Why Recessions Happen

Posted in   Investing   on  March 28, 2024 by  Money Bren0

Nothing in this article is financial advice. The writer is not your financial advisor. Investing contains risk and you can lose money. Consult your own professionals before making investment decisions. This article may contain affiliate links. 

Say I have a million dollars.

I put this million in the bank.

The bank is happy, because it now has a million dollars it can loan out to someone and make some money.

The next day you go into the bank.

You want to start a business (say, a car dealership) and you need a million dollars.

The bank says, no problem! We just got a deposit of a million dollars yesterday.

They lend the million dollars I deposited to you, and you use it to start your car dealership.

Once your car dealership is open, you need to start earning money, because you need a million dollars to pay back the loan.

For you to make a million dollars, however, there needs to be a customer that has a million dollars to spend.

Luckily for you, there is one.

Me!

I have a million dollars in the bank, remember?

So I take my million dollars out of the bank, and spend it at your car dealership.

Now the loan has been paid off, and the country has a successful car dealership.

This is how an economy grows, and businesses start and survive.

Notice how the mathematics works?

For you to borrow a million dollars, someone else must have saved a million dollars.

For you to earn a million dollars, someone else must have a million dollars to spend.

In other words, you can have capital or consumption, but not both.

This is because it’s when people forgo consumption (i.e. save their money) that provides the opportunity for capital investment, and when people forgo capital investment it provides the opportunity for consumption.

One must be sacrificed for the other.

In the above example, everything works, because the mathematics is sound. I saved a million, the bank lent a million, and you borrowed a million.

However, in the current financial system, the maths is not sound. And that’s why we have recessions.

Watch:

I have a million dollars, and I put it in the bank.

You go to the bank to borrow a million dollars for your car dealership.

The bank says no problem! They lend you my million dollars, and you start your car dealership.

However, the next day another person goes to the bank also asking for a million-dollar loan.

They want to start a car dealership too.

Even though the bank has no more money left (they lent it all to you), they still say, sure! Then they push a button on their computer and magically create another million dollars to lend to this person.

The next day, another person goes into the bank asking for a million dollars, and once again the bank says, sure!

This continues until the bank has lent out eight million dollars.

This is known as “fractional reserve banking”, a law which allows banks to lend out more money than they actually have.

So, since the bank has magically turned one million dollars into eight million dollars, there are now eight people starting car dealerships.

After a few months, all eight car dealerships are open and ready for business.

This is the “bull market” of the economic cycle. Eight new businesses! Amazing!

However, now we have eight car dealerships who all need to earn a million dollars to pay off their loans.

Unfortunately, this is mathematically impossible.

Why?

Because the consumer (me) only has one million dollars in the bank!

So here’s what happens:

I take out my million dollars, and spend it at one of the dealerships.

The other seven dealerships are doing their best to sell some cars and make money, but it’s simply not possible.

Because there is only one million dollars to go around, and eight million dollars of loans that need servicing, seven of the dealerships will inevitably default and go bankrupt.

This is the “recession” part of the economic cycle.

This happens because of the way our financial system is set up.

Because dollars can magically be “invented” with the push of a button, there is always too much debt to service. While bankers and the government know this happens, they can’t resist. It’s too good to print a bunch of money and see your GDP growth numbers in double digits. We probably can’t blame them. It’s human nature.

However, imagine living back when we still used gold coins as money.

You can’t magically produce gold coins. You must dig a hole and mine them, mint them and distribute them.

If I save a million gold coins in the bank, the bank can lend out that million coins. But it is impossible for them to lend out any more.

If a second customer comes in and wants to borrow another million gold coins, the bank cannot push a button and invent a million new gold coins in their computer screen. They simply need to say no. They don’t have it.

This keeps the mathematics of the economy sound, so 1+1 will always equal 2, and no recession is necessary or even possible.

However, we no longer live in the age of gold coins.

We live in the age of dollars, where millions of new dollars magically appear every day.

This means recessions are inevitable, and will always happen.

The bank will take $1 billion into deposits, turn it into $8 billion in loans, knowing that $7 billion of them will eventually default and crash the economy. And the cycle will continue over and over.

So what do we do?

Since the financial system we use is out of control, the goal is to simply navigate the one we have, and use it to our advantage:

  1. Always know which part of the economic cycle we’re in.
  2. During the “boom” stage (when the bank is magically turning 1 million dollars into 8 million dollars) you should be aggressively hustling. Sell something. Side hustle. Work overtime. You want to collect as much of that 8 million as possible while it’s floating around!
  3. During the “bust stage” (when everyone is fighting over 1 million dollars to pay 8 million dollars of loans), be prudent. Cut your spending down as much as possible. Keep money in the bank. Interest rates are usually high during these times. Buy assets – they’re usually cheap. Houses will probably be foreclosed. Keep your eye open for opportunities.
  4. Be careful borrowing money during the boom. It might seem like money is everywhere (because the bank just made 8 million dollars appear out of nowhere), but that money eventually needs to be paid back. Remember – it’s mathematically impossible for everyone to pay off their mortgages/loans. This means the environment will very quickly change from money being everywhere to money being very hard to find. Don’t get caught with your pants down.
  5. Prepare yourself for the bust. As long as you can weather the bust, you can be optimistic. During the bust many businesses will go bankrupt but the ones who survive will do extremely well in the next boom. Invest in them!

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