Fixing a Deflation: A Most Intelligent Analysis

I have reprinted in total an interview between fund manager Ray Dalio and Barrons.
This is the most detailed and well-thought-out description of what is a deflation and
how it is repaired that I have seen. It echoes my thoughts and commentary almost
verbatim, but with a lot more detail and credibility. Read on to understand what is
happening and how we get out. I will put my commentary in brackets[]:

http://online.barrons.com/article/SB123396545910358867.html?page=2&page;=sp

SATURDAY, FEBRUARY 7, 2009 INTERVIEW

Recession? No, It's a D-process, and It Will Be Long

Ray Dalio, Chief Investment Officer,

Bridgewater Associates

By SANDRA WARD

AN INTERVIEW WITH RAY DALIO: This pro sees a long and painful
depression.

NOBODY WAS BETTER PREPARED FOR THE GLOBAL market

crash than clients of Ray Dalio's Bridgewater Associates and
subscribers to its Daily Observations. Dalio, the chief investment
officer and all-around guiding light of the global money-management
company he founded more than 30 years ago, began sounding alarms
in Barron's in the spring of 2007 about the dangers of excessive
financial leverage. He counts among his clients world governments
and central banks, as well as pension funds and endowments.

"The regulators have to decide how banks will operate. That means
they are going to have to nationalize some in some form." No
wonder. The Westport, Conn.-based firm, whose analyses of world
markets focus on credit and currencies, has produced long-term
annual returns, net of fees, averaging 15%.

In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7%

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net of fees and Pure Alpha 2 delivered 9.4%. Here's what's on his
mind now.

Barron's: I can't think of anyone who was earlier in describing the

deleveraging and deflationary process that has been happening
around the world.

Dalio: Let's call it a "D-process," which is different than a recession,

and the only reason that people really don't understand this process is
because it happens rarely. Everybody should, at this point, try to
understand the depression process by reading about the Great
Depression or the Latin American debt crisis or the Japanese
experience so that it becomes part of their frame of reference. Most
people didn't live through any of those experiences, and what they
have gotten used to is the recession dynamic, and so they are quick to
presume the recession dynamic. It is very clear to me that we are in a
D-process.

Why are you hesitant to emphasize either the words depression or

deflation? Why call it a D-process?

Both of those words have connotations associated with them that can
confuse the fact that it is a process that people should try to
understand.

You can describe a recession as an economic retraction which occurs

when the Federal Reserve tightens monetary policy normally to fight
inflation. The cycle continues until the economy weakens enough to
bring down the inflation rate, at which time the Federal Reserve eases
monetary policy and produces an expansion. We can make it more
complicated, but that is a basic simple description of what recessions
are and what we have experienced through the post-World War II
period. What you also need is a comparable understanding of what a
D-process is and why it is different.

You have made the point that only by understanding the process can
you combat the problem. Are you confident that we are doing what's

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essential to combat deflation and a depression?

The D-process is a disease of sorts that is going to run its course.

When I first started seeing the D-process and describing it, it was
before it actually started to play out this way. But now you can ask
yourself, OK, when was the last time bank stocks went down so much?
When was the last time the balance sheet of the Federal Reserve, or
any central bank, exploded like it has? When was the last time interest
rates went to zero, essentially, making monetary policy as we know it
ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S.
post-World War II experience. This was the dynamic that occurred in
Japan in the '90s, that occurred in Latin America in the '80s, and that
occurred in the Great Depression in the '30s. Basically what happens
is that after a period of time, economies go through a long-term debt
cycle -- a dynamic that is self-reinforcing, in which people finance their
spending by borrowing and debts rise relative to incomes and, more
accurately, debt-service payments rise relative to incomes. At cycle
peaks, assets are bought on leverage at high-enough prices that the
cash flows they produce aren't adequate to service the debt. The
incomes aren't adequate to service the debt.

Then begins the reversal process, and that becomes self-reinforcing,

too. In the simplest sense, the country reaches the point when it needs
a debt restructuring. General Motors is a metaphor for the United
States.

As goes GM, so goes the nation?

The process of bankruptcy or restructuring is necessary to its viability.

One way or another, General Motors has to be restructured so that it is
a self-sustaining, economically viable entity that people want to lend to
again.

This has happened in Latin America regularly. Emerging countries

default, and then restructure. It is an essential process to get them

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economically healthy.

We will go through a giant debt-restructuring, because we either have

to bring debt-service payments down so they are low relative to
incomes -- the cash flows that are being produced to service them -- or
we are going to have to raise incomes by printing a lot of money
[Exactly, but keep reading, the story gets even better].

It isn't complicated. It is the same as all bankruptcies, but when it

happens pervasively to a country, and the country has a lot of foreign
debt denominated in its own currency, it is preferable to print money
and devalue.

Isn't the process of restructuring under way in households

and at corporations?

They are cutting costs to service the debt. But they haven't yet done
much restructuring. Last year, 2008, was the year of price declines;
2009 and 2010 will be the years of bankruptcies and restructurings.
Loans will be written down and assets will be sold. It will be a very
difficult time. It is going to surprise a lot of people because many
people figure it is bad but still expect, as in all past post-World War II
periods, we will come out of it OK. A lot of difficult questions will be
asked of policy makers. The government decision-making mechanism
is going to be tested, because different people will have different points
of view about what should be done.

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What are you suggesting?

An example is the Federal Reserve, which has always been an

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autonomous institution with the freedom to act as it sees fit. Rep.
Barney Frank [a Massachusetts Democrat and chairman of the House
Financial Services Committee] is talking about examining the authority
of the Federal Reserve, and that raises the specter of the government
and Congress trying to run the Federal Reserve. Everybody will be
second-guessing everybody else.

So where do things stand in the process of restructuring?

What the Federal Reserve has done and what the Treasury has done,
by and large, is to take an existing debt and say they will own it or lend
against it. But they haven't said they are going to write down the debt
and cut debt payments each month. There has been little in the way of
debt relief yet. Very, very few actual mortgages have been
restructured. Very little corporate debt has been restructured.

The Federal Reserve, in particular, has done a number of successful

things. The Federal Reserve went out and bought or lent against a lot
of the debt. That has had the effect of reducing the risk of that debt
defaulting, so that is good in a sense. And because the risk of default
has gone down, it has forced the interest rate on the debt to go down,
and that is good, too.

However, the reason it hasn't actually produced increased credit

activity is because the debtors are still too indebted and not able to
properly service the debt. Only when those debts are actually written
down will we get to the point where we will have credit growth.

There is a mortgage debt piece that will need to be restructured. There

is a giant financial-sector piece -- banks and investment banks and
whatever is left of the financial sector -- that will need to be
restructured. There is a corporate piece that will need to be
restructured, and then there is a commercial-real-estate piece that will
need to be restructured.

Is a restructuring of the banks a starting point?

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If you think that restructuring the banks is going to get lending going
again and you don't restructure the other pieces -- the mortgage piece,
the corporate piece, the real-estate piece -- you are wrong, because
they need financially sound entities to lend to, and that won't happen
until there are restructurings.

On the issue of the banks, ultimately we need banks because to

produce credit we have to have banks. A lot of the banks aren't going
to have money, and yet we can't just let them go to nothing; we have
got to do something. But the future of banking is going to be very, very
different. The regulators have to decide how banks will operate.

That means they will have to nationalize some in some form, but they
are going to also have to decide who they protect: the bondholders or
the depositors?

Nationalization is the most likely outcome?

There will be substantial nationalization of banks. It is going on now

and it will continue. But the same question will be asked even after
nationalization: What will happen to the pile of bad stuff?

Let's say we are going to end up with the good-bank/bad-bank

concept. The government is going to put a lot of money in -- say $100
billion -- and going to get all the garbage at a leverage of, let's say, 10
to 1. They will have a trillion dollars, but a trillion dollars' worth of
garbage. They still aren't marking it down.

Does this give you comfort?

Then we have the remaining banks, many of which will be broke. The
government will have to recapitalize them. The government will try to
seek private money to go in with them, but I don't think they are going
to come up with a lot of private money, not nearly the amount needed.

To the extent we are going to have nationalized banks [Citi, BAC for
sure, as I have maintained; they are already Fed controlled, if not
completely nationalized], we will still have the question of how those
banks behave. Does Congress say what they should do? Does

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Congress demand they lend to bad borrowers? There is a reason they
aren't lending.

So whose money is it, and who is protecting that money?

The biggest issue is that if you look at the borrowers, you don't want to
lend to them. The basic problem is that the borrowers had too much
debt when their incomes were higher and their asset values were
higher. Now net worths have gone down.

Let me give you an example. Roughly speaking, most of commercial

real estate and a good deal of private equity was bought on leverage
of 3-to-1. Most of it is down by more than one-third, so therefore they
have negative net worth. Most of them couldn't service their debt when
the cash flows were up, and now the cash flows are a lot lower.

If you shouldn't have lent to them before, how can you possibly lend to
them now?

I guess I'm thinking of the examples of people and businesses with

solid credit records who can't get banks to lend to them. Those
examples exist, but they aren't, by and large, the big picture. There are
too many non-viable entities. Big pieces of the economy have to
become somehow more viable. This isn't primarily about a lack of
liquidity. There are certainly elements of that, but this is basically a
structural issue. The '30s were very similar to this.

By the way, in the bear market from 1929 to the bottom, stocks
declined 89%, [note: in 1929 the DJI stocks were very extended and
had the same kind of PEs as 2000. When stocks tanked in 2008, the
PEs were much lower because the air was already let out of the stock
market, so we will not need to see a DJI of 1400 before this is over.
We probably already has seen the DJI low] with six rallies of returns of
more than 20% -- and most of them produced renewed optimism. But
what happened was that the economy continued to weaken with the
debt problem. The Hoover administration had the equivalent of today's
TARP [Troubled Asset Relief Program] in the Reconstruction Finance

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Corp. The stimulus program and tax cuts created more spending, and
the budget deficit increased.

At the same time, countries around the world encountered a similar

kind of thing. England went through then exactly what it is going
through now. Just as now, countries couldn't get dollars because of the
slowdown in exports, and there was a dollar shortage, as there is now.
Efforts were directed at rekindling lending. But they did not rekindle
lending. Eventually there were a lot of bankruptcies, which
extinguished debt.

In the U.S., a Democratic administration replaced a Republican one

and there was a major devaluation and reflation that marked the
bottom of the Depression in March 1933. [The timing of the change in
Presidents is remarkable in its similarity. The market decline and
recession started in 1930 and two years later, there was an election.
This time, the housing market peaked in 2006 and two years later,
there was an election. I think we are in early 1933 if we use the Great
Depression as our reference. That was a great time to get long the
stock market]

Where is the U.S. and the rest of the world going to keep getting
money to pay for these stimulus packages?

The Federal Reserve is going to have to print money [my blog friends
who fear the printing press need to pay attention here. This point is
why I discount

what I hear from Marc Faber, Jim Rogers and Peter Schiff. They don't
know their history]. The deficits will be greater than the savings. So
you will see the Federal Reserve buy long-term Treasury bonds, as it
did in the Great Depression [this answers the question about who will
lend us the money to back the printing press]. We are in a position
where that will eventually create a problem for currencies and drive
assets to gold [which, in this context, is okay. I am long gold, but I am
also long our economy].

Are you a fan of gold?

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Yes.

Have you always been?

No. Gold is horrible sometimes and great other times [because its only
value is as an alternate currency or jewelry. Gold has NO inherent
value. It is an unproductive asset]. But like any other asset class,
everybody always should have a piece of it in their portfolio.

What about bonds? The conventional wisdom has it that bonds are the
most overbought and most dangerous asset class right now.

Everything is timing. You print a lot of money, and then you have
currency devaluation. The currency devaluation happens before bonds
fall. Not much in the way of inflation is produced, because what you
are doing actually is negating deflation. So, the first wave of currency
depreciation will be very much like England in 1992, with its currency
realignment, or the United States during the Great Depression, when
they printed money and devalued the dollar a lot. Gold went up a
whole lot and the bond market had a hiccup, and then long-term rates
continued to decline because people still needed safety and liquidity
[this is a point that changes my thinking a bit. I think in terms of either /
or; but Dalio makes the case for an overlap of the appreciation of both
asset classes].

While the dollar is bad, it doesn't mean necessarily that the bond
market is bad. I can easily imagine at some point I'm going to hate
bonds and want to be short bonds, but, for now, a portfolio that is a
mixture of Treasury bonds and gold is going to be a very good
portfolio, because I imagine gold could go up a whole lot and Treasury
bonds won't go down a whole lot, at first.

Ideally, creditor countries that don't have dollar-debt problems are the
place you want to be, like Japan. The Japanese economy will do
horribly, too, but they don't have the problems that we have -- and they
have surpluses. They can pull in their assets from abroad, which will
support their currency, because they will want to become defensive.

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Other currencies will decline in relationship to the yen and in
relationship to gold [hmmmm, I don't know if "less bad" is good enough
for me. I think Japan is in this with the rest of us; though recent
currency action supports Dalio's case here].

And China?

Now we have the delicate China question. That is a complicated,

touchy question. The reasons for China to hold dollar-denominated
assets no longer exist, for the most part. However, the desire to have a
weaker currency is everybody's desire in terms of stimulus.

China recognizes that the exchange-rate peg is not as important as it

was before, because the idea was to make its goods competitive in the
world. Ultimately, they are going to have to go to a domestic-based
economy. But they own too much in the way of dollar-denominated
assets to get out, and it isn't clear exactly where they would go if they
did get out. But they don't have to buy more. They are not going to
continue to want to double down.

From the U.S. point of view, we want a devaluation [YES!! this is the
point I always make: we must create inflation to get out of this problem,
thereby devaluing the dollar]. A devaluation gets your pricing in line.
When there is a deflationary environment, you want your currency to
go down. When you have a lot of foreign debt denominated in your
currency, you want to create relief by having your currency go down.
All major currency devaluations have triggered stock-market rallies
throughout the world; one of the best ways to trigger a stock-market
rally is to devalue your currency.

But there is a basic structural problem with China. Its per capita
income is less than 10% of ours. We have to get our prices in line, and
we are not going to do it by cutting our incomes to a level of Chinese
incomes.

And they are not going to do it by having their per capita incomes
coming in line with our per capita incomes. But they have to come
closer together. The Chinese currency and assets are too cheap in
dollar terms, so a devaluation of the dollar in relation to China's
currency is likely, and will be an important step to our reflation and will

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 make investments in China attractive. [this is a major thesis of mine,
and I own FXI, the China equity index fund and will buy more. This is
a long term phenomena that will last my lifetime. China will be the
major source of commodity demand for decades, so commodities are
a great investment here]

You mentioned, too, that inflation is not as big a worry for you as it is
for some. Could you elaborate?

A wave of currency devaluations and strong gold will serve to negate

deflationary pressures [YES!! another of my points: inflation cancels
deflation], bringing inflation to a low, positive number rather than
producing unacceptably high inflation [this is the point where Faber,
Rogers and Schiff are most wrong because they do not acknowledge
the role of cancellation of deflation] -- and that will last for as far as I
can see out, roughly about two years.

Given this outlook, what is your view on stocks?

Buying equities and taking on those risks in late 2009, or more likely
2010, will be a great move because equities will be much cheaper than
now. It is going to be a buying opportunity of the century.

Thanks, Ray

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