According to the flow of funds data published by the Fed, the US debt to GDP ratio remains at a lofty level. Non-financial sector debt as a percentage of GDP stood at 251.7% in Q3 2016 against 230.1% in Q1 and 184.3% in Q1 2000.
Consumer credit as a percentage of GDP also remains at a record high — it stood at 19.9% in Q3 2016 against 15.8% in Q1 2000.
Most economic commentators regard these high ratios as alarming. Following in the footsteps of economist Irving Fisher, it is held that a very high level of debt relative to GDP runs the risk of setting in motion deflation and in turn a prolonged and severe economic slump. According to Fisher the high level of debt can trigger the following nine stages of events that culminate in a severe economic slump.1
Stage 1: The debt liquidation process is set in motion on account of some random shock. For instance, a sudden large fall in the stock market. The act of debt liquidation forces individuals into distressed selling of assets.
Stage 2: As a result of the debt liquidation the money stock starts shrinking and this in turn slows down the velocity of money.
Stage 3: A fall in money leads to a decline in the price level.
Stage 4: The value of assets falls while the value of liabilities remains intact. This results in a fall in net worth, which precipitates bankruptcies.
Stage 5: Profits start to decline and losses emerge.
Stage 6: Production, trade, and employment are curtailed.
Stage 7: All of this leads to growing pessimism and a loss of confidence.
Stage 8: This in turn leads to the hoarding of money and a further slowing in the velocity of money.
Stage 9: Nominal interest rates fall, however, but on account of a fall in prices real interest rates rise.
Observe that the critical stage in this story is stage two: debt liquidation results in a decline in the money stock. But why should debt liquidation cause a decline in the money stock?
Why Debt Liquidation Makes Money Disappear
Take a producer of consumer goods who consumes part of his produce and the rest he saves. In the market economy, our producer can exchange the saved goods for money. The money that he receives can be seen as a receipt, as it were, for the goods produced and saved. The money is his claim on the goods.
He can then make a decision to lend the money to another producer through the mediation of a bank. By lending his money the original saver — i.e., the lender — transfers his claims on real savings to the borrower. The borrower can now exercise the money and secure consumer goods that will support him whilst he is engaged in the production of other goods, for example, the production of tools and machinery.
Note that once a lender lends his money he relinquishes his claims on real goods for the duration of the loan.
Can the liquidation of credit which is fully backed by savings cause a decline in the money stock? The answer is categorically “No.” Once the contract expires on the date of maturity the borrower returns the money to the original lender. As one can see the repayment of the debt, or debt liquidation, doesn’t have any effect on the stock of money.
Even if the borrower defaults for some reason and cannot repay the debt the lender will suffer losses because the borrower didn’t use the money productively, however, there will not be a change in the money supply. The money will be somewhere in the economy.
Things are, however, different when a bank uses some of the deposited money and lends it out. In this case, the owner of deposited money continues to exercise demand for that money — he didn’t relinquish his claims on real savings in favor of a borrower. Hence when a bank uses some of the deposited money the bank effectively creates another claim on real savings.
This claim is just a paper entry — not backed by real savings. In the case of fully backed credit, the borrower secures goods that were produced and saved for him, so to speak.
Why Un-Backed Credit Is Different
This is however, not so with respect to un-backed credit. No goods were produced and saved here. Consequently, once the borrower exercises the un-backed claims this must be at the expense of the holders of fully supported claims.
On the date of the maturity of the loan, once the money is repaid to the bank this type of money must disappear since it never existed as such and never had a proper owner.
Debt Isn’t the Problem
The point that must be emphasized here is that the fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary policies of the central bank and not the liquidation of debt.
It is loose monetary policy which provides support for the creation of un-backed credit. (Without this support banks would have difficulty practicing fractional-reserve lending.) This un-backed credit in turn leads to the reshuffling of real wealth from wealth generators to non-wealth generators.
RELATED: How Money Disappears in a Fractional-Reserve Money System
This in turn weakens the economy’s ability to grow the pool of real wealth and in turn weakens economic growth. (Note that the heart of economic growth is the pool of real wealth.)
On account of prolonged and aggressive loose monetary policy a situation can emerge when the pool of real wealth starts shrinking — there are now more activities that consume real wealth than activities that produce real wealth. Once the pool of wealth starts falling then anything can trigger a so-called economic collapse.
Obviously when things are starting to fall apart banks try to get their money back. Once banks retrieve their money (i.e., credit that was created out of “thin air”) and don’t renew loans the stock of money must fall.
Note however that the consequent price deflation and the fall in the economy are not caused by the liquidation of debt as such, nor by the fall in money supply, but by the fall in the pool of real wealth on account of previous loose monetary policies.
As a result of the fall in the pool of real wealth and the consequent fall in economic activity banks’ bad assets start to pile up. Hence, to improve their solvency banks start to curtail the expansion of credit.
In his writings Fisher argued that the size of the debt determines the severity of the economic slump. He observed that the deflation following the stock market crash of October 1929 had a greater effect on real spending than the deflation of 1921 had because nominal debt was much greater in 1929.
However, it is not the size of the debt as such that determines the severity of a recession, but rather the monetary policies of the central bank and the state of the pool of real wealth. It is not the debt but these loose monetary policies that cause the misallocation of real wealth.
By putting the blame on debt as the cause of economic recessions, one in fact absolves the Fed from any responsibility for actually setting the whole process in motion. Note that many commentators are of the view that on account of price deflation the debt burden intensifies.
Consequently, it is held that by means of monetary printing this burden can be eased thereby arresting the economic plunge. In fact, pumping more money only dilutes the pool of real wealth and makes things much worse.
What a bunch of crap. When a bank loans me $1,000 I do not care where the money comes from, savings or out of thin air.
I purchase goods and services with the money. When I pay the loan down to zero the bank has the money back to loan to someone else and has made a profit on the loan. Banks may limit loans for different reasons, but if they do not lend money they will not make a profit and that is what they are in business for. A bank that does have more loans in default, has to tighten loan requirements, but needs to increase good loans on their books to offset loses. With the new loans, no matter where the money comes from allows people to buy cars, homes, and other goods and services, it is what keeps the economy going.