How The Economic Machine Works by Ray Dalio

How the economic machine works in 30 minutes. The economy works like a simple machine. But many people don't understand them – or have different opinions – which has led to much unnecessary economic hardship. I feel a strong responsibility to share my simple but practical business guide. Even though he's unconventional Did he help me foresee the world financial crisis and avoid it, and it has served me well for over 30 years. Let's get started. Although the economy seems complex, it works in a simple mechanical way. There are some simple parts and many simple transactions, which repeat themselves constantly x times. These transactions are primarily driven by humans, and they create 3 main drivers for the economy. No. 1: productivity growth # 2: the short-term debt cycle and # 3: the long-term debt cycle. We look at these three forces and how they are superimposed are a good guide to tracking economic movements and to understand what is happening.

Let's start with the simplest part of the economy: Transactions. An economy is simply the sum of its transactions and a transaction is very simple. You are making transactions all the time. Whenever you shop, it is a transaction. Every transaction has a buyer, the one for money or credit purchases goods, services or investments from the seller. Loans are like spending money. So by adding them up to the cash spent one comes to the total expenditure.

These total expenditures drive the economy. After spending through the shares sold quantity, you get the price. That's all. It's a transaction. It is the building block of the economic machine. All business cycles and forces are driven by transactions. So if we understand transactions we can understand the whole economy. A market includes all buyers and all sellers, who do transactions for the same things. For example there is a wheat market a car market a stock market Markets for any number of things. An economy is made up of all of these transactions in all of their markets. If you add up the total consumption and the total sales volume in all markets, do you have everything you need to know to understand the economy.

As simple as that. People, companies, banks, governments all deal with transactions, as just described: by exchanging money and credit for goods, services and investments. The greatest buyer and seller is the state, which consists of two important parts: A central government that collects taxes and spends money … … and a central bank, which is different from other buyers and sellers because they controls the amount of money and credit in the economy. It does this by influencing interest rates and by printing money. Hence, as we shall see the central bank plays an important role in the river of credit. Pay special attention to the credit. Credit is the most important part of the economy – and probably the least understood. It's the most important part because it makes up the majority and the most volatile is.

Just as buyers and sellers make transactions in the market, so do lenders and borrowers. Usually lenders want to grow their money and borrowers want to buy something they don't have the money to do like a house or a car or they want to finance the establishment of a new business. Credit can be used by both lenders as well as borrowers to fulfill wishes. Borrowers promise repayment of their debt, called the loan amount, plus an additional sum, the interest. When the interest rates are high less money is borrowed because it is expensive. When the interest rates are low borrowing increases because it is cheaper. When borrowers promise to repay, and the lenders believe them a loan arises. Two people can conjure up credit anytime! Sounds easy, but credit is complicated because it has different names. As soon as a loan is made, he turns into a debt.

Debt is a win to the lender and a liability to the borrower. Later, when a borrower repays his loan with interest, wealth and debt disappear, and the transaction is complete. So why is credit so important? Because the borrower through a loan can increase its spending. And think back, spending drives the economy. Because just the output of a person is someone else's income. Every dollar spent is someone else's credit every dollar earned is someone else's expense. So if you spend more, someone else will make more. When someone's income increases if the lender is more willing to lend him money, because now he's more creditworthy. A creditworthy borrower has two things: Repayment ability and collateral. With more income in relation to the debt, he can repay it. If he cannot, he has valuable goods that serve as collateral for sale. The satisfied lenders give him the money. Increased income thus allows higher loans, which leads to more spending. And since the one is the expense of the other, this leads to increased borrowing, etc.

This self-affirming pattern leads to economic growth and why we have cycles. In transactions, you have to give something in order to receive something. In the long run, the amount received is determined by how much you produce. Over time we learn that accumulated knowledge increases the standard of living. We call this productivity growth. Those who are creative and work hard increase their productivity and standard of living faster, than the satisfied and lazy. But that's not entirely true in the short term. In the long run, productivity is the most important thing, but in the short run, it's credit.

Because productivity growth does not fluctuate very much, it's not a big driver of business cycles. It is debts – since they allow us to consume more than we produce, and forcing us on repayment to consume less than we produce. Debt swings occur in two major cycles. One extends over approx. 5 – 8, the other over 75 – 100 years. While most feel the vibrations, they usually don't perceive them as cycles, because they experience it too closely – day after day, week after week. In this chapter we take a step back and look at these three great forces and how their interrelationship determines our experiences. As I said, vibrations around the line are not caused by the number of innovations or hard work. They are mainly due to the availability of loans. Let's briefly imagine an economy with no credit. In this economy I can only increase my expenses if I increase my income which demands more productivity and more work from me. Increased productivity is the only way to grow. Since my expenses are someone else's credit the economy grows every time I or others are more productive.

If we follow the transactions and continue doing so, shows an increase as with the productivity growth line. But since we borrow, we have cycles. It's not because of the laws or regulations but human nature and how credit works. Just think of borrowing as a way to drive spending. To buy something you don't have the money to do, you have to spend more than you make. So basically you need to borrow money from your future self. This creates a time in the future where you can't spend as much as you deserve to pay off your debt.

This very quickly resembles a cycle. So you create a cycle every time you borrow money. This applies to the individual as well as to the economy. This is why it is so important to understand credit because he's a future sets in motion a mechanical, predictable series of events. This is how credit is different from money. Money is used to complete transactions. If you pay for a beer with a bartender in cash, the transaction is completed immediately. However, if you pay for a beer with credit, it's like writing to you. They promise to pay in the future. You and the bartender create an asset and liability. You created credit out of nowhere. Only when you have paid the bill later, wealth and debt dissolve again. The guilt disappears and the transaction is complete. In reality, what most people call money is actually credit. The total amount of credit in the US is approximately $ 50 trillion, while the total sum of money is only 3 trillion. Remember, in a creditless economy: increased production is the only way to increase spending.

But in an economy with credit you can also increase your spending by borrowing. Result: an economy with credit can spend more and incomes can rise faster than productivity in the short term, but not in the long run. Do not get me wrong, Credit isn't necessarily something bad that just creates cycles. It is bad when it finances overconsumption that cannot be redeemed. However, he is good when he allocates funds efficiently and produces income to pay off debt. For example, if you buy a large television set on credit, this does not generate income for you to pay off the debt. But if you buy a tractor on credit – and this tractor helps them harvest more and make more money – you can pay off your debts and increase your standard of living. In an economy with credit we can follow the transactions and see how credit creates growth. I will give you an example: Say you make $ 100,000 a year with no debt. Your credit rating allows you to borrow $ 10,000 – let's say by credit card – now you can spend $ 110,000, even though you only earn 100,000.

Since your expenses are someone else's income, someone makes $ 110,000. The debt-free person with the $ 110,000 can borrow 11,000, and can spend $ 121,000 although she only made 110,000. Your expenses are someone else's income and by following the transactions, let's start to see how this process works in the self-affirming pattern. But don't forget that borrowing creates cycles. And when the cycle goes up, it has to come down at some point. This brings us to the short term debt cycle. We see expansion as economic activity increases – the first phase of the short-term debt cycle. Spending continues to rise and prices follow suit. This happens because the increased spending is fueled by loans, – which can be created instantly from nothing. When expenses and incomes grow faster than goods production, prices rise. When prices go up, we call it inflation. The central bank doesn't want high inflation, as this creates problems. An increase in price increases interest rates. When interest rates rise, fewer people can borrow money and the cost of existing debt increases. Think of it as if your credit card's monthly rate is increasing. Since less money is borrowed and you have higher debt repayments, there is less money left and spending is reduced.

And since the expenses of one are the income of the other, incomes decline … and so on and so forth. If you spend less, prices go down. We call this deflation. The economy is slowing down and we are in a recession. When the recession gets too bad and inflation is no longer a problem the central bank cuts interest rates so that the economy can recover. At low interest rates the redemption amounts decrease, Borrowing and consumption are picking up again, and we are experiencing another expansion.

As you can see, the economy works like a machine. In the short term debt cycle, consumption is only increased by willingness restrained by lenders and borrowers from giving and taking loans. When credit is easy to come by, the economy expands. If not, there's a recession. Note that this cycle is primarily controlled by the central bank. The short term debt cycle usually lasts 5-8 years and repeats itself over and over again for decades. Note, however, that the end and the beginning of every cycle generates more growth and debt than its predecessor. Why? Because the people push it – They tend to borrow and spend more instead of paying their debts.

It's human. Hence rise considered in the long term the debt faster than the income. This creates the long term debt cycle. Though people keep getting into debt Lenders are increasingly granting more permissive loans. Why? Because everyone thinks everything is going great! People only focus on what happened recently. And what has happened recently? Incomes have risen! Assets rise! The stock market is booming! We are on a boom! It pays to buy goods, services and equipment – with borrowed money! When that gets out of hand we call it a bubble.

So even though the debt has increased incomes rose almost as quickly to make up for them. Let's call the debt to income ratio the debt burden. As long as the income continues to rise the debt burden remains controllable. At the same time, assets are skyrocketing. The people take out huge loans to buy investment equipment, which make them even more expensive. People feel rich so that even with the accumulation of large debts, rising incomes and assets help borrowers to remain creditworthy for a long time. But of course this cannot go on forever. It doesn't either! Over the years, the debt burden slowly increases and the repayment amounts rise. At some point, the repayments grow faster than the income and force people. cut their expenses. And since the expenses of one are the income of the other, incomes go down … …. which leads to lower creditworthiness and less credit. The repayment payments continue to rise Spending will be further throttled …

… and the cycle is reversed. This is the long-term debt high. The debt burden just got too big. For the US, Europe, and most of the rest of the world, it is Happened in 2008. It happened for the same reason it happened in Japan in 1989 and in 1929 in the USA. Now the economy begins deleveraging. Debt reduction means: less spending, Income goes down, credit goes down, Investment prices fall, banks come under pressure, the stock market collapses, social tensions arise, and the whole system starts to eat itself up in reverse. With falling income and increasing repayments borrowers come under pressure. Are they no longer creditworthy the credit disappears and the borrowers run out of money for their repayments. In order to fill the hole, they are forced to sell their investments. The rush of asset sales is flooding the market, while spending is falling. At this point the stock market collapses the real estate market is bathing and the banks are getting into trouble. When asset values ​​decrease, the value of debtors' collateral decreases.

That makes them even less creditworthy. People feel penniless. There is a rapid decline in credit. Less consumption> less income> less prosperity> less credit> less borrowing, etc. It is a doom-loop. It looks like a recession, but the difference is in it is that interest rates cannot be lowered as a lifebuoy. In a recession, lowering interest rates stimulates borrowing. However, the interest rate cut is of no use in reducing debt, because the interest rates are already low, almost 0% – so the stimulation ends. Interest rates in the US fell to 0% during the deleveraging process the 30s, and again in 2008. The difference between a recession and a debt reduction is the debtor's debt reduction is simply too heavily indebted and cannot be relieved by a rate cut.

Lenders realize that the debt has gotten too large to ever pay off in full. The debtors are no longer repayable and their collateral has lost value. You feel hindered by guilt and don't want to anymore! Interest stops with lenders and borrowers. Think of the economy as bad credit similar to a person. So what do you do with deleveraging? The problem is that the debt burden is too high and needs to be reduced.

This can be done in four ways. 1. People, companies and the state are going on the back burner. 2. Debt is reduced through late payments and restructuring. 3. Wealth is redistributed from the "rich" to the "poor". and finally, 4. The central bank is printing new money. These 4 approaches have been used in every debt reduction process in modern history. As a rule, expenditure is cut first. As mentioned, people, companies, banks and even the state are stepping down and cut their spending to pay off their debts. This is often referred to as austerity. When borrowers stop taking out new loans and begin to pay off old debts, one would expect the debt burden to decrease.

But the opposite happens! Because the expenses are throttled – and the expenses of one are the income of the other – what leads to falling incomes. They fall faster than the repayment; the debt burden is even greater. We saw that this spending cut is deflationary and painful. Companies are forced to cut costs … which means less work and higher unemployment. This leads to the next step: debt needs to be reduced! Many borrowers are unable to repay their loans – and the debts of the borrowers are the assets of the lenders. When borrowers fail to repay the bank, one worries that the bank will could become insolvent. There is a storm on the banks. The banks are under pressure and People, Companies and banks are in arrears. This serious one economic downturn is a depression.

When people experience depression, the main thing they discover is that you assumed wealth does not exist. Let's go back to the bar. If you order a beer and have it written to you, promise to pay the bartender. Your promise becomes the bartender's "fortune". If you don't keep your promise – if you don't pay, and basically Bounce your bill – then his supposed "fortune" is worthless. Basically it no longer exists. Many lenders are reluctant to see their assets go away and are ready rescheduling. Debt rescheduling means lower repayment, over long periods of time, or at lower interest than originally agreed. Somehow a kind of breach of contract leads to debt reduction. The believer prefers that Sparrow in hand as the pigeon on the roof. Although the debt is dwindling, the debt restructuring leads to faster loss of income and assets and the debt burden continues to worsen.

Like cutting spending, so is reducing debt painful and deflationary. All of this affects the central government – less income, less work means less tax revenue. At the same time, spending is increasing due to rising unemployment. Many unemployed people hardly have any savings and need government support. There are also government funding packages, which also increase spending to help the economy. The state budget deficit is exploding Debt reduction because spending is higher than tax revenue.

That's what happens when there is news of the budget deficit. To finance the deficit, you need either taxes or the debt will be increased. Where should, however, with falling income and high unemployment the money come from? From the rich. Because the state needs more money and wealth is in their hands a small percentage of the population is the state increases the taxes of the rich, which facilitates the redistribution of wealth in the economy – from the "rich" to the "poor". The suffering "poor" begin to hate the rich. The rich, pressured by the weak economy – falling asset values, higher taxes – begin to hate the "poor". Persistent depression can lead to social unrest. The tensions not only rise in the country, they can also spread across borders – especially between creditor and debtor countries.

This can lead to political changes which can be extreme at times. In the 1930s this led to Hitler's rise to power, about war in Europe, about the economic crisis in the USA. The pressure to stop the economic crisis is increasing. Remember, people's supposed fortune was actually credit. So if the credit goes away, people don't have enough money. People are desperate for money. Do you remember who can print the money? The central bank.

After lowering interest rates to almost 0% – she is forced to print money. Unlike with spending cuts, Debt reduction, wealth distribution, money printing is inflationary and economic. Inevitably, the prints Central bank new money – out of nowhere – and use it to buy financial assets and government bonds. This is what happened in the USA at the time of the economic crisis, and again in 2008 when the US Federal Reserve – the Federal Reserve – printed over $ 2 trillion. Other central banks around the world that could also printed a lot of money. Buying financial assets with the money enables course prices to rise, making people creditworthy again. However, it only helps those who have financial assets. Because the central bank can print money, but only buy financial assets. The central government, on the other hand, can buy goods and services and bring the money to the population. But she can't print money.

So to stimulate the economy you have to both cooperate. By buying government bonds, the central bank lends to them State money, and allows it a deficit and increased spending for goods and services through funding programs and unemployment benefits. The national income increases but also the national debt. However it helps in lowering the overall debt burden of the economy. This is a very risky time. Decision makers need to follow the four avenues to Consider reducing the debt burden. Deflationary steps must offset inflationary steps to maintain stability. If balanced correctly, this can lead to a wonderful debt reduction result. You see, reducing debt can be hideous or beautiful. How Can Debt Reduction Be Beautiful? Although deleveraging is a difficult situation, its best possible handling can be beautiful. Better than the guilty, unbalanced excesses of the Debt phase. With good debt reduction debt decreases relative to income, real economic growth is positive, and inflation is not a problem. That is achieved through the right balance. The right balance requires a certain mix from spending cuts, debt reduction and wealth transfers and the printing of money to maintain economic and social stability.

One wonders if printing money increases inflation. No, not if it makes up for the lack of credit. As you know, it depends on the expenses. A dollar spent in cash has the same effect on the price as that Issue by credit payment. By printing money, the central bank can address the lack of credit make up for it with more money. In order to get a recovery, the central bank doesn't just have to do that Promote income growth, but also the rate of growth of revenue over the rate of interest Increase debt accumulation. What do I mean by that? In principle income must grow faster than debt. An example: Let's say a debt-reducing country has a debt-to- 100% income ratio.

This means that the amount of his debt corresponds to his annual income of the whole country. Now imagine the interest rate on that debt. Let's say it's 2%. When the debt grows by 2% due to the interest and income by only about 1%, you will never reduce the debt burden. You need to print enough money to keep the income rate above that Bring interest rate. However, printing money can easily be misused because it is simple and one prefers it to the alternatives. The point is, don't print too much money and not to cause undesirably high inflation, as in Germany during of the deleveraging of the 1920s. If the decision makers strike the right balance, deleveraging won't be as dramatic.

Growth is slow, but the debt burden is falling. That's nice deleveraging. As incomes rise, borrowers appear more creditworthy again. And when these seem more creditworthy again, Lenders are starting to offer loans again. The debt burden is beginning to decrease. People can borrow and spend again, the economy starts again to grow leading to the reflation phase of the long-term debt cycle. Although a poorly executed debt reduction process can be terrible, you can fix the problem at some point if handled correctly. It takes about a decade or more to reduce the debt burden and normalize the economy – hence the term "lost decade". To conclude: Of course, economics is a little more complicated than this guide suggests. But if you put the short-term debt cycle over the long-term and then both across the productivity growth line, makes this a relatively good guide to see where we have been where we are now and where we are likely to move. In short, there are three rules of thumb that I can give you from here want to give: First, don't let debt grow faster than income, otherwise one day debt will overwhelm you.

Second, don't let income grow faster than productivity, otherwise you will be unable to compete one day. And third: do everything you can to increase your productivity, because in the long term, that's what matters. This is simple advice for you and for policy makers too. You will be surprised, but most people – including policy makers – are aware of this unsatisfactory. This guide has served me well and I hope it helps you too. Thanks..

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