore don't want to own the bet the assets are gonna go down when the bubble is going to burst and move into the assets that'll be safer that's what I don't
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