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Ray Dalios Study of Big Debt Crises

We believe Ray Dalio to be one of the most believable sources for global macro thinking. This was such an important book that we all read it during our summer break and spent two days reviewing its contents and anything we should include in our process. Below are our notes.

Two things of note from our observations - "pushing on a string" with stimulus and also alternative forms of financing emerging with Buy Now Pay Later and debtor factoring.

How I think about credit & debt 

  • From my experiences and my research, I have learned that too little credit/ debt growth can create as bad or worse economic problems as having too much, with the costs coming in the form of foregone opportunities.

  • To give you an idea of what that might mean for an economy as a whole, really bad debt losses have been when roughly 40 percent of a loan’s value couldn’t be paid back. Those bad loans amount to about 20 percent of all the outstanding loans, so the losses are equal to about 8 percent of total debt. That total debt, in turn, is equal to about 200 percent of income (e.g., GDP), so the shortfall is roughly equal to 16 percent of GDP. If that cost is “socialized” (i.e., borne by the society as a whole via fiscal and/ or monetary policies) and spread over 15 years, it would amount to about 1 percent per year, which is tolerable. Of course, if not spread out, the costs would be intolerable. For that reason, I am asserting that the downside risks of having a significant amount of debt depends a lot on the willingness and the ability of policy makers to spread out the losses arising from bad debts. I have seen this in all the cases I have lived through and studied. Whether policy makers can do this depends on two factors: 1) whether the debt is denominated in the currency that they control and 2) whether they have influence over how creditors and debtors behave with each other.

  • Are Debt Crises Inevitable? Throughout history only a few well-disciplined countries have avoided debt crises. That’s because lending is never done perfectly and is often done badly due to how the cycle affects people’s psychology to produce bubbles and busts. While policy makers generally try to get it right, more often than not they err on the side of being too loose with credit because the near-term rewards (faster growth) seem to justify it. It is also politically easier to allow easy credit (e.g., by providing guarantees, easing monetary policies) than to have tight credit. That is the main reason we see big debt cycles.

  • you create a cycle virtually anytime you borrow money. Buying something you can’t afford means spending more than you make. You’re not just borrowing from your lender; you are borrowing from your future self. Essentially, you are creating a time in the future in which you will need to spend less than you make so you can pay it back. The pattern of borrowing, spending more than you make, and then having to spend less than you make very quickly resembles a cycle. This is as true for a national economy as it is for an individual. Borrowing money sets a mechanical, predictable series of events into motion.

  • Lending naturally creates self-reinforcing upward movements that eventually reverse to create self-reinforcing downward movements that must reverse in turn. During the upswings, lending supports spending and investment, which in turn supports incomes and asset prices; increased incomes and asset prices support further borrowing and spending on goods and financial assets. The borrowing essentially lifts spending and incomes above the consistent productivity growth of the economy. Near the peak of the upward cycle, lending is based on the expectation that the above-trend growth will continue indefinitely. But, of course, that can’t happen; eventually income will fall below the cost of the loans.

  • Economies whose growth is significantly supported by debt-financed building of fixed investments, real estate, and infrastructure are particularly susceptible to large cyclical swings because the fast rates of building those long-lived assets are not sustainable.

  • This type of cycle—where a strong growth upswing driven by debt-financed real estate, fixed investment, and infrastructure spending is followed by a downswing driven by a debt-challenged slowdown in demand—is very typical of emerging economies because they have so much building to do.

  • Contributing further to the cyclicality of emerging countries’ economies are changes in their competitiveness due to relative changes in their incomes. Typically, they have very cheap labor and bad infrastructure, so they build infrastructure, have an export boom, and experience rising incomes. But the rate of growth due to exports naturally slows as their income levels rise and their wage competitiveness relative to other countries declines. There are many examples of these kinds of cycles (i.e., Japan’s experience over the last 70 years)

  • One classic warning sign that a bubble is coming is when an increasing amount of money is being borrowed to make debt service payments, which of course compounds the borrowers’ indebtedness

  • When money and credit growth are curtailed and/ or higher lending standards are imposed, the rates of credit growth and spending slow and more debt service problems emerge.

  • In either case, when the costs of debt service become greater than the amount that can be borrowed to finance spending, the upward cycle reverses. Not only does new lending slow down, but the pressure on debtors to make their payments is increased.

  • The two main long-term problems that emerge from these kinds of debt cycles are:

    1. The losses arising from the expected debt service payments not being made.

    2. The reduction of lending and the spending it was financing going forward.

  • Can Most Debt Crises Be Managed so There Aren’t Big Problems?

    • In this study we examine ones that are extreme—i.e., all those in the last 100 years that produced declines in real GDP of more than 3 percent.

    • Based on my examinations of them and the ways the levers available to policy makers work, I believe that it is possible for policy makers to manage them well in almost every case that the debts are denominated in a country’s own currency.

  • Most of the really terrible economic problems that debt crises have caused occurred before policy makers took steps to spread them out. Even the biggest debt crises in history (e.g., the 1930s Great Depression) were gotten past once the right adjustments were made. From my examination of these cases, the biggest risks are not from the debts themselves but from a) the failure of policy makers to do the right things, due to a lack of knowledge and/ or lack of authority, and b) the political consequences of making adjustments that hurt some people in the process of helping others. It is from a desire to help reduce these risks that I have written this study.

  • Having said that, I want to reiterate that 1) when debts are denominated in foreign currencies rather than one’s own currency, it is much harder for a country’s policy makers to do the sorts of things that spread out the debt problems, and 2) the fact that debt crises can be well-managed does not mean that they are not extremely costly to some people.

  • There are four types of levers that policy makers can pull to bring debt and debt service levels down relative to the income and cash flow levels that are required to service them:

    • Austerity (i.e., spending less)

    • Debt defaults/ restructurings

    • The central bank “printing money” and making purchases (or providing guarantees)

    • Transfers of money and credit from those who have more than they need to those who have less

  • Each one of their levers has different impacts on the economy. Some are inflationary and stimulate growth (e.g., “printing money”), while others are deflationary and help reduce debt burdens (e.g., austerity and defaults). The key to creating a “beautiful deleveraging” (a reduction in debt/ income ratios accompanied by acceptable inflation and growth rates, which I explain later) lies in striking the right balance between them. In this happy scenario, debt-to-income ratios decline at the same time that economic activity and financial asset prices improve, gradually bringing the nominal growth rate of incomes back above the nominal interest rate.

The Template for the Archetypal Long-Term/ Big Debt Cycle

  • For clarity, I divided the affected countries into two groups:

    • 1) Those that didn’t have much of their debt denominated in foreign currency and that didn’t experience inflationary depressions, and

    • 2) those that had a significant amount of their debt denominated in foreign currency and did experience inflationary depressions. Since there was about a 75 percent correlation between the amounts of their foreign debts and the amounts of inflation that they experienced (which is not surprising, since having a lot of their debts denominated in foreign currency was a cause of their depressions being inflationary), it made sense to group those that had more foreign currency debt with those that had inflationary depressions.

  • Typically debt crises occur because debt and debt service costs rise faster than the incomes that are needed to service them, causing a deleveraging.

  • Classically, a lot of short-term debt cycles (i.e., business cycles) add up to a long-term debt cycle, because each short-term cyclical high and each short-term cyclical low is higher in its debt-to-income ratio than the one before it, until the interest rate reductions that helped fuel the expansion in debt can no longer continue.

  • While the chart gives a good general picture, I should make clear that it is inadequate in two respects:

    • 1) it doesn’t convey the differences between the various entities that make up these total numbers, which are very important to understand, and 

    • 2) it just shows what is called debt, so it doesn’t reflect liabilities such as pension and health care obligations, which are much larger.

Our Examination of the Cycle

  • The statistics reflected in the charts of the phases were derived by averaging 21 deflationary debt cycle cases and 27 inflationary debt cycle cases, starting five years before the bottom of the depression and continuing for seven years after it.

  • Notably long-term debt cycles appear similar in many ways to short-term debt cycles, except that they are more extreme, both because the debt burdens are higher and the monetary policies that can address them are less effective.

  • For the most part, short-term debt cycles produce bumps—mini-booms and recessions—while big long-term ones produce big booms and busts. Over the last century, the US has gone through a long-term debt crisis twice—once during the boom of the 1920s and the Great Depression of the 1930s, and again during the boom of the early 2000s and the financial crisis starting in 2008.

  • During the upswing of the long-term debt cycle, lenders extend credit freely even as people become more indebted. That’s because the process is self-reinforcing on the upside—rising spending generates rising incomes and rising net worths, which raises borrowers’ capacities to borrow, which allows more buying and spending, etc. Most everyone is willing to take on more risk. Quite often new types of financial intermediaries and new types of financial instruments develop that are outside the supervision and protection of regulatory authorities. That puts them in a competitively attractive position to offer higher returns, take on more leverage, and make loans that have greater liquidity or credit risk. With credit plentiful, borrowers typically spend more than is sustainable, giving them the appearance of being prosperous. In turn, lenders, who are enjoying the good times, are more complacent than they should be. But debts can’t continue to rise faster than the money and income that is necessary to service them forever, so they are headed toward a debt problem.

  • When the limits of debt growth relative to income growth are reached, the process works in reverse. Asset prices fall, debtors have problems servicing their debts, and investors get scared and cautious, which leads them to sell, or not roll over, their loans. This, in turn, leads to liquidity problems, which means that people cut back on their spending. And since one person’s spending is another person’s income, incomes begin to go down, which makes people even less creditworthy. Asset prices fall, further squeezing banks, while debt repayments continue to rise, making spending drop even further. The stock market crashes and social tensions rise along with unemployment, as credit and cash-starved companies reduce their expenses. The whole thing starts to feed on itself the other way, becoming a vicious, self-reinforcing contraction that’s not easily corrected. Debt burdens have simply become too big and need to be reduced. Unlike in recessions, when monetary policies can be eased by lowering interest rates and increasing liquidity, which in turn increase the capacities and incentives to lend, interest rates can’t be lowered in depressions. They are already at or near zero and liquidity/ money can’t be increased by ordinary measures. This is the dynamic that creates long-term debt cycles. It has existed for as long as there has been credit, going back to before Roman times. Even the Old Testament described the need to wipe out debt once every 50 years, which was called the Year of Jubilee. Like most dramas, this one both arises and transpires in ways that have reoccurred throughout history.

  • In this study we will examine big debt cycles that produce big debt crises, exploring how they work and how to deal with them well. But before we begin, I want to clarify the differences between the two main types: deflationary and inflationary depressions.

    • In deflationary depressions, policy makers respond to the initial economic contraction by lowering interest rates. But when interest rates reach about 0 percent, that lever is no longer an effective way to stimulate the economy. Debt restructuring and austerity dominate, without being balanced by adequate stimulation (especially money printing and currency depreciation). In this phase, debt burdens (debt and debt service as a percent of income) rise, because incomes fall faster than restructuring, debt paydowns reduce the debt stock, and many borrowers are required to rack up still more debts to cover those higher interest costs. As noted, deflationary depressions typically occur in countries where most of the unsustainable debt was financed domestically in local currency, so that the eventual debt bust produces forced selling and defaults, but not a currency or a balance of payments problem.

    • Inflationary depressions classically occur in countries that are reliant on foreign capital flows and so have built up a significant amount of debt denominated in foreign currency that can’t be monetized (i.e., bought by money printed by the central bank). When those foreign capital flows slow, credit creation turns into credit contraction. In an inflationary deleveraging, capital withdrawal dries up lending and liquidity at the same time that currency declines produce inflation. Inflationary depressions in which a lot of debt is denominated in foreign currency are especially difficult to manage because policy makers’ abilities to spread out the pain are more limited.

  • Throughout the Middle Ages, Christians could generally not legally charge interest to other Christians. This is one reason why Jews played a large part in the development of trade, as they lent money for business ventures and financed voyages. But Jews were also the holders of the loans that debtors sometimes could not repay. Many historical instances of violence against Jews were driven by debt crises.

The Phases of the Classic Deflationary Debt Cycle

  • The chart below illustrates the seven stages of an archetypal long-term debt cycle, by tracking the total debt of the economy as a percentage of the total income of the economy (GDP) and the total amount of debt service payments relative to GDP over a period of 12 years.

1) The Early Part of the Cycle

  • In the early part of the cycle, debt is not growing faster than incomes, even though debt growth is strong. That is because debt growth is being used to finance activities that produce fast income growth. For instance, borrowed money may go toward expanding a business and making it more productive, supporting growth in revenues. Debt burdens are low and balance sheets are healthy, so there is plenty of room for the private sector, government, and banks to lever up. Debt growth, economic growth, and inflation are neither too hot nor too cold. This is what is called the “Goldilocks” period.

2) The Bubble

  • In the first stage of the bubble, debts rise faster than incomes, and they produce accelerating strong asset returns and growth. This process is generally self-reinforcing because rising incomes, net-worths, and asset values raise borrowers’ capacities to borrow. This happens because lenders determine how much they can lend on the basis of the borrowers’ 1) projected income/ cash flows to service the debt, 2) net worth/ collateral (which rises as asset prices rise), and 3) their own capacities to lend. All of these rise together. Though this set of conditions is not sustainable because the debt growth rates are increasing faster than the incomes that will be required to service them, borrowers feel rich, so they spend more than they earn and buy assets at high prices with leverage. Here’s one example of how that happens: Suppose you earn $ 50,000 a year and have a net worth of $ 50,000. You have the capacity to borrow $ 10,000 per year, so you could spend $ 60,000 per year for a number of years, even though you only earn $ 50,000. For an economy as a whole, increased borrowing and spending can lead to higher incomes, and rising stock valuations and other asset values, giving people more collateral to borrow against. People then borrow more and more, but as long as the borrowing drives growth, it is affordable. In this up-wave part of the long-term debt cycle, promises to deliver money (i.e., debt burdens) rise relative to both the supply of money in the overall economy and the amount of money and credit debtors have coming in (via incomes, borrowing, and sales of assets). This up-wave typically goes on for decades, with variations primarily due to central banks’ periodic tightenings and easings of credit. These are short-term debt cycles, and a bunch of them generally add up to a long-term debt cycle. A key reason the long-term debt cycle can be sustained for so long is that central banks progressively lower interest rates, which raises asset prices and, in turn, people’s wealth, because of the present value effect that lowering interest rates has on asset prices. This keeps debt service burdens from rising, and it lowers the monthly payment cost of items bought on credit. But this can’t go on forever. Eventually the debt service payments become equal to or larger than the amount debtors can borrow, and the debts (i.e., the promises to deliver money) become too large in relation to the amount of money in existence there is to give. When promises to deliver money (i.e., debt) can’t rise any more relative to the money and credit coming in, the process works in reverse and deleveraging begins. Since borrowing is simply a way of pulling spending forward, the person spending $ 60,000 per year and earning $ 50,000 per year has to cut his spending to $ 40,000 for as many years as he spent $ 60,000, all else being equal. Though a bit of an oversimplification, this is the essential dynamic that drives the inflating and deflating of a bubble. The Start of a Bubble: The Bull Market Bubbles usually start as over-extrapolations of justified bull markets. The bull markets are initially justified because lower interest rates make investment assets, such as stocks and real estate, more attractive so they go up, and economic conditions improve, which leads to economic growth and corporate profits, improved balance sheets, and the ability to take on more debt—all of which make the companies worth more. As assets go up in value, net worths and spending/ income levels rise. Investors, business people, financial intermediaries, and policy makers increase their confidence in ongoing prosperity, which supports the leveraging-up process. The boom also encourages new buyers who don’t want to miss out on the action to enter the market, fueling the emergence of a bubble. Quite often, uneconomic lending and the bubble occur because of implicit or explicit government guarantees that encourage lending institutions to lend recklessly. As new speculators and lenders enter the market and confidence increases, credit standards fall. Banks lever up and new types of lending institutions that are largely unregulated develop (these non-bank lending institutions are referred to collectively as a “shadow banking” system). These shadow banking institutions are typically less under the blanket of government protections. At these times, new types of lending vehicles are frequently invented and a lot of financial engineering takes place. The lenders and the speculators make a lot of fast, easy money, which reinforces the bubble by increasing the speculators’ equity, giving them the collateral they need to secure new loans. At the time, most people don’t think that is a problem; to the contrary, they think that what is happening is a reflection and confirmation of the boom. This phase of the cycle typically feeds on itself. Taking stocks as an example, rising stock prices lead to more spending and investment, which raises earnings, which raises stock prices, which lowers credit spreads and encourages increased lending (based on the increased value of collateral and higher earnings), which affects spending and investment rates, etc. During such times, most people think the assets are a fabulous treasure to own—and consider anyone who doesn’t own them to be missing out. As a result of this dynamic, all sorts of entities build up long positions. Large asset-liability mismatches increase in the forms of a) borrowing short-term to lend long-term, b) taking on liquid liabilities to invest in illiquid assets, and c) investing in riskier debt or other risky assets with money borrowed from others, and/ or d) borrowing in one currency and lending in another, all to pick up a perceived spread. All the while, debts rise fast and debt service costs rise even faster. The charts below paint the picture. In markets, when there’s a consensus, it gets priced in. This consensus is also typically believed to be a good rough picture of what’s to come, even though history has shown that the future is likely to turn out differently than expected. In other words, humans by nature (like most species) tend to move in crowds and weigh recent experience more heavily than is appropriate. In these ways, and because the consensus view is reflected in the price, extrapolation tends to occur. 

  • The typical bubble sees leveraging up at an average rate of 20 to 25 percent of GDP over three years or so.

  • Bubbles are most likely to occur at the tops in the business cycle, balance of payments cycle, and/ or long-term debt cycle.

  • In the cases we studied, total debt-to-income levels averaged around 300 percent of GDP. To convey a few rough average numbers, below we show some key indications of what the archetypal bubble looks like:

Insert table The Role of Monetary Policy

  • This is one of the biggest problems with most central bank policies—i.e., because central bankers target either inflation or inflation and growth and don’t target the management of bubbles, the debt growth that they enable can go to finance the creation of bubbles if inflation and real growth don’t appear to be too strong. In my opinion it’s very important for central banks to target debt growth with an eye toward keeping it at a sustainable level—i.e., at a level where the growth in income is likely to be large enough to service the debts regardless of what credit is used to buy. Central bankers sometimes say that it is too hard to spot bubbles and that it’s not their role to assess and control them—that it is their job to control inflation and growth. 4 But what they control is money and credit, and when that money and credit goes into debts that can’t be paid back, that has huge implications for growth and inflation down the road. The greatest depressions occur when bubbles burst, and if the central banks that are producing the debts that are inflating them won’t control them, then who will? The economic pain of allowing a large bubble to inflate and then burst is so high that it is imprudent for policy makers to ignore them, and I hope their perspective will change.

  • While central banks typically do tighten money somewhat and short rates rise on average when inflation and growth start to get too hot, typical monetary policies are not adequate to manage bubbles, because bubbles are occurring in some parts of the economy and not others. Thinking about the whole economy, central banks typically fall behind the curve during such periods, and borrowers are not yet especially squeezed by higher debt-service costs. Quite often at this stage, their interest payments are increasingly being covered by borrowing more rather than by income growth—a clear sign that the trend is unsustainable. All this reverses when the bubble pops and the same linkages that inflated the bubble make the downturn self-reinforcing. Falling asset prices decrease both the equity and collateral values of leveraged speculators, which causes lenders to pull back. This forces speculators to sell, driving down prices even more. Also, lenders and investors “run” (i.e., withdraw their money) from risky financial intermediaries and risky investments, causing them to have liquidity problems. Typically, the affected market or markets are big enough and leveraged enough that the losses on the accumulated debt are systemically threatening, which is to say that they threaten to topple the entire economy.

Spotting Bubbles

  • If one holds a strong mental map of how bubbles form, it becomes much easier to identify them.

  • To identify a big debt crisis before it occurs, I look at all the big markets and see which, if any, are in bubbles. Then I look at what’s connected to them that would be affected when they pop. While I won’t go into exactly how it works here, the most defining characteristics of bubbles that can be measured are: Prices are high relative to traditional measures Prices are discounting future rapid price appreciation from these high levels There is broad bullish sentiment Purchases are being financed by high leverage Buyers have made exceptionally extended forward purchases (e.g., built inventory, contracted for supplies, etc.) to speculate or to protect themselves against future price gains New buyers (i.e., those who weren’t previously in the market) have entered the market Stimulative monetary policy threatens to inflate the bubble even more (and tight policy to cause its popping)

  • At this point I want to emphasize that it is a mistake to think that any one metric can serve as an indicator of an impending debt crisis. The ratio of debt to income for the economy as a whole, or even debt service payments to income for the economy as a whole, which is better, are useful but ultimately inadequate measures. To anticipate a debt crisis well, one has to look at the specific debt-service abilities of the individual entities, which are lost in these averages. More specifically, a high level of debt or debt service to income is less problematic if the average is well distributed across the economy than if it is concentrated—especially if it is concentrated in key entities.

3) The Top

  • While tops are triggered by different events, most often they occur when the central bank starts to tighten and interest rates rise.

  • The riskiest debtors start to miss payments, lenders begin to worry, credit spreads start to tick up, and risky lending slows. Runs from risky assets to less risky assets pick up, contributing to a broadening of the contraction.

  • Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates (i.e., the extra interest rate earned for lending long term rather than short term), lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted (i.e., long-term interest rates are at their lowest relative to short-term interest rates), people are incentivized to move to cash just before the bubble pops, slowing credit growth and causing the previously described dynamic.

  • Early on in the top, some parts of the credit system suffer, but others remain robust, so it isn’t clear that the economy is weakening. So while the central bank is still raising interest rates and tightening credit, the seeds of the recession are being sown. The fastest rate of tightening typically comes about five months prior to the top of the stock market. The economy is then operating at a high rate, with demand pressing up against the capacity to produce. Unemployment is normally at cyclical lows and inflation rates are rising. The increase in short-term interest rates makes holding cash more attractive, and it raises the interest rate used to discount the future cash flows of assets, weakening riskier asset prices and slowing lending. It also makes items bought on credit de facto more expensive, slowing demand. Short rates typically peak just a few months before the top in the stock market.

  • The more leverage that exists and the higher the prices, the less tightening it takes to prick the bubble and the bigger the bust that follows. To understand the magnitude of the downturn that is likely to occur, it is less important to understand the magnitude of the tightening than it is to understand each particular sector’s sensitivity to tightening and how losses will cascade. These pictures are best seen by looking at each of the important sectors of the economy and each of the big players in these sectors rather than at economy-wide averages.

  • In the immediate postbubble period, the wealth effect of asset price movements has a bigger impact on economic growth rates than monetary policy does. People tend to underestimate the size of this effect. In the early stages of a bubble bursting, when stock prices fall and earnings have not yet declined, people mistakenly judge the decline to be a buying opportunity and find stocks cheap in relation to both past earnings and expected earnings, failing to account for the amount of decline in earnings that is likely to result from what’s to come. But the reversal is self-reinforcing. As wealth falls first and incomes fall later, creditworthiness worsens, which constricts lending activity, which hurts spending and lowers investment rates while also making it less appealing to borrow to buy financial assets. This in turn worsens the fundamentals of the asset (e.g., the weaker economic activity leads corporate earnings to chronically disappoint), leading people to sell and driving down prices further. This has an accelerating downward impact on asset prices, income, and wealth.

4) The “Depression”

  • In normal recessions (when monetary policy is still effective), the imbalance between the amount of money and the need for it to service debt can be rectified by cutting interest rates enough to 1) produce a positive wealth effect, 2) stimulate economic activity, and 3) ease debt-service burdens. This can’t happen in depressions, because interest rates can’t be cut materially because they have either already reached close to 0 percent or, in cases where currency outflows and currency weaknesses are great, the floor on interest rates is higher because of credit or currency risk considerations. This is precisely the formula for a depression. As shown, this happened in the early stage of both the 1930–32 depression and the 2008–09 depression. In well managed cases, like the US in 2007–08, the Fed lowered rates very quickly and then, when that didn’t work, moved on to alternative means of stimulating, having learned from its mistakes in the 1930s when the Fed was slower to ease and even tightened at times to defend the dollar’s peg to gold.

  • Both lenders’ and depositors’ justified fears feed on themselves, leading to runs on financial institutions that typically don’t have the cash to meet them unless they are under the umbrella of government protections.

  • The depression can come from, or cause, either solvency problems or cash-flow problems. Usually a lot of both types of problems exist during this phase. A solvency problem means that, according to accounting and regulatory rules, the entity does not have enough equity capital to operate—i.e., it is “broke” and must be shut down. So, the accounting laws have a big impact on the severity of the debt problem at this moment. A cash-flow problem means that an entity doesn’t have enough cash to meet its needs, typically because its own lenders are taking money away from it—i.e., there is a “run.” A cash-flow problem can occur even when the entity has adequate capital because the equity is in illiquid assets. Lack of cash flow is an immediate and severe problem—and as a result, the trigger and main issue of most debt crises.

  • Each kind of problem requires a different approach. If a solvency problem exists (i.e., the debtor doesn’t have enough equity capital), it has an accounting/ regulatory problem that can be dealt with by either a) providing enough equity capital or b) changing the accounting/ regulatory rules, which hides the problem.

  • A good example of how these forces are relevant is highlighted by the differences between the debt/ banking crises of the 1980s and 2008. In the 1980s, there was not as much mark-to-market accounting (because the crisis involved loans that weren’t traded every day in public markets), so the banks were not as “insolvent” as they were in 2008. With more mark-to-market accounting in 2008, the banks required capital injections and/ or guarantees to improve their balance sheets. Both crises were successfully managed, though the ways they were managed had to be different.

  • Going into the “depression” phase of the cycle (by which I mean the severe contraction phase) some protections learned from past depressions (e.g., bank-deposit insurance, the ability to provide lender-of-last-resort financial supports and guarantees and to inject capital into systemically important institutions or nationalize them) are typically in place and are helpful, but they are rarely adequate, because the exact nature of the debt crisis hasn’t been well thought through. Typically, quite a lot of lending has taken place in the relatively unregulated “shadow banking system,” or in new instruments that have unanticipated risks and inadequate regulations.

  • Related to this, if the central bank produces more money to alleviate the shortage, it will cheapen the value of money, making a reality of creditors’ worries about being paid back an amount of money that is worth less than what they loaned. While some people think that the amount of money in existence remains the same and simply moves from riskier assets to less risky ones, that’s not true. Most of what people think is money is really credit, and credit does appear out of thin air during good times and then disappear at bad times. For example, when you buy something in a store on a credit card, you essentially do so by saying, “I promise to pay.” Together you and the store owner create a credit asset and a credit liability. So where do you take the money from? Nowhere. You created credit. It goes away in the same way. Suppose the store owner rightly believes that you and others won’t pay the credit card company and that the credit card company won’t pay him. Then he correctly believes that the credit “asset” he has isn’t really there. It didn’t go somewhere else; it’s simply gone. As this implies, a big part of the deleveraging process is people discovering that much of what they thought of as their wealth was merely people’s promises to give them money. Now that those promises aren’t being kept, that wealth no longer exists. When investors try to convert their investments into money in order to raise cash, they test their ability to get paid, and in cases where it fails, panic-induced “runs” and sell-offs of securities occur. Naturally those who experience runs, especially banks (though this is true of most entities that rely on short-term funding), have problems raising money and credit to meet their needs, so debt defaults cascade.

  • The depression phase is dominated by the deflationary forces of debt reduction (i.e., defaults and restructurings) and austerity occurring without material efforts to reduce debt burdens by printing money. Because one person’s debts are another’s assets, the effect of aggressively cutting the value of those assets can be to greatly reduce the demand for goods, services, and investment assets.

  • For a write-down to be effective, it must be large enough to allow the debtor to service the restructured loan. If the write-down is 30 percent, then the creditor’s assets are reduced by that much. If that sounds like a lot, it’s actually much more. Since most lenders are leveraged (e.g., they borrow to buy assets), the impact of a 30 percent write-down on their net worth can be much greater. For example, the creditor who is leveraged 2: 1 would experience a 60 percent decline in his net worth (i.e., their assets are twice their net worth, so the decline in asset value has twice the impact). 7 Since banks are typically leveraged about 12: 1 or 15: 1, that picture is obviously devastating for them and for the economy as a whole.

  • Even as debts are written down, debt burdens rise as spending and incomes fall. Debt levels also rise relative to net worth, as shown in the chart below. As debt-to-income and debt-to-net-worth ratios go up and the availability of credit goes down, naturally the credit contraction becomes self-reinforcing on the downside.

  • The capitalist-investor class experiences a tremendous loss of “real” wealth during depressions because the value of their investment portfolios collapses (declines in equity prices are typically around 50 percent), their earned incomes fall, and they typically face higher tax rates. As a result, they become extremely defensive. Quite often, they are motivated to move their money out of the country (which contributes to currency weakness), dodge taxes, and seek safety in liquid, noncredit-dependent investments (e.g., low-risk government bonds, gold, or cash).

Managing Depressions

  • Policy makers typically get the mix between austerity, money printing, and redistribution wrong initially. Taxpayers are understandably angry at the debtors and at the financial institutions whose excesses caused the debt crisis, and don’t want the government (i.e., their taxes) to bail them out. And policy makers justifiably believe that debt excesses will happen again if lenders and borrowers don’t suffer the downsides of their actions (which is called the “moral hazard” problem). For all these reasons, policy makers are usually reluctant and slow to provide government supports, and the debt contraction and the agony it produces increase quickly. But the longer they wait to apply stimulative remedies to the mix, the uglier the deleveraging becomes. 8 Eventually they choose to provide a lot of guarantees, print a lot of money, and monetize a lot of debt, which lifts the economy into a reflationary deleveraging. If they do these things and get the mix right quickly, the depression is much more likely to be relatively short-lived (like the short period of “depression” following the US crisis in 2008). If they don’t, the depression is usually prolonged (like the Great Depression in the 1930s, or Japan’s “lost decade” following its bubble in the late 1980s)

  • To reiterate, the two biggest impediments to managing a debt crisis are: a) the failure to know how to handle it well and b) politics or statutory limitations on the powers of policy makers to take the necessary actions. In other words, ignorance and a lack of authority are bigger problems than debts themselves. While being a successful investment manager is hard, it’s not nearly as hard as being a successful economic policy maker.

  • Austerity In the depression phase, policy makers typically try austerity because that’s the obvious thing to do. It’s natural to want to let those who got themselves and others in trouble to bear the costs. The problem is that even deep austerity doesn’t bring debt and income back into balance. When spending is cut, incomes are also cut, so it takes an awful lot of painful spending cuts to make significant reductions in the debt/ income ratios. As the economy contracts, government revenues typically fall. At the same time, demands on the government increase. As a result, deficits typically increase. Seeking to be fiscally responsible, at this point governments tend to raise taxes. Both moves are big mistakes.

Printing Money” to Stop the Bleeding and Stimulate the Economy

  • During the Great Depression there were six big rallies in the stock market (of between 16 percent and 48 percent) in a bear market that declined a total of 89 percent. All of those rallies were triggered by government actions that were intended to reduce the fundamental imbalance. When they are managed well, those shifts in policies to “print money,” buy assets, and provide guarantees are what moves the debt cycle from its depression/“ ugly deleveraging” phase to its expansion/“ beautiful deleveraging” phase. The chart below shows how this “money printing” happened in the US in the 1930s and again after 2008.

  • While highly stimulative monetary policy is a critical part of a deleveraging, it is typically not sufficient. When risks emerge that systemically important institutions will fail, policy makers must take steps to keep these entities running. They must act immediately to:

  • Curtail panic and guarantee liabilities

    • Governments can increase guarantees on deposits and debt issuance. Central banks can provide systemically important institutions (i.e., institutions whose failures would threaten the ongoing operating of the financial system and/ or that of the economy) with injections of money. Occasionally, governments can force liquidity to remain in the banking system by imposing deposit freezes, which is generally undesirable because it intensifies the panic, but is sometimes necessary because there is no other way of providing that money/ liquidity.

  • Provide liquidity.

    • When private credit is contracting and liquidity is tight, the central bank can ensure that sufficient liquidity is provided to the financial system by lending against a widening range of collateral or to an increasingly wide range of financial institutions that are not normally considered part of their lending practices.

  • Support the solvency of systemically important institutions.

    • The first step is usually to incentivize the private sector to address the problem, often by supporting mergers between failed banks and healthy banks and by regulatory pushes to issue more capital to the private sector. In addition, accounting adjustments can be made to reduce the immediate need for capital to maintain solvency, buying more time for the institutions to earn their way out of their problems.

  • Recapitalize/ nationalize/ cover losses of systemically important financial institutions.

    • Certain institutions are part of the plumbing of the system; one would hate to lose them even if they’re not making money at the moment. It would be like losing a shipping port in a depression because the port goes broke.

Debt Defaults/ Restructurings

  • The best-managed cases are those in which policy makers a) swiftly recognize the magnitude of the credit problems; b) don’t save every institution that is expendable, balancing the benefits of allowing broke institutions to fail and be restructured with the risks that such failures can have detrimental effects on other creditworthy lenders and borrowers; c) create or restore robust credit pipes that allow for future borrowing by creditworthy borrowers; and d) ensure acceptable growth and inflation conditions while the bad debts are being worked out. Longer term, the most important decision that policy makers have to make is whether they will change the system to fix the root causes of the debt problems or simply restructure the debts so that the pain is distributed over the population and over time so that the debt does not impose an intolerable burden.

  • How quickly and aggressively policy makers respond is among the most important factors in determining the severity and length of the depression.

  • Typically, nonsystemically important institutions are forced to absorb their losses, and if they fail, are allowed to go bankrupt. The resolution of these institutions can take several different forms. In many cases (about 80 percent of the cases we studied), they are merged with healthy institutions. In some other cases, the assets are liquidated or transferred to an “asset-management company” (AMC) set up by the government to be sold piecemeal.

  • There are relatively clear lines for which creditors receive protections:

    • Small depositors are given preference and experience minimal or no losses (in nearly every case).

    • In around 30 percent of cases studied, depositors did take losses, though they were often on foreign-exchange deposits through conversion at below-market exchange rates. In most cases when institutions fail, equity, subordinated debt, and large depositors absorb losses regardless of whether the institution was systemically important or not.

    • Sometimes policy makers prioritize domestic creditors over foreign creditors, especially when their loans are to private-sector players and are lower down in the capital structure.

  • Typically, the process of dealing with the failed lenders is accompanied by a spate of regulatory reforms. Sometimes these changes are modest and sometimes they are very large; sometimes they are for the better and sometimes they are for the worse.

  • There are two main ways in which failed lenders’ assets or existing lenders’ bad assets are managed: They are either a) transferred to a separate entity (an AMC) to manage the restructuring and asset disposal (about 40 percent of the cases studied) or b) they remain on the balance sheet of the original lending institution to manage (about 60 percent of cases). And there are several main levers for disposing of the nonperforming loans: a) restructuring (e.g., working out the loans through extended terms), b) debt-for-equity swaps and asset seizures, c) direct sales of the loans or assets to third parties, and d) securitizations.

  • Much as with lenders, there is usually a relatively clear distinction between how systemically or strategically important borrowers are handled and how those that aren’t are.

    • For systemically important borrowers or strategically important ones, policy makers generally take steps to ensure that the businesses remain intact as entities. In general this occurs through a restructuring of the debts to make the ongoing debt service manageable. This can occur through debt-for-equity swaps, through reducing the existing debts, lowering interest rates, or terming out the borrowing.

    • Nonsystemically important borrowers are usually left to restructure their loans with private lenders or are allowed to go bankrupt and are liquidated.

    • Central governments often take steps to help reduce the debt burdens on the household sector. AMCs may also take steps to restructure debt burdens rather than foreclosing on the loans as part of their goal of maximizing recovery values.

  • The table below shows how frequently the previously described policy moves were deployed in our study of the 48 historical cases detailed in Part 3.

Redistributing Wealth

  • Wealth gaps increase during bubbles and they become particularly galling for the less privileged during hard times. As a general rule, if rich people share a budget with poor people and there is an economic downturn, there will be economic and political conflict. It is during such times that populism on both the left and the right tends to emerge. How well the people and the political system handle this is key to how well the economy and the society weather the period.

  • As shown below, both inequality and populism are on the rise in the US today, much as they were in the 1930s. In both cases, the net worth of the top 0.1 percent of the population equaled approximately that of the bottom 90 percent combined.

  • In some cases, raising taxes on the rich becomes politically attractive because the rich made a lot of money in the boom—especially those working in the financial sector—and are perceived to have caused the problems because of their greed. The central bank’s purchases of financial assets also disproportionately benefit the rich, because the rich own many more such assets. Big political shifts to the left typically hasten redistributive efforts. This typically drives the rich to try to move their money in ways and to places that provide protection, which itself has effects on asset and currency markets.

  • It can also cause an economic “hollowing out” of those areas because the big income earners, who are also the big income taxpayers, leave, reducing overall tax revenues and leading these areas to suffer sharp declines in property values and reductions in services.

5) The “Beautiful Deleveraging”

  • A “beautiful deleveraging” happens when the four levers are moved in a balanced way so as to reduce intolerable shocks and produce positive growth with falling debt burdens and acceptable inflation. More specifically, deleveragings become beautiful when there is enough stimulation (i.e., through “printing of money”/ debt monetization and currency devaluation) to offset the deflationary deleveraging forces (austerity/ defaults) and bring the nominal growth rate above the nominal interest rate—but not so much stimulation that inflation is accelerated, the currency is devaluated, and a new debt bubble arises.

  • The best way of negating the deflationary depression is for the central bank to provide adequate liquidity and credit support, and, depending on different key entities’ needs for capital, for the central government to provide that too. Recall that spending comes in the form of either money or credit. When increased spending cannot be financed with increased debt because there is too much debt relative to the amount of money there is to service the debt, increased spending and debt-service relief must come from increased money. This means that the central bank has to increase the amount of money in the system.

  • The central bank can do this by lending against a wider range of collateral (both of lower quality and longer maturity) and also by buying (monetizing) lower-quality and/ or longer-term debt. This produces relief and, if it’s done in the right amounts, allows a deleveraging to occur with positive growth. The right amounts are those that a) neutralize what would otherwise be a deflationary credit market collapse and b) get the nominal growth rate marginally above the nominal interest rate to tolerably spread out the deleveraging process.

  • So, what do I mean by that? Basically, income needs to grow faster than debt. For example: Let’s assume that a country going through a deleveraging has a debt-to-income ratio of 100 percent. That means that the amount of debt it has is the same as the amount of income the entire country makes in a year. Now think about the interest rate on that debt. Let’s say it’s 2 percent. If debt is 100 and the interest rate is 2 percent, then if no debt is repaid it will be 102 after one year. If income is 100 and it grows at 1 percent, then income will be 101, so the debt burden will increase from 100/ 100 to 102/ 101. So for the burdens from existing debt not to increase, nominal income growth must be higher than nominal interest rates, and the higher the better (provided it is not so high that it produces unacceptable inflation and/ or unacceptable currency declines).

  • People ask if printing money will raise inflation. It won’t if it offsets falling credit and the deflationary forces are balanced with this reflationary force. That’s not a theory—it’s been repeatedly proven out in history. Remember, spending is what matters. A dollar of spending paid for with money has the same effect on prices as a dollar of spending paid for with credit. By “printing money,” the central bank can make up for the disappearance of credit with an increase in the amount of money. This “printing” takes the form of central bank purchases of government securities and nongovernment assets such as corporate securities, equities, and other assets, which is reflected in money growing at an extremely fast rate at the same time as credit and real economic activity are contracting. Traditional economists see that as the velocity of money declining, but it’s nothing of the sort. What is happening at such times is that credit destruction is being offset by money creation. If the balance between replacing credit and actively stimulating the economy is right, this isn’t inflationary.

  • But there is such a thing as abusive use of stimulants. Because stimulants work so well relative to the alternatives, there is a real risk that they can be abused, causing an “ugly inflationary deleveraging” (like the Weimar hyperinflation of the 1920s, or those in Argentina and Brazil in the 1980s). The key is to avoid printing too much money. If policy makers achieve the right balance, a deleveraging isn’t so dramatic. Getting this balance right is much more difficult in countries that have a large percentage of debt denominated in foreign currency and owned by foreign investors (as in Weimar Germany and the South American countries) because that debt can’t be monetized or restructured as easily.

  • Printing money/ debt monetization and government guarantees are inevitable in depressions in which interest rate cuts won’t work, though these tools are of little value in countries that are constrained from printing or don’t have assets to back printing up and can’t easily negotiate the redistributions of the debt burdens. All of the deleveragings that we have studied (which is most of those that occurred over the past hundred years) eventually led to big waves of money creation, fiscal deficits, and currency devaluations (against gold, commodities, and stocks).

  • The chart below conveys the archetypal path of money printing in deflationary deleveragings over the 21 cases. The money printing occurs in two classic waves—central banks first provide liquidity to stressed institutions, and then they conduct large-scale asset purchases to broadly stimulate the economy.

  • For example, when the value of the dollar (and therefore the amount of money) was tied to gold during the Great Depression, suspending the promise to convert dollars into gold so that the currency could be devalued and more money created was key to creating the bottoms in the stock and commodity markets and the economy.

  • In the end, policy makers always print. That is because austerity causes more pain than benefit, big restructurings wipe out too much wealth too fast, and transfers of wealth from haves to have-nots don’t happen in sufficient size without revolutions. Also, printing money is not inflationary if the size and character of the money creation offsets the size and character of the credit contraction.

  • The table below summarizes the typical amount of printing and currency devaluation required to create the turn from a depression to a “beautiful deleveraging.” On average the printing of money has been around 4 percent of GDP per year. There is a large initial currency devaluation of around 50 percent against gold, and deficits widen to about 6 percent of GDP.

  • On average, this aggressive stimulation comes two to three years into the depression, after stocks have fallen more than 50 percent, economic activity has fallen about 10 percent, and unemployment has risen to around 10 to 15 percent, though there is a lot of variation.

  • BUBBLE WELL MANAGED Central banks consider growth in debt and its effects on asset markets in managing policy. If they can prevent the bubble, they can prevent the bust. Central banks use macroprudential policies to target restraints in debt growth where bubbles are emerging and allow debt growth where it is not excessive. Fiscal policies are tightened. POORLY MANAGED Big bubbles are fueled by speculators and lenders over-extrapolating past successes and making further debt-financed investments, and by central banks focusing just on inflation and/ or growth and not considering debt bubbles in investment assets, thus keeping credit cheap for too long. TOP WELL MANAGED Central banks constrict the bubble either with the control of broad monetary policy or with well-chosen macroprudential policies and then ease selectively (via macroprudential policies). POORLY MANAGED Central banks continue to tighten well after bursting the bubble. DEPRESSION WELL MANAGED Central banks provide ample liquidity, ease short rates quickly until they hit 0%, and then pursue aggressive monetizations, using aggressive targeted macroprudential policies. Governments pursue aggressive and sustained fiscal stimulus, easing past the turn. Systemically important institutions are protected. POORLY MANAGED Central banks are slower to cut rates, provide more limited liquidity, and tighten too early. They also wait too long to pursue aggressive monetization. Governments pursue austerity without adequately easing. Systemically important institutions are left damaged or failed. BEAUTIFUL DELEVERAGING WELL MANAGED Reflations begin with aggressive monetizations through asset purchases or big currency declines, enough to bring nominal growth above nominal rates. Stimulative macroprudential policies are targeted to protect systemically important entities and to stimulate high-quality credit growth. Nonsystemically important institutions are allowed to fail in an orderly way. Policy makers balance the depressive forces of defaults and austerity with the reflationary forces of debt monetization, currency declines, and fiscal stimulus. POORLY MANAGED Initial monetizations stutter and start. Asset purchases are more muted and consist more of cash-like instruments rather than risky assets, so that purchases don't produce a wealth effect. Stimulation of the central bank is undermined by fiscal austerity. Overindebted entities are protected even though they are not systemically important, leading to zombie banks and malaise. Ugly inflationary depressions arise in cases where policy makers allow faith in the currency to collapse and print too much money.

6) “Pushing on a String”

  • Late in the long-term debt cycle, central bankers sometimes struggle to convert their stimulative policies into increased spending because the effects of lowering interest rates and central banks’ purchases of debt assets have diminished. At such times the economy enters a period of low growth and low returns on assets, and central bankers have to move to other forms of monetary stimulation in which money and credit go more directly to support spenders.

  • To help understand the different kinds of monetary policies that can be used throughout a deleveraging, I think of them as coming in three different styles, each with its own effects on the economy and markets.

  • Monetary Policy 1 Interest-rate driven monetary policy (which I’ll call Monetary Policy 1) is the most effective because it has the broadest impact on the economy. When central banks reduce interest rates, they stimulate the economy by a) producing a positive wealth effect (because the lower interest rate raises the present value of most investments); b) making it easier to buy items on credit (because the monthly payments decline), raising demand—especially for interest-rate-sensitive items like durable goods and housing; and c) reducing debt-service burdens (which improves cash flows and spending). MP1 is typically the first approach to a debt crisis, but when short-term interest rates hit around 0 percent, it no longer works effectively, so central banks must go to the second type.

  • Monetary Policy 2 “Quantitative easing” (QE) as it is now called (i.e., “printing money” and buying financial assets, typically debt assets), is Monetary Policy 2. It works by affecting the behavior of investors/ savers as opposed to borrowers/ spenders, because it is driven by purchases of financial assets, typically debt assets that impact investors/ savers the most. When the central bank buys a bond, it gives savers/ investors cash, which they typically use to buy another financial asset that they think is more attractive. What they do with that money and credit makes all the difference in the world. When they invest in the sort of assets that finance spending, that stimulates the economy. When they invest in those that don’t (such as financial assets), there must be very large market gains before any money trickles down into spending—and that spending comes more from those who have enjoyed the market gains than from those who haven’t. In other words, QE certainly benefits investors/ savers (i.e., those who own financial assets) much more than people who don’t, thus widening the wealth gap.

    • While MP2 is generally less effective than interest-rate changes, it is most effective when risk and liquidity premiums are large, because it causes those premiums to fall. When risk premiums are large, and money is added to the system, actual risks are reduced at the same time that there is more money seeking returns, which triggers purchases of riskier assets that are offering higher expected returns, driving their prices up and producing a positive wealth effect.

    • But over time, the use of QE to stimulate the economy declines in effectiveness because risk premiums are pushed down and asset prices are pushed up to levels beyond which they are difficult to push further, and the wealth effect diminishes. In other words, at higher prices and lower expected returns, the compensation for taking risk becomes too small to get investors to bid prices up, which would drive prospective returns down further. In fact, the reward-to-risk ratio could make those who are long a lot of assets view that terribly returning asset called cash as more appealing. As a result, QE becomes less and less effective. If they provide QE and private credit growth doesn’t pick up, policy makers feel like they are pushing on a string.

    • At this stage, policy makers sometimes monetize debt in even larger quantities in an attempt to compensate for its declining effectiveness. While this can help for a bit, there is a real risk that prolonged monetization will lead people to question the currency’s suitability as a store hold of value. This can lead them to start moving to alternative currencies, such as gold. The fundamental economic challenge most economies have in this phase is that the claims on purchasing power are greater than the abilities to meet them.

    • Think of it this way: There are only goods and services. Financial assets are claims on them. In other words, holders of investments/ assets (i.e., investors/ capitalists) believe that they can convert their holdings into purchasing power to get goods and services. At the same time, workers expect to be able to exchange a unit’s worth of their contribution to the production of goods and services into buying power for goods and services. But since debt/ money/ currency have no intrinsic value, the claims on them are greater than the value of what they are supposed to be able to buy, so they have to be devalued or restructured. In other words, when there are too many debt liabilities/ assets, they either have to be reduced via debt restructurings or monetized. Policy makers tend to use monetization at this stage primarily because it is stimulative rather than contractionary. But monetization simply swaps one IOU (debt) for another (newly printed money). The situation is analogous to a Ponzi scheme. Since there aren’t enough goods and services likely to be produced to back up all the IOUs, there’s a worry that people may not be willing to work in return for IOUs forever.

  • Low interest rates together with low premiums on risky assets pose a structural challenge for monetary policy. With Monetary Policy 1 (interest rates) and Monetary Policy 2 (QE) at their limits, the central bank has very little ability to provide stimulus through these two channels—i.e., monetary policy has little “gas in the tank.” This typically happens in the later years of the long-term debt cycle (e.g., 1937-38 and now in the US), which can lead to “pushing on a string.” When this happens, policy makers need to look beyond QE to the new forms of monetary and fiscal policy characterized by Monetary Policy 3.

  • Monetary Policy 3 Monetary Policy 3 puts money more directly into the hands of spenders instead of investors/ savers and incentivizes them to spend it.

  • Logic and history show us that there is a continuum of actions to stimulate spending that have varying degrees of control to them. At one end are coordinated fiscal and monetary actions, in which fiscal policy makers provide stimulus directly through government spending or indirectly by providing incentives for nongovernment entities to spend. At the other end, the central bank can provide “helicopter money” by sending cash directly to citizens without coordination with fiscal policy makers. Typically, though not always, there is a coordination of monetary policy and fiscal policy in a way that creates incentives for people to spend on goods and services. Central banks can also exert influence through macroprudential policies that help to shape things in ways that are similar to how fiscal policies might. For simplicity, I have organized that continuum and provided references to specific prior cases of each below.

    • An increase in debt-financed fiscal spending. Sometimes this is paired with QE that buys most of the new issuance (e.g., in Japan in the 1930s, US during World War II, US and UK in the 2000s).

    • Increase in debt-financed fiscal spending, where the Treasury isn’t on the hook for the debt, because:

      • The central bank can print money to cover debt payments (e.g., Germany in the 1930s).

      • The central bank can lend to entities other than the government that will use it for stimulus projects (e.g., lending to development banks in China in 2008).

    • Not bothering to go through issuing debt, and instead giving newly printed money directly to the government to spend. Past cases have included printing fiat currency (e.g., in Imperial China, the American Revolution, the US Civil War, Germany in the 1930s, and the UK during World War I) or debasing hard currency (Ancient Rome, Imperial China, 16th-century England).

    • Printing money and doing direct cash transfers to households (i.e., “helicopter money”). When we refer to “helicopter money,” we mean directing money into the hands of spenders (e.g., US veterans’ bonuses during the Great Depression, Imperial China). How that money is directed could take different forms—the basic variants are either to direct the same amount to everyone or aim for some degree of helping one or more groups over others (e.g., giving money to the poor rather than to the rich). The money can be provided as a one-off or over time (perhaps as a universal basic income). All of these variants can be paired with an incentive to spend it—such as the money disappearing if it’s not spent within a year. The money could also be directed to specific investment accounts (like retirement, education, or accounts earmarked for small-business investments) targeted toward socially desirable spending/ investment. Another potential way to craft the policy is to distribute returns/ holdings from QE to households instead of to the government.

    • Big debt write-down accompanied by big money creation (the “year of Jubilee”) as occurred in Ancient Rome, the Great Depression, and Iceland.

  • While I won’t offer opinions on each of these, I will say that the most effective approaches involve fiscal/ monetary coordination, because that ensures that both the providing and the spending of money will occur. If central banks just give people money (helicopter money), that’s typically less adequate than giving them that money with incentives to spend it. However, sometimes it is difficult for those who set monetary policy to coordinate with those who set fiscal policy, in which case other approaches are used.

  • Also, keep in mind that sometimes the policies don’t fall exactly into these categories, as they have elements of more than one of them. For example, if the government gives a tax break, that’s probably not helicopter money, but it depends on how it’s financed. The government can also spend money directly without a loan financed by the central bank—that is helicopter money through fiscal channels.

  • While central banks influence the costs and availabilities of credit for the economy as whole, they also have powers to influence the costs and availabilities of credit for targeted parts of the financial system through their regulatory authorities. These policies, which are called macroprudential policies, are especially important when it’s desirable to differentiate entities—e.g., when it is desirable to restrict credit to an overly indebted area while simultaneously stimulating the rest of the economy, or when its desirable to provide credit to some targeted entities but not provide it broadly. Macroprudential policies take numerous forms that are valuable in different ways in all seven stages of the big debt cycle. Because explaining them here would require too much of a digression, they are explained in some depth in the Appendix.

7) Normalization

  • Eventually the system gets back to normal, though the recovery in economic activity and capital formation tends to be slow, even during a beautiful deleveraging. It typically takes roughly 5 to 10 years (hence the term “lost decade”) for real economic activity to reach its former peak level. And it typically takes longer, around a decade, for stock prices to reach former highs, because it takes a very long time for investors to become comfortable taking the risk of holding equities again (i.e., equity risk premiums are high).


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