A Template for Understanding Big Debt Crises

by Ray Dalio

I bet on economic changes via the markets that reflect them, which forces me to focus on the relative values and flows that drive the movements of capital. Those, in turn, drive these cycles.

For my whole life, even when I didn’t have any money, I strongly preferred saving to borrowing, because I felt that the upsides of debt weren’t worth its downsides,

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.

I want to emphasize that I am talking about nothing more than logically-driven series of events that recur in patterns.

Borrowing money sets a mechanical, predictable series of events into motion.

early in the game, “property is king” and later in the game, “cash is king.”

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

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.

Contributing further to the cyclicality of emerging countries’ economies are changes in their competitiveness due to relative changes in their incomes.

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.

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.

when debts are denominated in foreign currencies rather than one’s own currency, it is much harder for a country’s policy makers to do the sorts of things that spread out the debt problems,

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

there was about a 75 percent correlation between the amounts of their foreign debts and the amounts of inflation that they experienced

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

Over the last century, the US has gone through a long-term debt crisis twice—once during the boom of the 1920s and the Great Depression of the 1930s, and again during the boom of the early 2000s and the financial crisis starting in 2008.

The central bank is generally able to bring the economy out of a recession by easing rates to stimulate the cycle anew. But over time, each bottom and top of the cycle finishes with more economic activity than the previous cycle, and with more debt. Why? Because people push it—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.

Even the Old Testament described the need to wipe out debt once every 50 years, which was called the Year of Jubilee.

At these times, new types of lending vehicles are frequently invented and a lot of financial engineering takes place.

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

bubbles are much more similar than they are different, and each is a result of logical cause-and-effect relationships that can be studied and understood.

To identify a big debt crisis before it occurs, I look at all the big markets and see which, if any, are in bubbles. Then I look at what’s connected to them that would be affected when they pop.

The Top When prices have been driven by a lot of leveraged buying and the market gets fully long, leveraged, and overpriced, it becomes ripe for a reversal.

The increase in short-term interest rates makes holding cash more attractive, and it raises the interest rate used to discount the future cash flows of assets, weakening riskier asset prices and slowing lending.

In the early stages of a bubble bursting, when stock prices fall and earnings have not yet declined, people mistakenly judge the decline to be a buying opportunity and find stocks cheap in relation to both past earnings and expected earnings, failing to account for the amount of decline in earnings that is likely to result from what’s to come.

the deleveraging dynamic is not primarily psychological. It is mostly driven by the supply and demand of, and the relationships between, credit, money, and goods and services—though

Most of what people think is money is really credit, and credit does appear out of thin air during good times and then disappear at bad times.

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.

The depression phase is dominated by the deflationary forces of debt reduction (i.e., defaults and restructurings) and austerity occurring without material efforts to reduce debt burdens by printing money.

These conditions can persist for many years if policy makers don’t offset the depression’s deflationary forces with sufficient monetary stimulation of a new form.

debt burdens fall under four broad categories: 1) austerity, 2) debt defaults/restructurings, 3) debt monetization/money printing, and 4) wealth transfers (i.e., from the haves to the have-nots).

To reiterate, the two biggest impediments to managing a debt crisis are: a) the failure to know how to handle it well and b) politics or statutory limitations on the powers of policy makers to take the necessary actions.

they must ease the credit crunch and stimulate the overall economy. Since the government is likely having trouble raising funds through taxation and borrowing, central banks are forced to choose between “printing” still more money to buy their governments’ debts

shifts in policies to “print money,” buy assets, and provide guarantees are what moves the debt cycle from its depression/“ugly deleveraging” phase to its expansion/“beautiful deleveraging” phase.

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. That’s not a theory—it’s been repeatedly proven out in history.

Remember, spending is what matters. A dollar of spending paid for with money has the same effect on prices as a dollar of spending paid for with credit.

governments with gold-, commodity-, or foreign-currency-pegged money systems are forced to have tighter monetary policies to protect the value of their currency

In the end, policy makers always print. That is because austerity causes more pain than benefit, big restructurings wipe out too much wealth too fast, and transfers of wealth from haves to have-nots don’t happen in sufficient size without revolutions.

when monetary and fiscal policies are rolled out faster and smarter, the results are much better than these averages.

I encourage you to read about the hyperinflation in Germany’s Weimar Republic,

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.

Which Countries/Currencies Are Most Vulnerable to Severe Inflationary Deleveragings or Hyperinflations?

Generally the causes of the top-reversal fall into a few categories:

It is typical during the currency defense to see the forward currency price decline ahead of the spot price.

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.

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

Here is what we typically see after policy makers let the currency go:

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

currency declines are double-edged swords;

In all inflationary depressions, currency weakness translates to higher prices for imported goods, much of which is passed on to consumers, resulting in a sharp rise in inflation.