The economy works like a simple machine, but many people don’t understand it—or they don’t agree on how it works—and this has led to a lot of needless economic suffering. I feel a deep sense of responsibility to share my simple but practical economic template. Though it’s unconventional, it has helped me to anticipate and sidestep the global financial crisis, and it has worked well for me for over 30 years. Let’s begin.
Though the economy might seem complex, it works in a simple, mechanical way. It’s made up of a few simple parts and a lot of simple transactions that are repeated over and over again a zillion times. These transactions are, above all else, driven by human nature, and they create three main forces that drive the economy:
- Productivity growth
- The short-term debt cycle
- The long-term debt cycle
We’ll look at these three forces and how laying them on top of each other creates a good template for tracking economic movements and figuring out what’s happening now. Let’s start with the simplest part of the economy: transactions.
An economy is simply the sum of the transactions that make it up, and a transaction is a very simple thing. You make transactions all the time. Every time you buy something, you create a transaction. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets. Credit spends just like money, so adding together the money spent and the amount of credit spent, you can know the total spending.
The total amount of spending drives the economy. If you divide the amount spent by the quantity sold, you get the price. And that’s it—that’s a transaction. It’s the building block of the economic machine. All cycles and all forces in an economy are driven by transactions. So, if we can understand transactions, we can understand the whole economy.
A market consists of all the buyers and all the sellers making transactions for the same thing. For example, there’s a wheat market, a car market, a stock market, and markets for millions of things. An economy consists of all of the transactions in all of its markets. If you add up the total spending and the total quantity sold in all of the markets, you have everything you need to know to understand the economy. It’s just that simple.
People, businesses, banks, and governments all engage in transactions the way I just described: exchanging money and credit for goods, services, and financial assets. The biggest buyer and seller is the government, which consists of two important parts: a central government that collects taxes and spends money, and a central bank, which is different from other buyers and sellers because it controls the amount of money and credit in the economy. It does this by influencing interest rates and printing new money. For these reasons, as we’ll see, the central bank is an important player in the flow of credit.
I want you to pay attention to credit. Credit is the most important part of the economy and probably the least understood. It’s the most important part because it’s the biggest and most volatile part. Just like buyers and sellers go to the market to make transactions, so do lenders and borrowers. Lenders usually want to make their money into more money, and borrowers usually want to buy something they can’t afford, like a house or a car, or they want to invest in something like starting a business. Credit can help both lenders and borrowers get what they want.
When borrowers promise to repay and lenders believe them, credit is created. Any two parties can agree to create credit out of thin air. For example, if you go to a bar and you don’t have any money, you might say to the bartender, “Can I pay you later?” If the bartender says yes, you just created credit. You have an asset—he owes you a drink—and he has a liability—he has to give you that drink. That’s credit.
The reality is that most of what people call money is actually credit. For instance, in the United States, the total amount of credit is about $50 trillion, but the total amount of money is only about $3 trillion. Credit is different from money because money is what you settle transactions with immediately, whereas credit is a promise to pay in the future.
When you buy something with a credit card, you’re creating credit because you’re promising to pay later. You and the lender—in this case, the credit card company—create an asset and a liability. Together, you’ve created credit out of thin air. As soon as credit is created, it becomes part of the total spending in the economy because it allows the borrower to spend more now. Since one person’s spending is another person’s income, this leads to more income in the economy.
When someone’s income rises, it makes lenders more willing to lend to them because they’re more creditworthy. Creditworthiness is determined by two things: their income and the value of their collateral—things like houses or stocks that they can use to back up their borrowing. When incomes rise and asset values go up, borrowers become more creditworthy, so they can borrow more. This allows them to spend more, which means someone else earns more, and the cycle continues.
This self-reinforcing pattern leads to economic growth through leverage and increased demand and economic activity. Every time you borrow, you create a cycle. This is as true for an individual as it is for the economy. This is why understanding credit is so important—it sets into motion a mechanical, predictable series of events that will happen in the future.
In an economy without credit, the only way to increase your spending is to produce more—to work harder or smarter, which increases productivity. Productivity growth is the most important driver of long-term prosperity because it means you’re producing more value over time. Over the long run, productivity growth is what matters most, but it moves slowly and doesn’t fluctuate much in the short term.
But because we borrow, we have cycles. Borrowing is simply a way of pulling spending forward. To buy something you can’t afford, you need to spend more than you make now, which means you’re borrowing from your future self. In the future, you’ll have to spend less than you make to pay back that debt. This creates cycles.
Let’s look at the short-term debt cycle first. When credit is easily available—say, because the central bank lowers interest rates—people borrow more, so they spend more. Since one person’s spending is another person’s income, this increases incomes, which makes people more creditworthy, so they borrow even more. Asset values like houses and stocks go up because people are spending more, and this makes people feel wealthier, so they borrow and spend even more.
This is an economic expansion. Everyone’s happy—businesses are selling more, people are buying more, incomes are rising, asset values are soaring, the stock market roars. It’s a boom. It pays to buy goods, services, and financial assets. When people do a lot of that, we call it a bubble.
But this can’t go on forever. As people borrow more, their debt burdens grow. Let’s call the ratio of debt to income the debt burden. At some point, the amount they’re spending on debt repayments starts to grow faster than their incomes. They can’t borrow any more because lenders won’t let them—lenders see that their debt burdens are getting too high.
When people can’t borrow more, they can’t spend as much. Since one person’s spending is another person’s income, incomes start to go down. Asset values—like houses and stocks—also start to fall because people aren’t buying as much. This makes borrowers less creditworthy because their collateral is worth less, so they can borrow even less. Spending drops further, incomes drop further, and the cycle reverses.
This is a recession. People feel poor, credit disappears, and spending slows down. But here’s where the central bank steps in. In a recession, the central bank lowers interest rates to make borrowing cheaper, which encourages people to borrow and spend again. When interest rates go down, debt repayments become more manageable, so people can borrow more, spending picks up, and the economy starts to expand again.
This short-term debt cycle typically lasts 5 to 8 years and happens over and over again. Note that it’s primarily controlled by the central bank, which influences the cost of borrowing by setting interest rates. But notice something else: each time we go through a cycle, we end up with more debt. People borrow during the expansion, and even though they cut back during the recession, they don’t cut back enough to reduce their overall debt levels. So, over time, debt keeps rising.
This brings us to the long-term debt cycle. Over a long period—say, 50 to 75 years—debts rise faster than incomes because people keep borrowing to spend more than they make. They’re pulling more and more spending forward from the future. Even though productivity is growing over time, debt is growing faster.
Eventually, debt burdens get so high that people can’t borrow any more. They’ve maxed out their credit cards, so to speak. Lenders stop lending because borrowers can’t afford to take on more debt—their incomes aren’t high enough to support it. When people can’t borrow more, they can’t spend as much. Since one person’s spending is another person’s income, incomes start to fall.
Asset values—like houses and stocks—drop because people aren’t buying as much. This makes borrowers even less creditworthy because their collateral is worth less. Credit disappears, spending collapses, and incomes plummet. This is called a deleveraging.
A deleveraging looks a lot like a recession, but it’s different because interest rates can’t be lowered to save the day. In a normal recession, the central bank can lower interest rates to stimulate borrowing. But in a deleveraging, interest rates are already near zero, and people still can’t borrow because their debt burdens are too high.
At this point, borrowers are scrambling to fill the hole. They’re forced to sell assets to raise cash, but since everyone’s selling at the same time, asset prices crash. This makes the situation worse—people feel poorer, so they spend even less. It’s a vicious cycle.
There are only a few ways out of a deleveraging, and they’re all painful: - Debt reduction—people cut spending drastically to pay down debt, but this reduces incomes because one person’s spending is another person’s income, so the economy shrinks.
- Debt restructuring—lenders agree to forgive some debt or reduce payments, but this means lenders lose money, which can cause problems for banks and other institutions.
- Wealth redistribution—governments might raise taxes on the wealthy to fund spending for those who are struggling, but this can cause political and social tension.
- Printing money—the central bank can print new money to fill the gap left by disappearing credit. This can help stimulate spending, but it risks inflation if too much money is printed.
In a deleveraging, governments and central banks have to balance these tools carefully. If they get it wrong, the deleveraging can spiral into a depression, where economic activity stays low for a long time—think of the 1930s in the United States.
The good news is that deleveragings don’t happen often—maybe once or twice in a lifetime. After a deleveraging, the economy resets. Debt levels come down, and the cycle can start again. But it takes a long time—usually about a decade—for the economy to recover fully. That’s why it’s sometimes called a “lost decade.”
To summarize, the economy is driven by transactions, and transactions are driven by spending, which is made up of money and credit. Credit creates cycles because borrowing pulls spending forward, which means less spending in the future to pay back debt. There are two main cycles: the short-term debt cycle, which lasts 5 to 8 years and is controlled by the central bank, and the long-term debt cycle, which lasts 50 to 75 years and ends in a deleveraging when debts get too high.
Productivity growth is what matters most in the long run, but credit drives the swings in the short run. By understanding these cycles, you can get a better sense of what’s happening in the economy and why.
That’s the template I use to understand how the economic machine works. It’s not perfect, but it’s helped me navigate some pretty tough economic environments. I hope it’s helpful to you, too.
