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The Credit Delusion

December 20, 2001Christopher Mayer

Tags Financial MarketsMoney and BanksMoney and Banking

"Everywhere life's illusions are all of the same sheer stuff; variety is a trick of refraction." --Garet Garrett, Where the Money Grows, 1911

Popular delusions pepper human affairs both past and present. And perhaps nowhere is such folly so liberally sprinkled as in matters of money--particularly when it comes to the nature and the consequences of credit. As the economy sputters along, various commentators and politicians tell us that the way out of this mess is to lower interest rates, increase spending, and, consequently, take on more debt.

One long-departed writer who was able to penetrate this soupy fog with great clarity was Garet Garrett, particularly in his book A Bubble That Broke the World, which first saw the light of day way back in the summer of 1932. By then, Garrett was already a seasoned newspaperman and salty critic of fiscal insanity.

"Since John Law and his Mississippi Bubble," Garrett noted, "individuals have been continually operating with the same scheme in new disguise." This was the credit delusion, in which debts never had to be repaid and prosperity could be created out of thin air with easy money.  Ever the student of the history of bubbles, especially with regards to the explosive combination of paper money and its government backers, Garrett saw that the "general shape of this universal delusion may be indicated by three of its familiar features."

The first of these is "the idea that the panacea for debt is credit." In other words, the delusion that the best way to relieve debtors is to make it easier for them to acquire more debt. Greenspan and crew have been hard at work in this department, pushing down interest rates and pumping the economy with money. In one year, the Fed Funds rate has been pushed from 6.75 percent all the way down to 1 percent.

 The money supply also continues to expand. The so-called "Broad Money Supply" (M3) has increased by about $1 trillion dollars, or 14 percent, over the past fifty-two weeks. Borrow! Spend!  Dallas Fed Chief McTeer urged us all to hold hands and buy SUVs.  They have helped foster a culture of spenders and debtors.  As has been widely reported, the average American pool of savings is paltry, even by our own standards (forget comparisons with the Japanese).  It used to be that people would make the argument that the rising stock market served to understate the true savings rate.  Well, after nearly two years of falling prices, that argument no longer has merit.

The second familiar feature is "a societal and political doctrine, now widely accepted, beginning with the premise that people are entitled to certain betterments of life."  Entitled, that is, even if they can't afford them.  Therefore, credit should be made readily available so that people can acquire homes, cars, and other things.  The government and its GSEs strive to make it easy for Americans to buy homes by providing a ready market for mortgages and subsidizing the industry with tax advantages and its implied guarantee.  The GSEs now hold more than half of domestic mortgages, for example.  Most people seem to believe that it is best for everyone to own their homes, costs and risks aside.  The consequence of this type of thinking is, of course, more debt.

The third of Garrett's familiar features is "the argument that prosperity is a product of credit."  With this, economic thought is ignored and, indeed, it invites a certain hostility.  It used to be that prosperity was the result of creating real wealth--making things better, providing services more efficiently, creating and multiplying capital.  Credit, or the availability of debt, is itself no creator of prosperity.  The result of this thinking is that the real engines of prosperity are neglected.  

The common purpose of all of these features is to encourage debt, and indeed it has achieved the result.  Debt as a percentage of disposable income, for example, is as high as it has ever been, over 100 percent.  As recently as 1990, debt represented 80-plus percent of disposable income. In 1982, it was in the 60-percent range. (See Why the bear market is just beginning, by David Tice.)

Things are not much different in the corporate world; the average company has quite a bit of debt. As Moody's John Puchella notes, "The non-financial debt-to-equity ratio has climbed from 77.4 percent at the end of 2000 to 81.2 percent at the end of September."

Is it not obvious what the fatal weakness of such a scheme is?  Once begun, it cannot be stopped until it reaches its gruesome natural end.  Garrett writes, "when creditors fail to present themselves faster than old creditors demand to be paid off, the bubble bursts."  This seems to be where we are now.  The average American consumer is a debt-laden mule.  Easy credit and more debt will not help him.  

At the heart of such a scheme--its sole logic--is that debt need not be repaid but postponed by increasing the debt of the debtor.

When the bubble bursts, what then?  Garrett wrote, "then you go to jail, like Ponzi, or just commit suicide like Ivar Kruegar."  Except our monetary system is so infected, its malaise so advanced, only a radical makeover can prevent the endless vicious cycle of boom and bust.  

When the bubble bursts, cash becomes king once again.  People hold onto it a little more tightly.  Debt becomes real again, no longer veiled by the illusion of easy money.

Debt is great on the way up.  You buy a house or buy stocks and they rise and your debt stays the same, accruing as it does some interest rate that is well below the rate of your advancing stocks and appreciating home. But when prices fall, debt becomes a very cruel master. The prices of assets--that home and those stocks--fall and the debt stays where it is, looming ever larger as your equity dissolves like antacids in water.

At the heart of the bubble, then, lies the problem of credit.And at the heart of the problem of credit is fiat currency and fractional-reserve banking.

This is what all those hardened old-school investment types worry about.  This is why they are always crowing about the gold standard.  The gold standard is not about gold; it never was.  Gold just happened to be the metal that evolved as the currency of choice.  First it was silver.  The American dollar was originally silver, as was the pound sterling.  But gold has certain features that people seemed to favor. It was unchangeable, difficult to get, and extensible.  

This last point is rather interesting.  Garrett, in speaking of the ancient goldbeater's art, writes that "between two pieces of fine leather made from the intestines of an ox it may be beaten to the impalpable thickness of 1/300,000th part of an inch, so that one troy grain may be made to cover 56 square inches."

The gold standard is about having money that is not under the control of governments and that is difficult to inflate.  As Ludwig von Mises wrote in his classic The Theory of Money and Credit, "the eminence of the gold standard consists in the fact that it makes the determination of the monetary unit's purchasing power independent of the measures of governments. . . . It make it impossible for them to inflate."  

The real merit of a 100-percent gold dollar, advocated by Murray Rothbard among others, is that it severs the link between politics and money.  It quashes the credit cycle, making it no longer possible to pyramid dollars upon dollars in a precarious house of cards.  Mining more gold is the only way to increase the stock of money.

Inflation, huge government debts, the pyramiding of credit, and periods of crisis--these are not part of free-market economics, though they are often linked by antimarket types.

Talk of gold may sound curmudgeonly, antiquated, impractical, unrealistic, improbable--you name it and gold has surely been smeared by it--but let us face facts.  As Ludwig von Mises wrote long ago, ".we have only the choice between two utopias; the utopia of a market economy, not paralyzed by government sabotage on the one hand and the utopia of totalitarian all-round planning on the other hand.  This choice of the first alternative implies a decision in favor of the gold standard."


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