Everything you need to know about the working of the economy and the simple mechanics that drive it

Screen Shot 2018-06-10 at 1.43.17 PM.pngThough the Economy may seem complex it works in a simple mechanical way, its made up of a few simple parts and a lot of simple transactions that are repeated over and over again probably a zillion times or more! These transactions are above all else driven by Human Nature and they create three main forces that drive the economy-

  1. Productivity Growth
  2. Short-term Debt Cycle
  3. Long-term Debt cycle

We’ll look at these 3 forces and how laying them on top of each other creates a good template for tracking economic movements and figuring out whats happening now. Let’s start with the simplest part of the economy –

          Transactions – An economy is simply the sum of the transactions that make it up and a transaction is a very simple thing, everytime you buy something you create a transaction. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services or financial assets. Credit is spent exactly like money so by adding together the total money spent and credit spent you can know the total spending. The total amount of spending drives the economy. If you divide the amount spent by the quantity sold, you get the price. And that it, that’s a transaction which is the building block of the economic machine.

All cycles and all forces in an economy are driven by transactions, so if we can understand transactions we can understand the whole economy. A market consist of all the buyers and all the sellers making transactions for the same thing, for eg:- there is a wheat market, a car market, a stock market etc. An economy consists of all of the transactions in all of its markets. If you add up the total spending and the total quantity sold in all of the markets, you have everything you need to know to understand the economy, it’s just that simple. People, businesses, banks and even governments all engage in transactions the way I just described i.e exchanging money and credit for goods, services or financial assets.

The biggest buyer and seller is the government which consist of two important parts

  • A central government that collects taxes and spends money
  • A central bank, which is different from other buyers and sellers because it controls the amount of money and credit in the economy.

Screen Shot 2018-06-10 at 1.39.34 PM.pngThe central bank does this by influencing interest rates and printing new money, for these reasons as we will see the central bank is an important player in the flow of credit. Credit is the most important part of the economy and probably the least understood. It’s the most important part because its the biggest and most volatile part. Just like buyers and sellers go to the market to make transactions, so do lenders and borrowers. Lenders usually want to make their money into more money, and borrowers usually want to buy something they cant afford eg- a house, a car or to start a business. Credit can help both lenders and borrowers get what they want. Borrowers promise to repay the amount they borrow called principal plus an additional amount called interest. So when interest rates are high, there is less borrowing because it’s expensive and when interest rates are low borrowing increases because it’s cheaper. And so when borrowers promise to repay and lenders believe them CREDIT is created. Any two people can agree to create credit out of thin air, that being simple enough we must know that credit can be tricky because it has different names, as soon as credit is created it immediately turns into debt, debt is both an asset to the lender and a liability for the borrower, in the future when the borrowers repay the principal + interest the asset and the liability disappears and the transaction is settled!

So why is credit so important? Because when a borrower receives credit, he is able to increase his spending and remember spending drives the economy, this is because one person’s spending is another person’s income. Think about it, every Rupee you spend someone else earns and every rupee you earn someone else spends, so when you spend more someone else earns more. When someone’s income rises you have more lenders willing to lend him money because now he is more worthy of credit.

A creditworthy borrower has two things- 1) The ability to repay and 2) Collateral. Having a lot of income in relation to this debt gives him the ability to repay and in the event, he cannot repay, he has valuable assets that can be used for collateral and can be sold. This makes lenders comfortable lending money to a creditworthy borrower.

So increased income allows increased borrowing which allows increased spending and since one person’s spending is another person’s income, this leads to more increased borrowing and so on… This self re-enforcing pattern leads to economic growth and is why we have cycles

In a transaction, you have to give something in order to get something, and how much you get depends on how much you produce. Over time we learn and that accumulated knowledge raises our living standards, this is called productivity growth. Those who are inventive and hardworking raise their productivity and living standard fast than those who are complacent and lazy, but that isn’t necessarily true of the short run. Productivity matters most in the long run but credit matters most in the short run. This is because productivity growth doesn’t fluctuate much and so it’s not a big driver of economic swings. Debt, on the other hand, is, because it allows us to consume more than we produce when we acquire debt and it forces us to consume less than we produce when we have to pay the debt back.

Debt swings occur in two big cycles, one takes about 5-8 years and the other takes about 75-100 years. While most people feel the swings they typically don’t see them as cycles because they see them too close i.e day by day and week by week.

Lets now see how these big forces interact to make up our experiences. As mentioned swings around the productivity line are not due to how much innovation or hard work there is, they are primarily due to how much credit there is. Let’s take a step to the side and imagine an economy without credit, in this economy for me to increase my spending requires me to increase my income which requires me to be more productive and do more work, increase productivity is the only way for growth. Since my spending is another’s income, the economy grows only when I or another is more productive. If we follow these transactions we see a progression like the productivity growth line, basically upward, slow and straight. But because we borrow we have cycles and this isn’t due to any laws or regulations but is due to human nature and the way that credit works. Think of borrowing as simply a way of pulling spending forward, inorder you buy something you cant afford you need to spend more than you make, to do this you essentially need to borrow from your future self and in doing so you create a time in the future where you have to spend less than you make in order to pay what you borrowed back, which resembles a cycle when looked at from far. Basically anytime you borrow you create a cycle, this is as true for an individual as it is for the economy. This is why understanding credit is so important because it sets into motion a mechanical and predictable series of events that will happen in the future.

This makes credit different from money. Money is what you settle transactions with eg:- “when you buy a beer from a bartender and pay by cash, the transaction is settled immediately and ends there”, but is not that case with credit eg:- “when you buy a beer from a bartender and pay by credit, its like opening a bar tab and you are essentially saying that you promise to pay in the future, together you and the bartender create an asset and a liability. You’ve just created credit out of thin air, it’s not until you pay the bartender later that the asset and the liability disappear and the transaction is settled”

The reality is most of what people call money is actually credit. The total amount of credit in the USA is around $50 trillion and the total amount of money is only around $3 trillion. Remember in an economy without credit the only way to increase spending is to produce more, but in an economy with credit, you can also increase your spending by borrowing. As a result and economy with credit allows more spending and allows income to rise faster than productivity over the short run but not over the long run.

Now credit isn’t necessarily something bad that just cause cycles, it’s bad when it finances overconsumption that cannot be paid back. However, it’s good when it efficiently allocated resources and produces income, so debt can be paid back.              E.g-  “If money is borrowed to buy a big screen tv, it doesn’t generate money to pay back, but if money is borrowed to buy let’s say a tractor and that tractor lets you harvest more thus increasing your productivity and income to pay back your debt and improve your living standards.”

In an economy with credit, we can follow the transactions and see how credit creates growth. One must remember that borrowing creates cycles and if a cycle goes up it eventually needs to come back down, and this leads us to the short-term debt cycle. As economic activity increases, we see an expansion which is the first phase of the short-term debt cycle, spending continue to increase and prices start to rise, this happens because the increase in spending is fueled by credit which as we have seen, can be created instantly out of thin air. When the amount of spending and income grow faster than the production of good, prices rise, when prices rise we call this inflation. The central bank doesn’t want too much inflation because it causes problems, seeing prices rise it raises interest rates, with higher interest rates fewer people can afford to borrow money and the cost of existing debt rises e.g- imagine this as your monthly payments on your credit cards going up. Because now people borrow less and have higher debt repayment, they have less money to spend so spending slows, and since one person’s spending is another person income, incomes drop. When people spend less we call this deflation, economic activity decreases and we have a recession. If the recession becomes too severe and inflation is no longer a problem, the central bank will reduce interest rates causing everything to pick up again. With low-interest rates, debt repayments are reduced and borrowing and spending pick up and we see another expansion.

As you can see the economy works like a machine, in the short-term debt cycle spending is constrained only by the willingness of lenders and borrowers to provide and receive credit. When credit is easily available, there is an economic expansion. When credit isn’t easily available, there’s a recession. Note that this cycle is controlled primarily by the central bank, the short-term debt cycle typically last 5-8 years and happens over and over again for decades. But what should be noticed is that the bottom and the top of each cycle have more growth than the previous cycle and with more debt, why? Because people push it, they have an inclination to borrow and spend more instead of paying back debt, that’s human nature and because of this over long periods of time debts rise faster than incomes creating the Long- Term Debt cycle.

Despite people becoming more indebted, lenders even more freely extend credit, why? Because everyone thinks things are going great! People are just focused on what been happening lately, and whats been happening lately? Incomes have been rising, asset values are going up, the stock markets are up it all feels like a boom, it pays to buy goods services and financial assets with borrowed money. What people do a lot of this, its called a bubble. So even though debts have been growing, incomes have been growing nearly as fast to offset them. Let’s call the ratio of debt : income the “debt burden”. So as long as incomes continue to rise the debt burden stays manageable, at the same time asset values soar, people borrow huge sums of money to buy assets as investments which causes their prices to rise even higher. People feel wealthy, so even with the accumulation of lots of debt, rising incomes and asset values help borrowers remain creditworthy for a long time, But this obviously cannot continue forever, and it doesn’t! Over decades the debt burden slowly increase creating larger and larger debt repayments and at some point debt repayments start growing faster than incomes forcing people to cut back on spending and since one person’s spending is another person’s income, incomes begin to go down which makes people less creditworthy causing borrowing to go down, debt repayments continue to rise which makes spending drop even further and the cycle reverses itself. This is the long-term debt peak, debt burdens have simply become too big. For most of the world, this happened in 2008 and it happened for the same reason it happened in Japan in 1989 and in the USA in 1929. Now the economy begins deleveraging.

In a deleveraging people cut spending and incomes fall, credit disappears, asset prices drop, banks get squeezed, the stock market crashes, social tensions rise and the whole thing starts to feed on itself the other way. As incomes fall and debt repayments rise, borrowers get squeezed and no longer creditworthy credit dries up and borrowers can no longer borrow money to make their debt repayment, scrambling to fill this hole the borrowers are now forced to sell assets, the rush to sell assets floods the markets at the same time as spending falls, this is when the stock markets collapse, the real estate markets tank and banks get into trouble. As asset value drops the value of the collateral borrowers can put up to borrow drops, this makes borrowers even less creditworthy and people feel poor and credit rapidly disappears. Less spending—less income – —less wealth—–less credit —-less borrowing and so on etc the vicious cycle continues. This may seem similar to a recession but the difference here is interest rates cannot be lowered by the central bank to save the day. In a deleveraging, lowering interest rate do not work because interest rates are already low and soon hit 0% so the stimulation ends. Interest rates in the USA hit 0 in the deleveraging of the 1930’s and again in 2008.

The difference between a recession and deleveraging is that in the deleveraging the borrower’s debt burden has got too big and cant be relieved by lowering interest rates. lenders realise now that debts have become too large to ever be paid back as borrows have lost their ability to repay and their collateral has lost value. Borrowers feel crippled by the debt and don’t even want more. So lenders stop lending and borrowers stop borrowing. Now the economy is not creditworthy just as an individual.

How and what do you do about a deleveraging economy? The problem is debt burden is too high and they must come down. There are 4 ways this can happen –

  1. People Businesses and governments cut their spending
  2. Debts are reduced through defaults and restructuring
  3. Wealth is redistributed from the have’s to the have not’s
  4. The central bank prints new money

The above 4 procedures have happened in every deleveraging in modern history – USA 1930’S, England 1950’s, Japan 1990’s, Spain and Italy 2010.

These methods are often referred too as austerity. When borrowers start taking on new debt and start paying back the old debt we might expect the debt burden to decrease, but the opposite happens! Because spending is cut and since one person’s spending is another’s income it causes incomes to fall, incomes fall faster than debts are repaid and the debt burden gets worse. As we now know, this cut in spending is deflation and painful, business is forced to cut cost which means fewer jobs and higher unemployment. Now since the next step is having to reduce debts, many borrowers find themselves unable to repay their loans and a borrower’s debts are a lender’s assets so if the borrower is unable to repay his debts the banks customers get nervous that the bank won’t be able to repay them, so they rush to withdraw all their deposits with the banks causing banks to get squeezed and people businesses and banks default on their debt. This severe economic contraction is called a depression.

A big part of a depression is people discovering much of what they really thought was their wealth, isn’t really there. Now many lenders don’t want their assets to simply go valueless and agree to debt-restructuring. Debt-restructuring means lenders get paid back less or get paid back over a longer time frame and at a lower interest rate than was first agreed, lenders would rather have a little of something rather than all of nothing.

Even though debt restructuring causes debt to disappear, it also causes income and asset values to disappear faster so the debt burden really doesn’t get any better. Like cutting spending, debt-restructuring is also painful and deflationary. All of this affects the central government because lower income and fewer employments mean the government collects fewer taxes and at the same time it needs to increase its spendings because unemployment has risen. Governments create stimulus plans and increase their spendings to make up for the decrease in the economy. Governments budget deficits explode because they spend more than they earn in taxes.

Now to fund their deficits, governments need to either raise taxes or borrow money, but with incomes falling and lending low, who is the money going to come from? Ans- The Rich! Since governments need money and wealth is highly concentrated in a small percentage of the population governments naturally raise taxes on the wealthy section of society which in turn facilitates a redistribution of wealth in the economy from the have’s to the have not’s. This generally leads to resentment between the have’s and the have not’s and if the depression continues social tensions may break out. This situation can lead to political change that can sometimes be extreme eg:- in the 1930’s this led to Hitler coming to power, a war in Europe and depression in the USA.

Now unlike Cutting spending, debt restructuring and wealth redistribution which are deflationary as we have seen, printing money by the central bank is inflationary and stimulative. With the this printed money the central banks can purchase financial assets and governments bonds, this has happened in the USA in the 1930’s and again in 2008. By buying financial assets with this money it drives up asset prices which makes people more creditworthy, however, this only helps those who own financial assets. Buy buying government bonds the central banks enable the government to run a deficit and increase spending on goods and services through its stimulus programmes and unemployment benefits, this, in turn, increases peoples income as well as the government’s debt, however, it will lower the economies total debt burden.

This is very risky as policymakers need to balance the 4 ways that debt burdens come down. The deflationary ways need to balance with the inflationary ways in order to maintain stability. If balance correctly there can be a beautiful deleveraging. A deleveraging can be ugly as shown above or beautiful, how? Even though a deleveraging is a difficult situation, handling the situation in the best possible way is beautiful, a lot more beautiful than an unbalance debt-fuelled excesses of the leveraging stage.

In a beautiful deleveraging debt decline relative to income, real economic growth is a positive and inflation isn’t a problem. All this is achieved by having the right balance. The right balance requires a certain mix of –

  • Cutting expenses
  • Reducing debt
  • redistribution of wealth
  • Printing money

So that economic and social stability can be maintained. Will printing money raise inflation? It won’t if it offsets credit. By printing money the central needs not only to pump up income growth but get the rate of income growth higher than the rate of interest on the accumulated debt, basically income needs to grow faster than debt grows. Hence Debt to income ratio is important. If deleveraging can be handled beautifully and balanced the economy can recover and reflation can occur and the problem can be fixed

It takes roughly 7-10 years for debt burdens to fall and economic activity to get back to normal, hence the term “lost decade”.

Offcourse the economy is more complex and has more to it than what I just explained out in brief but laying the short-term debt cycle over the long-term debt cycle and then laying both of them over the productivity growth line –Screen Shot 2018-06-10 at 1.31.53 PM.png

can give you a reasonably good template to see where we have been, where we are now and where we are probably headed. So 3 key point to take away from this –

  1. Don’t have debt rise faster than Income, because debt will eventually crush you
  2. Don’t have income rise faster than productivity. Because you will eventually become uncompetitive
  3. Do all that you can to raise your productivity because in the long run, that’s what matters the most

This is simple advice for you and simple advice for policymakers too, and you’d be surprised that most people including most policymakers don’t pay enough attention to this. This understanding has worked for me and I hope it will work for all reading this.

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