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How the economic machine works, in 30 minutes.
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The economy works like a simple machine.
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But many people don't understand it
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— or they don't agree on how it works
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— and this has led to a lot of needless economic suffering.
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I feel a deep sense of responsibility
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to share my simple but practical economic template.
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Though it's unconventional,
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it has helped me to anticipate
and sidestep the global financial crisis,
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and has worked well for me for over 30 years.
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Let's begin.
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Though the economy might seem complex,
it works in a simple, mechanical way.
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It's made up of a few simple parts and a lot of simple transactions
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that are repeated over and over again a zillion times.
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These transactions are above all else driven by human nature,
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and they create 3 main forces that drive the economy.
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Number 1: Productivity growth
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Number 2: The Short term debt cycle
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and Number 3: The Long term debt cycle
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We'll look at these three forces
and how laying them on top of each other
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creates a good template for tracking economic movements
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and figuring out what's happening now.
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Let's start with the simplest part of the economy:
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Transactions.
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An economy is simply the sum
of the transactions that make it up
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and a transaction is a very simple thing.
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You make transactions all the time.
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Every time you buy something
you create a transaction.
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Each transaction consists of a buyer
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exchanging money or credit
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with a seller for goods,
services or financial assets.
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Credit spends just like money,
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so adding together the money spent
and the amount of credit spent,
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you can know the total spending.
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The total amount of spending
drives the economy.
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If you divide the amount spent
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by the quantity sold,
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you get the price.
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And that's it. That's a transaction.
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It is the building block
of the economic machine.
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All cycles and all forces
in an economy are driven by transactions.
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So, if we can
understand transactions,
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we can understand
the whole economy.
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A market consists of all the buyers
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and all the sellers
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making transactions for the same thing.
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For example,
there is a wheat market,
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a car market,
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a stock market
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and markets
for millions of things.
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An economy consists
of all of the transactions
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in all of its markets.
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If you add up
the total spending
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and the total
quantity sold
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in all of the markets,
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you have everything
you need to know
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to understand the economy.
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It's just that simple.
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People, businesses, banks and governments
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all engage in transactions
the way I just described:
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exchanging money and credit
for goods, services and financial assets.
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The biggest buyer and seller
is the government,
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which consists of two important parts:
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a Central Government
that collects taxes and spends money...
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...and a Central Bank,
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which is different from other buyers
and sellers because it
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controls the amount of money
and credit in the economy.
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It does this by influencing
interest rates
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and printing new money.
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For these reasons,
as we'll see,
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the Central Bank is an
important player in the flow
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of Credit.
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I want you to
pay attention to credit.
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Credit is the most
important part of the economy,
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and probably the least understood.
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It is the most important part
because it is the biggest
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and most volatile part.
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Just like buyers and sellers
go to the market to make transactions,
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so do lenders and borrowers.
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Lenders usually want to
make their money into more money
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and borrowers usually want to
buy something they can't afford,
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like a house or car
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or they want to invest in
something like starting a business.
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Credit can help both lenders
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and borrowers get what they want.
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Borrowers promise to
repay the amount they borrow,
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called the principal,
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plus an additional amount, called interest.
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When interest rates are high,
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there is less borrowing
because it's expensive.
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When interest rates are low,
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borrowing increases
because it's cheaper.
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When borrowers promise to repay
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and lenders believe them,
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credit is created.
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Any two people can agree
to create credit out of thin air!
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That seems simple enough
but credit is tricky
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because it has different names.
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As soon as credit is created,
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it immediately turns into debt.
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Debt is both an asset to the lender,
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and a liability to the borrower.
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In the future,
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when the borrower repays the loan,
plus interest,
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the asset and liability disappear
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and the transaction is settled.
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So, why is credit so important?
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Because when a borrower receives credit,
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he is able to increase his spending.
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And remember,
spending drives the economy.
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This is because one person's spending
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is another person's income.
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Think about it,
every dollar you spend, someone else earns.
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and every dollar you earn,
someone else has spent.
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So when you spend more,
someone else earns more.
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When someone's income rises
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it makes lenders more willing
to lend him money
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because now he's
more worthy of credit.
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A creditworthy borrower
has two things:
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the ability to repay and collateral.
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Having a lot of income in relation to his debt gives him the ability to repay.
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In the event that he can't repay, he has valuable assets to use as collateral that can be sold.
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This makes lenders feel comfortable lending him money.
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So increased income allows increased borrowing
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which allows increased spending.
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And since one person's spending is another person's income,
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this leads to more increased borrowing and so on.
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This self-reinforcing pattern leads to economic growth
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and is why we have Cycles.
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In a transaction, you have to give something in order to get something
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and how much you get depends on how much
you produce
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over time we learned
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and that accumulated knowledge raises
are living standards
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we call this productivity growth
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those who were invented and hard-working raise
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their productivity and their living
standards faster
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than those who are complacent and lazy,
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but that isn't necessarily true over the short run.
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Productivity matters most in the long run, but credit matters most in the short run.
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This is because productivity growth doesn't fluctuate much,
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so it's not a big driver of economic swings.
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Debt is — because it allows us to consume more than we produce when we acquire it
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and it forces us to consume less than we produce when we pay it back.
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Debt swings occur in two big cycles.
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One takes about 5 to 8 years and the other takes about 75 to 100 years.
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While most people feel the swings, they typically don't see them as cycles
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because they see them too up close -- day by day, week by week.
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In this chapter we are going to step back and look at these three big forces
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and how they interact to make up our experiences.
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As mentioned, swings around the line are not due to how much innovation or hard work there is,
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they're primarily due to how much credit there is.
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Let's for a second imagine an economy without credit.
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In this economy, the only way I can increase my spending
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is to increase my income,
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which requires me to be more productive and do more work.
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Increased productivity is the only way for growth.
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Since my spending is another person's income,
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the economy grows every time I or anyone else is more productive.
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If we follow the transactions and play this out,
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we see a progression like the productivity growth line.
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But because we borrow, we have cycles.
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This isn't due to any laws or regulation,
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it's due to human nature and the way that credit works.
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Think of borrowing as simply a way of pulling spending forward.
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In order to buy something you can't afford, you need to spend more than you make.
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To do this, you essentially need to borrow from your future self.
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In doing so you create a time in the future
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that you need to spend less than you make in order to pay it back.
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It very quickly resembles a cycle.
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Basically, anytime you borrow you create a cycle.?
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This is as true for an individual as it is for the economy.
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This is why understanding credit is so important
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because it sets into motion
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a mechanical, predictable series of events that will happen in the future.
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This makes credit different from money.
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Money is what you settle transactions with.
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When you buy a beer from a bartender with cash,
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the transaction is settled immediately.
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But when you buy a beer with credit,
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it's like starting a bar tab.
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You're saying you promise to pay in the future.
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Together you and the bartender create an asset and a liability.
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You just created credit. Out of thin air.
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It's not until you pay the bar tab later
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that the asset and liability disappear,
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the debt goes away
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and the transaction is settled.
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The reality is that most of what people call money is actually credit.
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The total amount of credit in the United States is about $50 trillion
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and the total amount of money is only about $3 trillion.
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Remember, in an economy without credit:
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the only way to increase your spending is to produce more.
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But in an economy with credit,
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you can also increase your spending by borrowing.
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As a result, an economy with credit has more spending
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and allows incomes to rise faster than productivity over the short run,
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but not over the long run.
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Now, don't get me wrong,
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credit isn't necessarily something bad that just causes cycles.
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It's bad when it finances over-consumption that can't be paid back.
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However, it's good when it efficiently allocates resources
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and produces income so you can pay back the debt.
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For example, if you borrow money to buy a big TV,
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it doesn't generate income
for you to pay back the debt.
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But, if you borrow money
to buy a tractor —
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and that tractor let's you harvest
more crops and earn more money
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— then, you can pay back your debt
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and improve your living standards.
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In an economy with credit,
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we can follow the transactions
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and see how credit creates growth.
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Let me give you an example:
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Suppose you earn $100,000 a year and have no debt.
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You are creditworthy enough to borrow $10,000 dollars
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- say on a credit card
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- so you can spend $110,000 dollars
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even though you only earn $100,000 dollars.
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Since your spending is another person's income,
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someone is earning $110,000 dollars.
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The person earning $110,000 dollars
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with no debt can borrow $11,000 dollars,
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so he can spend $121,000 dollars
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even though he has only earned $110,000 dollars.
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His spending is another person's income
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and by following the transactions
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we can begin to see how this process
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works in a self-reinforcing pattern.
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But remember, borrowing creates cycles
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and if the cycle goes up, it eventually needs to come down.
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This leads us into the Short Term Debt Cycle.
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As economic activity increases, we see an expansion
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- the first phase of the short term debt cycle.
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Spending continues to increase and prices start to rise.
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This happens because the increase in spending is fueled by credit
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- which can be created instantly out of thin air.
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When the amount of spending and incomes grow faster than the production of goods:
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prices rise.
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When prices rise, we call this inflation.
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The Central Bank doesn't want too much inflation
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because it causes problems.
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Seeing prices rise, it raises interest rates.
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With higher interest rates, fewer people can afford to borrow money.
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And the cost of existing debts rises.
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Think about this as the monthly payments
on your credit card going up.
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Because people borrow less and have higher debt repayments,
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they have less money leftover to spend, so spending slows
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...and since one person's spending is another person's income,
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incomes drop...and so on and so forth.
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When people spend less, prices go down.
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We call this deflation.
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Economic activity decreases and we have a recession.
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If the recession becomes too severe
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and inflation is no longer a problem,
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the central bank will lower interest rates to cause everything to pick up again.
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With low interest rates,
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debt repayments are reduced
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and borrowing and spending pick up
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and we see another expansion.
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As you can see, the economy works like a machine.
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In the short term debt cycle,
spending is constrained only by the willingness of
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lenders and borrowers to provide and receive credit.
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When credit is easily available,
there's an economic expansion.
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When credit isn't easily available,
there's a recession.
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And note that this cycle is controlled primarily by the central bank.
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The short term debt cycle typically lasts 5 - 8 years
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and happens over and over again for decades.
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But notice that the bottom and
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top of each cycle finish
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with more growth than the previous cycle and with more debt.
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Why?
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Because people push it
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— they have an inclination to borrow
and spend more instead of paying back debt.
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It's human nature.
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Because of this,
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over long periods of time,
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debts rise faster than incomes
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creating the Long Term Debt Cycle.
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Despite people becoming more indebted,
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lenders even more freely extend credit.
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Why?
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Because everybody thinks things are going great!
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People are just focusing on what's been happening lately.
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And what has been happening lately?
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Incomes have been rising!
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Asset values are going up!
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The stock market roars!
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It's a boom!
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It pays to buy goods, services, and financial assets
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with borrowed money!
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When people do a lot of that, we call it a bubble.
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So even though debts have been growing,
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incomes have been growing nearly as fast to offset them.
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Let's call the ratio of debt-to-income the debt burden.
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So long as incomes continue to rise,
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the debt burden stays manageable.
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At the same time asset values soar.
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People borrow huge amounts of money
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to buy assets as investments
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causing their prices to rise even higher.
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People feel wealthy.
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So even with the accumulation of lots of debt,
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rising incomes and asset values
help borrowers remain creditworthy for a long time.
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But this obviously can not continue forever.
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And it doesn't.
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Over decades, debt burdens slowly increase
creating larger and larger debt repayments.
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At some point, debt repayments start growing faster than incomes
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forcing people to cut back on their spending.
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And since one person's spending is another person's income,
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incomes begin to go down...
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...which makes people less creditworthy
causing borrowing to go down.
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Debt repayments continue to rise
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which makes spending drop even further...
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...and the cycle reverses itself.
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This is the long term debt peak.
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Debt burdens have simply become too big.
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For the United States, Europe and much of the rest of the world this
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happened in 2008.
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It happened for the same reason it happened in Japan in 1989
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and in the United States back in 1929.
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Now the economy begins Deleveraging.
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In a deleveraging; people cut spending,
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incomes fall, credit disappears,
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assets prices drop, banks get squeezed,
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the stock market crashes, social tensions rise
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and the whole thing starts to feed on itself the other way.
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As incomes fall and debt repayments rise,
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borrowers get squeezed.
No longer creditworthy,
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credit dries up and borrowers can no longer borrow
enough money to make their
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debt repayments.
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Scrambling to fill this hole, borrowers are forced to sell assets.
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The rush to sell assets floods the market
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This is when the stock market collapses,
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the real estate market tanks and banks get into trouble.
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As asset prices drop, the value of the collateral borrowers can put up drops.
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This makes borrowers even less creditworthy.
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People feel poor.
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Credit rapidly disappears.
Less spending ›
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less income ›
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less wealth ›
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less credit ›
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less borrowing and so on.
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It's a vicious cycle.
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This appears similar to a recession but the difference here
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is that interest rates can't be lowered to save the day.
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In a recession, lowering interest rates works to stimulate the borrowing.
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However, in a deleveraging, lowering interest rates doesn't work because
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interest rates are already
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low and soon hit 0% - so the stimulation ends.
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Interest rates in the United States hit 0% during the deleveraging of
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the 1930s
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and again in 2008.
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The difference between a recession
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and a deleveraging is that in a deleveraging borrowers' debt burdens have
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simply gotten too big
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and can't be relieved by lowering interest rates.
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Lenders realize that debts have become too large to ever be fully paid back.
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Borrowers have lost their ability to repay and their collateral has lost value.
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They feel crippled by the debt - they don't even want more!
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Lenders stop lending.
Borrowers stop borrowing.
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Think of the economy as being not-creditworthy,
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just like an individual.
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So what do you do about a deleveraging?
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The problem is debt burdens are too high and they must come down.
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There are four ways this can happen.
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1. people, businesses, and governments cut their spending.
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2. debts are reduced through defaults and restructurings.
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3. wealth is redistributed from the 'haves' to the 'have nots'.
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and finally, 4. the central bank prints new money.
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These 4 ways have happened in every deleveraging in modern history.
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Usually, spending is cut first.
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As we just saw, people, businesses, banks and even governments tighten their belts and
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cut their spending so that they can pay down their debt.
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This is often referred to as austerity.
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When borrowers stop taking on new debts,
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and start paying down old debts, you might expect the debt burden to decrease.
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But the opposite happens!
Because spending is cut
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- and one man's spending is another man's income - it causes
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incomes to fall.
They fall faster than debts are repaid
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and the debt burden actually gets worse.
As we've seen,
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this cut in spending is deflationary and painful.
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Businesses are forced to cut costs...
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which means less jobs and higher unemployment.
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This leads to the next step: debts must be reduced!
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Many borrowers find themselves unable to repay their loans
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— and a borrower's debts are a lender's assets.
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When borrowers don't repay the bank,
people get nervous that the bank won't
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be able to repay them
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so they rush to withdraw their money from the bank.
Banks get squeezed and
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people,
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businesses and banks default on their debts.
This severe
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economic contraction is a depression.
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A big part of a depression is people discovering much of what they thought
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was their wealth isn't really there.
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Let's go back to the bar.
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When you bought a beer and put it on a bar tab,
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you promised to repay the bartender.
Your promise became an asset of the bartender.
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But if you break your promise
- if you don't pay him back and essentially default
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on your bar tab -
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then the 'asset' he has isn't really worth anything.
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It has basically disappeared.
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Many lenders don't want their assets to disappear and agree to debt
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restructuring.
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Debt restructuring means lenders get paid back
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less or get paid back over a longer time frame
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or at a lower interest rate that was first agreed.
Somehow
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a contract is broken in a way that reduces debt.
Lenders would rather have a
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little of something than all of nothing.
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Even though debt disappears, debt restructuring causes
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income and asset values to disappear
faster,
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so the debt burden continues to gets worse.
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Like cutting spending, debt reduction
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is also painful and deflationary.
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All of this impacts the central government because lower incomes and less employment
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means the government collects fewer taxes.
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At the same time it needs to increase its spending because unemployment has risen.
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Many of the unemployed have inadequate savings
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and need financial support from the government.
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Additionally, governments create stimulus plans
00:22:39
and increase their spending to make up for the decrease in the economy.
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Governments' budget deficits explode in a
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deleveraging because they spend more than they earn in taxes.
00:22:51
This is what is happening when you hear about the budget deficit on the news.
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To fund their deficits, governments need to either raise taxes
00:23:01
or borrow money.
But with incomes falling and so many unemployed,
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who is the money going to come from?
The rich.
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Since governments need more money and since wealth is heavily concentrated in
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the hands of a small percentage of the people,
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governments naturally raise taxes on the wealthy
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which facilitates a redistribution of wealth in the economy -
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from the 'haves' to the 'have nots'.
The 'have-nots,' who are suffering, begin to
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resent the wealthy 'haves.'
00:23:30
The wealthy 'haves,' being squeezed by the weak economy, falling asset prices,
00:23:36
higher taxes, begin to resent the 'have nots.'
00:23:39
If the depression continues social disorder can break out.
00:23:43
Not only do tensions rise within countries,
00:23:47
they can rise between countries - especially debtor and creditor countries.
00:23:52
This situation can lead to political change
00:23:56
that can sometimes be extreme.
00:23:58
In the 1930s, this led to Hitler coming to power,
00:24:02
war in Europe, and depression in the United States. Pressure to do something
00:24:08
to end the depression increases.
00:24:10
Remember, most of what people thought was money was actually credit.
00:24:14
So, when credit disappears, people don't have enough money.
00:24:18
People are desperate for money and you remember who can print money?
00:24:23
The Central Bank can.
00:24:27
Having already lowered its interest rates to nearly 0
00:24:30
- it's forced to print money. Unlike cutting spending,
00:24:34
debt reduction, and wealth redistribution,
00:24:37
printing money is inflationary and stimulative. Inevitably, the central bank
00:24:42
prints new money
00:24:43
— out of thin air — and uses it to buy financial assets
00:24:47
and government bonds. It happened in the United States during the Great Depression
00:24:52
and again in 2008, when the United States' central bank —
00:24:56
the Federal Reserve — printed over two trillion dollars.
00:24:59
Other central banks around the world that could,
printed a lot of money, too.
00:25:04
By buying financial assets with this money,
00:25:07
it helps drive up asset prices which makes people more creditworthy.
00:25:11
However, this only helps those who own financial assets.
00:25:15
You see, the central bank can print money but it can only buy financial assets.
00:25:21
The Central Government, on the other hand,
00:25:24
can buy goods and services and put money in the hands of the people
00:25:29
but it can't print money. So, in order to stimulate the economy, the two
00:25:34
must cooperate.
00:25:35
By buying government bonds, the Central Bank essentially lends money to the
00:25:40
government,
00:25:41
allowing it to run a deficit and increase spending
00:25:44
on goods and services through its stimulus programs
00:25:48
and unemployment benefits. This increases people's income
00:25:53
as well as the government's debt. However,
00:25:56
it will lower the economy's total debt burden.
00:25:59
This is a very risky time. Policy makers need to balance the four ways that debt
00:26:05
burdens come down.
00:26:06
The deflationary ways need to balance with the inflationary ways in
00:26:13
order to maintain stability.
00:26:14
If balanced correctly, there can be a
00:26:18
Beautiful Deleveraging.
00:26:21
You see, a deleveraging can be ugly or it can be beautiful.
00:26:25
How can a deleveraging be beautiful?
00:26:28
Even though a deleveraging is a difficult situation,
00:26:33
handling a difficult situation in the best possible way is beautiful.
00:26:37
A lot more beautiful than the debt-fueled, unbalanced excesses of the
00:26:42
leveraging phase.
In a beautiful deleveraging,
00:26:45
debts decline relative to income, real economic growth is positive,
00:26:51
and inflation isn't a problem.
It is achieved by having the right balance.
00:26:56
The right balance requires a certain mix
00:27:00
of cutting spending, reducing debt, transferring wealth
00:27:04
and printing money so that economic and social stability can be maintained.
00:27:09
People ask if printing money will raise inflation.
00:27:13
It won't if it offsets falling credit.
Remember, spending is what matters.
00:27:18
A dollar of spending paid for with money has the same effect on price as a dollar
00:27:24
of spending paid for with credit.
00:27:25
By printing money, the Central Bank can make up for the disappearance of credit
00:27:31
with an increase in the amount of money.
00:27:33
In order to turn things around, the Central Bank needs to not only pump up
00:27:38
income growth
00:27:39
but get the rate of income growth higher than the rate of interest on the
00:27:43
accumulated debt.
00:27:45
So, what do I mean by that? Basically,
00:27:48
income needs to grow faster than debt grows. For example:
00:27:52
let's assume that a country going through a deleveraging has a debt-to-
00:27:56
income ratio of 100%.
00:27:58
That means that the amount of debt it has is the same as the amount of income the
00:28:03
entire country makes in a year.
00:28:05
Now think about the interest rate on that debt,
00:28:09
let's say it is 2%.
00:28:11
If debt is growing at 2% because of that interest rate and
00:28:15
income
00:28:15
is only growing at around only 1%, you will never reduce the debt burden.
00:28:20
You need to print enough money to get the rate of income growth above the
00:28:24
rate of interest.
00:28:25
However, printing money can easily be abused because it's so easy to do and
00:28:30
people prefer it to the alternatives.
00:28:33
The key is to avoid printing too much money
00:28:36
and causing unacceptably high inflation, the way Germany did during its
00:28:41
deleveraging in the 1920's.
00:28:43
If policymakers achieve the right balance, a deleveraging isn't so dramatic.
00:28:48
Growth is slow but debt burdens go down.
00:28:51
That's a beautiful deleveraging.
00:28:54
When incomes begin to rise, borrowers begin to appear more creditworthy.
00:28:59
And when borrowers appear more creditworthy,
00:29:02
lenders begin to lend money again.
Debt burdens finally begin to fall.
00:29:08
Able to borrow money, people can spend more. Eventually, the economy begins to
00:29:13
grow again,
00:29:14
leading to the reflation phase of the long term debt cycle.
00:29:18
Though the deleveraging process can be horrible if handled badly,
00:29:22
if handled well, it will eventually fix the problem.
00:29:26
It takes roughly a decade or more
00:29:29
for debt burdens to fall and economic activity to get back to normal
00:29:33
- hence the term 'lost decade.'
00:29:37
Of course, the economy is a little more complicated than this template
00:29:42
suggests.
00:29:43
However, laying the short term debt cycle on top of the long term debt cycle
00:29:48
and then laying both of them on top of the productivity growth line
00:29:52
gives a reasonably good template for seeing where we've been,
00:29:55
where we are now and where we are probably headed.
00:29:58
So in summary, there are three rules of thumb that I'd like you to take away
00:30:03
from this:
00:30:03
First:
Don't have debt rise faster than income,
00:30:08
because your debt burdens will eventually crush you.
00:30:11
Second:
Don't have income rise faster than productivity,
00:30:16
because you will eventually become uncompetitive.
00:30:19
And third:
Do all that you can to raise your productivity,
00:30:24
because, in the long run, that's what matters most.
00:30:29
This is simple advice for you and it's simple advice for policy makers.
00:30:34
You might be surprised but most people — including most policy makers — don't pay enough attention
00:30:38
to this.
00:30:39
This template has worked for me and I hope that it'll work for you.
00:30:44
Thank you.
