Hello everyone..!!! Welcome to "INTROSPECTION". Today I'm back with a new post "BOOM OR BUST - II" which is a continuation for the previous week's post "BOOM OR BUST". But before entering into today's post, I strongly suggest you make sure that you read the first part of this topic, which is very much required to understand today's post. Hence I'm leaving the link in the next line...
BOOM OR BUST
STRONGLY REMEMBER THESE STATEMENTS:
Now, continuing from the first part...due to a rise in demand faster than supply which leads to an increase in prices cause "INFLATION". And the central bank needs to do something about it, as inflation is problematic to the economy. The central bank(which can regulate interest rates and print new money) raises(⇈⇈⇈⇈) interest rates, with higher interest rates fewer people can now afford to borrow money. When fewer people borrow the credit, the spending slows down, and due to this people's income drops which leads to a decrease in demand. As the demand decreases prices go down. When people spend less and prices go down, we call this "DEFLATION".
Increased interest rates →Decreased borrowing → Decreased spending → Decreased incomes→ Decreased demand →Decreased prices ⇛ DEFLATION
So when deflation occurs, which means that the effect of inflation is reversed the central bank lowers(⇊⇊⇊⇊) the interest rates again to stimulate borrowing. When the central bank decreases the interest rates the borrowing increases, then spending increases, and incomes also pick up. Economic activity is huge and it's a "BOOM". It pays to goods, services, and financial assets with borrowed money. Here we can say that borrowing more credit completely is depending on the human tendency to borrow more. And people always tend to borrow more whenever there is a chance because it helps them in spending more and make them feel wealthy. If people do this a lot we call it a bubble. People continue to borrow more to buy assets and make investments.
Ex: Sanjeev(person who bought a small shop in the 1st part), started his business by borrowing some more credit in addition to the Rs.2,00,000 he took to buy the shop. Sanjeev becomes very confident, seeing the returns for his investment within a short time. He becomes overconfident after seeing good profits or we can say that his business has BOOMED. Due to his overconfidence, he quits his job. As his business is on the high, he is creditworthy for more credit. This is the time when the central bank has lowered the interest rates. Sanjeev sees this as the opportunity to expand his business by borrowing more and more credit.
But this kind of borrowing and spending cannot continue forever, over decade debt burdens become huge and start growing faster than incomes. Because people's expenses and savings may vary from time to time but debts are constant. To pay back those debts, people have to cut down their spending. As we know that "SPENDING DRIVES THE ECONOMY" when people cut their spending, incomes go down(as one person's spending is another person's income). This makes people less creditworthy causing borrowing to go down more.
Ex: Now, being the owner of multiple businesses makes Sanjeev encounter some difficulties in getting the profits. Therefore a slight drop in his income occurs. But his debt burden keeps on growing nonetheless of his income. To meet his constantly growing debt burden he has to cut his spendings and compromise in his business development as well. As a result, he starts to see losses and he has to sell some of his businesses(assets) which leads his income to go down a lot. Due to this, he loses his creditworthiness and cannot borrow anymore. But the debt burdens keep on fraying on him. The situation completely has gone out of his hands.
NOTE:
DELEVERAGING: What exactly happens in deleveraging is incomes fall and debt repayments continue to rise. Borrowers get squeezed, sell their assets, no longer creditworthy, and cannot borrow any more to make their repayments. Banks also collapse as they cannot get back the debts they gave to people. Stock markets collapse because everyone hastens to sell their assets. And there is no lowering of interest rates to save the day. People feel poor and the entire economy is not creditworthy. We can call this a "BUST" of the economy.
BOOM OR BUST
STRONGLY REMEMBER THESE STATEMENTS:
- Spending increases faster than income due to credit(debt or loan).
- One person's spending is another person's income.
- Spending drives the economy.
Now, continuing from the first part...due to a rise in demand faster than supply which leads to an increase in prices cause "INFLATION". And the central bank needs to do something about it, as inflation is problematic to the economy. The central bank(which can regulate interest rates and print new money) raises(⇈⇈⇈⇈) interest rates, with higher interest rates fewer people can now afford to borrow money. When fewer people borrow the credit, the spending slows down, and due to this people's income drops which leads to a decrease in demand. As the demand decreases prices go down. When people spend less and prices go down, we call this "DEFLATION".
Increased interest rates →Decreased borrowing → Decreased spending → Decreased incomes→ Decreased demand →Decreased prices ⇛ DEFLATION
So when deflation occurs, which means that the effect of inflation is reversed the central bank lowers(⇊⇊⇊⇊) the interest rates again to stimulate borrowing. When the central bank decreases the interest rates the borrowing increases, then spending increases, and incomes also pick up. Economic activity is huge and it's a "BOOM". It pays to goods, services, and financial assets with borrowed money. Here we can say that borrowing more credit completely is depending on the human tendency to borrow more. And people always tend to borrow more whenever there is a chance because it helps them in spending more and make them feel wealthy. If people do this a lot we call it a bubble. People continue to borrow more to buy assets and make investments.
Ex: Sanjeev(person who bought a small shop in the 1st part), started his business by borrowing some more credit in addition to the Rs.2,00,000 he took to buy the shop. Sanjeev becomes very confident, seeing the returns for his investment within a short time. He becomes overconfident after seeing good profits or we can say that his business has BOOMED. Due to his overconfidence, he quits his job. As his business is on the high, he is creditworthy for more credit. This is the time when the central bank has lowered the interest rates. Sanjeev sees this as the opportunity to expand his business by borrowing more and more credit.
But this kind of borrowing and spending cannot continue forever, over decade debt burdens become huge and start growing faster than incomes. Because people's expenses and savings may vary from time to time but debts are constant. To pay back those debts, people have to cut down their spending. As we know that "SPENDING DRIVES THE ECONOMY" when people cut their spending, incomes go down(as one person's spending is another person's income). This makes people less creditworthy causing borrowing to go down more.
Ex: Now, being the owner of multiple businesses makes Sanjeev encounter some difficulties in getting the profits. Therefore a slight drop in his income occurs. But his debt burden keeps on growing nonetheless of his income. To meet his constantly growing debt burden he has to cut his spendings and compromise in his business development as well. As a result, he starts to see losses and he has to sell some of his businesses(assets) which leads his income to go down a lot. Due to this, he loses his creditworthiness and cannot borrow anymore. But the debt burdens keep on fraying on him. The situation completely has gone out of his hands.
NOTE:
- Here in the example, lowering of interest rates has made Sanjeev borrow more credit just as it happens with everyone in the economy because it is the human tendency.
- Sanjeev's story is just a fictitious illustration of what happens if people keep on borrowing more credit regardless of their income. In reality, the cases may vary.
Decreased spending→decreased incomes→ decreased prices⇛ DEFLATION
I know that I look like I'm repeating the same content from the top due to a lack of information. But I'm not and this is not deflation. This is "DELEVERAGING". The main difference between the two is:- In the case of deflation, the central bank has the chance of lowering the interest rates to stimulate borrowing and increase spending resulting in the economic drive.
- But in the case of deleveraging, the interest rates are already low(has gone down to 0%) and cannot be lowered further.
DELEVERAGING: What exactly happens in deleveraging is incomes fall and debt repayments continue to rise. Borrowers get squeezed, sell their assets, no longer creditworthy, and cannot borrow any more to make their repayments. Banks also collapse as they cannot get back the debts they gave to people. Stock markets collapse because everyone hastens to sell their assets. And there is no lowering of interest rates to save the day. People feel poor and the entire economy is not creditworthy. We can call this a "BUST" of the economy.
- In U.S.A this happened in the 1930s and 2008.
- In England, this happened in the 1950s
- Japan has faced deleveraging in the 1990s
- Spain and Italy are the recent victims of deleveraging, which happened in the 2010s
To make it simple deleveraging is the situation for which the central bank and the central government must come out with a way to retain the normal functioning of the economy. Even though I'm desperate to talk about that, I could not do it now as the length of this post is already too long(which is quite unexpected). As I don't want to lag this topic for one more week, so I'm going to post the continuation post on Tuesday itself. Hence wait for BOOM OR BUST-III till Tuesday. And I'm quite sure, it'll be the final part of this topic.
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