Looking back on 2015, one of the most important things I learned was about the concept of economic cycles.

Prior to this past year, the entire concept of an economic cycle was foreign to me. I saw the rise and fall of the stock market as more or less a random walk. In my mind, the most telling predictor of the future value of a financial asset was the momentum of the prior month or quarter. I reasoned: things that are going up will continue to go up, things that are going down will continue to go down.

However, I learned that I was playing the wrong game.

Jon Hsu (COO/CFO of AppNexus) introduced me to the concept of economic cycles and walked me through many of the core principles. He also showed me this video by Ray Dalio (founder of Bridgewater) on economic cycles that is simply amazing. It’s a little bit long, but I’ve watched it three times now. It’s packed with content and each time I watch it I learn something new.

Here are the basic concepts of economic cycles (largely cribbed from Dalio’s video):

  1. One person’s spending = another person’s income
    • If one person spends $100,000, that becomes $100,000 of income for other people
      • On a smaller scale, when I spend $500 to get my sink fixed by a plumber – that $500 becomes income for the plumber
  2. People can spend money to buy things, but they can also spend credit (borrowed money) to buy things
    • Examples of borrowed money are: spending on credit cards or a mortgage loan
  3. Both the money that’s spent and the credit that’s spent turn into other people’s income
    • So, if I make $100,000 income – it’s very likely a portion of that income was generated by other people spending credit (not money)
      • I could have paid the plumber from bullet 1 above $500 on a credit card – thus creating $500 of income for him without immediately spending any money of my own
  4. The vast majority of “money” in our economy is actually credit, not money
  5. The more income I have, the more money I can borrow (and spend), and turn into other people’s income
  6. The borrowing, spending cycle works like a feedback loop – the more one person borrows, the more someone else makes in income, which in turn means that person can borrow more themselves, which turns into even more income for someone else, who in turn can borrow even more, etc.
  7. When spending slows down, the same cycle from bullet 6 above works in reverse, reducing spending and reducing income
  8. The “short term” debt cycle – described in bullets 6 and 7 – is largely controlled by the central bank who can raise and lower interest rates to swing the borrowing cycle up or down
  9. The “long term” debt cycle is influenced by the overall debt-to-income ratio of people and governments – when debt piles too high, there is a recession and potentially a depression to reset debt-to-income ratios
  10. The short term debt cycle (controlled by the central bank) swings back and forth every 5-8 years
  11. The long term debt cycle (largely controlled by long term debt-to-income ratio’s) swings every 75-100 years

Up and down, up and down. When exactly the cycles are going to occur is somewhat hard to predict – but the fact that they will occur eventually is a certainty.

Having learned these lessons I now feel like a member of an elite club who understands the larger picture of why asset values, inflation, and interest rates rise and fall. Watch the video – you’ll feel the same way!

Economic Cycles
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