How The Economic Machine Works

Have you ever watched a news segment or read an article about fancy economic stuff and then realized you didn’t understand a thing they were saying? It happens a lot, even to people that have fancy degrees that are supposed to know this stuff. In times like that, I watch this.

Today’s book is not a book but a video (though I’ll still call this a BookMarc). The video we will be discussing today is How the Economic Machine Works by Ray Dalio.

I have watched this video in its entirety about two dozen times. It’s a regular go-to for me and I revisit it a few times a year, mostly in situations that I described above. In any kind of complex yet everyday field, I find that it is important to have a methodology that you follow. This “economic machine” video is a simpleton way to look at the economy, which can be complex, but is still fairly comprehensive. It acts as my economic manual and I hope more of you will use it as a resource as well.

Levers for Deleveraging

The four levers that can be used during a debt crisis as discussed in the video are: cut spending, reduce debt, redistribute wealth, and increase the amount of money printed.

A case is made that through the use of credit, a short-term debt cycle is unavoidable. At the point where debt is at its peak and is unsustainable, a deleveraging must take place in order for the debt to be reduced compared to income levels. The solutions to deleveraging are addressed in the following ways:

Cut Spending – There comes a time where debt/spending can no longer be maintained and that debt should be paid down. It is at this point that money that would normally go towards spending needs be redirected to pay down the debt. In personal lives, that would mean that your credit card is too high, and instead of eating out a few times a week, you need to eat in and put that money towards paying down your credit card bill. Countries may take on too much debt for various reasons (promote economic growth, crisis management, budget shortfalls, etc…). In response to debts accrued during lean times, those nations are supposed to curb their spending to pay those loans down during booming periods. Realistically, I don’t foresee federal government spending getting cut much. Local governments, on the other hand, are clearly cutting back their budget to help with their revenue shortfalls.

Reduce Debt – This lever is more than just paying down debt. This means that a) the debt is defaulted on and written down to zero by the lender or b) the debt is restructured to keep the loan out of default but with less obligation for the borrower (like lowering the loan amount of the loan or reducing its interest). When home loans are foreclosed on, the loan that was outstanding goes away, including on a bank’s balance sheet. Conversely, when a country owes debts that it cannot pay, it looks to restructure its debt with its creditors, as Argentina did early in August as it took $65BB and reduced it to about $36BB. A lender restructures debt because they would not like to write off the entire debt but they know the only way they will get paid anything is if the terms of the repayment are reasonable for the borrower. 

Redistribute Wealth – Taxation comes into play here. When governments have an income shortfall and they are dealing with many people out of jobs or otherwise struggling, they look to tax the rich as those taxpayers have the means to pay. Whether or not this taxation is fair to the rich is another question, but governments, in general, will look to those that have to help those that have-not. This lever pushes a lot of buttons on both the rich and the poor side causing each view to be more polarized.

Print Money – Lastly, the government can simply print their own currency, particularly if their currency is one that many people throughout the world use and trust. If existing national debt payments are difficult to meet, the government can simply print more money to more easily make them. Additionally, if new debt needs to be raised to juice the economy, the country can simply print money and lend it out. The reason that strong countries with trust in their currency can print more money better than struggling countries is that the associated government will probably pay it back. There is a low risk in the strong country defaulting on their obligations. Because that currency poses as a low-risk, then international trade and wealth storage is done in those currencies.  That makes the global use of the currency prevalent.

The US is producing a currency that the world uses. China, England, and the Eurozone also have a strong currency. Argentina does not. Inflation has been rampant in Argentina for years and this year is at over 50%. If people outside of Argentina were paid in the Argentine peso or kept their money in Argentine banks, they would lose money. If you told your boss that you wanted a salary of $1MM Argentine pesos a year (only about $14K in USD) you would probably be making only the equivalent of $7K in USD by next year, though still earning $1MM pesos. Argentina can print more money but it is kind of like Monopoly money after a while. Zimbabwe had a really bad problem with hyper-inflation as well where they had crazy dollar amounts. Here is a 100 Trillion Dollar note; its value is as a novelty now.

What levers will be utilized during this recovery? Will politicians look to cut spending and lower debts that way? Will the US renegotiate their debts? Worse, is the US in danger of defaulting? What will taxes look like under either party’s rule? 

Total Money In System = Cash + Credit

As per the video, which is dated, Mr. Dalio says that there is $3TT of cash circulating and $50TT of credit. Through my research, I have found less than $2TT in cash circulating and less than $20TT in credit. My research, however, is elementary and I would imagine that Bridgewater Associates (Mr. Dalio’s company and the largest hedge fund in the world) has much better research at their disposal…so I would go with his estimate. Credit has gone up since 2013 when this video was published so my guess is that the figure is larger than his reported $50TT number. Still, the main point made here is that credit outlay is much larger than cash but is all considered money in the system.

In the Great Recession, quantitative easing (QE) of $3.9TT meant that the amount of cash committed by the Fed went up about 575% over four years, which should be inflationary. I had expected inflation at the time! However, credit went down at the same time as cash increasing. Companies went bankrupt, mortgages were defaulted on, and people/businesses were less-credit-worthy due to lower incomes. Inflation did not happen because the unprecedented amount of cash printed (as the government used it to meet obligations that it committed to during QE) did not exceed the number of credit losses. The cash and credit scales balanced. Because there was not a lot more overall money in the system, hyperinflation did not happen, as it stayed between -2.1% and 3.9% during that time, within the normal range. I was missing the credit part of the equation when expecting inflation to rise.

Now we are seeing a much larger stimulus-response. The Fed has deployed $3TT more in commitments in only a few months. The CARES Act was $2.2TT. The HEROES Act will probably be around another $2TT. That amounts to over $7TT in commitments and we are half a year in. The total response will probably be 3 times larger than in The Great Recession within only a year from the coronavirus fallout. Cash is increasing greatly.

Initially, it seems like this pandemic could cause a number of bankruptcies or foreclosures as it did last time, which would mean credit loss might offset the increase in cash. If that were the case it would mean that the total amount of money in the monetary system would be flat as was the case in the Great Recession. However, new loans, particularly corporate loans and high-yield loans, have become prevalent, based on what I have seen on companies’ balance sheets and the low-interest-rate environment. 

Most recent data still shows Q4 of 2019 for consumer and corporate credit and nothing later, so it is a guessing game as to whether credit has indeed grown or fallen in the monetary system. It is most likely that there is more credit that is in the system now than at the end of the year. The money supply is (probably) increasing due to more cash (stimulus) and more credit (cheap available and highly suggested corporate loans). This surge in money should lead to inflationary pressures.

Will the credit in the system be shown to go up or down? Will we see hyperinflation or not? What would hyperinflation do to interest rates? 

Don’t Have Debt Rise Faster Than Income

Above is a rule, for individuals and governments, that Mr. Dalio points to towards the end of the video. It makes sense to the point of being folksy. Of course, debts shouldn’t grow faster than income.

But right now, the rule is being broken across most of the world, hard. 

Income is not going up; it is going down. Gross Domestic Product (GDP) is a barometer of a country’s output and therefore it’s income. Across the world, GDP is projected to go down by about 10% this year. It is estimated to be down by almost 9.5% and 15% in the US and Europe respectively.

Meanwhile, debt is going up. Due to the coronavirus stimulus and revenue shortfalls in government budgets, public debt will grow by around 10% globally. The US deficit is around 16% already and may get worse. 

In an exaggerated example, it is like getting fired and the next hour going to the hospital due to a major emergency. Your source of income is gone and you have a big bill to pay now. Your world is not ending but your day sucked.

What will this multiplier effect on both income lowering and debt rising do? How will governments respond, if at all, in the next few years to come due to the increased debt? Will GDP/income bounce back next year? Would governments use that bounce to help lower their debt?

One Person’s Spending Is Another’s Income

Equating spending with earning also seems like a no-brainer. If I give you $5 for a service, I spent that money and you earned it.

What’s confusing is that many of the things we spend money on don’t directly go to a person but rather a mysterious entity somewhere…out there. When we make a mortgage payment on a house, the money goes to a faceless bank. When car payments are made, they go to another faceless bank. When taxes are paid, they go to various faceless governments. Also, we don’t usually spend cash anymore but a bunch of digits on our computer screen. The whole process seems less tangible these days.

All of the money spent on products or services is then pooled together by those institutions that we purchase from and then those funds are divided up. Some of that money goes towards people’s salaries but they also go to shareholders, other creditors, more taxes, utilities, etc… It is in this division of income within large black boxes where things get too complicated for most to follow the dollar. 

What is impactful for me though, is to think about what happens when that money is not spent. For instance, take when sports were shut down during this coronavirus outbreak. People could not go to live games. Not only did they not spend money on tickets, but they did not spend money on parking, food, or merchandise. The hard-working vendors that supply those services, and count on those sports seasons to feed their families, are all of a sudden deprived of their income. 

Those vendors now do not have money, so they can’t spend. This means that their rent, car payment, groceries, clothing, and entertainment do not get paid for. With a bunch of those people not spending money like they used to, banks, stores, and venues make less income as well. Then those vendors/institutions don’t have money and so on. This ripple-effect throughout the economy gets complicated and voluminous fairly quickly. When countries across the world shut down, they effectively stopped transactions from occurring everywhere. 

Additionally, populations, in general, are scared. Today, people that are still earning money, are increasing their savings as a result of this panic. So even with an income to spend, consumers are not spending, which again means that incomes downstream are lowering. 

Once the unemployment stimulus runs out and the unemployment/jobs report stabilizes after the phased lockdowns are over, what will the employment picture actually look like (we are probably a few months from that)? Will incomes fall and, if so, how far? Will people go out and spend? Will we see higher than normal spending as people distribute the incomes they have been saving? Will the government force people to spend by putting extra stimulus on use-it-or-lose-it debit cards?