The ups and downs of the economy affect everyone, but it's a remarkably hard subject to understand. If you'd like to get a better grasp on the processes that power the markets, this video from legendary hedge fund manager Ray Dalio can help.
Dalio is among those who seem to have a firm grasp of the forces that drive the economy. His company, Bridgewater Associates, is one of world's largest hedge funds. (We've discussed some of Dalio's ideas about learning from mistakes in detail here.)
In an effort to improve the public's understanding of how the economy works, Dalio recorded the following simple video explanation of the forces that affect the economy. It's an easy-to-follow summary that demystifies some of the more perplexing parts of economic cycles using plain language and illustrations — including the role of human psychology.
You can watch the full video below; we've excerpted some of its most interesting takeaway points underneath the video.
Some interesting takeaways:
Three main forces drive economic cycles.
The short-term debt cycle (5-8 years long)
The long-term debt cycle (75-100 years long)
Credit is both the most important part of the economy because it's so large and so volatile.
Credit is the principle driver of the economy's boom/bust cycle, but that doesn't mean it's inherently bad.
Credit can be very useful for allocating resources efficiently, such as when businesses need to buy expensive new equipment that will allow them to expand. But it can also be misused to finance over-consumption that the borrower can't really afford.
For example, compare a farmer buying a new tractor on credit to your friend buying a fancy new TV on credit. The farmer's tractor will help him earn money and repay the loan, but your friend's TV surely won't do the same.
Human nature drives people to misuse credit.
By borrowing money taking on debt, you're basically borrowing from your future self. In doing so, you create a time in the future in which you need to spend less to pay it back.
However, people generally don't think in these terms — they make financial decisions based on how they feel in the moment and what's going on immediately around them. When times are good and people feel wealthy, they're more likely to take on debts that they can't repay.
The 2008 financial crisis was often called "the Great Recession," but it was no garden-variety recession. Like the Great Depression of the 1930s, it was a "deleveraging" — the downswing of the long-term debt cycle.
Deleveraging occurs after decades of mostly good times, in which lenders extend credit more and more easily.
At some point, the accumulated debts start growing faster than incomes do, eventually forcing both individuals and institutions to aggressively and painfully cut back.
This process and its aftermath can take a decade or more.
Deleveraging events are often ugly and can cause political upheaval, but if managed properly, they can be beautiful.