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. as led to a lot of needless economic suffering. I feel a deep sense of responsibility to share my se. My simple but practical economic template. Though it's unconventional, it has helped me to anticipate. And to 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 things. It works in a simple transaction that is repeated over and over again a zillion times. These transactions are above all else. They create three main forces that drive the economy. Productivity growth. Number two, the short-term debt cycle. And number three, 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 how to make a difference. 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. l 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 could know. he 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. That's the building block of the economic machine. All cycles and all forces in an economy are driven by transactions. So, with. 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 is a wheat market, a car market, a stock market, and more. 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. It's just that simple. People, businesses, banks, and governance. All of the markets are in the market. All engage in transactions the way I just described. Exchanging money and credit for good services and financial assets. The biggest buyer and seller is the government, which consists of two important parts, a central government that's. A central bank, which is different from other buyers and sellers because it controls the. It does this by influencing interest rates and printing new. 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 is the most important part of the economy and probably the least. 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. Barrowers promise to repay the amount they borrow, called principal, plus an addition. When interest rates are high, there is less borrowing because it's expensive. When interest rates are low, borrowing increases because it's cheaper. When borrowers promise to repay and let them know. And lenders believe them, credit is created. Any two people can agree to create credit out of thin air. That seems simple enough, but credit is tricky because it has different names. As soon as credit is created, it implies that credit is created. It immediately turns into debt is both an asset to the lender and a liability to the borrower. In the future, when the borrower repays the loan plus interest, the asset and the liability disappear. And the transaction is settled. So why is credit so important? Because when a borrower. eceives credit, he is able to increase his spending. And remember, spending drives the economy. This is the end of the video. This is because one person's spending is another person's income. Think about it. Every dollar you spend someone else's income is a good thing. Everyone else earns. And every dollar you earn someone else has spent. So when you spend more, someone else earns more. When someone's income rises, it makes lenders more willing to lend him money, because now he's more worthy of money. A credit worthy borrower has two things, the ability to repay and collateral. Having a lot of income in relation to his debt gives him the ability to repay. In the event that he can't repay, he has valuable assets to use as collateral that can be sold. This makes lenders feel comfortable lending him money. So increased income allows increased borrowing, which allows increased spending, and since... Since one person's spending is another person's income, this leads to more increased borrowing, and so on. This self-ream- self-reinforcing pattern leads to economic growth and is why we have cycles. In a transact... you have to give something in order to get something. And how much you get depends on how much you produce. Over time we learned and that accumulated knowledge raises our living standards. We call this productivity growth. Those who are inventive and hardworking raise their productivity and their living standards faster than those who are committed to making sure that they are safe. Those who are complacent and lazy. But that isn't necessarily true over the short run. Productivity matters most in the long run. But credit matters most in the short run. This is because productivity growth doesn't fluctuate much. So it's not a big drive to work. A big drive of economic swings. Dead is because it allows us to consume more than we produce when we acquire it. And it forces us to consume less than we produce when we have to pay it back. Death swings occur in two big cycles. One takes about five to eight years and the other takes about 75 to 100 years, while most people feel the same. The people feel the swings, they typically don't see them as cycles because they see them too up close, day by day, week by week. In this chapter we're going to step back and look at these three big forces and how they interact to make up our experiences. As mentioned, swings around the line are not due to how much innovation or hard work there is. They're primarily due to how much innovation is. Due to how much credit there is. Let's for a second imagine an economy without credit. In this economy, the only way I can include it is to make sure that the economy is not the only way I can include it. The only way I can increase my spending is to increase my income, which requires me to be more productive and do more work. Increased productivity is the only way for growth. Since my spending is another person's income, the economy grows every time. I, or anyone else, is more productive. If we follow the transactions and play this out, we see a progression like the progress. Like the productivity growth line. But because we borrow, we have cycles. This isn't due to any laws. If you're not a law, it's due to human nature and the way that credit works. Think of borrowing as simply a way to do it. Simply a way of pulling spending forward. In order to buy something you can't afford, you need to spend more than you make. To do this, you essentially need to borrow from your future self. In doing so, you create a time in the future that you need to spend more than you want. You need to spend less than you make in order to pay it back. It very quickly resembles a cycle. Basically, anytime you want to be able to do so, you need to spend less than you make in order to pay it back. Anytime you borrow, you create a cycle. This is as true for an individual as it is for the economy. This is why I understand... my understanding credit is so important because it sets into motion a mechanical, predictable series of events that will happen in the future. This makes credit different for money is what you settle transactions with. When you buy a new product, you can get a new product. When you buy a beer from a bartender with cash, the transaction is settled immediately. But when you buy a beer with credit, it's why you're not going to get a new product. It's like starting a bar tear. You're saying you promise to pay in the future. Together, you and the bartender create an asset to the future. You just created credit out of thin air. It's not until you pay the bar tab. Later, the asset and the liability disappear, the debt goes away, and the transaction is settled. The reality is that most of what people call money is actually credit. The total amount of credit in the United States is. The total amount of money is only about $3 trillion. Remember, in an economy, in a country that. In an economy without credit, the only way to increase your spending is to produce more. But in an economy with credit, you can also increase your spending. As a result, an economy with credit has more spending and allows incomes to rise faster. The productivity over the short run, but not over the long run. Don't get me wrong, credit isn't necessarily something bad. It's bad when it finances over consumption that can't be paid back. However, it's good when it efficiently allocates resources and produces income so you can pay back the debt. For example, if you're not a child,. For example, if you borrow money to buy a big TV, it doesn't generate income for you to pay back the debt. But if you borrow money to... Say buy a tractor, and that tractor lets you harvest more crops and earn more money, then you can pay back your debt and... improve your living standards. In an economy with credit, we can follow the transactions and see how credit creates... Growth. Let me give you an example. Suppose you earn a hundred thousand dollars a year and have no debt. You are credit... rthy enough to borrow ten thousand dollars. Say on a credit card. So you can spend a hundred and ten thousand dollars even though you only earn a hundred dollars a year. Since you are spending is another person's income, someone is earning a hundred and ten thousand dollars. The person earning a hundred and ten thousand dollars with no debt can borrow eleven thousand dollars so he can. pend one hundred and twenty one thousand dollars even though he has only earned one hundred and ten thousand dollars is spent. This spending is another person's income and by following the transactions we can begin to see how this process works in a self-reincentive way. We can't do this in a self-reinforcing pattern. But remember, borrowing creates cycles, and if the cycle goes up, it eventually needs to be done. This leads us into the short-term debt cycle. As economic accuracy is now in the future, the economy is still in the future. Economic activity increases as we see an expansion, the first phase of the short-term debt cycle. Spending continues to increase in price. And prices start to rise. This happens because the increase in spending is fueled by credit, which can be created instantly out of thin. When the amount of spending and incomes grow faster than the production of goods, prices rise. When prices rise, we call this inflation. The central bank doesn't want too much inflation. ecause it causes problems. Seeing prices rise, it raises interest rates, with higher interest rates. Fewer people can afford to borrow money, and the cost of existing debts rises. Think about this as a. e monthly payments on your credit card going up. If e-cause people borrow less, and have higher debt repayments, they have less money left over to spend. So spending slows. And since one person's spending is another person's income, drop, and so on and so forth. When people spend less, prices go down. We call this deflation. Economic activity decreases and we have a recession. If the recession becomes too severe and inflation is no longer a problem, the central bank will lower interest rates. With low interest rates, debt repayments are reduced and borrowing the space. We see another expansion. As you can see, the economy works like a machine. In the short-term debt cycle, spending is constrained only by the willingness of lenders and borrowers to provide and receive credit. When credit is easily available, there's an economic expansion. When credit isn't easily available, there's an economic expansion. So, there's a recession. And note that this cycle is controlled primarily by the central bank. The short-term debt cycle is. That cycle typically lasts five to eight years and happens over and over again for decades. notice that the bottom... And top of each cycle finish with more growth than the previous cycle and with more debt. Why? Because people push it. They have an inclination to borrow and spend more instead of paying back debt. It's human nature. Because of this, over long periods of time, debts rise faster than income. Creating the long-term debt cycle. Despite people becoming more indebted, less than a half-term debt cycle. Lenders even more freely extend credit. Why? Because everyone thinks things are. oing great. People are just focused on what's been happening lately. And what's been happening lately? Income have been rising. Asset values are going out. The stock market roars. It's a boom. It's. been happening lately. Been growing, incomes have been growing nearly as fast to offset them. Let's call the ratio of debt to income the debt burden. So long as incomes continue to rise, the debt burden is growing. The debt burden stays manageable. At the same time, asset values soar. People borrow huge amounts of money to buy it. People buy assets as investments, causing their prices to rise even higher. People feel wealthy. So even with the accumulation of lots of debt, rising incomes and asset values help borrowers remain creditworthy for a long time. But this obviously cannot continue forever. And it doesn't. Over decades, debt-free. The gains, debt burdens slowly increase, creating larger and larger debt repayments. At some point, debt repayment. Starts growing faster than incomes, forcing people to cut back on their spending. And since one person's spending is another person, income, incomes begin to go down, which makes people less credit worthy, causing borrowing to go down. Debt repayments continue to rise, which makes spending drop even further, and the cycle reverses. This is the long-term debt peak. Debt burdens have simply become too much. Debt has become too big. For the United States, Europe, and much of the rest of the world, this happened in 2008. It happened for the same reason it happened in Japan in 1989, and in the United States back in 1929. Now the economy begins deleveraging. In a deleveraging, people cut spending. Incomes fall. Credit disappears. Asset prices drop. Banks get squeezed. The stock market creates a. Market crashes. Social tensions rise and the whole thing starts to feed on itself the other way. As incomes fall all and debt repayments rise, borrowers get squeezed. No longer credit worthy, credit dries up. And borrowers can no longer borrow enough money to make their debt repayments. Scrambling to fill this hole, borrowers get. The borrowers are forced to sell assets. The rush to sell assets floods the market at the same time as spending falls. This is when the stock market collapses. The real estate market tanks and banks get into trouble. As asset prices drop. The value of the collateral borrowers can put up drops. This makes borrowers even less credit worthy. People. eel poor. Credit rapidly disappears. Less spending, less income, less income, less income. Less wealth, less credit, less borrowing, and so on. It's a vicious cycle. This appears similar to. It's similar to a recession, but the difference here is that interest rates can't be lowered to save the day. Lowering interest rates works to stimulate borrowing. However, in a deleveraging lowering interest rates doesn't work because interest rates are not. Interest rates are already low and soon hit 0%. So the stimulation ends. Interest rates in the United States. The difference between the United States and the United States hit 0% during the. difference between a recession and a deleveraging is that in a deleveraging, borrowers' debt burdens have simply gotten too big and too big. And can't be relieved by lowering interest rates. Lenders realize that debts have become too large to ever be fully paid back. Barbers have lost their ability to repay and their collateral has lost value. They feel crippled by the debt. They don't even want more. Lenders stop lending, borrowers stop borrowing. Think of the economy. being not credit worthy, just like an individual. So what do you do about a deleveraging? The problem is debt burdens are too high and they must come down. There are four ways this can happen. One, people, businesses and governments cut their spending. Two, debts are reduced through default to debt. Four, debts are reduced through default and restructuring. Three, wealth is redistributed from the halves to the half knots. And finally, four, debts are reduced through default. And finally, four, the central bank prints new money. These four ways have happened in every deleveraging and modern history. Usually spending is cut first, as we just saw people businesses. Even governments tighten their belts and cut their spending so they can pay down their debt.  This is often referred to as. Usually spending is cut first, as we just saw people. This is often referred to as. If we can't do this,. It's often referred to as. Businesses are forced to cut costs. Which means less jobs and higher unemployment. This leads to the next step. Deaths must be reduced. Many borrowers find themselves unable to repay their loans. And a borrower's debts... Are lender's assets. When a borrower doesn't repay the bank, people get nervous that the bank won't be able to repay them. So they rush to withdraw their money from the bank. Banks get squeezed and people, businesses and banks default on their debts. This severe economic contraction is a depression. A big part of a depression is a depression. Part of a depression is people discovering much of what they thought was their wealth isn't really there. Let's go back to the break. Go back to the bar. When you bought a beer and put it on a bar tab, you promised to repay the bartender. Your promise became an asset of the bartender. But if you break your promise, if you don't pay him back and essentially default on the bar, you'll be able to pay him back. If you don't pay him back and you don't pay him back, you'll be able to pay him back. Many lenders don't want their assets to disappear and agree to debt restructuring. means lenders don't want their assets to disappear and agree to debt restructuring. Sometimes lenders get paid back less, or get paid back over a longer timeframe, or at a lower interest rate than was first agreed. Somehow, a contract is broken in a way that reduces debt. lenders would rather have a little of something than a way to. Even though debt disappears, debt restructuring causes income and asset values to disappear. The debt burden continues to get worse. The debt burden is also painful and deflationary. All of this impacts the central government because lower incomes and less. At the same time, it needs to increase its spending because of the unemployment rate. Many of the unemployed have inadequate savings and need financial support from the government. Additionally, governments create stimulus plans and increase their spending to make up for the decrease in the economy. Governments' budget deficits explode in the deleveraging because they spend more than they earn in taxes. This is what's happening when you hear about the budget deficit on the news. To fund their deficits, government. need to either raise taxes or borrow money. But with incomes falling and so many unemployed. Who is the money going to come from? The rich. Since governments need more money and since wealth is heavily constant. The government has been heavily concentrated in the hands of a small percentage of the people. Governments naturally raise taxes on the wealthy. Which facilities are heavily concentrated in the hands of a small percentage of the people. Governments naturally raise taxes on the wealthy. Which facilities are heavily concentrated in the hands of a small percentage of the people. Governments naturally raise taxes on the wealthy. Which facilities are heavily concentrated in the hands of a small percentage of the people. Governments naturally raise taxes on the wealthy. Which facilities are  heavily concentrated in the hands of a small percentage of the people. Governments naturally raise taxes on the wealthy. Each facilitates a redistribution of wealth in the economy from the haves to the have-nots, the have-nots who are suffering. Begin to resent the wealthy haves, the wealthy have's being squeezed by the weak economy, falling asset prices, and high- taxes begin to resent the have-nots. If the depression continues, social disorder can break out. Not only do tensions rise within countries, they can rise between countries, especially data-increditor countries. This situation can lead to political change that can sometimes be extreme. In the 90s, the. In the 1930s, this led to Hitler coming to power, war in Europe, and depression in the United States. Pressure to do something to end the depression increases. Remember, most of what people thought was money was actually money. So when credit disappears, people don't have enough money. People are desperate for money, and you remember. ho can print money, the central bank can. Having already lowered its interest rates to new. It's forced to print money. Unlike cutting spending, debt reduction, and wealth redistribution. Printing money is inflationary and stimulative. Inevitably, the central bank prints new money out of thin air. And uses it to buy financial assets and government bonds. It happened in the United States during the Great Depression. And again in 2008, when the United States Central Bank, the Federal Reserve, printed over $2 trillion. Other central banks around the world that could, printed a lot of money too. By buying financial assets with this money, it helps drive up asset prices, which makes people more creditworthy. However, this only helps those who own food. If you're a financial asset, you see the central bank in print money, but it can only buy financial assets. The central government, on the other hand, can buy goods and services and put money in the hands of the people. But it can't print money. So in order to stimulate the economy, the two must cooperate by buying government boxes. The central bank essentially lends money to the government, allowing it to run a deficit and increase spending. On goods and services, through its stimulus programs and unemployment benefits. This increases people's. However, it will lower the economy's total debt burden. This is the most important part of the economy. This is a very risky time. Policymakers need to balance the four ways that debt burdens come down. The deflationary ways need to balance with the inflationary ways in order to maintain stability. If balanced correctly, there can be a beautiful deleveraging. can be ugly, or it can be beautiful. How can a deleveraging be beautiful? Even though a deleveraging is a difficult situation, handling a difficult situation in the best possible ways beautiful. A lot more beautiful than the debt-fueled unbalanced excesses of the leveraging phase. In a beautiful deleveration. Debt's decline relative to income. Real economic growth is positive. And inflation isn't a problem. It is achieved by having the right balance. requires a certain mix of cutting and cutting. Reducing debt, transferring wealth, and printing money, so that economic and social stability can be achieved. People ask if printing money will raise inflation. It won't if it offsets falling down. It's falling credit. Remember, spending is what matters. A dollar of spending paid for with money has the same effect on money. The fact on price is a dollar of spending paid for with credit. By printing money, the central bank can make up for the disappearance of the bank. In order to turn things around, the central bank needs to not only pump the bank's money, but to make up for the price of the bank. money is only pump up income growth, but get the rate of income growth higher than the rate of interest on the accumulated debt. So what do I mean by that? Basically, income needs to grow faster than debt grows. For example, let's assume that a. Country going through a deleveraging has a debt to income ratio of 100%. That means that the amount of debt it has. Is the same as the amount of income the entire country makes in a year. Now think about the interest rate on that debt. Let's say it's 2%. If debt is growing at 2% because of that interest rate, an income is only. growing at around 1%. You will never reduce the debt burden. You need to print enough money to get the rate of income. 2. The key is to avoid printing too much money and causing unacceptably high inflation. The way Germany did during its deleveraging in the 1920s. If policymakers achieved the right balance, a deleveraging is in so dramatic. Growth is slow, but debt burdens go down. That's a beautiful deleveraging. When incomes begin to rise, borrowers begin to appear more credit worthy. And when borrowers begin to rise, borrowers appear more credit worthy. Lenders begin to lend money again. Debt burdens finally begin to fall. Able to borrow money, people can spend more. Eventually, the economy begins to grow again, leading to the reflation phase. f the long-term debt cycle. Though the deleveraging process can be horrible if handled badly, if handled well,, then the risk of the debt. And, well, it will eventually fix the problem. It takes roughly a decade or more for debt burdens to fall and economic. ctivity to get back to normal. Hence the term "lost decade". In closing. Of course, the economy is a little bit more complicated than this template suggests. However, laying the short-term debt cycle on. The long-term debt cycle on top of the productivity growth line gives a reasonably good tempo. The long-term debt cycle is a good template for seeing where we've been, where we are now, and where we're probably headed. We're not going to be able to get a better idea of how we're going to be, but we're going to be able to get a better idea of how we're going to be. Because your debt burdens will eventually crush you. Second, don't have income rise faster than productivity, because you'll eventually become uncompetitive. And third, do all that you can to raise your productivity. Because in the long run, that's what matters most. This is simple advice for you and it's simple advice for policy makers. You might be surprised, but most people, including most policy makers, don't pay enough attention to this. template has worked for me, and I hope it will work for you. Thank you. Thanks for watching!