The economy as machine

The Economist recently had an article on Ray Dalio, hedge fund manager and founder of Bridgewater. The article quotes Paul Volcker describing the degree of detail in Mr Dalio’s work as “mind-blowing”, adding that “he has a bigger staff, and produces more relevant statistics and analyses, than the Federal Reserve.” So it was with some interest that I glanced at the Template for Understanding, a quick description of the analysis on which the Dalio’s philosophy is based. It is certainly simple, which is refreshing. After saying that the economy is “like a machine” he looks at the primary fact of markets — transactions — and concludes that “while seemingly complex, an economy is really just a zillion simple things working together, which makes it look more complex than it really is,” He considers motivation, in other words, regarding transactions as an “act” rather than a scientifically observable “fact”.

Perhaps most interesting is this comment he makes about the so called “balance” between supply and demand:

While in any market there are lots of buyers and sellers, and these buyers and sellers have different motivations, the motivations of the most important buyers are usually pretty understandable and adding them up to understand the economy isn’t all that tough if one builds from the transactions up.

What I am saying is conveyed in the simple diagram below. This perspective of supply and demand is different from the traditional perspective in which both supply and demand are measured in quantity and the price relationship between them is described in terms of elasticity. This difference has important implications for understanding markets.

This is different from the conventional economic bias towards quasi-scientific quantification.

Yet what emerges as one reads the tract is not a concentration on psychology but something very different. My first thought was to take issue with the opening claim that the economy is like a machine. Machines are not full of self aware parts each trying to outdo the other. At best it is a weak metaphor, at worst fundamentally deceptive. Indeed, Dalio’s concentration on the psychology of transactions contradicts his own simile. But as I went through his description of the basic elements of economies — goods and services for exchange, money and credit —  another thought or two occurred.

First, the economy may not be in truth a machine, but those who attempt to interpret think it is like a machine. That means independently acting, knowing and self aware individuals are trying to imagine collectively what it would be like if they were not independently acting, knowing and self aware. As if they were just robots reacting to supply and demand forces, “perfect” information and a slide rule with greed at one end and fear at the other. The metaphor thus becomes self proving, even though its premises are questionable. This in a sense makes the financial system more predictable, and more amenable to the kind of analyses Dalio employs. It also makes for an impoverished collective imagination.

The second problem I had was with what was missing from the analysis. Dalio talks of credit creation and long and short term cycles. But there is no mention of the explosion of meta money over the last 15 years. You know, things like hedge funds. The $700 trillion of derivatives that continue to accumulate. The high frequency trading that is taking over many markets. Unless one puts this under the category of “credit creation” — and some of it certainly is, especially highly leveraged hedge fund activity — then it is extraneous to Dalio’s simple model.

In truth this meta money is new, and increasingly dominant. We have a new sphere of transactions emerging that is based on exploiting the more conventional sphere of transactions by assuming that the conventional sphere operates like a machine. Then massive amounts of that “machine metaphor money” (i.e. the meta money invested players like Dalio) is applied to try to exploit the outcomes of the system. It is a very strange sort of loop, not unlike a Martin Escher drawing. Humans trying to behave like machines while demonstrating that, no matter what they do, they remain human. A very human consequence — mess — is likely to be the eventual outcome. The GFC was probably only the prelude.

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  1. Salient sentence? “.. A depression is the economic contraction phase of a deleveraging. It occurs because the
    contraction in private sector debt cannot be rectified by the central bank lowering the cost of money.”

    • Thanks SON. Dalio deserves more reading by everyone.
      Your criticism that he ignores the psychology of individuals etc may be due to your concentration on trying to work out the speed or behaviour of an individual cog or gear in the machine.

      I think his machine analogy is good from this viewpoint. For example many, even in these pages, advocate low interest rates without looking at the full ramifications. The machine analogy helps in this type of thinking. Everything effects everything.

      “machine metaphor money”

      Dalio deals with this somewhere. I can’t remember in which essay.
      Essentially he says that credit is generated if the cost is low. Logical enough! I create credit in my own business every day. If interest rates are 4% I supply more credit than if interest rates are 20%.
      So low interest rates create both an increased supply and an increased demand for credit.
      So ,logically, with interest rates at zero there is the potential for unlimited credit. Hence ‘meta money’ has come into existence…unlimited money with no restraint and, unless policy is changed, it will end up with no value.

      • “So low interest rates create both an increased supply and an increased demand for credit.”

        not in a deleveraging it doesnt flawse. have a look not at what your assumtion of what you think “might” happen under low rates but what IS actually happening in the real world under low rates. Are low rates in the US and europe creating both an increased supply and an increased demand for credit????? NO THEY ARE NOT.

        the low rates are assisiting with the deleveraging process that is going to run its course ragrdless of wether rates are high or not. there are 2 options. either let the deleveraging occur under low rates and keep it orderly or have the deleveraging occur under high rates and let it get disorderly. for some reason you seem to want the latter.

        • +1

          The number of people who don’t appear to have read fisher’s debt deflation paper is rather concerning.

          Past credit boom + financial crisis + overly tight monetary/fiscal policy = Deflationary depression.

  2. for those commentators on yesterdays poorly titled “Lew calls for a reinflated retail bubble” thread (sensationalist, misleading headline the MSM would be proud of) might want to read Dalio’s peice on what an economic “deleveraging” is.

    flawse, Rusty penny. you might learn something.

  3. GB You are selectively reading or listening. Actually Dalio goes to some effort to express the exact proposition. Credit is a supply demand issue dependent on price. The price is interest rates. Dalio expresses exactly the same view. Also listen carefully to Dalio’s final remarks in the ‘Economist’ interview re a US Balance of Payments crisis. That is the final outcome of the current policies. Along with it will come a whole host of other evils. A US BoP crisis is not one where nominally the US can’t pay back all its debts. It is a loss of faith in the currency. I contend that Niall Ferguson is correct in his opinion that when it happens it will happen quickly.
    There are one or two outliers that may intervene to significantly lesen the likelihood of that particular happening. However these are matters of some good fortune and enterprise not economics.

    Sure deleveraging is happening to Private debt, even in the US, under zero interest rates. However as usual you are taking a shallow half view of the ‘machine’. The deleveraging, under zero interest rates, will not run its course. It will run just a part it. Did you take any notice of the US CAD recently? That tells you that total US debt is now again increasing at an accelerating rate.

    When inflation is recognised deleveraging will cease. Those wanting a ‘little’ inflation will get a whole lot more than they bargained on because the deleveraging process has not run its course.
    As a whole the US is not deleveraging. It is now gearing up at an accelerating rate. Your version of deleveraging assumes the external account is an infinite and free source of money. It isn’t!
    That’s why you missed the whole point in yesterday’s debate. You think that by transferring money, through artificially low interest rates, from people who saver to people who spend, you are reducing debt. All you are doing is perpetuating the real debt that requires us to continue selling off our industries and mines to external ownership.

    Lastly, we were actually discussing “meta money” as discussed by SON. It only exists because of zero interest rates.
    The existence of the “meta money” is a quite different question to consumer debt. Without negative,zero, or near zero interest rates it cannot exist.

    Now I’m not talking trading opportunities here or how to make money in the short term. That is an entirely different question.

  4. Here’s the thing. Interest rate changes do not work in a symmetrical way. If Government policy is to limit credit expansion (for whatever reason) raising rates will at some stage have the effect of MAKING people stop-borrowing; the capacity to service the debt will stop new debt being assumed/created, even if borrower would still choose to borrow. But lowering interest rates cannot MAKE people borrow if they choose not to. ie: there is no financial penalty to ‘not borrowing’. So whist raising interest rate can force a stop to credit creation, lowering rates cannot force it to start. At a time of social uncertainty lower rates symbolises that uncertainty in the economy and deters borrowers from assuming new debt. Not until rates rise,; when the economy is looking better, will borrowing be more easily taken on.

  5. So if we return to the ‘conclusion’ that economics is about people not arithmatic, then I assert there is a correct price of credit and thus returns on savings.

    Because in the real world of people there is no such thing as a win / lose outcome.

    Manipulating the price of money will create winners and losers in the short run. However the longer term will revert to the rule of one of 2 possibilities: win / win or lose / lose.

    Take your pick

  6. canaryinthemine

    Interesting article. More please. Also about this meta money concept. Read somewhere recently about how each new dollar of debt creates less and less value from its application.

  7. “independently acting, knowing and self aware individuals are trying to imagine collectively what it would be like if they were not independently acting, knowing and self aware”

    More like each independently acting, knowing and self aware individual is imagining that all the other independently acting, knowing and self aware individual are a not independently acting, knowing and self aware individuals.

  8. I found Dalio’s paper really interesting and I think he does a great job of explaining to the lay person (like me) the big picture of what’s going on. Ironically, it seems like “this time it’s different” really does apply when seen in terms of one person’s experience. In other words, part of what’s ailing the MSM is that there is nobody there who is bringing a historical lens to what’s happening now. They are still in the business cycle mindset. And in Australia the business cycle has been quiet for so long even that has lost its power to terrify.

    • To expand on the theme in a way that is close to my heart (having just moved from Japan), what we are seeing is more akin to the tsunami that just hit north-east Japan than to the regular earthquakes they have there. It’s beyond living memory, but that makes it no less inevitable. It’s just that we as a species are ill equipped to prepare for these kinds of things, with the predictable outcome.