This is third post relating to Ray Dalio’s remarkable little video, How the Economic Machine Works (link at the bottom of this page). In this one, we will consider the relationship between economic productivity and credit, and how that affects the overall economy.
As Mr. Dalio explains, credit is important to the economy because when borrowers receive credit, they can increase their spending. Spending, you will recall, is what drives the economy. Because of the nature of transactions, one person’s spending is always another person’s (or entity’s) income. This makes perfect sense. Every dollar that you spend, someone else earns. Every dollar that you earn resulted from someone else spending. Economies consist of transactions, and those transactions tend to form long chains that depend on the preceding transaction to go forward. This means that when you spend more, someone else earns more.
When someone’s income rises, it makes lenders more willing to extend him or her credit. The person has more money coming in, so it is more likely that the person can pay down more debt. In other words, the person is more creditworthy. Creditworthiness is a big deal in our modern economy, and we use credit scores to determine the creditworthiness of individuals. To be truly worthy of credit, you need the ability to repay (a good income) and collateral. Collateral is something of value that you can sell to meet your obligations if you find in the future that your income is insufficient. When you buy a car or a house, for example, the thing you bought is the collateral. If you don’t pay your car loan, the bank will repossess it.
More income means that people can spend more, but it also means that they can borrow more. More credit leads to more spending. This, too, happens in a chain reaction. If my spending goes up, then the people that I buy stuff from also see an increase in income. This means that they have more money and more credit, so their spending will go up. The pattern is self-reinforcing, and it leads to economic growth. That sounds great, but the problem is that it leads to economic cycles.
In a normal transaction, you have to give something to get something. How much you get is determined by how much you produce. Over time, we learn and innovate, and that accumulated knowledge raises our living standard (because we can make more money). This tends to happen across the board, and we call such an increase productivity growth. Those that are inventive and hardworking can raise their standard of living quickly. If you are complacent and lazy, then the opposite will be true.
Often, we don’t see that fact because productivity matters most in the long run. In the short run, credit can make up for a lack of productivity. In practice, we can’t really tell if spending increases are caused by more productivity or more credit. A major factor in this timing issue is the fact that productivity tends to be slow and steady over time. This means that productivity growth is seldom a major factor in economic swings. On the graph we talked about earlier, there tends to be a straight line with a slight upward slope, representing the idea that productivity grows slowly but steadily over time.
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