Government debt default and the money supply

A United States debt default will hit the economy as a reduction of government spending and it could also  hurt by forcing changes in the money supply.

The first thing to say about debt is that there is so much of it around the world that there is a high probability most of it will be written off either by defaults of inflation.  This debt is not so much borrowing from children as a transfer of purchasing power within this generation, some/most of which will never be returned. And those with the most are likely to lose the most but will still probably be more comfortable than the rest of us.

The second thing to say is that the probable root  cause of the economic crisis is in the real side of the economy as well as the financial sector.  We have used up most of the easily accessible energy and mineral resources and those that are left take a lot more work to extract.

If the United States defaults  some of its debt the government will have less money to spend.  As government spending is a component of gross domestic product there will be a reduction in economic activity.  Government spending currently makes up about 20 percent of GDP but only a small part of this will likely be cut immediately.

The effect of a debt default on the money supply is more complex and uncertain.  A drastic reduction in the money supply would bring a lot of economic activity to a halt.

Money is based on loans issued by the banks, involves fractional reserves (they are required to keep a percentage of deposits as reserves)  and dependant upon what is called high powered money which is subject to a multiplier because of the fractional reserves. (for and explanation of how money is created see these links, one, two.)  In a default one issue would be how much the losses fall upon institutions subject to fractional reserves because losses would reduce their reserves.  A reduction in their reserves would bring down the quantity of loans they could make – by a multiplier.  Thus the money supply in the economy would be reduced and without money the exchange of goods and services becomes difficult.

Under normal circumstances a reduction in the money supply would mean a reduction in the real economy.  But the real economy is already in trouble as noted above.

At this point I need to remind you of the formula MV=PQ.  The money supply times its velocity or the rate at which it changes hands is equal to prices or a price index times the quantity of goods and services.

In an attempt to stimulate the economy central banks have been using “quantitative easing” to inject more high powered money into the financial system so the banks will have more money to lend.   If the above formula is correct then there should have been a reduction in velocity or an increase in prices (inflation) or economic activity.  It may be that velocity has fallen but there is little evidence that inflation or GDP has increased.

If the formula is correct then something has to have happened to one of the other variables.   One possibility is that at least some of this extra money has gone into the financial markets and inflation has hit stocks.  If this is correct, then a reduction in money supply could hit the financial sector.

So there you have it a U.S. default would probably lead to a reduction in economic activity and it could also cause problems in the financial markets.  I just had a horrible thought.  What would happen if a lot of the major countries were to default at the same time?

where is the economy going?

Where is the economy going?

That is always an interesting question and even more so when we are clearly on a down trend although there have been one or two minor positive indicators.

The easy answer is that we can’t say.  A more complex answer is that we can’t say but through the fog we can sort of see an outline..

I like to think the economy follows patterns similar to the stock and financial markets.  Therefore technical analysis may offer some help. Technical analysis is easier in the markets because every transaction is recorded and we can see what is happening with some precision. We don’t have that option with the overall economy. Even if we could define all the economic transactions it’s not clear we would want everything we do recorded.

My favorite technical tool is the Elliott wave theory with its series of ups and downs and with another series within each ups and each downs.  As you can imagine it can be somewhat complex.  There’s a line that if you give three Elliott wave practitioners the same data they will come up with seven or eight  different forecasts.

The part of this theory that I question is that each series has five legs.

Applying this theory to the economy the important thing is that there are going to be ups and downs and that there will be major changes in direction as well as minor changes.

It would appear there has recently been a major change from an up trend to a down trend.  Even a lot of establishment economists are predicting the down trend will continue for some time.

So what will it take for there to be a major shift to another up turn?

My theory is that there are two things that causes the ups and downs.  One is the availability of resources.  As resources become scarcer or more difficult to extract this will have an impact on the overall economy until the new resources are found and become available.  Another source of ups and downs may be complications in how the financial system works.

There is some probability the current downturn is caused by a shortage of resources to maintain seven billion people.

One thing that might turn the economy around is the discovery of another source of cheap energy and one which would not require a great deal of capital to exploit.  Even then would the planet be able to support seven billion people?

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