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Kindle Notes & Highlights
by
Ray Dalio
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February 23 - September 1, 2019
At the same time, we did our pro forma financial projections in Europe and saw a debt crisis brewing there due to a mismatch between: a) the amount of borrowing debtors needed to rollover maturing debt and sustain what they were doing, and b) the amount of lending that would be required to come from banks that had already stretched their balance sheets.
But the European debt crisis is a different story. While I won’t go into it now, it is noteworthy that the same sequence of events followed, in that policy makers didn’t believe they would face a debt crisis until they had it. When it came, they made the same rookie mistakes of leaning too heavily on deflationary levers like austerity and of not printing money and of not providing protections against defaults for systemically important entities until the pain became intolerable.
the decreased borrowing and spending (and consequences of these on employment and many other pain points) make this type of deleveraging as self-reinforcing on the downside as the increased debts and spending that cause bubbles is on the upside.
Between 1926 and 1929, the United States experienced a bubble that was
driven by a self-reinforcing cycle of rising debt, strong equity returns, and strong growth. By the bubble’s end, debts had reached a pre-crisis peak of 125% of GDP.
“ugly deleveraging,” which ran from 1929 to 1933.
High
debt levels left the United States vulnerable to a shock—which came in the form of th...
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Unlike many other cases, the United Kingdom didn’t experience a broad-based bubble in the years before the crisis, but it was tied to other countries, economies, and financial markets that were experiencing bubble-like conditions. And it did build up a substantial debt stock, with debts reaching 210% of GDP prior to the crisis. In this case, the debt was in the United Kingdom’s domestic currency, and the majority was owned domestically, too.
Unlike many other cases, Japan didn’t experience a broad- based
bubble in the years before the crisis, but it was tied to other countries, economies, and financial markets that were experiencing bubble-like conditions. And it did build up a substantial debt stock, with debts reaching 65% of GDP prior to the crisis. In this case, the debt was in Japan’s domestic currency, and the majority was owned domestically, too.
Eventually the cycle turned, producing a self-reinforcing bust and an “ugly deleveraging,” which ran from 1927 to 1931.
High debt levels left Japan vulnerable to a shock— which came in the form of the 1929 global stock market crash.
Eventually the dynamic turned, producing a self-reinforcing bust and an “ugly deleveraging,” which ran from 1929 to 1936. High debt levels left France vulnerable to a shock—which came in the form of ripples from a stock crash in the US and the early Great Depression.
After a relatively long bust phase, policy makers were able to provide enough stimulation to turn the deleveraging into a beautiful one and create a period of reflation, which began in 1936. In terms of monetary policy, the government broke the peg to gold, interest rates were ultimately pushed down to 2%, and real FX averaged -4% during the stimulative phase.
As is typical for winners of big wars, the United Kingdom experienced a brief postwar recession as the economy transitioned away from war production, and a more orderly deleveraging.
WW2. During the war, the United States borrowed a lot of money to finance its big fiscal deficit, shifted much of its economy to war production, and shifted much of its workforce to the armed services and war production.
As shown in the attribution chart to the right, even though the United States needed a deleveraging, its debt as a % GDP was roughly flat through this period.
Between 1984 and 1987, Norway experienced a bubble that was driven by a self-reinforcing cycle of strong growth, strong equity returns, and strong housing returns. By the bubble’s end, debts had reached a pre-crisis peak of 211% of GDP.
During this bubble period, policy makers initiated a large tightening (with short rates rising around 700 bps). Taken together, these bubble pressures, combined with tightening money and credit, created an unsustainable situation.
At its pre-crisis peak, debt service reached 58% of GDP, making Norway
vulnerable to a shock—which came in the form of ripples from commodity price declines.
Between 1987 and 1989, Finland experienced a bubble that was driven by a self-reinforcing cycle of strong growth and strong equity returns.
By the bubble’s end, debts had reached a pre-crisis peak of 272% of GDP.
debt levels left Finland vulnerable to a shock— which came in the form of asset price declines hitting bank solvency.
In particular, it nationalized banks, provided liquidity, and directly purchased troubled assets.
Between 1987 and 1990, Sweden experienced a bubble that was driven by a self-reinforcing cycle of rising debt, strong growth, and strong housing returns. Debts rose by 15% of GDP during the bubble to a pre-crisis peak of 239% of GDP.
At its pre-crisis peak, debt service reached 65% of GDP, making Sweden vulnerable to a shock—which came in the form of housing price declines hitting bank solvency.
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
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At its pre-crisis peak, debt service reached 78% of GDP, making Japan
vulnerable to a shock—which came in the form of real estate and stock market busts.
Between 2004 and 2007, the United States experienced a bubble that was driven by a self-reinforcing cycle of rising debt, strong growth and strong asset returns. Debts rose by 38% of GDP during the bubble to a pre-crisis peak of 349% of GDP. In this case, the debt was in the United States’s domestic currency, and the majority was owned domestically, too. During the bubble phase, investment inflows were moderately strong, averaging around 8% of GDP, which helped to finance a current account deficit of 6% of GDP. Aided by that rising debt and capital, growth was strong (at 3%), while levels of
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At its pre-crisis peak, debt service reached 68% of GDP, making the United States vulnerable to a shock—which came in the form of a housing bust.
Debts rose by 19% of GDP during the bubble to a pre-crisis peak of 279% of GDP. In this case, the debt was in Euros, which, while technically Austria’s domestic currency, is not a currency that Austria had control over. In addition, a high share of debt was owned by foreigners, which left Austria with some exposure to a pullback in foreign capital.
In this case, the debt was in Euros, which, while technically Greece’s domestic currency, is not a currency that Greece had control over. In addition, a high share of debt was owned by foreigners, which left Greece with some exposure to a pullback in foreign capital.
Eventually the dynamic turned, producing a self-reinforcing bust and an “ugly deleveraging,” which ran from 2008 to 2017. At its pre-crisis peak, debt service reached 42% of GDP, making Greece vulnerable to a shock—which came in the form of the 2008 global financial crisis.
Between 2005 and 2008, Ireland experienced a bubble that was driven by a self-reinforcing cycle of rising debt, strong growth, and strong housing returns.
A key determinant of how balance of payments/currency crises
play out is how policy makers respond to adverse capital flows: whether they let their currency go and allow a tightening of financial conditions to flow through (painful but typically necessary to resolve the crisis), or print money to make up for money leaving (which can be inflationary). In this case, they abandoned the currency peg and, after a slightly longer than average “ugly” phase, policy makers allowed enough tightening to flow through to reduce spending on imports (the current account balance improved by 3% of GDP), and make the currency more attractive to hold.
As shown in the attribution chart to the right, even though Peru needed a deleveraging, its debt as a % GDP went up by 163% (42% annualized), in part because the currency fell (which increased the burden of foreign-de- nominated debts)
As shown in the attribution chart to the right, even though Russia needed a deleveraging, its debt as a % GDP went up by 63% (58% annualized), in part because the currency fell (which increased the burden of foreign-denominated debts) and in part because the government had to borrow more in response to the crisis (with a peak fiscal deficit of 5% of GDP).
While the central bank is generally meant to provide one monetary policy for all (making money and credit broadly available through banks without deciding who gets it) and those who run fiscal policy are meant to apportion it well, macroprudential policies are tools for directing credit one way or another through the central bank’s regulatory authorities.
The need for macroprudential monetary policy is created by differentiation as credit grows: There can be a bubble in one area, and a starvation of credit in another area. If policy makers want to slow down credit where bubbles are emerging, and redirect credit to other areas, macroprudential policies can shift credit in that way. For instance, a classic countercyclical macroprudential policy is to make it easier to buy a house in a housing bust (say, by forcing credit standards lower or allowing lower down payments) or to make it harder to buy a house in a housing bubble (by doing the
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The typical case (drawing on the history of macroprudential tools being used in the US)…
