Notes - Principles For Navigating Big Debt Crises
October 11, 2024
Introduction
In the introduction, Dalio explains that he is writing the book on the 10th anniversary of the 2008 financial crisis. He states that his goal is to share his template for understanding debt crises, hoping to reduce the likelihood and severity of future crises. He emphasizes that by examining many historical cases of economic phenomena, he developed archetypal models like business cycles and big debt cycles. Analyzing differences between individual cases and the archetype illuminated the causes of those variations. Dalio compares this process to a doctor recognizing patterns in diseases. He outlines three key components of the book:
- The Archetypal Big Debt Cycle - this template will explain the mechanics of debt cycles
- Three Iconic Case Studies - detailed examinations of the 2007-2011 U.S. debt crisis, the 1928-1937 U.S. deflationary depression, and the 1918-1924 German inflationary depression
- Compendium of 48 Case Studies - summaries of most major debt crises in the last 100 years
Dalio emphasizes that his perspective is just one of many and encourages debate to further understanding. He also highlights that while debt crises can be painful, they can be managed to mitigate significant problems.
Four Levers for Managing Debt Crises
Dalio outlines four levers policymakers can utilize to manage debt crises:
- Austerity - reducing spending
- Debt defaults/restructurings - reducing debt burdens
- Central Bank “printing money” and buying assets - providing liquidity and stimulating growth
- Transfers of wealth - from those with more to those with less
He emphasizes that each lever has different impacts on the economy. Striking the right balance between these levers is key to a "beautiful deleveraging" where debt-to-income ratios decline while economic activity and asset prices improve.
Debt Cycles
Dalio explains that debt crises usually arise when debt service costs grow faster than incomes, leading to deleveraging. While lowering interest rates can initially alleviate debt burdens, severe crises, like depressions, emerge when interest rates hit 0% and this tool becomes ineffective. He highlights two shortcomings in traditional debt burden analysis:
- It fails to account for differences between entities contributing to total debt numbers.
- It doesn't include liabilities like pensions and healthcare obligations, which are significant
Deflationary Depressions
Dalio distinguishes between deflationary and inflationary depressions, focusing on deflationary depressions. He outlines seven key phases of a deflationary cycle, emphasizing the need for policymakers to strike a balance between deflationary and stimulative measures.
Stages of a Deflationary Cycle
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Early Part of the Cycle: Debt growth is strong but not outpacing income growth. Debt is used to finance productive activities, leading to a "Goldilocks" period.
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Bubble: Extrapolation of recent trends leads to rapid debt growth and asset price increases, with a typical leveraging rate of 20-25% of GDP over three years. Dalio cautions against using a single metric to predict a crisis and stresses the importance of examining debt service abilities of individual entities.
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Top: The bubble peaks, marked by tightening credit conditions. The higher the leverage and asset prices, the smaller the tightening needed to burst the bubble and trigger a larger bust. Understanding sector-specific sensitivities to tightening is crucial for gauging downturn magnitude.
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Depression: This phase is dominated by deflationary forces like debt reduction and austerity. Aggressive debt write-downs, while seemingly helpful, can devastate lenders' net worth due to leverage, creating a negative ripple effect throughout the economy.
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Beautiful Deleveraging: Policymakers employ a balanced mix of austerity, money printing, and wealth redistribution to mitigate the depression's effects and support borrowers and lenders.
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Pushing on a String: Despite efforts, policy responses fail to stimulate the economy adequately. This typically happens when policymakers prioritize austerity over stimulus.
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Normalization: The economy eventually normalizes, with debt burdens reduced and nominal growth exceeding interest rates. This phase is marked by economic recovery and financial asset price improvement.
Policy Responses During Depressions
Dalio discusses the typical policy responses during the depression phase:
- Austerity: Often the initial response, but ultimately ineffective in significantly reducing debt burdens as spending cuts lead to income cuts.
- Debt Defaults/Restructuring: Necessary but can create a downward spiral if not balanced with stimulative measures.
- Money Printing: Eventually becomes unavoidable as policymakers resort to "printing money" and buying government debt to provide liquidity and stimulate growth. This action is not inflationary if it offsets credit contraction.
- Guarantees and Liquidity: Policymakers must step in to guarantee liabilities, provide liquidity to systemically important institutions, and support their solvency to prevent systemic failure.
Recapitalizing Financial Institutions
Dalio explains the necessity of recapitalizing systemically important institutions, highlighting the different approaches used:
- Encouraging private sector solutions: Facilitating mergers between failed and healthy banks and encouraging capital issuance.
- Recapitalizing/Nationalizing: When private solutions are insufficient, governments must step in to recapitalize or nationalize failed banks.
- Resolving non-systemically important institutions: Allowing them to restructure loans, go bankrupt, or be liquidated.
Protecting Creditors
Dalio outlines the typical hierarchy of creditor protection during crises:
- Small depositors: Given top priority and experience minimal losses, often through deposit insurance schemes.
- Equity holders, subordinated debt holders, and large depositors: Usually absorb losses, regardless of the institution's systemic importance.
- Prioritization of domestic creditors: Sometimes occurs, particularly when deposit insurance funds are depleted. However, loans from multinational institutions like the IMF and BIS are often prioritized to maintain support from these lenders of last resort.
Supporting Borrowers
Dalio discusses policies aimed at supporting borrowers during crises:
- Systemically important borrowers: Debt restructuring through debt-for-equity swaps, debt reduction, interest rate lowering, or extended loan terms to ensure business continuity.
- Non-systemically important borrowers: Left to restructure loans or face bankruptcy and liquidation.
- Household sector: Central governments often intervene to reduce household debt burdens through various programs.
Beautiful Deleveragings vs Poorly Managed Deleveragings
Dalio contrasts characteristics of well-managed and poorly-managed deleveragings, highlighting the critical role of central bank and government actions in mitigating economic pain.
Monetary Policy 3
Dalio introduces Monetary Policy 3, which involves central banks directly injecting money into the hands of spenders rather than investors/savers, incentivizing spending. He explains the continuum of stimulative actions and emphasizes the importance of macroprudential policies for targeted credit control, especially during different stages of the big debt cycle.
Inflationary Depressions and Currency Crises
Dalio shifts focus to inflationary depressions and currency crises, outlining five key stages that largely mirror deflationary depressions, except for the crucial depression phase.
Stages of Inflationary Depressions
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Early Part of the Cycle: Similar to the early phase in deflationary cycles.
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Bubble: Similar to the bubble phase in deflationary cycles, but inflationary depressions are more likely in countries with high foreign-denominated debt and large asset bubbles.
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Top: The bubble bursts, triggering a loss of confidence in the currency and capital flight. Policymakers face the critical choice of allowing tightening or printing money to offset outflows, the latter potentially leading to inflationary pressures.
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Depression: This phase is distinct from deflationary depressions as it's characterized by a loss of confidence in the currency, leading to a sharp depreciation and a rise in inflation. Policymakers often resort to printing money to provide liquidity and support systemically important institutions, potentially exacerbating inflation.
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Normalization: In successful cases, incomes and spending recover, and inflation returns to normal levels.
Spiral into Hyperinflation
Dalio explains how inflationary depressions can spiral into hyperinflation when policymakers fail to address the imbalance between external income, spending, and debt service, resorting to excessive money printing to fund external spending.
War Economies
Dalio briefly discusses war economies, noting that governments typically run large fiscal deficits to fund wartime spending, leading to central banks accumulating reserves. He suggests examining case studies of Germany after World War I and the U.S. during the Great Depression to understand the dynamics of war economies.
Summary
Dalio reiterates that managing debt crises involves spreading out the pain of bad debts, which is achievable if debts are in the country's own currency. The biggest risks arise from policymakers' lack of knowledge or authority to implement appropriate measures. While debt crises can be devastating in the short- to medium-term, they become less significant compared to long-term productivity growth. He concludes by emphasizing the importance of political consequences arising from these crises, such as the rise of populism, which can be more impactful than the debt crises themselves.