Ray Dalio: The Most Important Principles When Thinking About Massive Government Debt and Deficits

Original Title: The Most Important Principle to Keep in Mind When Thinking About Large Government Debts and Deficits

Original author: Ray Dalio

Original translation: Block unicorn

The principles are as follows:

When national debt is excessive, lowering interest rates and devaluing the currency in which the debt is denominated are the most likely priority paths that government decision-makers will take, so it is worthwhile to bet on this situation occurring.

As I write this, we know that a massive deficit and a significant increase in government debt and debt repayment expenditures are expected in the future. (You can see this data in my works, including my new book "How Nations Go Bankrupt: The Big Cycle"; I also shared last week my thoughts on why I believe the U.S. political system cannot control the debt issue.) We know that the cost of debt repayment (paying interest and principal) will grow rapidly, squeezing other expenditures, and we also know that, in the most optimistic scenario, the likelihood of an increase in debt demand matching the supply of debt that needs to be sold is extremely low. I elaborate on what I believe all this means in "How Nations Go Bankrupt" and describe the mechanisms behind my thinking. Others have also stress-tested this, and there is currently almost complete agreement that the picture I have drawn is accurate. Of course, this does not mean I cannot be wrong. You need to judge for yourself what might be true. I am simply providing my thoughts for everyone to evaluate.

My Principles

As I have explained, based on my experience and research from over 50 years of investing, I have developed and documented some principles that help me predict events for successful betting. I am now at a stage in my life where I hope to pass these principles on to others to provide assistance. Furthermore, I believe that to understand what is happening and what might happen, it is essential to understand how the mechanisms work; thus, I also attempt to explain my understanding of the mechanisms behind the principles. Here are several additional principles along with my explanation of how I believe the mechanisms work. I consider the following principles to be correct and beneficial:

The most covert method that policymakers use to deal with excessive debt, and also the most popular and common method, is to lower real interest rates and real monetary rates.

Although lowering interest rates and currency exchange rates to address excessive debt and its issues can provide relief in the short term, it reduces the demand for currency and debt, leading to long-term problems as it decreases the returns on holding currency/debt, thereby diminishing the value of debt as a store of wealth. Over time, this often results in increased debt, as lower real interest rates are stimulative, exacerbating the problem.

In summary, when there is excessive debt, interest rates and currency exchange rates are often suppressed.

Is this good or bad for the economic situation?

Both have their merits, often being good and widely popular in the short term, but harmful in the long term, leading to more serious problems. Lowering real interest rates and real currency exchange rates is... beneficial in the short term because it is stimulative and often drives up asset prices... but harmful in the medium and long term because: a) it leads to lower real returns for those holding these assets (due to currency depreciation and lower yields), b) it results in higher inflation rates, c) it leads to greater debt.

In any case, this clearly cannot avoid the painful consequences of overspending and being deeply in debt. Here is how it works:

When interest rates fall, borrowers (debtors) benefit as this reduces the cost of debt repayment, making the cost of borrowing and purchasing lower, which in turn drives up the prices of investment assets and stimulates growth. This is why almost everyone is satisfied with lower interest rates in the short term.

However, at the same time, these price increases mask the negative consequences of lowering interest rates to undesirable low levels, which is detrimental to both borrowers and creditors. These are facts, as lowering interest rates (especially real interest rates), including central banks suppressing bond yields, will push up the prices of bonds and most other assets, leading to lower future returns (for example, when interest rates fall into negative territory, bond prices rise). This also leads to more debt, resulting in greater debt issues in the future. Therefore, the returns on debt assets held by lenders/creditors decrease, creating more debt.

Lower real interest rates also tend to reduce the actual value of currency, as they make the yield on currency/credit lower relative to alternatives in other countries. Let me explain why lowering the currency exchange rate is the preferred and most common way for government decision-makers to address excessive debt.

The preference for lower currency exchange rates by government decision-makers, which seems advantageous when explaining to voters, is due to two reasons:

1. A lower currency exchange rate makes domestic goods and services cheaper compared to those of countries with an appreciated currency, thereby stimulating economic activity and driving asset prices up (especially in nominal terms), and...

2. …It makes debt repayment easier, but this approach is more painful for foreign holders of debt assets than for domestic citizens. This is because another "hard currency" approach requires tightening monetary and credit policies, which leads to persistently high real interest rates, thereby suppressing spending, usually meaning painful service cuts and/or tax increases, as well as stricter loan conditions that citizens are unwilling to accept. In contrast, as I will explain below, lower monetary rates represent a "hidden" way of repaying debt, as most people are not aware that their wealth is decreasing.

From the perspective of depreciating currency, a lower exchange rate usually also increases the value of foreign assets.

For example, if the dollar depreciates by 20%, American investors can pay foreigners holding dollar-denominated debt with a currency that has lost 20% of its value (i.e., foreigners holding debt assets will incur a 20% currency loss). The dangers of a weaker currency are less obvious but do exist, namely that those holding a weaker currency experience a decline in purchasing power and borrowing capacity—purchasing power declines because their currency's purchasing power diminishes, and borrowing capacity decreases because buyers of debt assets are reluctant to purchase debt assets priced in a currency that is losing value (i.e., assets that promise currency) or the currency itself. It is not obvious because most people in countries experiencing currency depreciation (for example, Americans using dollars) do not see a decline in their purchasing power and wealth, as they measure asset values in their own currency, creating an illusion of asset appreciation, even though the currency value of their asset pricing is decreasing. For instance, if the dollar falls by 20%, American investors who only focus on the rising value of the assets they hold priced in dollars will not directly see that their purchasing power for foreign goods and services has decreased by .20%. However, for foreigners holding dollar-denominated debt, this will be apparent and painful. As they become increasingly concerned about this situation, they will sell (offload) the currency priced in debt and/or debt assets, leading to further weakness in the currency and/or debt.

In summary, viewing issues solely from the perspective of one's national currency clearly leads to a distorted viewpoint. For instance, if the price of something (like gold) rises by 20% when priced in dollars, we would perceive that the price of that item has increased rather than the value of the dollar has decreased. The fact that most people hold this distorted perspective makes these ways of dealing with excessive debt "hidden" and politically more palatable than other alternatives.

The way of looking at things has changed significantly over the years, especially from the time when people were accustomed to the gold standard monetary system to now being used to the fiat/paper currency monetary system (where currency is no longer backed by gold or any hard asset, a reality that emerged after Nixon decoupled the dollar from gold in 1971). When currency exists in the form of paper money and acts as a claim against gold (what we call gold-backed currency), people believe that the value of paper money will rise or fall. Its value almost always declines, and the only question is whether it declines faster than the interest rates earned from holding fiat currency debt instruments. Now, the world has become accustomed to viewing prices through the lens of fiat/paper currency; they have the opposite view — they believe that prices are rising rather than the value of currency declining.

Because a) priced in gold standard currency and b) the quantity of gold standard currency have historically been more stable than a) priced in fiat/paper currency; b) the quantity of fiat/paper currency prices is much more stable, so I believe that viewing prices from the perspective of gold standard currency may be a more accurate way. Clearly, central banks around the world hold similar views, as gold has become the second largest currency (reserve asset) they hold, second only to the US dollar, ahead of the euro and yen, partly for these reasons and partly because the risk of gold being confiscated is lower.

The decline in fiat currency and real interest rates, as well as the rise in non-fiat currencies (such as gold, Bitcoin, silver, etc.), has historically (and logically should) depended on their relative supply and demand relationships. For example, enormous debt that cannot be supported by hard currency can lead to significant monetary and credit loosening, resulting in a sharp decline in real interest rates and real currency exchange rates. The last major period when this occurred was during the stagflation period from 1971 to 1981, which led to significant changes in wealth, financial markets, the economy, and the political environment. Given the scale of existing debt and deficits (not only in the U.S. but also in other fiat currency countries), similar enormous changes may occur in the coming years.

Whether this statement is correct or not, the seriousness of debt and budget issues seems to be beyond doubt. In such times, having hard currency is a good thing. So far, and for many centuries around the world, gold has been considered hard currency. Recently, some cryptocurrencies have also been viewed as hard currency. For certain reasons, which I will not elaborate on, I prefer gold, although I do hold some cryptocurrencies.

How much gold should a person hold?

Although I'm not giving you specific investment advice, I will share some principles that helped me form my perspective on this issue. When considering the ratio of holding gold to bonds, I think about their relative supply and demand as well as the relative costs and returns of holding them. For example, the current interest rate on U.S. Treasury bonds is about 4.5%, while the interest rate on gold is 0%. If I believe that the price of gold will rise more than 4.5% in the next year, then holding gold makes sense; if I don't believe gold will rise 4.5%, then holding gold is unreasonable. To help me make this assessment, I will observe the supply and demand of both.

I also know that gold and bonds can diversify risks from each other, so I will consider what proportion of gold and bonds I should hold for good risk control. I understand that holding about 15% of gold can effectively diversify risks, as it can provide a better return/risk ratio for the portfolio. Inflation-linked bonds have the same effect, so it is worth considering adding both of these assets to a typical portfolio.

I share this perspective with you, rather than telling you how I think the market will change, or suggesting how many types of assets you should hold, because my goal is to "teach a man to fish, rather than give him a fish."