How The Economic Machine Works

Last updated Apr 1, 2023 Edit Source

• Economics

Autor: Ray Dalio Watch this: Video: https://www.youtube.com/watch?v=PHe0bXAIuk0)

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title: Ray Dalio
Il mondo è inpazzito e il sistema è rotto

It’s 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, and they create 3 main forces that drive the economy:

• Productivity growth
• The Short term debt cycle
• The Long term debt cycle

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 for goods, services or financial assets.

So adding together the money spent and the amount of credit spent, you can know the total spending. The total amount of spending drives the economy.

If you divide the amount spent by the quantity sold, you get the price. And that’s it. That’s a transaction.

• All cycles and all forces in an economy are driven by transactions. So, if we can understand transactions, we can understand the whole 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, a stock market.
• An economy consists of all of the transactions in all of its markets.

The biggest buyer and seller is the government, which consists of two important parts:

• a Central Government that collects taxes and spends money;

• Central Bank, which is different from 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 new money. the Central Bank is an important player in the flow of Credit.

Just like buyers and sellers go to the market to make transactions, so do lenders and borrowers.

Lenders usually want to make their money into more money and borrowers usually want to buy something they can’t afford, like a house or car.

Borrowers promise to repay the amount they borrow, called the principal, plus an additional amount, called interest. When interest rates are high, there is less borrowing because it’s expensive. When borrowers promise to repay and lenders believe them, credit is created.

As soon as credit is created, it immediately turns into debt. Debt is both an asset to the lender, and a liability to the borrower.

So, why is credit so important?

Because when a borrower receives credit, he is able to increase his spending. And remember, spending drives the economy. This is because one person’s spending is another person’s income.

So increased income allows increased borrowing (from the bank) which allows increased spending. And since one person’s spending is another person’s income, this leads to more increased borrowing and so on. This self-reinforcing pattern leads to economic growth and is why we have Cycles.

Those who were invented and hard-working raise their productivity and their living standards faster than those who are complacent and lazy. BUT Productivity matters most in the long run, but Credit matters most in the short run.

This is because productivity growth doesn’t fluctuate much (it is a linear function), so it’s not a big driver of economic swings. Debt is(non linear function) — because it allows us to consume more than we produce when we acquire it and it forces us to consume less than we produce when we pay it back.

Debt swings occur in two big cycles:

• One takes about 5 to 8 years;
• The other takes about 75 to 100 years.

But How does these three big forces (Productivity, Debt, Credit) interact with each others?

These non linear function that swings around the line are not due to how much innovation or hard work there is, they’re primarily due to how much credit there is.

Let’s for a second imagine an economy without credit. In this economy, the only way I can increase my spending is to increase my income, which requires me to be more productive and do more work. Increased productivity is the only way for growth: Linear.

But because we borrow, we have cycles. This isn’t due to any laws or regulation, it’s due to human nature and the way that credit works.

Think of borrowing as simply a way of pulling spending forward. In order to buy something you can’t afford, you need to spend more than you make. To do this, you essentially need to borrow from your future self. In doing so you create a time in the future that you need to spend less than you make in order to pay it back. It very quickly resembles a cycle.

The reality is that most of what people call money is actually credit. The total amount of credit in the United States is about $50 trillion and the total amount of money is only about $3 trillion.

As a result, an economy with credit has more spending and allows incomes to rise faster than productivity over the short run, but not over the long run.

NB: Now, don’t get me wrong, credit isn’t necessarily something bad that just causes cycles. For example, if you borrow money to buy a big TV, it doesn’t generate income for you to pay back the debt. But, if you borrow money to buy a tractor — and that tractor let’s you harvest more crops and earn more money — then, you can pay back your debt.

Suppose you earn $100,000 a year and have no debt. You are creditworthy enough to borrow $10,000 dollars, so you can spend $110,000 dollars even though you only earn $100,000 dollars.

Since your spending is another person’s income, someone is earning $110,000 dollars. The person earning $110,000 dollars with no debt can borrow $11,000 dollars, so he can spend $121,000 dollars even though he has only earned $110,000 dollars. His spending is another person’s income, exc. A cycle is beginning.

And if the cycle goes up, it eventually needs to come down. This leads us into the Short Term Debt Cycle.

As economic activity increases, we see an expansion, the first phase of the short term debt cycle. Spending continues to increase and prices start to rise. When prices rise, we call this Inflazione.

The Central Bank doesn’t want too much inflation because it causes problems. Seeing prices rise, it raises interest rates. With higher interest rates, fewer people can afford to borrow money.

Because people borrow less and have higher debt repayments, they have less money leftover to spend, so spending slows …and since one person’s spending is another person’s income, incomes drop! When people spend less, prices go down. We call this deflazione.

Economic activity decreases and we have a recessione.

If the recession becomes too severe and inflation is no longer a problem, the central bank will lower interest rates to cause everything to pick up again.

With low interest rates, debt repayments are reduced and borrowing and spending pick up and we see another expansion.

And note that this cycle is controlled primarily by the central bank. The short term debt cycle typically lasts 5 - 8 years and happens over and over again for decades.

..But notice that the bottom and top of each cycle finish with more growth than the previous cycle and with more debt.

Why? Because people push it — they have an inclination to borrow and spend more instead of paying back debt. It’s human nature. Over long periods of time, debts rise faster than incomes creating the Long Term Debt Cycle.

Despite people becoming more indebted, lenders even more freely extend credit (that’s strange, banks should be reclined to give credit to people that are in debt!).

But Why lenders do that? Because everybody thinks things are going great! They can see only the short term. Incomes have been rising! Asset values are going up! The stock market roars! It’s a boom! When people do a lot of that, we call it a bubble.

So even though debts have been growing, incomes have been growing nearly as fast to offset them.

People borrow huge amounts of money to buy assets as investments causing their prices to rise even higher. Over decades, debt burdens slowly increase creating larger and larger debt repayments.

At some point, debt repayments start growing faster than incomes forcing people to cut back on their spending. And since one person’s spending is another person’s income, incomes begin to go down…which makes people less creditworthy causing borrowing to go down. This is the long term debt peak.

But what is the difference between this situation and the short-term? This appears similar to a recession but the difference here in a Deleveraging is that interest rates can’t be lowered to save the day.

In a Deleveraging; people cut spending, incomes fall, credit disappears, assets prices drop, banks get squeezed, the stock market crashes, social tensions rise. borrowers get squeezed. No longer creditworthy, and they can no longer borrow enough money to make their debt repayments.

So borrowers are forced to sell assets. The rush to sell assets floods the market. More people wanna sell so they prices go down.This is when the stock market collapses.

In a recession, lowering interest rates works to stimulate the borrowing. However, in a Deleveraging, lowering interest rates doesn’t work because interest rates are already low and soon hit 0% - so the stimulation ends.

The difference between a recession and a deleveraging is that in a deleveraging borrowers’ debt burdens have simply gotten too big and can’t be relieved by lowering interest rates.

So what do you do about a deleveraging?

The problem is debt burdens are too high and they must come down. There are four ways this can happen:

1. Austerity: People, businesses, and governments cut their spending.
2. Debts are reduced through defaults and restructurings.
3. Wealth is redistributed from the ‘haves’ to the ‘have nots’.
4. The central bank prints new money.

Usually, spending is cut first. Because spending is cut, and one man’s spending is another man’s income - it causes incomes to fall. They fall faster than debts are repaid and the debt burden actually gets worse.

This cut in spending is deflationary and painful. Businesses are forced to cut costs… which means less jobs and higher unemployment.

Many borrowers find themselves unable to repay their loans – and a borrower’s debts are a lender’s assets. When borrowers don’t repay the bank, people get nervous that the bank won’t be able to repay them so they rush to withdraw their money from the bank. Banks get squeezed.

This severe economic contraction is a depression.

All of this impacts the central government because lower incomes and less employment means the government collects fewer taxes. At the same time it needs to increase its spending because unemployment has risen.

Additionally, governments create stimulus plans and increase their spending to make up for the decrease in the economy.

Governments’ budget deficits explode in a deleveraging because they spend more than they earn in taxes. This is what is happening when you hear about the budget deficit on the news.

To fund their deficits, governments need to either raise taxes or borrow money. But with incomes falling and so many unemployed, who is the money going to come from? The rich.

Since governments need more money and since wealth is heavily concentrated in the hands of a small percentage of the people, governments naturally raise taxes on the wealthy which facilitates a redistribution of wealth in the economy.

If the depression continues social disorder can break out. This situation can lead to political change that can sometimes be extreme. In the 1930s, this led to Hitler coming to power.

Inevitably, the central bank prints new money — out of thin air — and uses it to buy financial assets and government bonds. In 2008, when the United States’ central bank — the Federal Reserve — printed over two trillion dollars. $5.2 trillion in COVID.

The Central Government, on the other hand, can buy goods and services and put money in the hands of the people but it can’t print money. So, in order to stimulate the economy, the two must cooperate.

By buying government bonds, the Central Bank essentially lends money to the government, allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits.

However, it will lower the economy’s total debt burden. This is a very risky time. The deflationary ways need to balance with the inflationary ways in order to maintain stability. If balanced correctly, there can be a Beautiful Deleveraging.

Even though a deleveraging is a difficult situation, 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. It is achieved by having the right balance.

The right balance requires a certain mix of:

• cutting spending,
• reducing debt,
• transferring wealth
• printing money

The Central Bank needs to not only pump up income growth but get the rate of income growth higher than the rate of interest on the accumulated debt. Basically, income needs to grow faster than debt grows.

So If policymakers achieve the right balance, a deleveraging isn’t so dramatic. Growth is slow but debt burdens go down.

# 4.8 Reflation

When incomes begin to rise, borrowers begin to appear more creditworthy. And when borrowers appear more creditworthy, lenders begin to lend money again. Debt burdens finally begin to fall.

Able to borrow money, people can spend more. Eventually, the economy begins to grow again, leading to the reflation phase of the long term debt cycle. It takes roughly a decade or more for debt burdens to fall and economic activity to get back to normal

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 line gives a reasonably good template for seeing where we’ve been, where we are now and where we are probably headed.

So in summary, there are three rules of thumb that I’d like you to take away from this:

1. Don’t have debt rise faster than income, because your debt burdens will eventually crush you.

2. Don’t have income rise faster than productivity, because you will eventually become uncompetitive.

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