Why does the economy run in cycles?

Last week article on winners and losers in the economy raised some questions about policymakers, dept, money printing and crisis. Before we start to invest it is essential we understand how the economy runs at a macroscopic level and, in particular, why it runs in cycles. Some properties of the economy and of the financial markets are counter-intuitive, hence the need train our brain to think in a new way.

We often hear economists talk about economic cycles, but what is it and why does the economy runs in cycles? The economy might seem complex, however it works in a simple and mechanical way.

An essential question we will try to answer is what causes cycles? And why do we care?

Summary:

  • Policymakers, who are they, what are their roles in the economy

  • Economic cycles. What causes them?

  • What's the point of knowing this? I just wanna invest in financial markets!

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Policymakers: who are they? what are their roles in the economy?

Policymakers, in the general sense, refers to the organization responsible for making new rules and laws. In finance and economy policymakers usually refers to Central Banks and Governments.

The role of governments

Governments can buy goods and services, and are able to put money in the hands of the people in difficult times. They run stimulus programs to increase spending and boost the economy, help the unemployed and redistribute wealth. However governments are limited by their budget and need the help of another policymaker: central banks.

Key takeaways on governments:

  • Are the link between central banks and the people

  • Are limited by their budget and can't print money

  • Need the help of the central banks to finance their stimulus programs

The role of central banks

Central banks (such as the Fed or the ECB) are a major player in the economy especially in times of crisis and recession. By doings their job well they are able to considerably reduce the intensity of the economic cycles: They influence the flow of credits by leveling interest rates, they can also print money, buy financial assets and government bonds.

Governments can't print money, central banks can. Central banks can only buy financial assets and can't reach the people. Hence governments and central banks must work together: By buying government bonds the central bank lend money to the government and allow it to run a deficit and increase spending (in order to finance stimulus programs).

Let’s see in details how credit and money printing work.

Credit

To make a credit you need two interested parties:

  • A lender who wants to make more money

  • A borrower who wants to buy something he can't afford (buy a car, a house, start a new business)

Credit help both parties get what they want. It also increases spending by giving the borrower the power to buy what he could not afford.

Therefore credit fuels spending and investment.

Central banks drive interests rates in order to pilot the economy:

  • If they lower interest rates, credits are eased, spending and investment increases

  • If they increase interest rates, the opposite happen and the economy slow down (they use this to reduce inflation).

Money printing

If lowering the interest rates is not enough, central banks are forced to print money. The fresh cash (created out of thin air) is used to buy financial assets and government bonds in order to stimulate the economy (but this benefit mostly those who own financial assets, see winners and losers in the economy).

Recent examples:

  • 2008: The Fed printed over 2 trillion dollars

  • 2020: The Fed printed over 6 trillion dollars

Key takeaways on central banks:

  • Leveling (increase or decrease) interest rates

  • Print money

  • Finance governments by buying governments bonds

Economic cycles. What are they? What causes them?

One cycle is the fluctuation of the economy between a period of expansion and contraction. Even though these cycles are driven by a logical series of events that recur in patterns, they are not pre-destined to repeat in the sames ways nor to take the same amount of time. The key factor behind them is debt.

You create a cycle every time you borrow money. Every time you buy something you can't afford, it means you spend more than you make. You are not just borrowing from a lender, you are borrowing from your future self. You create a time in the future in which you will need to spend less than you make in order to pay it back. So the pattern is: (i) borrowing + spending more than you make (ii) spend less than you make + reimburse.

Credit is not something bad that only creates cycles, it is bad when it finances something that can't be paid back in the future: borrowing money to buy a TV does not generate income to pay back the debt, however if you borrow money to finance tools that increase your productivity and earn more money, then you can pay back your debt and improve your living standards more quickly.

Credit/debt boosts production/growth at first and depresses it later. Central banks provide it to put on gas when the economy is growing slowly and restrict it to put on brakes when it is growing fast.

Key takeaways:

  • Credits provide buying power and fuels spending and investments

  • Credits creates debt that must be paid back (in the future) lessening spending and investments

A cycle is usually broken down in four phases (i) expansion phase (ii) boom phase (iii) recession phase (iv) recovery phase.

Expansion phase

The expansion phase is characterized by rapid growth, low interest rate, and an increasing production. It is fueled by lending which creates a self-reinforcing upward movements which supports spending and investment, which in turn supports incomes and asset prices. This creates inflationary pressures.

Key takeaways on expansion phase:

  • Rapid growth / increase in production

  • Credit is easily available: Low interest rates → high lending rate

  • Inflationary pressures (increase in prices)

The crisis or boom phase

As we approached the end of the expansion phase, central banks do not want too much inflation because it causes problems (such as surge in prices for basic goods). So they eventually tighten their monetary policy as the inflationary pressures build up.

The peak is the point at which reckless lending result in high default rates. One classic warning sign a bubble is coming is when an increasing amount of money is being borrowed to make debt service payments, which of course compounds the borrowers’ indebtedness.

Key takeaways on boom phase:

  • Stock exchanges crash

  • Multiple bankruptcies of firms occur

Recession phase

At this stage interest rates are high, fewer people can borrow money and, as a result, spending and investment slow: there is a significant decline in economic activity.

Key takeaways on contraction phase:

  • High interest-rates

  • Lending rate slow down

  • Prices and production drop

Bottom or recovery phase

Low prices allow for spending and production to pick up again. Central banks lower interest rates to fuel the recovery.

Key takeaways on recovery phase:

  • Low prices

  • Stock exchanges recover

  • Central banks lower interest rates

What's the point of knowing this? I only wanna invest in financial markets!

The economy is the aggregates of the markets. In order to understand what is happening, and what is likely to happen, in the financial markets, it is essential to understand the relationship between the financial markets and the economy. The whole system is a never-ending process trying to find its equilibrium: by seeing which part are out of equilibria, we can anticipate what monetary policy shifts will occur, and what impacts theses shifts will have to the financial markets. Next week, we will see how what we learned today will help us make better investment decisions.

That’s all for today! If you liked the content remember to ❤️ it and share it with your friends:

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Also, if you have any question or feedback: leave a comment and I will reply to you directly.

See you next Monday!

Kevin


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