Special Report


September 30, 2015


It is necessary to understand how the economy works in order to develop a perspective on the financial markets both in the short-run as well as the long-term.  Ray Dalio, one of the best macro thinkers of our generation and founder of Bridgewater, the largest hedge fund in the world, has created a framework to explain the dynamics of an economy. 


In this discussion, I am going to use Dalio’s framework of the economy to offer a perspective on how we may be at one of the most significant junctures in the last 85 years as it relates to the global economy and implications for the financial markets.  In order for this perspective to make sense, you first need to understand Dalio’s framework.  He has created a short, thirty minute video which is a good depiction of how the economy functions.  Instead of explaining it here, it is much more effective for you to do a Google search for “How The Economic Machine Works” by Ray Dalio and watch the video yourself.  The video can be seen at www.economicprinciples.org or you can also search for it on YouTube.  So, I encourage you to stop reading, watch the video and then return to this discussion. 


Now that you have seen Dalio’s video, let’s use that framework to think through a possible scenario that may unfold in the economy and the financial markets.  To do this, I will first review a few key dynamics from the video.  Then, I will use his framework to offer a perspective on the current situation and a scenario that may be on the verge of unfolding.  In addition, I will put that scenario within the context of the global environment.  At the end, I will provide a few concluding remarks.  Let’s get started.




In Dalio’s description of The Economic Machine, productivity drives the long-term trend in economic growth by the participants working either harder or smarter.  Then, credit cycles either accelerate growth by pulling demand forward during credit expansions or slow down growth when credit contracts and repayments increase.  These credit cycles cause economic growth to oscillate above and below the longer-term trend.  Also, there is a short-term credit cycle that last usually between 5 and 8 years and a long-term credit cycle that typically occurs over a 75 to 100 year period. 


To provide a visual on how the short-term and long-term debt cycles oscillate around the productivity trend of fundamental growth, here is the chart Dalio used in his video.




In the chart above, the straight line going higher over time is the productivity line which drives long-term economic growth.  The larger wave is the long-term debt cycle and the smaller wave reflects the short-term credit cycle.  The short-term cycles trend higher as human nature drives consumption levels higher than income levels until an economy reaches an unsustainable amount of debt accumulation.  The long-term cycle begins at low levels of debt in the economy and ends at very high levels of debt.  And, the process of returning from the peak in the long-term cycle back to low amounts of debt is called a deleveraging. 


During these credit cycles, the central bank plays an active role as we have all seen.  In the short-term cycle, the central bank uses interest rates to influence either the acceleration or deceleration of credit growth.  When credit growth is accelerating quickly and inflation concerns begin to surface, the central bank raises rates to make the cost of credit more expensive so as to temper growth.  On the other side, when credit growth is slowing or contracting during a recession, the central bank lowers rates to make credit less expensive to try to increase spending and reignite growth.  This goes on for decades until an economy is saturated in debt. 


Then, there is a tipping point where a deleveraging occurs and even though the central bank lowers rates, it has little effect because participants in the economy cannot or will not take on new debt regardless of how cheap it is.  The long-term credit expansion is a self-reinforcing cycle of growth and a deleveraging feeds off itself as well but in a downward cycle.  Often, central banks are at or near zero interest rates during deleveragings. 


During deleveragings people cut their spending, debt is reduced through defaults and restructurings, wealth is redistributed through tax policies and the central bank prints money.  While inflation is the primary concern of central banks during the long-term credit expansion part of the cycle, fears shift to deflation in the deleveraging period of the cycle.  With this in mind, let’s now shift to putting the current environment within the context of Dalio’s Economic Machine framework.




Debt cycles are a key driver of the overall machine so let’s begin by taking a look at debt levels as a percent of GDP over the last 100 years.  Here is a chart from Gamco Mathers Fund.




If you look at the chart above, you can see the prior peak in the long-term debt cycle in the 1930’s and the subsequent deleveraging.  The debt levels were reduced back to a low level which then reset the economic foundation for the next long-term cycle of debt accumulation.  Now, if you look at the end of the chart, you see potentially another peak which was around 2007, and happens to be about 75 years from the last peak. 


After the recent peak, we saw the first wave of deleveraging in 2008 and 2009.  And, what have we seen from the central bank; move to the zero bound in interest rates and the printing of over $4 trillion in new money [the chart embedded at the top center above puts how much money we have printed into context].  The last time we saw anything close to these extreme monetary policies was in the Great Depression.  These are not policies found during the uptrend period of the long-term debt cycle. 




Now, here is where it gets even more interesting and these are my interpretations and I have not heard Dalio’s perspective on this.  So, as Dalio describes, the short-term credit cycle oscillates around the long-term debt cycle trend, as shown in the first chart earlier.  To dive deeper into the current environment, let’s magnify the chart of both short and long-term debt cycles of the recent period.




In the chart above, the black line represents the long-term debt cycle and the red line represents the short-term debt cycle.  So, here is the scenario.  The peak in both the short and long-term debt cycles occurred in 2007.  Period # 1 above shows that the short-term debt cycle accelerated downward at the same time the long-term debt cycle began to roll over.  When the short-term and long-term cycles line up, you get acceleration in the overall trend, both on the upside and on the downside. 




In this first wave down, we had the Great Recession and a financial crisis which led to a shift in monetary policies back to the Great Depression era with the central bank cutting rates to zero and starting up the printing press as fears of deflation surfaced.  Bernanke just happened to be the chair of the central bank and his field of academic study was focused on the Great Depression; and he pulled out the playbook.  During this wave #1 in the chart above, we also saw high profile bailouts of failed institutions, increased government guarantees in certain areas of the financial system, as well as significant debt restructurings.  These dynamics are picture perfect for what is found in a deleveraging.


These extreme monetary policies and government actions had the effect of slowing down the deleveraging process and turning it back up, but at a slower ascent, from 2009 through 2015, which is period # 2 above.  The initial descent and subsequent reprieve from the downward deleveraging force of the long-term cycle has played out in the form of another short-term credit cycle. 




Over the past six years or so since 2009, the short-term credit cycle turned back up in the midst of the long-term cycle being down.  Instead of good economic growth, we have seen very muted growth and one of the worst “recoveries” on record.  When the cycles are going against one-another in the long-term up cycle, you get a mild to moderate recession and when the cycles are going against one-another in the long-term down cycle, you get a mild recovery.  This mild economic recovery occurred during period # 2 in the chart above.  


This initial wave of the deleveraging process was met by unprecedented monetary policies.  That has created this battle between the deflationary forces of deleveraging and the inflationary forces of the monetary policies.  Dalio’s Economic Machine outlines what he calls a “Beautiful Deleveraging” when the central bank finds the right balance of monetary policy so that the deflationary pressures are balanced by the inflationary policies.  If the balance is managed appropriately, it enables the economy to deleverage and reset debt levels without too much pain or causing a depression.  Through periods # 1 and # 2 above, it might appear based on this framework that the deleveraging has been “beautiful” so far.


However, the significant challenge is that if you look back up at the total debt chart, you can see that the deleveraging of the long-term debt has only begun here in the U.S. and there is a whole lot left to go.  And, to accomplish this “beautiful” deleveraging so far, the central bank has already used much of its available ammunition.


Instead of allowing the deleveraging to occur, our central bank has created a short-term reflation of debt.  That implies that our central bank used too much force in the first wave down instead of achieving the desired balance of monetary policy.  The deleveraging cycle will continue and the perceived benefits of the monetary policies are subsiding.


Now, if we look at the possibility that the short-term credit cycle is peaking once again in the midst of the long-term cycle continuing downward, we could see another serious economic contraction which would have significant implications for financial markets as well as monetary policy.  By the way, the time between the ’07 peak and a ’15 peak in the short-term cycle would be 8 years which fits the typical range for the short-term cycle outlined by Dalio. 


Before I discuss the impact of the cycles converging again, let’s step back for a moment and consider the global environment.




Since the potential recent peak in the long-term debt cycle here in the U.S. back in 2007, global debt has continued to increase at an alarming rate.  McKinsey & Company, the leading global consulting firm, recently published a study in February of this year called “Debt and (Not Much) Deleveraging.  I will quote some of their findings here.


“Seven years after the bursting of a global credit bubble resulted in the worst financial crisis since the Great Depression, debt continues to grow.  In fact, rather than reducing indebtedness, or deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007.  Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points (Exhibit 1).  That poses new risks to financial stability and may undermine global economic growth.”




“In our study, we pinpoint three areas of emerging risk: the rise of government debt, which in some countries has reached such high levels that new ways will be needed to reduce it; the continued rise in household debt—and housing prices—to new peaks in Northern Europe and some Asian countries; and the quadrupling of China’s debt, fueled by real estate and shadow banking, in just seven years.”


“Government debt is unsustainably high in some countries.  Since 2007, government debt has grown by $25 trillion.  It will continue to rise in many countries, given current economic fundamentals.  Some of this debt, incurred with the encouragement of world leaders to finance bailouts and stimulus programs, stems from the crisis. Debt also rose as a result of the recession and the weak recovery.  For six of the most highly indebted countries, starting the process of deleveraging would require implausibly large increases in real-GDP growth or extremely deep fiscal adjustments.  To reduce government debt, countries may need to consider new approaches, such as more extensive asset sales, one-time taxes on wealth, and more efficient debt-restructuring programs.”


“Household debt is reaching new peaks.  Only in the core crisis countries—Ireland, Spain, the United Kingdom, and the United States—have households deleveraged.  In many others, household debt-to-income ratios have continued to rise.  They exceed the peak levels in the crisis countries before 2008 in some cases, including such advanced economies as Australia, Canada, Denmark, Sweden, and the Netherlands, as well as Malaysia, South Korea, and Thailand.”


“Fueled by real estate and shadow banking, China’s total debt has nearly quadrupled, rising to $28 trillion by mid-2014, from $7 trillion in 2007.  At 282 percent of GDP, China’s debt as a share of GDP, while manageable, is larger than that of the United States or Germany.  Three developments are potentially worrisome: half of all loans are linked, directly or indirectly, to China’s overheated real-estate market; unregulated shadow banking accounts for nearly half of new lending; and the debt of many local governments is probably unsustainable.”


McKinsey’s study raises questions about how much, if any, has the U.S. really deleveraged since 2007.  Households have deleveraged some but the government has added new debt.  Also, it is not unusual to see debt actually go up in the government sector during the initial phases of a deleveraging as they spend to try to maintain growth, while tax receipts fluctuate lower.  In summary, their study shows that the world is awash in debt.


Now, if we look at the three largest developed economies as the U.S., Europe, and Japan it is interesting to note what we have seen from a monetary policy standpoint.  Each is already at or near the zero bound in interest rate policy and each has printed significant amounts of money over the past few years.  Some countries within Europe have even gone the extra step of moving to negative rates.  These are deleveraging and Great Depression-type policy measures which match up well with the scenario that the world economies are either in or moving toward the deleveraging part of their long-term debt cycles. 




Next, let’s turn back to the potential scenario that the short-term and long-term credit cycles may be on the verge of lining up in the same direction here in the U.S. once again.  In the earlier chart showing the long-term cycle with the black line and the short-term cycle with the red line, this would mean that we are moving toward the wave down in period # 3. 


Then, the question comes to whether our central bank used up too much of its ammunition in the first wave down of the deleveraging cycle.  It is debatable what effects those policies have had on the real economy but what we do know is that it has inflated asset prices back up to very lofty levels from a valuation perspective.  It appears so far that the deflation pressures from the beginnings of the deleveraging cycle have continued to manifest itself in the real economy while the inflationary pushes from the monetary policies have been reflected in the financial markets with the levitation of asset prices.


If we are moving into that third period on the chart, monetary policy is likely to go even further out on the spectrum which would first include a new round of money printing or, QE 4.   Other types of asset purchases will likely be included as the central bank looks for more direct ways to push money into the system.  Also, negative interest rates would likely follow and we even had one central bank member mention that possibility at the latest meeting.  Fiscal policy will look for new ways to get involved as well.  This period would include the next economic contraction and a high probability that asset prices would reconnect to fundamentals.  Each incremental step in monetary policy over the past few years has been shown to be less effective and when you are already at extremes the perceived benefit will likely diminish even further.


If the central bank used up too much ammunition in the first phase of the deleveraging and the next frontier of monetary policy is perceived as being ineffective at a time when the short and long-term cycles converge once again, that is the point when the previous “beautiful” deleveraging turns ugly.




Now, overlay what is going on around the world and the potential for a global synchronous deleveraging at a time when the world central banks are already at extreme policies, the scenario turns even more interesting.  If we have the short-term credit cycles turn back down and reconnect with the long-term debt deleveraging cycles around the globe at the same time, the deflationary forces will be powerful relative to any conceptual monetary strategy.  The implications for stocks, bonds, currencies, commodities and other assets become tricky as all central banks would likely end up printing the money required for the debts that do not end up in default or restructured along the way.  How that money infiltrates into the economic system and financial markets is something to think through as one positions around this scenario.  Social implications will be notable as well.


Let’s conclude this discussion.  Ray Dalio’s Economic Machine framework for understanding how the economy works is one of the best depictions available.  Overlaying that framework on the U.S. and global economies with a historical perspective, helps one to understand potential scenarios that may unfold as this deleveraging process continues.  It is hard to imagine scenarios such as the one described here in the midst of daily activities and the extreme short-term focus in the financial markets by participants.  However, in 2007 most all did not imagine what would occur in the first phase of the deleveraging during 2008 and the subsequent monetary policies that followed.  It is a time to at least consider a scenario such as this since the implications are significant and ensure you have a plan to position appropriately. 


Joseph R. Gregory, Jr.





 Past results are not indicative of future results.  Joseph Gregory is President of Heritage Capital Partners, Inc., a registered investment advisor.  All materials presented herein are believed to be reliable but we cannot attest to its accuracy.  All material represents the opinions of Joseph Gregory.  Investment opinions or recommendations may change and readers are urged to check with their financial advisor before making any investment decisions.  Opinions expressed in these commentaries may change without prior notice.  Joseph Gregory and/or clients of Heritage Capital Partners, Inc. may or may not have investment positions that are in or aligned with any opinions mentioned in these commentaries.  There is risk of loss as well as opportunity for gain when investing in the financial markets.  Investment opinions or positions mentioned in these commentaries are not suitable for all readers and therefore, readers are urged once again to check with their financial advisors before making any investment decisions.