For the past week I have spent a considerable amount of time reading Ray Dalio’s (Trades, Portfolio) new book, "Principles for Navigating Big Debt Crises." Without a doubt, this book has joined my short list of modern favorites, which also include Charlie Tian’s "Invest Like a Guru," Howard Marks' "The Most Important Thing" and Nassim Nicholas Taleb’s "Fooled by Randomness."
The first 60 pages (Part 1: The Archetypal Big Debt Cycle) are exceptionally well written and provide the solid foundation of understanding that is needed to read the rest of the book. But if you’re not up for reading the entire book, it is these first 60 pages that I do suggest you make the time to read.
As I started reading the first part, I learned that it confirms many of my anecdotal observations of macroeconomics in the real world but provides invaluable context and the missing “why” behind many of my previous assumptions.
The book begins with a thorough explanation of the expected phases of a “Classic Deflationary Debt Cycle” lasting approximately 12 years. Such a cycle has six to seven parts including: Early Part of the Cycle, Bubble, Top, Depression, Beautiful Deleveraging and Pushing on a String/Normalization.
Each part of the cycle is discussed in detail, providing insights into how governments respond as well as investors. A particularly valuable section was the framework that Dalio provided for spotting economic bubbles. He applied seven criteria to 10 past bubbles around the globe spanning multiple generations. Dalio also made a hard distinction between these phases, as they can exist in a Classic Deflationary Debt Cycle or a Classic Inflationary Debt Cycle. Both debt cycles (inflationary and deflationary) can be addressed, although the strategies used are different.
Another important distinction mentioned early in the book is the difference between long-term debt cycles and short-term debt cycles. Put differently, what specifically made the long-term debt cycles of the Great Depression of the 1930s and the financial crisis of 2008 so extreme and similar? What was done better in 2008 that was not done or able to be accomplished in the 1930s? And most importantly, how do these events differ from the more common short-term debt cycles that occur every 10 to 15 years?
The management of such depressions and recessions is also discussed by diving into detail about four policies to reduce debt burden: austerity, debt defaults and restructuring, debt monetization and money printing, and wealth transfers. Each policy has pros and cons, and being able to recognize when they should and should not be used does help inform investors about the positions they have. The frequency of these policies during times of debt is shared for 48 historical cases.
Balancing these levers properly strikes at one of the central themes of the book: how to best accomplish a “Beautiful Deleveraging.” If accomplished, this type reduces shocks to the economy and produces positive growth along with falling debt burdens while balancing an acceptable amount of inflation.
Put another way, Dalio explained that a beautiful deleveraging exists when there is enough stimulation in the economy (through printing of money, debt monetization and currency devaluation) to offset deflationary deleveraging forces (such as austerity and defaults) while also bringing the nominal growth rate above the nominal interest rate. Too much stimulation, however, is a huge concern because it could drive inflation and currency devaluations, leading to a whole new bubble to worry about. It became very clear how complicated such a feat is. The following quote stood out:
“We investors only have to understand how the economic machine works and anticipate what will happen next. Policy makers have to do that, plus make everything turn out well—i.e., they have to know what should be done while navigating through all the political impediments that make it so hard to get it done. To do that requires a lot of smarts, a willingness to fight, and political savvy—i.e., skills and heroism—and sometimes even with all those things, the constraints under which they work still prevent them from being successful.”
Other topics covered include the limitations of being able to address economic debt when currency is denominated in a foreign currency and how the devaluation of a currency can be a very useful strategy to jump start an economy if other measures are exhausted. Last, there is a brief section on war aconomics, the extreme effects war can have on economies and how such effects differ for losers and winners.
For those interested in reading the book, Dalio has made it easy and free to download. In addition to the book, I also suggest watching a YouTube video entitled, “How the Economic Machine Works, by Ray Dalio,” which covers the seven phases of the debt cycle discussed above.
