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Key Takeaways:

• Debt cycles shape every economy — credit expansion drives booms, while excessive debt and deleveraging trigger slowdowns.
• Debt isn’t inherently good or bad — what matters is how it’s used (productive borrowing fuels long-term growth, unproductive borrowing creates fragility).
• Credit acts as money — loans create new money, and repayment destroys it, making credit a hidden engine of growth.
• Deleveraging is painful — when debt is paid down faster than new credit is created, the money supply shrinks, pulling growth and prices lower.
• Productivity is the long-term engine — raising efficiency is what sustains income growth, competitiveness, and resilience through cycles.

For the last 20 months, I’ve dragged you through the swamps of student loans, auto loans, corporate debt, margin debt, and government debt.

But it hit me - maybe I never really explained the beast itself.

I’m talking about the debt cycle.

See, debt itself isn’t inherently good or bad - it’s about how it’s used and at what scale. Once you understand how the cycle works, you’ll see the economy in a whole new light. You’ll be able to spot booms before they bubble over, and busts before they hit the news.

More importantly, you’ll realize that debt isn’t some side character in the economic story (like many PhD economists claim) - but that it’s actually a lead actor - the one who keeps the plot moving.

Now, I’m going to simplify all this. This isn’t a collegiate dissertation, and I’m not running regression models here.

So, consider this a primer - the first chapter in the story, with more to come in future Morning Pours.

Your Debt Cycle 101 class starts here.

What We Can Learn from Ray Dalio on Debt Cycles and Economic Crises

Back in 2018, I picked up Ray Dalio’s new book, Principles for Navigating Big Debt Crises.

• Dalio, founder of Bridgewater - the world’s largest hedge fund - spent decades studying how credit runs hot, collapses, and makes or breaks economies.

It’s a tome of a book - and was exhausting to read (here is the PDF if you feel up to the task¹).

But it’s a great history and key reading to understand major debt cycles – such as:

• The U.S.1929
• Scandinavia (Norway, Finland, Sweden) 1990-91
• Thailand 1996
• Russia 1997
• The whole world in 2008
• The Eurozone 2011

Dalio hasn’t left a debt crisis over the last 100 years unturned.

The key takeaway was that debt cycles are everywhere. Whether different decades or different countries – it’s the same anatomy.

And after studying these, it helps us understand debt cycles more clearly.

What Is a Debt Cycle and How It Works

A debt cycle is essentially an economic pattern marked by a prolonged credit boom - where borrowing rises, fueling growth and asset-price increases - followed by a tipping point where debt burdens become unsustainable and the economy falls into a phase of deleveraging (repaying debt), recession, and stagnation.

Put simply:

• Credit booms: Confidence builds, borrowing and spending rise, inflation rises, and asset prices climb - creating a positive feedback loop.
  
  
• A tipping point is hit: Excessive debt makes repayment difficult, thus stress in the system intensifies.
  
  
• Deleveraging phase: The economy contracts as debt is paid down through spending cuts, restructuring, or other measures.

Figure 1: Dunham, 2025

Think of debt cycles like a party.

First, the music’s good and the drinks flow (imagine the Great Gatsby). Banks are lending, borrowers are buying, and asset prices from houses to stocks to crypto surge.

Then the party hits its tipping point. Debt loads grow too heavy, payments start getting missed, confidence sinks, and lenders begin to pull back.

Finally comes the hangover - deleveraging. Spending dries up as debt is serviced, defaulted on, or restructured, and the economy slows - sometimes stalling altogether (think the Great Depression).

Credit Creation Explained: How Banks Actually Create Money

Here are the basics of what you need to know about credit (and thus money) creation.

Credit (money) is born the moment a lender decides you can pay them back.

See, banks don’t wait to see how many deposits came in today. If they think you’re creditworthy, they create the loan - out of thin air.

You, the borrower, use that new money to buy what you can’t yet afford - a home, a car, a business, stocks (creating demand for these things). And in return, you promise to repay the principal plus interest.

• When interest rates are high, borrowing typically slows as the cost of money makes people think twice.
  
• When rates are low, borrowing rises as it’s cheaper to finance big purchases.

And while interest rates matter - the real engine here is confidence. Lenders have to believe you’ll pay them back. Thus, without confidence, credit freezes - no matter what the interest rate is.

• I’ve written about this in more depth before - in The Truth About Banking Fragility: Why Unrealized Losses Still Matter - where I highlighted the misconceptions about how banks operate and showed why commercial banks, not central banks, are the true money creators.

With all this in mind, when banks create credit, two things happen at once:

• It becomes liability for the borrower - a debt they must repay.
• It becomes an asset for the lender - income they earn through interest.

And when that debt is repaid, the credit vanishes from the system.

Or said another way: Creation. Obligation. Extinction. Bank loans create money. And repayment destroys it (remember this for later).

Figure 2: Dunham, 2025

How Does a Credit Boom Fuel Growth?

“I get how easy credit can fuel asset price growth – but how does it fuel economic growth?”

Let’s keep it simple and look at both sides - the buyer and the seller.

The Buyer: Say Joe wants a $20,000 car. Without credit, he’d have to save his wages over time until he could afford it. That means no new TV, no cruise, no extras - every spare dollar goes to the car fund.

The Seller: The car maker has to wait until Joe saves enough (or slash prices) - delaying sales, profits, and growth. Meanwhile, because Joe isn’t buying a TV or booking that cruise, those businesses lose out too. They hold back on hiring, investing, or expanding because the demand just isn’t there.

This is the crux of saving. It’s responsible for the buyer - but it can slow down the economy.

Now let’s add credit to the mix. . .

Joe gets approved for a $15,000 loan - money created out of thin air - and combines it with his $5,000 savings. He drives off with the car today. And because he didn’t empty his wallet, he also buys that TV and books the cruise.

That’s credit in action - it pulls future spending into the present.

And from the seller’s side, the benefits are even clearer:

• The car dealer makes the sale now instead of waiting months (or years).
• The TV store rings up an extra purchase.
• The cruise line fills a cabin.

Those businesses hire more staff, order more supplies, and pay more wages. Those wages get spent elsewhere - on groceries, rent, gas. And the cycle spins on and on.

This is why credit is such a powerful economic driver.

• Remember, one person’s spending is another person’s income – aka when Joe spends $20,000 on a car, that money becomes someone else’s paycheck, which then gets spent again.

All this new credit thus sloshes around raising growth, prices (inflation), and incomes.

And while good at first, it can quickly become an issue.

The Debt Cycle Tipping Point

A rule of thumb is that when incomes grow faster than debt, the system stays balanced. But when debt grows faster than income, the debt burden rises - and the higher it climbs, the more dangerous it gets.

Every time you borrow, you borrow from your future self - a future where you must spend less than you earn to make the payments.

• Meaning your spending must eventually drop as more of your income goes to servicing old debt.

This sets a predictable chain in motion.

Credit becomes toxic when it funds overconsumption instead of productive investments.

• A TV or Louis Vuitton bag bought on credit is bad debt - it won’t earn a dime.
  
  
• A tractor bought on credit is good debt - it can generate income, repay the loan, and improve your life.

On a national scale, think Greece, Portugal, Italy, and Spain during the 2010s or China since 2019 - massive borrowing into non-productive uses, leaving little income to service the debt.

Deleveraging: The Long Hangover

When the debt burden gets too heavy, the cycle breaks. Asset prices fall, collateral values collapse, and credit tightens.

Thus, deleveraging begins - aka the drawn-out process of paying debt down². In theory, it’s healthy. But in reality, it’s painful.

Why? Because if households, businesses, and governments all cut spending to repay debt at the same time, demand collapses.

• Businesses see fewer sales.
• Workers lose jobs.
• Asset prices drop.
• Confidence evaporates.

And remember what I mentioned earlier - paying down debt faster actually destroys credit, which in our modern system means destroying money. Thus, with less money circulating, prices, growth, and incomes all come under pressure.

• Put simply, less credit = less spending power. If debt is repaid faster than new loans are created (aka deleveraging), the money supply contracts - and that contraction slows growth and drags everything down. 

Figure 3: Dunham, 2025

We saw this in 2008. Housing prices fell, wiping out collateral values. Banks tightened credit. New borrowing sank. Spending fell. Layoffs surged. And the feedback loop fed on itself³.

What’s worse is that during deleveraging, interest rates (the traditional tool to jump start the economy) can’t rescue growth.

Why? Because they’re already near zero as demand for new loans collapses.

• Just like supply and demand: if there’s no demand for new loans because households are already drowning in debt, interest rates drop until someone can take out a loan.

That’s what separates a normal recession from a deleveraging - the debt is simply too big to fix with cheaper money.

• Japan learned this after 1989 when its asset bubble burst, triggering decades of stagnation⁴. Recovery only begins when debt burdens fall, confidence returns, and productive lending resumes. Until then, the economy limps along.

Why Debt Fuels Both Booms and Busts

Credit is an amplifier. When it’s flowing, everything feels good - growth, jobs, optimism. But the same force that fuels the boom also sets up the bust.

Too much credit? Debts get too big to service. Defaults start. Confidence cracks. And suddenly, the same machine that pulled the future forward is grinding to a halt.

Dalio’s work - and a century of history - makes it clear: you can’t escape the debt cycle. You can only understand it, try to manage it, and hope you see the curve before it bends.

Dalio’s Takeaways and What to Watch

So, before you go, here are three recommendations that Dalio shared. . .

1. Don’t borrow more than your income can handle.
   If your debt grows faster than your paycheck, eventually the payments will be too heavy and drag you under.
   
   
2. For a firm, if wages or profits grow faster than productivity, costs will eventually outpace output.
   This makes the business less competitive, as others can produce the same goods or services more efficiently and at lower prices.
   
   
3. Focus on getting better and more efficient over time.
   The more you can produce with the same (or fewer) resources, the stronger and more resilient you’ll be in the long run (increasing earning power).

There you go - you’ve passed Debt Cycles 101.

You know when the party starts (look for rising productive debt levels), when the drinks flow too fast (when it surpasses incomes), and when to head for the exit before the hangover (when debt laps over incomes and valuations are sky-high).

• Put simply, keep an eye on bank lending, private sector debt burdens, wages, and asset prices. They offer the biggest clues.

Take care.

Sources:

1. Bridge Water | Big Debt Crises | Ray Dalio
2. Deleveraging - Wikipedia
3. Subprime mortgage crisis - Wikipedia
4. Japanese asset price bubble - Wikipedia

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