How The Economy Works Flashcards

Question

An economy without credit can only grow through…

Answer 1

Increased productivity

Answer 2

Both increased productivity and borrowing An economy with credit has more spending and can allow incomes to grow faster than productivity over the short run but not over the long run UNLESS you use it to acquire assets/knowledge that help you increase your income to pay back the debt AND improve your living standards! 💵👍

Answer 3

Phase 1 - EXPANSION, due to increased ability to spend after borrowing. 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… (people have more money so why not charge them more 🧏🏾‍♂️) When prices rise we call this INFLATION. The central bank doesn’t want too much inflation because it causes problems. When it sees prices rise too high, it raises interest rates. With higher interest rates fewer people can afford to borrow money and the cost of “existing debts” rises. And when people borrow less and have higher debt repayments they have less money left over to spend AND SO spending slows down and since one persons spending is another person’s income… incomes drop 🔄 When people spend less prices go down which is called 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 lower interest rates, debt repayments are reduced and borrowing and spending pick up again and we see another expansion. When credit is easily available there is an economic expansion When credit isn’t easily available there is a recession The short term debt cycle usually lasts only 5-8 years and happens over and over again for decades. Yet the bottom and the top of each cycle finish with more growth than the previous cycle and with more debt. Why? Because people push it… they have an inclination of borrowing and spending more without paying it back. It’s human nature… Because of this over long periods of time debts rise FASTER than incomes creating the LONG TERM DEBT CYCLE.

Answer 4

When people have been spending a lot of borrowed money on goods, services, and financial assets… even though debts have been growing incomes have been growing nearly as fast to offset them… The ratio of debts to incomes = debt burden… So as long as incomes continue to rise the debt burden stays manageable and at the same time asset values soar. 🧏🏾‍♂️ People borrow huge money to buy assets as investments causing their prices to rise even higher (people feel wealthy)… so therefore even with the accumulation of lots of debt, rising incomes, and asset values help borrowers remain creditworthy for a long time… BUT OBVIOUSLY IT CANNOT LAST FOREVER… At some point debt repayments grow faster than incomes forcing people to cut back on their spending and since one person’s spending is another person’s income, incomes begin going down which makes people less credit worthy causing borrowing to go down… debt repayments continue to rise which makes spending drop even further and the cycle reverses itself, THE BUBBLE POPS… 🫧

Answer 5

United States in 2008 and 1929

Answer 6

It happens at the peak of an economic bubble where spending dramatically stops and thus incomes decrease and in effect people borrow less which also reduces incomes and spending. Asset prices drop, banks get squeezed, the stock market crashes, social tensions rise and the whole momentum goes negative… Incomes fall while debt repayments rise and borrowers get squeezed and are no longer credit worthy. Credit dries up and borrowers can no longer borrow enough money to make their debt repayments…. As borrowers scramble to refill this whole they rush to SELL assets at the same time “spending falls”… (when the stock market crashes, the real estate market collapses, and banks get into trouble) As asset prices drop, the value of the collateral borrowers can put up drops. Which makes borrowers even less credit worthy. People feel poorer, credit rapidly disappears… less spending, less wealth, less credit, less borrowing 🔄 This appear similar to a recession but the difference is INTEREST RATES CANNOT BE LOWERED TO “SAVE THE DAY” 🧏🏾‍♂️🗝 In a recession lowering interest rates works to stimulate the borrowing. However in a deleveraging, lowering interest rates doesn’t work because interest rates are already low…

Answer 7

In a deleveraging, borrowers debt burdens have simply gotten too big and cannot be relieved by lowering interest rates. Lenders realize that debts have become too large 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 and don’t even want more. Lenders stop lending, borrowers stop borrowing and you now have an ECONOMY THAT IS NOT CREDIT WORTHY just like an individual.

Answer 8

The problem is, debt burdens are too high and they must come down…. There are 4 ways this can happen: 1. People, businesses and governments cut their spending (usually this happens first) commonly called “austerity” - but the issue is one man’s spending is another man’s income and it makes the problem of debt repayment worse… and causes deflation, less jobs and higher unemployment. 2. Debts are reduced through defaults and restructurings 3. Wealth is redistributed from the haves to the have nots 4. The central bank prints new money These 4 things have happened in every deleveraging in modern history.

Answer 9

When a borrower doesn’t repay the bank, people get nervous that the bank won’t be able to repay them so they make a “run on the bank” to get their money back before it’s gone SO THE BANKS GET SQUEEZED and people, businesses and banks default on their debts. THIS TYPE OF ECONOMIC CONTRACTION IS CALLED A “DEPRESSION” (what people thought of as their wealth greatly depreciated and is no longer)… Instead of getting back the full amount banks settle for getting paid back less or getting paid back over a longer timeframe or at a lower interest rate than first agreed… better to have a little of something than all of nothing… while this lowers debt repayments it still reduces income and is ultimately still deflationary.

Answer 10

Lower incomes and less employment means the government collects fewer taxes while at the same time needing to increase its spending because unemployment has risen… and 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. The government’s “budget deficit” explodes during a deleveraging because they spend more than they earn in taxes. To fund their deficits, governments either need to raise their taxes or borrow money… but with incomes falling and so many unemployed, who’s 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 governments 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 begin to resent the wealthy have’s and while the wealthy “haves” begin getting 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. Tension can not only rise within countries but between countries (especially debtor and creditor countries). This situation can sometimes lead to political change that can sometimes be extreme. For example in the 1930’s this lead to Hitler coming to power, war in Europe , and a depression in the U.S.

Answer 11

Unlike cutting spending, debt reduction, and wealth redistribution…. Printing money is inflationary and stimulative… the Central Bank prints money out of thin air and uses it to buy financial assets and government bonds… It happened in the Great Depression, and also during 2008. In buying financial assets it helps drive up asset prices which makes people more credit worthy. HOWEVER, this only helps those who own financial assets 🧏🏾‍♂️ The central bank can print money but it can only buy financial assets but 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 2 must cooperate… by buying government bonds… the central bank essentially lends money to the central government allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits. This increase peoples income as well as the government’s debt. However it will lower the economy’s total debt burden. This is a very risky time… policy makers must balance the 4 ways that debt burdens come down (inflationary one: printing money, balanced with the deflationary ones: reduce spending, reduce debt, wealth transfer) If the deflationary strategies are balanced well with the inflationary money printing there can be a beautiful deleveraging ⚖️

Answer 12

It can but it won’t if it “offsets” falling credit (people not borrowing and owing more than they earn - because 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…

Answer 13

In order for the central bank 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. Income must grow faster than the debt+interest. Yet printing money can easily be abused because it’s so easy to do and people prefer it to the alternatives. The key is to not print too much money to avoid unacceptably high inflation. (Germany made that mistake in the 1920s)

Answer 14

Policy makers achieve the right balance of deflationary activities (reduce spending, reduce debts, wealth transfer) and inflationary activity (printing more money)… growth will be slow but the debt burdens will go down. Incomes begin to rise, borrowers begin to appear more credit worthy, and now lenders want to lend money again to them. Debt burdens begin to fall and people are able to borrow money to spend more and eventually the economy begins to grow again leading to the REFLATIONARY PHASE of the long term debt cycle…. It takes roughly 10+ years for debt burdens to fall and economic activity to get back to normal. (Hence the term “lost decade” - derived from when this happened to Japan from 1991-2001)

Answer 15

Don’t have debt rise faster than income.

Answer 16

Don’t have income rise faster than productivity. Because you’ll eventually become uncompetitive.

Answer 17

Do all that you can to increase productivity because in the long run that’s what matters most.