The economic machine - what cycle are we in right now?
As part of my financial independence guide I talked about the economic machine and how this machine influences everyone’s lives. The economy consists of multiple cycles of growth and recessions. With everything going on in the world right now (2022), it might be a good time to think about the economic cycles and where we stand today. This might help you get a better insight into what might happen in the future.
Power of credit
First, it’s important to know that money consists of two parts:
- Physical money
Physical money is a very small part of the total money supply. Most of the time when people talk about money they are talking about credit. Credit is buying something of value right now but paying for it later. Because you can pay later, you have to pay interest to cover the loss of value due to inflation.
In order to take on credit you must be creditworthy. Creditworthiness means you have collateral in the form of physical materials or a steady income. For example, when you take on a mortgage your house acts as collateral. If you can’t pay your mortgage anymore, the bank has the legal right to sell your house. But in general, almost everyone's creditworthiness is based on their income.
To understand how economic cycles work you need to know that your creditworthiness is very important:
- The more creditworthiness you become, the more you can lend
- The more you can lend and earn, the more you will spend
- Your spended money is another person's income
- When another person’s income increases, his creditworthiness increases and the cycle continues.
How growth cycles come to an end
Credit is not the only thing that determines how much money you can spend. You can have the same income and same creditworthiness but are able to spend less money due to inflation. Inflation can be caused by many things. Wars, politics, pandemics, etc. Gasoline and energy prices are surging in Europe right now due to the war in Ukraine vs Russia. It also increased the price for many food products. This bumped up inflation for many countries over 10%. Meaning, your money buys you 10% less products and services vs last year. On top of that, the world just recovered from the Covid pandemic. Causing huge expenses in healthcare and many businesses had to close down and many people lost their jobs.
To battle high inflation rates, central banks all over the world are starting to increase interest rates. That means:
- People and businesses can borrow less money
- People and businesses can spend less money
- One’s spending is another person income, so another person will also earn less money
- And so the cycle continues the other way.
In july 2022, the U.S. reached a forty year high inflation rate of 9%+. In july 2022, the Netherlands (Europe) reached an inflation rate above 10%. And this number is the same in many countries. Things are not going to shift the other way anytime soon. Central banks are raising interest, many people have trouble paying their bills and overall have less money to spend. But in the meantime, the overall stock market went up the last few weeks/months like nothing is happening.
This might make you wonder why the stock market is going up while everything else is going down. You should always remember that the stock market is an emotional game. Nothing in the stock market is priced as it should be, there is always emotion involved. When a stock goes up, people start thinking of buying. When a stock goes down. People think about selling. That’s how it has been since the creation of the stock market and will continue for many years and decades.
It’s impossible to predict the future but you can interpret signs:
- People and businesses can borrow less money due to higher interest rates
- People and businesses can spend less money due to high inflation rates
- One’s spending (either people or business) is another's person's income
This will result in:
- Businesses cutting costs (less jobs, higher unemployment rates)
- People cut costs (less vacations, less going out, cutting the amount of services etc).
- As debts are a burden on anyone’s financial statement, they must be reduced. Lending stops and more money goes to paying off debt instead of spending.
- Less income and higher unemployment rates means that governments can collect fewer taxes
- Governments also need to increase their spending because of higher unemployment rates
And that’s what we are seeing today. Governments put all kinds of financial aid in place to help the unemployed and the people that still have jobs but can’t pay the bills anymore due to high inflation rates. On top of that, many governments spent billions on healthcare and saving businesses during the covid pandemic just a year ago. Many businesses are reducing their amount of employees.
There are a few ways for governments to raise money and one of them is raising taxes. But with high unemployment rates and people already struggling to pay the bills, who is able to pay more taxes? The rich! For example, in the Netherlands taxes are already raised for the rich people.
The overall stock market can’t grow like nothing happened when the majority of people and businesses have less money to spend. That’s simply impossible. The growth we saw the last few weeks was more likely a bull trap than a recovery of the market. In the end, people are still battling high inflation rates and central banks are still raising interest. The war in Ukraine is still going strong and is not going to end anytime soon. That means energy and food prices will remain high for at least another six months.
To have an idea where the economy is going you should always look at your own wallet. Can you spend more money versus last year? And how about the people around you? Do they have more money to spend? Always remember:
Join the conversation.