The economy might seem complex, but it is actually based on three simple processes that are repeated over and over again. These processes are based on human nature and the fact that most people tend to act in their own best interests. The following information is based on a presentation by Ray Dalio.
Who is Ray Dalio?
According to Wikipedia, Raymond Dalio was born August 8, 1949 and is an American billionaire investor, hedge fund manager, and philanthropist. Dalio is the founder of investment firm Bridgewater Associates, one of the world’s largest hedge funds. Bloomberg ranked him as the world’s 58th wealthiest person in June 2019.
The Three Main Forces of the Economy
- Productivity Growth
- The Short-Term Debt Cycle
- The Long-Term Debt Cycle
What is the Economy?
The total economy is simply the sum total of all the individual transactions that make it up. Each transaction is a buyer and a seller getting together and deciding on a mutually agreeable price. The buyer would rather have the product than $X and the seller would rather have the $X than the product. The “product” can be goods, services or financial assets. The buyer doesn’t have to have the cash on hand however, if he has credit.
Since credit spends just like money, so by adding the money spent to the credit spent you get the total spending. Total spending drives the economy. All cycles in an economy are driven by transactions.
Money Spent + Credit Spent = Total Spending
What is a “Market”?
A market consists of all the buyers and all the sellers making transactions for the same thing. So there is a “Car Market”, a “Wheat Market”, and a “Stock Market” and millions of others. Some markets are larger than others. For instance, the Crude Oil market is much bigger than the vitamin market or the noodle market.
The economy is made up of all the individual “markets” which as we said, is made up of all the individual transactions in that market. People, businesses all engage in transactions the same way. Some transactions are larger than others, but they are all interested in coming to an agreement that they believe is favorable to their interests.
The Biggest Buyer and Seller
The biggest buyer is the government which is made up of two components. The Central Government and the Central Bank. The Central Government collects taxes and spends money.
The Central Bank is different from other market participants because it has the ability to control the amount of money and credit in the economy. It does this by controlling interest rates and/or creating money (see our article on How the FED Controls the Money Supply).
Credit is the most important component of the Economy and probably the least understood. Just like buyers and sellers go to the market to make transactions so do lenders and borrowers. Lenders want to make their money grow and borrowers want to buy something they can’t afford. High-interest rates make borrowing expensive so there are fewer borrowers.
Credit is created when a lender agrees to lend, and a borrower takes the loan. At this point, “debt” is created. Debt is simultaneously an asset to the lender and a liability to the borrower. When a borrower receives credit, he is able to buy something that he previously wouldn’t be able to afford. And since spending drives the economy increased credit results in a bigger economy. The problem with debt is that at some point you have to pay it back. So, although you can consume more than you produce when you incur debt at some point in the future you have to consume less than you produce to pay it back. This creates cycles.
Most of what people consider money is actually credit. The total amount of Credit in the United States is about $50 Trillion while actual money is only about $3 Trillion.
Debt swings occur in two cycles. The short-term debt cycle takes about 5-8 years while the long-term cycle takes about 75 to 100 years. Borrowing now is like borrowing from your future self. You can spend it now but since your future self will have to repay it you will have to consume less in the future. This creates the short-term cycle with increased consumption now and decreased consumption 5 years from now.
Because an economy with credit allows spending to increase faster than productivity in the short run but not in the long run, eventually the piper must be paid.
But credit is not just a bad thing that causes cycles. It is only bad when it finances over-consumption which can’t be paid back. In “Is it ever wise to Owe money” we learn that there is good debt and bad debt. “Good debt” increases productivity and pays for itself while “bad debt” increases consumption and eventually becomes worthless.
The Expansion Phase
During the first phase of the cycle spending is rising as people borrow and increase their spending. This increases other people’s income which allows them to spend more but also to borrow more. At the same time, it also increases the prices of items. When the amount of spending and income grows faster than the production of goods prices rise. That is because demand is outpacing supply. When prices rise we call this inflation.
When prices begin rising the Central Bank raises interest rates in an effort to reduce the level of credit creation. As credit creation decreases spending decreases which lowers demand and prices begin falling. Falling prices is called deflation.
The Contraction Phase
Falling prices and reduced consumption can result in increased unemployment as producers need fewer employees. As economic activity decreases it can result in a recession. When credit is easily available there is an expansion but during the contraction phase credit isn’t easily available either due to fear on the part of lenders or fear of additional debt by borrowers or from the fact that credit is simply too expensive.
The Long-Term Debt Cycle
In the short-term debt cycle, not all debt is extinguished before the next cycle begins. So, each cycle is progressively higher than the previous one. This progressive increase in debt results in a long-term debt cycle. But things appear to be going well, so banks continue to lend, and asset values increase.
This results in a “bubble economy” people borrow huge amounts of money to buy assets causing their price to soar thus enticing even more people to jump on the bandwagon. This causes prices to go even higher. High prices for their assets cause people to feel wealthy so they spend more.
At some point debt repayment starts growing faster than incomes, forcing people to cut back on spending. Once again incomes begin to go down due to the decrease in spending causing “deleveraging”.
In a “deleveraging” a lot of bad things happen. People cut spending, incomes fall, credit disappears, banks get squeezed, asset prices begin falling, stock markets crash, social tensions rise, and problems snowball.
In an effort to repay debts, borrowers are forced to sell assets which drives down the price of all assets including stocks, real estate, and even gold. Banks get into trouble because the value of the collateral is falling, so borrowers are becoming less creditworthy. People feel poor so they don’t want to borrow and banks don’t want to lend.
This results in less spending, less income, less wealth, less credit and less borrowing causing the economy to tank. This looks similar to a recession but in this case, lowering interest rates no longer helps because interest rates hit 0% and still there are no borrowers and banks are no longer willing to lend. The entire economy has become “not creditworthy”.
The problem Is that debt burdens are too high and must come down. There are 4 ways that this can happen.
- Cut Spending
- Reduce Debt through Defaults and Restructuring
- Redistribute Wealth
- Central Banks Print Money
These factors are deflationary, so the central bank looks for ways to fight deflation. But government revenues are falling due to lower incomes which results in fewer tax revenues. At the same time, unemployment, welfare, and stimulus program expenses are rising. Deficits explode as government spending increases. Thus, governments raise taxes on the rich to help balance the budget. Stress increases between “the haves” and the “have-nots” this can result in revolution or even war.
To relieve the stress the Central Bank prints money out of thin air. Money printing is inflationary and tends to counteract the deflationary pressures.
- Don’t have debt rise faster than income (or debt will eventually crush you).
- Don’t have income rise faster than productivity (or you will become uncompetitive).
- Raise Your Productivity because in the long run that’s what matters most.
You might also like:
- How the FED Controls the Money Supply
- What Causes Unemployment?
- Marginal Utility
- What is “Leverage”?