What Causes The Economy To “Go Bad”?

It’s sometimes assumed that the economy going “bad” is the result of disappearing money.  That may occur, but isn’t the cause.  Money isn’t wealth … goods and services and capital are.

The money does change in value though. If you owe money and it happens to rise in value, your debt grows, and you lose. If you even owe money betting that it will lose value and it doesn’t, you lose relative to where you thought you would be.

When money rises in value, it takes less of it to buy the same stuff. We notice this in the form of falling prices. Leveraged assets like stocks are among the first and most to decline. The wealth of those that have heavy or leveraged exposure to such assets may “go bad”. They dominate the financial media and so when their wealth suffers, it’s “the economy” that is said to go bad. Your economy may or may not.

Unemployment may rise too, though. This is because the rise in value of the money is an effective pay hike for wage earners. If nominal wages don’t adjust to reflect this quickly enough, the pay increases become marginally less affordable to employers, and some operating on thin margins may reduce hiring and even cut jobs.

What is not widely understood, however, is what causes money to rise in value in the first place. Econ 101 tells us that the value of any commodity is a function of supply and demand. Many economists focus only on the supply part of the equation, though … if you follow financial media you’ll often hear about money supply, but rarely money demand. It only takes a few moments thought to understand it … when you owe money, you have a greater need for it than if you don’t. The more you owe, the greater your need. The biggest source of money demand is debt.

It’s clear, then, that an excess of debt can fuel money demand and cause its value to rise. There’s a conflict though … the creation of debt is how money gets created in the first place. Money is lent into existence. This occurs in the banking system when interest rates are cut, lowering the cost to borrow money. This increases the supply of money, reducing its value and leading to rising prices. But as the surge of new money abates, the newly created debt remains, adding to money demand and reversing the inflationary impulse. Policymakers respond with a new inflationary effort, leading to a repeating cycle of inflation and deflation. Paradoxically, the ultimate cause of deflation is inflation.

We’ve seen this happen over and again. Cycles of varying intensity may be called expansions and recessions or inflations and deflations. One of the most significant examples was the boom of the 1920s and the depression of the 1930s. More recently, in 2008, high inflation was marked most notably in soaring house and energy prices, with crude oil reaching $147 a barrel in June of that year. A mass of debt associated with the housing bubble triggered an intense deflation as the giant government sponsored mortgage agencies began totter and were taken into conservatorship, leading to the collapse of Lehman Bros on Wall Street, and a stock market crash. Debt-fueled demand for dollars caused their value to spike, resulting in losses of the type cited above.

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