Mark Whitehouse has a chart demonstrating one of the basic issues in a credit crisis. Despite the mythology that consumers have been paying down debt, the reality is that consumers have been defaulting on debt and the banks have declined to loan them any more.

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This is because despite Bourgeois ideals to contrary it is almost always better to be deep in debt. I know this is going to be a long hard conversation. It might take us months, but we will get there.

When you borrow money you either have stuff or liquid assets. When you loan money you have a promise. Stuff is typically better than an promise. Liquid assets are wholly superior.

Why?

Because, shocker of shockers, not all promises are kept. That is, lenders face default risk, borrowers do not.

Now it is often the case that people with lots of liquid assets – and who are therefore rich – become lenders. Its also the case that people who are short on liquid assets – and therefore poor – become borrowers.

However, the act of borrowing money makes you richer and the lender poorer. This is why the lender charges you interest. He needs to be compensated for his impoverishment. If the lender didn’t charge you interest then you would be getting away with highway robbery.

It also why rich people are more likely to become lenders. They can stand a little impoverishment. Its why your sister dithers when you ask her to front you some cash – she can’t afford the impoverishment.

All of this is to say that it is always going to be in the interest of many if not most borrowers to borrow more money. And, they will if a lender lets them. This is why credit constraints are such a big deal.

Its also why Minksy moments are such a big deal. When creditors suddenly become less willing to lend to borrowers that changes the actual opportunities available to people. Borrowers can’t fulfill the plans they had intended to fulfill. Business activity declines, asset values go down and fear goes even higher. A cascade forms where the closing of opportunities leads to a reduction in credit which leads to further closing of opportunities.

Previously sustainable patterns of specialization and trade are shut down. Not because preferences have changed, not because expectations of future real income have changed but because trust has changed.

Trust is a real input to economic activity and when it goes away economic activity goes away. The interdependent nature of the economy means that the trust between you and your economic partners can decline even when you or your partners have done nothing untrustworthy.

If someone that one of you deals with does something untrustworthy it rattles the whole system. Your partner depends on his other partners to come through so that he can come through. If his partner can’t come through then he might not be able to come through. But, if he doesn’t come through then you might not be able to come through. And, if you can’t come through then everyone who depends on you might not be able to come through.

You’re not just in bed with everyone you’re doing business with. You’re in bed with everyone they are doing business with and everyone they are doing business with and so on.

I experienced my first default as a creditor at the age of 7. It was a harrowing, emotionally painful experience. The debtors were my parents and the asset at stake was my then life savings. The moment of terror – when you find out that the trust you had was misplaced and that now everything that you thought was true is no longer true -  will stay with me for the rest of my life.

It also had long lasting effects on my demand for money. Not wealth – money. Physical cash. After that I kept it hidden in a roll in my sock drawer. I had taken cash that was previously in circulation and hoarded it. An economist might say that my real money balances had gone up and the money multiplier had declined.

Had the US Federal Reserve not accommodated my increase in money demand by printing more dollars the results could have been – well virtually insignificant. I think we were dealing with a max of $150 here. Still, the point stands! An unexpected default led to a surge in money demand.

Multiply that literally billions of times and you have our current situation. However, the Fed is not accommodating the increase in money demand because the Fed Funds rate has hit the zero lower bound and for reasons we won’t debate now, the Fed has chosen to pay banks interest on the money they hoard.

Hence, outstanding credit in the US is falling. There is no need to invoke recalculation. There is no reason to suppose a grand mismatch is upon us. We simply have to believe that in the wake of a string of unexpected defaults lenders have become skittish about lending. That’s all it takes.

Unexpected defaults lead to a hoarding of cash or other safe assets. The hoarding of cash means that some business arrangements have to breakdown. Business transactions require money and that money is now sitting in a sock drawer or a bank reserve account as the case may be.

This decline in business activity leads to further defaults and increased fear. That leads to more hoarding of cash and safe assets. The only way out is to produce more cash or more safe assets. Either by expanding the supply of money in actual circulation or by expanding the supply of AAA government bonds by increasing the deficit.

I favor methods to achieve the first, but I am open to the second.

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