“There is no means of avoiding the final collapse of a boom brought about by credit expansion.

The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

- Ludwig Von Mies

Mainstream macro models failed to predict the 2008 recession in the U.S. (and other debt crises) because they did not account for the role of debt.  Ref.

The Debt-Reset Theory

This post asserts that consistently positive GDP growth rates are only possible with both 1) freedom from debt and 2) freedom to borrow, and to escape from excess debt burdens and preserve positive GDP growth rates, some form of debt-reset is inevitable.

Proposed Mechanism

Freedom to borrow –> freedom to spend and innovate –> positive GDP growth rates, but over time as community-wide debt loads rise  –> higher % income and % profit dedicated to debt repayment (lenders become increasingly wealthy) –> diminished spending –> businesses fail and unemployment rises –> more businesses and individuals are unable to repay debts (during this period, in countries where debt bondage and slavery are not options, lenders become bankrupt and fail) –> small losses in expected future gains can have dramatic results, because many households and businesses have little income, profits, or savings in relation to debt, and a popped debt bubble in any market –> spiraling debt deflation as even more businesses and individuals are unable to repay debts  –> debt-reset in the form of community-wide, large-scale debt reduction with some combination of default, debt forgiveness, bankruptcy, poverty, policy changes, absorption of private debt into public sector, and/or inflation

Historical Significance of Debt

Sumerians modeled debt as rising exponentially, then dropping abruptly to zero.  Ref.  Prior to the 1700s, GDP growth rates were consistently 0%, with no prolonged periods of positive average GDP growth rates.  Ref.  (Take a look at the chart associated with that last link, it looks disturbingly like one, big, 300-year debt-bubble that is in the process of deflating.)  However, in the 1700s concerns about usery diminished and borrowing at interest became normal.  Ref.

Thus, consistently positive GDP growth rates only began to occur after borrowing at interest became acceptable.  The full spectrum of modern life, from technological and scientific advances to warfare,  likely occurred as a result of the increased freedom to borrow money associated with charging interest, meaning money purchased by borrowing on the future.  (A more detailed history of borrowing and usery may be found here.)

Possible Explanations for Increases in Community-Wide Debt

Hyperbolic discounting is one potential explanation for why lending at interest might lead to aggregate increases in private debt – humans have a tendency to overvalue “now” in relation to “later.”  If the sum total of private debt within any given contained economy tends to accumulate exponentially over time and then deflate, that might explain the fifty-year cycles of debt forgiveness observed for thousands of years, termed “jubilee” in the Bible, and also various religious prohibitions against usery.  (Coincidentally, the cycles observed in the photo above occurred about 55 years apart.)  The prediction of future global debt-reset might even have been the origins of the predicted apocalypse.  Ref.  Although many countries have legal methods of escape from debt, perhaps the “more money now” mentality still drives up prices in the short term, which in turn increases the need for loans.

Of course, there are other theories for why aggregate private debt might increase to unsustainable levels over time: expansions in bank credit associated with monetary supply, increased speculation due to long-term inflation and currency devaluation, smaller households and more single parents, or other cultural factors or public policy.  Yet it is unclear why those factors would lead to exponential growth of private debt loads within any given economy, rather than a more linear progression of private debt loads over time.  Notably, even if debt within any given economy does not rise exponentially, if it rises to excess levels the outcome will still be the same.

Evidence That Excessive Community-Wide Debt Causes Economic Depression

The graph above depicting U.S. aggregate (public + private) debt/GDP over time provides a visual example of the relationship between debt and GDP growth.  The steep up-slopes correspond with government bailouts of failing banks and businesses, and the down-slopes correlate with the historical time frames of depressions/recessions.  [See image]; Ref.  Similar bank bailouts and steep up-slopes in debt, followed by down-slopes of lengthy depressions (rather than business-cycle recessions), have occurred worldwide.  Ref.; Ref.; Ref.

The debt deleveraging process has historically been associated with periods of negative GDP growth rates.  During the 2008 – ? U.S. down-swing, there have been many foreclosures on homes, short-sales, and loss of mortgages; although some indications of the economy are positive, there is also a significant backlog of foreclosures, meaning many citizens are still living in homes without paying their monthly mortgage.  Ref.

Graphs of U.S. total debt and U.S. household debt both fit an exponential growth curve, as do other debt curves in modern economies.  Ref.; Ref.

The small decrease in private debt seen on those graphs starting in 2008 was temporary, private debt has since climbed to original levels.  Ref.; Ref.  Between 2006 and 2011, the number of bankruptcies for both households and businesses more than doubled; 2/3 of the household bankruptcies were due to job loss.  Ref.  Although filings have been going up, in the U.S. the average cost of filing for bankruptcy has also gone up (it now costs about $1500), so many Americans cannot afford bankruptcy and instead must opt to remain delinquent on payments.  Ref.  Somewhere between 200,000 and 1,000,000 Americans are “too broke to go bankrupt.”  Ref.

Images created by economist Steve Keen, who predicted the housing market collapse before it occurred, demonstrate that U.S. private debt was reset during the Great Depression, and GDP growth rates were consistently negative during the process.  Ref.  Steve Keen also recently argued before the U.S. Congress that private debt/GDP controls GDP growth rates in the short-term.  Ref.

Recent non-partisan, peer-reviewed economic research funded and published by the National Bureau of Economic Research (NBER) demonstrates that high levels of public debt are correlated with long-term depressed GDP growth rates.  Ref.  According to one of the Harvard researchers involved in the study, the financial crisis may actually be an innovation crisis, and “[c]redit contractions almost invariably hit small businesses and start-ups the hardest.”  Ref.  Above 90% public debt loads, default was almost inevitable.  Ref.  Also, during financial crises, private debt loads were often transferred to the public sector, and, in about half of the crises, interest rates remained low throughout the duration.  According to the authors, “[a]lthough we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an ‘all clear’ signal for a further explosion of debt.”  Id.

An article published by the St. Louis Fed stated that “debt starts to be a drag on economic growth . . . countries that continue to have poor economic performances are the ones that borrowed too much and . . . tended to have relatively high (and frequently increasing) unemployment rates and low or negative GDP growth.”  Ref.

Another paper published by NBER noted three industrial revolution episodes coinciding with three periods of both low debt/GDP and high GDP growth rates.  Ref.  Thus, each period of significant industrial growth and innovation coincides with particularly low levels of aggregate private and public debt/GDP ratios.  [See graph above.]

Yet another NBER paper found that private debts and domestic credit typically surge prior to a banking crisis, banking crises most often either precede or coincide with sovereign debt crises, and the “list of country examples of this sequencing is too long to enumerate.”  Further, “public debts follow a repeated boom-bust [private] cycle,” “public sector borrowing surges as the [sovereign debt] crisis nears,” “the boom-bust episodes are very numerous cutting across regions and time,” “short-term debts (public and private) escalate on the eve of banking crisis and sovereign defaults,” with private debts often becoming public debts after crises.   Ref.

There is mounting evidence that at high private debt loads, the purchasing power of debt has diminishing returns.  Ref.; Ref.; Ref.  If so, it might be the case that small amounts of public debt at low private debt/GDP ratios can purchase staggering GDP growth rates, but that large amounts of public debt at high private debt/GDP ratios will purchase decreasingly positive GDP growth rates until the GDP growth rate is zero.

Debt Transfers: Postponing the Inevitable?

In the modern era, debt-reset can be temporarily forestalled by large transfers of private debt to the public sector (i.e., wealth transfers from the private sector of one nation to the private sector of another, or wealth transfers from the publicly-held savings of a nation to the private sector), increased GDP growth rates in the short-term, or by some other mechanism of wealth or debt migration in a globalized economy.  Similarly, debt-reset may be spurred forward by factors decreasing GDP growth rates (for example, limited natural resources).

When significant private debt problems lead to transfer of debt from the private to the public sector, because of the exponential nature of compound interest and also because the fundamental debt problem has not been truly addressed, such transfers are unlikely to succeed in the long run.    A government might attempt to relieve individuals of debt-related problems, but without directly addressing the problem of a debt-laden private sector both private and public debt will soar.  Where private debts were reset by transfer to other sectors, the “actual” debt bubble (and corresponding overvaluation of assets) may be significantly larger than graphs depict, as previous patterns may not have demonstrated complete debt deflation.

We are currently at the point where GDP growth rates have stalled and we have maxed out our credit, at least among so-called “first world” economies.  (Many developing countries are currently reducing aggregate debt loads.  Ref.)  According to a recent article in the Guardian, “The fundamental problem is that we have too much debt in the system – private and public combined.  To create a more stable system we need to deleverage, in private and public sectors, to different degrees in different countries.  But once you have excessive leverage, it is very difficult to deleverage without depressing the economy.”  Ref.

Debt-Reset Options

Methods of reducing excess aggregate debt/GDP ratios include either 1) voluntary debt-forgiveness, 2) changes in public policy to discourage further private debt loads, perhaps depending on the current fragility of the economy, or 3) default, i.e. breaking the contract of debt (inflation can be a form of default).

Breaking the debt contract may happen quickly through debt deflation spirals [see image above for an example - during 1870s depression], over a lengthy period in a series of staggered, disorderly steps [id., during 1930s depression], or after a long period of stagnation and decline.  A lengthier default, or prolonged periods of stagnation in the period just prior to default, is associated with extended periods of negative GDP growth rates and therefore long-term reductions in overall wealth.  The “lost decade” in Japan and Latin America demonstrates why it is a bad idea to avoid debt-reset.  Ref.; Ref.  Although Japan is an interesting example of a nation attempting to avoid the social implications of debt-reset, because Japan is at a 0% GDP growth rate and must still pay interest on out-standing loans, it has become a large-scale debt slave.  Future default is likely.  Ref.

Voluntary debt-forgiveness has not been attempted in modern times.  However, periodic mass debt forgiveness finds thousands of years of historical support in the concept of jubilee, and in fact, the first recorded word for “freedom” meant freedom from debt.  Ref.  If modern-day debt forgiveness occurred in full, it would almost or entirely eliminate all investments in bank accounts, stocks, and bonds of all citizens and businesses, including all public and private retirement savings.  It is unclear who, if anyone, would have any credit to extend in order for individuals and businesses to proceed as usual.

Although alternatives to debt-reset may exist at low debt levels, they can not be implemented at high, unstable debt loads because of the necessity of continuing to pay interest on out-standing debt.  Thus, debt-reset must occur before alternatives are implemented.

I am not the first to arrive at this conclusion.  Ref.; Ref.; Ref.; Ref.; Ref.; Ref.; Ref.

According to one study researching the Great Depression, which concluded that the cause was a “credit boom gone wrong,” “[a]ccounts of the twenties . . . emphasize the ready availability of credit, reflecting the ample gold reserves accumulated by the country during World War I, the stance of Federal Reserve policies, and financial innovations ranging from the development of the modern investment trust [i.e., mutual fund] to consumer credit tied to purchases of durable goods like automobiles. Credit fueled a real estate boom in 1925, a Wall Street boom in 1928-9, and a consumer durables spending spree spanning the second half of the 1920s.”  Bank for International Settlements, “The Great Depression as a Credit Boom gone Wrong” Barry Eichengreen and Kris Michener (2003).

What cheap and easy credit have we offered, and what debt bubbles have we created as a result?  In the U.S., many eyes are on student debt.  Ref.

Debt-Reset Is Already Happening

Some European nations seem to be beginning to consider default, Greece is in the process.  Ref.  It is unclear what the local and global repercussions might be of global debt-reset.  From a place of apparent stability and prosperity, the global economy is increasingly in the red.  Ref.

The Telegraph speculated that if the United States defaults, the outcome could be more catastrophic:  “The global financial system collapses. You get political and economic meltdown. It would be the end of the world as we know it . . . . Global credit flows underpin global capitalism. Without them, countries would re-erect protectionist barriers and globalisation would come to a crashing halt. Asset prices would tumble, prices for core goods would rise and the world would become a lot smaller. Almost without exception, for the average person it would mean a massive destruction of wealth and a severe reduction in living standards.”  Ref.

If the Telegraph’s estimations are shared, it is possible that other nations will lend the U.S. money and forgive loans in order to stave off that eventuality.  Yet if this post’s thesis is correct, debt-reset is inevitable at some future juncture.  In any case, as other nations begin to debt-reset, they may not have the resources to provide a “free” debt-reset to the U.S. by lending and forgiving additional sums.  Even if that were possible, it may not be desirable.  If immense wealth is borrowed against a future that does not exist, citizens may lose the requisite skill sets necessary to survive in an accurately valued economy.  In the U.S., public debt may be difficult to eliminate, as two-thirds of the money that the government owes is to U.S. citizens, including retirees.  Ref.

In 2008, 38% of Americans believed a Great Depression was coming.  That number rose to 41% in 2009, and 48% in 2011.  Ref.  A majority may believe it in 2012.  Yet, despite dire warnings of the consequences of going off the fiscal cliff, or allowing the “too big to fail” businesses to do just that, popular media is remarkably silent about the overall dismal outlook of our economic future.  Perhaps we have remained publicly silent about private views, rather than noting that the emperor has no clothes.  Are we avoiding the truth because it sounds too terrible to be true?

One might dismiss the possibility that this is happening because the markets aren’t showing fear.  Long-term U.S. Treasury Bonds are still strong, for example.  However, the Federal Reserve has been buying up billions of dollars in long-term T-Bonds to fund bailouts, so with a phony buyer any market signals are stunted.  Ref.  The gold bull run has been astounding, and implies a global lack of confidence in the dollar and other types of currency, i.e. a concern that monetary depreciation and inflation are ahead.  There are other worrisome signs that U.S. businesses are preparing for the worst, foregoing $14 billion in profits in order to shore up $1.4 trillion in cash.  Ref.

Current Recommendations

If the thesis of this post is correct, future global financial restructuring and debt-reset may be rocky, particularly if citizens are unaware of what is occurring and why.  Just in case, citizens should prepare for the worst: please store reserves of antibiotics and long-term food supplies, and develop skills that will be useful in very hard times.  (Carpentry, medicine, agricultural, self-defense.)  The debt-reset process may occur smoothly and peacefully, but it is best to be prepared.

Future posts will explore various debt-reset options and potential debt-reset-delete mechanisms (i.e. eliminating the debt-reset cycle), and will explore whether or not debt-reset-delete is desirable.