The UK Government has taken the first tentative steps towards a solution to this crisis with its decision today to give stressed borrowers an interest repayment holiday of up to two years (New scheme to help people at risk of repossession).

The scheme is limited in scope to households that suffer ”a significant and temporary loss of income as a result of the economic downturn to defer a proportion of the interest payments on their mortgage for up to two years”. It also guarantees banks that the deferred payments will ultimately be made.

This is a step in the right direction–towards ultimately debt moratoria. It isn’t enough–because the interest will still be compounded–but it does make the important point that the accrual of interest on debt can be tampered with by legislative means as well as by economic ones.

I favour the legislative approach–which should ultimately include debt moratoria, or a revision of this scheme which involves no accrual of interest and repayments therefore reducing outstanding principal–because I don’t believe the accepted economic approaches to reducing the real debt burden will work.

The standard economic means to reduce the debt burden is to “print money to cause inflation”. Ben Bernanke himself is famous for the following remark:

If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. (Bernanke, Deflation: Making Sure “It” Doesn’t Happen Here)

I have little confidence in this mechanism. It is predicated on a Monetarist theory of money, in which, to quote the Godfather, “Inflation is always and everywhere a monetary phenomenon” (Milton Friedman, A Monetary History of the United States 1867-1960). It is possible to substantially agree with this argument and still argue that government printing of money won’t cause inflation–because Milton Friedman’s “model” of money completely ignored the existence of credit money.

Here is Milton’s model of money creation and how that engenders inflation:

Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated…

… When the helicopter starts dropping money in a steady stream … it takes time for people to catch on to what is happening…  As people catch on, prices must for a time rise even more rapidly, to undo an initial increase in real balances as well as to produce a long-run decline… (Friedman, “The Optimum Quantity of Money”, in THE OPTIMUM QUANTITY OF MONEY AND OTHER ESSAYS, pages 4-5 and 13)

IF a helicopter flying over the land dispensing largesse  (otherwise known as the Central Bank creating M0) was the only manner in which money could be created, and IF there was no private debt, and IF the economy was in long run general equilibrium and prices prior to the helicopter drop were therefore equilibrium prices… then this approach would work.

Yeah, right…

Instead, in the real world in which we live, financial institutions control the creation of money, private debt is at unprecedented levels, and the global economy is rapidly transiting from a far-from-equilibrium debt-financed boom into a far-from-equilibrium debt-induced crash in which the price of everything is totally out of whack.

In this world, government creation of M0 will be sent straight to the banks to reduce debt levels. The impact on turnover of goods and therefore prices will be minimal. Deflation will continue, and could do so for years as the government effectively swaps base money for credit money–only to see the absolute money supply drop. This was the Japanese experience.

Ultimately, I expect that the failure of the economy to respond to this Friedmanite tonic will result in a profound shift in politics, in which the unthinkable today will become policy: that much of the debt that the financial sector issued especially in the last two decades should never have been created in the first place, and it should be abolished–in conjunction with substantial reforms to financial assets that prevent a similar debt-bubble in the future.

We are still a very long way from that change in consciousness, but this move by the UK government is a first step towards it.