A Template for Understanding Big Debt Crises

by Ray Dalio

3) The Top and Currency Defense The top-reversal/currency-defense occurs when the bubble bursts—i.e., when the flows that caused the bubble and the high prices of the currency level, the high asset prices and the high debt growth rates finally become unsustainable. This sets in motion a mirror-opposite cycle from what we saw in the upswing, in which weakening capital inflows and weakening asset prices cause deteriorating economic conditions, which in turn cause capital flows and asset prices to weaken further. This spiral sends the country into a balance of payments crisis and an inflationary depression. Because at the top people are so invested in the optimistic scenario, and because that optimism is reflected in the prices, even a minor event can trigger a slowing of foreign capital inflows and an increase in domestic capital outflows. Though worsening trade balances typically play a role (usually because of the high currency level and excessive domestic consumption that led to high imports), adverse shifts in capital flows are usually more important.