Please see part 6 here:http://infiniterac.com/index.php/2018/04/28/basics-of-macroeconomics-6/
These series of articles are for those intelligent group of people whose expertise are not economics or finance, but are still interested to understand the impact of macroeconomic monetary and fiscal policies such as interest rates, taxes or spending on the overall course of economy, their businesses, their employers, investments and of course their daily life.Therefore, in these articles, I have knowingly avoided using economic and finance terms and jargon, as much as possible.
The impact of different macroeconomics monetary and fiscal policies on each other, economy and growth are complicated and may cause vicious, benign or virtuous cycles. It is like a polynomial equation with many different interactive factors and coefficients. Changing the value of each factor and each coefficient will not only generate a different result, but may even change the value of some other factors in that same equation! And of course, changing one factor may generate multiple or totally different results for different values of another factor.
Knowing all those facts, in this article, discussion is kept very simple and to the point. At any time, we focus on one causal impact of one factor only if ALL other factors are assumed to remain constant.
Part 7- Debt and Growth
Imagine a very simple scenario where you have a business, Orangina Inc., which uses oranges and sugar to produce orange juice. You sold $1,000,000 this year, paid $300,000 for raw material, $200,000 for labor, which will leave you with a profit of $500,000.
Now demand is growing for orange juice, and you have to add a plan with equipment to meet the increasing demand. Demand is expected to be $1,500,000 next year. Raw material and labor will grow proportionately to $450,000 and $300,000. So, profit is expected to be at $750,000. BUT to build a new plant, you need to borrow from the bank. You ask for $800,000 of loan at 10% (variable), to pay back in 5 years. This means that you will have to pay $80,000 of annual interest and $160,000 of principle or $180,000 in total.
Bank approves your request, because your growth rate is at 50% (profit is expected to grow to 750,000, or 50% higher than last year), which covers the 10% of interest rate very easily.
So, you expect to buy plant and equipments with the $800,000, and produce enough juice to meet demand and generate $750,000 of profit, that covers the loan peyment of $240,000 (principle+interest).
BUT, inflation starts rising by 5%. Therefore you will have to increase your employees’ salaries by 5% to almost 315,000. Interest rates increase in response to inflation by 5%, which means that you will have to pay 15% of interest, or almost $120,000. To make the matters worse, the increased cost of borrowing (interest rates) decrease demand for orange juice! So, your actual sales at the end of the year will be $1,200,000 instead of the estimated $1,500,000.
This means that your real profits are (1,200,000-315,000-200,000) or 685,000 instead of the expected 750,000. After paying off your loans, you will end up with only (690,000-280,000) or $310,000 of profit, which is even worse than last year.
Summary:
Businesses borrow to grow. If the rate of growth is lower than the borrowing rate, they will have problems with returning their debt. Problem manifests itself as a vicious cycle when rates increase: As interest rates increase, people buying power decrease, they buy less, companies make less money, and will therefore have less money to repay debt.
This is one of the main reasons behind lower stock prices, as interest rates increase.