Bridgewater Associates founder: The most important principle to consider when thinking about massive government debt and deficits
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Bridgewater Associates founder: The most important principle to consider when thinking about massive government debt and deficits
The most concealed, thus most favored, and also the most commonly used method for government policymakers to address excessive debt is lowering real interest rates and real exchange rates.
Navigating Web3 tides with focused insightsAuthor: Ray Dalio
Translation: Block unicorn
Principles:
When a country has excessive debt, lowering interest rates and devaluing the currency in which the debt is denominated are the most likely preferred paths for policymakers. Therefore, it's worthwhile to bet on this scenario unfolding.
As I write this, we know that large deficits, significant increases in government debt, and higher debt servicing costs are expected in the future. (You can find these figures in my writings, including my new book *How Countries Go Broke: The Big Cycle*; last week I also shared why I believe the U.S. political system cannot control the debt problem.) We know debt service costs—interest and principal payments—will rise rapidly, squeezing other expenditures. We also know that even under the most optimistic assumptions, the likelihood of rising debt demand matching the increasing supply of debt for sale is extremely low. In *How Countries Go Broke*, I detail what I believe all this implies and describe the mechanisms behind my thinking. Others have stress-tested this view and now almost entirely agree that my depiction is accurate. Of course, this doesn’t mean I can’t be wrong. You need to judge for yourself what might be true. I’m simply offering my thinking for your evaluation.
My Principles
As I’ve explained, based on over 50 years of investing experience and research, I’ve developed and documented principles that help me anticipate events and place successful bets. I’m now at a stage in life where I want to pass these principles on to others to provide help. Additionally, I believe that to understand what is happening and what could happen, one must understand how the mechanisms work, so I also try to explain my understanding of the mechanics behind these principles. Below are several additional principles, along with explanations of how I see the underlying mechanisms operating. I believe the following principles are correct and beneficial:
The most hidden—and therefore most favored and most commonly used—method for policymakers to address excessive debt is to lower real interest rates and the real exchange rate of the currency.
While lowering interest rates and currency exchange rates in response to excessive debt and its associated problems can provide short-term relief, it reduces demand for the currency and debt, creating long-term issues. This is because it lowers the return on holding currency/debt, thereby reducing the value of debt as a store of wealth. Over time, this typically leads to more debt, as lower real interest rates are stimulative and worsen the problem.
In summary, when debt is excessive, interest rates and currency exchange rates tend to be suppressed.
Is this good or bad for economic conditions?
Both. It’s often good in the short term and widely welcomed, but harmful in the long run, leading to more severe problems. Lowering real interest rates and real currency exchange rates is…
…beneficial in the short term because it’s stimulative and tends to push up asset prices…
…but harmful over the medium and long term because: a) it delivers lower real returns to those holding these assets (due to currency depreciation and lower yields), b) it leads to higher inflation, and c) it results in greater debt accumulation.
In any case, this clearly cannot avoid the painful consequences of overspending and deepening debt. Here’s how the mechanism works:
When interest rates fall, borrowers (debtors) benefit because this reduces debt servicing costs, makes borrowing and spending cheaper, pushes up investment asset prices, and stimulates growth. That’s why nearly everyone is pleased with lower interest rates in the short run.
But at the same time, these price increases mask the adverse effects of pushing rates down to undesirably low levels, which hurt lenders and creditors. These are facts: lowering interest rates—especially real interest rates—including central banks suppressing bond yields, pushes up bond and most other asset prices, leading to lower future returns (e.g., bonds rise when rates go negative). This also leads to more debt, creating bigger debt problems in the future. As a result, the returns on debt assets held by lenders/creditors decline, which in turn encourages even more borrowing and debt creation.
Lower real interest rates also tend to reduce the real value of the currency because they make the yield on money/credit less attractive relative to alternatives in other countries. This leads me to explain why currency devaluation is the preferred and most common method for policymakers to deal with excessive debt.
Currency devaluation is favored by policymakers and appears advantageous when explaining it to voters for two reasons:
1) A weaker currency makes domestic goods and services cheaper relative to those from countries whose currencies have appreciated, stimulating economic activity and pushing up asset prices (especially in nominal terms), and…
2) …it makes debt repayment easier in a way that is more painful for foreigners holding debt assets than for domestic citizens. This is because the alternative “hard money” approach would require tightening monetary and credit policies, keeping real interest rates high, suppressing spending, typically involving painful spending cuts and/or tax increases, and stricter lending terms that citizens are unwilling to accept. In contrast, as I’ll explain below, a lower currency value is an “invisible” way of repaying debt because most people don’t realize their wealth is being eroded.
From the perspective of the depreciating currency, a lower exchange rate also typically increases the value of foreign assets.
For example, if the dollar depreciates by 20%, American investors can repay foreign holders of dollar-denominated debt using money that’s worth 20% less (i.e., foreigners holding debt assets suffer a 20% currency loss). The harms of a weaker currency are less obvious but real: holders of the weak currency experience reduced purchasing power and borrowing capacity—purchasing power falls because their currency buys less, and borrowing ability declines because buyers of debt assets are reluctant to purchase debt (or the currency itself) denominated in a depreciating currency (i.e., promises to receive that currency). This is not obvious because most people in the depreciating-currency country (e.g., Americans using dollars) don’t directly see their purchasing power and wealth decline, since they measure asset values in their own currency, creating an illusion of asset appreciation even as the currency’s value falls. For instance, if the dollar drops 20%, U.S. investors focusing only on the rise in the dollar value of their holdings won’t immediately see their 20% loss in purchasing power over foreign goods and services. However, for foreigners holding dollar-denominated debt, this will be clear and painful. As they grow increasingly concerned, they sell (dump) the debt-denominated currency and/or debt assets, causing further weakness in the currency and/or debt markets.
In summary, viewing things solely through the lens of one’s domestic currency clearly creates a distorted perspective. For example, if something (e.g., gold) rises 20% in dollar terms, we think the item’s price went up, not that the dollar’s value declined. The fact that most people hold this distorted view makes such methods of handling excessive debt “hidden” and politically more acceptable than alternatives.
This way of seeing things has changed significantly over time, especially as people shifted from being accustomed to a gold-backed monetary system to today’s fiat/money system (i.e., money no longer backed by gold or any hard asset—a reality since Nixon severed the dollar from gold in 1971). When money existed as paper representing a claim on gold (what we called the gold standard), people thought about the paper’s value rising or falling. Its value almost always fell—the only question was whether it fell faster than the interest earned on holding fiat debt instruments. Now, the world is accustomed to viewing prices through a fiat/money lens, resulting in the opposite perception—they think prices go up, not that money’s value goes down.
Because a) prices measured in gold-standard money and b) the quantity of gold-standard money have historically been far more stable than a) prices measured in fiat/money and b) the quantity of fiat/money, I believe viewing prices through a gold-standard lens may be more accurate. Clearly, central banks share a similar view, as gold has become the second-largest reserve asset they hold, behind only the U.S. dollar and ahead of the euro and yen—partly for these reasons, partly because gold carries a lower risk of confiscation.
The degree to which fiat money and real interest rates fall, and non-fiat monies (like gold, bitcoin, silver, etc.) rise, has historically—and logically—depended on their relative supply and demand. For example, massive debts unsupported by hard currency lead to greatly expanded money and credit, resulting in sharp declines in real interest rates and real exchange rates. The last major period when this occurred was the stagflation era of 1971–1981, which led to enormous shifts in wealth, financial markets, the economy, and politics. Given the scale of current debt and deficits—not just in the U.S., but across fiat-money countries—similar large-scale changes could occur in the coming years.
Whether or not this assessment is correct, the severity of debt and budget problems seems undeniable. In such times, holding hard money is beneficial. Historically, and across many centuries around the world, gold has served as hard money. Recently, some cryptocurrencies have also been viewed as hard money. For certain reasons—which I won’t elaborate here—I prefer gold, though I do hold some cryptocurrencies.
How much gold should one hold?
While I’m not giving specific investment advice, I’ll share some principles that help shape my views on this question. When considering the ratio of gold to bonds, I think about their relative supply and demand, as well as the relative costs and returns of holding each. For example, currently U.S. Treasury bonds yield around 4.5%, while gold yields 0%. If you believe gold will rise more than 4.5% next year, holding gold makes sense; if not, it doesn’t. To help make this assessment, I examine the supply and demand dynamics of both.
I also know that gold and bonds can diversify each other’s risks, so I consider how much of each should be held for effective risk management. I know that holding approximately 15% in gold effectively diversifies risk, as it improves the portfolio’s return/risk profile. Inflation-linked bonds have a similar effect, so it’s worth considering including both in a typical portfolio.
I share this not to tell you how I think markets will move or how much of any asset you should hold, because my goal is to “teach people how to fish” rather than give them a fish.
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@RayDalio
