Alongside the physical economy that produces goods and services, there is a paper economy that produces claims on these goods and services. Many of today's economic problems have their origin in the uncontrolled growth of the paper economy.
Only a primitive barter society can function without paper claims. A modern society depends on paper claims that are far more extensive than conventional definitions of the money supply. The paper economy includes not only currency and bank accounts, but also commercial paper, long term debt, pension rights, mutual funds and most common stocks.
The components of the paper economy have two features in common. They represent someone's promise to pay; technically they are liabilities. Second, they are accepted as valid claims on the physical economy's goods and services.
For the last decade the paper economy has grown much faster than the physical economy's ability to produce goods and services. The obvious result has been inflation. The less obvious result is that there is no effective and painless way for the world's central bankers to control the cancerous growth of the paper economy.
Central bankers like the U.S. Federal Reserve have a great deal of control over currency and the reserves of commercial banks. This helps them control bank loans and the narrow definitions of the money supply, but large segments of the paper economy are beyond their direct control.
Central bankers have no control over their own government's addiction to deficit spending. Deficits must be funded by issuing more paper claims ranging from new currency to long-term treasury bonds. While treasury bonds are not defined as part of the money supply, in the long run they are just as potent in promoting the growth of the paper economy. So, too, are pension rights promised by the Social Security system.
While the private sector cannot print money as the public does, it can issue other forms of paper claims. Both corporations and consumers finance a large portion of their demand for goods and services through paper claims such as commercial paper, long-term debt, pension rights, mortgages and bank loans.
The same thing happens on an international scale as well. Both corporations and lesser developed countries (LDCs) borrow in the Euromarkets to finance their spending on goods and services. The Euromarkets are a vast pool of offshore paper claims that emerged as a response to the desire of the world's commercial bankers to escape the restrictions imposed by their own central bankers.
Like the sorcerer's apprentice, the world's central bankers watch the explosive growth of the paper economy without being able to stop it. Occasionally they attempt to slow the growth of paper claims in a fit of anti-inflationary zeal, but their enthusiasm wanes as unemployment rises. Last year's crusade for a balanced budget turned into a stampede toward a tax cut as soon as the recession began to bite.
Halting the growth of the paper economy would cause a massive deflation of demand of the kind that took place in the l930s. Without the ability to create large amounts of new paper claims, both the public and private sectors would have to reduce their demand for the physical economy's goods and services. Like the man who rode the tiger because he was afraid to dismount and be devoured, central bankers prefer to continue the inflationary ride rather than risk a depression by halting the growth of the paper economy.
LDCs face an even more unpleasant dilemma. They finance both their trade and budget deficits by borrowing abroad from commercial banks, the World Bank and any other lender who will accept their paper claims. If they were unable to issue more paper claims, they would be forced to cut their imports, deflate their economies and reduce their already modest living standards. They also would default on their existing debts to commercial banks, which is one reason that commercial bankers are so enthusiastic about larger loans to LDCs by the World Bank and the IMF.
The prospect of default points out the fact that not all paper claims are created equal. There is no doubt of the Treasury's ability to pay off its claims, if only by printing money. For LDCs and corporations, access to dollars is far less certain, particularly in a severe recession.
When a borrower faces the prospect of default, no one will accept his new paper claims. The desperate borrower then pressures someone else to guarantee his unacceptable paper claims, just as New York City and Chrysler successfully pressured the federal government to guarantee their debts. Many LDCs are no longer welcome in the Euromarkets, so they are pressuring the World Bank and IMF to grant them new loans and to create new paper claims in the form of Special Drawing Rights.
The threat of default becomes more real as everyone becomes more addicted to debt. The debt to equity ratio for U.S. nonfinancial corporations rose from 57 percent in l960 to 93 percent in l979. During the same period, money center banks expanded their loans far faster than their equity . Many LDCs borrowed at a faster rate than their exports.