How Economic Machine Works

The economy works like a simple machine, it’s made up of a few simple parts and a lot of simple transactions, which got repeated many times

These transactions are done by human nature and build three main forces to drive the economy

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

We will start understanding the economy by “Transaction”

Whenever we buy or sell something, we create a transaction; the market consists of buyer and sellers doing transactions

People, businesses, banks, and government all are engaged in the transaction – i.e. transfer of money or credit in exchange for goods or services or financial asset

The biggest buyer and seller are government, divided into central government and reserve bank (which take all transactions and credit into account and manage them by interest rates and printing of money)

Credit created when the lender believes in the borrower’s promise that he will repay the money; higher the interest rate, lower the number of borrowers, and vice versa

Credit terms as a different name like debt; and after times, when a borrower repays principal + interest, asset and liability disappeared

Credit is important because it makes borrower able to spend more, and spending create the whole economy because one person’s spending is someone else’s earning

And when someone’s income rises, it makes the lender more comfortable to lend him as he’s more worthy of credit, as he has high income and valuable assets to use as collateral

Hence, increased lending lead to increased spending, which is another’s earning and earning lead to more lending and so on

Every time, person A changes, i.e. when the borrower spends money, it becomes income for person A, which make him able to borrow, and every time, borrower spend to another person, and that another person came into the credit cycle, and the cycle keeps rolling

Productivity growth – i.e. higher the production, higher the earnings, and standard of living; it matters over the long-term, where credit matters most in the short run; this is because productivity growth doesn’t fluctuate much, so is not a big driver of the economy, but debt is because it allows us to consume more than we produce when we acquire it and it forces us to consume less than we produce when we pay it back

We have cycles because there is debt, debt is different from money – i.e. when we buy something and pay money, we settle transaction immediately, but when we buy on credit, we create asset and liability for lender and borrower respectively, which will disappear when a borrower pays

An economy without credit has only way to grow is to produce more; but in an economy with credit, one can increase its spending by borrowing

And so, an economy with credit can create more spending and more earning than productivity in the short run, but not in a long run (it will be the same in the long run as an economy without credit and with only productivity)

Credit is not bad when someone borrows to produce, it is bad when someone borrows, and don’t produce or produce less and can’t repay it

When credit increases, it increases spending and lead to an increased price, because spending is funded by credit, which creates inflation

When inflation is there, the central bank will raise interest rates, which will lead to costly borrowing, and the number of borrowers will decrease

Now, if only fewer people will borrow and they have to pay high interest, they will spend less, and so another person will earn less, leads to lower spending again and prices will decrease, creates deflation, and recession

Hence, the central bank will decrease interest rates and borrowing will become cheap and more people will borrow and it is economic expansion

When credit is easily available, it is economic expansion, and when credit is not easily available, there is a recession

And the controller of this cycle becomes the central bank

When everything is going right – i.e. people earn income by borrowed money and asset’s value rises, lenders more freely lend, we call it bubble

Over a long time, it can’t be continued, because, in long run, debt repayment burden increases faster than income, so people cut their spending, and as one’s spending is another’s income, people earn less and which make them less creditworthy

Debt repayment continues to rise and spending continues to fall, it is the burst of a bubble and the economy begins deleveraging

All lead to lower-income, no credit available, asset prices fall, stock market falls – because all want to sell assets, which lead to fall in the price of assets, stocks – which make collateral less valuable and borrowers less creditworthy

As interest rates are already low, it can’t affect deleveraging – which is the difference between deleveraging and recession as rate cuts can help recession

So, what to do with deleveraging? These things happen in every deleveraging

  1. People cut their spending
  2. Debt will be reduced
  3. Wealth will transfer from ‘haves’ to the ‘have nots’
  4. Central bank prints new money

Businesses have to cut their costs and lead to unemployment

Now, the bank can’t get back their lent money back and so, people start taking their deposits out and the bank can’t as it has lent that to the borrowers

People defaults, bank defaults, and businesses default; it is depression; it is deflation and all are painful

All these lead to the inability of borrowers to pay their debt, now, the borrower doesn’t want to borrow and the lender doesn’t want to lend; when the borrower doesn’t pay, debt disappears and debt will be reduced

All of that lead to lower taxes for the central government, and at the same time it has to increase its spending to rise employment, now the government is earning less and has to spend more; so, it has two ways to increase its earnings

  1. High taxes
  2. It has to borrow

Government charge higher taxes from wealthy people and spend for the economy, which is a redistribution of wealth in the economy from the ‘haves’ to ‘have nots’

And now, the central bank has to print money, when it creates money from thin air, and buy financial assets; but it will help only who have financial assets

The government can buy good and services, but it can’t print money

So, the central bank buys a government bond, i.e. lends money to the government and it allows it to increase spending on employment and increase people’s earnings, and stimulated the whole economy

To reduce the debt burden, the government have to grow income faster than debt

If policymaker achieves the right balance – between deflationary (cutting of spending, cutting of debt and wealth redistribution) and inflationary (printing money) tools, deleveraging can’t be so dramatic; growth is slow but debt burden goes down

Rules of thumb

Don’t let debt rise faster than your income, because it will crush you

Don’t let income rise faster than productivity, because you will eventually become noncompetitive

Do all that you can do to raise your productivity, because after all, in the long run, that’s what matters most

Let me summaries the long-term productivity growth and credit growth, have a look at the diagram below

The 0E line is the productivity growth line, i.e. if there is no such thing as a credit in the economy, the economy can grow from 0 to E

But our economy has the element called “Credit”, which make us consume more than we produced, which increases another person’s income (as we saw in the Credit cycle)

The economy is growing faster due to high credit availability; point A indicates people are spending more due to high credit, and the economy is growing

Point B is the peak of the economy, which is far much better than the growth we can have with only productivity

After point B, people don’t have money to repay as they are not able to earn to make repayments, which make them spend less and the economy will be started falling

Due to the low income and the inability of people to repay their debt, banks and businesses also defaults and it makes unemployment

Point C is the stage of the economy called “deleveraging”, which eliminated all credits, make the central bank print money

Point D is when the government started spending or infusing money into the economy to boost it up again

And economy stabilizes again, it is point E

Hence, credit can only boost growth in short-term, in the long-term, there no difference between productivity growth and credit growth

Source

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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