How does the economy work?
Reading time: 8-11 minutes (2.119 words)
Have you ever wondered or learned at school how the economy exactly works? The economy is a complex system in which money plays the leading role. Stock markets, currencies, housing markets, wars and many other things have a strong influence on our economy. How exactly does the economy work, what is money, what gives money its value and where does money come from?
These are all questions that are not easy to answer. Yet it is important to know how the economy works and where money comes from. This information can be useful in turbulent times like today (2022). Ukraine is at war with Russia, inflation reached the highest point in over forty years, interest rates are rising, the housing market reached all time highs, covid is still here and the FED pumping 2+ trillions dollars in the economy the last few years. All these things have huge effects on the economy. And especially affects your spending power. Knowing how economic cycles are created and what will happen next can give you a headstart.
Money = debt
Did you know that if everyone on earth pays off their debt in full, money no longer exists? Every dollar/euro you have in your bank account is someone else's debt. The principle is quite simple: There are a few institutions, such as the Federal Reserve (Central Bank of America), that can “print” money without supervision from governments. Only a small part of the printed money is physical, most of it digitally credited and debited to all banks around the world. It’s just a digital number in a database. Meaning, most money you know about is not physical money but digital credit.
The Federal Reserve lends money to banks (with interest), and banks lend this money (with yet again, interest) to people like you and me creating another source of money supply.
Now suppose you are the only person in the world who wants to borrow money from the bank. The bank says:
- You get $100,000 but I want $105,000 in return.
So you automatically have a debt that in theory, you can never pay off because the money you have to pay back in interest does not exist (because you are the only person in the world). But because we live in a world with billions of people, there is always someone with money you can work for. That way you can still pay off your debt + interest even though that money does not exist. That you get a salary from your employer does not automatically mean they have a lot of money. They might be in debt and pay their employers with credit.
In the end, if the entire world paid off their debts, money would no longer exist. It’s literally impossible for everyone on this planet to fully pay off their debts. In other words, it’s impossible that everybody on this planet has a healthy financial balance without any debts. There must always be someone with debt. That’s how our current money system works.
A famous quote from Marriner Eccles, the chairman of the Federal Reserve 1941:
Eccles: We created it.
Patman: Out of what?
Eccles: Out of the right to issue credit money.
Patman: And there is nothing behind it, is there, except our government's credit?
Eccles: That is what our money system is. If there were no debts in our money system, there wouldn't be any money.
In the U.S., the FED is responsible for the national monetary policy. They decide how to increase or decrease interest rates and determine whether to put more money in the economy or take some money out. They can do this in multiple ways:
- How much money banks must hold vs deposits
- Increase or decrease interest rates
- They can buy or sell government securities (for example, bonds)
The power of credit
Money consists of two parts:
- Physical money
- Credit
Credit is the most important part of the economy. Credit is the biggest and most volatile part.
What is credit?
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With credit you have two parties:
- The borrower
- The lender
The lender (banks) has the goal to make more money (and insure against inflation) by letting the borrower pay back the principal + interest. If interest rates are high, borrowers can borrow less money because it’s expensive. When interest rates are low, like they have been the last few years(2018-2021), borrowing increases and more money enters the economy.
Credit and physical money together drive the economy. All forces in the economy are driven by transactions (spending). Either with real money or credit. So if people have less money to spend or borrow, like they have in 2022 because of high inflation and interest rates rising, there will be less transactions which will impact the economy. This can turn into a recession.
Everybody can create credit. For example, you lend your best friend money and get the principal + interest in return. You not only created credit, you also created debt (your friend now has debt) and created money out of nothing (the interest your friend needs to pay you back).
How to get creditworthy
Your income plays a big role in the credit system. Based on your income, you are becoming more worthy of credit. In other words, if you earn more, you can borrow more money. And borrowing more money in general means you spend more money. Banks also use collateral to insure their loans get repaid in case your credit worthiness declines. For example, if you bought a house with a mortgage and you lose your job, you are becoming less creditworthy because you now have zero income. The house you bought was based on your creditworthiness when you still had a job. Thats why your house always acts as collateral in the case you can’t repay the mortgage anymore. Giving the bank the legal right to sell your house.
In general, an increased income leads to increased borrowing because of higher credit worthiness. Increased borrowing leads to increased spending.
Increased income -> increased borrowing -> increased spending
Increased spending is another person's income. The credit worthiness of the other person also increases which leads to increased borrowing.
Increased spending -> another person's income -> increased borrowing
If your creditworthiness increases, another person’s creditworthiness also increases. But if you can spend less money for whatever reason, another person can also spend less money. And this is how the economy grows and how recessions are created. In 2022, people will have less money to spend because inflation went up to almost 10%. Because your spending is another person's income, other people and businesses earn less money and thus spend less money. To battle high inflation rates, the Fed increased interest rates. Increased interest rates means people and business can borrow less money from banks.
But what is interesting is that this system totally depends on only one thing: spending money. So what happens if you stop spending your money? Not because you don’t have money but because you’re saving your money and investing it so you can retire sooner. Since spending money is another persons (or business) income, other people will earn less money. Meaning they are also less worthy of credit. In turn they can borrow less money. If this cycle continues, the economy would come to a halt.
So if you think about it, can anyone become financially independent? In theory, yes. In practise, it’s impossible. If everybody stopped borrowing, stopped spending and all started saving and investing everything we know today would collapse. They don’t teach you all the things you learn here in school. They want to keep you financially stupid because they want you to spend. But why would you work your entire life to only enjoy the last few years you have left? Not that you can’t enjoy life while you are working but working forty hours a week for decades just to pay for your needs and debt is a pretty weird thing to do. Just because everybody does it does not make it a sound thing to do. Actually, working for money is by far the least efficient way to make money. And in the end you end up with zero money and depend on the government and your pension fund.
It’s important to understand that by far the biggest amount of money that exists today is credit. And when people talk about money, they mean credit for the most part. The following video gives a clear view of our world economy: How recessions occur , what the exact role of the Federal banks is and what role credit has in all this. A must watch!
Your bank doesn't have the money in store to pay you back in times of trouble
Because most of the money in the system is based on credit, banks don’t have the money to pay you back when things go south. Remember, when all debt is repaid money does not exist anymore. So the money in your savings account is someone else's debt.
For example, if everybody in the U.S. goes to their bank to take out their money that would be impossible. There is nowhere near enough physical money available to make this happen. It simply does not exist. You might think your money is safely stored at your bank but it’s actually not safe at all. It’s only safe if everything is going fine. But what about financial recessions or war?
When the financial crisis hit in 2008, Greece went bankrupt. Citizens could not withdraw their money. Even though their savings accounts were full with their money. The simple fact is, it’s not your money. It’s the credit from someone else and almost the entire economy consists of credit. When things go south, the bank has nothing to back up your money and you will not be able to get access to your money. And don't think you get your money back with the so called insurance policies up to $100.000. You won’t get your money back when things go south and most banks collapse. It’s just a marketing tactic to lure in new customers. Because each customer that deposits money creates a new income source for the bank..
In fact, banks use your money to make more money. They use your deposits in your saving accounts as a positive balance to their books which allows them to make loans for new customers. That's why you receive interest over your savings in your bank account.
The real value of money
That brings us to the real value of money. The value of money was always measured by the "gold standard". Every dollar was backed by a piece of gold. However, with all the credit pouring in the system, it wouldn’t take long before there was no longer enough gold to represent every dollar. Therefore and among other reasons, in 1971, President Nixon abolished the gold standard. In order to battle high inflation rates and stop other governments from swapping dollars for gold. So what is the actual value of money today?
Money is nothing more than a piece of paper. Gold is nothing more than a shiny stone. We humans place great value on gold and money, but what would a dog choose if you presented him a lump of gold and a lump of cheese? The value of money rests on the general acceptance of money. As long as everyone uses the "system" it will never collapse. This system is maintained by the Federal banks and governments.
The dollar is also called the "petrodollar". Through OPEC (Organisation of the Petroleum Exporting Countries), you can only buy oil if you pay in dollars. Because almost all major oil countries are members of OPEC, this has a huge impact on the dollar. How does this affect the economy? Preparing for the collapse of the petrodollar system. The fact is, oil won’t be here forever. Latest estimates show that we will run out of oil in 2050. Besides, with the current transition to electric vehicles, oil will become less and less important. What will happen to the dollar that is strongly connected with oil is still unknown but it probably won’t turn out positive.
Money is important but to only have assets in the form of cash can also be very dangerous in troubling times. In 2022, the euro was worth less than a dollar. That did not happen for over twenty years. This will increase inflation in Europe even more.
Be aware that any bank or government can decide what they want to do with “your” money.