Steve Bain

The Long Term Debt Cycle Explained

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.

How to Mitigate the Bad Effects of Debt Crises

The book gets a lot more controversial in its suggested remedy for debt crisis situations in that it prescribes a much greater role for our regulatory bodies. Critics such as myself regard these institutions as wholly incapable of analyzing, let alone treating, complex macroeconomic money-market problems.

My personal experiences of public sector organizations is more in line with the experiences of the renowned economist Thomas Sowell who, after a single summer's internship with the US Labor Department, realized that these organizations are not well constructed to solve the very problems for which they exist. Rather, they become self-serving organizations that prioritize their own interests.

They do not do this out of malice or selfishness, but the human-beings who run them face all sorts of political and personal pressures that bias the work they do, with none of the competitive market pressures that force regular organizations to operate effectively in order to survive.

As Ray points out in his book, the central bankers themselves stress the difficulty of spotting bubble-markets as they appear, but Ray Dalio stresses the necessity of doing so, and of acting decisively in order to mitigate them as a key element of preventing the boom-bust business cycle and long term debt cycle from perpetuating.

This, to my eyes, is hopelessly naive thinking.

I believe that any further empowerment, and instruction, of a regulatory body to conduct economic interventions in matters in which it itself confesses to have little ability to do with any degree of accuracy, will tend to lead to worsening economic outcomes rather than improvements.

Improved economic outcomes nearly always require a reduction of regulatory intervention rather than an increase, and the financial services industry is already arguable the most regulated industry in existence. The problem is not too little regulation, it is that the entire fractional reserve system is seriously flawed, and only a replacement that is immune to its perverse economic incentives will fix the problem.

Sticking plasters on the disease won't do at all, we need a cure., which is why I support full reserve banking as the correct path forward.

Beautiful Deleveraging?

The concept of a beautiful deleveraging infers a process by which policymakers manage the depression in such a way that debts are reduced without causing too much hardship for anyone. Four policy levers are identified for achieving this purpose, and the optimal combination is thought to deliver the beautiful deleveraging:

  1. Austerity
  2. Debt Defaults or Restructurings
  3. Debt Monetization / Money Printing
  4. Wealth Transfers

The management of the US economy following the 2008 global financial crisis is offered as an example of a beautiful deleveraging, or something approximating it.

I again have to object here.

Mr Dalio simultaneously argues that a deleveraging takes about 10 years to reset an economy's finances whilst also maintaining that the USA went through an almost ideal version of such a process after 2008. To my reckoning that implies that the process should have been complete by 2018. The data does indeed confirm that much of the excessive household debt had been reduced by that time, but the data also shows that government debt expanded by an even larger amount.

Overall debt in 2018 was significantly higher than in 2008, and far from having achieved any beautiful deleveraging of a long term debt cycle, the government has only achieved a very ugly and unsustainable budget deficit and trade deficit, all whilst running up total debt. My article about fiscally responsible government covers this in some detail.

I do accept the point that replacing household debt with government debt is desirable because the repayment of it can be spread out over many years, but at some point there has to be evidence of an actual repayment happening. We have precisely the opposite evidence, and I don't foresee a time when any government will be able to resolve this issue. Fixing this problem, assuming that it does get fixed, will only be done by hard-working employees and innovative business leaders.

If I've been overly critical of Mr Dalio's work, that was not my intention. There is a lot to like about this book, and there is some good analysis of how the long term debt cycle comes into being. It's just that I can't agree with the book's central assertion that yet more government control of our lives is the correct way forward, which is somewhat a difference of philosophical approach. Readers can decide for themselves where they stand on that issue.


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