Last week's article on winners and losers in the economy raised some questions about policymakers, debt, money printing, and crisis. Before we start to invest, we must understand how the economy runs at a macroscopic level and, in particular, why it runs in cycles. Some properties of the economy and the financial markets are counter-intuitive. Hence, the need to train our brains to think in a new way.
We often hear economists talk about economic cycles, but what is it, and why does the economy runs in cycles? The economy might seem complicated; however, it works simply and mechanically.
An essential question to answer is, what causes cycles? And why do we care?
- Policymakers, who are they, what are their roles in the economy
- Economic cycles. What causes them?
- What's the point of knowing this? I just wanna invest in financial markets!
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Policymakers: who are they? What are their roles in the economy?
Policymakers, in the general sense, refers to the organization responsible for making new rules and laws. In finance and economy, policymakers usually refers to Central Banks and Governments.
The role of governments
Governments can buy goods and services and put money in the hands of the people in difficult times. They run stimulus programs to increase spending and boost the economy, help the unemployed and redistribute wealth. However, governments are limited by their budget and need the help of another policymaker: central banks.
Key takeaways on governments:
- Are the link between central banks and the people
- Are limited by their budget and can't print money
- Need the help of the central banks to finance their stimulus programs
The role of central banks
Central banks (such as the Fed or the ECB) are major players in the economy, especially during crisis and recession. By doing their job well, they can considerably reduce the intensity of the economic cycles. They influence the flow of credits by leveling interest rates; they can also print money, buy financial assets, and government bonds.
Governments can't print money, central banks can. Central banks can only buy financial assets and can't reach the people. Hence governments and central banks must work together: By buying government bonds the central bank lends money to the government and allows it to run a deficit and increase spending (to finance stimulus programs).
Let's see in detail how credit and money printing work.
To make a credit, you need two interested parties:
- A lender who wants to make more money
- A borrower who wants to buy something he can't afford (buy a car, a house, start a new business)
Credit help both parties get what they want. It also increases spending by giving the borrower the power to buy what he could not afford.
Therefore credit fuels spending and investment.
Central banks drive interests rates to pilot the economy:
- If they lower interest rates, credits are eased, spending and investment increases
- If they increase interest rates, the opposite happens, and the economy slows down (they use this to reduce inflation).
If lowering the interest rates is not enough, central banks are forced to print money. The fresh cash (created out of thin air) is used to buy financial assets and government bonds to stimulate the economy. It benefits mostly those who own financial assets (see winners and losers in the economy).
- 2008: The Fed printed over 2 trillion dollars
- 2020: The Fed printed over 6 trillion dollars
Key takeaways on central banks:
- Leveling (increase or decrease) interest rates
- Print money
- Finance governments by buying governments bonds
Economic cycles. What are they? What causes them?
One cycle is the fluctuation of the economy between a period of expansion and contraction. Even though these cycles are driven by a logical series of events that recur in patterns, they are not pre-destined to repeat in the same ways or take the same amount of time. The critical factor behind them is debt.
You create a cycle every time you borrow money. Every time you buy something you can't afford, it means you spend more than you make. You are not just borrowing from a lender; you are borrowing from your future self. You create a time in the future in which you will need to spend less than you make to pay it back. So the pattern is: (i) borrowing + spending more than you make (ii) spend less than you make + reimburse.
Credit is not something bad that only creates cycles, it is terrible when it finances something that can't be paid back in the future. Borrowing money to buy a TV does not generate income to pay back the debt. However, if you borrow money to finance tools that increase your productivity and earn more money. You can pay back your debt and improve your living standards more quickly.
Credit/debt boosts production/growth at first and depresses it later. Central banks provide it to put on gas when the economy is growing slowly and restrict it to put on brakes when it is growing fast.
- Credits provide buying power and fuels spending and investments
- Credits creates a debt that must be paid back (in the future), lessening spending and investments
A cycle is usually broken down into four phases (i) expansion phase (ii) boom phase (iii) recession phase (iv) recovery phase.
The expansion phase is characterized by rapid growth, low-interest rate, and increasing production. It is fueled by lending, which creates self-reinforcing upward movements that support spending and investment, supporting incomes and asset prices. This creates inflationary pressures.
Key takeaways on expansion phase:
- Rapid growth/increase in production
- Credit is readily available: Low-interest rates → high lending rate
- Inflationary pressures (increase in prices)
The crisis or boom phase
As we approached the end of the expansion phase, central banks do not want too much inflation because it causes problems (such as the surge in prices for essential goods). So they eventually tighten their monetary policy as the inflationary pressures build up.
The peak is the point at which reckless lending result in high default rates. One classic warning sign a bubble is coming is when an increasing amount of money is being borrowed to make debt service payments, which of course, compounds the borrowers' indebtedness.
Key takeaways on boom phase:
- Stock exchanges crash
- Multiple bankruptcies of firms occur
At this stage, interest rates are high, fewer people can borrow money, and, as a result, spending and investment slow: there is a significant decline in economic activity.
Key takeaways on contraction phase:
- High interest-rates
- Lending rate slows down
- Prices and production drop
Bottom or recovery phase
Low prices allow for spending and production to pick up again. Central banks lower interest rates to fuel the recovery.
Key takeaways on recovery phase:
- Low prices
- Stock exchanges recover
- Central banks lower interest rates
What's the point of knowing this? I only wanna invest in financial markets!
The economy is the aggregates of the markets. In order to understand what is happening, and what is likely to happen, in the financial markets, it is essential to understand the relationship between the financial markets and the economy. The whole system is a never-ending process trying to find its equilibrium. Seeing which parts are out of balance allows to anticipate what monetary policy shifts will occur and what impacts these shifts will have on the financial markets. Next week, we will see how what we learned today will help us make better investment decisions.