How the Economic Machine Works
(Part 1): Money vs. Credit

A Macroeconomics Overview

Posted: 29 March 2021


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To understand money and credit, we first have to understand what is an economy. Ray Dalio has laid out a simple and practical template of how to understand the economy, which I would like to share in this post. I am not a major in economics and I do not proclaim to be an expert on this subject. A large part of my research will be based on Ray Dalio’s video below, Lyn Alden’s research for more detailed macroeconomics and potentially the book “Dying of Money: Lessons of the Great German and American Inflations” (shared by Michael J. Burry). 

This article is the start of a multi-part series where I seek to explore and learn more about macroeconomics and how it is intertwined with the financial markets. Through multiple subsequent articles, I hope to cover (i) the basics of how our economy works, (ii) the difference between money and credit and the importance of credit, (iii) the short-term and long-term debt cycles, (iv) interest rates and their impact and (v) inflationary and deflationary pressures. 

Although economic machine is highly complex, it is made up of a lot of transactions that repeat over and over again. These transactions create 3 main forces that drive the economy: (1) productivity growth, (2) the short-term debt cycle and (3) the long-term debt cycle. Ray Dalio offers a great template to understand things from a very high-level/macro perspective by laying these three elements on top of each other to understand what is happening now.

Source: Ray Dalio

1. What is an Economy?

Building block of an Economy – Markets

A market consists of buyers and sellers making transactions for the same thing – e.g. a car market consists of buyers and sellers of cars, a stock market consists of buyers and sellers of stocks and so on. An economy is simply all of the transactions in all of its markets.

Building block of a market – Transactions

An economy is simply the sum of all transactions that makes up the economy. Transactions involve people buying and selling things to one another. People like you and I create transactions on a daily basis – e.g. buying a cup of coffee, going for a meal, taking the public transport and so on.

Each transaction consists of a buyer exchanging (i) money or (ii) credit for (a) goods, (b) services or (c) financial assets. Because money and credit works in the same way, adding money and credit gives us the total spending that drives the economy.

Source: Ray Dalio

Each transaction consists of a buyer exchanging (i) money or (ii) credit for (a) goods, (b) services or (c) financial assets. Because money and credit works in the same way, adding money and credit gives us the total spending that drives the economy.

Actors in the Markets

People, businesses, banks and governments all engage in transactions – exchanging money and credit for goods, services and/or financial assets. The biggest buyer and seller is the government, which consists of a central government and a central bank.

  • The central government collects taxes and spends money (e.g. on cash handouts, infrastructure spending, etc.); and
  • The central bank controls the amount of money and credit in the economy by (i) influencing interest rates, (ii) printing money [and (iii) the amount of money commercial banks (like DBS, OCBC, Citibank, JPMorgan, etc.) have to keep as reserves in the central bank].

Source: Ray Dalio

2. What is Money?

In this section, I will briefly discuss what is money and the uses of money. I will not delve into the evolution of money (i.e. how fiat money (government-backed paper money) came into existence) nor discuss the merits / laws of our current form of money.  

In order to understand the economy and transactions, we have to first understand and differential money and credit. Money is commonly defined as a generally accepted medium of exchange. Rather than exchanging goods and services directly (barter trading), money is used to facilitate indirect exchange. Money serves three primary functions:

  1. Medium of exchange / means of payment – accepted as a payment for goods and services
  2. Unit of account – i.e. proof that you have done some form of work
  3. Store of value

2.1 Measuring money

Narrow money refers to (i) the amount of notes and coins (fiat money) in circulation in an economy and (ii) the total balances in checkable bank deposits (i.e. money deposited with a bank which can be most easily accessed, either via withdrawal or writing a check). This represents the most liquid form of money (liquidity = how easily assets can be converted to cash).

  • NY Federal Reserve Bank definition of “M1”: restricted to the most liquid forms of money which consists of currency in the hands of the public, travelers checks, demand depots and other deposits against which checks can be written

Broad money refers to narrow money plus any amount available in liquid assets, which can be used to make purchases.

  • NY Federal Reserve Bank definition of “M2”: M1 plus savings accounts, time deposits of under $100,000 and balances in retail money market mutual funds

2.2 What people do with their money

Predominantly, there are three ways money is used in the economy: (1) to transact for goods and services, (2) to invest and (3) to save.
Throughout the world, there are three main reasons for households and firms in an economy choose to hold money:

  1. Transaction demand: The first use of money is to transact for goods and services. As the level of real GDP increases, the size and number of transactions will increase, and the demand for money to carry out transactions increases.
  2. Precautionary demand: Money held for “rainy day” / unforeseen future needs. In aggregate, the amount of precautionary demand for money increases with the size of the economy.
  3. Speculative demand: Money that is used for investment opportunities that arise in the future. As the market returns (from bonds and/or other financial instruments) get higher, the lower the speculative demand for money as the opportunity cost of holding cash increases.

3. Credit and the Economy

Credit spends just like money, and a lot of what we think is money is in fact credit. According to Ray Dalio, credit is the most important, but probably the least understood, part of the economy. It is the most important because it is the largest and most volatile part of an economy. So what exactly is credit?

3.1 What is Credit?

Just as buyers and sellers make transactions in a market, so do Borrowers and Lenders.

Lenders want to grow their money and Borrowers usually want to buy something they cannot afford or to invest in something – e.g. Bank loan to buy a HDB/house. Credit helps Lenders and Borrowers get what they want.

Anyone can create credit out of thin air – For example, when you lend money to a friend, you effectively create credit (which is an asset to you) and debt (which is a liability for your friend). As such, credit is also more commonly known as ‘debt’.

How does Credit Work?

Lenders lend money to Borrowers when they promise to pay back an extra amount (called “interest”) on top of the original sum they lent (called “principal”). This kind of transactions allows Lenders to grow their money and Borrowers to buy what they could not ordinarily afford, which helps both parties achieve their goals.

When Borrowers promise to repay and Lenders believe them, credit is created. The extent to which Lenders are willing to believe the Borrower is also known as ‘creditworthiness’.

When interest rates are low, borrowers flock to borrow money, and when interest rates are high, people shy away from it.

How does Credit drive the economy?

As the economy includes all the transactions of all markets, when people borrow money, they can spend more money. And spending drives the economy because one person’s spending is another’s income.

How is creditworthiness determined?

A person’s credit worthiness is determined by (i) the ability to repay debt and (ii) the amount of valuable assets that he/she has to use as collaterals (i.e if repayment obligations cannot be met, “collaterals” are sold by the Lenders to recoup money).

3.2 The self-reinforcing cycle of credit

When people borrow and increase their spending, this increases the income of another person. This makes the other person more creditworthy in the eyes of the borrower, allowing him/her to borrow even more money from a Lender.

This creates a positive feedback loop which drives more spending, increases incomes, raises productivity and drives more borrowing. This leads to economic growth and is one of the main drivers of “cycles”.

Source: Ray Dalio

3.3 The importance of Credit

In order to earn higher income, people need to produce more of something or better-quality goods/services. As we learn over time and become better at what we do, this raises our living standards and ability to produce more/better goods and services – this is called “productivity growth”.

Those who are inventive and more productive raise their living standards faster than those who are complacent and lazy.

But this only matters in the long run. In the short run, credit matters most because productivity growth does not fluctuate much and hence does not drive economic swings. Credit matters most in the short-term because:

  • it forces us to consume more than we produce when we borrow, and
  • it forces us to consume less than we produce when we pay it back

Source: Ray Dalio

Credit drives cycles more than innovation

Swings around the productivity growth line is not due to the level of innovation or amount of hard work put in by the economy. Rather, they are brought about by the level of credit in the economy.

An Economy without Credit (grows steadily)

In an economy without credit, the only way to drive economic growth is to be more productive in order to earn more money and to spend more. As such, productivity drives the amount of income and spending, and hence, the value of all transactions (i.e. the economy). Hence, in an economy without credit, growth is largely driven by productivity growth

If we follow these transactions over time, this should map a stable, upward-sloping line that resembles the productivity growth line.

Source: St. Louis Fed

An Economy with Credit (experiences cycles)

In an economy with credit, productivity is no longer the only way to drive economic growth. People can simply increase their spending by borrowing. As a result, economy with credit has more spending and allows incomes to rise faster than productivity improvement over the short run, but not over the long run.

Every time you borrow money, you effectively borrow from your future self as you will need to cut back on spending to repay debt in the future. This creates cycles and it is as true for individuals as it is for the economy.

This makes understanding credit important as it sets in motion a mechanical, predictable series of events that will happen in the future.

Much of what we think is money is actually credit. According to a Lyn Alden post in June 2020, a 2019 International Monetary Fund (IMF) report found that the global debt was $188 trillion, or over 220% of global GDP in 2018. The Bank for International Settlements (BIS) reported the following figures:

Note that credit is not something bad because it causes cycles – it becomes bad when it finances overconsumption that cannot be paid back (e.g. buying a TV which does not generate income to repay debt). It is good when it efficiently allocates resources and produces income to repay the debt (e.g. investing in a tractor to grow more crops).

Part 2: Debt Cycles

In the next part, we talk about the short-term and long-term debt cycles and detail the template which Ray Dalio lays out in his video. This will provide a basic understanding for us to interpret what is going on in the world around us today, and to better predict what might happen in the future. 


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