In my book How Countries Go Broke: The Big Cycle, I established a detailed template to describe how the unsustainable state of debt supply-demand imbalance triggers a specific evolution. Recently, three events have occurred simultaneously:

· The Japanese government sold part of its holdings of U.S. Treasury bonds, repatriating the funds to support the yen and Japanese capital markets, reducing its exposure to U.S. debt without the need for further significant interest rate hikes.

· U.S. Treasury yields, led by the long end, rose to new highs while the U.S. dollar weakened, due to the massive current and future supply of Treasury bonds and weakening demand.

· This week, Treasury Secretary [Name, presumably Yellen based on context] announced that the U.S. Treasury will buy back U.S. Treasury bonds, but his capacity to do so is limited, leading many to ask me: Are these events consistent with the classic template described in the book? The answer is yes. To anticipate what might happen next, it is necessary to revisit this template.

In the book, I detail how the government-level debt/currency restructuring process typically unfolds and provide calculations to show the degree of imbalance between new debt supply and debt rollover demand. This set of calculations serves as a template for comparing reality and anticipating the future. If you are a market participant who needs to understand this template in detail to time the market, I recommend reading the entire book. If you don't need that depth or don't want to spend that much time, you can read the following five-minute summary of the mechanism.

How the Mechanism Works

The debt dynamics of a central government follow the same logic as those of an individual or a company, with the key differences being: a central government has a central bank that can print money (thus devaluing the currency) and can extract funds from the people through taxation. Therefore, if you can imagine how you or your business would operate under the conditions of "being able to print money and tax," you can understand these dynamics. But remember, your goal is to make the entire system run well—not just for yourself, but for all citizens.

In my view, the credit/market system is like the body's circulatory system, delivering nutrients to all parts comprised of markets and the real economy. If credit is used effectively, it creates productivity and income sufficient to repay principal and interest; this is healthy. However, if credit is misused and fails to generate enough income to cover principal and interest, the debt burden builds up like plaque, squeezing out other expenditures. When debt service payments become very large, a debt service problem arises, eventually evolving into a debt rollover problem—because bondholders are unwilling to roll over and just want to sell. This naturally leads to a shortage of demand and a selling wave for bonds and other debt instruments; when demand is short relative to supply, either 1) interest rates rise, dragging markets and the economy down, or 2) the central bank "prints money" and buys the debt, devaluing the currency and thereby pushing up the original inflation level. Printing money also artificially suppresses interest rates, harming lenders' returns. Both paths are bad. When the scale of debt selling is too large to contain, and the central bank has already bought a large number of bonds, rising interest rates cause the central bank to incur losses, damaging its cash flow. If this continues, the central bank will eventually fall into negative net worth.

When the problem becomes severe, both the central government and the central bank borrow to pay debt service expenses. Due to insufficient free market demand, the central bank prints money to provide lending, and thus a self-reinforcing "debt-printing-inflation" spiral begins.

In summary, the three classic indicators to watch are:

1. The scale of government debt service payments relative to government revenue (akin to the amount of plaque in the circulatory system);

2. The scale of government debt sales relative to the demand for government debt (akin to plaque breaking off, triggering a heart attack);

3. The scale at which the central bank purchases government debt by printing money to cover the gap between the demand for government bonds and the supply of bonds for sale (akin to the central bank injecting a strong dose of liquidity/credit to ease liquidity strain, resulting in more debt, which becomes the central bank's exposure).

These indicators typically rise over cycles lasting decades—debt and debt service payments continuously rising relative to income—until it becomes unsustainable, either because 1) debt service payments excessively crowd out other expenditures to an unacceptable degree; or because 2) the supply of debt that must be bought is too large relative to purchasing demand, forcing interest rates to rise sharply and causing markets and the economy to plunge deeply; or because 3) the central bank, unwilling to watch interest rates rise and markets and the real economy deteriorate, prints a large amount of money and buys a large amount of government debt to cover the demand gap, causing the currency's value to shrink significantly. Whichever path is taken, bond returns will be poor until the currency and debt eventually become cheap enough to attract demand, and/or the government can repurchase or restructure the debt at low cost.

This is the most simplified picture of the big debt cycle.

Since these indicators can be quantified, we can continuously monitor the evolution of debt dynamics, making it easy to see the problem approaching. I have always used this diagnostic method in my investing and kept it secret, but now I have written it in detail in How Countries Go Broke: The Big Cycle because it is too important to keep to myself.

More specifically, you can observe: debt and debt service payments rising relative to income; debt supply exceeding debt demand; the central bank first lowering interest rates and responding with easing stimulus, then shifting to printing money to buy bonds, eventually incurring losses and falling into negative net worth; the central government continuously leveraging up to pay debt service expenses while the central bank monetizes the debt. All of this leads to a government debt crisis—it is equivalent to an economic heart attack: debt-supported spending contracts, cutting off the normal flow of the economic circulatory system.

In the early final stage of the big debt cycle, market performance reflects this dynamic: interest rates rise, led by long-term rates; the currency depreciates, especially relative to gold; and the central government's treasury shortens debt maturities due to insufficient long-term debt demand. Usually, when the dynamic is most intense at the cycle's end, a series of seemingly extreme measures are introduced, such as establishing capital controls and putting strong pressure on creditors to force them to buy rather than sell debt. This dynamic is explained more completely in the book, accompanied by numerous charts and data to show its evolution.

The U.S. Government's Situation: The Simplest Summary

Now, imagine you are running a large enterprise called the "U.S. Government." This perspective will help you understand the U.S. government's fiscal situation and the choices of its leadership.

This year's total revenue is about $5.5 trillion, total expenditures about $7.5 trillion, resulting in a budget deficit of about $2 trillion. That is, this institution will spend about 40% more than its income this year. And there is very little room to cut expenditures because almost all spending is previously committed or essential. Because this institution has borrowed heavily over a long period, it has accumulated massive debt—about 6 times its annual income (approximately $32 trillion), equivalent to about $240,000 for every household you need to care for. The interest bill on this debt is about $1 trillion, accounting for about 20% of the enterprise's income, also equivalent to half of this year's budget deficit (the deficit)—and these deficits still need to be financed by borrowing. But the $1 trillion is not all you need to pay creditors; besides interest, you also need to repay maturing principal, about $10 trillion. You hope creditors will either roll over the loans or lend you more money. Therefore, debt service payments—the principal plus interest you must repay to avoid default—are about $11 trillion, about 200% of incoming funds.

This is the current situation.

So, what happens next? Let's envision it. You will borrow to cover the deficit, whatever it ultimately is. There are various opinions on what the deficit will be. After accounting for the recently passed budget reconciliation bill, most independent assessment agencies estimate that in 10 years, U.S. debt will reach $55 to $60 trillion (about 7 times income), because there will be an additional $25 to $30 trillion in borrowing by then. Of course, 10 years from now, this institution will face heavier debt service payments crowding out other expenditures, and without a solution, the risk of insufficient demand for its debt for sale will also be greater.

My "3% Tripartite" Solution

I am confident that the U.S. government's fiscal situation is at an inflection point because if not addressed now, debt will accumulate to a level that will be difficult to manage without causing significant damage; and particularly important, this operation should be done while the system is relatively robust, not when it is weak. The reason is that when the economy contracts, the government's borrowing needs rise significantly.

Based on my analysis, I believe this situation needs to be resolved through what I call the "3% Tripartite" solution, which involves reducing the budget deficit to 3% of GDP and achieving a balance among three ways to cut the deficit: 1) cutting spending, 2) increasing tax revenue, 3) lowering interest rates. These three must be implemented simultaneously to avoid any one being too forceful—because if any is too severe, the adjustment process will be traumatic. Moreover, these adjustments should be achieved through good fundamental adjustments, not coercive means (for example, the Fed artificially forcing interest rates down is a very bad practice). According to my calculations, relative to current plans, spending cuts and tax increases of about 5% each, with a corresponding interest rate drop of about 1 to 1.5 percentage points, would reduce interest expenses by 1 to 2 percentage points of GDP over the next decade and stimulate a rebound in asset prices and economic activity, thereby generating much more revenue.

Frequently Asked Questions and My Answers

The book contains far richer content than this short article, including descriptions of the "Overall Big Cycle" (composed of debt/credit/currency cycles, domestic political cycles, external geopolitical cycles, natural events, and technological progress)—which drives all major changes in the world; my views on possible future scenarios; and some perspectives on how to invest amidst these changes. But for now, I will first answer some questions I am often asked while promoting the book. If you want to learn more in-depth, you are welcome to read the entire book.

Q1: Why do major government debt crises and big debt cycles occur?

Major government debt crises and big debt cycles occur and can be easily measured by three indicators: 1) Government debt service payments relative to government revenue rise to an unacceptable level of crowding out necessary government expenditures; 2) The volume of government debt sales relative to demand becomes so imbalanced that interest rates rise, causing market and economic decline; 3) Central banks respond to these conditions with low interest rates, which weakens bond demand, in turn forcing central banks to print money to buy government debt, devaluing the currency. These indicators typically rise over a cycle lasting decades until they become unsustainable—either because 1) debt service payments excessively crowd out other expenditures to an unacceptable degree; or because 2) the supply of debt to be purchased is too large relative to purchasing demand, forcing interest rates to rise sharply and causing markets and the economy to plunge deeply; or because 3) the central bank prints a large amount of money and buys a large amount of government debt to cover the demand gap, causing the currency's value to shrink significantly. Whichever path is taken, bond returns will be poor until they become cheap enough to attract demand, and/or the debt is restructured. These indicators are easily measurable, and people can clearly see them evolving toward an impending debt crisis. The crisis arrives when debt-supported spending contracts—like a debt-induced heart attack.

Throughout history, almost every country has experienced this kind of debt cycle, often multiple times, so there are hundreds of historical cases to study, even dating back to the beginning of written records. In other words, all monetary orders eventually collapse, and the debt cycle mechanism I describe is the driving force behind these collapses. The decline of all reserve currencies stems from this, such as the British pound and, before it, the Dutch guilder. I list 35 recent cases in the book.

Q2: If this process repeats, why is the underlying mechanism not widely known?

You are right, this mechanism is indeed not fully understood. Interestingly, I could not find any research on how it works. My speculation is that it is not understood because the collapse of a monetary order usually occurs only once in a lifetime in a reserve currency country; and when it happens in non-reserve currency countries, people assume it's a problem that reserve currency countries are immune to. I was able to discover this mechanism only because I witnessed it happen in sovereign bond market investments, which prompted me to study a large number of historical cases to be prepared to handle it (for example, handling the 2008 global financial crisis and the subsequent European debt crisis).

Q3: How concerned should we be about a "heart attack" style debt crisis in the U.S. before it blows up? People have heard too much about the "coming debt crisis" but it never happens. What's different this time?

I think we should be very concerned, for the reasons I mentioned earlier. I believe those who worried about a debt crisis when the situation was less severe were right, because addressing it earlier could have prevented the situation from deteriorating to its current state, just like a doctor warning a patient early not to smoke or overeat. Therefore, I speculate that this issue has not caused wider concern, partly because it is not fully understood, and partly because previous premature warnings have created a lot of numbness. It's like a person whose arteries are full of plaque, still eating a lot of high-fat food and never exercising, telling the doctor: "You warned me long ago that if I didn't change my lifestyle, something would happen, but I haven't had a heart attack yet. Why should I believe you now?"

Q4: Today, what could be the catalyst for a U.S. debt crisis? When might such a crisis occur? What would such a crisis look like?

The catalyst will be the convergence of the various effects mentioned earlier. As for timing, policy and exogenous factors—such as major political shifts and wars—can accelerate or delay its arrival. For example, if the budget deficit drops from the roughly 7% of GDP that I and most people expect to about 3%, the risk would be significantly reduced. If a major exogenous shock occurs, the crisis will come earlier; if not, it will be delayed, or might not even occur (provided it is managed properly). My guess—which I estimate will be a bad prediction—is: if we do not change the current path, the crisis will come within three years, plus or minus two years.

Q5: Are you aware of precedents where significant budget deficit reductions were achieved with good results?

Yes, I know of several. My plan would reduce the budget deficit by about 4 percentage points of GDP. The most similar successful precedent is the United States from 1991 to 1998, when the budget deficit was reduced by 5 percentage points of GDP. I also list several similar cases in other countries in the book.

Q6: Some believe that due to the dollar's dominant role in the global economy, the U.S. is generally less susceptible to debt-related issues/crises. What do you think those who hold this view are missing?

If they think so, they do not understand the mechanism and historical lessons. More specifically, they should study history to understand why all previous reserve currencies ultimately ceased to be reserve currencies. To put it more bluntly: currency and debt must be effective stores of wealth, otherwise they will be devalued and abandoned. The dynamic I describe is precisely how reserve currencies lose their effectiveness as stores of wealth.

Q7: Japan—with debt at 215% of GDP, the highest among developed economies—is often cited as a typical example of "a country can be safe with high debt levels without a debt crisis." Why are you not particularly comforted by Japan's experience?

The Japanese case is confirming and will continue to confirm the problems I describe; it is the embodiment of my theory in reality. Specifically, because the degree of Japanese government over-indebtedness is extremely high, Japanese bonds and debt have been poor investments. To cover the shortfall in demand for Japanese debt assets at interest rates low enough to be favorable domestically, the Bank of Japan printed large amounts of money and bought large amounts of Japanese government bonds. As a result, since 2013, investors holding Japanese bonds have lost 51% relative to those holding dollar bonds and lost 76% relative to holding gold. Since 2013, in common currency terms, the wages of ordinary Japanese workers have fallen 55% relative to American workers. I devote an entire chapter in the book to an in-depth explanation of the Japanese case.

Q8: From a fiscal perspective, which other regions in the world have particularly prominent problems that people may underestimate?

Most economies have similar debt and deficit problems—the UK, the EU, China, Japan are all like this. Precisely because of this, I expect most economies to undergo similar debt adjustment and currency depreciation processes, and precisely because of this, I expect non-government-produced currencies like gold and Bitcoin to perform relatively well.

Q9: How should investors respond to this risk/how should they position for the future?

As general advice, I recommend diversifying across asset classes and countries, preferring countries with sound income statements and balance sheets and without severe domestic political conflicts or external geopolitical conflicts; underweight debt assets like bonds, overweight gold and a small amount of Bitcoin. Allocating a small portion of funds—say 10% to 15%—to gold can reduce portfolio risk, and I think it can also increase its return.

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