A lot of persons don’t know how the economic system works which leads to lots of suffering.
I know you won’t love to be among those suffering and will love to know about how the economic system works. This insight drawn from Ray Dalio was meant to teach just that. Here’s how the system works;
The system is made up of simple transactions that are repeated a quadrillion times adding up. These transactions are driven by human nature and they make up three factors of the economy which includes
- Productivity growth
- The short term debt cycle
- The long term debt cycle
I will start by explaining the simple part of the economy called ”transactions.” An economy is made up of a lot of transactions.
Every time you buy, you create a transaction. A transaction is when you exchange money or credit for goods, services, or financial assets.
Explaining the Transaction.
Credit is spent like money. Money plus the credit makes the “Total Spending.”
This ‘Total Spending’ is what drives the economy. And if you divide the total spending by the quantity of the goods sold, then you get the price per good. This is what “Transaction” entails. It’s the building block of the economy. So if you can understand transactions, then you can understand the economy.
There’s a market for everything and an economy consists of the addition of the transactions in all of these markets.
Getting the capitalization of the economy means you know everything about the total spendings and the total quantity and can get the total price.
Everyone including the banks and government all buys and sells. The biggest buyer and seller is the government which consists of a Central government that collects taxes and spends money and a Central bank that is distinct from other banks because it controls the amount of money and credit in the economy by influencing national interest rates and printing new money.
The Central bank is important because it influences the flow in credit. Credit is a vital part of the economy but it’s also the least understood. Here is the explanation:
As the buyers and sellers make transactions so are the lenders and borrowers. Lenders usually make more money from this transaction. Borrowers usually want to buy liabilities they can’t afford like a car or they want to invest in a viable business. This transaction gives both the lenders and borrowers what they want.
The borrowers’ promise to return what they borrow (which is called “Principal”) plus a charge on top called the “Interest“. However, borrowing is low when interest rates are high because borrowing becomes expensive then. Borrowing increases when the interest rate is brought down low. When lenders promise to pay and the borrowers believe them, a credit transaction is created.
Where a lot of persons get confused about Credit knowledge is because ‘Credit’ is ‘Debt’ once the credit transaction is completed. This transaction is an Asset to the Lender and a Liability to the Borrower.
When the borrower finally pays back the money(principal) plus the interest in the future, the transaction gets closed.
Credit is vital because the borrower gets to be able to increase his spendings and spendings drives the economy. This is because one person’s spendings is another person’s income. For example, every money you spend is another person’s earnings. So more spending means more earning.
An increase in once income makes him more worthy of credit. So lenders would want to lend him money.
The creditworthy borrower has two qualities. 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 a valuable asset that can be used to pay.
An increase in income allows an increase in borrowing which also allows an increase in spending. This causes more increase in income, more increase in borrowing and the cycle continues which causes a continuous increase in economic system growth.
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Productivity and the debt cycle
In a transaction, you have to give something to get something. How much you get depends on how much you produce. In the long run, those who are productive and hardworking have a larger economic growth than the unproductive. But this may not be true for the short run as credit matters in the short run.
The productivity curve isn’t an economy driver because it doesn’t fluctuate much like the debt cycle. Debt cycle swings occur in a two-time range. One between 5-8 years and the other between 75-100 years. The swings depend on how much credit there is.
For example, the only way you can increase your spendings is to increase your income, which makes you more productive. Since my spendings is someone else’s income, an increase in productivity means the person earns more, and the economic system increases. That’s only those that are produced can grow and the redundant remain stagnant. This causes a straight growth productivity line.
But the economic system can’t grow faster that way as productivity grows in the long run. For the economic system to grow faster, credit has to be used. Credit access carries both the productive and redundant along, as far as they can access credit. In order to spend on something you can’t afford, you have to borrow. This increase in spending increases earnings and this increases the economic system.
Unlike credit, money is used to settle a transaction immediately.
What most people call money is actually credit. The total amount of credit in the United States is $50 trillion and the total money about $3 trillion. In an economy, without credit, you only can increase the economic system by producing more but in an economy, with the credit, you can increase it by borrowing more.
An economy with credit allows for increased spendings and increased earnings far faster than the productivity economy over the short run but this isn’t so in the long run.
Don’t get it mixed up, credit isn’t bad. It’s good if it provides viable resources that produce income that is used to pay back the credit. But it’s bad if it’s used for purchasing liabilities for consumption. For example, if you use credit to buy clothes, for your personal use then credit is bad. If you use credit to buy a house and put it on rent, then the rent is used to pay back the credit, the credit is good. This good credit improves living standards and the economy of individuals.
Keeping track of the economy
In the case of credit, we can continue to keep track of an upward progression of the economy. For example, if you earn $100 with no debt, and you’re eligible to borrow $10. That’s you can spend $110 and since your spending is another’s earning then they will get $110 to spend making them be eligible to borrow $11. This makes them be able to spend $121. And it continues in an upward trajectory. Remember that borrowing creates cycles and if the cycle goes up, it will eventually go down. This leads us to the short term debt cycle. When the first short term debt cycle ends another cycle begins with increasing spendings from the previous cycle. And this increase in spendings continues through various cycles. This is called an Expansion.
When the amount of spendings increases far more than the number of goods produced or services rendered then prices rise. This is called Inflation.
The Central Bank wouldn’t want prices of goods and services to rise so it increases interest rates on credit. An increase in interest rates causes borrowing to be expensive, therefore, making people borrow less. This makes the money available in the hands of people to spend to be less and so they spend less.
And since one’s spendings is another’s earnings then it means earnings drop. When spendings is less, then prices reduce. This is called Deflation. If this decrease is unchecked and keeps decreasing then it results in a Recession.
This is the reason why when spendings and prices go down and Inflation is no longer a problem, the Central Bank reduces interest rate for more persons to come to borrow and things to pick up once more and there is another expansion.
The short term debt cycle
The short term debt cycle is controlled by the availability of Credit. The availability of credit causes inflation and the non-availability of credit causes deflation.
The short term debt cycle lasts within 5-8 years. And it ends by crashing because people are more inclined to borrow and spend and not payback. Over time debt rises faster than income, thereby causing the long-term debt cycle. Despite all the debts owed by people the banks still give out more debts and people don’t take caution because they focus on the current economic boom. Assets prices rise high this period because people borrow large sums of money to buy these assets. People feel wealthy and they remain creditworthy because asset value is high.
Over some years debt increases so much that people have to pay their debt, which forces them to cut down on their spendings. And since spendings is another’s income, income reduces and people become less creditworthy and there’s less borrowing, fewer spendings. The economic system has gotten to its debt peak and this action of cut down is called Deleveraging.
During deleveraging, banks are overstrained, and social tension rises. There’s a continuous downward trend in the economy. And borrowers who can’t pay loans are desperate to sell their assets on the market in order to get money to pay loans. This makes borrowers even less creditworthy. This results in an even lesser economy.
In a Recession, lowering interest rates can solve the problem but in deleveraging lowering interest rates won’t work because the interest rate is already low. Debts have become too large to pay back. Borrowers have lost their ability to repay.
How to solve Deleveraging
Once debt has become too high and can’t be repaid, there are options to take to solve this:
- Government, people, and businesses cut down on spendings.
- Debts are reduced through restructuring.
- Wealth is redistributed from the rich to the poor.
- The Central bank prints new money.
These steps have been practiced to solve every deleveraging problem.
Firstly, spendings are cut down. This is called Austerity. But this doesn’t reduce debt as much because cut down spendings causes earnings to reduce. Income reduces faster than debts are repaid, so the debt gets worse. This cut in spendings is deflationary. Businesses are forced to cut costs, which means the loss of more jobs. This leads to applying the next step.
Restructuring to cut debt comes second. When people can’t pay back loans to the bank, people get scared and rush to the bank to withdraw their money. Banks get overstrained and banks, people, and businesses fail on their debts. This is called a Depression. This is when people realize that most of what they thought was their wealth isn’t really there. Many lenders won’t want to lose all their assets, so they agree to debt restructuring. Debt restructuring means lenders will be paid less, paid over a longer period of time, or at a lower interest rate than was formerly agreed. Even if debt disappears due to debt restructuring, asset value and income continue to disappear too and faster. And this debt continues to go worse.
Lower incomes and less employment affect the government because they get to take fewer taxes. And at the same time, it has to increase spendings for palliatives because unemployment has risen. This causes “Budget Deficit” as the government spends more than it receives. The government needs to raise taxes or borrow money. But as the economic system keeps falling and a lot of persons unemployed, the money has to come from elsewhere.
The government then gets the money by increasing taxes on high-income earners. There could be social disorder and tensions if the depression continues, as the poor majority protest against the rich. And with the rich being strained they will push back at the poor. If the tensions are too much this can lead to political change of power which may be extreme sometimes and can lead to a civil war. Since there isn’t another option to stop the depression and to prevent social tensions to go extreme, the government will ask the Central bank to print new money.
Unlike other options, printing money is inflationary. The Central Bank buys a financial asset with this money which drives up the asset prices. This doesn’t benefit the entire economy. Since the Central bank doesn’t have the power to make the money benefit the economy, it lends the money to the government in exchange for government bonds. This enables the government to overcome the Deficit challenge, so they can increase spendings and give out palliatives to the unemployed. This increases the income of each individual and government debt. But it will reduce the total economy debt.
To put a final solution to this challenge, the effect of the deflationary solution has to balance with the effect of the inflationary solution.
Economic system debt declines in relation to income, there’s a positive economic growth curve. The balance is achieved by the right proportion of cutting spendings, restructuring to reduce debt, transferring wealth from the rich to the poor by increasing taxes on the rich, and printing money.
Note that printing of money, in this case, won’t cause inflation if it pays for credit. The right balance is when the rate of income growth is higher than the interest rate on debt. So printing money can cause the income growth rate to be higher but caution must be taken not to overprint to avoid inflation.
When income begins to rise borrowers become more creditworthy and they start lending money again. And people begin to spend more. This makes the economy continue to grow. This is the Reflation phase.
It takes a decade to get the economic system back growing again. That is why you have what’s called the ‘lost decade‘.
Question; What insights have you drawn from this article?
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I’m the cofounder of WealthOnPoint. Business has always been where my interest lies. If you have any business, finance or investment related issue, feel free to contact WealthOnPoint via email [email protected]
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