The Longer We Wait, The Harder We Fall
On Friday, October 15, 2021, U.S. President Joe Biden signed legislation raising the government’s borrowing limit to $28.9 trillion. Many Americans are now accustomed to this recurring bureaucratic process and don’t think much of it or its consequences. Two sides fight, they get close to a deadline (and sometimes pass it!) and eventually raise the “debt ceiling” so they can fight over it again some months later.
We Americans, as a collective and a government, are deciding to delay paying our bills. At an individual level, we understand what happens when we don’t pay our own bills. But what happens when the most powerful nation today stops paying bills? To understand the effects of this — and how we got here in the first place — we need to study history. Let’s start with a simple short-term debt cycle.
Lending And The Short-Term Debt Cycle
The short-term debt cycle arises from lending. Entrepreneurs need capital to bring their ideas to fruition, and savers want a way to increase the value of their savings. Traditionally, banks sat in the middle, facilitating transactions between entrepreneurs and savers by aggregating savings (in the form of bank deposits) and making loans to entrepreneurs.
However, this act creates two claims on one asset: The depositor has a claim on the money they deposited, but so does the entrepreneur who receives a loan from the bank. This leads to fractional reserve banking; the bank doesn’t hold 100% of the assets that savers have deposited with it, they hold a fraction.
This system enabled lending, which is a useful tool for all parties — entrepreneurs with ideas, savers with capital, and banks coordinating the two and keeping ledgers.
When Times Are Good
When entrepreneurs successfully create new business ventures, loans are repaid and debts are cancelled, meaning there are no longer two claims on one asset. Everyone is happy. Savers and banks earn a return, and we have new businesses providing services to people thanks to the sweat and ingenuity of the entrepreneurs and staff.
The debt cycle in this case ends with debts being paid back.
When Times Are Bad
When Alice the entrepreneur fails at her business venture, she is unable to repay her loan. The bank now has too many claims against the assets that they have, because they were counting on Alice repaying her loan. As a result, if all depositors rush down to the bank at once to withdraw (a “run on the bank”) then some depositor(s) won’t get all of their money back.
If enough entrepreneurs fail at once, say because of an “Act of God” calamity, this can cause quite an uproar and a lot of bank runs. However, the debts are still settled, either through repayment to depositors or default, leaving depositors without their money.
The debt cycle in this case ends with some portion of debts defaulting.
The debt cycle either ends with payment or default — there is no other option. When borrowing overextends, there must be a crash. These crashes are painful but short and contained.
The Mini Depression Of 1920
The year 1920 was the single most deflationary year in American history, with wholesale prices declining almost 40%. However, all measures of a recession (not just stock prices!) rebounded by 1922, making the crash severe but short. Production declined almost 30% but returned to peak levels by October 1922.
This depression also followed the 1918–1920 Spanish Flu pandemic and came one year after the conclusion of the First World War. Despite these massive economic dislocations, the crash was short and now relegated to a footnote in history.
Finance writer and historian James Grant, founder of Grant’s Interest Rate Observer, noted about the 1920 Depression in his 2014 book “The Forgotten Depression, 1921”:
“The essential point about the long ago downturn of 1920–1921 is that it was kind of the last demonstration of how a price mechanism works and the last governmentally unmediated business cycle downturn.”
The Free Market And Hard Money Curtail Debt Cycles
When an economy runs on a hard money system, free market forces rein in excessive borrowing and thus keep the debt cycle short.
What Is Hard Money?
Hard money is a form of money that is expensive for anyone to produce. This ensures a level playing field: Everyone has to work equally hard to gain money. Nobody can create money and spend it into the economy without incurring a cost almost equal to the value of the money itself. Gold and bitcoin are two examples of hard money, mining them requires so much time and energy that it’s almost not worth it to do so.
How Do Free Markets Rein In Borrowing?
Free market forces are crucial to limiting speculative manias. On one side, you have lenders and savers who hope to make a return on their capital, while on the other, you have borrowers hoping to take borrowed money and turn it into more money.
In a free market that utilizes hard money, there are two options to conclude the extension of credit: Debts are repaid, or debts are defaulted on. The greed of lenders wanting more return on their capital by making more loans is kept in check by the risk of default. The greed of borrowers wanting more capital is kept in check by the burden on their future self or business from increased debt.
This applies at an individual level as well: As any borrower increases their debt pile, they become riskier and riskier to lend to. That risk means lenders will demand to be paid a higher interest rate on their loan. That higher rate makes it harder for the borrower to borrow more, leading them to either turn toward paying down some of their existing debts or default outright.
These forces keep lending in balance, cutting down speculative manias before they go too far.
The Lengthening Of The Debt Cycle
Powerful entities — like governments — can use their sheer power to make them a less risky borrower.
Over the past century or so, we’ve seen many governments take on debt so that they can lend to individuals and businesses, especially during hard economic times. Those loans help individuals and businesses pay their bills and debts, easing the pain of a crash. However, this lending by governments does not resolve debts; it simply transfers debt from private individuals to the government, putting it in a large pile of public debt.
Governments can build such a huge pile of debt because lenders know that a government has special tools for paying back that debt. You and I may not be able to seize the property of others in order to pay our debts, but a government can. Even the bastion of the free world, the United States, seized the privately held gold of its citizens in order to keep itself afloat in 1933.
This government debt issuance leads to a lengthening of the debt cycle. The depth of each drop is tempered, but the unwinding of debts is not completed — it is only delayed. Frequent short and sharp downturns are transformed into longer cycles with infrequent but devastating collapses.
This brings us back to the debt ceiling: The reason our politicians keep having this debate is thanks to ongoing debt issuance by our government in order to fund bailouts during downturns as well as government outlays that exceed government revenues. All this debt climbs on top of that massive $28+ trillion pile of public debt.
However, at some point, even powerful governments feel the heat from angsty lenders and need a new set of tools. Throughout history, governments in a corner have employed another tool to service their debt and continue to prolong the debt cycle: debt monetization. The U.S. government opened this toolbox in 1971 by disconnecting the U.S. dollar — and all global currencies — from gold thus creating the fiat currency system we still live with today.
Fiat currency, like that friend who only calls when he needs something, shows up often in history but never stays for long. “Fiat” roughly translates from Latin as “by decree.” Fiat currency is thus money which derives its use — and value — by decree from a governing body. Fiat currency is not hard money; the governing body often (solely) reserves the right to create the currency and distribute it through some mechanism.
In a fiat currency system where depositors are placing fiat currency into banks, we have a new trick for unwinding debts.
Remember how bad times in the debt cycle led to the bank having more claims against their assets than assets on their books? Within a fiat currency system, the governing body can now solve this little ledger problem by just creating more currency. Poof, everyone gets paid.
We call this tool for ending debt cycles monetization, because we “monetize” the debts by paying them with newly created currency.
Today, we often call these governing bodies that create currency “central banks,” and together with their…
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