How The Economic Machine Works One of the things I admire most in people is the ability to synthesise and convey complex ideas in a manner that are accessible and relatively easy to understand. Ray Dalio does this exceptionally well in his 30-minute YouTube video: How The Economic Machine Works: https://www.youtube.com/watch?v=PHe0bXAIuk0 Although the economic concepts presented by Ray in this video are oversimplified, it still provides an incredible framework for beginners wishing to learn more about Economics. In this blog, I will focus on writing about my passions, one of which is Economics. Without further adieu, this article will provide a brief summary of Ray’s video. Building The Economic Machine In the same way that atoms are the building blocks of matter, transactions are the fundamental building blocks of the economic machine. These transactions are above all else driven by human nature, and they create three main forces that drive the economy: (1.) Productivity Growth (2.) The Short-Term Debt Cycle (3.) The Long-Term Debt Cycle Transactions Transactions are simply the exchange of money or credit between a buyer and seller for goods, services, or financial assets. Credit simply refers to money that’s been borrowed. If we add together all the money and credit that’s been spent, that gives us the total spending. It is this total spending that drives the economy. Now that we can see how transactions drive the economy, we must begin to understand what markets are given that transactions cannot occur without markets. Markets, Governments & Central Banks A market consists of all the buyers and sellers making transactions for the same thing. For example, there is a wheat market, a property market, and a stock market among many others. An economy consists of all the transactions in all of its markets. If you add up the total spending and the total quantity sold in all markets, you have everything you need to know to understand the economy. The biggest buyer and seller is the government. You can think of the government as an entity that collects taxes and spends money. It is separate and different to a central bank. A central bank is different from the government because it can actually control the amount of money and credit circulating in the economy (also known as the money supply). For this reason, the central bank plays an integral role in the flow of credit within the economy. Credit We need to pay particularly close attention to credit because it is the most important and volatile part of the economy. Credit allows borrowers to buy things in the present that they otherwise wouldn’t be able to afford. In a similar manner, it allows lenders to make money since borrowers promise to repay the amount they borrowed (called the principal) plus interest. In this way, credit can help both lenders and borrowers get what they want. When interest rates are high, there is less borrowing because it is expensive. Conversely, when interest rates are low, borrowing increases because it’s cheaper. As soon as a lender lends money to a borrower, credit is created. As soon as credit is created, it immediately turns into debt. Debt is interesting because it is both an asset to the lender, and a liability to the borrower. In the future, when the borrower repays the loan, plus interest, the asset and liability disappear, and the debt is settled. I know exactly what you’re thinking, why on earth is credit so important? Well, credit is very important because when a borrower receives credit, they are able to increase their spending, and remember, it is spending that drives the economy. This is because one person’s spending is another person’s income. When someone’s income rises, it makes lenders more willing to lend them money because they are more creditworthy. A creditworthy borrower has two things: (1.) The ability to repay (2.) Collateral Having a lot of income in relation to their debt gives the borrower the ability to repay. In the event that they can’t repay, they have valuable assets to use as collateral that can be sold. This makes lenders feel more comfortable in lending them money. So increased income allows for increased borrowing which allows for increased spending, and since one person’s spending is another person’s income, this leads to more borrowing and the cycle repeats. This self-reinforcing pattern leads to economic growth, and this is why we have cycles. If you’re a seller in a transaction, you have to provide something in order to get paid, and how much you get depends not only on what you’re producing, but how much of it you’re producing i.e it depends on your productivity. In economics, productivity measures output per unit of input, such as labour hours or capital. It is intuitive to think that productivity growth is the most important factor in determining economic growth, and while this happens to be true in the long run, credit actually matters much more in the short run. This is because productivity growth doesn’t fluctuate much, so it’s not a big driver of economic swings. By contrast, debt is – because it allows us to consume more than we produce when we acquire it (think credit cards) and it forces us to consume less than we produce when we pay it back. Debt swings occur in two big cycles: (1.) The Short-Term Debt Cycle (Approximately 5-8 years long). (2.) The Long-Term Debt Cycle (Approximately 75-100 years long). These cycles along with one other factor: (3.) Productivity growth Are what drive the economy. The chart below shows a picture of long-term productivity growth over time (as shown by the straight line). The longterm productivity growth line shows us that over time, the average trend is increased economic growth and living standards (due to higher productivity over time). However, the volatile curved line represents the short-term debt cycle. That line shows us that while economic growth is increasing on average in the long-term, it fluctuates highly in the shortterm. As mentioned, these swings around the line are not due to how much innovation or hard work there is in the economy, but rather, they are due to the availability of credit. For a second, let’s just imagine an economy without credit. In this economy, the only way in which you can increase your 7:46 Let's for a second imagine an economy without credit. In this economy, the only way I can increase my spending 7:53 is to increase my income, which requires me to be more productive and do more work. 7:59 Increased productivity is the only way for growth. Since my spending is another person's income, 8:05 the economy grows every time I or anyone else is more productive. 8:10 If we follow the transactions and play this out, we see a progression like the productivity growth line. 8:16 But because we borrow, we have cycles. This isn't due to any laws or regulation, 8:23 it's due to human nature and the way that credit works. Think of borrowing as simply a way of pulling spending forward. 8:32 In order to buy something you can't afford, you need to spend more than you make. 8:37 To do this, you essentially need to borrow from your future self. In doing so you create a time in the future 8:44 that you need to spend less than you make in order to pay it back. It very quickly resembles a cycle. 8:51 Basically, anytime you borrow you create a cycle.? This is as true for an individual as it is for the economy. 8:59 This is why understanding credit is so important because it sets into motion a mechanical, predictable series of events that will happen in the future. 9:08 This makes credit different from money. Money is what you settle transactions with. 9:14 When you buy a beer from a bartender with cash, the transaction is settled immediately. 9:20 But when you buy a beer with credit, it's like starting a bar tab. You're saying you promise to pay in the future. 9:27 Together you and the bartender create an asset and a liability. You just created credit. Out of thin air. 9:35 It's not until you pay the bar tab later that the asset and liability disappear, H 6:03 which allows increased spending. And since one person's spending is another person's income, 6:09 this leads to more increased borrowing and so on. This self-reinforcing pattern leads to economic growth 6:17 and is why we have Cycles. In a transaction, you have to give something in order to get something 6:25 and how much you get depends on how much you produce over time we learned 6:31 and that accumulated knowledge raises are living standards we call this productivity growth 6:37 those who were invented and hard-working raise their productivity and their living standards faster 6:43 than those who are complacent and lazy, 6:48 but that isn't necessarily true over the short run. Productivity matters most in the long run, but credit matters most in the short run. 6:54 This is because productivity growth doesn't fluctuate much, so it's not a big driver of economic swings. 7:01 Debt is — because it allows us to consume more than we produce when we acquire it 7:06 and it forces us to consume less than we produce when we pay it back. Debt swings occur in two big cycles. 7:14 One takes about 5 to 8 years and the other takes about 75 to 100 years. 7:20 While most people feel the swings, they typically don't see them as cycles because they see them too up close -- day by day, week by week. 7:29 In this chapter we are going to step back and look at these three big forces and how they interact to make up our experiences. 7:37 As mentioned, swings around the line are not due to how much innovation or hard work there is, they're primarily due to how much credit there is. 7:46 Let's for a second imagine an economy without credit. In this economy, the only way I can increase my spending 7:53 is to increase my income, which requires me to be more productive and do more work. 7:59 Increased productivity is the only way for growth. Since my spending is another person's income, 8:05 the economy grows every time I or anyone else is more productive. 8:10 If we follow the transactions and play this out, we see a progression like the productivity growth line. 8:16 But because we borrow, we have cycles. This isn't due to any laws or regulation, 8:23 it's due to human nature and the way that credit works. Think of borrowing as simply a way of pulling spending forward. 8:32 In order to buy something you can't afford, you need to spend more than you make. 8:37 To do this, you essentially need to borrow from your future self. In doing so you create a time in the future 8:44 that you need to spend less than you make in order to pay it back. It very quickly resembles a cycle. 8:51 Basically, anytime you borrow you create a cycle.? This is as true for an individual as it is for the economy. 8:59 This is why understanding credit is so important because it sets into motion a mechanical, predictable series of events that will happen in the future. 9:08 This makes credit different from money. Money is what you settle transactions with. 9:14 When you buy a beer from a bartender with cash, the transaction is settled immediately. 9:20 But when you buy a beer with credit, it's like starting a bar tab. You're saying you promise to pay in the future. 9:27 Together you and the bartender create an asset and a liability. You just created credit. Out of thin air. 9:35 It's not until you pay the bar tab later that the asset and liability disappear, Credit Credit is the most important part of the economy because it is the biggest and most volatile part. Lenders lend money to make more of it. Borrowers borrow money to buy something they can’t afford, such as a house, a car, a business or stocks. Borrowers promise to repay the amount borrowed (the principal) with interest. When interest rates are high, borrowing is low. When interest rates are low, borrowing is high. When lenders believe borrowers will repay, credit is created. Credit can be created out of thin air. When credit is issued it becomes debt. It’s a liability for the borrower, and an asset for the lender. It disappears when the transaction is settled. Credit is important because it means borrowers can increase their spending. This is fundamental because one person’s spending is another person’s income. This means that the other person, on the back of an increase in income and more believability by lenders that they will repay their principle with interest, can now borrow more money to increase their own spending, which in turn becomes someone else’s income. This creates a cycle, per the chart below – The chart shows that short-run economic growth is not primarily driven by innovation but rather by the availability of credit. Productivity growth matters more in the long run. Productivity Growth Over time, we learn, we accumulate knowledge, we work and all of this drives productivity growth. Productivity matters in long run, but credit matters in the short run. Productivity growth doesn’t fluctuate much so it’s not big driver of economic swings, but debt is. Debt Debt allows us to consume more than we produce when it is acquired, and forces us to consume less when we have to pay it back. This ‘debt swing’ occurs in two cycles, short-term (5 to 8 years), and long-term (75 to 100 years). The thing is that most people don’t really see it because they are living day by day, week by week. If the economy lacks credit, the only way to boost it is by working harder or smarter. This means more productivity, which is slower and linear, per the diagonal line in the above chart. Debt Cycles Every time you borrow, you create a cycle. When you borrow, you’re effectively borrowing from future self — borrowing from a self that will need to spend less than they make. This is as true for the individual as it is for the economy at large. This sets into motion what Dalio calls a mechanical, predictable sequence of events. Credit isn’t necessarily bad. It’s bad when it finances over-consumption that can’t be paid back (kind of like Greece, Portugal, Italy and Spain during the 2010s). It’s good when it efficiently allocates resources that produce income so that debts can be paid back. For example, buying a consumable such as a television with debt is bad debt. Buying a tractor to harvest fields with, generate income, pay back debt, and enjoy a better quality of life is good debt. Like most things, when it comes to cycles, what goes up must eventually come down. Short-term Debt Cycle The first phase of the cycle is an expansion. Spending increases which increases incomes and asset values. and leads to inflation. When spending is faster than the production of goods, it means that we have more demand than supply, which results in inflation. The Central Bank manages inflation by raising interest rates, which makes credit more expensive and decreases borrowing, spending and incomes. This results in deflation — prices coming back down. Economic activity decreases, and if unchecked this can lead to a recession (zero or negative GDP growth in two successive quarters). At this point, Central Banks decrease interest rates in order to stimulate borrowing and spending, and boost economic activity and get the economy out of recession. If credit is available it leads to economic expansion. When it’s not, it leads to recession. In the short-term debt cycle, spending is only constrained by the willingness of lenders and borrowers to provide and receive credit. This short-term debt cycle lasts for about 5 to 8 years and happens over and over again for decades. The peak and trough of the cycle end up higher and higher with each subsequent cycle which means more growth and more debt is accumulated. This brings us to… Long-term Debt Cycle The long-term debt cycle lasts for about 75–100 years. Despite more debt being accumulated through the short-term debt cycles, lenders keep lending money. This is because of the short-now view of the world — high incomes, soaring asset prices, booming stock-markets and so on. Because of this, over a long period of time, debts rise faster than incomes creating the long-term debt cycle. But as COVID19 and previous crashes reminds us, the recent past is not always an accurate predictor of the future. This irrational exuberance is preempts an economic bubble. The Debt Burden This is good. When incomes grow in relation to debt, things are kept in balance But a debt burden emerges when debt growth exceeds income growth. This debt to income ratio is the debt burden. While people might feel wealthy as the value of their assets soar, a wise philosopher once said that we shouldn’t conflate the trappings of success with success in itself. People might remain creditworthy to borrow and spend and feel wealthy, but that’s because of the collateral that underpins their borrowings. But as the debt burden increases, the value of said collateral can vanish. As the debt burden increases, it creates larger debt repayments over decades, and eventually it hits a peak, as was the case with the global financial crisis in 2008, with Japan in 1989 or during The Great Depression in 1929. At this point, spending goes backwards, borrowing stalls, incomes drop, asset values plummet, stock-markets tank and social tensions rise — this is called a deleveraging. It’s a little like what we’re seeing today, although the COVID19 crisis wasn’t brought upon us by the long-term debt cycle correcting itself, but through a ‘force majeure’ external event and Government interventions. Suddenly the value of the collateral that was used to securitise loans is gone, and banks find themselves in trouble. This led to the massive bail-outs of banks like JP Morgan, Goldman Sachs, Wells Fargo, State Street and others in a massive US$700 billion bail-out bill in 2008. Lehman Brothers weren’t so lucky. At this point in the long-term debt cycle, interest rates can no longer be used to stimulate the economy because they are already at zero. The difference between a recession and a deleveraging is that the debt burden is too big and can’t be relieved by lowering interest rates. So what do we do now? Four Levers to Deleverage the Economy There are four levers we can pull to get the economy back on its feet during a deleveraging. 1 — Cut Spending Essentially austerity measures for businesses and individuals. But the thing about this is that. perhaps paradoxically, it causes incomes to fall because remember, one person’s spending is another person’s income, so the debt burden gets even bigger because people can’t afford to repay their debts anymore. Cutting spending is deflationary and painful, and as businesses further cut costs, it means less jobs and higher unemployment. 2 — Reduce Debt Debt can be reduced through defaults and restructures. When banks are squeezed, businesses can’t repay their loans, and individuals are lining up to withdraw their money from the bank for fear of it not being there tomorrow in case of bank defaults, you’re likely looking at a depression. Default This is essentially a failure to repay. This immediately and directly impacts the defaulting Government’s bondholders and has dire downstream consequences for the entire economy and people of a nation which is why countries like Greece were bailed out by the deeper-pocketed EU compatriots (even though the likes of Germany ultimately benefited). Debt Restructuring With restructuring, lenders get paid back less or paid back over longer period of time, or at a lower interest rate. Lenders would rather have a little of something than all of nothing (remember this when renegotiating your interest rates and repayment terms during this time of COVID19), and ultimately this serves to decrease debt. But debt restructuring also causes income and asset values to disappear faster, again causing the debt burden gets worse. We’re not having much luck here…the debt reduction is painful and deflationary as well! The Central Government is impacted, because it is collecting fewer taxes but needs to spend more because unemployment has risen! It needs to create stimulus plans to increase spending in the economy. The Government’s budget deficit explodes because it now needs to spend more than it earns in taxes. To fund this deficit, it either needs to raise taxes, borrow money, or both. And with unemployment at a high, where do those taxes come from? The rich. 3 — Redistribute Wealth from Haves to Have-Nots Much like Robin Hood stealing from the rich to give to the poor, incomes are redistributed. This can result in the wealthy being squeezed and resenting the have-nots, and vice versa for the contrast in outcomes. If this continues, social disorder and revolution can follow, both within and between countries, as was the case in the 1930s when Adolf Hitler came to power due to economic collapse in Germany. Pressure to end the depression mounts, but with no credit in the market, and with most ‘money’ being credit, as was mentioned earlier, the only thing left to do is… 4 — Print Money With interest rates at zero, the Central Bank is forced to print money. This is inflationary and stimulative, although it can decrease the value of a currency, especially if too much is printed, which can make nations uncompetitive or less competitive on a global scale. By buying financial assets, the Central Bank drives up asset prices but it only helps people who have financial assets. The Central Bank can only buy financial assets, not goods and services, so in order to support the economy at large, the Central Bank buys Government bonds which gives the Government the ability to buy goods and service. This gets money into the hands of people at large, not just those with financial assets. The Government can now run at a deficit while also spending on stimulus programs and unemployment benefits. This will lower the economy’s overall debt burden over time, and increase spending and incomes. However, policy makers need to balance the four levers in order to lead to what Dalio calls a ‘beautiful deleveraging’. When it’s beautiful, debts decline relative to income growth, real economic growth is positive, and inflation isn’t a problem. This is because a delicate balance between cutting spending, reducing debt, transferring wealth and printing money is maintained. Printing money won’t cause inflation providing it offsets the decrease in credit, but does not exceed it. However, if too much money is printed it can lead to hyper-inflation, is what Germany experienced during its deleveraging in the 1920s when 160 German marks were equivalent to just one US dollar. An ugly deleveraging follows if income growth is not higher than the rate of interest on accumulated debt to cut the debt burden. The ‘reflation’ or recovery phase of the long-term debt cycle — the time it takes for debt burdens to fall and economic activity to resume per usual — lasts roughly 7 to 10 (10 years for the Great Depression and seven for the global financial crisis). This is what’s known as a lost decade. Three Rules of Thumb For Life Finally, Dalio leaves us with three rules of thumb with which to navigate the economy ourselves, be it in our own businesses, organisations we work at or our personal finances. 1. Don’t have debt rise faster than income (because debt burdens will eventually crush you). 2. Don’t have income rise faster than productivity — it will eventually render you uncompetitive. 3. Do all you can to raise productivity — in the long run that’s what matters most.
