The Year of Jubilee

I have been a student of Dalio for the past decade.  This excerpt from The Alpha Masters may help you understand why. You might also ask if Ray Dalio is the Steve Jobs of Investing?  Over the years, Dalio has provided us with a working template of “How the Economic Machine Works” – a description far different than what most of us have been taught and unlike the descriptions offered by conventional economists.  In brief, Three Big Forces drive most economic activity: 1) trend line productivity growth which has proved remarkably resilient around 2% for the past century; 2) the long term debt cycle which typically last decades (i.e. 50 to 75 years); and 3) the short term business cycle, a five to eight year sequence, conventional economists are most familiar with.

Per Dalio, “A cycle is nothing more than a logical sequence of events leading to a repetitious pattern. In a capitalist economy, cycles of expansions in credit and contractions in credit drive economic cycles and they occur for perfectly logical reasons. Each sequence is not pre-destined to repeat in exactly the same way nor to take exactly the same amount of time, though the patterns are similar, for logical reasons. For example, if you understand the game of Monopoly®, you can pretty well understand credit and economic cycles.”

Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players give them cash. So as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property with lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So early in the game, “property is king” and later in the game, “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.

Now, let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it could make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other giving each other credit (i.e., promises to give money and at a later date). If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. There would be more spending on hotels (that would be financed with promises to deliver money at a later date). The amount owed would quickly grow to multiples of the amount of money in existence, hotel prices would be higher, and the cash shortage for the debtors who hold hotels would become greater down the road. So, the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash caused withdrawals from the bank at the same time as debtors couldn’t come up with cash to pay the bank. Basically, economic and credit cycles work this way.

These long-term cycles have endured for as long as credit has existed.  Even the Old Testament described the need to wipe out debt once every 50 years – The Year of Jubilee.  The cycle peaks when debt burdens are high and monetary policy fails to produce credit growth after interest rates hit zero.  That is when deleveragings begin, as they did after 1929 in much of the world, after 1989 in Japan and after 2007 in the US and the EU.  This is a complex process which is still widely misunderstood given the ongoing debate from Washington to Wall Street.  To truly understand “What is Happening Now” we highly recommend studying the work published by Bridgewater, How The Economic Machine Works, which they have made publically available on their website.   In full disclosure, this is probably not everyone’s idea of light reading, but for those looking for a deeper understanding of the “unpredictable” financial crisis, the “shockingly” sluggish recovery, the “surprising” global sovereign debt crisis and the “new normal” – it is a must read.