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SATURDAY, FEBRUARY 7, 2009
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 along and painful depression.
NOBODY WAS BETTER PREPARED FOR THE GLOBAL
market crash than clients of Ray Dalio's Bridgewater Associates and subscribers toits Daily Observations. Dalio, the chief investment officer and all-around guiding light of the global money-management company he foundedmore than 30 years ago, began sounding alarms in
Barron's
in the spring of 2007 about the dangers of excessive financial leverage. Hecounts among his clients world governments and central banks, as well as pension funds and endowments.No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus oncredit and currencies, has produced long-term annual returns, net of fees, averaging15%. In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of feesand 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 reasonthat people really don't understand this process is because it happens rarely. Everybodyshould, at this point, try to understand the depression process by reading about the GreatDepression or the Latin American debt crisis or the Japanese experience so that itbecomes part of their frame of reference. Most people didn't live through any of thoseexperiences, and what they have gotten used to is the recession dynamic, and so theyare 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 aD-process? 
Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try tounderstand.You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fightinflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve easesmonetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions areand what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-processis 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'sessential 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 centralbank, 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?
Matthew Furman for 
Barron's
 
"The regulators have to decide how banks will operate. Thatmeans they are going to have to nationalize some in someform."
-- Ray Dalio
 
Barron’s I
 NTERVIEW
 
 
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 inJapan 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, inwhich people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relativeto incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to servicethe debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In thesimplest 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 isa 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 themeconomically healthy.We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative toincomes -- 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.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 debtdenominated 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 verydifficult 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 IIperiods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism isgoing to be tested, because different people will have different points of view about what should be done.
What are you suggesting? 
An example is the Federal Reserve, which has always been an 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 FederalReserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessingeverybody 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 lendagainst 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 hasgone 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 properlyservice the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is amortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever isleft 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 acommercial-real-estate piece that will need to be restructured.
Is a restructuring of the banks a starting point? 
 
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 happenuntil 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 havemoney, 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 haveto 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 afternationalization: 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 toseek 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 amountneeded.To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say whatthey should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending. So whose money is it, and who isprotecting 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 muchdebt when their incomes were higher and their asset values were higher. Now net worths have gone down.
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