How much do you understand about the operation of the economy?

The economy operates like a simple machine, but many people do not understand this, leading to many unnecessary economic losses.

Here, I would like to share with you Ray Dalio's simple and practical economic analysis model.How do the three economic forces interact with each other, and how do they manifest in everyday economics?

In the previous text, we introduced the three significant economic forces generated by human transactions:

1. Improvement of productivity; 2. Short-term debt cycle; 3. Long-term debt cycle.

And the economic cycles generated under the self-driven pattern.

Among them, the fluctuations in the amount of debt have two major cycles:

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A short-term cycle, lasting about 5-8 years;

A long-term cycle, lasting about 75-100 years.We will examine these three forces here and observe how they interact with each other and how they manifest in the daily economy.

The Origin of Cycles

The ups and downs of the economy do not depend on how innovative or hardworking people are, but mainly on the total amount of credit.

An Economy Without Credit OperationTo facilitate understanding, let us first imagine an economy without credit.

In such an economic operation, the only way to increase spending is to increase income, hence, there is a need to enhance productivity and workload.

At this point, improving productivity is the sole path to economic growth. Since one person's expenditure is another person's income, it ultimately results in an asymptote similar to the growth trajectory of productivity.

Credit creates economic cycles.

However, because we borrow, cycles are generated.

The reason is not any regulation, but human nature and the way credit operates.

Borrowing is essentially consuming in advance, to purchase something you cannot afford now, your expenditure must exceed your income, therefore you need to borrow money, which is essentially borrowing from your future self.

At some point in the future, your expenditure must be less than your income, and you repay the debt, thus forming a cycle.Once you borrow money, you create a cycle. This is true for individuals and for the entire economic operation, which is why it is essential to understand credit.

Credit triggers a series of opportunities and predictable events that will occur in the future. This is where credit differs from money.

Transaction Completion

Completing a transaction requires the use of money:

When you buy a product in a store with cash, the transaction is completed immediately.When you purchase a good on credit, such as on an IOU, you are essentially committing to pay for that good in the future.

Together with the store, you create an asset and a liability, conjuring up credit out of thin air.

Only after you have settled the IOU in the future will the aforementioned asset and liability disappear, the debt will be repaid, and the transaction will be considered complete.

Most of what is commonly referred to as money is actually credit.

The total credit in the United States is about 50 trillion US dollars; while the total currency is only about 3 trillion US dollars.

Do not forget that spending is the driving force of the economy.

In an economy without credit, the only way to increase spending is to increase production.

In an economy with credit, spending can also be increased by borrowing.

Therefore, an economy with credit can increase spending, thereby allowing the growth rate of income to exceed the growth rate of productivity in the short term.In the long term, it is not always the case, but credit is not necessarily a bad thing; it just leads to cyclical changes in the economy, which is a result of human nature.

Bad Credit and Good Credit

If credit is used for excessive consumption beyond one's ability to repay, it is considered bad credit.

However, if credit is used to efficiently allocate resources and generate income, allowing you to repay your debts, it is considered good credit.

For example, borrowing money to buy the best buns to eat will not bring any income to repay your debt, which is bad credit.

On the other hand, borrowing money to open the best bun shop, using it to earn more income, allowing you to repay your debt, and improve your living standard, is good credit.Credit-Driven Economic Operation

In a credit-driven economic operation, we can track various transactions and observe how credit contributes to economic growth.

Assume you earn 100,000 yuan per year, have no debt, and have good credit that allows you to borrow an additional 10,000 yuan, such as through a credit card. Therefore, your annual spending capacity is 110,000 yuan.

Since your expenditure is someone else's income, another person earns 110,000 yuan as a result:

If this person also has no debt and has a credit card with a 11,000 yuan limit, they can spend 121,000 yuan, even though their annual income is only 110,000 yuan.

However, this person's expenditure becomes the income of the next person. By tracking various transactions, we can see this process continuously reinforcing itself.Do not forget, borrowing creates cycles; what goes up must come down.

Short-term Debt Cycle

Phase One: Expansion

As economic activity increases, spending also rises continuously, leading to a rise in prices.

At this point, the growth rate of income and expenditure exceeds the production speed of the goods being sold. The increase in prices is also known as inflation.Phase Two: Decline

Central banks do not wish for inflation to rise excessively, so when they observe an increase in prices, they will raise interest rates.

As interest rates rise, the number of people borrowing money will decrease. At the same time, the cost of existing debt will also increase, which is equivalent to an increase in the monthly credit card repayment amount.

Since people reduce their borrowing and the repayment amount increases, the remaining money available for spending will decrease.

One person's expenditure is another person's income, so the other person's expenditure will further decrease.

Following the chain of transactions, people's incomes will fall, and market prices will decline.At this point, the growth rate of income and expenditure is less than the production speed of the goods sold. The decline in prices, also known as deflation.

When the economy goes into recession, and if the recession is too severe and inflation is no longer a problem, the central bank will lower interest rates to re-accelerate economic activity.

As interest rates fall, the cost of debt repayment decreases, borrowing and expenditure increase, leading to another economic expansion.

It can be seen that the economy operates like a machine.

In the short-term debt cycle, the only factor that limits expenditure is the willingness of lenders and borrowers to lend and borrow.Easy access to credit leads to economic expansion; restricted access to credit leads to economic contraction.

We can deduce that the short-term debt cycle is primarily controlled by the central bank, typically lasting 5-8 years, and then repeating over several decades.

After each trough and peak of the cycle, the growth of the economy and debt exceeds that of the previous cycle. This happens because the inherent tendency of people to borrow more and spend more drives this phenomenon.In the long term, the growth rate of debt exceeds the growth rate of income, thereby forming a long-term debt cycle.