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Monday, March 09, 2009 7:31 PM

Is Debt the Lifeblood of the Economy?

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Everywhere you turn there is news that the Fed, the Treasury, or Congress is attempting to "get credit flowing again".

Kevin Depew was discussing this situation in Five Things: Credit is the Lifeblood of the Economy?

These are heady times we are living in. Collectively, our national intoxication runs deep and fierce. From moment to moment no one really knows whether to laugh, cry, or do both at the same time, and so the air on the street is juiced with a mildly psychotic hum.

Consider the assertion - made almost daily by politicians and monetary policy figures - that all we need to do to end this economic crisis is “kick start” lending and that credit is the “lifeblood of the economy.” These baseless assertions infect news article after news article and are repeated by the vast majority of economists and market pundits over and over again as “self-evident” truths.

The reality, however, as noted on Minyanville recently in the article, “Deflation Redux,” is that these assertions are non-sequiturs.
Like Kevin, I had to laugh the first I heard “Credit is the Lifeblood of the Economy”. After it was repeated 20 times then espoused by Congress, the Treasury, and the Fed, and indeed even President Obama, it became more scary than funny.

This is why:
The flip side of credit is debt. Is debt the lifeblood of the economy?

Surely not! It’s not that debt is bad in and of itself. Debt is fine as long as it is going to productive uses or as long as the lending is backed up by savings somewhere. No one can argue that savings should not be lent.

However, the problem is that credit has been extended without savings backing it up to those who had no possible means of paying it back, with leverage, and with “no money down”.

Were it not for fractional reserve lending, this could never have occurred.

Clearly debt is not the lifeblood of the economy. By extension, credit is not the lifeblood of the economy either. Rather it is savings that is the lifeblood of the economy, because without adequate savings, extending credit is nothing but a pyramid scheme that eventually implodes, which is of course what happened.

Amazingly, the “solution” in Congress is to encourage more reckless lending even though there is no savings to lend. This Ponzi financing scheme can’t possibly work, which by definition means it won’t.

Now let’s turn our attention to various proposals to solve the problem by rewriting the books on “Mark To Market” accounting.

Such proposals make for good sound bites. However, they miss the boat entirely. Had banks not lent with leverage and instead put those loans on the books in a hold to maturity portfolio (they could have done that), then the banks would not be in trouble.

The reason banks purposely put those assets into a mark to market portfolio is that allowed them to increase leverage (the number of loans with nothing backing them up). With leverage comes increased profit potential and increased risk. Banks were speculating pure and simple.

Without that excessive leverage banks would have had losses but they would still have been solvent, and we would not be in this mess. It was the excessive leverage that destroyed Bear Stearns, Lehman, Citigroup, AIG, Bank of America, Merrill Lynch, etc., not mark to market rules, evil short sellers, or hedge fund bets via Credit Default Swaps.

Suspending mark to market accounting does nothing to reduce the leverage so suspending mark to market accounting cannot fix the underlying problem. Instead, such games may further enhance the already huge mistrust in the system.

To fix the problem, one must go to the root cause. That root cause is fractional reserve lending that allowed banks, brokerages, and insurance companies to lever up to insane levels. Sadly, not a single peep has come from the Fed, the Treasury, or the Administration about addressing the real problem. Instead we hear complete nonsense on how to "get credit flowing again".

Mike "Mish" Shedlock
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