by Keith Weiner, Monetary Metals:

Have you ever heard someone say this? It falls into the category of, it’s so perverse, so wrong, and so wrong-headed that there has got to be a constituency out there somewhere, to assert this!

First, let’s head off at the pass the objection that the majority of US government debt is held by foreigners. As of March this year, the US Treasury estimates that $6.3 trillion worth of Treasury bills and bonds are owned by foreign holders. This is not even close to the majority of it.

It’s also not the point. The nature of debt is what it is, whether the creditor is the People’s Bank of China or Uncle Ernie who puts 10% of his salary into US Savings Bonds.

The constituency of wrongness is headed by Paul Krugman. He is willing to go beyond the debate of domestic vs. foreign creditors, and defend global collectivism as such. He wrote an article with a headline that is sheer irony. In Nobody Understands Debt he says, “…the world economy as a whole owes money to itself.”

Producing and Consuming
We don’t have much to say to Professor Krugman, other than collectivism is the resort of scoundrels. It is a cynical ploy to distract attention from individual action. When you drill down, you see that some people are productive and others are not. Some people produce more than they consume, saving the difference. Others consume more than they produce.

As an aside, the collectivism is not typically so naked. More often, we are just offered an aggregate statistic without explanation of why it is measured in aggregate. For example, GDP is taken as a given. The idea of “economy as a whole” is implicit in the concept of GDP. But suppose a fat man is eating two steak dinners in a restaurant. A starving man looks through the window longingly. Would you say it’s two men and two steaks, therefore one steak per capita, and therefore all is well?

The problem is doubly severe when it comes to the question of debt. It is of course true that if Erik owes money to Sue, then they add up to zero. His liability is her asset. If you take the aggregate of all debtors and all creditors in the economy, they cancel out. This does not tell you anything useful about economics, except perhaps that every liability of one party is the asset of another.

So declaring “we owe it to ourselves” is either meaningless tautology or breathtaking dishonesty. With Krugman, it’s clearly the latter. Yes, some of us owe others of us. Yes the aggregate sum is zero. But you cannot conclude from this that it’s not a problem. That is the dishonesty. The staggering amount of debt is a problem, and Krugman knows or reasonably ought to know it is.

Let’s look at a simple farm village example, to make this point clearer. Joe has a grain bin full of seed to plant wheat. That is his asset. He has no liabilities. Bill comes to Joe and asks to borrow the seed, and promises to return it in a year, before the next Spring. Joe is a trusting man, so he gives Bill the seed. Now Joe has an equivalent asset. He does not have the seed itself. But he has Bill’s promise to return the seed plus an additional 10% interest. Bill says he will plant it, and repay the principal plus interest from his own harvest. So long as Bill is good for his word, Joe is fine.

Of course, the seed is the edible part of the plant. It is the wheat. What if Bill simply eats it? Bill has a grand old time. He is experiencing the “wealth effect”, he feels rich while the seed holds out but he is not. All too soon, the seed is depleted. Bill will starve, as he has not used the capital asset to produce anything. He has only consumed.

Joe is in trouble, too. Joe thought he could let his field lie fallow, and earn income on his seed in the meantime. When Bill does not repay, Joe will not have seed to plant his field. He could starve too.

In the meantime, Joe does not know this. He doesn’t inspect Bill’s farm, so he thinks everything is going fine during the year. He knew Bill’s father, an upstanding man and pillar of the community, and has no reason to suspect Bill to be a deadbeat. So he borrows gold from Arthur to build a new threshing barn. He anticipates a larger harvest, as Bill is giving him 10% more seed plus his soil will be renewed by growing clover (a legume) that Joe can graze his horses on in the meantime.

Arthur is getting on in years. He is not able to work so long or so hard on his own farm. However, he has saved a lot over 50 years. He doesn’t want to just spend his savings. So he lends it out to younger farmers who work just as hard as he once did, and they pay him interest. He lives on the interest. He has helped Joe finance many improvements.

Inflation is Counterfeit Credit
Before we go further, let’s take stock of what we have. We have illustrated a general principle. The credit to Bill is counterfeit. Bill has neither the means nor the intent to repay. This is how we define inflation—the counterfeiting of credit. It is a pernicious act, and even in our limited example the damage will not just harm the immediate creditor, Joe. It will spread to Arthur.

If we extend the chain of credit longer and longer, we will see something else. Each party exchanges a physical good for a promise to pay. Each party is happy to give up wheat or gold, and accept paper in return, because the paper pays a yield (and they trust their counterparties).

Incidentally, the solution is not to say no one should trust anyone else. That is a recipe, not for a civilization, but for a small population subsisting off the land. If you want to become a hermit, and live as a hunter-gatherer, go find your side of a mountain somewhere and have at it. But this doesn’t work for most people.

Anyways, back to our growing farm village economy. And yes, it is growing if credit can be increasingly extended. Joe is building a new barn. Jennifer is borrowing to expand cheese production, and finance the time it takes to age the product. Samuel is buying the vats to brew beer, and so on.

Eventually, if this progresses far enough, few people keep a surplus of any goods. They keep just enough to meet immediate needs. The rest is lent to someone else, to be invested in increasing production.

But what if just enough people were like Bill? Perhaps they are smarter than him, and carefully limit their counterfeiting so that it washes with legitimate borrowing and production. What if there was an undercurrent of counterfeiting in these chains, a streak of just enough inflation? Most people in our agrarian society example have enough goods to meet immediate needs, and the rest of their wealth is in the form of paper promises to pay in real goods. At the same time, most of them are borrowing as well. In other words, each has a balance sheet, with assets and also liabilities.

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