Productivity, Credit, and the Economy (According to Ray Dalio)

This is third post relating to Ray Dalio’s remarkable little video, How the Economic Machine Works (link at the bottom of this page).  In this one, we will consider the relationship between economic productivity and credit, and how that affects the overall economy.

As Mr. Dalio explains,  credit is important to the economy because when borrowers receive credit, they can increase their spending.  Spending, you will recall, is what drives the economy. Because of the nature of transactions, one person’s spending is always another person’s (or entity’s) income.   This makes perfect sense.  Every dollar that you spend, someone else earns.  Every dollar that you earn resulted from someone else spending.  Economies consist of transactions, and those transactions tend to form long chains that depend on the preceding transaction to go forward.  This means that when you spend more, someone else earns more.

When someone’s income rises, it makes lenders more willing to extend him or her credit.  The person has more money coming in, so it is more likely that the person can pay down more debt.  In other words, the person is more creditworthy. Creditworthiness is a big deal in our modern economy, and we use credit scores to determine the creditworthiness of individuals.   To be truly worthy of credit, you need the ability to repay (a good income) and collateral.  Collateral is something of value that you can sell to meet your obligations if you find in the future that your income is insufficient.  When you buy a car or a house, for example, the thing you bought is the collateral. If you don’t pay your car loan, the bank will repossess it.  

More income means that people can spend more, but it also means that they can borrow more.  More credit leads to more spending. This, too, happens in a chain reaction. If my spending goes up, then the people that I buy stuff from also see an increase in income.  This means that they have more money and more credit, so their spending will go up. The pattern is self-reinforcing, and it leads to economic growth. That sounds great, but the problem is that it leads to economic cycles.  

In a normal transaction, you have to give something to get something.  How much you get is determined by how much you produce.  Over time, we learn and innovate, and that accumulated knowledge raises our living standard (because we can make more money).  This tends to happen across the board, and we call such an increase productivity growth.   Those that are inventive and hardworking can raise their standard of living quickly.  If you are complacent and lazy, then the opposite will be true.

Often, we don’t see that fact because productivity matters most in the long run.  In the short run, credit can make up for a lack of productivity. In practice, we can’t really tell if spending increases are caused by more productivity or more credit.  A major factor in this timing issue is the fact that productivity tends to be slow and steady over time. This means that productivity growth is seldom a major factor in economic swings.  On the graph we talked about earlier, there tends to be a straight line with a slight upward slope, representing the idea that productivity grows slowly but steadily over time.

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.