The future of the economy is yet to be defined around the world as many countries are still experimenting with various economical ideologies and attaining varying results of succession. Some economical models favour certain countries over others and many factors are taken into account when determining the perfect model such as geographical location, technological advancement, political stability, etc. The perfect economical model may be hard to determine but the principles of the economy remain the same and understanding these principles are integral to revolutionize the economy as we know it. The inner workings of a global economy may be extremely complex but they can be broken down for the sake of simplicity.
The Economic Machine
The economy is merely a complex yet logical system that can be analyzed as well as anticipated if studied correctly. It is a self-preserving machine that requires minor tweaks along the way to retain balance but in principle, it can be self-sufficient in most scenarios. The economic machine relies primarily on human nature and it is considered to be a natural system that is ingrained in human biology. Human beings may have developed the machine over time but in principle, it works in favour of our humanism.
The economy relies on continuous transactions that occur much like the environmental cycle. Transactions occur in the form of infinity and this loop is what allows the economy to exist as a self-sustaining system. An exchange of cash/ credit occurs to obtain the goods/ service/ financial assets. Transactions occur due to demand and the fact that one individual can never be fully sustainable without the help of a community. We demand one another to obtain our individualistic requirements and this becomes the driving factor of the economy. Specialization has allowed everyone in civilization to be worth something through the production of goods or the ability to carry out technical tasks. The more specialized one’s ability is, the higher the demand allowing the individual to be placed higher up in the transaction cycle.
In the past, transactions were not dictated by money rather they were dictated by needs/ wants. One person may have an abundance of chicken while the other has an abundance of cows so a trade occurs between both parties but an equal trade requires common sense. While most people would assume that the individual that rears cows will always profit, this is only true if over-saturation doesn’t exist. If too many people have cows, the scarcity of chickens increases causing the value of a chicken to be higher than a cow. The transaction cycle requires a balance in order to profit everyone as an oversaturated market space can cause the entire cycle to collapse.
A collection of similar transactions is known as a market and various markets exist for specific goods. The total spending and the total quantity sold is the ultimate principle of the economy and this continuity allows a structure to be formed and analyzed. The central government and the central bank are two major constants in the economy as the buyers and sellers fluctuate depending on population growth. Individuals, companies and governments deal with transactions of varying scales but they follow the same principles with the biggest entity being the central government. The central bank on the other hand doesn’t interact with transactions rather it plays a role in balancing out the economy by adjusting interest rates for credit and printing new money to be circulated. A huge portion of the economy runs on credit rather than cash, thus credit is integral to ensure the exponential growth of the economy.
Credit is pretty intangible as value is created out of thin air. In the past transactions relied on the physical exchange of goods and this didn’t allow space for a lot of growth in the economy. There is never enough money in circulation to allow for the advancement of an industry as economical growth relied on the productivity rate. As humans, we can only do so much within a day and min-maxing our productivity rate is tedious for many. The easiest way to attain large sums of money is by borrowing it but even then, if everyone starts borrowing and large capital is in the hands of the majority, the value of currency starts to decrease. Credit protects the value of money as credit in principle is just borrowing from your future self. New money isn’t created, rather you take from your future self first in the hopes you can make a large profit today.
Starting a business or buying a house requires huge capital but this can allow an individual’s income to increase. An increase in income over a long period of time can diminish credit and account for extra cash. The flow of credit requires two parties and by the end, both sides are satisfied as the lender increases their money while the borrower can increase their spending. Interest rates affect the rate at which we borrow as low-interest rates are far more enticing compared to higher ones. An integral part that allows the system to work is trust and nowadays that trust is measured in the form of your FICO score which is a credit score created by Fair Isaac Corporation. Regardless of advance credit reports and debt-income ratios, in reality, credit can be created between any two people.
Once credit is created, it becomes a debt for the borrower and this, in turn, is an asset for the lender but a liability for the other party. Only when the loan is paid off with interest will the debt disappear and allow the transaction to be settled. The use of credit increases a person’s spending and this will allow another person to increase their income. This constant cycle of increased spending and income will allow for the growth of the economy within a shorter time frame as more money exists in the markets. However, the money that exists in the market is virtually useless as it doesn’t exist yet considering a majority of it is credit. During this economic boom, we consume more than we produce knowing very well that there will come a time where we have to consume less than we produce in the future to account for our accumulation of debt.
Credit ultimately causes debt cycles to occur as every high must have a low. Our ability to speed up the economy with credit comes at the cost of a possible all-time low known as an economic downturn. A world without credit only allows for linear projection and because cash is tangible, it is the safest way to traverse the economy without getting hurt. If you have debt when the economy tanks, there is no longer any money to pay it forward and you will ultimately lose all forms of capital.
The debt cycle can be a vicious one as a functional economy works on settled transactions but during the low point of the cycle, debt can never be settled and this causes varying degrees of problems. The total amount of cash that exists in the world is roughly $6.6 trillion but the amount of ‘broad money’ that exists is estimated to be $80 trillion which proves that most of what we consider to be money really isn’t in circulation rather it exists from thin air. There are two types of debt cycles, one being the short term cycle and the other being the long term cycle. Both cycles work in tandem and exist mutually exclusive from the linear productivity growth of the economy.
Short Term Debt Cycle
The growth in economic activity allows for expansion to occur as more people start spending due to increased incomes. When more money is in circulation, the price of goods, services and assets start to rise as there is a higher demand and this is known as inflation. The worst case of hyperinflation was seen in Venezuela in 2016 due to the country’s ongoing socio-economic and political crisis. The average inflation rate in Venezuela amounted to about 438.12 percent in 2017 compared to the previous year and the primary causes include the heavy printing of money and deficit spending. Typically, when inflation occurs in a country, the central bank increases interest rates so less people borrow money and this effectively reduces the amount of credit in the economy.
The reduction of credit causes debt repayment to increase leaving the individual with less cash to spend causing the prices of goods to reduce effectively causing a deflation. When economic activity hits an all-time low, a recession occurs causing interest rates to be decreased by the central bank. This will cause the economy to slowly pick up as the availability of credit encourages more spending to allow for expansion. The short term debt cycle occurs every 5-7 years and the cycle always ends with more debt being added up over time and this occurs due to human nature. When borrowers don’t pay lenders, the debt to income ratio in the country slowly loses balance and this will lead to the long term debt cycle.
Long Term Debt Cycle
The long term debt cycle occurs once every 50-75 years due to the steady accumulation of debt in the country. This debt exists behind the facade of a blossoming economy and it is impossible to really recognize the breaking point. In the short term, incomes are rising alongside property value, stocks, etc and this exponential growth with borrowed money causes the economy to be in a precarious position. The growth of debt slowly offsets the growth of income causing the debt burden to rise and individuals to become less creditworthy. Thus, incomes slowly decline as people no longer want to lend money and spending slowly declines. This is when a true financial crisis occurs and this hit the USA in the form of The Great Depression in 1929-2939 caused by the Wall Street crash in ’29. Many countries around the world also experienced this in 2008 during The Great Recession after the burst of the U.S. housing bubble and the global financial crisis.
When income offsets the debt burden, people still consider themselves to be wealthy thus the prices of assets, goods and services increase. This is inflation isn’t caused by actual economic growth as it comes at the expense of increased debt in the nation. This allows the common man to live with the illusion of wealth above all else as the reality is there still remains a striking amount of debt that is left untouched and no asset truly belongs to the individual as it paid off with credit rather than cash. When debt repayments are finally worth more than income, the long term debt peak has been reached and deleveraging starts to happen. Spending is reduced at an exponential rate causing the economy to dry up as everything relies on transactions. This causes individuals to be less creditworthy causing credit to dry up and now most people have no money at all even to survive. This is when social tensions rise and revolutions seem like the only chance for a possible future as nothing has value anymore considering nobody has money in their pocket.
During a deleveraging, the central bank doesn’t have many options as the interest rates can’t be reduced any lower to stimulate borrowing considering the rates is already at 0% during a certain point. People no longer have to urges to borrow more after realizing how poor they actually are when credit vanishes. There is over $756 billion outstanding credit card debt in the US alone and these numbers are projected to rise in the upcoming years with many people wanting to live a life of perceived wealth without actually having tangible funds to their name. It is found an estimated 73% of Americans will die with debt and since debt doesn’t necessarily die with the borrower, future generations will suffer those consequences. A huge portion of the global population are never fully able to recover form a deleveraging but there are some ways which the country can do in order to reclaim economic strength.
Reduced Spending & Debt
Everyone has to spend less and this includes large companies and governments as this is the first step to start paying off debt. The problem with this method is the economy relies on spending and when that is cut in half, it comes at the cost of reduced income for others. This eventually causes the debt burden to be even more prominent as the rate of income decreases faster than the debt. Now more people will end up losing their jobs and some companies have to shut down due to poor risk management. Reduced spending will cause investment and development rates to decrease, crippling any form of advancement within the company/ nation. Austerity within a company or government is the primary reason social revolts occur as workers feel squeezed by billion-dollar conglomerates. When job demand s at an all-time low and the government lacks the funds to help the citizens, the middle class start losing options and they start to drop below the poverty line.
Besides cutting spending, new loans can’t be taken on so many people have to put their life plans on hold. Making large purchases is out of the question so the mere thought of buying a house with a loan is far too much to handle. Reduced debt is also caused due to the lack of funds in the bank as borrowers can no longer pay off older debts. People slowly lose confidence in the central bank and everyone starts withdrawing their money causing a bank run. Banking runs typically happen when people think a bank will be insolvent meaning it can no longer repay its depositors so everyone starts withdrawing their money simultaneously. In response to this, the Federal Deposit Insurance Corporation (FDIC) was founded in 1933 to insure bank deposits for stability as bank runs can turn into bank panics if economic stability isn’t achieved quickly. To resolve the issue of unpaid debts. a method known as debt restructuring is used to provide borrowers with longer time frames or lower interest rates.
Reduced spending and debt, affects the central government tremendously as the government lacks the funds to provide stimulus checks for the unemployed and this causes budget deficits to occur. To resolve the issue, the central government has to increase taxes or borrow money and the only people with money during a depression is the upper 1% as a huge portion of wealth is concentrated amongst the extremely rich. When governments raise taxes on the wealthy, the money goes into the hands of those who need it but this creates a dilemma between the rich and the poor. Those who don’t have money start resenting the rich while the rich feel pressurized to pay for the mistakes of others.
The Robin Hood Effect of taxing the rich and helping the poor is said to decrease the growth of the economy in the long run as large scale advancements are no longer enticing due to the lack of financial incentives. Wealth redistribution comes at the cost of the economic pie becoming smaller as it reduces the reward of handwork and innovation but it is said to be the solution to end poverty. Taxes for the sake of income redistribution discourages the taxpayer from earning taxable income as they stand to lose a part of their personal earnings, reducing the overall wealth in the country and slowing down the economic growth due to reduced production of goods and services.
When all systems fail, the central bank has to print money as this is the only inflationary way to impact the economy. Printing new money is tricky and it can end in a disaster if not done right so this is the last resort that is executed sparingly. The new money is used to buy financial assets and government bonds which are the two things that are enough to balance out the economy. The federal deficit hit an all-time high of $3.1 trillion in the 2020 fiscal year causing the Federal Reserve to print nearly $3 trillion in response which was higher than the $2 trillion printed during The Great Depression. New money not only stimulates the economy, but it also helps the government assist those who are unemployed through stimulus programs. However, when too much money is printed, the money you have becomes worthless because when the supply of cash exceeds the amounts the goods and services, inflation occurs.
Balancing the economy requires a constant effort from all parties and if handled poorly, it comes at the cost of hyperinflation causing a nation’s currency to lose all value. The way to retain a balanced economy is by ensuring the income rate is always higher than the rate of debt so everyone is always creditworthy. Fixing a broken economy can take up to 10 years thus the term the ‘Lost decade’ but the economic crash due to the pandemic is expected to recover within 2-3 years due to strong major economies such as the U.S. and China. The economy is always going to be volatile and while we may predict possible drops, there isn’t a realistic way to solve the problems without any loss in productivity. Economic growth is the backbone of any country and while social policies are important so are economic policies. All parties have to be well educated when it comes to the basics of how the economy functions in order to dive deeper and study the different variations of the economic model.
While politics and economics have always been intertwined in government, a clear distinction has to be drawn and both sides have to be evaluated separately when making legislative change. Good sociopolitics isn’t enough to keep a country together as the wealth of the country is integral to retain strong diplomatic relationships. There are many countries that have achieved economic success through their own means and while one method might work for a certain country, it may not be so suitable for the rest of the world. Economical ideologies depend on the culture or values instilled in the citizens so a change in the economical model would require the rewiring of millions of minds. The economy has become such an intrinsic part of our life that many philosophers have theorized that the solution to the world’s problems is by figuring out the perfect economical model and honestly that system may just be a fantasy.
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