This week we went over the nuances of how the economy works. There are three main forces responsible for driving the entire economic cycle: productivity growth, short-term debt, and long-term debt.
An economy encompasses all activities related to the production, consumption, and exchange of goods and services, and all the cycles and forces in an economy are driven by marketplaces and transactions. Individuals, corporations, and governments all engage in transactions on a daily basis, and markets consist of the buyers and sellers that make up a variety of these transactions. For example, every time you buy a good, service, or financial asset with money or credit, you create a transaction.
Central Banks: A central bank is an independent national authority responsible for monetary policy, regulating banks, and maintaining a nation’s long-term economic goals, such as keeping unemployment low and preventing inflation. Central banks are able to affect economic growth by influencing the liquidity in the financial system through controlling interest rates and the supply of money. With these goals in mind, their roles are to control the money supply by setting interest rates on loans and bonds, to regulate member banks through cash and reserve requirements, and to act as an emergency lender to distressed commercial banks and government. In Canada, our central bank is the Bank of Canada (BoC). The BoC work with the central government to put money in Canadian pockets by purchasing government bonds. Ultimately, the central government drives fiscal policy, and the central banks run monetary policy.
Lenders Vs. Borrowers: In an economy, lenders are those who are is willing to lend money now as they expect to gain more in the future through interest and increased returns while borrowers promise to repay the principal plus interest in the future. Lenders consist of individuals, public or private groups, and financial institutions. They prefer to lend to creditworthy borrowers who can repay debts and have collateral if they end up being unable to repay. When borrowers promise to repay, and lenders believe them, credit is created. As soon as credit is created, it immediately turns into debt. Debt becomes a liability, and credit becomes an asset.
As mentioned, central banks control interest rates, which directly impacts spending in an economy. When interest rates rise, borrowing goes down due to the increased cost, consumers are more willing to save to earn higher interest, and spending falls. Vice-versa, when interest rates fall, borrowing goes up due to the cheaper cost, consumers are less willing to save, and spending rises.
When considering spending, we can only spend the amount we make; therefore, incremental spending is equal to incremental income. The only way to increase this spending and income is by increasing productivity, where productivity is how hard you are working. Therefore, economic growth without credit is linear as it is constrained by society’s current productivity.
Short Term Debt Cycle
Economic growth is linear without credit, but with credit, it creates a cycle. Credit allows you to spend money today that you aren’t paying for, but in the future, you will be spending less money than you make to be able to repay your debts. Short-term fluctuations in the economy are dictated by credit, but the net impact is zero. Debt markets are able to accelerate the spending of today by sacrificing the spending of tomorrow, so the economic cycle is driven by credit, not productivity. Productivity growth is what really drives the underlying economy and its linear growth.
Every short-term cycle is compromised of only two components:
Expansion: As economic activity accelerates, due to credit, we see an expansion. When increased spending is fueled by borrowing, spending and incomes are growing faster than production, which results in rising prices; also known as inflation. Central Bank’s often want to avoid inflation over 2% as it leads to problems such as the devaluation of currency, so to curb it, they raise interest rates. This reduces borrowing and spending while increasing saving; credit becomes widely available as it is cheap to borrow and easy to access.
Recession: As economic activity slows down due to higher borrowing costs and increasing returns of savings, we see a recession. Spending and incomes then quickly decrease, despite the production of goods and services remaining relatively stable, which results in decreasing prices, also known as deflation. When a recession becomes severe, it becomes a depression, and Central Bank’s will lower interest rates to spur economic activity. Credit becomes limited and expensive, with barriers to access.
The economic cycle can be sectioned into six stages with the following characteristics:
- Expansion: increasing spending and income, optimistic outlook, and increasing standard of living.
- Peak: high standard of living, high inflation, devaluing currency, increased wage gap.
- Recession: increased interest rates.
- Depression: decreased spending & income, lowering standard of living, stabilizing currency & prices.
- Trough: stable currency and prices, decreased wage gap, low standard of living.
- Recovery: increasing spending & income, optimistic outlook, increasing standard of living.
Long Term Debt Cycle
As humans, we are inclined to borrow and spend, and even when people are in debt, credit is still available. Over a long period of time, debt rises faster than income, which creates a debt burden. This leads to the concept of deleveraging. Deleveraging is similar to a recession, but the Central Bank can’t lower interest rates as they are already low. Instead, spending is cut, which causes asset prices to fall, the stock market then crashes, and banks get squeezed. Finally, borrowers are no longer creditworthy, so they can’t borrow more to fulfill their debt repayments, ultimately defaulting. Asset prices fall because when you pay off debts, you may choose to sell off your assets to do so, but if everyone sells their assets simultaneously, the market becomes flooded, and asset values drop.
There are four ways to lower a debt burden:
- Cut Spending: People, businesses, and governments cut their spending to pay down debt, and borrowers stop taking on new debt.
- Reduce Debt: Many borrowers are unable to repay loans, and banks get squeezed as they aren’t getting their returns because of this. Due to economic uncertainty, people panic and withdraw their bank deposits, which further hurts banks. Then, banks and people end up defaulting on debt. Banks need to restructure their debts by lowering interest rates, as they want to be paid back a percentage of their lent debt instead of having these debts all default. The reduced interest rate makes it cheaper for people to pay banks back.
- Redistribute Wealth: During these times, the Central Government collects fewer taxes due to lower incomes, increases spending due to unemployment, and creates stimulus plans to increase spending. They, in turn, need to raise taxes or borrow money to fund the deficit.
- Print Money: Here, the Central Government essentially borrows from the Central Bank. The Central Bank prints money to buy financial assets and government bonds issued by the Central Government. This drives up prices and asset bases, making owners more credit-worthy as they have stronger collateral and spending increases.
How can economies succeed?
- Don’t have debt rise faster than income because large enough debt burdens will eventually crush you.
- Don’t have income rise faster than productivity — it will eventually render you uncompetitive.
- Do all you can to raise productivity — in the long run, that’s what matters most.