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How the Economy Works | Macro and Micro economic Perspective

The first thing you have to understand is that the economy is cyclical in its very nature, which means that if the economy is doing good at the moment, then there will be a time when it will turn rancid. It might not happen immediately, but it will happen someday (Forget about predicting it). And here I would like to explain why that is the case. Let’s first try and understand the three main forces that drive the economy, which is: 1. Productivity growth, 2. Short term debt cycle, and 3. Long term debt cycle.

debt cycle

Disclaimer: This article is not an original idea. Most of what I will be writing from here on else is taken from a Youtube Video by Ray Dalio. It was the video that changed my whole perspective on money, the economy, and how it works. You should check it out if you are at all curious about the economy. I am writing this article for a very selfish reason. I want to solidify the ideas in the video. So you can use the video as a guide or this article or both.

In this article I will divide this topic into the following:

Defining the economy with transactions

The economy at its core is a sum of simple transactions carried out over and over again. Two leading players (Buyers and Sellers) contribute to the economy as a whole. Buyers use money or credit to buy goods and services (Food, House, Stocks, e.t.c) from the sellers. We, as human beings, make regular transactions in different markets, such as the apple market, the fish market, or the stock market. There can be millions of these markets. All of them run like gears on a watch and form the economy. As I have discussed in an earlier article, money and credit work the same way. Hence, the total amount of spending in the economy is the sum of all cash plus credit.

Understanding this is important because the total amount of spending drives the economy. Hence to identify the price of all goods and services, all you have to do is divide total expenditure by the total quantity sold (e.g., 100 Rs./Kg).

Government and its role in the economy

The biggest buyer and seller in an economy is the government. The government can be further divided into two separate entities that help to drive the economy. The central government (which collects taxes and spends money) and the central bank (which controls the amount of cash and credit in the economy). The central bank helps to control the amount of money by two methods; 1. Influencing interest rates 2.Printing new money (More on these later)

Credit and its role in the economy

Credit is the most volatile part of the economy. Just like there are buyers and sellers, there are lenders and borrowers. Lenders give out money, hoping to make more money in the future, and borrowers want to buy something they can’t afford at present (House, iPhone 11, e.t.c). When lenders lend money to the borrowers, credit is created. The lender gives money to the Borrower, and the Borrower signs a contract (figuratively or literally) to pay back the principal with interest in the future.

Influencing Interest rates (from the perspective of the Borrower)

When interest rates go up, borrowing goes down and vice versa. Borrowing is affected by interest rates manipulations because people want to pay less interest in the future for the money they borrow at present (Basic human nature). However, when you create credit (Asset to the lender), you also end up creating debt for the Borrower (Liability to the Borrower). When the Borrower pays back the principal+interest, the transaction is settled (credit and debit disappear).

When people receive credit, they can increase their spending, and you have to understand that the total amount of spending drives the economy. This is because one person’s spending is another person’s income. Why is it so? Imagine you just won a lottery for a million dollars, what will you do? You may not spend all of it at once, but you will end up spending a lot more than you did earlier. And when you spend more then the shopkeeper you buy the goods from, earns more and so on.

The funny thing is when your income rises; lenders want to lend you more money. This is where the concept of creditworthiness comes from. A creditworthy borrower has two things; An ability to repay the credit and collateral (Financial Assets: House, car, stocks, e.t.c.)if he cannot pay the money back. This, in turn, creates more spending, more income, and more borrowing and the economy grows as a whole

A system without credit

But the question you might be asking is, why do we need credit at all if it ends up creating economic cycles. This is because an economy without credit only consists of income, spending, and productivity. Hence, we get a straight line, and income can only be increased by increasing productivity. This might sound great on paper, but the major issue with this idea is that in the real world, it is just too damn slow.

Borrowing is a way of pulling spending forward. To buy something you can’t afford, you have to spend more than what you make. Hence, cycles are created because we borrow money from our future self, saying that we will spend less in the future to pay the money back. We know that most of what people call money is actually credit (see the last post for more). Thus, the short-run income can rise faster than productivity but not in the long run.

Inflation and Deflation

Credit is not a bad thing, but it can turn bad when it fuels overconsumption, which people cannot payback. E.g., buying a 60-inch T.V., which can not create a source of income. But credit is good when it influences growth, such as starting a business.

When the amount of spending and income grows faster than the production of the number of goods, prices rise and create inflation. But the central bank does not want inflation to rise too much as it can create problems in the future. So seeing prices rise, the central government increases the interest rate for borrowing money. Because of this, only a few people and companies can afford to borrow money.

When people start paying back their debt, their income falls. And when income falls, spending falls with it. As one person’s spending is another person’s income, the economy slows down and enters a phase of deflation. Economic activity also goes down, and we get a recession. If the recession is severe enough and inflation is no longer a problem, then the central bank decreases the interest rates, and the cycle starts all over again.

Human nature and its role in the economy

This idea on paper seems to be a perfect model. Then why do we have problems in the economy and more debt at the end of each cycle?

Because we push the system, we are inclined to borrow and spend more instead of paying back our debt, which is the epitome of human nature. This is why, over the long run, debt rises faster than income. This creates a long term debt cycle. When markets are doing good, people borrow more and spend more, but it cannot last forever as, at some point, the money has to be paid back. The ratio of debt and income is called the debt burden.

If the income can offset the amount of debt in the economy, then we have a perfect system. But in the real world, debt rises faster than income (Generally).

Economic Bubble and what exactly is it?

One of the significant disadvantages of human nature is that when times are good, we think it will last forever. Because how can the economy crash when it is doing so well. Well, in reality, it can. And if we turn to our history books, we can see that this has happened time and time again. The 2008 financial crash is a recent example of such an event(Also known as the housing bubble).

An economic bubble is a time or a situation in which assets prices are impractically high (Let’s dive a little deeper into this)

Summary of the 2008 financial crisis

Let us suppose that you are looking for ways to make a lot of money, and all of a sudden, you find a way to do that by going into real estate. Your idea is to buy a house and sell it at a higher price to the next guy. But you do not have enough money, so being the financial expert that you are, you decide to borrow money because interest rates are very low. Thus thinking you can easily borrow money from the bank and pay it later after you sell the house.

Because the economy is going well, the bank easily lends you the money because houses are selling like crazy, and in no way, shape or form can the bank lose money by letting you buy a home, right. Imagine thousands of people doing the same thing. The banks do not care anymore because the housing prices are rising. This is because now everyone wants to buy a house and sell it to the next sucker.

The rest of the world then starts to say, ” Borrow money at lower interest rates, buy a house and make more money. It’s that easy. “. But the problem is that at some point there will be too many sellers and too few buyers. This is what is known as a financial bubble as speculation is the only reason for the rise in housing prices.

Image showing the housing crash

When the bubble finally bursts, people get stuck. Because of this, they end up losing most of their money, if not all. Now you have houses you cannot sell and the debt you can’t pay. People, on the other hand, start to default on their bank loans because they can’t sell the houses to pay the bank. Due to this, Banks begin to collapse. This is a summary of what happened with the 2008 financial crisis.

Economic crashes and deleveraging

When the crash happens, people lose money because they are stuck with “assets” they can’t sell. Or they end up selling those “assets” at a loss. During this period, people start to cut spending; incomes fall, credit disappears as people do not want to borrow more money. Asset prices drop, Banks are squeezed as people want their money back. People start to default on their loans, stock market crashes, and social tension rises. Think about the primary reason for Hitler’s rise to power and the french revolution.

Now, as debt in the economy increases, the creditworthiness of people goes down, spending decreases, and people can’t pay the money back. People are forced to sell their assets at a very low cost. Market collapse and banks get scared, as they cannot pay back their depositors. As asset price drops, people become even less creditworthy.

This might seem like a recession, but in this case, lowering interest rates cannot control the economy. This is because interest rates are already low. This is what is called a deleveraging. At deleveraging, debt in the economy is too much, and people start to cut costs. Borrowers are crippled by the debt and seeing the value of the assets drop, they do not even want more money.

Ways to control a Deleveraging

There are mainly four ways of controlling deleveraging :

1. Cut spending (People, Businesses & Government)

This is when borrowers stop taking new debt & start paying off their remaining debt. But this doesn’t help much as this cuts spending and income. This process is deflationary and painful, and because of this, businesses are forced to cut costs, meaning fewer jobs and high unemployment.

2. Decreasing or increasing the value of money (Debt restructuring)

Borrowers find themselves unable to pay back their debt. Because of this, people get nervous and pull money out of their investments. This period in the economic cycle is called a depression. After this, people start to think much of what they thought of assets are not there. Debt restructuring can be mainly done in three ways :

  1. Lenders get less of what they lent. This is because lenders do not want to lose all of there money.
  2. Lenders and borrowers agree to settle the debt over a long period at lower interest rates.
  3. The credit and debt contract is broken. This means people default and does not pay anything.

This, however, causes assets value to drop even faster. This process is also painful and deflationary.

3. Increasing taxes on the wealthy

Lower-income and unemployment mean the government collects fewer taxes. To tackle this government has to provide money to stimulate growth. This increases the budget deficit (A budget deficit is a financial loss for during a period where expenses exceed revenues). And to decrease the deficit, the government has to increase taxes. But people with low income cannot pay taxes.

Hence, the government will start raising taxes on the wealthy. So, people who do not have money begin to hate the people who have it. Social disorder and tension rise (sometimes to a crazy level as people may try to flip the system; e.g., the french revolution). Also, an example will be Hitler’s rise in power after the 1929 depression.

4. Printing more money

Now, we reach a phase where the amount of credit in the economy is much more significant than physical cash. Hence the central bank starts to print more money to stimulate the economy. The government can buy goods and services, but it can’t use the money.

Hence government buys bonds (A loan contract where the government loans the money to the banks) from the central bank. The central bank then distributes the money through various programs.

printing machine prints money pop art vector 16897311

Printing more money is inflationary. And If the balance of printing money and inflation is adequately managed, it can create a beautiful deleveraging. Which means the debt is reduced relative to income. But as we know from real-world examples like Germany in the 1920s and Zimbabwe recently, printing money can be heavily misused.

P.S. Short term debt cycles and long term debt cycles vary from country to country. But on average short term debt cycles can be anywhere between 7-10 years and long term debt cycle every 40-50 years.

P.P.S In Nepal, I have found that the short term debt cycle averages about 5-7 years, and for the long term debt cycle, I have no clue.

P.P.P.S I know the article is long, and I will break each of these ideas down individually in more detail, but for now, I just want to give a general overview of how the economy works. If you have any problem in understanding any of the ideas I shared, feel free to comment down below.

Summary

  • The total amount of spending drives the economy
  • Central government helps to control the economy by either influencing interest rate or by printing more money
  • Amount of credit in the economy is more compared to currency
  • When interest rates are low people borrow more money and vice-versa
  • A system without credit will be slow
  • One person’s spending is another person income
  • We have a tendency to borrow more and pay less
  • Printing of money is inflationary
  • Economy run in a cycle
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