We Study Billionaires - The Investor’s Podcast Network - TIP498: Ray Dalio's Book - Big Debt Crises & How the Economic Machine Works

Starting point is 00:00:00 You're listening to TIP. Hey, everyone, welcome to The Investors Podcast. I'm your host, Clay Fink, and boy, am I as excited as ever to bring you today's episode talking about Ray Dalio's thesis on the long-term debt cycle. Today's episode dives into Ray Dalio's book, Big Debt Crisis, Part 1, which gives an overview of the archetypal big debt cycle. For those who may not be aware of Ray Dalio, he is the founder of Bridgewater Associates, which is the largest hedge fund in the world.

Starting point is 00:00:32 TIP actually had the honor of featuring Ray on our show on January 1st of 2022 to chat about his most recent book, Principles for Dealing with the Changing World Order. Ray's personal net worth is around $20 billion, according to Forbes, and because of his knowledge of cycles and investing, he was actually able to sidesteped the great financial crisis. While most investment managers were down big at the time, Dallio's fund was up 8.7% after fees in 2008. Ray Dalio, put simply, is an incredible thinker and a very contrarian investor. He is extraordinarily good at putting his feelings and emotions aside and investing in a way that is rational, despite what the crowd or what other investors are doing.

Starting point is 00:01:18 All of his books have had a tremendous impact on how we hear at TIP think and invest, as well as how we operate as a company. Dallio's book, Big Debt Crisis, is cat. categorized into three parts. The first part explains the big picture of how our economy works and how the archetypal big debt cycle evolves and has played out throughout history. Ray and his team have studied more than 48 debt crises that have occurred, and those are covered in parts two and three of his book. Part two of the book dives deep into Weimar, Germany's hyperinflation event that occurred from 1918 to 1924, the Great Depression in the U.S. from 1928 to 1937, and the Great Financial Crisis.

Starting point is 00:01:59 from 2007 to 2011. Part 3 dives into all of the other case studies he looked into, but for this podcast episode, I will be focusing on part one of his book, which summarizes his findings on how these debt bubbles and debt cycles pop up in our economy and eventually end up getting resolved. Dahlia's book, Big Debt Crisis, is offered for free online if you're interested in checking it out yourself and learning more. The physical copy is, of course, available if you're also interested in purchasing that. I will warn you that the content in the book and in this episode is fairly complex.

Starting point is 00:02:34 So if you're really new to investing, you might need to go back and re-listen to some parts and maybe look up some terms that Ray uses throughout his book. This definitely is not your easy read that you can simply sift through really quickly. So just wanted to make that known before we dive in. Without further delay, let's get right to it. You are listening to The Investors Podcast, where we study the financial markets and read the book that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Starting point is 00:03:16 Before we dive into the specifics of the book, Dahlio has this very popular video that I wanted to mention. It's called How the Economic Machine Works. It's a 30-minute video on YouTube, so if you'd like to learn more about this type of content and learn more of the basics, I'd recommend checking out that video to better understand his thesis on the long-term debt cycle. I'll be sure to link that in the show notes if you're interested. Now, what I really love about this book is that when you're reading through it, you can tell

Starting point is 00:03:44 that Ray Dalio thinks very logically, and it really makes a lot of sense as you read through it. He states that outcome A naturally leads to outcome B, which naturally leads to outcome C and so on. I just love how he takes this very complex topic, which is our world economy, how it works, and he breaks it down into the fundamental building blocks. That's not to say that this book is an easy read by any means. I think that it takes probably two or three slow, thorough reads to really understand it as there's a lot of terminology we may not be super familiar with and he's really breaking down the fundamentals of the economy, which definitely is no easy task.

Starting point is 00:04:24 So at the very beginning, Dahlio points out from the start that credit and debt are the key drivers of the economy. So to understand the economy, it's critical that we understand what these terms mean. Dahlio defines credit as the giving of buying power. The buying power is given in exchange for a promise to pay it back, which is debt. To use a real-world example, if you were to go out and buy a house for, say, $300,000, but you only put down 20% of that. That's $60,000.

Starting point is 00:04:55 So the remaining amount that's paid to the seller is $240,000, which is financed by the bank. So the bank issues credit to give to you, which is the $240,000. and that is debt that is what you hold. So the bank issued credit and the borrower holds the debt. The credit was the giving of the buying power and the debt is the promise to pay it back over time with interest. Now credit in itself can be a really good thing because we can purchase something today that we otherwise wouldn't be able to. It's especially good when credit is used by individuals and businesses to expand the production of the overall economy, such as when Amazon builds out a warehouse so they can send goods cheaply to households everywhere. The debt that is

Starting point is 00:05:42 accumulated can eventually become a problem, though, if the debt levels reach a point where it can't be paid back. Dahlio states that it's important for an economy to have debt if it wants to increase productivity and living standards for society. He says that from his experience and research, a society having too little credit and debt growth can create as bad or worse economic outcomes as having too much with the costs coming from the foregone opportunities that weren't sought after. So the right balance of credit or debt is a good thing in society if the borrowed money is used productively enough to generate sufficient income to service the debt. Dalia warns that throughout history, most countries eventually run into what's called debt crises.

Starting point is 00:06:28 And policymakers generally err on the side of being too loose with credit because of the near-term rewards that they receive. It's also politically easier to allow easy credit than to have tight credit, as the policymakers can oftentimes delay the debt problems and pass them along to the next politician. The reason that these cycles play out over and over again is simply because of human nature. When things are good, people tend to be optimistic and take on too much debt. and lenders trust their ability to repay because incomes are high at the time. Human nature is the crux of what allows these cycles to play out over and over again throughout history.

Starting point is 00:07:08 Now, Dahlia has popularized this idea of the long-term debt cycle. Credit and debt naturally create cycles in an economy, as when credits issued, the person taking on the debt is spending more than they make today, so in a sense they are borrowing from their future selves. In order to pay that debt back, that person will need to spend less than they make at some point in the future. So today, the person is spending more than they make, and in the future, they will need to spend less than they make in order to make good on that debt and pay it back. This is true for anyone taking on debt, whether it be individuals, corporations, or countries. Dallio says that, quote,

Starting point is 00:07:49 lending naturally creates self-reinforcing upward movements that eventually reverse to create self-reinforcing downward movements that must reverse in turn. During the upswings, lending supports spending and investment, which in turn supports incomes and asset prices. Increased incomes and asset prices support further borrowing and spending on goods and financial assets. The borrowing essentially lifts spending and incomes above the consistent productivity growth of the economy. Near the peak of the upward cycle, lending is based on the expectation that the above-trend growth will continue indefinitely. But of course, that can't happen. Eventually, income will fall below the cost of the loans, end quote. Now, eventually, this upswing turns into a bubble, and bubbles occur in an economy when the overall

Starting point is 00:08:41 expectations are simply unrealistic, and reckless lending standards lead to many bad loans handed out. Once the bubble becomes apparent to the central banks, they start to tighten the economy, leading to the deflation of the bubble. One classic warning sign of a bubble is when an ever-increasing amount of debt is borrowed to service the existing debt, which of course makes the debt problem even worse. Now, when a borrower can't make good on their loans to the lending institutions, those lending institutions can't make good on their obligations to their own creditors. It's as if everything in the economy is connected and intertwined, leading to potential risks of contagion. Policymakers have to address this issue by dealing with the lending institutions first,

Starting point is 00:09:27 such as what they did to bail out the major banks during the great financial crisis. Lenders in the economy post the biggest risk and can create knock-on effects throughout the economy. This includes the banks, insurance companies, non-bank trusts, broker dealers, and special purpose vehicles. There are two main long-term problems that arise from these debt cycles. The first is the losses arising from the expected debt service payments not being made. This leads to the lender not being paid back according to the original terms or the value of the debt is written down. The second issue with cycles is a reduction of lending and spending going forward. This is an issue because it's unlikely that the entities that borrowed too much can generate the same level of spending in the future than before the crisis.

Starting point is 00:10:16 In the book, Dahlia focused on examining the cases where the cycles didn't end particularly well in the past 100 years, but this was the German hyperinflation in the 1920s, the U.S. Great Depression in 1929, and the Great Financial Crisis in 2007-09. After his research, he concluded that countries are much more equipped to manage the cycles well if the country's debts are denominated in their own currency, which today this applies to the United States as they are the reserve currency of the world. Dallio highlighted, quote, the key to handling debt crises well lies in policymakers knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will

Starting point is 00:11:01 have to be spread out, and who will benefit and who will suffer and in what degree so that the political and other consequences are acceptable, end quote. Then the book lays out the four levers that policymakers can use to bring the debt levels down to a point that is manageable relative to the income and cash flows. 1. Austerity, which is spending less money. 2. Debt defaults and restructurings.

Starting point is 00:11:27 3. The central bank printing money and making purchases or providing guarantees. 4. Transfer is of money and credit from those who have more than they need to those who have less. Each of these levers have different implications for the economy and its benefits. people as some levers are inflationary while others are deflationary. Some take from the rich and give to the poor, and some are beneficial to the rich and hurt the poor. So in a way, politicians are put in a really tough position because in a sense they are picking winners and losers in terms of how the

Starting point is 00:12:02 high debt levels are going to be repaid and resolved. Debt crises in a particular country occur because debt and debt service costs rise faster than incomes that are needed to service them. Because debt levels are too high relative to incomes, some sort of de-leveraging is required in order to bring debt levels down on a relative basis. Earlier, I mentioned how Dahlio popularized the long-term debt cycle. According to Dahlio, the long-term debt cycle lasts every 75 to 100 years, and the shorter term debt cycles or the business cycle occurs every five to eight years or so. During the short-term debt cycles, the debt at the end of each cycle tends to be higher than

Starting point is 00:12:43 the previous. So you see these higher lows and higher highs in the economy with each short-term debt cycle because everyone gets more and more levered up than the previous cycle. These shorter-term debt cycles play out until the end of the longer-term debt cycle when the expansion in the debt can't last any longer. These short-term cycles are primarily driven by credit. When credit is easily available, there's an economic expansion. When credit isn't easily available, there's a recession.

Starting point is 00:13:14 And the availability of credit is primarily driven by the central bank through their interest rate policy. As we all know, over the past 40 years until 2022, interest rates have essentially gone straight down over a long enough time period until just recently, and the federal funds rate set by the Federal Reserve eventually hit 0%. after the great financial crisis to try and stimulate the economy the best they could. Over that period, because interest rates went lower and lower, individuals, corporations, and countries took on more and more debt, so debt rose faster than incomes, which creates

Starting point is 00:13:51 the long-term debt cycle. When the limits on debt growth relative to income have been reached, the cycle that has been reinforced on the way up reverses. Asset prices fall. those who take on debt have trouble servicing those debts, investors get scared and cautious as things become tight in the economy, the economy contracts, and liquidity dries up. The stock market then crashes and social tensions in unemployment rise. This is a sort of dynamic that plays out in the long-term debt cycles that has been seen

Starting point is 00:14:22 time and time again dating all the way back to the Roman Empire. These de-leveraging events are painful for all players in the economy, and these can cause tremendous social tensions for those involved. Historians say that the problems that arose from credit creation or lending money to be paid back with interest was considered to be a sin in both Catholicism and Islam. Even in the Old Testament, they described the need to wipe out debt once every 50 years, which was called the Year of Jubilee. Dallio categorized the two main types of ways in which these de-leveraging events end up playing out, the deflationary depression and the inflationary depression.

Starting point is 00:15:03 During the deflationary depression, policymakers drop interest rates to zero, but there is no longer an effective way to stimulate the economy anymore. Debt restructuring and austerity dominate as the overall economy contracts. Most deflationary depressions occur in countries where most of the unsustainable debt

Starting point is 00:15:23 was financed domestically in the local currency. The inflationary depressions tend to occur in countries that are reliant on form. foreign capital flows and have built up debt denominated in a foreign currency that can't be monetized, meaning that the debt can't be purchased by the central bank with newly printed money. Dahlio states that in an inflationary to leveraging, capital withdrawal dries up lending and liquidity at the same time. That currency declines produce inflation. Inflationary depressions in which a lot of debt is denominated in foreign currency are especially difficult to manage because

Starting point is 00:16:00 policymakers' abilities to spread out the pain are more limited. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 8th.

Starting point is 00:16:30 18th year bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building technology under censorship and authoritarian pressures. These aren't abstract ideas. These are tools real people are using right now. You'll be in the room with about 2,000 extraordinary individuals. dissidents, founders, philanthropists, policymakers, the kind of people you don't just listen to, but end up having dinner with. Over three days, you'll experience powerful mainstage talks, hands-on workshops on freedom tech, and financial sovereignty, immersive art installations, and conversations that continue

Starting point is 00:17:18 long after the sessions end. And it's all happening in Oslo in June. If this sounds like your kind of room, well, you're in luck because you can attend in person. Standard and patron passes are available at Osloof Freedom Forum.com with patron passes offering deep access, private events, and small group time with the speakers. The Oslo Freedom Forum isn't just a conference, it's a place where ideas meet reality and where the future is being built by people living it. If you run a business, you've probably had the same thought lately.

Starting point is 00:17:50 How do we make AI useful in the real world? Because the upside is huge, but guessing your way into it is a risky move. With NetSuite by Oracle, you can put AI to work today. NetSuite is the number one AI Cloud ERP, trusted by over 43,000 businesses. It pulls your financials, inventory, commerce, HR, and CRM into one unified system. And that connected data is what makes your AI smarter. It can automate routine work, surface actionable insights, and help you cut costs while making fast AI-powered decisions with confidence.

Starting point is 00:18:24 And now with the Netsuite AI connector, you can use the AI of your choice to connect directly to your real business data. This isn't some add-on, it's AI built into the system that runs your business. And whether your company does millions or even hundreds of millions, Netsuite helps you stay ahead. If your revenues are at least in the seven figures, get their free business guide, demystifying AI at Nessuite.com slash study. The guide is free to you at Nessuite.com slash study. NetSuite.com slash study.

Starting point is 00:18:56 When I started my own side business, it suddenly felt like I had to become 10 different people overnight wearing many different hats. Starting something from scratch can feel exciting, but also incredibly overwhelming and lonely. That's why having the right tools matters. For millions of businesses, that tool is Shopify. Shopify is the commerce platform behind millions of businesses around the world, and 10% of all e-commerce in the U.S. from brands just get to be. Getting started to household names. It gives you everything you need in one place, from inventory

Starting point is 00:19:29 to payments to analytics. So you're not juggling a bunch of different platforms. You can build a beautiful online store with hundreds of ready-to-use templates, and Shopify is packed with helpful AI tools that write product descriptions, and even enhance your product photography. Plus, if you ever get stuck, they've got award-winning 24-7 customer support. Start your business today with the industry's best business partner, Shopify, and start hearing, sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. Next, I wanted to dive deeper into the two ways the long-term debt cycle ends up playing out, starting with the deflationary depression. So Dalia breaks down the

Starting point is 00:20:24 archetypal deflationary depression into seven parts. These include the early part of the cycle, the bubble, the top, the depression, the beautiful de-leveraging, and the pushing on the string and normalization. So I'll briefly summarize what each of these mean. The early part of the cycle is when incomes are rising faster than debt levels. This is because the debt is used in a productive manner as it's reinvested into projects that produce income. Farmers are purchasing equipment to produce more crops, governments investing in infrastructure so the economy can be more efficient and so on. The debt is used productively so income is rising faster than debt levels. This leads to great times for the economy because productive members of society are becoming well.

Starting point is 00:21:13 wealthier. This is when economic times are really good because they're steady growth, balance sheets are strong, and there isn't too much debt. Dahlio calls this the Goldilocks period. Then eventually, Thang's approached the bubble territory. In the bubble, debts rise faster than incomes, and they produce accelerating and strong asset returns and growth. This becomes a self-reinforcing cycle. Credit is issued and spent within the economy. People's incomes rise. Asset prices rise, and people feel really wealthy. Since they feel really wealthy, they go lever up their house, they go and make many purchases on credit, which leads to more economic growth, and the cycle pushes upwards and upwards as debt continues to grow faster than incomes.

Starting point is 00:22:01 This is when times seem really good, and people feel really wealthy, at least on paper, because asset values are high. People eventually become euphoric and assume that the great times will continue for the years to come. And to add fuel to the fire, lenders start to become reckless in their lending practices and lend out money to borrowers that aren't creditworthy. This is exactly what was happening prior to the 2008 great financial crisis, as people assume that housing could only go up, and people who shouldn't have been able to buy expensive houses were allowed to do so with money they didn't have. The lenders and the speculators make a lot of money really fast, and this easy money encourages more people to pile in and join the party as everyone is getting rich

Starting point is 00:22:46 on paper. However, this cycle is not sustainable as debts cannot grow faster than incomes forever, as eventually the debts become unsustainable. One reason that this cycle lasts for decades is because the central banks are able to decrease interest rates to make the increased debt levels more manageable. Dallio states that, quote, when promises to deliver money, i.e. debt can't rise any more relative to the money and credit coming in. The process works in reverse and de-leveraging begins." Bubbles are most likely to occur at the tops in the business cycle, the balance of payment cycle, and or the long-term debt cycle. Dalyo cautions that central bankers should be cautious of debt levels and of bubbles, and to keep debt levels at a level that is sustainable

Starting point is 00:23:35 because of the consequences of having unsustainable debt levels can be catastrophic. He stated, quote, The greatest depressions occur when bubbles burst, and if the central banks that are producing the debts that are inflating them won't control them, then who will? The economic pain of allowing a large bubble to inflate and then burst is so high that it is imprudent for policymakers to ignore them, and I hope their perspective will change, end quote.

Starting point is 00:24:04 I also loved how Dahlia laid. out the seven characteristics of bubbles to help us identify when we are in one ourselves. These seven characteristics include one, prices are high relative to traditional measures. Two, prices are discounting future rapid price appreciation from those high levels. Three, there is broad, bullish sentiment. Four, purchases are being financed by high leverage. Five, buyers have made exceptionally extended forward purchases to speculate, or to protect themselves against future price gains.

Starting point is 00:24:39 Six, new buyers have entered the market who previously weren't in the market. And seven, stimulative monetary policy threatens to inflate the bubble even more, and tight policy may cause to pop it. Again, I can't help but think of what was happening in the markets in 2020 and 2021. And with all the euphoria that occurred, and it really makes me believe that markets aren't going to do well as long as interest rates continue to rise in the short term, and central banks are not accommodative as they've been in the past decade. But I tend to be wrong when considering these types of big macro decisions,

Starting point is 00:25:16 so I push myself to not try and time the market too much. Because Dahlia was putting such a heavy emphasis on debt levels, I was curious how the U.S.'s debt levels have changed over time. So I pulled up the debt-to-GDP ratio for the U.S., which isn't perfect because there are many unfunded liabilities such as Social Security, but the debt to GDP is one indicator to see where we stand. During the 1970s, the debt to GDP was around 30%. That gradually rose over time. Right before the great financial crisis, it was around 60%. And then that ratio spiked dramatically ever since. It hit 80% in 2009, 90% in 2010. Right after COVID, it spiked slightly above 130 and 30% And today, that metric is around 121%. So although Ray has called the great financial crisis

Starting point is 00:26:10 the popping of the bubble, it seems to me that because the debt to GDP has increased so much, I think central banks have simply reinflated the bubble rather than actually addressing the issue that's in the system, which is too much debt. I'll also mention that Dahlia does state that looking at the debt to GDP isn't an appropriate way to view the overall economy, whether it's over indebted or not. We would need to analyze individual entities and how the debt is spread out across the key players in the economy. Now, the third part of the classic deflationary depression is the top of the cycle. While the tops are triggered by different events, most often they occur when central banks start to tighten credit conditions and interest rates rise. Tightening credit

Starting point is 00:26:56 conditions naturally lead to a decrease in asset prices, which creates a negative wealth effect. As prices of stocks and real estate decline, this leads to people feeling less wealthy and potentially less willing to go out and spend and borrow as much as they did in the years prior. This in turn leads to lower levels of economic activity, which can potentially make the downward spiral even worse without intervention from central banks. Dallio states that, quote, in the immediate post-bubble period, the wealth effect of asset price movements has a bigger impact on economic growth rates than monetary policy does. People tend to underestimate the size of this effect. In the early stages of the bubble bursting, when stock prices fall and earnings have not yet

Starting point is 00:27:43 declined, people mistakenly judge the decline to be a buying opportunity and find stocks to be cheap in relation to both past earnings and expected earnings, failing to account for the amount of decline in earnings that is likely to result from what's to come. But the reversal is self-reinforcing. As wealth falls first and incomes fall later, creditworthiness worsens, which constricts lending activity. This hurts spending and lowers investment rates while also making it less appealing to borrow to buy financial assets. This in turn, the fundamentals of the asset, leading people to sell, and driving down prices further. This has an accelerating downward impact on asset prices, income, and wealth, end quote. Turning to the fourth

Starting point is 00:28:33 part of the cycle is the Depression. In a normal recession, central banks can relieve the imbalance between the amount of money and the need for it to service debt by cutting interest rates in order to produce a positive wealth effect, stimulate economic activity, and ease the servicing of the debt. This can't happen in depressions because interest rates can't be cut materially because they've already reached close to 0%. There's the saying some people say that eventually the heroin addict becomes immune to the drugs. That's what Dahlia is really getting at here saying that the stimulation isn't effective any longer. When relating this to the great financial crisis, the Federal Reserve lowered interest rates to 0%, but that wasn't enough to keep

Starting point is 00:29:20 the economy functioning. So they turned on the spigot of quantitative easing. Dahlia also showed the chart displaying the average of the 21 total deflationary debt crises his team analyzed. It shows that interest rates at the top of the cycle were around 4%, then they quickly dropped down to nearly 0% during the Depression phase. He also states that at this point of the cycle, debt defaults and austerity, which are the forces of deflation, dominate, and they're not sufficiently balanced with the stimulative and inflationary forces of printing money to cover debts, which is debt monetization. With investors unwilling to continue lending and borrowers scrambling to find cash to cover

Starting point is 00:30:04 their debt payments, liquidity, etc., the ability to sell investments for money becomes a major concern. As an illustration, when you own a $100,000 debt instrument, you presume that you will be able to exchange it for $100,000 in cash and in turn exchange the $100,000 of cash for goods and services. However, since the ratio of financial assets to actual money is high, when a large number of people rush to convert their financial assets into money and buy goods and services in bad times, the central bank either has to provide the liquidity that's needed by printing more money or they allow a lot of defaults, end quote. When I read this, it reminded me exactly of the COVID shock in March 2020 because it's something that I actually lived through as an investor.

Starting point is 00:30:54 When there was a liquidity crisis, the Fed had to make a decision. Would they print money and supply the dollars to the markets where it was needed, or would they let the free market take hold and allow firms that were too levered up to fail? And they obviously choose the first. They printed money, a lot of it, and added the necessary liquidity back into the system and kept the levered-up firms alive for the most part. One of the points that one of the founders of TIP, Preston Pish, constantly hits on is the idea that these liquidity events or sell-offs are not emotionally driven. And Dahlio touches on this as well.

Starting point is 00:31:35 It's common for people to believe that these depressions or stock market crashes are emotionally driven and driven by panic and driven by fear. He says that rather than these crashes being driven by investor psychology, they are driven by the supply and demand of credit, money, and goods and services. More specifically, debtor's obligations to deliver money are too large relative to the money they have coming in. For example, in March 2020, institutions were selling financial assets because they simply had to come up with dollars. It wasn't. particularly an emotional decision. It was more or less something they were forced to do if they wanted to make good on their debt. During bubbles, people believe they are wealthy, but much of

Starting point is 00:32:22 that wealth is actually driven by credit, which is really just created out of nowhere. For example, if someone at a bar walks up to a bartender and asks for a beer and to put it on its tab, this creates credit, an asset to the bar and a liability to the person ordering that beer. If that person ends up not paying off his tab or his debt, then that asset really isn't there. It's just sort of made up. Dallio states that, quote, a big part of the de-leverging process is people discovering that much of what they thought they had as wealth was merely people's promises to give them money. Now that those promises aren't being kept, that wealth no longer exists. When investors try to convert their investments into money in order to raise cash, they test their ability.

Starting point is 00:33:11 to get paid, and in cases where it fails, panic-induced runs and sell-offs of securities occur. Naturally, those who experience runs, especially banks, have problems raising money and credit to meet their needs. So debt defaults cascade, end quote. As debt is reduced in the economy, this leads to a cascading effect and a deflationary force on asset prices. This is really catastrophic for everyone living in this environment. Incomes collapse. job losses are severe. Homes are foreclosed on because payments can't be made. Retirement accounts are crashing, etc. Dahlio says that these conditions persist for many years if policymakers don't offset the Depression's deflationary forces with sufficient monetary stimulation of a new

Starting point is 00:34:00 form. So in this scenario he's describing, the deflationary cascade is really inevitable without intervention from the central banks to provide liquidity the market. is demanding. So again, the four ways in which policymakers can try and manage the economy are austerity, debt defaults and restructurings, debt monetization slash money printing, and wealth transfers. What they can try to do is find the right balance between the four of these to work to mitigate the bad effects of a depression and the institutions that are failing. The key is for them to get the right mix to manage the inflationary and deflationary forces at play. But Dahlio believes that policymakers typically get the mix between the four ways wrong initially,

Starting point is 00:34:47 and that they are usually reluctant and slow to provide government supports in the debt contraction and the agony it produces increase quickly. But the longer they wait to apply stimulative remedies to the mix, the uglier the de-leverging becomes. Eventually, they choose to provide a lot of guarantees, print a lot of money, and monetize a lot of the debt. this lifts the economy into a reflationary de-leveraging. I certainly wasn't an investor in the 2008 financial crisis, but this was the Fed's playbook then. They weren't accommodative enough to the markets initially, and then when things got really bad with the major banks failing, they stepped in with unprecedented levels of monetary easing to give the market the relief that it was screaming for.

Starting point is 00:35:35 So because of the response central banks had at the time, the Depression was relatively short-lived when comparing it to the Great Depression in the 1930s because of the response to the crisis. So the way these debt crises really play out all depend on how central banks and governments react to them. I also wanted to touch more on the four tools that policymakers have in the sort of effects they have on the economy. Austerity essentially means decreased spending. Although it might make sense for governments to decrease spending to pay off their existing debts, the problem is that decreasing spending is deflationary. Remember that one person's spending is another person's income. So if the government cuts spending, for example, that means that incomes overall decline.

Starting point is 00:36:22 And this might cascade as well because lower government spending leads to tightening economic conditions, which means lower government revenues. Because of the significant demand for government support during these crises, taxes really tend to increase. Tool number two, printing money. Money printing is used to stop the bleeding and stimulate the economy. This puts the government in a position where they have to pick winners and losers and who is most essential and who should be saved in the economy. Oftentimes, institutions that are systemically important end up becoming nationalized by the governments. So the first source of the printing goes to the bailouts. Because during these times, the government is having issues raising funds through taxation and borrowing,

Starting point is 00:37:07 central banks are forced to fill the gap and provide that borrowing to the governments. So the second source of the money printing is for the money to be used to purchase government debt, which is also referred to as the monetization of the debt. On top of the monetization of the debt, central banks can also ensure sufficient liquidity is provided to the financial system by lending against collateral. Now, the third tool is, debt defaults and restructurings. Dalia says that the process of cleansing existing bad debts is critical for the future flow of money and credit and for return to prosperity. The challenge for policymakers is to allow that process to work itself out in an orderly way

Starting point is 00:37:49 that ensures economic and social stability. Longer term, the most important decision that policymakers have to make is whether they will change the system to fix the root causes of the debt problems, or simply restructure the debt so that the pain is distributed over the population, and over time so that the debt does not impose an intolerable burden. Typically, institutions that are not systemically important will be forced to absorb the losses, and if they fail, the central banks will allow them to go bankrupt and bust. Also, when most institutions fail, the holders of equity, subordinated debt, and the large depositors will end up absorbing the losses, regardless whether the institution was systemically important or not.

Starting point is 00:38:37 Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customers, Trust together on one AI-powered platform. So whether you're prepping for a SOC 2 or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving. Instead of chasing spreadsheets and screenshots, VANTA gives you continuous automation across more than 35 security

Starting point is 00:39:14 and privacy frameworks. Companies like Ramp and Ryder spend 82% less time on audits with VANTA. That's not just faster compliance, it's more time for growth. If I were running a startup, or scaling a team today, this is exactly the type of platform I'd want in place. Get started at vanta.com slash billionaires. That's vanta.com slash billionaires. Ever wanted to explore the world of online trading, but haven't dared try? The futures market is more active now than ever before, and plus 500 futures is the perfect place to start. Plus 500 gives you access to a wide range of instruments, the S&P 500, NASDAQ, Bitcoin, gas, and much more. Explore equity indices, energy, metals, 4X, crypto, and beyond.

Starting point is 00:40:04 With a simple and intuitive platform, you can trade from anywhere, right from your phone. Deposit with a minimum of $100 and experience the fast, accessible futures trading you've been waiting for. See a trading opportunity. You'll be able to trade it in just two clicks once your account is open. Not sure if you're ready, not a problem. Plus 500 gives you an unlimited risk-free demo account with charts and analytic tools for you to practice on. With over 20 years of experience, Plus 500 is your gateway to the markets.

Starting point is 00:40:37 Visit Plus500.com to learn more. Trading in futures involves risk of loss and is not suitable for everyone. Not all applicants will qualify. Plus 500, it's trading with a plus. Billion dollar investors don't typically park their cash in high-yield savings. accounts. Instead, they often use one of the premier passive income strategies for institutional investors, private credit. Now, the same passive income strategy is available to investors of all sizes thanks to the Fundrise income fund, which has more than $600 million invested

Starting point is 00:41:12 and a 7.97% distribution rate. With traditional savings yields falling, it's no wonder private credit has grown to be a trillion dollar asset class in the last few years. Visit five, Fundrise.com slash WSB to invest in the Fundrise Income Fund in just minutes. The fund's total return in 2025 was 8%, and the average annual total return since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund's prospectus at fundrise.com slash income. This is a paid advertisement.

Starting point is 00:41:58 All right. Back to the show. The fourth and final tool available to policymakers is the redistribution of wealth. Wealth gaps tend to increase during bubbles, as those at the top financially are holding the majority of the equity and financial assets. This rise in wealth inequality can lead to populism movements from both the left and the right, as they both claim to have the solution to the problem and that the system needs changed. The bubble then becomes problematic because when the central banks perform actions like quantitative easing, this is extremely beneficial for the wealthy as it leads to asset price appreciation. The rise of populism and demands for taxing the rich leads to the wealthy people oftentimes crafting ways to protect

Starting point is 00:42:43 their assets to try and keep them from getting tax and redistributed to the others. The problem with heavily taxing the rich is that this incentivizes them to move to a different jurisdiction that is more tax-friendly. This in turn leads to less tax revenues for the government instead of more. Policymakers may also try to put a wealth or inheritance tax in place, but the challenge with this is that so much wealth is illiquid, making it difficult to collect such taxes. To conclude, Dallio states that, quote, transfers rarely occur in amounts that contribute meaningfully to the de-leverging, unless there are revolutions and huge amounts of property that are nationalized, end quote. All right, so moving along to the fifth step of the cycle

Starting point is 00:43:28 is what he calls the beautiful de-leverging. And I find it kind of funny he uses the word beautiful here because oftentimes it seems like it's anything but beautiful, but I digress. Dalia states that, quote, a beautiful de-leverging happens when the four levers are moved in a balanced way, so to reduce the intolerable shocks and produce positive growth with falling debt burdens and acceptable inflation. More specifically, de-levergings become beautiful when there is enough stimulation to offset the deflationary de-leveraging forces and bring the nominal growth rate above the nominal interest rate. But not so much simulation that inflation is accelerated, the currency is devalued, and a new debt bubble arises, end quote. So like I mentioned earlier,

Starting point is 00:44:14 it's all about the policymakers trying to find that right balance between the inflationary and deflationary tools. The best way for policymakers to navigate deflationary to leveraging events is to ensure that adequate liquidity and credit support is provided. In order for de-leveraging to actually occur at the end of the day, income will need to rise faster than debt. A beautiful de-leveraging occurs when debts decline relative to incomes, real economic growth is positive, and inflation isn't a big problem. He also says that money printing, debt monetization, and government guarantees are inevitable during depressions, in which interest rate cuts are not enough.

Starting point is 00:44:55 All of the de-levergings, his team studied, eventually led to big waves of money creation, fiscal deficits, and currency devaluations against gold, commodities, and stocks. Ray also hits on the fact that during the Great Depression, the dollar was actually backed by gold. So having a currency that is backed by something physical constrained their ability to print more money. This meant that they couldn't be as accommodative as they probably would have liked. The reason that the 2008 financial crisis in the crash in March 2020 ended up reflating the economy was because central banks weren't necessarily constrained to how much they could

Starting point is 00:45:32 print because it wasn't backed by something physical and real such as gold or commodities. Dalia states that, quote, in the end, policymakers are, always print. That is because austerity causes more pain than benefit, big restructurings wipe out too much wealth too fast, and transfers of wealth from halves to have-nots don't happen in sufficient size without revolutions. Also, money printing is not inflationary if the size and character of the money creation offsets the size and character of the credit contraction. It is simply negating deflation. In virtually all past de-levergings, policymakers had to discover this for themselves after they

Starting point is 00:46:15 first tried other paths without satisfactory results. History has shown that those who did it quickly and well, like the U.S. in 2008, have derived much better results than those who did it late, like the U.S. in 1930 through 1933. The sixth step of the deflationary depression is, quote, pushing on a string. Later on in the long-term debt cycle, central banks have trouble with their stimulative policies to actually lead to increased spending in the real economy. And increased spending is what drives economic growth. The effects of lowering interest rates and purchases of debt isn't as effective as it was in years

Starting point is 00:46:52 past, thus they have to turn to other forms of monetary stimulation to try and drive spending. The big risk with this is that they end up taking the money printing too far and severe currency devaluation occurs leading to an ugly inflationary de-leveraging. Like I mentioned, the first tool of choice by policymakers is setting interest rates, which has the broadest impact on the overall economy. Reducing interest rates does three things to help support the economy. It produces a wealth effect, such as increased asset prices, it makes it easier for market participants to buy things on credit because interest payments are cheaper, and it reduces debt service burdens as companies can refinance or roll over their existing debt at a lower interest rate. However,

Starting point is 00:47:36 once interest rates hit the lower zero bound, the tool of lowering interest rates has been tapped out and it's no longer as effective. The second tool of choice is quantitative easing, or what people call QE. QE is simply money printing, which is used to buy financial assets, typically debt assets such as U.S. treasuries. This is essentially a transfer of wealth to those who hold financial assets. You look at markets after 2008. The stock market went essentially straight up and to the right as the central bank continued to print money and perform QE. This largely benefits the rich, particularly the top 1 to 5%, and didn't really benefit the bottom half of the U.S. in particular. Just like what you see with interest rates, the effect of QE diminishes over

Starting point is 00:48:24 time as well, because risk premiums are pushed down and asset prices are lifted, making it more and more difficult to produce the wealth effect to encourage spending. To think of it another way, when the stock market is trading at highly elevated levels, it becomes more and more difficult to, in a sly, roundabout way, encourage investors to continue to bid the prices up. So, in a sense, investors start looking for other places or other ways to store their wealth. This is where the term pushing on a string comes into play. Policymakers can print more and more money to encourage spending, but it's no longer becoming an effective tool. The other problem is that if they double down on QE and print even more money, they're threatening the credibility of the currency being a

Starting point is 00:49:10 reliable store of value, which can lead investors to alternative currencies such as gold, and some people would even say Bitcoin. Dahlio says that the fundamental economic challenge most economies have in this phase is that the claims on purchasing power are greater than the abilities to meet them. I was actually quite surprised that Ray was explaining how the Fiat currency system works, and he actually referred to it as a Ponzi scheme. He says that since the currency has no intrinsic value, the paper claims or paper promises or even paper debt on that money are far greater than the overall value of what they would be able to buy in the economy. Therefore, the debt has to be either devalued or restructured. Moving along,

Starting point is 00:49:56 since lowering interest rates and QE are no longer effective at this point, this forces them to move on to policy tool number three, which is direct handouts to the population, also known as Universal Basic Income or UBI. Since wealthier people have less incentive to spend the purchasing power they receive through QE, giving the population the money directly is more effective at encouraging spending. This isn't mentioned in the book, but I can't help but think of all the talks of CBDCs and how the Central Bank through a CBDC will be able to give handouts to people with the requirement that it must be spent on certain things or that it has to be spent within a certain amount of time.

Starting point is 00:50:37 Although I don't advocate CBDCs at all, something like this would give the central banks more power on how the helicopter money they give to people could be spent in the economy. Moving on to step seven of the deflationary depression is the normalization. Dahlio states that it takes roughly five to 10 years for the system to get back to normal and for real economic activity to reach its former peak level, and it takes around a decade for stock prices to reach former highs. Next, I'd like to talk a little bit about the phases of the classic inflationary debt cycle that he outlines in his book.

Starting point is 00:51:14 Over time, central banks typically relieve debt crises by printing a lot of currency in which the debt is denominated, while stimulating spending and cheap. the value of said currency. If a currency falls in relation to another currency at a rate greater than the currency's interest rate, the holder of that debt in the weakening currency is experiencing a loss of their purchasing power. If the holders of that debt expect that to continue and for interest rates to remain relatively low, then this sows the seeds for a dangerous currency dynamic, as the holders of the debt are incentivized to store that buying power elsewhere, such as in another currency or gold or some other hard asset. This currency dynamic is what leads to inflationary

Starting point is 00:51:59 depressions, such as what happened in Weimar, Germany in the 1920s. Central banks are much more equipped to manage their economy when capital is flowing into their country's currency rather than flowing out of it. This is why the U.S. as a world's reserve currency is in a much better position internationally than most other countries, because it has the currency of choice relative to all other fiat currencies. Whereas when I think of a country like Japan, they are printing their currency to perform yield curve control on their debt, which is inflationary and encourages holders of that debt to store their purchasing power elsewhere in a place that's more likely to hold its real buying power. Dallio states that, quote, to make matters worse, those who fund their

Starting point is 00:52:43 activities in the country that has the weaker currency by borrowing the stronger currency see their debt costs soar. That drives down the weaker currency relative to the stronger one even more. For these reasons, countries with the worst debt problems, a lot of debt denominated in a foreign currency, and a high dependence on foreign capital typically have significant currency weaknesses. The currency weakness is what causes inflation when there is a depression, end quote. Countries that are most susceptible to severe inflationary de-levergings or even hyperinflation include those who don't have the reserve currency, have low foreign exchange reserves, have a large foreign debt, have a large and increasing budget or account deficit, have negative real interest rates,

Starting point is 00:53:30 and have a history of high inflation and negative total returns in the currency. Now, you may be wondering whether it's possible for the U.S. to experience an inflationary depression as the world's reserve currency. I'm by no means one to state which path we are going down, but Dahlio states that, quote, if a reserve currency country permits much higher inflation in order to keep growth stronger by printing lots of money, it can further undermine demand for its currency, erode its reserve currency status, and turn its de-leveraging into an inflationary one, end quote. Now, the five steps of the classic inflationary cycle include the early part of the cycle, the bubble, the top and currency defense, the depression, which is when the currency is let go,

Starting point is 00:54:16 and the normalization. Inflationary de-levergings end up transpiring in a similar way to deflationary ones up until step four, which is when the doom loop occurs with the currency. Walking through each of these, the early part of the cycle is when the country's economy is in good shape as there's favorable capital flows and good fundamentals because times are good. This encourages investing, which is oftentimes funded with debt. As more debt is taken on, we know this naturally leads to the bubble.

Starting point is 00:54:46 phase, the bubble emerges in the midst of a self-reinforcing virtuous cycle of strong capital flows, good asset returns, and strong economic conditions. During the bubble phase, further growth is largely financed by debt rather than by productivity gains, and the country becomes highly reliant on foreign financing, thus their debts denominated in foreign currencies rise. These countries borrow from abroad for a number of reasons, including the local financial system is not well developed yet, there's less faith in the local currency, and there's much more foreign capital available. Step three is the top and the currency defense. The top is made when the

Starting point is 00:55:26 flows that cause the bubble and prices of the currency become unsustainable, this motion runs the opposite way. As capital flows weaken and lower asset prices lead to poor economic conditions, which becomes self-reinforcing and leads to less capital flowing into their country year after year. Dahlio states that this sends the country into a balance of payments crisis and an inflationary depression. The economy suffers a debt bust as asset prices fall and banks fail. Because these particular countries' currencies become weaker relative to their foreign debt obligations, there is currency, devaluation, and the printing of money in order to afford the payments on the debt. This leads to investors worrying about the currency being able to hold up,

Starting point is 00:56:11 so ideally they want to store their wealth elsewhere. This also creates a dynamic where, on the one hand, the economy is weak, but the situation with the currency being devalued leads to investors demanding a higher interest rate, and an increase in interest rates leads to tightening economic conditions in a time where the economy is already weak. Because investors are fleeing the currency, this oftentimes leads to capital controls by policymakers, which limit or try to prevent investors from moving out of the local currency. However, when investors see policymakers making these kind of moves, it can lead them to want

Starting point is 00:56:47 to get out of the currency even more, as this is a major warning sign and red flag and can lead to a spiral downwards and a loss of trust in the currency's stability. The fourth step of the inflationary cycle is the depression, and when the currency is let go. Eventually, policymakers have no choice but to let the value of the currency fall. Dallio and his team found that, on average, currencies in the economy, in an inflationary depression fell by 30% in real terms. Real interest rates are negative during this period, so anyone holding the currency or debt in that currency are losing significant buying power. Despite the local currency inflating, equities or stocks in that local currency on average

Starting point is 00:57:30 fell by around 50%. This is because of the drastically lower levels of economic activity, which somewhat caught me by surprise, actually. What was great times in euphoria can quickly become the opposite where everyone is fearful and everyone's panicking. Ray states that hitting bottom is typically so painful that it produces a radical metamorphosis in pricing and policies that ultimately produces the changes that are needed to turn things around. In theater, or for that matter, in one's own personal life, crisis sows the seeds for change and ultimately renewal. Because the currency becomes very cheap, this leads to less spending on imports and more production done within the country, which with the right policies in place and potentially

Starting point is 00:58:15 international aid can lead to new economic growth going forward. How the inflationary depression ends up playing out really comes down to how well policymakers can handle it. Eventually, the country reaches step five of the inflationary depression, which is the reversal, and eventually return to normalcy when there is a balance between supply and demand of the currency relative to others. It can take some time for capital to flow back into the country as investors who were burnt by the bubble are reluctant to invest in that country again. But the price of domestic goods and domestic labor fell with the currency, so the country is now an attractive destination for investment again.

Starting point is 00:58:56 Next, Ray wrote a little bit about hyperinflations that can come about. Hyperinflation is defined as when the prices of goods and services more than double every year or worse, coupled with extreme losses of wealth and severe economic hardship. He states that the most important characteristic of cases that spiral into hyperinflations is when policymakers don't close the imbalance between external income, external spending, and debt service, and keep funding external spending over sustained periods of time by printing lots of money. YMAR Germany is a classic example that everyone has heard about.

Starting point is 00:59:34 Y-Mar Germany had a crushing external debt service burden or war reparations which couldn't be defaulted on. The amount of capital that needed to flow out of the country was so high that it was highly probable that inflation was imminent. Ironically, even though in Ymart Germany they were experiencing very high inflation, since capital was leaving the country so quickly, there was an actual shortage of cash to go out and buy things. Thus, this really exacerbation. the issue, as more and more printing was required to maintain a functioning economy. As Preston Pish mentions on our show quite often, the value of the currency over time primarily boils down to trust. If people don't fundamentally trust the underlying currency, then any

Starting point is 01:00:22 rational person will continue to transfer said currency into real or foreign assets. Policymaker's ability to keep that trust together and maintained is what will lead to the stability or the eventual failure of the currency as time progresses. During a hyperinflation type scenario, there is a massive wealth redistribution. Lenders see their wealth get inflated away. Anyone who took on debt sees the value of that debt evaporate, making it extraordinarily easy to make payments on that debt. When investing during hyperinflation events, you'll want to be short the currency, long commodities and gold, and long certain types of equities that will benefit from high inflation. Past hyperinflation events showed us that gold is the best performer.

Starting point is 01:01:10 Stocks are a mixed bag as many equities don't hold their value well relative to gold, and bondholders are totally wiped out. After the currency collapses, a new currency emerges as the new storehold of wealth with a very hard backing. Now that pretty much sums up part one of Dahlio's book, Big Debt Crisis. Rapping it all together, here are the primary points. that Dahlio is driving home with the book. Quote, Managing debt crises is all about spreading out the pain of the bad debts, and this can almost always be done well if one's debts are in one's own currency.

Starting point is 01:01:47 The biggest risks are typically not from the debts themselves, but from the failure of policymakers to do the right things due to lack of knowledge and or lack of authority. If a nation's debts are in a foreign currency, much more difficult choices have to be made to handle the situation well. And in any case, the consequences will be more painful, end quote. It's worth noting that no two debt crises are going to look the same, as the policymakers and the political environment varies with each country.

Starting point is 01:02:18 Although checks and balances within a system are generally good, restrictions that are put in place might prevent policymakers from taking the steps necessary to help ease the transition. and policymakers who make the bold decisions will most definitely be heavily criticized. While debt crises can be devastating in the short to medium term, say three to 10 years, productivity is what matters in the long run for investors. In productivity is what's going to drive the overall prosperity. Productivity growth isn't as apparent as it's less volatile. The credit swings in the system are what catches everyone's attention as they have the violent and volatile swings.

Starting point is 01:02:59 All right, that is all I have for today's episode. I've really enjoyed reading through part one of Dahlio's book, Big Debt Crisis, and hope you guys found this episode super valuable. If you enjoyed the show, I'd be extremely grateful if you shared it with just one friend to help us continue to grow the show. Also, if you'd like to get connected with me on socials, I'm at Clay underscore Fink on Twitter, C-L-A-Y-U-N-C-K. Thank you so much for taking the time to tune into today's episode. It truly means the world to me. And hopefully, I'll see you again next Monday. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes,

Starting point is 01:03:46 transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional. This show is copyrighted by the Festus Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP498: Ray Dalio's Book - Big Debt Crises & How the Economic Machine Works

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.