In order to expand a debt bubble beyond reasonable bounds, lenders have to find more and more players and more and more collateral to lend against. As the debt bubble progresses, the collateral creates itself, as accumulated balances against debt produce purchasing power to speculate on various assets. Stocks and real estate are the backbone of any credit bubble, the perceived wealth from appreciation justifying more debt. The bubble bursts when the money represented by the debt is no longer sufficient to pay debt with a positive cash flow.
In truth, modern finance is nothing but a game on paper. This is known in modern finance as a ledger or balance sheet. In this kind of game, what is on one side of the equation is counter balanced with what is on the other side of the equation. What is on one side is perceived assets, while the other side are what is represented as money and capital. To the extent the real value of what is on the debt side exceeds the amounts of liabilities on the credit side is known as capital. If a bank ledger was 100% capital, there would be no credits in existence to pay the debts owed the bank. To the extent the stated value of the assets doesn't exist, neither does the capital. Going forward, if the means of repayment of debts on the debt side of banks is insufficient, then the asset values have to be reduced, either in truth or fiction, as time shows who is naked in these matters. This reduction comes directly out of the capital accounts of the banks, before any deposit balances are reduced, including bonds and preferred stock issued by the banks. It is the capital position of banks that allow them to make loans, not the reserves that so many people seem to believe lead to money creation. The money backed by the reserves is already universally owed by the banks to their existing depositors. At best additional reserves grease the wheels of interbank exchanges and make the decision to lend easier. Reserves are nothing more than cushions against withdrawals of funds or loan proceeds from one bank to pocket cash or to another bank and little else. In these times, reserves are basically increased because bank credit is no longer sufficient to carry the amount of debt we have in the system.
Everything on a bank ledger is reflected on a ledger somewhere in the non-bank world, on the other side of the ledger. Thus the banks debits are someone's credits or liabilities and their credits are someone's debit or asset. The capital position is recognized as an asset in someones stock portfolio. I know stocks sell for more or less than book, so the private account would need to be adjusted for an entry on both sides of the ledger to recognize this excess value, sort of like a paid in excess of par account along with another account on the credit side to keep the transaction in balance. Being the bank balance is supposed to represent what is really there, as it is a direct accounting of financial assets, what exists on the shareholders balance sheet should reflect book plus another account. This only to clarify what I am describing. Thus the loans of banks are the liabilities of borrowers and the deposits in banks are the cash and other balances of depositors and other creditors. The entries on a bank ledger can be reflected contrarily on the balance sheets of thousands, millions and as to the TBTF banks, hundreds of millions of people and institutions.
This balance sheet idea is important if one is to have any idea of where we stand and how insufficient the current solutions to the problem are to its solution. The entire world is based on a modified version of vendor financing and there is one thing that isn't recognized. That is every financial intermediary is liable for the performance of its assets. The bank ledger is comprised of loan assets on one side balanced by deposits and other borrowings and liabilities of banks and the liability of the agent bank to its principal shareholders. Nothing can exist on the credit side of the balance sheet that actually exceeds the value of its assets and the reduction in assets must be borne by the bank itself. When the loan is made, the bank becomes liable for the proceeds of the asset it places on its balance sheet. Thus it acts as surety for collection rather than lender and the process is called credit, for the entry on the credit side of the balance sheet. Any failure to collect must come from the credit side of the balance sheet.
Extend this around the world and you find the surplus exporters vendor finance the deficit importers. To the extent the importers can't pay, the balance sheet of the exporter must be reduced. Then there is capital investment, which is more like a non-recourse loan, where the investment itself determines repayment by performance. The current situation in Europe is a illustration in miniature, as Greece's debts are in part the vendor financing of German and other exporters, which have merely changed collection agents. If you stop the vendor financing, then you stop the flow of goods and you may stop the capacity to pay, as they were already borrowing to pay what they acquired. This can be counter balanced by the foreign investment of Greek citizens into Germany, but this feature is much harder to tie down. The same goes for the US and China and I would venture US citizens and institutions own a much larger share of the asset base in China than is represented by the debt of the US, but only if you can keep both economies inflated. To a sizable extent, growth in China has been financed by foreign investment as much as trade.
To take this idea further, in regard to banks, the only money there is to pay anything on the debit side of banks has to exist on the credit side. Loans are greater than deposits and other bank liabilities to the extent of capital minus capital assets on the ledger. Thus, the real estate the bank occupies that it owns is a reduction of the gap between liabilities and capital.
This brings us to the $64,000 question or maybe the $6.4 trillion question. On what balance sheets are the credits for the debits of the banks? The depositors possess the means to pay these debits and no one else. Even if the government injects money into banks through borrowing and financing, this remains true. Thus, if the balance sheet of those that own the income producing assets are enriched by government spending through doing business with increased cash balances, the bank is still liable to those that don't need the money to pay. But, what about the people that owe the loans?
If someone owes money and they have the same amount of money in the bank, then the game is a wash. If they have more money than debt, then they too end up on the surplus side of the equation with the person with deposits and no debt. But, the person who has a ton of debt and little money, he is insolvent to the bank, no matter what his other asset base might be. He is then faced with selling what he has to those that own the deposits in order to gain possession of cash to extinguish his debts or there is no remedy or potential to pay the debt. He can sell labor or physical assets to pay the debt over time or he can default. As long as cash balances increase in the accounts of debt free or high cash surplus individuals, those that are net debtors to cash are unable to extinguish the debts they owe. On a current basis, the debit entries of these debts on bank ledgers are pure fiction.
What would have to happen for these debtors to make good on the money and capital on bank balance sheets? For one, the individual or institution would need to have the means to produce income and liquidation of assets sufficient to live and pay the debts down. If they had the assets, they could merely sell them to someone who has cash and pay the bank and the credit side and a like sized debt would be done on the bank ledger and the cash and the loan would no longer exist. But, if they had to labor, absent an increase in pay, which in itself depends on credit expansion to a great extent, they would have to reduce their expenditures on non-essentials to the extent of the debt plus the extent of their prior deficit spending. This is simple math in a way, but it is not only important, it eludes the general economic arena today.
What has transpired over the last 50 or more years has been an accelerating equity extraction from housing and other real estate through leverage. Consumers have been doing a modified version of vendor financing through equity extraction by refinance or contracts for financed sale of housing for years. This practice accelerated in the 2000's and eventually equity disappeared and the loans became in doubt. What else went with this procedure was the credit standing of people and their means to repay current and future debt that existed prior to the busted bubble. These people, which included a sizable share of the first worlds population, no longer had the means to spend or repay, because of the end of Ponzi financing of home equity. This additional money greased a lot of financial wheels around the world and the game no longer functions. Their capacity to borrow and spend has been sucked dry. To a very large extent, these are the people who list on their credit side, the assets or debits of banks. Selling the house is no longer a remedy.
This is the essence of deflation. Cash is capitive and it cannot exist beyond the extent of the assets on the balance sheet of banks and other institutions. Thus, the writing off of debt is by itself a reduction in money. There is very little difference between a pretend and extend loan and one that has been wiped out through default. Banks and governments know this money doesn't exist, but they have no choice but to extend and pretend.
The great secret about Greece is that not only are they having problems refinancing their debt, but that their economy is faltering with a 7.5% of GDP budget deficit. A shrinking debt base is what is needed to fix this mess, but shrinking in itself produces more shrinking. In the long run, there is no money on a banks ledger in excess of its good assets. The other reality is if they lose the capacity to create new credit, they also lose the capacity to produce what allows for the payment of interest in general, as interest is never created. I theorize that the monetary base, which includes accumulated interest will shrink to wipe out all accumulated interest since the last great depression. This is all credit as well.