The article, excerpted from Conquer the Crash, was originally published in March 2002.
Following the Great Depression, the Fed and the U.S. government embarked on a program, sometimes consciously and sometimes not, both of increasing the creation of new money and credit and of fostering the confidence of lenders and borrowers so as to facilitate the expansion of credit. These policies both accommodated and encouraged the expansionary trend of the ’Teens and 1920s, which ended in bust, and the far larger expansionary trend that began in 1932 and which has accelerated over the past half-century.
Other governments and central banks have followed similar policies. The International Monetary Fund, the World Bank and similar institutions, funded mostly by the U.S. taxpayer, have extended immense credit around the globe. Their policies have supported nearly continuous worldwide inflation, particularly over the past thirty years. As a result, the global financial system is gorged with non-self-liquidating credit.
Conventional economists excuse and praise this system under the erroneous belief that expanding money and credit promotes economic growth, which is terribly false. It appears to do so for a while, but in the long run, the swollen mass of debt collapses of its own weight, which is deflation, and destroys the economy. Only the Austrian school understands this fact. A devastated economy, moreover, encourages radical politics, which is even worse. We will address this topic in Chapter 26.
A House of (Credit) Cards
The value of credit that has been extended worldwide is unprecedented. At the Crest of the Tidal Wave reported in 1995 that United States entities of all types owed a total of $17.1 trillion dollars. I thought it was a big number. That figure has soared to $29.5 trillion at the end of 2001, so it should be $30 trillion by the time this book is printed. That figure represents three times the annual Gross Domestic Product, the highest ratio ever.
Worse, most of this debt is the non-self-liquidating type. Much of it comprises loans to governments, investment loans for buying stock and real estate, and loans for everyday consumer items and services, none of which has any production tied to it. Even a lot of corporate debt is non-self-liquidating, since so much of corporate activity these days is related to finance rather than production. The Fed’s aggressive easy-money policy of recent months has cruelly enticed even more marginal borrowers into the ring, particularly in the area of mortgages.
This $30 trillion figure, moreover, does not include government guarantees such as bank deposit insurance, unfunded Social Security obligations, and so on, which could add another $20 trillion or so to that figure, depending upon what estimates we accept. It also does not take into account U.S. banks’ holdings of $50 trillion worth of derivatives at representative value (equaling five full years’ worth of U.S. GDP), which could turn into IOUs for more money than their issuers imagine. Then there is the problem of major coporations’ unfunded pension plan liabilities. Companies have promised billions of dollars in fixed-income pensions, but their plan assets will fall so much in value that they will have to fund those pensions from their operating budgets. How much of those liabilities will turn into debt is unknown, but the risk is large and real. Is it not appropriate that you are now reading Chapter 11?
Figures 11-1 through 11-4, along with Figure 7-6, show some aspects of both the amazing growth in credit — as much as 100 fold since 1949 — and the astonishing extent of indebtedness today among corporations, governments and the public, both in terms of total dollars’ worth and as a percent of GDP. There are so many measures revealing how extended debtors have become that I could dedicate a whole book to that topic alone.
Runaway credit expansion is a characteristic of major fifth waves. Waxing optimism supports not only the investment boom but also a credit expansion, which in turn fuels the investment boom. Figure 11-5 is a stunning picture of the credit expansion of wave V of the 1920s (beginning the year that Congress authorized the Fed), which ended in a bust, and of wave V in the 1980s-1990s, which is even bigger.
I have heard economists understate the debt risk of the United States by focusing on the level of its net debt to foreigners, which is just above $2 trillion, as if all other debt we just “owe to ourselves.” But every loan involves a creditor and a debtor, who are separate entities. No one owes a debt to himself. Creditors in other countries who have lent trillions to the U.S. and their own fellow citizens have added to the ocean of worldwide debt, not reduced it. So not only has there been an expansion of credit, but it has been the biggest credit expansion in history by a huge margin. Coextensively, not only is there a threat of deflation, but there is also the threat of the biggest deflation in history by a huge margin.
Broader Ideas of Money
It is a good thing that deflation is defined as a reduction in the relative volume of money and credit, so we are not forced to distinguish too specifically between the two things in today’s world. Exactly what paper and which book entries should be designated as “money” in a fiat-enforced debt-based paper currency system with an overwhelming volume of credit is open to debate.
Many people believe that when they hold stock certificates or someone’s IOUs (in the form of bills, notes and bonds), they still have money. “I have my money in the stock market” or “in municipal bonds” are common phrases. In truth, they own not money but financial assets, in the form of corporate shares or repayment contracts. As we will see in Chapter 19, even “money in the bank” in the modern system is nothing but a call on the bank’s loans, which means that it is an IOU.
There is no universally accepted definition of what constitutes “the money supply,” just an array of arguments over where to draw the line. The most conservative definition limits money to the value of circulating cash currency and checking accounts. As we have seen, though, even they have an origin in debt. Broader definitions of money include the short-term debt of strong issuers. They earn the description “money equivalents” and are often available in “money market funds.” Today, there are several accepted definitions of the “money supply,” each with its own designation, such as M1, M2 and M3.
The mental quality of modern money extends the limits of what people think is money. For example, a futures contract is an IOU for goods at a certain price. Is that money? Many companies use stock options as payment for services. Is that money? Over the past fifteen years, a vast portion of the population has come to believe the oft-repeated phrase, “Owning shares of a stock fund is just like having money in the bank, only better.” They have put their life’s savings into stock funds under the assumption that they have the equivalent of a money account on deposit there. But is it money? The answer to all these questions is no, but people have come to think of such things as money. They spend their actual money and take on debt in accordance with that belief. Because the idea of money is so highly psychological today, the line between what is money and what is not has become blurred, at least in people’s minds, and that is where it matters when it comes to understanding the psychology of deflation. Today the vast volume of what people consider to be money has ballooned the psychological potential for deflation far beyond even the immense monetary potential for deflation implied in Figures 11-1 through 11-5.
A Reversal in the Making
No tree grows to the sky. No shared mental state, including confidence, holds forever. The exceptional volume of credit extended throughout the world has been precarious for some time. As Bolton observed, though, such conditions can maintain for years. If the trend toward increasing confidence were to reverse, the supply of credit, and therefore the supply of money, would shrink, producing deflation. Of course, that is a big “if,” because for half a century, those wary of credit growth in the U.S. have sounded warnings of collapse, and it has not happened. This is where wave analysis comes in.
Recall that two things are required to produce an expansionary trend in credit. The first is expansionary psychology, and the second is the ability to pay interest. Chapter 4 of this book makes the case that after nearly seven decades of a positive trend, confidence has probably reached its limit. Chapter 1 demonstrates a multi-decade deceleration in the U.S. economy that will soon stress debtors’ ability to pay. These dual forces should serve to usher in a credit contraction very soon.
Wave analysis can also be useful when applied directly to the realm of credit growth. Figure 11-4 is a plot of consumer credit and commercial loans divided by the Producer Price Index to reflect loan values in constant dollars. It shows that the up-trend in real credit value extended to consumers and businesses has traced out five waves since the major bottom of 1974. This is nearly the same picture that we see in stock market margin debt (Figure 7-4). Plots of the credit expansion’s rate of change show that the growth in credit is running out of steam at multiple degrees of trend, which is what the analysis in Chapter 1 reveals about the economy. The downturn, it appears, is imminent if not already upon us.
If borrowers begin paying back enough of their debt relative to the amount of new loans issued, or if borrowers default on enough of their loans, or if the economy cannot support the aggregate cost of interest payments and the promise to return principal, or if enough banks and investors become sufficiently reluctant to lend, the “multiplier effect” will go into reverse. Total credit will contract, so bank deposits will contract, so the supply of money will contract, all with the same degree of leverage with which they were initially expanded. The immense reverse credit leverage of zero-reserve (actually negative-reserve) banking, then, is the primary fuel for a deflationary crash.