Original Author: Ray Dalio

Original Title: How Countries Go Broke Dynamic Behind What Happening Now

Original Translation: BlockBeats

In my book "How Countries Go Broke: The Big Cycle," I have established a detailed template to describe how the unsustainable state of debt supply-demand imbalance leads to evolving consequences. Three recent events have occurred simultaneously:

· The Japanese government has sold part of its U.S. Treasury holdings, repatriating funds to support the yen and Japanese capital markets, reducing exposure to U.S. bonds without the need for significant further interest rate hikes;

· U.S. Treasury yields have risen to new highs led by the long end, while the U.S. dollar has weakened due to the current and future significant supply of government debt and weakening demand;

· This week, Treasury Secretary Bennett announced that the U.S. Treasury will buy U.S. Treasuries, but with limited room to maneuver. Many have asked me if these events align with the classic template described in the book. The answer is yes. To predict what might happen next, it is necessary to reexamine this template.

In the book, I elaborated on how the government-level debt/currency restructuring process typically unfolds and provided calculations to demonstrate the extent of imbalance between new debt supply and debt rollover demand. This set of calculations can serve as a template for comparing reality and anticipating the future. If you are a market participant who needs to thoroughly understand this template at a detailed level to seize market opportunities, I recommend reading the entire book. If you do not need that level of depth and do not want to spend that much time, you can read the following five-minute mechanism summary.

How the Mechanism Works

The debt dynamics of a central government follow the same logic as that of individuals or businesses, with the key difference being that the central government has a central bank that can print money (leading to currency devaluation) and can extract funds from the public through taxation. Therefore, if you can imagine how you or your business would operate under the conditions of "printing money" and taxation, you can understand this dynamic. However, remember that your goal is to ensure the entire system functions well—not just for yourself, but for all citizens.

In my view, the credit/market system is like the circulatory system of the human body, delivering nutrients to all parts of the body composed of markets and the real economy. If credit is used effectively, it can create enough productivity and income to repay principal and interest, which is healthy. However, if credit is misused and fails to generate sufficient income to repay principal and interest, the debt burden will accumulate like plaque, squeezing out other expenditures. When the debt repayment becomes very large, a debt repayment problem arises and eventually evolves into a debt rollover problem because bondholders are unwilling to extend further and only want to sell. This naturally leads to a shortage of demand for bonds and other debt instruments and a selloff. When demand is in short supply relative to supply, either 1) interest rates rise, dragging down the market and the economy, or 2) the central bank "prints money" and buys debt, devaluing the currency, thereby raising the original level of inflation. Printing money will also artificially lower interest rates, impairing the return of lenders. Neither path is good. When the scale of debt selloff becomes uncontrollable and the central bank has already bought a large amount of bonds, rising interest rates will cause the central bank to incur losses, thereby damaging its cash flow. If this situation persists, the central bank will eventually fall into negative net worth.

When the situation becomes serious, both the central government and the central bank will borrow to meet debt obligations. Due to insufficient demand in the free market, the central bank prints money to provide loans, thus initiating a self-reinforcing spiral of "debt-money printing-inflation."

In summary, three key indicators to watch are as follows:

1. The scale of government debt payments relative to government revenue (similar to the amount of plaque in the human circulatory system);

2. The amount of government debt for sale relative to the demand for government debt (similar to plaque shedding, triggering a heart attack);

3. The scale of central bank money printing to purchase government debt to fill the gap between demand for government debt and the available supply (similar to the central bank injecting a powerful dose of liquidity/credit to alleviate liquidity stress, resulting in more debt, which then becomes a liability for the central bank).

These indicators typically continue to rise over a period of several decades—the debt and debt payments relative to income keep increasing—until it becomes unsustainable for one of three reasons: 1) Debt payments excessively crowd out other expenditures to an intolerable level; 2) The supply of debt that must be absorbed is too large relative to the demand, leading to a sharp increase in interest rates, causing a significant market and economic downturn; or 3) The central bank refuses to allow interest rates to rise, witnessing a deterioration in the market and real economy, and thus resorts to massive money printing and purchasing of government debt to fill the demand gap, resulting in a substantial devaluation of currency. Regardless of the path taken, bond returns will be very poor until the currency and debt become cheap enough to attract demand and/or the government can repurchase or restructure the debt at a low cost.

This is the most basic overview of the large debt cycle.

Since these indicators are quantifiable, we can continually monitor the evolution of debt dynamics, making it easy to see the approach of the problem. I have always used this diagnostic method in investing and have kept it a secret, but now I have detailed it in "How Nations Go Bankrupt: The Big Cycle" because it is too important to keep to myself.

More specifically, you can observe: the continuous increase in debt and debt payments relative to income; debt supply exceeding debt demand; the central bank first lowering interest rates and providing loose stimulus, then turning to money printing to buy debt, eventually leading to its own losses and negative net worth; the central government leveraging up continuously to meet debt payments, while the central bank monetizes the debt. All of these lead to a government debt crisis—equivalent to an economic heart attack: expenditure supported by debt contracts, cutting off the normal flow of the economic circulatory system.

In the early stages of the final phase of the large debt cycle, market performance will reflect this dynamic: rising interest rates, with long-term rates leading the rise, currency devaluation, especially relative to gold devaluation, and the central government's finance department shortening the debt issuance maturity due to insufficient long-term debt demand. Typically, in the late stage of the cycle when the dynamic is most intense, a series of seemingly extreme measures will be implemented, such as imposing capital controls, exerting strong pressure on creditors to force them to buy debt and prohibiting them from selling debt. The book provides a more comprehensive explanation of this dynamic and is accompanied by numerous charts and data to illustrate its evolution.

The U.S. Government's Dilemma: A Brief Overview

Now, imagine that you are running a large enterprise named the "U.S. Government." This perspective will help you understand the financial situation of the U.S. government and the choices made by its leadership.

This year, total revenue is around $5.5 trillion, while total spending is around $7.5 trillion, resulting in a budget deficit of around $2 trillion. In other words, this year, this organization's spending will exceed its income by about 40%. The room for spending cuts is very limited because almost all expenditures are either previously committed or necessary. Due to the organization's long-standing significant borrowing, it has accumulated a huge debt—about 6 times its annual income (around $32 trillion), equivalent to about $240,000 per household you are responsible for. The interest bill on this debt is around $1 trillion, about 20% of this enterprise's revenue, also equivalent to half of this year's budget deficit—and these deficits still need to be financed by borrowing. However, $1 trillion is not all you owe to creditors because in addition to interest, you also need to repay maturing principal, around $10 trillion. You hope creditors either roll over the debt or lend you the money. Therefore, debt service—meaning the principal and interest that must be repaid to avoid default—is around $11 trillion, about 200% of the incoming funds.

This is the current situation.

So, what happens next? Let's speculate. You will borrow to fill the deficit, no matter how large it ends up being. There are various opinions on how large the deficit will be. Accounting for recent budget reconciliation bills, most independent assessment organizations project that in 10 years, U.S. debt will reach $55 to $60 trillion (about 7 times revenue) as there will be an additional $25 to $30 trillion in borrowing. Of course, in 10 years, this organization will face heavier debt service squeezing other expenditures, and without a plan, the risk of unsold debt finding insufficient demand will increase.

My "3% Rule" Solution

I am confident in my assessment that the U.S. government's financial situation is at a turning point because if not addressed now, debt will accumulate to a level that will be difficult to manage without significant damage, and more importantly, this action should take place while the system is relatively robust, not when it is weak. This is because when the economy contracts, the government's borrowing needs will rise significantly.

Based on my analysis, I believe this situation needs to be addressed through what I call the "3% Rule," which involves capping the budget deficit at 3% of GDP and balancing among three ways to reduce the deficit: 1) spending cuts, 2) increased tax revenue, and 3) lowered interest rates. All three must move forward simultaneously to prevent any one from being too aggressive—because if any one is overly forceful, the adjustment process will be traumatic. Furthermore, these adjustments should be achieved through sound fundamental adjustments, not through coercion (for example, forcefully lowering interest rates by the Fed is a very bad practice). According to my calculations, relative to current plans, spending cuts and tax revenue increases of about 5% each, along with a corresponding 1 to 1.5 percentage point reduction in interest rates, will reduce interest expenses as a share of GDP by 1 to 2 percentage points over the next decade and stimulate asset prices and economic activity to a much greater extent, thereby generating much more revenue.

Frequently Asked Questions and My Answers

The book contains much more content than this article, including a description of the "Long-term Debt Cycle" (comprising the debt/credit/money cycle, domestic political cycle, external geopolitical cycle, natural events, and technological progress) that drives all major changes in the world; my views on potential future scenarios; and some perspectives on how to invest in this series of changes. But for now, I'll start by answering some of the questions I'm often asked when recommending this book. If you'd like to delve deeper, please feel free to read the entire book.

Q1: Why do large government debt crises and long debt cycles occur?

Large government debt crises and long debt cycles occur for easily measurable reasons: 1) Government interest payments as a proportion of government revenue rise to levels that squeeze out necessary government spending; 2) The volume of debt offerings by the government exceeds demand, causing interest rates to rise, leading to a market and economic downturn; 3) Central banks, in response to these conditions, use low interest rates, which weaken bond demand, forcing central banks to print money to buy government debt, resulting in currency devaluation. These indicators typically rise over a period of several decades until they can no longer be sustained—either because 1) interest payments excessively crowd out other spending or 2) the supply of debt to be purchased is far too large relative to demand, causing interest rates to spike, leading to a deep market and economic decline or 3) the central bank prints a large amount of money, buying government debt in quantity to fill the demand gap, causing significant currency devaluation. Whichever path is taken, bond returns are very poor until they become cheap enough to attract demand and/or until the debt is restructured. These indicators are easily measurable, and people can clearly see them evolving into an imminent debt crisis. When debt-supported spending begins to contract, the crisis unfolds—similar to a heart attack triggered by debt.

Throughout history, almost every country has experienced this debt cycle, often multiple times, providing hundreds of historical cases for study, some of which can be traced back to the dawn of recorded history. In other words, all monetary orders eventually collapse, and the debt cycle mechanism I describe is the driving force behind these collapses. The decline of all reserve currencies, such as the pound, and those that came before, like the Dutch guilder, stems from this. I have listed the most recent 35 cases in the book.

Q2: If this process occurs repeatedly, why is the underlying mechanism not well known?

You are correct that this mechanism is not fully understood. Interestingly, I couldn't find any research on how it operates. My speculation is that it is not well understood because the collapse of monetary orders in reserve currency countries typically occurs only once in a lifetime, and when it happens in non-reserve currency countries, people assume it is an issue that reserve currency countries are immune to. The only reason I could discover this mechanism is that I witnessed it firsthand in sovereign bond market investments, prompting me to study numerous related historical cases to be prepared to respond calmly (e.g., to the 2008 global financial crisis and subsequent European debt crisis).

Q3: How Concerned Should We Be About a “Debt Heart Attack” in the U.S. Before the Debt Crisis Hits? People have heard too much about an imminent “debt crisis” that never seems to materialize. What makes this time different?

I think we should be very concerned, precisely because of the conditions I mentioned earlier. I believe that those who were concerned about a debt crisis even when the situation was less dire were correct to be worried, as taking action earlier could have prevented things from deteriorating to the current point, much like a doctor warning a patient about the dangers of smoking and overeating. Therefore, I speculate that the reason this issue has not raised more widespread concern is partly due to a lack of full understanding and partly because prior premature warnings have led to a great deal of complacency. It's like someone with clogged arteries who continues to eat high-fat foods and never exercises saying to the doctor, “You warned me a long time ago that I would be in trouble if I didn't change my lifestyle, but I haven't had a heart attack yet. Why should I believe you now?”

Q4: Today, What Could Serve as a Catalyst for the U.S. Debt Crisis? When Might It Occur? What Would Such a Crisis Look Like?

The catalyst will be the convergence of the various impacts mentioned earlier. As for timing, policy and exogenous factors—such as significant political shifts and war—can hasten or delay its onset. For example, if the budget deficit were to decrease from around 7% of GDP, as I and most people expect, to around 3%, the risk would be significantly reduced. If a major external shock occurs, the crisis could come sooner; if not, it could be postponed, or even averted (assuming proper management). My guess—and it is just that—is that if we stay on the current path, the crisis will come within three years, with a margin of error of two years.

Q5: Are you aware of any precedents where significant budget deficit reductions have been achieved with positive results?

Yes, I am aware of several. My proposal would reduce the budget deficit by about 4 percentage points of GDP. The closest parallel to a successful precedent is the United States from 1991 to 1998, when the budget deficit was reduced by 5 percentage points of GDP. I also cite several similar cases from other countries in my book.

Q6: Some argue that the U.S., due to the dominance of the dollar in the global economy, may not be as vulnerable to debt-related issues/crises overall. What do you think those holding this view are overlooking?

If they think that way, they fail to understand the mechanisms and historical lessons involved. More specifically, they should delve into history to understand why all past reserve currencies eventually ceased to be reserve currencies. Put bluntly: a currency and debt must serve as effective stores of wealth, or they will be devalued and abandoned. The dynamics I describe are precisely how a reserve currency loses its effectiveness as a store of wealth.

Q7: Japan — where its debt-to-GDP ratio is as high as 215%, the highest among advanced economies — is often cited as “an example of a country that can endure a high debt burden without a debt crisis.” Why are you not particularly comforted by Japan's experience?

Japan's case is confirming, and will continue to confirm, the issues I have described, it is the embodiment of my theory in reality. Specifically, due to the extremely high level of over-indebtedness of the Japanese government, Japanese bonds and debt have always been a bad investment. In order to compensate for the lack of demand for Japanese debt assets at interest rates low enough and favorable to Japan, the Bank of Japan has extensively printed money and massively purchased Japanese government bonds, resulting in investors holding Japanese bonds experiencing a 51% loss relative to holding U.S. bonds and a 76% loss relative to holding gold since 2013. Since 2013, in terms of a common currency, the wages of Japanese ordinary workers have declined by 55% relative to U.S. workers. I delve into Japan's case extensively in a whole chapter in my book.

Q8: From a fiscal perspective, which regions in the world have particularly pronounced issues that people may underestimate?

Most economies face similar debt and deficit issues — the U.K., E.U., China, and Japan are no exception. It is for this reason that I expect most economies to go through a similar debt restructuring and currency devaluation process, which is also why I expect non-governmental production currencies like gold and Bitcoin to perform relatively well.

Q9: How should investors deal with this risk/position themselves for the future?

As a general recommendation, I suggest that everyone should have a diversified allocation across asset classes and countries, preferably selecting countries with robust income statements and balance sheets and without significant domestic political or external geopolitical conflicts; underweight debt assets such as bonds, overweight gold, and a small amount of Bitcoin. Allocating a small portion of funds — like 10% to 15% — to gold can reduce portfolio risk, and I believe it can also enhance its returns.

Source

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