Why can’t credit just expand forever?
Two things are required to produce an expansionary trend in credit. The first is increasing confidence, and the second is the ability to pay interest. After over seven decades of credit expansion, confidence reached its limit in 2006-2008. Since then confidence has slipped, and bank lending and consumer borrowing have contracted (the only exception being in education loans, but we think that’s about to end). As confidence slips, deflation accelerates, and the economy contracts. A contracting economy stresses debtors’ ability to pay interest and ultimately principal. Once debtors start defaulting, all these trends get worse. That’s why the Fed and the government bailed out so many bad debtors in 2008. They knew the system was in trouble. But they can’t bail out everyone, and in our view virtually all debts are at risk. We think the next bout of deflation and economic contraction will prove it.