Why The Debt Bubble Is Due To Burst – Inspired By Ray Dalio

Why Debt Moves In Cycles: Self-Reinforcing Movements

During the good times, lending gathers momentum like a runaway train that becomes unstoppable – except for a head-on collision into something solid that knocks it off the tracks.

Lending supports spending and investment, propping up asset prices and fuelling incomes.

Bigger asset prices and incomes give banks more confidence to lend even more money, as borrowers have better collateral.

But all the while, debt is building and eventually outpaces incomes. At some point, some event will happen that triggers banks to panic, who reign in their credit lines.

Projects pause; incomes stagnate; outlooks for asset price growth look bleak; bad debts mount; and banks stop lending.

This makes the problem worse, and the debt cycle spirals downward into the end-phase.

How Debt Crises Can Be Managed

There are 5 ways to manage a debt crisis:

#1 – Austerity

Cameron and Osborne tried this in 2010 after the Recession, with limited effect.

The problem with austerity is that it is deflationary and discourages growth at the same time as the debt crisis is already doing both of those things.

It does help reduce debt, but it lowers incomes too, so can be counterproductive.

#2 – Debt Cancellations

Just cancelling the debt is not great, as the lenders lose out and this reinforces a downward spiral of deflation, but the crisis can be so severe that it might be sometimes necessary.

It’s widely believed that this needs to happen to solve the Greek debt crisis in the Eurozone, ongoing since 2009.

#3 – Slash Interest Rates

Slashing rates makes it easier for people to pay the interest on their debts, at the same time discouraging people from hoarding their money in a bank savings account.

In this way it encourages investment into the economy again.

#4 – The Magic Money Tree

The central bank just prints more money.

This only works if the country’s debts are in their own currency, but it does encourage growth and spending in the economy which really does help get things moving again.

But is this storing up a currency problem for a later day?

#5 – Raise Taxes

Raising taxes may be necessary eventually to pay for the country’s debts. But raising taxes whilst in a crisis is a big mistake.

This makes everyone poorer at a time when you need money to flow freely again.

The tax hike doesn’t even help the less-well-off, as the money is not being invested to help people, but wasted on debt payments.

However, this is the inevitable final destination for a country in ever rising net debt.

Long-Term Debt Cycles

Remember that each short-term debt cycle leaves the country a little more indebted than it was before, and after many short-term cycles the problem adds up to result in a mega crash like the Great Depression in 1929.

Many of the levers that were pulled by central banks to resolve the last several short-term crises become less effective each time.

After the 2008 recession, we lowered interest rates to almost zero. Even a decade later, rates have not recovered, so that lever cannot now be pulled again.

And the UK is now in over £2trn of debt – over 3 times higher than in 2008!

Where We Are Now In The Debt Cycle

It has been over 12 years since the start of the 2008 Credit Crunch, also now called the Great Recession.

The UK recovered: unemployment went to historic lows, the banking sector was reformed, and city centres underwent massive renovation projects.

But debt built up, and the kindling of the next debt crisis was waiting to be lit by something, and the coronavirus was more of a flamethrower than a match.

Now, we’ve seen banks pulling low LTV mortgages at the height of Covid.

We’ve seen the Bank of England base-rate slashed to 0.1%, businesses forced to shut down, and people forced to stop spending, taking credit out of the economy.

We believe we’re in the end-phase of the short-term debt cycle.

But as for the long-term cycle, 2008 might not have been the end-phase that some people assumed it was. It was a body blow, but is the knock-out punch still to come?

The levers that were pulled at the time to resolve it have been exhausted and haven’t recovered since.

Austerity has already cut back public spending as much as is politically tolerable; taxes have been raised by stealth to what we feel is the upper limit of what can be tolerated by most families; and interest rates have been slashed to the max.

Perhaps worst of all, the money printing was not rolled back at all over the last decade, and was then increased dramatically in 2020.

There is little room for manoeuvre when the next debt crisis hits. We may be just years away from a full blown 1929 style disaster.

Can Investors Take Advantage Of A Debt Crisis?

During good times of growth and demand, productive investment assets like stocks and property are favoured.

During debt crises, these assets stop being as productive, and money runs into cash and precious metals like gold and silver.

It may be too early to say, but crypto currencies like Bitcoin should logically do well during a debt crisis as well, as they act in many ways like a digital version of gold.

We’ve said before how cash itself should be given respect as an asset class in your portfolio, with perhaps a 10% allocation, and perhaps a further 10% to precious metals, and some of you may even want a small portion in crypto currencies.

During times of deflation, cash is naturally well placed to outperform, as many other assets lose value relative to it.

We’ll still hold the vast majority of our portfolios in well-diversified equities and other productive assets, but to ignore cash and precious metals entirely is to ignore the real risk of a major debt crisis coming down the road.

As long as the government keeps on printing magic money, that day keeps getting closer.

Are Debt Crises Unavoidable?

Almost. As Ray said, lending is never done perfectly and tends to be done badly.

The short-term rewards of funding faster growth with credit helps governments to justify the rising debt, and it is politically more popular to let people have easy credit than to take it away.

What politician would impose austerity and tighter restrictions on the voters during good times, before a crash had even happened?

Are you worried about the debt bubble? Tell us your take in the comments below.