Ray Dalio: The most important principle when thinking about large government debts and deficits

Original title: The Most Important Principle to Keep in Mind When Thinking About Large Government Debts and Deficits

Original article by Ray Dalio

Traducción original: Unicornio en bloque

The principles are as follows:

When a country has too much debt, lowering interest rates and devaluing the currency in which the debt is denominated are the most likely priority paths that government policymakers will take, so it pays to bet on that happening.

As I write this, we know that large definicióncits and significant increases in government debt and debt-servicing spending are projected in the future. (You can see this data in my writings, including my new book, How Nations Go Bankrupt: The Big Cycle; I also shared last week why I think the U.S. political system cannot control its debt problem.) We know that the costs of debt service (interest and principal payments) will grow rapidly, crowding out other spending, and we also know that the odds that the increase in demand for debt will be matched by the supply of debt that needs to be sold are extremely low in the best-case scenario. I lay out in detail what I think all this means in How Nations Go Bankrupt, and describe the mechanics behind my thinking. Others have also stress-tested this, and there is now near-complete agreement that the picture I paint is accurate. Of course, that doesn’t mean I can’t be wrong. You need to make your own judgment about what is likely to be true. I’m just offering my thinking for you to evaluate.

My principles

As I explained, based on my experience and research over the past 50+ years of investing, I have developed and documented some principles that help me predict events so that I can bet successfully. I am now at a stage in my life where I want to pass these principles on to others to help. In addition, I believe that to understand what is happening and what may happen, one needs to understand how the mechanics work, so I have also tried to explain my understanding of the mechanics behind the principles. Here are a few additional principles and an explanation of how I believe the mechanics work. I believe the following principles are correct and helpful:

The most insidious way for government policymakers to deal with excess debt, and also the most popular and common way, is to reduce real interest rates and the real money rate.

While lowering interest rates and currency exchange rates to deal with excess debt and its problems can provide relief in the short term, it reduces demand for money and debt and creates long-term problems because it reduces the return on holding money/debt, thereby reducing the value of debt as a store of wealth. Over time, this generally leads to more debt because lower real interest rates act as an incentive, making the problem worse.

In summary, when there is too much debt, interest rates and currency exchange rates tend to be pushed down.

Is this good or bad for the economy?

Having both is often good and popular in the short term, but harmful in the long term and leads to more serious problems. Lowering the real interest rate and the real currency exchange rate is…good in the short term because it is stimulative and tends to push up asset prices…but harmful in the medium and long term because: a) it gives those who hold those assets a lower real return (due to currency depreciation and lower yields), b) it leads to higher inflation, c) it leads to greater debt.

However, this obviously does not prevent the painful consequences of overspending and deep debt. Here is how it works:

When interest rates fall, borrowers (debtors) benefit because it reduces the cost of debt repayment, making it cheaper to borrow and buy, which in turn pushes up investment asset prices and stimulates growth. This is why in the short term, almost everyone is happy with lower interest rates.

But at the same time, these price increases mask the undesirable consequences of lowering interest rates to undesirably low levels, which is bad for both lenders and creditors. This is true because lowering interest rates (especially real interest rates), including by central banks pushing down bond yields, pushes up the prices of bonds and most other assets, which leads to lower future returns (for example, when interest rates go negative, bond prices rise). It also leads to more debt, which creates a bigger debt problem in the future. As a result, lenders/creditors receive less return on the debt assets they hold, which leads to more debt.

Lower real interest rates also tend to reduce the real value of a currency because it makes the yield on money/credit lower relative to alternatives in other countries. This allows me to explain why lowering the currency exchange rate is the first and most common way for government policymakers to deal with debt overhangs.

There are two reasons why a lower currency exchange rate is favored by government policymakers and appears advantageous when explained to voters:

1) A lower currency exchange rate makes domestic goods and services cheaper relative to those of countries whose currencies have appreciated, thereby stimulating economic activity and driving up asset prices (especially in nominal terms), and…

2) …it makes it easier to pay off debt in a way that is more painful for foreigners who hold debt assets than for citizens. This is because the alternative “hard money” approach requires tightening monetary and credit policy, which keeps real interest rates high, which in turn discourages spending, and usually means painful service cuts and/or tax increases, as well as tighter loan conditions that citizens are unwilling to accept. In contrast, as I will explain below, lower money interest rates are an “implicit” way to pay off debt because most people do not realize that their wealth is decreasing.

From the perspective of a depreciating currency, a lower currency exchange rate will also generally increase the value of foreign assets.

For example, if the dollar depreciates by 20%, U.S. investors can pay foreigners who hold dollar-denominated debt in a currency that is 20% less valuable (i.e., foreigners holding debt assets will suffer a 20% currency loss). Less obvious but real harm from a weaker currency is that holders of a weaker currency experience reduced purchasing power and borrowing capacity—less purchasing power because their currency has less purchasing power, and less borrowing capacity because buyers of debt assets are unwilling to buy debt assets (i.e., assets that promise to receive money) or the currency itself, which is denominated in a currency that is depreciating in value. It is less obvious because most people in countries with depreciating currencies (e.g., Americans who use dollars) will not see their purchasing power and wealth decline because they measure asset values in their own currencies, which creates the illusion of asset appreciation even though the value of the currency in which their assets are denominated is declining. For example, if the dollar falls by 20%, U.S. investors will not directly see that they have lost .20% of their purchasing power on foreign goods and services if they only focus on the increase in the dollar value of the assets they hold. However, it will be obvious and painful for foreigners holding dollar-denominated debt. As they become more concerned about this situation, they dump (sell) the currency and/or debt assets that the debt is denominated in, causing the currency and/or debt to weaken further.

In summary, seeing things only through the lens of one’s own currency obviously creates a distorted perspective. For example, if the price of something (like gold) rises by 20% in terms of dollars, we would perceive the price of that thing as rising, not as a fall in the value of the dollar. The fact that most people have this distorted perspective makes these ways of dealing with excess debt “secret” and more politically acceptable than other alternatives.

This way of looking at things has changed a lot over the years, especially from people being used to a gold standard monetary system to today’s fiat/paper monetary system (i.e. money is no longer backed by gold or any hard asset, which became true in 1971 when Nixon decoupled the dollar from gold). When money existed in the form of paper and as a claim on gold (we call this a gold standard currency), people thought that the value of paper money would go up or down. Its value almost always went down, the only question was whether it went down faster than the interest rate you were getting on holding the fiat debt instrument. Now that the world has been used to looking at prices through a fiat/paper lens, they see it the other way around – they think prices go up, not that the value of money goes down.

Because a) prices in gold-denominated currencies and b) the amount of gold-denominated currencies have historically been much more stable than a) prices in fiat/paper currencies and b) the amount of prices in fiat/paper currencies, I think that looking at prices through the lens of a gold-denominated currency is probably a more accurate way to go. Obviously, central banks hold a similar view, as gold has become their second-largest currency (reserve asset) held, second only to the dollar and ahead of the euro and yen, partly for these reasons and partly because of the lower risk of gold being confiscated.

How far fiat currencies and real interest rates fall, and how far non-fiat currencies (such as gold, Bitcoin, silver, etc.) rise, has historically (and logically should) depend on their relative supply and demand. For example, large debts that cannot be backed by hard currency can lead to large monetary and credit easing, which can lead to large declines in real interest rates and real currency exchange rates. The last major period when this happened was the stagflation period of 1971-1981, which led to huge changes in wealth, financial markets, economics, and political environments. Based on the size of existing debts and deficits (not only in the United States, but also in other fiat currency countries), similar huge changes may occur in the next few years.

Whether or not this is true, the severity of the debt and budget problems seems unquestionable. In times like these, it is good to have hard currency. Gold has been hard currency to date, and for many centuries around the world. Recently, some criptocurrencies have also been considered hard currency. For reasons I won’t go into, I prefer gold, although I do hold some cryptocurrencies.

How much gold should a person hold?

While I am not here to give you specific investment advice, I will share some principles that help me form my perspective on this issue. When considering how much gold to hold versus bonds, I think about their relative supply and demand and the relative costs and rewards of holding them. For example, with the current interest rate on U.S. Treasuries at about 4.5% and gold at 0%, it would be logical to hold gold if you believe that the price of gold will rise by more than 4.5% over the next year, and it would be irrational to hold gold if you do not believe that gold will rise by 4.5%. To help me make this assessment, I look at the supply and demand for the two.

I also know that gold and bonds can diversify each others risk, so I consider what proportion of gold and bonds should be held for good risk control. I know that holding about 15% in gold can effectively diversify risk because it provides a better return/risk ratio for the portfolio. Inflation-linked bonds have the same effect, so it is worth considering adding both assets to a typical portfolio.

I share this view with you rather than telling you how I think the market will change or suggesting how many assets you should own because my goal is to teach a man to fish rather than giving him a fish.

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