Big Debt Crises

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In this up-wave part of the long-term debt cycle, promises to deliver money (i.e., debt burdens) rise relative to both the supply of money in the overall economy and the amount of money and credit debtors have coming in (via incomes, borrowing, and sales of assets). This up-wave typically goes on for decades, with variations primarily due to central banks’ periodic tightenings and easings of credit. These are short-term debt cycles, and a bunch of them generally add up to a long-term debt cycle. Since 1971, it has been simply what central banks printed and provided in the form of credit. Money, unlike credit, at this time can only be created by central banks [1] and can be created in whatever amounts the central banks choose to create. Lending naturally creates self-reinforcing upward movements that eventually reverse to create self-reinforcing downward movements that must reverse in turn. During the upswings, lending supports spending and investment, which in turn supports incomes and asset prices; increased incomes and asset prices support further borrowing and spending on goods and financial assets. The borrowing essentially lifts spending and incomes above the consistent productivity growth of the economy. Near the peak of the upward cycle, lending is based on the expectation that the above-trend growth will continue indefinitely. But, of course, that can’t happen; eventually income will fall below the cost of the loans. During this time period, the geopolitical landscape changed as the Soviet Union fell, China rose, and wealth gaps increased. The reduction of lending and the spending it was financing going forward. Even after a debt crisis is resolved, it is unlikely that the entities that borrowed too much can generate the same level of spending in the future that they had before the crisis. That has implications that must be considered.

Most debt crises, even big ones, can be managed well by economic policy makers and can provide investment opportunities for investors if they understand how they work and have good principles for navigating them well. That money/credit/debt surge in 2020 produced a huge increase in inflation which was exacerbated by the external conflicts (i.e., which is the third of the five major forces that I will touch on later).I think there will be exceptionally big differences between the performance levels of countries, investors, and companies that will penalize those who choose poorly and reward those who choose well enormously. The money and debt devaluations of 1971 and the newly gained free ability of central banks to create money, credit, and debt to fight economic stagnation led to the massive stagflation of the 1970s.

A “beautiful deleveraging” can be engineered by central governments and central banks to reduce debt burdens if the debt is in their own currencies. If you understand the game of Monopoly®, you can pretty well understand how credit cycles work on the level of a whole economy. Early in the game, people have a lot of cash and only a few properties, so it pays to convert your cash into property. As the game progresses and players acquire more and more houses and hotels, more and more cash is needed to pay the rents that are charged when you land on a property that has a lot of them. Some players are forced to sell their property at discounted prices to raise that cash. So early in the game, property is king and later in the game, cash is king. Those who play the game best understand how to hold the right mix of property and cash as the game progresses. Every investment involves risk and in volatile or uncertain market conditions, significant variations in the value or return on that investment may occur. Investments in hedge funds are complex, speculative and carry a high degree of risk, including the risk of a complete loss of an investor’s entire investment. Also, because the Chinese and other emerging market producers had become more competitive which took away jobs at the same time that new technologies took away jobs which contributed to the hollowing out of the middle class, that also increased class warfare. People who were hurting economically believed that the “elites” running things and the system were rigged against them. That led to the rise of populist sentiment and nationalism. These developments were also analogous to those that happened in the early 1930s and many times before under similar circumstances. The only important difference between today’s money (which is now fiat money) and prior monies (which were not fiat monies, such as that in the 1945-71 period) is the link to hard currency isn’t there. That means that central banks can now more freely create money and credit than in the past.As had happened repeatedly over thousands of years, the much larger financial claims on the money than the actual money in the bank led to a run on the central bank to get the money (i.e., the gold), which led the US in 1971 to default on its promises to allow holders of debt assets to turn them in for the money (gold). Ray Dalio, the legendary investor and international bestselling author of Principles - whose books have sold more than five million copies worldwide - shares his unique template for how debt crises work and principles for dealing with them well. This template allowed his firm, Bridgewater Associates, to antic­ipate 2008’s events and navigate them well while others struggled badly. Each policy has a different effect on the economy and thus on markets. Austerity and defaults are deflationary. Money printing is inflationary and stimulates growth. Transfers of money, by definition, produce winners and losers. Austerity, defaults, and wealth transfer are all politically challenging. Inevitably, therefore, countries choose to print. 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.

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: Banks [2] are the intermediaries between lender-creditors and borrower-debtors, so their motivations and how they work are important too. In all countries for thousands of years up to now, banks did essentially the same thing, which is borrow money from some and lend it to others, making money on the spread to generate a profit. To be clear, I appreciate that different people have different perspectives, that mine is just one, and that by putting our perspectives out there for debate we can all advance our understandings. I am sharing this study to do just that.

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One person’s financial assets are another’s financial liabilities (i.e., promises to deliver money). When the claims on financial assets are too high relative to the money available to meet them, a big deleveraging must occur. Then the free-market credit system that finances spending ceases to work well, and typically works in reverse via a deleveraging, necessitating the government to intervene in a big way as the central bank becomes a big buyer of debt (i.e., lender of last resort) and the central government becomes a redistributor of spending and wealth. At such times, there needs to be a debt restructuring in which claims on future spending (i.e., debt) are reduced relative to what they are claims on (i.e., money). Three Detailed Cases (which examines in depth the 2008 financial crisis, the 1930s Great Depression, and the 1920s infla­tionary depression of Germany’s Weimar Republic) What hasn’t changed through these shifts in monetary systems over the millennia—and hasn’t been eliminated as a problem—is the creation of unsustainably big debt liabilities and assets relative to the amounts of money, goods, services, and investment assets in existence, which can lead to a run for the money and the goods and services that have intrinsic value. Over the long term, being productive and having healthy income statements (i.e., earning more than one is spending) and healthy balance sheets (i.e., having more assets than liabilities) are the markers of financial health. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed.

In this study we will examine big debt cycles that produce big debt crises, exploring how they work and how to deal with them well. But before we begin, I want to clarify the differences between the two main types: deflationary and inflationary depressions. These levers shift around who benefits and who suffers, and over what amount of time. Policy makers are put in the politically difficult position of having to make those choices. As a result, they are rarely appreciated, even when they handle the debt crisis well. The Template for the Archetypal Long-Term/Big Debt Cycle

While the gold-dollar-based system broke down, the US remained the dominant world power economically, militarily, and in most other respects, and most world trade and global lending was done in dollars so the dollar remained the world’s leading currency. Though a bit of an oversimplification, this is the essential dynamic that drives the inflating and deflating of a bubble. That is what has been happening since 2008. At such times, central banks are making up for the shortfall in the private sector’s demand for debt. They are happy to do so even if it doesn’t make economic sense because their objective is to stabilize markets and economies, not to make a profit.