I think there will be exceptionally big differences between the performance levels of countries, investors, and companies that will penalize those who choose poorly and reward those who choose well enormously. Principles for Navigating Big Debt Crises provides a framework for understanding the mechanics of these crises. Dalio sets out six stages, from the seeds of the crisis to its resolution. He analyzes 48 historical episodes of debt crises when GDP growth fell by 3% or more. These episodes cover both developed and emerging economies. Dalio categorizes big debt crises into two types — deflationary and inflationary — and provides economic and market data for both. The template that follows is based on my examination of 48 big debt cycles, which include all of the cases that led to real GDP falling by more than 3 percent in large countries (which is what I will call a depression). For clarity, I divided the affected countries into two groups: 1) Those that didn’t have much of their debt denominated in foreign currency and that didn’t experience inflationary depressions, and 2) those that had a significant amount of their debt denominated in foreign currency and did experience inflationary depressions. Since there was about a 75 percent correlation between the amounts of their foreign debts and the amounts of inflation that they experienced (which is not surprising, since having a lot of their debts denominated in foreign currency was a cause of their depressions being inflationary), it made sense to group those that had more foreign currency debt with those that had inflationary depressions. Over time environments will shift between those that are good and bad for lender-creditors and borrower-debtors, and it is critical for everyone who is involved in markets and economies in any way to know how to tell the difference. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

The key to handling debt crises well lies in policy makers’ knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable. During this time period, the geopolitical landscape changed as the Soviet Union fell, China rose, and wealth gaps increased. In this Part 2, I will briefly review some of the timeless and universal cause/effect relationships that drive how “the machine” works, then I will review what happened from 1945 until now to compare what actually happened with my template, and then I will focus on what’s happening now and what this template leads me to believe about the future. Deflationary debt cycles typically occur when the majority of debt is denominated in a country’s own currency. Dalio believes it is possible for policymakers to manage these crises well, but even a good outcome will be extremely costly to some people.As always, I’m not certain of anything, I am putting these thoughts out for your consideration to take or leave as you like, and I hope that you find them helpful. Debt crises, even big ones, can usually be managed to reduce the pain of them to acceptable levels.

Having said that, I want to reiterate that 1) when debts are denominated in foreign currencies rather than one’s own currency, it is much harder for a country’s policy makers to do the sorts of things that spread out the debt problems, and 2) the fact that debt crises can be well-managed does not mean that they are not extremely costly to some people. While the gold-dollar-based system broke down, the US remained the dominant world power economically, militarily, and in most other respects, and most world trade and global lending was done in dollars so the dollar remained the world’s leading currency.I find that whenever I start talking about cycles, particularly big, long-term cycles, people’s eyebrows go up; the reactions I elicit are similar to those I’d expect if I were talking about astrology. For that reason, I want to emphasize that I am talking about nothing more than logically-driven series of events that recur in patterns. In a market-based economy, expansions and contractions in credit drive economic cycles, which occur for perfectly logical reasons. Though the patterns are similar, the sequences are neither pre-destined to repeat in exactly the same ways nor to take exactly the same amount of time. Generally speaking, because credit creates both spending power and debt, whether or not more credit is desirable depends on whether the borrowed money is used productively enough to generate sufficient income to service the debt. If that occurs, the resources will have been well allocated and both the lender and the borrower will benefit economically. If that doesn’t occur, the borrowers and the lenders won’t be satisfied and there’s a good chance that the resources were poorly allocated. Ray Dalio, the legendary investor and international bestselling author of Principles - whose books have sold more than five million copies worldwide - shares his unique template for how debt crises work and principles for dealing with them well. This template allowed his firm, Bridgewater Associates, to antic­ipate 2008’s events and navigate them well while others struggled badly. There is also a glossary of economic terms at the end of Part 3, and for a general overview of many of the concepts contained in this study, I recommend my 30-minute animated video, How the Economic Machine Works, which can be accessed at www.economicprinciples.org