A Template for Understanding Big Debt Crises

by Ray Dalio

those who fund their activities in the country that has the weaker currency by borrowing the stronger currency see their debt costs soar; that drives down the weaker currency relative to the stronger one even more.

negative real interest rates (i.e., interest rates that are significantly less than inflation rates),

The bubble emerges in the midst of a self-reinforcing virtuous cycle of strong capital flows, good asset returns, and strong economic conditions.

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.

This upswing tends to be self-reinforcing until it is so overdone that it reverses. It is self-reinforcing because the inflows drive up the currency, making it desirable to hold assets denominated in it (and desirable to hold liabilities denominated in other currencies), and/or produce more money creation that causes prices to rise more.

Over time, the country becomes the hot place to invest, and its assets become overbought so debt and stock-market bubbles emerge. Investors believe the country’s assets are a fabulous treasure to own and that anyone not in the country is missing out. Investors who were never involved with the market rush in. When the market gets fully long, leveraged, and overpriced, it becomes ripe for a reversal.

key economic developments typically seen as the bubble inflates. Foreign capital flows are high (on average around 10 percent of GDP) The central bank is accumulating foreign-exchange reserves The real FX is bid up and becomes overvalued on a purchasing power parity (PPP) basis by around 15 percent Stocks rally (on average by over 20 percent for several years into their peak)

they often find themselves in this position without explicitly taking it on or fully recognizing it.

There are lots of different ways that a sustained bull market will lead to multinational entities getting long that local currency. The influx of foreign capital finances a boom in consumption Imports rise faster than exports, and the current account worsens

In such currency defenses, policy makers—especially those defending a peg—will typically make boldly confident statements vowing to stop the currency from weakening. All of these things classically happen just before the cycle moves to its next stage, which is letting the currency go.

It is typical during the currency defense to see the forward currency price decline ahead of the spot price. This is a consequence of the relationship between the interest rate differential and the spot/forward currency pricing

a country’s inflationary deleveraging is analogous to what happens when a family has trouble making payments—with one major difference. Unlike a family, a country can change the amount of currency that exists, and hence, its value. That creates an important lever for countries to manage balance of payments pressures, and it’s why the world doesn’t have one global currency.

The currency decline tends to cause assets to rise in value measured in that weakened currency, stimulate export sales, and help the balance of payments adjustment by bringing spending back in line with income. It also lowers imports (by making them more expensive), which favors domestic producers, makes assets in that currency more competitively priced and attractive, creates better profit margins for exported goods, and sets the stage for the country to earn more income from abroad (through cheaper and more competitive exports).

currency weakness translates to higher prices for imported goods, much of which is passed on to consumers, resulting in a sharp rise in inflation. A gradual and persistent currency decline causes the market to expect continued future currency depreciation, which can encourage increased capital withdrawal and speculation, widening the balance of payments gap. A continual devaluation also makes inflation more persistent, feeding an inflation psychology.

And if the one-off devaluation isn’t expected by the market (i.e., it’s a surprise), then policy makers won’t have to spend reserves and/or allow interest rates to rise to defend the currency going into the devaluation. This is why policy makers generally say they’ll continue to defend the currency right up until the moment they stop doing it.

the assets that had been seen as a fabulous treasure a short time ago now look like trash. They quickly go from overbought to oversold and prices plummet.

As their local currency depreciates, debtors who owe foreign currency debt face a rising debt burden (in local currency).

While most people, including most policy makers, think that the best thing they can do is defend the currency during the currency defense phase, actually the opposite is true, because a currency level a) that is good for the trade balance, b) that produces a positive total return, and that c) has an interest rate that is appropriate for domestic conditions, is a low one.

Devaluing currencies is like using cocaine, in that it provides short-term stimulation but is ruinous when abused.

The most important characteristic of cases that spiral into hyperinflations is that policy makers don’t close the imbalance between external income, external spending, and debt service, and keep funding external spending over sustained periods of time by printing lots of money. In some cases, it’s not voluntary.

The result is a currency devaluation that doesn’t stimulate growth.

During inflationary deleveragings, average debt maturities always fall.

When interest rates are insufficient to compensate for future currency declines, this provision of liquidity provides the funds that enable investors to continue to borrow and invest abroad and in inflation hedges (like real assets or gold), which further contributes to the inflation and depreciation spiral.

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 a major war ends, all countries—both the winners and losers—are saddled with debt and the need to transition from a war-economy to a more normal economy.

those shorting the mark lost considerable sums (a notable case is John Maynard Keynes, who personally lost about £13,000 on the trade).

Keynes wrote “the whips and scorpions of any government recorded in history [would not have been] potent enough to extract nearly half…[the required] income from a people so situated.”61

It reflected a rush to get out of money or to get short money (i.e., borrow it) against a long “stuff” position.

People tend to think that hyperinflations are caused by central banks recklessly printing too much money, and all they need to do to stop it is to turn off the printing press. If it were that easy, hyperinflations would almost never occur! Instead, inflation spirals push policy makers into circumstances where printing is the least bad of several terrible options.

Reckless money printing was less the cause of the hyperinflation than what was required to prevent massive deflationary defaults by banks (and just about everyone else) and a deflationary economic collapse.

Remember that money and credit serve two purposes: As a medium of exchange and a store hold of wealth.

Since finding new creditors is usually impossible in an inflationary deleveraging, and monetizing debt only postpones the problem, the budget ultimately needs to be balanced.

more and more of this leverage occurred outside the regulated and protected banking system. Classically, new and fast-growing lending markets where a lot of levering up occurs are symptomatic of bubbles.

“A great river of gold began to converge on Wall Street, all of it to help Americans hold common stock on margin.”

Typically the worst debt bubbles are not accompanied by high and rising inflation, but by asset price inflation financed by debt growth.

when debts are denominated in one’s own currency, deleveragings can generally be managed well. Being on a gold standard is akin to having debts denominated in a foreign currency

Austerity seems like the obvious response, but the problem is that one person’s spending is another person’s income, so when spending is cut, incomes are also cut, with the result that it takes an awful lot of painful spending cuts to make significant reductions in debt/income ratios.

In 1931 Germany was the epicenter of the emerging dollar squeeze. It had previously faced great difficulty paying back the reparation debt it owed and had been forced to borrow as a result. The country had become a popular destination for the “carry trade,” in which investors would lend their dollars to Germany to earn a higher yield than they would get in dollars and Germans would borrow in dollars to get the lower interest rate. Once again, this type of behavior is classic in the “good times,” when there is little perceived risk and large cross-country credit creation, and sets up the conditions that make the “bad times” worse when the reversal happens.

bear market rallies like this are classic in a depression, since workers, investors, and policy makers have a strong tendency to exaggerate the importance of relatively small things that appear big close-up.

attempted to alleviate the liquidity squeeze while maintaining the gold standard by increasing the Federal Reserve’s ability to print money, but only to buy government bonds (which 75 years later would be called “quantitative easing”).

But despite these efforts, the budget deficit grew significantly relative to GDP because the austerity was contractionary and the economy shrank faster than the budget deficit did.156 As mentioned earlier, Hoover’s attempt to balance the budget through austerity was a rookie move that is classic in depressions.

By the way, politicians and policy makers frequently make disingenuous promises that are expedient and inconsistent with economic and market fundamentals, and such promises should never be believed.

These moves ended the depression on a dime.

it had become obvious that all countries could just as easily devalue their currencies in response to other devaluations, creating a huge amount of economic turbulence that left everyone in the same place. At the end of the day, all currencies had devalued a lot against gold, but not so much against each other.

In the early and healthy part of the typical debt cycle, debt grows appropriately in line with income growth because the debt is being used to finance activities that produce fast income growth to service debts.

The price rise was classically self-reinforcing in a way that often creates bubbles. Because most houses are bought with borrowed money, home price gains have magnified impacts on equity values. For example, if a household used their savings of $50,000 as a down-payment on a $250,000 house, and that house went up in value to $350,000, then the household’s investment tripled. This allowed for more borrowing and attracted other buyers and other lenders to finance them, as this lending was very profitable.

So it was not just low interest rates that fueled the bubble, but rather a combination of easy money, lax regulation, and risky financial innovations. As the Fed was looking at inflation and not debt growth when setting interest rates, and as policy makers allowed the lax regulation of shadow lending channels to continue, the bubble was allowed to grow.

I believe that one should bet on the opposite of what happened lately, because boring years tend to sow the seeds of future instability,

I must say that they are much more reactive than proactive, which is understandable because, unlike investors, they are not in the business of having to bet against the consensus and be right, and they operate within political systems that don’t act until there is a broad consensus that there is an intolerable problem. As a result, policy makers generally don’t act decisively until a crisis is on top of them.

Paulson’s political people had told him that if they put a big dollar number in front of Congress for approval, Congress would likely get spooked. As Paulson couldn’t ask for unlimited authority to inject capital into the two GSEs, he decided to ask for “unspecified” authority.