Ray Dalio, founder of the worlds largest hedge fund Bridgewater Associates, has a simple framework of how the economy works. He kindly shares this framework in “How The Economic Machine Works”. In his framework one can find many links to how Raoul Paul analyzes the global economy, as I discussed previously.
So let us have a look at Ray´s view of how the economic machine works.
The economy is a machine and it works in a simple and mechanical way. It is made up of many, many simple transactions which are repeated over and over again. There are three main factors that have to be considered and which drive the economy. These three factors are:
- Productivity growth
- The short term debt cycle
- The long term debt cycle
(Remember Raoul´s view?)
Let´s start from the simplest part of every economy – transactions. An economy simply is the sum of all its transactions. In each transaction a buyer exchanges money or credit for the seller´s goods, services or financial assets. Therefore money and credit equal the total spending. Total spending is what drives the economy. It is a crucial measure. If you divide total spending by the quantity sold you arrive at the price of goods, services and assets. This is how you can evaluate inflation as we will see later.
A “market” within an economy consists of all buyers and all sellers of the same product, service or asset. The economy itself consists of all transactions in all markets existing.
The biggest and most important buyer and seller of an economy is the government, consisting of two bodies. There is the central government and the central bank. How do these two bodies influence the economy? Well, the central government influences through fiscal policy while the central bank controls monetary policy, it controls money and credit supply within an economy. It does so by setting interest rates and by printing money. Therefore, it strongly influences credit.
What is credit? We tend to think a lot in terms of money. But credit, according to Dalio, is “the most important part of the economy and probably the least understood”. In a second we will see why.
As we saw earlier, in every market there are buyers and sellers. The same counts for the credit market which consists of lenders and borrowers who make transactions in this specific market. Credit can help an individual to finance what she wants, may it be consumption or investment in order to produce productivity. Interest rates, set by the central bank, strongly influence the supply and demand of credit. When interest rates are high, borrowing becomes more expensive and investments are required to yield a high rate of return in order to justify the financing costs. When interest rates are low on the other hand, credit can be obtained and financed easily and even marginally profitable investments may be undertaken. In this situation the economy may easily overheat.
But there is more to consider. As soon as credit is created, debt is created as well. Thus credit has two sides. It is an asset for the lender while it is a liability for the borrower. These assets and liabilities disappear only when debt is repaid or forgiven.
So why is credit so important? When a borrower receives financing, when he receives credit, he is able to increase his spending. As we saw earlier, spending is what drives the whole economy. Because the spending of one person is someone else´s income, more spending results in more income. More income on the other hand makes lenders more willing to lend. This is because of two factors. Firstly, the increased incomes makes individuals´ ability to repay debt increase and secondly the value of collateral secures the lender in the case of default
Thus, when a borrower receives credit he can increase his spending. Spending drives the economy because everybody´s spending is someone else´s income. More spending equals more income. More income then makes lenders more willing to lend even more because individuals become more worthy of credit through the effects of increased income and appreciated collateral. Thereby, increased income leads to even more borrowing and more spending – a self-reinforcing pattern ensures. This is why we have economic cycles.
While productivity growth matters a lot for economic growth in the long run, what matters in the short run is credit and debt. This is because if we live above our means during one period we will have live below our means in subsequent periods when deleveraging takes place.
If we would not borrow, economic growth would only depend on productivity growth. But because we borrow, we do have cycles. This is because of human nature. To buy more than you can afford you have to borrow against your future self, which means that you will be able to spend less in the future, leading to cycles.
We have to be aware of the fact that credit is different than cash even though what people call money often actually is credit. Money is used when a transaction is settled immediately. Credit on the other hand represents the promise to settle a transaction in the future. Credit is not necessarily bad. It may be used to finance productivity enhancing investments. However it is bad when it finances over-consumption as opposed to investment.
So, as we have seen borrowing creates cycles. Everything that goes up most come down. This leads us to the short term debt cycle. With an increase of economic activity we see economic expansion. At the same time prices rise because total spending increases at a faster pace than the quantity of units, assets and services sold. Inflation is the result. If inflation reaches levels which are considered by central banks to be too high, it raises interest rates. This in turn leads to people not being able to borrow anymore and existing debt becomes more expensive. What results is the opposite of what we have seen before. There is less spending, resulting in less income. Instead of inflation, deflation occurs and the result is a recession. This is when interest rates are lowered again in order to stimulate the economy. Credit becomes easily available and we see another economic expansion.
We see how credit influences the economy. In the short term spending is only constrained by borrowers´and lenders´willingness to lend and borrow. If credit is easily available, an economic expansion takes place. When credit is not easily available, a recession is the result. This short term debt cycle in general lasts 5 to 8 years and happens over and over and over again during many decades. But when a short term debt cycle ends it does not lead us to the same level of debt at which we started the cycle. Instead, in general each cycle ends with more debt and more spending. This leads us to the long-term debt cycle.
In the long-term debt cycle “everyone thinks things are going great”. Credit leads to inflation of asset prices and increases of income. A bubble is created. At this point even though debt has been growing, income and asset prices have been growing at the same pace or faster. The debt burden has not deteriorated and people feel wealthy despite the huge debt (does this remind you of current times?).
However, this development cannot continue forever. Over decades and decades debt rises and debt repayments become larger and larger. Debt increases faster than income. In order to repay the increased interest expenses spending has to be reduced. We know were this leads us. Less spending leads to less income leads to less credit and so on. The result is a recession and maybe even a depression.
We arrive in the deleveraging phase of an economy. People cut spending, income is generally lower, there is less credit, asset prices drop which decreases collateral and the willingness to lend. At the same time the central bank may not be able to stimulate the economy with lower interest rates if interest rates are low already. The central bank faces the so called zero-lower bound (even though in the last years negative interest rates have been reality in many parts of the world in the central banks´ pursuit to encourage consumption).
As Ray puts it: “The difference between a recession (short term debt cycle) and a deleveraging (long term debt cycle) is that during a deleveraging borrowers´ debt burdens simply have gotten too big and can´t be relieved by lowering interest rates”.
At this point the economy is not credit worthy anymore. So what can be done about this situation? The conclusion is that the debt burden is too high and needs to come down. There are four ways through which the burden may decrease.
The first thing to usually happen is that spending is cut. We call this austerity. Even though we expect this to decrease the debt burden, it actually results in the opposite outcome. Because spending is decreased, incomes fall even faster and the debt burden gets worse. This way of austerity is deflationary. Governments and businesses need to cut expenditure leading to higher unemployment. Consequently debt needs to be reduced. When debts are not repaid, people fear for the stability of banks and withdraw their cash. Bank runs result. Finally, people, business, banks and even governments default on their debt – we arrive in a depression. This is when people realize that much of what they thought was their wealth does not really exist. The debt cuts, through its effects on the economy, actually lead to more decreased income and asset values. Consequently, the debt burden increases even further. Lower incomes and less employment bring the central government on the plan which collects less taxes. At the same time however it has to service higher unemployed people and has to finance more stimulus plans. This in turn increases the national debt burden even more, leading to the third step. To finance the budget deficits redistribution is attempted next. The “rich” are taxed more heavily in order to finance increased spending. Redistribution may lead to resentment between the “haves” and the “have nots”. This may result in rise of populism, social disorder, national conflicts and even wars.
The last resort is the central bank which, even though interest rates are already at zero, has another tool in its tool kit. The central bank may print money. Unlike the first three approaches, austerity, debt reduction and redistribution of wealth, which are all deflationary, the printing of money is inflationary and a stimulus for the economy. The central bank prints money “out of thin air” and uses it to purchase financial assets and government bonds. Buy doing so it helps to drive up asset prices, supporting individuals holding financial assets. At the same time however, the government bond purchases allow the government to finance stimulatory fiscal policy. This increases government debt but peoples´ income too. The economy´s total debt burden decreases though.
The four measures introduced need to be balanced in an optimal way. Austerity, debt restructuring, redistribution of wealth and printing of money need to be in equilibrium. In this way a “beautiful deleveraging”, as Dalio calls it, may take place. At this point debts decline relative to income. The debt burden consequently improves and real economic growth is positive.
But doesn´t the printing money create inflation? It will not if the printed money offsets credit. As we know already, prices depend on total spending on the one hand, consisting of credit and money, and the quantity of goods, services and assets on the other hand. If printed money replaces the disappearing credit inflation is not a problem. The key however is not to abuse this and print too much money, as did for example Germany during the Weimar Republic.
It takes an economy about a decade to make debt burdens fall and for the economy to recover again (the lost decade). This of course is a long period and may be very painful. So what can we do to avoid this painful process? What are the rules we should adhere to? There are three main takeaways from Ray Dalio´s framework.
- Don´t have debt rise faster than income. Debt burdens ultimately will bury the economy alive.
- Don´t have income rise faster than productivity.
- Try to encourage a rise in productivity as much as possible.
All this nowadays seems to be very relevant if we think about debt burdens in Europe, the United States, Japan and even China of present days. But many policy makers seem not to have understood these fairly easy principles. Hopefully we will.