How The Economic Machine Works: Part 2

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 learn, and that accumulated knowledge raises our living standards. We call this productivity growth. Those who are inventive and hardworking 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 have to 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're 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 regulations; 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 the 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 overconsumption 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 say buy a tractor, and that tractor lets you harvest more crops and earn more money, then you could 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, say on a credit card, so you can spend $110,000 even though you only earn $100,000.

Since your spending is another person's income, someone is earning $110,000. The person earning $110,000 with no debt can borrow $111,000, so he can spend $121,000 even though he has only earned $110,000. 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.