Debt – The American Drug of Choice

I think we can look at this from another direction, as well. I would argue that in the past few years we have not held back to the degree that we should have. The personal savings rate in the US have been almost zero for some time. We have been in a cycle where China, Japan and other Asian countries with high savings rates have been lending to Americans, who purchase products made in those countries. These countries then use many of those dollars to lend back to the US to finance more consumption by Americans. As a result, we have been running trade deficits of around $700 billion per year and consuming much more than we produce. This has meant an ever increasing US debt level. Combined with low interest rates (which eliminate the incentive to save) resulting from the Federal Reserves’ rapid expansion of the money supply post 9/11, we created a large asset bubble in real estate prices. During the 1990s, the Federal Reserve facilitated the creation of a similar bubble in stock prices.

Japan followed similar policies in the 1980s (although they maintained a savings rate of approximately 30%), and the result was a twin stock and real estate bubble which burst in 1991. After 18 years, Japan has not yet recovered from its bubble. The Nikkei stock index was at 40,000 yen when the bubble burst. Yesterday (Feb. 20, 2009) the Nikkei closed at 7,416 yen. What is particularly troublesome is that these bubbles seem to be increasing in size and in the damage caused when they burst. Yet, the response from the Federal Reserve at this point in time is to push the Fed Funds rate to zero and the US government is piling on new massive amounts debt new debt.

The current policy is not irrational. It will likely result in some increased economic activity in the short-term. Following the ideas of John Maynard Keynes, there is a valid argument that failing to do such things in the short-term could result in such significant damage that the economy would not be able to recover for a very long time. As Keynes put it: “In the long we are all dead.” However, at some point the long-term effects of such policies have to be addressed, or we will keep going through more and more extreme bubble creation and bubble destruction cycles.

The current economy is like a drug addict. In this case, debt is the drug of choice. When a drug addict is going through withdrawal, the surest and quickest way to help the addict feel better and get rid of the withdrawal symptoms is to give them another hit of the drug. However, unless the addict eventually kicks his habit, the drug will surely kill him.