How the Economic Machine Works
(Part 2): Debt Cycles

A Macroeconomics Overview

Posted: 29 March 2021


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To understand money and credit, we first have to understand what is an economy. Ray Dalio has laid out a simple and practical template of how to understand the economy, which I would like to share in this post. I am not a major in economics and I do not proclaim to be an expert on this subject. A large part of my research will be based on Ray Dalio’s video below, Lyn Alden’s research for more detailed macroeconomics and potentially the book “Dying of Money: Lessons of the Great German and American Inflations” (shared by Michael J. Burry). 

This article is the second part of a multi-part series where I seek to explore and learn more about macroeconomics and how it is intertwined with the financial markets. Through multiple subsequent articles, I hope to cover (i) the basics of how our economy works, (ii) the difference between money and credit and the importance of credit, (iii) the short-term and long-term debt cycles, (iv) interest rates and their impact and (v) inflationary and deflationary pressures. 

Having touched on the basics of credit/debt in Part 1, let’s now take a deeper dive into what Ray Dalio calls Debt Cycles. In this article, we cover the short-term debt cycle and the long-term debt cycle. (If you missed Part 1, click here to read it!)


Source: Ray Dalio

1. What is a Debt Cycle?

For starters, what is a debt cycle? In its simplest form, debt cycles can be described as the economic expansions caused by increased debt levels and the subsequent and contractions that results from repaying or extinguishing these debts.

There are two main patterns of debt cycles that works in line with the economy (1) the short-term debt cycle and (2) the long-term debt cycle. This is how Ray Dalio illustrates the relationship of these two debt cycles with economic growth:

Source: Ray Dalio

2. The Short-term Debt Cycle

As the name suggests, the short-term debt cycle occurs over a shorter period of time, typically a 3- to 10-year business cycle. The short-term debt cycle has two distinct phases: (1) an expansion cycle and (2) a deflationary cycle.

Source: Ray Dalio

2.1 Short-term debt cycle phase 1: Expansion Cycle

The short-term debt cycle starts when people borrow to spend. Recall that in an economy without credit, productivity growth is the main driver of economic growth – over time, knowledge accumulate and technology improves, productivity growth rises steadily.

However, in the short-term, credit allows people to borrow to spend more. This can help pull forward some of that growth to create a period of rapid GDP growth (a “boom”). In the expansion cycle, people and business generally become more productive or are able to spend more. Thus, income levels rise and people become more creditworthy, allowing them to borrow more to spend more. This creates a positive feedback loop and leads to an expansion cycle (i.e. economic growth).

As people spend more, prices start to rise (also known as “inflation”) because this spending becomes supercharged by credit and production cannot keep up.

2.2 Short-term debt cycle phase 2: Deflationary Cycle

When inflation rises above the government’s level of comfort, central banks step in.

They do so by raising interest rates to discourage borrowers from borrowing more. This also increases the cost of existing debts as some have floating rates (i.e. interest rates on loans can change over the tenor of the loan (e.g. LIBOR)).

As people borrow less and repay more of their existing debts, they naturally have to cut back on spending. This reduces the income of someone else which leads them to cut their spending, causing a negative feedback loop. When people spend less, prices go down.

As economic activity decreases (recall people cut back on spending) and economic growth turns negative, we enter recession.

2.3 New cycle: Repeat expansion cycle

As spending lower, inflation cools. Central banks now become concerned with promoting economic activity. Hence, they decrease interest rates again. People start borrowing to spend and we witness yet another expansion cycle.

In the short term, spending is only constrained by the willingness of lenders and borrowers to provide and receive credit. When credit is easily available, there is an expansion; when credit isn’t easily available, there is a recession.

 This cycle is largely controlled by the central bank and typical lasts for 5 – 8 years. This happens repeatedly over decades with the top and bottom of each cycle being higher than the previous one. And hence, we accumulate more debt after each cycle. If we zoom in on the long-term debt cycle, we will see multiple short-term debt cycles and the debt accumulation over this period of time:

Source: Ray Dalio

3. The Long-term Debt Cycle

3.1 Overview of the Long-term Debt Cycle

Debt continues to grow after each short-term debt cycle because it is human nature to borrow and spend rather than to repay it. So people tend to push it because things have been going great.

Incomes have been rising, asset values are going up, the stock markets are roaring and it pays to buy goods, services and financial assets with borrowed money. When people do it a lot, this becomes what is called a “bubble”.

Source: Ray Dalio

The long-term debt cycle consists of three phases: (1) Debt Accumulation over multiple cycles (lasting 50-100 years in total), (2) a Deleveraging phase where debt is repaid or extinguished, and (3) a Reflation phase where economic activity starts to pick up again.

Over the debt accumulation phase (multiple short-term debt cycles), debt accumulates and eventually hits unsustainable levels. This triggers a much larger deleveraging event that typically involves a currency devaluation to smooth out such a big, systemic adjustment.

Source: Ray Dalio

A key metric to observe is the “debt-to-income” ratio or “debt burden”. Often, investors look at the debt-to-GDP as a proxy of this. This can be obtained from public sources like the St. Loius Fed or ECB. Below is an example of the data from the United States central bank.

Source: St. Loius Fed

3.2 Long-term debt cycle phase 1: Debt Accumulation

Debt levels can continue grow because people have been borrowing to buy assets as investments, which pushes up asset prices and make them feel wealthier. So even with the rising amount of debt, rising asset values help Borrowers remain creditworthy. But this eventually becomes unsustainable.

Debt Accumulation Phase: The Tipping Point

Over decades, debt burden slowly increases and creates increasingly larger repayments. At some point, debt repayment starts growing faster than incomes and people must cut back on their spending. This causes incomes to fall as economic activity slows, making people less creditworthy and triggering a negative self-reinforcing cycle.

This is the long-term debt peak, where debt burdens have grown too big. For the U.S. and much of the rest of the world, this happened in 2008; for Japan, it happened in 1999; for the U.S., it happened in 1929 too.

3.3 Long-term debt cycle phase 2: Deleveraging

In a deleveraging, people cut spending and incomes fall. Credit quickly disappears, asset prices drop, banks get squeezed, the stock market crashes and social tensions rise. And the self-reinforcing cycle goes in the opposite direction:

  • With lower incomes, Borrowers become less creditworthy and credit dries up
  • With no credit, Borrowers can no longer borrow enough money to meet their debt repayment (also known as “refinancing”)
  • Borrowers are forced to sell assets, which floods the market at a time when spending is falling. This causes the stock markets to crash, the real estate market to collapse and banks get into trouble as the value of their collaterals rapidly depreciates.
  • This becomes a vicious cycle and people feel poor and stop borrowing more money
  • Less spending = Less income = Less Wealth = Less credit = less borrowing (and repeat).

While this appears similar to a recession in the Short-term Debt Cycle, the difference is that the central bank can no longer spur growth by lowering interest rates because interest rates have already hit near-zero/zero levels and credit has dried up. In other words, Borrower’s debt burden has simply gotten too big and cannot be relieved by lowering interest rates. This was what happened in 1930s and also in the 2008 for the U.S.

Source: Ray Dalio

Ways to Deleverage

There are four ways for debt levels to come down: (1) people, businesses and governments cut spending, (2) reduce debt via defaults or restructuring, (3) redistribute wealth by taxing the rich to give to the poor and (4) the central bank prints new money.

Source: Ray Dalio

3.3 (a) Deleveraging phase 1: Cutting Spending

This is normally the first thing to happen. When people, businesses and governments cut spending to pay down their debt, this is often referred to as “austerity”. While it seems logical that spending less to pay off debt will lighten the debt burden, debt burden actually increases.

With less spending, incomes fall as businesses are forced to cut cost by docking salaries, freezing bonuses and, worst of all, retrench workers. As such, debt decreases slower than income disappears, which increases the debt burden. This makes cutting spending painful and deflationary.

3.3 (b) Deleveraging phase 2: Reducing Debt via Defaults / Restructuring

Reducing Debt via Defaults

When many Borrowers become unable to repay loans, banks have a hard time collecting those money back. Depositors get nervous that the banks won’t repay them and rush to withdraw their money from the bank. This squeezes the bank and can cause a “bank run”.

This can lead people, businesses and banks to default on their debts. This causes a severe economic recession, known as a “depression”.

A big part of a depression is people discovering that what they thought was their wealth isn’t really there – e.g. asset values falling, banks are unable to give depositors their cash, etc.

Reducing Debt via Debt Restructuring

Because most lenders would rather recover part of what they loaned rather than nothing at all, they agree to “debt restructuring”. This means lenders are paid back less or over a longer period of time. Even though debt disappears, debt restructuring causes income and asset values to decrease faster which increases the debt burden. This makes debt restructuring painful and deflationary too.

3.3 (c) Deleveraging method 3: Redistribution of Wealth from "Haves" to "Have-nots"

All these happens at a time when government receives lower taxes (due to lower incomes and spending) and have to increase their spending due to high unemployment. Governments also have to increase fiscal stimulus to fill the gaps that were left behind by the lower spending in the economy.

This forces governments to run a “budget deficit” as they spend more than they earn in taxes. To fund spending, governments either raise taxes or borrow money (e.g. by issuing treasury bonds/bills).

But with most of the economy suffering, where is the money going to come from? Well, the rich.

Since the government needs money and wealth is heavily concentrated in a small proportion of people, governments raise taxes on the wealthy and facilitate a redistribution of wealth from the “Haves” to the “have-nots”.

The “Have-nots” begin to resent the wealthy “Haves” and the wealthy “Haves”, being squeezed by the government and falling asset prices, start to resent the “Have-nots”. If not handled properly, this could descend into social disorder within countries and between countries, which can sometimes lead to political change that can be extreme (e.g. In the 1930s, this led to Hilter’s rise to power, war in Europe and depression in the U.S.). However, since credit disappeared and money is merely changing hands in the economy, overall spending cannot rise back to the levels when credit existed. So this is also deflationary in nature as overall spending in the economy falls and prices fall.

3.3 (d) Deleveraging method 4: Money Printing

Having already lowered interest rates to near-zero levels, the central bank can only print money now.

As people become desperate for money, the central bank inevitably prints new money out of thin air. The dilemma is that the central bank can only print money and buy financial assets. Hence, it can only put money directly in the hands of people who own financial assets.
As such, the central bank has to work together with the central government, who can buy goods and services and put money in the hands of people.

The Central Bank does this by buying government bonds – This is effectively the central bank lending to the central government for it to run a fiscal deficit and increase spending through (i) stimulus programs and (ii) unemployment benefits.

This increases people’s income and the government debts but lowers the overall debt burden in the economy. Imagine an economy with $10 in debt and $1 of income, it has a 1,000% debt burden. If the central bank prints series of $5 to buy government bonds and the central government engages in a series of $5 stimulus, debt and income goes up by $5 each time.

3.3 (e) A Beautiful Deleveraging is a Balancing Act

The inflationary way of money printing must be balanced carefully against the deflationary ways of (i) cutting spending, (ii) reducing debt and (iii) redistributing wealth to achieve what Ray Dalio calls a “beautiful deleveraging”.

Even though deleveraging is a difficult situation, if handled carefully, it can be more beautiful than the uncontrolled, debt-fuelled, unbalanced excesses of the leveraging phase. In a beautiful deleverage, debts decline relative to income, real economic growth starts picking up and inflation isn’t a problem. This is achieved via the right balance of the 4 methods of deleveraging, which can allow economic and social stability to be maintained.

3.4 Long-term debt cycle phase 3: Reflation

When balanced carefully, the impacts will not be as drastic. Economic growth may slow but debt burdens go down – this is a beautiful deleveraging. As incomes rise, people become more creditworthy again and are able to borrow money to spend more. Eventually, the economy starts to grow again, leading to the “Reflation” phase of the long-term debt cycle.

As it takes roughly a decade or so for debt burdens to fall and economic activity to get back to normal, it is often called the “lost decade”.

4. Ray Dalio's Key Takeaways

  1. Don’t have debts rise faster than income because the debt obligations will eventually crush you.
  2. Don’t have income rise faster than productivity because you eventually become uncompetitive.
  3. Do all that you can to raise productivity because in the long run, this is what matters most.

5. Does Money Printing Cause Inflation

As we hear more talks on inflation / reflation trades dominate the markets and media, this is the question on everybody’s mind – does money printing actually cause inflation? Bitcoiners are all in on the idea that money printing is free advertising for Bitcoin (due to hyperinflation), but others have also argued the opposite. Ray Dalio suggests that as long as the new money replaces the falling credit, inflation wouldn’t be a problem.

In other words, if money printing increases much faster than debt decreases, inflation may become a problem. This was seen in the hyperinflation in the German economy from 1918 to 1930s.

In the next article, we will touch on inflation and the inflationary and deflationary forces that the economy encounters (and potentially discuss different investors’ stance on inflation in the coming year including, amongst others, Michael J. Burry, Lyn Alden and Ray Dalio.


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