Running the Economy - IV
Up to this point, all is ok, the First, Second, and Third episode of the series "Running an Economy". The fourth episode tells you about how we get into a recession which we're currently in, because of poor run financial institutions and the novel virus. The virus is on its verge, and the government is working on stabilizing the lenders and make them brawny.
When the amount of spending
and incomes grow faster than the production of goods:
prices rise. When prices rise, we call this inflation.
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The Central Bank doesn't want
too much inflation because it causes problems. Seeing prices raise interest
rates raises. 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 left over to spend, so spending
slows ...and since one person's spending is another person's income, incomes
drop... 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?
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Because people push it — they incline to borrow and spend more instead of paying back debt. It's human nature. Because of this, over long periods, 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's value goes up! The 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 time.
But this obviously cannot
continue forever. And it doesn't. Over the 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 creditworthy causing
borrowing to go down.
Debt repayments continue to rise which makes spending drop even further...and the cycle reverses itself. This is a long-term debt peak. Debt burdens have simply become too big.
Now the economy begins Deleveraging. In a
deleveraging; people cut spending, incomes fall, credit disappears, asset 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. Scrambling to fill this hole, borrowers are forced to sell assets.
The rush to sell assets
floods the market. This is when the stock market collapses, the real estate
market tanks, and banks get into trouble. As asset prices drop, the value of
the collateral borrowers can put up drops. This makes borrowers even less
creditworthy.
People feel poor. Credit
rapidly disappears.
Less spending › less income ›
less wealth › less credit › less borrowing, and so on.
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It's a vicious cycle. This appears similar to a recession but the difference here is that interest rates can't be lowered to save the day. So what can be done to make the economy run again as before? Let's stretch a bit and relax.
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