How The Economic Machine Works: Part 3

[Music] 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 left over 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.

Note that this cycle is controlled primarily by the central bank. The short-term debt cycle typically lasts 5 to 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 everyone thinks things are going great.

People are just focused on what's been happening lately, and what's been happening lately? Incomes have been rising, asset values are going up, and 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 cannot 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. 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.