Reggie Middleton is an entrepreneurial investor who guides a small team of independent analysts, engineers & developers to usher in the era of peer-to-peer capital markets.
1-212-300-5600
reggie@veritaseum.com
Part 2 of the Global Macro Op Ed pieces from the BoomBustBlog readers:
Our banks have grown out of control. They have every incentive in normal times to expand lending to grow profits. They were given the ability to gorge on this lending way beyond normalcy through the ability to create debt independent of deposits or anything else, through the removal of all watchdogs, and through fractional reserve lending. They exist not only in the US, but in almost all countries in quite the "non-zero sum fashion". They are now bursting at the seams due to their enormous size.
We are not primarily a fiat economy driven by central bank actions. We are primarily a PRIVATE CREDIT economy, driven by the desire and the ability of banks to create debt, with a fiat economy on the side.
This is not right. We have become overly reliant on debt. Our politicians and our business leaders are trying to convince us that more debt is the solution. They have it completely backwards. Debt is the problem. It is why we are in this situation to begin with. There is nothing wrong with a reasonable amount of debt. Our debt load is completely unreasonable - it is simply not sustainable, even in a purely utilitarian sense. There is no economy like ours where debt originated purely for consumption is as prevalent, or as accepted. It's not right on many levels.
Table of Contents
Conclusions
There are a few conclusions from all of the analysis on our system over the past week:
Our economy has become overly reliant on consumption driven by unsustainably large volumes of debt.
What are the empirical parameters of this system?
In a prior analysis we referenced the following graph:
This elucidates the basic elements of the system:
I would add a fourth - Output.
Output is spending. It is what we call GDP. We think about GDP a lot here, and spending (and income) are what drive our economy. Important variable! In the table above, GDP goes up when money is spent, but not at any other time. (1), (2), (3), (4) and (5) would show cumulative GDP of $0, $900, $900, $1710, $1710. Note how an initial $1000 was able to create $9000 of GDP simply due to credit growth and a zero savings rate.
These are the parameters we should be thinking about.
What are the theoretical properties of a pure fractional reserve lending system?
These are some of the properties of a fractional reserve lending system, as they pertain to the 4 variables identified above. All are evident from that simple example.
These are simple enough to see, and are intuitively appealing.
Why is plain vanilla Fractional Reserve Lending with low reserve requirements an unsustainable Ponzi scheme?
In "Deposits are a fiction - but base money is not part of the Ponzi", I argued a few things:
I would add a few other points:
When the economy is growing, this is not a problem. In fact, when things are going well all these loans reinforce the good times. The problem is that this structure leaves the system horribly vulnerable to defaults. We just finished a debt binge on an unproductive asset bubble and consumption.
What are the EMPIRICAL properties of a pure fractional reserve lending system?
There is no reason why we need to stop with the theory. We have all of this data for the US.
These are where we find the parameters, from 1st principles:
The theory behind the choice of these figures was explained in "Monetary base is "cash"".
These are the results.
Debt, GDP, Monetary Base, Deposits
Before showing what the actual results are, consider what the simulated result would be assuming $1000 of initial money and a required reserve of 10% with each iteration:
This is what the actual figures have been from 1918 to Q2 2008:
These are the results adjusting all figures to equalize the monetary base over the data series to its Q2 2008 value of $839B:
Observations:
These results heavily call into question the hypothesis that we are purely on a fractional reserve lending system on 2 fronts.
Debt versus GDP
We can look at this in a few ways - (1) Ratio of Debt / GDP ; (2) Change in Debt / Change in GDP.
This is the now infamous graph of Private vs Public vs Total Debt / GDP:
GDP, as noted earlier, is a proxy for the income of our nation. This chart, then, shows that an ever increasing amount of debt is being supported by the income of our country. This should cause a drag on the ability of GDP to grow.
Below is a graph of Change in Debt / Change in GDP:
Observations:
The original 1-for-1 relationship b/w debt and GDP growth is supportive of what we would theoretically expect. The lack of "high" in later periods is supportive of the notion that we are now buckling under the weight of our collective debt load.
As noted above and elsewhere, lending beyond a certain limit requires Ponzi-like perpetual growth. In the absence of miraculous output growth, we must be able to continually borrow the interest on the incremental debt. This graph strongly suggests we are borrowing ever increasing amounts of interest on a growing mountain of unsustainable incremental debt.
Debt versus Deposits
Debt in the theoretical model is always supposed to be less than total deposits. This has never been the case though, as can be seen in the graph below:
Private Debt / Deposits had been 250% or below from 1934 to 1980 or so. Then it spiked up to 580%. This supports the idea that we *truly* began our debt binge in 1980. In a pure fractional reserve lending system, how could such growth be possible? The same amount of deposits somehow translated into a heck of a lot more loans.
I believe this is due to 2 factors:
The securitization model is extremely perverse from a macro perspective. It has pumped a lot of loans into the system that could not be supported by the banks alone. It has allowed for a far greater accumulation of debt within our country than would have ever been possible in a traditional banking system. It removed due diligence and loan underwriting standards.
Debt's size vis a vis deposits strongly supports the notion that our system has primarily been driven by DEBT.
Monetary Base versus Deposits
This is a graph of Monetary Base as a % of Deposits. This is how much our society is holding aside in actual cash, supporting our deposits.
Observations:
Debt by itself
As another way of thinking about it, below is a graph of real private debt per capita, from 1918 until Q2 2008:
Observations:
It is one thing to be on an FRL system and have total debt per person at a manageable level of say $30k even. Median household income is $43k, when there are around 120k households in this country. This implies a median debt per household of $380k. Does this sound normal to you?
This is the problem with an FRL system in a short term capitalist society, on a credit system with a fiat subsystem. It has every ability and every desire to create this much debt, and doesn't know when to stop.
Monetary Base versus Debt
This is how much cash is underlying the loans in this country. Cash, or monetary base, is the "input", and loans are the "output". The magnitude of the output vis a vis the input is a function of how aggressive the banks are.
Observations:
Reggie Middleton is an entrepreneurial investor who guides a small team of independent analysts, engineers & developers to usher in the era of peer-to-peer capital markets.
1-212-300-5600
reggie@veritaseum.com