A Template for Understanding Big Debt Crises

by Ray Dalio

moratorium

On June 20, Hoover officially announced his proposal for a moratorium on Germany’s debts for one year. Under his proposal, the US would forgo $245 million in debt service payments due over the next year from Britain, France, and other European powers. However, in order to receive these concessions, the allies had to suspend $385 million in reparations due from Germany.110 In what became known as the “moratorium rally,” the Dow rallied 12 percent in the two days following Hoover’s announcement

Hitler was gearing up to run for Chancellor; he adopted the strongly populist stance of threatening to not repay the country’s reparation debts at all.

Germany’s problems proved to be a key source of contagion. UK banks had lots of loans to Germany, so they couldn’t get their money out; when foreign investors saw that the UK’s banks were in trouble, they began to pull their money. On July 24, France began withdrawing gold from England. This was interpreted as a lack of confidence in the pound, which prompted more countries to pull their deposits from Britain, and the run on sterling began.

Hoover approved of them, but acknowledged after the fact that, “Both loans, however, mostly served to create more fear.”

Other countries followed the UK in abandoning gold

convertibility so they could finally “print money” and devalue their currencies.

Most of these devaluations were roughly 30 percent (e.g., the Nordic countries, Portugal, much of eastern Europe, New Zealand, Australia, India), in line with sterling’s devaluation. The chart, bel...

Consistent with these pressures, UK stocks and bonds both rallied after selling off sharply through the currency defense phase and immediately following the devaluation. It is important to understand that these moves are very classic. Why they work as they do is explained in the archetypal template.

Naturally investors and savers around the world began to question whether the US was safe from either default or devaluation, so they started to sell out of their dollar debt positions. That raised interest rates and tightened liquidity, bringing on the most painful period of the depression, lasting until FDR took the US off the gold standard eighteen months later to devalue the dollar and print money.

The depression deepened in 1932, as the economy continued to plunge with deflation and credit problems worsening.

Once the Federal Reserve began purchases, yields on short-term Treasury securities fell rapidly with three month T-Bill yields falling more than two percent over the first half of the year. Fed purchases also relieved pressure in the market for longer-term treasury bonds, where the supply-demand imbalance for dollars had reached a breaking point amid large deficits and foreign reluctance to hold US assets. After rising above 4.3 percent in January, yields on ten-year treasuries fell below 3.5 percent over the next six months.

The change in accounting rules relieved some of the most immediate pressure on banks.

In March, stocks sold off and the market suffered a decline that extended through 11 weeks. The Dow Jones dropped 50 percent, from 88 on March 8 to 44 on May 31. The Dow Jones closed in May on a low for the month, and volume further declined that month to about 750,000 shares per day.

Social unrest and conflict continued to rise globally. In Germany, Hitler won the most seats in the Reichstag election. Japan slipped toward militarism, invading Manchuria in 1931 and Shanghai in 1932. In the US, strikes and protests were also increasing.

By the summer, the big stimulation and relief to banks appeared to be helping. The downward spiral began to moderate, asset prices stabilized, and production actually increased in certain areas of the economy, like autos.

The collapse of the economy throughout 1932 was breathtaking.

Consumer spending and production fell by more than 20 percent and unemployment rose by more than 16 percent. Severe deflation had taken hold and prices were falling by almost one percent every month.

Before the banks were set to reopen on March 9, Congress passed the Emergency Banking Act of 1933. The act extended the bank holiday and gave the Fed and the Treasury unprecedented powers to provide liquidity and capital to the banking system.

Most important, the act granted the Fed the ability to issue dollars that were backed by bank assets instead of gold, which broke the link between the dollar and gold and allowed the Fed to print money

So that the Fed could print money without facing a run on its gold reserves, Roosevelt banned gold exports under the...

When markets finally opened on Wednesday, the Dow rose 15.3 percent and commodities also soared.

Within two weeks of leaving the gold peg, the Federal Reserve was able to decrease its liquidity injections; short-term rates decreased by one percent to two percent, bankers’ acceptance rates dropped back to two percent, and call loan rates decreased to three percent.176 The money supply increased by 1.5 percent over the next three months, and the Dow was up by almost 100 percent over the next four months.

These moves ended the depression on a dime. (Most people mistakenly think that the depression lasted through the 1930s until World War II so I want to be clear on what actually happened. It is correct that it took until 1936 for GDP to match its 1929 peak. But when you look at the numbers in the charts below, you can see that leaving the gold peg was the turning point; it was exactly then that all markets and economic statistics bottomed.

When you read through them, focus on how they map to the template for handling debt problems.

As a result of all of this stimulation, deflation turned into acceptable rather than horrible inflation.

The economy and the markets continued to recover through 1934 and into 1935, when the Federal Reserve began contemplating tightening once again.

By 1935 the economy had recovered, deflation had disappeared, and stock prices had soared as a result of the Fed’s earlier policies.

The debate continued at the start of 1936.

By 1936, war was brewing in Europe, driving capital flight to the US, which continued to fuel advances in stocks and the economy.

That year, the president and other policy makers were becoming increasingly concerned by gold inflows (which allowed faster money and credit growth).196 The concerns were threefold:

Instead, starting December 23, the gold inflows/newly mined gold were sterilized—literally, the Treasury purchased gold inflows by drawing down its cash account at the Federal Reserve instead of printing money.

The Revenue Act of 1937 was passed to help to close loopholes in the Revenue Act of 1935 (which was sold as the “wealth tax”).200 That act had increased the federal income tax for the highest incomes up to 75 percent.

Stocks bottomed a year later, in April 1938, declining a total of nearly 60 percent!

As markets and the economy turned down in 1937, the Fed accelerated a twist into longer-dated assets and started to do a small amount of net asset purchases. By the end of the year, the Treasury began to reverse its sterilization program in partnership with the Fed.

While 1939 and 1941 are known as the official start of the wars in Europe and the Pacific, the wars really started about 10 years before that, as economic conflicts that were at first limited progressively grew into World War II.

More precisely:

when you read about the pooling and securitization of mortgages, the levering up of investment banks, and the rapid growth of derivatives that were traded off of regulated exchanges, see these as new ways of providing leverage outside the protection and regulation of authorities. If you don’t make the connection between the particulars of this case and the generalization, then you will miss how classic this debt crisis really was.

The 2001 recession, which was caused by the tightening of monetary policy, the bursting of the dot-com bubble, and the shock of the 9/11 terrorist attacks, prompted the Federal Reserve to lower interest rates all the way from 6.5 percent to 1 percent.

2004 and 2006. During this period, US economic conditions looked excellent by most measures.

Growth was relatively steady at 3 to 4 percent, the unemployment rate was below its long term average at between 4 and 5 percent, and inflation was mostly between 2 and 3.5 percent—a bit higher than desirable, but not worrisome by traditional measures.

During the bubble, there were five key components that helped fuel leveraging outside the traditional banking system:

The US financial regulatory system did not keep pace with these developments. It did not provide adequate regulatory visibility into the shadow banks and markets, nor did it provide the authorities with the powers they needed to curb their excesses,

So it was not just low interest rates that fueled the bubble, but rather a combination of easy money, lax regulation, and risky financial innovations. As the Fed was looking at inflation and not debt growth when setting interest rates, and as policy makers allowed the lax regulation of shadow lending channels to continue, the bubble was allowed to grow.

Keep in mind that up until this time, hardly anyone was concerned about hardly anything because both the markets and the economy were doing great. Stocks were reaching new highs, the job market remained strong, retail sales were strong, and so was consumer sentiment.

In

mid-June, 10-year Treasury yields hit 5.3 percent (the highest point since 2002), and in mid-July, the 90-day T-bill rate hit 5 percent, meaning the yield curve was very flat. That was the cyclical peak because of what came next.

As interest rates rose, home prices began to decline, since debt service payments on new homes would be higher, and interest payments on many existing mortgages rose quickly because many subprime borrowers had taken out adjustable rate mortgages (ARMs). As interest rates rose, so did their debt service payments.

In early August 2007, the mortgage market began to seriously unravel. On August 9, BNP Paribas, France’s largest bank and one of the largest in the world by assets, froze $2.2 billion worth of investments in three of its funds because its holdings in US subprime mortgages had exposed it to big losses.

The unraveling could be seen in interbank markets. The following chart shows a classic measure of interbank stress, the TED spread, in which a higher number means banks are demanding a higher interest rate to compensate for the risks of lending to each other.