“THE most beautiful deleveraging yet seen” is how Ray Dalio describes
what is now going on in America's economy. As America has gone through
the necessary process of reducing its debt-to-income ratio since the
financial crash of 2008, he reckons its policymakers have done well in
mixing painful stuff like debt restructuring with injections of cash to
keep demand growing. Europe's deleveraging, by contrast, is “ugly”.
Mr Dalio's views are taken seriously. He made a fortune betting
before the crash that the world had taken on too much debt and would
need to slash it. Last year alone, his Bridgewater Pure Alpha fund
earned its investors $13.8 billion, taking its total gains since it
opened in 1975 to $35.8 billion, more than any other hedge fund ever,
including the previous record-holder, George Soros's Quantum Endowment
Fund.
Mr Dalio, an intense 62-year-old, is following in the footsteps of
Mr Soros in other ways, too. Mr Soros has published several books on his
theories, and is funding an institute to get mainstream economists to
take alternative ideas seriously. Mr Dalio, too, is now trying to
improve the public understanding of how the economy works. His economic
model “is not very orthodox but gives him a pretty good sense of where
the economy is,” says Paul Volcker, a former chairman of America's
Federal Reserve and one of Mr Dalio's growing number of influential
fans.
Whereas Mr Soros credits the influence of Karl Popper, a philosopher
who taught him as a student, Mr Dalio says his ideas are entirely the
product of his own reflections on his life as a trader and his study of
economic history. He has read little academic economics (though his work
has echoes of Hyman Minsky, an American economist, and of best-selling
recent work on downturns by Carmen Reinhart and Kenneth Rogoff) but has
conducted in-depth analysis of past periods of economic upheaval, such
as the Depression in America, post-war Britain and the hyperinflation of
the Weimar Republic. He has even simulated being an investor in markets
in those periods by reading daily papers from these eras, receiving
data and “trading” as if in real time.
In the early 1980s Mr Dalio started writing down rules that would
guide his investing. He would later amend these rules depending on how
well they predicted what actually happened. The process is now
computerised, so that combinations of scores of decision-rules are
applied to the 100 or so liquid-asset classes in which Bridgewater
invests. These rules led him to hold both government bonds and gold last
year, for example, because the deleveraging process was at a point
where, unusually, those two assets would rise at the same time. He was
right.
What Mr Dalio calls the “timeless and universal” core of his economic ideas is set out in a 20-page “Template for Understanding”
that he wrote shortly after the collapse of Lehman Brothers in 2008 and
recently updated. The document begins: “The economy is like a machine.”
This machine may look complex but is, he insists, relatively simple
even if it is “not well understood”. Mr Dalio models the macroeconomy
from the bottom up, by focusing on the individual transactions that are
the machine's moving parts. Conventional economics does not pay enough
attention to the individual components of supply and, above all, demand,
he says. To understand demand properly, you must know whether it is
funded by the buyers' own money or by credit from others.
A huge amount of Bridgewater's efforts goes into gathering data on
credit and equity, and understanding how that affects demand from
individual market participants, such as a bank, or from a group of
participants (such as subprime-mortgage borrowers). Bridgewater
predicted the euro-zone debt crisis by totting up how much debt would
need to be refinanced and when; and by examining all the potential
buyers of that debt and their ability to buy it. Mr Volcker describes
the degree of detail in Mr Dalio's work as “mind-blowing” and admits to
feeling sometimes that “he has a bigger staff, and produces more
relevant statistics and analyses, than the Federal Reserve.”
Two sorts of credit cycle are at the heart of Mr Dalio's economic
model: the business cycle, which typically lasts five to eight years,
and a long-term (“long wave”) debt cycle, which can last 50-70 years. A
business cycle usually ends in a recession, because the central bank
raises the interest rate, reducing borrowing and demand. The debt cycle
ends in deleveraging because 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.” Business cycles happen often, they are well
understood and policymakers are fairly adept at managing them. A debt
cycle tends to come along in a country once in a lifetime, tends to be
poorly understood and is often mishandled by policymakers.
An ordinary recession can be ended by the central bank lowering the
interest rate again. A deleveraging is much harder to end. According to
Mr Dalio, it usually requires some combination of debt restructurings
and write-offs, austerity, wealth transfers from rich to poor and
money-printing. A “beautiful deleveraging” is one in which all these
elements combine to keep the economy growing at a nominal rate that is
higher than the nominal interest rate. (Beauty is in the eye of the
beholder: Mr Dalio expects America's GDP growth to average only 2% over a
15-year period.)
Print too little money and the result is an ugly, deflationary
deleveraging (see Greece); print too much and the deleveraging may
become inflationary, as in Weimar Germany. Although Mr Dalio says he
fears being misunderstood as saying “print a lot of money and everything
will be OK, which I don't believe, all deleveragings have ended with
the printing of significant amounts of money. But it has to be in
balance with other policies.”
Mr Dalio admits to being wrong roughly a third of the time; indeed,
he attributes a big part of his success to managing the risk of bad
calls. And the years ahead are likely to provide a serious test of
whether the economic machine is as simple as he says. For now, he is in a
more optimistic mood thanks to the European Central Bank's recent
moves, in effect, to print money. Although he still expects debt
restructuring in Spain, Portugal, Italy and Ireland, on top of that in
Greece, he says that the “risk of chaos has been reduced and we are now
calming ourselves down.” Here's hoping he is right again.
The above is an article published in the economist website on the 10/03/2012 economist
(http://www.economist.com/node/21549968)
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