How The Economy Works (2/2)

By Richard Reis

Hello dear,

I know you’re probably wondering “Gee, where did you find that sweet, sweet image?”

It came from my awesome designer friend, Alejandra (Unfortunately, Alejandra doesn’t have a website… But she’s working on it!).

For any and all design requests, I highly recommend emailing her . She’s really talented.

Some of you might also wonder “what’s up with the animals in the image?”

This is a simple, visual tool. I want you to remember it whenever you hear the words “bear market” or “bull market.”

See the sad bear? It means a “bear market” is a condition in which the market is going down (to be specific, 20% down from its peak).

See the happy bull? It means a “bull market” is a condition in which the market is going (you guessed it) up!

Now, you’ll never forget 🙂

Bonus: When a market goes down 10% from its peak, it’s called a correction.

Anyways, onto today’s letter.

Cycles

Last week, we learned that productivity is what matters most in the long-run.

However, in the short-run, what matters most are cycles.

Why? Because they can affect everyone (Google “Financial Crisis of 2007–2008”).

What causes these cycles? If you read last week’s letter, you know the answer is credit.

Contrary to now-popular thinking, cycles do not develop because of a decrease in productivity.

They develop from declines in demand. Specifically, because credit creation decreases. Let me explain:

  • If you can’t borrow more money, you’ll buy less things.
  • If you buy less things, businesses make less money.
  • If businesses make less money, their stock prices go down and they can’t pay all their employees (leading to a lot of layoffs).

This is a downward spiral. If it happens to enough people and businesses, the economy goes down.

Cycles are nothing more than a logical sequence of events. Their patterns repeat themselves over and over again.

If you remember last week, we saw two cycles make up 2/3 of the three major forces that drive most economic activity:

  1. The short-term debt cycle.
  2. The long-term debt cycle.

Now, let’s look at each in detail.

The Short-Term Debt Cycle (lasts 5–8 years)

This is commonly called The Business Cycle.

This cycle is primarily controlled by The Central Bank (they increase interest rates during inflation and decrease them during deflation).

That’s all it is!

Sidenote: Remember, inflation means prices are rising. Deflation means prices are lowering.

This cycle is divided into two parts: The Expansion, and the Recession.

Expansion

Here, people are spending money faster than businesses are producing goods.

How can people spend so much? Because they’re borrowing A LOT of money.

“Why?”

Because interest rates are low! Borrowing money is cheap.

However, when too many people buy things, inflation rises. But remember the Central Bank doesn’t like too much inflation.

So what does the Central Bank do? Raise interest rates! That way, people will borrow less.

If they borrow less, they spend less.

If they spend less, businesses make less.

If enough businesses make less money, the economy starts going down (this is also known as a Recession).

Recession

A Recession is an economic contraction within a short-term debt cycle. These are well understood because they happen often (and most of us have experienced them).

Typically, people spend less money, so the economy goes down.

On the good side, prices also go back down (deflation).

Once inflation isn’t an issue anymore, The Central Bank lowers interest rates again.

This will lead the economy to pick back up. People will start borrowing money and buying things (AGAIN).

And so, the cycle repeats itself. Over and over and over again.

Final Note

I want you to notice one thing.

Throughout all this, people never really paid back their debt.

Each cycle begins at a higher level than the last one (see image below).

Yikes. I should have asked Alejandra for a graph instead of designing it myself… But you get the idea!

If a large number of people keep increasing their debt for long-enough, you will have a long-term debt cycle.

Let’s look into it.

The Long-Term Debt Cycle (lasts 50–75 years)

Long-term debt cycles have existed for as long as there has been credit.

Even the Old Testament talks about wiping out debt once every 50 years (they call this the Jubilee year).

What can I say? People and debt go way back. It’s human nature.

This cycle is divided into three parts: The Leveraging, the Deleveraging, and the Reflation.

Yikes… Another graph that could look nicer.

Leveraging (lasts 50+ years)

During this time, the economy experiences several short-term debt cycles.

Meanwhile, debts aren’t being repaid.

Debt burdens get higher and higher because people borrow more and more money.

At some point, people have to repay their debts. So they start spending less money (and the economy starts slowing down).

“Not a problem,” you say. “Just lower interest rates again! That way people will borrow more and the economy will start going up again.”

Normally, that would work.

However, at this point the Central Bank can’t lower interest rates anymore.

“Why?”

Because interest rates hit 0%.

… Uh oh.

Deleveraging (lasts 2–3 years)

A Deleveraging is nothing more than an economic contraction within a long-term debt cycle.

Deleveraging literally means the process of reducing debt burdens (Get it? People are too leveraged so they literally de-leverage… Hehe).

“How can you tell you’re going through a Deleveraging?”

These three things occur together only during a deleveraging:

  1. Interest rates hit 0%.
  2. The Fed’s production and spending of money grows.
  3. Budget deficits explode (aka the government spends more money than they make in taxes).
Sidenote: Why does the fed’s production and spending of money grow? And why do budget deficits explode? Because the government is trying to make up for the decrease in economic activity.

Watch 2008’s deleveraging below:

Sidenote: Wondering where I found these sweet charts? I highly recommend Trading Economics and FRED Economic Data (p.s. I love you Y Charts, but your premium prices are too much for this frugal blogger).

How To End a Deleveraging?

A Deleveraging ends via a mix of four things:

  1. Austerity: People cut their spending so they can pay back their debt. This is usually the first thing to end a deleveraging.
  2. Debt Reduction: Lenders either reduce the amount people owe or increase the time people have to repay their debt. Lenders would rather have a little of something than all of nothing.
  3. Debt Monetization: Typically, the government prints money.
  4. Redistributions of Wealth: Usually, the government raises taxes on the rich. This plus other economic conditions usually leads the rich to lose a tremendous amount of wealth, so they become defensive (Quite often, they do things like move their money out of the country, or illegally dodge taxes). This leads tensions to rise between the rich and the poor. Quite often, the majority of people will move from the Right to the Left.
Sidenote: In fact, there is a saying that says “in booms everyone is a capitalist and in busts everyone is a socialist.”

a. If a Deleveraging is well managed, it’s called a Beautiful Deleveraging.

Even though a deleveraging is a difficult situation, handling it in the best possible way is beautiful.

Austerity, Debt Reduction, and Redistributions of Wealth are Deflationary.

Debt Monetization (printing money) is Inflationary.

Doing too much of any of those things could cause prices to rise or lower uncontrollably. And things would get ugly.

However, if you achieve the right balance between those four things you’ll get a beautiful deleveraging.

b. If a Deleveraging is poorly managed, it can cause a Depression.

If people can’t repay the debt they owe banks, they’ll go bankrupt or “default.”

If banks can’t pay customers, they’ll go bankrupt or “default.”

If people lose the money they had in the banks, they’ll (you guessed it) go bankrupt or “default.”

When people, businesses, and banks go bankrupt or “default,” it’s a severe economic contraction known as a Depression.

The Government will try to redistribute wealth by taxing the rich even more.

At this point, the rich start resenting the poor, and the poor start resenting the rich.

If this continues, social disorder can break out.

Tensions rise within countries. But they can also rise between countries (especially debtor and creditor countries).

This situation can lead to political change that can be extreme.

For example, in 1789 economic tensions led to the French Revolution. The poor resented the rich (which led to Marie Antoinette’s beheading in 1793). And a dictator, Napoleon Bonaparte, came to power.

Another example, in the 1930s economic tension led to the rise of Hitler, war in Europe, and The Great Depression in the US.

Yeah… Scary.

Reflation (lasts 7–10 years)

At this point the economy is still low, but economic activity is picking back up.

Usually, it takes 7–10 years for the economy to return to the same level it was before the Deleveraging.

This is why this phase is known as Lost Decade.

And that’s it for today!

Phew… That was a lot. Today, we learned:

  • What is a “bear” and “bull” market.
  • Why do cycles happen.
  • What is the short-term debt cycle (and how to solve it).
  • What is the long-term debt cycle (and what directions it can take).
  • How do Depressions happen.
  • What conditions allow for dictators to rise to power (and why you should ignore “Utopian” political ideologies).
Sidenote: This was a very simple way of describing something enormously complicated. However, you now have a basic understanding of how the Economy works! Give yourself a HUGE pat on the back!

See you next week (follow the series here to be notified).

Be well.

R

P.S.: Coincidentally, Ray Dalio released his awesome TED Talk last week right after I posted my letter. I find the concept of a “radically transparent” company fascinating. I love knowing my weaknesses (and wish more people helped me figure them out). Ray Dalio’s concept looks like the best way to become the best version of yourself.

P.P.S.: Also, if you haven’t checked out his work yet, his new book comes out next week! I couldn’t be more excited!! 😄


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Since I write about finance, legal jargon is obligatory (because the guys in suits made me). Before following any of my advice, read this disclaimer.

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