A Template for Understanding Big Debt Crises

by Ray Dalio

credit/debt that produces enough economic benefit to pay for itself is a good thing. But sometimes the trade-offs are harder to see. If lending standards are so tight that they require a near certainty of being paid back, that may lead to fewer debt problems but too little development. If the lending standards are looser, that could lead to more development but could also create serious debt problems down the road that erase the benefits. Let’s look at this and a few other common questions about debt and debt cycles.

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

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.

Lending naturally creates self-reinforcing upward movements that eventually reverse to create self-reinforcing downward movements that must reverse in turn. During the upswings, lending supports spending and investment, which in turn supports incomes and asset prices; increased incomes and asset prices support further borrowing and spending on goods and financial assets. The borrowing essentially lifts spending and incomes above the consistent productivity growth of the economy. Near the peak of the upward cycle, lending is based on the expectation that the above-trend growth will continue indefinitely. But, of course, that can’t happen; eventually income will fall below the cost of the loans.

Economies whose growth is significantly supported by debt-financed building of fixed investments, real estate, and infrastructure are particularly susceptible to large cyclical swings because the fast rates of building those long-lived assets are not sustainable. If you need better housing and you build it, the incremental need to build more housing naturally declines. As spending on housing slows down, so does housing’s impact on growth.

Except that for NZ we have a protracted shortage of housing at this time and for at least five years ahead? 21/09/2018 - will that shortage, despite unaffordable housing at low interest rates (4% - 20% deposit on a 900k home, overcome that cycle? Presumably housing does not stimulate economic growth, so if interest rates grow and we’ve lent to risky debtors, then we’re in trouble

One classic warning sign that a bubble is coming is when an increasing amount of money is being borrowed to make debt service payments, which of course compounds the borrowers’ indebtedness.

When borrowers cannot meet their debt service obligations to lending institutions, those lending institutions cannot meet their obligations to their own creditors. Policy makers must handle this by dealing with the lending institutions first. The most extreme pressures are typically experienced by the lenders that are the most highly leveraged and that have the most concentrated exposures to failed borrowers. These lenders pose the biggest risks of creating knock-on effects for credit worthy buyers and across the economy. Typically, they are banks, but as credit systems have grown more dynamic, a broader set of lenders has emerged, such as insurance companies, non-bank trusts, broker-dealers, and even special purpose vehicles.

Does this suggest that early leading indicators exist amongst alternative lenders? Or particularly ones that focus on consumer lending that doesn’t generate economic productivity? e.g GEM, Q Card. What reports on these lenders’ performance can you source to provide an early warning of economic troubles.

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. Most of the really terrible economic problems that debt crises have caused occurred before policy makers took steps to spread them out.

From my examination of these cases, the biggest risks are not from the debts themselves but from a) the failure of policy makers to do the right things, due to a lack of knowledge and/or lack of authority, and b) the political consequences of making adjustments that hurt some people in the process of helping others.

The key to handling debt crises well lies in policy makers’ knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable.

There are four types of levers that policy makers can pull to bring debt and debt service levels down relative to the income and cash flow levels that are required to service them: Austerity (i.e., spending less) Debt defaults/restructurings The central bank “printing money” and making purchases (or providing guarantees) Transfers of money and credit from those who have more than they need to those who have less

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.