Back to the future

Ray Dalio, founder, Bridgewater Associates, explains why the 1930s hold clues to what lies ahead for the economy


This is not a normal business cycle; monetary policy will be a lot less effective in the future; investment returns will be very low. These have come to be widely held views, but there is little understanding as to why they are true. I have a simple template for looking at how the economic machine works that helps shine some light. It has three parts.

First, there are three main forces that drive all economies: 1) productivity; 2) the short-term debt cycle, or business cycle, running every five to ten years; and 3) the long-term debt cycle, over 50 to 75 years. Most people don’t adequately understand the long-term debt cycle because it comes along so infrequently. But this is the most important force behind what is happening now.

Second, there are three equilibriums that markets gravitate towards: 1) debt growth has to be in line with the income growth that services those debts; 2) economic operating rates and inflation rates can’t be too high or too low for long; and 3) the projected returns of equities have to be above those of bonds, which in turn have to be above those of cash by appropriate risk premiums. Without such risk premiums the transmission mechanisms of capital won’t work and the economy will grind to a halt. In the years ahead, the capital markets’ transmission mechanism will work more poorly than in the past, as interest rates can’t be lowered and risk premiums of other investments are low. Most people have never experienced this before and don’t understand how this will cause low returns, more debt monetisation and a “pushing on a string” situation for monetary policy.

Third, there are two levers that policy-makers can use to bring about these equilibriums: 1) monetary policy, and 2) fiscal policy. With monetary policy becoming relatively impotent, it’s important for these two to be co-ordinated. Yet the current state of political fragmentation around the world makes effective co-ordination hard to imagine.

The long and the short of it

Although circumstances like these have not existed in our lifetimes, they have taken place numerous times in recorded history. During such periods, central banks need to monetise debt, as they have been doing, and conditions become increasingly risky.

What does this template tell us about the future? By and large, productivity growth is slow, business cycles are near their mid-points and long-term debt cycles are approaching the end of their pushing-on-a-string phases. There is only so much one can squeeze out of a long-term debt cycle before monetary policy becomes ineffective, and most countries are approaching that point. Japan is closest, Europe is a step behind it, the United States is a step or two behind Europe and China a few steps behind America.

For most economies, cyclical influences are close to being in equilibrium and debt growth rates are manageable. In contrast to 2007, when my template signalled that we were in a bubble and a debt crisis was ahead, I don’t now see such an abrupt crisis in the immediate future. Instead, I see the beginnings of a longer-term, gradually intensifying financial squeeze. This will be brought about by both income growth and investment returns being low and insufficient to fund large debt-service, pension and health-care liabilities. Monetary and fiscal policies won’t be of much help.

As time passes, how the money flows between asset classes will get more interesting. At current rates of central-bank debt buying, they will soon hit their own constraints, which they will probably have to abandon to continue monetising. That will mean buying riskier assets, which will push prices of these assets higher and future returns lower.

The bond market is risky now and will get more so. Rarely do investors encounter 
a market that is so clearly overvalued and also so close to its clearly defined limits, as there is a limit to how low negative bond yields can go. Bonds will become a very bad deal as ­central banks try to push more money into them, and savers will decide to keep that money elsewhere.

Right now, while a number of riskier assets look like good value compared with bonds and cash, they are not cheap given their risks. They all have low returns with typical volatility, and as people buy them, their reward-to-risk ratio will worsen. This will create a growing risk that savers will seek to escape financial assets and shift to gold and similar non-monetary preserves of wealth, especially as social and political ­tensions intensify.

For those interested in studying analogous periods, I recommend looking at 1935-45, after the 1929-32 stockmarket and economic crashes, and following the great quantitative easings that caused stock prices and economic activity to rebound and led to “pushing on a string” in 1935. That was the last time that the global configuration of fund­amentals was broadly similar to what it is today.

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