› › Effect of Debt

Effect of Debt on the Economy

This is a more complete discussion of the effect of debt on the economy, than we could cover within The WelderDestiny Compass newsletter. It is part of a wider discussion to predict if we are headed to a utopian or dystopian future. You can read the complete edition #006 of The WelderDestiny Compass e-zine by clicking here...

If you have not yet subscribed to The WelderDestiny Compass e-zine, then please enter your details in the subscription box below. As a token of my appreciation for your subscription, I will send you a spreadsheet that can assist you in performing dissimilar metal welding calculations based on the Schaeffler diagram.

 The WelderDestiny Compass: Weekly e-zine Subscription

You can take a look at "The WelderDestiny Compass" back-issues by clicking here.

Effect of Debt on the Economy

The other major factor to consider when talking about money, is debt. As we have previously discussed, when banks issue debt, they are in effect making money from thin air. The more debt, the more money there is in the economy.

The cost of debt has a big influence on both the amount and the flow of money. The cost of debt is the interest rate. In a truly free market economy, the interest rate is naturally set by the market. Parties such as reserve banks should theoretically not have any influence on the interest rate.

We would think that the wealthy would like a high interest rate, because then they can lend out their money at a higher rate of return. But, keeping in mind that the wealthy generally keep their money in investment assets, this is not a big factor. In fact, as interest rates go down, asset values rise.

Think of this in terms of buying a home on credit. When the interest rate goes down, the monthly bond repayment decreases. For this reason, you can afford to buy a more expensive property. The property prices then automatically rise to take account of this greater “purchasing power” of the buyers. (We will discuss this in terms of economic rent in a future e-zine.)

In short, reducing the interest rate pushes up the values of investment assets in the system. If we furthermore understand that loans are generally given by banks by using these same assets as collateral for the loans, then a reducing interest rate is a self-feeding mechanism for growing the size of further debt.

In this way, we see that the value attributed to the investment assets gives rise to the amount of debt that can be extended. Keep in mind that the value attributed to these investment assets is a sentiment factor, so if the sentiment changes for any reason, then the feedback loop starts moving in the other direction and can seriously upset the apple cart. This is what happened in 2000 when the value attributed to internet companies dropped, and again in 2008 to the values attributed to real estate.

When the value of the investment assets reduces, it is not a problem in itself. The problem arises when there is a loan outstanding that uses that asset as collateral. The loan was extended in “money” by the bank, so when the value of the asset reduces, depositors in the bank may want their money back because they are scared of losing their money. The bank then needs its money back to cover its own commitments to its depositors. If the people that borrowed the money can no longer pay back the money, because the value of their underlying asset has reduced, then there is a serious problem for the bank.

A bank with a 10% reserve, will go bankrupt when 10% of their outstanding loans go bad. This is why the banks needed to be “bailed out” in 2008, and even now in Europe. Some of the European banks have a reserve as low as 2%, so even a 2% level of bad debts will give them serious problems.

In 2008, world debt stood at around $225 trillion. The shock of the sub-prime mortgage problems in the USA resulted in the debt unwinding scenario that is described above. The debt unwinding resulted in what we now know as the Global Financial Crisis. (GFC) Currently world debt stands at around $300 trillion. The next crisis will surely result in a worse situation than the GFC in 2008.

The great depression was triggered in 1929 by a similar mechanism, because the debt levels rose hugely during the “roaring twenties”. Many of the commentators today believe that we are close to experiencing the next credit crisis on the scale of the great depression.

While there will definitely be an economic crisis, because they do happen at regular intervals, the next crisis will in all probability be different. While history rhymes, it never repeats exactly. The chances are that the next big crisis will result in a currency crisis.

I believe this will happen because the reserve banks in the USA, Japan, China and Europe have shown that they are happy to just “print” their way out of trouble. In effect, the central banks just bought up the market, thereby “short circuiting” the mechanism where debt is eliminated from the system. Japan has been playing this game for more than 20 years, and their economy has gone nowhere in all that time.

People will start to lose confidence in paper money when this same strategy is followed too often. There will need to be a subtle change to how people perceive money and debt, to restore confidence in the system. How this will play out is anybody’s guess, but I suspect that there may be a move back to a precious metal backed currency arrangement.

Eventually the prevailing currency may be an electronic currency controlled by nations, or even centrally controlled, and backed by gold. If future currencies are to be gold backed, it will obviously result in a big upheaval in the gold market, and could conceivably destroy a lot of “paper wealth” in the process. This will not be a big problem if you are keeping your wealth in hard investment assets, rather than paper assets, just like the wealthy do!

Return Navigation:

› › Effect of Debt

 The WelderDestiny Compass: Weekly e-zine Subscription

You can take a look at "The WelderDestiny Compass" back-issues by clicking here.