Hey guys, hope everyone’s exams went well. I concluded my last post with a rather dramatic graph of the U.S. debt to GDP ratio from 1916 to 2012. Although it does not completely justify Ray Dalio’s economic model, it does provide some solid proof for the existence of the long-term debt cycle (LTDC)– the third and final pillar of Dalio’s model. This blog post will continue the discussion about the long-term debt cycle. I will try to do touch on a couple of points in this post: (1) reiterate what causes a depression, (2) clarify the difference between a depression and a recession, (3) summarize what a government can do to recover from a depression, and (4) briefly discuss the last part of the LTDC– the reflationary period.
1. What Causes a Depression?
I answered this question in the last blog post, but I got a question about it yesterday, so I thought I’d restate the explanation in a more clear, concise manner: According to Dalio’s model, an economic depression is the second part of the long term debt cycle and it occurs after a long (~50 year) leveraging period. A depression begins precisely at the moment when lenders realize that the debt repayments on the loans they gave out are growing faster than borrowers’ incomes. As soon as the debt growth rate overtakes the income growth rate, borrowers lose creditworthiness. Lenders refuse to lend (aka credit disappears) à spending decreases à people’s incomes decrease à people sell assets to compensate à flood of asset supply makes assets lose value à people’s wealth decreases à lenders refuse to lend even more…and the vicious cycle repeats.
2. What Is The Difference Between a Depression and a Recession?
Technically this is a matter of how you define each term, but the way Dalio distinguishes the two concepts is that a depression is a long-term phenomenon that happens once every 60-80 years (once every LTDC), and a recession is a short-term occurrence, happening once ever 5-8 years (once every STDC).
The economy experiences many smaller recessions throughout the ~50 years prior to the large scale depression, but these recessions can be curbed by the Fed lowering interest rates and stimulating spending. The key difference between the less menacing STDC recessions and the LTDC depression is that unlike a recession, a depression cannot be tamed by lowering nominal interest rates. Why? Because interest rates are already low when a depression begins. In this situation the Fed faces the problem we discuss so much in class: the zero lower bound on nominal interest rates. Even if the Fed is able to decrease interest rates slightly, the change is not enough to extinguish borrowers’ large debt burdens.
3. What Can A Government Do To Recover From A Depression?
The government’s role in a depression is a tricky one. It requires an extremely careful balance between the use of four key strategies: (1) Cutting Spending, (2) Reducing Debt, (3) Redistributing Wealth, and (4) Printing Money.
Cutting spending is necessary in order reduce the government’s debt burden in the long run, but there’s a problem with this strategy: after government spending decreases, the public debt burden gets worse initially. In the short term, a spending cut causes incomes to decrease, prices to drop, and unemployment to rise. Accordingly, the government must be careful not to cut too much spending in the beginning of a recovery because it may push the economy into an even deeper hole.
Reducing debt essentially involves the organization and facilitation of debt default and debt restructuring programs. Most of the time banks handle this, but government can play a role in incentivizing them to do so. During a depression, there are inevitably lots of borrowers who cannot pay back their debts. However, since banks would much rather get at least some of the repayment back than none, they agree to restructure certain loans in order to make them more manageable for the borrower to pay off. However, much like cutting spending, reducing debt also increases the public debt burden initially because people’s incomes decrease as a result of paying back the restructured loans. Even lower incomes = even less spending.
Redistributing wealth is a necessary tactic to encourage low and middle-income citizens (aka the majority of a country’s population) to find jobs and start spending money on goods and services again. Governments start running deficits to increase spending on stimulus and unemployment benefits. Furthermore, the government raises taxes on the rich in order to at least partially fund the stimulus programs. It must be careful not to tax too dramatically though. Not only can social tensions escalate quickly as a result of heavy taxation, but also incomes drop. And as we know very well by now, lower incomes = less spending.
The final strategy typically used in depression recoveries is printing money and buying assets. The central bank prints money, and then uses the money to buy financial assets and government bonds. It buys existing assets and bonds from the public, and also buys newly issued bonds from the government. In turn, the government uses the money it got from selling newly issued bonds to fund its fiscal stimulus, raising incomes and eventually pushing the public debt burden down. Again though, the government must be careful when printing money/buying assets because buying up financial assets drives up their price (inflation) and increases the government debt burden.
Phew. That’s a lot to digest for one blog post but the main idea is this: In a depression recovery the government must strike a keen balance between strategies that cause deflationary pressures (cutting spending, debt reduction, wealth redistribution) and strategies that cause inflationary pressures (printing money + buying assets). If the balance between these pressures is struck correctly, the recovery pulls the economy out of depression and the last phase of the LTDC begins: the reflationary period. Growth is slow initially, but incomes increase, credit becomes available again, and debt burdens finally begin to fall.