Isn't all Growth built on Debt?

I have had a comment on the question of debt, and consumer debt in economic growth, from a regular commentator 'Lemming' (whose questions become ever more perceptive and interesting):

'I'm still a bit baffled, and this section seems to fit quite neatly with my question on fractional reserve banking. If money is created only when someone takes out a loan, then by definition isn't all economic growth really a growth in debt? And as the debt is taken on in order to spend the money, isn't that growth going to be driven, in large part, by consumer spending?

I was thinking of this when I asked my earlier question. If I understand the UK's 'FRB' system correctly, it appears that someone, at some point, decided that the best way to regulate the growth of the economy is to base it on the man-in-the-street's judgement, as measured by his requests for loans.'

The poster, for example, describes the irresponsible person buying a plasma TV for every room in his house, relying on debt to fund this purchase. The poster suggested that the growth of such debt was the driver for growth of finance overall, and that this the driver for the economy in the hands of 'stupid people' (ordinary consumers, though I think Lemming means financially illiterate here) .

In order to lend the money to the individual, the bank must first borrow money in order to lend money, with for example central banks providing the initial liquidity. This initial liquidity is then fed through the banking system, and appears to multiply many times over, due to fractional reserve banking (see here for and explanation of this). At the end of the chain is the bank lending money to consumers.

These consumers are then borrowing money, which then flows from the banking system into consumption - in this case a plasma T.V. At each stage of the lending chain, one organisation is guaranteeing, repayment to another, all the way up the lending chain. In other words, each bank is often reliant on many banks all making repayments.

Is the consumer in the driving seat, and driving the economy by driving demand for finance? This is a very interesting question. Is demand for finance creating a debt laden economy?

Of course, the above is massively simplified, as there are often a multiplicity of interdependencies and relationships between different banks, and financial institutions. I do not want to give a more complex explanation than this, as the key question in such a system, is whether all growth is built upon debt. Is it possible to have the capitalist system without growth in debt?

The issue here is what the debt is being used for. If the generation of debt is being used to finance a productive asset, then few people would argue that this will benefit the economy in general and therefore consumers indirectly. On the other hand, if there is a massive expansion in the money supply being fed into credit based consumption, then this creates a situation in which consumers will just be foregoing future wealth. The trouble arising from such a scenario is when the supply of money expands such that there is an oversupply of money, and this money is then allocated poorly (the current situation). In this situation there is a ballooning of debt, which must one day be paid, and finance becomes so cheap/available that it gives consumers incentives/capacity to be 'stupid' (to use Lemming's expression). In so doing the banks fuel what appears to be expansion through consumer led growth, such that the economy appears to be performing well, which in turn maintains an illusion that the consumers will be able to continue paying debt.

So which causes which? Is it growth in the money supply that creates the debt, or is it demand from the consumers which produces debt. It is actually a combination of the two. Without the expansion in the money supply, debt would not be offered to consumers who are relatively high risk, but the consumers still need to take on the debt in order for the money to be allocated to consumer debt. What we have is a feedback loop in which one encourages the other.

The result of such a self-reinforcing system is that the increase in money supply is built on confidence in the economy, on the ability of consumers to continue to service their debt, which is built upon an assumption of continued employment. If the growth in employment is built upon foundations of growth in consumption, then we have the makings of a bubble. Debt pays for consumption, consumption drives employment, and employment drives further lending. One factor reinforces the other. All the time the overall amount of lending and debt is building. Right up to the point where consumption stops, and then the credit bubble bursts, leaving banks and consumers in trouble, and a wreck of an economy.

As an answer then, we can say that, in part, the economy is being driven by 'stupid' consumers. However, we can also say that the economy (in this case) is also being driven by 'stupid' bankers, whose economists have not grasped that consumer credit led growth is a bubble. Had the economists asked where the future repayments of their lending was going to come from, then they might have suggested that their lending was irresponsible. The trouble is that, whilst the economy continued to expand, they ignored the warning signs (increase in values of housing), and chose to imagine that the new 'service' economy was sustainable long term. As such they continued to lend into an already saturated market. At some time, it was inevitable that an increasing number of consumers would be unable to service their debt, leading to a shrinkage in consumption, and a bursting of the credit bubble.

In this case we have the complication of house prices, which enjoyed price rises due (in part) to an increase in the availability of finance on ever more relaxed terms (poor/higher risk allocation of money). This generated a boom in house prices, such that the banks could point to illusory security on their debt, and for consumers to have the illusion of growing wealth in assets to justify their irresponsible borrowing. Without the factor of house price rises, the credit bubble would have burst much sooner. The illusion of security for both parties kept the credit bubble inflating. If you then throw in the unusual factor of migrants coming into an apparently booming economy, increasing the population, and thereby increasing demand for housing, thereby creating further upward leverage on house prices, you have the mess that we are in today.

I am simplifying here and pretending, for the sake of argument, that the UK is a closed economy, ignoring government borrowing etc. The complication in all of this is that external confidence in the UK economy has also been a factor. However, I hope that this goes some way to answering the question. It is not just the consumer that has driven the debt bubble, but also the banks, who have misunderstood the risks inherent in a consumer credit based economy.

A note for Dan, who made a comment on another post.

Dan suggested the idea that he should be able to opt out of certain benefits provided by the government, such as unemployment benefit, with a subsequent reduction in his individual tax rate. This is a perfectly fine idea, as long as he is able to continue in employment. However, if he were to lose employment, what would then happen? Looking at the case of unemployment benefits, there are some problems.

In the case of Dan becoming unemployed it is likely that he would then become completely destitute and would therefore potentially starve to death, or become a beggar (I am assuming that he is not wealthy enough to have a very large amount of savings for the sake of argument). Both outcomes would be unacceptable to society. The only option would be for charity to help out, but would charity be inclined to help in the situation that he actively opted out of the protection of the state in order to benefit from the savings on taxation whilst he was in employment? The answer is probably 'no'.

Modern society does not accept begging or starvation, and therefore society would still (in some way) have to offer some support. As such, an opt out system would not work, on the basis that as a society we would not accept such an extreme level of destitution. Dan's concern is presumably that he feels that taxation is too high. The only option is to either completely abandon, or reform, benefits for everyone to reduce the overall demand on taxation. At some time in the future I hope to look at these questions, and hope that I can propose a solution that would be acceptable to Dan, and to society as a whole.