Dalio’s big picture perspective applies not only to temporal and geographic breadth, but also to viewing the markets and economies through the lens of long-term cycles and trends. Dalio’s template for understanding economies consists of superimposing three forces that together explain the position and direction of any economy:
1. Productivity growth
—Real per capita GDP in the United States has increased at an average rate of near 2 percent over the past 100 years as a result of productivity gains, but has fluctuated widely around this trend based on the prevailing long-term and business cycles.
2. Long-term credit expansion/deleveraging cycle
—Initially, the availability of credit expands spending beyond income levels. As Dalio
explains, [This process] is self-reinforcing because rising spending generates rising incomes and rising net worths, which raise borrowers’ capacity to borrow, which allows more buying and spending. . . . The up-wave in the cycle typically goes on for decades, with variations in it primarily due to central banks tightening and easing credit (which makes business cycles).
Although self-reinforcing, the credit expansion phase ultimately reaches a point where it can no longer be extended. Dalio describes this transition in the credit cycle as follows:
It can’t go on forever. Eventually the debt service payments become equal to or larger than the amount we can borrow and the spending must decline. When promises to deliver money (debt) can’t rise any more relative to the money and credit coming in, the process works in
reverse and we have deleveragings. Since borrowing is simply a way of pulling spending forward, the person spending $110,000 per year and earning $100,000 per year has to cut his spending to $90,000 for as many years as he spent $110,000, all else being equal. . . . In deleveragings, rather than debts rising relative to money as they do in up-waves, the reverse is true. As the money coming in to debtors via incomes and borrowings is not enough to meet debtors’ obligations, assets need to be sold and spending needs to be cut in order to raise cash. This leads asset values to fall, which reduces the value of collateral, and in turn reduces incomes. Because of both lower collateral values and lower incomes, borrowers’ creditworthiness is reduced, so they justifiably get less credit, and so it continues in a selfreinforcing manner.
Dalio emphasizes that deleveragings are very different from recessions:
Unlike in recessions, when cutting interest rates and creating more money can rectify this imbalance, in deleveragings monetary policy is ineffective in creating credit. In other words, in recessions (when monetary policy is effective) the imbalance between the amount of money and the need for it to service debt can be rectified because interest rates can be cut enough to (1) ease debt service burdens, (2) stimulate economic activity because monthly debt service payments are high relative to incomes, and (3) produce a positive wealth effect; however, in deleveragings, this can’t happen. In deflationary depressions/deleveragings, monetary policy is typically ineffective in creating credit because interest rates hit 0 percent and can’t be lowered further, so other, less-effective ways of increasing money are followed. Credit growth is difficult to stimulate because borrowers remain overindebted, making sensible lending impossible. In inflationary deleveragings, monetary policy is ineffective in creating credit because increased money growth goes into other currencies and inflation hedge assets because investors fear that their lending will be paid back with money of depreciated value.
3. Business cycle
—The business cycle refers to fluctuations in economic activity. Dalio explains that “In the ‘business cycle,’ the availability and cost of credit are driven by central bankers, while in the ‘long wave cycle,’ the availability and cost of credit are driven by factors that are largely beyond central banks’ control.” In the standard business cycle, the central bank can boost a lagging economy by lowering interest rates. In the deleveraging phase of the long wave cycle, central banks can’t exert any influence by lowering rates because rates are already at or near zero.
It should now be clear why Dalio believes that any fundamental market analysis based solely on the entire post–World War II period in the United States is entirely inadequate. Although encompassing nearly 70 years, this period in the United States does not contain any deleveragings other
than the current one that began in 2008. And, as explained, economies and markets behave very differently in deleveragings than in standard recessions. By focusing more broadly through both time and geography, Dalio is able to draw upon past instances that are comparable to the current situation (e.g., Great Depression, postbubble Japan, Latin American defaults).
In regard to the cycles that affect individual countries, Dalio takes an even broader perspective, measured in centuries, which he calls, appropriately enough, “the really big picture.” Dalio believes that all countries move through a five-phase cycle:
Stage 1
—Countries are poor and think that they are poor.
Stage 2
—Countries are getting rich quickly, but still think they are poor.
Stage 3
—Countries are rich and think of themselves as rich.
Stage 4
—Countries become poorer and still think of themselves as rich.
Stage 5
—Countries go through deleveraging and relative decline, which they are slow to accept.
This is how Dalio describes countries in Stage 4:
This is the leveraging up phase—i.e., debts rise relative to incomes until they can’t anymore. . . . Because spending continues to be strong, they continue to appear rich, even though their balance sheets deteriorate. The reduced level of efficient investments in infrastructure, capital goods, and R&D slow their productivity gains. Their cities and infrastructures become older and less efficient than those in the two earlier stages. Their balance of payments positions deteriorate, reflecting their reduced competitiveness. They increasingly rely on their reputations rather than on their competitiveness to fund their deficits. They typically spend a lot of money on the military at this stage, sometimes very large amounts because of wars, in order to protect their global interests. Often, though not always, at the advanced stages of this phase, countries run “twin deficits”—i.e., both balance of payments and government deficits.
In the last few years of this stage, frequently bubbles occur. . . . These bubbles emerge because investors, businessmen, financial intermediaries, individuals, and policy makers tend to assume that the future will be like the past so they bet heavily on the trends continuing. They mistakenly believe that investments that have gone up a lot are good rather than expensive so they borrow money to buy them, which drives up their prices more and reinforces this bubble process. . . . Bubbles burst when the income growth and investment returns inevitably fall short of the levels required to service these debts. . . . The financial losses that result from the bubble bursting contribute to the country’s economic decline. Whether due to wars or bubbles or both, what typifies this stage is an accumulation of debt that can’t be paid back in nondepreciated money, which leads to the next stage.
And Stage 5:
After bubbles burst and when deleveragings occur, private debt growth, private sector spending, asset values, and net worths decline in a selfreinforcing negative cycle. To compensate, government debt growth, government deficits, and central bank “printing” of money typically increase. In this way, their central banks and central governments cut real interest rates and increase nominal GDP growth so that it is comfortably above nominal interest rates in order to ease debt burdens. As a result of these low real interest rates, weak currencies, and poor economic conditions, their debt and equity assets are poor performing and increasingly these countries have to compete with less expensive
countries that are in the earlier stages of development. Their currencies depreciate and they like it. As an extension of these economic and financial trends, countries in this stage see their power in the world decline.
The foregoing Stage 4 and Stage 5 profiles sound like uncomfortably close descriptions of the United States (Stage 5—current situation; Stage 4 preceding decades), don’t they?
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