How the Economic Machine Works
The economy is like a machine.At the most fundamental level it is a relatively simple machine.But many people
don’t understand it – or they don’t agree on how it works – and this has led to a lot of needless economic
suffering.I feel a deep sense of responsibility to share my simple but practical economic template, and wrote this
piece to describe how I believe it works.My description of how the economy works is different from most
economists'.It has worked better, allowing me to anticipate the great deleveragings and market changes that
most others overlooked.I believe that is because it is more practical.Since I certainly do not want you to blindly
believe in my description of how the economic machine works, I have laid it out clearly so that you can assess the
value of it yourself.So, let’s begin.
How the Economic Machine Works: “A Transactions-Based Approach”
An economy is simply the sum of the transactions that make it up.A transaction is a simple thing.Because there
are a lot of them, the economy looks more complex than it really is. If instead of looking at it from the top down,
we look at it from the transaction up, it is much easier to understand.
A transaction consists of the buyer giving money (or credit) to a seller and the seller giving a good, a service or a
financial asset to the buyer in exchange. A market consists of all the buyers and sellers making exchanges for
the same things – e.g., the wheat market consists of different people making different transactions for different
reasons over time.An economy consists of all of the transactions in all of its markets.So, while seemingly
complex, an economy is really just a zillion simple things working together, which makes it look more complex
than it really is.
For any market, or for any economy, if you know the total amount of money (or credit) spent and the total
quantity sold, you know everything you need to know to understand it. For example, since the price of any good,
service or financial asset equals the total amount spent by buyers (total $) divided by the total quantity sold by
sellers (total Q), in order to understand or forecast the price of anything you just need to forecast total $ and total
Q.While in any market there are lots of buyers and sellers, and these buyers and sellers have different
motivations, the motivations of the most important buyers are usually pretty understandable and adding them up
to understand the economy isn’t all that tough if one builds from the transactions up.What I am saying is
conveyed in the simple diagram below.This perspective of supply and demand is different from the traditional
perspective in which both supply and demand are measured in quantity and the price relationship between them
is described in terms of elasticity.This difference has important implications for understanding markets.
Price = Total $ / Total Q
Total $ = Money + Credit
Total
Q
Total
$
Reason A
Reason B
Reason C
Seller 1
Reason A
Reason B
Reason C
Seller 2
Reason A
Reason B
Reason C
etc…
Reason A
Reason B
Reason C
Buyer 1
Reason A
Reason B
Reason C
Buyer 2
Reason A
Reason B
Reason C
etc…
Credi
t
Mone
y
Credi
tMone
y
Credit
Money
Price = Total $ / Total Q
Total $ = Money + Credit
Total
Q
Total
$
Total
Q
Total
$
Reason A
Reason B
Reason C
Seller 1
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C
Seller 1
Reason A
Reason B
Reason C
Seller 2
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C
Seller 2
Reason A
Reason B
Reason C
etc…
Reason A
Reason B
Reason C
etc…
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C
etc…
Reason A
Reason B
Reason C
Buyer 1
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C
Buyer 1
Reason A
Reason B
Reason C
Buyer 2
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C
Buyer 2
Reason A
Reason B
Reason C
etc…
Reason A
Reason B
Reason C
Reason A
Reason B
Reason C
etc…
Credi
t
Mone
y
Credi
tMone
y
Credit
Money
2015 Ray Dalio1
The only other important thing to know about this part of the Template is that spending ($) can come in either of
two forms – money and credit.For example, when you go to a store to buy something you can pay with either a
credit card or cash. If you pay with a credit card you have created credit, which is a promise to deliver money at a
later date,1 whereas, if you pay with money, you have no such liability.
In brief, there are different types of markets, different types of buyers and sellers and different ways of paying
that make up the economy. For simplicity, I will put them in groups and summarize how the machine works.
Most basically:
All changes in economic activity and all changes in financial markets’ prices are due to changes in the
amounts of 1) money or 2) credit that are spent on them (total $), and the amounts of these items sold
(total Q). Changes in the amount of buying (total $) typically have a much bigger impact on changes in
economic activity and prices than do changes in the total amount of selling (total Q).That is because
there is nothing that’s easier to change than the supply of money and credit (total $).
For simplicity, let’s cluster the buyers in a few big categories.Buying can come from either 1) the private
sector or 2) the government sector.The private sector consists of “households” and businesses that can
be either domestic or foreign.The government sector most importantly consists of a) the Federal
Government,2 which spends its money on goods and services and b) the central bank, which is the only
entity that can create money and, by and large, mostly spends its money on financial assets.
Because money and credit, and through them demand, are easier to create (or stop creating) than the production
of goods and services and investment assets, we have economic and price cycles.
Seeing the economy and the markets through this ”transactions-based” perspective rather than seeing it through
the traditional economic perspective has made all the difference in the world to my understanding of what is
going on and what is likely to happen. It lets me see what is actually happening and why it’s happening in much
more granular ways than the traditional way of looking at things.I will give you a few examples:
1. The traditional way of looking at the relationship between supply, demand and price measures both
supply and demand via the same quantity number (i.e., at any point the demand is equal to the supply
which is the amount of quantity exchanged) and the price is described as changing via what is called
velocity.There is no attention paid to the total amount of spending that occurred, who spent it, and why
they spent it.Yet, in any time and across all time frames, the relationship between the change in the
quantities exchanged and the change in the price will change based on these factors that are being
ignored.Throwing all buyers into one group (rather distinguishing between them and understanding
their motivations) and measuring their demand in terms of quantity bought (rather than in the amount
spent) and ignoring whether the spending was paid for via money or credit, creates a theoretical and
imprecise picture of the markets and the economy.
2. Most of what economists call the velocity of money is not the velocity of money at all – it is credit
creation.Velocity is a misleading term created to explain how the amount of spending in a year (GDP)
could be paid