Long-Term Debt Cycles: Destiny or Choice?
“Give me control of a nation’s money and I care not who makes the law.”
This quote is credited to Mayer Amschel Rothschild (1744 – 1812), which raises an important question. What is money?
According to world renowned hedge fund manager Ray Dalio in his book The Changing World Order, “money is a medium of exchange that can also be used as a storehold of wealth.” Understanding the three types of money is an important exercise in abstraction.
1. Type 1: Hard money includes intrinsically valuable commodities, like gold. The money supply cannot increase unless more gold is added to the system (and vice versa). Hard money maximizes credibility and minimizes credit.
2. Type 2: Paper money includes printed currency that serves as a claim on gold at a fixed exchange rate. The money supply or credit can grow by printing more currency because few people will exchange their currency for gold. However, if there’s a crisis or people fear that too much currency is being printed, a run on the bank for gold could implode the system. Paper money expands credit but compromises credibility.
3. Type 3: Fiat money severs the link between currency and gold by creating money and credit freely, which works while people have confidence in the currency. Fiat money maximizes credit but minimizes credibility.
Long-term debt cycles last 50 to 75 years, which includes six to 10 short-term debt cycles or business cycles. (According to Dalio, we are in the late phase of the current cycle.) Most people experience the painful ending of a long-term debt cycle only once in their life, which makes them difficult to anticipate or imagine how disruptive they can be.
The long-term debt cycle transpires in six stages:
1. Stage 1 begins with hard money (usually gold). No trust is required to carry out exchanges because gold is the only financial asset that isn’t someone else’s liability.
2. Stage 2 begins with paper money. Credible parties establish banks by putting gold in a safe place and issuing paper currency (money supply = gold).
3. Stage 3 begins when banks discover credit and debt. The banks print more currency for loans (money supply > gold) and reward depositors with interest payments. Win-win, until there’s not enough income to service the debts and the depositors lose trust and begin to withdraw the gold.
4. Stage 4 begins when debt crises, defaults, and devaluations come, which leads to the printing of money and severing the link to gold. Economic goods and services and gold are finite whereas paper money and debt are constantly growing, so we are led to believe that this result is inevitable.
5. Stage 5 begins with fiat money and the debasement of currency (we are here). The expansion of credit is often linked to tangible assets, such as homes for mortgages, but the path of least resistance usually means printing money or monetizing debt to ease economic pain. In fact, Dalio claims that “all currencies devalue or die.”
6. Stage 6 begins with the return to gold – wash, rinse, repeat.
Give that the transitions from Type 1 to Type 2 money and from Type 2 to Type 3 money involve people making choices, it seems out of place to refer to the six stages as a “cycle,” which suggests natural or causal events, such as the seasons. Dalio notes that this sequence of events has repeated itself in history many times, which is good to know as an investor, but are we doomed to repeat it again and again?
One of the reasons Type 2 money gives way to Type 3 money is the entities allowed to print money or issue credit are backstopped by the implicit understanding that the system will come to the rescue: moral hazard. If the same entities faced bankruptcy, or even criminal charges, their behavior would change.
In 1944, the Bretton-Woods Agreement established a system of Type 2 money backed by gold, but the United States printed excessive money, which prompted many to exchange their dollars for gold, until Nixon ended the gold standard in 1971. This reckless money printing, much of it to fund the war in Vietnam, could have been prevented with legislation.
Granted, our economy is massive and complex, so we need financial and monetary tools to mitigate short-term shocks. However, history has taught us that many of these tools have been used to mitigate problems that were created by fiat money, especially when they bail out the financial economy at the expense of the real economy.
Granted, there are many benefits to having a reserve fiat currency, to include leveraging world events to our advantage, but it promotes a lack of discipline that gives misguided ideas a voice at the table. The amount of waste and pork included in omnibus spending bills never ceases to amaze. Again, change the rules, change the behavior.
As Dalio noted, we’re at the end of the current long-term debt cycle, which means many of us will probably endure a once in a lifetime economic “reset” or “new world order” that includes the return of Type 2 money. If you're looking for clues about how things might unfold, I recommend tracking gold purchases by central banks.