Welcome to another blog, In this blog I will try to help you understand how the economy works in general.
The economy is a place where many different markets are put together, we have car markets, financial markets, sports markets,... When adding all those markets together you'll have the whole economy.
An economy is built by various factors:
As the name says MICROeconomics studies the behaviour of individuals, enterprises or one industry in making decisions regarding the allocation of scarce resources and it's reaction. I'll give you an example to put this into perspective:
Every person has a monthly budget that they can spend on groceries, clothes, technology,... and so do businesses, they have to buy things according to their budget.
So let's say your mother makes the same salad every day which contains tomatoes, salad, cucumber and other vegetables. One day there's a short supply of tomatoes and the price rises!
Well, Micro-economics studies how she'll react to the surge in price, will she continue buying tomatoes? Will she buy more cucumber instead?
An other example would be: If the price of a car rises, what will happen to consumer demand?
To summarise this, Microeconomics studies the supply and demand on a smaller scale than macroeconomics.
While the Micro-economy studies individuals and enterprises, Macro-economics studies the total economic activity which includes; regional, national and global economies. It tries to understand how the economy functions the best when comparing factors such as:
- GDP (Gross Domestic Product = national income)
- Unemployment rates
- Many more, ...
Some questions we try to answer with Macroeconomics are for example:
What happens if money supply increases?
What causes the economy to grow?
Microeconomics and Macroeconomics are related to each other, if you want to understand one of them, you'll have to understand both. For example, when interests rates go down, how will GDP change?
Before we can answer this question we need to know how a consumer will react to the lower interest rates, so in this case we first need to understand the microeconomics to then understand the macroeconomics.
The difference between money and credit
Learning the difference between money and credit is an important, if not the most important factor to consider when trying to understand an economy.
An economy is made up by transactions, whether it's buying food or buying stocks, they're all transactions. All of those transaction are driven by humans nature and create 3 main causes that drive the economy:
Short term debt cycle
Long term debt cycle
We'll compare these 3 causes into 1 chart which represents the whole economy and tells us whats happening now. Keep this in mind as we'll come back to this later on.
As mentioned above, an economy is the sum of all the transactions that are being made, every time you buy something you create a transaction, every time you sell something you create a transaction.
A transaction is the building block of every part of the economy, all cycles are caused by transactions.
Each transaction has a buyer and a seller, the buyer buys goods, services or financial assets from the seller in exchange for money or credit. Whether it's money or credit, you can spend them in the same way.
So if you acknowledge the fact that credit spends just like money, you can calculate the total spending by adding the money and credit together.
Money + credit = total spending (this could be the total spending of one person, one family,...)
The total amount of spending drives the economy because it's not the money OR credit that one has, but the money AND credit one has.
Now, If you devide the total amount spent by the total quantity sold you get the price of a certain good, service or financial asset. This essentially is basic supply and demand.
It's very important to understand that everybody in this economy does transactions, individuals, banks, companies,... they are all involved in this in the exact same way as explained above, the goods or services might be different but the transactions are done in an equal manner.
The biggest buyer and seller is the government which consists of 2 parts:
The Central government focusses on collecting taxes and spending money.
The central bank controls the money and credit in the economy. How? By printing new money or influencing interest rates.
This brings us to the next chapter: credit
Credit, everything you don't know about money
To create credit we need 2 different individuals, A person, company or institution that wants to lend money and a person, company or institution that wants to borrow money. So essentially we need a lender and a borrower.
A person, company or institution that lends out money in order to make more money from the interests they receive.
A person, company or institution that borrows money to buy a good, service of financial asset which they currently can't afford. Borrowers promise to pay the back the amount of money they've lent + interest.
High interest rates attract less borrowers, low interest rates attract more borrowers
When acknowledging the stated above, we can define credit. Credit is created when a lender trusts a borrower and lends them the money in return for the money + interest in the future.
But it has a tricky part, once you borrow money (=credit) you create debt. Debt is an asset to the lender and a liability to the borrower. Once the borrower repays the money + interest, the debt disappears.
Why is credit so important?
In the beginning of the previous chapter, transactions, we said that spending drives the economy. This is because one person his spending is another person his income, so when you spend more, someone else earns more.
So since we borrowed money we now have increased spending, as mentioned above, one persons spending is another persons income. Since the spender can spend more money because he borrowed money, someone else has an increased income.
Having an increased income causes increased borrowing at the bank because you got more creditworthy. Since you got more creditworthy you can take a higher loan which increases your spending, your increased spending will cause an higher income for someone else.
This leads to economic growth and leads to market cycles.
As mentioned earlier, the economy is made by 3 main causes: Productivity growth, the short-term and the long-term debt cycle.
1. Productivity growth
Productivity growth represents the efficiency in production, meaning when a person works more, they are more productive are and will earn more money. On the other hand, when a person is lazy, they are less productive and they'll earn less money.
It's very important to know that productivity growth doesn't take credit into account because credit is a transaction made out of thin air, while money is earned by working and being productive. Hence why the only way to increase your spending in by increasing your productivity
So the people who work hard will improve their living standards faster than those who are lazy. This won't make a change in the short run but will definitely make a change in the long run.
2. Short term debt cycle
While money is important for productivity growth in the long run, credit is important in the short run. This is because productivity doesn't fluctuate a lot, while debt (=credit) has it's own cycles and fluctuates a lot.
The fact that credit is available drives our economy more than money. Money is something we first need to acquire before we can spend it while credit is created out of thin air and spends just like money. You may be wondering why credit boosts the economy more than money, this is because people their total spending increases (=money + credit).
Let's say we have 3 people, I'll name them person A, person B and person C.
Imagine that person A takes a loan, meaning he gets credit. This credit will be added to his money and will increase his total spending (=money + credit). Since person A his spending is the income of person B, person A generates a higher income for person B since he can spend more.
Now that person B has earned more money, he also can borrow money and get credit, this will increase his spending even more than the total spending of person A. Again, since one persons spending is another persons income, person B creates a higher income for person C and so on ...
The example above is a perfect example of how credit stimulates an economy and makes it grow faster than productivity (=money).
The big difference between money and credit is that credit offers you to buy something that you currently can't afford, essentially you're borrowing money from your future.
There's a big difference between being able to buy something and being able to afford something
Because we borrow money, we create cycles. You have to see borrowing as spending more than you make, right? So since we are spending more than we make, we will need to spend less than we make in the future. Essentially you create a series of predictable events that will happen in the future by borrowing money.
Make no mistake, credit isn't a bad thing. In fact it's good thing because it stimulates our economy to grow if the credit is well invested, such as: materials that increase your productivity, your company or even yourself (knowledge).
Credit is bad when it finances overconsumption and can't be paid back, for example buying a big TV, clothes,... Why? Because the materials that have been bought don't increase your income, they will only decrease in value.
Now that we went though the introduction of the short term cycle, we can now go review this in depth.
One phase of the short term debt cycle:
When a lot of people, companies, etc take loans, their income grows and other people are spending more. This leads to growth in the economy, we call this expansion.
When the economy is expanding the prices of goods and services rises, simply because the increase in spending is caused by credit. When the amount of total spending grows faster than the growth in production of goods the price rises, we call this inflation.
Now, remember the biggest buyer and seller in the economy? The Government, which consists of a central government and a central bank. The central bank doesn't want too much inflation because this causes problems (uncertainty and falling investments). One way the central bank controls inflation is by increasing the interest rates which causes less peoples and companies to borrow money.
Since one persons spending is another persons income, people will start earning less money because other people have less money to spend. When people spend less, we call this deflation. This could lead to de recession, or a depression in the worst case.
When the recession is severe enough the bank will start to lower the interest rates so they can attract people who want to borrow money. This will lead to a new expansion.
This cycle takes 5-8 years and repeats itself for decades. After each cycle the economy comes back bigger and stronger and... with more debt.
In technical terms of charts, the economy is making Higher Highs and Higher lows. Each new HH comes with more debt. You might be wondering why it comes back with more debt? because people push it, it's human nature.
Because of this, debts rise faster than incomes, which creates the long term debt cycle.
When credit is easy available the economy is in expansion.
When credit is hard to get, the economy is in recovery.
This cycle is primarly controlled by the central bank which in/decrease interest rates when it needs to.
3. The long term debt cycle
Despite the fact that debt keeps increasing banks still borrow more and more money to lenders, why? Because people forget about the past.
Because of the economy expanding again, incomes rise again, stocks are increasing in value and in general it's a great time for everyone, plenty of people feel wealthy. As good as this sounds, this can't go on forever. This situation can sustain as long as incomes rise as fast as the debt rises
Over time the growth of debts will surpass the growth in income, this will will be the needl that pops the bubble and reveals actual 'health' of the economy. For Europe and America this has been the case in 1930 and 2008.
Once this level has been reached the the stock market starts to fall, the housing market decreases in value. Plenty of people can't pay their debts and need to sell assets in order to pay their bills and debts. Since many people sell their assets over a shot period of time, the supply surpasses the demand which means the prices will fall even more.
This brings us back to the beginning of this article where we stated that one persons spending is another persons income:
Less spending -> Less income -> Less Wealth -> Less credit -> less borrowing
This is very similar to a recession, the big difference is that during a recession the central bank can lower the interest rates to make borrowing attractive again. But this doesn't work for the long term debt cycle, the interest rates are at their lowest possible %.
The central bank has a few options left:
1. Cut Spending
2. Reduce Debt
3. Redistribute wealth
4. Print money
Usually the central bank will print new money, print money out of thin air. But there's a tricky part, the money that has been printed can only be invested in financial assets. The other 3 options will also be executed but on a smaller scale.
This will stimulate the stock market and will help those who own stocks to become more valuable. The only problem is that this only helps the people that actually own stocks. So the central bank will buy government stocks, by doing this the government is has new capital coming in and is able to buy goods and services. By investing the new capital in good and services the income of a lot of people will rise, meaning their spending will rise accordingly. The only problem with printing money is that inflation could rise if the money printing isn't in balance with the other 3 options, therefor it's very important to maintain a good balance between both.
Only if this is executed successfully the economy will recover is a proper way. Another factor that the central banks needs to take in consideration is to keep the income rate higher than the debt rate.
Once this has been executed successfully, the economy will recover successfully and start expanding again. In general it takes 10 years to recover from a depression / severe recession.
How to implement this into our current economy, a brief explication:
As you may have noticed we are currently having an economic crisis caused by a health crisis (COVID-19). This crisis affects a lot of different industries and sectors, many people are obligated to stay at home instead of going to work. This creates a huge decrease in GDP and it's felt across the globe.
We've seen a huge sell-of in the stock market, some of the indices were 30+% down over the period of 2 weeks. The market reached it's lowest point on 23/03 and has been soaring ever since then.
Let's take a look at the charts:
Chart: NAS100 - NASDAQ
Ever since the sharp drop from 9800 to 6600 the price has recovered 2/3 of it's losses in 25 days, or a 35% surge since 23/05. This is very unusual for a stock to recover this quick from such a big decline, so how is this possible?
On the 23rd of march the FED in America started printing money, 2.3 trillion dollar. Since the new printed money can only be invested in financial assets, they bought financial assets which boosts the economy and increases the value of stocks. So It's evident that the stock market started surging once the FED pumped 2.3 trillion into the stock market.
An other confluence to this is the following chart:
The last time that the NAS100 made an surge equal in % to the last surge, it needed 345 days instead of 25 days. So this is another confirmation that the market has been pushed in a certain direction.
Either way, I don't expect the market to maintain it's bullish momentum as the actual price will catch up with the fundamentals.
For more information about an economy I highly suggest to read our article https://www.theforexdictionary.com/post/how-the-covid-19-virus-could-start-a-new-recession
I hope you enjoyed this article and learned something new about the economy in general.
Let me know what you think in the comments below.