The US Federal Reserve’s Childishly Naïve Theory of Credit


Today, we return to familiar territory. We have seen it before: The slowdown in the economy. The overpricing of assets (particularly stocks). The huge increase in debt. The US Federal Reserve’s QE and ZIRP.

But for all its familiarity, it remains strange… and mysterious.

Let’s backtrack…

The foundation for today’s peculiar economy was laid in the 1960s and 1970s. In 1968, President Johnson asked Congress to end the requirement that US dollars be backed by gold.

Then in 1971, President Nixon issued Executive Order 11615, which ‘closed the gold window.’ This meant the US dollar was not directly convertible to gold. The supply of money and credit no longer had any anchor in a physical commodity. It could now be created ex nihilo and ad nauseam by private banks, aided and abetted by the US Federal Reserve.

The PhDs running the Fed had a theory – one that seems childishly naïve but that, nevertheless, seems to work in practice (so far).

The more you could get people to borrow, they reasoned, the more demand for goods and services there’d be… and the more the US economy would produce to meet this new demand. This would give Americans more access to jobs, incomes… and the satisfaction of getting something for nothing.

The theory maintained that, as long as consumer prices didn’t get out of control, banks could create as much credit as they wanted, stimulating growth.

After some shilly-shallying in the 1970s, the new credit-driven economy began to take shape in the 1980s. Since then, $33 trillion of spending, buying, investing, producing, consuming and speculating has taken place – all funded by credit. Had the level of debt to GDP kept steady, there would have been about $1 trillion a year less economic activity over the last three decades.

Is that a success for the PhDs? Or what?

‘Or what?’ is our guess and our question.

During almost that entire time – from 1980 to 2013 – consumer prices did not get out of control. Instead, they seemed to come more under control – with a gradually falling CPI (aided by jiving the figures!) from over 13% in 1980 to barely 1% today.

But here is the curious and incomprehensible part.

If you earned $100 a week, you could normally spend $100 a week. If you had $10 in savings, your savings would represent stored-up buying power. So you might choose, in one week, to spend that too.

In that week, you would enjoy $110 worth of what the world had on offer. And the economy around you would enjoy an extra $10 worth of demand.

But the $33 trillion spent by Americans over the last four decades or so did not come from savings. Instead, it came out of thin air – from the banking system, which contrary to the common belief that it requires some pre-existing money (in the form of cash deposits or reserves) to make loans, simply creates them out of nothing.

In other words, this credit creation did not represent resources that had been set aside – like seed corn – to prime future growth.

No one ever deprived himself of a single meal, or as much as a single beer, to save the money. No one troubled himself to work even a single hour to earn it. No one toiled or spun…

Now, if the guy with the saved $10 lent it to someone else… and the borrower spent it… it would have the same effect as if he had spent it himself. So, if the economy had borrowed $33 trillion from savings… and spent it… you’d see the same effect, right?

And what if the $10 or the $33 trillion couldn’t be paid back?

Then the savings would be lost. The savers would be out. But at least it would make sense. The automobiles, shopping malls, vacations, retirements, silly gadgets, health-care scams, parasitic legal actions and false-shuffle financial products would have been funded by real money. They would exist for a reason, if not necessarily a good one.

But what happens if the $33 trillion of pure credit, unbacked by savings, cannot be repaid? Who is out? Who loses?

And how did all those real things… the $33 worth of goods and services… come to exist in the first place, if there were no real money or resources ever made available to fund them?

Is anyone else concerned about this? Are we all alone here?


Bill Bonner
for Markets and Money

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Bill Bonner

Bill Bonner

Since founding Agora Inc. in 1979, Bill Bonner has found success and garnered camaraderie in numerous communities and industries. A man of many talents, his entrepreneurial savvy, unique writings, philanthropic undertakings, and preservationist activities have all been recognized and awarded by some of America's most respected authorities.

Along with Addison Wiggin, his friend and colleague, Bill has written two New York Times best-selling books, Financial Reckoning Day and Empire of Debt. Both works have been critically acclaimed internationally. With political journalist Lila Rajiva, he wrote his third New York Times best-selling book, Mobs, Messiahs and Markets, which offers concrete advice on how to avoid the public spectacle of modern finance. Since 1999, Bill has been a daily contributor and the driving force behind Markets and MoneyDice Have No Memory: Big Bets & Bad Economics from Paris to the Pampas, the newest book from Bill Bonner, is the definitive compendium of Bill's daily reckonings from more than a decade: 1999-2010. 

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1 Comment on "The US Federal Reserve’s Childishly Naïve Theory of Credit"

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slewie the pi-rat
at the risk of being the bee in Bonner’s bonnet: are you SURE the credit is ‘unbacked by savings’, comrade Bill? if folks missed TBTF/J and ‘privatizing gains, socializing losses’, they may never grok slewienomics, where: *FED policy = the checks are in the mail*. if folks have not yet ‘noticed’ Dodd/Frank [passed into law ~4 years ago], the bail-in template @ Cyprus, the recent ‘safety’ reflected in EU peripheral debt spreads, the underlying meaning to the endless dithering and blithering about the Volker Rule in the US, and/or the continuing delays around savoring the latest Basel sweet basil, well,…… Read more »
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