Understanding Debt Cycle

It seems that market participants and economic operators completely underestimate or misunderstand the role of credit and debt in our market economy.

Credit and debt play a big role in driving demand and economic growth, creating fluctuations in both the short-term and long-term resulting in cycles.

There is nothing new in it, they are caused by how the monetary system works and showed up many times in history as a progression that follows a certain pattern over time.

What is the relationship between credit and debt?
Let’s start with two definitions that are really helpful.

Credit and debt are the two sides of the same coin and go together.

Credit is the creation and transfer of purchasing power

Debt is the promise to pay it back

Those two concepts that are here presented as simple as they sound have really huge implications on economic growth.

There are no absolute rules but the balance among the two and the actual use of credit are a key to understand the implications on the economy.

If you take credit, it is a good thing by itself because it allows to make purchases and investments. Not providing credit may be a really bad thing for the economy and we recently saw that during the credit crunch after the market crash of 2008.

The problem with the other side of credit, which is debt, arises when it becomes difficult to pay it back.

This may start to happen for several reasons combined, but the real question to understand the dynamics is: what’s the credit used for?

A rapid increase in credit not good or bad, it really depends on what credit produces and what are the means to pay debt back.

In fact, a higher level of credit is desirable is the borrowed money is used to produce a sufficient amount of income required to pay the debt back. In this case, credit would be used to boost productivity and foster economic growth.

The opposite scenario is when credit is not used for productive investments, instead it is used to finance expenses that don’t generate any income, like consumption. Often times this kind of use is called bad debt.

It is a balance with trade-offs that are difficult to see: if credit produces enough economic benefits to pay for itself, great! At the same time, too tough lending requirements would likely result into less credit and less development.

How the debt cycle works

First of all let’s define a cycle. A cycle is a pattern, a series of events that are regularly repeated in the same order.

The debt cycle is a series of events that drive economic expansions and contractions. Although every cycle is a bit different in terms of size and, timing, those events happen for precise reasons that are inherently linked to mechanism of borrowing.

In you are using debt to buy something that you can’t afford you are spending the money that you don’t have. This is true for a house, a car, or smaller purchases financed with credit cards. By borrowing money you are taking money from your future self, the act of spending the money that you don’t have today creates a time in the future when you will have to spend less in order to pay it back.
This is basically the nature of a cycle and it is true for an individual as it is for the entire economy.

Lending creates a self-reinforcing cycle that works upward in the first phase and downward in the second phase.

The charts below give you an idea of how this mechanism works.

What really drives economic growth in the long run is productivity. The turning point comes after the levels of income and spending surpass the productivity growth of the economy. The assumption of debt brings spending and investments above this level and, as you can imagine, the cycle isn’t going to continue indefinitely.

In fact, this is what happens when lending and income levels start to decrease:

In the late part of the upper cycle, the economic growth (or maybe we should say “what is perceived to be economic growth”) is fuelled and made possible only by credit. When growth slows down and credit decreases, we are left with the big problem of the service of debt.

Often times the cost of debt is higher than the amount that can be borrowed to finance other consumption.

Eventually the levels of income will fall below the cost of the loans and the cycle starts to work downward. People start to have problems paying their debt and this puts pressure on debtors and lending reduction, that results in a credit contraction that can no longer be used to make debt service payments.

The same mechanism that lifted growth thanks to credit now works in the opposite direction with negative effects on the entire economy.

This pattern has showed up many times in history, cycles of expansion and contraction happened again and again over the course of history. Each one slightly different but the script was more or less the same.

Today, we are in the second longest economic expansion in recent economic history and it is about to become the longest one.

As I described in this article about the long-term debt cycle, credit played a big role in fostering the economic growth during the last years of recovery, right now it would be natural that growth starts to slow down and consolidate. This event could potentially mark the turning point of the cycle, indeed when growth and lending start to decline the mechanism starts to work downwards.

We are arguably near the upper part of the upward cycle, just look at levels of consumer credit, that is 45% higher than 2008 and the overall level of debt in the system, both public and private.

Conclusions

In conclusion, credit and debts are fundamental components of the economic machine and have strong implications on economic growth, unemployment, income, spending and investments.

There is not a right balance between credit and debt, lending is never perfect and people’s psychology helps to create bubbles and busts. The same is true also for the amount of debt, there isn’t a right amount of debt for the economy, too much creates a bubble and too little hampers economic growth, it all comes down to how credit is used and how the debt is paid back.

The overall amount of debt has to be managed, here is where policy makers come into play. They should watch out and try to regulate the amount of credit and debt in the system by leveraging on tools such as monetary policy and regulation before the cycle goes out of control.

The point is that there are strong political implications in doing so. Often times policy makers tend to be more supportive to credit because the short-term reward is economic growth, it is easier from a political perspective to increase credit rather than tight credit. The second thing to consider is that when the cycle is in its upper phase, nobody wants to cause an inversion by tightening on credit and get all the blame for that. This may be the number one reason why there are huge debt crisis.


This article is for informational purposes only, it should not be considered financial advice.
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