Basics of how our economy works

Hello ladies and gents,

I know, I know, I missed not one, but two weeks. Sometimes you have those weeks you know? The ones where you just have had enough of everything and you are able to do the bare minimum. And that is what I did.

But I have pulled myself together and I am continuing this journey of expanding your financial and economical horizons. How poetic of me 😏

And to make it up to you, I have prepared a longer post today, but because it was too long, it became a two part post. Part I this week, part II next week.
So back to our regularly scheduled program.

• Where it all starts - how does the economy actually work?

• Closing the Gap - Sophia Amoruso

• Book of the month - The Almanack Of Naval Ravikant - part III

LET’S COVER THE BASICS

How does the economy actually work?

Even though we manage our finances and money in a different way, we all participate in the same financial and money system. Well, not the same, because we live in different countries, with different policies, but the basics are pretty much the same, so let’s map them out shall we?

At this point you probably know how much I like me some matcha latte, so I’ll try to show you how the economy works on a matcha latte example 🍵

Picture this. It’s a lovely Saturday morning, the sun is shinning and you decide to go to the farmers market to stock up on your veggies for the week. While in the city you stop by your favorite local coffee place to buy a warm almond matcha latte. You grab your wallet and swipe the card. When you do that, a transaction happens, money goes from your bank account to the bank account of the coffee place. And this transaction represents the smallest part of a bigger economic machine that makes the world go round.

Moving on.

To make that perfect matcha latte, the coffee place needs a good quality matcha from Japan. They buy it from a trusted distributer of premium matcha and he buys it directly from one of the traditional matcha farms in Kyoto. As you did in the coffee place, they pay for it with money. Probably not by swiping the card, but by making a bank transfer.

To simplify the money flow:

If we look at this example, we see a pattern that goes something like this:

• 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

Bottom line - Spending drives the economy.

How can that coffee shop make more money? Well, a couple of ways. They can either work longer hours, lift their prices, invest in marketing to attract new clients, open another location, etc. It all comes down to same thing - they need to be more productive to make more money.

Let’s say they don’t have any spare money to invest into a new location, but they can extend their working hours with a small cost and make some extra money. If everybody would build their businesses like this, by working more, the productivity would go up and the economy would grow. Surely but slowly. In economic terms this is called productivity growth ¹ - being inventive and working hard.

However, in this way, you can’t grow your business quickly in the short term. Which brings us to the next point.

One day, the coffee place decides to expand their business, go to the bank and ask for credit ² to open a new location, a matcha only place 🍵 #musictomyears. Since their existing business is going well, bank does not have a problem lending them the money, because they are a creditworthy borrower ³ .

Now let’s talk about credit for a bit.

Credit is the most important part of the economy, and probably the least understood. It is essentially the money you need to borrow from your future self, that you want to spend in the present, and the banks help you do that. When they lend you the money, they charge you interest rates ⁴. When interest rates are low, there is more credit being created, than when the interest rates are high, because who wants to pay high interest rates?

And this brings us to the short term debt cycle. But didn’t we talk about credit? Why are we now talking about debt? Because as soon as credit is created, it turns into debt. Ok, sure, make sense. But why cycle?

Back to the coffee place.

For them to be able to open a new location, they need a substantial amount of money all at once - to buy or rent the place, buy coffee machine, additional matcha and coffee, employ new people etc. The credit allowed them to spend more than they produced at that given time. More spending → economy growth.

But whatever goes up, must come down eventually. This happens when in the future, the coffee place needs to start repaying back the money they borrowed with additional interest rates. So there will come a time in the future, when they will be spending less than they will produce, because they will be paying back the credit. Less spending → economy declines.

Cycle is created.

This same logic applies to all credit - when you buy a car, house, renovate an apartment or even finance your expensive trip to Maldives, because you are not able to afford it now. And this is where the potential problem start to wiggle it’s way in.

Credit becomes bad, when it finances over-consumption that can't be paid back. Don’t get me wrong, completely understandable that you get a credit to buy a house or an apartment, or even better, to expand your business and increase your income, because as we learned:

That trip to Maldives? Maybe skip it this year, save the money and go next year. Especially if you know in the present moment, that there is a chance, you're not gonna be able to pay back the credit.

Another “side effect” of more spending is also something else. Prices go up, especially if production of goods is not able to catch up with the amount of spending people are doing. Basic law of supply and demand. Which brings us to something we discussed before - inflation ⁵.

And what happens once your favorite matcha latte 🍵 becomes too expensive?

Stay tuned for part 2 next Wednesday! 😄

GLOSSARY

• ¹ productivity growth - productivity growth means more value is added in production and this means more income is available to be distributed.

• ² credit - credit is typically defined as an agreement between a lender and a borrower. The borrower promises to repay the lender, often with interest, or risk financial or legal penalties.

• ³ creditworthy borrower - is a measure of a borrower’s risk to a lender.

• ⁴ interest rates - is the amount charged on top of the principal by a lender to a borrower for the use of assets.

• ⁵ inflation - a rise in prices, which can be translated as the decline of purchasing power over time.

CLOSING THE GAP

Sophia Amoruso

The OG girlboss - Sophia Amoruso.

You may know her from the Netflix series that depicted the story of her building the first business she founded, which was a fashion retailer called Nasty Gal. Maybe your read her book called #Girlboss. Or maybe you read an article about her overall amazing success building various different businesses. She was also on the Forbes cover as one of America’s richest self-made women.

These days she is busy with teaching other people the skills you need to build a successful business in her online course Business Class and investing in potential great businesses via Trust Fund - early-stage venture fund she launched.

I follow her on Instagram, where she is very candid about her being an awkward introvert, things that she doesn’t know, failures, among which is also a bankruptcy of the beforementioned Nasty Gal. She also doesn’t take herself too seriously and is not a typical business woman. And I like her for that. A lot.

BOOK OF THE MONTH

The Almanack of Naval Ravikant - part III

by Eric Jorgenson

In previous two parts we spoke mostly about building wealth. In the second chapter of the book Naval talks about building judgment. Very important thing in my opinion.

Judgment is not only about having opinions on things. Judgment is also a way of thinking and how, not what you think about things, can make a difference.

Another part of judgment and thinking is decision making. And what is the best way of making sound and smart decisions? By ignoring your “monkey mind”. Our monkey mind will always respond emotionally and make the decisions in line with how “the world should be”. We are not able to see the truth. For people to be able to do that, they need to ignore their ego, because the ego doesn’t want to face the truth. Our ego gets constructed by the environment we lived in for the first two decades and for the rest of our lives, we are trying to make our ego happy. We interpret anything new through our ego.

Some self reflection is needed, if you want to become a clear thinker, not driven by your ego. You need to find the root of your ego and essentially your thinking patterns. They probably started somewhere in your childhood because you wanted your parents attention for example. And by reinforcing them for years, they became part of your identity. You need to ask yourself -

Like many other successful people he says, that what we should live by a set of principles, instead of listening to our ego. Mental models. He lists many of them, but I’ll list just a couple:

• Economics - microeconomics and game theory are fundamental, especially in business and nowadays modern capitalist society

• Compound interest - not only in the financial context, but also in the intellectual domain.

• If you can’t decide, the answer is no - especially when you stumble upon important life questions such as “should I take this job?” or “should I marry this person?” - my version of this is “if it’s not a hell yes, it’s a hell no”.

And what is the best way to build new mental models? Read a lot - just read. 

He says that reading is a superpower. Read the greats in math, science and philosophy. When you read, you learn and with that you become a perpetual learning machine. You will never be out of options for how to make money, if you become that.

And since the month has come to an end and I have deprived you of other parts of Naval’s book, I will send out, like every month, a bonus edition on the 1st of February with the entirety of the book. But if you wish to read the book cover to cover, here is the free online version of it. I highly recommend it.

SOME NEWS

• Are you an introvert and still need to network occasionally? This might help.

• All the prices are going up, except in Ikea. They are going down.

• Who know that pickles are popular. I have been watching these two girls building their pickle business for the past month. Their branding game is strong.