Economics & Crypto: Why Traditional Finance Knowledge is Essential for Your Investments

"It's the economy, stupid!" That's a famous line from James Carville during the 1992 Presidential campaign. And in today's age of crypto, understanding the economy has never been more crucial. In this series, we will start with the basics of what an economy is, then look at how the US economy has evolved over the last decade, where we are today, and finally, where we are going.

Some of this will be review for most of you, but I feel it's always helpful for any investor to have a refresher on economic basics, which helps us understand what’s going on in today’s economy, which gives us the alpha for successful investing. Let's dive in.

My Journey into the Depths of Crypto and Traditional Finance

My Dad was a banker, so I grew up around financial terms, but I was the family's black sheep and wanted nothing to do with banking and finance. I graduated with a degree in psychology but pursued a career in tech. I spent most of my life with just enough financial knowledge to put some of my paychecks into the company 401k but not enough knowledge to understand that I should have put in way more than I did in those early days. If I had, I'd be pretty set for retirement, so I got so enamored with crypto.

Like most budding crypto enthusiasts, I first dabbled in Bitcoin, dreaming of the big returns. But as time revealed, crypto behaves just like any other market – influenced by economic factors and vulnerable to the age-old patterns of booms and busts. To truly master the crypto space, I realized a comprehensive understanding of traditional finance and economics was essential.

Back to Basics: An Economic Primer

Most of this primer is a synopsis of Ray Dalio's The Changing World Order and Principles For Navigating Big Debt Crises.

The Essence of an Economy: An economy is the sum of all transactions - where a buyer and seller exchange money or credit for goods and services. Ray Dalio simplifies the economy's workings into three primary forces:

• Productivity Growth

• The short-term debt cycle

• The long-term debt cycle.

Transactions, Credit, and Markets: All transactions boil down to buyers and sellers in a market. If we view the entire economy as a 'market’, then adding up the spending in all these markets gives us an insight into its health. In this vast landscape, the government controls money and credit flow, particularly the central bank. It does this by influencing interest rates and printing new money.

It's essential to differentiate between money and credit: while money settles a transaction, credit is essentially a promise to repay, and it is credit that plays the biggest role in an economy as it creates immense wealth but also financial bubbles.

Productivity Growth

As buyers and sellers go to the markets to make transactions, so do lenders and borrowers. Lenders want to turn their money into more money, and borrowers want to buy something they can't afford, like a house or a car. Or borrowers want to invest in something like a business. Credit can help both parties get what they want. Borrowers promise to repay the amount they borrow, called principle, plus an additional amount called interest. When interest rates are high, there is less borrowing because it's expensive. When interest rates are low, borrowing increases because it's cheaper. When borrowers promise to repay, lenders believe them, credit is created.

But credit is tricky because it has different names. As soon as credit is created, it immediately turns into debt. Debt is both an asset to the lender and a liability to the borrower. In the future, when the borrower repays the loan plus the interest, the asset and the liability disappear, and the transaction is settled. So why is credit so important? Because when the borrower receives credit, they can increase spending. And remember, spending is what drives the economy. This is because one person's spending is another person’s income.

When someone's income rises, lenders are more willing to lend them money because they are now more creditworthy. A credit-worthy borrower has two things. The ability to repay and collateral. Having a lot of income in relation to their debt gives them the ability to repay. If they can't repay, they have valuable assets to use as collateral that can be sold. This makes lenders feel comfortable lending money.

So increased income allows increased borrowing, which allows increased spending. And since one person’s spending is another person’s income, this increases borrowing. This self-reinforcing pattern leads to economic growth and is why we have cycles.

The Short-Term Debt Cycle

Economic expansion is often buoyed by credit. As spending rises, so does inflation. Central banks might hike interest rates to combat excessive inflation, making borrowing expensive and triggering reduced spending. This cycle of expansion and contraction, driven primarily by the central bank's policies, recurs roughly every five to eight years.

For example, you earn $100,000 a year and have no debt. You are credit-worthy enough to borrow $10,000, let's say, on a credit card. This allows you to spend $110,000 even though you only earn $100,000. Since your spending is another person’s income, someone earns $110,000. Now that person earning $110,000 with no debt can borrow $11,000 to spend $121,000, even though they only earn $110,000. This is the self-reinforcing pattern. But remember borrowing creates cycles, and if the cycle goes up, it will eventually come down. And this leads us into the short-term debt cycle.

The Short-Term Debt Cycle & Inflation

As economic activity increases, we see expansion, the first phase of the short-term debt cycle. Spending continues to increase, and prices rise because the increase in spending is fueled by credit which can be created instantly out of thin air. Prices rise when incomes grow faster than the production of goods and services. When prices rise, we call this inflation.

The central bank doesn't want too much inflation because it causes economic problems and raises interest rates. With higher interest rates, fewer people can borrow money, and the cost of existing debts rises. This would be seen as monthly mortgage and credit card payments going up. Because people borrow less and have higher debt repayments, they have less money to spend. And since one person's spending is another person's income, incomes drop, and so on. When people spend less, prices decrease, and we call this deflation.

Economic activity decreases, and the economy moves into a recession. If the recession becomes too severe and it looks like we might drift into a depression and inflation is no longer a problem, the central bank will lower interest rates, and everything will pick up again, and we will see an expansion. As you can see, this all works like a machine controlled by the central bank. As mentioned, this short-term debt cycle typically lasts five to eight years and repeatedly happens for decades.

But notice that each cycle's bottom and top finish with more growth than the previous cycle and more debt. This eventually leads us into the long-term debt cycle, which we will cover in the next newsletter.

Why Does All This Matter for a Crypto Investor?

Understanding the economy's fundamentals is paramount for anyone investing in crypto. Why? Because crypto, while a unique asset class, doesn't exist in a vacuum. It's influenced by the broader economic forces at play. With a solid grasp of economics, you can better navigate the turbulent waters of the crypto market.

Next time we'll finish the economic cycle with the long-term debt cycle and look at how the US economy has evolved over the last decade.

Till our next economic exploration, invest wisely!

J. Scott

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