(This is Part 1 of a 2-part article.)
There is a very real danger that the economy of the U.S. could implode in the next few years. And since the U.S. economy is such a large part of the world economy, that would mean an implosion in the world economy. Very few are focused on this at present, but the fragility of the U.S. and world financial system will become apparent to everyone in the not-too-distant future.
If we want to understand what is coming to the U.S. in the future, we need only look at Argentina now. After years of exponentially increasing public and private debt burdens, Argentina went into a financial crisis from 1999 to 2002 which wiped out much of the middle class. An economy which was once the fifth-largest in the world
collapsed into impoverishment.
That couldn't happen in the United States, the mightiest economy in the world? Yes, it can. Though it might seem remote now, what happened in Argentina is also coming to the U.S. Though it might seem a fantasy right now, a depression is in our future. This eventually will include a general failure of the banking system and a government default, just as happened in Argentina.
In the modern world, a financial and economic collapse has a prior condition—an enormous credit expansion that precedes it. Indeed, it is that very credit overexpansion that causes the economic collapse that comes afterward. The one follows the other as surely as outbreath follows the inbreath.
But why? How does it happen?
A credit expansion crucially depends upon two things: the willingness of people and institutions to lend and borrow, and their ability to do so. The willingness depends upon
confidence among both lenders and borrowers that debts can and will be repaid. The ability to do so depends upon
production, the ability of the economy to produce goods and services.
In 1932, from the bottom of the previous deflationary depression, when all excess credit had been wrung out of the system, confidence and production slowly, slowly began to build, like a train gathering steam as it moved out of the station. This is how the cycle begins, just as it began in 1856 and culminated at the top in 1929.
As confidence begins to increase, businesses invest in more plants and equipment and hire more people. This puts more money in the pockets of consumers, who are then more willing to borrow based on confidence in the future. This stimulates borrowing by companies to finance new business investments.
As lenders see the economy picking up, they are more willing to lend. And so the credit expansion begins. As it keeps going, it feeds upon itself. More lending begets more production, which pays more wages, which begets more purchases which begets more lending and borrowing and production and confidence, and so it spirals upward.
As this happens, prices also rise, as increased credit ripples through the monetary system. Though rising prices are actually a symptom of inflation—the actual inflation is the rise in the supply of money and credit—rising prices are commonly referred to as inflation itself.
And it's not only the prices of good and services which rise in an inflation. The prices of financial instruments or housing can also rise. In the 1970's we saw the prices of everyday goods rise. In the 1980's and 1990's we saw the prices of stocks and bonds and real estate rise. It's the same phenomenon, just showing up differently.
Behind rising prices is an increase in money and credit. Where does this increase come from? We've seen that willingness and ability to lend and borrow play major roles. Another large contribution comes from what is known as the fractional reserve banking system.
When we deposit money in a bank, the bank does not keep most of that money. For instance, banks used to be required to keep 10% of their deposits in reserve—this was the reserve requirement. The other 90% could be loaned out.
As that 90% was loaned out it would then show up as deposits in other banks, which could then lend out 90% of that, and so on. This is called the multiplier effect, where a given increase in credit is multiplied many times as it works its way through the economic system.
More recently the reserve requirements of banks have been effectively eliminated for savings deposits and drastically lowered for demand deposits. On average, banks are keeping only 1% of their deposits at present. This has vastly increased the multiplier effect. By some measures, credit has increased 100 times since 1932.
U.S. banks now hold about $45 billion in reserves, mostly cash on hand to meet daily withdrawals. Compare that to the $4.5 trillion in outstanding bank liabilities or the $40
trillion in total credit in the U.S. And this is not just an American phenomenon; it's happening all over the world.
(This is the end of Part 1. Go to Part 2.)
—jim sloman, 10/5/02 for Nov 27
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