Is the high level of debt a major economic risk factor?

By Dr Frank Shostak

According to the British newspaper Daily Mail from February 8 2024 the US debt bomb is on the verge of exploding. US national debt is at a historic high – hitting a massive $34 trillion earlier this year. By some economic commentators the high level of debt is likely to trigger a decline in the money supply. Consequently, this decline is going to pose a major threat to the economy’s health. But why should this be the case? We suggest that not every decline in the debt is going to 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 make a decision to deposit the money with a bank or lend the money to another producer through the mediation of the bank. 

By lending the money, the lender transfers his savings to a borrower for the duration of the lending contract. The borrower could employ the money in the buying of consumer goods that will support him whilst he is engaged in the production of other goods, let us say the production of tools and machinery.  

Note that money being the medium of exchange also fulfills the role of the medium of savings. By means of money, individuals’ channel real savings i.e., unconsumed consumer goods to other individuals’, which in turn permits the widening of the process of wealth generation. Thus, with the borrowed money Bob can exchange it for various consumer goods that will sustain him whilst he is busy doing other things. 

Now instead of Joe lending directly his $10 to Bob, he could do it through a bank. The bank here fulfills the role of an intermediary. The bank also fulfills another service by providing the money storage facility in terms of demand deposits.  

Whenever the bank abides by the increase in the demand for credit without an increase in real savings this leads to troubles ahead. For instance, the farmer Bob has approached the Bank A for a loan to the tune of $5. The Bank A abides by this request, whilst there wasn’t an increase in real savings, and places the $5 into the Bob’s demand deposit.  As a result, the money supply increases by $5. Now, when lending is fully backed by real savings money is transferred from a lender to the borrower’s demand deposit.

Once Bob the borrower of the $5 uses the borrowed money, he engages in an exchange of nothing for something. The reason being because the $5 is not backed by any real savings – it is empty money.    

Observe that when the loaned money is fully backed by real savings, on the day of the loan’s maturity it is returned to the original lender. Bob – the borrower of $5 – will pay back on the maturity day the borrowed sum plus interest to the bank.  The bank in turn will pass to Joe the lender the $5 plus interest adjusted for bank fees.  

In contrast, when lending is not backed by real savings and is returned on the maturity day to the bank, this leads to the withdrawal of money from the economy i.e., to the decline in the money stock. The reason being because in this case we never had a saver/lender, since we have here an unbacked by real savings credit. 

Could the liquidation of credit, which is fully backed by real savings, cause a decline in the money stock? Once the contract expires on the date of maturity, the borrower returns the money to the original lender. Note that the repayment of the debt, or the debt liquidation, does not have here any effect on the stock of money. 

The essence of unbacked by real savings credit 

Note that the loan to Bob resulted in the increase in the money supply by $5. Observe, that when loaned money is fully backed by real savings it is instrumental in the channeling of real savings thereby strengthening the wealth generation process. (It is instrumental in the exchange of something for something).

However, when nothing is backing up the loaned money it becomes instrumental in the channeling of illusion thereby weakening the wealth generation process. (It is instrumental in the exchange of nothing for something). 

Again, when the bank generates new deposit for $5 whilst real savings do not back up this deposit – we do not have here any original lender/saver to whom the $5 must be returned. Hence, the money will decline by $5 once it is repaid to the bank.   

Unbacked by real savings credit sets platform for non-productive activities 

Note again that the extra $5 of the new money sets in motion an exchange of nothing for something. This provides the platform for various non-productive activities that prior to the generation of unbacked by real savings lending would not have emerged, all other things being equal. 

As long as the banks continue to expand unbacked by real savings lending, various non-productive activities continue to expand. Once however, the continuous generation of unbacked lending lifts the pace of wealth consumption above the pace of wealth production, the positive flow of real savings is arrested and a decline in the pool of real savings is set in motion. 

Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to increase.   In response to this, banks curtail their lending activities and this in turn sets a decline in the money stock. Remember the money stock starts to decline once the unbacked by real savings loans are repaid to the bank. The decline in the money stock begins to undermine various non-productive activities i.e., an economic recession emerges.   We hold that a proper free market – without the central bank and in the framework of the gold standard – is going to minimize banks’ lending unbacked by real savings. To avoid bankruptcy in the clearing of their checks, lending by banks that is not backed by real savings will likely vanish. In the free market banks most likely will only fulfill the role of intermediary. In a proper free market, no one would have to worry whether banks’ lending is fully backed by real savings or not. The free market will prevent the emergence of unbacked by real savings lending. 

Note that the consequent price deflation and the fall in economic activity is not caused by the liquidation of debt as such, nor by the fall of money supply but by the decline in the pool of real savings because of previous loose monetary policies.  

Conclusions 

Contrary to the popular way of thinking, the threat to US economy is not the high level of debt as such but loose monetary policies that undermine the pool of real savings. Hence, the fall in the money stock, that precedes price deflation and an economic slump is actually triggered by the previous loose monetary policies and not by the liquidation of debt as such. 

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