In our last article, we discussed Free Market and Supply and Demand.  Free Markets create wealth for all by creating incentives for new ideas, new products and overall innovation.  Supply and Demand dictate prices based on what consumers want to buy and the amount of it available.

The next piece of economics that everyone should understand are the factors that cause economic cycles.  While often referred as boom and bust cycles, there are fundamental principles that underlie these cycles and they would better be referred to productivity gains and debt correction cycles.  Productivity is what drives growth as it allows people with additional technology to produce more.

This can be explored from a fundamental level of food production.  If the history that we have been taught is correct, then about 10,000 years ago homo-sapiens stopped being hunter gatherers and transitioned into farmers and ranchers.  Farming was very tedious and required a large workforce and a lot of manual labor to create enough for everyone to eat.  According to Yuval Noah Harari, in his book Sapiens:  A Brief History of Humankind, changing from hunter gatherer to farmer required people to work more.  For a period of time, humans became less productive while populations increased to provide enough labor to grow food.

As humans learned to adapt tool and especially once metalworking became normal, the tools allowed people to be more productive.  Even more so, as explain in Guns, Germs and Steel by Jared Diamond, the use of animals to plow fields significantly improved crop production.  Another major advance was human’s ability to transfer water to the fields.  As agricultural techniques improved so did productivity and soon one person was able to grow enough food for more than himself.  This allowed other people to pursue additional learning and create inventions to make agriculture even more productive.

The more advancements made, the fewer people required to grow food.  This is the original increase in productivity that allowed for advanced economies by not requiring everyone be tied to land to produce enough food for all of us to eat.  Today, direct on-farm employment is only 1.3% of US Employment and that accounts for only 1% of GDP.  There are many additional jobs in food related industries including food manufacturing, grocery stores, beverage, restaurants, etc., but very few people are now required to grow our food and those that do are very productive.

If we look at the large economic cycles, they are closely related to productivity growth.  If we look at the last 20 years, there have been several things that have significantly impacted our productivity.  In the 1990’s, personal computers and the internet were the drivers of growth.  Offices that previously required a staff of administration could be shrunk to one person with a computer, letter templates, a copy and paste function and email addresses.  Administrative tasks previously done by paper could now be completed much faster by computers and computer programs.  This accelerated growth.

In the past 10 years, computers have been shrunk to fit into our pockets, allowing us to get directions, request a ride, look up anything we need to know and contact anyone in the world all from our smartphone.  Apps for these phone allow companies to stay in constant contact with their customer and allow customers to order food, request a ride or book a trip without any human interaction at all.  These features make me more productive.

The second part of economics that is responsible for more of the boom and bust is credit and debt.  Credit is the availability of money and debt is when credit is spent and owed.  Credit only become important at the end of the cycle, debt is more important in creating the cycles.  Not all debt is the same.  When a person or a company borrows and that money is invested in increasing productivity, lets say buy purchasing a computer that can allow you to do more tasks, which in turn make you worth more, then debt is usually good for the economy because it is supporting productivity gains which repay themselves. 

But what if instead of buying a computer, you buy a new television with debt.  That television will not help you be more productive, it may even take up more of your time making you less productive.  Because the debt is not creating additional productivity, you could say that is was spent and not invested.  We will discuss this as intent.  If the debt is intended to create productivity, then overall that is better for the long term economy than when it is just spent.  The opposite is also true, when debt is used just to purchase goods that do not support increased productivity, then they do no help the long term economy.  Sometimes, even when the intent of the debt is to increase productivity, it doesn’t work out.

Regardless of how the debt is used, when it is spent, it increases the number of things being purchases, so it is a boost to the current economy.  For example, regardless of whether or not your new iPhone is going to make you more productive, when you buy one, even on credit, it increases the amount of money spent, which is growth in the economy.  There are lots of companies making components of the phone and Apple itself makes the largest profit, but all of those companies experience growth because of the increase in purchases.  If our iPhone’s make us more productive, then we should earn more from our increased production and we can repay the money we borrowed with the additional wages we earned from being more productive.  This is the real growth of the economy because it can be repeated.

But what happens when the debt is used not for something that makes us more productive?  Or, what happens when we use debt for something we think will make us more productive, but it doesn’t work out that way?  At an individual level, eventually you have too much debt and no one will give you more credit because they don’t believe you will be able to pay it back.  Eventually, this type of debt – that doesn’t improve productivity - causes the crashes in markets that we all fear.

We can explore these ideas understanding the main pieces of debt in our society.  The largest amount of debt is for housing.  Homes are expensive, but they are also useful for long periods of time.  A home can also generate income by renting the entire home, renting a room or renting part or all the home part time on Airbnb.  Under the assumption that we all need a place to live, then a home is providing the place to live.  But what happens we buy a larger house?  Does it make us more productive?  If we are renting it and we can get more rental income, then yes.  But if we just borrow more money to live in a larger house then the debt does not make us more productive.  So there is a point at which more debt is not making you more productive

The same is true of a car, the second largest expense for most of us and the second largest place of debt.  When we buy a car, that allows us to go to a job and earn money.  It may be a requirement to go to an office or if you work in manufacturing, you need to get to work.  At work, equipment is available that makes you more productive.  Having a reliable car may make you more productive because you miss fewer days of work due to transportation issues.  But at some point, a more expensive car is not adding any increase to your productivity.  Just as with a house, some debt for cars is good to increase productivity, but at a point it becomes excessive and does not support productivity/growth in your wages.

We can then apply this to everything else that is purchased on credit cards and with debt.  Student loans are the latest to balloon in cost without an increase in productivity and therefore earnings.  Tuition has increased over 550% but the additional value from a degree has increased as a much lower rate.  Some debt for school that supports productivity and therefore additional wages is good, but just like with a house or a car, at some point more debt does not increase productivity and wages.

At an individual level we can figure out, based on how much we earn and our expenses, at which point our debt will only continue to grow because we cannot afford to pay more than the interest expense.  This is when we are “broke” and typically when no one will extend any additional credit.   When you cannot make your debt payments then you are bankrupt, by definition.  Without additional credit and with debt you cannot pay, individually you would file for bankruptcy and most of your assets would be taken.  The home sold and car sold to someone else.  Your student loan debt remains and the amount of credit card debt that will remain depends on how much you make.

When this happens to one individual it is not a problem for the economy.  But in addition to individuals spending on debt and buying things that may not increase their productivity, companies and government are doing the same thing.  When everyone is borrowing and a lot of the debt is not being used for increases in productivity, there is a crash.

The first lesson here is that what they tell us is “Growth”, is not always actual growth.  Typically, it is a combination of growth (increases in productivity) and debt spending.  Some of the debt spending will lead to productivity increases and is growth, but much of it will go to higher mortgages and car payments that do not increase productivity so they are temporary increases in spending that are not sustainable and that is not growth, its just additional spending this year.  The difference is whether or not others can repeat it for growth.

For example, if you own a legal office and you were one of the first to adopt a digital office, you likely would have borrowed tens, if not hundreds of thousands of dollars to buy computers, software, servers and training for your staff.  Over time, the ability to search records immediately and access all client files at any time would lead to productivity growth at your firm.  This would increase the amount you can charge clients, increasing profits that can be used to repay the debt.  If this process works, then you can safely wager that other firms will follow and the process can be repeated, not again for the same firm, but across the industry. 

At the same law firm, with it’s increased profits, lets say the firm borrows to build a new office and they borrow a lot of money to make it as nice as possible.  Marble floors and a view from the top.  It is unlikely that any of these additional expenditures will allow them to charge more for their services, so this debt is not increasing productivity and likely will not be repeated across the industry unless clients are willing to pay a premium for a nicer office to meet.  This type of debt spending will likely not be repeated, but suppose that it is.  Suppose all the other laws firms copy this spending on space, not because it is increasing productivity, just because everyone else is doing it.  This will create a debt bubble, where money spent is not increasing productivity and when it reaches the same tipping point that the individual faces when they can no longer pay the bills, the firm goes bankrupt.  If many firms did the same thing, they all go bankrupt.

Now think of these same scenarios across the entire economy.  When debt is spent on things that do not increase productivity, it is a one time expense, not really growing the economy, just increasing purchasing this year.  In future years, when that money is not spent again, they will say it is a reduction in the economy, but it should have never been included in the first place.  The hard part about this is how are we to know what does and what does not increase productivity?  Sometimes it is hard to tell, other times it is obvious.  Larger home and more expensive cars don’t increase productivity, they just increase costs making default and bankruptcy more likely.

On a big scale, country or even world, when the amount of debt exceeds productivity growth, then there has to be a correction.  The first correction comes just like it does for you personally, it comes as a reduction of your credit.  Companies have credit too, and when their expenses increase from buying but their revenue (productivity) does not increase as well, then those that offer credit reduce or eliminate their credit and just like you, they go bankrupt.

Again, just like you as an individual, when this happens to a few people or a few firms, it is not a problem.  But when this happens at a systemic level, then there is a crash.  The crash starts off as those that loan just being scared.  Image you are the one loaning all the money to 100 of your neighbors.  You have loaned them money for bigger houses, bigger cars and boat and RV’s and trips and anything they wanted and now you see they have so much debt they cannot even pay the interest.  One bankruptcy doesn’t change you, but after the 10th you start feeling the losses pile up and you get scared.  The first thing you do is stop loaning anyone else money, even if it would make them more productive.

This same things happens to a country or even globally.  Everyone gets scared to lend.  They are scared everyone is going to go bankrupt and they can’t tell who has invested wisely in productivity and who is just spending.  Credit becomes very hard to get.  That stops all purchases that are not already approved and known to be copying previous increases in productivity.  When all those purchases stop, the companies making those products that were not increasing productivity lay people off or go out of business.  All those people that lost their jobs and are in debt now cannot make their payments and the downward cycle begins and creates its own momentum. 

More foreclosures tighten credit.  Tighter credit leads to less spending.  Less spending leads to more foreclosures and it keep repeating until prices to buy all of the goods and businesses reach levels at which people feel comfortable buying them knowing that based on the price of purchase they can increase productivity and make a profit.  But sometimes, it can take a long time because none of us know how long the cycle of foreclosure -tightened credit-less spending – more foreclosures will continue. 

There is one more type of debt that we need to discuss when evaluating economic growth and that is government debt.  Government debt comes in many forms, Federal, State, City and many other specific districts that can borrow money for power, water and transportation.  For example, the New York City Transit Authority (MTA) provides bus, subway and other transit services throughout New York City.  It currently has over $37 billion of debt and is not profitable.  Interest payments on its debt continue to increase and it is possible those could prevent it from ever being solvent without a bailout from the state.  It also needs more money to invest.

The Federal Government currently says that the Federal debt is $21.6 Trillion dollars and it is increasing at almost $1 Trillion dollars per year.  Depending on who you talk to and those that understand how government accounting works, many think the real number owed, when including pensions and other long-term obligations that a public company would have to include in their debt, it could be north of $80 Trillion.

We need to return to our discussion of how debt is used to determine whether the government debt will help us.  Some government debt does improve productivity such as making more roads to improve travel time of goods.  But how much of the government debt is used for improvements versus spent on things that do not improve productivity?   It is hard to tell but based on the limited growth that the economy has seen, it seems safe to assume that most of it was spent of things that will not increase productivity.  More military spending is like more TV’s, not going to improve long term productivity.  While it is important to keep us safe, how much can we afford to spend on things that are not improving productivity considering how much debt we already have? 

When will the market forces stop wanting to lend to governments?  What effect does the large government debt have on long term interest rates?  If the government increases the interest rate then it will have a bigger deficit each year and just like a person who can’t pay off his debt, the government will be in trouble.  What will be the options?  Increase taxes, reduce services, sell assets or all of the above?  No one really know because the world has never seen so much debt from so many countries.  The US is not alone, many countries have more debt than the US.

The government debt bubble is one that we discuss but we really don’t know what to do about it, other than to tell our politicians that they need to live within their means, just like the markets expect the rest of us to do.  If the spending is not increasing productivity, then the country shouldn’t be going into debt for it.

When the current credit bubble bust?  None of us know.  We can speculate at which levels of debt that credit will stop being given, but we really don’t know.  So why discuss all of this, because if you don’t know how the cycles work then you can’t protect yourself from them.  The signs are usually there if you know what to look for and there are things you can do to protect yourself.  That starts with having an emergency fund (as-in the emergency of the place you work just laid you off) and trying to stay out of debt. 

When we look at debt and credit today, we see that overall, according the New York Federal Reserve, US household debt is at an all time high, 24% above where it was in 2013 and $1.2 Trillion higher than it was in 2008 before the last big correction.  Seeing more debt doesn’t mean it is all bad if it is increasing productivity, but when we look at where the increases are coming from, they don’t seem to indicate investment.

Home mortgages, cars and student loans are the three largest increases in household debt and cars and student loan debt are substantially higher than ever before.  How much of that do we think is the investment kind of good debt? 

Business debt is also at an all-time high.  Just like people, business can use money for a variety of things.  They can invest it in people and equipment to increase productivity.  They can invest in new products.  Or they can spend it on a lot of different things that sometimes don’t make any sense.   Often a company has a lot of debt from a purchase, known as leveraged debt, it is often used to buy companies and take them private.  This large amount of debt can often be too big for the company and leveraged corporate debt is similar to student loans in that it is not leading to future productivity increases and is therefore very burdensome.

Other uses of corporate debt include stock buybacks, where companies purchase their own shares to reduce the number of shares outstanding.  This can make it look like the company is performing better because the amount of money they make per share increases.  Stock buybacks have certainly been in vogue recently, especially with interest rates so low.  Companies can also use debt to pursue new markets where they can spend a lot of money trying to build a market or take market share but not making any money (think Uber and WeWork) and in fact losing billions of dollars.  Sometimes investors seemed concerned about losses but often, especially in the Tech market, losing money up front is considered normal.  Uber has never earned a profit and is worth billions, or at least some people believe so.  How long will people keep investing in companies that do not make any money?  Your guess is as good as mine.

When these companies go out of business because the credit dries up, it will have a ripple effect.  The question is always how big and for how long?  No one has answers to the total debt question because we have never seen corporate, individual and government debt so large.  When the credit starts to go away, remember, it’s a correction not a crash, even though it looks so messy it is hard to call it anything else.

Resources:

AnnaMaria Andriotis and Ben Eisen, The Wall Street Journal. A $45,000 Loan for a $27,000 Ride: More Borrowers Are Going Underwater on Car Loans

Federal Reserve Bank of New York, Center for MicroEconomic Data. Quarterly Report on Household Debt and Credit

Akrur Barua and Dr. Patricia Buckley, Deloitte. Rising corporate debt: Should we worry?

Truth in Accounting. Our Debt Clock

Ariel Santos-Alborna, Seeking Alpha. The Corporate Debt Bubble

Rachael Fauss & John Kaehny, the Gotham Gazette. The MTA is Fiscally Exhausted

United States Department of Agriculture Economic Research Service. Ag and Food Sectors and the Economy