How the Economic Machine Works

Sharing this interesting video that I found on Youtube, not sure if any of you have seen it before, that may help you understand the economy and how it works better and answer questions such as why we have cycles, what is the role of the central bank, etc. It is by Ray Dalio, founder of Bridgewater Associates.

I'm guessing that most of you would not be able to shell out 30 minutes just to watch this video (though it would be good if you did to gain a better understanding), so I'll just put a brief summary of the main points here, as well as some of my thoughts on them.

Main Points

1. The economy is made up of transactions
2. One person's spending is another person's income
3. Lending increases one's spending and another person's income, while allows the next person to borrow more money and the process repeats
4. The economy grows in the short-term due to this increased spending, but there will be a time when debts have to repaid and the cycle reverses
5. Long term growth stems from productivity growth
6. The Central Bank is able to control the economy by printing more money and controlling interest rates. Increasing interest rates reduces borrowing, reducing amount of credit and decreasing inflation and vice-versa
7. The video goes on to talk about de-leveraging but I shall stop here

Thoughts (and more detailed summary)

The basic form of the economy is the transaction, which is an exchange of goods, services or financial assets (stocks), which is guided by human emotions. During this transaction, someone spends money and someone earns money, hence someone's spending is another person's income. This cycle repeats itself over and over again.

Lending (Borrowing) comes into this cycle as a way for a person to spend more than he earns. Let's look at it this way, when buying a house and taking up a mortgage, you are spending more than you have or can earn and borrow to use future money to buy the house. By increasing spending, lending helps to increase income and pushes the economy up as one's increased spending would increase another's income.

But this method can only work for the short-term as the Central Bank does not want uncontrolled inflation and would increase interest rates to reduce inflation. Increasing interest rates makes borrowing less attractive and also increases interest expenses of current borrowers, making them less creditworthy. While borrowing dries up, debt repayments increase, which is the time when we have to repay the debt that we have taken up and we have to consume less than we produce to repay the debt and the economy enters a recession. This cycle is the short-term debt cycle.

Though increasing interest rates will force us to repay our debts, however, this only works in the short-term as debts accumulate to form the long-term debt cycle and during the time to repay, the economy enters a depression and deleveraging occurs.

Does this mean that borrowing is no good as it creates cycles? Not exactly, borrowing money can help increase productivity, an example is purchasing machinery to reduce labour costs. But borrowing money to fund expenditures that do not contribute to productivity growth such as the latest fashion trends or the latest car model is of course, not good. Productivity is the only way for the economy to grow in the long run and borrowing money that helps to grow productivity, which increases your output, would help to grow the economy.

This model is good for the average investor, it gives a broad overview of how the market works and what are the effects that interest rate hikes, printing money, etc, have on the market. It would be good if you could watch the full video to get the details which I have missed during this summary and get a better understanding it.

For some present context, with the interest rates still low and the Fed pushing off the interest rate hike due to the soft data coming from the US, it seems unlikely that there will be another recession on the horizon if we subscribe to the ideas mentioned in the video.

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