It’s All About Debt, Part 1

What in the world is going on with the world’s economies? After a twenty-year stock market boom, we had the tech bubble and crash in 2000. Then there was the housing bubble and crash in 2008, followed by the credit crisis. Now Europe seems to be going down the tubes. Markets rally, then crash. The days of steadily rising 401ks seem to be over. What’s going on?

In short, debt is what’s going on--not only personal debt, but even more importantly government debt. This is not just a typical economic slump. Nations all over the world are drowning in debt and this has created a situation which cannot be solved in the typical way--because the typical way governments address economic problems is by taking on more debt. It's not hard to understand that you can't solve a debt problem by borrowing more.

So how did we arrive at this place?

A Very Short History of Economics

Economics refers to how societies distribute limited resources. This distribution is largely done by trade, and people have developed sophisticated ways to do this. Money was invented to make trading more convenient. In a sense, money is now the problem, because although money was once measured and distributed as things that had real value (e.g., salt, silver, gold), or that at least were backed by something else that had real value (e.g., gold certificates), now money is simply created out of thin air and is “backed” only by the belief that others will honor it. This is called fiat money, and it is the way of the world now.

Fiat money is created by central banks. Almost all nations now have some kind of central banking system. The United States central bank is called the Federal Reserve, or just the Fed. The Federal Reserve has the power to literally create money out of thin air. You may have heard of the “quantitative easing.” That is simply the Fed creating money and distributing it to banks with the hopes of stimulating the economy.

Years ago, an economist named John Maynard Keynes came up with the theory that government borrowing and spending and creating money out of thin air was actually good for a nation's economy, because it could help smooth out economic rough patches. Most leaders over time have assumed this attitude, mostly because it makes their short-term goals of getting re-elected easier. People have come to think it's primarily the government's responsibility to ensure prosperity. Politicians don't mind this because it allows them to take credit for good times and blame their opponents for bad times. Voters mostly just tend to back whomever's ideas seem to be working at the moment. Everything has become about the short term.

That, as Yoda said, leads to the dark side. Once a central banking system and fiat money are in place, the restraints on leaders to make wise long-term economic choices are greatly reduced, and the incentives to make convenient short-term choices are greatly increased. If you were a political leader and all you had to do to stimulate the economy right before an election was to borrow and spend money, what would motivate you--the long-term effects of debt or the election? This, in a nutshell, is the world’s problem.

So the world has gotten itself into a situation where it’s just too easy for governments to borrow money they don’t have (and which often really doesn’t even exist!). Some pundits are screaming that we need to borrow and create even more money. People in general wonder if this process is really so bad, since it seems to have worked for so long.

The answer is as long as investors are willing to buy debt with hope of future profit the day of reckoning will be pushed into the future. Although we will see signs of it approaching; that’s what all these bubbles and crashes have been. But if we continue on the path we are on, investors will at some point refuse to buy our debt, and the real day of reckoning will arrive. And when it does, the medicine we will have to take then will taste a lot worse than the medicine we could take now.

More in Part 2...