Mr. Dalio’s Final Thoughts on the Economic Machine

In this final post concerning Mr. Dalio’s fabulous little video How The Economic Machine Works, we will follow along with him and consider the role of the Government in dealing with depressions, and also some final pieces of advice he leaves us (both as participants in the global economy and as individuals).

During major economic downturns,  most of the credit that people thought was really money has all dried up and there is no money and there is no credit.  Wouldn’t it be nice if we could just print a bunch of money and flood it into the economy? That is precisely what the central bank can do.  This can work if it is done carefully. Remember that all of the solutions we’ve discussed so far to the debt load were deflationary.  Printing money by the central bank is inflationary. When the central bank prints new money, they use it to buy financial assets and government bonds.  This, in turn, allows the central government to engage in stimulus spending. The purchase of financial assets drives the prices back up, and people become more worthy of credit because the value of their assets has increased.   Of course, this only really helps those that own financial assets.

The rules put in place for the way the central government and the central bank operate work in such a way that each provides checks and balances for the other.  The central bank has to buy government bonds with the money it printed, and the central government has to put that money into the hands of the people. This serves to increase the central government’s overall debt, but it lowers the economy’s overall debt burden.

For this to work without destroying the economy, it has to be very carefully choreographed.  The deflationary ways of reducing the debt burden have to be balanced with the printing of new money so that the net inflation effect is minimized.  Many people wrongly assume that printing money will have an inflationary effect, and buying power will be lost to the degree that the new money is introduced into the economy.  This is not the case. When the new money is used to replace disappearing credit, it serves to keep spending level, which is what is necessary to keep inflation in check.

To really be effective in reducing the debt load, the central bank has to get the rate of income growth higher than the rate of interest.  The trick is to make sure that all methods of reducing the debt load are utilized such that inflation does not rise outside of an acceptable range.  Nobody wants to cut spending, restructure debt, and raise taxes, so printing money is the most popular alternative. If this is the only alternative used, it will cause hyperinflation and be a complete disaster.  If it is done correctly, the debt burden starts to fall, we start to lift out of the depression. Depressions usually last two to three years, and reflation tends to last seven to ten years.

Mr. Dalio ends his presentation by suggesting three major points that viewers should take away:

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

These are powerful lessons for personal finance, corporate finance, and national policy.  

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