How the Economic Machine Works: Part 1

How the economic machine works in 30 minutes.

The economy works like a simple machine, but many people don't understand it, or they don't agree on how it works, and this has led to a lot of needless economic suffering. I feel a deep sense of responsibility to share my simple but practical economic template. Though it's unconventional, it has helped me to anticipate and to sidestep the global financial crisis, and it has worked well for me for over 30 years.

Let's begin. Though the economy might seem complex, it works in a simple mechanical way. It's made up of a few simple parts and a lot of simple transactions that are repeated over and over again, a zillion times. These transactions are, above all else, driven by human nature, and they create three main forces that drive the economy:

Number one, productivity growth.

Number two, the short-term debt cycle.

Number three, the long-term debt cycle.

We'll look at these three forces and how laying them on top of each other creates a good template for tracking economic movements and figuring out what's happening.

Now, let's start with the simplest part of the economy: transactions. An economy is simply the sum of the transactions that make it up, and a transaction is a very simple thing. You make transactions all the time; every time you buy something, you create a transaction. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets.

Credit spends just like money, so adding together the money spent and the amount of credit spent, you could know the total spending. The total amount of spending drives the economy. If you divide the amount spent by the quantity sold, you get the price. And that's it; that's a transaction. It's the building block of the economic machine. All cycles and all forces in an economy are driven by transactions, so if we can understand transactions, we can understand the whole economy.

A market consists of all the buyers and all the sellers making transactions for the same thing. For example, there is a wheat market, a car market, a stock market, and markets for millions of things. An economy consists of all of the transactions in all of its markets. If you add up the total spending and the total quantity sold in all of the markets, you have everything you need to know to understand the economy. It's just that simple.

People, businesses, banks, and governments all engage in transactions the way I just described, exchanging money and credit for goods, services, and financial assets. The biggest buyer and seller is the government, which consists of two important parts: a central government that collects taxes and spends money, and a central bank, which is different from other buyers and sellers because it controls the amount of money and credit in the economy. It does this by influencing interest rates and printing new money.

For these reasons, as we'll see, the central bank is an important player in the flow of credit. I want you to pay attention to credit; credit is the most important part of the economy and probably the least understood. It's the most important part because it's the biggest and most volatile part.

Just like buyers and sellers go to the market to make transactions, so do lenders and borrowers. Lenders usually want to make their money into more money, and borrowers usually want to buy something they can't afford, like a house or a car, or they want to invest in something, like starting a business. Credit can help both lenders and borrowers get what they want.

Borrowers promise to repay the amount they borrow, called principal, plus an additional amount called interest. When interest rates are high, there is less borrowing because it's expensive. When interest rates are low, borrowing increases because it's cheaper. When borrowers promise to repay and lenders believe them, credit is created.

Any two people can agree to create credit out of thin air. That seems simple enough, but credit is tricky because it has different names. As soon as credit is created, it immediately turns into debt. Debt is both an asset to the lender and a liability to the borrower. In the future, when the borrower repays the loan plus interest, the asset and the liability disappear and the transaction is settled.

So why is credit so important? Because when a borrower receives credit, he is able to increase his spending, and remember, spending drives the economy. This is because one person's spending is another person's income. Think about it: every dollar you spend, someone else earns, and every dollar you earn, someone else has spent. So when you spend more, someone else earns more.

When someone's income rises, it makes lenders more willing to lend him money because now he's more worthy of credit. A creditworthy borrower has two things: the ability to repay and collateral. Having a lot of income in relation to his debt gives him the ability to repay. In the event that he can't repay, he has valuable assets to use as collateral that can be sold.

This makes lenders feel comfortable lending him money. So increased income allows increased borrowing, which allows increased spending, and since one person's spending is another person's income, this leads to more increased borrowing, and so on. This self-reinforcing pattern leads to economic growth and is why we have cycles.