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A loan is money that is provided for a period of time with the condition of repayment. Credit fuels the economy.
An increase in the number of loans means an increase in expenses. Large expenses of some individuals bring large incomes to others, as a result of which funds accumulate for future loans.
Credit is inextricably linked with debt. Borrowed money must be repaid, so expenses must be reduced.
Governments raise and lower interest rates to control the economy.
Introduction
Economics is at the heart of everything. It affects the lives of each of us, and therefore it is important to understand it at least at a basic level.
The concept of “economy” has more than one definition, but in the broadest sense of the word, economy can be described as the area of production, consumption and trade of goods. As a rule, it is discussed at the national level. Every day we hear about the economy of the United States, China and other countries from the news and reports of journalists. Economic activity can also be viewed globally, taking into account the situation in each specific country.
In this article we will look at the constituent elements of the economy, based on Ray Dalio’s model (more about this model in the video How the Economic Machine Works).
What does the economy consist of?
Let's move from simple to complex. Every day we all contribute to the economy by buying (goods) and selling (our labor). All people, groups, governments and businesses around the world buy and sell in three market sectors.
The primary sector is concerned with the extraction of natural resources, such as logging, farming, and gold mining (to name just a few examples). The resulting materials are then used in the secondary sector, which is responsible for the production of goods. Finally, the tertiary sector covers tasks from advertising to distribution.
Dividing the economy into three sectors is a generally accepted model. However, it is sometimes expanded by adding quaternary and quinary sectors to differentiate services in the tertiary sector.
Assessment of economic activity
To assess the state of the economy, special methods are used, the most common of which is accounting for GDP, that is, gross domestic product. This indicator allows you to calculate the total value of goods and services produced in a country over a certain period.
GDP growth indicates an increase in production, income and expenses, and vice versa - a fall in GDP is associated with a decrease in production, income and expenses. Note that real GDP takes inflation into account, but nominal GDP does not.
Although GDP is only an approximation, it is extremely important for national and international analysis. To assess the economic condition of countries, everyone turns to its use - from small financial market participants to the International Monetary Fund.
GDP is a reliable indicator of a country's economy, but as with technical analysis, it is best compared to other data to reach the most complete conclusions.
Loans, debts and interest rates
Lenders and borrowers
We mentioned earlier that the whole economy comes down to buying and selling. However, lending and borrowing are also very important. Let's say you have a large amount of money that is currently not being used anywhere, and you decide to use these funds to generate additional income.
One of the available options is to lend them to someone who needs funds, for example, to buy equipment for a business. Now this person has no money, but after purchasing the equipment, he will be able to earn money by selling his products and will return the debt to you. In this situation, you act as the lender and the other person acts as the borrower.
The lender's benefit is the commission on the money he lends. Suppose you are asked to borrow $100,000, and you give it on the condition that the borrower will pay you 1% of this amount for each month until the money is returned. This additional fee is called interest.
In our example, the borrower will pay you $1,000 for each month until the debt is repaid. If the borrower repays the loan after three months, you will receive $103,000, plus any additional fees.
When you lend money, you create a loan—an agreement in which the borrower agrees to repay the funds at a later date. Credit card users are very familiar with this concept. When you pay by card, the money is not immediately withdrawn from your bank account. You may have no funds on it at all, but will have to pay the bill later.
Credit implies debt. The borrower must repay the money to the lender, and his debt will be exhausted when he repays the loan with interest.
Banks and interest rates
Nowadays, the main creditors are banks. These financial institutions also act as intermediaries (or brokers) between lenders and borrowers, and may act as both.
You put money in the bank on the condition that you will get it back. Other people do the same. Since the bank has such a large amount, it lends it to borrowers.
Banks do not keep all their creditors' money. They operate on a fractional reserve system. If all the creditors asked for their money back at the same time, the bank would have problems, but this happens extremely rarely. In this case (for example, if people lose confidence in the bank), a bank panic occurs, which can lead to the collapse of the bank. The most striking examples of banking panics occurred in 1929 and 1933 during the Great Depression in the United States.
Banks motivate their customers to bring in money by offering interest rates. High interest rates are more attractive to lenders because they will receive more money. For borrowers, the opposite is true - low interest rates are more profitable for them.
The importance of loans
Credit is a kind of fuel for the economy. It allows individuals, businesses, and even governments to spend money they don't already have available. Some economists see borrowing as a problem, but others argue that increased spending is a sign of a thriving economy.
If someone spends money, then someone else receives income. Banks are more willing to offer loans to people with high incomes, giving them even more money and credit. The more money and credit a borrower has, the more spending they make, resulting in more people receiving income, and the cycle continues.
More income → more loans → more expenses → more income.
Of course, this cycle cannot last forever. If you borrow $100,000, you will have to pay back more than $100,000. Although your expenses will increase for a while, one day you will have to reduce them to pay back the debt.
Ray Dalio describes this concept as the short-term debt cycle. According to his estimates, this cycle repeats every 5-8 years.
Increasing productivity is marked in red. The volumes of available loans are marked in green.
Let's figure it out. First of all, it is important to note that productivity is steadily increasing. Without credit, productivity would be the only source of economic growth, since more and more must be produced to generate income.
In the first part of the chart, we see that due to credit, income grows faster than productivity, which drives economic growth. At a certain point, growth stops and economic recession begins. In the second part of the chart, credit availability declines significantly after the initial boom. It becomes more difficult to get credit and inflation sets in, forcing the government to take measures to correct the situation.
We will look at this situation in more detail in the next section.
Central banks, inflation and deflation
Inflation
Let's assume everyone has access to a lot of credit (the first part of the diagram from the previous section). By taking out a loan, people will be able to purchase many more goods. Costs are skyrocketing, but production is not. The supply of goods and services remains at the same level, while the demand for them increases.
The result of all this is inflation: prices for goods and services rise due to high demand. Inflation is measured by the Consumer Price Index (CPI), which tracks the prices of popular goods and services over time.
How does a central bank work?
The banks we mentioned earlier are commercial banks that typically serve individuals and businesses. Central banks are government agencies responsible for managing a country's monetary policy. Such institutions include the US Federal Reserve, the Bank of England, the Bank of Japan and the People's Bank of China. Central banks perform functions such as increasing the amount of money in circulation (through quantitative easing) and controlling interest rates.
Central banks resort to raising interest rates when inflation gets out of control. As rates rise, interest increases, making borrowing less profitable. Since individuals also need to pay off debts, expenses will be reduced.
In an ideal world, high interest rates would lead to lower prices due to falling demand, but in practice they can lead to deflation and other problems.
Deflation
As the name suggests, deflation is the antonym of inflation. This concept describes a general decrease in prices over a period of time, usually associated with a decrease in expenses. Reduced spending, in turn, may be accompanied by a recession (more on this in the article The Financial Crisis of 2008).
One possible solution to deflation is to lower interest rates. By reducing loan interest, banks motivate people to take out more loans. With greater availability of credit, spending in various sectors of the economy is also expected to increase.
Like inflation, deflation can be measured using the consumer price index.
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What happens when the economic bubble bursts?
According to Dalio, the chart we looked at above (the short-term debt cycle) is just a short period within the long-term debt cycle.
Long-term debt cycle
The pattern described above (increasing and decreasing availability of credit) repeats itself over time, but at the end of each cycle, debt only increases. This eventually leads to massive deleveraging (as people try to reduce their debts). This is illustrated on the graph by the sudden decrease.
When deleveraging occurs, incomes begin to fall and the availability of credit decreases. Unable to pay off debt, people begin to sell their assets, but as many do the same, asset prices fall.
All this leads to the collapse of stock markets and at this stage the central bank can no longer reduce interest rates, which are already at 0%. A further reduction would create negative interest rates, which is controversial and ineffective.
So what to do? The most obvious option is to cut expenses and forgive debts. However, this will lead to other problems: cutting costs will trigger a reduction in business profits, and therefore employee income. Businesses will have to cut their workforce, which will lead to increased unemployment.
With low incomes and a smaller workforce, the government will not be able to collect enough taxes to provide for its unemployed citizens. The government, spending more than it receives, will face a budget deficit.
One possible solution is to start printing money (just like in the English-language meme money printer go brrrrr, popular in cryptocurrency circles). The central bank will be able to lend this money to the government to stimulate the economy, but this can also lead to problems.
Printing money without any backing leads to inflation due to the increase in funds. This is a dangerous development that could eventually develop into hyperinflation—a situation where a currency depreciates in value, leading to economic disaster. Hyperinflation occurred in the 1920s in the Weimar Republic, in Zimbabwe in the late 2000s, and in Venezuela in the late 2010s.
Compared to short-term cycles, the long-term debt cycle lasts much longer and repeats itself every 50 to 75 years.
How is it all connected?
Above we touched on many important issues. Ultimately, Dalio's model is based on the availability of credit: the more credit, the better the economy, and vice versa. Periods of availability and unavailability alternate, creating short-term debt cycles that are part of long-term debt cycles.
Interest rates greatly influence the behavior of economic agents. When interest rates are high, people tend to save money, and when interest rates are low, they tend to spend.
Summary
The economy is a huge, complex mechanism that is very difficult to understand. However, we can identify certain trends and patterns that repeat again and again as economic entities interact.
We hope we've helped you understand the relationship between lenders and borrowers and the importance of credit and debt, and demonstrated the steps central banks are taking to mitigate difficult economic situations.