The Dollar’s Debt Trap
On the fiftieth anniversary of the Nixon Shock, this article explains why fiat currencies have become joined at the hip to financial asset values. And why with increasing inevitability they are about to descend into the next financial crisis together.
I start by defining the currencies we use as money and how they originate. I show why they are no more than the counterpart of assets on central bank and commercial bank balance sheets. Including bonds and other financial issues emanating from the US Government, the individual states, with the private sector and with broad money supply, dollar debt totals roughly $100 trillion, to which we can add shadow banking liabilities realistically estimated at a further $30 trillion.
This gives us an idea of the scale of the threat to asset values and banking posed by higher interest rates, which are now all but certain. The prospect of contracting financial asset values is potentially far worse than in any post-war financial crisis, because the valuation base for them starts at zero and even negative interest rates in the case of Europe and Japan.
I focus on the dollar because it is everyone’s reserve currency and I show why a significant bear market in financial asset values is likely to take down the dollar with it, and therefore, in that event, threatens the survival of all other fiat currencies.
Dickensian attitudes to debt (Annual income twenty pounds, annual expenditure twenty pounds ought and six, misery) reflected the discipline of sound money and the threat of the workhouse. It was an attitude to debt that carried on even to the 1960s. But the financial world changed forever in 1971 when post-war monetary stability ended with the Nixon shock, exactly fifty years ago.
Micawber’s aphorism was aimed at personal spending. It was advice given to a young David Copperfield, rather than a recipe for life. But since money’s transmogrification into pure fiat and as soon as youngsters in the fiat-currency world began to earn, Micawberism no longer held. Figure 1 shows the decline in purchasing power of fiat currencies in which earnings are paid relative to the sound money (gold) that had underpinned the post-war Bretton Woods agreement.
In the four major currencies, Micawber’s advice turns out to have been inappropriate and the opposite of being the path to riches. To benefit from a lender’s losses, a borrower merely had to ensure two things: that he could always service his debt and that the lender could not reclaim the debt before it was due so long as it was serviced according to the contract.
Unsurprisingly, everyone who could dismiss Micawberisms did so and increasingly turned borrower, financing house purchases with mortgages and supplementing earnings with borrowing for consumption. Since 1970, average house prices in the UK have increased from £4,057 to £256,000 today. But as a means of hedging the fall in the pound’s purchasing power, it has underperformed sound money. Instead of buying a house, if £4,057 had been hedged into gold it would now be worth £100,000 more. And according to the St Louis Fed’s statistical base, median sales prices of houses sold in the US rose from $23,000 in 1970 to $375,000 today, an increase of 16.3 times. Invested in gold, it would have risen to $1,162,000.
These figures assume no mortgage borrowing, which would have made all the difference. The message for those who speculated in residential property is to have borrowed as much as could be afforded. 90% loan-to-value mortgages would have knocked the socks off the long-term decline in fiat money’s purchasing power.
The basic lesson hasn’t been lost on industry either. It has moved on from borrowing with a view to repayment from the profits of production to running debt permanently, further encouraged by the practice of private equity using debt to leverage returns. Governments too have exploited the dubious benefits of debt: it enables them to spend without increasing unpopular taxes. And today, according to the Congressional Budget Office’s baseline budget projections for the current fiscal year, 44% of government spending is financed by debt.
The origin of all this debt is monetary expansion, mostly from the banking system but topped up by the central banks. It is a mistake to view it as deposit money originating from savers, which is the common fallacy, as we shall now illustrate.
The origin of debt
Many economists and financial commentators assume that deposits equate to savings, when instead they equate to debt. The error arises from not understanding how deposits are created. To explain it we shall start with the central bank. A central bank acquires assets in the form of bills, bonds, and loans, by issuing deposits matched by them to the government’s account and to commercial banks, along with bank notes to the public.
The point is that the central bank issues deposits and bank notes to acquire assets, and they do not arise by any other means.
It is true that bank notes can be deposited at a bank, in return for which a customer’s deposit account is credited, but this is a minor part of total bank deposits. The origin of the rest of deposit money is always the consequence of credit creation. A bank lends money to a borrower by recording the loan as an asset, and at the same time it credits the borrower’s deposit account with the proceeds. This is because through double entry book-keeping a credit in its asset column must always match an equal debit on the liability side. It is through this process that deposits are created. And as a bank loan is drawn down, both the bank’s assets and liabilities reflect the change in balances.
The borrower draws down his loan from the bank to pay his creditors, and in turn they pay the proceeds into their bank accounts. To the latter, they have earned the money, but its origin nonetheless is bank credit, or if they are paid in bank notes, central bank credit. Consequently, it is a mistake to look at a bank’s balance sheet, observe that it has, say, $100 billion of deposits and conclude that the bank possess it. It doesn’t. Among its assets, it will have a small amount of vault cash (bank notes) and some assets that can be liquidated immediately to meet withdrawals if need be. And all the deposits on a bank’s balance sheet showing as liabilities are debts to its lending customers.
So, what about savings? Savings are simply unspent bank credit and hoarded bank notes. The only true money, a medium of exchange whose origin is not debt, is physical gold. Otherwise, savings in the form of bank deposits and bank notes owe their origin entirely to debt. We can now explain the mystery of the accumulation of money supply. It is not an accumulation of savings, but an accumulation of the counterpart to debt financed by the expansion of bank credit. Figure 2 shows how dramatically bank and central bank credit have expanded over time.
M3 is the US’s broadest measure of currency and has expanded nearly seventy times since 1960. Since 1971 when Bretton Woods was suspended, the expansion has been 34 times, while the US population increased by just under 59%. The average of all bank liabilities therefore rose from $2,881 per head of population to $61,562. The subtle point is that they are not to be regarded as currency owed to depositors, but debt owed by the
Article from LewRockwell