Start with the simplest possible example of a society consisting of capitalists and workers only, assume further that the value of raw materials and machinery worn out in production is small and that the consumption of the capitalist class is small compared with the total mass consumption of the workers. This last assumption identifies the workers exclusively as the consumers. Now say the cash outlay of the capitalists in a production cycle is 100u (u is a ‘unit’ of money - $1 million, Rs1 billion or what you will), and in our simple example it all goes to the worker-consumers as wages. The value of the output is, obviously, more than 100u because value is added in production (the Classicists profit, Marx’s surplus value) so let us say the value of the output is 120u. Here comes the problem; the cash in the hands of the worker-consumers is only 100u so how is the capitalist going sell all his commodities? Obviously unless goods can be sold and a profit realised the capitalist will not engage in a second cycle of production, nor will workers have jobs; the whole economy will grind to a halt.

This is Hema Senanayake’s starting point in this little book Indispensable Bad Debt (Author House, 2008). His answer is simple; the credit system does the trick. Credit is needed to bridge what Senanayake calls the ‘economic system gap’ - in the example 20u of credit. Consumers obtain credit from banks (or whoever) and this raises the cash in circulation to 120u, goods are sold, the capitalist recoups his costs with a profit, and a second cycle can start. In fact capital can even expand and investment can increase outlay to 120u next time round. As the cycle repeats, capital grows and so does the indebtedness of the worker-consumer. Therefore, for Senanayake, debt is ‘indispensable’ because without it the system cannot function; it is ‘bad’ because it keeps piling up and worker-consumers will never have the means to pay it back. These ideas are simple, elegant, part explanation of the economic system, and not new – the concepts are implicit in all of classical economics. What is novel is the huge emphasis the author places on one aspect of this process – credit to bridge the ‘economic system gap’ and the implications thereof. But a short digression first.

Expanding the picture

The author does not explain properly, or at least not to my satisfaction, how some of the simplifying assumptions can be dropped without vitiating his result. It can be done, so let me close the loopholes quickly. Let us say in the previous example of the 100u outlay of what we will, from now on, call the consumption goods producing capitalist, 50u was spent in wages, 30u in raw materials and 20u was the value of machinery worn out (depreciation). To get on quickly let us say the whole 30u goes directly to primary raw material producers – there is no loss of generality in this – such as miners, cotton farmers, self-employed component makers and so on. In that case the 30u is added to the 50u as consumption wages to raise consumer demand 80u. Say the machine making capitalist spends 10u on wages, 5u on raw materials bought from primary producers and adds 5u as his profit. This equals the 20u obtained by the machine making capitalist from the consumption goods, that is final marketed commodities making, capitalist.

The consumption good producing capitalist still put down 100u and wants 120u of sales – a profit rate of 20%. The machine making capitalist puts 15u and wants 20u back – a slightly higher profit rate but let that pass; I don’t want to equalise the profit rate and complicate the arithmetic at this point. But the basic problem remains, the purchasing power of worker-consumers is 95u and 25u of credit has to be created. (If the second capitalist spends his 5u profit on consumption goods, then gross demand rises to 100u and the process still requires 20u of credit to reach equilibrium). Leaving aside excessive detail, I think Senanayake drives home his point well. In the capitalist process of production and circulation, cycles of consumer credit, and therefore accumulation of indebtedness is unavoidable. Actually Senanayake says this is true not only of capitalism, but of any money based economy and this too is largely true. Note that his is a simple goods producing economy without a large financial services sector or an asset market prone to bubbles.

Credit creation

The second leg on which this book stands is what is known as the fractional-reserve system by which banks expand credit – they actually make money in a manner of speaking. If the central bank makes a rule that a bank must at all times have at least 10% of its deposits in reserve but can lend out the rest, let us see what happens. If John Singho deposits 100u in the bank, it keeps 10u in its vaults and lends out 90u to, say a businessman. He does his thing and eventually the 90u comes back to the banking system though various hands. Walla! The banking system is allowed to keep 9u in the vault and lend out 81u again; next round, when these money reach the banks they keep 8.1u and lend another 71.9u. If you go on like this you will find that the banking system has lent/relent a total of 900u and has 100u sitting in its vaults. So you see John Singho, when he deposited100u created another 900u of circulating money.

It is this fractional-reserve system (keep a small part and lend the rest) that allows banks to create credit (and earn and re-earn interest) and to match the expanding credit needs of consumers. For Senanayake these two – indispensable credit need, easy credit creation - are the core of today’s, and indeed all capitalist economic crisis, QED. I am afraid the real world is a little more complicated, but more on this anon.

This stuff is all Economics-101but Senanayake devotes the whole of chapter 1 to declaring that conventional economists don’t understand it. Search me why! For example he picks on someone called Ingam ("He had been attached to Cambridge University for over four decade"), quotes a passage, and says Ingam does not explain fractional reserve banking. The quoted passage, however, is perfectly straightforward, accurate and as well stated as in any Econ-101 text. The book suffers from many such sillinesses. The most silly silliness is chapter 3 entitled "Critique of Keynesianism".

Keynesian economics

Keynes is considered the greatest of the depression economists and his work had considerable impact in the years between the Great Depression and the beginning of the post-war boom. In a nutshell, Keynes’ contribution was that he disagreed with the Classical Economists (CE) about the self-perpetuating stability of capitalist market systems. The CEs believed that free markets would always ensure that the system ran at full output (full employment output) and that due to competition prices and wages would always adjust ‘by an invisible hand as it were’ to reach this optimum condition. That is, as conditions change, markets would move the economy to a new optimal equilibrium state quickly.

Keynes analysed depressions and recessions differently; he said it was possible for the system to get stuck for long periods in situations where output and employment were way below these optimal conditions. He said that wages, prices and savings were sticky (can’t change easily for institutional reasons that I have no space to summarise here), that is, they are hard to change, and hence the CEs expectation of reaching a new optimal condition quickly as the economic environment changes can be falsified. Therefore, on such occasions, capitalism’s market mechanism fails to be self-correcting; the intervention of an outside agent, the government, is required. Additional demand must be created, huge stimulus packages and New Deals are in order; the affect of this, egged on by a multiplier-effect, will help the economy recover to full employment and output.

Now there are plenty of critiques of Keynesian economics, especially the Monetarists (Friedman etc), the neo-liberals of the Austrian School and a queer lot known as the Rational Expectations School. Strangely, Senanayake seems to know none of this, but says things like this about Keynes: "because of a great irrational assumption, he missed the target, and that led him to a very wrong analysis" and "there is no basis for Keynesian theory to stand on" and "the . . . methodology above is wrong and so is Keynes’s (sic) methodology". What he means is that Keynes’ analysis is not based on Senanayake’s ‘economic gap’ theory, so he is wrong. The truth is that, right or wrong, Keynes had a very complex theoretical model, he was not concerned very much with the credit problem as developed by Senanayake, but that hardly makes him a fool.

"Cash for Trash"

Paul Krugman’s colourful description of US Government schemes to buy or guarantee ‘toxic assets’ (unreliable mortgages, bonds and securities), is "cash for trash"; meaning, the government won’t get its money back, as much of the stuff is crap and will have to be flushed down the loo. Senanayake’s notions cover only consumer credit (mortgages and credit cards mainly) but the debt problem underlying the Great Crash of 2008 is much wider; the larger portion is within the system of finance capital and includes leverages, credit default swaps and an alphabet soup of derivatives based securities. This cesspit runs into about $600 trillion and a goodly portion of it is trash. Whoever guarantees it, or buys part of it even at a discount, is going to lose out. Kugman’s fears may eventually prove more correct than Guithner’s hopes that risky asset will regain value as the economy recovers and the government may eventually make a profit. This whole problem is a far more complex than anything this slim volume touches and a vast literature now spans print and cyber space.