This much needs to be understood right off the bat: for our current (worldwide) economic system to survive, debt-fueled consumption is essential. To put it differently, what we are dealing with on a global scale is a “paradox of thrift” situation, where the global financial system and subsequently global economy would risk grinding to a halt if all of a sudden everyone were to become “prudent” by embarking on journeys such as paying off their debt.
As strange as it may sound, virtue became folly and the other way around.
Simply because (and, once again, we understand how peculiar all of this sounds) at this point in time, debt is money.
To elaborate, let us assume Person A goes to his bank (Bank 1) and makes a $100,000 deposit under a 10% fractional reserve banking framework. The bank sets 10% aside as reserves and lends the remaining 90% to other individuals. One of them (Person B) might get a loan to buy a car from Person C, who deposits the money he receives after the sale to Bank 2, which once again sets 10% aside and lends the rest. Person D takes out a loan which leads to yet another bank deposit and so on, rinse and repeat.
The end result is that Person A’s $100,000 deposit (one hundred thousand actual US dollars in US dollar bills) can lead to another let’s say $900,000 in “money” being created (not actual US dollar bills but merely numbers in a database, created by commercial banks). And yes, we are still referring to money because whether you make a $100 cash purchase or use your credit card, $100 is still $100. Therefore, as downright strange as all of this may seem, debt is money.
Think about what would happen if Person B, Person D and so on wanted to quickly pay back their loans. Quick hint: that would not be possible due to the fact that there is more “money 2.0” (debt created by commercial banks) in the system than “old school” money (actual physical currency, issued by the Federal Reserve in our case or other central banks if referring to a different nation). To put it in more plastic terms, “old school” money would quickly run out well before all loans would be paid back, leading to a situation in which you have a lot of outstanding loans (even if less than before) and no “old school” money to pay them.
Broadly speaking, we are referring to a widespread tendency of paying off existing debt and not taking on new debt as deleveraging.
This is something that, for example, tends to happen during a financial panic, where people go from being overly optimistic to becoming frightened about their futures and deciding to refrain from spending so as to pay off debt.
But… isn’t paying off your debt a good thing?
On a granular level, when simply analyzing one individual or company, the answer is most definitely yes. By paying off your debt, you are embarking on a more sustainable financial journey. For you as an individual and perhaps your family, this represents a positive development.
On a macro level, due to the nature of our current financial system, the financial and ultimately economic cogs stop turning if everyone does it, for the reasons which have been outlined previously. As such, on a macro scale, virtue does indeed become folly and the other way around… a rather plastic illustration of the (in)famous paradox of thrift.
As can be seen, for society as we know it, deleveraging would spell… well, the end of the financial system in its current form.
Some thinkers believe this needs to be avoided at all costs, whereas others are of the exact opposite opinion, stating that we are better off moving away from an unsustainable system as soon as possible so as to hopefully build a more robust one.
That, however, is a topic for a future article.
For now, the elephant in the room in terms of questions should be obvious: how does China fit into all of this?
As always… it depends.
While China does indeed embrace its own system, socialism with Chinese characteristics, it doesn’t mean it shies away from debt. In some cases, China seems to be in better shape than other nations with respect to the debt dimension, for example its public debt to GDP level is considerably lower than that of Western nations, especially in light of how high the bar has been set by Japan, with its 240%+ public debt to GDP level. The same way, the household debt situation of China is not horrible either but on the other hand, its very high corporate debt to GDP level is more than troublesome, with it for example even being greater than Japan’s.
To put it differently, China has more than enough vulnerabilities for it to be anything but thrilled about deleveraging scenarios.
Would it be hit less hard than Western nations?
Hard to tell, but… well, probably not.
On the contrary, a valid case could be made that it might be hit harder, at least initially.
On the one hand, as explained previously, it is in better shape than many Western countries when it comes to metrics such as public debt to GDP or household debt to GDP. On the other hand, unlike certain highly developed nations, China is not yet perceived as a safe haven jurisdiction and therefore, as counter-intuitive as it may seem, even in the event of a let’s say public debt to GDP framework, China with its well under 100% public debt to GDP level might lose market access sooner than even Japan, let’s not even mention the ultimate safe haven jurisdiction at this point in time: the United States. Until this status quo changes, the ChinaFund.com team believes China would stand more to lose than its Western counterparts in a global deleveraging scenario.