Summary: Asset-First Economics tells us to focus on the Balance Sheet, not GDP. Interest rates are determined by tangible asset inflation, not the CPI or the PCE. Existing home price inflation of 1.9% means the Fed should not raise rates. Worries about the budget deficit and interest rates are misplaced. There is no doubt that AI will raise productivity and GDP and that AI/Data Center Capex is the main driver of both output and earnings today. But we should remember that information businesses have increasing returns and declining costs, which makes them winner-takes-all natural monopolies. Natural monopolies only have one winner. The first guy that gets to scale will drive prices to zero and kill all of its competitors; it will earn revenues not by selling product but by monetizing the eyeballs of its massive user base. Regardless of which company wins the race, its founder will be anointed as a true genius. Its competitors growth plans will vaporize, along with their capital spending plans. The ultimate script for the impact on stock and bond prices when markets figure that out is still to be written. It will be a lot more volatile that the one you read in the newspaper.

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Some Headline Topics

Here are a few comments on some things I am actively working innow and will write about in future posts:

Inflation. Both CPI and PCE have serious measurement errors. Housing costs for existing homeowners are dramatically overstated by adding a made-up (imaginary) measure called “Owner’s Equivalent Rent.” It should be removed from both indexes. Correcting that mistake would reduce the June Core PCE inflation rate from 2.6% to 2.2%, and July Core PCE inflation from 2.5% to 2.2%. More on that in my next post.

Fed Policy. I like what Kevin Warsh is doing to get rid of the Dotplot and reduce the endless string of Fed Governor lunch talks we call Fedspeak. If I were advising him what to do at the next FOMC meeting I would say to leave rates right where they are.

And I think shrinking the Fed’s balance sheet, getting the Fed out of the business of financing budget deficits, and returning to the days when the size of bank reserves was an important tool for the Fed, are good ideas.

AI. It is beyond question that the adoption of AI will raises productivity and drive growth higher. Like miles per hour, GDP’s dollars per year is just a measure of speed. AI makes work get done faster. GDP has to go up .

The construction economy is booming, due to the data center buildup, which is both helping employment and putting upward pressure on inflation through its impact on construction costs and information equipment prices.

Ultimately, AI will drive inflation lower for a given level of interest rates.

The impact of AI on jobs depends on how fast AI adoption takes place. Over long periods, improvements in technology have important impacts on where people work, but not whether they have jobs. (In Ben Franklin’s time, 93% of Americans were farmers, When I was born, 50% were farmers. Today just 3% are farmers. The former farmers are just doing different work.) The only real issue is how fast people need to, and are able to, change. Here are a few things to keep in mind:

• The booming information sector is having a huge impact on corporate earnings and stock prices. Some of that is fake—the reported profits announced by companies that come from holding shares of each other’s stock. But most of it is real.

• Information companies have fat gross margins by their very nature. They are the declining marginal cost, increasing return, businesses that Brian Arthur writes about at the Santa Fe Institute. That makes them natural monopolies, which increases the concentration of wealth, turns the founders of the winning companies into imaginary geniuses, and makes a lot of people mad.

• It also pushes profit higher as a percent of GDP. (Earnings growth estimates have increased by 25% this year.)

• It pushes labor’s share of income lower, increasing people’s sensitivity to food and gasoline, and health care prices. And it increases the percentage of consumer spending that comes from the owners of all that stock, making GDP more volatile. This is the source of the political breakdown that has plagued us for the last decade.

• And it has created meaningful Bubble Risk that people are beginning to talk about. One day investors are going to figure out that industries that are natural monopolies only have one winner. That means the other companies that are not winners won’t be able to follow through on the things they have announced to shareholders and will have to curtail their plans, i.e., their Capex plans are going to shrink. That’s when we should worry about the reaction from bond and stock markets. More to come on this.

Asset-First

My work on economics and investing comes from an analytical framework that I call Asset-first Economics. It rests on a simple idea: there are two economies, not one. The first economy is our $618 trillion balance sheet economy that measures the value of what we own, what we owe, and our net worth. The second is our $32 trillion paycheck economy that measures our income and the value of the work we do over the course of a year. Economists all write about the paycheck economy. For investors, the balance sheet economy is the only one that matters.

All of the major economic and financial storm systems that matter for investors originate in the balance sheet when changes in inflation, tax rates, tariffs, regulations, and global conflict trigger the massive changes in demand for tangible and financial assets that drive the tsunamis we experience in stock, bond, real estate, and commodity prices.

Interest Rates

I have written extensively about two ideas. One is that inflation impacts interest rates by triggering changes in investor demand for tangible and financial assets, not via flows of funds like savings, investment, and budget deficits. As such, the right inflation measure is tangible asset inflation, which measures the capital gains yield on the $191 trillion stock of real assets that we call net worth, not the CPI or the PCE. A pretty good proxy for tangible asset inflation is existing home prices because homes make up the lion’s share of household net worth. The most recent numbers for July show that existing single-family home prices increased by 1.9% over the past year, slightly below the Fed’s 2% inflation target, which is why I would advise the Fed not to increase interest rates at their next meeting.

The second idea concerns how to think about the impact of budget deficits on interest rates. In Asset-First Economics, comparisons of deficits, government debt, and GDP mean nothing. What matters is whether investors want to hold the debt. That’s largely a matter of investor net worth and of the relative returns of different types of assets.

The National Debt

Today’s $34 trillion national debt makes up only 5.5% of America’s immense ($618 trillion) stock of total assets and 18% of our ($191 trillion) household net worth. All of those Treasury securities are willingly held (demanded) by investors at today’s interest rates. And the demand to hold Treasury securities is increasing every year in line with our growing net worth, which has grown by an average 7% per year over the past 50 years. That means next year investors will want to own 7% (+ $2.5 trillion) more Treasury securities than they already own today. In other words, the first $2.5 trillion of new Treasuries issued next year—next year’s budget deficit—are already spoken for. The budget deficit would have to be bigger than $2.5 trillion to put any upward pressure on interest rates at all.

The big numbers in the preceding paragraph come out of the Fed’s quarterly Z.1 Report, the single most valuable economics report published today. You should know, however, that the report dramatically understates both total assets and net worth for two reasons. First, the asset figures in the Z.1 balance sheet exclude the value of all non reproducible tangible assets, including the roughly 700 million acres of land, the energy and mineral rights attached to it, and the Continental Shelf, owned by Federal, State, and Local governments. And second, because the Fed’s Net Worth calculation counts the market value of outstanding shares of stock as Liabilities of the company’s that issued them, i.e., they show the corporate sector as having a massive negative net worth. But corporate equities are not debt; they are claims on the future free cash flow of the companies the shareholders own. Setting these two accounting matters right would increase the resulting net worth figures by at least half.

Before you start calling me a Commie Socialist Lefty, though, let’s get one thing straight. None of this means I’m in love with government spending, deficits, or the national debt. It doesn’t mean the budget deficit or national debt aren’t higher than I’d like them to be—they are. It doesn’t mean that spending, the budget deficit, and the national debt won’t go vertical when you add in the off-budget promises like future social security and Medicare claims that the politicians conveniently forgot to include in the budget. And it doesn’t mean there won’t be huge tax increases and/or benefit cuts when those expenditures show up down the road—there will, although they will likely be in the form of wealth taxes, not income taxes because there won’t be much income left to tax. It just means that we should stop whining about how the deficit is going to explode interest rates and focus on getting our accounting right and whether the stuff the government is spending money on is worth its cost.

Next Topics

In my next posts I will give you some of the technical details of the ideas above. I’ll show you how the BLS chose exactly which three components in the PCE index to reinvent. I’ll explain why we should change the way we calculate the CPI. And I’ll show you a graphical analysis of the logic behind my budget deficit, interest rate statements above.

Dr. John

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Summary: Advice I would give Kevin Warsh before his first FOMC press conference:

• 1) Don’t use the words data dependent—ever. You’re supposed to be in charge of the price level, not chasing last month’s numbers.

• 2) Inflation is higher (4.8%) and real incomes are lower (-1.2%) than the numbers you saw in last week’s reports, especially for blue collar workers. See below.

• 3) People will be watching what you do, not what you say. Lose the dotplot and delete any forward guidance from the FOMC press release. Tell the FOMC members they are policy makers, not influencers and to knock off the Fedspeak luncheon talks.

• You are right that the Fed balance sheet is too big, the result of trying to peg long-term interest rates and micromanage the labor market. But reduce it slowly and steadily over time.

• Forget the trimmed-mean inflation index; it’s just a way to pretend inflation is low by removing the prices that are driving the average up. Easier to get your staff to fix the current index by removing the OER bias—imaginary rent—from the index. See below for why.

• 4) Don’t trust the forecasts from your staff. They are based on macro models that look at the wrong thing—GDP—and ignore the right thing—the health and stability of our massive Balance Sheet.

• There is no neutral rate, the (unobservable) interest rate that would somehow magically bring about both stable prices and full employment at the same time. The neutral rate only exists in the minds of macroeconomists as a device for solving macro models that pretend the Fed, by setting the level of a short-term interest rate, can bring about equilibrium in our $30 trillion product and labor markets. More important—considering what’s happening in our massive balance sheet containing $622 trillion of total assets and $183 trillion of Household Net Worth.

• 5) The Fed does not print oil, copper, sulphur, or optical fiber. The Fed can’t stop wars or make El Niño go away. Your job is to restore people’s faith in stable prices, not to react to supply shocks.

• Today’s low visibility on the economy means you are right to leave rates unchanged at today’s meeting. But you are going to have a chance to earn people’s trust next year by raising rates. Don’t blow it.

• PS: Don’t talk about the stock market. Telling the reporters in the room that the IPO Emperor has no clothes will only make your job harder.

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Six Degrees from Kevin Warsh

Everyone knows about Stanley Milgram’s Small World research showing that every actor in Hollywood is, at most, six other actors removed from Kevin Bacon. The question of the day is how many degrees you are removed from Kevin Warsh.

On a personal note, I can claim to be only one degree from Kevin Warsh with almost a straight face. I met him in 2002 when he propped me up to do a press conference on the White House lawn on the impact of W’s proposed dividend tax cut on the stock market. But I know that the average cell in the human body only lives for seven years, which gives it a 3.5 year half-life. That makes 2002 7 half-lives ago, which means only 0.78% of Kevin’s and my current cells were actually there at the time. Truth is, I’m probably a 2 or 3, which means it would take 1 or 2 phone calls to make arrangements to reintroduce the rest of our cells over lunch. If you like the advice I have for Chairman Warsh forward this post to a friend who can forward it to someone who can forward it to Kevin and we can run our own small world experiment. If you don’t like it then, well, don’t send it.

What everyone is worried about, of course, is that Kevin Warsh is only one degree from President Trump, who has made it clear that lower interest rates would make him very happy. There is ample reason to worry, both because the families are close and because the independence of the Fed is so important. But I, for one, think there is a good chance Kevin will surprise us and focus on controlling inflation. I should disclose, however, that I do have a certain amount of gold, copper, natural gas, pipelines, infrastructure, and real estate in my personal portfolio just in case I’m wrong.

In the summary, I told you that May inflation was higher than the number you saw in the newspapers. I’ll explain why below and write more on the other bullet points in a later post.

May CPI Inflation 4.5% but 4.8% for blue collar workers

Last week’s CPI report told us that the consumer prices in May had increased 4.2% over the past twelve months. As I have written before, however, there is a serious flaw in the structure of the market basket of goods used to measure the CPI. The problem is a completely made-up number known as Owners’ Equivalent Rent (OER) that dramatically overstates the impact of housing costs on the CPI.

As shown in Figure 1, above, the May CPI report showed 4.2% headline (all items) inflation over the previous 12 months. The elephant in the index is always housing costs because Rent of Shelter has a 34.950% weight in the overall index. In the footnotes, you will see that Rent of Primary Shelter—real checks paid by real renters to real landlords—only makes up 7.7% of the index. In comparison, Owners’ Equivalent Rent of Residences accounts for 25.8% of the index. What, exactly, does OER measure?

If you dig through enough footnotes, you will conclude, as I did, that OER is a measure of nothing and should be removed from the index. It purports to measure what the two-thirds of American households who own their own homes—40% of whom own their homes free and clear with no mortgage—would have had to pay for rent if they were to rent their own house from themself. In practice, the data wizards have to invent a number for OER from whole cloth because there is no economic exchange to measure. They do this by starting with the rent paid for actual nearby rented apartments, which are adjusted upwards to account for t for sure footage differences, etc. The net result is to make the weight of apartment rents in the overall CPI about 4x bigger than it should be.

Why does this matter? Because rent can grow at a significantly higher, or lower, rate than the rest of the index for extended periods of time, warping the information in the CPI. For various reasons, rent today is growing more slowly than other prices, so OER bias pulls the reported number down. In Figure 1, May inflation, after correcting for OER bias by removing OER from the index is 4.5%, not 4.2% in the official report. In a previous post, I showed that OER bias forced the CPI to under-state inflation in 2021-23, and overstate inflation in 2024-2025, leading to serious policy errors win both cases.

But the same OER bias also pollutes the data on income and earning, as we will see below.

Figure 2, above, uses data from last week’s May Real Earnings report to show the impact of OER bias on real earnings for all employees on private payrolls. Using the corrected CPI (4.5%), reduces real average hourly earnings from (-0.7%) to (-1.1%).

Data in the Real Earnings report allows us to zero in on whose hourly earnings are falling. Figure 3 shows that production and nonsupervisory (blue collar) employees experienced higher inflation and a bigger drop in real hourly earnings than we saw in Figure 2 for all employees. Correcting the CPI Figure for OER bias shows that blue collar workers in May experienced 4.8% inflation and a (-1.2%) drop in hourly earnings.

If the White House knew all this, of course, there would be a lot more late-night tweets about reducing interest rates. I’m not going to tell them.

Figure 4, above shows that the problems in the May CPI report are going to pollute the next several CPI reports in the same manner, resulting in artificially low reported inflation figures, because rents are now rising more slowly than other prices. These artificially low reported CPI numbers will make Kevin’s trips to the podium for the rest of the year a little easier than they deserve to be.

Dr. John

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Personal note: I first met Kevin Warsh in the Roosevelt Room of the White House in 2002. He was a young staffer working for George W. Bush. I was there to walk President Bush through work I had done to estimate the impact of his proposed dividend tax cut on the economy and the stock market. Kevin introduced himself and asked me give a short briefing to the press after the meeting. I remember him as a smart, energetic, and kind young man. Later, when W. appointed Kevin to fill a vacancy on the Federal Reserve board, I recall thinking he was too young for the job but he got plenty of on the job training saving the world and bailing out the banks during the 2008 financial crisis. I have only good wishes for him in his new assignment, admittedly a little restrained by worries that he was appointed by a President who has made it clear he wants the Fed to lower interest rates and whose close friend is Kevin’s father-in-law. The stakes couldn’t be higher. If the Fed were to fall into the hands of the politicians we would lose our last institutional anchor on the U.S. price level and you could kiss Fed inflation targets goodbye.

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Summary: Kevin Warsh was sworn as Fed Chairman on Friday. Yesterday was his first day at the office. But there’s no time for a honeymoon. April inflation was 4%. The world is sinking into recession. That giant sucking sound you hear is our oil and gas reserves running dry. Ukraine is blowing up Russian refineries every day. Much of the energy infrastructure in the Gulf has been destroyed. And the only two spots in the world that should be called real rare earth—the Straits of Hormuz and the land under TSM’s headquarters in Taiwan—are both in play thanks to the man who appointed him to the job.

The FOMC meets in 3 weeks to set interest rates. Will Kevin push to raise rates to fight inflation, which would please the bond market? Or will he lower rates to protect jobs, which would please the White House? If history (the 1979 OPEC embargo) is a guide, the answer will have a major impact on the November elections. It won’t take long to find out which team he is playing for.

Brace yourself for wild swings in bond, stock, currency, and commodity prices in the coming weeks as this story plays out.

My advice to Kevin: remember that the Fed doesn’t print oil and that no interest rate decision will tame inflation or boost growth today. The Fed influences demand but has no control over supply. Both rising inflation and fading growth were caused by the Iran war, which has shut off critical access to oil, gas, fertilizer, and critical commodities for every country in the world. He should use whatever influence he has with the President to press the case that a quick end to the Iran War would be good for the economy and good for Trump’s prospects in November.

Opening the Straits of Hormuz to shipping, and allowing the 800 ships trapped in the Persian Gulf safe transit would do more to solve both inflation and growth than anything the Fed could do. But he has to do it now. It will take several months to restore some sense of normalcy to global energy and commodity supply chains; the capacity that has been destroyed and will never come back. And the November elections are only 5 months away.

While you are there, you can also mention that removing tariffs, restoring trade, and delivering the defensive weapons that we already sold to Taiwan and Japan would help on both counts too.

Inflation is already 4%

Last week the Treasury issued 30 year bonds with a 5% coupon for the first time since 2007 because, as the Financial Times wrote over the weekend that “investors believe the inflation rate in a year’s time could be 4 percent.”

Fun fact: April inflation was already 4%, more than double the Fed’s 2% target. May inflation will be higher still.

As I have written before, there is a fatal flaw in the market basket of goods and services used to construct the CPI index. Rent of primary residence—the actual checks that people pay to their landlords—makes up just 7.7% of consumer spending, as shown in the table below, because two-thirds of the people in the U.S. own their own homes, a third of which own their homes free and clear with no mortgage, another third own their homes with a mortgage rate less than 4%.

But the Labor Department puffs that 7.7% Rent of primary residence number up to a measure they call Rent of shelter, 35% weight in the CPI index, by adding an imaginary figure they refer to as Owners’ equivalent rent (OER) that purports to measure what people who live in their own houses would have to pay in rent every month if they had to rent their own homes from themselves at market rates. (I’m not making this up.) That sleight of hand is the reason the Fed underestimated inflation during the first two years of COVID—they called it transitory inflation—and overestimated inflation in 2023-2024, leading to policy errors in both cases.

A quick calculation of consumer prices, after removing the bogus OER from the index using the weights provided in the table below, shows that the right measure of April consumer prices—All items less OER—was 4.0% higher than a year earlier.

Prices up, growth down in May

That 4% corrected figure for April includes the direct impact of the 15% increase in energy costs during the first two months of the war, but not the impact on the prices of everything else as the spikes in oil, gas, and commodity prices work their way through the rest of index. But we can catch a glimpse of it from the S&P Global Flash PMI report released last Thursday (the day before Warsh was sworn in) titled “subdued growth in May amid price surge”. You can see for yourself in the charts below.

This price spike is a supply-chain story, of course, reminiscent of what we saw during COVID. Factories, already reporting lengthened supplier delivery times and lead times due to tariff impacts, are stockpiling input materials.

The supply-chain story is showing up in growth too. Overall employment in May fell, as sharply falling service sector jobs were partially offset by a temporary bump in manufacturing jobs as manufacturers staff up to fill precautionary stockpiling orders. Overall, the May numbers are consistent with Q2 GDP growth that has slipped to about 1% annual rate and will weaken further in the second half. The same story, of course, is playing out everywhere else in the world as China, India, Japan, and Germany all struggle to operate with less oil and gas.

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Home prices don’t show it yet

The rise of inflation hasn’t hit the stock market yet, in part because home prices are still subdued. The sales price of an existing home in March was $412,400, just 1.3% higher than a year earlier. As students of Asset-First Economics know, asset prices are driven by comparisons of returns on tangible assets, like real estate, and returns on financial assets, like stocks and bonds. Low home price inflation, which makes up the lion’s share of household net worth, have made financial asset returns look more attractive to investors. Rising inflation will soon put an end to that. So far, the bond market has gotten the message. The stock market will be sure to follow.

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There is no K-shaped economy

All this is taking place in a place where the fortunes of one group of people are diverging sharply from the fortunes of everyone else. As the chart below shows, people who make their living in the stock market are doing just fine; people who make their living in the job market not so much.

The people who call this the K-shaped economy are missing the point. There is no K-shaped economy. There are two different economies. You can think of them as different ships and of the people as passengers on either one ship or the other. One ship is the balance sheet economy where success is measured as net worth. The other is the paycheck economy where success is measured by whether you have a job and how much you get paid. As the chart below shows, they have been sailing different courses for some time.

The most telling metric, however, is Labor’s share of income, the percentage of total income that goes to people collecting a paycheck, with the rest going to people who collect rent, royalties, dividends, or capital gains.

Labor share has declined during most of the postwar period, but the decline has accelerated since the millennium. I believe this change in labor share is the root of much of the political instability we are dealing with today. I am convinced that the increasing returns nature of businesses in the rapidly growing information sector is driving both the decline in labor share and the increasing concentration of stock market returns. I’ll write more about that in the next post.

Dr. John

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Summary: With the world in such turmoil today, it is difficult to focus on the fundamentals . But we can’t afford to allow fear to drive our investment decisions. I am writing this to remind you that, no matter what is in the headlines or the economic reports, the future of our economy will be determined by the stability of our enormous balance sheet. So, I’m using this post to bring your attention to a little-known source of information you can count on when making long-term investment decisions.

The Q4/25 report on our big balance sheet, released late last week to a wall of silence from the Fed, the economics community, and the financial press, is more important for investors to understand than the employment report, the CPI report, or the FOMC minutes. On 12/31/25 total U.S. assets were valued at $618 trillion. That’s 19.7 year’s U.S. GDP ($31.4 trillion). U.S. households and businesses chose to hold $195 trillion (32%) of that in the form of tangible assets, like homes, used cars, and gold coins and $423 trillion (68%) as financial assets, like stocks, bonds, and money market funds.

Household net worth equals $184 trillion, which is worth 7.9 years of disposable income. Households own $206 trillion of assets, including $52 trillion of homes, of which 71% ($34 trillion) is net owners equity. They have just $21 trillion of total liabilities, almost all of which is home mortgages. Net worth has grown by about 7% per year for the last 50 years.

Remember these numbers the next time someone tells you we are going broke.

Asset-First Economics

Asset-First Economics is the key to understanding stock prices, home prices, and interest rates, as I have written here, here, here, here, here, and here and discussed with my dear friend Laurence Kotlikoff on his excellent podcast. (You should subscribe to it.) It’s foundations are simple, and they are rock solid.

Here is Asset-First Economics in 10 easy to digest bullet points:

• The U.S. balance sheet is many times larger than the GDP accounts (see numbers above.) It’s health is more important than output, income, or GDP.

• Asset supplies are fixed at a moment in time. They can only change slowly over long periods of time.

• Asset prices are entirely determined by investors’ demand to hold assets, based on their understanding of relative after-tax returns.

• Asset demand is information-dependent; it can change in a New York minute.

• Seemingly small changes in relative asset demand can have huge and immediate impacts on asset prices, net worth, and the value of assets held as collateral.

• The most important investor decision is the division of their net worth between tangible and financial assets.

• Inflation and tax rates on different assets are the key to this decision. Higher inflation leads investors to shift a portion of their net worth from financial assets to tangible assets. As a result, real asset prices and interest rates rise; stock and bond prices fall.

• Lower marginal tax rates lead investors to shift net worth from real assets to financial assets due to favorable treatment of real asset income in the tax code. As a result, stock and bond prices rise; real asset prices and interest rates fall.

• The inflation rate that matters is not the CPI, the PPI, or the PCE, as commonly believed. It is the annual rate of increase in tangible asset prices because that’s a measure of the capital gains yield on tangible assets.

• Real interest rates and the so-called neutral rate should be calculated using tangible asset inflation, not the CPI.

Readers Guide to the Q4/25 Balance Sheet report

Once each quarter, the Federal Reserve Board releases a document called Financial Accounts of the United States—Z.1 that contains information on the U.S. balance sheet. It is 212 pages long, so I will only give you a few of the key metrics to consider.

Financial Assets

My first question is always how big is the balance sheet. The value of total financial assets on 12/31/2025, as you can see in the upper right corner of the table above, rounded to the nearest trillion dollars, is $423 trillion.

Tangible Assets

Next we calculate the value of total tangible (nonfinancial) assets on 12/31/2025 from data found on p. 25. By adding the value of tangible assets held by Households (line 2), Nonfinancial noncorporate businesses (line 7), Financial noncorporate businesses (line 12), the Federal government (line 16), and State and local governments (line 20) we find that the value of total tangible assets on 12/31/2025 is $195 trillion.

Total Assets

Add these numbers together to get the value of the total U.S. balance sheet of $618 trillion. Of that total, $36 trillion (5.8% of total assets) is held in the form of Federal government securities, which is the gross value of the national debt that everyone hates so much.

Government Debt

At this point, it is worth making two comments regarding government debt. The first should be obvious. All existing government securities are already owned by someone at today’s prices so whatever effect that debt has on asset prices and interest rates is already baked into today’s the market prices of securities and interest rates. That doesn’t tell us how big that effect was. It just says that only future borrowing, not the size of the existing national debt is relevant for thinking about future changes in interest rates.

Second, the document tells us that the Federal government (line 16) only holds $4.9 trillion, which amounts to just 2.5% of total tangible assets which doesn’t ring true for anyone who has ever visited a national park. In the footnotes, elsewhere in the document, you find the reason. We know for a fact that the federal government owns some 700 million acres of land plus the 200 million acre continental shelf. Together with state and local governments, they own a third of all the land in the country.1 But the accounting geniuses at the Fed have excluded from the official figures the value of all the land, oil, gas, coal, iron ore, copper, gold silver and other commodities under the land, and all of the timber and other natural resources that sit on top of it. Oh, and they use the same sleight-of-hand accounting for state and local government-owned land and natural resources too. I call bullshit on both. Repairing this violation of accounting rules would make total assets, tangible assets, and net worth many trillions of dollars bigger and the size of the net national debt many trillions of dollars smaller than shown in the reported figures.

The Case of the Missing Corporate Equity

Now for another anomaly. I promise it’s the last one I’ll show you today. Based on the way they tote up the numbers, the Z.1 report records the net worth of all of the corporations in America and all of our banks, investment banks and financial institutions as negative numbers.

In Table 1, we saw that Americans own corporate equities (line 24) worth $111.4 trillion on 12/31/25. But Table 3, above, tells us that the net worth of the entire corporate business sector is minus $52.6 trillion and the net worth of all of our financial institutions is minus $25.3 trillion. Where did it all go?

The geniuses at the Fed canceled it out, I believe inappropriately. In the second column from the right Table 1, you can see that when the sectors are added together, most of the rows show total liabilities equal to total asset value. That makes sense for debt securities because every IOU has both a person who owns it (the lender) and a person who owes it (the borrower). So, when you add them together the asset and liability cancel each other out.

But that’s not true for equities. The market value of a stock represents the value of the stream of future cash flow that investors collectively believe the company will produce. There is no offsetting liability. If I am right, then total assets, total financial assets, and net worth are all understated by more than $100 trillion.

Adding the bizarre multi-trillion dollar “government-owned land and natural resources don’t count as assets” accounting gimmick and the equally bizarre “the entire $111.4 trillion value of U.S. corporate equities should be counted as a liability and subtracted from net worth” claim together, as I think is appropriate, would result in total assets, tangible assets, and financial assets many trillions of dollars higher and net worth perhaps twice as large as shown in the official numbers posted in the report. All of which reinforces the principal arguments of Asset-Based Economics. Pay attention to the balance sheet; forget GDP.

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Household Net Worth

Households (real people like you and me) are the largest sector in the economy. We own $206 trillion of assets including $52 trillion of tangible and $144 trillion of financial assets, as shown in Table 4.

Our biggest holdings are $53 trillion worth of homes and $47 trillion of corporate equities. We owe $22 trillion of debts, almost all of which ($21 trillion) are home mortgages. We have $34 trillion in homeowners equity, which amounts to 71% of home values. Our net worth was $184 trillion, which is 7.9 times last year’s ($23 trillion) disposable income and 5.9 times as large as last year’s GDP.

And the balance sheet grows almost every year. Net worth has increased by an average of 7% per year over the past 50 years.

So What?

I have several reasons for giving you this information.

First, I want you to be aware of this incredible document so you know where to get all the delicious information you want on the U.S. balance sheet. I have found this information to be extremely valuable in making investment decisions.

Second, I wanted to give you a short summary (the ten bullet points at the top of the post) of what I mean by Asset-First Economics so you can start using it yourself.

Third, I want you to see how big these numbers are compared with the usual numbers people worry about in the financial press and compared with anything in the national income accounts. And wouldn’t it be shocking if that were not true. The balance sheet is a huge pile of stuff, basically equal to everything we received for free from Mother Nature, plus everything that everybody who has ever lived here has produced that didn’t wear out yet. (Think Ben Franklin and the Liberty Bell.) Plus whatever we have produced in our own lifetimes (142 million homes, 285 million used cars, and the sofa in your living room) that we haven’t worn out yet.

Why does this matter? Because it will help you sleep better at night. Whatever your politics, it is clear that there are some big messes in the world that we have to clean up. But the sheer size and duration of our stock of assets should give us a lot of comfort that no single group of policy makers from either party can destroy the engine that powers the U.S. economy. So, although I keep my eyes open for the credit crises2 we get whacked with once every decade or so, I have faith that this economy will hold together and keep growing for a long, long time. Stay invested in great U.S. companies and hold plenty of cash to buy the best assets at fire-sale prices every time we run into tight credit.

Dr. John

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Summary: Our topic today is real interest rates. In this post we discuss two ideas from my published papers. The first is that, viewed through the lens of Asset-First Economics, the right way to define and measure real interest rates is the difference between market interest rates and tangible asset inflation, not the CPI. The second is that central banks using the wrong measure have caused great damage. That’s how the BOJ triggered Japan’s Lost Decade.

Investors who understand these ideas have a real advantage over those who don’t.

Academia.edu has produced the above audio review of one of my academic papers as a simple summary of the main ideas. You can download the original source article from Academia.edu or by clicking the following link. A transcript of the audio file is below. You can find more information on our Asset-First Economics podcast and video series at www.safanad.com. An archive of my written work is available at drjohnrutledge.substack.com.

I hope that you enjoy the podcast. As a teaser, I will tell you that the logic in this paper was the source of the greatest single trade I have ever made. The long U.S./short Japan bet that Deborah Allen and I outlined in our book Rust to Riches in 1989 had a 16.8x return (25% per year) over the next thirteen years. As always, I welcome your questions and comments.

I have copied the (unedited) transcript of the audio file below in case of interest.

Dr. John

Transcript of audio file below

Welcome to Asset First Economics. Today’s topic is real interest rates. Standard measures that subtract CPI Inflation from a market interest rate get it wrong. The right way to measure real rates is to use tangible asset inflation in place of consumer prices. In Japan’s last decade, the Bank of Japan pushed interest rates to zero, but prices of tangible assets collapsed and effective real rates were sky high.

I hope you enjoyed the discussion and welcome your comments.

Dr. John.

 Welcome everyone to another episode of In Depth With Academia. I’m Richard Price, your host and the founder of academia.edu, and I’m here today to walk you through a fascinating of work, one that well might seem a little technical at first, but I promise there’s something pretty important here for all of us, no matter what your background is.

the paper I’m diving into today is by Dr. John Rutledge, and it looks at Japan’s real interest rates during its so-called lost decade plus, the extraordinary financial strategies and misguided policies that shaped the economic history of, one of the world’s largest economies.

What’s the main question? Dr. Rutledge tackles Why did Japan stay stuck in deflation for so long? Despite ultra-low interest rates and frankly, Herculean efforts by its government and central bank to pump up the economy? And more importantly, what should we actually make of real interest rates is the way most economists measure them actually capturing what’s happening in the real world.

That’s not just a technical puzzle for economists. This is the kind of thing that influences your investments, your pension, even your job security. If you’re part of this global economy, so why does this matter to you? Well, understanding what drives economic growth or contraction affects decisions about saving, buying property, taking out loans, and even how governments try to get us out of recessions.

If the story we tell about interest rates and prices is off base, it means a lot of policies could, um, actually make things worse. Now let’s dig into the heart of Rutledge approach. Here’s the deal. Most economists and the Bank of Japan at the time assumed that if you set low nominal interest rates, you’re making money easy to borrow and therefore stimulating the economy.

Hold on. Maybe you’re looking at the wrong measurement. Instead of focusing on nominal rates or using the consumer price index, CPI to adjust for inflation, we should be paying attention to the gap between returns on financial assets like bonds, and returns on real tangible assets.

Think land buildings, commodities that people use to store wealth into the future. rather than subtracting CPI inflation from the nominal rate to get a so-called real interest rate, Rutledge suggests using something called the TPI or Tangible Price Index, which in his work he proxies with Tokyo land prices.

Because land is long lived, holds a ton of value and is critical for wealth in Japan and. Get this. While CPI based measures suggested money was easy, the real rates based on uh, tangible assets were actually the highest in the world. People just didn’t want to buy property because prices were still falling, and that creates a massive drag.

I want to pause for a second here because. Honestly, it’s a bit weird to think about, like, do you ever think about how the value store aspect of wealth, whether that’s stocks, gold, How that storage of value plays into economic cycles. In Japan’s case, the negative land price inflation made people not want to invest. Not want to take risks and made it hard for businesses, especially manufacturers who hold lots of physical assets to keep their heads above water. Rutledge argues that Japan’s Central Bank actually kept monetary policy way too tight because they only looked at interest rates and inflation through a textbook Keynesian lens. Rather than understanding the real world asset-based mechanisms, Keynes himself described, especially in chapter 17 of his general theory, if you’re a Keynes nerd, that’s a fun rabbit hole, by the way.

Okay. The key finding here is that high real interest rates based on tangible assets explain Japan’s stagnant growth. And more critically, that ending deflation would probably add at least two percentage points to Japan’s growth rate. Policymakers actually measured and targeted these sorts of real returns.

They’d realize that until asset price deflation ends, there’s basically no hope for strong recovery. So for you, the listener, what does this mean? Well, first question, assumptions. Just because the numbers say easy money doesn’t mean people are actually incentivized to invest or spend. It depends on what’s really happening with the assets that matter in your life.

And second, seeing how academic research questions established measurement methods can make us all a little more humble or maybe just a little wary of claims about economic certainty. As always, remember, I’m not endorsing the view here. Dr. Rutledge perspective is one lens, and like all academic research, it invites us to keep exploring questioning challenging.

Thanks for joining me on in depth with academia. If this episode made you think about Japan money. Or, maybe just made you want to check your own savings, you’re in the right place. and until next time, keep exploring the incredible, imperfect world of academic thought.

Thank you for listening to Asset First Economics. You can find more information on our Asset First Economics podcast and video series at www.safanad.com, and you can find the complete downloadable archive of my written work at Dr. John Rutledge dot substack.com.

Dr. John

Summary: The most important economic report for investors is not the Employment Report, the CPI report, or the GDP report. It’s the 210 page Z.1 report on the U.S. balance sheet that the Fed publishes once a quarter but no one ever talks about. It’s more important because, in the most recent report, total U.S. assets of $576 trillion and Household Net Worth of $186 trillion dwarf our $31 Trillion GDP and our $2 trillion budget deficit. As you know from my earlier posts, Asset-First Economics is based on the idea that all major economic events take begin in the balance sheet and the only economic policies that really matter are the ones that trigger changes in people’s decisions on which assets to own. The most important decision is always how to divide wealth between tangible and financial assets. Gold, silver, platinum and copper markets show which way they are going today. Hint: I own more gold today than any previous time.

The Z.1 Report

If you are going to build an asset-first economic framework you’re going to need a source of good information on the values of assets, liabilities, and net worth on household balance sheets. Problem is, most of the economic reports you hear about on TV and read about in the Wall Street Journal were designed to measure what’s happening to flows of spending, employment and production in the national income (GDP) accounts, not stocks of assets.

There’s only one place to get good balance sheet information—the quarterly Z.1 report Financial Accounts of the United States published by the Federal Reserve Board. Before you download it, I should warn you that it is a 210 page report so you will need a little time to dig through it. But it’s time well spent.

Key balance sheet metrics

Some of the more important metrics from the current Z.1 report for Q3/2025 are summarized in my hand-written notes from my initial reading of the current report below.

At the top of the page, you will see that on 9/30/2025 the U. S. balance sheet contained $383 trillion of total assets (approximately 20x 2025 GDP.) The net worth of households and nonprofit organizations was $181.6 trillion (roughly 6x 2025 GDP.)

The yellow highlighted Box 1 on the upper left reports the details of the U.S. worth calculation on page 8 of the report. According to the Fed’s methodology, the U.S. net wealth is the result of adding the market value of tangible (nonfinancial) assets owned by households and nonprofits ($61.2 trillion), nonfinancial noncorporate businesses ($19.2 trillion), financial noncorporate businesses ($0.158 trillion), corporations ($90.2 trillion), the federal government ($4.9 trillion), and state and local governments ($17.1 trillion), then subtracting an estimate of net foreign assets owned by people in other countries. That leads the Fed to conclude that U.S. net wealth (the whole country, not just households) on September 30, 2025 was $167 trillion, up by $5.2 trillion, or 3.2%, over the previous quarter.

Wait a minute! Why did they just add up the tangible assets? What about all of the paper assets? Their logic, which (mostly) makes sense, is that every piece of paper that one person owns is a liability of the person who issued it so financial assets all cancel out. Read below for the reason I said “mostly.”

It shouldn’t surprise people that the balance sheet numbers are so big, both as absolute numbers and as a multiple of GDP. After all, the pile of existing tangible assets contains all of the natural resources that we received from Mother Nature plus everything that we have produced over the past 250 years that we didn’t consume yet or didn’t wear out. For example, there are 142 million existing homes already in place. Since we only produced a little over 1 million homes last year (that’s the figure that will appear in the GDP accounts) the supply (stock) of homes is fixed. So the only thing that can change their prices in a period as short as a year is a change in asset demand.

In spite of the fact that the reported numbers are so big, there are two important reasons why I believe they are significantly understated.

1. First, all government balance sheets (federal, state, and local) intentionally (and nonsensically) exclude the value of all land and other non-reproduced natural resources from the balance sheet. That means the Federal government has properly reported the value of all the mail trucks and black Cadillac Escalades they own but they forgot to include the value of 700 million acres of federally-owned land. Oops. I have no idea how they convinced the accountants to go along with it but excluding the value of the 700 million acres of land owned by the Bureau of Land Management and other agencies and all of the timber, minerals, and other natural resources is nuts.

2. Second, for some reason, the official balance sheets treat the value of corporate equities as liabilities in calculating net worth. As a result, for example, the market value of Apple and Microsoft stock owned by households is completely erased by subtracting the same number from the net worth of the corporate sector. That would make sense if they were debt securities but makes no sense at all for equities. Creating a business that is worth more than the initial capital invested in it is literally the entire purpose of corporations. Adding it back in would increase net worth by about half.

Box 2 on the upper right shows the calculation of U.S. total assets ($576 trillion) as the sum of total tangible assets ($193.3 trillion) from Box 1 and total financial assets ($383 trillion) from page 3 of the report. Tangible assets make up 33.5% and financial assets 66.5% of that total. (Note: tangible assets made up more than 50% of total assets when I first started tracking this in the late 1970s.

Box 3 is a calculation I keep track of to help me not lose sleep over the national debt. Federal debt of $33.2 trillion amounts to 5.8% of total assets, 19.9% of national wealth, and 18.3% of household net worth. More on that below.

Box 4 on the balance sheet of households and nonprofits is the really interesting one to me. Households own $202.8 trillion of total assets, made up of $61.1 trillion (30.5%) of tangible assets and $141.2 trillion (69.5%) in financial assets like stocks, bonds, and bank accounts. In the tangible asset detail, households own $50.2 trillion of real estate and $8.5 trillion of sofas, dishwashers, used cars and other durable goods. Household net worth, at $181.6 trillion, about 6x last year’s GDP and 7.9x the annual Disposable Personal Income of everybody in the country.

Households have liabilities too (mostly mortgages) of $21.2 trillion, which is just 11.7% of household net worth. After subtracting (paying off) mortgages, households own $33.4 trillion in home equity, which is 71.6% of the value of their homes.

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So What?

OK, people have a lot of assets and a huge net worth. So what does that mean? I have gone over the implications of Asset-First Economics in some detail in recent text, audio, and video posts. Here are a few of the reasons why that’s important.

1. The fact that Asset markets are way bigger than goods and services markets implies that most of the big economic stories in our lifetimes have been balance sheet stories. That’s what investors need to keep track of.

2. Asset markets are different. The fact that stocks are so much bigger than flows means that the supply of assets can’t materially change over the course of a year. That means almost all asset price changes (which is what investors care about) are the result of changes in demand, not supply. As a corollary, the much-lamented housing affordability crisis is entirely the result of houses being expensive, not supply restrictions. Houses are expensive because households really want to own their house.

3. As a result, asset prices are almost entirely determined by how households choose to divide up their net worth between tangible and financial assets. That decision is strongly influenced by government policy on tax rates, interest rates, and inflation because those policies directly affect the total return of different kinds of assets. For example, inflation (inflation of tangible asset prices, not consumer prices) matters because it measures the capital gains yield on the stock of tangible assets. And the deductibility of mortgage interest and the ability to expense capital spending matter for the same reason.

4. And finally, I will drop in one fact that almost everyone reading this is going to hate. We all hate debt. We especially hate big budget deficits and the national debt. But federal debt only amounts to 5.8% of total assets and 18.3% of household net worth. And remember, net worth grows over time, both because we produce new assets and because their market prices go up. Over the past 50 years, household net worth has increased by an average of 7% per year, which households will dutifully allocate to different categories of tangible and financial assets in their portfolios. One of those categories is Treasury securities. If household net worth grows by 7% ($12.7 trillion) next year and they want to keep the same percentage of net worth in Treasury securities as they held this year. To do that, they will have to add an additional $2.3 trillion to the Treasury securities they already own. The only way to do that would be for the government to sell $2.3 trillion in new Treasuries—run a $2.3 trillion budget deficit—next year in addition to rolling over any securities that reach maturity. If they do so, people will gobble up the new Treasuries and there will be no meaningful pressure on asset prices or interest rates.

I will give a longer treatment of budget deficits, the national debt, and interests rates in more detail in my next post.

Dr. John

Summary: Welcome to Asset-First Economics. In this episode, we discuss two ideas from my published papers. The first is that all economic activities are energy transformations and all economic change is driven by the Second Law of Thermodynamics. The second is that the market economy is a far-from-equilibrium, Complex Adaptive System with an Achilles Heel--the  temporary, abrupt, and violent phase transitions that we call financial crises.

Investors who understand these ideas have a real advantage over those who don’t.

I created the audio file using Notebook LM to produce a simple summary of the main ideas. You can download the original source article from the Review of Financial Economics by clicking the following link. A transcript of the audio file is below. You can find more information on our Asset-First Economics podcast and video series at www.safanad.com. An archive of my written work is available at drjohnrutledge.substack.com.

As always, I welcome your questions and comments.

Dr. John

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For Those Who Prefer Reading:

You can download the original article in the Review of Financial Economics by clicking this link.

Transcription of the Audio File

Welcome to the Deep Dive. We are going straight into the deep end today, synthesizing a truly fascinating stack of articles by Dr. John Rutledge. Quite a stack. We have decades of economic history, complex systems theory, and even physics, specifically thermodynamics, all coming together to explain something very concrete.

The really erratic relationship between inflation, interest rates and financial crises. It sounds like a wild jump from physics to finance. But that’s really our mission here. We’re taking these traditional economic concepts and looking at them through this powerful if a bit counterintuitive lens of a far from equilibrium framework, and why do we need to do that.

The standard models that assume the economy just chugs along your smooth, gentle equilibrium. They just completely fail when the real world gets hit by massive sudden shocks, and that failure is huge. I saw one of the sources put the global economies balance sheet, so the value of all assets, stocks, real estate at $566 trillion at the end of 2024.

Yeah, $566 trillion and the actual economic flow, the GDP, is only about $30 trillion, so the standard models are focused on the small flow, but they completely ignore the massive reservoir that can have these violent, unpredictable swings. We need a map for those swings. We need a framework that treats catastrophic events like 2008 or the inflation of the seventies as well.

Normal outcomes of a complex system, not as some gentle temporary shock that you can just model away. Okay, so to get to the root of this, we have to go back in time. Let’s start with the early 1980s? Economists back then were really grappling with this brutal persistent inflation, and the main idea was all about price stability and how people, you know, structured their wealth.

This gets us back to something called the portfolio balance Theory. The core idea was actually pretty simple. It said interest rates are basically two things. The real interest rate. So the return you get after inflation, plus whatever you expect inflation to be. But the real driver, the mechanism behind it all was the collective portfolio decisions of households.

That’s the key. It was all about what people chose to own. So interest rates weren’t just a lever the Fed pulled, they were a reflection of what the average person was buying and selling. So walk us through that asset market whiplash of the seventies and eighties when inflation started raging.

What did people do to protect their money? It was a massive capital migration, just a huge shift. People abandoned financial assets, stocks, corporate bonds, you name it. Because their value was just getting eaten away. Eroded by inflation. So instead, they move their capital into tangible assets, things you could physically touch, like housing, gold, and farmland. That’s trillions of dollars moving out of traditional credit markets.

Okay, wait. Connect the dots for me. How does me buying a house for some gold directly push up interest rates? Because that capital is no longer available to lend. If you’re buying land, Instead of buying bonds, you’re effectively shrinking the supply of credit available to borrowers.

Ah, and with less credit supply, assuming demand stays the same, the price of that credit, the interest rate, has to go up dramatically. And I assume the reversal was just as dramatic when disinflation kicked in during the eighties? Precisely. As soon as Paul Volcker showed he was serious about fighting inflation, expectations flipped direction. Financial assets looked safe again, not just safe but profitable. So capital reverses course, flooding back into bonds and stocks. That surge in demand for financial assets made bond prices rise and by definition interest rates fell sharply in 1982.

That’s what economists call arbitrage. Okay, so let’s use that concept of arbitrage, the relentless flow of capital, as our bridge to physics. We’re moving from supply and demand curves to energy gradients. This is where it gets really interesting.

Yeah. This is the leap. What happens when we view that whole economic process, even that 1980s portfolio shift as a system governed by the laws of thermodynamics?

The first concept to grasp is that all economic activities are just energy transformations. The ultimate source of all wealth is solar energy, either current, like a solar panel or vintage stored energy that could be fossil fuels. But it’s also the complexity stored in our infrastructure, in technology, and in human knowledge.

So if the economy is an energy transformer, then we have to distinguish between useful output and waste. Just like a power plant. Exactly. Thermodynamics, separates organized, useful work from waste, which is heat. Economic work is coherent energy transformed by production or innovation, and economic waste in the form of heat.

That’s incoherent energy, wasted effort, bureaucracy conflict. Good policy from this perspective is just anything that encourages coherent work and minimizes waste, heat. That analogy clicks immediately. We’ve all seen effort turn into heat instead of work. So how does the second law of thermodynamics, the rule that energy has to disperse, how does that drive the system?

In physics, energy flows down a gradient. Hot to cold. In economics, we call that arbitrage. So arbitrage is just the second law at work in our world. It is, it’s driven by these energy gradients. These are just differences in prices, wages, or going back to our 1980s example, in the expected returns between tangible and financial assets.

The steeper the gradient, the faster the flow. And that flow, in turn, flattens the gradient a little bit.

Arbitrage is this universal force just relentlessly exploiting those differences. And technology has just turbocharged this whole process. Optical fiber and high speed communications have dramatically lowered friction. Moving capital used to be slow and expensive. Now it flows at the speed of light.

And while that makes markets incredibly efficient, reducing the heat from transaction costs, there’s a downside, a huge one. The increased speed also massively increases volatility in the systems. Well, it’s susceptibility to crisis. It’s like speeding up a river. It gets where it’s going faster, but the rapids are way more violent.

That’s a perfect analogy. And this brings us to the core concept, non-equilibrium thermodynamics or NET. Okay. Traditional economics, focuses on systems near equilibrium with smooth, gradual change. But NET argues that the most important events happen when the system is pushed far from equilibrium. So we need NET to analyze these abrupt, discontinuous changes that physicists call phase transitions.

What’s the financial aha moment here? What’s a phase transition in finance? Think about water. You heat it up, it expands smoothly. That’s near-equilibrium change. But then suddenly at a hundred degrees Celsius, it abruptly turns to steam, a completely different state.

That’s a phase transition. In finance, we call them financial crises. Sudden market collapses. The best way to think of them is as temporary network blackouts.

A network blackout. Unpack that for me.

A market is basically an information network. Prices are the signals. In a crisis, trust just evaporates, liquidity vanishes, and prices stop transmitting reliable information.

The system just breaks. It switches from a functioning state A, to a broken dysfunctional state B. It’s a cascading network failure. The whole system’s capacity to transmit information just drops instantly. That makes so much sense. It reminds me of those old fluid dynamics experiments. You increase the velocity of a fluid and at a certain point it just snaps from smooth, predictable flow to chaotic, turbulent flow.

That’s the core realization from the NET framework. We have to accept that the economy can exist in at least two distinct states. And a crisis is just the violent switch between them. And we can actually model this cycle as a round trip

State one is the potential output state full employment where prices are efficiently transmitting information to the people who need it to make decisions.

State two is the failed netwo state where trust is gone and credit is rationed. All right, let’s apply this map to a real event. Let’s use the Subprime Mortgage crisis to walk through the four stages of this round trip.

Okay Stage one. That’s the run-up say 2003 to 2007. The system is near full employment. Profits are strong. Valuations are climbing. But good times, breed complacency, excessive optimism. Credit discipline gets weaker and weaker across the system, and we get closer and closer to that threshold of turbulence, the classic setup for a Minsky Moment.

That’s point A. It triggers stage two, the phase transition itself. The violent collapse. It’s usually short, weeks, maybe months, but incredibly destructive. The system switches from State One to State Two instantly, and this move forces over leveraged investors to sell. They become forced sellers regardless of the quality of what they’re selling.

And during that collapse, what are the only assets that actually do well? Historically, only cash and high quality government bonds. Cash holds its value and bonds rally because of a flight to safety and central banks cutting rates like crazy. Everything else gets hammered. So the destruction is done.

Now we enter State Three, the bottom. This is where find the real pain and the real opportunity. State Three is the recession, and the lenders are forcing fire sales. People who can’t service their debt are forced to liquidate assets at huge discounts, so it’s painful for them. But for an astute, unleveraged investor, it’s the time of extraordinary opportunity.

If you are holding cash, you are now a king. You can buy assets at a price far below their real value. And the sources say this is especially true in real estate. Absolutely. The biggest fortunes in real estate are often made by buying depressed assets during these State Three fire sales. When credit is at its tightest, you’re buying value that the temporarily broken network can’t even see.

And that leads us finally to State Four, regrowth and the journey back to full employment. State Four is the investor’s Paradise. Markets slowly become more accommodating. Credit eases up and the economy starts growing again. Returns in this stage are explosive. Why explosive? Because they’re driven by two things at once, improving performance of the actual assets and the market, re-rating those assets back toward their normal valuations.

You get a double whammy on the way up. You do. Post subprime, for example, hospitality assets climbed 322%. Industrial assets, 272%. Huge gains during that recovery phase. It’s the snapback effect. We’ve used this framework for financial volatility, but in another article, Dr. Rutledge also applies it to something else. The resilience of cities, especially after a shock like the pandemic?

Cities are classic, complex adaptive systems. They have huge network effects. They exhibit something called super linear scaling. Okay. Define that for us. Super linear scaling means that if you double the population of a city, the socioeconomic outputs like wages, GDP, and patents don’t just double, they increase by about 15% more than you’d expect from linear growth. So doubling the inputs gives you more than double the output. That extra 15%, that’s the magic that is the persistent energy gradient. That 15% productivity advantage acts as a massive gravitational force, pulling innovative and ambitious people back no matter what happens.

So, even after a pandemic, people return. History shows they always return to successful urban centers. The network advantage is just too powerful to give up long term. And from an investment strategy perspective, that scaling law is a really powerful predictive tool. The research shows that a city’s relative advantage tends to be preserved for decades.

So investors are wise to focus on top quality assets in places like New York or San Francisco because their underlying network structure pretty much guarantees they’ll recover faster and stronger, and you’ll capture that explosive Stage Four recovery game.

This has been a remarkable journey. We started by looking at inflation in the 1980s forcing a portfolio choice, which then set interest rates. And we ended up realizing those big financial shifts are just manifestations of energy flows, arbitrage driven by return differentials that can push the whole economic system into a completely different state. And that thermodynamic view forces us to confront some uncomfortable truths. It challenges standard financial models because it says there’s no single fixed risk-free rate in a world that can flip between states. When the system shifts, all our assumptions about risk and value have to shift with it.

Which brings us to our final provocative thought for you to consider. Since the economy is prone to those violent stage two phase transitions, cash isn’t just a low yield asset. It’s something more, it functions as a composite security. It embodies a highly valuable, real option.

In a State Two credit crisis liquidity is gone. The cash you’re holding has an extremely high shadow price. (You can think of a shadow price as a black market price.) Holding that cash gives you the option, but not the obligation, to purchase incredible assets at fire sale prices for potentially extraordinary gains when the economy eventually climbs back to State One. So you should consider what premium you are truly willing to place on holding that powerful option today because its value spikes precisely when you need it the most. 

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You can also view and download the video on YouTube here.

https://lnkd.in/guUuY-dD

I hope you enjoy and would welcome your comments and questions on the ideas.

Summary: This post serves three related purposes. First, it gives a short history of Asset-Based Economics, the analytical framework that I have built over the past 45 years to repair what I view as structural weaknesses in standard textbook macroeconomics. Second, it is an experiment in using a new audio technology, in the form of a podcast, to augment the video series I am producing for Safanad. Third, it is a request for questions, comments, and advice from my readers about what you would like to see in this series. Hope you enjoy and look forward to hearing from you.

But first, I want to say Merry Christmas and thank you to all of the people who have read my work and contributed ideas in so many ways since my first piece was published 53 years ago. You are truly the reason why I write.

What is Asset-Based Economics?

In many ways, Asset-Based Economics is a summary of my professional life’s work. I have been building, testing, and refining it, and using it to restructure corporate balance sheets and manage investment portfolios since I was a graduate student in the early 1970s. I’m about halfway through writing a book about the ideas and my adventures along the way to discovering them. I’ll post the chapters one by one here on substack and on the Safanad website as they are complete.

The driving force behind all of my work was the cognitive dissonance I experienced when comparing textbook macroeconomics with what I was seeing in the real world. They just didn’t match.

Asset-Based Economics rests on two fundamental ideas.

The first is that balance sheets—both tangible and real assets—are too big to ignore. The official numbers put the U.S. balance sheet at $566 trillion balance sheet about nineteen times bigger than GDP, which is about $30 trillion per year. So it shouldn’t come as a surprise to learn that even a small disturbance in our balance sheet, say, when people change their minds about what they want to own, will swamp any change in spending, saving, or borrowing taking place in the GDP accounts. That’s why, to a first approximation, all big economic and financial market stories are triggered by balance sheet events.

The second idea is that the economy is a living, breathing, complex adaptive system in which observable events depend more on the interactions among people than on the so-called rational decisions of a utility-maximizing robot. Friedrich von Hayek taught us almost a century ago that a market economy is a vast and efficient communications network that transmits signals, using symbols called prices, about relative wants and scarcities to the people who need the information to make decisions about what to produce and what to consume. That market economy works very well most of the time but, like all networks, experiences occasional system failures, or blackouts. In investing, we call those cascading system failures “financial crises” when markets shift abruptly from price-clearing to nonprime rationing. The bad news is those situations are sudden, violent, and unpredictable. The good news is they are temporary.

Asset-Based Economics puts the two idea together in a framework that focuses on balance sheets to understand both how economies behave when they are operating in a near equilibrium state and when they are operating in a state far from equilibrium.

So, I decided to put a full description of this framework down on paper to share with readers. The problem is how to do it. I have an entire bookcase filled with 1200 or so books and articles I have written about these ideas over the past 50 years. The audio recording above is a start at telling the story.

The Podcast technology

The podcast, attached, is a first attempt at putting together a history of the ideas. I produced it by uploading a half dozen of my own articles that I wrote over the years along with an excerpt from Bob Bartley’s Seven Fat Years that describes how my early work fit into the policy and Wall Street environment at the time I wrote them. I used Google’s Notebook LM AI software to summarize the articles and convert them to a podcast format where two hosts talk about the ideas. The only thing I will say about the technology, other than the fact that is very fast and very amazing, is that 1) to my reading it did an extremely accurate job summarizing the ideas, and 2) it treated both me and my ideas with kindness and respect, perhaps even more than deserved.

I have listed the articles I uploaded to make the piece below along with links to the articles in case you would like to read the originals. And you can see my related videos on the Safanad Chief-Strategist page. Hope you enjoy.

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Historical Articles Used in the Podcast

I gave Notebook LM 6 PDF files.

1. Wall Street Journal Op-Ed, December 14, 1981, “Why Interest Rates Must Fall in 1982.”

   In this Op-Ed, I argued that the debate raging on Wall Street, whether or not there would be enough savings to finance the budget deficit without increasing interest rates, was wrong. Interest rates, and all other asset prices, will be whatever they need to be to make people willing to own the stock of existing tangible and financial assets. The inflation rate that matters for interest rates is real Asseet inflation, not the CPI. Inflation was already headed lower. Interest rates must fall.

2. New York Times Op-Ed, June 20, 1982, “Ghost Town.”

   In this Op-Ed, I pointed out that corporations and households had loaded up their balance sheets with inflation hedges and tax shelters during the late 1970s, that they would be lining up to unload those assets to restructure for low inflation, and that the resulting drop in real asset prices would cause irreparable damage to many companies.

3. Wall Street Journal Op-Ed, August 4, 1983, “The Structural Deficit Myth.”

   In this Op-Ed, I suggested that the “Structural Deficit” that worried many on Wall Street was a monster under the bed and that interest rates would continue to fall.

4. Financial Times Op-Ed, October 25, 1985, “The Forest Fire of Disinflation.”

   In this Op-Ed, I described a rolling real asset deflation process in which the restructuring activities of some companies can lead to asset price changes that force other companies to follow suit, leading to a decade of restructuring.

5. Robert Bartley, 1992, Seven Fat Years, pp. 125-128.

   This is Bob Bartley’s classic book on the history of the Reagan Economic Plan that Larry Kudlow and I helped create and show it worked its way through the economy. The pages I uploaded contain Bob’s thoughts on the contrast between my interest rate analysis and the dominant flow of funds approach used on Wall Street by Dr. Doom and Mr. Gloom.

   Bob was the editor of the Wall Street Journal for many years, won a Pulitzer Prize, and received the Presidential Medal of Freedom from President George W. Bush in 1983.

6. Safanad. “The Impact of COVID on Urban Real Estate.” “Part 1 of 2: COVID and Urbanization. Cities hit hard by COVID. Review of historical, Economic and Scientific Literatures”, and Part 2,” and “Part 2 of 2: COVID and Cities. Investment Strategy.”

   This is a piece I wrote for Safanad that reviews the academic literature in both economics and physics on the resilience of cities, my analysis of the 2008 subprime mortgage crisis, and how an economy works through the multi-state dynamics following a cascading network failure. This is my best attempt to describe the economy as a complex adaptive system and credit crises as phase transitions. It also contains estimates of which investment strategy performs best in each phase of the process.

Help Please

OK, now to the please help part. It’s clear to me that many readers/viewers prefer to engage with ideas in short audio or video format but I am not sure how many or what would be the most helpful format. I am experimenting with both audio and video podcasts where I have a conversation with a friend/host on topics of interest to subscribers rather than an AI generated podcast produced from my written work. It would help me a lot if you would send me a comment with your opinions on how you would best like to see the information delivered.

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And thank you for reading and listening.

Dr. John

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My Asset-First Economics Book Project

As you may know, I am writing a book to explain the Asset-First Economics framework that I have developed help people to understand economic change and to protect their family’s capital from the occasional cascading network failures that we quaintly refer to as financial crises. Those the times when all the real money is made and lost by investors.

The asset-First Shift framework has two essential differences from accepted contemporary economics models.

Our Big, Beautiful Balance Sheet

The first is that it is built on the foundational fact that our $566 trillion U.S. balance sheet, not our $30 trillion GDP, is where all the big stories in economics originate. Those stories happen when investors receive information that makes them change their mind about the assets they want to hold, typically when a change in inflation or tax rates alters the after-tax return on our $171 trillion stock of tangible assets.

Our Amazing, Quirky Complex Adaptive System

The second is realizing that the economy is a complex dynamic system built on a communication network that uses price signals to transmit information about wants and scarcities across the vast information network we call a market economy. As von Hayek told us 85 years ago, that price system is an extraordinarily efficient invention. But, as recent work in complex systems and network theory how, all networked experience failures from time to time. The big, infrequent ones are called cascading network failures. In the newspapers and on cable TV, they call them credit crises.

I will keep you posted on my progress on the book—maybe 40% drafted at this point. In the meantime, I am going to make a series of short videos that introduce some of the ideas I will treat in the book. I have dome more than 10K TV hits in my career but that’s different because you are speaking with a knowledgeable anchor and there are experienced professionals in the control room. These are made at my desk and I am in learning by doing mode. Because of that, I would be delighted to receive any comments or advice from you about what you would like to see in the videos.

Thanks for reading and for watching my video.

Dr. John

If you are tired of tribal chest thumping and blaming our problems on others you will like to read this marvelous book by Johan Norbert, who reminds us of the benefits of living together and talking with each other in an open society. And it will help us remember the role that trade and immigration have played in our histories.

I have included an image, below, of my notes from reading the book on bits I will want to refer to later. Hope they are useful.

Here is a quote from Karl Popper written in 1945 at the close of WWII to get you started:

“Civilization has not yet fully recovered from the shock of its birth—the transition from the closed society or “enclosed society”, with its submission to magical forces, to the “open society” which sets free the critical powers of man. The shock of this transition is one of the factors that have made possible the rise of those reactionary movements which have tried, and still try, to overthrow civilization and return to tribalism.”

Dr. John

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To help jog my memories, Scott graciously send me a copy of Tip and the Gipper, Chris Matthew’s wonderful book about the way politics worked in the days when our leaders could fight like hell all day and still enjoy having dinner together. I miss those days more than I can say.

As some of you know, I attack reading a book with a pen in both hands, marking the hell out of the parts I want to remember. I can’t show you every page here but I did take a pic of my notes from the inside front cover to help your reading.

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Here are a few of the points I want to remember:

• “They respected elections, accepted who won, knew that duty came with office.” (p. xvii.)

• “…there is a political center in America that can govern for the benefit of the country even when there are extremely difficult problems to be faced and strongly held differences of opinion…” (p. 250.)

• “They argued mightily each man belting out his separate, deeply cherished political philosophy—but then they would, both together, bow to the country’s judgment.” (p. xv.)

• “You can disagree and still be friendly.” (p. 293.)

• Why did it work? “Both had been brought up to respect positions of authority…Both preferred to play by the rules…Neither acted like a spoiled kid…Always be able to talk…” They were two old Irishmen who had to work together to get things done. (p. 367).

I’m looking forward to talking with Scott and an extraordinary group of Institutional investors, family offices, fund managers, and business owners about the importance of moving away from today’s government by tantrum and back to governing with civility. I like to think that we can do that.

And please read this thoughtful book.

Dr. John

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Summary: Last week I reminded you that excess of fear and anger in the world is going to last a long, long time. Fear and anger drive people into the imagined-safety of their own tribes where they line up behind strongman leaders and blame their problems on the other tribe. The result is tribal warfare, radical change, and unstable economies and financial markets.1 And I advised you that when headline events make you scared or excited you should step away from your portfolio, as I do, and walk around the block. Never allow emotions like FOMO and FONGO trick you into a bad investment decision.2

Yesterday I got to walk around the block 6 times when stock markets tanked. Or, as I prefer to think about it, when the market put all of the best companies on sale. But don’t buy them just yet. As I explain below, conditions like these can push financial markets into the state of temporary paralysis we call credit crisis. In this post, I show you an analysis of the 2008 crisis and explain why more liquidity and less leverage can protect your capital.

What to Do When We’re All Outraged

Before I launch into credit market failures and what to do about them I want to ask you to read a book. I had the good fortune to learn to read very fast at a young age, so I don’t read books; I devour them. As you know, I have been fascinated by the link between pandemics, human behavior, and system science, so I read more than a hundred books on epidemiology, history, evolutionary biology, sociobiology, and social psychology over the past year. I learned a ton.

I read a book today that I want to recommend to you, Outraged, by Kurt Gray, a Professor of Psychology and Neuroscience at UNC. It explains that evolutionary history has hard-wired our brains to protect our families from predators by collapsing into defensive tribes when we feel threatened or vulnerable to harm. That is what has happened to politics, in the U.S. and everywhere else, over the past 5 years. Both sides feel that “we” are victims and “they” are trying to harm us. We have stopped communicating across tribes and get all our information within our own echo chambers—one team only listens to MSNBC, the other only listens to Fox News. And we have developed false beliefs about what the other tribe is thinking, feeling, or doing.3 Gray’s research finds that each team thinks of the other team as less intelligent than their own and that each team thinks that the other side lacks a basic sense of right and wrong. The result is certain conflict.4

Without giving away the spoiler about what Gray says we can do to unwind the situation I will give you my short pitch about where we are today. IMHO, we are the luckiest people in the history of the world with both more freedom and a higher standard of living than anyone who has ever lived and than most of the people alive on earth today. Not too long ago, we all knew we were on the same team, and we all knew that we were on the winning team. But, somehow, we forgot all of We broke the country.

We have to fix this thing for our kids and grandkids. And we need to do it now. To do that, we’re going to have to stop blaming each other, stop referring to each other as lefties or righties or socialists or fascists, lose the “-isms”, and learn how to work together again. As Kissinger reminded us, “even paranoid people have enemies.” There actually are people out there who would like to do us harm. They love it when we are mired in tribal warfare. Think about it.

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More Liquidity/Less Leverage

Adequate liquidity and low leverage are paramount during an extended period of fear and turbulence.

Tribal warfare, itself, is a source of systemic risk. Network theory teaches us that the associated reduction in trust increases the likelihood of extreme outcomes. It also increases the fragility of financial and communication networks, raising the chances that a large and highly connected information network abruptly fractures into a collection of smaller networks that no longer communicate with each other, much like politics has disrupted communication between friends and in families.

In network theory, these events are known as cascading network failures.5 In economics, we call them credit crises. They occur when buyers and sellers of financial assets no longer trust that the prices they are quoted by highly connected market participants accurately reflect underlying scarcity and no longer believe that liquidity will be there when they need it. In a credit crisis, a market abruptly switches from price-clearing to nonprice-rationing. The most memorable recent example was the 2008 Subprime debt crisis. The poster child was Lehman Brothers.

In the early days of COVID, I posted an analysis of the 2008 credit crunch. In my analysis, the sudden collapse of credit availability we call a credit crisis is a phase transition between a state of normal, price-clearing equilibrium and a temporary state of nonprice credit caused by a cascading network failure. In 2008, that phase transition is called the Lehman Moment when we all had the same look on our face as Wiley Coyote when he realized he had run past the edge of the cliff and solid ground was a long way down.

I prepared a graphic representation, which I have copied above, of what happens when a sudden phase transition throws the economy into an alternative state where businesses have to get by without access to working capital, how the broken network recovers back to normal over time, and how different asset classes perform along the way. I won’t give you the full explanation here but invite you to read it here.

The table above shows the returns on different asset classes—cash, stocks, bonds, and 5 categories of commercial real estate--for each phase of the credit crunch. The cumulative returns for each asset class are shown above. Read the full analysis here.

The lesson is clear. Cash and bonds are the only safe place to be during the crash phase of a credit crisis. To the extent that you hold cash, you will have underperformed relative to everything else during the prior Full Employment phase. But you will have preserved your capital during the crash and could have used the cash to buy top quality stocks and bonds at deep discounts and ride the escalator all the way back to the top for huge returns over the ensuing decade.

So where are we now? No one is capable of precisely predicting when the next phase transition is going to happen. But there are plenty of signs that we are ripe for one. We have enjoyed high returns for a long time. There are huge fixed-income and commercial real estate losses on regional bank balance sheets that will one day have to be written down to reality. As a result, banks have completely shut down business lending. Banks have made minus $42 billion of net new loans to their business customers since January 2023, i.e., they have collected $42 billion more in loan principal repayments from business customers than they have lent tobusiness customers over the past 2 years.

This puts the radical headlines coming out of Washington in a new light. Every announcement of a big program cut, government employee furlough, or suspension of outlays makes somebody clench up, reduce their purchases, and delay hiring and capital spending projects. All of these things push output lower. They reduce somebody’s income and raise questions about that somebody’s credit worthiness and the value of collateral behind outstanding loans. That’s why people are talking about recession again today.

To be clear, my point has nothing to do with whether any program should be cut or expanded. It is simply that if you try to do too much, too fast, in a cloud of uncertainty, you run the risk of eroding trust enough to push the financial network into nonprice rationing, creating an ugly downdraft in asset prices, and an interruption of economic activity. That’s something neither tribe wants to happen.

So, what can an investor do to protect capital from the risk of a credit crisis so you have sufficient purchasing power to be able to take advantage of a sharp drop in stock prices. In my case, I have decided to hold double the amount of cash that I would hold in a more normal time. For me, that number is 30% of total assets. And I am holding the cash in Treasury bills, currently paying 4.3%, so I have quick liquidity when I need it. I am not yet ready to deploy all of that cash, but that time may not be far away.

Dr. John

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References

Andelman, D. A. (2008). A Shattered Peace. New York: John Wiley & Sons.

Andelman, D. A. (2021). A Red Line in the Sand. New York: Pegasus Books.

Bak, P. (1996). How Nature Works: The Science of Self-Organized Criticality. New York: Springer Verlag.

Gray, K. (2025). Outraged: Why pe fight about morality and politics and how to find common ground. New York: Pantheon Books.

Haidt, J. (2012). The Righteous Mind. New York: Vintage.

Kandel, E. (2006). In Search of Memory. New York: Norton.

McNeill, W. H. (1977). Plagues and Peoples. New York: Doubleday.

I have decided that the best thing I can do is to let you know that these things are affecting me in the same way. Fifty years as a professional investor, however, have taught me to never allow fear or emotions to enter into an investment decision. That is both harder and more important today than at any time in my memory.

You and I have the same job. We are both charged with protecting and growing our family’s capital. That doesn’t change just because the world has become more uncertain.

There are 4 things we can do to mitigate risk.

1. Stop doomscrolling the Internet for news.

2. When events make you scared or excited, step away from your portfolio and walk around the block; never allow an emotion to trigger a trade.

3. Hold enough cash in your portfolio to offset both the financial and operating risk of the companies you own and the systemic risk of radical change—for me, that’s 40%, about twice normal levels.

4. Trim your portfolio to hold only the best companies with strong brands and IP, enough cash to weather storms and enough free cash flow to finance growth, pay dividends and, when appropriate, buy back their own shares.

Welcome Home

Last week was a first for me. This was the first time I took off from the Gulf region1 knowing the political risk would be higher when I landed at LAX than it was when flying over Tehran and Moscow.

The fear and anger that have divided Americans has erupted into mean-spirited tribal warfare that is tearing the country apart. I’m not going to review the talking points of either tribe here; you can get that on cable TV. I’m going to talk about how to be a successful investor no matter what your tribe.

FOMO and FONGO Both Cost You Money

One of the (very few) benefits of being old is you can look back at all of the mistakes you have made and ask what went wrong. In my case, some were caused by FOMO (Fear Of Missing Out)--the fear that someone else is getting something you are not. And some were caused by FONGO (Fear Of Not Getting Out)--the fear that someone else is going to get out before you do and leave you holding a bag of worthless stocks. Both types of fear cost you money.

I am a better investor today than I was in past years. It’s not because I’m smarter. It’s just that, after 50 years of making and losing money as a professional investor, I’ve been FOMO’d and FONGO’d so many times that I have learned how to not allow fear or anger to affect my investment decisions. That lets me ignore the headlines and focus on whether the companies I own pieces of, whether privately or through the stock market, are likely to produce the streams of sustainable free cash flow that make them worth owning. And it helps me identify situations where other people’s fears have pushed prices so far from underlying value that something is deeply undervalued.

All of which adds up to the most important thing I know about investing. When you have the responsibility to protect and grow capital—whether yours or someone else’s—you really can’t afford to let your emotions affect your decisions.

The interesting question is why we are so scared and angry today. Spoiler alert—it’s our neurons.

So, why are we so afraid?

Since January 2020, when we learned to spell COVID, I have warned readers repeatedly (see here and here for examples) not to let their guard down when they heard we had “beaten” the virus because the worst part of plagues is what happens when they are over.

As William McNeil (1977) wrote in Plagues and Peoples, there have been hundreds of plagues and pandemics in history—many more destructive than COVID. What investors need to know is that plagues in history were typically followed by twenty years or more of violent economic and political change that caused as much human suffering as the plagues themselves.

Why 20 years? Because, as Nobel Prize winner Eric Kandel (2006) proved, prolonged states of fear produce physical changes in the structure of neurons that produce a state of permanent hyper-vigilance. In Kandel’s words, “memory of traumatic experience remains powerful for decades…Indeed, after a single exposure to a threat, the amygdala can retain the memory of that threat throughout an organism’s entire life” p. 343. Through most of recorded history, when lifespans were barely half what they are today, 20 years would have been about the number of years a person old enough to remember the terror of plague had left to live. Today, that number would be much higher. COVID may be “over,” but the fear in our brains will never go away.

Why violent economic and political change? After pandemics, scared and scarred people retreat into the imagined safety of their own tribes, embrace strongman leaders, adopt us-versus-them rhetoric, and blame their problems on the “other” tribe. The result, time and time again, has been violent inter-tribal conflict, civil wars, and wars between nations.

The post-COVID version of this story is playing out now in the news headlines. My good friend David Andelman tracks every war, coup, and election—legit/stolen or otherwise--every week in his brilliant newsletter Andelman Unleashed. It is a sobering read.

The past two years have seen voters take a sharp shift to the right in the U.S., Germany, France, Italy, and the Netherlands (but, interestingly, not the U.K.) with tribes dividing along left/right, rich/poor, more/less educated, color, religion, origin, gender, language, and immigration lines in the sand.2

We have shooting wars. Russia invaded Ukraine with help from Chinese drones, Iranian missiles, and North Korean soldiers. Israel is waging war with Hamas and has exchanged missiles with Iran.

U.S./China relations are at a low point. China has dramatically tightened censorship at home and has imposed a chilling new national security law that has dried up the flow of Foreign Direct Investment (FDI) into China to a trickle.3 The U.S. imposed restrictions on the export of advanced technology goods and the machines that make them. China has embargoed exports of certain strategic minerals to the U.S., stepped up provocative naval actions in the South China Sea, and taken part in Russian efforts to sabotage undersea communications cables and gas pipelines in Europe.

Not to be out-headlined, the U.S. has threatened China, Mexico, Canada, and the E.U. with huge tariff hikes—all of whom say they will reciprocate—has floated ideas to take over Greenland, and the Panama Canal, and has demanded half of Ukraine’s mineral resources.

The number of coups, attempted coups, and conspiracies to overthrow a government has risen sharply since 2021. Governments have been overthrown in Bangladesh, Syria, Haiti, Gabon, Niger, Burkina Faso, Chad, Guinea, Mali, Sudan, Sri Lanka, Kazakhstan, Afghanistan, and Myanmar. The list of attempted, but failed, coups and conspiracies is a long one, including South Korea, Armenia, Belarus, Ukraine, the Reichsburger arrests in Germany, and the January 6 events in the U.S.

Then there is Putin, who meddled in elections in Moldova ($15 million in bribes), Georgia (stuffed ballot boxes), Romania (election annulled), and Mozambique. Voters threw out corrupt incumbents in Botswana, Ghana, and Senegal. There are mass demonstrations in Georgia and Kenya. Rwanda has troops (with no insignia on their uniforms) in Congo.

Needless to say, this hike in instability imposes a massive human cost. Based on the latest figures from the United Nations High Commissioner for Refugees (UNHCR), political instabilities forced 117 million people to flee their homes in 2023.4

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Investing During a Time of Instability

So, what does this have to do with investing? Everything.

Investing is difficult in the best of times. When things are turbulent, it is harder still. Here are five things that help me invest through this difficult period.

1. It is OK to admit that you’re scared. It is a scary time to be an investor and will continue to be so for some time. But remember, there have been much scarier times in history. Our parents lived through World War II, the Great Depression, the Korean War and the Cuban Missile Crisis. Their parents lived through World War I and the Spanish flu. Their parents lived through the Civil War, deflation, and banking panics.

2. This is a special place. We have survived bigger shocks than this. We will survive this one too. Be patient. It takes more than one generation to build wealth. Each of us has benefited from the work and thrift of our parents and grandparents. Our job is to help our children and grandchildren do even better.

3. Exhale and remain calm. Strong emotions lead to bad investment decisions. Leave your emotions at the door when you sit down to review your portfolio. If you can’t do that, hire someone who can do so to manage your portfolio.

4. Place your long-term bets on safety and on drivers of change that will outlast the turbulence. Don’t invest in anything exotic or exciting. Keep the bulk of your portfolio here at home, where you know what you are doing. The U.S. is still the safest and most stable place to keep your money. We are still the place in the world where people come to start and grow businesses and invent new technologies. And we still have laws and judges in long black robes to protect your property rights. None of that is going to change.

5. Adequate liquidity and low leverage are paramount during an extended period of fear and turbulence. Tribal warfare itself is a source of systemic risk. The associated reduction in trust increases the likelihood of extreme outcomes. It also increases the fragility of financial and communication networks, raising the chances that a large and highly connected financial network abruptly fractures. In network theory, these events are known as cascading network failures. In economics, we call them credit crises.

This puts the radical headlines coming out of Washington in a new light. Every announcement of a new program cut, government employee furlough, suspension of outlays, or potential tax increase makes somebody clench up, reduce their purchases, and delay hiring and capital spending projects until the fog clears. All of these things are pushing the economy and markets in the same direction. They reduce somebody’s income and raise questions about that somebody’s credit worthiness and the value of the collateral behind outstanding loans. To be clear, my point has nothing to do with whether any specific program should be cut or expanded or with which tribe is right and which is wrong. It is simply that if you try to do too much too fast in a cloud of uncertainty, you run the risk of eroding trust enough to push the credit network into nonprice rationing, a downdraft in asset prices, and an interruption of economic activity. That’s something neither tribe wants to happen.

So, what can an investor do to protect capital from the risk of a credit crisis? Protect sufficient purchasing power to be able to take advantage of a sharp drop in stock prices. In my case, I have decided to double the amount of cash I would hold in a more normal time. For me, that number today is 40% of total assets. And I am holding the cash in Treasury bills, currently paying 4.3%, so I will have quick liquidity when I need it. I hope that I don’t need to deploy the cash, but I am ready to do so if needed.

Dr. John

Selected References

Andelman, D. A. (2008). A Shattered Peace. New York: John Wiley & Sons.

Andelman, D. A. (2021). A Red Line in the Sand. New York: Pegasus Books.

Kandel, E. (2006). In Search of Memory. New York: Norton.

McNeill, W. H. (1977). Plagues and Peoples. New York: Doubleday.

Note: I recently gave the keynote talk for the MoneyShow Alternative Investments Conference. You can see a video of my presentation by clicking here or by clicking on the image below .

And you can download a PDF file of the slides I used on the keynote by clicking on the link below.

20241112 John Rutledge Moneyshow

1.12MB ∙ PDF file

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Summary

• I am a private equity guy and a real estate guy. I have been investing in private equity (PE) and real estate (RE), both as a General Partner and, in select cases, a Limited Partner, for more than 40 years. I love the work.

• Alternative Assets are not a thing. It is a term someone made up to describe the “other” things you can own besides stocks, bonds, and money market funds.

• A better description would be either “private markets” or "illiquid investments”. My friends in the intelligence community would describe passive stock and bond investing as “surveillance.” They would call investing in private, illiquid assets “wet work.” It is much more rewarding.

• When you invest in private markets, you are on your own. You leave behind the luxury of publicly available information and the stamp of approval from the SEC or a trustworthy auditor.

• When you sign up to invest in illiquid assets, you can’t change your mind and get off the boat halfway through the cruise. You are in for the whole ride. So, you’d better trust the captain (the General Partner).

• Even with these challenges, PE and RE investing offer opportunities to earn attractive returns while enjoying the privilege of being part of building great businesses.

• In this talk, I will review the strategies that the great PE and RE investors have used to find, acquire, build, and grow world-class companies. And I will talk about how you can use these ideas yourself to do the same work with the small and mid-sized companies in your own local market.

Dr. John

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Summary: After 50 years of investing, I have decided it’s time to share my secret strategy with you, the thing that will keep you in the game when things go bad. The secret strategy is to avoid SLS—Sudden Loss Syndrome—that happens when you put your money in something that can go “POOF!” and disappear when some guy decides he doesn’t like you. Today, that somebody is Xi Jinping. As I told the FastMoney crew, don’t be tricked by the China stock market head fake. Keep your money someplace where they have judges in long black robes to (usually) uphold the law. You can see a video of the interview by clicking here. And I have copied the talking points, below, that I wrote to brief the anchors before the show.

Retail investors shouldn’t touch China stocks, warns Safanad’s John Rutledge

John Rutledge, Safanad chief investment strategist, joins ‘Closing Bell Overtime’ to talk China’s market pullback and how U.S. investors should navigate it. TUE, OCT 8 20246:16 PM EDT

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Talking Points

I always prepare briefing notes before a show so the producer (Stephanie in this case) can brief the anchor (today it was Melissa) before the show. The schedule today was a little tight, so I just talked her through the main arguments over the phone. Here are the notes I put together to prepare for the hit.

If you fight your way through the bad penmanship, you will see that the Chinese economy is still in the crapper (technical term), and that investors have concluded that the recently-announced government stimulus measures add up to a nothing-burger. That’s largely because property prices are still falling. Home prices in August took their biggest drop (-5.3%) in 9 years.

That’s reason enough for investors to stay clear of the Chinese stock market, but it’s not why I advised viewers to put their smart phones down and back away slowly from the BUY button. The reason is SLS.

Sudden Loss Syndrome (SLS) is what happens when you put your money into anything that can be wiped out in an instant by the wave of a single person’s hand. The person I am referring to, of course, is Xi Jinping, China’s supreme ruler and one and only policy maker. And, in spite of the assumptions you used in Finance class, Xi Jinping is NOT normally distributed.

Risk is not the backward-looking standard deviation of a stock’s price history. It is an investment that does not pay you back your capital and the stream of profits you expected when you bought it.

It’s only fair to tell you that I learned about SLS the hard way, by owning assets that suddenly went “POOF” when an autocrat woke up in a bad mood one day and decided I couldn’t own them. In today’s case, there are two such risks: 1) the big risk that Xi Jinping wakes up crabby and announces that foreigners can no longer own Chinese assets, and 2) the smaller but still meaningful risk that whoever wins the U.S. election in 3 weeks decides that Americans can no longer own Chinese assets.

When you own a portfolio of stocks, you are making a bet that you can collect a stream of cash flow that goes far into the future. In the first year, for example, the only thing you will collect is the dividend, if there is one. If the dividend yield is 2%, then, what makes it worth paying the other 98% of the price to buy it? Future cash, of course. But you have to actually own it and have the legal right to collect the dividends for that to be worth owning. That means the duration of the cash flow stream is the key variable when figuring out what to pay for the stock.

Dr. John

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Summary: Corrected August PCE inflation was 1.6%, not 2.5%—Fed needs to keep cutting. Spring is in the air in New York—commercial real estate moguls I met with this week are sharpening their knives for later this year when they expect thawing credit markets to spike foreclosures and discount sales. First few of my “things that are not a thing.” Please use the Comments button help me add more.

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Corrected PCE Inflation 1.6%

In my last post, I explained that the corrected August 12 month CPI inflation rate, after removing Owners’ Equivalent Rent (OER), was just 1.4%, not the 2.5% in the official report. Making the same correction for OER bias to the Fed’s favorite inflation measure, PCE, in this week’s August Personal Income and Outlays report reduces August inflation from 2.5% to just 1.6%. Corrected PCE inflation has averaged 1.6% over the past 3 months—past time to start cutting rates.

Spring is in the Air

My calendar tells me it is the first week of October, but there is a whiff of springtime in the air—maybe even two whiffs! I’m in New York at Safanad this week having conversations with an extraordinary lineup of private equity, credit, and commercial real estate investors. Now that the Fed has changed directions and interest rates will be heading lower for at least the next two years, they are all starting to think about how to position their portfolios for the eventual thawing of the credit market and associated turnaround of commercial real estate that is already starting to happen.

That counts on rates continuing to decline, of course, but I think that is a safe bet. The Fed waited too long to start cutting rates but surprised me when they chopped 50 basis points off the rates last week. (I didn’t think they had the nerve—or the good sense—to do it.) The cut will help floating rate borrowers to some degree but will reduce the incomes of the people who own our $6.5 trillion in Money Market funds by $32 billion per month, which almost exactly erases the $34.2 billion increase in disposable income for the month of August so don’t look for a jump in economic activity just yet.

The fact that bond yields went up, not down, tells us that 50 bps. wasn’t enough. They need to do another 50 right away and another 100 as soon as they have time to hike up their pants again. We need 3% interest rates, not 5% rates, to bring bond yields down enough to rejuvenate the underwater assets on regional bank balance sheets and get the credit markets open for business again.

This week’s employment reports told us that economic activity is doing well, but it will do even better when rates drop below 4% next year on their way to 3% and credit markets open up again. And make no mistake—credit markets are still closed for small business customers of regional banks. Bank commercial and industrial loans—$2779 on September 18—billion were $21 billion lower than they were 21 months ago, in January 2023.

That explains why this week’s ADP report showed that in September, even though total job gains (+143K) were strong, businesses with less than 50 employees lost 8000 jobs.

Today’s Employment Report confirmed ADP’s strong job growth story. Nonfarm payrolls added +254K jobs in September and July/August were revised upward by +72K, amounting to +326K total new jobs against a +203K average over the past year.

Strong job growth, falling interest rates, and a thawing credit market are all good for investors. As credit markets thaw out, there will be some interesting opportunities in small cap stocks, in credit, and in commercial property.

Today, many regional and community banks are in “extend and pretend” mode (also known as “a rolling loan gathers no loss.”) By extending the maturity date on an unrefinancable commercial property loan, a bank can avoid taking over the property and writing down the loan and the borrower can avoid a forced sale that would wipe out his equity. As credit the markets thaw, however, and banks see potential buyers for foreclosed properties, some of those forced-sales are going to happen, allowing cash-rich value investors to buy good properties at deep discounts. But remember, to be a cash-rich value investor you have to have cash, so you need to be patient.

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My Favorite Whine—Things That are Not a Thing

Thinking is hard work, which may be why people go to such great lengths to avoid it. Jargon is the short-cuts that people use to suppress thinking and questions about issues they think are already decided. At best, jargon saves time by compressing a paragraph into a single word. At worst, it channels all subsequent mental activity into well-worn grooves, leading to a kind of group-think, more like a religious mantra than analysis. Unfortunately, when the world gets complicated jargon-users rarely know how to rewind the tape and rethink the basics. That’s why I try so hard not to use jargon in the things I write.

I think of jargon that no longer makes sense as things that are not a thing. Here are some of the terms on my “things that are not a thing” list:

1. Modern anything. Referring to your own thinking as “Modern” takes a special kind of hubris because it basically says that all of the ideas that have come before were just the on-ramp to the correct way of thinking—the way that you do it now. That is true for Modern Portfolio Theory, for Modern Macroeconomics, and for Modern Monetary Theory, referring, respectively, to the illusions that you can control risk, that you can control the economy, and that you can print all the money you want without creating inflation. None of them are true.

2. Optimal Portfolio. The illusion that you can measure the risk of owning an asset by calculating the standard deviation of its trailing returns and their correlation to the returns on other assets is a load of bunk. IMHO, risk is the likelihood that the thing you bought doesn’t generate the cash flow you thought it would when you bought it, which is a different beast altogether.

3. Risk-On, Risk-Off. These are terms people made up to explain away the times when the correlation coefficients they use to build so-called optimal portfolios don’t stay put. Correlation coefficients and covariances are not facts of nature; they are accidents of history. They are more like your brother-in-law; never there when you need them.

4. Alpha, Beta. These are terms that only have meaning if you have already accepted the jargon I have already talked about. I don’t, which is why I never use those terms.

5. r*, or R-Star. This is a term that macroeconomists and Federal Reserve officials use to refer to some magical interest rate that would be “just right,” like the baby bear’s bowl of oatmeal in Goldilocks, leading to both full employment (general equilibrium) and no inflation. Fact is, r* only has meaning if you have already accepted Modern Macroeconomics (see thing #1 above), an economic model built on the idea that only one person in the economy, who is really smart, and that you can ignore the balance sheet that, in the real world, is more than 15x bigger than annual GDP.

6. Space, as in “This is the fastest growing company in its space.” Call me old fashioned but, to me, space is either a place to park your car, as in “parking space” or it’s a frontier where no man has ever gone before, like in Star Trek. It is not a code word for an industry or an economic sector. The first time I ever heard it used this way was in 2001, at the height of the dotcom bubble, when an investment banker brought a high school senior to my office who wanted $10 million so he could use the internet to build an online shopping mall that would “redefine the retail space.” It was a short meeting.

These will do for a start; I will be adding more to the list in future posts. I am very interested in your thoughts on jargon that should be on my list. Please use the comments button below to let me know your thoughts.

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Dr. John

Summary: Today’s baby step by the Fed is too little, too late. Correcting the August CPI for Owners' Equivalent Rent (OER) bias reduces 12 the month inflation rate from 2.5% to just 1.4%. By not switching to lower rates a year ago, the Fed has damaged bank balance sheets and shut down bank loans. Small businesses and their employees are paying the price.

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Corrected August Inflation 1.4%

As I have argued many times over the past 18 months, there is a fatal flaw in the composition of the “market basket” the Department of Labor uses to calculate the consumer price index. Although the CPI is typically described as a measure of out-of-pocket costs—as opposed to the PCE, a broader index that includes spending on behalf of households made by third parties—businesses, governments and nonprofit organizations—such as employer-paid health and life insurance and pension contributions.

As shown in the table above from the August CPI report, the All-items index increased by 2.5% over the preceding 12 months. “Rent of primary residence”, an appropriate measure of the housing costs for people who rent their residence from someone else increased by 5.2% during the year but makes up only 7.662% of the total index.

The problem is with “Owners’ equivalent rent of residences” (OER) shown in the bottom row because OER because OER is a made-up number that purports to measure the hypothetical amount that I , as a homeowner, would would have to pay every month to rent my own house from myself. OER, which accounts for a whopping 26.825% of the total index, increased by 5.4% over the year. The appropriate weight is zero.

Fortunately, it is an easy problem to fix. All we have to do it to use the numbers in the table to calculate how much the legitimate portion of the All items index (everything except for OER; I’ll call it CPIXOER) would have had to rise to make the appropriately weighted average of CPIXOER and OER equal to 2.5%. The result: in the 12 months ending in August CPIXOER increased by 1.4% far below the Fed’s 2% target.

Business Loans Have Flatlined

Small businesses depend on bank loans for the working capital they need to meet payroll and pay other costs before they get paid, in turn, by their customers. In normal times, lending decisions are based upon interest rates, fees, and credit quality of the customers, and bank loans grow in line with GDP. On occasion, however, something goes wrong with bank balance sheets, banks shut down lending, and we go through a period of non-price rationing. The newspapers call it a credit crunch.

As you can see in the chart, above, we have a baby credit crunch brewing today. After their wild ride during the COVID pandemic, business loans resumed their normal course until they flatlined in January, 2023, just before the Silicon Valley Bank bust.

In fact, the total outstanding stock of bank commercial and industrial loans ($2779 billion) today is $34 billion lower than it was in January, 2023 ($2813 billion). That means, over the past 20 months, banks have collected $34 billion more from their customers than they have loaned to their customers, not including payments for interest and fees!

The proximate cause of the flatlined business loans was the damage done to the values of the Treasury bonds and mortgage securities on regional bank balance sheets when the Fed jacked up interest rates to current levels.

As credit crunches go, this is a mild one so far. For comparison, during the Subprime Mortgage recession bank commercial and industrial loans fell by 20% ($401 billion) between October 2008 and October 2010. Where it goes from here will depend on what the Fed does with interest rates. If they quickly bring rates down, regional bank balance sheets will improve and banks will sooner or later start lending again. If the Fed continues to drag its feet, business loans will decline and the economy will deteriorate.

The monthly ADP employment reports are the best way to track the damage. I prefer the ADP report to the official BLS Employment Situation report for two reasons. First, the ADP report is published a few days earlier than the official report that everyone else agonizes over, giving me time to think things through before everyone else freaks out when they see the jobs number. Second, ADP measures actual paychecks paid by actual businesses to actual employees rather than self-reported answers to monthly surveys conducted by the Bureau of Labor Statistics. In August, ADP reported that private employers added only 99,000 employees, as shown in the chart above. Small businesses with 20-49 employees—the ones that depend on bank loans to meet payroll—reduced employment by 12,000 people.

How Low Can They Go?

So, how low does the Fed funds rate have to go to solve the problem and restore growth? While there is no precise answer, my gut tells me that money market yields would have to fall substantially, say from 5% to 3%, to repair the damage to bank balance sheets and make business loans broadly available again. How long it takes the Fed to get there will determine whether the economy grows or shrinks over the next 2 years.

Dr. John

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NOTE TO READERS: Stock and bond markets were spooked by the August CPI report (+0.6% for August, +3.7% over year ago). But don’t be tricked—the imaginary Owners’ Equivalent Rent (OER) component I have written about (that should be thrown out of the index) accounted for more than half of it. Over the past 12 months, OER contributed 1.8% to the overall (3.7%) inflation number. Excluding OER, CPI inflation was just 1.9%. (1.3% excluding rent). I hope the Fed understands this!

Summary: Last week I had a great time working with my good friend Debbie Osborne again to give a keynote talk at MoneyShow’s Accredited Investor Virtual Expo. I gave the participants my thoughts on an investment strategy to protect capital. Thought you might like to see the notes I wrote up ahead of the talk. You can see the video file by clicking this link.

After the last three years, investors have every right to feel fatigued. I certainly do.

We have lived through a once-a-century pandemic, an attack on the U.S. Capitol, the attempted overthrow of a Presidential election, the decoupling of US/China relations, rising risk surrounding Taiwan and the world’s supply of high-end microchips, Russia’s brutal invasion of Ukraine, and supply-chain interruptions that, along with wild swings in government spending and Fed policies, spiked inflation and triggered a dramatic run-up in interest rates that have made buying a home virtually unaffordable at today’s prices. Pundits, policy makers, and economists saw none of this coming.

As investors, our main job today is to protect the net worth we have worked so hard to accumulate from geopolitical, economic, and policy risk. In this Keynote Address, I will explain why economics did such a bad job and give you a simple framework for understanding these massive asset-market disruptions. I will explain where we are today, and help you understand what to expect in the post-pandemic years ahead.

And I will give you five simple disciplines behind my investment strategy today:

1. Leave your emotions at the door before you make investment decisions. Excited investors—both optimists and pessimists—make big mistakes.

2. There are 2 economies: our $23 trillion GDP economy, and the $481 trillion of assets on our balance sheet. Forget GDP; the tsunami events (financial crises) occur in the balance sheet when people decide they want to change the mix of tangible and financial assets they already hold.

3. The major asset market events are triggered by changes in inflation (the capital gains yield on tangible assets) relative to interest rates, and by periodic financial crises that temporarily shut down credit markets and give us once-a decade opportunities to buy the best assets at back-to-school sale prices.

4. To do that you need to keep the core of your portfolio always invested in equities of the world’s best companies—you already know their names, companies like APPL, AMZN, GOOGL, BX, MSFT, PFE, MRK, LLY, JNJ, CVX, EQNR, LMT, TSM—with great management, history, bullet-proof brands, dominant market positions, cash, low leverage, free cash flow, and a path to improving shareholder value through growth, reinvestment, dividends, and stock buybacks. You need to avoid excessive leverage and you need to hold plenty of cash during good times so you are able to buy great companies for half price during financial crises.

5. If you have done these things, turn off your TV, put down your phone, and spend time with your family. If we learned one thing during the pandemic, it is that time with the people you love is more important than money.

Dr. John

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