One day I was going through a blog and found the title very interesting- “The Coffee Machine Principle.” We all love coffee and drink it to re-energize our day. However, the writer found 3 behaviors that shape the performance of the coffee machine. Similarly, the economy works like a coffee machine with certain principles. The 3 rules of thumb of the economy are:
- Keep the debt growth rate under the income growth.
- Keep the income growth rate under the productivity rate.
- Increase your productivity.
If we think the economy as a machine and the rules of thumb as principles than the economy will work perfectly if the principles are followed accordingly. Otherwise, the economy will collapse quickly.
A Global financial crisis in 2008 opened our eyes. It forced us to know more about how the economy works. Shockingly, the economy runs in a way that is very simple yet mechanical. Repeated small events drive the entire economy to behave in a certain way.
The first action that starts the machine of the economy is Transactions. Every day billions of individuals perform transactions that shape the way the economy will run in the long run. In other words, the entire economy is the sum of all the transactions. When a buyer wants to buy something, he/she exchanges money to the seller for the product, financial asset, or service. At that time we can say that one transaction has been recorded. Like this, millions of transactions are happening all the time in exchange for something. When the buyer has nothing to offer he/she might ask for a credit. And that’s how the total spending amount can be found by adding the products bought using cash and credit at a certain time.
Figure 1: Forms of transaction
So, all the might of the economy, whether upward or downward are the results of transactions. Hence, understanding the simple transaction we make each day will guide us to learn the entire economy we are living in.
Now we know how the transaction is responsible for running the economic show. But where the transactions are taking place? You obviously need a place where sellers can wait for a potential buyer to come and complete the transaction. This is how the formation of the market improves the overall number of transactions, eventually growing the economy in the process. Just getting the sum of spending in all of the markets in the economy and the quantity sold will give us a very clear picture of the entire economy and that data can be further compared to other weak or strong economies.
Again, when the buyer has nothing to pay for the transaction, he/she ask the seller for a credit. And when the credit is approved the economic machine pumps up and things start to get complex. Unfortunately, credit is the most important part of the economic machine which is often overlooked by the individuals and the policymakers. There are separate markets that only focus on credit, for instance, banks. But the complexity rise when the borrower with less capital in hand can spend more using the credit facility of the lender. Consequently, the purchasing power of the buyer increases which improves the income of the seller. So the entire economy rises in the process.
Another interesting factor is that since we borrow we create economic cycles or seasonality. Borrowing again and again for a long time will reduce your purchasing power. So borrowing creates cycles in the economy despite it never gets enough spotlight.
Figure 2: Short term debt cycle
As a consequence of borrowing, the first cycle that we see in the economy is the Short term Debt cycle. When the economic activity improves due to the quality of the credit the economic cycle moves up, creating an expansion. But borrowing imposes extra interest payment to the borrowers and they have to cut their spending. Hence, the income of sellers comes down creating deflation in the economy. The Central bank has to react due to the slower economic growth by reducing the interest rate. And suddenly the borrowing improves creating expansion again. Like a machine, this process occurs in a cycle creating the short term debt cycle for around 5-8 years.
Figure 3: Long term debt cycle
As the short term debt cycles are creating expansion and decline in the economy for shorter periods, it is actually mounting the overall growth of the economy. But the debt, in general, is also rising at the same time. So in the long term, the debt crosses the income of the economy. And the long term debt cycle occurs in the process. At first, the entire economy rises using the willingness of the lenders to lend money at any possible place. Hence, the income rise, stock prices go up rapidly, and asset prices are higher than ever. At such time, the economy is actually heading towards a bubble. Since the debt is rising more than the income, debt burden increases and forcing the people to cut their expenses like the short term debt cycle. So the long term expanding cycle suddenly reverses and the economy unexpectedly collapses creating deleveraging.
But how the economy can be saved from deleveraging? The answer is reducing the debt burden. The Government can reduce the debt, redistribute wealth or print money to solve the problem. Individuals and institutions can also cut spending to save the day.
Finally, when the policymakers balance deflationary policies like reducing debt or redistributing wealth and inflationary policies like printing money the economic machine wakes up again. It starts to reduce the debt burden and the cycle shifts again within a decade.
In closing, like a machine, our economy is constantly producing results depending on the rules we impose. If the rules are followed perfectly we get better economic results. But if the rules are overlooked, economic cycle quickly descends and creates unimaginable problems in our lives.