Why debt is a huge problem

Generally accepted wisdom tells us that excessive debt is a serious problem although some people question why government debt to a central bank is problematic. After all what is wrong with one government agency owing money to another?  Why not just let the debt build up?

In this case the generally accepted wisdom is probably correct because debt is an important part of our money supply.   If we were to lose our money supply our economy would be in big trouble.

Money is a complex part of our economy and I suspect few people, including a lot of economists, really understand how it works.  Fractional reserve banking is complex but I have found it relative easy to understand.  I have explained it in the essay  LETS go to market: Dealing with the financial crisis on this weblog and there are numerous explanations that can be found with any search engine.  I encourage you to figure it out.

About 90 per cent of our money supply is based on the debt created in fractional reserve banking. This is a problem for three reasons.

The first is that the money supply needs to be flexible up and down.  The amount of money we need to facilitate the exchange of goods and services must be proportional to the quantity of goods and services we need to exchange.  I know economists like to model the economy on a least squares regression formula which gives an upwards line with a steady slope.  However, the reality is that the economy behaves like a fractal which means there are a series of ups and downs and more ups and downs within each trend. The amount of money needed varies with each up and down but fractional reserve money can only keep on increasing.  This sort of works when there is continuous economic growth but if growth slows or reverses, then there are problems.

The second problem with fractional reserve banking is that interest is charged on the debt created. This adds a purely financial demand for more money in that it is not needed for exchange of goods and services.  If all outstanding debts plus interest had to be repaid at the same time there would not be enough money in the economy. From time to time this feature of fractional reserve banking catches up with us and we call it a financial crisis.

The third problem is that when there is a financial crisis lots of people lose their savings.  The need to save for a rainy day, or retirement, is a part of our psyche and fully exploited by the marketing arm of the financial industry but there are three ways in which we can lose our savings: a financial crises, inflation or a major economic downturn. these are more likely when the economy is not growing or declining. With the current economic climate most of us would probably be better off to live for today and worry about tomorrow when that day comes.  The best way to secure one’s future is probably a market garden.

These are real problems and from time to time they cause havoc in the lives of most of us.  Therefore we are right to worry about excessive debt.  The good news is that there are other ways of creating money and the bad news is that money is such an emotional concept that most people are not prepared to consider other ideas.

One of the other ways of creating money is discussed in my ebook Funny Money: Adapting to a down economy which is available free from the link at the top of this weblog.

We tend to take money for granted so long as the economy is working but it is such an important concept that we would do well to try to understand it and make changes.  I cannot see that happening so in the meantime we should remember the advise of Shakespeare: Neither a lender nor a borrower be.

 

The downside of falling oil prices

One would expect lower oil prices to be great economic news.  However there are a couple of problems which could make them the worst possible news  –  our economy does not cope well with deflation and this could indicate the start of a major economic decline.

Oil is such an important part of our economy that lower prices should stimulate economic activity to the point we would easily achieve full employment and all our economic problems would be solved.  Life may be a little more complicated. Most news reports suggest the problem is increased supply from U.S. fracking but there could also a decreased demand for oil.

The first complication is that our economy does  not cope well with deflation.  We can probably cope with falling prices but falling wages are a different matter.  Very few people would willingly take a cut in income.  A further and more serious complication is that most of our money supply is based on debt and it is likely the owners of this debt would want  to be repaid in full in deflated money.  Instead of having economic utopia we could have economic chaos.

The second concern about falling oil prices is with what is happening in the real side of the economy.  Too often we evaluate economics only in financial  terms.  Sometimes this hides problems.

Probably the most serious economic problem is that we have used up the most easily accessible energy and mineral resources.  There are lots of these left on the earth’s surface but they are so difficult  and expensive to extract that it is no longer viable to do so.  This is bound  to have a profound effect on our economy, reduce the potential for economic growth and maybe force us into negative growth.  It could be that high prices for energy and mineral resources have messed up the economy so that we can no longer produce as many goods and services as we  were.   It may be the recent high costs of oil has contributed to its own reduced demand.

If this scenario is correct or even nearly correct then we are in for some serious economic problems.  It could be that falling oil prices are a leading indicator of a crisis.

This has been a difficult post to write because one does not want to witness the human suffering that will come with a prolonged economic downturn.

One further observation: Although headlines show the price of oil has been falling the news has been slow to reach the owner of our local gas bar.

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

Let this time be not different

Please, let this time be not different.  Please let this recovery be the similar to all the previous recoveries.

I have just finished reading This time is different by Carmen M. Reinhart and Kenneth S. Rogoff.  They bring together statistical data on all the world’s known debt and banking crises and look for patterns that precede them.  Their title comes from people saying during each boom that there will not be another crisis because we now have knowledge and experience from previous crises and  “this time will be different.”

Following each crisis there has been recovery in which the economy has grown to a new high. For the sake of all the people who are suffering from the current crisis it would be good if this time is not different and we could have a full normal recovery.  It would be even better for the planet and our long-term well-being  if we could adapt our economy so that people would not suffer from zero or negative economic growth.

One of the things which is different for this recovery  is that the marginal cost of extracting energy, mineral and agriculture resources has increased.  We have used up the most easily available of these resources and those that are left take a lot more work to extract.  This is bound to limit the potential for further economic growth.  We should beware of believing economic growth can continue forever.

I think there is an element of truth in the Elliott Wave Theory which applies to economics as well as the stock market. This theory says ups and downs run in series of fives and after the fifth the overall trend reverses.  Within each up and down there are series within a series.  I don’t  know about the fives but I believe the economy is fractal in nature and that there can be major turning points.  We should not rule out the possibility that we have passed a major turning point and that for some time to come we will have a series of downs and ups with each down going even lower.

As I read this book I wondered how the crises impacted people’s lives.  How serious was the unemployment?  How did people cope with unemployment?  Who were the people who lost their savings from defaults or inflation and how did they cope?  Did some of the one percent find themselves joining the poor?

In the current crisis, the headlines indicate young people are being hit hard and are the lost generation.  Meanwhile the cruise ships are packed with older people planning their next cruise.

It could be that during an economic boom we have a psychological need for economists to be telling us the boom will not end in a crisis.  Then we can work hard to prepare for retirement and to provide short-term profits for people in the financial industry.   We want to hide from ourselves the possibility we will lose the benefits of our hard work to defaults, haircuts or inflation.

As I was reading about all the financial crises I was saying “why oh why oh why would anyone want to put effort into the financial industry when there is such a high probability we will lose a lot of our savings?”  But then I have never been much for ambition.

Why stimulus is not working

At least since Keynes conventional economic wisdom has been that the cure for an economic depression is government stimulus spending – even if it means increasing the government debt.  Recently, some people, especially  those who will lose their savings from inflation or if debt has to be written off, have been fighting plans for stimulus spending.

There are other reasons to be leery of stimulus spending.  It isn’t working and it could bring forward an even more serious economic collapse.

To explain this we have to go to the blackboard of an economics classroom where the professor draws an x-shaped graph.  One line represents the financial side of the economy and the other line represents the physical aspect.  The problem is that we measure the physical side in financial terms and tend to forget this distinction as soon as we get away from the blackboard.

polettix_stone_age_wheel_1For stimulus to work there has to be adequate energy and mineral resources to support the increased economic activity.  When Roosevelt implemented the New Deal and when we undertook the Second World War there were still loads of resources.  Now we have used up the most easily accessible energy and minerals.   What’s left requires a lot more work and energy to extract.  Putting more energy into extracting resources is taking away from the standard of living most of us want.

The other problem with stimulus spending is that it will use up even more of the existing resources and make the economic crisis even worse.

If stimulus is going to make things worse, what do we do?  After all people are suffering from the crisis. I think the answer is to drop our commitment to economic growth and the consumer society.  The economic task should be to see that everyone has adequate food, shelter. clothing,  hobbies and entertainment.  It is important to be able to communicate but I’m not certain it is necessary for everyone to have a micro cell phone.

Solving the debt crisis with two coins in the bank. Probably not.

Two platinum coins worth $1 trillion each to solve the U.S. debt problem.  This proposal is reported in this article on the Huffington Post.  The coins would be made by the mint and deposited with the federal reserve to meet debt requirements.  Platinum would be used to get around legal requirements.

The good part of this proposal is that it would replace fractional reserve money with fiat money.  Fractional reserve money is created by the banks when they make loans.  Very little economic thought has gone into the effect of interest rates in this money creation.    This new fiat money would not involve interest charges and that is probably very good.

The problem would be what it does to the money supply.  Presumable  the $2 trillion would be used to pay off government debt.  Some of this debt would be held by the central bank and repaying this shouldn’t change the money supply.  The rest would be to repay bondholders and this would increase the money supply.  Further it would be what economists call high-powered money which is subject to a multiplier effect as it worked its way through the banking system.

The result would be the potential for a massive increase in money supply.  This is the opposite to a return to the gold standard which would force a decrease in the money supply.    The result would be deflation and a decrease in economic activity.

There are four variables in the equation that connects the financial system and the physical side of the economy: the amount of money, the quantity of goods and services produced,  the price index and the velocity or speed at which money circulates. The formula is MV=PQ.  If one of these changes at least one of the others has to change.

If we were to have an increase on the money supply then the velocity must decease or either the price index (inflation) will go up and/or the quantity of goods and services will go up(economic growth).

In an attempt to stimulate economic growth central banks have been trying to increase the money supply and called it quantitative easing.  So far there has been little indication of its working.  This leaves either inflation or a decrease in velocity.

There has been little inflation from quantitative easing so probably the velocity has fallen.

So the impact of the two little platinum coins is unclear but they would certainly be disruptive and have the potential for hyperinflation.

For a fuller explanation of fractional reserve money is created and some of its problems please see the essay “LETS go to market: dealing with the economic crisis” on this weblog.

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

The Euro and fiscal timebombs

The Euro crisis and the fiscal cliff are such serious threats they should be considered time bombs.  For that reason I have been trying hard not to even read about them let alone think and write. Well, anyways, here goes.

There are two parts to the problems – the physical and the financial.

The physical is that the resource base is in trouble.  We have used up the most easily extracted resources.  Those which are left are difficult to extract and require a lot of energy – energy which was previously used for other economic activity.

As most of these resources, especially energy, are non-renewable there is bound to be a negative impact on our lives.  Yes, I know we can recycle some items and there are several sources of renewable energy, but so for there is not a lot of evidence that either of these will save us.

The impact of resources will probably be a slow steady decline.  For those people hit be natural disasters recovery will be slow and difficult.

The impact of the financial crisis will likely be a much wilder ride.

The source of the financial crisis is the fractional reserve way of creating money.  Money is created when the banks make loans.  Thus most of our money supply is based on debt and the fact interest is being charged on this debt means there is never enough money in existence to repay all the debts.  (For a more detailed explanation of how money is created and the problems, please see the essay LETS go to market: dealing with the financial crisis on this weblog.)  The effect is that our money supply is a Ponzi scheme which is likely to collapse at any time. And it has in the past.  We could say we are living in a house of cards.

At this point in the crisis the question is whose standard of living is going to be hurt.  So far the answer is “everybody but me.”  Thus we have demands for austerity which impacts those with less income, demands for stimulus which means inflation which impacts those with savings, and protests in the streets.  If or rather when the crash happens a lot of people are going to lose their jobs, savings or fortunes.

Just thinking about all this makes me depressed.  At this time I want to spend the rest of my life in the  wood shop  or taking the dog for walks in the forest.  However, it won’t be long before the urge to write resurfaces.

Last week I received in the mail a little statue of the Laughing Buddha.  One of his functions is to tell us to laugh in spite of all the suffering in this world because there is also a lot of joy and happiness.

Greek debt world wide

An editorial in this week’s The Economist calls for Greece’s official creditors to write off a big chunk of the Greek debt so that country can start over again.

Debt is not a problem restricted to Greece.  It is a problem for most of the countries around the world.

So much debt, government and consumer, has been for projects that will not earn the income with which to repay the debt.  There is little hope  any of this debt will ever be repaid and therefore it will eventually have to be written off or defaulted.

The down side of this is that a lot of people are going to lose their savings.

Once the big crash happens I hope the survivors will be smart enough to find a way of creating money that is not based on debt.

 

Banking union and rearranging the deck chairs

One of the ways being proposed to deal with the European part of the economic crisis is  centralized banking supervision.  More on that in this article in this week’s Economist.

The question here is would a banking union solve the problem.

Back when Russia was trying central planning and having problems, some people figured the solution was decentralized central planning.  Banking union  sounds like the reverse thinking. It also sounds like rearranging the deck chairs.

If the basic problems is the people or institutions or governments to whom the banks have loaned money are unable to repay those debts then centralization will not work because it will do nothing to reduce or repay the debt.

I think the financial side of the current economic crisis is rooted in the way we create money.  For more on this please see the essay on this  weblog titled “LETS go to market: Dealing with the economic crisis.”

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

Conseqences of Greece leaving the Euro

It appears a Greek departure from the Euro would be a surprise to the Greeks but not to everyone else.  If it does happen what would be the impact on them and the rest of us?

As I believe economic problems should be analyzed in terms of the physical side of the economy lets start there and then look at financial concerns.

Following an exit from the Euro the Greek standard of living would depend upon the quantity of goods and services the Greek people would be able to produce divided by the number of people.   This does not mean they would have to be self-sufficient as they would still be able to trade.

There could be a problem. If they were currently producing enough for their desired standard of living they probably would not now be in a crisis.

There are a number of factors which might reduce or improve their standard of living.

Some of the outside money they have been receiving was probably  used to import goods and services.  This would probably be lost although if things are really tough they might be given some aid.

If there were to be massive emigration (not a sure thing) things would be better.

The standard of living could be reduced by an obligation to repay some of the current debt to foreigners.  This would be because money repayments would be followed by goods and services.

They would also be adversely affected by what happens in other countries.  If things get worse elsewhere the number of tourists could drop which would reduce the foreign money they have for outside purchases.

On the financial side it appears there will be a massive write off of debt which means a lot of people will lose a lot of purchasing power.  A lot of people will be a lot less rich than they thought.  Both in and out of Greece this will fall upon individuals in the form of lost or devalued pensions or investments.

The writing off of debt will also mean a loss of money supply both in and out of Greece.  As there appears to be a lot of unused credit around this might not be too serious a problem

If Greece leaves the Euro its government will have to manage the replacement money and will have to be very careful not to create too much.  The consequences of too much money is inflation, maybe even hyperinflation.   Inflation is a loss of purchasing power just like the writing off of debt.  It can be a sneaky way for governments to steal from their people.

If I were a Greek politician I would want to write off all debt and start over with a national exchange trading system as outlined in my essay “LETS go to market”>

In working on this post I am very grateful I was born and raised in Western Canada.  However, I have to recognize our turns is probably coming soon.

Money creation problems on YouTube

It’s great to see a criticism of how we create money getting a good airing on YouTube. (Here)

Victoria Grant is a 12-year old young lady who speaks with a great deal of confidence on a subject about which most people know nothing.  It is hardly surprising that she got a standing ovation for her explanation of how the banks and government are defrauding Canadians.

She clearly has  a good understanding of the problems with our money creation mechanisms but her proposed solution would probably be an even greater ripoff.

She got it right on when she said “under the present system all money is debt” and when she points out debt is enslavement.  I would take issue with her suggestion that money issued by the banks if fake while money issued by the Bank of Canada is real.  It is probably good that both are money “generated out of thin air” as the alternative, a commodity money, has its own problems.

Her concern is that the Canadian government is defrauding us by borrowing money from the banks and paying commercial interest rates. I would be more concerned that the government will never be ale to repay its debts with the same purchasing power as it borrowed.

Miss Grant’s solution is for the government to borrow directly from the Bank of Canada rather than the commercial banks and use the money for economic infrastructure..  This is quantitative easing and would increase the money supply.  It would work only if there are available lots of physical resources for infrastructure and that is not clear.

If the increased money supply is not matched by an increase in the goods and services produced, the result would probably be inflation.

Inflation is a more subtle and more efficient way for governments to steal from their people.  Any one with financial assets in fixed prices or with pensions would lose purchasing power.  I’m not sure Miss Grant would want that.

However, she should be lauded for pointing out some problems with our banks and money supply and for getting a lot people to think about them.

Temporary money for a bailout

Here’s n interesting little story about money.

A tourist in a small depressed Irish town leaves a hundred pound note with the hotel keeper while he inspects the rooms.

While the inspection is happening the money is used to by a series of business people to pay off their debts to each other and lands back with the innkeeper just as the tourist returns to collect his money and leave..

The story ends with these lines:

“No one produced anything. No one earned anything. However, the whole town is now out of debt and looking forward to a brighter future.

And that, gentle reader, is how a successful bailout works.”

This town was using debt as money which is the case in our own economies.  However, this “bailout” was only able to work because there was no interest charged on any of the debts.  It could be that we would be much better off if we were to create our own money supply without interest charges to make things more complicated.

The people of this town would probably be better off if they were to use playing cards or candies as money or better still adopt a LETS (local exchange trading system).

Debt write off – a haircut or worse

Here’s another idea to kick-start the American economy – a large write off of consumer debt so that people can start spending again.  If the economic crisis is because our use of resources is unsustainable then this would probably not solve that problem.

Nevertheless,  it is an interesting idea depending upon who would ultimately get the haircut.

Banks and other financial institutions are financial intermediaries in that they act as an in between for people with excess money in their hands and people who need to borrow.  Thus if there were to be a write off of debt it would probably  end up on individual  savers – likely a reduction in pensions and personal savings.

Most of these people are unlikely to willingly see a reduction in their savings and pensions and they have considerable political power.

It is possible many of these people are going to get a haircut or worse, so it might be less painful if it were to be done in an orderly fashion – rather a barber than an executioner.

Debt reduction problems

Deleveraging or debt reduction is the topic of an editorial in The Economist. It lists three ways in which debt can be reduced – paying it off, defaulting or inflation.

 Debt can be reduced in several ways. It can be paid off with the help of higher thrift (though not everyone can spend less than they earn at the same time). Its burden can be reduced through higher inflation or faster growth. Or it can be defaulted on. In practice, rich countries seem to be using different combinations of these approaches.

While debt reduction is a highly desirable goal there are two serious problems with which to deal.

First, if it is achieved either by write offs or inflation, then some where some how or the other some people are going to loose some of their savings. No doubt a few people will easily cope with that but probably the pain will be felt mostly by people upon whom it with will inflict considerable suffering.

The second problem is that our money supply is based on debt and reducing debt will probably mean a reduction in the amount of money in the economy (with a multiplier effect. Of course with less money a lot of exchanges won’t take place and people will be out of jobs and there will be even more suffering.

How not to become a slave

Through the centuries/millenia those people who have built empires have needed others to do the grunt work of agriculture, manufacturing and administration. This has often meant using force or capture to make people into slaves or serfs. A more subtle way to enslave people is to give them cash loans. In peasant societies loans have often been for weddings or funerals. While people owe money they remain under control and if they can’t repay the loan they and often their descendants become formal slaves.

Of course, this doesn’t apply to us. Or does it? It may be that many in our society are unable to do the things they really want to do because they have to work to pay of a debt which was encouraged and easy to get. A further complication is that in a time of economic difficulty people are losing their jobs but the debt is still there.

The CBC filled a report today from Statistics Canada that “the total amount of debt that Canadians hold in relation to their incomes continued to inch higher in the first quarter.

“The debt-to-income level ticked almost a full percentage point higher to 147.3 per cent in the January to March period, the agency said. The figure is a measure of total debt load — including mortgage and consumer debt — versus disposable income.”

If you don’t want to become a slave, then try not to get into debt.

Dangerous debt

I came across this article from the Guardian about the U.S. spend or cut debate shortly after I started reading This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff.  The article reports Paul Krugman is urging  the Obama administration to go with a trillion dollars of stimulus.

In the book the second paragraph of the preface talks of excessive debt accumulation.  Granted that the authors are talking about dept during a boom, but if that is a problem what is it during a  recession.

If there is one common theme to the vast range or crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations or consumers, often poses greater systemic risk that it seems during a boom.  Infusions of cash can make a government look like it is providing greater growth to its economy that it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable they really are.  Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short  term and needs to  be constantly refinanced.  Debt-fueled booms all too often provide  false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living.  Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget

My own reasons for objecting to stimulus spending is stated in the post Economic policy, least squares and the Elliott wave

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