A Template for Understanding Big Debt Crises

by Ray Dalio

known as Black Thursday, the major indices were down more than 10 percent.

As is common in severe economic downturns, protectionist and anti-immigrant sentiment began to

So policy makers were working with a limited toolkit until they broke the link to gold.

which is a classic example of how debt and liquidity problems prompted by runs can be rectified by providing liquidity rather than holding it back.

That saved my butt a number of times (e.g., in 2008). The events I am describing to you that happened in the 1930s have happened

misleading because the recovery benefited the rich more than the poor, and

6.5 percent to 1 percent. Note how close the US rate was to 0 percent at this

com bubble of the late 1990s. With the economy strong, inflation moderate, and asset prices appreciating well, the economy appeared to most people as though it was in a “Goldilocks” period—not too hot and not too cold. Debt/GDP grew at an average rate of 12.6 percent during the period. Typically that’s when bubbles emerge

Prices are high relative to traditional measures. Prices are discounting future rapid price appreciation from these high levels. There is broad bullish sentiment. Purchases are being financed by high leverage. Buyers have made exceptionally extended forward purchases (e.g., built inventory, contracted forward purchases, etc.) to speculate or protect themselves against future price gains. New buyers (i.e., those who weren’t previously in the market) have entered the market. Stimulative monetary policy helps inflate the bubble, and tight policy contributes to its popping.

aggressively on prices continuing to increase. At the same time, supplies were increasing as the higher prices encouraged production. Logic should dictate precisely the opposite behavior: those betting on price changes ought to be more inclined to deleverage or sell, and those who lend to them should be more cautious when these things are happening. However, this sort of nonsensical thinking is typical in bubbles.

At the time, some leverage ratios were nearing 100:1. To me, leverage is a much better indicator of future volatility than VAR.

knowledge of what it takes to manage it and the authority to do so, then they are capable of handling these situations in a way that minimizes spill-over effects

is that they didn’t have all the legal authority they needed to make some of the moves that were necessary. For example, by law, the

Treasury and the Fed’s actions so far, it became clearer in the last couple months of 2008 that the economy was falling at a far faster pace than even the most pessimistic observers feared, and that we were heading for the worst downturn since the Great Depression

This was their first Quantitative Easing (QE) program. This was a classic and critical step in managing a deleveraging. Central bankers in the midst of crises are forced to choose between 1) “printing” more money (beyond what’s needed for bank liquidity) to replace the decline in private credit, and 2) allowing a big tightening as credit collapses. They inevitably choose to print, as they did in this case, which is when things changed dramatically.

populist calls to “punish the bankers that caused this mess” are the norm and they make it difficult for policy makers to take the actions that are necessary to save the financial system and the economy.