Friday, May 07, 2010

Addicted to Debt

In the fall of 2008 when the debt crisis unfolded I freely admit that I didn't really understand what it meant. I was hearing that people weren't taking out loans and were busy paying off their debt. The fact that Americans were finally saving some money seemed like such a good thing. What could be wrong with that? These very things were in fact exactly what I was doing in my own life. So, what did a credit crisis mean to me? The language of Wall Street, CNBC and high finance gurus may as well have been Greek to me. I had no idea that one simple principle ruled our monetary system.

Money is debt. No debt, no money.

We had always been taught to believe that debt was a bad thing, a necessary evil. We certainly were never told that debt was the very life blood of our financial system. Yet there we were (and still are) in the midst of a debt crisis. I took it as a challenge to at least try to understand what the hell a debt crisis was.

Start with this notion: the creation of (new) money always involves the extension of credit by private commercial banks.

And this one: the money that one borrower uses to pay interest on a loan has been created somewhere else in the economy by another loan.

Or consider this: someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money we prosper; if not, we starve...

These are quotes from financial gurus and Federal Reserve directors.

In other words our entire economy is debt based. It this good or bad? Whatever - it is what it is. New money is created by banks (and credit card issuers, if you will) when they extend credit. This money did not exist before. Yes, money is literally created out of thin air!

Think about it this way; when a bank takes in $10 in deposits it traditionally would leverage that money 10-1, thereby loaning out $100 with just $10 in the vault. Where did the $90 come from? It was created out of thin air. Is it real money? Well, the person who took out the loan can take that $100 down to Target and buy something with it, so yes, it's very real. This is how new money enters the economy, it is the only way new money enters the economy. The money is extinguished when the loan is repaid. As such "old money" is not liquid and can't be reused once its value has been tied up in assets such as property, cars, refrigerators, etc etc. Even if the asset is re-sold the buyer most likely had to take a loan in some form which is the action of brand new money entering the economy again.

Scale this up by magnitudes and you have the basis of the modern monetary system. Without debt our economy suffers, people suffer. As crazy as seems debt is absolutely essential to prosperity. Private commercial banks are allowed by the government to "create" money in this way. Of course there are limits and banks are/were traditionally the most regulated business in the land. The overall money supply is managed by the central bank. In the U.S. it is the Federal Reserve of course, which is also a private bank. It is also given its power by the government. Obviously the system is far more complicated than this simple primer, but this is in general the way money is created in America. It sounds crazy, and it probably is, but this is the system we have.

Whatever the ultimate cause of the crisis, a subject that is still a hot topic among pundits and economists, the credit shock stifled private sector business as well as ordinary consumers as fear gripped the land. Everyone pulled back simultaneously. No one was incurring any new debt. Since all money is created on the books of private banks to be injected into the economy when there is no debt, there is no money. Unfortunately it's not getting better. New debt creation in the U.S is contracting at a rate never seen before. What this means is there isn't the money to buy goods and services, so people get laid off and factories and car dealerships shut down thus contributing to a vicious cycle of economic doldrums and eventually, quite possibly, a depression. The only way reverse the cycle is for credit to be restored... When the banks can't do it, the government will have to. Can you say government stimulus?

The problem with Obama's stimulus was that it wasn't designed to restore wealth. A key point: money does not equal wealth... Instead Obama's stimulus was largely used for political payoffs. What is the point of pumping new money into the economy if it isn't intended to create wealth? Wealth is a dirty word to this administration. There is absolutely nothing wrong with government priming the pump when the private sector isn't doing it as long increasing wealth is the goal. Because of Obama/Pelosi/Reid's irresponsible spending there is no appetite for the government to prime the pump because of the fear of massive "government debt". But it is the myth long perpetrated by the financial elites in this country - that allowing the government to increase the money supply will lead to hyper-inflation. As little as I knew about finance way back in the late 80's and 90's I argued that government debt was not a problem as long as prosperity and wealth were the goal. We have not seen significant inflation outside the energy sector in decades, and we have certainly not seen hyper-inflation.

Unfortunately the current government is not interested in wealth creation for the United States. That's why this new pile of government debt is different. The goal of Obama and company is wealth transfer not wealth creation. Instead of injecting the liquidity the nation needs because the banks aren't doing it we hear rumblings of an austerity movement. This would be devastating. The problem with the current clowns in charge is that the austerity will be ours, yours and mine, not theirs. The government will continue to grow and spend and we will be asked to do with less.

The Tea Party Movement, God bless it, is wrong about government debt as a flash point. Public debt isn't like private debt. There's a big difference, we need to be aware of that and separate our personal fears about over extending ourselves and the fear that government debt is a ticking time bomb. The act of the of the government increasing the money supply is not inflationary if the money is used to increase actual goods and services and not just transfer payments. We get inflation when demand (money) exceeds supply (goods and services). When supply and demand increase in concert, prices basically remain stable.

So why, if the government gives commercial banks the power to "create" money, does it then turn around and borrow money from banks for which it has to tax its citizens to pay interest on the debt. It makes no sense - unless you are a politician in league with the giant banks. The only thing this serves is reelection committees and giant banks. We need to create wealth for everyone not just the few giant Wall Street banks. Wealth creation involves only three things. It happens through combination of our labor with our natural resources and our great ideas. When wealth is created there is no debt. Debt and is not in any way, shape, or form, an evidence of wealth. So, if new money is needed to grease the gears of wealth creation then why can't government grant to itself the very power they give to banks and create new money for real stimulus projects (infrastructure) and real private sector job creation

If I am hard on Obama and company over this issue it is because it is richly deserved, since either they are ignorant about how the monetary system works or they are calculating our demise. But unfortunately most Republicans are as stupid as the Democrats are dangerous. Where are the leaders who can articulate that increasing wealth should be the goal?