Though the economy might seem complex, it works in a simple mechanical way. It is made up of small parts and repeated transactions over a zillion times over and over again. These transactions are governed by human nature and they create 3 main forces that drive the economy
Productivity Growth
Short Term debt cycle
Long-Term Debt Cycle
Transactions.
Every time a trade happens between a "buyer" & and a "seller" results in a "transaction". The buyer exchanges cash/credit/electronic money in exchange for goods, and services or financial assets from the seller.
Price = Total Spending/Total Quantity
A market consists of all "buyers" and "sellers" for different sets of domains. The economy is the sum of all the transactions happening in all the markets of a nation. Eg - Oil, Gas, Cereals, cars e.t.c
The biggest "buyer" and "seller" is the government, which consists of 2 important parts.
The Central Government - Collects "taxes" and "spends" money
The Central Bank - Different from other banks, controls the amount of money supply and credit in the economy. This process is done by "printing money" and influencing "interest rates".
Credit:
Is the most important part of the economy. Consider a "lender" and a "borrower", a "lender" gives credit to create more money and a borrower takes credit to buy stuff that they can’t afford, starting a business.
When the "interest rate" is "high", there is "less borrowing" as it’s expensive, whereas when the "interest rates" are "lower", the "borrowing" is "higher" as it’s less expensive. As soon as the credit is created between the "lender" & and the "borrower", it turns into "debt" for the "borrower". In this case, it’s an "asset" for the "lender" and a "liability" for the "borrower".
Why "Credit" is important?
The credit increases "spending" and "spending" drives the economy. One person’s "spending" is another person’s "income". So this cycle increases "income" and the lenders can lend more due to higher "income".
A credit-worthy borrower has 2 things: The ability to repay & collateral to take more credit
So increased "income" leads to an increase in "borrowing", increased "borrowing" leads to increased "spending" and as one person’s "spending" is another person’s "income" it results in more borrowing and the cycle goes on. These lead to economic growth.
A productive person can bring in more income and more economic boost to the country. Productivity is effective in the long run and does not have much fluctuation in comparison to credit which matters in the short run. Productivity growth does not fluctuate much and is not a big driver of economic swing."Debt" allows us to consume more than we "produce" and "consume" less than we produce.
Debt swings happen in 2 cycles
One in (5-7) years and the other in (75-100) years.
Think of a world without "credit". In this case, the only way to increase "income" is by being "productive". Since one's 'spending" is another man’s "income", the economy grows when another person is productive as well.
But because we "borrow" we have cycles, so it results economic boost in the short run.
"Credit" is good if it’s not used for overconsumption and can’t be repaid but it’s useful when invested in something that generates "income".
Eg: You invest in a tractor and that tractor helps you to sell crops and generate more income. In this way, you can repay the debt, borrow more, be more productive and generate more income resulting in better living standards.
Short Term Debt Cycle
For Example, if You earn 1,00,000, you can take a credit of 10,000, now you can spend 1,10,000. Because your "spending" is another man’s "income", another man can get credit on 1,10,000 and can spend 1,21,000 and similarly that man’s "spending" will be another man’s "income". This is how the cycle goes on.
As "spending" tends to increase, "prices" start to rise, because the increase in spending is fuelled by credit created out of thin air.
When the amount of "spending" is faster than the "production of goods", it leads to an increase in "price". When "prices" rise, we call it “Inflation”. Too much "inflation" is a problem with the central bank, so it increases "interest rates" so that "borrowing" is reduced. When "borrowing" is less, the person spends less and as your "spending" is another man’s "income", the "income" drops. This results in the reduction of prizes and the terminology is “Deflation” and when there is too much deflation it results in “depression”. When "Inflation" is not a problem, the central bank decreases "interest rates" to cause everything to pick up again. The short-term debt cycle lasts typically 5-7 years.
Long-term Debt Cycle:
If the ratio of "Debt: Income" is stable, then the rise in "debt" does not create too much trouble. When Debt: Income keeps on increasing, it creates a bubble after which everything begins collapsing under the "debt" repayment. In times of depression, as debt repayment rises, borrowers try to sell their assets at a cheaper rate, this in turn reduces the value of the collateral with the banks and thus reduces the creditworthiness of the bank clients.
Eg - the 1929 Depression & the 2008 real estate crisis.
In the case of "deleveraging", the central bank's "Interest rates" come to 0 and the economy is on the verge of collapse. In the case of deleveraging, the debt burdens are too high and they must come down.
Decrease in spending - Borrowers take less, "spending" is cut, and "income" is cut. Cutting in "spending" is "deflationary" and painful, businesses cut down on costs, which leads to unemployment.
Borrowing less - Borrower debt is the lender’s asset, When the borrower doesn’t repay the bank, people get nervous so they rush to banks to withdraw money, the bank gets squeezed and this state leads to "depression".
Redistribute wealth from haves to have-nots - Debt Reconstruction( Lower "Income" leads to lower "taxes", government budget deficit increases, government raise taxes from the rich and gives it to the poor to increase spending, if the depression continues the rich hesitate and default on taxes.
Printing Money - Printing Money is "Inflationary". Inevitably the central bank prints money out of thin air and uses it to buy government bonds. Buying financial assets with this printed money improves asset prices, hence making people more creditworthy, however, this only helps those who own financial assets.
To stimulate the economy, the "central bank" and the "central government" must work in harmony. By buying central bonds, the central bank "lends" money to the government, allowing it to run a deficit and increase "spending" on goods and services. This increases people’s "income" and government "debt", however, the "Deflationary" phase needs to balance with the "Inflationary" phase to have a stable economy.
A beautiful deleveraging is when "Debt: Income" is stable or "1:2", If "Income" is increasing at a slightly higher rate than the "debt" then the creditworthiness is not affected.
3 rules of thumb:
Don’t have "debt" rise faster than "income" because your "debt" burden will eventually crush you.
Don’t have "income" rise faster than "productivity"(because you will eventually become uncompetitive)
Do all that you can to raise your "productivity"(helpful in the long run)
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