this way has been the biggest missing piece in their quest to understand the lessons of history, and I explained to them that their perspectives helped me understand the political dynamics that a ect policy choices. This chapter is focused on the money, credit, and economic piece.
Let’s start with money and credit.
THE TIMELESS AND UNIVERSAL FUNDAMENTALS OF MONEY AND CREDIT
All entities—people, companies, nonprofit organizations, andgovernments—deal with the same basic financial realities, and always have. They have money that comes in (i.e., revenue) and money that goes out (i.e., expenses) that, when netted, make up their net income. These ows are measured in numbers that appear in income statements. If an entity brings in more than it spends, it has a pro t that causes its savings to go up. If it spends more than it earns, its savings go down, or it makes up the di erence by borrowing or taking money from someone else. If an entity has many more assets than liabilities (i.e., a large net worth), it can spend above its income by selling assets until the money runs out, at which point it has to slash its expenses. If it doesn’t have much more in assets than it has in liabilities and its income falls beneath the amount it needs to pay out to cover the total of its operating expenses and its debt-service expenses, it will have to cut its expenses or will default or restructure its debts.
All of an entity’s assets and liabilities (i.e., debts) can be shown in its balance sheet. Whether it writes those numbers down or not, every country, company, nonpro t organization, and individual has them. When economists, for example, combine each entity’s income, expenses, and savings, they get all
entities’ incomes, expenses, and savings. The way entities collectively handle their finances as reflected in their income statements and balance sheets is the biggest driver of changes in internal and world orders. If you can take your understanding of your own income, expenses, and savings, imagine how that applies to others, and put them together, you will see how the whole thing works.
Take a moment to think about your own nancial situation. How much income do you have now relative to your expenses and how much will you have in the future? How much savings do you have and what are those savings invested in? Now play things out. If your income fell or disappeared, how long would your savings last? How much risk do you have in the value of your investments and savings? If that value fell by half, how would you be nancially?
Can you easily sell your assets to get cash to pay your expenses or service your debts? What are your other sources of money, from the government or from elsewhere? These are the most important calculations you can make to ensure your economic well-being. Now look at others—other people, businesses, nonpro t organizations, and governments—realizing that the same is true for them. See how we are interconnected and what changes in conditions might mean for you and others who might a ect you. Since the economy is the sum of these entities operating in this way, it will help you understand what is happening and what is likely to happen.
For example, since one entity’s spending is another’s income, when one entity cuts its expenses, that will hurt not just that entity, but it will also hurt others who depend on that spending to earn income. Similarly, since one entity’s debts are another’s assets, an entity that defaults reduces other entities’ assets, which requires them to cut their spending.
This dynamic produces a self-reinforcing downward debt and economic contraction that becomes a political issue as people argue over how to divide the shrunken pie.
As a principle, debt eats equity. What I mean by that is that debts have to be paid above all else. For example, if you own a house (i.e., you have
“equity” ownership) and you can’t make the mortgage payments, the house will be sold or taken away. In other words, the creditor will get paid ahead of the owner of the house. As a result, when your income is
less than your expenses and your assets are less than your liabilities (i.e., debts), you are on the way to having to sell your assets.
Unlike what most people intuitively think, there isn’t a xed amount of money and credit in existence. Money and credit can easily be created by central banks. People, companies, nonpro t organizations, and governments like it when central banks make a lot of money and credit because it gives them more spending power. When the money and credit are spent, it makes most goods, services, and investment assets go up in price. It also creates debt that has to be repaid, which requires people, companies, nonpro t organizations, and governments to eventually spend less than they earn, which is di cult and painful. That is why money, credit, debt, and economic activity are inherently cyclical. In the credit-creation phase, demand for goods, services, and investment assets and the production of them are both strong, and in the debt-repayment phase, both are weak.
But what if the debts never had to be paid back? Then there would be no debt squeeze and no painful paying back period. But that would be terrible for those who lent because they’d lose their money, right? Let’s think for a moment to see if we can nd a way of resolving debt issues without harming either borrowers or lenders.
Since governments have the ability to both make and borrow money, why couldn’t the central bank lend money at an interest rate of about 0 percent to the central government to distribute as it likes to support the economy?
Couldn’t it also lend to others at low rates and allow those debtors to never pay it back? Normally debtors have to pay back the original amount borrowed (principal) plus interest in installments over a period of time. But the central bank has the power to set the interest rate at 0 percent and keep rolling over the debt so that the debtor never has to pay it back. That would be the equivalent of giving the debtors the money, but it wouldn’t look that way because the debt would still be accounted for as an asset that the central bank owns, so the central bank could still say it is performing its normal lending functions. This is the exact thing that happened in the wake of the economic crisis caused by the COVID-19 pandemic. Many versions of this have happened many
times in history. Who pays? It is bad for those outside the central bank who still hold the debts as assets—cash and bonds—who won’t get returns that would preserve their purchasing power.
The biggest problem that we now collectively face is that for many people, companies, nonpro t organizations, and governments, their incomes are low in relation to their expenses, and their debts and other liabilities (such as those for pensions, healthcare, and insurance) are very large relative to the value of their assets. It may not seem that way—in fact, it often seems the opposite—because there are many people, companies, nonpro t organizations, and governments that look rich even while they are in the process of going broke. They look rich because they spend a lot, have plenty of assets, and even have plenty of cash. However, if you look carefully, you will be able to identify those that look rich but are in nancial trouble because they have incomes that are below their expenses and/or liabilities that are greater than their assets, so if you project what will likely happen to their nances in the future, you will see that they will have to cut their expenses and sell their assets in painful ways that will leave them broke. We each need to do those projections of what the future will look like for our own nances, for others who are relevant to us, and for the world economy. In a nutshell, for some people, companies, nonpro t organizations, and countries, the liabilities are enormous relative to the net incomes and the asset values that are required to meet those obligations, so they are nancially weak, but they don’t look that way because they spend a lot nanced by borrowing.
If anything I’ve written here is confusing to you, I urge you to take a moment to try to apply it to your own circumstances. Pencil out what your nancial safety margin looks like (how long will you be nancially OK if the worst-case scenario happens—e.g., you lose your job and your investment assets fall to be only half as much to account for possible price falls, taxes, and in ation). Then do that calculation for others, add them up, and then you will have a good picture of the state of your world. I’ve done that with the help of my partners at Bridgewater and nd it invaluable in imagining what is likely to happen.1
In summary, these basic nancial realities work for all people, companies, nonpro t organizations, and governments in the same way
they work for you and me, with the one big, important exception I mentioned earlier. All countries can create money and credit out of the air to give to people to spend or lend out. By producing money and giving it to debtors in need, central banks can prevent the debt crisis dynamic that I just explained. For that reason I will modify the prior principle to say: debt eats
equity but central banks can feed debt by printing money instead. It should be no surprise that governments print money when debt crises cause politically unacceptable amounts of equity-eating debt and corresponding economic pain.
However, not all money that governments print is of equal value.
The monies (i.e., currencies) that are widely accepted around the world are called reserve currencies. At the time of my writing this, the world’s dominant reserve currency is the US dollar, which is created by the US central bank, the Federal Reserve. A much less important reserve currency is the euro, which is produced by the Eurozone countries’ central bank, the European Central Bank. The Japanese yen, the Chinese renminbi, and the British pound are relatively small reserve currencies now, though the renminbi is quickly growing in importance.
Having a reserve currency is great while it lasts because it givesa country exceptional borrowing and spending power and significant power over who else in the world gets the money and credit needed to buy and sell internationally. However, having a reserve currency typically sows the seeds of a country ceasing to be a reserve currency country. That is because it allows the country to borrow more than it could otherwise a ord to borrow, and the creation of lots of money and credit to service the debt debases the value of the currency and causes the loss of its status as a reserve currency. The loss of its reserve currency status is a terrible thing because having a reserve currency is one of the greatest powers a country can have because it gives the country enormous buying power and geopolitical power.
In contrast, non-reserve currency countries often nd themselves in need of money in a reserve currency (e.g., dollars) when they have a lot of debt denominated in that currency, which they can’t print, or they don’t have much savings in that currency and their ability to earn the currency they need falls o . When countries desperately need reserve currencies to service their reserve currency-denominated debts, and to buy things from sellers who
only accept reserve currencies, they can go bankrupt. This has happened often in the past and it is where things now stand for a number of countries. It is also where things stand for local governments and states and for many of us.
This con guration of circumstances has been handled in the same way, so it’s easy to see how this machine works—and that is what I will show you in this chapter.
Let’s start with the basics and build from there.