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Sydnee Gatewood
Sydnee Gatewood
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Ray Dalio Commentary- The Changing World Order Chapter 2: Money, Credit and Debt

From the Bridgewater Associates founder's LinkedIn blog

April 28, 2020 | About:

Note: To make this an easier and shorter article to read, I tried to convey the most important points in simple language and bolded them, so you can get the gist of the whole thing in just a few minutes by focusing on what’s in bold. Additionally, if you want a simple and entertaining 30-minute explanation of how what a lot of what I’m talking about here works, see “How the Economic Machine Works,” which is available on YouTube.

This article, along with others in this series, are an early preview of a book I’m working on called The Changing World Order. I will publish the book this fall but felt that, as I was writing it, the learning I was getting from my research was very helpful in understanding what is happening right now, so I wanted to pass it along to you as a work-in-progress. If you’d like to sign up to receive updates on this series, go to principles.com. You can also pre-order the book at Amazon or Barnes and Noble.

In order to understand why empires and their economies rise and fall and what is happening to the world order right now, you need to understand how money, credit, and debt work. Understanding how they work is critically important because that which has historically been, and still is, what people are most inclined to fight for is wealth—and the biggest single influence on how wealth rises and declines is money and credit. So, if you don’t understand how money and credit work, you can’t understand how economies work, and if you can’t understand how economies work, you can’t understand the most important influence on economic conditions, which is the biggest driver of politics and how the whole economic-political system works.

For example, if you don’t understand how the Roaring ’20s led to a debt bubble and a big wealth gap, and how the bursting of that debt bubble led to the 1930-33 depression, and how the depression and wealth gap led to conflicts over wealth all around the world, you can’t understand the forces that led to Franklin D. Roosevelt being elected president. You also wouldn’t understand why, soon after his inauguration in 1933, he announced a new plan in which the central government and the Federal Reserve would together provide a lot of money and credit, a change that was similar to things happening in other countries at the same time and similar to what is happening now. Without understanding money and credit, you wouldn’t understand why these things changed the world order nor would you understand what happened next (i.e., the war, how it was won and lost, and why the new world order was created as it was in 1945), and you won’t be able to understand what is happening now or imagine the future. However, by seeing many of these cases and understanding the mechanics behind them, you will be able to better understand the past, the present, and what is likely to happen in the future. I did this study because I personally needed what it would teach me and am passing it along to you in the hope that it will help you and the world understand the economic pandemic that is now transpiring.

In doing this study of history as it relates to the present and future, I spoke with several of the most knowledgeable historians and political practitioners. In those discussions, it was clear to both them and me that we each had different pieces of the puzzle that made the picture clearer when we put them together. They lacked adequate practical understanding of how money and credit work, and I lacked adequate practical understanding of how politics and geopolitics work. Several told me that this has been the biggest missing piece in their quest to understand the lessons of history. It is understandably difficult for those who are experts in history and politics to simultaneously be experts in money, credit, economics, and markets, and for those who are experts in money, credit, economics, and markets to simultaneously be experts in history and politics. That is why, in doing this study, I needed to learn from, and triangulate with, the best experts in history and politics and why they wanted to do the same with me about money, credit, economics, and markets. Through this triangulation, we came away with a richer understanding of how the whole machine works that I’m sharing in this book.

Let’s start with the timeless and universal fundamentals of money and credit.

The Timeless and Universal Fundamentals of Money and Credit

All entities—countries, companies, nonprofit organizations, and people—deal with the same basic financial realities, and always have. They have money that comes in (i.e., revenue) and money that goes out (i.e., expenses) which, when netted, makes up their net income. These flows are measured in numbers that can be shown in their income statements. If one brings in more than one spends, one has a profit that causes one’s savings to go up. If one’s spending is more than one’s earnings, one’s savings goes down or one has to make up the difference by borrowing it or taking it from someone else. The assets and liabilities (i.e., debts) that one has can be shown in one’s balance sheet. Whether one writes these numbers out or not, every country, company, nonprofit organization, and person has them.

If one entity has a large net worth (i.e., many more assets than liabilities), it can spend above its income until the money runs out, at which point it has to slash its expenses, and if it has significant liabilities/debts and not enough income to pay for both expenses and debt payments, it will default on its debts. Since one person’s debts are another’s assets, that defaulting on debts reduces other entities’ assets, which requires them to cut their spending, and a self-reinforcing downward debt and economic contraction ensues. It is important to understand how that machine works.

To understand what is happening financially with individuals, companies, nonprofit organizations, governments, and whole economies, it is important to watch how their income statements and balance sheets are doing and to imagine what will likely happen. Think about how this is happening for you and your own financial situation. How much income do you have relative to your expenses, how much savings do you have, and what’s that savings in? If your income fell or disappeared, how long would your savings last? How much risk do you have in the value of that savings? These are the most important calculations you can make to assure your economic well-being. Now look at others—other people, businesses, nonprofit organizations, and governments—realizing that the same is true for them and seeing how we are interconnected.

This money and credit system works for all people, companies, nonprofit organizations, and governments in the same way it works for you and me, with one big, important exception. All countries can print money to give to people to spend or to lend it out. However, not all money that governments print is of equal value.

Those monies (i.e., currencies) that are widely accepted around the world are called reserve currencies. At this time the world’s dominant reserve currency is the US dollar, which is created by the US central bank, which is the Federal Reserve; it accounts for about 55% of all international transactions. A much less important currency is the euro, which is produced by the Eurozone countries’ central bank, the European Central Bank; it accounts for about 25% of all international transactions. The Japanese yen, the Chinese renminbi, and the British pound all are relatively small reserve currencies now, though the renminbi is growing quickly in importance.

Countries that have reserve currencies find it easier to get away with borrowing a lot (i.e., creating credit and debt) and creating a lot of money because others around the world are inclined to hold that debt and money because it can be used for spending around the world. For that reason countries that produce reserve currencies can produce a lot of money and credit/debt that is denominated in them, especially when there is a shortage of them such as now. In contrast countries that don’t have reserve currencies don’t have that option. They are especially prone to finding themselves in need of these reserve currencies (e.g., dollars) when a) they have a lot of debt that is owed in the reserve currencies that they can’t print (e.g., dollars), b) they don’t have much savings in those reserve currencies, and c) their ability to earn the currencies they need falls off. When countries that don’t have reserve currencies desperately need reserve currencies to pay their debts that are denominated in reserve currencies and to buy things from sellers who want them to pay in reserve currencies, their inability to get enough reserve currencies to meet those needs can bankrupt them. That is where things now stand for a number of countries.

It is also where things stand for local governments and states and for the rest of us. For example a number of states, local governments, companies, nonprofit organizations, and people have suffered income losses and don’t have much savings relative to their losses. They will have to cut their expenses or get money and credit some other way.

At the time of this writing the income levels of a number of people, companies, nonprofit organizations, and governments have plunged to be below their expense levels by amounts that are large in relation to their net worths so they will be forced either to slash their expenses, which is painful to do now, or they risk running out of their savings and having to default on their debts. Governments that have the power to do so are printing money to help ease the debt burdens and help finance the expenses that are denominated in their own currencies, which will weaken their own currencies and raise their levels of monetary inflation to offset the deflation that is coming from reduced demand and forced asset sales that are happening as those that are stretched have to raise cash. This configuration of circumstances has happened throughout history and has been handled in the same way so it’s easy to see how this machine works. That is what I want to make sure that I convey in this chapter.

Let’s start with the real basics and build from there.

What is money?

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

By medium of exchange, I mean that it can be given to someone to buy things. Basically people produce things in order to exchange them with people who have other things that they want. Because carrying around non-money objects in the hope of exchanging them for what one wants (i.e., barter) is inefficient, virtually every society that has ever existed has invented money (also known as currency) to be something portable that everyone agrees is of value so it can be exchanged for what we want.

By a storehold of wealth, I mean a vehicle for storing buying power between acquiring it and spending it. While people can store their wealth in assets that they expect will retain their value or appreciate (such as gold, gems, paintings, real estate, stocks, and bonds), one of the most logical things to store it in has been the money that one will use later. But they actually don’t hold the currency because they believe that they can hold something a bit better and always exchange the thing they’re holding to get the currency to buy the things they want to buy. That is where credit and debt come into the picture.

When lenders lend, they assume that the money they will receive back will buy more goods and services than if they just held onto the money. If done well, the borrowers used the money productively and earned a profit so that they can pay the lenders back and keep some extra money. When the loan is outstanding it is an asset for the lender (e.g., a bond) and a liability (debt) for the borrower. When the money is paid back, the assets and liabilities disappear, and the exchange is good for both the borrowers and lenders. They essentially split the profits that come from doing this productive lending. It is also good for the whole society, which benefits from the productivity gains that result from this.[1]

So, it’s important to realize that 1) most money and credit (especially the fiat money that now exists) has no intrinsic value, 2) it is just journal entries in an accounting system that can easily be changed, 3) the purpose of that system is to help to allocate resources efficiently so that productivity can grow, rewarding both lenders and borrowers, and 4) that system periodically breaks down. As a result, since the beginning of time, all currencies have either been destroyed or devalued. When currencies are destroyed or devalued that shifts wealth in a big way that sends big reverberations through the economy and markets.

More specifically, rather than working perfectly the money and credit system swings the supplies, demands, and values of money in cycles that in the upswings produce joyful abundance and in the downswings produce painful restructurings. Let’s now get into how these cycles work building from the fundamentals up to where we now are.

The Fundamentals

While money and credit are associated with wealth, they aren’t wealth. Because money and credit can buy wealth (i.e., goods and services) the amount of money and credit one has and the amount of wealth one has look pretty much the same. But one cannot create more wealth simply by creating more money and credit. To create more wealth, one has to be more productive. The relationship between the creation of money and credit and the creation of wealth (actual goods and services) is often confused yet it is the biggest driver of economic cycles, so let’s look at this relationship more closely.

There is typically a positive correlation between a) the creation of money and credit and b) the amount of goods, services, and investment assets that are produced so it’s easy to get them confused. They go together and can be confused as being the same thing because when people have more money and credit they can, and they want to, spend more. Give people more money and credit and they’ll feel richer and spend more on goods and services. To the extent that spending increases economic production and raises the prices of goods, services, and financial assets, it can be said to increase wealth, because the people who own those assets become “richer” when measured by the way we account for wealth. However, that increase in wealth is more an illusion than a reality for two reasons: 1) the increased credit that pushes prices and production up has to be paid back, which, all things being equal, will have the opposite effect when it has to be paid back and 2) the intrinsic value of things doesn’t increase just because their prices go up. Think of it this way: if you own a house and the government creates a lot of money and credit the price of your house will go up but it’s still the same house; your actual wealth hasn’t increased, just your calculated wealth has increased. Similarly, if the government creates a lot of money and credit that is used to buy goods, services, and investment assets (e.g., stocks, bonds, and real estate) which go up in price, the amount of calculated wealth goes up but the amount of actual wealth hasn’t gone up because you own the exact same thing as you did before it was considered worth more. In other words, using market values of what one owns to measure one’s wealth gives an illusion of changes in wealth that doesn’t really exist. The big thing is that money and credit is stimulative when it’s given out and depressing when it has to be paid back. That’s what makes money, credit, and economic growth so cyclical.

The people who control money and credit (i.e., central banks) vary the costs and availability of money and credit to control markets and the economy as a whole. When the economy is growing too quickly and they want to slow it down, they make less money and credit available, causing both to become more expensive. This encourages people to lend rather than to borrow and spend. When there is too little growth and central bankers want to stimulate the economy, they make money and credit cheap and plentiful, which encourages people to borrow and invest and/or spend. These variations in the cost and availability of money and credit also cause the prices and quantities of goods, services, and investment assets to rise and fall. But banks can only control the economy within their capacities to produce money and credit growth, and their capacities to do that are limited.

Think of the central bank as having a bottle of stimulant that they can inject into the economy as needed with the amount of stimulant in the bottle being limited. When the markets and the economy sag they give them shots of the money and credit stimulant to pick them up, and when they’re too hot they give them less stimulant. These moves lead to cyclical rises and declines in the amounts and prices of money and credit, and goods, services, and financial assets. These moves typically come in the form of short-term debt cycles and long-term debt cycles. The short-term cycles of ups and downs typically last about eight years, give or take a few. The timing is determined by the amount of time it takes the stimulant to raise demand to the point that it reaches the limits of the real economy’s capacity to produce. Most people have seen enough of these short-term debt cycles to know what they are like—so much so that they mistakenly think that they will go on working this way forever. They’re most popularly called “the business cycle,” though I call them “the short-term debt cycle” to distinguish them from “the long-term debt cycle.” Over long periods of time these short-term debt cycles add up to long-term debt cycles that typically last about 50 to 75 years.[2]Because they come along about once in a lifetime most people aren’t aware of them; as a result they typically take people by surprise, which hurts a lot of people. The last big long-term debt cycle, which is the one that we are now in, was designed in 1944 in Bretton Woods, New Hampshire, and was put in place in 1945 when World War II ended and we began the dollar/US-dominated world order.

These long-term debt cycles start when debts are low after previously existing excess debts have been restructured in a way so that central banks have a lot of stimulant in the bottle, and they end when debts are high and central banks don’t have much stimulant left in the bottle. More specifically, the ability of central banks to be stimulative ends when the central bank loses its ability to produce money and credit growth that pass through the economic system to produce real economic growth. That lost ability of central bankers typically takes place when debt levels are high, interest rates can’t be adequately lowered, and the creation of money and credit increases financial asset prices more than it increases actual economic activity. At such times those who are holding the debt (which is someone else’s promise to give them currency) typically want to exchange the currency debt they are holding for other storeholds of wealth. When it is widely perceived that the money and the debt assets that are promises to receive money are not good storeholds of wealth, the long-term debt cycle is at its end, and a restructuring of the monetary system has to occur. In other words the long-term debt cycle runs from 1) low debt and debt burdens (which gives those who control money and credit growth plenty of capacity to create debt and with it to create buying power for borrowers and a high likelihood that the lender who is holding debt assets will get repaid with good real returns) to 2) high debt and debt burdens with little capacity to create buying power for borrowers and a low likelihood that the lender will be repaid with good returns. At the end of the long-term debt cycle there is essentially no more stimulant in the bottle (i.e., no more ability of central bankers to extend the debt cycle) so there needs to be a debt restructuring or debt devaluation to reduce the debt burdens and start this cycle over again.

Since these cycles are big deals and have happened virtually everywhere for as long as there has been recorded history, we need to understand them and have timeless and universal principles for dealing with them well. However, these long-term debt cycles take about a lifetime to transpire, unlike the short-term debt cycles that we all experience a number of times in our lifetimes so most people understand better. When it comes to the long-term debt cycle most people, including most economists, don’t recognize or acknowledge its existence because, to see a number of them in order to understand the mechanics of how they work, one has to look at them operating in a number of countries over many hundreds of years in order to get a good sample size. In Part 2 of this study we will look at all of the most important cycles with reference to the timeless and universal mechanics of why money and credit have worked and failed to work as mediums of exchange and storeholds of wealth. In this chapter, we will look at how they archetypically work.

I will start with the basics of the long-term debt cycle from way back when and bring you up to the present, giving you a classic template. To repeat, while I’m saying that this is a classic template I’m not saying that all cases transpire exactly like this, though I am saying that almost all follow this pattern closely.

The Long-Term Debt Cycle

Let’s start with the basics.

1. It Begins with No or Low Debt and "Hard Money"

When societies first invented money they used all sorts of things, like grain and beads. But mostly they used things that had intrinsic value, like gold, silver, and copper. Let’s call that “hard money.”

Gold and silver (and sometimes copper and other metals like nickel) were the preferred forms of money because 1) they had intrinsic value and 2) they could easily be shaped and sized to be to portable so they could easily be exchanged. Having intrinsic value (i.e., being useful in and of themselves) was important because no trust—or credit—was required to carry out an exchange with them. Any transaction could be settled on the spot, even if the buyer and seller were strangers or enemies. There is an old saying that “gold is the only financial asset that isn’t someone else’s liability.” That is because it has widely accepted intrinsic value, unlike debt assets or other assets that require an enforceable contract or a law to ensure the other side will deliver on its promise to deliver whatever it promised to deliver (which when it’s just “paper” currency that can easily be printed isn’t much of a promise). On the other hand, if during such a period of lack of trust and enforceability one receives gold coins from a buyer, that doesn’t have a credit component to it—i.e., you could melt them down and still receive almost the same amount of value because of its intrinsic value—so the transaction can happen without the same sort of risks and lingering promises that need to be kept. When countries were at war and there was not trust in the intentions or abilities to pay, they could still pay in gold. So gold (and to a lesser extent silver) could be used as both a safe medium of exchange and a safe storehold of wealth.

2. Then Come Claims on “Hard Money” (aka, “Notes” or “Paper Money”)

Because carrying a lot of metal money around was risky and inconvenient, credible parties (which came to be known as banks, though they initially included all sorts of institutions that people trusted, such as temples in China) arose that would put the money in a safe place and issue paper claims on it. Soon people treated these paper “claims on money” as if they were money themselves. After all, they were as good as money because they could be redeemed for tangible money. This type of currency system is called a linked currency system because the value of the currency is linked to the value of something, typically a “hard money” such as gold.

3. Then Comes Increased Debt

At first there is the same number of claims on the “hard money” as there is hard money in the bank. However, the holders of the paper claims and the banks discover the wonders of credit and debt. They can lend these paper claims to the bank in exchange for an interest payment so they get interest. The banks that borrow it from them like it because they lend the money to others who pay a higher interest rate so the banks make a profit. And those who borrow the money from the bank like it because it gives them buying power that they didn’t have. And the whole society likes it because it leads asset prices and production to rise. Since everyone is happy with how things are going they do a lot of it. More lending and borrowing happens over and over again many times, there is a boom, and the quantity of the claims on the money (i.e., debt assets) rises relative to the amount of actual goods and services there are to buy. Trouble approaches when either there isn’t enough income to survive one’s debts or the amount of the claims (i.e., debt assets) that people are holding in the expectation that they can sell them to get money to buy goods and services increases faster than the amount of goods and services by an amount that makes the conversion from that debt asset (e.g., that bond) implausible. These two problems tend to come together.

Concerning the first of these problems, think of debt as negative earnings and a negative asset that eats up earnings (because earnings have to go to pay it) and eats up other assets (because other assets have to be sold to get the money to pay the debt). It is senior—meaning it gets paid before any other type of asset—so when incomes and the values of one’s assets fall, there is a need to cut expenditures and sell off assets to raise the needed cash. When that’s not enough, there needs to be a) debt restructurings where debts and debt burdens are reduced, which is problematic for both the debtor and the creditor because one person’s debts are another’s assets and/or b) the central bank printing money and the central government handing out money and credit to fill in the holes in incomes and balance sheets (which is what is happening now).

Concerning the second of these problems, it occurs when holders of debt don’t believe that they are going to get adequate returns from it. Debt assets (e.g., bonds) are held by investors who believe that they are storeholds of wealth that can be sold to get money, which can be used to buy things. When the holders of debt assets try to make the conversion to real money and real goods and services and find out that they can’t, this problem surfaces. Then a “run” occurs, by which I mean that lots of holders of that debt want to make that conversion to money, goods, services, and other financial assets. The bank, regardless of whether it is a private bank or a central bank, is then faced with the choice to allow that flow of money out of the debt asset, which will raise interest rates and cause the debt and economic problems to worsen, or to “print money” and buy enough of those bonds that others are selling to prevent interest rates from rising and hopefully reverse the run out of them. Sometimes their doing that buying works temporarily, but if the ratio of a) claims on money (debt assets) to b) the amount of money there is and the quantity of goods and services there is to buy is too high, the bank is in a bind that it can’t get out of because it simply doesn’t have enough money to meet the claims so it will have to default on its claims. When that happens to a central bank it has the choice either to default or to print the money and devalue it. They inevitably devalue. When these debt restructurings and currency devaluations are big they lead to breakdowns and possibly destructions of the monetary system. Whatever the bank or the central bank does, the more debt (i.e., claims on money and claims on goods and services) there is, the more the likelihood that it will be necessary to devalue the money.

Remember that there is always a limited amount of goods and services because the amount is constrained by the ability to produce. Also remember that, in our example of paper money being claims on “hard money,” there is a limited amount of that “hard money” (e.g., the gold on deposit), while the amount of paper money (e.g., the claims on that hard money) and debt (the claims on that paper money) is constantly growing. And, as that amount of paper money claims grows relative to the amount of hard money in the bank and goods and services in the economy, the risk increases that the holders of those debt assets may not be able to redeem them for the amounts of hard money or goods and services that they expect to be able to exchange them for.

It is important to understand the difference between money and debt. Money is what settles claims—i.e., one pays one’s bills and one is done. Debt is a promise to deliver money. In watching how the machine is working it is important to watch a) the amounts of both debt and money that exist relative to the amount of hard money (e.g., gold) in the bank and b) the amounts of goods and services that exist, which can vary, remembering that debt cycles happen because most people love to expand their buying power (generally through debt) while central banks tend to want to expand the amount of money in existence because people are happier when they do that. But this can’t go on forever. And it is important to remember that the “leveraging up” phase of the money and debt cycle ends when bankers—whether private bankers or central bankers—create a lot more certificates (paper money and debt) than there is hard money in the bank to give and the inevitable day comes when more certificates are turned in than there is money to give. Let’s look at how that happens.

4. Then Come Debt Crises, Defaults, and Devaluations

History has shown that when the bank’s claims on money grow faster than the amount of money in the bank—whether the bank is a private bank or government-controlled (i.e., central bank) eventually the demands for the money will become greater than the money the bank can provide and the bank will default on its obligations. That is what is called a bank run. One can quite literally tell when a bank run is happening and a banking crisis is imminent by watching the amounts of money in banks (whether “hard” or paper) decline and approach the point of running out due to withdrawals.

A bank that can’t deliver enough hard money to meet the claims that are being made on it is in trouble whether it is a private or a central bank, though central banks have more options than private banks do. That’s because a private bank can’t simply print the money or change the laws to make it easier to pay their debts, while a central bank can. Private bankers must either default or get bailed out by the government when they get into trouble, while central bankers can devalue their claims (e.g., pay back 50-70%) if their debts are denominated in their national currency. If the debt is denominated in a currency that they can’t print, then they too must ultimately default.

5. Then Comes Fiat Money

Central banks want to stretch the money and credit cycle to make it last for as long as they can because that is so much better than the alternative, so, when “hard money” and “claims on hard money” become too painfully constrictive, governments typically abandon them in favor of what is called “fiat” money. No hard money is involved in fiat systems; there is just “paper money” that the central bank can “print” without restriction. As a result, there is no risk that the central bank will have its stash of “hard money” drawn down and have to default on its promises to deliver it. Rather the risk is that, freed from the constraints on the supply of tangible gold or some other “hard” asset, the people who control the printing presses (i.e., the central bankers working with the commercial bankers) will create ever more money and debt assets and liabilities in relation to the amount of goods and services being produced until a time when those who are holding the enormous amount of debt will try to turn them in for goods and services which will have the same effect as a run on a bank and result in either debt defaults or the devaluation of money. That shift from a) a system in which the debt notes are convertible to a tangible asset (e.g., gold) at a fixed rate to b) a fiat monetary system in which there is no such convertibility last happened in 1971. When that happened—on the evening of August 15, when President Nixon spoke to the nation and told the world that the dollar would no longer be tied to gold—I watched that on TV and thought, “Oh my God, the monetary system as we know it is ending,” and it was. I was clerking on the floor of the New York Stock Exchange at the time, and that Monday morning I went on the floor expecting pandemonium with stocks falling and found pandemonium with stocks rising. Because I had never seen a devaluation before I didn’t understand how they worked. Then I looked into history and found that on Sunday evening March 5 President Franklin Roosevelt gave essentially the same speech doing essentially the same thing which yielded essentially the same result over the following months (a devaluation, a big stock market rally, and big gains in the gold price), and I saw that that happened many times before in many countries, including essentially the same proclamations by the heads of state.

In the years leading up to 1971 the US government spent a lot of money on military and social programs then referred to as “guns and butter” policy, which it paid for by borrowing money that created debt. The debt was a claim on money that could be turned in for gold. The investors bought this debt as assets because they got paid interest on this government debt and because the US government promised that it would allow the holders of these notes to exchange them for the gold that was held in the gold vaults in the US. As the spending and budget deficits in the US grew the US had to issue much more debt—i.e., create many more claims on gold—even though the amount of gold in the bank didn’t go up. Naturally more investors turned in their promises to get the gold for the claims on the gold. People who were astute enough to pay attention could see that the US was running out of gold and the amount of outstanding claims on gold was much larger than the amount of gold in the bank, so they realized that if this continued the US would default. Of course the idea that the United States government, the richest and most powerful government in the world, would default on its promise to give those who had claims on gold the gold it promised to give them seemed implausible at the time. So, while most people were surprised at the announcement and the effects on the markets, those who understood the mechanics of how money and credit work were not.

When credit cycles reach their limit it is both the logical and the classic response for central governments and their central banks to create a lot of debt and print money that will be spent on goods, services, and investment assets to keep the economy moving. That is what was done during the 2008 debt crisis, when interest rates could no longer be lowered because they had already hit 0%. As explained that was also done in response to the 1929-32 debt crisis, when interest rates had been driven to 0%. This creating of the debt and money is now happening in amounts that are greater than at any time since World War II.

To be clear, central banks’ “printing money” and giving it out for spending rather than supporting spending with debt growth is not without its benefits—e.g., money spends like credit, but in practice (rather than in theory) it doesn’t have to be paid back. In other words, there is nothing wrong with having an increase in money growth instead of an increase in credit/debt growth, provided that the money is put to productive use. The main risks of printing money rather than facilitating credit growth are a) market participants will fail to carefully analyze whether the money is being put to productive use and b) it eliminates the need to have the money paid back. Both increase the chances that money will printed too aggressively and not used productively so people will stop using it as a storehold of wealth and will shift their wealth into other things. Throughout history, when the outstanding claims on hard money (debt and money certificates) are far greater than there is hard money and goods and services, a lot of defaults or a lot of printing of money and devaluing have always happened.

History has shown us that we shouldn’t rely on governments to protect us financially. On the contrary, we should expect most governments to abuse their privileged positions as the creators and users of money and credit for the same reasons that you might do these abuses if you were in their shoes. That is because no one policy maker owns the whole cycle. Each one comes in at one or another part of it and does what is in their interest to do at that time given their circumstances at the time.

Because early in the debt cycle governments are considered trustworthy and they need and want money as much or more than anyone else, they are typically the biggest borrowers. Later in the cycle, when successive leaders come in to run themore indebted governments the new government leaders and the new central bankers have to face the greater challenge of paying back debts when they have less stimulant in the bottle. To make matters worse, governments also have to bail out debtors whose failures would hurt the system. As a result, they tend to get themselves into big cash flow jams that are much larger than those of individuals, companies, and most other entities.

In other words, in virtually all cases the government contributes to the accumulation of debt in its actions and by becoming a large debtor and, when the debt bubble bursts, bails itself and others out by printing money and devaluing it. The larger the debt crisis, the more that is true. While undesirable, it is understandable why this happens. When you can manufacture money and credit and pass it out to everyone to make them happy, it is very hard to resist the temptation to do so.[3]It is a classic financial move. Throughout history, rulers have run up debts that won’t come due until long after their reign is over, leaving it to their successors to pick up the pieces.

How do governments react when they have debt problems? They do what any practical heavily indebted entity with promises to give money that they can print would do. Without exception, they print money and devalue it if the debt is in their own currency. When central banks print money and buy up debt that puts money into the financial system and bids up the prices of financial assets (which also widens the wealth gap because it helps those with the financial assets that are bid up relative to those who don’t have financial assets). It also puts a lot of debt in the hands of the central bank, which allows the central bank to handle the debts however they see fit. Also their printing of the money and buying the financial assets (mostly bonds) holds interest rates down, which stimulates borrowing and buying and encourages those holding these bonds to sell them and encourages the borrowing of money at low interest rates to invest it in higher-returning assets, which leads to central banks printing more money and buying more bonds and sometimes other financial assets. That typically does a good job of pushing up financial asset prices but is relatively inefficient in getting money and credit and buying power into the hands of those who need it most. That is what happened in 2008 and has happened for most of the time since until just recently. Then, when the printing of money and the central bank buying up of financial assets fails to get money and credit to where it needs to go, the central government—which can decide what to spend money on—borrows money from the central bank (which prints it) so it can spend it on what it needs to be spent on. In the US the Fed announced this plan on April 9, 2020. This approach of printing money to buy debt (called debt monetization) is vastly more politically palatable as a way of getting money and shifting wealth from those who have it to those who need it than imposing taxes, which leads taxed people to get angry. That is why in the end central banks always print money and devalue.

When governments print a lot of money and buy a lot of debt so the amounts of both money and debt increase, they cheapen money and debt, which essentially taxes those who own it to make it easier for debtors and borrowers. When this happens enough that the holders of this money and debt assets realize what is happening, they seek to sell their debt assets and/or borrow money to get into debt that they can pay back with cheap money. They also often move their wealth to other storeholds of wealth like gold, certain types of stocks, and/or somewhere else (like another country that is not having these problems). At such times central banks have typically continued to print money and buy debt directly or indirectly (e.g., by having banks do the buying for them) and outlawed the flow of money into inflation-hedge assets and alternative currencies and alternative places.

Such periods of reflation either stimulate another money and credit expansion that finances another economic expansion (which is good for stocks) or devalue money so that it produces monetary inflation (which is good for inflation-hedge assets such as gold). Earlier in the long-term debt cycle when the amounts of outstanding debts aren’t large and when there is lots of room to stimulate by lowering interest rates (and failing that, printing money and buying financial assets), the greater the likelihood that credit growth and economic growth will be good, while later in the long-term debt cycle when the amounts of debt are large and when there isn’t much room to stimulate by lowering interest rates (or printing money and buying financial assets) the greater the likelihood that there will be a monetary inflation accompanied by economic weakness.

6. Then Comes the Flight Back into Hard Money

When taken too far, the over-printing of fiat currency leads to the selling of debt assets and the earlier-described bank “run” dynamic, which ultimately reduces the value of money and credit, which prompts people to flee out of both the currency and the debt (e.g., bonds). They need to decide what alternative storehold of wealth they will use. History teaches us that they typically turn to gold, other currencies, assets in other countries not having these problems, and stocks that retain their real value. Some people think that there needs to be an alternative reserve currency to go to, but that’s not true as the same dynamic of the breakdown of the monetary system and the running to other assets happened in cases in which there was no alternative currency to go to (e.g., in China and in the Roman Empire). The debasement of the currency leads it to devalue and have people run from it and debt in it into something else. There is a whole litany of things people run to when money is devalued, including rocks (used for construction) in Germany’s Weimar Republic.

Typically at this stage in the debt cycle there is also economic stress caused by large wealth and values gaps, which lead to higher taxes and fighting between the rich and the poor, which also makes those with wealth want to move to hard assets and other currencies and other countries. Naturally those who are governing the countries that are suffering from this flight from their debt, their currency, and their country want to stop it. So, at such times, governments make it harder to invest in assets like gold (e.g., via outlawing gold transactions and ownership), foreign currencies (via eliminating the ability to transact in them), and foreign countries (via establishing foreign exchange controls to prevent the money from leaving the country). Eventually the debt is largely wiped out, usually by making the money to pay it back plentiful and cheap, which devalues both the money and the debt.

Continue reading here.

About the author:

Sydnee Gatewood
I am the editorial director at GuruFocus. I have a BA in journalism and a MA in mass communications from Texas Tech University. I have lived in Texas most of my life, but also have roots in New Mexico and Colorado. Follow me on Twitter! @gurusydneerg

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