A Template for Understanding Big Debt Crises

by Ray Dalio

One of the most important asset/liability mismatches is foreign-denominated debt.

it primarily comes when the central bank succeeds in making it desirable to hold the currency again, and secondarily when spending and imports have fallen sufficiently to bring about an adjustment in the balance of payments.

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.

Here is what we typically see when the country reaches the bottom:

Below, we provide a summary of what well-managed and poorly managed

the price of domestic goods and domestic labor fell with the currency, so the country is an attractive destination for foreign

The real FX is undervalued (typically by around 10 percent on a PPP basis) at the start of stabilization and stays cheap.

Because these cases are more common than one might think, it is worth walking through how inflationary depressions spiral into hyperinflations.

Currency declines inspire additional capital flight, which causes an escalating feedback loop of depreciation, inflation, and money printing.

With each round of printing, more of the printed money is transferred to real or foreign assets instead of being spent on goods and services that fuel economic activity.

short cash and buy foreign and physical assets.

Investors shorten the duration of their lending, or stop lending entirely, because they are worried about risks of default or getting paid back in worthless money.

also cheap to short cash, as higher inflation and money printing lowers real interest rates, so the withdrawal of capital and faster borrowing cause illiquidity in the financial system.

governments respond to rising debt burdens by raising taxes on income and wealth. With their net worths already eroding because of the bad economy and their failing investments, the wealthy desperately try to preserve their rapidly shrinking wealth at all costs.

Investing during a hyperinflation has a few basic principles: get short the currency, do whatever you can to get your money out of the country, buy commodities, and invest in commodity industries (like gold, coal, and metals).

during this time gold becomes the preferred asset to hold,

economic rivalries within and between countries often lead to fighting in order to establish which entities are most powerful.

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

Politics is horrendous during debt crises, and distortions and outright misinformation are pervasive.

big, dramatic cycle. During the war years Germany left the gold standard, accumulated a large stock of domestic and foreign debts, began the practice of money printing to finance its ever-growing fiscal deficits, and experienced its first bout of currency depreciation and inflation.

classic case of a country with large foreign currency denominated debt that is held by foreign creditors.

citizens rushed to exchange their paper money for bullion, which caused a run on the banking system.

Currency is both a medium of exchange and a store hold of wealth. When investors hold a lot of promises to deliver currency (i.e., a lot of debt denominated in a currency) and the supply of that currency is tied to something that backs it, the ability of the central bank to produce currency is limited.

Financing this spending would mean either raising new revenues (i.e., taxation) or increasing government borrowing.

debt monetization is inflationary (there is more money in the economy chasing the same quantity of goods and services),

In economic crises, policies to redistribute wealth from “haves” to “have-nots” are more likely to occur.

the economic pain of deleveragings/depressions can give rise to populist and reactionary leaders on both the Left and the Right.

when capital is flowing into a country, it tends to lower the country’s inflation rate and stimulate its growth rate (all other things being equal);

Rising unemployment, and the potential social unrest it could cause, were considered much more menacing than the return of rising prices.

reparations were set at 132 billion gold marks (about 330 percent of German GDP).

the most important characteristic of cases that spiral into hyperinflation is that policy makers don’t close the imbalance between income and spending/debt service; instead, they fund and keep funding spending over sustained periods of time by printing lots of money.

when there is too much reflationary printing of money/monetization, and too severe a currency devaluation (which is reflationary) relative to the other levers for managing a deleveraging—especially the deflationary levers of austerity and debt restricting/default—the most severe inflationary depressions can and do occur.

Rising inflation led to a surge in retail purchases. This pickup in demand was not a sign of increasing economic activity but rather a flight of income and savings into real goods before inflation could eat away at the purchasing power of money.

this burst of economic activity was not a sign of economic prosperity, but a classic flight into inflation-hedge assets.

some clear benefit from the collapse of the mark was the export sector.

Once again, this bull market was not driven by improving economic fundamentals, or a more optimistic discounting of future economic conditions. It reflected a rush to get out of money or to get short money

Instead of a possible moratorium, Germany would now have to pay France whatever the French thought was appropriate, or risk a sustained occupation of some of its most valuable territory.

Following the French declaration, the loan committee was forced to conclude that extending credit to Germany was impossible.

The liquidity crisis was self-reinforcing.

with each round of printing, more money leaves the currency instead of going into economic activity.

inflation spirals push policy makers into circumstances where printing is the least bad of several terrible options.

The stock market was one of the few remaining domestic escapes from the inflation.

prompted by Germany missing a promised delivery of timber as a reparation payment, a French-Belgian force invaded Germany and occupied the Ruhr

why would any investor or saver want to hold German currency if they knew the government had huge external liabilities it could not pay?

trade associations, or companies, and were usually at least theoretically backed by real assets.129 This emergency money, though often illegal, was easier to use than the paper mark, and by the fall of 1923, nearly 2,000 types of it were actively circulating in Germany.

unlike the old gold loan bills, rentenmarks were directly secured by mortgages on 5 percent of all German agricultural and industrial property

the new reichsmark could be exchanged directly for bullion

In order to build confidence in a new currency, countries in inflationary deleveragings need to stop monetizing debt.

the budget ultimately needs to be balanced.