A Template for Understanding Big Debt Crises

by Ray Dalio

Buying something you can’t afford means spending more than you make. You’re not just borrowing from your lender; you are borrowing from your future self. Essentially, you are creating a time in the future in which you will need to spend less than you make so you can pay it back. The pattern of borrowing, spending more than you make, and then having to spend less than you make very quickly resembles a cycle. This is as true for a national economy as it is for an individual. Borrowing money sets a mechanical, predictable series of events into motion.

While I won’t go into exactly how it works here, the most defining characteristics of bubbles that can be measured are: Prices are high relative to traditional measures Prices are discounting future rapid price appreciation from these high levels There is broad bullish sentiment Purchases are being financed by high leverage Buyers have made exceptionally extended forward purchases (e.g., built inventory, contracted for supplies, etc.) to speculate or to protect themselves against future price gains New buyers (i.e., those who weren’t previously in the market) have entered the market Stimulative monetary policy threatens to inflate the bubble even more (and tight policy to cause its popping)

In the immediate postbubble period, the wealth effect of asset price movements has a bigger impact on economic growth rates than monetary policy does. People tend to underestimate the size of this effect. In the early stages of a bubble bursting, when stock prices fall and earnings have not yet declined, people mistakenly judge the decline to be a buying opportunity and find stocks cheap in relation to both past earnings and expected earnings, failing to account for the amount of decline in earnings that is likely to result from what’s to come.