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.

 

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