Wednesday, January 9, 2013

Thought Experiment…a Credit-Based Economy

I've been shouting from the rooftops the fact (or what I consider a fact) that a monetary economy structured like that of the U.S. cannot run on a credit circuit alone, without fiscal support. I decided to construct a model that relates various components of a simplified economy and fund them with private debt to see if the paths of any components become unsustainable and if so, when?

To begin with I set up a circuit for which household income was identically equal to business expenditure, which has to be true in a closed system with no external sources of funding. The following assumptions were made:

• A gross profit target of 42% is assigned to the Business Entities (S&P average over the past several years).

• Both income and profits would grow at a rate of 4% (GDP growth).

• Any debt incurred to fund the system would be at 5% interest. Further, since there is a cross-section of maturities associated with household debt I derived a weighted-average or composite of payments in order to approximate overall debt service.

The debt-service calculation:


So, average household debt service is about 11% of the outstanding balance of household debt.

Next, I constructed a spreadsheet calculating two series over a 15-year period in order to graph the relationship between debt and income.

The Debt Series spreadsheet:


the debt service series was constructed as follows:

The accum column is simply the current year shortfall plus the accrued debt from previous periods.

In the first period debt service is calculated as one-half of the first years debt accrued.
The second period is calculated as 11% of the previous period accrued debt plus one-half (5.5%) of the current period.
The 3rd period is calculated as 11% of the previous balance plus one-half of the current period…
Repeat until completion.

Below is a chart of the result, illustrating the relationship between debt service and net income keep in mind all of the assumptions are conservative, meaning the chart illustrates a best-case outcome:

The first observation is that just beyond 9 years debt service completely overcomes income. Failure.

Practically speaking trouble begins when debt service is at 1/3rd of income…after about 4 years. Failure.

This doesn't look promising. Then we examine some likely realities:

1. The model assumes 100% efficiency in clearance of payments. Impossible. Fail.
2. The model assumes that 100% of participants would be willing and able to fund a significant portion of their lifestyle with borrowed funds, which they then would not be able to service. Impossible. Fail.
3. The model assumes that 100% of household would participate…if they didn't other households would have to take up the slack, which isn't possible. Fail.


All things considered this hypothetical appears to be a non-starter from the beginning with no possibility of success under real-world conditions. We must have fiscal spending for a monetary capitalist economy to function in a sustainable way. Why does anyone even bother trying to prove otherwise?

Further, if household can't afford to borrow funds necessary to purchase products, businesses in the aggregate will fail…there's no reason for businesses to take on debt to fund their operations. Business depends on fiscal…net fiscal…to succeed.

Question: is it a coincidence that when the level of $NFA held domestically lags the level of household debt by more than 5 years the lag correlates to financial crises?  Check it out:

https://dl.dropbox.com/u/33741/Debt_NFA%20series.png

Commence to tearing it apart!!!