The Capital Cycle

How The Capital Cycle Works

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

If you’ve been following Macro Ops for a while, then you know the Bridgewater Debt Cycle model is the foundation for how we view larger market movements. The debt cycle drives the short-term business cycle (5-8 years) as well as the longer-term secular cycle (50-75 years).

Here’s how it works:

  1. The central bank lowers interest rates, bringing down the cost of money
  2. This lower rate feeds into the rest of the economy, bringing down lending rates
  3. Borrowing becomes cheaper and more attractive, driving consumers and businesses to borrow and spend more (boosting demand)
  4. Existing debt becomes cheaper to service, leaving consumers and businesses with more income to spend (boosting demand)
  5. The discount rate at which businesses and financial assets (risk-premia spread) are valued is lowered, increasing the present value of assets, which creates a flow into riskier assets (boosting demand)
  6. Since one person’s spending is another’s income, a wealth effect is created and credit profiles improve, allowing consumers/businesses to borrow and spend more, creating a virtuous demand cycle

Eventually, central banks raise interest rates and the feedback loop shifts into reverse, until interest rates are lowered once again and the cycle starts anew. Short-term debt cycles compound into long-term debt cycles. This is how demand spawns and how bull and bear markets are born and die.

Again, if you’ve been following us for some time, then you know that we’re in the tail end of the current short-term debt cycle. And this short-term debt cycle is on the backend of the long-term debt cycle. This means we’re in the early stages of a secular deleveraging, which is why growth has been so elusive and also why Western politics have been so populous (a period not unlike the last secular deleveraging in the 1930’s).

The Debt Cycle model looks at everything from a demand perspective. But we can also look at these cycles from the viewpoint of supply. Doing so gives us greater granularity of the forces at work. Read more

How Short-Term and Long-Term Debt Cycles Work

How Short-Term and Long-Term Debt Cycles Work

Conventional economic “wisdom” fails to understand the role of credit/debt in our market based system. Mainstream economics completely neglects to understand not only credits affect on demand, but also how this credit demand fluctuates in both short and long-term cycles. Read more


Bridgewater’s Five Stages of a Sovereign’s Life Cycle

According to Ray Dalio (and we believe this as well) there are four drivers of economic growth: culture, indebtedness, competitiveness, and luck.

And the two most positive influences on these growth drivers are [1] the psychological framework that creates people’s desire to work, borrow and consume and [2] war.

It’s these different socioeconomic experiences that form long-term cultural and psychological biases. These biases in turn drive the cycle of a nation’s economic growth, power, and influence — all in a very complex and reflexive loop.

Here’s Bridgewater’s explanation of the five different stages of this process in a sovereign’s life cycle: 

1) In the first stage countries are poor and think that they are poor. 

In this stage they have very low incomes and most people have subsistence lifestyles, they don’t waste money because they value it a lot and they don’t have any debt to speak of because savings are short and nobody wants to lend to them. They are undeveloped.

2) In the second stage countries are getting rich quickly but still think they are poor.
At this stage they behave pretty much the same as they did when they were in the prior stage but, because they have more money and still want to save, the amount of this saving and investment rises rapidly. Because they are typically the same people who experienced the more deprived conditions in the first stage, and because people who grew up with financial insecurity typically don’t lose their financial cautiousness, they still a) work hard, b) have export-led economies, c) have pegged exchange rates, d) save a lot, and e) invest efficiently in their means of production, in real assets like gold and apartments, and in bonds of the reserve countries.

3) In the third stage countries are rich and think of themselves as rich.
At this stage, their per capita incomes approach the highest in the world as their prior investments in infrastructure, capital goods and R&D are paying off by producing productivity gains. At the same time, the prevailing psychology changes from a) putting the emphasis on working and saving to protect oneself from the bad times to b) easing up in order to savor the fruits of life. This change in the prevailing psychology occurs primarily because a new generation of people who did not experience the bad times replaces those who lived through them. Signs of this change in mindset are reflected in statistics that show reduced work hours (e.g., typically there is a reduction in the average workweek from six days to five) and big increases in expenditures on leisure and luxury goods relative to necessities.

4) In the fourth stage countries become poorer and still think of themselves as rich.
This is the leveraging up phase – i.e., debts rise relative to incomes until they can’t any more. The psychological shift behind this leveraging up occurs because the people who lived through the first two stages have died off or become irrelevant and those whose behavior matters most are used to living well and not worrying about the pain of not having enough money. Because the people in these countries earn and spend a lot, they become expensive, and because they are expensive they experience slower real income growth rates. Since they are reluctant to constrain their spending in line with their reduced income growth rate, they lower their savings rates, increase their debts and cut corners. Because their spending continues to be strong, they continue to appear rich, even though their balance sheets deteriorate. The reduced level of efficient investments in infrastructure, capital goods and R&D slow their productivity gains. Their cities and infrastructures become older and less efficient than those in the two earlier stages. Their balance of payments positions deteriorate, reflecting their reduced competitiveness. They increasingly rely on their reputations rather than on their competitiveness to fund their deficits. They typically spend a lot of money on the military at this stage, sometimes very large amounts because of wars, in order to protect their global interests. Often, though not always, at the advanced stages of this phase, countries run “twin deficits” – i.e., both balance of payments and government deficits.

5) In the last stage of the cycle they typically go through deleveraging and relative decline, which they are slow to accept.
After bubbles burst and when deleveragings occur, private debt growth, private sector spending, asset values and net worths decline in a self-reinforcing negative cycle. To compensate, government debt growth, government deficits and central bank “printing” of money typically increase. In this way, their central banks and central governments cut real interest rates and increase nominal GDP growth so that it is comfortably above nominal interest rates in order to ease debt burdens. As a result of these low real interest rates, weak currencies and poor economic conditions, their debt and equity assets are poor performing and increasingly these countries have to compete with less expensive countries that are in the earlier stages of development. Their currencies depreciate and they like it. As an extension of these economic and financial trends, countries in this stage see their power in the world decline.

Which stage would you say the US and the rest of the developed markets are in?

Understanding these large secular dynamics is essential to fully grasping the interesting economic times we now find ourselves in.




Spread Thin — How The Fed Manipulates Financial Spreads

“The Fed is manipulating markets…”

“Central Banks are destroying capitalism…”

“Yellen has distorted true price discov… yada-yada-yada”

We’ve all heard the constant chorus of central bank bashing. The ridicule comes from a diverse crowd, ranging from retail Joe Schmoes to prominent hedge fund managers… and I admit, Fed economists make for easy targets. Read more

Who’s Buying And Why? — The Transactions Approach

Theory turns toxic when institutionalized.

Need an example?

Just look at modern economics.

Economists surround themselves with models that are supposed to predict everything from inflation growth to GDP.

But do they work?

Eh… not usually. Read more