Yesterday was a regular Depression-o-rama here because many of the articles I wrote were very much centered around the Depression theme. I would like to move away from this subject. But before I do, I feel compelled to relay a news piece that came out at the weekend (Hat tip Scott).
Bridgewater Associates founder Ray Dalio gave an interview to U.S. investment publications Barron’s in which he said that we are in a deleveraging deflationary depression. He labeled this the ‘D-Process.’ Now, you may remember Bridgewater Associates is the company which correctly predicted enormous writedowns in this downturn back in July. While many were incredulous, their predictions have turned out to actually understate the likely eventual losses.
Fast forward 7 months and we get a sense of what this influential financial firm is thinking via the Barron’s interview with Ray Dalio. I have highlighted the most noteworthy points.
Barron’s: I can’t think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.
Dalio: Let’s call it a "D-process," which is different than a recession, and the only reason that people really don’t understand this process is because it happens rarely.Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn’t live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.
[Barron’s:] Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?
[Dalio:] Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.
You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.
[Barron’s:] You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what’s essential to combat deflation and a depression?
[Dalio:] The D-process is a disease of sorts that is going to run its course.
When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?
The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the ’90s, that occurred in Latin America in the ’80s, and that occurred in the Great Depression in the ’30s.
Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.
[Barron’s:] As goes GM, so goes the nation?
[Dalio:] The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.
This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.
We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.
It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.
[Dalio:] Isn’t the process of restructuring under way in households and at corporations?
They are cutting costs to service the debt. But they haven’t yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.
[Barron’s:] What are you suggesting?
An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.
[Dalio:] So where do things stand in the process of restructuring?
What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven’t said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.
The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.
However, the reason it hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.
Dalio is essentially saying that we will not see renewed lending until the bad debt is cleared away – until we see the credit writedowns taken for all of the existing debts. Basically, debtors cannot take on any more loans. The corollary of what he is saying is that the approach taken to date by Paulson and Bernanke and likely to be followed by Geithner will be a failure.
What is interesting about Dalio’s analysis is that he focuses on the debtors. He sees debtors as incapable of taking on more debt given the decline in asset prices and income. All of this was possible as asset prices rose. But no longer. I have come to similar conclusions by focusing on the lenders i.e. that no increase in lending will get done until the lenders get a handle on their bad debt and feel they can write everything down without going bankrupt.
You should also notice that he is inferring that the United States is a banana republic (i.e. a country that is overly indebted to foreigners) when he makes the comparison to Latin America, much as Willem Buiter has done regarding the U.S. and the U.K. One must use the term ‘banana republic’ because there is a pride, an arrogance if you will, that the United States is better than the countries in Latin America like Argentina and Mexico which have had similar problems in the past. It is not, and to deal with this problem, Americans need to get rid of that notion.
A few other points:
- He also takes a view on Treasuries that I share: the Fed will eventually have to come in and start buying Treasuries. He says: "The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold."
- So Dalio sees quantitative easing i.e. printing money as an attractive solution for a country which is indebted in its own currency. In Latin America, the problem was that the debt was in foreign currency. Here, the U.S. has a relief valve — it’s called devaluation. That makes gold attractive.
- Nationalization is inevitable. The U.S. banking system is effectively bankrupt. That means that the bad debts are greater than the capital in the system. Many institutions are solvent. However, today, so many large ones are not that nationalization must happen. Eventually. In my view, the sooner, the better. But, we know that politicians will only do this as a last resort.
- To the question of whether we need to get more credit to good businesses because they ae credit starved, he says: "Those examples exist, but they aren’t, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn’t primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The ’30s were very similar to this."
Dalio has a lot more to say about China, the Chinese currency, inflation and more. It is a very good piece and I believe it is accessible to those without a subscription. See the link below.
Recession? No, It’s a D-process, and It Will Be Long – Barron’s