Economy might seem complex, but works in a simple, mechanical way. It’s made up of simple parts and a lot of simple transactions repeated over and over again. They create three main forces that drive the economy,
(i) Productivity Growth
(ii) Short Term Debt Cycle
(iii) Long Term Debt Cycle
We’ll look at these three factors and how they work together in an economy,
The simplest part of economic activities is Transactions – An economy is simply the sum of all the transactions.
A transaction is basically buying a good, service, or a financial asset for either cash or credit.
A transaction is something very easy to understand because you do it everyday. You bought a Maggi from a store for which you paid cash, that’s a transaction. You bought a mobile for which you took a no-cost EMI (credit), that’s a transaction. You paid a technician to get your AC cleaned, that’s a transaction. You bought a RIL share, that’s a transaction.
The biggest spender is the Government which consists of :
- Central Government – It collects and spends taxes
- Central Bank (RBI) – It controls the amount of money and credit in the economy (money supply) by influencing the interest and printing money. It is for the same reason that the RBI plays an important part in the flow of credit.
Credit, the least understood part of the economy. It extremely important because it’s the biggest and the most volatile part (we’ll understand why)
Credit = Debt
A credit is created when people buy things they can’t afford. It is also known as debt or loan. A single debt is both an asset and a liability. Asset for the lender and liability for the borrower. Lenders strive to maximise their lending. This lending enables the borrower to spend more, and this money spent turns into an income for another and higher income for the seller enables him to borrow more and spend more. This endless spending cycle continues and leads to economic growth.
One can buy only what is sold, and something can be sold only if it sold, if it is produced. Productivity plays an important role in economy in the long run. Not so much in the short run because it doesn’t fluctuate much but debt does fluctuate in the short run.
Productivity plays a key role in an economy without credit. Without credit, you can only spend what you to earn. Thus, to enable economic growth which requires increased spending and hence increased income you need to work harder and increase the productivity. The higher the productivity, more the economic growth.
But in an economy with credit, the higher the credit, the higher the spending and thus, higher the growth. But debt runs in cycles, and as we said before you take debt when you can’t afford it. You’re spending more than what you’re earning. To pay it back in future you need to be spending less than what you’re earning. In other words, you’re borrowing from your future self. This creates a cycle, and whenever an individual borrows, he creates a cycle. Just like an individual the economy works in cycles too, and that’s exactly why understanding credit helps us understand the economy. It sets into motion a mechanical, predictable series of events that will happen in the future. Borrowing and spending enables economy growth in the short term but not in the long run, as it follows cycles.
Note that credit is good for the economy only when you use the credit to increase income and pay back the debt.
Borrowing creates cycle and if the cycle goes up, it eventually needs to come down. This leads us into short term debt cycle. As economic activity increases, we see an expansion, the first phase of the short-term debt cycle.
As spending using credit leads to increase in prices. It is because credit can be created out of thin air but production can’t. This leads to higher demand than supply production. Prices rise (inflation) leading to higher interest rates, so fewer people can take credit and even existing debt becomes more expensive, so EMIs rise leaving people with lower disposable income, leading to lower spending. Lower spending leads to lower demand, leading to a fall in prices (deflation), economic activity also decreases and we call this a recession. Now, if the recession becomes too severe and inflation is no longer a problem, the Central bank comes into picture, reduces the interest rates and gets the economy flowing back again leading to another expansion.
So, in a short-term debt cycle, the economy expands with the availability if debt and depresses without credit. This cycle is the short-term debt cycle and primarily influenced by the Central Bank. This short-term debt cycle lasts 5-8 years and happens over and over again for decades.
But notice that the bottom and top of each cycle finish with more growth than the previous cycle and with more debt. This happens because with every lower interest rate, leading to expansion and higher incomes, people use this opportunity to spend and borrow more rather than pay off their prior debt. This leads to debt rising faster than income over long periods of time and is called Long term debt cycle.
Even though the debts have been rising, the income and the asset prices have been rising too and people are feeling even more wealthy and thus seeming to be even more credit-worthy to lenders. So, lenders keep lending and borrowers keep borrowing and buying more assets as investments. This leads to asset prices rising even higher and this is called a bubble. But this obviously doesn’t last forever, and there comes a time when debt repayments rise faster than incomes rising, leaving people with very little to spend and as one person’s spending is another’s income, it makes them less creditworthy and leads to lower borrowing. But the debt repayments are still high and it leads to even lower spending, the cycle continues. This makes lenders unwilling to lend no further but existing debts peaks and is called the long-term debt cycle peak. This is what happened in 2008.
Now the economy starts to delever (lower debt) themselves. In a deleveraging state, Spending lowers further, incomes fall, credits fall, stock market tanks, social tensions rise. Borrowers are now getting squeezed because the income can’t cover the obligations and they can’t even borrow more. Everyone rushes to sell their assets which causes asset prices to crash along with stocks crashing. Just as in a short term debt cycle interest rates can’t be reduced because theyre already low and soon hit 0%. In such a situation, the debt pile can be reduced by:
- Cutting of Spending – Everyone in the economy even the government tries to cut upon spending to pay off how much ever debt possible leading to unemployment and also lower income for others (as we’ve learnt before that one person’s spending is other’s income)
- Reduction of debt – Piles of debt which are not serviceable by borrowers are now defaulted upon and restructured. As the debts are the bank’s asset, not being paid upon the public starts doubting the banks with their money and rushes to withdraw it. Banks get squeezed. This is more or less depression.
- Distribution of wealth – Wealth is distributed from the haves to the have nots or even by the government. But the government is in a tough spot because with people having lower incomes, the government’s source of income which is taxes has been hit. The government also has to distribute stimulus to the unemployed. All these massive expenditures lead to the government ending up in massive budget deficits. The government ends up raising taxes on the wealthy.
- Printing of Money – Money is printed by the central bank. They buy bonds issued by central government for the newly printed money. The central government then spends the money to generate income for others and help them delever.
Money printing is an effective way to reduce the burden of the economy. But leads to inflation. Therefore, it must be matched perfectly with the other three non-inflationary measures for the economy to delever in a balanced manner. The perfect stability can be maintained by the perfect mix of cutting spending, transferring wealth, reducing debt and printing money to maintain social and economic benefits.
Does money printing always leads to inflation? Not always (I’ve discussed this concept in great detail here)
If the money printed offsets the falling credit, it won’t lead to inflation. Spending is important not the mode of payment (cash or credit).
Now to turn things around, the central bank needs to not only pump up income growth but get the rate of income growth to be higher than the rate of interest on the accumulated debt.
If not so, you’re definitely in a bad position because if your loan of 100 is growing at a 10% interest rate but your income only at a 5%, your debt burden will never reduce. Thus, the money printing should be able to solve that issue, but it should not end up in too much printing.
Now as incomes begin to rise, borrowers can take more debt as they are more credit worthy now. They spend more and the economy begins to recover. This leads us to the reflation phase of the long-term debt cycle.
Of course, the economy is much more complicated than this, but the three components we studied about : Productivity growth, Short term debt cycle and Long term debt cycle, all three of them together give us a good understanding of where we’ve been and where we are headed.
The three rules of thumb we need to constantly follow are :
Rule 1 – Don’t have debt rise faster than your income, because your debt burdens will ultimately crush you.
Rule 2 – Don’t let your income rise faster than productivity, because you’ll eventually become unproductive.
Rule 3 – Do everything you can to increase your productivity, because in the long run this is what matters the most.
Make sure to check out the entire video if you find this interesting.