Debt and Economic Cycles – A Love Story

What drives economic cycles?

I first encountered this question when I started working in commercial real estate brokerage. It was 2012, and the common sentiment around the office was that “real estate values move in 7 year cycles.” I’d hear that 3-4 times a week, and I was shocked at how sure everyone seemed of that “fact” despite having no good explanation as to why that was the case.

“Well damn…” I thought, “no wonder people make a fortune in real estate. Buy low, sell 7 years later, and repeat.”

Here we are more than a decade into our current bull run, and no bust has occurred. Turns out economic cycles are a lot more complicated than simply repeating every 7 years. For decades, this sort of misunderstanding has been igniting debate over whether or not our economy is, in fact, consistently cyclical. 

People too often seek to predict the timing of a cycle rather than understand the economic factors that create a cycle. The answer as to why our economy is cyclical is surprisingly simple, and can be summed up in a word: debt.

Debt influences economic cycles in the same way the rotation of the earth influences weather. We know that winter will begin towards the end of the year, but not precisely when. We know it will be colder than summer, but not precisely how cold. We know certain regions will see more severe weather than others, but not to what extent. Similarly, we know using debt to stimulate the economy will incite growth, but we don’t know to what extent. We know that over-leveraging will eventually become unsustainable, but we don’t know exactly when. What we can observe in both cases is the reasons why winter begins at the end of the year, and why debt will stimulate economic growth. Understanding the indicators that proceed cyclical changes can give us an idea of when cyclical changes are imminent. 

So, let’s talk about debt as a cyclical indicator.

Our global macro-economy is simply the culmination of all of the micro transactions you and I make every single day. It’s the combination of everything from the coffee we buy in the morning, to the cash we pay the landscaper, to the billions of dollars that large enterprises spend on mergers and acquisitions (and ultimately, those massive corporate expenditures are driven and funded by our small micro-transactions).

Because the global economy is the amplification of millions of individual spending habits, we can simplify the explanation of macroeconomic cycles by focusing on one individual. Meet Tom. Tom makes $100,000/year after taxes, and spends all of his money in one place. He lives in an apartment complex that has a grocery store, a restaurant, coffee shop, gym, gas station, everything he needs. Tom is the only tenant/customer at this property, making him their only source of income. Tom spends everything he earns between rent and expenses, which means the apartment complex earns $100,000/year as well.

One year, Tom gets a $10,000 line of credit. He spends this extra $10,000 on restaurants, bar tabs, and a new wardrobe. This is great news for the apartment complex, as they now see 10% growth in their earnings. This represents debt driving economic expansion. Well the next year, Tom must repay his debt, and has to reduce his spending to $90,000. This is bad for the apartment complex, because they now see a steep decrease in annual revenue. This represents an economic retraction, or recession. This example also shows why the effect of recessions is often magnified in comparison to the growth periods that proceed them. The debt driven expansion produced a 10% YOY increase, while the resulting recession when Tom’s debt matured was an 18% YOY decrease.

Now let’s look at another scenario to illustrate the difference between frivolous debt, and productive debt.

Let’s say Tom wised up and spent only $5,000 of his $10,000 loan on bar tabs, restaurants, and a new wardrobe. He spent the remaining $5,000 on furthering his education to increase his personal worth. At the end of the year, his new education resulted in his income increasing by 15% to $115,000. Now, when Tom has to repay his debt next year, he’ll repay the $10,000, and still have $5,000 left over to spend at restaurants and stores, which will further stimulate the economy.

The result of the productive debt was a 5% increase in revenue in year 1, and that increase remained flat in year two when Tom had to repay his debt. Year 3 will likely see even greater growth as Tom can use all of his increased income to buy goods and services, and not repay debt. Was it more fun to buy $10,000 of clothes and bar tabs? Of course. But the result of the frivolous debt was a 10% economic increase in year 1, followed by an 18% decline in year 2, dropping the total economic value by 8% over 2 years.

This is obviously a dramatic oversimplification, but it’s a good representation of how debt creates cycles and ultimately affects our economy. Frivolous debt and reckless spending can have short term positive effects, but ultimately hurt our economy and jeopardize its long term stability. Productive debt creates less short term stimulus, but has sustainable long term positive effects. Productive debt in the real world is things like infrastructure development, education, research and development, logistical or supply chain improvements, and job creating public projects.

The Tom scenario underestimates the magnifying effect debt has when recessions occur because it doesn’t account for interest. When massive global economic cycles turn, it’s often because the economy becomes so overburdened with debt and interest payments that individuals, organizations, and governments can no longer stimulate growth and must repay debt. Let’s take a look at how a debt cycle works on a macroeconomic scale.

In the early stages of a bull run, people spend their money freely, stimulating the economy like in the example above. As debt enters the economy, people’s ability to spend continues to rise. People use this debt to buy bigger homes and nicer cars. As more people seek to buy homes, the price of homes rises. As the value of people’s homes rise, so does their net worth. As their net worth rises, so does their ability to borrow more money.

This cascading effect is what eventually creates a “bubble.” Debt enters the economy, people spend more money, increased spending increases asset values, increased asset values increase people’s net worths, more debt enters the economy based on higher net worths, and so forth. Eventually, debt must be repaid, spending slows, demand drops, asset values topple, and suddenly the high debt burden is no longer supported by high asset values and net worths, and bam, the bubble bursts.

That’s the basis of how debt creates our economic cycles. The effect these debt cycles have on the stock market follows similar principals as the stock market is ultimately supported by personal spending and asset values. In articles to follow, we’ll build on this understanding and discuss why economic cycles will become shorter as inflation continues to outpace income growth, and lastly, how people and policy makers can alleviate the often devastating effects of these cycles.