How the Economy Works (According to Ray Dalio)

Over the past three or so years, I have written well over 1,000 pages on personal finance and investing.  Every concept, it seems, requires diving off into another concept. Explanation calls for explication, after all.  Given this background in the explication of often difficult topics, I was stunned by the elegant simplicity of Mr. Dalio’s “How the Economic Machine Works” video.  It is cleverly animated, and you should watch it:

As Mr. Dalio suggests in his concluding remarks, the video presents an oversimplification.  Obviously, the complete science of economics cannot be adequately presented in a 30 minute animated presentation.  However, it does hit the high points, and provides a reference for those of us who have never considered credit cycles and how they run the economy.

Mr. Dalio’s basic premise is that the economy runs “like a machine.”  Because most people don’t understand how the machine works, there has been a lot of needless economic suffering over the ages.  According to Mr. Dalio, this simple understanding was what enabled him to anticipate and sidestep the most recent global economic crisis, as well as informing his investment decisions for over thirty years.  

He uses the machine analogy because at its core, the economy functions in a simple, mechanical way.  Like a natural scientist, he breaks down the functioning of the economy into its most basic parts: Transactions.  Each transaction may be simple in its own right, but there are “zillions” of them each and every day.  Humans conduct these transactions, and they are driven by human nature. This collective action results in three major forces that drive the economy.  The first major economic force he discusses is productivity growth.   The second major force is what he calls the short-term debt cycle.   The third is the long-term debt cycle.   These three factors go a long way in explaining Gross Domestic Product, which is the pulse of the national economy.

The easiest way to visualize how these factors work together is to plot them on top of each other as lines on a graph.  The height of the line (the vertical axis) tells us the level of GDP and the “run” of the line (the horizontal axis) tells us the amount of time that passes.  In this way, we can see how conditions are changing for better or for worse over time.

Mr. Dalio defines an economy as the sum of the transactions that make it up.  Transactions involve the transfer of something of value for something else of value.  In our economy, the buyer usually transacts in cash, and the seller is usually selling some good or service (or financial assets like stocks and bonds).  Any time you buy or sell something, you are creating a transaction. It is critically important to note that the buyer doesn’t care whether you use money that you have earned or credit when you conduct a transaction.  They get their money regardless. Therefore, credit and money spend the same way and a transaction takes place when either is used to buy something.

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