"At the end of the long-term debt cycle there is essentially no more stimulant in the bottle (i.e., no more ability of central bankers to extend the debt cycle) so there needs to be a debt restructuring or debt devaluation to reduce the debt burdens and start this cycle over again." - Ray Dalio
There are many models and theories that try to explain how the economy works, but this model articulated below by Ray Dalio is my favorite. It is simple and has a good track record of prediction...which is better than you can say for most macro models that rely on concepts like market "equilibriums".
Ray Dalio calls his model the "Economic Machine" and it is composed of essentially three parts: Productivity Growth, Short Term Debt Cycle, and the Long Term Debt Cycle. These three pieces combine to create growth in gross domestic product (GDP) which is the total value of all final goods and services.
Productivity Growth is GDP per hour worked. Since the Industrial Revolution the world has generally had positive productivity growth. Economists attribute this to a combination of technology, capital investment, and human capital (i.e. education and experience). Ray Dalio believes that productivity growth is largely exogenous and constant...with variations more attributable to noise than any lasting trends. Many other reputable economists disagree. There is a ton of research on the nature and causes of productivity growth, but suffice to say that over time we can expect it to improve so long as we don't have WWIII.
Short Term Debt Cycles explain most recessions. Periods of prosperity help to create wealth...but typically also lead to excesses. Short term debt cycles start after a crash and during recessions. Households and businesses tighten their belts and have to work hard to improve their situations. Over time this hard work pays off and we all start feeling comfortable. A few years later we start to forget about risks and begin buying silly things we don't need using money we don't have. Debts build up and so do risks...like dead wood on the forest floor. Inevitably...a spark catches the economy on fire. Often times because central banks raise rates in order to prevent further debt buildups. Sometimes because of a global pandemic. Either way...the result is the same...a recession that starts the process over again.
Long Term Debt Cycle occurs over a lifetime. Usually the process starts with challenging events that cause a tremendous amount of wealth destruction. The most common example is war. The destruction of wealth corresponds with the destruction of debts because much of the world's wealth is invested in credit markets. The destruction of debt leaves households and businesses with much more room to borrow...but the destruction of wealth also means that interest rates are higher. Only over many decades of peace and prosperity do wealth levels build back up to the point we are at today...at the end of a long term debt cycle.
The end of a long term debt cycle occurs when central banks can no longer stimulate the economy by lowering interest rates. That effectively occurs when interest rates are near zero. The industrialized world is at that point today; which is why governments have had to step in an spend trillions of dollars to try to prop up the economy. As a result...government debt levels and deficits are skyrocketing in a manner similar to that of the War Economy last experience during WWII.
We are sharing this post today because reaching the end of the Long Term Debt Cycle usually creates critical challenges. Debt levels are so high across governments, companies, and households, that some combination of bankruptcies, bailouts, taxes and inflation are needed to pay for them. Who gets stuck with the bill is going to be hotly debated...and how we respond to this crisis will help to determine the strength of our economy for years to come.
The "Economic Machine" Theory also goes hand in hand with the "Fourth Turning"...a second theory that we find helpful in understanding how the future may unfold. If you found this article helpful then you may want to watch the video version below.