Stanley Fisher and The Fed versus #OYVEyDonaldTrump Debt Isn't a Problem — Easy-Money Policies Are the Problem

According to the flow of funds data published by the Fed, the US debt to GDP ratio remains at a lofty level. Non-financial sector debt as a percentage of GDP stood at 251.7% in Q3 2016 against 230.1% in Q1 and 184.3% in Q1 2000.
Consumer credit as a percentage of GDP also remains at a record high — it stood at 19.9% in Q3 2016 against 15.8% in Q1 2000.

Most economic commentators regard these high ratios as alarming. Following in the footsteps of economist Irving Fisher, it is held that a very high level of debt relative to GDP runs the risk of setting in motion deflation and in turn a prolonged and severe economic slump. According to Fisher the high level of debt can trigger the following nine stages of events that culminate in a severe economic slump.[1]

Stage 1: The debt liquidation process is set in motion on account of some random shock. For instance, a sudden large fall in the stock market. The act of debt liquidation forces individuals into distressed selling of assets.
Stage 2: As a result of the debt liquidation the money stock starts shrinking and this in turn slows down the velocity of money.
Stage 3: A fall in money leads to a decline in the price level.
Stage 4: The value of assets falls while the value of liabilities remains intact. This results in a fall in 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 of this leads to growing pessimism and a loss of confidence.
Stage 8: This in turn leads to the hoarding of money and a further slowing in the velocity of money.
Stage 9: Nominal interest rates fall, however, but on account of a fall in prices real interest rates rise.

Observe that the critical stage in this story is stage two: debt liquidation results in a decline in the money stock. But why should debt liquidation cause a decline in the money stock?
Why Debt Liquidation Makes Money Disappear

Take a producer of consumer goods who consumes part of his produce and the rest he saves. In the market economy, our producer can exchange the saved goods for money. The money that he receives can be seen as a receipt, as it were, for the goods produced and saved. The money is his claim on the goods.

He can then make a decision to lend the money to another producer through the mediation of a bank. By lending his money the original saver — i.e., the lender — transfers his claims on real savings to the borrower. The borrower can now exercise the money and secure consumer goods that will support him whilst he is engaged in the production of other goods, for example, the production of tools and machinery.Note that once a lender lends his money he relinquishes his claims on real goods for the duration of the loan.
Can the liquidation of credit which is fully backed by savings cause a decline in the money stock? The answer is categorically “No.” Once the contract expires on the date of maturity the borrower returns the money to the original lender. As one can see the repayment of the debt, or debt liquidation, doesn’t have any effect on the stock of money.
Even if the borrower defaults for some reason and cannot repay the debt the lender will suffer losses because the borrower didn’t use the money productively, however, there will not be a change in the money supply. The money will be somewhere in the economy.
Things are, however, different when a bank uses some of the deposited money and lends it out. In this case, the owner of deposited money continues to exercise demand for that money — he didn’t relinquish his claims on real savings in favor of a borrower. Hence when a bank uses some of the deposited money the bank effectively creates another claim on real savings.
This claim is just a paper entry — not backed by real savings. In the case of fully backed credit, the borrower secures goods that were produced and saved for him, so to speak.
Why Un-Backed Credit Is Different

This is however, not so with respect to un-backed credit. No goods were produced and saved here. Consequently, once the borrower exercises the un-backed claims this must be at the expense of the holders of fully supported claims.On the date of the maturity of the loan, once the money is repaid to the bank this type of money must disappear since it never existed as such and never had a proper owner.
Debt Isn't the Problem
The point that must be emphasized here is that the fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary policies of the central bank and not the liquidation of debt.
It is loose monetary policy which provides support for the creation of un-backed credit. (Without this support banks would have difficulty practicing fractional-reserve lending.) This un-backed credit in turn leads to the reshuffling of real wealth from wealth generators to non-wealth generators.
RELATED: How Money Disappears in a Fractional-Reserve Money System
This in turn weakens the economy’s ability to grow the pool of real wealth and in turn weakens economic growth. (Note that the heart of economic growth is the pool of real wealth.)
On account of prolonged and aggressive loose monetary policy a situation can emerge when the pool of real wealth starts shrinking — there are now more activities that consume real wealth than activities that produce real wealth. Once the pool of wealth starts falling then anything can trigger a so-called economic collapse.
Obviously when things are starting to fall apart banks try to get their money back. Once banks retrieve their money (i.e., credit that was created out of “thin air”) and don’t renew loans the stock of money must fall.
Note however that the consequent price deflation and the fall in the economy are not caused by the liquidation of debt as such, nor by the fall in money supply, but by the fall in the pool of real wealth on account of previous loose monetary policies.
As a result of the fall in the pool of real wealth and the consequent fall in economic activity banks’ bad assets start to pile up. Hence, to improve their solvency banks start to curtail the expansion of credit.
In his writings Fisher argued that the size of the debt determines the severity of the economic slump. He observed that the deflation following the stock market crash of October 1929 had a greater effect on real spending than the deflation of 1921 had because nominal debt was much greater in 1929.
However, it is not the size of the debt as such that determines the severity of a recession, but rather the monetary policies of the central bank and the state of the pool of real wealth. It is not the debt but these loose monetary policies that cause the misallocation of real wealth.
By putting the blame on debt as the cause of economic recessions, one in fact absolves the Fed from any responsibility for actually setting the whole process in motion. Note that many commentators are of the view that on account of price deflation the debt burden intensifies.
Consequently, it is held that by means of monetary printing this burden can be eased thereby arresting the economic plunge. In fact, pumping more money only dilutes the pool of real wealth and makes things much worse.

Donald Trump: What he could do.

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52 COMMENTS

Today Donald Trump becomes the 45th president of the United States. American voters rejected the devil they know so well — Hillary Clinton — for the devil they don’t. Why they did so, and how Trump prevailed, is the biggest political story of our age. But the rejection of progressive hubris, what Friedrich Hayek called the “fatal conceit” of those who would presume to plan our lives, is at the heart of that story.

The Left views Trump’s election as an absolute calamity, despite his support for unions and protectionist trade policies, despite his identity as a New York elite rather than some despised red state politician, and despite his ambivalence toward the social issues that animate Christian conservatives. One would think Democrats would be relieved not to suffer an ideologue like Santorum or Cruz in the White House. Yet their hysteria and lack of self-awareness prompt them to attack the Electoral College, of all things. 

Progressives bear direct responsibility for Trump’s victory. They grossly miscalculated in nominating Mrs. Clinton, an avaricious and humorless technocrat who utterly failed to engage ordinary people. They abandoned populist economic themes and union halls in favor of global trade deals. They stayed silent while the Obama administration spent two full terms at war. They excused Obama’s NSA scandals. They cheered the growth of an imperial presidency and an activist judiciary, both of which they are now shocked to imagine outside their control.

But worst of all, progressives have poisoned America with vicious identity politics and a deeply false narrative of racism, sexism, xenophobia, and privilege. How could a backlash not result? By demonizing history, religion, traditional families, and middle America, they deliberately politicized whole areas of life that should be off limits to government. Politics is war, but it is also sales. 

Yet Trump represents no victory for conservatives. The political Right, despite installing an ostensible Republican in the White House and gaining seats in Congress, is in ideological tatters. It has no coherent ideology of individualism, capitalism, and opportunity to counter the progressive narrative of dependency and victimhood. Republican identity lies simply in being less progressive than progressives, in merely wanting to engineer society toward different ends. The GOP long ago forfeited any claim to limited government or constitutionalism, as demonstrated by the disastrous debt-fueled presidency of George W. Bush. Republicans remain deeply committed to interventionism and nation-building, a foreign policy doctrine that originated with leftwing radicals. They refuse to address entitlements, either structurally or in the more important sense of rejecting government’s role in healthcare and retirement. Most importantly, conservatives forfeited the wider culture: progressives now dominate academia, media, literature, performing arts, philanthropy, churches, synagogues, and boardrooms across America.  

So what can Trump actually do, in the face of this political and cultural stalemate? That’s the wrong question. What matters is what he can undo, or at least avoid doing. The last thing we need is more laws, New Deals, or Contracts with America. What we do need is less political control of society, meaning less state involvement in the economic, cultural, and social issues of the day. Can Trump possibly choose forbearance over action, at least in a few key areas?

Let us offer three suggestions.

First, Trump should stand by his pledge to pursue an “America first” foreign policy. Both the Left and Right oppose this, which suggests it’s a very good idea. Voters plainly want an end to our intractable conflicts in Afghanistan and Iraq, and they don’t want another dollar or drop of blood expended to install western democracy in the sectarian Middle East. Trump must resolve to stay out of Syria, stop the saber rattling toward Iran, and reject the crazed calls for resurrecting a Cold War with Russia. He must refuse to normalize constant war as an acceptable feature of American life. By trusting his deal-making nature and refusing to start — or intensify — another conflict, Trump could shock the world by actually presenting a kinder, gentler America.

Second, Trump should get serious about the Federal Reserve. By purchasing Treasury debt, the Fed is the shabby enabler of a deficit-addicted Congress. Interest rates are too low, savers (especially seniors) are suffering, and business malinvestment is once again creating bubbles throughout the economy. Interviewing John Allison — the former BB&T executive who understands sound money — for vice-chair of the Fed was a good sign that Trump understands this (nominating former Goldman Sachs insider Steven Mnuchin for Treasury Secretary, however, was tone deaf). The Fed is the biggest source of cronyism in the economy, and thus anti-Fed populism is both good policy and good politics. It’s time to dispel the myth that monetary policy can make us richer. For starters, Trump should pressure Congress to pass Senator Rand Paul’s Audit the Fed bill.

Finally, Trump should use his platform to continue attacking the illiberal code of political correctness. PC is not just another social issue, like abortion or marriage. It underlies all other issues, because it attempts to frame how we think and speak. The conscious manipulation of language is inherently authoritarian, and Trump’s reflexive disdain for PC comes from his better angels. Trump’s twitter feed can serve him well here.