As the United States national debt officially surpassed the staggering threshold of $40 trillion earlier this August, economic commentators, financial analysts, and market experts have intensified their scrutiny regarding the long-term viability of this fiscal trajectory. Many within the economic community view this historic accumulation of debt as a profound and growing threat to the stability of the broader U.S. economy.
To understand the mechanics of why mounting debt can jeopardize a financial system, modern economists frequently look back to the foundational writings of American economist Irving Fisher. In his seminal analyses, Fisher identified a primary systemic risk known as debt liquidation. According to Fisher’s framework, a rapid or forced liquidation of debt has the potential to trigger a sharp contraction in the overall money supply. This monetary decline, in turn, creates downward pressure on the prices of goods and services—a phenomenon known as deflation—which historically paves the way for a severe economic slump or depression. Fisher theorized that such a downward spiral is typically catalyzed by an acute economic shock, such as a dramatic collapse in the stock market.
To grasp why debt liquidation can impact the money supply, it is helpful to examine the fundamental mechanics of saving and lending in a market economy. Consider a producer of consumer goods who chooses to consume only a portion of what they produce while saving the remainder. Within a healthy market economy, this producer can exchange their saved goods for money and subsequently decide to lend that money to another producer. By executing this loan, the lender effectively transfers their genuine savings to a borrower for the agreed-upon duration of the lending contract. Utilizing this money, the borrower is then able to purchase necessary consumer goods to support their daily life and ongoing well-being.
Once the lending contract reaches its date of maturity, the borrower fulfills their obligation by returning the principal sum of money to the original lender. Crucially, in a transaction of this nature, the repayment of the debt—or the formal liquidation of that debt—has no net effect on the aggregate supply of money circulating within the economy.
These loaned savings serve an indispensable role in fostering economic growth. It is genuine savings that ultimately fund the production of capital goods, which subsequently permit an expansion in the production of consumer goods. This increased production clears the path for further saving, assuming all other conditions remain equal. Together, these transactions support the gradual buildup and refinement of a more sophisticated and productive economic structure.
Consequently, an increase in lending driven by genuine savings is widely viewed as positive news for the economy. Through this type of lending, existing savings are efficiently directed to various productive sectors, thereby stimulating organic economic growth. Under these conditions, a higher volume of debt—understood here as an increased volume of fully backed lending—benefits the economy. An expansion in lending that is firmly rooted in real savings actively strengthens the underlying wealth-generation process.
Inflation and Economic Impoverishment
Under normal market conditions, ordinary lenders find it exceedingly difficult to lend capital that they do not actually possess. However, the economic landscape shifts dramatically when financial institutions introduce lending practices that are completely unsupported by pre-existing savings. This distinct category of lending permits the generation of credit through unbacked credit expansion.
To illustrate this dynamic, consider a hypothetical scenario involving an individual named Joe, who decides to lend $1,000 for a period of one year through the mediation of a commercial bank. In this case, the transaction represents a straightforward transfer of $1,000 from Joe’s demand deposit account into a one-year term deposit account. The funds resting securely in the one-year term deposit can then be safely lent out for that specific duration. Here, the one-year term deposit of $1,000 provides legitimate backing for the corresponding one-year loan of $1,000.
Now, consider a contrasting scenario in which an individual named Bob approaches Bank A to request a loan of $1,000 for one year. Bank A accommodates Bob’s request by issuing the $1,000 loan simply by opening a new demand deposit account in Bob’s name to the tune of $1,000. In this second scenario, there is no corresponding transfer of $1,000 from the accounts of existing depositors, such as Joe, into a term deposit. Consequently, the loan extended to Bob by Bank A is entirely unbacked by savings. In effect, Bank A has inflated a $1,000 loan completely out of thin air.
Once Bob utilizes the newly created funds injected by Bank A, he engages in an economic exchange of receiving something for nothing. In a strictly free market economy, a commercial bank that attempts to issue loans out of thin air runs an immediate and severe risk of bankruptcy. Such a bank would inevitably fail to clear its checks during routine interbank settlement processes because it would fundamentally lack the necessary monetary reserves to cover the transactions.
However, the presence of a central bank alters this vulnerability by enabling commercial banks to engage in systemic inflation and credit expansion. For instance, if Bank A finds itself short by $1,000 during an interbank settlement and cannot cover its obligations to Bank B, it can readily secure the needed funds by borrowing directly from the central bank. This naturally raises the question: where does the central bank acquire the money? The central bank simply inflates the money supply out of thin air.
As economist Murray Rothbard observed regarding this institutional arrangement, the central bank functions as a government-backed cartelizing device designed to coordinate commercial banks. This coordination allows individual institutions to effectively evade the natural restrictions imposed by free markets and free banking, enabling them to inflate the money supply uniformly and harmoniously together.
Money Supply and the Subsistence Fund
As a general rule, a contraction in the money supply that precedes a bout of price deflation and a subsequent economic slump is almost invariably triggered by the prior expansionary monetary policies enacted by the central bank. It is these expansionary policies that provide the foundational support for excessive growth in both money and credit. In turn, this credit expansion leads to the artificial diversion of capital and savings away from genuine wealth-generators and toward non-wealth-generators. Consequently, this process undermines the economy’s ability to maintain and grow its subsistence fund, thereby weakening overall economic growth.
When loaned money remains fully backed by savings on the day of its maturity, the capital is returned to its original owner. For example, when Bob—the borrower of the unbacked $1,000—repays the borrowed sum alongside accrued interest to the bank on the maturity date, the bank subsequently passes the original $1,000 plus interest, adjusted for administrative fees, back to Joe, the original lender. The money completes a full circle and returns cleanly to its point of origin.
Conversely, when lending originates through institutional inflation and credit expansion and is eventually returned to the bank upon maturity, the result is a net withdrawal of money from the economy, leading directly to a contraction in the money supply. This occurs because the initial transaction lacked a genuine saver or lender. Driven by previous expansionary monetary policies and the resulting deterioration of the subsistence fund, broader economic activity tends to contract as a consequence.
As economic conditions deteriorate, commercial banks naturally respond by curtailing their expansionary lending practices. Once these existing loans are repaid to the banks and are left unrenewed, the overall supply of money comes under severe downward pressure.
From this perspective, the ensuing deflation and the accompanying slowdown in economic activity are not caused by the process of debt liquidation itself, nor are they strictly the result of a falling money supply. Rather, they are the direct outcome of the degradation of the subsistence fund caused by prior expansionary monetary interventions.
Furthermore, attempts by central banks to counteract deflationary pressures by intentionally increasing the supply of money typically exacerbate the underlying problem. Pumping additional liquidity into the financial system further weakens the delicate process of wealth-generation, ultimately deepening and prolonging the economic slump.
Turning to the matter of government borrowing, particularly obligations held abroad, these foreign liabilities pose a distinct and substantial threat to the domestic economy. Because the government is not inherently a wealth-generating entity, it must ultimately rely on the productive capacity of the private sector to secure the funds necessary for debt repayment.
However, once the economy’s subsistence fund begins to contract, the private sector faces mounting difficulties in sustaining the fiscal demands of the government. Consequently, aggressive monetary policies enacted by the Federal Reserve that weaken the subsistence fund simultaneously create severe obstacles for the government’s ability to service its foreign debt obligations.
