A Quick Recap
To continue with the main points from Ray Dalio’s video called How The Economic Machine Works, I’ll note specifics and illustrations from the video, and this time will include a few historical examples and observations of exactly what he’s talking about, and how it’s perhaps affected us within the last few decades. If you’d like to recap Part 1, Click Here. You can also tune into the video again by watching here –
We left off in Part 1 describing the economic expansion part of the economic cycle, where the economy is generally humming along. Incomes are rising, unemployment is low, most people can pay off their debts, the economy is expanding due to more credit being created (through higher incomes), home prices are rising, stocks are rising, and everything is generally pretty peachy.
We all know this doesn’t last forever. But why? Why does it seem like every 5-10 years like clockwork there is some sort of calamity throughout the country? Whereby either the stock market crashes (2000 and 2008), housing crashes (early 90’s, mid-2000’s), and unemployment spikes and falls almost to a rhythm?
*Sidenote on unemployment – I actually find it quite fascinating how consistent the unemployment rate lowers and spikes throughout the last 70 years or so. Take a look at this FRED (Federal Reserve Bank of St. Louis) graph below of the unemployment rates over time. This all has to do with the nature of the economic cycles Dalio describes.
If you take a look at the graph, and if we agree that the economic system and “ruleset” we live in has not changed, where perhaps might the unemployment go from here, in November of 2019? As of this writing, we are sitting at a 50 year low at a 3.6% unemployment rate, with the summer of 1969 being the last time it was down this low.
As Dalio explains, this is all part of the monetary and economic cycles we live in. And the bottom line is –
Borrowing Creates Cycles
Productivity over time is not what creates cycles, debt is. Debt allows us to buy and consume more than we produce when we acquire it, and forces us to buy or consume less when we have to pay it back.
Another way to think of it is that you are borrowing now from your future self. If you only have $500 today but you want a new fancy $1,000 TV, you are borrowing from your future self, whereby you’ll need an extra $500 on top of your living expenses, plus interest as a cost of taking on more than you can afford now. You will need to spend much less than you are earning at that point in time so that you can pay it off.
So because we are borrowing from the future, when we actually get to that point in the future, we have less money to spend, creating the downcycle effect. Everyone more-or-less acts the same at the same time, coming back to the emphasis on human behavior and psychology. We’re all doing it together, creating the whole economic cycle.
Most people don’t see these cycle swings because we are too up-close – day-to-day, week-by-week.
The size of the cycles and swings depend really on how much debt there is in the system. In an economy with no debt, there’s more of a straight line, constant growth, because we’re paying with things in full with funds we have right now. With a lot more debt in the system, the swings are more violent.
Recent Cycle Examples
Take a look at the housing price index just from the past 15 years or so. The last economic crash in 2008 was focused mostly on the housing market, whereby many took on huge amounts of debt to buy houses, more than what could eventually be paid back. Everyone was in on it – think of The Big Short movie. When the downcycle hit housing prices in many cities and states got hit very hard, and some areas have not even recovered yet to reach previous highs 8-10 years earlier.
Take a look at the 40-50% corrections in the S&P 500 stock market in the early 2000s and then about 7-8 years later, and the subsequent bull run that happened afterward and that continues (for now).
The two above examples are recently painful times whereby the cycles shifted downward due in large part to too much debt being in the system, and the inability to pay it. This includes everyone – Wall Street banks, individuals, corporations, city, state, and federal governments around the world. We’ll talk about how the recoveries are engineered soon here. Back to the video!
Credit is Not The Same as Money
Credit is different from money. Money is what you settle transactions with right now. Credit is like starting a bar tab – you are promising to pay in the future. Together you’re crediting an asset and a liability. This creates credit out of thin air, not unlike the central banks. When these cycles are set in motion – it is predictable in a mechanical way.
Most of what we call money is actually called credit. The actual amount of money floating around is only about $3 trillion, while the amount of credit is upwards of $50 trillion.
In economies without credit, you have to produce more to make more. In economies with credit, you can also increase your spending by borrowing. So with more debt and credit existing, this economy has more spending, incomes rise faster over the short run, but not over the long run, because at some point you have to pay this back.
Credit is not bad in and of itself, it’s only bad when you borrow too much and you cannot pay it back. It’s good however when you can use it to produce more income for yourself.
The Entire Basis of Personal Finance and Getting Ahead
I wanted to specifically separate these two images below. If we ignore for a minute everything discussed so far other than just our own funds from a personal perspective – these two images sum up the entire basis of why we can either get ahead financially or fall behind. The key to all of it is –
If you spend your money buying more assets than liabilities over time, you will become more wealthy.
You can also use debt smartly to increase your buying power to buy more assets, which speeds up your income. Some call this “good debt”.
An asset is defined officially as a useful or valuable thing, person, or quality. I would like to add to that in that in real the world an asset is –
Something that goes up in value over time, due to the scarcity or perceived long-term value of it, and/or its ability to produce income.
If you buy assets that produce an income or are known to go up over time – business, real estate, land, tools for your job, a tractor to plow your field above, gold, classic cars, antiques, etc, you’ll be able to generate income to pay this back, or sell it in the future for a higher value than what you paid for it today. Another key note –
The wealthy use their money to buy more assets, and proportionally way fewer liabilities.
If you borrow for buying TV’s, cars, cell phones and other things like this, it does not generate any income for you to pay this debt back (with interest) and improve your living standards. You will always need to earn more and more money to pay these debts down, and the liabilities you bought will lose value over time.
At the end of the day – borrowing creates cycles. What goes up must come down. What is borrowed from your future self, must be paid back, with interest.
On the up-cycle – spending (+borrowing) continues to rise. But when the amount of spending and incomes rise faster than the production of goods or things available in the market, this creates –
Inflation and Deflation
Have you noticed the price of groceries lately? Or really anything – housing, cars, insurance, health care, etc.
The central banks around the world are monitoring and manipulating inflation – because they want to keep this number at a target they set for various reasons. This is a whole other topic of debate, but in the USA, the actual goal for inflation per year is 2%. The European Central Bank (ECB) has the same target. It is not a coincidence. What they’re saying is – they are trying to make sure that prices rise 2% per year.
Inflation is simply the cost of things going up, and we see this all around us.
What this means is that all else being equal – unless your earnings/wages rise at least 2% per year along with it, you will fall behind.
When they want to slow down price growth/inflation – they raise interest rates, making borrowing more expensive.
When they want to boost inflation or prices – they lower interest rates, making borrowing cheaper.
Here is a chart of about the last 70 years of the federal funds rate. This is the lever that the central banks move up and down to control the levels of inflation and other factors.
Federal Funds Rate
Since the Great Recession in 2008 – you can see how low interest rates have been kept. As of November 2019, we are at only 1.5%, after almost a decade of being at literally 0% to spur the economy after the 08 recession. This helps explain the huge run-up in the stock market and expensive housing since then. This also affects things like personal loans, mortgages, credit card rates, auto loan rates, etc.
When interest rates are low, borrowing is cheaper, which creates more debt, and allows you to purchase more of something. This pushes up asset prices, and it’s no wonder that many cannot afford homes these days. You can see in real-time the direct correlation between these things.
So now when they raise interest rates, this sets off the cycle in the other direction – downward.
Higher interest rates mean less borrowing. Less borrowing means less spending. Since my spending is your income, incomes also go down. The cycle has now gone down, but the debt from before remains.
This creates Deflation. People are now spending less, therefore prices go down.
Overall economic activity decreases, and this is what causes a Recession.
The central banks want inflation, so recessions and deflation are the enemies. They will do anything in their power to spur growth and inflation again, and do this again by using two of their tools –
- Lowering interest rates and
- Printing money.
They are doing both of these right now as I write this.
Lower interest rates mean debt payments are now cheaper. There are also defaults & bankruptcies, wiping out some of the debt from before – effectively clearing out credit from the system.
Short-Term Debt Cycle Completed
With all these forces (natural and unnatural) at work, the cycle now turns upward again. This completes the short-term debt cycle, which happens over and over again every 5-8 years.
The short term debt cycles finish each cycle with more growth, but also more debt. So the long-term debt cycle is still trending upwards, as there are many small short term cycles within it.
Why then does this happen? Because of human nature. People push it. People want to borrow and spend more instead of paying it back. Look at our government, corporations, personal debt, and everything else around us. All-time highs everywhere.
So with this long term debt cycle – over long periods of time, debts continue to mount and rise faster than incomes (75-100 years).
More debt is given out. It’s party time! Incomes are rising, asset values continue to go up, stock markets have new highs every week! It pays to buy things with borrowed money.
Well, this is great only as long as income continues to rise enough to pay off the debt burden. This is also called creditworthiness.
At this same time – everything starts costing more. Everyone’s borrowing to spend more, buy stuff (even though it’s getting very expensive), and generally feel wealthy, even with a ton more debt. This cannot continue forever…and it won’t.
The Bubble Bursts
Over decades the debt piles up, pushing debt repayments well above incomes. Now people cut back on spending, and the long term cycle turns south (same reasons as the short term cycle). This is the long term cycle peak. The debt has become too big. This was what happened throughout the entire world in 2008, and in the USA in 1929 (79 years apart), for example.
What happens when the bubble bursts? Now we go into a deleveraging phase – which is to basically evaporate debt in the system. How?
People cut spending, incomes fall, defaults & bankruptcies happen, asset prices (stocks/real estate/other) fall, there are runs on the bank (people storm the banks to get their cash out) and banks start failing, social tensions rise, and the whole thing feeds on itself in a downward spiral.
People start selling things they own to repay their debts and try to stay solvent. This drives prices down and perhaps creates crashes in the stock market, real estate, etc.
The whole system is crippled. Lenders won’t lend, people can’t borrow, and central banks manipulating interest rates do nothing.
The rush to sell assets like stocks and real estate floods the market at the same time that spending and incomes fall. Values drop, and the collateral that borrowers have dries up, making everyone even less creditworthy. People feel poor, cautious, and depressed, and this constantly feeds on itself.
The big difference in this long term cycle downshift is that interest rates can’t be lowered anymore to save the economy. With interest rates already at zero – you cannot stimulate borrowing anymore.
The Economy Itself is Uncreditworthy
We have to eliminate debt in the system, which has become too large to ever be paid back. We are crippled and the math simply doesn’t work. The economy itself is now uncreditworthy.
So what now? We’ll continue in Part 3 – which explains the four main tools used historically to get out of this cyclical mess. These tools are used, once again, over and over throughout most countries over the past centuries.
As the famous investor Howard Marks says in his book about market cycle timing and prudent investing The Most Important Thing – while we cannot predict the future, we can look around and have a pretty good idea of where we are right now in the cycle.
“You can’t predict. You can prepare.”Howard Marks
With federal deficits approaching $1 trillion per year, markets at all-time highs, unemployment at a 50 year low, the wealth gap at the highest level since the ’30s, personal and corporate debts at all-time highs, real estate at all-time highs, where do we go from here? The Fed funds rate is also only at 1.5% right now. Will going back to zero really have much impact when we hit the next recession? We have already been at near-zero since 2008. We can’t say for sure but we can see what’s happened in the past in similar situations.
If we agree the system hasn’t changed, and that the central banks will continue to act in the same way, then Ray Dalio’s video may very well give us some clues as to what may happen next. As the saying goes – while history doesn’t repeat itself, it often rhymes.