Big Debt Crises: The Phases of the Classic Deflationary Debt Cycle
1) The Early Part of the Cycle
In the early part of the debt cycle debt is growing slower than incomes as it is being used to finance productive activities leading to growing revenues. In this stage debt burdens are low and balance sheets are healthy, allowing room for companies, the government, and the financial sector to lever up. This phase is characterized by strong (but not too strong) growth and tame inflation, in other words it’s a Goldilocks period.
2) The Bubble
In this phase debt starts to rise faster than incomes. This accompanies strong asset returns and growth, boosting collateral values and the perceived credit-worthiness of borrowers leading to even more borrowing to purchase now more expensive assets, and boosting their prices. A classic self fulfilling cycle that can last decades with variations due to periodic tightening and easing by the central bank (i.e. short term debt cycles). During this period assets appear as “fabulous treasures” to own and anyone who isn’t holding them appears to be missing out.
The reason this phase can last for decades is that central banks progressively bring interest rates lower and lower boosting asset values (lower discount rates) and reducing debt burdens.
During this period outstanding debt increases relative to the amount of money in the economy. Eventually promises to deliver money are larger than can ever be repaid leading to the bubbling popping and the previous cycle working in reverse. Which is how we get a deleveraging.
In the bubble phase substantial asset-liability mismatches are developed such as borrowing short to lend long, taking liquid liabilities to purchase illiquid assets, investing in ever riskier assets, and borrowing in one currency to invest in another (carry trade).
Ironically, in many cases monetary policy helps inflate rather than constrain bubbles. This is particularly true when inflation and growth are both doing well and investment returns are great. The central bank’s classic indicators are not flashing any warning signs which makes them fall asleep at the well of the financial instability that’s building up in the system. In Dalio’s opinion CBs should target debt growth in addition to inflation and GDP growth. Specifically making sure debt growth is at a sustainable level, i.e. where income growth is large enough to service the debts. The pain of allowing a bubble to inflate and burst is so high that policy makers can’t afford to ignore it.
3) The Top
Tops form when prices have been driven up from a lot of leveraged buying, all participants are fully long and markets overpriced. The principle is that “When things are so good that they can’t get better — yet everyone believes that they will get better — tops of markets are being made.”
Tops can be triggered by different events but generally it is due to central bank tightening. Debt service payments start increasing, hurting asset prices and lenders start getting worried that their loans won’t be able to get paid back.
At the start of this point the yield curve tends to flatten (and eventually invert) as short rates increase relative to long rates decreasing the benefits of lending long term and moving people to cash further constraining credit growth. Some parts of the credit system start suffering (the most vulnerable and levered) while others seem fine making it harder to spot issues. At this point unemployment is generally at cyclical lows, inflation is increasing and growth is strong. At this point the picture is best seen on a sector by sector basis as this is where the excess has likely built up rather than the economy as an aggregate which may look fine (think of real estate in 07–08).
In markets a curious phase develops. Markets begin dropping and start to look cheap on a past and estimated earnings basis leading to the impression of a buying opportunity as these figures have yet to incorporate the likely declines in earnings that are to come.
4) The ‘Depression’
In short term cycles the imbalance between debt payments and the available income to service it can generally be resolved through the lowering of interest rates. In long-term debt cycles this lever stops working as interest rates quickly hit 0% limiting the impact, in addition credit spreads tend to widen out increasing debt service costs further. The knowledge of this leads to runs on financial assets, but since the ratio of financial assets to money is high either the central bank needs to print money (so there is enough for these conversions) or defaults will inevitably occur.
Part of the problem is that what people generally think of and treat as ‘money’ is really credit, which can and does appear and disappear into thin air (i.e. the endogenous theory of money). For example a company’s accounts receivables are generally treated as money even though they’re just credit. They’re a promise from the buyer to deliver actual money in the future. When financial conditions tighten people are less likely to grant this credit and this form of money disappears into thin air, which is what leads to the deflation associated with deflationary depressions as suddenly there’s a shortage of money. This is why the central bank ‘printing’ money during a depression doesn’t cause inflation, as this new money simply replaces the money that ‘disappeared’ when credit stopped being granted. This disappearance of credit and subsequent write-down of investment assets makes the economy slow down and incomes to fall as well leading to debt-to-income ratios to actually increase in the depression.
Related to the above the depression will generally cause liquidity and solvency problems. Somewhat counterintuitively in some cases solvency problems tend to really be accounting/regulatory problems. In other words institutions have less capital than required by law to operate but could operate at these levels without causing defaults. So a tool in policy makers belts is to temporarily adjust regulatory and accounting rules so institutions no longer appear insolvent. An alternative of course is to inject more equity capital into institutions. This generally takes the place of a government ‘bail out’ or nationalization of the failed institution.
An example of the impact of accounting rules is the difference between the banking crises of the 1980s and 2008. In the 80s there was not much mark-to-market accounting as banks held illiquid loans where there were no observable prices, while in 2008 banks did mark their securities to market prices. This lead to the appearance of much more insolvency in ’08 than in the 80’s requiring capital injections. The differences in this situation require regulators to utilize different tools to get through the crisis.
Policy makers have four general tools for reducing debt burdens, austerity, debt defaults, money printing, and wealth transfers. By using these levers they can help mitigate the worst effects of a depression. Historically policy makers have gotten the initial mix wrong focusing too much on austerity and not enough on stimulation (money printing). It is only after much pain that enough stimulation is generally carried out. The two biggest impediments for policy makers to manage a debt crisis are not knowing how to handle them, and political or regulatory limitations on their powers.
Austerity: It’s the obvious thing to do, tackle too much debt by reducing spending and letting those who got in trouble bear the costs. The problem is that this is generally not enough bring debt and income levels back into balance.
Money Printing: It generally takes a few forms. One way is by guaranteeing the liabilities of institutions in order to prevent runs that get started from the financial panic. Another is by providing liquidity to institutions by for example lending against more suspect collateral that was ineligible before. Supporting systematically important institutions solvency by encouraging private market recapitalizations and mergers, and if this doesn’t work injecting capital into these institutions directly through nationalizations or taking a partial ownership stake. While some may decry this as ‘bailouts’ the logic is similar to that of taking over a shipping port. You want the port to be open so ships can come in and trade to continue to flow even though the ‘old’ equity may be worthless and the company insolvent.
Debt Defaults/Restructuring: Bad debts ultimately need to be removed from the system so that it can begin running smoothly and central banks generally have latitude to decide how losses get allocated. Non-systematically important institutions are generally allowed to fail and file for bankruptcy. Their non-performing assets are then transferred into a larger institution or ideally new institutions are created designed specifically to deal with these distressed assets (i.e. so called ‘Bad Banks’).
Redistribution: Wealth gaps increase during bubbles and become extremely painful during depressions. This combination generally makes it politically feasible for populist leaders to rise on a platform of taxing the rich. This tool generally does not contribute meaningfully to the deleveraging.
5) The Beautiful Deleveraging
A beautiful deleveraging occurs when the four tools are combined in such a way that intolerable shocks are reduced, growth is encouraged and most importantly incomes are growing faster than debt and thus reducing debt burdens; all of this while maintaining acceptable inflation.
The best way of combating a deflationary depression is by making up the disappearance of spending from credit through money printing in order for nominal growth rates to be above nominal interest rates. The general (and valid) concern is that money printing will lead to runaway inflation Weimar/Venezuela style. While it is true that money printing can and has been abused in these cases policy makers are generally looking to replace the spending that has disappeared from credit with spending from money creation. The total amount of spending in the economy would not necessarily change much it would just come from a different source.
The path of this money printing has generally been for the central bank to first provide liquidity to stressed institutions and later (when it is clear the situation is not improving) to conduct large scale asset purchases (i.e. quantitative easing). The key is to balance the deflationary forces with the inflationary ones.
Dalio outlines the key differences between well managed and poorly managed debt crises in the table below:
6) Pushing on a String
The final phase in the debt cycle rears it’s head when lowering rates and asset purchases lose their stimulative powers. This generally happens since rates are at 0 and the large scale asset purchases have pushed markets so high that risk premiums have disappeared. The economy generally enters a phase of low growth and low market returns. At this point policy makers need to get more creative in their stimulation and generally try to put money directly into spenders hands, generally with strings attached incentivizing them to spend.
7) Normalization
Eventually the deleveraging gets the system back to normal over a period of time. Generally GDP takes 5–10 years to get back to pre-crisis levels while equity levels can take a decade or more as equity risk premiums rise following people’s fresh memories of crisis losses.