Ray Dalio on How the Economic Machine Works, and on High Cholesterol, Inflammation and Heart Disease!

From: aditya rana
Date: Mon, Nov 4, 2013 at 1:10 PM
Subject: Ray Dalio on How the Economic Machine Works, and on High Cholesterol, Inflammation and Heart Disease!


Ray Dalio, who runs the hugely successful $150 BN hedge fund Bridgewater Associates, is an out-of-the box thinker and has a unique (and deeply insightful) framework to think about the intricate workings of an economy. It explains, in a simple and straightforward way, without being obfuscated by ideological preferences (sadly the bane of most writings in the media and academia these days!), importance of key concepts like credit cycles, austerity, fiscal spending, QE and inflation. He recently produced a 31 minute video clip on his framework which required viewing for serious investors as well as people interested in learning about the functioning of the economy (http://www.economicprinciples.org/ ) . To summarise:

-Three main factors drive the economy -productivity gains, the short-term debt cycle and the long-term debt cycle.

-The basic building block of the economy is a transaction, which involves the purchase of good, services and financial assets. An economy is just the sum total of such transactions paid for by money or credit, and the price is the amount spent divided by the quantity bought.

-Therefore, total spending and total amount of goods, services and financial assets bought and sold are enough to understand an economy. Banks, businesses, individuals and the government are the entities who make transactions, with the biggest player being the government.

-The government comprises the central government and central bank, with the government being responsible for collecting taxes and spending while the central bank controls money and credit, by being able to print money and influencing interest rates.

-Credit provides borrowers and lenders with what they need, and is the most important part of the economy, as it increases spending. Credit increases when interest rates are low and decreases when interest rates are high.

-When credit is created it is called debt, which is an asset to the lender and a liability to the borrower. When a debt is repaid, credit disappears.

-Spending drives the economy as a dollar spent is a dollar of someone else’s income. As income increases, borrowers become more credit-worthy and are able to borrow even more setting off a self-reinforcing cycle which creates growth and economic cycles.

-Productivity growth is a result of accumulated knowledge over the long run, but is steady in the short run. Credit is what drives growth over the short-term as it allows us to consume more than we produce when we increase debt, and forces us to consume less than what we produce when we reduce it.

-Debt swings are of two types: short-term debt cycles which typically take 5-8 years and long-term debt cycles which take 75-100 years. While people feel the impact of the swings, they are unable to visualise them as cycles as they are too caught-up in the day-to-day changes.

-In an economy with only productivity and no credit, an increase in income can only happen because of an increase in productivity which is fairly steady over the short-term.

-Credit causes business cycles (i.e. above and below productivity growth) because it involves reducing future spending to increase current spending – this applies to individuals as well as the whole economy. Credit dwarfs the amount of money in supply in an economy – the U.S. has about $3 trillion of money and about $50 trillion of credit.

-Credit is good when it is used to allocate resources efficiently by purchase of goods which increase income to repay the debt later, while it’s bad when it lead to overconsumption which generates no income and the debt cannot be repaid.

-When credit induced spending and income increase faster than the production of goods, prices rise which is called inflation. Central banks then intervene by raising interest rates, which reduces borrowing and increases debt repayment, which in turn reduces spending and income leading to lower growth, lower inflation and eventually a recession.

-Central banks then intervene by reducing interest rates, which fuels more borrowing resulting in increased spending and income which leads to higher growth. Short-term debt cycles are essentially controlled by the central bank.

-However, over time the short-term debt cycles have higher peaks and troughs (in terms of both higher growth and debt), as debts are not being repaid resulting in debt rising faster than income as people resort to more debt to fuel their consumption. This results in the long-term debt cycle.

-Banks facilitate this increase in debt as asset prices and income are rising allowing borrowers to remain credit worthy – eventually causing a bubble. However, this process cannot go on forever, as the long-term debt cycle eventually peaks and debt repayments start rising faster than incomes, forcing people to cut back on spending and incomes start falling.

– The reduced spending and income, with still rising debt repayments, causes a period of deleveraging – which is what happened in much of the world in 2008, in Japan in 1989 and in the U.S. in 1929.

-A period of deleveraging unleashes a vicious cycle of less spending, less income, less wealth (as stocks and real estate prices collapse), less borrowing, less spending and so on. This cannot be fixed by central banks lowering rates, as they are already very low. U.S. interest rates reached 0% only in 2008 and 1929.

-Debt burdens have to be reduced – there are four ways this can happen: cut spending, reduce debt, redistribute wealth and print money. These methods have been applied in every deleveraging instance in modern history – U.S. in the 1930s, U.K. in the 1950s, Japan in the 1990s and Spain & Italy in the 2010s.

-Typically, spending (by governments, businesses and individuals) is cut first so debt can be repaid – this is known as "austerity".

-However, as spending is cut, and spending is someone else’s income, income levels fall more than the debt being rapid and the debt burden actually increases. This is a deflationary environment with businesses cutting costs leading to higher unemployment.

-This leads to the next step of debt reduction as borrowers are unable to pay debts, nervous depositors withdraw money from banks leading to widespread defaults and a severe economic contraction – "a depression".

-To avoid defaults, lenders resort to debt restructuring, where the debt amount is reduced, its maturity is extended or the interest rate is reduced. Even though debt reduces, income and asset values fall faster leading to even higher debt burdens. Debt reduction is also deflationary.

-Lower income and employment leads to lower taxes for the central government, while it needs to increase spending via transfers to support the unemployed who have inadequate savings. Governments also increase spending in the economy to replace the decreased spending by individuals and businesses, leading to budget deficits as they spend more than they can earn via taxes.

-To finance the budget deficits the government needs to either raise taxes or increase borrowing – and with falling incomes and rising unemployment, the burden of the increase in taxes falls on the rich. This facilitates a redistribution of wealth in the economy from the haves to the haves-not, increasing social tensions within countries as well as between creditor and debtor nations, leading to possible political change and even war.

-The ongoing depression creates pressure on governments to act, and with credit disappearing in the economy people don’t have enough money – forcing the central bank to step-in to print money.

-Unlike cutting spending, debt reduction and wealth redistribution, printing money is inflationary and stimulative. The central bank prints money – in the U.S. the Fed printed money in the 1930s and again in 2008 when it printed $2 trillion of new money, as did central banks around the world.

-The central bank buys financial assets and government bonds, driving up their prices and making their owners wealthier and therefore more credit-worthy. However, financial assets are held mainly by the rich.

-While the central bank can only buy financial assets benefiting mainly the rich, the central government can put money in the hands of the people by buying goods and services. Therefore, the two need to work together to stimulate the economy – by buying government bonds the central bank is lending money to the government who can the buy goods and services in the economy.

-This increases income levels and government debt, but lowers the overall debt burden of the economy. This is a risky process for the economy, and policy makers need to balance the four ways of reducing the debt burden.

-The deflationary measures need to balance the inflationary measures, and if achieved it can result in a "beautiful deleveraging".This is when incomes increase more than debt thereby decreasing the debt burden, growth is positive and inflation is not a problem.

-Money creation does not result in inflation if it offsets the reduction of credit in the economy. A dollar spent on goods and services has the same effect on prices if it comes from money or credit.

-For an economy to turnaround and reduce its debt burden the rate of income growth needs to exceed the rate of interest paid on the debt. For example, if a country has a debt-to-income ratio of 1:1, and pays a 2% interest rate on its debt, then income needs to grow by more than 2% for the debt burden (i.e. debt/income) to come down.

-The risk is that governments rely mainly on money printing to address the problem, as it’s less painful than the alternatives. This can result in hyperinflation, as experienced by Germany in the 1920s.

-If policy makers achieve the right balance, incomes start rising making borrowers more credit-worthy and lending picks up. Debt burdens reduce gradually and the economy starts to recover – resulting in the era of reflation. It takes about 7-10 years for the debt burdens to fall and the economy activity to get back to normal.

-In conclusion, laying the short-term debt cycle on the long-term debt cycle and then laying both of them on the productivity growth rate provides a good framework to analyse where we are now and where we are headed. It has worked well for over 30 years, and was key in being able to predict the 2008 financial crisis.

-In sum, are three basic rules to follow:

-Don’t have debt rise faster than income as the debt burden will eventually cause a crisis.

-Don’t have income rise faster than productivity as this eventually makes the economy uncompetitive.

-Focus on raising productivity as that is the only thing which matters in the long run.

A brilliantly insightful and clear note on the important economic issues of the day. I do hope that the message is passed onto policy makers and individuals around the world, as too much time is wasted fighting ideological differences rather than focusing on addressing the core issues at hand. There is no hard and fast rules – that debt is bad, deficit financing is bad, austerity is bad, QE is bad etc – it’s all about achieving a judicious balance to prevent a long grinding depression.

Regarding valuations of stock markets, peripheral and Eastern Europe and select EM currently provide the most attractive opportunities as per Scott Minerd, CIO of Guggenheim Partners:

"With continued monetary easing around the world and signs of a synchronous global expansion taking root, countries that were particularly hard hit over the past few years now present potentially attractive opportunities. Measured by market capitalization as a percent of GDP, Eastern Europe and smaller euro zone peripheral countries now appear to be the most undervalued of major regions worldwide. Major peripheral countries in the euro zone (Greece, Ireland, Italy, Portugal, and Spain) are also below their average level of market cap to GDP over the past 10 years, indicating further room for equity returns, compared to other developed markets. Emerging markets that suffered selloffs over the past few months also remain undervalued, including India, China, and South America."


Source: Bloomberg, Haver, Guggenheim Investments. Data as of 3Q2013 for market cap, 2Q2013 for GDP

High Cholesterol, inflammation and Heart Disease:

Sep. 23, 2013 (Science Daily): University of Buffalo researchers are developing a richer understanding of atherosclerosis in humans, revealing a key role for stem cells, induced by high levels of cholesterol, that promote inflammation

-The research was published last month in PLOS One. It extends to humans previous findings in lab animals by researchers at Columbia University that revealed that high levels of LDL ("bad") cholesterol promote atherosclerosis by stimulating production of stem cells.

-"Our research opens up a potential new approach to preventing heart attack and stroke, by focusing on interactions between cholesterol and the stem cells," says Thomas R. Cimato, lead author on the PLOS One paper and assistant professor in the Department of Medicine in the University of Buffalo School of Medicine and Biomedical Sciences.

-He notes that the finding about the importance of these stem cells in atherosclerosis could lead to the development of a useful therapy in combination with statins, or one that could be used in place of statins in individuals who cannot tolerate them.

-The study demonstrated for the first time in humans that high total cholesterol recruits stem cells from the bone marrow into the bloodstream which has been implicated in many chronic inflammatory diseases, including atherosclerosis.

-They also found that statins do reduce the levels of stem cells in the blood but not every subject responded similarly, Cimato says.

-"We’ve extrapolated to humans what other scientists previously found in mice about the interactions between LDL cholesterol and these stem cells," explains Cimato. The demonstration that a finding in lab animals is equally relevant in humans is noteworthy, adds Cimato.

-The next step, he says, is to find out if stem cells, like LDL cholesterol levels, are connected to cardiovascular events, such as heart attack and stroke.

The final conclusion of my serialization of the book "The Blue Zones of Longevity" will be sent this weekend. Apologies for the delay in sending the newsletter this week due to conflicting commitments!

I would like to wish my readers a very happy Diwali and a prosperous year ahead!




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