I have been offline for a few weeks, so apologies for the delay in getting Part 2 out. My new book is now available in all formats via Amazon. I have also been doing presentations to students in schools about making good financial decisions. The presentations were based around the ‘Latte Factor’ (David Bach) and the powers of compounding… both topics covered in my book. Anyway, following from the last blog where I looked at the Economic Cycle, this week I look at what makes the Economic Cycle behave like it does:
Just as at school, when we exaggerate a story in order to get everyone’s attention, the media will do the same. After all, that is their job, to get your attention and sell more newspapers. You may also find that people in general (and the media) focus more on the bad news as bad news tends to sell better than good news. This can mean two things when talking about the economy; the media will often exaggerate the good times causing the booms to be even more aggressive and then overhype the bad causing them to be even more severe than they are. Probably just like your friends ‘big up’ their grades when they do very well or become very down when they do badly.
Depending on which media sources you choose, this will influence the opinions you have. Some of you may think that you don’t read the news, so how can the media influence you? Just because you don’t read the news does not mean that you are not influenced by the media. Most young adults are on some form of social media. On these platforms, you will often read other people’s opinions via messages, tweets, links, pictures and videos. This will influence your opinion, decisions and behaviour. An important thing to remember is the motive that the media have; they have stories to sell in order to generate money.
In the good times:
The media can increase confidence levels or decrease them dramatically, just as some of the most popular students in school are creating trends and fashions by what they say and post online. Such excitement can create confidence, which can lead to people increasing their spending. This is likely to lead to businesses producing more and increasing their sales. This will then result in more jobs being created, more business ideas being promoted, more success stories and more development of infrastructure being shown all over the front pages. People then have the confidence to take out more loans to fund their spending. In terms of the economic cycle, this means that GDP continues to increase at an even faster rate. As people, we tend to have very short memories and think that these good times will continue forever (Dalio, 2013). Think back to the exam results; students start to get complacent when we have had a couple years of ‘booming’ results. Future students then start to think that good results are easy to achieve.
The media at work:
In the example above, I have chosen bitcoin because at the time of writing (2018), we have had a bitcoin boom with the crypto currency hitting record highs over the course of a number of weeks. It has since fallen quite significantly. The media fuelled this with success stories of millionaires being made over night. It then fuelled its decline as it reported on hard luck stories of people who bought bit coin at its highest and lost a substantial amount of money. Of course, this created fear, causing more people to sell their bitcoin and the price to drop even further.
In the bad times:
The opposite happens in a downturn or recession. If times are looking like they are declining, the media will often focus on the negative stories that make for exciting reading. Back to the popular students at school. They are now painting a picture of doom and gloom. Stories of students whose grades were not as good as expected and subjects that are just too difficult. This sort of behaviour then will lead to a drop in confidence. The economy is no different, however, when confidence is lost, consumers stop spending. If consumers stop spending, businesses must cut back their production, so the GDP decreases. Jobs are lost as a result since companies must make cost reductions.
We have already touched on human behaviour; as humans we base our decisions on our emotions (Bach, 2016). If you ask any sensible person, they would say that they would want to ‘buy low, sell high’. Due to human behaviour, emotions, media influences and the people around us, we are more inclined to do the opposite. Most people will panic when prices are falling and sell, whilst when prices are high, the majority of people will buy. This behaviour further fuels a boom as we all start buying and as a result push prices up.
It is not all down to human behaviour and there are other factors that cause the cycle. However, it is human behaviour that often starts things off. Then the government try to bring the cycles under control again by trying to minimise the declines and avoid aggressive growth.
The government will use the following techniques:
Interest rates are the rate at which a bank charges people for borrowing money from them. It is also the rate that they pay you for saving your money in their bank. This will control the amount of money in the economy.
When interest rates are low, this will often encourage investment, as money is effectively cheap. This means that you can borrow it and pay it back over a period of time for a low charge (% of interest). For example, at the time of writing you can get a bank loan for 3%, so in practise, if you borrowed £100, then you have to pay back £103 if you have borrowed the money for one year. If this borrowing rate (interest rate) is low, then more people and businesses are encouraged to borrow money, as it is effectively cheaper.
If people have access to more money, they can increase their spending. As a result, they can buy more. This will mean that in time, the economy needs to produce more to meet the growing demand. This will generate a period of growth and potentially a ‘Boom’ period.
This can also work vice versa; they could also increase interest rates to encourage people to stop borrowing. This will often slow the economy down as people are less inclined to spend as it is more expensive to borrow money. This will mean that people stop buying as much so businesses start to produce less, as demand has fallen.
Please remember that this is all in theory. As with all these things, there will be other factors that can influence the stage of the economy. It is, however, an influencing factor. At the time of writing, the interest rates have been at a record low for ten years and we are only just starting to see rises in GDP due to people slowly starting to increase their level of spending.
Savings and interest rates
I realise that I have focused more on the borrowing side here. This is because at the time of writing (2018), we are in a time of record low interest rates. This has meant that it really is a borrower’s market and not a saver’s market. This is because if you save now, you get a very low interest rate in return for your money. Many bank accounts will be offering interest rates of 0.5%, so if you decide to save £100 for a year, you will get back £1.05. This is not really a good rate of return and as a result people are less tempted to save their money. If the Bank of England (who control the interest rates) wanted to encourage people to save and not spend, they would start to put the interest rate up so that instead of perhaps getting 0.5%, you are now getting 1.5%, which is obviously more appealing. Currently, they are trying to encourage spending to help increase the GDP, but there has been a lot of talk in the media of increasing the interest rates.
This post has been largely influenced from my book ‘Money lessons left at the school gate’, please follow the link if you would like to read the first three chapters for free.
Next week we will look at what the economy really looks like, and how it progresses over time. To quote Andy Hart at Maven Money, the economy progresses 75% of the time and declines 25%. Find out why next week.
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