Ray Dalio: The huge dangers of huge bubbles and wealth disparity

Author:Ray Dalio

While I am still an active investor with a passion for investing, at this stage in my life I am also a teacher, trying to teach others what I have learned about how reality works and the principles that have helped me deal with it.Since I have been involved in global macro investing for over 50 years and have learned many lessons from history, what I teach is naturally relevant.

The content of this article will cover:

The most important difference between wealth and money, and
How this distinction drives bubbles and crashes, and
How this dynamic, when accompanied by huge wealth disparities, punctures bubbles, leads to collapses that are devastating not only on a financial level, but also on a social and political level.

It is important to understand the difference between wealth and money and the relationship between them, most importantly: 1) how bubbles arise when financial wealth becomes very large relative to the amount of money and 2) how bubbles burst when the need for money leads to the sale of wealth to obtain money.

This very basic, easy-to-understand concept of how things work is not widely understood, but it has helped me a lot in my investing career.

The main principles to master are:

Financial wealth can be created very easily, but this does not represent its true value;
Financial wealth only has value if it is converted into money available for consumption;
Converting financial wealth into money that can be spent requires selling it (or collecting its proceeds), which often causes bubbles to burst.

About “Financial wealth can be created very easily, but this does not represent its true value” argument, for example, today if a founder of a startup sells a stake in the company—let’s say it’s worth $50 million—and values the company at $1 billion, that seller becomes a billionaire.This is because the company is valued at $1 billion, when in fact the company’s actual wealth is nowhere near $1 billion.Likewise, if a buyer of a public company buys a small number of shares from a seller at a specific price, all the shares will be valued at that price, so by valuing all the shares, the total amount of wealth owned by the company can be determined.Of course, the actual value of these companies may not be as high as these valuations, since the value of the assets depends on the price at which they are sold.

About “Financial wealth is essentially worthless unless converted into money” This is because wealth cannot be spent, but money can.

The third principle applies when wealth is very large relative to the amount of money, and the person who owns the wealth needs to sell the wealth to obtain the money: “Converting financial wealth into money that can be spent requires selling it (or collecting its proceeds), which usually causes a bubble to burst.“

If you understand these things, you can understand how bubbles are created and how they burst, which will help you predict and respond to bubbles and crashes.

It’s also important to note that while both money and credit can be used to buy things, a) money is the means by which transactions are ultimately settled, while credit creates debt that requires raising funds in the future to repay the transaction; b) credit is easy to create, while money can only be created by a central bank.People may think that money is needed to buy things, but this is not entirely true because people can also buy things with credit, and credit creates debt that needs to be repaid.Bubbles often result from this.

Now, let’s look at an example.

While all bubbles and crashes throughout history work essentially the same way, I will use the 1927-1929 bubble and the 1929-1933 crash as examples.If you think in terms of mechanisms about how the bubble of the late 1920s, the crash of 1929-1933, and the Great Depression occurred, and the steps President Roosevelt took to mitigate the crash in March 1933, you can see how the principles I just described work.

What funds drove the stock market to soar and eventually formed a bubble?And where does the formation of bubbles come from?Common sense tells us that if the money supply is limited and everything must be purchased with money, then buying anything means diverting money from something else.As a result of the sell-off, the price of appropriated merchandise may fall while the price of purchased merchandise may rise.However, then (for example, in the late 1970s) and now, it was not money but credit that drove the stock market boom.Credit is created without money and used to buy stocks and other assets that make up the bubble.The mechanism at that time, and the most classic one, was this: people created and borrowed credit to buy stocks, thereby creating debt, which had to be repaid.When the money needed to repay debt exceeds the money generated by stocks, financial assets have to be sold off, causing prices to fall.The bubble formation process in turn causes the bubble to burst.

The general principle behind these dynamic factors driving bubbles and crashes is:

A bubble forms when the purchase of financial assets is funded by a massive credit expansion and the total amount of wealth rises significantly relative to the total amount of money (i.e., there is far more wealth than money); and a crash occurs when wealth needs to be sold to obtain funds..For example, between 1929 and 1933, stocks and other assets had to be sold to pay off the debt used to buy them, and the bubble dynamics reversed course and became a crash.Naturally, the more you borrow and buy stocks, the better the stocks perform and the more people want to buy them.These buyers don’t have to sell anything to buy the stock because they can buy it on credit.As credit purchases increase, credit tightens and interest rates rise, both because of strong demand for borrowing and because the Fed allows interest rates to rise (i.e., tightens monetary policy).When the borrowed money needs to be repaid, stocks must be sold to raise funds to repay the debt, so prices fall, debt defaults occur, the value of collateral decreases, the supply of credit decreases, and the bubble turns into a self-reinforcing crash, followed by a depression.

To explore how this dynamic, which comes with a huge gap between rich and poor, could puncture a bubble and lead to a crash that could wreak havoc in society, politics, and finance, I examined the chart below.This graph shows the past and present wealth/money gap, as well as the ratio of total stock market capitalization to total money.

The next two charts show how this metric predicts nominal and real returns over the next 10 years.The charts speak for themselves.

When I hear someone try to assess whether a stock or stock market is in a bubble by determining whether the company will ultimately be profitable enough to support its current stock price, I often get the impression that they simply don’t understand how bubbles work.Long-term returns on investments are important, but they are not the main reason why the bubble bursts.Bubbles don’t burst because people wake up one morning and suddenly realize that the company’s future revenue and profits won’t be enough to support the current stock price.After all, it often takes many years, even decades, to see whether you can generate enough revenue and profits to support a good return on investment.The principles we need to remember are:

Bubbles burst because inflows into assets begin to dry up and holders of stocks or other wealth assets need to sell their assets for currency for some purpose (most commonly repaying debt).

What usually happens next?

After a bubble bursts, when money and credit are insufficient to meet the needs of financial asset holders, markets and economies decline, and internal social and political unrest often intensifies.This is especially true if there is a large gap between rich and poor, as this can exacerbate divisions and anger between the rich/right and the poor/left.In the 1927–1933 case we examine, this dynamic triggered the Great Depression, which in turn led to serious internal conflicts, especially between the rich/right and the poor/left.This dynamic ultimately led to the ouster of President Hoover and the election of President Roosevelt.

Naturally, when the bubble bursts and markets and economies tanked, it brought with it huge political changes, huge fiscal deficits, and massive debt monetization.In the case of 1927-1933, market and economic downturns occurred in 1929-1932 and political changes occurred in 1932. These factors caused President Roosevelt’s administration to run a large budget deficit in 1933.

His central bank printed money in large quantities, causing the currency to lose value (relative to gold, for example).This devaluation alleviates currency shortages and: a) helps systemically important debtors who are overwhelmed by their debt repay their debt; b) pushes up asset prices; c) stimulates the economy.Leaders who come to power during such periods also typically make many shocking fiscal reforms that I cannot explain in detail here, but I am certain that these periods often lead to great conflicts and huge transfers of wealth.In Roosevelt’s case, these conditions led to a series of major fiscal policy reforms designed to transfer wealth from the top to the bottom (e.g., raising the top marginal income tax rate from 25 percent in the 1920s to 79 percent, significantly increasing estate and gift taxes, and significantly increasing social welfare programs and subsidies).This has also led to huge conflicts within and between countries.

This is a typical dynamic.Throughout history, this situation has recurred in countless countries and over many years, forcing countless leaders and countless central banks to respond again and again, in cases too numerous to list here.Incidentally, before 1913, the United States had no central bank and the government did not have the power to print money, so bank defaults and deflationary depressions were more common.In either case, bond holders will suffer losses while gold holders will profit handsomely.

While the 1927-1933 example is a good example of a classic bubble burst cycle, that event was also somewhat extreme.The same dynamics were evident in the actions taken by President Nixon and the Federal Reserve in 1971 that led to nearly every other bubble and crash (e.g., the Japanese financial crisis of 1989-1990, the dot-com bubble of 2000, etc.).There are many other typical characteristics of these bubbles and crashes (for example, the market is extremely popular among inexperienced investors who get caught up in the hype, buy with leverage, lose huge amounts of money, and then get angry).

This dynamic pattern (i.e. demand for money is greater than supply) has been true for the past thousands of years.People have to sell their wealth to obtain currency, bubbles burst, and with them defaults, currency issuance, and bad economic, social, and political consequences.In other words, the imbalance between financial wealth and the amount of money, and the conversion of financial wealth (especially debt assets) into money, has been a source of runs on banks, whether private banks or government-controlled central banks.These runs either led to defaults (which mostly occurred before the Fed was created) or prompted central banks to create money and credit to institutions that were too critical to fail to ensure that they could repay their loans and avoid bankruptcy.

So please keep this in mind:

When the size of the certificate that promises to deliver money (i.e., the debt asset) is much larger than the total amount of existing funds, and financial assets need to be sold to obtain funds, it is important to be alert to the bursting of the bubble and ensure that you are protected (for example, avoid taking on excessive credit risks and hold a certain amount of gold).If this happens during a period of large wealth disparities, you need to pay close attention to the potential for significant political and wealth redistribution changes and make sure you are prepared to deal with them.

While rising interest rates and tight credit are the most common reasons for people selling assets to obtain needed funds, any reason for a need for funds, such as wealth taxes, as well as the sale of financial wealth to obtain funds, can contribute to this dynamic.

When a large wealth/currency gap coexists with a large wealth gap, it should be considered an extremely dangerous situation.

From the 1920s to the present

(You can skip this section if you don’t want to read a brief recap of how we got from the 1920s to the present.)

While I’ve mentioned before how the bubble of the 1920s led to the Crash and Great Depression of 1929-1933, to quickly recap, the bursting of this bubble and the resulting Great Depression led to President Roosevelt in 1933 reneging on the U.S. government’s promise to deliver then-hard currency (gold) at the promised price.The government printed a lot of money and the price of gold rose by about 70%.I will skip over how the reflation of 1933-1938 led to the deflation of 1938; how the “recession” of 1938-1939 created the economic and leadership factors that combined with the geopolitical dynamics of the rise of Germany and Japan to challenge the two great powers of Britain and the United States led to World War II; and how the classic “great cycle” took us from 1939 to 1945years (the old monetary, political and geopolitical order collapses and a new one is established).

I won’t go into the reasons why, but it’s important to point out that these factors led to the United States becoming extremely wealthy (the United States controlled two-thirds of the world’s currency at the time, and that currency was gold) and powerful (the United States generated half of the world’s GDP and was the military dominant force at the time).So when the Bretton Woods system established a new monetary order, it was still based on gold, with the U.S. dollar pegged to gold (other countries could use the dollars they received to buy gold at $35 an ounce), and other countries’ currencies pegged to gold.Then, between 1944 and 1971, the U.S. government spent far more than it collected in taxes, so it borrowed heavily and sold that debt, creating claims on gold that far exceeded the central bank’s gold reserves.Seeing this, other countries began to exchange their banknotes for gold.This led to an extreme tightening of money and credit, so President Nixon in 1971 followed President Roosevelt’s lead in 1933 and once again devalued fiat currencies relative to gold, causing gold prices to surge.Simply put, since then to the present day, a) government debt and debt-servicing costs have risen sharply relative to the tax revenue needed to service government debt (especially in the 2008-2012 period following the 2008 global financial crisis and the 2020 COVID-19 financial crisis); b) income and wealth gaps have widened to the extent they are today, creating irreconcilable political differences; c)There can be bubbles in the stock market, fueled by speculation in new technologies, underpinned by credit, debt and innovation.

The chart below shows the income share of the top 10% relative to the bottom 90% – you can see that the gap is now quite large.

where we are now

The United States, and all other over-leveraged democratic governments, are now faced with the dilemma that a) they cannot increase debt as much as before; b) they cannot raise taxes significantly; and c) they cannot cut spending significantly to avoid running deficits and increasing debt.They are now in a dilemma.

Explain it in more detail:

They cannot borrow enough money because there is no longer enough free market demand for their debt.(This is because they are already heavily indebted and their debt holders already hold too much debt.) In addition, debt asset holders in other countries, such as China, are worried that a war conflict may prevent them from collecting their debts, so they are buying fewer bonds and shifting their debt assets to gold.

They can’t raise taxes because if they raise taxes on the top 1-10% (who own most of the wealth), a) these people will leave, taking their tax dollars with them, or b) politicians will lose the support of the top 1-10% (which is crucial to funding expensive campaigns), or c) they’ll pop the bubble.

Nor can they make deep cuts in spending and benefits because that would be politically and even morally unacceptable, especially since such cuts would disproportionately hurt the bottom 60 percent…

So they are trapped.

Because of this, all governments in democracies with high debts, huge wealth gaps, and deeply divided values are in trouble.

Given these circumstances, as well as the workings of democratic political systems and human nature, politicians who promise quick fixes fail to deliver satisfactory results and are quickly ousted and replaced by a new generation of politicians who also promise quick fixes, fail and are replaced again, and so on.That’s why Britain and France, two countries with systems for rapid leadership change, have each had four prime ministers in the past five years.

In other words, we are now seeing a classic pattern typical of this phase of the great cycle.This dynamic is extremely important and should be obvious by now.

At the same time, the stock market and wealth boom are highly concentrated in top AI-related stocks (e.g., the “Magnificent 7”) and in the hands of a handful of ultra-rich individuals, while AI is replacing humans, exacerbating the wealth/currency gap and the wealth gap between people.This dynamic has occurred many times in history, and I think it is highly likely to trigger a strong political and social backlash that will at least significantly change the distribution of wealth, and in the most severe cases may even lead to serious social and political unrest.

Now let’s look at how this dynamic and large wealth gaps combine to create problems for monetary policy, and how wealth taxes can puncture bubbles and trigger crashes.

What the data looks like

Now I will compare the top 10% in wealth and income to the bottom 60% in wealth and income.I chose the bottom 60% because they make up the majority.

In short:

The wealthiest people (top 1-10%) own far more wealth, income, and stocks than the majority (bottom 60%).
The richest people derive much of their wealth from asset appreciation, which is not taxed until the wealth is sold (unlike income, which is taxed when earned).
As artificial intelligence booms, these gaps are widening, and likely to widen at an even faster rate.
If wealth were taxed, assets would need to be sold to pay the tax, which could burst the bubble directly.

More specifically:

In the United States, the top 10 percent of households are the most well-educated and economically productive households, accounting for about 50 percent of income, owning about two-thirds of total wealth, holding about 90 percent of stocks, and paying about two-thirds of federal income taxes, and these numbers are growing rapidly.In other words, they live a good life and make great contributions.

In contrast, the bottom 60 percent of the population is less educated (for example, 60 percent of Americans read below a sixth-grade level) and has relatively low economic productivity. They earn only about 30 percent of the nation’s total income, own only about 5 percent of total wealth, hold only about 5 percent of total stocks, and pay less than 5 percent of total federal taxes.Their wealth and economic prospects are relatively stagnant, and thus they are struggling financially.

Naturally, there is tremendous pressure to tax and redistribute wealth and money from the richest 10% to the poorest 60%.

Although the United States has never had a wealth tax, there is now strong clamor for one at both the state and federal levels.Why was there no wealth tax before, but now it is?Because the money is concentrated among them – that is to say, the top people mainly get rich through asset appreciation, rather than through labor income, and the appreciation part is currently not taxed.

There are three major problems with wealth tax:

Rich people can immigrate. Once they immigrate, they take their talents, productivity, income, wealth and tax-paying ability with them. The place they leave will all decrease, while the place they move in will all increase;
They are difficult to implement (for reasons you probably know, but I won’t go into details because this article is already too long);
It is extremely unrealistic to take away funds used for investment and productivity improvement and give them to the government, hoping that the government can use them efficiently so that the bottom 60% of people become productive and prosperous.

For these reasons, I would prefer an acceptable tax rate (e.g. 5-10%) on unrealized capital gains.But that’s another topic for another time.

So how exactly would a wealth tax work?

I will explore this issue more fully in a subsequent article.In short, the U.S. household balance sheet shows total wealth of about $150 trillion, but less than $5 trillion of that in cash or savings.Therefore, an annual wealth tax of 1-2% would require cash reserves in excess of $1-2 trillion per year – and the actual size of the liquid cash pool would be much smaller than that.

Anything like that would pop the bubble and cause the economy to collapse.Of course, a wealth tax would not be levied on everyone, but only on the wealthy.This article is long enough, so I won’t go into specific numbers.In short, a wealth tax would: 1) trigger forced sell-offs in private and public equity, driving down valuations; 2) increase demand for credit, potentially driving up borrowing costs for wealthy people and the market as a whole; and 3) prompt an outflow or transfer of wealth to more friendly jurisdictions.These pressures will be even more pronounced if governments impose wealth taxes on unrealized gains or illiquid assets such as private equity, venture capital, or even concentratedly held listed equities.