At this critical time when economic activity has all but ground to a halt, a lot of people are struggling and many are having sleepless nights worrying about what the future holds for them. At such a time, it is helpful to get informed or educated about how the economy works, and this blog post shares the highlights of a simple template developed by Ray Dalio to explain how the economy works. Use this information to make better decisions regarding your economic affairs so that this current pandemic can mark a new beginning for your finances.
A Brief Intro of How the Economy Works
The economy works like a simple machine, but many people don’t understand it or they don’t agree on how it works, and this has led to a lot of endless economic suffering. This simple but practical template of how the economy works may seem unconventional, but it helps to anticipate and sidestep the global financial crises and it has worked well for over 30 years.
Though the economy might seem complex, it works in a simple mechanical way. It is 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. They create three main forces that drive the economy;
- Productivity growth
- The short term debt cycle
- The long term debt cycle
These three forces and laying them on top of each other provides a template for tracking economic movements and figuring out what’s happening now. The simplest part of the economy is transactions.
Related: Ten Tips On How To Master Your Money
An economy is simply the sum of the transactions that make it up, and a transaction is a pretty simple thing. You make transactions 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 of goods, services or financial assets (stocks and bonds, for example).
Credit is spent in just the same way as money, so when you add the money spent and the credit spent, you get what is called total spending. The total amount of spending drives the economy. If you divide the amount spent by the quantity of items sold, you get the price.
If we can understand transactions, we can understand the economy because transactions are the drivers of the 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, and markets for so many other things.
Central Banks and Central Governments
The biggest buyer and seller is the government, and this consists of two important parts. The first is the central government that collects taxes and spends money.
The second is the central bank which is different from all other buyers and sellers because it controls the amount of money and credit in the economy. It does this by influencing interest rates and printing money. For these reasons, the central bank is a major player in the control of the flow of credit.
Pay a lot of attention to credit because it is the most important part of the economy and probably the least understood. It is the most important because it is the biggest and most volatile part of the economy.
Just as buyers and sellers go to markets to make transactions, so do lenders. Lenders usually want to make more money and borrowers usually want to buy something that they can’t afford, such as a house or car, or they may want to invest in something like starting a business.
Credit helps borrowers and lenders get what they want. Borrowers are able to buy what they want using credit and lenders are able to make more money through the interest charged on the money they lend out.
When interest rates are high, there is less borrowing because it is expensive. However, when interest rates are low, there is more borrowing because it is cheap. Credit is created when borrowers promise to pay and the lenders believe them.
Debt or credit can be both an asset and a liability. It is an asset to the lender and a liability to the borrower. The transaction is settled at some point in the future when the borrower repays the debt and interest. When that happens, the asset and liability both disappear because the debt has been settled.
Why is Credit Important?
When a borrower receives credit, he is able to increase his spending, and as already mentioned, spending drives the economy. One person’s spending is another person’s income. Every dollar you earn was spent by someone, and every dollar you spend is earned by someone.
As your income rises, more lenders are willing to lend to you because your creditworthiness is high. You have the ability to pay, and you have collateral. In the event that the borrower cannot repay debt, they have sufficient assets (collateral) that can be sold to repay the debt.
So, increased income allows increased borrowing, which in turn allows increased spending, and increased income for sellers. This increased spending is the reason why we have economic cycles because the patterns are self-reinforcing.
Productivity and Credit vs. Economic Cycles
Over time, we learn and that accumulated knowledge raises our living standards. We call this “productivity growth.” The productivity of those who are lazy and complacent doesn’t grow as fast as that of people who are inventive and hardworking. This isn’t always true in the short run because productivity matters most in the long run while credit matters most in the short run.
This is because productivity doesn’t fluctuate a lot, so it isn’t a big driver of economic swings. Debt is a bigger driver of economic swings because it allows people to consume more than they are producing, and debt forces us to consume less than we are producing when we paying back that debt.
Debt swings occur in two big cycles. One takes about 5-8 years while the other takes about 75-100 years. While most people feel the swings, they typically don’t see them as cycles because they experience them on a day by day basis.
We shall look closer at these three big forces and how they interact to make up our experiences.
As already stated, cycles are created by credit since each time you borrow you are spending more than you produce and when it is time to pay, you will have to spend less than you produce.
In contrast, in an economy without credit, there is steady growth in productivity because people are forced to produce more in order to spend more. As they spend, other people are earning and increasing their spending power, so the economy grows steadily without any cycles.
This is why understanding credit is so important. It sets into motion a mechanical and predictable series of events that will happen in the future. This makes credit different from money.
Credit vs. Money
Money is what you settle a transaction with. For example, when you pay cash for a pint of beer in a bar, the transaction is settled immediately. However, when you pay with credit, you and the bartender create an asset and a liability. The bartender has an asset in the form of the credit extended to you, and you have debt (liability) to pay for that beer at a future date. The asset and liability disappear once you pay the debt.
The reality is that most of what people in the U.S. call money is actually debt. The total credit in the U.S. economy is about $50 trillion dollars while the total amount of money is about $3 trillion.
Credit isn’t necessarily bad. It is bad when it finances overconsumption that the borrowers are unable to pay back. Credit is good when it efficiently allocates resources and facilitates production which generates income.
For example, when you use credit to buy a big TV, that TV will not increase your productivity. But, if you use credit to buy a tractor and increase your farm harvest, your standard of living increases because you have used debt correctly to increase productivity.
The Short Term Debt Cycle
As productivity and credit increases, we see an expansion. This is the first phase of the cycle. As credit (created from thin air) increases, prices start rising because the growth of credit has exceeded production.
As prices rise, inflation sets in. The central bank doesn’t want too much inflation, so it raises interest rates. With higher interest rates, fewer people are willing or able to borrow, so their ability to spend reduces since their monthly debt repayment will have increased. As incomes reduce, people spend less and prices go down. This is called deflation. Economic activity reduces and we now have a depression.
The central bank will then step in and lower interest rates in order to increase borrowing, spending and economic activity in general. Another cycle of expansion, followed by contraction, starts all over again, time and time again.
It is human nature to push one’s ability to borrow and spend rather than to increase productivity and spend one’s income. Because of this, debt rises faster than incomes to create the long term debt cycle.
The Long Term Debt Cycle
A bubble refers to a situation in which the growth of credit results in the growth of incomes and asset value. This brings in the debt burden. The debt burden is the ratio of debt to income. As long as income continues to rise, the debt burden remains manageable.
The increase in income and asset value makes borrowers eligible for even more debt, and those borrowers feel wealthy. This, obviously, cannot continue forever. Over decades, debt obligations keep getting bigger and bigger until incomes are unable to support the expected repayments.
This forces people to cut back on spending. Since one person’s spending is another person’s income, incomes start going down, and this makes people less creditworthy, so borrowing goes down. Debt repayment continues to rise, so spending drops even further. This is now the long term debt burden peak.
For the U.S., Europe, and the rest of the world, that peak happened in 2008. At that point, the economy starts deleveraging. In this situation, people reduce their spending, incomes drop, asset values disappear, lenders drastically cut credit, banks get squeezed, stock markets crash, social tensions rise and the whole structure starts to feed on itself in the other way from what was happening when things were looking up.
Borrowers rush to sell their assets but there are no buyers since incomes are down and lenders aren’t lending. Real estate markets tank, stock markets crash, and banks get into trouble. People feel poor, incomes reduce further, people are less creditworthy, and the whole thing is dragged down by its own weight.
In a deleveraging, lowering interest rates to stimulate economic activity cannot work since interest rates are already at their lowest. The debt obligations of borrowers are so great that the situation can’t be helped by lowering interest rates. Lenders stop lending, borrowers stop borrowing. Borrowers feel crippled by their existing debt, so they have no desire to get into more debt. This happened in 1940 and again in 2008 when interest rates hit zero but borrowers weren’t interested in taking loans.
What Do You Do About a Deleveraging?
Think of the economy as being not creditworthy in the same way as an individual wouldn’t be creditworthy.
When debt burden are too high, there are four ways through which they can come down.
- People, businesses and governments cut their spending.
- Debts are reduced through defaults and restructurings
- Wealth is redistributed from the haves to the have-nots
- The central bank prints new money
Those four ways have all happened in every deleveraging in modern history, such as in the U.S. in 1940 and in 2008. Usually, spending is cut first (austerity measures). Rather than reduce the debt burden, the reduction of spending causes incomes to drop further and debt burdens become larger.
Next, there is a run on banks because people fear that the banks will be unable to give them their deposits. Loan defaults occur on a large scale, and this is called a depression. To avoid losing their assets, lenders agree to restructure credit facilities (loans). Debt restructuring means that lenders agree to either be paid less, be paid over a longer time, or be paid at lower interest rates. This restructuring causes assets and income to disappear even faster.
All this affects the central government because less income means lower tax collections. At the same time, government spending goes up because unemployment has gone up. Budget deficits explode because the government is spending more (on unemployment benefits and stimulus packages, for example) yet revenue from taxes is low.
To get out of this situation, governments can either raise taxes or borrow. But since incomes are already so low, the government turns to the rich. Governments raise taxes on the small population of wealthy people in what becomes a redistribution of wealth.
The have-nots begin to resent the haves who are getting wealthier while the haves who are faced by heavy taxes, a weak economy, and falling asset prices begin to resent the have-nots.
If the depression continues, the ground is set for social disorder. Tensions can rise within countries and between countries as well, especially debtor and creditor countries. This situation can lead to political change that can at times be extreme. For example, Hitler came to power in the 1930s under this sort of situation.
Remember, what people thought was money was actually credit, so with credit gone, they realize they don’t have enough money. Remember, only the central bank can print money, so with interest rates at zero, the central bank has no choice but to print more money.
Unlike cutting spending and reducing interest rates, printing money is inflationary. The central bank prints this money out of air and uses it to buy bank assets and government bonds. This happened in the U.S. in the 1940s and in 2008 when more than two trillion dollars were printed. Other central banks did the same.
By buying financial assets, the prices of those assets go up and this helps to make the owners more creditworthy. However, only those who had assets benefit from this intervention. On the other hand, the central government which can buy goods and services (thereby putting money into the hands of consumers) cannot print money.
In order to stimulate the economy, the central government must cooperate with the central bank. By buying government bonds, the central bank essentially lends money to the central government, allowing it to run a deficit and increase spending (stimulus packages, unemployment benefits, etc.). This increases people’s incomes and the government’s debt. However, it will lower the overall debt burden of the economy.
This is a delicate time and efforts must be taken to balance the deflationary waves with the inflationary waves in order to maintain stability. If balance is attained, there can be a beautiful deleveraging. A deleveraging can be ugly, or it can be beautiful.
How Deleveraging Can Be Beautiful
Handling a difficult situation in the best possible way is beautiful, a lot more beautiful than the debt-fueled unbalanced 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. This is achieved by having the right balance between cutting spending, reducing debt, transferring wealth, and printing money.
People wonder whether printing money will not trigger inflation. It won’t if it offsets forward credit. Remember, it is spending that matters. A dollar of spending paid for with credit has the same effect on price as a dollar of spending paid for with money.
By printing money, the central bank can make up for the disappearance of credit. In order to turn things around, the central bank has to not only pump up income growth but get the rate of income growth higher than the rate of interest on accumulated debt.
The key is to print just enough money to prevent 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!
When incomes begin to rise, borrowers begin to appear more creditworthy, and lenders begin to lend money again. Able to borrow more, people begin to spend more. Eventually, the economy begins to grow again, leading to the reflation phase of the long term debt cycle.
Though the deleveraging process can be horrible if handled badly, it will eventually fix the problem if handled well. It takes approximately a decade for debt burdens to fall and economic activity to return to normal, hence the term “lost decade.”
Summing it up…
Of course, the economy may feel a little more complex than this template suggests. However, 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 cycle gives a reasonably good template for seeing where we’ve been, where we are and where we are probably headed.
Take just three rules of thumb from this discussion;
- Don’t let your debt rise faster than your income because it will financially crush you.
- Don’t have income rise faster than productivity because you will eventually become uncompetitive.
- Do all that you can to raise your productivity because, in the long run, that is that matters most.
This is simple advice for you and it is simple advice for policymakers. You might be surprised that most people, including most policymakers, don’t pay enough attention to this. This template works, and it will work for you.
To Your Success,