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:

Commence to tearing it apart!!!


  1. Hey Paul. I admire the effort you put into this.

    I think I have your "Debt Series spreadsheet" figured out. Dunno about anybody else, but for me it would help if you linked to a copy of the spreadsheet itself... in Google Docs or whatever.

    I am somewhat disturbed to find that the system fails within ten years despite your conservative assumptions. It takes the real-world economy substantially longer to reach the fail point. Maybe your system would have lasted longer if you let your 5% interest rate fall gradually for 20 years or something. Oh I like where your work takes my mind.

    Paul, you write: We must have fiscal spending for a monetary capitalist economy to function in a sustainable way.
    Also, in your opening: a monetary economy structured like that of the U.S. cannot run on a credit circuit alone, without fiscal support
    I'm not on top of the terminology. I am thinking by "fiscal support" you mean "exogenous money" or "outside money" or government money or like that. And by "a credit circuit" you mean endogenous money or inside money or creditmoney.


  2. Your "debt-service calculation" is interesting. I never explored such a calc, but I have at times wanted one. If you feel like expanding on that topic, I'll be glad to have the input. Q: Do you have links to this topic, or did you just develop the whole thing yourself?

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  4. Art, this is because by deficit spending the government is effectively funding the debt service. We have never not had this support (except for a handful of surpluses) and it isn't a coincidence that every surplus in history has been followed closely by a recession or depression, and every bubble bursts.

    Failure would likely occur much faster than the hypothetical I've presented in my view, because my model is friction-free, it assumes perfect payment clearance and consistent behavior by all participants. Good luck with that, and even then it fails.

    The most important concept anyone analyzing economics should internalize , especially one that depends on a money system is this…

    "It is impossible for an effect to be stronger than its cause" - (Aquinas, 1274)

    I will respond to your second comment one way or the other later. Thanks for your interest.

  5. Your "debt-service calculation" is interesting

    Art, it's a method I've used most of my life in solving problems dealing with composites. It's pretty straightforward.

    We have an outstanding balance of household debt made up of loans of varying term structures and interest rates. There are too many variations (millions probably) but the bulk of the variations are closely similar, so that we can form a pretty accurate estimate of what the composite payment would be.

    Most mortgages are 30-year or 15-year term. There are others but I am reasonably sure that these two terms represent at least 90% of the outstanding loans. The variations from there will not be great because the effect will be a small change in the difference only. The loan balances are accounted for.

    Car loans are mostly 60-month term these days.

    Credit cards are revolving credit subject to a minimum monthly payment. Interest rate is less important here…there is no term limit…it can be rolled over indefinitely.

    Interest rates? Wide variation but the average loan only lasts about 7 years before it is refinanced and since 1990 mortgages have been in a range between 8+% and 3.5%.

    I chose 5% for a median…it's pointless to try to figure it out any closer because there are too many possibilities and it doesn't add much to my argument, which is from a very conservative perspective anyway…I'm not splitting hairs.

    So now it's just a matter of crunching the numbers. Payments per dollar of loan can be found from any set of amortization tables or by using a financial calculator.

    We have $9805 in outstanding mortgages, I chose to split this amount 50/50 between 30-year and 15-year fixed-rate. Then:

    ($9805B)(0.5)(0.064119) = $314.34B (contribution to overall debt service from 30-year fixed-rate mortgages @ 5%)

    ($9805)(0.5)(0.094995) = $465.22B (contribution to overall debt service from 15-year fixed-rate mortgages @ 5%)

    ($1992B)(0.226455) = $451.10B (contribution to overall debt service from 5-year car loans @ 5%)

    ($600B)(0.24) = $144.00B (contribution to overall debt service from revolving credit)

    Add them all up and we get $1,375B annual debt service ==> 11.1% of the outstanding balance (9805+1992+600).

    For perspective on how sensitive this number is to rate changes or portfolio balance, I re-ran the numbers using a 4% rate for the mortgages and a 75/25 mix of 30-year to 15-year mortgages.

    In this case we get $1,233B annual debt service ==>9.95% of the outstanding balance.

    I think I'm pretty close to the sweet spot.

    Here's a link to a discussion of weighted averages or weighted means in Wikipedia:

    Hope this helps.