How Money Works
“When Business Stops Spending”
If you look at the trend of the financial markets they tend to follow a fairly predictable path, in the long run, called business cycles. Business cycles have peaks (their high points) and troughs (their low points) and one business cycle tends to happen every 7 or 8 years. Since economists know about these business cycles and they collect data that helps predict when the down turns are going to happen, they can use tools such as interest rates and money supply in the economy to help offset these down years. In the longer run though, anywhere between 30-60 years (4-7 business cycles), there tend to be cycles called financial cycles which people are a lot less familiar with.
The trough in these financial cycles are usually caused by a “bubble” burst or a catastrophic world event, in either case, leaving a severe impact on the financial markets. The problem with the troughs in the financial cycles is that economists try to fix the problems by treating it like any other business cycle trough. They lower interest rates, expecting more people to borrow money at low rates which should get money flowing back into the economy and the government increases the money supply and throws money into the economy via certain projects (such as fixing roads, building bridges etc). The problem is that at the trough of a financial cycle (such as the housing bubble burst in 2008) companies do not behave as they normally would. The objective of companies is to expand their business and make the most profit as possible but when a financial crises happens companies’ objectives change. During a financial crises, the value of companies’ assets (the things they own) go down and their liabilities (the bills they have to pay) go up so, on paper (the make believe world of accountants) they are on the verge of bankruptcy.
Economist Richard Koo refers to these scenarios as “Balance Sheet Recessions”. On paper the companies look bankrupt and this does not look good to shareholders and investors. Therefore, the companies change their goals. They are no longer focused on maximizing profits but now their main focus is on minimizing their debts. So companies stop borrowing money to expand, stop hiring and instead retain all their profits to pay down debts inside the company. This creates hazard in the economy because now the normal reactions to a recession are not solving problems. The Bank of Canada lowering interest rates does nothing because companies are paying down debts and not expanding. So even at 0% interest rate, companies are not borrowing because they are focusing on paying down debts. Therefore, no money is being recycled into the economy and the recession continues. This is what we saw in 2008 and is why the recession in the economy lasted so long. We are now seeing lots of uptrends in the markets and judging by the rise of mortgage rates and interest rates I think that there has been a shift towards a return to more normal business conditions. We can only hope!
This information is for general interest only and is not meant to be financial advice. Always consult your personal financial advisor before investing.
Trevor is a consultant with the Investors Group and serves the Tobique River Valley. He was born inPerth-Andover and moved toPlaster Rock at age 14. Trevor graduated from Tobique Valley Middle High School in 2009 and went on to attend UNB. During summers, between university terms, he worked a number of different jobs including house painting, tree trimming and labourer at Twin Rivers. He graduated from UNB Saint John in 2013 with a degree in Economics and joined the Investors Group, Fredericton Branch.
Trevor has obtainedhislicence to sell insurance and mutual funds.now resides in Plaster Rock and provides financial services in the entire Tobique River Valley.
Trevor Bowmaster BSc Economics
Comments: . Trevor.Bowmaster@investorsgroup.com
