This is the first post in a three part series on the economic impact of COVID-19. If you would like to be notified of future posts sign up here for free. Also, this post was heavily inspired by this video by Ray Dalio, founder of the largest hedge fund in the world. Check it out for a more detailed overview.

We are in a time of unprecedented economic turmoil.

Even though I studied Finance in college, I’m embarrassed to admit that I’ve frequently found myself googling questions like “what does it mean when the Fed lowers interest rates” and “how tf does an economic stimulus package work”.

To sound smart, I usually just parrot back what some seemingly smart person says on a podcast or CNBC.

Source

After realizing I don’t know jack shit about what’s going on, I decided to gain a better understanding of how the economy works.

Turns out, the economy is simpler than you may think. It’s like a machine. Once you deconstruct it, you begin to see the relationship between causes and effects within the system.

The goal of this post is to give you a foundational understanding of the economic machine so you can sound smart over Zoom calls with your friends and family.

Let’s see how it works.

Key Components Of The Economic Machine

Economists measure GDP - Gross Domestic Production - to determine the health of an economy.

It sounds fancy but it’s simply the sum of a bunch of transactions happening over and over again.

So, what’s a transaction?

A transaction is an exchange between two parties - a buyer and a seller.

Buyers can purchase with cash or credit.

Meanwhile, sellers provide either goods, services, or financial assets to buyers.

Whenever the same good, service, or financial asset is being sold, we call this a market. There are markets for oil, stocks, and super duper cute plush pink Care Bears.

So, an economy is made up of markets, which are made up of transactions

Transactions can be executed by a person, business, bank, or government.

In the U.S., the government is the largest buyer and seller in the economy. It consists of two entities:

  • The Central Government
  • The Central Bank

The Central Government determines tax rates and funds programs like unemployment benefits and small business loans.

Meanwhile, The Central Bank controls the money supply and interest rates.

Because of this, the Central Bank is a key player in the flow of credit. Ray Dalio, who runs the largest hedge fund in the world, says:

“Credit is the most important and least understood part of the economy.” Source

To make sure we understand it, let’s explore the magical world of credit.

Credit: The Most Important and Least Understood Part of the Economy

Credit is magical because it allows people to spend more than they have. This supercharges economic growth.

So, how does it work?

As mentioned earlier, a buyer can either pay with cash or credit.

Cash is money the buyer owns. On the other hand, credit is borrowed money.

Once borrowed, the credit turns into a debt that needs to be repaid in the future. The borrower also pays a fee, called interest, so the lender has an incentive to loan their money.

In the classic book on human history, Sapiens, the author argues that credit was the key innovation that catalyzed modern economic growth. He says:

“Before the modern era, money could only represent things that actually existed in the present. This imposed a severe limitation on growth, since it made it very hard to finance new enterprises… Humankind was trappped in this predicament for thousands of years. As a result, economies remained frozen.” - Source

In the premodern era, societies didn’t believe the future would be much better than the past. This limited the amount of credit that was offered which slowed growth.

As a result, a self-reinforcing cycle stunted economic growth for thousands of years.

Here’s what happened next:

“Then came the Scientific Revolution and the idea of progress. The idea of progress is built on the notion that if we admit our ignorance and invest resources in research, things can improve. This idea was soon translated into economic terms. Whoever believes in progress believes that geographical discoveries, technological inventions and organisational developments can increase the sum total of human production, trade and wealth.” - Source

Basically, the Scientific Revolution gave people hope that they could build a better future. Therefore, more credit was offered.

People finally trusted that the future would produce enough economic output to pay back debt, so credit became freely available. This created a virtuous cycle.

As we can see, credit is important because it increases spending. And spending is the rocket fuel that shoots an economy into orbit.

Let’s see how.

The Economic Feedback Loop

Healthy economies spend on goods and services that increase productivity. This includes innovative technologies, scientific research, and manufacturing capabilities.

Productivity growth happens whenever an economy produces more output with the same input. For example, adding technology to an assembly line may enable more cars to be manufactured in less time.

An increase in productivity allows us to increase our income since there is more output for the same input. This enables us to borrow more credit and the cycle starts again. This creates The Economic Feedback Loop.

Source

Things get interesting once you realize that one person’s spending is another person’s income. Remember, every transaction has a buyer and a seller!

Source

Therefore, the economy is an interconnected web of these loops feeding on themselves.

When an economy spends on assets that increase productivity, like innovative technologies, scientific research, and improving manufacturing capabilities, it creates a positive feedback loop.

But what happens when an economy spends too much on unproductive assets?

For example, when a corporation uses cash to purchase stock to enrich its shareholders (e.g., mainly hedge funds and executives) instead of research and development.

Or what about when tech companies keep fat piles of cash on their balance sheet instead of investing in new technology?

It creates a negative feedback loop because there isn’t enough productivity growth.

Lowered productivity leads to outsourcing production to other countries, which drives down incomes, which leads to less borrowing and less spending.

And the vicious cycle begins.

Many U.S. companies have spent the past few years propping up their stock price with share buybacks instead of investing in productive assets.

This is why we are kinda fucked right now. We’ll get more into that in the next post in this series.

For now, let’s take a deeper look into what drives economic activity, recessions, and depressions.

Three Drivers of Economic Activity

The three drivers of economic activity are:

  1. Productivity Growth
  2. Short-term debt cycles (every 5-7 years)
  3. Long-term debt cycles (every 75-100 years)

Source

As mentioned earlier, productivity growth is simply creating more output with the same input.

However, productivity in the U.S. usually only increases one to two percent a year. Therefore, if you only rely on productivity growth to grow GDP, the economy would grow very slowly.

Source

So, how can an economy grow GDP faster than they grow productivity?

That’s right, credit!

As discussed above, credit enables borrowing. This borrowing causes you to spend more than you make today. However, you will eventually need to pay off the debt.

This creates a cycle.

Source

Therefore, an economy with credit allows spending, and therefore GDP, to increase faster than productivity growth in the short-term.

However, over time, as debt cycles wax and wane, productivity growth becomes the main driver of economic growth.

Credit isn’t inherently bad though. Yet, bad things can happen if credit is primarily used on unproductive assets and overconsumption. Like buying Yeezy’s for $2,000.

Ideally, credit is used to invest in the production of goods and services that produce enough income to pay off the debt, like a thriving coffee shop owner.

As we can see, credit creates economic cycles. Both good times and bad.

In good times, people tend to borrow heavily.

Why?

Because everything seems to be going great!

Incomes are rising. Asset prices are increasing. The stock market is on a tear.

People become more creditworthy because their incomes are rising and asset prices are increasing. As a result, they borrow more which increases debt.

However, as long as incomes are rising faster than debt, everything seems fine because the debt can be paid off.

This cycle of rising income, rising asset prices, and rising debt is what happened leading up to the 2008 Finanical Crisis and has been happening over the past few years.

As people continue paying for goods and services with borrowed money, it can create a bubble.

A bubble occurs when the market price for an asset is much higher than it’s intrinsic value. Once people lose faith in the asset, the market becomes flooded with people looking to sell. Since more people want to sell than buy. Prices tank and the bubble POPS!

For example, leading up to 2008, people would borrow money to purchase a home even though there was a high likelihood they couldn’t pay the loan back.

Wall Street traders packaged these loans up, gave them a fancy name -“mortgage-backed securities” - and sold them to each other. They became so popular that traders were making billions of dollars off of them. Nobody wanted the profits to stop so they didn’t bother questioning whether this asset was actually worth what the traders were paying for them.

It was like a massive game of hot potato.

Eventually, borrowers started defaulting on their loans so the mortgage-backed securities lost their value. This caused massive selloffs and sparked the 2008 recession

Similar to the loan defaults in 2008, unexpected external events such as 9/11 and COVID-19 can halt a majority of economic activity out of nowhere.

If the shock has enough activation energy, a negative feedback loop can be catalyzed.

Stock prices drop. Banks stop lending. People cut spending. Productivity decreases. Incomes fall. This starts The Negative Economic Feedback Loop.

If GDP falls for two consecutive quarters, the economy is officially in a recession.

So what strategies does an economy have for combatting an economic crisis like a recession? Let’s discuss that next.

The 5 Strategies for Handling An Economic Crisis

The five strategies are:

  • Lower interest rates
  • Spend less
  • Reduce debt
  • Redistribute wealth
  • Print money

Let’s explore each.

Lower Interest Rates

Lowering interest rates makes it cheaper to borrow money. As a result, more people may borrow which hopefully kicks off a positive feedback loop.

In times of severe economic distress, The Central Bank may lower interest rates to 0%. This is what happened in 2008 and is happening today. Economies try to avoid negative interest rates since it means people get paid for borrowing money, which is costly.

At this point, other measures need to be taken.

Spend Less

As people, businesses, banks, and governments are saddled with debt, they decide to slash costs to meet their debt obligations. Because the economy is a network of buyers and sellers, the effects of spending less are felt in many parts of the economy.

Remember, since one person’s spending is another person’s income, the economy is an interconnected web of feedback loops.

For example, COVID-19 has impacted companies in travel, retail, and commercial real estate. As more companies default on their loans, banks will limit access to credit which will lead to less borrowing, less spending, less productivity growth, and less income. This will cause negative feedback loops across many industries.

Unfortunately, it’s just getting started.

Reduce Debt

There are two options for reducing debt:

  • Default
  • Restructuring

When a borrower can’t pay back any of the debt and their collateral has lost value, they must default on the debt. This basically leaves the creditors holding their respective dicks.

Since that isn’t a viable financial strategy, creditors prefer to restructure when they can. This consists of either reducing the total debt amount, lowering the interest rate, or extending the payment period.

As the banks receive a fraction of the debt they lent out, they also have customers looking to withdraw cash. The bank gets squeezed like a ripe orange. If it gets squeezed hard enough, the bank can run out of funds and become insolvent. This is known as a “run on the bank”.

It happened in 2008 with Washington Mutual. In this case, either the government bails out the bank by giving it access to credit or the bank goes out of business.

Redistribute Wealth

As this entire clusterfuck is going on, The Central Government finds itself in a precarious situation.

On one hand, their income decreases because less people are paying income taxes. On the other hand, their spending increases because more people are filing for unemployment benefits.

The government also needs to introduce stimulus packages in order to maintain the production of essential goods and services like banking. Additionally, to prevent mass unemployment, the government may bail out bankrupt companies that employ thousands of people, like car manufacturers.

During this time, budget deficits skyrocket because the government is spending more and earning less.

So, what do they do?

They have two options:

  • Increase taxes
  • Borrow money

During these times, taxes are usually increased on the wealthy and redistributed to the less wealthy.

At this point, people need money. If only there was an institution that printed money.

Hmmm… Oh yeah!

The Central Bank.

Print Money

Since interest rates are already at 0%, The Central Bank needs to print money to stimulate productive spending.

In 2008, The Central Bank printed over 2T dollars!

Source

The Central Bank can print money, but it can only buy financial assets like government bonds.

The Central Government can’t print money but it can purchase goods and services and put money in the hands of people in need.

As a result, The Central Bank and The Central Government must work together to ensure the economy is stimulated in an efficient manner.

Summary

In this post, we’ve learned that the economy is made up of a bunch of small transactions between buyers and sellers.

Additionally, we learned that credit is powerful because it enables economies to grow faster than their productivity growth because credit increases spending.

However, if debts rise faster than incomes, it can halt spending which creates a vicious cycle that can lead to a recession or depression.

Once an economy gets to this point, they can use a variety of measures to stimulate the economy like lowering interest rates, spending less, reducing debt, redistributing wealth, and printing money.

Great.

Now that we have an understanding of how the economy works, next week we’ll look into what is happening to the economy today due to COVID-19.

Spoiler alert - it doesn’t look good.

This was the first post in a three part series on the economic impact of COVID-19. If you would like to be notified of future posts sign up here for free.

Posted 
Apr 5, 2020
 in 
Strategy
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