To understand this most recent crisis, let’s depict the major parts of the story first.
“Borrowers and lenders had severe asset/liability mismatches, which left them especially vulnerable in a downturn. This is a classic ingredient of a severe debt crisis. Most commonly these mismatches come in the following forms:
1) Borrowing short-term and lending long-term, leaving them to be squeezed when those who lent to them short-term don’t want to lend to them anymore or only want to lend to them at interest rates much higher than what they are earning on the loans they have already made.
2) Lending to risky borrowers who will pay higher interest rates than they borrowed at in order to collect the credit spread—until the default rates pick up to a level greater than the credit spread.
3) Borrowing in one currency and lending/investing in another. When the currency they borrowed in rises, it forces borrowers to pay back the loan at a higher exchange rate or a higher interest rate than they can manage.
All these things happened during this bubble, which made these financial intermediaries and those who trusted them with their money very vulnerable to runs and credit problems.
During this supreme fragile time, The GDP gap rose to 3 percent, while inflation rose to 3.7 percent. The Fed continued to tighten to bring the nominal short rate to 5.25 percent and the real short rate to 1.5 percent in 2007.
Apparently, Ray Dalio is pro-Keynes, not Hayek according to his mentioning of “beautiful deleveraging” multiple times. In particular, he wrote, “In contrast, the moral hazard framework leads people to believe that if you let things burn, the government will assume less risk. In reality, if you let everything burn, the government will end up taking on all of the risks, as it will have to nationalize the system in a much more costly and damaging way.” “Geithner credits it to the Fed and Treasury’s very aggressive
response and their willingness to put moral hazard concerns aside. I agree.”
In January 2008, he concludes “this was not going to be a typical recession but rather a
deleveraging/depression-type dynamic, which is quite different in terms of both its potential magnitude and the linkages that drive the contraction.” In the Bridgewater Daily Observations on January 31, they wrote: “(BDO) January 31: The Really Big Picture; Not Just a Normal Recession The “R” word has been used a lot to describe the possible contraction in economic activity because all contractions are now called recessions. However, to use that term to describe what’s happening would be misleading in that it
connotes an economic contraction like those that occurred in the US many times before, as distinct from those that occurred in Japan in the 1990s and in the US in the 1930s, which are better characterized by the “D” word (e.g., deleveraging).
Contrary to popular belief, a “D” is not simply a more severe version of an “R”—it is an entirely different process…An “R” is a contraction in real GDP, brought on by a tight central bank policy (usually to fight inflation) that ends when the central bank eases. It is relatively well managed via interest rate changes…A “D” is an economic contraction that results from a financial deleveraging that leads assets (e.g., stocks and real estate) to be sold, causing asset prices to decline, causing equity levels to decline, causing more forced
selling of assets, causing a contraction in credit and a contraction in economic activity, which worsens cash flows and increases asset sales in a self-reinforcing cycle. In other words, the financial deleveraging causes a financial crisis that causes an economic crisis.”
So, as Ray Dalio had praised and expected, the market finally came out of the trough, manifested in the below S&P chart:
However, meanwhile, public discontent kept piling up, illustrated in below note from Bridgewater on February 17th, 2009:
To make his point more clear, if not enough according to the above script, let’s take a look at this one: In closing, Ray reiterates his view that the U.S. government applied a relatively fast speed to rescue the market by credit unwinding programs, such as TARP, which was repaid. And he stated that there are good overall financial returns no the rescue across the various programs. It’s worth mentioning that Nassim Taleb, the author of Black Swan, holds an entirely different opinion. He likened the situation to a patent had been treated with novocaine or cortisone, as a result, everything seems merry and pleasant, but rotten and worsen in the core.
As of present, the debt level looks like below, note that the whole deficit is reaching a whopping $17 trillion, about ~85% of the current GDP. Being the expert on debt crisis cycle, Ray Dalio seems to be quite cool and nonchalant, expressing no concern about this observation in his book.
Among the debtors, China and Japan are the top with $1.2 and $1.1 trillions respectively. The largest owner is the Federal Reserve (source from Bloomberg), which basically is what Geitner, Bernanke, supported by Obama had done – Quantitative Easing (QE). To be more specific, the Fed printed/created money from thin air, then rather than confer directly, lend to the Treasury, who wrote an “I owe you” note back to the Fed, making the Fed the largest debt holder to the U.S.
Some people overly simplified QE as equivalent to “printing money”, which is obviously wrong. Because if it’s really printing money, then inflation will be inevitable. However, in the past decade, we didn’t experience serious inflation at all. The reason, I pondered is that this big chunk of money is not helicoptered unanimously to everybody but targeted to purchase those bad assets of banks and insurers. These are sort of cooking their accounting books. Instead of writing off assets cruelly and abruptly, the QE program allows their balance sheets still look same as before. Therefore, its effect on causing inflation is trivial.
I also look at it as if somebody lends him/herself money collateralized by the future capacity to generate more. So premised on two major factors: 1. nobody will not be lenient to him/herself, and 2. nobody is not optimistic about the future self, borrowing tomorrow’s money to maintain the sickened economic body is far better than a painful surgery-like deflation treatment. That’s exactly what Ray Dalio extolled and what occurred in this 2007-2011 crisis. And certainly, as Mr. Dalio emphasized over and over again, the debt has to be denominated in local currency, or you forfeit the right to print money to repay.
As is coined as “beautiful deleveraging” by Ray Dalio, governmental intervention by QE or other stimulating policies maintains the puffed-up ill patient at a certain time point, then given a sufficient time, the patient gets fully recuperated by filling in puffiness with real flesh and blood, so the economy is booming and rosy again.