How does the Economy Work?

I recently came to know that there are countries where if you take a loan to buy a house, the bank in addition to giving the loan will pay interest to you instead of taking interest. Quite shocking Isn't it? That is when I became curious to understand how economies work!

What I am going to try and do in the next few minutes of your read is put forth the thoughts and reflection of Ray Dalio on Economic cycles and a book by Howard Marks called Mastering the Market cycles. So,my value addition is only adding my commentary(in Italics) on the human emotions of Fear and Greed and its relation to economies..

1. Spending Creates Income

In one of my earlier blogs, I had mentioned about how money works thru many transactions across Consumers,Sellers,Banks, Corporates and government.

Lets take a classic example of buying a house.

If you want to buy a house, you contact a realtor to help you out. The money you spend on buying the house and paying the realtor is income for every person

involved in creating that house.(Construction workers, builders, architects, etc).

In simple words, one person Spending in some sense creates an income for many.

Spending money is a capitalist equivalent to putting money in a temple hundi.

The reason I say this is, People put money in hundi with the intention that the temple will in turn give back to the society by means of giving Food to poor and do other good things. If that is true, Spending money is a more efficient way of achieving that goal.

Many years ago, I remember watching a budget speech by Mr. P.Chidambaram, former finance minister who said,' Gold is just a piece of metal, Do not hoard it'. Its now that I understand the significance of him saying that. When you hoard Gold, you are effectively stalling some portion of economic activity which generates income to many people and is also a cycle that comes back to you at some point. Saving gold may be a hedge from a personal financial point of view but not to the economy on the whole.

2. Debt - Make or Break

If you want to buy a house but did not have the money to do so, you would probably decide to take a loan. To take that loan you go to a bank. The bank gives you that loan at an interest of say 10%. You now have created a debt. This debt though, will create income for the architect and the builder. They furthermore will take their own debt and that will create income for someone else. Basically debt creates expenditure and in return income for others.

Debt is a double edged sword!

You can either make Debt work for you or You will work the rest of your life for Debt. Unfortunately, majority of people particularly in Indian society fall in the latter category.

In my view, its also one of the reason Rich get richer and poor become poorer. The few people who understand this let the money work for them more than the rest. There are also people who leverage debt due to greed to an extent that they cannot handle it, wiping out all their wealth.

It is so difficult to be a contrarian in a society that works in a certain way. That is the primary reason I write this blog to reinforce my belief and to improve my fluency over financials that we essentially deal with everyday!

Debt in economy happens at a superficial level. There are technical ways a country can borrow for expenditure of money from other countries or financial institutes like IMF.

The other easier way is by printing money out of thin air which is what many central banks of different countries did in 2008 crisis to infuse money into the economy to create economic activity. When that infusion happened, there was a lot of liquidity or flow of money within the system. This created a lot create economic activity to bring the economy on its feet and pushed it to the growth phase.

3. Growth

The loan you took created expenditure. Your expenditure is income for someone else. This flow of money leads to growth in incomes of individuals. The economy flourishes due to the debt that was created creating a compounded effect. This phase of the economy happens for several years.

This is the phase when all your Friends and relatives buy assets of one form or another. One of the basic emotions of Human behaviour is FOMO, Fear of Missing out. Everybody brags about the property or stocks that they bought which has grown in value due to spurt in demand.

During the growth phase after 2008 crisis, though the liquidity created a lot of economic activity it is said that many parties that did not want to use the money bought Real estate as an investment that inflated the prices of Real estate to roof-top between 2009-2013. This has many after effects like, the cost of businesses became expensive because most businesses require Real estate of some sort(Shops, Warehouses, Restaurant, Companies) creating a negative effect. Common man had to pay more rent due to rise in Real estate prices and also creating price rise of basic products because the cost of businesses increased forcing them to increase the price of the products. In other words,Inflation became high eroding the value of money. This is one of the main reason the budget and fiscal discipline of the government becomes very important.

Slowdown

As the house is built completely, the repayment process begins. As you have to repay the money, you start spending less. Accordingly, the builder and the architect too start spending less. This reduction in expenditure due to repayments leads to lower incomes in the economy. Due to this growth slows down in the economy.

Nothing can grow to the sky! Every growth phase has to stop. The only question is When?

This is the phase when the salary increments fall. Consumers become Frugal. Unemployment rises, People become frugal to Spend. Stock market crashes! The plots and other illiquid assets don't sell.

Everything gets locked. All the Greed in people disappear and Fear creeps in!

Interest Rates to Pent up Demand

Seeing the slowdown in the economy, the Central Bank decides to reduce interest rates. Now people can borrow money at 5% interest (compared to the previous 10%). Seeing this low-interest rate, people eventually start borrowing money again. The borrowing will create an income. This income will create more expenditure and more income. Eventually when this loan has to be repaid, growth again will slow down. Seeing this the government, will reduce interest rates even more. The cycle continues.

The interest rate is the gearbox for the government to control the speed of economic activity. Whenever the demand goes up, government increases interest rate to control demand and when demand falls they reduce interest rate to stimulate demand.

The Climax!

Now that you understand how economies work, let me explain how some countries give Loans with Interest to make you buy homes.

Imagine a situation where the demand skyrockets, you can keep increasing the interest rate to infinity to control the demand. But, Imagine if the demand dies out. Can you go below zero interest rate to stimulate economy? Its a situation called Stagflation! Its a state when no change in interest rate creates any difference to demand.

But, remember there are deflating economies in the world as well.

In some of the scandinavian countries the prices of commodities are so high. Scandinavian countries are possibly the costliest tourist destinations as well. While there is high tourist attractions, the population is not rising and there is no demand for real estate as people who live there already have sufficient real estates to live and do business. Also, some people migrate to other parts of Europe to escape the extreme climatic conditions.

The Real estate is so expensive already that it makes no sense for anyone to buy them as it is more likely that the prices will only fall in the future.

So, in order to create value for investors and to create demand of the vast real estate that is available in the country, the banks will pay you interest for taking the loan because unlike inflating economy where the price of asset increase, some of scandinavian economies have Real estate prices falling over time.

Funny isn't it?