A note: I originally wrote this post a few years ago – but I think it’s worth re-visiting. Here goes…

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. I realise that 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 we’re talking about 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”, we’re constantly learning new ways to make things, and we’re also discovering new things, so there is general advancement.

In economic terms, this is productivity growth:

Thanks Ray Dalio
Thanks Ray Dalio

And being more productive means that we have more resources to spend, and everyone is generally better off*.
*The standard example is: this is one of the best times in human history to be poor. Most poor people have access to mobile phones and the internet and clean water. Even if the relative wealth levels are worse, overall living standards are better.

The trouble is: 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, I need to mention central banks. Under our current monetary system, central banks control credit (or, at least, they control most of it).

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 inflation); 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 (although I’d question whether taxes on the wealthy really causes them to “spend less”)
  • 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.

At least, that’s Ray Dalio’s view.

An Update

Years down the line, I guess I now have one big criticism of this view of the economy. One of Dalio’s main assumptions is:

“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.”

I have problems with this one. It implies that our earnings are “fixed” – which is not always the case. I may take on debt as a 25 year old that I plan to repay out of my higher earnings as a 35 year old. That is: I borrow from my future productivity, without having to change my spending patterns at all. And if I borrow in the knowledge that I can become more productive, then I don’t have to “spend less” in order to pay back the credit. I will simply be earning more, and using the surplus to repay the debt. And once I’m done repaying the debt, then the free surplus will go into investments, which will then become someone else’s “debt”. At no point in that equation was the ‘surplus’ going to be used for consumption.

Which is not to say that some people don’t borrow from their future selves. They do, and this can affect the credit cycle.

But there is also a part of the credit cycle which sounds something like:

  • There are people who have accumulated more resources than they wish to spend.
  • There are people whose earnings potential mean that they will soon accumulate more resources than they will wish to spend.
  • And credit is the mechanism whereby those accumulated resources can be more efficiently allocated across lifespans.

It’s just a thought.

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.