Ray Dalio's latest macro analysis in full: Buy more gold, and buy some Bitcoin

Original Author: Ray Dalio

Original Title: How Countries Go Broke Dynamic Behind What Happening Now

Original Compilation: Rhythm BlockBeats

In my book "How Countries Go Broke: The Big Cycle," I established a detailed template to describe how the unsustainable state of debt supply and demand imbalance can trigger certain evolutions. Recently, three things have occurred simultaneously:

• The Japanese government sold part of its U.S. Treasury holdings and repatriated the funds to support the yen and the Japanese capital market, while reducing exposure to U.S. Treasuries without needing to raise interest rates significantly further;

• U.S. Treasury yields have risen to new highs, led by long-term rates, while the dollar has weakened, due to the current and future massive supply of Treasuries and weakening demand;

• This week, Treasury Secretary Yellen announced that the U.S. Treasury would buy U.S. Treasuries, but her capacity to do so is limited, prompting many to ask me: Are these events consistent with the classic template described in the book? The answer is yes. To anticipate what might happen next, it is necessary to revisit this template.

In the book, I elaborate on how the debt/money restructuring process at the government level typically unfolds and provide calculations to demonstrate the extent of imbalance between new debt supply and debt rollover demand. This calculation can serve as a template for comparing reality and predicting the future. If you are a market participant who needs to grasp this template in detail to seize market opportunities, I recommend reading the entire book; if you do not need to go that deep and do not wish to spend that much time, you can read the following five-minute mechanism overview.

How the Mechanism Works

The debt dynamics of central governments follow the same logic as those of individuals or businesses, with the distinction that central governments have a central bank that can print money (thereby devaluing currency) and can extract funds from the public through taxation. Because of this, if you can imagine how you or the business you operate would function under the conditions of "being able to print money and tax," you can understand this dynamic. But remember, your goal is to ensure the entire system operates well—not just for yourself, but for all citizens.

In my view, the credit/market system is like the blood circulation system of the human body, delivering nutrients to all parts of the body constituted by the market and the real economy. If credit is effectively utilized, it can create productivity and income sufficient to repay principal and interest, which is healthy. However, if credit is misused and fails to generate enough income to repay principal and interest, the debt burden will accumulate like plaque, squeezing out other expenditures. When debt repayment expenditures become excessively large, it will create repayment problems and eventually evolve into debt rollover issues—because bondholders are unwilling to renew and only want to sell. This naturally leads to a shortage of demand for bonds and other debt instruments and a wave of selling; when demand is relatively short compared to supply, either 1) interest rates rise, dragging down the market and economy, or 2) the central bank "prints money" and buys debt, devaluing the currency and pushing up the already existing inflation levels. Printing money will also artificially suppress interest rates, harming lenders' returns. Neither path is good. When the scale of debt selling becomes so large that it is difficult to contain, and the central bank has already bought a large amount of bonds, rising interest rates will lead to losses for the central bank, thereby harming its cash flow. If this situation continues, the central bank will eventually fall into negative net assets.

When the problem becomes severe, both the central government and the central bank will incur debt to pay for repayment expenditures. Due to insufficient demand in the free market, the central bank will print money to provide loans, thus initiating a self-reinforcing "debt—printing money—inflation" spiral.

In summary, three classic indicators to watch are as follows:

1. The scale of government debt repayment expenditures relative to government revenue (like the amount of plaque in the circulatory system);

2. The scale of government debt selling relative to government debt demand (like plaque shedding, triggering a heart attack);

3. The scale at which the central bank buys government debt through printing money to fill the gap between Treasury demand and the supply of Treasuries for sale (like the central bank injecting a dose of strong liquidity/credit to alleviate liquidity tension, resulting in more debt, which then becomes the central bank's exposure).

These indicators typically continue to rise over decades—debt and repayment expenditures relative to income keep increasing—until they can no longer be sustained, either because 1) repayment expenditures excessively crowd out other expenditures to an unacceptable degree; or 2) the supply of debt that must be purchased is too large relative to demand, forcing interest rates to rise significantly, causing the market and economy to plummet; or 3) the central bank, unwilling to sit idly by as interest rates rise and the market and real economy deteriorate, prints a large amount of money and buys a large amount of government debt to fill the demand gap, leading to a significant devaluation of currency value. Regardless of the path taken, bond returns will be poor until currency and debt become cheap enough to attract demand, and/or the government can repurchase or restructure debt at low cost.

This is the simplest picture of the big debt cycle.

Since these indicators are quantifiable, we can continuously monitor the evolution of debt dynamics, making it easy to see the approaching problems. I have consistently used this diagnostic method in my investments and have kept it confidential, but now I have detailed it in "How Countries Go Broke: The Big Cycle" because it is too important to keep to myself.

More specifically, you can observe that: debt and repayment expenditures relative to income are continuously rising; debt supply exceeds debt demand; the central bank first lowers interest rates to stimulate through easing, then shifts to printing money to buy debt, ultimately incurring losses and falling into negative net assets; the central government continually leverages itself to repay repayment expenditures, while the central bank monetizes the debt. All of this leads to a government debt crisis—it is akin to an economic heart attack: the contraction of spending supported by debt cuts off the normal flow of the economic circulatory system.

In the early stages of the final phase of the big debt cycle, market performance will reflect this dynamic: interest rates rise, led by long-term rates, currency devalues, especially relative to gold, and the central government's Treasury shortens the issuance period due to insufficient long-term debt demand. Typically, in the latter stages of the cycle, when dynamics are most intense, a series of seemingly extreme measures will be introduced, such as establishing capital controls, applying strong pressure on creditors to force them to buy and not sell debt. This dynamic is explained more comprehensively in the book, accompanied by numerous charts and data to illustrate its evolution.

The Situation of the U.S. Government: A Brief Summary

Now, imagine you are running a large enterprise called "U.S. Government." This perspective will help you understand the financial situation of the U.S. government and the choices of its leadership.

This year's total revenue is about $5.5 trillion, and total expenditures are about $7.5 trillion, resulting in a budget gap of about $2 trillion. In other words, this year, this institution's expenditures will exceed its revenues by about 40%. There is very little room for expenditure cuts, as almost all expenditures are either previously committed or necessary. Due to this institution's long history of significant borrowing, it has accumulated massive debt—about six times its annual revenue (approximately $32 trillion), equivalent to about $240,000 for each household you need to care for. The interest bill on this debt is about $1 trillion, which accounts for about 20% of this institution's revenue, also equivalent to half of this year's budget gap (deficit)—and this deficit still needs to be covered by borrowing. But $1 trillion is not all you need to pay to creditors, as in addition to interest, you also need to repay maturing principal, which is about $10 trillion. You hope creditors will either renew loans or lend you money. Therefore, repayment expenditures—which are the principal and interest that must be repaid to avoid default—are about $11 trillion, approximately 200% of incoming funds.

This is the current situation.

So, what will happen next? Let's speculate. You will borrow to fill the deficit, regardless of what the final deficit is. There is much debate about what the deficit will be. After accounting for the recently passed budget reconciliation bill, most independent assessment agencies expect U.S. debt to reach $55 to $60 trillion (about seven times revenue) in ten years, as there will also be an additional $25 to $30 trillion in borrowing by then. Of course, ten years from now, this institution will face heavier repayment expenditures squeezing out other expenditures, and without a solution, the risk that its debt for sale will not find sufficient demand will also increase.

My "3% Three-Part Method" Solution

I am confident in judging that the U.S. government's financial situation is at a turning point because if not addressed now, debt will accumulate to a level that is difficult to manage without severely damaging the system; and importantly, this operation should be conducted while the system is relatively strong, not when it is weak. The reason is that when the economy contracts, the government's borrowing needs will rise significantly.

According to my analysis, I believe this situation needs to be addressed through what I call the "3% Three-Part Method," which involves reducing the budget deficit to 3% of GDP and balancing three methods of reducing the deficit: 1) cutting expenditures, 2) increasing tax revenues, and 3) lowering interest rates. All three must be advanced simultaneously to avoid any one measure being too strong—because if any one is too aggressive, the adjustment process will cause trauma. Moreover, these adjustments should be achieved through good fundamental adjustments rather than coercive measures (for example, the Federal Reserve artificially suppressing interest rates is a very bad approach). According to my calculations, reducing expenditures and increasing tax revenues by about 5% each, with interest rates correspondingly decreasing by about 1 to 1.5 percentage points, will reduce future interest expenditures by 1 to 2 percentage points of GDP and stimulate asset prices and economic activity, leading to much more revenue.

Frequently Asked Questions and My Answers

The book contains far richer content than this short article, including a description of the "Overall Big Cycle" (composed of debt/credit/money cycles, domestic political cycles, external geopolitical cycles, natural events, and technological advancements)—which drives all major changes in the world; my views on possible future scenarios; and some perspectives on how to invest amid this series of changes. But for now, I will first answer some questions I am often asked when promoting this book, and if you want to delve deeper, feel free to read the entire book.

Q1: Why do large government debt crises and big debt cycles occur?

Large government debt crises and big debt cycles can be easily measured by three indicators: 1) government debt repayment expenditures relative to government revenue rising to an unacceptable level that crowds out necessary government expenditures; 2) the scale of government debt selling relative to demand being large enough to create an imbalance, causing interest rates to rise and leading to market and economic downturns; 3) the central bank responding to these conditions with low interest rates, which weakens bond demand, forcing the central bank to print money to buy government debt, leading to currency devaluation. These indicators typically continue to rise over a long cycle of decades until they can no longer be sustained—either because 1) repayment expenditures excessively crowd out other expenditures to an unacceptable degree; or 2) the supply of debt to be purchased is too large relative to demand, forcing interest rates to rise significantly, causing the market and economy to plummet; or 3) the central bank prints a large amount of money and buys a large amount of government debt to fill the demand gap, leading to a significant devaluation of currency value. Regardless of the path taken, bond returns will be poor until they become cheap enough to attract demand, and/or the debt can be restructured. These indicators are easily measurable, and people can clearly see that they are heading towards an imminent debt crisis. When spending supported by debt contracts, the crisis arrives—like a heart attack triggered by debt.

Historically, almost every country has experienced such debt cycles, often multiple times, providing hundreds of historical cases for study, even tracing back to the earliest recorded history. In other words, all monetary orders ultimately lead to collapse, and the debt cycle mechanism I describe is the driving force behind these collapses. The decline of all reserve currencies stems from this, such as the pound sterling, and the Dutch guilder before it. I list 35 recent cases in the book.

Q2: If this process occurs repeatedly, why is the underlying mechanism so little understood?

You are correct that this mechanism has not been fully understood. Interestingly, I cannot find any studies on how it operates. My speculation is that it is not understood because the collapse of the monetary order typically occurs only once in a lifetime for reserve currency countries; and when it occurs in non-reserve currency countries, people assume it is a problem that reserve currency countries can be immune to. I was able to discover this mechanism simply because I witnessed its occurrence in sovereign bond market investments, prompting me to study a large number of relevant historical cases to respond calmly (for example, to deal with the 2008 global financial crisis and the subsequent European debt crisis).

Q3: Before the U.S. debt problem explodes, how concerned should we be about a "heart attack" style debt crisis occurring in the U.S.? People have heard too much about the "upcoming debt crisis" that has yet to happen. What is different this time?

I believe we should be very concerned, for the reasons I mentioned earlier. I think those who were worried about a debt crisis when the situation was not as severe were correct, because addressing the issue earlier could have prevented the situation from deteriorating to its current state, just as doctors warn patients not to smoke or overeat. Therefore, I speculate that the reason this issue has not raised broader concern is partly because it has not been fully understood, and partly because previous premature warnings have caused a lot of numbness. It is like someone whose arteries are already full of plaque, yet continues to eat a lot of high-fat foods and never exercises, telling the doctor: "You warned me long ago that if I didn't change my lifestyle, something would happen, but I haven't had a heart attack yet. Why should I believe you now?"

Q4: Today, what could become a catalyst for a U.S. debt crisis? When might the crisis occur? What would such a crisis look like?

The catalyst will be the convergence of the various influences mentioned earlier. As for timing, policy and exogenous factors—such as significant political shifts and wars—can accelerate or delay its arrival. For example, if the budget deficit decreases from the approximately 7% of GDP that I and most people expect to about 3%, the risk would be significantly reduced. If a major exogenous shock occurs, the crisis could arrive earlier; if not, it could be delayed or even avoided (provided it is managed properly). My guess—though I estimate this will be a bad prediction—is that if we do not change our current path, the crisis will arrive within three years, with a margin of error of two years.

Q5: Do you know of any precedents for significantly reducing budget deficits and achieving good results?

Yes, I know several. My plan would reduce the budget deficit by about 4 percentage points of GDP. The most similar successful precedent is the U.S. from 1991 to 1998, when the budget deficit was reduced by 5 percentage points of GDP. I also list several similar cases from other countries in the book.

Q6: Some believe that due to the dollar's dominant position in the global economy, the U.S. is generally less susceptible to debt-related problems/crises. What do you think those holding this view are overlooking?

If they think that, they do not understand the mechanisms and historical lessons involved. More specifically, they should study history to understand why all previous reserve currencies ultimately cease to be reserve currencies. To put it bluntly: currency and debt must serve as effective stores of wealth; otherwise, they will be devalued and abandoned. The dynamics I describe are precisely how reserve currencies lose their effectiveness as stores of wealth.

Q7: Japan—whose debt-to-GDP ratio is as high as 215%, the highest among developed economies—is often cited as a typical example of "a country that can remain unscathed at high debt levels without a debt crisis." Why do you not find much comfort in Japan's experience?

Japan's case is confirming, and will continue to confirm, the problems I describe; it is a manifestation of my theory in reality. Specifically, due to the extremely high level of over-indebtedness of the Japanese government, Japanese bonds and debt have consistently been poor investments. To compensate for the insufficient demand for Japanese debt assets at a sufficiently low and favorable interest rate, the Bank of Japan has printed a large amount of money and bought a large amount of Japanese government bonds, resulting in investors holding Japanese bonds losing 51% relative to those holding U.S. dollar bonds and losing 76% relative to those holding gold since 2013. Since 2013, the wages of ordinary Japanese workers, when measured in common currency, have decreased by 55% relative to U.S. workers. I dedicate an entire chapter in the book to elaborating on Japan's case.

Q8: From a fiscal perspective, what other regions in the world have particularly prominent problems that people may underestimate?

Most economies face similar debt and deficit issues—this includes the UK, EU, China, and Japan. For this reason, I expect most economies to undergo similar debt adjustments and currency devaluation processes, and I also expect non-government-produced currencies like gold and Bitcoin to perform relatively well.

Q9: How should investors respond to this risk/how should they position themselves for the future?

As a general recommendation, I suggest diversifying across asset classes and countries, favoring those with robust income statements and balance sheets, and without severe domestic political conflicts or external geopolitical conflicts; underweighting bonds and other debt assets, while overweighting gold and a small amount of Bitcoin. Allocating a small portion of funds—such as 10% to 15%—to gold can reduce the risk of the investment portfolio, and I believe it can also enhance its returns.