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Will Our Economic System Collapse?

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The answer is: It might. You will help decide.

Our economic system is Creditism. Creditism evolved out of – but is very different from – Capitalism. Economic growth under Capitalism was driven by recurring cycles of investment, profit and savings (i.e. capital accumulation; hence Capitalism). Creditism creates economic growth through recurrent cycles of credit creation and consumption. Creditism has created very rapid economic growth for decades – much more growth than Capitalism could have created over the same period. The trouble is that Creditism is now in crisis because the private sector in the US cannot bear any more debt. A few charts help illustrate these points.

US: Total Credit Market Debt - Up 50 Times Since 1964

Total debt (that is household sector debt, government debt, corporate debt and financial sector debt) first exceeded $1 trillion in the United States in 1964. Over the next 43 years, it expanded 50 times to $50 trillion. That explosion of credit – and the transformation of our economic system from Capitalism to Creditism – would not have been possible if the United States had continued to employ gold as money. However, in 1968, Congress ended the requirement that the Fed back dollars with gold. Afterwards, credit and Creditism reshaped our world. By the way, debt and credit are two sides of the same coin. Every quarter, the Federal Reserve publishes a document called The Flow of Funds which provides a comprehensive breakdown of who owes the debt (the debtors) and who owns the debt (the creditors). Here’s the link:

In our economic system, credit growth drives economic growth. Since 1952, on an inflation- adjusted basis, there have been only nine years when total credit grew by less than 2%. Each time there was a recession; and the recession, it did not end until there was another surge of credit expansion.

Credit Growth Drives Economic Growth

So, the question now is: Will credit begin to expand again? We can determine that by looking at each of the major sectors of the economy to see which ones, if any, can take on more debt.

Non-Financial Sector Debt

Chart 3 shows the breakdown of debt within the non-financial sectors of the economy. The top line shows the increase in the debt of the household sector. Household sector debt rose from $4 trillion in 1993 to $14 trillion in 2008. That expansion of debt financed a surge of consumption in the US that fuelled a global economic boom. Sadly, in 2008, a significant part of the household sector began to default on its debt. As a result, that sector was cut off from any additional debt and forced to spend less; for that reason, the global economic crisis began.

The household sector is the largest and most important sector of the economy. Its debt has now begun to contract. Will it expand again? An individual’s house is generally his or her most important source of collateral. On average, Hhome prices are now down 34% on average across the US. With less collateral, households will have access to less credit. Moreover, the median income in the US is dropping because globalization is putting strong downward pressure on wages. That means households cannot afford more debt. For these reasons, household sector debt is more likely to continue to contract rather than to expand.

The next line on Chart 3 represents the debt of the federal government. It has nearly doubled since this crisis began. Had government debt not risen so sharply, total debt would not have simply flattened out (see Chart 1), it would have contracted significantly and a new great depression would have begun.

The third line shows the debt of the corporate sector. Corporations are unlikely to borrow more and expand their production capacity so long as households are retrenching. The other sectors shown on this chart are too small to matter, so let’s now look at the fFinancial sectors in Chart 4.

Financial Sector

The top line here shows the debt of the Government Sponsored Enterprises, a.k.a. Fannie Mae and Freddie Mac. Their debt rose from $1 trillion in 1987 to $8 trillion in 2008. As they increased their debt, they obtained cash, which they used to buy up mortgages. That created the US property bubble, which, in turn, drove global economic growth. In 2008, however, Fannie and Freddie effectively went bankrupt and were put into “conservatorship” by the government. Their debt is more likely to contract than to expand going forward. So too is the debt of the private sector issuers of asset backed securities, whose debt is shown in the next line. They were largely responsible for the subprime disaster; now, they are largely out of business.

So, what does all of the above tell us? It tells us that the debt of the private sector is likely to contract during the years ahead. The Austrian economists such as Ludwig von Mises and Murray Rothbard, believed that credit creates an artificial economic boom and that when credit stops expanding, the depression begins. In their world, however, where gold was money, credit expansion could only continue for a relatively short period because it was always constrained by the amount of money (i.e. gold) in the economy; and that constraint was tight since gold was always in short supply. Consequently, the credit induced booms and the resulting depressions were relatively short-lived and mild. If only, that were the case today!

Alas, their world is not the world we live in. In our world, gold is not money and it has not supplied a constraint on credit creation since 1968. In our world, credit has expanded 50 times in less than 50 years. That explosion of credit has created a global economic boom without precedent. The credit boom of the 1920s (the Roaring Twenties) lasted only 16 years – from the abandonment of the gold standard in Europe at the beginning of World War I to 1930 when the credit that caused the boom could not be repaid. Consider the severity of that depression when credit ceased to expand. If credit begins to contract now, the depression that our world would collapse into would be, in all probability, worse than that of the 1930s – that is, if there could be anything worse. In the 1930s, US GDP contracted by 46% and unemployment ranged between 15% and 25% for a decade. That depression did not end until US government spending expanded 900% at the beginning of World War II, a war that took 60 million lives.

Is it regrettable that we are in this situation? Of course it is. Were mistakes made? Therey certainly were. We should never have broken the link between dollars and gold. Had we retained gold as our money, we would have enjoyed much less material prosperity over the last four decades, but we would not now be teetering on the edge of a new great depression. Should we just give up, let credit contract and allow the new great depression to begin? Absolutely not! To surrender without a fight to a replay of the 1930s and the 1940s would be the greatest act of stupidity imaginable.

Well, then, what is the alternative? How can credit continue to expand if the private sector can bear no additional debt? There is only one way, only one possible way out of this catastrophe. The government must borrow and invest. If it invests wisely and aggressively, in transformative 21st Century technologies such as solar, nanotechnology, genetic and biotech, the returns on that investment could prevent the collapse of our economic system. And, in the very worst case, where the government wastes every single penny borrowed and spent (no cure for cancer is found, no genetic therapy that reverses aging, no cheap, clean, limitless energy supply), then at least the collapse of our civilization would have been postponed by a decade or perhaps even longer. If we sharply cut government spending now and allow total credit to contract, then our economic system, -- and the world we know, -- will not survive even 10 more months.

In a democracy, the people must decide what our government will do. To lack faith in the ability of government to solve problems is to lack faith in democracy. As a democratic society, we must choose between two alternative paths. We can invest and prosper or we can retrench and collapse. What we, the people, decide to do will determine our fate.

Original publish date: May 01, 2012

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