The Last Catfish

On Sunday I wrote

Salmon's view is that for GDP to keep growing on the path established by Potential GDP, total debt has to keep rising like [it] was rising before the Great Recession. But that is only true if we insist on using credit for growth -- or, really, for everything. And that is a plan which cannot succeed.

We need a better plan.

Sometimes we start out using credit for growth, and end up using credit for everything. That's what happened between 1947 and 2007.

Using credit for everything costs too much. That's how we got in trouble.

All told, before the Great Recession we had about $3.50 of debt for every dollar's worth of GDP. In a good year we might get 5% GDP growth, five cents on the dollar. So we had $3.50 of debt for every 5 cents of economic growth.

$3.50 credit-in-use for every 5 cents of growth. Obviously we were not using credit only for growth. We were using credit for everything. That's how we got in trouble.


Using credit for growth works well when the accumulation of debt is not large. It works less and less well as the accumulation grows. Ultimately, the accumulation of debt grows so large that the economy can no longer function normally. That's when people start noticing there is a problem.

By that point, of course, we're not just using credit for growth. We're using credit for everything.

All we need is to pay off debt a little faster -- a little faster than we have in the past. This is accelerated repayment of debt, and it will reduce total debt, reduce the cost of that debt, and reduce the economy's inflationary urge besides.

The money created by taking on debt is destroyed when debt is repaid. Repayment of debt is deflationary. We could use it to fight inflation, if we need to. That's what we should have done in the 1970s.

If people are paying down debt faster, we might be creating a deflationary trend. We would want to adjust for that possibility, to keep prices stable. This is where the Fed comes in. The Fed can monetize some government debt, to put money enough into circulation to keep prices stable.

When the economy grows, we need more money. Not more credit. So we use credit for growth, and the economy grows, and we pay down our debt, and the Federal Reserve increases the quantity of money to compensate. That way, we don't have to use credit for everything.

It's not complicated. The confusion arises because people think printing money causes inflation. People think the Fed causes inflation. But private credit use is the culprit.

So here is the plan: We use credit for growth, just as always, but then we pay off our debt a little faster, and the Fed compensates for that by monetizing enough to keep the quantity of money growing in proportion to the economy.

The next year, the economy is N% bigger, the quantity of circulating money is N% bigger, and total debt is N% bigger or less.

In our case the debt number must be less, until balance is restored to our money.


So the plan is to use credit for growth, and then stop using that credit by paying off the debt. This will keep private debt small -- something we all seem to want for ourselves -- and it will keep private credit creation from interfering with Federal Reserve policy decisions regarding the appropriate quantity of money. The Fed will be better able to control inflation.

The use of credit does us a great service: It allows the real economy to expand. But once the economy has grown, the credit that drove it does us no good. It remains only as the cost of accumulating debt. The plan is to limit that accumulation so it does no harm.

To do it, we must pay down private debt. But paying down debt puts downward pressure on prices. So the Fed must step in to keep prices stable.

Later, when we've worked down the accumulation of debt to a low level, we might even think about restoring the value of the dollar by allowing some of that deflation to occur.


Accelerated repayment of debt is the key. But it won't happen by itself. We need incentives to make it happen. Tax incentives.

Right now we have the tax deduction for mortgage interest paid. People think of it as something that helps us afford to buy a home. And it is. But it also encourages the accumulation of debt.

Congress apparently keeps getting closer to eliminating the tax deduction for mortgage interest. They should have done that in the 1960s when the economy was still good. But no, they want to do it now, after the financial crisis, when the world has fallen apart.

It's bound to happen sooner or later. And we should give it up, you know, because it contributes to the accumulation of debt. But we shouldn't give it up easily. We should demand something in exchange.

We should expect Congress to replace the tax deduction for interest paid, replace it with a tax credit to help us make extra payments on our debts. We could get exactly the same dollar-value of benefit that we get from the mortgage interest tax deduction, or more. But the effect of the new policy would be to help us pay down our debt, instead of helping us accumulate more.