The Council on Foreign Relations sponsored “A Conversation with Ray Dalio” last week. The hour long discussion is a great explanation of what is going on in the global economy today. For anyone who has not seen it, click here to watch Ray Dalio discuss global economics.
For those of you who don’t have the time or much patience for economics, I’ll provide a summary and my interpretation of what he said below. However, please note that this summary based on my understanding of macroeconomics is no substitute for actually watching the CFR event with Ray Dalio, Founder of Bridgewater Associates, the world’s largest hedge fund and arguably the most successful.
According to Dalio, and many economists, the world economy is in the midst of a great deleveraging. The deleveraging of a nation’s economy (or a global economy) refers to the reduction of debt across government and private sectors as the “Total Debt/GDP” ratio decreases. The deleveraging is unavoidable as the United States has been spending at higher amounts than income earned for decades. There is a tipping point when debt to income becomes too high and the debts need to be reduced. The last time we had a deleveraging to this magnitude was the Great Depression of the 1930s.
In the United States, we have seen a reduction in the Total Debt to GDP ratio. While Government debt is still growing, private debt from individuals and corporations have been decreasing. The greatest risk during a deleveraging is slipping into an economic Depression.
During a deleveraging, the economy faces both deflationary and inflationary pressures. According to Dalio, the best deleveragings, which he calls a “beautiful deleveraging”, brings down the debt to income ratio and includes all of these four necessary actions:
- Austerity (Deflationary)
- Debt Write Downs (Deflationary)
- Printing Money (Inflationary)
- Transfer of Wealth (Inflationary)
Austerity is the reduction of spending. The government is not doing its part right now but individuals and corporations are. One of the best arguments for better stock valuations since 2008 is that corporate balance sheets are infinitely better now. The reduction of spending is best when it is gradual and not instantaneously severe.
Debt write downs are also deflationary because one man’s debt is another man’s asset. Once you write down debt, you are also destroying wealth. Not only is the amount of wealth reduced, but the ability to borrow and credit creation is also reduced. The best example of this has been with the real estate market since the bubble popped. Defaults and foreclosures in the residential home sector are a big part of the debt write downs. Debt restructuring as we are seeing with Greece is also a prime example of write downs.
The problem with Austerity and Debt Write Downs is that they cause deflation and can lead us into an economic depression. During the deleveraging (which is now unavoidable), Austerity and Debt Write Downs will happen. There is no way to prevent it.
If the government and/or central banks do not want to be in a depression, they have the option to buy assets and provide the market with much needed liquidity. This is what many refer to as “printing money”. This is what Bernanke and the Federal Reserve are doing. They are buying assets and providing the system with enough liquidity to counter the depression forces. The printing of money is inflationary but the goal is to create enough inflation to balance the deflation from Austerity and Debt Write Downs.
These three combined forces (Austerity, Debt Write Downs and Printing Money) lead to the Transfer of Wealth effect. Wealth is effectively transferred from the creditors to the debtors. Wealth is also transferred from monetary inflation policies and debts become worthless in real money terms.
Eventually, the economic system is saved as debt to income levels come back to normal, asset valuations stabilize, the credit/debt system functions normally, and economic growth is achievable and lasting.
Finally, inflation in the long term is a concern, but it is trumped by the near term threat of deflation. As the US and world economy deals with the deflationary risks, central banks will have to be very concerned with inflation. Time will tell how they combat the inflation risks in the future.
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