Are There Flaws in Ray Dalio’s “Machine”?

I was recently asked in the Forum to critique Ray Dalio’s popular video describing how the “economic machine” works.  If you haven’t seen the video you should take a look.  It’s very good.  But I do have some issues with his description of the economic machine.  Here are some of the ones that really jump out at me:

• Early in the video Dalio says “the central bank “controls the amount of money and credit in the economy”.  This is a common view, but an incorrect one.  The Central Bank indirectly influences the amount of credit in the economy by changing its target on the overnight interest rate.  This helps influence the spread at which banks lend, but it does not “control” several other variables such as the demand for credit, the creditworthiness of borrowers or the interest rate at which loans are made.  These factors are all out of the Central Bank’s control and are far more important in the credit creation process than the overnight lending rate.

 

• At about the 7 minute mark Dalio puts a timeframe on the credit and production cycle, but I have to say that I really don’t like doing that.  It implies that the past is prologue, but as we know from the current credit cycle, the past doesn’t always repeat.  Not a major complaint in the description, but worth keeping in mind.

 

• At the 9 minute mark Dalio says money and credit are different things.  Specifically, he says that cash is “money”.  I don’t think this is correct.  Money is a medium of exchange.  And credit is the ultimate medium of exchange.  Therefore, credit is money.  Cash is simply a derivative of credit.  That is, in order to use cash in a modern monetary system you must first have a deposit account with a bank.  That is, someone must have borrowed the funds into existence which created the bank deposits which allowed someone to draw down that bank account.  Cash comes AFTER credit.  Not before it.  That doesn’t mean cash isn’t money.  It is.  As I’ve described before, cash is “outside money” and credit is “inside money”.   Understanding the distinction is crucial to understanding the monetary system and I don’t think Dalio’s distinction puts the “money supply” in the proper perspective as it implies that the Central Bank and government create the “real money” and the banks are just creating something fake or totally different.

 

• At the 24 minute mark Dalio goes on to state that the Central Bank can “print money”.  He says this is “inflationary”.  He’s basically describing QE and we know that QE hasn’t been inflationary.  He fails to explain that QE is really not “money printing”, but “asset swapping”.  That is, the private sector is experiencing a simple change in their portfolio composition (from bonds to deposits/reserves).  So the bonds are the equivalent of being “unprinted” from the private sector while the deposits/reserves are “printed”.  As we know, the confusion over this sort of terminology has created all sorts of flawed thinking in recent years.   See my primer on QE for more.

That’s about it.  Overall I think it’s a tremendously good video.  You’ll learn a lot from it.  So give it a watch.