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by
Ray Dalio
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September 8, 2019 - September 21, 2020
Credit is the giving of buying power. This buying power is granted in exchange for a promise to pay it back, which is debt.
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).
those who make policy for society have controls that individuals don’t.
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.
sometimes not enough money/credit is provided for such obviously cost-effective things as educating our children well (which would make them more productive, while reducing crime and the costs of incarceration), or replacing inefficient infrastructure, because of a fiscal conservativism that insists that borrowing to do such things is bad for society, which is not true.
I am talking about nothing more than logically-driven series of events that recur in patterns.
You’re not just borrowing from your lender; you are borrowing from your future self. Essentially, you are creating a time in the future in which you will need to spend less than you make so you can pay it back. The pattern of borrowing, spending more than you make, and then having to spend less than you make very quickly resembles a cycle.
I believe that it is possible for policy makers to manage them well in almost every case that the debts are denominated in a country’s own currency. That is because the flexibility that policy makers have allows them to spread out the harmful consequences in such ways that big debt problems aren’t really big problems.
The key to creating a “beautiful deleveraging” (a reduction in debt/income ratios accompanied by acceptable inflation and growth rates, which I explain later) lies in striking the right balance between them. In this happy scenario, debt-to-income ratios decline at the same time that economic activity and financial asset prices improve, gradually bringing the nominal growth rate of incomes back above the nominal interest rate.
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. Throughout history these two groups have been called different things—e.g., the first group has been called workers, the proletariat, and “the have-nots,” and the second group has been called capitalists, investors, and “the haves.”
Proletariat-workers earn their money by selling their time and capitalists-investors earn their money by “lending” others the use of their money
central banks progressively lower interest rates, which raises asset prices and, in turn, people’s wealth, because of the present value effect that lowering interest rates has on asset prices.
deleveraging begins. Since borrowing is simply a way of pulling spending forward, the person spending $60,000 per year and earning $50,000 per year has to cut his spending to $40,000 for as many years as he spent $60,000, all else being equal.
Bubbles usually start as over-extrapolations of justified bull markets.
The boom also encourages new buyers who don’t want to miss out on the action to enter the market, fueling the emergence of a bubble.
new types of lending institutions that are largely unregulated develop (these non-bank lending institutions are referred to collectively as a “shadow banking” system). These shadow banking institutions are typically less under the blanket of government protections. At these times, new types of lending vehicles are frequently invented and a lot of financial engineering takes place.
The lenders and the speculators make a lot of fast, easy money, which reinforces the bubble by increasing the speculators’ equity, giving them the collateral they need to secure new loans. At the time, most people don’t think that is a problem; to the contrary, they think that what is happening is a reflection and confirmation of the boom.
During such times, most people think the assets are a fabulous treasure to own—and consider anyone who doesn’t own them to be missing out. As a result of this dynamic, all sorts of entities build up long positions. Large asset-liability mismatches increase in the forms of a) borrowing short-term to lend long-term, b) taking on liquid liabilities to invest in illiquid assets, and c) investing in riskier debt or other risky assets with money borrowed from others, and/or d) borrowing in one currency and lending in another, all to pick up a perceived spread. All the while, debts rise fast and debt
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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. In other words, humans by nature (like most species) tend to move in crowds and weigh recent experience more heavily than is appropriate.
As a bubble nears its top, the economy is most vulnerable, but people are feeling the wealthiest and the most bullish.
because central bankers target either inflation or inflation and growth and don’t target the management of bubbles, the debt growth that they enable can go to finance the creation of bubbles if inflation and real growth don’t appear to be too strong.
Central bankers sometimes say that it is too hard to spot bubbles and that it’s not their role to assess and control them—that it is their job to control inflation and growth.4 But what they control is money and credit, and when that money and credit goes into debts that can’t be paid back, that has huge implications for growth and inflation down the road.
To anticipate a debt crisis well, one has to look at the specific debt-service abilities of the individual entities, which are lost in these averages.
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.
Typically, these types of credit/debt problems start to emerge about half a year ahead of the peak in the economy,
Early on in the top, some parts of the credit system suffer, but others remain robust, so it isn’t clear that the economy is weakening.
Unemployment is normally at cyclical lows and inflation rates are rising.
These pictures are best seen by looking at each of the important sectors of the economy and each of the big players in these sectors rather than at economy-wide averages.
In the early stages of a bubble bursting, when stock prices fall and earnings have not yet declined, people mistakenly judge the decline to be a buying opportunity and find stocks cheap in relation to both past earnings and expected earnings, failing to account for the amount of decline in earnings that is likely to result from what’s to come. But the reversal is self-reinforcing. As wealth falls first and incomes fall later, creditworthiness worsens, which constricts lending activity, which hurts spending and lowers investment rates while also making it less appealing to borrow to buy
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A cash-flow problem can occur even when the entity has adequate capital because the equity is in illiquid assets.
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.
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. Now that those promises aren’t being kept, that wealth no longer exists.
Because one person’s debts are another’s assets, the effect of aggressively cutting the value of those assets can be to greatly reduce the demand for goods, services, and investment assets.
In other words, ignorance and a lack of authority are bigger problems than debts themselves.
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
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.
This “printing” takes the form of central bank purchases of government securities and nongovernment assets such as corporate securities, equities, and other assets, which is reflected in money growing at an extremely fast rate at the same time as credit and real economic activity are contracting. Traditional economists see that as the velocity of money declining, but it’s nothing of the sort. What is happening at such times is that credit destruction is being offset by money creation.
In the end, policy makers always print. That is because austerity causes more pain than benefit, big restructurings wipe out too much wealth too fast, and transfers of wealth from haves to have-nots don’t happen in sufficient size without revolutions.
The right amounts of stimulus are those that a) neutralize what would otherwise be a deflationary credit-market collapse and b) get the nominal growth rate above the nominal interest rate by enough to relieve the debt burdens, but not by so much that it leads to a run on debt assets.
Stimulation of the central bank is undermined by fiscal austerity.
When central banks reduce interest rates, they stimulate the economy by a) producing a positive wealth effect (because the lower interest rate raises the present value of most investments); b) making it easier to buy items on credit (because the monthly payments decline), raising demand—especially for interest-rate-sensitive items like durable goods and housing; and c) reducing debt-service burdens (which improves cash flows and spending).
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.
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 would drive prospective returns down further.
there is a real risk that prolonged monetization will lead people to question the currency’s suitability as a store hold of value. This can lead them to start moving to alternative currencies, such as gold. The fundamental economic challenge most economies have in this phase is that the claims on purchasing power are greater than the abilities to meet them.
Think of it this way: There are only goods and services. Financial assets are claims on them. In other words, holders of investments/assets (i.e., investors/capitalists) believe that they can convert their holdings into purchasing power to get goods and services. At the same time, workers expect to be able to exchange a unit’s worth of their contribution to the production of goods and services into buying power for goods and services. But since debt/money/currency have no intrinsic value, the claims on them are greater than the value of what they are supposed to be able to buy, so they have to
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Policy makers tend to use monetization at this stage primarily because it is stimulative rather than contractionary. But monetization simply swaps one IOU (debt) for another (newly printed money). The situation is analogous to a Ponzi scheme. Since there aren’t enough goods and services likely to be produced to back up all the IOUs, there’s a worry that people may not be willing to work in return for IOUs forever.
Because wealthy people have fewer incentives to spend the incremental money and credit they get than less wealthy people, when the wealth gap is large and the economy is weak, directing spending opportunities at less wealthy people is more productive.
If a currency falls in relation to another currency at a rate that is greater than the currency’s interest rate, the holder of the debt in the weakening currency will lose money.
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.
in times when money is flowing out of a currency, real interest rates need to rise less if real exchange rates fall more (and vice versa).
