Where Does the Future of Investments Lie? Ray Dalio on the Japanese & World Economies

September 6, 2013

Ray Dalio
, Chairman & Chief Investment Officer, Bridgewater Associates

Tim Schilt
, Partner, Berens Capital Management, LLC

Ray Dalio, Chairman and Chief Investment Officer of Bridgewater Associates, the world's largest hedge fund, visited Japan Society to talk about credit cycles, deleveraging and his expectations for the Japanese and world economies.

The Economic Machine: Transactions, Spending, Money and Credit
"An economic machine is a very, very simple thing," Mr. Dalio said. It's "nothing more than a whole lot of transactions." It works the same in Japan and in the U.S., today or 100 years ago.

"If we can agree on how that machine works, then we can understand and we can move on to deal with what to do about it."

"And a transaction is a very simple thing. There is a buyer who pays for goods, services or financial assets with either money or credit."

Total up payments in money plus payments on credit and you have spending. And "spending is what matters in terms of the economy. GDP is to be determined by spending."

Divide spending by the quantity sold, and you have price. "You spend $100 and you have 200 units, and it's 50 cents each. That's it."

Credit is created both through the banking system and through private agreement, for example when a service provider extends credit to a customer. "We go through cycles of credit" that are "self-reinforcing."

Credit Cycles
"Let's say I'm earning $100 and I go borrow $10, because I go to a bank and they say, 'Because you're earning $100, I'll lend you $10 against that,' I can spend $110. My spending of $110 is somebody's income of $110. And because of that income of $110, he can go to a bank and he can borrow against that income," maybe a bank loan for another $10, he explained.

"As we spend more on goods, services and financial assets through credit creation, the incomes rise, asset values go up, debt-to-income ratios rise. As debt-to-income ratios continue to rise... there is more prosperity, and goods, services and financial assets are bought on credit as well as money."

Debt being a promise to deliver money, debt-to-income ratios can't rise forever. Lowering interest rates alleviates this for a time. Lower interest rates make it easier for debtors to cover their payments. They bump up asset prices; the resulting wealth effect stimulates spending.

When interest rates get to zero, they can't be lowered any more. "Then we have classic deleveragings," something that's "happened many, many times in history. In the Old Testament they talk about every 50 years—they call it the Year of Jubilee," when debts are to be forgiven.

Three Forces in the Economic Machine
"There are three main forces in an economy," Mr. Dalio noted: productivity, short-term debt cycles, and long-term debt cycles.

Productivity is output per worker times the number of hours worked. "As people get smarter and invent" and work harder, productivity goes up, "usually at a fairly steady pace." This "raises your living standards over the long term."

Firms and individuals can spend a lot more, based on their productivity, if they borrow. The amount of borrowing that firms and individuals engage in tends to change in two big cycles, one short term and the other long term.

Short-Term Credit Cycles have happened in every country, and typically last five to eight years. A period of recession and falling inflation will prompt the central bank to ease money policies. "What they do is produce money and credit, and that money and credit causes spending." As spending picks up and "you go up to a higher level of capacity, you run into a shortage of capacity. You start to have inflation. And as inflation starts to become a problem, then you raise interest rates or tighten money policy... and that tightening then causes another cycle, another weakening."

Right now we're in the middle of a short-term debt cycle; "the Federal Reserve has an inclination to take its foot off the gas, and then if things continue to move it would be inclined to put its foot on the brake. That's how those short-term debt cycles work."

Long-Term Credit Cycles. The difficult reality is that "we're having the short-term debt cycle on top of a longer-term debt cycle," more specifically the deleveraging phase of a longer-term debt cycle, Mr. Dalio said. It's a process of reducing the debt-to-income ratio; typically these longer-term cycles play out over a period of 50 to 75 years.

Mechanics of Deleveraging
"Deleveragings, which Japan has been wrestling with since 1990, can happen in four ways," Mr. Dalio said: debt restructuring, austerity, redistribution of wealth and monetization. Each of these has some shortcomings:

• "The problem with restructuring a debt is that one man's debt is another man's assets." Writedowns have a negative wealth effect, "and the process feeds on itself."

Austerity reduces debt, but "a consequence of austerity is that one man's spending is another man's income." You spend less, but "you also reinforce a contraction in economic activity."

• With redistribution of wealth, you have to wrestle with how much of a transfer of wealth there will be. The Germans and the southern Europeans are trying to figure this out right now.

Debt monetization—the printing of money—works for a while, but the effect wears off.

Typically countries end up with a mix of these. What that mix comprises is important:

"There are such things as beautiful deleveragings—in other words, reducing the debt-to-income ratio while there is positive growth and not too much inflation," Mr. Dalio said. Examples are the U.S. from 1933 to 1937, Japan from 1932 to 1936, the UK from 1947 to 1969, and the U.S. in this current period.

"There are ugly deleveragings, which have the effect of actually raising the debt-to-income ratios and making miserable economies," he continued: the Great Depression in the U.S., Japan in 1929 to 1931, the U.S. in 2008 to 2009, Spain and Italy in this current crisis, and Japan from 1990 to the present.

"The difference between them is in striking the right balance." Restructuring debt and austerity are both deflationary, whereas "if we're monetizing debt, that is inflationary and has a simulative effect. If those things are working together in balance," you won't have the ugly-deleveraging problem.

How does a beautiful deleveraging happen? "The number-one rule for that is to have income growth that is faster than debt growth," he said. If, however, you have, say, a nominal interest rate of 5 percent and a nominal GDP growth rate of 0 percent, "those fives are going to compound against those zeros, and that's going to mean your debt is going to rise and become an increasing burden."

Spending, Money and Credit
"GDP is going to be determined by spending, and spending can either be money or credit," he reminded the audience. If there's "negative credit growth, therefore negative spending, there has to be more money to have that same level of spending. And it isn't inflationary if money is increased when debt is decreased, because the only thing that's going to affect the cost of things is spending."

"And whether it's spent by money or it's spent by credit doesn't make a difference, other than when the time comes for paying back. But it really is not more inflationary.... The popular belief that somehow spending a lot more money and creating money is somehow worse than creating credit is a mistaken concept."

Where We Are Today
"The world economy as a whole is kind of in the middle of a cycle," Mr. Dalio said.

The U.S. was able to decrease the impact of the bursting of the debt bubble in the 2008-2009 financial crisis through a sharp rise in money. "The production of money stimulated the response that caused the debt-to-income ratio to decline while there was positive growth in the economy."

In both core Europe and southern Europe, debt as a percentage of GDP rose during the period, but the increase in core Europe was more gradual than in peripheral Europe.

"Now we have China. China has become an important force in the world. We have debt-to-income ratios rising lower than they are elsewhere. But we have a serious debt bubble emerging in China. The new government knows that and is dealing with a serious reallocation, particularly because a lot of that debt is to finance investment that really will not produce the cash flow to service that debt."

The emerging world ex-China "is very fragmented," he said. "But the countries that are having problems now in the emerging world are having problems for basically the same reason, which is that they had unsustainable capital flows," India being a prime example.

India became popular among investors, who came to expect high returns on a steady basis. Then when the rate of investment slowed, Indian companies experienced a funding gap.

"What's happening in the emerging countries is those that have a dependence on capital, and whose investors were largely international investors, particularly in emerging market equities, those investors are starting to receive a bad return through the currency. And so they're increasingly disinclined to add to those investments at the same rate."

The World Economy and Japan
"So, we're seeing a very important shift in the world economy," Mr. Dalio said. "China is no longer the locomotive in the same way. It has its issues. Emerging countries are no longer the locomotive. Europe has now achieved balance. So, in other words, no longer is there a funding gap. But in order to achieve balance, it's been necessary that they cut their spending."

Japan's economy has been "in a very depressed state for a very, very long time," he continued. "Then we have had the change in monetary policy for the purpose of targeting a nominal GDP growth that's going to be above the nominal interest rate. My reaction to that is: Finally! Finally. Because it's necessary."

With debt ratios so high and given an aging population, this policy change is "coming at a very difficult time."

"A lot of the Japanese savings has been funding government bonds. As you're dealing with that, who is going to fund those deficits? And what will those people react like? Japan has come almost to the end of the line in terms of that cycle."

The printing of money has had "very classic effects" on the currency, the stock market, economic activity. "But the nature of this beast is that that effect will wear off." This is all the more so in Japan because the government is buying bonds mostly from banks, which are using most of the proceeds to increase reserves. "They're not doing much with that money. Call that pushing on a string."

"At the same time you're going to have a negative fiscal impact, and there will need to be another round of that monetization, and circumstances will transpire politically in ways that you understand better than I."


The Q&A began with questions from Tim Schilt of Berens Capital Management:

In the economic environment you've described, how do you make money? What type of instruments do you want to own?

"It's not only own; you don't want to get shorted—either one of those," Mr. Dalio said.

"It gets very complicated. What happens is I think that the emerging countries' currencies, particularly if I were to rattle off the names of those countries, are in major balance of payment problems, and that will lead to very bad negative things for those countries that are irreversible."

There is a new central bank governor who has assumed office in India very recently. What advice would you have for him?

"Prepare for the worst." Equity flows aren't going to come in at the same pace. "It's not a matter of faith. It's a matter of many basic structural things."

"You have to be prepared for the currency decline," and to accept and manage it. "It's better to have an abrupt currency decline than to have a gradual one. And the reason is as parties begin to anticipate a currency decline, they move their capital out.... That quick currency depreciation hurts domestics less and it hurts foreigners more, which if I was the running the policy I would prefer."

There will be domestic inflation, "but that wave of inflation will taper off if the exchange rate is moved down to a fast level. The only other choice is to go to the IMF, and I don't think that's a recommended choice."

What would you think the BOJ could do from here that would be incrementally stimulative and would maybe offset the impact of a tighter fiscal policy?

"They're going to have to do another big round of purchases," Mr. Dalio said. "Ultimately there has to be a cooperation between monetary and fiscal policy."

In a recent letter to clients about China, Scott Minard, the Chief Investment Officer for Guggenheim Partners, pointed out that major financial crises seem to occur every five years or so. What is your hunch about where the next one is going to come from?

France, Mr. Dalio said, which "has not dealt properly with reducing its debt-to-income ratios rising and the debt service. And so France is a country that I'm somewhat particularly concerned with."

"I don't think it's going to come to China," he added. "In China, if you take the amount of resources and the fact that the debt is denominated in the local currency, I think that that can be very well managed.... But there will be an adjustment."

—Katherine Hyde

Topics:  Business, Policy

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