How the Economic Machine Works

This week’s content is a video titled How The Economic Machine Works.

The video breaks down the economy into its building blocks and explains each part of it individually. Then, like a clockmaker, it assembles the full picture from the parts, showing you on the way how the pieces fit together.

It is dense, and you have to pay attention, but it is also very accessible and rewarding. After watching it, you will have a strong foundation on which to develop further and more detailed knowledge.

The outline

Fundamentally, the economy is all of the transactions taking place in all of its markets.

Three forces act on it:

  • productivity growth;
  • short-term debt cycles; and
  • long-term debt cycles.

Productivity

Productivity increases are the main long-term driver of economic growth: doing less with more.

Simplistically, if you become more productive and do twice the work, you get twice the reward. You can then spend more, which allows others to earn more.

In the long-term, only changes in productivity are important. However, in the short-term, there is also credit.

Credit

The use of credit is what leads to cycles of economic expansion, and contraction. Without it, economic growth would correlate directly with the increases in productivity.

Credit is a huge part of the economy. For example, in the US economy, there is ~15x more credit than actual money.

Credit allows incomes to rise faster than productivity growth. For example:

  • if you earn $100k and qualify for $10k of credit, you can spend $110k;
  • other participants in the economy will earn that $110k, and they can now spend - including credit - $121k;
  • now someone will spend $121k. Add 10% credit to that, and, well, you see where this is going.

Credit is - in a sense - borrowing from yourself in the future. Today it lets incomes rise faster, but tomorrow - when you have to repay the debt - it will cause your income to rise slower.

Credit is good when it efficiently allocates resources. If people can borrow to buy equipment, they can improve their productivity quicker than they otherwise could.

Credit is bad when it leads to excess consumption. If people borrow to buy something that does not improve their productivity, then it has not accomplished anything useful.

The short-term debt cycle

When income rises faster than productivity, prices go up (because everybody has more to spend, but the supply is the same). This is inflation.

At some point, the central bank will raise interest rates to make borrowing more expensive. This will make the unproductive debt more expensive (good), but also hinder resource allocation to productive use cases. So at some point, the interest rates will be lowered again.

The short-term debt cycle is a juggling act by the central bank, to encourage productivity-increasing credit, and discourage excess credit that does not contribute to productivity.

Throughout multiple short-term debt cycles, the overall debt-burden is increasing. This is because:

  • there is a non-zero percentage of non-productive debt; and
  • while productive debt can be repaid with increased productivity, consumption debt can only be repaid by spending less in the future; and
  • people don’t want to spend less, and if credit is easily available, they will keep borrowing.

This leads to the…

Long-term debt cycle

The long-term debt cycle is when the bubble bursts. Debt repayments have collectively outpaced the rise in income:

  • people are forced to spend less to pay back their debt;
  • this leads to reduced incomes (as there is less spending in the economy);
  • which leads to increased debt-burden;
  • which causes defaults;
  • which causes asset prices to false;
  • which causes less borrowing (through reduced collateral values);
  • which causes less spending, which, you get the picture, is not great.

Just like the economy’s a feedback loop going up, it’s a feedback loop going down as well.

Policy tools

To deal with a major economic deleveraging, policymakers have four main tools:

  • cut spending (i.e. austerity); and
  • debt reduction (through defaults, and restructuring); and
  • wealth redistribution through increased taxation; and
  • printing money.

The first three are deflationary, and the last approach is inflationary.

None of them is a solution on their own. However, when their inflationary and deflationary natures are well balanced by policy-makers:

  • overall debts decline relative to income; and
  • real economic growth is positive.

Get the policy wrong, however, and you can end up with hyperinflation, and social unrest.

The key takeaways

After all is said and done, there are three recommended takeaways for everybody who views the video:

  • Your income must rise faster than debt; and
  • Your income should not rise faster than productivity; and
  • In the long run, only productivity growth matters. Prioritize it above all.

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