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In the event that he can't repay, he has valuable assets to use as collateral th
at can be sold.
This makes lenders feel comfortable lending him money.
So increased income allows increased borrowing
which allows increased spending.
And since one person's spending is another person's income,
this leads to more increased borrowing and so on.
This self-reinforcing pattern leads to economic growth
and is why we have Cycles.
In a transaction, you have to give something in order to get something
and how much you get depends on how much you produce
over time we learned
and that accumulated knowledge raises are living standards
we call this productivity growth
those who were invented and hard-working raise
their productivity and their living standards faster
than those who are complacent and lazy,
but that isn't necessarily true over the short run.
Productivity matters most in the long run, but credit matters most in the short
run.
This is because productivity growth doesn't fluctuate much,
so it's not a big driver of economic swings.
because it allows us to consume more than we produce when we acquire it
Debt is
and it forces us to consume less than we produce when we pay it back.
Debt swings occur in two big cycles.
One takes about 5 to 8 years and the other takes about 75 to 100 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 are 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 how 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.
Increased 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 regulation,
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,
prices rise.
When prices rise, we call this inflation.
The Central Bank doesn't want too much inflation
because it causes problems.
Seeing prices rise, it raises interest rates.
With higher interest rates, fewer people can afford to borrow money.
And the cost of existing debts rises.
Think about this as the monthly payments on your credit card going up.
Because people borrow less and have higher debt repayments,
they have less money leftover to spend, so spending slows
...and since one person's spending is another person's income,
incomes drop...and so on and so forth.
When people spend less, prices go down.
We call this deflation.
Economic activity decreases and we have a recession.
If the recession becomes too severe
and inflation is no longer a problem,
the central bank will lower interest rates to cause everything to pick up again.
With low interest rates,
debt repayments are reduced
and borrowing and spending pick up
and we see another expansion.
As you can see, the economy works like a machine.
In the short term debt cycle, spending is constrained only by the willingness of
lenders and borrowers to provide and receive credit.
When credit is easily available, there's an economic expansion.
When credit isn't easily available, there's a recession.
And note that this cycle is controlled primarily by the central bank.
The short term debt cycle typically lasts 5 - 8 years
and happens over and over again for decades.
But notice that the bottom and
top of each cycle finish
with more growth than the previous cycle and with more debt.
Why?
Because people push it
they have an inclination to borrow and spend more instead of paying back debt.
It's human nature.
Because of this,
over long periods of time,
debts rise faster than incomes
creating the Long Term Debt Cycle.
Despite people becoming more indebted,
lenders even more freely extend credit.
Why?
Because everybody thinks things are going great!
People are just focusing on what's been happening lately.
And what has been happening lately?
Incomes have been rising!
Asset values are going up!
The stock market roars!
It's a boom!
It pays to buy goods, services, and financial assets
with borrowed money!
When people do a lot of that, we call it a bubble.
So even though debts have been growing,
incomes have been growing nearly as fast to offset them.
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 values soar.
is to increase my income,
which requires me to be more productive and do more work.
Increased 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 regulation,
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 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
and the total amount of money is only about $3 trillion.
Remember, in an economy without credit:
the only way to increase your spending is to produce more.
But in 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 that just causes cycles.
It's bad when it finances over-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 borrow money to buy a tractor
and that tractor let's you harvest more crops and earn more money
then, you can 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 me give you an example:
they have an inclination to borrow and spend more instead of paying back debt.
It's human nature.
Because of this,
over long periods of time,
debts rise faster than incomes
creating the Long Term Debt Cycle.
Despite people becoming more indebted,
lenders even more freely extend credit.
Why?
Because everybody thinks things are going great!
People are just focusing on what's been happening lately.
And what has been happening lately?
Incomes have been rising!
Asset values are going up!
The stock market roars!
It's a boom!
It pays to buy goods, services, and financial assets
with borrowed money!
When people do a lot of that, we call it a bubble.
So even though debts have been growing,
incomes have been growing nearly as fast to offset them.
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 values 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 creditworthy for a long ti
me.
But this obviously can not continue forever.
And it doesn't.
Over decades, debt burdens slowly increase creating larger and larger debt repay
ments.
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 creditworthy 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 burdens 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 cut spending,
incomes fall, credit disappears,
assets prices drop, banks get 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 get squeezed. No longer creditworthy,
credit dries up and borrowers can no longer borrow enough money to make their
debt repayments.
people,
businesses and banks default on their debts. This severe
economic contraction is a depression.
A big part of a depression is people discovering much of what they 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 bartend
er.
But if you break your promise - if you don't pay him back and essentially defaul
t
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 at a lower interest rate that was 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 disappears, debt restructuring causes
income and asset values to disappear faster,
so the debt burden continues to gets worse.
Like cutting spending, debt reduction
is also painful and deflationary.
All of this impacts the central government because lower incomes and less employ
ment
means the government collects fewer taxes.
At the same time it needs to increase its spending because unemployment has rise
n.
Many of the unemployed have inadequate savings
and need financial support from the government.
Additionally, governments create 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 is 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 need more money and since wealth is 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 'haves' to the 'have nots'. The 'have-nots,' who are suffering, begin t
o
resent the wealthy 'haves.'
The wealthy 'haves,' being squeezed by the weak economy, falling asset prices,
higher taxes, begin to resent the 'have nots.'
If the depression continues social disorder can break out.
Not only do tensions rise within countries,
they can rise between countries - especially debtor and creditor countries.
This situation can lead to political change
that can sometimes be extreme.
In the 1930s, this led to Hitler coming to 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 its interest rates to nearly 0
- it's forced to print money. Unlike cutting 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. It happened in the United States during the Great Depressi
on
and again in 2008, when the United States' central bank
the Federal Reserve
printed over two trillion dollars.
Other central banks around the world that could, printed a lot of money, too.
By buying financial assets with this money,
it helps drive up asset prices which makes people more creditworthy.
However, this only helps those who own financial assets.
You see, the central bank can print money but it can only buy financial assets.
The Central Government, on the other hand,
can buy goods and services and put money in the hands of the people
but it can't print money. So, in order to stimulate the economy, the two
must cooperate.
By buying government bonds, the Central Bank essentially lends money to the
government,
allowing it to run a deficit and increase spending
on goods and services through its stimulus programs
and unemployment benefits. This increases people's income
as well as the government's debt. However,
it will lower the economy's total debt burden.
This is a very risky time. Policy makers need to balance the four ways that debt
burdens come down.
The deflationary ways need to balance with the inflationary ways in
order to maintain stability.
If balanced correctly, there can be a
Beautiful Deleveraging.
You see, a deleveraging can be ugly or it can be beautiful.
How can a deleveraging be beautiful?
Even though a deleveraging is a difficult situation,
handling a difficult situation in the best possible way is beautiful.
A lot more beautiful than the debt-fueled, unbalanced excesses of the
leveraging phase. In a beautiful deleveraging,
debts decline relative to income, real economic growth is positive,
and inflation isn't a problem. It is achieved by having the right balance.
The right balance requires a certain mix
of cutting spending, reducing debt, transferring wealth
and printing money so that economic and social stability can be maintained.
People ask if printing money will raise inflation.
It won't if it offsets falling credit. Remember, spending is what matters.
A dollar of spending paid for with money has the same effect on price as a dolla
r
of spending paid for with credit.
By printing money, the Central Bank can make up for the disappearance of credit
with an increase in the amount of money.
In order to turn things around, the Central Bank needs to not only pump up
income growth
but get the rate of income growth higher than the rate of interest on the
accumulated debt.
So, what do I mean by that? Basically,
income needs to grow faster than debt grows. For example:
let's assume that a country going through a deleveraging has a debt-toincome ratio of 100%.
That means that the amount of debt it has is the same as the amount of income th
e
entire country makes in a year.
Now think about the interest rate on that debt,
let's say it is 2%.
If debt is growing at 2% because of that interest rate and
income
is only growing at around only 1%, you will never reduce the debt burden.
You need to print enough money to get the rate of income growth above the
rate of interest.
However, printing money can easily be abused because it's so easy to do and
people prefer it to the alternatives.
The key is to avoid printing too much money
and causing unacceptably high inflation, the way Germany did during its
deleveraging in the 1920's.
If policymakers achieve the right balance, a deleveraging isn't so dramatic.
Growth is slow but debt burdens go down.
That's a beautiful deleveraging.
When incomes begin to rise, borrowers begin to appear more creditworthy.
And when borrowers appear more creditworthy,
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
for debt burdens to fall and economic activity to get back to normal
- hence the term 'lost decade.'
Of course, the economy is a little 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 are 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 will 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 it's simple advice for policy makers.
including most policy makers
don't pay en
You might be surprised but most people
ough attention
to this.
This template has worked for me and I hope that it'll work for you.
How the economic machine works, in 30 minutes.