An Analysis of ‘How the Economic Machine Works’: Part 3

In my last blog post, I discussed the short-term debt cycle and began to talk about the long-term debt cycle. This is the third post in the set and will focus on the long-term debt cycle and will begin to look at some of the data backing up Dalio’s claims.  In the short-term debt cycle (STDC) spending is restricted only by the willingness of lenders and borrowers to provide and receive credit, but as was discussed at the end of the last blog post, the STDC doesn’t give us a full picture of what’s going on. The long-term debt cycle gives us a broader view of what is happening.

3. The Long-Term Debt Cycle (LTDC) (60-80 years)

The LTDC is the final of the three factors that Dalio asserts drives the economy. The LTDC has three parts: (i) leveraging (50+ years), (ii) depression (2-3 years), and (iii) reflation (7-10 years). The main idea is that over the course of about 60 to 80 years, the economy undergoes a large cycle, starting with a period of above-average productivity growth (leveraging), which eventually falls dramatically (depression), and then starts growing again (reflation). Let’s take a closer look at each part separately.

The leveraging period has been discussed throughout my past two blog posts and is directly tied to the idea that credit allows people to increase income growth beyond productivity growth in the short run. During the leveraging period, the economy is undergoing short term debt cycles of expansions and recessions, but each cycle’s bottom and top finishes with more income per person and more debt per person than the last one. At first, incomes increase faster than debts do, and as long as borrowers’ incomes rise faster than their debts, they remain creditworthy. This is what is known as ‘a bubble’; with asset values and incomes growing quickly, lenders are still willing to lend even though the public debt burden is increasing. Goods, services, and financial assets are all being bought with borrowed money. At some point, however, this false paradise must end. The bubble pops at precisely the moment when debt repayments start growing faster than incomes. Queue the depression.

In a depression, the large debt repayments cause incomes to fall dramatically. Many borrowers can no longer afford to pay back their debts with income, so they resort to selling assets. Since many borrowers are selling assets at once, the market is flooded with supply causing asset prices plummet. Plummeting asset prices mean that the value of borrowers’ collateral drops as well, making them even less creditworthy. Incomes drop, credit disappears, asset prices fall, and borrowers can’t repay their debts, making for a self-perpetuating disaster. It’s the same negative feedback loop I talked about in the last blog post, except in epic proportions.

Take a look at the following graph that illustrates the U.S. debt to GDP ratio from 1916 to 2012. Notice that the debt/GDP ratio increased steadily before both 1929 and 2008, spiked upward right after, and then falls dramatically:

U.S. Debt to GDP Ratio

This graph is not a full justification of Dalio’s claims, but it does illustrate a certain cyclical nature in the debt/GDP ratio, which gives credence to the LTDC. It’s pretty clear that after the Great Depression was over by the mid 1940’s, debts began to grow steadily until 2008. That’s about 50 years and resembles the characteristics of the leveraging period of the LTDC I discussed earlier.

In the next blog post I will take a closer look at the strategies government use to deal with large-scale recessions and further explain the reflation period of the LTDC.