How the Economy Works  

Ray Dalio is the founder of the investment firm Bridgewater Associates, a hedge fund utilizing global macro investment. This means that although his job is not easy, its aim is simple: understand the trends affecting the economy at large. Luckily, Mr Dalio shares his understanding of the economy in a video titled “How the Economic Machine Works.”

The key to his understanding of the economy is the view of credit as fundamental to the economy, and as simply borrowing cash from one’s future self. Under this interpretation, it becomes clear why our economy would behave in cycles: a ramp up of spending after successful borrowing will be followed by a decline in spending as debts must be paid off.

Hence, we have a simple, short-term cycle in which money is borrowed and spending increases, then debts kick in and spending decreases. When spending decreases, so do incomes, and thus so does credit-worthiness and the rate of borrowing. The central bank sees this and decides to stimulate loaning by making the cost of money lower, i.e., lowering their interest rates. Banks start lending more and people start borrowing, so the economy expands and growth continues.

The key to Dalio’s model, however, lies in a larger underlying cycle. This cycle is caused by the growth of debts relative to income over a long period of time. Despite the ups and downs of the short-term cycle, debt continues to pile up over time; it’s human nature for a man to want more than he can afford. Luckily, most of the time over-spending is justified; improvements in efficiency and technology produce an ever-rising productivity. Yet after many cycles of justified over-spending, debt will outpace rising productivity. At this point, there is a bubble.

All bubbles will inevitably pop through a process known as deleveraging. This deleveraging begins with a recession; debt is high, borrowing is low, and so interest is cut. But zero percent interest is not enough for the economy to recover. People simply do not want the free credit. Deflation follows naturally and the economy slows with rising unemployment. Credit disappears with debts being restructured or defaulting and borrowing no longer taking place.

The only way to keep the economy from shrinking despite disappearing credit is to print cash. The two should balance to avoid inflation. At the same time, there will be much social unrest. There will need to be cuts to spending as debts are fought down and wealth redistribution will be needed to keep the populace happy.

If all of these measures are taken, the deleveraging should go smoothly. Revolution will be avoided and debts will be cut down. After the economy suffers its “lost decade,” the economy will be ready to grow. Productivity will ramp up and borrowing will grow. Credit will be created and fortunes will be made.

 
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