The Rules of a Debt-Based Monetary System
[courtesy Google Images]
“I’m having a hard time understanding how anyone can have a debt; if there is no real money, how can there be a real debt?
“Without real money, how could there even be a bankruptcy court, or bankruptcy protection? All my friends/acquaintances who went to US Bankruptcy court to try to get protection, to try to save their homes got only a few months’ protection; all had their cases dismissed and the courts/attorneys got richer.
“If all we have is debt paper for currency, that debt paper is lent into existence, backed by nothing, how can there be a debt? I’m not trained in finance/accounting but this whole system is insane and makes no sense to dummies like me.”
My (speculative) Answer:
• First, as you’ve intimated,the modern concept of “money” (actually, “currency” as exemplified by the fiat dollar) is so bizarre that it’s made “dummies” out of all of us—including me.
But that’s not so surprising. In his A.D. 1919 book, The Economic Consequences Of Peace, economist John Maynard Keynes observed that,
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Keynes wasn’t kidding.
He essentially argued that not one man in a million truly understands the concept of “money”. If Keynes was right, there may be less than 500 people in the whole USA who truly understand our modern “money”.
I believe that, thanks to a heightened interest in economics and the internet, the number of people who currently understand money is more than “one man in a million”. I’d bet that the number is more like one in one hundred thousand or perhaps even one in ten thousand. Who knows? Maybe one in one thousand currently understands money.
But it’s a virtual certainty that 99.9% of the American people don’t understand anything more about “money” than how to count it and how to spend it.
If you, dear reader, feel mystified by the nature of modern “money”—you’re not alone. You’re merely one of over 300 million Americans who are also “dummies” when it comes to understanding “money”.
I, too, am among the 300 million American “dummies” who are mystified by modern “money”. Nevertheless, I’ve thought about for twenty years and even written about it from time to time, so, while I may not yet know the truth, I can at least offer some semi-intelligent speculation.
Therefore, I have some answers for you, but they]re all speculative and should be taken with salt.
• Second, your premise that, “. . . all we have is debt paper for currency, that debt paper is lent into existence, [and is] backed by nothing” is inaccurate or even false.
While it’s true that our debt-based currency is not backed by “some tangible thing” like gold or silver, it is backed by the presumption of our intangible promises to pay.
The paper dollars in your wallet have value only because we agree that they have value. If we change our minds, those dollars could have less value or even no value.
Depending on our agreement, the $100 bill in your wallet might be worth 100 dollars, or it might be worth one dollar, or it might even be worth one-thousand dollars. The fiat dollar’s value is whatever we say it is and any point in time.
How odd, hmmm?
The fiat dollar’s changeable value is almost as mind-boggling as saying that the distance from Dallas, Texas, to New York city is 1,550 miles today, 1,800 miles tomorrow and just 500 miles in months whose names have an “r” in them.
No wonder that “not one man in a million” understands fiat currency. It’s so strange as to be as incomprehensible as alchemy.
In the national sense, all of the debt is backed by the American people’s presumed pledge of “full faith and credit”. I.e., the national debt is backed by Americans’ ability to go deeper into debt.
Implications?
1) If Americans run out of “credit,” the national debt won’t be paid and the dollar bill will become worthless.
2) Conversely, if the government defaults on the national debt, Americans’ credit—and the US dollar—may disappear. If government defaults, those who store their wealth in the form of paper dollars may suddenly be bankrupt.
• A great significance—and danger—of our debt-based monetary system is that “one man’s debt is another man’s asset“. Because debt and assets are as intimately linked as the two sides of a single coin, if one disappears, so does the other.
If I “borrow” $100,000, I sign a note (promise to pay) for $100,000. My mere promise creates the $100,000 in currency.
If I sign a $100,000 note (intangible promise to pay), whoever holds that note treats it as if it were a tangible asset like gold or silver. If you ask the holder, he’ll tell you that he has $100,000 in wealth because he has a piece of paper with my signature on it.
The only thing that makes that paper valuable is my signature and promise to pay. But if I can’t keep my promise, the man holding the note (paper debt instrument) will lose his $100,000.
There’s no surprise in that. No news. It’s been common knowledge for thousands of years that if the borrower defaults on his loan, the lender loses his assets.
But if a borrower defaults on his loan in a debt-based monetary system, something largely unrecognized also occurs. Currency disappears out of the economy. Default makes currency cease to exist.
For example, if I default on my $100,000 debt, I destroy the value of the $100,000 note (paper debt instrument) that memorialized that debt. If I default, my $100,000 note becomes worthless and the man who thought his piece of paper was a $100,000 asset will lose $100,000.
In a debt-based monetary system, bankruptcy doesn’t just wipe out the debtor’s debts, it also wipes out the creditor’s correlative assets.
• This destruction of assets wouldn’t happen if we had a gold- or silver-based monetary system.
I.e., in a gold or silver-based monetary system, if I borrowed 74 ounces of gold (about $100,000 worth at current prices) and I went bankrupt, I couldn’t repay the 74 ounces in gold. Whatever paper debt instrument memorialized my debt to my creditor would become worthless. But the 74 ounces ($100,000 worth) of gold would still remain in the hands of multiple people within the economy. I would’ve borrowed the gold and spent the gold. I might not have any more gold. My creditor might never cover the gold he loaned me. But the gold I’d borrowed would still exist.
Suppose I borrowed 74 ounces to start a new business but became infatuated with a topless dancer at the “Gentlemen’s Club”. Suppose I gave all of the gold to her, and she gave it to her boyfriend or pimp. No matter. That gold would still be available and circulating in the economy.
Maybe the dancer used it to purchase a new car or for a down payment on a house. The car dealer would have some of the gold and might spend it on a new flat-screen TV. The real estate agent would have some of gold to spend on groceries or a new car. The gold would still exist and be available as a medium of exchange within the economy.
I’d lose the 74 ounces of gold for playing the fool with the stripper. The banker would lose his 74 ounces of gold for being fool enough to lend to me. I’d be damaged by the loss; my creditor would be damaged; but the economy would not be damaged because the gold did not disappear—it merely changed hands from the greater fools to the lessor (or even to the wise).
• With a debt-based monetary system, that’s not so.
If I “borrow” $100,000 in fiat currency (promises to pay) from a bank, the bank doesn’t reach into the vault and hand me one thousand $100 bills. The bank gives me a check for $100,000. Where’d that $100,000 come from? It came from me. I created that $100,000 when I signed the note and promised to repay the $100,000 that I allegedly borrowed”. I “spun” that $100,000 “out of thin” air with my mere promise to pay. Get that? The bank didn’t create the $100,000 I borrowed. The Federal Reserve didn’t create the $100,000 I borrowed. I created that $100,000 with my promise to pay (note).
And then I “borrowed” the same $100,000 that I had initially created.
Is this a great monetary system or what?!
Of course, if any borrower looked at the system too closely, he might not only wonder why he should be obligated to repay a loan of currency that he created. He might even wonderwhy he should pay interest on the loan of the currency that he created.
But, as Henry Ford once observed,
“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
Like Lord Maynard Keynes, Ford also understood and even applauded the fact that the vast majority of people “do not understand” our monetary system because, if they did, they people would quickly foment a shooting revolution. That tells that the monetary system isn’t merely mysterious, but works to the disadvantage of the vast majority of people. Ford knew that the existing monetary system was the people’s adversary or even enemy.
Nevertheless, let’s not look the gift horse of bank loans in the mouth too closely. Let’s just stay blissfully ignorant of the fact that we live in a debt-based monetary system where each of us can “spin currency out of thin air” to the limit of our credit rating. In that system, those few Americans who understand currency and know how to “work” this system can get fabulously wealthy without really “working”. Those who don’t understand the monetary system can be persistently robbed, but in a way that’s so subtle they won’t even know they’re being robbed.
• My fundamental argument is that a primary difference between a gold-based monetary system and debt-based monetary system is the virtual indestructability of money in the gold-based system versus the potential destruction of currency in a debt-based monetary system.
In a debt-based monetary system (which we have now), if I default on my $100,000 loan, my $100,000 note becomes worthless, my creditor loses $100,000, but so does the economy. The $100,000 disappears from the money supply. Result? The economy also loses $100,000. The economy’s money supply falls by $100,000 and tends to push the currency towards deflation and the economy towards depression.
If I’m the only one who defaults on his loan, the impact on the economy is trivial. But if millions of Americans simultaneously default on, say, their mortgages, the currency supply can be reduced by hundreds of billions of dollars. The result could be economic collapse.
• Curiouser and curiouser. Fractional reserve banking the temptation and the dangers a debt-based monetary system. If I signed a $100,000 note, the banking system can use that note as collateral to lend up to ten times the face value of my note ($1 million total) to other borrowers. That’s a great system for leveraging some assets into many paper assets . . . so long as the vast majority of borrowers can pay their debts.
But if one or more of the borrowers goes broke and can no longer pay his debts (promises to pay), the same 10:1 leverage that made everyone rich when the economy was booming, can turn against us and make everyone poor when the economy declines.
I.e., if I default, my $100,000 note becomes worthless. If that note’s been used as collateral, the bank may have to “call in” up to $1 million in loans based on my failed note.
Now the economy is in big trouble. My failure to repay $100,000 might cause the economy to lose an additional $1 million.
• The “leveraged” decline that might occur if there were a widespread default on loans (as happened with home mortgages back around A.D. 2007) may explain why the federal government and Federal Reserve distributed most of their Quantitative Easing monetary “stimulus” to banks. If the banks had to call in $1 million in consumer loans every time a $100,000 mortgage went into default, that fractional reserve “leverage” might’ve cascaded into an economic collapse.
But if the government and/or Federal Reserve could “inject” enough extra currency into the banks to offset the losses attributed to mortgage defaults, they might be able to stop that leveraged collapse.
For example, if the banks had used my $100,000 note as collateral to justify lending an additional $1 million, but I failed to pay my $100,000 note, the banks might have to call in some or all of the additional $1 million they’d loaned. If enough people defaulted on their mortgages, the leveraged impact on the economy might be devastating.
But if the government and/or Federal Reserve could give the bankers $100,000 in new notes for every $100,000 mortgage note that defaulted, the adverse leveraged effects could be mitigated and perhaps even eliminated. If the banks found a new $100,000 to substitute for the $100,000 note that defaulted, the banks wouldn’t have to call in some or all of the $1 million they might’ve loaned. The economy would be saved and “Helicopter” Ben Bernanke and “Whirlybird” Janet Yellen would be our heroes.
This hypothesis seems consistentwith the fact that the banks, after receiving several trillion dollars from the government and/or Federal Reserve as QE “stimulus,” only loaned a small percentage of that currency into the economy. Instead of lending, they kept most of that “stimulus” in their vaults. Holding the QE currency in their vaults is consistentwith the idea that the banks needed to keep those QE trillions as substitute collateral to replace the former “collateral” (mortgage notes) that had failed.
If so, the trillions in QE “stimulus” didn’t “stimulate” the economy to go faster with new loans to the American people—but it did “stimulate” the economy by preventing trillions of dollars in preexisting consumer (and other) loans from being called in because they were no longer justified by mortgage note “collateral”.
Perhaps, the QE stimulus didn’t stimulate the economy to grow faster with new loans—it stimulated the economy to not collapse based on the default of previous loans.
• A fantastic potential for leveraged gains is possible with fractional reserve banking. The more we borrow, the more collateral we create, and the more currency we can borrow. Every paper debt instrument can be used as collateral to justify creating more loans, more collateral and, again, more loans.
In a debt-based monetary system, the faster and deeper we went into debt, the richer we could become. That sounds crazy, but who cares so long as the system is making us richer and richer?
Unfortunately, those who live by a fractional reserve banking system can also die by fractional reserve banking. The same fractional-reserve leverage that can generate a fortune when times are good, can cause a sudden and devastating collapse when times are bad.
• In the event of a depression in a debt-based monetary system, the wealth that stored in the form of currency isn’t merely transferred from the fools to the wise—it’s destroyed and ceases to exist.
How can that be?
Easy. There are no “wise” in a debt-based monetary system—only fools and the greedy.
Once that fiat wealth is destroyed by individual bankruptcies and national economic depression, where will we find the capital to rebuild after the depression ends?
If we go into a depression in a gold-based monetary system, when the depression ends, the gold is still available as capital and collateral to rebuild the economy. If we go into a depression in a debt-based monetary system, when the depression ends, there’ll be little or no currency remaining to use as capital/collateral to rebuild the economy. How do we rebuild an economy once the currency fails and disappears?
• Finally, the previous analysis may be grossly mistaken. But I warned you from the beginning that this article was speculative.
Besides, if Keynes was right no more than one man in a million truly understands the concept of currency, which man in a million has sufficient knowledge to declare that my analysis was wrong?
One of the consequences of a debt-based monetary system is that virtually no one fully understands the subject. Therefore any analysis (no matter how fantastic) might be right and almost no one knows enough to declare an analysis is wrong.
Welcome to the world of debt-based monetary sorcery where “Now you see it—now your don’t.”
For 99.9% of the world, the debt-based monetary system is a mystery that will keep them in or near bondage and poverty for most of their lives. For the 0.1% (or less) who do understand the debt-based monetary system, our currency is a means to acquire fabulous, unearned wealth.