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What’s a Recession and Why Does It Happen?
A jargon-free explanation.
A jargon-free explanation.
In the last article, we looked at the difficult situation the ECB had gotten itself into and what we could expect for the European economy in the next couple of months.
This week, we will take a look at what a recession is, how it happens, and why.
In order to understand it well, we will use Ray Dalio’s theories, author, investor, and founder of Bridgewater Associates, the biggest hedge fund in the world.
What’s a Recession?
A recession is a period during which the economy produces less output than it did in the past.
Developed countries typically grow their economy by 1–2% a year. A recession happens when growth becomes negative.
Why Do Recessions Happen?
To understand why recessions happen, we need to understand how the economy works.
The economy is the sum of all the transactions that are made within a geographical area.
A transaction happens when someone exchanges a good or a service for money.
This means that in the economy, someone’s spending is someone else’s income.
Your spending at the bakery contributes to the salary of the baker.
The more you spend, the more the baker will earn.
The less you spend, the less he will.
A recession happens when everyone in the economy spends less than they used to in the past.
As a result, everyone earns less money.
The Short-Term Debt Cycle
Why do people spend less?
Spending in the economy is influenced by two variables.
Productivity: the more you work, the more output you produce, so the more money you earn and the more you can spend. However, most people don’t get more money by being more productive. Productivity tends to stagnate once the economy reaches an advanced level of development, such as Japan, for example.
Credit: credit is what helps people spend more money the most. Credit is borrowing money from the bank with the promise to pay it back later.
When banks give out a lot of loans, there is a fresh inflow of money in the economy. If people spend more so the companies they spend their money at earn more. If these companies earn more, they can also spend more.
As a result, the economy grows. It’s a self-reinforcing cycle.
Up to a certain point at least.
If banks give too much money, there is too much spending relative to the volume of goods and services, so prices increase. This is inflation, and this is exactly what has been happening in 2022.
Governments printed trillions to support the economy during the pandemic. People went to spend these trillions but there weren’t enough goods compared to the amount of money that was being printed, so the price for everything increased.
Normally, central banks do not like when inflation is too high, so they increase interest rates and decrease the influx of money in the economy to “cool it off” — that is, to reduce consumption.
If there’s less money in the economy, the economy slows down.
It happens at a bad time in the cycle. Indeed, there comes a point when people have to pay back all of their loans. This means that they’re going to have to reduce their spending to refund their debts.
As we said, one’s spending is another one’s income? When people spend less in the economy, everyone earns less. If everyone earns less, everyone spends less. It becomes a vicious cycle.
The economic predictions are slashed, the economy slows down, people aren’t either producing or spending as much as before. The stock market crashes, and everyone has become poorer.
The economy entered a recession.
The Economy Is Cyclical
The existence of credits means the economy is cyclical.
When central banks lower interest rates, people borrow more, spend more, and the economy grows. The stock market goes up. Everyone is getting richer.
But this cannot last forever. Comes a time when people need to refund their loans, so they spend less — and everyone is earning less.
If banks have been given too many loans, then interest rates increase and it gets harder to borrow.
The economy recedes. This is a recession.
After a while, once prices have cooled down, the central bank lowers interest rates again to stimulate the economy and restart growth.
People borrow again, spend again, prices increase, and the whole cycle starts again.
On average, the short-term debt cycle lasts eight years before the next recession hits.
What It Means for Investors
So, how can investors hedge against this?
It all depends on what you invest in. Certain asset classes are more prone to bubbles, like real estate and stocks, while others are usually safer and less volatile, like bonds.
In any way, successful investing comes down to following two rules that are very easy to understand yet very hard to respect.
Buy when it’s low: that means buy directly after a crash, during a recession.
Sell when it’s high: that means sell before a crash, at the end of the eight-year cycle.
Easier said than done.
This cycle has been existing for as long as states have been minting money and banks have been lending it.
Despite the appearances, economic cycles don’t depend on the “economy”or “the system”. They depend on how people behave with money.
It is our propensity to spend money now instead of sacrificing to enjoy it later that drives the economy to expand fast, then shrink when the bill comes due. If borrowers borrowed less and made more efforts to refund their loan, the economic cycle wouldn’t be as impactful as it is.
Luckily, stocks, real estate, bonds and gold aren’t the only assets that exist.
Alternative assets such as farmland have the specificity not to be valued according to the state of the economy, but according to the value of their outputs and the natural supply and demand for farmland.
Since farmland produces food that people eat regardless of whether there is a recession or not, farmland is uncorrelated to the stock market and one of the best assets to diversify risks.
With LandEx, you can conveniently invest in farmland from €10 onward.
Register on landex.ai and begin your land investment journey today.
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