The narrator suggests in his economic model, that the economy consists of 3 key ingredients, which are the main driving force of the economy.
These three forces are:
- Productivity Growth
- Short Term Debt Cycle
- Long Term Debt Cycle
These three forces create a good template for tracking economic movement and the financial market. Ray describes these from small building blocks of the economy to explaining the biggest global financial disaster and their causes. To understand those complex economical events which shape our human history and the reality we lived in, we start by simple, the smallest building block of our economy :
Transaction:It consists of a buyer exchanging money or credit or both with the seller for goods, services, or financial assets.
The total amount of spending = Money + Credit
Price = Amount spend/ The quantity sold
The total amount of spending drives the economy. This individual transaction for the same things creates accumulatively a market. An economy consists of all those different markets.
The main participants in the economical transactions are:
- People
- Businesses
- Banks
- Government
The government is by far the biggest buyer and seller. It consists of two important parts:
- The Central Government
- The Central Bank
They both have different roles in the economy. The central government collects taxes and spends money, and The Central Bank controls the amount of money and credits in the economy.
The Central Bank controls the economy in two ways:
- Influencing Interest rates
- Printing Money
Now comes the most important part of the economy i.e. "Credit".Just like Buyer and Seller, there are also Lenders and Borrowers. Lenders lend their money in exchange for credit and borrowers borrow money to buy what they can't afford. As soon as credit is created it turns into debt. "The Debt is both an asset to the lender and a liability to the borrower."In the future after the borrower repays the loan the asset and liability disappear, and the transaction is settled. But why is the credit is so important?
This is because credit increases spending and the spending drives the economy. One person's spending is another person's income. If someone's spending increases then it means there is someone who's income is also increased. When someone's income rises it makes lenders more willing to lend money because he now becomes more worthy of credit. A creditworthy person has two things:
- The ability to repay
- Collateral if He can't
Having a lot of income in relation to the debt gives him the ability to repay, and if he can not repay he has valuable assets to be sold. This makes lenders feel comfortable lending him money. So,
Increased Income → Increased borrowing → Increased Spending
As one person's spending is another person's income, this leads to more income, more borrowing, and more spending. This self-reinforcing pattern creates economic growth and it is the reason why we have cycles.
Over time we learn and that accumulated knowledge made our living standers high, and we become more productive, it is productivity growth, but productivity is more or less increase in a linear fashion. Productivity is the ultimate driver of the economy in the long run.
On the other hand, Debt is one of the biggest drivers of economic swings because it allows us to consume more than we produce when we acquire it and less than when we pay it back. The Debt swing occurs in both the short and long term :
- Short term Debt cycles( 5-8 years)
- Long term Debt cycles (75-100 years)
As economic activity increases, we see an expansion. It is the first phase of the short term debt cycle. Spending continues to increases and prices start to rise, this leads toInflation.It happens when the amount of spending, as well as income, grow faster than the goods produces influenced by credit.
Though inflation is a by-product of economic expansion, too much can create problems as people will lose faith in money if it happens. To protect this Central Bank increases interest rates. As interest rates increase fewer people will borrow money, and low borrowing leads to low spending and low income for another person, inflation reduces. As the prices of goods starting to fall, we call thisDeflation. Economic activities decrease and we havea Recession.If the recession is too severe and inflation is not a problem then the central bank low down the interest rates, with lower interest rates borrowing and spending pick up again.
This expansion and recession create the short term debt cycles, which happens to occur over and over again for decades. But, the bottom and the top of each cycle finish with more growth than the previous cycles and more with debt. Why? Because people incline to borrow and spend more than paying back debt, it's human nature. As a result of this in the longer period of time debt rises faster than incomes, creating The Long Term Debt Cycle.
Despite being more indebted lenders lends money to the borrower because income is rising, asset prices are going up, stock market roars, and everyone thought it's an economic boom. When people do extensive borrowing a lot of spending, we call it aBubble.
Debt Burden = Debt / Income
As long as income increases the debt burden stays manageable, and the asset values soar, causing the borrowers to remain creditworthy for a long time. But it obviously can't continue forever. Over decades debt value increase causing larger and larger debt repayment. At some point it starts to growing faster than the income and forcing people to cut back on their spending and as some one's spending is another person's income, income decreases. Unlike short term debt cycles it cannot be controlled by lowering the interest rates as the interest rates are already low and soon hit 0%.
When the borrowers can't pay back debt and also can't borrow money, they rush to sell their assets, causing asset prices to go down. Stock and Real Estate market shrinks. Less Spending → Less Income → Less Wealth → Less Credit → Less Borrowing and so on. This is what we callDeleveraging Economy.
So, What should be done in a Deleveraging Economy? There are four ways we used to manage this condition in history, they are,
- Cut Spending:People, businesses, and government cut their spending.
- Reduce Debt:Debt is reduced through defaults and restructuring.
- Redistribution of Wealth:Wealth is redistributed from the have to the have nots by increasing tax on the wealthy individuals and give it to the poor.
- Print Money:The central banks prints more money.
When spending decreases it leads to less income, and when the income goes down faster than the debt it creates a severe debt burden. People and businesses default on their debt. It causes other people to think that the bank can't pay them back, so people started to withdrawing money. When all people are trying to withdraw their money simultaneously, the bank can't pay them back. So, banks also default on their debts. This severe economic contraction is calledDepression.
Even though Debt restructuring causes debt lowering but income and asset value go down much faster causing the deflationary economy. This affects the Central Government because lower-income means lower taxes and it needs to increases spending as unemployment has increased. Government budget deficit explodes in a deleveraging when it spends more than it earns in taxes. Then the Government increases taxes on the wealthy to manage its spending, which facilitates the Redistribution of Wealth. The wealthy try to protect their wealth and the have nots begin to resent the haves, creating social and political change even causes the Civil War.
Now the Central Bank comes into play, it starts to print money. Unlike Cutting spending, Debt Restructuring and Redistribution of Wealth printing money are stimulative and inflationary. It uses the new print money to buy financial assets and government bonds. By buying government bonds it essentially lends money to the government, allowing it to run a deficit and increase spending on goods and services, through its stimulus programs and unemployment benefits. It increases people's income as well as government debt. However, it lowers the economy's total debt burden. Policymaker needs to balance the four ways that the debt comes down.
If the inflationary and deflationary ways of reducing the debt burden balanced correctly can create a beautiful deleveraging. And eventually, the economy begins to grow again leading to theReflation Phaseof a long term Debt Cycle. It takes a decades or more for debt burden to fall and the economic activity to back normal, hence it's calledLost Decade. Of course, the economy is much more complicated but we can understand the basic structure of the economy by understanding the above concepts.
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