Limits to spending growth financed by debt and money raises risks of policy ‘pushing on a string’
In brief, the Federal Reserve’s template, and that of most economists and market participants, reflects the business cycle.
Based on it, tightening should occur when a) the rate of growth in demand is greater than the rate of growth in capacity and b) the usage of capacity (as measured by indicators such as the GDP gap and the unemployment rate) is becoming high.
As a result, tightening now makes sense.
However, as I see it, there are two important cycles to pay attention to — the business cycle, or short-term debt cycle, and the debt supercycle, or long-term debt cycle.
We are seven years into the expansion phase of the business/short-term debt cycle — which typically lasts about eight to 10 years — and near the end of the expansion phase of a long-term debt cycle, which typically lasts about 50 to 75 years.
It is because of the long-term debt cycle dynamics that we are seeing global weakness and deflationary pressures that warrant global easing rather than tightening.
Since the dollar is the world’s most important currency, the Fed is the most important central bank for the world as well as the central bank for Americans, and as the risks are asymmetric on the downside, it is best for the world and for the US for the Fed not to tighten.
Since the long-term debt cycle issue is the biggest issue that separates my view from others, I’d like to briefly focus on its mechanics.
What I am contending is that there are limits to spending growth financed by a combination of debt and money. When these limits are reached, it marks the end of the upward phase of the long-term debt cycle. In 1935, this scenario was dubbed “pushing on a string”.
This scenario reflects the reduced ability of the world’s reserve currency central banks to be effective at easing when both interest can’t be lowered and risk premia are too low to have quantitative easing be effective.
Since we commonly understand why lowering interest rates stimulates debt and economic growth, and less commonly understand how QE works, I’d like to explain it.Our whole capital allocation system — banking and investing — is driven by spreads so that when they are large, QE works better than when they are small
You see, our whole capital allocation system — banking and investing — is driven by spreads so that when they are large, QE works better than when they are small.
When there are good spreads — in other words a large risk premia — and those who sold their bonds take their newly acquired cash to buy those assets that offer attractive spreads, bid up their prices and drive down those expected return spreads (ie risk premia) of those assets.
That is where things now stand across the world’s reserve currencies, where the expected returns of bonds (and most asset classes) are relatively low in relation to the expected returns of cash.
As a result, it is difficult to push the prices of these assets up and it is easy to have them fall. And when they fall, there is a negative impact on economic growth.
When this configuration exists — and it is also the case that debt and debt service costs are high in relation to income, so that debt levels cannot be increased without reducing spending — stimulating demand is more difficult, and restraining demand is easier, than is normally the case.
At such times the risks are asymmetric on the downside and it behoves central banks to err on the side of waiting until they see the whites of the eyes of inflation before tightening.
That, in my opinion, is now the case.
Ray Dalio is the founder and head of hedge fund group Bridgewater
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