According to many economic commentators and various experts, the high level of debt, which surpassed the $40 trillion in August this year, is a major threat to the US economy. A view that debt could pose a threat to the economy originates from the writings of American economist Irving Fisher. According to Irving Fisher, a major risk is debt liquidation. Fisher was of the view that debt liquidation could cause a decline in the money supply. This decline, in turn, is likely to cause a decline in the prices of goods and services, called deflation, and, in turn, produces an economic slump. According to Fisher, the trigger for this could be a shock such as a large decline in the stock market.
Why however should debt liquidation cause a decline in the money supply? Take a producer of consumer goods who consumes part of his produce and saves the rest. In the market economy, the producer could exchange the saved goods for money. He could then decide to lend his money to another producer. By lending the money, the lender transfers his savings to a borrower for the duration of the lending contract. By means of money, the borrower could now purchase consumer goods to support his life and wellbeing.
Once the contract expires on the date of maturity, the borrower returns the money to the original lender. The repayment of the debt, or the debt liquidation, does not have any effect here on the supply of money.
The loaned savings are key for economic growth. It is savings that fund the production of capital goods, which, in turn, permits the increase in the production of consumer goods. This increase permits further saving, all other things being equal. All this supports the buildup of a more sophisticated production structure.
An increase in lending is great news to the economy. By means of lending, savings are directed to the various parts of the economy thereby promoting economic growth. Hence, the more debt (i.e., the more lending) the better it is for the economy. An increase in lending that is fully backed by savings promotes economic growth. Hence, an increase in debt strengthens the wealth-generation process.
Inflation and Economic Impoverishment
Ordinary lenders will find it difficult to lend something that they do not have. However, things are different once we introduce into our analysis lending by banks unsupported by savings. This type of lending permits the generation of lending via credit expansion.
If Joe were to decide to lend $1,000 for one year through the mediation of a bank, we would have here a transfer of $1,000 from Joe’s demand deposit to a one-year term deposit. The money in the one-year term deposit could be lent out for one year. The one-year term deposit of $1,000 backs the one-year loan of $1,000 here.
Now, let us consider a case when Bob approaches Bank A for a loan of $1,000 for one year. Bank A accommodates this request and lends Bob the $1,000 by opening a demand deposit to the tune of $1,000. Also, note that we do not have here a transfer of $1,000 from the holders of demand deposits such as Joe to the one-year term deposit. Hence, the loan to Bob by Bank A is unbacked by savings. Bank A has inflated $1,000 loan out of thin air.
Once Bob, the borrower of the $1,000, uses the money, which Bank A inflated, Bob is engaging in an exchange of nothing for something. In a free market economy, a bank runs the risk of bankruptcy if it were to issue loans out of thin air. The bank will not be able to clear its checks during the interbank settlement. The reason is because the bank will not have enough money.
A central bank, however, makes it possible for banks to engage in inflation and credit expansion. Thus, if during the interbank settlement Bank A is short of $1,000 and cannot settle the claim from bank B, it can secure the $1,000 by borrowing it from the central bank. Where does the central bank get the money from? It inflates the money out of thin air. Hence, according to Rothbard,
The Central Bank can see to it that all banks in the country can inflate harmoniously and uniformly together. . . . In short, the Central Bank functions as a government cartelizing device to coordinate the banks so that they can evade the restrictions of free markets and free banking and inflate uniformly together.
Money Supply and the Subsistence Fund
As a rule, a decline in the money supply that precedes price deflation and an economic slump is triggered by the previous expansionary monetary policies of the central bank. It is expansionary monetary policy which provides support for the expansion of money and credit. This in turn leads to the diversion of savings from wealth-generators to non-wealth-generators. Consequently, this weakens the ability to grow the subsistence fund and weakens economic growth.
When loaned money is fully backed by savings on the day of the loan’s maturity, it is returned to the original lender. Bob—the borrower of $1,000—will pay back on the maturity date the borrowed sum and interest to the bank. The bank, in turn, will pass to Joe the lender his $1,000 plus interest adjusted for bank fees. The money makes a full circle and goes back to the original lender.
In contrast, when lending originates through inflation and credit expansion and returns on the maturity date to the bank, this leads to a withdrawal of money from the economy (i.e., to the decline in the money supply). The reason is because, in this case, we never had a saver/lender. Because of an expansionary monetary policy and the deterioration in the subsistence fund, economic activity is likely to follow suit.
With a deterioration in economic conditions, banks are likely to curtail their expansionary lending. Once such loans are repaid to the bank and not renewed, the supply of money comes under downward pressure.
The consequent deflation and the decline in economic activity are not caused by the liquidation of debt as such, nor by the decline in money supply, but by the deterioration in the subsistence fund because of the previous expansionary monetary policies.
The central bank policy to increase the supply of money in order to arrest deflation makes things much worse. For the increase in the monetary pumping weakens the process of wealth-generation thus deepening the economic slump.
As far as the government’s foreign borrowings are concerned, these borrowings could pose a threat to the economy. The government is not a wealth-generator, it necessarily relies for the debt repayment on the wealth-generating private sector.
Once however, the subsistence fund starts declining the private sector will have difficulty supporting the government. Hence, the Fed’s monetary policy, which weakens the subsistence fund, poses difficulties to the government foreign debt repayment.
Conclusion
Contrary to much popular thinking, the threat to the US economy is not the high level of debt but the expansion of lending unbacked by private savings. The increase in such lending is an agent of economic growth. Debt that is unbacked by savings is an agent of economic destruction. That type of debt emerges because of the expansionary monetary policy of the central bank, which makes it possible for the banks to issue lending not backed by savings.
