Author: Ray Dalio, Author of Go Broke global macro investor with over 50 years of experience navigating debt cycles.

Purpose: To share a detailed study of “Big Debt Cycles” over the last 100-500 years, highlighting concerns about current economic trends and their potential implications.

I. Core Concepts of the Big Debt Cycle – How Countries Go Broke

Dalio’s perspective on the economy is rooted in his experience as a global macro investor, not an economist. He sees markets and economies as aggregates of transactions, where “the price equals the amount of money/credit the buyer gives divided by the quantity of whatever the seller gives in that transaction.”

A. Money vs. Credit: How Countries Go Broke

• Money: Defined as a medium of exchange and a “storehold of wealth that is widely accepted around the world.” Early-stage money is “hard,” meaning its supply cannot be easily increased (e.g., gold, silver, Bitcoin).
• Credit: “Leaves a lingering obligation to pay, and it can be created by mutual agreement of any willing parties.” It produces buying power without necessarily creating money, allowing borrowers to spend more than they earn in the short term, but requiring them to spend less later for repayment.
• The fundamental risk to money as a storehold of wealth is the ability to create a lot of it. “Imagine having the ability to create money; who wouldn’t be tempted to do a lot of that? Those who can always are. That creates the Big Debt Cycle.”

B. The Big Debt Cycle Explained: How Countries Go Broke

• A “Ponzi scheme or musical chairs” where “investors holding an increasing amount of debt assets in the belief that they can convert them into money that will have buying power to get real things.”
• It involves the buildup of “paper money” and debt assets/liabilities relative to “hard money” and real assets, and relative to the income required to service the debt.
• Key difference between short-term and long-term debt cycles: The central bank’s ability to reverse them. Short-term cycles can be reversed with money and credit if there’s capacity for non-inflationary growth. Long-term cycles are more complex due to accumulated debt.
• “Debt is currency and currency is debt.” If one dislikes the currency, they must also dislike the debt assets (e.g., bonds), considering their relative yields.

C. Five Major Players Driving Cycles: How Countries Go Broke

1. Borrower-debtors: Private or government entities that borrow.
2. Lender-creditors: Private or government entities that lend.
3. Banks: Intermediaries that make profits by borrowing at lower costs and lending at higher returns, which “creates the debt/credit/money cycles, most importantly the unsustainable bubbles and big debt crises.” Crises occur when loans aren’t repaid or banks’ creditors demand more money than banks possess.
4. Central Governments: Can take on more debt when the private sector cannot, as lender-creditors often view government debt as low-risk due to the central bank’s ability to print money.
5. Government-controlled Central Banks: Can create money and credit in the country’s currency and influence its cost. “If debts are denominated in a country’s own currency, its central bank can and will ‘print’ the money to alleviate the debt crisis.” This reduces the value of the money.

II. Stages and Mechanisms of Debt Cycles – How Countries Go Broke

A. Early Stage: How Countries Go Broke

• Money is “hard” or convertible into hard money at a fixed price.
• Low outstanding “paper money” and debt.
• Private and government debt and debt service ratios are low relative to incomes or liquid assets.

B. Progression and Crisis Points:

• Debt/credit expansions require willingness from both borrower-debtors and lender-creditors, even though “what is good for one is quite often bad for the other.”
• Central banks, through their creation of money and credit, determine total spending on goods, services, and investment assets. “As a result, goods, services, and financial assets tend to rise and decline together with the ebb and flow of money and credit.”
• “Doom loop”: Upward pressure on interest rates weakens the economy, increases government borrowing needs, and creates a supply-and-demand mismatch in the bond market. This forces central banks to “print money” and buy debt (Quantitative Easing – QE).

C. Monetary Policy Phase 2 (MP2) – Fiat System with Debt Monetization:

• Implemented when interest rates cannot be lowered further and private market demand for debt assets is insufficient.
• Central banks create money/credit to buy investment assets (bonds, mortgages, equities).
• “Good for financial asset prices, so it tends to disproportionately benefit those who have financial assets.”
• Ineffective at delivering money to financially stressed individuals and not very targeted.
• The US was in this phase from 2008-2020. This era saw “the amount of debt creation and the amount of debt monetization… greater than the one before it.”

D. Fiscal Adjustments and Their Outcomes: How Countries Go Broke

• Painless cases: Often involved fiscal changes into strong domestic/global economies or coincided with easier financial conditions. Debt was typically not in significant hard currency. These cases showed “Growth vs Potential” largely positive.
• Painful cases: Often involved significant hard currency debts and did not occur in strong economic environments. They resulted in lower growth, higher unemployment, and often rising bond yields.

III. Devaluation and Deleveraging

A. Gradual Devaluation in Fiat Systems: How Countries Go Broke

• Unlike hard currency systems where devaluations are abrupt when governments break convertibility promises, in fiat systems, they “happen more gradually.”
• Example: Bank of Japan’s aggressive debt monetization and low-interest rates led to the yen’s devaluation. Since 2013, Japanese government bond holders lost significantly against gold, USD debt, and domestic purchasing power.

B. Central Bank Interventions and Reserve Sales:

• Central banks use interest rates, debt monetization, and money tightness to incentivize lending and holding debt assets.
• In crises, central governments take on more debt because they are perceived as not defaulting due to the central bank’s ability to print money. The risk shifts to inflation and devalued money for lender-creditors.
• Central bank balance sheets expand as money is printed to finance the government or roll over distressed debts.
• The sale of reserves to defend the currency leads to a shift from hard assets (gold, FX reserves) to soft assets (claims on government/financials). This “contributes to the run on the currency… as investors see the central bank’s resources to defend the currency rapidly decreasing.”
• “The monetization of debts combined with the sale of reserves causes the ratio of the central bank’s hard assets (reserves) to its liabilities (money) to decline, weakening the central bank’s ability to defend the currency.” This is more pronounced in fixed-rate currency regimes.

C. Asset Performance During Devaluations:

• “Government debts devalue relative to real assets like gold, stocks, and commodities.” Digital currencies like Bitcoin may also benefit.
• On average, gold outperforms holding the local currency by roughly 60% from the start of devaluation until the currency bottoms.
• Across various historical cases of currency devaluations and debt write-downs:
• Gold (in Local FX): Average excess return of 81%. (e.g., Japan WWII: 282%, Weimar Germany: 245%)
• Commodity Index (in Local FX): Average excess return of 55%.
• Equities (in Local FX): Average excess return of 34%. (e.g., Weimar Germany: 754%)
• Nominal Bonds: Average excess return of -5%.
• Gold vs. Bonds (vol-matched) averaged 94% excess return. Equities, Gold, and Commodities vs. Bonds (vol-matched) averaged 71% excess return.

D. Deleveraging Process:

• Often involves “inflationary depressions” where debt is devalued.
• Governments raise reserves through asset sales.
• Transition to a stable currency achieved by linking it to a hard currency/asset (e.g., gold) with “very tight money and a very high real interest rate,” penalizing borrower-debtors and rewarding lender-creditors, which stabilizes the debt/currency.

IV. Historical Context and Current State

A. Dalio’s Long-Term Perspective:

• “There has always been, and I expect that there will always be, short-term cycles that over time add up to Big Debt Cycles.”
• Average short-term cycle: ~6 years.
• Average long-term Big Debt Cycle: ~80 years (plus or minus 25 years).
• These cycles are influenced by and influence “the four other big forces” (not detailed in these excerpts, but likely refer to wealth gaps, internal conflict, external conflict/war, and a changing world order).

B. Lessons from Japan (Post-1990):

• Japan built up huge debt funding a bubble that burst in 1989-90.
• Despite a more than doubling of total government debt from 2001 to today (99% to 215% of GDP), “debt held by public is only up ~30%” because the Central Bank (BoJ) monetized enough debt.
• Average interest rates on government debt fell significantly (2.3% in 2001 to 0.6% today), and interest paid by the government to the public is down over 50%.
• Vulnerability: A 3% rise in real interest rates for Japan would lead to:
• BoJ mark-to-market loss of ~30% of GDP on bond holdings, with serious negative cash flow (~-2.5% of GDP).
• Government deficit widening from ~4% to ~8% of GDP over 10 years.
• Government debt surpassing post-WWII peak, rising from 220% to 300% in 20 years.
• Combined cash flow need of 5-6% of GDP per year, requiring debt issuance, money printing, or deficit reduction, “which would be the equivalent of another round of QE in terms of expansion of the money stock.” This would lead to “even greater write-downs in debt and devaluations of the currency—with the Japanese people becoming relatively poorer in the process.”

C. Current Big Debt Cycle (Focus on US):

• The current global money/debt market has been a US dollar debt market since 1945.
• Dalio believes we are “near the end of these orders and our current Big Cycle.”
• “The real bond yield has averaged about 2% over the last 100 years.” Periods deviating from this norm lead to “excessively cheap or excessively expensive credit/debt” contributing to big swings.
• In the “new MP2 era (2008-20),” there were two short-term cycles, each with “greater” debt creation and monetization.
• US Trajectory Today: With US government debt at 100% of GDP and a 6% deficit, Dalio’s models show debt-to-income rising significantly over 10 years if interest rates exceed income growth. For example, with a constant primary deficit of 12% (CBO Projection), starting debt-to-income of 500% could reach 676% in 10 years with a 1% Nominal Interest Rate – Nominal Growth.

V. Indicators and Risks

A. Assessing Long-Term Debt Risks:

• Key indicators include:
• Government Assets vs. Debt (% Ctry GDP)
• Government Debt (% Ctry GDP) and 10-year forward projection
• Debt held by Central Bank, other domestic players, and abroad
• Whether a significant share of debt is in hard currency
• Government Interest (% Govt Revenue)
• FX Reserves (% Ctry GDP)
• Total Debt (% Ctry GDP)
• Current Account 3Yr MA (% Ctry GDP)
• Reserve Currency Status (World Trade, Debt, Equity, Central Bank Reserves in Ctry FX). Being a reserve currency is a “great risk mitigator.”

B. Dalio’s Risk Gauges for US:

• Central Bank Long-Term Risk: Currently at -1.0z (lower is better, suggesting less vulnerable).
• Central Bank Profitability: Current profitability at -0.2% of GDP, but if rates rise, projected at -0.4%.
• Central Bank Balance Sheet: “Unbacked Money (% GDP)” is 71%, and “Reserves/Money” is -1.5z.
• Currency as Storehold of Wealth Gauge: -2.0z.
• Reserve FX/Financial Center: -3.3z.
• History of Losses for Savers: 1.1z.
• Long-Term Real Cash Return (Ann): -1.4%.
• Long-Term Gold Return (Ann): 9.8%.

C. Policy Recommendation:

• Dalio believes the Fed should be less extreme and volatile.
• Goal: “Keep the long-term real interest rate relatively stable at a rate that balances the needs of both borrower-debtors and lender-creditors and doesn’t contribute to the making of debt bubbles and busts.”
• Target: Real Treasury bond yield around 2% (varying by ~1%), with a yield curve slope where short-term rate is ~1% below long-term rate, and short-term rate divided by long-term rate is ~70%.

Key Takeaways:

• Debt cycles are inevitable and driven by the interplay of money, credit, and the actions of key players, particularly central banks and governments.
• The ability to print fiat money allows governments to avoid outright default but leads to gradual currency devaluation and inflation.
• Real assets like gold, commodities, and equities tend to outperform nominal bonds and local currency during periods of debt write-downs and currency devaluations.
• Current global trends, particularly in major economies like the US and Japan, suggest the world is approaching the later stages of a Big Debt Cycle, characterized by increasing debt monetization and the potential for significant economic shifts.
• Dalio emphasizes the importance of monitoring debt and financial indicators, while also acknowledging the influence of broader geopolitical and social forces.

Dalio’s How Countries Go Broke : The Big Cycle” – Study Guide

Quiz

Instructions: Answer each question in 2-3 sentences.

1. Distinction between Short-Term and Long-Term Debt Cycles: What is the primary difference Ray Dalio identifies between short-term and long-term debt cycles concerning the central bank’s ability to manage them?
2. “Hard” vs. “Paper” Money: Explain the concept of “hard” money in the early stages of a Big Debt Cycle and how it differs from “paper money.” Provide examples of hard money.
3. Debt as a Ponzi Scheme/Musical Chairs: How does Dalio describe the progression of the Big Debt Cycle in terms of a “Ponzi scheme” or “musical chairs” for investors holding debt assets?
4. Monetary Policy 2 (MP2): Describe Monetary Policy 2 (MP2) and its typical effects on financial asset prices and the distribution of money within an economy. When is it typically implemented?
5. Credit vs. Money: How does Dalio differentiate credit from money in terms of their creation and their impact on buying power and future spending?
6. Debt and Currency Equivalence: Explain Dalio’s perspective on why debt and currency are “essentially the same thing,” especially when considering their relative yields.
7. Role of Banks in Debt Cycles: According to Dalio, how do private sector banks contribute to the creation of “unsustainable bubbles and big debt crises”?
8. Central Bank’s Power with Own Currency Debt: What critical power does a central bank possess when a country’s debts are denominated in its own currency, and what is the inevitable consequence of exercising this power to alleviate a debt crisis?
9. Impact of Interest Rates vs. Income Growth on Debt: Explain how the relationship between nominal interest rates and nominal income growth rates affects a country’s debt-to-income ratio.
10. Hard vs. Floating Currency Devaluations: How do devaluations differ in “hard currency” regimes compared to “fiat monetary systems” (floating currencies) according to Dalio?

Answer Key – How Countries Go Broke

1. Distinction between Short-Term and Long-Term Debt Cycles: The main difference lies in the central bank’s ability to reverse their contraction phases. Short-term cycles can be reversed with a significant injection of money and credit because the economy still has the capacity for non-inflationary growth. Long-term cycles, however, reach a point where this is no longer effective or sustainable.
2. “Hard” vs. “Paper” Money: “Hard money” is a medium of exchange and a storehold of wealth that cannot be easily increased in supply, such as gold, silver, or more recently, Bitcoin. In contrast, “paper money” (fiat currency) is convertible into hard money at a fixed price in the early stages of a Big Debt Cycle, but its supply can be easily increased by those in power, leading to the cycle.
3. Debt as a Ponzi Scheme/Musical Chairs: Dalio explains that the Big Debt Cycle works like a Ponzi scheme or musical chairs because investors accumulate an increasing amount of debt assets based on the belief they can convert them into money with real buying power. This becomes impossible as debt assets grow disproportionately large relative to real things, eventually leading to a scramble to sell debt for hard money or real assets.
4. Monetary Policy 2 (MP2): MP2 is a type of monetary policy implemented by central banks where they use their ability to create money and credit to buy investment assets. It is employed when interest rates cannot be lowered further and private market demand for debt assets is insufficient. This policy tends to benefit financial asset prices and those who hold them, but it is not effective in directly delivering money to financially stressed individuals and is not very targeted.
5. Credit vs. Money: Money is both a medium of exchange and a storehold of wealth, while credit is a promise to pay money that creates buying power without necessarily creating money itself. Credit allows borrowers to spend more than they earn in the short term, but creates a future obligation to spend less than they earn to repay debts, contributing to the cyclical nature of the system.
6. Debt and Currency Equivalence: Dalio states that debt and currency are “essentially the same thing” because a debt asset is a promise to receive a specified amount of currency at a future date. Therefore, an investor’s dislike for one (e.g., a currency due to devaluation risk) should logically extend to the other (e.g., bonds denominated in that currency), especially when considering their relative yields and expected price changes.
7. Role of Banks in Debt Cycles: Private sector banks contribute to unsustainable bubbles and big debt crises by lending out significantly more money than they possess, aiming to profit from the spread between borrowing and lending rates. Crises occur when loans are not repaid adequately, or when banks’ creditors demand more money back than the banks actually hold.
8. Central Bank’s Power with Own Currency Debt: If a country’s debts are denominated in its own currency, its central bank can “print” money to alleviate a debt crisis. While this allows for better management of the crisis compared to situations where they cannot print money, the inevitable consequence is a reduction in the value of the money, leading to devaluation and inflation.
9. Impact of Interest Rates vs. Income Growth on Debt: When nominal interest rates are higher than nominal income growth rates, existing debt grows relative to incomes because the debt compounds faster than incomes grow. This dynamic exacerbates the debt burden, making it harder for governments and individuals to service their debts.
10. Hard vs. Floating Currency Devaluations: In hard currency regimes, devaluations tend to happen abruptly and all at once when a government breaks its promise to convert paper money into a hard money storehold of wealth (e.g., gold). In contrast, in fiat monetary systems (floating currencies), devaluations occur more gradually as central banks print money to manage debt, progressively reducing the currency’s value.

Essay Format Questions – How Countries Go Broke

1. Dalio argues that the “Big Debt Cycle” functions like a “Ponzi scheme or musical chairs.” Elaborate on this analogy, explaining how the cycle builds up debt assets and liabilities, and what triggers the eventual realization that the system is unsustainable for investors.
2. Analyze the role of central banks in managing both short-term and long-term debt cycles. Discuss the tools they employ (e.g., MP2, interest rates, debt monetization) and the inherent trade-offs, particularly concerning the value of the currency and the distribution of wealth.
3. Compare and contrast the outcomes and dynamics of currency devaluations and debt write-downs in fixed exchange rate systems versus floating fiat currency systems, using examples or principles from the provided text to support your points.
4. Discuss the interplay between “the five major types of players that drive money and debt cycles” as identified by Dalio. How do their differing motivations (e.g., borrower-debtors vs. lender-creditors) influence the expansion and contraction of credit, and what role do intermediaries like banks play in this process?
5. Based on Dalio’s assessment, what are the key indicators and factors that contribute to a country’s long-term and short-term debt risks? Explain how being a reserve currency country might mitigate some of these risks, and what specific data points or “gauges” he considers important for evaluating central bank health.

Glossary of Key Terms

• Big Debt Cycle: A long-term economic cycle, typically lasting about 80 years, give or take 25, characterized by the build-up of “paper money” and debt assets/liabilities relative to “hard money,” real assets, and income. It culminates in debt restructuring or monetization.
• Central Bank: A government-controlled institution that can create money and credit in a country’s currency and influence the cost of money and credit. A key player in money and debt cycles.
• Credit: A promise to pay money in the future. It produces buying power that didn’t exist before and creates a lingering obligation to repay, influencing future spending and prices.
• Currency Forward: The exchange rate at which a currency can be bought or sold for delivery at a future date. Influenced by the difference in sovereign interest rates between two countries.
• Debt Monetization (Quantitative Easing – QE): A monetary policy implemented by a central bank where it creates money and credit to buy investment assets, typically government bonds, to alleviate debt crises and stimulate the economy. Often referred to as MP2.
• Devaluation: The official lowering of the value of a country’s currency relative to other currencies or a hard asset. In fiat systems, it tends to happen gradually through money printing; in hard currency systems, it can be abrupt.
• Fiat Monetary System: A monetary system in which the currency is not backed by a physical commodity (like gold) but is declared legal tender by government decree. Central banks primarily use interest rates and debt monetization to manage it.
• Fixed Exchange Rate (Pegged Currency): A currency regime where a country’s currency value is tied to the value of another single currency, a basket of currencies, or a commodity (like gold). These systems tend to experience more pronounced currency defenses and sharper devaluations when they break.
• Floating Exchange Rate: A currency regime where a country’s currency value is determined by market forces (supply and demand) and is not pegged to another currency or commodity. Devaluations in these systems tend to be more gradual.
• Hard Money: A medium of exchange and a storehold of wealth that cannot easily be increased in supply, such as gold, silver, or cryptocurrencies like Bitcoin.
• Inflation-Indexed Bond Market (e.g., TIPS): A market for bonds whose principal or interest payments are adjusted for inflation. Dalio considers them important indicators and storeholds of wealth.
• Interest Rate: The cost of borrowing money or the return on lending money. Central banks influence this to affect the economy.
• Long-Term Debt Cycle: See Big Debt Cycle.
• Monetary Policy 2 (MP2): See Debt Monetization (Quantitative Easing – QE).
• Money: A medium of exchange and a storehold of wealth that is widely accepted.
• Nominal Interest Rate: The stated interest rate without adjustment for inflation.
• Nominal Income Growth Rate: The rate at which a country’s income grows without adjustment for inflation.
• Ponzi Scheme/Musical Chairs: Analogies used by Dalio to describe the unsustainable nature of the Big Debt Cycle, where an increasing amount of debt assets are held based on faith in their convertibility to real buying power, which eventually proves impossible.
• Quantitative Easing (QE): See Debt Monetization.
• Real Interest Rate: The nominal interest rate adjusted for inflation, representing the true cost of borrowing or return on lending in terms of purchasing power. Dalio suggests a target of around 2%.
• Reserve Currency: A currency widely accepted around the world as both a medium of exchange and a storehold of wealth. Being a reserve currency country offers a significant risk mitigator during debt cycles.
• Short-Term Debt Cycle: A shorter economic cycle, typically around six years, give or take three, where central banks can effectively reverse contractions through monetary and credit injections. These cycles aggregate to form the Big Debt Cycle.
• Storehold of Wealth: An asset that maintains its value over time, despite inflation or economic fluctuations. Gold, silver, and Bitcoin are cited as examples of “hard” storeholds of wealth.
• Transaction: The most basic building block of markets and economies, where a buyer gives money (or credit) to a seller in exchange for a good, service, or financial asset. Prices are determined by the aggregate of these transactions.
• Yield Curve: A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. Dalio notes it is typically upward-sloping.

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