CHART OF THE DAY

THE MAIN STORY: MANAGING DEBT CRISES

Debt crises and financial panics have transcended time and space, rearing their ugly heads across nearly every major civilization to have ever existed. 

As we work through an inflationary crisis while central banks are raising interest rates and pulling money out of the global economy, it seems appropriate to check in with Ray Dalio, author of the excellent book Principles For Navigating Big Debt Crises.

To better understand the big picture of where we are and where we’re going, Dalio tells us that there are five main parts of our “money-credit-debt-markets-economic machine.”

These include:

In this machine, there are a few major players: 

• Those who borrow from others and become debtors  
• Those that lend to them and become creditors   
• Financial intermediaries between the two (aka banks)  
• Government-controlled central banks that can create money and credit in a country’s currency and determine the cost of money and credit by raising or lowering interest rates

Piecing it together

Dalio tells us that although goods, services, and investment assets can be bought with either money or credit, only money can “settle” these transactions. 

For example, buying a car with all cash provides finality to the deal for both parties, whereas taking out a loan to pay for the car creates a lingering obligation, despite acting like money (by allowing you to take ownership of the car).

“Credit produces buying power that didn’t exist before, without necessarily creating money. It allows borrowers to spend more than they earn…while creating debt that requires the borrowers, who are now debtors, to spend less than they earn when they have to pay back their debts.”

How debts grow

Debt-fueled economic expansions can only occur when creditors are willing to lend, and debtors are willing to borrow, which is captured by the interest rate they mutually agree on. If rates are too high for borrowers, they will have to slash spending or sell assets to service their debts. 

This, in part, is why the economy has slowed, and the stock market has declined as the Fed began pushing interest rates up across the economy in 2022.

If rates are too low, lenders will hamper nominal economic growth by refusing to lend, as they don’t feel adequately compensated for the financial risks they’re incurring. 

For over a decade, central banks have largely aimed to suppress interest rates to boost credit expansion and economic growth by keeping rates low. To compensate lenders, they ‘printed money’ to buy their debts.

Productive lending

Regular, non-central banks are incentivized to earn profits by lending at rates that exceed their borrowing costs. 

This facilitates the flow of capital for society. 

So long as these loans are made productively, meaning that borrowers can utilize the funds and then pay back the loans entirely, the system typically works well for all involved.

However, debt crises occur if loans can’t be sufficiently paid back en masse. 

Dalio says, “big debt crises come about when the amounts of debt assets and debt liabilities become too large relative to the amount of money in existence and/or the amounts of goods and services in existence.”

In a debt crisis, when debts have become too large compared to society’s incomes and ability to manage said debt burdens, there are four possible solutions:

Managing crisis

Austerity cuts activity across the economy, making everyone “poorer,” which makes it the most painful choice and, therefore, the path least followed historically. 

Dalio tells us that the best response to a debt crisis is a “beautiful deleveraging,” where policymakers restructure debts to reduce them or spread them out over longer periods, balanced with central bank money printing that eases debt burdens. 

Because central banks can only print money in their own currency (the Fed can’t print euros), beautiful deleveragings are much less likely when most of a country’s borrowings are denominated in a foreign currency or gold/silver.

Takeaways

In summary, Dalio argues that “debt crises are inevitable,” as collective exuberance in good times fuels excess borrowing that makes the bad times worse as sentiment reverses dramatically.

We are likely in the midst of a debt crisis, though so far, policymakers have seemingly threaded the needle on a beautiful deleveraging. This doesn’t mean that in the coming years debt crises can be avoided entirely, but there’s some reason for optimism that these can be mitigated.

Dalio believes that “Most debt crises, even big ones, can be managed well by economic policymakers and can provide investment opportunities for investors if they understand how they work and have good principles for navigating them well.”

Dive deeper

What do you make of Dalio’s blueprint for debt crises?

To read his recent post on the topic, you can find that here. Or check out his full book on Principles For Navigating Big Debt Crises.