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Many economic commentators view debt as a major risk factor as far as economic health is concerned. This way of thinking has its origins in the writings of Irving Fisher. According to Fisher, the high level of debt runs the risk of setting in motion deflation and, in turn, a severe economic slump. According to Fisher, the high level of debt sets in motion the following sequence of events.

Stage 1: The debt liquidation process is set in motion because of random shocks; for instance, a sudden, large fall in the stock market. The act of debt liquidation forces individuals into the distressed selling of assets.

Stage 2: Because of the debt liquidation, the money stock starts shrinking and this, in turn, slows down the velocity of money.

Stage 3: A fall in the money stock leads to a decline in the price level.

Stage 4: The value of individuals’ assets falls while the value of their liabilities remains unchanged. This results in a decline in the net worth, which precipitates bankruptcies.

Stage 5: Profits start to decline and losses emerge.

Stage 6: Production, trade, and employment are curtailed.

Stage 7: All this leads to a growing pessimism and a loss of confidence.

Stage 8: This leads to the hoarding of money and a further slowing in the velocity of money.

Stage 9: Nominal interest rates decline; however, because of a fall in prices, real interest rates rise.

Note that the critical stage in this way of thinking is stage 2 (i.e., the debt liquidation that sets in motion a decline in the money stock). Why, however, should debt liquidation cause a decline in the money stock?

Not Every Debt Liquidation Causes a Decline in the Money Stock

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 can then make a decision to deposit the money with a bank or lend his money to another producer through the mediation of the bank. By lending his money, the lender transfers his savings to a borrower for the duration of the lending contract.

The borrower could employ the money in the purchase of consumer goods that will support him while he is engaged in the production of other goods, let us say the production of tools and machinery.

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

Things are, however, different when a bank uses some of the deposited money and lends it out without the depositor’s consent. Note that the owner of the deposited money has an absolute claim over the money.

On the day of loan maturity, once the money is repaid to the bank, this type of money will disappear since it never had a proper owner to whom it should be returned.

In a free market without the central bank, if a bank makes loans unbacked by savings it is likely to end up in serious trouble. If depositors were to decide to withdraw money from their respective demand deposits at the same time, the bank would not be able to oblige since it would not have enough money.

On this Ludwig von Mises wrote,

People often refer to the dictum of an anonymous American quoted by Tooke: “Free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.”

Money Supply and the Pool of Savings

We suggest that the decline in money stock that precedes price deflation and an economic slump is triggered by the previous loose monetary policies of the central bank and not by debt liquidation.

It is caused by easy monetary policy, which provides support for the generation of unbacked credit. (Without this support, banks would have difficulties practicing fractional reserve lending.)

The unbacked credit leads to the reshuffling of savings from wealth generators to non–wealth generators. This weakens the ability of wealth generators to grow the pool of savings or the subsistence fund and weakens the economic growth. Note that the heart of economic growth is the pool of savings or the “subsistence fund.”

According to Eugen von Böhm-Bawerk, “The entire wealth of the economical community serves as subsistence fund, or advances fund, and, from this, society draws its subsistence during the period of production customary in the community.”

Similarly, Richard von Strigl wrote,

Let us assume that in some country production must be completely rebuilt. The only factors of production available to the population besides labourers are those factors of production provided by nature. Now, if production is to be carried out by a roundabout method, let us assume of one year’s duration, then it is self-evident that production can only begin if, in addition to these originary factors of production, a subsistence fund is available to the population which will secure their nourishment and any other needs for a period of one year. . . . The greater this fund, the longer is the roundabout factor of production that can be undertaken, and the greater the output will be. It is clear that under these conditions the “correct” length of the roundabout method of production is determined by the size of the subsistence fund or the period of time for which this fund suffices.

Because of the prolonged and aggressive loose monetary and fiscal policies, a situation can emerge when the pool of savings starts declining. We now have more activities that consume wealth than activities that produce wealth. Once the pool of savings starts dwindling then anything can trigger an economic collapse.

With the deterioration in economic conditions, banks are starting to curtail their supply of credit out of “thin air.” As a result, once loans out of “thin air” are repaid and not renewed, the stock of money comes under downward pressure.

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

Unbacked by Savings, Lending Poses a Risk to the Economy

Observe that when banks fulfill the role of the intermediary, they are engaged in the mediation of the lending of savings. In this sense banks make an important contribution in the wealth-generation process. By means of lending, banks widen this process.

An increase in debt because of wealth expansion is great news. The larger the debt the more prosperous the economy. The problem is not with the size of the debt but with policies that weaken the wealth-generation process through weakening the pool of savings or the subsistence fund.

Furthermore, lumping individuals’ and the government’s debt into a total national debt is a questionable practice. The government is not a wealth-generating unit and derives its livelihood from the private sector. Consequently, any government debt incurred means that the private sector will have to foot the bill sometime in the future.

Conclusion

Contrary to the popular way of thinking, the threat to the US economy is not the high level of debt but loose monetary policies that undermine the pool of savings and the wealth-generation process. 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.

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