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Beginning Traders Macroeconomics Theory

How The Economic Machine Works by Ray Dalio

This is the best video we’ve ever seen that explains economics and the economy in terms that most people can understand.  Seriously – so well worth watching.

The video, created by Ray Dalio, answers the seemingly simple question: how does the economy work? Using Dalio’s practical template which he developed through years of firsthand experience, the video breaks down aspects of the economy like credit, deficits and interest rates. It presents a clear, simpler understanding that allows viewers to learn about the basic driving forces behind the economy, how economic policies work, and why economic cycles occur.

Dalio’s template may be unconventional, but it has personally allowed him to anticipate and to sidestep the global financial crisis; it has worked well for him for over 30 years.

Introduction

The economy works like a simple machine, but many people don’t understand it – or they don’t agree on how it works, which has led to a lot of needless economic suffering. While the economy might seem complex, 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 over and over again a zillion times. These transactions are, above all else, driven by human nature and create three main forces that drive the economy.

The first is productivity growth. The second is the short-term debt cycle. The third is the long-term debt cycle. The video looks at these forces and how laying them on top of each other creates a good template for tracking economic movements and figuring out what’s happening now.

Transactions

A good place to start is the simplest part of the economy: transactions. An economy is simply the sum of transactions that make it up, and a transaction is a very simple thing – 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. Credit spends just like money, so adding together the money spent and the amount of credit spent equals total spending. The total amount of spending drives the economy.

If you divide the amount spent by the total quantity sold, you get the price. And that’s an entire transaction. It’s 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 consists of all the buyers and all the sellers making transactions for the same thing. For example, there is a wheat market, a car market, a stock market, an oil market and markets for millions of things. An economy consists of all the transactions in all of the markets.

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. It’s just that simple. People, businesses, banks and governments all engage in transactions the way that has been 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 is different from other buyers and sellers because it controls the amount of money and credit in the economy. It does this by influencing interest rates and by printing money. For these reasons, the central bank is an important player in the flow of credit.

Credit

Credit is the most important part of the economy and probably the least understood. It’s the most important part because it’s the biggest and most volatile part. Just like buyers and sellers go to the market to make transactions, so do lenders and borrowers.

Lenders usually want to make their money into more money, and borrowers usually want to buy something they can’t afford, like a house or a car, or they want to invest in something like starting a business. Credit can help both lenders and borrowers get what they want. Borrowers promise to pay the amount they borrow, called principal, plus an additional amount called interest. When interest rates are high, there is less borrowing because it’s expensive. When interest rates are low, borrowing increases because it’s cheap. When borrowers promise to repay, and lenders believe them, credit is created. Any two people can agree to create credit out of thin air.

That seems simple enough, but credit is tricky because it has different names. As soon as credit is created, it immediately turns into 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 the liability disappear, and the transaction is settled.

So why is credit so important? When a borrower receives a credit, he can increase his spending, and remember, spending drives the economy. This is because one person’s spending is another person’s income. 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 rises, it makes lenders more willing to lend because now, he’s more worthy of credit.

A creditworthy borrower has two things: the ability to repay and collateral. Having a lot of income in relation to his debt gives him the ability to repay. In the event that he can’t repay, he has valuable assets to use as collateral that can be sold. This makes lenders comfortable lending him money.

So increased income allows increased borrowing, which allows increased spending. And since one person’s spending is another person’s income, this leads to more increased borrowing and so on. This self-reinforcing pattern leads to economic growth and is why we have cycles.

Productivity Growth

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 learn, and that accumulated knowledge raises our living standards. This is called productivity growth. Those who are inventive and hard-working raise their productivity and living standards faster than those who are complacent and lazy. But this isn’t necessarily true over the short run.

Productivity matters most in the long run, but credit matters most in the short run. This is because productivity growth doesn’t fluctuate much, so it’s not a big driver of economic swings. Debt is, because it allows us to consume more than we produce when we acquire it, and it forces us to consume less than we produce when we have to pay it back.

Debt swings occur in two big cycles: one takes about 5-8 years, and the other takes about 75-100 years. While most people feel the swings, they typically don’t see the as cycles because they see them too up close – day by day, week by week.

Swings around the line are not due to how much innovation or hard work there is, as mentioned. They’re primarily due to how much credit there is. Imagine an economy without credit. In this economy, the only way to increase spending is to increase income, which requires more productivity. Increased productivity is the only way for growth. Since spending is another person’s income, the economy grows every time someone is productive. If you follow the transactions and play this out, you’ll see that the progression goes upwards in a productivity growth line.

But because people borrow, there are cycles. And this is due to human nature and the way that credit works. Think of borrowing as a way of pulling spending forward. In order to buy something you can’t afford, you need to spend more than you make. To do this, you essentially need to borrow from your future self. In doing so, you create a time in the future that you need to spend less than you make in order to pay it back. It very quickly resembles a cycle. Anytime you borrow, you create a cycle. This is as true for an individual as it is for the economy. This is why understanding credit is so important because it sets into motion a mechanical, 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 is settled immediately. But when you buy a beer with credit, it’s like starting a bar tab. You’re saying you promise to pay in the future. Together, you and the bartender create an asset and liability, and you just created credit. It’s not until you pay that the debt goes away, and the transaction is settled.

The reality is that what most 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 about $3 trillion. Remember, in an economy without credit, the only way to increase spending is to produce more. But in an economy with credit, you can also increase your spending by borrowing.

As a result, 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 isn’t necessarily something bad that just causes cycles. It’s bad when it finances over consumption that can’t be paid back. However, it’s good when it efficiently allocates resources and produces income so you can pay back the debt.

For example, if you borrow money to buy a big television, it doesn’t generate income for you to pay back the debt. But if you borrow money to buy a tractor, and that tractor lets you harvest more crops and earn more income, then you can pay back your debt and improve your living standards. In an economy with credit, we can follow the transactions and see how credit creates growth.

Suppose you earn $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 spending is another person’s income, someone is earning $110,000. This person, with no debt, can borrow $11,000 so he can spend $121,000, even though he has only earned $110,000. His spending is another person’s income, and by following the transactions, we can begin to see how this process works in a self-reinforcing pattern.

The Short-Term Debt Cycle

But remember, borrowing creates cycles. And if the cycle goes up, it eventually needs to come down. This leads into the short-term debt cycle. As economic activity increases, there is an expansion – the first phase of the short-term debt cycle. Spending continues to increase, and prices start to rise. This happens because the increase in spending is fueled by credit, which can be created instantly. When the amount of spending and income grow faster than the production of goods, prices rise. When prices rise, this is called inflation.

The central bank doesn’t want too much inflation because it causes problems. Seeing prices rise, it raises interest rates. With higher interest rates, fewer people can afford to borrow money, and the cost of existing debts rises. Think of these as the monthly payments on your credit card going up. Because people borrow less and have higher debt repayments, they have less money left over to spend.

So spending slows, and since spending is another person’s income, incomes drop, and so on. When people spend less, prices go down. This is called deflation. Economic activity decreases, and there is a recession. If the recession becomes too severe, and inflation is no longer a problem, the central bank will lower interest rates to cause everything to pick up again. With low-interest rates, debt repayments are reduced, and borrowing and spending pick up, creating another expansion.

In the short-term debt cycle, spending is constrained only by the willingness of lenders and borrowers to provide and receive credit. When credit is easily available, there is an economic expansion. When credit is unavailable, there is a recession. This cycle is primarily controlled by the central bank. The short-term debt cycle typically lasts for 5-8 years and happens over and over again for decades.

But notice that the bottom and top of each cycle finish with more growth than the previous cycle, and with more debt. Why? Because people push it – they have an inclination to borrow and spend more, instead of paying back debt. This is human nature. Because of this, over long periods of time, debts rise faster than incomes, creating the long-term debt cycle.

The Long-Term Debt Cycle

Despite people becoming more indebted, lenders even more freely extend credit. Why? Because everyone thinks, things are going great. People are just focused on what’s been happening lately, and what’s been happening lately is that incomes have been rising, assets have become more valuable, the stock market is roaring, it’s a boom – it pays to buy goods, services and financial assets with borrowed money.

When people do a lot of that, it’s called a bubble. So even though debts have been growing, incomes have been growing nearly as fast to offset them. The ratio of debt to income is called the debt burden. So long as incomes continue to rise, the debt burden stays manageable. At the same time, asset values soar. People borrow huge amounts of money to buy assets as investments, causing their prices to rise even higher. People feel wealthy. So even with the accumulation of lots of debt, rising incomes and asset values help borrowers remain creditworthy for a long time.

But this obviously cannot continue forever. Over decades, that burden slowly increases, causing larger and larger debt repayments. At some point, debt repayments start growing faster than incomes, forcing people to cut back on their spending. This leads to incomes going down, which makes people less creditworthy, causing borrowing to go down. Debt repayments continue to rise, which makes spending drop even further, and the cycle reverses itself.

There is a long-term debt peak. Debt burdens have simply become too big. For the United States, Europe and much of the rest of the world, this happened in 2008. It happened for the same reason it happened in Japan in 1989, and in the United States back in 1929. Now the economy begins deleveraging.

Deleveraging

In a deleveraging, people cut spending, incomes fall, credit disappears, asset prices drop, banks get squeezed, the stock market crashes, social tensions rise and the whole thing starts to feed on itself the other way. Scrambling to fill the hole, borrowers are forced to sell assets, and the rush to sell assets floods the market at the same time as spending falls. This is when the stock market collapses, the real estate market tanks and banks get into trouble. As asset prices drop, the value of the collateral borrowers can put up also drops, making borrowers even less creditworthy. People feel poor.

Less of everything leads to a downward cycle, which appears to be a recession. But the difference here is that interest rates can’t be lowered to save the day. In a recession, lowering interest rates works to stimulate borrowing. However, in a deleveraging, lowering interest rates doesn’t work because they are already low, and will soon hit zero. Interest rates in the United States hit zero percent during the deleveraging of the 1930s and again in 2008.

The difference between a recession and a deleveraging is that in the latter, borrowers’ debt burdens have simply become too big and can’t be relieved by lowering interest rates. Lenders realize that debts have become too large ever to be fully paid back, borrowers have lost their ability to repay, and their collateral has lost value. They feel crippled by the debt and don’t even want more. Lenders stop lending, borrowers stop borrowing, it becomes so that the economy is not creditworthy. So what should be done in a deleveraging?

The problem is that debt burdens are too high and that they must come down. There are four ways this can happen: cut spending, reduce debt, redistribute wealth or print money. These four ways have occurred in every deleveraging in history.

Usually, spending is cut first so that debt can be repaid. This is often referred to as austerity. When borrowers stop taking on new debts and start paying down old debts, the debt burden can be expected to decrease. But the opposite happens. Because spending is cut, incomes fall faster than debt is repaid and the debt burden gets worse.

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 a borrower doesn’t repay the bank, people are nervous that the banks won’t be able to repay them, so they rush to withdraw their money from the bank. Banks get squeezed, and people, businesses, and banks default on their debts. This severe economic contraction is a depression.

Depression

A big part of a depression is people discovering much of what they thought were their wealth isn’t really there. Going back to the bartender, when you bought a beer and put it on a bar tab, you promise to repay the bartender. Your promise became an asset for him and liability for you. But if you don’t pay him back, and essentially default on your tab, then the asset he has isn’t worth anything. Many lenders don’t want their assets to disappear, so they agree to debt restructuring.

Debt restructuring means lenders get paid back less, or get paid back over a longer time frame, or at a lower interest rate than what was first agreed on. Somehow, a contract is broken in a way that reduces debt. Lenders would rather have a little of something than all of nothing. Even though debt disappears, debt restructuring causes income and asset values to disappear faster, so the debt burden continues to get worse.

All of this impacts the central government because lower incomes and less employment mean fewer taxes. At the same time, it needs to increase spending because unemployment has risen. Many of the unemployed have inadequate savings and need financial support from the government. Additionally, 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. This is what’s happening when you hear about the budget deficit.

To fund their deficits, governments either need to raise taxes or borrow money. But with incomes falling and so many unemployed, who is the money going to come from? The rich, since governments need more money and since wealth is heavily concentrated in the hands of a small percentage of the people, governments naturally raise taxes on the wealthy, which facilitates the redistribution of wealth in the economy. This redistributes the wealth from the haves to the have-nots, and the have-nots begin to resent the haves. The wealthy haves, being squeezed by the economy, begin to resent the have-nots.

If the depression continues, social disorder can break out. Not only do tensions rise within countries, but they can also rise between countries. This situation can lead to political change that can sometimes be extreme. In the 1930s, this led to Hitler coming to power, the war in Europe and depression in the United States. Pressure to do something to end the depression increases.

When all this happens, people need money. Here enters the central bank. Having already lowered its interest rates to nearly zero, it’s forced to print money. Unlike cutting spending, debt reduction and wealth redistribution, printing money is inflationary and stimulating. Inevitably, the central bank prints more 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, the federal reserve, printed over $2 trillion. Other central banks around the world that could, also printed money.

By buying financial assets with money, it helps drive up asset prices which makes people more creditworthy. However, this only helps those who have financial assets. 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 can’t print money. So to stimulate the economy, the two 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. This increases people’s incomes, as well as the government’s taxes. However, it will lower the economy’s total debt burden. This is a very risky time. Policy makers need to balance the four ways that debt burden comes down; the deflationary ways need to balance with the inflationary ways in order to maintain stability. If balanced correctly, there can be a beautiful deleveraging.

Managing Deleveraging

A deleveraging can be beautiful, or it can be ugly. How can it be beautiful? Even if it is a difficult situation, handling a difficult situation in the best possible way is beautiful – a lot more beautiful than the debt-fueled on balanced excesses of the leveraging phase. In a beautiful deleveraging, debts decline relative to income, real economic growth is positive, and inflation isn’t a problem. It is achieved by having the right balance. The right balance requires a certain mix of cutting spending, reducing debt, transferring wealth and printing money so that economic and social stability can be maintained.

People ask if printing money can raise inflation. It won’t if it can offset falling credit. Remember, spending is what matters; a dollar of spending paid for with money has the same effect on price as a dollar spending paid for with credit. By printing money, the central bank can make up for the disappearance of credit with an increase in the amount of money. In order to turn things around, the central bank needs to not only pump up income but get the rate of income growth higher than the rate of interest on the accumulated debt.

This means that income needs to grow faster than debt. For example, assuming that a country is going through a deleveraging and has a debt to income ratio of 1:1, it means the amount of debt it has is the same as the amount of income it makes. Now say the interest rates on the debt is 2%. If the debt is growing at 2% because of that interest rate, and income is only growing at around 1%, the debt burden will never be reduced. Enough money needs to be printed 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. The key is to avoid printing too much money and causing unacceptably high inflation, the way Germany did during its deleveraging in the 1920s.

If policymakers achieve the right balance, a deleveraging isn’t so dramatic. Growth is slow, but debt burdens go down – that’s a beautiful deleveraging. And when incomes begin to rise, borrowers begin to appear more creditworthy, then lenders begin lending again, and the cycle begins to go up, leading to the reflation phase of the economy. 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 closing, of course, the economy is a little more complicated than this template suggests. However, laying the short-term debt cycle over the long-term debt cycle, and laying both over the productivity growth line gives a reasonably good template for seeing where we’ve been, where we are now, and where we’re probably headed.

In summary, there are three rules of thumb to take away: first, don’t have debt rise faster than income because your debt burdens will eventually crush you. Second, don’t have income rise faster than productivity, because you’ll eventually become uncompetitive. Lastly, do all that you can to raise your productivity, because, in the long run, that’s what matters most.

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