The Long Term Debt Cycle
By Steve Bain
The long term debt cycle is not generally well recognized by the standard economics textbooks, and it is only really known due to the work done by Ray Dalio, the American billionaire investor and hedge fund manager. On this page I will give my thoughts about Ray's book 'Principles for Navigating Big Debt Crises'.
First of all, I should point out that this book lays out a set of ideas for achieving better management of the fractional reserve banking system, and the way that credit expansion plays a major role in fueling the boom-bust business cycle.
As I will explain below, I am in some agreement with the criticisms of how monetary policy is routinely mishandled by governments and central banks, but fundamentally I approach this problem from an entirely different perspective i.e. I think it is better to replace the fractional reserve system rather than reform how it is managed.
My preference is to adopt a full reserve banking system, but I do acknowledge that it is far less likely that such a replacement will occur anytime soon, and that consequently Ray's approach of seeking better management of the system we have is of more practical value.
What is the Long Term Debt Cycle?
The long term debt cycle refers to a timeline along which a economy experiences multiple episodes of growth and recession, with each episode accruing a gradual expansion of household debt until, ultimately, a severe depression resets the entire financial system.
By 'depression' Ray means a recession that incurs at least a 3% decline in economic output, as has happened in the US twice in modern economic history i.e. the Great Depression of the 1930s, and the Global Financial Crisis of 2007-08.
Whether or not such a debt crisis leads to a deflationary bust or an inflationary bust is thought to depend on many specific factors, but chiefly it depends on whether the debt that has been accrued is denominated in term of the national currency, or foreign currency. If the former, the tendency is for a deflationary depression to occur, whilst the later tends to lead to an inflationary depression.
How does the Long Term Debt Cycle Develop?
Underlying the development of the long term debt cycle is the standard boom-bust business cycle. This starts with improving economic circumstances that encourage people to borrow heavily for speculative purposes e.g. in order to purchase assets like houses whilst their prices are rising, in anticipation of making future capital gains (or simply to get on the property ladder whilst it is still affordable to do so). This leads to 'bubble markets' developing for these assets, with rapid expansion of consumer spending and an overheating of the economy, which eventually leads to a downturn.
The difference is that whilst the typical business cycle can be accommodated by monetary and fiscal policy maneuvering (interest rate cuts in particular) in order to boost the economy once it enters a downturn, these tools fail once interest rates are already close to zero.
This is the critical point, that each business cycle is initiated by a bubble-market of some sort, and ends with household debts at a higher level than during the previous cycle and interest rates at lower levels. Eventually a point comes at which further interest rate cuts are impossible, and the next economic downturn will lead to a depression.
Creation of an economic stimulus when interest rates are already near to zero is much tougher to achieve with the normal macroeconomic policy tools. The Great Depression of the 1930s is the clearest example of what happens when the government stands idly by and just hopes for the best. US unemployment peaked at 24.9% in 1933, and the money supply contracted (largely due to bank failures) by around 35% with similar falls in the price level (i.e. deflation).
In Germany, where much of the country's debts in this period existed in the form of First World War reparations denominated in US Dollars, the burden of the debt became unbearable as the exchange rate of dollar shot up following a US deflationary recession in 1920-21 (deflation of the US price-level meant that the purchasing power of each dollar was rising, and thus its exchange rate against other currencies was rising).
Rapid expansion of the German money-supply via the printing press was then used to pay for essential services, and the end result was hyperinflation of the German Mark (starting in 1921 and peaking in 1923).
The economic cost and misery from this sort of inflationary depression is even more serious than a deflationary depression, and it can easily create enough anger and resentment to pave the way for extremist political parties to gain power; as happened in Germany with catastrophic global consequences.