Without debt, the majority of people would never be able to own a home. Companies would struggle to build data centers and manufacturing plants. Governments wouldn’t be able to build subway systems, hospitals or highways. No debt means no growth. Still, there are limits. Too much debt, poorly managed, leads to disasters. With this in mind, Ray Dalio and his firm Bridgewater published a massive global study of the past 100 years of debt crises, how they occurred and how they were handled. The book is called Principles For Navigating Big Debt Crises. Whether you are a policymaker or an investor, he offers meaningful insights.
Dalio’s firm, managing $160 billion, is the largest hedge fund in the world. He doesn’t need to make money from publishing. Given his track record, his perspective deserves attention. I won’t go into all of the different lessons; there are many. Here are some key takeaways.
Three Types of Financial Stress
When people talk about a weakness in the economy or a looming market crash, they are typically talking about one or more of these three financial scenarios: “The Bubble,” “The Recession,” and “The Debt Crisis.”
- Bubbles are the most common type of financial stress. Bubbles reach their apex when a particular asset class gets too much attention from new investors looking for quick riches. Bitcoin has experienced a few bubbles, so have tech stocks, marijuana stocks, and the housing market in ’07. Since there are often many bubbles occurring at once, the majority of them burst without creating too much havoc or drawing much attention. You can read all about Bubbles in this article.
- Recessions are declines in general economic activity. In the US, a recession is two consecutive quarters of declining GDP. Stock markets do correlate to GDP numbers, but because GDP data is compiled after the fact, it’s not possible to use it to predict the direction of the stock market. There have been 22 recessions in the US since the start of the 20th century. They are unpleasant, relatively common, and not at all fatal on their own.
- Debt Crises are by far the most problematic financial issue for any person, business or economy. Dalio’s book points out that we’ve only had three of them in the US since 1900 — the Great Depression of ‘27, the Post WWII economic transition of ’45, and the Great Recession and Housing Crisis of ‘07.
People In Charge Matter
Bubbles and recessions can be financially fatal once unchecked debt becomes a factor. The biggest personal, corporate and government meltdowns have all included inappropriate levels of debt (leverage). When both the creators and users of debt get too aggressive and too short-term focused, danger looms. It’s an inherent problem in our system that both the creators and users of debt are by default too aggressive and too short-term focused.
Dalio points out that in order for debt to be used appropriately, it must be managed thoughtfully and with close attention. Importantly, the cost of servicing the debt (interest) needs to be in line with incoming cash flows. Unfortunately, austerity (spending less) is so unpopular that it’s often considered a career risk to even suggest it. (1) Austerity is one of four ways to bring debt back under control.
The other three methods are (2) debt defaults, (3) printing more money, and (4) redistributing debt from those who have more than they need to those who have less.
There are always losers after debt is managed down from crisis levels back to appropriate levels. As a result, the people in charge end up despised, regardless of how well they perform their duty.
Keep the Debt in Your Own Currency
Just over half of the 48 global debt crises covered in Dalio’s book involve owing money in a currency other than your own. Imagine trying to pay down a mortgage when all you have saved up is a stash of Bitcoin. In reality, the equivalent has happened many times for many countries. We’re lucky that our own currency happens to also be the world’s reserve currency. But imagine if the pound, yuan or yen took over as the world’s reserve currency. If we owed debt in another currency, then we would no longer be able to print money as an effective deleveraging tool; we would be in big trouble. This is why leaders are starting to make noise warning us and policymakers to not take our dollar for granted.
Germany 1919 following the Treaty of Versailles is probably the most famous currency-related debt crisis scenario. After WWI, the Germans owed 350% of their GDP in British pounds when all they had left was a quickly plunging German Deutschmark. German equity markets fell 99% as a result. Even the equity recovery over the next 10 years was just a fraction (30%) of the high. The Germans were never able to pay it back and the despair of that debt burden only created future problems.
Debt crises follow familiar patterns. The average debt crisis cycle lasts 12 years from the early signs to the last part of the cycle. That timeframe shouldn’t be taken as a rule by any means. It’s just an average of the most common 48 cases.
How can we spot a debt crisis in the making? Dalio proposes seven questions:
- Are prices high relative to traditional measures? (prices often seem too high anyways)
- Are prices discounting future rapid price appreciation from these high levels?
- Is there a broad bullish sentiment?
- Are new purchases being financed by high leverage?
- Are companies making forward purchases to protect against future price increases?
- Have new participants entered the market?
- Could tight monetary policy pop the bubble?
What About Today?
Investors should expect to experience bubbles and recessions; we can’t escape them. They are manageable as long as the debt in the system (household, corporate and government) is reasonable. We feel that debt levels today are fair, especially considering that the cost of debt is very low and GDP has grown considerably over the past 10 years. We would be happy to discuss this in more detail. The same concepts apply to leverage associated with growing family wealth.
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