Conventional economic “wisdom” fails to understand the role of credit/debt in our market based system. Mainstream economics completely neglects to understand not only credits affect on demand, but also how this credit demand fluctuates in both short and long-term cycles.

Now when I say cycles, don’t roll your eyes and think I’m some tinfoil hat wearing conspiracy theorist. I don’t believe in Elliot Waves or Fibonacci or Pi or that some other hidden universal force has set us on a predetermined path of repetition —  though I admit, I do look good in tinfoil.

A debt cycle is simply the logical progression of large economic sequences that follow a certain order. These sequences arise due to predictable human nature and the inherent structure of our monetary system.

Understanding these cycles won’t give you the ability to predict the future. But it will give you the ability to better understand the present and enable you to assign significant probabilities to what’s around the corner.

Our view of the world and the dynamics of debt were born out of the work done by Ray Dalio and Bridgewater (the most successful hedge fund of all time). If you’re not familiar with their work on “How The Economic Machine Works”, I suggest you check out this site.

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Here’s a quick overview of how the economic machine and debt cycles work:

The economic machine starts with money, or more specifically, what we think of as money; which is cash + credit.

Mainstream economics tends to focus solely on physical hard cash. But it is credit that makes up the majority of transactions in the world. In the US, the supply of physical cash amounts to roughly $3 trillion. But total credit is near $60 trillion. Most buying (demand) is through credit, not cash.

It’s important to know this because though many people mistakenly think of credit as cash, the two actually work very differently. And it’s this difference that has compounding second and third order large scale effects.

You see, when you buy something with cash, you exchange that cash for a service or good. The transaction is closed. Complete. There is no further obligation between the two parties.

When you buy something with credit, you exchange credit (a promise to pay in the future) for a good or service now. That transaction is not complete until the borrower pays off that debt. So in this instance, credit or money is created out of thin air, without the help of the central bank or US treasury. All you need is two willing parties and credit (money) can be created. An asset to the lender is created, as well as a liability to the debtor, that lasts until the transaction is closed by the debt being repaid.

It is this ability to create “money” independently through credit purchases that compounds over time and builds cycles. And it is these credit cycles that drive the economic machine.

There are three primary forces that drive the economy over time. These are:

(Charts via Bridgewater “How The Economic Machine Works”)

Debt Cycles

Long-Term Productivity Growth

Over time, the economy (real GDP per capita) averages 2% growth. This is the result of efficiency gains born from the accumulation of knowledge — we become more productive over time.

It’s this steady build up of knowledge (advancements in our technology and know how) that drives productivity and results in the continuous improvement of our living standards.

Many of us love to be pessimistic about the current state of the world, complaining that “things were so much better back in the day”. But were they? Truth is, we as a society have it pretty good when compared to the generations before us. As Buffett noted in Berkshire’s recent letter:

“Indeed, most of today’s children are doing well. All families in my upper middle-class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth. His unparalleled fortune couldn’t buy what we now take for granted, whether the field is – to name just a few – transportation, entertainment, communication or medical services. Rockefeller certainly had power and fame; he could not, however, live as well as my neighbors now do.”

But we are interesting creatures. We’re not satisfied with just a 2% average increase in living standards. We base the quality of our lives in comparison to those around us (usually those who are wealthier than us). And in addition to our instinctual pettiness, we’re actually neurologically wired with the propensity to live beyond our means. Jason Zweig explains this phenomena in his excellent book Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich (emphasis added by me):

“You would expect logically that the borrowing and spending of money would be emotionally painful to people because having money is intrinsically a good thing, and having less money would have to be worse… Going from more money to less would be painful. When people borrow and spend money, it’s really the reward centers of the brain that become activated… When you borrow money, you are thinking not about the long-term consequences but the short-term result: You have more cash in your pocket. The pain you are going to experience down the road of having to pay — that’s in the future, it’s remote, it’s abstract.”

So credit is like a drug… we’re addicted to shots of dopamine that we receive every time we purchase something. We are literally programmed to overvalue present rewards and greatly underestimate future costs.

Credit allows us to delude ourselves into thinking we can outpace this 2% trend. But in the long run we can only consume (spend) as much as we produce (earn). When we spend more than we earn we create bad debts — debts that will not be repaid.

The way we’re wired and the structure of our credit system clashes with the limits of our average long-term productivity growth. This irreconcilable difference creates cycles.

These cycles, that oscillate around the 2% productivity trendline are called debt cycles. They’re comprised of leveragings and deleveragings of debt/credit.

A debt leveraging occurs as we increase our debt spending over time (total debt load relative to income). By doing so we pull future consumption forward while causing temporary increases in productivity above the 2% trendline average.

Eventually these leveragings reach a saturation point where debt servicing costs relative to incomes grow too large. They begin to hamper demand growth. When that point is reached, the economy will begin a deleveraging. In a deleveraging, we fall below the 2% productivity trendline.

The chart below (again, via Bridgewater) shows the overlay of all three forces over the last 100 years.

Debt Cycles

These leveragings and deleveragings are the result of the long-term and short-term debt cycles.

The Short-Term Debt Cycle

The short-term debt cycle (otherwise known as the business cycle) is fairly well understood, since it tends to occur every 5-7 years.

These short-term cycles result from the easing and tightening of money by the Federal Reserve Bank. Here’s a quick rundown of what happens when the Fed eases (lowers interest rates).

The three immediate impacts of lower interest rates are:

  1. New credit becomes more attractive, so
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