How Countries Go Broke

The vernacular that says companies “go broke” means they fail, become insolvent, default on debts, “go out of business,” “liquidate,” or declare bankruptcy to stay creditors and re-emerge in a sustainable form. What does it mean, however, for a country to “go broke?” How does it happen—and why? How does a nation that’s “going broke” affect creditors, companies, households, pension plans, or international relations? What about the impact on a country’s currency, economy, stock market, or credit markets? If “going broke” is a terrible thing for a country, can it be predicted or prevented?

Many of these questions are addressed intelligently in the latest book by Ray Dalio, famed investor, billionaire ($18 billion, per Forbes magazine), and founder (in 1975) of one of today’s largest hedge funds, Bridgewater Associates. Having accumulated decades of experience and wealth, Dalio now says he wants to share them publicly. As a philanthropist he has donated much to Connecticut’s failing public schools (but has not advised privatization); now he wishes to give to those who need (but can’t pay a lot for his valuable) investment advice. The timing of his new book is propitious, he says, because he believes the U.S. is in the fourth and final stage of a public debt “bust,” meaning that in the coming decade Americans will suffer from sky-high, double-digit interest rates and a sharp (30–50 percent) plunge in government bond prices. It’s a terrible but also perfectly avoidable result, he says, if the federal deficit is cut to 3 percent of GDP (it’s 6 percent at present). How? By a combination (he suggests) of federal spending cuts of 3 percent per year, tax revenue increases of 3 percent per year, and a cut (by the Federal Reserve) of 1 percentage point in “real interest rates” (so interest expense doesn’t become a large, growing share of total outlays). If only some of these three “levers” are pulled, he warns, the percentage changes will have to be more severe. If the lever is spending alone, it would have to be cut by 12 percent per annum (47 percent of “discretionary spending”). If the lever is tax revenues alone, they’d have to increase by 11 percent per annum (p. 358). Dalio concedes that even if his 3 percent–3 percent–1 percent policy mix is adopted, it would only “lead to the debt burden [debt/GDP ratio] being about 17 percent lower in ten years than it would be otherwise” (p. 337). That is, the U.S. debt/GDP ratio would drop from 100 percent to 87 percent (versus 33 percent in 2000). 

If history is a guide and debt risks are acknowledged yet American voters still prefer a large federal government devoted to domestic welfare and foreign warfare, Dalio’s dire outlook is more likely to occur, while his cure will not. U.S. outlays over the past century have increased by 8.1 percent per year, surpassing growth in tax revenues of 7.4 percent per year. The latter have declined in 21 percent of those years (amid recessions), while outlays have dropped in only 15 percent of them (including three years right after World War II). Dalio blames most of America’s current ills on capitalism and is a fan, not a foe, of big government, so he doesn’t address the root cause of burgeoning U.S. public debt. Gross federal debt (including inter-government holdings) has boomed from $483 billion (31 percent of GDP) in 1975 to $37 trillion (and 125 percent of GDP) today, due not to insufficient revenue growth but to ever-expanding outlays for Social Security, Medicare, Medicaid, and debt interest, which are deemed “non-discretionary.” This is profligacy on autopilot. Dalio knows that financial crises typically are blamed not on reckless public borrowers, who gain votes by pledging higher spending and lower taxes, but on “predatory lenders.”

Early in How Countries Go Broke, Dalio warns that he’s neither an economic theorist nor historian, but in the book’s nearly four hundred pages he cleverly illustrates decades of empirical data in dozens of colorful, helpful exhibits (roughly 200, or one every two pages), while providing big, sweeping accounts of how government bonds tend, he says, to transition from initial issuance to boom, then bust (default). Dalio says he finds patterns (“cycles”) that are so “timeless” (a dozen mentions, starting at p. 3) and “unfailingly” (p. 83) repetitive that they’re exploitable by those (like him) who know best when to buy, sell and short public bonds. As he puts it, “I discovered that there are big, long-term debt cycles that have unfailingly led to big debt bubbles and busts,” even finds the phenomenon “described in the Old Testament,” and tells of how it has “repeatedly played out in Chinese dynasties over thousands of years” (p. 3). It’s not clear why Dalio finds these relevant to his case studies, since sovereign public debt instruments didn’t arise until 1700 or so. Still, he believes that “time and again [debt cycles have] foreshadowed the fall of empires, countries, and provinces” (p. 3).

For Dalio, “Big Debt Cycles have always worked in timeless and universally consistent ways that are not well-understood but should be.” The “dynamic,” he says, “is not widely understood because big, long-term debt cycles typically last about one lifetime—roughly eighty years, give or take twenty-five years—so we don’t get to learn about them through experience” (p. 3). This measure seems at odds with his count of forty-eight debt cycles and crises since World War I (p. 4, n. 1). Are sovereign debt crises frequent, thus easily characterized and understood, or infrequent, thus easily missed and misunderstood? It’s unclear. Dalio believes his “Big Debt Cycle template is unconventional” (it isn’t) but he’s “confident that it exists because I’ve made a lot of money using it to bet on how things would go” (p. 3). Here it would have been a powerful demonstration had Dalio reported Bridgewater’s track record on sovereign bond management, so readers could learn the extent of its success and whether Dalio’s wealth reflects the truth of his debt cycle theory. The firm has managed equities, commodities, and other non-bond assets over the decades, so readers don’t get the real story.  

To his credit, Dalio doesn’t blithely theorize in the air but tries to support his analyses and conclusions with long-term data series and case studies of public debt booms and busts globally. It would have helped the serious reader to check and corroborate his work had he provided an index, or links to his debt data, or a bibliography of recent, important, foundational works, including Carmen M. Reinhart and Kenneth S. Rogoff’s This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009) and Richard M. Salsman’s The Political Economy of Public Debt: Three Centuries of Theory and Evidence (Elgar, 2017). The lengthy last chapter of the latter work (“The Limits of Public Debt”) relates directly to Dalio’s worthy quest. Both works document relevant, reliable metrics for judging why, how, and when prodigal states will default. 

In addition to collecting more anecdotal and episodic data on public debt and its relation to GDP, interest rates, inflation rates, and default rates, Dalio tries valiantly (on occasion, even successfully) to organize and structure it all conceptually, positing “cycles,” “orders,” “stages,” “forces,” and “players.” At times this approach helps, but too often it seems contrived and Hegelian. What Dalio sees, you may not. A devout cyclist, he variously discusses business cycles, “big debt cycles,” “small debt cycles,” “long-term debt cycles,” “short-term debt cycles,” “cycles of social and political order and disorder,” “peace and war cycles,” and even a “Big” (non-debt) Cycle” within which all the aforementioned cycles operate, while simultaneously (or with a lag?) “drive” the overarching cycle. All this cycling may help Dalio discern patterns, but it’s likely to make the usual reader’s head spin. 

In addition to his many cycles, Dalio contends that debt crises are driven by “five big forces,” including “acts-of-nature shocks such as droughts, floods, and pandemics” and even “human inventiveness, especially of new technologies that increase productivity” (p. 36). For Dalio, “the interactions between these forces drive how conditions change” and “tend to reinforce each other both upwardly and downwardly” (pp. 63–64). Now he has “forces” reinforcing and accelerating the speed of cycles. In addition, Dalio discusses what he calls the “three orders” (monetary, political-intranational, and geopolitical-international) which he says are controlled and transformed episodically by five main players: borrowers/debtors, lenders/creditors, banks, central governments, and central banks (p. 50). His heroic attempt to structure a vast public debt history is laudable but not fully plausible. There are so many moving parts in his “mechanism,” his debt grinder “machine,” that he can “explain” anything.  

Still, Dalio is a rarity, the thinking man’s money manager, and he knows enough about financial history and the company/country distinction to be precise about the meaning of a sovereign state “going broke.” It’s not “countries” (or nations) per se that “go broke” or default on public debt but specific governments issuing particular, eventually unserviceable bonds. To be sure, electorates in democratic nations can vote for and reward politicians for chronic budget deficits and debt accumulations, by demanding more spending and less taxing. Oddly, this isn’t Dalio’s focus, nor is it included in his models. States nevertheless choose to issue bonds and service them or not and the principle of sovereign immunity precludes lenders from suing states for non-payment. Moreover, although some states default in the traditional manner (not paying interest or principal when due), Dalio properly notes that this risk arises when a state borrows in currencies other than its own; those that borrow in their own money, like the U.S., can issue nearly unlimited debt and make its central bank “monetize” it (create more money to pay whatever debt service is required), albeit in money of lesser purchasing power (revealed as price inflation). Dalio is correct to call this a form of default. In fact, it’s implicit (not explicit), hence typically unrecognized by the public. He doesn’t stress how this tactic has been institutionalized over the past half century, with no national currency any longer on the gold standard. He also neglects to emphasize the most significant official defaults of the past century: the gold standard suspensions of 1931 (by Britain), 1933 (by Franklin Roosevelt, domestically), and 1971 (by Richard Nixon, internationally). This is odd, because absent these defaults (especially the last), states would have little room to become overindebted, or becoming so, to default continuously and surreptitiously by inflating. 

At times in the book Dalio seems sympathetic to “Modern Monetary Theory” (MMT), without naming it explicitly. He suggests that finance ministers may, for a time at least, borrow excessively without causing higher interest rates; likewise, central bankers may, for a time, issue money excessively without causing higher inflation rates. But (he surmises) if debt and money holders don’t bid up the relevant rates–which seems the case in recent history–perhaps there’s no “excessiveness” in fact. Dalio could identify (but doesn’t) what I’ve dubbed “the paradox of profligacy,” wherein the G-7 nations for four decades (1980–2020) enjoyed ever-lower bond yields amid ever-rising debt/GDP ratios. That too defies his mechanistic model, but since he prefers a state that needn’t rely so much on taxes, especially if it hurts the electoral prospects of “progressives,” he accepts the anomaly. Nowhere does he cite the strong empirical record of the Laffer Curve, which shows limits to how high tax rates can rise before reducing tax revenues; nor does he recognize Hauser’s Law, which identifies a relatively constant share of federal tax revenues as a share of GDP (19–20 percent) regardless of the height of tax rates. Taken together, Laffer and Hauser imply that nations like America, with a finite taxable capacity but an insatiable appetite for more state spending and subsidies, will necessarily become subject to default-prone rulers. 

Dalio is an interesting case, not only because most money managers aren’t as thoughtful about “the big picture” (while most academic debt theorists aren’t as market-tested), but because he’s alert to the patterns and possibilities of public debt crises even while endorsing the oversized, overspending governments that cause them. The real problem, he claims, is capitalism, the system that most people associate with limited government, fiscal conservatism, balanced budgets, modest levels of public debt, international peace, and a gold standard that precludes politicized money printing. Booms and busts Dalio attributes, conventionally, to the “greed and fear” of insufficiently restrained market actors. The better “version” of capitalism, he declares, has been practiced in China since 1978, what he calls “market-oriented, capitalism-infused communism” (p. 237). Dalio says he can “understand how [the Chinese] can find capitalism and individualism antithetical to their beliefs because they see both as selfishness that will fragment people and lead to disharmony and disorder.” This, he implies, is the moral (not merely emotional) root of boom-bust. Dalio believes “humanity has struggled with . . . the relative merits of capitalist self-interest and democracy” versus “communist common interest and dictatorship,” and “has swung back and forth between [these] for all recorded history.” All this swinging brings cycles. “The Chinese core values” are “more similar to the core values that Christianity espouses” and these “are quite different from those of capitalism when capitalism is taken to an extreme.” He hints that China’s hybrid system is less cyclical because of the communist part. He concedes that “capitalism has been a far more effective approach in producing prosperity, including broad-based prosperity,” but “that approach has tended to operate in the Big Cycle way that has produced the booms and busts that we are looking at comprehensively in this study” (p. 281, n. 46). There’s no mention of the biggest geopolitical-communist bust ever: the end of the U.S.S.R. in 1991. 

Given Dalio’s focus on public debt crises and nations “going broke,” it’s odd that he neglects to cite publicly available evidence that both the Federal Reserve and the U.S. federal government are insolvent. The value of their liabilities exceeds the value of their assets, the Fed by roughly $50 billion, the U.S. by $40 trillion. The two are related. The U.S. Treasury issues a cascade of liabilities (bonds) to help fund the burgeoning welfare-warfare state while the Fed, fearing insufficient demand for the bonds, buys (“monetizes”) more of them, which creates more money (its main liability), more inflation, and higher interest rates (which lowers the value of its main asset, the bonds). Nor does Dalio mention the growing phenomenon of fiscal repression—officials mandating the holding of public debt, to cap interest rates by creating artificial demand, not alone from central banks but from the private sector. 

On the whole, this is a fine performance and a worthwhile read. But I’m a public-debt wonk. Most normal folks aren’t. Still, many intelligent Americans care about their nation’s future, as does Dalio. Interested readers wishing to save $40 in preparation for the coming debt bust should know that Dalio’s latest book is an extension of Principles for Navigating Big Debt Crises, his 2018 effort, available gratis online, accompanied by high praise from the elite academics, Treasury heads, and Federal Reserve chiefs who’ve been most involved in recent debt booms and busts, including Larry Summers, Ben Bernanke, Hank Pauslon, and Tim Geithner. Although such high-powered endorsers don’t seem much bothered by Dalio’s critique of the profligate public finance they’ve practiced, readers might be.