Book summary: Understanding big debt crisis by Ray Dalio

The economic system

Functions of money

  • A store of wealth
  • a means of exchange

Two types of cycle

  • economic cycle
    • tied to production activity and output
  • credit cycle
    • the underlying basis is trust
    • capital employed as a means of production
    • when trust breaks down and credit starts to tighten credit cycle is said to be in the contraction phase and deleveraging occurs

Types of deleveraging

  • inflationary deleveraging
    • generally occurs when country’s currency is not a reserve currency or when currency is pegged to a specific commodity like gold
    • foreign lenders are unwilling to roll over existing credit or provide new credit leading to credit contraction within the economy
    • price of good rises during an inflationary deleveraging
  • deflationary deleveraging
    • generally occurs when country’s currency is a reserve currency
    • money is hoarded as cash instead of being utilized to support economic activity
    • domestic lenders are unwilling to provide credit leading to credit contraction within economy

Methods of deleverage

  • Austerity – spending less
  • Debt defaults / restructuring
  • Central bank print money and making purchases or providing guarantees
    • hard to implement if currency is tied to the gold standard
  • Transfers of money and credit from those who have more than they need to those who have less
    • will generally trigger exodus of funds

Beautiful deleveraging

  • Reduced debt to income ratio
  • improved economic activity
  • improved financial asset prices
  • bring nominal economic growth rate above nominal interest rate

Ugly deleveraging

  • bank runs
  • bankruptcies
  • severe unemployment
  • hoarding of gold
  • war / riots

Noteworthy similarities in period prior to WW2 and present day 2019

  • Dire income inequalities where 40% of the wealth is owned by 1% of the population
  • Rise of populism
    • Hitler
    • Franklin DeRoosevelt
    • Winston Churchill
  • rise of protectionism
    • US launches trade war against Canada
  • Rise of militarism
    • Hitler Germany
    • Japan
  • Continue professing by politicians that there is nothing wrong with the economy
    • President Hoover attempts to allay fears
  • Extreme volatility in the financial markets
  • riots due to economic hardship
  • sudden shifts from relatively free trade and interconnected supply chains around the world to protectionism and trade war through the use of tariffs
    • US versus Canada trade war
  • Out break of war
    • WW2
    • increase

Noteworthy case studies and observations

The war economy – Germany during WW1

  • GDP will tend to improve during war time as countries involved in war borrow heavily through the issue of bonds to finance production of war equipments
  • GDP will start to deteriorate after period of war is over as it transits back its prior state
  • GDP of the loosing faction will tend to be more severely affected during the post war period as they get slabbed with war reparations – WW1
  • Nature of loans during war period
    • Loans will initially be denominated in local currency due to high levels of patriotism
    • As war drags on and there are no signs of a positive outcome and loans becomes harder citizens will have either exhausted their loanable assets or are not confidant in the government’s ability
    • Further loans will need to be borrowed from foreigners which might result in loans denominated in foreign currencies

Connectedness of financial systems around the world – the 1930s Great Depression

USA 1930s deflationary deleveraging chain of events
  • investors buy financial assets and utilize increasing financial asset prices as collateral to buy more financial assets
  • government increases interest rate to tighten monetary policy and bring down inflation
  • brokerages increases margin interest rates
  • investors who cannot afford margin interest rates starts unwinding their positions leading to fall in financial asset prices
  • fall of financial asset prices triggers margin calls on other investors who borrowed to buy financial assets. This vicious cycle continues and confidence starts deteriorating and credit starts unwinding
  • bankers attempt to prop up asset prices and boost confidence by buying assets. Efforts were not enough, and asset prices continue to decline – as much as 90%
  • other entities are impacted
    • actual companies start experiencing problems getting credit
    • banks whose assets are in financial assets experience solvency issue due to rapidly deteriorating
  • bankruptcies and unemployment rate increases
  • government steps into prop up the market by lowering interest rate
  • interest rate is at all time low, investors lacking confidence is unwilling to provide credit many started withdrawing cash from banks causing bank runs. They also started hoarding gold.
  • There is an international shortfall of USD
Europe 1930s inflationary deleveraging chain of events
  • Confidence worldwide gets affected by US market deleveraging
  • Germany whose WW1 reparation denominated in USD experiences were mainly financed through the issuing of bonds experience difficulties finding buyers for new bonds.
  • investors loose confidence in ability of German government to repay bonds and start believing in the probability of a default
  • investors started dumping bonds and withdrawing gold from the German economy
  • inflation ensues
  • UK have many banks with assets tied to German bonds. Investors are concerned that UK will get affected and started withdrawing gold in droves.
  • UK government and German government decoupled their currencies from the gold standard, lowered interest rates and allowed exchange rates to decline
USA 1930s inflationary deleveraging chain of events
  • USA continues to peg their currency to the gold standard but experiences continued outflow of gold because gold is now considered to be priced too cheap against USD when compared to other European currencies that have gone off the gold standard
  • USA bans the purchase of gold, decouples their currency from gold and allow exchange rates to float freely
  • The world economy starts recovering

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