And for those who don’t know who Ray Dalio is, he founded the largest hedge fund in the world, Bridgewater Associates, which manages well more than US$100 billion (see Contrarian Investor yesterday for a very informative guide to visualizing this number).
The paper is entitled, “A Template for Understanding…How the Economic Machine Works and How it is Reflected Now,” and is 20 pages. Believe it or not, it’s more cleanly written than a lot of economics papers I was forced to read as a graduate student, nearly all of them written by people widely acclaimed as leading thinkers in the discipline.
Page 5: The first thing I think about when I look at the graph showing U.S. GDP growth over the past century is China. The second thing I think about is Africa. Generally, what I think about is countries with explosive rates of economic growth over the past few years after decades of stagnation and whose graphs would look absolutely nothing like this–so smooth and consistent. So the first thing to bear in mind about laying this template over any underdeveloped country is that the extent to which the line on the graph does not so much resemble a straight diagonal line is the extent to which the country in question has historically deviated from the capitalist model.
Page 8 is where Dalio outlines the essential difference between the U.S., Japan, Germany, et al, and many developing countries, and this should give you an idea for the plainness of his language:
Basically, there are two types of monetary systems: 1) commodity-based systems – those systems consisting of some commodity (usually gold), currency (which can be converted into the commodity at a fixed price) and credit (a claim on the currency); and 2) fiat systems – those systems consisting of just currency and credit. In the first system, it’s more difficult to create credit expansions. That is because the public will offset the government’s attempts to increase currency and credit by giving both back to the government in return for the commodity they are exchangeable for. As the supply of money increases, its value falls; or looked at the other way, the value of the commodity it is convertible into rises. When it rises above the fixed price, it is profitable for those holding credit (i.e., claims on the currency) to sell their debt for currency in order to buy the tangible asset from the government at below the market price. The selling of the credit and the taking of currency out of circulation cause credit to tighten and the value of the money to rise; on the other hand, the general price level of goods and services will fall. Its effect will be lower inflation and lower economic activity.
Anyone familiar with Dutch Disease should see that sooner or later two glaring dynamics common to many developing countries will have to be addressed at greater length: 1. borrowing in another currency; 2. managing “hot money”, a k a incoming foreign investment inflows.
On page 13, Dalio describes the essential problem with the US economy today in a single paragraph:
Unlike in recessions, when cutting interest rates and creating more money can rectify this imbalance, in deleveragings monetary policy is ineffective in creating credit. In other words, in recessions (when monetary policy is effective) the imbalance between the amount of money and the need for it to service debt can be rectified by cutting interest rates enough to 1) ease debt service burdens, 2) stimulate economic activity because monthly debt service payments are high relative to incomes and 3) produce a positive wealth effect; however, in deleveragings, this can’t happen. In deflationary depressions/deleveragings, monetary policy is typically ineffective in creating credit because interest rates hit 0% and can’t be lowered further, so other, less effective ways of increasing money are followed. Credit growth is difficult to stimulate because borrowers remain over-indebted, making sensible lending impossible. In inflationary deleveragings, monetary policy is ineffective in creating credit because increased money growth goes into other currencies and inflation hedge assets because investors fear that their lending will be paid back with money of depreciated value.
Pages 15 through 17 are where Dalio gets into the basic dynamics of foreign debt and hot money. In the interest of keeping it brief-ish, I’m paraphrasing here, but because commodity producers are less able to “print” money than central banks with fiat systems for the reasons listed above, when they do come to a point of printing money, the interaction of growing amounts of money with contracting credit and contracting economy necessarily result in a devalued currency, lower interest rates and investment leaving the country. While a devaluation does have the benefit of boosting exports, the rest of the downside risks (inflation being one) can very quickly lead into a downward spiral.
Now that we have the theory out of the way, what next? Where do we see any of this apply in developing countries not 10 years ago, but now, today?