In our previous post we explored how the US dollar became a fiat currency, as well as the velocity of money and the fractional reserve banking system.
While many people would be shocked to find out that money has no essential value, they may be even more surprised to find out that most spending is done with credit and not money at all.
Our credit based economy operates in two different cycles: the short-term debt cycle and the long-term debt cycle. These cause different economic phases of expansion, recession, deleveraging and depression.
The short-term debt cycle.
In How the Economic Machine Works, hedge fund manager, Ray Dalio says, borrowing money is like pulling spending forward. If you can’t afford to buy a house, for example, you can borrow the amount you need and make the purchase. But you must repay the debt at some point in the future. So, while you are pulling spending forward to make the purchase, you are also creating a point at which you must spend less than you earn in order to pay the bank back.
An economy based on credit creates short-term debt cycles in which people borrow in order to spend more. One person’s spending creates another person’s income – so, as spending increases in an economy, so do incomes. Income growth leads to further spending while also making people more and more creditworthy in the eyes of lenders. This makes it easier for people to borrow more, spend more and earn more.
This phase of expansion leads to inflation. Since more people are consuming goods, the price of those goods goes up. This happens when the amount of spending and income growth outstrips the rate that goods are produced.
But, since borrowed money has to be repaid at some point in time, an economy’s growth phase must inevitably come to a halt.
Also, if inflation starts to rise too much, the economy is put at risk. This is when the central bank of an economy says enough is enough. It raises interest rates so fewer people can afford to borrow. Existing debts rise, and people are forced to slow down spending in order to repay debt.
When spending decreases, incomes tend to drop – and since people are spending less, the price of goods and services go down. This leads to deflation.
Which also leads to recession.
If this gets too severe, the central bank will usually lower interest rates again. This makes borrowing money more affordable, which means people can increase spending. This then leads to income growth and further borrowing which prompts the start of another phase of expansion.
The short term debt cycle repeats itself over and over again – with each cycle usually lasting 5 to 8 years.
But, these phases of expansion and recession don’t tend to balance themselves out over the long run. Instead, says Dalio, the top and bottom of each cycle ends with more growth and more debt.
When our spending creates a bubble.
It seems that lenders have a short term perspective when it comes to issuing credit. They focus on economic expansion: income growth, asset growth and stock market growth, and continue to lend more and more money.
While debt has been growing more and more, so has income – just enough to offset the burden of borrowed money looming in the background.
People start to feel rich – especially when asset prices soar. They borrow huge amounts to buy assets as investments, and since their assets are worth so much, they remain creditworthy in the eyes of the banks.
But, this can’t continue forever.
At some point, this debt needs to be paid back, which will result in less spending and lower income.
Long term debt cycle.
This is the long term debt cycle, and it happens over a period of 75 to 100 years. When debt burdens outstrip income, people must cut back on spending. Incomes drop, making people less credit worthy. Borrowing then also drops and the economy begins to deleverage.
As credit dries up and incomes drop, people struggle to repay loans. They sell assets in order to cope with this. But, as more and more people sell, this floods the market at the same time that spending falls.
Asset prices drop, banks get squeezed and more and more people default on their loans.
How to cope with a deleveraging.
According to Dalio, policy makers tend to do these four things during a deleveraging:
1) Cut spending,
2) Reduce debts through defaults and restructuring,
3) Redistribute wealth through tax increases to the highest income earners,
4) Print more money.
Also known as austerity measures, these four things need to be balanced properly in order to avoid hyperinflation, social unrest and possibly even war.
How does a depression come about?
When spending is cut, incomes fall – and this can happen faster than debt is repaid.
Due to deflation, businesses are forced to cut costs in order to keep afloat. This means jobs are lost, which leads to higher rates of unemployment.
When people default on their loans en masse the banks begin to feel squeezed. People panic and rush to withdraw their savings, leaving the banks in an even more desperate situation.
Businesses also default on their loans while asset prices continue to fall.
What happened to all that wealth that was there just a few years ago? Turns out it isn’t worth much anymore.
This is a depression.
Since lenders don’t want their assets to disappear (remember, their assets are our debts), they agree to restructuring. Borrowers are told they can pay back mortgages over longer periods of time, or at lower interest rates.
But, this doesn’t fix the debt burden.
When governments feel the squeeze too.
High unemployment and lower incomes results in less tax being collected.
When coupled with the greater costs of unemployment benefits and stimulus packages that the government must then pay, the government itself becomes squeezed.
It raises taxes on the wealthy.
When credit dries up.
Since most of what people thought was money in the economy was actually credit, policy makers must deal with the loss of this credit by turning on the printing presses.
Central banks thus print more money in exchange for government bonds. This basically means that the central bank of an economy is lending the money to the central government. This allows it to run a deficit and increase spending within the economy by offering stimulus packages and unemployment benefits.
While this helps to create income growth and lower the debt burden of the economy, it also increases the amount of debt that the government is in.
Why not just print more money?
While this seems like an easy solution to clear debts – especially since the central banks can essentially print money out of nothing, it isn’t a viable solution.
Printing too much money too quickly causes hyperinflation, and this is bad news for those with savings. In the space of a few years, what was once enough to buy a house may only be enough for one week’s worth of rent. So, clearly, policy makers want to prevent this.
If they print just enough money to offset falling credit, and enable increased spending within the economy, says Dalio, then they can create a “beautiful deleveraging.”
As spending picks up again once more, incomes begin to increase, and the cycle starts a new phase of growth. However, this new cycle begins out of the struggle that preceded it – so surely borrowers, banks and businesses will be a bit more careful this time … right?
How are you going to make the money system work for you? Contact our team for a free consultation today.