How the Economic Machine Works (by Ray Dalio)
Essence
Billions of financial Transactions (driven by Human nature)
result in :
- Productivity Growth
- Short Term Debt Cycle
- Long Term Debt Cycle
Transactions
An Economy is basically the sum of the transactions that make it up.
Buyer has money or credit to be exchanged with a Seller for goods, services or financial assets.
(In a single transaction) Credit spent + Money spent = Total Spending
The total amount of spending drives the economy.
Total Spending/ Total Quantity (sold) = Price
A Market consists of all the Buyers and Sellers for the same thing.
An Economy consists of all the transactions in all of its Markets.
(For all Markets) Total Spending/ Total Quantity (sold) = Price
The Central Bank is important for the Flow of Credit, which it manipulates with
- interest rates
- printing money
Credit is the most important part of the economy. Because its the biggest and most volatile part.
Lenders want to make more money. Buyers want something they cant afford. Credit can help borrowers and lenders get what they want.
Borrowers will return Principle + Interest When interest rates are high, there is less borrowing because its expensive. When Borrowers promise to repay and lenders believe them, credit is created. Any two people in agreement can create credit out of thin air.
The tricky thing is, that as soon as Credit is created, it exists in two parts. An Asset to the Lender and a Liability to the Borrower. Once the Borrower, returns the Principle and Interest, both these disappear.
When a Buyer is able to borrow credit, he is able to increase his spending. And spending is what drives the economy. One persons spending is another persons income.
A credit worthy borrower has two things:
- the ability to repay
- collateral if he cant
Increased borrowing -> Increased Spending -> Increased Income -> Cycles
People who more productive, earn more and thus spend more. Productivity matters most in the long run but credit matters most in the short run. Productivity does not fluctuate much and is not a big driver in economic swings.
Debt is a big driver in economic swings because it allows us to consumer more when we cant afford and it and less when we have to pay it back.
Debt cycles:
- 5 to 8 years
- 75 to 100 years
Any time you borrow you create a cycle. More for yourself now, means less for yourself sometime in the future.
Expansion: first phase of short term debt cycle Spending increases and prices rise Increase in spending is fueled by credit There is more money than goods, so prices go up. -> Inflation
Central Bank controls Expansion -> Inflation -> Increased Interest Rates -> Less Borrowing -> Less Spending -> Decreased Prices -> Deflation -> Recession -> Decreased Interest Rates
! The bottom and top of the short term debt cycle finishes with more productivity and more debt than the previous cycle. This is because of human nature, people have an inclination to borrow and spend more instead of paying off debt. Which leads, to the Long Term Debt cycle.
Debt burden: ratio of debt to income
So, despite increasing debt, the increase in income and asset values help make borrowers remain credit worthy. This obviously cannot continue forever. And it doesnt, at some point debt repayments grow faster than income, forcing people to cut back on their spending. Which leads to Deleveraging.
Similar to recession, but interest rates cannot be lowered to save the day! Borrowers stop borrowing because of existing debt burden. Lenders dont feel safe lending, because lenders might not be able to pay back. The Economy is no longer credit worthy.
Solution to decreasing debt burden in a deleveraing
- cut spending (austerity)
- reduce debt (defaults, restructuring)
- redistribute wealth (taxes)
- print money
Depression: People discovering what the thought of their wealth, isnt really there.
In order to have a beautiful deleveraging, there needs to be balance in the four methods. The printing of money needs to be such the the growth of income is higher than the growth of debt.
Leveraging -> 50+ years (lost decade) Depression -> 2-3 years Reflation -> 7-10 years
Three Rules of Thumb
- dont have debt rise faster than income, because your debt burdens will eventually crush you
- dont have income rise faster than productivity, because you will eventually become uncompetitive
- do all that you can to raise your productivity, because in the long run, thats what matters most.
Thoughts
This is the secret of what to learn…whatever increases your productivity!