Summary
The economy is made up of transactions, which are driven by human nature. Transactions create the three main forces that drive the economy: (1) productivity growth, (2) the short term debt cycle, and (3) the long term debt cycle.
Transactions
The transaction is the building block of the economic machine. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets. Markets consist of the buyers and sellers for things such as wheat, cars, and steel.
Credit spends just like money. Credit + money = total spending, which drives the economy. Total spending / total quantity = price. If you add up total spending and total quantity of goods and services sold you have what you need to understand the economy.
Government
The biggest buyer and seller is the government, which comprises the central government and the central bank, which controls the amount of money and credit in the economy via interest rates and printing money. The central bank is an important player in the flow of credit, which is the most important part of the economy since it is the biggest and most volatile part.
Credit: borrowing creates cycles
Any two people can create credit -- which happens when borrowers promise to repay and lenders believe them. In contrast to money, which is used to settle transactions, credit is more like a bar tab. Most of what people call money is actually credit ($50 trillion vs. $3 trillion). In an economy without credit, the only way to make more money is to produce more.
When a borrower receives credit, he can increase spending, which drives the economy. Because one person's spending is another's income, increased income --> increased borrowing --> increased spending --> increased income --> and so on. Credit sets in motion a series of mechanical predictable events. We have cycles because we borrow.
As soon as credit is created, so is debt. Debt allows us to consume more than we produce when we acquire it and vice versa. An economy with credit has more spending and allows incomes to rise faster than productivity in the short run. Credit is fine when it finances investment in productive resources like a tractor and bad when it finances over-consumption that can't be paid back.
Productivity, Short-term debt cycle, Long-term debt cycle
Productivity creates long run growth. The overall trend of economic growth is positively sloped because of slow, steady productivity growth. Fluctuations around the trend are caused by short-term and long-term debt cycles (as mentioned- caused by borrowing).
The short-term debt cycle lasts 5-8 years. In the expansion phase, spending rises more than quantity produced. Eventually inflation picks up, and in response the central bank raises interest rates, leading to a contraction in which spending decreases faster than quantity produced.
The long-term debt cycle lasts 50-75 years. The ratio of debt to income -- the debt burden [private and public debt burdens] -- builds up over time through the short-term debt cycles. Eventually, the debt burden is simply too high and must come down. The long-term debt cycle ends in a deleveraging.
Deleveraging
At the end of a long-term debt cycle, a vicious cycle begins: Less spending -> less income -> less wealth -> less credit -> less borrowing
Lower interest rates stimulate borrowing in a recession but not a deleveraging because interest rates are already low. Rates hit 0% in the deleveraging of the 1930s and in 2008. Borrowers' debt burdens have gotten too big and can't be relieved by lowering interest rates. Lenders realize that debts have become too large to pay back, borrowers don't even want more debt, the entire economy is not creditworthy.
Four things happen in a deleveraging: (1) cut spending, (2) reduce debt, (3) redistribute wealth, and (4) print money. We saw all four in 1930s US, 1950s England, 1990s Japan, 2010s Spain and Italy.
(1) Cut spending: Spending is cut first. Austerity is deflationary because incomes fall faster than debts are repaid.
(2) Reduce debt: Next, banks get squeezed and we enter a depression where people discover that what they thought was their wealth isn't really there. At this point we need to default or restructure. Lenders don't want their assets to disappear (default) so eventually they agree to debt restructuring. Restructuring happens in one of three ways -- lower principal, lower interest rate, or extended maturity. Even though debt disappears, restructuring causes income and asset values to disappear faster, so the debt burden gets worse.
(3) Redistribute wealth: All of this affects the central government through lower tax revenues and higher unemployment spending. Governments need to raise taxes or borrow -- who does money come from? The rich [MMT might disagree..]. It facilitates redistribution from haves to have nots. The haves and have nots begin to resent each other. Tensions can arise not just within countries but also between debtor and creditor countries.
(4) Print money: People are desperate for money, and the central bank can print it. Printing money is inflationary and stimulative. The central bank prints money to buy financial assets and government bonds (over $2 trillion worth after the 2008 crash). Buying financial assets drives up asset prices, making people more creditworthy (the rich who already own financial assets). The central government on the other hand can buy goods and services. By buying government bonds, the central bank lends money to the government, allowing it to run a deficit and increase spending on goods & services (stimulus) and unemployment. This increases government debt but lowers the overall debt burden.
These deflationary and inflationary responses need to balance together for A Beautiful Deleveraging, in which (1) debts decline relative to income, (2) real economic growth is positive, and (3) inflation isn't a problem. It is achieved by having the right balance.
Inflation
Will printing money raise inflation? Not if it offsets falling credit, since a dollar in spending paid for with money has the same effect on price as a dollar in spending paid for with credit.
The central bank needs to print enough money to get the rate of income growth above the rate of interest, but it needs to avoid printing too much money, creating unacceptably high inflation.
Three rules of thumb
1) Don't have debt rise faster than income (because your debt burdens will eventually crush you)
2) Don't have income rise faster than productivity (because you'll eventually become uncompetitive)
3) Do all that you can to raise your productivity (because in the long run that's what matters most)
Notes
I have not seen a better 30-minute introduction to the economy. Of course I have some thoughts and mini gripes
- Minsky characterized the economic system as a system of interlocking balance sheets. Dalio's transactions focus is the "flow" version of that?
- Curious about the relative size of private and public debt burdens (usually I see these statistics as the assets/liabilities as a percent of GDP, not a comparison of the debt service coverage ratios)
- What's the link between the debt cycle and natural rate of interest (i.e., does it account for the decrease in interest rates due to the accumulation of capital and lack of investment opportunities)
- Makes austerity sound like a necessary -- I don't know if that's the case, although it is usually demanded first by creditors
- Rule of thumb number 3 --> ties into innovation policy
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