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How The Economic Machine Works by Ray Dalio

Feb 27, 2020
How the

economic

machine

works

, in 30 minutes. The economy

works

like a simple

machine

. But many people don't understand it, or don't agree on how it works, and this has led to a great deal of unnecessary financial suffering. I feel a deep sense of responsibility to share my simple yet practical budget template. Although unconventional, it has helped me anticipate and avoid the global financial crisis, and it has served me well for over 30 years. Let's start. Although the economy may seem complex, it works in a simple and mechanical way. It is made up of a few simple parts and many simple transactions that are repeated over and over a million times.
how the economic machine works by ray dalio
These transactions are, above all, driven by human nature and create 3 main forces that drive the economy. Number 1: Productivity Growth Number 2: The Short-Term Debt Cycle and Number 3: The Long-Term Debt Cycle We'll look at these three forces and how overlapping them creates a good template for following

economic

movements and finding out what's happening now. Let's start with the simplest part of the economy: transactions. An economy is simply the sum of the transactions that make it up, and a transaction is something very simple. You trade all the time. Every time you buy something you create a transaction. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets.
how the economic machine works by ray dalio

More Interesting Facts About,

how the economic machine works by ray dalio...

Credit is spent like money, so by adding the money spent and the amount of credit spent, you can find your total spend. The total amount of spending drives the economy. If you divide the amount spent by the amount sold, you get the price. And that is. That is a transaction. It is the building block of the economic machine. All cycles and all forces in an economy are driven by transactions. So if we can understand transactions, we can understand the whole economy. A market is made up of all the buyers and all the sellers who trade for the same thing.
how the economic machine works by ray dalio
For example, there is a wheat market, a car market, a stock market, and markets for millions of things. An economy consists of all the transactions in all its markets. If you add up the total spend and the total amount sold across all markets, you have everything you need to know to understand the economy. It's that easy. People, companies, banks, and governments engage in transactions in the ways I have just described: exchanging money and credit for goods, services, and financial assets. The biggest buyer and seller is the government, which consists of two important parts: a Central Government that collects taxes and spends money... ...and a Central Bank, which differs from other buyers and sellers because it controls the amount of money and credit in the economy.
how the economic machine works by ray dalio
It does this by influencing interest rates and printing new money. For these reasons, as we will see, the Central Bank is an important actor in the flow of Credit. I want you to pay attention to credit. Credit is the most important part of the economy and probably the least understood. It is the most important part because it is the largest and most volatile part. Just as buyers and sellers go to the market to transact, so do lenders and borrowers. Lenders usually want to turn their money into more money, and borrowers usually want to buy something they can't afford, like a house or car, or want to invest in something like starting a business.
Credit can help both lenders and borrowers get what they want. Borrowers promise to repay the amount they borrow, called principal, plus an additional amount, called interest. When interest rates are high, there are fewer loans because they are expensive. When interest rates are low, loans increase because they are cheaper. When borrowers promise to pay and lenders believe them, credit is created. Two people can agree to create credit out of thin air! That sounds simple enough, but credit is tricky because it goes by many different names. As soon as credit is created, it immediately becomes debt. Debt is both an asset to the lender and a liability to the borrower.
In the future, when the borrower repays the loan, plus interest, the asset and liability disappear and the transaction is settled. So why is credit so important? Because when a borrower receives credit, he can increase his expenses. And remember, spending drives the economy. This is because one person's expense is another person's income. Think about it, every dollar you spend someone else earns. And every dollar you earn, someone else has spent. So when you spend more, someone else earns more. When someone's income increases, lenders are more willing to lend them money because they are now more creditworthy. A solvent borrower has two things: the ability to pay and the guarantee.
Having a lot of income relative to your debt gives you the ability to pay. In case he can't pay, he has valuable assets to use as collateral that he can sell. This makes lenders feel comfortable lending you money. So higher income allows for higher borrowing, which allows for higher spending. And since one person's spending is another person's income, this leads to more borrowing and so on. This self-reinforcing pattern leads to economic growth and that is why we have Cycles. In a transaction, you have to give something to get something and how much you get depends on how much you produce over time we learned and that accumulated knowledge raises the standard of living we call this productivity growth those who were invented and workers raise their productivity and their standard of living faster than those who are complacent and lazy, but that is not necessarily true in the short term.
Productivity is more important in the long run, but credit is more important in the short run. This is because productivity growth doesn't fluctuate much, so it's not a big driver of economic swings. The debt is because it allows us to consume more than what we produce when we acquire it and forces us to consume less than what we produce when we pay it back. Debt swings occur in two major cycles. One takes around 5-8 years and the other takes around 75-100 years. While most people feel the changes, they usually don't see them as cycles because they look at them too closely, day by day, week by week.
In this chapter we are going to take a step back and look at these three great forces and how they interact to create our experiences. As mentioned, the changes in the line are not due to how much innovation or hard work there is, they are mainly due to how much credit there is. Let's imagine for a second an economy without credit. In this economy, the only way I can increase my expenses is to increase my income, which requires me to be more productive and work harder. Increased productivity is the only form of growth. Since my expenses are someone else's income, the economy grows every time I or anyone else is more productive.
If we follow the transactions and look at this, we see a progression like the productivity growth line. But because we borrow, we have cycles. This is not due to any law or regulation, it is due to human nature and the way credit works. Think of borrowing simply as a way to boost spending. To buy something you can't afford, you need to spend more than you earn. To do this, you essentially need to borrow from your future self. By doing so, you create a time in the future when you need to spend less than you earn to pay it back.
Very quickly it resembles a cycle. Basically, every time you borrow you create a cycle. This is as true for an individual as it is for the economy. That is why it is so important to understand credit because it sets in motion a mechanical and predictable series of events that will happen in the future. This makes credit different from money. Money is what you settle transactions with. When you buy a beer from a bartender with cash, the transaction settles immediately. But when you buy a beer with credit, it's like opening a bar tab. You are saying that you promise to pay in the future.
Together, you and the bartender create an asset and a liability. You just built credit. Of nothing. It's not until you pay the bar bill later that the asset and liability disappear, the debt disappears, and the transaction is settled. The reality is that most of what people call money is actually credit. The total amount of credit in the United States is about $50 trillion and the total amount of money is only $3 trillion. Remember, in a creditless economy: the only way to increase your spending is to produce more. But in a credit economy, you can also increase your spending by borrowing.
As a result, an economy with credit has more spending and allows income to rise faster than productivity in the short run, but not in the long run. Now, don't get me wrong, credit isn't necessarily a bad thing that just causes cycles. It is bad when it finances excessive consumption that cannot be repaid. However, it is good when it allocates resources efficiently and produces income so that you can pay off debt. For example, if you borrow money to buy a large television, you do not generate income to pay off the debt. But if you borrow money to buy a tractor, and that tractor allows you to grow more crops and earn more money, then you can pay off your debt and improve your standard of living.
In an economy with credit, we can follow the transactions and see how credit generates growth. Let me give you an example: Suppose you make $100,000 a year and have no debt. You are creditworthy enough to borrow $10,000, say on a credit card, so you can spend $110,000 even though you only earn $100,000. Since your expenses are someone else's income, someone is earning $110,000. The person who earns $110,000 with no debt can borrow $11,000, so they can spend $121,000 even though they only earned $110,000. Your spending is someone else's income and by following the transactions we can begin to see how this process works in a self-reinforcing pattern.
But remember, borrowing creates cycles and if the cycle goes up, eventually it has to go down. This brings us to the short-term debt cycle. As economic activity picks up, we see an expansion – the first phase of the short-term debt cycle. Spending continues to rise and prices begin to rise. This happens because the increase in spending is driven by credit, which can be created instantly out of thin air. When the amount of expenses and income grows faster than the production of goods: prices rise. When prices rise, we call it inflation. The Central Bank does not want too much inflation because it causes problems.
Seeing prices rise, interest rates rise. With higher interest rates, fewer people can afford to borrow money. And the cost of existing debt increases. Think of this as your monthly credit card payments going up. Because people borrow less and have higher debt payments, they have less money left over to spend, so spending slows...and since one person's spending is another person's income, income decrease... and so on. When people spend less, prices go down. We call this deflation. Economic activity slows down and we have a recession. If the recession becomes too severe and inflation is no longer an issue, the central bank will lower interest rates to get everything back on its feet.
With low interest rates, debt payments come down and borrowing and spending go up and we see another expansion. As you can see, the economy works like a machine. In the short-term debt cycle, spending is limited only by the willingness of lenders and borrowers to extend and receive credit. When credit is readily available, there is an economic expansion. When credit is not readily available, there is a recession. And keep in mind that this cycle is mainly controlled by the central bank. The short-term debt cycle typically lasts 5-8 years and occurs over and over again for decades. But notice that the bottom and the top of each cycle end with more growth than the previous cycle and more debt.
Why? Because people push it: they have an inclination to borrow and spend more rather than pay down the debt. It is human nature. Because of this, over long periods of time, debts increase faster than income, creating the long-term debt cycle. Even as people borrow more, lenders extend credit more freely. Why? Because everyone thinks things are going great! People are just focusing on what's been going on lately. And what has been going on lately? Income has been increasing! Asset values ​​are going up! The stock market roars! It's a boom! It pays to buy goods, services and financial assets with borrowed money!
When people do a lot of that, we call it a bubble. So even though the debts have been growing, the income has grownalmost fast enough to make up for them. Let's call the debt-to-income ratio the debt burden. As long as income continues to rise, the debt load will remain manageable. At the same time, asset values ​​are skyrocketing. People borrow large amounts of money to buy assets as investments, driving their prices up even higher. People feel rich. So even with the accumulation of a lot of debt, the increase in income and asset value helps borrowers to remain solvent for a long time.
But this obviously cannot go on forever. And it doesn't. Over decades, the debt burden slowly increases, creating ever-increasing debt payments. At some point, debt payments start to grow faster than income, forcing people to cut back on spending. And since one person's spending is another person's income, income starts to decline... ...making people less creditworthy and lending less. Debt payments continue to rise, causing spending to fall further... ...and the cycle is reversed. This is the peak of long-term debt. The debt burden has simply become too great. For the United States, Europe and much of the rest of the world this happened in 2008.
It happened for the same reason that it happened in Japan in 1989 and in the United States in 1929. Now the economy is beginning to deleverage. In a deleveraging; people cut spending, incomes fall, credit disappears, asset prices fall, banks take a hit, the stock market crashes, social tensions rise, and it all starts to feed itself back in the other direction. As incomes fall and debt payments rise, borrowers come under pressure. No longer creditworthy, credit dries up, and borrowers can no longer borrow enough money to pay off their debts. Struggling to fill this hole, borrowers are forced to sell assets.
The rush to sell assets floods the market That's when the stock market crashes, the housing market crashes, and the banks get into trouble. As asset prices fall, the value of collateral borrowers may fall. This makes borrowers even less creditworthy. People feel poor. Credit disappears quickly. Less spending › less income › less wealth › less credit › less debt and so on. It is a vicious circle. This seems similar to a recession, but the difference here is that interest rates cannot be lowered to save the day. In a recession, lowering interest rates works to stimulate borrowing. However, in a deleveraging process, lowering interest rates doesn't work because interest rates are already low and will hit 0% soon, so the stimulation ends.
Interest rates in the United States hit 0% during the deleveraging of the 1930s and again in 2008. The difference between a recession and deleveraging is that in a deleveraging, the debt burden on borrowers has simply been lifted. become too large and cannot be alleviated by lowering Interest Rates. Lenders realize that the debts have become too large to pay in full. Borrowers have lost their ability to pay and their collateral has lost value. They feel paralyzed by debt, they don't even want more! Lenders stop lending. Borrowers stop borrowing. Think of the economy as if you were not creditworthy, just like an individual.
So what to do with a deleveraging? The problem is that the debt burdens are too high and need to be reduced. There are four ways this can happen. 1. people, companies and governments cut their spending. 2. Debts are reduced through defaults and restructuring. 3. Wealth is redistributed from the haves to the have-nots. and finally, 4. the central bank prints new money. These 4 ways have happened in every deleveraging in modern history. Expenses are usually cut first. As we have just seen, people, companies, banks and even governments tighten their belts and reduce their expenses in order to pay off their debts. This is often known as austerity.
As borrowers stop taking on new debt and start paying down old debt, the debt burden may decrease. But the opposite happens! Because spending is cut, and one man's spending is another man's income, it causes income to fall. They fall faster than the debts are paid off and, in fact, the debt burden worsens. As we have seen, this spending cut is deflationary and painful. Businesses are being forced to cut costs... which means fewer jobs and higher unemployment. This leads to the next step: debts must be reduced! Many borrowers find themselves unable to repay their loans, and a borrower's debts are a lender's assets.
When borrowers don't pay the bank, people get nervous that the bank won't be able to pay them, so they rush to withdraw their money from the bank. The banks are squeezed and people, companies and banks do not pay their debts. This severe economic contraction is a depression. A big part of a depression is that people discover that much of what they thought was their wealth isn't really there. Let's go back to the bar. When you bought a beer and put it on a bar tab, you promised to pay the bartender. The promise of him became an asset to the bartender.
But if he breaks his promise, doesn't pay you back, and essentially defaults on his bar account, then the 'asset' he has is really worthless. It has basically disappeared. Many lenders do not want their assets to disappear and agree to debt restructuring. Debt restructuring means lenders are paid less or are paid over a longer term or at a lower interest rate than initially agreed upon. Somehow, a contract is broken in a way that reduces the debt. Lenders would rather have a little of something than all of nothing. Even though the debt disappears, debt restructuring causes income and asset values ​​to disappear faster, so the debt burden continues to worsen.
Like cutting spending, debt reduction is also painful and deflationary. All of this impacts the central government because lower revenues and less employment mean that the government collects less tax. At the same time, you need to increase your spending because unemployment has risen. Many of the unemployed have inadequate savings and need financial support from the government. In addition, governments create stimulus plans and increase their spending to compensate for the decline in the economy. Government budget deficits explode in deleveraging because they spend more than they earn in taxes. This is what happens when you hear about budget deficits on the news.
To finance their deficits, governments need to raise taxes or borrow money. But with falling incomes and so many unemployed, who is the money going to come from? The rich. Since governments need more money and wealth is heavily concentrated in the hands of a small percentage of the population, governments naturally raise taxes on the rich, facilitating a redistribution of wealth in the economy, from those who have to those who have not. . The 'poor', who are suffering, begin to resent the rich 'rich'. The rich 'haves', being squeezed by the weak economy, falling asset prices, higher taxes, begin to resent the 'have-nots'.
If the depression continues, social disorder may break out. Tensions are not only rising within countries, but may also rise between countries, especially between debtor and creditor countries. This situation can lead to political change that can sometimes be extreme. In the 1930s, this led to Hitler's rise to power, war in Europe, and depression in the United States. The pressure to do something to end the depression increases. Remember, most of what people thought was money was actually credit. So when credit goes away, people don't have enough money. People are desperate for money and remember who can print money?
The Central Bank can Having already lowered his interest rates to almost 0, he is forced to print money. Unlike cutting spending, reducing debt, and redistributing wealth, printing money is inflationary and stimulating. Inevitably, the central bank prints new money—out of thin air—and uses it to buy financial assets and government bonds. It happened in the United States during the Great Depression and again in 2008, when the central bank of the United States, the Federal Reserve, printed more than two trillion dollars. Other central banks around the world that could have also printed a lot of money. By buying financial assets with this money, you help increase asset prices, making people more creditworthy.
However, this only helps those who own financial assets. You see, the central bank can print money but it can only buy financial assets. The Central Government, on the other hand, can buy goods and services and put money in the hands of the people, but it cannot print money. So, to stimulate the economy, the two must cooperate. By buying government bonds, the Central Bank is essentially lending the government money, allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits. This increases people's income as well as government debt.
However, it will reduce the overall debt burden of the economy. This is a very risky time. Policy makers must balance the four ways in which the debt burden is reduced. Deflationary forms must be balanced by inflationary forms to maintain stability. If balanced correctly, there can be beautiful deleveraging. You see, deleveraging can be ugly or it can be beautiful. How can deleveraging be beautiful? Although deleveraging is a difficult situation, handling a difficult situation in the best possible way is beautiful. Much more beautiful than the unbalanced, debt-fueled excesses of the leverage phase. In a beautiful deleveraging, debt falls relative to income, real economic growth is positive, and inflation is not an issue.
It is achieved by having the right balance. The right balance requires some combination of spending cutting, debt reduction, wealth transfer, and money printing so that economic and social stability can be maintained. People ask if printing money will increase inflation. It won't if it makes up for the drop in credit. Remember, the expense is what matters. A dollar of spending paid for with money has the same effect on price as a dollar of spending paid for with credit. By printing money, the Central Bank can make up for the disappearance of credit with an increase in the quantity of money.
To turn things around, the Central Bank needs to not only boost revenue growth, but also make the revenue growth rate higher than the interest rate on accumulated debt. So what do I mean by that? Basically, income must grow faster than debt grows. For example: Suppose a country going through a deleveraging process has a debt-to-income ratio of 100%. That means the amount of debt you have is the same as the amount of income the entire country generates in a year. Now think about the interest rate on that debt, let's say it's 2%. If debt grows at 2% because of that interest rate and income only grows about 1%, you'll never reduce your debt load.
You must print enough money to earn a growth rate of income that is greater than the interest rate. However, printing money can be easily abused because it is so easy to do and people prefer it over the alternatives. The key is to avoid printing too much money and causing unacceptably high inflation, as Germany did during its deleveraging in the 1920s. If politicians get the balance right, deleveraging isn't that dramatic. Growth is slow, but the debt burden is decreasing. That's a beautiful deleveraging. When incomes start to rise, borrowers start to look more creditworthy. And when borrowers seem more creditworthy, lenders start lending money again.
Debt loads are finally starting to fall. Able to borrow money, people can spend more. Eventually, the economy begins to grow again, leading to the reflation phase of the long-term debt cycle. Although the deleveraging process can be horrible if mishandled, if handled well, it will eventually fix the problem. It takes roughly a decade or more for the debt burden to decrease and economic activity to return to normal, hence the term "lost decade." Of course, the economics are a bit more complicated than this template suggests. However, placing the short-term debt cycle above the long-term debt cycle andthen placing both on the productivity growth line gives a reasonably good template for where we've been, where we are now, and where we are. probably directed.
So, in summary, there are three rules of thumb I'd like you to take away from this: First: Don't let debt grow faster than income, because your debt load will eventually crush you. Second: Don't let revenue grow faster than productivity, because eventually you'll stop being competitive. And third: Do everything you can to increase your productivity, because, in the long run, that's what matters most. This is simple advice for you and it is simple advice for policy makers. You may be surprised, but most people, including most policy makers, don't pay enough attention to this. This template has worked for me and I hope it works for you.
Thanks.

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