One man’s spending is another man’s income – Ray Dalio
Honestly, I have never asked the question, what is the economy? All I understood about the economy was that I go to work, get a paycheck, pay my bills and that is about it. That was my complete understanding of the economy. It wasn’t until I came across this video by Ray Dalio that I got a better grip on what the economy means and what it does. In this blog post, we are going to talk about what is the economy and how it works.
What is the economy
The economy is the sum total of all money spent plus the amount of credit in the economy. It is this simple – nothing more than that.
What are Markets?
Markets are the place where you create a transaction for a particular product. For example, gold, silver, cars, etc. Combining all markets create the economy.
Who are the biggest ballplayers?
The federal government is the biggest ballplayer in the markets. The government collects taxes and the central bank controls the amount of money and credit in the economy. There are 2 ways the central bank controls the money: printing money and influencing the interest rates.
What is Credit?
When I used to think about credit, I used to think about credit cards. Credit is a lot bigger than just credit cards. Credit includes all the credit in the economy. From credit cards to a loan to your family, everything is credit.
One thing to keep in mind that credit is the most important part of the economy. Without credit, there is no economy. As discussed in the quote above, one man’s spending is another man’s income. The same goes for credit. If a lender wants to make money, and the borrower wants the money right now but cannot afford it, he/she goes to the lender, and the agreement is made that the borrower will pay it back with interest. This is how credit is created.
Think about it, if you go to your buddy and ask him for money. He loans it to you = credit created. It is that simple. When credit is created, it creates a debt for the borrower but an asset to the lender.
If I was told how much cash is in the US economy, I would think the majority of the money is cash, but if you look closely, the majority of the economy is credit. There is only $2 trillion cash vs $50 trillion credit. So, the next question is how interest rates affect the economy and credit? Well if interest rates go higher, people borrow less and if they borrow less, the economy slows down. This is because credit leads to spending and the more people spend, the more the economy grows.
But, credit is a wonderful thing if it is done to finance productivity. For example, a farmer using credit to buy a tractor. On the other hand, it is a terrible thing when it is done to fund non-productive things such as buying a TV. This is because productivity plays a huge role in the long term debt cycle – something we will discuss later.
What are cycles?
Cycles are one of the most important things to understand when it comes to the economy. Because if you can understand the cycle, you can understand the patterns.
There are two types of cycles: Short term and Long term debt cycles.
The long term debt cycle
The long term debt cycle is anywhere from 75 to 100 years. Usually is an aggregation of the short term debt cycles. The increase in borrowing leads to the accumulation of debts. The long term borrowing leads to what is called the debt burden. In Debt burdens, debt is rising as fast as incomes. The equal growth leads to us not being able to service that debt. Well, let’s say it becomes hard to service the debt.
Now in order to reduce the debt, people have to slow down the spending, When people reduce spending, the economy goes down. Often, as the economy goes down, the credit disappears, asset prices decrease and stock market crashes. As this happens, people become less creditworthy and there is less credit in the economy. This leads to a positive reinforcing cycle. Due to this positive reinforcing cycle, social tensions rise. Often, this can lead to civil unrest. But, there is a solution and if done correctly, can help bring the economy back on track.
One of the ways to fix this is by what is called deleveraging. Think about deleveraging as a set of tools that can be used to “fix” the economy.
De-leveraging
1.Cutting spending
This makes sense. As you have a lot of debt, you want to pay it down. But, as you pay down the debt, you are not spending as much. And as we know, one person’s spending is another man’s income. So, if people are spending less, the economy takes a hit.
2. Defaulting on the debt
Defaulting on the debt can lead to depression. This happens because as people do not pay the bank, the bank runs out of money and people start withdrawing in panic. People start to realize that a lot of what people think is wealth, is not real wealth. For example, houses (2008 housing crisis). As companies make a plan to pay back over time, the government gets less revenue, it starts to rack up the deficit. In a situation like this, the government often creates a stimulus plan to increase growth and spending.
3. Wealth redistribution
As the economy goes down, wealth starts to concentrate to a few wealthy people. One way to counter this is by taxing wealthy people in order to bring the wealth back to the middle class. This is often met with resistance as no one wants their taxes raised.
4. Printing money
Another way to reduce the debt burden is to print more money. This is done by the central bank. As the central bank prints more money, inflation occurs and the government buys stocks which intern leads to an increase in asset prices. The increase in asset prices leads to people being more creditworthy. This leads to more spending and increases the availability of credit. If all of these things are done correctly, it takes 8-10 years for the economy the be normal. This is called the lost decade.
The short term debt cycle
Short term debt cycle is seen in terms of availability of credit. Usually happens in 8-10 years. The short term cycle is pretty simple, as spending increases, the prices increase due to inflation. The central bank controls this by increasing interest rates and reducing the availability of credit.
Few lessons learned
- Don’t have income rise faster than productivity
- Don’t have debt rise faster than income
- Do all you can to increase productivity
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