GMR 138: Understanding How The Economy Works
Having a basic understanding of how The Economy works is not just for financial experts. Understanding market cycles, consumer spending, and the role credit plays in the economy is more important than you realize. In this episode, we introduce you to the three main forces that drive the economy and how they personally impact your finances.
Show Notes
Understanding how the economy works
3 main forces that drive an economy
Productivity growth - measures the output of labor, and is typically calculated for the economy as a ratio of production to hours worked.
GDP - total monetary or market value of all the goods and services produced within a country's borders in a specific time period.
Short term debt cycle - a cycle that lasts 5 to 8 years.
Long term debt cycle - a cycle that lasts around 75-100 years.
Transactions (the building block of the economic machine) -
A transaction happens between a buyer and seller exchanging goods and services and financial assets.
Total spending (drives the economy) = all cash and credit spending.
Price = total spending / total quantity sold.
All cycles and all forces in an economy are driven by transactions.
Market = all buyers and sellers making transactions for the same thing (ie. wheat, car, stock, steel, etc.)
All spending and the total quantity in all of the markets make up the economy.
The government is the biggest buyer and seller. It consists of two working parts.
Central Government - collect taxes and spends money
White House + Senate + Congress etc
Central Bank - The Federal Reserve (The “Fed”) -controls the amount of money and credit in the economy. It does this by influencing interest rates and printing money. It is a key player in the flow of credit (most important part!).
Executive, Judicial, Legislative.
Supposed to have Checks & Balances.
Sometimes the Checks & Balances slow things down from getting done.
U.S. Government income from taxes is around $4 Trillion, not including the credit being extended by the Central Bank. So the government's spending power is HUGE!
Important Terms
Money is the available Dollars.
Credit = Ability to borrow.
Borrowing or Debt = Pulling money from the future, into today. It’s promising to give future dollars, in exchange for the ability to use someone else’s dollars today.
Lenders and borrowers
Lenders want to make their money into more money.
Borrowers what to buy something they can’t afford (house, car, business start-up).
Credit can get both lenders and borrowers get what they want
Borrower's promise to pay the amount they borrow - principal + interest.
When interest rates are high there’s less borrowing because it’s expensive.
When interest rates are low there’s more borrowing because it’s cheaper.
When borrower's promise to repay and lenders believe them, credit is created.
Why do people allow for Credit? = Ability to repay & Collateral
Income
Collateral assets
Sometimes just based on family name and trust (handshake deal)
Credit
As soon as credit is created it turns into debt.
Debt is both an asset (to the lender) and a liability (to the borrower).
When the borrower repays the loans, plus the interest, both the asset and the liability disappear and the transaction is settled.
Credit is important because when a borrower can get credit, he is able to increase his spending, which drives the economy.
One person’s spending is another person’s income.
Every dollar you spend is a dollar someone else earns.
When you spend more someone else earns more.
When someone’s income rises it makes lenders more willing to lend them money because they are creditworthy.
Remember a creditworthy borrower has two things that make lenders comfortable lending him money.
The ability to repay - more income than a liability to pay.
Collateral - assets that can be sold to repay
Increased income allows increased borrowing, which allows more spending, which increases someone else's income, which leads to more increased borrowing. This self-reinforcing pattern leads to economic growth and this shows up in cycles.
Can borrowing ever be smart?
Yes, when someone borrows in a way that increases their productivity (ability to earn) and they can pay back the debt and have an increase on top of that.
Can borrowing ever be dumb?
Yes, when someone borrows to buy something that doesn’t increase their productivity, or they anticipate it will help them grow their productivity, but it doesn’t.
Examples:
TV - bad debt
Car - likely bad debt (new car vs used car) | surety?
College - 50% Good / 50% Bad?
Housing - 70% Good / 30% Bad?
Equipment for a Business - 70% Good / 30% Bad?