Diagnosing the Disease

Spending ain’t spending, to paraphrase the old Castrol ad about oils.

Where government stimulus spending ends up, and how, are quite as vital as the spending itself. In the end, it’s no more immune to the logic of productivity than private investment, even though the primary goal will often be something quite different.

Unfortunately, discussions about the merits of stimulus spending often skate around this issue.

There’s another complication that also too rarely sees the light of day. Each credit induced boom generates its own combination of imbalances and unless government policy takes these into account, efforts to cope with the ensuing crisis will be kneecapped.

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Credit ain’t just credit, either.

By their very nature, booms generated by a fractional reserve banking system don’t result from the lending of genuine savings. Much of the credit produced is in effect ex-nihilo, literally “out of nothing”. Loans are made, recycled back into the banking system when spent and then for the most part lent out again in an endless cycle.^[1] Out of it comes a rapidly expanding and intricately interlocked set of IOUs. The only constraints are the reserve requirements (if any) imposed on the system together with a need for continued loan demand.

In a non-fractional reserve system, money lent is no longer available to the lender until it’s paid back. The act of lending is literally the transfer of the use of those funds for the duration of the loan. Not so under our system. As depositors, we all retain access to most of our funds while they are at the same time lent out in the continuous process described above.

As a result, for as long as the credit expansion lasts we’re collectively misled into acting as if there were more resources available than in fact exist. Certain structural consequences must follow and these are common to every credit induced boom.

First, credit funded economic activity is, in large part, effectively stolen from the future. Unless the borrowed funds are fruitfully invested, future consumption must be reduced. No ifs, no buts, just a cool, unpalatable fact.

If we bought on hire purchase, ran up our credit cards or withdrew equity by increasing our mortgage, we have no choice but to consume less in the future than we could have otherwise. Until the debt is renegotiated, paid off or defaulted on, part of our current and future income is already spoken for.

(None of this, by the way, is a comment on whether borrowing for consumption is good or bad in some moral sense; we must each of us make that decision for ourselves. If the costs are properly understood and can be weighed up against the benefits, then caveat emptor. My intent here is purely to consider the broader economic consequences).

Second, businesses respond to this credit induced demand with new capacity and hiring, higher wages and, quite often, additional borrowing. All of which in turn make their own contribution to economic activity in an apparently virtuous cycle.

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And the end result when at last the growing imbalances become too heavy to bear?

What had been seen as sustainable growth turns out to be anything but. It had instead been temporarily supercharged by non-savings based credit. Households who joined in the game are left to face the unpleasant side of the cost/benefit equation while businesses have to grapple with excess or, even worse, entirely misconceived capacity, much of it debt financed.

None of this is exactly rocket science.

Unfortunately, though, generations of immersion in a world of fiat currency, fractional reserve financial systems has undermined our grasp of the relationship between money, credit and reality. Both of the former are for the most part still treated as if they had the same meaning as under the far simpler and less leveraged systems of days past.

This confusion, together with a continued failure to accept that much of recent economic growth was inherently unsustainable, has badly distorted our policy responses to the crisis.

It’s not easy to correctly treat a disease if the diagnosis is flawed.

I will of course be returning to these issues from time to time. This was merely intended as a brief introduction and overview. The specific pathology of our malaise, and the sort of treatments we might choose if it were better understood, are both immensely challenging topics.

With some countries already knocking up against sovereign limits while next to nothing has been achieved in the way of structural change, there aren’t many topics that rate as more critical.

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1 This picture has been somewhat complicated in recent years (particularly in the US) by the growth of the shadow banking system. The broad principle being laid out here, however, remains essentially unchanged. For more on all of this, see the essay “Money, Credit and Financial Systems” .