HOW THE ECONOMIC MACHINE WORKS

The economic machine is simple but people don’t

understand it and so this leads to economic suffering.
While the economy seems complex, it is underpinned by
simple transactions that are driven by human nature, and
repeated zillions of times.

‍
THREE FORCES DRIVE THE ECONOMY
‍

Source: Ray Dalio

1. Productivity Growth

1. Short-term Debt Cycle

1. Long-term Debt Cycle

We’ll get to these later, but first…

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TRANSACTIONS

Transactions are essentially the exchange

of money or credit between
a buyer and seller for goods, services or financial
assets. This is how individuals, businesses,
banks and Government all operate.

Price is simply the result of total spending / quantity

sold.

Transactions are the building blocks of the economic

machine.

If you understand how transactions work, you understand

the whole economy.

The economy is simply the sum of all transactions in it.

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Money and credit account for the total spending in an
economy and are key drivers.

‍
THE MARKET, GOVERNMENT AND CENTRAL BANK

All buyers and sellers making transactions represent the

market.

For example, we have wheat markets, stock markets,

steel markets, oil markets and so on.The combination of
all of these sub-markets is the entire market, or the entire
economy.

Government is the biggest buyer and seller.

However, we must distinguish between the Central

Government and the Central Bank.

The Central Bank, such as the Federal Reserve in the

United States, controls the amount of money and credit in
the economy, which it does by influencing interest rates
and printing money.

The Central Bank is fundamental when it comes to

the flow of credit.

‍
CREDIT

Credit is the most important part of the economy because

it is the biggest and most volatile part.

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LENDERS AND BORROWERS

Source: Ray Dalio

Lenders lend money to make more of it.

Borrowers borrow money to buy something they can’t

afford, such as a house, a car, a business or stocks.

Borrowers promise to repay the amount borrowed (the

principal) with interest.

When interest rates are high, borrowing is low.

When interest rates are low, borrowing is high.

When lenders believe borrowers will repay, credit is

created.

Credit can be created out of thin air — in fact, at the time

the video was released, US$50 trillion of the US$53 trillion
in the economy was credit, as opposed to ‘real’ money.

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When credit is issued it becomes debt. It’s a liability for the
borrower, and an asset for the lender. It disappears when
the transaction is settled.

Credit is important because it means borrowers can

increase their spending. This is fundamental because
one person’s spending is another person’s income.

This means that the other person, on the back of an

increase in income and more believability by lenders that
they will repay their principle with interest, can now borrow
more money to increase their own spending, which in turn
becomes someone else’s income.

This creates a cycle, per the chart below.

Source: Ray Dalio

‍PRODUCTIVITY GROWTH

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Over time, we learn, we accumulate knowledge, we work
and all of this drives productivity growth. Productivity
matters in long run, but credit matters in the short run.

Productivity growth doesn’t fluctuate much so it’s not big

driver of economic swings, but debt is.

‍
DEBT

Debt allows us to consume more than we produce when it

is acquired, and forces us to consume less when we have
to pay it back.

This ‘debt swing’ occurs in two cycles, short-term (5 to 8

years), and long-term (75 to 100 years).

The thing is that most people don’t really see it because

they are living day by day, week by week, kind of like
when you don’t notice yourself getting older by looking at
yourself in the mirror, and then an insensitive friend from
high school sees you and says “man…you’ve aged!”. Of
course I’m not talking about myself here.

Back to the economic machine…

If the economy lacks credit, the only way to boost it is by

working harder or smarter. This means more productivity,
which is slower and linear, per the diagonal line in the
above chart.

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‍
DEBT CYCLES

Source: Ray Dalio

Every time you borrow, you create a cycle.

When you borrow, you’re effectively borrowing from future

self — borrowing from a self that will need to spend less
than they make. This is as true for the individual as it is for
the economy at large.

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This sets into motion what Dalio calls a mechanical,
predictable sequence of events.

Credit isn’t necessarily bad.

It’s bad when it finances over-consumption that can’t

be paid back (kind of like Greece, Portugal, Italy and
Spain during the 2010s).

It’s good when it efficiently allocates resources that

produce income debts can be paid back.

For example, buying a consumable such as a television

with debt is bad debt.

Buying a tractor to harvest fields with, generate income,

pay back debt, and enjoy a better quality of life is good
debt.

Like most things, when it comes to cycles, what goes up

must eventually come down.

SHORT-TERM DEBT CYCLE

The first phase of the cycle is expansion.

Spending increases which increases incomes and asset

values. and leads to inflation.

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When spending is faster than the production of goods, it
means that we have more demand than supply, which
results in inflation.

The Central Bank manages inflation by raising interest

rates, which makes credit more expensive and decreases
borrowing, spending and incomes.

This results in deflation — prices coming back down.

Economic activity decreases, and if unchecked this can

lead to a recession.

At this point, Central Banks decrease interest rates in

order to stimulate borrowing and spending, and boost
economic activity and get the economy out of recession.

If credit is available it leads to economic expansion. When

it’s not, it leads to recession.

This short-term debt cycle lasts for about 5 to 8 years and

happens over and over again for decades. The peak and
trough of the cycle end up higher and higher with each
subsequent cycle which means more growth and more
debt is accumulated. This brings us to…

‍
LONG-TERM DEBT CYCLE
The long-term debt cycle lasts for about 75–100 years.

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Despite more debt being accumulated through the short-
term debt cycles, lenders keep lending money. This is
because of the short-now view of the world — high
incomes, soaring asset prices, booming stock-markets
and so on.

But as COVID19 and previous crashes reminds us, the

recent past is not always an accurate predictor of the
future. This irrational exuberance is preempts
an economic bubble.

THE DEBT BURDEN

This is good.

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Source: Ray Dalio

When incomes grow in relation to debt, things are kept in

balance

But a debt burden emerges when debt growth exceeds

income growth.

This debt to income ratio is the debt burden.

While people might feel wealthy as the value of their

assets soar, a wise philosopher once said that we
shouldn’t conflate the trappings of success with
success in itself.

People might remain creditworthy to borrow and spend

and feel wealthy, but that’s because of the collateral that
underpins their borrowings.

But as the debt burden increases, the value of said

collateral can vanish. As the debt burden increases, it
creates larger debt repayments over decades, and
eventually it hits a peak, as was the case with the global
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financial crisis in 2008, with Japan in 1989 or during The
Great Depression in 1929.

At this point, spending goes backwards, borrowing stalls,

incomes drop, asset values plummet, stock-markets tank
and social tensions rise — this is called a deleveraging.
It’s little like what we’re seeing today, although the
COVID19 crisis wasn’t brought upon us by the long-term
debt cycle correcting itself, but through a ‘force majeure’
external event and Government interventions.

Suddenly the value of the collateral that was used to

securitise loans is gone, and banks find themselves in
trouble. This led to the massive bail-outs of banks like JP
Morgan, Goldman Sachs, Wells Fargo, State
Street and others in a massive US$700 billion bail-out bill
in 2008. Lehman Brothers weren’t so lucky.

At this point in the long-term debt cycle, interest rates can

no longer be used to stimulate the economy because they
are already at zero.

The difference between a recession and a deleveraging is

that the debt burden is too big and can’t be relieved by
lowering interest rates.

So what do we do now?

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FOUR LEVERS TO DELEVERAGE THE
ECONOMY
There are four levers we can pull to get the economy back
on its feet during a deleveraging.

‍
1 — CUT SPENDING
Essentially austerity measures for businesses and
individuals.

But the thing about this is that. perhaps paradoxically, it

causes incomes to fall because remember, one person’s
spending is another person’s income, so the debt burden
gets even bigger because people can’t afford to repay
their debts anymore.

Cutting spending is deflationary and painful, and as

businesses further cut costs, it means less jobs and higher
unemployment.

‍
2 — REDUCE DEBT
Debt can be reduced through defaults and restructures.

When banks are squeezed, businesses can’t repay their

loans, and individuals are lining up to withdraw their
money from the bank for fear of it not being there

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tomorrow in case of bank defaults, you’re likely looking at
a depression.

‍
DEFAULT

This is essentially a failure to repay. This immediately and

directly impacts the defaulting Government’s bondholders
and has dire downstream consequences for the entire
economy and people of a nation which is why countries
like Greece were bailed out by the deeper-pocketed EU
compatriots (even though the likes of Germany ultimately
benefited).

DEBT RESTRUCTURING

With restructuring, lenders get paid back less or paid back

over longer period of time, or at a lower interest
rate. Lenders would rather have a little of something
than all of nothing (remember this when renegotiating
your interest rates and repayment terms during this
time of COVID19), and ultimately this serves to decrease
debt.

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But debt restructuring also causes income and asset
values to disappear faster, again causing the debt burden
gets worse. We’re not having much luck here…the debt
reduction is painful and deflationary as well!

The Central Government is impacted, because it is

collecting fewer taxes but needs to spend more because
unemployment has risen!

It needs to create stimulus plans to increase spending in

the economy.

The Government’s budget deficit explodes because it now

needs to spend more than it earns in taxes.

To fund this deficit, it either needs to raise taxes, borrow

money, or both. And with unemployment at a high, where
do those taxes come from? The rich.

‍
3 — REDISTRIBUTE WEALTH FROM HAVES TO
HAVE-NOTS
Much like Robin Hood stealing from the rich to give to the
poor, incomes are redistributed. This can result in the
wealthy being squeezed and resenting the have-nots, and
vice versa for the contrast in outcomes.

If this continues, social disorder and revolution can follow,

both within and between countries, as was the case in the

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1930s when Adolf Hitler came to power due to economic
collapse in Germany.

Pressure to end the depression mounts, but with no credit

in the market, and with most ‘money’ being credit, as was
mentioned earlier, the only thing left to do is…

4 — PRINT MONEY
With interest rates at zero, the Central Bank is forced to
print money. This is inflationary and stimulative, although it
can decrease the value of a currency, especially if too
much is printed, which can make nations uncompetitive or
less competitive on a global scale.

By buying financial assets, the Central Bank drives up

asset prices but it only helps people who have financial
assets.

The Central Bank can only buy financial assets, not goods
and services, so in order to support the economy at large,
the Central Bank buys Government bonds which gives the
Government the ability to buy goods and service. This
gets money into the hands of people at large, not just
those with financial assets.

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Source: Ray Dalio

The Government can now run at a deficit while also

spending on stimulus programs and unemployment
benefits. This will lower the economy’s overall debt burden
over time, and increase spending and incomes.

However, policy makers need to balance the four levers in

order to lead to what Dalio calls a ‘beautiful
deleveraging’.

When it’s beautiful, debts decline relative to income

growth, real economic growth is positive, and inflation isn’t
a problem. This is because a delicate balance between
cutting spending, reducing debt, transferring wealth and
printing money is maintained.

Printing money won’t cause inflation providing it offsets

the decrease in credit, but does not exceed it. However, if

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too much money is printed it can lead to hyper-inflation,
is what Germany experienced during its deleveraging in
the 1920s when 160 German marks were equivalent to
just one US dollar.

An ugly deleveraging followers if income growth is not

higher than the rate of interest on accumulated debt to cut
the debut burden.

The ‘reflation’ or recovery phase of the long-term debt

cycle — the time it takes for debt burdens to fall and
economic activity to resume per usual — lasts roughly 7 to
10 (10 years for the Great Depression and seven for the
global financial crisis). This is what’s known as a lost
decade.

‍
THREE RULES OF THUMB FOR LIFE
Finally, Dalio leaves us with three rules of thumb with
which to navigate the economy ourselves, be it in our own
businesses, organisations we work at or our personal
finances.

1. Don’t have debt rise faster than income (because

debt burdens will eventually crush you).
2. Don’t have income rise faster than productivity — it
will eventually render you uncompetitive.

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3. Do all you can to raise productivity — in the long run
that’s what matters most.

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Another Summary

Summary of Ray Dalio’s

Economic Principles: How the
Money Machine Works
The Economy is made up of markets, which are made up
of transactions.

A transaction is when someone buys and someone sells.

You can buy a beer at a bar with cash and that would be a
cash transaction.

You can also buy a beer with the promise to pay in the
future, and that would be credit.

Every time you buy with credit, you create an asset (the
loan or credit) and a liability (the debt).

When the borrower pays back the credit/debt, they have

settled the transaction.

The more transactions that occur, the more the economy

grows, because the more people spend the more money
the seller makes and the more they spend and so on.

With a cash economy, the only way for you to get more
money is to increase your productivity. Make more or
better products/services and sell more.

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If we lived in a cash based economy, we wouldn’t have
market cycles, we would just have a steady upward
climb.

The reason we have cycles is because of credit. There is

50 trillion dollars of credit and only 3 trillion dollars in the
US economy.

There are small debt cycles and large debt cycles.

The small debt cycles happen every 5-8 years.

The large debt cycles happen every 75 to 100 years.

A small debt cycle is described like this:

 When interest rates are low, borrowers borrow

more money because credit is cheap.
 As they borrow more and spend more money
prices go up (inflation and economic growth)
 The government doesn’t want too much inflation
so it raises interest rates.
 Then borrowers are squeezed, can’t pay their
debts and there is less spending (economy
declines), prices decrease (inflation)
 Then the government lowers interest rates again
and the cycle begins again

A large debt cycle is described as this:

 The government can no longer help borrowers out

of their debt because interest rates are already at
zero and then there is a deleveraging (unloading
debt)
 If the decline lasts too long, it becomes a
depression, and can lead to social chaos, protests

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 and wars. If it is handled properly, it is a beautiful
deleveraging.
 Solution #1 is for borrowers to spend less
(austerity) – Borrowers owe more money than they
can pay back, and they stop spending as much,
and stop paying back their debts, spend less.
Businesses cut jobs, unemployment rises, and the
economy declines and there is deflation as assets
go down in value.
 Solution #2 is for debt to be re-negotiated –
debtors take longer to pay it back, lower their
interest rates, or pay back less and the bank takes
the loss (if this happens too much, people might
distrust their bank and withdraw their money
causing bank failures)
 Solution #3 is for to tax the rich and redistribute to
the poor – by creating public service projects to
employ them or to pass out unemployment
benefits
 Solution #4 is for the government to print money
and buy stocks and bonds – this allows the
government to lend itself money to pay for
government programs to help the poor. Too much
printing though leads to excessive inflation and
social chaos (as Germany did after the first world
war).

So why do people borrow more than they can pay back?

The answer is human nature.

Conclusion
So that is a summary of Economic Principles: How the
Economic Machine Works by Ray Dalio.

I suggest you watch the video yourself!

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I’m grateful for your visit today and invite you to leave a
comment below on your thoughts.

What's all the Yellen About? Monetary

Policy and the Federal Reserve: Crash
Course Economics #10

1) The Federal Reserve is the central bank of

US. Europe has the European Central Bank. a.
Most Central Banks have two jobs: - they
regulate and oversee the nation's commercial
banks by making sure that banks have enough
money in reserve to avoid bank runs. - they
conduct monetary policy which is increasing or
decreasing the money supply to speed up or
slow down the overall economy.

2) Interest rate - the price of borrowing

money. a. When interest rates are low,
borrowers will find it easier to pay back loans
so they will borrow more and spend more.

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When interest rates are high, borrowers borrow
less and spend less. b. Expansionary monetary
policy - when central bank wants to speed up
the economy, it will increase the money
supply, which will decrease interest rates and
lead to more borrowing and spending. c.
Contractionary monetary policy - when central
bank wants to slow down the economy, they
decrease the money supply. Less money
available will increase interest rates and
decrease borrowing and spending.

3) Liquid assets - an asset that can be

converted into cash quickly and with minimal
impact to the price received.

4) Open market operations - this is when the

federal reserve buys or sells short term
government bonds.

5) Quantitative easing (Q.E.) - when central

banks buy longer term assets from banks.

6) Monetary policy - changing money supply to

speed up or slow down economy.
Show less

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