A Wicksell-Minsky approach with a dash of Abba Lerner thrown in…
A Conversation with Ray Dalio: Selections (edited):
(1) The economy works like a machine. There are cause-effect relationships. The problem is that most people encounter these relationships for the first time the very first time it happens to them in their life. But those same relationships have happened many, many times throughout history.
(2) There's such a thing as deleveraging. How does deleveragings work? There's a bubble. You know a bubble when you see a bubble. An economy is not a complicated thing. There's a transaction: Somebody makes a purchase of a good, a service, or of financial assets either with money or credit. When you make a purchase with money, you end the transaction: you don't owe anything. When you make it with credit, then there is a liability, a debt, a future obligation to deliver money…. Credit can be created. It's not created through the velocity of money, as is commonly believed. Credit can be created out of thin air. When I go into a store, or when I have somebody paint my house, then if I say I'm going to pay you later, I've created credit….
What we have is a credit cycle. If you don't have much debt, then you have the ability to borrow money. Let's say you earn a hundred thousand dollars a year and you don't have any debt. You can then borrow 10,000 dollars a year. You therefore can spend $110,000. Your spending of $110,000 is somebody else's income of $110,000. They earn $110,000, and the cycle becomes self-reinforcing. Debt rises faster than income. But debt can't rise faster than income forever.
What causes the debt cycle to stop? Traditionally, lowering interest rates has three positive effects:(i) lowering interest rates makes it easier to service debt; (ii) it makes items cheaper to buy on credit because the monthly payments are less; (iii) it has a present-value effect raising asset prices. That produces wealth and allows more borrowing. When you get to a situation where you can't lower interest rates anymore, that part of the cycle ends.
Then you go through a deleveraging you can't raise debt relative to income anymore, and so the cycle begins to work in reverse.
(3) A depression is the phase of the deleveraging in which there's a combination of austerity and debt restructuring. If you have too much debt to service, you've got to do something about it. There are a limited number of things that you can do. You can transfer the debt--you can transfer resources from the rich to the poor…. The alternative is a combination of austerity and debt restructuring…. The problem is one man's debts are another man's assets. So when you write it down in half, you have a big negative wealth effect…. You could restructure it by writing it down, or you could lengthen the payments, or you could forcibly lower the interest rate. Some way or another, you have got to get the payments in line with the cash flows so that you can service the debt. That's a very painful process….[A] depression is the phase of the deleveraging when there's a combination of austerity and writing down debts.
In the Great Depression, 1930 to 1933, we print money. The printing of money means that essentially a central bank slips into the system a certain amount of money each year, and that can make that deleveraging easier.
The best deleveragings are ones in which you have a balance. You have to bring down the debt-to-income ratio. You're going to have a certain amount of transfer of wealth. You're going to have a certain amount of austerity. You're going to have a certain amount of debt writedowns. And you're going to have a certain amount of printing of money. The debt writedowns and the austerity are deflationary. The printing of money is inflationary. If you can get the balance right of those things, then you have what I call a beautiful deleveraging…
(4) Look at debt-to-income ratios and say: "How have they come down over time?" Consider England after World War II or the United States in the Great Depression. They came down with relatively good conditions because there's enough of the printing of money that the nominal growth rate in GDP exceeds the nominal interest rate. So the most important thing in these deleveragings, as the United States is now doing, is that you have enough printing of money to produce a nominal growth rate that's above the nominal interest rate. I am oversimplifying. But that is the most important single thing…
(5) The most common mistake of monetary policy is that it targets inflation and growth. What it really has to pay attention to is debt growth relative to income growth: debt growth relative to sustainability. When you have a lot of debt growth that goes into the purchase of financial assets, that's a classic bubble. That's a riskier situation than inflation. In 2007 and similar periods, you see that there's a lot of debt growth, which is accumulating for the purchase of financial assets, and then you look at the financial assets, and you say: "They will not be able to service that debt".
There was this behavior: Volatility went down. There is this notion of value at risk. And there is not an understanding of volatility changes. What happened was that as volatility was going down, everybody thought that it was an easy thing: you sell the asset that has the lower interest rate, you buy the asset that has the higher interest rate, and you are going to be OK, and you do a lot of that because volatility is low. Well, volatility changes.
We had mark-to-market accounting. So it was fairly easy to see what the bank's assets were. You go through 10K reports, you see we're going to have a big hit to equity, and when you have a big hit to equity, you're going to have to contract balance sheets.
There was a lack of awareness. People think that the things that haven't happened recently are implausible. So you look at the leveraging, and they say: "That's a crazy scenario because it's not within the range of expectations". In my life, through my whole range of expectations, everything's been a surprise. Most things just have not happened before in our lifetimes that are big things, and there are a lot of them…
(6) I estimate that there'll be about 2 trillion euros' worth of losses on the European debt that exists. What are we going to do with those losses? Who's going to bear what in those losses? There are three ways of dealing with them. You can either transfer wealth, and so that's a fiscal transfer from the Germans or the northern Europeans to the others. The Germans don't want to do that. The transfer is going to fall short. The second way is austerity and debt write-downs. That is a depression.
In March of 1933, Roosevelt gets in front of the television and he says: "We're going to have a bank holiday". And that was when there was a severing of the dollar's relationship with gold. That was the bottom in the Great Depression. That was the point where they print the money. So what we have -- but printing money is a transfer of wealth too. It is a subtle transfer of wealth…
(7) Here's the negotiation between the Germans and the Southern Europeans regarding what should be done with monetary policy. There's an interesting dynamic pertaining to that. The Bundesbank has a sense of responsibility. It has its mission. There's the issue of the printing of money. There's the question of whether countries would leave the euro. There's a realization that the Southern Europeans have the votes. They control monetary policy if it's a voting organization.
So we had a standoff, and talk about whether the Southern Europeans would be forced out. Why should they be forced out? They don't have to be forced out; they control it. If somebody's going to be forced out, it's more likely the Germans would be forced out. We were at an inflection point, and the question was would monetary policy print the needed money.
Let's be clear that the basic difference between Spain and Italy and the United States, to a large extent, is the ability to print money. If you've got the capacity to print money, then you don't have a credit spread.
Now we're going into a dynamic where the ECB's policy is, as in all deleveraging, in the natural last phase because it's the least painful--none of them are good--which is is the movement toward printing money…
(8) The Southern European countries will see a classic lost decade, very similar to the Latin American debt crisis. We're at the early stages of a major deleveraging. That will produce a depression environment. Credit comes from private sector credit. Private sector credit typically comes through banks. There will be a bank deleveraging. And then in the public sector, there'll be a deleveraging because you can't continue to run the deficit. There will be the equivalent of the IMF type of program. Conditions will be very bad for those countries.
The question becomes really a social question: how much tolerance for those types of conditions there will be? If it's dealt with well socially, that becomes a test of the character of the people. We have a capacity to get through these things if we have a capacity to not have such conflict that in itself becomes a terrible thing. You'll go through cycles, very much like Japan, in which you'll have bull markets and bear markets…
(9) We have our deleveraging too. But you will have bull markets, there will be injections, there will be cycles, very similar to our quantitative easings. Everybody says: "OK, the problems are behind us". And then things go on for quite a long time--we call them lost decades. They usually take 15 years, something like that…
(10) The template creates a framework for this deleveraging. It gets down to the nitty-gritty of who is the buyer and who's the seller. There was a lot of talk by policymakers and a lot of people that if I can keep the markets having faith and confidence, everything would be fine. That was not correct. If you actually knew who the buyers of the financial assets were, their confidence had very little to do with the decisions of the amounts of money that were being provided. You can give banks today in various places, you can give them all the confidence in the world; they can't expand their balance sheets. Knowing who the buyers are and the motivations of the buyers is very key.
The "greater fool" theory can go on for a really long time. As we look at the United Sates, certainly it's the case in Japan, we can't support these kinds of debts. Anybody with a sharp pencil will know that we're not going to be able to support that. The question is, what are the choices?
The world has lots of liquidity. The question is: what do its choices look like? Do you stop buying U.S. bonds, or do you stop buying Japanese bonds when you have no interest rate and a currency risk, so when do you stop buying?
Well, it's ultimately when it's driven to something else. At some point, you get a move toward inflation. Until you don't have that move to move toward inflation assets, you have a capacity for a lot of the buying there. Tis could go on for quite a long time because you have to go back to the buyer, and you say, who is that big buyer? We know who the big buyers are of U.S. Treasurys…
(11) There needs to be a certain amount of austerity. But if that austerity is too much, we have to worry as much also about the social consequences. We cannot have a bad downturn. We have to balance in a way that does not produce another 2008 because if you have a downturn, then you're going to have social consequences of the rich and the poor at each other's throats and the possibility of doing crazy things, and then the political shifts. Hitler came to power in 1933 because it was the bottom of the Great Depression. Democracies have a challenge in terms of effective decision-making. Soyou have to worry about getting the balance right. The fiscal cliff next year is also something to worry about. So we can't just worry about too much debt. We have to worry about too much austerity. We have to worry about getting that balance right.
(12) And my biggest worry: You can do the calculations. There's a certain amount of spending: nominal GDP and real GDP. Who are the buyers of goods and services? Where did they get their money from? And then how much do they need? And so I'm worried about balance.
When we're in a deleveraging, and you have that austerity, and you realize you've got too much debt. Everybody's got too much debt and they're not aware of it. Then you have the too much debt, and everybody's aware of it, and gets very depressed about it. And then we have a crisis. And then they print money, and then we go through our cycles. And these are the cycles that happens during these 10-year periods.
When the Fed makes a purchase and prints money, it can expand its balance sheet. The key is: are you getting the money in the hands of that person who's going to use it the way you want it to be used? If you go buy a mortgage-backed security it's probably not going to be good enough because it puts the money in the hands of the owner of that Treasury bond, and they're going to want to buy something that's like a Treasury bond because that's what they had before. It's a long way between that person who's holding that financial asset and the guy who's going to buy a car or a house.
Central banks can buy financial assets, but they can't buy goods and services. Central governments through fiscal policy can buy goods and services, but they can't print money…. You can have monetary stimulation by the central bank. But if they buy Treasury bonds, it's not going to stimulate the economy very much because it won't buy cars and houses. And so you need fiscal policy. Then the question is: how does fiscal policy, because of the politics of it, the ideologies of it, respond to that kind of circumstance?