TheBucket

Many people don’t realise that if their wages and assets aren’t growing by at least 12% annually, they are effectively becoming poorer. To clarify this concept, I’ve summarised a theory developed by Raoul Pal, a prominent macro investor.

Pal’s theory, known as the Everything Code, centres on the debasement of currency by central banks. This debasement drives asset prices up and creates significant investment opportunities. The theory is based on several key observations:

1. Currency Debasement: Central banks are consistently debasing currency to manage economic growth, which means that the value of money decreases over time.
2. Asset Price Inflation: As a result of currency debasement, the prices of assets increase, which can create opportunities for investment but also raises the bar for maintaining purchasing power.
3. Investment Returns: To keep up with this inflation and debasement, investments need to generate at least a 12% annual return to ensure that their real value remains stable and doesn’t diminish. 

Understanding these dynamics is crucial for making informed investment decisions and protecting your financial future.

Components of GDP Calculation

At the heart of the Everything Code is the formula for calculating GDP: Population Growth + Productivity Growth + Debt Growth. These three factors collectively determine the economic output of nations. However, recent trends have shown a significant decline in population growth, leading to an ageing demographic globally. This demographic shift, has resulted in a persistent slowdown in GDP growth across Western countries.

Historical Trends and Debt Reliance

In the late 20th century, particularly during the 1980s, 1990s, and early 2000s, the world experienced substantial technological advancements such as the advent of computers, the internet, and mobile phones. Despite these innovations, productivity per capita did not increase as expected, primarily due to the ageing population. 

To compensate for stagnant productivity and slowing population growth, economies increasingly relied on debt to fuel GDP growth. This debt-driven growth model, however, reached its limit in 2008, culminating in a financial crisis that exposed the vulnerabilities of this approach. You see the debt bubble popped in 2008 when the collateral behind the debts (real estate and equities) deflated resulting in debts far outweighing the value of the assets.

The Role of Quantitative Easing (QE)

Post-2008, central banks around the world resorted to Quantitative Easing (QE) as a solution. QE involves injecting money into the economy by purchasing government bonds and other financial assets. While initially intended to stimulate economic growth, QE primarily resulted in asset price inflation rather than consumer price inflation. This process effectively debases the currency, reducing its purchasing power and leading to a significant increase in asset prices (collateral of the system), especially in markets with limited supply ie Bitcoin, S&P 500 or quality real estate.

Debt and Interest Payments

Governments globally now hold debt levels close to or exceeding 100% of their GDP. The interest payments on this debt are a significant burden. Since GDP growth has been sluggish, many countries cannot cover these interest payments through economic growth alone. Instead, they rely on central banks to monetize this debt. This process involves central banks purchasing government debt, effectively creating money to cover interest payments and preventing crowding out of the private sector.

Falling GDP Growth

The trend rate of GDP growth has been declining globally, currently around 1.75%. This decline is driven by three factors:

1. Population Growth: Population growth has been slowing down as the workforce ages. The working-age population (aged 15-64) has been declining, which has a direct impact on economic productivity.
2. Productivity Growth: Productivity has been declining due to an aging population. Older populations tend to be less productive, and this trend has been mirrored in many developed economies.
3. Debt Growth: While debt growth has been rising, household debt growth stalled in 2008. This is largely because banks have been more restrictive in lending, making it harder for households to accumulate debt. Meanwhile, corporate and government debt has grown, but it has only grown by the amount of interest due and debt needed to maintain economic stability. Since 2008 debt is no longer a lever that can be used to generate GDP growth.

What this means? Excess Liquidity Results in Currency Debasement

1. Government Debt and Liquidity: As fewer people participate in the labor force, government debt increases to maintain economic stability. This debt is serviced by debasing currency and increasing liquidity. Central banks around the world have been using their balance sheets to inject liquidity into the system, which helps to inflate asset prices.
2. Global Liquidity: Global liquidity has been growing at an annualised rate of 8%. Combined with global inflation, which is approximately 4%, this creates a 12% hurdle rate for investments. This means that any investment needs to generate at least 12% returns to maintain its real value.

Correlation of Liquidity with Asset Prices

The increase in global liquidity has a direct correlation with asset prices. For example, the NASDAQ has a 97.5% correlation with the total liquidity index. This correlation demonstrates how liquidity injections by central banks drive up asset prices.

As central banks expand their balance sheets through QE, asset prices, particularly those of technology stocks, leveraged real estate and cryptocurrencies, tend to surge.

Conclusion

Investors must understand these economic dynamics to make informed decisions. By recognising the impact of currency debasement and the necessity of achieving a 12% annual return, investors can better navigate the complexities of today’s financial landscape.

Our targeted annual return for our Family Trust is 14% which for now is above the 12% hurdle. We chose this figure as our goal is to see our assets grow beyond the 12% hurdle rate. We feel an additional 2% per year growth is achievable without going too far-out on the risk curve.