Economics » Faulty Reasoning in Dalio's "How The Economic Machine Works"

Faulty Reasoning in Dalio's "How The Economic Machine Works"

This post is an explanation of faulty reasoning in “How The Economic Machine Works by Ray Dalio” video.

The specific claim I have a problem with is “When interest rates are high, there’s less borrowing because it’s expensive” (time: 4:15).

This statement is important not mainly because it’s wrong, but because it’s a perfect example of something that sounds entirely uncontroversial, common-sense, and does not raise any red flags, unless you’re deliberately looking for them.

Setup: time 0

Higher r (real interest rate) → lending is more lucrative → quantity of investment supplied increases. Investment supplied is denoted by Q_s.

Higher r → borrowing is less lucrative → quantity of investment demanded decreases. Investment demanded is denoted by Q_d.

The place these lines intersect at is called equilibrium.

Situation 1: time 1

Lenders start to feel pessimistic about the future and want to lend less → there’s less investment supplied (Q_s shifts up) → equilibrium quantity of investment supplied decreases and r increases, in other words, there’s less borrowing and borrowing is more expensive.

This is exactly what Ray Dalio says happens, but consider another possibility:

Situation 2: time 1

Borrowers start to feel optimistic about the future and want to borrow more → there’s more investment demanded (Q_d shifts up) → equilibrium quantity of investment supplied increases and r increases, in other words, there’s more borrowing and borrowing is more expensive.

This is exactly the opposite what Ray Dalio says happens.

If you open the video, Dalio doesn’t tell us, which situation he considers. He simply says that higher interest rates are associated with less borrowing (I think he actually makes a causal claim but I won’t push this).

Acknowledgement

This post is heavily inspired by Scott Sumner’s post “Reasoning from a price change, example #341”.


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