Let's Talk About the Economic Machine

Let's Talk About the Economic Machine

In our journey through the world of finance, we've tackled many topics from budgeting to investing. Today, let’s take a simplified look into economics and specifically the economic machine we are all part of. An economy is like a giant machine where everyone contributes to and benefits from the production and exchange of goods and services. It’s built on the activities we all partake in every day, whether it’s working at a job, buying groceries, or selling products. This machine is fueled by money, which helps us measure the value of these goods and services and makes trading between people easier than swapping items directly like in old times. In essence, the economy is the total sum of all these transactions happening within a country or region, driven by the needs and wants of its people.

To understand how this machine works in a clear, accessible way, I turned to Ray Dalio’s excellent animated video, How The Economic Machine Works. This video breaks down complex economic concepts into straightforward, digestible pieces. Dalio explains that the economy operates through simple, repetitive cycles, which can be predicted and harnessed for better financial decision-making.

He identifies three main forces driving the economy:

Productivity Growth: The steady improvement in our ability to produce goods and services, which slowly and steadily raises our living standards.

The Short-Term Debt Cycle: Roughly every 5-8 years, economies expand and contract, creating recessions and booms that are a result of credit expansion and tightening.

The Long-Term Debt Cycle: Occurring over 50-75 years, this cycle represents large swings in debt accumulation that eventually need to be corrected through painful deleveraging processes.

By watching this video, you’ll gain invaluable insights into the patterns and principles that underlie much of our economic experiences and decisions. Understanding these cycles can make a significant difference in how we approach financial planning, investing, and even career choices. The Video is 30 Minutes and may need a couple of viewings to really ingrain the learnings over a couple of sittings

Watch the video here to deepen your understanding and we can go onto explore further once you have completed it. If this is where you leave us this week, please do watch the video for an amazing explanation that should help you understand the machine around you a little better.

Understanding the Economic Machine

If you managed to come back after your viewing of Mr. Dalio's video, many thanks – So, what did you think? As simple as that, the levers being pulled in a direction can really impact the little guy, that’s for sure.

Following your viewing of Ray Dalio's "How The Economic Machine Works," you're likely intrigued by the simplicity yet profound depth with which economics can be understood. Let's unpack some of these concepts further and explore how they apply not just to global economies but to our personal financial decisions.

Productivity Growth

Productivity growth is the bedrock of any economy. It’s about how efficiently goods and services are produced and improved over time. This growth stems from factors like technological advancements, skill enhancements, and innovative processes. For you, this means understanding which industries are growing and how changes in technology might impact your job or investments. Staying informed about technological trends and upgrading your skills can be a great personal investment.

The Short-Term Debt Cycle

The short-term debt cycle, which typically lasts about 5-8 years, reflects the fluctuating pace of spending and borrowing. When people feel confident, they spend more and borrow more, leading to economic expansion. Conversely, when confidence drops, so does spending and borrowing, leading to a contraction or recession. Observing these cycles can help you make smarter decisions about when to take risks and when to save. For instance, starting a business or investing in real estate might be more favorable during an economic upswing.

The Long-Term Debt Cycle

Perhaps more impactful is the long-term debt cycle, which spans 50-75 years and involves larger debt accumulations that ultimately require corrections. This cycle ends in a deleveraging period, where debts are reduced, and economic restructuring occurs. Understanding this cycle is crucial for long-term financial planning. For example, recognizing a deleveraging period might influence you to be more conservative with your investments, prioritize debt reduction, or diversify your financial portfolio to mitigate risks.

Practical Applications

Debt Management: Managing your debt in alignment with the economic cycle can lead to more sustainable personal finances. Hindsight is 20:20; was it luck or a good reading of the economy that led me to fix my current residential mortgage at 1.12% in 2021 for 5 years?

Investment Strategies: Recognizing the phase of the economic cycle can guide your investment decisions. After the boom in 2021, I stuck with investing in growth stocks through 2022 and was slaughtered with the rate hiking cycle. Lessons learned, and I built an investment checklist to identify when may be the time to start tapping out and winding off risk. Now in 2023/2024 during a period of economic recovery, you might consider investing in stocks or sectors poised for significant growth.

Career Decisions: Your career choices can also be influenced by understanding these economic cycles. Entering industries that thrive during economic expansions or are essential during recessions can provide job security regardless of the economic climate.

As we navigate through 2024, it seems we are nearing the end of a tightening cycle characterized by increased interest rates. Such periods often set the stage for a shift toward more favorable conditions for debt expansion, as lower rates typically encourage borrowing, injecting more money into the economy. This cyclical motion is a fundamental aspect of how our economic machine operates.

Reflecting on Our Current Economic Cycle

Given this backdrop, I’d love to hear your thoughts and observations:

Where do you think we are in the economic cycle right now? Do you see signs in your local economy, job market, or personal financial situation that indicate we are moving from tightening to expansion?

How have increased interest rates affected you personally or professionally? Have these changes influenced your spending, saving, or investing strategies?

Looking ahead, how do you plan to adjust your financial strategies as we anticipate lower interest rates and a potential debt expansion phase? Are there specific investments or financial moves you’re considering to capitalize on this next phase?

What lessons from past economic cycles are you keeping in mind during this transition? Sometimes historical patterns offer valuable insights into managing our finances during different economic phases.

Your insights and experiences are invaluable as we navigate these concepts together. What resonated most with you from the video? How do you see applying these principles in your own financial life? Let's continue this discussion and learn from each other's experiences.

Matt, The Compound Coach