Understand Big Debt Cycles - Macroeconomics of Monopoly

Introduction

Credit is the giving of buying power. This buying power is granted in exchange for a promise to pay it back, which is debt. Credit can buy also a purchase of time. Let’s imagine a small company, with an high growth potential which seeks for capital to sustain its expansion. If the company owner is not willing to give shares to external investors, the only one solution is to borrow money and this happens typically from a bank. If the bank credit worth assessment confirms an acceptable financial position for the company’s owner, a new line of credit will be opened. That’s how is commonly defined as bank loan. In a nutshell, the loan is generating a credit (which is an asset) for the bank that will be a debt (which is a liability) for the borrower: a promise to pay it back.

The company owner could have spent more daily hours and years to save and reach the same amount of money available in the loan case. He opts for the loan because he knows that that money will help to support a productivity growth, that will produce higher profit margins, that will repay-back the investment and improve the entrepreneur’s wealth. In other words, instead of waiting years of profit savings the business owner borrows money to get immediately the financial capabilities to achieve his results. Immediately it’s earlier than years. So the credit, which is a promise to pay it back, somehow buys the time.

As we will see, the credit in se represents a big help for those who use it for growth and productivity enhancement purposes. On the other hand, it can become a bacterium of the economic system which can be destructive if policy makers don’t have a direct and complete control of the situation. Observing the economic historical events by country and assessing the majority of them, I have noticed that too little credit/debt growth can create as bad or worst economic problems as having too much. Generally speaking, because credit creates both spending power and debt, whether or not more credit is desirable depends on whether the borrowed money is used productively enough to generate sufficient income to service the debt. In a nutshell: debt growth is sustainable as long as productivity grows faster than it.

Are Debt Crisis Inevitable?

Throughout history, only few well-disciplaned countries have avoided debt crisis. That’s because lending is never done perfectly and it’s often done badly due to how the cycle affects people’s psychology to produce bubbles and busts. It’s also politically easier to allow easy credit than to have tight credit. This is the main reason we see big debt cycles.

The game of Monopoly

If you understand the game of Monopoly®, you can pretty well understand how credit cycles work on the level of a whole economy. Early in the game, people have a lot of cash and only a few properties, so it pays to convert your cash into property. As the game progresses and players acquire more and more houses and hotels, more and more cash is needed to pay the rents that are charged when you land on a property that has a lot of them. Some players are forced to sell their property at discounted prices to raise that cash. So early in the game, “property is king” and later in the game, “cash is king.” Those who play the game best understand how to hold the right mix of property and cash as the game progresses. 

Now, let’s imagine how this Monopoly® game would work if we allowed the bank to make loans and take deposits. Players would be able to borrow money to buy property, and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which in turn would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other on credit (i.e., by promising to pay back the money with interest at a later date). If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. The amount of debt-financed spending on hotels would quickly grow to multiples of the amount of money in existence. Down the road, the debtors who hold those hotels will become short on the cash they need to pay their rents and service their debt. The bank will also get into trouble as their depositors’ rising need for cash will cause them to withdraw it, even as more and more debtors are falling behind on their payments. If nothing is done to intervene, both banks and debtors will go broke and the economy will contract. Over time, as these cycles of expansion and contraction occur repeatedly, the conditions are created for a big, long-term debt crisis. 

Lending naturally creates self-reinforcing upward movements that eventually reverse to create self-reinforcing downward movements that must reverse in turn. During the upswings, lending supports spending and investment, which in turn supports incomes and asset prices; increased incomes and asset prices support further borrowing and spending on goods and financial assets. The borrowing essentially lifts spending and incomes above the consistent productivity growth of the economy. Near the peak of the upward cycle, lending is based on the expectation that the above-trend growth will continue indefinitely. But, of course, that can’t happen; eventually income will fall below the cost of the loans. 

Having said that, I want to reiterate that 1) when debts are denominated in foreign currencies rather than one’s own currency, it is much harder for a country’s policy makers to do the sorts of things that spread out the debt problems, and 2) the fact that debt crises can be well-managed does not mean that they are not extremely costly to some people. 

The key to handling debt crises well lies in policy makers’ knowing how to use their levers well and having the authority that they need to do so, knowing at what rate per year the burdens will have to be spread out, and who will benefit and who will suffer and in what degree, so that the political and other consequences are acceptable.