How to Economic Machine Works by Ray Dalio
Three main forces that drive the economy
- Productivity
- Short-term Debt Cycle
- Long-term Debt Cycle
It all starts with transactions. An economy is the sum of the transactions that make it up.
money + credit = total spending, which drives the economy
Price = . That arises out of transactions.
A market for something (say ) is the group of all buyer and sellers for .
All markets together constitute the economy. The biggest buyer and seller → Government
- Central Government (collects taxes and spends money)
- Central Bank (controls the amount of money and credit in the economy)
The story of credit
I feel he explained it best.
But, I will try to summarize it to the best of my abilities:
Credit deals with borrowing and lending.
- lenders wish to earn more money (through interests that borrowers pay)
- borrowers need money to
- buy something they cannot afford
- accumulate capital to start a new business
When interest rates are high, rate of borrowing reduces and vice versa.
When credit is created, it turns into debt.
- debt is an asset to the lender
- debt is a liability for the borrower
- this asset and liability disappear when the principal and interest are repaid
Spending Drives the Economy
When someone spends more, someone earns more income
When someone’s income increases, it makes him more credit-worthy, why?
- He has the ability of repay (because he has income)
- He has collateral (in the form of valuable assets) in case he cannot repay
The story of productivity
Over time as we grow in income, our standard of income increases…
Those who are
- hardworking
- inventive grow in terms of productivity and ⇒ living standards.
Productivity matters in the long-run (because its effect is too slow to be apparent) and it doesn’t fluctuate much.
But in the short-run, credit matters more.
How does credit lead to growth in the short-run?
Consider a scenario where only productivity matters for growth (and no credit). So, in order for us to grow, the only way is to improve our productivity. End of story. In this case we will have a straight up-trending line…
But in reality we have cycles, and the reason for that is simply human nature with the fact that we take debt.
”The Credit today is Debt tomorrow” by Ray
Credit can be created out of thin air. Most of all what people call money is actually credit.
In an economy without credit, the only way to increase our spending is by productivity growth, but with credit, we can increase our spending by borrowing.
Credit is:
- bad, when it is used to buy something that is not going to lead to any productivity growth (like buying a TV)
- good, when it improves productivity or generates revenue in some way (like buying a tractor for improved agriculture)
To be continued…