As we wrap up the “Invest Money” series, I want to dedicate two letters to exploring an essential topic: understanding how the economy functions.
Why Discuss the Economy?
It’s crucial to grasp economic concepts because the news often exaggerates financial events. When economic downturns occur, it can feel like the sky is falling. But if you take a moment to study history, you’ll realize that many of these situations have happened before.
As Theodore Roosevelt wisely stated, “The more you know about the past, the better prepared you are for the future.” By comprehending economic principles, you become better equipped to navigate today’s challenges and anticipate future developments.
Meet Your Guide
The insights we’ll discuss come from a leading expert—Ray Dalio, the founder of Bridgewater Associates, known for his impressive track record in investing.
As Charlie Rose put it:
“His company manages roughly $125 billion in global investments, serving clients that include foreign governments, central banks, and institutional pension funds. Over recent years, Bridgewater has emerged as the top-performing hedge fund globally.”
In the following sections, we’ll summarize Dalio’s teachings. While we will only skim the surface, you can gain deeper knowledge by watching his 30-minute video, “How the Economic Machine Works,” or reading his comprehensive 300-page research paper on economic principles. Additionally, Dalio’s book, titled “Principles,” is a fantastic resource I highly recommend.
The Economy as a Machine
Like a machine, the economy operates on cause-and-effect relationships. Understanding this can help you notice patterns in economic events that repeat over time.
What is an Economy?
Simply put, an economy is the aggregate of all transactions occurring within it. Instead of analyzing it from the top down, we’ll adopt a bottom-up approach, starting with individual transactions. This groundwork simplifies the understanding of broader economic concepts.
The Three Major Forces
Three primary forces drive economic activity:
- Productivity Growth
Measured by Real Per Capita GDP, this metric divides a country’s Gross Domestic Product (GDP)—representing the total value of goods and services—by its population. In the U.S., productivity has consistently grown by about 2% annually over the past century. This growth indicates that, on average, people are becoming wealthier year after year. Why does productivity increase?
As knowledge and technology advance, efficiency improves (for example, one tractor can do the work of ten farmers). Thus, productivity growth directly enhances living standards. - The Short-Term Debt Cycle
This cycle lasts approximately 5 to 8 years and significantly influences economic conditions. We will explore this in greater detail next week. - The Long-Term Debt Cycle
Spanning 50 to 75 years, this cycle offers insight into historical economic patterns. We will delve into this next time as well.
Starting at the Individual Level
Let’s zoom in further.
Every economic activity begins with a transaction, which starts with you—the buyer.
A Transaction Defined
A transaction involves the exchange of money or credit by a buyer for a good, service, or financial asset.
Money
Money, or cash, facilitates these transactions. For instance, if you purchase an apple, the exchange is completed through the transfer of cash.
Credit
Credit represents a promise to pay at a later date. When you buy something using a credit card, this transaction isn’t settled until you repay the debt, which is why you sign a receipt acknowledging your commitment.
A significant portion of consumer spending is made through credit, making it a crucial component of economic cycles.
When credit is readily available, the economy expands; when it’s constrained, recessions occur. We’ll discuss this dynamic in detail next week.
Understanding Markets
A market is formed by all buyers and sellers engaged in transactions for specific goods or services. For example, when you buy that apple, you’re participating in the apple market. Different markets exist for a variety of products, including cars and stocks.
Together, these markets comprise the broader economy.
Pricing
The price of goods is determined by total spending (combining credit and cash) divided by the number of units sold.
Understanding price is essential because it influences inflation—and in turn, the economy. Inflation occurs when prices rise, while deflation happens when they fall.
The Role of Government
While the economy starts with individual transactions, governance is necessary to maintain order and ensure adherence to rules.
The government has two main components:
- The Federal Government, which spends on infrastructure and public services.
- The Central Bank, which regulates the money supply and can print currency—a power that individuals lack.
The Government as a Major Buyer
The government acts as the largest buyer in the economy, interacting with both the private sector (individuals and businesses) and itself.
Conclusion
Congratulations! You’ve gained a foundational understanding of how the economy functions, from individual transactions to broader economic cycles.
In our next session, we’ll delve deeper into these concepts, including the short-term and long-term debt cycles and their implications for future economic understanding.
Thank you for joining me today!
Feel free to let me know if you need any further modifications or additional information!