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.
Transactions are the bedrock of the economy. It's simply buying and selling -- we make transactions all the time.
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.
There are millions of different markets, and the economy consists of all transactions in all markets.
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.
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.
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 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!
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.
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.
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.
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.
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.
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.
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.
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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