Explain Like I'm Five
Economics and the Debt Cycle
Every issue our resident engineer and all-round smart person Kurt Schmidt explains complex stuff so a five-year-old could understand it (admittedly, a pretty smart five-year-old). Illustrations by Hope McConnell.
Buying and Selling
When you buy something, a transaction takes place. Every transaction consists of a buyer exchanging money or credit (borrowed money) with a seller for goods or services. And the economy is simply the sum of all the transactions that occur. Luckily we all know what money is, but what about credit? Well credit is like money except it’s created when someone wants to buy something they can’t afford. To do this they borrow money from someone and agree to pay the full amount back, plus interest. Take a second to thank whatever god you believe in that our student loans are credit loans without interest. What a deal! Unfortunately our loans do eventually have to be paid off and, because you’re spending more than you have now, at some point in the future you will have to spend less to pay back the loan. This is unless the loan was used to increase your productivity. This brings me to our next point - productivity.
Productivity is the amount that is produced per the amount of time or resources that are put in. For example, a first-year law student may spend 20 hours writing a report, whereas a law professor may finish the same report to a better standard in two hours, making the professor way more productive. The main way economists like to measure the productivity of a country is using what's called the Gross Domestic Product, or GDP for short. Remember we said that the economy is simply the sum of all transactions? Well GDP is that sum. It’s the monetary value of all the finished goods and services produced within a country's borders in a specific time period. So how does this relate to real things? Well, let's start first with how pricing is set. We all know there's no such thing as a free lunch, so it’s fair to say that all transactions come at a price to the buyer; if you want something, it’ll cost you. Interestingly, the price of something doesn’t actually depend on what you’re buying, but depends instead on the quantity of the something available and the amount of people trying to buy it. This is what old white men call ‘supply and demand’, and when this causes prices to rise, the rise is what is called ‘inflation’. To put this into practical terms, if people stopped buying houses in Auckland, then the prices would drop and I could actually afford one.
Here Comes the BOOM
So what does supply and demand have to do with productivity? Well, demand comes from people needing things and supply comes from people producing things. When you spend more, someone else earns more. Earning more makes people richer, and the goblins in Gringotts Bank prefer giving loans to rich people. This is called being ‘worthy of credit’. And being credit worthy makes lenders feel comfortable lending out money. When there is more demand, there is more supplied and more people getting richer. When more people are richer, more people can loan money, making them even richer. A snowball of wealth then begins to form and we end up with what is often coined a ‘boom period’. Unfortunately, the boom is only one part of the cycle, and it’s the side of credit we love. But like every bad relationship, there's a hate side. And on the hate side, bad credit is to blame, and it results in dropping GDP and those soul crushing terms, a ‘recession’, or even worse a ‘depression’.
When credit is used to buy something that increases a person's productivity and hence their output (think of a farmer buying a tractor), they are able to pay back the loan plus interest and still have money left in their pocket. This is called using credit to buy a productive asset. Even a student loan can be looked at as a productive asset; you create a large amount of debt, sure, but your future earning potential becomes so much higher that it easily offsets the debt over time. Now remember, when you take out credit and create debt, you gain money for now but promise to pay it back in the future. This means if your productivity doesn’t increase, you will have to spend less in the future to make up for the greater spending now. The amount that we have to pay back compared to our income is called ‘the debt burden’ and, yes, it really is a burden. When our debt burden becomes too large, it causes another cycle like the one we described above, but this time in reverse. First you spend less because you’re paying off that hefty investment property in Otahuhu and because you spend less someone else earns less. When earnings drop, so does creditworthiness. The goblins get scared and loan less, and the cycle reduces transactions and hence the GDP. All of a sudden, hello recession! And all because too many people spent too much credit on non-productive assets and created a debt burden they couldn’t afford to pay off. Moral of the story: don’t buy fast cars, TVs, yachts or houses on credit you can’t afford, as you will be help create a recession. (And yes, houses are non-productive assets, as they don’t actually make anything for the economy, they’re just places people live.)
Interest Rates are Actually Interesting
It’s important to note that credit drives the economy more than money does, because, well there is more of it. Way more of it. On average there is 10 times more credit in the world than money, and this is possible because of a system called ‘fractional reserve banking’. In this system, banks only have to hold a fraction of the money they loan out. So essentially if everyone requested their money all at once, well the banks wouldn’t have it… but hey when would that ever happened, right? (FYI, it actually does happen.)
There are systems in place that the reserve bank (our country's bank, which loans to all the other banks) uses to try balance productivity. And this is achieved by influencing interest rates (known as the official cash rate, which is the interest rate that banks loan at) and by printing new money. Changing interest rates affect how attractive it is to borrow. For example, with low interests rates, people borrow more, and with high interest rates, people don’t, because the amount you have to pay back is too high. It’s important to remember credit isn’t exactly the bad guy, the bad guy is human nature and the fact that people use credit to buy non-productive assets like flash cars, TVs and yachts.
A Worrying Future
We spoke about the how the economy cycles from boom period to recession. History has shown that these happen in two big cycles, one that takes about five to eight years, and the other which takes about 75 to 100 years. We’re currently sitting at 10 years since the last recession, which is very worrying for our economy, especially seeing as the official cash rate is low, meaning we can’t reduce it much more to stimulate loaning and spending. And guess what? Productivity is slowing down. As a closing note, the country’s economy is our responsibility. Financial policy aside, it’s individual spending and productivity that has one of the largest impacts on whether we sink or swim. So here are a few simple rules to remember:
1) Make sure income rises faster than debt, otherwise the debt burden will eventually crush us.
2) Make sure incomes do not rise faster than productivity, otherwise you will not be competitive and inflation will crush us (this is important to consider when raising things like the minimum wage.)
3) Do all you can to raise productivity, as that is all that matters in long run.