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The World's Most Brilliant Hedge Fund Manager Put Together A Guide To How The Economy Really Works

Ray DalioAP

Ray Dalio manages the world’s largest hedge fund, Bridgewater Associates.

It has a tremendous track record, so when the man talks about markets, people usually listen.

Beyond that, Dalio is known for having one of the most cogent and refined understandings of the economy in the financial industry.

Lots of investors pontificate, but Dalio’s views are legitimately well respected.

As part of his mission to explain how the economy works, Dalio has put together a neat, new 30-minute animated video called “How the Economic Machine Works,” where Dalio narrates his big picture view of the economy.

“I feel a deep sense of responsibility to share my simple but practical economic template,” Dalio says. “Though it’s unconventional, it’s helped me to anticipate and sidestep the financial crisis, and it has worked well for me for over 30 years.”

Dalio is worth almost $13 billion, so it’s safe to say his economic template has served him well.

These are the three main forces that drive the economy.

Laying them on top of each other shows our economic 'cycle.'

Transactions are the bedrock of the economy. It's simply buying and selling -- we make transactions all the time.

You can make a transaction with money or credit, and that gives you the total spending.

If you take total spending and divide it by the total quantity, we get price. 'If we can understand transactions, we can understand the whole economy,' Dalio says.

A market is simply all the buyers and all the sellers making transactions for the same thing.

There are millions of different markets, and the economy consists of all transactions in all markets.

People, banks, businesses and governments all interact via transactions.

At the heart of it is the central bank, which controls interest rates and the money supply. In so doing, the central bank impacts the flow of credit.

And credit is essential.

Without credit, the modern economy would look very different. Since we have credit, lenders use it to make more money and borrowers use it to buy something they can't immediately afford.

The borrower makes a promise to pay a loan back in the future and also pays interest on that loan.

The credit the bank extends to the borrower then becomes debt.

Debt is a 'liability' for the borrower, but it's an 'asset' for the bank.

In the short term, more credit is good for the economy because one person's spending is another person's income. If more people have more money via credit, the economy grows.

So a 'creditworthy borrower' (someone banks should and will loan to) is someone who has both the ability to repay (income) and collateral just in case (a house, financial assets).

The act of borrowing creates a 'cycle.'

The problem is that borrowers are too close to the 'short term debt cycle' line to really understand the impact of their borrowing decisions.

It is human nature to want to borrow to get the things we want now. Thanks to credit, we can always just pay it back later!

It's hard to take a step back and see short-term debt versus long-term debt and productivity.

If that's a grim picture, what would an economy without credit look like? Well, the only way to boost spending (and thus growth) would be to increase productivity.

But we have a credit system. If I make $US100,000 a year, the bank gives me $US10,000 in credit. Now I have $US110,000 to spend. And since my spending is your income, now you have earned $US110,000 and can get $US11,000 from the bank.

And so on. The credit cycle spurs growth.

But the central bank doesn't want things to get out of hand, and so it raises and lowers interest rates to either promote or lessen the amount of borrowing.

Because a central bank has to keep an eye on the debt burden.

Notice how in 2008, the debt burden was out of control. Lending conditions were too easy and people borrowed too much. There's only one way to go from here.

When things start heading south, you can get a recession and social unrest.

The system is forced to unwind. It's called deleveraging, and it's what happened after the financial crisis.

Now we want to kick borrowing into gear, but the problem is that the central bank has pushed interest rates as low as they can go.

Banks worry if they can actually get paid back. Borrowing suffers.

There are four ways to deleverage. Most people have an appetite for the last option (print money) because it feels the best in the short term.

One way we delever is through debt restructuring. Basically, banks would rather have some of something than all of nothing.

The government and households can cut spending. We know this as austerity. The government can also redistribute wealth to Main Street, hoping that will help grow the economy as people spend more.

That means you have to raise taxes on the wealthy. Everybody starts to resent each other.

The central bank also buys up financial assets and government bonds. This helps ease the system.

The U.S. is doing it now in a process known as quantitative easing. As you can see, the reaction to this financial crisis resembles the 1930s.

So what makes a cycle a so-called 'beautiful' deleveraging?

It's the right balance between deflationary measures (austerity, debt restructuring, income redistribution) and inflationary measures (printing money, central bank bond-buying).

You want income to increase at a higher rate than debt, so that the country is 'creditworthy' again. Banks will lend and people can borrow.

Check out the timing though. Deleveraging takes a long period of time sometimes known as a 'lost decade.'

For Dalio, this is the key template. Short-term debt, long-term debt, and the productivity growth line. Looking at these three lines in conjunction can show you where we've been, where we are now, and where we're headed.

If debts rise faster than income, debt burdens will crush you.

If income rises faster than productivity, you'll eventually become uncompetitive.

In the long run, productivity matters most. Credit will come and go, but notice how productivity stays on a steady climb. That goes for governments and it goes for individuals.

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