Ray Dalio’s Economic Machine — 12 Minute Summary

April 23, 2020
Business
Entrepreneurship
Leadership

Ray Dalio is one of most successful hedge fund managers of our time, having founded Bridgewater Associates in 1975 — a company which today boasts US $160 billion in assets under management. Needless to say, Dalio is a billionaire in his own right.

He credits much of his success to guiding principles that he has used to make decisions both in his professional and in his personal life. More recently, as Dalio was closing in on his 70s, he decided to give back and codify these principles into what became his book, aptly titled Principles: Life and Work. It has had a profound impact on how I navigate the world.

He has since gone on to not only influence global financial markets but also global minds, with his book becoming a New York Times bestseller, and his YouTube videos which demystify complex topics such decision-making and the global economy, popularise ideas such as idea meritocracies and radical transparency, and generate tens of millions of views and followers along the way.

Most recently, Dalio has been on the lockdown-imposed podcast trail, sharing his sentiments on what he thinks the short to long term economic outlook might be relative to COVID-19. His commentary builds upon a beautiful video he shared six years ago called ‘How the Economic Machine Works in 30 Minutes’ — it has been viewed over 14 million times and I highly recommend that you check it out, along with his book.

While Dalio concedes that the video offers us a simplification of the economy, he says that this fundamental understanding has served him well for over 30 years. And as is the case with Occam’s Razor, sometimes the simplest answer is the best answer.

Upon watching the video and listening to a few recent interviews with Ray Dalio, I took some notes to solidify my own understanding of these concepts, refresh what I learned in macroeconomic principles back in my college days (now a good 18 years ago — oh dear!), and better navigate what is coming our way. Turning notes into blogs, or finding ways to teach others what you have learned is a great way to reinforce your understanding, for as Roman philosopher Seneca put it, “while we teach, we learn”.

As I often like to do, when I think there is value to others in my notes, I take the time to polish them a little and share them with the world. Where I’ve found it useful or fun to do so, I’ve also interjected with some commentary of my own. I hope you find this helpful.

With that, please find below my summary of how the economic machine works, according to Ray Dalio.

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…

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.

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.

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.

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

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.

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.

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.

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.

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.

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 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?

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 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.

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 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.

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

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