A Template for Understanding Big Debt Crises

by Ray Dalio

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 or allowing their governments and their private sector to compete for the limited supply of money, which will only tighten money further. Inevitably, they choose to print.

Typically, though not necessarily, these moves come in progressively larger doses as more modest initial attempts fail to rectify the imbalance and reverse the deleveraging process. However, those early efforts do typically cause temporary periods of relief that are manifest in bear-market rallies in financial assets and increased economic activity. During the Great Depression there

were six big rallies in the stock market (of between 16 percent and 48 percent) in a bear market that declined a total of 89 percent. All of those rallies were triggered by government actions th...

When risks emerge that systemically important institutions will fail, policy makers must take steps to keep these entities running. They must act immediately to:

Certain institutions are part of the plumbing of the system; one would hate to lose them even if they’re not making money at the moment. It would be like losing a shipping port in a depression because the port goes broke. You want the port to continue to operate and ships to come in, so you have to protect it one way or another—whether through a nationalization, loans, or capital injections.

Policy makers typically fail to recognize the magnitude of the problem initially, instead enacting a number of one-off policies that are insufficient to move the needle. It is only after what is usually a couple of years and a lot of unnecessary economic pain that they finally act decisively.

Typically, nonsystemically important institutions are forced to absorb their losses, and if they fail, are allowed to go bankrupt. The resolution of these institutions can take several different forms. In many cases (about 80 percent of the cases we studied), they are merged with healthy institutions. In some other cases, the assets are liquidated or transferred

to an “asset-management company” (AMC) set up by the government to be sold piecemeal.

There are relatively clear lines for which creditors receive protections:

For systemically important borrowers or strategically important ones, policy makers generally take steps to ensure that the businesses remain intact as entities. In general this occurs through a restructuring of the debts to make the ongoing debt service manageable. This can occur through debt-for-equity swaps, through reducing the existing debts, lowering interest rates, or terming out the borrowing.

Wealth gaps increase during bubbles and they become particularly galling for the less privileged during hard times. As a general rule, if rich people share a budget with poor people and there is an economic downturn, there will be economic and political conflict. It is during such times that populism on both the left and the right tends to emerge. How well the people and the political system handle this is key to how well the economy and the society weather the period.

1930s. In both cases, the net worth of the top 0.1 percent of the population equaled approximately that of the bottom 90 percent combined.

A “beautiful deleveraging” happens when the four levers are moved in a balanced way so as to reduce intolerable shocks and produce positive growth with falling debt burdens and acceptable inflation.

The best way of negating the deflationary depression is for the central bank to provide adequate liquidity and credit support, and, depending on different key entities’ needs for capital, for the central government to provide that too.

So, what do I mean by that? Basically, income needs to grow faster than debt. For example: Let’s assume that a country going through a deleveraging has a debt-to-income ratio of 100 percent. That means that the amount of debt it has is the same as the amount of income the entire country makes in a year. Now think about the interest rate on that debt. Let’s say it’s 2 percent. If debt is 100 and the interest rate is 2 percent, then if no debt is repaid it will be 102 after one year. If income is 100 and it grows at 1 percent, then income will be 101, so the debt burden will increase from 100/100 to 102/101. So for the burdens from existing debt not to increase, nominal income growth must be higher than nominal interest rates, and the higher the better (provided it is not so high that it produces unacceptable inflation and/or unacceptable currency declines).

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.

This “printing” takes the form of central bank purchases of government securities and nongovernment assets such as corporate securities, equities, and other assets, which is reflected in money growing at an extremely fast rate at the same time as credit and real economic activity are contracting.

But there is such a thing as abusive use of stimulants. Because stimulants work so well relative to the alternatives, there is a real risk that they can be abused, causing an “ugly inflationary deleveraging” (like the Weimar hyperinflation of the 1920s, or those in Argentina and Brazil in the 1980s). The key is to avoid printing too much money. If policy makers achieve the right balance, a deleveraging isn’t so dramatic. Getting this balance right is much more difficult in countries that have a large percentage of debt denominated in foreign currency and owned by foreign investors (as in Weimar Germany and the South American countries) because that debt can’t be monetized or restructured as easily.

The money printing occurs in two classic waves—central banks first provide liquidity to stressed institutions, and then they conduct large-scale asset purchases to broadly stimulate the economy.

For example, when the value of the dollar (and therefore the amount of money) was tied to gold during the Great Depression, suspending the promise to convert dollars into gold so that the currency could be devalued and more money created was key to creating the bottoms in the stock and commodity markets and the economy.

Printing money, making asset purchases, and providing guarantees were much easier to do in the 2008 financial crisis, as they didn’t require a legalized and official change in the currency regime.

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.

To reiterate, the key to having a beautiful deleveraging lies in balancing the inflationary forces against the deflationary ones. That’s because too much money printing can also produce an ugly inflationary deleveraging (which we will go through later). The right amounts of stimulus are those that a) neutralize what would otherwise be a deflationary credit-market collapse and b) get the nominal growth rate above the nominal interest rate by enough to relieve the debt burdens, but not by so much that it leads to a run on debt assets.

BUBBLE

TOP

DEPRESSION

To help understand the different kinds of monetary policies that can be used throughout a deleveraging, I think of them as coming in three different styles, each with its own effects on the economy and markets.

Eventually the system gets back to normal, though the recovery in economic activity and capital formation tends to be slow, even during a beautiful deleveraging. It typically takes roughly 5 to 10 years (hence the term “lost decade”) for real economic activity to reach its former peak level.

please remember that:

That last dynamic, i.e., the currency dynamic, is what produces inflationary depressions.

Holders of debt denominated in the poorly returning currency are motivated to sell it and move their assets into another currency or a non-currency store hold of wealth like gold.

Capital outflows tend to happen when an environment is inhospitable (e.g., because debt, economic, and/or political problems exist), and they typically weaken the currency a lot.

The currency weakness is what causes inflation when there is a depression.

the squeeze ends when a) the debts are defaulted on and/or enough money is created to alleviate the squeeze, b) the debt service requirements are reduced in some other way (e.g., forbearance) and/or c) the currency depreciates much more than inflation picks up, so that the country’s assets and the items it sells to the world become so competitively priced that its balance of payments improves. But a lot depends on politics. If the markets are allowed to run their courses, the adjustments eventually take place and the problems are resolved, but if the politics get so bad that productivity is thrown into a self-reinforcing downward spiral, that spiral can go on for a long time.

While inflationary depressions are possible in all countries/currencies, they are far more likely in countries that:

They transpire pretty much as deflationary deleveragings do up until the fourth stage, the depression.

section. (This archetype was created by averaging 27 inflationary deleveragings in which there was a lot of debt denominated in foreign currencies.)

Capital flows—both within countries and among them—are typically the most important flows to watch because they are the most volatile.

As the cycle begins, debt and incomes rise at comparable rates and both debt and equity markets are strong, which encourages investing, often with borrowed money. The private sector, government, and banks start to borrow, which makes sense for them because incomes are rising quickly, making it easier to service the debt. These strong fundamentals and early levering up set the country up for a boom that in turn attracts more capital.

At these times of early currency strength, some central banks choose to enter the foreign-currency exchange market to sell their own currency for the incoming foreign currency in order to prevent it from rising (and to prevent the adverse economic effects of its rise). If the central bank does this, it needs to do something with that newly acquired currency, which is to buy investment assets denominated in that foreign currency (most typically bonds)

and put them in an account called “foreign-exchange reserves.” Foreign-exchange reserves are like savings: They can be used to bridge imbalances between the amount of currency demanded and the amount supplied by the free market in order to cushion the movements of the currency markets.

At this juncture, the currency’s total return will be attractive because either a) those who want to buy what the country has to offer need to sell their own currency and buy the local currency or b) the central bank will increase the supply of its own

currency and sell it for the foreign currency, which will make the country’s assets go up when measured in its own currency.

The capital that came in during the early upswing produced good returns, as it was invested productively and led to asset price appreciation, which attracted even more capital. In the bubble phase, the prices of the currency and/or the assets get bid up and increasingly financed by debt, making the prices of these investments too high to produce adequate returns, but the borrowing and buying continues because prices are rising, and so debts rise rapidly relative to incomes.

we show some key economic developments typically seen as the bubble inflates. Foreign capital flows are high (on average around 10 percent of GDP) The central bank is accumulating foreign-exchange reserves The real FX is bid up and becomes overvalued on a purchasing power parity (PPP) basis by around 15 percent Stocks rally (on average by over 20 percent for several years into their peak)

There are lots of different ways that a sustained bull market will lead to multinational entities getting long that local currency.

The influx of foreign capital finances a boom in consumption Imports rise faster than exports, and the current account worsens

But levels of economic activity can remain strong at the top of the cycle only as long as continued inflows, motivated by expectations of continued high growth, drive up asset prices and cause the currency to strengthen further. At this point, the country is increasingly fragile and even a minor event can trigger a reversal.

This sets in motion a mirror-opposite cycle from what we saw in the upswing, in which weakening capital inflows and weakening asset prices cause deteriorating economic conditions, which in turn cause capital flows and asset prices to weaken further. This spiral sends the country into a balance of payments crisis and an inflationary depression.

In the typical cycle, the crisis arises because the unsustainable pace of capital that drove the bubble slows, but in many cases, there is some sort of a shock (like a decline in oil prices for an oil producer). Generally the causes of the top-reversal fall into a few categories: