Why Debt Cycles Are Inevitable.

I was assembling a post about how our public debt is a problem not because of it’s size per se, but because of it’s size as compared to our ability to pay. It is one thing to have a lot of public debt but very low private debt, which would allow a tax structure that could pay off the debt, but we keep spending like there is a pool of cash to pay with when there really isn’t, the populace has so much consumer debt that there isn’t anything to pay the public debt with. Yes if it weren’t for the wars and the Bush tax cuts things would be rosy, and yes we can always bleed the wealthy and those pesky corporations but there is a far more basic problem, that is that our basic model is totally screwed up, and that is why we are doomed to travel in these endless debt cycles that end in defaults. Remember these cycles go as far back as there is history, farther back than banks, even into times when all you had to do with debtors was make them your slaves, or have them sell you their children as slaves.

Let’s take a look at how an economy like ours would function in a small community, spreadsheet style.

BasicEcon1

Now as we can see wages are equal to the selling price of widgets, so everyone is happy and the loop is closed, the accounts are balanced. Lets take a look at what happens when the owner decides to take a profit out of what is made.

BasicEcon2Now as we can see workers are running a deficit, debt is required to continue purchasing widgets. This can be offset by having the owner also buy a widget, but it flies in the face of the purpose of being an owner. After all the purpose of making a profit is to accumulate wealth, to continually skim off and retain a portion of what is being circulated. This is the point of being either an owner or a king. Two things may be of interest, lowering the price of widgets, or workers delaying purchasing them, illustrated below.

BasicEcon3O.k. so for brevities sake we dropped the price of widgets, had workers delay some of their purchase, and had the owner buy some of a widget, yet the shortfall remains. The reason the shortfall remains is that ultimately wages are tied to business income, if the price of widgets drops what people earn making them must drop also. Now in the real world this, of course, doesn’t happen so easily, wages are sticky as they like to say, but people cannot be paid more than can be made from what they create. If we really run this in favor of workers what happens is that the owner starts running a deficit, and that is another not very realistic scenario.

Let’s take a look at a real world scenario, one in which the  percentages more closely reflect actual distributions.

BasicEcon4We can assume that expenses cover anything and everything that isn’t directly related to production, and that the money used to cover expenses is used to buy widgets. The “owner” is aggregate for all owners, the “widgets” the only thing to buy, etc. (You have, no doubt, noticed the “thingamajig” entry, this is because the spreadsheet has been set up to run scenarios were trade is involved, but that hasn’t been necessary to use in setting out the basic argument). We still have the owner buying a bit of widgets, and the shortfall is again pronounced.

So by this view in order for accounts to balance all funds must remain in circulation, as soon as anything is taken away debt results, profit creates debt, it is inevitable. Now the true way to get out of this is to sell widgets to someone else, someone you don’t have to pay wages to. This is why there are saving societies, Germany, China, Japan, they are all export countries, they have found someone to sell widgets to, they have transferred the debt element to them. In countries that do manage private savings while not having export economies you will most likely see public debt making up the shortfall.

In reality saving would create the same effect, and that points to one of the perverse aspects of this system, people save which results in a need for debt somewhere down the line, saving pays less than debt costs, who wins?

Now there are many influences on the system which keep it from just out and out crashing instantly. Moving workers from low productivity to high productivity jobs, the continual rise and fall of players within the system, injections of  funds by central banks, etc. But the above scenarios are the bedrock of what everything is built on, nice huh?

None of this is really new, in many respects it is simple accounting, but we ignore that in favor of the magic of economics. Think about those invisible hands, the whole imagery involved is one of a mysterious force that impels economies forward, best not look behind the curtain, the Wizard of Oz is not quite what you think. Hopefully this incredibly simple exercise will help illustrate, however, why it is so easy for debt cycles to happen.

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2 Responses to “Why Debt Cycles Are Inevitable.”

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  1. old_athlete says:

    Until the great equalizer from the heavens steps down and destroys everything… which seems to be the program for ending debt cycles, btw, … we live in a constant flux between a million market forces that no one can track. macro is really hard to simplify… if you do simplify it, you didn’t cover it. I always found it frustrating because I could never figure out how much was the right amount to take on in a single post. It’s like looking for a corner in a box of circles.

    Right now, the single biggest behavior affecting American manufacturing is this colonizing of the eastern Pacific Rim nations. When they broke the yuan and then pegged it to the dollar so low there’s no way to compete… it makes it impossible to build new ventures. Like my scaffold drum hoist. If I build it and it is needed, China is going to copy it before anyone buys a single hoist from an American maker. Nothing I can do about it. price, price, price and price is killing my seed before it can grow. I have a big ticket item, and it is easily copied. If I don’t build it, it will never exist. If I do build it, no one will buy it from me, they will wait for the same thing @ 1/2 or even 1/4th the price. This is all about currency exchange rates.

    What’s an American manufacturer to do? Our only option: become Chinese. (build it in China)

    • EricRhoades says:

      Exactly, that is why this debt which accumulates must be flushed out on a regular basis. Now this is always going on to some degree, businesses go under, people go bankrupt, but you have the lesser events and the more major ones. Sort of like chaos theory in which the lesser events that don’t come to pass create a network of weakness in the system which must find release in a larger event.
      If you play by the book you manufacture it there and then sell it here, there is no reason you can’t make profit off something made somewhere else. But whether you make it there or here the system is rigged against the success of smaller businesses, not that it doesn’t happen of course, but it is far easier for a large business to survive and expand than it is for a small business to make it. You can always just sell the patent too.
      What is a U.S. manufacturer to do? Well some do survive, and prosper, so what they do should be looked to as examples first off. But in a larger picture kind of way one needs to remember that as far as China is concerned their economy is incredibly dependent on infrastructure investment. The idea that they can run an economy with that many people based on the levels of manufacturing they are doing now without huge public spending projects is a fantasy. China’s day will come.

What do you think?