Transactions, Credit, and Why Spending Is Someone Else's Income

Friday morning. The payout from your software company lands: a few thousand dollars from a few hundred customers, most of them paying on a card. You didn't think about where their money came from. Why would you? It's yours now.

Trace one of them back anyway. A customer in Ohio paid you forty dollars on a credit card. The card company paid you with money it borrowed overnight. The customer will pay the card company next month out of a paycheck. The paycheck comes from a company that ran payroll on a short-term loan. The loan came from a bank that didn't have the money either. It typed it.

Every dollar you've ever been paid was, one step earlier, a dollar somebody else spent. That's not a metaphor. It's arithmetic. So here's the question this lesson answers: if your income is always someone else's spending, where did their dollar come from, and what happens to you when it stops?

Washington, D.C., the early 1970s. About two hundred young couples on Capitol Hill, most of them congressional staff, run a babysitting co-op. No cash changes hands. A couple that sits for another couple earns a paper coupon worth half an hour. You spend coupons when you go out. You earn them when you stay in with somebody else's kids.

It's an economy with one product and one currency, and it's about to have a recession.

New couples joined and did the sensible thing. They saved. They wanted a cushion of coupons before they'd spend a Saturday night out. But every coupon saved was a Saturday night nobody else got to sit. Fewer nights out meant fewer coupons earned, so more couples decided they'd better save too. The co-op ground to a stop with everyone eager to work and nobody willing to spend.

Two members, an economist and his wife, wrote it up in a banking journal a few years later. The fix wasn't a speech about confidence. The committee issued more coupons: thirty hours to a new member instead of twenty. Nights out came back. Spending and income aren't two things. They're one transaction seen from two ends, and when one end pulls back, the other end falls the same instant.

Now the same lesson at full scale. Monday, September 15, 2008. Lehman Brothers, one of the oldest banks on Wall Street, files for bankruptcy. The next afternoon, a money market fund nobody outside finance had heard of, the Reserve Primary Fund, announces it holds $785 million of Lehman's paper and that the paper is now worth nothing.

A money market fund is supposed to be the boring place: a dollar in, a dollar out, always. Reserve's dollar was now worth ninety seven cents. It's called breaking the buck, which means a fund built never to lose a penny has just lost three. Investors pulled $27.3 billion in two days.

Here's what those funds did with their cash. They bought commercial paper, which is a short loan, a few days to a few months, that big companies use to pay suppliers and make payroll while they wait for their own customers to pay. When the funds stopped buying, the loans stopped rolling. Payroll at companies that had nothing to do with mortgages got hard to fund in a week.

Ask the question you learned in lesson four. Who made the rule that a fund could hold Lehman paper at a dollar? The fund industry, with the regulator's blessing. Who gained? Everyone who earned a little extra yield for years. Who paid? The company in Ohio that couldn't roll its paper, and the worker whose paycheck depended on it. Then everyone that worker bought from.

Strip the economy to its smallest part and it's a transaction: one buyer, one seller, money or credit moving one way, a good or a service moving the other. Everything else, the markets, the Fed, GDP, is those transactions added up. Ray Dalio built his whole model of the economy on that one part, and it holds.

Step one is the identity. In every transaction, what the buyer spends is exactly what the seller receives. Add up every transaction in a country for a year and total spending equals total income, not roughly, exactly. Economists count the same year twice, once from the spending side and once from the income side, and get one number. Your revenue line is somebody else's expense line.

Step two is where the money comes from, and this is the part almost nobody is taught. A buyer can pay with money he has, or with credit, which is money he doesn't have yet: a promise to pay later, plus interest. When a bank makes a loan, it doesn't hand over money that a saver deposited. It creates a new deposit in the borrower's account by writing it down.

The Bank of England said it in plain words in 2014. The majority of money in the modern economy is created by commercial banks making loans. The loan makes the deposit, not the other way round. Most of the money you've ever been paid was born as somebody's loan.

Step three is the spend. The borrower spends the new deposit. Someone's income just went up by money that didn't exist last week. That person spends most of it, and the next person's income rises too. One loan, many incomes. Credit isn't a side dish in the machine. It's the fuel line.

Step four is the pull, and it's the step that ends careers. When a loan is repaid, the deposit is deleted. When a lender refuses to roll a loan, the deposit never arrives. Either way somebody's income falls, and he cuts his spending, which cuts the next person's income.

The co-op couples weren't lazy. The Ohio company wasn't badly run. In both cases the chain had a link pulled out upstream, and every link downstream fell in order. A recession isn't people deciding to buy less. It's credit deciding to lend less, and the buying follows.

Now the numbers, over decades, so you can see the chain get longer.

Take everything owed by everyone in America: households, companies, banks, and every level of government. The Fed counts it every quarter. In 1960 it was about $770 billion, against a yearly output of about $540 billion. Call it a dollar forty of debt for every dollar the country produced.

By 2000 it was $29 trillion against $10 trillion, nearly three dollars per dollar. At the end of 2008, the quarter the chain snapped, it stood at $58 trillion against $14.6 trillion. Four dollars of promises for every dollar of output. Today the total is $118.9 trillion against $32.5 trillion of output.

Read that as a machine, not as a moral. Every one of those dollars was, on its way in, someone's income. The economy you sell into isn't running on money earned and then spent. It's running on money borrowed and then spent, with more than three dollars of promises stacked on each dollar of goods.

Now the six weeks that show what the pull looks like at speed.

The week of September 10, 2008, there was $1.82 trillion of commercial paper outstanding. By October 22 there was $1.45 trillion. A fifth of the loans that run American payroll vanished in six weeks, not because companies stopped needing them but because the buyers stopped buying. Then the Fed announced it would buy the paper itself, saying in its own release that investors had become increasingly reluctant to purchase it.

The economy shrank by more than four percent from top to bottom. Unemployment doubled. Most of the people who lost jobs had never held a mortgage bond or heard of Lehman. They were three or four links down a chain that got pulled at the top.

The incentive map. Who made the rules? Lenders and their regulators, who decided how much credit could stack on how much output. Who gained on the way up? Whoever borrowed first and bought assets with it, and whoever collected the interest. Who paid on the way down? Whoever's income sat at the end of the chain: the worker, the small supplier, the freelancer whose client's client couldn't roll a loan.

Here's the reveal. You've been taught to watch the consumer. Consumer confidence, retail sales, the shopper. But the shopper doesn't decide whether he can spend. His lender does, and his employer's lender, and that lender's lender. The number that predicts your revenue isn't how your customers feel. It's whether the people upstream of your customers can still borrow.

The people who ran the co-op understood it after one bad winter. Most operators never learn it, because the cut arrives looking like their own fault.

A digital tycoon sells into this machine every day, and he's usually paid on the far end of the chain. Card payments, subscriptions, ad budgets, agency retainers: all of it's somebody's spending, and much of it's somebody's credit. Here's how the office reads the lesson.

First, map your own chain. For each revenue line, ask what your customer's money is made of. A consumer subscription rides on a paycheck and a card. A business contract rides on a budget, which rides on that company's revenue or its credit line. Two links up from you, somebody is either earning or borrowing. Know which.

Second, watch the fuel line, not the dashboard. When banks tighten, when short-term lending gets expensive, when the commercial paper number shrinks, the effect reaches your revenue in months, not years. The lesson after this one gives you the timing of that cycle. For now, put credit on the list of things you read, next to the price of the things you own.

Third, build so a pulled link doesn't pull you. The office keeps a written plan and cash the way the co-op needed a coupon reserve: not out of fear, but because the chain has stopped before and it'll stop again, always from upstream. Your business is also a link in someone else's chain. When you cut spending, the next tycoon's income drops. The machine runs on all of us at once.

Our paper fund reads it by its rules: every position carries a written reason, we hold no leverage, so no lender can pull our link, and we watch what credit is doing before we ask what the price is doing.

• Total debt of all U.S. sectors (FRED series TCMDO, Federal Reserve Financial Accounts): $766.9 billion in Q1 1960; $4.65 trillion in Q1 1980; $29.06 trillion in Q1 2000; $58.31 trillion in Q4 2008; $118.89 trillion in Q2 2026.
• U.S. GDP, annual rate (FRED series GDP): $542.6 billion in Q1 1960; $2.79 trillion in Q1 1980; $10.00 trillion in Q1 2000; $14.61 trillion in Q4 2008; $32.49 trillion in Q2 2026.
• Debt per dollar of output, the two series divided: 1.41 in 1960, 1.67 in 1980, 2.91 in 2000, 3.99 in Q4 2008, 3.66 in Q2 2026.
• Commercial paper outstanding (FRED series COMPOUT, weekly): $1,815.0 billion on September 10, 2008; $1,764.4 billion on September 17; $1,607.7 billion on October 1; $1,449.1 billion on October 22, 2008, a fall of 20.2 percent in six weeks.
• Lehman Brothers filed for Chapter 11 on September 15, 2008. Yale Journal of Financial Crises; Federal Reserve History.
• The Reserve Primary Fund held $785 million of Lehman commercial paper and medium-term notes, marked to zero at 4:00 pm ET on September 16, 2008; its net asset value fell to $0.97 per share; redemptions were $27.3 billion on September 15 and 16 combined. Crane Data; Yale Journal of Financial Crises.
• The Federal Reserve announced the Commercial Paper Funding Facility on October 7, 2008, stating that money market mutual funds and other investors had become increasingly reluctant to purchase commercial paper. Federal Reserve press release.
• U.S. GDP fell 4.3 percent from peak to trough in the 2007 to 2009 recession; unemployment rose from under 5 percent to 10 percent. Federal Reserve History.
• "The majority of money in the modern economy is created by commercial banks making loans," and banks "do not act simply as intermediaries, lending out deposits that savers place with them." Bank of England Quarterly Bulletin, 2014 Q1, McLeay, Radia and Thomas, March 14, 2014.
• The Capitol Hill Babysitting Co-op was founded in the late 1950s and grew to over 200 couples by the early 1970s; one scrip coupon equaled half an hour of sitting; new members received twenty hours of scrip and paid fourteen hours a year in dues; the shortage was fixed by issuing thirty hours to new members. Wikipedia; Sweeney and Sweeney, Journal of Money, Credit and Banking, February 1977.
• Ray Dalio's model of the economy as transactions, credit, and cycles is set out in How the Economic Machine Works, 2013. economicprinciples.org.