How the economy works

How the economy works

It's time for another episode of Get Rich Slowly Theater, boys and girls! This week, we're going to enjoy a thirty-minute YouTube video exploring how the economy works. Think of it as Economics 101, but instead of a semester spent sitting in a classroom, you get all of the info in the time it would take you to watch an episode of Big Bang Theory.

Here's the video:

This animated presentation, written and narrated by billionaire investor Ray Dalio, breaks down economic concepts like credit, deficits and interest rates, allowing viewers to learn the basic driving forces behind the economy, how economic policies work, and why economic cycles occur.

Basically, Dalio says, economic cycles are a combintation of productivity growth, short-term debt cycles, and the long-term debt cycle. It sounds boring, but it's not.

Components of the Economic Cycle

This is the model Dalio uses to view the world and make big bucks. He thinks it can be helpful to other people.

If, like me, you're not a huge fan of watching videos, I've paraphrased Dalio's presentation below.

Transactions

“The economy works like a simple machine,” Dalio begins. “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 three main forces that drive the economy.”

Transactions are the building blocks of the economic machine. A transaction is any exchange of money for goods or services. (Money includes both cash and credit.) “All forces in an economy are driven by transactions,” says Dalio. “If we can understand transactions, we can understand the whole economy.”

Markets consist of all buyers and sellers making transactions for the same thing. The stock market is made up of all buyers and sellers of stocks. The wheat market is made up of all buyers and sellers of wheat. The fruit market is made up of all buyers and sellers of fruit. And so on.

When you combine all of the transactions in all of the markets, you get an economy. So, the U.S. economy is made up of all of the transactions in all of the markets in the United States.

Simple so far, right?

The biggest buyer and seller in the economy is the government, which is made up of two parts: the central government (which collects taxes and spends money) and the central bank (which controls the amount of money and credit in the economy by setting interest rates and printing new money).

The Most Important Part of the Economy

Dalio says that credit is the most important part of the economy because it's the largest and most volatile component. “Credit can help both lenders and borrowers get what they want,” he says. “Why is credit so important? Because when a borrower receives credit, he is able to increase his spending. And remember, spending drives the economy.”

He explains: “This is because one person's spending is another person's income.

Dalio makes the point that one person's spending is another person's income. When you spend a dollar, that dollar becomes income for somebody else. And every dollar you earn was spent by somebody else. The economy is made up of an endless interconnected loop of transactions in which one person spends money that becomes income for somebody else.

Cycles

So, transactions are the atomic particles of elemental economics. In each transaction, the buyer gives money to the seller based on how much she values what the seller has produced. “How much you get depends on how much you produce,” Dalio says. “Those who are inventive and hardworking raise their productivity and their living standards faster.” Productivity matters most over the long run — but credit matters most in the short run.

Productivity growth tends to be linear. As we age, we become more productive. And as the economy as a whole ages, it becomes more productive too. It's the use of credit that leads to economic cycles. Debt allows us to consume more than we produce when we acquire it, but forces us to consume less than we produce when we pay it back. When we use credit, we're borrowing from our future selves.

The Credit Cycle

And here Dalio makes an interesting point. He says that in our economy, debt swings occur in two main cycles. The shorter cycle takes about five to eight years (which echoes William Cowie's metaphor of the four seasons of the U.S. economy), and the longer cycle takes about 75 to 100 years.

These cycles aren't due to laws or regulation. They're due to human nature. They occur because we as individuals (or as a larger economy) use credit.

“Credit isn't necessarily bad,” Dalio points out. “It's bad when it finances over-consumption that can't be paid back. However, it's good when it efficiently allocates resources and produces income so you can pay back the debt.” Dalio uses the example of a farmer who buys a tractor in order to become more productive. In this case, credit is good. But if you borrow money to, say, buy a new television, that television does nothing to help you become more productive. In this case, credit is bad.

The bottom line: Borrowing creates cycles.

The Short-Term Debt Cycle

As economic activity increases — as people and businesses borrow and lend money to each other — there's economic growth, an expansion. This is the first phase of the short-term debt cycle. As spending increases, so do prices. When spending and income grow faster than the production of goods, prices rise. This is called inflation.

We often think of inflation as bad, but it's actually a reflection of increased productivity and easier access to money. Still, too much inflation is a problem. So, when inflation gets too high, the central bank steps in and raises interest rates, which makes it more costly to borrow money. This causes spending to slow. And because one person's spending is another person's income, this decreased spending leads to lower incomes. And so on. When people spend less, prices go down. This is called deflation.

As economic activity slows, we have a recession. If the recession becomes too severe, the central bank will lower interest rates to increase borrowing and stimulate economic activity. This leads to another expansion.

“When credit is easily available, there's an economic expansion,” explains Dalio. “When credit isn't easily available, there's a recession.” This short-term debt cycle, which is controlled primarily by the central bank, typically lasts between five and eight years. (For those who are counting, the current expansion has lasted nearly nine years. I'm one of those who fully expects a recession sometime soon. I think we can already see the economy sputtering a little.) This happens over and over again for decades.

The Long-Term Debt Cycle

Throughout this process of short-term ups and downs, the economy is actually growing. The bottom of each cycle is higher than the one before. Over the long-term, borrowing and debt are increasing, which fuels a gradual overall expansion of the economy. But as debts are growing, incomes grow nearly as fast to offset them. “So long as incomes continue to rise,” says Dalio, “the debt burden stays manageable.”

As the economy grows, asset values soar. Home prices skyrocket, which leads to people borrowing huge amounts of money. But it's not just homes. Other assets gain value too, which leads people to borrow money to purchase them, which causes their prices to rise even higher. “People feel wealthy.”

“But this obviously cannot continue forever,” notes Dalio. “And it doesn't.”

Over decades, debt burdens increase until they reach a point where they exceed the ability of incomes to keep up. This causes people to spend less. And since one person's spending is another person's income, this causes incomes to drop, which makes people less able to borrow money. Meanwhile, debt repayments continue to increase, which makes spending drop even further. This causes the economy to shrink: prices fall, the stock market crashes, and social tensions rise.

U.S. Debt Burden over Time

As individuals (and companies) feel squeezed by the shrinking economy, they rush to sell assets. But this is happening at the same time that spending falls and the stock market crashes. People feel poor. They spend less and credit disappears. Banks can't lower interest rates to stimulate borrowing because interest rates are already zero. They can't go any lower.

How do you get out of this vicious cycle? Dalio says people and governments can do four things:

  • Spend less.
  • Reduce debt — including default.
  • Redistribute wealth (through taxes and social programs).
  • Print money. The central bank can do this literally, but individuals have to become more productive.

“These four ways have happened in every deleveraging in modern history,” Dalio says.

You might expect decreased spending to help decrease the debt burden, but that's not what actually happens. Because on person's spending is another person's income, incomes fall. They tend to fall faster than debts are repaid. As we've seen, this leads to deflation and unemployment. This severe economic contraction is called a depression.

“A big part of a depression is people discovering much of what they thought was their wealth isn't really there,” explains Dalio.

During a depression, governments spend more to stimulate the economy. Individuals can't, so the central government steps in. But this causes the government to spend more than it's receiving through taxes. The budget deficit explodes. In order to get money, the government turns to those who have it: the rich. At this stage, taxes on the rich are generally increased in order to redistribute wealth to those who need it. Naturally, this leads to tension between economic classes. The rich resent the poor, and the poor resent the rich. If the depression lasts long enough, these tensions can become explosive.

To save the day, the central bank is forced to print money. But whereas deflation comes when you reduce spending and debt and you redistribute wealth, the printing of money is inflationary and stimulative.

The bottom of a depression is a very risky time. There's a lot of disorder and chaos. Governments and need to balance both inflationary and deflationary policies in order to create what Dalio calls “a beautiful deleveraging”.

A Beautiful Deleveraging

“In a beautiful deleveraging,” says Dalio, “debts decline relative to income, real economic growth is positive, and inflation isn't a problem. It's achieved by having the right balance. The right balance requires a certain mix of cutting spending, reducing debt, transferring wealth, and printing money so that economic and social stability can be maintained.”

People often worry that printing money will increase inflation, and it certainly can. But Dalio argues that printing money is fine if it offsets falling credit. Ultimately, it's spending that causes inflation. So, printing money won't lead to increased prices if there's less credit used in the economy. “A dollar of spending paid for with money has the same effect on price as a dollar of spending paid for with credit.”

In order to escape a depression, you need to print enough money to get the rate of income growth above the rate of interest paid on existing debt. The problem is that it's easy to abuse the money-printing process. “The key is to avoid printing too much money and causing unacceptably high inflation,” says Dalio. This is what happened in Germany during the 1920s.

If things are handled well and balance is achieved, deleveraging isn't dramatic. Slow growth returns and debt burdens go down. This is what Dalio means by a beautiful deleveraging. All of this leads back to the start of the long-term debt cycle. But it can take up to a decade for the economy to recover from a depression.

The Components Combined

Dalio admits that the economy is more complicated than his thirty-minute presentation allows, but he believes this model gives a reasonably good template for seeing where we've been — and where we're going.

I'll confess right now that I'm no expert on the economy. And I realize there are many different theories as to what creates (and hinders) healthy economic growth. Still, based on what I do know, Dalio's presentation makes sense. After watching it, I feel like I have a better understanding of how our economy works.

More about...Economics

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Joe
Joe
2 years ago

At the first glance, I thought 30 minutes! That’s a long time. However, the video is really good. I couldn’t stop watching. This is a great primer. I’ll have to save this for my kid. Good find.

Diana
Diana
2 years ago

Thanks for summarizing it, I hate watching videos but learned a lot from the blog.

Some Old Guy
Some Old Guy
2 years ago

The thing that people should bear in mind is that debt doesn’t just appear by magic. The money that the debtors borrowed comes from other people. Right now there is a lot of talk about how we should just forgive the huge college debts of the young today. While I agree that this would be a great boost for them (and I do sympathize that it is rediculous how much debt many young adults have ended up with) it would only happen if either the people they ultimately borrowed from take a huge loss of their savings, or the government… Read more »

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