The Economic Machine (summary of Ray Dalio's video)

Been a fan of Ray Dalio since his TED talk. Took a couple months, but finally finished watching his How the Economic Machine Works YouTube video:

Sure, it's only about 30 min long, but I think it's chock-full of helpful info. While the ideas described are deceptively simple -- largely due to copious illustrations and animations -- I think they really capture the essence of an economy. Definitely didn't learn this in Econ 101. Anyway, sharing my notes in hopes that someone else finds it useful:

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Economy

Like machine, made up of few parts and transactions repeated numerous times. Transactions are driven by human nature.

3 main forces that drive economy: productivity growth, short-term debt cycle, long-term debt cycle.

Economy is sum of transactions. Each transaction consists of buyer exchanging money or credit with seller for goods, services, or financial assets. Money + credit is total spending. Total spending / total quantity sold = price. Understand transaction, understand economy.

Market consists of all buyers and sellers making transactions for same thing. Economy is consisted of all markets.

Credit

Most important part of economy. Biggest and most volatile. Lenders (want to grow their money) and borrowers (buy things they can't afford, like houses, cars, businesses) engage in transactions. Credit is created when lender believes borrower's promise to pay principal + interest in future. Number of borrowers proportional to interest rate. When credit is created, it becomes debt: asset to lender, liability to borrower.

Borrower, with credit, increases spending and drives economy. One person's spending is another's income. When one's income rises, lenders more willing to lend them money. Creditworthy borrower has ability to repay and has collateral. Cycle:

Inventive and hard-working people raise productivity faster, get more income. Not always true in short run. Productivity growth (matters in long run) doesn't fluctuate much, not big driver of economic swing like debt (matters in short run). Debt, when acquired, allows more spending than we produce, forces less spending when we pay back.

Debt swing occurs in 2 cycles: 5-8 years, 75-100 years. Can't observe if too close.

In economy without credit, increasing productivity only way to increase spending (growth). With credit, can borrow. Credit creates cycle, borrowing from future self. Credit sets in motion mechanical and predictable series of events.

Money settles transaction. Credit delays settlement. 50 trillion dollars credit in US, 3 trillion money.

Credit is bad when financing transaction that can't be paid back. Good when efficiently allocating resources to produce income to pay back debt.

Short-Term Debt Cycle

First phase: expansion. As economic activity increases (people borrow and spend more), so does price (spending/quantity=price, and quantity not increasing). Inflation. Central bank raises interest rate. Credit more expensive, less borrowing.

Second phase: recession. Less spending, price decreases. Deflation. Central bank lowers interest rate.

Typically 5-8 years, primarily controlled by central bank. Each cycle has higher top and bottom growth than previous. Human nature to borrow and spend more instead of paying debt.

Long-Term Debt Cycle

Over time, debt rises faster than income. People generally optimistic and short-sighted, only see things go well. Lenders lend more money. Income and asset/stock value rise, so borrow more money, and bubble.

Ratio of debt to income: debt burden. So long as income keeps up with debt, burden manageable. Can't last forever. When debt too large, need to cut spending, which cuts income of another, and trend reverses (at long-term debt peak).

Happened in 1929 and 2008 in US. Economy in deleveraging. Less spending, less income, less wealth, less credit, less borrowing, vicious cycle. Not same as recession, interest rate already at 0 and debt burden too big.

4 ways to help:

1. Cut spending. Austerity. Causes income to fall.
2. Reduce debt through default and restructuring. Banks (lenders) can't get debt paid, get squeezed by clients withdrawing money. Depression. Bank's asset value lower than previously believed. To avoid asset completely disappear, restructure debt (pay back less, over longer time, or at lower interest rate). Causes income and asset value to lower faster.
3. Redistribute wealth. Lower income, less tax for govt, but needs to spend more to keep economy going, deficit. Tax rich more. Haves and have-nots resent each other. Social disorder if depression lasts long. Can be across countries.
4. Print money. Only method stimulative and inflationary (all 3 above are deflationary). Central bank prints money but can only buy financial assets. Central govt can't print money but can buy goods and services. To work together, central bank buys govt bonds, essentially lending money to govt. Print money to cover for disappearing credit.

Risky. Policy makers need to balance deflationary and inflationary measures to achieve beautiful deleveraging. Need income growth higher than interest rate (debt growth).

As debt burden rebalances, enter reflation. Deflation typically 2-3 years, reflation 7-10 (other 50+ is leveraging). Reflation sometimes called lost decade.

Conclusion

Simple model of laying short-term debt cycle over long-term debt cycle, then over productivity growth.

3 rules of thumb:

1. Don't have debt rise faster than income. Debt burden will crush.
2. Don't have income rise faster than productivity. Will become uncompetitive.
3. Do all I can to raise productivity. Matters most in long run.

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In case you're interested in his TED talk:

Looking forward to reading his latest book, Principles (will share my thoughts when I'm finished):