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on how it works, and this has led to a lot of needless economic suffering. I feel a deep sense of
responsibility to share my simple but practical economic template. Though it’s unconventional, it has
helped me to anticipate and to side step the global financial crisis and it has worked well for me for
over 30 years. Let’s begin. Though the economy might seem complex, it works in a simple
mechanical way, it’s made up of a few simple parts and a lot of simple transactions that are repeated
over and over again a zillion times. These transactions above all else are driven by human nature
and they create three main forces that drive the economy. Number one, productivity growth.
Number two, the short term debt cycle. And number three the long term debt cycle. We’ll look at
these three forces and how laying them on top of each other creates a good template for tracking
economic movements and figuring out what’s happening now. Let’s start with the simplest part of
the economy, transactions.
Economics 101
An economy is simply the sum of the transactions that make it up and a transaction is a very simple
thing. You make transactions all the time. Every time you buy something, you create a transaction.
Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or
financial assets. Credit spends just like money, so adding together the money spent and the amount
of credit spent, you could know the total spending. The total amount of spending drives the
economy. If you divide the amounts spent by the quantity sold, you get the price and that’s it, that’s a
transaction. It’s the building block of the economic machine. All cycles and all forces in an economy
are driven by transactions. So, if we can understand transactions, we can understand the whole
economy. A market consists of all the buyers and all the sellers making all transactions for the same
thing. For example, there is a (wheat) market, a farm market, a stock market and markets from
millions of things. An economy consists of all of the transactions and all of its markets. If you add up
the total spending and the total quantity sold in all of the markets, you have everything you need to
know to understand the economy, it’s just that simple.
People, businesses, banks and governments all engage in transactions the way I just described.
Exchanging money and credit for goods, services and financial assets. The biggest buyer and seller is
the government which consists of two important parts. A central government that collects taxes and
spends money and a central bank, which is different from other buyers and sellers because it
controls the amount of money and credit in the economy, it does this by influencing interest rates
and printing new money. For these reasons as we’ll see, the central bank is an important player in
the flow of credit. I want you to pay attention to credit. Credit is the most important part of the
economy and probably the least understood. It’s the most important part because it’s the biggest and
most volatile part. Just like buyers and sellers go to the market to make transactions, so the lenders
and borrowers. Lenders usually want to make their money into more money and borrowers usually
want to buy something they can afford, like a house or a car, or they want to invest in something like
starting a business. Credit can help both lenders and borrowers get what they want. Borrowers
promise to pay the amount they borrow called principal, plus an additional amount called interest.
When interest rates are high, there is less borrowing because it’s expensive. When interest rates are
low, borrowing increases because it’s cheaper. When borrowers promise to repay and lenders
believe them, credit is created. Any two people can agree to create credit out of thin air, that seems
simple enough but credit is tricky because it has different names, as soon as credit is created, it
immediately turns into debt. Debt is both an asset to the lender and a liability to the borrower. In the
future, when the borrower repays the loan plus interest, the asset and the liability disappear and the
transaction is settled. So why is credit so important? Because when a borrower receives credit, he is
able to increase his spending, and remember, spending drives the economy. This is because one
persons spending is another person’s income. Think about it, every dollar you spend, someone else
earns and every dollar you earn, someone else’s spend. So when you spend more, someone else
earns more. When someone’s income rises, it makes lenders more willing to lend them more money
because now he’s more worthy of credit. A credit worthy borrower has two things, the ability to
repay and collateral.
Debt swings occur in two big cycles. One takes about five to eight years and the other takes about 75
to a hundred years, while most people feel the swings, they typically don’t see them as cycles
because they see them too up close, day by day, week by week. In this chapter, we’re going to step
back and look at these three big forces and how they interact to make up our experiences. As
mentioned, swings around the line are not due to how much innovation or hard work there is,
they’re primarily due to ho much credit there is. Let’s for a second 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. Increase productivity is the only way for
growth. Since my spending is another person’s income, the economy grows every time I or anyone
else is more productive. If we follow the transactions and play this out, we see a progression like the
productivity growth line but because we borrow, we have cycles. This isn’t due to any laws or
regulations, it’s due to human nature and the way that credit works. Think of borrowing as simply a
way of pulling spending forward. In order to buy something you can’t afford, you need to spend
more than you make. To do this, you essentially 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 in order to pay it back, it
very quickly resembles a cycle. Basically, anytime you borrow you create a cycle. This is as true for
an individual as it is for the economy. This is why understanding credit is so important because it
sets into motion, a mechanical, predictable series of events that will happen in the future, this makes
credit different from money. Money is what you settle transactions with. When you buy a beer from
a bartender with cash, the transaction is settled immediately but when you buy a beer with credit,
it’s like starting a bar tab. You’re saying you promise to pay in the future, together you and the
bartender create an asset and a liability, you just created credit out of thin air. It’s not until you pay
the bar tab later, that the asset and the liability disappear, the debt goes away and the transaction is
settled.
The reality is, that most of what people call money is actually credit. The total amount of credit in the
United States is about 50 trillion dollars and the total amount of money is only about three trillion
dollars. Remember, in an economy without credit the only way to increase your spending is to
produce more, but with an economy with credit, you can also increase your spending by borrowing.
As a result, an economy with credit has more spending and allows incomes to rise faster than
productivity over the short run but not over the long run. Now don’t get me wrong, credit isn’t
necessarily something bad but just causes cycles. It’s bad when it finances over a consumption that
can’t be paid back, however it’s good when it efficiently allocates resources and produces income, so
you can pay back the debt. For example, if you borrow money to buy a big TV, it doesn’t generate
income for you to pay back the debt. But if you buy money to, say buy a tractor, and that tractor let’s
you harvest more crops and earn more money, then you could pay back your debt and improve your
living standards. In an economy with credit, we can follow the transactions and see how credit
creates growth.
Let’s call the ratio of debt to income the debt burden. So, long as incomes continue to rise, the debt
burden stays manageable, at the same time, asset value soar. People borrow huge amounts of money
to buy assets as investments causing their prices to rise even higher, people feel wealthy. So even
with the accumulation of lots of debt, rising incomes and asset values, help borrowers remain credit
worthy for a long time, but this obviously cannot continue forever, and it doesn’t. Over decades, debt
burdens slowly increase creating larger and larger debt repayments. At some point, debt repayments
start growing faster than incomes, forcing people to cut back on their spending. And since one
person’s spending is another person’s income, incomes begin to go down, which makes people less
credit worthy, causing borrowing to go down. Debt repayments continue to rise, which makes
spending drop even further and the cycle reverses itself. This is the long term debt peak, debt
burden have simply become too big. For the United States, Europe and much of the rest of the world,
this happened in 2008, it happened for the same reason it happened in Japan in 1989 and in the
United States back in 1929, now the economy begins deleveraging. In a deleveraging, people cuts
spending, incomes fall, credit disappears, asset prices drop, banks gets squeezed, the stock market
crashes, social tensions rise and the whole thing starts to feed on itself the other way. As incomes fall
and debt repayments rise, borrowers gets squeezed, no longer credit worthy, credit rise up and
borrowers can no longer borrow enough money to make their debt repayments.
Lenders realize that debts have become too large to ever be fully paid back. Borrowers have lost
their ability to repay and their collateral has lost value. They feel crippled by the debt, they don’t
even want more, lenders stop lending, borrowers stop borrowing. Think of the economy as being
not credit worthy, just like an individual, so what do you do about a deleveraging? The problem is
that debt burdens are too high and they must come down. There are four ways this can happen, one,
people, businesses and governments cut their spending. Two, debts are reduced through defaults
and restructuring. Three, wealth is redistributed from the have’s to the have not’s and finally four,
the central bank print new money. These four ways have happened in every deleveraging in modern
history. Usually spending is cut first, as we just saw people, businesses and even governments
tighten their belts and cut their spendings, so that they can pay down their debt. This is often
referred to as austerity. When borrowers stop taking on new debts and start paying down old debts,
you might expect a debt burden to decrease but the opposite happens because spending is cut and
one man’s spending is another man’s income, it causes incomes to fall. They fall faster than debts are
repayed and the debt burden actually gets worse. As we’ve seen, this cut in spending is deflationary
and painful, businesses are forced to cut costs, which means less jobs and higher unemployment.
This leads to the next step, debts must be reduced.
Many borrowers find themselves unable to repay their loans and a borrower’s debts are a lender’s
assets. When a borrower doesn’t repay the bank, people gets nervous that the bank won’t be able to
repay them, so they rush to withdraw their money from the bank, banks gets squeezed and people,
businesses and banks to fault on their debts. This severe economic contraction is a depression, a big
part of a depression is people discovering much of what they’ve thought was their wealth isn’t really
there. Let’s go back to the bar, when you bought a beer and put it on a bar tab, you promised to repay
the bartender. Your promise became an asset of the bartender, but if you break your promise, if you
don’t pay them back and essentially default on your bar tab, then the asset he has isn’t really worth
anything, it has basically disappeared. Many lenders don’t want their assets to disappear and agree
to debt restructuring. Debt restructuring means lenders get paid back less or get paid back over a
longer time frame or to lower interest rates than what first agreed. Somehow, a contract is broken in
a way that reduces debt. Lenders would rather have a little of something than all of nothing. Even
though debt disappear, debt restructuring causes income and asset values to disappear faster, so the
debt burden continues to get worse. Like cut in spending, debt reduction is also painful and
deflationary. All of this impacts the central government because lower incomes and less employment
means the government collects fewer taxes. At the same time, it needs to increase it’s spending
because unemployment has risen. Many of the unemployed have inadequate savings and need
financial support from the government. Additionally, governments creates stimulus plans and
increase their spending to make up for the decrease in the economy. Governments, budget deficits
explode in a deleveraging because they spend more than they earn in taxes. This is what’s happening
when you hear about the budget deficit on the news.
To fund their deficits, governments need to either raise taxes or borrow money. But with incomes
falling and so many unemployed, who is the money going to come from? The rich. Since governments
needs more money and since wealth has heavily concentrated in the hands of a small percentage of
the people, governments naturally raise taxes on the wealthy, which facilitates a redistribution of
wealth in the economy from the have’s to the have not’s. The have not’s who are suffering begin to
resent the wealth he haves. The wealth he haves being squeezed by the weak economy, falling asset
rises and higher taxes begin to resent the have not’s. If the depression continues, social disorder can
breakout, not only detentions rise within countries, they can rise between countries, especially
deterring credited countries. This situation can lead to political change that can sometimes be
extreme. In the 1930’s, this led to Hitler come into power, war in Europe and depression in the
United States, pressure to do something to end the depression increases. Remember, most of what
people thought was money was actually credit. So when credit disappears, people don’t have enough
money. People are desperate for money and you remember who can print money, the central bank
can. Having already lowered already its interest rates to nearly zero, it’s forced to print money.
Unlike cut in spending, debt reduction and wealth redistribution, printing money is inflationary and
stimulative. Inevitably, the central bank prints new money out of thin air and uses it to buy financial
assets and government bonds.
When incomes begin to rise, borrowers begin to appear more credit worthy, and when borrowers
appear more credit worthy, lenders begin to lend money again. Debt burdens finally begin to fall,
able to borrow money, people can spend more, eventually the economy begins to grow again, leading
to the reflation phase of the long term debt cycle though the deleveraging process can be horrible if
handled badly. If handled well, it will eventually fix the problem. It takes roughly a decade or more to
debt burdens to fall and economic activity to get back to normal, hence the term lost decade
enclosing. Of course, the economy is a little bit more complicated than this template suggests,
however laying the short term debt cycle on top of the long term debt cycle and then laying both of
them on top of the productivity growth line, gives a reasonably good template for seeing where
we’ve been, where we are now and where we’re probably headed. So, in summary there are three
rules of thumb that I’d like you to take away from this. First, don’t have debt rise faster than income
because your debt burdens will eventually crush you. Second, don’t have income rise faster than
productivity because you’ll eventually become uncompetitive. And third, do all that you can to raise
your productivity because in the long run, that’s what matters most. This is simple advice for you
and its simple advice for policy makers. You might be surprised, but most people including most
policy makers don’t enough attention to this.