Freshwater versus saltwater circa 1988

Re: “Robert E. Lucas, the undisputed dean of the fresh-water school and chairman of the economics department at the University of Chicago, said, ”What we’re turning against is the idea that you can fine-tune the economy with any policy at all.” The university has long been the home of monetarist economics, which maintains that steady, noninflationary growth results from steady growth of the money supply and of which the newer theory is an offshoot.”

The monetarists are right about this. Steve Keen shows that money supply growth and employment growth enjoy an almost perfect 1:1 correlation.

But money supply can only grow if businesses and households take on new debt, as bank loans are overwhelmingly the original source of money. In other words, the only way Americans (or people in any other country, as pretty much everyone uses this same bank-debt monetary system) can have jobs is to collectively self-finance those jobs by taking on more debt to buy stuff. When money supply growth goes negative, like it’s doing now, employment growth goes negative.

Money supply shrinks by the amount that debts are repaid. Money is created as a debt to the bank and repayment of that debt uncreates the money. Loan defaults usually end up leaving ‘loose’ money in the economy, money that is not owed to any bank, so it becomes ‘permanent’ money. When borrowers default and the bank repossesses and sells for less than the outstanding principal balance of the loan, the bank writes off the unrecovered part of the loan principal. The “money”, which was the original loan proceeds, was spent into the economy by the borrower and it stays in the economy until the borrower retrieves it from the economy and takes it to the bank to pay down his loan principal.

Or in the case of a foreclosure sale, somebody else takes money out of the economy to buy the foreclosed asset from the bank, and the bank writes down as much of the principal as it can and writes off the rest. The written off amount was not recovered by the bank to uncreate the loan-money, so that amount remains ‘loose’ in the economy. Creating a loan adds to the money supply; repaying a loan decreases the money supply. Writing off a loan leaves loose money in the economy. The effects of loose money are ignored by financial economics, but they are an inherent feature of this kind of monetary system whose effects need to be taken into account.

Once you recognize where money comes from, the monetarist program of constant debt-money expansion becomes limited by the national economy’s ability to service its collective debts. Michael Hudson believes we have reached “terminal debt”. A constant percentage growth is an exponential function. For a long time the rate of growth of total debt doesn’t seem to be increasing too fast but eventually it reaches the vertical phase of its exponential growth curve, which we reached in 2007 or 2008. Remember, a year ago “billions” was a lot of money. Now it’s trillions. Trillions is unrepayable, terminal debt. Debt cannot grow like this anymore.

To be able to make principal and interest payments on their bank-debts, everybody in the economy needs to be earning incomes. But as Keen showed graphically, employment rises and falls with the rises and falls of total debt levels. When more people are paying down debts than are taking on new debts, money supply contracts and employment declines, which leaves some people (the newly unemployed) with no way of getting money out of the economy to repay their own bank-debts.

This kind of money supply deflation causes economic recessions with job losses. In shallow recessions, after the initial money supply contraction a new burst of borrowing turns the economy back towards positive employment growth. But in deep recessions, like now, there is no foreseeable large group of people who will want to be borrowing more money anytime soon (aside from banksters, who use the money to play financial markets, which does not trickle down into the economy where people can earn some of it as incomes). The boomers are past our prime borrowing years. People are in paydown mode and there is no turnaround to this mood on the horizon.

QE has been adding to money supply but the QE money was used to shore up bank balance sheets against past and future losses. That money will never get into the economy to spur an employment recovery. The banks are holding that money because they have to. Their loan levels are already too high for the capital cushion they have, and with the falling value of their loan collateral the banks’ capital is the difference between solvency and insolvency. For banks, their capital has to be at least equal to the underwater portion of their total loan portfolio, or else their assets plus capital are worth less than their liabilities, and the banks are insolvent and by law must be liquidated.

So banks can’t lend and borrowers can’t or won’t borrow, and people are paying down debt, so the deflationary trend will continue to exacerbate the economic recessionary trend and job losses. This is the deflationary spiral that follows a major credit bubble that inflates assets rather than spurs new profitable productive investment. The deflation of this kind of speculative bubble ends in a depression, with asset price collapse, large scale bankruptcy and the writeoff of debts.

But a depression has another consequence: it leaves a whole lot of ‘loose’ money in the economy, owned by the people who sold assets to the last greater fool before the bubble burst. ALL of the money that is needed to pay ALL of the debts is always in the world somewhere. It is just not available to the indebted to earn back by working and selling stuff to the people who have the money because those money owners want to save and invest in financial assets, not spend and invest in productive assets that create jobs.

Money only ever gets uncreated when bank-debts are paid down, not when bank-debts are written off. So the investor class, let’s say the top 10% of net worth individuals, is ‘hoarding’ money, and the economy is income starved. This happened in the Great Depression and it’s happening again today. A couple of weeks ago I made a ‘bragging rights’ bet that within 2 years the US will either be creating money and handing it out to everybody (Friedman’s “helicopter) or the US would be spiraling down into another deflationary depression. We’ll see which way the powers that be choose to play this one out. My money’s on Helicopter Ben.