A Template for Understanding Big Debt Crises

by Ray Dalio

Generally speaking, because credit creates both spending power and debt, whether or not more credit is desirable depends on whether the borrowed money is used productively enough to generate sufficient income to service the debt. If that occurs, the resources will have been well allocated and both the lender and the borrower will benefit economically. If that doesn’t occur, the borrowers and the lenders won’t be satisfied and there’s a good chance that the resources were poorly allocated.

I want to be clear that credit/debt that produces enough economic benefit to pay for itself is a good thing. But sometimes the trade-offs are harder to see.

To give you an idea of what that might mean for an economy as a whole, really bad debt losses have been when roughly 40 percent of a loan’s value couldn’t be paid back. Those bad loans amount to about 20 percent of all the outstanding loans, so the losses are equal to about 8 percent of total debt. That total debt, in turn, is equal to about 200 percent of income (e.g., GDP), so the shortfall is roughly equal to 16 percent of GDP. If that cost is “socialized” (i.e., borne by the society as a whole via fiscal and/or monetary policies) and spread over 15 years, it would amount to about 1 percent per year, which is tolerable. Of course, if not spread out, the costs would be intolerable.

For that reason, I am asserting that the downside risks of having a significant amount of debt depends a lot on the willingness and the ability of policy makers to spread out the losses arising from bad debts. I have seen this in all the cases I have lived through and studied. Whether policy makers can do this depends on two factors: 1) whether the debt is denominated in the currency that they control and 2) whether they have influence over how creditors and debtors behave with each other.

Throughout history only a few well-disciplined countries have avoided debt crises. That’s because lending is never done perfectly and is often done badly due to how the cycle affects...

While policy makers generally try to get it right, more often than not they err on the side of being too loose with credit because the near-term rewards (faster growth) seem to justify it. It is also politically easier to allow easy credit (e.g., by providing guarantees, easing monetary polici...

A “beautiful deleveraging” happens when the four levers are moved in a balanced way so as to reduce intolerable shocks and produce positive growth with falling debt burdens and acceptable inflation.

More specifically, deleveragings become beautiful when there is enough stimulation (i.e., through “printing of money”/debt monetization and currency devaluation) to offset the deflationary deleveraging forces (austerity/defaults) and bring the nominal growth rate above the nominal interest rate—but not so much stimulation that inflation is accelerated, the currency is devaluated, and a new debt bubble arises.

The best way of negating the deflationary depression is for the central bank to provide adequate liquidity and credit support, and, depending on different key entities’ needs for capita...

Recall that spending comes in the form of either money or credit. When increased spending cannot be financed with increased debt because there is too much debt relative to the amount of money there is to service the debt, increased s...

This means that the central bank has to increase the amount of ...

Late in the long-term debt cycle, central bankers sometimes struggle to convert their stimulative policies into increased spending because the effects of lowering interest rates and central banks’ purchases of debt assets have diminished. At such times the economy enters a period of low growth and low returns on assets, and central bankers have to move to other forms of monetary stimulation in which money and credit go more directly to support spenders. When policy makers faced these conditions in the 1930s, they coined the phrase “pushing on a string.”

One of the biggest risks at this stage is that if there is too much printing of money/monetization and too severe a currency devaluation relative to the amounts of the deflationary alternatives, an “ugly inflationary deleveraging” can occur.

Monetary Policy 2 “Quantitative easing” (QE) as it is now called (i.e., “printing money” and buying financial assets, typically debt assets), is Monetary Policy 2. It works by affecting the behavior of investors/savers as opposed to borrowers/spenders, because it is driven by purchases of financial assets, typically debt assets that impact investors/savers the most.

When the central bank buys a bond, it gives savers/investors cash, which they typically use to buy another financial asset that they think is more attractive. What they do with that money and credit makes all the difference in the world.

When they invest in the sort of assets that finance spending, that stimulates the economy. When they invest in those that don’t (such as financial assets), there must be very large market gains before any money trickles down into spending—and that spending comes more f...

In other words, QE certainly benefits investors/savers (i.e., those who own financial assets) much more than people who d...

While MP2 is generally less effective than interest-rate changes, it is most effective when risk and liquidity premiums are large, bec...

When risk premiums are large, and money is added to the system, actual risks are reduced at the same time that there is more money seeking returns, which triggers purchases of riskier assets that are offering higher expected returns, driving their prices up and producing a positive wealth effect.

Important point - QE works by reducing RISK PREMIUMS

But over time, the use of QE to stimulate the economy declines in effectiveness because risk premiums are pushed down and asset prices are pushed up to levels beyond which they are difficult to push further, and the wealth effect diminishes.

In other words, at higher prices and lower expected returns, the compensation for taking risk becomes too small to get investors to bid prices up, which wo...

In fact, the reward-to-risk ratio could make those who are long a lot of assets view that terribly returning asse...

As a result, QE becomes less and less effective. If they provide QE and private credit growth doesn’t pick up, policy makers fee...

While central banks influence the costs and availabilities of credit for the economy as whole, they also have powers to influence the costs and availabilities of credit for targeted parts of the financial system through their regulatory authorities.

These policies, which are called macroprudential policies, are especially important when it’s desirable to differentiate entities—e.g., when it is desirable to restrict credit to an overly indebted area while simultaneously stimulating the rest of the economy, or when its desirable to provide credit to some targeted entities but not provide it broadly. Macroprudential policies take numerous forms that are valuable in different ways in all seven stages of the big debt cycle.

Important point - QE works by reducing RISK PREMIUMS But Risk can only be REDUCED upto a certain point - When markets are sky high the RISK/REWARD does not make sense anymore - So Cash starts becoming more attractive for investors This happens just before the crash - By that point the market is “begging” for a correction

While the central bank is generally meant to provide one monetary policy for all (making money and credit broadly available through banks without deciding who gets it) and those who run fiscal policy are meant to apportion it well, macroprudential policies are tools for directing credit one way or another through the central bank’s regulatory authorities.

The need for macroprudential monetary policy is created by differentiation as credit grows: There can be a bubble in one area, and a starvation of credit in another area. If policy makers want to slow down credit where bubbles are emerging, and redirect credit to other areas, macroprudential policies can shift credit in that way. For instance, a classic countercyclical macroprudential policy is to make it easier to buy a house in a housing bust (say, by forcing credit standards lower or allowing lower down payments) or to make it harder to buy a house in a housing bubble (by doing the opposite).

By directing credit through regulatory authorities, macroprudential policies can resemble fiscal policies in that they can be...

While this is generally avoided, the challenges of managing an economy through a deleveraging make macroprudential policies a really usef...

For instance, QE often fuels pockets of frothiness in the economy, particularly in asset markets, even as the broader economy is still in recovery. In the Great Depression and during World War II, central bankers used macroprudential measures to reduce the pockets of frothiness, while...