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Four Levers to Deleverage the Economy | Summary of Ray Dalio’s Economic Machine

No Filter | Steve Glaveski | Jan 4, 2020

the economy - Four Levers to Deleverage the Economy | Summary of Ray Dalio’s Economic Machine

Ray Dalio is one of most successful hedge fund managers of our time, having founded Bridgewater Associates in 1975 — a company which today boasts US $160 billion in assets under management. Needless to say, Dalio is a billionaire in his own right.

He credits much of his success to guiding principles that he has used to make decisions both in his professional and in his personal life. More recently, as Dalio was closing in on his 70s, he decided to give back and codify these principles into what became his book, aptly titled Principles: Life and Work. It has had a profound impact on how I navigate the world.

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Dalio has been on the lockdown-imposed podcast trail, sharing his sentiments on what he thinks the short to long term economic outlook might be relative to COVID-19. His commentary builds upon a beautiful video he shared six years ago called ‘How the Economic Machine Works in 30 Minutes’ — it has been viewed over 14 million times and I highly recommend that you check it out, along with his book.

The Debt Burden

When incomes grow in relation to debt, things are kept in balance but a debt burden emerges when debt growth exceeds income growth.  This debt to income ratio is the debt burden.  While people might feel wealthy as the value of their assets soar, a wise philosopher once said that we shouldn’t conflate the trappings of success with success in itself.

People might remain creditworthy to borrow and spend and feel wealthy, but that’s because of the collateral that underpins their borrowings.  But as the debt burden increases, the value of said collateral can vanish. As the debt burden increases, it creates larger debt repayments over decades, and eventually it hits a peak, as was the case with the global financial crisis in 2008, with Japan in 1989 or during The Great Depression in 1929.

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At this point, spending goes backwards, borrowing stalls, incomes drop, asset values plummet, stock-markets tank and social tensions rise — this is called a deleveraging. It’s little like what we’re seeing today, although the COVID19 crisis wasn’t brought upon us by the long-term debt cycle correcting itself, but through a ‘force majeure’ external event and Government interventions.  Suddenly the value of the collateral that was used to securitise loans is gone, and banks find themselves in trouble. This led to the massive bail-outs of banks like JP Morgan, Goldman Sachs, Wells Fargo, State Street and others in a massive US$700 billion bail-out bill in 2008. Lehman Brothers weren’t so lucky.

At this point in the long-term debt cycle, interest rates can no longer be used to stimulate the economy because they are already at zero.  The difference between a recession and a deleveraging is that the debt burden is too big and can’t be relieved by lowering interest rates.  So what do we do now?

Four Levers to Deleverage the Economy

There are four levers we can pull to get the economy back on its feet during a deleveraging.

1 — Cut Spending

Essentially austerity measures for businesses and individuals.  But the thing about this is that. perhaps paradoxically, it causes incomes to fall because remember, one person’s spending is another person’s income, so the debt burden gets even bigger because people can’t afford to repay their debts anymore.  Cutting spending is deflationary and painful, and as businesses further cut costs, it means less jobs and higher unemployment.

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2 — Reduce Debt

Debt can be reduced through defaults and restructures.  When banks are squeezed, businesses can’t repay their loans, and individuals are lining up to withdraw their money from the bank for fear of it not being there tomorrow in case of bank defaults, you’re likely looking at a depression.

3 — Redistribute Wealth from Haves to Have-Nots

Much like Robin Hood stealing from the rich to give to the poor, incomes are redistributed. This can result in the wealthy being squeezed and resenting the have-nots, and vice versa for the contrast in outcomes.  If this continues, social disorder and revolution can follow, both within and between countries, as was the case in the 1930s when Adolf Hitler came to power due to economic collapse in Germany.  Pressure to end the depression mounts, but with no credit in the market, and with most ‘money’ being credit, as was mentioned earlier, the only thing left to do is…

4 — Print Money

With interest rates at zero, the Central Bank is forced to print money. This is inflationary and stimulative, although it can decrease the value of a currency, especially if too much is printed, which can make nations uncompetitive or less competitive on a global scale.  By buying financial assets, the Central Bank drives up asset prices but it only helps people who have financial assets.  The Central Bank can only buy financial assets, not goods and services, so in order to support the economy at large, the Central Bank buys Government bonds which gives the Government the ability to buy goods and service. This gets money into the hands of people at large, not just those with financial assets.


Three Rules of Thumb For Life

Finally, Dalio leaves us with three rules of thumb with which to navigate the economy ourselves, be it in our own businesses, organisations we work at or our personal finances.

  1. Don’t have debt rise faster than income (because debt burdens will eventually crush you).
  2. Don’t have income rise faster than productivity — it will eventually render you uncompetitive.
  3. Do all you can to raise productivity — in the long run that’s what matters most.

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