Hussman Weekly Market Comment: Two One-Way Lanes on the Road to Ruin

Let's go back to the last line in Schumpeter's remark. Only when the lending ultimately results in a surplus of productive activity is the loan successful. Only then "has the bank done good business - then and only then however, is there also no inflation."

This point is crucial, because all of us are presently benefiting from the continued demand for default-free securities (specifically, U.S. base money and Treasury debt - which I do continue to view as default-free). It is only that demand that has allowed inflation to remain low despite the massive expansion of government liabilities far exceeding GDP growth, and of misallocated credit that has produced losses rather than surplus output. The overhang of mortgage obligations and sovereign debt, matched neither by current value nor future output, is an extraordinary threat. First, it contributes to keeping resources idle, because it forces consumers and whole nations to remain on a path of austerity and debt reduction rather than spending. At the same time, it prevents businesses from hiring, because they know that demand is not forthcoming. Finally, to the extent that we pursue policies that use public subsidies and money creation to make that debt whole instead of restructuring it, we can expect inflationary pressure in the back half of this decade, because the amount of credit created is not commensurate with the amount of productive capacity that has resulted from it.

Indeed, we have pursued policies that would be aptly described as Schumpeter's nightmare:

"Only in one other case could the banking world... arbitrarily determine the price level, not only without loss but even with profit: namely, if it pumped credit means of payment into the circular flow either by making bad commitments good by a further creation of new circulating media or by giving credits which really serve consumptive ends. In general, no single bank could do this. For while its issue of means of payment would not appreciably affect the price level, the bad commitment would remain bad and the consumptive credit become bad if it did not lie within the limits in which it could be repaid by the debtor out of his income. But all banks together could do it... The banks could do likewise if the state were to transfer the right to them in their interest and for their purposes, and common sense did not prevent them from exercising it."

Schumpeter was something of an optimist in that he dismissed this sort of nightmare, because he viewed it as "self evident" that such a possibility was "the chief reason why special legal restrictions and special safety-valves are actually necessary in practice."

Unfortunately, we increasingly have a situation where the entire thrust of our nation's economic policy is aimed precisely at "making bad commitments good by a further creation of new circulating media, or by giving credits which really serve consumptive ends." Those policies operate primarily for the benefit of banks and bondholders who made reckless and unproductive loans. To use Schumpeter's words, our public policy now operates "in their interest and for their purposes." It is the insistence of policy makers on making these bad loans whole, instead of restructuring the obligations, that is at the heart of our prolonged economic slump.