JANUARY 2006

Debt Trap
Daniel J. O'Connor

A study of the US monetary system reveals that we

are already caught in a system-wide debt trap rooted
in the design of our currency.
Debt Trap
Daniel J. O'Connor
On this last day of Alan Greenspan's extraordinary
reign as Chairman of the Federal Reserve, many in the
media have been reflecting on his legacy. Judging from
the dozen or so articles and television interviews I've
seen in the past week, the mainstream media and their
chosen pundits seem to regard it as a very positive
legacy, characterized by strong economic growth, mild
price inflation, and relatively benign unemployment
rates. The one point of concern raised by some is the
troubling accumulation of debt throughout the
economy, particularly in the past several years.
As the chart indicates, the total accumulated debt
in the US economy—Total Credit Market Debt—is
approaching $40 trillion at the close of 2005. Since
1970, the year before the US government severed the
final link between the dollar and its gold backing, Total
Credit Market Debt has grown by an average annual
rate of 9.6%, a remarkably high rate that is even
greater than the 7.3% average annual growth rate in
the inflation-saturated Nominal Gross Domestic
Product. Thus, even fully inflated economic growth has
not kept pace with the growth in debt over the past 36
years.
While I am glad to see the media paying attention
to this important economic factor, I think they are
missing the essential point: given our current
O’Connor: Debt Trap
monetary system, economic growth and debt
accumulation come hand-in-hand.
The reason for this is to be found in the design of
our currency. The US dollar, like all national currencies
these days, is a credit-based currency created, not by
the Fed's printing press, but through the extension of
credit from the Fed, via the fractional-reserve banking
system, to borrowers in the government, business, and
household sectors. As each new dollar comes into
existence, a new dollar of debt also comes into
existence. And as the supply of dollars accumulates
over time, so too does the amount of debt.
As if defying reality, central
bankers must navigate an
increasingly treacherous route
between the Scylla of
deflationary depression and
massive debt defaults and the
Charybdis of hyperinflation and
currency destruction.
How does the growth in money and debt relate to
overall economic growth?
The answer to this begins with a closer look at
what happens when new money is created. Each new
dollar makes its first appearance as a new asset on the
books of some bank and a new liability on the books of
some borrower. But there's a catch. When new dollars
are loaned into existence, they are recorded on the
books of both the lender and the borrower, or creditor
and debtor, as the principal amount of the
loan. However, the interest that the debtor will have to
pay back to the bank along with the principal is not
created as part of the transaction. As anyone with a 30-
year mortgage knows, the interest payments can be
even greater than the principal payments over the life
of the loan. Few people realize, however, that our
entire economic system is structured in a similar
fashion, with the total supply of money currently in
circulation being dwarfed by the total future debt
service payments—both principal and interest—that
must be paid by all government, corporate, and
household debtors.
Where do these debtors find the additional dollars
required to pay interest on their loans?
Page 1 January 2006
 In the existing supply of money already in
circulation at the time of the loan, as well as any future
net increases in the supply of money that precede each
future interest payment. If the central bank holds the
supply of money fixed from this day forth, then every
debtor in the economy will be forced into a highly
competitive zero-sum game to get what each one of
them needs to make their debt service payments
before the others get what they need. So the only way
to ensure a sufficient supply of money to meet the
demand of today's debtors is to systematically increase
the supply of money each and every year in the future
by an amount roughly equivalent to the average
interest rate on all existing debt. This way there will be
just enough money in circulation to ensure that just
about every one of today's borrowers can get what he
or she needs to pay back the interest and principal on
their loans as it becomes due.
But there's another catch.
The only way to increase the supply of money in
the future is to extend additional credit and thereby
create new debt over and above whatever debt is being
repaid through principal payments. As we've seen, this
brings with it the same constraint on future repayment,
which means that the central bank will have to
facilitate the creation of even more money for all the
new debtors whose new loans are helping the old
debtors pay their interest. Thus, we take care of the
older generation of debtors by creating a new
generation of debtors who will suffer immeasurably
unless the next generation of debtors is coaxed into the
credit system. And so it continues, seemingly without
end, until we have an economy so choked with old debt
and so dependent on new debt that the most we can
hope for is perpetual, credit-based growth in output
that keeps pace with the perpetually growing debt
service obligations of the entire monetary system. As if
defying reality, central bankers must navigate an
increasingly treacherous route between the Scylla of
deflationary depression and massive debt defaults and
the Charybdis of hyperinflation and currency
destruction.
We don’t have to wait for
deflation or hyperinflation to
arrive before we acknowledge
our predicament. We are
already caught in a system-wide
debt trap with no easy exit.
A bit too dramatic, given how successful the Fed
O’Connor: Debt Trap
has been in recent decades, no?
The dark secret of our relatively successful era of
credit-based growth in economic output, driven as it
has been by the exponential growth in money and debt,
is that the returns on each new credit-based
investment have diminished over time. Smoothing out
the variability from one year to the next, the trend is
unmistakable: since 1970, each new dollar of debt in
our economic system—Total Credit Market Debt—has
yielded a decreasing amount of economic growth—
Nominal Gross Domestic Product —even before
adjusting to remove the effects of inflation. Lately, it
seems that we are to be celebrating the generation of
$0.25 of nominal economic growth for every $1.00 of
additional debt.
What to do?
To stimulate additional growth using monetary or
fiscal policies would create additional debt, because
fiscal stimuli are deficit-funded and, to a large extent,
systematically monetized by the Fed and the banking
system. This would tend to off-set the benefits of the
economic growth, thereby having little impact on the
ratio of growth-to-debt. To reduce indebtedness or
slow the growth in debt through more restrictive
monetary or fiscal policies would tend to slow
economic growth, with, once again, little impact on the
ratio of growth-to-debt.
Therefore, we don’t have to wait for deflation or
hyperinflation to arrive before we acknowledge our
predicament. We are already caught in a system-wide
debt trap with no easy exit. More than Greenspan's
legacy, this is the legacy of a series of currency design
Page 2 January 2006
decisions made long before Greenspan took the helm at
the Fed.
Daniel J. O'Connor, MBA, MA, C FA, is the managing
director of Integral Ventures, a developmental
consultancy committed to fostering more conscious and
sustainable ways of doing business.
email: daniel@integralventures.com
website: www.integralventures.com
O’Connor: Debt Trap
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A ttribution–Noncommercial-No D erivative Works 3 .0 L icense .
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Page 3 January 2006