A Template for Understanding Big Debt Crises

by Ray Dalio

Between 1987 and 1989, Japan experienced a bubble that was driven by a self-reinforcing cycle of rising debt, strong growth and strong asset returns. Debts rose by 24% of GDP during the bubble to a pre-crisis peak of 307% of GDP. In this case, the debt was in Japan’s domestic currency, the majority was owned domestically, and Japan was a net creditor (which helped keep the exchange rate strong even through shocks, due to capital repatriations). During the bubble phase, investment inflows were low, averaging around 1% of GDP. Aided by that rising debt, growth was strong (at 5%), while levels of economic activity were high (the GDP gap peaked at 4%). Furthermore, strong asset returns (equities averaged 28% annualized returns over the bubble period) encouraged more borrowing and helped to stimulate growth. During this bubble period, policy makers initiated a large tightening (with short rates rising around 450 bps). Taken together, these bubble pressures, combined with tightening money and credit, created an unsustainable situation.