A Template for Understanding Big Debt Crises

by Ray Dalio

German minister of finance, “If we do not succeed in cutting loose from the inflationary economy through ruthless choking off of Reich expenditures, then the only prospect we have is general chaos.”

the government took aggressive measures to reduce expenses, dismissing 25 percent of its employees and cutting the salaries of the remainder by 30 percent.

Just as debt reductions have the effect of easing credit, weakening the currency, and increasing inflation, debt revaluations tighten credit, support currencies, and lower inflation.

the Great Depression, which is probably the most iconic case of a deflationary deleveraging.

Though the Great Depression happened nearly a century ago, its dynamic was basically the same as what occurred in and around 2008.

Technology breakthroughs filled the newspapers, driving wide-spread optimism about the economy.

As is classic, the bubble had its roots in the dizzying productivity and technological gains of the period and people making leveraged bets that they would continue.

Gold flowed from other countries to the US, because that was effectively how investors bought dollars. This played an important role in determining how events transpired during the lead-up to the crash in 1929,

At the start of 1929, The Wall Street Journal described the pervasive strength of the US economy: “One cannot recall when a new year was ushered in with business conditions sounder than they are today… Everything points to full production of industry and record-breaking traffic for railroads.”

I’ll repeat my defining characteristics of a bubble:

New buyers flooded the market, and many of them were unsophisticated investors with no prior experience with stocks, one of the classic signs of a bubble.

borrowers were using short-term debt to fund the purchases of risky long-term assets,

One of the classic ingredients of a debt crisis is the squeezing of lenders and borrowers who have debt/liability mismatches that they took on during the bubble.

As a historian later described it, “A great river of gold began to converge on Wall Street, all of it to help Americans hold common stock on margin.”

lenders and borrowers found lending and buying stocks with borrowed money to be very profitable.

Classically, bank earnings and balance sheets look healthy during the good times because the assets are highly valued and the deposits that back them are there. It’s when there’s a run on deposits and the assets fall in value that banks have problems.

From February to July, rates had risen by 1.5 percent to five percent. The Fed was hoping to slow the growth of speculative credit, without crippling the economy.

Declining asset prices created a negative wealth effect, which fed on itself in the financial markets and fed back into the economy through declining spending and incomes. The bubble reversed into a bust.

Because the sell-off was so sharp and came so late in the day, an unprecedented number of margin calls went out that night, requiring investors to post significantly more collateral to avoid having their positions closed out when the market opened on Thursday.

Notably, significant selling came from brokers whose loans from corporations were suddenly called amid the panic.

Classically the checks and balances designed to ensure stability during normal times are poorly suited for crisis scenarios where immediate, aggressive action is required. In the late 1920s, there were few well-established paths for dealing with the debt implosion and its domino effects.

The market had fallen by 23 percent over two days and problems with leveraged speculators and their lenders were already starting to emerge.

on Wednesday, rising 12.3 percent in one of the sharp bear market rallies that classically occur repeatedly during the depression phases of big debt crises.

By mid-November, the Dow was down almost 50 percent from its September peak.

the New York Fed aggressively provided liquidity during the crash.

On November 13, the market bottomed and began what was to be a 20 percent rally going into December. A sense of optimism took hold.

By New Year’s Day of 1930 it was widely believed that the stock market’s 50 percent correction was over, which helped drive a strong rebound in the first four months of the year.

The consensus among economists, including those at the American Economic Association and the Federal Reserve, was that the simulative policy moves would be enough to support an economic rebound.

the early stages of deleveragings, it’s very common for investors and policy makers to underestimate how much the real economy will weaken, leading to small rallies that quickly reverse, and initial policy responses that aren’t enough.

Over the course of the year, the rate of unemployment rose by over 10 percent (to 14 percent) and capacity utilization fell by 12 percent (to 67 percent). Housing and mortgage debt collapsed.

By October of 1930, the stock market had fallen below the lows reached in November 1929.

Market analysts and investors alike were realizing that their hopes for a quick recovery would not materialize.

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

As similar policies piled up in the years that followed, they accelerated the collapse in global trade caused by the economic contraction.

Runs on non-guaranteed financial institutions are classic in such depressions/deleveragings, and they can lead to their failure in a matter of days.

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

even a sound bank can fail if it can’t sell its assets fast enough to meet its liabilities.

Because of the gold standard, the Federal Reserve was restricted in how much it could print money, limiting how much it could lend to a bank facing liquidity problems

and other experts in both the US and Europe still retained hope that there would be an imminent return to normalcy because the problems still seemed manageable.

The fiscal policy debate centered on whether or not the Federal government should significantly ramp up spending to support the economy.

Because dollar-denominated credit was collapsing and a lot of dollar-denominated debt that required dollar credit to service it existed around the world, a global dollar shortage emerged

Classically, there is a squeeze in a reserve currency that is widely lent by foreign financial institutions when there is a collapse of credit creation in that currency.

Also, as is typical in such times, economies and wealth disparities fuel the rise of populist and extremist leaders globally, with the ideological fight between the authoritarian left and the authoritarian right.

Together, the far right and far left parties easily had enough parliamentary support to force Germany into an unstable multi-party coalition government. Germany was essentially becoming ungovernable.

The global trade war made economic conditions and the dollar squeeze worse.

The shortage of dollars made borrowing more expensive, creating a liquidity squeeze

To alleviate the liquidity squeeze and allow the continued financing of fiscal deficits, these governments naturally turned to some money printing (since the alternative of allowing the credit crunch to spiral was worse).

increased inf...

pockets of weakness: capital flight, currency difficulties, unemployment, global tightening of credit, pressures for debt payments, and refusals to renew foreign held German bank accounts.

bank runs spread throughout Europe.