How The Economic Machine Works by Ray Dalio (2)

debt repayments are reduced

and borrowing and spending pick up

and we see another expansion.

As you can see, the economy works like a machine.

In the short term debt cycle, spending is constrained only by the willingness of

lenders and borrowers to provide and receive credit.

When credit is easily available, there's an economic expansion.

When credit isn't easily available, there's a recession.

And note that this cycle is controlled primarily by the central bank.

The short term debt cycle typically lasts 5 - 8 years

and happens over and over again for decades.

But notice that the bottom and

top of each cycle finish

with more growth than the previous cycle and with more debt.

Why?

Because people push it

— they have an inclination to borrow and spend more instead of paying back debt.

It's human nature.

Because of this,

over long periods of time,

debts rise faster than incomes

creating the Long Term Debt Cycle.

Despite people becoming more indebted,

lenders even more freely extend credit.

Why?

Because everybody thinks things are going great!

People are just focusing on what's been happening lately.

And what has been happening lately?

Incomes have been rising!

Asset values are going up!

The stock market roars!

It's a boom!

It pays to buy goods, services, and financial assets

with borrowed money!

When people do a lot of that, we call it a bubble.

So even though debts have been growing,

incomes have been growing nearly as fast to offset them.

Let's call the ratio of debt-to-income the debt burden.

So long as incomes continue to rise,

the debt burden stays manageable.

At the same time asset values soar.

People borrow huge amounts of money

to buy assets as investments

causing their prices to rise even higher.

People feel wealthy.

So even with the accumulation of lots of debt,

rising incomes and asset values help borrowers remain creditworthy for a long time.

But this obviously can not continue forever.

And it doesn't.

Over decades, debt burdens slowly increase creating larger and larger debt repayments.

At some point, debt repayments start growing faster than incomes

forcing people to cut back on their spending.

And since one person's spending is another person's income,

incomes begin to go down...

...which makes people less creditworthy causing borrowing to go down.

Debt repayments continue to rise

which makes spending drop even further...

...and the cycle reverses itself.

This is the long term debt peak.

Debt burdens have simply become too big.

For the United States, Europe and much of the rest of the world this

happened in 2008.

It happened for the same reason it happened in Japan in 1989

and in the United States back in 1929.

Now the economy begins Deleveraging.

In a deleveraging; people cut spending,

incomes fall, credit disappears,

assets prices drop, banks get squeezed,

the stock market crashes, social tensions rise

and the whole thing starts to feed on itself the other way.

As incomes fall and debt repayments rise,

borrowers get squeezed. No longer creditworthy,

credit dries up and borrowers can no longer borrow enough money to make their

debt repayments.

Scrambling to fill this hole, borrowers are forced to sell assets.

The rush to sell assets floods the market

This is when the stock market collapses,

the real estate market tanks and banks get into trouble.

As asset prices drop, the value of the collateral borrowers can put up drops.

This makes borrowers even less creditworthy.

People feel poor.

Credit rapidly disappears. Less spending ›

less income ›

less wealth ›

less credit ›

less borrowing and so on.

It's a vicious cycle.

This appears similar to a recession but the difference here

is that interest rates can't be lowered to save the day.

In a recession, lowering interest rates works to stimulate the borrowing.

However, in a deleveraging, lowering interest rates doesn't work because

interest rates are already

low and soon hit 0% - so the stimulation ends.

Interest rates in the United States hit 0% during the deleveraging of

the 1930s

and again in 2008.

The difference between a recession

and a deleveraging is that in a deleveraging borrowers' debt burdens have

simply gotten too big

and can't be relieved by lowering interest rates.

Lenders realize that debts have become too large to ever be fully paid back.

Borrowers have lost their ability to repay and their collateral has lost value.

They feel crippled by the debt - they don't even want more!

Lenders stop lending. Borrowers stop borrowing.

Think of the economy as being not-creditworthy,

just like an individual.

So what do you do about a deleveraging?

The problem is debt burdens are too high and they must come down.

There are four ways this can happen.

1. people, businesses, and governments cut their spending. 2. debts are reduced through defaults and restructurings. 3. wealth is redistributed from the 'haves' to the 'have nots'. and finally, 4. the central bank prints new money.

These 4 ways have happened in every deleveraging in modern history.

Usually, spending is cut first.

As we just saw, people, businesses, banks and even governments tighten their belts and

cut their spending so that they can pay down their debt.

This is often referred to as austerity.

When borrowers stop taking on new debts,

and start paying down old debts, you might expect the debt burden to decrease.

But the opposite happens! Because spending is cut

- and one man's spending is another man's income - it causes

incomes to fall. They fall faster than debts are repaid

and the debt burden actually gets worse. As we've seen,

this cut in spending is deflationary and painful.

Businesses are forced to cut costs...

which means less jobs and higher unemployment.

This leads to the next step: debts must be reduced!

Many borrowers find themselves unable to repay their loans

— and a borrower's debts are a lender's assets.

When borrowers don't repay the bank, people get nervous that the bank won't

be able to repay them

so they rush to withdraw their money from the bank. Banks get squeezed and

people,

businesses and banks default on their debts. This severe

economic contraction is a depression.

A big part of a depression is people discovering much of what they thought

was their wealth isn't really there.

Let's go back to the bar.

When you bought a beer and put it on a bar tab,

you promised to repay the bartender. Your promise became an asset of the bartender.

But if you break your promise - if you don't pay him back and essentially default

on your bar tab -

then the 'asset' he has isn't really worth anything.

It has basically disappeared.

Many lenders don't want their assets to disappear and agree to debt

restructuring.

Debt restructuring means lenders get paid back

less or get paid back over a longer time frame

or at a lower interest rate that was first agreed. Somehow

a contract is broken in a way that reduces debt. Lenders would rather have a

little of something than all of nothing.

Even though debt disappears, debt restructuring causes

income and asset values to disappear faster,

so the debt burden continues to gets worse.

Like cutting spending, debt reduction

is also painful and deflationary.

All of this impacts the central government because lower incomes and less employment

means the government collects fewer taxes.

At the same time it needs to increase its spending because unemployment has risen.

Many of the unemployed have inadequate savings

and need financial support from the government.

Additionally, governments create stimulus plans

and increase their spending to make up for the decrease in the economy.

Governments' budget deficits explode in a

deleveraging because they spend more than they earn in taxes.

This is what is happening when you hear about the budget deficit on the news.

To fund their deficits, governments need to either raise taxes

or borrow money. But with incomes falling and so many unemployed,

who is the money going to come from? The rich.

Since governments need more money and since wealth is heavily concentrated in

the hands of a small percentage of the people,

governments naturally raise taxes on the wealthy

which facilitates a redistribution of wealth in the economy -

from the 'haves' to the 'have nots'. The 'have-nots,' who are suffering, begin to

resent the wealthy 'haves.'

The wealthy 'haves,' being squeezed by the weak economy, falling asset prices,

higher taxes, begin to resent the 'have nots.'

If the depression continues social disorder can break out.

Not only do tensions rise within countries,

they can rise between countries - especially debtor and creditor countries.

This situation can lead to political change

that can sometimes be extreme.

In the 1930s, this led to Hitler coming to power,

war in Europe, and depression in the United States. Pressure to do something

to end the depression increases.

Remember, most of what people thought was money was actually credit.

So, when credit disappears, people don't have enough money.

People are desperate for money and you remember who can print money?

The Central Bank can.

Having already lowered its interest rates to nearly 0

- it's forced to print money. Unlike cutting spending,

debt reduction, and wealth redistribution,

printing money is inflationary and stimulative. Inevitably, the central bank

prints new money

— out of thin air — and uses it to buy financial assets

and government bonds. It happened in the United States during the Great Depression

and again in 2008, when the United States' central bank —

the Federal Reserve — printed over two trillion dollars.

Other central banks around the world that could, printed a lot of money, too.

By buying financial assets with this money,

it helps drive up asset prices which makes people more creditworthy.

However, this only helps those who own financial assets.

You see, the central bank can print money but it can only buy financial assets.

The Central Government, on the other hand,

can buy goods and services and put money in the hands of the people

but it can't print money. So, in order to stimulate the economy, the two

must cooperate.

By buying government bonds, the Central Bank essentially lends money to the

government,

allowing it to run a deficit and increase spending

on goods and services through its stimulus programs

and unemployment benefits. This increases people's income

as well as the government's debt. However,

it will lower the economy's total debt burden.

This is a very risky time. Policy makers need to balance the four ways that debt

burdens come down.

The deflationary ways need to balance with the inflationary ways in

order to maintain stability.

If balanced correctly, there can be a

Beautiful Deleveraging.

You see, a deleveraging can be ugly or it can be beautiful.

How can a deleveraging be beautiful?

Even though a deleveraging is a difficult situation,

handling a difficult situation in the best possible way is beautiful.

A lot more beautiful than the debt-fueled, unbalanced excesses of the

leveraging phase. In a beautiful deleveraging,

debts decline relative to income, real economic growth is positive,

and inflation isn't a problem. It is achieved by having the right balance.

The right balance requires a certain mix

of cutting spending, reducing debt, transferring wealth

and printing money so that economic and social stability can be maintained.

People ask if printing money will raise inflation.

It won't if it offsets falling credit. Remember, spending is what matters.

A dollar of spending paid for with money has the same effect on price as a dollar

of spending paid for with credit.

By printing money, the Central Bank can make up for the disappearance of credit

with an increase in the amount of money.

In order to turn things around, the Central Bank needs to not only pump up

income growth

but get the rate of income growth higher than the rate of interest on the

accumulated debt.

So, what do I mean by that? Basically,

income needs to grow faster than debt grows. For example:

let's assume that a country going through a deleveraging has a debt-to-

income ratio of 100%.