Thursday, February 19, 2015

History and Introduction

We go to grade school to get a good knowledge base to go to high school.  When in high school the generally accepted goal is to get in to a good college.  We go to college to learn marketable skills that once in the work force will allow us to earn money.  We work our entire life for money, and invest in hopes that that money will grow, but during all of that schooling and for most of our lives we never learn the history of our money and what it is.  I think it’s about time we all find out.


The story of our money starts as a simple fraud.  It is a fraud that has infiltrated every facet of our lives.  When one benefits from this fraud, the draw to perpetuate it is in most cases overwhelming.

Imagine an Old English goldsmith.  He makes a handsome living minting coins for the local lord, and at times the king himself, along with other services associated with the working of precious metals.  He has used some of the profits from this enterprise to invest in a grand safe in which to store, not only his gold, but the gold of his clients.  As his business grows he adds additional 24 hour trusted guards to add to the security of his vault. 

This security, is visible and imposing.  This introduces a new business opportunity to the metals worker.  Clients begin to request that their wealth, in the form of gold and silver, be stored in his facility.  For a small fee he agrees.  In return for the gold, he gives the owner a simple receipt. Among his other services he becomes a storage facility, a legitimate service for fair compensation. 

After some time the gold smith was making nearly as much income from his storage fees as he was from his metal working.  It was a lucrative business.  A few new things occur, the first of which was people began to use the receipts as a medium of exchange.  The receipts are lighter and more convenient than carrying around the gold and silver coins, but the bearer of such receipts could be confident that they could be returned to the gold smith and claim their wealth.  Originally it was no different than a coat check receipt you might receive at a restaurant, but now that they were being used as money, they took on a very unique characteristic before only allotted to the precious metal coins; they were a medium of exchange.  On the surface there is nothing fraudulent about this development either.

One thing the use of this paper “currency” did facilitate was that gold was rarely taken from the custody of the goldsmiths vault.  Once the goldsmith realized this, he felt it a shame that all that money sat there idle.  Temptation started working on him, urging him to put this money to work.  He had some options. He could simply use it to purchase whatever he wished, but to the bright business man, this was a sure path to disaster as he had no way of regaining the gold, and eventually the clients may want it back… imagine that.  Instead a smart goldsmith could loan a portion to farmers, other businessmen, even the lords or king and other members of the government, at interest of course.  Now he could convince himself he was not stealing since he was only keeping the interest.  Now this was sustainable, but very clearly fraud.  To loan other people’s money and profit, without their knowledge most would agree is an immoral act.  But even if the goldsmith started small, the returns in many cases must have been irresistible.  

The people watching the goldsmith attain impressive wealth, through jealously, self-interest, or curiosity may have started paying close attention and determined that he may not be gaining his wealth through just means.  These curious onlookers may have thought he was just spending the gold and silver that he was storing, or completely picked up on the whole lending scheme.  Either way the result would be clear to the observer; there would be more claims on the precious metals in the vault than there was actual gold and silver stored there.

If that observer was a client of the goldsmith it would cause a loss of confidence.  Those who realized it would rush to trade in there receipts for their gold.  People often move as a herd and,  whether the first to pick up on the fraud actually vocalize there concerns or those watching the long lines at the vault felt it’s better to be just part of the crowd, the result will be the same, what we now know of as a bank run.  The remaining gold and or silver quickly disappears from the vault, many that had entrusted the storage of their wealth to the goldsmith would have been devastated at the loss of their savings.  The grieving would hit the well-known anger phase and the goldsmith may have paid with his life.  There is though, no question that the practice could create immense wealth for the perpetrator, and people have risked more for less.

The most cunning of these goldsmiths, attempted to make this fraud more legitimate, to at least not shut the cash cow down all together.  Undoubtedly the interest on the loans, in some cases, may have been even more profitable than either their storage or goldsmith fees.   Loans allow people to have now what you would otherwise have to wait for.  So loans feed on a human condition for pleasure in the moment and the demand for loans, at the right terms, would always be high.  So how could the goldsmith continue to feed that demand and profit from it?  The answer was to become what we now know as a banker.  They essentially bribed their customers to allow them to continue making loans.  They would use the deposits of gold and silver to make a loan and split the interest with the depositor. 

Making loans on deposits in this manner actually doesn’t appear to be fraud at all, on one condition, and that is if the depositor is willing to wait for the duration of the term of the loan to get their money and interest back.  Unfortunately for the banker this does not work nearly as well.  Considering the gold has been earned by the depositor through hard work, they are less likely to loan that hard earned money at an interest rate nearly as low as the banker would be willing to.  The banker did not have to work very hard for the loanable funds in the previous model, it was given to him.  Now on top of the already high interest the depositor demands, the banker has to tack on his cut.  With higher interest rates the demand for loans would be lower.  Less loans would mean that compared to the fraudulent model, not only would the banker have to pay the depositor their cut, there wouldn’t be nearly the volume.  Both these conditions equal less money for the banker and after it was so lucrative, it was only a matter of time before another fraudulent version would be born.   The receipts would also lose their usefulness as a medium of exchange since they could not be exchanged for gold and silver on demand.

All the banker needed to do was convince the depositors that it was safe to give the bank their gold and silver while at the same time continuing to allow them to use the receipts to collect their precious metals on demand.  This is known as a demand deposit.  If depositors could get their savings on demand they would not insist on such a high rate of interest.  The banker would continue to make loans with the deposits but would compensate/bribe the depositors with the interest.  The receipts could also continue to be used as a medium of exchange.  Due to the interest payments to the depositor this arrangement was not quite as good as the secretive theft.   This new slightly more transparent deal didn’t protect the system from bank runs, and thus was unstable in that it could not ensure that the depositors could always get their hard earned money.  Bankers certainly would make every attempt to convince them that the deposits were safe though.

It was similar to a much later scheme started by a Mr. Ponzi, the depositors who, in the event of a bank run, got out first, did just fine.  They got their gold as well as all of the interest for however long the scheme held together, but the last ones out got none of the original deposit let alone interest.  This was still clearly an immoral system, but the depositors certainly share in some of the blame for knowingly participating.  Although, it has become a tradition in banking to make the system confusing but also, in a way, explainable to make it seem viable.  The bankers give the depositors and borrowers a list of exactly what they want. Excuses as to why they can participate, collect interest, or as a borrower, get cheap loans, and in general continue the good times.  I'm sure in some cases the bankers even convince themselves that these excuses were real.

Now enters the final piece of the puzzle.  If the government is fair and just it, even if the depositors want such a system, will see it for what it is and shut it down through its laws, just like any other system of fraud.  So to get such a government to allow such a system the bankers will, in addition to the depositors, need to give the government a cut of the wealth and benefits.  They can do this through paying taxes, providing cheap loans to the government, or providing other benefits to those who control the implementation of the laws. 

The bankers could also attempt to convince the governmental powers that this system is actually good and healthy for the economy, and thus those in power.  Direct payments to governmental officials, cheap loans, along with a healthy dose of opacity and confusion will allow the government to endorse such a system.  Now this fraud has legitimacy, it is lawful, yet still immoral.  Governmentally sanctioned fractional reserve banking has now been born. 

A key point is fractional reserve banking was born of fraud.

This system also increases the amount of money in the economy.  Initially there is only the number of gold or silver coins circulating.  When those coins are deposited and the receipt is given out, that recipe will flow in the economy just as if it were the gold itself.  But the gold coin is also loaned out entering the economy.  The gold could also be re-deposited, adding another gold receipt, and loaned out again, repeating this cycle over and over.   This increase in the money supply was originally termed inflation, because it was an inflation of the money supply. 

If there was a perfectly commensurate increase in goods and services (the boom), the increase in the money supply would not affect prices.  If the increase in goods and services did not keep pace with the increase in money, prices would rise.  And finally in the event that the amount of goods and services increased faster during the boom than the money supply, prices would actually fall.  The main takeaway is that the term inflation initially only referred to the increase in money supply and could be a cause of changes in prices although there were other variables, namely money velocity, and actual economic growth. 

One other issue arising from these booms is that due to the volatile growth that is born from monetary inflation, there can be great misallocation of resources as a result of bubbles.  Bubbles can be defined as overinvestment in one sector of the economy due to incorrect market signals.  Usually this incorrect market signal is increasing price action in the investment giving the false impression of assured gains, but other factors can also cause these incorrect market signals such as manipulation. 
Fractional reserve systems grew and infiltrated the economies of Europe.  As long as they held together, using them could be quite prosperous, but the collapse was actually inevitable.  When these banking systems collapsed the economic turmoil left in their wake could be so devastating that the initial boom created by the monetary expansion as a result of the bankers loans would be erased or worse, could cause the economy to regress.

Here is how Ludwig von Mises put it:

"There is no means to avoiding the final collapse of a boom brought on by credit expansion."

The second part of that quote is more profound but that is for later on.

The boom may bring true economic growth, to some degree.  It may cause farmers to produce more crops, builders to build more homes, and fisherman to catch more fish.  In addition, during the boom, the depositors benefit, government benefits, even the general population may benefit from the wealth created. But the bankers benefit most of all with very little effort.  During the boom none of these groups will resist, after all they are making money and living better. The splinter in the side of the system is the crash, and one of the aspects that makes fractional reserve banking an even harder pill to swallow is that one generation may enjoy the benefit  of the boom and leave the crash for their children or grandchildren.  This feels even against human nature to benefit at the detriment of your offspring, but again those caught up in the boom want to believe and will justify it by any means possible, or may just not be paying attention.  

A key point with the boom is that the longer it is able to continue the larger the crash can be.

The mechanism through which the crash happens is simple.  After a bank run the unredeemed receipts no longer have value since they cannot be exchanged for specie (another term for gold and silver coins). They are no different than the coat tag that you can no longer use to get your coat.   The receipts are no longer money.   Just like the worthless coat tag the receipts can be discarded.  At this point the only money left in the economy are the gold and silver coins, there is far less money than there appeared to be when the receipts were still generally accepted.  This reduction in money supply is the flip side of inflation and is a factor in the opposite effects. 

There are other effects that result from the boom and subsequent crash.  Some of the specie may have also traveled far from the immediate economy causing even less money to circulate.  Another issue is after any shock it is human nature to store what is needed, and this extends beyond just food after a famine.  In an economic light this storing can cause humans to store or “save” money in an unproductive manner i.e. keep it under their mattress instead of investing it in productive assets. 

Storing money hits on one of the variables that was mentioned when discussing price levels, money velocity.  And now is a perfect time to explain it.  Here is one example.  A pig farmer and an apple orchard owner would like to trade their apples and pork chops.  The owner of the orchard has one gold piece that they will use as their medium of exchange, a simple place holder.  In our first example the apple orchard grower goes down the road to the pig farmer and asks if he can buy a pig for the gold piece, the pig farmer agrees and the apple man goes down the road with his pig.  Later that year, in the fall, the pig farmer decides he wants to go down the street and buy some cider with his gold piece.  The pig farmer and orchard owner decide that 26 casks of cider is a fair for one piece of gold, and the pig farmer loads the casks of cider in his cart and drives home for the year.  So what was the income of each man if these were the only transactions that took place that year?  Easy right, once gold piece. 

Let’s try another example.  The same two men have the same farm and orchard and one piece of gold between them.  This time the apple man goes to the pig farmer on the first weekend of the year and asks for some pork chops for the coin, they agree, and the following week the pig farmer goes and gets a cask of cider for the for the same coin.  Similar exchanges take part every weekend, bacon for pie, ribs for apple butter, pork loin for hard cider and so it goes for the rest of the year, 52 weeks.  Each man gets the gold 26 times and thus their annual income is 26 pieces of gold.  Essentially they exchanged the same amount of goods, nothing was wrong with either way to do the transaction but their income varied by 2600%.  Money velocity can have tremendous effects on economic perception, as much as or more so than the money supply. 

After a bank run some may have thought they had a large store of wealth, only that wealth was not in the form of gold but paper gold receipts, which after the run, were worthless.  Maybe he wants more for the precious gold piece or maybe he won’t spend his last precious piece of metal at all and will wait for the economic storm to pass.  The natural reaction to store the only real money left, the gold and silver coins, after a bank run causes the money velocity to plummet making the reduction in the apparent money supply fall by even more than just the elimination of paper money in the system. 
I’m sure it is easy to see that with the real reduction in the medium of exchange, as well as the perceived reduction due to the reduction in money velocity  incomes would suffer and could make it difficult to pay back loans for the farmers or businessmen, say, to a neighboring towns bank.  These failing, also known as non-performing loans, along with the rumor of the first bank run could cause depositors in those neighboring towns to panic and cause bank runs in their own towns.  Thus the crash does not remain isolated and spreads like a disease throughout a fractional reserve banking system, causing just as much devastation as one.

Since the creation of this fractional reserve economic system there have been those that support and perpetuate its use, but this is mostly rooted in their greed and normalcy bias.  Not because they think fractional reserve banking is the best for their country or its citizens.  Then there are those that see it for what it is, fraud, and try to rid it from their country.  Like liberty and tyranny it is a constant battle that must be waged, at times hot and at times cold but this battle has been going on for centuries.

I have left the origins abstract, the origination actually took place over millennia and not just in England, but through your own research you can find examples of all that has been laid out.

There are two very real services that the bankers supplied to their clients that deserved just compensation.  The first has been covered in the form of safe storage of wealth.  The second was the facilitating of loans and guiding their depositor’s money into productive assets, also known as investing.  These storage and investment services should be paid for, but under the fractional reserve system the compensation for the bankers is much higher than would otherwise be justified in a free market system, the profit share taken by the banks is not fair to their clients, whether the depositors or the recipients of the loans.

This also reminds me of another injustice in which real services were supplied but it did not change the deplorable nature of the arrangement.   This is the instance of southern slavery during the first part of our nation’s history.  The masters of the slaves certainly exploited their labor, but they were supplying a service, management of the plantation, and as businessmen of today know a good manager is a valuable part of the team.  That said these managing masters took an unfair cut of the profits, and the basis of the arrangement was still rooted in an immoral system. 

Now it’s time to make this notion of fractional reserve banking a little more real…in the history of the United States.


Prior to the birth of our nation gold and silver was usually the basis for the colonies monetary system. Individual colonies attempted to use paper money and it failed, through high and hyper price inflation in all instances.  Just prior to and during the revolution the new nation, as a whole experimented with a fiat paper money called the Continental.  Fiat money is given value by government decree; it has value because the government says it has value. 

In prior examples we assumed that the paper money was backed by gold and when the holders of the paper money realized it no longer could be redeemed they immediately discarded it.  In some of these early examples of paper money the links to gold were less clear.  In these cases the point at which the currency could not be used was not as punctual.  This brings up another aspect of money velocity. 

As the users of a currency notice that its value is decreasing and cannot buy as much as it once did,  they are more likely to want to get rid of it as soon as possible and get real goods or services before it goes down in value even more.  The holders of the currency want to get rid of it for something else, anything else, and this increases money velocity. Picture an economic game of hot potato.  This is a physiological shift of the market participants and as the velocity of money increases the loss of purchasing power increases at a greater and greater rate until the currency is worthless.  This is what is termed hyperinflation, but in reality it is just the loss of purchasing power of a fiat currency, due to a loss of faith in that currency.

So it is not the government action of increasing the money supply that causes a hyperinflation but a psychological loss of faith in the currency causing a rapid rise in money velocity. I remember an adage when wrestling, that being strong isn’t necessarily essential to be a good wrestler but it doesn’t hurt.  The will to work your butt off is more important in that sport. Similarly an increase in the money supply of 10 20 or 100% doesn’t necessarily cause high or hyperinflation but it doesn’t hurt.  Like the will to work hard in wrestling, money velocity is the most important factor in the shift from no or low inflation to high or hyperinflation than is money supply. 

The founders of our nation learned firsthand the flaws in paper money by their experience with the Continental, a paper currency used by the colonies.   The inflation of the money supply occurred by the over printing of the money by the new United States Government as well as counterfeiting by their enemy, the British.  As people lost faith in the continental the resulting loss of purchasing power was exacerbated by the inevitable drop in the production of goods and services caused by the strains of war. Exemplified by the quote by George Washington that “a wagon load of continentals’ could barely secure a wagon load of supplies” and by a common phrase of the time describing items of little value “wasn’t worth a continental.”

The failure of the continental was fresh in the minds of the framers of the constitution when they decreed that only gold and silver was to be legal tender and the federal government shall not be allowed to issue bills of credit.  Bills of credit in their view were similar to the receipts of the early bankers, they were a promise to pay gold and silver, and would circulate as currency.  They prevented the government from directly partaking in the fraud, but unfortunately stopped short of preventing private institutions, banks, from doing the same.  This has turned out to be very unfortunate. 

To say that the founders installed capitalism in our American system would clearly be incorrect.  Capitalism was already used under the crown and in most civilizations around the world.  Its use almost seemed organic.  Capitalism can be defined as using money as a medium of exchange fostering specialization through trade, and postponing consumption to invest in productive assets allowing increased efficiency.

The benefits of capitalism in my view are twofold. First it incentivizes specialization through one’s own self-interest.   A farmer for example, in the absence of capitalism will only spend enough time to produce enough grain to feed his own family, splitting the remainder of his time building and maintaining shelter, ensuring a supply of water, raising food animals for meat, ect.  He may not be nearly as good at producing the other items as he is at producing grain but there is no incentive for him to produce more than he needs, until, that is, the introduction of capitalism and trade.  If those around him are willing to supply the production of meat, shelter, water ect through trade the farmer can focus on grain production. 

This focus or specialization will allow the farmer to become even more productive allowing for the benefit of those around him and vice versa.  As the system continues the specialization will become even more focused and real growth and prosperity results.

The second and actually much related benefit of this specialization is cooperation of individuals that would otherwise be difficult.  A good example is the one given by Milton Friedman that no one man can produce a simple pencil, but through the power of capitalism it is made a reality.  It goes that the rubber for the eraser is produced in Brazil.  The aluminum that holds that eraser to the end of the pencil is mined in Mexico and fabricated in Korea.  The wood is supplied from the American North West; the graphite arrives from China, and the paint from Germany.  All of these raw materials are constructed into a finished pencil in Taiwan.  The people who produced the raw materials and finally put the pencil together, do not speak the same language, and if they ever met may not even be able to work together.  But through the amazing power of capitalism they can cooperate to produce.  It is an impressive benefit of capitalism.

At its root, you may be thinking, that specialization and cooperation are really the same thing, different sides of the same coin, and the same mechanism.  You would be right, but this cooperation and trade also fosters peace, what most would strive for.  One instance where someone may want war and conflict is if they are in a position to lend to countries waging war and profit from the interest paid back on those loans.

Capitalism is used in many socio-governmental systems and seems essential to be able to have any success in those systems.  Capitalism can be used in monarchical, fascist, democratic, or republican forms of government.  The only attempted large scale system that does not use capitalism, is communism; though in practice even the most pure communist systems allow the creep of capitalism so as to sustain the system.  That said if the doctrine of communism, from each according to his abilities to each according to his need, is adhered to, the system will fail.  Socialism appears to be an amalgamation of capitalism and communism.  The closer to communism a socialist system gets the less prosperous, the closer to capitalism the more prosperous, though the results of a more communist system may take time to develop. 

Capitalism is essential for any successful, large scale, societal structure and this is based on the failure of the alternatives throughout history, the founders seem to have agreed.  We will continue now to focus on the monetary aspect of our capitalist system. 

The governmental and banking interests had, prior to the revolution, found another patch that, similar to splitting the gains of fractional reserve banking with the depositors, was meant to make fractional reserve banking more resilient.  It was the advent of a central bank.  The main focus of the central bank was to provide a central authority to interconnect the banks and provide cooperation to sustain the system when it was showing signs of stress.

The central bank could do this by having the authority to shift money to a bank that was experiencing a bank run from one or a number of banks that were not.  This could show the depositors at the bank experiencing the run that there was indeed enough money in the bank to satisfy the redemptions of the receipts, at this point commonly known as bank notes.  The bank may not have had the specie to satisfy the run the day before but if the central bank had the ability to shift the gold and silver during the night and quell fears during the next day, the contagion to the other banks could be stopped.  Granted if it was not successful, and it did spread, the banks that had lent the money to the bank that originated the run would fall even faster than the first.  It was another patch because it was merely an illusion, a slight of hand as any street magician would use.  Central banks also could supply their own bank notes, backed by the government’s treasury, or its own capital.  Once again this patch was a way to continue the fraud.

The central bank did however prove useful to perpetuate the banking systems in Europe.  The bankers of the United States knew this and applied political pressure for the United States to form its own central bank, which it did in 1791.  This strengthened the ability of private and state banks (not federal) to be able to add to the money supply through bank notes, and thus allow the bankers to keep taking their unfair cut.  Ironic since the following year in the coinage act of 1792 it was deemed that anyone who would make anything but gold and silver money would be put to death.  Ironic because these bank notes circulated as money, and though they were presumed to be backed by gold and silver, any child could identify that they were not what was deemed lawful money, gold and silver coins. 

This First Bank of the United States, the name of this first central bank, had shareholders, many of whom were not American, yet still were paid a dividend from the central banks’ profits.  It was a private corporation not a government entity, and only operated under government charter.  The United States government was one of the shareholders, but sold its shares in 1795 to raise money, leaving it even less control of the bank.  This first banks governmental charter expired in 1811; it lost its central bank status, and was then completely private.

It was not long after the First Bank of the United States lost its charter that banking interests started to advocate for another Central Bank, which became a reality in 1816.

During the time of the first two central banks of this nation there was tremendous economic expansion, some possibly promoted by the expansion of credit and money supply, but the growth may have been just as impressive without the influences of the banks.  It certainly would have been healthier for the economy.

One such person that saw the undue gains by the bankers for what it was, was President Andrew Jackson.  Far from a perfect man, he had his flaws, but became fixated on what he clearly saw as an injustice.  He said of the bankers “You are a den of vipers and thieves, I intend to route you out, and by the eternal grace of god I will route you out”.

This was a brave stance, for the power held by the bankers was immense, but General Jackson was nothing if not brave.  The leader and antithesis of Jackson, one who had been lulled into the trappings of fractional reserve banking, was Nicolas Biddle the president of the central bank appointed by James Monroe in 1823.

Biddle held no reservations as to the weapons he held at his disposal to fight off the president in his quest to rid the country of the central bank and thus weaken the banking system in America.  He had the power to control the credit and money supply in the fledgling nation, and the ability to cause a crash.  If wielded properly he could cause a crash resulting in suffering for the American people.  At the same time he could use the media, news papers of the time, to paint the economic troubles as a result of Jackson’s policies against the central bank. All the while the bank was causing the crisis on purpose.   Biddle directly threatened to destroy the American economy by contracting the money supply through the removal of bank notes from the system which was well within the central banks power.  Does that sound like an entity with the nation’s best interest at heart or a response from a threatened animal with its own self interest in mind?  I believe, future central banks, if put to the test would react in the same manner if they felt their existence was threatened.

Though it was a bitter battle Jackson prevailed, but there was the inevitable reduction in the money supply causing the crash of 1837.  The economy quickly recovered and prosperity regained footing.

Jackson had bravely beaten a powerful foe, the central bank was no more, and for the first time in America’s short history, the federal government paid off the national debt, it also was the only time.

Fractional reserve banking had been weakened in America, a good thing, yet it had not been destroyed.  Banks continued to expand the money supply resulting in inevitable crashes every several years for the remaining 60 odd years of the 19th century.

With the banking system weakened the expansions of the money supply were short, and crashes were thus smaller than the one that occurred in ’37, and the American economy quickly would recover.

These crashes were known at the time as panics, an apt name considering they were kicked off by people panicking after a loss of confidence in their bank’s ability to pay gold and silver for the private bank notes that had been distributed. 

This next point is a key take away from the booms, panics and economic turmoil of the 19th century.  They were caused by the expansion and contraction of money and credit as a result of fractional reserve banking not from the use of gold as money.  Critics of the gold standard and supporters of fiat money, debt, and central banks often cite these panics as proof that a gold standard is the cause of instability.  But this is just not the case, the panics were caused by what they support, debt based money and fractional reserve banking.

The banks attempted to organize during the latter part of the 19th century, trying to put in the safe guards offered by a central bank.  Under the strains of war the government did assist in 1860’s under the National Currency and Banking Acts.  These efforts actually only allowed for more credit expansion, made the system more unstable, and the panics continued at a faster rate.

There was a very prominent banking family during this time by the name of Morgan.  In the end of the 19th and beginning of the 20th century the patriarch was J.P. Morgan.  He was all too aware of the limitations and risks posed by the current banking system.  Even his, the largest and most powerful bank in America, could be destroyed by a bank run like any other. 

Another banking family emerged after the Morgan’s.  The name of this family was Rockefeller, the patriarch of this family was J.D. Rockefeller.  Rockefeller started making his fortune in the oil business.  He became amazingly wealthy drilling black gold, but even he was lured to the easy gains possible in the banking industry. 

There was a major banking panic in 1907 that nearly brought Wall Street to its knees.  The story goes that the only thing that prevented the system from a complete crash was J.P. Morgan, who acted as lender of last resort, recapitalized the banks, and halted the bank run.  There is evidence that the initiation of the crash was actually planned by Mr. Morgan. 

Whether by design or happenstance the panic of 1907 provided an opportunity for the banking industry to take a page out of Nicholas Biddles’ playbook.  They would attempt to persuade public as well as political opinion to insist that the only answer to panics, such as the one in 1907, was a central bank.  A central bank would be a governmental solution and under the “control” of the government.  After all it was JP Morgan’s bank that halted the last crash, what if a private entity did not have the will or ability to stop the next crisis, a governmental solution was needed, or so the argument for yet another central bank went. 

The banking interests went to work in both politics and the newspapers to attempt to put in place a central bank.

This scheme required tremendous coordination and a secret meeting was held between the representatives from the Rockefellers, Morgan’s, as well as Senator Aldrich the political arm of the banking industry.  An academic from Harvard was also included in the meeting for good measure.  This meeting was held on Jekyll Island, a resort along the Georgia Coast.

The meeting was held under tight secrecy to the point that all of the representatives traveled under assumed names.

The point of this meeting was not to determine how to set up the bank so as best to serve the American people, but to find a way to sell the idea of a central bank to the people and their representatives in the Senate and House of Representatives.  The meeting was denied for years afterward but eventually the truth of the secret meeting was acknowledged. 

The Federal Reserve Act founding the Federal Reserve Bank of the United States was passed in December of 1913.   Besides gold and silver it established the federal reserve note as the only legal tender of the land.  Private Banks would no longer issue their own currency.   There is a quote of J.P. Morgan before congress several years later that makes his own feelings about this new currency more clear -"Money is gold, and nothing else."

The Federal Reserve Bank, though it sounds like it is some kind of government entity and its board members are appointed by the president, has shareholders just like the prior US central banks.  These shareholders, though not known by name are presumed to be the large American banks. They are paid a dividend by law.  The Fed doesn’t sound like any other government agency.  It sounds like a corporation or more descriptively, since it includes all of the banks working in concert, a cartel.

The Federal Reserve Act and the Currency and Banking Acts of the 1860’s allowed for a completely new basis for the nation’s money.   Prior to that point money could be created from debt through fractional reserve bank loans, but the basis for those loans was always gold and silver, barring the issuance of completely un-backed fiat paper money called greenbacks during the civil war.  The new Federal Reserve had the ability to create new money based only on debt.

For the first few years only corporate debt could be used as a basis for the initial creation of money, a few short years later government bonds could also be used.  This money is backed by the entity originating the debt having the ability to pay it back, so in the case of corporate debt the money would be backed by that corporation’s profit.  Considering that corporate debt based money is backed by the corporation’s only means of paying back their debt, its profit, then it is understandable that money based on government debt would be backed by the only form of revenue the government has, its ability to tax its citizens.

Isn’t it ironic that earlier that year the government passed an amendment to the Constitution to be able to directly tax their citizens’ income?  Yep, the birth of our third central bank coincided with the income tax.

The creation of this new debt based money is simple.  A corporation or the US government wants to borrow money and issue bonds.  The bonds are traded for money created by the Federal Reserve, and then the government or corporation spends that money into the economyVoil√† money is created.  This new money is then further expanded through the normal fractional reserve banking system.  As the famous 20th century economist John Kenneth Galbraith said “The process by which banks create money is so simple that the mind is repelled.” 

Before we move on I would like to drill down a debt based monetary system using a fractional reserve system to only one, and the first transaction:  The bank makes a loan to a merchant for 1000 dollars, and like all loans it has interest, we’ll say 5% after one year.  After that year the bank attempts to collect.  The merchant has the 1000 dollars and pays it back, but since these 1000 dollars are the only money in existence how could he ever pay back the additional 50 dollars?  Well there is one way; the bank could ask the merchant to wax the banks floor, or some other service that the bank could pay the merchant 50 dollars out of the 1000.  The merchant would then have 50 dollars to pay the bank back with. 

So simplifying even further the banker, through essentially no effort, created the money and the loan.  The merchant takes the loan and is beholden to provide a service to the banker.  This seems like a great scheme for the banker to be able to put whoever is foolish enough to take out a loan into servitude.   Said another way, the banker makes the borrower his slave.

Though there is certainly some of this scheme going on, allowing the bankers to once again take much more than their fair share, they cannot remove the 1000 dollars from the economy without dire consequences.  As we have shown, decreasing the money supply would result in a crash.  So to ensure that there is not a deflationary crash, under a purely debt based monetary system, the debt outstanding must grow each year based on the interest accrued the year before.  The money in the system will also grow but at a slower rate.   In the example above it is easy to see that when money is created, 1000 dollars, more debt is created, 1050 dollars. 

The mathematically inclined probably just had their ears perk up. They will know that whenever something is growing by a certain percentage each year it sets up an exponential system, granted it’s based on changing interest rates, but it still acts as an exponential system.  We’ll show this in more detail later.

This requirement of debt based money to continually grow at a faster and faster pace is at the heart of many of the policies our nation undertook over the next century.  Many of the policies are touted as progress, but are only in place to perpetuate the debt based monetary system through ever expanding credit or loan creation.  Think of all the governmental “programs” that involve loans.

Another point should be made; if a debt based monetary system must grow based on the interest rate it would put it in direct conflict with the other monetary system being used at the time, precious metals.  Gold and silver in an economy can only grow based on the mine supply or by trade surplus.  The growth of the two money supplies are based on completely different variables.  This makes the two completely incompatible.  Some different types of money can be used together, and can even complement each other; precious metals and debt based money do not. 

There was a provision under the Federal Reserve Act that there was to be 40% gold backing for Federal Reserve Notes.  This can be completely ignored.  The reason this can be ignored is it had no real effect on how debt based money functioned.  If 100 dollars of Federal Reserve notes were created, 40 of them would act no differently than gold certificates or gold itself in the economy; this is not the case with the remaining 60 dollars of debt based money.  This provision was put in place to calm the concerns of some lawmakers in 1913 who may have thought this would put some kind of control as to how much money could be created.  But in practice every time the connections to gold limited or threatened to limit the debt based money creation the laws were changed to allow for further expansion.

The only substantive reigning in of fractional reserve banking was that done by Andrew Jackson.  From that point in the 1830’s till the Civil War, the government mainly stayed neutral. The Currency and Banking Acts of the 1860’s begins a trend of cooperation between the Government and the Banking industry. With the creation of America’s third central bank that trend intensifies and perpetual strengthening of debt based money, fractional reserve banking and the ties between banking and government becomes the norm.  Some of these events were large some small, and all were portrayed as beneficial to the American people, but nothing could be further from the truth. 

To say that the government strengthened the debt based monetary system might be misleading.  Fractional reserve banking is inherently weak and prone to breaking, without government help it would fail.  Debt based monetary systems are like communism, weak, non-organic and without strong governmental support destine to fall apart under their own poor structure.  It would be more accurate to say that the government spent the next century supporting debt based money. 

The banks and government over the following century continually added patches such as the Federal Reserve to continue the credit expansion that is so necessary for fractional reserve banking to continue.  Their hands may seem to be forced, but only in the light that debt based and fractional reserve banking is the only option, which it is not.  One thing that is very consistent when observing these patches is they will always directly benefit the government and or the banks in a very direct manner, while they will be publicly touted to be for the greater good.

Shortly after the creation of the Federal Reserve the world fell into the largest war the world had ever seen.  The creation of the new central bank allowed credit expansion and monetary expansion in the United States similar to the central banks of Europe.  This credit extended by the central banks of the time financed World War One, but the real effects of the new Federal Reserve occurred during the following decade.

As mentioned during the First World War the Federal Reserve gained the ability to purchase government debt in addition to corporate debt, this was forbidden under the original structure to prevent debt monetization.  Debt monetization is when a central bank creates money to trade for existing government debt to fund the government when rational investors will not.  It was also assumed that private debt would add to goods and services in the economy commensurate with the added money that was created when the Fed bought the corporate loans.  This would prevent prices from increasing, but when buying government debt, particularly the kind to fund war, there was a much better chance of price inflation.

Some terminology also changed during this time period, the term inflation was deemed to be synonymous with price increases when the government started tracking price increases and called the measure inflation. In addition the term panic to describe a crash was replaced with recession and depression.  These changes were probably not just a natural progression of the English language. It is more likely they were changed to induce confusion about economics, and the effects of increasing the money supply.  

Then came the roaring twenties which were “roaring” simply because it was a boom created through credit and monetary expansion brought on by the strengthening of fractional reserve banking and introduction of a truly debt based monetary system. 

This, the largest credit created boom to that point was punctuated by a crash in the stock market.  This crash ushered in the Great Depression.   As previously discussed credit created booms often are defined by misallocation of resources, but a generally accepted cause of this crash was that investors were taking on debt to buy stocks.  This debt is called margin debt.  Using debt to buy any asset is also termed “levering up”.  It is called levering because if you borrow to buy assets, the gains, if that asset goes up in value, are intensified, just like the force when using a lever. 

The other side of the coin when using borrowed money to buy assets is the losses can also be amplified.  If you put 20% down to buy say, 100,000 dollars’ worth of stock and it drops by 20%, you have just lost all of your investment.  Not to mention you still owe the full 80k, and interest!  So you can lose much more than the amount you invested.  This exacerbates the panic to sell when an investment bubble begins to pop. 

The drop in assets put tremendous pressure on the banks but before we delve into the banks and governments response to the inevitable crash of the roaring 20’s I would like to revisit the second portion of the Von Mises Quote mentioned earlier. 

Here is the quote in its entirety:

"There is no means to avoiding the final collapse of a boom brought on 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.”

I finish the quote now while we are discussing the 1920’s because in the beginning of the ‘20’s a very prominent government of the time took the second option to ending a credit expansion.  The nation was Germany or the Weimar Republic.  The debt that caused this crash was imposed on them by the victors over them in World War One in the form of reparations.  The debt was un-payable in real terms, but Germany attempted to make good on those debts in a very familiar fashion, they turned to the printing press. 

The German central bank used their power to print money, but France and England quickly caught on and demanded repayment of reparations in gold.  Though in the beginning of this experiment a small economic boom did occur in Germany, the conditions were right for the monetary inflation to quickly cause prices to start to rise and in turn an infamous hyperinflation.  Any Germans holding their savings in the currency lost it all.  An interesting development considering the Federal Reserve was in many ways modeled off of the German central bank.  The hyperinflation destroyed the German economy for years to come and made it vulnerable to a charismatic, yet dangerous and insane leader. 

Back to the United States that voluntarily abandoned further credit expansion.  The banks understood what the falling stock prices could precipitate into.  In an attempt to instill confidence a representative of the banks arrived on the trading floor on the stock exchange and began buying stock, even above the current market rates.  At its essence this attempt to instill confidence was market manipulation, and like most market manipulations the attempt failed, this manipulation failed faster than most.  The commercial banks, even with considerable resources, were getting into trouble themselves, and did not have the ability to stem the tide of selling.  The one entity that may have been able to extend the boom that it created, the Federal Reserve, did not. 

The real action after this crash took place was in the governmental arena.  One of the major reasons for this was an Economist named John Maynard Keynes.  Keynes looked at the booms and busts that had occurred throughout the history of fractional reserve banking and concluded that the booms, causing real economic growth, could be extended indefinitely.  There is no doubt that Keynes was brilliant, his logic appears to be sound at first glance, and many were lulled into believing it.  His thoughts did have a huge advantage over other kinds of economic thought.  It told the banks and government what they wanted to hear.

His ideas boiled down to this these two key points. First, interest rates were generally too high and central banks should intervene to lower them during economic downturns, the crash.  Second, during the crash the government could act as the borrower of last resort to pick up the slack from the private economy until confidence was revived.  The opposite was true during the booms the central bank could raise rates and government pay back what it had borrowed during the downturn while the private sector started borrowing again.  The idea was the booms associated with credit expansion via fractional reserve banking could be smoothed out and the crashes could be eliminated.  It was a very tempting theory but upon further examination and in practice proves to be false. 

The huge advantage this thought has was it not only enticed banks to continue their scheme it also asked governments to spend more as a necessity for economic growth.

Now to define power, power is the ability of a person or entity to give or withhold something another wants or needs.  Power is far from a bad thing, the breadwinner in a household holds power over the family, but if that person is benevolent and has the families best interest at heart there is nothing wrong with that power.  There are many examples of power being held over others that isn’t necessarily bad, but often power is sought after by the worst among us.  In a capitalist society there are many examples of power, but in a free marketplace the power is divided purely based on voluntary transactions. 

The economic theory put forth by Keynes required the government to take a larger role in the economy, thus the government would become more powerful.

Herbert Hoover started to pursue some of these policies by borrowing to start public works projects to attempt to put the American people back to work, but the central bank did not follow the second portion of Keynes’s economic vision, loosen monetary policy, and lower interest rates.  In fact at times they even did the opposite and increased interest rates. 

Next we have an example of the incompatibility of a debt based fractional reserve monetary system and gold.  The president following Hoover, Franklin D. Roosevelt, attempted to follow Keynes’s economic cure.  He wanted to loosen monetary policy, which means creating more money, the question was how to accomplish this with failing banks who didn’t want to lend and potential borrowers becoming more cautious, as is normal during an economic downturn, and there was no demand for loans.  All that while the fed was raising interest rates.  This ruled out the possibility of money creation through the normal means of fractional reserve banking.

Another means to add to the money supply was to revalue the gold already in the hands of the American people.  If each ounce of gold in circulation was worth a percentage more in dollars than its original 20 dollars the inflation in the money supply would help stave off the deflation going on in the banking system.  The easiest way to complete this would be to have all Americans holding gold return it to the US mints. For every ounce of gold that was then stamped with 20$ that they turned in they would receive an ounce of gold stamped with 35$.  Who wouldn’t sign up for that?   People would flock with their gold to have it revalued and the deflation would quickly be halted, and borrowers would have an easier time paying off the debt overhang.

This, allowing the American people to retain their wealth, would not be allowed.   Instead the president issued executive order 6102. The executive order stated that all Americans were required to turn in their gold to the federal reserve banks.  In return for their gold they would receive 20 dollars in Federal Reserve notes, the same value that was stamped on the gold they had turned in. 

Americans at the time were trusting of their government and for the most part complied, but those that were not we labeled by their government to be hoarders, not to mention those that did not comply faced the possibility of 10 years in jail or a 10,000 dollar fine.  To put that fine into perspective, that is equal to about 500 ounces of gold or a 625,000 dollar fine today.  That’s a heck of a motivation in case anyone was wondering if they should or should not turn in their gold.  Much of the nation’s gold was turned in to the government and as the saying goes; he who has the gold makes the rules. 

The next rule to come down was gold was to be revalued from 20 dollars an ounce to 35 dollars an ounce.  So if the people were paid 20 dollars an ounce for their gold and now it was worth 35 dollars an ounce, who gets the other 15 dollars per ounce?  The answer is the US government.  So in this roundabout way the government stole 43% of the nation’s monetary wealth held in gold.  So the reason they did the necessary revaluation in this much more labor intensive (not to mention logistical nightmare) fashion was so that the government could gain access to this huge percentage of the American wealth. 

They used this money, as well as borrowed money to give Americans what they were desperate for, work, actually, work for pay, so they could sustain themselves.  This work came in the form of public work projects.  Government spending during a downturn was a page out of the new economics playbook written by Keynes.   The government gained the ability to give the people what they desperately needed, and thus the government gained additional power.  Those with these government jobs were now dependent.  Whenever a person, company, or government, makes a person or people dependent on that entity, that entities power naturally increases.

The other major change was in the banking system.   The government found a way to increase their power, now the other major power in the country, the bankers, needed to increase theirs.  It came in the form of deposit insurance.  Deposit insurance simply was the government backing the demand deposits at banks up to a certain amount.  Banks were failing by the hundreds in the early 30’s, people were losing money simply by holding it in the banking system.  Depositors were losing faith that is paramount in a fractional reserve banking system, and something had to be done.  Once again, at the time, the Government was still trusted and with it backing banking deposits the doubts held by Americans were, for the most part, put at ease.  The money flows reversed and money started going back into banks.  The final result is the American people were reassured by a guarantee that ultimately THEY were backing.  But the fact that the American people collectively backed their own accounts was covered by just enough steps people didn’t appear to make the connection. 

Reserve requirements were replaced with capital requirements, but this doesn’t change the fact that we have a debt based monetary system.  I will still continue to use the term fraction reserve to describe our system since the change was not really material. 

Even with these “patches” put in place to help the “people”, the real economy didn’t recover and floundered during the 1930’s .  Perhaps these patches were not really put in place to help the people; possibly it was just a power grab, by those that already had a foothold. 

So to recap, the Federal Reserve was created in 1913 and supported the already established fractional reserve banking system to cause a rapid expansion in the money supply.  After World War One there was the predictable boom that would be expected after an expansion in the money supply.  The equally predictable crash after the boom happened toward the end of the 20’s.  The government, after seizing a huge portion of the nation’s wealth, used that wealth as well as borrowed money to position itself as the savior, increasing its power and control.  The banking system also was strengthened by a guarantee on deposits they were not on the hook for, the American people were.  The banks put pressure on the government, the government created the Fed, the Fed and banks caused a boom and crash, and after this failure both the banks and government came out stronger.  

Power is like a pie chart, the pie can grow but the percentages always equal 100%, so if the banks and government took up a larger percentage of that pie, who lost.  The answer was the people and non-financial sectors of the economy lost power during this time.

World War Two, as horrible as it was, refocused the American economy.  The addition of a real threat mobilized the American people and building liberty ships, tanks, food for the soldiers and sailors, and everything else for the war effort did what all of the government work programs of the ’30’s could not do, it stabilized the economy.  All of this funded through borrowing by the US government, this debt caused another boost in money creation.  The economy improved, but there was also tremendous austerity for the average American, rationing and funneling so much in the way of the nation’s resources into the war effort made everyday life for Americans not much better than during the depression if at all. 

The main thing that World War Two provided was an enormous borrower that was not there in the necessary magnitude in the '30s.  Even though the US government took on large debts for its work programs, it was not sufficient compared to the borrowing that took place in the boom years of the 20's.  Remember, the key point, total debt must grow, and even if governmental debt increases, if it doesn't eclipse the collapsing private debt, the money supply will contract and the economy will continue to crash.  Politicians now needed to win the war at all costs; the cost of unprecedented new debt was taken on without thinking twice.

The fact that this huge amount of borrowing actually did restart the boom caused Keynesian economists to come to the conclusion that perpetual new debt and thus money was the cure to economic downturns.  They should have come to the conclusion that such a system that had to grow exponentially may not be the best system in the first place. 

These same economists feared, as the end of the war approached, that without this governmental demand for debt to fund war, the economy would once again slip into depression.  This fear was never realized.  You see, after the war there was only one industrialized nation left that had not had its manufacturing base destroyed.  There was tremendous work to be done rebuilding all of the nations that had been decimated.  American corporations would provide the products that would complete that rebuilding.  They would have to borrow to get that process going so there would be corporate debt demand.  Those foreign nations would want to borrow as well to facilitate that rebuilding.  Americans would now have steady employment, and wanted homes, cars, refrigerators, ect, and with a reliable income stream they were confident in borrowing to get them. 

So while the economists of the time thought nothing could fill the debt void left by a government at war, they were pleasantly surprised that new private debt demand allowed the system not only to continue but to thrive.  After a decade of bust, a war finally jumpstarted the economy, again through massive government loans, and that borrowing continued through the private sector at an exponential rate after the war.  This allowed Keynesian Economists to believe that the possibility of a perpetually credit created boom was possible.  Great for the bankers, they could continue their fractional reserve scheme, and the government was in a great position as well.  If private loan creation ever faltered they could save the day by filling the gap and borrowing for whatever pet project politicians thought would best get them re-elected.  Wow, even saying it, it sounds possible, but remember Mises’s Quote, and the old saying if it seems too good to be true…well you know the rest.

The end of the war also ushered in a new international "monetary system".  There was a meeting of all the allied powered at the Bretton Woods resort in New Hampshire to determine what that system would be.  It was decided that the US dollar would be backed by gold at 35 dollars per ounce.  Other nations could back there currency with dollars, since the dollars were backed by gold, this system set up a loose form of an international gold standard.

With most nations rebuilding, there were huge payments being made to the United States for goods of all types, these payments were made in what the nations had for international settlement, gold.  The gold was held by the Federal Reserve or at Fort Knox and at its peak US gold holdings reached 20,000 tons. 

This tie to gold could not work, as we mentioned, a debt based monetary system is completely incompatible with any tie to gold and the consequences’ would come in due time.

This post war private credit created boom lasted through the 1950's, and only began to truly falter in the 1960's.  The government though stood ready to pick up the debt slack.

Private debt did not rise exponentially in the 1960’s.  L. B. Johnson’s great society as well as the war in Viet Nam gave the United States an excuse to borrow, and with this newly formed debt, new dollars sprang into existence continuing the needed exponential credit growth.

During this time the incompatibility of a debt based monetary system and gold became clear.  It became clear to nations who now were running a trade surplus with the United States, particularly France.  They realized that the United States was creating dollars, and paying for goods with those dollars without increasing gold reserves.  Put another way nations running trade surpluses with the United States realized that they could not trade all of their dollars for American gold as was agreed under Bretton Woods.  Those nations didn’t hesitate to get as much gold as possible though.

From the 20,000 ton peak, US gold holdings had dwindled to just over 8000 tons by 1971.  If the United States was to keep any of its gold something needed to be done.  President Nixon on August 15th 1971, shut the so called gold window preventing other nations from trading their dollars that they were using to back their own currencies for gold as was agreed.

So did the use of gold as the monetary base end because gold had lost its usefulness in the monetary system, had we evolved past it?  Did the United States stop using it because it was no longer a store of value?  No, the gold window was shut precisely because it had value, and the powers that be, in this case Nixon alone; decided he did not want to give it up to the rest of the world as had been promised.  Closing the gold window was a reaction to the largest bank run in history; only in this case the bank (US government) didn’t run out of gold, they just didn’t want to give it all to the depositors.

All the world currencies at once were now fiat, backed up by nothing except the individual nations ability to tax the production of its people, or if those nations backed their currencies with dollars, the productive capacities of US citizens.   Many nations objected strongly, but against the military might of the US, they truly had no repercussions at their disposal.  They would go along with this new precarious agreement whether they liked it or not.  The sole other superpower on earth, was communist, not a signatory of Bretton Woods agreement, and was not being cheated by the breaking of those agreements.

The closing of the gold window ushered in economic turmoil in the 1970’s and rampant inflation.  This inflation was impossible according to Keynesian economists who thought prior to the 1970’s that high inflation was not possible during times of high unemployment.  This was proven false, since the 1970’s, in addition to high inflation, also saw high unemployment.

There was another view voiced by the Keynesians’.  They felt that since the main demand for gold was as a monetary base, and gold was no longer going to be used in that role, the price of gold would drop.  It sounds reasonable; drop in demand would equal a drop in price.  But even though Keynesian economists are often very certain of their views, the prediction of a drop in gold price was another example of false logic.  The central banks, though officially not holding gold as a monetary base, understood that gold was still good insurance in case this new monetary experiment failed.  They did not sell their hoards, and with the pent up demand from individual investors, also weary of the new system, the price skyrocketed. Gold’s role as a store of value was still intact, and the dollar price increased from 35 dollars an ounce to over 800 dollars in about a decade.   Granted there were several pull backs during that time, plus a massive drop from the $800+ peak to under $300, but the trend was clear. Up. 

By the beginning of the 1980’s something once again had to be done.  Enter a new Federal Reserve Chairman, Paul Volker.  He did what the Keynesian playbook said to do to stop inflation; he raised interest rates to above the rate of inflation, up to nearly 20%.  This would quell demand for credit, cause people to save instead of spend, slow money velocity, and stop the spiraling inflation.  Many economists predicted like after World War Two this would cause a recession that would be too painful for the economy to withstand.  

In a way they were right, this would have been the voluntary abandonment of further credit expansion that Mises was referring to, but the caveat was the rise in interest rates would only curb private/rational borrowers from borrowing.  The federal government, luckily for the debt based monetary system, isn’t constrained by economic rationality.  The government benefits immensely from the debt based monetary system, so what sounds economically irrational to an individual or business makes no difference to the federal government, all that matters to them is, can something be done, and will it perpetuate the status quo.

In 1981 the federal government did have the ability to continue borrowing.  The federal income through taxes was over 500 billion dollars per year; the total federal debt was 860 billion.  Much of that debt was serviced at rates well below 10% and only new debt, as well as maturing debt that needed to be rolled over would be near the 20% mark.  The increase in the debt service cost was a small fraction of the tax receipts, and so the answer was yes the US federal government could borrow at the higher rates implemented by Volker.  These higher rates succeeded in quelling price inflation.

The new debt in the coming years was mostly spent on the military but where the money is spent matters not, as long as someone is borrowing in sufficient quantities the system can continue.  The new president, Ronald Reagan, presided over this spending and also implemented pro capitalistic reforms that, after a short recession, caused the economy to boom.  Although, there is no doubt the boom was a credit created boom even if real growth occurred.

Through the latter 1980’s, with inflation tame, the fed had the ability to lower interest rates, and individuals and businesses were able to take a larger chunk of the credit expansion.  By the 1990’s now under the Fed reign of Alan Greenspan interest rates were at historical lows, and private loan demand had become so great that the federal government could take its own foot off the credit creation pedal. 

What were those private entities borrowing money for?  Well it was nothing new, it was for stocks among other investments.  There was a new technology that seemed to hold amazing promise, computers and the internet.  This new technology deserved investment, there is no doubt, but similar to the 1920’s which also was a time of great innovation, the debt based monetary system allowed this investment to get out of control and a bubble formed.  Technology stocks are listed mostly in the Nasdaq stock exchange so the bubble was most pronounced in that exchange.

Stocks were going up and, just like in the 1920’s, you could multiply your gains by borrowing money.  Some individuals would even take out a second mortgage on their homes to speculate on the stock market.  People got caught up in the markets, prudence went out the window, and as long as the business was involved with the web or computers people bought.  Gains beget gains and it seemed as if it would never end, and excuses were easy to come by as to why that would be the case. 

Government all the while was getting their cut; the capital gains that investors realized were all taxed.  It appeared as if the then president, Bill Clinton, and the new Republican congress had put in place reforms to balance the budget, but this was not the real cause of the improvement of the governmental balance sheet.  Sure it helped but it was mainly because private entities were borrowing in a fashion great enough to perpetuate the debt based monetary system, thus the pressure was off the government to borrow.  This along boom related taxable windfall such as the ability to tax the capital gains of the bubble in stocks, balanced the budget.

The fun ended in 2000, the most prudent investors started to pull their money from the stock market, if they hadn’t already done so. The stock prices fell, leading to losses, these losses were greater for those that had borrowed, losses led to fear, fear led to more selling, and a full crash in the stock market ensued. 

Once again the private side of the economy was no longer willing to borrow as they once had to maintain the ever important credit expansion.  The government would again need to step in and borrow; this time there was the convenient need to borrow to fund the wars in retaliation for the 9-11 terrorist attacks.  One issue this time is the governments’ balance sheet was not sufficient to maintain the exponential debt creation necessary.  Policies would have to be put in place to entice private help.  As self-proclaimed neo-Keynesian economist Paul Krugman wrote in 2002, “To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.” The Fed reduced interest rates to the lowest in history, so they had done their part. The federal government also strengthened policies already in place to, as they describe, encourage homeownership, when the real goal was to encourage borrowing in the form of home mortgages.

They succeeded and produced the largest bubble in history, and yet again it was just a misallocation of resources.  The gains in housing enticed more individuals to bet well beyond their lifesavings on housing.  The stories of barbers, waitresses, and cabbies retiring wealthy and early by getting rich in the real estate market pervaded society.  But this dream like the last ended in the same fashion. 

Failed Crash and the Consequences 

In 2007 home prices started to do what they had not done since the great depression, far removed from the memories of the current generations, they began to fall.  People had not just levered up putting down a fraction of the purchase price of the properties, they were infinitely levered, by putting nothing down.  As with the fall in the stock prices less than a decade earlier the gains and greed quickly turned to losses and fear.   Actually there was even a stock bubble at this point as well, following on the tails of the housing bubble, and it too collapsed in the same fashion.  Each crisis is larger than the last and where a bubble in stocks is enough to maintain in the first, you need a bubble in real estate and stocks in the next, and real estate, stocks, and government bonds in the one after that.

This recession was different than any since the great depression.  Not only did credit expansion get knocked from its perfect exponential track based on interest rates, it actually began to contract. 

In this type of contraction debt actually begins to destroy money.  In any debt based monetary system the money in the system and the debt are similar to matter and antimatter, when they meet they destroy each other.  This destruction is done by the simple action of paying off loans or deleveraging. Unfortunately in 2008 when this contraction began to take place there was about 8 trillion dollars in existence and over 50 trillion dollars’ worth of debt.  The now downward trajectory of total credit represented dollars and debt being destroyed simultaneously.  With multiples more debt built up over years due to debt growing at a faster rate than actual dollars, the dollars would disappear far faster than the debt.  With dollars, the medium of exchange gone, it does not take an economic genius to realize that the financial system and economy would be frozen into destruction. 

The onset of the debt based monetary system was a want for power, its perpetuation was in the maintenance of that power, but at this point the crash was so unimaginable the systems continuation, at all costs was one of survival.  No one could know the consequences of a crash if allowed to continue, it was difficult even to contemplate, the American economy with no medium of exchange/dollars. Loan defaults were also taking place during this time destroying debt but not dollars, though defaults inflict equally devastating effects on the economy. 

Mises’s foretold crash had to be stopped by any means necessary.  The government started, with their Keynesian prescribed remedy to borrow, and since this downturn in credit expansion was unprecedented so to was their borrowing for two massive trillion dollar stimulus programs (shovel ready of course) that included essentially handing money to the banks, cutting the Social Security tax, infrastructure projects, unemployment benefits and even giving cash directly to the citizens.  The government still had the ability to borrow, though this option may not always be available in the future.

The Fed had to take several unprecedented steps, many of which we will never know the full extent of due to their secretive nature, allowed because Keynesians demand that a central bank be “independent”.  There normal tool, of lowering interest rates, was ineffective since they lowered it to zero near the beginning of the crisis and it was not enough to stimulate loan creation.  But their main weapon to fight this credit contraction was a new method; it was done in the open, and had the impressive sounding name, quantitative easing, or QE.

Before we delve into what exactly QE is, we will first discuss what QE, in reality, is meant to combat.  You will hear from commentators in the main stream media, on CNBC, from economists and from the fed itself that QE is meant to stimulate the economy, support certain markets, maintain low interest rates, or help the job market.  Yeah, it’s meant to help the little guy get a job.  In truth QE is meant to do one thing remove debt from the economy, though in theory the removal of the debt is supposed to be temporary.

What is quantitative easing?  Despite its imposing name, quantitative easing is quite simple, the Fed does what it does best and creates money out of thin air and uses that money to buy assets from the banks, those assets are debt instruments.  Thus the fed is putting cash into the economy and removing debt.  Still it is a process of creating money out of debt going back to why it is termed a debt based monetary system.

As previously stated this is supposed to be temporary and the process, according to the fed can be reversed, but until they show it can be reversed I will assume that they can’t reverse it.  And if they can’t I will assume it is debt monetization, a play taken from the books of the Weimar Republic, and other economies that have fell victim to hyperinflation.  The fed holds the debt instruments, treasury and mortgage bonds, on their balance sheets and maintains them, handing the interest for the most part on to the treasury, and reinvesting principal.   Since the debt still exists they can pretend that they could be sold back into the economy soaking up all of the dollars they had previously put into the economy, more on that later.  If the fed just destroyed the debt and told the borrowers they didn’t have to pay it back that would be clear debt monetization.  But what makes them think that if this move was so necessary for the economy in the first place that the economy will ever be able to support the bonds being resold?  It doesn’t appear with the debt overhang, that the economy could support a move like that, ever.

Now for some charts to show why QE was so necessary, at least if the Fed wanted the debt based money to continue.

Source: Graph: Gross Domestic Product - FRED - St. Louis Fed. (n.d.). Retrieved from

This first chart shows total credit market debt, (Black Trend).  This includes public debt including federal, state, and municipal, as well as private debt such as mortgage, credit card, education, corporate, car loans, and pretty much anything else a private entity would borrow money for.  In essence this trend is all the debt in the US economy.  Oh for those that weren’t quite sure when we said that; “In a debt based monetary system, that debt must grow exponentially based on the interest accrued the year before”, this should make things more clear.  That chart, up until things went very very wrong in 2008, was almost a perfect exponential chart ever increasing at a faster and faster rate.  Oh and sorry this chart is a bit old, in mid-2014 debt now stands at over 60 trillion, not the 59 shown.
The red trend is Gross Domestic Product, what can be thought of as national income.  It is also growing by a varying percentage each year but at a much slower rate than total debt hence the large divergence.
It makes sense, that the macro economy, just like for an individual, would have a point at which the income can support no more debt.  With the many variables of a complex system the point when market participants are not willing to take on any more debt may be hard to pinpoint, but it appears to have been reached in 2008, at least under the set of criteria  that existed at that time.
What do I mean by that set of criteria, well the amount of income the participants had, the amount of debt they had, interest rates, and their perceived returns on what they would take on debt to purchase such as housing, education and stocks.

So like in the past the Federal Reserve and government set out to change the criteria for those market participants, unfortunately the governments balance sheet may throw a wrench into their little plan.
As already covered the monetary system must start to create more credit/loans or it will destroy itself and this can be private (individuals or corporations) or public (governments).  The private will only borrow more based on semi-rational reasons.  I say semi-rational because the entity borrowing believes the loan is for a good reason, but in retrospect the loan may be to its detriment.  For example they can take out a student loan because they believe education is always a good investment, or take out a mortgage because they think real estate will always go up.  There could also be reasons to refinance such as the interest rate going down or making the term longer to make the payments more manageable. 

Eventually though a stopping point will be reached, prices for whatever those loans are used to buy will reach a point where people will not borrow any more for them, and borrowing will stop. Tuition has gotten to the point where the return on investment has made it clear that education in many cases is no longer a good service to borrow for, real estate prices have proven they can go down and thus can be a poor reason to take out a loan as well.  Rates have gone about as low as they can go, and the terms of mortgages have reached about as far as it appears home buyers willing to borrow for.  The standard 30 year mortgage has not morphed into the logical next step of a 40 year loan.  Home buyers in their prime may conclude that a loan that may not be paid off by retirement or even before their death is not practical. Whatever the reason or reasons it appears that people will not borrow for more than 30 years to buy a house.  Below is a chart illustrating the point above on education cost and benefit.

Source: New York Federal Reserve, U.S. Census Bureau and U.S. Bureau of Labor Statistics, Current Population Survey, March Supplement; U.S. Bureau of Labor Statistics, consumer price index

At some point, even for education, the cost or tuition does not justified by the return or increase in wages.

There has been some more luck with corporations and investors who have borrowed to buy back stock or invest.  But there will be rational limits to this as well.  It is amazing how The Fed, Banks, and the government have enticed so much borrowing from the private sector with programs like the Making Home Affordable Programs under Bush and Clinton and the Higher Education Act.
The way the government treats second homes is a perfect example of one of these pro credit policies. Second home mortgage interest is tax deductible. This essentially means the federal government subsidizes rich people’s vacation homes. There is no rational reason for the federal government to subsidize vacation homes, until you look through the lens we have been polishing. Second home mortgages are a huge source of expanding credit. The government doesn't care if you buy a vacation bungalow, but it does if you’re willing to go into debt to buy it.

Vacation home subsidies are also a great example of misallocation of resources. Because of the subsidy a buyer may buy a vacation home instead of another investment that without government intervention should rightfully have the capital based on free market forces. These other investments could be stock in a promising biotech company, solar panels and additional insulation in a primary residence, or a welding class.

If the federal government were truly concerned about the “little guy’s” well-being wouldn’t they subsidize food purchases or essential utilities such as electric water and heat?  Even medical expenses can be difficult to itemize on a federal tax return.  But food and utilities are often bought with all cash, so there is little loan creation, vacation home purchases on the other hand...

The final issue making the real intention of the subsidy clear is HOW they apply the tax deduction.  We’ll give the federal government the benefit of the doubt and assume they subsidize primary home mortgage interest to subsidize shelter (somewhat believable), and second homes to help spur the economy through home building and associated spending (reaching).  Why then would they choose to provide the subsidy though the loan?  If they are trying to help the people who might otherwise rent why wouldn’t the hard earned down payment be tax deductible?  Is there less economic growth if a home buyer uses cash to purchase a second home instead of a mortgage?  If the subsidy had anything to do with enticing actual home ownership the down payments would actually be encouraged and included in the subsidy not excluded as is done currently, unless of course the actual goal is loan creation.

Even with the massive push towards credit creation and attempts to change the borrowing “criteria” the private sector appears to be reaching its borrowing limit in 2014 just as in 2008.

So that leaves the government. 

Central banks like the Fed, as was understood over 100 years ago, can only solve a liquidity crisis but are much more limited when dealing with a solvency crisis.  The fed is supposed to allow insolvent entities such as an insolvent bank to fail.  They can fix a bank, the entire banking system or the federal government if the issue was liquidity, but not an insolvent one.  During the 2008 crash no insolvent entities were allowed to fail.  Not surprising considering one of them was the US government.  So what is the difference between a liquidity and solvency crisis? 

To give you an example of a liquidity crisis consider the following.  You have 5000 dollars of bills due on the 20th of each month, you have an income of 10,000 dollars that is paid out on the 1st of each month, and you have 30,000 dollars in cash.  On the 15th of the month you make the decision to buy a new car, and pay 30,000 dollars in cash.  Oops, you used all of your cash and your 5000 dollars’ worth of bills are due in a few days.  Anyone who has been in this situation knows that the creditors will probably not have a huge problem waiting 10 more days for payment or you could get a bridge loan, and after that point the problem will be solved. From that point on, your income will always be able to cover your outflow.

Central banks are designed to provide loans for just this kind of liquidity issue for individual banks or even the entire banking system; that is their stated role as “lender of last resort”.  Theoretically it could do the same for the federal government.  Unfortunately this is not the issue that our government has.  It has a solvency crisis.

Now for the solvency crisis example, in this example imagine you have 10,000 dollars of bills, a 5000 dollar income, and 30,000 dollars of cash.  Just looking at that balance sheet shows you have a solvency issue.  There is not a liquidity problem, yet.  There is enough cash to pay your bills, but after 6 months when that cash runs out then you have both a solvency and liquidity issue.  You can gain more liquidity through a loan, and put off the problem for a few more months but this just adds to the problem.  If you borrow an additional 30,000 dollars with a loan which will cost an additional 800 dollars a month to service, you will hit the same point of not being able to pay your bills in 5 or 6 months, but now, even deeper in debt.  Borrowing is the preferred method the federal government is using to attempt to fix their solvency crisis.

To see if they can borrow the needed amounts to continue credit creation we should first determine if the US government is solvent.  But before we do that lets look at another individual. This individual has 1.7 million dollars’ worth of debt, an income of 250,000 dollars a year, bills of 350,000 dollars a year and lives hand to mouth, meaning they have no savings and have to borrow every penny of the additional 100,000 dollars to pay their bills each year.  They don’t have a liquidity crisis because they have lenders that are willing to lend them money at between 0 and 4% depending on the term, but they are clearly insolvent.  As soon as the lenders stop lending they will not only be insolvent but illiquid as well.  Even if the lenders irrationally keep lending, eventually the cost of servicing this debt will cause the crisis, but it gets worse.  This same individual has even more bills that he is not servicing yet but in a few years it will cost him 600,000 dollars a year.

These are the exact figures the United States federal government is dealing with, only I chopped 7 zero’s off the end of the numbers to make them believable for an individual.  Granted no one would lend to an individual or small business with that kind of a balance sheet.  Lets take a rough look at the Federal Governments balance sheet, $17,500,000,000,000 in debt, $2,500,000,000,000 in annual tax receipts, $3,500,000,000,000 in yearly expenditures, and a deficit around 1,000,000,000,000 a year.  The deficit has recently come down but like in the 90’s this is thanks to temporary boom related federal revenue windfall.  For example if capital gains from the rise in stock prices turn to losses due to a correction in the market that we are overdue for, those taxable gains will turn into tax deductible losses  A recession, which historically occurs every 6-8 years, can cause some of the jobs that are providing taxable income during a boom to disappear.

But the issue gets even worse, as alluded to for the individual above, if GAAP is used.  GAAP is Generally Accepted Accounting Practices.  This is the way companies must crunch their numbers, by law, so investors, and anyone else that is interested in a company’s balance sheet can determine if that company is solvent.  GAAP doesn’t just look at what a company is servicing in debt currently, but what they have contractually agreed to pay in the future, such as benefits for employee pensions.
If the US government were to use GAAP the deficit wouldn’t be the stated 750 billion or 1 trillion but several trillion dollars.  Why is there such a big difference, well just like a company that is responsible for paying a pension and must carry it on their books, to examine the governments balance sheet we must look at all of what it has promised to pay out.  The US government also has payments it is responsible for in the form of Medicare, and Social Security for the baby boomers and future generations, which along with other entitlements balloon the GAAP annual deficit to over 6 trillion. Even a fraction of that deficit along with the debt load makes it clear the government is in no place to borrow.  State and local governments are at similar points in their borrowing story. 

So, though they may not acknowledge it, governments should not be borrowing and soon will have no choice but to stop once forced by its creditors in the bond market. So if the private sector can’t do it and the public sector can’t do it than who will, there is no one else.  If you question that, just look what is happening in different debt markets, the mortgage market, car loans, or student loans.  Creating exponential debt increases is just no longer in the cards. 

The question may be raised that if the Fed can create money out of thin air then all these numbers are bunk and don’t matter so let’s investigate that.   It is true that the fed can create dollars, but they have to loan them into existence, and as we saw above, borrowing money cannot solve a solvency crisis. 

This brings us back to outright debt monetization, granted it is illegal under current statutes. Debt monetization if done in sufficient quantities would appear to fix the problem or significantly postpone it, but how much money would they have to create?  Currently, as shown in the chart below there are about 12 trillion dollars in existence going by the MZM money supply.  There are different measures of the amount of dollars in existence due to the definition of a dollar being a bit hazy, MZM is sufficient for our purposes.  

Federal Reserve Bank of St. Louis, MZM Money Stock [MZM], retrieved from FRED, Federal Reserve Bank of St. Louis, January 3, 2015.
Increasing the money supply from 8 to a little over 12 trillion dollars in the past few years has been sufficient to re-inflate the housing market, push the stock and bond market to new all time highs and cause price increases in many other sectors of the economy, all this while money velocity has been dropping to an all-time low.  Now imagine the fed adds enough dollars to attempt to make the US government appear solvent, and take enough of a load off the private sector to get them borrowing again, how much would it take?  To monetize enough debt just to take the debt load back to where it was in 2006 we would have to monetize 10 trillion dollars’ worth of debt.  That’s 10 trillion new dollars floating around out there.  Would taking us back to the 2006 debt load be sufficient?  Would we need 20 trillion (2004) or 30 trillion (2001)?  Remember the amount of money in an economy doesn’t necessarily cause rising prices, but it doesn’t hurt. 

Through QE The Fed has put a few trillion into the economy but prices have not risen as quickly due to a rapid decrease in money velocity as well as some other variables including money being sent overseas causing inflation in foreign economies.  If the fed were to pump tens of trillions of dollars into the economy the necessary psychological shift to increase money velocity here at home would certainly occur and would cause massive inflation.  The point at which this would happen is difficult to pinpoint but there is no doubt that this kind of money creation would cause people to lose faith in the currency.  Money velocity is at a historic low but unlike the money supply there can be relatively massive changes in money velocity overnight.  Every .1 tick mark on the chart on the scale below is equal to an increase of apparent money in circulation of 6%.

Source: Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis

The final wall that completely boxes the fed in is their inability to fight inflation. 
It has already been explained why, in 1981, the federal government was able to stop the inflation through raising interest rates.  The mechanism through which inflation is stopped is simple, if an individual holding cash is experiencing 10% inflation the natural reaction would be to get rid of that money before it loses value.  That is, unless they can get 12% return in a savings account.  If the interest rate is above the inflation rate that individual will rationally put the money in the bank account, the bank then hands the money over to the fed at an even higher rate, the money velocity slows as the money sits in accounts at banks or at the fed, thus inflation drops.  This process raises the interest rates for any entity who wants to borrow money. 

One of the borrowers is the US government. In 1981 the government could handle the higher rates, but could they now?  The federal government needs to roll over trillions of dollars of debt each year, meaning as the term of one bond ends they cannot pay it off and have to borrow again with a fresh bond to pay it off.  For some quick and dirty numbers let’s say inflation is running at 10%, and rising, and the fed raised rates to some point above that.  This pushes the new rates at which the federal government borrows at to around 15%.  If in that year the federal government needs to roll over 5 trillion in debt, the additional cost to service the debt would represent an increase in government expenditures of 750 billion.  All new debt would also be at these higher rates, and of course additional old debt would need to be rolled over each year, further adding to debt service load.  With only 2.5 trillion in annual revenue these numbers are clearly not possible.  Do you remember how the media portrayed the “fiscal cliff”? Armageddon comes to mind.  That was a cut of less than 100 billion a year, the cut into the federal budget that would be necessary to get high inflation under control through higher rates would be closer to a trillion dollars per year.

 The recent savior and debt purchaser for the federal government has been the Federal Reserve itself, through QE, but this would not be available while fighting inflation.  It would be counterproductive to fund the government with newly printed money while raising interest rates to slow money velocity, though I wouldn’t be surprised if the fed did something like this in secret.  Raise interest rates in public while printing and funding the government in private in hopes the reduction in money velocity would overcome the increase in money supply.  That would be a last gasp of the current monetary system.

The other “tool” you may hear the fed has at its disposal to fight inflation is the virtual money incinerator.  This is what the fed touts as the balance to the virtual printing press.  They are virtual due to the fact that new money is created electronically thus not printed, similarly the incinerator does not literally burn money, it similarly just electronically deletes it.  But though the fed does have the ability to destroy some of the money supply, to do so it must get ahold of it first. 

The fed can’t just take money to destroy it; it must trade for that money.  What does it have to trade?  Well the debt instruments it has on its balance sheet that it has acquired through QE and generating base money.  The fed sells the mortgage or government bonds into the market and destroys the proceeds, “incinerating the money”. 

So how much money could the fed destroy thus reduce the money supply using this mechanism?  To find the answer we must know how to price the bonds it has on its balance sheet.

I am going to dig into some formulas but the main takeaway is as the yield (interest paid) goes up the price goes down.  If you don’t feel the need to see the numbers feel free to skip the next section.
Here is the formula on how to price a bond, whether muni, federal, mortgage, or corporate.

So let’s do a few of examples, one where the price of the benchmark 10 year treasury bond is around 2% similar to where the rates during much of the QE, and one during a possible future high inflation environment where the long term bond rates are similar to the rates necessary to kill inflation in the early 1980’s under Paul Volker.

And finally, let’s see the result if the Fed sold all of the bonds acquired at an average rate of 2.5% during QE. We’ll assume $4 trillion total, and the bonds are sold at an average interest rate of 15% with an average duration of 16 years.

This is all to illustrate the fact that the fed could get 100% bang for their buck with their printing press but would only be able to reverse that to the tune of 25% using their “money incinerator” in a high rate environment.  The sale of long term bonds would also exacerbate the rise in rates, more supply=lower price =higher yield/interest rate. 

Consider that you have cash on hand, you are concerned about inflation and are considering purchasing a tangible good such as storable food or toilet paper for fear it will be more expensive in the future.  Official inflation statistics are running at 10% but at the grocery store, week to week, it seems higher.  Even the official inflation rate trend is up.  How much would you be willing to pay for an investment that is going to end up paying you back in dollars IN TEN YEARS.  I’m guessing your answer is very low, pennies on the dollar, if anything at all.  This rational reaction may completely remove the bid for what the Fed is selling rendering the incinerator completely worthless, but even if the fed were successful in destroying a trillion dollars from the money supply, that is more than made up for by an increase in the money velocity of just 10% on the ratio in the chart above.

Also consider as a side note that the above losses represent the losses that could be incurred by long term bonds and bond funds held by a huge percentage of the population in 401k’s and pensions if liquidation is necessary.  Essentially when bond interest rates rise, a seller of a bond with lower coupon rate than the current rate incurs a loss commensurate with the difference between the two over the duration of the bond.  This is how bonds can be traded with different coupon rates seamlessly. If a bond can be sold at a 65-80% loss why are they touted as risk free?  Granted bond investors have enjoyed the mirror of this mechanism over the past thirty years as rates have fallen but one should remember the blade cuts both ways.

Our monetary system is in dire straits but to make matters worse, since the entire country is on a fiat currency system there is no gold, silver, or alternative currency in circulation to fall back.  If there is massive inflation or a destruction of the money supply through deflation there is no easy answer to maintain a functioning economy.  In the case of the hyperinflation in Zimbabwe a few years ago there was already a functioning economy in dollars to fall back on, no such luck in the US.  If there was hyper-inflation or massive deflation I’m sure another medium of exchange would pop up, or trade could be done by barter which is currently happening in Greece, but it would be pretty ugly.    

We are nearing a point that even with the patches put in place over the past several hundreds of years including, paying interest to depositors, governmental support, central banks, deposit insurance, and abandonment any attachment to gold are not working, and, once again the fraud of fractional reserve banking and debt based money is about to fail.

Oh and I hope anyone who thought that a balanced budget amendment might be the answer to the nation’s woes now understands that it is just not possible without undoing 100 years of monetary inertia.  Turning a ship that size around will cause a lot of pain, and by pain I mean millions would die in the economic destruction.  There will be pain one way or another when these imbalances are reconciled but thinking that if we just pay off all of our debt in a debt based monetary system all will be well is about the worst way to way to go about it.  That path will maximize the turmoil.  I am all for the government living within its means but it simply is not possible independent of major monetary reform, so any discussion of a balanced budget must be done in the same breath, and after, a plan for a monetary overhaul.

 To pay off all of the debt in a debt based monetary system is similar to having an economy that uses gold as money; millions of contracts written with gold as payment, millions of daily transactions done in gold, all of peoples savings held in gold, and some brilliant politicians saying we need to gather up all of the gold, put it on a ship (it would easily fit by the way) sending it to the middle of the ocean and sinking it in the Marianas trench with no way to recover it.  How do you think that economy would do going forward?  Do you think I’m being overdramatic saying millions would perish?  This is what I hear when I hear politicians saying we should pay off our national debt or balance the budget when I know there is little to no chance of the private sector picking up the slack in creating new loans.  Not that private loan creation would be the solution it would just postpone the inevitable.  If we accept that the longer a credit created boom lasts the larger the crash will be, it must be considered that we have been in the current boom for over 70 years.


So how could this problem be solved while still making the benefactors of the system rich?  We’ll there was a time that I thought it could not be solved without a slow reintroduction of precious metals back into our monetary system, thus allowing the money supply to expand without introducing new debt.  But that would not help the banks or the government besides preventing collapse.  And even a reintroduction of gold and silver may not solve anything without a corresponding overhaul of the rest of the monetary system considering the incompatibility of precious metals and debt based money.   

So I didn’t see a viable solution, until I saw a recent story on several main stream media sights that would fit the mold of past monetary transitions.  

Below is the story; There's An Electronic Currency That Could Save The Economy — And It's Not Bitcoin, in it’s entirety by Danny Vinik originally published in the Business Insider:
The United States has been marred in slow economic growth and a weak recovery for years now. Unemployment remains high. This is despite extraordinary efforts by the Federal Reserve to stimulate the economy. This drawn out period of low inflation and high unemployment has gotten more and more people talking about a "new normal" of mediocre growth.
Economists have been looking for ways to give central banks more power to combat recessions and prevent these long, drawn out recoveries. Larry Summers laid out this major impending economic challenge  in his recent speech at the IMF. Normally, when a recession hits, central banks cut interest rates to incentivize firms to invest and to spur economic growth. But when interest rates hit zero, those banks lose one of their most important tools to combat recessions. This is called the zero lower bound.
Hitting the zero-lower bound means that interest rates cannot reach their natural equilibrium where desired investment equals desired savings. Instead, even at zero, interest rates are too high, leading to too much saving and a lack of demand. Thus we get the slow recovery.
Until recently, we hadn't hit that bound. But since the Great Recession, we've been stuck up against it and the Fed has been forced to use unconventional policy tools instead. What Summers warned of is that this may become the new normal. When the next recession hits, interest rates are likely to be barely above zero. The Fed will cut them and we'll find ourselves up against the zero lower bound yet again and face yet another slow recovery.
So what's the answer?
University of Michigan economist Miles Kimball has developed a theoretical solution  to this problem in the form of a new electronic currency that would allow the Fed to bring nominal rates below zero to combat recessions. He's been presenting his plan to different economists and central bankers around the world. Kimball has also written repeatedly about it and was recently interviewed by Wonkblog's Dylan Matthews.
"If you have a bad recession, then firms are afraid to invest," he told Business Insider. "You have to give people a pretty good deal to make them willing to invest and that good deal means that the borrowers actually have to be paid to tend the money for the savers."
But paper currency makes this impossible. 
"You have this tradition that as it is now is enshrined in law in various ways that the government is going to guarantee to all savers that they will get [at least] a zero interest," Kimball said.
If the Fed lowered rates below zero in our current financial system, savers would simply withdraw their money from the bank and sit on it instead of letting it incur negative returns. The paper currency itself — because it's something that can be physically withdrawn from the financial system — prevents rates from going negative.
This is where Kimball's idea for an electronic currency comes in. However, unlike Bitcoin, which prides itself on its decentralization and anonymity, Kimball's digital currency would be centralized and widely used. He would effectively set up two different types of currencies: dollars and e-dollars. Right now, your $100 bill is equal to the $100 in the bank. If you're bank account has a 5% interest rate, you earn $5 of interest in a year and that $100 bill is still worth $100. But what would happen if that interest were -5%? Then you would lose $5 over the course of the year. Knowing this, you would rationally withdraw the $100 ahead of time and keep it out of the bank. This is where the separate currencies come in.
"You have to do something a little bit more to get the negative rate on the paper currency," Kimball said. "You have to have the $100 bill be worth $95 a year later in order to have a  -5% interest rate. The idea is to arrange things so let’s say $100 in the bank equals $100 in paper currency now, but in a year, $95 in the bank is equal to $100 in paper currency. You have an exchange rate between them."
"After a year, I could take $95 out of the bank and get a $100 bill or if I wanted to put a $100 bill into the bank, they would credit my account with $95."
Got that? After a year of a -5% interest rate, $100 dollars are equal to $95 e-dollars. This ensures that paper currency also faces a negative interest rate as well and eliminates the incentive for savers to hoard dollar bills if the Fed implements a negative rate. Presto! The zero lower bound is solved.
The benefits of this policy go even further though: We can say goodbye to inflation as well.
"Once you take away the zero lower bound, there isn't a really strong reason to have 2% inflation at this point," Kimball said. "The major central banks around the world have 2% inflation and Ben Bernanke explained very clearly why that is. It's to steer away from the zero lower bound."
He's right. Back in March, Ryan Avent asked Bernanke why not have a zero percent inflation target. Bernanke answered, "[I] f you have zero inflation, you’re very close to the deflation zone and nominal interest rates will be so low that it would be very difficult to respond fully to recessions."
But if nominal interest rates are allowed to go below zero, then the Fed has ample room to respond to recessions even if rates start out low. This is another major benefit from eliminating the zero lower bound.
What Kimball, whose blog is titled   Confessions of a Supply Side Liberal, is most excited about is moving beyond the demand shortfall the economy currently faces to the supply side issues that hold back long-term growth.
"If you care at all about the future of this country, one of the things you need to realize is we need to solve the demand side so we can get back to the supply side issues that are really the tricky thing for the long run," he said. "The way to solve the demand side issues that is the most consistent with not messing up our supply side is monetary policy and making it so we can have negative interest rates."
At the moment, e-dollars are still only a theoretical concept, but Kimball is hopeful that they could be put into action in the near future. He believes that if a government bought in, it could be using an electronic currency in three years and reap the benefits of it soon after. 
"This is going to happen some day," he concluded. "Let me tell you why. There are a lot of countries in the world and some country is going to do this and it's going to be a whole lot easier for other countries to do it once some country has stepped out."
Talk about a patch! There are plenty of problems with this article such as how they don’t indicate why borrowers will not borrow to invest, but we know it is because there is already too much debt.  They also use the word invest in place of what should be the word borrow.  Insert borrow for invest and the story will make more sense.  The cause of the slowing or stopping of borrowing to invest is not some strange physiological new normal; it’s a rational realization that the nation as a whole, in all sectors, already has borrowed enough. But this solution makes perfect sense for central planners in the Fed, member banks, and the government.  So much so that I think it is going to be put in place in the not so distant future, although that’s just an educated guess. 

The reasons start with the fact that this plan maintains the unbreakable covenant of changing monetary systems, the powers that be, the government and the banks get stronger. After a number of years eventually paper dollars would lose so much valve they would go extinct.

The list of ways this helps the government is long.  First, since eventually the old paper dollar would go extinct and all commerce would be electronic, it would be easy for the government to track money thus easier to tax.  This would certainly please tax and spend liberals who try and vilify anyone who attempts to avoid taxes, even though that is what this nation was founded on. 

Another benefit of being able to track the new e-dollars is black market transactions in dollars would disappear.   This would delight right of center.  Without cash, illegal drug trade would have a major barrier.  An even a bigger feather to the right is that it would be more difficult for people to hide secondary income thus take advantage of entitlements while working “under the table”.  Illegal immigrates would also have a much more difficult time living in the US, talk about a plus for the conservatives.  The government also wouldn’t need to spend money to create new bills and coinage.
Finally the biggest pro is the governmental debt will be priced in the “old” dollars, meaning the burden of the national debt would decrease by as much as the Fed decides to set the negative interest rate at annually.

So we’ve pleased both sides of the isle, now on to the banks.

Well the benefit to the banks is quite clear, not only are you forced to keep your savings with them to speculate with and collect their standard fees on, but they also will be able to charge you interest for the privilege. 

Some of the concerns that run a distant third, those of the people of the United States COULD also be addressed.  I emphasize COULD because they will only help a certain portion of the population and only if the powers in the government and banks feel as if they need more popular support for the E dollar.  As with the government debt, the new system COULD allow ALL old debt to be priced in the old dollars thus lessening the burden on anyone holding previous debts, and with a large portion of the population with underwater home mortgages and huge student loans I’m sure the relief would be welcome. 

The losers in this would be those who were prudent and didn’t take on large debts but since there are far more debtors then savers, politically the plan would still be a winner.  I have to admit before learning the truth about our system I racked up my fair share of debt and a little piece of me would be relieved.

Though I think the Government would allow all debt to be priced in the old dollars the only debt that must be would be the government debt.  It would certainly be fairer to price all old debt in the old dollars, but I would not be surprised if the banks were able to use their substantial influence to swap old debts into the gradually more valuable E Dollar.  This is historically what has taken place when there have been failed currencies, and even though the debt agreements may have been made in those currencies the banks attempted, and were often successful in demanding payment in gold.  Even the most powerful such as President Thomas Jefferson was subject to such a debt payment.  

As was shown the Government and banks have no problem not only giving the citizens the short end of the stick in such monetary changes, but actions tantamount to theft are commonplace. An unfair arrangement surrounding the E Dollar would not be surprising. 

The other interesting thing that came out of the above story was the reference to bitcoin, and more importantly how the US government reacted to the Crypto Currency recently.  

When competing currencies to the dollar arise the governmental response has always been the same.  The threat is violently destroyed.  An example is the Liberty Dollar.  The Liberty Dollar was a silver backed currency that the founder, a Mr. Bernard von NotHaus, began to circulate to allow users an alternative to the dollar.  Ironically using the same medium to back the currency that was the original definition of the US dollar, a fixed weight of silver.  

This silver was stored in a central location while the paper currency circulated and could be redeemed at any time for the physical metal.  The owners of this silver were not the originators of the currency but those who were using it as an alternative to the dollar.

Von NotHaus was arrested by the FBI, tried and on March 18, 2011, was pronounced guilty of "making, possessing, and selling his own currency".   Take note that he was not charged with fraud but making and selling his own currency.   The silver backing the notes was seized and is still held by the government to this day. There was no due process for the rightful owners of the silver, not Von NauHaus, but the holders of the Liberty dollar certificates.

One of issues held by the government was the use of the name “dollar”, as if this word held special meaning.  The simple solution would have been to have the creators simply change the name, not throw the originator in prison, and steel property.  No this was done to set an example to those who would challenge the dollars homogony.  The point is any true threat to the dollar would be crushed in short order.

Now this next part is pure speculation but, why, would bitcoin, something that is touted by many as a direct competitor and even destroyer of the dollar be allowed to survive?  In addition, during the hearings held in congress on bitcoin, there were many positive things said.  According to the headline of a Bloomberg story “U.S. Agencies to Say Bitcoins Offer Legitimate Benefits” or the Wall Street Journal “Authorities See Worth of Bitcoin”.  It was referred to in the hearings as digital currency, and a car dealership in California even called it legal tender in the media. This struck me as very strange considering I knew of the treatment of other “competing currencies”

This cordial treatment of bitcoin is confusing.  I came to the conclusion that maybe the US government felt that they could control bitcoin.  They could have easily noticed the possible threat of bitcoin early on and decided to obtain as many as possible. Bitcoins come into existence through a system of electronically “mining” them, by which computers solve math problems and in exchange gain the currency similar to real world gold or silver mining.  The mining of bitcoins is how the first owners come to possess them.  They have to be initially distributed somehow.  Well the US government has pretty much more computing capacity than anyone so they could have obtained them through mining.  They could have also bought a significant amount at under a dollar, where the price was for a significant time.   This in addition to the governments seizure of a huge number of bitcoin after the shutdown of the Silkroad, a black-market using bitcoin in drug and other illicit trade, could allow the US government to hold 70, 80 or 90% of the bitcoin market and no one would be the wiser because of the claimed anonymity of bitcoin. 

I thought that they could then use this market share to crush the market and claim “see bitcoin doesn’t work”.  But this left a big hole in my thought process.  What then, what if bitcoin survived and after the government used its bitcoin to crush the market, bitcoin rebounded and started competing with the dollar again.  Government agencies officially classed bitcoin as a money service similar to money gram or Paypal, not a currency which is how it is being used.  The FBI claimed that the Liberty Dollar was illegal because it was a currency.  Bitcoin is clearly a currency but instead of classing it as a currency and thus having to shut it down under the same laws that brought down the Liberty Dollar, the government went out of its way to class it as a money service.   Why would it not be crushed swiftly like the liberty dollar?

The answer came to me while reading about the E dollar and listening to an interview of one of the creators of bitcoin, Gavin Andresen by Chris Martenson.  Mr. Andresen was questioned as to how other crypto currencies, which have popped up by the dozens, would compete against bitcoin.  He indicated that bitcoin’s design and source code could not be improved upon enough to overcome bitcoin’s “first kid on the block” advantage.  He said this with one caveat, if a government created a crypto currency similar bitcoin, supported by tax collection and legal tender laws it would have clear advantages over bitcoin, and take back market share.

This and reading the story on the E dollar made a possibility clear.  The government could easily crush bitcoin price with their market share, say it is illegal, and make a few examples sending people to prison, sizing assets ect, all in the name of protecting the American people, for any number of reasons.  At the same time they could say, as in the congressional testimony, that bitcoin had many benefits but was too dangerous without oversight.  But with the introduction of a US crypto currency, the E Dollar, all of those benefits would be realized without the risk because of additional regulation and safeguards.  Point being, they may be allowing bitcoin to soften people up to the idea of a purely electronic currency, and that is why it is being handled with kid gloves. 

The hypothesis on bitcoin may be reaching, but something certainly feels off with how the government has handled bitcoin.  The E dollar is a real possibility though, and if you’re still not convinced, consider how you think an everyday business man living in 1926 would have responded if told the US Government would take all of the citizens’ gold coins in 1933 under the harsh penalty of 10 years in prison?  How about if you told someone living in 1961 that ten years later the dollar would not be backed by gold and would, in fact, be backed by nothing.  Still skeptical of the possibility of the E dollar and of a bank taking a little from your account each month, and paper dollars going away?  Well half of that was just introduced in May 2014 when a central bank just as large as the FED, the European Central Bank, the issuer of the Euro, just introduced negative interest rates, and from the responses on CNBC it is a great move. Cash transactions in Europe are also illegal over 1000 Euro. I don’t think the American people will even bat an eye at the E dollar.

So if this new E dollar system addresses main issue with the current economic environment, namely too much debt, which under the current system cannot be solved, why should it be resisted?  Well first, the E dollar would still be a debt based dollar and future generations, our children and grandchildren, would end up in the same place we are today in twenty, fifty or one hundred years. Second and most importantly it is still rooted in fraud just like the goldsmith loaning what isn’t his to loan.  Fraud should not be addressed by finding a patch to allow it to continue, you stop it.  Granted rash decisions have no place while we are in such a precarious position, bold yes; rash no. 
The E Dollar could be used as a bridging tool to maintain a functioning economy while transitioning to a more sound monetary system, but any such attempt should be treated with skepticism and monitored closely. 

There is another challenge to a shift to the E-Dollar, will the international community accept being paid back in the “old” dollars that would decrease in value.  Other nations are certainly relatively more powerful compared to the last major monetary shift when the US decided they would not redeem dollars for gold, and probably are developing their own plan for how to deal with the inevitable failure of the current monetary system. Unlike shutting the gold window in 1971, the rest of the world may not just “go along”. Dealing with interest rates and the bond market would also pose significant challenges.

The E dollar may never come to fruition, but one thing is for certain the current monetary system is unsustainable, and will be overhauled as it was in 1913, 1933, 1945, and 1971.  Based on stresses now being observed in our economy this overhaul could be in the relatively near future, and due to larger imbalances will be more profound.  To be best prepared for and even prosper in this new economic system it would be invaluable to understand the forces that made it necessary and that the powers that develop it DO NOT have your best interest at heart. 


So why would you pay more attention to a paper written by an author with Captain in front of his name instead of Economics PhD?  Well first I do believe in Will Hunting’s quote in the movie Good Will Hunting when confronting a Harvard student “You dropped a hundred and fifty grand on a f****n' education you coulda' got for a dollar fifty in late charges at the public library." The information that is in libraries and countless other sources to educate yourself are immense if only you are willing to put in the time and effort to learn.  This is not to say that econ students don’t put in time and effort, and clearly universities have tremendous educational resources at their disposal, but those universities don’t exist in a vacuum.

Imagine a freshman econ student at a major University.  She starts learning economics in a Keynesian light, how debt based money is superior to gold and silver, and how governmental intervention is necessary.  Some of what is taught doesn’t seem to make sense to her but if she challenges the professor, or puts opposing views on a paper or exam there are negative repercussions.  If she regurgitates the teachings of the professor good grades and success follow. 

 Why would the professor teach Keynesianism over other schools of economic thought?  Well consider that much of the funding for that Universities economics department comes from the financial system (banks) and through grants from the government.  Both of which are dependent on the current monetary system.  The professors that rise to the top and are tenured are much more likely to support views that would support who are paying the bills. 

The Econ Student then graduates, and wants to pursue her PhD.  Fortunately for her she will not have to pay for this portion of her education, and I’m sure you can guess where funding comes from.  Now picture her frame of mind.  She has spent 7 years and well into six figures (most with debt) to get her education in business or economics. What is the worth of all of that time and money if she comes to the conclusion that much of what was learned was false?  I don’t know about you but I don’t like to have to run back to the hardware store if I buy the wrong stuff to make a repair, and that’s a waste of 30 minutes and a few bucks.  In the case of such a large investment in both time and money I am sure it is much easier to just accept what was learned as truth.  The physiological repercussions of not doing so would be difficult for anyone to deal with.

There are those who study economics or business who cannot reconcile Keynesianism and go in a more sane direction, such as Dr. Thomas Sowell, but their employment opportunities are much more limited.  Most who receive formal education in economics are going to be naturally employed in finance, the public sector, or in academia.  I don’t think a bank will hire an applicant whose thesis is on the immoralities of fractional reserve banking.  The government would probably shy away from hiring an economist into the treasury who has written published papers on how the government has essentially committed fraud against the American people and the dollar should not exist in its current form.

The employment prospects are much brighter for those who help to maintain the status quo, and there is a revolving door, particularly at the top, between the three main options for economic professionals, government, finance, and academia.  The list is long but here are a few highlights.
·      Henry Paulson was the CEO at Goldman Sachs prior to becoming Treasury Secretary under George W Bush From 2006-2009.
·      Jon Corzine was the CEO at Goldman Sachs prior to becoming the Governor of New Jersey.  Subsequently he was CEO of the now failed futures broker and bond dealer MF global.  Although there were allegations of fraud at MF Global and Charges were filed against Corzine, he amazingly was not convicted despite sound evidence.  He is now a partner with the private equity firm J.C. Flowers & Co.
·      Ben Bernanke was the head of the Princeton University Economics Department prior to being hired as the chairman of the quasi-governmental quasi-private US Federal Reserve from 2006-2014.

A ship captain, on the other hand, can approach monetary history unbiased, deciding what information is valid purely based on logic and reason, and I don’t think my job prospects are limited by my economic views.

This paper is not intended to convince you that any of what is written is true. There are two goals and both start with hopefully piquing your curiosity.  The first goal is to get you to do your own research on our monetary history even if you start that research in hopes of proving the ideas in this paper false; believing that all is right in the world of finance. The second goal if you would rather blow off what you have read is to hold the ideas vaguely in the back of your mind and test them as you hear stories about the economy in the news or read about events in the paper. 


  1. Superb! Best analysis of the system I have read yet. The prospect of a digital currency like the one mentioned is new and completely terrifying.

    1. @TheGregster881 Thanks for the kind comment, and here is the link in case you were thinking I made up the E-Dollar story.

  2. Would 100% reserve banking from the beginning have prevented the current crisis?

    1. Joe, yes it would have, and this was actually suggested by Irving Fisher in the 1930's. With a 100% reserve ratio all of the control of money creation would lie with the central bank. With this complete control also comes complete responsibility and remove the veil of confusion that seem so important to central bankers and bankers in general.

      So again, yes, it would solve the main issue brought up in the above post of preventing the inevitable crash resulting from fractional reserve banking and debt based money. However it would not correct the undying theme of the dangers of allowing unlimited control over the creation of money in the hands of the government. I do believe that a 100% reserve system would be vastly superior to the current system.

      Thanks for a great question and here is a link to summary of the 100% reserve banking proposal put forth by Fisher.

    2. 100% reserve banking will turn banks into mere safe keepers of money. In turn, depositors will be charged small percentage for the services provided, which would have the same effect of negative interests of E-dollar. The power of central banks and banks in fractional reserve banking would be shifted to individuals, as the latter will now have control over which securitised debts to invest in rather than money sitting idly in the banks. Individuals will exercise good judgement over their own investments unlike the irresponsible banks and governments. Well, but those greedy bankers and politicians will never let such powers taken from them.

    3. Joe. In the 100% reserve system you envision what would be the initial money creation mechanism? Milton Friedman was a proponent of having a constant 3% growth of money in circulation which you could attempt to enforce by law. A 100% reserve system based on gold would also curtail money creation, but a 100% reserve system with giving the ability of money creation to the central bankers on a whim might cause its own issues. Commercial banks would lose control to the central bank but in reality they are part of the same entity so I don't see a huge benefit there. It just doesn't appear as if power would made a dramatic shift to the individual. This is not a disagreement I would just like clarification as to how initial money creation would be accomplished in your system? Currently it is done through central banks for base money and debt creation by commercial banks.

    4. I envision a system where money / credit creation powers will not be centrally controlled rather it should be distributed among individuals. In this way risks will also be spread out, so there will not be too-big-to-fail instances.

      In ancient times hypothetical debt-based monetary system (rather than commodity-based), if two individuals want to trade where one has nothing while the other has a product, the one with no money will write on stone promising to pay back in order to buy the product, thus money / credit is created. Whoever holds the stone will receive payment + interest. It is up to the individual lender to make good judgement on the promise. So money can be created based on individual willingness to borrow & lend, or one can just go make more products. So the economy will be mainly driven by real supply & demand rather than artificial financial engineering.

      In current modern digital age, we can invent a system, where everyone is assign a credit account. We create a peer-2-peer lending system, where anyone can issue bonds and buy bonds. Bonds can be securitised into groups with different credit ratings, risks and interests calculated based on payment history or some other variables.

      In this way, the powers to create money / credit lie in the hands of individuals rather than central powers which tend to abuse their powers. This is just some fantasy in a Neverland.

  3. Thanks for your thoughts, I've enjoyed reading them. Your analysis about Bitcoin and E-Dollars is particularly interesting. In your opinion, how can an individual best protect and allocate his financial resources now, to prepare for the negative-interest rate future?

  4. I can best answer this question with what NOT to do. Do not own any debt instruments, particularly sovereign bonds. You may be invested in them and not even know it, read the prospectus even on money market accounts.

    As far as what TO invest in is a tougher question considering we don’t know if we will go into an inflation or deflation. My bet is on inflation but that can’t be known for sure. If that’s the case the answer is easy, precious metals, no need to purchase investment newsletters because that is the clear solution to anyone who has a grasp of the issue with our current system.

    A massive deflation is even harder, in that case cash is king…almost. I actually suggest keeping quarters and dimes in your house, and I understand how crazy that sounds. I kind of stumbled onto this one. I started by satisfying the nerd in me. I’d get a few rolls of quarters and dimes to check for silver. As I built a little pile I kind of liked having it rather than cash in the safe, here are the reasons. First, in a fire rated safe there is a pretty good chance you could lose the cash, coins would probably be fine. Second it doesn’t take much effort to take cash but try carrying a bucket full of dimes up some stairs. They are issued directly by the treasury and not the fed and the with the heat the central banks might get in the future this may offer some protection. Finally if there were to be a massive deflation that money might be all that is left as the digital cash in your bank account is destroyed.

    In the case of an implementation of the E dollar, which I’m not saying is going to happen, which would allow negative interest rates, I would say precious metals would again do very well. That said since they do well in low interest rate environments they might do so well in a negative interest rate environment confiscation might become a real possibility. Equities might also do well. I believe equities should be at the core of any portfolio through an broad index fund such as VT world stock index, unfortunately with current valuations now probably isn't the best entry point. In addition, I see shocks coming to our system and equities don’t like shocks.

    Thanks for the question and I hope I answered them.

    1. I hold some gold ETF (IAU), do you think it's safe in the event of crisis? Will the American government confiscate them like it used to do?

    2. The safest way to own gold is physical bullion in your possession. You will hear this over and over from pretty much every advocate of PM’s, and that’s because it’s true. I have no problem owning certain ETF’s or mining stocks, but only after you have a physical position. If there is a confiscation, which is always possible, they will go after the largest piles of bullion, so that means the ETF’s and major bullion dealers. Thanks.

  5. If the underlying problem of the system is the expotential nature of intrest,
    should we not expect the current policy of practical zero intrest combined with inflation and a certain real growth in economy to solve the issue over time?

    Also in the very nice example for money velocity you have used very different price levels when comparing the flows of money generated. If you consider the price for a porkchop to be 1/26 of a whole pork you end up with no difference?

    1. “Should we not expect the current policy of practical zero interest combined with inflation and a certain real growth in economy to solve the issue over time?”

      There is actually a name for holding interest rates below the rate of inflation to transfer a debt burden from the government to savers, and it is called financial repression. The government actually used it successfully after WW2, and though they are attempting it right now they are not succeeding. Without a doubt they are robbing savers but not to the extent necessary for the scheme to work.

      There is actually a simple way to determine if financial repression is working. If it is working federal debt would be falling as a percentage of GDP. It’s not, not even close, and will get much worse if we enter a recession which we are overdue for. The spread between interest rates and real inflation would have to be much higher for the scheme to work and since we’re up against the zero bound, interest rates can’t move significantly lower. The only thing that can move would be inflation which would have to increase to well north of 10% without moving rates, and the chances of that are nil. That is why I thought the E dollar was such a good possibility since it would allow rates to move negative.

      Thanks good question.

    2. Tom one other thing. Financial repression does not solve the issue of exponentially increasing debt in a debt based monetary system, it just shifts the burden of that debt to the private sector.

  6. Why would people keep their E-dollars if every year, they take away some of them. Nobody accepts money being taken away from them. It's basically the same than taxing them higher or make inflation higher. Only with taxes you can give it a reason that people might accept (Co2, green blabla tax) and inflation most people don't understand. The one thing people will not accept is having their E-dollars been taken away year after year. It's the same as a 5% wealth confiscation every year for all the money you have in a bank so why would you keep it in a bank. The only backdoor you closed with this system, is to hold it in cash under a matress but all the other backdoors are still open.

    1. Please re read the section on the E-dollar. The whole point is money held with in the system in the form of e dollars have an exchange rate with paper dollars, so while you have a negative interest rate on your e dollar account paper dollars are losing value faster. It solves the issue of a zero lower bound and eventually paper dollars lose all of their value so you wouldn't want keep the money under your mattress.

    2. You can buy gold and silver and bury it under your basement floor. But someone else has to get the cash, which can't leave the banking system.

  7. I have only become financially aware since 2007 and I still have trouble with the concept of money as debt even when it is explained patiently clearly and logically by Captain Debt Crash. Thank you for this excellent education.
    (I came here via Zero Hedge)
    What do you make of the accumulation of gold by China and Russia?

  8. LOL, I happen to be a ship captain, and picked debtcrash as the name of my blog but it never occurred to me to put the two together. Refer to me how you wish, but I don't think I'll be changing my moniker just yet. Thanks though, it made me laugh.

    To answer your question, just as any individual, the Chinese and Russians, are protecting themselves from a perceived threat. First, I respect the Chinese and Russian people. That said, just because their governments may be preparing the same way you are that does not make them the "good guys", I actually trust them less than my own government if that's possible.

  9. You are not the first to come up with the idea of all-electronic currency with negative rates. The "mark of the beast" currency described in Revelations is probably such a system, using some kind of implanted chip/biometric marker for security. More than negative rates, an all-electronic currency can also give money a "color" that defines what kind of goods it can be spent on, much as food stamps can only be used for food. This can be done to compartmentalize inflation. But what happens if the interest rate accelerates more and more negative with time? Does the currency system implode after all units are taxed away by increasing negative rates, until there is no currency left? Is hyperdeflationary collapse possible?

  10. Captain this is excellent. I have never seen such a clear and concise summary anywhere. I will be flinging it far and wide.

    1. Thank you very much. Funny, when I wrote it I didn't think anyone would ever read it, but it seems, for the most part, to be getting some pretty good feed back.

      Please let me know if there are any problems or questions and I will try to correct them or clarify.

  11. It "appears" that the only way to really prepare for the coming economic collapse is to have hard assets in hand; food, skills, paid for shelter, etc. However with the "e-dollar" on the horizon, this makes me think about how we will all be forced to use some kind of electronic card or even a RF embedded (more secure) chip in our hand to buy & Sell on the market......if we want to eat. The Gov't has been training people for years to bypass cash and swipe the card. With Debt per person at an all time high, it's become second nature to have a card of some type in your wallet.

    It also seems like the BRICS nations are putting the PetroDollar on the ropes. Russia and China have already signed an agreement to not use the US Dollar, and it shouldn't be too much longer before those dollars come back home to the US.....devauling the dollar even more.....

    Interesting times...

  12. Fantastic blog post. Great job.

    My only comments are directed at the bitcoin aspect. You are correct, any significant financial institution, not just the U.S. gov't, could crush the bitcoin market at any time they choose to. The market capitalization there is just too small to self-protect it's own perception as having value.

    So, bitcoin's only salvation lies in network effect. In plain english this is simply the very thing that makes the USD a worldwide currency, everyone is willing to use it (and it's primary debt instruments, T-bills) as a medium of exchange. When I look at bitcoin's "founders" or "core developers" and what they say, they are taking the cautious nerd approach to the creation. This is a recipe for disaster in the financial realm. Those guys need to be working out all possible bugs towards increasing their transaction speed, and pushing worldwide acceptance as if their life depended on it. Right now the bitcoin ledger system can handle between 3 and 7 transactions per second. This is beyond insufficient as a worldwide medium of exchange, it probably couldn't even handle a single municipality with greater than 5,000 residents. The network and capacity need to grow by orders of magnitude, until they can handle tens of thousands of transactions per second. Until they reach that point, it's purely a beautiful experiment that has questionable future financial value. It is a beautiful solution to the trustless network problems, but without massive network capacity upgrades (in the form of coding, more nodes, and greater node capabilities), it cannot attain the "network effect" that it needs to replace any currency.

    I would wager, based on what I've just said, that the U.S. Gov't is treating bitcoin the way it is because it knows that it is no real threat. Yes, it has significant appeal in 3rd world countries where people can be their own bank with little more than a smartphone, but it stands absolutely no chance of replacing the USD without major technical achievements.

    All that said, yes, I own significant amounts of bitcoin.

    1. Anonymous, Thanks for your comments. I certainly see the benefits of bitcoin and its block chain technology, but I struggle with how it will be accepted by the current power structure and socio-economic system. That could be said for the use of gold as currency as well.

  13. While much of the above article is great and true, one statement in one of the final paragraphs (fortunately) is not (yet) correct: cash transactions above 1000 EUR are not illegal!

    Some European countries try to make the daily use of cash more and more difficult but cash is still widely accepted and a lot of people still prefer using it. There are also a lot of early signs that banks try to completely monitor the use of your hard earned money by trying to make people use debt cards and NFC enabled bank cards instead of cash... beware!

    Personally I believe that both the USD's and the Euro's end is coming rather sooner than later and we may best prepare for it by trying to stay out of debt and anonymously buy as much gold, silver and land as we can (which I understand will sadly not be an option for many).

    1. Anon, Your criticism is partly correct limitations on cash euro transactions are covered under national laws. I would have been more correct in saying Spain limits cash transactions to under 2500 Euro, Italy under 1000 Euro, and France 3000 Euro but there is pressure to change that to 1000 euro. Greece has a 1500 Euro Limit, and Portugal has a limit of 1000 euro between consumers and businesses. Thanks for the clarification, although it seems like the trend toward more capital controls is clear.

  14. damn I fucking loved it, especially the afterword, how it's safer to be a sheep and go with the tide than searching for truth.

    I could observe it in other areas of life. Media for example. If you don't join the anti-Assad, -Putin, -Ghaddafi rethoric, you'll be left sitting on sidewalk, fired if you work for a major newspaper. The same crooks everywhere.

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