Steve Bain

The Long Term Debt Cycle Explained

The long term debt cycle is not usually explained in the standard economics textbooks, and it is only entering the national debate due to the work done by Ray Dalio, the American billionaire investor and hedge fund manager. On this page I will give my thoughts about Ray's book 'Principles for Navigating Big Debt Crises'.

First of all, I should point out that this book lays out a set of ideas for achieving better management of the fractional reserve banking system, and the way that credit expansion plays a major role in fueling the boom-bust business cycle.

As I will explain below, I am in some agreement with the criticisms of how monetary policy is routinely mishandled by governments and central banks, but fundamentally I approach this problem from an entirely different perspective i.e. I think it is better to replace the fractional reserve system rather than reform how it is managed.

My preference is to adopt a full reserve banking system, but I do acknowledge that it is far less likely that such a replacement will occur anytime soon, and that consequently Ray's approach of seeking better management of the system we have is of more practical value.

What is the Long Term Debt Cycle?

The long term debt cycle refers to a timeline along which an economy experiences multiple episodes of growth and recession, with each episode accruing a gradual expansion of debt via artificially low interest rates until, ultimately, a severe depression resets the entire financial system.

By 'depression' Ray means a recession that incurs at least a 3% decline in economic output, as has happened in the US twice in modern economic history i.e. the Great Depression of the 1930s, and the Global Financial Crisis of 2007-08.

Whether or not such a debt crisis leads to a deflationary bust or an inflationary bust is thought to depend on many specific factors, but chiefly it depends on whether the debt that has been accrued is denominated in terms of the national currency, or foreign currency. If the former, the tendency has been for a deflationary depression to occur, while the later has tended to lead to an inflationary depression.

I should note here that the main historical examples that Ray gives predate the wholesale adoption of Keynesian economics i.e., governments of the past did not actively pursue deficit spending to fight recessions. Deficits would naturally occur during recessions, but governments would try to maintain relatively balanced budgets.

These days, enthusiastically printing money to fund deficit spending is the norm, and that makes inflationary recessions much more likely - even if a country's debt is denominated in its own currency.

Inflationary depressions of the past occurred when a national currency depreciated in value against an important foreign currency, with many debts/costs being priced in terms of the national currency, but varying according to the value of the foreign currency. After a depreciation, debt repayment costs and the costs of production increase, plunging the economy into recession.

Fighting recession in such circumstances (which may be necessary in order to maintain public order) typically leads to even more depreciation, leaving governments with little choice but to print ever greater amounts of the national currency to pay the bills and stave off an immediate collapse of the economy. Inevitably, an inflationary depression would then follow in due course.

How does the Long Term Debt Cycle Develop?

Underlying the development of the long term debt cycle is the standard boom-bust business cycle. This starts with improving economic circumstances that encourage people to borrow heavily for speculative purposes e.g. in order to purchase assets like houses while their prices are rising, in anticipation of making future capital gains (or simply to get on the property ladder before it is unaffordable to do so). This leads to 'bubble markets' developing for these assets, with rapid expansion of consumer spending and an overheating of the economy, which eventually leads to a downturn.

The difference is that while the typical business cycle could be accommodated by monetary and fiscal policy maneuvering (interest rate cuts in particular) in order to boost consumer spending once it enters a downturn, these tools would fail once interest rates are already close to zero (remember that the emphasis in the past was on boosting consumer borrowing/spending via lower interest rates - printing money to fund government deficit spending was not the policy of the day).

This is the critical point, that each business cycle is initiated by a bubble-market of some sort, and ends with household debts at a higher level than during the previous cycle, and interest rates at lower levels. Eventually a point comes at which further interest rate cuts are impossible, and the next economic downturn will lead to a depression.

Creation of an economic stimulus when interest rates were already near to zero was much tougher to achieve with the standard macroeconomic policy tools of the day. The Great Depression of the 1930s is the clearest example of what happens when the government stands idly by and does nothing more once interest rates are bottomed out. US unemployment peaked at 24.9% in 1933, and the money supply contracted (largely due to bank failures) by around 35% with similar falls in the price level (i.e. deflation).

In Germany, where much of the country's debts in this period existed in the form of First World War reparations denominated in terms of gold and other commodities, the burden of the debt became unbearable as France and the other Allies demanded massive reparation payments.

Capital flight from Germany occurred as wealthy Germans sought to get their money into foreign countries where it might escape excessive taxes, or confiscation, by the German authorities (and where it might escape the constant loss of purchasing power that inflation inflicted upon it). The result of this was a sharp deterioration of the exchange rate, making it impossible to generate enough marks through taxes and loans to meet reparation demands.

Rapid expansion of the German money-supply via the printing press was resorted to in order to pay the debts and maintain vital services, and the end result was hyperinflation of the German mark (starting in 1921 and peaking in 1923).

The economic cost and misery from this sort of inflationary depression is even more serious than that of a deflationary depression, and it can easily create enough anger and resentment to pave the way for extremist political parties to gain power; as happened in Germany in the 1930s, with catastrophic global consequences as a result.

How to Mitigate the Bad Effects of Debt Crises

The book gets a lot more controversial in its suggested remedy for debt crisis situations in that it prescribes a much greater role for our regulatory bodies. Critics, such as myself, regard these institutions as wholly incapable of analyzing, let alone treating, complex macroeconomic problems.

My personal experiences of public sector organizations is more in line with the experiences of the renowned economist Thomas Sowell who, after a single summer's internship with the US Labor Department, realized that these organizations are not well constructed to solve the very problems for which they exist. Rather, they become self-serving organizations that prioritize their own interests.

They do not do this out of malice or selfishness, but the human-beings who run them face all sorts of political and personal pressures that bias the work they do, with none of the competitive market pressures that force regular organizations to operate efficiently.

As Ray points out in his book, the central bankers themselves stress the difficulty of spotting bubble-markets as they appear, but Ray Dalio stresses the necessity of doing so, and of acting decisively in order to mitigate them as a key element of preventing the boom-bust business cycle and long term debt cycle from perpetuating.

This, to my eyes, is hopelessly naive thinking.

I believe that any further empowerment, and instruction, of a regulatory body to conduct economic interventions in matters in which it itself confesses to have little ability to do with any degree of accuracy, will tend to lead to worsening economic outcomes rather than improvements.

Improved economic outcomes nearly always require a reduction of regulatory intervention rather than an increase, and the financial services industry is already the most heavily regulated industry in existence. The problem is not too little regulation, it is that the entire fractional reserve system is seriously flawed, and only a replacement that is immune to its perverse economic incentives will fix the problem.

Sticking plasters on the disease won't do at all, we need a cure., which is why I support full reserve banking as the correct path forward.

Beautiful Deleveraging?

Mr Dalio's concept of a 'beautiful deleveraging' infers a process by which policymakers manage the depression in such a way that debts are reduced without causing too much hardship for anyone. Four policy levers are identified for achieving this purpose, and the optimal combination is thought to deliver the beautiful deleveraging:

  1. Austerity
  2. Debt Defaults or Restructurings
  3. Debt Monetization / Money Printing
  4. Wealth Transfers

The management of the US economy following the 2008 global financial crisis is offered as an example of a beautiful deleveraging, or something approximating it.

Here again, I have to object.

Mr Dalio simultaneously argues that a deleveraging takes about 10 years to reset an economy's finances while also maintaining that the USA went through an almost ideal version of such a process after 2008. To my reckoning that implies that the process should have been complete by around 2018. The data does indeed confirm that much of the excessive household debt had been reduced by that time, but the data also shows that government debt expanded by an even larger amount.

Overall debt in 2018 was significantly higher than in 2008, and far from having achieved any beautiful deleveraging of a long term debt cycle, the government has only achieved a very ugly and unsustainable budget deficit and trade deficit, all while running up total debt. My article about fiscally responsible government covers this in some detail.

I do accept the point that replacing household debt with government debt has some advantages, because the repayment of it can be spread out over many years, but at some point there has to be evidence of an actual repayment occurring. We have precisely the opposite evidence, and I don't foresee a time when any government will be able to resolve this issue. Instead, it looks like government deficit spending, funded by ever greater amounts of money-printing, is leading us to an even bigger crisis than that experienced in 2008.

If I've been overly critical of Mr Dalio's work, that was not my intention. There is a lot to like about this book, and there is some good analysis of how historical long term debt cycles came into being. It's just that I can't agree with the book's central assertion that yet more government control of our lives is the correct way forward. This is somewhat a difference of philosophical approach, of course, and readers can decide for themselves where they stand on that issue.

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