Famed Bridgewater hedge fund manager Ray Dalio has a knack for taking the complex and breaking it down into a more understandable avenue.
With so much going on in the economy right now, I thought that it would be a good idea to post a paper that Dalio had published back in October 2008 but was updated this past March. Dalio goes on to say the following:
- The economy is like a machine. At the most fundamental level it is a relatively simple machine, yet it is not well understood. I wrote this paper to describe how I believe it works. My description is not the same as conventional economists’ descriptions so you should decide for yourself whether or not what I’m saying makes sense. I will start with the simple things and build up, so please bear with me. I believe that you will be able to understand and assess my description if we patiently go through it.
The full paper can be found here in PDF format. Below are a few highlights that I pulled from the piece.
- Contrary to now-popular thinking, recessions and depressions do not develop because of productivity (i.e., inabilities to produce efficiently); they develop from declines in demand, typically due to a fall-off in credit creation.
- The Federal Reserve has chosen to define “money” in terms of aggregates (i.e., currency plus various forms of credit – M1, M2, etc.), but this is misleading. Virtually all of what they call money is credit (i.e., promises to deliver money) rather than money itself. The total amount of debt in the U.S. is about $50 trillion and the total amount of money (i.e., currency and reserves) in existence is about $3 trillion. So, if we were to use these numbers as a guide, the amount of promises to deliver money (i.e., debt) is roughly 15 times the amount of money there is to deliver. In such an economy, demand is constrained only by the willingness of creditors and debtors to extend and receive credit. When credit is easy and cheap, borrowing and spending will occur; and when it is scarce and The main point is that most people buy things with credit and don’t pay much attention to what they are promising to deliver and where they are going to get it from, so there is much less money than obligations to deliver it.
- There are two ways demand can increase: with credit or without it. Of course, it’s far easier to stimulate demand with credit than without it. For example, in an economy in which there is no credit, if I want to buy a good or service I would have to exchange it for a comparably valued good or service of my own. Therefore, the only way I can increase what I own and the economy as a whole can grow is through increased production. As a result, in an economy without credit, the growth in demand is constrained by the growth in production. This tends to reduce the occurrence of boom-bust cycles, but it also reduces both the efficiency that leads to high prosperity and severe deleveraging, i.e., it tends to produce lower swings around the productivity growth trend line of about 2%.
- By contrast, in an economy in which credit is readily available, I can acquire goods and services without giving up any of my own. A bank will lend the money on my pledge to repay, secured by my existing assets and future earnings. For these reasons, credit and spending can grow faster than money and income. Since that sounds counterintuitive, let me give an example of how that can work.
- This process can be, and generally is, self-reinforcing because rising spending generates rising incomes and rising net worths, which raise borrowers’ capacity to borrow, which allows more buying and spending, etc. Typically, monetary expansions are used to support credit expansions because more money in the system makes it easier for debtors to pay off their loans (with money of less value), and it makes the assets I acquired worth more because there is more money around to bid them. As a result, monetary expansions improve credit ratings and increase collateral values, making it that much easier to borrow and buy more.
- Unlike in recessions, when cutting interest rates and creating more money can rectify this imbalance, in deleveraging monetary policy is ineffective in creating credit. In other words, in recessions (when monetary policy is effective) the imbalance between the amount of money and the need for it to service debt can be rectified by cutting interest rates enough to 1) ease debt service burdens, 2) stimulate economic activity because monthly debt service payments are high relative to incomes and 3) produce a positive wealth effect; however, in deleveragings, this can’t happen. In deflationary depressions/deleveragings, monetary policy is typically ineffective in creating credit because interest rates hit 0% and can’t be lowered further, so other, less effective ways of increasing money are followed. Credit growth is difficult to stimulate because borrowers remain over-indebted, making sensible lending impossible. In inflationary deleveragings, monetary policy is ineffective in creating credit because increased money growth goes into other currencies and inflation hedge assets because investors fear that their lending will be paid back with money of depreciated value.
- For example in the Great Depression there were six big rallies in the stock market (of between 21% and 48%) in a bear market that totaled 89%, with all of these rallies triggered by these sorts of increasingly strong dosages of government actions which were intended to reduce the fundamental imbalance.
- First, contrary to popular thinking, the deleveraging dynamic is not primarily psychologically driven. It is primarily driven by the supply and demand of and relationships between credit, money and goods and services.
- Second, it is not correct that the amount of money in existence remains the same and has simply moved from riskier assets to less risky ones. Most of what people think is money is really credit, and it does disappear.
- As implied by this, a big part of the deleveraging process is people discovering that much of what they thought was their wealth isn’t really there.
- In other words, the government “prints” money and uses it to negate some of the effects of contracting credit.This is reflected in money growing at an extremely fast rate at the same time as credit and real economic activity contract, so the money multiplier and the velocity of money typically initially contract. If the money creation is large enough, it devalues the currency, lowers real interest rates and drives investors from financial assets to inflation hedge assets. This typically happens when investors want to move money outside the currency, and short-term government debt is no longer considered a safe investment.
- The decline in economic and credit creation activity (the depression phase) is typically fast, lasting two to three years. However, the subsequent recovery in economic activity and capital formation tends to be slow, so it takes roughly a decade (hence the term “lost decade”) for real economic activity to reach its former peak level. Though it takes about a decade to return the economy to its former peak levels, it typically takes longer for real stock prices to reach former highs, because equity risk premiums take a very long time to reach predeleveraging lows. During this time nominal interest rates must be kept below nominal growth rates to reduce the debt burdens. If interest rates are at 0% and there is deflation, central banks must “print” enough money to raise nominal growth.