A Template for Understanding Big Debt Crises

by Ray Dalio

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).

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.

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.

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.

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.

Lending naturally creates self-reinforcing upward movements that eventually reverse to create self-reinforcing downward movements that must reverse in turn.

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 the costs of debt service become greater than the amount that can be borrowed to finance spending, the upward cycle reverses.

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

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

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.

The bull markets are initially justified because lower interest rates make investment assets, such as stocks and real estate, more attractive so they go up, and economic conditions improve, which leads to economic growth and corporate profits, improved balance sheets, and the ability to take on more debt—all of which make the companies worth more.

As a bubble nears its top, the economy is most vulnerable, but people are feeling the wealthiest and the most bullish.

The greatest depressions occur when bubbles burst, and if the central banks that are producing the debts that are inflating them won’t control them, then who will?

central banks typically fall behind the curve during such periods, and borrowers are not yet especially squeezed by higher debt-service costs. Quite often at this stage, their interest payments are increasingly being covered by borrowing more rather than by income growth—a clear sign that the trend is unsustainable.

While tops are triggered by different events, most often they occur when the central bank starts to tighten and interest rates rise.

The more leverage that exists and the higher the prices, the less tightening it takes to prick the bubble and the bigger the bust that follows.

It is mostly driven by the supply and demand of, and the relationships between, credit, money, and goods and services—though psychology of course also does have an effect, especially in regard to the various players’ liquidity positions.

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.

ignorance and a lack of authority are bigger problems than debts themselves.

When spending is cut, incomes are also cut, so it takes an awful lot of painful spending cuts to make significant reductions in the debt/income ratios.

don’t save every institution that is expendable, balancing the benefits of allowing broke institutions to fail and be restructured with the risks that such failures can have detrimental effects on other creditworthy lenders and borrowers;

Longer term, the most important decision that policy makers have to make is whether they will change the system to fix the root causes of the debt problems or simply restructure the debts so that the pain is distributed over the population and over time so that the debt does not impose an intolerable burden.

Wealth gaps increase during bubbles and they become particularly galling for the less privileged during hard times.

In some cases, raising taxes on the rich becomes politically attractive because the rich made a lot of money in the boom—especially those working in the financial sector—and are perceived to have caused the problems because of their greed.

The right amounts are those that a) neutralize what would otherwise be a deflationary credit market collapse and b) get the nominal growth rate marginally above the nominal interest rate to tolerably spread out the deleveraging process.

Basically, income needs to grow faster than debt.

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.

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.

In virtually all past deleveragings, policy makers had to discover this for themselves after they first tried other paths without satisfactory results. History has shown that those who did it quickly and well (like the US in 2008–09) have derived much better results than those who did it late (like the US in 1930–33).

To reiterate, the key to having a beautiful deleveraging lies in balancing the inflationary forces against the deflationary ones.

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.

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.

world. When they invest in the sort of assets that finance spending, that stimulates the economy. When they invest in those that don’t (such as financial assets), there must be very large market gains before any money trickles down into spending—and that spending comes more from those who have enjoyed the market gains than from those who haven’t.

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

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.

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.

When we refer to “helicopter money,” we mean directing money into the hands of spenders (e.g., US veterans’ bonuses during the Great Depression, Imperial China).

It typically takes roughly 5 to 10 years (hence the term “lost decade”) for real economic activity to reach its former peak level. And it typically takes longer, around a decade, for stock prices to reach former highs, because it takes a very long time for investors to become comfortable taking the risk of holding equities again (i.e., equity risk premiums are high).

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

Holders of debt assets expect to convert them into money and then into goods and services down the road, so they are very conscious of the rate of its loss of purchasing power (i.e., inflation) relative to the compensation (i.e., the interest rate) they get for holding it

gold. When there is a debt crisis and economic weakness in a country, it is typically impossible for the central bank to raise interest rates enough to compensate for the currency weakness, so the money leaves that country and currency for safer countries.

When there is a debt crisis and economic weakness in a country, it is typically impossible for the central bank to raise interest rates enough to compensate for the currency weakness, so the money leaves that country and currency for safer countries.

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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.