How The Economic Machine Works by Ray Dalio

Summary

El guion del video explica cómo funciona la economía a través de un modelo simple y mecánico, basado en transacciones, productividad, ciclos de deuda a corto y largo plazo. Destaca la importancia del crédito y cómo influye en la economía, creando ciclos de expansión y recesión. Describe los mecanismos del ciclo de deuda a corto plazo, controlado por el banco central, y el ciclo de deuda a largo plazo, que lleva a la desleverage cuando las deudas son insostenibles. El guion sugiere que una desleverage equilibrada, conocida como 'desleverage hermosa', puede reducir las cargas de deuda sin generar inflación, a través de la reducción de gastos, reestructuración de deudas, redistribución de riqueza y emisión de dinero por parte del banco central. El mensaje final enfatiza la importancia de la productividad a largo plazo y la sostenibilidad de la deuda.

Takeaways

• 📚 La economía funciona como una máquina sencilla, compuesta por transacciones repetidas y movida por la naturaleza humana.
• 💼 Las transacciones son la base de la economía, donde se intercambian bienes, servicios o activos financieros contra dinero o crédito.
• 💹 El crédito es la parte más importante y menos entendida de la economía, siendo el elemento más grande y volátil que impulsa el crecimiento económico.
• 🔄 El endeudamiento crea ciclos económicos, ya que al tomar prestado se consume más de lo que se produce y se genera un futuro de menor gasto para pagar deudas.
• ⏳ Existen dos ciclos de deuda: uno a corto plazo de 5 a 8 años y otro a largo plazo de 75 a 100 años, que afectan la economía de manera cíclica.
• 🌐 El Banco Central es un actor clave en la economía, controlando la cantidad de dinero y crédito a través de la tasa de interés y la emisión de dinero nuevo.
• 📉 En una recesión, el Banco Central eleva las tasas de interés para frenar la inflación, lo que disminuye el endeudamiento y el gasto, llevando a una reducción de ingresos.
• 📈 El crecimiento económico a corto plazo puede ser impulsado por el crédito, pero a largo plazo, la productividad es la verdadera fuente de aumento de los estándares de vida.
• 💔 Un exceso de endeudamiento lleva a un punto de inflexión donde las deudas se vuelven insostenibles, desencadenando un proceso de desleverage o reducción de deuda.
• 🌐 En un desleverage o reducción de deuda, las personas y el gobierno deben reducir el gasto, las deudas se reestructuran, la riqueza se redistribuye y los bancos centrales pueden emitir más dinero.
• 🔄 La reducción de la deuda puede ser hermosa si se logra el equilibrio adecuado entre la reducción de gasto, la reestructuración de deuda, la redistribución de riqueza y la emisión de dinero.

Q & A

¿Cómo funciona la economía según el guion del video?

La economía funciona como una máquina simple, compuesta por partes sencillas y una gran cantidad de transacciones que se repiten una y otra vez. Las transacciones están impulsadas por la naturaleza humana y generan tres fuerzas principales que mueven la economía: el crecimiento de la productividad, el ciclo de deuda a corto plazo y el ciclo de deuda a largo plazo.

¿Qué son las transacciones y cómo son fundamentales para la economía?

Las transacciones son la suma de todas las operaciones que la componen y son muy simples. Consisten en un comprador intercambiando dinero o crédito con un vendedor por bienes, servicios o activos financieros. El gasto total impulsa la economía y, dividiendo el monto gastado por la cantidad vendida, se obtiene el precio.

¿Qué papel juegan el gobierno y el banco central en la economía?

El gobierno, compuesto por el gobierno central y el banco central, es el mayor comprador y vendedor en la economía. El banco central es diferente porque controla la cantidad de dinero y crédito en la economía, influyendo en las tasas de interés y la emisión de nuevo dinero.

¿Por qué el crédito es considerado la parte más importante y menos entendida de la economía?

El crédito es la parte más grande y volátil de la economía. Es importante porque permite que los tomadores de crédito aumenten su gasto, lo que a su vez impulsa la economía. Además, el crédito se crea y se convierte en deuda de inmediato, lo que puede generar ciclos económicos debido a que el endeudamiento lleva a un aumento y disminución del gasto.

¿Cómo afecta la tasa de interés al endeudamiento y al ciclo económico?

Cuando las tasas de interés son altas, hay menos endeudamiento porque es costoso. Cuando las tasas de interés son bajas, aumenta el endeudamiento porque es más económico. Esto afecta directamente al ciclo económico, ya que el endeudamiento permite consumir más de lo que se produce y, al pagar la deuda, se consume menos de lo que se produce.

¿Qué son los ciclos de deuda a corto y largo plazo y cómo se relacionan con la economía?

Los ciclos de deuda son dos grandes fluctuaciones que ocurren en la economía. El ciclo de deuda a corto plazo dura aproximadamente 5 a 8 años y el ciclo de deuda a largo plazo dura aproximadamente 75 a 100 años. Estos ciclos son causados por el endeudamiento, que permite consumir más de lo que se produce y, al pagar la deuda, se consume menos de lo que se produce.

¿Cómo se relaciona el crecimiento de la productividad con las fluctuaciones económicas a corto plazo?

El crecimiento de la productividad es importante a largo plazo, pero no fluctúa mucho y, por lo tanto, no es un gran impulsor de oscilaciones económicas a corto plazo. En cambio, el endeudamiento es lo que causa estas fluctuaciones, ya que permite consumir más o menos de lo que se produce en función de si se está endeudando o pagando deudas.

¿Qué sucede durante un Deleveraging y cómo es diferente a una recesión?

Durante un Deleveraging, las personas reducen el gasto, disminuyen los ingresos, desaparece el crédito, las precios de los activos bajan, los bancos se enfrentan a dificultades, aumentan las tensiones sociales y se genera un ciclo vicioso. La diferencia principal con una recesión es que en un Deleveraging no se puede reducir la tasa de interés para estimular el endeudamiento, ya que las tasas ya están bajas y llegan a 0%.

¿Cuáles son las cuatro formas en que se pueden reducir las cargas de deuda durante un Deleveraging?

Durante un Deleveraging, las cargas de deuda se pueden reducir de cuatro maneras: 1) las personas, las empresas y los gobiernos reducen sus gastos, 2) se reducen las deudas a través de incumplimientos y reestructuraciones, 3) se redistribuye la riqueza de los 'tienen' a los 'no tienen', y 4) el banco central imprime nuevo dinero.

¿Cómo se puede lograr un Deleveraging 'hermoso' y qué implica?

Un Deleveraging 'hermoso' se logra manteniendo la estabilidad económica y social a través del equilibrio adecuado entre reducir el gasto, reducir la deuda, transferir la riqueza y imprimir dinero. Esto implica que los ingresos aumentan más rápidamente que el crecimiento de la deuda, y que se evita la inflación descontrolada.

¿Qué tres reglas prácticas se pueden extraer del modelo económico presentado en el guion?

Las tres reglas son: 1) No permitir que la deuda crezca más rápido que los ingresos, 2) No permitir que los ingresos crezcan más rápido que la productividad, y 3) Hacer todo lo posible por aumentar la productividad, ya que a largo plazo es lo que realmente importa.

Outlines

00:00

📚 Funcionamiento de la máquina económica

El primer párrafo introduce el concepto de que la economía funciona como una máquina simple, compuesta por transacciones básicas y fuerzas que la impulsan, como el crecimiento de la productividad, el ciclo de deuda a corto plazo y el ciclo de deuda a largo plazo. Se enfatiza la importancia de entender las transacciones económicas, que son la base del funcionamiento económico y cómo el crédito, creado por prestadores y tomadores, es fundamental para el crecimiento económico y la generación de ciclos económicos.

05:02

💳 El poder del crédito y su influencia en la economía

En el segundo párrafo, se discute cómo el crédito permite un gasto superior a los ingresos, lo que impulsa la economía a través de un ciclo de endeudamiento y pago. Se explica que el endeudamiento crea ciclos económicos, ya que al tomar préstamos creamos un ciclo de pago futuro. Se enfatiza que el crédito es diferente al dinero, ya que el dinero resuelve transacciones de inmediato, mientras que el crédito crea una deuda que se liquida en el futuro. Además, se menciona que la mayoría de lo que se considera dinero en realidad es crédito.

10:02

🔄 Ciclos económicos y su relación con el crédito

El tercer párrafo explora cómo el crédito influye en los ciclos económicos a corto y largo plazo. Se describe cómo la expansión económica y la inflación llevan al banco central a aumentar las tasas de interés, lo que a su vez disminuye el endeudamiento y el gasto, provocando una recesión. Se detalla cómo el ciclo de deuda a corto plazo, que dura aproximadamente de 5 a 8 años, es controlado por el banco central y cómo el ciclo de deuda a largo plazo se ve afectado por el endeudamiento que crece más rápido que los ingresos, lo que lleva a un punto de ajuste económico.

15:02

💔 El impacto del agotamiento del endeudamiento

El cuarto párrafo se centra en el concepto de 'deleveraging' o desendeudamiento, que ocurre cuando las deudas son demasiado grandes para ser pagadas y los ingresos no pueden mantener el ritmo de los pagos de deuda. Se describe cómo esto lleva a una reducción del gasto, disminución de los ingresos, caída de los precios de los activos y problemas en el sector bancario. Se menciona que en una deleverage, los tipos de interés ya están bajos y no pueden ser utilizados para estimular la economía, lo que contrasta con una recesión donde la reducción de las tasas de interés ayuda a estimular el endeudamiento.

20:07

🛠 Manejo de la deleverage y su impacto en la economía

En el quinto párrafo, se discuten las cuatro maneras de reducir la carga de la deuda durante un proceso de deleverage: la reducción del gasto, la reducción de deudas a través de incumplimientos y reestructuraciones, la redistribución de la riqueza y la emisión de nuevo dinero por parte del banco central. Se destaca cómo cada una de estas acciones tiene efectos inflacionarios o deflacionarios y cómo la política gubernamental y las decisiones del banco central son fundamentales para evitar una depresión y lograr un deleverage 'hermoso', que mantiene la estabilidad económica y social.

25:07

🌟 La deleverage hermosa y su importancia

El sexto párrafo habla sobre cómo un proceso de deleverage puede ser manejado de manera que resulte en una situación 'hermosa', donde las deudas se reducen en relación con los ingresos, el crecimiento económico real es positivo y no hay problemas de inflación. Se enfatiza la importancia de equilibrar las medidas deflacionarias y inflacionarias para lograr un deleverage exitoso. Además, se presentan tres reglas generales para evitar problemas económicos a largo plazo: no permitir que la deuda crezca más rápido que los ingresos, no permitir que los ingresos crezcan más rápido que la productividad y trabajar en el aumento de la productividad, ya que a largo plazo es lo más importante.

30:08

📘 Conclusiónes y consejos finales

El último párrafo resume los puntos clave del video, ofreciendo consejos sencillos tanto para individuos como para los tomadores de políticas. Se enfatiza la importancia de prestar atención a las lecciones del modelo económico presentado y se espera que estos consejos ayuden a evitar sufrimientos económicos innecesarios y a anticipar crisis financieras futuras.

Keywords

💡Economía

La economía es el sistema mediante el cual los recursos son producidos, distribuidos y consumidos. En el video, se describe cómo funciona la economía como una máquina simple, compuesta por transacciones repetidas y dirigida por la naturaleza humana.

💡Transacción

Una transacción es el intercambio de dinero o crédito entre un comprador y un vendedor por bienes, servicios o activos financieros. Es el bloque de construcción de la máquina económica y el núcleo de todas las actividades económicas.

💡Mercado

Un mercado es el lugar donde todos los compradores y vendedores realizan transacciones de un mismo artículo. Ejemplos dados en el video incluyen el mercado de trigo, el mercado de automóviles y el mercado de valores.

💡Producto

El producto se refiere a los bienes, servicios o activos financieros que son objeto de intercambio en una transacción. La calidad y la cantidad de los productos ofrecidos afectan directamente el funcionamiento de la economía.

💡Crédito

El crédito es el dinero prestado que permite a los tomadores de decisiones aumentar su gasto inmediatamente, creando un ciclo de deuda. Es un componente crítico de la economía, ya que permite el gasto adicional y, por tanto, impulsa el crecimiento económico.

💡Deuda

La deuda es el dinero que un tomador de decisiones ha prometido pagar, conocido como el principal, más una cantidad adicional llamada interés. La deuda es tanto un activo para el prestador como una obligación para el deudor y es fundamental en la creación de crédito.

💡Ciclo de Deuda a Corto Plazo

Este ciclo describe las fluctuaciones económicas que ocurren a lo largo de 5 a 8 años, donde el crédito y el gasto crecen y disminuyen en respuesta a las tasas de interés establecidas por el banco central.

💡Ciclo de Deuda a Largo Plazo

Este ciclo abarca un período de 75 a 100 años y se enfoca en cómo la deuda puede acumularse a lo largo del tiempo, llevando a un punto crítico donde la deuda se vuelve insostenible y requiere de una reducción.

💡Desleverage

El desleverage es el proceso por el cual las personas y las instituciones reducen sus niveles de deuda. Este proceso puede ser doloroso y deflacionario, pero es necesario para restablecer la solidez financiera y la credibilidad crediticia.

💡Banco Central

El banco central es una entidad clave en la economía que controla la cantidad de dinero y crédito en la economía a través de la influencia de las tasas de interés y la emisión de nuevo dinero. Juega un papel crucial en el flujo de crédito y en la estabilización de la economía.

💡Productoividad

La productividad es el aumento en la eficiencia con la que se producen los bienes y servicios. A largo plazo, la productividad es el factor más importante para el crecimiento económico, aunque a corto plazo, el crédito y el ciclo de deuda son más influyentes.

Highlights

The economy operates like a simple machine driven by human nature and transactions.

Three main forces drive the economy: productivity growth, the short-term debt cycle, and the long-term debt cycle.

Transactions are the building blocks of the economy, consisting of buyers exchanging money or credit with sellers.

Credit is the most important and least understood part of the economy, being the largest and most volatile component.

Borrowers increase their spending when they receive credit, which in turn drives the economy.

A self-reinforcing cycle of borrowing and spending leads to economic growth.

Productivity growth is the most significant factor in the long run, but credit has the most impact in the short run.

Debt allows consumption to exceed production, creating cycles that swing the economy.

The short-term debt cycle, typically 5-8 years, is controlled by the central bank and involves periods of expansion and recession.

The long-term debt cycle, around 75-100 years, sees debts outpace incomes, leading to bubbles and eventual deleveraging.

Deleveraging occurs when debt burdens become unsustainable, leading to a reduction in spending, falling incomes, and asset price drops.

During deleveraging, interest rates can't be lowered to stimulate borrowing as they are already too low.

There are four ways to reduce debt burdens: spending cuts, debt reduction, wealth redistribution, and central bank money printing.

Austerity measures, debt restructuring, and wealth transfer are deflationary, while central bank money printing is inflationary.

A 'beautiful deleveraging' is achieved through a balanced approach of spending cuts, debt reduction, wealth transfer, and money printing.

Policymakers must balance deflationary and inflationary measures to maintain stability during deleveraging.

The economy can recover from deleveraging with the right policies, although it may take a 'lost decade' or more.

Three key rules for individuals and policymakers: control debt growth relative to income, ensure income growth doesn't outpace productivity, and focus on raising productivity.

Transcripts

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 is — 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 pay it back.

Debt swings occur in two big cycles.

One takes about 5 to 8 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 air — and 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 Reserve — printed 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 people — including most policy makers — don't pay enough attention

to this.

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

Thank you.