Ray Dalio, Debt, and the Dollar

Ray Dalio, founder of Bridgewater Associates, has been promoting his new book, The Changing World Order in recent months. The book will be released in March of 2021, but a free pre-release e-book is currently available. I have linked to the e-book at the bottom of this article if anyone is interested in downloading it.

The book synthesizes his deep research over an 18 month period in which he studied the rises and declines of empires, their reserve currencies, and their economies. 

Ray’s desire to embark on the project stems from his observation of the current confluence of three major factors in the US and around the world:

1. High levels of indebtedness and extremely low interest rates, which limits central banks’ powers to stimulate the economy
2. Large wealth gaps and political divisions within countries which leads to increased social and political conflicts
3. A rising world power (China) challenging the overextended existing world power (the US), which causes external conflict.  

As he got into the research, he realized that the time period most analogous to today was 1930-1945. He has explained that this is quite concerning to him. So much so that he felt obligated to share his research and work in the form of his latest book.

And while Ray has been exposed to quite a bit around the world over his 50 year career, he has often stated that his biggest mistakes have always come from missing market moves that hadn’t happened in his lifetime, but have happened many times before. These mistakes taught him that he needed to understand how economies and markets have worked throughout history and in faraway places so that he could learn the timeless and universal mechanics underlying them, and develop timeless and universal principles for dealing with them.  

For example, if some big and important event had happened in the past (like the Great Depression of the 1930’s), we cannot be sure that it will not happen in our lifetimes. Through his research, Ray has learned that there are many cases of the same things happening (e.g. depressions) and that by studying them just like a doctor studies many cases of a particular disease, we can gain a deeper understanding of how they work. It allows him to view events around the world as “another one of those.” 

While Ray has had unparalleled success at the helm of Bridgewater, he is also a meditator, a deep thinker, and a truth seeker. Ray’s NorthStar has always been truth and the pursuit of figuring out that which is true. He has chased truth over the years through his leadership style of “radical transparency” in which he encourages thoughtful debate. Decisions at Bridgewater are made democratically in which his employees respectfully “poke holes” in each other's work and investment ideas to stress test them for truth and accuracy. I’m admittedly biased to this approach as this is also how decisions were made within the Global Investment team at my former employer, MIT Investment Management Company.

The way he works is to study as many of the important cases of a particular event he can find, and then form a picture of a typical one or an archetype. The archetype then helps him see the cause-effect relationship that drives how these cases typically progress. He’ll then compare how specific cases transpire relative to the archetypical one to understand what causes the differences between each cause and the archetype. This process helps him refine his understanding of the cause-effect relationship to the point where he can create decision making rules in the form of “if/then” statements - i.e. if X happens, then make Y bet. Then he’ll watch the actual events transpire relative to his template of what he’s expecting to happen. If events are on track, he continues to bet on what typically comes next, and if events start to deviate he’ll try to understand why and course correct. 

This is done in a systematic way - backed by his resources and research team at Bridgewater. The approach for his book, The Changing New World Order, follows these same principles. It is a practical approach that he has followed throughout his career to help him do his job well. 

Ray is not some washed up has-been looking to cash in his book deal. He has stated many times publicly that he is motivated to leave the world a better place than the one that adopted him. He is focusing on education to do so. His prior books follow a similar ethos in that they also echo his sentiments around sharing his learnings and knowledge in the later part of his life. 

His approach to teaching is to explain his thought process, his research, and his principles. He does this in a gentle, non overbearing way. A “take it or leave it” approach. He has no interest in preaching or changing people's minds. He is simply seeking truth. I’ve always had a lot of respect for him for these reasons. He also makes it clear that he is not someone that believes what happened in the past will necessarily continue into the future without understanding the cause-effect mechanics that drive changes. He is using history and data to study those cause-effect relationships and then use that understanding to explore what might be coming at us.

So when Ray Dalio says that the 2020’s are currently set up to be similar to the 1930’s, I listen.  

I'll link to a brief interview Ray did with Yahoo Finance recently summarizing his research at the bottom of the article.

In this article we’ll explore the main themes uncovered from Ray’s research, why they matter, and what we might be able to expect going forward this decade. 

The Long Term Money and Debt Cycle

At no point over the last 80 years have interest rates been so low (or negative) on so much debt as they are today around the world. At the start of 2020, more than $10 trillion of debt was at negative interest rates and an unusually large amount of additional new debt will soon need to be sold to finance deficits. Meanwhile, the pandemic is rapidly accelerating debt around the world. This is happening at the same time as huge pension and healthcare obligations are coming due with more and more baby boomers retiring every day. These circumstances should raise some interesting questions for us:

1. Why would anyone want to hold debt yielding a negative interest rate? 
2. How much lower can interest rates be pushed?
3. What will happen to economies and markets when interest rates cannot be pushed lower? 
4. How would central banks be stimulative in economic downturns with rates already at zero and negative?
5. Would central banks print massive amounts of currency, causing it’s value to go down?
6. What would happen if the currency that the debt is denominated in goes down while interest rates are so low?
7. What happens if investors flee debt denominated in the world's reserve currencies?

We’ll revisit these questions a little later. For now, let’s take a look at the timeless and universal fundamentals of money and credit.

For thousands of years there have always been three types of monetary systems.

• Hard Money (Gold and Silver coins)
• “Paper Money” - paper used as claims on the Gold and Silver backing it. The paper makes it easier to transact and move around. It acts as a checkbook with the gold being the actual money in the bank. The US had this system up until 1971.
• Fiat Money - currency that has no backing and can be created out of thin air. The US has operated in this system since 1971. 

Throughout history, countries have transitioned across these different types of systems for logical reasons. As a country needs more money and credit than it currently has, whether to deal with debts, wars, or other problems, it naturally moves from Type 1 to Type 2, or Type 2 to Type 3, so that it has more flexibility to print money.  

Eventually, history shows us that creating too much money and debt depreciates its value, causing people to get out of holding the debt and money as a storehold of wealth, and moving back into hard assets (like gold) and other currencies (Bitcoin?). Since this typically takes place when there is wealth conflict and sometimes a war, there is typically also a desire to get out of that country. Such countries then need to reestablish confidence in the currency as a storehold of wealth before they can restore their credit markets. 

The monetary cycle looks like this:

These cycles typically play out over 50-75 years, and at the end, are typically characterized by a restructuring of debts and the monetary system. The abrupt parts of these restructurings - i.e. the debt and currency crisis periods - typically happen quickly, lasting only months to up to three years, depending on how long it takes the governments to exercise these moves. With that said, the ripple effects of them can be quite powerful. For example, these circumstances can lead to reserve currencies losing their reserve status. Within each of these currency regimes there are typically two to four big debt crises - big enough to cause banking crises and debt write downs - but not big enough to break the entire system. The Great Recession of 2008 is an example of a big debt crisis. We are currently in another one caused by the pandemic.

Where is the US currently in this long term cycle? 

The current world order began after the end of WWII in 1945, with the Bretton Woods agreement having put the dollar in the position of being the world's leading reserve currency in 1944. The US and the dollar were somewhat of a natural fit for the role because the US owned about two thirds of the world's gold supply after the war, accounted for approximately 50% of the world's GDP, and was the dominant military power. 

This system was initially a type 2 (paper claims on hard money), in which paper dollar claims on gold could be exchanged by other countries' central banks for an ounce of gold at a price of $35/ounce. 

Over the years, and due to the “exorbitant privilege” bestowed on the country with the reserve currency, America began to spend more money than it was taking in. The US Federal Reserve (Central Bank) allowed the creation of a lot more claims on gold (i.e. dollar-denominated money and credit) than could actually be converted into gold at that $35/ounce price. As a result, the Bretton Woods monetary system broke down on August 15, 1971 when President Nixon defaulted on the US’s promise to allow holders of paper dollars to turn them in for gold. Thus, the dollar devalued against gold and other currencies. This is when the US and all countries went to a Type 3 fiat monetary system. 

This move to a fiat monetary system freed the Federal Reserve and other central banks to create massive amounts of dollar denominated money and credit, which led to the inflationary 1970’s where we saw inflation get as high as 13%. Interest rates were raised as high as 20% to stifle the inflation, causing all kinds of turmoil in the economy. 

In the chart below, we can see how the amount of government debt to GDP has grown over the last five decades since 1971 when we came off the gold standard. Debt to GDP is now almost 140% in America, the highest it has been in history, including WWII when it climbed over 100%. A recent study by Hirshmann Capital found that 51 out of 52 countries that reached this level of indebtedness went on to default on their debt - either through outright default, restructuring, devaluation, or high inflation (link at the bottom of the article to the report).

Source: Federal Reserve of St. Louis

Below we can also see the entire cycle up and down of interest rates and inflation rates since the new fiat dollar denominated monetary system began in 1971.

Source: Federal Reserve of St. Louis

Finally, the chart below shows the exponential growth in debt across all sectors since Nixon took America off of the Gold Standard in 1971. Total debt in America has increased from $2 Trillion to over $80 Trillion since we came off the Gold Standard. That is not a typo. Total debt in America is currently $80 Trillion ??.

The “Exorbitant Privilege”

For 75 years, the dollar has been the reserve currency of the world. It is used globally for importers, exporters, investors, governments, and central banks alike. Per the Bank of International Settlements, 80% of worldwide transactions are thought to involve US dollars. 

This widespread use and adoption over the years has led to incredibly strong network effects for the dollar. Almost all foreign nations hold dollar denominated debts and assets. 

Because of the network effects and dollar denominated debts worldwide, there is always strong demand for dollars. This has allowed the United States to run large budget deficits in which we consistently spend more than we earn in taxes. It has also allowed us to run large trade deficits in which we import and consume much more than we export and produce.  

Because of the incredible network effect of the dollar, and the fact that the United States consumes so much of the rest of the world’s production (higher imports than exports), there has been a consistent demand for dollar denominated debt, further amplifying America’s debt and trade imbalance. 

Let’s not forget that America has interests all over the world and the largest military that we use to protect those interests. This secures the network effect of the dollar. 

However, currencies aren’t really supposed to trade this way. A country is supposed to be able to develop a strong currency because they produce more than they consume. They export more than they import. This makes sense if we break it down and compare to an individual. If you make more money then you spend, you are in a better financial position than if you spend more than you earn, right? This hasn’t applied to the United States over the last 50+ years. Meanwhile, efficient countries that produce more than they consume must devalue their currency against the dollar in order to maintain their trade relationships with America.

At the risk of sounding “unamerican,” the United States has created leverage over the rest of the world because we consume a ton of goods, we own the reserve currency of the world and have flooded the world with dollars (creating a network effect and infinite demand for dollars), and we have the largest military in the world protecting our interests. This is called the Exorbitant Privilege. 

Is this privilege merit based? We can certainly argue that we deserve this status because we promote peace around the world. We can also argue that our military and economy is stabilizing to the rest of the world. This is true to some extent, though if you asked our adversaries I'm sure they may see it differently. With this said, at the end of the day there is no such thing as free lunch. Why? Triffin’s Dilemma. 

Triffin’s Dilemma

Named after Robert Triffin, a Yale professor and economist, the Triffin Paradox is a view that gained traction in 1959. The Triffin Dilemma or Paradox states that the dollar as the reserve currency of the world must be temporary. The reason for this is that the system is doomed unless the United States runs ever growing deficits because we must supply the rest of the world with dollars to keep the system alive.  

This makes sense if we think about it. There are so many dollar denominated debts abroad ($12 trillion not including derivatives), that there is always massive demand for dollars. Companies abroad must get dollars to service their dollar denominated debt. But why is there so much dollar denominated debt abroad? Because of the network effect of the dollar - there is so much trade done in dollars that creditors and investors typically like to see companies take on dollar denominated debt. Many companies abroad cannot get financing unless it is in dollars. This creates massive leverage for the US over the rest of the world.

So what does this mean for the US?

It means that if we produce our own goods and services, there will not be enough dollars escaping America and the system would break down abroad. There wouldn’t be enough dollars to service the debts abroad.

So what have we seen internally in America over the last 50 years? As a result of this demand for dollars abroad, we have seen the middle of America become hollowed out. Manufacturing jobs have moved abroad, primarily to China. The American middle class has suffered. Inequality is rising. Populism is rising. Social and political division has been on the rise for decades. These are all features consistent with a reserve currency at the end of its debt cycle per Dalio’s research.

The system is set up such that it makes sense for China and other countries to devalue their currency against the dollar and produce cheaper goods for Americans than we can produce domestically. 

The problem here is that America must balance it’s interests at home with those abroad. We are also likely to see more inequality, and more social and political division if we stay in this current arrangement. History tells us that countries that experience these type of internal tensions typically look to a populist/nationalist leader. These leaders are seen as “strong men” that can push other countries around and stand up for America’s best interests. Does this sound like America under Donald Trump? Again, this is consistent with Ray’s research for what has transpired at the end of a long term debt cycle throughout history.

Summarizing Triffin’s Dilemma

If America does nothing about our trade deficits, we will continue to compile more and more debt on our books. The burden will grow and grow. At what point will holders of US debt decide we are not good for it? Remember, this is all a trust game. We are also likely to continue to see political and social division and inequality rise to what could become an unsustainable level. History tells us this can lead to revolutions, social uprisings, and ultimately change. Though painful, this may not be such a bad thing in the long run if it leads to change and progress. 

If America moves our supply chains back to the US to address the trade deficit (and help our middle class) we risk hurting the American consumer who will have to pay more for goods and services produced domestically. This would hurt our economy. This would also be disruptive to many countries whose economies depend on exporting goods and services to America. China is the largest exporter to America and also a rising world power. If America stops or slows its imports, we are essentially starving foreign countries from getting the dollars they need to service dollar debts on their books. This could be quite destabilizing abroad and could potentially lead to conflict. 

Quite the dilemma indeed. 

A Few Thought Experiments

Let’s quickly revisit the questions raised at the beginning of this article to imagine scenarios that could possibly play out. These are questions we should entertain considering the level of debt around the world and interest rates at zero. 

1. Why would anyone want to hold debt yielding a negative interest rate? 

To answer this one, we need to understand the incentives for Foreign Countries, as well as Pension Funds and individuals who hold American debt (treasuries).  

Foreign countries: why does a country like China buy US debt? The most important thing to understand is that China’s economy is dependent on exporting goods - close to 20% of their GDP comes from exports. For this to continue, China’s currency, the RMB, must be cheaper or devalued relative to the countries they export to. 

When Chinese companies export goods to America, they receive dollars. But they need RMB to pay their workers. This means the central bank of China must swap the dollars held by export companies for RMB. 

The act of doing this devalues the RMB against the dollar. This is because the swap is removing dollars from the system (reducing supply) while increasing supply of the RMB. The net effect is it pushes the dollar higher relative to the RMB due to supply/demand of the two currencies. 

The Chinese central bank now has dollars after the swap with their export companies. They purchase US debt so that the US continues to over consume and buy Chinese goods. It allows us to not have to worry about balancing our budget. This keeps the relationship going - the US benefits from cheap goods, and China’s economy benefits from selling the goods to America and elsewhere. 

So now that we understand that China is incentivized to keep the RMB devalued against the dollar, what would happen if they stopped buying US debt or sold their existing holdings? 

What if China sold their $1 Trillion of US debt? This would remove dollars from the system (increasing demand and driving the dollar higher). Removing dollars from the system also would drive interest rates higher. In the post WWII era, many nations around the world held reserves in the British Pound - these countries did not intend to spend their GBP reserves or invest in the U.K. but were retaining the pounds purely as safe reserves (similar to China holding dollars). When the GBP reserves were sold off, it caused a currency crisis in the U.K., leading to high interest rates. If this happened now we would expect to see the same thing occur. The Fed would likely step in, print money, and try to purchase the excess supply of treasuries to drive the rates back down. But would this have other unintended consequences? This is impossible to predict but high inflation is one possible scenario. 

It is also important to think about other countries besides China. While a rising dollar is good for China and it’s exports, it is not necessarily good for other countries. Emerging markets such as Brazil suffer when the dollar rises because they also have a lot of dollar denominated debt. When the dollar is rising, it makes it very difficult to service the debt because they must sell their local currency, the Real, to get dollars to service the debt. In an environment when the dollar is rising, they must use more of their revenues (which are in Real) to service that debt, eating into profit. Their central bank may also have to print Real’s to get currency for the swap. This debases the currency and causes inflation locally. 

So while a rising dollar would be ok for China and other large export countries, it would hurt emerging markets that have dollar denominated debts and not a lot of dollar denominated assets. It would also continue to widen America’s trade deficit, driving us further into debt. 

Pension funds and Individuals are incentivized to hold dollar debt because it is seen as a safe investment. If inflation were to rise past the yield on Treasury bonds, there would be no incentive for the pension funds to hold them. There is also a belief that the US cannot default on this debt because the government can just raise taxes. This is the equivalent of lending someone money, and then when they cannot pay you back, they take more of your money and pay you back with your own money. Seems a little silly, right? 

If pension funds and individuals lose trust in the dollar, or cannot gain purchasing power from the yield on the treasuries, they may choose to sell them. This again would remove dollars from the system which would drive the dollar higher and cause interest rates to rise. The Fed would need to step in, print money, and purchase the debt to keep interest rates low.

2. How much lower can interest rates be pushed?

It is tough to imagine they can go much lower. The Fed Funds Rate is currently targeted for zero. 10 year Treasuries are currently yielding .83%. 30 Year Treasuries are currently yielding 1.53%. Meanwhile, the Federal Reserve is targeting inflation over 2%. This means anyone investing at these yields is likely to lose money (through purchasing power) on them. Why would anyone want to own an asset that has a negative real yield? You wouldn’t. This is why bond investors have been pushed into the stock market. This is potentially leading to a distorted market and unnatural price discovery in equities. If the Fed Funds rate went negative in America (the Fed has indicated they are not interested in this) it would likely signal to the rest of the world that America has some serious problems. This perception alone could cause turmoil and selling of US treasuries worldwide. 

Additionally, with the Fed Funds rate at the zero bound, the yield curve for bank lending is almost flat. Banks make money by receiving funds at low rates and lending them out at higher rates. If the yield curve is such that they cannot make money, and there is elevated uncertainty and risk in the market, they will not lend. The risk does not outweigh the reward. This puts further deflationary pressure on the economy, forcing more central bank action and money printing.

3. What will happen to economies and markets when interest rates cannot be pushed lower? 

This depends on what the Federal Reserve decides to target in terms of interest rates. They can continue to push rates lower if they want through QE. The problem with this is they are creating more and more debt to do so. This ultimately could lead to holders of the debt losing trust in the ability to repay. This would force the Fed to do more and more QE until they owned basically all of the government debt. At this point the dollar would likely be debased from all of the printing and likely have lost its status as the reserve currency.  

4. How would central banks be stimulative in economic downturns with rates already at zero and negative?

Central banks lose their ability to be stimulative to the economy when rates are already at the zero bound and a recession sets in. This is because the Central Bank cannot force the rest of the banking system to lend into the economy. If you were a bank, would you want to lend right now? Interest rates are historically low, and inflation expectations are high. The risk simply does not offset the reward. The incentive is not there for the banks to lend. 

This raises the question of whether or not Congress would amend the Federal Reserve Act of 1913 to allow the Fed to directly stimulate the economy with helicopter money. This is what we saw last March, but it came from Fiscal Policy and was approved by Congress. The Fed does not have these powers though many economists believe that if the economy continues to get worse we could see this power given to them at some point. This would likely be the “crossing the rubicon” moment for America where inflation would likely increase at high levels immediately, though we are definitely not quite there yet. 

5. Would central banks print massive amounts of currency, causing it’s value to go down?

Historically, when given the option of austerity (cutting spending, raising taxes) and printing money, central banks always choose printing money. This is because it would be career suicide for a politician to propose austerity to the American people. We want our cake and we want to eat it too. Under consuming for a period of time to make up for decades of over consumption is not really on the table. 

6. What would happen if the currency that the debt is denominated in goes down while interest rates are so low?

Banks cannot make money in an environment where interest rates are at zero and the value of the currency is dropping. This is because the purchasing power of the money they are being paid back in is dropping while they are receiving very low interest to begin with. This is a major problem. Will the Government guarantee all bank debt so that the banks lend? Will they start to lend at that point? And why would we assume they are good for the debts? Because they can just print money and continue to debase the currency? I think we can see where this ultimately takes us - more and more printing of currency. History tells us this eventually leads to high levels of inflation.

7. What happens if investors flee debt denominated in the world's reserve currencies?

If interest rates are low and inflation is high, we should expect investors to flee the dollar. If this happens, there will also be no more buyers of the US debt. The Federal Reserve would have to print money and purchase all of the debt. This would mean that America essentially owes massive amounts of money to itself. Again, we can see that this is all leading to places where there seem to be few answers or options.

Note that these “thought experiments” are mostly me riffing on what the possibilities could be while drawing on what I've learned from Ray and others research. If anyone has anything to add or to poke holes, please do so in the comments. 

Conclusion

I’ve barely scratched the surface of the main themes covered in Ray’s book. With that said, he goes very, very deep by looking at over 500 years of reserve currencies, empires, and long term debt cycles. He covers the British Empire and the rise and fall of the British pound. He also examines the Dutch Empire and the rise and fall of the Dutch Guilder. 

Ray also explores the key measures of success for rising world powers: education, competitiveness, financial centers, trade, military, output, innovation & tech, and the reserve currency status. He uses these metrics and data to compare China’s rise concurrent to America’s decline. And finally, he goes deep on the causes of revolutions and wars while laying out the possibilities of a conflict with China in the coming decade. I left most of this part of the book out here. While relevant and something we should consider, the goal of this articles is more to lay out where we are currently in the long term debt cycle.

Ultimately, the challenges we face boil down to what Ray refers to as “the end of the long term debt cycle.” Almost everything else in society (political/social climate, inequality, etc) is an offshoot of this powerful force within the economy. You can learn more about Ray’s research on long term debt cycles by checking out his free book, Principles for Navigating Big Debt Crises. I have linked to where you can find the free e-book at the bottom of this article if anyone is interested in downloading it.

Rising inequality, social and political division, populism & nationalism, isolationist trade policies, and trade & technology wars are all features of a monetary system and a reserve currency at the end of its long term debt cycle. History tells us this. This is why Ray Dalio is asking us to open our eyes and view what is happening around us through a slightly different lens.

Ultimately, there is really no way to know how this plays out. But by walking through these thought experiments, we can start to learn that there seem to be some serious challenges coming toward us in the coming decade. 

History also tells us that these problems can be solved peacefully, but they depend on how we treat each other. If we play nice, we’ll act in ways that create win/win situations internally and also abroad for our trading partners. If we view America’s success as a zero sum game, we will likely politicize the dollar. We will extend dollar denominated loans and currency swaps to our allies and let our adversaries suffer. Where will this ultimately lead us? Only time will tell.  

It is important to note that Ray also points out that if it is true that the Dollar is on its last leg as the reserve currency, this really should not be viewed as such a bad thing. Society needs change to grow and evolve. Ultimately, if we have to take a step back to take 5 steps forward it will be worth it. Just like you have to get through winter to make it to summer, sometimes you have to go through a period of restructuring to ultimately regain progress. Bankruptcy can be a good thing. It is absolutely true that over long periods of time societies progress. Productivity increases. New innovations and technologies are created. We get smarter. We learn from our mistakes. We treat each other better. And ultimately we make the world a better place. Just because that line isn’t perfectly linear doesn’t mean we aren’t moving in the right direction in the long run.  

Here is a brief interview Ray did with Yahoo Finance summarizing his research.

Here is a link to the pre-released free e-book, The Changing World Order

Here is a link to the free e-book, Principles for Navigating Big Debt Crises

Here is a link to the Hirshmann Capital Report.

The analysis presented here is for informational and discussion purposes only and does not constitute investment advice.

Thanks for reading. Please leave your thoughts in the comments and let me know if I got anything wrong here.