JANUARY 2006

Debt Trap
Daniel J. O'Connor

A study of the US monetary system reveals that we are already caught in a system-wide debt trap rooted in the design of our currency.

Debt Trap
Daniel J. O'Connor

On this last day of Alan Greenspan's extraordinary reign as Chairman of the Federal Reserve, many in the media have been reflecting on his legacy. Judging from the dozen or so articles and television interviews I've seen in the past week, the mainstream media and their chosen pundits seem to regard it as a very positive legacy, characterized by strong economic growth, mild price inflation, and relatively benign unemployment rates. The one point of concern raised by some is the troubling accumulation of debt throughout the economy, particularly in the past several years. As the chart indicates, the total accumulated debt in the US economy—Total Credit Market Debt—is approaching $40 trillion at the close of 2005. Since 1970, the year before the US government severed the final link between the dollar and its gold backing, Total Credit Market Debt has grown by an average annual rate of 9.6%, a remarkably high rate that is even greater than the 7.3% average annual growth rate in the inflation-saturated Nominal Gross Domestic Product. Thus, even fully inflated economic growth has not kept pace with the growth in debt over the past 36 years.

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 currencies these days, is a credit-based currency created, not by the Fed's printing press, but through the extension of credit from the Fed, via the fractional-reserve banking system, to borrowers in the government, business, and household sectors. As each new dollar comes into existence, a new dollar of debt also comes into existence. And as the supply of dollars accumulates over time, so too does the amount of debt.

As if defying reality, central bankers must navigate an increasingly treacherous route between the Scylla of deflationary depression and massive debt defaults and the Charybdis of hyperinflation and currency destruction.
How does the growth in money and debt relate to overall economic growth? The answer to this begins with a closer look at what happens when new money is created. Each new dollar makes its first appearance as a new asset on the books of some bank and a new liability on the books of some borrower. But there's a catch. When new dollars are loaned into existence, they are recorded on the books of both the lender and the borrower, or creditor and debtor, as the principal amount of the loan. However, the interest that the debtor will have to pay back to the bank along with the principal is not created as part of the transaction. As anyone with a 30year mortgage knows, the interest payments can be even greater than the principal payments over the life of the loan. Few people realize, however, that our entire economic system is structured in a similar fashion, with the total supply of money currently in circulation being dwarfed by the total future debt service payments—both principal and interest—that must be paid by all government, corporate, and household debtors. Where do these debtors find the additional dollars required to pay interest on their loans?

While I am glad to see the media paying attention to this important economic factor, I think they are missing the essential point: given our current

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In the existing supply of money already in circulation at the time of the loan, as well as any future net increases in the supply of money that precede each future interest payment. If the central bank holds the supply of money fixed from this day forth, then every debtor in the economy will be forced into a highly competitive zero-sum game to get what each one of them needs to make their debt service payments before the others get what they need. So the only way to ensure a sufficient supply of money to meet the demand of today's debtors is to systematically increase the supply of money each and every year in the future by an amount roughly equivalent to the average interest rate on all existing debt. This way there will be just enough money in circulation to ensure that just about every one of today's borrowers can get what he or she needs to pay back the interest and principal on their loans as it becomes due. But there's another catch. The only way to increase the supply of money in the future is to extend additional credit and thereby create new debt over and above whatever debt is being repaid through principal payments. As we've seen, this brings with it the same constraint on future repayment, which means that the central bank will have to facilitate the creation of even more money for all the new debtors whose new loans are helping the old debtors pay their interest. Thus, we take care of the older generation of debtors by creating a new generation of debtors who will suffer immeasurably unless the next generation of debtors is coaxed into the credit 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 can hope 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 an increasingly treacherous route between the Scylla of deflationary depression and massive debt defaults and the Charybdis of hyperinflation and currency destruction. We don’t have to wait for deflation or hyperinflation to arrive before we acknowledge our predicament. We are already caught in a system-wide debt trap with no easy exit. A bit too dramatic, given how successful the Fed

has 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-based investment have diminished over time. Smoothing out the variability from one year to the next, the trend is unmistakable: since 1970, each new dollar of debt in our economic system—Total Credit Market Debt—has yielded a decreasing amount of economic growth— Nominal Gross Domestic Product —even before adjusting 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 or fiscal policies would create additional debt, because fiscal stimuli are deficit-funded and, to a large extent, systematically monetized by the Fed and the banking system. This would tend to off-set the benefits of the economic growth, thereby having little impact on the ratio of growth-to-debt. To reduce indebtedness or slow the growth in debt through more restrictive monetary or fiscal policies would tend to slow economic growth, with, once again, little impact on the ratio of growth-to-debt. Therefore, we don’t have to wait for deflation or hyperinflation to arrive before we acknowledge our predicament. We are already caught in a system-wide debt trap with no easy exit. More than Greenspan's legacy, this is the legacy of a series of currency design

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decisions made long before Greenspan took the helm at the Fed.
T his c opyrighted work is lic ensed under a C reative C ommons A ttribution–Noncommercial-No D erivative Works 3 .0 L icense .

Daniel J. O'Connor, MBA, MA, C FA, is the managing director of Integral Ventures, a developmental consultancy committed to fostering more conscious and sustainable ways of doing business. email: daniel@integralventures.com website: www.integralventures.com

Catallaxis explores the potential for a more integral approach to the business and economic challenges of our time. It features original articles and essays, thoughtful reviews and commentary, and referrals to other work in the field. website: www.catallaxis.com

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