Consider two economic systems.

In one, consumers work for employers to produce products and services. The employees are paid wages and salaries, and business owners earn profits. They use much of that income to purchase the goods and services produced by the economy. They save the remainder. A certain portion of the output represents “investment” goods, which are not consumed, and the portion of income not used for consumption – what we call “saving” – is used to directly or indirectly purchase those investment goods.

There may be some goods that are produced and are not purchased, in which case they become unintended “inventory investment,” but in a general sense, this first economic system is a well-functioning illustration of what we call “circular flow” or “general equilibrium.” As is always the case in the end, income equals expenditure, savings equal investment, and output is absorbed either as consumption or investment.

The second economic system is dysfunctional. Consumers work for employers to produce goods and services, but because of past labor market slack, weak bargaining power, and other factors, they are paid meaningfully less than they actually need to meet their consumption plans. The government also runs massive deficits, partly to supplement the income and medical needs of the public, partly to purchase goods and services from corporations, and partly to directly benefit corporations by cutting taxes on profits (despite being the only country in the OECD where corporations pay no value-added tax).

Meanwhile, lopsided corporate profits generate a great deal of saving for individuals at high incomes, who use these savings to finance government and household deficits through loans. This creation of new debt is required so the economy’s output can actually be absorbed. Businesses also use much of their profits to repurchase their own shares, and engage in what amounts, in aggregate, to a massive debt-for-equity swap with public shareholders: through a series of transactions, corporations issue debt to buy back their shares, and investors use the proceeds from selling those shares, directly or indirectly, but by necessity in equilibrium, to purchase the newly issued corporate debt.

The first of these economic systems is self-sustaining: income from productive activity is used to purchase the output of that productive activity in a circular flow. Debt is used primarily as a means to intermediate the savings of individuals to others who use it to finance productive investment.

The second of these economic systems is effectively a Ponzi scheme: the operation of the economy relies on the constant creation of low-grade debt in order to finance consumption and income shortfalls among some members of the economy, using the massive surpluses earned by other members of the economy. Notably, since securities are assets to the holder and liabilities to the issuer, the growing mountain of debt does not represent “wealth” in aggregate. Rather, securities are the evidence of claims and obligations between different individuals in society, created each time funds are intermediated.
So it’s not just debt burdens that expand. Debt ownership also expands, and the debt deteriorates toward progressively lower quality. The dysfunctional economic system provides the illusion of prosperity for some segments of the economy. But in the end, the underlying instability will, as always, be expressed in the form of mass defaults, which effectively re-align the enormous volume of debt with the ability to service those obligations over the long-term.

This is where we find ourselves, once again.

If you examine financial history, you’ll see how this basic narrative has unfolded time and time again, and is repeated largely because of what Galbraith called “the extreme brevity of the financial memory.” Debt-financed prosperity is typically abetted by central banks that encourage consumers and speculators to borrow (the demand side of Ponzi finance) and also encourage yield-seeking demand among investors for newly-issued debt securities that offer a “pickup” in yield (the supply side of Ponzi finance). The heavy issuance of low-grade debt, and the progressive deterioration in credit quality, ultimately combine to produce a debt crisis, and losses follow that wipe out an enormous amount of accumulated saving and securities value. The strains on the income distribution are partially relieved by borrowers defaulting on their obligations, and bondholders receiving less than they expected.

The hallmark of an economic Ponzi scheme is that the operation of the economy relies on the constant creation of low-grade debt in order to finance consumption and income shortfalls among some members of the economy, using the massive surpluses earned by other members of the economy.