How Do Economic Cycles Work? Part I

In that post, I would like to bring to your attention some simple aspects of how the economy work, having a simple notion can help you to sidestep and anticipate the global financial crisis.

Although until today we haven't found a common ground about how that economic machine works, there are some simple and practical economic concepts that can help us to grasp in the big picture how it works.

The economy might seem complex, but it works in a simple mechanical way. The economy is made up of a lot of simple transactions that are repeated over and over again a zillion times and these transactions are driven by human nature.

Transactions is a very simple thing, we make transactions all the time. Every time we buy or sell something we create a transaction. Now, transactions are fulfilled either by money or credit in exchange for a product, service, or a financial asset. Credit + money spending = total spending and the total spending drives the economy.

All cycles and all forces of the economy are driven by transactions, so in a way, if we understand transactions we can understand the direction of the whole economy.

People, banks, businesses, and the government are all actors and engaged in transactions, exchange money and credit for goods, services, and financial assets.

The biggest buyer and seller is the government, which collects taxes and spends money and also control the amount of money and credit in the economy, and it does that by adjusting interest rate and printing new money.

The Central bank plays an essential role in the flow of creating credit and credit is the most critical part of the economy.

But, why credit is so important? Credit is made of lenders and borrowers, in a practical way lenders want to make their money into more money and borrowers usually want to buy something they can't afford, like a car or a house or maybe starting a new business.

In a simple transaction, borrowers pay principal + interest, when interests are high there are fewer borrowers because it is more expensive, when interest rates are low borrowing increases because is cheaper.

When the level of confidence in the economy is high, lenders will be comfortable in borrowing money, and credit is created. When a credit is created debt is also created. A debt is an asset to the lender and a liability to the borrower. The transaction is settled when the debt, principal plus interest is paid.

The importance of credit is big because when a borrower receives the credit he/she is able to increase spending, and spending drives the economy. One person spending is another person's income, simple like that.

When you spend more someone earns more. That translates into more borrowing, which equals more spending that equals more income. That's why we have what we called economic cycles. Debt is the main force of that cycle. 

In a hypothetical economy without debt, the only way to acquire more income would be through productivity growth, We would have to work more or better to produce more income. But, because we borrow we have cycles. When you are borrowing you are anticipating income from the future and in the future to pay it back you will have to spend less.

Credit is bad when it is used to finance overconsumption that can't be paid back and it is good when is efficiently allocated to produce income to pay back the debt. If you borrow money to buy frivolous goods it doesn't generate income for you to pay back the debt, however, if you borrow money to grow your business and that investment allows you to make more money, then you can pay back the debt and increase your living standards.

The succession of borrowing creates a short term debt cycle, during an expansion spending is fueled by credit when spending and debt grows faster than the number of goods produces prices rises, inflation.

Higher inflation translates into higher interest rates, higher interest rates fewer people borrowing money, and the cost of existing debt rises. If the cost of existing debt rises, people have less money to spend, so spending slows, and since one person's spending is another person's income drop and so on.

When people spend less, prices go down, we called that deflation. Economy activity decreases and we have a recession.

If the recession is severe and deflation is not a problem, the Central Bank will low interest rates to stimulate the economy again, existing debt costs are reduced, and borrowing and spending grow again., translating into another expansion.

When credit is easily available there is an economic expansion when credit isn't easily available there's a recession. That cycle is believed to typically last 5-8 years.

That explains in a simple, practical way the effects of the short-term debt cycle. However, to better understand the economic cycle we also have to analyze the effect that the long-term debt cycle plays on the economic cycle, and that's what we are going to do in the next post.

If you liked the subject or you are interested in the next post please drop a comment with your thoughts.