Debt Cycles Explained

Plain language financial education

How the Economic Machine Works is a 30-minute video by Ray Dalio which provides the layman with an animated, plain language description of how our economy functions.  If you want to make a financial investment in yourself, it is a great way to learn a lot in a short time.  I have viewed it several times over the years to learn and Be Prepared.

The following is a quick review which I hope will encourage you to invest 30 minutes in yourself.

Dalio opens by identifying the three main forces in the economy:

·         Productivity Growth

·         Short Term Debt Cycles

·         Long Term Debt Cycles

Woven into those three main forces and their timelines are Transactions.  The total of all transactions between people, businesses, banks, and governments adds up to make the economy.  Every dollar you spend someone else earns.  He explains transactions can be completed with money or credit.  You can buy groceries from a business with cash or a credit card.  A bank can give you credit to buy a car from a business.  You pay tax to the government and get your road repaired.  Etc., etc.

Of money or credit, credit is the most complex and most important part of the economy.  Why?  Because it is human nature to want something now that you can’t afford until later.  As a result, the total amount of credit is many times the total amount of money in the economy.  Thus, it is our human nature that is driving the short- and long-term debt cycles.

·         Short term debt cycles occur every 5-8 years

·         Long term debt cycles occur every 75-100 years

Over time, these cycles peak and valley around long-term growth in productivity.  Productivity matters most in the long run.  Debt (created from credit) and its cycles matter most in the short run.  Like any cycle, what goes up must go back down and repeat again.  Dalio identifies the 1920’s and 30’s as the last bottom of a long-term debt cycle.  Here we are about a hundred years later in what appears to be another long-term debt cycle bottom.

Long term debt cycles are resolved through a process called deleveraging or debt reduction.  This applies to individuals, businesses, banks and government.  There are four typical stages of deleveraging:

·         1st is austerity – spending less

·         2nd is debt restructuring – loans are called or refinanced at worse terms than before

·         3rd is taxing the ‘haves’ – to reduce inequality with ‘have nots’ and reduce government debt

·         4th is money printing – to stimulate the economy and create inflation to reduce debts

The government and central banks must very carefully balance the first three deflationary actions with the fourth inflationary action.  Too much deflation leads to a depression and too much inflation leads to hyperinflation.  Neither depression nor hyperinflation is good.  Having to rely on government to get it right is equally concerning.

Dalio concludes with three rules of thumb, which can be applied to people as they can to business, banks and government:

·         Don’t have debt rise faster than income

·         Don’t have income rise faster than productivity (you become uncompetitive)

·         Do all you can to raise your productivity – this is what matters most

This blog is a quick review of a fundamentally important piece of financial literacy.  I strongly recommend you take the time to watch the video.  Invest in yourself.  Be Prepared.