How economic cycles work, explained by Ray Dalio

Editor’s note: This article was first published in February 2018. Descriptions such as “largest hedge fund in the world” and “the US is now doing quantitative easing” reflect 2013–2018, and the slideshow dates from 2013. Dalio stepped down from running Bridgewater in 2022.

Ray Dalio runs the largest hedge fund in the world, Bridgewater Associates, so when he talks, we should simply listen. He is also known for explaining financial and economic terms in a very simple way.

Everyone respects Dalio and his views, especially given his flawless track record on Wall Street. Dalio set out to explain the economy in a 30-minute video (in English), which you can watch at the end of this article, and in an explanation in PDF (also in English), so that anyone can understand it.

He apologises in advance for how simple his explanation is, but says that keeping the terms simple is what has kept him away from many big mistakes, and helped him sidestep the financial crisis. This sequence of slides comes courtesy of Business Insider, which summarised Ray Dalio’s explanation of the economy.

The three main forces driving the economy: productivity growth, the short-term debt cycle and the long-term debt cycle

1. Stack them on top of each other and you get the economic “cycle”.
2. Transactions are the cornerstone of the economy. They are simply buying and selling, and we make transactions like these all the time.
3. You can make a transaction with money or with credit, and that gives you total spending.
4. If you take total spending and divide it by the total quantity, you get the price. “If we can understand transactions, we can understand the whole economy,” says Dalio.
5. A market is nothing more than all the buyers and sellers making transactions all the time.
6. There are thousands of different markets, and the economy is made up of all the transactions in all the markets.
7. People, banks, companies and governments all over the world interact through transactions.
8. At the heart of this is the central bank, which controls interest rates and the money supply. That way, the central bank influences the flow of credit.
9. And credit is essential.
10. Without credit, the modern economy would be very different. Because we have credit, lenders use it to make more money and borrowers use it to buy something they can’t pay for straight away.
11. The borrower promises to repay a loan in the future and also pays interest on that loan.
12. Once the bank extends credit, it becomes debt for the borrower.
13. The debt is a “liability” for the borrower, but an “asset” for the bank.
14. In the short term, more credit is good for the economy, because one person’s spending is another person’s income. If more people have more money through credit, the economy grows.
15. So a “creditworthy borrower” (someone banks should and will lend to) is a person who has both the ability to repay (income) and collateral, just in case (a house, financial assets).
16. The act of borrowing creates a “cycle”.
17. The problem is that borrowers are too close to the “short-term debt cycle” line to really understand the impact of their borrowing decisions.
18. It’s human nature to want to borrow to get the things we want now. Thanks to credit, you can always pay it back later!
19. It’s hard to step back and see short-term debt against long-term debt and productivity.
20. If that’s a gloomy picture, what would an economy without credit look like? Well, the only way to increase spending (and therefore growth) would be to increase productivity.
21. But we do have a credit system. If I earn 100,000 euros a year, the bank gives me 10,000 euros in credit. Now I have 110,000 euros to spend. And since my spending is your income, now that you’ve earned 110,000 euros you can get 11,000 euros from the bank.
22. And so on. The credit cycle stimulates growth.
23. But the central bank doesn’t want things to get out of hand, so it raises and lowers interest rates to encourage or reduce the amount of lending.
24. That’s because a central bank has to keep an eye on the debt burden.
25. Notice how, in 2008, the debt burden was out of control. Credit conditions were very easy and people borrowed too much.
26. When things start heading “south”, you can get a recession and social unrest.
27. The system is forced to take a rest. This is called deleveraging, and it’s what happened after the financial crisis.
28. Now we want to get lending going again, but the problem is that the central bank has already brought interest rates down as low as it can.
29. Banks worry about whether they’ll actually get paid back. Lending suffers.
30. There are four ways to reduce leverage. Most people have an appetite for the last option (printing money), because it feels better in the short term.
31. One way to deleverage is through debt restructuring. Basically, banks would rather have something of something than all of nothing.
32. Governments and households can cut spending. We know this as austerity. The government can also redistribute wealth, hoping it will help the economy grow as people spend more.
33. That means you have to raise taxes on the rich.
34. The central bank also buys financial assets and government bonds. This helps relieve the system.
35. The US is now going through a process known as quantitative easing. As you can see, the reaction to the financial crisis resembles that of the 1930s.
36. So what makes a so-called “beautiful” deleveraging?
37. It’s the right balance between deflationary measures (austerity, debt restructuring, income redistribution) and inflationary measures (printing money, central bank bond buying).
38. You want incomes to rise faster than debts, banks to lend and you to be able to borrow.
39. Look at the timing, though. Deleveraging takes a long time, sometimes known as a “lost decade”.
40. For Dalio, this is the key issue: the short-term debt line, the long-term debt line and the productivity growth line. Looking at these three lines together can show where we have been, where we are and where we are heading.
41. If debts grow faster than incomes, the debt burden will crush us.
42. If income rises faster than productivity, you will eventually stop being competitive.
43. In the long run, productivity is what matters most. Credit comes and goes, but notice how productivity keeps rising steadily. That goes for governments and individuals alike.

Ray Dalio’s video

Watch: How the Economic Machine Works, by Ray Dalio

Featured image: National Archives Photo, Public domain, via Wikimedia Commons.