Debt Cycles part 2. Long term debt cycle

A warning: This text is long and takes a while to read.

The majority of the long-term debt cycle is largely based on changes in interest rates regulated by the central bank, which make the above-mentioned processes work. Most of it is the sum of changes in short debt cycles. They are mainly based on changes in interest rates regulated by central banks, which reflect the willingness of people and businesses to borrow or borrow money. The short debt cycle will be discussed later. At the end of the cycle, the role of interest rate changes diminishes and the focus is on printing money with the central bank's key interest rates close to zero.

At the beginning of a long debt cycle, the parts of the above equation are much smaller than when the debt bubble bursts in the end. The money supply is often tied to fixed assets held by the central bank. In practice, the amount of debt cannot grow significantly faster than the amount of real assets. This affects the right side of the equation, reducing the amounts on that side. The growth rate of money in circulation and debt remain limiting factors as the money supply is linked to the central bank's fixed assets.

At some point, policymakers will be pressured to increase money supply to improve economic development. This is done by breaking the link between the money supply and the fixed assets. In other words, the amount of money is growing faster than before. The central bank can tighten or loosen monetary policy by regulating interest rates and money supply. The latter is rarely a significant factor. This mostly happens at the end of the cycle.

The long-term debt cycle lasts 60-100 years. In the initial phase, debt and consumption are roughly in balance with money and income. The increase in the money supply allows for an increase in debt, which enables increases in consumption and an increase in wealth. The former allows additional liabilities. Creditors provide additional debt as borrowers ’income, cash flows, and collateral values increase. These increase the willingness of creditors to borrow. Development strengthens itself and the economy grows.

The growth phase lasts most of the cycle. It progresses variably according to short debt cycles. Through the key interest rate, central banks regulate the willingness of creditors and debtors to lend or pay the debt. Total debt is slowly increasing. The peak of the cycle is manifested by high debt levels and / or the failure of monetary policy to generate economic growth. One of the signs of the peak is found in the granting of debt, which focuses more on collateral values than on debtors’ income. Interest rates are close to zero or at zero. Debt service costs are higher than the borrowers' ability to borrow. This reduces consumption. Debt ratios are declining. Too many businesses, households and financial institutions are becoming insolvent. They need to reduce consumption which increases unemployment, reduces people's incomes and increases other problems.

Debt problems are often the sum of many stages. First, the expectations of the general public about large cash flows in the distant future arise. Secondly, expectations arise about the increases in value in the near future and the gains they will bring. Thirdly, the wildest paintings of a glorious future emerge, exploiting the general public and eventually generating the outrageous scams that make money for their developers.

The above development is compounded by the fact that the investments are made by over-indebtedness and future cash flows are not sufficient for debt management costs. The differences between expectations and reality are the greatest when the debt bubble bursts. Prior to this, the positive effects of rising asset prices have been visible and not enough people have understood their unsustainability. Before the bubble bursts, there is usually low inflation and a debt-driven boom. The latter seems more of a boom created by high productivity growth and prudent investment than the absurd euphoria which will be revealed later to the general public. Debt payment begins. Economies can do it in four ways:

1. Austerity
2. Debt reduction
3. Increasing the money supply by lowering interest rates to zero, continuing it with the central bank purchases of bonds as interest rates fall to zero
4. Income transfers

The first two reduce income and consumption. All are necessary, although few are desirable. They also produce less unwanted effects and, when going into excesses, more harm than good. Financial discipline is necessary because there is no extra money. Savings need to be made where they have the least impact on long-term economic growth and quality of life. Excessive savings increase problems. Some economic actors must save. They can be either public or private actors. Without saving, there can be no needed investments in the long run. Some of them can be financed with the central bank´s bond purchases, but not all of them. The reason is that the government usually has too much debt.

Debt write-downs take place through insolvency, debt restructuring and forced asset sales. The latter have the greatest negative effects. Debt restructuring reduces creditors' income because at the same time the prices of assets also decrease, which also means the decreased debt collateral. The ratio of debt to asset values and income is increasing as a result. This leads to forced sales of debts as they are diminishing assets of creditors.

Forced sales lead to the sale of other assets and the payment of bank loans, which reduces the rate of money circulation, which accelerates forced sales, which leads to deflation, i.e. an increase in the value of money if the printing of money does not prevent it. At the same time, paying off debts adds to the problem of paying off debts as they increase as the value of money increases. The value of the business decreases, reducing corporate returns, which in turn reduces production and employment and increases bankruptcies. They lead to pessimism and a lack of confidence which lead to hoarding which reduces the speed of money circulation. The negative spiral feeds itself, shrinking the economy if nothing is done about it. During it, it is difficult to produce sensible indebtedness.

The worst thing that can follow from forced sales is a lack of trust between creditors and debtors. This means that no companies or governments can borrow money. Payment transactions cease to operate and society is paralyzed for hours, days or weeks. Nothing can be bought in stores and people depend on others. At the same time, financial markets are likely to close for longer than regular payments. The former do not happen suddenly but e.g. the stock market is likely to have fallen for weeks or months. The situation has been close before. The lack of confidence was caught up in the days or hours of the previous financial crisis. The situation is recognized by the fact that the prices of all asset classes are falling at the same time. It may not last more than hours and offers the opportunity to buy cheaply when the risks are high.

For this situation, I recommend buying quick-to-eat foods first and taking tap water where it is possible for several days or buy large amounts of water from somewhere. You can then follow which direction the investment prices are going. At the same time, it is worth following the news about the decisions of central banks to put money on the market. If it works, the prices of asset classes will start to rise. The length of the situation depends on how faith returns to the markets.

Printing money is a necessary evil so that the financial system does not collapse and there is no depression. It is needed to break the deflationary cycle, but too much printing can produce bad problems. It is not automatically a good or bad thing. As overshoot, it can cause additional amounts of money to be transferred to other currencies, which will increase the prices of imported products. In addition, it can transfer too much money to inflation-hedged investments. It can produce hyperinflation when the value of money falls sharply. Its risk is greatest when the debts are in other currencies and owned by foreigners, but the income of people and businesses are not. Large economies with their own currencies have the lowest risks, but they can also experience hyperinflation.

The end user and uses of printed money mean a lot. Saving the economic system and increasing the growth of economic activity are the main reasons for the pressure on money printing. The end user can be the state, other public actors, companies and citizens. There are many possible uses: investing in tangible and intangible capital such as infrastructure and know-how, maintaining bankrupt companies by buying their loans, buying other assets, direct consumption, savings, etc. The first use is usually to buy loans, without which the economic system becomes too likely to collapse. Economic activity will increase as asset prices rise and the potential for growth-generating investments will increase as the availability of money improves. The rationality of the state and public actors determines the usefulness of the investment.

Ultimately, the question is whether the benefits of printing money outweigh its less desirable effects. In the beginning, it produces the greatest benefits. The more the operation is utilized, the lower the relative benefit. The result is ever-increasing bond purchases. In the end, the situation may be that the disadvantages outweigh the benefits. The relationship between the disadvantages and the benefits of printing money is impossible to determine no matter what central banks or other financial experts say. One common denominator for central bankers deciding on printing is that they have no idea of the undesirable effects of their actions. They are missing from the models they use. The following list tells about possible side effects:

• New massive revaluations of bonds and other asset classes

• Non-functioning price formation in various assets

• The emergence of an interdependence between priting and the financial markets

• Decreased long-term productivity growth

• The growth of zombie-companies and the favoring of large companies at the expense of small ones

• Moral hazard

• Negative side-effect of rewarding fools

• Increased wealth disparities leading to internal conflicts

Money going into government and corporate bonds naturally raises their prices. They can become insane. Market participants buy bonds so that they can sell them to central banks at a higher price. This will raise prices even further. If central banks buy too many bonds, there will be absurd self-sustaining price increases. In the end, prices are so absurd that bonds are mostly bought only by central banks. This means increasing negative real yields on bonds. At the same time, the prices of other asset classes are rising as some of the printed money flows into their prices. Although the intention is to put money into the real economy, the biggest benefits flow elsewhere, to the wealthy.

Excessive monetary pressure means that the prices of bonds are not determined by the market, but the real price makers are in the central banks. It leads to the markets´ dependence on them. They start making their biggest moves depending on how central banks signal the amounts of printed money or bond sales. The latter is a rarer phenomenon, but it happens when central banks believe they have gone too far. The market may crash if this dependency exists. In that case, the catastrophe is ready to happen if the central banks do not stop selling. It might happen anyway.

When most of the money goes to rising asset class prices, the real economy suffers in the long run. There will be no productivity growth because no sensible investment is made and the money goes to other uses. In the worst case, they go into the survival of companies that should go bankrupt. These companies are unable to make investments but keep themselves alive. Maintaining them is the same as peeing on the leg in the winter frost.

Bond purchases favor large companies because small ones are unable to obtain financing by selling bonds. They finance their growth either with the owner’s assets or with bank loans. Smaller companies are better able to adapt to change, but the benefits to the overall economy diminish when purchases favor the large companies. Few of them are as productive as more efficient small businesses paying more for their loans.

Printing money rewards the wrong kind of risk-taking because fools who buy too expensive assets don’t suffer so easily from their mistakes. They get the reward even if they make mistakes paid for by others. In this case, the others are taxpayers who receive the invoice e.g. as rising costs of living. At the same time, executives who have used the cash flows of their companies either for excessive dividends or to buy their own shares are rewarded. When companies are bankrupt because of these acts, the purchase of bonds in cash will save them. At the same time, company executives will be able to increase their share-based bonuses.

Wealth disparities will increase if money is not distributed to citizens. The printed money is then mostly transferred to the prices of the assets, which can cause internal conflicts. The feeling of injustice is growing, although the majority of the population does not understand why wealth disparities are growing. Printing enriches the already rich more than the ordinary people. The latter relieve their pain through violence or hatred towards the former. If the situation persists, politicians may begin to feel tempted to distribute money directly to citizens. This is one sign that indebtedness is escaping central bank control. As an isolated case, the situation is not bad, but the transition to a continuous distribution of money will destroy the currency.

When citizens receive free money, they can put it for consumption, investment, debt repayment or savings. The desired destination for money is private consumption. In this case, some of the money is forced to be saved because it is the result of a bad economic situation. There is little to reserve for extra consumption. Where the money mostly goes depends on the needs and wants of a large section of the population. Different nations can consume, save, and invest in different ways. In the United States, money is more likely to go to investment than, for example, in Europe. This, too, produces undesirable effects, as unemployment can be a prerequisite for access to money. Not everyone wants to go to work because they can get almost the same money for free. Again, an excessive distribution of money does not make sense.

Over-indebtedness generates deficits in the economies and smaller public actors, regardless of whether money is printed. It can also produce currency escape. Capital can look for better returns abroad. The state can create mechanisms to reduce it. One way may be to restrict or prohibit the transfer of currency by imposing high taxes on currency transfers. Smart money always finds a way to circumvent these restrictions. On the other hand, ordinary citizens cannot do it. This increases wealth disparities and tensions between the rich and the poor.

Tax increases are one way to raise more money for the administration to distribute. They are less popular with the public than printing money because they are better understood. The lower amount transferred from salary to personal account is a signal of higher taxes. The same applies to the taxation of consumption. It is easy to read the tax rate on trade receipts. The same is true when higher taxes are passed on to product prices. If the withdrawals are large, they will lead to tax planning for large capital. Ordinary citizens cannot do it as effectively. People can move out of the country or move to places with lower tax rates. The latter applies to countries that do not have common national taxes. There are numerous tools for tax planning, but the former are perhaps the most important.

Debt Cycles part 1. Introduction and Short term cycle

 Debt is, at its simplest, a promise to repay a sum of money borrowed later. It may involve interest and other debt service charges. Payment of interest usually means an extra portion of the amount borrowed that is payable over a period of time. The creditor wants the interest rate to be higher than the cost of borrowing and the rate of inflation. It wants the value of the money to be depreciated in excess of the total amount of money repaid and interest over the loan period. In other words, real returns must be positive. A sensible debtor wants a used debt to bring a positive real return. Sometimes it makes sense to take on debt with a negative real return to avoid complete economic collapse. In other words, the debtor buys time to get his finances in order.

The debtor becomes insolvent if he is unable to pay the debt. To do this, he has to provide collateral. The creditor must make a probability assessment of how well the debtor can pay his money back, either directly from the debtor or by redeeming the collateral. The more uncertain the repayment and the lower the security, the higher the interest the debtor will have to pay. This happens when the creditor understands the situation of the debtor. At the peak of debt cycles, creditors’ lack of understanding of debtors’ ability to repay is at its greatest.

The best understanding of the role of debt in the economy is obtained by looking at remittances in the big picture of the economy. In the following equation, the sources of money are on the left and the uses are on the right:

Money + Liabilities + Income = Consumption + Assets + Savings

The equation is bidirectional. For example, consumption is the income of the counterparty. Some of the increased money supply from the left side can be consumed, some can be used to buy assets or put into savings. When the central bank tightens its monetary policy and interest rates rise, debt is often reduced. This reduces consumption and / or the purchase of assets which reduces revenue. The opposite phenomenon occurs when the interest rate decreases. It will increase the amount of debt which is likely to increase consumption which will increase revenue. Both are self-reinforcing series of events. By looking at the varying amounts of the parts of the equation, you can see how the debt cycles are progressing.

Short debt cycle

Short debt cycles normally last 3-8 years. The length depends on the previous cycle and some other factors like changes in central banks´ interest rate policies. The further it progresses and / or or the deeper the economy goes down the longer the next one will last. What I mean is how much excesses people, companies and central banks have made. The worse the over-indebtedness, the longer the damage will be repaired. The short debt cycle is also called the general economic cycle. As I mentioned earlier, central banks regulate short debt cycles mostly by either tightening or loosening monetary policy. This is mostly done by raising or lowering interest rates. Exceptions arise mainly from the bursting of a debt bubble at the end of the long debt cycle.

Short debt cycles can be divided into four parts: growth, peak, decline and recession. Growth starts at the beginning. Interest rates are low and borrowing is easier. Demand for interest-sensitive products such as housing and cars is growing first. Growth is initially rapid. Unemployment is falling and the average working week is lengthening through rising demand and output growth. Inflation remains low despite debt increases and economic growth. The best investment targets can be found in equities. The situation for commodities and inflation-hedges is deteriorating. Later, economic growth will slow temporarily. Inflation will remain low, interest rates will fall and stock prices will calm down. The decline in the prices of commodities and inflation-protecting assets is slowing down.

At the end of the growth, the pace accelerates. Wages are rising faster and production capacity is coming back. Inflation is accelerating, consumption is peaking and interest rates are rising. Equities make their last rise in the cycle before falling, and inflation-hedged investments perform best. The peak is coming because the economy has overheated. The latter will lead to tightening of the central bank's monetary policy. Liquidity is declining and interest rates are rising. Economic growth is starting to decline. The amount of money is shrinking and the growth rate of debt is declining. The stock market will start to decline before economic growth goes into the red. Eventually the recession will hit.

Economies are in recession on average 10-12% of the time. During them, economic growth will average -3%. At the beginning of the recession, the economy is shrinking. At the same time, the prices of shares and inflation-hedged investments are falling. The central bank is not loosening its monetary policy and inflation is falling. In the end, the central bank fears recession and deflation, so it loosens its monetary policy. Interest rates fall and stocks rise. Commodity prices are low, as are inflation-hedged investments. With low interest rates and rising stock prices, we are moving from a recession to the beginning of a new cycle.

The operation of short cycles depends much more on external factors such as major natural disasters like pandemics and wars. The latter are wars between great powers and neighboring states. Less often, export bans like OPEC`s regulation of oil production have effects on cycles. Utilizing short debt cycles in investing requires skill which most of us do not have. I cannot recommend anyone to take advantage of them. It is easier to understand longer cycles.

One of the best signs of a recession is the shift of the yield curve to negative. It refers to a situation where the interest rates on longer government bonds are lower than those on their short-term bonds. This usually occurs about 12 to 18 months before the recession. The exact timing of interest rates does not tell the future recession. This indicator is not easy for an investor to take advantage of. It may be used as a signal to increase cash position for future investments. It can be seen as an indication that the leverage should not be increased. Stock prices can also predict a future recession 6-12 months before that, but they are a more uncertain indicator. They can be used more to invest in other asset classes.

Recessions are poorly predicted. This is true for both amateurs and professionals. The latter manages to predict a recession when it is underway. According to an IMF research paper, between 1992 and 2014, economists out of 153 recessions in 63 different countries managed to predict only 5 in April of the previous year. Instead, in October of the recession, economists correctly predicted 118 times out of 153 recessions. It can be said that economists ’predictions of a recession are not worth reading or listening to.

World leading economy cycle part 3 Dropping from the top and brief overview of the whole cycle

 Reaching the peak probably includes a double-digit number of short debt cycles and usually at least one long debt cycle. I will discuss the peak and fall in more detail later, in a long debt cycle. The road to the top leads to the sowing of the seeds of the fall. Prosperous times increase people’s incomes which makes the cost of labor more expensive. The competitiveness of labor is declining. The smartest, disadvantaged nations know how to select the ways that work best for them from the ways produced by the top nation, which further reduces its competitiveness. Copying is easier and faster than developing anything new which improves their competitiveness at a lower cost.

Newer generations will replace those who have raised the nation to the top of the world. They are accustomed to wealth without as much effort as previous generations. They have not experienced time without wealth. They demand more of their free time which reduces work ethic. More money and less work will lower the nation’s productivity compared to its competitors. If it lasts long enough, the country's relative situation will deteriorate too much.

The reserve currency position of a leading economic country allows for a high debt burden. Consumption and borrowing capacities are growing first, leading management and citizens to believe in a strong economy. The country is growing its army and fighting to maintain its leading position in the world more than is necessary. In the end, the former consumes more government resources than brings benefits. At the same time, citizens are spending more on borrowed money. The former will improve the chances of the country and its citizens to borrow abroad as the reserve currency strengthens. They increase wealth disparities. Citizens' ability to cooperate deteriorates as the wealthy safeguards its interests at the expense of others.

The decline begins as the peak surpluses turn into declines and the interests of the rival nation strengthen. The central bank’s ability to increase debt and economic growth will be lost and at the same time the nation is hit by a recession or depression. This leads to the printing of money which leads to an excessive depreciation of the reserve currency. The relative position of the poor is deteriorating more than the prosperous, increasing the popularity of political extremism. The former require the latter to take action to reduce wealth disparities, i.e. they want income transfers by raising taxes. The wealthiest transfer their wealth to safety with a lower tax rate, which further weakens the position of the poor.

These factors reduce productivity and the wealth distribution is reduced. In the worst case, the result is totalitarianism like Hitler's Germany. At the same time, a rival nation can challenge a leading economic country, which increases the potential for military conflict, which in turn increases the number one country’s spending that it cannot afford. It has to choose between either military conflict or avoiding it. The decline is further in the long debt cycle.

Brief description of the progress of the cycle

The cycle of a leading economic country follows the same formula. It begins with a new world order and ends with the birth of a new one. In the beginning, the leading economic country will determine the creation of new rules. It has the most power. Now such actors are e.g. The IMF and the World Bank. In the end, power is gone. The next leader contributes to the renewal of the rules or orders the creation of new ones. If a new world order emerges through military conflict, then the most likely new leader is its winner.

The economic situation of the leading country is the best at the beginning of the new world order. The country probably doesn’t have much debt. The debts of others to it are much greater. In the coming decades, the country will prosper. It develops as short-term debt cycles fluctuate, so does the economic growth. During fluctuations, economic agents become slightly more indebted on average until a large-scale debt bubble is created, for which the country's main economic operator, usually the central bank, will have to lower interest rates to zero. At the same time, it will have to grow its money supply, otherwise it would result in massive bankruptcies and / or long-term deflation. Excessive monetary pressure leads to hyperinflation and / or other economic catastrophe. A suitable amount of printing is difficult to accomplish in the long run.

Debt bubble management tends to weaken the financial position of taxpayers in relative terms the most because they have been used by the smart money. The latter usually has so much power that it does not have to pay as high a price as it should. Taxpayers become bitter towards the rich which adds to internal contradictions. The bitterness is also compounded by the fact that money supply is increased until its benefits to the national economy go to zero. The purchasing power of the people is declining as the prices of various asset classes rise despite non-existent economic growth. At the same time, income disparities are widening.

Too much bitterness can lead to the division of the people which can lead to a civil war. Another option is for the people to find a common enemy and fight against it. Whatever the conflict, it will eventually lead to debt restructuring and a renewal of the political system. After these, a new world order is born. Although the above-mentioned course of events present themselves mainly as separate events, many take place at the same time as possible wars and political reorganizations.

World leading economy cycle part 2. Reserve currency

 Although the reserve currency is the most important and easiest indicator of a leading economic country, it is one of the laggard indicators. Currencies act as a medium of exchange. Reserve currencies are the largest single components of the world's central banks and other financial institutions in their reserves and the most important individual trading instruments. Now the US dollar is the most important. It accounts for about 60% of the reserve currencies. The second most important reserve currency is the euro, which accounts for about 20%. Others come far behind in single-digit positions. If you count gold as your reserve currency then it is the third most important. The position of the dollar as the main reserve currency is the result of World War II and subsequent international agreements.

There are three requirements for a reserve currency: it must retain its value in the eyes of the people, it must be an accepted trading currency around the world, and it must be accepted by governments, central banks and other financial institutions. Currencies retain their value better as central banks retain them as additional reserves. There should be enough, but not too much, reserve currency in circulation. Its position may be lost if the latter occurs. Mainly a large-scale war or a failed repair of the destruction of a long debt cycle can lead to the loss of the position.

The values of the trading currencies must not fluctuate excessively as they move between the parties. The less the value of a currency fluctuates, the more suitable it is for trading. A currency is only suitable for trading if its value is believed by both parties to the trade. Large fluctuations erode credibility. When credibility is lost, the currency is mainly suitable for wiping the back if it does not have real estate in the back. Confidence can be lost without a warning or little by little. Large fluctuations occur when there is not enough currency in the market.

Regulatory approval is required. This means, among other things, that it is up to the central banks to increase and decrease the money supply. It means that the reserve currency acts as an instrument of power for the authorities that govern it. Therefore, Bitcoin or any other privately managed virtual currency will never achieve reserve currency status. This will never be said out loud by any central bank or government. Cryptocurrencies will be banned if they threaten the status of the former. The reason given is something else such as use as an instrument of crime or environmental damage. The increase in the market share of virtual currencies will lead to bans.

The world's largest economic power is practically always found in the country that dominates the most popular reserve currency. For example, the United States may choose to exclude any actor that uses their dollars in trade. In addition, the country has the most decision-making power, e.g. At the World Bank and the IMF. The reserve currency cycle usually has three stages:

1. Extensive agreement on new reserve currency + coupling to real assets like gold
2. Decoupling and switching to a free currency
3. Depreciation compared to the new reserve currency

The change in the reserve currency requires a global crisis or a massive debt crisis in the country administering it. They may cause the value of the reserve currency to collapse. In most cases, this has been the first situation. In most cases, it requires a massive debt crisis. The global crisis is almost always a major military conflict. It does not always mean a loss of reserve currency. In a war, the ruler of the previous reserve currency goes into war with another major country, causing the new ruling country to become the most powerful country in the world. An agreement on a new reserve currency often allows for the largest share of votes in global economic organizations. For example, the United States has the largest share of votes in the IMF.

An agreement often initially involves tying money to real assets, such as precious metals. A certain amount of money equals a certain amount of them. Money may not be in circulation more than an equivalent amount of precious metal. In the first phase of the current cycle, one ounce of gold was equivalent to 35 US dollars. The good thing about the arrangement was that it was harder to produce inflation because it was difficult to increase the amount of gold and thus the amount of money. The downside, again, was that the amount of gold could not be increased enough compared to the growth rate of working-age people. In other words, more people entered the market than money. The solution is problematic in the long run and may limit economic growth.

The previous solution lacks sufficient flexibility in terms of the value of the currency. Before long, the state managing the reserve currency will move to the second stage, i.e. scrap the link to real assets. The United States did so in 1971. This increases long-term inflation and may cause short-term inflation to accelerate. In addition, the price of real estate pegged to the reserve currency will increase because the price used for pegging is likely to lag behind its real value. Stock prices will also rise, at least in the long run, as the amount of money grows even faster and some of it is transferred to shares.

Inflation rose in the 1970s, but that was not the only reason for it. It was also affected by OPEC's actions. The money supply is based on a decision by a central bank or other financial authority to print the amount it deems necessary for the reserve currency. The price elasticity of the reserve currency is increasing. This is the best way to act in theory. It works for a long time, but not indefinitely. It's easy to go too far. In the end, the result is the loss of reserve currency status.

World leading economy cycle part 1. Rise to the top

A leading economic country dictates the basic rules of the world economy. Others have to follow them if they want to cooperate with it. They are more likely to run into financial difficulties if they try to deviate from the rules it creates. They can also ensure that weaker economies do not catch the lead. The United States has been acting ruthlessly for a long time. The same is expected from the nation that dictates the rules next time. The cycle includes three phases: rising to the top, staying there, and falling. Operating at peak includes a reserve currency cycle. The leading country changes after the country has gone through the cycle. This is as natural an event as the rain in England. The duration with its stages is about a century. The rise and peak are slow, but the decline is fast compared to them.

The more economically developed a state is, the more it is hoping weaker states will follow the rules of the market economy. This means that more developed countries should make sure that weaker countries do not exploit practices that are unfavorable to them. This is especially true for the biggest competitors. The closer the countries are in the development cycle, the more this matters. The United States should not care about Bangladesh, but China is another matter.

The leading economy is in many ways the leader of the world economy. It has the largest share of world trade, is the most competitive, controls the main financial center, is a leading technology developer and industrial country, has the best education, a reserve currency, and has such a strong military power that it cannot be shaken by war. It is also likely to be a ruthless economic actor that will discipline other countries, if necessary militarily, if they threaten its interests.

Rise to the top

There are several roads to the top, but together they are the most efficient way to get there. Wealth can be created by harnessing domestic intellectual capital to develop the products and services that others want. It can be created by finding natural resources within its borders that can be resold to other nations at a higher price than the cost of exploiting them. In addition, there is a third way.

Imagine a country where tariffs on industrial products have averaged 40 to 55 percent for decades, the majority of the population is not allowed to vote, votes are bought, elections are cheated, and the government does not hire workers without the permission of those who bought the votes. In addition, the state economy is on the edge, the country has gone bankrupt and foreign investors are being discriminated against, especially in the banking sector, and shareholders cannot vote if they are not citizens of the country. It also has no competition law. It allows cartels and monopolies and does not care about foreigners' intellectual rights. What is this country? The answer is the United States in the late 19th century.

Lie, steal, and cheat. These three commandments of striving for the position of a ruling state in the world economy run counter to those who believe in Western values ​​and the rules of the game in a market economy. These are often necessities for those aspiring to become dominant economies. The three commandments have also been China’s means as it strives to become a leading economy. Warfare requires a bit of explanation because people perceive it mainly as a military conflict. In this context, it means e.g. a currency war, one way of which is to manipulate the exchange rate to create. In addition, it means protectionism, etc.

Getting to the top doesn’t just mean breaking the rules. It means improving the factors that are important for the economy at home. The journey to the top requires e.g. a large workload, a people whose vast majority adhere to common rules of the game, cooperation between citizens and government, high-quality education, finding new ideas from abroad, importing top foreign professionals when needed and investing heavily in the necessary infrastructure and high quality of leadership.

The above will lead to a prudent investment of capital, high productivity and the creation and the use of new competitive technologies. These will increase the country’s share of world trade which will require a strong army so that trade is not jeopardized. The above factors attract large amounts of foreign capital, which reaches the country's stock markets, foreign exchange and credit markets. Eventually, they will become more attractive than in other countries, so in the end, the reserve currency will also be held by a leading economic country. The reserve currency has its cycles.

National economic development cycle and investors

The significance of the economic cycle for the investor depends on few things. Index investors are in a particular need to understand that in addition to price. The stage and direction of the development cycle tell about the potential for long-term returns. The duration of the phases can be decades or centuries. In such a long run, the investor is often dead. The nation´s internal direction of the phase indicates about the return opportunities. A downward-going state is rarely able to change direction before moving on to the next development phase. Changes in direction require radical changes in social systems and citizens' thought patterns. Here are some examples of my estimates for countries at different stages of development:

1. Ethiopia, South Africa, Bangladesh, India, Ukraine, Bulgaria, Brazil, Bolivia, Cuba
2. Malta, Czech Republic, Slovenia, Cyprus, Puerto Rico, China mostly
3. Luxembourg, Singapore, Switzerland, Norway, Denmark, the Netherlands, Sweden, Canada, Germany, Australia, major cities on and around the east coast of China
4. United States
5. Portugal, Japan, Spain, Italy, Finland, Belgium, France, United Kingdom

My thought process was not entirely clear in which category any country should be placed. Instead, the direction of development was easier to notice. It is clear that many impoverished countries that are clearly going downhill have been rich, but whether they are impoverished or still rich is more difficult to assess. Such countries, I think, include at least Japan, Britain, Finland, and France. It is clear that the direction is downwards. The location of the countries in the second phase can also be difficult to see. As an outsider, it’s hard to see if people really feel poor. China is a difficult country to evaluate because the countryside is poor, but big cities are more prosperous. The United States is an exception because of its reserve currency status. It will allow it to become more indebted than other countries without moving to the fifth stage.

The importance of a direction to stock index investors often depends on the state. For example, the direction in Finland is downwards, but most of the large companies on the Helsinki Stock Exchange are export companies, whose results and turnover mostly come from elsewhere. The same does not apply to all other countries, such as the United States and all its indices. The Russell 2000 Small Business Index is more dependent on the direction of the state. Equity investments, mainly in companies operating in the internal market, are subject to the same rules as for equity index funds.

One of the main factors behind the change in direction is the taxation of investors. A downward trend often means tightening taxation and an upward trend. Investors in export-dependent countries need to monitor tax developments. Bond investors also need to understand where countries are and in what direction they are going. On average, the debt of improving countries is falling and that of backward moving countries is rising. Debt securities of a leading economic country are generally considered to be the best asset hedges. Their attractiveness only diminishes when the position begins to look precarious. It may then be too late to respond to maintain status.

National economic development cycle and its stages

 First stage

In the first stage of the national economy, states are poor and citizens consider themselves poor. Many countries have not escaped this stage. The average income is poor and the standard of living is not soaring. People live hand to mouth and don’t waste their money. They have to spend a lot of time getting food and clean water. They have small savings and no one will lend them money unless international organizations do so. Everyone capable of leaving moves for more prosperous places. Citizens receive support from abroad. Birth rates are high. Average life expectancy is low. Corruption is a major reason why countries are not rising. Often countries are dictatorships.

For those countries, location and culture are of great importance. Significant natural resources facilitate opportunities to move forward. It will also be easier for those on the side of richer countries to move forward if they do not have to wage war against their neighbors. Belief in work, opportunities for better conditions in the home country and one's own development facilitate the development of people and the country. People are slowly earning more money than living from hand to mouth. They do so to improve their chances of surviving in the future and do not consume everything because they are worried about their financial future.

The low cost of labor enables countries to develop. Low birth rates ​​are common denominators. The number of employees in relation to the use of machinery is poor. The textile industry and similar labor-intensive industries deliver the best export products. Industry is taking advantage of obsolete machines in richer countries, whose productivity is nowhere near the level of the new ones. Focusing on price competition, usually foreign companies, operate in these countries due to low costs. They consider the risks to be the highest and want a high return on their investment. In general, countries also generate high returns. Old machines and other crap is being exported to countries that richer countries want to get rid of, such as decades-old vans.

Currencies are weak and nations do not have decent capital markets. The real values ​​of the currencies can be found on the black market and it is not worth relying on the official exchange rate. There are a few companies on the stock exchanges and there is no reliability on the financial statements. Foreign investors may be weak in disputes. Citizens who save money either invest in their own businesses or in real estate such as real estate. They believe their money is better safe than stocks or bonds. Countries are only suitable for a few investors.

Second stage

In the second stage, the state is rich, but the citizens feel poor. The behavior is not significantly different from the first stage, but the basic living conditions are better. There is less corruption, people are freer and dictators do not control the lives of citizens as much. Birth rates are higher. Food is easier to buy and clean water requires less energy and life expectancy is higher.

In this phase, personal savings and investment are growing rapidly. People have more money left to save and invest, which can be seen in e.g. on stock exchanges. The number and quality of machines to help with the work is significantly higher than in the first stage. People are motivated employees and work long hours. Exchange rates are often pegged to the reserve currency or to fixed assets such as gold. The economies of the countries are export-driven. They invest efficiently in industrial production. Competitiveness is high because wages are low and exchange rates are deliberately kept too low. Productivity growth will be rapid and debt will not increase too much relative to income.

Supply of many products in these countries is growing more slowly than demand, which is accelerating inflation. Nominal interest rates are not as high as inflation due to currency pegs. Everything is reflected in excessive investment and a balance of payments surplus. Eventually, states will have to switch to their own monetary policy. At the same time, capital markets are becoming more attractive. Private sector borrowing will begin and investors from both home and abroad will participate in the investment. New cities are growing, savings rates are high as revenues rise and foreign exchange reserves are growing.

These economies can be gold mines for the investor. Many of them are progressing to the third stage. It means decades of economic growth. According to Jim Rogers, one important milestone for the country is cutting the currency peg. It tells of the country doing well on its own. The market economy is working well enough. Bureaucracy should be minimal for the investor and adequate liquidity is mandatory. This may limit investments in major listed companies or indices.

Third stage

The third stage is the most prosperous for most nations. State is rich and citizens are rich, both in their own minds and in reality. Productivity growth is at its peak as citizens, businesses and governments invest in products and product development. Enjoying the fruits of work is the prevailing psychological state of affairs as citizens move into it from work and preparing for the worst of times. New generations have not experienced difficult times, so they do not understand the importance of saving and investing. Statistics show that this is reflected in reduced working hours and an increase in demand for luxury goods and services. They also put more money into necessities.

States are moving from net exporters to net importers. Foreign products are cheap compared to domestic ones, and especially cheap ones are imported. The investments of domestic industrial companies is growing in cheaper countries and it is moving away more and faster. Third stage countries and stock exchanges are seen as safe alternatives, which increases speculation in the financial markets by using leverage. The majority of the nations in this phase increase their military performance to advance their interests in the world. Few achieve the status of a dominant economic country. The rest will soon begin to decline and move on to the fifth stage.

Fourth stage

The fourth stage is for the country to become a leading economic nation. Only a few and selected countries do this. The fourth stage country has a reserve currency and its bonds are the best safe haven until the country moves to the next stage. In practice, a country does not have to be the richest, but its economy needs to be big enough to function as a ruling state. The phase lasts for about a lifetime. When a country acts as a holder of a reserve currency, it is a safe investment. However, the prices of assets cannot be forgotten.

Fifth stage

In the fifth stage, countries become impoverished, but citizens feel rich. The delusions of the latter are due to over-indebtedness, as incomes grow slower than debt. The limits of indebtedness are being met and must be reduced. The ultimate reason for this is that there are too few citizens who remember poor periods and the majority have not had to worry about the adequacy of money. Prices are rising when wages and consumption are too high. Savings rates are falling and leverage is rising. Real wealth is deteriorating, even though people think it is growing. Productivity growth will slow as investment in product development, infrastructure and capital-intensive products declines. Competitiveness is deteriorating and deficits are growing. Some countries in the phase are also investing in warfare to protect their own interests.

Economic booms and busts are more common in the final years of a phase because people live in the success of the past and believe the future will match it. The reality is hard to accept. With revenue growth and investment returns lower than debt service costs, the booms will be effectively wiped out. The losses brought about by the collapses are accelerating the downturn. The value of the currency depreciates, destroying the ability to pay debts. Finally, the countries will lose their status at the end of the phase.

The debt burden and the downturn of the nation are facts. Debt repayment is causing a negative self-reinforcing trend in which private sector consumption and wealth are declining. Government debt and deficit are rising. They are paid with central bank money printing, which lowers real interest rates. At the same time, the currency is weakening. Nominal GDP is growing faster than nominal interest rates. This is done to reduce the pain of paying off debt. Investment returns are low due to weak currency and deteriorating economic conditions. States start to compete against weaker nations. The superpower positions are disappearing from countries that were once successful economies. The likelihood of totalitarianism increases when citizens find themselves impoverished.