Ugly = Beautiful; Beautiful = Ugly: Ray Dalio On Deleveraging

This article originally appeared on The Daily Capitalist.

I've been working on an article about the state of economic recovery and have been studying deleveraging, debt levels, bank balance sheets, foreclosures, and the like. So I was very pleased to find a long research piece put out by Bridgewater's Ray Dalio on that topic. As readers may know, I am a fan of Dalio and I appreciate his often unique and out-of-the-box view of the markets and the economy. Bridgewater also agrees with my belief that the economy is heading for stagnation and decline this year.

Dalio's piece was very disappointing because it was an incorrect look at how business cycles work and the role of deleveraging and the liquidation of malinvestment. It may actually lead one to make bad investment decisions.  Because Bridgewater's macro economic forecast came to conclusions similar to mine, I had assumed that perhaps they had done a somewhat "Austrian" analysis, but now I question that. Again, as I mentioned in the above article, you don't have to be "Austrian" reach similar conclusions, but they would have to look at indicators an "Austrian" would look at and interpret them in the same way.

Dalio's article, "An In-Depth Look at Deleveragings" is apparently authored by him. It concludes that the best way to "deleverage" is a "proper" combination of debt reduction (defaults and restructurings) and debt monetization (monetary inflation). This is what he considers to be a "beautiful" deleveraging whereas deleveraging by debt reduction and austerity are "ugly." The ugly ones cause recessions/depressions and deflation which is bad. Beautiful deleveragings minimize debt reduction and revive economies with monetary stimulation.

Unfortunately this is a very conventional view and it is wrong. 

I'm not going to get into the entire 31 page article, but he examines six historical events that supposedly exemplify "beautiful" and "ugly" deleveragings. They are the U.S. Great Depression (1930-1932), Japan (1990 to present), Spain (9/2008 to present), UK (1947-1969), and U.S. 9/2008 to 2/2009 (pre-QE). At the end he tackles an analysis of the Weimar hyperinflation. 

I'm not as familiar with the UK and Spain, but I am familiar with both U.S. events and the Weimar hyperinflation. Dalio unfortunately accepts the conventional wisdom of contemporary neo/Keynesian-Classical-Monetarist econometric analysis of these events and fails to understand most of the real causes underlying these crises. To save you the suspense, he believes that the current boom-bust cycle is an example of a "beautiful" deleveraging.

Dalio defines a beautiful deleveraging as one "in which enough 'printing' occurred to balance the deflationary forces of debt reduction and austerity in a manner in which there is positive growth, a falling debt/income ratio and nominal GDP growth above nominal interest rates."

He says,

Thus far, this deleveraging would win our award of the most beautiful deleveraging on record. The key going forward will be for the policy makers to maintain balance so that the debt/income ratio keeps declining in an orderly way.

What he is saying is that the Fed's policy of ZIRP, debt guarantees, and QE avoided a disaster, prevented a collapse of the credit markets, and has allowed deleveraging to occur on a more or less orderly basis, and has promoted growth. He notes that the credit markets are "largely healed" and that "private section credit growth is improving."

This is the Conventional View of the Crisis and he, like most people holding this view, are engaging in a wishful thinking analysis of how things occurred. One could believe that a chariot pulled the sun across the heavens every day, and because the sun came up every day, this analysis is correct. We understand that there are other forces at work. But he is not alone in his conclusions. 

He uses a monetarist view which says that tinkering with money supply can prevent the worst from happening. He sees the problem as one in which there was a shortage of money which caused the bust, rather than it being the result of "money printing". If the Fed could have prevented the worst from happening by printing money, then all of our problems would be solved. Unfortunately for the monetarists at the Fed, including Mr. Bernanke, they have yet to achieve their goal.

Dalio also takes a classical view of the economy as one big aggregate machine which can be properly measured by GDP. His main measure of the problem is the amount of debt to GDP, a measure which really doesn't tell us much. All GDP can tell us is how much money was spent at any given time. At best it is a rough measure; at worst it is a misleading measure because the data is not revealing of what really happened in an economy where millions of individual decisions are made every day. The amount of debt versus GDP tells us nothing about the role of debt, the value of underlying assets, the ability of pay debt, whether the debt was built on monetary steroids or real economic activity, or really anything. "Economies" don't incur debt, people do.

Further he measures everything in nominal terms which makes any conclusion misleading without at least trying to apply a deflator to the measure. Then one has to choose the right deflator to determine if the measured activity was really positive or negative. It is many Austrians' belief that price inflation is actually much higher than officially stated and that there are a number of ways to game the data to make it look better. I have written many times about this and my conclusion is that what we are seeing as "growth" is actually a data fiction because it fails to properly measure the impact of price inflation. In fact what we are seeing as "growth" now is really a further destruction of capital by investors and businesses.

He then uses a neo-Keynesian econometric methodology to interpret and analyze the results. That is, tinkering with the big machine called "the economy" can more or less solve our problems if it is done just right. And we all know that the tinkerers have done a great job of "running" the economy. In fact the current policies proposed and implemented by mainstream economists have been failures and have resulted in an increasingly unstable and fragile economy.

Thus faith in all that tinkering, especially by the Fed, caused the boom-bust credit cycle, and further tinkering with QE and ZIRP, plus the Fed's and the federal government's role in preventing a liquidation of malinvestment has only caused the economic pain to be stretched out much longer than it otherwise would have had the government had not interfered. Further, these policies have only served to create further future instability and economic risk. Other than that his analysis is fine.

What he calls "ugly", an austerity and debt reduction, is actually "beautiful". While it is painful, it is painful for a much shorter period of time and enables the "economy", i.e., people, to go bankrupt, repair their finances, start saving again, create new capital, and then create new economic growth and jobs. By preventing or delaying this process the policy makers only doom us to economic stagnation, inflation, and permanent high unemployment. And I fear that is exactly where we are headed.