Summary of “How the Economic Machine works by Ray Dalio”

Here is the link to the video https://youtu.be/PHe0bXAIuk0

Economy looks complex but it works in simple, mechanical way. It is made up of simple transactions which are repeated over and over again. Transactions are done by everyone. It can be done in two ways either by paying cash or on credit. By adding both of these we get total spending. It can be said that transaction is the building block of economic machine. Economy consist different markets and every market has buyers and sellers that are doing transactions. Every bank, institution, individuals etc. are transacting in the same way i.e. either by paying cash or on credit. Government is the biggest buyer and seller in an economy. Now, government can be divided among two institutions – Central government and central bank. Government is collecting taxes and spending while central bank is managing the money in an economy. Central bank manages money by interest rates and by printing new money. Credit is the most important part of an economy. It can help both lenders and borrowers to fulfil their needs. Borrowers borrow money with a promise to repay the principal with interest. When interest rates are high, borrowing is lesser in economy because it is expensive (higher interest need to be paid) and when interest rates are low, borrowings are high because it is cheap (lower interest need to be paid).

Why is credit important?

Credit is important because when people borrow money they spend and this spending is income for a third person. This third person will further spend it and it will become income for another person and this is how this cycle works. A person having good income has good credit worthiness i.e. banks are ready to lend him as he has ability to repay or put some of his assets as collateral. This is how cycles are created in economy. The more a person earns the more he raises his living standards. This is productivity growth. Productivity matters most in long run because it doesn’t fluctuate much. Debt is a driver of economy because it allows us to consume more when we borrow and we pay it back we spend less.

Let’s assume two case where in one economy doesn’t have credit and other has. In the economy with no credit, the only way through which spending can be increased is by increasing our income which require us to produce more. But in the economy where credit is available there will be cycles. This cycle is because of the nature of credit. Every time a person takes credit he spends more in that time but in future when he will have to repay it he will spend less. Credit is different from money because in money the transaction is settled immediately but in credit transaction is settled in future. Credit can be both good as well as bad depending on its usage. Example – If the credit is used to buy a T.V. it will not generate any return but if it used to buy a tractor, it will help in farming through which you can earn money. Credit leads to short term debt cycle. This is how it works – one person earns, say for example, $100,000 with no debt. He can borrow $10,000. So he can spend a total of $110,000. This $110,000 becomes another person’s income with no debt. He will be able to borrow $11,000. His spending will rise to $121,000 which will later become another person’s income and the cycle goes up. But as the cycle goes up it will need to come down. Over the time as the people will spend more, expansion will be there. As the spending is increased the prices rise too, which we refer as Inflation. In this scenario the central bank increases interest rates. This will lead to fewer borrowings and also cost of existing borrowings will rise. As the borrowing will be lesser and debt payments will be higher, this will lead to lower spending and eventually lower incomes. This again will lead to drop in price and overall economy will face recession. In this scenario, when inflation is not a problem, central bank will decrease the interest rates so that economy pick up again. Overall, when the credit is available easily there is a credit expansion and when credit is not available easily there is a recession. This cycle is managed by central bank (generally by changing interest rates). Now comes in long term debt cycle. At the end of short term debt cycle, growth and debt rises. This is because people spend more rather than paying debt. Even if people have rising debts, lenders lend freely because things are going great. Incomes are rising, spending is rising, asset prices are rising, stock market is rising and overall there is a boom. If this is done in huge volumes it is called as bubble. Rising income and asset values help borrowers remain creditworthy. As this debt burden increases slowly over time, debt repayment grows faster than income. Due to this spending is cut and income for other people decreases which makes them less creditworthy. To pay back the debt, spending is to be cut even further. Economy begins deleveraging. In deleveraging there less income, assets price falls, credit is not available, the stock market crashes. As the income drops and there is a pressure of debt repayment, people are forced to sell their assets. Due to this stock market crashes, real estate market crashes. This appears to be recession but is not. In recession, central banks changes interest rates to stimulate the borrowing. But in deleveraging the interest rates are almost near to zero or zero only. Four ways through which deleveraging (repayment of debt burdens) can be done are – cut the spending, reduce debt through defaults and restructuring, redistribution of wealth and finally central banks printing new money. But it is not that easy. As the spending is cut, income also stops for other people. Businesses cut cost which leads to removal of employees. As the employees will have no income they won’t be able to repay the loans/debt. This will result in banks unable to pay the depositors and there will be defaults all around. When credit is given both assets and liabilities arises. Lender doesn’t want to see their assets disappearing. So here comes debt restructuring. Debt restructuring means lender gets lesser money or gets money over a longer time or at a lower interest rate (from the rate which was agreed earlier). As the incomes are less and unemployment is seen, government’s source of income i.e. collecting taxes is affected. At the same time government has to spend for those who lost their jobs. Basically, government spend more than they earn. In this case government has to borrow more. But the question is from whom to borrow. Now what government does is that they raise taxes on wealthy people and by this wealth is distributed from “haves” to “have not’s”. Then central bank steps in. Central bank prints more money and buy assets and asset prices starts rising. But this will only help those who have financial assets. So government and central banks cooperate. Central bank buys government bonds which result in inflow of money for government. Then government can buy goods and services and eventually help lending money in the hands of people.  If all the factors of deleveraging are done in balanced way then deleveraging can be beautiful. If the deleveraging is done beautifully growth will be slow but debt burden will be reduced. Overall, economy will start to rise again.

Few points to remember:

• Don’t have debt rise faster than income.
• Don’t have income rise faster than productivity.
• Do all that you can to raise your productivity.