A Template for Understanding Big Debt Crises

by Ray Dalio

Weakening capital flows are often the first shoe to drop in a balance of payments crisis.

central banks typically try to defend their currencies by a) filling the balance of payments deficit by spending down reserves and/or b) raising rates.

There is a critical relationship between a) the interest rate difference and b) the spot/forward currency relationship. The amount the currency is expected to decline is priced into how much less the forward price is below the spot price. For example, if the market expects the currency to fall by 5 percent over a year, it will need that currency to yield a 5 percent higher interest rate. The math is even starker when depreciation is expected over short periods of time. If the market expects a 5 percent depreciation over a month, than it will need that currency to yield a 5 percent higher interest rate over that month—and a 5 percent monthly interest is equivalent to an annual interest rate of about 80 percent10 —a level that’s likely to produce a very severe economic contraction in an already weak economy. Because a small expected currency depreciation (say 5 to 10 percent in a year) would equal a large interest rate premium (5 to 10 percent per year higher), this path is intolerable.

It is typical during the currency defense to see the forward currency price decline ahead of the spot price. This is a consequence of the relationship between the interest rate differential and the spot/forward currency pricing that I discussed above. To the extent that the country tightens monetary policy to try to support the currency, they are just increasing the interest rate differential to artificially hold up the spot currency. While this supports the spot, the forward will continue to decline relative to it. As a result, what you see is essentially a whip-like effect, where the forward tends to lead the spot downward as the interest rate differential increases. The spot then eventually catches up after the currency is let go, and the fall in the spot exchange rate allows the interest differential to narrow, which mechanically causes the forward to rally relative to the spot.

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.

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.

And if the one-off devaluation isn’t expected by the market (i.e., it’s a surprise), then policy makers won’t have to spend reserves and/or allow interest rates to rise to defend the currency going into the devaluation. This is why policy makers generally say they’ll continue to defend the currency right up until the moment they stop doing it.

Weaker growth causes investors to pull their money out anyway; the assets that had been seen as a fabulous treasure a short time

ago now look like trash. They quickly go from overbought to oversold and prices plummet.

One of the most important asset/liability mismatches is foreign-denominated debt. As their local currency depreciates, debtors who owe foreign currency debt face a rising debt burden (in local currency).

catharsis

Here are some key economic developments that characterize this phase:

Devaluing currencies is like using cocaine, in that it provides short-term stimulation but is ruinous when abused.

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

Typically it takes a few years for the country to recover. Investors who were burned on their investments from the last cycle are reluctant to return, so it can take some time before capital inflows become strongly positive. But the price of domestic goods and domestic labor fell with the currency, so the country is an attractive destination for foreign investment and the capital starts to come back.

The country is back to the early part of the cycle and starts a new virtuous cycle where productive investment opportunities attract capital, and capital drives up growth and asset prices, which attracts more capital.

Hyperinflations consist of extreme levels of inflation (goods and services prices more than doubling every year or worse) coupled with extreme losses of wealth and severe economic hardship.

As stated earlier, contrary to popular belief, it’s not so easy to stop printing money during a crisis. Stopping printing when capital is flowing out can cause an extreme tightness of liquidity and often a deep economic contraction.

(By late October 1923, toward the end of the

crisis, Germany’s entire 1913 stock of money would have just

about gotten you a one-kilo loaf of rye bread.) To stop printing would have meant there was so little cash that commerce would have virtually ground to a halt (at least until they came up with an alternate currency). In an inflation spiral, printing money can seem like the prudent choice at the time—but continuing to p...

When continual currency declines lead to persistent inflation, it can become self-reinforcing in a way that nurtures inflation psychology and changes investor behavior. A key way this occurs is when inflation pressures spread to wages and produce a wage-cost spiral.

Workers demand higher wages to compensate for their reduced purchasing power. Compelled to raise wages, producers increase their prices to compensate. Sometimes this happens mechanically because of wage indexing—contracts in which employers agree to increase wages with inflation. As is normal in such cases of price and wage indexing, a vicious cycle is established: the currency depreciates, internal prices rise, the increase of the quantity of paper money once more lowers the value of the currency, prices rise once more, and so on.

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. During inflationary deleveragings, average debt maturities always fall.

These higher debt burdens also mean foreign investors want higher interest rates as compensation for the risk of default. This means that currency declines and inflation often increase debt service and debt burdens, making it even harder to stimulate through the currency.

Many 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. This leads to extremely high rates of tax evasion and increases the flight of capital abroad. This is typical in deleveragings.

Money also breaks down as a medium of exchange, because the currency instability makes producers unwilling to sell their products for domestic currency, and producers often demand payment in foreign currencies or barter. Because there is a shortage of foreign exchange, illiquidity reaches its peak and demand collapses. This form of illiquidity can’t be relieved by money printing. Stores close and unemployment rises. As the economy enters hyperinflation, it contracts rapidly because the currency declines that were once beneficial now just create chaos.

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). Buying equities is a mixed bag: investing in the stock market becomes a losing proposition

as inflation transitions to hyperinflation. Instead of there being a high correlation between the exchange rate and the price of shares, there is an increasing divergence between share prices and the exchange rate. So, during this time gold becomes the preferred asset to hold, shares are a disaster even though they rise in local currency, and bonds are wiped out.

Once an inflationary deleveraging spirals into hyperinflation, the currency never recovers its status as a store hold of wealth. Creating a new currency with very hard backing while phasing out the old currency is the classic path th...

When 1) within countries there are economic conflicts between the rich/capitalist/political right and the poor/proletariat/political left that lead to conflicts that result in populist, autocratic, nationalistic, and militaristic leaders coming to power, while at the same time, 2) between countries there are conflicts arising among comparably strong economic and military powers, the relationships between economics and politics become especially intertwined—and the probabilities of disruptive conflicts (e.g., wars) become much higher than normal.

The worst thing a country, hence a country’s leader, could ever do is get into a lot of debt and lose a war because there is nothing more devastating.

Losers experience a much deeper depression, resort to more money printing, meaningfully spend down their savings/reserves, and see much higher inflation rates (sometimes experiencing hyperinflation).

I want

to reiterate my headline: managing debt crises is all

about spreading out the pain of the bad debts, and this can almost always be done well if one’s debts are in one’s own currency. The biggest risks are typically not from the debts themselves, but from the failure of policy makers to do the right things due to a lack of knowledge and/or lack of authority. If a nation’s debts are in a foreign currency, much more difficult choices h...

World War I (July 1914–November 1918) set the stage for this 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. Based on their experience of the Franco-Prussian War of 1870, the Germans had expected the war to be short, and they assumed it would ultimately be paid for by large indemnities levied on the defeated Allied powers. Instead it turned out to be an extremely long and expensive affair that was financed primarily through domestic debt, and Germany ended up having to pay a huge war reparation bill rather than collecting on one.

In order to prevent further losses, ensure liquidity in the banking system, and avoid a major contraction in the money supply, policy makers suspended the conversion of money to gold on July 31, 1914.3

So, whenever (a) the amount of money in circulation is much greater than the amount of gold held in reserves to back the money at the designated price of conversion, and (b) investors are rushing to convert money into gold because they are worried about the value of their money, the central bank is in the untenable position of either reducing the supply of money in circulation (i.e., tighten credit) or ending convertibility and printing more money. Central banks almost always choose suspending convertibility and printing more money versus allowing a credit contraction to take place, because it’s less painful.

Fighting the war required the German government to significantly increase expenditures (government spending as a share of GDP would increase 2.5x between 1914 and 1917). Financing this spending would mean either raising new revenues (i.e., taxation) or increasing government borrowing. As there was huge resistance to increasing taxation at home, and as Germany was mostly locked out of international lending markets, the war had to be financed by issuing domestic debt.5 In 1914, German government debt was insignificant. By 1918, Germany had amassed a total local currency debt stock of 100 billion marks, about 130 percent of German GDP.

Up until the second half of 1916, the German public was both willing and able to finance the entire fiscal deficit by purchasing government debt.9 In fact, war bond issuances were regularly oversubscribed. However, as the war dragged on and inflation accelerated, the Treasury found that the public was no longer prepared to hold all the debt it was issuing.

The currency remained an effective medium of exchange while losing its effectiveness as a store hold of wealth. So, the government borrowed money to pay for its war expenditures, and the Reichsbank was forced to monetize the debt as investors came up short in supplying the money. This had the effect of increasing the money supply by an amount equal to the fiscal deficit not financed by the public.

As debt monetization is inflationary (there is more money in the economy chasing the same quantity

of goods and services), a self-reinforcing spiral ensued—i.e., debt monetization increased inflation, which reduced real interest rates, which discouraged lending to the governmen...

The pace of money creation accelerated after 1917 as German citizens became increasingly unwilling to purchase government debt, and the central bank was forced to monetize a growing share of the deficit.14 Although the number of marks in circulation almost doubled between mid-1917 and mid-1918, it did not cause a material decline in the currency. In fact, the mark rallied over this period as Russia’s withdrawal increased expectations of a German victory. The mark only began falling in the second half of 1918, as a German defeat began looking increasingly likely.

In the last two years of the war, the German government began borrowing in foreign currencies because lenders were unwilling to take promises to pay in marks.

the money supply grew by about 50 percent and the inflation rate climbed to 30 percent.

Many Germans therefore expected that their country would come out of the war with its territory and economic capacity intact, and that the reparation burden would not be too vindictive.25 When the final terms of the Treaty of Versailles were revealed, they came as a huge shock.