A Template for Understanding Big Debt Crises

by Ray Dalio

the question of whether rapid credit/debt growth is a good or bad thing hinges on what that credit produces and how the debt is repaid (i.e., how the debt is serviced).

too little credit/debt growth can create as bad or worse economic problems as having too much, with the costs coming in the form of foregone opportunities.

really bad debt losses have been when roughly 40 percent of a loan’s value couldn’t be paid back.

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 policies) than to have tight credit. That is the main reason we see big debt cycles.

In a market-based economy, expansions and contractions in credit drive economic cycles, which occur for perfectly logical reasons. Though the patterns are similar, the sequences are neither pre-destined to repeat in exactly the same ways nor to take exactly the same amount of time.

In “bubbles,” the unrealistic expectations and reckless lending results in a critical mass of bad loans.

gradually bringing the nominal growth rate of incomes back above the nominal interest rate.

That is because the central bank (in this case, the Federal Reserve) lowers interest rates to keep the debt-financed expansion going until they can’t do it any more (because the interest rate hits 0 percent). When that happens, the deleveraging begins.

When credit is easily available, there’s an economic expansion. When credit isn’t easily available, there’s a recession.

But over time, each bottom and top of the cycle finishes with more economic activity than the previous cycle, and with more debt. Why? Because people push it—they have an inclination to borrow and spend more instead of paying back debt. It’s human nature. As a result, over long periods of time, debts rise faster than incomes. This creates the long-term debt cycle.

Remember that money serves two purposes: it is a medium of exchange and a store hold of wealth. And because it has two purposes, it serves two masters: 1) those who want to obtain it for “life’s necessities,” usually by working for it, and 2) those who have stored wealth tied to its value.

Proletariat-workers earn their money by selling their time and capitalists-investors earn their money by “lending” others the use of their money in exchange for either a) a promise to repay an amount of money that is greater than the loan (which is a debt instrument), or b) a piece of ownership in the business (which we call “equity” or “stocks”) or a piece of another asset (e.g., real estate).

One person’s financial assets are another’s financial liabilities (i.e., promises to deliver money). When the claims on financial assets are too high relative to the money available to meet them, a big deleveraging must occur.

Many historical instances of violence against Jews were driven by debt crises.

Though this set of conditions is not sustainable because the debt growth rates are increasing faster than the incomes that will be required to service them, borrowers feel rich, so they spend more than they earn and buy assets at high prices with leverage. Here’s one example of how that happens:

Taking stocks as an example, rising stock prices lead to more spending and investment, which raises earnings, which raises stock prices, which lowers credit spreads and encourages increased lending (based on the increased value of collateral and higher earnings), which affects spending and investment rates,

In markets, when there’s a consensus, it gets priced in. This consensus is also typically believed to be a good rough picture of what’s to come, even though history has shown that the future is likely to turn out differently than expected.

humans by nature (like most species) tend to move in crowds and weigh recent experience more heavily than is appropriate. In these ways, and because the consensus view is reflected in the price, extrapolation tends to occur.

When prices have been driven by a lot of leveraged buying and the market gets fully long, leveraged, and overpriced, it becomes ripe for a reversal. This reflects a general principle: When things are so good that they can’t get better—yet everyone believes that they will get better—tops of markets are being made.

First, contrary to popular belief, the deleveraging dynamic is not primarily psychological. It is mostly driven by the supply and demand of, and the relationships between, credit, money, and goods and services—though

Most of what people think is money is really credit, and credit does appear out of thin air during good times and then disappear at bad times.

As this implies, a big part of the deleveraging process is people discovering that much of what they thought of as their wealth was merely people’s promises to give them money.

since both their net worth and their income fall faster than their debts, borrowers become less creditworthy and lenders more reluctant to lend. This goes on in a self-reinforcing manner.

How quickly and aggressively policy makers respond is among the most important factors in determining the severity and length of the depression.

increased taxation takes the form of greater income, property, and consumption taxes because these forms of taxation are the most effective at raising revenues.

Recall that spending comes in the form of either money or credit.

People ask if printing money will raise inflation. It won’t if it offsets falling credit and the deflationary forces are balanced with this reflationary force. That’s not a theory—it’s been repeatedly proven out in history. Remember, spending is what matters.

All of the deleveragings that we have studied (which is most of those that occurred over the past hundred years) eventually led to big waves of money creation, fiscal deficits, and currency devaluations (against gold, commodities, and stocks).

QE certainly benefits investors/savers (i.e., those who own financial assets) much more than people who don’t, thus widening the wealth gap.

Think of it this way: There are only goods and services. Financial assets are claims on them.

If central banks just give people money (helicopter money), that’s typically less adequate than giving them that money with incentives to spend it.

Currency and debt serve two purposes: to be 1) mediums of exchange and 2) store holds of wealth

Debt is one person’s asset and another’s liability

what is not widely known is that the central bank’s trade-offs between inflation and growth are easier to manage when money is flowing into a country’s currency/debt and more difficult to manage when it’s flowing out.

countries with the worst debt problems, a lot of debt denominated in a foreign currency, and a high dependence on foreign capital typically have significant currency weaknesses. The currency weakness is what causes inflation when there is a depression.

If a reserve-currency country permits much higher inflation in order to keep growth stronger by printing lots of money, it can further undermine demand for its currency, erode its reserve currency status (e.g., make investors view it as less of a store hold of wealth), and turn its deleveraging into an inflationary one.

country sells more to foreigners than it buys from them, a country’s balance of payments will become favorable—i.e., the demand for its currency will be greater than its supply.

In the bubble phase, the prices of the currency and/or the assets get bid up and increasingly financed by debt, making the prices of these investments too high to produce adequate returns, but the borrowing and buying continues because prices are rising, and so debts rise rapidly relative to incomes.

As the bubble emerges, there are fewer productive investments, and at the same time there is more capital going after them.

Changing the value of the currency changes the price of a country’s goods and services for foreigners at a different rate than it does for its citizens.

That’s why it’s generally better to have a large, one-off devaluation that gets the currency to a level where there’s a two-way market for it (i.e., where there isn’t broad expectation that the currency will continue to weaken so people are both buying and selling it). This means higher inflation is less likely to be sustained.

The bottom in activity comes after about one year, with the trough in the GDP gap typically near -4 percent

the best way to ensure that investors expect positive total returns going forward at a relatively low real interest rate (which is what the weak domestic conditions need) is to depreciate the currency enough.11

The central bank’s objective should be to allow the currency to get cheap enough that it can provide the needed stimulation for the economy and the balance of payments, while running a tight enough policy to make the returns of owning the currency attractive.

As stated earlier, contrary to popular belief, it’s not so easy to stop printing money during a crisis. Stopping printing when capital is flowing out can cause an extreme tightness of liquidity and often a deep economic contraction.

Because there is a shortage of foreign exchange, illiquidity reaches its peak and demand collapses.

Investing during a hyperinflation has a few basic principles: get short the currency, do whatever you can to get your money out of the country, buy commodities, and invest in commodity industries (like gold, coal, and metals).

after wars, there are typically extended periods of peace with the dominant country setting the rules and other countries following them for the time it takes for the cycle to happen all over again.

The worst thing a country, hence a country’s leader, could ever do is get into a lot of debt and lose a war because there is nothing more devastating. ABOVE ALL ELSE, DON’T DO THAT.

The biggest risks are typically not from the debts themselves, but from the failure of policy makers to do the right things due to a lack of knowledge and/or lack of authority.