- Credit – money you receive that you must repay later – powers the economy.
- More credit means more spending. More spending means more income, and more income means more credit is available from lenders.
- Credit also creates debt: the borrowed money must be paid back, so spending must decrease later.
- Governments raise and lower interest rates to keep the economy in check.
The economy makes the world go round. It deeply affects each of us in our daily lives, so it’s certainly something worth understanding, even at a high level.
Definitions of “the economy” vary, but, broadly speaking, an economy could be described as an area where goods are produced, consumed, and traded. Typically, you’ll see them discussed at the national level, with op-eds and news reporters referencing the U.S. economy, the Chinese economy, etc. However, we can also look at economic activity through a global lens by taking into account every country’s activities and affairs.
Who makes up the economy?
Let’s begin at a small scale before working our way up. Every day, we contribute to the economy by buying (i.e., groceries) and selling (i.e., working in exchange for payment). Other individuals, groups, governments, and businesses worldwide do the same across three market sectors.
Measuring economic activity
Broadly speaking, a rising GDP signifies an increase in production, income, and spending. Conversely, a falling GDP indicates decreasing production, income, and spending. Note that there are a couple of variations you can use: real GDP accounts for inflation, whereas nominal GDP does not.
GDP is still only an approximation, but it carries tremendous weight in analyses at national and international levels. It’s used by everyone from small financial market participants to the International Monetary Fund to gain insight into countries’ economic health.
Credit, debt, and interest rates
Lenders and borrowers
We touched on the fact that everything boils down to buying and selling. It’s worth noting that lending and borrowing are essential as well. Suppose that you’re sitting on a large amount of cash that isn’t currently doing anything. You might wish to put that money to work so that it can generate more money.
Going with simple interest would mean that the other party owes you $1,000 every month until the money is returned. If it were repaid after three months, you’d expect to receive $103,000, plus whatever additional fee you specified.
Banks and interest rates
Banks are probably the most notable types of lenders in today’s world. You could think of them as middlemen (or brokers) between lenders and borrowers. These financial institutions actually take on the role of both.
When you put money into the bank, you do so on the condition that they’ll give it back to you. Many others do the same. And, since the bank has such a large amount of cash on hand now, it lends it out to borrowers.
Why is credit important?
Credit could be seen as a kind of lubricant for the economy. It allows individuals, businesses, and governments to spend with money that they don’t have immediately available. To some economists, this is problematic, but many believe that increased spending is a sign of a thriving economy.
If more money is being spent, more people receive an income. Banks are more inclined to lend to those with higher incomes, meaning that individuals now have access to more cash and credit. With more cash and credit, individuals can spend more, meaning that more people receive an income, and the cycle continues.
More income → more credit → more spending → more income.
Of course, this cycle can’t just continue indefinitely. By borrowing $100,000 today, you deprive yourself of $100,000+ tomorrow. So, while you can temporarily increase your spending, you’ll eventually have to decrease your spending to pay it back.
In red is productivity, which grows over time. In green is the relative amount of credit available.
So what are we looking at, exactly? Well, let’s first note that productivity is steadily increasing. Without credit, we’d expect that to be the only source of growth – after all, you would need to produce to receive income.
Let’s explore this more in the next section.
Central banks, inflation, and deflation
Suppose that everyone has access to lots of credit (part one of the previous section’s graph). They can buy a lot more than they would be able to without it. But while spending is growing skyrocketing, production isn’t. In effect, the supply of goods and services does not materially increase, but its demand does.
How does a central bank work?
Increasing interest rates is something that central banks might do when inflation gets out of hand. When rates are increased, the interest owed is higher, so borrowing doesn’t seem as attractive. Since individuals also need to repay debts, spending is expected to decrease.
Like inflation, deflation can be measured through a Consumer Price Index.
What happens when the economic bubble bursts?
The long-term debt cycle.
When deleveraging occurs, incomes begin to drop, and credit dries up. Unable to repay debt, individuals attempt to sell their assets. But with so many doing the same thing, asset prices tumble due to an abundance of supply.
So what can they do? Well, the most obvious way forward would be to decrease spending and forgive the debt. These bring other issues, though: reduced spending means that businesses won’t be as profitable, meaning that employees’ incomes will decrease. Industries will need to cut down on their workforce, leading to higher unemployment rates.
When compared to the short-term cycles, the long-term debt cycle plays out across a much longer time frame, believed to occur every 50 to 75 years.
How does it all tie together?
We’ve covered quite a few topics here. Ultimately, Dalio’s model revolves around the availability of credit – with more credit, the economy booms. With less credit, it contracts. These events alternate to create short-term debt cycles, which, in turn, make up part of long-term debt cycles.
Interest rates influence much of the behavior of the economy’s participants. When rates are high, saving makes more sense, as spending is not as much of a priority. When they’re lowered, spending appears to be the more rational decision.
The economic machine is so colossal that it can be difficult to wrap your head around its various components. However, by looking closely, we can see the same patterns repeating themselves over and over as participants engage in transactions with each other.
At this stage, you’ve hopefully got a better understanding of the relationship between lenders and borrowers, the importance of credit and debt, and the steps that central banks take to try and mitigate economic disaster.