How does the economy work?

And what does it have to do with the stock market?


Quick Shoutout: this post was inspired by Ray Dalio’s 30 minute video, How the Economic Machine Works. We’re just distilling his video into a 3-minute read (and infusing some classic Big Later flavors). 

The stock market is a loose proxy for the future health of the U.S. economy.

To understand why the market goes up and down in the short term but up and to the right in the long term, we have to take a look at how the economy works – exciting!!!

What is the economy?

The economy is the total of all the transactions between all the buyers and sellers in every market. Oh, and by the way, a “market” is just a physical or virtual place where people buy and sell stuff (usually we’re talking about goods, services, or financial assets... but trust me when I say there is a market for everything). 

Some of these transactions are made with money, more are made with credit, and credit just so happens to be the most important part of understanding our economy. 

Credit works like money, except that it has an additional cost – interest. This is not interest that you’re earning... it’s interest you’re paying. It is the cost of borrowing money (usually from a bank). Think of it as the premium you pay for early access to money you expect to have in the future. Because you want it now, you’ve gotta pay a lil’ extra for it. Fair enough.

We like credit because it lets us buy things we can’t afford upfront.

Every time you use credit to spend more than you can afford in the present, you are signing yourself up to spend less in the future. That’s not necessarily good or bad, it just kinda is. Credit is great when it helps borrowers buy things that make them more productive, however, it’s important to note that the literal millisecond credit is created, it becomes “debt.”

Take this fun and not-at-all-dated example…

A wheat farmer buys a tractor with credit to produce more of that sweet-ass wheat. Does he have to pay back the debt plus interest? Yes, but that shiny new steel beast should help produce more crops with less effort. That means he can be more productive, make more money, afford to pay off the debt, and then still have some leftover (hopefully)

When credit helps you become more productive, your income rises. When your income rises, you spend more on other people’s shit (our farmer is now spending his excess cash on a flashy pair of white-washed overalls at the town store). When you spend more on other people’s shit, their income rises, and the cycle continues upwards, creating a thriving, breathing, sexy-eyes-making, happy economy. 

Ah, if only it were so simple... 

There’s a phenomenon that occurs when incomes and spending are growing faster than the production of the goods: prices rise. 

Economists and balloon aficionados call this “inflation.”

Inflation isn’t a bad thing per se 

But it can blow up out of control — producing disastrous effects (google Weimar Republic inflation” if you want to feel better about how you’re currently using wheelbarrows). 

In 1913, to stabilize our financial system — keep inflation in check, babysit other banks, and generally make sure the country doesn’t get money problems — our country’s leaders created this thing called a CENTRAL BANK. Kind of intense when it’s in all caps, huh? 

The Central Bank is the same thing as “the Federal Reserve”, also known as “the Fed”. We’ll call it the Fed from now on. And one the Fed’s main responsibilities is to manage inflation by controlling interest rates. Still with me? No? Okay, let me explain.

To combat inflation, the Fed raises interest rates. 

Higher interest rates means getting credit becomes more expensive — basically you have to pay more interest to get the same amount of credit as you could’ve gotten when interest rates were lower. 

If credit is more expensive, there are fewer borrowers and less spending. Less spending means that incomes decrease and ultimately the economy sees a deflation in prices because spending is no longer outpacing the production of goods. When a sufficient amount of deflation has occurred, the Fed drops interest rates back down. Then the cycle restarts. I’m literally gasping for air right now, I promise we’re almost done.

Wait.. how does this relate to the stock market?

Our economy experiences the cycles I just described on a relatively consistent basis — roughly every 5-8 years. Most people call this the “business cycle”.

These cycles impact the stock market because many of the goods and services — all the “stuff” we buy — are provided to us by companies that are traded on the stock market (Nike! Coca Cola! Toyota! Bank of America!). 

When we have more money to buy stuff (i.e. when interest rates are low and credit is cheap), their profits go up. When their profits go up, their stock prices typically go up too. As the economy expands and contracts during short term cycles, the stock market reflects (and often foreshadows) those changes. I’m oversimplifying a bit but… isn’t that what this is all about?

You still haven’t explained why the stock market goes up long term.

Oh, right. This is actually pretty simple. Over long periods of time, the economy grows through increases in labor (more people), capital (businesses and people making good investments), and efficiency (science-y stuff, industrial innovation, information innovation, new technologies, etc.).

So, if you feel comfortable banking on the long term outlook of baby-making and the evolutionary trend of human progress, the stock market does a pretty good job capturing and compounding that value... so long as you can ride out the rough parts of the shorter cycles. And sure, that may not be a luxury everyone can afford, but as young people planning for the future, we are uniquely positioned to do just that. 

*Huge deep breath out* 

That wasn’t particularly fun or easy for either of us, but hey – like the SATs or a lecture from your mother on the dangers of drugs, we got through it. 

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