How does the economy work?

Introduction

Economics makes the world go round. It profoundly affects each of us in our daily lives. Therefore, it is worth understanding, even at a high level.

Definitions of "economy" vary, but, in a broad sense, the economy can be described as an area where goods are produced, consumed, and sold. As a rule, you will see how they are discussed at the national level, with comments and news reporters relating to the US economy, the Chinese economy, etc. However, we can also look at economic activity through a global prism, taking each country, action, and affairs into account.

This article will delve into the concepts that make up the economy, based on Ray Dalio's model (explained in the section "How the Economic Machine works").

Who makes up the economy?

Let's start small before moving on. Every day we contribute to the economy by buying (for example, products) and selling (for example, working for a fee). Other people, groups, governments, and companies worldwide are doing the same in three market sectors.

The primary sector refers to the extraction of natural resources. These can be things like tree felling, gold mining, and agriculture (these are just a few examples). This material is then used in the secondary sector, responsible for production. Finally, the tertiary industry covers services from advertising to distribution.

The breakdown into "three sectors" is a generally accepted model. However, some have expanded it to include the quaternary and fifth sectors to further differentiate services in the tertiary industry.

Measuring economic activity

To determine the economy's health, we want to be able to measure it somehow. The most popular method for this is to use GDP or gross domestic product. This indicator is designed to calculate the total cost of goods and services produced in the country for a certain period.

Generally speaking, GDP growth means increased production, income, and expenses. Conversely, falling GDP indicates a reduction in production, revenue, and costs. Note that there are several options that you can use: real GDP takes into account inflation, while nominal GDP does not.

GDP is still an approximation, but it is essential for analysis at the national and international levels. It is used by everyone, from small financial market participants to the International Monetary Fund, to get an idea of the economic health of countries.

GDP is a reliable indicator of a country's economy, but, as in technical analysis, it is better to compare it with other data to get a complete picture.

Credit, debt, and interest rates

Lenders and borrowers

We touched on the fact that everything comes down to buying and selling. It is worth noting that lending and borrowing are also necessary. Suppose you are sitting on a large amount of money currently doing nothing. You might want to use this money so that it brings in more money.

One way to do this is to lend to someone who needs to buy something, such as equipment for their business. They do not have cash, but they can pay it off after purchasing equipment by selling their finished products. You act as a lender, and the other party acts as a borrower.

To make it worthwhile, you set a commission for cash withdrawal. If you borrowed $100,000, you could say something like, "you can get this money provided you pay me 1% for each month during which it is not returned." This additional fee is called interest.

Using simple interest will mean that the other party owes you $1,000 every month until the money is refunded. If it were repaid in three months, you would expect to receive $103,000 plus any additional fee you specify.

By offering this money, you create a loan: an agreement that the borrower will pay you later. Credit card users will be familiar with this concept. Cash is not withdrawn instantly from your bank account when paying with a card. It shouldn't even be there if you pay the bill later.

With credit comes debt. Acting as a lender, you have borrowed money, and acting as a borrower, you owe money. The debt disappears after the loan is repaid with interest.

Banks and interest rates

Banks are probably the most prominent leaders in the modern world. You can think of them as intermediaries (or brokers) between lenders and borrowers. These financial institutions are taking on the role of both.

When you put money in the bank, you do it on the condition that they return it to you. Many others do the same. And, since the bank now has such a large amount of cash, it lends them to borrowers.

Of course, this means that the bank will not hold all the money owed to it at once. There is a partial reserve system here. It would be problematic if everyone asked for their money back simultaneously, but this rarely happens. When this happens, the consequences can lead the bank to collapse. Banking operations during the Great Depression in the United States in 1929 and 1933 are good examples.

Banks usually offer you a loan in the form of interest rates. Naturally, higher interest rates will be more attractive to lenders (as they will get more money). The opposite applies to borrowers - lower interest rates mean that they will not have to pay the same amount above the principal amount.

Why is credit essential?

Credit can be seen as a kind of lubricant for the economy. This allows individuals, businesses, and governments to spend money they don't have at the moment. For some economists, this is problematic, but many believe that increased spending is a sign of a thriving economy.

If more money is spent, more people get income. Banks are more likely to lend to those with higher incomes, which means that people now have access to more cash and loans. With more money and loans, people can spend more, which means more people get income, and the cycle continues.

More income → more credit → more expenses → more income.

Of course, this cycle cannot continue indefinitely. If you borrow $100,000 today, you will lose more than $100,000 tomorrow. So, while you may temporarily increase your expenses, you will eventually have to cut your costs to get them back.

Ray Dalio describes this concept as a short-term debt cycle. According to his estimates, these patterns are repeated for 5-8 years.

Central banks, inflation, and deflation

Inflation

Assume that everyone has access to a large number of credits. They can buy a lot more than without it. But while costs are skyrocketing, production is not. The supply of goods and services does not increase significantly, but their demand increases.

Then there is inflation: this is when you start to see the prices of goods and services rise due to higher demand. A popular indicator to measure this is the Consumer Price Index (CPI), which tracks the prices of typical consumer goods and services over time.

How does the central bank work?

The banks we described earlier are primarily commercial - they serve mainly individuals and legal entities.

Central banks are government agencies responsible for managing a country's monetary policy. This category includes such financial institutions as the US Federal Reserve, the Bank of England, the Bank of Russia, the Bank of Japan, and the People's Bank of China. Well-known functions include adding money to circulation (through quantitative easing) and controlling interest rates.

Central banks can raise interest rates when inflation gets out of control. When rates go up, the interest rate is higher, so borrowing doesn't seem so attractive. Since individuals also need to pay off debts, expenses are expected to decrease.

Higher interest rates should lower the prices in an ideal world due to less demand. But in practice, it can also cause deflation, which can be problematic in specific contexts.

Deflation

As you might guess, deflation is the opposite of inflation. We will define this as a general decline in prices over some time, usually caused by a reduction in costs. Since there are fewer expenses, this may be accompanied by a recession.

One of the proposed solutions for deflation is lowering interest rates. By reducing the interest rate on loan, people get an incentive to take out more loans. Then, when more loans are available, the government expects the parties in their economy to increase their spending.

Like inflation, deflation can be measured using the consumer price index.

What happens when the economic bubble bursts?

When there is a reduction in the share of borrowed funds, incomes begin to fall, and loans dry up. Unable to pay off the debt, people are trying to sell their assets. But because so many people are doing the same thing, asset prices are falling because of the abundance of supply.

In such scenarios, stock markets crash, and at this stage, the central bank cannot lower interest rates to ease the burden if they are already at 0%. This creates negative interest rates, a controversial solution that doesn't always work.

So what should they do? The most obvious way forward is to cut costs and write off debts. However, this raises other problems: cutting costs means that the business will not be as profitable, which means that employee incomes will decrease. Industries will have to reduce their labor force, which will lead to an increase in the unemployment rate.

Then lower incomes and a smaller workforce mean the government can't collect as much taxes. At the same time, we need to spend more to ensure an increased number of unemployed citizens. Since they spend more than they receive, they have a budget deficit.

The proposed solution is to start printing money (to make the money printer work, as it is called in cryptocurrency circles). With this money, the central bank can provide loans to the government, trying to stimulate the economy. But this can also lead to problems.

Creating money out of thin air causes inflation by increasing the money supply. This slippery slope can eventually lead to hyperinflation when inflation accelerates so fast that it undermines the currency's value and leads to economic disaster. Just look at the examples of the Weimar Republic in the 1920s, Zimbabwe in the late 2000s, or Venezuela in the late 2010s to see what impact hyperinflation can have.

Compared to short-term cycles, the long-term debt cycle lasts much longer, and it is believed that it occurs every 50-75 years.

How is it all connected?

We've covered quite a few topics here. Ultimately, the Dalio model revolves around credit availability - the more loans, the bigger the economy. With a smaller amount of credit, it is reduced. These events alternate, creating short-term debt cycles, which form part of long-term debt cycles.

Interest rates largely influence the behavior of economic participants. When the stakes are high, saving makes more sense because spending is not a priority. When they go down, spending seems like a more rational solution.

Final thoughts

An economical machine is so colossal that it is difficult to comprehend its various components. However, if we look closely, we can see the same patterns repeatedly repeating when participants make transactions with each other.

We hope that at this stage, you have a better understanding of the relationship between lenders and borrowers, the importance of credit and debt, as well as the steps that central banks are taking to mitigate the consequences of an economic catastrophe.