| The economy works like a simple machine. |
| But many people don't understand it |
| — or they don't agree on how it works |
| — and this has led to a lot of needless economic suffering. |
| I feel a deep sense of responsibility |
| to share my simple but practical economic template. |
| Though it's unconventional, |
| it has helped me to anticipate and sidestep the global financial crisis, |
| and has worked well for me for over 30 years. |
| Let's begin. |
| Though the economy might seem complex, it works in a simple, mechanical way. |
| It's made up of a few simple parts and a lot of simple transactions |
| that are repeated over and over again a zillion times. |
| These transactions are above all else driven by human nature, |
| and they create 3 main forces that drive the economy. |
| Number 1: Productivity growth |
| Number 2: The Short term debt cycle |
| and Number 3: The Long term debt cycle |
| We'll look at these three forces and how laying them on top of each other |
| creates a good template for tracking economic movements |
| and figuring out what's happening now. |
| Let's start with the simplest part of the economy: |
| Transactions. |
| An economy is simply the sum of the transactions that make it up |
| and a transaction is a very simple thing. |
| You make transactions all the time. |
| Every time you buy something you create a transaction. |
| Each transaction consists of a buyer |
| exchanging money or credit |
| with a seller for goods, services or financial assets. |
| Credit spends just like money, |
| so adding together the money spent and the amount of credit spent, |
| you can know the total spending. |
| The total amount of spending drives the economy. |
| If you divide the amount spent |
| by the quantity sold, |
| you get the price. |
| And that's it. That's a transaction. |
| It is the building block of the economic machine. |
| All cycles and all forces in an economy are driven by transactions. |
| So, if we can understand transactions, |
| we can understand the whole economy. |
| A market consists of all the buyers |
| and all the sellers |
| making transactions for the same thing. |
| For example, there is a wheat market, |
| a car market, |
| a stock market |
| and markets for millions of things. |
| An economy consists of all of the transactions |
| in all of its markets. |
| If you add up the total spending |
| and the total quantity sold |
| in all of the markets, |
| you have everything you need to know |
| to understand the economy. |
| It's just that simple. |
| People, businesses, banks and governments |
| all engage in transactions the way I just described: |
| exchanging money and credit for goods, services and financial assets. |
| The biggest buyer and seller is the government, |
| which consists of two important parts: |
| a Central Government that collects taxes and spends money... |
| ...and a Central Bank, |
| which is different from other buyers and sellers because it |
| controls the amount of money and credit in the economy. |
| It does this by influencing interest rates |
| and printing new money. |
| For these reasons, as we'll see, |
| the Central Bank is an important player in the flow |
| of Credit. |
| I want you to pay attention to credit. |
| Credit is the most important part of the economy, |
| and probably the least understood. |
| It is the most important part because it is the biggest |
| and most volatile part. |
| Just like buyers and sellers go to the market to make transactions, |
| so do lenders and borrowers. |
| Lenders usually want to make their money into more money |
| and borrowers usually want to buy something they can't afford, |
| like a house or car |
| or they want to invest in something like starting a business. |
| Credit can help both lenders |
| and borrowers get what they want. |
| Borrowers promise to repay the amount they borrow, |
| called the principal, |
| plus an additional amount, called interest. |
| When interest rates are high, |
| there is less borrowing because it's expensive. |
| When interest rates are low, |
| borrowing increases because it's cheaper. |
| When borrowers promise to repay |
| and lenders believe them, |
| credit is created. |
| Any two people can agree to create credit out of thin air! |
| That seems simple enough but credit is tricky |
| because it has different names. |
| As soon as credit is created, |
| it immediately turns into debt. |
| Debt is both an asset to the lender, |
| and a liability to the borrower. |
| In the future, |
| when the borrower repays the loan, plus interest, |
| the asset and liability disappear |
| and the transaction is settled. |
| So, why is credit so important? |
| Because when a borrower receives credit, |
| he is able to increase his spending. |
| And remember, spending drives the economy. |
| This is because one person's spending |
| is another person's income. |
| Think about it, every dollar you spend, someone else earns. |
| and every dollar you earn, someone else has spent. |
| So when you spend more, someone else earns more. |
| When someone's income rises |
| it makes lenders more willing to lend him money |
| because now he's more worthy of credit. |
| A creditworthy borrower has two things: |
| the ability to repay and collateral. |
| Having a lot of income in relation to his debt gives him the ability to repay. |
| In the event that he can't repay, he has valuable assets to use as collateral that can be sold. |
| This makes lenders feel comfortable lending him money. |
| So increased income allows increased borrowing |
| which allows increased spending. |
| And since one person's spending is another person's income, |
| this leads to more increased borrowing and so on. |
| This self-reinforcing pattern leads to economic growth |
| and is why we have Cycles. |
| In a transaction, you have to give something in order to get something |
| and how much you get depends on how much you produce |
| over time we learned |
| and that accumulated knowledge raises are living standards |
| we call this productivity growth |
| those who were invented and hard-working raise |
| their productivity and their living standards faster |
| than those who are complacent and lazy, |
| but that isn't necessarily true over the short run. |
| Productivity matters most in the long run, but credit matters most in the short run. |
| This is because productivity growth doesn't fluctuate much, |
| so it's not a big driver of economic swings. |
| Debt is — because it allows us to consume more than we produce when we acquire it |
| and it forces us to consume less than we produce when we pay it back. |
| Debt swings occur in two big cycles. |
| One takes about 5 to 8 years and the other takes about 75 to 100 years. |
| While most people feel the swings, they typically don't see them as cycles |
| because they see them too up close -- day by day, week by week. |
| In this chapter we are going to step back and look at these three big forces |
| and how they interact to make up our experiences. |
| As mentioned, swings around the line are not due to how much innovation or hard work there is, |
| they're primarily due to how much credit there is. |
| Let's for a second imagine an economy without credit. |
| In this economy, the only way I can increase my spending |
| is to increase my income, |
| which requires me to be more productive and do more work. |
| Increased productivity is the only way for growth. |
| Since my spending is another person's income, |
| the economy grows every time I or anyone else is more productive. |
| If we follow the transactions and play this out, |
| we see a progression like the productivity growth line. |
| But because we borrow, we have cycles. |
| This isn't due to any laws or regulation, |
| it's due to human nature and the way that credit works. |
| Think of borrowing as simply a way of pulling spending forward. |
| In order to buy something you can't afford, you need to spend more than you make. |
| To do this, you essentially need to borrow from your future self. |
| In doing so you create a time in the future |
| that you need to spend less than you make in order to pay it back. |
| It very quickly resembles a cycle. |
| Basically, anytime you borrow you create a cycle.? |
| This is as true for an individual as it is for the economy. |
| This is why understanding credit is so important |
| because it sets into motion |
| a mechanical, predictable series of events that will happen in the future. |
| This makes credit different from money. |
| Money is what you settle transactions with. |
| When you buy a beer from a bartender with cash, |
| the transaction is settled immediately. |
| But when you buy a beer with credit, |
| it's like starting a bar tab. |
| You're saying you promise to pay in the future. |
| Together you and the bartender create an asset and a liability. |
| You just created credit. Out of thin air. |
| It's not until you pay the bar tab later |
| that the asset and liability disappear, |
| the debt goes away |
| and the transaction is settled. |
| The reality is that most of what people call money is actually credit. |
| The total amount of credit in the United States is about $50 trillion |
| and the total amount of money is only about $3 trillion. |
| Remember, in an economy without credit: |
| the only way to increase your spending is to produce more. |
| But in an economy with credit, |
| you can also increase your spending by borrowing. |
| As a result, an economy with credit has more spending |
| and allows incomes to rise faster than productivity over the short run, |
| but not over the long run. |
| Now, don't get me wrong, |
| credit isn't necessarily something bad that just causes cycles. |
| It's bad when it finances over-consumption that can't be paid back. |
| However, it's good when it efficiently allocates resources |
| and produces income so you can pay back the debt. |
| For example, if you borrow money to buy a big TV, |
| it doesn't generate income for you to pay back the debt. |
| But, if you borrow money to buy a tractor — |
| and that tractor let's you harvest more crops and earn more money |
| — then, you can pay back your debt |
| and improve your living standards. |
| In an economy with credit, |
| we can follow the transactions |
| and see how credit creates growth. |
| Let me give you an example: |
| Suppose you earn $100,000 a year and have no debt. |
| You are creditworthy enough to borrow $10,000 dollars |
| - say on a credit card |
| - so you can spend $110,000 dollars |
| even though you only earn $100,000 dollars. |
| Since your spending is another person's income, |
| someone is earning $110,000 dollars. |
| The person earning $110,000 dollars |
| with no debt can borrow $11,000 dollars, |
| so he can spend $121,000 dollars |
| even though he has only earned $110,000 dollars. |
| His spending is another person's income |
| and by following the transactions |
| we can begin to see how this process |
| works in a self-reinforcing pattern. |
| But remember, borrowing creates cycles |
| and if the cycle goes up, it eventually needs to come down. |
| This leads us into the Short Term Debt Cycle. |
| As economic activity increases, we see an expansion |
| - the first phase of the short term debt cycle. |
| 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. |
| When prices rise, we call this inflation. |
| The Central Bank doesn't want too much inflation |
| because it causes problems. |
| Seeing prices rise, it raises interest rates. |
| With higher interest rates, fewer people can afford to borrow money. |
| And the cost of existing debts rises. |
| Think about this as the monthly payments on your credit card going up. |
| Because people borrow less and have higher debt repayments, |
| they have less money leftover to spend, so spending slows |
| ...and since one person's spending is another person's income, |
| incomes drop...and so on and so forth. |
| When people spend less, prices go down. |
| We call this 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 low interest rates, |
| debt repayments are reduced |
| and borrowing and spending pick up |
| and we see another expansion. |
| As you can see, the economy works like a machine. |
| In the short term debt cycle, spending is constrained only by the willingness of |
| lenders and borrowers to provide and receive credit. |
| When credit is easily available, there's an economic expansion. |
| When credit isn't easily available, there's a recession. |
| And note that this cycle is controlled primarily by the central bank. |
| The short term debt cycle typically lasts 5 - 8 years |
| and happens over and over again for decades. |
| But notice that the bottom and |
| 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 to borrow and spend more instead of paying back debt. |
| It's human nature. |
| Because of this, |
| over long periods of time, |
| debts rise faster than incomes |
| creating the Long Term Debt Cycle. |
| Despite people becoming more indebted, |
| lenders even more freely extend credit. |
| Why? |
| Because everybody thinks things are going great! |
| People are just focusing on what's been happening lately. |
| And what has been happening lately? |
| Incomes have been rising! |
| Asset values are going up! |
| The stock market roars! |
| It's a boom! |
| It pays to buy goods, services, and financial assets |
| with borrowed money! |
| When people do a lot of that, we call it a bubble. |
| So even though debts have been growing, |
| incomes have been growing nearly as fast to offset them. |
| Let's call the ratio of debt-to-income the debt burden. |
| So long as incomes continue to rise, |
| the debt burden stays manageable. |
| At the same time asset values soar. |
| People borrow huge amounts of money |
| to buy assets as investments |
| causing their prices to rise even higher. |
| People feel wealthy. |
| So even with the accumulation of lots of debt, |
| rising incomes and asset values help borrowers remain creditworthy for a long time. |
| But this obviously can not continue forever. |
| And it doesn't. |
| Over decades, debt burdens slowly increase creating larger and larger debt repayments. |
| At some point, debt repayments start growing faster than incomes |
| forcing people to cut back on their spending. |
| And since one person's spending is another person's income, |
| incomes begin to go down... |
| ...which makes people less creditworthy causing borrowing to go down. |
| Debt repayments continue to rise |
| which makes spending drop even further... |
| ...and the cycle reverses itself. |
| This is the long term debt peak. |
| Debt burdens have simply become too big. |
| For the United States, Europe and much of the rest of the world this |
| happened in 2008. |
| It happened for the same reason it happened in Japan in 1989 |
| and in the United States back in 1929. |
| Now the economy begins Deleveraging. |
| In a deleveraging; people cut spending, |
| incomes fall, credit disappears, |
| assets prices drop, banks get squeezed, |
| the stock market crashes, social tensions rise |
| and the whole thing starts to feed on itself the other way. |
| As incomes fall and debt repayments rise, |
| borrowers get squeezed. No longer creditworthy, |
| credit dries up and borrowers can no longer borrow enough money to make their |
| debt repayments. |
| Scrambling to fill this hole, borrowers are forced to sell assets. |
| The rush to sell assets floods the market |
| This is when the stock market collapses, |
| the real estate market tanks and banks get into trouble. |
| As asset prices drop, the value of the collateral borrowers can put up drops. |
| This makes borrowers even less creditworthy. |
| People feel poor. |
| Credit rapidly disappears. Less spending › |
| less income › |
| less wealth › |
| less credit › |
| less borrowing and so on. |
| It's a vicious cycle. |
| This appears similar to a recession but the difference here |
| is that interest rates can't 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 and soon hit 0% - so the stimulation ends. |
| Interest rates in the United States hit 0% during the deleveraging of |
| the 1930s |
| and again in 2008. |
| The difference between a recession |
| and a deleveraging is that in a deleveraging borrowers' debt burdens have |
| simply gotten too big |
| and can't be relieved by lowering interest rates. |
| Lenders realize that debts have become 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 - they don't even want more! |
| Lenders stop lending. Borrowers stop borrowing. |
| Think of the economy as being not-creditworthy, |
| just like an individual. |
| So what do you do about a deleveraging? |
| The problem is debt burdens are too high and they must come down. |
| There are four ways this can happen. |
| 1. people, businesses, and governments cut their spending. |
| 2. debts are reduced through defaults and restructurings. |
| 3. wealth is redistributed from the 'haves' to the 'have nots'. |
| and finally, 4. the central bank prints new money. |
| These 4 ways have happened in every deleveraging in modern history. |
| Usually, spending is cut first. |
| As we just saw, people, businesses, banks and even governments tighten their belts and |
| cut their spending so that they can pay down their debt. |
| This is often referred to as austerity. |
| When borrowers stop taking on new debts, |
| and start paying down old debts, you might expect the debt burden to decrease. |
| But the opposite happens! Because spending is cut |
| - and one man's spending is another man's income - it causes |
| incomes to fall. They fall faster than debts are repaid |
| and the debt burden actually gets worse. As we've seen, |
| this cut in spending is deflationary and painful. |
| Businesses are forced to cut costs... |
| which means less jobs and higher unemployment. |
| This leads to the next step: debts must be reduced! |
| Many borrowers find themselves unable to repay their loans |
| — and a borrower's debts are a lender's assets. |
| When borrowers don't repay the bank, people get nervous that the bank won't |
| be able to repay them |
| so they rush to withdraw their money from the bank. Banks get squeezed and |
| people, |
| businesses and banks default on their debts. This severe |
| economic contraction is a depression. |
| A big part of a depression is people discovering much of what they thought |
| was their wealth isn't really there. |
| Let's go back to the bar. |
| When you bought a beer and put it on a bar tab, |
| you promised to repay the bartender. Your promise became an asset of the bartender. |
| But if you break your promise - if you don't pay him back and essentially default |
| on your bar tab - |
| then the 'asset' he has isn't really worth anything. |
| It has basically disappeared. |
| Many lenders don't want their assets to disappear and agree to debt |
| restructuring. |
| Debt restructuring means lenders get paid back |
| less or get paid back over a longer time frame |
| or at a lower interest rate that was first agreed. Somehow |
| a contract is broken in a way that reduces debt. Lenders would rather have a |
| little of something than all of nothing. |
| Even though debt disappears, debt restructuring causes |
| income and asset values to disappear faster, |
| so the debt burden continues to gets worse. |
| Like cutting spending, debt reduction |
| is also painful and deflationary. |
| All of this impacts the central government because lower incomes and less employment |
| means the government collects fewer taxes. |
| At the same time it needs to increase its spending because unemployment has risen. |
| 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. |
| Governments' budget deficits explode in a |
| deleveraging because they spend more than they earn in taxes. |
| This is what is happening when you hear about the budget deficit on the news. |
| To fund their deficits, governments need to either raise taxes |
| or borrow money. But with incomes falling and so many unemployed, |
| who is 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,' who are suffering, begin to |
| resent the wealthy 'haves.' |
| The wealthy 'haves,' being squeezed by the weak economy, falling asset prices, |
| higher taxes, begin to resent the 'have nots.' |
| If the depression continues social disorder can break out. |
| Not only do tensions rise within countries, |
| they can rise between countries - especially debtor and creditor countries. |
| This situation can lead to political change |
| that can sometimes be extreme. |
| In the 1930s, this led to Hitler coming to power, |
| war in Europe, and depression in the United States. Pressure to do something |
| to end the depression increases. |
| Remember, most of what people thought was money was actually credit. |
| So, when credit disappears, people don't have enough money. |
| People are desperate for money and you remember who can print money? |
| The Central Bank can. |
| Having already lowered its interest rates to nearly 0 |
| - it's forced to print money. Unlike cutting spending, |
| debt reduction, and wealth redistribution, |
| printing money is inflationary and stimulative. Inevitably, the central bank |
| prints new money |
| — out of thin air — and uses it to buy financial assets |
| and government bonds. It happened in the United States during the Great Depression |
| and again in 2008, when the United States' central bank — |
| the Federal Reserve — printed over two trillion dollars. |
| Other central banks around the world that could, printed a lot of money, too. |
| By buying financial assets with this money, |
| it helps drive up asset prices which makes people more creditworthy. |
| However, this only helps those who own financial assets. |
| You see, the central bank can print money but it can only buy financial assets. |
| 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 two |
| must cooperate. |
| By buying government bonds, the Central Bank essentially lends money to the |
| government, |
| allowing it to run a deficit and increase spending |
| on goods and services through its stimulus programs |
| and unemployment benefits. This increases people's 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 need to balance the four ways that debt |
| burdens come down. |
| The deflationary ways need to balance with the inflationary ways in |
| order to maintain stability. |
| If balanced correctly, there can be a |
| Beautiful Deleveraging. |
| You see, a deleveraging can be ugly or it can be beautiful. |
| How can a deleveraging be beautiful? |
| Even though a deleveraging is a difficult situation, |
| handling a difficult situation in the best possible way is beautiful. |
| A lot more beautiful than the debt-fueled, unbalanced excesses of the |
| leveraging phase. In a beautiful deleveraging, |
| debts decline relative to income, real economic growth is positive, |
| and inflation isn't a problem. It is achieved by having the right balance. |
| The right balance requires a certain mix |
| of cutting spending, reducing debt, transferring wealth |
| and printing money so that economic and social stability can be maintained. |
| People ask if printing money will raise inflation. |
| It won't if it offsets falling credit. Remember, 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. |
| In order 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. |
| So, what do I mean by that? Basically, |
| income needs to grow faster than debt grows. For example: |
| let's assume that a country going through a deleveraging has a debt-to- |
| income ratio of 100%. |
| That means that the amount of debt it has is the same as the amount of income the |
| entire country makes in a year. |
| Now think about the interest rate on that debt, |
| let's say it is 2%. |
| If debt is growing at 2% because of that interest rate and |
| income |
| is only growing at around only 1%, you will never reduce the debt burden. |
| You need to print enough money to get the rate of income growth above the |
| rate of interest. |
| However, printing money can easily be abused because it's so easy to do and |
| people prefer it to the alternatives. |
| The key is to avoid printing too much money |
| and causing unacceptably high inflation, the way Germany did during its |
| deleveraging in the 1920's. |
| If policymakers achieve the right balance, a deleveraging isn't so dramatic. |
| Growth is slow but debt burdens go down. |
| That's a beautiful deleveraging. |
| When incomes begin to rise, borrowers begin to appear more creditworthy. |
| And when borrowers appear more creditworthy, |
| lenders begin to lend money again. Debt burdens finally begin to fall. |
| Able to borrow money, people can spend more. Eventually, the economy begins to |
| grow again, |
| leading to the reflation phase of the long term debt cycle. |
| Though the deleveraging process can be horrible if handled badly, |
| if handled well, it will eventually fix the problem. |
| It takes roughly a decade or more |
| for debt burdens to fall and economic activity to get back to normal |
| - hence the term 'lost decade.' |
| Of course, the economy is a little more complicated than this template |
| suggests. |
| However, laying the short term debt cycle on top of the long term debt cycle |
| and then laying both of them on top of the productivity growth line |
| gives a reasonably good template for seeing where we've been, |
| where we are now and where we are probably headed. |
| So in summary, there are three rules of thumb that I'd like you to take away |
| from this: |
| First: Don't have debt rise faster than income, |
| because your debt burdens will eventually crush you. |
| Second: Don't have income rise faster than productivity, |
| because you will eventually become uncompetitive. |
| And third: Do all that you can to raise your productivity, |
| because, in the long run, that's what matters most. |
| This is simple advice for you and it's simple advice for policy makers. |
| You might be surprised but most people — including most policy makers — don't pay enough attention |
| to this. |
| This template has worked for me and I hope that it'll work for you. |
| Thank you. |

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