Ray Dalio has a video clip on youtube called “How the Economic Machine Works: In 30 Minutes“. It’s actually 31 minutes long – which is a significant chunk of time. And even if you’d happily while away double that on Candy Crush – that tends to happen in small chunks and snippets. It’s difficult to locate a clear 31 minutes where you could just sit and watch a youtube clip.


You should.

I like it because it feels very “pluralist”. There’s not one school of economic thought at play here: it’s a bit Austrian (because it sounds a lot like Austrian Business Cycle theory); it’s a bit Monetarist (because credit); it’s almost Keynesian (because of all the consuming driving everything); and it’s definitely behaviouralist (people are fooled and/or wilfully blind).

How Ray Dalio Sees The World

  1. We learn stuff.
  2. We buy stuff.
  3. One man’s income is another man’s spending.
  4. You can spend money that you’ve already earned (cash), or money that you hope to earn (credit).
  5. Extrapolate that, and you have a world of cycles.
  6. But generally, we ignore (or we’re ignorant of) the cycles until the tide turns against us.

Because we learn stuff, it means that we’re constantly learning new ways to make things, and we’re also discovering new things, so there is a grand ascension toward more awesome.

In economic terms, this is productivity growth:

Thanks Ray Dalio
Thanks Ray Dalio

But we don’t just spend more because we’re more productive. We also spend more because we borrow from our future selves. And borrowing from our future selves means that we’re spending more than we earn; and therefore, at some point, we’re going to have to spend less than we earn in order to pay back the credit. Therefore, you get cycles.

Before we get to the cycles, one more important question because we’re dealing with credit: who really controls it?

Central banks.

And they do so in two ways:

  1. Interest rates (they increase interest rates to reduce credit and spending and inflation; they decrease interest interest rates to increase credit and spending and be all stimulative); and
  2. Money creation (when interest rates become ineffective).

Obviously, the interest rate manipulation is the general status quo, and the money creation happens in emergencies.

According to Ray Dalio, this creates, and is also the result of, two types of debt cycle:

The Short Term Debt Cycle:

Thanks Ray
Thanks Ray

Where credit expands and contracts with the Central Bank trying to control inflation through interest rates.

The Long Term Debt Cycle:

And thanks again.
And thanks again.

Where average credit expands over time until it destabilises (like the 1929 crash and the 2008 financial crisis), leading to a giant deleveraging of the economy.

When you put it all together, you get a template for the giant cycles that economies go through.

Screen Shot 2014-10-03 at 9.20.37 AM

The next question, then, is how to deal with deleveragings?

The Beautiful Deleveraging

There are only so many ways to address a deleveraging:

  • Government austerity – which causes unemployment and deflation.
  • Debt-restructuring – which is deflationary because there is still a general reduction of credit.
  • Redistribution of wealth – caused by increasing taxes on the wealthy, which can apparently also be deflationary (if not revolutionary)
  • Printing Money – which is inflationary, and hyperinflationary if you’re not careful.

So on the one hand, you can deal with the debt burden by spending less – but this can be a vicious cycle of deflation causing unemployment causing more deflation causing more unemployment.

Or you can deal with the debt burden by inflating it away.

Or both. Better to do both. Because the deflationary effects of austerity, restructurings and redistribution can be offset by the larger money supply.

That is: the Central Bank must create enough actual money to replace the credit that is being lost by the other three methods.

This is the beautiful deleveraging: a good balance between monetary and fiscal policy.

I think it’s worth considering.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.