The Future Is Now

Debt pulls demand forward in time. Borrowers use debt to pay for consumption today and commit future income to service the debt.

The amount available for consumption today represents the present value of that committed income, discounted by the prevailing interest rates.

The further that borrowers reach into the future, the more that discount lessens the amount available today. The Fed wants consumption today, so it attempts to induce inflation in order that borrowers are more confident of their future nominal incomes, while holding interest rates low so that the discounting of that income is minimized.

This strategy has sustained consumption in the short term, at the expense of reducing future income available for consumption.

The problem is that the future is now.

As consumption slows, so does production and inflationary pressure. Defaults rise – just look at the subprime auto loans. Yes, defaults eliminate debt – but only at the expense of the creditor who takes an immediate hit to income, charged against net worth or equity capital. Lenders are forced to reduce their assets.  Borrowers find that debt service takes more of their income than they had expected. Purchasing power erodes and deflation sets in. Spending capacity falls even more rapidly and the economy slides into recession and depression.

The larger the accumulation of debt, the longer it takes to purge the financial system and restore it to stability. Debt – credit – is a necessary and healthy part of the economic system. But the economy cannot depend on consumption funded by the continuous growth of debt. Debt must revolve, expanding and contracting within limits proportional to the size of the economy.

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