How does the economy work?

Transactions

“The economy works like a simple machine,” Dalio begins. “It’s made up of a few simple parts and a lot of simple transactions that are repeated over and over again a zillion times. These transactions are above all else driven by human nature, and they create three main forces that drive the economy.”

Transactions are the building blocks of the economic machine. A transaction is any exchange of money for goods or services. (Money includes both cash and credit.) “All forces in an economy are driven by transactions,” says Dalio. “If we can understand transactions, we can understand the whole economy.”

Markets consist of all buyers and sellers making transactions for the same thing. The stock market is made up of all buyers and sellers of stocks. The wheat market is made up of all buyers and sellers of wheat. The fruit market is made up of all buyers and sellers of fruit. And so on.

When you combine all of the transactions in all of the markets, you get an economy. So, the U.S. economy is made up of all of the transactions in all of the markets in the United States.

Simple so far, right?

The biggest buyer and seller in the economy is the government, which is made up of two parts: the central government (which collects taxes and spends money) and the central bank (which controls the amount of money and credit in the economy by setting interest rates and printing new money).

Dalio says that credit is the most important part of the economy because it’s the largest and most volatile component. “Credit can help both lenders and borrowers get what they want,” he says. “Why is credit so important? Because when a borrower receives credit, he is able to increase his spending. And remember, spending drives the economy.”

He explains: “This is because one person’s spending is another person’s income.

Dalio makes the point that one person’s spending is another person’s income. When you spend a dollar, that dollar becomes income for somebody else. And every dollar you earn was spent by somebody else. The economy is made up of an endless interconnected loop of transactions in which one person spends money that becomes income for somebody else.

Cycles

So, transactions are the atomic particles of elemental economics. In each transaction, the buyer gives money to the seller based on how much she values what the seller has produced. “How much you get depends on how much you produce,” Dalio says. “Those who are inventive and hardworking raise their productivity and their living standards faster.” Productivity matters most over the long run — but credit matters most in the short run.

Productivity growth tends to be linear. As we age, we become more productive. And as the economy as a whole ages, it becomes more productive too. It’s the use of credit that leads to economic cycles. Debt allows us to consume more than we produce when we acquire it, but forces us to consume less than we produce when we pay it back. When we use credit, we’re borrowing from our future selves.

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