Private Credit Cycles Drive Economic Instability More Than Deficits

Mainstream economics relies on a fundamental misunderstanding of how money enters the system. This leads to an obsession with government debt while ignoring the more volatile engine of private credit. By treating banks as intermediaries that loan out existing deposits rather than creators of money, policymakers misdiagnose the causes of economic booms and busts. This conversation shows that GDP is a function of money supply and velocity. When private debt is paid down, money is literally destroyed, pulling liquidity out of the economy and triggering recessions. Understanding this relationship between debt and money provides an advantage: it explains why government austerity often backfires and why private credit cycles, not public deficits, are the true precursors to financial instability.

The Myth of the Loanable Funds Model

Mainstream economic models, specifically those taught in universities and used by institutions like the Government Accountability Office, rely on the loanable funds theory. This theory suggests that the government competes with firms for a fixed pool of savings, implying that government deficits crowd out private investment.

As Professor Steve Keen argues, this is a mathematical error. Banks do not wait for deposits to accumulate before issuing loans; they create money in the act of lending.

Banks do not act simply as intermediaries, lending out deposits of their safest place with them and order they multiply up central bank money.

-- Bank of England (quoted by Steve Keen)

When economists ignore this, they treat debt as a static burden rather than a dynamic flow of money. If you believe banks are just intermediaries, you will be blindsided by financial crises because you are failing to track the primary mechanism that pumps money into and drains it from the real economy.

The Matter and Antimatter of Debt

The most important systems-level insight is that every dollar of debt is simultaneously an asset and a liability. In a functioning economy, this creates a feedback loop: rising private debt drives GDP growth by increasing the money supply. However, the reverse is equally true and far more destructive.

When loans are repaid, they do not simply transfer money from one pocket to another; the money is extinguished. The debt and the asset cancel each other out, disappearing from the system entirely.

This is what we have today. Nominal wages are up but real wages are down. So it does not matter that people are quote unquote making more money they feel poor because they are poor.

-- Tom Bilyeu

This explains why aggressive debt repayment during a downturn, while appearing fiscally responsible, actually accelerates economic contraction. It shrinks the total money supply, reduces velocity, and forces a downward spiral in employment. The mainstream focus on government debt levels is a distraction from the reality that private credit cycles are the true drivers of macroeconomic health.

Why Systems Respond to Your Solutions

Systems thinking teaches us that interventions often trigger compensatory responses. When the government floods the system with liquidity to fix a crisis, it does not always result in productive growth. If the economy lacks the capacity to produce goods, as seen during the COVID-19 supply chain disruptions, that excess money simply chases the same amount of goods, resulting in inflation rather than prosperity.

The danger of the current paradigm is that it creates a moral hazard. If the public expects a debt jubilee or a bailout every time the cycle turns, they are incentivized to engage in reckless behavior. The system routes around your solutions, turning what was intended as a stimulus into a systemic distortion that makes future stability harder to achieve.

Key Action Items

• Audit your economic indicators: Stop prioritizing government debt-to-GDP ratios as your primary signal for economic health. Over the next quarter, shift your focus to private credit growth and household debt levels, as these are more predictive of impending recessions.
• Recognize the money destruction phase: When you see a trend of rapid deleveraging across the economy, anticipate a contraction in GDP. This is a lagging indicator that the money supply is shrinking.
• Prepare for inflationary shocks: Understand that liquidity injections are only productive if there is slack in the system. If you are investing, assess whether the current stimulus is hitting a supply-constrained environment, which creates inflation, or a demand-constrained one, which creates growth.
• Invest in innovation over nominal gains: In an environment where nominal wages rise but real purchasing power falls, prioritize assets that represent true innovation or productivity gains, rather than those that simply benefit from monetary expansion.
• Study the Double-Entry reality: If you want a long-term advantage in understanding market movements, spend the next 12-18 months learning the basics of double-entry bookkeeping. It is the only way to see through the models used by mainstream economists.