What is an economic cycle? The explanation by Ray Dalio, the founder of Bridgewater, is very classic.
Trading#
Although the economy may seem complex, it actually operates in a simple and mechanical way. The economy consists of a few simple components and countless repetitions of simple transactions.
If we break down the economic machine into smaller parts, we will get the smallest economic unit - trading. Just like cells in the human body, the economy is nothing more than the sum of countless transactions.
A transaction consists of two parties: the buyer and the seller. In each transaction, the buyer exchanges money or credit with the seller for goods, services, or financial assets. Money is exchanged for goods - the transaction is completed.
Moreover, this simplest model of a transaction tells us a simple truth: one person's income equals another person's expenditure, meaning the money earned by the seller is equal to the money spent by the buyer.
Credit is used in the same way as money, so adding the money spent and the credit together gives us the total expenditure.
The total expenditure is the driving force behind economic development, and all economic cycles and dynamics are caused by transactions.
A market is composed of all buyers and sellers of the same commodity, such as the wheat market, the car market, the stock market, and millions of other markets. The economy is made up of all transactions in all markets.
Individuals, businesses, banks, and governments all engage in transactions in the same way, exchanging goods, services, and financial assets with money and credit. The government is the largest buyer and seller, and the government has two components: the central government, which collects taxes and spends money, and the central bank. The central bank controls the quantity of money and credit in the economy, so unlike other buyers and sellers, the central bank controls this by influencing interest rates and issuing more money.
Adding up the total expenditure of all markets and dividing it by the total sales volume gives us the price:
Credit#
Credit is the economic behavior of a person borrowing money from a bank or others and promising to repay the principal and interest in the future.
Once credit is created, it immediately becomes debt. Debt is an asset for the lender and a liability for the borrower. When the borrower repays the loan and interest, these assets and liabilities disappear, and the transaction is completed.
Don't forget that expenditure is the driving force of the economy because one person's expenditure is another person's income. Think about it, every time you spend a dollar, someone else earns a dollar, and every time you earn a dollar, someone else has spent a dollar. So the more you spend, the more others earn. If someone's income increases, their creditworthiness will also increase, and lenders will be more willing to lend them money. Creditworthy borrowers have two conditions: the ability to repay and collateral. If the debt-to-income ratio is high, the borrower has the ability to repay. If they cannot repay, the borrower can use valuable assets that can be sold as collateral, so lenders can confidently lend them money. Therefore, an increase in income increases borrowing, which in turn increases expenditure. Since one person's expenditure is another person's income, this will further increase borrowing and continue the cycle. This self-reinforcing pattern leads to economic growth and is the reason for economic cycles.
Of course, banks do not lend money to everyone, they only lend money to creditworthy borrowers. In simple terms, banks only consider two indicators for lending:
- Debt serviceability (debt-to-income ratio)
- Collateral value
Only those with a high debt-to-income ratio and those with high-value collateral are considered creditworthy borrowers and can borrow from banks.
According to Ray Dalio's research, almost all circulating currency in the US market at that time was credit. And according to
Under the premise of unchanged social productivity, market prices are basically determined by credit.
In order to control market prices from experiencing severe fluctuations, central banks must control the quantity of credit circulating in the market by controlling loan interest rates. And this brings another economic phenomenon - cycles.
Three Driving Forces of Economic Operation#
In Ray Dalio's view, there are three driving forces behind economic operation:
- Improvement in productivity
- Short-term debt cycle: 5-8 years
- Long-term debt cycle: 75-100 years
Productivity#
The improvement of social productivity is the underlying driving force of economic prosperity, and it is also a decisive factor in the development of a social economy. However, its growth rate is also the slowest. It grows linearly.
Short-term Debt Cycle#
The short-term debt cycle typically lasts for 5-8 years, and its core influencing factor is the willingness of lenders.
This cycle is mainly controlled by the central bank. When the central bank offers low loan interest rates, lenders can borrow at lower interest rates, which increases their willingness to borrow. This leads to an increase in the circulation of credit currency in the market. In the short term, there is little change in social productivity, and the total output of goods and services remains relatively constant. As a result, the prices of goods increase, leading to inflation. At this time, people who produce the same products will earn higher profits, and everyone feels that they are becoming richer. This is the upward phase of the short-term debt cycle.
However, in order to control prices and prevent excessive inflation, the central bank will raise loan interest rates. This makes borrowing more expensive, and lenders are less willing to lend. As a result, the circulation of credit currency in the market decreases, leading to a decrease in prices, and the short-term debt cycle enters the downward phase. At this time, due to the decrease in profits from producing goods, people's enthusiasm for labor declines, and the market becomes sluggish. In order to stimulate economic prosperity, the central bank will lower loan interest rates again, and this cycle repeats, creating the short-term debt cycle.
Long-term Debt Cycle#
However, due to human greed and laziness, people always tend to borrow money from their future selves, borrowing in advance for consumption. Borrowing more during the upward phase of the short-term debt cycle and borrowing less during the downward phase creates a continuous accumulation of debt, leading to the long-term debt cycle.
The long-term debt cycle lasts for 75-100 years, and its core factor is no longer the willingness to borrow, but the leverage ratio and repayment ability of the entire society. The leverage ratio is the ratio of borrowed funds to one's own assets or net worth. In simple terms, if you borrow 1000 yuan by mortgaging something worth 100 yuan, the leverage ratio is 1000/100 = 10. By using this tool, the results of investments can be amplified, whether it is profit or loss, it will increase by a fixed ratio.
When the economic situation is good, people tend to increase their leverage ratio to obtain excess returns. As long as the economy is in an upward phase, whether it is borrowing to buy houses and cars or borrowing to invest in stocks, people can earn high returns. This leads to a shift from borrowing for consumption to borrowing for investment. The goods purchased with borrowed money are not for use but for appreciation.
During the upward phase of the long-term debt cycle, the economy is thriving, and everyone has both debt and financial assets. Under the illusion of high returns from financial assets, people make incorrect estimates of their income (financial asset returns have significant volatility, and future returns may not be the same as this year's). At this time, due to the increase in income and the increase in the value of collateral such as financial assets, people's creditworthiness increases, and their borrowing capacity increases. Coupled with the willingness to borrow, the leverage ratio of the entire society continues to rise, laying the foundation for future economic crises.
In the absence of an increase in social productivity, economic prosperity created solely by financial leverage is called an economic bubble. If the bubble becomes too large, it will eventually burst.
When the leverage ratio of the entire society reaches its peak, new credit currency no longer increases, and the prices of financial assets gradually stabilize. At this time, the returns on financial assets only come from their current production capacity. Compared to the previous period of rapid growth, the returns decrease. At this time, aggressive investors find that their income is gradually falling below the debt line, and they no longer have the ability to repay their debts. This marks the downward phase of the long-term debt cycle.
During the downward phase of the long-term debt cycle, more and more people have debts that exceed their assets, and their consumption decreases. As one person's expenditure is another person's income, the income of others also decreases, leading to more people having debts that exceed their assets. At the same time, as everyone is running out of money, they start selling the financial assets they hold (such as houses, cars, and stocks), causing the prices of financial assets to plummet. At this point, people realize that not only has their expected income disappeared, but their assets are also worthless. This is the most vulnerable period for the economic machine, and if not handled properly, it can lead to a widespread economic crisis.
Expenditure is the driving force of economic development. When people have no income, the economy gradually declines. At this time, the central bank's strategy of stimulating the economy by lowering loan interest rates is no longer effective because people are not unwilling to borrow money, but they are unable to borrow money. With income less than debt, the value of collateral decreasing, and the creditworthiness of borrowers generally decreasing, even if the central bank lowers interest rates to 0, it is useless because banks are unwilling to lend money to those who are about to go bankrupt, and there are fewer people with good credit in society. No one can borrow money to save the economy.
This marks the painful era of deleveraging. In the process of deleveraging, people reduce their expenditure, their income decreases, credit disappears, asset prices fall, banks face a run, the stock market crashes, social tension intensifies, and the whole process begins to decline and form a vicious cycle. With decreasing income and increasing debt servicing costs, borrowers feel increasingly tight. As credit disappears and credit currency dries up, borrowers can no longer borrow enough money to repay their debts. Borrowers try to fill this gap by selling assets. As expenditure decreases, the market is flooded with assets for sale. At this time, the stock market crashes, real estate market slumps, and banks are in trouble. As the prices of assets decline, the value of collateral that borrowers can provide decreases, further reducing their creditworthiness. People feel poor, and credit quickly disappears.
How to deal with deleveraging? The problem lies in the heavy burden of debt, which must be reduced. This can be achieved through four methods: reducing expenditure, wealth redistribution (taxing the rich and transferring to the poor through social welfare measures), debt restructuring (borrowers are afraid that lenders will not be able to repay the money, so they agree to repay less, which is better than nothing), and issuing currency (central banks directly printing money). The first three methods cause deflation, while issuing currency causes inflation. If they can achieve a balance between saving the market and preventing severe inflation, they can achieve deleveraging harmoniously.
Issuing currency is a common method used by countries during the deleveraging phase. Faced with economic problems, the government's instinctive response is to alleviate them by printing money. However, when issuing currency, caution must be exercised to avoid triggering severe inflation. Whether it can maintain a balance between saving the market and curbing severe inflation is the key to achieving deleveraging and surviving an economic crisis. Only when the country operates properly can deleveraging be implemented safely, overcome difficulties, and return to the upward phase of the long-term debt crisis. Otherwise, a severe economic crisis will occur, causing serious damage to the national economy.