A Mechanical Economic Model; a review on Ray Dalio’s principles

 By: Shahab Sabahi, Policy Analyst in Energy Security and Policy Research Group

Ray Dalio articulates dynamics of economic growth in three principles; perpetual productivity growth, short time business cycle, and long term cycle. In this sense, he portrays the economics as machines, whose elements mechanically respond and interact to / with each other. His principles appear on two videos, which I checked out; they are reachable at http://www.youtube.com/watch?v=PHe0bXAIuk0 and http://www.youtube.com/watch?v=SFaRazMpxcM . The former has been prepared in an educational format with clear explanations and referred by New York Time. The latter presents Ray’s talks in the “Council of the Foreign Relations”, which is hard to stay with since Ray is a businessman, so he hardly puts his ideas in words, the job that professors/teachers do very well. I recommend watching the former video.

 

What I took away from his principles!

Alike economists who practice business, he tries to generalize the replication of some historical events in a single mental model. He develops the mental model to understand interlinks of historical events and in order to predict futures. His model simplifies a complex system which is inherent with social, political and technical elements, while in effect each element by itself is a complex system. From this sense, one should appreciate his efforts because his simplified model is easy to grasp for non-technical people and even technical persons encourage revisiting their views on economic systems.

Ray in his model takes “the existence of a perpetual productivity growth” for granted!!! He assumes a few small independent markets interact with each other at a higher level (aggregated), the level in which governments / central banks influence the trend of the “market interactions”. Furthermore from his point of view, economies experience two cyclic moves; namely short term and long run; which take place due to governments/central banks influences on credit/money markets by imposing fiscal/monetary policies. 

 

In short, he puts up his economic growth model upon these fundamental assumptions and he concludes such ups-downs is a nature of economic system and he predicts more financial crisis /recovery in the years to come.

 Critique of perpetual productivity growth

Advocators of technology growth may praise Ray’s idea. In his talk, like technologists Ray took the “perpetual productivity growth” for granted (Schumpeter, J., The notion of Destructive Innovation). Despite he gives a description at length about the source of business cycles (cyclic moves) before taking them as assumption, in his simplified model he fails to link business cycle with the productivity growth and does not explain “how to sustain productivity growth in long term”.  One with a background in industrial economics may think of “investments in R&D (research and Development)” as the source of productivity growth which has been theoretically proven (Endogenous Growth Theory; Arrows, K.; Uzawa, H.; Romer, R.). But one may fail to see the underlying principle of the endogenous growth theory which is POLICY measures such as subsidy which has financial consequences on country’s balance sheet. In fact there is a threefold reason that “I do not believe to the notion of the perpetual productivity growth”.

First, theoretically it depends on investment which in turn is subject to business cycle (cyclic moves). It means the productivity growth contributes in both causes and effects of business cycle.

So Ray’s straight line for productivity growth should be teeth-shaped or cyclic-waved.

Second, the empirical data from the “DOT COM” era shows the “effectiveness of investment” in R&D is also matter. Even DOT COM market failed to effectively allocate the investment resources to high-tech activities which rely heavily on R&D activities (same is true in pharmaceutical industries.) It partly stems from the phenomenon of “emergence of asset bubble.”

Third, from an energetic analysis perspective (from the book “biofuels an illusion”), productivity cannot infinitely grow at least in a constant pace. Inter and intra human, capital, and energy replacement are constrained with the capacity of system which means a nonlinear productivity growth trend.

Having the above mentioned arguments, I beef with Ray’s idea of perpetual growth (a British expression of disagreement.)

 

Critique of Ray’s notion of money and credit

True. Changes in the volume of credit and money in the market lead to cyclic moves of the economic growth. Also true where Ray said government’s income sourced from taxes and selling governmental bonds and a central banks was independent from government for controlling the value of currency. But Ray’s model falls short to define three important phenomena:

 

·         Government investments; their needs and effects. Think about them in lights of the fact that private businesses are much capable than governments to allocate investment resources effectively by tracking the market forces (please assume for a moment that there is no market failures; in financial downturns, private businesses are reluctant to invest, even price signals tell the private businesses “Go Ahead” WHY?)

·         Whether short business cycle causes a long business cycles or vice versa or there is no fundamental link between two (Ray jumps over this topic)

·         Consumer saving behavior and its effect on the credit and money markets (Ray’s model cannot capture this non-mechanical phenomenon however Ray talks about only borrowing but not saving.)

 With reducing social systems in general and economic systems in particular to the mechanical systems (as economic modelers do, not econometricians) many phenomena are either excluded from models or their causes/effects are not fully captured. Economic models; from simple to complex ones; tend to be calibrated based on a benchmark. In other words, they are forced to look like the true models. These economic models simplify many behavioral or institutional phenomena to single parameters which in reality are nonlinear variables.

Government bonds, for example, and their effects on the central bank’s balance sheet when the bonds are purchased back by the central bank is a delicate institutional variable which is ignored in Ray’s model and many other models. It could explain why government investments are needed and how far these investments can go.

It also explains the phenomenon of money printing (please note that, there are four monies in economies, printing money DOES not mean increasing the money base). Again it is about balance between spending, earning and value of creating outcome.

 In Ray’s model, it seems that the accumulation of short term business cycles leads to the long term cycle. We should take it with the grain of salt. The latter cycle, if I may use Hegel’s dialectic approach, is a synthesized product of lifestyle changes, political & ideological shifts, markets integration, and evolution of inter and intra society’s relations. Doubtless, the long term cycle is indirectly affected by the short business cycle. In my opinion there is no general pattern for long term cycle as our observation through history goes back only 200 years. But I agree with Ray’s model for the short term cycle and its causes by credit expansion / contraction.

Undoubtedly the saving behavior correlates with fiscal and monetary policies. Increasing tax will reduce the saving level as households’ disposable income slashed and price levels shift upward. A downward move for interest rates would cut the desire for short term saving too as yields are not significant in comparison to alternative investments. But the saving behavior strongly links to the societal demography and institutions.  An aging society with well-structured pension funds tends to buy safe government bonds regardless the movement of fiscal or monetary policies. Such a behavior is hard to be abstracted within a parameter as it varies over time and space.

In addition, the long term behavior of saving / investment links to the prospect of inflation trend which is function of many parameters and hardly influenced by short term fiscal and monetary policies. 

 Conclusion       

Ray Dalio’s principles and idea on the economic system provides an abstract, simple, mechanical and illustrative model. The model introduces very fundamental dynamics of the economic system in very simple language. However it falls short to dig out the realities behinds the evolution of the economic system as a mechanical economic model is far weak to capture underlying socio-political forces.

The linear perpetual growth is a notion that being supported with no empirical evidence. 

Printing money is an abstract and vague term. There are at least four types of money, and in the last three decades no hard currency has be printed in excess in the sense of printing paper.

The Ray’s model provides a nice simplified definition for short business cycle. However it looks over the role of saving behavior and institutions in shaping, intensifying the cycle. The model also mechanically and linearly links the long cycle with short business cycle, which is half true.  The long cycle is a complex phenomenon and with a handful historical data, it is hard to offer a generalized model for them.