Big Debt Crises

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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) The key to handling debt crises well lies in policy makers’ knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable. Inflationary depressions classically occur in countries that are reliant on foreign capital flows and so have built up a significant amount of debt denominated in foreign currency that can’t be monetized (i.e., bought by money printed by the central bank). When those foreign capital flows slow, credit creation turns into credit contraction. In an inflationary deleveraging, capital withdrawal dries up lending and liquidity at the same time that currency declines produce inflation. Inflationary depressions in which a lot of debt is denominated in foreign currency are especially difficult to manage because policy makers’ abilities to spread out the pain are more limited. In developing the template, we will focus on the period leading up to the depression, the depression period itself, and the deleveraging period that follows the bottom of the depression. As there are two broad types of big debt crises—deflationary ones and inflationary ones (largely depending on whether a country has a lot of foreign currency debt or not)—we will examine them separately. 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 this big-picture, simplified model of the money-credit-debt-markets-economic machine, the following describes the major parts and the major players and how they operate together to make the machine work. The template that follows is based on my examination of 48 big debt cycles, which include all of the cases that led to real GDP falling by more than 3 percent in large countries (which is what I will call a depression). For clarity, I divided the affected countries into two groups: 1) Those that didn’t have much of their debt denominated in foreign currency and that didn’t experience inflationary depressions, and 2) those that had a significant amount of their debt denominated in foreign currency and did experience inflationary depressions. Since there was about a 75 percent correlation between the amounts of their foreign debts and the amounts of inflation that they experienced (which is not surprising, since having a lot of their debts denominated in foreign currency was a cause of their depressions being inflationary), it made sense to group those that had more foreign currency debt with those that had inflationary depressions.While of course changes over time and differences between countries exist, they are comparatively unimportant in relation to the timeless and universal mechanics and principles that are far less understood than they should be.

I did the research and developed this template with the help of many great partners at Bridgewater Associates. This template allowed us to prepare better for storms that had never happened to us before, just as one who studies 100-year floods or plagues can more easily see them coming and be better prepared. 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. I have a template for explaining how “the machine” works that I hope to convey in an easy-to-understand way so you and others can assess it for yourselves. Very simply a) money (i.e., the access to resources) + b) talented people + c) an environment that is conducive to conjuring up and building out developments = d) economic success (and economic success contributes to all sorts of other successes such as health, education, social, and military). In fact, any two of these ingredients will be enough (though all three together is best). For example, talented people in the right environment will earn or attract the money/resources that they need to succeed, and money with the right environment will attract talented people. In this 2008-2020 period there were two short-term credit-debt-economic cycles (including the one we’re currently in) with each amount of debt creation and each amount of debt monetization greater than the one before it.A terrific piece of work from one of the world’s top investors who has devoted his life to understanding markets and demonstrated that understanding by navigating the 2008 financial crisis well.” Inflationary debt cycles occur when most debt is denominated in foreign currencies. This situation makes it harder for a country’s policymakers to “spread out the harmful consequences,” a key part of resolving the crisis. They must decide who will benefit and who will suffer — to what degree and for how long — “so that the political and other consequences are acceptable.” This process often entails a need to recapitalize systemically important institutions.

Central banks want to keep debt and economic growth and inflation at acceptable levels. In other words, they don’t want debt and demand to grow much faster or slower than is sustainable and they don’t want inflation to be so high or so low that it is harmful. As always, I’m not certain of anything, I am putting these thoughts out for your consideration to take or leave as you like, and I hope that you find them helpful. I guarantee that if you take the trouble to understand each of these three perspectives, you will see big debt crises very differently than you did before. Throughout these times, there were boom-bust cycles because borrower-debtors, lender-creditors, and banks went through the credit-debt cycles I just described. These cycles turned into big debt and economic busts when too many debt assets and liabilities led to creditor “runs” to get money from debtors, most importantly the banks.Where do central banks get their money from? They “print” it (literally and digitally), which, when done in large amounts, alleviates the debt problems because it provides money and credit to those who desperately need it and wouldn’t have had it otherwise. But doing so also reduces the buying power of money and debt assets and raises inflation from what it would have been.

The statistics reflected in the charts of the phases were derived by averaging 21 deflationary debt cycle cases and 27 inflationary debt cycle cases, starting five years before the bottom of the depression and continuing for seven years after it.Principles for Navigating Big Debt Crises provides a framework for understanding the mechanics of these crises. Dalio sets out six stages, from the seeds of the crisis to its resolution. He analyzes 48 historical episodes of debt crises when GDP growth fell by 3% or more. These episodes cover both developed and emerging economies. Dalio categorizes big debt crises into two types — deflationary and inflationary — and provides economic and market data for both. For that reason there remains the risk that those who are holding financial assets will turn them in for money to buy goods and services which would cause either inflationary spirals or severe economic weakness, depending on how much the central bank tries to fight the economic contraction effects by printing money and making credit easily available.