Bridgewater Associates founder Ray Dalio recently presented an exquisite tutorial on how the economy works entitled, How the Economic Machine Works: Leveraging and Deleveraging.
He presented this tutorial in the form of the game Monopoly and gave seven examples through history, providing an explanation of the model through each one.
The key to understanding Dalio’s model is to recognize that the availability of credit is what drives economic growth. If you monitor this credit expansion and contraction, you are better able to understand and profit from what is going on.
The Game of Monopoly
Because most of us have played Monopoly at some point in time, the use of this board game is a great example primarily because we can see the game in fast-forward. The winner is declared by who has the most money and the majority of available properties. The losers of the game typically are bankrupt as they no longer have cash to pay their debt. As Dalio explains:
In the game of Monopoly, those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into real estate in order to profit from other players landing on their properties. So as the game progresses, more hotels are acquired, which creates the need for more cash (to pay the bills of landing on someone else’s property with a hotel on it). At the same time, many folks have run down their cash supply in order to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. Early in the game, we see that “property is king” and later in the game that “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash as the game changes.
The only way to make this more realistic would be to have the bank take deposits and for players to be able to freely exchange property back and forth. Ultimately, you need to balance the right amount of cash with the ownership of property.
Seven Examples
In order to give us more clarity, Dalio provides seven examples in history to show the expansion and contraction cycles: U.S. in the 1930s, Japan in the 1930s, United Kingdom in the 1950s and 1960s, Japan from 1990 until now, U.S. from 2008 until present, Spain now and the Weimer Republic in the 1920s.
The seven examples that Dalio provided all show an increase in debt. More specifically, they indicate that the debt burden increased and the cost of paying interest and principal became too large for the individuals to handle, causing a contraction to ensue to lower this debt burden.
These seven examples show three categories of deleveraging: ugly, beautiful and ugly inflationary.
Beautiful deleveraging is managed by balancing the reduction of debt burden. It occurs when debt-to-income is declining and there is a slow but steady increase in the economy. This occurred in the U.S. from 1933 to 1937, Japan from 1932 to 1936, the United Kingdom from 1947 to 1969, and currently in the U.S. with quantitative easing.
Ugly deleveraging occurred in the U.S. right at the start of the Great Depression from 1930 to 1932 and briefly from July 2008 to February 2009, in Japan from 1929 to 1931 and again from 1990 to the present, and currently in Spain.
Ugly inflationary deleveraging occurred in the Weimer Republic from 1919 to 1923 and in several South American countries in the 1980s.
Deleveraging happens in one of four ways:
- Debt reduction
- Austerity
- Transferring wealth
- Debt monetization
Debt reduction and austerity are deflationary, while debt monetization (printing of money to buy bonds and stocks) is inflationary. Dalio explains:
“When a good balance of debt reduction, austerity, and “printing/monetizing” occurs, debt burdens can fall relative to incomes with positive economic growth.”
This is what we are currently experiencing now
The success factor seems to be printing money in order to purchase risky assets. Unfortunately, the government and individuals often get lured into believing that stock and bond price appreciation is a good thing; however, if there is too much of an increase, it results in the balance tipping over. Dalio demonstrates:
“Inflation in financial assets is far more dangerous than inflation in goods and services because financial asset inflation appears to be a good thing even though it is as dangerous as any other form of over-indebtedness. In fact, debt-financed asset increases that are accompanied by low inflation appear to consumers to be investment-generated productivity booms; however, they are typically precursors of busts.”
Economic Model
Dalio’s model is driven by three parts: productivity, long-term debt cycle and short-term debt cycle. It is the recognition of the long-term and short-term debt cycle that has personally driven his understanding and has enabled him to manage the largest successful hedge fund.
The short-term debt cycle is also known as the business cycle. The business cycle is driven by the Federal Reserve (or other central banks) lowering and raising interest rates. As inflation increases, interest rates are tightened to slow down GDP growth.
When the economy has capacity to spare and individuals for work, interest rates are reduced to increase demand.
Through this cycle, Dalio explains there are six phases:
- Early cycle (lasts 5 to 6 quarters): The cycle is driven by demand for interest rate-sensitive items like cars and housing. Retail sales increase due to low interest rates and higher credit availability. This in turn increases the average workweek and demand for workers. At this time, stocks are typically the best investment.
- Mid cycle (lasts 3 to 4 quarters): Economic growth slows, inflation remains low, consumption diminishes, inventory accumulation declines and interest rates dip. The increase in the stock market tapers off and the rate of decline in Treasury Inflation Protected Securities (TIPS) trails off.
- Late cycle (begins 2.5 year into expansion): Economic growth accelerates, capacity constraints emerge, credit and demand are still strong and inflation expands higher. Additionally, consumption increases, inventories increase, interest rates rise and stocks prices advance. During this time, TIPS are the best investment.
- Tightening phase: Expectations of inflation causes federal funds rates to tighten, which causes reduced liquidity, yield curve flattening, money supply and credit growth to slow and a decline in the stock market.
- Early recession: The economy contracts, the gap in GDP expands, inflation declines, unemployment increases and stocks, commodities and TIPS decline.
- Late recession: The monetary policy eases, concern over inflation eases and interest rates decline. Lower interest rates cause stock prices to increase. Commodity prices and TIPS continue to decline.
A short-term debt cycle is caused by two things: the rate of growth in spending accelerates faster than the capacity to produce or high spending is curtailed by tight money and credit. These cycles tend to last about seven years. They can be shorter or longer at various times, specifically during a short-term cycle recession or when central banks crank up credit and ease money supply.
The current state of the economy is as follows:
A long-term debt cycle is more difficult to grasp. Debt increases so long as individuals and companies can maintain paying interest and principal. For a period of time, increased debt is self-fulfilling, allowing more spending to occur.
However, there is a tipping point when individuals can no longer pay the interest and principal. Eventually individuals, companies and the government can no longer sustain the debt payments and high debt service (principal and interest payments) causes a debt squeeze.
Long-term debt contractions occur due to two things: high debt service and the lack of monetary growth. Long-term cycles are caused when debt rises faster than income and more importantly, when the cost-to-service debt is greater than income. In order to reduce the cost of servicing debt, a form of deleveraging must occur.
Overall, Dalio urges individuals and policy makers to view the economy as a sum of multiple transactions that are composed of money and credit and are driven by any number of reasons.
Much like understanding the changes in the game of Monopoly, understanding the dynamic between the long-term and short-term cycle can provide a much better insight into the rise and fall of stock and bond prices.