"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

Tuesday, November 23, 2010

We Are Now Faced With the Two Paths of Fiat Evolution - Part 1


We are entering an historic phase of the evolution of fiat money.  This will be a three part series describing that evolution, and it's likely outcome.

I'm not going to reiterate what is transpiring in Ireland, or Greece, or Portugal.  I think readers of this blog are pretty well read on current events and I'm not going to repeat what countless bloggers are covering in this series of posts.

Let's step back and see the big picture.  We need to see what other nations are doing, we need to see what current super-sovereign institutions (IMF and G20) are doing, we need to see how the world's largest banks and central banks are doing.  Only then can we see the big picture, that is, how all these systems are interacting with each other.  What we are witnessing is the final stage of post Bretton Woods fiat evolution.  There are two choices in this final stage, and the EU and US are examples of it.

I am only focusing on the EU and the US for a reason.  The rest of the world (minus Japan) has only recently entered the fiat modeled global economy in a meaningful way.  The BRICS and other emerging markets have either already gone thru default while the rest of the financial world continued to function, so their defaults did not create severe contagion, or like China and India - they didn't really exist as meaningful economies to the rest of the world.  These are new economies with low wages, and are basically infants when it comes to debt accumulation.  The EU and US, on the other hand, best illustrate mature economies that have functioned under the post Bretton Woods fiat model the longest and have thus accumulated debt the most under the current global monetary regime.

Path One: The US emerging fiat model

It is obvious now that the US does not collect nearly enough in tax revenues to finance its spending:

This will continue for the foreseeable future, unless you think the economy will miraculously recover.  But how can the US run such large deficits for so long?  Well, the Federal Reserve will continue to be the primary buyer of Treasuries - that's what QE2 is all about.  The Federal Reserve is now the largest holder of US Debt.  From Zero Hedge:

I know that many people immediately go into hysterics about China no longer financing our debt, and that the US will subsequently go bankrupt.  But that's not true.  China never financed US debt.  The US can never go bankrupt (officially/legally) so long as it prints its own free floating currency. Yes, China and others purchase US Government debt, but that does not finance US spending.  Modern Monetary Theory best describes this  process.  Under a fiat model, money is created by Government Spending and the Federal Reserve.  Money is also created thru the private sector with the creation of loans.  Lending creates money that did not exist before.  But private sector loan creation, in this balance sheet recession, is not growing fast enough to keep the economy and ongoing debt servicing from collapsing.  

Enter the Fed.

The Fed has taken over this role and is creating money from nothing.  And you know what else?  The interest that is "owed" to the Fed is returned to the US Treasury minus costs.  It's basically a free loan to the US Government.  Modern Monetary Theorists love to point this out, that we are not facing a solvency crisis on the federal level.  They are right, but they ignore something else, which I will cover later in Part 3.

So you're probably thinking:  Why the hell do I pay taxes if we can create free money?  Why the hell do we sell government debt to nations that collect interest off that debt?  

Those are good questions.

Tax collection is used to control the money supply and inflation.  It's not a coincidence that the Federal Reserve and the Internal Revenue Service (Federal Income Tax) were created within a year of each other.  One (the IRS) sops up the money the other (the Fed)  creates.  That's how it works.  The EU doesn't have this feature.  There is no EU income tax or EU Treasury.  But I'll cover that in Part 2.

The US, by selling Treasuries abroad, also accomplishes the same thing:  it controls the global dollar supply.  Why do others buy it?  Nations trade with each other, and as local corporations exchange their dollars for their local currency, the dollars ultimately end up in the local central bank.  That central bank now owns these dollars and wants a return on them, so it buys US debt.  That is changing somewhat, however.  China is using dollars now to buy up resources, which I will cover later in Part 3.  

Earlier, I called this Path One for a reason.  The private  markets are not working as they used to.  I don't see an end to this anytime soon.  We have entered a new period where the central bank - the Federal Reserve, will be creating money from nothing so the government can spend it as it wishes.  Fiat money has changed, it has evolved.  All insolvencies, state budget crises, pension shortfalls, federal budget gaps, etc...  will now be addressed indirectly by the Federal Reserve.  The US economy is now officially on life support.  In this analogy, the EU is not running all the machines to keep the patient alive, only a few of them.  It has structural differences that does not allow it to do so.

But that's will be addressed in my conclusion.  For now, I just want to explain that we have entered a new era.  The Modern Monetary Theorists are claiming this as a victory.  They say that interest free money from the government is our cure.  They are terribly misguided and ignore other variables.

In Part 2 I will address the EU model, and compare it to the US in depth.  In my conclusion, I will describe how I believe fiat money, post Bretton Woods, will end under the two scenarios - the US path, and the (current) EU path.  


Jim Slip said...

Great posts. Keep 'em coming!

Misthos said...

Thanks Jim, will do!

Dave Narby said...

Great stuff, love deep thinking that results in explanations I can understand. Eagerly awaiting parts II & III.