When Everyone Cuts Spending at Once, Debt Gets Harder to Pay
Incomes fall faster than debts shrink, which is why cutting spending alone backfires.
Principles by Ray Dalio · How The Economic Machine Works by Ray DalioPaying down debt sounds simple: spend less. For one family, it works. For a whole economy doing it at the same time, it backfires.
That is the argument of Ray Dalio, the investor who lays out how the economy works as a machine driven by credit. His starting rule is blunt: "one person's spending is another person's income." As he puts it, "every dollar you spend, someone else earns."
Normally that connection helps economies grow. Borrowed money lets one person spend more, which becomes someone else's pay, which lets that next person borrow and spend more. The trouble starts after debts pile so high they cannot be eased by lowering interest rates. Then lenders stop lending and borrowers stop borrowing, and everyone tries to get out of debt the obvious way.
Dalio says there are four ways debt burdens come down: people, businesses, and governments cut spending, "debts are reduced through defaults and restructurings," meaning lenders agree to accept less or wait longer to be repaid, wealth is redistributed from the haves to the have-nots, and "the central bank prints new money." Usually, he says, cutting spending comes first.
But when households and firms stop borrowing and start repaying old loans, the burden does not shrink. Because spending is cut, incomes fall. In Dalio's words, "They fall faster than debts are repaid and the debt burden actually gets worse."
The squeeze spreads. With less demand, prices fall and pain spreads as businesses cut costs, jobs disappear, and unemployment rises. The belt tightening that was supposed to lighten the load makes the load heavier relative to what people earn.
That is why he argues that when "people, businesses, banks and even governments tighten their belts and cut their spending" at once, the debt burden gets worse. Paying down debt requires income to pay it with, and when everyone cuts at once, that income falls.
Questions people ask
If cutting spending makes debt worse, how does debt ever come down?
Dalio argues it takes a mix of four tools: spending cuts, defaults and restructurings, redistribution from wealthy to less wealthy, and newly printed money from the central bank. Printing can offset disappearing credit, while defaults wipe out debts that cannot be repaid. The goal is to keep incomes growing faster than the interest owed.
Why can't the central bank just cut interest rates to fix it?
In an ordinary recession, lower rates encourage borrowing and spending. In what Dalio calls a deleveraging, rates are already near zero and cannot go much lower. Borrowers are too burdened to want more loans, lenders are too scared to make them, and collateral has lost value, so cheap credit no longer restores spending.
What happens to lenders when borrowers default?
One borrower's debt is a lender's asset, so a default destroys that asset. If many borrowers fail at once, banks look shaky and depositors may rush to withdraw their cash. That fear can force bank failures, fire sales of assets, and a deeper contraction in lending.