Ten years ago this month, the world’s financial system nearly ground to a halt. It was a dramatic and pivotal time, which has had lasting effects on many people’s lives. But, as the founder of the world's largest hedge fund, Bridgewater's Ray Dalio, notes, it was also something that has happened many times in history and will happen many times in the future.
As you know, I believe that everything happens over and over again and that by looking at those things happening many times, one can see the patterns and understand the cause-effect relationships to develop principles for dealing with them. Prior to 2008, I had studied these relationships for debt crises with my colleagues at Bridgewater, and because we understood these relationships, we were able to navigate the crisis well when many others struggled.
Today I am sharing our understanding of how debt crises work and how to navigate them well in a new book called “A Template for Understanding Big Debt Crises.”
I am making it available for free because I am now at a stage of life where what’s most important to me is to pass along the principles that have helped me. My hope is that sharing this template will reduce the chances of big debt crises happening and help them be better managed in the future.
The template comes in three parts.
The first explains the template for understanding how debt cycles work and provides principles for dealing with them well.
In the second, I look at how three big debt crises worked in depth - the 2008 financial crisis, the US Great Depression of the 1930s, and Germany’s inflationary depression of the 1920s. That way you can experience them in the context of the template. In that part, I also share the notes that I and others at Bridgewater wrote during the 2008 financial crisis so that you can see it unfold through our eyes.
Then, in part three, I show all the major debt crises that happened over the last 100 years - all 48 of them - in brief form so that you can see how the template applied to all of these cases.
To summarize some of the key points found in the book:
- All big debt cycles go through six stages, which I describe and explain how to navigate:.
The Early Part of the Cycle
The Beautiful Deleveraging
Pushing on a String/Normalization
2. Getting the balance right between having too much debt (that causes debt crises) and too little debt (which causes suboptimal development) is never done perfectly. Cycles always swing from having too little debt relative to the opportunities to having too much and back to having too little and back to having too much. These swings are exacerbated because people tend to remember what happened to them more recently rather than what happened a long time ago. As a result, it is pretty much inevitable that the system will face a big debt crisis every 15 years or so.
3. There are two major types of debt crises - deflationary and inflationary - with the inflationary ones typically occurring in countries that have significant debt dominated in foreign currency. The template explains how both types transpire.
4. Most debt crises can be well-managed if 1) the debts denominated in one’s own currency and 2) the policy makers both know how to handle the crisis and have the authority to do so. As I write in the book: “Managing debt crises is all about spreading out the pain of the bad debts, and this can almost always be done well if one’s debts are in one’s own currency. The biggest risks are typically not from the debts themselves, but from the failure of policy makers to do the right things due to a lack of knowledge and/or lack of authority.”
5. There are four ways of managing debt crises to produce a deleveraging. They are:
Printing money to stimulate the economy
6. The way to manage a debt crisis well so there is a “beautiful deleveraging” (i.e. a deleveraging in which debt burdens go down at the same time as economic growth is positive and inflation is not a problem) is to balance these paths so that the deflationary forces balance with the inflationary ones.
7. In general, central bankers could do better jobs of smoothing the cycles and preventing big debt crises if, rather than having a single mandate to control inflation or a dual mandate to control inflation and growth, they have a three-part mandate that includes preventing investment bubbles by curtailing the excess debt growth that is funding them.
8. When in a big debt crisis, saving the system (by providing lots of liquidity, guarantees, etc.) is most important – and not trying to be precise about it. This includes putting aside moral hazard considerations at that time. As I write: “How quickly and aggressively policy makers respond is among the most important factors in determining the severity and length of the depression.”
9. It’s important that economic policy makers have sufficient knowledge and emergency powers to handle crises well and don’t get caught by legal or regulatory barriers: “ignorance and lack of authority are bigger problems than the debts themselves.” I am particularly worried about how these factors will affect the next debt crisis due to the way regulations now constrain the freedoms to do the right throngs and the fragmented political state of affairs.
10. After the restructurings and the passing of the debt crisis, policy makers typically need to provide significant stimulus for a number of years (5 to 10) until the hangover effects wear off. “The recovery in economic activity and capital formation tends to be slow, even during a beautiful deleveraging. It typically takes 5-10 years (hence the term “lost decade”) for real economic activity to reach its former peak level.”
This week and next, I’ll be sharing more short excerpts and summaries from the book so you can get a sense of what’s in it and I’d be happy to have a conversation with you about debt crises here on LinkedIn.