Abstract

• Credit refers to funds that individuals need to repay on time after obtaining them. It plays a role in promoting economic development.
• More credit means more spending. More spending leads to more income, and increased income provides access to more credit funds from lenders.
• With credit comes debt: borrowed funds must be repaid, so subsequent expenditures must be reduced.
• The government controls the economy by raising and lowering interest rates.

Introduction

The economy maintains the movement of the world and closely affects each of our daily lives. . Even though this question is profound, it is still worth exploring in depth.

Definitions of "economy" vary, but broadly speaking, the economy can be described as an area in which goods are produced, consumed, and traded. The economy is often discussed as a national-level topic, and column articles and journalists always mention the U.S. economy, the Chinese economy, etc. However, we can also look at global economic activity and consider the activities and affairs of each country.

In this article, we will delve into the concept of economic architecture based on the model proposed by Ray Dalio. This model is explained in detail in the How the Economic Machine Works video.

What is the economy made of?

Let us start with a microscopic explanation and gradually advance to the macroscopic level. We contribute to the economy by buying groceries and selling our labor for wages. Individuals, groups, governments and companies around the world are doing the same thing in the three major industries.

Primary industry is associated with the extraction of natural resources. To name a few, it includes tree felling, gold mining and farmland cultivation. The raw materials obtained here will be used in the subsequent manufacturing and production of thesecondary industry. The final tertiary industry covers a variety of services from advertising to distribution.

The division of "three major industries" is a model generally recognized by the public. However, some people extend the concept to the Fourth Industry and the Fifth Industry to further distinguish various services in the tertiary industry.

Measuring economic activity

We would like to have some way of measuring the health of the economy. By far the most common method is to useGDP, orGross Domestic Product. This indicator calculates the total value of goods and services produced by a country in a given period.

Broadly speaking, rising GDP means rising production, income and spending. On the other hand, a decline in GDP indicates a decline in production, income and spending. Note that there are different versions of this concept: real GDP includes inflation, while nominal GDP does not.

Although GDP is only an estimate, it accounts for a huge proportion in national and international economic analysis. From small financial market players to the International Monetary Fund, GDP can be used to gain insight into the health of a country's economy.

GDP is a reliable indicator of a country's economy, but during technical analysis, it is best to cross-compare other data to obtain a more comprehensive understanding.

Credit, Debt, and Interest Rates

Lenders and Borrowers

We can recognize the fact that everything can be reduced to buying and selling. It is worth noting that borrowing is also essential. Assume that there is currently a large amount of idle funds. We will hope to utilize these funds and let money make money.

To achieve this goal, you can lend money to people who need to buy supplies, such as machinery needed to start a business. The borrower has no current cash on hand for the time being, but after purchasing the machine, he can make money by selling the finished product and repay the funds. The person who lends idle funds is alender, and the other party is aborrower.

In order to obtain loan proceeds, lenders can set fees for lending cash. If you lend $100,000, the lender can ask, "To use this money, the borrower needs to pay me 1% per month while the principal has not been repaid." ”This 1% additional charge is called “Interest”.

Based on simple interest, that is, the borrower needs to pay an additional $1,000 per month until the principal is paid off. If paid off after three months, the lender will receive $103,000, plus other specified fees.

By lending this money, the lender creates credit, an agreement with the borrower to repay the funds at a later date. Credit card users will be familiar with this concept. When paying with a credit card, the money is not immediately deducted from one's bank account. It doesn't matter if there is no balance in the account, as long as the bill is settled later.

Where there is credit, there is also debt. Lenders lend money and borrowers create liabilities. Once the loan is repaid with interest, the debt disappears.

Banks and interest rates

Banks should be the most typical lenders in the world today. We can think of banks as intermediaries (or brokers) between lenders and borrowers. These financial institutions are actually both lenders and borrowers.

Individuals deposit money in the bank because they are sure that they can withdraw the money from the bank at any time. Most people do this too. This way, banks hold large amounts of cash that they can lend to borrowers.

Of course, banks do not lend out all their funds at once, but operate on a fractional reserve system. Banks can have problems if everyone asks to withdraw their money at the same time, but this rarely happens. Once this happens (for example, everyone generally loses confidence in banks), a bank run will occur, which may lead to bank failure. The bank runs during the Great Depression in the United States in 1929 and 1933 were very typical.

Banks often use interest rates as an incentive to encourage others to deposit money in the bank. Higher interest rates are more attractive to lenders because they get more money. For borrowers, the opposite is true. Low interest rates mean they don’t have to pay much in interest on top of the principal.

Why is credit important?

Credit can be regarded as the lubricant of the economy, allowing individuals, companies and governments that temporarily have no capital reserves to use funds in advance. Some economists believe there are problems with this approach. However, many people assume that increased spending means the economy is booming.  

More money spent means more people receive income. Banks tend to lend to people with higher incomes, meaning these people have more cash and credit resources. With more cash and credit, they can increase consumption, which in turn allows more people to earn income, and the cycle continues.

More income→More credit→More spending→More income.

Of course, this cycle will not continue indefinitely. Borrowing $100,000 now means having to pay back tens of thousands of dollars in the future. So even though your spending capacity increases, you'll ultimately have to spend less to pay off your debt.

Ray Dalio describes this concept as the “Short-term debt cycle”, as shown in the chart below. He predicts these patterns will repeat in five- to eight-year cycles.

Red represents productivity, which increases over time. Green is the relative amount of credit available.

So, what should we pay attention to? First, note that productivity is steadily increasing. In the absence of credit, productivity is the only source of growth. After all, only production can generate income.

In the first part of the chart, we can see that due to credit, income grows faster than productivity, which causes the economy to expand. The expansion eventually stops and the economy enters a contraction. In the second part, after the initial "boom", credit resources are significantly reduced. As a result, loans became harder to come by andinflation began, forcing the government to take remedial measures.

We will explore this issue further below.

Central banks, inflation and deflation

Inflation

Assume everyone has access to a lot of credit (first part in the diagram above). They will use credit to spend a lot in advance. But despite a surge in spending, production has not increased. In fact, the supply of goods and services has not increased materially, but the demand for them has.

Inflation then occurs, in the form of rising prices for goods and services due to increased demand. A commonly used measure of inflation is the Consumer Price Index (CPI). The index tracks the prices of goods and services commonly used by consumers over a period of time.

How does a central bank work?

The banks we introduced before are usually commercial banks, which mainly serve individuals and businesses. A Central Bank is a government entity responsible for managing a country's monetary policy. Financial institutions such as the Federal Reserve, Bank of England, Bank of Japan and People's Bank of China fall into this category. The main functions of these institutions include: issuing additional currency in circulation through quantitative easing policies and regulating interest rates.

If inflation gets out of control, central banks will raise interest rates. After interest rates rise, borrowing interest will increase and borrowing will lose its appeal. Spending will decrease in due course as individuals still need to repay debts.

In an ideal world, higher interest rates would reduce demand, causing prices to fall. But in practice, this may causedeflation. In some cases, this can be bad.

Deflation

We can roughly infer that deflation is the opposite of inflation. We define it as a general decline in prices over a period of time caused by reduced spending. A reduction in spending may be followed by anrecession. Please read "Details of the 2008 Financial Crisis".

The answer to deflation is usually cut interest rates. Lowering interest rates on credit borrowing can encourage individuals to borrow more. Then, as credit becomes available, the government expects parties within the economic environment to increase spending.  

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

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What happens when an economic bubble bursts?

Dalio explained that the chart shown above (the short-term debt cycle) is a small cycle within the long-term debt cycle.

The long-term debt cycle.

The cyclical pattern described above (increases and decreases in available credit) repeats itself over and over again. However, at the end of each cycle, debt increases. Eventually, debt becomes unmanageable, triggering massivedeleveragings, in which individuals try to reduce their debt. This shows up on the chart as a sharp drop in debt.

After deleveraging occurs, income begins to decline and credit resources dry up. When individuals are unable to repay their debts, they try to sell their assets. However, with many people operating at the same time, asset prices can plummet due to excess supply.

In this case, it will cause the stock market to crash. At this stage, if the interest rate is already 0%, the central bank can no longer reduce the interest rate to ease the burden, because any further reduction will result in negative interest rates. This solution is controversial and doesn't necessarily work.

What measures should be taken? The most immediate solution is to reduce spending and eliminate debt. However, other problems will arise. Lower expenses mean that the company is unable to make a profit, so employees will earn less. Various industries need to lay off workers, causing unemployment to rise.

Shrinking incomes and the labor force mean the government is unable to collect the same amount of taxes as before. At the same time, the government needs to spend more money to feed the growing number of unemployed citizens. Abudget deficit occurs when spending exceeds revenue.

One solution is to start printing money (Money printing machine, go ahead! This meme is well known in cryptocurrency circles). With funds at their disposal, the central bank can lend to the government, which can then try to stimulate the economy. But this is still full of problems.

Printing money out of thin air increases the money supply, which will lead to inflation. This catastrophic slide eventually leads to hyperinflation, a sharp acceleration in inflation that destroys the value of the currency and triggers economic disaster. Anyone who has experienced the Weimar Republic in the 1920s, Zimbabwe in the late 2000s, or Venezuela in the late 2010s can understand the power of hyperinflation.

Long-term debt cycles last much longer than short-term cycles. According to statistics, it occurs every 50 to 75 years.

How are the above concepts related to each other?

We have covered many concepts in this article. Dalio's model ultimately revolves around the availability of credit. As long as credit increases, the economy thrives. Reduction in credit will lead to economic contraction. These events alternate and form short-term debt cycles, which in turn form part of long-term debt cycles.

Interest rates affect many behaviors of economic participants. When interest rates rise, it makes more sense to save, when spending is no longer a priority. With interest rates lowered, spending seems to be the smarter decision.

Summary

The economic machine is so huge that it is difficult for us to sort out its various components. However, upon closer inspection, we see that the same patterns are repeated over time as participants trade with each other.

After reading this article, I hope you will have a deeper understanding of the relationship between lenders and borrowers, the importance of credit and debt, and the relevant measures taken by central banks to alleviate economic crises.