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.  

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.