Wednesday, September 21, 2011

A Template for Understanding What’s Going On - by Ray Dalio

I provided a link to this in a previous post, but I thought I’d also give it its own post as I believe this paper from Ray Dalio is one of the most important things I’ve read all year. As Dalio mentions, there is a big difference between a normal recession and a long wave deleveraging cycle, and the Fed and our policy makers are mostly treating this as a normal recession. The consequences of mistaking this current recession as normal are likely to be quite large, and it is something that investors of all stripes and strategies should probably be paying attention to.

Link to: A Template for Understanding What’s Going On


Excerpt describing a deleveraging process:

A deleveraging is an economic contraction that is due to a contraction in real capital (i.e., credit and equity) that arises when there is a shortage of capable providers of capital and/or a shortage of capable recipients of capital (borrowers and sellers of equity) that cannot be rectified by the central bank changing the cost of money. In deleveragings, a) a large number of debtors have obligations to deliver more money than they have to meet their obligations, and b) monetary policy is ineffective in reducing debt service costs and stimulating credit growth. In deleveragings central banks can not control money and credit creation by changing the cost of money. Typically, monetary policy is ineffective in stimulating credit growth either because interest rates can’t be lowered (because interest rates are near 0%) to the point of favorably influencing the economics of spending and capital formation (this produces deflationary depressions), or because money growth goes into the purchase of inflation hedge assets rather than into credit growth, which produces inflationary depressions. Deleveragings typically end via a mix of 1) debt restructurings that reduce debt service obligations, 2) increases in the supply of money that make it easier for debtors to meet their debt service obligations, 3) redistributions of wealth, 4) businesses lowering their break-even levels through cost-cuttingand 5) substantial increases in risk and liquidity premiums that restore the economics of capital formation (i.e., lending and equity investing).