All of the information in this article comes from Ray Dalio. Dalio is the founder and co-chief investment officer of the most successful hedge fund in the world, Bridgewater. His insights and expertise on the economy and how it functions are indispensable.
He shares his insights about the economy and politics in his articles on LinkedIn.
This article essentially summarizes his views on how the economy works. I strongly recommend watching his video “How the Economic Machine Works by Ray Dalio” on YouTube.
How the Economy Works according to Ray Dalio
Understanding the macro economic cycles is vital to knowing where society stands currently and what to expect for the future.
The economy according to Ray Dalio has three major components. They are 1) productivity growth, 2) short term debt cycles, and 3) long term debt cycles.
1) Productivity growth is the most important component over the very long term, and is generally not volatile. Productivity of the economy trends higher as people learn and become more efficient over time. This allows the society to raise its overall output. You can easily see that over the last hundred years that living standards and quality of life has increased dramatically. That's because we know more and are better at getting things done.
To understand debt cycles you need a basic understanding of credit and debt. People make trades that not only include what they currently have, but also what they assume they can afford in the future. This causes borrowing and lending of money that creates both credit and debt. Credit is the asset of the lender since they most likely will make money on any interest rates associated with lending, and trust that the borrower can pay everything back in the future. Debt on the other hand is a liability for the borrower since they will have to eventually pay it all back with interest.
2) The short term debt cycle is what we tend to focus on more. These cycles in the economy happen every 5 - 10 years and are driven by the amount of credit available in the system. The amount of credit available in the system is mostly controlled by central banks raising or lowering interest rates, making it either less or more appealing to borrow credit. When debts are too much for the system to bear, central banks raise interest rates to slow borrowing and encourage debts to be managed. This causes the economy to pull back growth and bring debt down to more manageable levels. To be clear this slows down the accumulation of debt, but does not pay it all back. This is known as a recession and often lasts for about 1 year. After debts are considered to be more manageable, central banks lower interest rates again, causing credit to be cheap and appealing which in turn increases growth of the economy for another 5-10 year period.
3) The long term debt cycle is arguably the most important component in understanding if the economy is healthy and still has room for growth. The long term debt cycle is the accumulation of a lot of short term debt cycles which add on more debt to the economy over many decades. The debt burdens created by the short term debt cycles eventually become so large that they are unmanageable. This becomes a self-reinforcing downward spiral of economic fallout. Businesses fail, assets become very cheap, unemployment rises, and income levels are not high enough to handle debt burdens.This period of managing accumulated debt is known as a depression and often takes the economy 10 years to recover and become credit worthy and able to grow. The process of managing the accumulated debt in the economy is known as deleveraging. Throughout history, deleveraging has happened through 4 measures. They are 1) cutting spending, 2) reducing and restructuring debt, 3) redistributing wealth and, 4) printing money. Lowering interest rates will no longer stimulate growth since interest rates at this point are already at 0% and no one is looking to lend or borrow considering the over-leveraged state of the economy. I’ll go more in depth in another article about how a deleveraging should be managed for best results. With the economy struggling, society looks for strong leadership to manage the economic crisis. This leads to a rise in populist sentiments and growing tensions both within a nation and between nations. The most recent example of this occurred during the 1930-1945 period, with the great depression and culmination of tensions during WW2. If the deleveraging is managed well, real productivity can still be growing even while the economy is in a deflationary state. Also if managed correctly, tensions within nations and between nations will be less severe. After the depressionary period, there will inevitably be a reflationary period in the economy where lending and borrowing become appealing again since debts are manageable in comparison to income levels. This is essentially the beginning of a new long term debt cycle.
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