A Template for Understanding Big Debt Crises

by Ray Dalio

To put these complicated matters into very simple terms, you create a cycle virtually anytime you borrow money. Buying something you can’t afford means spending more than you make. 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. This is as true for a national economy as it is for an individual. Borrowing money sets a mechanical, predictable series of events into motion.

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.

Typically debt crises occur because debt and debt service costs rise faster than the incomes that are needed to service them, causing a deleveraging.