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Economics 101: Bridgewater's Dalio demystifies the 'Machine'

Updated 7:56 pm, Thursday, October 24, 2013
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If you think doing things efficiently can be beautiful, then you'll appreciate the pointedness of "How the Economic Machine Works," a video published on YouTube by hedge fund magnate Ray Dalio.

The title appears in white lettering against a dark blue background and quickly vanishes. A clock can be heard ticking. The words "The Economy" show up and grow bigger and bigger until they finally explode.

Cue Dalio.

"How the economic machine works in 30 minutes," he says to kick off the film. "The economy works like a simple machine. But many people don't understand it, or they don't agree on how it works. And this has led to a lot of needless economic suffering."

Dalio is founder and chairman of Bridgewater Associates, the 37-year-old hedge fund based in Westport with $145 billion in assets under management. Dalio, who's 64 and lives in Greenwich, was recently named the 31st wealthiest person in the U.S., with a net worth of $12.9 billion, according to Forbes.

If you're looking for a new explanation of the global markets -- a way to wrap your head around whether the U.S. economy is floundering in uncharted waters or slowly steering itself out of something that's actually familiar, something that some people might even find beautiful -- then you could do worse than land on Bridgewater's YouTube feed.

"I feel a deep sense of responsibility to share my simple but practical economic template," Dalio explains in the early minutes. "Though it's unconventional, it has helped me to anticipate and to sidestep the global financial crisis and it has worked well for me for over 30 years."

* * *

The video, which was published on YouTube in late September, has been viewed more than 300,000 times so far. It's available in Russian and Chinese, too, though those versions don't feature Dalio channeling his best Tom Hanks-like voice over. The video is actually a lively cartoon, full of graphics and sprightly stick figures and sound effects and music. Essentially, it's Dalio's distillation of the template he uses to understand the world economy.

It's not the first time Dalio shared his bird's eye view of things. His hedge fund is built upon a set of 212 principles crafted over a series of years after his company started growing too fast and large for him to put his personal stamp on everything, he told Hearst Connecticut Newspapers in a September interview. You can download those principles on Bridgewater's website. (Dalio, through his outside public relations firm, declined to comment for this story.)

Then, in October 2008, at the height of the financial crisis, he published a 21-page treatise called "How the Economic Machine Works: A Template for Understanding What is Happening Now."

This video is an updated adaption of that document.

* * *

What's happening, the 30-minute film explains, is a process called "de-leveraging," which generally takes about a decade and has a habit of recurring every few generations.

Before he gets to that, though, he establishes some basics: How economies are the sum total of all transactions. How transactions can be carried out with either money or credit. How credit supplies can easily overwhelm the supply of actual money. How credit is therefore probably the most important and least understood part of the economy.

The template itself is the interplay of three forces, which he superimposes on a chart of economic growth. The first is the rather simple "productivity growth," which steadily climbs. The second is the more manic "short term debt cycle," which leaps and dives through five-to-eight year cycles. The third is the "long-term debt cycle," which inexorably mounts over a series of decades and then sends the whole thing tumbling because people have pushed some natural lending and borrowing limit.

* * *

In a world without credit, Dalio posits, economic growth might continue unabated through productivity growth. The living standards of industrious people would methodically rise, while they would somewhat lag for the lazy and complacent.

But because people lend and borrow, Dalio says, short-term debt cycles arise. By borrowing, people, governments and businesses spend more than they otherwise would, driving up prices and incomes and fostering inflation. Inevitably, central banks put the brakes on the rapid growth by raising interest rates, setting off recessions. Generally, recessions bottom out at production levels greater than that of previous recessions, meaning the short-term debt cycle traces an up-and-down path that is at a higher level than productivity growth -- that is, up to a point.

It happened in 1929 and again in 2008, Dalio says. As the short-term debt cycles mount, the long-term debt burden steadily mushrooms to support the ever higher booms and busts. Asset values spike. But at some point, debt levels start growing faster than income growth, which sends the greater long-term debt cycle into a tailspin. Welcome to the de-leveraging period. Asset values tank. Central banks only can lower interest rates so much. The skidding spending and incomes continues throughout the vicious cycle.

Ultimately, Dalio says, four forces emerge to counteract this. First, people, businesses and governments cut their spending. Second, debts are reduced through defaults and restructurings. Third, wealth is redistributed from the haves to the have-nots. Finally, central banks resort to printing money.

The first three methods are deflationary, he says. The last one is inflationary.

"This is a very risky time," Dalio says. "Policy makers need to balance the four ways the debt burdens come down. The deflationary ways need to balance with the inflationary ways in order to maintain stability."

Ultimately, he says, governments need to print enough money to get the rate of income growth above the rate of interest on their debts. But they can't print too much money or they'll spur run-away inflation. Failing to strike this balance can lead to social unrest that can unleash even bigger problems.

The de-leveraging period of the "Economic Machine," then, can be painful if managed poorly, but relatively efficient if it's handled right, Dalio says.

"How can a de-leveraging be beautiful?" he asks, as piano music picks up in the background of the film. "Even though a de-leveraging is a difficult situation, handling a difficult situation in the best possible way is beautiful."

To watch the video or read Dalio's essays on these topics visit http://www.economicprinciples.org/