Substituting Debt for Income Is Not Success–It’s Failure on an Epic Scale

The Fed’s substitution of debt for income has only doomed the nation to a deeper, more painful realignment of real income and expenses.

The economic “recovery” has been based on a simple premise: debt can be substituted for income with no ill effects. As real household incomes have declined, the legitimate foundation of additional spending–more income–has eroded for the bottom 90%.

Even the ephemeral foundation of additional debt-based spending–the Fed’s beloved wealth effect–has eroded for all but the thin layer at the very top of the wealth pyramid.

To replace this diminished income, the Status Quo has substituted debt as the source of additional spending: household debt, corporate debt and government debt.

But debt is not income. Rather, debt requires income to be diverted to pay interest and principal. So substituting debt for income ends up further depleting declining income.

This scheme of keeping a bloated, inefficient Status Quo afloat with debt is not a success–it’s a failure on an epic scale.

Let’s start by reviewing household income, which has declined in real (adjusted for inflation) terms. The drop in real income is across the board; those in the top rungs have experienced a smaller relative decline than their lower-income brethren, but they still has less purchasing power than they did six years ago.

Here’s another look at the same basic data:

Here’s real median household income:

Some apologists claim median income doesn’t reflect how well most households are doing in the New Normal. As researchers Piketty and Saez found, the gains in income have all accrued to the top 10%. So while this might be good news for Porsche dealerships in wealthy enclaves, it doesn’t follow that the economy is healthy because a relative handful of households are doing very well for themselves.

If we add up all debt–household, finance, corporate and government–we see debt has soared and growth has stagnated: this is a classic case of diminishing returns as more debt is required to add each additional increment of GDP.

At some point, additional debt is taken on to simply make interest payments; at that juncture, there is no consumption/buying taking place with the new debt: it’s simply keeping the borrower out of default.

The Fed has pulled out all the stops to reflate the housing and stock market bubbles, as a means of boosting the wealth effect, i.e. the belief that people who see their homes and 401K accounts rising will feel wealthier and therefore more likely to borrow and spend money on stuff they don’t need.

Housing has entered an echo-bubble:

But alas, these unprecedented Fed-inflated bubbles haven’t pushed household wealth up to previous levels. The power of the wealth effect is greatly diminished when wealth has yet to recover to previous levels.

source: Wealth Levels, Wealth Inequality And The Great Recession (PDF)

Even the top 10% have seen their real wealth decline sharply from the peak in 2007. So much for the wealth effect, which can only work on those with short memories.

The scheme of substituting debt for income to prop up a corrupt, bloated and ineffective Status Quo is a financial game with a predictable end: even with low interest rates, each additional unit of debt requires more future income be diverted to pay interest and principal. As income erodes due to Fed-induced inflation and other structural deformations, spending more of the diminishing income pie on servicing debt becomes increasingly destructive–especially to the core dynamic of our consumerist economy: taking on more debt to consume more stuff.

No wonder so many households are behind on their debt payments: Delinquent Debt in America (Urban Institute): An alarming 77 million Americans — 35 percent of adults with credit files — have debt in collections reported in their credit files, with an average debt amount of nearly $5,178.

Substituting debt for income can fill the widening gap between income and expenses for a few months. Beyond a few months, however, the household, company or nation that wants to avoid insolvency and default must align expenses with real income (as defined by purchasing power of the income).

Six years is not a few months. The Federal Reserve has gamed and manipulated the financial system to enable every person and entity in the U.S. to take on more debt at lower rates of interest. The past six years have been a grandiose gambit that additional debt-based spending would magically transform a financialized, debt-dependent, bloated and ineffective economy into a productive economy based on prudent risk management and investment of capital.

Sorry, members of the Fed–magical thinking doesn’t work in the real world. Your substitution of debt for income has only doomed the nation to a deeper, more painful realignment of real income and expenses, and a more devastating recognition of phantom assets and collateral.

How much did subprime loans fuel the GDP boom? (MarketWatch) 

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  • Voice of Reason

    The Fed’s “magical thinking” is based upon illusions about the nature of money shared by the entire world – sometimes it seems by Charles himself. Money IS debt, not wealth. It doesn’t matter if it is
    made out of gold or computer digits. It is a claim on society’s present or future wealth, a debt society owes to the holder of money providing, of course, the holder came by that money honestly. Smith’s “magical thinking” and that of other free market proponents goes something to the effect of ‘if everyone had enough money the free market would provide exactly the right type and amount of wealth society needs.

    The flaw in this is the belief that free markets are created by some magical force in the universe rather than by politicians and marketers bought and paid for by those with money or the ability to create it, i.e.
    bankers and financiers. Smith seems to get the fact that for a sustainable monetary and financial system people need income not debt, i.e. their own not other people’s money, to keep themselves
    and their economy above water. What I’m not sure he does get however is the unsustainability of requiring people to work for that income. For the last 200 years and counting the whole thrust of capitalism has been replacing people with machines or, more recently, people with lower priced people.

    I am old enough to remember when even establishment economists spoke of the promise of a ‘leisure society’. That logically implies that the economy in which they live is capable of producing enough real wealth their labor is no longer required. But it also implies that there is no longer a need for ever more GDP or the money to make it happen. And that is where the U.S. and its “Empire of Debt” (the title of a well-written if not especially meaty book by Bill Bonner and Addison Wiggins) enter the picture.

    For the last half-century, if not longer, the United States has been providing a sink for the world’s money (to an increasingly ungrateful world). In other words, it has been running a full-employment program – for money. The alternatives are not especially pleasant to contemplate. When the wealth-producing capabilities of Old Europe’s industrial economies of outran the boundaries of a social order based
    upon extreme wealth for the few and poverty for the rest, the powers that be attempted to rectify the situation by destroying (twice) each others capabilities, thus clearing the decks for the U.S.

    With a virgin continent to pillage, the U.S. attempted to keep the peace by supplying a market of last resort complete with consumers conditioned to a waste and excess AKA ‘the American lifestyle’, again to an unreceptive world. The problem here was a business model that called for products the rest of the world and increasingly the country’s own consumers could no longer afford. Rather than change business models (and adjust the social order accordingly) American business decided to go out of
    business. More precisely American finance decided to go out of the business of producing things and into the business of producing debt.

    But one of the first rules of capitalism, finance or industrial, is that money must make more money.
    And after you have sold the family farm, leveraging debt upon more debt, money (i.e. debt) creation becomes difficult to impossible.

    And the rest, as they say is (the end of?) history.