Conclusion - it is basically one big economic machine

Hello ladies and gents,

How are you? I hope you liked last week’s edition and it gave you some clarity on how our economic world is turning.

First newsletter of February is here which means that we are starting a new book. One that touches a lot on the topic of economy and how it actually works.

• Because it doesn’t hurt to know more - how does the economy actually work? - part 2

• Closing the Gap - Sallie Krawcheck

• Book of the month - Capital in the Twenty-First Century by Thomas Piketty - part I

LET’S COVER THE BASICS

No, but how does the economy actually work?

Last time we spoke, we stopped at inflation. As a reminder - to read last week’s newsletter click here.

But let’s recap here anyways:

• Every time you buy something you create a transaction

• Each transaction consists of a buyer exchanging money with a seller for goods or services

• One person's spending is another person's income

Conclusion - spending drives the economy.

Ok, back to inflation.

We know good and bad inflation. The good inflation is around 2% and if it stays there, countries are happy and all is good in the world. But like we said last week, it can be a problem when the inflation goes up too much and your beloved matcha late becomes too expensive. Prices go up due to people taking out a lot of credit, that they spend on goods and if production of goods is not able to catch up, demand is bigger than the supply, prices go up. So what happens next?

The countries say - not under my watch - and the Central banks¹ raise the interest rates to slow down the credit flows, so fewer people can borrow money and of course spend it. This action also raises the interest rates on existing credit and people have to make higher debt repayments. Less money borrowed, less money spent.

We got rid of the inflation. And what is on the opposite side? Deflation² . This means that the prices are going down. And that is a good thing right? Well, it can be up to a point. If the spending goes down too much, we stumble upon a new issue on the other side of the spectrum - recession³ .

Recession means that things in the economy are not going well and is again something that central banks don’t like. To solve this issue, they will now lower interest rates to encourage spending and hopefully everything picks up again. As you can see, the economy works like a machine. Cycle turned back up again.

These short term debt cycle are primarily controlled by central banks and happen every 5-8 years. In these cycles spending is solely based on how much credit the lenders (mostly banks) are willing to give. When credit is easily available, we talk about an economic expansion. When credit isn't easily available, we talk about a recession. Funny thing about these cycles is, that each of them finishes at a higher point than the previous one and also with more debt.

How so?

Because we are not robots, we are humans and it is in our nature that we prefer to borrow and spend, not to return back the debt. We basically push the limits and like living on the edge (sense the sarcasm). If we would look at our historical behavior, we never have enough. And this brings us to long term debt cycle. Do you remember the bank crisis of 2008 and the housing bubble⁴ ? That was part of a long term debt cycle.

Let’s dive into it.

What happened in 2008 is that the debt became too big and people weren’t able to repay it. In the long term debt cycle the biggest problem comes from the assets that have certain value such as stocks or real estate. What happens is that people are not able to pay back the credit they used to buy them. To solve this predicament, they are trying to offload them, the market gets flooded and their prices go down. And this means trouble - real estate market goes down, stock markets crash and banks are hanging by a thread. We call this deleveraging⁵ .

But you may be wondering - “but can’t the central banks just lower the interest rates and all is well again?”. Not this time. This time the interest rates are already so low, that they can’t go lower. They are so low, no one can dance under that limbo stick.

Debts have become too large to ever be fully paid back. Assets that could cover the debts, have lost their value. People are not spending money. Economy is down.

To solve this unfortunate situation, the following measures are put in place, at least that is what happened in the near past when trying to solve such crisis:

1. Spending is cut even more
   People, businesses, banks and even governments tighten their belts and cut their spending so that they can pay down their debt. However, this raises the following issues - higher unemployment rates, because as we learned - one person's spending is another person's income.

2. Debt gets reduced
   How? By restructuring. Because a bit of something is better than a lot of nothing, the borrower and lender can agree to restructure the debt - by lowering the interest rates, by extending the timeframe in which the debt needs to be repaid or they can even agree that the borrower will pay back less than they borrowed.

3. Wealth redistribution

   We now know that regular people are not spending their money in this economy, because they don’t have any, and the government is scraping the bottom of the barrel. No much taxes are coming their way. But who doesn’t have a money problem? The rich. So the government raises their taxes, which makes them not so happy and can also cause some social tensions.

4. Printing new money

   Last one on the list of things that can be done is of course printing new money. Central banks print money out of thin air which brings it’s own set of problems, however, it does stimulate the economy. With this money the central bank buys financial assets and government bonds (a.k.a. lending money to the government). People that own financial assets now become more creditworthy and with the money that government got from selling their bonds, it is able to stimulate the economy through spending and other unemployment benefits.

All four actions have to be done in balance, because if one goes overboard, all hell can break lose. The money printing is especially very tricky, because it can easily be abused and out of all measures people prefer it the most because it affects them the least, at least on the short run. What happens if too much money gets printed? High inflation can enter the scene again and we are back to square one.

What important lessons have we learned today and last week?

• Don’t spend the money you don’t have.

• Read the newspapers to see what is happening in the economy.

• Spending, credit, inflation, recession and all the other things are part of a "well oiled machine” that goes round and round and it is a must that you understand the basics.

GLOSSARY

• ¹ central bank - a central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base.

• ² deflation - a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy.

• ³ recession - a recession is a business cycle contraction that occurs when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending.

• ⁴ housing bubble - a housing or real estate bubble is a run-up in housing prices fueled by demand, speculation, and exuberant spending. It can lead to the point of collapse.

• ⁵ deleveraging - is responsible for the continuing fall in the prices of both physical capital and financial assets after the initial market downturn. It is part of the process that leads the economy to recession and the bottom of the leverage cycle.

CLOSING THE GAP

Sallie Krawcheck

The first time I heard about Sallie was 10 years ago. 
And I liked here immediately.

Sallie and I have the same wish - “to help women build wealth so that they can live the lives they want”. She is on a mission to close one of the female gaps which is the investment gap. Sallie is the founder of Ellevest, which is an investment platform built by women for women. She is also a former head of Bank of America's Global Wealth and Investment Management division.

She is a very honest and candid about her money mistakes as well, because how else will all the other women learn? I suggest listening to her story about how her money mistakes in 2008 bank crisis and the importance of investing.

Speaking of investing - have you started yet?

BOOK OF THE MONTH

Capital in the Twenty-First Century

by Thomas Piketty

This book is quite something. It has 753 pages. However, the reviews are stellar. “The most important economics book of the decade” and “…the most important study of inequality in over fifty years” to name just a few. It has also received many awards and landed on various best selling lists. Even though I have not finished it yet, I am sure it has many great lessons that I will try and share with you.

Introduction starts with the following sentence “The distribution of wealth is one of today’s most widely discussed and controversial issues.” Looking at news these days I have to strongly agree. There isn’t a day where you wouldn’t read something about the inequality in societies. And at the bottom of it all it always money.

Piketty says that we are currently in the same position as the world was in the early nineteenth century. We are witnessing impressive changes in economies around the world and it is very difficult to predict how these changes will progress and turn out.

The distribution of wealth is not only economical. It is always also deeply political and we already mentioned before the factor of human nature in the entire economy is significant. The history of inequality and also of nowadays inequality is shaped by the way economic, social and political actors view what is just/fair and what is not. They have a lot of power in their hands and their collective choices affect us all.

Author did a huge study and one of the conclusions is that the dynamics of wealth are in a huge part based on a powerful mechanism that pushes alternatively toward convergence (merging) and divergence (diversification).

The main forces for convergence are the diffusion of knowledge and investment in training and skills. They are the key to the productivity growth which we already mentioned last week and contribute the most to the reduction of inequality in society. Without understanding anything about economy it is quite obvious that lack of adequate investment in training can exclude entire social groups from the benefits of economic growth.

Which is why it is important to read newsletters and educate yourself on all things economy and money related 😏

Talk to you next week!

SOME NEWS

• If you want to learn more about the bank crisis that happened back in 2008, you can watch this movie or this documentary to learn a bit more.

• Another weekend documentary recommendation. The book of the month was also turned into a documentary.