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Summary of “How the economic Machine works by Ray Dalio”

“Economy works like a simple machine”.

Ray Dalio

Economy might seem complex but it works in a simple mechanical way. It is made up of simple transactions which are repeated over and over again. There are 3 main force which drive the economy:

1. Productivity Growth
2. Short term Debt cycle
3. Long term debt cycle.

After telling this forces author has started explaining the meaning of transaction. Economy is basically any activity related to goods, services, production and consumption within a country. In simple terms it is the sum of all the transactions. .The total transactions of the economy can be divided into two types:

1. Money transaction
2. Credit transaction. The total amount of spending drives the economy (money + credit transaction)

Ray Dalio says credit is the main part of the economy and it is less understood. Credit is the most important part because it is the most biggest and volatile part. When borrowers promise to repay and the lender believe them then the credit is created. As soon as credit is created it immediately turns into debt (Asset for lender & liability for borrower). Then the author has explained why credit is so important

• Whenever borrowers receives a credit he is able to increase his spending.

• Spending drives the economy. As your expense is someone’s income.

• So when you spend more then someone earns more.

• When someone income arises it makes lenders more willing to lend their money because now that guy is more worthy of credit

A credit rating borrower has two thing:

1. Ability to repay.
2. Collateral.

As we have seen that increased income allows increased borrowing which allows increased spending and since one person spending is one person’s income this lead to more increased borrowings and so on. This led to economic growth and this is why we have cycles.

2. Short term debt cycles

Productivity matters in long run whereas credit matters more in short run.

This is because the productivity growth doesn’t fluctuate much so it is not big driver of economic swings. But debt is because it allows us to consume more than we produce when we acquire it and it forces us to consume less then we produce when we have to pay it back. Debt swings occour in two big cycles:

1. Which takes 5-8 years and other,
2. which take 75-100 years.

The economic cycles happen because of the debt cycles. A debt cycle is typically like any other cycle-initially, borrowers spend more (by taking credit) than their income and later, they pay more (repayment of the loan) and thus, reduce their spending. After this the author has given us an example explaining why we need credit: Assume two case where in one economy doesn’t have credit and other economy has. In the economy with no credit, the only way through which spending can be increased is by increasing their income which require them to produce more (more productive then before). But in the economy where credit is available there will be cycles. This cycle is because of the nature of credit. Every time a person takes credit he spends more in that time but in future when he will have to repay it he will spend less. Credit is different from money because in money the transaction is settled immediately but in credit transaction is settled in future. Credit can be good as well as bad depending on its usage. Example – If the credit is used to buy a T.V. it will not generate any return but if it used to buy a tractor, it will help in farming through which you can earn money. Credit leads to short term debt cycle.  This is how it works – one person earns, say for example, $100,000 with no debt. He can borrow $10,000. So he can spend a total of $110,000. This $110,000 becomes another person’s income with no debt. He will be able to borrow $11,000. His spending will rise to $121,000 which will later become another person’s income and the cycle goes up. But as the cycle goes up it will need to come down. Over the time as the people will spend more, expansion will be there. As the spending is increased the prices rise too, which we refer as Inflation. In this scenario the central bank increases interest rates. This will lead to fewer borrowings and also cost of existing borrowings will rise. As the borrowing will be lesser and debt payments will be higher, this will lead to lower spending and eventually lower incomes. This again will lead to drop in price and overall economy will face recession. In this scenario, when inflation is not a problem, central bank will decrease the interest rates so that economy pick up again. Overall, when the credit is available easily there is a credit expansion and when credit is not available easily there is a recession. This cycle is managed by central bank (generally by changing interest rates).

3. Long term debt cycle

Now comes in long term debt cycle. At the end of short term debt cycle, growth and debt rises. This is because people spend more rather than paying debt. Even if people have rising debts, lenders lend freely because things are going great. Incomes are rising, spending is rising, asset prices are rising, stock market is rising and overall there is a boom. If this is done in huge volumes it is called as bubble. Rising income and asset values help borrowers remain creditworthy. As this debt burden increases slowly over time, debt repayment grows faster than income. Due to this spending is cut and income for other people decreases which makes them less creditworthy. To pay back the debt, spending is to be cut even further. Economy begins deleveraging. In deleveraging there less income, assets price falls, credit is not available, the stock market crashes. As the income drops and there is a pressure of debt repayment, people are forced to sell their assets. Due to this stock market crashes, real estate market crashes. This appears to be recession but is not.

In recession, central banks changes interest rates to stimulate the borrowing. But in deleveraging the interest rates are almost near to zero or zero only. Four ways through which deleveraging (repayment of debt burdens) can be done are – cut the spending, reduce debt through defaults and restructuring, redistribution of wealth and finally central banks printing new money. But it is not that easy. As the spending is cut, income also stops for other people. Businesses cut cost which leads to removal of employees. As the employees will have no income they won’t be able to repay the loans/debt. This will result in banks unable to pay the depositors and there will be defaults all around. When credit is given both assets and liabilities arises. Lender doesn’t want to see their assets disappearing. So here comes debt restructuring. Debt restructuring means lender gets lesser money or gets money over a longer time or at a lower interest rate (from the rate which was agreed earlier). As the incomes are less and unemployment is seen, government’s source of income i.e. collecting taxes is affected. At the same time government has to spend for those who lost their jobs. Basically, government spend more than they earn. In this case government has to borrow more. But the question is from whom to borrow. Now what government does is that they raise taxes on wealthy people and by this wealth is distributed from “haves” to “have not’s”. Then central bank steps in. Central bank prints more money and buy assets and asset prices starts rising. But this will only help those who have financial assets. So government and central banks cooperate. Central bank buys government bonds which result in inflow of money for government. Then government can buy goods and services and eventually help lending money in the hands of people.  If all the factors of deleveraging are done in balanced way then deleveraging can be beautiful. If the deleveraging is done beautifully growth will be slow but debt burden will be reduced. Overall, economy will start to rise again.

At last author has told three things which we need to remember:

1. Don’t let debt rise faster than income.
2. Don’t let income rise faster than productivity.
3. Do all that to raise productivity.

Source/ Link of the video: https://www.youtube.com/watch?v=PHe0bXAIuk0

Article-2

Summary on How to avoid common mistakes and uncommon losses

• Not every time bear market is bad and bull market is good.
• Long term investing is very critical.
• Price vs value case study, people have a mentality that stock with higher price will go down and stock will lower price will go up. That myth was broken by showing an example of stock prices of 2 companies.
• People lost around 34k crores+ in equity markets in last 2 years, most of them lost in retail.
• How to choose a good company?
• Look at its financial statements from annual reports.
• Cashflow is very important for analysis which most of the people doesn’t understand. Operating cashflow tells a lot about a company.
• Have a look at its net profit and interest.
• Check if company has made any pledging or not. If there is a pledging, consider its sold.
• It is preferable to invest in a company in which promotor’s stake is more than 50%.
• Always read MDA and ceo statements in an annual report of a company. It tell us regarding futures operations company might take.
• Consolidated financial statements is better than standalone because we are not buying one stock, we are buying entire business.
• Never judge a company by its dividend payout ratio. If a company is paying dividend but has high debt also and a company is not paying dividend but is reducing its debt and the second company is better than the first one.
• Operating cashflow can be manipulated but it is not sustainable in nature.
• Case study of two infra companies was done which started around same time (company A and company B).
• In the beginning Company A had higher stock price than Company B.
• But as of today, Company B has higher stock price than Company A.
•  In the quaterly statements of 8 years of both the companies, it could be seen that comapny A had pledging around 31.58% and company B had 0% pledging.
• In the cashflow statements it could be seen that company A’s CFO was not healthy over the years.
• Analysis on a company can be done by knowing about the directors and independent directors in a company and about how the company has described itself in the annual reports. Too much show off should always rings the bell of an investor.
• A case study was shown on a dairy company who had charged very low depriciation, companies debt was going high every year and its CFO was also negative. Dilution of equity was also increasing. It was doing sales but with it receivables were also increasing every year which means that it might be a hoax sales or the company is not able to collect money which might turn into bad debt. That company is now a NCLT case.
• Company might alter money by the name of acquisition in order to attract investments from FII.
• Everything becomes rosy when peak comes. It is very necessary to research whenever a company announces a big acquisition and a foreign country is involved. Too much hype in news about a company might mislead investors and can end up facing losses.

In the end with a help of a video it was shown that how patiences is so necessary in life. The same goes when you are investing in a equity market