Debt Liquidation and Economic Recovery

Email Print
FacebookTwitterShare

In order to accurately appraise the status of the much-touted "global economic recovery" we are supposedly experiencing today it is vitally important to clearly and correctly understand the relationship between debt liquidation and economic recovery. Unfortunately, this relationship is frequently misunderstood by both so-called "experts" and the general public, both of whom are often inclined to view the liquidation of bad debt as sufficient in itself to right a capsized economy. This view is a gross distortion of economic reality, and can lead to the erroneous assumption that an economy is in much better condition than it actually is.

To see why this is true, it is important to recognize that there is more to a recession or depression than the accumulation of bad debt. Specifically, recessions and depressions are manifestations of real economic dislocations that must be corrected if the economy is to recover. The liquidation of bad debt is an extremely important step in the correction of these real economic dislocations, but it is not the only step. Other vitally important dislocations must be corrected, and, until they are, no lasting recovery can occur — even if all bad debts have been liquidated.

The truth of this observation can be difficult to appreciate when one views the economy as a whole, because the liquidation of bad debt and the correction of other economic dislocations are ordinarily related to one another in an intimate way. Thus, for example, the liquidation of bankrupt companies and the sale of their remaining assets to more competent owners corrects both a debt dislocation and a capital dislocation in the economy. The correction of the capital dislocation occurs as capital changes hands and gets employed in a different and more useful sector of the economy. What is critical to appreciate, however, is that the correction of a debt dislocation in the economy does not necessarily result in the correction of a capital dislocation in the economy if something impedes this ordinary market process. In other words, it is possible for all bad debts to be liquidated without correcting other serious and potentially crippling dislocations in the economy. These other dislocations can lead to continuing economic stagnation or even intensifying contraction in the economy, even though all bad debts have been liquidated.

An example can perhaps best illustrate this point. Imagine that you and I live on an island in the South Pacific. I get the idea into my head that I should build a five-star hotel on the island, and I convince you to lend me all of your money in order to build it. To our dismay, however, we find that not a single visitor comes to the island after the hotel has been completed, and I find myself quickly bankrupted. The ownership of the hotel thus reverts to you, as my creditor, and the bad debt I have incurred is thus liquidated. It should be obvious, however, that this debt liquidation alone will not produce economic recovery for our island micro-economy. What is needed is for you to liquidate the physical hotel itself, insofar as this is possible, in order to use its component parts more efficiently to satisfy more urgent wants on the island. Until you do this, (and you might be unwilling to do this at all because, hopeless optimist that you are, you believe visitors will show up eventually), you and I will not experience much of an economic recovery. Debt liquidation alone will not have helped our island economy recover from our unwise use of our capital in the past. The economy cannot even begin to move toward its previous level of productivity until the capital goods that are tied up in the hotel are freed for more productive use elsewhere.

This same process of debt liquidation without the correction of other dislocations in the economy can occur whenever government steps into the picture. Government has the power to intervene on behalf of bankrupt present owners of capital goods to keep them from handing over those capital goods to more competent owners. In the preceding example this would occur if a government bailed me out and kept me from handing the hotel over to you, my creditor. No one is benefited by having me, incompetent forecaster that I have proven to be, holding onto valuable and scarce resources that could be put to better use elsewhere in the economy by more competent owners. (This is to say nothing of the galling injustice involved in forcing you, my creditor, to bear the entire loss from my bad business decisions, while I suffer no losses whatsoever.)

Government also has the power to force or entice economic actors to continue producing goods that have been exposed as completely undesirable from the point of view of consumers. In the preceding example this would occur if government forced or enticed either you or me to continue building five-star hotels on the island, even though it is obvious to everyone that doing so is a gigantic waste of our valuable time and resources, since the original project resulted in nothing but my bankruptcy. It should go without saying that economic recovery will be sabotaged and forestalled indefinitely as long as we continue to waste our valuable time and resources in producing hotels nobody wants to visit. If we were producing something people actually want, moreover, we would need no government incentive to do so, since we would be rewarded by consumers with profits rather than bankruptcy.

Still another way in which governments can impede the reallocation of capital to more productive uses is by making business conditions more difficult or even intolerable in those sectors of the economy that the capital would otherwise flow into. For example, if the government sees that the mining industry is reaping heady profits during the recession and thus steps in to tax the daylights out of them, this will impede the flow of capital into those demonstrably productive sectors of the economy. This can also be accomplished by making the hiring of workers and the burden of tax reporting so onerous that it is virtually impossible for new businesses to open in those sectors of the economy where they would otherwise reap profits. It should be obvious that the reallocation of capital to its most productive use will be indefinitely forestalled as long as government makes it virtually impossible to start new businesses, or punishes those who earn profits through crippling taxes.

Finally, government has the power to simply take capital goods away from private owners altogether and use them howsoever its planners might see fit. In the preceding example this would occur if a government stepped in and simply took the hotel away from both of us, to be used for…well, whatever. Clearly, this is no step in the direction of economic recovery, or else it would be beneficial for the government to take over all aspects of the economy; i.e., institute a thoroughgoing system of socialism. But, given the insurmountable problem of rationally allocating resources under socialism, this means that such a decision by the government will make capital misallocation a permanent feature of the entire economy, rather than eliminate it.

All of these interventions by government impede the process of capital reallocation to correct real capital dislocations in the economy. It is true that each of these interventions also liquidates the bad debts that appear on the balance sheets of various actors in the economy, in the sense that the bad debts are wiped away for the time being, but they do absolutely nothing to correct the fundamental capital dislocations in the economy that are fundamentally responsible for poor economic performance during the recession. The sine qua non for real recovery is thus for the poorly employed capital in the economy to be reallocated to those people who are capable of using it to produce things that are actually demanded by consumers. Wiping away bad debts alone will not accomplish this task.

These considerations should lead us to view the current "global economic recovery" as nothing but a highly touted chimera. For, the governments of the world have managed to impede the reallocation of capital in all of the ways just discussed. Bankrupt companies like AIG and General Motors have been bailed out, and the reallocation of their capital to more productive uses has been completely obstructed. Lines of production that have been exposed as completely unsustainable have nevertheless been encouraged and subsidized, which has resulted in the continuation, for example, of building homes and commercial real estate that no one wants or can afford at unsubsidized market prices. And, finally, governments have simply taken capital goods for themselves, which has kept them from being reallocated to other productive uses. The Federal Reserve, for example, has a balance sheet bloated with resources it has bid away from private businessmen with money printed out of thin air, and which can no longer be redeployed to more productive uses.

In conclusion, it is extremely important to appreciate that economic recovery does not miraculously appear as soon as the slate of bad debt in an economy is wiped clean. What is truly critical for recovery is the reallocation of existing and newly created capital to new lines of production that are capable of satisfying consumers better. Insofar as this process is impeded by governments, we should expect no improvement in the economy. It makes no one better off to announce to the world that all debts have been wiped clean while leaving the structure of production just as retarded and distorted as it was when the recession began. Thus, the likelihood is nil that the current so-called "global economic recovery" is sustainable and real, and anyone who tells you differently, simply because bad debts have been liquidated, is a modern day alchemist promising a magical transformation of bad debt into economic growth.

Mark R. Crovelli [send him mail] writes from Denver, Colorado.

The Best of Mark R. Crovelli

Email Print
FacebookTwitterShare
  • LRC Blog

  • LRC Podcasts