Dalio's latest warning: the US debt crisis may explode within three years. The antidote is...
By Ray Dalio, founder of Bridgewater Foundation
Original title: How Countries Go Broke: The Dynamic Behind What Is Happening Now
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I'm in“How Countries Go Bankrupt: The Big Cycle”An analytical framework is described in detail to describe dynamic processes that are likely to occur due to unsustainable imbalances between debt supply and demand.
Three things happened at the same time recently:
1) The Japanese government sold part of its US Treasury bond holdings to return capital to Japan to support the yen and the Japanese capital market, and reduce exposure to US Treasury bonds, while avoiding being forced to raise interest rates beyond its wishes in order to support the yen;
2) US bond yields reached new highs under long-term leadership, while the US dollar weakened. The reasons include not only the current and anticipated supply of huge debt, but also weak demand for US bonds;
3) Treasury Secretary Vincent announced this week that the US Treasury will buy US Treasury bonds, and the amount of capital he can use is limited
Many people ask me: do these events fit the classic template I set out in my book? The answer is yes. To anticipate what might happen next, let's first review this operating mechanism.
Detailed explanation of the operating mechanism
The central government's debt dynamics are based on the same principles as the debt dynamics of individuals or companies. The only difference is that the central government has a central bank that can print money (which will depreciate the currency), and it can obtain funds from the public through taxation. Because of this, if you imagine how the debt dynamic would work if you or the business you run could print money, or get capital from people through taxation — then you can understand this process. But remember, your goal is for the entire system to work well, not only for yourself, but for all citizens.
In my opinion, the credit/market system is like the human body's circulatory system, delivering nutrients to every corner that makes up the market and economy. If credit is used effectively, it can generate productivity and income to repay debt and interest on debt, which is a healthy state of affairs. However, if credit is not properly used to generate sufficient income to repay debts and interest, debt payments will continue to pile up like plaques in blood vessels, squeezing other expenses. When debt payments become very large, debt repayment problems arise, and eventually evolve into debt rollover problems — because debt holders are unwilling to continue to roll over and instead want to sell.
Naturally, this will lead to a shortage of demand and sell-off of debt instruments such as bonds; when demand is scarce relative to supply, it either causes a) interest rates to rise, thereby suppressing the market and economic downturn, or b) the central bank “prints money” and buys debt, which will cause the value of the currency to fall, thereby driving up inflation (compared to the original level). Banknote printing also artificially lowers interest rates and harms lenders' returns.
Both options are bad. When debt sell-offs are too large and difficult to contain, and the central bank has already purchased large amounts of debt, rising interest rates can cause the central bank to lose money and damage its cash flow. If this continues, the central bank will fall into a situation where net assets are negative.
When this situation became serious, the central government and central bank needed to borrow money to repay the principal and interest of the debt, while the central bank printed money to provide loans due to insufficient free market demand, so a self-reinforcing spiral between debt/banknote printing/inflation formed.
In summary, the classic metrics to keep an eye on are the following:
the ratio of government debt payments to government revenue (this is like the amount of plaque in the circulatory system),
The ratio of the amount of government debt sold to the demand for government debt (this is like a plaque falling off and causing a heart attack), and
The amount of government debt the central bank prints to make up for the gap between the demand for government debt and the supply of government debt to be sold (this is like the central bank applying a higher dose of liquidity/credit to mitigate the shortage of liquidity, thereby generating more debt, and the central bank has a risk exposure to this debt).
These indicators usually rise over a long cycle of decades — debt and debt payments continue to grow in relation to income — until this state of affairs cannot continue because: 1) debt repayment expenses unacceptably crowd out other expenses, 2) the supply of debt that must be purchased is too large, causing interest rates to rise sharply, leading to a sharp decline in the market and economy, or 3) central banks are unwilling to let interest rates rise and suffer bad market/economic consequences, so they print large amounts of money and buy large amounts of government debt to cover the demand gap, thereby making the value of the currency significant Decreased.
In any case, the return on bonds will be poor until the money and debt eventually become cheap enough to attract demand, or the government is able to cheaply buy back or restructure the debt.
This is what a big debt cycle looks like in a tiny nutshell.
Because these things can be quantified, people can monitor how this debt dynamic is unfolding, so it's easy to see that problems are looming. I've always used this diagnostic method in my investments.
More specifically, you can see the rise in debt and debt payments compared to income, and the supply of debt exceeds demand. The central bank deals with these problems — initially by cutting interest rates to stimulate the economy, then by printing money and buying debt. Eventually, the central bank loses money and falls into a negative net asset situation. At the same time, the central government borrows more debt to pay the principal and interest of the debt, while the central bank monetizes the debt. All of this points to a government debt crisis, which has consequences equivalent to an economic heart attack — a crisis that comes when a contraction in debt-financing spending shuts down the normal flow of the economic cycle system.
Early in the final stages of the big debt cycle, market behavior reflected this dynamic through rising interest rates (led by long-term interest rates), currency depreciation (especially relative to gold), and the central government's finance department shortening the length of its debt issuance due to insufficient demand for long-term debt. Usually, in the latter stages of this process, when the dynamics are most severe, a series of seemingly extreme measures are also implemented, such as establishing capital controls and putting unconventional pressure on creditors to buy and not sell debts.
The Current State of the US Government: A Brief Version
Now imagine you're running a large business called the “US Government.” This will give you a perspective to help you understand the financial situation of the US government and the choices facing its leadership.
This year's total revenue was around $5.5 trillion, while total expenditure was around $7.5 trillion, so the budget gap was around $2 trillion. In other words, your organization will spend about 40% more than revenue this year. Moreover, there is very little room for cutting expenses, since almost all expenses are either previously promised or necessary. As your organization has borrowed heavily over a long period of time, it has accumulated huge debt—about six times your annual income (about $32 trillion [1]), equivalent to about $240,000 in debt for each household in need of your care. And interest expenses on debt are about 1 trillion US dollars, accounting for about 20% of your company's revenue, and half of this year's budget gap (deficit). You need to borrow money to fill this gap. But that $1 trillion isn't all you owe to your creditors, because in addition to interest, you also need to repay the principal due, which is about $10 trillion. You want your creditors to either re-lend or lend the money to you. As a result, debt payments — that is, the principal and interest required to avoid default — are approximately $11 trillion, or about 200% of revenue.
This is the current state of affairs.
So what's going to happen next? Let's imagine that. You have to borrow money to cover the deficit, no matter how much the deficit ends up being. There is much debate about how much the deficit will be. Taking into account the recently passed Budget Settlement Act, most independent evaluators predict that after 10 years, debt will reach $55-60 trillion (about 7 times revenue), as additional $25-30 trillion will be borrowed at that time. Of course, after 10 years, this will expose the organization to more debt repayment squeeze expenses, and in the absence of a coping plan, the debt it needs to sell may face insufficient demand.
[1] The federal government debt is $32 trillion, not including internal government holdings. When these are factored in, the total federal debt is approximately $40 trillion.
My 3% three-part solution
I am confident that the US government's financial situation is at an inflection point because if not addressed now, debt will accumulate to a level that cannot be managed without major trauma; and it is particularly important that this operation be carried out when the system is relatively strong rather than weak. Because when the economy is in contraction, the government's demand for borrowing will increase dramatically.
Based on my analysis, I think this situation needs to be addressed through what I call a “3% three-part solution.” In other words, reduce the budget deficit to 3% of GDP and achieve it on the premise of balancing the three deficits reduction methods — the three methods are: 1) cutting spending, 2) increasing tax revenue, and 3) lowering interest rates.
All three need to be done simultaneously to prevent either method from being too aggressive, because if one method is too aggressive, the adjustment process will be painful. Moreover, these measures should be achieved through good fundamental adjustments rather than through coercive measures (for example, it would be very bad for the Federal Reserve to artificially lower interest rates). According to my forecast, compared to the current plan, spending cuts and tax increases of about 5% each, while interest rates fall by about 1-1.5%. This will reduce interest expenses by 1-2% of GDP over the next ten years, and stimulate rising asset prices and active economic activity, thereby bringing in more fiscal revenue.
Frequently asked questions and my answers
Question 1: Why do big government debt crises and big debt cycles happen?
The reason why major government debt crises and large debt cycles occur is easy to measure by the following indicators: 1) the ratio of government debt payments to government revenue rises to the point where necessary government spending is unacceptably squeezed; 2) the ratio of government debt sales to demand becomes too large, leading to a rise in interest rates, which causes the market and economy to decline; and 3) central banks respond to these conditions by lowering interest rates, which in turn causes the central bank to print money to buy government debt, thereby depreciating the currency.
These indicators usually rise over a long cycle of decades until they can no longer continue, because: 1) debt repayment expenses unacceptably crowd out other expenses; 2) interest rates must rise sharply in relation to the demand for purchases; or 3) central banks print large amounts of money and buy large amounts of government debt to cover the demand gap, causing the value of the currency to drop sharply. In any case, the return on bonds will be poor until they become cheap enough to attract demand, or the debt can be restructured. One can easily quantify these metrics and see them moving towards an impending debt crisis. When debt financing expenses shrink, it's like a debt-induced economic heart attack.
Throughout history, these debt cycles have occurred in almost every country, often more than once, so there are hundreds of historical examples to refer to. They date back to the beginning of recorded history. In other words, the entire monetary order eventually collapsed, and the debt cycle process I described was the reason behind these collapses. It was this process that led to the collapse of all reserve currencies, such as the British pound and the Dutch guilder before that. In my book, I've listed 35 recent cases.
Q2: If this process happens repeatedly, why isn't the dynamic mechanism behind it widely understood?
You're right, this process really isn't widely understood. Interestingly, I couldn't find any research on how this happened. I'm guessing that the reason it isn't widely understood is because the collapse of the monetary order usually only happens once in a lifetime in reserve currency countries, and when it happens in non-reserve currency countries, people also assume that it is an immune problem for reserve currency countries.
The only reason I discovered this process was because I saw it happen in my own investment in the sovereign bond market, which prompted me to study many such cases in history to be able to manage them well (such as managing the 2008 global financial crisis and the subsequent European debt crisis).
Question 3: While everyone is waiting for the US debt problem to break out, how worried should we be about a “heart attack” debt crisis? People have heard a lot about the impending debt crisis, but it never came. What's different this time around?
I think we should be very concerned because the conditions mentioned earlier already exist. I think those who were worried about a debt crisis before — conditions weren't that serious at the time — were right, because dealing with it earlier would have prevented the situation from getting to the point where it is today, just as doctors warned early against smoking and a bad diet. So I'm guessing that this issue isn't receiving more widespread concern, partly because it isn't fully understood, and on the other hand, because earlier premature warnings have caused a great deal of paralysis.
It's like a person with lots of plaque in his arteries, eating lots of fatty foods, and not exercising, saying to the doctor, “You warned me before that bad things would happen if I didn't change my lifestyle, but I haven't had a heart disease until now. So why should I trust you now?”
Q4: What could be the catalyst for the current US debt crisis? When will this happen? What would such a crisis look like?
The catalyst would be a combination of the effects mentioned earlier. As for time, it can be accelerated or delayed by policies and external factors, such as major political changes and wars.
For example, if the budget deficit falls from the level of around 7% of GDP that I and most others predicted, to about 3%, this would greatly reduce risk. If there is a major external shock, it will come sooner; if not, it will come later or not at all (if managed properly).
My guess -- I think this would be a bad guess --Yes, if the current route does not change, it will arrive in about 3 years, and the margin of error is plus or minus 2 years.
Q5: Do you know of a similar situation — the budget deficit has been drastically reduced in the way you described it, with good results?
Yes. I know a few. My plan would cut the budget deficit by about 4% of GDP. The most similar example with good results is the US from 1991 to 1998, when the budget deficit cut 5% of GDP. In my book, I've listed similar cases that have occurred in several other countries.
Q6: Some people think that due to the dollar's dominance in the global economy, the US is generally less vulnerable to debt-related issues/crises. What do you think people with this view have overlooked/underestimated?
If they think so, they are ignoring the understanding of operating mechanisms and the lessons of history. More specifically, they should study history to understand why all previous reserve currencies are no longer reserve currencies. Quite simply, money and debt must be able to effectively store wealth; otherwise, they will depreciate and be abandoned. The dynamic process I have described explains exactly how reserve currencies lose their effectiveness as a means of storing wealth.
Q7: Japan — with a debt-to-GDP ratio of 215%, the highest of any developed economy — is often used as a prime example to support the idea that “a country can sustain a high level of debt without a debt crisis.” Why don't you think your experience in Japan can give you much comfort?
The Japanese case illustrates and continues to illustrate the problem I described, and it shows how my theory works in practice. More specifically, Japanese bonds and debt have always been a poor investment due to the Japanese government's high level of debt. To make up for insufficient demand for Japanese debt assets at sufficiently low interest rates — low enough to be beneficial to the country — the Bank of Japan has printed large amounts of money and bought large amounts of Japanese government debt, which has caused Japanese bondholders to lose 51% compared to holding dollar debt since 2013 and 76% compared to holding gold since 2013. Typical wages for Japanese workers, in common currency, have fallen 55% compared to American workers' wages since 2013. I have an entire chapter in my book dedicated to exploring the case of Japan in depth.
Question 8: From a fiscal perspective, are there any other regions in the world that seem particularly problematic, and people may have underestimated these problems?
Most economies have similar debt and deficit problems. This is true of the United Kingdom, the European Union, China, and Japan. This is why I expect most economies to go through similar debt and currency depreciation adjustments, and why I expect non-government produced currencies such as gold and bitcoin to perform relatively well.
Q9: How should investors deal with this risk/how should positions be allocated?
As a general recommendation, I recommend a good diversification of asset classes and countries, giving priority to countries with strong profit and loss statements and balance sheets, and no serious internal political or external geographical conflicts.Debt assets such as low allotment bonds, overallocation of gold, and small amounts of Bitcoin.Allocating a small amount of money — maybe 10-15% — to gold can reduce the risk of the portfolio, and I think it will also increase its return.
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