By Karl Arnold Belser
10 September 2014

Can the Federal Reserve of the United States avoid runaway inflation as the US recovers from the current deflation super-cycle? The answer is "Yes" as I learned from the YouTube Video  How the Economic Machine Works by Ray Dalio. The video is about a half hour long and describes a convincing model of what the Federal reserve is currently doing. The following paragraphs give a brief summary of Dalo's mental model.


Dalio points out that the economic price P used in the inflation measure is simply the total amount of money spent divided by the amount of goods and services sold. The amount of money spent comprises the total of the cash and credit used. He does not talk about the velocity of money as one is customarily taught in an economics class because velocity is not an independently measurable variable.

Dalio further points out that credit is a large portion of the money supply. Hence if people have trouble finding work then they might have trouble getting credit or paying the interest on existing debt. In this case the P might fall so that one gets deflation. On the other hand, if people have good paying work then they can borrow and spend easily. In this second case the P can rise and there might be inflation. the trick is to manage credit by government borrowing, which in turn controls the money supply, so that P neither rises or falls.

The total amount of goods and services sold is Gross Domestic Product (GDP), and one would like the GDP to grow at a faster rate than does the total interest payment. It the GDP grows faster than total interest payments, then the debt can be repaid. If the reverse is true then unmanageable debt growth might occur. The trick is balancing the creation of public or private debt payments with the growth of GDP. Dalio calls this balance a "Beautiful De leveraging."

In Short Dalio recommends:

1) Don't have debt rise faster than income,

2) Don't have income rise faster than productivity, and

3) Do everything possible to raise productivity.


Ray Dalio's economic machine is a mental model that I think explains what the Federal Reserve is doing and why it is doing it. Further it appears to be working. Although the dramatic financial interventions have been able to keep the GPD from falling, it has not been able to really stimulate growth. I ask why?

Dalio's economic machine assumes that people are central to the working of the economy so that there will be well paid employment and that there will be unconstrained availability of resources such as water, energy, minerals and food. So the model may be a reasonable representation of past economic activity, but constraints that have not been considered may have an influence on future economic growth.

Suppose that full employment is not possible given that much future work will be done by robots and intelligent machines? 
Suppose that there is not enough potable water or food for the domestic population? What happens then?  

Can the economy grow while supporting a huge non-productive load? Mightn't these factors prevent per capita productivity increases? Mightn't there be civil war or some other kind of backlash from people who now do not have a place in the economy?

I think that it remains to be seen how well the current economic de-leveraging works. However, I do suspect that Dalio's economic machine will allow Beautiful De-leveraging without run-away inflation.

The question will be that of collateral damage like that caused by wealth inequality? If GDP goes into a very low growth period, then the government will have to hold interest rates below the GDP growth rate to avoid run-away inflation. In this case the value of capital assets will compound making the rich richer and the world economy may become more feudal in which society will be  dominated by those who have capital assets. My worry is about what happens to everyone else.
Last updated September 10, 2014
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