The Phases of the Classic Deflationary Debt Cycle

Published June 25, 2020

The following are my notes from the book Big Debt Crises by Ray Dalio. I’ve broken this series out into separate posts, which align with the contents of the book:

  • The Archetypal Big Debt Cycle
  • The Phases of the Classic Deflationary Debt Cycle (This post)
  • Inflationary Depressions and Currency Crises
  • The Phases of the Classic Inflationary Debt Cycle
  • The Spiral from a More Transitionary Inflationary Depression to Hyperinflation

There are seven stages of an archetypal long term debt cycle:

  1. Early Part of the Cycle
  2. Bubble
  3. Top
  4. Depression
  5. Beautiful Deleveraging
  6. Pushing on a String
  7. Normalization

1) The Early Part of the Cycle

“Debt growth, economic growth, and inflation are neither too hot nor too cold. This is what is called the ‘Goldilocks’ period.”

  • Debt growth is strong, but not growing faster than income.
  • Debt growth is being used to finance activities that produce fast income growth.
  • Debt burdens low, balance sheets healthy, plenty of room to lever up.
  • Debt growth, economic growth, inflation in goldilocks period.

2) The Bubble

“Bubbles usually start as over-extrapolations of justified bull markets.”

  • Debts start rising faster than incomes, and produce accelerating strong asset returns and growth.
  • Creates self reinforcing situation of rising incomes, net-worths, and asset values, which increases credit and the borrowers capacity to borrow.
  • Borrowers feel rich, and spend more than they earn, buy assets at high prices with leverage.
  • This is not sustainable, and further causes debts to rise faster than incomes.
  • Central banks draw out this period by increasing money supply, along with periodic tightening to create short term debt cycles.
  • These short cycles turn into long term debt cycles with progressively lower interest rates.
  • Which raise asset prices and, in turn, people’s wealth.
  • This keeps debt service burdens from rising, and lowers the monthly payment cost of items bought on credit.
  • Eventually, debt can’t rise any more relative to income, and the process works in reverse.
  • Deleveraging begins.

The Start of a Bubble: The Bull Market

  • Initially justified, low interest rates cause:
    • Investment assets (stocks, real estate) go up
    • Leads to improved economic conditions and growth
    • Improved balance sheets, ability to take on more debt
    • Increases value of companies
    • Net worth and spending/income rises
    • Levering up process
    • New buyers FOMO enter market
    • Credit standards fall as more speculators and lenders enter market
    • Banks lever up
    • Unregulated institutions sprout up (shadow banking system)
    • Fast, easy money reinforces
  • People think assets are a fabulous treasure to own.
  • Long positions build, resulting in asset-liability mismatches in the form of:
    1. Borrowing short term to lend long term
    2. Taking on liquid liabilities to invest in illiquid assets
    3. Investing in riskier debt or other risky assets with borrowed money
    4. Borrowing in one currency, lending in another for spread
  • Consensus view that current conditions will continue gets priced in.
  • Typical bubble sees leveraging up at an average rate of 20-25% of GDP over 3 yrs.
  • In most cases, debt-to-income levels averaged around 300% of GDP at top of bubble.

The Role of Monetary Policy

  • Problem with central bankers is they usually target inflation and growth, and don’t target mgmt of bubbles.
  • If growth and inflation are good, then Central Bankers can inadvertently help inflate bubbles by keeping money too loose.
  • When they do tighten, usually due to inflation running hot, it’s usually too late.
  • Monetary policy alone is usually not sufficient, because bubbles are in different parts of the economy.

Spotting Bubbles

  • Dalio looks across big markets to identify if there are bubbles.
  • Then looks at what is connected to them, and what would be affected when bubble pops.
  • Characteristics of bubbles:
    1. High prices relative to traditional measures
    2. Prices discounting future rapid price appreciation from these high levels
    3. There is broad bullish sentiment
    4. Purchases being financed by high leverage
    5. Buyers have made exceptionally extended forward purchases to speculate or protect against future price gains
    6. New buyers have entered the market
    7. Stimulative monetary policy threatens to inflate the bubble even more, and tight policy to cause its popping

3) The Top

“When things are so good that they can’t get better - yet everyone believes they will get better - tops of markets are being made.”

  • Tops can be triggered by various events:
    • Central banks tighten and increase rates
    • If country is reliant on external creditors, the pulling back of lending due to exogenous causes will lead to liquidity tightening
    • Tightening of monetary policy in which debts are denominated in can cause foreign capital to pull back
    • Rise in currency the debt is in relative to the currency incomes are in can cause squeeze
  • Debt service squeeze causes negative wealth effect as asset prices decline.
  • Borrowers squeezed, as increasing share of new borrowing goes to pay debt service.
  • Lenders worry about not being paid back.
  • Credit spreads widen, as riskiest debtors miss payments, and risky lending slows.
  • These types of problems happen 6 months ahead of peak of economy.
  • Early stages of top, short term rates rise, causing a flattening of yield curve.
  • Increase in short term rates makes holding cash more attractive.
  • Also raises interest rate used to discount future cash flows of assets.
  • This weakens riskier asset prices, slows lending, and makes items bought on credit more expensive, slowing demand.
  • Short rates typically peak a few months before top in the stock market.
  • The more leverage and the higher the prices, the less tightening it takes to prick the bubble.
  • Tightening affects each sector differently depending on their sensitivity.
  • In immediate post bubble period - wealth effect of asset prices has more impact on economic growth rates than monetary policy. ie… changes in stock prices have bigger impact than policy itself.
  • Wealth falls first, and incomes fall later. ie… stock prices fall, causing people to feel less wealthy, they spend less, causing company earnings to fall. Self reinforcing.

4) The “Depression”

“When one owes money or needs to borrow money and the interest rate rises on the debt, naturally one’s financial conditions worsens. And when one’s financial conditions worsens, naturally lenders are more reluctant to lend, which leads to interest rates to rise even more… I call this self-reinforcing process a ‘debt death spiral’.”

  • In normal recessions interest rates can be cut to:
    1. Produce positive wealth effect
    2. Stimulate economic activity
    3. Ease debt-service burdens
  • This can’t happen in depressions, because rates are already at zero.
  • Hence the debt death spiral.
  • Debt defaults and austerity dominate in this part of the cycle.
  • Usually not sufficiently balanced with stimulative forces of printing money to cover debts.
  • When people rush to convert financial assets to cash, usually not enough cash, causing liquidity issues.
  • Interest rate cuts also don’t help with liquidity issues or bank runs.
  • So Central Banks need to print money to provide liquidity, OR allow for a wave of defaults.
  • Depressions can come from and cause either solvency problems and/or cash-flow problems.
    • Solvency problems:
      • Entity does not have enough equity capital to operate (defined by accounting/regulatory rules).
      • Can be solved by providing enough equity capital, or by changing accounting / regulatory rules
    • Cash flow problems:
      • Entity does not have enough cash to meet operating needs.
      • Lack of cash flow is immediate and severe, and usually the trigger of most debt crises.
      • Fiscal / monetary policy can provide either cash, or guarantees to resolve.
  • Most of what people think is money is really credit.
  • Credit appears out of thin air in good times, and disappears during bad times.
  • During deleveraging, people discover what they thought was wealth was merely people’s promises to give them money.
  • If promises aren’t kept, the wealth no longer exists. (HK: This is why we don’t want to hold assets that have counter-party risk going into a depression.)
  • When investors rush to convert assets into cash, panic induced ‘runs’ or sell-offs occur.
  • Debt defaults and restructurings hit leveraged lenders, and fear cascades through system.
  • This fears feed on themselves, and lead to scramble for cash that causes liquidity shortage:
    1. Income to lenders falls short of meeting debtors obligations
    2. Assets need to be sold, spending cut to raise cash
    3. Leads to asset values falling
    4. Reduces value of collateral
    5. In turn reduces incomes
    6. Since both net worth and income fall faster than debts, borrowers become less creditworthy, and lenders don’t lend
  • Depression dominated by deflationary forces of debt reduction and austerity.
  • Restructuring needs to be large enough for debtor to service the loan.
  • A 30% write down of debt, is 30% write down of creditors assets.
  • Sometimes these write downs have much greater impact, because lenders are often leveraged.
  • Banks are typically leveraged 12:1 or 15:1, so a 30% write down across the board would be catastrophic.

Managing Depressions

  • The four levers to manage debt & debt service levels are:
    1. Austerity (spending less)
    2. Debt defaults / restructurings
    3. Printing money and making purchases (or providing guarantees)
    4. Wealth transfer (Transfer money and credit from those who have more than they need, to those who have less)
  • Key is to get the right mix, so deflationary forces are balanced with inflationary ones.
  • Historically, policy makers usually wait too long before applying the stimulative measures.
  • Eventually they provide guarantees, print money, and monetize debt.
  • If right mix, then reflationary deleveraging, and depression short lived (like 2008).
  • Wait too long, and it’s prolonged, like Great depression in 1930’s.
  • Two biggest impediments is failure to know how to handle well, and politics or statutory limitations on powers of policy makers. (HK: This is probably why Central Banks acted so quickly with Covid in 2020.)

Four levers in detail:


  • Obvious thing to do.
  • However even deep austerity doesn’t bring debt and income back to balance.
  • Government revenues fall at the same time demands of government increase, resulting in higher deficits.
  • Governments may try to be responsible, and raise taxes. Big mistake.

Printing Money

  • These moves come in progressively larger doses as more modest initial attempts fail to fix imbalance, and reverse deleveraging process.
  • Often they result in bear market rallies and increased economic activity.
  • Allowing private sector to compete for the limited supply of money will only tighten money further.
  • Governments need to print.
  • The following steps are taken as part of money printing:
  1. Curtail panic and guarantee liabilities
    • Governments increase guarantees on deposits and debt issuance
    • Provide systemically important institutions with injections of money
    • Deposit freezes (force liquidity to remain)
    • Guarantees are easier and preferable to providing cash
    • Only kicks in when the worst scenario happens
    • Lenders get too reliant on guarantor, no longer care about credit worthiness of borrower
  2. Provide liquidity
    • Central banks lend to widening range of collateral
    • Or to increasingly wide range of financial institutions not normally considered (HK: This is like Fed buying Junk bonds / corporate bonds)
  3. Support solvency of systemically important institutions
    • Incentivize private sector to address problem - support mergers between failed and healthy banks
    • Accounting adjustments to reduce immediate need for capital to remain solvency (HK: in May 2020, FED changed SLR, supplementary leverage ratio for banks)
  4. Recapitalize / nationalize / cover losses of systemically important financial institutions
    • When all else fails, governments step in to recapitalize failed banks
    • Maintaining credit supply is critical to prevent crises getting worse

Debt Defaults / Restructurings

  • Process of cleansing bad debts is best when:
    1. Policy makers recognize and act early
    2. Don’t save every expendable institution
    3. Create or restore credit pipes to allow for future borrowing
    4. Ensure acceptable growth and inflation conditions while bad debts are worked out
  • Usually followed by spate of regulatory reforms (ie.. Dodd-Frank)
  • Two ways failed lenders’ assets or bad assets are managed:
    1. Transferred to separate entity (AMC) Asset mgmt company (40% of the time)
    2. Remain on balance sheet of original lending institution (60% of the time)
  • Main levers for disposing of bad loans:
    1. Restructuring
    2. Debt-for-equity swaps and asset seizures
    3. Direct sales of loans or assets to third parties
    4. Securitizations
  • Use of AMC allows banks to go back to lending (HK: Bailout!)

Redistributing Wealth

  • Wealth gaps increase during bubbles.
  • During these times, populism on both left and right tend to emerge.
  • In both 1930’s and today, net worth of the top 0.1% of population equal approximately that of bottom 90%.
  • Central bank asset purchases also disproportionately benefit the rich.
  • Big political shifts to the left typically hasten redistributive efforts.
  • Drives rich to move money in ways and places to provide protection.
  • Transfers rarely happen in amounts big enough to make a difference.
  • Unless there are revolutions and huge amounts of property are nationalized.

5) The “Beautiful Deleveraging”

“In the end, policy makers always print”

  • A ‘beautiful deleveraging’ happens when the four levers are moved in a balanced way as to offset deflationary forces with stimulative ones to bring growth rate above interest rate.
  • Too much stimulation would accelerate inflation, devalue currency, and cause another debt bubble.
  • Spending comes from either money or credit.
  • When increased spending cannot be financed by more credit because debts are too high, central banks provide the spending relief by adding more money.
  • Printing money won’t cause inflation if it offsets falling credit.
  • And if deflationary forces are offset by inflationary ones.
  • A dollar spent paid for with money has the same effect on prices as a dollar spent paid for by credit.
  • Central banks make up for the disappearance of credit by printing more money.
  • Printing is done through asset purchases of government or corporate assets.
  • Money grows at extremely fast rate at the same time as credit and real economic activity are contracting.
  • Credit destruction is being offset by money creation.
  • If balance is right, then it isn’t inflationary. (HK: Not inflationary for prices, but what about monetary inflation? Paul Tudor Jones letter)
  • Getting balance right is much more difficult in countries that have large % of debt denominated in foreign currency, and owned by foreign investors.
  • In these cases, debt cannot be monetized as easily.
  • Past 100 years of deleveraging scenarios that Dalio has studied show that they eventually led to big waves of money creation, fiscal deficits, and currency devaluations (against gold, commodities, and stocks).
  • Governments with gold (commodity, foreign currency) pegged money are forced to have tighter monetary policy than those with fiat.
  • Eventually debt burdens become too painful and they break the link, and print.
  • Austerity causes more pain than benefit.
  • Big restructurings wipe out too much wealth, too fast.
  • Transfers of wealth don’t happen in sufficient size without revolutions.
  • In the end, policy makers always print.

6) “Pushing on a String”

“Late in the long-term debt cycle, central bankers sometimes struggle to convert their stimulative policies into increased spending…”

  • Effects of lowering interest rates, and central banks debt purchase has diminished.
  • During period of low growth, low returns, central banks move to other forms of monetary stimulation.
  • Biggest risks: too much printing, and too severe a currency devaluation could cause ugly inflationary deleveraging.
  • Three types of monetary policy:

Policy 1: Interest Rate Driven

  • Most effective because it has broadest impact on economy
  • Produce positive wealth effect (low rates raise present value of investments)
  • Makes it easier to buy items on credit
  • Reduce debt-service burdens
  • When short term rates hit zero, no longer effective

Policy 2: Quantitative Easing (QE)

  • Printing money and buying financial assets (typically debt assets)
  • Influences behavior of investors & savers as opposed to borrowers & spenders
  • Central banks give cash for bonds, which makes savers go buy other financial assets
  • If that money goes into assets that finance spending, then it stimulates economy
  • If instead it gets invested into assets that don’t finance spending, (like stocks, real estate), there must be very large market gains before any of that trickles into economy as spending. (HK: Asset bubble / inflation anyone?)
  • Benefits those with financial assets much more than people who don’t. Widens wealth gap.
  • Most effective when risk and liquidity premiums are large
  • Over time, limited effectiveness due to higher prices, lower expected returns
  • At this stage, sometimes central banks monetize large amounts of debt to compensate for decline in effectiveness
  • Prolonged monetization will lead people to question the currency’s sustainability as store of value
  • Leads to people buying alternative currencies such as gold
  • There are only goods and services. Financial assets are claims on them
  • Holders of these assets believe they can convert them to purchasing power for real goods and services
  • But since debt, money, currency have no intrinsic value, the claims on them are greater than the value of what they are supposed to be able to buy. So they must be devalued or restructured.
  • Monetization swaps one IOU (debt), for another (newly printed money)
  • Since not enough goods and services to back up all the IOUs, there is worry that people may not be willing to work for IOUs forever.

Policy 3: Helicopter Money

  • Put money directly into the hands of spenders instead of investors/savers
  • Wealthy people have fewer incentives to spend incremental money than less wealthy people
  • Direct spending of less wealthy people is more productive
  • Can be done through coordinated fiscal and monetary actions, or directly from central banks. Examples:
    1. Increase in debt financed fiscal spending
    2. Same as above, but Fed will monetize the debt.. ie Print money to pay for the bonds
    3. Don’t bother with bonds, give newly printed money directly to governments
    4. Printing money, and direct cash transfers to households
    5. Big debt write-down accompanied by big money creation - Debt jubilee
  • Most effective involve fiscal and monetary. Fiscal will help incentivize people to spend it

7) Normalization

“It typically takes 5-10 years (hence the term ‘lost decade’) for real economic activity to reach its former peak level.”

  • Capital formation tends to be slow
  • Takes around a decade for stock prices to reach former highs