By Monish Chhabra ǀ February 21, 2019

One simple way to think about an economy is the interplay between lenders and borrowers.

Lenders have excess capital and lend it out on interest. The interest rate is meant to compensate them mainly for inflation (to preserve the buying power of their money), and a little bit extra on top. This extra interest, beyond the rate of inflation, is called ‘real rate’.

Borrowers need capital to run a business (or buy an asset), and pay interest on it. That business (or asset) must generate enough profit (or growth), such that after paying off the lenders, the borrowers have something left for themselves. This extra spread - the difference between ‘real growth’ and ‘real rate’ – is what the borrowers work for.

Thus, the whole economy can be represented in the chart below as just two big players; one big lender (the red line) and one big borrower (the blue line). This chart covers the US economy over the last 15 years.

Shaded area indicates US recession
Source: FRED, BEA, Board of Governors

The red line is the ‘real rate’; it is what the lender makes, after inflation. The blue line is the ‘real growth’; its spread above the red line is what the borrower makes, after paying off the lender.

The blue line must stay comfortably above the red line, for the borrower to make enough and survive. The red line must stay comfortably above zero, for the lenders to cover inflation and survive. That was the case for the US economy, from where the chart starts.

A bit of then

During 2004-2005, the lenders received nice real rate of 1% (the extra above inflation). The borrowers received real growth of 4%, which after paying 1% to the lenders, left them with a nice spread of 3%.

However, things changed during 2006-2007. The gap between the blue and red line closed i.e. nothing left for the borrowers after paying off the lenders. This indicated that the interest rates were too high (in other words, the money was too tight).

If there is nothing left for the borrowers, they would stop borrowing. The business activity would reduce, less assets would be purchased and the economy may fall into recession. That is what happened during 2008-2009 (the grey part on the chart).

This period also saw a financial crisis, which made the lenders too scared to lend. They raised the real rate (the red line) even further up, to almost 3%. On the other hand, the economy (the blue line) collapsed to a real contraction of -4%.

Imagine the double whammy for our dear borrower; his business lost 4% and on top of that, he had to pay 3% to the lender. He was down 7% from his pocket, and with nothing from his venture to take home. He hit rock bottom, as did the blue line.

The central banks came to the rescue. They cut the interest rates aggressively (the red line started coming down), and money became ‘loose’ again. The borrower saw some opportunities for growth again (blue line moving up), and started borrowing.

By 2011, the gap between the real growth and real rate – the blue line and red line - widened back to the range of 2% to 3%. The wheels of the economy were churning normally, once again.

However, by 2013, the central banks had gone too far down, in easing the money. The red line fell too far below zero; the real rate went down to -1.5%.

Now the lenders were hurting. The interest rate they received, was below the rate of inflation. They were losing 1.5% of their money’s buying power every year.

On the other hand, the borrowers were having too good a time. From 2013 to 2015, the gap between real growth and real rate, spiked to 4%. This was unusually large spread for the borrowers to make.

So, the lenders starting tightening the money again; the red line started moving up. By 2017, the real rate crossed the key barrier of 0%; the lenders could at least make enough to cover the inflation.

Since then, both the lines have been moving up in tandem.

A bit of now

Today, the red line stands at the real rate of 1%; lenders are being paid well above inflation. The blue line stands at the real growth of 3%, which after paying 1% to the lenders, leaves a decent spread of 2% for the borrowers.

The economy in the US isn’t too hot today, nor too cold. The money isn’t too tight today, nor too loose. Our lender and borrower; both are getting compensated enough, to keep doing what they do.

Neither of them can complain much. Nor can we.

We stay tight, on the ride.