I feel a deep sense of responsibility to share my simple but practical economic template
-Ray Dalio

Here’s a simple and straightforward explanation of how the US economy works from hedge fund manager Ray Dalio. Keep in mind that this explanation is a theory, albeit a very pragmatic one, and not definitive law. That being said it’s probably the best 30 minutes of economic education out there on the inter-web. For those who don’t have 30 minutes here’s the high points:

Basics Of The Economy

• Transactions are driven by human nature and create three main forces that drive the economy
  1. Productivity Growth
  2. The Short Term Debt Cycle
  3. The Long Term Debt Cycle
• An economy is simply the sum of all transactions occurring in a specified area or region. A transaction is an exchange of money or credit for goods, services or financial assets.
• Credit and money are spent in the same way. Spending drives the economy
  Money Spent + Credit Spent = Total Spending
• Price relates total spending to the total quantity of goods sold
  Price = (Total Spending) / (Total Quantity Sold)
• Money is used to settle transactions, but credit is the more important part of the economy as it allows a borrower to increase their spending.
• Credit is created out of thin air when it is extended by a lender to a borrower. Credit is an asset to the lender and a liability (debt) to the borrower.
• Extending credit to borrowers drives short-term economic cycles by allowing borrowers to spend and consume more than they earn in the short run.
• Without credit the only way to increase economic growth is to increase productivity. Productivity is achieved through innovation and hard work and rises slowly over time.
• Borrowing is simply a way of pulling spending forward. Borrowing to spend now means spending less in the future to repay the debt. Therefore, borrowing creates cycles which apply to individuals, businesses and the overall economy.
• Credit is bad when it finances excess consumption that can’t be paid back. It’s good when it efficiently allocates resources and helps to produce additional income that can be used to repay the debt.

The Short-Term Debt Cycle

• Credit allows people to borrow money and spend more than their income. The spending of one person is the income of another. When incomes rise people become more credit worthy and lenders are more willing to extend additional credit, which creates even more spending. This self-reinforced increase in spending creates an economic expansion.
• When spending increases faster than the production of goods, prices will increase and cause inflation.
• The central bank controls inflation by raising interest rates, which makes borrowing money more expensive. When borrowing is more expensive, less credit is created and there is less spending as a result.
• When spending decreases faster than the production of goods, prices decline and cause deflation.
• Decreased spending also leads to a reduction of income and sends the economy into a recession.
• A short-term debt cycle typically lasts around 5 to 8 years.

The Long-Term Debt Cycle

• People and businesses borrow and spend more than they use to repay the debt they have. As a result each short-term debt cycle ends with slightly more growth and slightly more debt.
• Over long periods these debt burdens slowly increase and debt repayments begin growing faster than incomes. This results in a reduction of spending.
• Debt Burden = (Total Debt) / (Total Income)
• When the long-term debt peak is reached a process of deleveraging (repayment of debts) occurs. In a deleveraging spending is reduced, incomes fall, credit disappears and asset prices drop. Debt burdens cannot be relieved by reducing interest rates.
• There are four ways to reduce the debt burden during a deleveraging:
  1. People, businesses and governments reduce spending (austerity)
  2. Debts are reduced through defaults and restructuring
  3. Wealth is redistributed from the rich to the poor
  4. The central bank prints new money
• Austerity: A reduction in spending also causes incomes to decline and is deflationary. Businesses are forced to cut costs and unemployment increases. Debtors become less able to pay back their loans and are more likely to default. Incomes fall faster than debts are repaid. This is action is deflationary and causes the debt burden to get worse.
• Defaults & Restructuring: Lenders want to avoid defaults as they end up losing assets. Therefore, they restructure debts so that they receive something rather than nothing.
• Wealth Redistribution: Lower incomes and higher unemployment means the government collects less taxes but must increase spending on welfare and stimulus programs (the government runs a deficit). To help fund these activities the government can raise taxes on the wealthy to redistribute money to the less fortunate.
• Money Printing: Credit has essentially disappeared but people and businesses still need money. The central bank can print money to purchase government bonds and financial assets. This allows the government to fund stimulus programs and the prices of financial assets to rise. Unlike the other actions printing money stimulates economic growth and leads to increased spending and higher prices. It is inflationary.
• The four methods of debt reduction need to be balanced in order to create social stability. When balanced correctly, a “beautiful deleveraging” will cause debts to decline relative to income, real economic growth will be positive and inflation won’t be a problem.
• Printing money won’t lead to excessive inflation if it offsets the reduction in credit. The rate of income growth needs to balance with the rate of debt reduction.
• It takes approximately a decade (sometimes longer) for the debt burden to decline and normal economic activity to pick up.
• Dalio’s three rules of thumb
  1. Don’t let your debt rise faster than your income
  2. Don’t let your income rise faster than your productivity
  3. Do everything possible to increase your productivity

UPDATE
2 January 2017
Updated link to Dalio’s Economic Principles paper

• What Billionaire Ray Dalio Gets Wrong About Money (Bloomberg)
• Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves (Paul Sheard)
• The Basics of Banking (Cullen Roche)