A Skyscraper of Cards by Robert Gore

Every now and then the world is visited by one of these delusive seasons, when “the credit system,” as it is called, expands to full luxuriance, everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open; and men are tempted to dash forward boldly, from the facility of borrowing….Every one now talks in thousands; nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer….Speculation is the romance of trade, and casts contempt upon all its sober realities….a panic succeeds, and the whole superstructure, built upon credit and reared by speculation, crumbles to the ground, leaving scarce a wreck behind: ‘It is such stuff as dreams are made of.’

Washington Irving, The Great Mississippi Bubble, 1820

Had the Nobel Prize for economics existed back in 1820, Mr. Irving would have been a worthy candidate. He certainly had a better grasp of the subject than many who have won it. As Deacon Bainbridge, a character in The Golden Pinnacle, noted: “Historically, you’ve been able to tell everything you need to know about a government by the quality of its money.” Money has become the “stuff as dreams are made of”: ephemeral, evanescent, lighter than air…vanishing when eyes are opened. As chaos engulfs the world, governments stand revealed; they’re of the same quality as their currencies.

Money reduces the transaction costs and inefficiencies associated with barter and is a store of value, the standard of accounting, and the medium of exchange. Debt allows those who produce more than they consume to lend and earn a return from those who use that surplus to consume or invest. A system whereby money and debt are created at the whim of either a government or its central bank will not work, in that long run Keynes infamously dismissed, because it cannot work. When money and credit are divorced from the underlying economy, they become agents of destruction rather than production and growth.

The mathematics of debt growth in excess of underlying economic growth are inescapable. Taken to its logical extreme, every asset would be collateralized and debt service would stifle economic activity. Before that point is reached, however, debt becomes an unbearable economic burden—its costs exceed its benefits—which throws debt formation into reverse. The reversal in a system whereby fiat money, governmental borrowing, and central banking have divorced debt growth from the real economy is swift, dramatic, and inevitably contractive and deflationary.

The global government- and central bank-promoted expansion of debt the last five years has been sold as a means of restoring aggregate demand, combatting perceived threats of deflation, raising the prices of financial assets and real estate, and creating economically beneficial wealth effects. It actually marks the end game of many decades in which debt and the price of debt have been completely untethered from the real economy.

A skyscraper of cards has been built on a superabundance of debt priced at interest rates that offer creditors no compensation for credit or market risk, much less a real return on their capital. The purported justifications for the debt explosion are specious. It is actually a last-gasp attempt by governments to reduce their debt service costs and devalue their staggering levels of debt through currency devaluation and inflation. Central banks have been willing accomplices; buyers of government debt whose interest-rate-insensitive demand has driven rates far lower than what would have prevailed if the market were not subject to their manipulation.

Much of the global economy is a mirage. An appreciable percentage of malls, auto dealerships, restaurants, real estate developments, office towers and other hallmarks of the developed countries’ way of life would not exist but for debt promotion and below-market interest rates. Many of the assets listed on individual and corporate balance sheets are debt, somebody else’s liability. The borrower expects the return on investment or speculation will be higher than the interest rate he or she must pay. The majority of lenders lend, notwithstanding low rates, because they are either interest-rate-insensitive central banks or must generate some sort of return to fund future liabilities (pension funds) or present lifestyles (retirees).

Once debt starts contracting, speculative flows reverse first, because speculation is the most leveraged economic activity. Contracting credit is a margin call, and assets whose prices had been bid up as credit expanded must be sold to meet the claims of creditors. Because it is impossible to satisfy all claims (especially when many financial assets are collateral for multiple loans, our present situation), debt must be written off and losses realized, threatening creditor solvency. They sell assets and the cycle turns vicious. While it is unclear how much rising wealth promotes economic activity on the way up—the much ballyhooed wealth effect—wealth destruction accompanies economic contraction on the way down. People cannot spend paper wealth they no longer have and against which they can no longer borrow.

Expanding debt cannot “solve” the economic problem of too much debt any more than another drink can solve alcoholism. Additional debt became an unbearable burden before 2008—costs exceeded benefits, as the housing bust and financial crisis made clear—and the world has added almost $30 trillion since then. What was obvious to Washington Irving in 1820 remains obvious. The remedies pursued the last five years have been blind to the consequences and counterproductive. Governments and central banks’ debt expansion has only delayed and ultimately will amplify the economic and social pain. The end of quantitative easing this month will take the blame for recent global equity weakness. It shouldn’t; at most it hastens by a few months the collapse of a skyscraper of cards as the “superstructure, built upon credit and reared by speculation, crumbles to the ground, leaving scarce a wreck behind.

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