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How the Paper Money Experiment Will End – Philipp Bagus – Mises Daily

How the Paper Money Experiment Will End – Philipp Bagus – Mises Daily.

A paper currency system contains the seeds of its own destruction. The temptation for the monopolist money producer to increase the money supply is almost irresistible. In such a system with a constantly increasing money supply and, as a consequence, constantly increasing prices, it does not make much sense to save in cash to purchase assets later. A better strategy, given this senario, is to go into debt to purchase assets and pay back the debts later with a devalued currency. Moreover, it makes sense to purchase assets that can later be pledged as collateral to obtain further bank loans. A paper money system leads to excessive debt.

This is especially true of players that can expect that they will be bailed out with newly produced money such as big businesses, banks, and the government.

We are now in a situation that looks like a dead end for the paper money system. After the last cycle, governments have bailed out malinvestments in the private sector and boosted their public welfare spending. Deficits and debts skyrocketed. Central banks printed money to buy public debts (or accept them as collateral in loans to the banking system) in unprecedented amounts. Interest rates were cut close to zero. Deficits remain large. No substantial real growth is in sight. At the same time banking systems and other financial players sit on large piles of public debt. A public default would immediately trigger the bankruptcy of the banking sector. Raising interest rates to more realistic levels or selling the assets purchased by the central bank would put into jeopardy the solvency of the banking sector, highly indebted companies, and the government. It looks like even the slowing down of money printing (now called “QE tapering”) could trigger a bankruptcy spiral. A drastic reduction of government spending and deficits does not seem very likely either, given the incentives for politicians in democracies.

So will money printing be a constant with interest rates close to zero until people lose their confidence in the paper currencies? Can the paper money system be maintained or will we necessarily get a hyperinflation sooner or later?

There are at least seven possibilities:

1. Inflate. Governments and central banks can simply proceed on the path of inflation and print all the money necessary to bail out the banking system, governments, and other over-indebted agents. This will further increase moral hazard. This option ultimately leads into hyperinflation, thereby eradicating debts. Debtors profit, savers lose. The paper wealth that people have saved over their life time will not be able to assure such a high standard of living as envisioned.

2. Default on Entitlements. Governments can improve their financial positions by simply not fulfilling their promises. Governments may, for instance, drastically cut public pensions, social security and unemployment benefits to eliminate deficits and pay down accumulated debts. Many entitlements, that people have planned upon, will prove to be worthless.

3. Repudiate Debt. Governments can also default outright on their debts. This leads to losses for banks and insurance companies that have invested the savings of their clients in government bonds. The people see the value of their mutual funds, investment funds, and insurance plummet thereby revealing the already-occurred losses. The default of the government could lead to the collapse of the banking system. The bankruptcy spiral of overindebted agents would be an economic Armageddon. Therefore, politicians until now have done everything to prevent this option from happening.

4. Financial Repression. Another way to get out of the debt trap is financial repression. Financial repression is a way of channeling more funds to the government thereby facilitating public debt liquidation. Financial repression may consist of legislation making investment alternatives less attractive or more directly in regulation inducing investors to buy government bonds. Together with real growth and spending cuts, financial repression may work to actually reduce government debt loads.

5. Pay Off Debt. The problem of overindebtedness can also be solved through fiscal measures. The idea is to eliminate debts of governments and recapitalize banks through taxation. By reducing overindebtedness, the need for the central bank to keep interest low and to continue printing money is alleviated. The currency could be put on a sounder base again. To achieve this purpose, the government expropriates wealth on a massive scale to pay back government debts. The government simply increases existing tax rates or may employ one-time confiscatory expropriations of wealth. It uses these receipts to pay down its debts and recapitalize banks. Indeed the IMF has recently proposed a one-time 10-percent wealth tax in Europe in order to reduce the high levels of public debts. Large scale cuts in spending could also be employed to pay off debts. After WWII, the US managed to reduce its debt-to-GDP ratio from 130 percent in 1946 to 80 percent in 1952. However, it seems unlikely that such a debt reduction through spending cuts could work again. This time the US does not stand at the end of a successful war. Government spending was cut in half from $118 billion in 1945 to $58 billion in 1947, mostly through cuts in military spending. Similar spending cuts today do not seem likely without leading to massive political resistance and bankruptcies of overindebted agents depending on government spending.

6. Currency Reform. There is the option of a full-fledged currency reform including a (partial) default on government debt. This option is also very attractive if one wants to eliminate overindebtedness without engaging in a strong price inflation. It is like pressing the reset button and continuing with a paper money regime. Such a reform worked in Germany after the WWII (after the last war financial repression was not an option) when the old paper money, the Reichsmark, was substituted by a new paper money, the Deutsche Mark. In this case, savers who hold large amounts of the old currency are heavily expropriated, but debt loads for many people will decline.

7. Bail-in. There could be a bail-in amounting to a half-way currency reform. In a bail-in, such as occurred in Cyprus, bank creditors (savers) are converted into bank shareholders. Bank debts decrease and equity increases. The money supply is reduced. A bail-in recapitalizes the banking system, and eliminates bad debts at the same time. Equity may increase so much, that a partial default on government bonds would not threaten the stability of the banking system. Savers will suffer losses. For instance, people that invested in life insurances that in turn bought bank liabilities or government bonds will assume losses. As a result the overindebtedness of banks and governments is reduced.

Any of the seven options, or combinations of two or more options, may lie ahead. In any case they will reveal the losses incurred in and end the wealth illusion. Basically, taxpayers, savers, or currency users are exploited to reduce debts and put the currency on a more stable basis. A one-time wealth tax, a currency reform or a bail-in are not very popular policy options as they make losses brutally apparent at once. The first option of inflation is much more popular with governments as it hides the costs of the bail out of overindebted agents. However, there is the danger that the inflation at some point gets out of control. And the monopolist money producer does not want to spoil his privilege by a monetary meltdown. Before it gets to the point of a runaway inflation, governments will increasingly ponder the other options as these alternatives could enable a reset of the system.

Note: The views expressed in Daily Articles on Mises.org are not necessarily those of the Mises Institute.

Comment on this article. When commenting, please post a concise, civil, and informative comment.
Philipp Bagus is an associate professor at Universidad Rey Juan Carlos. He is an associate scholar of the Ludwig von Mises Institute and was awarded the 2011 O.P. Alford III Prize in Libertarian Scholarship. He is the author of The Tragedy of the Euro and coauthor of Deep Freeze: Iceland’s Economic CollapseThe Tragedy of the Euro has so far been translated and published in GermanFrenchSlovakPolishItalianRomanianFinnishSpanishPortugueseBritish EnglishDutchBrazilian PortugueseBulgarian, and Chinese. See his website. Send him mail. Follow him on Twitter @PhilippBagus See Philipp Bagus’s article archives.


The Mythical Merits of Paper Money

The Mythical Merits of Paper Money.

One economic myth is that paper money is wealth. The proponents of big government oppose honest money for a very specific reason. Inflation, the creation of new money, is used to finance government programs not generally endorsed by the producing members of society. It is a deceptive tool whereby a “tax” is levied without the people as a whole being aware of it. Since the recipients of the newly created money, as well as the politicians, whose only concern is the next election, benefit from this practice, it’s in their interest to perpetuate it.

For this reason, misconceptions are promulgated about the “merits” of paper money and the “demerits” of gold. Some of the myths are promoted deliberately, but many times they are a result of convenient rationalizations and ignorance.

Paper money is not wealth. Wealth comes from production. There’s no other way to create it.

Paper money managers and proponents of government intervention believe that money itself — especially if created out of thin air — is wealth. A close corollary of this myth — which they also believe — is that money supply growth is required for economic growth.

Paper money is not wealth. Wealth comes from production. There’s no other way to create it. Capital comes from production in excess of consumption. This excess is either reinvested, saved, or loaned to others to be used to further produce and invest. Duplicating paper money units creates no wealth whatsoever, it distorts the economy, and it steals wealth from savers. It acts as capital in the early stages of inflation only because it staels real wealth from those who hold dollars or have loaned them to someone.

Instead of economic growth being dependent on money growth as the paper money advocates claim, great economic harm comes from central banks creating new money out of thin air. This leads to the sort of economic stagnation and economic decline that we are experiencing today. Inflation — increasing the supply of paper money — is the cause of malinvestment and the business cycle, and literally destroys the capital needed for economic growth and stability. The formation of capital through savings is discouraged or eliminated by a paper money system. Instead of paper money producing economic growth, it accomplished the opposite. If money growth were necessary for economic growth, the 1970’s would have been a great decade. During this period of time the Federal Reserve nearly tripled the total money supply but the economy grew only 37 percent.

Although the supply under a gold standard would in all probability increase at the rate of two to three percent per year, this growth is not a requirement for gold to function as a sound currency. This natural or market increase in the money supply easily accommodates population growth and economic growth as long as prices are freely adjusting.

If population or economic growth presents a need for “more” purchasing media, prices merely adjust downward if the money supply is not growing. In the latter part of the nineteenth century this occurred. Wholesale prices dropped 47 percent from 1879 to 1900 and economic growth averaged nearly four percent per year. Obviously, although prices were decreasing, there was no depression. While an increase in the supply of money is never needed to produce economic growth, under a gold standard there might be honest money growth (i.e. not money created out of thin air by the politicians and bankers for the benefit of special interests) and this would serve to smooth out price adjustments.

The myth that paper money is wealth has another corollary: the myth that there’s “not enough gold” for reestablishing a gold standard. But this is merely a device used by paper money advocates to confuse the uninformed, and should carry no weight in the debate of gold versus paper. Hans Sennholz explains this clearly in his essay “No Shortage of Gold”:

On the other hand, if the supply of goods increases while that of money remains unchanged, a tendency toward enhancement of the purchasing power of money results. This fact is probably the most popular reason advanced today for policies of monetary expansion. “Our expanding national economy,” economic and monetary authorities proclaim, “requires an ever-growing supply of money and credit in order to assure economic stability.”

No one can seriously maintain that present expansionary policies have brought about economic stability. During the last forty years of almost continuous monetary expansion, whatever else it may have achieved, did not facilitate economic stability. Rather it gave our age it’s economic characteristic — unprecedented instability.

Ludwig von Mises, in his book A Critique of Interventionism (1929), clearly denounces the belief that government can create wealth by printing paper money. He explains:

By its very nature, a government decree that “it be” cannot create anything that has not been created before. Only the naive inflationists could believe that government can create anything; its orders cannot even evict anything from the world of reality, but they can evict from the world of the permissible. Government cannot make man richer, but it can make man poorer.

This is a powerful political and economic message, and yet it seems that so few understand it. Unfortunately, the poorer the people get, the moe economic problems we have, the more inflation we endure, and the higher the interest rates go, since more people demand government intervention. This trend has to be changed if we expect to preserve our freedoms and our standard of living.

Fact: Paper money is not wealth, it steals wealth.

A second myth is that “easy” money causes low interest rates. This myth is based on the erroneous assumption, itself a myth about government, that government officials — the Federal Reserve Board, the Congress, or the Treasury — can actually set interest rates. In reality the market determined interest rates. Governments can dictate rates, but if these rates are contrary to the market, government will not achieve the intended goal. For instance, if a usury law establishes a ten percent interest rate and the market rate if fifteen percent, no funds will be available except those allocated through government force and the creation of new money.

One reason this myth is so persistent is that in the early stages of inflation, an “easy” monetary policy temporarily lowers interest rates below market levels. Before the people are aware of the depreciation of their currency and do not yet anticipate higher prices, the law of supply and demand serves to lower “cost” of money and interest rates fall. But when the people become aware of the depreciation of the dollar’s value and anticipate future loss of purchasing power, this prompts higher interest rates due to inflationary expectations.

This expectation of future inflation and higher risk is determined subjectively by all borrowers and lenders and not by an objective calculation of money supply increases. These increases in the money supply certainly are important and contribute to the setting of the interest rates, but they are not the entire story. Interest rates vary from day to day, week to week, and year to year. There is no close correlation between money supply figures and interest rates.

Crises and panics can occur for political as well as financial reasons; and interest rates can be pushed higher than monetarist theory says they “should be.” In the early stage of inflation, rates may be lower than they “should be,” and in the latter stages frequently are higher than they “should be,” if by “should be” one means commensurate with money supply growth. Nevertheless, wrong ideas die slowly. “Easy” money, that is, inflation of the paper money supply, is still thought of as an absolute method by which the monetary authorities can achieve low interest rates.

This is not to say the Federal Reserve is helpless in manipulating interest rates. If it alters the discount rate and injects new money into the market, the immediate reaction can be that of lowering rates. But a gold-backed dollar, even if only partially backed, is a different sort, and at the time of the ’30s and the ’40s rates were at historic lows.

If the demand for lower interest rates is great enough and not accompanied by a call for sound currency — gold — the politicians will be “forced” to accommodate the demand by means of massive inflation of the money supply with strict credit controls and credit allocation. This would solve nothing, would serve to worsen economic conditions, and real interest rates in the markets would eventually soar. There is no substitute for sound money, and the sooner we realize this the better.

“Easy” money causes hard times.


Ron Paul
for The Daily Reckoning

Excerpted with permission from Dr. Paul’s FREE Foundation work

Ed. Note: People blindly trust that “easy money” will bring about growth. They assume that those in power know what they’re doing and that, in the end, the U.S. is simply far to great to fall into the traps that have snared so many other countries throughout history. Of course, you know better. But this is only half the story. The other half is detailed every day in The Daily Reckoning email edition. To get the full analysis, sign up for the FREE Daily Reckoning email edition, right here.

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Posted Oct 1, 2013.

Stay tuned for a scene right out of the hit TV show, The Walking Dead. Although, instead of human zombies, expect to see a growing army of zombie dollars. Byron King explains…

Ron PaulDr. Ron Paul is a former Republican member of Congress from Texas and perhaps the only voice in Washington still advocating “limited” government in the Jeffersonian tradition. He has delivered several stunning addresses before Congress, including: “Sorry, Mr. Franklin, We Are All Democrats Now” and “We’ve Been Neo-Conned.” Ron Paul is also the author of The Revolution: A Manifesto,End The FedLiberty Defined, and The School Revolution: A New Answer for Our Broken Education System.

What Is A Gold Standard? | Zero Hedge

What Is A Gold Standard? | Zero Hedge.

Given our earlier discussion of Nobel winner Sargent’s comments on Greece and the gold standard, and the ongoingmelt-up in asset markets due to the ‘limitless money-printing’ of central banks around the world, we thought it worth a look at what a gold standard is (and is not). Before 1974, U.S. dollars were backed by gold. This meant that the federal government could not print more money than it could redeem for gold. While this constrained the federal government, it also provided citizens with a relatively stable purchasing power for goods and services. Today’s paper currency has no intrinsic value.

It is not based on the value of gold or anything else. Under a gold standard, inflation was really limited. With floating value, or fiat, currency, however, some countries have seen inflation reach extremely high levels—sometimes enough to lead to economic collapse. Gold standards have historically provided more stable currencies with lower inflation than fiat currency. Professor Larry White asks, should the United States return to a gold standard?



The Mother of All Bubbles?

The Mother of All Bubbles? 


Supply and Demand Analysis of Gold and Silver | Zero Hedge

Backwardation in gold is a sign that the regime of irredeemable paper money based on the dollar is coming to an end. When it becomes permanent, then gold will no longer be offered in exchange for dollars (or yuan, pounds, euro, etc.) There will be no gold “price”. In other words, paper money will be worthless.

via Supply and Demand Analysis of Gold and Silver | Zero Hedge.


Confession Time: Money Printing Enthusiasts Should Admit the Obvious | CYNICONOMICS

Confession Time: Money Printing Enthusiasts Should Admit the Obvious | CYNICONOMICS.

Neil Macdonald: The secretive world of printing money – World – CBC News

Neil Macdonald: The secretive world of printing money – World – CBC News.

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