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.  

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Recessions and Depressions (According to Ray Dalio)

According to Mr. Dalio, a deleveraging looks like a recession, but interest rates can no longer be lowered to save the day.  In other words, in a deleveraging, the central bank can’t lower interest rates because interest rates are already low.  When rates hit 0%, the stimulus ends. The economic conditions are such that lenders realize that the debt burden is simply too large, and many outstanding loans will never be paid back.  Everyone worries about the economy, and lenders stop lending and borrowers stop borrowing.

Mr. Dalio points out that there are only four basic approaches to lowering the debt burden in such cases.

  1.  People, businesses, and governments can lower spending.  When governments “tighten their belts,” the results are often called “austerity measures.”
  2.  Debts can be reduced through defaults and restructuring.  
  3.  Wealth can be redistributed from the “haves” to the “have nots.”
  4.  The central bank can print new money.

Every deleveraging in every economy throughout modern history has used these four basic methods of reducing the debt burden.  The first step is usually to reduce spending. This almost never helps the overall situation because, as you will recall, one person’s spending is another person’s income.  If everyone is saving money, then nobody is getting paid very much. This causes incomes to fall, and the rate if income reduction can be faster than the debts are being repaid.  If this happens, there is little “getting ahead” going on. As counterintuitive as it may sound, across the board spending cuts are deflationary and painful. Remember that businesses must take the same cost cutting measures, which usually means fewer jobs, less pay, and high unemployment.

When people get into this predicament, they can’t pay back the banks.  If this happens enough times, people start to worry about the solvency of the bank, and they rush to take their money out.  This can cause the banks to get into trouble, and they also begin to default on their debt. Such a severe economic contraction is known as a depression.

Some people have accused banks of wanting to default on loans so they could seize control of homes, automobiles, and other tangible assets.  This is not the case. Banks need money to be banks, and owning a bunch of houses in a depressed real estate market doesn’t help them very much.  Banks want borrowers to pay their loans back, because those debts are down on the balance sheets as assets. If borrowers never pay the bank back, then the asset vanishes, and the bank is much less wealthy than it was before.  This is why financial institutions often agree to debt restructuring when times are economically bad. Debt restructuring causes assets to lose value faster than debt is relieved, so the overall economic problem—the debt burden—just gets worse.  Debt reduction is also deflationary and painful.

When incomes are low and unemployment is high, the central government is in a weakened position to help because they are collecting fewer taxes.   This comes at a time when the government needs to increase spending because unemployment has risen. Many unemployed people have inadequate savings and will need financial assistance from the government to make ends meet.  Governments can increase spending, which helps make up for the decrease in the economy. This causes government deficits to explode during a deleveraging because they are spending much more than they are taking in in the form of taxes.  The only way governments can afford to stimulate the economy is to raise taxes or borrow money. However, when the economy is already bad and many people are unemployed, who do we tax? The rich, of course.

The rich have been hurt by the falling asset prices and poor economy.  They resent the “have nots” who have not saved enough to get through the lean times.   The “have notes” are angry at the wealthy for various reasons. We all need somebody to blame.  This causes social unrest within countries, and can even cause tensions between countries. Certain inflection points in history, such as the rise of the Nazi party, are the result of populism brought on by economic depression.

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The Psychology of Debt (According to Ray Dalio)

The thing that economists have noticed is that even during a recession, we tend to wind up a little more in debt at the bottom and top of each new cycle.  This Mr. Dalio attributes to the psychology of debt. We had rather borrow money and keep spending than we had pay down debt. The result of this is the long-term debt cycle.   While people are digging themselves into deeper and deeper holes, lenders (strangely) become more likely to loan them increasingly large sums of money.  This is another trick of psychology—because all of the debt-fuelled spending has the economy roaring, everybody assumes that everything is going great. You may have never thought about it that way, but lenders are people too.  People in general focus much more on what is happening right now than they do what happened in the past and what may happen in the distant future.

In the immediate past, incomes have gone up, and all of your stuff (houses, land, investments) is worth more now than ever.  Life seems pretty great. When people are borrowing and spending without end, we call it a bubble.  When the bubble bursts, we find that the spending and borrowing were in fact not without end.  There is always an end.

Even when we are in the middle of one of these credit cycles, we cannot see “the forest for the trees.”  Part of the problem is that during boom times, incomes rise about as fast as debts rise. This means that the ratio of income to debt—known as the debt burden—stays relatively constant.   The rising value of homes and investments increase people’s feelings of being wealthy, and bankers agree, lending them more money.  This would be great if the bubble was not artificially inflating those assets. When the bubble bursts, people find that they are “upside down” in their debt; banks find that their borrowers don’t have sufficient collateral anymore, and things start to go downhill in a big way.  When the debt burden gets big enough, the cycle goes into reverse—the economy begins deleveraging.

In a deleveraging, people cut spending, incomes start to fall, credit disappears, and asset prices start to drop.  Banks start to feel squeezed, and lending rules get very strict. Social tensions can start to rise, and people begin to blame the politicians—and every other group that is not like them—for the economic downturn.  If things keep going, borrowers are forced to sell assets to cover their debts. Assets will have declined in value, and investors will receive only a fraction of the previous value. Lower and lower prices create a panic in the markets, and stocks sell off and prices plummet.  Real estate values fall as well, and banks get into trouble. With no valuable assets to use as collateral, people have a hard time borrowing, and a hard time paying the bills. People start to feel poor.

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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.

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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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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.

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The Role Of Credit In The Economy (According to Ray Dalio)

In a previous post, I summarized Ray Dalio’s take on how the “Economic Machine” works.  In this article, we will consider the role fo credit within that economy.

If we add up the total money spent and the total credit spent, we will know the total spending.   This is important because the total amount of spending is what drives the economy.  Transactions, then, are the atoms that make up the economic machine. These powerful substances drive all economic forces and cycles.  If that makes good sense, then you will be in good shape. If you can understand transactions, says Mr. Dalio, you can understand the whole economy.

A market is made up of all the buyers and sellers making transactions for the same type of things.  We hear this term in finance often; there are stock markets, bond markets, and commodity markets.  The idea is no different than the idea of a “supermarket” where you buy groceries, or a “flea market” where you buy antiques and such.  

An economy, then, consists of all of the transactions in all of its markets.  It is important to note that while many transactions are between individuals, transactions occur between businesses, banks, governments, and a host of other organizations.  If a person or an entity engages in transactions, then we must include it in our consideration of the economy. In fact, the absolute biggest buyer and seller is the government.  At the national level, the idea of “government” consists of two important parts. There is the central government that collects taxes and spends money.   Also of great importance to the economy is the central bank.  In the United States, the central bank is called the Federal Reserve.  The Federal Reserve is different than other market participants (buyers and sellers) because it controls the amount of money and credit in the economy.

The Federal Reserve can do this because it has the power to set interest rates, and it has the power to print money.   This makes the central bank a key player in the flow of credit. According to Mr. Dalio, credit is the most important and least understood part of the economy.  This importance comes from the fact that it is at once the biggest and most volatile part.

If we think about how credit works, it consists of lenders and borrowers making transactions in a credit market.  Lenders are usually those that have excess money, and they want to make that money grow. Borrowers, on the other hand, usually want to buy something that they can’t afford.  Think about how integrated this idea is in our society. Who do you know that has purchased a house or a car without using credit? Some (more responsible) people also borrow money to start or expand a business.  Despite my assertions to the contrary, credit isn’t totally evil. It can help both lenders and borrowers get what they want.

The nature of credit, then, involves a borrower promising to repay what they borrowed (the principal) and pay an additional amount known as interest.  When interest rates are high, there is less borrowing because borrowing, under those circumstances, is expensive.  When interest rates are low, borrowing tends to increase because it is cheaper. All that is necessary to create credit is that a borrower is willing to make a promise to repay and a lender is willing to believe the borrower.  This means that any two parties can agree to create credit out of thin air. This is all really pretty simple, but we complicate it by giving it a bunch of different names. As soon as two parties create credit, it immediately turns into something called debt.  Debt is considered an asset by the lender, and a liability to the borrower.  

When the agreed upon date arrives and the borrower pays back the loan with interest, the debt disappears (back into the thin air from which it came) and the transaction is said to be settled.  

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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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