Conditions for Big Debt

"Watch that purgatory they call a gym. No shots six foot in. That'll do."
--Wilbur "Shooter" Flatch (Hoosiers)

Despite its pretty common title, I found this little article remarkably salient. The author argues that the only way that if debt was created in proportion to economic growth, which is how it would grow in an unhampered market over time, then there is no way our debt levels would be so out of whack.

Debt can only be created in the quantities that we currently deal with when financial institutions can lend new money, unbacked by real income, into existence. The root cause of the problem, he suggests, is fractional reserve banking.

Of course, fractional reserve banking can occur in an unhampered economy. Indeed, the 1800s saw many banks lending out more than they took in. In free markets, however, leveraged banks are prone to getting wiped out when risk appetites turn. Over time, depositers are likely to think twice about putting money into leveraged institutions because of the fear of banks runs.

In a free market, then, the amount of leverage banks can take on is likely to be modest at best.

Enter the central bank--in the US case this is the Federal Reserve. Central banks provide a backstop for leveraged banks in times of crisis. They can inject capital into member banks to prop them up and keep them solvent.

However, central bank support can only go so far when a currency is backed by gold, since money cannot be created in sufficient quantities to cover high levels of leverage.

Thus, the gold standard needed to be eliminated. This was done over a period of years once the Fed commenced operations after its 1913 charter. A major was the confiscation of gold from the citizenry in the early 1930s. Unpegging the dollar from gold literally gave the Fed a license to printing unlimited quantities of dollars to liquify overleveraged banks during crises.

Even under these conditions, however, a shadow of doubt might rest in depositor's minds about the soundness of banks in any condition. To alleviate those fears, government-sponsored deposit insurance (FDIC et al) was provided so that bank customers no longer thought twice about the safety of their deposits. Moral hazard becomes de rigueur...

And there you have it. A basic four point program for creating massive quantities of debt over time.

1) fractional reserve banking
2) central banks
3) remove link between currency and gold
4) government sponsored deposit insurance