Ray Dalio of Bridgewater Associates put together an animated video called How the Economic Machine Works in 30 Minutes.  The video itself is on www.economic priciples.org.  It is well worth taking a look at for a quick and concise lesson on economic trends, why they exist and how to know where in the cycle we are right now.  Here are some key points to remember when predicting the economy.

 The Economy and Productivity Growth

Ray describes the economy as the sum of the transactions that make it up, and he points out that it only appears to be complex due to the sheer number of transactions that occur.  Transactions consist of any combination of money and credit used to purchase goods, services or assets.  As productivity increases with innovation and advancing technology, the economy grows at a steady rate.  This is what’s referred to as productivity growth.  While productivity growth is not something we as consumers feel on a day to day basis, it’s ultimately responsible for economies increasing at steady rates over extended periods of time.  If we reflect back over the past few decades, it’s easy to see that several aspects of the economy seem to rise alongside productivity growth.  Since we can produce more than we could 100 years ago, incomes are much higher now than they were then.  With these higher incomes come higher prices and the devaluation of the dollar.

How the Economic Machine Works

Credit

As we borrow money, we create both a debt for the borrower and an asset for the lender.  This process is called credit.  While the economy is increasing over time, you and I feel the day to day fluctuations of it.  Our proximity to the effects makes it difficult to see the big picture, and it give the illusion that the economy is difficult to predict.  These variations exist because credit is essentially the money or assets from our future selves being used to make a purchase now.  As the video puts it, “Debt allows us to consume more than we produce when we acquire it and forces us to consume less than we produce when we pay it back.”   Credit leads to what Ray calls the short-term and long-term debt cycles.  The good news is that these cycles occur in very predictable manners.

The Short-Term Debt Cycle

Credit allows us to spend more than our income.  This additional spending raises the income of the sellers we buy from, who then turn around and spend their income and credit elsewhere.  With all of this spending, everybody feels like they have more money, and they spend even more.  The economic boom of the short-term debt cycle is called an expansion.

Increased spending leads to increased prices.  Consumers buy more, and to keep up with the high demands, sellers need to spend more on raw materials, services and employees.  To do this, they must raise their prices.  The rising price of goods, services and assets is called inflation, and over time it decreases the value of our currency.  Inflation is an expected and unavoidable result of production growth, but it cannot be allowed to rise out of control.  If a nation were to allow this, their currency would rapidly lose its value, severely crippling the economy.  The Central Bank monitors prices to prevent that from happening.  When prices increase, interest rates are raised.  Higher interest rates result in less borrowing, leading to less spending and causing both prices and incomes drop, leading to what's called a recession.

Once the prices are under control, the Central Bank can drop the interest rates.  Consumers begin to borrow and spend more money; prices and incomes rise, and the economy begins another expansion.  It’s in this predictable way that the Central Bank influences the short-term debt cycle.  Each cycle of expansion and recession typically lasts five to eight years.

The Long-Term Debt Cycle

The long-term debt cycle is a bit trickier, and Ray estimates that it plays out over a 75 to 100-year period.  The basic impetus for the long-term debt cycle is human nature.  Each short-term debt cycle’s peak tends to be higher than the last as people borrow more and more.  Each short-term debt cycle’s valley tends to be higher than the last as people start borrowing again before they’ve paid off their debts.  Over time, more and more money enters the market, leading people to feel prosperous.  In actuality, most of this ‘money’ flooding the market isn’t money at all; it is credit.  The US economy is made up of around $50 trillion in credit, compared to only $3 trillion in actual currency. 

A healthy economy is one where income outweighs debt.  Since credit exists, incomes go through periods where they rise much faster than production growth, eventually causing them to level out.  After all, if you can’t produce more, you can’t earn more.  At the same time, debt continues to increase despite the stagnation in income.  Eventually borrowing becomes so prolific that the scales tip and rising incomes can no longer keep up with rising debt.

To repay their debts, consumers must sell their assets, such as real estate, stocks, and commodities.  The market becomes flooded with assets, driving down their value.  So not only have our debts outgrown our incomes, the value of our assets has plummeted.  It’s at this point that the banks realize they’re never going to be fully repaid, and credit evaporates.  The banks foreclose on homes and repossess vehicles, but the falling markets and lack of creditworthy consumers mean the banks still can’t recoup their money.  This probably sounds familiar, since we don’t have to think back very far to remember when major banks across the country were panicking, refusing to lend money and consuming each other.  This process is like a tailspin, plummeting the whole economy at a rate far faster than the long-term economic growth that led up to the predicament, causing what's known as a deleveraging.

Deleveraging

The difference between a deleveraging and a recession is that debt has risen to the point that consumers can no longer afford to repay it, even if interest rates drop to 0%.  The deleveraging is an attempt to tip the debt to income scales back in the right direction.  Four things must be done to accomplish this:

  1. Consumers, businesses, and governments cut spending.
  2. Debts are restructured, allowing banks to recoup at least a portion of their investment.
  3. Wealth is redistributed by raising taxes on the wealthy to take care of the less affluent, who suffer the most from a deleveraging.
  4. Money must be printed to compensate for the reduction of credit in the economy.

A deleveraging be handled well, leading to a recession, or it can be dealt with poorly, leading to depressions, wars, and social upheaval. For example, if the Central Bank does not print enough money, incomes will continue to plummet.  Remember that much of the economy is credit.  When credit dries up, enough money needs to be produced to keep income levels above the cost of debt repayments.  If too much money is printed, the influx of currency reduces its value.  Each of these four methods  must be balanced in order to prevent scenarios such as Germany’s struggles during the Great Depression, which led to World War II; the Lost Decade of Japan following their deleveraging in 1991; or the complete economic collapses of countries such as Greece and Iceland after the Financial Crisis of 2008.

Using the Economy to Your Advantage

To avoid significant downturns, Ray Dalio outline three essential steps that you and I, businesses and governments should all follow.

  1. Don’t let debt rise faster than income. Keep track of what you can afford to spend in either cash or credit.
  2. Don’t let incomes rise faster than productivity. This trend cannot last, nor can it keep up with rising prices.
  3. Raise productivity. The best way to do better financially is to work harder, smarter and more efficiently.

You have all heard of buyers markets and sellers markets, but one of the keys to predicting them is to realize that either one leads to the other.  At this point in the U.S. economy, we are experiencing the first expansion since the deleveraging of 2008.  Credit has started to become readily available again; people are buying homes, stocks and 50-inch televisions; and the struggles of a few years ago are beginning to fade from memory.  Right now everybody is buying, without a care in the world.  That makes now the perfect time to sell.