Covid-19 Day 77 : How the Economy Works



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I just watched a really insightful video in youtube about How the Economic Machine Works. Actually I got the link from LinkedIn which is the continuation of this article. And I found this article while watching the video about Crypto from IvanOnTech about Ethereum. Confusing right? The explanation in this video is really simple, at least for me. Actually we have learned in in the school long time before, but probably we have lost the idea. Haha. So, as we know, economy basically about supply and demand that meet in the market. There is lot of kind of market running in this world e.g comodity, stocks, cryptos, property, bonds, etc. Those market will work together and influencing each other. On the other side, to support the market to be even bigger, there is an entity called credit that will create asset/debt. Anyway, if you interested in this video, you can read the summary in the end of this post. I copy from Tapas 2017 comment that summarize the video very well. The thing that I want to emphasize is the correlation with our condition right now with covid-19. Many country leader, especially in Indonesia, is considered scarifying the people by running again the economy. I don’t really agree with this opinion. Economy is really important, as important as public health, that can not be neglected. Let say that lock down will be prolonged until the vaccine is released to public, which is in the long term, many people will suffer from no income. No income means, no credit, no productivity. It will leads the gap between the poor and the rich at the end. With the big gap, it can trigger the social issue and even bigger mess in the society. People will try to do everything to get their stomach filled. On the nation level, it will burden the government to pay the debts as scheduled. Every country in this world has debt between each other, even USA is has the biggest debt in percentage of GDP. So, imagine if one country can not pay the debt, probably it will trigger regional political issue or even ‘war’. When this is happens, it will be more difficult to cope with and bring back to ‘normal’. It requires lot of efforts. One of the effort to tackle this situation is Central Bank has to printing money. We have heard that many central bank is printing lot of money. This is not a good news. If the government/central bank can not keep the good balance, it will be a disaster to the respective country. Just like in USA, the FED say that they are printing money right now and buy the assets from corporate to get the balance. So doesn’t mean that they can print money out of thin air. So, lets support our government and give a supportive feedback. I know that we can not see the big picture of our country condition right now as clear as them. Not all of us understand about the economy, we just think how to survive and see everything just around us in the short term.

Video Summary: Part 1
Economy works in a simple mechanical way. It is made of simple parts and simple transactions that are repeated over and over. Transactions are created by human nature. These transactions create three main forces that drive the economy.
  1. Productivity growth
  2. Short term debt cycle
  3. Long term debt cycle.
Let us start with simplest part of economy. Transaction. Economy is sum of transactions that make it up. Every time you buy something you create a transaction.
Each transaction consists of buyer exchanging money or credit with a seller for goods, services or financial assets. Credit spends just like money. Total spending = Credit+ Money. Total spending is what drives the economy. If you drive amount spent/quantity sold you get the price. This equation is called transaction. If you understand a transaction you understand the economy. Market consists of all buyers and sellers making transactions for the same thing. Eg Wheat/corn/stock market. An economy consists of all transactions in all the markets. If you add total spending and total quantity sold of all all market you call it economy. People, businesses banks and governments all engage in transactions: exchanging money nd credits for goods service and financial assets.
Biggest buyer and seller is Government. It consists of two parts :
  1. A central govt that collects taxes and spends money
  2. A central bank which is different from other buyers and sellers, because it controls amount of money and credit in economy. It does by influencing interest rates and printing new money. Central bank is important player in flow of CREDIT.
CREDIT is most important part and least understood part for economy. It most important because it is biggest and most volatile part. just like buyers and sellers go to market go to market to make transactions. So do lenders and borrowers. Lenders lend money to make more money. Borrowers usually borrow to buy something they cannot afford (House or car) or to invest (start a business). CREDIT can help both lenders and borrowers get what they want. Borrowers promise to repay amount they borrowed (Principle) plus additional amount called interest. When interest rates are low, borrowing is more as borrowing is cheaper (and vice versa).
When borrowers promise to repay and lenders believe them, CREDIT is created. So credit is created out of thin air. As soon as credit is created it IMMEDIATELY turns into debt.
Debt is an asset to a lender and liability is to the borrower. In the future when borrower repays the loan plus interest, the asset and liability disappear and transaction is settled. When borrower borrows they can increase their spending. Spending drives the economy. One persons spending is another persons income.
Every dollar you spend, someone else earns more. When someone’s income rises it makes lender more willing to lend them money, because now he is more worthy of credit. Credit worthy borrowers have 2 qualities.
  1. Ability to repay: Because having a lot of income.
  2. Having a lot of collaterals: In event he cannot repay, he has valuable assets that can be sold.
Increased income allows increased borrowing and increased spending. More you borrow, more you spend, more the transactions in the market the bigger the economy.
This self reinforcing patterns leads to economic growth and is why we have CYCLES. In a transaction you have to give something to get something. How much you get depends on how much you produce.
Over time we learn, and that accumulated knowledge raises our living standards called productivity growth.
Those who are inventive and hard working raise productivity and living standards faster than who are complacent and lazy. BUT productivity matters in LONG RUN and credit matters most in short run. This is because the productivity growth does not fluctuate much, so not a big driver of economic swings.
Debt is: Allows us to consume more than we produce when we acquire it and forces us to consume less than we produce it when we have to pay it back. Debt swings occurs in two big cycles.
Short term debt cycles: 5-8 years.
Long term debt cycles: 75-100 years. While most people Feel the swings they don’t SEE the cycles as they see them to up close and personal: Day by day, week by week (Miss the forest for the tree?
Swings around the line are not due to how much innovation/hard work there is . It is primarily due to how much credit there is. In an economy credit with only way to increase spending is to increase income by being more productive (Do more work). That is increased productivity is the only way for growth.
Since my spending is other persons income, economy grows only when all participants are more productive. But because we borrow we have cycles. This is due to human nature and way the credit works. In order to buy something you cannot afford, you need to spend more than you make.
To do this you need to borrow from your future self. Any time you borrow you create a cycle. Credit sets into a motion a mechanical predictable series of events that will unfold in future. Money is what you settle transactions, eg Buy beer from a bartender with cash.
If you buy the same beer using credit you have created an asset and a liability that is you created credit out of thin air.
It is not until you pay the bartender later the asset liability disappear, debt goes away and transaction is settled.
Problem is that what people called money is actually credit.
Credit is US is 50 T USD. Money is ONLY 3 T dollars.
Only way to spend more is produce more.
In economy with credit you can increase spending by borrowing.
More spending, income rises faster than productivity over short term but not over long run.

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