The Debt Cycle In The Changing World Order

In his book “The Changing World Order, Ray Dalio stated that while the focus is on those forces that affected the big cyclical swings in wealth and power. There are classic cycles that are mutually reinforcing in ways that tend to create a single very big cycle of ups and downs. According to Ray, the most important three cycles are the ones he mentioned in the intro- duction: the long-term debt and capital markets cycle, the internal order and disorder cycle, and the external order and disorder cycle.


The author highlighted that, while money and credit are associated with wealth, they aren’t wealth.  Because money and credit can buy wealth (the amount of money and credit one has and the amount of wealth one has look pretty much the same.  But one cannot create more wealth simply by creating more money and credit.  To create more wealth, one has to be more productive.  The relationship between the creation of money and credit and the creation of wealth (actual goods and services) is often confused yet it is the biggest driver of economic cycles. In the real economy, when the level of goods and services demanded is strong and rising and the capacity to produce those things demanded is limited, the real economy’s capacity to grow is limited and, if demand keeps rising faster than the capacity to produce, inflation rises. During normal times, which is through most of the long-term debt cycle, central banks turn on and turn off credit, which raises and lowers demand and production. Because they do that imperfectly we have the short-term debt cycles, which we also call overheated economies and recessions. The big thing is that money and credit is stimulative when it’s given out and depressing when it must be paid back.  That’s what normally makes money, credit, and economic growth so cyclical. 


Changing world order scheme by Ray Dalio


Focusing on debt, Ray Dalio staged the Long-Term Debt Cycle as follows:


It Begins with No or Low Debt and “Hard Money”: When societies first invented money they used all sorts of things, like grain and beads.  But mostly they used things that had intrinsic value, like gold, silver, and copper, “hard money.”  Having intrinsic value (i.e., being useful in and of themselves) was important because no trust or credit was required to carry out an exchange with them.  Any transaction could be settled on the spot, even if the buyer and seller were strangers or enemies. When countries were at war and there was not trust in the intentions or abilities to pay, they could still pay in gold.  So gold (and to a lesser extent silver) could be used as both a safe medium of exchange and a safe store-hold of wealth.  


Then Come Claims on “Hard Money” (aka, “Notes” or “Paper Money”): Because carrying a lot of metal money around was risky and inconvenient, credible parties known as banks, though they initially included all sorts of institutions that people trusted, arose that would put the money in a safe place and issue paper claims on it. This type of currency system is called a linked currency system because the value of the currency is linked to the value of something, typically a “hard money” such as gold.  


Then Comes Increased Debt: At first there is the same number of claims on the “hard money” as there is hard money in the bank.  However, the holders of the paper claims and the banks discover the wonders of credit and debt.  They can lend these paper claims to the bank in exchange for an interest payment, so they get interest.  The banks that borrow it from them like it because they lend the money to others who pay a higher interest rate, so the banks make a profit.  And those who borrow the money from the bank like it because it gives them buying power that they didn’t have.  And the whole society likes it because it leads asset prices and production to rise. Trouble approaches either when there isn’t enough income to survive one’s debts or when the amount of the claims (i.e., debt assets) that people are holding in the expectation that they can sell them to get money to buy goods and services increases faster than the amount of goods and services by an amount that makes the conversion from that debt asset (e.g., that bond) implausible.  These two problems tend to come together.


Then Come Debt Crises, Defaults, and Devaluations: when the bank’s claims on money grow faster than the amount of money in the bank—whether the bank is a private bank or government-controlled (i.e., central bank)—eventually the demands for the money will become greater than the money the bank can provide and the bank will default on its obligations.  That is what is called a bank run. private bank can’t simply print the money or change the laws to make it easier to pay their debts, while a central bank can.  Private bankers must either default or get bailed out by the government when they get into trouble, while central bankers can devalue their claims (e.g., pay back 50-70%) if their debts are denominated in their national currency.  If the debt is denominated in a currency that they can’t print, then they too must ultimately default.


Then Comes Fiat Money: Central banks want to stretch the money and credit cycle to make it last for as long as they can because that is so much better than the alternative, so, when “hard money” and “claims on hard money” become too painfully constrictive, governments typically abandon them in favor of what is called “fiat” money.  No hard money is involved in fiat systems; there is just “paper money” that the central bank can “print” without restriction.  As a result, there is no risk that the central bank will have its stash of “hard money” drawn down and have to default on its promises to deliver it.  Rather the risk is that, freed from the constraints on the supply of tangible gold or some other “hard” asset, the people who control the printing presses (i.e., the central bankers working with the commercial bankers) will create ever more money and debt assets and liabilities in relation to the amount of goods and services being produced until a time when those who are holding the enormous amount of debt will try to turn them in for goods and services which will have the same effect as a run on a bank and result in either debt defaults or the devaluation of money.


Then Comes the Flight Back into Hard Money: When taken too far, the over-printing of fiat currency leads to the selling of debt assets and the earlier-described bank “run” dynamic, which ultimately reduces the value of money and credit, which prompts people to flee out of both the currency and the debt (e.g., bonds).  They need to decide what alternative store-hold of wealth they will use.  History teaches us that they typically turn to gold, other currencies, assets in other countries not having these problems, and stocks that retain their real value.  


Long-term debt cycle scheme


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