the Reinhart and Rogoff study defaulted are marked in a darker shade.
World Debt More Than Doubles in Ten Years
GRAPH 3. Rich-country debt has grown remarkably in the past ten years because of the amount of lending generated by capital flows from fossil energy — and commodity-producing nations was used to inflate asset bubbles. The emerging economies, by contrast, invested borrowed money in increasing production. As a result, their debt/GDP ratio declined. Source: The Economist.
As Debt Increases, US Economy Grows by Less and Less
GRAPH 4. Because borrowings have been invested predominantly in purchasing assets rather than in production capacity, each increase in borrowing in the US has raised national income by less and less. The most recent bout of borrowing — to rescue the banking system — actually achieved negative returns because it failed to stop the economy contracting. Graph prepared by Christopher Rupe and Nathan Martin with US Treasury figures dated 11 March 2010. Source: economicedge.blogspot.com/2010/04/guest-post-and-more-on-most-important.html
Now suppose that rather than buying furniture, I invest my borrowed money in buying shares from someone who holds them already, rather than a new issue. Of the
So one reason why the debt burden has grown in “rich” countries and fallen in “emerging” ones is the way the debt was used. A very much higher proportion of the money borrowed in some richer countries went to buying up assets, and thus bidding up their prices, than it did in the poorer ones. After a certain point in the asset-buying countries, it was the rising price of assets that made their purchase attractive, rather than the income that could be earned from them. Rents became inadequate to pay the interest on a property’s notional market value, while in the stock market, the price-earnings ratio rose higher and higher.
Only a small proportion of the money created when the banks lent money to buy assets was spent in what we might call the real economy, the one in which everyday needs are produced and sold. The rest stayed as what the money reform activist David J. Weston called “stratospheric money” in his contribution to the New Economics Foundation’s 1986 book The Living Economy; in other words, money that moves from bank account to bank account in payment for assets, with very little of it coming down to earth. The fraction that does flow down to the real economy each year is normally balanced — and sometimes exceeded — by flows in the other direction such as pension contributions and other forms of asset-based saving. The flows in the two directions are highly unstable, however, not least because those who own stratospheric assets know that they can only convert them to real-world spending power at anything like their current paper value if other people want to buy them. If they see trouble coming, they need to sell their assets before everyone else sees the trouble too and refuses to buy. This creates nervousness and an incentive to dump and run.
If all asset holders lost all faith in the future and wanted to sell, prices would fall to zero and the loans that the banks had secured on their value would never be repaid. The banks would become insolvent, unable to pay their depositors, so the huge amounts of money that were created when the asset-backed loans were approved would disappear, along with the deposits created by loans given out to finance activities in the real economy. In such a situation, the deposit guarantees given by governments would be of no avail. The sums they would need to borrow to honor their obligations would be beyond their capacity to secure, particularly as all banks everywhere would be in the same situation.
No one wants such a situation so, since a decline in asset values could easily spiral downwards out of control, the only safe course is to keep the flow of money going into the stratosphere greater than that coming out. This keeps asset prices going up and removes any reason for investors to panic and sell. The problem is, however, that maintaining a positive flow of money into the stratosphere depends on having a growing economy. If the economy shrinks, or a greater proportion of income has to be spent on buying fuel and food because their prices go up, then less money can go up into the stratosphere in investments, rents and mortgage repayments. This causes asset values to fall and could possibly precipitate an investors’ stampede to get into cash.
In effect, the money circulating in the stratosphere is another currency — one that has only an indirect relationship with energy availability and which people use for saving rather than to buy and sell. Because there is a fixed one-to-one exchange rate between the atmospheric currency and the real-world one, the price of assets has to change for inflows and outflows to be kept in balance. As we’ve just discussed, the banking system will collapse if asset values fall too far, so governments are making heroic efforts to ensure that they do not. As 20% of the assets involved are owned by 1% of the population in Britain and Ireland (the figure is 38% in the US), this means that governments are cutting the services they deliver to all their citizens in order to keep the debt-money system going in an effort to preserve the wealth of the better-off.
In 2007, the burden imposed on the real economy by the need to support the stratospheric economy became too great. The richer countries that had been running balance of payments deficits on their current accounts found that paying the high energy and commodity prices, plus the interest on their increased amount of external debt, plus the transfer payments required on their internal ones, was just too much. The weakest borrowers — those with sub-prime mortgages in the US — found themselves unable to pay the higher energy charges and service their loans. And, since many of these loans had been securitized and sold off to banks around the world, their value as assets was called into question. Banks feared that payments that they were due from other banks might not come through as the other banks might suddenly be declared insolvent because of their losses on these doubtful assets. This made inter-bank payments difficult and the international money-transfer system almost broke down.
All asset values plunged in the panic that followed. Figures from the world’s stock markets show that the FTSE-100 lost 43% between October 2007 and February 2009 and that the Nikkei and the S&P 500 lost 56% and 52% respectively between May-June 2007 and their bottom, which was also in February 2009. All three indices have since recovered some of their previous value but this is only because investors feel that incomes are about to recover and increase the flow of funds into the stratosphere to support higher levels. They would be much less optimistic about future prices if they recognized that, in the medium term at least, a growing shortage of energy means that incomes are going to fall rather than rise.
This analysis of the origins of the current crisis leads to four thoughts that are relevant to planning the flight from Vesuvius:
1. It is dangerous and destabilizing for any country, firm or individual to borrow from abroad, even if they are borrowing their own national currency. Net capital movements between countries should be prohibited.
2. An inflation is the best way of relieving the current debt crisis. An attempt to return the debt-GNP ratio to a supportable level by restricting lending would be a serious mistake. Instead, money incomes should be increased.
3. A debt-based method of creating money cannot work if less and less energy is going to be available. New ways of issuing money will therefore need to be found.
4. New ways of borrowing and financing are going to be required too, since,
