Economic Cycles

Notes from How the Economic Machine Works, by Ray Dalio.

The economy is complex, but ultimately consists of a few simple elements repeated over and over again. There are three main forces that drive the economy:

1. Productivity growth
2. The short-term debt cycle
3. The long-term debt cycle

Transactions

An economy is the sum of the transactions that make it up, and a transaction is very simple. It's an exchange of money or credit for goods, services or financial assets.

A market is a group of buyers and sellers that make transactions for the same thing, e.g. the wheat market. There are thousands of markets, and the economy consists of all the transactions in all markets.

Credit

The central bank controls the amount of money and credit in the economy. It does this by influencing interest rates and printing new money. The central bank has a big role in the flow of credit because of its control over interest rates.

When interest rates are high, there's less borrowing because it's expensive. Less borrowing means less spending (and spending drives the economy). One person's spending is another person's income. This sets the whole system of economic growth in motion. Increased income leads to more borrowing, leads to more spending.

How much sellers receive in a transaction depends on how much they produce. Accumulated knowledge over time has allowed us to increase productivity. This grows roughly linearly, which means it does not drive economic swings.

Debt, on the other hand, creates a cycle. Debt allows us to consume more when we acquire it, and forces us to consume less when we pay it back. This plays out in two cycles that occur at different time intervals:

• 5-8 years (the short-term debt cycle)
• 75-100 years (the long-term debt cycle)

About $50 trillion dollars of credit currently exists in the United States, versus only $3 trillion in actual cash. This credit isn't necessarily bad — it's good when it's efficiently allocated, to generate income. For example, credit to invest in building a business.

The short-term debt cycle

The short-term debt cycle plays out like so:

1. An expansion, where credit allows increased spending. Prices rise because spending and incomes grow faster than the production of goods. This is known as inflation.
2. The central bank typically doesn't want to see inflation. To curb inflation, it raises interest rates, which causes a decrease in credit (because it's more expensive), which causes less spending. Spending also drops to repay debts.
3. With less spending, prices go down. This is known as deflation. Overall economic activity decreases, and we have a recession. To prevent a recession from becoming too severe, the central bank will lower interest rates again.

When credit is easily available, there is economic expansion. When it's not, there is contraction. This is primarily controlled by the central bank via interest rates.

The long-term debt cycle

Over long periods of time, debts rise faster than incomes. People tend to take more credit than they can pay back in each short-term cycle, so the total amount of debt continues to increase.

People borrow money to buy financial assets, which cause prices to rise. The continuation of this effect causes a bubble. This is the peak of the long-term cycle. Debt repayments continue to rise, and the cycle begins to reverse itself. Spending drops propagate throughout the economy.

The economy begins deleveraging. Forced to sell assets to make debt repayments, the market is flooded while spending is falling. Lowering interest rates can't prevent the downturn. Typically, interest rates are already low (and often hit 0%). This happened during the 1930s and in 2008 in the United States.

Deleveraging

The difference between a recession and a deleveraging is that in a deleveraging, borrowers' debt burdens have simply become too big, and can't be relieved by lowering interest rates. Borrowers have lost the ability to repay and their collateral has lost value.

So how is deleveraging dealt with?

1. Cutting spending to pay down debt. Often referred to as austerity. Unfortunately, this often means that incomes fall as well (since spending has fallen), and so this can increase the debt burden.
2. Reducing debt (through defaulting). People default on their debts to banks, then banks default on the people who held money with them. This is a depression. Often debt restructuring occurs, whereby debt is repaid over a longer period of time, in a less amount, or at a different interest rate. This also causes income and asset values to decline.

Lower income and less employment means the government collects less taxes. Simultaneously, it need to increase spending, because unemployment has risen (and often stimulus plans are needed). The government's budget deficit increases because the government is spending more than it earns via taxes.

3. Redistributing wealth. Governments can raise taxes on the wealthy, who have retained some capital despite the downturn.
4. Printing money. Most of what people thought was money was actually credit. So when credit disappears, people don't have enough money. Printing money is inflationary and stimulative. The government uses the printed money to buy financial assets, which helps drive up asset prices, making people more creditworthy. The central bank can also buy government bonds, which allows the government to increase spending on financial stimulus programs.

Deflationary deleveraging strategies need to balance with inflationary ones to maintain stability. In a good, or "beautiful deleveraging", debts decline relative to income, real economic growth is positive, and inflation isn't a problem.

Printing money does not necessarily increase inflation if it offsets falling credit. This is because it doesn't matter whether a good was paid for with money or with credit. By printing money, the central bank can make up for the disappearance of credit with an increase in money.

To escape the deleveraging period, income growth (via printing money) needs to exceed debt growth. But this is a careful balancing act. Too much printing results in hyperinflation, similar to what happened in Germany in the 1920s.

Reflation

If balanced correctly, economic growth slows, but debt burdens begin to decrease. As incomes rise, borrowers appear more creditworthy, and reflationary period begins. Typically, depressions have lasted two to three years, and the reflationary period lasts seven to ten years. This is where get the term "lost decade".

Conclusions for policymakers

1. Don't have debts rise faster than income, because the debts will eventually crush you.
2. Don't have income rise faster than productivity, because you will eventually become uncompetitive.
3. Do everything that you can to raise economic productivity, because that will raise the standard of living.