JANUARY 2006

Debt Trap

A study of the US monetary system reveals that weare already caught in a system-wide

debt trap

rootedin the design of our currency.

O’Connor: Debt Trap

January 2006

Page 1

Debt Trap

Daniel J. O'Connor

On this last day of Alan Greenspan's extraordinaryreign as Chairman of the Federal Reserve, many in themedia have been reflecting on his legacy. Judging fromthe dozen or so articles and television interviews I'veseen in the past week, the mainstream media and theirchosen pundits seem to regard it as a very positivelegacy, characterized by strong economic growth, mildprice inflation, and relatively benign unemployment rates. The one point of concern raised by some is thetroubling accumulation of debt throughout theeconomy, particularly in the past several years.As the chart indicates, the total accumulated debt in the US economy

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Total Credit Market Debt

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isapproaching $40 trillion at the close of 2005. Since1970, the year before the US government severed thefinal link between the dollar and its gold backing, TotalCredit Market Debt has grown by an average annualrate of 9.6%, a remarkably high rate that is evengreater than the 7.3% average annual growth rate inthe inflation-saturated Nominal Gross DomesticProduct. Thus, even fully inflated economic growth hasnot kept pace with the growth in debt over the past 36years.While I am glad to see the media paying attentionto this important economic factor, I think they aremissing the essential point: given our current monetary system, economic growth and debt accumulation come hand-in-hand.The reason for this is to be found in the design of our currency. The US dollar, like all national currenciesthese days, is a credit-based currency created, not bythe Fed's printing press, but through the extension of credit from the Fed, via the fractional-reserve bankingsystem, to borrowers in the government, business, andhousehold sectors. As each new dollar comes intoexistence, a new dollar of debt also comes intoexistence. And as the supply of dollars accumulatesover time, so too does the amount of debt.How does the growth in money and debt relate tooverall economic growth?The answer to this begins with a closer look at what happens when new money is created. Each newdollar makes its first appearance as a new asset on thebooks of some bank and a new liability on the books of some borrower. But there's a catch. When new dollarsare loaned into existence, they are recorded on thebooks of both the lender and the borrower, or creditorand debtor, as the principal amount of theloan. However, the interest that the debtor will have topay back to the bank along with the principal is

not

created as part of the transaction. As anyone with a 30-year mortgage knows, the interest payments can beeven greater than the principal payments over the lifeof the loan. Few people realize, however, that ourentire economic system is structured in a similarfashion, with the total supply of money currently incirculation being dwarfed by the total future debt service payments

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both principal and interest

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that must be paid by all government, corporate, andhousehold debtors.Where do these debtors find the additional dollarsrequired to pay interest on their loans?

As if defying reality, centralbankers must navigate anincreasingly treacherous routebetween the Scylla of deflationary depression andmassive debt defaults and theCharybdis of hyperinflation andcurrency destruction.

O’Connor: Debt Trap

January 2006

Page 2

In the existing supply of money already incirculation at the time of the loan, as well as any futurenet increases in the supply of money that precede eachfuture interest payment. If the central bank holds thesupply of money fixed from this day forth, then everydebtor in the economy will be forced into a highlycompetitive zero-sum game to get what each one of them needs to make their debt service paymentsbefore the others get what they need. So the only wayto ensure a sufficient supply of money to meet thedemand of today's debtors is to systematically increasethe supply of money each and every year in the futureby an amount roughly equivalent to the averageinterest rate on all existing debt. This way there will bejust enough money in circulation to ensure that just about every one of today's borrowers can get what heor she needs to pay back the interest and principal ontheir loans as it becomes due.But there's another catch.The only way to increase the supply of money inthe future is to extend additional credit and therebycreate new debt over and above whatever debt is beingrepaid through principal payments. As we've seen, thisbrings with it the same constraint on future repayment,which means that the central bank will have tofacilitate the creation of even more money for all thenew debtors whose new loans are helping the olddebtors pay their interest. Thus, we take care of theolder generation of debtors by creating a newgeneration of debtors who will suffer immeasurablyunless the next generation of debtors is coaxed into thecredit system. And so it continues, seemingly without end, until we have an economy so choked with old debt and so dependent on new debt that the most we canhope for is perpetual, credit-based growth in output that keeps pace with the perpetually growing debt service obligations of the entire monetary system. As if defying reality, central bankers must navigate anincreasingly treacherous route between the Scylla of deflationary depression and massive debt defaults andthe Charybdis of hyperinflation and currencydestruction.A bit too dramatic, given how successful the Fedhas been in recent decades, no?The dark secret of our relatively successful era of credit-based growth in economic output, driven as it has been by the exponential growth in money and debt,is that the returns on each new credit-basedinvestment have diminished over time. Smoothing out the variability from one year to the next, the trend isunmistakable: since 1970, each new dollar of debt inour economic system

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Total Credit Market Debt

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hasyielded a decreasing amount of economic growth

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Nominal Gross Domestic Product

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even beforeadjusting to remove the effects of inflation. Lately, it seems that we are to be celebrating the generation of $0.25 of nominal economic growth for every $1.00 of additional debt.What to do?To stimulate additional growth using monetary orfiscal policies would create additional debt, becausefiscal stimuli are deficit-funded and, to a large extent,systematically monetized by the Fed and the bankingsystem. This would tend to off-set the benefits of theeconomic growth, thereby having little impact on theratio of growth-to-debt. To reduce indebtedness orslow the growth in debt through more restrictivemonetary or fiscal policies would tend to sloweconomic growth, with, once again, little impact on theratio of growth-to-debt.

Therefore, we don’t have to wait for deflation or

hyperinflation to arrive before we acknowledge ourpredicament. We are already caught in a system-wide

debt trap

with no easy exit. More than Greenspan'slegacy, this is the legacy of a series of currency design

We don’t have to wait for

deflation or hyperinflation toarrive before we acknowledgeour predicament. We arealready caught in a system-wide

debt trap

with no easy exit.