Thursday , 17 August 2017

Debt and the Santa Claus Principle

“An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.” [This article discusses the reality of the current economic crisis and] what is required to revive the economy. Words: 1666

The above quote is by Ludwig von Mises as conveyed in an article* by Frank Shostak ( which Lorimer Wilson, editor of (Your Key to Making Money!), has edited further below for length and clarity – see Editor’s Note at the bottom of the page. (This paragraph must be included in any article re-posting to avoid copyright infringement.)

Shostak goes on to say, in part:

The famous American economist Irving Fisher held that a very high level of debt relative to GDP (currently at around 400% in the U.S. and 450% in the eurozone when both public- and private- debt sectors are taken into account) runs the risk of setting deflation in motion and, in turn, a severe economic slump in the…following sequence:

  1. The debt liquidation process is set in motion because of some random shock, for instance, a sudden large fall in the stock market. The act of debt liquidation forces individuals into distressed selling of assets.
  2. As a result of the debt liquidation the money stock starts shrinking, and this in turn slows down the velocity of money.
  3. A fall in money leads to a decline in the price level.
  4. The value of people’s assets falls while the value of their liabilities remains intact. This results in a fall in the net worth, which precipitates bankruptcies.
  5. Profits start to decline, and losses emerge.
  6. Production, trade, and employment are curtailed.
  7. All this leads to growing pessimism and a loss of confidence.
  8. This in turn leads to the hoarding of money and a further slowing in the velocity of money.
  9. Nominal interest rates fall, however; but because of a fall in prices, real interest rates rise.

Stage Two is the Critical Stage

Stage 2 is the critical stage in this story: debt liquidation results in a decline in the money stock. But why should debt liquidation cause a decline in the money stock?

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Take 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.
  • The money received can be seen as a receipt as it were for the goods he produced and saved. The money is his claim on these goods.
  • The producer can then make a decision to lend his money to another producer through the mediation of a bank. By lending his money, the original saver — i.e., lender — transfers his claims on real savings to the borrower.
  • The borrower can now exercise the money — i.e., the claims — and secure consumer goods that will support him while he is engaged in the production of other goods, let us say the production of tools and machinery.
  • Once the contract expires on the date of maturity the borrower returns the money to the original lender. The repayment of the debt, or debt liquidation, doesn’t have any effect on the stock of money.

Things are, however, different when a bank uses some of the deposited money and lends it out….

  • [While] the owner of the deposited money continues to exercise demand for money – he didn’t relinquish his claims on real savings in favor of a borrower -, the bank effectively creates another claim on real savings.
  • This claim is just empty stuff. In the case of fully backed credit, the borrower, so to speak, secures goods that were produced and saved for him but this is not so with respect to unbacked credit. No goods were produced and saved here.
  • Consequently, once the borrower exercises the unbacked claims, this must be at the expense of the holders of fully backed claims. The bank here creates money “out of thin air.” On the date of maturity of the loan, once the money is repaid to the bank, this type of money must disappear, because it never existed as such and never had a proper owner.

The point that must be emphasized here is that:

  • The fall in the money stock…is actually triggered by the previous loose monetary policies of the central bank and not the liquidation of debt.
  • This loose monetary policy that provides support for the creation of unbacked credit. (Without this support, banks would have difficulty practicing fractional-reserve lending.)
  • The unbacked credit in turn leads to the reshuffling of real funding from wealth generators to non–wealth generators.
  • This, in turn, weakens the ability to grow the pool of real funding.
  • When the pool of real funding starts shrinking (i.e. there are now more activities that consume real wealth than activities that produce real wealth)
  • This, in turn, weakens the economic growth…[at which point] anything can trigger the so-called economic collapse.
  • When things start falling apart, banks try to get their money back.
  • Once banks get their money (credit that was created out of thin air) and don’t renew loans, the stock of money must fall. (Note that the consequent price deflation and the fall in the economy is not caused by the liquidation of debt, as such, nor by the fall of the money supply, but by the fall in the pool of real funding on account of previous loose monetary and fiscal policies.)

The Size of the Debt and the Severity of the Economic Slump

In his writings, Fisher argued that the size of the debt determines the severity of an economic slump…[but] we, however, maintain that it is not the size of the debt…but rather the state of the pool of real funding. Again, it is not the debt but loose monetary and fiscal policies that cause the misallocation of real funding. (The level of debt is just a symptom, as it were; it doesn’t cause damage as such.)

By putting the blame on debt as the cause of economic recessions, one in fact absolves the Fed, and the banking system it maintains, from any responsibility for setting the whole thing in motion…[and] appears to justify the idea that the Fed must step in and lift monetary pumping in order to offset the disappearing money supply. Rather than countering the emerging depression, however, what monetary pumping does here, in fact, is to further weaken the pool of real funding and thereby deepen the economic crisis.

Many commentators are of the view that, because of price deflation, the debt burden intensifies and that, as such, this burden can be eased by means of monetary printing thereby arresting the economic plunge. Again we suggest that pumping more money only dilutes the pool of real funding and makes things much worse. Additionally, the emergence of monetary deflation is a positive development for wealth generators, because it slows down the diversion of real funding toward nonproductive activities.

The Fallacy of Insufficient Aggregate Demand

Keynes and Friedman felt that the Great Depression was due to an insufficiency of aggregate demand, and so the way to fix the problem was to boost the aggregate demand.

  • For Keynes, this was to be done by having the federal government borrow more money and spend it when the private sector wouldn’t.
  • Friedman advocated that the Federal Reserve pump more money to revive the demand.
  • Fisher, while agreeing that the problem was with insufficient demand, held that insufficiency of aggregate demand was a symptom of excessive indebtedness. Therefore, what was needed to contain a major debt depression was to prevent it ahead of time. You have to prevent the buildup of debt.

Fisher deals here with symptoms and not the true cause, which is the declining pool of real funding that results from loose fiscal and monetary policies. In addition, we maintain that there is never such a thing as insufficient aggregate demand, as such.

We suggest that an individual’s effective demand is constrained by his ability to produce goods. Demand cannot stand by itself and be independent — it is limited by production. Hence, what drives the economy, is not demand, as such, but the production of goods and services. The more goods an individual produces, the more of other goods he can secure for himself. In short, an individual’s effective demand is constrained by his production of goods. Demand, therefore, cannot stand by itself and be an independent driving force…

If a population of five individuals produces ten potatoes and five tomatoes — this is all that they can demand and consume. No government or central-bank tricks can make it possible to increase effective demand. The only way to raise the ability to consume more is to raise the ability to produce more.

The dependence of demand on the production of goods cannot be removed by means of loose-interest-rate policy, monetary pumping, or government spending. On the contrary, loose fiscal and monetary policies will only impoverish real wealth generators and weaken their ability to produce goods and services. It will weaken effective demand.


What is required to revive the economy is not boosting aggregate demand but sealing off all the loopholes for the creation of money out of thin air and curbing government spending. This will enable true wealth generators to revive the economy by allowing them to move ahead with the business of wealth generation.

  • The threat to the U.S. economy is not the high level of debt as such but loose fiscal and monetary policies that undermine the pool of real funding.
  • The fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary and fiscal policies and not the liquidation of debt as such.
  • Once the pool of funding becomes stagnant or begins to shrink, economic growth follows suit and the myth that government and central-bank policies can grow the economy is shattered.

* (Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to

Editor’s Note: The above article has been has edited ([ ]), abridged, and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.

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