I recommend diversifying investments in asset classes and countries with strong profit and loss statements and balance sheets, and without significant internal political and external geopolitical conflicts, while reducing the allocation to debt assets like bonds, and increasing holdings in gold and a small amount of Bitcoin.
Written by: Ray Dalio
Translated by: Block unicorn
Preface
Today, my new book "How Nations Go Broke: 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 communicate the core points in a minimalist way, leaving the depth of exploration to the readers' discretion.
My Background
I have been engaged in global macro investing for over 50 years, with nearly the same amount of time betting in the government bond market, and I have done very well. While I have previously been reticent about the mechanisms behind major debt crises and the principles for dealing with these crises, I have now reached another stage in my life where I am eager to pass on this understanding to others and help them. This is especially true when I see the United States and other countries heading towards what is equivalent to an economic "heart attack." This prompted me to write "How Nations Go Broke: The Big Cycle," which comprehensively elaborates on the mechanisms and principles I use, along with a brief overview of the book.
How the Mechanism Works
The dynamics of debt operate the same way for governments, individuals, or companies, with the distinction that central governments have central banks that can print money (which leads to currency devaluation) and can obtain funds from the people through taxation. Therefore, if you can imagine how the debt dynamics would work for yourself or the business you operate in a situation where money can be printed or obtained through taxation, you can understand this dynamic. But remember, your goal is to keep the entire system running 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 various parts of the market and economy. If credit is used effectively, it can create productivity and income sufficient to repay debt and interest, which is healthy. However, if credit is misused, leading to income insufficient to repay debt and interest, the debt burden will accumulate like plaque in blood vessels, squeezing out other expenditures. When the amount of debt repayment becomes very large, it leads to debt repayment issues, ultimately resulting in debt rollover problems, as debt holders are unwilling to roll over and want to sell it. Naturally, this leads to insufficient demand for debt instruments like bonds, creating a surplus supply, which in turn leads to: a) rising interest rates, depressing the market and economy; or b) the central bank "printing money" and purchasing debt, which reduces the value of the currency and pushes up inflation. Printing money also artificially depresses interest rates, harming creditor returns. Both methods are undesirable. When the scale of debt sales becomes too large, and the central bank has purchased a significant amount of bonds but cannot curb rising interest rates, the central bank incurs losses, affecting its cash flow. If this situation persists, the net worth of the central bank will turn negative.
When the situation becomes severe, both the central government and the central bank will borrow to pay interest on the debt, with the central bank printing money to provide loans due to insufficient demand in the free market, leading to a self-reinforcing spiral of debt/money printing/inflation. In summary, attention should be paid to the following classic indicators:
- The ratio of government debt repayment costs to government revenue (similar to the amount of plaque in the circulatory system);
- The ratio of government debt sales to government debt demand (similar to plaque breaking off leading to a heart attack);
- The amount of government debt purchased by the central bank through money printing to fill the debt demand gap (similar to a doctor/central bank injecting a large amount of liquidity/credit to alleviate liquidity shortages, creating more debt, with the central bank bearing the risk).
These typically increase gradually over a long-term, multi-decade cycle, with debt and debt repayment costs rising relative to income until it becomes unsustainable because: 1) debt repayment costs excessively crowd out other expenditures; 2) the supply of debt needing to be purchased is too large relative to demand, leading to a significant rise in interest rates, severely impacting the market and economy; or 3) to avoid rising interest rates and market/economic deterioration, the central bank prints a large amount of money and purchases government debt to fill the demand shortfall, leading to a significant decline in the value of the currency.
In any case, bond returns will be poor until the currency and debt become very cheap enough to attract demand, and/or the debt can be repurchased or restructured cheaply by the government.
This is a brief overview of the big debt cycle.
Because these factors can be measured, the occurrence of debt dynamics can be monitored, making it easy to foresee impending problems. I have used this diagnostic method in investing and have not disclosed it publicly until now, but I will explain it in detail in "How Nations Go Broke: The Big Cycle," as it is now too important to keep confidential.
More specifically, one can see the rising debt and debt repayment costs relative to income, the supply of debt exceeding demand, the central bank initially stimulating by lowering short-term interest rates, and then responding by printing money and purchasing debt, ultimately leading to the central bank incurring losses and having negative net worth, with the central government and central bank borrowing to pay interest on the debt, and the central bank monetizing the debt. All of this leads to a government debt crisis, equivalent to an economic "heart attack," as the constraints on debt-financed spending block the normal flow of the circulatory system.
In the early stages of the final phase of the big debt cycle, market behavior reflects this dynamic through rising long-term interest rates, currency devaluation (especially relative to gold), and the central government's treasury shortening the debt issuance period due to insufficient long-term debt demand. Typically, in the later stages of this process, when the dynamics are most severe, some seemingly extreme measures are taken, such as implementing capital controls and exerting immense pressure on creditors to buy rather than sell debt. My book explains this dynamic more comprehensively through numerous charts and data.
Overview of the Current Situation of the U.S. Government
Now, imagine you are running a large enterprise called the U.S. government. This will help you understand the financial situation of the U.S. government and the choices of its leadership.
This year, total revenue is about $5 trillion, while total expenditure is about $7 trillion, resulting in a budget deficit of about $2 trillion. In other words, your organization will spend about 40% more than it earns this year. Moreover, there is almost no ability to cut spending, as nearly all expenditures are previously committed or necessary expenses. Due to your organization borrowing excessively for a long time, it has accumulated a massive debt—about six times its annual revenue (approximately $30 trillion), equivalent to about $230,000 of debt per household. The interest bill on the debt is about $1 trillion, accounting for about 20% of the organization's revenue, which is half of this year's budget deficit, and you will need to borrow to fill this gap. But this $1 trillion is not the total you must pay to creditors, as in addition to interest, you also need to repay maturing principal, which is about $9 trillion. You hope that your creditors or other wealthy entities can lend to you again or lend to other wealthy entities. Therefore, the cost of debt repayment— in other words, the principal and interest that must be repaid to avoid default— is about $10 trillion, which is about 200% of revenue.
This is the current situation.
So, what will happen next? Let’s imagine. Regardless of the deficit, you must borrow money to cover it. There is much debate about the specific amount of the deficit. Most independent assessment agencies predict that debt will reach about $50-55 trillion in ten years, approximately 6.5-7 times revenue (about $3-5 trillion). Of course, in ten years, if there is no plan to address this situation, the organization will face more pressure to repay debt, which will squeeze expenditures, and it will also face greater risks: the debt it must sell will not have sufficient demand.
This is 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 issue is not addressed now, debt will accumulate to unmanageable levels, leading to tremendous trauma. It is especially important that this operation be conducted while the system is relatively strong, rather than during economic weakness. Because during economic contractions, the government's borrowing demand will increase significantly.
Based on my analysis, I believe this situation needs to be addressed through what I call the "3% Three-Part Solution." This means balancing the budget deficit down to 3% of GDP through the following three ways: 1) cutting expenditures, 2) increasing tax revenue, and 3) lowering interest rates. All three need to happen simultaneously to avoid any one adjustment being too large, as any excessive adjustment could lead to traumatic consequences. These adjustments need to be achieved through good fundamental adjustments rather than being forced (for example, if the Federal Reserve unnaturally suppresses interest rates, it would be very detrimental). According to my projections, spending cuts and tax revenue would each increase by about 4% relative to current plans, with interest rates correspondingly decreasing by about 1-1.5%, which would lead to average interest expenditures declining by 1-2% of GDP over the next decade, stimulating asset prices and economic activity, thus generating more revenue.
Here are common questions and my answers
The content of the book far exceeds what can be covered here, including descriptions of the "overall big cycle" (including debt/money/credit cycles, domestic political cycles, external geopolitical cycles, natural behaviors, and technological advancements) that drive all major changes in the world, my outlook on possible futures, and some views on investing during these changes. But now, I will answer some questions that are often asked when discussing this book and invite you to read the complete book for a deeper understanding.
Question 1: Why do large government debt crises and big debt cycles occur?
Large government debt crises and big debt cycles can be easily measured in the following ways: 1) the ratio of government debt repayment amounts to government revenue rises to unacceptable levels, thereby squeezing the government's basic expenditures; 2) the amount of government debt sold is too large relative to demand, leading to rising interest rates, which in turn causes market and economic downturns; 3) the central bank responds to these situations by lowering interest rates, which reduces demand for bonds, leading the central bank to print money to purchase government debt, thereby devaluing the currency. These typically increase gradually over a long-term, multi-decade cycle until they become unsustainable because: 1) debt repayment costs excessively crowd out other expenditures; 2) the supply of debt needing to be purchased is too large relative to demand, leading to a significant rise in interest rates, severely impacting the market and economy; or 3) the central bank prints a large amount of money and purchases government debt to fill the demand shortfall, leading to a significant decline in the value of the currency. In any case, bond returns will be poor until they become cheap enough to attract demand or until the debt is restructured. All of these can be easily measured, and one can see they are heading towards an impending debt crisis. When the constraints on debt-financed spending occur, it leads to an economic "heart attack" similar to that caused by debt.
Throughout history, almost every country has experienced this debt cycle, often occurring multiple times, so there are hundreds of historical cases to reference. In other words, all monetary orders will collapse, and the debt cycle process I describe is the underlying reason for these collapses. This situation can be traced back to recorded history. It is the process that leads to the collapse of all reserve currencies (such as the pound and the previous Dutch guilder). In my book, I present the 35 most recent cases.
Question 2: If this process occurs repeatedly, why is the underlying dynamic not widely understood?
You are right; this point is indeed not widely understood. Interestingly, I cannot find any dedicated studies on how this process occurs. I speculate that it is not widely understood because, in reserve currency countries, this process typically happens only about once in a lifetime—when their monetary order collapses—and when it occurs in non-reserve currency countries, people believe that reserve currency countries will not encounter such problems. The only reason I found this process is that I observed it happening in sovereign bond market investments, which prompted me to study many similar historical cases to be able to respond appropriately (for example, I dealt with the 2008 global financial crisis and the European debt crisis from 2010 to 2015).
Question 3: How concerned should we be about a "heart attack" style debt crisis in the U.S. as we await the explosion of the U.S. debt problem? People have heard a lot about impending debt crises that never materialized. What is different this time?
I believe we should be very concerned, given the aforementioned circumstances. I think those who worry about debt crises when conditions are less severe are correct because if measures are taken early, such as warning people against smoking and poor diets, the situation can be avoided from becoming so dire. Therefore, I believe the reason this issue has not garnered broader attention is both due to a lack of deep understanding and because premature warnings have led to a sense of complacency. It’s like someone with a lot of plaque in their arteries, eating a lot of high-fat foods and not exercising, telling the doctor, "You warned me that I would have problems if I didn’t change my lifestyle, but I haven’t had a heart attack yet. Why should I believe you now?"
Question 4: What might be the catalysts for today's U.S. debt crisis, when might it occur, and what would the crisis look like?
The catalysts will be a convergence of the various factors mentioned earlier. As for timing, policy and external factors (such as significant political changes and wars) could accelerate or delay its occurrence. For example, if the budget deficit decreases from about 7% of GDP, as I and most people predict, to about 3%, the risks would be greatly reduced. If a significant external shock occurs, the crisis could come sooner; if not, it could come later or not at all (if managed properly). My guess—though it may be inaccurate—is that if the current path is not changed, the crisis will occur within three years, with a two-year fluctuation either way.
Question 5: Do you know of any similar cases where budget deficits were significantly reduced in the way you describe, and good outcomes were achieved?
Yes, I know of several cases. My plan would reduce the budget deficit to about 4% of GDP. The most similar case with good results is the reduction of the fiscal deficit in the U.S. from 1991 to 1998, which decreased by 5% of GDP. My book also lists several similar cases from other countries.
Question 6: Some people believe that due to the dollar's dominance in the global economy, the U.S. is generally less susceptible to debt-related problems/crises. What do you think those who hold this view are overlooking or underestimating?
If they believe this, they are overlooking the understanding of the mechanisms and the lessons of history. More specifically, they should examine history to understand why all previous reserve currencies are no longer reserve currencies. Simply put, money and debt must be effective stores of wealth; otherwise, they will be devalued and discarded. The dynamics I describe explain how reserve currencies lose their effectiveness as stores of wealth.
Question 7: Japan—whose debt-to-GDP ratio is as high as 215%, the highest among all developed economies—is often cited as a typical example of "a country that can sustain high levels of debt without experiencing a debt crisis." Why can't Japan's experience comfort you?
Japan's case exemplifies the problems I describe and will continue to serve as a testament to my theory. More specifically, due to the excessive debt of the Japanese government, Japanese bonds and debt have consistently been poor investments. To compensate for the lack of demand for Japanese debt assets at low interest rates, the Bank of Japan has printed a large amount of money and purchased a significant amount of government debt, resulting in Japanese bondholders losing 45% relative to dollar debt and 60% relative to gold since 2013. Since 2013, the cost of Japanese workers has decreased by 58% relative to American workers. My book contains an entire chapter dedicated to discussing Japan's situation in depth.
Question 8: From a fiscal perspective, which regions of the world appear particularly tricky, and where might people underestimate the risks?
Most countries have similar debt and deficit issues. The UK, EU, China, and Japan are all in this situation. This is why I expect most countries to undergo similar debt and currency devaluation adjustment processes, which is also why I anticipate that non-government-issued currencies, such as gold and Bitcoin, will perform relatively well.
Question 9: How should investors respond to this risk, and how should they position themselves for the future?
Everyone's financial situation is different, but as a general recommendation, I suggest diversifying investments in asset classes and countries with strong profit and loss statements and balance sheets, and without significant internal political and external geopolitical conflicts, while reducing the allocation to debt assets like bonds, and increasing holdings in gold and a small amount of Bitcoin. Allocating a small amount of funds to gold can reduce the risk of the investment portfolio, and I believe it will also enhance the portfolio's returns.
Finally, the views expressed here are solely my own and do not necessarily represent the views of Bridgewater Associates.
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