How the world works?

The  world economy works in a simple way, though not many understand it. Though the economy might seem complex, it works in a simple way, it’s made up few simple parts and lot of transactions that are repeated. These transactions are above all else are driven by human natures which create three main things that drive the economy.

  1. Productivity growth
  2. The short-term debt cycle
  3. The long-term debt cycle

Let’s the start with the simplest part of the economy, the transactions.

An economy is simply the sum of the transactions that make it up, and a transaction is very simple thing, every time you buy something you create transaction . Each transaction consists of buyer exchanging money or credit with the seller for good, services or financial assets. Credit spends  just like money, so just by adding credit spend and the money you can figure out the value of the transactions in the economy , 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, it’s the building block of economic machine. All cycles and all forces of the economy are driven by transactions. So, if we could understand transactions, we can understand the whole economy.

Financial growth chart. 3d illustration

A Market consists of all the buyers and all the sellers’ making transactions for the same thing. For e.g. there is wheat market, a car market, a stock market and for million other things, And economy consist of all the transactions in these markets. If you add up total spending and total quantity sold in all of the markets, you have everything to understand the economy, it’s  just that simple. People , businesses , banks and Governments all engage in transactions the  way I just told, exchanging money and credit for good services etc. , The biggest buyer and seller is the government which consists of two important parts , a central government  that collects taxes and spend money and central bank which is different from other buyers and sellers because it control the amount of money and credit in the economy , it does things by influencing interest rates, and printing new money , for these reasons , the central bank is an important player in the flow of CREDIT.

Credit is most of the important part the economy and probably the least understood . It’s the most important part and because it’s the biggest and most volatile part. Just like buyer and sellers go to market to make transactions, so do lender and borrowers. Lenders want their money to converted into more money and borrowers usually want  something that they cant afford like a house or a car  or they want to invest . Credit can help both lender and borrowers get what they want. Borrowers promise to repay the amount they borrowed -the principle plus additional called interest. When interest rates are high there is less borrowing, because its expensive to borrow money . When borrowers promise to repay and lenders believe them , credit is created, Any two  people can agree to create credit out of thin air, But credit is tricky because it has different names.

As soon it is created it is termed as debt , debt is both an asset to lender and liability to borrower. In the future when the borrower repays the loan, the assets and liability disappear and the transaction is settled . So why is credit so important, because when a borrowers  receives credit , he is able to increase his spending , remember spending drives the economy , this is because one person’s spending is another person’s income. Every Rupee you spend someone else’s earns and vice vera.

So, when you spend more someone else earns more, When someone’s incomes rises it makes lenders give more to the borrower , as his income has risen . As credit worthy borrower has two thing , the ability to repay and collateral. Having a lot of income gives him the ability to repay , in the event he can’t he has valuable assets to use as collateral , this makes lender comfortable lending him money. , so increased income allows increase borrowing  which allows increase spending , since one person spending is another person’s income , this leads to more increased borrowing and so on , this is pattern of  economic growth and is why we have cycles.

In a transaction you have to give something to get something, how you get depend how much you produce, over time we learn and the knowledge raises our living standard , we call that productivity growth. Those who  are hardworking raise their productivity  faster than those are lazy , but that is not  true for short term , productivity  only matters in the long run , in the short term credit matters, this is because productivity growth doesn’t fluctuate much , so it is not big driver of economic swings, Debt is , because it allows us to consumer more than we produce , it forces us to consume less than  what we produce when we have to repay it .

Debt swings occurs in two big cycles, one takes about 5-8 years and other takes about 75 to 100 years. What most people feel the swings they don’t feel them as cycles, as they don’t look at the bigger picture.

As mentioned, swings around the line, of the productivity is not much due to the innovation but due to the credit. 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 one way to growth since my spending is another person’s income, the economy grows overtime and  everyone  else is more productive , if this happens then the productivity  growth happens in the economy and the economy grows.  But because we borrow we have cycles , its due to human nature and the way the credit works.

Think of borrowing a way of pulling spending forward , in order to buy something you can’t afford you need to spend more than you make , you 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 , it very much looks like a cycle. Any time you borrow you create a cycle , this is as true for an individual and also for economy , this is why understanding credit is so important , it sets into motion a series of events that would happen in future, this makes credit different from money ,

Money is what you settles transactions with, when you buy beer from a bar tender from cash , You create asset and a liability . It’s not until you pay that the assets and liability disappear the debt goes away, and the transaction is settled.

The reality is that most of what people call money is credit, the total amount of credit in India 2.5 trillion dollars, and the total amount of money is only .3 trillion  dollars. In a economy without credit the only way to increase  spending is to produce more. 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 short run but not in long run.

Credit is not something bad that causes cycles, it’s  bad when it finances over consumption that can’t be paid back , it’s  good when it allocates resources which produce income . If you borrow money to buy big TV it doesn’t generate income to pay back the debt , but if you borrow money to buy a tractor and that tractor lets your harvest crops, that debt can improve your living standards . In an economy with credit, we can follow the transaction and see where credit creates growth.

So long the incomes continue to rise, the debt can be managed, people feel wealthy.

Short term Debt cycle– As economic activity increase we see an expansion, first phase of short term debt cycle, Spending continues to increase and price start to rise, this happens because the spending is fueled by credit. When, the amount of spending grows faster than the production of goods prices rises, we call this inflation. The central bank doesn’t want too much inflation, seeing prices rise it raises interest rates, with higher rates fewer people can afford to borrow money, and cost of debt rise, Because people borrow less, they have less money left to spend, so spending slows, since one person spending is other person’s  income, incomes drop. When people spend less prices go down, we call this deflation. Economic activity decrease and we have recession ,  if the recession become too much and inflation is no longer a problem the central banks to lower interest to cause everything  to pick up again, with low interest debt cost reduces and borrowing pick up , and we see another expansion, The economy works like a machines, in the short term debt cycle spending is only constraint by the willingness of the lenders and borrowers to provide and get credit. When the credit is easily available there is expansion, when the credit isn’t easily available there is a recession, this cycle is controlled by central bank. This cycles last to about 5-8 years and happens repeatedly.

However, the bottom and top of this cycle finishes higher with more growth and more debt each time, why? because people push it. They have an inclination to borrow and spend more , instead  of paying back debt, because of this over the long period debt rises faster than income , which creates a long term debt cycle.

Despite people becoming more indebted, lenders become freer to extend credit?

Why, because everyone thinks thing are going great, people just focus on what’s happening lately , incomes have been rising , asset values have been growing up , it’s a boom , when people do a lot of that , we call it a bubble.

Over Decade debt burden slowly increases creating larger debt repayment, at some point debt repayment start growing larger than income, this causes the spending to slow down . At this point In time the cycle reverse itself.    This is what happened in the US in 2008 and in 1929 and in Japan in 1970s.

Long term Debt Cycle:

This is where the economy starts to deleverage –  In a deleveraging people cut spending , incomes fall, credit disappears, asset prices drop , bank gets squeezed. Borrowers are forced to sell assets , the rush to sell assets floods the markets and all the markets tank, Banks get in trouble.

At this point in the long term debt cycle, interest rates can’t be lowered to save the day , like what happens when the recession hits during the downturn of short term debt cycle . In recession lowering interest rates work, in deleveraging lowering interest rates doesn’t work , because the interest rates are already touching zero.

Interest rates in the US hit zero during the deleveraging in the 1920s and 2008.  In deleveraging the debt burden is so high that incomes can’t support more borrowing , in a recession debt burden is still low, so interest rates could be lowered to increase borrowing.

In this case four things can be done.

  1. Cut spending (Austerity Drive)
  2. Reduce Debt
  3. Redistribute Wealth
  4. Print more money
  1. Cut spending – People, business and government tighten their belts and start “austerity Drives” to repay debt. In this case you might think that debt burden might reduce, but opposite happens, the spending is cut so incomes go down, it causes debt burden gets worse. Businesses are forced to cut costs which means less jobs and higher unemployment. Remember the Greece Crisis.?
  2. Debt Reduction – Many borrowers cant repay loans, in this case banks lose out on money, people get nervous and they rush to banks to take their deposits, banks gets squeezed and people and banks defaults under debt, This is where depression hits us.  So, this doesn’t help much either. All of this impact central government, as the taxes of government also reduce.
  3. Redistribute wealth – The unemployed need support, so the government creates stimulus plans to increase spending, the budgeting deficit explodes in the deleveraging . So, to fund their deficit in this case,  the government gets to the super rich of the country , their wealth gets taxed , which creates the distribution from the haves to the have nots.

The Have-nots starts to resent the huge wealth disparity which creates social unrest, This situation can lead to political change , in the 1930s this led to Hitler coming to power , war in Europe etc.

  • Print money – having already lowered rates to zero , the government is forced to print money , it is inflationary in nature. The government uses the money to buy financial assets and bonds. This increases the prices of the assets in market, it makes people more credit worthy. The government also starts buying services and goods from the people to start putting money in the hands of the people.

Essentially , the Central banks print money , and lends to the gov by buying gov bonds, who in turn buy goods and services from people . This is also called as quantitative easing . This leads to hug gov debt, but leads to lowering economy’s  debt burden.

In this stage , The Deflationary ways have to be balanced with the inflationary ways, if balanced correctly , it can be beautiful deleveraging .   In a beautiful deleveraging, debt declines in comparison to income, and the inflation is  not much of a problem.

It requires a mix of cutting spending, reducing debt , printing money and Distribution of wealth .  The entire purpose of this exercise is to reduce debt from the economy and increase income, however care needs to taken that too much money is not printed to increase inflation too much .

After the debt burden goes away , the incomes begin to rise and the economy grows again , people become credit worthy again . This is called Reflation, It take almost 10 years to the economic activity to retrain to normal and hence the term Lost decade .

In summary, the following a key takeaway for the countries,

  1. Don’t have the debt rise faster than income.
  2. Don’t have income rise faster than productivity
  3. Do all what you can to raise your productivity  

Above are the set of rules all policy makers need to take care of, but this cycle of long- and short-term debt have been going on and on, better countries release where they are in this cycle and take appropriate steps before it’s too late.

Written By: Ankur Kushwaha, Sr. Consultant, Invest Punjab | Govt. of Punjab.

 DISCLAIMER: Views expressed are personal.​

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