How The Economic Machine Works by Ray Dalio

Principles by Ray Dalio

22 Sept 201331:00

EducationalLearning

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TLDRThe economy functions like a simple machine, driven by human nature and comprised of transactions, three key forces, and cycles of growth and recession. Though complex, the economy can be understood by examining productivity, debt cycles, and the interplay between inflationary and deflationary pressures. Following three basic rules can lead to stability: don't let debt outpace income, don't let income outpace productivity, and maximize productivity growth above all, as this is crucial for long-term prosperity.

Takeaways

😀 The economy works like a simple machine driven by productivity growth, short term debt cycles, and long term debt cycles.
😊 Transactions between buyers and sellers are the basic building blocks of the economy.
🧐 Credit is extremely important because it allows spending to increase faster than income and productivity.
😯Short term debt cycles cause alternating periods of economic expansion and recession every 5-8 years.
😲Long term debt cycles with excessive debt accumulation end with painful deleveragings lasting about 10-15 years.
🤔Central banks use monetary policy like interest rates to manage the short term debt cycle.
🤨Central governments use fiscal policy like taxation and spending to redistribute wealth and income.
😀Productivity matters most in the long run, while credit matters most in the short run.
☹️Don't let income rise faster than productivity or debt rise faster than income.
🙂Do all you can to increase productivity because it drives long term economic growth.

Q & A

What are the three main forces that drive the economy?
-The three main forces that drive the economy are: 1) Productivity growth, 2) The Short term debt cycle, and 3) The Long term debt cycle.
Why is credit the most important part of the economy?
-Credit is the most important part of the economy because it is the biggest and most volatile part. Credit allows people to spend more than they produce, driving economic expansions, but also leads to economic contractions when debt burdens get too high.
How do short term debt cycles work?
-In the short term debt cycle, increased availability of credit leads to economic expansion and inflation. Central banks raise rates to reduce inflation, making borrowing more expensive. This causes spending and incomes to drop, leading to recession. Central banks then lower rates to stimulate borrowing and restart the cycle.
What happens during a deleveraging?
-In a deleveraging, debt burdens have become too large relative to incomes. People cut spending to pay debts, but incomes fall faster. Defaults rise, lending dries up, asset prices drop, and the economy contracts. Deleveragings reverse long term debt cycles.
What are the four ways debt burdens can come down?
-The four ways debt burdens can come down are: 1) Cutting spending, 2) Debt defaults and restructurings, 3) Wealth redistribution from rich to poor, and 4) Printing money (inflationary).
How can central banks and governments stimulate a depressed economy?
-Central banks can print money to buy financial assets and government bonds, while governments can run deficits to fund increased spending on goods, services and benefits. This increases incomes and creditworthiness.
What is a 'beautiful deleveraging'?
-A beautiful deleveraging is when debts decline relative to income, economic growth is positive, and inflation is low, due to the right balance of cutting spending, reducing debts, transferring wealth and printing money.
Why can printing money be risky?
-Printing money can easily be abused because it is easy to do and people prefer it over cutting spending or reducing debts. However, printing too much money leads to unacceptably high inflation.
How can income growth help reduce debt burdens?
-If income grows faster than the interest rate on debt, the debt burden (debt-to-income ratio) will decline over time. Printing money may raise income growth enough to achieve this.
What are the key lessons for policymakers and individuals?
-The key lessons are: 1) Don't let debt grow faster than income, 2) Don't let income grow faster than productivity, and 3) Focus on raising productivity over the long run.

Outlines

00:00

😀 How the Economy Works

This introductory paragraph explains that the economy works like a simple machine made up of transactions, but many people don't understand how it works, leading to economic suffering. The narrator feels a responsibility to share a practical economic template that has helped anticipate financial crises.

05:02

😊 Transactions Drive the Economy

This paragraph explains that the economy is made up of transactions between buyers and sellers exchanging money, credit, goods, services and assets. The total spending amount drives the economy. Prices are determined by dividing amount spent by quantity sold.

10:02

😲 Credit Allows Faster Growth

This paragraph explains that credit allows spending to increase faster than income and productivity in the short run, creating economic cycles, because borrowing pulls future spending forward. But income and productivity determine long run growth.

15:02

📈 The Short Term Debt Cycle

This paragraph explains the short term debt cycle of expansion and recession over 5-8 years caused by fluctuating availability of credit. Central banks influence this cycle by adjusting interest rates.

20:07

📉 The Long Term Debt Cycle

This paragraph explains the long term debt cycle of debt accumulation over decades leading to a deleveraging. This happens when debts grow faster than incomes for too long, eventually reducing creditworthiness.

25:07

😣 The Painful Deleveraging Process

This paragraph details the deflationary, depressing deleveraging process of cutting spending, defaulting on debts, redistributing wealth and printing money to bring down excessive debt burdens.

30:08

😌 Achieving a Beautiful Deleveraging

This concluding paragraph suggests balancing the deleveraging methods to maintain stability and positive growth while reducing debt can produce an optimal, beautiful deleveraging over a decade.

Mindmap

Keywords

💡Productivity Growth

Productivity growth refers to the rate at which an economy can produce goods and services. The video explains that over long periods of time, accumulated knowledge and technology raises productivity, which raises living standards. However, productivity growth happens steadily, so it does not cause economic cycles.

💡Credit

Credit, or debt, is the most important driver of economic cycles because it allows spending to grow faster than income in the short run. Easy availability of credit fuels economic expansions, while tight credit availability causes recessions. The narrator stresses that credit is created 'out of thin air' through agreements between lenders and borrowers.

💡Short Term Debt Cycle

The short term debt cycle lasts 5-8 years as credit availability expands and contracts. In the expansion phase, easy credit allows spending and asset prices to grow rapidly. To combat inflation, the central bank raises interest rates, making credit tighter and causing a recession. Lower rates then restart the cycle.

💡Long Term Debt Cycle

Over decades, debts rise faster than incomes, eventually becoming unsustainably large. This long term debt cycle ends in a deleveraging, where debts must be reduced through defaults, restructuring, and reduced spending. Deleveraging resets the cycle, but is painful.

💡Central Bank

A nation's central bank controls money supply and credit availability. It can lower interest rates to stimulate borrowing or print new money to inflate financial assets. Central bank policy is key to managing economic cycles smoothly.

💡Inflation

When spending grows faster than the production of goods, prices rise. The video explains how excess easy credit can cause harmful inflation. The central bank raises rates to control inflation.

💡Deflation

When spending decreases, prices drop. This deflation occurs after a credit boom ends and people pay down debts. Deflation makes debt burdens worse despite lower spending, and is painful.

💡Budget Deficits

Government budget deficits expand during deleveragings as tax revenues decrease and unemployment spending rises. Deficits must be financed through taxes, borrowing, or printing money.

💡Printing Money

Printing new money is inflationary but necessary during deleveragings to offset disappearing credit. If balanced properly, printed money prevents deflation while keeping inflation moderate.

💡Beautiful Deleveraging

If policymakers properly balance different policies, a deleveraging can occur without high inflation or depression. This ideal 'beautiful deleveraging' slowly reduces debt burdens without major harm.

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Transcripts

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