Bridgewater Associates founder: The most important principle when considering massive government debt and deficits.

Written by: Ray Dalio

Compiled by: Block unicorn

The principles are as follows:

When national debt is excessive, lowering interest rates and devaluing the currency in which the debt is denominated are the most likely priority paths that government decision-makers will take, so betting on this scenario is worthwhile.

As I write this, we are aware that a massive deficit and a significant increase in government debt and debt repayment expenditures are expected in the future. (You can see this data in my works, including my new book "How Nations Go Bankrupt: The Big Cycle"; I also shared last week my thoughts on why I believe the American political system cannot control the debt problem.) We know that the cost of debt repayment (interest and principal payments) will rise rapidly, squeezing other expenditures, and we also know that, in the most optimistic scenario, the likelihood of debt demand increasing matching the supply of debt that needs to be sold is extremely low. I elaborate on what I believe this all means in "How Nations Go Bankrupt" and describe the mechanisms behind my thinking. Others have also stress-tested this, and currently, there is almost complete agreement that the picture I have painted is accurate. Of course, this does not mean I cannot be wrong. You need to judge for yourself what might be true. I am merely providing my thoughts for everyone to evaluate.

My principle

As I explained, based on my experience and research in investing over the past 50 years, I have developed and documented some principles that help me predict events in order to make successful bets. I am now at a stage in my life where I hope to pass these principles on to others to provide help. Furthermore, I believe that to understand what is happening and what may happen, it is essential to understand how the mechanisms work, so I also attempt to explain my understanding of the mechanisms behind the principles. Here are a few additional principles and my explanations of how I believe the mechanisms work. I believe the following principles are correct and beneficial:

The most covert, and therefore most favored, method that government decision-makers use to address the issue of excessive debt is to lower real interest rates and real exchange rates.

Although lowering interest rates and currency exchange rates to address excessive debt and its issues can provide short-term relief, it reduces the demand for currency and debt, leading to long-term problems as it lowers the returns on holding currency/debt, thereby diminishing the value of debt as a store of wealth. Over time, this often results in increased debt, as lower real interest rates are stimulative, exacerbating the problem.

In summary, when debt is excessive, interest rates and currency exchange rates tend to be suppressed.

Is this good or bad for the economic situation?

Both are present, often good and widely popular in the short term, but harmful in the long run, leading to more serious problems. Lowering the real interest rate and the real currency exchange rate is...

...is beneficial in the short term because it is stimulating and often drives up asset prices...

...but it is harmful in the medium and long term because: a) it results in lower real returns for holders of these assets (due to currency depreciation and lower yields), b) it leads to higher inflation rates, c) it results in greater debt.

In any case, this clearly cannot avoid the painful consequences of overspending and being deeply in debt. Here is how it works:

When interest rates decrease, borrowers (debtors) benefit, as this lowers the cost of debt repayment, making borrowing and purchasing cheaper, which in turn drives up the prices of investment assets and stimulates growth. This is why nearly everyone is satisfied with lower interest rates in the short term.

However, at the same time, these price increases mask the adverse consequences of lowering interest rates to undesirable low levels, which is detrimental to both lenders and creditors. These are facts, as lowering interest rates (especially real interest rates), including central banks suppressing bond yields, will push up the prices of bonds and most other assets, leading to lower future returns (for example, when interest rates drop to negative values, bond prices rise). This also leads to more debt, resulting in greater debt problems in the future. Therefore, the returns on the debt assets held by lenders/creditors decrease, thus creating more debt.

Lower real interest rates also tend to reduce the actual value of money, as they make the yields on money/credit lower compared to alternatives in other countries. Let me explain why lowering the currency exchange rate is the preferred and most common way for government decision-makers to deal with excessive debt.

There are two reasons why lower currency exchange rates are favored by government decision-makers and seem beneficial when explaining to voters:

1. A lower currency exchange rate makes domestic goods and services cheaper compared to those of countries with currency appreciation, thus stimulating economic activity and driving up asset prices (especially in nominal terms), and...

2. …It makes debt repayment easier, but this method is more painful for foreign holders of debt assets than for domestic citizens. This is because another approach of "hard currency" requires tightening monetary and credit policies, which leads to high real interest rates, thereby suppressing spending, usually meaning painful service cuts and/or tax increases, as well as stricter loan conditions that citizens are unwilling to accept. In contrast, as I will explain below, lower monetary rates are a "subtle" way of repaying debt because most people are unaware that their wealth is diminishing.

From the perspective of depreciated currency, a lower currency exchange rate usually increases the value of foreign assets.

For example, if the dollar depreciates by 20%, American investors can pay foreigners holding dollar-denominated debt with currency that has lost 20% of its value (i.e., foreigners holding debt assets will incur a 20% currency loss). The harm of a weaker currency is less obvious but indeed exists, namely that those holding weaker currencies experience a decline in purchasing power and borrowing capacity—the decline in purchasing power occurs because their currency's purchasing power is reduced, and the decline in borrowing capacity happens because buyers of debt assets are unwilling to purchase debt assets priced in depreciating currency (i.e., assets that promise to receive currency) or the currency itself. It is not obvious because most people in countries with currency depreciation (e.g., Americans using dollars) do not see a decline in their purchasing power and wealth, as they measure the value of assets in their own currency, creating the illusion of asset appreciation, even though the currency value of their assets is declining. For example, if the dollar falls by 20%, American investors, if they only focus on the increase in the value of their assets priced in dollars, will not directly see that they have lost 20% of their purchasing power on foreign goods and services. However, for foreigners holding dollar-denominated debt, this will be obvious and painful. As they become increasingly concerned about this situation, they will sell (offload) the currency priced in debt and/or the debt assets, leading to further weakening of the currency and/or debt.

In summary, viewing issues solely from the perspective of one's own currency clearly leads to a distorted viewpoint. For example, if the price of something (like gold) increases by 20% when priced in dollars, we perceive that the price of that item has risen, rather than the value of the dollar has decreased. The fact that most people hold this distorted perspective makes these ways of handling excessive debt "hidden" and politically more acceptable than other alternatives.

The way of viewing things has changed significantly over the years, especially from the time when people were accustomed to the gold standard monetary system to the present, where they are used to the fiat/paper currency monetary system (i.e., currency is no longer backed by gold or any hard assets, a situation that became a reality after Nixon decoupled the dollar from gold in 1971). When currency exists in the form of paper money and represents a claim to gold (what we call gold standard currency), people believed that the value of paper money would rise or fall. Its value almost always declines, and the only question is whether it declines faster than the interest rate earned on holding fiat debt instruments. Now, the world has become accustomed to viewing prices through the lens of fiat/paper currency, and they have the opposite view—they believe that prices are rising rather than that the value of currency is declining.

Because a) the prices denominated in gold standard currency and b) the quantity of gold standard currency have historically been much more stable than a) the prices denominated in fiat/paper currency; b) the quantity of prices denominated in fiat/paper currency is much more stable, so I believe that viewing prices from the perspective of gold standard currency may be a more accurate approach. Obviously, central banks around the world share a similar view, as gold has become their second largest currency (reserve asset) after the dollar, ahead of the euro and yen, partly for these reasons and partly because the risk of gold being confiscated is relatively low.

The decline in fiat currency and real interest rates, as well as the rise in non-fiat currencies (such as gold, Bitcoin, silver, etc.), has historically (and logically should) depend on their relative supply and demand relationships. For example, huge debts unsupported by hard currency can lead to significant monetary and credit easing, resulting in a sharp decline in real interest rates and real currency exchange rates. The last major period when this occurred was during the stagflation from 1971 to 1981, which led to significant changes in wealth, financial markets, the economy, and the political environment. Given the scale of existing debt and deficits (not only in the United States but also in other fiat currency countries), similar significant changes may occur in the coming years.

Whether this claim is correct or not, the seriousness of debt and budget issues seems to be beyond doubt. In such times, having hard currency is a good thing. So far, and for many centuries around the world, gold has been the hard currency. Recently, some cryptocurrencies have also been viewed as hard currency. For certain reasons, which I will not elaborate on, I prefer gold, although I do hold some cryptocurrencies.

How much gold should a person hold?

Although I am not giving you specific investment advice, I will share some principles that help me form my perspective on this issue. When considering the ratio of holding gold to bonds, I think about their relative supply and demand, as well as the relative costs and returns of holding them. For example, the current interest rate on U.S. Treasuries is about 4.5%, while the interest rate on gold is 0%. If one believes that the price of gold will rise more than 4.5% in the next year, then holding gold makes sense; if one does not believe that gold will rise 4.5%, then holding gold is unreasonable. To help me make this assessment, I observe the supply and demand of both.

I also know that gold and bonds can diversify risks from each other, so I will consider how much proportion of gold and bonds should be held for good risk control. I know that holding about 15% of gold can effectively diversify risks, as it can bring better return/risk ratios to the portfolio. Inflation-linked bonds have the same effect, so it is worth considering adding both of these assets to a typical portfolio.

I share this perspective with you, rather than telling you how I think the market will change or suggesting how many types of assets you should hold, because my goal is "teach a man to fish rather than give him a fish."