“The rich ruleth over the poor, and the borrower is servant to the lender.” – Book of Proverbs, Old Testament
In the previous posts, I have often linked gold and Bitcoin to an equity based monetary system and linked fiat money to a debt based monetary system. What is the difference between the two systems, and what are their implications?
An equity based monetary system, like the gold standard, is one where money creation and usage is based on the production of a real asset which is driven by free markets. For notes to be issued by banks, they had to be backed by a precise quantity of gold. As we have seen in the previous post Bitcoin, Gold and Fiat, gold is very difficult to produce, and is thus very inelastic to demand, which is key for the preservation of value and wealth because production can’t be increased at will, leading to debasement. The notes that were issued by banks were redeemable in specie, meaning that there was a legal obligation for banks to exchange notes for gold. Therefore, if you were to hold your wealth through gold at a certain bank, and it came to your attention that your bank was printing more notes than it held gold, you had the right and the bank had the obligation to exchange your notes for gold thus allowing you to take your gold out of the banking system or deposit your gold in a more responsible bank. If you were last to redeem your gold from a bank inflating its supply of notes, chances are that you could lose part or all your wealth. Central banks were created to alleviate the problem related to runs on banks for these institutions that were irresponsibly overstretching their balance sheets.
Central banks are cornerstone in a debt based monetary system. This system runs on the underlying principles of the perpetuation of debt and interest through the creation of debt backed by debt. Therefore, the money you hold in your wallet or in your account is debt backed by an obligation to pay in the future. Here is an example of how this works. When the FED judges that the economy needs easing in terms of monetary policy, it lowers the federal fund rates through its Federal Open Market Committee (FOMC) by purchasing government obligations (assets) and creating money (liabilities). The money created, federal notes or equivalently electronic funds, are not redeemable by any commodity under the Federal Reserve Act of 1913, but are collateralized on debt assets owned by the FED. So, debt is backed by debt, and therefore money is debt and under the debt based monetary system of fractional banking, money can be expanded and contracted at will, with not much efforts.
Debt transcends into all the facets of the financial economy. Markets use governments debt to establish the risk-free rate in defining the pricing of most capital assets. Pretty much all the world considers US Treasury bonds the safest asset there is. Why? In their book “This Time is Different: Eight Centuries of Financial Folly”, Carmen Reinhart and Kenneth S. Rogoff provide insightful information regarding debt markets in the world and the US from 1800 to 2010. Although there have been many cases of currency, inflation and banking crises, stock market crashes and domestic debt crises, the US has never had, so far, an external sovereign debt crisis. That’s the reason why US Treasury equals risk-free in the minds of investors, as seen during the Great Recession. As the successes of the US to avoid such crises is well known, the failure of other countries is also well known. Think about Zimbabwe, Venezuela, Argentina and many other countries which have inflated their money supply because of debt default or to prevent debt default with catastrophic consequences.
To understand the institutionalization of debt in the world, see below a graph illustrating the position of the US regarding total debt and money supply:
As per the graphs of previous posts, you can observe here a change of trend in 1973, the year the gold standard was abandoned. In 1973, total debt in the US was 2.05 trillion USD with a GDP of 1.38 trillion USD, or put it differently, 1.48 USD of debt contributed to 1 USD in GDP. At the end of Q3 2017, total debt in the US was a whopping 70 trillion USD with a corresponding GDP of 20 trillion USD, or 3.5 USD of debt for 1 USD of GDP. What this means is that, under the current debt monetary system, more debt is needed to maintain a steady growth of GDP.
Yes, the intervention of the FED did manage to generate growth and stabilize total debt to GDP. However, we need to consider two things.
First, total debt reversed its short-lived fall in growth relatively quickly and is gaining momentum. Therefore, in the current monetary policy environment, it is highly probable that the debt bubble will shift to another sector of the economy, which will pressurize the total debt to GDP ratio to increase again.
Second, GDP growth in the aftermath of the Great Recession was not entirely a direct consequence of real productivity gains, innovation and creativity, but rather was a feat of monetary policy and financial innovation. When the FED intervened, it expanded MB by a factor slightly greater than 4 over the period of 2008-2014, from 900 billion to 4 trillion USD, with various conventional monetary policy tools under the FOMC activities by purchasing US Treasury bonds, but also by engaging into unorthodox monetary policies such as quantitative easing by purchasing toxic securities like MBSs and the likes. The intent of this strategy was to re-liquify the credit markets since debt is necessary to create economic growth. Remember that in the past, the FED created money that was collateralized on ‘’risk-free” securities. But during the Great Recession, newly created money was also partly collateralized on risky and toxic assets which are still on the FED’s balance sheet and are still being promoted in the banking system.
This “financial engineering” is precisely the element which brought upon us the Great Recession in the first place, and which brought upon us various previous credit crises.
Indeed, debt securities have been central to the rise of financial, banking and economic crises since it began to be institutionalized in 1973. Still in the book “This Time is Different: Eight Centuries of Financial Folly”, Reinhart and Rogoff propose the following graph:
What this graph illustrates is very interesting.
The pre-Bretton Woods era, up to the beginning of WW1, was characterized by a relatively stable share of countries in banking crisis, between 5 and 10 percent. The panics of 1893, 1903 and 1907 were periods in which the general public loss confidence in the value of money in the case of 1893 (Sherman Silver Purchase Act of 1890) and in the banking system with respect to the panics of 1903 and 1907. The period covering the two world wars was disastrous as the share of countries experimenting banking crises was high, with an all time high reached during the occurrence of the Great Depression in the early 1930s. From the early 1800s to the end of WW2, the durations of banking crises were relatively narrow, although not painless.
Under the equity based monetary system of Bretton Woods, established in 1944, the world economy enjoyed a peaceful period of almost 30 years, with a negligible share of countries in banking crises. However, the abandonment of the gold standard under Bretton Woods in 1973 led to an increase in the share of countries in banking crisis which durations were far greater than for the period of 1800-1914. For anyone having experienced a debt crisis, this is not surprising: debt gives rise to uncertainty and instability. The growing stock of debt since 1973 has fuelled the strength, duration and occurrences of banking crises.
In my opinion, the two graphs presented above are very illustrative of the properties of a debt based monetary system, demonstrating that money as we know it is not an asset but is debt, that fractional banking is cornerstone in the perpetual growth of the total debt stock, and that debt is central in the unravelling of banking crises.
Another negative aspect of a debt based monetary system is the introduction of important moral hazards that are sustained in the perpetuation of debt.
First, the master piece of the system consists in the establishment of central banks. Most Central Banking Acts around the world provide central banks with independence regarding monetary policy making. However, most central banks have board of directors who are typically selected by governments’ executive branches and officialised by the legislative branches. Therefore, the very structure of authority of the government on the central bank makes the claim of independence questionable since there exists a link between a central bank and a government. Additionally, under law, central banks must hand over profits to governments. Although central banks’ purpose is not to engage in profits generation, it is not straightforward to completely decouple the typical shareholder’s pressure on an institution in the quest for profits. There exist many examples of the predatory position of governments towards central banks in the world because of the organizational structure of central banks, most notably in emerging countries like Venezuela, Zimbabwe, Argentina, Turkey, and many more, which are subject to the intense pressure of populism and which has led to catastrophic consequences.
Second, a debt based monetary system incentivizes governments to expand their societal mandate. Take for example US federal agencies like Fannie Mae and Freddie Mac, which had as an objective upon their creation the expansion of the American dream of owning a house by subsidizing the issuance of mortgages to risky individuals. With the safety net of the Federal Deposit Insurance Corporation (FDIC), commercial banks are incentivized to gamble with public funds for the sole purpose of increasing credit for the achievement of the endless desire to expand the economy at all costs. This situation led to excesses which in turn delivered the great credit contraction under the Great Recession. At that point, only the FED could intervene to re-liquify credit markets and re-capitalize banks, by purchasing toxic debt-based assets and acting as a bad bank. Federal agencies and enterprises are great vehicles for governments to win over the electorate by making social issues, such as housing and different subsidies, leading government policies. Ultimately, debt represents the best solution available to governments for their expansions through irresponsible social and fiscal policies.
Third, a debt based monetary system introduces market inefficiencies. Think about the stories of the bridges and roads to nowhere and the ghost cities in China. Massive investments with no economic fundamentals were made with money created out of thin air for no reason other than for maintaining a target for GDP growth. This kind of policies leads to a faulty allocation of resources and capital and reduce the probability of more meaningful projects to be undertaken.
Finally, the debt based monetary system creates a system of elitism and clientelism. The results of the earlier post Bitcoin: Sound Money and Equality shows that inequality in the US started growing large again between the top 10% and the bottom 90% of the population when the debt system was fully unleashed in the 1980s. Access to credit for leverage is accessible at low cost to the wealthiest during good times, effectively increasing income inequality. Similarly, during recessions, credit is eased and facilitated mainly for the top 10%. Who really benefited from the real estate crash during the Great Recession to purchase properties at deflated costs? Who really benefited from the surge of stock markets by leveraging their positions with debt? During difficult times, credit creation collapses mainly because banks stop lending to 90% of the population who, as we have seen in the earliest post Bitcoin: Sound Money and Equality, do not hold enough assets to secure loans. However, the top 10% of the population, owning 80% of the wealth, maintain its unlimited access to credit to leverage their positions at all time.
I could go on with other examples of flaws in a debt based monetary system, but I will stop here.
The objective of this post was to compare equity versus debt based monetary systems.
We have first determined the very difference between the two systems. Equity based monetary systems tend to keep the management of the monetary base out of the hands of politicians by relying of the involvement of free markets in the production of a defined asset, like gold or Bitcoin. On the other hand, debt based monetary systems like fiat are established such that money constitutes debt because it is collateralized against debt. Furthermore, fractional banking allows the money supply and debt to be expanded at worrying levels.
The graphs in this post illustrated once again an important trend shift in 1973, the year the gold standard, and thus an equity based monetary system, was abandoned. Indeed, we have seen that in 1973, the trend in total debt started expanding exponentially. At first sight, the increase in total debt seems to be positively correlated with GDP growth. However, what we have seen is that to maintain GDP growth within an ‘’acceptable’’ threshold, the ratio of total debt to GDP needs to grow at a faster rate, meaning that ever more debt, and thus money created out of thin air, is necessary to maintain current economic growth. The increase of total debt is historically associated with instability as we have seen with greater occurrences of banking crises having longer durations. Therefore, the situation hardly seems sustainable.
Why did the system change from an equity to a debt based monetary system in the first place anyways? Remember that, as discussed in Bitcoin: Sound Money and Socio-Economic Prosperity in the case of the resignation of FED chairman William McChesney Martin, a sound money system like the gold standard was a hurdle to politicians because it constrained their electoral promises to grow the economy. It is widely accepted and proven that the electorate disproportionally view the economy as the most important parameter when they vote, as suggested by the below figure:
By decoupling money completely from a real asset in favor of an asset constituting a promise to pay (debt), the government found a way to impose its view on how an economy should be managed. The debt based monetary system under fiat is plagued with moral hazards which allow governments’ size to expand beyond their social mandates and to impose irresponsible fiscal policies on the mass. It also supports societal segregation by allowing the banking system to be at the services of the wealthiest, leading to increased social inequality. Most importantly, the world has developed an obsession with GDP growth, an obsession fulfilled and fueled by debt, which is not sustainable for social and environmental reasons.
It also needs to be reminded that sound money is key to social stability, as proven by history. Debasement has always led to inflationary environment and increased inequality, which has in most cases always resulted in severe social revolutions.
The historical purpose of money has always been the following: a medium of exchange, a unit of account and a store of value. Unlike gold and Bitcoin, fiat money does not espouse the concepts of store of value which is cornerstone in the betterment of everybody in society.
Gold has constituted for nearly 6,000 years the preferred equity based monetary system for the reasons defined in the previous post Bitcoin, Gold and Fiat. Because of its recognized properties, gold has been the favored media of store of wealth and money because its supply can’t be inflated by operating machines like printing presses. These properties are enhanced with the evolution of Bitcoin, which is much more difficult to confiscate than gold.
In the next post, I will review the concepts of inflation and deflation (or low inflation). We will discuss how inflation is cornerstone to the constant increase of debt and credit.