Patrick Donohoe: How Economies Grow and Why They Crash

If you want to create real wealth, you've simply got to have capital formation. The capital can come in the form of savings to invest, or in terms of assets that produce income. Hey, Patrick, it's good to see you again.

Hey, same here, Jason.

So one of those listener questions you sent over was about the economy growing and shrinking and why that happens. So we could talk about the business cycle or a variety of things. And then we have to ask ourselves, right. Have the rules changed in an era of pandemics and riots, civil unrest? What do you think?

Well, I'd first say that it's interesting that people are asking these questions, and I think it's because they're more aware of what's going on in society than they have been in the past. And this is a question that you can spend days on. I mean, there's whole PhD programs on why this and why that as it relates to the economy. But I think the long and short of it is the economy is just the measurement of resources that are used for particular purposes. When an economy grows, I think that indicates that there is an increase in production, an increase in value. In a nutshell, in really easy terms, that's why a. An economy grows, right? In theory, but I think our economy is different than when those kind of first economists started to define economies and then start to measure it. So today, I mean, our economy is in large part based on debt and consumption. And that's where it gets really complicated in a sense, because most people think that, you know, money is value, but money is ultimately debt. If you. If you think about how money is created today, and it's a different monetary system than the past, at the same time, the more you understand about that, the more questions I think you can ask. Because although our economy grows, right, gdp, well, obviously right now, but previous, you know, to Covid, you know, the economy was growing at a small percentage, but also what was growing was the expansion of credit and debt. Right? So that is what expanded, I would say, overall economic growth.

So, yes, we live in an economy that's built on a house of cards, essentially, and money is created through debt and this crazy fractional reserve banking system we have, and both of us have studied that stuff a lot. If people don't understand it, believe me, it's really obscure and it's hard to get your head around. It's just so weird. And, you know, read books like A Creature from Jekyll Island. We both know G. Edward Griffin, of course. I'm sure you've interviewed him. I know I have on my podcast several times. And, and it's just hard to get your head around this stuff. It's, you know, even if you think you get it, it's like there's another layer. You can keep peeling back the onion on this. But I do think we'd be remiss if we didn't just talk for a moment about the good old fashioned business cycle. And that's largely an Austrian economic type of thing. And if there's any economic school of thought that I most subscribe to, and I think you too, it's the Austrian school. And the Austrian school is. And by the way, this is by no means an academic definition. It's just a sort of man on the street view of it is. You know, where they would say that the opposite of it would be John Maynard Keynes. The opposite would be Karl Marx, who, by the way, Karl Marx. As much as I don't like him and don't agree with him, I have to give him credit. He's responsible for the deaths of hundreds of millions of people. I'm not giving him credit for that. So he's. I definitely do not like his ideas. But he is far and away the most influential economist in world history. He changed the world massively. The entire Soviet Union was based on his idea. And, you know, it's awful that so much of the world adopted his policy.

So sometimes you need contrast, Jason. You need contrast to understand the value of one system versus when it's compared to something else.

I love it. That's a great. I'm glad you pointed that out. That's really good. So Austrian school would say, you know, the way to create wealth is through capital formation and production. That's like reality, right? And it totally makes sense. But we don't live in that world, as you were alluding to a moment ago, we don't live in a world of reality. We live in a world of money being a super symbolic idea and really literally an idea based on fiat. And we live in a world where Keynesianism has prevailed largely and it is the way it is. But going back to that Austrian school business cycle concept. Let's just talk about that for an idea. So, you know, they would say that the economy always acts in cycles. And, you know, if you're looking at a chart, it goes like this, right? And there's this cycle where it's a boom time and there's expansion and more inventory of products and services is created. And I even say inventory in the world of services because if we look at what happened during the shutdowns when nobody could get a haircut, nobody could go to a nail salon, nobody could get a massage, nobody could get a lot of stuff, Right? Those are all services, right? So even services have an inventory in a sense, right? Because if those businesses go out of business, which many of them will or have already, there's lower inventory. Okay? Now we mostly think of inventory in terms of widgets, right? So this is an economic widget, right? And so inventories expand because manufacturing expands, credit expands, and everything's going well, and there's a wealth effect and people feel good. And then that gets to a point where people start to wonder. They start to lose faith in the system. They think, gosh, this can't go on forever, right? Maybe we better save a little money for a rainy day. Maybe the sun won't always be shining, okay? And they start to rein in their horns a little bit. And then you see the stock market pull back, right? And you see some bad days occur. And then you see the houses in your neighborhood aren't selling for those crazy prices they once were selling for. And then you see, well, you know, maybe it's not quite as easy to get a raise and at my job or to get a new job or to get that promotion, or maybe my company laid a few people off and people start to get a little bearish, right? So that sets up for the next cycle, which is the bust, right? So I'll let you.

Yeah, those are great. Those are great thoughts. And if you think about it, it's like the growth and the crash of economies is in large part the dance between the rational and the irrational. And I think from a rational side of things, right, It's. I think people are naturally wired to grow first and foremost, and then they're wired to either get the same for less or get more for the same. Okay, meaning the phone, right? The efficiency of phone and technology. You're paying a little bit more, but look at how much more you're getting compared to five years ago, ten years ago, right? Or you get the same. You know, you get the same for a less. For less price. I mean, the.

The.

I think the Apple, the new C version of it, right, Is. Is much less. At the same time, it still does a lot. So I look at, you know, just in a nutshell, that's kind of the rational side of things. But then, like you alluded to, Jason, you have the irrational side of things, which is. Which is emotion, right? I think emotion. Sometimes it. Well, not sometimes. A lot of times it Drives behavior, okay, for, you know, one direction or.

Or another.

And when someone becomes afraid, they behave a certain way. When somebody is excited, they behave a certain way. There's like an investor curve, right, as far as risk levels are concerned. And the highest risk investment is when there's like peak euphoria.

Right.

The best time to invest. Right. Is when there's the, the, you know, greatest fear and despondency of people.

Right. The blood in the streets metaphor. Right? Yeah, yeah. Buy when there's blood in the streets and sell when everybody's partying.

Exactly. So that's. That's kind of like, I would say, a very Austrian way of looking at things. But I would say that the thing that's important to understand about the Austrian school of economics is it's based on freedom. There's no government intervention. If somebody makes a bad choice, whether it's starting a business or allocating capital to something, no bailouts and they fail, right? There's no bailouts. They have to fail. They go bankrupt. They go out of business. And that's necessary for the learning experience of how people provide a service, provide a good. To make sure that what their ideas in their mind is actually in demand in the economy. And that's what I love about the creative destruction.

For sure. It's great.

You know, we're so afraid of failure, but failure is one of the greatest teachers, especially in business. And, you know, if you just continue to Band Aid and Band Aid and Band Aid and Band Aid something, people are just going to. The bone is eventually going to break, the wound is eventually going to get infected, and a person's going to die.

That's a very good point. And I would put it maybe another way, though, because the, you know, we all saw that with the bailouts, right, in the Great Recession. And a lot of people were very upset about the bailouts. And the bailouts prevent. They artificially prevent what needs to happen. And those, those failures, those bankruptcies, those businesses going away, it needs to happen. And when you don't let it happen, when you interfere with the process, when the government comes in and bails them out, then you get this situation where you're encouraging bad behavior. There's a, you know, a moral hazard, as they say. And, and these companies, and then the greater economy in general become. They become like these zombie companies, and then the whole economy becomes like this zombie economy where. Think of it this way, you know, when, when you wake up in the morning and, you know, the first thing millions of people do is they have a Cup of coffee. I know it's the first thing I do pretty much. Okay. And you know, you want to kind of jump start your system and your system will naturally wake up. I mean, Pat, you don't drink coffee, right? But I do. And I didn't used to, okay? I had this girlfriend got me into Starbucks years ago and ever since then I've been addicted, right? Not to them, but just coffee in general. So now I need it, but you don't need it, okay? And you still wake up. But I kind of need it as a crutch, right? Because my system has become used to it. And so, you know, after a while you, you know, like any form of addiction. And caffeine is an addictive substance. Like many other things, many behaviors, you know, drugs, alcohol, that's what we think of as addictions, overeating, whatever. But there's lots of little addictions we all engage in all the time, okay? Little addictive behaviors here and there, little compulsions. And what the nature of it is is you always need more to get the same result. And the same thing happens to zombie companies and zombie economies. The poster child of this would be Japan, okay? And Japan has had, they first had the lost decade, then they had the last two decades, and then going into the lost three decades where their economy just, no matter what you do, it just kind of can't really get to where it was. And they have the highest debt to GDP ratio, about 230% of any developed country because they basically keep spending into it. And after a while, you know, it just doesn't work anymore.

And those debt levels continue to grow and so forth. So, yeah, it's one of those things where, you know, I love one of your ten commandments of real estate investing because it alludes to use using debt and using debt using leverage as part of purchasing an asset. Because these days people don't use debt to purchase their assets and purchase their savings. And what it does, it kind of goes against our current economic system, which is fueled by debt. I mean, debt is essentially priced into everything, including real estate, including cars. So you look at what exists today, whether it's the Japan economy or whether it's our economy, and the growth of the economy in large part is due to credit expansion when there is stimulus. And that's why the Federal Reserve in the United States has had to do constant quantitative easing, right? And continue to expand because they have to grow. And the reason why they have to grow is because there's interest that's due on the debt, right? And they need to pay the interest. So it's one of those things where they have to grow the economy so that there's greater output, greater taxes, which then pays the debt.

It's a treadmill. It's a treadmill.

It is. And that's where, you know, Richard Duncan, I'm not sure how much you've studied him.

Yeah, he's been on my show several times.

Yeah. And, you know, he, I think, understands as well not to say that it's a good system. I think it's an incredibly flawed system, but it's the system that we have. And as credit expands, things are most likely going to grow as credit contracts, things are going to crash. But this is the thing. It's like debt is like an accelerator. It's like, you know, gasoline or jet fuel.

It's an accelerator.

Yeah, right. It just. It makes everything go quicker, faster, and worse.

Right, right. Yep. No, that's. That's, that's a great point. And the difference between using leverage to, say, buy real estate versus a country or, you know, bailing out companies that shouldn't be bailed out, or, you know, spending on the welfare state, that isn't really a capital investment. Whereas the property you're buying, as long as it's a sensible property, is a capital investment. Look at the bottom line, and maybe we can wrap up this little segment with that, is that the idea is if you want to create real wealth, you've simply got to have capital formation. The capital can come in the form of savings to invest, or in terms of assets that produce income. That's it. Like, it's really that simple. Okay. You know, you. You cannot. You cannot spend on welfare programs or bailing out zombie companies to grow your economy. That's not the way to spend your way out of it. It just gets progressively more difficult, requires more stimulus every time, more caffeine every time. You know, that idea. Yeah.

I'll end with this, Jason, which is, I think, really interesting when I realized this, but let's say, you know, you have a government worker that is renting a home that you own, that you've purchased with leverage. You purchase it the right way. They're paying, but the way in which they're paid is based on the government being able to have debt and be able to provide capital in the form of debt so that that person can get paid. Same thing with if a person works for, you know, Fortune 500 company, that is fueled in large part by corporate bonds, which they use. Right. To capitalize their company and work their company, grow their company. That money is then used to pay this person who then pays the rent on your property. Same thing with the suppliers of lumber, you know, builders, you know, in large part, a lot of that supply comes from being able to have access to debt, which allows them to produce. So it's an it's interesting just to see debt is this is that kind of foundational thing, that domino that's required these days in order for the economic machine to be working.

We live in a world of credit based assets, and when the credit dries up, things get tough and there's another cycle right there. Good stuff. Pat. Thanks for. Thanks for having this talk with me.

This was great. I love the conversation. We kept it, I think, as simple as you can.