US Economy and Debt

One of the main causes of the current financial crisis is the fact that too many Americans have become addicted to the debt-fuelled lifestyle. By buying things they cannot afford, putting everything on credit and getting into debt that they are unable to pay off, the financial crisis is exacerbated. Let us take a look at this illuminating graph.

While national income only grows modestly, debt has exploded upwards. How did the US accumulate all this debt? It is due to the easy credit that has become the cornerstone of the relationship between developing China and America. Niall Ferguson, author of The Ascent of Money, termed this relationship Chimerica. China did the saving, America did the spending. China exported, America imported. China lend, and America borrowed. By pursuing an export-oriented economy, China was helping to finance the debt-fuelled American economy. As China poured its surplus back into buying Treasury securities, thus keeping its currency pegged to the dollar, interest rate in the US is artificially lowered. With the economy awash with easy money, America is thus able to pursue a debt-fuelled economy, where banks tend to lend recklessly to individuals and individuals cand spend in excess of their earned income.

Obviously, a debt-fuelled economy is unsustainable and cannot last forever. Debt has to be repaid, one way or the other. How it is going to be repaid will depend very much on what the US intends to do to the dollar.

Typically, when you owe a lot of debt, you will have two routes available to pay off the debt—deflation or devaluation.

Let us first focus on deflation. As was mentioned above, because of Chimerica, America has been awash with easy credit for a long time. This led to asset price inflation(eg. housing market, stocks, etc).

Meanwhile, income does not seem to enjoy the same surge upwards.

Ultimately, debt must be paid off using earned income. A look at the above graphs tells you that this is well nigh impossible unless one of the following happens—income has to rise significantly, or significant debt destruction has to occur. To quote Andrew Mellon, “Liquidate labor, liquidate stocks, liquidate farmers.” After so many years of asset price inflation, we are now due for asset price deflation. Debt destruction will have to occur, hopefully in as orderly a fashion as possible, to bring asset prices down where people can realistically pay them off using earned income.

Unfortunately, such an approach is likely to be a political hot potato. It is almost certainly to involve a lot more pain in the short term, setting off a chain of debt defaults and bankruptcies and increasing unemployment. Certainly, it will face opposition from powerful lobby groups in Congress. Going down this path, the pain will be sharp. However, once the economy has recovered, at least, the rottenness will have been purged out of the system.