【Coin Circle Practical Information】
99.99% of people don't understand why the economy is in recession.
Here's what you need to know: Let's start with the absolute basics. In almost every country around the world, banks receive deposits from their customers.
When you place a deposit with a bank, the bank offers you interest as an incentive to keep the deposit.
You sign an agreement to lend your money to the bank and earn interest.
Banks generate profits by lending money to borrowers at a higher interest rate than they offer to their customers.
When you deposit money into your account, the bank adds it to a pool of funds owned by all depositors.
If you want to withdraw the money, the bank takes it out of the pool and reduces its liability to you (your bank balance).
In order to pay interest to depositors, banks use deposits to earn interest by lending them to customers who want to borrow funds. In other words, banks act as intermediaries between people who want to borrow money and others who want to borrow these savings.
While you have to work hard to earn money and earn interest on your savings, banks make money because they get to loan out the money you save!
Fractional reserve banking allows banks to lend out all of their cash while still promising that your money is there! A mortgage is an example of a loan created through fractional reserve banking.
Let's think about it this way: A bank has $100,000 in deposits. It lends 90% of this money to people who want to buy houses. Now, there is $190,000 in the system. The funds held by the depositor are still "withdrawable" - the depositor's account still holds $100,000. The newly created money expands the economy, but also causes price inflation (because more money is competing for the same amount of goods).
This process of borrowing and lending money is the main cause of the debt cycle.
The debt cycle begins when we start living beyond our means, spending more than we can afford, or starting a business with borrowed money.
A central bank is a national bank that provides banking services to the government of its country. The goal of a central bank is to achieve price stability (low inflation).
The main tool they have to achieve their goals is interest rates. Central banks control debt cycles by increasing the interest rates on borrowers. These cycles lead to huge booms and busts.
Companies are built, then fail. This severely affects ordinary citizens, who may lose their jobs and the ability to pay for necessities. In a fractional reserve banking system, recessions are intentional.
FRBs lead to over-leveraged positions, and recessions wash them out of the system.
Since March 2020, banks have had no reserve requirements. This means they can lend out all the deposits they receive! A recession officially occurs when Gross Domestic Product (GDP - the market value of goods produced by a country) falls for 2 consecutive quarters. The opposite of a recession is an expansion - an increase in the level of economic activity and GDP. The crazy thing is that these numbers can be intentionally manipulated to "avoid" a recession.
For example. Inflation is 5%, prices are rising, and the Bureau of Labor Statistics tells you that inflation is actually only 2%, so they can roadblock the 3% difference. If central banks want a period of expansion, they lower interest rates to increase borrowing and investment. If they want to trigger a recession (on purpose), they raise interest rates to lower borrowing. During expansions, businesses and individuals are incentivized to spend and invest. When interest rates are too low, more money is borrowed. Some of these borrowers are companies that have taken on more debt than they can still pay back, not expecting interest rates to rise again.
When inflation is too high, the central bank needs to raise interest rates to reduce consumption and investment. Companies that borrow too much cannot repay their loans, so they default on their debts. Everything is interconnected in our economy (companies borrow assets from each other).
Defaults have ripple effects throughout the economy. Ordinary people suffer as companies default on their loans and go bankrupt.
Bankruptcy leads to unemployment. Unemployment leads to consumer debt and defaults on debt to buy assets like homes. When a homeowner defaults on their mortgage, the bank takes possession of the home and sells it on the market.
Debt cycles are more painful when interest rates rise rapidly.
The recession made it so that not only were several homes on the market, but many were quickly sold to pay off debts.
Lowering house prices can lead to panic selling and a wave of home sales. Rising interest rates lead to a stronger currency and less demand for risk (because interest rates are higher than risky asset returns).
More and more borrowers need money to make debt payments, which is now greater due to higher interest rates.
Signs that the central bank will lower interest rates: - Consumers stop spending - Business production falls - Companies lay off workers - Investment appetite decreases - Foreign export volume As soon as the central bank lowers interest rates again, we will start a new debt cycle.
Understanding cycles is the most powerful thing you can do as an individual. Understanding market cycles and debt cycles leads to less panic in the markets and better decisions by investors.
During the buildout period, everyone should build an emergency fund. An emergency fund prevents you from having to take serious action, such as selling your home, in case you lose your job. For good times, build a 3-12 month cash reserve.
The eternal fraud of finance
