Navigating Economic Cycles: A Guide to Understanding Productivity, Debt, and Growth

Table of Contents

• The Building Blocks of the Economy: Transactions and the Flow of Money
• The Short-Term Debt Cycle: Expansions, Recessions, and the Central Bank
• The Long-Term Debt Cycle: Leveraging, Deleveraging, and Lost Decades
• The Interplay of Productivity, Debt Cycles, and Policy Responses

The Building Blocks of the Economy: Transactions and the Flow of Money

The economy is made up of transactions between buyers and sellers. A transaction occurs when a buyer exchanges money or credit for goods, services, or financial assets from a seller. Credit can be used just like money, so adding together money spent and credit spent gives the total spending in the economy. The total spending drives economic activity - it is the fuel that powers the economic engine.

The price of something is determined by dividing the total amount spent by the total quantity sold in the market. Markets consist of all the buyers and sellers transacting for a particular item, like the wheat market or stock market. An economy is the sum of all transactions occurring in all of its markets.

People, businesses, banks, and governments all engage in transactions as buyers and sellers. The biggest buyer and seller is the central government, which collects taxes and spends money, and the central bank, which controls the money supply and interest rates. The central bank does this by printing new money and influencing interest rates. This makes it an important player in the flow of credit.

What Drives Economic Activity

Economic activity is ultimately driven by transactions between buyers and sellers. More transactions means more spending, which increases incomes and consumption in a virtuous cycle. Understanding transactions provides insight into the mechanics of the whole economy.

The Vital Role of Credit and Debt

Credit is a critical component of the economy that is often poorly understood. It allows spending to increase beyond what incomes alone would permit. When a borrower receives credit, they can spend more than they earn. Their spending then becomes income for someone else. Credit is created whenever a borrower and lender agree to a loan. The borrower promises to repay the principal plus interest. This creates debt - an asset for the lender and a liability for the borrower. When the loan is repaid, the debt disappears. Since credit boosts spending beyond productivity, it drives cycles of economic expansion and contraction. Managing credit properly is crucial to maintaining stability.

The Short-Term Debt Cycle: Expansions, Recessions, and the Central Bank

As economic activity increases during an expansion, spending is fueled by easily available credit. Prices rise due to increased spending and incomes growing faster than production. This inflation leads the central bank to raise interest rates.

Higher interest rates reduce borrowing and spending, causing incomes to drop. Lower spending leads to lower prices, called deflation. This economic contraction is a recession. If it becomes severe, the central bank will lower interest rates to stimulate borrowing and spending again.

This short-term debt cycle of expansion and recession typically lasts 5-8 years. The cycles recur but finish each time with higher growth and debt than the previous cycle. This is because people have an inclination to borrow and spend more rather than pay down debts.

How Borrowing Fuels Growth in the Short Run

Borrowing allows spending to exceed incomes, boosting economic activity. When one person's spending becomes another's income, it enables more borrowing and spending in turn. This self-reinforcing pattern is why short-term debt cycles occur.

Inflation, Deflation, and the Levers of Monetary Policy

Inflation results from too much spending relative to production capacity. Deflation is the reverse. By adjusting interest rates and the money supply, the central bank tries to steer between these extremes. Lower rates stimulate borrowing, higher rates restrict it.

The Long-Term Debt Cycle: Leveraging, Deleveraging, and Lost Decades

Over decades, incomes can rise faster than productivity due to increased leverage. But debts cannot outpace incomes forever. At some point, debt burdens become too heavy, spending declines and deleveraging begins.

In deleveraging, defaults and restructuring reduce debt burdens. Assets decline and painful austerity can result. Deleveraging can take a decade or more as the economy slowly rebalances.

If handled properly, with the right mix of policies, the deleveraging process can reduce debt burdens without major instability. This is termed a 'beautiful deleveraging'.

The Accumulation of Debt Over Time

As borrowing increases over decades, debt burdens rise faster than incomes. Lenders extend more credit because asset values and incomes are still rising. This buildup of leverage creates fragility.

When Burdens Become Too Heavy to Bear

Eventually debts grow too large relative to incomes. Borrowers cut spending, credit tightens, and the cycle reverses. The deleveraging phase brings austerity and falling asset values.

The Painful Process of Debt Reduction

In deleveraging, defaults, restructuring, and reduced spending shrink credit. Asset prices fall and unemployment rises. Time and the right policy mix are required to restore stability.

The Interplay of Productivity, Debt Cycles, and Policy Responses

Productivity is the most important driver of long-run economic growth. But credit cycles create volatility around the productivity trendline.

By understanding these cycles, individuals can manage their borrowing prudently. Policy makers can pursue balanced responses that smooth out the booms and busts.

Why Understanding These Cycles Matters

Productivity growth determines the economy's capacity, while credit cycles create unsustainable swings above and below that trend. Recognizing this interplay leads to wiser decision making.

Rules of Thumb for Individuals and Policy Makers

For individuals, don't let debts grow faster than income. For policy makers, allow incomes to rise faster than debt burdens while preventing excessive inflation.

FAQ

Q: What causes economic expansions and recessions?
A: The availability of credit drives cycles of expansion and recession in the short-term debt cycle. When credit is readily available, borrowing and spending increase, fueling growth. When credit tightens, spending falls, incomes drop, and the economy contracts.

Q: What triggers a financial crisis?
A: Over long periods of time, debt burdens can become dangerously high relative to incomes. When growth in the real economy no longer keeps pace with growing debt repayments, borrowers cut back spending, defaults rise, and a financial crisis can occur.

Q: What can policy makers do about economic crises?
A: Central banks can lower interest rates to stimulate borrowing or print money to stabilize asset prices, incomes, and spending power. Fiscal policy makers can also run deficits to support incomes.