The following are my notes from the book Big Debt Crises by Ray Dalio. I’ve broken this series out into separate posts, which align with the contents of the book:

• The Archetypal Big Debt Cycle (This post)
• The Phases of the Classic Deflationary Debt Cycle
• Inflationary Depressions and Currency Crises
• The Phases of the Classic Inflationary Debt Cycle
• The Spiral from a More Transitionary Inflationary Depression to Hyperinflation

How Ray thinks about Credit and Debt

• Credit is the giving of buying power in exchange for promise of paying it back.
• Credit creates both spending power and debt.
• Buying power (ie.. credit), is a good thing, and not having buying power to do good things is bad.
• Rapid credit/debt growth can be good or bad.
• It depends on what the credit it used for, and how the debt is serviced.
• If the borrowed money is used productively and generates sufficient income to service the debt, this generates positive outcomes.
• Too little credit/debt growth can be bad or cause worse economic problems due to foregone opportunities. Positive examples of having credit / debt include:
  • Borrowing money to spend on educating children (increases future productivity)
  • Replacing inefficient infrastructure

Bad debt vs. opportunity cost of good spending?

• Say 40% of the loan on a debt financed subway system couldn’t be paid back. How does the benefit society gets from that subway system compare to the bad debt?
• It depends on if policy makers can spread out the losses over long periods of time. If they can, then the debt has a minimal impact, and society gets the benefit of the subway system.
• Whether policy makers can do this is dependent on if they control the currency the debt is denominated in, and whether they have influence over how creditors and debtors behave with each other.

Are debt crises inevitable?

• History shows that debt crises are inevitable. It’s too easy for policy makers to be loose with credit because near term rewards justify it. Politically, it’s much more difficult to keep credit tight.

Why do debt crises come in cycles?

• A cycle is created anytime you borrow money.
• You’re not just borrowing from lender, but from your future self, in which you will need to spend less in order to repay.
• This pattern of spending more than you make now, and less in the future is a cycle.
• Lending creates self-reinforcing upward movements that eventually reverse to create self-reinforcing downward movements.
• Borrowing lifts spending and incomes above the consistent productivity growth of the economy. This cannot be sustained forever, and eventually spending and income will fall below the cost of the loans.
• Unrealistic expectations of this sustained growth results in bubbles. One classic warning sign is when an increasing amount of borrowing is needed to make debt services payments.
• When borrowers can’t meet obligations to lending institutions, these institutions in turn cannot meet their obligations. Highly leveraged large institutions pose biggest risk of creating knock-on effects for rest of economy.

Can most debt crises be managed so there aren’t big problems?

• Policy makers have more ability to manage in cases where debts are denominated in country’s own currency because they can spread out the consequences in a way that minimizes damage.
• In these cases biggest risks are not from debt themselves, but from:
  1. Failure of policy makers to do the right things (lack of knowledge or authority)
  2. Political consequences of making adjustments that hurt some while helping others
• When debts are denominated in foreign currencies, it is much harder for policy makers to spread out debt problems.
• The fact that debt crises can be well managed, does not mean they are not extremely costly to some people.
• Key to handling well is for policy makers to know how to use levers well, have authority, and manage political consequences of who will benefit / suffer and to what degree.
• The four levers to manage debt & debt service levels are:
  1. Austerity (spending less)
  2. Debt defaults / restructurings
  3. Printing money and making purchases (or providing guarantees)
  4. Wealth transfer (Transfer money and credit from those who have more than they need, to those who have less)
• Some levers are inflationary (printing money), some are deflationary (austerity and defaults).
• A balanced use of these levers creates a ‘beautiful deleveraging’ - a happy scenario where debt/income ratios decline, while economic and financial asset prices improve gradually. Where nominal growth rates of income are back above nominal interest rates.

Template for Archetypal Long Term / Big Debt Cycle

• Debt crises occur when debt and debt service costs rise faster than incomes needed to service them.
• A lot of short term debt cycles will add up to a long term debt cycle.
• Each short term cycle has a higher debt-to-income ratio than the one before it until the interest rate reductions that fueled the previous expansion can not go any lower.
• Depressions occur when Central Banks can no longer alleviate by lowering real and nominal interest rates.

Our Examination of the Cycle

• Two broad types of big debt crises:
  1. Deflationary (Countries that didn’t have much debt denominated in foreign currencies)
  2. Inflationary (Countries that had significant amount of debt in foreign currency)
• Both long and short debt cycles occur due to debt burdens being higher, and monetary policies being less effective.
• Long term debt cycles happen through accumulation of many short term cycles, where each bottom and top of the cycle finishes with more economic activity than previous cycle, and with more debt.
• As a result, over long periods of time, debts rise faster than incomes, creating a long term debt cycle.
• On the upswing:
  • Lenders extend credit freely
  • Which increases spending
  • Generates more income
  • Increases net worth
  • Raises borrowers’ capacity to borrow
  • Allow more buying and spending
  • Everyone willing to take more risks
  • New financial intermediaries and instruments created which have less regulatory oversight
  • Allows them to offer higher returns and take on more leverage
  • This appearance of prosperity fosters complacency
• Debts can’t rise faster than income forever. Once limits are reached:
  • Asset prices fall
  • Debtors have problems servicing debt
  • Investors get scared and cautious
  • Leads them to sell or not roll over loans
  • Causes liquidity problems
  • So people cut back on spending
  • Results in incomes going down, making people less credit worthy
  • Debt repayments rise, causing spending to further go down
  • Stock market crashes, social tensions rise with unemployment
  • Interest rates already at zero, and liquidity/money cannot be increased by ordinary measures
• This cycle has been happening going back before the Roman times

Who are the players in the debt crises?

• Money serves two purposes, and thus two masters:
  1. Medium of exchange serves:
     • Those who want to spend it (usually by working for it)
     • Workers (have nots)
     • Earn money by selling their time
  2. Store of wealth serves:
     • Those who have stored wealth tied to its value
     • Capitalists (haves)
     • Earn money by lending or through equity ownership
• These two groups along with the government are the major players of the crises
• When debt crises occur and deleveraging begins, the government steps in, and uses the 4 levers described above to redistribute spending and wealth.
• It is typically painful for both parties, but they are affected differently depending on how the government uses these levers.
• Sometimes this causes a battle between the haves and the have nots.

Going Forward

Ray outlines two main types of debt crises. These will be examined in detail in the following posts:

• The Phases of the Classic Deflationary Debt Cycle
• The Phases of the Classic Inflationary Debt Cycle

But in summary:

• Deflationary depressions:
  • Policy makers respond to initial shock by lowering interest rates
  • Rates reach 0%, no longer effective
  • Debt restructuring and austerity dominate
  • But not balanced by stimulative policies (money printing)
  • Debt burdens rise as % of income
  • Incomes fall faster than debt restructuring
  • Borrowers required to take on more debt to cover service costs
  • Debt typically financed domestically in local currency, causes forced selling and defaults, but not a currency or balance of payments problem
• Inflationary depressions:
  • Typically occur in countries reliant on foreign capital flows
  • Significant debt denominated in foreign currency and can’t be monetized (money printing and bought by central bank)
  • Foreign capital flows slow, credit creation turns to credit destruction
  • Capital withdrawal dries up lending and liquidity while currency declines produce inflation
  • Difficult to manage because policy makers cannot spread out the pain (not their currency)