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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