The recent flow of funds data released by the Fed shows that a level of private debt continues to soar. For instance, home mortgages as a percentage of disposable income rose to 97.9% in Q2 from 97% in the quarter before. The non-financial debt-to-nominal-GDP ratio stood at a record 2.1 in Q2 the same figure as in the previous quarter.
Some analysts regard these high ratios as alarming. Following in the footsteps of the famous American economist Irving Fisher,1 they believe that a very high level of debt relative to GDP runs the risk of setting in motion deflation and in turn a severe economic slump.
According to Fisher the high level of debt can set in motion the following sequence of events that culminate in a severe economic slump.
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 people’s assets falls while the value of their liabilities remains intact. This results in a fall in the 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 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, on account of a fall in prices, real interest rates rise.
Note that the critical stage in this story is the stage 2, i.e., debt liquidation results in a decline in the money stock. But why should debt liquidation cause a decline in the money stock?
Consider 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., lender — transfers his claims on real savings to the borrower. The borrower can now exercise the money — i.e., the claims — and secure consumer goods that will support him while he is engaged in the production of other goods, let us say the production of tools and machinery.
Observe 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 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.
Things are, however, different when a bank uses some of the deposited money and lends it out. Remember that the owner of deposited money continues to exercise demand for 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 without content.
In the case of fully backed credit, the borrower, so to speak, secures goods that were produced and saved for him. This is however not so with respect to unbacked credit. No goods were produced and saved here. Consequently, once the borrower exercises the unbacked claims, this must be at the expense of the holders of fully backed-up claims. The bank here creates money “out of thin air.” On the date of 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.
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 that provides support for the creation of unbacked credit. (Without this support, banks would have difficulties practicing fractional-reserve lending).
The unbacked credit in turn leads to the reshuffling of real funding from wealth generators to non-wealth generators. This in turn weakens the ability to grow the pool of real funding and weakens the economic growth. Note that the heart of the economic growth is the pool of real funding, or the subsistence fund. According to Böhm-Bawerk,
The entire wealth of the economical community serves as a subsistence fund, or advances fund, from this, society draws its subsistence during the period of production customary in the community.2
Similarly von Strigl wrote,
Let us assume that in some country production must be completely rebuilt. The only factors of production available to the population besides laborers are those factors of production provided by nature. Now, if production is to be carried out by a roundabout method, let us assume of one year’s duration, then it is self-evident that production can only begin if, in addition to these originary factors of production, a subsistence fund is available to the population which will secure their nourishment and any other needs for a period of one year…. The greater this fund, the longer is the roundabout factor of production that can be undertaken, and the greater the output will be. It is clear that under these conditions the “correct” length of the roundabout method of production is determined by the size of the subsistence fund or the period of time for which this fund suffices.3
Because of a prolonged and aggressive loose monetary policy, a situation can emerge when the pool of real funding starts shrinking. In short, there are now more activities that consume real wealth than activities that produce real wealth.
Once the pool of funding begins to fall, anything can trigger the so-called economic collapse. Obviously when things are starting to fall apart, banks try to get their money back. Once banks get their money (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 of money, but by the fall in the pool of real funding because of previous loose monetary policies.
In his writings, Fisher argued that the size of the debt determines the severity of an 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. We, however, maintain that it is not the size of the debt as such that determines the severity of a recession, but rather monetary policies of the central bank and the state of the pool of real funding. Again, it is not the debt but loose monetary policies of the central bank that cause the misallocation of real funding.
By putting the blame on debt as the cause of economic recessions, one absolves the Fed from any responsibility in actually setting the whole thing in motion. Additionally, once it is accepted that debt can set in motion a monetary implosion and in turn an economic depression, it seems to make sense that the Fed must step in and lift monetary pumping in order to offset a disappearing money supply.
However, rather than countering depression, what monetary pumping in fact does here is to further weaken the pool of real funding and thereby deepen the economic crisis. (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. Again we suggest that pumping more money only dilutes the pool of real funding and makes things much worse).
It is quite possible that real savings do not support a large percentage of the present level of US debt. This, we suggest, may correspond to the situation of a falling pool of real funding. If this is the case then pessimists might have a valid reason to be concerned with the growing debt-to-GDP ratio. It is, however, also possible that the present debt level might have good support if the pool of real funding is still growing.
While we cannot quantify the present state of the pool of real funding, we can however provide some qualitative assessment of the damage that the past loose monetary policies of the Fed may have inflicted on this pool. For instance, the aggressive lowering of interest rates by the Fed between 2001 to June 2004 has most likely inflicted serious damage on the pool. As a result of the misallocation of real funding, on account of easy interest rate policy, the pace of consumption of final consumer goods and services has most likely increased, while the pace of the production of final consumer goods and services has likely weakened.
An illustration for the likely misallocation of real funding is depicted by the ratio of the production of consumer durable goods to non-durable consumer goods. In August the ratio stood at 1.3 against the historical average between 1959 to 1992 of around 0.6. This means that if things were to come back to some normality, there could be a large correction in this ratio, which in turn could produce a severe economic upheaval.
Additionally, in relation to the trend that was estimated from the data between 1959 to 1979 (the period prior to the onset of financial deregulation) our monetary measure AMS jumped to a record 47.3% in May this year. In short, the massive monetary pumping in relation to the 1959–79 trend raises the likelihood that the pool of real funding has been under pressure for a prolonged period of time (see chart). All this, however, does not imply that the pool is shrinking.
What matters here is the overall pool of funding and in this regard we shouldn’t forget the contribution of the outside world to the US pool. In return for pieces of paper called American dollars, foreigners are still happy to supply a large chunk of their real wealth to the United States, thereby enabling the US economy to push ahead. In fact it is quite likely that foreigners’ contribution to the US pool of real funding may have averted serious US economic bust.
Conclusions
Contrary to popular way of thinking, the threat to US economy is not the high level of debt as such but credit that is not backed up by real savings. Also, 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.
So far, the contribution of the rest of the world to the US pool of real funding has enabled the US economy to avert a serious economic slump. Once the pool of funding becomes stagnant or begins to shrink, economic growth follows suit and the myth that government and the central bank policies can grow the economy is shattered. According to Mises,
An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.4
- 1Irving Fisher, Boom and Depressions, London: George Allen, p. 39.
- 2Eugen von Böhm-Bawerk, The Positive Theory of Capital, Book 6, chapter 5, Macmillan and Co., 1891.
- 3Richard von Strigl, Capital & Production, Mises Institute, p. 7.
- 4Ludwig von Mises, Human Action, chapter 36, “The Crisis of Interventionism.”
