New Zealand is a primary producer of red meat.
We supply 5% of the world’s lamb and beef.
For a country as tiny as New Zealand, that’s enormous production.
Now imagine this:
New Zealand goes through an enormous earthquake and all our ports are destroyed.
For the next six months, New Zealand cannot ship beef anywhere in the world.
How would the world’s beef market react?
This is easy to predict because human behaviour is predictable.
- Other countries will get a sudden increase of beef orders, because those usually buying from NZ farms will now start buying from Brazilian or Irish farms instead.
- These farms cannot fill this entire supply gap with their current production, i.e. they’ll have orders for 1,000 kg a week, but can only produce 600kg a week. This means they will increase prices, meaning PRICE OF BEEF GOES UP.
- PRICE OF BEEF GOING UP will attract more supply to the market – farms worldwide will see all the extra money they can make by selling beef, and start producing more beef.
- Beef buyers will react to the increase in price by reducing their demand. For example, Burger King might temporarily pause an upcoming new beef burger, and promote a chicken burger instead. Companies will aim to postpone any non-urgent beef projects until prices are more affordable. This will mean THE PRICE OF BEEF COMES DOWN.
- Eventually, the price will go up and down in reaction to the above events until it settles on a new market price based on natural market forces.
This is basic economics and nothing revolutionary. Everybody has experienced this in their own life.
If the school cafeteria doubles the price of mince pies, kids will buy chicken pies instead. But if it halves the price of mince pies, kids will buy more mince pies, maybe even two per day instead of one.
Eventually, the cafeteria will figure out the right price so it sells as many mince pies and chicken pies as possible to maximise its profit.
This is what a free market does. It is the perfect mechanism for discovering what the “correct” price is if left to its own devices. This is true for all markets.
On the flip side this means when price is NOT determined by a free market, and the market is instead interfered with by tariffs, taxes, or a government bureaucrat, the price is no longer meaningful.
Imagine if the Ministry of Education said to all the school cafeterias – “You must sell mince pies for $1, and chicken pies for $3.”
What would happen?
Nobody would buy the chicken pies. Other than a handful of students who cannot eat beef for religious or personal reasons, everyone would buy the mince pies. Even when the mince pies are sold out, and only chicken pies are left, only the hungriest students will bring themselves to fork up $3 for a chicken pie when they know that $3 could buy them three mince pies tomorrow!
There will be piles of unsold chicken pies at the end of every day, and the school cafeteria might plead with the ministry for permission to sell them at $2 or even $1.50. But the ministry, not understanding how a free market works, will continue to say no, and every day, boxes of chicken pies will continue to go unsold.
Eventually, the cafeteria will stop stocking chicken pies (since customers never buy them), putting the chicken pie suppliers out of business. They will either close down, or start making mince pies instead.
As we see, an “unfree” market leads to unsatisfied customers, unsatisfied sellers, wastage of supply, and suppliers going out of business. In other words, a completely dysfunctional market!
Now that you understand market forces, let’s apply this knowledge to the money market.
What is the price of money?
The interest rate.
When you go to a bank and ask for money, the interest rate is the “price” you pay.
For example, if you take out a loan for $10,000 at 10% p.a., the price you are paying for that money is $1,000 per year.
If the interest rate fell to 1%, you would only pay $100 per year. This might encourage you to borrow $50,000 instead of $10,000, since money is so cheap. On the other hand, if the interest rate went up to 30%, you probably wouldn’t want to borrow anything at all.
Now let’s look at how efficiently the money market sets this price. The money market is arguably the most important market in the country, since money is the lifeblood of every other market and the economy in general, so we would hope it’s extremely efficient.
Well, let’s see.
In a truly efficient market, the price of money would be set like this:
Let’s say a bank has 1 billion dollars to loan out.
If demand is high and $5 billion of loans are being requested by customers, the banks would increase the price of money (just like all the farms increased their price of beef).
In other words, they would increase the interest rate.
When the interest rate rises from 3% to 5%, fewer people will be asking for mortgages, loans, and credit cards (because it’s more expensive).
If demand for loans has only reduced from $5 billion to $3 billion, the bank will know the price is still too low (remember they only have $1 billion to loan out). So the bank will increase interest rates again, perhaps from 5% to 9%.
Eventually, the banks will find the “correct” price, where demand for money is exactly $1 billion. This means the bank maximises profit, and everybody who wants a loan (at the current price) can get one.
However, as you know this is not how the money market works.
The price of money is set by a central bank, which changes the price every quarter depending on their “feeling” of how the economy is doing.
“The economy is doing really well, maybe we should raise the interest rate to slow it down”
“The economy is doing badly, let’s lower the interest rate to rev it up!”
This is the equivalent of the ministry setting the price of chicken pies. The problem, as we saw earlier, is the ministry is not standing in line to buy the pies, or standing behind the counter selling the pies, or working in the factory making the pies, so it doesn’t know what’s really happening in the pie market! Obviously, this leads to them setting the “wrong” price.
We know this, because there is only one way to set the “right” price, which is when the market sets the price.
That’s the first flaw of the money market.
The second flaw is – the supply isn’t real either. We learned this in Why Recessions Happen – Part 1.
Remember in our example, the bank had $1 billion of money to loan out, and if demand was more than $1 billion they would raise the interest rate, and if demand was less they would lower the interest rate, to maximise profit from their $1 billion in funds, since that’s all they had available.
However, in the real world, their limit isn’t $1 billion. Their limit is – infinity!
Since money can be printed infinitely, an infinite amount of money can be lent by the bank, and if they run out, they can just get more.
Even when they lend out way too much money and manage to bankrupt themselves, it doesn’t matter. As we saw in 2008, the government will just print even more money to get them out of bankruptcy.
What does this mean?
It means in the current financial system, the interest rate is never correct. It is set by a bunch of guys in the government, and is only assessed once per quarter which means price-change is always reactionary, rather than real-time. This means it will always lag the actual reality of the true supply and demand in the economy and not represent what the price of money should truly be.
So if the price of money is wrong, what does that mean? We already figured that out in our pie example, didn’t we? It means the market won’t function! It means some pies will sell really well, while some will sell badly, some pie suppliers will go out of business, and some pie suppliers will boom.
The ideal solution to this problem would be to educate the government and convince them to stop meddling in the money market so the price can be correctly said and the market can function properly. However, you would need to dedicate your life to infiltrating politics and trying to become Prime Minister so you could overhaul the financial system. Since I’m sure you’re not interested in doing that (neither am I) my suggestion is to do the next best thing – use your knowledge of this flaw in the system to MAKE MONEY.
How do we do that?
Well, we know that when the interest rate is too low people are going to borrow way too much money. We know the interest rate is wrong (because it’s always wrong) so when people are borrowing way too much money, it means a bubble is going to form. Credit card debt is going to go too high. Mortgages are going to go too high. Business debt is going to go too high. Personal debt is going to go too high. The money from this debt will flow to businesses, and things like stocks and housing (because all printed money always flows into assets and businesses), so those markets will reach new highs, and business profits will boom.
However, since too much money has been lent out (because the price of money was wrong), it means a lot of this money people have borrowed won’t get paid back. This will lead to a crash. Crashes include things like house foreclosures, stock market crashes, business closures, or what the government likes to call a “recession”.
Ironically, the government caused this recession (because they set the price of money wrongly), yet they will try and fix it by doing the exact same thing they did to cause it, which is to (wrongly) change interest rates again.
They will jack interest rates up very high and very quick (we saw this after Covid). In a blink interest rates can rise from 1% to 5% or 6%. This will expose who can afford to pay their debts and who cannot, and as many people start to default, the crashing will accelerate. Only the richest people will be able to borrow money, and people will only be borrowing for very specific high-return projects, rather than every other car and holiday. Businesses will earn less (because people are spending less) so stocks start missing earnings targets and start crashing too.
Remember – when everyone “loses” money in a recession, that money isn’t magically lost. It still exists, it’s just been transferred from poor people to rich people. How? Because, once again, as we learned in my post How To Stay Rich, all money eventually flows to people with assets. When someone takes out $100k in credit card debt, and buys a car and a boat, then fails to pay it off and the car and boat get repossessed, what happened to the $100k? Did it magically vanish? No! It’s in the hands of the guy who owns the car and boat shop. When you buy a house for $1m, and its value crashes to $700k, what happened to the missing $300k? Did it magically vanish? No, it’s in the hands of the person who sold you the house before the crash!
So the key lesson is – during the boom times, lots of money will be floating around because interest rates are (wrongly) very low, and you want to spend that time accumulating as much of that floating-around-money for yourself as possible. While most people are busy spending, you should be accumulating and saving.
Why? Because there will soon come a time where lots of money isn’t floating around because everything has crashed and now interest rates are (wrongly) too high, people will be desperately in need of money willing to sell their assets at very low prices, and the one who has the money to buy those assets will be you.
In summary:
We have a period where the economy is “booming” and high prices are everywhere. And we have a period where the economy is “crashing” and we have low prices everywhere.
The way to make money from this knowledge is extremely simple, and you have heard it before.
- Always know where you are in the cycle
- Buy assets when they are “crashing”
- Sell assets when they are “booming”
Most people understand points 2 and 3, but they struggle to execute because they don’t understand point number 1.
Hopefully now you do.
Remember:
- The interest rate is always wrong.
- This means a bubble is inevitable.
- This means a crash is inevitable.
- Stay prudent during the bubble, so you have cash during the crash.
- Be aggressive during the crash, so you have assets during the bubble.
- Profit.
