#108 Understanding Capitalism : Part-II
04.16.2023
In the first part of the series Understanding Capitalism, we learned that the economy operates like a machine. When borrowing is easy and interest rates are low, the economy expands. On the other hand, when borrowing is difficult and interest rates are high, there is a recession.
The economy wants individuals to borrow as much as possible, which is why it prefers to keep interest rates low. The central bank will lower interest rates as soon as inflation is no longer a major concern to promote economic growth.
However, high-interest rates may cause individuals to focus on repaying their debts for a short period, but the debt never fully disappears. Instead, it becomes less powerful and waits for the right moment to strike back with vengeance. As soon as interest rates decrease, people tend to shift gears and prioritize spending over debt repayment. Borrowing and spending more money is a natural inclination of human beings. This results in an increase in spending, income, and debt, which compounds over time.
Individuals tend to postpone repaying their debts. Lenders continue to lend more money despite individuals becoming increasingly indebted, as interest rates remain low and incomes continue to rise.
Optimism, combined with low-interest rates and rising incomes, creates a highly volatile mix. This time, people are not just spending on goods and services, but they are also investing in financial assets. Individuals are primarily focused on growing their wealth during this boom, rather than just their living standards. As a result, many people borrow heavily and invest in stocks, housing, and speculative markets to ensure a prosperous future.
When a large number of people engage in this behavior, it causes asset prices to skyrocket. This phenomenon is commonly referred to as a bubble, where people feel wealthy, at least on paper.
A bubble can be compared to inflation, but the difference lies in perception. Inflation happens when the value of money decreases, causing prices to rise. With a bubble, the value of an asset is inflated beyond its true value due to speculation and public frenzy. This leads to a rise in prices, causing more people to buy, which further reinforces the loop. However, the easy flow of money and accumulation of debt cannot last forever, and eventually, banks start to tighten their lending rules, causing a downward spiral. Japan experienced this in the 1980s, where asset prices rapidly increased, leading to a bubble that eventually burst, causing economic stagnation and high levels of debt and non-performing assets for many companies and households.
It is important to note that bubbles burst all the time. But once in a while, when everything else is lined up, the bursting of a bubble at a very apt moment creates the recipe for a massive massive economic disaster. This happens roughly once in every 80–100 years.
In times of economic downturn, when people have less money to spend and more debt to repay, they are unable to borrow money to pay off their debts. This leads to a process called deleveraging, where people are forced to sell their assets to generate cash to repay their debts. This sudden increase in supply of assets results in a decrease in their value, causing a market crash and a decline in spending. This can lead to a recession, and traditional methods of stimulating the economy, such as lowering interest rates, may not be effective. The central bank may then focus on reducing the overall amount of debt in the economy and printing new money to promote stability.
More on that later…
See you next Saturday, Until then, have a great time :)
Cheers!