Tuesday, August 14, 2012

A Dalio explanation of Evan-Pritchard's dilemma

Ambrose Evans-Pritchard had an article in The Telegraph on the weekend lamenting that the world remains in a long slump five years (see Five years on, the Great Recession is turning into a life sentence). The article is a good summary of what has happened since the Subprime Crisis of 2007 and what might be possible:
There is no doubt that the three superpowers acting in concert can launch a mini-cycle of growth early next year - assuming they deliver on their rhetoric - but the twin headwinds of debt-leveraging and excess manufacturing plant across the globe cannot easily be conjured away.

He went on to wring his hands and lament the long road ahead:
As for our debt mountain, we have barely begun the great purge. Michala Marcussen from Societe Generale says the healthy level is around 200pc of GDP for advanced economies. If so, we have 100 points to cut.

This cannot be achieved by austerity alone because economic contraction would tip us all into a Grecian vortex. Such a cure is self-defeating.

Much of the debt will have to be written off. Whether this done by inflation (1945-1952) or default (1930-1934) will be the great political battle of this decade. Pick your side. Pick your history.
Ray Dalio's explanation
Maybe because Evans-Pritchard is such a euroskeptic that he has become excessively gloomy. I found Ray Dalio's explanation of the debt supercyle using the Monopoly analogy a great framework for analysis - and once you have the framework, you will naturally understand what is happening and be able to forecast the outcomes for yourself instead of waiting for some pundit to tell you what is likely to happen next.
[I]f you understand the game of Monopoly®, you can pretty well understand credit and economic cycles. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players give them cash. So as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property with lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So early in the game, “property is king” and later in the game, “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.

Now, let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it could make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other giving each other credit (i.e., promises to give money and at a later date). If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. There would be more spending on hotels (that would be financed with promises to deliver money at a later date). The amount owed would quickly grow to multiples of the amount of money in existence, hotel prices would be higher, and the cash shortage for the debtors who hold hotels would become greater down the road. So, the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash caused withdrawals from the bank at the same time as debtors couldn’t come up with cash to pay the bank.

The deleveraging process
Now that we understand the process, what happens next? Ray Dalio went on to detail why he believed that the United States is undergoing a "beautiful deleveraging" with just the right mix of policy in this Barrons interview,
Barron's: You've called the current phase of the U.S. deleveraging experience "beautiful." Explain that, please.

Dalio: Deleveragings occur in a mechanical way that is important to understand. There are three ways to deleverage. We hear a lot about austerity. In other words, pull in your belt, spend less, and reduce debt. But austerity causes less spending and, because when you spend less, somebody earns less, it causes the contraction to feed on itself. Austerity causes more problems. It is deflationary and it is negative for growth.

Restructuring the debt means creditors get paid less or get paid over a longer time frame or at a lower interest rate; somehow a contract is broken in a way that reduces debt. But debt restructurings also are deflationary and negative for growth. One man's debts are another man's assets, and when debts are written down to relieve the debtor of the burden, it has a negative effect on wealth. That causes credit to decline.

Printing money typically happens when interest rates are close to zero, because you can't lower interest rates any more. Central banks create money, essentially, and buy the assets that put money in the system for a quantitative easing or debt monetization. Unlike the first two options, this is an inflationary action and stimulative to the economy.

Barron's: How is any of this "beautiful?"

Dalio: A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn't dramatic. It doesn't produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That's a beautiful deleveraging.

We're in a phase now in the U.S. which is very much like the 1933-37 period, in which there is positive growth around a slow-growth trend. The Federal Reserve will do another quantitative easing if the economy turns down again, for the purpose of alleviating debt and putting money into the hands of people.

We will also need fiscal stimulation by the government, which of course, is very classic. Governments have to spend more when sales and tax revenue go down and as unemployment and other social benefits kick in and there is a redistribution of wealth. That's why there is going to be more taxation on the wealthy and more social tension. A deleveraging is not an easy time. But when you are approaching balance again, that's a good thing.

Barron's: What makes all the difference between the ugly and the beautiful?

Dalio: The key is to keep nominal interest rates below the nominal growth rate in the economy, without printing so much money that they cause an inflationary spiral. The way to do that is to be printing money at the same time there is austerity and debt restructurings going on.
Evans-Pritchard believes that the resolution problem is a binary one - either "inflation (1945-1952) or default (1930-1934)". Dalio is far more nuanced. You just need the right policy mix of austerity, debt write-offs and defaults and money printing.

Once you understand the framework, you understand the situation and you can analyze it all by yourself.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Anonymous said...

Cam, could you expand on this comment: "The key is to keep nominal interest rates below the nominal growth rate in the economy." That's very neat/linear but I wonder what's the conceptual basis for this assertion.

walt said...

A very important post, but
"You just need the right policy mix of austerity, debt write-offs and defaults and money printing." Just what austerity do you mean: household, government?

walt said...

After 2 failed attempts to comment, walt gives up.

Cam Hui, CFA said...

Walt - I assume that Dalio means government austerity.

Anonymous said...

i agree with dalio except for one major point.. the US hasn't begun deleveraging!!! total credit mkt debt is at an all time high. consumer deleveraging has been completely offset by government borrowing- our debt is up over 5 trillion in 5 years! http://research.stlouisfed.org/fred2/series/TCMDO

so in essence its been a debt swap and dalio is correct in that its beautiful as long as private demand eventually can pick up which will serve to lower the debt burden... but.. the trick is if that occurs, the governments funding needs will likely crowd out private demand through interest rate increases and demand will collapse as a result. in other words when the fed talks about exit strategies try not to laugh too hard...

Anonymous said...

Hi Cam,

Couple of points re Dalio's Monopoly analogy I picked up from a great French book I am reading by Philippe Herlin (Rethinking the analogy - unfortunately he doesn't have an English editor, if you know one let me know, I'll pass on the info to him).
In order to understand the difference between a "Gaussian" universe from a "Power law" universe, one can use as well the Monopoly analogy according to Philippe Herlin. In essence, Dalio is right that there are indeed two sequences in the game. In the first sequence, which is Gaussian, it is almost impossible to default. One can not lose or win the game on one throw of dice. At the end of the first sequence players will have roughly the same amount of properties. If you consider 4 players, 22 properties, they will have around 5 to 6 properties each. Lucky ones might get 7 or 8, unlucky ones might only get 3 or 4. But the probability of one of the player getting 50% or two thirds of the properties is extremely remote. Therefore the distribution during the first sequence of the game is "normal".
The second sequence is more interesting and highly unprobable given the game's concept is that the winner accumulate the properties and money of the unlucky ones. You can lose or win on one throw! The distribution is no more "normal"! The differences between those who have most properties and those who have not increase exponentially. "Money" goes to "Money" during the second phase. The winning player distort the game to his advantage because he earns more "money" and is able to buy more properties therefore distorting the probabilities space. The aim of the second phase is in essence to be the last one to "default".
During the 1st sequence of the game of Monopoly, the risk is limited because of the "Gaussian" distribution, but, in the second sequence, the risk obeys to the "law of power", where risk is exponential, so goes Philippe Herling great explaination.

Ironically the game of Monopoly was invented in 1934, following the crash of 1929...

Dalio' explaination is correct in that sense. But "printing more money" as in Dalio's Monopoly game with rules being changed do not necessarily change the outcome or remove the randomness.

Banks have already learned the hard way about what it costs to be "fooled by randomness" in similar fashion to the Monopoly game described by Dalio.

"A Throw of Dice will Never Abolish Chance" - Stéphane Mallarmé