Ray Dalio's latest macroeconomic analysis: Buy more gold, and some more Bitcoin.

Original author: Ray Daou

Original title: How Countries Go Broke Dynamic Behind What Happening Now

Original translation by BlockBeats

In my book, *How Countries Go Broke: The Big Cycle*, I developed a detailed template to describe how the unsustainable state of debt supply and demand imbalance can evolve. Three recent events have occurred simultaneously.

• The Japanese government sold off some of its U.S. Treasury bond holdings and repatriated the funds to support the yen and the Japanese capital market, thereby reducing its exposure to U.S. Treasury bonds without having to raise interest rates significantly further.

• U.S. Treasury yields rose to new highs, led by longer-term yields, while the dollar weakened, due to the current and future huge supply of Treasury bonds and weakening demand.

This week, Treasury Secretary Bessant announced that the U.S. Treasury would purchase U.S. Treasury bonds, but his capacity to do so is limited. This has led many to ask me: Do these events conform to the classic template described in the book? The answer is yes. To predict what might happen next, it is necessary to re-examine this template.

In the book, I elaborate on how the government-level debt/currency restructuring process typically unfolds and provide calculations to demonstrate the degree of imbalance between new debt supply and debt rollover demand. These calculations can serve as a template for comparing reality with future predictions. If you are a market participant who needs to thoroughly understand this template at a detailed level in order to seize market opportunities, I recommend that you read the entire book; if you do not need such in-depth knowledge or do not wish to spend that much time, you can read the following five-minute summary of the mechanism.

How does the mechanism work?

The debt dynamics of the central government follow the same logic as those of individuals or businesses, the only difference being that the central government has a central bank that can print money (thus devaluing the currency) and can extract funds from the public through taxation. Therefore, if you can imagine how you or your business would operate under conditions of "being able to print money and levy taxes," you can understand this dynamic. But remember, your goal is to ensure the entire system functions well—not just for yourself, but for the entire nation.

In my view, the credit/market system is like the circulatory system in the human body, delivering nutrients to all parts of the body, which consists of the market and the real economy. If credit is used effectively, it can create enough productivity and income to repay principal and interest, which is healthy. However, if credit is misused and fails to generate sufficient income to repay principal and interest, the debt burden will accumulate like a plaque, crowding out other expenditures. When debt servicing expenditures become very large, a debt servicing problem arises, eventually evolving into a debt rollover problem—because bondholders are unwilling to renew and only want to sell. This naturally leads to a shortage of demand for bonds and other debt instruments, and a sell-off. When demand is less than supply, either 1) interest rates rise, dragging down the market and the economy, or 2) the central bank "prints money" and buys up debt, causing currency devaluation and thus pushing up the existing inflation level. Printing money also artificially lowers interest rates, harming borrowers' returns. Neither path is good. When the scale of debt selling becomes uncontrollable, and the central bank has already purchased a large amount of bonds, the rise in interest rates will cause the central bank to incur losses, thereby damaging its cash flow. If this situation continues, the central bank will eventually fall into negative net assets.

When problems become severe, the central government and central bank borrow money to pay for debt repayments. Due to insufficient demand in the free market, the central bank prints money to provide loans, thus starting a self-reinforcing "debt-money printing-inflation" spiral.

In summary, the three classic indicators that need to be paid attention to are as follows:

1. The size of government debt service expenditures relative to government revenue (like the amount of plaque in the human circulatory system);

2. The scale of government debt sell-offs relative to the demand for government debt (like a plaque breaking off, triggering a heart attack).

3. The scale of government debt purchased by the central bank through printing money to make up for the gap between the demand for government bonds and the supply of government bonds available for sale (similar to the central bank injecting a strong dose of liquidity/credit to alleviate liquidity tension, resulting in more debt, which in turn becomes the central bank's exposure).

These indicators typically climb steadily over decades—debt and debt servicing expenditures rising relative to income—until they become unsustainable for either 1) excessively crowding out other expenditures, becoming unacceptable; or 2) an oversupply of debt that must be bought out of demand, forcing interest rates to rise sharply and causing a deep market and economic downturn; or 3) central banks, unwilling to allow interest rates to rise and markets and the real economy to deteriorate, print large amounts of money and buy up large amounts of government debt to fill the demand gap, causing a significant devaluation of the currency. Whichever path they take, bond returns will be poor until currency and debt eventually become cheap enough to attract demand, and/or the government is able to buy back or restructure debt at low cost.

This is the simplest picture of a major debt cycle.

Because these indicators are quantifiable, we can continuously monitor the dynamic evolution of debt, making it easy to see when problems are approaching. I have been using this diagnostic method in my investments and have kept it a secret, but now I am writing it down in detail in "How Nations Go Bankrupt: The Great Cycle" because it is too important to keep to myself.

More specifically, you can observe the following: debt and debt servicing expenditures are rising relative to income; debt supply exceeds debt demand; central banks initially responded with interest rate cuts and easing stimulus, then turned to printing money to buy bonds, ultimately incurring losses and falling into negative net assets; the central government is continuously increasing leverage to repay debt servicing expenditures, while the central bank monetizes debt. All of this leads to a government debt crisis—equivalent to an economic heart attack: the contraction of debt-supported spending disrupts the normal flow of the economic cycle.

In the early, final stages of a major debt cycle, market performance reflects this dynamic: interest rates rise, led by long-term rates; currencies depreciate, particularly relative to gold; and central government treasuries shorten bond issuance maturities due to insufficient demand for long-term debt. Typically, towards the end of the cycle, when the dynamics are most intense, a series of seemingly extreme measures are introduced, such as establishing capital controls to exert strong pressure on creditors, forcing them to buy debt rather than sell it. The book explains this dynamic more comprehensively, providing numerous charts and data to illustrate its evolution.

The US Government's Predicament: A Brief Overview

Now, imagine you are running a large corporation called the "U.S. government." This perspective will help you understand the U.S. government's financial situation and the choices made by its leadership.

This year, total revenue is approximately $5.5 trillion, and total expenditure is approximately $7.5 trillion, resulting in a budget deficit of about $2 trillion. This means the institution will spend about 40% more than it earns this year. There is very little room for spending cuts, as almost all expenditures are either pre-committed or necessary. Due to its long-term heavy borrowing, the institution has accumulated a massive debt—approximately six times its annual revenue ($32 trillion), equivalent to about $240,000 for every household you care for. The interest bill on this debt is approximately $1 trillion, about 20% of the company's revenue, and half of this year's budget deficit—which will still be covered by borrowing. But $1 trillion isn't all you need to pay creditors, because in addition to interest, you also have to repay principal maturing, about $10 trillion. You expect creditors to either renew the loan or lend you money. Therefore, debt servicing expenditure—the principal plus interest that must be repaid to avoid default—is about $11 trillion, about 200% of inflows.

This is the current situation.

So, what happens next? Let's imagine it. You'll borrow to cover the deficit, whatever its final size. Opinions vary on how large the deficit will be. After factoring in the recently passed budget reconciliation bill, most independent assessment agencies project that U.S. debt will reach $55 to $60 trillion in 10 years (about seven times revenue), with an additional $25 to $30 trillion in borrowing expected. Of course, 10 years from now, the institution will face heavier debt servicing burdens squeezing out other spending, and without a solution, the risk of its unsold debt not finding sufficient demand will be greater.

My "3% Three-Part Solution"

I am confident that the U.S. government's fiscal situation is at a turning point because, if not addressed now, the debt will accumulate to a level that is difficult to manage without significantly damaging the system; and, importantly, this action should be taken when the system is relatively strong, not when it is weak. This is because when the economy contracts, the government's borrowing needs increase dramatically.

Based on my analysis, I believe this situation needs to be addressed using what I call the "3% three-part approach," which involves reducing the budget deficit to 3% of GDP and striking a balance among three deficit-reduction methods: 1) cutting spending, 2) increasing tax revenue, and 3) lowering interest rates. All three must be implemented simultaneously to avoid any one being too aggressive—because if any one is too drastic, the adjustment process will be traumatic. Moreover, these adjustments should be achieved through sound fundamental adjustments, rather than coercive measures (for example, the Federal Reserve artificially suppressing interest rates is a very bad practice). According to my calculations, relative to the current plan, spending cuts and tax revenue increases of approximately 5% each, along with a corresponding interest rate decrease of approximately 1 to 1.5 percentage points, would reduce interest expenses by 1 to 2 percentage points of GDP over the next decade and stimulate a recovery in asset prices and economic activity, thereby generating significantly more revenue.

Frequently Asked Questions and My Answers

The book contains far more than this short essay, including a description of the "Grand Cycle" (composed of debt/credit/monetary cycles, domestic political cycles, external geopolitical cycles, natural events, and technological advancements)—driving all major changes in the world; my views on possible future scenarios; and some perspectives on how to invest amidst these changes. But for now, I'll answer some questions I'm frequently asked when recommending this book. If you'd like to delve deeper, feel free to read the entire book.

Q1: Why do large-scale government debt crises and debt cycles occur?

Large-scale government debt crises and debt cycles can be easily measured by three indicators: 1) Government debt servicing expenditures rise unacceptably relative to government revenue, crowding out necessary government spending; 2) The volume of government debt sales becomes disproportionately large relative to demand, leading to rising interest rates and a market and economic downturn; 3) Central banks respond to these conditions with low interest rates, which weaken bond demand, forcing central banks to print money to buy government debt and depreciate the currency. These indicators typically rise steadily over a decades-long cycle until they become unsustainable—either because 1) debt servicing expenditures excessively crowd out other spending, becoming unacceptable; or because 2) the supply of debt to be purchased is too large relative to demand, forcing interest rates to rise sharply and causing a deep market and economic downturn; or because 3) central banks print large amounts of money and purchase large amounts of government debt to fill the demand gap, causing a significant devaluation of the currency. Whichever path they take, bond returns will be poor until they become cheap enough to attract demand and/or debt is restructured. These indicators are easy to measure, and one can clearly see them evolving towards an impending debt crisis. A crisis occurs when debt-backed spending contracts—like a debt-induced heart attack.

Throughout history, almost every country has experienced such debt cycles, often multiple times, resulting in hundreds of historical cases for study, dating back to the earliest recorded history. In other words, all monetary orders eventually collapse, and the debt cycle mechanism I describe is the driving force behind these collapses. The decline of all reserve currencies stems from this, such as the pound sterling and its predecessor, the Dutch guilder. I have listed 35 recent examples in the book.

Q2: If this process happens repeatedly, why is the underlying mechanism so little known?

You're right, this mechanism is indeed not fully understood. Interestingly, I couldn't find any research on how it works. My guess is that it's misunderstood because the collapse of the monetary order typically only happens once in a reserve currency country's lifetime; while when it occurs in non-reserve currency countries, it's assumed to be a problem that reserve currency countries are immune to. I only discovered this mechanism because I witnessed it firsthand in sovereign bond market investments, which prompted me to study numerous historical cases to prepare for potential crises (such as the 2008 global financial crisis and the subsequent European debt crisis).

Q3: Before the US debt crisis explodes, how serious should our concerns be about a "heart attack"-style debt crisis in the US? People have heard too much about the "imminent debt crisis" but it hasn't happened yet. What's different this time?

I believe we should be very concerned, for the reasons I mentioned earlier. I think those who worried about the debt crisis before the situation became so dire were right, because acting earlier could have prevented the situation from worsening to where it is today—like a doctor warning a patient early on not to smoke or overeat. Therefore, I suspect the problem hasn't generated wider concern because it wasn't fully understood, and because the premature warnings created a lot of apathy. It's like someone with plaque-filled arteries who continues to eat large amounts of high-fat food and never exercises telling their doctor, "You warned me long ago that I'd have problems if I didn't change my lifestyle, but I haven't had a heart attack yet. Why should I believe you now?"

Q4: What could be the catalyst for a US debt crisis today? When will the crisis occur? What would such a crisis look like?

The catalyst will be the convergence of the aforementioned influences. As for timing, policy and exogenous factors—such as major political shifts and war—can accelerate or delay its arrival. For example, if the budget deficit falls from about 7% of GDP, as I and most people expect, to about 3%, the risk will be significantly reduced. If a major exogenous shock occurs, the crisis will arrive sooner; if not, it will be delayed or even not arrive (provided it is managed properly). My guess—and I suspect this is a bad prediction—is that if we do not change our current path, the crisis will arrive within three years, with a margin of error of two years.

Q5: Are you aware of any precedents for similar significant budget deficit reductions with positive results?

Yes, I know several. My proposal would reduce the budget deficit by about 4 percentage points of GDP. The most similar successful precedent is the United States from 1991 to 1998, when the budget deficit reduced GDP by 5 percentage points. I also cite similar cases from several other countries in the book.

Q6: Some argue that the US is less susceptible to debt-related issues/crises due to the dollar's dominant position in the global economy. What do you think this viewpoint overlooks?

If they think this way, then they haven't grasped the underlying mechanisms and historical lessons. More specifically, they should study history to understand why all previous reserve currencies ultimately ceased to be reserve currencies. To put it bluntly: currency and debt must become effective stores of wealth, or they will be devalued and abandoned. The dynamics I've described are precisely how reserve currencies lose their effectiveness as stores of wealth.

Q7: Japan—with a debt-to-GDP ratio of 215%, the highest among developed economies—is often cited as a prime example of a country that can thrive with high debt levels without experiencing a debt crisis. Why don't you find much comfort in Japan's experience?

The Japanese case is confirming, and will continue to confirm, the problems I've described; it's a real-world manifestation of my theory. Specifically, due to Japan's extremely high level of government debt, Japanese bonds and debt have consistently been poor investments. To compensate for the insufficient demand for Japanese debt assets at sufficiently low and favorable interest rates, the Bank of Japan has printed massive amounts of money and purchased large quantities of Japanese government bonds. As a result, since 2013, investors holding Japanese bonds have lost 51% relative to those holding dollar bonds and 76% relative to those holding gold. Since 2013, in common currency terms, the wages of ordinary Japanese workers have fallen by 55% relative to those of American workers. I've dedicated an entire chapter in the book to elaborating on the Japanese case.

Q8: From a fiscal perspective, which regions in the world have particularly prominent problems that people may underestimate?

Most economies face similar debt and deficit problems—the UK, the EU, China, and Japan are all examples. For this reason, I expect most economies to experience similar debt adjustments and currency devaluations, and for this reason, I anticipate relatively strong performance from non-government-produced currencies like gold and Bitcoin.

Q9: How should investors deal with this risk/how should they plan for the future?

As a general recommendation, I suggest diversifying your portfolio across asset classes and countries, prioritizing those with sound income and balance sheets and no serious domestic or external geopolitical conflicts; underweighting debt assets such as bonds, and overweighting gold and a small amount of Bitcoin. Allocating a small portion of your funds—say, 10% to 15%—to gold can reduce portfolio risk and, I believe, improve returns.