The current state of the United States economy is called “deleveraging.” As we as a nation traverse a series of severe economic events, namely, as a result of an unexpected worldwide Covid-19 virus pandemic, it is essential to note this position is also a result of repeated economic cycles. There are several periods in history in which the US was forced to deleverage. To realize the US’s current financial state, it helps to understand the inner workings of our economic system.
Forces That Drive Our Economy
Our economic system is logical and based on common sense principles, but not all Americans realize how our cyclical financial system performs. The economic cycle is generally straightforward, but impactful factors can change what history has usually proven to be true. Ray Dalio, Author, Entrepreneur, and Hedge Fund Manager, shared a video entitled How The Economic Machine Works. He states, “the economy works like a simple machine, but many people don’t understand it or don’t agree on how it works…” Dalio believes in an economic template for dealing with the global financial crisis.
Oxford Languages defines economy as: “the wealth and resources of a country or region, especially in terms of the production and consumption of goods and services.” Dalio describes the economy as transactions generated by human nature. He says three primary forces drive our economy: 1) productivity growth, 2) short-term debt cycle, and 3) long-term debt cycle. He believes buyer and seller “transactions” are the foundation of our economic system.
How Transactions Are Constructed
The economy is based on buyer and seller transactions performed with money or credit, usually for goods, services, or financial assets. When you add credit to money spent, the result is total spending, which drives our economy. There are markets for everything we buy and sell. Therefore, the economy is made up of all transactions in all markets. Dalio says the largest buyers and sellers include the central government and the central bank. These entities have a great deal of control in tax collecting, spending money, and controlling cash and credit, making up the economy. Keep in mind that the central banks have control of interest rates and the printing of money along with the credit.
The Key Role of Credit
Most people do not realize that credit is one of the most critical yet volatile factors of the economy. Lenders and borrowers are behind the credit cycle in which principal and interest payments are significant. For example, once the credit is created in the form of a loan, it is called a “debt.” While Debt is considered a liability to a borrower, it is viewed as an asset to a lender. Credit transactions result in spending—which we know drives the economy. Credit patterns ultimately lead to these economic cycles: productivity growth, short-term Debt, and long-term Debt. The periods for debt swings generally range from 5-8 years and 75-100 years. Dalio explains that an economy without credit (Debt) is not feasible and that borrowing helps with spending and allows time for advancing productivity, thus the cycles.
Pros and Cons of Credit
The amount of credit in the economy far outweighs the actual amount of money. Credit allows income to rise and increase spending, creating growth, while borrowing creates cycles. Dalio states, “In an economy without credit, the only way to increase spending is to produce more – but in an economy, with confidence, you can increase credit by borrowing. “If borrowing money is done with purpose, it can help people and the economy (as long as it can be paid back). A pattern is created called a short-term debt cycle. Here we see expansion–increased spending fueled by credit, rising prices, leading to inflation. Then the central bank raises interest rates, so less borrowing is possible. Spending slows, incomes drop, and prices go down, which ultimately leads to a recession. When the central bank lowers interest rates, debts are reduced, and borrowing picks up. More simply, credit provides for economic expansion.
A long-term debt cycle takes place when debts rise faster than incomes. Lenders continue to lend when revenues are rising, assets become more valuable, and the stock market increases. Borrowing continues leading to a bubble. Prices continue to go up and lead to more massive debts over time. Finally, people stop spending, incomes, and borrowing decreases, and liabilities increase. Debt burden becomes too high (as we experienced in both 2008 and 1929). Dalio states, “The economy begins “deleveraging” – people cut spending, incomes fall, credit disappears, assets prices drop, banks get squeezed, the stock market crashes, social tension rises…” He says borrowers can no longer borrow enough, and they rush to sell assets. Spending falls, real estate markets fall, resulting in “less spending, less income, less wealth, less credit, and less borrowing – a vicious cycle.” At this point, the only reason we are in a recession is that the interest rates are already at their lowest point (the 1930s and 2008). We find ourselves in a non-credit worthy economy.
What Happens in Deleveraging
According to Dalio, when deleveraging occurs, the steps to resolve high debt burdens require the government to:
- Cut Spending — people businesses, and governments cut their spending
- Reduce Debt — debts are reduced through defaults and restructuring
- Redistribute Wealth — wealth is redistributed from the haves to the have-nots
- Print Money — the Central Banks print new money
- Create Stimulus Plans – the government offers stimulus funds to the people
Deleveraging has occurred in the US and many other countries experiencing deflation, depression, debt restructuring, tension, and political pressures. These steps were effective in the US during the 1930s, England in the 1950s, Japan in the 1990s, and Spain and Italy in the 2010s.
Dalio explains that the central government can buy goods and services to support the people, but they cannot print money while the central bank can print money but buy only financial assets. He says to stimulate the economy, the central bank and central government need to work together. “The central bank buys government bonds, lending money to the government to run a deficit and increase spending on goods and services through a stimulus program, and through unemployment benefits.” These increases in consumer income are expected to add balance and stability for a positive deleveraging effort. Finding balance is significant in a deleveraging success.
Economic Cycle Takeaways
Dalio leaves his How The Economic Machine Works video audience with three takeaways:
- Don’t have debt rise faster than income (your debt burdens will crush you)
- Don’t have income rise more quickly than productivity (you will eventually become uncompetitive)
- Do all that you can to raise your productivity (it matters most)
When you consider how the economy operates, and the historically cyclical processes involving productivity, short-term, and long-term Debt, the current state of the economy makes sense. In this case, it gives Americans peace of mind for the present and hopes for the future as we move through our economic deleveraging state to better times.