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  • How the economic machine works, in 30 minutes.

  • The economy works like a simple machine.

  • But many people don't understand it

  • or they don't agree on how it works

  • and this has led to a lot of needless economic suffering.

  • I feel a deep sense of responsibility

  • to share my simple but practical economic template.

  • Though it's unconventional,

  • it has helped me to anticipate and sidestep the global financial crisis,

  • and has worked well for me for over 30 years.

  • Let's begin.

  • Though the economy might seem complex, it works in a simple, mechanical way.

  • It's made up of a few simple parts and a lot of simple transactions

  • that are repeated over and over again a zillion times.

  • These transactions are above all else driven by human nature,

  • and they create 3 main forces that drive the economy.

  • Number 1: Productivity growth

  • Number 2: The Short term debt cycle

  • and Number 3: The Long term debt cycle

  • We'll look at these three forces and how laying them on top of each other

  • creates a good template for tracking economic movements

  • and figuring out what's happening now.

  • Let's start with the simplest part of the economy:

  • Transactions.

  • An economy is simply the sum of the transactions that make it up

  • and a transaction is a very simple thing.

  • You make transactions all the time.

  • Every time you buy something you create a transaction.

  • Each transaction consists of a buyer

  • exchanging money or credit

  • with a seller for goods, services or financial assets.

  • Credit spends just like money,

  • so adding together the money spent and the amount of credit spent,

  • you can know the total spending.

  • The total amount of spending drives the economy.

  • If you divide the amount spent

  • by the quantity sold,

  • you get the price.

  • And that's it. That's a transaction.

  • It is the building block of the economic machine.

  • All cycles and all forces in an economy are driven by transactions.

  • So, if we can understand transactions,

  • we can understand the whole economy.

  • A market consists of all the buyers

  • and all the sellers

  • making transactions for the same thing.

  • For example, there is a wheat market,

  • a car market,

  • a stock market

  • and markets for millions of things.

  • 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 have everything you need to know

  • to understand the economy.

  • It's just that simple.

  • People, businesses, banks and governments

  • all engage in transactions the way I just described:

  • exchanging money and credit for goods, services and financial assets.

  • The biggest buyer and seller is the government,

  • which consists of two important parts:

  • a Central Government that collects taxes and spends money...

  • ...and a Central Bank,

  • which is different from other buyers and sellers because it

  • controls the amount of money and credit in the economy.

  • It does this by influencing interest rates

  • and printing new money.

  • For these reasons, as we'll see,

  • the Central Bank is an important player in the flow

  • of Credit.

  • I want you to pay attention to credit.

  • Credit is the most important part of the economy,

  • and probably the least understood.

  • It is the most important part because it is the biggest

  • and most volatile part.

  • Just like buyers and sellers go to the market to make transactions,

  • so do lenders and borrowers.

  • Lenders usually want to make their money into more money

  • and borrowers usually want to buy something they can't afford,

  • like a house or car

  • or they want to invest in something like starting a business.

  • Credit can help both lenders

  • and borrowers get what they want.

  • Borrowers promise to repay the amount they borrow,

  • called the principal,

  • plus an additional amount, called interest.

  • When interest rates are high,

  • there is less borrowing because it's expensive.

  • When interest rates are low,

  • borrowing increases because it's cheaper.

  • When borrowers promise to repay

  • and lenders believe them,

  • credit is created.

  • Any two people can agree to create credit out of thin air!

  • That seems simple enough but credit is tricky

  • because it has different names.

  • As soon as credit is created,

  • it immediately turns into 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 liability disappear

  • and the transaction is settled.

  • So, why is credit so important?

  • Because when a borrower receives credit,

  • he is able to increase his spending.

  • And remember, spending drives the economy.

  • This is because one person's spending

  • is another person's income.

  • Think about it, 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 two things:

  • the ability to repay and collateral.

  • Having a lot of income in relation to his debt gives him the ability to repay.

  • In the event that he can't repay, he has valuable assets to use as collateral that can be sold.

  • This makes lenders feel comfortable lending him money.

  • So increased income allows increased borrowing

  • which allows increased spending.

  • And since one person's spending is another person's income,

  • this leads to more increased borrowing and so on.

  • This self-reinforcing pattern leads to economic growth

  • and is why we have Cycles.

  • In a transaction, you have to give something in order to get something

  • and how much you get depends on how much you produce

  • over time we learned

  • and that accumulated knowledge raises are living standards

  • we call this productivity growth

  • those who were invented and hard-working 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, but credit matters most in the short run.

  • This is because productivity growth doesn't fluctuate much,

  • so it's not a big driver of economic swings.

  • Debt isbecause 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 pay it back.

  • Debt swings occur in two big cycles.

  • One takes about 5 to 10 years and the other takes about 75 to 100 years.

  • While most people feel the swings, they typically don't see them as cycles

  • because they see them too up close -- day by day, week by week.

  • In this chapter we are going to step back and look at these three big forces

  • and how they interact to make up our experiences.

  • As mentioned, swings around the line are not due to how much innovation or hard work there is,

  • they're primarily due to how much credit there is.

  • Let's for a second imagine an economy without credit.

  • In this economy, 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.

  • But because we borrow, we have cycles.

  • This isn't due to any laws or regulation,

  • it's due to human nature and the way that credit works.

  • Think of borrowing as simply a way of pulling spending forward.

  • In order to buy something you can't afford, you need to spend more than you make.

  • To do this, you essentially need to borrow from your future self.

  • In doing so you create a time in the future

  • that you need to spend less than you make in order to pay it back.

  • It very quickly resembles a cycle.

  • Basically, anytime you borrow you create a cycle.?

  • This is as true for an individual as it is for the economy.

  • This is why understanding credit is so important

  • because it sets into motion

  • a mechanical, predictable series of events that will happen in the future.

  • This makes credit different from money.

  • 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 liability disappear,

  • the debt goes away

  • and the transaction is settled.

  • The reality is that most of what people call money is actually credit.

  • The total amount of credit in the United States is about $50 trillion

  • and the total amount of money is only about $3 trillion.

  • Remember, in an economy without credit:

  • the only way to increase your spending is to produce more.

  • But in an economy with credit,

  • you can also increase your spending by borrowing.

  • As a result, 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.

  • Now, don't get me wrong,

  • credit isn't necessarily something bad that just causes cycles.

  • It's bad when it finances over-consumption that can't be paid back.

  • However, it's good when it efficiently allocates resources

  • and produces income so you can pay back the debt.

  • For example, if you borrow money to buy a big TV,

  • it doesn't generate income for you to pay back the debt.

  • But, if you borrow money to buy a tractor

  • and that tractor let's you harvest more crops and earn more money

  • then, you can 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.

  • Let me give you an example:

  • Suppose you earn $100,000 a year and have no debt.

  • You are creditworthy enough to borrow $10,000 dollars

  • - say on a credit card

  • - so you can spend $110,000 dollars

  • even though you only earn $100,000 dollars.

  • Since your spending is another person's income,

  • someone is earning $110,000 dollars.

  • The person earning $110,000 dollars

  • with no debt can borrow $11,000 dollars,

  • so he can spend $121,000 dollars

  • even though he has only earned $110,000 dollars.

  • 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 remember, borrowing creates cycles

  • and if the cycle goes up, it eventually needs to come down.

  • This leads us into the Short Term Debt Cycle.

  • As economic activity increases, we see an expansion

  • - the first phase of the short term debt cycle.

  • Spending continues to increase and prices start to rise.

  • This happens 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.

  • 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.

  • Because people borrow less and have higher debt repayments,

  • they have less money leftover to spend, so spending slows

  • ...and since one person's spending is another person's income,

  • incomes drop...and so on and so forth.

  • When people spend less, prices go down.

  • We call this deflation.

  • Economic activity decreases and we have a recession.

  • 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.

  • With low interest rates,

  • debt repayments are reduced

  • and borrowing and spending pick up

  • and we see another expansion.

  • As you can see, the economy works like a machine.

  • In the short term debt cycle, 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 a recession.

  • And note that this cycle is controlled primarily by the central bank.

  • The short term debt cycle typically lasts 5 - 8 years

  • and happens over and over again for decades.

  • But notice that the bottom and

  • top of each cycle finish

  • with more growth than 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.

  • Despite people becoming more indebted,

  • lenders even more freely extend credit.

  • Why?

  • Because everybody thinks things are going great!

  • People are just focusing on what's been happening lately.

  • And what has 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.

  • Let's call the ratio of debt-to-income the debt burden.

  • So long as incomes continue to rise,

  • the debt burden stays manageable.

  • At the same time 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 creditworthy for a long time.

  • But this obviously can not continue forever.

  • And it doesn't.

  • Over decades, debt burdens slowly increase creating larger and larger debt repayments.

  • At some point, 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.

  • This is the long term debt peak.

  • 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.

  • Now the economy begins Deleveraging.

  • In a deleveraging; people cut spending,

  • incomes fall, credit disappears,

  • assets 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 creditworthy,

  • 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

  • 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 the borrowing.

  • However, in a deleveraging, lowering interest rates doesn't work because

  • interest rates are already

  • low and soon hit 0% - so the stimulation ends.

  • Interest rates in the United States hit 0% during the deleveraging of

  • the 1930s

  • and again in 2008.

  • The difference between a recession

  • and a deleveraging 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!

  • Lenders stop lending. Borrowers stop borrowing.

  • Think of the economy as being not-creditworthy,

  • just like an individual.

  • So what do you do about a deleveraging?

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

  • There are four ways this can happen.

  • 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'.

  • and finally, 4. the central bank prints new money.

  • These 4 ways have happened in every deleveraging in modern history.

  • Usually, spending is cut first.

  • As we just saw, people, businesses, banks 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 stop 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's 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. 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 lender's assets.

  • When borrowers don'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.

  • 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 a beer 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.

  • Debt restructuring means lenders get paid back

  • less or get paid back over a longer time frame

  • or at a lower interest rate that 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 gets worse.

  • Like cutting spending, debt reduction

  • is also painful and deflationary.

  • All of this impacts the central government because lower incomes and less employment

  • means the 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.

  • Governments' budget deficits explode in a

  • deleveraging because they spend more than they earn in taxes.

  • This is what is happening when you hear about the budget deficit on the news.

  • 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'. The 'have-nots,' who are suffering, begin to

  • resent the wealthy 'haves.'

  • The wealthy 'haves,' being squeezed by the weak economy, falling asset prices,

  • 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.

  • Remember, most of what people thought was money was actually credit.

  • So, when credit disappears, people don't have enough money.

  • People are desperate for money and you remember who can print money?

  • The Central Bank can.

  • Having already lowered its interest rates to nearly 0

  • - it's forced to print money. Unlike cutting spending,

  • debt reduction, and wealth redistribution,

  • printing money is inflationary and stimulative. Inevitably, the central bank

  • prints new money

  • out of thin airand uses it to buy financial assets

  • and government bonds. It happened in the United States during the Great Depression

  • and again in 2008, when the United States' central bank

  • the Federal Reserveprinted over two trillion dollars.

  • Other central banks around the world that could, printed a lot of money, too.

  • By buying financial assets with this money,

  • it helps drive up asset prices which makes people more creditworthy.

  • However, this only helps those who own financial assets.

  • You see, the central bank can print money but it can only buy financial assets.

  • The Central Government, on the other hand,

  • can buy goods and services and put money in the hands of the people

  • but it can't print money. So, in order to stimulate the economy, the two

  • must cooperate.

  • By buying government bonds, the Central Bank essentially lends money to the

  • government,

  • allowing it to run a deficit and increase spending

  • on goods and services through its stimulus programs

  • and unemployment benefits. This increases people's income

  • as well as the government's debt. However,

  • it will lower the economy's total debt burden.

  • This is a very risky time. Policy makers need to balance the four ways that debt

  • burdens come down.

  • The deflationary ways need to balance with the inflationary ways in

  • order to maintain stability.

  • If balanced correctly, there can be a

  • Beautiful Deleveraging.

  • You see, a deleveraging can be ugly or it can be beautiful.

  • How can a deleveraging be beautiful?

  • Even though a deleveraging is a difficult situation,

  • handling a difficult situation in the best possible way is beautiful.

  • A lot more beautiful than the debt-fueled, unbalanced excesses of the

  • leveraging phase. In a beautiful deleveraging,

  • debts decline relative to income, real economic growth is positive,

  • and inflation isn't a problem. It is achieved by having the right balance.

  • 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.

  • People ask if printing money will raise inflation.

  • It won't if it offsets falling credit. Remember, 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 100%.

  • 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 is 2%.

  • If debt is growing at 2% because of that interest rate and

  • income

  • is only growing at around only 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 can easily be abused because it's so easy to do 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 1920's.

  • If policymakers achieve 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.

  • Though the deleveraging 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.'

  • Of course, the economy is a little more complicated than this template

  • suggests.

  • However, laying the short term debt cycle on top of the long term debt cycle

  • and then laying both of them on top of the productivity growth line

  • gives a reasonably good template for seeing where we've been,

  • where we are now and where we are probably headed.

  • So in summary, there are three rules of thumb that I'd like you to take away

  • from this:

  • First: Don't have debt rise faster than income,

  • because your debt burdens will eventually crush you.

  • Second: Don't have income rise faster than productivity,

  • because you will eventually become uncompetitive.

  • And third: Do all that you can to raise your productivity,

  • because, in the long run, that's what matters most.

  • This is simple advice for you and it's simple advice for policy makers.

  • You might be surprised but most peopleincluding most policy makersdon't pay enough attention

  • to this.

  • This template has worked for me and I hope that it'll work for you.

  • Thank you.

How the economic machine works, in 30 minutes.

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How The Economic Machine Works by Ray Dalio

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    Jamie Linning に公開 2013 年 12 月 01 日
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