How the Economic Machine Works - Ray Dalio Summary

Understand the Economy in Less than 30 Minutes

The economy is largely misunderstood by many people and myself included, until I stumbled upon Ray Dalio's presentation on how the economy works. Most of us read news headlines daily, if not at least once a week. But because we are so concerned about the day to day activities of the economy, we lose sight of the overall multi-year picture.

In Ray Dalio's How the Economic Machine Works, he argues that the economy works like a machine. The economy is made up of gazillions of transactions that are driven by human nature and create three main forces that drive the economy. 

1) Productivity Growth
2) Short Term Debt Cycle
3) Long Term Debt Cycle

Key Definitions:

Transaction - When a buyer and seller exchanges money or credit for goods, services, and financial assets.
Market - All buyers and sellers making transactions in a specific area. Examples include the wheat, stock, cheese, steel markets.
Economy - This is the sum of all transactions in all markets.

The biggest buyer and seller is the government. The central bank controls the amount of money and credit in the economy by influencing interest rates and printing more money.

Why is credit so important? 

With credit you are essentially borrowing money from your future self. As a result you are able to spend more than you actually currently earn. When you spend money, that money becomes someone else's income. As a result of, that person will be able to borrow more money.

For example, suppose I made $100 and I'm able to find a lender that will lend me $20 plus interest. I spend $120 dollars, which becomes someone else's income. That person will be able to borrow $30 dollars and when he spends that it becomes another person's income. 

However, this eventually all needs to be paid back.

More Income -> More Borrowing -> More Spending -> More Productivity -> More Income

Short term debt cycle (5-8 yrs) 

When we are in an expansion, spending increases faster than the capacity to produce goods and services. However, prices will start to rise resulting in what we understand as inflation. The government will then raise interest rates in an attempt to lower prices. Thereby fewer people will be able to borrow money and prices will eventually fall resulting in deflation. When the rate of spending can no longer be sustained by the available money or credit a recession occurs. Recessions end when the central banks lower interest rates to stimulate demand for goods and services.

Long term debt cycle (75-100 yrs) 

Debts rise faster than both income and money until it can no longer be sustained because debt servicing costs have become too excessive. This is similar to the recession in the short term debt cycle. The difference is that interest rates can not be reduced any more to raise spending. They are already at or close to 0%. When this happens a deleveraging occurs.

Borrows can't borrow -> Sell assets to pay loans -> Real estate & stock markets plummet -> Poor credit -> Less borrowing -> Less spending -> Less income

Remember your spending is someone else's income.

A deleveraging is the process of reducing debt burdens and is usually done in four different ways. 

1) People, governments and business cut spending.
2) Debt is reduced through write downs or extending payment terms.
3) Wealth is redistributed from the wealthy to the poor via government taxes.
4) The central bank prints more money to buy stocks and financial assets.

Income needs to grow faster than debt grows. However there needs to be a balance between the ways to reduce debt otherwise inflation and deflation will be out of control.

For example, if the government prints too much money inflation rates will soar like that of Germany in 1920s.

3 Rules Everyone Should Follow

1) Make sure income rises faster than debt otherwise the debt burden will eventually crush you.
2) Make sure incomes do not rise faster than productivity otherwise you will not be competitive.
3) Do all you can to raise productivity as that is what matters in long run.