Ray Dalio and the De-leveraging Cycle


Ray Dalio at Bridgewater Associates wrote a paper (updated Oct 2011) describing how a debt-deleveraging cycle works: http://tinyurl.com/7p5pc9y. A debt-deleveraging cycle is VERY different from a normal business cycle slowdown. From peak-to-trough, equities typically decline by 80% and real economic activity by 20%.

The Federal Reserve has printed trillions of dollars in an effort to overcome the deflationary effects of a debt-deleveraging cycle. (I do not fault Bernanke or the Fed for a heroic attempt, based on a great deal of economic research, to help a severely struggling U.S. job market.) The problem so far is that while M1 money supply has surged up 60% since 2008 to $2.2 trillion and climbing, the velocity of money has plunged. In other words, massive liquidity from the Fed is not translating into more economic activity because of the debt-deleveraging cycle. The new money supply is simply remaining idle (e.g., as bank reserves).

Bernanke has argued that printing money inflates asset prices such stocks, which creates a “wealth effect” leading to greater spending. But home prices have much more of an effect on most Americans than stock prices, and more importantly, higher stock prices may not have anything more than a temporary and insignificant impact on economic expansion (especially in a debt-deleveraging cycle).

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The Fed printing trillions is a major reason why the S&P 500 Index has experienced a huge bear market rally and has become significantly overvalued again. But the S&P 500 Index will inevitably decline to approximate fair value (1000 or lower), regardless of massive money-printing. So the net effect of extremely aggressive monetary policy is unclear and worrisome. It may create a temporary illusion of stability (like before the U.S. housing bubble burst) while actually creating massive imbalances that may distort and delay the natural healing of the economy.

As both John Taylor (Taylor Rules — http://tinyurl.com/76sp5jz) and Warren Buffett have long argued, after the initial government interventions in the 2008/9 financial crisis, most of the healing of the economy is natural self-healing that must occur over many painful years as consumers and businesses deleverage and make adjustments. Too much ongoing government intervention may contribute to mini-bubbles (e.g., stocks and commodities), a false sense of stability, and massive imbalances (e.g., a huge money supply) that later must be corrected (in ways that may hurt the economy). John Taylor argues that the huge money supply has contributed to economic uncertainty (because people don’t know how all that excess money will be withdrawn from the system), causing people to sit on large amounts of cash.

Bottom line: To paraphrase Nouriel Roubini (http://nourielroubiniblog.blogspot.com/), kicking the can down the road — especially in a debt-deleveraging cycle — without using the additional time to address the fundamental problems (too much debt and massive trade imbalances) does not restore healthy and sustainable economic growth and does not lead to a stable equilibrium. Artificially inflated asset prices almost always revert to fair values (and usually overshoot in a secular bear market).

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