16 Aug | 2020
Daviano

The Economic Machine by Ray Dalio

My Personal Summary

Every 75 - 100 years the world goes into a process called deleveraging (being the last one during the 1930's) and besides from that happening 90 years ago, there's plenty of indicators that appoint for the world to be facing the next one...

If you're reading this in 2020, you're probably aware that we're living challenging times. Difficult for many people, specially the ones who don't know what's really happening beyond the current global pandemic. So I hope you find this summary of "The Economic Machine" by Ray Dalio as useful as I have, and helps you take better decissions when dealing with finance or with any other thing for that matter. I didn't write this for Traderbook, in fact I wrote it several months before I even had the idea of building Traderbook, and it was originally written for me to better understand Dalio's video, since I knew that I'd need a quick and effective way of understanding global macroeconomy if I wanted to successfully trade the markets, but more than helping me to improve as a trader (which it has) this information made me take probably the best decissions I've taken in my life just a few months before Coronavirus, and that's why I want to share it, because I now know that anyone involved in any kind of business; either as an entrepreneur, an investor, an executive or an employee, is going to need to know this stuff not to be successfull in business or finance (we'll talk about that later), but just to survive to the days to come.

If you don't know who's Ray Dalio, he's basically one of the most brilliant investors and financial innovators of our times. He has not only made it possible for McDonald's to produce and sell McNuggets but he also founded and runs Bridgewater Associates, the largest hedge fund in the world, currently trading with over $160,000,000,000 USD in Assets Under Management, and his understanding of the economic cycles (commonly known as business cycle) is probably one of the most accurate in the history of finance, so I'm humbled to be able to even understand these concepts since 4 years ago, I was clueless, and I cannot even imagine what I'd be doing with my life during these times if it wasn't for this knowledge, and I want to be very clear... I am not telling you that mastering this information alone is going to save you from the difficult times ahead because it probably won't, but it will certainly put you in the right direction for you to start making your own homework; or should I say, your lifework.

So let's begin by defining what the word Economy means…

The economy seems complex but it works in a simple mechanical way. It’s made up of a few simple parts and a lot of simple Transactions that are repeated all over again. These transactions are driven by Human Nature and they create the 3 main forces that drive the Economy:

1.- Productivity Growth

2.- Short-Term Debt Cycle (5 to 8 years)

3.- Long-Term Debt Cycle (75 to 100 years)

So an Economy is nothing more than the sum of the Transactions that make it up, and the parties engaged in all the transactions that drive the Economy are:

1.- People

2.- Businesses

3.- Banks

4.- Governments

The Government is the biggest #buyer and #seller, and it consists of 2 parts:

Central Government: Collects Taxes and spends Money.

Central Bank: Unlike other Buyers and Sellers, it controls the amount of Money and Credit in the economy by influencing Interest Rates and printing money; therefore, the Central Bank of a country is probably the most important player in the flow of Credit, and credit is without a doubt the most important part of modern economy, and probably the least understood.

So let's get back to transactions... 

A Transaction consists of a Buyer exchanging Money or Credit with a Seller for Goods, Services or Financial Assets. So in essence, for a #Transaction to be made, one has to give something in order to get something, and how much one gets depends on how much one produces.

So...

Money Spent + Credit Spent = Total Spending

And spending drives the Economy!

In other words...

Transactions are the building blocks of the Economic Machine (because they're the fuel of the 3 forces that drive the economy), so if we understand Transactions, we can understand the whole Economy, or said in other words, an economy consists of all of the Transactions in all of its markets. So, if you add up the Total Spending and the Total Quantity sold in all of the Markets, you have everything you need to know to understand the Economy, but now let's talk about Markets.

A #market consist of all Buyers and all Sellers making Transactions for the same thing.

Just like Buyers and Sellers go to specific Markets and make #transactions, so do Lenders and Borrowers since Lenders usually want to make their Money into more Money, and Borrowers usually want to either buy something they can’t afford or invest in a business.

Borrowers promise to repay the amount they borrow, called Principal, plus an additional amount, called Interest. When Interest Rates are high, there’s less borrowing because it is expensive, and when Interest Rates are low, borrowing increases because it’s cheaper. So, when borrowers promise to repay and lenders believe them, Credit is created out of thin air, and as soon as Credit is created, it turns into Debt.

Debt is both an Asset to the Lender and a Liability to the Borrower, and when the Borrower repays the #loan plus #interest, the Asset and the Liability disappears, and the Transaction is settled.

So why is Credit so Important?

Because when a Borrower receives Credit, he is able to increase his spending, and remember...

Spending drives the Economy!

And the reason of this is because one person’s spending is another person’s Income, so if I spend more, someone else earns more, and when someone’s Income rises, it makes lenders more willing to lend him money because now he’s more worthy of Credit, which in other words mean that he has the following 2 things:

1.- Ability to repay, because he has a lot of Income...

2.- Collateral, which means that in the event that he or she can’t repay, he/she has valuable Assets to use as Collateral that can be sold. So, increased Income allows increased borrowing, and increased borrowing allows increased spending, and since one person’s spending is another person’s Income, this leads to more increased borrowing and so on, and this self-reinforcing pattern leads to economic growth, and this is the reason of why we have Cycles.

Remember that we said that how much you get from a Transaction depends on how much you Produce?

Well, this would make us think that hard-working people raise their Productivity and their living standards faster than those who are complacent and lazy, however that’s not necessarily true over the short run since Productivity matters most in the long run, but Credit matters most in the short run.

Why?

Because Productivity Growth does not fluctuate much and therefore it’s not a big driver of Economic Swings unlike Debt, because Debt allows us to consume more than we Produce when we acquire it, and it forces us to consume less than we produce when we pay it back.

Debt Swings occur in 2 big Cycles, and while most people feel the swings, they typically don’t see them as Cycles because they see them way too close. So, swings are not due to how much innovation or hard work there is, but to how much #credit there is.

In an Economy without Credit, the only way I would be able to increase my spending would be increasing my Income, which would require for me to be more productive and to work more. In other words, increased Productivity would be the only way for growth because since my spendings would be another person’s Income, then the Economy would grow every time I or anyone else would be more productive, and such scenario could be visualized as a linear graph with positive growth, however because we do borrow, we actually have Cycles with a more interesting visual representation and practical effects in our daily life, and the most interesting aspect of this cycle is that the only force that drives it is human nature!

Think of borrowing as a way of pulling spending forward by buying things that you cannot afford. In a way, you’re actually borrowing from your future self and by doing so, you’re creating a time in the future that you’ll need to spend less than you make in order to pay it back. It’s a cycle. Every time you borrow you create a cycle, and this is as true for an individual as it is for the Economy as a whole.

This makes Credit different from #money (which is what you settle transactions with), and most of what people call Money is actually Credit.

The total amount of Credit in the U.S. is about $50,000,000,000,000 USD (50 Trillion), and the total amount of Cash is only about $3,000,000,000,000 USD (THIS INFO HAS SIGNIFICANTLY CHANGED DURING COVID). It is important to repeat and understand that an Economy with Credit has more spending and allows Incomes to rise faster than Productivity over the short run, but not over the long run. Credit is bad when it finances over-consumption that can’t be paid back, but it’s good when it efficiently allocates resources and produces income, for your future self to pay back the Debt and improve your living standards; however like on any #investment, there’s always risk!

In an Economy with Credit, we can follow the Transactions and see how Credit creates growth. For example: Suppose you earn $100,000 a year and have no Debt. You are creditworthy enough to borrow $10,000, so even though you only earned $100,000, you can actually spend $110,000, and since your spending is another person’s Income, someone is earning $110,000, and this person (assuming he doesn’t have Debt) can then borrow $11,000, and therefore he can spend $121,000 even though he has only earned $110,000 and this pattern continues in an uptrend Cycle, however like all Cycles, if it goes up, it eventually needs to come down, and this leads us into the Short-Term Debt Cycle.

The Short-Term Debt Cycle

The Short-Term Debt Cycle is about 5 to 8 years long and its first phase consists of an increased spending due to an increased economic activity and Credit, which causes an expansion (the first phase) and when the amount of spending and Income grow faster than the Production of Goods, then the Price of those Goods (and Services) starts increasing, causing what we know as Inflation, and the Central Bank does not want too much Inflation because it causes problems, so the Central Bank raises Interest Rates (which diminishes the amount of people that can afford to borrow Money) and the cost of existing Debts rises (i.e. monthly credit card payments go up), so because people now borrow less and have higher Debt repayments, they have less money leftover to spend, so spending slows, and since a person’s spending is another person’s Income, now Income drops and since there’s less spending, Prices go down (Deflation) and economic activity decreases, causing a Recession.

If the Recession becomes too severe and Inflation is no longer a problem, then the Central Bank will lower Interest Rates to cause everything to pickup again, and with low Interest Rates, Debt repayments are reduced, and borrowing and spending pick up again causing another expansion...

In the Short-Term Debt Cycle, spending is constrained only by the willingness of Lenders and Borrowers to provide and receive Credit. So, when Credit is available, there’s an economic expansion, and when Credit isn’t easily available, there’s a Recession, and this entire Cycle is controlled primarily by the Central Bank, happening over and over again for decades, however the bottom and top of each cycle ends with more growth than the previous cycle and with more Debt, because people push it as Human Nature makes people to have an inclination to borrow and spend more instead of paying back their Debts!


Human Nature is the cause of every economic phenomenon, and because of this phenomenon repeating during long periods of time, Debts rise faster than Incomes, creating...

The Long-Term Debt Cycle

Interestingly enough and because everybody thinks things are going great, despite people becoming more indebted, Lenders even more freely extend Credit, and this is because people are just focusing on what’s been happening lately (Incomes, Asset values and stock market are rising), and everybody believes that it pays to buy Goods, Services and Financial Assets with borrowed money, and when a lot of people behave this way, a Bubble is created; therefore and even though Debts have been growing, Incomes have been growing nearly as fast in order to offset them. The ratio of Debt-to-Income is called Debt Burden, and as long as Incomes continue to rise, the Debt Burden stays manageable. At the same time, Asset values soar, and people borrow huge amounts of Money to buy Assets as investments, causing the Prices to rise even higher! So even with the accumulation of lots of Debt, people feel wealthy, because their rising Incomes and Asset values help them remain creditworthy for a long time, and therefore being able to keep borrowing Money, but this does not last forever.

Over decades, Debt Burden slowly increase and creates larger and larger Debt Repayments which eventually start growing faster than Incomes forcing people to cut back on their spending, and since one person’s spending is another person’s Income, Incomes begin to go down, which makes people less creditworthy, causing borrowing to go down and so on... this creates the Cycle to reverse.

At the Long-Term Debt Cycle peak, Debt Burdens have simply become too big (i.e. USA & World in 2008, Japan in 1989 & USA in 1929), and now the economy begins Deleveraging.

And what happens on a Deleveraging?

People cut spending.

      Incomes fall.

            Credit disappears.

                  Asset prices drop.

                        Banks get squeezed.

                           Stock market crashes.

                              Social tensions rise.

                                 And the Long-Term Debt Cycle starts to feed on itself the other way!

As Incomes fall and Debt Repayments rise, Borrowers get squeezed, a lot of them Default and are no longer creditworthy, Credit dries up and Borrowers can no longer borrow enough Money to make their Debt Repayments, so they are forced to sell their Assets, but since there are millions of people selling, the stock market collapses, Real Estate market tanks and banks get into trouble.

So...

As Asset prices drop, the value of the Collateral Borrowers can put up drops too, making Borrowers even less creditworthy. Credit rapidly disappears and people feel poor.

Less spending, less Income, less wealth, less credit, less borrowing and so on... It’s a vicious Cycle that appears to be similar to a recession but the difference here is that since Interest Rates are already low, they cannot be lowered to stimulate borrowing and save the day. So, the difference between a Recession and a Deleveraging is that in a Deleveraging Borrowers’ Debt Burden have gotten too big and cannot be relieved by lowering Interest Rates.

Lenders realize that Debts have become too large to ever be fully paid back. Borrowers have lost their ability to repay and their Collateral has lost value, they don’t even want more Debt! Lenders stop lending and Borrowers stop borrowing. It’s as if the Economy itself is not-creditworthy. So the main problem with Deleveraging is that Debt Burdens are too high and they must come down, and there are 4 ways this can happen:

1.- Cut Spending: People Businesses and Governments cut their spending.
2.- Reduce Debt: Debts are reduced through Defaults and Restructurings.

3.- Wealth Redistribution: Wealth is redistributed from the “haves” to the “have nots”.
4.- Printing Money: The Central Bank prints new Money.

These 4 ways have happened in every deleveraging in modern history.

- The United States (1930s) - England (1950s)
- Japan (1990s)
- Spain & Italy (2010s)

1.- Cut Spending:

Usually spending is cut first, so they (People, Businesses & Governments) can all pay their Debts. This is often referred to as Austerity. When Borrowers stop taking new Debts and start paying down old Debts, you might expect the Debt Burden to decrease, but since spending is cut and one person’s spending is another person’s Income, then Incomes fall and the opposite actually happens and Debt Burden rises!

This cut in spending is Deflationary and painful for almost everyone. Businesses are forced to cut costs, which means they fire people and unemployment increases, and this leads to the next step.

2.- Reduce Debt:

Many borrowers find themselves unable to repay their loans, and a Borrower’s Debts are a Lender’s Assets, so when Borrowers don’t pay the bank, people get nervous that the bank won’t be able to repay them so they rush to withdraw their Money from the bank, so banks get squeezed and people, businesses and banks Default on their Debts, and this severe economic contraction is called a Depression, which among other things means that much of what people think is their wealth, isn’t really there (because everyone’s Defaulting on their Debts)! And since many Lenders don’t want their Assets to disappear, they agree to a Debt Restructure, which in other words means breaking a contract in order to reduce Debt (Interest Rate, Amount and/or Time). Even though Debt disappears, Debt Restructuring causes Income and Asset Values to disappear faster, so the Debt Burden continues to get worse.

Like cut in spending, Debt Restructure is also painful and Deflationary, and it impacts the Central Government because lower Incomes and less employment means fewer taxes for the Government while an increased spending because unemployment has risen and they must support the unemployed people. Governments create Stimulus Plans and increase their spending to make up for the decrease in the Economy. Government’s Budget Deficits explode in a Deleveraging because they spend more than they earn in taxes, and to fund their Deficits, Governments need to either raise taxes or borrow Money, but with Incomes falling and so many unemployed they can just borrow Money from the rich people.

3.- Wealth Redistribution:

 

Since Governments need more Money and since wealth is heavily concentrated in the hands of a small percentage of people, Governments naturally raise Taxes on the wealthy (meaning companies) which facilitates a redistribution of wealth in the Economy from the “Haves” to the “Have Nots” who are suffering and begin to resent the wealthy “Haves”, who also start resenting the “Have Nots” due to the higher Taxes, the weak Economy, the falling Asset prices, and when the Depression is prolonged, social disorder can break out, not only within countries but between countries too; especially Debtor and Creditor countries, and sometimes this can lead to extreme political change. In the 1930s this led to Hitler coming to power, war in Europe, and a Depression in the United States, so pressure to do something to end the Depression increases, and since most of what people thought was Money was actually Credit, and because in a Depression Credit disappears, then the bottom line is that people don’t have enough Money, so having already lowered Interest Rates to nearly 0%, the Central Bank is forced to print Money.

4.- Printing Money:

Unlike cutting spending, Debt reduction and wealth redistribution, printing Money is Inflationary and stimulative, and that’s why inevitably the Central Bank prints new Money out of thin air, and uses that Money to buy Financial Assets and Government Bonds. This happened in the United States during the Great Depression and it happened again in 2008, when the US Central Bank “The Fed”; as well as other Central Banks (Bank of England “BoE” and European Central Bank “ECB”) that could print Money too, printed over 2 trillion dollars, and therefore by buying Financial Assets with this Money, it helped driving up Asset Prices again, which made people more creditworthy again and so on. However, this only helped those who owned Financial Assets. The Central Bank can print Money but it can only buy Financial Assets, but the Central Government, on the other hand, can actually buy Goods and Services putting Money in the hands of the people, but it cannot print Money. So, in order to stimulate the Economy, the 2 must cooperate. By buying Government bonds, the Central Bank essentially lends money to the Government allowing it to run a Deficit and increase spending on Goods and Services through its stimulus programs and unemployment benefits, and this increases people’s Income as well as Government’s Debt, however, it will lower the economy’s total Debt Burden.

In general, policy makers need to balance the 4 ways on which Debt Burden comes down. The Deflationary ways need to balance with the Inflationary ways in order to maintain stability, and if balanced correctly, there can be a beautiful Deleveraging.

Some people ask if printing Money will raise #Inflation, and it won’t if it offsets falling Credit, since spending is what really matters!

 

So, by printing Money, the Central Bank can make up for the disappearance of Credit with an increase in the amount of Money, and in order to turn things around, the Central Bank needs to not only pump up Income growth, but get the rate of Income higher than the rate of Interest on the accumulated Debt. So, basically Income needs to grow faster than Debt. For example, let’s assume that a country going through a Deleveraging has a Debt Burden ratio of 100%, which means that the amount of Debt it has is the same as the amount of Income the entire country makes in a year. Think about the Interest Rate on that Debt, let’s say is 2%. If Debt is growing at 2% because of that Interest Rate and Income is only growing at around 1%, you will never reduce the Debt Burden. You need to print enough Money to get the rate of Income growth above the rate of Interest. However, printing Money can easily be abused because it’s so easy to do and people prefer it to the alternatives. So, the key is to avoid printing too much Money and causing unacceptable high inflation, the way Germany did during its Deleveraging in the 1920s.

When Incomes begin to rise, Borrowers begin to appear more creditworthy and Lenders begin to lend Money again. Debt Burdens finally begin to fall, and since people is again able to borrow Money, spending increases and the Economy begins to grow again, leading to the reflation phase of the Long-Term Debt Cycle.

It takes roughly a decade or more for Debt Burdens to fall and Economic Activity to get back to normal, hence the term “Lost Decade”.

In conclusion and even though the Economy is more complex than what this summary describes, by laying the Short-Term Debt Cycle on top of the Long-Term Debt Cycle and then laying both of them on top of the Productivity Growth line, gives a very good template for seeing where we’ve been, where we are now and where we are probably headed, as well as to understand how does the Human Nature makes the Economy behave as it does.

3 Rules of Thumb:

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 eventually become uncompetitive.

3.- Do all that you can to raise your Productivity, because in the long run, that’s what matters most!

Share This Post