A Template for Understanding Big Debt Crises

by Ray Dalio

Unlike the rentenmark, which had only been formally backed by mortgage bonds, the new reichsmark could be

exchanged directly for bullion at th...

All remaining paper marks were withdrawn from circulation by June 5, 1925, while the old currency (the rentenmark) was gradually phased out over the next decade.

But as we will see, it took much more than a new currency to create a lasting stabilization. The rentenmark and reichsmark were crucial pieces of the reform process, but they weren’t the only pieces. Currency depends on the credibility of the institutions issuing it.

As long as the government can force the central bank to print to cover its liabilities, there is a risk that the new currency will be debased and its supposedly hard backing abandoned. That is one of the reasons it is important that central banks be independent of the political system.

The government had run budget deficits since the outbreak of the war in 1914.151 However, in August 1923, the government took steps to address the problem by indexing certain taxes to inflation and passing additional emergency taxes.152 By October, it had indexed all taxes to inflation.

Such austerity was extremely painful, and would have been almost impossible to stomach a year or two before. But the hyperinflation had caused so much suffering and chaos by the end of 1923 that the German public was willing to do almost anything to bring prices back under control.

By January 1924, the government was running a surplus.

Second—and more significantly—on April 7 1924, the Reichsbank decided to cap the total amount of credit it would extend to the private sector. It wouldn’t call back any existing debt, but it would extend new credit only as prior debts were paid off.162 This strict cap on new credit creation was painful for businesses in the short term, but it also meaningfully stabilized German inflation, which turned slightly negative in May 1924.163

The second major shift came through the Dawes Plan. In addition to reducing reparations burdens, the Dawes Committee also extended Germany a significant foreign exchange loan.168 The loan, issued in October 1924, amounted to 800 million gold marks worth of foreign currency, divided mainly between dollars, pounds, and francs.169 Though the amount was not extraordinarily large, it meaningfully improved the Reichsbank’s credibility when it came to defending against speculative attacks.170 It also sent a reassuring signal to foreign investors. In the four years following the implementation of the Dawes Plan, American investors poured money into German debt, attracted by its relatively high yields.

By 1924, the crisis was largely over. Germany would enter a brief period of recovery before the Great Depression hit it hard a decade later. This second crisis was not only economically devastating but fueled the rise of right wing and left wing populists, Hitler’s rise to power, and all that followed.

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

In the midst of that technology boom, the early part of the cycle (roughly from 1922 to 1927) saw strong economic growth and subdued inflation.

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, but we won’t get into that now.

The easing by the Federal Reserve also produced a bull market in stocks that showed every sign of a classic bubble. I’ll repeat my defining characteristics of a bubble:

In 1929, call loans and investment trusts were the fastest-growing channels for increasing leverage outside the banking system.11 The call loan market, a relatively new innovation, developed into a huge channel through which investors could access margin debt. The terms of call loans adjusted each day to reflect market interest rates and margin requirements, and lenders could “call” the money at any time, given the one-day term.

First originated and popularized in Great Britain, investment trusts were companies that issued shares and invested the proceeds in the shares of other companies.

restrain the rapid lending that was fueling stock speculation, they were hesitant to raise short-term interest rates because the economy wasn’t overheating, inflation remained subdued, and higher interest rates would hurt all borrowers, not just speculators.

Rather than raising its discount rate, the Fed enacted macroprudential (i.e., regulatory) measures aimed at constraining the supply of credit via banks. Some of these regulatory measures included lowering the acceptance rate for loans and increasing supervision of credit facilities.23 The Fed publicly released a letter it had written to regional banks, deriding the “excessive amount of the country’s credit absorbed in speculative security loans” and threatening that banks attempting to borrow money from the Fed in order to fund such loans might be refused.24 But these policies were largely ineffective.

In 1928, the Fed started to tighten monetary policy. 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. A year later, in August 1929, it raised rates again, to six percent.

While growth had moderated somewhat, the economy remained strong through the middle of 1929.

Bank of New York raised its discount rate to 6 percent,29 as it became clear that macroprudential measures had failed to slow speculative lending.

At the same time, concerns about the high stock prices and interest rates caused brokers to tighten their terms in the call loan market and raise margin requirements. After dropping them as low as 10 percent the previous year, margin requirements at most brokers rose to 45 to 50 percent.

The stock market peaked on September 3 when the Dow closed at 381—a level that it wouldn’t reach again for over 25 years.

The Dow suffered what was then its largest one-day point loss in

history, falling 20.7 points (6.3 percent) to close at 305.3.

After a quieter opening, the avalanche of selling materialized and panic took hold of the market.42 Sell orders poured in from across the country, pushing down prices and generating new margin calls, which in turn pushed down prices even more. The pace of selling was so frantic that operators struggled to keep up. One exchange telephone clerk captured the scene well: “I can’t get any information. The whole place is falling apart.”43 Rumors of failures swirled and as news spread, huge crowds formed in the financial district.44 By noon of what would become known as Black Thursday, the major indices were down more than 10 percent.

Around midday, a small group of the biggest bankers met at the offices of J.P. Morgan and hatched a plan to stabilize the market. “The Bankers’ Pool,” as they were known, committed to buy $125 million in shares. Early in the afternoon, traders acting on behalf of the bankers began to place large buy orders above the most recent price.45 As news of the plan spread, other investors began to buy aggressively in response and prices rose. After hitting a low of 272 (down 33), the Dow Jones Industrial Index bounced back to close at 299, down only six points for the day.46 But as it turned out, this would just be the first of many failed attempts to bolster the market.

But the collapse and panic resumed on Monday the 28th as a flood of sell orders came in from all types of investors.

Trading volume set another record as 9 million shares changed hands over the course of the day (3 million in the last hour of trading)51 and the Dow finished down 13.5 percent—its largest one-day loss in history—on what became known as Black Monday.

While the Fed’s liquidity eased credit conditions and likely prevented a number of failures, it wasn’t enough to stop the stock market’s collapse on what became known as Black Tuesday. Starting at the open, large blocks of shares flooded the market and pushed prices down.

The Dow closed down 11.7 percent, the second worst one-day loss in history. The market had fallen by 23 percent over two days and problems with leveraged speculators and their lenders were already starting to emerge.

Both the Fed and the Bank of England cut rates on Thursday. The Fed dropped its bank rate from 6 percent to 5 percent in coordination with the Bank of England’s

move to decrease its discount rate from 6.5 percent to 6 percent.

Railroad bonds and other high-grade bonds performed well during the crash, as investors sought safer investments after pulling back from stocks and call loans. At the same time, the yields between high-grade and lower-grade corporate bonds (rated BAA and below) reached their widest level in 1929, so the riskier corporate bonds were flat to down. That sort of market action—equities and bonds with credit risk falling and Treasury and other low credit risk assets rising—is typical in this phase of the cycle.

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

Although the Hoover Administration’s handling of the market crash and economic downturn is now often criticized, its early moves were broadly praised and helped drive a meaningful stock rally. On November 13, President Hoover proposed a temporary one percent reduction in the tax rate for each income bracket and an increase to public construction spending of $175 million.

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 April 10, the Dow had rallied back above 290. But despite stimulation and general optimism, economic weakness persisted.

First quarter earnings were disappointing, and stocks began to slide starting in late April.

Over the second half of 1930, the economy clearly began to weaken.

From May through December, department store sales fell 8 percent and industrial production fell 17.6 percent. 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).

Protectionist sentiment resulted most notably in the passage of the Smoot-Hawley Tariff Act, which imposed tariffs on nearly 20,000 US imports. Investors and economists alike feared that the proposed 20 percent increase in tariffs would trigger a global trade war and cripple an already weak global economy.

The most impactful initial response came from the US’s largest trading partner, Canada, which at the time took in 20 percent of American exports. Canadian policy makers increased tariffs on 16 US goods while simultaneously lowering tariffs on imports from the British Empire.79 As similar policies piled up in the years that followed, they accelerated the collapse in global trade caused by the economic contraction.

The fiscal policy debate centered on whether or not the Federal government should significantly ramp up spending to support the economy. Senate Democrats, joined by some Republicans, pushed the President to increase “direct relief” for those facing particularly difficult circumstances. That would of course mean larger deficits and more debt, and it would mean changing the rules of the game to shift wealth from one set of players to others, rather than letting the game play out in a way that would provide good lessons to help prevent such problems in the future (i.e., the moral hazard perspective).

Although other currencies faced a shortage amid the credit crunch, the dollar was particularly impacted because of its role as a global funding currency. At the same time, falling US imports reduced foreigners’ dollar income, intensifying the squeeze. Note that virtually the same dollar squeeze dynamics occurred in the 2008 crisis for the same reasons.

In the interim, bank runs spread throughout Europe. Hungary

reported bank runs starting in May, leading to the imposition of a bank holiday.105 The German government nationalized Dresdner Bank, the nation’s second largest bank, by buying its preferred shares.106 Major financial institutions failed across Romania, Latvia, and Poland.

In May, German stocks fell 14.2 percent, British stocks were down 9.8 percent and French stocks sold off 6.9 percent. In the US, the Dow sold off 15 percent in May following a 12.3 percent decline in April. The world was imploding.

Political turmoil in Europe led funds to flow into the US, which increased demand for US Treasuries and pushed down interest rates.