Our economy is so fucked!! I gotta get this out:
Our monetary system is the biggest pyramid scheme in human history. We have inherited and fully embellished a fractional reserve banking system that depends on ever expanding levels of debt in order to stay afloat. Private banks, with the assistance of the Federal Reserve have virtually unchecked power to control the money supply; they create new money every time they make a loan. And since the 70s, a growing proportion of big industrial and corporate loans are made with absolutely NO reserve requirements!!
These loans are being funded with bank CDs and money market deposits, not hard currency held in reserve at a central bank. This has allowed overall loan to reserve ratios (i.e. leverage) in our financial system to skyrocket. Even checking account deposits are overwhelmingly comprised of debt money. Banks are only required to hold 10% of their total checking deposit liability in reserve at the central bank. Further complicating this picture is the market for securitized debt. This enables financial institutions to essentially pass the buck, by selling their liability to a third party, thus getting it off their own balance sheet.
At the same time fractional reserve requirements for FDIC-insured banks were falling to next to nothing, the Federal Reserve was pursuing the most profligate monetary policy in U.S. history under the auspices of the highly revered Alan Greenspan. After the tech bubble burst in 2000, he ramped up the stimulus by slashing the fed funds rate to 1% and kept it there for a year!! The financial services industry had a field day with the easy money and we know the result all too well – a massive credit bubble that inflated housing prices and a wide range of other assets.
But at the time we didn’t recognize this monetary policy as inflationary – we thought it was fuelling real growth because the economy was effectively being subsidized by cheaply imported consumer goods from China. So the Consumer Price Index was stable, and core inflation was within a healthy range. But if you look at the expansion of the money supply over this period, it’s absolutely shocking – we’re talking exponential growth in debt money. And where was the commensurate growth in economic productivity? Was it in the magical financial engineering that created the now infamous slew of structured debt instruments? Was it in the flip-a-house get rich quick scheme out in Calee-fornia? Seriously, what do we have to show for this rapid expansion of the money supply?
Well, we got a massively over-leveraged financial system + a massively indebted federal government + record levels of household debt, which = Peak credit!!
A conversation between me and my evil twin about the implications of peak credit: Enjoy!
ME: Right, so this is peak credit – maybe that’s OK. After all, a little debt deflation is just what the doctor ordered for this bloated economy, right? Loan defaults will rise for a while, but at least it will encourage people to stop borrowing, start saving and pay off their debts if they can. And most importantly, it would allow financial institutions to de-leverage – restoring loan to reserve ratios to more normal levels. What’s wrong with allowing all of that?
MY EVIL TWIN: Did you say you want to encourage Americans to save? We can’t allow that. 70% of our economy depends on them buying shit they don’t need – that’s why they’re called CONSUMERS. Save? Ha, that fell out of fashion back in the 80s. If we saved as much today as we did in the 70s, our economy would hemorrhage jobs, and Starbucks would become an endangered species. And I, for one, like my gingerbread lattes this time of year. So please, get off your “We need to encourage savings” soap box.
ME: Alright I’m off it already – agree to disagree. Let’s talk about how to best stimulate the economy. Obama’s fiscal stimulus sounds promising, but the Fed seems determined to re-inflate the money supply at all costs. This is wrong-headed and reckless to say the least. Any effort to stimulate the economy during the now-unavoidable deflationary recession should come in the form of fiscal investment in projects of real long-term value to the American people. Can anybody say renewable energy infrastructure?!? Why can’t we stick with that? Why do we have to keep pumping money into the financial system? Aren’t they the ones who got us into this mess?
EVIL TWIN: We need both a fiscal and a monetary stimulus because deflation is the Fed’s worst nightmare. Honestly, given the size of the current money supply, unchecked deflation should be everyone’s worst nightmare. We owe it to ourselves to at least try to make an orderly retreat from this debt peak. The value of the dollar will suffer as the Fed prints hard currency to buy government debt (i.e. monetizing debt instead of selling bonds on a market that’s soon to be saturated with too many govt. bonds). Budget deficits will soar. And there will be more layoffs across all sectors of the economy as banks deleverage and credit markets stay tight. There may even be mild deflation. But perhaps we can avoid the worst case scenario of repeating the Great Depression. We’ve already committed to sinking $5 trillion into this money pit, and we still have a threat of deflation – this recession could be far worse than anyone is predicting. That’s why the Fed has to print right now. There’s not another choice.
ME: I hate your evil logic. Damn, our economy is so fucked.