The best time to adjust is before the storm arrives, not after the crisis breaks out.

Written by: Ray Dalio, Founder of Bridgewater Associates

Translated by: Chopper, Foresight News

Abstract: Behind the fluctuations of US debt, a grand debt cycle is unfolding. Dalio warns in his article that the US fiscal situation has reached a critical turning point, and without timely adjustments, a debt crisis could break out within a few years. He dissects the entire process of a debt crisis from its inception to eruption by borrowing historical laws, providing reform solutions, and directly addressing the most concerning controversies: Can the hegemony of the dollar protect it? Why should Japan's high debt not be emulated? Standing at the crossroads of monetary order transition, aside from gold, Bitcoin is also seen as one of the tools to hedge against currency depreciation. The following is the translated content:

In my book "Why Nations Succeed or Fail: The Big Cycle," I detail a framework for analysis, explaining the likely evolution process when there is an unsustainable imbalance in debt supply and demand. Recently, three events have coincided: 1) The Japanese government sold some US Treasuries to bring funds back home, supporting the yen and lifting the Japanese capital market; this reduces exposure to US Treasuries without having to raise interest rates to levels it is unwilling to accept. 2) Due to a massive supply of existing and new debt along with weakening debt demand, the yield on long-term US bonds reached a new high, while the dollar weakened. 3) This week, US Treasury Secretary Yellen announced that the Treasury will repurchase US Treasuries, but the scale of the repurchase that can be executed is very limited.

After these events occurred, many people asked me if these phenomena align with the classic debt cycle model described in my book. The answer is affirmative. To predict the potential future situations, we need to revisit this analytical framework.

In the book, I detail how the debt monetary restructuring process at the government level typically evolves. I also provide projections that show the imbalance between the supply of new debt and the refinancing of maturing debt, and the market's demand for debt. Readers can use this framework to compare with real events to predict future trends.

Operational Mechanism: Debt is Like Blood, Imbalance is Dangerous

The logic of debt operation for the central government is essentially no different from that of individuals or corporations; the only difference is that the central government has a central bank behind it, which can print money (causing currency depreciation) and can also draw funds from the populace through taxation. To understand this, you might imagine: if you or your business had the power to print money and also collect funds through taxation, how would debt evolve? This can help you understand this logic. But remember, the government’s goal is to ensure the whole system operates in a healthy manner, taking into account all citizens, and not just its own interests.

In my view, credit and the market system are like the circulatory system of the human body, delivering nutrients to all parts that make up the market and economy. When credit is efficiently utilized, it creates output and income sufficient to repay the principal and interest on debt, which is a healthy state. However, if credit is misused, the income generated may not be enough to cover both principal and interest, and the pressure of debt repayment will compress other expenditures like arterial plaque. When the burden of repaying debt becomes extremely heavy, a debt repayment crisis will erupt; subsequently, the refinancing of maturing debt will also face problems: debt holders will be unwilling to refinance and will choose to sell bonds.

Naturally, debt instruments like bonds will see insufficient demand and face sell-offs. When supply far exceeds demand, two results will occur: a) Interest rates will rise, dragging down the market and economy; b) The central bank will activate the printing press to buy debt, subsequently devaluing the currency and pushing inflation levels higher. Printing money will also artificially suppress interest rates, harming lenders’ investment returns. Neither outcome is ideal. When the scale of debt sell-off becomes large enough to be uncontrollable, interest rates will be forced up, while the central bank has already purchased a significant amount of bonds, leading the central bank itself to incur book losses and cash flow pressure. If the situation continues to worsen, the central bank could even end up with negative net assets.

Once the situation deteriorates severely, both the central government and the central bank must incur debt to repay principal and interest; the demand from the free market is already insufficient, and the central bank can only print money to provide credit, thus forming a self-reinforcing "debt-printing-inflation" spiral.

In short, there are three core signals worth close attention: 1) The ratio of government debt repayment scale to government fiscal revenue (like the degree of plaque accumulation in an artery); 2) The scale of government bond sell-offs relative to the demand in the bond market (like plaque detachment, triggering heart disease); 3) The scale at which the central bank prints money to buy government bonds to fill the gap between supply and market demand (equivalent to the central bank injecting liquidity into the system on a large scale to alleviate liquidity crises, but also creating a lot of new debt that the central bank must bear corresponding risk exposure for).

Over several decades in the long-term cycle, the above indicators tend to rise in sync: the size of debt and repayment scale relative to income continuously expands until the situation becomes unsustainable. There are three scenarios that can trigger a critical point: 1) Debt principal and interest payments severely crowd out other fiscal expenditures; 2) The scale of debt supply waiting to be taken on far exceeds market willingness to take on, leading to significant interest rate increases, with market and economic downturns; 3) The central bank unwilling to see soaring interest rates and economic and market collapse, thus massively prints money to buy debt to fill the demand gap, resulting in significant currency devaluation.

No matter which scenario appears, bond returns will all be poor. Until the debt and currency depreciation reach a sufficiently low level to attract market purchases again, or the government can buy back debt at low prices and complete debt restructuring, the situation will not improve.

This is a very simplified summary of the grand debt cycle.

These indicators are all quantifiable, hence we can track debt dynamics in real time, detecting risks in advance. This analytical diagnostic tool I have previously used for my investments has never been publicly disclosed; but now I have included it in my book "How Nations Go Bankrupt: The Big Cycle" in its entirety, as this knowledge is too important to be neglected.

To be more specific, the complete evolution path is: debt and repayment scale relative to income continuously rise, with debt supply exceeding market demand; the central bank first enacts stimulus through lowering short-term interest rates, then transitions to printing money to buy debt. Eventually, the central bank falls into losses and turns to negative net assets, while the central government borrows more new debt to repay old debt, with the central bank directly monetizing the debt. All these factors together drive the emergence of a government debt crisis, when debt-driven spending contracts, and the normal circulation of the economy is interrupted, a crisis akin to "economic heart disease" will erupt.

In the early stages of the grand debt cycle entering its final stage, the market will show these signals: long-term interest rates will rise first; currency (especially relative to gold) will depreciate; due to insufficient demand for long-term bonds, the Treasury will shorten the maturity period of newly issued debt. In the later stages of the cycle, when the situation is most severe, a series of seemingly extreme measures are often introduced, such as implementing capital controls, exerting immense pressure on creditors to force them to buy in and prohibiting them from selling debt.

Current Situation in the US: Debt at Historic Highs, Crisis at a Turning Point

It may be helpful to imagine the US government as a giant corporation, making it easier to understand the US fiscal situation and the choices facing policymakers.

US total fiscal revenue this year is about $5.5 trillion, total expenditure is about $7.5 trillion, resulting in a fiscal gap of about $2 trillion. In other words, this "corporation" has expenditures about 40% higher than income this year. And the government has almost no room to cut expenses, as the vast majority of expenditures are rigid, already committed outflows.

Long-term excessive borrowing has led to the accumulation of massive debt, approximately six times its annual fiscal revenue (about $32 trillion), translating to about $240,000 in debt burden per household. Debt interest expenditures amount to about $1 trillion, making up 20% of fiscal revenue and half of this year’s fiscal deficit, which needs to be covered by new borrowings. However, the $1 trillion is not the entire amount payable to creditors: besides interest, there is approximately $10 trillion in principal due, for which the government can only hope creditors are willing to refinance.

Therefore, to avoid default, the total scale of principal and interest due (debt repayment pressure) is about $11 trillion, equivalent to 200% of annual fiscal revenue.

This is the current reality.

So what will happen next? Let’s speculate: regardless of what the final fiscal deficit is, the US will have to borrow to fill the gap. There is heated debate about the size of future deficits. Based on the recently passed budget coordination bill, most independent institutions estimate that US debt will reach $55-60 trillion in 10 years (around 7 times fiscal revenue), with new borrowing during this period expected to be $25-30 trillion. If no feasible solutions are proposed, in 10 years, the repayment of debt principal and interest will further squeeze fiscal expenditures, and the risk of insufficient demand in the treasury bond market will also be magnified.

Path to Resolution: Three-Pronged Approach, Stabilize to 3%

I am convinced that the US fiscal situation is at a critical turning point. If not dealt with now, debt will continue to expand, and waiting until the situation is uncontrollable to adjust will inevitably bring about significant social pain. The optimal adjustment window is precisely when the system is still relatively stable, not waiting until the economy has already fallen into recession. Once the economy declines, government borrowing demand will further soar.

Based on my analysis, the solution should adopt what I call the 3% three-part strategy: reduce the fiscal deficit to 3% of GDP while balancing the use of three means to cut deficits: 1) Reduce fiscal expenditures; 2) Increase taxes; 3) Lower interest rates. All three must progress synchronously, avoiding a single measure from being overly aggressive causing severe shocks; if one is too drastic, the adjustment process will be painful. Adjustments should rely on fundamental healthy reforms, not forced interventions (for example, the Fed artificially suppressing interest rates would lead to severe consequences).

According to my calculations: based on existing plans, a 5% reduction in expenditures and a 5% increase in taxes could drive interest rates down by 1-1.5 percentage points; over the next ten years, the interest burden as a percentage of GDP will decrease by 1-2 percentage points, simultaneously boosting asset prices, activating economic activities, and bringing in more fiscal revenue.

Frequently Asked Questions

There is more content in the book which cannot be fully elaborated here due to length constraints, including the "Grand Cycle" driving major global changes (including the debt-credit cycle, domestic political cycles, external geopolitical cycles, natural disasters, technological advancements), my judgments about the future, and thoughts on how to invest amid dramatic cyclical changes. Below, I will answer some frequently asked questions when discussing the book; for deeper understanding, reading the original book is recommended.

Question 1: Why do large-scale government debt crises and grand debt cycles occur?

The occurrence of large-scale government debt crises and grand debt cycles can be identified through three sets of observable indicators: 1) The ratio of government debt principal and interest repayments to fiscal revenue rises, severely crowding out necessary fiscal expenditures; 2) The scale of government bond sell-offs far exceeds market capacity, leading to rising interest rates and subsequent declines in the stock market and economy; 3) The central bank cuts interest rates to respond to the crisis, further diminishing the attractiveness of bonds, subsequently the central bank prints money to buy government bonds, resulting in currency depreciation.

These phenomena will continue to worsen over decades until a critical point comes: 1) Debt principal and interest payments severely crowd out other public expenditures; 2) The scale of debt waiting to be sold far exceeds market capacity, causing interest rates to rise sharply, with markets and the economy deeply declining; 3) The central bank massively prints money to buy bonds to fill demand gaps, leading to significant currency depreciation.

No matter how any of these paths unfold, bond returns will continue to worsen until prices fall to sufficiently low levels to attract buyers again or the debt is restructured. All these indicators are quantifiable, allowing for the early prediction of the advent of a debt crisis. When a crisis breaks out, the contraction of debt-driven spending will trigger a debt-induced "economic heart disease".

Throughout history, nearly all countries have repeatedly experienced such debt cycles, with hundreds of historical examples available for reference, well-documented in written history. In other words, all monetary orders have faced collapse, and the debt cycle I described is the underlying cause. The fall of currencies like the pound and guilder, once reserve currencies, follows this mechanism. The book includes 35 recent典型案例.

Question 2: Since this process recurs, why hasn't the underlying operating logic been widely understood?

Indeed, this mechanism has not been fully recognized by the public. Interestingly, I cannot find literature specifically studying this evolutionary process. My hypothesis is that for reserve currency countries, each generation may only experience one monetary order collapse; while in non-reserve currency countries, when a debt crisis erupts, people tend to assume that reserve currency countries can somehow be immune to such risks.

The reason I discovered this rule is that I personally witnessed crises while investing in sovereign bond markets, leading me to review numerous historical cases to prepare for such situations (e.g., the 2008 global financial crisis, subsequent European debt crisis).

Question 3: Many have heard early warnings of a US debt crisis, but the crisis has yet to materialize. How cautious should we be regarding a US "economic heart disease"-style debt crisis? Why is this time different?

Based on the conditions mentioned earlier, I believe we should be highly vigilant. In the past, when the debt environment was not as dire, those who issued crisis warnings were not wrong; had solutions been implemented back then, it would not have developed into the troublesome situation we face today. It is akin to doctors advising against smoking and overeating long before issues arise.

I believe the public has not sufficiently recognized this issue; on one hand, the cognitive barrier of this mechanism is high, on the other hand, multiple early warnings not being fulfilled has created a general state of numbness. It’s like a person whose arteries are already clogged with plaque still indulging in a high-fat diet, not exercising, and then retorting to the doctor, "You warned me long ago that I would have problems if I didn't change my habits, but I haven't had a heart attack yet, so why should I believe you now?"

Question 4: What could be the trigger for the current US debt crisis? When will it erupt? What will the crisis specifically look like?

The trigger is the multiple factors mentioned earlier brewing together. As for the timing, policy changes, geopolitical conflicts, and other external shocks can either accelerate or delay a crisis. For example, if fiscal deficits drop from an estimated 7% of GDP to 3%, the risk would significantly reduce. Conversely, if a major external shock occurs, the crisis may come earlier; if there are no external shocks and policies are handled properly, the crisis may be postponed or even avoided.

According to my speculation, if the existing policy trajectory remains unchanged, the crisis will likely arrive in around 3 years, with a fluctuation of plus or minus 2 years.

Question 5: Are there historical examples of large-scale fiscal deficit reduction achieving good results?

Yes, there are many. My proposal requires reducing fiscal deficits by about 4% of GDP. The most comparable case is the US from 1991 to 1998, during which the fiscal deficit reduction reached 5% of GDP, leading to positive outcomes.

Question 6: Some argue that the dollar’s dominant position in the global economy makes it less likely for the US to face a debt crisis. What have those holding this view overlooked?

Those holding this view have not understood the operating mechanism of debt currencies and have neglected historical lessons. They should research history: how all previous reserve currencies gradually lost their status. Simply put, a currency must effectively store wealth in correspondence to the debts, otherwise, it will be devalued and abandoned. The cyclical logic I described explains precisely how reserve currencies lose their wealth storage function.

Question 7: Japan's debt-to-GDP ratio is as high as 215%, the highest among developed economies, often cited as evidence that a country can endure high debt for extended periods without facing a debt crisis. Why can't we feel optimistic about the Japanese case?

The current situation in Japan actually confirms the theory I described, as the issues discussed in the book are indeed unfolding in reality. The Japanese government's high debt has made Japanese bonds a long-term poor investment. To compensate for insufficient demand in the government bond market in a low-interest environment, the Bank of Japan has printed large amounts of money to purchase domestic government bonds. Since 2013, holders of Japanese bonds have incurred a book loss of 51% relative to US dollar bonds, and 76% relative to gold. When using a unified currency scale for comparison, the wages of ordinary Japanese workers have fallen by 55% compared to US workers' salaries since 2013.

Question 8: What other countries' fiscal risks are underestimated by the market?

The vast majority of economies face similar debt and deficit issues, including the UK, EU, China, and Japan. Therefore, I predict that most economies will experience a round of debt adjustments and currency devaluation. This is also why I am optimistic about currencies and assets such as gold and Bitcoin that are not issued by governments.

Question 9: How should investors respond to such risks and make asset allocations?

General advice: Diversify adequately, choosing countries and asset classes that have stable revenues and balance sheets, and that do not prominently feature internal political conflicts or external geopolitical issues; allocate a small amount to bonds as debt assets; allocate a significant amount to gold, with a moderate allocation to a small amount of Bitcoin. Allocating a small portion of total assets (around 10-15%) to gold can reduce portfolio risk while also enhancing overall returns.