Markets and Money - Pt 2
Part 2 of Ray Dalio's "How The Economic Machine Works"
In this series I directly quote Dalio’s words, adding bits of my own here and there. I will summarize the entire series once I’ve laid out each section in full.
Last Monday we started going through Ray Dalio’s How The Economic Machine Works. Today, we are continuing on that path.
Last time we discussed some of the key players and key concepts, ending with an explanation of credit. Today begins with an explanation of cycles.
In a transaction, you have to give something in order to get something, and how much you get depends on how much you produce. Over time, we learn, and that accumulated knowledge raises our living standards.
We call this productivity growth.
Put simply, those who are inventive and hard-working raise their productivity and their living standards faster than those who are complacent and lazy.
But that isn’t necessarily true over the short run. Productivity matters most in the long run, but credit matters most in the short run.
Remember, the 3 main forces that drive the economy are productivity, short term debt, and long term debt. We see here that Dalio is getting into the first two.
Productivity growth doesn’t fluctuate much, so it’s not a big driver of economic swings. Instead, debt is, 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.
Keep in mind, that Debt occurs in two big cycles.
One takes about 5 to 8 years. (Short-term debt cycle)
One takes about 75 to 100 years. (Long-term debt cycle)
We see the same picture as before, but this one has short term debt cycles added.
While most people feel the swings, they don’t typically see them as cycles. They seem them too up-close - day by day, week by week.
How These 3 Forces Interact
The swings around the productivity line are not due to how much innovation 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.
The economy grows every time I, or anyone else, is more productive.
But because we borrow (going back to our economy) we have cycles. This isn’t due to any laws or regulations, it’s due to human nature and the way that credit works.
Think of borrowing as 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 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.
Basically… Anytime you borrow, you create a cycle. This is as true for an individual as it is for the economy. This is why understanding credit is so important because it sets into motion a mechanical and predictable series of events that will happen in the future.
This makes credit different from money.
Money is what you settle a transaction with. If you buy a beer from a bartender with cash, the transaction is settled immediately. But when you buy a beer with credit, it’s like starting a bar tab.
Together, you and the bartender create an asset and liability.
You just created credit out of thin air. It’s not until you pay the bar tab later that the asset and liability disappear, the debt goes away, and the transaction is settled.
The reality is, 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 is only about $3 trillion. (These numbers have surely changed since this video was first released.)
Remember, in an economy without credit, the only way to increase your spending is to produce more. Bit in an economy with credit you can also increase your spending by borrowing. 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.
Credit isn’t necessarily something bad that just causes cycles. 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 yu can pay back the debt.
Example: Borrowing to buy a big TV = bad. Borrow money to buy a tractor (to harvest more crops) = good.
In an economy with credit, we can follow the transactions and see how credit creates growth. Let me give you an example.
Suppose you earn $100k a year and have no debt. You’re creditworthy enough to borrow $10k, allowing you to spend $110k, even though you only earn $100k.
Since your spending is another person’s income, someone is earning $110k. The person earning $110k, with no debt, can borrow $11,000. This allows spending of $121k.
His spending is another person’s income, and by following the transaction, we can begin to see how this process works in a self-reinforcing pattern.
But remember, borrowing creates cycles, and if the cycle goes up, it eventually needs to come down.
This leads us into, the Short Term Debt Cycle, which we’ll get into next Monday.