Sunday, January 9, 2011

Debt and Fiat Money

In Part One of this series (see menu) I said that credit-use boosts the economy, but also creates debt, and that this debt

creates an "equal and opposite" drag on the economy, which must eventually balance out against the boost resulting from credit-use.

One could ask: So if there's no real gain from the use of credit, why bother?

Well... If there is inflation -- or deflation -- things don't work out exactly equal, because the dollars are not equal. That's the reason inflation is sometimes used to help solve debt problems. Inflation lets us pay off debt in cheaper dollars. So there's a "gain" to be had that way. But it's cheating.

Inflation is not a solution. It has been used as a "fix" for the debt problem, but it's not a solution. Still, it does tell us there are ways around the "no gain" problem.

We just need to find a better way.

"Why bother?" The objection raised by this question is that credit-use increases growth, but repayment of debt reduces growth -- "equally" -- so there is no net gain. This objection considers only the accounting of things, not the work that gets done. The objection ignores output.

Credit-use increases output. The increased output justifies expansion of the money supply. And increased economic activity requires such expansion.

Having achieved greater size, the economy demands a greater quantity of money.

If the debt arising from the credit-use is repaid (and if there is no other change in the quantity of money) there will be a decrease in economic activity, and a decrease in economic growth, or outright recession. This is the "equal and opposite" thing.

Up to now, it has been policy to allow debt to accumulate, in order to avoid the "equal and opposite" decline. This policy cannot be allowed to continue. The repayment of private-sector debt must be accelerated. It is the only way to prevent financial crisis.

But as debt is repaid, the quantity of money'n'credit in circulation decreases. And we must not allow that decrease to happen, as it undermines the advantage of credit-use.

As debt is repaid, the monetary authority must allow the increase of non-credit money enough to keep "money'n'credit relative to output" essentially stable. In other words, if a binge of credit-use helps our economy grow by five percent, it should be our goal to pay off the resulting debt and at the same time increase the quantity of non-credit money by five percent.[1]

The government money must increase, replacing the credit-money that is destroyed by accelerated repayment of debt. That such an arrangement is even possible is the magnificent advantage of the fiat money system.


1. Milton Friedman made a similar suggestion to keep the quantity of money growing in proportion to output. But as I point out elsewhere, Friedman overlooked the significance of the difference between money and credit, and considered money in savings equivalent to money in circulation. [Return]

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