Bridgewater Associates founder: Interest rate cuts + currency depreciation have become the government's inevitable choice

Written by: Ray Dalio

Compiled by: White55, Mars Finance

Original title: Bridgewater Fund Founder: The Most Important Principle When Thinking About Huge Government Debt and Deficits

The principles are as follows:

When a country has excessive debt, 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. Therefore, it is worth betting on this scenario.

As I write this, we know that a huge deficit and a significant increase in government debt and debt repayment expenditures are expected in the future. (You can see this data in my work, including my new book "How Nations Go Bankrupt: The Big Cycle"; I also shared last week my thoughts on why I believe the U.S. political system cannot control the debt issue.) We know that the cost of debt repayment (paying interest and principal) 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. In "How Nations Go Bankrupt," I elaborate on what I believe all of this means and describe the mechanisms behind my thinking. Others have also stress-tested this, and currently, there is almost total 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 simply providing my thoughts for everyone to evaluate.

My Principles

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 offer help. Furthermore, I believe that understanding what is happening and what may happen requires an understanding of how the mechanisms work, so I also attempt to explain my understanding of the mechanisms behind the principles. Here are several 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 the most favored and commonly used method for government decision-makers to address the issue of excessive debt is to reduce 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 because 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 an increase in 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 often good and widely popular in the short term, but in the long run, they can be harmful and lead to more serious problems. Lowering the real interest rate and the real 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 causes holders of these assets to achieve lower real returns (due to currency devaluation and lower yields), b) it leads to higher inflation rates, c) it leads to greater debt.

Regardless, this clearly cannot avoid the painful consequences of overspending and being deep in debt. Here is how it works:

When interest rates decline, borrowers (debtors) benefit because it reduces 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 almost 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 fall to negative values, bond prices rise). This also leads to more debt, resulting in greater debt problems in the future. Therefore, the returns on debt assets held by lenders/creditors decrease, leading to more debt.

Lower real interest rates also tend to reduce the actual value of currency, as they make the yield on currency/credit lower relative 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 advantageous when explained to voters:

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

2. …It makes debt repayment easier, but this way is more painful for foreign holders of debt assets than for domestic citizens. This is because another "hard currency" approach requires tightening monetary and credit policies, which leads to persistently high real interest rates, thereby suppressing spending, often resulting in 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 interest rates represent a "hidden" way of repaying debt, as most people are not aware that their wealth is decreasing.

From the perspective of devalued currency, a lower currency exchange rate usually also 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 decreased in value by 20% (i.e., foreigners holding debt assets will incur a 20% currency loss). The dangers of a weaker currency are less obvious but do exist, namely that those holding weaker currency experience a decline in purchasing power and borrowing capacity—purchasing power diminishes because their currency's purchasing power decreases, and borrowing capacity declines because buyers of debt assets are unwilling to purchase debt assets priced in depreciating currency (i.e., assets that promise to yield currency) or the currency itself. It is not obvious because most people in countries experiencing currency depreciation (for instance, Americans using dollars) will not see a decline in their purchasing power and wealth, as they measure asset values in their own currency, which creates the illusion of asset appreciation, even though the currency value of their assets is declining. For instance, if the dollar falls by 20%, American investors, if they only focus on the rising dollar-denominated value of their assets, will not directly see their purchasing power loss of .20% on foreign goods and services. However, for foreigners holding dollar-denominated debt, this will be evident and painful. As they become increasingly worried about this situation, they will sell (offload) the currency and/or debt assets priced in that currency, leading to further weakness in the currency and/or debt.

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

The way of viewing things has changed significantly over the years, especially from people's habit of the gold standard monetary system to the current habit of the fiat/paper currency 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 acts as a claim on gold (what we call gold standard currency), people believe that the value of paper money can rise or fall. Its value almost always declines, the only question being whether it declines faster than the interest rate earned on holding fiat currency debt instruments. Now, the world has become accustomed to viewing prices through the lens of fiat/paper currency; they have the opposite view—they believe that prices are rising rather than the value of money declining.

Because a) priced in gold standard currency and b) the quantity of gold standard currency have historically been much more stable than a) priced in fiat/paper currency; b) the quantity of fiat/paper currency priced has been much more stable. Therefore, I believe that viewing prices from the perspective of gold standard currency may be a more accurate approach. Clearly, central banks around the world hold a similar view, as gold has become their second largest currency (reserve asset), second only to the US dollar, ahead of the euro and yen, partly due to 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, enormous debts that cannot be supported by hard currency will lead to significant easing of money and credit, resulting in a substantial decline in real interest rates and real currency exchange rates. The last significant period when this occurred was during the stagflation period from 1971 to 1981, which resulted in massive 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 massive changes may occur in the coming years.

Regardless of whether this statement is correct, the severity 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 considered 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?

While I'm not providing you with 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. Treasury bonds is approximately 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 by 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 because it can bring better return/risk ratios to the portfolio. Inflation-linked bonds have the same effect, so it is worth considering including both of these assets in 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."