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Economic cycles

How The Economic Machine Works

Super useful video with basic concepts on how the economy works.

What is Economy?

The Economy is the set of all transactions in the market. A transactions is the exchange of money with goods or services. Each transactions is one person's spending and another person's income. Hence total spend in one country is the total income in that country.

What is Credit?

Credit is just an IOU. It is a promise that one person makes to another. Credit is a liability to the one taking it and an asset to the one giving it. Rather than being a modern innovation, credit is a very primitive and fundamental economic building block. The concept of credit has been created before the concept of money. Types of credit:

  • car loan (liability)
  • mortgage (liability), but you can get asset if you give a rent contract
  • shares (asset)
  • savings account (asset)
  • work contract: you work now, the company promises to pay you in the end of the month (asset if you are employee)
  • rent contract: you pay now, the landlord promises you to provide shelter for the month (liability if you are renting)
  • student loan (liability)

Why there are economic cycles?

The reason economic cycles exist is because there is credit. In an economy with no credit there will not be any cycles. Credit allows people to spend money now and pay back in the future. In economy with no credit thre will be no cycles. Think of your mum's and dad's lives. They have lived their whole live with no credit and their lives has been relatively linear.

Economic cycles exists because there is credit!!! Credit intrinsically has a cycle nature - spend now, pay in the future. Money on the other hand is not the same as credit. Spend now and pay now. You earn then you spend and so on. Money has a linear nature.

  • In economy with no credit, increase in spend can be done only with increase with money/income increase with productivity
  • In economy with credit, increase in spend can be done using credit (created out from thin air)

Definition. The economy is the space of all transactions in the market. A transaction is an exchange of money with product/service and can be funded with money either from income or from credit.

Market is the place where people buy and sell products/services.

Lemma. Each person's spending is another's person income. Therefore higher spending leads to higher income.

Theorem. Price = Total spend/Total products

MOST OF THE SPEND IS FROM CREDIT and not money! Most transactions are funded with credit. As credit has cyclyc nature, the market will have cycles.

Lemma. When credit is easily available there is an economic expansion, when it is not easily available there is a recession

  • When credit is easily available economy is expanding. When credit is not available the economy is contracting

Lemma. Credit is a liability to a borrower and an asset to a lender.

The short term debt cycle

The short term debt cycle (5-8 years) is controlled mainly by the interest rates. When credit is cheap, total spend increases, prices increases, leading to INFLATION. Central bank does not like inflation. To tackle it they increase interest rates. Credit becomes expensive, people borrow less, pay more for interest and this leads to decrasing total spend, price decrease = DEFLATION. Since one person spend is anothers person income, income decreases, economic activity decreases = RECESSION.

After this increase of interest rates, the bank waits until inflation decreases and recession is not a big problem. Then central bank decreases interest rate and this marks the End of the short term debt cycle. Next short term debt cycle would have larger spend and larger credit. People like to push it.

Having many growing short term debt cycles is not sustainable and cannot continue forever...

Long term debt cycle

When debt repayments become higher than income for long period of time, total spend reduces as people spend more to cover their debt. Then spend decreases, and since one person's debt is another person's income, income decreases. The Central Bank decreases interest rates and when it hits 0 and people still have large debt this is when the DEPRESSION begins. There is no iterest on the debpt but people still cannot repay their debt. Identify DEPRESSION by looking at the DEBT Burden. What comes next is the economy deleveraging, same as depression. Less spending - Less income - Less borrowing - Less credit vicious cycle.

Economic depression is the state of the market whereas economic deleveraging is the process that is happening during this market state. Market depression is very similar to recession. However, the difference is that in recession the government can decrease interest rates to stimulate more borrowing, more credit more spending. In depression interest rates are already very low (Japan's lost decade). Japan's interest rate was negative for 8 years. From 2000 to 2020 Japans debt rose from 100% to 200% relative to GDP.

During deleveraging these 4 things happen, all with the goal to reduce the debt burden:

  • people, businesses and even governments cut spending to pay down their debt

  • debt restructuring and defaults(pain)

  • redistribute wealth from those that have to those that have not

  • bank prints money

  • 1 could not work when there is large decrease in spend. Since one person's spend is another person's income, total income decreases and could decrease faster than debt.

  • 2 is usually not enough measure

  • 3 income decreases means taxes decrease. Government need to raise more money to cover costs and help the poor

  • 4 bank prints money when interest rates are already close to 0 and there is crisis. It uses to buy financial assets and government bonds. Happened in 1930 and in 2008. The central bank prints money, and loans using bonds to the central government which then redistributes it to people in need.

Proposition. When the bank prints money, this helps only those who have financial assets!!! And those who use stimulus programs.

Long term debt cycle:

  • Leveraging 50 years
  • Deleveraging/depression 2-3 years
  • Reflation 7 years

Hence the term lost decade. After the reflation things are back to the same level as after 50 years of leveraging. Deleveraging is the process of selling assets to reduce debt. Paying off your debt.

Takeaways

You need to navigate in short term cycles and defend yourselve from the big drop in the long term cycle.

Let's recap the short term cycle phases:

  • grow, decrease, grow again, decrease again
  • low interest rates, high interest rates, low again, high again
  • growth -> inflation -> deflation -> new cycle begins with growth that is higher than the previous growth

(?) The best time to buy when interest rates are low again -> this is when the new cycle will start You need to save cash for this time. Best time to sell (usually after 7-8 years) is when interest rates are high, as this will mark the start of the deflation (end of the cycle).

Lemma. During low interest rates you need assets, during high interest rates you need cash.

Lemma. Note the timeline for the short term debt cycle can be very different for different markets (per country, per city, per neighborhood, per asset)

Actions during long term cycle. In your lifetime you'd expect to have 1 or max 2 depressions. There is only one/two VERY important action you need to take:

  • if you can identify the peak or near the peak of the end of the long term debt cycle (track debt burden). SELL ASSETS
  • at the end of the depression BUY ASSETS

Worst case scenarios if you mess up:

  • If you buy at the peak of short term cycle, you'd be screwed for 4-5 years, after which you'd be at 0. Lost 4-5 years and then in 4-5 years you are at profit.
  • If you buy at the peak of the long term cycle you lose 10 years and would be in profit in 15-16 years. (example. 2008 till 2023)
  1. Don't confuse recession with depression! Lots of people do mot act because of fear of depression.
  2. Don't have debt rate larger than income. Debt burden will crush you.
  3. Dont have income rise faster than productivity. You won't be competitive.
  4. In the long term all that matters is productivity.

Currency devaluation in 1970 Nixon says "In order to defend the dollar we would exchange dollar for gold only when it is in the best interest for America" The truth was that Ameraca would have defaulted as they did not have enough gold. This allowed to the US spend more than they earned as they could print more. In 1930 Roosevelt put embargo on gold too. In both occasions this caused the stock prices to rise. As the bank could print 🤑🤑🤑 WHENEVER THE BANK PRINTS MONEY THE VALUE OF STOCKS, COMMODITIES ASSETS RISE AND THE VALUE OF PAPER MONEY WILL FALL.

  • The 1920 economic boom led to the 1930 depression
  • The 2007 housing bubble led to the 2008 housing crash