Become a Multi Millionaire level-3

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 Economics of stock market

The stock market does not work the way most people think. A commonly held belief
— on Main Street as well as on Wall Street — is that a stock-market boom is the
reflection of a progressing economy: as the economy improves, companies make
more money, and their stock value rises in accordance with the increase in their
intrinsic value. A major assumption underlying this belief is that consumer
confidence and consequent consumer spending are drivers of economic growth.
A stock-market bust, on the other hand, is held to result from a drop in consumer and
business confidence and spending — due to inflation, rising oil prices, high interest
rates, etc., or for no reason at all — that leads to declining business profits and rising
unemployment. Whatever the supposed cause, in the common view a weakening
economy results in falling company revenues and lower-than-expected future
earnings, resulting in falling intrinsic values and falling stock prices.
This understanding of bull and bear markets, while held by academics, investment
professionals, and individual investors alike, is technically correct if viewed
superficially but is substantially misconceived because it is based on faulty finance
and economic theory.
In fact, the only real force that ultimately makes the stock market or any market rise
(and, to a large extent, fall) over the longer term is simply changes in the quantity of
money and the volume of spending in the economy. Stocks rise when there is
inflation of the money supply (i.e., more money in the economy and in the markets).
This truth has many consequences that should be considered.
Since stock markets can fall — and fall often — to various degrees for numerous
reasons (including a decline in the quantity of money and spending), our focus here
will be only on why they are able to rise in a sustained fashion over the longer term.
The Fundamental Source of All Rising Prices
For perspective, let's put stock prices aside for a moment and make sure first to
understand how aggregate consumer prices rise. In short, overall prices can rise only
if the quantity of money in the economy increases faster than the quantity of goods
and services. (In economically retrogressing countries, prices can rise when the
supply of goods diminishes while the supply of money remains the same, or even
rises.)
When the supply of goods and services rises faster than the supply of money — as
happened during most of the 1800s — the unit price of each good or service falls,
since a given supply of money has to buy, or "cover," an increasing supply of goods
or services. George Reisman offers us the critical formula for the derivation of
economy-wide prices:
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In this formula, price (P) is determined by demand (D) divided by supply (S). The
formula shows us that it is mathematically impossible for aggregate prices to rise by

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any means other than (1) increasing demand, or (2) decreasing supply; i.e., by either
more money being spent to buy goods, or fewer goods being sold in the economy.
In our developed economy, the supply of goods is not decreasing, or at least not at
enough of a pace to raise prices at the usual rate of 3–4 percent per year; prices are
rising due to more money entering the marketplace.
The same price formula noted above can equally be applied to asset prices — stocks,
bonds, commodities, houses, oil, fine art, etc. It also pertains to corporate revenues
and profits. As Fritz Machlup states:
It is impossible for the profits of all or of the majority of enterprises to rise without an
increase in the effective monetary circulation (through the creation of new credit or
dishoarding).
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To return to our focus on the stock market in particular, it should be seen now that the
market cannot continually rise on a sustained basis without more money —
specifically bank credit — flowing into it.
There are other ways the market could go higher, but their effects are temporary. For
example, an increase in net savings involving less money spent on consumer goods
and more invested in the stock market (resulting in lower prices of consumer goods)
could send stock prices higher, but only by the specific extent of the new savings,
assuming all of it is redirected to the stock market.
The same applies to reduced tax rates. These would be temporary effects resulting in
a finite and terminal increase in stock prices. Money coming off the "sidelines" could
also lift the market, but once all sideline money was inserted into the market, there
would be no more funds with which to bid prices higher. The only source of ongoing
fuel that could propel the market — any asset market — higher is new and additional
bank credit. As Machlup writes,
If it were not for the elasticity of bank credit … a boom in security values could not
last for any length of time. In the absence of inflationary credit the funds available for
lending to the public for security purchases would soon be exhausted, since even a
large supply is ultimately limited. The supply of funds derived solely from current
new savings and current amortization allowances is fairly inelastic.… Only if the
credit organization of the banks (by means of inflationary credit) or large-scale
dishoarding by the public make the supply of loanable funds highly elastic, can a
lasting boom develop.… A rise on the securities market cannot last any length of time
unless the public is both willing and able to make increased purchases.

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The last line in the quote helps to reveal that neither population growth nor consumer
sentiment alone can drive stock prices higher. Whatever the population, it is using a
finite quantity of money; whatever the sentiment, it must be accompanied by the
public's ability to add additional funds to the market in order to drive it higher.

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Understanding that the flow of recently created money is the driving force of rising
asset markets has numerous implications. The rest of this article addresses some of
these implications.
The Link between the Economy and the Stock Market
The primary link between the stock market and the economy — in the aggregate — is
that an increase in money and credit pushes up both GDP and the stock market
simultaneously.
A progressing economy is one in which more goods are being produced over time. It
is real "stuff," not money per se, which represents real wealth. The more cars,
refrigerators, food, clothes, medicines, and hammocks we have, the better off our
lives. We saw above that, if goods are produced at a faster rate than money, prices
will fall. With a constant supply of money, wages would remain the same while
prices fell, because the supply of goods would increase while the supply of workers
would not. But even when prices rise due to money being created faster than goods,
prices still fall in real terms, because wages rise faster than prices. In either scenario,
if productivity and output are increasing, goods get cheaper in real terms.
Obviously, then, a growing economy consists of prices falling, not rising. No matter
how many goods are produced, if the quantity of money remains constant, the only
money that can be spent in an economy is the particular amount of money existing in
it (and velocity, or the number of times each dollar is spent, could not change very
much if the money supply remained unchanged).
This alone reveals that GDP does not necessarily tell us much about the number of
actual goods and services being produced; it only tells us that if (even real) GDP is
rising, the money supply must be increasing, since a rise in GDP is mathematically
possible only if the money price of individual goods produced is increasing to some
degree.

5 Otherwise, with a constant supply of money and spending, the total amount of
money companies earn — the total selling prices of all goods produced — and thus
GDP itself would all necessarily remain constant year after year.
"Consider that if our rate of inflation were high enough, used cars would rise in price
just like new cars, only at a slower rate."
The same concept would apply to the stock market: if there were a constant amount
of money in the economy, the sum total of all shares of all stocks taken together (or a
stock index) could not increase. Plus, if company profits, in the aggregate, were not
increasing, there would be no aggregate increase in earnings per share to be imputed
into stock prices.
In an economy where the quantity of money was static, the levels of stock indexes,
year by year, would stay approximately even, or drift slightly lower

6 — depending on the rate of increase in the number of new shares issued. And,
overall, businesses (in the aggregate) would be selling a greater volume of goods at
lower prices, and total revenues would remain the same. In the same way, businesses,
overall, would purchase more goods at lower prices each year, keeping the spread

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between costs and revenues about the same, which would keep aggregate profits
about the same.
Under these circumstances, capital gains (the profiting from the buying low and
selling high of assets) could be made only by stock picking — by investing in
companies that are expanding market share, bringing to market new products, etc.,
thus truly gaining proportionately more revenues and profits at the expense of those
companies that are less innovative and efficient.
The stock prices of the gaining companies would rise while others fell. Since the
average stock would not actually increase in value, most of the gains made by
investors from stocks would be in the form of dividend payments. By contrast, in our
world today, most stocks — good and bad ones — rise during inflationary bull
markets and decline during bear markets. The good companies simply rise faster than
the bad.
Similarly, housing prices under static money would actually fall slowly — unless
their value was significantly increased by renovations and remodeling. Older houses
would sell for much less than newer houses. To put this in perspective, consider that
if our rate of inflation were high enough, used cars would rise in price just like new
cars, only at a slower rate — but just about everything would increase in price, as it
does in countries with hyperinflation The amount by which a home "increases in
value" over 30 years really just represents the amount of purchasing power that the
dollars we hold have lost: while the dollars lost purchasing power, the house — and
other assets more limited in supply growth — kept its purchasing power.
Since we have seen that neither the stock market nor GDP can rise on a sustained
basis without more money pushing them higher, we can now clearly understand that
an improving economy neither consists of an increasing GDP nor does it cause the
overall stock market to rise.
This is not to say that a link does not exist between the money that companies earn
and their value on the stock exchange in our inflationary world today, but that the
parameters of that link — valuation relationships such as earnings ratios and stock-
market capitalization as a percent of GDP — are rather flexible, and as we will see
below, change over time. Money sometimes flows more into stocks and at other times
more into the underlying companies, changing the balance of the valuation
relationships.
Forced Investing
As we have seen, the whole concept of rising asset prices and stock investments
constantly increasing in value is an economic illusion. What we are really seeing is
our currency being devalued by the addition of new currency issued by the central
bank. The prices of stocks, houses, gold, etc., do not really rise; they merely do better
at keeping their value than do paper bills and digital checking accounts, since their
supply is not increasing as fast as are paper bills and digital checking accounts.
"An improving economy neither consists of an increasing GDP nor does it cause the
overall stock market to rise."
The fact that we have to save for the future is, in fact, an outrage. Were no money
printed by the government and the banks, things would get cheaper through time, and
we would not need much money for retirement, because it would cost much less to
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live each day then than it does now. But we are forced to invest in today's
government-manipulated inflation-creation world in order to try to keep our
purchasing power constant.
To the extent that some of us even come close to succeeding, we are still pushed
further behind by having our "gains" taxed. The whole system of inflation is solely
for the purpose of theft and wealth redistribution. In a world absent of government
printing presses and wealth taxes, the armies of investment advisors, pension-fund
administrators, estate planners, lawyers, and accountants associated with helping us
plan for the future would mostly not exist. These people would instead be employed
in other industries producing goods and services that would truly increase our
standards of living.
The Fundamentals are Not the Fundamentals
If it is, then, primarily newly printed money flowing into and pushing up the prices of
stocks and other assets, what real importance do the so-called fundamentals —
revenues, earnings, cash flow, etc. — have? In the case of the fundamentals, too, it is
newly printed money from the central bank, for the most part, that impacts these
variables in the aggregate: the financial fundamentals are determined to a large
degree by economic changes.
For example, revenues and, particularly, profits, rise and fall with the ebb and flow of
money and spending that arises from central-bank credit creation. When the
government creates new money and inserts it into the economy, the new money
increases sales revenues of companies before it increases their costs; when sales
revenues rise faster than costs, profit margins increase.
Specifically, how this comes about is that new money, created electronically by the
government and loaned out through banks, is spent by borrowing companies.

7 Their expenditures show up as new and additional sales revenues for businesses.
But much of the corresponding costs associated with the new revenues lags behind in
time because of technical accounting procedures, such as the spreading of asset costs
across the useful life of the asset (depreciation) and the postponing of recognition of
inventory costs until the product is sold (cost of goods sold). These practices delay
the recognition of costs on the profit-and-loss statements (i.e., income statements).
Since these costs are recognized on companies' income statements months or years
after they are actually incurred, their monetary value is diminished by inflation by the
time they are recognized. For example, if a company recognizes $1 million in costs
for equipment purchased in 1999, that $1 million is worth less today than in 1999; but
on the income statement the corresponding revenues recognized today are in today's
purchasing power. Therefore, there is an equivalently greater amount of revenues
spent today for the same items than there was ten years ago (since it takes more
money to buy the same good, due to the devaluation of the currency).
"With more money being created through time, the amount of revenues is always
greater than the amount of costs, since most costs are incurred when there is less
money existing."
Another way of looking at it is that, with more money being created through time, the
amount of revenues is always greater than the amount of costs, since most costs are
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incurred when there is less money existing. Thus, because of inflation, the total
monetary value of business costs in a given time frame is smaller than the total
monetary value of the corresponding business revenues. Were there no inflation, costs
would more closely equal revenues, even if their recognition were delayed.
In summary, credit expansion increases the spreads between revenue and costs,
increasing profit margins. The tremendous amount of money created in 2008 and
2009 is what is responsible for the fantastic profits companies are currently reporting
(even though the amount of money loaned out was small, relative to the increase in
the monetary base).
Since business sales revenues increase before business costs, with every round of new
money printed, business profit margins stay widened; they also increase in line with
an increased rate of inflation. This is one reason why countries with high rates of
inflation have such high rates of profit.

8 During bad economic times, when the government has quit printing money at a
high rate, profits shrink, and during times of deflation, sales revenues fall faster than
do costs.
It is also new money flowing into industry from the central bank that is the primary
cause behind positive changes in leading economic indicators such as industrial
production, consumer durables spending, and retail sales. As new money is created,
these variables rise based on the new monetary demand, not because of resumed real
economic growth.
A final example of money affecting the fundamentals is interest rates. It is said that
when interest rates fall, the common method of discounting future expected cash
flows with market interest rates means that the stock market should rise, since future
earnings should be valued more highly. This is true both logically and
mathematically. But, in the aggregate, if there is no more money with which to bid up
stock prices, it is difficult for prices to rise, unless the interest rate declined due to an
increase in savings rates.
In reality, the help needed to lift the market comes from the fact that when interest
rates are lowered, it is by way of the central bank creating new money that hits the
loanable-funds markets. This increases the supply of loanable funds and thus lowers
rates. It is this new money being inserted into the market that then helps propel it
higher.
(I would personally argue that most of the discounting of future values [PV
calculations] demonstrated in finance textbooks and undertaken on Wall Street are
misconceived as well. In a world of a constant money supply and falling prices, the
future monetary value of the income of the average company would be about the
same as the present value. Future values would hardly need to be discounted for time
preference [and mathematically, it would not make sense], since lower consumer
prices in the future would address this. Though investment analysts believe they
should discount future values, I believe that they should not. What they should
instead be discounting is earnings inflation and asset inflation, each of which grows
at different paces.)

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Asset Inflation versus Consumer Price Inflation
Newly printed money can affect asset prices more than consumer prices. Most people
think that the Federal Reserve has done a good job of preventing inflation over the
last twenty-plus years. The reality is that it has created a tremendous amount of
money, but that the money has disproportionately flowed into financial markets
instead of into the real economy, where it would have otherwise created drastically
more price inflation.
There are two main reasons for this channeling of money into financial assets. The
first is changes in the financial system in the mid and late 1980s, when an explosive
growth of domestic credit channels outside of traditional bank lending opened up in
the financial markets. The second is changes in the US trade deficit in the late 1980s,
wherein it became larger, and export receipts received by foreigners were
increasingly recycled by foreign central banks into US asset markets.

10 As financial economist Peter Warburton states,

a diversification of the credit process has shifted the centre of gravity away from
conventional bank lending. The ascendancy of financial markets and the proliferation
of domestic credit channels outside the [traditional] monetary system have greatly
diminished the linkages between … credit expansion and price inflation in the large
western economies. The impressive reduction of inflation is a dangerous illusion; it
has been obtained largely by substituting one set of serious problems for another.

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And, as bond-fund guru Bill Gross said,
what now appears to be confirmed as a housing bubble, was substantially inflated by
nearly $1 trillion of annual reserve flowing back into US Treasury and mortgage
markets at subsidized yields.… This foreign repatriation produced artificially low
yields.… There is likely near unanimity that it is now responsible for pumping nearly
$800 billion of cash flow into our bond and equity markets annually.

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This insight into the explanation for a lack of price inflation in recent decades should
also show that the massive amount of reserves the Fed created in 2008 and 2009 — in
response to the recession — might not lead to quite the wild consumer-price inflation
everyone expects when it eventually leaves the banking system but instead to wild
asset price inflation.
One effect of the new money flowing disproportionately into asset prices is that the
Fed cannot "grow the economy" as much as it used to, since more of the new money
created in the banking system flows into asset prices rather than into GDP. Since it is
commonly thought that creating money is necessary for a growing economy, and
since it is believed that the Fed creates real demand (instead of only monetary
demand), the Fed pumps more and more money into the economy in order to "grow
it."

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That also means that more money — relative to the size of the economy — "leaks"
out into asset prices than used to be the case. The result is not only exploding asset
prices in the United States, such as the NASDAQ and housing-market bubbles but
also in other countries throughout the world, as new money makes its way into asset
markets of foreign countries.

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A second effect of more new money being channeled into asset prices is, as hinted
above, that it results in the traditional range of stock valuations moving to a higher
level. For example, the ratio of stock prices to stock earnings (P/E ratio) now
averages about 20, whereas it used to average 10–15. It now bottoms out at a level of
12–16 instead of the historical 5. A similar elevated state applies to Tobin's Q, a
measure of the market value of a company's stock relative to its book value. But the
change in relative flow of new money to asset prices in recent years is perhaps best
seen in the chart below, which shows the stunning increase in total stock-market
capitalization as a percentage of GDP

The changes in these valuation indicators I have shown above reveal that the
fundamental links between company earnings and their stock-market valuation can be
altered merely by money flows originating from the central bank.
Can Government Spending Revive the Stock Market and the Economy?
The answer is yes and no. Government spending does not restore any real demand,
only nominal monetary demand. Monetary demand is completely unrelated to the real
economy, i.e., real production, the creation of goods and services, the rise in real
wages, and the ability to consume real things — as opposed to a calculated GDP
number.
Government spending harms the economy and forestalls its healing. The thought that
stimulus spending, i.e., taking money from the productive sector (a de-accumulation
of capital) and using it to consume existing consumer goods or using it to direct
capital goods toward unprofitable uses, could in turn create new net real wealth —
real goods and services — is preposterous.
What is most needed during recessions is for the economy to be allowed to get worse
— for it to flush out the excesses and reset itself on firm footing. Broken economies
suffer from a misallocation of resources consequent upon prior government
interventions and can therefore be healed only by allowing the economy's natural
balance to be restored. Falling prices and lack of government and consumer spending
are part of this process.
Given that government spending cannot help the real economy, can it help the
specific indicator called GDP? Yes it can. Since GDP is mostly a measure of
inflation, if banks are willing to lend and borrowers are willing to borrow, then the
newly created money that the government is spending will make its way through the
economy. As banks lend the new money once they receive it, the money multiplier
will kick in and the money supply will increase, which will raise GDP.

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Here is a chart of the LEI series with documented recessions as identified .

!
:
"The upward trend in the US LEI seems to be gaining more momentum with another
large increase in June pointing to continued strength in the economic outlook for the
remainder of the year,” said Ataman Ozyildirim, Director, Business Cycles and
Growth Research, at The Conference Board. “Housing permits and the interest rate
spread drove the latest gain in the LEI, while labor market indicators such as average
workweek and initial claims remained unchanged."
For a better understanding of the relationship between the LEI and recessions, the
next chart shows the percentage off the previous peak for the index and the number of
months between the previous peak and official recessions.

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!
LEI and Its Six-Month Smoothed Rate of Change
Based on suggestions from Neile Wolfe of Wells Fargo Advisors, LLC and Dwaine
Van Vuuren of RecessionAlert, we can tighten the recession lead times for this
indicator by plotting a smoothed six-month rate of change to further enhance our use
of the Conference Board's LEI as gauge of recession risk.

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!
As we can see, the LEI has historically dropped below its six-month moving average
anywhere between 2 to 15 months before a recession. The latest reading of this
smoothed rate-of-change suggests no near-term recession risk.

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When the price of a product you want to buy goes up, it affects you. But why does the
price go up? Is the demand greater than the supply? Did the cost go up because of the
raw materials that make the CD? Or, was it a war in an unknown country that affected
the price? In order to answer these questions, we need to turn to macroeconomics.

What Is It?
Macroeconomics is the study of the behavior of the economy as a whole. This is
different from microeconomics, which concentrates more on individuals and how
they make economic decisions. Needless to say, macroeconomy is very complicated
and there are many factors that influence it. These factors are analyzed with various
economic indicators that tell us about the overall health of the economy.
Macroeconomists try to forecast economic conditions to help consumers, firms and
governments make better decisions.
Consumers want to know how easy it will be to find work, how much it
will cost to buy goods and services in the market, or how much it may cost to borrow
money.
Businesses use macroeconomic analysis to determine whether expanding
production will be welcomed by the market. Will consumers have enough money to
buy the products, or will the products sit on shelves and collect dust?
Governments turn to the macroeconomy when budgeting spending,
creating taxes, deciding on interest rates and making policy decisions.
Macroeconomic analysis broadly focuses on three things: national output (measured
by gross domestic product (GDP)), unemployment and inflation.

National Output: GDP

Output, the most important concept of macroeconomics, refers to the total amount of
goods and services a country produces, commonly known as the gross domestic
product. The figure is like a snapshot of the economy at a certain point in time.
When referring to GDP, macroeconomists tend to use real GDP, which takes inflation
into account, as opposed to nominal GDP, which reflects only changes in prices. The
nominal GDP figure will be higher if inflation goes up from year to year, so it is not
necessarily indicative of higher output levels, only of higher prices.
The one drawback of the GDP is that because the information has to be collected
after a specified time period has finished, a figure for the GDP today would have to
be an estimate. GDP is nonetheless like a stepping stone into macroeconomic
analysis. Once a series of figures is collected over a period of time, they can be
compared, and economists and investors can begin to decipher the business cycles,
which are made up of the alternating periods between economic recessions (slumps)
and expansions (booms) that have occurred over time. (For more, see High GDP
Means Economic Prosperity, Or Does It?)
From there we can begin to look at the reasons why the cycles took place, which
could be government policy, consumer behavior or international phenomena, among
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other things. Of course, these figures can be compared across economies as well.
Hence, we can determine which foreign countries are economically strong or weak.
Based on what they learn from the past, analysts can then begin to forecast the future
state of the economy. It is important to remember that what determines human
behavior and ultimately the economy can never be forecasted completely.
Unemployment
The unemployment rate tells macroeconomists how many people from the available
pool of labor (the labor force) are unable to find work.

Macroeconomists have come to agree that when the economy has witnessed growth
from period to period, which is indicated in the GDP growth rate, unemployment
levels tend to be low. This is because with rising (real) GDP levels, we know that
output is higher, and, hence, more laborers are needed to keep up with the greater
levels of production.

Inflation

The third main factor that macroeconomists look at is the inflation rate, or the rate at
which prices rise. Inflation is primarily measured in two ways: through the Consumer
Price Index (CPI) and the GDP deflator. The CPI gives the current price of a selected
basket of goods and services that is updated periodically. The GDP deflator is the
ratio of nominal GDP to real GDP. (For more on this, see The Consumer Price Index:
A Friend To Investors and The Consumer Price Index Controversy.)
If nominal GDP is higher than real GDP, we can assume that the prices of goods and
services has been rising. Both the CPI and GDP deflator tend to move in the same
direction and differ by less than 1%.

Demand and Disposable Income

What ultimately determines output is demand. Demand comes from consumers (for
investment or savings - residential and business related), from the government
(spending on goods and services of federal employees) and from imports and exports.
Demand alone, however, will not determine how much is produced. What consumers
demand is not necessarily what they can afford to buy, so in order to determine
demand, a consumer's disposable income must also be measured. This is the amount
of money after taxes left for spending and/or investment.
In order to calculate disposable income, a worker's wages must be quantified as well.
Salary is a function of two main components: the minimum salary for which
employees will work and the amount employers are willing to pay in order to keep
the worker in employment. Given that the demand and supply go hand in hand, the
salary level will suffer in times of high unemployment, and it will prosper when
unemployment levels are low.
Demand inherently will determine supply (production levels) and an equilibrium will
be reached; however, in order to feed demand and supply, money is needed. The
central bank (the Federal Reserve in the U.S.) prints all money that is in circulation in
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the economy. The sum of all individual demand determines how much money is
needed in the economy. To determine this, economists look at the nominal GDP,
which measures the aggregate level of transactions, to determine a suitable level of
money supply.

Greasing the Engine of the Economy - What the Government Can Do

Monetary Policy
A simple example of monetary policy is the central bank's open-market operations.
When there is a need to increase cash in the economy, the central bank will buy
government bonds (monetary expansion). These securities allow the central bank to
inject the economy with an immediate supply of cash. In turn, interest rates, the cost
to borrow money, will be reduced because the demand for the bonds will increase
their price and push the interest rate down. In theory, more people and businesses will
then buy and invest. Demand for goods and services will rise and, as a result, output
will increase. In order to cope with increased levels of production, unemployment
levels should fall and wages should rise.
On the other hand, when the central bank needs to absorb extra money in the
economy, and push inflation levels down, it will sell its T-bills. This will result in
higher interest rates (less borrowing, less spending and investment) and less demand,
which will ultimately push down price level (inflation) but will also result in less real
output.

Fiscal Policy

The government can also increase taxes or lower government spending in order to
conduct a fiscal contraction. What this will do is lower real output because less
government spending means less disposable income for consumers. And, because
more of consumers' wages will go to taxes, demand as well as output will decrease.
A fiscal expansion by the government would mean that taxes are decreased or
government spending is increased. Ether way, the result will be growth in real output
because the government will stir demand with increased spending. In the meantime, a
consumer with more disposable income will be willing to buy more.
A government will tend to use a combination of both monetary and fiscal options
when setting policies that deal with the macroeconomy.

The Bottom Line

The performance of the economy is important to all of us. We analyze the

macroeconomy by primarily looking at national output, unemployment and inflation.
Although it is consumers who ultimately determine the direction of the economy,
governments also influence it through fiscal and monetary policy.

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1990-08-11 2015-08-11 OK

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 Understand the Economy

In Ray Dalio's How the Economic Machine Works, he

argues that the economy works like a machine. The
economy is made up of gazillions of transactions that
are driven by human nature and create three main
forces that drive the economy.

1) Productivity Growth
2) Short Term Debt Cycle
3) Long Term Debt Cycle

Key Definitions:

Transaction - When a buyer and seller exchanges money or

credit for goods, services, and financial assets.
Market - All buyers and sellers making transactions in a
specific area. Examples include the wheat, stock, cheese,
steel markets.

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Economy - This is the sum of all transactions in all
markets.

The biggest buyer and seller is the government. The

central bank controls the amount of money and credit in
the economy by influencing interest rates and printing

You can make a transaction with money or credit, and that

gives you the total spending.more money.

Why is credit so important?

With credit you are essentially borrowing money from your

future self. As a result you are able to spend more than
you actually currently earn. When you spend money, that
money becomes someone else's income. As a result of,
that person will be able to borrow more money.

For example, suppose I made $100 and I'm able to find a lender that will
lend me $20 plus interest. I spend $120 dollars, which becomes

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someone else's income. That person will be able to borrow $30 dollars
and when he spends that it becomes another person's income. 

However, this eventually all needs to be paid back.

More Income -> More Borrowing -> More Spending ->

More Productivity -> More Income

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!

At the heart of it is the central bank, which controls interest rates and the
money supply. In so doing, the central bank impacts the flow of credit

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 !

DEBT IS A "LIABILITY" FOR THE BORROWER, BUT IT'S AN "ASSET"

FOR THE BANK.

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THE ACT OF BORROWING CREATES A "CYCLE."

BUT WE HAVE A CREDIT SYSTEM. IF I MAKE $100,000 A YEAR, THE

BANK GIVES ME $10,000 IN CREDIT. NOW I HAVE $110,000 TO SPEND.
AND SINCE MY SPENDING IS YOUR INCOME, NOW YOU HAVE EARNED
$110,000 AND CAN GET $11,000 FROM THE BANK.

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!

THERE ARE FOUR WAYS TO DELEVERAGE. MOST PEOPLE HAVE AN

APPETITE FOR THE LAST OPTION (PRINT MONEY) BECAUSE IT FEELS
THE BEST IN THE SHORT TERM.

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Short term debt cycle (5-8 yrs)

When we are in an expansion, spending increases faster

than the capacity to produce goods and services. However,
prices will start to rise resulting in what we understand as
inflation. The government will then raise interest rates in
an attempt to lower prices. Thereby fewer people will be
able to borrow money and prices will eventually fall
resulting in deflation. When the rate of spending can no
longer be sustained by the available money or credit a
recession occurs. Recessions end when the central banks
lower interest rates to stimulate demand for goods and
services.

Long term debt cycle (75-100 yrs)

Debts rise faster than both income and money until it can
no longer be sustained because debt servicing costs have
become too excessive. This is similar to the recession in
the short term debt cycle. The difference is that interest
rates can not be reduced any more to raise spending. They
are already at or close to 0%. When this happens a
deleveraging occurs.

Borrows can't borrow -> Sell assets to pay loans -> Real
estate & stock markets plummet -> Poor credit -> Less
borrowing -> Less spending -> Less income

Remember your spending is someone else's income.

A deleveraging is the process of reducing debt

burdens and is usually done in four different ways.

1) People, governments and business cut spending.

2) Debt is reduced through write downs or extending
payment terms.
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3) Wealth is redistributed from the wealthy to the poor via
government taxes.
4) The central bank prints more money to buy stocks and
financial assets.

Income needs to grow faster than debt grows. However

there needs to be a balance between the ways to reduce
debt otherwise inflation and deflation will be out of control.

For example, if the government prints too much money inflation rates will
soar like that of Germany in 1920s.

3 Rules Everyone Should Follow

1) Make sure income rises faster than debt otherwise the

debt burden will eventually crush you.
2) Make sure incomes do not rise faster than productivity
otherwise you will not be competitive.
3) Do all you can to raise productivity as that is what
matters in long run.

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