Why the economy operates on credit ( and how it destabilizes )

The market economy operates on a simple principle: credit fuels growth, and growth generates more credit. But what happens when this engine overheats?

The three pillars of a market economy

Any market economy is built on three sectors that operate in tandem:

Primary sector extracts resources – wood, gold, agricultural products. Secondary sector processes and transforms them into finished products. Tertiary sector provides services – distribution, marketing, consulting.

Every day, we all participate in this movement: we buy (consumers), we sell (producers), we work (labor), we invest (creditors). The market economy could not function without this constant dynamic.

But how do we measure the health of such a complex system? Through GDP – Gross Domestic Product. This index calculates the total value of goods and services produced in a country over a given period. An increase in GDP signifies expansion; a decrease indicates contraction.

Credit: the lubricant of the market economy

Here is the scenario: you have money that you are not using. Someone else wants to start a business but does not have the funds available. You offer to lend them $100,000 on the condition that they pay you an additional fee – interest.

This is the essence of credit. Creditors ( and debtors ) the other party ( create a contractual relationship. The debtor gets money now and promises to pay it back later with interest. In return, the creditor generates income from nothing.

Commercial banks are the intermediaries in this equation. They collect deposits from people and lend them to borrowers. The fractional reserve system allows a bank to lend more than it has available – essentially, it creates money out of thin air. And this works day in and day out, until everyone wants their money back at the same time, generating a bank run.

How Short-Term Credit Cycle Works

Imagine a market economy with easy access to credit:

Step 1: People and companies are borrowing massively. Expenditures are increasing exponentially.

Stage 2: More money in circulation = more people have incomes. Banks are offering even more credit, as borrowers appear solvent.

Stage 3: Revenues are growing faster than productivity. The economy is overheating.

But here comes the problem: you cannot spend more than you produce indefinitely. Goods become scarce, but demand explodes. Prices rise – this is inflation.

When inflation gets out of control, the central bank comes into play. Institutions like the American Federal Reserve or the European Central Bank raise the interest rate. A higher interest rate means that loans become expensive. People think twice before taking out a loan. Spending decreases. Prices should fall.

The problem is that sometimes they drop too much, and we end up with deflation – the general decline in prices. A deflationary economy is dangerous: no one spends )waiting for lower prices(, companies don’t make sales, employees are laid off. Recession comes.

The solution: the central bank reduces the interest rate, making loans cheap again. People feel encouraged to spend. The cycle starts again.

This oscillation repeats every 5-8 years – what Ray Dalio calls the short-term debt cycle.

Long-term debt cycle: when the system destabilizes

But what happens after years, after decades? Each short cycle leaves behind more unpaid credit. Debts accumulate.

At some point, debt becomes unmanageable. People and companies think: I need to cut my expenses and pay off my debts. Deleveraging )deleveraging( begins. Millions of people are selling assets simultaneously to raise cash. Stock markets crash, because the supply of assets is enormous and demand falls.

Now, the central bank wants to lower the interest rate again, but it can't - it is already at 0%. What does it do then?

Print money. The central bank creates money out of nothing and injects it into the economy. The government uses it to stimulate the economy – and it seems to work in the short term.

But the problem? Creating money out of nothing increases the money supply. We have the same amount of goods, but more money chasing them. Suddenly, there are fewer of them. Inflation accelerates.

In extreme cases – when governments print money uncontrollably – we reach hyperinflation: inflation goes so fast that it destroys the value of the currency. The Weimar Republic in 1920, Zimbabwe in 2008, Venezuela in 2018 – all faced this disaster.

The long-term debt cycle takes place once every 50-75 years. It is much more devastating than short cycles.

What keeps market economies in balance?

The answer is: interest rate. This is the main lever of central banks to control economic behavior.

High interest rate → people save, not spend. Investments decrease. The economy contracts.

Low interest rate → people spend, borrow. Investments increase. The economy expands.

The central bank must balance between expansion ) too much credit leads to inflation ( and contraction ) too little credit leads to recession (. The difficulty lies in the fact that the effects are delayed and unpredictable. Therefore, monetary policy is more of an art than a science.

Conclusions: the market economy as a perpetual machine

The market economy is not chaotic – it follows repetitive patterns. Credit fuels growth. Growth creates more credit. Debts accumulate. At some point, the system becomes unbalanced, and central institutions must intervene.

Understanding these mechanisms will not make you rich, but it will help you understand why financial crises occur, why central banks make certain moves, and how the market economy self-corrects )sometimes painfully, sometimes unsustainably(.

The economic car is colossal, but if you look closely, it is not mysterious – it is just a game of credit, debt, and the hope that the next generation will be able to pay the bill.