Mr. Dalio’s Final Thoughts on the Economic Machine


In this final post concerning Mr. Dalio’s fabulous little video How The Economic Machine Works, we will follow along with him and consider the role of the Government in dealing with depressions, and also some final pieces of advice he leaves us (both as participants in the global economy and as individuals).


During major economic downturns,  most of the credit that people thought was really money has all dried up and there is no money and there is no credit.  Wouldn’t it be nice if we could just print a bunch of money and flood it into the economy? That is precisely what the central bank can do.  This can work if it is done carefully. Remember that all of the solutions we’ve discussed so far to the debt load were deflationary.  Printing money by the central bank is inflationary. When the central bank prints new money, they use it to buy financial assets and government bonds.  This, in turn, allows the central government to engage in stimulus spending. The purchase of financial assets drives the prices back up, and people become more worthy of credit because the value of their assets has increased.   Of course, this only really helps those that own financial assets.

The rules put in place for the way the central government and the central bank operate work in such a way that each provides checks and balances for the other.  The central bank has to buy government bonds with the money it printed, and the central government has to put that money into the hands of the people. This serves to increase the central government’s overall debt, but it lowers the economy’s overall debt burden.

For this to work without destroying the economy, it has to be very carefully choreographed.  The deflationary ways of reducing the debt burden have to be balanced with the printing of new money so that the net inflation effect is minimized.  Many people wrongly assume that printing money will have an inflationary effect, and buying power will be lost to the degree that the new money is introduced into the economy.  This is not the case. When the new money is used to replace disappearing credit, it serves to keep spending level, which is what is necessary to keep inflation in check.

To really be effective in reducing the debt load, the central bank has to get the rate of income growth higher than the rate of interest.  The trick is to make sure that all methods of reducing the debt load are utilized such that inflation does not rise outside of an acceptable range.  Nobody wants to cut spending, restructure debt, and raise taxes, so printing money is the most popular alternative. If this is the only alternative used, it will cause hyperinflation and be a complete disaster.  If it is done correctly, the debt burden starts to fall, we start to lift out of the depression. Depressions usually last two to three years, and reflation tends to last seven to ten years.

Mr. Dalio ends his presentation by suggesting three major points that viewers should take away:

  1.  Don’t have debt rise faster than income, because your debt burdens will eventually crush you.
  2.  Don’t have income rise faster than productivity, because you will become uncompetitive.
  3.  Do all that you can to raise your productivity, because, in the long run, that’s what matters most.

These are powerful lessons for personal finance, corporate finance, and national policy.  



Credit and the Curious Lack of Money in the Economy (According to Ray Dalio)

A major difference between cash and credit is that when you settle a transaction in cash, it is settled immediately.  When you settle it with credit, you are “starting a tab.” Each such transaction creates both an asset and a liability.  The asset and the liability remain until you pay off the debt and the transaction is settled.

The shocking truth is that what most people consider money is in truth credit. The total amount of credit in the United States today is somewhere in the neighborhood of $50 Trillion, while the amount of actual money is only about $3 Trillion.  Economies with credit can “heat up” quicker than hypothetical economies without it, but the boom times cannot last because, at some point, the debt must be repaid.

So is credit merely an evil that causes painful economic cycles?  Not necessarily. It is evil when it fosters overconsumption that borrowers can’t pay back.  It can be a good thing when it efficiently allocates resources. This usually happens when people intelligently use credit to increase productivity.  It is especially valuable when it increases productivity driven income above the amount borrowed, which leaves the borrower in a better position despite having to pay off the debt.  Buying an awesome new 65-inch television on your credit card is stupid because it doesn’t generate income to help you pay back the debt. The bottom line is that credit is only good when it helps you make more money than the credit costs.  Borrowing money from your parents to take a college class that gets you a raise at work is an excellent example (assuming that Mom isn’t charging you too much interest).

The result of all of these increases in spending and paying back debt, we eventually reach an inflection point.  An inflection point is a point (usually on a graph) where the trend reverses and starts to go the other way. This is what causes the short-term debt cycle.  The early spending (largely on credit) phase is usually referred to as an (economic) expansion.  During this time, spending continues to increase, and prices start to rise because the supply of money and credit outstrip the production of goods.   We pay more to get what we want now.  

When prices rise like this, we call it inflation.  The central bank likes a little inflation (say around 2%), but they will take action if it gets much higher than that because high inflation generates problems.  The most common way to deal with rising inflation is to raise interest rates; the higher rates make money more expensive to borrow, and the credit cycle slows down. You can think of this as being like the monthly payments on your credit cards going up.  You can’t afford to borrow any more money because it is more expensive to pay for what you already borrowed. The lack of cash (it’s going to pay off debt) and the lack of credit (you’re already extended) means that spending slows down.

When spending slows down, none of the people that you were buying stuff from are making as much money, so, in turn, their spending slows down.  In this way, the interest rate can be used by the Federal Reserve as a thermostat for the entire economy. When people are spending less is that prices go down, which is called deflation.  Economic activity decreases across the board and we have a recession.  If the recession gets too severe and inflation isn’t a problem, the central bank will lower interest rates and cause the economy to pick up again.  

This works because with low-interest rates, debt is reduced.  The cost of borrowing money is cheaper, and people and businesses are more likely to borrow.  That borrowing results in increased spending, and the cycle starts all over again. We see another expansion.  We can talk about these effects in terms of credit availability. When credit is easily available, there is an economic expansion.  When credit is not easily available, there is a recession. Whichever way the economy is moving, the central bank usually has a hand in it.  These short-term cycles tend to last from five to eight years, and they happen over and over again for decades.