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How the Economy Works
The economy is a complex beast, hard to grasp like the sea at night. It can be a 10 volume book set and we won't cover it all, but let's try to do something to help each other understand it.
Why Understanding the Economy Matters
Starting a business in Ghana gives you less chance to become rich than in the USA. The economy dictates your fate. If you miss the big picture, the details won't save you. Blockbuster ignored streaming, Kodak ignored digital; both went under.
The Economic Cycle
In good times, money flows easy in many businesses. But when the tide turns, these same businesses fail. Knowing where we stand in the cycle is important.
The Puzzle of Economics
Understanding the economy is like piecing together a puzzle with too many dimensions. Government actions, central banks, wars, pandemics - all these move the pieces. Even with AI, predicting it all remains elusive.
For example:
Money and Credit
**Money (principal) + cost (interest) = Debt.**
One person's debt is another person's asset.
The **credit -> spending -> debt paying back** dynamic is cyclical.
At a country level:
- when inflation is lower than desired, and
- interest rates are low
- interest rates are low relative to rates of return on other investments,
this leads to credit creation. Borrowing is easy, cheap, and returns on investment elsewhere make it desirable. As a result, borrowing intensifies, and prices start going up (remember money + cost = debt, thus a higher return is required elsewhere to cover the debt). Inflation picks up until it's higher than desired; then interest rates go up, and credit tightens. Interest rates become high compared to inflation and relative to other investments.
This means that at the time when there is stimulus - starting a business, getting customers is far easier. You can have debt form banks, not only approvals are easier, but the borrowing rates are lower - servicing debt is easier. More people lean into debt (credit) and more products, inventions and services are produced in the market.
**Money (and credit) are like the blood in our veins for the economy.** Cash is like oxygen but for companies (remember, you can only hold your breath for so long and the fastest way to go bankrupt is to run out of cash).
In summary: your debt is someone else's asset. Credit, spending, debt repayment - it's a wheel that keeps turning:
- Credit Creation: Low inflation, low rates, high investment returns make borrowing attractive. Then, spending goes up, pushing inflation.
- Stimulus: When the economy gets a boost, starting a business or finding customers is simpler. Debt is easy and cheap, fuelling more creation.
The Mechanics of the Economy
Think of the economy as Monopoly. Resources are scarce; your fate depends on your plays. Imagine a new country where everyone starts with the same chips. Soon, some lend, some borrow, some win, some lose - that's the economy in action.
- Production: Businesses make what we need.
- Distribution: Markets spread the wealth around.
- Consumption: We all consume, from individuals to governments.
- Foreign Impact: The world outside can shake our economy.
Key Economic Concepts
1. Supply & Demand
2. Economic systems: capitalism, socialism, mixed
3. Monetary policy
4. Fiscal policy
5. Labour markets
6. Cycles
1. Supply & Demand:
The high prices are not the reason why we can't all live on a beach front. The reason is that there are only so many homes that can be built on the beach. This is scarcity. It will exist no matter the political environment. However, the allocation of this desired type of property can be done in many ways: price is just one way.
Prices are like messengers that deliver news. Some are good news, some are bad. Their primary role is to provide incentives to affect behaviour in the use of resources and resulting products. They not only guide consumers, they guide producers too.
From society as a whole point of view, the cost of anything is the value it has in alternative uses.
When you think about milk, the supply & demand for it will also be dependent on butter, yogurt and every other milk based product. If there is a higher demand for yogurt, there may be less supply of milk. All resources are relatively available against alternative uses.
A simple concept leads to profoundly complex outcomes. Just because it is simple, does not make it any less true or powerful. Supply and demand is a very simple concept at affects our economy.
2. Economic Systems:
Ghana was committed to a government-run economy and the Ivory Coast to a freer market. By 1982, the Ivory Coast had so surpassed Ghana economically that the poorest 20 percent of its people had a higher real income per capita than most of the people in Ghana.
It seems known but sometimes forgotten that free market economy, with all the flaws it may have, is a far better economic system than government run alternatives.
I'll leave this section at that.
3. Monetary Policy:
Central Banks create monetary policy. It typically means injection or withdrawal of availability of credit through interest rates. Central bank sets the borrowing rate up or down depending on wether the economy needs to be stimulated or cooled off.
**Interest rate monetary policy**
Interest rate monetary policy increases the value of investments, causes purchasing on credit to become more lucrative, and lowers the carrying cost of existing debt burden. Interest rate policy also inflates asset values and puts money in the hands of the wealthy, focused on incentivizing spending.
Unfortunately, there are limits. One, as we approach near zero-rates it becomes less effective.
And two, the wealthy might not spend the money and instead save or invest, which drives up the value of investments such as real estate.
**Quantitative easing (“QE”) monetary policy**
QE policy is for central banks to buy bonds and other financial instruments, giving investors cash in return. The hope is that investors use that capital on productive activities that stimulates the economy, but it doesn't mean this is what happens.
When the interest rates approach zero, the interest rate monetary policy becomes less effective. QE policy has the same effect at later stages. At some point the price for assets is too high and returns are too low to motivate spending.
Other than interest rate and QE, central banks can do little to effectively motivate institutional buyers to spend.
**“Helicopter money” monetary policy**
“Helicopter money” is the idea to put money in the hands of those who need it most and will spend it. Think of the various stimulus packages we have seen for the individuals and businesses during the pandemic.
This policy can be incredibly effective, as people who receive such money are most in need and will spend it on living, thus increasing consumption and stimulating the economy. On a flip side, it is inflationary if done when not needed.
4. Fiscal Policy:
Government spending might push when banks pull, or vice versa, creating a dance between public and private actions.
Example:In 1944, the ratio of:
1. US Gov debt divided by the amount of gold the US gov had = 7x
2. US Money Supply divided by the amount of gold the US gov had = 1.3x
Today, these ratios are 37x and 6x respectively.
Which leaves only two options for the government:
- default
- print more
Every government in history has chosen to print more. This continued until the debt and investment growth became greater than could be serviced by the incomes being produced.
Put another way, print until the devaluation of the currency becomes so severe that it leads to a default anyway...
More to follow... on labour markets, cycles, discussion on whether we need central banks, Bitcoin, Gold, fiat vs hard currency etc.
@MitchC @heavy_industry @WJK @amp0193 and anyone else reading this, please add and ask questions to make this thread better.
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