Ray Dalio: The Great Wealth Transfer Explained

Can't keep spending without bringing down inflation. So here's what I think: Ray Dalio is one of the greatest economic minds of all time. He is the founder of Bridgewater, the largest and arguably most prestigious hedge fund in the world. This spot at the pinnacle of finance gives Dalio an unparalleled view into the inner workings of the economy and the stock market, which is why I got my attention when recently he began talking about what he is calling the great wealth transfer.

He describes the so-called great wealth transfer as a once-in-a-century shift that will almost certainly have impacts for generations to come. Ray Dalio recently released an essay titled "What's Happening with the Economy: The Great Wealth Transfer," and here's what he had to say: "The economy clearly isn't reacting in the usual way to the Fed's tightening. It is much stronger than normal and stronger than expected. Why is that?"

There was a big government-engineered shift in wealth from the public sector—the central government and central bank—to holders of government bonds, to the private sector, i.e., households and businesses. This made the private sector relatively insensitive to the Fed's very rapid tightening to a more normal monetary policy. As a result of this coordinated government maneuver, the household sector's balance sheets and income statements are in good shape, while the governments are in bad shape.

In the U.S. and globally, the central government's balance sheets and income statements are bad and getting worse because the governments ran and are still running large deficits. Said more simply, central governments took on a lot more debt, so their balance sheets deteriorated. Central banks printed a lot more money, which caused inflation to rise and bought a lot of the debt to get money into the hands of the private sector, which as a result is now in relatively good shape financially.

In order to avoid a complete economic collapse, the U.S. government and Federal Reserve took truly unprecedented actions to support the economy, which included the Fed cutting interest rates to zero and the U.S. government stepping in to support businesses and households. These government programs took the form of direct cash payments to citizens, a.k.a. stimulus checks, as well as enhanced unemployment benefits and pausing certain debt payments.

These programs ultimately accomplished the goal of supporting the economy during a difficult time but definitely were not cheap. So here's an analogy to explain all of that: When investors are analyzing a stock, one of the first things they do is take a look at this thing called an income statement. An income statement shows a company's revenue. Think of this as the total dollar amount of sales that company made during a given period.

The income statement then shows the expenses the business incurred during that same time period. The difference between the company's revenue and expenses is its profit. Just like businesses, governments also have income statements, albeit with a few important differences. For a government, the revenue line doesn't come from sales of products; instead, it comes in the form of taxes paid by businesses and citizens. The higher the taxes, the more revenue for the government.

Moving down to the expenses section of the income statement, think of a government's expenses as anything it spends money on. The main expense categories for the U.S. government consist of pensions, Social Security, health care, defense, welfare, and a catch-all category called "other." For a business, if revenue is higher than expenses, that difference is called a profit. But for a government, it's called a surplus.

On the other hand, however, when a business has more expenses than revenue, it's called a loss. Governments call that a deficit. During 2020, government revenue remained relatively flat as the economy slowed and people and businesses earned less money, while at the same time, government expenses increased dramatically as a result of all the actions the government took to support the economy. These higher expenses far exceeded revenue, leaving the U.S. government with a large deficit.

As we can see here, the U.S. government deficit surged to a staggering $3.1 trillion in 2020 and $2.8 trillion in 2021. When a government doesn't have enough tax revenue to cover its expenses, it has to make up for that deficit by using debt, and this is exactly what happened in the United States. Here we have two balance sheets: one for the U.S. government and one for U.S. households.

On the left of each balance sheet is the assets. Think of this as things that people own. For households, that takes the form of cash sitting in a bank account, stocks, real estate, and anything else that can be sold for cash. On the right side of the balance sheet are liabilities, which is just a fancy way of essentially saying debt. The more assets there are relative to liabilities, the so-called stronger the balance sheet is.

In order to fund the large deficit, the U.S. government had to issue trillions of dollars of debt. This increased the liability side of the U.S. government's balance sheet, and this concept is visualized here in this chart of the total U.S. national debt. The U.S. national debt is $32 trillion, nearly 40% higher than where it ended in 2020. At the same time, the cash that the government generated from issuing that debt was sent out to households to stimulate the economy.

These payments increased the assets on U.S. households' balance sheets. As we can see here, both household assets and wealth are at an all-time high, which is exactly the wealth transfer Dalio is talking about. The U.S. government essentially transferred wealth from itself to the private sector by issuing trillions of dollars of debt and sending the proceeds to households and businesses. Put another way, the U.S. government weakened its own balance sheet in order to strengthen the balance sheet of households.

At first, this sounds very much like a good thing. The average American household net worth has never been higher, the economy is growing, wages are up, and unemployment is low. However, Dalio is warning that this wealth transfer will likely have serious long-term consequences. We are going to get into what he had to say in just a second, but first some quick background on Dalio and alternative asset classes.

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Now back to the video. Here's what Dalio had to say on the consequences of the wealth transfer he described: "Does it matter that the central governments and central banks have such bad balance sheets and income statements if the real economy is in pretty good shape? Of course it does. As with people and companies, governments that borrow have debt service payments and eventually have to pay back principal, which is painful. The only difference in their finances is that governments can confiscate wealth through taxes and print money via the central bank."

So that's what we should expect to happen. When a person is in too much debt and wants to pay it off, there are two main things they can do. They can either increase their income, which may take the form of finding a higher-paying job or doing some part-time work on the side. The other option to be able to pay down the debt is to cut expenses, doing things like getting a cheaper place to live, buying a less expensive car, or going out to eat less frequently.

The math behind a person paying back their debt is simple: they need to increase the money they have coming in and decrease the amount of money going out. That same exact logic applies to governments that have found themselves in too much debt and with a weak balance sheet. So let's go back to our example of the government's income statement from earlier.

If a government wants to stop adding to its debt and clean up its balance sheet, it needs to stop operating at a deficit, and this can be done in one of two ways: either increasing revenue or reducing expenses. There's just one massive problem: both of these options are extremely unpopular with the country's citizens. In order to increase government revenue, taxes on businesses and citizens have to be raised. To decrease expenses, government spending programs will have to be reduced.

While these actions are critical to the long-term success of a country, these hard choices will make the politicians that decide them very unpopular. And what do you call an unpopular politician? You call them unemployed. This dynamic is exactly why governments are highly incentivized to kick the proverbial can down the road. Instead of raising taxes or cutting spending, they can simply issue more debt to fund the deficit.

As Dalio explains, this too will eventually come back to haunt them. Here's what he had to say: "However, over the long term, from looking at history and penciling out what is likely, it is virtually certain that central governments' deficits will be large, and it is highly probable that they will grow at an increasing rate as the increasing debt service costs plus increasing other budget costs compound upward. As they increase, governments will need to sell more debt, so there will be a self-reinforcing debt spiral that will lead to market-imposed debt limits."

While central banks will be forced to print more money and buy more debt as they experience losses and deteriorating balance sheets, the concerning scenario that could occur if deficits compound so that there is more supply of government bonds than there is demand is that either interest rates will rise, or central banks will have to buy more to try to hold them down.

At first, this explanation by Dalio may sound complicated; however, the point he is making is simple, so let me explain using this chart here. This chart represents the supply and demand of money that can be loaned to the U.S. government. On this line here, we have the supply of money available to be loaned to the government. Think of this as the amount of money investors across the world are willing to spend to purchase government bonds.

This other line represents demand from the government for that money. The larger the government deficit, the higher the demand from the government to borrow money from investors to fill that gap with debt. The point at which these lines cross is the interest rate the U.S. government has to pay on its debt. As government debt increases—which is what happened as a result of the great wealth transfer Dalio described—our demand line gets pushed upward.

Notice how now the point at which our two lines cross is at a higher interest rate. Because of this mismatch between supply and demand, the U.S. government now has to pay a higher interest rate on its debt in order to get the money it needs. This is where the concept of a debt spiral comes into play. As government debt increases, the interest rate the government has to pay becomes higher, and this results in larger annual interest payments, which puts the government even further into debt, ultimately increasing the interest rate to borrow money yet again.

And so the cycle continues, just like a person that has fallen behind on large amounts of credit card debt. The government runs the risk of stumbling into a vicious debt cycle that it can't recover from. According to Dalio, there is only one thing a government can do when it finds itself in this situation: print money, in order to get the interest rate back down.

The concern is that the Federal Reserve will be forced to print money and use that newly printed money to buy government bonds. The newly printed money will increase the supply of money available to be loaned to the government, pushing our supply line out to the right. As we can see, this increased supply of money results in our lines crossing at a lower interest rate. While this solves one goal for the government, it opens up an entirely different can of worms.

Listen to Dalio explain it himself: "Unlike cutting spending, debt reduction, and wealth redistribution, printing money is inflationary and stimulative. Inevitably, the central bank prints new money out of thin air and uses it to buy financial assets and government bonds. It happened in the United States during the Great Depression and again in 2008 when the United States central bank, the Federal Reserve, printed over $2 trillion. Other central banks around the world that could printed a lot of money too."

By buying financial assets with this money, it helps drive up asset prices, which makes people more creditworthy. However, this only helps those who own financial assets. You see, the central bank can print money, but it can only buy financial assets. The central government, on the other hand, can buy goods and services and put money in the hands of the people, but it can't print money.

So in order to stimulate the economy, the two must cooperate by buying government bonds. The central bank essentially lends money to the government, allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits. This increases people's income as well as the government's debt; however, it will lower the economy's total debt burden.

This is a very risky time. Policymakers need to balance the four ways that debt burdens come down, the deflationary ways need to balance with the inflationary ways in order to maintain stability. If balanced correctly, there can be a beautiful deleveraging. There's a saying in economics that there is no such thing as a free lunch. What this means is that every economic decision comes with a set of trade-offs.

While this great wealth transfer Dalio described resulted in a booming economy, eventually the cost associated with those actions will have to be paid. Only time will tell, but it's worth listening to Ray Dalio because, let's just say, he knows a thing or two about what he's talking about.

So there we have it. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.