Will US Debt Cause an Economic Crisis?

Many economic commentators are of the view that the high level of debt poses a threat to the US economy. The debt-to-GDP ratio stood at 345.7 in Q3 2024 against 130.4 in Q1 1952 (see chart).

This way of thinking originates in the writings of Irving Fisher who held that a major risk factor is the debt liquidation. According to Fisher, this can occur on account of a shock such as a decline in the stock market. As a result, this is likely to generate a decline in money supply. The decline in money supply, in turn, is likely to cause a decline in the prices of goods, labeled as “deflation” and this will produce an economic slump. Why, however, should the debt liquidation cause a decline in the money supply?

Take, for example, a producer of consumer goods, who consumes part of his produce and saves the rest. In the market economy, the producer can exchange the saved goods for money. He can then make a decision to deposit the money with a bank. He can also decide to lend his money to another producer through the mediation of the bank. By lending his money, the lender transfers his savings to a borrower for the duration of the lending contract. Once the contract expires on the date of maturity, the borrower returns the money to the original lender plus interest. The repayment of the debt, or the debt liquidation, does not have any effect on the supply of money.

Loaned savings are key for economic growth. It is savings that fund the production of the capital structure (e.g., tools, machinery), which permits the more productive and efficient expansion of consumer goods. This facilitates further increases in savings, all other things being equal. The process can continue with the buildup of an even more sophisticated production structure. The increase in lending is great news to the economy. By means of lending, savings are channeled to the various parts of the economy, thereby promoting economic growth.

Inflationary Lending

Ordinary lenders will find it difficult to lend something that they do not have. However, things are different once we introduce into our analysis lending by banks that is not supported by savings. This type of lending permits the generation of lending out of thin air (i.e., inflation).

Now, if Joe were to decide to lend $1000 for one year, we would have here a transfer of $1000 from Joe’s demand deposit to a one-year term deposit. The money in the one-year term deposit can be lent out for one year. (The one-year term deposit of $1000 backs the one-year loan of $1000 here).

Now, let us consider a case when Bob approaches Bank A for a loan of $1000 for one year. Bank A accommodates this request and lends Bob the $1000 by opening a demand deposit for $1000. We do not have here a transfer of $1000 from the holders of demand deposits, such as Joe, to the one-year term deposit. Hence, the loan to Bob by Bank A is unbacked by savings. Bank A has generated the $1000 loan via inflation.

Once Bob, the borrower of the $1000, uses the money, Bob is engaging in an exchange of nothing for something. In a free market economy, a bank runs the risk of bankruptcy if it were to issue such loans, especially if it does it at a large scale. The likelihood of a bankruptcy increases when there are many competitive banks. As the number of banks rises and the number of clients per bank declines, the chances that clients will spend money on goods from individuals that are banking with other banks increases. This, in turn, raises the risk that the bank will not be able to clear its checks during the interbank settlement. According to Rothbard,

…as soon as the new money ripples out to other banks—the issuing bank is in big trouble. For the sooner and the more intensely clients of other banks come into picture, the sooner will severe redemption pressure, even unto bankruptcy, hit the expanding bank.

Consequently, in an unhampered market economy, without the central bank, competition between banks is likely to minimize fractional reserve banking and inflationary lending. Conversely, as the number of competitive banks declines and the number of clients per bank increases, the likelihood of bankruptcy diminishes. In the extreme case of one bank, it can practice inflationary lending without any fear of bankruptcy. In this case, the bank does not require clearing its own checks. Hence, the bank is not going to bankrupt itself.

Inflationary lending is ensured with a system of central banking. In this system, banks can be seen as the branches of the central bank. The central bank through “monetary policy” (i.e., inflation) and other interventions—legal suspension of specie payment, bank holidays, compulsory par laws, legal tender laws, federal deposit insurance, acting as a “lender of last resort,” and bailouts—prevent banks in the system from going bankrupt. There is also no interbank competition to regulate practices. Under a system of central banking, one bank can issue unlimited lending of inflationary money and credit without going bankrupt.

The central bank makes it possible for banks to engage in the expansion of inflationary lending. Thus, if during the interbank settlement, Bank A is short of $1000 and cannot settle the claim from Bank B, it can secure the $1000 by borrowing it from the central bank. Where does the central bank get the money? The answer is monetary alchemy—it “prints” it out of “thin air.” Hence, according to Rothbard,

…the Central Bank can see to it that all banks in the country can inflate harmoniously and uniformly together…. In short, the Central Bank functions as a government cartelizing device to coordinate the banks so that they can evade the restrictions of free markets and free banking and inflate uniformly together.

Money Supply and the “Subsistence Fund”

As a rule, a decline in the money supply that precedes price deflation and an economic slump is triggered by the previous expansionary monetary policies of the central bank. It is the expansionary monetary policy which creates this situation. This leads to the diversion of savings from wealth-generators to non-wealth-generators. Consequently, this undermines the ability to grow the “subsistence fund” and weakens economic growth. Note that the heart of economic growth is the “subsistence fund.”

Because of expansionary monetary policies, a situation can emerge when the subsistence fund starts declining—capital consumption occurs. As a result, economic activity is likely to follow suit. With the deterioration in economic conditions, banks are likely to curtail their lending. The consequent deflation and the decline in economic activity is not caused by the liquidation of debt as such, nor by the decline of money supply, but by the decline in the subsistence fund because of the previous expansionary monetary policies.

Conclusions

Contrary to much popular thinking, the threat to the US economy is not the high level of debt as such, but the artificial monetary and credit expansion unbacked by genuine savings. Lending as a result of increased savings can cause stable economic growth. Artificial expansion of money and credit to supply loans emerges because of the monetary policy of a central bank. It is “monetary policy,” not the size of the debt, that poses a threat to the economy.

Courtesy of Mises.org

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