As the founder of Bridgewater Associates, one of the world's top hedge funds, Ray Dalio has unique insights into investment principles and cycles. In June this year, Dalio posted a long article on "X," introducing the core ideas of his new book, "How Countries Fail: The Big Debt Cycle." This global macro investor, with over 50 years of investment experience, once again systematically reveals how countries move toward debt crises: it is not an abrupt event, but a quantifiable and monitorable "big debt cycle" that eventually leads to systemic collapse, as he metaphorically described it, "an economic heart attack."

Dalio has not only systematically studied and analyzed the past 500 years of world history, but also distilled a theoretical framework to explain the cyclical patterns of national rise and fall.

"To my Chinese friends: I hope this book will help you deal with this interesting era." — Ray Dalio

Dalio:

Over the past 50 years, I have personally experienced multiple debt cycles in many countries. To bet on these cycles, I must fully understand and accurately grasp them. I carefully studied all major debt cycles in the past 100 years and made a rough examination of more cases from the past 500 years, so I believe I have mastered the essentials of managing these cycles.

Given the current economic situation deeply concerns me, I feel responsible to make this research public for independent judgment by all sectors of society.

Since my work is to gamble in the market, and the debt market almost dominates everything, for decades I have been fascinated by studying the mechanisms of debt. I firmly believe that those who understand these mechanisms, whether investors, entrepreneurs or policymakers, can cope with them; conversely, those who do not understand these mechanisms will suffer greatly.

Through my research, I found that there exists a long-term debt cycle, which inevitably creates significant debt bubbles and their bursts. From my observation, among the approximately 750 debt/money markets that have existed since 1700, only about 20% have survived, and all surviving markets have seen severe currency depreciation after going through the mechanisms outlined in my research. I have seen this long-term debt cycle recorded in the Bible's Old Testament, repeated in the dynastic changes of China over thousands of years, and repeatedly predicted the decline of empires, nations, and provinces.

We can imagine the development of the big debt cycle as the progression of a disease or life cycle, where each stage exhibits different symptoms. By identifying these symptoms, we can roughly determine the stage of the cycle and anticipate its subsequent development. In short, the big debt cycle begins with sound money/hard currency and credit, gradually shifting towards increasingly loose monetary and credit policies, ultimately leading to a debt crisis that forces the economy to return to sound money/hard currency and credit.

Dalio during an interview with CNBC, screenshot

More specifically, initially, the private sector engages in healthy borrowing, which can be repaid normally; then the private sector borrows excessively, incurs losses, and faces repayment difficulties; followed by government intervention to rescue, yet itself faces solvency crises due to excessive borrowing; finally, the central bank attempts to ease the situation by "printing money" and purchasing government debt, but also finds itself in a repayment困境, if conditions permit (debt is denominated in a currency that the central bank can issue), the central bank will monetize more debt. Although not all situations are exactly the same, most big debt cycles go through the following five stages:

1. Stable Currency Stage

When net debt levels are low, money remains stable, the country is competitive, and debt growth drives productivity increases, thereby creating income sufficient to repay debt. This will promote the growth of financial wealth and confidence.

2. Debt Bubble Stage

When debt and investment growth exceed what current income can support:

· In this stage, funds are abundant and costs are low, debt-driven economic expansion brings economic prosperity. Large amounts of borrowing for consumption drive up demand and prices for goods, services, and investment assets, and market sentiment is extremely optimistic. According to most traditional valuation standards, market prices are already at high levels.

· This stage usually sees truly transformative inventions, and investors often invest blindly without the ability or assessment of whether future cash flows can cover the cost.

· This dynamic eventually creates a bubble, characterized by debt used for speculation and repayment expenses growing faster than income growth needed to support debt repayment. At this stage, the market and economy appear prosperous, and most people believe the situation will continue to improve. This prosperity is supported by large-scale borrowing, and the so-called "wealth" is essentially created out of nothing.

· Eventually, the debt spiral reaches and exceeds an irreversible tipping point. This means that debt and repayment levels have gone beyond control, and unless debt investors suffer massive losses, the deterioration cannot be prevented. When investors begin to realize the risks of holding debt/currency, interest rates rise, and debtors still need to borrow new debts to repay old ones, this self-reinforcing "death spiral" is triggered, ultimately causing a debt crisis.

3. Peak Stage

When the bubble bursts, debt, credit, markets, and the economy contract simultaneously.

4. Deleveraging Stage

When debt and repayment levels undergo painful adjustments, and finally match income levels, debt sizes can return to sustainable status.

5. Decline Stage of Major Debt Crisis

When a new balance is achieved, a new cycle begins.

After a major deleveraging, due to the traumatic memories of depreciation/debt restructuring, creditors often become risk-averse and hesitant to lend. At this point, the central government and central bank must take measures to rebuild credit: on one hand, the central government needs to achieve fiscal surplus; on the other hand, the central bank needs to reshape the value of money by providing high real yields, increasing reserve requirements, or pegging to gold/strong currencies. In this stage, interest rates typically need to be significantly higher than inflation rates and sufficiently compensate for currency depreciation risks, thus giving creditors considerable returns while increasing the financing costs for debtors. This cycle stage is highly attractive to creditors.

The Nine Stages Leading to the Final Crisis

Now I will focus on the final period of the big debt cycle, when both the central government and the central bank are bankrupt. This period usually goes through nine stages.

Although the following content shows a typical pattern, there are significant variations in specific events and timing, and they may not necessarily follow the order I describe. Therefore, the following content can be considered as the pathogenic factors that induce crises and the classic steps to address them. The more pathogenic factors accumulate, the greater the risk of the central government and central bank "having a heart attack" (i.e., bankruptcy). Specifically, the reasons for a country's bankruptcy are numerous, such as long-term overspending and debt accumulation, costly wars, droughts, floods, pandemics, or combinations of these factors, etc.

No matter the specific cause, the items listed in this checklist can constitute risk indicators. The more pathogenic factors there are, the higher the probability of a debt/currency crisis. Here is the typical sequence of pathogenic factors in the late stage of the big debt cycle:

1. The private sector and the government are deep in debt.

2. The private sector experiences a debt crisis, and the central government falls deeper into debt by helping the private sector.

3. The central government faces debt pressure, and the free market's debt demand cannot match the supply. This causes debt problems. At this point, either (a) a shift in monetary and fiscal policy occurs, balancing the supply and demand of money and credit; or (b) a self-reinforcing net sale of debt occurs, triggering a severe debt liquidation crisis, and reducing the debt size and debt repayment level relative to income after the crisis. A large-scale net sale of debt is an important red flag.

4. The sale of government debt leads to (a) a market-driven tightening of money and credit, resulting in (b) economic weakness, (c) pressure on the currency, and (d) a decrease in foreign exchange reserves. Because this tightening is too harmful to the economy, the central bank usually eases credit and experiences currency depreciation. This stage is easily observable in market behavior: interest rates rise, and the increase in long-term (bond) interest rates is faster than that of short-term rates, while the currency weakens.

5. When a debt crisis erupts and interest rates cannot be further reduced (for example, interest rates are zero or long-term interest rates limit the decline of short-term interest rates), the central bank will "print money" (create money) and buy bonds, trying to lower long-term interest rates and ease credit, making debt repayment easier. It is not really printing money. In this process, the central bank essentially borrows reserves from commercial banks and pays a very short-term interest rate. If the sale of debt and rising interest rates continue, this will cause problems for the central bank.

On July 3 local time, the U.S. House of Representatives passed the "Big and Beautiful" Act, which is expected to add $3.4 trillion in debt over ten years. Visual China

6. If the sale continues and interest rates keep rising, the central bank will incur losses because it must pay an interest rate higher than the rate it receives from the debt assets it purchases. When this happens, it is worth noting, but not a major alarm, unless the central bank has a significant negative net worth and is forced to print more money to compensate for its negative cash flow caused by receiving less income from assets than spending on debt. The occurrence of the above situation is an important red flag because it indicates that the central bank is experiencing a death spiral (interest rate increases causing creditors to avoid holding debt assets, which leads to higher interest rates or the need to print more money, resulting in currency depreciation, triggering more sales of debt assets and currency, and so on in a cycle). This is what I call the central bank's bankruptcy. I call it "bankruptcy" because the central bank has lost its normal ability to repay debts, although it can avoid debt default by printing money, large-scale money printing will lead to currency depreciation and cause an inflationary recession.

7. Debt restructuring and depreciation. When managed optimally, fiscal and monetary policy makers can achieve what I call "harmonious deleveraging"—balancing ways to reduce debt burdens through deflation (such as debt restructuring) and ways to reduce debt burdens through inflation (such as debt monetization), ensuring that the deleveraging process does not cause unacceptable deflation or inflation.

8. During this period, unconventional policies such as special taxes and capital controls are usually implemented.

9. The deleveraging process will inevitably reduce the debt burden and achieve a return to equilibrium. Regardless of the method used, debt and debt repayment levels will eventually match the income available for debt repayment. In most cases, an inflationary depression will cause debt to depreciate at the end of the cycle. At this time, the government increases reserves by selling assets; the central bank links the currency to hard currency or hard assets (such as gold), and achieves a strict transition from rapidly depreciating currency to relatively stable currency, with the central government and private sector returning to sustainable financial levels.

In the early stages of this phase, the credibility of the currency and credit must be re-established by significantly increasing the returns on holding the currency and its denominated bonds, and strictly punishing debt defaults, which manifests as rewarding creditors and punishing debtors. This stage implements extremely tight monetary policy and very high real interest rates, although it causes short-term pain, it is very necessary. If it can be sustained, the supply and demand relationships of money, credit, debt, spending, and savings will eventually return to balance.

The specific implementation path mainly depends on two key factors: first, whether the debt is denominated in a currency that the central bank can create, and second, whether the creditors and debtors are primarily domestic entities. These two key factors will determine the flexibility of the central government and central bank in regulating during this process. If these two conditions are met, the adjustment process will be relatively smooth; otherwise, it will inevitably be more painful. Additionally, whether the currency is a widely used reserve currency is crucial—reserve currency status brings higher marginal purchase tendencies, and people are more willing to hold the currency and its denominated debt. However, it should be noted that historical experience shows that governments often abuse their bond issuance privileges, ultimately losing their privileges, and their decline will be more sudden and painful.

For nearly three decades, global debt has continued to rise. Now, more and more signals are warning of a debt crisis, and the deterioration of debt is gradually evolving into conflict, the world is sliding toward a dangerous edge. When should we be concerned about debt issues, and what are the solutions?

My "3% Three-Part" Solution

I want this solution to be clear and easy to remember. If you remember the number 3, it will help you remember the following: the budget deficit should be cut to 3% of GDP (compared to around 6% according to the CBO's current forecast). These cuts can come from three areas: reducing spending, increasing taxes, and lowering interest rates, with the impact of lowering interest rates being the most significant.

If the president and members of Congress agree that action is needed, and they can reach a consensus on a bipartisan-supported safety net plan (I will propose a suggestion), they will greatly reduce the risk of the U.S. government going bankrupt, thus achieving this goal. In short, this is the core. Next, I will elaborate in detail.

In my view:

1. Policy makers who are committed to controlling the debt problem (some have given up this idea) are dealing with the issue from the bottom up, meaning they are studying which spending cuts and/or tax increases are more effective than other measures, rather than from the top down. A top-down approach means first determining the total amount needed to achieve the goal, then examining the three levers that government policymakers can pull (i.e., spending cuts, tax increases, and interest rate reductions), and finally deciding which specific spending cuts, tax increases, and interest rate adjustments to implement.

2. Decision-makers are overly focused on arguing for their desired specific clauses, which makes the possibility of catastrophic consequences (whether failing to limit debt or experiencing a severe government shutdown) far greater than the possibility of achieving a good result.

To solve this problem, I think they should take the following two steps: (1) work from the top down, i.e., reach an agreement on the scale of deficit reduction and the proportion of the deficit to GDP to ensure debt stability; (2) develop a contingency plan to automatically implement necessary budget cuts when no agreement can be reached on specific details. This contingency plan could include equal percentage cuts on all reducible expenditures and equal percentage increases on all taxable revenues, ensuring the achievement of the goal even if other consensus cannot be reached.

The following figure shows the percentage of U.S. government debt relative to income. The current debt trajectory is represented by a blue dashed line. Based on my understanding of how the mechanism works and the indicators of the most likely scenario, I believe that policymakers must adjust the government debt trajectory to the green dashed line shown in the figure to prevent the central government from going bankrupt. Changing this trajectory will require some degree of spending cuts, and/or increased tax revenue, and/or reduced debt interest rates, such that the sum of these three measures can reduce the deficit to 3% of GDP. Such deficit reduction would make the debt burden 17% lower 10 years later compared to the current projected path (equivalent to reducing $9 trillion in debt over 10 years). After 20 years, adopting this "3% three-part" solution would reduce government debt by 31%, or $26 trillion. This would greatly reduce the risk of the central government, the institutions that provide it with loans, and all individuals potentially affected by the huge debt issue suffering a "heart attack."

There are three main regulatory levers to control the deficit. To achieve the goal of keeping the debt-to-income ratio stable, under other conditions being equal, if only one lever is used alone, it would require raising taxes by about 11%, cutting spending by about 12%, or lowering interest rates by about 3%. Of course, any of these numbers individually is too large, so to properly manage this adjustment, it is necessary to reasonably combine the use of two or three of these levers.

Let's look more closely at these numbers, which are interesting because they show how much more impactful changes in interest rates are compared to changes in taxes. For example, a 1% decrease in interest rates over the next 20 years would have an effect on reducing the debt-to-income ratio that is about four times that of a 1% increase in tax revenue. These numbers also indicate that tax changes are more impactful than spending changes—within the same 20-year time frame, a 1% increase in tax revenue has an effect 1.2 times that of a 1% decrease in spending. However, these direct effect estimates underestimate the total effect when considering possible secondary effects.

More specifically, the effect of lowering interest rates is more significant than the estimates I provided, because in addition to reducing government debt repayment expenses, lower interest rates also raise asset prices, thereby increasing capital gains tax revenue and stimulating the economy, while also increasing inflation, which in turn increases tax revenue. Notably, (1) the secondary effects of cutting spending are negative for economic activity, thus also negative for income tax; (2) the secondary effects of increasing taxes are also negative, as it reduces spending and hinders economic growth.

The most successful case of budget deficit reduction in the United States occurred between 1993 and 1998, during which the deficit went from 4% of GDP to a surplus of 1% (improving by 5% of GDP), equivalent to reducing a deficit of $1.5 trillion today. My plan will reduce the deficit by a smaller amount than this.

Regarding this, my eternal and universal principle is as follows: when government debt is large and growing rapidly, requiring significant budget deficit cuts, the most critical actions include:

(1) significantly cutting the deficit to correct the issue.

(2) cutting the deficit when the economic situation is good, making the cuts countercyclical.

(3) ensuring that monetary policy is sufficiently loose to keep the economy strong while implementing these cuts.

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