How The Economy Works (1/2)

By Richard Reis

Hello dear,

I wanted to end this “Invest Money” series with two letters explaining the economy.

Specifically, how the economy works.

“Why?”

Because understanding the economy is an incredibly worthwhile subject.

“Why?”

Because the news tends to blow things out of proportion. If something bad happens to the economy, it will feel as if the world has come to an end.

However, once you study history and zoom out far enough, you’ll notice a lot of what we’re seeing today has already happened many, many times before.

“I believe that the more you know about the past, the better you are prepared for the future.” — Theodore Roosevelt

Studying the economy allows you to understand what is going on today, what is likely to happen tomorrow, and most importantly how you should act.

Onward.

Meet Your Teacher

Obviously, what you’re about to learn didn’t come from my personal “ideas.”

I found a practitioner. Someone who doesn’t only write about the economy, but also puts his money where his mouth is.

Not only has he had an incredible track record (he’s been called the “Steve Jobs of Investing”), but he’s also one of the few people who’s beat the market consistently for many years.

That someone is Ray Dalio.

I’ll let Charlie Rose introduce him for me:

“[His] company manages roughly $125Billion in global investments.
Its clients include foreign governments, sovereign banks, central banks, and institutional pension funds.
Over the last 2 years Bridgewater ranked as the largest and best-performing hedge fund in the world.
In 2010 its returns were greater than the profits of Google, Amazon, and eBay combined.” — Charlie Rose

During these next two letters, Ray will be your teacher. All I’ll do is summarize his lessons.

Obviously, explaining the economy in two letters will leave a lot of holes.

If you’d like to dig deeper, check out Ray’s 30min video “How The Economic Machine Works.”

If you’d like to dig even deeper, check out Ray’s 300-page Research paper “Economic Principles.

Sidenote: I have learned A LOT from Ray. Here I’ll only talk about his lessons on the economy. However, there’s much more you can learn from him. Luckily, he wrote a paper describing his thinking process. It’s titled “Principles” and it is one of the most important documents I’ve ever read. He also has a book coming out September 19th. I’ve already pre-ordered it, I highly recommend you do the same.

Anyways, back to the economy.

The Economy Is Like A Machine

Like a machine, the economy has cause-effect relationships (for every action, there’s a reaction).

Also, if you give it enough time, you’ll see the same economic events happen over and over again (just in different ways).

What is an Economy?

An economy is simply the sum of all the transactions that make it up.

Instead of studying the economy from the top down, we’ll study it from the bottom up.

What does this mean? That we’ll start small. We’ll look at a single transaction.

This way you’ll understand the economy much more easily.

“This different way of looking at the economy and markets has allowed us to understand and anticipate economic booms and busts that others using more traditional approaches have missed.” — Ray Dalio

But first, a small explanation of the order in which we’ll study the economy.

Three Major Forces

There are three major forces that drive most economic activity.

1. Productivity Growth

This is measured in Real Per Capita GDP.

This means you take the country’s Gross Domestic Product or GDP (aka the added value of alllll the goods and services in the country) and divide it by the number of citizens in the country.

Do that and you get this nice little graph.

Productivity in the US has grown more or less 2% each year. This has happened over the last 100 years (although I couldn’t find a graph that goes that far).

This means the country (and its citizens) are getting wealthier on average year, after year, after year.

“Why does productivity grow?”

Because knowledge increases over time (1 tractor is more efficient than 10 farmers, 1 excel sheet is more efficient than 10 mathematicians).

This in turn raises productivity and living standards.

Productivity is what matters most in the long-run!

Yes, the economy will have its ups and downs, but we can be relatively confident that, with time, the economy will get back on track.

2. The Short-Term Debt Cycle

These last 5–8 years on average.

We’ll look at them more in detail next week.

3. The Long-Term Debt Cycle

These last 50–75 years on average.

We’ll look at them more in detail next week.

Productivity Growth: It All Starts With You

Let’s zoom in.

Everything about the economy starts with a single transaction.

This means it all starts with you buying something.

Yes, you. Reading these very words.

“The [economic] machine works in the same way for an individual. A country is nothing more than the collection of its individuals or companies.” — Ray Dalio

A Transaction

A transaction consists of the buyer (that’s you) giving money or credit, to a seller in exchange for a good, service, or financial asset.

Money

Money is what you call “cash.”

Money is what allows you to settle the transaction.

Someone gives you an apple, you give them money, the transaction is settled.

Credit

Credit is a promise to pay money at a later date.

For example, if you buy an apple with a credit card, the transaction is not settled. This is why you sign a little piece of paper, you are promising you will pay later.

Most spending comes from credit.

“Why?”

Because credit can be created out of thin air (if I give you an apple and you tell me you’ll pay back later, we’ve created credit!).

Credit is what creates cycles in the economy:

  • When credit is easily available, there is an economic expansion.
  • When credit isn’t easily available, there is a recession.

We’ll talk about this more in detail next week.

Markets

A market consists of all the buyers and sellers making exchanges for the same things.

For example, when you bought that apple, you were participating in the apple market.

There’s a market for everything. An apple market, a wheat market, a car market, a stock market, etc…

Put all these markets together, and you have the economy.

Price

The price of anything comes from the total spending (credit + money) divided by the quantity sold by sellers.

In other words: Price = Total Spending (Credit + Money) / Total Quantity

For example, if you took all the money made from selling apples in the apple market, and divided it by the number of apples sold, you’d find the true price of an apple.

Price also matters because it influences two important forces in the economy:

  1. Inflation: This happens when prices are rising. The government doesn’t like too much inflation because it creates problems (for example, if prices are too high, only the rich will be able to afford most things. This is bad).
  2. Deflation: This happens when prices are lowering. Typically, because people are spending less.

The Government

Remember I said the economy starts with you? That’s true.

However, someone has to make sure you and everyone else in the economy play by the same rules.

Not only that, they also have to make sure bad things don’t happen to the economy. And if bad things happen, they make sure the solutions are managed as well as possible.

That someone is The Government.

The government consists of two parts.

  1. The Federal Government: Who spends money on goods and services (for example, to build your roads).
  2. The Central Bank: Who controls how much money is in the economy. This is the only entity that can print money (if you do it, it’s illegal). The central bank mostly spends money on financial assets (specifically government Bonds).

Buying

You’re a tiiiiiiny buyer in the economy. The government is the biggest buyer of all.

Buying can come from either a) The Private Sector (you, households, and businesses that can be either domestic or foreign) or b) The Government (the 800-pound Gorilla).

Congrats! You Understand The Basics

Now you know all the pieces that make the economy.

You know that productivity is always increasing. And that’s what matters most in the long-run.

The goal of an economy is to increase productivity.

In fact, if you want to become wealthy, your goal is to increase your productivity.

However, this is only half the picture.

Most people don’t focus on increasing their productivity. Most people want to spend more than they have and they want to spend it now.

This is why we have Credit.

Credit is why we have cycles, recessions, depressions, bear markets, bull markets, and all the other exciting economic buzzwords you hear on the news.

If Credit creates cycles, why live in an economy with credit?

Because credit isn’t necessarily a bad thing.

It’s only bad if it finances things that don’t generate more money (like a new car or a TV). A lot of people do this because they want things they can’t afford.

However, credit is good if it allows you to achieve something that increases your productivity (like borrowing money to start a business, IF done successfully).

If we didn’t have credit, you couldn’t buy something unless you could afford it.

Since we have credit, its expansion is only constrained by the willingness of creditors and debtors to extend and receive credit.

You probably guessed this by now; people push it.

This is why we have cycles, this is why credit is the most important part of the economy.

Next week, we’ll look more into this.

And that’s it for today!

Today, we learned:

  • Who is Ray Dalio and why people trust his way of seeing the economy.
  • Why the economy is like a machine.
  • What three major forces drive the economy.
  • Why productivity matters most (and how it all starts with you).
  • What are markets.
  • And what roles does the government play.

See you next week (follow the series here to be notified).

Be well.

R


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