Original subtitles

how the economic machine works in 30

minutes

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 has led to a lot of needless

economic suffering

i feel a deep sense of responsibility to

share 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 simple

transactions that are repeated over and

over again

a zillion times these transactions are

above all else

driven by human nature and they create

three main forces that drive the economy

number one 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 what's happening

now 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 all 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 the 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 block of the economic

machine

all cycles and all forces in an economy

are driven by transactions

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 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 the economy

it's just that simple people

businesses banks and governments 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 collects

taxes and spends money and a central

bank

which is different from other buyers and

sellers because it controls the amount

of money

and credit in the economy it does this

by influencing interest rates

and printing new money 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 credit is the most important part

of the economy

and probably the least understood 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

borrowers promise to repay the amount

they borrow

called principal plus an additional

amount called interest

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

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

immediately turns into debt

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 receives credit

he is able to increase his spending

and remember spending drives the economy

this is because one person's spending is

another person's income

think about it every dollar you spend

someone 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 credit a

creditworthy 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 one person's spending is another

person's income

this leads to more increased borrowing

and so on

this self-reinforcing pattern leads to

economic growth and is why we have

cycles in a transaction

you have to give something in order to

get something

and how much you get depends on how much

you produce

over time we learn and that accumulated

knowledge raises our living

standards we call this productivity

growth

those who are inventive and hard working

raise their productivity and their

living standards faster

than 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 driver of economic

swings debt 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

debt 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 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 credit there

is

let's for a second imagine an economy

without credit

in this economy 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 productivity growth line

but because we borrow we have cycles

this isn't due to any laws or

regulations

it's due to human nature and the way

that credit works

think of borrowing as 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 less than you

make in order to pay it back

it very quickly resembles a cycle

basically

anytime you borrow you create a cycle

this is as true for an individual as it

is for the economy

this is why 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

money is what you settle transactions

with

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 like starting a bar tab

you're saying you promise to pay in the

future

together you and the bartender create an

asset

and a liability you just created credit

out of thin air it's not until you pay

the bar tab

later that the asset and the liability

disappear

the debt goes away and the transaction

is settled

[Music]

the reality is that most of what people

call money

is actually credit the total amount of

credit in the united states is about 50

trillion dollars

and the total amount of money is only

about three trillion dollars

remember 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 by borrowing as a

result

an economy with credit has more spending

and allows incomes to rise faster than

productivity over the short run

but not over the long run now don't get

me wrong

credit isn't necessarily something bad

that just causes cycles

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 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 worthy 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

thousand dollars

since your 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 spend a hundred and twenty one

thousand dollars

even though he has only earned a hundred

and ten thousand dollars

his spending is another person's income

and by following the transactions

we can begin to see how this process

works in a self-reinforcing pattern

but remember borrowing creates cycles

and if the cycle goes up it eventually

needs to come down this leads us

into the short-term debt cycle

as economic activity increases we see an

expansion

the first phase of the short-term debt

cycle spending continues to increase and

prices start to rise

this happens because the increase in

spending is fueled by

credit which can be created instantly

out of thin air

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 because 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 the monthly payments

on your credit card going up

because 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

incomes 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 to cause

everything to pick up again with low

interest rates

debt repayments are reduced and

borrowing and spending pick up

and 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 a

recession

and note that this cycle is controlled

primarily by the central bank

the short-term debt cycle typically

lasts five to eight years

and happens over and over again for

decades

but 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 incomes

creating the long-term debt cycle

despite people becoming more indebted

lenders even more freely extend credit

why because everyone thinks

things are going great people are just

focused on what's been happening lately

and what's been happening lately incomes

have been rising

asset values are going up the stock

market roars

it's a boom it pays to buy goods

services and financial assets with

borrowed money

when people do a lot of that we call it

a bubble

so even though debts have 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

stays manageable at the same time asset

values soar

people borrow huge amounts of money to

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 credit worthy for a

long time

but this obviously cannot continue

forever

and it doesn't over decades debt burdens

slowly increased creating larger and

larger debt repayments

at some point debt repayments start

growing faster than incomes

forcing people to cut back on their

spending and since one person's spending

is another person's 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 itself

this is the long-term debt peak debt

burdens have

simply 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

crashes

social tensions rise and the whole thing

starts to feed on itself the other way

as incomes fall 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

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 feel poor credit rapidly

disappears

less spending less income less wealth

less credit less borrowing and so on

it's a vicious cycle this appears

similar to a recession but the

difference here

is that interest rates can't be lowered

to save the day

in a recession lowering interest rates

works to stimulate

borrowing however in a deleveraging

lowering interest rates doesn't work

because interest rates are already low

and soon hit zero percent

so the stimulation ends interest rates

in the united states hit zero percent

during the deleveraging of the 1930s

and again in 2008

the difference between a recession and a

deleveraging

is that in a deleveraging borrower's

debt burdens have simply gotten 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

borrowers 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 as being not credit

worthy

just like an individual so what do you

do about it 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 defaults

and restructurings

three wealth is redistributed from the

haves to the have-nots

and finally four the central bank prints

new money

these four ways have happened in every

deleveraging in modern history

[Music]

usually spending is cut first as we just

saw people businesses and even

governments tighten their belts

and cut their spending so that they can

pay down their debt

this is often referred to as austerity

when borrowers stop taking on new debts

and start paying down old debts

you might expect the death burden to

decrease

but the opposite happens because

spending is cut

and one man's spending is another man's

income it causes

incomes to fall they fall faster than

debts are repaid and the debt burden

actually gets worse

as we've seen this cut in spending is

deflationary and painful

businesses are forced to cut costs which

means less

jobs and higher unemployment this leads

to the next step debts must be reduced

many borrowers find themselves unable to

repay their loans

and a borrower's debts are a 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 people discovering much of

what they thought was their wealth

isn't really there let's 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 your bar tab

then the

asset he has isn't really worth anything

it has basically disappeared many

lenders don't want their assets to

disappear and agree to debt

restructuring

debt restructuring means lenders get

paid back less

or get paid back over a longer time

frame 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 all of nothing

even though debt disappears debt

restructuring causes

income and asset values to disappear

faster

so the debt burden continues to get

worse

like cutting spending debt reduction is

also painful and deflationary

all of this impacts the central

government because

lower incomes and less employment means

the government collects fewer taxes

at the same time it needs to increase

its spending because unemployment has

risen

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

government's budget deficits explode in

the leveraging 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 governments 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 concentrated in

the hands of a small percentage of the

people

governments naturally raise taxes on the

wealthy

which 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 wealth he has

the wealthy halves being squeezed by the

weak economy

falling asset prices and higher 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 debtor and creditor

countries

this situation can lead to political

change

that can sometimes be extreme 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 credit

so when credit disappears people don't

have enough money

people are desperate for money and you

remember who can print

money the central bank can

[Music]

having already lowered its interest

rates to nearly zero 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 two trillion dollars 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

financial assets

you see the central bank can 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 bonds 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 income as well

as the government's debt

however it will lower the economy's

total debt burden

this is a very risky time policy makers

need to balance the four ways that debt

burdens come down

the deflationary waves need to balance

with the inflationary ways in order to

maintain

stability if balanced correctly there

can be a

beautiful deleveraging

[Music]

you see a deleveraging could 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 way is beautiful

a lot more beautiful than the

debt-fueled unbalanced excesses of the

leveraging phase

in a beautiful deleveraging debts

decline relative to income

real economic growth is positive and

inflation isn't a problem

it is achieved by having the right

balance

the right balance requires a certain mix

of cutting spending

reducing debt transferring wealth and

printing money

so that economic and social stability

can be maintained

people ask if printing money will raise

inflation

it won't if it offsets falling credit

remember

spending is what matters a dollar of

spending paid for with money has the

same effect on price as a dollar of

spending paid for with credit

by printing money the central bank can

make up for the disappearance of credit

with an increase in the amount of money

in order to turn things around the

central bank needs to

not 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 a hundred percent

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 two percent if debt is

growing at two percent because of that

interest rate

and income is only growing at around one

percent

you will never reduce the debt burden

you need to print enough money to get

the rate of income growth above the rate

of interest

however printing money could easily be

abused because it's so easy to do and

people prefer it to the alternatives

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 achieve the right

balance a deleveraging isn't 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

creditworthy and when

borrowers appear more creditworthy

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 of

the long-term debt cycle

though the deleveraging process can be

horrible if handled badly

if handled well it will eventually fix

the problem

it takes roughly a decade or more for

debt burdens to fall in economic

activity 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 top of the long-term debt cycle

and then laying both of them on top of

the productivity growth line

gives a reasonably good template for

seeing where we've been

where we are now and where we're

probably headed

so in summary there are three rules of

thumb that i'd like you to take away

from this

first don't have debt rise faster than

income

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

this template has worked for me and i

hope it will work for you

thank you

you