Ray Dalio, the successful investor and eccentric founder of Bridgewater Associates, believes he has the economic cycle figured out. In 2015, Dalio published a 306-page research document titled, "How the Economic Machine Works: Leveragings and Deleveragings," which opened by saying of the economy that, "at the most fundamental level it is a relatively simple machine."
Simplicity and clarity are two of the theory's great strengths. Dalio presents ideas logically, one after the other, and builds a smooth model buttressed with heavy empirical research. Moreover, he sells the idea of simplicity with excellent marketing. Versions of the word "simple" (simple, simplistic, simply and simplify) appear nearly 50 times in the document. The word "complex" appears five times and "complicated" only once.
Dalio's paper is a force on the study of credit, exchange and modern banking. He rarely sounds like a stuffy economist or policy wonk. However, his theory is riddled with unspoken assumptions, while other assumptions are presented as causal facts rather than disputed aspects of economic theory. That doesn't mean Dalio is wrong, per se, but rather that readers shouldn't be distracted by the elegance of simple solutions.
Why You Should Listen
Dalio is one of the wealthiest people in the United States. His estimated net worth as of April 22, 2016, was $15.6 billion. Under his stewardship, Bridgewater Associates grew into the biggest hedge fund in the world, managing greater than $150 billion in assets. In 2007, Dalio predicted certain aspects of the coming credit crunch, calling it a part of a larger deleveraging cycle. These seem reasons enough to take seriously what he has to say or at least hesitate before discounting his economic acumen.
The Economic Machine Model
Dalio builds on the theory of market exchange and the dual functions of money: store of value and medium of exchange. After describing the nature of economic transactions and the potential for rising productivity, Dalio clearly distinguishes between standard money used to settle payments and credit-based money, which creates assets and liabilities in an exchange.
After establishing some other basic economic functions, Dalio identifies three crucial inputs for his economic machine model: increases in the rate of productivity, the short-term debt cycle and the long-term debt cycle. It is the "interaction of these three forces," according to Dalio, that "gives a good conceptual road map for understanding the market-based system and seeing both where the economy is now and where it is probably headed."
The economic machine model doesn't fit with any schools of thought in economics. The assumptions are largely Keynesian, but the methodology doesn't consistently fit. Dalio's emphasis on credit cycles, time and the impact of human nature all differ from the general equilibrium models of standard Marshellian macroeconomics.
Economic Success: How Nations Thrive
Dalio calls the recipe for economic success timeless and universal. Unlike in his analyses of spending, debt, interest rates and inflation, Dalio is not rigidly Keynesian in his beliefs about what creates nationwide growth. He openly discusses the importance of cultural and structural variables to growth and argues that many customs and regulations inhibit competitiveness.
The most important cultural aspects include whether individuals receive benefits and realize costs of their actions; how much individuals value achieving, something Dalio pits against savoring life; whether the culture promotes innovation and commercialism; whether bureaucracy is overbearing; and the rule of law.
Dalio believes nations thrive by encouraging productivity on an individual level and balancing the money supply at an aggregate level. Like Keynesians, Dalio follows the Phillips curve model of employment and inflation.
The economic machine model hastily establishes productivity theory and the quantity theory of money. Each is assumed to be relatively stable, if not fixed, but few economists would agree with those assumptions. He largely ignores the politics and uncertainty of fiscal and monetary policy. There is virtually no theory of physical capital structure or price discovery.
Dalio also presents a strikingly limited view of interest rates. In the economic machine model, Dalio sees interest rates as the mechanism by which central banks encourage or discourage borrowing and inflation. Dalio doesn't have a defined capital theory and largely ignores the structure of capital, so he misses the role of interest rates in coordinating real resources across time. Instead, interest rates only determine the rate at which credit payments are settled in the future.
These are critical omissions. Without them, there is no reason to believe assets or interest rates should ever correctly reflect the scarcity of underlying resources, so when Dalio says the government should give people "money tied to spending incentives," as he wrote in early 2016, it's possible he isn't considering how that contributes to malinvestments and misalignments.