According to Raymond Dalio of Bridgewater Associates, the economy works like a machine. It is simply the sum of transactions that make it up. Of course, the economy looks complex as there are a lot of transactions to aggregate. However, from a bottom up or transaction up view, the economy is much easier to understand.

Ray Dalio

Ray Dalio points out there are two main forms of payment

A transaction is an exchange between buyer and seller. A buyer provides money or credit and in return gets a good or service from a seller. Ray Dalio points out there are two main forms of payment, cash (immediate payment) or credit (a promise to pay at a later date). A market consists of buyers and sellers engaging in exchanges for the same thing (e.g. the wheat market, where buyers and sellers exchange money for wheat). The economy is the aggregation of markets of different items, and it seems complex as there are so many transactions taking place.

To understand any market, one needs to know the total amount of money (or credit) spent and the total of goods or services available for sale. To forecast the price of a good, service, or financial asset, one needs to estimate quantity (total available for sale) and funds available to spend. Since price equals funds divided by quantity, once those two variables are forecasted, one can estimate price. Even though there are many buyers and sellers with different motivations, once one understands the motivations of the most important buyers and sellers, one can structure an understanding of markets and economies, as shown in the diagram below.

Source: Economic Principles, Bridgewater Associates

 Thus, there are different types of markets, different categories of buyers and sellers and different payment options that compose the economy. The machine works as follows:

  1. All changes in transaction volume (economic activity) and in financial asset prices are due to changes in the amount of money and credit spent (funds available) and changes in quantity.
  2. For simplicity, buyers come from two main sectors – private and government. The private sector consists of households and businesses, which can be domestic or foreign. The government in turn is divided into the Federal (or central) government and the central bank. The latter is the only market participant with the ability to create money and in large spends such resources in financial assets.

Economic and price cycles driven by demand and money creation

Changes in funds available have a greater impact than changes in quantity on economic activity and prices, as is it easier to change the supply of money and credit relative to modifying production quantities. Changes in buyer demand, money supply, and credit availability drive economic and price cycles. The relationship between the change in quantities exchanged and the change in price will evolve depending on the buyer type, amount spent, and type of financing (money versus credit). A significant part of spending comes from credit creation and changes in spending drive prices. So if an increase in amount of money available is offset by declining availability of credit, the economy will not suffer inflationary pressures. In fact, if the amount of credit available is contracting and the amount of money remains constant, the amount of spending will decline and prices could fall.

Economic machine framework helped to foresee 2008 financial crisis

Bridgewater has used the transactions-based approach to study boom and bust cycles during certain periods, including the 1925-1935 cycle in the U.S., the 1975-1985 period in Latin America, and the 1985-1995 timeframe in Japan. These periods were characterized by large deleveraging and Bridgewater created a depression gauge to identify debt contractions that cannot be reversed by lowering interest rates because rates are close to zero.

Ray Dalio noted that debt was rising faster than income

Such gauge started displaying warning signs as early as 2006. The following year, Bridgewater warned readers in its popular “Daily Observations” newsletter about the “crazy lending and leveraging practices.” Particularly, Ray Dalio noted that debt was rising faster than income and that such debt was being used to buy goods, services, and financial assets that were not generating enough income to service the debt. Such situation is unsustainable, and asset prices became inflated. Temporarily, the growth in debt contributed to financial asset price increases and credit spread declines in financial assets, as market participants thought that the abundance of credit implied low credit risk. In April 2008, Bridgewater noted that “the role of banks will once again change for the worse.” Such forecast was spot on. While the banking industry lost more than $500 billion in 2008, Bridgewater and its hedge funds prospered. Bridgewater’s flagship Pure Alpha Strategy – a macro hedge fund that invests in a variety of investment vehicles including bonds, stocks, commodities, and currencies – rose 8.7 percent in 2008. Institutional investors invested in the firm, whose assets grew from $36 billion at the beginning of 2008 to $85 billion at that years’ end. Currently, the firm manages $145 billion.

Long safe assets, short risky assets during financial crisis

During 2006-2008, Bridgewater positioned its funds to take various uncorrelated bets. The largest one was to be long in long term safe assets and be short in short term risky (spread) assets. For example, Bridgewater was long in sovereign bonds that did not have credit risk, long yen and long gold. Bridgewater also abstains from systematic biases that may drive long or short positions, and Ray Dalio points out that the “only reason for losing money is being wrong.”

Federal Reserve’s quantitative easing helped economy normalize

Quantitative easing is essentially injecting money into the financial system. Debt is a promise to deliver payment at a later date, so it effectively creates a short money position. To relieve that short money position, the Federal Reserve provided more money and made servicing of debt easier (i.e. lowered interest rates) by purchasing financial assets. The central government acts as a buyer of goods and services but only the central bank is authorized to buy financial assets. As the latter are bought by the Federal Reserve, their prices improve making people feel wealthier. Financial assets are worth more on paper and people are driven to borrow and spend more improving demand in the economy. Over the long term, challenges regarding improving productivity remain as changing spending and demand comprise only one side of economic transactions.

Federal Reserve policymakers should monitor debt creation and the ability of servicing such debt, in Ray Dalio’s view. Specifically, the Federal Reserve needs to ensure that debt growth and serviceability are benign relative to income growth trends. Currently, the economy is returning to normalcy thanks to the Federal Reserve’s accommodative policy but it still has high debt levels. Ray Dalio believes that decelerating asset purchases is appropriate but only to keep a proper balance between debt growth and income increases. Essentially, debt must not rise or fall too much relative to income for long periods.