Big Debt Crises – Deflationary Debt Cycle

The following paragraphs are from Part 1 of Ray Dalio’s book: Principles for Navigating Big Debt Crises and are the most important given where we are today with monetary policy, inflation, and debt.

A copy of his book is at the end of this post.

The figures in the following charts were calculated by averaging 21 deflationary debt cycle cases and 27 inflationary debt cycle cases from five years before the bottom of the downturn to seven years after it.

Source: Dalio

The Phases of the Classic Deflationary Debt Cycle

The chart illustrates the seven stages of an archetypal long-term debt cycle over a period of 12 years.

1) The Early Part of the Cycle

Debt growth, economic growth, and inflation are neither too hot nor too cold. This is what is
called the “Goldilocks” period.

2) The Bubble

Debt growth rates are increasing faster than the incomes that will be required to service them, borrowers feel rich, so they spend more than they earn and buy assets at high prices with leverage. We are most likely ending this period today.

3) The Top

The rise in short rates narrows or eliminates the spread with long rates (1 year yield – 20 year yield).

As a result of the yield curve being flat or inverted, people are incentivized to move to cash just before the bubble pops, slowing credit growth.

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.

4) The “Depression”

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.

As the depression begins, debt defaults and restructurings hit, especially leveraged lenders (e.g., banks), like an avalanche.

Both lenders’ and depositors’ justified fears feed on themselves, leading to runs on financial institutions that typically don’t have the cash to meet them unless they are under the umbrella of government protections.

Cutting interest rates doesn’t work adequately because the floors on risk-free rates have already been hit and because as credit spreads rise, the interest rates on risky loans go up, making it difficult for those debts to be serviced.

Interest rate cuts also don’t do much to help lending institutions that have liquidity problems and are suffering from runs.

At this phase of the cycle, debt defaults and austerity (i.e., the forces of deflation) dominate, and are not sufficiently balanced with the stimulative and inflationary forces of printing money to cover debts (i.e., debt monetization).

With investors unwilling to continue lending and borrowers scrambling to find cash to cover their debt
payments, liquidity—i.e., the ability to sell investments for money—becomes a major concern.

Since the ratio of financial assets to money is high, when a large number of people rush to convert their financial assets into money and buy goods and services in bad times, the central bank either has to provide the liquidity that’s needed by printing more money or allow a lot of defaults.

Going into the “depression” phase of the cycle some protections learned from past depressions (e.g., bank-deposit insurance, the ability to provide lender-of-last-resort financial supports and guarantees and to inject capital into systemically important institutions or nationalize them) are typically in place and are helpful, but they are rarely adequate, because the exact nature of the debt crisis hasn’t been well thought through.

Typically, quite a lot of lending has taken place in the relatively unregulated “shadow banking system,” or in new instruments that have unanticipated risks and inadequate regulations.

What happens in response to these new realities depends on the capabilities of the policy makers in the decision roles and the freedom of the system to allow them to do what is best.

Related to this, if the central bank produces more money to alleviate the shortage, it will cheapen the value of money, making a reality of creditors’ worries about being paid back an amount of money that is worth less than what they loaned.

While some people think that the amount of money in existence remains the same and simply moves from riskier assets to less risky ones, that’s not true. Most of what people think is money is really credit, and credit does appear out of thin air during good times and then disappear at bad times.

As this implies, a big part of the deleveraging process is people discovering that much of what they thought of as their wealth was merely people’s promises to give them money. Now that those promises aren’t being kept, that wealth no longer exists.

When investors try to convert their investments into money in order to raise cash, they test their ability to get paid, and in cases where it fails, panic-induced “runs” and sell-offs of securities occur.

Naturally those who experience runs, especially banks (though this is true of most entities that rely on short-term funding), have problems raising money and credit to meet their needs, so debt defaults cascade. Debt defaults and restructurings hit people, especially leveraged lenders (e.g., banks), and fear cascades through the system.

These fears feed on themselves and lead to a scramble for cash that results in a shortage (i.e., a liquidity crisis). The dynamic works like this: Initially, the money coming in to debtors via incomes and borrowing is not enough to meet the debtors’ obligations; assets need to be sold and spending needs to be cut in order to raise cash. This leads asset values to fall, which reduces the value of collateral, and in turn reduces incomes. Since borrowers’ creditworthiness is judged by both a) the values of their assets/collaterals in relation to their debts (i.e., their net worth) and b) the sizes of their incomes relative to the sizes of their debt-service payments, and since both their net worth and their income fall faster than their debts, borrowers become less creditworthy and lenders more reluctant to lend. This goes on in a self-reinforcing manner.

The depression phase is dominated by the deflationary forces of debt reduction (i.e., defaults and restructurings) and austerity occurring without material efforts to reduce debt burdens by printing money.

Because one person’s debts are another’s assets, the effect of aggressively cutting the value of those assets can be to greatly reduce the demand for goods, services, and investment assets. For a write-down to be effective, it must be large enough to allow the debtor to service the restructured loan. If the write-down is 30 percent, then the creditor’s assets are reduced by that much. If that sounds like a lot, it’s actually much more. Since most lenders are leveraged (e.g., they borrow to buy assets), the impact of a 30 percent write-down on their net worth can be much greater. For example, the creditor who is leveraged 2:1 would experience a 60 percent decline in his net worth (i.e., their assets are twice their net worth, so the decline in asset value has twice the impact). Since banks are typically leveraged about 12:1 or 15:1, that picture is obviously devastating for them and for the economy as a whole.

Even as debts are written down, debt burdens rise as spending and incomes fall. Debt levels also rise relative to net worth, as shown in the chart below. As debt-to-income and debt-to-net-worth ratios go up and the availability of credit goes down, naturally the credit contraction becomes self-reinforcing on the downside.

The capitalists-investor class experiences a tremendous loss of “real” wealth during depressions because the value of their investment portfolios collapses (declines in equity prices are typically around 50 percent), their earned incomes fall, and they typically face higher tax rates. As a result, they become extremely defensive. Quite often, they are motivated to move their money out of the country (which contributes to currency weakness), dodge taxes, and seek safety in liquid, noncredit-dependent investments (e.g., low-risk government bonds, gold, or cash).

Of course, the real economy as well as the financial economy suffers. With monetary policy constrained, the uncontrolled credit contraction produces an economic and social catastrophe. Workers suffer as incomes collapse and job losses are severe. Hard-working people who once were able to provide for their families lose the opportunity to have meaningful work and suddenly become either destitute or dependent. Homes are lost because owners can no longer afford to pay their mortgages, retirement accounts are wiped out, and savings for college are lost. These conditions can persist for many years if policy makers don’t offset the depression’s deflationary forces with sufficient monetary stimulation of a new form.

5) The “Beautiful Deleveraging”

A “beautiful deleveraging” happens when the four levers are moved in a balanced way so as to reduce intolerable shocks and produce positive growth with falling debt burdens and acceptable inflation. More specifically, deleveragings become beautiful when there is enough stimulation (i.e., through “printing of money”/debt monetization and currency devaluation) to offset the deflationary deleveraging forces (austerity/defaults) and bring the nominal growth rate above the nominal interest rate—but not so much stimulation that inflation is accelerated, the currency is devaluated, and a new debt bubble arises.

The best way of negating the deflationary depression is for the central bank to provide adequate liquidity and credit support, and, depending on different key entities’ needs for capital, for the central government to provide that too. Recall that spending comes in the form of either money or credit. When increased spending cannot be financed with increased debt because there is too much debt relative to the amount of money there is to service the debt, increased spending and debt-service relief must come from increased money. This means that the central bank has to increase the amount of money in the system.

So, what do I mean by that? Basically, income needs to grow faster than debt. For example: Let’s assume that a country going through a deleveraging has a debt-to-income ratio of 100 percent. That means that the amount of debt it has is the same as the amount of income the entire country makes in a year. Now think about the interest rate on that debt. Let’s say it’s 2 percent. If debt is 100 and the interest rate is 2 percent, then if no debt is repaid it will be 102 after one year. If income is 100 and it grows at 1 percent, then income will be 101, so the debt burden will increase from 100/100 to 102/101. So for the burdens from existing debt not to increase, nominal income growth must be higher than nominal interest rates, and the higher the better (provided it is not so high that it produces unacceptable inflation and/or unacceptable currency declines).

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.

Printing money/debt monetization and government guarantees are inevitable in depressions in which interest rate cuts won’t work, though these tools are of little value in countries that are constrained from printing or don’t have assets to back printing up and can’t easily negotiate the redistributions of the debt burdens. All of the deleveragings that we have studied (which is most of those that occurred over the past hundred years) eventually led to big waves of money creation, fiscal deficits, and currency devaluations (against gold, commodities, and stocks). In different cases, policy makers have varied which exact combination of the levers they used, typically as a function of the nature of their monetary systems. The chart below conveys the archetypal path of money printing in deflationary deleveragings over the 21 cases. The money printing occurs in two classic waves—central banks first provide liquidity to stressed institutions, and then they conduct large-scale asset purchases to broadly stimulate the economy.

In the end, policy makers always print. That is because austerity causes more pain than benefit, big restructurings wipe out too much wealth too fast, and transfers of wealth from haves to have-nots don’t happen in sufficient size without revolutions. Also, printing money is not inflationary if the size and character of the money creation offsets the size and character of the credit contraction. It is simply negating deflation. In virtually all past deleveragings, policy makers had to discover this for themselves after they first tried other paths without satisfactory results.

History has shown that those who did it quickly and well (like the US in 2008–09) have derived much better
results than those who did it late (like the US in 1930–33). The table below summarizes the typical amount of printing and currency devaluation required to create the turn from a depression to a “beautiful deleveraging.” On average the printing of money has been around 4 percent of GDP per year. There is a large initial currency devaluation of around 50 percent against gold, and deficits widen to about 6 percent of GDP. On average, this aggressive stimulation comes two to three years into the depression, after stocks have fallen more than 50 percent, economic activity has fallen about 10 percent, and unemployment has risen to around 10 to 15 percent, though there is a lot of variation.

6) “Pushing on a String”

Late in the long-term debt cycle, central bankers sometimes struggle to convert their stimulative policies into
increased spending because the effects of lowering interest rates and central banks’ purchases of debt assets have diminished. At such times the economy enters a period of low growth and low returns on assets, and central bankers have to move to other forms of monetary stimulation in which money and credit go more directly to support spenders. When policy makers faced these conditions in the 1930s, they coined the phrase “pushing on a string.” One of the biggest risks at this stage is that if there is too much printing of money/monetization and too severe a currency devaluation relative to the amounts of the deflationary alternatives, an “ugly inflationary deleveraging” can occur.

7) Normalization

Eventually the system gets back to normal, though the recovery in economic activity and capital formation tends to be slow, even during a beautiful deleveraging. It typically takes roughly 5 to 10 years (hence the term “lost decade”) for real economic activity to reach its former peak level. And it typically takes longer, around a decade, for stock prices to reach former highs, because it takes a very long time for investors to become comfortable taking the risk of holding equities again (i.e., equity risk premiums are high).