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How The Economy Functions: A Summary

By Edited Jan 5, 2016 0 2




It can be said that over the past few years, we have witnessed a number of upheavals in the financial landscape. In September 2008, the iconic financial services firm Lehman Brothers went into bankruptcy protection, under the weight of subprime holdings which were plummeting in value. This was followed by an accelerated decline in world equity markets and in asset prices in general. In the same period, following the freezing of credit markets and the decline in liquidity, the US government commenced the  bailout of numerous institutions which eventually included firms such as AIG and Citigroup. General unemployment spiked and the world economies went into a swoon, as consumers cut consumption and businesses reduced their investments. In a controversial attempt to improve the economy, the US government started to inject liquidity into the economy, by printing money and buying bonds, a move that was euphemistically termed Quantitative Easing. This in turn resulted in a rally in asset prices, to an extent that many observers now regard many asset classes to be in bubble territory.


The challenge is to make sense of what is happening around us. What is the relationship between interest rates and equity markets? How does the money supply affect asset prices?What should we do to prepare for the future? In order to answer these questions, we need to go back to the basics and understand the dynamics that govern the economy.


The modern economy may be likened to a machine. Understanding how this machine functions is key to understanding the economic changes that we see around us and will eventually enable us to respond effectively to a landscape that changes invariably. The economy works like a machine and is essentially made up of many economic transactions that are repeated many times. The combined sum of these transactions constitutes the total economic activity in the country. Transactions are driven by human nature and it is important to understand how economic activity goes through trends and cycles. The three major cycles present are

1) Productivity growth cycle

2) Short term debt cycle

3) Long term debt cycle


Transactions : The basic building block of

the economy

A transaction is defined as a buyer exchanging money or credit for goods, services or financial assets. All economic cycles are driven by transactions. In the later part of this article, we will discuss how transactions play a key role in the three major economic cycles.

The market is defined as buyers and sellers making transactions for the same good or product. Common participants in a market include people like you and I. One notable participant is the Central government, by far the most influential player.


The government may be subdivided into two categories: Central government and the Central bank. The central government collects taxes and interacts with the economy by spending money, while the Central bank controls the flow of money and credit by adjusting interest rates and printing money.


The Role of Credit in the Economy and its

Relationship with Spending

Credit helps borrowers to afford assets which they would have been unable to afford if credit was not available to them. Governments sometimes increase the flow of credit and liquidity in the system to increase spending and boost growth. However, this move sometimes leads to excesses and the formation of asset bubbles which inevitably bursts, resulting in dire outcomes. Prior to the financial crisis in 2008, asset prices enjoyed a good run on the back of low interest rates and easy credit. Housing prices attained unprecedented levels in the U.S. When the bubble burst, property prices went into an accelerated downward spiral, which in turn affected other asset prices. Credit and liquidity all but vanished. The U.S government was eventually obliged to replace the loss of credit with what we now know as Quantitative Easing, which involves increasing the money supply to boost liquidity.


We must bear in mind, however, that credit must be used judiciously in order to achieve the desired results. Ideally, credit should be used to boost productivity and income levels. If credit is used to fuel unnecessary consumption without a view of increasing productivity, it may only serve to increase asset prices and general inflation.


An Introduction to Debt and Debt Cycles

Debt allows us to consume more than we produce. However, we must not forget that the loan has to be repaid sometime in the future. The use of debt thus obliges us to reduce our consumption sometime in the future when the debt is repaid.


To put it in another way, borrowing and debt is simply a way to pull spending forward. To buy something that we can ill afford, we need to spend more than we make. Eventually, we have to pay back the loan by spending less than we make. The availability and use of debt create spending and economic activity which fluctuates. It is at the origin of what we term ‘Debt Cycles’ or ‘Debt Swings’. The magnitude of these cycles often depends on the amount of credit available in the economy.


The Difference bet ween Money and Credit

Money is not the same as Credit. When goods are purchased using money, the transaction is settled immediately. However, when goods are purchased with credit, an asset and a liability is created. For example, when an individual purchases a television set on credit, he is contractually bound to repay the loan sometime in the future. This obligation to repay creates a liability. At the other side, the electronic store acquires a right to demand payment of the debt sometime in the future. This right to collect creates an asset for the store.


Most transactions are fuelled by credit, not money. In fact there is approximately $50 tln of credit and only about $3 tln of money in the economy. For an economy without credit, the only way to increase spending is to increase production. Credit allows incomes to rise faster than productivity in the short run.


Is Credit Good or Bad ?

It depends on the type and purpose of the debt. Debt is desirable if it efficiently allocates resources and allows the borrower to acquire assets that produce income. An example of a good debt is borrowing to buy a tractor to harvest crops for sale, which improves the borrower’s economic prospects. Debt is undesirable if it finances consumption that does not generate returns and cannot be paid back. An example of a bad debt would be financing linked to the purchase of a Television set.


The Short Term Debt Cycle

In the first phase of the short term debt cycle, increased credit causes spending to go up which in turn causes prices to rise. In order to curb inflation, the Central Bank raises interest rates which increase the debt servicing costs. As debt repayments rise and an individual’s spending goes towards debt servicing, they have less money remaining to spend. Spending slows and the same process causes incomes to drop, borrowing to slow and prices to drop. Economic activity decreases and the economy falls into a recession. The Central Bank then lowers interest rates to stimulate borrowing and economic activity and the short term debt cycle repeats itself.


The Long Term Debt Cycle

In the short term debt cycle, even though spending rises and drops in every cycle, we should note that the peak and trough of the cycle as it repeats itself gets higher and higher. In other words, for every successive short term cycle, the maximum spending level reached gets higher and higher while the minimum spending level reached gets higher as well.

By nature, borrowers tend not to repay debt fully. Lenders also tend to focus on the present. Their short sighted nature causes them to lend more and more, as asset values and incomes continue to rise. Even as debt levels increase, incomes continue to go up as fast to offset the rise in debt. This means that borrowers often remain creditworthy even as total debt levels increase. The ratio of debt to income is known as the debt burden. Debt burdens are manageable if incomes continue to rise as people borrow money to buy assets, causing prices to rise even more. So even with rising debts, the rise in asset prices and the rise in incomes help borrowers to remain solvent.

Does this process go on forever? Definitely not. A larger debt burden results in larger debt repayments which becomes a problem when these repayments grow faster than income levels, forcing a reduction in spending. As spending decreases, income levels decrease. General credit worthiness decreases as debt repayments continue to hold or increase. This causes a downward spiral where people cut spending, incomes fall, credit markets tighten and asset prices drop. Statistical studies have shown that in the United States, long term debt peaked in 1929 and 2008.


Deleveraging : Sol ving the Long Term Debt Crisis

As the long term debt crisis is fuelled by an unsustainable debt burden, central banks cannot simply lower interest rates to boost spending and the economy. This is especially so if interest rates are already close to 0%. Interest rates last hit 0% in the 1930s and 2008. In the earlier part of the article, we discussed the concept of recessions in a short term debt cycle which may be overcome by interest rate stimulus. However, in a deleveraging process, the underlying cause is an unsustainable debt burden. We believe the world is currently in a deleveraging phase where governments are using Austerity, Debt forgiveness, Wealth redistribution and Money Printing to boost economic growth and reduce the risk of asset price deflation.


Responding to a Deleveraging Situation

There are four ways to deal with a deleveraging situation.

They are

1) Spending Cuts (Austerity)

2) Debt Forgiveness

3) Wealth Redistribution

4) Increase in Money Supply (a.k.a. Money Printing)

1. Austerity

In an austerity drive, spending is cut with the aim of reducing the overall debt burden. However, because cutting spending reduces income levels (since one person’s spending is another person’s income), there is a risk that income may decline faster than the rate at which debt is repaid. This creates undesirable side effects like high unemployment and a deflationary environment. A recent example is the austerity program in Greece, whereunemployment stands at about 27 percent.

2. Debt Forgiveness

In a debt restructuring, lenders write off a portion of the debt or allow borrowers to make repayments over a longer period of time. A key downside of this solution is that if borrowers are allowed to default on their obligations, it may result in a widespread loss of confidence. In the case of a bank, if borrowers are allowed not to repay their loans, bank depositors may worry about the security of their deposits and may grow more hesitant about depositing money with the bank.

 The problem with debt restructuring, as in austerity, is that it causes asset values to decline. When asset prices decline, the debt burden worsens. Remember that the debt burden is defined as the ratio of debt to income. Debt forgiveness is thus also painful and deflationary.

Another negative side effect of debt forgiveness is that the asset price decline lowers incomes and results in greater unemployment. For the government, this means that the amount of taxes collected goes down. At the same time, it is forced to increase social spending. The concurrent increase in spending and reduction in tax receipts result in a deficit. When the government incurs a deficit, it often resorts to tax increases to raise revenue, which brings us to the next solution known as Wealth Redistribution.


3. Wealth Redistribution

Wealth redistribution is often defined by raising taxes on the wealthy. The poor often resent the Rich for their resources, and politicians are often quick to capitalise on this fact by announcing populist initiatives. The problem with Wealth Redistribution is that it engenders resentment among the rich and poor. The poor remain envious of the rich, while the rich resent the poor for the higher taxes.


4. Printing Money

Out of the four approaches, increasing the money supply is the only method which is inflationary and simulative. Mass money printing occurred during the great depression in the 1930s and more recently in 2008, where up to $2 tln were printed. The exercise typically involves the Central Bank printing money to buy financial assets, which has the effect of raising overall prices. But how can this money reach the general economy? Remember that the Central Bank can print money but can only use it to buy financial assets. The Central Government, on the other hand, can buy goods and services in the general economy but is unable to print money. To get around this problem, the central government normally issues bonds which are purchased by the Central bank. The most recent example of Money Printing is the Quantitative Easing program undertaken by the U.S government. The program has been widely criticized for causing destabilising fund flows to emerging economies and for causing asset price bubbles. However, we must be mindful that the QE program played a key role in providing emergency credit which replaced the loss of liquidity when credit markets froze over.



One question remains unanswered: Where are we in the economic cycle? While it is impossible for anybody to pinpoint the exact stage of the economic cycle that we are in, it is highly probable that we are in the deleveraging phase of the long term debt cycle. With interest rates currently close to zero, central banks around the world no longer have the means to stimulate the economy through lower rates. At the same time, many European economies are struggling with unsustainable levels of sovereign debt which continues to weigh on public spending and consumer confidence, which in turn exerts downward pressure on incomes.

While the economic model does not purport to solve all the problems that we may face, it allows us to identify the stage of the cycle that we’re in and to make tactical decisions in managing our portfolio.

This article is inspired by “How the Economic Machine Works” by Ray Dalio, Founder of Bridgewater Associates.


Jul 27, 2014 12:48pm
very interesting article
Jan 13, 2015 9:19pm
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  1. "How the Economic Machine Works." How the Economic Machine Works. 14/07/2014 <Web >

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