Written by: Ray Dalio
Translated by: Block unicorn
The principles are as follows:
When national debt is excessive, reducing interest rates and depreciating the currency in which the debt is denominated is the path most likely to be taken by government policymakers, so betting on this situation is worthwhile.
As I write this, we know that massive deficits and substantial increases in government debt and debt repayment expenditures are expected in the future. (You can see this data in my works, including my new book (How Countries Go Bankrupt: The Big Cycle); I also shared last week my reasons for believing that the American political system cannot control the debt issue). We know that the cost of debt repayment (interest and principal payments) will rapidly grow, squeezing other expenditures, and we also know that, in the most optimistic scenario, the likelihood of increased debt demand matching the supply of debt that needs to be sold is extremely low. I elaborated on what I think all this means in (How Countries Go Bankrupt) and described the mechanisms behind my thinking. Others have also stress-tested this and currently almost entirely agree that the picture I painted is accurate. Of course, this does not mean I cannot be wrong. You need to judge for yourself what may be true. I simply provide my thoughts for everyone to evaluate.
My principles
As I explained, based on my more than 50 years of investment experience and research, I have developed and documented some principles that help me predict events in order to successfully place bets. I am now at a stage in my life where I hope to pass these principles on to others to provide assistance. Furthermore, I think understanding how mechanisms work is necessary to comprehend what is happening and what might happen, so I also try to explain my understanding of the mechanisms behind these principles. Here are a few additional principles and explanations of how I think the mechanisms work. I believe the following principles are correct and beneficial:
The most covert, and therefore most favored, yet most commonly used method by government policymakers to address the problem of excessive debt is to lower real interest rates and real exchange rates.
While lowering interest rates and currency exchange rates to address excessive debt and its problems can provide short-term relief, it reduces demand for currency and debt, creating long-term issues because it lowers the returns on holding currency/debt, thereby diminishing the value of debt as a store of wealth. Over time, this typically leads to increased debt, as lower real interest rates are stimulative, worsening the problem.
In summary, when there is too much debt, interest rates and currency exchange rates tend to be suppressed.
Is this good or bad for the economic situation?
Having both is often good and popular in the short term, but harmful in the long term, leading to more severe problems. Lowering real interest rates and real currency exchange rates is...
...in the short term, it is beneficial because it is stimulative and tends to push up asset prices...
...but is harmful in the medium and long term because: a) it gives those holding these assets lower real returns (due to currency depreciation and lower yields), b) it leads to higher inflation rates, c) it results in greater debt.
In any case, this clearly cannot avoid the painful consequences of excessive spending and being deep in debt. Here is how it works:
When interest rates fall, borrowers (debtors) benefit because this lowers the cost of debt repayment, making borrowing and purchasing less expensive, which in turn pushes up investment asset prices and stimulates growth. This is why nearly everyone is satisfied with lower interest rates in the short term.
However, at the same time, these price increases obscure the negative consequences of lowering interest rates to undesirable low levels, which is adverse to both lenders and creditors. These are facts because lowering interest rates (especially real interest rates), including central banks suppressing bond yields, pushes up the prices of bonds and most other assets, leading to lower future returns (for example, when interest rates fall to negative values, bond prices rise). This also leads to more debt, causing greater debt issues in the future. Thus, the returns on debt assets held by lenders/creditors decrease, resulting in more debt.
Lower real interest rates also tend to diminish the real value of currency because it makes the yield on currency/credit lower relative to alternatives in other countries. Let me explain why lowering the currency exchange rate is the preferred and most common method for government policymakers to deal with excessive debt.
The reasons why a lower currency exchange rate is favored by government policymakers and seems beneficial when explaining to voters are twofold:
1) A lower currency exchange rate makes domestic goods and services cheaper relative to those of countries with appreciating currencies, thereby stimulating economic activity and pushing asset prices up (especially in nominal terms), and...
2) ...it makes repaying debt easier, which is more painful for foreigners holding debt assets than for domestic citizens. This is because another 'hard currency' approach would require tightening monetary and credit policies, which would keep real interest rates high, suppressing spending, which usually means painful service cuts and/or tax increases, and stricter loan terms that citizens would be unwilling to accept. In contrast, as I will explain below, lower currency interest rates are a 'covert' way of repaying debt because most people are unaware that their wealth is decreasing.
From the perspective of depreciated currency, a lower currency exchange rate typically also increases the value of foreign assets.
For example, if the dollar depreciates by 20%, American investors can pay foreigners holding dollar-denominated debt with currency that has decreased in value by 20% (i.e., foreigners holding debt assets will suffer a 20% loss in currency value). The harm of a weaker currency is less obvious but does exist, namely, that those holding weaker currency experience a decrease in purchasing power and borrowing capacity—purchasing power declines because their currency's purchasing power has diminished, and borrowing capacity decreases because buyers of debt assets are reluctant to purchase debt assets priced in depreciating currency (i.e., assets that promise to receive currency) or the currency itself. It is less obvious because most people in countries experiencing currency depreciation (for example, Americans using dollars) will not see their purchasing power and wealth decline, as they measure the value of assets in their own currency, creating an illusion of asset appreciation, even though the currency value of their assets is declining. For instance, if the dollar drops by 20%, American investors, if they only focus on the value of their assets rising when priced in dollars, will not directly see their purchasing power loss of .20% on foreign goods and services. However, for foreigners holding dollar-denominated debt, this will be evident and painful. As they grow increasingly concerned about this situation, they will sell (dump) the currency denominated in debt and/or debt assets, leading to further weakness in the currency and/or debt.
In summary, viewing matters solely from the perspective of one's own currency clearly leads to a distorted viewpoint. For example, if the price of something (like gold) rises by 20% when priced in dollars, we think the price of that thing has risen, rather than the value of the dollar has fallen. The fact that most people hold this distorted viewpoint makes these methods of dealing with excessive debt 'covert' and politically easier to accept than other alternatives.
This way of viewing things has changed significantly over the years, especially from a time when people were accustomed to a gold standard currency system to now being used to a fiat/paper currency system (where money is no longer backed by gold or any hard asset, a reality that became true after Nixon decoupled the dollar from gold in 1971). When money exists in paper form and acts as a claim on gold (what we call gold-backed currency), people believe the value of the paper currency will rise or fall. Its value almost always declines; the only question is whether it declines faster than the interest earned on holding fiat currency debt instruments. Now, the world has become accustomed to viewing prices through the lens of fiat/paper money, and they have the opposite view—they think prices are rising rather than the value of the currency is falling.
Because a) prices measured in gold-backed currency and b) the quantity of gold-backed currency have historically been far more stable than a) prices measured in legal/tender paper money; b) the quantity of prices measured in legal/tender paper money, I think viewing prices from the perspective of gold-backed currency may be a more accurate way. Clearly, central banks also hold similar views, as gold has become their second-largest currency (reserve asset) held, after the US dollar, ahead of the euro and the yen, partly for these reasons and partly because of the lower risk of gold being confiscated.
The decline in legal tender and real interest rates, as well as the rise in non-legal tender (such as gold, Bitcoin, silver, etc.), has historically (and logically should) depended on their relative supply and demand relationship. For example, enormous debt unsupported by hard currency can lead to significant monetary and credit easing, resulting in a sharp decline in real interest rates and real currency exchange rates. The last major period when this occurred was during the stagflation period from 1971 to 1981, which resulted in tremendous changes in wealth, financial markets, the economy, and the political environment. Given the scale of existing debt and deficits (not only in the United States, but also in other legal tender countries), similar significant changes may occur in the coming years.
Whether this assertion is correct or not, the severity of the debt and budget issues seems indisputable. In such times, holding hard currency is a good thing. So far, and for many centuries around the world, gold has been hard currency. Recently, some cryptocurrencies have also been viewed as hard currency. For certain reasons, I will not elaborate, but I prefer gold, although I do hold some cryptocurrencies.
How much gold should one hold?
While I am not giving you specific investment advice, I will share some principles that have helped me form my perspective on this issue. When considering the proportions of gold and bonds to hold, I think about their relative supply and demand relationship, as well as the relative costs and returns of holding them. For example, currently, the interest rate on U.S. Treasury bonds is about 4.5%, while gold's interest rate is 0%; if one expects the price of gold to rise more than 4.5% in the next year, then holding gold makes sense; if not, holding gold is unreasonable. To help me make this assessment, I observe the supply and demand for both.
I also know that gold and bonds can diversify risk against each other, so I would consider what proportion of gold and bonds should be held for good risk control. I know that holding about 15% of gold can effectively diversify risk, as it brings a better return/risk ratio to the portfolio. Inflation-linked bonds have the same effect, so it’s worth considering adding both assets to a typical portfolio.
I share this perspective with you, rather than telling you how I think the market will change, or suggesting how many types of assets you should hold, because my goal is to 'teach a man to fish rather than give him a fish.'
