Bridgewater Associates founder: How countries go bankrupt

Article author: Ray DalioArticle compiler：Block unicorn

Foreword

Today, my new book "How Nations Go Bankrupt: The Big Cycle" is officially released. This article aims to briefly share the core content of the book. For me, the most important thing is to convey understanding at this critical moment, so I hope to convey the core ideas in a very concise way through this newsletter. As for the degree of depth, it is up to the readers to decide.

My Background

I have been investing in global macro for over 50 years and have been betting on government bond markets for almost as long, and have done very well. While I was previously very secretive about the mechanisms by which major debt crises occur and the principles for dealing with them, I have now reached a stage in my life where I am eager to pass on this understanding and help others. This is especially true as I see the United States and other countries heading for the equivalent of an economic heart attack. This led me to write How Nations Go Broke: The Big Cycle, a comprehensive account of the mechanisms and principles I use, along with a brief overview of the book.

How the Mechanism Works

The debt dynamics work the same way for a government, an individual, or a company, except that the central government has a central bank, can print money (which devalues ​​the currency), and can take money from the people through taxation. So if you can imagine how the debt dynamics would work for you or a business you run if you could print money or get money through taxation, you can understand the dynamics. But remember, your goal is to make the whole system work well, not just for yourself, but for all citizens.

To me, the credit/market system is like the circulatory system of the human body, providing nutrients to all parts of the market and economy. If credit is used effectively, it creates productivity and income that is enough to pay off the debt and interest, which is healthy. However, if credit is used improperly, resulting in insufficient income to pay off the debt and interest, the debt burden will accumulate like plaque in a blood vessel, crowding out other spending. When the debt repayment amounts become very large, it will create debt repayment problems, and eventually debt rollover problems, because debt holders don't want to roll over and want to sell them. Naturally, this will lead to insufficient demand for debt instruments such as bonds and oversupply, which will lead to: a) higher interest rates, which will depress the market and economy; or b) central banks "printing money" and buying debt, which will reduce the value of money and drive up inflation. Printing money also artificially lowers interest rates, hurting the returns for creditors. Neither approach is ideal. When debt sales are too large and the central bank buys a lot of bonds but cannot curb rising interest rates, the central bank will lose money, affecting its cash flow. If this situation continues, the central bank's net assets will become negative.

When the situation becomes serious, both the central government and the central bank will borrow to pay the interest on the debt, and the central bank will print money to provide loans due to the lack of free market demand, resulting in a self-reinforcing spiral of debt/printing money/inflation. In summary, the following classic indicators need to be paid attention to:

1. the ratio of government debt repayment costs to government revenue (similar to the amount of plaque in the circulatory system);

2. the ratio of government debt sales to government debt demand (similar to the shedding of plaque causing a heart attack);

3. the amount by which the central bank purchases government debt by printing money to make up for the debt demand gap (similar to doctors/central banks injecting large amounts of liquidity/credit to alleviate liquidity shortages, generating more debt, and the central bank bears risks for this).

These typically build up gradually over a long, multi-decade cycle, with debt and debt-servicing costs rising relative to income until they become unsustainable because: 1) debt service costs crowd out other spending too much; 2) the supply of debt that needs to be purchased becomes too large relative to demand, causing interest rates to rise sharply, wreaking havoc on markets and the economy; or 3) to avoid rising interest rates and worsening markets/economy, central banks print a lot of money and buy up government debt to make up for the lack of demand, causing the value of the currency to fall sharply.

In either case, bonds will offer poor returns until money and debt become cheap enough to attract demand and/or the debt can be bought back or restructured cheaply by the government.

That’s a quick overview of the Great Debt Cycle.

Because one can measure these factors, one can monitor debt dynamics as they occur, making it easy to foresee problems coming. I have used this diagnostic in my investing and have kept it secret, but I will now explain it in detail in my book How Nations Go Bankrupt: The Great Cycle, because it is now too important to keep secret.

More specifically, you can see a rise in debt and debt-servicing costs relative to income, a greater supply of debt than is needed, central bank stimulus initially by lowering short-term interest rates, then responding by printing money and buying debt, and eventually central bank losses and negative net assets, central governments and central banks paying the interest on their debts through borrowing, and central banks monetizing their debts. All of this leads to a government debt crisis, the economic equivalent of a “heart attack,” as restrictions on debt-financed spending block the normal flow of the circulatory system.

In the early stages of the final stage of the Great Debt Cycle, market behavior reflects this dynamic through rising long-term interest rates, depreciation of currencies (especially relative to gold), and central government treasuries shortening the maturity of debt issuance due to insufficient demand for long-term debt.

Often, late in the process, when the dynamics are most severe, seemingly extreme measures are taken, such as imposing capital controls and exerting enormous pressure on creditors to buy rather than sell debt. My book explains this dynamic more fully, with numerous charts and data.

A Brief Overview of the Current State of the U.S. Government

Now, imagine that you run a big business called the U.S. Government. This will help you understand the financial situation of the U.S. Government and the choices its leadership makes.

This year, total revenues are about $5 trillion, while total expenditures are about $7 trillion, so the budget shortfall is about $2 trillion. That is, your organization will spend about 40% more than it takes in this year. And there is little ability to cut back, because almost all of it is previously committed or necessary. Because your organization has long borrowed too much, it has accumulated a huge debt—about six times its annual revenues (about $30 trillion), equivalent to about $230,000 in debt per household. The interest bill on the debt is about $1 trillion, about 20% of corporate revenues, and half of this year's budget gap (deficit), which you will need to borrow to fill. But that $1 trillion is not all you have to pay your creditors, because in addition to the interest, you also have to pay back the principal due, which is about $9 trillion. You hope that your creditors or other wealthy entities will re-lend to you or lend to other wealthy entities. So the debt service costs - in other words, the principal and interest that must be paid back in order not to default - are about $10 trillion, or about 200% of income.

That's the current situation.

So what happens next? Let's imagine it. You have to borrow money to finance the deficit, no matter what the deficit is. There is a lot of debate about the exact amount of the deficit. Most independent assessors predict that the debt will be about $50-55 trillion in ten years, about 6.5-7 times income (about $3-5 trillion). Of course, a decade from now, without a plan to deal with this situation, the organization will face more debt repayment pressures, which will squeeze spending, and there will be a greater risk that there will not be enough demand for the debt it has to sell.

That's the full picture.

My 3% Three-Part Solution

I firmly believe that the government's financial situation is at a turning point because if this problem is not dealt with now, debt will accumulate to unmanageable levels, causing huge trauma. It is especially important that this operation be done when the system is relatively strong, not when the economy is weak, because when the economy contracts, the government's borrowing needs increase significantly.

Based on my analysis, I believe this situation needs to be dealt with through what I call the "3% Three-Part Solution." That is, reducing the budget deficit to 3% of GDP in a balanced way by: 1) cutting spending, 2) increasing tax revenues, and 3) lowering interest rates. All three need to happen simultaneously to avoid any one adjustment being too large, which would lead to traumatic consequences if any one of them were too large. These adjustments need to be made by good fundamental adjustments, not forced (e.g., it would be very unfavorable if the Fed pushed interest rates down unnaturally). Based on my forecast, spending cuts and tax revenue increases of about 4% each, and a corresponding reduction in interest rates of about 1-1.5%, relative to current plans, would result in an average reduction in interest payments of 1-2% of GDP over the next decade, and stimulate asset price increases and economic activity, which would bring in more revenue.

Below are some frequently asked questions and my answers

There is much more to the book than can be covered here, including a description of the "big cycles" (including debt/monetary/credit cycles, domestic political cycles, external geopolitical cycles, the behavior of nature, and technological progress) that drive all major changes in the world, my outlook for the possible future, and some ideas for investing during these changes. But now I will answer some of the questions I am often asked when discussing the book, and I invite you to read the full book for a deeper understanding.

Question 1: Why do big government debt crises and big debt cycles happen?

Big government debt crises and big debt cycles can be easily measured by the following ways: 1) the ratio of government debt repayments relative to government revenues rises to unacceptable levels, squeezing the government's basic spending; 2) the amount of government debt sold relative to the demand for it is too large, causing interest rates to rise, which in turn causes a market and economic downturn; 3) the central bank responds to these situations by lowering interest rates, which reduces the demand for bonds, which in turn causes the central bank to print money to buy government debt, which in turn devalues ​​the currency. These usually increase gradually in a long-term, multi-decade cycle until they can no longer continue because: 1) the cost of debt repayments excessively crowds out other spending; 2) the supply of debt that needs to be purchased is too large relative to the demand for it, causing interest rates to rise sharply, which hits the market and economy; or 3) the central bank prints a lot of money and buys government debt to make up for the lack of demand, causing the value of the currency to fall sharply. In either case, the returns on bonds will be poor until they become cheap enough to attract demand or the debt is restructured. These can be easily measured and seen as heading towards an impending debt crisis. When the limits on debt-financed spending occur, something like a debt-induced economic "heart attack" will occur.

Throughout history, almost every country has gone through this debt cycle, often multiple times, so there are hundreds of historical cases to reference. In other words, all monetary orders collapse, and the debt cycle process I describe is behind these collapses. This can be traced back to recorded history. This is the process that led to the collapse of all reserve currencies, such as the British pound and previously the Dutch guilder. In my book, I show 35 recent cases.

Question 2: If this process happens repeatedly, why are the dynamics behind it not widely understood?

You are right that it is not widely understood. Interestingly, I can't find any specific research on how this process occurs. I speculate that the reason this is not widely understood is that in reserve currency countries this process usually only happens about once in a lifetime - when their monetary order breaks down - and when it happens in non-reserve currency countries, people assume that reserve currency countries will not have this problem. The only reason I discovered this process is that I saw it happen in my sovereign bond market investments, which prompted me to study many similar cases in history so that I could respond appropriately (for example, I responded to the 2008 global financial crisis and the 2010-2015 European debt crisis).

Question 3: How worried should we be about a "heart attack" debt crisis in the United States while we wait for the US debt problem to explode? People have heard a lot about impending debt crises that never happened. Is this time different?

I think we should be very worried given the circumstances mentioned above. I think those who worried about debt crises when conditions were not so severe were right because if measures were taken early, such as warning people not to smoke and eat poorly, it would have prevented the situation from getting so bad. So I think the reason this issue hasn’t gotten more widespread attention is both because it’s not well understood and because there’s a lot of complacency that has been created by premature warnings. It’s like someone with a lot of plaque in his arteries, who eats a lot of fatty foods and doesn’t exercise, saying to his doctor, “You warned me I’d have problems if I didn’t change my lifestyle, but I haven’t had a heart attack yet. Why should I trust you now?”

Question 4: What might be the catalyst for a debt crisis in the U.S. today, when would it happen, and what would it look like?

The catalyst would be a confluence of the various influences mentioned earlier. As for timing, policy and external factors (such as major political changes and wars) could accelerate or delay it. For example, if the budget deficit were to fall to about 3% of GDP from the roughly 7% I and most people predict, the risk would be much lower. If there is a major external shock, the crisis could come sooner; if not, it could come later or not at all (if managed properly). My guess—which may not be accurate—is that the crisis will happen within three years, give or take two years, if nothing changes on the current path.

Q5: Do you know of any similar cases where the budget deficit was reduced significantly in the way you describe and good results were achieved?

Yes, I know of several. My plan would reduce the budget deficit by about 4% of GDP. The most similar case with good results is the US fiscal deficit reduction of 5% of GDP between 1991 and 1998. I also list similar cases in several countries in my book.

Q6: Some people believe that the US is generally less susceptible to debt-related problems/crises due to the dominant role of the US dollar in the global economy. What do you think people who hold this view are ignoring or underestimating?

If they believe this, they are ignoring the understanding of the mechanism and the lessons of history. More specifically, they should look at history and understand why all previous reserve currencies are no longer reserve currencies. In simple terms, money and debt must be effective stores of wealth or they will be devalued and abandoned. The dynamics I describe explain how reserve currencies can lose their effectiveness as stores of wealth.

Question 7: Japan—whose debt-to-GDP ratio, at 215%, is the highest of any advanced economy—is often cited as the poster child for the argument that a country can sustain persistently high debt levels without experiencing a debt crisis. Why shouldn’t Japan’s experience bring you comfort?

The Japanese case exemplifies and continues to exemplify the problems I describe, and it also validates my theory in practice. More specifically, Japanese bonds and debt have been poor investments because the Japanese government is overindebted. To compensate for the lack of demand for Japanese debt assets at low interest rates, the Bank of Japan has printed a lot of money and purchased a lot of government debt, which has caused Japanese bondholders to lose 45% relative to U.S. dollar debt and 60% relative to gold since 2013. The cost of a Japanese worker has fallen 58% relative to an American worker since 2013. I have an entire chapter in my book dedicated to the Japanese situation that explains this in depth.

Q8: Are there other areas of the world that look particularly troubled from a fiscal perspective that people may be underestimating?

Most countries have similar debt and deficit problems. This is true for the UK, the EU, China, and Japan. This is why I expect most countries to go through a similar debt and currency devaluation adjustment process, and why I expect non-government currencies, such as gold and Bitcoin, to perform relatively well.

Q9: How should investors respond to this risk/position themselves going forward?

Everyone’s financial situation is different, but as a general recommendation, I recommend diversifying into asset classes and countries that have strong P&L and balance sheets and are free of major internal political and external geopolitical conflicts, while reducing the allocation to debt assets such as bonds and increasing holdings of gold and a small amount of Bitcoin. Having a small allocation to gold can reduce portfolio risk, which I believe will also improve portfolio returns.

Finally, the opinions expressed here are my own and do not necessarily reflect those of Bridgewater Associates.