Recessions and Depressions (According to Ray Dalio)

According to Mr. Dalio, a deleveraging looks like a recession, but interest rates can no longer be lowered to save the day.  In other words, in a deleveraging, the central bank can’t lower interest rates because interest rates are already low.  When rates hit 0%, the stimulus ends. The economic conditions are such that lenders realize that the debt burden is simply too large, and many outstanding loans will never be paid back.  Everyone worries about the economy, and lenders stop lending and borrowers stop borrowing.

Mr. Dalio points out that there are only four basic approaches to lowering the debt burden in such cases.

  1.  People, businesses, and governments can lower spending.  When governments “tighten their belts,” the results are often called “austerity measures.”
  2.  Debts can be reduced through defaults and restructuring.  
  3.  Wealth can be redistributed from the “haves” to the “have nots.”
  4.  The central bank can print new money.

Every deleveraging in every economy throughout modern history has used these four basic methods of reducing the debt burden.  The first step is usually to reduce spending. This almost never helps the overall situation because, as you will recall, one person’s spending is another person’s income.  If everyone is saving money, then nobody is getting paid very much. This causes incomes to fall, and the rate if income reduction can be faster than the debts are being repaid.  If this happens, there is little “getting ahead” going on. As counterintuitive as it may sound, across the board spending cuts are deflationary and painful. Remember that businesses must take the same cost cutting measures, which usually means fewer jobs, less pay, and high unemployment.

When people get into this predicament, they can’t pay back the banks.  If this happens enough times, people start to worry about the solvency of the bank, and they rush to take their money out.  This can cause the banks to get into trouble, and they also begin to default on their debt. Such a severe economic contraction is known as a depression.

Some people have accused banks of wanting to default on loans so they could seize control of homes, automobiles, and other tangible assets.  This is not the case. Banks need money to be banks, and owning a bunch of houses in a depressed real estate market doesn’t help them very much.  Banks want borrowers to pay their loans back, because those debts are down on the balance sheets as assets. If borrowers never pay the bank back, then the asset vanishes, and the bank is much less wealthy than it was before.  This is why financial institutions often agree to debt restructuring when times are economically bad. Debt restructuring causes assets to lose value faster than debt is relieved, so the overall economic problem—the debt burden—just gets worse.  Debt reduction is also deflationary and painful.

When incomes are low and unemployment is high, the central government is in a weakened position to help because they are collecting fewer taxes.   This comes at a time when the government needs to increase spending because unemployment has risen. Many unemployed people have inadequate savings and will need financial assistance from the government to make ends meet.  Governments can increase spending, which helps make up for the decrease in the economy. This causes government deficits to explode during a deleveraging because they are spending much more than they are taking in in the form of taxes.  The only way governments can afford to stimulate the economy is to raise taxes or borrow money. However, when the economy is already bad and many people are unemployed, who do we tax? The rich, of course.

The rich have been hurt by the falling asset prices and poor economy.  They resent the “have nots” who have not saved enough to get through the lean times.   The “have notes” are angry at the wealthy for various reasons. We all need somebody to blame.  This causes social unrest within countries, and can even cause tensions between countries. Certain inflection points in history, such as the rise of the Nazi party, are the result of populism brought on by economic depression.



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