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Reflexivity Run Wild: A Debt Theory

Cash in a trap
Nicholas Eveleigh | Stockbyte | Getty Images
Cash in a trap

As regular readers know, I've been exploring the possible causes of a debt trap lately.

For non-regular readers (shame on you!), the debt trap arises when it is impossible for a government to stimulate the economy by spending money that is accompanied by debt accumulation because the very fact of raising the debt constrains economic growth. In other words, the economy contracts because you have more debt.

There have been several studies establishing this relationship. It's not really even controversial anymore. The only question is whether the causation is backwards. Do extreme debt levels cause contraction, or do they simply reflect the fact that a contraction is already underway?

The answer is: yes.

Extreme debt levels are typically caused by economic contraction.

Governments attempt to fill in the hole left by a lack of consumer demand.

But the cycle doesn't stop there. If the accumulation of debt goes far enough, it becomes self-defeating. Consumers and businesses see the very high levels of debt as a signal that the economy is broken. They respond by saving, rather than consuming or investing. What's more, smart businesses and consumers anticipate that this is how others will react to extreme debt levels, and so they save to prepare for the coming recession.

In other words, the debt trap is really a reflexivity trap.

This has dire consequences for a number of economic theories. It undermines the Keynesian "spend till it mends' approach, at least in so far as spending is accompanied by further debt incursion. It undermines the Modern Monetary Theory approach that sees debt as simply a way of controlling capital flows. If the incurrence of debt itself is a contractionary macro-economic factor, the policy implications for government counter-cyclical activity are severely limited.

One implication of this is that Federal Reserve Chairman Ben Bernanke is basically wrong when he implies that fiscal policy would be more effective than monetary policy in the present situation. There's basically no more room for the government to issue debt. We must either muddle through a long recession or attempt to inflate our way out of it. There is no other choice.

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