Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
Further Clues Reveal Gold’s Weakness - 26th Nov 20
Fun Things to Do this Christmas - 26th Nov 20
Industries that Require Secure Messaging Apps - 26th Nov 20
Dow Stock Market Trend Analysis - 25th Nov 20
Amazon Black Friday Dell 32 Inch S3220DGF VA Curved Screen Gaming Monitor Bargain Deal! - 25th Nov 20
Biden the Silver Bull - 25th Nov 20
Inflation Warning to the Fed: Be Careful What You Wish For - 25th Nov 20
Financial Stocks Sector ETF Shows Unique Island Setup – What Next? - 25th Nov 20
Herd Immunity or Herd Insolvency: Which Will Affect Gold More? - 25th Nov 20
Stock Market SEASONAL TREND and ELECTION CYCLE - 24th Nov 20
Amazon Black Friday - Karcher K7 FC Pressure Washer Assembly and 1st Use - Is it Any Good? - 24th Nov 20
I Dislike Shallow People And Shallow Market Pullbacks - 24th Nov 20
Small Traders vs. Large Traders vs. Commercials: Who Is Right Most Often? - 24th Nov 20
10 Reasons You Should Trade With a Regulated Broker In UK - 24th Nov 20
Stock Market Elliott Wave Analysis - 23rd Nov 20
Evolution of the Fed - 23rd Nov 20
Gold and Silver Now and Then - A Comparison - 23rd Nov 20
Nasdaq NQ Has Stalled Above a 1.382 Fibonacci Expansion Range Three Times - 23rd Nov 20
Learn How To Trade Forex Successfully - 23rd Nov 20
Market 2020 vs 2016 and 2012 - 22nd Nov 20
Gold & Silver - Adapting Dynamic Learning Shows Possible Upside Price Rally - 22nd Nov 20
Stock Market Short-term Correction - 22nd Nov 20
Stock Market SPY/SPX Island Setups Warn Of A Potential Reversal In This Uptrend - 21st Nov 20
Why Budgies Make Great Pets for Kids - 21st Nov 20
How To Find The Best Dry Dog Food For Your Furry Best Friend?  - 21st Nov 20
The Key to a Successful LGBT Relationship is Matching by Preferences - 21st Nov 20
Stock Market Dow Long-term Trend Analysis - 20th Nov 20
Margin: How Stock Market Investors Are "Reaching for the Stars" - 20th Nov 20
World’s Largest Free-Trade Pact Inspiration for Global Economic Recovery - 20th Nov 20
Dating Sites Break all the Stereotypes About Distance - 20th Nov 20
THE STOCK MARKET BIG PICTURE - Video - 19th Nov 20
Reasons why Bitcoin is Treading at it's Highest Level Since 2017 and a Warning - 19th Nov 20
Media Celebrates after Trump’s Pro-Gold Fed Nominee Gets Blocked - 19th Nov 20
DJIA Short-term Stock Market Technical Trend Analysis - 19th Nov 20
Demoncracy Ushers in the Flu World Order How to Survive and Profit From What Is Coming - 19th Nov 20
US Bond Market: "When Investors Should Worry" - 18th Nov 20
Gold Remains the Best Pandemic Insurance - 18th Nov 20
GPU Fan Not Spinning FIX - How to Easily Extend the Life of Your Gaming PC System - 18th Nov 20
Dow Jones E-Mini Futures Tag 30k Twice – Setting Up Stock Market Double Top - 18th Nov 20
Edge Computing Is Leading the Next Great Tech Revolution - 18th Nov 20
This Chart Signals When Gold Stocks Will Explode - 17th Nov 20
Gold Price Momentous ally From 2000 Compared To SPY Stock Market and Nasdaq - 17th Nov 20
Creating Marketing Campaigns Using the Freedom of Information Act - 17th Nov 20
ILLEGITIMATE PRESIDENT - 17th Nov 20
Stock Market Uptrend in Process - 17th Nov 20
How My Friend Made $128,000 Investing in Stocks Without Knowing It - 16th Nov 20
Free-spending Biden and/or continued Fed stimulus will hike Gold prices - 16th Nov 20
Top Cheap Budgie Toys - Every Budgie Owner Should Have These Safe Bird Toys! - 16th Nov 20
Line Up For Your Jab to get your Covaids Freedom Pass and a 5% Work From Home Tax - 16th Nov 20
You May Have Overlooked These “Sleeper” Precious Metals - 16th Nov 20
Demystifying interesting facts about online Casinos - 16th Nov 20
What's Ahead for the Gold Market? - 15th Nov 20
Gold’s Momentous Rally From 2000 Compared To Stock Market SPY & QQQ - 15th Nov 20
Overclockers UK Quality of Custom Gaming System Build - OEM Windows Sticker? - 15th Nov 20
UK GCSE Exams 2021 CANCELLED! Grades Based on Mock Exams and Teacher Assessments - 15th Nov 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Government Debt Default, How (Not If) Will it Happen

Economics / US Debt Nov 21, 2009 - 08:25 AM GMT

By: Gary_North

Economics

Diamond Rated - Best Financial Markets Analysis ArticleI have surveyed the Austrian School's theory of money. This theory began with Ludwig von Mises' "Theory of Money and Credit" (1912). I presented Mises' theory of fractional reserve banking and the creation of the business cycle in my mini-book, Mises on Money (2002).

The previous parts of this series are on-line here.


I have done my best to get across a line of reasoning regarding money. This line of reasoning is not shared by other schools of economic thought. To the extent that it is understood by the decision-makers in the governments of the world and central banks, it is resisted. It is regarded as old-fashioned and out of touch with newer, more scientific theories of money and banking.

The crisis of 2008 has led to a revival of interest in the Austrian School's theory of the business cycle. Why? Because several Austrian School economists and newsletter writers warned of the looming crisis. They did so two years before it hit. These predictions were dismissed as radical and out of touch. The most widely viewed debate over this matter – after the fact – took place on CNBC in 2006. Peter Schiff warned of the recession. Arthur Laffer dismissed it.

Finally, the Wall Street Journal ran an article on Mises' prediction of the Great Depression. The article ran on November 6, 2009. Better late than never.

MY FUNDAMENTAL POINT

In Part 1, I made the point that the Austrian School's theory of money is an extension of its overall theory of economic exchange. This distinguishes the Austrian School's view from all rival views of money.

The rival views insist that the free market is insufficient to provide a reliable monetary system. Either the national government or the nation's central bank must intervene in the free market in order to provide stability and reliability to the money system and therefore to the economy.

The logical extension of this outlook is that there is a great need for a world government and a world central bank, which together provide such stability internationally. Most economists and politicians refuse to say this in public, but this is a matter of prudence, not logic.

In contrast, the Austrians say that the free market can provide such a system of world money. We have already seen this system in operation. It was called the gold standard. It operated for most of the nineteenth century. It needed no world government and no world central bank to make it work. It did not need trained economists to make it work. You can imagine how popular Austrian School economics is with economists – about as popular as the gold standard.

The non-Austrians insist that money needs government coercion in order to be money. Money may have started without coercion, but this condition cannot last for long, nor did it. The defenders of this position rarely come out and explain why, in terms of their theory of markets, money is different from other goods and services. If private property and the right of exchange produce efficient markets for other scarce resources, why not for money? They do not say, exactly. They just insist that this is the case.

Then, not surprisingly, we find that in exception after exception, they insist that other aspects of the economy also cannot function without state coercion. In niche after niche, in sector after sector, we are told that market-clearing bids cannot arise. But the biggest sector of all is money.

WHAT IS MONEY?

Mises defined money in 1912. Money is the most marketable commodity. This identifies the central benefit of money: a means of exchange.

Contrary to the standard textbook accounts, money is not a measure of value. There is no measure of value. Value is subjective. You could as easily measure your love for your children.

Also contrary to these accounts, money is not a store of value, although it is a valuable thing to store. There is no store of value. There is at best continuity of price.

Money is a unit of account. It makes possible modern double-entry bookkeeping. Mises said that this was one of the greatest inventions of the modern world.

Mises argued that money arose out of voluntary exchange. A commodity that had been sought and bought for attributes other than its use as a means of exchange became a commonly accepted means of exchange. This created new demand for it. The government did not create money. Individual decision-makers did.

Civil government soon insisted on sovereignty over money. It stamped coins. This authenticated the coins. But, when governments found that they could steal from the public by debasing the gold or silver coins with cheaper (base) metals, the newer unauthentic coins de-legitimized the inflating governments. Authenticity became unauthenticity.

Fiat money is a form of counterfeiting. In a world of fiat national moneys that are in competition with each other, national governments have become members in a kind of competitive cartel of counterfeiters. "My counterfeit money is better than yours!" they insist.

Gresham's law states that bad money drives out good money. This law holds true only when governments set price controls – fixed rates of exchange – between different forms of money. The artificially overvalued money drives the artificially undervalued money out of circulation. We do not see gold and silver coins in use as money today because governments have artificially overvalued their own national currencies.

FIVE DECIDING ISSUES

There are five fundamental issues in every social order and every institution: (1) sovereignty, (2) authority, (3) law, (4) sanctions, and (5) continuity. Put in easily memorized form, they are:

1. Who's in charge here?
2. To whom do I report?
3. What are the rules?
4. What do I get if I obey? (disobey?)
5. Does this outfit have a future?

With respect to money, the Austrian theory of money answers these questions as follows:

1. The free market
2. The individual who has money
3. The right of exchange/contract
4. Profit and loss
5. Long use encourages future use

With respect to money, the other schools of opinion differ from each other, but not on these issues:

1. The state
2. The fractional reserve banking system
3. Never allow price deflation
4. Big bank bailouts
5. People will adjust to price inflation

The universal outlook of the non-Austrian schools of thought is that a steady price deflation is always bad, but a little price inflation is not so bad, and it is surely better than price deflation, recession, or depression. In all theories of money except Austrianism, the state is seen as the necessary agent of planning. Even in schools of thought that proclaim the inefficiency of central planning, the members hold to the necessity of scientific central planning of money. All of them call for the economists employed by the state-created central bank to adjust the money supply in order to achieve specific outcomes.

Deep within every non-Austrian free market economist, there is a central planner screaming to get out.

FRACTIONAL RESERVE BANKING

Under fractional reserve banking, banks are allowed to lend out money that has been promised to depositors. The depositors think of their deposits as money. So do borrowers. Borrowers spend this money. Then, one dark day, depositors also try to spend this money. A bank run begins.

Let us review how the system works. A bank accepts a deposit of $100. It sends $10 to the regional Federal Reserve Bank as its mandated legal reserve. It lends out $90. The borrower spends this money. His bank takes $9 and sends it to the FED. Then it lends out $81. On and on it goes, until the original $100 deposit turns into $900.

Inflationary? You bet!

The fractional reserve process allows the banking system to expand the money supply. This creates an economic boom by lowering commercial interest rates. To lend this new money, banks must find borrowers. To lure them in, the banks have to offer lower interest rates than what prevailed before the fiat money was created.

Entrepreneurs who borrow the money begin new projects. But then they find that they are running short of capital. The increase in fiat money did not represent an increase in thrift: future-orientation of consumers, i.e., a willingness to defer consumption. Businessmen must now compete for more money to finish projects. Interest rates rise. More companies then shut down incomplete projects. The recession begins.

Fractional reserve banking rests on an impossibility: that all depositors can withdraw currency at the same time, even though the money has been loaned out. The bank's contract allows depositors to withdraw currency on demand. This contract is inherently fraudulent. It cannot be fulfilled in a banking crisis. There are two legal claims on the same money: depositor and borrower.

If the bank's contract with depositors had specified that the money would not available until the subsequent loan was repaid by the borrower, there would be no problem. The problem arises from the simultaneity of economic value across time. Future value is always discounted by time. This is the phenomenon known as the time value of money. Mises called it time preference.

The heart of the contract's problem is that current money is always worth more than future money. The value of future money is discounted by three factors:

1. The discount of all future value
2. The risk of non-payment
3. The inflation premium (depreciated money)

Fractional reserve banking rests on an impossibility: "The discount applied to future money will not change." When a banking crisis occurs because of this, the size of the discrepancy between the present value of money and its future value, there are bank runs. The discount applied to future money increases due to a rising risk of default. "A bird in hand is worth two under the bush." Depositors want their now even more valuable present money rather than a legal claim on now less valuable future money. The banks do not have the currency to pay off the depositors.

The bank then calls in whatever loans that it can. The debtors cannot repay. They go bankrupt. Then banks that lent them the money go bankrupt.

A depression takes place because pricing of capital goods was made on a false assumption: the depositors would never all demand their money at the same time.

The assumption is false because the initial premise was false: "The present value of future money will not depreciate so much as to cause a run on the banks."

But couldn't bans raise the interest paid to depositors? Of course. They could get out their iPhones and speed dial 1-800-FREE-LUNCH 1-800-FREE-LUNCH .

Maybe depositors get fired because their employers could not meet the demand for repayment to the banks. The depositors then demand immediate money. Banks cannot deliver. The collapse of overextended banks exacerbates the depression.

The inverted pyramid of debt collapses. What goes up (boom) must come down (bust). But not for long. The central bank then steps in and creates new money to forestall this collapse. Another round of counterfeiting begins.

BOOM-BUST, BUST-BOOM

The reason why economies suffer from booms and busts is because the fractional reserve banking process continues. It continues because there is an enforcer who calls the bust to a stop before prices have adjusted to the new conditions of supply and demand. The enforcer is the central bank.

A central bank's primary function in every nation is to keep large banks in the banking cartel from going bankrupt. The big banks are never allowed to go belly-up.

The central bank always intervenes and creates new fiat money to bail out the big banks. If it doesn't, the government does. The cure for the bad outcome of fiat money inflation – depression – is always another round of monetary inflation. This sets off the boom-bust cycle once again.

Once started, the process continues, generation after generation. The groups that prospered from the fiat money–induced boom demand bailouts. Some of them do get bailed out by the government. These bailouts are paid for by new government debt (no change in the money supply) and also by fiat money issued by the central bank.

There is never a day of final reckoning. Everyone plays kick the can. This is point five: continuity. It is the continuity of deferred judgment (point four). The profit and loss system is not allowed to work.

Monetary reform never takes place because everyone wants to defer final judgment. Everyone wants to go to heaven, but nobody wants to die. Everyone wants a stable economy with growth. No one wants recession and increased bankruptcies to re-price capital goods. So, kick the can always results in another round of monetary inflation. The boom-bust cycles repeat.

This is continuity in the modern fiat money economy. The voters want it. The debtors want it. The banks want it. Businessmen want it.

The result: American prices as measured by the consumer price index have risen by a factor of 20 since the Federal Reserve System began operating in 1914. The dollar has depreciated by about 95%.

There is never a monetary reform that in fact reforms the system. All monetary reforms are applications of kick the can.

WHERE DOES IT ALL END?

If kick the can continues, fiat money will depreciate. People will take on new debt on the assumption that inflation will let them repay their debts with money of reduced purchasing power. When recession hits, they demand government action. This means more inflation.

Mises argued that when people catch on to the game, they will take evasive action. They will make plans in terms of rising prices. Other economists have agreed. But this led Mises to argue that the economic contraction would come if the supply of money were not increased at an ever-higher rate and unexpected rate. Inflation would become hyperinflation. He saw this take place in Austria a decade after The Theory of Money and Credit was published.

He was once asked if he had a hedge against inflation. He replied: "Age."

There must be a default at some point. The question is: "Which kind?" If the central bank ceases to inflate, a recession begins. If the government or the central bank refuses to intervene, many banks go under. This shrinks the money supply. The recession becomes a depression. Bankruptcies and unemployment increase.

Tax revenues fall. The government cannot pay its debt and also meet all of its promises. It must choose:

1. Default on all of the debt
2. Default on part of the debt
3. Tell the central bank to inflate
4. Raise taxes and cut expenditures

Choice #3 starts the process over. The ultimate result: the destruction of the currency. This is default through inflation. It is nonetheless a default.

CONCLUSION

Decide which way of default is most likely. Then decide when. Then plan accordingly.

Or you can do what the policy-makers do. Kick the can. Most people do.

But then, one day, there is a day of reckoning. However, until then. . . .

"We'll have fun, fun, fun till the market takes our T-bills away."

Gary North [send him mail ] is the author of Mises on Money . Visit http://www.garynorth.com . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .

    http://www.lewrockwell.com

    © 2009 Copyright Gary North / LewRockwell.com - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules