Nery Alaev

How does the ‘economic machine’ work?

Nery Alaev writes about the work of Ray Dalio.

This week, I summarise an important piece of literature written by Ray Dalio about the machinations of the global economy.

There are many key factors and drivers of the global economy to consider including productivity, debt, rising incomes and the policy of central banks around the world.

A transactions-based approach

Nery Alaev

Dalio summarises productivity

“An economy is simply the sum of the transactions made and a transaction is a simple thing. A transaction consists of the buyer giving money (or credit) to a seller and the seller giving a good, a service or a financial asset to the buyer in exchange.”

 “A market consists of all the buyers and sellers making exchanges for the same things – e.g., the wheat market consists of different people making different transactions for different reasons over time. An economy consists of all of the transactions in all of its markets. So, while seemingly complex, an economy is really just a zillion simple things working together, which makes it look more complex than it really is.”

This means that the economy of the world is a massive network of transactions happening at once on an overwhelming scale. The three ‘main’ drivers of economies worldwide are:

  • Trend line productivity growth
  • The long-term debt cycle
  • The short-term debt cycle

Trend line productivity growth

Dalio points to knowledge as a key driver of productivity growth – recent developments in technology can definitely vindicate this claim.

In his report, he states:

“Real per capita GDP has increased at an average rate of a shade less than 2% over the last 100 years and didn’t vary a lot from that.

This is because, over time, knowledge increases, which in turn raises productivity and living standards.”

The Long-Term (i.e., Long Wave) Cycle

On Long-Term Debt Cycles, Dalio states:

“…When debts and spending rise faster than money and income, the process is self-reinforcing on the upside because rising spending generates rising incomes and rising net worths, which raise borrowers’ capacity to borrow which allows more buying and spending, etc.”

Dalio goes on to summarise that debt has been around since the times of the Old Testament and it (the Old Testament) suggested that debt be wiped every half-century.

There is a clear standpoint on long-term debt – that it’s a primarily cyclical, almost inevitable force that is driven by different factors over time and has strong ties to income and the wealth of nations. This debt is different, however, to short-term debt.

Nery Alaev

Debt is an important factor

The Short-Term Debt Cycle

Dalio describes the Short-Term Debt Cycle as:

“…primarily controlled by central banks’ policies that a) tighten when inflation is too high and/or rising uncomfortably because there isn’t much slack in the economy (as reflected in the GDP gap, capacity utilization and the unemployment rate) and credit growth is strong; and b) ease when the reverse conditions exist.”

This means that the short term cycle is more related to short-term, less macroeconomic issues and can be better-related to individual nations as opposed to whole regions or the world at large.

In conclusion, the three factors highlighted are clearly important to the economic ‘machine’ – there are plenty of other factors that can drive the fate of economies across the world, such as resources and political changes, but the three factors highlighted are definitely of high importance.

To see more, see: Dalio – Understanding Economy.

Nery Alaev

Nery Alaev is the current Director of ESN Investments GmbH, which engages in acquisition and development of commercial and residential property in Germany and Austria.