Lesson 1: How the Economic Machine Works

Today, we will explore how the economic system works.

Above, I am featuring Ray Dalio’s famous video “How the Economic Machine Works,” and below, I have integrated additional insights that include the massive role that demographics and liquidity play in our economy.

The Fundamentals: Understanding Money & Credit

Below are a few core concepts we will use to understand the economic machine.

What is money?

In its essence, money represents two things:

1. Energy & Capacity for Work: Each dollar is like a unit of energy that initiates work. This is its value.

   1. When you save money, you are essentially storing your past productivity, creating a transferable token of value that can be used to hire others to do work on your behalf in the future.

   2. When you invest money, you deploy capital into productive ventures that have the potential to generate returns exceeding the initial investment, creating value through economic activity and growth.

2. Scarcity: Money retains its value due to its scarcity. There is a balance between the amount of money in the system and the costs of products, services, and financial instruments.

What are the two types of money?

1. Cash & Credit: Cash and credit are both types of money and are spent the same way. There are $3 trillion dollars of cash in the system and about $50 trillion dollars of credit.

2. Liquidity: Liquidity is the total amount of money in supply. When more money is in the system, more transactions occur, and we have an economic expansion. When the money supply shrinks, there are fewer possible transactions, and we have a recession.

How is money managed?

1. Monetary Policy: Central Banks, like the FED, manipulate the money supply by making money more or less expensive via interest rates and tools like ‘quantitative easing.’

2. Fiscal Policy: The Government (Congress and the President) can directly affect aggregate demand by putting money into circulation through spending or taking it out through taxes.

Key Concepts

Here are a core list of economical terms:

• Transactions: An exchange where buyers and sellers trade goods, services, and financial instruments.

• Supply and Demand: The fundamental forces determining the price and quantity of goods/services/assets influenced by production capacity and costs, consumer preferences, income levels, and liquity.

• Demographics: Population size, age distribution, and growth rates significantly affect supply (labor force) and demand (consumption patterns). For instance, an aging population may reduce the labor supply and shift demand towards healthcare and retirement services.

• Inflation and Deflation: Inflation erodes purchasing power, while deflation can lead to reduced consumer spending and economic stagnation. Demographics can drive both.

  • For example, the large Baby Boomer generation drove inflation higher in the 1970’s. Today, prices for homes and assets are high mainly due to two large generations (Baby Boomers & Millennials).

• Productivity and Value Creation: Enhanced value creation by producing more output with the same or fewer inputs, fostering economic growth.

• Debt Cycles: Debt allows people and organizations to buy goods or services on credit or to invest in the future by purchasing financial instruments.

  • When debt is used to start a business or purchase financial instruments, it increases our productivity.

  • People can use debt to make big purchases, like a house or car, and improve their quality of life.

  • There is a limit to the amount of debt a person/organization can take on.

  • Debts decrease our disposable funds, which reduces future spending.

  • Less spending in the future means that there will be lower economic activity.

  • Economies experience short-term debt cycles (5-8 years) and are driven by borrowing and lending behaviors.

  • The long-term debt cycle refers to a timeline along which an economy experiences multiple episodes of growth and recession, with each episode accruing a gradual expansion of household debt until, ultimately, a severe depression resets the entire financial system.

Core Economic Concepts and Their Interrelations

Below is a set of relationships on a hierarchy. The top of the hierarchy has the biggest impact.

1. Demographics: The size of a population and demographics determine the supply and demand of goods, services, assets, and labor. A big population, like the Baby Boomers, will all grow up and go through the same life stages together, meaning that they will compete for the same universities, jobs, and houses, pushing up the prices for inelastic goods, services, and assets.

   1. Demographics drive the macrocycles and patterns.

2. Liquidity: The amount of money in the system drives economic activity and asset prices. Here is the general pattern of a debt cycle:

   1. When times are good, people and businesses start to borrow

   2. The credit increases the liquidity in the system, driving up economic activity and asset prices.

   3. This incentivizes people and businesses to borrow even more, further increasing prices.

   4. Too much liquidity can lead to inflation. When Central Banks notice a rise in inflation, they increase interest rates, which decreases liquidity.

   5. Less money in the system decreases spending, lowers incomes, increases unemployment, and pushes asset prices down.

   6. People feel worse about the economy, so they spend and invest less, which pushes prices down.

   7. This drag on the economy is a recession. To help the economy get out of a recession, Central Banks decrease interest rates, which increases liquidity in the system.

   8. Current Debt Cycle: The 2008 Global Financial Crisis reset everyone’s debts simultaneously. A large number of organizations throughout the world refinanced their debts at the same time, which now gives us a very predictable four-year debt cycle!

      1. GFC reset debts in 2008

      2. Many businesses refinance their debts every 4 years or so

      3. This produces a very predictable 4-year cycle where liquidity comes into the system and then out.

      4. As a result, markets perform better on Presidential Election Years (2024/2025, 2020/2021, 2016/2017, etc) as liquidity increases versus years when liquidity decreases (2018/2019, 2022/2023, 2026/2027).

3. Productivity and Value Creation: Over time, society is able to produce more output with the same or fewer inputs, fostering economic growth.

   • Technology tends to be deflationary, bringing the costs down and productivity up. This means less labor and lower costs for products and services.

   • Productivity is the way we pay our debts.

Demographics is Destiny

Demographics play a pivotal role in shaping the macroeconomy. Population size, age distribution, and generational dynamics influence the economy's supply and demand sides.

Population Size Effects

• Labor Force: A larger population increases the labor supply, potentially boosting production and GDP.

• Consumption Patterns: Diverse age groups influence demand for goods and services, shaping market dynamics.

• Dependency Ratios: High proportions of dependents (youth or elderly) can strain public finances and social services.

Generational Challenges and Solutions

Baby Boomers:

• Challenges: Aging population, increased healthcare and pension costs, potential labor shortages.

• Solutions: Encouraging later retirement, investing in healthcare technology, and promoting higher labor force participation among older adults.

Generation X:

• Challenges: Balancing work-life demands, managing debt from education and housing, and adapting to technological changes.

• Solutions: Flexible work arrangements, financial literacy programs, continuous education, and reskilling initiatives.

Millennials:

• Challenges: Student debt burden, housing affordability, delayed family formation.

• Solutions: Policy reforms for education financing, affordable housing projects, and fostering gig and remote work opportunities.

Generation Z:

• Challenges: Entering the workforce during economic uncertainty, climate change impacts, and mental health issues.

• Solutions: Sustainable economic policies, investment in green technologies, robust mental health support systems, and inclusive education models.

Impact on the Macroeconomy

• Consumption and Savings: Younger generations tend to spend more on education and housing, while older generations may save for retirement, influencing overall economic liquidity.

• Innovation and Productivity: Younger cohorts are often more adaptable to technological changes, driving innovation and productivity growth.

• Fiscal Policies: Demographic shifts necessitate adjustments in taxation, spending, and social security systems to maintain economic stability.

• Big Generations = increased prices of homes, assets, education, and health care.

• A young and dynamic population is what carries everything—from spending and productivity to workforce and economic growth. (USA in the 1950’s, India & Mexico Today)

• A middle-aged population is at the peak of their earning and spending power as they care for households and families. (China, Germany, & Canada Today)

• An aging population is a big drag on the economy as seniors leave the labor force, spend less, sell their assets, and need young people to support them (Russia, Bulgaria, & Japan Today)

• Demographics produce feedback loops. An aging population strains young people, as they have to support them via higher taxes and lower asset prices, making it hard to raise a family.

• A growing, productive population can boost GDP, whereas an aging population may slow economic growth.

What’s Next?

In Lesson 2, we will do a deep dive into how demographics produced wholesale changes in our economic system, which ultimately led to our current economic situation and the core challenges we face today.

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