Dalio & The End of the Long Term Debt Cycle

Yesterday we summarised the first part of Ray Dalio’s new book preview on the rise and fall of empires over history.  Today we dive in to how money and credit in large part dictate the rise and fall of these economic empires that typically last 50 to 75 years.  The current US economic empire started in 1945, ominously 75 years ago.  When you look at the current economic happenings and that timeframe the penny should drop that this could indeed be the ‘big one’ of our life time.

To get the gravity of this we need to repeat verbatim his 2 opening paragraphs of this chapter:

“In order to understand why empires and their economies rise and fall and what is happening to the world order right now, you need to understand how money, credit, and debt work. Understanding how they work is critically important because that which has historically been, and still is, what people are most inclined to fight for is wealth—and the biggest single influence on how wealth rises and declines is money and credit. So, if you don’t understand how money and credit work, you can’t understand how economies work, and if you can’t understand how economies work, you can’t understand the most important influence on economic conditions, which is the biggest driver of politics and how the whole economic-political system works.

For example, if you don’t understand how the Roaring ’20s led to a debt bubble and a big wealth gap, and how the bursting of that debt bubble led to the 1930-33 depression, and how the depression and wealth gap led to conflicts over wealth all around the world, you can’t understand the forces that led to Franklin D. Roosevelt being elected president. You also wouldn’t understand why, soon after his inauguration in 1933, he announced a new plan in which the central government and the Federal Reserve would together provide a lot of money and credit, a change that was similar to things happening in other countries at the same time and similar to what is happening now. Without understanding money and credit, you wouldn’t understand why these things changed the world order nor would you understand what happened next (i.e., the war, how it was won and lost, and why the new world order was created as it was in 1945), and you won’t be able to understand what is happening now or imagine the future.”

We want to give you 2 choices today given our usual promise to present short and sharp articles.  First, Dalio’s summary and second (and you can cut straight to it) a link to the full excerpt.  We think the summary falls well short of capturing this excellent piece.  The full excerpt is well worth the read but maybe better digested after reading the summary first.  It is easily the best summary of money and credit as macro economic drivers over history I have ever read.  You can go straight to that here if you wish > https://www.principles.com/the-changing-world-order/#chapter1TheShiftsInWealth

His summary:

“Stepping back to look at all of this from the big-picture level, what I’m saying about the relationship between 1) the economic part (i.e., money, credit, debt, economic activity, and wealth) and 2) the political part (both within countries and between countries) of rises and declines looks like the picture shown below. Typically the big cycles start with a new world order—i.e., a new way of operating both domestically and internationally that includes a new monetary system and new political systems. The last one began in 1945. Because at such times, after the conflicts, there are dominant powers that no one wants to fight and people are tired of fighting, so there is a peaceful rebuilding and increasing prosperity that are supported by a credit expansion that is sustainable. It is sustainable because income growth exceeds or keeps pace with the debt-service payments that are required to service the growing debt and because of central banks’ capacities to stimulate credit and economic growth is great. Along the way up there are short-term debt and economic cycles that we call recessions and expansions. With time investors extrapolate past gains into the future and borrow money to bet on them continuing to happen, which creates debt bubbles at the same time as the wealth gaps grow because some benefit more than others from this money-making upswing. This continues until central banks run out of their abilities to stimulate credit and economic growth effectively. As money becomes tighter the debt bubble bursts and credit contracts and with it the economy contracts. At the same time, when there is a large wealth gap, big debt problems, and an economic contraction, there is often fighting within countries and between countries over wealth and power. At such times of debt and economic problems central governments and central banks typically create money and credit and/or devalue their currencies. These developments lead to the restructuring of the debts, the monetary system, the domestic order, and the world order. Then it starts again. While none go exactly like that almost all of them by and large go that way. For example, while the debt bubble bursting generally leads to economic contraction and the economic contraction with the large wealth gaps generally leads to the internal and external fighting, sometimes the order is a bit different. However, more often than not money, credit, and debt cycles lead to economic changes, which lead to domestic and international political changes.”

And just a few snippets we want you to read:

“To review, in the long-term debt cycle, holding debt as an asset that provides interest is typically rewarding early in the cycle when there isn’t a lot of debt outstanding, but holding debt late in the cycle when there is a lot of it outstanding and it is closer to being defaulted on or devalued is risky relative to the interest rate being given. So, holding debt (e.g., bonds) is a bit like holding a ticking time bomb that rewards you while it’s still ticking and blows you up when it goes off. And as we’ve seen, that big blow-up (i.e., big default or big devaluation) happens something like once every 50 to 75 years.”

The recent history in a nutshell:

“After the 1980s debt restructurings were completed the 1990s new global increase in money, credit, and debt began again, which again produced a prosperity that led to debt-financed purchases of speculative investments that became the dot-com bubble, which burst in 2000. That led to an economic downturn in 2000-01 that spurred the Federal Reserve to ease money and credit, which pushed debt levels to new highs and created another prosperity that turned into another and bigger debt bubble in 2007, which burst in 2008, which led the Fed and other reserve currency countries’ central banks again eased, leading to the next bubble that just recently burst. However, this time the money and credit creation needed to address the downturn was engineered differently.

Short-term interest rates hit 0% in 2008, and that amount of decline wasn’t enough to create the money and credit expansion that was needed. Stimulating money and credit growth by lowering interest rates is the first-choice monetary policy of central banks. I call it “Monetary Policy 1.” With this approach no longer available to central banks, they turned to the second-choice monetary policy (which I call “Monetary Policy 2”), which is the printing of money and the buying of financial assets, mostly government bonds and some high-quality debt. The last time they had needed to do that because interest rates had hit 0% began in 1933 and continued through the war years. This approach is called “quantitative easing” rather than “debt monetization” because it sounds less threatening. All the world’s major reserve currency central banks did this. That led to the next money/credit/economic paradigm, which has lasted until the economic downturn that we are now in.”

And now:

“With both long-term and short-term interest rates around 0% and central banks’ purchases of bonds not flowing through to stimulate economic growth and help those who needed it most, it became apparent to me that the second type of monetary policy wouldn’t work well and the third type of monetary policy—“Monetary Policy 3,” or MP3—would be needed. MP3 works by the reserve currency central governments increasing their borrowing and targeting their spending and lending to where they want it to go with the reserve currency central banks creating money and credit and buying debt (and possibly other assets, like stocks) to fund these purchases.”

“The coronavirus trigged economic and market downturns around the world, which created holes in incomes and balance sheets, especially for indebted entities that had incomes that suffered from the downturn. Classically, central governments and central banks had to create money and credit to get it to those entities they wanted to save that financially wouldn’t have survived without that money and credit. So, on April 9, 2020 the US central government (the president and Congress) and the US central bank (the Fed) announced a massive money and credit creation program that included all the classic MP3 techniques, including helicopter money (direct payments from the government to citizens). It was essentially the same announcement that Roosevelt made on March 5, 1933. While the virus triggered this particular financial and economic downturn, something else would have eventually triggered it, and regardless of what did, the dynamic would have been basically the same because only MP3 would have worked to reverse the downturn. The European Central Bank, the Bank of Japan, and—to a lesser extent—the People’s Bank of China made similar moves, though what matters most is what the Federal Reserve did because it is the creator of dollars, which are still the world’s dominant money and credit.”

And finally in answer to why the US dollar is in such demand now but why that may last..

“As with all banks that printed reserve currencies, the Federal Reserve is now in the strong but awkward position of running its monetary policy in a way that is good for Americans but that might not be good for others around the world who are dependent on dollars. For example the US central government just recently decided that it would borrow money to give it and dollar credit to Americans and the Federal Reserve decided to buy that US government debt and a lot more other debt of Americans to help them through this financial crisis. Understandably little of that will go to foreigners. The European Central Bank will do something similar for those in the Eurozone. The Bank of Japan, which is still smaller on the world scene, will do the same thing for the Japanese, and the People’s Bank of China will do the same thing for the Chinese. A couple of other relatively small countries (like Switzerland) might be able to do something similar for their people, but most of the world won’t get the money and credit they need to fill their income and balance sheet holes the way Americans will. This dynamic of countries not being able to get the hard currency they need is like what happened in the 1982-91 period, except interest rates can’t be cut significantly this time while they could be cut very significantly in that 1982-91 period.

At the same time, dollar-denominated debt owed by non-Americans (i.e., those in emerging markets, European countries, and China) is about $20 trillion (which is about 50% higher than what it was in 2008), with a bit less than half of that total being short-term. These dollar debtors will have to come up with dollars to service these debts and they will have to come up with more dollars to buy goods and services in world markets. So, the US, by having the US dollar as the world’s reserve currency and having the world’s bank that produces that currency, and by having the power to put these needed dollars in the hands of Americans, can help Americans more effectively than other countries’ governments can help their own citizens. At the same time the US risks losing this privileged position by creating too much money and debt.”

Again, if you have the time it is worth reading the full text here > https://www.principles.com/the-changing-world-order/#chapter1TheShiftsInWealth