Credit and Economic Cycles (According to Ray Dalio)

This is the fourth post in my series on Mr. Ray Dalio’s remarkable little film How the Economic Machine Works.  I suggest you read those before beginning this one.  In this post, we will follow along with Mr. Dalio and examine the interaction between productivity and credit, and how that interaction plays into economic cycles.

According to Mr. Dalio, the proximate cause of economic swings is credit.  Credit allows us to spend more than we produce as soon as we get it.  When we start to pay it back, it forces us to spend less than we consume.  This superimposes an S-shaped curve over the nice, smooth line of productivity.  While we are spending credit, we are above the line of our productivity; when we are paying the loan back, we are spending below our productivity line.   According to Mr. Dalio, we can expect two different types of debt cycles. The short one takes from five to eight years, and the (much) longer one takes between 75 and 100 years.  

These are cycles, but often we don’t see them that way because we aren’t considering the spans of time involved.  When I can’t afford to pay my bills, I’m not considering how my behavior five years ago led me to my current predicament.  When we only view them from day to day or week to week, they just look like “booms” and “busts” and their cyclicality is hidden. It is important to note that swings around the line are not due to how much innovation or hard work there is.  The slope of the productivity line may be affected by massive amounts of innovation and hard work over a long period of time, but rapid swings are almost always the product of credit cycles. In other words, whipsaw action in economic conditions is most often a direct effect of how much credit there is.

In an economy without credit, the only way to grow is to increase your productivity.  You can learn more, innovate more, and work harder, but you can’t borrow money in such an economy.  An economy like this would be very flat on our graph. There would be an almost imperceptible move forward, and we would see it as if it were standing still. In other words, there would be no cycles.

In the real economy, as a natural result of our collective borrowing behavior, we have cycles.  You can’t blame Congress for this one. The lawmakers don’t cause economic downturns more than they do economic upturns (Sorry, Mr. President).  Cycles in the economy are caused by credit, and credit works the way it does because of human nature and the system we have in place to facilitate that credit.

Borrowing has the effect of pulling earnings forward.  To buy something you can’t afford, you must spend more than you make.  You must borrow productivity from your future self. Your poor future self must spend less than is produced in order to pay back the debt.  Therefore, when you spend what you make, the spending curve is “flat.” When you spend more than you make (use credit) your spending is in an uptrend.  When you must start paying back the borrowed money, your spending goes into a downtrend. Because you spending effects the income of everyone connected to you in the money chain, their income drops are your spending drops.  By definition, a cycle is formed. Anytime you borrow, you create a cycle. This is just as true for overall economies as it is for individuals. If follows that as long as there is credit in the economy, there will be economic cycles.

If all of this sounds rather mechanical, that’s because it is.  That’s why Mr. Dalio called it the “economic machine.” According to him, it also means that these cycles are predictable.  

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