Introduction

I hear a lot of talk about the impending “debt crisis.” Commentators seem to have a fixation on the Federal Debt-to-GDP ratio, yet I have never heard why they place such significance on it. The Federal Debt to GDP ratio actually compares a stock—the accumulation of flows over a long period—with a flow—the measure of the rate at which some periodic action contributes to the stock.

[Briefly envision a bathtub. The rate at which water enters the tub consists of the flow. The amount of water in the tub consists of the stock.]

The Federal Debt-to-GDP ratio might make sense with more information. People miss the point that a better understanding of the flow might give more meaning to the question of whether the U.S. faces an impending debt crisis.

Subsistence Fund

To explain the breakdown in Government debt, I will introduce a mental construct called the “subsistence fund.”

The subsistence fund consists of all the goods and services produced by an economy that satisfy the wants and needs of various consumers. Producers add to the subistence fund. Consumers withdraw from the fund. Since producers do not know what segments of the fund workers desire, they pay them with “money.” Producers who become consumers use the money they receive to acquire a portion of the subsistence fund

Two Types of Money

The “money” used to acquire parts of the subsistentence fund comes in two types. I will refer to the first type of “money” as “earned money.” To acquire “earned money,” a producer/consumer must have received it in exchange for a good or service that they value less than the “money” they receive.

I will refer to the second type of “money” as “unearned money.” Consumers receive “unearned money” mostly from government “spending.” Another portion of “unearned money” consumers acquire by promising to pay banks a larger amount of “money” sometime in the future. The banks create this money out of nothing.

In the market, no one makes a distinction between “earned money” and “unearned money.” “Unearned money,” the result of monetary expansion, creates a problem in the subsistence fund. Spenders of “unearned money” acquire goods from the subsistence fund without contributing to it. The use of “unearned money” will eventually deplete the subsistence fund. I will address this problem later.

For this explanation, I will focus on that portion of government “spending” paid for with “unearned money” created by monetary expansion.

An Hypothesis

The graph below indicates the likelihood that most of the increase in government spending has been through monetary expansion. If federal deficits were paid for by borrowing from entities that actually contributed to the subsistence fund, the M2 line would be nearly flat.

Money Supply (M2) and Federal Government Current Expenditures (semi-log scale)

Government Payments

It seems likely that production—contributions to the subsistence fund—have not supported most of the increase in government spending. The fact that producers cannot tell which portion of their sales comes from “unearned money” creates a calculation problem for them. They have to make their business decisions based on current pricing. If they can sell all of their inventory at the current prices, that amounts to a signal that they should raise prices and increase inventory/

Producer Response

Composite

To aid my description, I have provided a composite of four diagrams that represent four stages of a supply chain. I have generated these graphics using a systems dynamics program to show the impact of changes in demand for a product (beer) at the retail level and how those changes affect the entire supply chain.

This effect might occur regardless of the source of changes in retail sales. For this explanation, I will assume that all the increase in sales is due to monetary expansion (i.e., “unearned money”).

Retail Sales

Sales have remained steady for roughly 5 weeks. Because of an “economic stimulus,” consumers have a little more spending money and decide to spend it on beer. Sales continue at a fluctuating amount until it finally settles into a new pattern somewhat above the original steady level.

Wholesale Sales

Wholesaler sales mirror the retailer’s orders.

The retailer increases its orders to the wholesaler to support the higher sales it expects to continue. The retailer does not want to get caught with low inventory if sales continue to increase.

In week 20, the retailer begins cutting back its orders. Those orders plummet to near 5 cases/week around week 26. The retailer needs to work off its excess inventory before it starts placing regular orders again around week 26. After that, wholesaler sales to retailer begin to settle at about 10 cases/week.

Distributor Sales

Similar to wholesalers’ sales reflecting retailer orders, distributor sales reflect wholesale orders.

To keep product flow moving, the wholesaler has increased its orders to peak around week 20. After that, orders begin to plunge, hitting near zero in week 26 and lasting about 2 weeks. They rebound to about 10 cases/week.

Factory Sales

Remember, factory sales consist of orders from distributor.

To fulfill its role in keeping the supply chain rolling, the distributor increases its orders to the factory to a peak of about 25 cases/week. When the wholesaler cuts their order to the distributor to zero, the distributor must act quickly and do the same.

The distributor places no orders with the factory for nearly 10 weeks. The factory must shut down production for nearly 10 weeks.

Summary

Whether you followed the above explanation or not, keep one thing in mind: changes in sales at the retail level ripple through the economy from retail back to manufacturing. I have offered only one hypothetical example, but this same effect occurs for every business in the economy. The results will differ with every artificial “stimulation.”

Resource Allocation

I suggest that every dollar of “unearned money” spent in the economy causes a misallocation of resources. Someone gets to take part of the subsistence fund without contributing to it. They take something the market has priced at a specific amount without contributing anything else that the market would price similarly.

All government spending misallocates resources, but when the government taxes or borrows “earned money,” it simply reallocates existing resources. When, on the other hand, government finances “spending” with “unearned money,” it not only rearranges resources but also depletes them (as depicted by the subsistence fund).

Malinvestment

If you look at the Factory Sales chart, you can see the source of “malinvestment.” The factory sees a dramatic surge in sales. The owners do not know the cause of the surge in sales that began at the retail level; they just want to satisfy that demand in the future by expanding production.

Boom

The beer factory sees this increased demand as a great benefit. When this effect spreads across the economy, macroeconomic statisticians classify it as a boom. The stock market reacts to these signals and rises dramatically. Many producers, from retailers to factories, increase production capabilities. Things are great.

But have astute businessmen made sound business decisions based on flawed information?

Bust

At some point (as the beer factory found), sales increases based on “unearned money” cannot sustain. Expansion plans get shelved, and layoffs rise. Market prices across the board decline. The stock market crashes. The statisticians declare, “Hey, we’ve been in a recession for months.”

The bust has happened.

Inflation

Many people misunderstand the causes of price inflation: the increase in prices in nearly all sectors of the economy. Price inflation has only one cause: monetary expansion.

Price inflation occurs only after the misallocation of resources, and the depletion of the subsistence fund have both occurred.

Conclusion

All government “spending” causes a misallocation of resources. “Spending” financed by monetary expansion creates even greater distortions in the market. Using “unearned money” to support increased “spending” creates a dual problem: a misallocation of resources and a distortion of the pricing mechanisms that help free markets operate effectively and efficiently.

If you wonder why people don’t ask about this source of government spending, please don’t attribute it to a well-kept “dirty little secret”. I don’t believe that many people understand the importance of this distinction. Congress debates increasing the debt ceiling. They do not make the important distinction between the sources of their “borrowing”: “earned money” and “unearned money.”

Study the Austrian Business Cycle fully understand this phenomenon.