"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Monday, October 11, 2010

Debt Based Money and Democracy... Can They Co-Exist?

Two important videos that summarize many of my concerns: Debt based money, its influence on government, and sustainability issues. Damon Vrabel discusses money and power in the first video, describing money creation and balance sheet dynamics. In the second video, he accurately questions if the US is still a Constitutional Republic, and if not, what is it?



11 comments:

OilPrince said...

Vrabel doesn't think through the whole process of money creating. What he doesn't understand is that when debt is created by commercial banks someone demands this credit. The credit taker obviously won't store the money, but will spent it, i.e. to buy a car. So the manufacturer of the car will put the money he received from the buyer on his account at another bank. The balance sheet of the manufacturers bank now shows a liability on which the bank must pay interest to the car manufacturer whose balance sheet shows the money he got from the car buyer as an asset.
So in the whole process two asset-liability-pairs are created, not one.
This also solves the mathematical flaw of the system that many see: The exponential growth of debt because of compound interest (when money = debt, where is the money for the interest that has to paid on the debt?). Debt grows because it is demanded. You don't have to take on debt to pay off old debt.
The monetary system itself is not inherently instable or rigged.
But you have to see that credit should be liquifying of underlying collateral. If credit is not "backed" (enough) it is "toxic".
So the problem is you can abuse (willingly or unwillingly) this monetary system by artificially creating debt demand i.e. when lending institutions act irresponsible (encouraged through de-regulation, legislation and monetary policy) and give credit to irresponsible non-creditworthy persons who then default on their debt (and, as was the case especially in the shadow banking system, if lending institutions over-leverage themselves on bad debt that is packed into securities, rated AAA and spread around the world).
So at one point if the excesses get too big you have a systemic risk and must bail out the TBTF. And that's exactly what happened (imo a "run on the shadow banking system").
If the excess was constructed on purpose or not is up to the conspirationists. ;-)

Misthos said...

OilPrince,

Welcome to the blog, and thanks for posting. I still agree with Damon Vrabel, but I also accept the fact that economics, unlike, say physics, is much more open to debate. People are still debating what money is, let alone how it acts. So I respect your opinion.

As for the exponential growth of debt - I believe it is inherent in a debt backed system. Actually, in any system that has fractional reserve lending. In your scenario, you have two pairs of balance sheets. But you have to admit, it continues well beyond that. That initial money is always re-lent, and thus the money supply expands (the money multiplier). Keep in mind also, that the velocity of money also has an effect here.

But some have even argued persuasively against the theory of fractional reserve lending: http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

Let's look at another example. I get a 30 year mortgage for $100,000at 6% interest. Over the next thirty years, I need to pay back $215,838 dollars. Where do I get that money? Others get mortgages, car loans, etc... The money supply expands. And as it does, so too does the interest that needs to be paid off. Yes, debt self liquidates through pay off or default, but overall, I still believe that it grows much faster than the money supply. Whereas debt grows with usury, money does not. So if we look at a balance sheet, we look at outstanding loans, but not necessarily the total interest, which normally exceeds the interest paid on "parked cash."

But every economy functions differently. Some economies are exprt based, others are consumption based. It is in consumption based economies that debt really takes off. But there are exceptions as well. Just look at Japan.

Here's an interesting chart- debt to gdp of various nations. Imagine what would happen to gdp if the debt never grew faster than gdp.

As for conspiracy theories, I tend to avoid that kind of analysis. It seems to me that you do too. I believe that in any stable society, money and power ultimately have the most influence, and over time, all the laws passed to support the various moneyed interest groups, in the aggregate, create a plutocracy of sorts. It's not some evil rich guys hiding in the shadows. It's merely a natural progression... an incremental process of layers of laws that in the aggregate, support one class to the detriment of others classes.

I believe that what the Banks are doing today is not a massive conspiracy, but the natural end result of a debt based private monetary system. Speculation runs rampant, government backing encumbers sovereigns, and the system merely collapses on its own. And a new system is reborn.

It's a cycle that's repeated in different forms, through-out history.

OilPrince said...

Hi Misthos,

imo this is not about economics and if it is a "hard" science or not.
It is about understanding a system, in this case the monetary system.
If you understand it on the basic level, you understand it as a whole.
No offense, but your conclusions show that you don't understand it, as many others do not.
Please re-read my comment above and look if you can follow the logic.

"As for the exponential growth of debt - I believe it is inherent in a debt backed system. Actually, in any system that has fractional reserve lending. In your scenario, you have two pairs of balance sheets. But you have to admit, it continues well beyond that. That initial money is always re-lent, and thus the money supply expands (the money multiplier). Keep in mind also, that the velocity of money also has an effect here."
Debt growth has nothing to do with fractional reserve lending.
To stay with my example, if the manufacturer`s bank wants to lend out a part of the manufacturer's deposit, it has to find a credit taker (by providing him a good interest rate). Debt has to be demanded to grow.
The next step is again that the credit taker spends his money and the balance sheet extention is continued to another bank (perhaps again bank 1). The principle is always the same as in the example in my comment above.

"Let's look at another example. I get a 30 year mortgage for $100,000at 6% interest. Over the next thirty years, I need to pay back $215,838 dollars. Where do I get that money? Others get mortgages, car loans, etc... The money supply expands. And as it does, so too does the interest that needs to be paid off. Yes, debt self liquidates through pay off or default, but overall, I still believe that it grows much faster than the money supply. Whereas debt grows with usury, money does not. So if we look at a balance sheet, we look at outstanding loans, but not necessarily the total interest, which normally exceeds the interest paid on "parked cash.""
A mortgage is, like any other credit, future's consumption now. You pay the home owner step by step, and he receives interest for bearing the risk of default on the payment.
You have to produce value to get that money to pay him. If you can't produce value, you default and the lender takes your collateral.
Let's say you work for the car manufacturer, and the home owner buys a car from your employer, you have a quite direct ability to "pay him back".

The interest paid on credit must be higher than "parked cash" to allow the lending institution to pay for its operation costs, i.e. paying its employees etc and generate profit which can be payed as dividends etc..
But see that this interest margin is as close as the competition around it, which is big (banks have to compete for depositors etc.). Banks do not profit excessively from interest margins.
This is the reason why interest won't compound and lead to inevitable systemic collapse.

BTW:
A weakness of the monetary system that I see is that we have incentives to aim for infinite extention of credit demand / debt growth, even if it is toxic, (which works like a drug, but destabilizes the system) because our monetary tool to prevent falling credit / investment demand and cash hoarding (which should be negative nominal interest rates, as the interest rates function as regulator (but only in a credit/investment expansion), but is not possible because of hoarding of cash at home instead of in a bank account), which is QE, is imo merely a psychological tool and has other drawbacks in our global currency system.
But "excessive" QE (or better announcement thereof) is absolutely the right thing to do now (since '08) as you try to create "inflation expectation" and, in combiantion with ZIRP, negative real interest rates (remember the deflationary spiral of the Great Depression).

OilPrince said...

Regarding money:
You have to see that debt money is not a "thing", but a contract (the bank should guarantee with its equity, the credit taker with his collateral). It's not designed as a store of value (but it can function as one), and it can be abused by lowering equity-ratios and lending standards and so on.

OilPrince said...

Fiat money is the debtor's money, which can be devalued for the benefit of all.
Somewhere I read "easy money".
"Hard money" is accordingly a debtor-free asset.

OilPrince said...

addendum to "money is a contract": Money creation is a contract to "liquify" long-term illiquid "collateral" of the credit taker under the guarantees of the bank's equity and an inherent risk premium called interest.

Of course all these attributes above let money act as a very good medium of exchange.

Misthos said...

OilPrince,

I will address many of your points in detail in a separate post sometime this week. But I'm not one to pass up on a good monetary theory debate, so I'll continue to respond to some of your points.

You said:

"A weakness of the monetary system that I see is that we have incentives to aim for infinite extention of credit demand / debt growth, even if it is toxic, (which works like a drug, but destabilizes the system) because our monetary tool to prevent falling credit / investment demand and cash hoarding (which should be negative nominal interest rates, as the interest rates function as regulator (but only in a credit/investment expansion), but is not possible because of hoarding of cash at home instead of in a bank account), which is QE, is imo merely a psychological tool and has other drawbacks in our global currency system.
But "excessive" QE (or better announcement thereof) is absolutely the right thing to do now (since '08) as you try to create "inflation expectation" and, in combiantion with ZIRP, negative real interest rates (remember the deflationary spiral of the Great Depression)."

Here's my take: the reason the Fed needs to commit to QE, and the Fed Gov't needs to stimulate, is not to boost the economy. It is done to keep it from collapsing. We are facing an extreme deflationary event - historic. And the Gov't and Federal Reserve's response has been equally historic. And what has happened to GDP? It has barely grown 2%.

You know why? Because of the deflation in the system. Yes, the lending incentives you discuss exist. But they are merely symptoms... more importantly, they need to exist or else the system collapses. I'm not saying it goes to zero, but the drop in gdp and increase in debt destruction without QE or deficit spending would be extremely unstable, and overshoot to the downside.

To summarize in few words:

A debt based system is a Ponzi System. It shares the same dynamics. There is no equilibrium - only unsustainable permagrowth.

As this system approaches its end, you will see enormous efforts to hold it up, to continue this unsustainable system. And during this period, you will also see extreme theft, i.e. irresponsible lending and then bailouts.

What has transpired these last few years is not a typical recession, but the natural progression of a debt based monetary system entering its terminal stage.

This is basically a summary response, you bring up some other points in other posts above - I will address these as well. Pardon in advance the speed of my responses.

OilPrince said...

addendum to "Debt growth has nothing to do with fractional reserve lending": Of course the possible max. amount of debt is logically determined by what fraction of the reserves can be lent out.

Misthos said...

If you have time, please read the link I posted above:

http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

I know its long, but extremely interesting stuff challenging the notion of fractional reserve lending.

OilPrince said...

Hi,
I read the article.
Living either in a "fiat money system" or a "credit money system" or both doesn't change anything I said regarding this system. The same with fractional reserve lending or if debt is created before or after looking for reserves.
If debt is demanded and lenders decide they can take the risk debt grows. It gets dangerous and threatens the whole system if a increasing part of the debt is backed by nothing except rising future prices and if you can't let the ones fail who underestimated the risk and should go bankrupt due to toxic credit defaults because they are TBTF.

Misthos said...

I want to thank you for taking the time to read that article.

I mention that article because I want to be honest with my views. When people discuss economics or monetary theory, I think it's important that they use certain words and theories correctly - or at least, they agree to the theory or term's definition. By mentioning fractional reserve lending, I wanted to illustrate how private banks create money thru deposits, but at the same time, I could not leave out the view that I find compelling, that private banks really create credit out of nothing - they look for reserves later. Which brings me to another point. I'm not changing the topic, just adding to my view I have expressed so far.

Money is also created by the government. So far, we have been discussing the private banking system. But the relationship between the Treasury and the Federal Reserve can not be ignored, IMO. Money is also created thru debt in that relationship. Just look at a dollar bill - compared to a dollar bill from 100 years ago. 100 plus some years ago, it was a "certificate" redeemable for gold. Today, it is not a certificate, but a "note," i.e. a promise to pay. It is born of debt, not a supply of gold.

So one can also argue that debt is never really extinguished, but transferred. That is, if you lend me money, in theory, I can pay you back with new money "borrowed" by the US government. My debt is replaced by the government's new debt. Ownership of that debt amount merely changed hands. And the interest continues to accrue...

And thus the debt still grows in the system. Exponentially so.

You also state:

"If debt is demanded and lenders decide they can take the risk debt grows. It gets dangerous and threatens the whole system if a increasing part of the debt is backed by nothing except rising future prices and if you can't let the ones fail who underestimated the risk and should go bankrupt due to toxic credit defaults because they are TBTF."

I am in TOTAL agreement with you here. True capitalism requires that unsustainable models FAIL. The current banking model is a failure, and needs to evolve to a sustainable model. Yet the influence the banking sector has on the federal gov't does not allow this to happen.

But, I will also accept the fact that if true darwinian capitalism was allowed to run its course in 2008, you and I may have likely be hunting squirrels in our backyards for food. I truly believe that the system was ready to crash and something had to be done. But it should have been along the lines of the Swedish model, where the banks were taken over with a subsequent orderly wind down.

What did we have instead? Record bonuses and the competitors of the largest banks were absorbed, arguably, with a federal subsidy by the largest banks.

And did we really solve the crisis?

As I mentioned, I will write a post describing my view that the system can not function perpetually. I will incorporate both government and private sector banks' involvement, and please feel free to fire away at anything you feel I missed or overlooked.