Big Debt Crises
Ray Dalio

Ended: June 17, 2019

We used our understanding to develop our principles and build computer decision-making systems that laid out in detail exactly how we’d react to virtually every possible occurrence This approach helped us enormously. For example, eight years before the financial crisis of 2008, we built a “depression gauge” that was programmed to respond to the developments of 2007–2008, which had not occurred since 1929–32. This allowed us to do very well when most everyone else did badly.
Credit is the giving of buying power. This buying power is granted in exchange for a promise to pay it back, which is debt. Clearly, giving the ability to make purchases by providing credit is, in and of itself, a good thing, and not providing the power to buy and do good things can be a bad thing. For example, if there is very little credit provided for development, then there is very little development, which is a bad thing. The problem with debt arises when there is an inability to pay it back. Said differently, the question of whether rapid credit/debt growth is a good or bad thing hinges on what that credit produces and how the debt is repaid (i.e., how the debt is serviced).
From my experiences and my research, I have learned that too little credit/debt growth can create as bad or worse economic problems as having too much, with the costs coming in the form of foregone opportunities. Generally speaking, because credit creates both spending power and debt, whether or not more credit is desirable depends on whether the borrowed money is used productively enough to generate sufficient income to service the debt. If that occurs, the resources will have been well allocated and both the lender and the borrower will benefit economically. If that doesn’t occur, the borrowers and the lenders won’t be satisfied and there’s a good chance that the resources were poorly allocated.
In assessing this for society as a whole, one should consider the secondary/indirect economics as well as the more primary/direct economics. For example, sometimes not enough money/credit is provided for such obviously cost-effective things as educating our children well (which would make them more productive, while reducing crime and the costs of incarceration), or replacing inefficient infrastructure, because of a fiscal conservativism that insists that borrowing to do such things is bad for society, which is not true.
I am asserting that the downside risks of having a significant amount of debt depends a lot on the willingness and the ability of policy makers to spread out the losses arising from bad debts. I have seen this in all the cases I have lived through and studied. Whether policy makers can do this depends on two factors: 1) whether the debt is denominated in the currency that they control and 2) whether they have influence over how creditors and debtors behave with each other.
Are Debt Crises Inevitable? Throughout history only a few well-disciplined countries have avoided debt crises. That’s because lending is never done perfectly and is often done badly due to how the cycle affects people’s psychology to produce bubbles and busts. While policy makers generally try to get it right, more often than not they err on the side of being too loose with credit because the near-term rewards (faster growth) seem to justify it. It is also politically easier to allow easy credit (e.g., by providing guarantees, easing monetary policies) than to have tight credit. That is the main reason we see big debt cycles.
Economies whose growth is significantly supported by debt-financed building of fixed investments, real estate, and infrastructure are particularly susceptible to large cyclical swings because the fast rates of building those long-lived assets are not sustainable.
In “bubbles,” the unrealistic expectations and reckless lending results in a critical mass of bad loans. At one stage or another, this becomes apparent to bankers and central bankers and the bubble begins to deflate. One classic warning sign that a bubble is coming is when an increasing amount of money is being borrowed to make debt service payments, which of course compounds the borrowers’ indebtedness.
There are four types of levers that policy makers can pull to bring debt and debt service levels down relative to the income and cash flow levels that are required to service them: Austerity (i.e., spending less) Debt defaults/restructurings The central bank “printing money” and making purchases (or providing guarantees) Transfers of money and credit from those who have more than they need to those who have less
To identify a big debt crisis before it occurs, I look at all the big markets and see which, if any, are in bubbles. Then I look at what’s connected to them that would be affected when they pop. 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)
When prices have been driven by a lot of leveraged buying and the market gets fully long, leveraged, and overpriced, it becomes ripe for a reversal. This reflects a general principle: When things are so good that they can’t get better—yet everyone believes that they will get better—tops of markets are being made.
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. But the reversal is self-reinforcing. As wealth falls first and incomes fall later, creditworthiness worsens, which constricts lending activity, which hurts spending and lowers investment rates while also making it less appealing to borrow to buy financial assets. This in turn worsens the fundamentals of the asset (e.g., the weaker economic activity leads corporate earnings to chronically disappoint), leading people to sell and driving down prices further. This has an accelerating downward impact on asset prices, income, and wealth.
In normal recessions (when monetary policy is still effective), the imbalance between the amount of money and the need for it to service debt can be rectified by cutting interest rates enough to 1) produce a positive wealth effect, 2) stimulate economic activity, and 3) ease debt-service burdens. This can’t happen in depressions, because interest rates can’t be cut materially because they have either already reached close to 0 percent or, in cases where currency outflows and currency weaknesses are great, the floor on interest rates is higher because of credit or currency risk considerations.
People ask if printing money will raise inflation. It won’t if it offsets falling credit and the deflationary forces are balanced with this reflationary force. That’s not a theory—it’s been repeatedly proven out in history. Remember, spending is what matters. A dollar of spending paid for with money has the same effect on prices as a dollar of spending paid for with credit. By “printing money,” the central bank can make up for the disappearance of credit with an increase in the amount of money. This “printing” takes the form of central bank purchases of government securities and nongovernment assets such as corporate securities, equities, and other assets, which is reflected in money growing at an extremely fast rate at the same time as credit and real economic activity are contracting. Traditional economists see that as the velocity of money declining, but it’s nothing of the sort. What is happening at such times is that credit destruction is being offset by money creation. If the balance between replacing credit and actively stimulating the economy is right, this isn’t inflationary.
Typically, governments with gold-, commodity-, or foreign-currency-pegged money systems are forced to have tighter monetary policies to protect the value of their currency than governments with fiat monetary systems. But eventually the debt contractions become so painful that they relent, break the link, and print (i.e., either they abandon these systems or change the amount/pricing of the commodity that they will exchange for a unit of money). For example, when the value of the dollar (and therefore the amount of money) was tied to gold during the Great Depression, suspending the promise to convert dollars into gold so that the currency could be devalued and more money created was key to creating the bottoms in the stock and commodity markets and the economy. Printing money, making asset purchases, and providing guarantees were much easier to do in the 2008 financial crisis, as they didn’t require a legalized and official change in the currency regime. The chart below shows the archetypal path of gold prices. In the US Great Depression, gold rose overnight when Roosevelt broke the gold peg, and during the more recent financial crisis, Fed moves helped push down the value of the dollar versus all currencies, including gold.
Capital outflows tend to happen when an environment is inhospitable (e.g., because debt, economic, and/or political problems exist), and they typically weaken the currency a lot. To make matters worse, those who fund their activities in the country that has the weaker currency by borrowing the stronger currency see their debt costs soar; that drives down the weaker currency relative to the stronger one even more. For these reasons, countries with the worst debt problems, a lot of debt denominated in a foreign currency, and a high dependence on foreign capital typically have significant currency weaknesses. The currency weakness is what causes inflation when there is a depression. Normally this all runs its course when the currency and the debt prices go down enough to make them very cheap. More specifically, the squeeze ends when a) the debts are defaulted on and/or enough money is created to alleviate the squeeze, b) the debt service requirements are reduced in some other way (e.g., forbearance) and/or c) the currency depreciates much more than inflation picks up, so that the country’s assets and the items it sells to the world become so competitively priced that its balance of payments improves. But a lot depends on politics. If the markets are allowed to run their courses, the adjustments eventually take place and the problems are resolved, but if the politics get so bad that productivity is thrown into a self-reinforcing downward spiral, that spiral can go on for a long time.
Which Countries/Currencies Are Most Vulnerable to Severe Inflationary Deleveragings or Hyperinflations? While inflationary depressions are possible in all countries/currencies, they are far more likely in countries that: Don’t have a reserve currency (so there is not a global bias to hold their currency/debt as a store hold of wealth) Have low foreign-exchange reserves (the cushion to protect against capital outflows is small) Have a large foreign debt (so there is a vulnerability to the cost of the debt rising via increases in either interest rates or the value of the currency the debtor has to deliver, or a shortage of the availability of dollar denominated credit) Have a large and increasing budget and/or current account deficit (causing the need to borrow or print money to fund the deficits) Have negative real interest rates (i.e., interest rates that are significantly less than inflation rates), therefore inadequately compensating lenders for holding the currency/debt Have a history of high inflation and negative total returns in the currency (increasing lack of trust in the value of the currency/debt) Generally speaking, the greater the degree to which these things exist, the greater the degree of the inflationary depression.
In either case, during these bubbles the total returns of these assets to foreigners (i.e., asset prices in local currency plus the currency appreciation) are very attractive. That plus that country’s hot economic activity encourage more foreign inflows and fewer domestic outflows. Over time, the country becomes the hot place to invest, and its assets become overbought so debt and stock-market bubbles emerge. Investors believe the country’s assets are a fabulous treasure to own and that anyone not in the country is missing out. Investors who were never involved with the market rush in. When the market gets fully long, leveraged, and overpriced, it becomes ripe for a reversal. In the bullets here and in the ones that follow, we show some key economic developments typically seen as the bubble inflates. Foreign capital flows are high (on average around 10 percent of GDP) The central bank is accumulating foreign-exchange reserves The real FX is bid up and becomes overvalued on a purchasing power parity (PPP) basis by around 15 percent Stocks rally (on average by over 20 percent for several years into their peak)
As inflation worsens, bank depositors understandably want to be able to get their funds on short notice, so they shorten their lending to banks. Deposits move to short-term checking accounts rather than longer-term savings. Investors shorten the duration of their lending, or stop lending entirely, because they are worried about risks of default or getting paid back in worthless money. During inflationary deleveragings, average debt maturities always fall.
Investing during a hyperinflation has a few basic principles: get short the currency, do whatever you can to get your money out of the country, buy commodities, and invest in commodity industries (like gold, coal, and metals). Buying equities is a mixed bag: investing in the stock market becomes a losing proposition as inflation transitions to hyperinflation. Instead of there being a high correlation between the exchange rate and the price of shares, there is an increasing divergence between share prices and the exchange rate. So, during this time gold becomes the preferred asset to hold, shares are a disaster even though they rise in local currency, and bonds are wiped out.
Once an inflationary deleveraging spirals into hyperinflation, the currency never recovers its status as a store hold of wealth. Creating a new currency with very hard backing while phasing out the old currency is the classic path that countries follow in order to end inflationary deleveragings.
When it comes to determining whether or not to save in a credit instrument, the motivations of domestic investors are different than those of foreign investors. Domestic investors care about the inflation rate relative to interest rates. For them, if inflation is high relative to the interest rates that they are getting to compensate them for it, they will move out of holding credit instruments to holding inflation hedge assets (and vice versa). Foreign lenders just care about the rate of change in the currency relative to the interest rate change. So for policy makers hoping to stabilize the balance of payments, inflation is a secondary consideration compared to ensuring that there are positive expected returns for saving in that currency. They have to get the currency cheap enough so that it, with the desired interest rate, will produce a positive return.
After the war period, during the paying back period, the market consequences of the debts and the outcome of the war (whether it is won or lost) will be enormous. The worst thing a country, hence a country’s leader, could ever do is get into a lot of debt and lose a war because there is nothing more devastating. ABOVE ALL ELSE, DON’T DO THAT. Look at what it meant for Germany after World War I in the 1920s (which is explained in Part 2) and for Germany and Japan after World War II in the late 1940s and the 1950s.
I want to reiterate my headline: managing debt crises is all about spreading out the pain of the bad debts, and this can almost always be done well if one’s debts are in one’s own currency. The biggest risks are typically not from the debts themselves, but from the failure of policy makers to do the right things due to a lack of knowledge and/or lack of authority. If a nation’s debts are in a foreign currency, much more difficult choices have to be made to handle the situation well—and, in any case, the consequences will be more painful.
As mentioned in the archetype template, while inflationary depressions are possible in all countries/currencies, they are most common in countries that: Don’t have a reserve currency: So there is not a global bias to hold their currency/debt as a store hold of wealth Have low foreign exchange reserves: So there is not much of a cushion to protect against capital outflows Have a large stock of foreign debt: So there is a vulnerability to the cost of debt rising via increases in either interest rates or the value of the currency the debtor has to deliver, or a shortage of available credit denominated in that currency Have a large and increasing budget and/or current account deficit: So there is a need to borrow or print money to fund the deficits Have negative real interest rates: So lenders are not adequately compensated for holding the currency/debt Have a history of high inflation and negative total returns in the currency: So there is a lack of trust in the value of the currency/debt By the end of the war, the German economy met all of these conditions.
Germany faced the classic dilemma: whether to help those who are long the currency (i.e., creditors who hold debt denominated in it) or those who are short it (i.e., debtors who owe it). In economic crises, policies to redistribute wealth from “haves” to “have-nots” are more likely to occur. This is because the conditions of the “have-nots” become intolerable and also because there are more “have-nots” than “haves.”