Ray Dalio : Debt cycle and zero interest rates

That cycle and how it works when debt rises faster than income, you get to spend more. I'll explain it briefly. Let's imagine you're earning $100,000 a year and have no debt. Then I can go out and borrow because I have no debt; I can go to the bank and borrow, say they lend me ten thousand dollars a year. So now I have a hundred and ten thousand dollars a year that I could spend. When I spend that hundred and ten thousand, somebody else earns a hundred and ten thousand, so that causes their earnings to go up. As their earnings go up, they also can go to the bank, and so you build a cycle in which debt rises faster than income. Most importantly, the debt rises faster than the ability to service income. That is a self-reinforcing upward cycle. It causes asset prices to rise because if incomes are rising, companies are doing better so their earnings do better, and so people with debt can buy goods, services, or financial assets, and those things cause them to go up. So there's a debt expansion, but obviously debt can't rise faster than income forever. Usually, when we had a downturn, you'd lower interest rates because lowering interest rates has stimulative effects on the economy. First, when you lower interest rates, it makes it easier to service your debt. Lower interest rates make it easier to service the debt; also, it makes items bought on credit cheaper. Your monthly payments go down if you buy a car or a house when interest rates are lower, so it makes it cheaper, meaning you could afford more. So it stimulates the economy and also has the effect of raising asset prices because assets, if you have an income stream, say renting a property, you compare it with the going interest rate, and if the interest rate goes down, the value of the asset goes up. So it has a wealth effect. As the economy works, when they lower interest rates, it stimulates the economy, and that stimulating economy really stimulates debt growth and therefore purchasing on debt. So the economy always has gone through these cycles where interest rates go up when trying to slow the economy and go down when trying to stimulate it. However, when interest rates get close to zero, it doesn't work. So you have a lot of debt, debt is rising faster than income, can't go on forever, can't lower interest rates, they hit zero, and the world changes. That's the basic cause-effect dynamic. So in 2006, 2007, it was very clear we were in a bubble, but like all these situations, people at the time get carried away with what's happening. Like 2005, 2006, everybody says the stock market goes up, it's a great investment because it went up, but they don't realize it's more expensive. Going up may make it more expensive, but no, they look back and say it's a great investment, or houses, or I can go borrow money and buy houses, but they don't think about paying back. This is human nature, this has happened through hundreds and thousands of years. And so they get to the point where interest rates can't go down, there's no rectifying of the problem, and you begin a deleveraging. Then the process begins to work in reverse. A deleveraging means no longer can you raise your debt faster than your income. So if you can't, you have to slow your debt, you have to slow your spending. As you slow your spending, you're slowing somebody else's income. And when I say your, it's the purchase of goods, services, and financial assets. As you slow those purchases, the economy goes down and assets go down. As assets go down and incomes go down, there's more need to cut spending, and it begins to build a self-reinforcing negative cycle. There's not enough money in the system. Because again, think of it: spending can be paid for either by money or credit. If you go into a store and buy something, say I'm buying a suit, I can pay by credit or money. If I pay by credit, it's a promise to deliver money; if by money, the transaction's complete. But since I can pay by credit, I can stimulate demand, have a strong economy, but I owe money. So the owing of money means that when I can no longer produce credit and have to get money, I need more money in the system. And when you have zero interest rates, then the central bank is stuck because this deleveraging continues to feed on itself. It continues: I don't spend, you don't earn, it goes down. Can't service debts because I don't have enough money. Banks get in trouble because the person they lent money to doesn't pay back. What is a bank? A bank is simple: people put money in a bank, the bank lends it to others and hopes to get paid back at a higher interest rate. When those people can't pay back because the credit cycle works in reverse, banks get in trouble. They lose money, become bad banks, and the whole system fails. So you see that at the same time as credit contraction, there was a stock market falling because assets need to be sold, and because of credit contraction, people spend less, company earnings go down, companies are worth less, and debt problems cause banks to do poorly. So we have a banking crisis. Deleveraging happens in familiar ways: private sector debt doesn't increase, spending is less, banks get in trouble, markets go down. There's not enough money, central banks lower interest rates, rates hit zero, they're stuck. That's a deleveraging and depression part. Deleveraging examples are the 1930s and Japan's lost decades. At first, austerity is the path because debt is a problem and we must stop getting into more debt. That becomes obvious, so we go through austerity. But austerity has a feedback loop: lack of spending and debt means someone else's income goes down. Then there's a problem with debts, so we encounter debt defaults and think about restructuring. Debt defaults mean re-entering agreements to pay what you can afford. So there's debt restructuring, but it also brings problems because one man's debts are another man's assets. If I lower your debt, say through restructuring, you can pay half your mortgage, then I have to write down that mortgage, so my wealth goes down, and as wealth goes down, I can borrow less and spend less. It feeds on itself. The problem is too much debt relative to income. You can reduce debt by austerity and cutting debt, which is good but deflationary and negative for growth because austerity means less spending. You can restructure, which is also deflationary and negative for growth, producing a lot of pain. Like in the 1930s, after the 1929 crash, it keeps feeding on itself and isn't enough because of the self-reinforcing process. Eventually, central banks print money. In March 1933, the bottom of the Great Depression, President Roosevelt severs the link with gold and prints money because debt is a promise to deliver money. Printing money eases pressure. The printing of money is inflationary in itself, but if it happens alongside deflationary factors like austerity and restructuring, they balance. All three approaches lower debt relative to income, so you can do it without a terrible situation. It still takes a long time; they call it the Lost Decade, usually more than a decade, maybe 15 years, but it's an adjustment process if done well with the right mix between austerity, not raising debt relative to income, restructuring, getting debt payments in order, and putting enough money into the system. So you're seeing Europe go through that; it's classic. And all countries, people, and companies through history have experienced this. The main lesson, though not human nature, is not to have debt rise faster than income for an extended period because that's a bubble that won't last.