How The Economic Machine Works by Ray Dalio

How the economic machine works

• The economy is like a simple machine made up of repetitive, simple transactions, driven by human nature.
• These transactions consist of a buyer exchanging money or credit with a seller for goods, services, or financial assets.
• Credit is the most important and the largest part of the economy.
• Credit is created when a borrower promises to repay the principal amount and additional interest.

“Any two people can agree to create credit out of thin air!”

Transactions and Markets

• Transactions are simple building blocks of the economic machine, and they consist of all the buyers and sellers exchanging goods, services, or financial assets.
• The economy consists of all the transactions in all its markets, and the total amount of spending and quantity sold in all of these markets can summarize the economy.
• The government, businesses, people, and banks engage in these transactions.

“People, businesses, banks, and governments all engage in transactions the way I just described, exchanging money and credit for goods, services, and financial assets.”

Credit

• Credit is the most important part of the economy and the least understood. It is crucial because it is the most significant and most volatile part.
• Lenders and borrowers make transactions by creating credit out of thin air. Lenders try to make more money while borrowers try to buy something they can’t afford or invest in something.
• credit turns into debt as soon as it is created; it is both an asset to lenders and a liability to borrowers.
• When the borrower repays the loan along with interest, the credit turns into transaction debt. At that time, the asset and liability disappear, and the transaction is settled.

“Credit is the most important part of the economy, and probably the least understood. It is the most important part because it is the biggest and most volatile part.”

Borrowing and Lending

• Borrowing and lending help borrowers get the money they need to buy something they can’t afford, such as a car or a house or invest in a business.
• Credit can help both borrowers and lenders get what they want.
• The terms of credit are that the borrower promises to repay the amount they borrow along with the interest, and the lender believes them.
• When the interest rate is high, lending decreases as it becomes expensive, and when it’s low, borrowing increases as it becomes cheaper.

“Now let’s go to borrowing and lending. Borrowers promise to repay the amount they borrow, called the principal, plus an additional amount called interest.”

How Income Increase Allows Increased Borrowing and Spending

• When someone’s income rises, it makes lenders more willing to lend him money because now he is more worthy of credit.
• A creditworthy borrower has 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 feel comfortable lending him money.
• So increased income allows increased borrowing which allows increased spending.
• This self-reinforcing pattern leads to economic growth and is why we have cycles.
• “And since one person’s spending is another person’s income, this leads to more increased borrowing and so on.”

The Short Term Debt Cycle

• Credit creates economic growth
• Example: borrowing $10,000 when earning $100,000 allows spending $110,000 and generates another person’s income of $110,000
• Borrowing eventually leads to cycles
• Short-Term Debt Cycle: economic activity increases, there is a spending expansion and price increase due to credit created out of nowhere
• A faster growth of spending and income compared to the production of goods leads to inflation
• Central Bank intervenes by raising interest rates to lower borrowing rates, people borrow and spend less, the income drops, debts’ costs rise monthly, and there is a decrease in spending and a decrease in income (deflation), leading to a recession
• The cycle repeats over decades, each cycle ends with higher growth and debt than the previous cycle, due to people’s tendency to borrow and spend more instead of paying back the debt

“In an economy with credit, we can follow the transactions and see how credit creates growth…and by following the transactions, we can begin to see how this process works in a self-reinforcing pattern.”

“When the amount of spending and incomes grow faster than the production of goods: prices rise. When prices rise, we call this inflation.”

“Because people push it — they have an inclination to borrow and spend more instead of paying back debt. It’s human nature.”

The Long Term Debt Cycle

• Debts rise faster than incomes
• Long Term Debt Cycle: incomes and asset values rise, people borrow, feel wealthy and invest in financial assets, causing asset prices to rise
• Debt-to-income ratio is the debt burden
• As long as the burden stays manageable, borrowers remain creditworthy
• Over decades, debt burdens increase, debt repayments grow faster than incomes, people cut back spending, incomes go down causing less creditworthiness, borrowing goes down, debt repayments continue to rise and spending drops further, cycle reverses itself
• The Long Term Debt Peak happens when debt burdens become too high

“But notice that the bottom and top of each cycle finish with more growth than the previous cycle and with more debt.”

“Because everybody thinks things are going great! People are just focusing on what’s been happening lately.”

“But this obviously can not continue forever.”

Deleveraging

• The deleveraging stage is when the economy begins to contract after the long expansion stage.
• People cut spending, incomes fall, credit disappears, and assets prices drop.
• As borrowers struggle to pay off their debts, they’re forced to sell their assets, which floods the market.

“Borrowers get squeezed… they can no longer borrow enough money to make their debt repayments… The rush to sell assets floods the market. This is when the stock market collapses, the real estate market tanks, and banks get into trouble.”

The difference between a recession and a deleveraging

• In a recession, lowering interest rates works to stimulate borrowing. However, in a deleveraging, this solution doesn’t work because interest rates are already low and soon hit 0%.
• Interest rates in the United States hit 0% during the deleveraging of both the 1930s and 2008.
• The difference between a recession and a deleveraging is that in a deleveraging, borrowers’ debt burdens have gotten too big and can’t be relieved by lowering interest rates.

“The difference is that in a deleveraging, borrowers’ debt burdens have simply gotten too big and can’t be relieved by lowering interest rates.”

The four ways to reduce debt burdens

• Debt burdens must come down during deleveraging, and there are four ways for this to happen.
• The first way is for people, businesses, and governments to cut their spending.
• The second way is for debts to be reduced through defaults and restructurings.
• The third way is for wealth to be redistributed from the “haves” to the “have nots.”
• Finally, the fourth way is for the central bank to print new money.

“There are four ways this can happen. 1. People, businesses, and governments cut their spending. 2. Debts are reduced through defaults and restructurings. 3. Wealth is redistributed from the ‘haves’ to the ‘have nots. 4. The central bank prints new money.”

Spending cuts and debt reduction

• Usually, spending is cut first. People, businesses, banks, and even governments tighten their belts and cut their spending so that they can pay down their debt.
• When borrowers stop taking on new debts and start paying down old debts, one might expect the debt burden to decrease. However, the opposite happens because incomes fall faster than debts are repaid, causing the debt burden to actually get worse.
• This cut in spending is deflationary and painful, as businesses are forced to cut costs and decrease jobs.
• Many borrowers find themselves unable to repay their loans, and borrowings default on their debts.

“Usually, spending is cut first. When borrowers stop taking on new debts and start paying down old debts, you might expect the debt burden to decrease. But the opposite happens! Because spending is cut – and one man’s spending is another man’s income – it causes incomes to fall. They fall faster than debts are repaid and the debt burden actually gets worse. This severe economic contraction is a depression.”

Debt restructuring

• Debt restructuring means lenders get paid back less or get paid back over a longer time frame.
• Many lenders don’t want their assets to disappear and agree to debt restructuring.

“Many lenders don’t want their assets to disappear and agree to debt restructuring. Debt restructuring means lenders get paid back less or get paid back over a longer time frame.”

Government response during deleveraging

• During deleveraging, the income and asset values disappears faster, even though debt disappears, debt restructuring causes pain and deflationary pressure.

“Like cutting spending, debt reduction, is also painful and deflationary.”

• Lower incomes and less employment means the government collects fewer taxes. At the same time, it needs to increase its spending because unemployment has risen.

“Many of the unemployed have inadequate savings and need financial support from the government.”

• The government creates stimulus plans and increases spending to make up for the decrease in the economy, but governments’ budget deficits explode in deleveraging because they spend more than they earn in taxes.

“Governments’ budget deficits explode in a deleveraging because they spend more than they earn in taxes.”

Wealth redistribution through taxation

• Governments naturally raise taxes on the wealthy which facilitates a redistribution of wealth in the economy from the ‘haves’ to the ‘have nots’.

“Governments naturally raise taxes on the wealthy which facilitates a redistribution of wealth in the economy from the ‘haves’ to the ‘have nots’.”

• The ‘have-nots,’ who are suffering, begin to resent the wealthy ‘haves,’ and the wealthy ‘haves’ begin to resent the ‘have nots’ due to falling asset prices and higher taxes.

“The ‘have-nots,’ who are suffering, begin to resent the wealthy ‘haves.’ The wealthy ‘haves,’ being squeezed by the weak economy, falling asset prices, higher taxes, begin to resent the ‘have nots.'”

Risk of social disorder and political changes

• Continuation of the depression can lead to social disorder, tensions rising within countries, and can rise between countries, especially debtor, and creditor countries.

“Not only do tensions rise within countries, they can rise between countries – especially debtor and creditor countries.”

• The future can bring political changes that can sometimes be extreme and can lead to something like Hitler coming to power.

“This situation can lead to political change that can sometimes be extreme. In the 1930s, this led to Hitler coming to power, war in Europe, and depression in the United States.”

Printing money by the central bank

• When credit disappears, people don’t have enough money, and they are desperate for money; hence, the Central Bank has to print money, which is inflationary and stimulative.

“People are desperate for money, and you remember who can print money? The Central Bank can.”

• The Central Bank prints new money by buying financial assets with this money, and it helps drive up asset prices, which makes people more creditworthy.

“By buying financial assets with this money, it helps drive up asset prices which makes people more creditworthy.”

Cooperative effort of the central bank and the central government

• The Central Government can buy goods and services and put money in the hands of the people through its stimulus programs and unemployment benefits, increasing people’s income, but it can’t print money.

“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.”

• 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, increasing people’s income as well as the government’s debt.

“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.”

• People ask if printing money will raise inflation, but it won’t if it offsets falling credit.

“People ask if printing money will raise inflation. It won’t if it offsets falling credit.”

How Central Banks can create inflation

• Spending paid for with money or credit has the same effect on prices.
• Central Banks can make up for the disappearance of credit with printing more money.
• The Central Bank needs to not only pump up income growth but also to get the rate of income growth higher than the rate of interest on the accumulated debt.
• To reduce the debt burden, income needs to grow faster than debt grows.
• If debt is growing at the interest rate of 2%, and income is only growing at around 1%, it is not possible to reduce the debt burden.
• Printing enough money to get the rate of income growth above the rate of interest would help reduce the debt burden.
• Printing too much money can cause unacceptably high inflation, as happened in Germany during its deleveraging during the 1920s.

“However, printing money can easily be abused because it’s so easy to do and people prefer it to the alternatives.”

The beautiful deleveraging

• If policymakers achieve the right balance in printing money, a deleveraging isn’t so dramatic, and growth is slow but debt burdens go down.
• When incomes begin to rise, borrowers begin to appear more creditworthy, and lenders begin to lend money again.
• Able to borrow money, people can spend more, and eventually, the economy begins to grow again, leading to the reflation phase of the long term debt cycle.

“That’s a beautiful deleveraging.”

The long-term debt cycle and productivity

• The deleveraging process can be horrible if handled badly; if handled well, it will eventually fix the problem, but it takes roughly ten years or more for debt burdens to fall, and economic activity to get back to normal.
• The long-term debt cycle can be laid on top of the short-term debt cycle, and both can be laid on top of the productivity growth line to see where we’ve been, where we are now, and where we are likely headed.
• Three rules of thumb to be taken from this: Don’t have debt rise faster than income, don’t have income rise faster than productivity, and do all that you can to raise your productivity, because, in the long run, that’s what matters most.

“Don’t have debt rise faster than income because your debt burdens will eventually crush you. Don’t have income rise faster than productivity because you will eventually become uncompetitive. And do all that you can to raise your productivity, because, in the long run, that’s what matters most.”