The Psychology of Debt (According to Ray Dalio)

The thing that economists have noticed is that even during a recession, we tend to wind up a little more in debt at the bottom and top of each new cycle.  This Mr. Dalio attributes to the psychology of debt. We had rather borrow money and keep spending than we had pay down debt. The result of this is the long-term debt cycle.   While people are digging themselves into deeper and deeper holes, lenders (strangely) become more likely to loan them increasingly large sums of money.  This is another trick of psychology—because all of the debt-fuelled spending has the economy roaring, everybody assumes that everything is going great. You may have never thought about it that way, but lenders are people too.  People in general focus much more on what is happening right now than they do what happened in the past and what may happen in the distant future.

In the immediate past, incomes have gone up, and all of your stuff (houses, land, investments) is worth more now than ever.  Life seems pretty great. When people are borrowing and spending without end, we call it a bubble.  When the bubble bursts, we find that the spending and borrowing were in fact not without end.  There is always an end.

Even when we are in the middle of one of these credit cycles, we cannot see “the forest for the trees.”  Part of the problem is that during boom times, incomes rise about as fast as debts rise. This means that the ratio of income to debt—known as the debt burden—stays relatively constant.   The rising value of homes and investments increase people’s feelings of being wealthy, and bankers agree, lending them more money.  This would be great if the bubble was not artificially inflating those assets. When the bubble bursts, people find that they are “upside down” in their debt; banks find that their borrowers don’t have sufficient collateral anymore, and things start to go downhill in a big way.  When the debt burden gets big enough, the cycle goes into reverse—the economy begins deleveraging.

In a deleveraging, people cut spending, incomes start to fall, credit disappears, and asset prices start to drop.  Banks start to feel squeezed, and lending rules get very strict. Social tensions can start to rise, and people begin to blame the politicians—and every other group that is not like them—for the economic downturn.  If things keep going, borrowers are forced to sell assets to cover their debts. Assets will have declined in value, and investors will receive only a fraction of the previous value. Lower and lower prices create a panic in the markets, and stocks sell off and prices plummet.  Real estate values fall as well, and banks get into trouble. With no valuable assets to use as collateral, people have a hard time borrowing, and a hard time paying the bills. People start to feel poor.

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