How the Economic Machine Works, by Ray Dalio

How the economic machine works. In 30 minutes, the economy works like a simple machine. However, many people don't understand it or don't agree on how it works, and that has led to a lot of unnecessary economic suffering. I feel a deep obligation to share my simple but practical economic template. Although it's not conventional, it helped me predict and avoid the global financial crisis, and it has served me well for over 30 years. Let's begin. Although the economy may seem complex, it works in a simple, mechanical way. It consists of a few simple parts and many simple transactions that repeat over and over again countless times. These transactions are driven above all by human nature and create three main forces that move the economy: one, productivity growth; two, the short-term debt cycle; and three, the long-term debt cycle. We'll look at these three forces and how, by superimposing them on one another, we create a good template for tracking economic movements and understanding what is happening. Let's start with the simplest part of the economy: transactions. An economy is simply the sum of the transactions that make it up, and a transaction is something very simple. All the time we make transactions. Every time we buy something, we create a transaction. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets. Credit is spent just like money, so adding the money spent to the credit spent gives us total spending. Total spending drives the economy. If we divide the total amount spent by the quantity sold, we get the price. And that's it. That's a transaction. It is the building block of the economic machine. All cycles and forces in an economy are driven by transactions. So if we understand transactions, we understand the entire 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, and markets for millions of things. An economy consists of all the transactions in all its markets. If we add up total spending and the total quantity sold in all markets, we have everything we need to know to understand the economy. It's that simple. People, companies, banks, and governments all engage in transactions as I described earlier: they exchange money and credit for goods, services, and financial assets. The biggest buyer and seller is the government, which consists of two important parts: a central government that collects taxes and spends money, and a 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. For these reasons, as we will see, the central bank is an important player in the flow of credit. Now let's pay attention to credit. Credit is the most important part of the economy, and probably the least understood. It is the most important part because it is the largest and most volatile. Just as buyers and sellers go to the market to make transactions, so do lenders and borrowers. Lenders usually want to turn their money into more money, and borrowers usually want to buy something they can't afford, like a house or a car, or invest in something like starting a business. Credit can help both lenders and borrowers get what they want. Borrowers promise to repay the amount borrowed, called the principal, plus an additional amount called interest. When interest rates are high, fewer loans are taken because they are expensive. When interest rates are low, more loans are taken because they are cheaper. When borrowers promise to repay and lenders believe them, credit is created. Any two people can agree to create credit out of thin air. This seems simple enough, but credit is tricky because it has different names. Once credit is created, it immediately becomes debt. Debt is an asset for the lender and a liability for the borrower. In the future, when the borrower repays the loan with interest, the asset and liability disappear, and the transaction is settled. So why is credit so important? Because when a borrower gets credit, they can increase their spending. And remember, spending drives the economy. This is because one person's spending is another person's income. Think about it: every dollar we spend, someone else earns, and every dollar we earn was spent by someone else. So when we spend more, someone else earns more. When someone's income rises, lenders are more willing to lend to them because they are now more creditworthy. A creditworthy borrower has two things: the ability to repay and collateral. Having high income relative to debt allows them to repay. In case they can't, they have valuable assets as collateral that can be sold. This makes lenders comfortable lending money. So higher income allows more borrowing, which in turn allows more spending, and since one person's spending is another person's income, this leads to more borrowing, and so on. This self-reinforcing behavior leads to economic growth, and that's why we have cycles. In a transaction, you have to give something to get something, and how much you get depends on how much you produce. Over time, we learn, and that accumulated knowledge raises living standards. We call this productivity growth. Those who are creative and work hard increase their productivity and living standards faster than those who are complacent and lazy. Although not necessarily in the short term, productivity matters most in the long run. Credit matters in the short run. This is because productivity growth doesn't fluctuate much, so it's not a major driver of economic swings. Debt is, because when we take on debt, it allows us to consume more than we produce, and it forces us to consume less than we produce when we pay it back. Debt swings follow two big cycles: one of about 5 to 8 years, and the other of about 75 to 100 years. Although most people feel the ups and downs, they usually don't see them as cycles because they see them too close up, day to day, week to week. In this chapter, we'll step back to see these three big forces and how they interact to create our experiences. We saw that the swings around the line don't come from how much innovation or hard work there is, but mostly from how much credit there is. Imagine for a moment an economy without credit. In this economy, I can only increase my spending if I increase my income, which requires me to be more productive and work harder. Higher productivity is the only way to growth. Since my spending is another person's income, the economy grows every time I or anyone else becomes more productive. If we follow the transactions and chart them, we see a progression like the productivity growth line. But because we take out loans, we have cycles. This doesn't come from any law or regulation, but from human nature and how credit works. Think of it as stretching spending forward to buy something we can't afford. To do that, we have to spend more than we earn. To do that, we have to borrow from our future. So we create a time in the future when we will have to spend less than we earn in order to pay it back. Very quickly, it resembles a cycle. In essence, every loan we take creates a cycle. This is as true for an individual as it is for the economy. That's why it's so important to understand credit, because it sets in motion a series of future events that are mechanical and predictable. This differentiates credit from money. Money is what we use to settle transactions. When we buy a beer with cash, the transaction is settled immediately. But if we buy it on credit, it's like opening a tab at the bar. We promise to pay in the future, and together with the bartender, we create an asset and a liability. We just created credit out of thin air. Only later, when we pay the tab, do the asset and liability disappear, the debt vanishes, and the transaction is settled. In reality, what most 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 in circulation is only about $3 trillion. Remember, in an economy without credit, the only way to spend more is to produce more. But in an economy with credit, we can also spend more by borrowing. As a result, in an economy with credit, spending is higher, allowing incomes to rise faster than productivity in the short run, but not in the long run. Now, don't get me wrong. Credit isn't necessarily something bad that only causes cycles. It's bad when it finances excessive consumption that can't be repaid. However, it's good when it allocates resources efficiently and produces income that allows us to repay the debt. For example, if we take out a loan to buy a big TV, the TV doesn't generate income to pay back the loan. But if we take out a loan to buy a tractor and harvest more crops and earn more money, we can repay the loan and improve our standard of living. In an economy with credit, we can follow the transactions and see how credit generates growth. Let's look at an example. Imagine we earn $100,000 a year and have no debt. Then if we are lent $10,000, say on a credit card, we could spend $110,000 even though we only earn $100,000. Since my spending is another person's income, someone is earning $110,000. That person, with no debt, can borrow $10,000 and spend $121,000, even though they only earned $110,000. Their spending is another person's income, and by following the transactions, we can begin to see how this process follows a self-reinforcing pattern. But remember, borrowing creates cycles, and if the cycle goes up, at some point it must come down. This brings us to the short-term debt cycle. When economic activity increases, we see an expansion, the first phase of the short-term debt cycle. Spending continues to grow, and prices begin to rise. This happens because increased spending is fueled by credit, which can be created instantly out of thin air. When spending and income grow faster than the production of goods, prices rise. Rising prices are called inflation. The central bank doesn't want too much inflation because it causes problems. Seeing prices rise, the bank raises interest rates. With higher interest rates, fewer people can afford to borrow, and the cost of existing debt rises. For example, monthly credit card payments go up. Because people borrow less and have to pay more on their debt, they have less money to spend, and spending slows. And since one person's spending is another person's income, incomes fall, and so on. When people spend less, prices fall. That's called deflation. Economic activity decreases, and we have a recession. If the recession becomes too severe and inflation is no longer a problem, the central bank will lower interest rates to get things going again. With low interest rates, debt repayments are reduced, more borrowing and spending occur, and we see another expansion. As you can see, the economy works like a machine. In the short-term debt cycle, spending is constrained only by the willingness of lenders and borrowers to give and receive credit. When credit is easily available, there is an economic expansion. When it's not, there is a recession. And note, this cycle is controlled primarily by the central bank. The short-term debt cycle typically lasts 5 to 8 years and repeats over and over for decades. But you'll notice that the bottom and top of each cycle end with higher growth than the previous cycle, and with more debt. Why? Because people push it. People are more inclined to borrow and spend than to pay back debt. It's human nature. That's why, over the long run, debts grow faster than incomes, creating the long-term debt cycle. Although people are more indebted, lenders are more willing to lend. Why? Because everyone thinks things are going well. People only think about recent events. And what happened recently? Incomes rose, asset values rose, the stock market boomed. It's a boom. It pays to buy goods, services, and financial assets with borrowed money. When people do a lot of that, we call it a bubble. So even though debts have been growing, incomes have grown almost as fast to offset them. The ratio of debt to income, I'll call it the debt burden, remains manageable as long as incomes keep rising. At the same time, asset values soar. People borrow huge amounts to buy assets as investments, driving their prices even higher. People feel rich, so even with a lot of accumulated debt, rising incomes and assets help borrowers remain creditworthy for a long time. Obviously, this can't continue forever. And it doesn't. Over decades, the debt burden slowly increases, creating larger and larger debt repayments. When these repayments begin to grow faster than incomes, people are forced to cut their spending. And since one person's spending is another person's income, incomes begin to fall, which makes people less creditworthy and reduces borrowing. Debt repayments continue to rise, causing spending to fall even further, and the cycle reverses. This is the long-term debt peak. Debt burdens have become too large. In the United States, Europe, and much of the world, this happened in 2008. It happened for the same reason as in Japan in 1989 and in the United States in 1929. The economy now begins to deleverage. In this phase, people reduce spending, incomes fall, credit disappears, assets fall, banks suffer, stock markets crash, social tensions rise, and everything begins to feed back in the opposite direction. As incomes fall and debt payments rise, borrowers become constrained and no longer creditworthy. Their credit dries up, and they can't borrow enough to pay their debts. Desperate, borrowers are forced to sell assets. The fire sale floods the market. This is where the stock market collapses, the real estate market crashes, and banks get into trouble. When asset prices fall, the value of borrowers' collateral falls, making them even less creditworthy. People feel poor. Credit disappears rapidly. Less spending, less income, less wealth, less credit, less borrowing, and so on. It's a vicious cycle. It resembles a recession, but the difference here is that interest rates can't be lowered to save the situation. In a recession, lowering rates stimulates borrowing. But in a deleveraging, lowering rates doesn't work because interest rates are already low and soon hit 0%. So the stimulus is gone. Interest rates in the United States hit 0% during the deleveraging of the 1930s and again in 2008. The difference between a recession and a deleveraging is that in a deleveraging, the debt burden on borrowers has grown too large and cannot be relieved by lowering interest rates. Lenders realize that such excessive debts cannot be fully repaid. Borrowers have lost their ability to repay, and their collateral has lost value. They feel paralyzed by debt and don't want more. Lenders stop lending. Borrowers stop borrowing. Think of the economy as being uncreditworthy, like a person. So what to do about a deleveraging? The problem is that debt burdens are too high and must come down. There are four ways this can happen: one, people, companies, and governments cut their spending; two, debts are reduced through defaults and restructurings; three, wealth is redistributed from the haves to the have-nots; and four, the central bank prints new money. These four ways have occurred in every deleveraging in modern history. Typically, spending cuts come first. As we saw, people, companies, banks, and even governments tighten their belts and cut spending to pay down their debts. This is often called austerity. When borrowers stop taking on new debt and start paying down old debt, you might expect the debt burden to fall. But the opposite happens. Because spending is cut, and one person's spending is another person's income, incomes fall faster than debts are paid down, and the debt burden actually gets worse. As we saw, this cutting of spending is deflationary and painful. Companies are forced to cut costs, which means fewer jobs and higher unemployment. This leads to the next step: debts must be reduced. Many can't pay their loans, and a borrower's debt is a lender's asset. When borrowers don't pay the bank, people fear the bank can't pay them, and they rush to withdraw their money. Banks become constrained, and people, companies, and banks default on their debts. This severe economic contraction is a depression. Much of a depression consists of discovering that what we thought was our wealth isn't there. Let's go back to the bar. When we bought a beer on credit, we promised to pay the bar owner. Our promise became an asset for the bartender. If we don't keep the promise, we don't pay, and we default on our bar tab. Then that asset he had is actually worth nothing. It has essentially disappeared. Many lenders don't want to see their assets disappear, so they agree to restructure the debt. This means lenders will receive less repayment, or be paid over a longer period, or at a lower interest rate than originally agreed. In this way, a contract is broken, but even though debt is reduced, lenders prefer a little something to total nothing. Even though debt disappears, its restructuring causes income and asset values to disappear faster, so the debt burden continues to worsen. Like cutting spending, reducing debt is also painful and deflationary. All of this affects the central government because lower incomes and less employment mean the government collects less taxes. At the same time, it needs to increase spending due to rising unemployment. Many of the unemployed have inadequate savings and need financial support from the government. Additionally, governments create stimulus plans and increase spending to offset the economic downturn. Government budget deficits explode during a deleveraging because they spend more than they collect in taxes. That's what's happening when we hear about the deficit in the news. To finance deficits, governments must raise taxes or borrow money. But with falling incomes and so many unemployed, where will the money come from? From the rich. Since governments need more money and wealth is highly concentrated in the hands of a small percentage of people, it's natural for governments to tax the wealthy more, which facilitates a redistribution of wealth in the economy from the haves to the have-nots. The have-nots begin to feel resentment toward the haves. The haves, suffering from a weak economy, falling asset prices, and rising taxes, begin to feel resentment toward the have-nots. If the depression continues, social order can break down. Not only will internal tensions rise within countries, but also between countries, especially between debtors and creditors. This situation can lead to political change, which can sometimes be extreme. In the 1930s, this led to Hitler coming to power, war in Europe, and the Great Depression in the United States. The pressure to do something to end the depression increases. Remember, what most people thought was money was actually credit. So when credit disappears, people don't have enough money. People are desperate for money. Remember who can print it? The central bank. Having lowered its interest rates to nearly zero, it is forced to print money. Unlike cutting spending, reducing debt, and redistributing wealth, printing money is inflationary and stimulative. Inevitably, the central bank prints new money out of thin air, which it uses to buy financial assets and government bonds. This happened in the United States during the Great Depression and again in 2008, when its central bank, the Federal Reserve, printed over $2 trillion. Other central banks around the world that could also printed a lot of money. Buying financial assets with this money helps raise asset prices, making people more creditworthy. But this only helps those who have financial assets. The central bank can print money, but it can only buy financial assets. The central government, on the other hand, can buy goods and services and pass money to people, but it can't print money. So 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 insurance. This increases people's incomes as well as the government's debt. However, it will reduce the total debt burden in the economy. This is a moment of great risk. Policymakers must balance the four ways of reducing the debt burden. The deflationary ways must be balanced with the inflationary ways to maintain stability. If balanced correctly, a beautiful deleveraging can occur. A deleveraging can be ugly or beautiful. How can it be beautiful? Although a deleveraging is a difficult situation, handling a difficult situation optimally is something beautiful, much more beautiful than the unbalanced, debt-fueled excesses of the leveraging phase. In a beautiful deleveraging, debts decline relative to incomes, real economic growth is positive, and inflation is not a problem. This is achieved with the right balance. The right balance requires a certain mix of spending cuts, debt reduction, wealth transfers, and money printing to maintain economic and social stability. People ask if printing money will cause inflation. No, if it offsets the falling credit. Remember, spending is what matters. A dollar of spending paid with money affects prices the same as a dollar of spending paid with credit. By printing money, the central bank can offset the disappearance of credit with an increase in the amount of money to change this situation. The central bank needs not only to encourage income growth, but to achieve a rate of income growth that exceeds the interest rate on accumulated debt. What do I mean by that? Essentially, incomes must grow faster than debts. For example, suppose a country in deleveraging has a debt-to-income ratio of 100%. This means its total debt equals the country's entire income for one year. Now think about the interest rate on that debt, say 2%. If the debt grows at 2% due to that interest rate, and income grows only at 1%, the debt burden will never be reduced. You need to print enough money so that the income growth rate exceeds the interest rate. However, it's easy to abuse money printing because it's so easy and because people prefer it to the alternatives. The key is to avoid printing too much money and causing unacceptable inflation. In the 1920s, if policymakers achieve the right balance, a deleveraging is not so dramatic. Growth is slow, but debt burdens come down. That's a beautiful deleveraging. With rising incomes, borrowers begin to look more creditworthy, and when that happens, lenders start lending again. Debt burdens finally begin to come down. Being able to borrow, people can spend more, and the economy begins to grow again, moving into the reflation phase of the long-term debt cycle. Although a deleveraging can be horrible if mismanaged, when handled properly, it will solve the problem. It takes about 10 years or more for debt burdens to come down and economic activity to return to normal, hence the expression 'lost decade.' In conclusion, of course, the economy is a bit more complex than this template suggests. But by superimposing the short-term debt cycle on the long-term debt cycle, and both on top of the productivity growth line, we get a reasonable model for seeing where we've been, where we are, and where we are likely to go. In summary, there are three rules of thumb I'd like you to take away from this talk. First, don't let debt grow faster than income, because debt burdens will eventually crush you. Second, don't let income grow faster than productivity, because you will eventually become uncompetitive. Third, do all you can to raise your productivity, because in the long run, that's what matters most. These are simple advice for everyone, including policymakers. Surprisingly, most people and also most policymakers don't pay enough attention to this. This template has worked for me, and I hope it works for you. Thank you very much.