A Template for Understanding…
…How the Economic Machine Works and How it is Reflected Now
Ray Dalio
Created October 31, 2008 | Updated October, 2011
The economy is like a machine.  At the most fundamental level it is a relatively simple machine, yet it is not well understood.  I wrote this paper to describe how I believe it works.  My description of how the economy works is not the same as conventional economists’ descriptions so you should decide for yourself whether or not what I’m saying makes sense.  I will start with the simple things and build up, so please bear with me.  I believe that you will be able to understand and assess my description if we patiently go through it.
How the Economic Machine Works
An economy is simply the sum of the transactions made and a transaction is a simple thing.  A transaction consists of the buyer giving money (or credit) to a seller and the seller giving a good, a service or a financial asset to the buyer in exchange.  A market consists of all the buyers and sellers making exchanges for the same things – e.g. the wheat market consists of different people making different transactions for different reasons over time.  An economy consists of all of the transactions in all of its markets.  So, while seemingly complex, an economy is really just a zillion simple things working together, which makes it look more complex than it really is.
For any market, or for any economy, if you know the total amount of money (or credit) spent and the total quantity sold, you know everything you need to know to understand it.  For example, since the price of any good, service or financial asset equals the total amount spent by buyers (total $) divided by the total quantity sold by sellers (total Q), in order to understand or forecast the price of anything you just need to forecast total $ and total Q.  While in any market there are lots of buyers and sellers, and these buyers and sellers have different motivations, the motivations of the most important buyers are usually pretty understandable and adding them up to understand the economy isn’t all that tough if one builds from the transactions up.  What I am saying is conveyed in the simple diagram below.  D
oes it make sense to you?
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C Price = Total $ / Total Q
There are different types of markets, different types of buyers and sellers and different ways of paying.  For simplicity, we will put them in groups and summarize how the machine works.  Most basically:
∙All changes in economic activity and all changes in financial markets’ prices are due to changes in th
e amounts of 1) money or 2) credit that are spent on them (total $), and the amounts of these items sold (total Q).  Changes in the amount of buying (total $) typically have a much bigger impact on changes in economic activity and prices than do changes in the total amount of selling (total Q).  That is because there is nothing that’s easier to change than the supply of money and credit (total $).
∙For simplicity, let’s cluster the buyers in a few big categories.  Buying can come from either 1) the private sector or 2) the government sector.  The private sector consists of “households”, and businesses that can be either domestic or foreign.  The government sector most importantly consists of a) the Federal G overnment which spends its money on goods and services and b) the central bank, which is the only entity that can create money and, by and large, mostly spends its money on financial assets.
The Capitalist System
As mentioned, the previously outlined economic players buy and sell both 1) goods and services and 2) financial assets, and they can pay for them with either 1) money or 2) credit.  For example, when you go into a store to buy something, you can either pay with cash (in which case the transaction is settled) or with credit (in which case you still owe the money).
In a capitalist system, this exchange takes place through free choice – i.e., there are “free markets” in which buyers and sellers of goods, services and financial assets make their transactions in pursuit of their own interests.  The production and purchases of financial assets (i.e., lending and investing) is called “capital formation”.  It occurs because both the buyer and seller of these financial assets believe that the transaction is good for them.  Those with money and credit provide it to recipients in exchange for the recipients’ “promises” to pay them more.  So, for this process to work well, there must be large numbers of capable providers of capital (i.e., investors/lenders) who choose to give money and credit to large numbers of capable recipients of capital (borrowers and sellers of equity) in exchange for the recipients’ believable claims that they will return amounts of money and credit that are worth more than they were given.  When this condition exists, the free market approach to capital formation performs well so private sector capital formation and spending pick up, the economy grows and investment assets typically have good returns.  When these conditions don’t exist, this process performs poorly.
When capital contractions occur, economic contractions also occur.  These contractions typically occur for two reasons, which are most commonly known as recessions and deleveragings.  Recessions are typically well understood because they happen often and most of us have experienc
ed them, whereas deleveragings are typically poorly understood because they happen infrequently and are not widely experienced.
Recessions are very different from deleveragings in the following ways (in brief):
∙  A recession is an economic contraction that is due to a contraction in private sector capital (i.e., debt and equity) arising from tight central bank policy (usually to fight inflation), which ends when the central bank eases. During “normal” times, central banks influence the amount of credit creation that finances a lot of demand for goods, services and financial assets by changing the cost of money until an adequate number of borrowers and lenders are interested in transacting so that the desired levels of credit growth and economic growth are achieved.
1 State and local governments are of course still significant.
Recessions occur when central banks raise the cost of credit so that it drives down the demand for it and what it buys.  Recessions end when central banks lower interest rates to stimulate demand for goods and services and the credit growth that finances these purchases, because lower interest rates 1) reduce debt service costs; 2) lower monthly payments (de-facto, the costs) of items bought on credit, which stimulates the demand for them; and 3) raise the prices of income-producing assets
like stocks, bonds and real estate through the present value effect of discounting their expected cash flows at the lower interest rates, producing a “wealth effect”
on spending.
A deleveraging is an economic contraction that is due to a contraction in real capital (i.e., credit
and equity) that arises when there is a shortage of capable providers of capital and/or a shortage of capable recipients of capital (borrowers and sellers of equity) that cannot be rectified by the central bank changing the cost of money.  In deleveragings, a) a large number of debtors have obligations to deliver more money than they have to meet their obligations, and b) monetary policy is ineffective in reducing debt service costs and stimulating credit growth. In deleveragings, central banks cannot control money and credit creation by changing the cost of money.  Typically, monetary policy is ineffective in stimulating credit growth either because interest rates can’t be lowered (because interest rates are near 0%) to the point of favorably influencing the economics of spending and capital formation (this produces deflationary deleveragings), or because money growth goes into the purchase of inflation hedge assets rather than into credit growth, which produces inflationary deleveragings. Deleveragings typically end via a mix of 1) debt restructurings that reduce debt servic
e obligations, 2) increases in the supply of money that make it easier for debtors to meet their debt service obligations, 3) redistributions of wealth, 4) businesses lowering their breakeven levels through cost-cutting, 5) substantial increases in risk and liquidity premiums that restore the economics of capital formation (i.e., lending and equity investing) and 6) nominal interest rates being held under nominal growth rates.
In other words, recessions can be rectified by central banks changing interest rates to make it profitable for increased capital formation and economic activity to occur, while deleveragings can not be rectified by these actions, so more structural changes are required.  That is why recessions are relatively brief (typically a few to several months) and deleveragings are long-lasting (typically a decade or more). While in both recessions and deleveragings there are contractions in private sector credit and spending that lead the government to increase its creation and spending of money and credit, in deleveragings the interventions of the government are typically much larger, more extensive and long-lasting.  Differences in how governments typically behave in recessions and deleveragings are a good clue that signal which is happening.  For example, in deleveragings, central banks typically “print” money that they use to buy large quantities of financial assets in order to compensate for the decline in private sector credit, while these actions are unheard of in recessions.2  Also, in del
everagings, central governments typically spend much, much more to make up for the fall in private sector spending.
But let’s not get ahead of ourselves.  Since these two types of contractions are just parts of two different types of cycles that are explained more completely in this template, let’s look at the template.
The Template:The Three Big Forces
I believe that three main forces drive most economic activity: 1) trend line productivity growth, 2) the long-term debt cycle and 3) the business/market cycle.  Since business/market cycles repeat frequently, they’re pretty well understood, but the other two forces are less well understood, so we will explain all three.  I will then show how, by overlaying the archetypical "business" cycle on top of the archetypical long-term debt cycle and overlaying them both on top of the productivity trend line, one 2 These show up in changes in their balance sheets that don’t occur in recessions.
can derive a good template for tracking most economic/market movements.  While these three forces apply to all countries’ economies, we will use the U.S. economy over the last hundred years or so as an example to convey the template.
1) Productivity Growth
As shown below in chart 1, real per capita GDP has increased at an average rate of a shade less than 2% over the last 100 years and didn’t vary a lot from that.  This is because, over time, knowledge increases, which in turn raises productivity and living standards.  As shown in this chart, over the very long run, there is relatively little variation from the trend line.  Even the G reat Deleveraging in the 1930s looks rather small.  As a result, we can be relatively confident that, with time, the economy will get back on track.  However, up close, these variations from trend can be enormous.  For example, typically in deleveragings the peak-to-trough declines in real economic activity are around 20%, the destruction of financial wealth is typically more than 50% and equity prices typically decline by around 80%. The losses in financial wealth for those who have it at the beginning of deleveragings are typically greater than these numbers suggest because there is also a tremendous shifting of who has wealth.
Chart 1
Real GDP Per Capita (2008 Dollars, ln)
1.0
1.5
2.0
2.5
3.0
3.5
4.0
understandable0010203040506070809000
2.8%0.8%  1.8%0.2%  4.1%
2.1%
3.0%  2.3%
2.0%  2.1%  1.1%so far
Sources: Global Financial Data & BW Estimates
Swings around this trend are not primarily due to expansions and contractions in knowledge.  For example, the Great Deleveraging didn't occur because people forgot how to efficiently produce, and it wasn't set off by war or drought.  All the elements that make the economy buzz were there, yet it stagnated.  So why didn't the idle factories simply hire the unemployed to utilize the abundant resources in order to produce prosperity?  These cycles are not due to events beyond our control, e.g., natural disasters.  They are due to human nature and the way the system works.
Most importantly, major swings around the trend are due to expansions and contractions in credit – i.e., credit cycles, most importantly 1) a long-term (typically 50 to 75 years) debt cycle (i.e., the “long wave cycle”) and 2) a shorter-term (typically 5 to 8 years) debt cycle (i.e., the “business/market cycle”).
About Cycles
We find that whenever we start talking about cycles, particularly the "long-wave” variety, we raise eyebrows and elicit reactions similar to those we’d expect if we were talking about astrology.  For this reason, before we begin explaining these two debt cycles we'd like to say a few things about cycles i
n general.
A cycle is nothing more than a logical sequence of events leading to a repetitious pattern.  In a capitalist economy, cycles of expansions in credit and contractions in credit drive economic cycles and they occur for perfectly logical reasons.  Each sequence is not pre-destined to repeat in exactly the same way nor to take exactly the same amount of time, though the patterns are similar, for logical reasons.  For example, if you understand the game of Monopoly®, you can pretty well understand credit and economic cycles.  Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels.  Those who have more hotels make more money.  Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players give them cash.  So as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property with lots of hotels on it) at the same time as many folks have run down their cash to buy hotels.  When they are caught needing cash, they are forced to sell their hotels at discounted prices.  So early in the game, “property is king” and later in the game, “cash is king.”  Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.
Now, let’s imagine how this Monopoly® game would work if we changed the role of the bank so that i
t could make loans and take deposits.  Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend.  If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates.  More money would be put into hotels sooner than if there were no lending, the amount owed would quickly grow to multiples of the amount of money in existence, and the cash shortage for the debtors who hold hotels would become greater. So, the cycles would become more pronounced.  The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash caused withdrawals from the bank at the same time as debtors couldn’t come up with cash to pay the bank.  Basically, economic and credit cycles work this way.
We are now going to look at how credit cycles – both the long-term debt cycle and the business cycle – drive economic cycles.
How the System Works
Prosperity exists when the economy is operating at a high level of capacity: in other words, when demand is pressing up against a pre-existing level of capacity.  At such times, business profits are go
od and unemployment is low.  The longer these conditions persist, the more capacity will be increased, typically financed by credit growth.  Declining demand creates a condition of low capacity utilization; as a result, business profits are bad and unemployment is high.  The longer these conditions exist, the more cost-cutting (i.e., restructuring) will occur, typically including debt and equity write-downs. Therefore, prosperity equals high demand, and in our credit-based economy, strong demand equals strong real credit growth; conversely, deleveraging equals low demand, and hence lower and falling real credit growth.  Contrary to now-popular thinking, recessions and deleveragings do not develop because of productivity (i.e., inabilities to produce efficiently); they develop from declines in demand.
Since changes in demand precede changes in capacity in determining the direction of the economy, one would think that prosperity would be easy to achieve simply through pursuing policies which would steadily increase demand.  When the economy is plagued by low capacity utilization, depressed business profitability and high unemployment, why doesn't the government simply give it a good shot of whatever it takes to stimulate demand in order to produce a far more pleasant environment of high capacity utilization, fat profits and low unemployment?  The answer has to do with what that shot consists of.

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