When Ray Dalio, founder of the world’s largest hedge fund, Bridgewater Associates, referred to a possible economic depression as he was being interviewed at the World Economic Forum at Davos, it does not mean what most people think it means.
Most of us think about recessions and depressions in a linear way. That is, a depression is a really, really bad recession featuring even higher levels of unemployment and lower overall levels of economic activity.
But for Mr. Dalio, recessions are kind of normal, business-cycle related economic events that regularly occur every 5-10 years or so. The economy begins to overheat, the Fed raises rates in response (the removal of the “punch bowl”), business activity slows perhaps a bit too much in response, and voila! A recession results.
Depressions on the other hand are secular or long term, occurring much less frequently. That’s because according to Mr. Dalio, it takes a long time (perhaps decades) to accumulate the excess levels of corporate and government debt that end up triggering this type of economic event. A depression is a condition where more debt cannot be added to the system and instead it must be reduced, or as we say, deleveraging must occur. A depression always threatens systemic solvency.
There are several hallmarks of a systemic deleveraging or depression if you will:
- Various asset classes begin to be sold (like oil and gas wells today for example)
- As a result of these widespread asset sales, prices decline
- Equity levels decline as a result
- This triggers more selling of assets
- Since there is less worthwhile collateral available credit levels contract
- Overall economic activity declines. In short, there isn’t enough cash flow being generated to service all the accumulated debt. As a result assets have to be sold, bankruptcies become more common.
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