The Economic Cycle: How National Debt is Created

For years now, we have been hearing about Greece’s and Italy’s huge national debt and the global economic crisis. Newspapers mention or even invent many economic terms that we are often not taught at school nor are they part of our cultural background.

There are different economic theories that explain the current phase: the Austrian school adopts a complex approach with human desire at the center, while the traditional school has more of a mechanical view.

We have found in the theory provided by the great investor Ray Dalio a compromise between the two approaches, that is effective in providing a wide perspective even to non-experts.

So let’s find out how public and private debt arises from a macroeconomic and historical point of view, while clarifying the attached terminology.

Debt: the steering wheel of the economy

While the market economy is based on the relationship between supply and demand, i.e. on transactions between buyers and sellers, our economic-monetary system is based on the relationship between creditors and debtors.

Just think that a substantial portion of the new money that is put into circulation every day is created by commercial banks when they grant a loan.

The money that these banks deposit on the current account of the borrower, in fact, is brand new money. This money will disappear when (and if) the loan is repaid with interest.

Loans are taken out every day by all participants in the economy: businesses, small entrepreneurs, individuals. Creditors are banks and financial institutions, which sell the loan in order to obtain a repayment with interest in the future.

This is how you create that two-sided entity called credit, or debt depending on where you stand.

When interest rates are high, fewer loans are taken out. When interest goes down, more loans are applied for.

When you borrow, you increase your spending power. Spending drives the economy, as every time you make a purchase or expense, someone receives income.

The more income you have, the more creditworthy you are, and lenders will be more willing to give you a loan because you will likely be able to pay it back.

If the reliable party takes out a loan, the business cycle starts over, wealth circulates, and the economy grows.

Productivity: the fuel of the economy

The real driver of long-term economic growth is productivity.

The more you produce, the more you earn, and if we increase production over time, we increase our capital.

This value in the graph below is represented by the straight line, and is usually measured by GDP. Productivity is usually a constant, so its percentage has a long-term impact without much fluctuation.

In contrast, debt (or credit) has a short-term impact, because it allows us to consume more than we produce in the immediate term.

If you consume more than you produce, you create debt.

The moment you have to repay the debt, paradoxically you will produce more but consume less.

According to Ray Dalio, the economy is composed of two types of cycles: long term and short term. The cycle of the short term runs on the cycle of the long term, as in the diagram.

Cycles, i.e. the alternation between growth and recession, are caused precisely by the debt/credit mechanism. Every time I take out a loan, I obtain “wealth” in the present in which I produce less and spend more. At the same time I create “poverty” in my future where I will produce more and spend less, thus generating a cycle in my personal economy.

Let’s think of a pre-capitalist world where the debt mechanism did not exist. In that kind of world, the only way to get rich was to produce more. Remove debt from the equation, you remove the business cycle and you get steady growth in the overall economy.

Quoting Mario Draghi, there is good debt and bad debt. Good debt is the debt that is repaid timely and creates value. Bad debt is the chronic kind that never manages to be repaid and creates an accumulated interest that does nothing but weighing on the debtor.

Importantly, the alternation between booms and recessions is reinforced by human psychology, whereby enthusiasm increases initial cycle debt, and fear fuels crisis.

The short-term debt economic cycle

In the short term, the generation of loans increases inflation, as anticipated, and simultaneously increases spending, which in turn further fuels inflation through price growth.

Faced with excessive inflation, central banks tend to raise interest rates in order to discourage borrowing. This activates the opposite mechanism, which catalyses the next phase of the cycle: recession.

In fact, less lending means less spending, and less spending means less income, and therefore even less spending and less lending. A vicious cycle that aims straight for the abyss.

To “save the economy” the banks also change direction and lower interest rates. Thus the expansion begins again and the short-term cycle continues, which Ray Dalio estimates to last between 5 and 8 years.

However, this short cycle has an impact on the long term, which is represented by an inflated cycle with extreme fluctuations.

The long-term debt economic cycle

The first series of short cycles is characterised by an increase in growth and credit. This leads to a swelling of debt in the long term, partly because people do not realise the problem.

Per capita income rises in tandem with debt, and everyone rides the economic boom with only the present in mind.

However, as income rises, the market also raises its prices. This leads people and businesses to take out more loans in order to buy assets on the market.

Governments also spend, thus generating a deficit (when expenditures exceed revenues) and to pay off the deficit they borrow, thus incurring national debt.

The National Debt

One way for a government to borrow is to issue bonds, i.e. government securities on the market. In this way, institutional and non-institutional investors can buy shares and the state will pay them interest.

When a government issues too many bonds or borrows in other ways and reaches an excessively high debt-to-GDP ratio (above 100%), it’s a red flag.

Over the years, the burden of national debt begins to exceed incomes. This puts the brakes on spending. As we know, spending is the engine of the economy, and in this phase of the economic cycle, spending collapses substantially, bringing down the economy. This phase is called deleveraging.

In Europe, we found ourselves in this situation in 2008, as did the United States in 1929, or Japan in 1989.

The change in direction of the economic cycle is exacerbated by falling incomes, which together with the repayment of debts leads to discontent and social tensions.

Stock markets collapse because everyone sells their assets for liquidity and no one has enough money to invest. So also the banks see their credit reduced because there is much less creditworthiness among their customers.

During this phase, called recession, banks cannot lower interest rates any further, because they would fall below zero.

At this point there are four possible ways to reduce the now intolerable debt:

From what has been explained above, we know that cutting spending may seem like a solution in the short term, but it does not help the recovery, in fact, it increases deflation and unemployment.

When banks accumulate too much credit that is never repaid by debtors, their depositors lose trust and withdraw money from their accounts. At this point even the banks themselves cannot repay their debts, so they go into default.

Taxing the rich in order to distribute incentives to those most affected by crises seems the fairest solution, but it is one of the most difficult to implement and one of the biggest problems in history.

In fact, taxing the wealthy classes historically leads to social tensions and recriminations on all sides.

To reduce debt, central banks often print new money with which they can buy financial assets. Wealth is thus redistributed only to those who issue these assets.

The government cannot buy assets, but it can buy goods and services. Therefore central banks and governments must cooperate to redistribute value in all sectors of the economy.

At this crucial moment, the depression, it is key to balance deflationary measures (the first three) with inflationary ones in a controlled mix.

Over time, this will lead to a gradual regrowth (Reflation).

Ray Dalio estimates that from the onset of recession to significant growth takes about 10 years, in fact the case of Japan in the 1990s is known as the “Lost Decade”.

In conclusion, the experienced investor gives us three rules to follow to reduce the pain of the economic cycle, rules that apply to both individuals and governments.