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Debt, a curse or necessity

by on 16/10/2018

What’s so bad about debt? After all debt of one sector of the economy is savings of other sector. Yet too big debt causes several problems on the macroeconomic level. But to start with, we have to separate in our analysis, the sovereign debts of the governments with the right to issue independently currency and debts of all the other sectors of the economy, namely the private households, and corporate, non-corporate private businesses.

1. To answer to the question, at first it has to be explained shortly how debts became the basis of money creation and the foundation of the monetary system, then, it is necessary to categorise the different debts, modern monetary system is based on, and to understand the major developments of these debts since the 2008 crisis.

A. The following short essay explains in understandable way for every reader, what does it means that money is debt?

B. Since the 2007, when the economic crisis started, several dramatic developments evolved in the US and EU economies, the sovereign emitters of the most important world currencies, the US dollars and the Euro, that can be characterised by dramatic public debt increase since 2007, as seen in the next chart.

B1. The US economy a major shift occurred from private non financial debts to public debt. Since 2008-2017, the private debt declined from 170% to about 150% of GDP. Out of it the private households debt dropped from about 100% of the GDP to about 80%. The private non-financial corporate businesses total debt is about 70% of the GDP, similar to the 2008 data.
In parallel with it the public debt increased in the same time between 2008-2017 from about 68% to more than 100% of the GDP.

B2. In Euro zone a less dramatic shift occurred from private non financial debts to public debt. Since 2008 the private debt declined from 165% to about 160% of GDP. Out of it the private households debt dropped from about 64% of the GDP to about 58%. And the private non-financial corporate businesses total credit stabilized at 80% of the GDP since 2008.

In parallel with it the public debt increased from about 69% to more than 87% of the GDP peaking at 92% in year 2014.
B3. In China the private debts, most of it of non financial businesses, increased to unprecedented level of above 240% of the GDP, from just about 100% of the GDP in 2008.
Chinese public debt even if grew from 35% in 2008 to 48% in 2017, it still remains very low compared to the US and Eurozone debts. Most probably, in the future, if and when the private businesses will have difficulty with their debt, that is by large the highest among the big economies, to save the financial system and the Chinese economy from collapse, the private debt will be nationalised, just as it happened after 2008 in the US.
C. Since debt is Money, and money is an agent, that represents one to one the aggregate value of the products exchange, volume of money in circulation influences the volume of economy. So we have to ask, how money influences the real economy’s circulation.
We can recognise two states of money, state of potential circulation or actual circulation. In the modern times the act of transfer of money, in most of the cases is done by stroke on a keyboard. Since it usually takes a blink of time to transfer money from one account to an another one, the money mostly is accumulated as stock in the financial institutions, in state of potential circulation, and only small parts of it is in circulation every moment. This fact is not only a technical issue, but also influences the volume of money in the financial system.
D. As contrary to every other sector in the economy, by definition a sovereign government, with sovereign right to emit its own currency, can never default on it’s debts, if they are in local currency to the local entities. (Default means loss of capacity to repay contractual obligations.) This uniqueness is enabled by sovereign governments capacity to emitte currency without limits. Yet unlimited emission of currency by governments, may cause devaluation of the currency against other economic items of local suppliers, that will increase their products prices, and cause by it inflation. The value devaluation can be against currencies of other countries, tangible or intangible assets, or consumer goods and services. The volume of currency is not the only way, the debt translated to money influences the economy through money circulation. Every additional currency volume added to the economic circulation, if not accompanied by equivalent increase in production capacity, will have to couse general increase in prices, (inflation).
E. The volume of currency is not the only way, the debt translated to money influences the economy through money circulation. Except of money volume issued by the government, the other factor is the velocity of money circulation. Money circulation velocity can be influenced by different variables.
-The most obvious variable to influence money circulation velocity, and highly manipulated by the central banks is the interest rate. Higher interest rate, lower velocity of money circulation, vice versus.
-Other important factor influencing the level of velocity of money circulation is the level of inequality of income in the economy. Higher equality in income increases the money circulation velocity, vice versus.
-Level of indebtedness of private households and corporations also influences negatively the velocity of the money circulation.
-Since income tax is on annual basis, level of income taxation also influences negatively the money velocity.
-If the money still would be in form of physical items, like paper bills or coins, and to pay with it, it would have to be brought physically to the supplier, the time period that the money would be out of financial system would be much longer. This would influence the available money in the banks for overnight deposits, as minimum reserve required by the bank. This means, the potential level of available funds for credit would be more limited, and this has also negative influence on money velocity.
– the velocity of money circulation can be influenced even by technical issues, like the frequency of wage payments. Change from one week paycheck to one month paycheck will influence money velocity, since one week paycheck enables to reduce the value of necessary buffer stock money held in bank accounts.
– The demographic developments of the society, as for example the age structure of the population has to have influence on population propensity to savings in form of money. Expected rational would be: as individual ages, his life expectancy decreases, so he should rather reduce his propensity for savings. In reality it’s not clear, what saving behavior is to be expected from aging population.

The two charts above obviously show the decline of velocity of money circulation in the most advanced currency regions. Interestingly even the 2008 crisis and the almost zero interest rates that followed, didnt change substantially the general trend of reduced velocity, as contrary to what would be expected.
F. But the financial world is more than money emitted by the government. Additional money creation by central banks, happens too in commercial banking system, that multiplies through credits several times the original money emitted by the government. The relation between credit and the currency issued by the government can be regulated by the government, or rather the central bank itself. The government has several tools how to influence the volume of money in circulation, while regulating the banking system.
F1. Minimum Reserve Ratio Requirements, defined as percentage of the value of deposits in commercial banks, that are their liabilities to its depositors – savers, that have to be stored physically in the bank vault in form of cash, or as balance of the commercial banks account in the central bank. This percentage is defined as obligatory by the central banks, that are part of the sovereign governments operation. In most of the countries this ratio is about 10%, what means, that theoretically the bank credit can be up to 9 times more than the deposits in the central bank.
F2. Other requirement the banks have to fulfil is the minimum capital adequacy ratio, or equity requirement ratio to the total credit, the commercial banks lent to creditors.
These two instruments were created to secure financial stability of the banks, and as such, the whole financial system. But the result is, that when the government creates new debts, and finances it by emitting additional currencies to the economy, it always can control the amount of money in circulation, unless all the deposits of savers in the banks will be covered by equivalent currency bills in the bank vaults, and all the credits given by the banks will be out of banks equities. Banks equities by their nature are limited, since their source is either from emitting shares to investors, or from accumulated profits, that were not paid as dividends to the owners. The credit on the other hand is out of deposits, what is the usual state of liquid money, unless it is currency bills, saved in mattresses. When a bank gives a credit, it will be again deposited in a bank account of the borrower, or if money is used as payment, that is also deposited in a bank account of the supplier. So in modern banking system money never actually leaves the banking system, but for a blink of second.
A financial system based on banks equities would be financially very stable, but it also means, that the capacity of the commercial banks to lend money would be limited, and the government would have to be the major source of the money supply to the economy. This would have to be by creating excess expenditures, and this also means nationalisation of most of the economic activities and suppression of the private sector. Since government cannot act in competitive environment, it’s activities are usually out of monopolistic power. It means also relative inefficiency of activities in government fields.
G. The debt of the private househo lds as contrary to public debt has limited capacity to grow. Private households if indebted above their capacity to repay debts, are forced either to sell their assets, usually private dwellings, that were mortgaged to banks, or reduce their level of consumption. If the private indebtedness is a large-scale, whole country phenomenon, it causes collapse of the aggregate demand, and the economic activity is depressed. The result may be an economic crisis of reduced level of economic activity, unemployment, etc.
H. The corporate and non corporate businesses have several debt types. Equity, bank loans, and corporate bonds. Each of this liabilities behave differently. As in the case of private households, the private businesses cannot create debts exceeding their repayment capacity, but as a temporary state.
2. After analysing the state of debt following the 2008 economic crisis, and explaining the connection between debt and money we can try to answer the question why debt is bad after all.
Historically economic activities could be without exchange of money. In the agrarian societies, the peasantry was self sufficient in supplying most of the needs of the family or the community. The exchange of products was necessary because of seasonal overproduction and high storage costs. Many produced agricultural items were also unsuitable for storage and had to be sold. On the other hand the peasantry needed some products, that was unable to produce by itself. Such a product could be salt or seasoning, necessary for food storing, or products produced by specialist craftsmen, who processed iron, wood, leather or textiles, like blacksmith, cobblers, tailors, etc. But most of the needs of the population, who lived in the rural regions were based on self-supply, without need for exchange of goods and services, so also without need for money. Such an economy was pre monetarised.
Even today most of the housewifes activities are economic activities of production, without commercialization and monetization, meaning without money exchange. Such an economic activity is not counted as part of the income on individual as well as on the national level. This activity doesn’t participate on the GDP creation, can’t be taxed, and hardly can be financed by debt.
Since the industrialisation, more and more economic activities were about transfer of ownership of products produced by human activity between two legal entities, the supplier and the purchasers. On one side, the supplier brings to the deal product, on the other side, the purchaser brings money. Because of it, availability of money is crucial for any economic transaction. Collapse of money supply, because of money’s abundance or scarcity, will necessarily cause disruption in products production and commercialisation, even in extreme cases to its total collapse. Economic crisis in form of inflation or deflation is all about collapse of commerce, because of discrepancies between the value of money or product circulation.
Such a discrepancy is almost necessary because of very different timeline of money elasticity to grow or to shrink, as compared to the product’s production capacity change, that on the short term is very inelastic. To put it metaphorically, to create money all you need is keyboard connected to a right computer program, while to create production capacity, you need an additional, well planned production facility, its building an introduction to operation may take years.
Yet not everything is lost.
The financial system has its stock buffers too, using money’s value holding property in form of financial savings and deposits, that are influenced by many factors, among them the most important probably is the interest rate. High interest rate causes increased savings, vice versa.
Yet, any economic item or commodity if to abundant its value decreases, and if too scarce increases. The same with money, if too much of it, it causes inflation, or lose of money value and too little of it deflation., that is price decrease.
As described previously, the 2008 economic crisis resulted an unprecedented increase of public debt in US and EU, and big increase of private debt in China. If private debt can endanger the financial stability of the whole financial system, as it was proved since 2008, the government can always rescue the economy on the macroeconomic level. By doing it, it takes over the private debts, while this process creates cash money.
Does this unprecedented increase in public debt, translated to additional cash money in the financial system causes the expected inflation? Yes and no. As to consumers basket price index, that influences on short term the standard of living, it’s not translated to inflation, because of globalisation of the economy, and the excess production capacity worldwide for these products. But at the same time money loses its purchase power against other value holding assets, like real estate properties, publicly traded company shares, even cryptocurrencies, etc.
An another question is, because of tendency of existing economic monetary system to continue to increase debts, does the described system have capacity to repeat itself, and eliminate again the danger of total collapse of the monetary system as it happened after 2008? It seems, until most of the debt and so the money in circulation originates from the commercial banks and not from the government, the government has still big space to squeeze the credit volume in the economy, or manipulate the money circulation velocity, if it is needed. Also the government always can issue new currency and introduce it to the financial markets.
As i see it, the major threat to the existing economic-monetary system is in shaking the trust, the people have in money, as value holding and value representing item, what is the foundations of the existing economic system. More and more voices are heard about the absurdity of the most universal faith the humanity has, the fath in the universal value of money, and mainly of the reserve currency money, the US dollar. Viz:

The faith in money, mainly the US dollar or Euro is universal, and stable, even crossing borders of countries and nations with animosity towards the sovereign government, that emitted the currency. This faith has irrational foundations and is not consequence of any external preconditions, just as any other religion, like believing in almighty God, or faith in humorous Spaghetti Monster. Yet, as any other religion, with increased human awareness to the fact, that money doesn’t represent any real value, except the very faith that it has value, secularization of faith in money can appear out of nowhere or out of deep economic crisis.
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