Austrian Economics teaches that a circulation-credit-fueled boom can only be sustained by ever-greater doses of credit and money expansion, provided at ever-lower interest rates. As soon as the growth rate of credit and the money supply slows down, the illusionary upswing collapses. Mal-investment is revealed, firms cut employment, and the economy goes into recession. [Sound familiar?]
The current upward dynamic of the debt-to-GDP ratio in the U.S. is economically unsustainable but something can be done to correct the situation. While we do not know how much debt relative to GDP an economy can shoulder the level of debt relative to income cannot rise without limit. This insight is important, given that there is strong reason to believe that the extraordinary rise in the debt-to-GDP ratio is a result of the government-controlled, fiat-money system in which the money supply is increased through bank lending.
The Correction Scenario
Let us assume, for the sake of argument, that the current debt-to-GDP ratio has exceeded its sustainable level. What are the chances that output could start expanding more strongly than debt, thereby lowering the ratio? This would be a rather favorable scenario, as the debt-to-GDP ratio would decline, while income and employment would increase. Unfortunately, however, it is a rather unlikely correction scenario.
Lenders can then be expected to demand higher interest rates and/or to stop extending loans as the outlook for the possibility of borrowers repaying their debt (in real terms) deteriorates. In other words, market forces start pressing for a change in the hitherto-observed path of the total-debt-to-GDP ratio.
If commercial banks make their debtors repay their loans, the money supply declines. A drop in the money supply, in turn, would represent deflation and the symptoms would be declining prices for goods and services of current production, and for existing assets such as, for instance, stocks and real estate.
Deflation would lead to credit losses as a growing number of borrowers would find their incomes greatly diminished and — most importantly — falling short of expectations. Many borrowers would default on their debt.
If credit-related losses exceed their equity base, banks go bankrupt. Savers and investors in bank debentures would have to accept losses, as banks could not meet their debt service. It doesn’t take much to see that such an outlook could trigger a “flight out of debt.”
Investors would try to dump their bonds, causing interest rates to go up. Borrowers in need of rolling over their debt would have to accept higher refinancing rates, which would leave a growing number of investment projects unprofitable. The mere expectation of rising credit costs would therefore make possible an anti-correction scenario.
The Anti-correction Scenario
In the anti-correction scenario, central banks — seeing an unraveling debt pyramid — would decide to prevent banks from defaulting on their debt by pushing short-term interest rates to record lows and providing additional base money for bank refinancing — by monetizing banks’ debentures and/or (troubled) assets.
Keeping a circulation-credit boom going requires ever-greater amounts of credit and money, provided at ever-lower interest rates. However, credit and money cannot be increased indefinitely by the central bank and commercial banks. In fact, it is money demand that would set a limit.
If inflation — that is, a rise in the money supply — does not exceed an unacceptable level, people may well continue to use money even if it loses its purchasing power. If, however, inflation exceeds an acceptable level, or if people start expecting inflation to continue to rise further, the money is doomed to fail.
As Ludwig von Mises noted in 1923, “once the people generally realize that the inflation will be continued on and on and that the value of the monetary unit will decline more and more, then the fate of the money is sealed. Only the belief, that the inflation will come to a stop, maintains the value of the notes.”
The private sector may be able to cope with deflation (and the ensuing redistribution of property rights). The institution of government, in its current size and scope, however, cannot. Inflation — the rise in the money supply — is an indispensable tool for financing government outlays for which the taxpayer would presumably not want to pay out of his current income.
Mises noted, “inflation becomes one of the most important psychological aids to an economic policy which tries to camouflage its effects. In this sense, it may be described as a tool of anti-democratic policy. By deceiving public opinion, it permits a system of government to continue which would have no hope of receiving the approval of the people if conditions were frankly explained to them”.
The effort to prevent government from defaulting on its debt is, therefore, the greatest danger for the value of money and this is why an unsustainable debt-expansion path poses such a great danger to the exchange value of money.
Central banking makes it possible for the government to expand the money supply by any amount, at any time deemed necessary and once (hyper)inflation is publicly seen as being the lesser evil of all options available for the government meeting its debt service, it cannot be dismissed out of hand that (hyper)inflation would be the consequence of an unsustainable debt-to-GDP ratio.[The original article as written by Thorsten Polleit (mises.org) is presented here by the editorial team of munKNEE.com (Your Key to Making Money!) and the FREE Market Intelligence Report newsletter (see sample here – sign up in the top right corner) in a slightly edited ([ ]) and/or abridged (…) format to provide a fast and easy read.]