How the economic machine works in 30 minutes
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The economy works like a simple machine, but many people don’t understand it. They don’t agree on how it works and this has led to a lot of needless economy suffering. I feel a deep sense of responsibility to share my simple but practical economic template.
Though is unconventional, has help me to anticipate and to sidestep the global financial crisis and it has work well for me for over 30 years. Let’s begin:
Although the economy might seem complex, it works in a simple mechanical way. It’s made up of a few simple parts and a lot of simple transactions that are repeated over and over again a zillion times. These transactions are above all else driven by human nature and they create three main forces that drive the economy:
- Productivity growth
- The short term debt cycle
- The long term debt cycle
We’ll look at these three forces and how laying them on top of each other creates a template for tracking economy movements and figuring out what’s happening now. Let’s start with the simplest part of the economy: transactions.
An economy is simply the sum of transactions that make it up and a transaction is a very simple thing. You make transactions all the time, every time you buy something you create a transaction.
Each transaction consist of a buyer exchanging money or credit with a seller for goods, services or financial assets. Credit spends just like money so adding together the money spent and the amount of credit spend, 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’s it, that’s a transaction, is the building block of the economy machine.
All cycles and all forces in the economy are driven by transactions, so if we can understand transactions, we can understand the whole economy.
A market consists of all the buyers and all the sellers making transactions for the same thing. For example, there’s a wheat market, a car market, a stock market and markets for millions of things and economy consists in all of its transactions in all of its markets.
If you add up the total spending and the total quantity sold of all of the markets you have everything you need to know to understand the economy. It’s just that simple.
People, businesses, banks and governments all engage in transactions the way I just described: exchanging money and credit for goods, services and financial assets. The biggest buyer and seller is the government, which consists in two important parts: a central government that collects taxes and spends money, and a central bank which is different from other buyers and sellers because it controls the amount of money and credit in the economy. It does this by influencing interest rates and printing new money.
For these reasons, as we’ll see, the central bank is an important player in the flow of credit. I want you to pay attention to credit.
Credit is the most important part of the economy and probably the less understood. Is the most important part because is the biggest and most volatile part. Just like buyers and sellers go to the market to make transactions, so the lenders and borrowers. Lenders usually want to make their money into more money and borrowers usually want to buy something they can’t afford, like a house or a car, or they want to invest in something like starting a business.
Credit can help both lenders and borrowers get what they want. Borrowers promise to repay the amount they borrow, called principle, plus an additional amount, called interest.
When interest rates are high there is less borrowing because is expensive. When interest rates are low, borrowing increases because is cheaper. 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 seems simple enough, but credit is 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 to the borrower. In the future, when the borrower repays the loan plus interest, the asset and a liability disappear and the transaction is settled.
So why is credit so important? Because when a borrower receives credit he’s able to increase his spending, and remember, spending drives the economy. This is because one person spending is another person’s income. Think about it: every dollar you spend, someone else earns, and every dollar you make, someone else spent. So when you spend more, someone else earns more.
When someone’s income rises, it makes lenders willing to lend him money because now he’s more worthy of credit. A creditworthy borrower has two things:the ability to repay and collateral. Having a lot of income in relation to his debt gives him the ability to repay, in the event that he can’t repay he has valuable assets to use as collateral that can be sold. This makes lenders feel comfortable lending him money.
So, increase income allows increase borrowing which allow increase spending, and since one person’s spending is another’s person income, this leads to more increased borrowing and so on. This reinforcing pattern leads to economic growth and it’s 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. We call this productivity grow.
Those who are inventive and hard working raise their productivity and their living standards faster than those who are complacent and lasy. But that isn’t necessarily true over the short run. Productivity matters the more in the long run, but credit matters most in the short run, this is because productivity growth doesn’t fluctuate much, so is not a big driver of economic swings. Debt is, because it allows us to consume more than we produce when we acquire it, and it forces us to consume less than we produce when we have to pay it back.
Debt swings occurs in two big cycles: one takes about 5 to 8 years and the other takes about 75 to 100 years. While more people feel the swings, they typically don’t see them in cycles because they see them too up close. Day by day, week by week.
In this chapter we’re going to step back and look at this three big forces and how they interact to make up our experiences.
As mentioned, swings around the line are not due to how much innovation or hard work there is, they’re primarily due to how much credit there is. Let’s for a second imagine an economy without credit.
In this economy the only way I can increase my spending is to increase my income, which requires me to be more productive and do more work. Increased productivity is the only way for growth and since my spending is another’s person’s income, the economy grows any time I or anyone else are productive. If we follow the transactions and play this out, we see a progression like the productivity growth line.
But because we borrow, we have cycles. This isn’t due to any laws or regulations, it’s due to human nature and the way the credit works.
This of borrowing as simply a way to pull spending forward. In order to buy something you can’t afford, you need to spend more that you can make. To do this you esencially need to borrow from your future self. In doing so, you create a time in the future that you need to spend less than you make in order to pay it back. It very quickly resembles a cycle. Basically any time you borrow, you create a cycle.
This is as true for the individual as it is for the economy. This is why understanding credit is so important because it sets into motion a mechanical, predictable series of events that will happen in the future. This makes credit different from money.
Money is what you settle transactions with. When you buy a beer from a bartender with cash, the transaction is settled immediately, but when you buy a beer with credit, it’s like starting a bar tab: you’re saying 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!
Is not until you pay the bar tab later that the asset and the liability disappear, the debt goes away and the transaction is settle.
The reality is that most of what people call money is actually credit. The total amount of credit in the United States is about 50 trillion dollars and the total amount of money is only about 3 trillion dollars.
Remember, in an economy without credit the only way to increase your spending is to produce more, but in an economy with credit you can also increase your spending by borrowing.
As a result, an economy with credit has more spending and allows income to rise faster than productivity in the short run but not over in the long run. Now, don’t get me wrong, credit isn’t necessarily something bad that just causes cycles, it’s bad when it finances over consumption that can’t be paid back, however it’s good when it efficiently allocates resources and produces income so you can pay back the debt.
For example, if you borrow money to buy a big TV it doesn’t generate income for you to pay back the debt, but if you borrow money to, say, buy a tractor, and that tractor lets you harvest more crop and make more money, then you can pay back your debt and improve your living standards.
In an economy with credit we can follow the transaction and see how credit creates growth. Let me give you an example, suppose you earn a hundred thousand a year and have no debt, you are creditworth enough to borrow 10 thousand dollards, say on a credit card, so you can spend a hundred and ten thousand dollars even though you only earn a hundred thousand dollars.
Since your spending is another person’s income, someone is earning a hundred and ten thousand dollars. The person earning a hundred and ten thousand dollars with no debt, can borrow eleven thousand dollars so he can spend a hundred and twenty one thousand dollars, even though he has only earn a hundred and ten thousand dollars. His spend is another’s person income and by following the transactions we can begin to see how this process works in a self reinforcing pattern. But remember, borrowing creates cycles and if the cycles goes up it eventually needs to come down.
This leads us to the short term debt cycle
Short term debt cycle
As economic activity increases, we see an expansion. The first phase of the short term deby cycle. Spending continues to increase and prices start to rise, this happens because the increase in spending is fuelled by credit, which can be created instantly out of thin air.
When the amount of spending and income grows faster than the production of goods, prices rises. When prices rises we call this inflation.
The central bank doesn’t want too much inflation because it causes problems. Seen prices rise it raises interest rates, with higher interest rates, fewer people can affort to borrow money and the cost of existing debts rises. Think about this as the monthly payments of your credit card going up.
Because people borrow less and have higher debt repayments, they have less money leftover to spend, so spending slows, and since one’s person spending is another’s person income, incomes drop and so on and so forth. When people spend less, prices go down, we call this deflation.
Economy activity decreases and we have a recession, if the recession becomes too severe and inflation is no longer a problem, the central bank will lower interest rates to cause everything to pick up again.
With low interest rates debt repayments are reduce 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 constrain only by the willingness of lenders and borrowers to provide and receive credit.
When credit is easily available there’s an economy expansion, when credit isn’t easily available there’s a recession, and note that this cycle is controller primarily by the central bank. The short term debt cycle typically last 5 to 8 years and happens over and over again for decades, but notice that the bottom and top of each cycle finish with more grow 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. It’s human nature.
Because of this over long periods of times debt rise faster than income, creating the long term debt cycle.
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’s been happening lately, and what’s been happening lately? Incomes have been rising, asset values are going up, the stock market roars. It’s a boom! It pays to buy goods, services and financial assets with borrowed money. When people do a lot of that we call it 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 to income the debt burden. So as long as incomes continue to rise, the debt burden stays manageable. At the same time, asset value soar. People borrow huge amount of money to buy assets as investments causing 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 debt burden slowly increases creating larger and larger debt repayments. At some point debt repayments start growing faster than incomes, forcing people to cut back on their spending and since one’s person 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 make spending drop even further and the cycle reverses itself.
This is the long term debt peak. Debt burdens have simply become too big. For the United States, Europe and much of the rest of the world, this happened in 2008, it happened for the same reason it happened in Japan in 1989 and in the United States back in 1929.
Now the economy begins deleveraging. In a deleveraging people cut spending, income fall, credit dissapears, assset prices drop, banks get squezzed, the stock market crashes, social tension rises and the whole thing starts to feed on itself the other way.
As income fall and debt repayment rises, borrowers get squeezed. No longer creditworthy, credit dries up and borrowers no longer borrow enough money to make their debt repayments. Scrambling to fill this hole, borrowers are forced to sell assets, the rush to sell assets floods the market at the same time spending floss. This is when the stock market collapses, the real state market tanks and banks get into trouble. As asset prices drop the value of the collateral borrowers can put up drops, this makes borrowers even less creditworth. People feel poor, credit rapidly disappears. Less spending, less income, less wealth, less credit, less borrowing and so on. It’s a vicious cycle.
This appears similar to a recession but the difference here is that interest rates can’t be lowered to save the day. In a recession lowering interest rates works to stimulate borrowing, however in a deleveraging lowering interest rates doesn’t work because interest rates are already low and soon hit zero percent, so the stimulation ends. Interest rates in the United States hit zero percent during the deleveraging of the 1930’s and again in 2008.
The difference between a recession and a deleveraging is that in a deleveraging borrowers debt burden has simply gotten too big and can’t be relieved by lowering interest. Lenders realize the debts have become too large to ever be fully paid back. Borrowers have lost their ability to repay and their collateral has lost value. They feel crippled by the debt, they don’t even want more.
Lenders stop lending, borrowers stop borrowing. Think of the economy as being not creditworthy, just like an individual. So what do you do about a deleveraging.
The problem is debt burdens are too high and they must come down. There are 4 ways this can happen:
- People, businesses and governments cut their spending.
- Debts are reduced through defaults and restructuring.
- Wealth is redistributed from the haves to the havenots.
- The central bank prints new money.
These four ways have happened in every deleveraging in modern history (The United States, 1930s; England, 1950s; Japan, 1990s; Spain and Italy, 2010s)
Usually spending is cut first, as we just saw, people, businesses, banks and even governments tighten their belts and cut their spending so that they can pay down their debt. This is often refer to as austerity, when borrowers stop taking on new debts and start paying up old debts you might expect the debt burden to decrease but the opposite happens, because spending is cut and one man’s spending is another man’s income, it causes income to flaw. They fall faster than debts are repaid and the debt burden actually gets worst.
As we’ve seen, this cut in spending is deflationary and painful, businesses are forced to cut costs which mean less jubs and higher unemployment. This leads to the next step, debts must be reduced.
Many borrowers find themselves unable to repay their loans and a borrower’s debts are a lender’s assets. When a borrower doesn’t repay the bank, people get nervous that the bank won’t be able to repay them so they rush to withdraw their money from the bank, bank gets squezed and people, businesses and banks default on their debts.
This severe economic contraction is a depression, a big part of a depression is people discovering much of what they thought was their wealth isn’t really their. Let’s go back to the bar, when you bought a beer and put it on a bar tab you promised to repay the bartender. Your promise became an asset to the bartender, but if you break your promise, if you don’t pay them back and essentially default default on your bar tab, then the asset he has isn’t really worth anything, it has basically disappeared.
Many lenders don’t want their assets to disappear and agree to debt restructuring. Debt restructuring means lenders get paid back less or get paid back over a longer time frame or at a lower interest rate that was first agreed. Somehow a contract is broken in a way that reduces debt. Lenders would rather have a little of something than all of nothing.
Even though debt disappears, debt restructuring causes income and asset values to disappear faster so the debt burden continues to get worst. Like cutting spending, debt reduction is also painful and deflationary.
All of this impacts the central government because lower income and less employment means the government collects fewer taxes. At the same time it needs to increase spending because unemployment reasons. Many of the unemployed have inadequate savings and need financial support from the government. Additionally governments create stimulus plans and increase their spending to make up for the decrease on the economy. Governments budget deficits explode in a deleveraging because they spend more than they earn in taxes. This is what happens when you hear about the budget deficit on the news.
To fund their deficits, governments need to either raise taxes or borrow money, but with incomes falling and so many unemployed, who is the money going to come from? The rich!
Since governments need more money and since wealth is heavily concentrated in the hands of a small percentage of the people, governments naturally raise taxes on the wealthy which facilitates a redistribution of wealth on the economy from the haves to the haves not. The haves not who were suffering begin to resent the wealthy haves. The wealthy haves, being squeezed by the weak economy, falling asset prices and higher taxes begin to resent the have nots. If the depression continues, social disorder can break out.
Not only detentions rise within countries, they can rise between countries, specially debitors and creditors countries. This situation can lead to political change that sometimes can be extreme. In the 1930s this lead to Hitler coming to power, war in Europe and depression in the United States. Pressure to do something to end the depression increases.
Remember, most of what people thought was money, was actually credit, so when credit disappears, people don’t have enough money. People is desperate for money and you remember who can print money: the central bank can.
Having already lowered its interest rates to nearly zero, is forced to print money. Unlike cutting spending, debt reduction and wealth redistribution, printing money is inflationary and stimulative. Inevitably the central money prints money out of thin air and uses it to buy financial assets and government bonds.
It happened in the United States during the great depression and again in 2008 when the United States central bank, the Federal Reserve, prinet over 2 trillion dollars. Other central banks around the world that could printed a lot of money too.
By buying financial assets with this money it helps drive up asset prices which makes people more creditworthy. However, this only helps those who own financial assets. You see, the central bank can print money but it can only buy financial assets, the central government, on the other hand, can buy goods and services and put money in the hands of the people but it can’t print money, so in order to stimulate the economy the two must cooperate. By buying government bonds the central bank essentially lends money to the government, allowing it to run a deficit and increase spending on goods and services through stimulus programs and unemployment benefits, this increases people’s income as well as the government’s debt, however it will lower the economy’s total debt burden.
This is a very risky time. Policy makers need to balance the 4 ways the debt burdens come down. The deflationary ways need to balance with the inflationary way in order to maintain stability. If balance correctly, there can be a beautiful deleveraging.
A Beautiful Deleveraging
You see, a deleveraging can be ugly or it can be beautiful. How can a deleveraging be beautiful? Even though a deleveraging is a difficult situation, handling a difficult situation in the best possible way is beautiful, a lot more beautiful than the debt fueled, unbalanced excesses of the leveraging phase.
In a beautiful deleveraging debts decline relative to income, real economic growth is possible and inflation isn’t a problem. It is achieve by having the right balance. The right balance requires a certain mix of cutting spending, reducing debt, transferring wealth and printing money so the economic and social stability can be maintain.
People ask if printing money will raise inflation. It won’t if it offset falling credit. Remember spending is what matters. A dollar spending paid for with money has the same effect on price as a dollar spending paid for with credit. By printing money the central bank can make up for the disappearance of credit with an increase on the amount of money.
In order to turn things around the central bank needs to not only pump up income growth but get the rate of income growth higher than the rate of interest on the accumulating debt. So what do I mean by that: basically income needs to grow faster than the debt grows.
For example, let’s assume that a country going through a deleveraging has a debt to income ratio of a 100%, that means that the amount of debt it has is the same as the amount of income the entire country makes in a year.
Now think about the interest rate on that debt, let’s say is 2%. If debt is growing at 2% because of that interest rate and income is only growing at around 1% you would never reduce the debt burden. You need to print enough money to get the rate of income grow above the rate of interest.
However printing money could easily be abused because is so easy to do and people prefer it to the alternatives. The key is to avoid printing too much money and causing unacceptably high inflation, the way Germany did during its deleveraging in the 1920s.
If policy makers achieve the right balance, a deleveraging isn’t so dramatic. Growth is slow but debt burdens go down. That’s a beautiful deleveraging.
When incomes begin to rise, borrowers being to appear more creditworthy, lenders being to lend money again. Debt burdens finally being to fall, able to borrow money people can spend more. Eventually the economy begins to grow again, leading to the reflation phase of the long term debt cycle.
Though the deleveraging process can be horribly when handled badly, if handled well it would eventually fix the problem.
It takes roughly a decade of more for debt burden to fall and economic activity to get back to normal, hence the term: lost decade.
Of course the economy is a little bit more complicated than this template suggest. However laying the short term cycle on top of the long term cycle, and laying both of them on top of the productivity growth line gives a reasonably good template for seeing where we’ve been, where we are now and where we’re probably headed.
So, in summary, there are three rules of thumb that I like you to take away from this:
- Don’t have debt rise faster than income because your debt burdens will eventually crush you.
- Don’t have income rise faster than productivity because you’ll eventually become uncompetitive.
- Do all that you can to raise your productivity because in the long run that’s what matters most.
This is simple advice for you and it is simple advice for policy makers. You might be surprised but most people, including most policy makers, don’t pay enough attention to this.
This template has work for me and I hope it will work for you. Thank you.