My two geek hobbies are happiness research and economics. I post about them often. Today I’ll talk a about economics and money as it relates to the big, bad looming/imminent debt crisis.

I’ve written before about Fiat money. Fiat money is money with no intrinsic value, backed by nothing of intrinsic value. It is just paper and we all agree that it will be treated as money, and so behave as if it had value.

Most modern economies (us included) use fiat money. In the early 1970s profligate spending mostly brought on by the Vietnam war forced us to abandon Bretton Woods (an agreement for currency backed by gold instead of fiat). Of course there would be no economic lessons to be learned about Iraq from Bretton Woods/Vietnam ๐Ÿ˜‰

The problem with money that isn’t backed by anything of value is that its easy to abuse with a printing press. Government controls the printing press for money and everyone agrees to keep up the charade that it has value as long as the government is responsible with the printing, since a stable money supply equals a money of stable value.

That is the advantage of gold…even though gold doesn’t really have an intrinsic value either (its just a yellow rock)…it is of limited supply and it has a long history of value…so people trust it. (If we could figure out how to manufacture gold in a lab, gold would lose its value too.)

So the incentive is for a government to be responsible with the printing press of money, because they’ll make their currency worthless if they print too much. It is a dangerous temptation though to know that you can just print another reem of hundred dollar bills and you’ll magically have thousands more dollars. Printing free money is a temptation that government will eventually yield to (yes, I know I have a dangling preposition). Our government is currently yielding.

Once you get irresponsible with the printing press, you’re on your way to worthless currency…as well as wrecking your nation’s standard of living.

The US government creates money several ways, but the main way is by allowing banks to lend money in a fractional banking system and then regulating the lending and reserve rate. This is our complicated way of printing money; the effect is the same.

For instance, when the Fed “lowers the rate”, it suddenly becomes cheaper for banks to borrow money (they borrow money from the government, which creates money since the government doesn’t really have any money except through the printing press). The banks generally (but not always) pass along this savings to us….which makes money cheaper.

We borrow more, but the banks don’t have to keep all of it on hand. They may have 100 bucks in their bank vaults, but 1000 bucks in outstanding loans. That extra 900 bucks is created when they lend. The more they lend, the more money is created. The cheaper it is to borrow, the more we borrow, the more money is created.

So when the Fed “lowers the rate”, he is creating money. Creating money generally stimulates the economy. Why? Two reasons: 1) The loans (which create the money) are usually taken out to pay for some sort of business or personal investment, which is actually good for the economy (but what happens when it isn’t…what if its wasted on some foreign war like is happening now?). 2) Creating more money can give the illusion of being richer for a short time. “Flooding” the market with money (this is sometimes called “papering over” an economic issue) gives us money through inflation, which we spend, which stimulates the economy…but it is eroding the value of the currency at the same time.

What happens though if it is a big crisis? What if the crisis isn’t with a specific part of the economy, but with the debt/banking system itself (the worldwide financial markets get scared of “debt” because they think it won’t be paid off, that they haven’t valued the risk correctly. They will steer clear of the risk.)? Remember that trust is the ONLY thing that gives the US dollar value.

US debt was considered good and so people value the dollar. Now it appears the whole system is under stress (since debt itself is what creates our money). The debts people thought were safe, were not. The US dollar is not safe.

That creates two problems. 1) Even with a stable money supply, when the international community thinks your currency is more risky, the value falls. 2) We are creating more money by lowering rates to stimulate the economy. An increase in the supply of money devalues your currency.

Those two things are working against us in tandem. The more the Fed tries to rescue the economy by lowering rates, the more value the dollar loses….which is part of the problem to begin with. You’re in a catch-22.

There is a choice to make: On the one hand we can devalue our currency to try to stimulate the economy (which is the traditional approach). On the other hand if a debt crisis is what caused the economic problems in the first place…how can issuing more debt help?

What if lowering the rate doesn’t stimulate the economy? Well, they lower it more…further devaluing the dollar, causing more of what got us into the mess in the first place: too much debt.

The Fed pumping money into the system to “save” the economy is only postponing the debt crisis and making it worse. The Fed knows this as well, but I am guessing there is tremendous policital pressure to keep the economy limping along. No politicians will take the pain now for a better day tomorrow…since there won’t be a tomorrow (no re-election) if things aren’t good today.

People can also invest in (lend to) the government, as well as borrowing from them. The government sells bonds, and US government bonds are considered one of the safest investments in the world. They yield a low but passable return, let’s say 5% annually.

In this scenario the government is in debt to us (the US citizens), and we get 5% interest on our loan to the governement. But what if the government inflates the currency 5%? We break even, which is just like hiding money under the mattress..not a good investment. Investors (<– the people with the real money) get really mad about inflation, since it erodes their profits.

What happened to the 5% return we were supposed to get though? This is where it gets interesting: The government stole it back from you. They spent too much money (on wars or whatever), and didn’t want to raise it with taxes, so they raised the money a different way: Instead of paying back your loan to them with 5% interest, they inflated the currency and kept the 5%. They pay back their debts with ever more worthless money, and we can’t do anything about it. In the process they are eroding our savings (since every dollar we have saved is now worth less…we need ever higher rates of return just to maintain its present value).

In the extreme scenario, you can see that an overspent government is forced to inflate the money more and more to make paying back the interest on their loans less painful. In essence, as you inflate/devalue the currency, any debt denominated in that currency becomes cheaper.

Here is another extreme example: The government owes me a trillion billion dollars. They obviously can’t pay it off. What does Uncle Sam do? Prints off a trillion billion dollar bills and gives them to me; yet in the act of doing so has made them worthless. I can’t do anything because technically the debt has been paid.

Let’s think about this internationally: Many commodities are priced in US dollars. Oil is one (but anything priced in US dollars follows the analogy). Many oil rich countries are mad about our inflationary monetary policy, and have threatened to price oil in Euros and break their peg to the dollar.

What is the effect of dollar denominated oil as we’re inflating our currency? We get to buy oil with every more worthless dollars (in essence, stealing). If oil were priced in another currency, we’d see the price of oil rise for us, but it would be stable for everyone else. We’d price ourselves out of the market for oil (since it would be so expensive for us), and would have to stop the devaluing of our currency (since we couldn’t buy anything with our worthless currency. In the extreme case, countries would no longer accept US dollars as payment). But since its in US dollars, the price can’t jump that high, because the price would also jump for everyone else. Again, in essence we’re forcing the rest of the world to deal in and accept our ever more worthless currency. (Coincidentally, the price of oil is at an all time high and is rising…much faster than inflation…which makes you wonder how accurate the inflation numbers are when all goods/services depend on oil.)

Also, there are the countries that peg to the dollar (lots of them): We are exporting our inflating currency to them as well, and many of their economies are not as stable as ours. Exporting inflation (as we saw in the other example) is sort of like the government stealing from you. There is a good reason many countries are mad about what the US is doing. We are stealing from, and exporting our problems to them.

Everyone pegged their currencies to the dollar and priced international commodities in dollars in the first place because they trusted the US government and its responsibility with its currency. We have broken that trust.

But what if the debt train stops (they don’t buy our dollar denominated debt), and commodities are no longer priced in dollars? What if a country’s foreign exchange reserves are no longer dollar denominated?

The government fails. The dollar is worthless. We’ve printed ourselves into oblivion. (This actually happens occasionally)

The government fails?? Really? I know you’re thinking that can’t happen….but it can. A government supported by worthless money can yield no power. No one would accept their payments. They wouldn’t be able to afford upkeep of their infrastructure (roads, military, etc.). You can’t trust them…and it really goes back to that trust.

A crisis of the debt agreement (what we have now), is much more significant than manufacturing jobs leaving, or the auto market struggling. A crisis of debt is a crisis of the foundation of the economy, and government.

Not to sound too alarmist though: Our government will not fail (at least in the same manner as my extreme example). Why? Because other countries will and are subsidizing us. And they aren’t happy about it. In essence, we are stealing from them in a very sophisticated way.

All the countries out there pegged to the dollar (and many others in general) are holding US dollar reserves to stabilize their country’s currency. If all of them suddenly liquidated those dollars for another currency….we would see a glut of dollars hit the market, and a fall in demand for the dollar. Again, rising money supply = inflation, and fall in currency demand (less dollars would be demanded because country X has decided it no longer wants dollar reserves) = less value for the currency.

Also, we’d have to start buying the goods from that country at a real market rate (instead of our dollar subsidized rate). This is the same analogy as with dollar denominated oil above. As long as a commodity (bananas, or copper or whatever) is priced in dollars, we can just print more paper and force others to accept the money. Price the commodity in a stable currency (Euros or whatever) and we have to pay market rate by first buying Euros. In this scenario we don’t get the advantage of the “dollar subsidy”.

But Elliott (I hear you thinking), we don’t “print” money persay; we issue debt to create money. What if people simply quit borrowing? What if foreign governments quit holding US reserves, or quit buying or Govt T bills?

Well, the fact is there are trillions of dollars already out there…..many trillions…owned by other countries. If other countries “quit” all their dollar denominated assets…..they would essentially make them worthless by the act of selling them. There would be a “run on the bank” for US dollars.

Other countries have a vested interest in the seeing the dollar continue to be strong because they would devalue their own US dollar assets if the dollar failed. Also, many governments/economies depend on the US economy. If the dollar failed, the world economy is in real trouble.

Because so many countries have a vested national interest in US economy, we are able to devalue the dollar, and force the world to pay for it. The have to keep buying our crap in dollars…otherwise their own dollars become worthless, the US economy would fail, which in turn causes their own economy to fail.

Its a strong-arm tactic by the US government: They’ve spent too much money, and they’re forcing the world to pay for it…because they can.

So in reality, political pressure will save the economy if it happens…forcing foreign governments to finance our financial irresponsibility by continuing to invest in US dollar assets/concerns until the money supply re-adjusts to growth.

In the long term though, this won’t work. It only works now because we are the lynchpin in the world economy. We’re too big to fail, so other countries must bail us out. However, with the rest of the world economies growing and a distrust of the US economy/currency, they’ll cut us out of the loop, and the US will lose relevancy: death by a thousand cuts. We’ll look up in twenty years and realize we’ve lost the lynchpin status and we’re just a nation among many others, perhaps worse….no special favors available.

You think I’m just making this stuff up about the government “stealing” from us through inflation?

Here is what Alan Greenspan said (too bad he never remained true to it):

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the “hidden” confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.”

This plays out all the time in real life. The Dow Jones Industrial Average is doing ok these days, even if the economy isn’t doing all that well right? It sits relatively close to its all time high, even with all our woes. That depends on how you price it.

Think about inflation again. Priced in dollars, we can make the Dow look like its rising, even when its falling…just inflate the currency. But when we price the Dow against other assets (gold for instance), it tells a different story.

Here is the Dow priced in dollars:

Here is the Dow priced in gold:

Think it doesn’t matter? It does. You always pay the piper eventually (though admittedly perhaps not in our lifetime).

Also, I note that inflation, even today with all my alarmist rantings about what’s going on, is not that high. Well, the CPI (consumer price index), which is the general surrogate for inflation, is not a number without controversy. Many people think it far underestimates real inflation, and once you delve a bit into how the number is calculated…you’ll get suspicious too.

The basket of goods the BLS (bureau of labor statistics) uses changes (at their discretion), and they use several “weighting-factors” for quality of goods that basically allows them to massage the number to say whatever they like. It doesn’t mean they ARE manipulating the numbers, it just means that based on the way they calculate CPI….massaging is very possible. Under-reporting inflation would allow the government to steal and then tell us nothing is happening.

Fiat money is a pyramid scheme, but it is so complicated that it becomes very possible to fool all the people all the time…almost always. Sometimes the politicians even fool themselves and forget that printing money is not the same thing as creating value.

So when you hear talk about these bailout schemes by the government or complex financial products to help smooth over the crisis….beware…there is only one scheme that is being put on the table: Devaluing the currency (which forces us and other countries to bail out the US govt).

Why are we not outraged by all of this? Why are we not calling for the head of the Federal Reserve Chairman, a return to the gold standard, or writing our politicians asking them to stop fleecing us?

Easy: I have a masters degree in international business, read econ books for fun, and actually spend time thinking about these issues (as evidenced by this post)…..and its still hard for me to explain.

No one understands what’s going on. And even though I’m right, there is no way to know when it might all come to a head, or if our govt is crafty enough to really force the world to bail us out.

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2 Responses to “Inflation, the Printing Press, Theft and the Jedi Mind Trick of Fiat Money”
  1. Jason says:

    Elliot…that is a very interesting post. Thanks for the education.

  2. Elliott says:

    Here is an article by Representative Ron Paul (a minor Republican presidential candidate this year) saying basically the same thing I just said:

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