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Ray Dalio is widely considered one of the greatest living investors. He is the founder of Bridgewater Associates, as well as a master educator through How the Economic Machine Works and his latest book Principles For Navigating Big Debt Crises. What follows are my notes of Dalio’s Chapter 2: Money, Credit, and Debt, the second installment in his series “The Changing World Order” (originally published 4/23/2020).

the timeless and universal fundamentals of money and credit

  • All entities (countries, people) have revenue & expenses.
  • Profit = revenue > expenses ➡ increased savings
  • Loss = expenses > revenue ➡ decrease savings OR take on debt OR take $$$ from someone else.
  • Balance Sheet: Assets, liabilities
  • Loans: One person’s assets are another’s liabilities.
  • When a loan goes unpaid, someone else has to cut spending ➡ economic contraction begins
  • Money and credit work for everyone in the same way … except countries, who can printing money (though not all that money is created equal)
  • Reserve currency = widely, globally accepted medium of exchange or store of value
    • USD = 55% of all international transactions
    • EUR = 25%
    • JPY = 10%
    • RMB = 2%
  • Countries with reserve currencies can borrow a lot more.
  • Countries without a reserve currency often have to borrow in other reserve currencies, which limits how much they can borrow. Bankruptcy happens if they can’t get enough of those reserve currencies to service debts.

what is money?

Money is a medium of exchange that can also be used as a storehold of wealth.

  • Most money (especially fiat) has no intrinsic value.
  • It’s just records in an accounting system database that can be changed.
  • The purpose of the money system is to allocate resources efficiently ➡ greater productivity ➡ benefiting borrowers and lenders
  • The system eventually breaks down.
  • All currencies eventually die or are devalued.

the fundamentals

  • Money and credit are not the same as wealth.
  • Wealth comes from productivity.
  • More money and credit does not create wealth (unless it increases productivity)
  • When people have more money/credit they feel richer (wealth effect)
  • That increase in wealth is an illusion somewhat
    1. Increased credit pushes prices up … needs to be paid back
    2. Intrinsic value doesn’t go up just because prices go up
  • Example: The price of your house goes up, but it’s still a house. You can only swap it for a similar house (purchasing power remains constant).
  • Money/credit stimulates when given out, depresses when paid back.
  • Central banks (CBs) use money/credit to control markets and the economy (though they have limited capacity)
  • CBs giveth and taketh away stimulants ➡ short-term and long-term debt cycles.
    • Short-term cycle = ~8 years (aka “the business cycle”)
    • Long-term cycle = 50 – 75 years
  • Current long-term cycle began in 1944/45 under Bretton Woods agreement (enacted after WWII). This began the US dollar-denominated global monetary system.
  • Long-term debt cycles start when debts are low and end when debts are high and CBs run out of stimulants ➡ debt restructuring ➡ new long-term cycle.
  • CB stimulants “run out” when they fail to produce real economic growth. This happens when:
    1. High debt levels & interest rates can’t go lower
    2. Printing money pumps financial assets (like stocks) more than it does real economic activity.
  • At this point, debt owners want to sell the debt for other stores of wealth (like gold).
  • When debt levels are high, lenders are less likely to get great returns
  • At this point in the cycle, credit has failed as a stimulant. Debt restructuring is needed so the cycle can reboot.

the long-term debt cycle

The big picture:

  1. it begins with no or low debt and “hard money”
  2. then come claims on “hard money” (aka “notes” or “paper money”)
  3. then comes increased debt
  4. then comes debt crises, defaults, & devaluations
  5. then comes fiat money
  6. then comes the flight back to hard money

1. it begins with no or low debt and “hard money”

  • Early money mostly included things with intrinsic value (gold, silver, copper)
  • Gold & silver proved popular because:
    1. intrinsic value
    2. divisible & portable for easier exchange
  • Intrinsic value is important because:
    1. it’s not a liability
    2. allow for final settlement (without which, you’re left holding something that may or may convert into something with intrinsic value)

2. then come claims on “hard money” (aka “notes” or “paper money”)

  • Carrying a lot of hard money (gold) around is risky.
  • Credible parties (banks, temples) emerge to store the money and issue paper claims (so you can go retrieve your gold with the paper claim)
  • People begin to treat these paper claims as money

3. then comes increased debt

  • Initially, the # of claims on hard money matches the actual amount of hard money (claims = underlying assets)
  • Then the holders of paper claims lend these paper claims to the bank in exchange for an interest payment.
  • The banks then lend the money (paper claims) to others for an even higher interest rate.
  • At this point, paper claims > underlying hard money
  • But everyone’s happy because asset prices and productivity rise.
  • More and more borrowing/lending leads to a Boom
  • The quantity of claims on the money (debt assets) rises faster than the amount of actual goods/services to buy.
  • Trouble happens when:
    1. Income isn’t enough to pay debts: To make up for the gap, people cut expenses and sell off assets. After that, comes debt restructurings and CBs printing money.
    2. Holders of debt assets can’t convert to hard money: A “run” occurs. To stave this off, CBs buy the debt to prevent skyrocketing interest rates by printing money.
  • If ratio is too high for debt assets to actual money (claims to underlying assets) (paper to gold) ➡ CBs must choose between default or devalue ➡ they choose devalue ➡ destruction of monetary system
  • There is always a limited amount of goods and services, constrained by productivity.
  • Money vs debt:
    • Money settles claims (pays bills)
    • Debt is a promise to deliver
  • The “leveraging up” phase of the debt cycle ends when the # paper claims exceeds the actual hard money by too much.
  • This is inevitable.

4. then comes debt crises, defaults, & devaluations

  • Eventually demand for money is greater than what the banks can provide ➡ bank runs.
  • Private banks default or the government bails them out
  • Central banks (CBs) can devalue their claims if their debts are denominated in their nation’s currency by printing money.
  • If a nation can’t print its way out of debt, it will default.

5. then comes fiat money

  • CBs and central governments want to stretch the cycle as long as possible.
  • First hard money was too constrictive, then paper claims on hard money was too constrictive.
  • Next comes “fiat” money, which has no relation to hard money. Central banks can print as much as they want.
  • This buys time.
  • But there is still the problem of how much debt-based money can be converted into actual goods and services.
  • When the fiat money supply overshoots goods/services available to buy, CBs are left with the same choice of default or devalue.
  • When credit cycles reach their limit, governments and CBs create a lot more debt and print a lot more money to keep things moving.
  • It happened in 1929-32, 2008. It’s happening now.

History has shown us that we shouldn’t rely on governments to protect us financially.

  • Governments and CBs finding it impossible to resist the temptation to print money and extend credit.
  • Today’s rulers live for today and run up debts that tomorrow’s rulers must deal with.
  • Every government, every time chooses to print money and devalue if the debt is in their own currency.
  • Debt problems ➡ print money ➡ devalue ➡ asset prices rise ➡ wealth gap grows
  • Fiscal policies are more effective and reducing the wealth gap through spending. Increasing taxes on the wealthy is politically difficult.
  • Printing money ➡ cheapens money and debt ➡ “taxes” holders of money and debt ➡ holders seek to sell their debt (or borrow money that they can pay back with cheap money) ➡ move their wealth to other stores of value (like gold) ➡ CBs keep printing money and buying debt ➡ outlaw the flow of money into stores like gold
  • These periods of reflation either:
    • Stimulate economic expansion (through money/credit expansion). Likely early in the long-term cycle.
    • Or devalue money and create inflation. Likely late in the long-term cycle.

6. then comes the flight back to hard money

  • Over-printing fiat money ➡ run on the bank (selling off debt assets) ➡ reduces money & credit
  • People flee the currency and debt (bonds) into safer stores of value (like gold or other national currencies)
  • At this stage, economic stress from large wealth gaps ➡ rich vs poor fights ➡ wealthy flee to hard assets ➡ government makes it harder by outlawing ownership of hard assets
  • At extreme, governments are forced back into a hard currency to rebuild people’s trust in its money as a store of wealth.
  • Holding debt late in the long-term cycle is rewarding. Holding it late in the cycle is risky (default or devaluation).
  • Cycles of debt and writing off debts have been around for thousands of years. The Old Testament provided for a Jubilee every 50 years when debts were forgiven.
  • Cycles of debt and writing off debts have been around for thousands of years. The Old Testament provided for a Jubilee every 50 years when debts were forgiven.

8 And thou shalt number seven sabbaths of years unto thee, seven times seven years; and the space of the seven sabbaths of years shall be unto thee forty and nine years.

9 Then shalt thou cause the trumpet of the jubilee to sound on the tenth day of the seventh month, in the day of atonement shall ye make the trumpet sound throughout all your land.

10 And ye shall hallow the fiftieth year, and proclaim liberty throughout all the land unto all the inhabitants thereof: it shall be a jubilee unto you; and ye shall return every man unto his possession, and ye shall return every man unto his family.

11 A jubilee shall that fiftieth year be unto you: ye shall not sow, neither reap that which groweth of itself in it, nor gather the grapes in it of thy vine undressed.

12 For it is the jubilee; it shall be holy unto you: ye shall eat the increase thereof out of the field.

13 In the year of this jubilee ye shall return every man unto his possession.

Leviticus 25:8-13

the long-term debt cycle summary

  • for thousands of years there have been three types of monetary systems:
1. Hard moneyMost restrictive Minimizes credit Maximizes credibilityGold coins
2. Paper moneyLess restrictiveGold-backed US dollar
3. Fiat moneyLeast restrictive Minimizes credibility Maximizes creditToday’s US dollar
  • As a country needs more money/credit (e.g. wars, gov’t programs), governments and CBs naturally move from hard to paper to fiat.

having a reserve currency gives a country incredible power

  • Today’s world order began after WWII with the Bretton woods agreement.
  • United States had 2/3 of the world’s gold (when gold was money), 50% of its economic production, and military dominance.
  • The new monetary system was Type 2 – paper claims based on gold ($35/ounce)
  • US government ran budget deficits, so it borrowed money ➡ increase in USD-denominated debt
  • Federal Reserve allowed a lot more debt and money to be created on the underlying gold
  • As people/countries converted paper money into gold, the gold supply in US banks declined … meanwhile claims continued to rise
  • August 15, 1971: President Nixon ends the gold redeemability.
  • US dollar was now Type 3 – fiat money.
  • Federal Reserve, now unrestrained, printed more money and debt ➡ inflationary 1970s ➡ people fleeing USD ➡ interest rates rose ➡ gold price increased to $670/ounce
  • Debts continued to rise ➡ 1979-82 credit crisis ➡ USD on verge of losing world reserve status
  • Enter Paul Volcker
  • Volcker tightened the money supply ➡ drove the interest rates sky high ➡ strong dollar ➡ inflation down ➡ allowed Fed to eventually lower interest rates
  • Debtors had to pay more to service debts as their incomes and asset values declined.
  • Many debtors (countries) went broke, followed by a decade of depression and debt restructuring.
  • US debt management & restructuring begun under Volcker ended in 1991.
  • From 1979-81 peak to now
    • Inflation and interest rates fell to nearly 0%
    • USD-denominated money, credit, debt continued to rise related to income
  • 1980s debt restructuring ➡ 1990s increase in money/credit/debt ➡ 2000 dot-com bubble pops ➡ 2000-01 recession ➡ Fed eases money/credit ➡ debt levels at new highs ➡ 2007 even bigger bubble ➡ 2008 Great Financial Crisis ➡ Fed and other CBs ease further ➡ 2019 bubble ➡ 2020 crisis.
  • 3 Types of Monetary Policy
    • MP1: Stimulating money and credit growth
    • MP2: Printing money and buying financial assets (aka “debt monetization” or “quantitative easing”)
    • MP3: Increasing borrowing, targeting spending/lending, printing more money, buying debt (and other things like stocks)
  • 2008: MP1 wasn’t enough, so Fed turned to MP2, buying gov’t bonds and high-quality debt ➡ pushed asset prices up and created a new debt bubble
  • 2008 MP2 ➡ bond prices up ➡ sellers of bonds used cash to buy other assets (stocks) ➡ those assets up (and drove future expected returns down).
  • COVID-19 triggered the downturn. However, without COVID-19 it was only a matter of time before another trigger emerged.
  • MP3 began April 9, 2020: US government and Federal Reserve announced helicopter money (direct payments to citizens). (Roosevelt did the same on March 5, 1933).

A reserve currency is probably the most important power to have, even more powerful than military power.

  • With a reserve currency, a country can print and borrow money to suit its needs.
  • However the US (Federal Reserve) is now in the difficult position of doing what’s good for Americans at the direct expense of other countries dependent on dollars.
  • Other countries will have to come up with dollars to pay their debts ($20 trillion globally).

The US risks losing this privileged position [of world reserve currency] by creating too much money and debt.