Ray Dalio: The big bubble and the widening wealth gap are leading to greater dangers.

Author: Ray Dalio

Compiled by: Deep Tide TechFlow

Although I am still an active investor addicted to investment games, at this stage of my life, I also bear the role of a teacher, attempting to impart my understanding of how reality operates and the principles that help me face challenges. As a global macro investor, I have over 50 years of experience and have drawn many lessons from history, so most of what I share is naturally related to this.

This article mainly discusses the following points:

The important distinction between wealth and money;

How this distinction drives the formation and bursting of bubbles;

This dynamic, accompanied by a huge wealth gap, could burst the bubble, leading not only to a financial collapse but also potentially triggering severe social and political turmoil.

Understanding the difference between wealth and money and their relationship is crucial, especially in the following two points:

When the scale of financial wealth is much larger than the scale of currency, how does a bubble form?

How bubbles burst when the demand for currency leads to the selling of wealth to obtain currency.

This very basic and easy-to-understand concept about how things work is not widely recognized, but it has helped me a lot in my investment process.

The core principles that need to be understood include:

Financial wealth can be created very easily, but it doesn't truly represent its real value;

Financial wealth has no value in itself unless it is converted into currency that can be used for consumption;

Converting financial wealth into consumable currency requires selling it (or collecting its returns), which is often the key point where a bubble turns into a collapse.

Regarding “financial wealth can be created very easily, but it does not represent its true value”, for example, if the founder of a startup sells shares of the company valued at $50 million and values the company at $1 billion, then this founder becomes a billionaire.

This is because the company is considered to be worth 1 billion dollars, even though there is no actual support close to 1 billion dollars behind this wealth figure. Similarly, if a buyer of a publicly traded stock purchases a small amount of shares from a seller at a specific price, then all shares will be valued at that price. This valuation method can yield the total wealth that the company possesses. Of course, these companies may not actually be worth these valuations, as the value of assets ultimately depends on the price at which they can be sold.

Regarding “financial wealth is essentially worthless unless converted into currency,” the reason is that wealth cannot be consumed directly, whereas currency can.

When the scale of wealth far exceeds the scale of currency, and the wealthy need to sell their wealth in exchange for currency, the third principle is touched upon: “Converting financial wealth into consumable currency requires selling it (or taking its returns), and this is often the key to the transformation of a bubble into a collapse.”

If you understand these concepts, you will be able to comprehend how bubbles are formed and how they burst into crashes, which will help you predict and respond to bubbles and crashes.

It is equally important to understand that, although currency and credit can both be used to purchase goods, there are the following differences between them:

a) Currency can complete transactions, while credit incurs debt, which needs to be settled in the future by acquiring currency.

The creation of credit is relatively easy, while currency can only be created by central banks.

Although people may think that purchasing goods requires currency, this is not entirely correct, as goods can also be purchased through credit, which creates a debt that needs to be repaid. This is often the basis for the formation of bubbles.

Next, let's take a look at an example.

Although the way all historical bubbles and crashes have operated is fundamentally the same, I will use the bubble of 1927-1929 and the crash of 1929-1933 as examples. If you think about the bubble of the late 1920s, the crash of 1929-1933, and the Great Depression from a mechanistic perspective, as well as the actions taken by President Roosevelt in March 1933 to alleviate the crash, you will see how the principles I have just described come into play.

Where does bubble capital come from? How is a bubble formed?

So, where does all the money that drives the stock market up and ultimately creates bubbles come from? And what makes it a bubble?

Common sense tells us that if the existing money supply is limited and everything needs to be purchased with money, then buying something means that funds need to be withdrawn from somewhere else. The items from which funds are withdrawn may see their prices decrease due to being sold, while the prices of the items being purchased will increase.

However, in the late 1920s and now, it is not currency that drives the bubble, but credit. Credit can be created in the absence of money, used to purchase stocks and other assets, thus forming a bubble. The dynamic at that time—which is also the most classic dynamic—was that credit was created and borrowed to purchase stocks, leading to the accumulation of debt that needed to be repaid. When the money required for repayment exceeds the returns generated by the stocks, financial assets must be sold, leading to a drop in asset prices, and the dynamic of the bubble begins to reverse, ultimately forming the dynamic of collapse.

The fundamental principles driving these dynamic bubbles and crashes are:

When the purchase of financial assets is supported by a large amount of credit growth, and the total wealth continues to rise compared to the total money supply (wealth far exceeds money), a bubble will form. When wealth needs to be sold to exchange for money, it will lead to a collapse. For example, during the period from 1929 to 1933, stocks and other assets had to be sold to pay the interest on the debt used to purchase them, causing the dynamics of the bubble to begin to reverse.

Naturally, the more borrowing and purchasing of stocks there is, the better the stock performance will be, leading more people to want to buy stocks. These buyers do not need to sell other assets to complete the purchase, as they can buy stocks on credit. As this behavior increases, credit begins to tighten, and interest rates rise accordingly. This is both due to strong borrowing demand and because the Federal Reserve allows interest rates to rise (i.e., tightening monetary policy). When borrowing needs to be repaid, stocks must be sold to raise funds to pay off the debt, leading to price declines, defaults on debts, shrinking collateral values, further reduction in credit supply, and a bubble turning into a self-reinforcing collapse, ultimately triggering a great economic depression.

How does wealth disparity burst bubbles and trigger crashes?

To explore how this dynamic punctures bubbles in the context of significant wealth disparities, leading not only to financial collapses but also to social and political unrest, I studied the following chart. The chart illustrates the gap between wealth and currency in the past and present, specifically represented by the ratio of total stock value to total currency value.

The next two charts show how this ratio becomes an indicator of nominal and real returns over the next decade. These charts themselves already explain everything.

When I hear people trying to determine whether a stock or the entire stock market is in a bubble by analyzing whether the company will be able to profit in the future to provide sufficient returns for the current stock price, I think to myself that they do not really understand the dynamics of a bubble. While the long-term returns of an investment are certainly important, this is not the main reason for a bubble to burst. A bubble does not burst simply because people suddenly realize one morning that the income and profits are not enough to support the current prices. After all, whether there is enough income and profit to provide a good return on investment often takes years or even decades to become truly clear.

The principle to remember is:

The reason for the bubble burst is that the funds flowing into assets start to dwindle, and holders of stocks or other wealth assets need to sell these assets to obtain funds for certain purposes (most commonly to repay debts).

What usually happens next?

When the bubble bursts and the funds and credit in the market are insufficient to meet the needs of financial asset holders, the market and economy will decline, and internal social and political unrest will usually intensify. This dynamic is exacerbated, especially in the presence of a significant wealth gap, leading to further divisions and anger between the affluent class (which tends to lean right) and the impoverished class (which tends to lean left).

Taking the case from 1927 to 1933 as an example, this dynamic led to the Great Depression and triggered serious internal conflicts, especially the opposition between the wealthy and the poor. This series of events ultimately resulted in President Hoover being ousted and President Roosevelt being elected.

Naturally, when the bubble bursts and is accompanied by market and economic recession, it often triggers significant political changes, large-scale fiscal deficits, and debt monetization. In the example from 1927 to 1933, the market and economy declined between 1929 and 1932, and political changes came in 1932, which prompted President Roosevelt to begin implementing large fiscal deficit policies in 1933.

President Roosevelt's central bank printed a large amount of currency, leading to a devaluation of the currency (for example, relative to gold). This devaluation alleviated the problem of funding shortages and brought about the following effects:

a) helps those systemically important debtors alleviate pressure and be able to pay debt interest;

b) pushed up asset prices;

c) stimulated economic development.

Leaders who come to power during such moments often implement many shocking changes in fiscal policy. Although it cannot be elaborated in detail here, it is certain that these periods are usually accompanied by significant conflicts and major transfers of wealth. In the case of Roosevelt, these circumstances prompted many significant changes in fiscal policy to achieve the transfer of wealth from the top to the general public. For example, raising the top marginal income tax rate from 25% in the 1920s to 79%, significantly increasing inheritance and gift taxes, and funding the massive growth of social programs and subsidies. These policies also led to significant conflicts both domestically and internationally.

This is a classic dynamic. Historically, many leaders and central banks have repeated similar practices in many countries over many years, so many that it is difficult to list them all. By the way, before 1913, the United States did not have a central bank, and the government did not have the ability to print money, which made bank failures and deflationary economic depressions more common. In either case, bondholders were usually in a poor position, while gold holders performed well.

Although the cases from 1927 to 1933 are a typical example of a classic bubble burst cycle, they represent a more extreme situation. Similar dynamics can also be observed in other periods, such as the events that led President Nixon and the Federal Reserve to take similar actions in 1971, as well as the occurrence of almost all other bubbles and bursts (such as the Japanese economic bubble from 1989 to 1990, the internet bubble in 2000, etc.). These bubbles and bursts are often accompanied by other typical characteristics, such as the market attracting a large number of inexperienced investors due to popularity, who are driven by market fervor to buy on leverage, ultimately suffering heavy losses and feeling angry.

This dynamic has existed for thousands of years, when these conditions are present (i.e., when the demand for money exceeds supply). Wealth must be sold to obtain funds, bubbles burst, defaults occur, and issues arise in the economic, social, and political realms. In other words, the imbalance between financial wealth (especially debt assets) and money, as well as the process of converting financial wealth into money, is the fundamental cause of bank runs—whether in private banks or government-controlled central banks. These runs either lead to defaults (which primarily occurred before the establishment of the Federal Reserve) or prompt central banks to create money and credit to support those institutions that are “too big to fail” in order to help them repay loans and avoid failure.

Please keep the following points in mind:

When the promise of currency delivery (i.e., debt assets) far exceeds the existing amount of currency, and there is a need to sell financial assets to raise funds, be wary of the possibility of a bubble bursting and ensure your protection. For example, do not hold a large credit exposure and have some gold as a hedge asset. If this situation occurs during a time of significant wealth disparity, also be alert to the potential for major political and wealth changes, and take measures to protect yourself from the impact.

While interest rate hikes and credit tightening are the most common reasons for assets being sold to raise funds, any factors that increase the demand for funds (such as wealth taxes) as well as the act of selling financial wealth to meet funding needs can trigger similar dynamics.

When a significant gap exists between currency/wealth and the inequality of wealth distribution, this situation should be regarded as a very high-risk environment that requires extra caution.

From the 1920s to the present: The cycle of bubbles, bursts, and new orders.

(If you do not wish to learn a brief history from the 1920s to the present, you may skip this part.)

Although I previously mentioned how the bubble of the 1920s led to the crash and Great Depression from 1929 to 1933, to quickly supplement the background information, that crash and the subsequent depression ultimately prompted President Roosevelt to default on the U.S. government's promise to provide hard currency (gold) at a fixed price in 1933. The government printed money in large quantities, and the price of gold rose by about 70%.

I will skip how the re-inflation from 1933 to 1938 led to the tightening of 1938; and how the “economic recession” from 1938 to 1939 created the conditions for the economy and leadership, combined with the geopolitical dynamics of the rise of Germany and Japan challenging British and American hegemony, which together led to World War II; I will also skip how the classic large cycle dynamics took us from 1939 to 1945—when the old monetary, political, and geopolitical order collapsed, and a new order was established.

I will not go into detail about the reasons, but it should be pointed out that these events made the United States very wealthy (holding two-thirds of the world's currency at that time, namely gold) and powerful (producing half of the world's GDP and becoming a military dominant force). Therefore, in the new monetary order established by the Bretton Woods Agreement, currency was still based on gold, with the dollar pegged to gold (other countries could purchase gold with the dollars they obtained at a price of $35 per ounce), and the currencies of other countries were also pegged to gold.

However, between 1944 and 1971, U.S. government spending far exceeded tax revenue, resulting in significant borrowing and the sale of debt, which created a gold claim far exceeding the central bank's gold reserves. Realizing this, other countries began to exchange paper currency for gold. This led to a tightening of money and credit, prompting President Nixon in 1971 to take actions similar to those of President Roosevelt in 1933, once again devaluing fiat currency relative to gold, leading to a surge in gold prices.

In short, from then to now:

a) Government debt and its servicing costs have risen significantly compared to tax revenue, especially during the period from 2008 to 2012 following the global financial crisis of 2008, as well as after the financial crisis triggered by the COVID-19 pandemic in 2020;

The income and value gap has widened to a huge level, leading to irreconcilable political differences;

c) Due to credit, debt, and speculative support for new technologies, the stock market may be in a bubble state.

The chart below shows the income share of the top 10% compared to the bottom 90% in income distribution - it is clear that today's income disparity is extremely large.

Current situation

Governments of the United States and other democratically governed and over-indebted countries are facing a dilemma today:

a) can no longer continue to increase debt as it did in the past;

b) cannot be compensated for by sufficient tax revenue growth to fill the fiscal gap;

c) cannot significantly reduce expenditures to avoid deficits and prevent further increases in debt.

They are in a deadlock.

Detailed analysis

These countries cannot borrow enough funds because the demand for their debt in the free market has already diminished. (The reason is that these countries have excessive debt, and creditors already hold too many debt assets.) In addition, international creditors (such as China) are concerned that war conflicts may lead to the inability to repay the debt, thus reducing their purchases of bonds and instead converting debt assets into gold.

They cannot solve the problem through sufficient tax growth because if taxes are levied on the wealth concentrated in the top 1%-10% of the population:

a) These wealthy classes may choose to leave, taking their tax contributions with them;

b) Politicians may lose the support of the top 1%-10% groups, and the support of these groups is crucial for funding expensive election campaigns.

c) may lead to a market bubble burst.

At the same time, they are also unable to cut enough spending and benefits, as doing so may be politically or even morally unacceptable, especially since these cuts would disproportionately affect the bottom 60% of the population…

Therefore, they are at an impasse.

For these reasons, governments of democratic countries with high levels of debt, significant wealth disparities, and severe value differences are facing dilemmas.

Under the current conditions, combined with the operation of democratic political systems and human nature characteristics, politicians continuously promise to quickly solve problems, but fail to deliver satisfactory results, thus being swiftly ousted and replaced by a new batch of politicians who also promise quick solutions, only to fail again and be replaced, creating a cycle. This is precisely why countries like the UK and France—where their systems allow for quick leadership changes—have experienced four prime ministers in the past five years.

In other words, we are witnessing the classic pattern of the “big cycle” phase. This dynamic is very important and deserves in-depth understanding, and it should now be evident.

At the same time, the stock market and wealth prosperity are highly concentrated in the top artificial intelligence-related stocks (such as the “Magnificent Seven” Mag 7) and in the hands of a few super-rich individuals. Meanwhile, artificial intelligence is replacing human jobs, exacerbating the inequality in wealth and currency distribution, as well as the wealth gap between individuals. Historically, similar dynamics have occurred multiple times, and I believe it is very likely that there will be significant political and social backlash, which will at least substantially change wealth distribution, and in the worst case, could lead to serious social and political turmoil.

Next, let us explore how this dynamic and the huge wealth gap can pose problems for monetary policy and potentially trigger a wealth tax, thereby bursting the bubble and leading to economic collapse.

How is the data?

I will compare the top 10% of people ranked by wealth and income with the bottom 60% of people ranked by wealth and income, choosing the bottom 60% because this group represents the majority.

In brief:

The wealth, income, and stock assets of the richest group (the top 1%-10%) far exceed those of the bottom 60%.

For the wealthiest individuals, their wealth primarily comes from the appreciation of asset values, and this appreciation is not taxed until the assets are sold (unlike income, which is taxed at the time it is earned).

With the prosperity of artificial intelligence, these gaps are widening and may further expand at an accelerated pace.

If wealth is taxed, it will require selling assets to pay the tax, which may lead to a bubble burst.

More specifically:

In the United States, the top 10% of households are well-educated and have high economic productivity. They earn about 50% of total income, hold about two-thirds of total wealth, own about 90% of stock assets, and pay about two-thirds of federal income tax. These figures are steadily increasing. In other words, their economic status is very good, and they also make significant contributions to society.

In contrast, the bottom 60% of households have a lower level of education (for example, 60% of Americans have reading skills below the sixth-grade level), relatively low economic productivity, earning only about 30% of total income, holding only about 5% of total wealth, owning about 5% of stock assets, and paying less than 5% of federal taxes. Their wealth and economic prospects are relatively stagnant, thus facing financial pressure.

Naturally, this situation has led to immense pressure for the redistribution of wealth and funds from the top 10% of the population to the bottom 60%.

Although the United States has never imposed a wealth tax in its history, there is an increasing call for wealth taxes at both the state and federal levels today. Why is there a push for wealth taxation now, when it wasn't there before? The reason is simple – because wealth is concentrated there. In other words, the top 10% have mostly become richer through wealth growth, and this growth has not been taxed, rather than accumulating wealth through labor income.

The wealth tax faces three major issues:

The rich can choose to migrate, and once they leave, they take with them not only their talents, productivity, income, and wealth, but also their tax contributions. This will weaken the regions they leave while enhancing the regions they move to.

Implementing a wealth tax is very difficult (you may already understand the specific reasons, so I won't elaborate to avoid making this article longer).

Wealth taxes siphon funds away from investment activities that support productivity enhancement and transfer them to the government, and the assumption that the government can properly manage these funds to make the lower 60% of the population more productive and affluent is almost unrealistic.

For the reasons mentioned above, I would prefer to see an acceptable tax rate (for example, 5%-10%) imposed on unrealized capital gains, but this is another topic that needs to be discussed separately.

P.S.: How will the wealth tax be implemented?

In future articles, I will explore this issue in more detail. In simple terms, the balance sheet of American households shows a total wealth of about $150 trillion, but the amount of cash or deposits is less than $5 trillion. Therefore, if a wealth tax of 1%-2% is levied annually, the required cash would exceed $1-2 trillion, while the existing pool of liquid cash is only slightly above this value.

Any similar policies could lead to asset bubbles bursting and trigger an economic recession. Of course, the wealth tax will not be imposed on everyone, but rather targeted at the wealthy. While this article does not delve into specific numbers, it is clear that the wealth tax may have the following effects:

Force private and public equity to undergo mandatory sales, thereby depressing valuations;

Increased demand for credit may drive up borrowing costs for the wealthy and the overall market;

Encourage the transfer of wealth to tax-friendly regions or offshore tax havens.

If the government imposes a wealth tax on unrealized gains or illiquid assets (such as private equity, venture capital holdings, or even concentrated positions in public equities), these pressures will be particularly pronounced and may even trigger more severe economic issues.