Like in other areas of life, we see many cycles in the financial markets and the economy. Cyclical periods of borrowing – both literally and metaphorically speaking – can be observed in the economic world.
Since Adam Smith first gave us The Wealth of Nations, the first modern work of economics in 1776, our knowledge has greatly advanced in this field. However, economists are still in disagreement about many aspects.
We are not yet in control of the economic cycle.
Human nature and the market cycle
When we think about economic cycles, we tend to focus on the financial cost of borrowing and repaying debt and forget about the psychological drive behind the process.
At its core, the act of borrowing is a cycle of renting from the future to reap the rewards in the present. You can choose to enjoy instant gratification and only have to pay back a portion of your spend in the future (of course, this is without taking into consideration interest).
Spending more in the present and ‘less’ in the future creates an artificial increase in current spending levels, which in turn increases asset prices, which then enables more borrowing. While this cycle may seem functionally sound (theoretically speaking), the upwards trajectory of the cycle leads to the expectation that this growth will continue indefinitely.
This is not possible. The upward spiral will inevitably reach a point where the borrowings become greater than income and cannot be repaid.
The downward spiral
When borrowers cannot cover the loans, lenders cannot meet their obligations, leading to a downward spiral in the economic cycle.
Governments have several options to reign in Debt:
- Tighten the belt – spend less
- Default written-off debt
- Print money by buying back bonds issued
- Transfer money from those with more to those with less.
Each of these incur a different impact and different political ramification. Politicians are not favoured for doing any of the above.
Is Australia in a bubble that is now deflating?
Consider the following aspects:
- Stock prices are high relative to history
- Recent bullish sentiment (investors are in general agreement that there is upward price movement in the stock market)
- Assets purchased through high leverage (using borrowed money to increase assets, measured as the ratio of total debt to total assets)
- Recent policy changes have resulted in tighter lending regulations for banks, which is reducing the amount available to borrow
I do know that a traditional measure for handling debt crises or bubbles is to lower interest rates, however that method has now been exhausted with interest rates currently already at an all-time low.
We live in interesting times.
If you or someone you know would like financial advice on staying ahead and out of the debt cycle, please contact me for a free consultation.