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This article presents the key works of Ray Dalio, founder of Bridgewater Associates, notably his thought processes for understanding how an economy works. His model essentially defines the market as an aggregation of transactions. Interestingly, I had been pondering this idea for a while and never quite came up with a satisfactory model so I'm pleased to find a similar idea has already been developed (and tested). I've written several articles on the nature of the dynamics of economies, each time I've strived to distil the complex web of processes into simple actions and statements. There is a lot of good descriptions and explanations of recessions, depressions, deleveraging, inflation and deflation.

The Bridgewater website hosts a small selection of PDFs that outline Dalio's thoughts as described above. You can find them here: How an economic machine works. IN this article I will focus upon the PDF entitled "How an economic machine works".

Overview of the machine

The aim of Dalio's machine is to determine the price by considering all possible transactions. Each transaction has a buyer and a seller. The former uses money or credit (in their various forms) in order to purchase a good or service, while the latter has a quantity of goods or items for sale. The price is determined by taking the ratio of the total amount of dollars ($) spent by buyers and the total amount (quantity) of items sold by the sellers: Price = Total $ / Total Q. This is approximately saying that price is governed by supply and demand, as you would expect, but Dalio says that his model differs from traditional notions of supply and demand which considers the totals of dollars and quantity in terms of price elasticity. Personally, I think I need to brush up my understanding of supply and demand in order to make a better assessment.

I can see some contention in determining price if we only consider the actual dollars spent on a supply particular items, this would give the price of an item now but unless we look at the total available number of dollars available we could not determine how a price will change. I believe this is essentially what Dalio does, he states that an increase in credit leads to an increase in prices (inflationary) and inevitably leads to bubbles (where too much credit has been created than can actually be serviced and hence finally leading to busts).

Price and forces

The price of an item is almost singular, updated near instantly and is global in scope. By singular I mean that the price published in the financial market is the latest transaction price, which 'moves' all the time. That's not to say that everyone agrees upon the price in terms of undervalued or overvalued.  There can, of course, be differences in the price paid for items due to (say) transportation or additional servicing/ management costs. Further to that is the spread at which brokers buy and sell the same item at different prices depending on whether they are doing the buying of the selling. As a simplification we can assume that price is singular, and that the price is updated on globally to all participants almost instantly (accepting that light has a finite speed).

The aggregation of transactions is an 'instantaneous' price and over several instants of time we have a price chart. What Dalio goes on to explain is how price evolves in a fairly predictable pattern. There are three main drivers which are all variations of credit and debt supply. This basically suggests that a greater amount of cash allows for a higher price, it doesn't quite say that a price should go higher. In order for price to go higher there needs to be a buyer who is willing (have a reason) to pay a higher price, provided they have enough cash to make the transaction. Therefore, if on aggregate there are enough buyers with enough money to push price up then it will happen (the proverbial bulls). While Dalio doesn't say it in the first PDF he does state in an interview that all price increases are based on the greater fool theory.

A decrease in price isn't, as some people may be inclined to say, from an over-abundance of sellers or short sellers but from a lack of money and reason on the buying side (no greater fool at that particular instant). Therefore it is possible that there are more potential buyers than potential sellers but there is a lack of reason and money to push the price upward. This has been apparent to me for some time but I think it is quite clearly illustrated with Dalio's model.

Interestingly, Dalio doesn't provide any potential reasons that buyers or sellers may hold for pushing price up or down. He merely assumes that price will change over time because it always has (at least he implicitly assumes this). The ultimate drivers are the availability of credit and debt, and that the ultimate reasons of the individuals don't matter because people will always find a reason to pay a higher price (greater fools).

The three main drivers has different characteristic time scales, such as the long-term growth of productivity versus the short term debt cycle (business cycle).

Conclusion

Price depends on the availability of money/credit and of the supply of an item or service. Over time this has lead to some fairly predictable and repeating patterns. These patterns have characteristic time scales and can be 'easily' seen from any historic price chart.

To finish off I'll link to a video which is an hour long chat with the man himself: Ray Dalio at CRF.