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How the economic machine works, in 30 minutes.
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The economy works like a simple machine.
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But many people don't understand it
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— or they don't agree on how it works
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— and this has led to a lot of needless economic suffering.
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I feel a deep sense of responsibility
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to share my simple but practical economic template.
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Though it's unconventional,
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it has helped me to anticipate and sidestep the global financial crisis,
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and has worked well for me for over 30 years.
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Let's begin.
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Though the economy might seem complex, it works in a simple, mechanical way.
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It's made up of a few simple parts and a lot of simple transactions
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that are repeated over and over again a zillion times.
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These transactions are above all else driven by human nature,
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and they create 3 main forces that drive the economy.
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Number 1: Productivity growth
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Number 2: The Short term debt cycle
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and Number 3: The Long term debt cycle
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We'll look at these three forces and how laying them on top of each other
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creates a good template for tracking economic movements
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and figuring out what's happening now.
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Let's start with the simplest part of the economy:
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Transactions.
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An economy is simply the sum of the transactions that make it up
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and a transaction is a very simple thing.
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You make transactions all the time.
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Every time you buy something you create a transaction.
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Each transaction consists of a buyer
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exchanging money or credit
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with a seller for goods, services or financial assets.
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Credit spends just like money,
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so adding together the money spent and the amount of credit spent,
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you can know the total spending.
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The total amount of spending drives the economy.
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If you divide the amount spent
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by the quantity sold,
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you get the price.
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And that's it. That's a transaction.
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It is the building block of the economic machine.
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All cycles and all forces in an economy are driven by transactions.
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So, if we can understand transactions,
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we can understand the whole economy.
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A market consists of all the buyers
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and all the sellers
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making transactions for the same thing.
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For example, there is a wheat market,
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a car market,
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a stock market
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and markets for millions of things.
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An economy consists of all of the transactions
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in all of its markets.
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If you add up the total spending
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and the total quantity sold
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in all of the markets,
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you have everything you need to know
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to understand the economy.
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It's just that simple.
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People, businesses, banks and governments
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all engage in transactions the way I just described:
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exchanging money and credit for goods, services and financial assets.
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The biggest buyer and seller is the government,
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which consists of two important parts:
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a Central Government that collects taxes and spends money...
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...and a Central Bank,
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which is different from other buyers and sellers because it
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controls the amount of money and credit in the economy.
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It does this by influencing interest rates
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and printing new money.
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For these reasons, as we'll see,
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the Central Bank is an important player in the flow
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of Credit.
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I want you to pay attention to credit.
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Credit is the most important part of the economy,
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and probably the least understood.
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It is the most important part because it is the biggest
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and most volatile part.
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Just like buyers and sellers go to the market to make transactions,
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so do lenders and borrowers.
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Lenders usually want to make their money into more money
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and borrowers usually want to buy something they can't afford,
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like a house or car
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or they want to invest in something like starting a business.
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Credit can help both lenders
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and borrowers get what they want.
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Borrowers promise to repay the amount they borrow,
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called the principal,
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plus an additional amount, called interest.
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When interest rates are high,
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there is less borrowing because it's expensive.
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When interest rates are low,
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borrowing increases because it's cheaper.
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When borrowers promise to repay
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and lenders believe them,
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credit is created.
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Any two people can agree to create credit out of thin air!
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That seems simple enough but credit is tricky
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because it has different names.
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As soon as credit is created,
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it immediately turns into debt.
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Debt is both an asset to the lender,
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and a liability to the borrower.
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In the future,
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when the borrower repays the loan, plus interest,
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the asset and liability disappear
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and the transaction is settled.
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So, why is credit so important?
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Because when a borrower receives credit,
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he is able to increase his spending.
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And remember, spending drives the economy.
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This is because one person's spending
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is another person's income.
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Think about it, every dollar you spend, someone else earns.
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and every dollar you earn, someone else has spent.
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So when you spend more, someone else earns more.
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When someone's income rises
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it makes lenders more willing to lend him money
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because now he's more worthy of credit.
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A creditworthy borrower has two things:
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the ability to repay and collateral.
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Having a lot of income in relation to his debt gives him the ability to repay.
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In the event that he can't repay, he has valuable assets to use as collateral that can be sold.
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This makes lenders feel comfortable lending him money.
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So increased income allows increased borrowing
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which allows increased spending.
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And since one person's spending is another person's income,
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this leads to more increased borrowing and so on.
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This self-reinforcing pattern leads to economic growth
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and is why we have Cycles.
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In a transaction, you have to give something in order to get something
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and how much you get depends on how much you produce
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over time we learned
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and that accumulated knowledge raises are living standards
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we call this productivity growth
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those who were invented and hard-working raise
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their productivity and their living standards faster
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than those who are complacent and lazy,
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but that isn't necessarily true over the short run.
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Productivity matters most in the long run, but credit matters most in the short run.
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This is because productivity growth doesn't fluctuate much,
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so it's not a big driver of economic swings.
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Debt is — because it allows us to consume more than we produce when we acquire it
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and it forces us to consume less than we produce when we pay it back.
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Debt swings occur in two big cycles.
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One takes about 5 to 8 years and the other takes about 75 to 100 years.
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While most people feel the swings, they typically don't see them as cycles
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because they see them too up close -- day by day, week by week.
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In this chapter we are going to step back and look at these three big forces
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and how they interact to make up our experiences.
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As mentioned, swings around the line are not due to how much innovation or hard work there is,
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they're primarily due to how much credit there is.
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Let's for a second imagine an economy without credit.
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In this economy, the only way I can increase my spending
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is to increase my income,
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which requires me to be more productive and do more work.
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Increased productivity is the only way for growth.
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Since my spending is another person's income,
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the economy grows every time I or anyone else is more productive.
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If we follow the transactions and play this out,
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we see a progression like the productivity growth line.
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But because we borrow, we have cycles.
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This isn't due to any laws or regulation,
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it's due to human nature and the way that credit works.
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Think of borrowing as simply a way of pulling spending forward.
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In order to buy something you can't afford, you need to spend more than you make.
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To do this, you essentially need to borrow from your future self.
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In doing so you create a time in the future
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that you need to spend less than you make in order to pay it back.
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It very quickly resembles a cycle.
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Basically, anytime you borrow you create a cycle.?
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This is as true for an individual as it is for the economy.
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This is why understanding credit is so important
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because it sets into motion
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a mechanical, predictable series of events that will happen in the future.
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This makes credit different from money.
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Money is what you settle transactions with.
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When you buy a beer from a bartender with cash,
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the transaction is settled immediately.
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But when you buy a beer with credit,
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it's like starting a bar tab.
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You're saying you promise to pay in the future.
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Together you and the bartender create an asset and a liability.
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You just created credit. Out of thin air.
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It's not until you pay the bar tab later
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that the asset and liability disappear,
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the debt goes away
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and the transaction is settled.
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The reality is that most of what people call money is actually credit.
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The total amount of credit in the United States is about $50 trillion
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and the total amount of money is only about $3 trillion.
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Remember, in an economy without credit:
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the only way to increase your spending is to produce more.
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But in an economy with credit,
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you can also increase your spending by borrowing.
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As a result, an economy with credit has more spending
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and allows incomes to rise faster than productivity over the short run,
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but not over the long run.
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Now, don't get me wrong,
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credit isn't necessarily something bad that just causes cycles.
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It's bad when it finances over-consumption that can't be paid back.
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However, it's good when it efficiently allocates resources
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and produces income so you can pay back the debt.
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For example, if you borrow money to buy a big TV,
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it doesn't generate income for you to pay back the debt.
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But, if you borrow money to buy a tractor —
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and that tractor let's you harvest more crops and earn more money
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— then, you can pay back your debt
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and improve your living standards.
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In an economy with credit,
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we can follow the transactions
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and see how credit creates growth.
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Let me give you an example:
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Suppose you earn $100,000 a year and have no debt.
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You are creditworthy enough to borrow $10,000 dollars
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- say on a credit card
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- so you can spend $110,000 dollars
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even though you only earn $100,000 dollars.
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Since your spending is another person's income,
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someone is earning $110,000 dollars.
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The person earning $110,000 dollars
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with no debt can borrow $11,000 dollars,
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so he can spend $121,000 dollars
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even though he has only earned $110,000 dollars.
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His spending is another person's income
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and by following the transactions
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we can begin to see how this process
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works in a self-reinforcing pattern.
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But remember, borrowing creates cycles
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and if the cycle goes up, it eventually needs to come down.
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This leads us into the Short Term Debt Cycle.
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As economic activity increases, we see an expansion
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- the first phase of the short term debt cycle.
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Spending continues to increase and prices start to rise.
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This happens because the increase in spending is fueled by credit
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- which can be created instantly out of thin air.
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When the amount of spending and incomes grow faster than the production of goods:
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prices rise.
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When prices rise, we call this inflation.
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The Central Bank doesn't want too much inflation
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because it causes problems.
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Seeing prices rise, it raises interest rates.
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With higher interest rates, fewer people can afford to borrow money.
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And the cost of existing debts rises.
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Think about this as the monthly payments
on your credit card going up.
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Because people borrow less and have higher debt repayments,
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they have less money leftover to spend, so spending slows
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...and since one person's spending is another person's income,
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incomes drop...and so on and so forth.
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When people spend less, prices go down.
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We call this deflation.
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Economic activity decreases and we have a recession.
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If the recession becomes too severe
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and inflation is no longer a problem,
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the central bank will lower interest rates to cause everything to pick up again.
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With low interest rates,
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debt repayments are reduced
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and borrowing and spending pick up
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and we see another expansion.
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As you can see, the economy works like a machine.
261
00:13:40,250 --> 00:13:44,159
In the short term debt cycle,
spending is constrained only by the willingness of
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00:13:44,159 --> 00:13:47,139
lenders and borrowers to provide and receive credit.
263
00:13:47,139 --> 00:13:52,509
When credit is easily available,
there's an economic expansion.
264
00:13:52,509 --> 00:13:56,090
When credit isn't easily available, there's a recession.
265
00:13:56,090 --> 00:14:00,450
And note that this cycle is controlled primarily by the central bank.
266
00:14:00,450 --> 00:14:05,120
The short term debt cycle typically lasts 5 - 8 years
267
00:14:05,120 --> 00:14:08,409
and happens over and over again for decades.
268
00:14:08,409 --> 00:14:10,409
But notice that the bottom and
269
00:14:10,409 --> 00:14:12,399
top of each cycle finish
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00:14:12,399 --> 00:14:16,669
with more growth than the previous cycle and with more debt.
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00:14:16,669 --> 00:14:18,039
Why?
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00:14:18,039 --> 00:14:20,740
Because people push it
273
00:14:20,740 --> 00:14:25,529
— they have an inclination to borrow
and spend more instead of paying back debt.
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00:14:25,529 --> 00:14:27,480
It's human nature.
275
00:14:27,480 --> 00:14:29,379
Because of this,
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00:14:29,379 --> 00:14:30,679
over long periods of time,
277
00:14:30,679 --> 00:14:33,469
debts rise faster than incomes
278
00:14:33,470 --> 00:14:36,670
creating the Long Term Debt Cycle.
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00:14:38,070 --> 00:14:39,670
Despite people becoming more indebted,
280
00:14:40,169 --> 00:14:44,029
lenders even more freely extend credit.
281
00:14:44,029 --> 00:14:45,029
Why?
282
00:14:45,029 --> 00:14:48,669
Because everybody thinks things are going great!
283
00:14:48,669 --> 00:14:51,969
People are just focusing on what's been happening lately.
284
00:14:51,970 --> 00:14:55,649
And what has been happening lately?
285
00:14:55,649 --> 00:14:57,649
Incomes have been rising!
286
00:14:57,649 --> 00:14:59,250
Asset values are going up!
287
00:14:59,250 --> 00:15:01,549
The stock market roars!
288
00:15:01,549 --> 00:15:02,479
It's a boom!
289
00:15:02,480 --> 00:15:06,690
It pays to buy goods, services, and financial assets
290
00:15:06,690 --> 00:15:08,390
with borrowed money!
291
00:15:08,389 --> 00:15:11,769
When people do a lot of that, we call it a bubble.
292
00:15:11,769 --> 00:15:14,639
So even though debts have been growing,
293
00:15:14,639 --> 00:15:18,110
incomes have been growing nearly as fast to offset them.
294
00:15:18,110 --> 00:15:21,970
Let's call the ratio of debt-to-income the debt burden.
295
00:15:21,970 --> 00:15:25,210
So long as incomes continue to rise,
296
00:15:25,210 --> 00:15:27,040
the debt burden stays manageable.
297
00:15:27,039 --> 00:15:30,230
At the same time asset values soar.
298
00:15:30,230 --> 00:15:33,230
People borrow huge amounts of money
299
00:15:34,029 --> 00:15:35,059
to buy assets as investments
300
00:15:35,059 --> 00:15:37,659
causing their prices to rise even higher.
301
00:15:37,659 --> 00:15:40,259
People feel wealthy.
302
00:15:40,259 --> 00:15:43,259
So even with the accumulation of lots of debt,
303
00:15:43,259 --> 00:15:49,490
rising incomes and asset values help borrowers remain creditworthy for a long time.
304
00:15:49,490 --> 00:15:52,529
But this obviously can not continue forever.
305
00:15:52,529 --> 00:15:54,250
And it doesn't.
306
00:15:54,250 --> 00:16:00,519
Over decades, debt burdens slowly increase creating larger and larger debt repayments.
307
00:16:00,519 --> 00:16:05,399
At some point, debt repayments start growing faster than incomes
308
00:16:05,399 --> 00:16:08,240
forcing people to cut back on their spending.
309
00:16:08,240 --> 00:16:12,200
And since one person's spending is another person's income,
310
00:16:12,200 --> 00:16:14,500
incomes begin to go down...
311
00:16:14,500 --> 00:16:19,019
...which makes people less credit worthy causing borrowing to go down.
312
00:16:19,019 --> 00:16:22,019
Debt repayments continue to rise
313
00:16:22,019 --> 00:16:24,439
which makes spending drop even further...
314
00:16:24,440 --> 00:16:27,140
...and the cycle reverses itself.
315
00:16:27,139 --> 00:16:30,960
This is the long term debt peak.
316
00:16:30,960 --> 00:16:34,150
Debt burdens have simply become too big.
317
00:16:34,149 --> 00:16:38,829
For the United States, Europe and much of the rest of the world this
318
00:16:38,830 --> 00:16:40,759
happened in 2008.
319
00:16:40,759 --> 00:16:45,429
It happened for the same reason it happened in Japan in 1989
320
00:16:45,429 --> 00:16:48,750
and in the United States back in 1929.
321
00:16:48,750 --> 00:16:51,980
Now the economy begins Deleveraging.
322
00:16:51,980 --> 00:16:56,500
In a deleveraging; people cut spending,
323
00:16:56,500 --> 00:16:59,539
incomes fall, credit disappears,
324
00:16:59,539 --> 00:17:02,699
assets prices drop, banks get squeezed,
325
00:17:02,700 --> 00:17:06,340
the stock market crashes, social tensions rise
326
00:17:06,339 --> 00:17:09,708
and the whole thing starts to feed on itself the other way.
327
00:17:09,709 --> 00:17:13,850
As incomes fall and debt repayments rise,
328
00:17:13,849 --> 00:17:17,990
borrowers get squeezed.
No longer creditworthy,
329
00:17:17,990 --> 00:17:22,359
credit dries up and borrowers can no longer borrow
enough money to make their
330
00:17:22,359 --> 00:17:23,599
debt repayments.
331
00:17:23,599 --> 00:17:28,439
Scrambling to fill this hole, borrowers are forced to sell assets.
332
00:17:28,440 --> 00:17:31,549
The rush to sell assets floods the market
333
00:17:31,549 --> 00:17:36,369
This is when the stock market collapses,
334
00:17:36,369 --> 00:17:39,739
the real estate market tanks and banks get into trouble.
335
00:17:39,740 --> 00:17:44,940
As asset prices drop, the value of the collateral borrowers can put up drops.
336
00:17:44,940 --> 00:17:48,279
This makes borrowers even less creditworthy.
337
00:17:48,279 --> 00:17:50,200
People feel poor.
338
00:17:51,299 --> 00:17:55,009
Credit rapidly disappears.
Less spending ›
339
00:17:55,009 --> 00:17:55,890
less income ›
340
00:17:55,890 --> 00:17:57,890
less wealth ›
341
00:17:57,890 --> 00:17:58,590
less credit ›
342
00:17:58,589 --> 00:18:00,799
less borrowing and so on.
343
00:18:00,799 --> 00:18:03,000
It's a vicious cycle.
344
00:18:03,000 --> 00:18:06,529
This appears similar to a recession but the difference here
345
00:18:06,529 --> 00:18:10,160
is that interest rates can't be lowered to save the day.
346
00:18:10,160 --> 00:18:14,590
In a recession, lowering interest rates works to stimulate the borrowing.
347
00:18:14,589 --> 00:18:18,569
However, in a deleveraging, lowering interest rates doesn't work because
348
00:18:18,569 --> 00:18:20,529
interest rates are already
349
00:18:20,529 --> 00:18:25,309
low and soon hit 0% - so the stimulation ends.
350
00:18:25,309 --> 00:18:29,210
Interest rates in the United States hit 0% during the deleveraging of
351
00:18:29,210 --> 00:18:30,840
the 1930s
352
00:18:30,839 --> 00:18:33,439
and again in 2008.
353
00:18:33,440 --> 00:18:35,840
The difference between a recession
354
00:18:35,839 --> 00:18:40,269
and a deleveraging is that in a deleveraging borrowers' debt burdens have
355
00:18:40,269 --> 00:18:41,930
simply gotten too big
356
00:18:41,930 --> 00:18:45,049
and can't be relieved by lowering interest rates.
357
00:18:45,049 --> 00:18:50,240
Lenders realize that debts have become too large to ever be fully paid back.
358
00:18:50,240 --> 00:18:55,309
Borrowers have lost their ability to repay and their collateral has lost value.
359
00:18:55,309 --> 00:18:59,369
They feel crippled by the debt - they don't even want more!
360
00:18:59,369 --> 00:19:03,489
Lenders stop lending. Borrowers stop borrowing.
361
00:19:03,490 --> 00:19:07,019
Think of the economy as being not-creditworthy,
362
00:19:07,019 --> 00:19:09,000
just like an individual.
363
00:19:09,000 --> 00:19:12,599
So what do you do about a deleveraging?
364
00:19:12,599 --> 00:19:17,539
The problem is debt burdens are too high and they must come down.
365
00:19:17,539 --> 00:19:20,789
There are four ways this can happen.
366
00:19:20,789 --> 00:19:24,489
- people, businesses, and governments cut their spending.
367
00:19:24,489 --> 00:19:28,409
- debts are reduced through defaults and restructurings.
368
00:19:28,409 --> 00:19:34,139
- wealth is redistributed from the 'haves' to the 'have nots'.
369
00:19:34,138 --> 00:19:37,979
and finally, 4. the central bank prints new money.
370
00:19:37,980 --> 00:19:42,999
These 4 ways have happened in every deleveraging in modern history.
371
00:19:45,699 --> 00:19:47,778
Usually, spending is cut first.
372
00:19:47,878 --> 00:19:52,128
As we just saw, people, businesses, banks and even governments tighten their belts and
373
00:19:52,128 --> 00:19:54,868
cut their spending so that they can pay down their debt.
374
00:19:54,868 --> 00:19:58,558
This is often referred to as austerity.
375
00:19:58,558 --> 00:20:01,829
When borrowers stop taking on new debts,
376
00:20:01,829 --> 00:20:06,769
and start paying down old debts, you might expect the debt burden to decrease.
377
00:20:06,769 --> 00:20:10,720
But the opposite happens!
Because spending is cut
378
00:20:10,720 --> 00:20:14,610
- and one man's spending is another man's income - it causes
379
00:20:14,609 --> 00:20:19,028
incomes to fall. They fall faster than debts are repaid
380
00:20:19,028 --> 00:20:23,210
and the debt burden actually gets worse. As we've seen,
381
00:20:23,210 --> 00:20:26,329
this cut in spending is deflationary and painful.
382
00:20:26,329 --> 00:20:29,388
Businesses are forced to cut costs...
383
00:20:29,388 --> 00:20:32,778
which means less jobs and higher unemployment.
384
00:20:32,778 --> 00:20:37,138
This leads to the next step: debts must be reduced!
385
00:20:37,138 --> 00:20:41,148
Many borrowers find themselves unable to repay their loans
386
00:20:41,148 --> 00:20:44,298
— and a borrower's debts are a lender's assets.
387
00:20:44,298 --> 00:20:48,749
When borrowers don't repay the bank, people get nervous that the bank won't
388
00:20:48,749 --> 00:20:50,308
be able to repay them
389
00:20:50,308 --> 00:20:54,908
so they rush to withdraw their money from the bank.
Banks get squeezed and
390
00:20:54,909 --> 00:20:55,590
people,
391
00:20:55,589 --> 00:21:00,079
businesses and banks default on their debts.
This severe
392
00:21:00,079 --> 00:21:03,569
economic contraction is a depression.
393
00:21:03,569 --> 00:21:08,648
A big part of a depression is people discovering much of what they thought
394
00:21:08,648 --> 00:21:11,088
was their wealth isn't really there.
395
00:21:11,088 --> 00:21:13,490
Let's go back to the bar.
396
00:21:13,690 --> 00:21:17,619
When you bought a beer and put it on a bar tab,
397
00:21:17,618 --> 00:21:23,569
you promised to repay the bartender.
Your promise became an asset of the bartender.
398
00:21:23,569 --> 00:21:28,128
But if you break your promise - if you don't pay him back and essentially default
399
00:21:28,128 --> 00:21:29,308
on your bar tab -
400
00:21:29,308 --> 00:21:32,648
then the 'asset' he has isn't really worth anything.
401
00:21:32,648 --> 00:21:35,778
It has basically disappeared.
402
00:21:35,778 --> 00:21:39,710
Many lenders don't want their assets to disappear and agree to debt
403
00:21:39,710 --> 00:21:40,759
restructuring.
404
00:21:40,759 --> 00:21:44,319
Debt restructuring means lenders get paid back
405
00:21:44,319 --> 00:21:48,048
less or get paid back over a longer time frame
406
00:21:48,048 --> 00:21:52,329
or at a lower interest rate that was first agreed.
Somehow
407
00:21:52,329 --> 00:21:56,888
a contract is broken in a way that reduces debt.
Lenders would rather have a
408
00:21:56,888 --> 00:21:59,418
little of something than all of nothing.
409
00:21:59,419 --> 00:22:03,450
Even though debt disappears, debt restructuring causes
410
00:22:03,450 --> 00:22:06,558
income and asset values to disappear faster,
411
00:22:06,558 --> 00:22:09,678
so the debt burden continues to gets worse.
412
00:22:09,679 --> 00:22:12,950
Like cutting spending, debt reduction
413
00:22:12,950 --> 00:22:16,009
is also painful and deflationary.
414
00:22:16,009 --> 00:22:21,940
All of this impacts the central government because lower incomes and less employment
415
00:22:21,940 --> 00:22:27,048
means the government collects fewer taxes.
416
00:22:27,048 --> 00:22:30,210
At the same time it needs to increase its spending because unemployment has risen.
417
00:22:30,210 --> 00:22:33,960
Many of the unemployed have inadequate savings
418
00:22:33,960 --> 00:22:36,419
and need financial support from the government.
419
00:22:36,419 --> 00:22:39,999
Additionally, governments create stimulus plans
420
00:22:39,999 --> 00:22:43,879
and increase their spending to make up for the decrease in the economy.
421
00:22:43,878 --> 00:22:47,509
Governments' budget deficits explode in a
422
00:22:47,509 --> 00:22:51,058
deleveraging because they spend more than they earn in taxes.
423
00:22:51,058 --> 00:22:55,720
This is what is happening when you hear about the budget deficit on the news.
424
00:22:55,720 --> 00:23:01,319
To fund their deficits, governments need to either raise taxes
425
00:23:01,319 --> 00:23:06,058
or borrow money. But with incomes falling and so many unemployed,
426
00:23:06,058 --> 00:23:09,788
who is the money going to come from? The rich.
427
00:23:09,788 --> 00:23:14,579
Since governments need more money and since wealth is heavily concentrated in
428
00:23:14,579 --> 00:23:17,108
the hands of a small percentage of the people,
429
00:23:17,108 --> 00:23:20,378
governments naturally raise taxes on the wealthy
430
00:23:20,378 --> 00:23:24,449
which facilitates a redistribution of wealth in the economy -
431
00:23:24,450 --> 00:23:29,278
from the 'haves' to the 'have nots'.
The 'have-nots,' who are suffering, begin to
432
00:23:29,278 --> 00:23:30,970
resent the wealthy 'haves.'
433
00:23:30,970 --> 00:23:36,308
The wealthy 'haves,' being squeezed by the weak economy, falling asset prices,
434
00:23:36,308 --> 00:23:39,940
higher taxes, begin to resent the 'have nots.'
435
00:23:39,940 --> 00:23:43,890
If the depression continues social disorder can break out.
436
00:23:43,890 --> 00:23:47,280
Not only do tensions rise within countries,
437
00:23:47,279 --> 00:23:52,200
they can rise between countries - especially debtor and creditor countries.
438
00:23:52,200 --> 00:23:56,039
This situation can lead to political change
439
00:23:56,039 --> 00:23:58,839
that can sometimes be extreme.
440
00:23:58,839 --> 00:24:02,629
In the 1930s, this led to Hitler coming to power,
441
00:24:02,630 --> 00:24:08,080
war in Europe, and depression in the United States. Pressure to do something
442
00:24:08,079 --> 00:24:10,069
to end the depression increases.
443
00:24:10,069 --> 00:24:14,950
Remember, most of what people thought was money was actually credit.
444
00:24:14,950 --> 00:24:18,400
So, when credit disappears, people don't have enough money.
445
00:24:18,400 --> 00:24:23,190
People are desperate for money and you remember who can print money?
446
00:24:23,190 --> 00:24:27,370
The Central Bank can.
447
00:24:27,369 --> 00:24:30,308
Having already lowered its interest rates to nearly 0
448
00:24:30,308 --> 00:24:34,089
- it's forced to print money. Unlike cutting spending,
449
00:24:34,089 --> 00:24:37,298
debt reduction, and wealth redistribution,
450
00:24:37,298 --> 00:24:42,190
printing money is inflationary and stimulative. Inevitably, the central bank
451
00:24:42,190 --> 00:24:43,210
prints new money
452
00:24:43,210 --> 00:24:47,150
— out of thin air — and uses it to buy financial assets
453
00:24:47,150 --> 00:24:52,259
and government bonds. It happened in the United States during the Great Depression
454
00:24:52,259 --> 00:24:56,009
and again in 2008, when the United States' central bank —
455
00:24:56,009 --> 00:24:59,940
the Federal Reserve — printed over two trillion dollars.
456
00:24:59,940 --> 00:25:04,179
Other central banks around the world that could, printed a lot of money, too.
457
00:25:04,179 --> 00:25:07,440
By buying financial assets with this money,
458
00:25:07,440 --> 00:25:11,679
it helps drive up asset prices which makes people more creditworthy.
459
00:25:11,679 --> 00:25:15,820
However, this only helps those who own financial assets.
460
00:25:15,819 --> 00:25:21,839
You see, the central bank can print money but it can only buy financial assets.
461
00:25:21,839 --> 00:25:24,899
The Central Government, on the other hand,
462
00:25:24,900 --> 00:25:29,580
can buy goods and services and put money in the hands of the people
463
00:25:29,579 --> 00:25:34,519
but it can't print money. So, in order to stimulate the economy, the two
464
00:25:34,519 --> 00:25:35,650
must cooperate.
465
00:25:35,650 --> 00:25:40,470
By buying government bonds, the Central Bank essentially lends money to the
466
00:25:40,470 --> 00:25:41,190
government,
467
00:25:41,190 --> 00:25:44,909
allowing it to run a deficit and increase spending
468
00:25:44,909 --> 00:25:48,650
on goods and services through its stimulus programs
469
00:25:48,650 --> 00:25:53,080
and unemployment benefits. This increases people's income
470
00:25:53,079 --> 00:25:56,240
as well as the government's debt. However,
471
00:25:56,240 --> 00:25:59,539
it will lower the economy's total debt burden.
472
00:25:59,539 --> 00:26:05,428
This is a very risky time. Policy makers need to balance the four ways that debt
473
00:26:05,429 --> 00:26:06,590
burdens come down.
474
00:26:06,589 --> 00:26:13,049
The deflationary ways need to balance with the inflationary ways in
475
00:26:13,049 --> 00:26:14,710
order to maintain stability.
476
00:26:14,710 --> 00:26:18,130
If balanced correctly, there can be a
477
00:26:18,130 --> 00:26:21,479
Beautiful Deleveraging.
478
00:26:21,479 --> 00:26:25,359
You see, a deleveraging can be ugly or it can be beautiful.
479
00:26:25,358 --> 00:26:28,838
How can a deleveraging be beautiful?
480
00:26:28,838 --> 00:26:33,428
Even though a deleveraging is a difficult situation,
481
00:26:33,429 --> 00:26:37,548
handling a difficult situation in the best possible way is beautiful.
482
00:26:37,548 --> 00:26:42,210
A lot more beautiful than the debt-fueled, unbalanced excesses of the
483
00:26:42,210 --> 00:26:45,940
leveraging phase. In a beautiful deleveraging,
484
00:26:45,940 --> 00:26:51,088
debts decline relative to income, real economic growth is positive,
485
00:26:51,088 --> 00:26:56,888
and inflation isn't a problem.
It is achieved by having the right balance.
486
00:26:56,888 --> 00:27:00,158
The right balance requires a certain mix
487
00:27:00,159 --> 00:27:04,229
of cutting spending, reducing debt, transferring wealth
488
00:27:04,229 --> 00:27:09,149
and printing money so that economic and social stability can be maintained.
489
00:27:09,148 --> 00:27:13,638
People ask if printing money will raise inflation.
490
00:27:13,638 --> 00:27:18,878
It won't if it offsets falling credit. Remember, spending is what matters.
491
00:27:18,878 --> 00:27:24,248
A dollar of spending paid for with money has the same effect on price as a dollar
492
00:27:24,249 --> 00:27:25,969
of spending paid for with credit.
493
00:27:25,969 --> 00:27:31,298
By printing money, the Central Bank can make up for the disappearance of credit
494
00:27:31,298 --> 00:27:33,079
with an increase in the amount of money.
495
00:27:33,079 --> 00:27:38,509
In order to turn things around, the Central Bank needs to not only pump up
496
00:27:38,509 --> 00:27:39,519
income growth
497
00:27:39,519 --> 00:27:43,848
but get the rate of income growth higher than the rate of interest on the
498
00:27:43,848 --> 00:27:45,098
accumulated debt.
499
00:27:45,098 --> 00:27:48,378
So, what do I mean by that? Basically,
500
00:27:48,378 --> 00:27:52,308
income needs to grow faster than debt grows. For example:
501
00:27:52,308 --> 00:27:56,079
let's assume that a country going through a deleveraging has a debt-to-
502
00:27:56,079 --> 00:27:58,579
income ratio of 100%.
503
00:27:58,579 --> 00:28:03,658
That means that the amount of debt it has is the same as the amount of income the
504
00:28:03,659 --> 00:28:05,799
entire country makes in a year.
505
00:28:05,798 --> 00:28:09,009
Now think about the interest rate on that debt,
506
00:28:09,009 --> 00:28:11,159
let's say it is 2%.
507
00:28:11,159 --> 00:28:15,028
If debt is growing at 2% because of that interest rate and
508
00:28:15,028 --> 00:28:15,690
income
509
00:28:15,690 --> 00:28:20,230
is only growing at around only 1%, you will never reduce the debt burden.
510
00:28:20,230 --> 00:28:24,808
You need to print enough money to get the rate of income growth above the
511
00:28:24,808 --> 00:28:25,950
rate of interest.
512
00:28:25,950 --> 00:28:30,720
However, printing money can easily be abused because it's so easy to do and
513
00:28:30,720 --> 00:28:33,048
people prefer it to the alternatives.
514
00:28:33,048 --> 00:28:36,200
The key is to avoid printing too much money
515
00:28:36,200 --> 00:28:41,110
and causing unacceptably high inflation, the way Germany did during its
516
00:28:41,109 --> 00:28:43,128
deleveraging in the 1920's.
517
00:28:43,128 --> 00:28:48,269
If policymakers achieve the right balance, a deleveraging isn't so dramatic.
518
00:28:48,269 --> 00:28:51,339
Growth is slow but debt burdens go down.
519
00:28:51,339 --> 00:28:54,470
That's a beautiful deleveraging.
520
00:28:54,470 --> 00:28:59,829
When incomes begin to rise, borrowers begin to appear more creditworthy.
521
00:28:59,829 --> 00:29:02,999
And when borrowers appear more creditworthy,
522
00:29:02,999 --> 00:29:08,509
lenders begin to lend money again.
Debt burdens finally begin to fall.
523
00:29:08,509 --> 00:29:13,499
Able to borrow money, people can spend more. Eventually, the economy begins to
524
00:29:13,499 --> 00:29:14,399
grow again,
525
00:29:14,398 --> 00:29:18,008
leading to the reflation phase of the long term debt cycle.
526
00:29:18,009 --> 00:29:22,490
Though the deleveraging process can be horrible if handled badly,
527
00:29:22,490 --> 00:29:26,278
if handled well, it will eventually fix the problem.
528
00:29:26,278 --> 00:29:29,579
It takes roughly a decade or more
529
00:29:29,579 --> 00:29:33,668
for debt burdens to fall and economic activity to get back to normal
530
00:29:33,669 --> 00:29:37,899
- hence the term 'lost decade.'
531
00:29:37,898 --> 00:29:42,719
Of course, the economy is a little more complicated than this template
532
00:29:42,720 --> 00:29:43,639
suggests.
533
00:29:43,638 --> 00:29:48,849
However, laying the short term debt cycle on top of the long term debt cycle
534
00:29:48,849 --> 00:29:52,628
and then laying both of them on top of the productivity growth line
535
00:29:52,628 --> 00:29:55,918
gives a reasonably good template for seeing where we've been,
536
00:29:55,919 --> 00:29:58,919
where we are now and where we are probably headed.
537
00:29:58,919 --> 00:30:03,019
So in summary, there are three rules of thumb that I'd like you to take away
538
00:30:03,019 --> 00:30:03,720
from this:
539
00:30:03,720 --> 00:30:08,220
First:
Don't have debt rise faster than income,
540
00:30:08,220 --> 00:30:11,429
because your debt burdens will eventually crush you.
541
00:30:11,429 --> 00:30:16,059
Second:
Don't have income rise faster than productivity,
542
00:30:16,058 --> 00:30:19,158
because you will eventually become uncompetitive.
543
00:30:19,159 --> 00:30:24,000
And third:
Do all that you can to raise your productivity,
544
00:30:24,000 --> 00:30:29,028
because, in the long run, that's what matters most.
545
00:30:29,548 --> 00:30:34,079
This is simple advice for you and it's simple advice for policy makers.
546
00:30:34,079 --> 00:30:38,470
You might be surprised but most people — including most policy makers — don't pay enough attention
547
00:30:38,470 --> 00:30:39,509
to this.
548
00:30:39,509 --> 00:30:44,058
This template has worked for me and I hope that it'll work for you.
549
00:30:44,058 --> 00:30:46,379
Thank you.
