Deep Dive : First Principles of the Economy

So What are Deep Dives (DD) and Why?

DD’s is an effort to accommodate the twitching desire that has been tingling in the back of my mind, to simplify; to silo, the swarm of ideas in my thought pool. These DD’s intend to play a role in organising my mental semantic trees. The long run theme is to positively influence my habitual behaviour and have seamless availability heuristics, as well as to facilitate an easier build of memory palaces.

Articles in the Deep Dive Series:

Deep Dive into the ‘Digital Macrocosm’

Deep Dive into the First Principles of the Economy

This is an Economic Template based on insights and principles from Bridgewater Associates’ Ray Dalio’s How the Economic Machine Works video. I found that the video was sensational, but was plenty to digest and grasp. Hence, this breakdown.

This can help you understand the why, what and how of past periods of economic upheaval like the

• Depression in America and Post-war Britain
• Hyperinflation of the Weimar Republic (Germany)

It models the macro-economy from the bottom up, as a machine, where individual transactions are the machine’s moving parts. Paying enough attention to the individual components of supply and, above all, demand. To understand demand properly, it delves into whether it is funded by the buyers’ own money or by credit from others. The model is also advantageous for long term positions that do not rely on short term fluctuations for capital gains.

What is the Economy?

The Economy is the sum of the small parts called ‘Transactions’ that make it up.

Transactions are driven by human nature and create 3 forces that drive the economy:

1. Long-Term Debt Cycles
2. Short-Term Debt Cycles
3. Productivity Growth

What is a TRANSACTION?

• A transaction is a building block of the economic machine.
• All cycles and all forces in an economy are driven by transactions.
• Understanding transactions = Understanding the economy

Every transaction has a buyer and a seller involved.

Buyers have

• Money
• Credit

Total Buyer Spending = Money + Credit

Sellers have

• Goods
• Services
• Financial Assets

The Price = Total Spending divided by Total Quantity

What is a MARKET?

A market is buyers and sellers making transactions for the same thing.

ECONOMY

• An economy consists of all of the transactions in all of its markets.
• If you add up the total spending and the total quantity sold in all of the markets → You can understand the economy.

The biggest buyer and seller is the government, which consists of two important parts:

A central government

• Collects taxes
• Spends money

A central bank

• Controls the amount of money by printing new money
• Controls the flow and amount of credit in the economy by influencing interest rates

CREDIT

Credit is the most important and volatile part of the economy

Just like we have Buyers & Sellers for Transactions, we have Lenders (make money into more money) + Borrowers (buy something they can’t afford)

Borrowers promise to repay

• the amount they borrow called principal
• plus an additional amount called interest

Interest Rates & Borrowing

• When interest rates are high → there is less borrowing because it’s expensive
• When interest rates are low → borrowing increases because it’s cheaper

Where does credit come from?

When borrowers promise to repay and lenders believe them, credit is created. As soon as credit is created it immediately turns into debt.

DEBT

• Debt is both an asset to the lender and a liability to the borrower in the future.
• When the borrower repays the loan plus interest the asset and the liability disappear and the transaction is settled

Why is credit so important?

• Because when a borrower receives credit he is able to increase the spending
• Spending drives the economy this is because one person spending is another person’s income
• Every dollar you spend someone else earns and every dollar you earn someone else has spent. So when you spend more someone else earns more
• When someone’s income rises it makes lenders more willing to lend him money because now he’s more worthy of credit

A Creditworthy Borrower has

• the ability-to-repay
• having a lot of income in relation to his debt gives him the ability to repay
• Collateral → in the event that he can’t repay he has valuable assets to use as collateral that can be sold

ECONOMIC GROWTH

• Increased Income → Increased Borrowing → Increased Spending → Increased Income

This self-reinforcing pattern leads to economic growth and is why we have cycles in a transaction

The Economic Template

PRODUCTIVITY GROWTH

• You have to give something in order to get something and how much you get depends on how much you produce over time
• Accumulated knowledge raises our living standards we call this productivity growth
• Those who are inventive and hardworking raise their productivity and their living standards faster than those who are complacent and lazy but that isn’t necessarily true over the short-run
• Productivity matters most in the long run
• Productivity growth doesn’t fluctuate much so it’s not a big driver of economic swings

Productivity’s role in GDP growth over time

Credit matters most in the short run

Debt is a major driver of economic swings because

• it allows us to consume more than we produce when we acquire it and it forces us to consume less than we produce when we have to pay it back

Debt swings occur in two big cycles

1. one takes about five to eight years and
2. the other takes about seventy-five to a hundred years while

In an economy without credit,

• The only way I can increase my spending → is to increase my income → which requires me to be more productive and do more work
• Increased productivity is the only way for growth since my spending is another person’s income
• The economy grows every time I or anyone else is more productive
• If we follow the transactions and play this out we see a progression like the productivity growth line

Why do we have cycles?

Because we borrow, this is due to

• human nature
• the way that credit works

What is Borrowing?

• A way of pulling spending forward

Why do we Borrow?

• To buy things we can’t afford → we need to spend more than you make → To do this, we essentially need to borrow from our future self

What’s the problem with Borrowing?

• It creates a time in the future where we need to spend less than we make in order to pay it back
• This phenomenon resembles a cycle created whenever an individual/economy borrows.
• This cycle initiation is why credit is different from money
• It sets into motion a mechanical predictable series of events that will happen in the future

How do you settle a transaction?

Money is what you settle transactions with

• when you buy a beer from a bartender with cash the transaction is settled immediately
• but when you buy a beer with credit it’s like starting a bar tab you’re saying you promise to pay in the future
• together you and the bartender create an asset and a liability
• you just created credit out of thin air it’s not until you pay the bar tab later that the asset and the liability disappear the debt goes away and the transaction is settled

The total amount of credit in the United States is about fifty trillion dollars and the total amount of money is only about three trillion dollars

In an economy you can increase your spending by

• Producing more
• Borrowing

Why would one want Credit?

• Because an economy with credit has more spending and allows incomes to rise faster than productivity over the short run but not over the long run.
• Credit is bad when it finances over consumption that can’t be paid back
• For example, if you borrow money to buy a big TV it doesn’t generate income for you to pay back the debt
• It’s good when it efficiently allocates resources and produces income so you can pay back the debt.
• If you borrow money to say buy a tractor and that tractor lets you harvest more crops and earn more money then you could pay back your debt and improve your living standards

In an economy with credit we can follow the transactions and see how credit creates growth

• Suppose you earn $100,000 a year and have no debt, you are credit worthy enough to borrow $10,000 say on a credit card so you can spend $110,000 even though you only earn $100,000.
• Since your spending is another person’s income, someone is earning a $110,000, the person earning $110,000 with no debt can borrow $11,000 so he can spend $121,000 even though he has only earned $110,000
• His spending is another person’s income and by following the transactions we can begin to see how this process works in a self-reinforcing pattern
• BUT, borrowing creates cycles and if the cycle goes up it eventually needs to come down

Short-term Debt Cycle

Short Term Debt Cycle’s effect on economic growth over time

FIRST PHASE: INFLATIONARY EXPANSION → fueled by an increase in economic activity

• Spending continues to increase And Prices start to rise because the increase in spending is fueled by credit which can be created instantly out of thin air
• when the amount of spending and incomes grow faster than the production of goods → prices rise,
• when prices rise we call this inflation

First Intermediary Phase : INTEREST RATE INCREASE: The central bank doesn’t want too much inflation because it causes problems, seeing prices rise

• it raises interest rates with
• higher interest rates fewer people can afford to borrow money and the cost of existing debts rises (think about this as the monthly payments on your credit card going up)

SECOND PHASE: DEFLATIONARY RECESSION

• Spending SLOWS & Incomes decrease →because people borrow less and have higher debt repayments they have less money left over to spend
• when people spend less prices go down , we call this deflation → economic activity decreases and we have a recession

Second Intermediary Phase : INTEREST RATE DECREASE

• If the recession becomes too severe and inflation is no longer a problem the central bank will lower interest rates to cause everything to pick up again
• Debt repayments are reduced
• Borrowing and spending pick up and we see another expansion

SUMMARY:

Spending is constrained only by the

• willingness of lenders and borrowers to provide and receive credit
• when credit is easily available there’s an economic expansion
• when credit isn’t easily available there’s an economic recession
• This cycle is controlled primarily by the central bank
• Typically lasts five to eight years and happens over and over again for decades

The bottom and top of each short term debt cycle finish with more growth in the previous cycle and with more debt

• why? because people push it → they have an inclination to borrow and spend more instead of paying back debt it’s human nature because of this over long periods of time debts rise faster than incomes creating the long term debt cycle

A BUBBLE

Despite people becoming more indebted, why do lenders even more freely extend credit?

• Because everyone thinks things are going great people are just focused on what’s been happening lately
• Incomes have been rising
• Asset values are going up
• The stock market roars → it’s a boom → it pays to buy goods, services and financial assets with borrowed money.
• When people do a lot of that we call it a bubble → so even though debts have been growing incomes have been growing nearly as fast to offset them

DEBT BURDEN

• Debt: Income Ratio
• Manageable as incomes are high

Long Term Debt Cycle

Long Term Debt Cycle’s effect on economic growth over time

LEVERAGING

Asset values soar, people borrow huge amounts of money to buy assets as investments, causing their prices to rise even higher, people feel wealthy. So even with the accumulation of lots of debt, rising incomes and asset values help borrowers remain credit worthy for a long time. But this obviously cannot continue forever and it doesn’t over decades debt burdens slowly increase, creating larger and larger debt repayments

Long-term Debt Peak

• Debt repayments start growing faster than incomes forcing people to cut back on their spending and since one person’s spending is another person’s income, incomes begin to go down which makes people less creditworthy causing borrowing to go down. Debt repayments continue to rise which makes spending drop even further and the cycle reverses itself
• Debt burdens have simply become too big for the United States, Europe and much of the rest of the world
• this happened in 2008 it happened for the same reason it happened in Japan in 1989 and in the United States back in 1929

DELEVERAGING

• Post the long term debt peak → incomes fall, credit disappears, asset prices drop, banks get squeezed, the stock market crashes social tensions rise and the whole thing starts to feed on itself the other way.
• As incomes fall and debt repayments rise, borrowers get squeezed → no longer credit worthy, credit dries up and borrowers can no longer borrow enough money to make their debt repayments, scrambling to fill this hole, borrowers are forced to sell assets, the rush to sell assets floods the market at the same time, as spending Falls this is when the stock market collapses, the real estate market tanks and banks get into trouble as asset prices drop the value of the collateral borrowers can put up drops this makes borrowers even less creditworthy people feel poor, credit rapidly disappears less spending less income less wealth less credit less borrowing and so on
• It’s a vicious cycle this appears similar to a recession but the difference here is that interest rates can’t be lowered to save the day in a recession lowering interest rates works to stimulate borrowing however in a deleverage this glorious traits doesn’t work because interest rates are already low and soon hits 0% so the stimulation ends
• Interest rates in the United States hit zero percent during the the deleveraging of the 1930s and again in 2008
• The difference between a recession and a deleverage is that in a deleveraging, borrowers debt burdens have simply gotten too big and can’t be relieved by lowering interest rates
• Lenders realize that debts have become too large to ever be fully paid back, borrowers have lost their ability to repay and their collateral has lost value they feel crippled by the debt they don’t even want more

The Economy becomes non-creditworthy

• lenders stopped lending
• borrowers stop borrowing

What do you do about a deleveraging?

The problem is debt burdens are too high and they must come down!

There are 4 ways this can be done:

1. People, businesses and governments cut their spending
2. Debts are reduced through defaults and restructurings
3. Wealth is redistributed from the haves to the have-nots
4. The central bank prints new money

FIRST

AUSTERITY → Spending Cuts to cover debt costs

Usually spending is cut first as we just saw a people businesses and even governments tighten their belts and cut their spending so that they can pay down their debt this is often referred to as austerity.

When borrowers stopped taking on new debts and start paying down old debts you might expect the debt burden to decrease but the opposite happens because spending is cut and one-man spending is another man’s income it causes incomes to fall they fall faster than debts are repaid and the debt burden actually gets worse

SECOND

as we’ve seen this cut in spending is deflationary and painful businesses are forced to cut costs which means less jobs and higher

unemployment this leads to the next step

Debts must be reduced many borrowers find themselves unable to repay their loans and a borrower’s debts are a lenders

assets, when a borrower doesn’t repay the bank, people get nervous that the bank won’t be able to repay them so they

rush to withdraw their money from the bank

Banks get squeezed and people, businesses and banks default on their debts → this severe economic contraction is a Depression

As borrowers cant keep their promises with their liabilities, lenders assets could be worthless!

A big part of a depression is people discovering much of what they thought was their wealth isn’t really there! let’s go back to the bar when you bought up the year and put it on a bar tab you promised to repay the bartender your promise became an asset of the bartender but if you break your promise if you don’t pay him back and essentially default on your bar tab then the asset he has isn’t really worth anything it has basically disappeared.

many lenders don’t want their assets to disappear and agree to Debt Restructuring, which is painful and deflationary

Debt Restructuring means

• lenders get paid back less or get paid back over a longer time frame or at a lower interest rate than was first agreed
• somehow a contract is broken in a way that reduces debt
• lenders would rather have a little of something than all of nothing
• even though debt disappears debt restructuring causes income and asset values to disappear faster so the debt burden continues to get worse

All of this impacts the central government because

• lower incomes
• less employment
• government collects fewer taxes
• at the same time it needs to increase its spending because unemployment has risen many of the unemployed have inadequate savings and need financial support from the government
• additionally governments create stimulus plans and increase their spending to make up for the decrease in the economy

THIRD

BUDGET DEFICITS

Governments spend more than they earn in taxes! They are spending on financial support for the poor whose income is less because they have lost their jobs and they do not have viable financial support + on stimulus packages to make up for the lack of spending in the economy as one man’s spending is another man’s income.

Government’s Budget Deficits explode in the de-leveraging because they spend more than they earn in taxes

this is what’s happening when you hear about the budget deficit on the news

How do GOVERNMENTS FUND THESE DEFICITS:

To fund their deficits governments need to either raise taxes or borrow money but with incomes falling and so many unemployed who is the money going to come from the rich. Since governments need more money and since wealth is heavily concentrated in the hands of a small percentage of the people governments naturally raise taxes on the wealthy which facilitates a redistribution of wealth in the economy from the haves to the have-nots

SOCIAL DISORDER BREAKS LOOSE

• The have-nots who are suffering begin to resent the wealthy haves
• the wealthy haves being squeezed by the weak economy,falling asset prices and higher taxes begin to resent the have-nots
• if the depression continues social disorder can break out not only do tensions rise within countries. they can rise between countries especially debtor and creditor countries this situation can lead to political change that can sometimes be extreme
• in the 1930s this led to Hitler coming to power, war in Europe and depression in the United States
• pressure to do something to end the depression increases

Now Credit has disappeared! So the only other way people can spend is if they get more money.

FOURTH

THE CENTRAL BANK CAN PRINT MORE MONEY out of thin air! → It is forced to after lowering interest rates to nearly zero.

It uses this money it printed to

• Buy Financial Assets — It helps drive up asset price → makes people more creditworthy — helps only those with financial assets
• Co- operate with the Central Government to buy Government Bonds → To help the central government put money in the hands of people and stimulate the economy.
  Essentially lending money to the government, allowing it to run a deficit and increase spending on goods and
  services through its stimulus programs and unemployment benefits
• Increases People’s Income
• Increases Governments Debt
• Lowers the economy’s total debt burden

BALANCING OF THE 4 WAYS DEBT BURDENS COME DOWN IS ESSENTIAL:

DEFLATIONARY

• cutting spending
• debt reduction
• wealth redistribution

INFLATIONARY

• printing money is inflationary and stimulative

STABILITY NEEDS TO BE MAINTAINED BY BALANCING THE DEFLATIONARY AND INFLATIONARY WAYS

• If balanced correctly there can be a beautiful deleveraging, where debts decline relative to incomes and real income growth is positive with inflation not being a problem
• The right balance requires a certain mix of cutting spending, reducing debt, transferring wealth
  and printing money → so that economic and social stability can be maintained

The leveraging phase is an incredible debt-fueled unbalanced excess!

Printing money will NOT raise inflation as long as it offsets falling credit

SPENDING IS WHAT MATTERS

• A dollar of spending paid for with money has the same effect on price as a dollar of spending paid for with credit
• By printing money the central bank can make up for the disappearance of credit with an increase in the amount of money
• In order to turn things around the central bank needs to not only pump up income growth but get the rate of income growth higher than the rate of interest on the accumulated debt so what do I mean by that
• basically income needs to grow faster than debt grows
• for example let’s assume that a country going through a deleveraging has a debt to income ratio of a hundred percent that means that the amount of debt it has is the same as the amount of income the entire country makes in a year
• now think about the interest rate on that debt let’s say it’s 2% if debt is growing at 2% because of that interest rate an income is only growing at around 1% you will never reduce the debt burden you need to print enough money to get the rate of income growth above the rate of interest however printing money could easily be abused because it’s so easy to and people prefer it to the alternatives the key is to avoid printing too much money and causing unacceptably high inflation the way Germany did during its deleveraging in the 1920s if policymakers achieved the right balance a deleveraging isn’t so dramatic. growth is slow but debt burdens go down that’s a beautiful deleveraging!
• When incomes begin to rise borrowers begin to appear more creditworthy and when borrowers appear more creditworthy lenders begin to lend money again debt burdens finally begin to fall
• able to borrow money people can spend more eventually the economy begins to grow again leading to the reflation phase of the long-term debt cycle

Lost Decade

Though the de leveraging process can be horrible if handled badly if handled well, it will eventually fix the problem it takes roughly a decade or more for debt burdens to fall and economic activity to get back to normal hence the term Lost Decade.

LESSONS

1. Don’t have debt rise faster than income because your debt burdens will eventually crush you
2. Don’t have income rise faster than productivity because you’ll eventually become un-competitive
3. Do all that you can to raise your productivity because in the long run that’s what matters most