“The rich ruleth over the poor, and the borrower is servant to the lender.” – Book of Proverbs, Old Testament
In the previous post, Bitcoin: Equity vs Debt Based Monetary Systems, we have seen how a debt based monetary system like fiat encourages the expansion of money through the perpetuation of debt. The creation of money out of thin air increases the money supply, which typically generates inflation. Inflation is a key parameter on the dashboard of central banks because it is essential to promote the growth of the economy through the growth of the debt stock, fuelled by consumption.
In this post, we will review the concept of inflation, which is cornerstone is the sustainment of the fiat monetary system and investigate what are the ramifications of lower inflationary or slightly deflationary monetary policy environments.
The debate between an equity based monetary system like Bitcoin or gold and a debt based monetary system like fiat regards each system’s flexibility regarding money supply. As discussed in the previous post, money supply under an equity based monetary system is tied to the production of an asset whereas money supply under a debt based monetary system can be theoretically expanded without any ceiling, as per the examples of Weimar Germany or Zimbabwe. Proponents of the credit theory of money, who are adepts of debt based monetary systems, claim that equity-based systems like gold and Bitcoin are deflationary by nature. This claim is not true. Remember this graph from a previous post Bitcoin, Gold and Fiat:
As can be seen, gold production (green) and Bitcoin production (orange) are positive, decreasing and stable compared to fiat. Therefore, gold and Bitcoin are currently not deflationary, but slightly inflationary. Low inflation is seen as deflationary in the eye of the proponents of the perpetual growth of debt since it can’t be controlled at will. For the intent of this post, we will pretend that indeed, gold and Bitcoin are currently mainly deflationary.
What exactly is inflation? People tend to think about inflation as the rate of increase of prices in general. I prefer to look at it in a different angle: inflation is the rate at which the purchasing power of money decreases. Inflation therefore represents a tax on wealth because it reduces real interest rates. Central banks in developed economies typically target an inflation target of 2% per year. This threshold is generally higher in developing economies. For example, the Reserve Bank of India maintains inflation between 2% and 6%.
What about deflation? Well it is the opposite of inflation. Namely, it is the rate of decrease of prices in general, or said differently, it is the rate at which money’s purchasing power increases. Deflation therefore represents a dividend on wealth because it increases real interest rates.
In which universe is a tax more desirable than a dividend? In a universe denominated by debt.
When central banks need to stimulate or slow down the economy, their intent is to modulate money supply with the expected objective of producing or reducing inflation, which in turns lowers and increases real interest rates, respectively. Take the example of the US Federal Reserve Bank during the Great Recession of 2007-2008. Once credit started to contract and debt defaults started to plague the financial system, the economy began to cool down. Prices started receding and households were reluctant to maintain their pre-crisis expense patterns in the face of uncertainty. In a nutshell, households were unwilling to keep spending because the burden of debt contracted through credit cards, mortgages and other debt facilities was becoming to high to support. The FED reduced its federal fund rate (nominal) to 0% and developed other unorthodox monetary policy tools to trigger inflation and repress real interest rates. Monetary tightening works similarly, but in reverse.
Although at first glance it may seem like a friendly gesture to reduce the debt burden of households, the problem is that central banks’ expansionist monetary policies incentivize households to spend more because the lowering real interest rates through inflation reduces their purchasing power. In other words, central banks’ approach to a debt problem is to solve it through the issuance of more debt in order to promote inflation and repress real interest rates. You might remember hearing during the Great Recession many economists claim that it was counterproductive for a government not to increase debt when the growth in debt service payment is lower that GDP growth, or heard Milton Friedman’s “famous” quote of “helicopter money” to increase personal debt to bolster consumption, again, with the objective to service our obsession with GDP growth.
When you know that your money’s purchasing power is decreasing, and that it is worth less, you tend to spend it right away.
As mentioned before, society is obsessed with GDP growth, and GDP growth is possible only through the perpetuation of debt fuelled by consumption. To illustrate this claim, see below a graph illustrating the relationship between personal savings, inflation and personal expenditures as a percentage of GDP:
When inflation increases, the above graph proves that people reduce their savings, and thus favour consumption right away instead of saving money for harder time or for their retirements. Note how falling personal savings is corelated with an increase of personal expenditures as a percentage of GDP.
However, when inflation or deflation runs low, households tend to delay expenditures in favour of more noteworthy project undertakings such as savings and investment to shield for future economic downturns or to prepare their retirement plans. Notice how, on the graph above, low inflation resulted in higher personal savings, and consequently, in a decreasing share of personal expenditures in the overall GDP. For politicians and the banking system, this is precisely the problem.
In a previous post Bitcoin: Sound Money and Socio-Economic Prosperity, we have seen that most of the US population are wage earners, and that real wages have been stagnating for over 45 years since the abandonment of the gold standard. We have seen that real wages were “neutralized” because of the sharp devaluation of the dollar, and because of the inflationary environment made possible under a debt based monetary system. Since wage earners saw their money’s purchasing power degrading, they increased consumption which lowered their positions in savings. This is exactly what we see again in the graph above.
Where does this fear of decreasing inflation comes from? From the occurrence of one of the most traumatizing economic downturns in modern history: The Great Depression of the 1930s. Keynesians exclusively blame the gold standard for making the Great Depression worst. Yet, they forget to mention that politicians and central banks economic competency were questionable in the post WW1 era, and that the world banking system’s solvency was greatly overstretched by the war’s economic destruction, hyperinflation and the massive increase in the total world debt stock required to wage war and in war reparations. All of these facts resulted in a failing banking system, which investors and citizens rightfully decided to run away from by pulling their deposits out of banks in favour of gold ownership. This in turn triggered President Roosevelt’s Executive Order 6102, making the private ownership of gold illegal in order to return gold to the banking system.
From that event up to now, Keynesians and proponents of the credit theory of money have argued that during economic instability, central banks have the duty to relax monetary policy and governments have the duty to relax fiscal policies to escape deflation at all costs. Households, being the prime contributor to GDP growth through personal expenditures, are the prime targets to mitigate debt deflation by engaging in more consumption supported by more debt and higher inflation. Therefore, more debt is required to cover for the irresponsible monetary policies and financial excesses of the past, resembling to a downward spiral with no end in sight.
The adherents of loose money point out that, notwithstanding the occurrence of economic downturns, inflation is necessary no matter what, and that deflation leads to the impoverishment of society. This claim is absolutely false. First, because what some economists seem to fail to recognize is that the deflationary environment of the Great Depression and the Great Recession, for example, was a direct consequence of the inflationist monetary policies which promoted the perpetuation of debt. As we have seen in Bitcoin – Sound Money and Equality, the share of wealth of the bottom 90% of the population of the US fell in 2008 because of the excessive levels of debt.
Second, Keynesians argue that falling prices are bad for the economy. There are various instances whereby falling prices are good for the economy, when this occurs as a result of competition. See below figure:
The figure above illustrates consumer price indexes for electronic goods, a proxy for creativity, innovation and productivity, concepts which are cornerstone to assess the wealth of an economy. As can be observed, the prices of top end technology electronic goods have decreased significantly since 1997. The reasons behind those falling prices is competition, which allow the development of new technologies and market share strategies by manufacturers, to the benefit of consumers.
Finally, remember that, as we have seen in the post Bitcoin: Sound Money and Equality, the period of the early 1870s to 1900s represented one of the most prosperous in the history of the US and which was characterized by consumer price index regressing by 30% (Wikipedia):
During that period of deflationary environment, the economy doubled in size, productivity sky-rocketed and real wages consequently increased.
What we have seen in this post and the earlier post Bitcoin: Equity vs Debt Based Monetary Systems is the relationship of interdependence between debt and inflation. Debt typically causes inflation and inflation is absolutely necessary for debt to be perpetuated. And in a system denominated by debt, debt is cornerstone in the pursuit of society’s obsession regarding GDP growth as displayed on the graph below:
Notice how, after 1973, the yearly growth in total debt started to surpass yearly GDP growth, and how inflation and total debt are intimately correlated.
While the wages of wage earners in the US has stagnated since the abandonment of the gold standard in 1973, households have maintained their living standards and wealth through the accumulation of debt, which is cornerstone in the obsession to achieve economic growth at all cost. Maintaining real interest rates low by manipulating inflation through expansive monetary policies favoring the perpetual growth of debt has incentivized households to participate in hyper-consumerism since they don’t see the benefits of deferring consumption while their wealth is constantly being eroded by a tax called inflation.
The current debt based monetary system has effectively turned society in a quasi state of consumption feudalism whereby the system provides means of partial and full ownership of various types of assets to members of society in exchange for hyper-consumption and the perpetual growth of debt and payment of interest.
Equity assets such as gold and Bitcoin are extremely important to hedge our exposure from the folly of the current debt based monetary system which rely on inflationary environments to reduce the debt burden of debtors, encouraging them to consume even more at the expense of saving.
This inflationary environment has led to the erosion of the purchasing power of major currencies since 1973, due to the abandonment of the gold standard:
The dramatic increase in the gold price since 2002, from approximately 250 USD per ounce to a peak of 1,800 USD per ounce in 2011, shows a lost of confidence in major currencies and in the global monetary policy given the endless erosion of the purchasing power of fiat money under an inflationary environment.
Of particular interest, Bitcoin has also significantly appreciated versus major currencies, especially the US dollar:
This appreciation of Bitcoin versus major currencies is not solely linked to speculation as Bitcoin’s detractors suggest, but to a growing understanding of Bitcoin’s core properties of being an equity asset, having a hard cap on the supply of Bitcoins and its decentralized nature. Its ownership allows people to hedge their exposure to the current debt based monetary system of fiat, similarly to gold. Its nature limits monetary supply growth and thus the inflation required to perpetuate debt, which is immoral. Instead of seeing wealth eroded by an inflationary tax, the supply cap of Bitcoin provides appreciation upside in time, and acts as a dividend on wealth.
I strongly believe, as discussed in earlier posts, that equity based monetary systems are key for intra and inter-generational societal equality because such systems use assets as collateral instead of debt. Not only would wealth be distributed more fairly across society, it would also allow households to become more responsible financially by deferring consumption in time in favour of savings. A decrease in consumption would furthermore re-enforce the concept of intra and inter-generation equality with respect to the management of the environment.