Bridgewater Fund Founder: How a Country Goes Bankrupt

I recommend diversifying investments in asset classes and countries with strong profit and loss statements and balance sheets, and without significant internal political and external geopolitical conflicts, while dropping the allocation ratio of debt assets such as bonds, and increasing holdings in gold and a small amount of Bitcoin.

Written by: Ray Dalio

Compiled by: Block unicorn

Introduction

Today, my new book, How Nations Go Bankrupt: The Great Cycle, is officially released. The purpose of this post is to briefly share the core content of the book. For me, the most important thing is to convey understanding at this critical time, so I hope to convey the core ideas in a minimalist way with this newsletter, and the depth is up to the reader.

My Background

I've been involved in global macro investing for over 50 years, and I've been betting on the government bond market for almost the same amount of time, and I've done it brilliantly. While I was previously secretive about the mechanisms by which major debt crises occur and the principles for dealing with them, I have reached another stage in my life and desire to pass on these understandings to others and help others. This is especially true when I see that the United States and other countries are heading for what amounts to an economic "heart attack." This led me to write How Nations Go Broke: The Big Cycle, a book that comprehensively expounds the mechanisms and principles I use, with a brief overview of the book.

How the mechanism works

Debt dynamics operate in the same way for governments, individuals, or companies, with the difference that the central government has a central bank, can print money (which causes the currency to depreciate), and can get money from the people through taxes. So, if you can imagine how the debt dynamics would work if you or the business you run could print money or get money through taxes, you could understand the dynamics. But remember, your goal is to make the whole system work well, not only for yourself, but for all citizens.

For me, the credit/market system is like the circulatory system of the human body, feeding the market and all parts of the economy. If credit is used effectively, it can generate productivity and income that is sufficient to pay off debt and interest, which is healthy. However, if credit is misused, resulting in insufficient income to pay off debt and interest, the debt burden can accumulate like plaque in the veins, squeezing out other expenses. When the amount of debt repayment becomes very large, a debt repayment problem arises, which eventually leads to a debt rollover problem because the debt holder is reluctant to roll it over and wants to sell it. Naturally, this leads to a lack of demand and an oversupply of debt instruments such as bonds, which in turn leads to a) higher interest rates, depressing the market and the economy; Or b) central banks "print money" and buy debt, which lowers the value of the currency and pushes up inflation. Printing money can also artificially drive down interest rates, hurting returns for creditors. Neither approach is ideal. When debt is sold too large and the central bank buys a large amount of bonds but is unable to curb the rise in interest rates, the central bank loses money, affecting its cash flow. If this continues, the central bank's net assets will become negative.

When the situation becomes serious, the central government and the central bank will borrow to pay interest on debts. The central bank prints money to provide loans due to insufficient demand in the free market, leading to a self-reinforcing spiral of debt / money printing / inflation. In summary, attention should be paid to the following classic indicators:

1. The ratio of government debt repayment costs to government revenue (similar to the number of patches in a circulation system);
2. The ratio of government debt sales to government debt demand (similar to plaque rupture leading to heart attacks);
3. The amount by which the central bank prints money to purchase government debt to fill the gap in debt demand (similar to how a doctor / central bank injects a large amount of liquidity / credit to alleviate liquidity shortages, resulting in more debt, for which the central bank assumes the risk).

These typically increase gradually over a long-term, decades-long cycle, with debt and debt repayment costs rising relative to income until unsustainable because: 1) debt repayment costs excessively crowd out other expenditures; 2) the supply of debt to be purchased is excessively high relative to demand, resulting in a sharp rise in interest rates, severely impacting markets and the economy; or 3) to avoid rising interest rates and deterioration of the market/economy, central banks print money in large quantities and purchase government debt to compensate for insufficient demand, leading to a significant drop in the value of the currency.

In any case, the bond returns will be very poor until the currency and debt become very cheap enough to attract demand, and/or the debt can be repurchased or restructured by the government at a low cost.

This is a brief overview of the great debt cycle.

Because people can measure these factors, the dynamics of debt can be monitored, making it easy to foresee impending problems. I have used this diagnostic method in investments and have never disclosed it publicly, but now I will explain it in detail in the book "How Nations Go Bust: The Big Cycle", as it is now too important to keep confidential.

More specifically, it can be seen that the cost of debt and debt repayment rises relative to income, the supply of debt is greater than the demand, the central bank initially stimulates by lowering short-term interest rates, then responds by printing money and buying debt, and eventually the central bank loses money and has negative net worth, the central government and the central bank pay interest on the debt by borrowing, and the central bank monetizes the debt. All of this has led to a government debt crisis, the equivalent of a "heart attack" in the economy, as restrictions on debt-financed spending have interrupted the normal flow of the circulatory system.

At the beginning of the final phase of the large debt cycle, market behavior reflects this dynamic through rising long-term interest rates, depreciation of currencies (especially relative to gold), and shortening the maturity of debt issuance by the central government's treasury due to insufficient demand for long-term debt. Often, later in the process, when the dynamics are at their worst, seemingly extreme measures are taken, such as imposing capital controls and exerting intense pressure on creditors to buy rather than sell debt. My book explains this dynamic more comprehensively through a large number of graphs and data.

Overview of the Current Situation of the U.S. Government

Now, imagine you are running a large enterprise called the United States government. This will help you understand the financial situation of the United States government and the choices of its leadership.

The total revenue this year is about $5 trillion, while the total expenditure is about $7 trillion, so the budget gap is about $2 trillion. That said, your organization will spend about 40% more than it earns this year. And there is little ability to cut spending, because almost all of the spending is previously committed or necessary. Because your organization has been borrowing too much for a long time, you've accumulated a huge amount of debt—about six times your annual income (about $30 trillion), which equates to about $230,000 per household. The interest bill on debt is about $1 trillion, or about 20% of a business's revenue, which is half of this year's budget gap (deficit), and you will need to borrow to fill that gap. But this $1 trillion isn't all you have to pay to creditors, because in addition to interest, you also have to repay the principal amount due, which is about $9 trillion. You want your creditors or other wealthy entities to be able to re-lend to you or lend to other wealthy entities. As a result, the cost of debt repayment – in other words, the principal and interest that must be repaid in order not to default – is about $10 trillion, or about 200% of revenue.

This is the current situation.

So, what happens next? Let's imagine. No matter what the deficit is, you have to borrow money to cover it. There is a lot of controversy about the exact amount of the deficit. Most independent assessors predict that debt will be about $50 to $55 trillion in 10 years, which is about 6.5 - 7 times the amount of revenue (about $3 - 5 trillion). Ten years from now, of course, if there is no plan to deal with this situation, the organization will face more debt repayment pressure, squeezing spending, and also a greater risk: the debt it must sell will not have enough demand.

This is the whole picture.

My 3% Three-Part Solution

I firmly believe that the government's finances are at an inflection point, because if this problem is not dealt with now, the debt will accumulate to an unmanageable level, leading to great trauma. It is especially important that this should be done when the system is relatively strong, not when the economy is weak. Because when the economy contracts, the government's demand for borrowing increases substantially.

Based on my analysis, I think this situation needs to be handled through what I call the "3% three-part solution". That is, to reduce the budget deficit to 3% of gross domestic product (GDP) in a balanced way by 1) cutting spending, 2) increasing tax revenues, and 3) lowering interest rates. All three need to happen at the same time to avoid any one adjustment being too large, because if any one is too large, it can lead to traumatic consequences. These adjustments need to be achieved through good fundamental adjustments, not forced (for example, if the Fed does not naturally lower interest rates, it will be very unfavorable). According to my projections, spending cuts and tax revenues will increase by about 4% each, and interest rates will fall by about 1-1.5% relative to the current plan, which will lead to an average reduction in interest expenses of 1-2% of GDP over the next decade, and spur higher asset prices and active economic activity, resulting in more revenues.

Here are the common questions and my answers

The content of the book far exceeds what can be covered in this space, including descriptions of the "overall long cycle" (including debt / currency / credit cycles, domestic political cycles, external geopolitical cycles, natural behavior, and technological advancements), which drive all significant changes in the world, my possible outlook for the future, and some views on investing during these changes. But now, I will answer some questions that are often asked when discussing this book and invite you to read the complete book for a deeper understanding.

Question 1: Why do large government debt crises and major debt cycles occur?

The occurrence of large government debt crises and large debt cycles can be easily measured by: 1) the ratio of government debt repayments to government revenues rises to an unacceptable level, squeezing the government's basic spending; 2) the sale of government debt is too large relative to demand, leading to higher interest rates, which in turn leads to a market and economic downturn; 3) Central banks respond to these situations by lowering interest rates, which reduces the demand for bonds, which in turn causes central banks to print money to buy government debt, which devalues the currency. These typically increase gradually over a long, multi-decade cycle until they can no longer be continued because: 1) debt servicing costs are excessively crowding out other expenses; 2) the supply of debt that needs to be purchased is too large relative to the demand for purchases, leading to a sharp rise in interest rates, which has hit the market and the economy hard; or 3) the central bank prints a lot of money and buys government debt to make up for the lack of demand, resulting in a significant drop in the value of the currency. In either case, bonds will have a poor rate of return until they become cheap enough to attract demand or the debt is restructured. These can be easily measured and seen on their way to an impending debt crisis. A debt-like economic "heart attack" occurs when debt-financed spending restrictions occur.

Throughout history, almost every country has experienced this debt cycle, which typically occurs multiple times, leading to hundreds of historical cases for reference. In other words, all monetary orders will collapse, and the debt cycle process I described is the underlying reason for these collapses. This situation can be traced back to recorded history. This is the process that has led to the collapse of all reserve currencies, such as the pound and the previous Dutch guilder. In my book, I showcase the 35 most recent cases.

Question 2: If this process happens repeatedly, why are the dynamics behind it not widely understood?

You're right, this is really not widely understood. Interestingly, I couldn't find any specific research on how this process happens. I speculate that the reason why this is not widely understood is that in reserve currency countries, this process usually occurs only about once in a lifetime – when their monetary order collapses – whereas in non-reserve currency countries, it is thought that reserve currency countries do not experience such problems. The only reason I found this process was because I saw it happen in my sovereign bond market investments, which led me to study many similar cases throughout history in order to be able to deal with them properly (for example, I dealt with the 2008 global financial crisis and the 2010-2015 European debt crisis).

Question 3: How worried should we be about a "heart attack" style debt crisis in the U.S. as we await the outbreak of the American debt issue? People have heard a lot about debt crises that were supposed to erupt but never did. What is different this time?

I think we should be very worried, given the circumstances mentioned earlier. I think those who are worried about the debt crisis when the conditions are less severe are right, because if measures can be taken early, such as early warnings to people not to smoke and poor diet, the situation can be avoided from getting so bad. Therefore, I think the reason why this issue has not attracted wider attention is both because people don't know enough about it and because there is a lot of complacency caused by premature warnings. It's like a person who has a lot of plaque in their arteries, eats a lot of fatty foods, and doesn't exercise and says to the doctor, "You warned me that something would go wrong if I didn't change my lifestyle, but I haven't had a heart attack yet. Why should I trust you now?"

Question 4: What could be the catalysts for today's debt crisis in the United States, when might it occur, and what would the crisis look like?

The catalyst will be the convergence of the various influencing factors mentioned earlier. As for the timing, policies and external factors (such as major political changes and wars) may accelerate or delay its occurrence. For example, if the budget deficit drops from about 7% of GDP, as I and most people predict, to around 3%, the risks will be significantly reduced. If a major external shock occurs, the crisis may arrive sooner; if not, it may come later or not at all (if managed properly). My guess—possibly inaccurate—is that if the current path is not changed, the crisis will occur within three years, fluctuating by two years up or down.

Question 5: Do you know of any similar cases where budget deficits were significantly reduced in the way you described, and achieved good results?

Yes, I know a few cases. My plan will reduce the budget deficit as a share of GDP by about 4%. The most similar case that achieved good results is the United States, where the fiscal deficit was reduced by 5% of GDP between 1991 and 1998. My book also lists several similar cases that occurred in other countries.

Question 6: Some people believe that due to the dominant position of the US dollar in the global economy, the United States is generally less susceptible to debt-related issues/crises. What do you think those who hold this view overlook or underestimate?

If they believe this, they overlook the understanding of mechanisms and historical lessons. More specifically, they should examine history to understand why all previous reserve currencies are no longer reserve currencies. Simply put, currency and debt must be effective wealth storage tools; otherwise, they will be devalued and discarded. The dynamics I describe explain how reserve currencies lose their effectiveness as wealth storage tools.

Question 7: Japan – with its debt-to-GDP ratio of 215%, the highest of any advanced economy – is often cited as a prime example of the argument that a country can sustainably high levels of debt without experiencing a debt crisis. Why can't the Japanese experience bring you comfort?

The Japanese case exemplifies the problems I have described and will continue to be an example of them, and it also validates my theory in practice. More specifically, Japanese bonds and debt have been poor investments due to the Japanese government's over-indebtedness. To compensate for the lack of demand for Japanese debt assets at low interest rates, the Bank of Japan printed heavily and bought large amounts of government debt, which resulted in Japanese bondholders losing 45% of their debt against the dollar and 60% against gold since 2013. Since 2013, costs for Japanese workers have fallen by 58% relative to U.S. workers. I have an entire chapter in my book devoted to the situation in Japan, which explains this in depth.

Question 8: From a fiscal perspective, which regions in the world appear particularly tricky and may be underestimated by people?

Most countries have similar debt and deficit issues. The UK, the EU, China, and Japan are no exception. This is why I expect most countries to experience a similar process of debt and currency depreciation adjustment, which is also the reason I anticipate that non-government issued currencies, such as gold and Bitcoin, will perform relatively well.

Question 9: How should investors respond to this risk / How should they position themselves for the future?

Everyone's financial situation is different, but as a general recommendation, I recommend diversifying into asset classes and countries that have strong P&L and balance sheets and no major internal and external geopolitical conflicts, while reducing the allocation to debt assets such as bonds, and adding to gold and a small amount of Bitcoin. Investing a small amount of money in gold reduces portfolio risk, and I think it will also improve portfolio returns.

Finally, the views expressed here are solely my own and do not necessarily represent the views of Bridgewater Associates.