A Template for Understanding Big Debt Crises

by Ray Dalio

At this juncture, the currency’s total return will be attractive because either a) those who want to buy what the country has to offer need to sell their own currency and buy the local currency or b) the central bank will increase the supply of its own currency and sell it for the foreign currency, which will make the country’s assets go up when measured in its own currency. So, during this time when a country has a favorable balance of payments, there is a net inflow of money that leads to the currency appreciating and/or the foreign-exchange reserves increasing.

As the bubble emerges, there are fewer productive investments, and at the same time there is more capital going after them.

During this stage, growth is increasingly financed by debt rather than productivity gains, and the country typically becomes highly reliant on foreign financing.

As with all debt cycles, the positive effects come first and the negative effects come later.

During the bubble, the gap between the country’s income and its spending widens.

the countries that were most externally reliant through the upswing and experienced the biggest asset bubbles ultimately experienced the most painful outcomes.

The income from selling goods and services to foreigners drops (e.g., the currency has risen to a point where it’s made the country’s exports expensive; commodity-exporting countries may suffer from a fall in commodity prices).

Weakening capital flows are often the first shoe to drop in a balance of payments crisis. They directly cause growth to weaken because the investment and consumption they had been financing is reduced. This makes domestic borrowers seem less creditworthy, which makes foreigners less willing to lend and provide capital. So, the weakening is self-reinforcing.

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. Changing the value of the currency changes the price of a country’s goods and services for foreigners at a different rate than it does for its citizens.

In other words, currency declines allow countries to offer price cuts to the rest of the world (helping to bring in more business) without producing domestic deflation.

In fact, devaluations are stimulative for the economy and markets, which is helpful during the economic contraction.

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.

One of the most important asset/liability mismatches is foreign-denominated debt. As their local currency depreciates, debtors who owe foreign currency debt face a rising debt burden (in local currency).

The bottom is the mirror opposite of the bubble stage. While investors during the bubble are aggressively getting in, investors during the catharsis are aggressively getting out.

The reversal and eventual return to normalcy comes when there is a balance between the supply and the demand for the currency relative to those of other currencies.

In other words, the best way to ensure that investors expect positive total returns going forward at a relatively low real interest rate (which is what the weak domestic conditions need) is to depreciate the currency enough.

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

If investors are burned with negative returns for too long and the currency keeps falling, that’s frequently the break-point that determines if you’re going to have an inflationary spiral or not.

The devaluation is large enough that the people are no longer broadly expecting the currency weakening more (creating a two-way market).

The initial devaluation is small, and further devaluations are needed. The market expects this, causing higher interest rates and inflation expectations.

wage-cost spiral. Workers demand higher wages to compensate for their reduced purchasing power. Compelled to raise wages, producers increase their prices to compensate.

Because much of the country’s debt is denominated in a foreign currency, debt burdens rise when the currency falls, which requires spending cuts and asset sales.

At the most big-picture level, the periods of war are followed by periods of peace in which the dominant power/powers get to set the rules because no one can fight them. That continues until the cycle begins again (because of a rival power emerging).

After the war period, during the paying back period, the market consequences of the debts and the outcome of the war (whether it is won or lost) will be enormous. The worst thing a country, hence a country’s leader, could ever do is get into a lot of debt and lose a war because there is nothing more devastating.

the understandings and authorities of policy makers varies a lot across countries, which can lead to dramatically different outcomes, and they tend not to react forcefully enough until the crisis is extreme. Their

the most iconic inflationary depression cycle in history—the German debt crisis and hyperinflation that followed the end of World War I and carried into the mid-1920s, which set the stage for the economic and political changes of the 1930s.

So, whenever (a) the amount of money in circulation is much greater than the amount of gold held in reserves to back the money at the designated price of conversion, and (b) investors are rushing to convert money into gold because they are worried about the value of their money, the central bank is in the untenable position of either reducing the supply of money in circulation (i.e., tighten credit) or ending convertibility and printing more money.

Unlike local currency debt, hard currency (foreign currency and gold denominated) debt cannot be printed away.

German citizens rushing to get their capital out of the country because they justifiably feared that these promises to deliver currency (i.e., these debt obligations) would make it very difficult, if not impossible, for the German government to meet its liabilities with hard money.

the Reich would have to levy extortionately high taxes and confiscate private wealth. As the real wealth of private citizens was at risk, getting out of the currency and the country made sense.