how the economic machine works in 30 minutes the economy works like a simple machine but many people don't understand it or they don't agree on how it works and this has led to a lot of needless economic suffering I feel a deep sense of responsibility to share my simple but practical economic template though it's unconventional it has helped me to anticipate and to sidestep the global financial crisis and it has worked well for me for over 30 years let's begin though the economy might seem complex it works in a simple mechanical way it's made up
of a few simple parts and a lot of simple transactions that are repeated over and over again a zillion times these transactions are above all else driven by human nature and they create three main forces that drive the economy number one productivity growth number two the short-term debt cycle and number three the long-term debt cycle we'll look at these three forces and how laying them on top of each other creates a good template for tracking economic movements and figuring out what's happening now let's start with the simplest part of the economy transactions an economy is
simply the sum of the transactions that make it up and a transaction is a very simple thing you make transactions all the time every time you buy something you create a transaction each transaction consists of a buyer exchanging money or credit with a seller for goods services or financial assets credit spins just like money so adding together the money spent and the amount of credit spent you can know the total spending the total amount of spending drives the economy if you divide the amount spent by the quantity sold you get the price and that's it
that's a transaction it's the building block of the economic machine all cycles and all forces in an economy are driven by transactions so if we can understand transactions we can understand the whole economy a market consists of all the buyers and all the sellers making transactions for the same thing for example there is a wheat market a car market the stock market and markets for millions of things an economy consists of all of the transactions in all of its markets if you add up the total spending and the total quantity sold in all of the
markets you have everything you need to know to understand the economy it's just that simple people businesses banks and governments all engage in transactions the way I just described exchanging money and credit for goods services and financial assets the biggest buyer and seller is the government which consists of two important parts a central government that collects taxes and spends money and a central bank which is different from other buyers and sellers because it controls the amount of money and credit in the economy it does this by influencing interest rates and printing new money for these
reasons as we'll see the central bank is an important player in the flow of credit I want you to pay attention to credit credit is the most important part of the economy and probably the least understood it's the most important part because it's the biggest and most volatile part just like buyers and sellers go to the market to make transactions soda lenders and borrowers lenders usually want to make their money into more money and borrowers usually want to buy something they can't afford like a house or a car or they want to invest in something
like starting a business credit can help both lenders and borrowers get what they want borrowers promise to repay the amount they borrow called principal plus an additional amount called interest when interest rates are high there is less borrowing because it's expensive when interest rates are low borrowing increases because it's cheaper when borrowers promise to repay and lenders believe them credit is created any two people can agree to create credit out of thin air that seems simple enough but credit is tricky because it has different names as soon as credit is created it immediately turns into
debt debt is both an asset to the lender and a liability to the borrower in the future when the borrower repays the loan plus interest the asset and the liability disappear and the transaction is settled so why is credit so important because when a borrower receives credit he is able to increase the spending and remember spending drives the economy this is because one person spending is another person's income think about it every dollar you spend someone else earns and every dollar you earn someone else has spent so when you spend more someone else earns more
when someone's income rises it makes lenders more willing to lend him money because now he's more worthy of credit a creditworthy borrowers as two things the ability to repay and collateral having a lot of income in relation to his debt gives him the ability to repay in the event that he can't repay he has valuable assets to use as collateral that can be sold this makes lenders feel comfortable lending and money so increased income allows increased borrowing which allows increased spending and since one person 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 learn and that accumulated knowledge raises our living standards we call this productivity growth those who are inventive and hardworking 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 debt is because it allows us to consume more than we produce when we acquire it and it forces us to consume less than we produce when we have to pay it back debt swings occur in two big cycles one takes about five to eight years and the other takes about seventy-five to a hundred years while most people feel the swings they typically don't see them as cycles because they see them two up close day by day week by
week in this chapter we're going to step back and look at these three big forces and how they interact to make our experiences as mentioned swings around the line are not due to how much innovation or hard work there is there 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 regulations 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 for 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 tear 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 the 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 fifty trillion dollars and the total amount
of money is only about three trillion dollars 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 overconsumption 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 say buy a tractor and that tractor lets you harvest more crops and earn more money then you could 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 suppose you earn $100,000 a year and have no debt you are
credit worthy enough to borrow $10,000 say on a credit card so you can spend a hundred and ten thousand dollars even though you only earn a hundred thousand dollars since your spending is another person's income someone is earning a hundred and ten thousand dollars the person earning a hundred and ten thousand dollars with no debt can borrow eleven thousand dollars so he can spend a hundred and twenty-one thousand dollars even though he is only earned a hundred and ten thousand dollars his spending is another person's income and by following the transactions we can begin to
see how this process works in a self-reinforcing pattern but remember borrowing creates cycles and if the cycle goes up it eventually needs to come down this leads us into the short-term debt cycle as economic activity increases we see an expansion the first phase of the short-term debt cycle spending continues to increase and prices start to rise this happens because the increase in spending is fueled by credit which can be created instantly out of thin air when the amount of spending and incomes grow faster than the production of goods 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 left over to spend so spending slows and since one person spending is another person's income income strata 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 five to eight years and happens over and over again for decades but notice that the bottom and top of each cycle finish with more growth in 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 everyone thinks things are going great people are just focused on what's been happening lately and what's been happening lately incomes have been rising asset values are going up the stock market roars it's a boom in pace 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 dead rising incomes and asset values help borrowers remain credit worthy for a long time but this obviously cannot continue forever and it doesn't over 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 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 deleverage encodings 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 credit worthy 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 at the same time as spending Falls 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 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 in a recession lowering interest rates works to stimulate borrowing however in a deleverage Inglourious traits doesn't work because interest rates are already low and soon hits 0% so the stimulation ends interest rates in
the United States hit 0% during that the leveraging of the 1930s and again in 2008 the difference between a recession and a deleverage is that in a deleveraging borrowers debt burdens have simply gotten too big and can't be relieved by lowering interest rates lenders realize that debts have become too large to ever be fully paid back borrowers have lost their ability to repay and their collateral has lost value they feel crippled by the debt they don't even want more lenders stop lending borrowers stop borrowing think of the economy as being not credit worthy just like
an individual so what do you do about a deleveraging the problem is debt burdens are too high and they must come down there are four ways this can happen one people businesses and governments cut their spending to debts are reduced through defaults and restructurings three wealth is redistributed from the haves to the have-nots and finally for the central bank prints new money these four ways have happened in every deleveraging in modern history usually spending is cut first as we just saw a people businesses and even governments tighten their belts and cut their spending so that
they can pay down their debt this is often referred to as austerity when borrowers stopped taking on new debts and start paying down old debts you might expect the death burden to decrease but the opposite happens because spending is cut and one man spending is another man's income it causes incomes to fall they fall faster than debts are repaid and the debt burden actually gets worse as we've seen this cut in spending is deflationary and painful businesses are forced to cut costs which means less jobs and higher unemployment this leads to the next step debts
must be reduced many borrowers find themselves unable to repay their loans and a borrower's debts our lenders assets when a borrower doesn't repay the bank people get nervous that the bank won't be able to repay them so they rush to withdraw their money from the bank banks get squeezed and 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 walk isn't really there let's go back to the bar when you bought up the year and
put it on a bar tab you promised to repay the bartender your promise became an asset of the bartender but if you break your promise if you don't pay him back and essentially default 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 timeframe or at a lower interest rate than 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 death disappears debt restructuring causes income and asset values to disappear faster so the debt burden continues to get worse like cutting spending debt reduction is also painful and deflationary all of this impacts the central government because lower incomes and less employment means the government collects fewer taxes at the same time it needs to increase its spending because unemployment has risen 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 government's budget deficits explode into de leveraging because they spend more than they earn in taxes this is what's 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 government's 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 to resent the wealthy haves the wealthy haves being squeezed by the weak economy falling asset prices and 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 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 zero 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 happens in the
United States during the Great Depression 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 print it a lot of money to buy 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 burdens this is a very risky time policymakers 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 de leveraging could be ugly or it can be beautiful how can it deleverage and be beautiful even though a de leveraging 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 face 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 dollar 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 to income ratio of a hundred percent that means that the amount of debt it has is the same as the amount of income the entire country makes in a year now think about the interest rate on that debt let's say it's 2% if debt is growing at 2% because of that
interest rate and income is only growing at around 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 could easily be abused because it's so easy to 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 1920s if policymakers achieved 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 de leveraging 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
in closing of course the economy is a little bit 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're 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'll 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 policymakers you might be surprised but most people including most policymakers don't pay enough attention into this this template has worked for me and I hope it will work for you thank you you
